Transcript Chapter 1
Part I
The International Financial Environment
Multinational Corporation (MNC)
Foreign Exchange Markets
Exporting
& Importing
Product Markets
Dividend
Remittance
& Financing
Subsidiaries
Investing
& Financing
International
Financial
Markets
1
CHAPTER 1
Multinational Financial Management:
An Overview
• Chapter Objectives
¤ To identify the main goal of the 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.
¤ 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, but
can vary with the management style of the MNC.
• Goal of the MNC
¤ Various forms of corporate control can reduce agency problems - stock
compensation, threat of hostile takeover, monitoring by large shareholders.
¤ As MNC managers attempt to maximize their firm’s value, they may be
confronted with various environmental, regulatory, or 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.”
3
Theories of International Business
• Product Cycle Theory
1
Firm creates
product to
accommodate
local demand.
2
Firm exports
product to
accommodate
foreign demand.
4a
Firm differentiates
product from
competitors and/or
expands product
line in foreign
country.
3
or
4b
Firm’s foreign
business declines
as its competitive
advantages are
eliminated.
Firm
establishes
foreign
subsidiary
to establish
presence in
foreign
country and
possibly to
reduce
costs.
• International Business Methods
¤ International Trade - a relatively conservative approach involving exporting
¤
¤
and/or importing.
Licensing - provision of technology in exchange for fees or some other
benefits.
Franchising - provision of a specialized sales or service strategy, support
assistance, and possibly an initial investment in the franchise in exchange
for periodic fees.
• International Business Methods
¤ Joint Ventures - joint ownership and operation by two or more firms.
¤ Acquisitions of Existing Operations
¤ Establishing New Foreign Subsidiaries
Any method of increasing international business that requires a direct
investment in foreign operations normally is referred to as a direct foreign
investment (DFI).
5
International Opportunities
Cost-benefit Evaluation for
Purely Domestic Firms versus MNCs
Purely
Domestic
Firm
Marginal
Return on
Projects
MNC
MNC
Purely
Domestic
Firm
Marginal
Cost of
Capital
Appropriate
Size for Purely
Domestic Firm
X
Appropriate
Size for MNC
Y
Asset Level of Firm
• International Opportunities
¤ Opportunities in Europe
-
Single European Act of 1987
Removal of the Berlin Wall in 1989
Single currency system in 1999
¤ Opportunities in Latin America
-
North American Free Trade Agreement (NAFTA) of 1993
General Agreement on Tariffs and Trade (GATT) accord
• International Opportunities
¤ Opportunities in Asia
-
Significant growth expected for China
Asian economic crisis in 1997-1998
• Exposure to International Risk
¤ Exposure to Exchange Rate Movements
-
exchange rate fluctuations affect cash flows and foreign demand
¤ Exposure to Foreign Economies
-
economic conditions affect demand
¤ Exposure to Political Risk
-
political actions affect cash flows
7
Overview of an MNC’s Cash Flows
Profile A: MNCs focused on International Trade
U.S.based
MNC
$ for products
U.S. Customers
$ for supplies
U.S. Businesses
$ for exports
Foreign Importers
$ for imports
Foreign Exporters
8
Overview of an MNC’s Cash Flows
Profile B: MNCs focused on International Trade and
International Arrangements
U.S.based
MNC
$ for products
U.S. Customers
$ for supplies
U.S. Businesses
$ for exports
Foreign Importers
$ for imports
Foreign Exporters
$ for service
cost of service
Foreign Firms
9
Overview of an MNC’s Cash Flows
Profile C: MNCs focused on International Trade,
International Arrangements, and Direct Foreign Investment
U.S.based
MNC
$ for products
U.S. Customers
$ for supplies
U.S. Businesses
$ for exports
Foreign Importers
$ for imports
Foreign Exporters
$ for service
cost of service
Foreign Firms
funds remitted
funds invested
Foreign Subsidiaries
10
Valuation Model for an MNC
• Domestic Model (Present value of expected cash flows)
n
Value =
t =1
E CF$, t
1 k
t
where E (CF$,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
11
Valuation Model for an MNC
• Valuing International Cash Flows
m
E CFj , t E ER j , t
n j 1
Value =
t
t =1
1 k
where 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
Impact of New International Opportunities
on an MNC’s Value
New International Opportunities
More Exposure to Foreign Economies
More Exposure to Exchange Rate Risk
More Exposure to Political Risk
m
E CFj , t E ER j , t
n j 1
Value =
t
t =1
1
k
13
How Chapters Relate to Valuation
Exchange Rate
Behavior
(Chapters 6-8)
Background
on
International
Financial
Markets
(Chapters
2-5)
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 MNC’s Management Style on Agency Costs
Impact of Corporate Control on Agency Costs
Constraints Interfering with the MNC’s Goal
Theories of International Business
-
Theory of Comparative Advantage
Imperfect Markets Theory
Product Cycle Theory
¤ International Business Methods
-
¤
International Trade
¤ Licensing
Franchising
¤ Joint Ventures
Acquisitions of Existing Operations
Establishing New Foreign Subsidiaries
International Opportunities
-
Opportunities in Europe
Opportunities in Latin America
Opportunities in Asia
¤ Exposure to International Risk
-
Exposure to Exchange Rate Movements
Exposure to Foreign Economies
Exposure to Political Risk
¤ Overview of an MNC’s Cash Flows
¤ Valuation Model for an MNC
-
Domestic Model
Valuing International Cash Flows
How Chapters Relate to Valuation
15
CHAPTER 2
International Flow of Funds
©2000 South-Western College Publishing
• 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.
The recording of transactions is done by double-entry bookkeeping.
The balance-of-payments statement can be broken down into various
components, the chief ones being the current account and the capital account.
• Balance of Payments
¤ The current account represents a summary of the flow of funds between one
¤
specified country and all other countries due to the purchases of goods or
services, or the provision of income on financial assets, over a specified period
of time.
The current account is commonly used to assess the balance of trade, which is
the difference between merchandise exports and merchandise imports.
• Balance of Payments
¤ The capital account represents a summary of the flow of funds resulting from
the sale of assets between one specified country and all other countries over a
specified period of time.
¤ Assets include direct foreign investments, portfolio investments, as well as
other capital investments.
17
International Trade Flows
Distribution of Annual Exports and Imports by the U.S.
Exports
Imports
Eastern Europe
Eastern Europe
1% $8b
1% $8b
Others
Asia
Japan
Others
3% $22b
21%
$145b
Asia
3% $25b
27%
$235b
10% $66b
Europe
Latin
America
23%
$153b
20%
$133b
Japan
14%
$122b
Europe
20%
$175b
Latin
America
16%
$142b
Canada
22% $152b
Canada
19% $171b
• International Trade Flows
¤ Since the 1970s, international trade has grown for most countries. The
¤
recent value of U.S. exports and imports is more than eight times the 1975
value.
Since 1976, the value of U.S. imports has exceeded the value of U.S.
exports, causing a balance of trade deficit.
• International Trade Flows
¤ Recent Changes in North American Trade
-
A free trade pact between U.S. and Canada was initiated in 1989 and completely phased in
by 1998.
In 1993, the North American Free Trade Agreement (NAFTA), which removed numerous trade
restrictions among Canada, Mexico, and the U.S., was passed.
• International Trade Flows
¤ Recent Changes in European Trade
-
Single European Act of 1987
Momentum for free enterprise in Eastern Europe
Single currency system in 1999
¤ Trade Agreements Around the World
-
In 1993, a General Agreement on Tariffs and Trade (GATT) accord calling for lower tariffs was
made among 117 countries.
• International Trade Flows
¤ Friction Surrounding Trade Agreements
-
Dumping refers to the exporting of products by one country to other
countries at prices below cost.
Another situation that can break a trade agreement is copyright piracy.
19
• Factors Affecting International Trade Flows
¤ Inflation
-
A relative increase in a country’s inflation rate will decrease its current account.
¤ National Income
-
A relative increase in a country’s income level will decrease its current account.
• Factors Affecting International Trade Flows
¤ Government Restrictions
-
An increase in the tariffs on imported goods will increase the country’s current account.
A government can also reduce its country’s imports by enforcing a quota.
¤ Exchange Rates
-
If a country’s currency begins to rise in value, its current account balance will decrease.
Note that the factors are interactive, such that their simultaneous influence is
complex.
• Correcting a Balance of Trade Deficit
¤ By reconsidering the factors that affect the balance of trade, some common
-
revised pricing policy by foreign competition,
weakening of some other currencies,
trade prearrangements (J curve effect), and
intracompany trade.
U.S. Trade Balance
¤
correction methods can be developed.
However, a weak home currency may not necessarily improve a trade deficit
due to:
J Curve Effect
0
J Curve
Time
20
• International Capital Flows
¤ Capital flows usually represent direct foreign investment or portfolio
¤
¤
investment.
The DFI positions in the U.S. and outside the U.S. have risen substantially
over time, indicating increasing globalization.
DFI by U.S. firms are mainly targeted at the United Kingdom and Canada,
while much of the DFI in the U.S. comes from the United Kingdom, Japan,
the Netherlands, Germany, and Canada.
• Factors Affecting DFI
¤ Changes in Restrictions
-
New opportunities may arise from the removal of government barriers.
¤ Privatization
-
DFI has also been stimulated by the movement toward free enterprise.
¤ Potential Economic Growth
-
Countries that have more 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 DFI in countries where the local currency strengthens against their
own.
21
• Factors Affecting International Portfolio Investment
¤ Tax Rates on Interest or Dividends
-
Investors assess their potential after-tax earnings from investments in foreign securities.
¤ Interest Rates
-
Money tends to flow to countries with high interest rates.
¤ Exchange Rates
-
If a country’s home currency is expected to strengthen, foreign investors may be attracted.
-
IMF goals encourage increased internationalization of business.
Its compensatory financing facility attempts to reduce the impact of export instability on
country economies.
Financing by the IMF is measured in special drawing rights.
• Agencies that Facilitate International Flows
¤ International Monetary Fund (IMF)
-
• Agencies that Facilitate International Flows
¤ World Bank
-
The primary objective of the profit-oriented bank is to make loans to countries in order to
enhance economic development.
The World Bank may spread its funds by entering into cofinancing agreements.
A recently established agency offers various forms of political risk insurance.
• Agencies that Facilitate International Flows
¤ World Trade Organization
-
This was established to provide a forum for multilateral trade negotiations and to settle trade disputes related
to the GATT accord.
International Financial Corporation (IFC)
The IFC promotes private enterprise within countries through loans and stock purchases.
¤ International Development Association (IDA)
-
The “World Bank” for less prosperous nations.
22
• Agencies that Facilitate International Flows
¤ Bank for International Settlements (BIS)
-
The BIS facilitates international transactions among countries. It is the “central banks’ central
bank” and the “lender of last resort.”
Regional Development Agencies
These agencies, such as the Inter-American Development Bank and the Asian Development
Bank, have regional objectives relating to economic development.
Impact of International Trade on an MNC’s Value
National Income in Foreign Countries
Inflation in Foreign Countries
Trade Agreements
Exchange Rate Movements
m
E CFj , t E ER j , t
n
j 1
Value =
t
t =1
1 k
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 = the weighted average cost of capital of the U.S. parent
• Chapter Review
¤ Balance of Payments
-
Current Account
¤
Capital Account
¤ International Trade Flows
-
Distribution of U.S. Exports and Imports
U.S. Balance of Trade Trend
Recent Changes
Trade Agreements Around the World
Friction Surrounding Trade Agreements
• Chapter Review
¤ Factors Affecting International Trade Flows
-
Inflation
National Income
¤ Government Restrictions
¤ Exchange Rates
¤ 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 and in the U.S.
Factors Affecting DFI
Factors Affecting International Portfolio Investment
• Chapter Review
¤ Agencies that Facilitate International Flows
-
International Monetary Fund
World Bank
World Trade Organization
International Financial Corporation
International Development Association
Bank for International Settlements
Regional Development Agencies
¤ How International Trade Affects an MNC’s Value
24
CHAPTER 3
International Financial Markets
© 2000 South-Western College Publishing
• 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
¤ Several barriers deter the complete integration of the markets for real or financial
¤
¤
assets.
Examples include tax differentials, tariffs, quotas, labor immobility, cultural
differences, financial reporting differences, and costs of communication.
Yet, these barriers can also create unique opportunities for specific geographic
markets that will attract foreign creditors and investors.
• Motives for Using International Financial Markets
¤ Motives for investing in foreign markets:
-
economic conditions
exchange rate expectations
international diversification
¤ Motives for providing credit in foreign markets:
-
high foreign interest rates
exchange rate expectations
international diversification
¤ Motives for borrowing in foreign markets:
-
low interest rates
exchange rate expectations
26
• Foreign Exchange Market
¤ The foreign exchange market allows currencies to be exchanged to facilitate
¤
international trade or financial transactions.
The system for establishing exchange rates has changed over time:
-
1876-1913: gold standard
WWI & Great Depression: period of instability
1944: Bretton Woods Agreement
1971: Smithsonian Agreement
1973: some official boundaries were eliminated
• Foreign Exchange Market
¤ 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.
Trading between banks makes up what is often referred to as the interbank
market.
The forward market for currencies enables an MNC to lock in the exchange
rate (called a forward rate) at which it will buy or sell a currency.
• Foreign Exchange Market
¤ Attributes of banks important to customers in need of foreign exchange:
-
competitiveness of quote
special relationship with the bank
speed of execution
advice about current market conditions
forecasting advice
¤ Banks provide foreign exchange transactions for a fee: the bid (buy) quote
for a foreign currency will be less than its ask (sell) quote.
27
Foreign Exchange Market
ask rate - bid rate
• bid/ask spread =
ask rate
• The bid/ask spread is normally greater for those currencies that are
less frequently traded.
• Exchange rate quotations for widely traded currencies are listed in
many newspapers on a daily basis. Forward rates and cross exchange
rates may be quoted too.
Foreign Exchange Market
• cross exchange rate :
value of 1 unit of
value of currency A in $
currency A in units =
value of currency B in $
of currency B
• Quotations that represent the value of a foreign currency in
dollars are referred to as direct quotations, while those that
represent the number of units of a foreign currency per dollar
are referred to as indirect quotations.
28
• Foreign Exchange Market
¤ Some MNCs involved in international trade use the currency futures and
¤
¤
options markets to hedge their positions.
Futures are similar to forward contracts, except that they are sold on an
exchange while forward contracts are offered by banks.
Currency options are classified as either calls or puts. They can be
purchased on an exchange too.
• Eurocurrency Market
¤ U.S. dollar deposits placed in banks in Europe and other continents are
¤
¤
called Eurodollars and are not subject to U.S. regulations.
In the 1960s and 70s, the Eurodollar market, or what is now called the
Eurocurrency market, grew to accommodate increasing international
business.
The market is made up of several large banks called Eurobanks that accept
deposits and provide loans in various currencies.
• Eurocurrency Market
¤ Although the market focuses on large-volume transactions, at times no
¤
single bank is willing to lend the needed amount. A syndicate of Eurobanks
may then be composed.
Two regulatory events allow for a more competitive global playing field:
-
The Single European Act opens up the European banking industry and calls for similar
regulations.
The Basel Accord includes standardized guidelines on the classification of capital.
29
• 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 of one year or longer extended by Eurobanks to MNCs or government
¤
¤
agencies are called Eurocredit loans. These loans are provided in the
Eurocredit market.
Eurocredit loans often have a floating rate, to lessen the risk resulting from a
mismatch in the banks’ asset and liability maturities.
Syndicated Eurocredit loans are popular among big borrowers too.
• Eurobond Market
¤ There are two types of international bonds:
-
A foreign bond is issued by a borrower foreign to the country where the bond is placed.
Eurobonds are sold in countries other than the country represented by the currency
denominating them.
¤ Eurobonds are underwritten by a multi-national syndicate of investment
banks and simultaneously placed in many countries. They are usually issued
in bearer form.
30
• Eurobond Market
¤ Eurobonds increased rapidly in volume when in 1984, the withholding tax
•
was abolished in the U.S. and corporations were allowed to issue bonds
directly to non-U.S. investors.
¤ Interest rates for each currency and credit conditions change constantly,
causing the market’s popularity to vary among currencies.
¤ In recent years, governments and corporations from emerging markets have
frequently utilized the Eurobond market.
Why Interest Rates Vary Among Currencies
¤ Interest rates, which can vary substantially for different currencies, 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.
¤ As the demand and supply schedules change over time for a specific
currency, the equilibrium interest rate for that currency will also change.
31
Why U.S. Dollar Interest Rates Differ from Brazilian Real
Interest Rates (for loanable funds)
S
Interest
Rate
for $
S
Interest
Rate
for Real
D
D
Quantity of $
Quantity of 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.
32
• Global Integration of Interest Rates
¤ Many investors shift their savings around currencies to take advantage of
¤
¤
higher interest rates.
Borrowers sometimes also borrow a currency different from what they need
to take advantage of a lower interest rate.
Ultimately, the freedom to transfer funds across countries causes the
demand and supply conditions for funds to be integrated, which in turn
causes interest rates to be integrated.
• International Stock Markets
¤ MNCs can obtain funds by issuing stock in international markets, in addition
¤
¤
to the local market.
By having access to various markets, the stocks may be more easily
digested, the image of the MNC may be enhanced, and the shareholder
base may be diversified.
The proportion of individual versus institutional ownership of shares varies
across stock markets. The regulations are different too.
• International Stock Markets
¤ The locations of the MNC’s operations may affect the decision about where to place
¤
¤
stock, in view of the cash flows needed to cover dividend payments in the future.
Stock issued in the U.S. by non-U.S. firms or governments are called Yankee stock
offerings.
Non-U.S. firms can also issue American depository receipts (ADRs), which are
certificates representing bundles of stock. The use of ADRs circumvents some
disclosure requirements.
33
• Use of International Financial Markets
Foreign cash flow movements of a typical MNC:
¤ Foreign trade. Exports generate foreign cash inflows, while imports require
cash outflows.
¤ Direct foreign investment. Cash outflows to acquire foreign assets generate
future inflows.
¤ Short-term investment or financing in foreign securities, usually in the
Eurocurrency market.
¤ Longer-term financing in the Eurocredit, Eurobond, or international stock
markets.
Impact of Global Financial Markets on an MNC’s Value
E (CFj,t ) = expected cash
flows in currency j to be
received by the U.S. parent
at the end of period t
E (ERj,t ) = expected
exchange rate at which
currency j can be
converted to dollars at the
end of period t
k = the weighted average
cost of capital of the U.S.
parent
Improved global image from
issuing stock in global markets
Cost of borrowing funds in
global markets
m
E CFj , t E ER j , t
n j 1
Value =
t
t =1
1
k
Cost of parent’s equity in global
markets
Cost of parent’s
funds borrowed in
global markets
34
• Chapter Review
¤ Motives for Using the International Financial Markets
Motives for Investing in Foreign Markets
- Motives for Providing Credit in Foreign Markets
- Motives for Borrowing in Foreign Markets
- Foreign Exchange Market
- Foreign Exchange Transactions
- Forward Markets
- Attributes of Banks that Provide Foreign Exchange
- Bid/Ask Spread of Banks
- Direct versus Indirect Quotations
- Cross Exchange Rates
- Currency Futures and Options Markets
-
¤
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
¤ Eurobond Market
-
¤
¤
¤
¤
¤
Development of the Eurobond Market
Why Interest Rates Vary Among Currencies
Global Integration of Interest Rates
International Stock Markets
Use of International Financial Markets
How Financial Markets Affect an MNC’s Value
35
CHAPTER 4
Exchange Rate Determination
© 2000 South-Western College Publishing
• 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.
A decline in a currency’s value is referred to as depreciation, while an
increase is referred to as appreciation.
% D in foreign currency value = (S - St-1) / St-1
A positive % D represents appreciation of the foreign currency, while a
negative % D represents depreciation.
37
Exchange Rate Equilibrium
Value of £
S
equilibrium
exchange
rate
D
Quantity of £
• An exchange rate represents the price of a currency, which is
determined by the demand for that currency relative to supply.
38
Factors that Influence Exchange Rates
Value of £
r2
r
S2
S
D2
D
Quantity of £
• Relative Inflation Rates
A relative increase in U.S. inflation will increase the U.S. demand for
British goods, and hence the U.S. demand for British pounds.
¤ In addition, the British desire for U.S. goods, and hence the supply of
pounds, will drop.
¤
Factors that Influence Exchange Rates
Value of £
r
r2
S
S2
D
D2
Quantity of £
• Relative Interest Rates
A relative rise in U.S. interest rates will decrease the U.S. demand for
British pounds.
¤ In addition, the supply of pounds by British corporations will increase.
¤
40
Factors that Influence Exchange Rates
Real Interest Rates
A relatively high interest rate may reflect expectations of relatively high
inflation, which may discourage foreign investment.
¤ Real interest rates adjusts nominal interest rates for inflation:
real
nominal
interest = interest – inflation
rate
rate
rate
This relationship is sometimes called the Fisher effect.
¤
41
Factors that Influence Exchange Rates
Value of £
S
r2
r
D2
D
Quantity of £
• Relative Income Levels
A relative increase in the U.S. income level will increase the U.S. demand
for British goods, and hence the demand for British pound.
¤ The supply of pounds does not change.
¤
42
• Factors that Influence Exchange Rates
¤ Government Controls
-
Governments can influence the equilibrium exchange rate in many ways, including :
» the imposition of foreign exchange barriers,
» the imposition of 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 too.
Because of speculative transactions, foreign exchange rates can be very volatile.
43
Factors that Influence Exchange Rates
Trade-Related
Factors
1. Inflation
Differential
2. Income
Differential
3. Gov’t Trade
Restrictions
Financial
Factors
1. Interest Rate
Differential
2. Capital Flow
Restrictions
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
• Interaction of Factors
Trade-related factors and financial factors sometimes interact. For
example, an increase in income levels sometimes causes expectations of
higher interest rates.
¤ 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.
¤
45
Dollar’s Index
How Factors Have Influenced Exchange Rates
180
high U.S. interest rates, a
somewhat depressed U.S.
economy, and low inflation
high U.S.
interest rates
140
100
60
1972
Persian Gulf War
large balance of
trade deficit
high U.S.
inflation
1977
1982
1987
1992
1997
Year
¤
Because the dollar’s value changes by different magnitudes relative to each foreign
currency, analysts measure the dollar’s strength with an index.
46
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
Returns $20,120,000
Profit of $792,320
Exchange at
$0.52/NZ$
Exchange at
$0.50/NZ$
2. Holds
NZ$40 million
4. Holds
$20,912,320
Lends at 6.48%
for 30 days
3. Receives
NZ$40,216,000
47
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
Exchange at
$0.50/NZ$
2. Holds
$20 million
Borrows at 6.96%
for 30 days
4. Holds
NZ$41,900,000
Returns NZ$40,232,000
Profit of NZ$1,668,000
Exchange at
or $800,640
$0.48/NZ$
Lends at 6.72%
for 30 days
3. Receives
$20,112,000
48
Impact of Factors that Influence
Exchange Rates on an MNC’s Value
Inflation rates
Interest rates
Income levels
Government controls
Expectations
m
E CFj , t E ER j , t
n
j 1
Value =
t
t =1
1 k
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 = the weighted average cost of capital of the U.S. parent
49
• Chapter Review
¤ Measuring Exchange Rate Movements
¤ Exchange Rate Equilibrium
-
Demand for a Currency
Supply of a Currency for Sale
• 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
¤ Speculating on Anticipated Exchange Rates
¤ How Exchange Rate Determination Affects an MNC’s Value
50
CHAPTER 5
Currency Derivatives
© 2000 South-Western College Publishing
• Chapter Objectives
¤ To explain how forward contracts are used to hedge based on anticipated exchange
¤
¤
rate movements;
To explain how currency futures contracts are used to speculate or hedge based on
anticipated exchange rate movements; and
To explain how currency options contracts are used to speculate or hedge based on
anticipated exchange rate movements.
• Forward Market
¤ 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.
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 not normally used by consumers or small firms.
• Forward Market
¤ If the forward rate exceeds the existing spot rate, it contains a premium. If it is less
than the existing spot rate, it contains a discount.
Suppose spot rate = $1.681, and
90-day forward rate = $1.677.
forward = $1.677 - $1.681 x 360 = – 0.95%
discount
$1.681
90
¤ The premium (or discount) reflects the difference between the home interest rate and
the foreign interest rate, so as to prevent arbitrage.
52
• Forward Market
¤ Non-deliverable forward contracts (NDFs) are forward contracts whereby the
¤
currencies are not actually exchanged. Instead, a net payment is made by
one party to the other based on the contracted rate and the market
exchange rate on the day of settlement.
While the NDF does not involve delivery, it can effectively hedge future
foreign currency cash flows that are anticipated by the MNC.
• Currency Futures Market
¤ Currency futures contracts are contracts specifying 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.
The contracts can be traded by firms or individuals on the trading floor of an
exchange, on automated trading systems, or over the counter.
• Currency Futures Market
¤ Currency futures differ from forward contracts in many ways:
-
Size of contract
Delivery date
Participants
Security deposit
Clearing operation
¤ Marketplace
¤ Regulation
¤ Liquidation
¤ Transaction costs
¤ Normally, the price of a currency future is similar to the forward rate for a
given currency and settlement date, but different from the spot rate.
53
• Currency Futures Market
¤ Holders of futures contracts can close out their position by selling an
identical futures contract. Similarly, sellers of futures contracts can close out
their position by purchasing a currency futures contract with a similar
settlement date.
¤ The gain or loss to the firm is dependent on the difference between the
purchase price and the sale price.
¤ Most currency futures contracts are closed out before their settlement date.
• Currency Futures Market
¤ The contracts are guaranteed by the exchange clearinghouse, and margin
¤
¤
¤
requirements are imposed to cover fluctuations in value.
Corporations that have open positions in foreign currencies can use futures
contracts to offset such positions.
Speculators also use them to capitalize on their expectation of a currency’s
future movement.
Brokers who fulfill orders to buy or sell futures contracts earn a transaction
fee in the form of a bid/ask spread.
• Currency Options Market
¤ A currency option is another contract that can be bought or sold by
¤
¤
¤
speculators and firms.
The standard options that are traded on an exchange through brokers are
guaranteed.
In contrast, the options that are tailored to the specific needs of the firm are
offered by commercial banks and brokerage firms in an over-the-counter
market. There are no credit guarantees for these options.
Currency options are classified as either calls or puts.
54
• Currency Call Options
¤ A currency call option grants 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 when the present exchange rate exceeds the
strike price, at the money when the rates are equal, and out of the money
otherwise.
¤ Option owners will at most lose the premiums they paid for their options.
• Currency Call Options
¤ Premiums of call options vary due to:
-
the level of existing spot price relative to strike price,
the length of time before the expiration date, and
the potential variability of the currency.
¤ Corporations can use currency call options to cover their foreign currency
¤
positions.
Unlike a futures or forward contract, if the anticipated need does not arise,
the firm can choose to let the options contract expire. The firm can also sell
or exercise the option.
• Currency Call Options
¤ Individuals may also speculate in the currency options market based on their
¤
¤
expectations of the future movements in a particular currency.
When brokerage fees are ignored, the currency call buyer’s gain will be the
seller’s loss if both parties begin and close out their positions at the same
time.
The purchaser of a call option will break even when the spot rate at which
the currency is sold is equal to the strike price plus the option premium.
55
• Currency Put Options
¤ A currency put option grants 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 when the present exchange rate is less than the
strike price, at the money when the rates are equal, and out of the money
otherwise.
¤ Since option owners are not obligated to exercise their options, they will at
most lose the premiums they paid.
• Currency Put Options
¤ Premiums of put options vary due to:
-
the level of existing spot price relative to strike price,
the length of time before the expiration date, and
the potential variability of the currency.
¤ Corporations can use currency put options to cover their foreign currency
positions.
¤ Individuals may also speculate with currency put options based on their
expectations of the future movements in a particular currency.
• Currency Put Options
¤ For volatile currencies, one possible speculative strategy is to purchase a
straddle, which represents both a put option and a call option at the same
exercise price.
¤ 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.
56
Contingency Graphs for Call Options
For sellers of
British pound call options
exercise price = $1.50
premium = $0.02
+$.06
+$.06
+$.04
+$.04
+$.02
$1.46
$1.50
$1.54
- $.02
- $.04
- $.06
Future spot rate
Net profit per unit
Net profit per unit
For purchasers of
British pound call options
exercise price = $1.50
premium = $0.02
+$.02
$1.46
$1.50
$1.54
- $.02
- $.04
Future spot rate
- $.06
57
Contingency Graphs for Put Options
For sellers of
British pound put options
exercise price = $1.50
premium = $0.03
+$.06
+$.06
+$.04
+$.04
+$.02
$1.46
$1.50
$1.54
- $.02
- $.04
- $.06
Future spot rate
Net profit per unit
Net profit per unit
For purchasers of
British pound put options
exercise price = $1.50
premium = $0.03
+$.02
$1.46
$1.50
$1.54
- $.02
- $.04
Future spot rate
- $.06
58
Conditional Currency Options
• Some options are structured with the premium conditioned on
the actual movement in the currency’s value over the period of
concern.
• For example, suppose a conditional put option on British pounds
has an exercise price of $1.70, and a so-called trigger of $1.74.
The premium will have to be paid only if the pound’s value
exceeds the trigger value.
• The payment of the premium is avoided conditionally at the cost
of a higher premium.
59
Conditional Currency Options
Effective Exchange Rate
Option Type Exercise Price
basic put
$1.70
conditional put
$1.70
Trigger
$1.74
Premium
$0.02
$0.04
$1.80
$1.78
Basic Put
$1.76
$1.74
Conditional Put
$1.72
$1.70
$1.68
$1.66
$1.66 $1.70 $1.74 $1.78 $1.82
Spot Rate
60
• 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 foreign currency 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/or currency 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.
61
Impact of Currency Derivatives
on an MNC’s Value
Currency futures
Currency options
m
E CFj , t E ER j , t
n j 1
Value =
t =1
1 k t
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 = the weighted average cost of capital of the U.S. parent
62
• Chapter Review
¤ Forward Market
-
How MNCs Use Forward Contracts
Premium or Discount on the Forward Rate
Non-Deliverable Forward Contracts
¤ Currency Futures Market
-
Comparison of Currency Futures and Forward Contracts
Pricing Currency Futures
Closing Out a Futures Position
Credit Risk of Currency Futures Contracts
Corporate Use of Currency Futures
Speculation with Currency Futures
Transaction Costs of Currency Futures
¤ Currency Options Market
¤ Currency Call Options
-
Factors Affecting Call Option Premiums
Hedging with Currency Call Options
Speculating with Currency Call Options
Break-Even Point from Speculation
¤ Currency Put Options
-
¤
¤
¤
¤
¤
Factors Affecting Put Option Premiums
Hedging with Currency Put Options
Speculating with Currency Put Options
Speculating with Combined Put and Call Options
Contingency Graphs for Options
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
63
Part II Exchange Rate Behavior
Existing spot
exchange rate
locational
arbitrage
triangular
arbitrage
Existing spot
exchange rates
at other locations
covered interest arbitrage
Existing cross
exchange rates
of currencies
Existing forward
exchange rate
Existing inflation
rate differential
Fisher
effect
purchasing power parity
covered interest arbitrage
Existing interest
rate differential
international
Fisher effect
Future exchange
rate movements
CHAPTER 6
Government Influence on Exchange Rates
© 2000 South-Western College Publishing
• Chapter Objectives
¤ To describe the exchange rate systems used by various governments;
¤ To explain how governments can use direct intervention to influence exchange rates;
¤ To explain how governments can use 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
¤
exchange 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 Systems
¤ In a fixed exchange rate system, exchange rates are either held constant or
¤
allowed to fluctuate only within very narrow boundaries.
Examples: Bretton Woods era (1944-1971)
Smithsonian Agreement (1971)
¤ Pros: Work becomes easier for the MNCs. Cons: The government may alter
the value of
a specific currency.
¤ In fact, the dollar was devalued more than once after the United States
experienced balance of trade deficits.
66
• Freely Floating
Exchange Rate Systems
¤ In a freely floating exchange rate system, exchange rates are determined by
market forces without intervention by governments.
¤ Pros:
¤ World stability is enhanced as problems
experienced by one country may not easily spread to other countries.
¤ No intervention policies are needed and
governments are not restricted by exchange rate boundaries when setting new policies.
¤ Less capital flow restrictions are needed, thus
enhancing the efficiency of the financial market.
• Freely Floating
Exchange Rate Systems
¤ Cons:
¤ The MNCs will need to devote substantial
resources to managing exposure to exchange rate fluctuations.
¤ The country that initially experienced economic
problems (such as high inflation, increasing unemployment rate) may have its problems
compounded.
• Managed Float
Exchange Rate Systems
¤ A managed float or “dirty” float exchange rate system resembles the freely
floating system in that rates are allowed to fluctuate freely on a daily basis.
Yet, it is like the fixed system in that governments may intervene to prevent
the rates from moving too much in one direction.
¤ It has been pointed out that a government can manipulate exchange rates
such that its own country benefits at the expense of others.
¤ Examples: Korea (1997), Russia (1997)
67
• Pegged Exchange Rate Systems
¤ 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.
Examples:
-
Malaysia and Thailand before the Asian crisis
The European Economic Community’s snake arrangement (1972-1979)
The European Monetary System’s exchange rate mechanism (ERM) (1979-1999)
• Pegged Exchange Rate Systems
¤ The ERM experienced severe problems in the fall of 1992, as economic
conditions and goals varied among European countries.
¤ Speculators make it even more difficult for a currency board to defend its
position against pressures exerted by economic conditions.
¤ Note that the local interest rates must be aligned with the interest rates of
•
the currency to which the local currency is tied.
Pegged Exchange Rate Systems
How will a country (called PEG) whose currency is pegged to the U.S. dollar
be affected when the currency of another country (called FLOAT) fluctuates
against the dollar?
When FLOAT’s currency depreciates against the dollar (and hence against
PEG’s currency), FLOAT exports more to and imports less from both the
U.S. and PEG. The volume of trade between the U.S. and PEG decreases
too.
The reverse happens when FLOAT’s currency appreciates against the dollar. 68
• The Euro
¤ On January 1, 1999, the euro was introduced. By 2002, the national currencies of the
¤
¤
participating countries will be withdrawn from the financial system and replaced with the
euro.
The Frankfurt-based European Central Bank is responsible for setting a common monetary
policy. It aims to control inflation and to stabilize the value of the euro.
As currency movements among the European countries will be eliminated, more long-term
business arrangements between firms of European countries will be encouraged.
• The Euro
¤ Non-European firms can also compare European products and European firms
¤
more easily, as their values are denominated in the same currency.
Cross-border investing may increase due to the elimination of exchange rate risk.
However, non-European investors may not achieve as much diversification as in
the past.
• Government Intervention
¤ Each country has a government agency (called the central bank) that may intervene in the
¤
¤
foreign exchange markets to control the value of the country’s currency.
In the United States, the Federal Reserve System (Fed) is the central bank.
Central banks manage exchange rates
-
to smooth exchange rate movements,
to establish implicit exchange rate boundaries, and/or
to respond to temporary disturbances.
• 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.
¤ Example: To strengthen the dollar, the Fed will exchange foreign currencies for
dollars.
¤ Direct intervention is usually most effective when there is a coordinated effort
among central banks.
69
Effects of Direct Central Bank Intervention
in the Foreign Exchange Market
S1
Value of £
Value of £
S
V2
V1
D1
Quantity of £
S2
V1
V2
D2
D
Quantity of £
70
• Government Intervention
¤ When the change in money supply is not adjusted for, the intervention is said to
be nonsterilized. A sterilized intervention occurs when Treasury securities are
bought or sold simultaneously to maintain the money supply.
¤ 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.
• Government Intervention
¤ The central bank can also intervene indirectly by influencing the factors that
•
determine a currency’s value, such as interest rates.
¤ Note that high interest rates adversely affects local borrowers, and may weaken
the economy.
¤ Some governments also use foreign exchange controls (such as restrictions on
the exchange of the currency) as a form of indirect intervention.
Exchange Rate Target Zones
¤ Many economists have criticized the present system because of the wide swings in the
¤
¤
exchange rates of major currencies.
It has been suggested that target zones be used, whereby an initial exchange rate will be
established with specific boundaries.
The ideal target zone should allow rates to adjust to economic factors without causing wide
swings in international trade and fear in financial markets. However, the actual result may
be a system no different from what exists today.
• Intervention as a Policy Tool
¤ The exchange rate is a tool, like tax laws and money supply, with which the
¤
¤
government can use to achieve its desired economic objectives.
A weak home currency can stimulate foreign demand for products (and hence
local jobs), but may lead to higher inflation.
A strong currency is a possible cure for high inflation, but may cause higher
unemployment.
71
Impact of Government Actions on Exchange Rates
Government Monetary
and Fiscal Policies
Relative National
Income Levels
Relative National
Income Levels
Relative National
Income Levels
Relative National
Income Levels
Relative National
Income Levels
Relative National
Income Levels
Government
Purchases & Sales
of Currencies
Tax Laws,
etc.
Government Intervention in
Foreign Exchange Market Quotas,
Tariffs, etc.
72
Impact of Central Bank Intervention
on an MNC’s Value
Direct intervention
Indirect intervention
m
E CFj , t E ER j , t
n
j 1
Value =
t =1
1 k t
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 = the weighted average cost of capital of the U.S. parent
73
• Chapter Review
¤ Exchange Rate Systems
-
Fixed Exchange Rate System
Freely Floating Exchange Rate System
Managed Float Exchange Rate System
Pegged Exchange Rate System
» Europe’s Exchange Rate Mechanism
» Currency Boards
» Impact of Exchange Rates on Countries with Pegged Currencies
• Chapter Review
¤ A Single European Currency
-
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
¤ Government Intervention
-
Reasons for Government Intervention
Direct Intervention
Indirect Intervention
• Chapter Review
¤ Exchange Rate Target Zones
¤ 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
74
CHAPTER 7
International Arbitrage
and Interest Rate Parity
© 2000 South-Western College Publishing
• Chapter Objectives
¤ To explain the conditions that will result in various forms of international
¤
arbitrage, along with the realignments that will occur in response to the
various forms of international arbitrage; and
To explain the concept of interest rate parity, and how it prevents arbitrage
opportunities.
• International Arbitrage
¤ Arbitrage can be defined as capitalizing on a discrepancy in quoted prices. Often, the
¤
funds invested are not tied up and no risk is involved.
Locational arbitrage is possible when the bid price of one bank is higher than the ask
price of another bank for the same currency.
e.g.
Bank A
Bank B
dollars -> pounds
$1.61 / £
pounds -> dollars
$1.62 / £
In response to the imbalance in demand and supply resulting from such arbitrage
activity, the prices will adjust very quickly.
• International Arbitrage
¤ Triangular arbitrage is possible when a quoted cross exchange rate differs
from that calculated using the appropriate spot rates.
e.g. Bank A
Bank B
Bank C
$ -> £
£ -> Canadian$ Canadian$ -> $
$1.60 / £
0.50£ / C$
$0.81 / C$
Note: Calculated cross rate = 0.50625£ / C$
In response to the imbalance in demand and supply resulting from such
arbitrage activity, the prices will adjust very quickly.
76
• International Arbitrage
¤ Covered interest arbitrage tends to force a relationship between the interest
rates of two countries and their forward exchange rate.
e.g. 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%.
In response to the imbalance in demand and supply resulting from such
arbitrage activity, the rates will adjust very quickly.
• 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.
Any discrepancy will trigger arbitrage, which will then eliminate the
discrepancy. Arbitrage thus makes the foreign exchange market more
orderly.
• Interest Rate Parity
¤ When market forces cause interest rates and exchange rates to be such that
¤
¤
covered interest arbitrage is no longer feasible, the equilibrium state
achieved is referred to as interest rate parity (IRP).
When IRP exists, the rate of return achieved from covered interest arbitrage
should equal the rate available in the home country.
By simplifying
and rearranging terms:
forward
premium
+ home interest rate) _ 1
=(1 +(1foreign
interest rate)
77
• Interest Rate Parity
If the 6-month Mexican peso interest rate = 6% ,
6-month U.S. dollar interest rate = 5% ,
then from the U.S. investor’s perspective,
_ .9434%
forward = (1 + .05) _ 1 =
premium (1 + .06)
(not annualized)
If the peso’s spot rate is $.10/peso,
then the 6-month forward rate
= spot rate x (1 + premium)
_
= .10 x (1 .009434) = $.09906/peso
• Interest Rate Parity
¤ The relationship between the forward rate and the interest rate differential
can be simplified and approximated as follows:
forward
=
premium
forward rate - spot rate
spot rate
home
_ foreign
» interest
rate
interest rate
¤ This approximated form provides a reasonable estimate when the interest
rate differential is small.
78
Graphic Analysis of Interest Rate Parity
Interest Rate Differential (%)
home interest rate - foreign interest rate
4
IRP line
2
Forward
Discount (%)
-3
-1
1
3
Forward
Premium (%)
-2
-4
79
Graphic Analysis of Interest Rate Parity
Home Interest Rate - Foreign Interest Rate (%)
IRP line
4
Zone of potential
covered interest
arbitrage by
foreign investors
Forward
Discount (%)
-1
-3
Zone where
covered
interest
arbitrage is
not feasible
2
1
3
Forward
Premium (%)
Zone of potential
- 2 covered interest
arbitrage by
local investors
-4
80
Interest Rate Parity
• IRP generally holds. Where it does not hold, covered interest
arbitrage may still not be worthwhile due to transaction costs,
currency restrictions, differential tax laws, political risk, etc.
• 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.
81
t0
iA
iU.S.
t1
Spot and
Forward Rates
Because of
interest rate
parity, a forward
rate will normally
move in tandem
with the spot rate.
This correlation
depends on
interest rate
movements.
Interest Rates
Correlation Between Spot and Forward Rates
t0
time
t2
SpotA
ForwardA.
t1
time
t2
82
Impact of Arbitrage on an MNC’s Value
Forces of Arbitrage
m
E CFj , t E ER j , t
n
j 1
Value =
t
t =1
1 k
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 = the weighted average cost of capital of the U.S. parent
83
• Chapter Review
¤ International Arbitrage
-
Locational Arbitrage
Triangular Arbitrage
Covered Interest Arbitrage
Comparison of Arbitrage Effects
• Chapter Review
¤ Interest Rate Parity
-
Derivation of Interest Rate Parity
Numerical Example
Graphic Analysis of Interest Rate Parity
Interpretation of Interest Rate Parity
Considerations When Assessing Interest Rate Parity
¤ Correlation Between Spot and Forward Rates
¤ Impact of Arbitrage on an MNC’s Value
84
CHAPTER 8
Relationships between Inflation,
Interest Rates, and Exchange Rates
© 2000 South-Western College Publishing
• Chapter Objectives
¤ To explain the purchasing power parity (PPP) theory and its implications for
exchange rate changes;
¤ To explain the international Fisher effect (IFE) theory and its implications for
exchange rate changes; and
¤ To compare the PPP theory, IFE theory, and theory of interest rate parity
(IRP).
• Purchasing Power Parity
¤ When a country’s inflation rate rises relatively, decreased exports and
increased imports depress the country’s currency. The theory of purchasing
power parity (PPP) focuses on this inflation - exchange rate relationship.
¤ The absolute form is the “law of one price.” It suggests that similar products
in different countries should be equally priced when measured in the same
currency.
¤ The relative form of PPP accounts for market imperfections like
transportation costs, tariffs, and quotas.
• Purchasing Power Parity
¤ When inflation occurs and PPP holds, the exchange rate will adjust to
maintain the parity:
Pf (1 + If ) (1 + ef ) = Ph (1 + Ih )
where Ph = price index of goods in the home country
Pf = price index of goods in the foreign country
Ih = inflation rate in the home country
If = inflation rate in the foreign country
ef = % change in the foreign currency’s value
¤ Since Ph = Pf , solving for ef gives:
ef = (1 + Ih ) _ 1
(1 + If )
86
Purchasing Power Parity
• The relationship can_be simplified as follows:
•
ef » Ih
If
This formula is appropriate only when the inflation differential is small.
Suppose that the inflation rate in U.S. is 9%, while U.K.’s rate is 5%. Then
PPP suggests that the £ should appreciate by about 4%.
U.S. will import more, while U.K. will import less, until the £ has risen by
about 4%. At this point, U.K. goods will cost 5+4=9% more to U.S.
consumers, while U.S. goods will cost 9-4=5% more to U.K. consumers.
87
Graphic Analysis of Purchasing Power Parity
Inflation Rate Differential (%)
home inflation rate - foreign inflation rate
4
PPP line
2
-3
-1
1
-2
-4
3
%D in the
foreign
currency’s
spot rate
88
Graphic Analysis of Purchasing Power Parity
Inflation Rate Differential (%)
home inflation rate - foreign inflation rate
4
PPP line
Increased
purchasing
power of
2
foreign
goods
-3
-1
1
-2
-4
3
Decreased
purchasing
power of
foreign
goods
%D in the
foreign
currency’s
spot rate
89
• Purchasing Power Parity
¤ If the actual inflation differential and exchange rate % change for two or more
¤
countries deviate significantly from the PPP line over time, then PPP does not hold.
A statistical test can be developed by applying regression analysis to the historical
exchange rates and inflation differentials:
ef = a0 + a1 { (1+Ih)/(1+If) - 1 } + m
The appropriate t-tests are then applied to a0 and a1, whose hypothesized values are 0
and 1 respectively.
• Purchasing Power Parity
¤ PPP may not occur consistently due to:
-
the existence of other influential factors like differentials in income levels and risk, as well as government
controls; and
the lack of substitutes for traded goods.
¤ A limitation in testing PPP is that the results may vary according to the base period
¤
used.
PPP can also be tested by assessing a “real” exchange rate over time. If this rate
reverts to some mean level over time, this would suggest that it is constant in the long
run.
• International Fisher Effect
¤ According to the Fisher effect, nominal risk-free interest rates contain a real
rate of return and an anticipated inflation.
If the same real return is required across countries, differentials in interest
rates may be due to differentials in expected inflation.
According to PPP, exchange rate movements are caused by inflation rate
differentials.
The international Fisher effect (IFE) theory suggests that currencies with
higher interest rates will depreciate because the higher rates reflect higher
expected inflation.
90
International Fisher Effect
• According to the IFE, the expected effective return on a foreign
investment should equal the effective return on a domestic
investment:
•
(1 + if ) (1 + ef ) _ 1 = ih
where ih = interest rate in the home country
if = interest rate in the foreign country
ef = % change in the foreign currency’s value
• Solving for ef :
ef = (1 + ih ) _ 1
(1 + if )
• The simplified form, ef » ih _ if , provides reasonable
estimates when the interest rate differential is small.
91
International Fisher Effect
Investors Attempt
Residing
to
in
Invest in
ih if
ef
Return
in Home
Currency
Ih
Real
Return
Earned
5%
5
5
3%
3
3
2%
2
2
3
0
-5
8
8
8
6
6
6
2
2
2
8
5
0
13
13
13
11
11
11
2
2
2
Japan
Japan
U.S.
Canada
5% 5% 0%
8 -3
5
5 13 - 8
U.S.
Japan
U.S.
Canada
8
8
8
5
8
13
Canada Japan
U.S.
Canada
13
13
13
5
8
13
92
Graphic Analysis of the International Fisher Effect
Interest Rate Differential (%)
home interest rate - foreign interest rate
4
IFE
line
Lower
returns from
investing in
2
foreign
deposits
-3
-1
%D in the
foreign
currency’s
Higher
returns from spot rate
investing in
foreign
deposits
1
-2
-4
3
93
• International Fisher Effect
¤ While the IFE theory may hold during some time frames, there is evidence
¤
that it does not consistently hold.
A statistical test can be developed by applying regression analysis to the
historical exchange rates and nominal interest rate differentials:
ef = a0 + a1 { (1+ih)/(1+if) - 1 } + m
The appropriate t-tests are then applied to a0 and a1, whose hypothesized
values are 0 and 1 respectively.
• International Fisher Effect
¤ Since the IFE is based on PPP, it will not hold when PPP does not hold.
¤ According to the IFE, the high interest rates in southeast Asian countries before the
¤
Asian crisis should not attract foreign investment because of exchange rate
expectations.
However, since narrow bands were being maintained by some central banks, some
foreign investors were motivated.
Unfortunately for these investors, the efforts made to stabilize the currencies were
overwhelmed by market forces.
94
Comparison of IRP, PPP, and IFE Theories
Interest Rate Parity
(IRP)
Interest Rate
Differential
Fisher
Effect
Forward Rate
Discount or Premium
Inflation Rate
Differential
Purchasing
Power Parity
International
Fisher Effect (IFE)
(PPP)
Exchange Rate
Expectations
95
Impact of Inflation on an MNC’s Value
Effect of Inflation
m
E CFj , t E ER j , t
n j 1
Value =
t =1
1 k t
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 = the weighted average cost of capital of the U.S. parent
96
• Chapter Review
¤ Purchasing Power Parity (PPP)
-
Derivation of PPP
Rationale Behind PPP Theory
Graphic Analysis of PPP
Testing the PPP Theory
Why PPP Does Not Occur
Limitation in Tests of PPP
PPP in the Long Run
• Chapter Review
¤ International Fisher Effect (IFE)
-
Derivation of the IFE
Graphic Analysis of the IFE
Tests of the IFE
Why the IFE does Not Occur
Application of the IFE to the Asian Crisis
¤ Comparison of IRP, PPP, and IFE Theories
¤ Impact of Foreign Inflation on the Value of the MNC
97
Part III
Exchange Rate Risk Management
Information on existing
and anticipated
economic conditions of
various countries and
on historical exchange
rate movements
Information on existing
and anticipated
cash flows in
each currency
at each subsidiary
Forecasting
exchange
rates
Managing
exposure to
exchange rate
fluctuations
Measuring
exposure to
exchange rate
fluctuations
CHAPTER 9
Forecasting Exchange Rates
© 2000 South-Western College Publishing
• Chapter Objectives
¤ To explain how firms can benefit from forecasting exchange rates;
¤ To describe the common techniques used for forecasting; and
¤ To explain how forecasting performance can be evaluated.
• Why Firms Forecast Exchange Rates
¤ MNCs need exchange rate forecasts for their:
-
hedging decisions,
short-term financing decisions,
short-term investment decisions,
capital budgeting decisions,
long-term financing decisions, and
earnings assessment.
• Forecasting Techniques
¤ Technical forecasting involves the use of historical data to predict future values.
¤
It includes statistical analysis and time series models, and is similar to the
technical forecasting of stock prices.
Speculators may find technical forecasting models useful for predicting day-today movements. For MNCs however, their use may be limited, since they
typically focus on the near future, and rarely provide point or range estimates.
• Forecasting Techniques
¤ Fundamental forecasting is based on the fundamental relationships between
¤
¤
economic variables and exchange rates.
A forecast may arise simply from a subjective assessment, or it can be based on
quantitative measurements.
For example, in a regression model, the coefficients are estimated using
historical data. Forecasts can then be made using the appropriate variable
values. If the values are uncertain, sensitivity analysis can be applied.
10
• Forecasting Techniques
¤ Known relationships like the PPP can also be used. However, problems may
arise because:
¤ the timing of the impact of inflation fluctuations
on trade behavior is not known for sure,
¤ the relative prices may be measured
inaccurately,
¤ trade barriers may disrupt the trade patterns
that should emerge according to PPP,
¤ other factors that affect exchange rates exist.
• Forecasting Techniques
¤ In general, fundamental forecasting is limited by :
¤ the uncertain timing of the impact of factors,
¤ the need for forecasts for factors with
instantaneous impact,
¤ the possibility that other relevant factors may be
omitted from the model,
¤ changes in the sensitivity of currency
movements to each factor over time.
• Forecasting Techniques
¤ Market-based forecasting involves developing forecasts from market indicators.
¤ Usually, either the spot rate or the forward rate is used, since they should reflect the
¤
¤
market expectation of the future rates.
For long-term forecasting, the quoted interest rates on risk-free instruments can be used
to determine what the forward rates should be under conditions of interest rate parity.
Note that the use of forward rates has been criticized because they are driven by another
market force - the interest rate differential.
10
• Forecasting Techniques
¤ Mixed forecasting refers to the use of a combination of forecasting
techniques.
¤ The actual forecast is a weighted average of the various forecasts
developed.
• Forecasting Services
¤ The corporate need to forecast currency values has prompted some
consulting firms and banks to offer forecasting services.
¤ Advice on international cash management, assessment of exposure to
exchange rate risk and hedging may be provided too.
¤ One way to determine whether a forecasting service is valuable is to
compare the accuracy of its forecasts with the accuracy of publicly available
and free forecasts.
• Evaluation of Forecast Performance
¤ An MNC that forecasts exchange rates should monitor its performance over time to
¤
determine whether its forecasting procedure is satisfactory. The MNC will also want to
compare its various forecasting methods.
One such measure is the absolute forecast error as a percentage of the realized
value:
| forecasted value - realized value |
realized value
¤ MNCs may have more confidence in their forecasts when they know the mean error
for their past forecasts.
10
Evaluation of Forecast Performance
• Note that the degree of forecast accuracy may vary for different
currencies. For example, the value of a less volatile currency is
likely to be forecasted more accurately.
• If the errors are consistently positive or negative over time, then
there is a bias in the forecasting procedure.
• The following regression model can test for bias: actual_rate = a0
+ a1 forecast + m
If a bias is found, the estimated a0 and a1 values can be used to
correct the systematic error.
10
Graphic Evaluation of Forecast Performance
Perfect
forecast
line
Realized Value
z
Region of
downward
bias
Region of
upward bias
x
x
Predicted Value
z
10
• Forecasting Under Market Efficiency
¤ If the foreign exchange market is weak-form efficient, then the current
¤
¤
exchange rates already reflect historical information. So, technical analysis
would not be useful.
If the market is semistrong-form efficient, then all the relevant public
information is already reflected in the current exchange rates.
If the market is strong-form efficient, then all the relevant public and private
information is already reflected in the current exchange rates.
• Forecasting Exchange Rate Volatility
¤ MNCs also forecast exchange rate volatility. This enables them to develop best-case
¤
and worst-case scenarios along with their point estimate forecasts.
Several methods are possible:
¤ Use the volatility of historical exchange rate
movements as a forecast.
¤ Use a time series of the volatility patterns in
previous periods.
¤ Derive the exchange rate’s implied standard
deviation from the currency option pricing model.
• Application of Exchange Rate Forecasting to the Asian Crisis
¤ Before the crisis, the spot rate served as a reasonable predictor, while the
¤
¤
use of fundamental factors was not as suitable, because of intervention by
the central banks.
But even after the crisis began, it is unlikely that the degree of depreciations
could have been accurately predicted by the usual models.
The two key factors leading to the sharp decline in the Asian currency values
are:
-
the large amount of foreign investment, and
the fear of a massive selloff of the currencies.
10
Impact of Forecasted Exchange Rates
on an MNC’s Value
Technical forecasting
Fundamental forecasting
Market-based forecasting
Mixed forecasting
m
E CFj , t E ER j , t
n j 1
Value =
t =1
1 k t
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 = the weighted average cost of capital of the U.S. parent
10
Chapter Review
• Why Firms Forecast Exchange Rates
• Forecasting Techniques
Technical Forecasting
Fundamental Forecasting
¤ Market-Based Forecasting
¤ Mixed Forecasting
¤
¤
• Forecasting Services
• Evaluation of Forecast Performance
•
•
•
•
¤
¤
¤
¤
Forecast Accuracy Over Time
Forecast Accuracy Among Currencies
Forecast Bias
Graphic Evaluation of Forecast Performance
Forecasting Under Market Efficiency
Forecasting Exchange Rate Volatility
Application of Exchange Rate Forecasting to the Asian Crisis
How Exchange Rate Forecasting Affects an MNC’s Value
10
CHAPTER 10
Measuring Exposure to
Exchange Rate Fluctuations
© 2000 South-Western College Publishing
• 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.
¤ 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 themselves 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.
¤ 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.
• Types of Exposure
¤ Exposure to exchange rate fluctuations comes in three forms:
-
Transaction exposure
Economic exposure
Translation exposure
10
• 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.
¤ Two steps are involved in measuring transaction exposure:
1 determine the projected net amount of inflows or outflows in each foreign currency, and
2 determine the overall risk of exposure to those currencies.
• Transaction Exposure
¤ To determine the overall risk, assess the standard deviations and
¤
¤
correlations of the currencies, taking into account the size of the MNC’s
position in each currency in terms of a standard currency.
The standard deviation statistic on historical data measures currency
variability. Note that the variability may change over time.
Correlation coefficients indicate the degree to which two currencies move in
relation to each other. They may change over time too.
• 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.
11
Economic Exposure
Transactions that
Influence the
Firm’s Local
Currency Inflows
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
Impact of Local Impact of Local
Currency
Currency
Appreciation on Depreciation on
Transactions
Transactions
Decrease
Increase
Decrease
Increase
Decrease
Increase
Decrease
Increase
11
Economic Exposure
Transactions that
Influence the
Firm’s Local
Currency Outflows
Firm’s imported
supplies denominated
in local currency
Firm’s imported
supplies denominated
in foreign currency
Interest owed on
foreign funds
borrowed
Impact of Local Impact of Local
Currency
Currency
Appreciation on Depreciation on
Transactions
Transactions
No Change
No Change
Decrease
Increase
Decrease
Increase
11
• Economic Exposure
¤ Even purely domestic firms can be affected by economic exposure if there is
¤
foreign competition within the local markets. However, their degree of
exposure is likely to be much less than for MNCs.
One method of measuring economic exposure is by reviewing how the
earnings forecast in the income statement changes in response to
alternative exchange rate scenarios.
• Economic Exposure
¤ Another method of assessing a firm’s economic exposure is by applying regression
¤
analysis to historical cash flow and exchange rate data as follows:
% D in the inflation % D in the
adjusted cash flows
exchange
measured in the = a0 + a1 x rate of the + m
firm’s home currency
currency
over period t
over period t
The model can be varied by including more currencies, using an index of currencies,
focusing on selected cash flows only, or using the stock price.
• Translation Exposure
¤ The exposure of the MNC’s consolidated financial statements to exchange
¤
¤
rate fluctuations is known as translation exposure.
Translation exposure may not be relevant because translating financial
statements for consolidated reporting purposes does not affect an MNC’s
cash flows.
In reality however, translation exposure may affect the stock price of a firm
through its impact on consolidated earnings.
11
• Translation Exposure
¤ Note that the current translation of earnings may be a useful base to derive
the expected future cash flows when earnings are remitted by the foreign
subsidiaries to the parent.
¤ Translation exposure is dependent on:
-
the degree of foreign involvement by foreign subsidiaries,
the locations of foreign subsidiaries, and
the accounting methods used.
• Translation Exposure
¤ According to estimates, the total translated earnings of U.S.-based MNCs
were reduced by $20 billion in the third quarter of 1998 alone simply
because of the depreciation of Asian currencies against the dollar.
¤ In general, translation exposure is more closely monitored when the foreign
earnings of the subsidiaries are more likely to be remitted to the parent,
because this signals a business operation that is subject to economic
exposure.
11
Impact of Exchange Rate Exposure
on an MNC’s Value
Transaction exposure
Economic exposure
m
E CFj , t E ER j , t
n j 1
Value =
t =1
1 k t
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 = the weighted average cost of capital of the U.S. parent
11
• Chapter Review
¤ Is Exchange Rate Risk Relevant?
-
Purchasing Power Parity Argument
The Investor Hedge Argument
Currency Diversification Argument
Stakeholder Diversification Argument
¤ Types of Exposure
-
-
Transaction Exposure
Economic Exposure
Translation Exposure
• Chapter Review
¤ Transaction Exposure
-
Transaction Exposure to Net Cash Flows
Transaction Exposure Based on Currency Variability & Currency Correlations
Transaction Exposure Based on Value-at-Risk
¤ Economic Exposure
-
Economic Exposure to Local Currency Appreciation & Depreciation
Economic Exposure of Domestic Firms & MNCs
Measuring Economic Exposure
» Sensitivity of Earnings to Exchange Rates
» Sensitivity of Cash Flows to Exchange Rates
• Chapter Review
¤ Translation Exposure
-
Does Translation Exposure Matter
Determinants of Translation Exposure
» The Degree of Foreign Involvement by Foreign Subsidiaries
» The Locations of Foreign Subsidiaries
» The Accounting Methods Used
¤ Impact of Exchange Rate Exposure on an MNC’s Value
11
CHAPTER 11
Managing Transaction
© 2000 South-Western College Publishing
Exposure
• 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 among hedging techniques; and
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.
However, on the average, hedging may not reduce the MNC’s costs.
If transaction exposure exists, the MNC should
1
2
3
identify the degree of transaction exposure,
decide whether to hedge and how much to hedge based on its degree of risk aversion and exchange rate
forecasts, and
choose among the various hedging techniques available if it decides to hedge.
• Transaction Exposure
¤ MNCs that adopt a centralized approach to hedging must identify the net
¤
transaction exposure in each currency for all its subsidiaries.
Note that sometimes, a firm can reduce its transaction exposure by pricing
its exports in the same currency that will be needed to pay for imports.
• Techniques to Eliminate Transaction Exposure
¤ A futures hedge involves the use of currency futures to hedge transaction
exposure.
¤ Recall that futures contracts represent a standardized number of units for
each currency.
¤ A futures hedge is not always beneficial, but some firms may be more
comfortable locking in their exchange rates than remaining exposed to
exchange rate fluctuations.
11
• Techniques to Eliminate Transaction Exposure
¤ A forward hedge involves the use of forward contracts by large corporations to
hedge transaction exposure.
¤ Based on the firm’s degree of risk aversion, the decision about whether to
hedge can be made by comparing the known result of hedging to the possible
results of remaining unhedged.
• Techniques to Eliminate Transaction Exposure
¤ For payables :
real
nominal cost
nominal cost
cost of = of payables –
of payables
hedging
with hedging
without hedging
¤ For receivables :
nominal
nominal
real
home currency
home currency
cost of =
revenues
–
revenues
hedging
received
received
without hedging
with hedging
¤ If the real cost is negative, then hedging is more favorable than not hedging.
• Techniques to Eliminate Transaction Exposure
¤ To estimate the real cost, the probability distribution of the exchange rates is
needed:
expected
probability
real cost
real cost = S that exchange x of hedging
of hedging i
rate is i
when rate is i
¤ The overall probability that hedging will be more costly can also be computed.
¤ Note that to avoid distortion, the real cost of hedging for each currency should
be expressed as a percentage of their respective hedged amounts if they are to
be compared.
11
• Techniques to Eliminate Transaction Exposure
¤ A money market hedge involves taking one or more money market position to
¤
cover a future payables or receivables position.
Often, two positions are required:
-
For payables, (1) borrow the home currency representing future payables, and (2) invest in the
foreign currency.
For receivables, (1) borrow the foreign currency representing future receivables, and (2) invest in
the home currency.
• Techniques to Eliminate Transaction Exposure
¤ If interest rate parity (IRP) exists, and transaction costs do not exist, the money
market hedge will yield the same results as the forward hedge.
¤ This is so because the forward premium on the 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.
Recall that the option owner can choose not to exercise the contract.
Hence, the firm will be insulated from adverse exchange rate movements, but
may benefit from favorable movements.
However, the firm must assess whether the advantages are worth the premium
paid for the option.
• Techniques to Eliminate Transaction Exposure
¤ Most MNCs determine which hedging technique is optimal on a case-by-case
¤
¤
basis.
Note that when using a futures, forward, or money market hedge, the firm can
determine its future cash flows with certainty. However, this is not the case when
using a currency option hedge or when remaining unhedged.
A further complication for many firms is that the amount of foreign currency to be
received at the end of the period being analyzed is uncertain.
12
• Hedging Long-Term Transaction Exposure
¤ Over the long run, the continual hedging of repeated transactions that are expected in the near
¤
¤
¤
future has limited effectiveness.
Hence, MNCs that are certain of their future cash flows may attempt long-term hedging.
The commonly used techniques are long-term forward contracts, currency swaps, and parallel
loans.
Long-term forward contracts, or long forwards, with maturities of ten years or more, can be set up
for very creditworthy customers.
• Hedging Long-Term Transaction Exposure
¤ 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.
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 on a future date.
• Alternative Hedging Techniques
¤ Sometimes, a firm may not be able to eliminate its transaction exposure completely because it
cannot accurately predict its cash flows, or because the costs of hedging are too high.
¤ To reduce exposure under such conditions, the firm can consider leading and lagging, cross¤
hedging, or currency diversification.
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.
• Alternative Hedging Techniques
¤ When a currency cannot be hedged, cross-hedging may be practiced. With cross-hedging, a
¤
currency that is highly correlated with the currency of concern is hedged instead. The stronger
the positive correlation, the more effective the strategy will be.
With currency diversification, the firm diversifies its business among numerous countries whose
currencies are not highly correlated.
12
Impact of Hedging Transaction Exposure
on an MNC’s Value
Hedging decisions on
transaction exposure
m
E CFj , t E ER j , t
n
j 1
Value =
t
t =1
1 k
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 = the weighted average cost of capital of the U.S. parent
12
• Chapter Review
¤ Transaction Exposure
-
Selective Hedging of Transaction Exposure
Identifying the Net Transaction Exposure
Adjusting the Invoice Policy to Manage Exposure
¤ Techniques to Eliminate Transaction Exposure
-
Futures Hedge
Forward Hedge
Money Market Hedge
Currency Option Hedge
Calculating the Real Cost of Hedging
Determining the Optimal Hedge
¤ Limitation of Repeated Short-Term Hedging
¤ Hedging Long-Term Transaction Exposure
-
Long-Term Forward Contract
Currency Swap
Parallel Loan
¤ Alternative Hedging Techniques
-
Leading and Lagging
Cross-Hedging
Currency Diversification
¤ How Transaction Exposure Management Affects an MNC’s Value
12
CHAPTER 12
Managing Economic Exposure
and Translation Exposure
© 2000 South-Western College Publishing
• Chapter Objectives
¤ To explain how an MNC’s economic exposure can be hedged; and
¤ To explain how an MNC’s translation exposure can be hedged.
• Economic Exposure
¤ Economic exposure refers to the impact exchange rate fluctuations can have on
¤
a firm’s future cash flows. Recall that cash flows can be affected in ways not
directly associated with foreign transactions.
The management of economic exposure tends to result in a long-term solution.
Its importance can be seen from the bankruptcy of Laker Airways, and from the
impact the 1997/8 Asian crisis had on firms.
• Economic Exposure
¤ A firm can assess its economic exposure by determining the sensitivity of its
¤
expenses and revenues to various possible exchange rate scenarios.
The firm can then reduce its exposure by restructuring its operations.
• Economic Exposure
¤ For example, a firm may attempt to balance its exchange-rate-sensitive
revenues and expenses by :
1. increasing or reducing sales in new or existing
foreign markets,
2. increasing or reducing its dependency on
foreign suppliers,
3. establishing or eliminating production facilities
in foreign markets, and/or
4. increasing or reducing its level of debt
denominated in foreign currencies.
12
• Economic Exposure
¤ Note that computer spreadsheets can be very helpful in assessing alternative
scenarios.
¤ MNCs must be very confident about the long-term potential benefits before they
proceed to restructure their operations, because of the high costs of reversal.
• Translation Exposure
¤ Translation exposure results when an MNC translates each subsidiary’s financial
¤
¤
data to its home currency for consolidated financial reporting.
Some firms are concerned about translation exposure because of its potential
impact on reported consolidated earnings, and may attempt to avoid it by
matching its foreign liabilities with its foreign assets.
To hedge translation exposure, forward contracts can be used.
• Translation Exposure
¤ For example, a U.S.-based MNC that is concerned about the translated value of
its British earnings may enter a one-year forward contract to sell pounds.
¤ If the pound depreciates during the fiscal year, the gain generated from the
forward contract position may offset the translation loss.
• Translation Exposure
¤ Hedging translation exposure is limited by:
-
-
inaccurate earnings forecasts,
inadequate forward contracts for some currencies,
accounting distortions, and
increased transaction exposure.
¤ Perhaps, the best way for MNCs to deal with translation exposure is to clarify
how their consolidated earnings have been affected by exchange rate
movements.
12
Impact of Hedging Economic Exposure
on an MNC’s Value
Hedging decisions on
economic exposure
m
E CFj , t E ER j , t
n
j 1
Value =
t
t =1
1 k
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 = the weighted average cost of capital of the U.S. parent
12
Chapter Review
• Managing Economic Exposure
¤
¤
¤
¤
¤
Importance of Managing Economic Exposure
Assessing Economic Exposure
Reducing Economic Exposure by Restructuring
Expediting the Analysis with Computer Spreadsheets
Issues Involved in the Restructuring Decision
¤
¤
¤
Use of Forward Contracts to Hedge Translation Exposure
Limitations of Hedging Translation Exposure
Alternative Solution to Hedging Translation Exposure
• Managing Translation Exposure
• How Economic Exposure Management Affects an MNC’s Value
12
Part IV
Long-Term Asset and Liability Management
Existing
Host Country
Tax Laws
Potential
Revision in
Host Country
Tax Laws or
Other
Provisions
MNC’s Access
to Foreign
Financing
International
Interest Rates
on Long-Term
Funds
Exchange
Rate
Projections
Country Risk
Analysis
MNC’s Cost
of Capital
Risk Unique to
Multinational
Project
Estimated
Cash Flows of
Multinational
Project
Multinational
Capital
Budgeting
Decisions
Required
Return on
Multinational
Project
CHAPTER 13
Direct Foreign Investment
© 2000 South-Western College Publishing
• Chapter Objectives
¤ To describe common motives for initiating direct foreign investment; and
¤ To illustrate the benefits of international diversification.
• Motives for Direct Foreign Investment
There are several ways in which DFI can boost revenues or reduce costs :
1. Attract new sources of demand, especially
when growth is limited in the home country.
2. Enter markets in which superior profits are
possible.
3. Fully benefit from economies of scale,
especially for firms that utilize much
machinery.
4. Use foreign factors of production.
5. Use foreign raw materials.
• Motives for Direct Foreign Investment
6. Use foreign technology.
7. Exploit monopolistic advantages, especially
for firms that possess resources or skills
not available to competing firms.
8. React to exchange rate movements. DFI can
be considered when the foreign currency
appears to be undervalued. DFI can also
help reduce economic exposure.
9. React to trade restrictions.
10. Diversify internationally.
13
• Motives for Direct Foreign Investment
¤ The optimal method for a firm to penetrate a foreign market is partially
¤
¤
dependent on the characteristics of the market.
Before investing in a foreign country, the potential benefits must be weighed
against the costs and risks.
As conditions change over time, the potential benefits from pursuing DFI in
various countries change too.
• Benefits of
International Diversification
overall
expected return
return
x expected
=i S poni business
unit i
overall variance = S pi2si2 + S S pi pj Covij
i
i j,j ¹i
where pi = % of funds invested in business unit i
si2 = variance of the return on business unit i
Covij = covariance between the returns on
business unit i and business unit j
13
Average Variance
of Returns
Benefits of International Diversification
Domestic
Project Portfolio
Global
Project Portfolio
Number of Projects
• When a firm invests in foreign projects, the overall return will be more
stable because of the lower correlations between the returns of projects
implemented in different economies.
13
Expected Return
Benefits of International Diversification
Frontier
of efficient
project portfolios
Risk
• An MNC with projects positioned around the world is concerned
about the risk and return characteristics of the projects.
13
Expected Return
Benefits of International Diversification
Efficient frontier of
project portfolios for
a multi-product MNC
Efficient frontier of
project portfolios for
a single-product MNC
Risk
• The actual location of the frontier of efficient project portfolios depends
on the business in which the firm is involved.
13
• Decisions Subsequent to DFI
Some periodic decisions are necessary:
¤ Should further expansion take place?
¤ Should the earnings be remitted to the parent, or used by the subsidiary?
• Host Government View of DFI
¤ DFI may provide needed employment or technology. However, locally owned
¤
companies may lose business due to the new competition.
The ability of a host government to attract DFI is dependent on the country’s
markets and resources, as well as government regulations and incentives.
13
Impact of Direct Foreign Investment
Decisions on an MNC’s Value
DFI decisions on type
of business and location
m
E CFj , t E ER j , t
n
j 1
Value =
t
t =1
1 k
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 = the weighted average cost of capital of the U.S. parent
13
Chapter Review
• Motives for Direct Foreign Investment
• Benefits of International Diversification
¤
¤
Diversification Benefits of Multiple Projects
Risk-Return Analysis of International Projects
• Decisions Subsequent to DFI
• Host Government View of DFI
• Impact of the DFI Decision on an MNC’s Value
13
CHAPTER 14
Multinational Capital Budgeting
© 2000 South-Western College Publishing
• Chapter Objectives
¤ To compare the capital budgeting analysis of an MNC’s subsidiary with that
¤
¤
of its parent;
To demonstrate how multinational capital budgeting can be applied to
determine whether an international project should be implemented; and
To explain how the risk of international projects can be assessed.
• Subsidiary versus Parent Perspective
¤ Should a parent or its subsidiary conduct the capital budgeting for a multinational
¤
¤
project?
The results may vary with the perspective because the net after-tax cash inflows to
the parent can differ substantially from those to the subsidiary.
The difference in cash inflows is due to :
1. tax differentials
2. restricted remittances
3. excessive remittances
4. exchange rate movements
14
Remitting Subsidiary Earnings to the Parent
Cash Flows Generated by Subsidiary
Corporate Taxes Paid
to Host Government
After-Tax Cash Flows to Subsidiary
Retained Earnings
by Subsidiary
Cash Flows Remitted by Subsidiary
Withholding Tax Paid
to Host Government
After-Tax Cash Flows Remitted by Subsidiary
Conversion of Funds
to Parent’s Currency
Cash Flows to Parent
Parent
14
• Input for Multinational Capital Budgeting
The following forecasts are normally required:
1. initial investment
2. consumer demand
3. price
4. variable cost
5. fixed cost
6. project lifetime
7. salvage (liquidation) value
8. fund-transfer restrictions
9. tax laws 10. exchange rates 11. required rate of return
• Multinational Capital Budgeting
¤ Capital budgeting is necessary for all long-term projects that deserve consideration.
¤ One method of performing the analysis is to calculate the net present value of the
project:
net
n cash flow
present = _ initial + S in period t + value
value
outlay t =1 (1+ k )t
(1+ k )n
k = required rate of return on the project
n = lifetime of the project (number of periods)
salvage
If the net present value is positive, the project may be accepted.
• Factors to Consider in Multinational Capital Budgeting
¤ A variety of factors may affect the capital budgeting analysis :
1.
Exchange rate fluctuations - Different
scenarios should be considered together with their probability of occurrence.
2.
Inflation - Inflation can be quite volatile
from year to year in some countries.
3.
Financing arrangement - Many foreign
projects are partially financed by foreign subsidiaries.
14
Factors to Consider in Multinational Capital Budgeting
4.
Blocked funds - Some countries may
require that the earnings be reinvested locally for a certain period of
time before they can be remitted to the parent.
5.
Uncertain salvage value - The salvage
value typically has a significant impact on the project’s net present
value.
6.
7.
Impact of project on prevailing cash flows.
Host government incentives.
14
• Adjusting Project Assessment for Risk
¤ If an MNC is unsure of the cash flows of a proposed project, it needs to adjust its
assessment for this risk.
¤ One method is to use a risk-adjusted discount rate. The greater the uncertainty,
the larger the discount rate that is applied.
¤ Many computer software packages are also available to perform sensitivity
analysis and simulation.
Impact of Multinational Capital Budgeting Decisions on an MNC’s Value
E (CFj,t ) = expected cash
flows in currency j to be
received by the U.S.
parent at the end of period
t
E (ERj,t ) = expected
exchange rate at which
currency j can be
converted to dollars at the
end of period t
k = the weighted average
cost of capital of the U.S.
parent
Multinational capital
budgeting decisions
m
E CFj , t E ER j , t
n
j 1
Value =
t
t =1
1 k
14
• Chapter Review
¤ Subsidiary versus Parent Perspective
-
Tax Differentials
Restricted Remittances
Excessive Remittances
Exchange Rate Movements
¤ Input for Multinational Capital Budgeting
¤ Multinational Capital Budgeting
• Chapter Review
¤ Factors to Consider in Multinational Capital Budgeting
-
Exchange Rate Fluctuations
Inflation
Financing Arrangement
Blocked Funds
Uncertain Salvage Value
Impact of Project on Prevailing Cash Flows
Host Government Incentives
• Chapter Review
¤ Adjusting Project Assessment for Risk
-
-
Risk-Adjusted Discount Rate
Sensitivity Analysis
Simulation
¤ Impact of Multinational Capital Budgeting on an MNC’s Value
14
CHAPTER 15
Multinational Restructuring
© 2000 South-Western College Publishing
• Chapter Objectives
¤ To provide a background on how MNCs use international acquisitions as a form of
¤
¤
•
multinational restructuring;
To explain how MNCs conduct valuations of foreign target firms;
To explain why valuations of a target firm vary among MNCs that plan to restructure
by acquiring a target; and
To identify other types of multinational restructuring.
¤
Multinational Restructuring
¤ Decisions by an MNC to build a new subsidiary, to acquire a company, to
¤
sell an existing subsidiary, to downsize some of its operations, or to shift
some production from one subsidiary to another, represent different forms of
multinational restructuring.
MNCs continuously assess possible forms of multinational restructuring to
capitalize on changing economic, political and industrial conditions across
countries.
• International Acquisitions
¤ Through an international acquisition, a firm can immediately expand its
¤
international business, since the structure is already in place, and customer
relationships have already been established.
However, it usually costs more to acquire a company than to establish a new
subsidiary. It is also necessary to integrate the parent management style
with that of the acquired company.
14
Trends in International Acquisitions
Number of
Acquisitions
1200
U.S. Acquisitions of Foreign Firms
1000
800
600
Foreign Acquisitions
of U.S. Firms
400
200
0
Value of
Acquisitions
(in billions of $)
1988 1989 1990 1991 1992 1993 1994 1995 1996 1997
100
80
60
40
20
Foreign Acquisitions
of U.S. Firms
U.S. Acquisitions
of Foreign Firms
0
1988 1989 1990 1991 1992 1993 1994 1995 1996 1997
14
• International Acquisitions
¤ All countries have one or more agencies that monitor mergers and
acquisitions. MNCs need to be aware of the barriers that may be imposed by
them.
¤ Examples of such barriers include laws against hostile takeovers, restricted
foreign majority ownership, “red tape”, and special requirements.
¤ The cost of overcoming the barriers should be taken into consideration when
acquiring a foreign company.
• International Acquisitions
¤ One method of valuing a foreign target is to calculate its net present value :
net
n cash flow
present = _ initial + S in period t + value
salvage
value
outlay t =1 (1+ k )t
(1+ k )n
k = required rate of return on the acquisition
n = lifetime of the acquired company
Note that the relevant exchange rates, taxes and blocked-funds restrictions should be
taken into account.
If the net present value is positive, the foreign company may be acquired.
• International Acquisitions
¤ During the Asian crisis, some MNCs capitalized on the low property values,
¤
weakened currencies, and the need for funds by many firms, to invest in
Asia. These MNCs must not ignore the adverse effects of the crisis too.
In Europe, the adoption of the euro as the local currency by several
countries simplifies the analysis for an MNC that is comparing possible
target firms in these participating countries.
14
• Factors that Affect the Expected Cash Flows of the Foreign Target
¤ Target-Specific Factors
•
1. Target’s previous cash flows 2. Managerial talent of the target
Factors that Affect the Expected Cash Flows of the Foreign Target
¤ Country-Specific Factors 1. Target’s local economic conditions
2. Target’s local political conditions
4. Target’s currency conditions
3. Target’s industrial conditions
5. Target’s local stock market conditions
6. Taxes applicable to the target
• The Valuation Process
¤ The MNC first conducts an initial screening of the prospective targets to
¤
¤
¤
identify those that deserve a closer assessment.
The MNC then values each of the targets that passed the screening process
by calculating their net present values, for example.
Only those targets with positive net present values will be further considered.
If the MNC decides not to bid for a target at this time, it will need to redo its
analysis the next time it reconsiders acquiring the target.
• Why Valuations of a Target May Vary Among MNCs
¤ The target’s expected future cash flows varies.
-
Different MNCs will manage the target’s operations differently.
Each MNC may have a different plan for fitting the target within the structure of the MNC.
Acquirers based in certain countries may be subjected to less taxes on remitted earnings.
¤ The effect of exchange rates varies.
-
Different MNCs have different schedules for the target to remit funds to the parent.
15
• Why Valuations of a Target May Vary Among MNCs
¤ The required rate of return varies.
-
Different MNCs may have different plans for the target, with different levels of risk.
The local risk-free interest rate may be different for MNCs based in different countries.
MNCs in some countries have more flexibility in their ability to use financial leverage.
• Other Types of Multinational Restructuring
¤ An MNC may engage in a partial international acquisition of a firm, by
purchasing a portion of the existing stock of a foreign firm.
The valuation of the firm will vary depending on whether the MNC plans to
acquire enough shares to control the firm.
• Other Types of Multinational Restructuring
¤ Many MNCs also acquire businesses that are being sold by governments all
over the world.
It is usually difficult to measure the value of these privatized businesses
because of the many uncertainties surrounding the transition.
• Other Types of Multinational Restructuring
¤ MNCs commonly engage in international alliances, such as joint ventures
and licensing agreements, with foreign firms.
The initial outlay is typically smaller, but the cash flows to be received will be
smaller too.
• Other Types of Multinational Restructuring
¤ An MNC should also conduct periodic assessments to determine whether to
retain its foreign investments or to divest them.
The MNC should compare the present value of the cash flows if the project is
continued to the proceeds that would be received if the project is divested. 15
Impact of Multinational Restructuring
Decisions on an MNC’s Value
Multinational restructuring decisions
m
E CFj , t E ER j , t
n
j 1
Value =
t
t =1
1 k
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 = the weighted average cost of capital of the U.S. parent
15
• Chapter Review
¤ Background on Multinational Restructuring
¤ International Acquisitions
-
-
Trends in International Acquisitions
Barriers to International Acquisitions
Model for Valuing a Foreign Target
Assessing Potential Acquisitions in Asia and Europe
¤ Factors that Affect the Expected Cash Flows
-
Target-Specific Factors
Country-Specific Factors
¤ The Valuation Process
-
International Screening Process
Estimating the Target’s Value
¤ Why a Target’s Value May Vary Among MNCs
-
Expected Cash Flows From the Target
Exchange Rate Effects on Remitted Funds
Required Return of the Acquirer
¤ Other Types of Multinational Restructuring
-
International Partial Acquisitions
International Acquisitions of Privatized Businesses
International Alliances
International Divestments
¤ Impact of Multinational Restructuring on an MNC’s Value
15
CHAPTER 16
Country Risk Analysis
© 2000 South-Western College Publishing
• Chapter Objectives
¤
¤
¤
¤
To identify the common factors used by MNCs to measure a country’s political risk;
To identify the common factors used by MNCs to measure a country’s financial risk;
To explain the techniques used to measure country risk; and
To explain how the assessment of country risk is used by MNCs when making financial
decisions.
• Why Country Risk Analysis Is Important
¤ Country risk represents the potentially adverse impact of a country’s
¤
environment on the MNC’s cash flows.
Country risk can be used :
-
to monitor countries where the MNC is presently doing business;
as a screening device to avoid conducting business in countries with excessive risk; and
to improve the analysis used in making long-term investment or financing decisions.
• Political Risk Factors
¤ Attitude of Consumers in the Host Country
-
Some consumers may be very loyal to local products.
-
The host government may impose special requirements, restrictions, or additional taxes, subsidize
local firms, or fail to enforce copyright laws.
Blockage of Fund Transfers
Funds may not be optimally used.
¤ Attitude of Host Government
-
• Political Risk Factors
¤ Currency Inconvertibility
-
The MNC parent may need to exchange earnings for goods.
¤ War
-
Internal and external battles, or even the threat of war, can have a devastating effect.
-
Bureaucracy can complicate business.
-
Corruption can increase the cost of conducting business or reduce revenue.
¤ Bureaucracy
¤ Corruption
15
• Financial Risk Factors
¤ One financial factor is the current and potential state of the country’s economy.
-
A recession can severely reduce demand.
Financial distress can also encourage the government to restrict the MNC’s operations.
¤ A country’s economy is dependent on other financial factors, such as interest
¤
rates, exchange rates, and inflation.
Government purchasing power indicators, such as the budget deficit, are also
important if the government is a customer of the MNC.
• Types of Country Risk Assessment
¤ A macro-assessment of country risk is an overall risk assessment of a country
¤
¤
without consideration of the MNC’s business.
A micro-assessment of country risk is the risk assessment of a country as
related to the MNC’s type of business.
The overall assessment of country risk thus consists of :
1. Macro-political risk
2. Macro-financial risk
3. Micro-political risk
4. Micro-financial risk
• Types of Country Risk Assessment
¤ Risk assessors often differ in opinion due to subjectivities in :
-
identifying the relevant political and financial factors,
determining the relative importance of each factor, and
predicting the values of the factors.
• Techniques to Assess Country Risk
¤ A checklist approach involves measuring all the identified factors and assigning
weights to them.
¤ The Delphi technique involves collecting independent opinions on country risk.
¤ Quantitative analysis tools like discriminant analysis and regression analysis can
be used when financial and political variables have been measured for a period
of time.
15
• Techniques to Assess Country Risk
¤ Inspection visits involve traveling to a country and meeting with government
officials, firm executives, and/or consumers.
¤ In some cases, it may be most appropriate to use a combination of two or
more techniques.
Comparing Risk Ratings Among Countries: The Foreign Investment Risk Matrix (FIRM)
Political Risk Rating
Stable
Unstable
Financial Risk Rating
Poor
Good
Acceptable
Zone
Unclear
Zone
Unacceptable
Zone
15
• Quantifying Country Risk
1. Assign values and weights to the political risk factors.
2. Multiply the factor values with their respective weights, and sum up to give the political risk
rating.
3. Derive the financial risk rating similarly.
4. Assign weights to the political and financial ratings according to their perceived importance.
5. Multiply the ratings with their respective weights, and sum up to give the overall country
risk rating.
• Incorporating Country Risk in Capital Budgeting
¤ Adjustment of the Discount Rate
-
The higher the perceived risk, the higher the discount rate applied to the project’s cash flows.
-
By analyzing each possible impact, the MNC can determine the probability distribution of the net
present values for the project.
¤ Adjustment of the Estimated Cash Flows
• Applications of Country Risk Analysis
¤ While the overall risk rating of a country can be useful, it cannot always detect
upcoming crises.
¤ The Persian Gulf crisis is an example of how a country’s risk can change over
time.
¤ Through the 1997/8 Asian crisis, MNCs realized that they had underestimated
the potential financial problems that could occur in the high-growth Asian
countries.
• Reducing Exposure to Host Government Takeovers
¤ Use a Short-Term Horizon
This technique concentrates on recovering cash flow quickly.
¤ Rely on Unique Supplies or Technology
In this way, the host government will not be able to take over and operate the subsidiary successfully.
¤ Hire Local Labor
-
The local employees can apply pressure on their government.
15
• Reducing Exposure to Host Government Takeovers
¤ Borrow Local Funds
-
The local banks can apply pressure on their government.
¤ Purchase Insurance
-
Many home countries of MNCs have investment guarantee programs that insure to some
extent the risks of expropriation, wars, or currency blockage.
Similar programs may be offered by the host country or an international agency too.
Impact of Country Risk on an MNC’s Value
E (CFj,t ) = expected
cash flows in currency
j to be received by the
U.S. parent at the end
of period t
E (ERj,t ) = expected
exchange rate at which
currency j can be
converted to dollars at
the end of period t
k = the weighted
average cost of capital
of the U.S. parent
Exposure of foreign projects
to country risk
m
E CFj , t E ER j , t
n j 1
Value =
t
t =1
1
k
15
• Chapter Review
¤
¤
¤
¤
Why Country Risk Analysis Is Important
Political Risk Factors
Financial Risk Factors
Types of Country Risk Assessment
-
-
Macro-Assessment of Country Risk
Micro-Assessment of Country Risk
¤ Techniques to Assess Country Risk
-
Checklist Approach
Delphi Technique
Quantitative Analysis
Inspection Visits
Combination of Techniques
¤ Comparing Risk Ratings Among Countries
¤ Quantifying Country Risk
¤ Incorporating Country Risk in Capital Budgeting
-
Adjustment of the Discount Rate
Adjustment of the Estimated Cash Flows
¤ Applications of Country Risk Analysis
¤ Reducing Exposure to Host Government Takeovers
¤ Impact of Country Risk on an MNC’s Value
16
CHAPTER 17
Multinational Cost of Capital
and Capital Structure
© 2000 South-Western College Publishing
• Chapter Objectives
¤ To explain how corporate and country characteristics influence an MNC’s
¤
¤
cost of capital;
To explain why there are differences in the costs of capital among countries;
and
To explain how corporate and country characteristics are considered by an
MNC when it establishes its capital structure.
• Cost of Capital
¤ A firm’s capital consists of equity (retained earnings and funds obtained by
¤
¤
¤
issuing stock) and debt (borrowed funds).
The cost of equity reflects an opportunity cost, while the cost of debt is
reflected in interest expenses.
Firms attempt to use a capital structure that will minimize their cost of
capital.
The lower a firm’s cost of capital, the lower is its required rate of return on a
given proposed project.
• Cost of Capital
¤ A firm’s weighted average cost of capital can be measured as :
(
debt
) kd
debt+equity
(1 _ t ) + (
equity
debt+equity
) ke
where kd is the before-tax cost of its debt
t is the corporate tax rate
ke is the cost of financing with equity
16
Cost of Capital
Cost of Capital
Debt Ratio
• The interest payments on debt are tax deductible. However, when
interest expense increases, the probability of bankruptcy will
increase too.
16
• Cost of Capital for MNCs versus Domestic Firms
¤ Because of their size, MNCs are often given preferential treatment by
•
creditors. Their per unit flotation costs is usually smaller too.
¤ MNCs are also normally able to obtain funds through international capital
markets.
¤ MNCs may have more stable cash inflows due to international
diversification.
¤ However, MNCs are exposed to exchange rate risk.
¤ MNCs are also exposed to country risk.
Cost of Capital for MNCs versus Domestic Firms
¤ The capital asset pricing model (CAPM) defines the required return on a
stock as :
Rf + b ( market return - Rf )
where Rf = risk-free rate of return
b = beta of stock
¤ A stock’s beta represents the sensitivity of the stock’s returns to market
returns.
¤ The lower a project’s beta, the lower the systematic risk, and the lower the
required rate of return, if the unsystematic risk is considered irrelevant.
• Costs of Capital Across Countries
¤ The cost of debt is primarily determined by :
-
the risk-free interest rate for the borrowed currency, and
the risk premium required by creditors.
The risk-free rate may vary across countries.
-
This is due to different tax laws, demographics, monetary policies, and economic conditions.
The risk premium may vary across countries.
-
This is due to different economic conditions, relationships between corporations and creditors, government
intervention, and degrees of financial leverage.
16
Comparative Costs of Debt Across Countries
9
U.K.
Costs of Debt
8
7
U.S.
U.S.
Canada
6
5
Australia
Germany
4
3
Japan
2
1
1996
1997
1998
• There is some positive correlation among the costs of debt
for different countries.
16
• Costs of Capital Across Countries
¤ The cost of equity is determined by :
-
the risk-free interest rate that could have been earned by the shareholders,
the premium that reflects the firm’s risk, and
the investment opportunities in the country.
¤ Since the costs may vary across countries,
-
MNCs based in some countries may have a competitive advantage over others,
MNCs may be able to adjust their sources of funds to capitalize on the differences, and
MNCs in different countries may have different optimal debt-equity ratios.
• Using the Cost of Capital for Assessing Foreign Projects
¤ Foreign projects may have risk levels different from that of the MNC, such that the MNC’s
¤
weighted average cost of capital may not be the appropriate required rate of return.
To account for this risk differential in the capital budgeting process,
-
the probability distribution of net present values can be computed, or
the MNC’s weighted average cost of capital may be adjusted accordingly.
• The MNC’s Capital Structure Decision
¤ Corporate characteristics may influence the MNC’s capital structure :
-
MNCs with more stable cash flows can handle more debt.
Lower credit risk means more access to credit.
More profitable MNCs may be able to finance most of their investment with retained earnings.
If the parent backs the subsidiary’s debt, the subsidiary may be able to borrow more.
Local shareholders may monitor a subsidiary, though not from the parent’s perspective.
• The MNC’s Capital Structure Decision
¤ Host country characteristics may influence the MNC’s capital structure too:
-
MNCs in countries where investors have less investment opportunities may be able to raise equity
at a relatively low cost.
Interest rates may vary across countries.
A currency’s strength may change over time.
Different countries have different risks.
Different countries have different tax laws.
16
• The MNC’s Capital Structure Decision
¤ MNCs may prefer to use a more debt-intensive capital structure when they
•
exhibit characteristics such as stable cash flows, low credit risk, and limited
access to retained earnings.
¤ MNCs may prefer that their subsidiaries use a more debt-intensive capital
structure when their subsidiaries are subject to low local interest rates,
potentially weak local currencies, a high degree of country risk, and high
taxes.
Interaction Between Subsidiary and Parent Financing Decisions
¤ Increased debt financing by the subsidiary
Û Larger amount of internal funds available
to the parent
Û Reduced need for debt financing by the
parent
¤ Reduced debt financing by the subsidiary
Û Smaller amount of internal funds available
to the parent
Û Increased need for debt financing by the
parent
• Using a Target Capital Structure on a Local versus Global Basis
¤ An MNC may deviate from its “local” targets, and yet still achieve its “global”
¤
¤
target capital structure when the capital structures of all its subsidiaries are
consolidated.
This may be done to offset abnormal degrees of financial leverage in certain
subsidiaries as necessitated by local conditions.
However, this strategy is rational only if it is acceptable by the MNC’s
creditors and investors.
16
Impact of Multinational Capital Structure
Decisions on an MNC’s Value
Parent’s capital structure decisions
m
E CFj , t E ER j , t
n
j 1
Value =
t
t =1
1 k
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 = the weighted average cost of capital of the U.S. parent
16
Chapter Review
• Cost of Capital
• Cost of Capital for MNCs versus Domestic Firms
¤
¤
¤
¤
¤
¤
Size of Firm
Access to International Capital Markets
International Diversification
Exposure to Exchange Rate Risk
Exposure to Country Risk
Capital Asset Pricing Model
16
• Chapter Review
¤ Costs of Capital Across Countries
-
-
Country Differences in the Cost of Debt
» Differences in the Risk-Free Rate
» Differences in the Risk Premium
Country Differences in the Cost of Equity
¤ Using the Cost of Capital for Assessing Foreign Projects
¤ The MNC’s Capital Structure Decision
-
-
Influence of Corporate Characteristics
» Stability of MNC’s Cash Flows
» MNC’s Credit Risk
» MNC’s Access to Retained Earnings
» MNC’s Guarantees on Debt
» MNC’s Agency Problems
Influence of Country Characteristics
» Stock Restrictions in Host Countries
» Interest Rates in Host Countries
» Strength of Host Country Currencies
» Country Risk in Host Countries
» Tax Laws in Host Countries
¤ Interaction Between Subsidiary and Parent Financing Decisions
-
Impact of Increased Debt Financing by the Subsidiary
Impact of Reduced Debt Financing by the Subsidiary
¤ Using a Target Capital Structure on a Local versus Global Basis
¤ Impact of Capital Structure Decisions on an MNC’s Value
17
CHAPTER 18
Long-Term Financing
© 2000 South-Western College Publishing
• Chapter Objectives
¤ To explain why MNCs consider long-term financing in foreign currencies;
¤ To explain how to assess the feasibility of long-term financing in foreign
¤
currencies; and
To explain how the assessment of long-term financing in foreign currencies
is adjusted for bonds with floating interest rates.
• Long-Term Financing Decision
¤ To make the long-term financing decision, the MNC must
1
2
3
3
determine the amount of funds needed,
forecast the price (interest rate) at which the bond may be issued,
forecast the periodic exchange rates for the borrowed currency over the life of the bond, and
account for the uncertainty of the actual financing costs that will be incurred.
Long-Term Financing Decision
Annualized Bond Yields
(10-year maturity, as of June 1998)
40
30
20
10
0
17
• Comparing Bond Denomination Alternatives
¤ One approach to assessing a currency is to forecast its exchange rate for each
point in time that a payment is needed, in order to determine the home currency
required.
¤ Alternatively, exchange rate probabilities can be developed to compute the
expected cost of financing.
¤ The probability distributions of exchange rates can also be fed into a simulation
program to generate a probability distribution of financing costs.
• Financing with Floating-Rate Eurobonds
¤ Eurobonds are often issued with a floating coupon rate. For example, the rate
¤
may be tied to the London Interbank Offer Rate (LIBOR).
If the coupon rate is floating, projections are required for both exchange rates
and interest rates.
• Exchange Rate Risk of Foreign Bonds
¤ Some foreign currencies exhibit more risk than others.
¤ The exchange rate risk from financing with bonds in foreign currencies can be
hedged with
1
2
3
offsetting cash inflows in that currency,
forward contracts, or
currency swaps.
• Long-Term Financing in Multiple Currencies
¤ Sometimes, the appropriate selection for a borrower may be a portfolio of
¤
¤
bonds denominated in various diversified currencies.
To avoid the higher transactions costs associated with issuing various types of
bonds, the MNC may develop a currency cocktail bond.
A popular currency cocktail is the Special Drawing Right (SDR), which is a
weighted composite of various major currencies.
17
• Using Swaps to Hedge Financing Costs
¤ Interest rate swaps can be used to hedge interest rate risk. They enable a
¤
firm to exchange fixed rate payments for variable rate payments, or vice
versa.
Financial intermediaries are usually involved in swap agreements. They
match up participants and also assume the default risk involved for a fee.
Illustration of An Interest Rate Swap
Quality Company
Choice of 9% fixed or
LIBOR+.5% variable
Fixed Rate
Payments
at 9%
Investors in Fixed
Rate Bonds Issued
by Quality Company
Risky Company
Choice of 10.5% fixed or
LIBOR+1% variable
Variable Rate
Payments at
LIBOR+1%
Investors in Variable
Rate Bonds Issued
by Risky Company
17
Illustration of An Interest Rate Swap
Quality Company
Choice of 9% fixed or
LIBOR+.5% variable
Fixed Rate
Payments
at 9%
Investors in Fixed
Rate Bonds Issued
by Quality Company
Variable Rate
Payments at
LIBOR+.5%
Fixed Rate
Payments at
9.5%
Risky Company
Choice of 10.5% fixed or
LIBOR+1% variable
Variable Rate
Payments at
LIBOR+1%
Investors in Variable
Rate Bonds Issued
by Risky Company
Using Swaps to Hedge Financing Costs
• Currency swaps can be used to hedge exchange rate risk. They enable
•
firms to exchange currencies at periodic intervals.
An alternative method is the parallel (or back-to-back) loan, which
represents simultaneous loans provided by two parties with an agreement
to repay the loans at a specified point in the future.
17
Illustration of A Currency Swap
Marks Received From
Ongoing Operations
Mark
Payments
Miller Company
[known within the dollardenominated market]
Dollar
Payments
Investors in Dollardenominated Bonds
Issued by Miller
Dollars Received From
Ongoing Operations
Mark
Payments
Dollar
Payments
Dollar
Payments
Beck Company
[known within the markdenominated market]
Mark
Payments
Investors in Markdenominated Bonds
Issued by Beck
17
Illustration of A Parallel Loan
1
U.S. Parent
Provision
of Loans
Subsidiary of
U.S.- based MNC
that is located
in the U.K.
2
British Parent
Subsidiary of
U.K.- based MNC
that is located
in the U.S.
Repayment
of Loans in
the Currency
that was
Borrowed
Foreign Debt Maturity Decisions
• An MNC must decide on the maturity for any potential debt. To do
•
this, the MNC may want to assess the yield curve for the currency the
bond is to be denominated in.
Since the slopes of yield curves can vary among countries, the
choice of financing with long-term debt versus short-term or
medium-term debt may vary among countries too.
17
17
Yield Curves
Annualized Yield
as of June 1998
Term to Maturity
17
Yield Curves
Annualized Yield
as of June 1998
Term to Maturity
18
Impact of Long-Term Financing Decisions
on an MNC’s Value
m
E CFj , t E ER j , t
n j 1
Value =
t
t =1
1
k
Parent’s long-term financing decision
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 = the weighted average cost of capital of the U.S. parent
18
• Chapter Review
¤ Long-Term Financing Decision
¤ Comparing Bond Denomination Alternatives
-
Use of Exchange Rate Probabilities
Use of Simulation
¤ Financing with Floating-Rate Eurobonds
¤ Exchange Rate Risk of Foreign Bonds
-
Hedging Exchange Rate Risk
¤ Long-Term Financing in Multiple Currencies
-
Currency Cocktail Bonds
¤ Using Swaps to Hedge Financing Costs
-
Interest Rate Swaps
Currency Swaps
¤ Foreign Debt Maturity Decisions
¤ Impact of Long-Term Financing Decisions on an MNC’s Value
18
Part V
Short-Term Asset and Liability Management
Subsidiaries
of MNC with
Excess Funds
Deposits
Provision
of Loans
Eurobanks in
Eurocurrency
Market
Deposits
Borrow
Funds
Borrow
Funds
Borrow Funds
Purchase
Securities
Provision
of Loans
Purchase
Securities
MNC
Parent
Borrow
Funds
International
Commercial
Paper Market
Borrow
Funds
Subsidiaries
of MNC with
Deficient Funds
Borrow Funds
CHAPTER 19
Financing International Trade
© 2000 South-Western College Publishing
• Chapter Objectives
¤ To describe the methods of payment for international trade;
¤ To explain common trade finance methods; and
¤ To describe the major agencies that facilitate international trade with export
insurance and/or loan programs.
• Payment Methods for International Trade
¤ In any international trade transaction, credit is provided by either
-
the supplier (exporter),
the buyer (importer),
one or more financial institutions, or
any combination of the above.
¤ The form of credit whereby the supplier funds the entire trade cycle is known
as supplier credit.
• Payment Methods for International Trade
Method 1 : Prepayments
Time of payment : Before shipment
Goods available to buyers : After payment
Risk to exporter : None
Risk to importer : Relies completely on
exporter to ship goods as
ordered
18
• Payment Methods for International Trade
Method 2 : Letters of credit (L/C)
These are issued by a bank on behalf of the importer promising to pay the exporter upon presentation
of the shipping documents.
Time of payment : When shipment is made
Goods available to buyers : After payment
Risk to exporter : Very little or none
Risk to importer : Relies on exporter to ship
goods as described in documents
• Payment Methods for International Trade
Method 3a : Sight Drafts (bills of exchange) or
Documents against payments
These are unconditional promises drawn by the exporter instructing the buyer to pay
the face amount of the drafts.
Time of payment : On presentation of draft
Goods available to buyers : After payment
Risk to exporter : If draft is unpaid, must
dispose of goods
Risk to importer : Relies on exporter to ship
goods as described
• Payment Methods for International Trade
Method 3b : Time Drafts (bills of exchange) or
Documents against acceptance
Most transactions handled on a draft basis are processed through banking channels.
Time of payment : On maturity of draft
Goods available to buyers : Before payment
Risk to exporter : Relies on buyer to pay drafts
Risk to importer : Relies on exporter to ship
goods as described in documents
18
• Payment Methods for International Trade
Method 4 : Consignments
The exporter ships the goods to the importer while still retaining actual title to the
merchandise.
Time of payment : At time of sale by buyer
Goods available to buyers : Before payment
Risk to exporter : Allows importer to sell
inventory before paying exporter
Risk to importer : None
• Payment Methods for International Trade
Method 5 : Open accounts
The exporter ships the merchandise and expects the buyer to remit payment according
to the agreed-upon terms.
Time of payment : As agreed upon
Goods available to buyers : Before payment
Risk to exporter : Relies completely on buyer to
pay account as agreed upon
Risk to importer : None
• Trade Finance Methods
Banks play a critical role in financing trade :
¤ Accounts Receivable Financing
-
The bank’s loan to the exporter is secured by an assignment of the account receivable.
¤ Factoring, especially cross-border factoring
-
The exporting firm sells the accounts receivable to a third party known as a factor.
The factor then assumes all administrative responsibilities involved in collecting from the
buyer and the associated credit exposure.
18
• Trade Finance Methods
¤ Letters of Credit (L/C)
-
The bank undertakes to make payments on behalf of the buyer to the exporter upon presentation of the
required documents, which typically include a draft (sight or time), a commercial invoice, and a bill of lading.
Sometimes, the exporter may request that a local bank confirm the L/C.
Letters of credit are usually irrevocable.
Variations include the standby L/C, the transferable L/C, and an assignment of proceeds under the L/C.
Documentary Credit Procedure
1. Sale Contract
Importer
Exporter
5. Deliver Goods
2.
Request
for Credit
8.
6.
Documents
Present
& Claim for
Documents
Payment
7. Present Documents
Importer’s
Bank
9. Payment
4.
Deliver
Letter of
Credit
Correspondent
Bank
3. Send Credit
18
• Trade Finance Methods
¤ Banker’s Acceptance (B/A)
-
This is a time draft, drawn on and accepted by a bank. The accepting bank is obliged to pay
the holder of the draft at maturity.
The exporter does not need to worry about the credit risk of the importer. In addition, there is
little exposure to political risk or to exchange controls imposed by governments.
A B/A allows an exporter to receive funds immediately, while yet allowing an importer to delay
its payment until a future date.
Life Cycle of a Typical Banker’s Acceptance
Importer
1. Purchase Order
Exporter
5. Ship Goods
2. Apply
4. L/C
for L/C
6.
Notification
11.
10. Sign
Shipping
Shipping
Promissory
9. Pay
Documents
Documents
Note to Pay
Discounted
& Time
Value of
Draft
14. Pay
B/A
3. L/C
Face Value
8. Pay Discounted Value of B/A
of B/A
Importer’s
Exporter’s
Bank
Bank
7. Shipping Documents &
Time Draft
12. B/A
1 - 7 : Prior to B/A
16. Pay Face Value of B/A
8 -13 : When B/A
Money Market
is created
Investor
13. Pay Discounted Value of B/A
14-16 : When B/A
15. Present B/A at Maturity
matures
18
• Trade Finance Methods
¤ Working Capital Financing
-
This bank loan finances the working capital cycle that begins with the purchase of inventory
and continues until the eventual conversion to cash.
Medium-Term Capital Goods Financing (Forfaiting)
The importer issues a promissory note to pay for its imported capital goods. The exporter then
sells the note to a forfaiting bank, which then assumes total responsibility for the note.
• Trade Finance Methods
¤ Countertrade
-
This denotes all types of foreign trade transactions in which the sale of goods to one country
is linked to the purchase or exchange of goods from that same country.
Examples of countertrade include barter, compensation, and counterpurchase.
The primary participants are governments and multinationals, with assistance provided by
specialists.
• Agencies that Motivate International Trade
¤ Due to the inherent risks of international trade, insurance against the various
•
forms of risk is desirable.
¤ The Export-Import Bank is an agency of the U.S. government that aims to
finance and facilitate the export of U.S. goods and services and maintain the
competitiveness of U.S. companies in overseas markets.
¤ The Eximbank offers guarantees, loans, bank insurance, and export credit
insurance.
Agencies that Motivate International Trade
¤ The Private Export Funding Corporation (PEFCO) is owned by a U.S.
consortium of commercial banks and industrial firms.
-
It provides medium- and long-term financing for foreign buyers.
¤ The Overseas Private Investment Corporation (OPIC) is an U.S. federal
agency responsible for insuring direct U.S. investments in foreign countries
against the risks of currency inconvertibility, expropriation, and other political
risks.
19
Impact of International Trade Financing
on an MNC’s Value
Trade financing decisions
m
E CFj , t E ER j , t
n j 1
Value =
t
t =1
1
k
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 = the weighted average cost of capital of the U.S. parent
19
• Chapter Review
¤ Payment Methods for International Trade
-
Prepayments
Letters of Credit
Sight Drafts and Time Drafts
Consignments
Open Accounts
¤ Trade Finance Methods
-
Accounts Receivable Financing
Factoring
Letters of Credit
Banker’s Acceptances
Working Capital Financing
Medium-Term Capital Goods Financing (Forfaiting)
Countertrade
¤ Agencies that Motivate International Trade
-
Export-Import Bank of the U.S.
Private Export Funding Corporation
Overseas Private Investment Corporation
¤ Impact of International Trade Financing on an MNC’s Value
19
CHAPTER 20
Short-Term Financing
© 2000 South-Western College Publishing
• Chapter Objectives
¤ To explain why MNCs consider foreign financing;
¤ To explain how MNCs determine whether to use foreign financing; and
¤ To illustrate the possible benefits of financing with a portfolio of currencies.
• Sources of Short-Term Financing
¤ Euronotes are unsecured debt securities with typical maturities of 1, 3 or 6
months. They are underwritten by commercial banks.
¤ MNCs may also issue Euro-commercial papers to obtain short-term
financing.
¤ MNCs typically utilize direct Eurobank loans to maintain their relationships
with Eurobanks too.
• Internal Financing by MNCs
¤ Before an MNC’s parent or subsidiary searches for outside funding, it should
¤
determine if any internal funds are available.
Parents of MNCs may also raise funds by increasing their markups on the
supplies that they send to their subsidiaries.
• Why MNCs Consider Foreign Financing
¤ An MNC may finance in a foreign currency to offset a net receivables
¤
position in that foreign currency.
The cost of financing may vary with the currency borrowed in the
Eurocurrency market. A Eurocurrency loan may also offer a slightly lower
rate than a loan in the same currency through the home country.
19
• Determining the Effective Financing Rate
¤ The actual cost of financing is dependent on
1
2
the interest rate on the loan, and
the movement in the borrowed currency’s value over the life of the loan.
¤ Effective financing rate = ( 1+ if ) ( 1+ ef ) - 1
where if = interest rate on the loan
ef = % D in the currency’s spot rate
• Criteria Considered for Foreign Financing
¤ There are various criteria an MNC must consider in its financing decision,
including
-
interest rate parity,
the forward rate as a forecast, and
exchange rate forecasts.
¤ If interest rate parity exists, foreign financing with a simultaneous hedge of
that position in the forward market will result in financing costs similar to
those for domestic financing.
19
Implications of IRP for Financing
IRP
holds?
Yes
Yes
Yes
Yes
No
No
Scenario
Type of Financing
costs*
financing
Covered
Similar
Forward rate accurately
Uncovered Similar
predicts future spot rate
Forward rate overestimates future spot rate Uncovered Lower
Forward rate underestimates future spot rate Uncovered Higher
Forward premium(discount)
exceeds (is less than)
Covered
Higher
interest rate differential
Forward premium (discount)
is less than (exceeds)
Covered
Lower
interest rate differential
* as compared to the financing costs for domestic financing
19
• Criteria Considered for Foreign Financing
¤ If the forward rate is an unbiased predictor of the future spot rate, then the
¤
effective financing rate of a foreign currency will on average be equal to the
domestic financing rate.
Exchange rate forecasts will also assist the firm in its financing decision.
Sometimes, it may be useful to develop a probability distribution, instead of
relying on a single point estimate.
• Financing with a Portfolio of Currencies
¤ While foreign financing can result in lower financing costs, the variance in
¤
¤
the costs is higher.
MNCs may be able to achieve lower financing costs without excessive risk
by financing with a portfolio of currencies.
This is so because if the chosen currencies are not highly correlated, they
are not likely to appreciate simultaneously to offset the advantage given by
their low interest rates.
• Financing with a Portfolio of Currencies
¤ A firm that repeatedly finances in a currency portfolio will normally prefer to
¤
¤
compose a financing package that exhibits a somewhat predictable effective
financing rate.
The portfolio variance can measure how volatile the portfolio’s effective
financing rate is.
Hence, MNCs can use historical variability to compare various financing
packages.
19
Impact of Short-Term Financing Decisions
on an MNC’s Value
Expenses incurred from
short-term financing
m
E CFj , t E ER j , t
n j 1
Value =
t =1
1 k t
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 = the weighted average cost of capital of the U.S. parent
19
• Chapter Review
¤ Sources of Short-Term Financing
¤ Internal Financing by MNCs
¤ Why MNCs Consider Foreign Financing
-
Foreign Financing to Offset Foreign Receivables
Foreign Financing to Reduce Costs
¤ Determining the Effective Financing Rate
• Chapter Review
¤ Criteria Considered for Foreign Financing
-
Interest Rate Parity
The Forward Rate as a Forecast
Exchange Rate Forecasts
¤ Financing with a Portfolio of Currencies
-
Portfolio Diversification Effects
Repeated Financing with a Currency Portfolio
¤ Impact of Short-Term Financing Decisions on an MNC’s Value
19
CHAPTER 21
International Cash Management
© 2000 South-Western College Publishing
• Chapter Objectives
¤ To explain the difference between a subsidiary perspective and a parent
¤
¤
¤
perspective in analyzing cash flows;
To explain the various techniques used to optimize cash flows;
To explain common complications in optimizing cash flows; and
To explain the potential benefits and risks of foreign investments.
• Cash Flow Analysis:
Subsidiary Perspective
¤ The management of working capital has a direct influence on the amount
and timing of cash flow :
-
inventory management
accounts receivable management
cash management
liquidity management
• Centralized Cash Flow Management
¤ While each subsidiary is managing its working capital, there is a need to
¤
¤
monitor and manage the cash flows between the parent and its subsidiaries.
This task of international cash management should be delegated to a
centralized cash management group, and can be segmented into two
functions:
optimizing cash flow movements, and
-
investing excess cash.
20
Cash Flow of the Overall MNC
Interest &/or Principal
Purchase
Loans or Investment
Sale
Fees & Earnings
Short-Term
Securities
Long-Term
Investment
Subsidiary Excess Cash
Return on Long-Term
Investment Projects
Funds for
Supplies
Parent
Loans
Subsidiary Excess Cash
Sources
of Debt
Repayment
Fees & Earnings
Loans or Investment
Interest &/or Principal
New Issues
Stockholders
Cash Dividends
20
• Techniques to Optimize Cash Flows
1. Accelerating Cash Inflows
¤ The more quickly the inflows are received, the more quickly they can be
invested or used for other purposes.
¤ Common methods include the establishment of lockboxes around the world
and preauthorized payments.
• Techniques to Optimize Cash Flows
2. Minimizing Currency Conversion Costs
¤ Netting is the accounting of all transactions over a period to determine one
net payment.
¤ A bilateral netting system involves transactions between two units, such as
between a parent and its subsidiary, or between two subsidiaries.
¤ A multilateral netting system usually involves more complex interchanges
among the parent and several subsidiaries.
• Techniques to Optimize Cash Flows
3. Managing Blocked Funds
¤ A government may require funds to remain within the country in order to
create jobs and reduce unemployment.
¤ To deal with funds blockage, the MNC may reinvest the excess funds in the
host country, adjust the transfer pricing policy, borrow locally to finance
operations, or find a use for the funds within the host country.
20
• Techniques to Optimize Cash Flows
4. Managing Intersubsidiary Cash Transfers
¤ Proper cash flow management can also be beneficial to a subsidiary in need
of funds.
¤ For example, a subsidiary with excess funds can provide financing by paying
for its supplies earlier than is necessary. This is called leading.
¤ Alternatively, a subsidiary in need of funds can be allowed to lag its
payments. This is called lagging.
• Complications in Optimizing Cash Flows
¤ Company-Related Characteristics
-
When a subsidiary delays its payments to the other subsidiaries, the other subsidiaries may
be forced to borrow until the payments arrive.
Government restrictions
Some governments may prohibit the use of a netting system, or periodically prevent cash
from leaving the country.
• Complications in Optimizing Cash Flows
¤ Characteristics of Banking Systems
-
The abilities of banks to facilitate cash transfers for MNCs may vary among countries.
• Investing Excess Cash
¤ Should the excess cash of all subsidiaries remain separated or should they
be pooled together?
Centralized cash management allows for more efficient usage of funds and
possibly higher returns.
However, the pooling and matching of funds may result in excessive
transaction costs, especially when the subsidiaries are transacting in
different currencies.
20
• Investing Excess Cash
¤ How can the MNC determine the effective yield expected from each
alternative?
The effective yield for foreign deposits is
quoted
% D in the
(1 + interest )(1 + the currency ) – 1
rate
value
The above relation can be similarly applied to other short-term foreign
investments.
• Investing Excess Cash
¤ What does interest rate parity (IRP) suggest about short-term investing?
A foreign currency with a high interest rate will normally exhibit a forward
discount that reflects the differential between its interest rate and the
investor’s home interest rate.
However, even if IRP holds, short-term foreign investing on an uncovered
basis may result in a higher effective yield than domestic investing.
• Investing Excess Cash
¤ How can the forward rate be used to evaluate the short-term investment
decision?
If IRP exists, the forward rate can be used as a break-even point to assess
the short-term investment decision.
The effective yield is higher if the spot rate at maturity is more than the
forward rate at the time the investment is undertaken, and vice versa.
20
Use of the Forward Rate as a Forecast
IRP
holds?
Yes
Scenario
Type of
Financing
financing
costs*
Covered
Similar
Forward rate accurately
Uncovere
Similar
predicts future spot
d
rate
Similar on
Forward rate forecasts
Uncovered
Yes
average
future spot rate with no
bias
Forward
rate overUncovered
Lower
Yes
estimates future spot
rate
Forward
rate underUncovered Higher
Yes
estimates future spot
rate
Forward
premium(discount)
Covered
Higher
No
exceeds (is less than)
interest
ratepremium
differential
Forward
(discount)
No
Covered
Lower
is less than (exceeds)
interest
differential
* as compared
to the rate
financing
costs for domestic financing
Yes
20
• Investing Excess Cash
¤ How can forecasted exchange rates influence the short-term investment
decision?
Given an exchange rate forecast, the effective yield can be forecasted, and
then compared with the yield on a local currency deposit.
By rearranging terms, the exchange rate percentage change that equates
foreign and domestic yields can also be computed.
At times, it may be useful to use a probability distribution instead of a single
prediction.
• Investing Excess Cash
¤ Is it worthwhile to diversify investments among currencies?
If an MNC is not sure how exchange rates will change over time, it may
prefer to diversify its cash among securities with different currency
denominations.
The degree to which such a portfolio will reduce risk depends on the
correlations among the currencies.
• Investing Excess Cash
¤ Some banks offer dynamic hedging for firms that invest in short-term
¤
¤
securities denominated in foreign currencies.
Dynamic hedging reflects periodic hedging by the bank : hedges are applied
when the currencies held are expected to depreciate and removed when
they are expected to appreciate.
The overall performance is dependent on the manager’s ability to forecast
the direction of exchange rate movements.
20
Impact of Direct Foreign Investment
Decisions on an MNC’s Value
Returns on International
Cash Management
m
E CFj , t E ER j , t
n
j 1
Value =
t
t =1
1 k
E (CFj,t ) = expected cash flows in currency j to be received
by the U.S. parent in 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
20
• Chapter Review
¤ Cash Flow Analysis: Subsidiary Perspective
¤ Centralized Cash Management
¤ Techniques to Optimize Cash Flows
-
-
Accelerating Cash Inflows
Minimizing Currency Conversion Costs
Managing Blocked Funds
Managing Intersubsidiary Cash Transfers
• Chapter Review
¤ Complications in Optimizing Cash Flows
-
Company-Related Characteristics
Government Restrictions
Characteristics of Banking Systems
• Chapter Review
¤ Investing Excess Cash
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Centralized Cash Management
Determining the Effective Yield
Implications of Interest Rate Parity
Use of the Forward Rate as a Forecast
Use of Exchange Rate Forecasts
Diversifying Cash Across Currencies
Using Dynamic Hedging to Hedge Investments
¤ Impact of International Cash Management on an MNC’s Value
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