e fac e

co n tep rnts
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Preface xii

Part One Foundations of International Financial Management 1

1
2
3
4
5

Globalization and the Multinational Firm, 2

International Monetary System, 26
Balance of Payments, 52
The Market for Foreign Exchange, 68
International Parity Relationships and Forecasting Foreign
Exchange Rates, 96

Part Two World Financial Markets and Institutions 124

6
7
8
9
10
11

International Banking and Money Market, 125

International Bond Market, 152
International Equity Markets, 177
Futures and Options on Foreign Exchange, 203
Interest Rate and Currency Swaps, 232
International Portfolio Investment, 253

Part Three Foreign Exchange Exposure and Management 287

12 Management of Economic Exposure, 288

13 Management of Transaction Exposure, 313
14 Management of Translation Exposure, 335

Part Four Financial Management of the Multinational Firm 353

15
16
17
18
19
20
21

Foreign Direct Investment and Cross-Border Acquisitions, 354

International Capital Structure and the Cost of Capital, 387
International Capital Budgeting, 414
Multinational Cash Management, 431
Exports and Imports, 452
International Tax Environment, 469
Corporate Governance around the World, 486

Glossary 510
Index 521

c on
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co
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Preface xii

Part One
Chapter 1

Globalization and
the Multinational
Firm 2

Foundations of International Financial Management 1

1.1 What Is Special about International
Finance? 3
Foreign Exchange and Political Risk 3
Market Imperfections 5
Expanded Opportunity Set 6

International
Monetary
System 26

Trade Liberalization and Economic

Integration 10
Privatization 12
1.4 Multinational Corporations 13

1.2 Goals for International Financial

Management 6

1.5 Organization of the Text 15

1.3 Globalization of the World Economy:

Recent Trends 7

Mini Case: Nikes Decision 23

Emergence of Globalized Financial

Markets 7

Chapter 2

The Euro 9

2.1 Evolution of the International Monetary

System 27

Summary 21
Appendix 1A: Gains from Trade: The Theory of
Comparative Advantage 24

2.9 The Euro and the European Monetary

Union 39

2.2 Bimetallism: Before 1875 57

A Brief History of the Euro 40

2.3 Classical Gold Standard:

18751914 28

What Are the Benefits of the Monetary

Union? 41

2.4 Interwar Period: 19151944 29

Costs of the Monetary Union 43

2.5 Bretton Woods System: 19451972 30

Prospects of the Euro: Some Critical

Questions 44

2.6 The Flexible Exchange Rate Regime:

1973Present 33
2.7 The Current Exchange Rate
Arrangements 34

2.10 Fixed Versus Flexible Exchange Rate

Regimes 46
Summary 49

2.8 European Monetary System 38

Mini Case: Will the United Kingdom Join

the Euro Club? 51

Chapter 3

3.1 Canadas Balance of Payments 52

Summary 64

Balance of
Payments 52

3.2 Balance of Payments Accounts 53

Mini Case: Mexicos Balance-of-Payments

Problem 66

The Current Account 56

The Capital Account 57
External Balance and the Exchange
Rate 59

Appendix 3A: The Relationship between

Balance of Payments and National Income
Accounting 67

3.3 Balance-of-Payments Trends in Major

Countries 61

Chapter 4

The Market
for Foreign
Exchange 68

4.1 Function and Structure of the FOREX

Market 69
FX Market Participants 74

Alternative Expressions for the

Cross-Exchange Rate 81

Correspondent Banking Relationships 75

The Cross-Rate Trading Desk 82

4.2 The Spot Market 76

Spot Rate Quotations 76
The Bid-Ask Spread 79
Spot FX Trading 80

vi

Cross-Exchange Rate Quotations 80

Triangular Arbitrage 83
Spot Foreign Exchange Market
Microstructure 84

contents

vii

4.3 The Forward Market 86

Summary 92

Forward Cross-Exchange Rates 89

Mini Case: Shrewsbury Herbal Products,

Ltd. 95

Swap Transactions 89

Chapter 5

International Parity
Relationships
and Forecasting
Foreign Exchange
Rates 96

Forward Premium 91

Forward Rate Quotations 86

5.1 Interest Rate Parity 96

Interest Rate Parity and Exchange Rate
Determination 100
Reasons for Deviations from Interest Rate
Parity 101
5.2 Purchasing Power Parity 103
PPP Deviations and the Real Exchange
Rate 106
Real versus Nominal Exchange Rates
A Closer Look 107

5.3 Fisher Effects 112

5.4 Forecasting Exchange Rates 113
Efficient Market Approach 113
Fundamental Approach 114
Technical Approach 115
Performance of the Forecasters 116
Summary 119
Mini Case: Turkish Lira and Purchasing
Power Parity 122

Evidence on Purchasing Power Parity 110

PART TWO
Chapter 6

International
Banking and Money
Market 125

World Financial Markets and Institutions 124

6.1 International Banking Services 125
The Worlds Largest Banks 126
6.2 Types of International Banking
Offices 128

Global Debt Crisis of the 1980s 138

Mexican Peso Crisis 140

Representative Offices 128

Asian Financial Crisis, 1997 141

Foreign Branches 128

Subsidiary and Affiliate Banks 129

Argentinas Currency Board Collapse,

2002 144

Edge Act Banks 130

Japanese Banking: A Crisis? 144

Offshore Banking Centres 130

US Sub-Prime Implosion and Credit

Crunch, 2007 146

6.4 International Money Market 132

Eurocurrency Market 132
Eurocredits 134

International Bond
Market 152

Eurocommercial Paper 137

6.5 International Financial Crises 137

Correspondent Bank 128

6.3 Capital Adequacy Standards 130

Chapter 7

Euronotes 137

7.1 The Worlds Bond Markets: A Statistical

Overview 153
7.2 Foreign Bonds and Eurobonds 153
Bearer Bonds and Registered Bonds 154
National Security Regulations 155
Withholding Taxes 156
Other Regulatory Changes 156
Global Bonds 157
7.3 Types of Instruments 157
Straight Fixed-Rate Issues 157
Euro-Medium-Term Notes 158
Floating-Rate Notes 158
Equity-Related Bonds 159

Summary 146
Mini Case: Detroit Motors Latin American
Expansion 148
Appendix 6A: Eurocurrency Creation 150

Zero-Coupon Bonds 159

Dual-Currency Bonds 160
7.4 International Bonds and Notes: Currency,
Nationality and Type of Issuer 161
7.5 International Bond Market Credit
Ratings 163
7.6 Eurobond Market Structure and
Practices 168
Primary Market 168
Secondary Market 170
Clearing Procedures 171
7.7 International Bond Market Indexes 171
Summary 174

viii

contents

Chapter 8

International
Equity
Markets 177

8.1 A Statistical Perspective 177

Market Capitalization of Emerging
Markets 179
Measures of Liquidity 182
Primary and Secondary Markets 180
8.2 International Equity Market
Benchmarks 183
iShares MSCI 184
8.3 Trading in International Equities 184
Cross-Listing of Shares 184

The European Stock Market 192

Depository Receipts 193
Global Registered Shares 197
8.4 Factors Affecting International Equity
Returns 197
Macroeconomic Factors 198
Exchange Rates 198
Industrial Structure 198
Summary 199
Mini Case: regional reviewasia-pacific 200

Canadian Cross-Listed Shares 189

Chapter 9

Futures and
Options on Foreign
Exchange 203

9.1 Futures Contracts: Some

Preliminaries 204

9.8 Currency Option-Pricing Relationships

at Expiry 218

9.2 Currency Futures Markets 206

Hedging With Currency Options 221

9.3 Basic Currency Futures Relationships 206

Comparing the Forward, Futures and

Options Hedges 222

Speculating and Hedging with Currency

Futures: Managerial Perspectives 212
9.4 Eurodollar Interest Rate Futures
Contracts 213
9.5 Currency Options: Some
Preliminaries 214
9.6 Market Structure 217

Currency Options Pricing: What a

Manager Should Know 224
Summary 225
Mini Case: The Options Speculator 229
Appendix 9A: Foreign Currency Option Pricing
Model 230

9.7 Currency Futures Options 000

Chapter 10

10.1 Types of Swaps 232

Interest Rate
and Currency
Swaps 232

10.2 Size of the Swap Market 233

10.3 The Swap Bank 233
10.4 Interest Rate Swap Illustration 234
10.5 Another Interest Rate Swap Illustration
Highlighting the Quality Spread
Differential and Costs 236
Unwinding an Interest Rate Swap 238

Chapter 11

International
Portfolio
Investment 253

Pricing the Currency Swap 244

10.9 Finally, A Little More Realism on Currency
Swaps 244
10.10 Variations of Basic Currency and interest
Rate Swaps 245
10.11 Risks of Interest Rate and Currency
Swaps 245
10.12 Is the Swap Market Efficient? 246

10.6 Interest Rate Swap Quotations 238

10.13 Concluding Points about Swaps 247

10.7 Currency Swaps 240

Summary 248

10.8 Equivalency of Currency Swap Debt

Service 243

Mini Case: The centralia Corporations

Currency Swap 252

11.1 Portfolio ArithmeticInternational

Perspectives 254

11.6 International Diversification with

WEBS 271

International Portfolio Diversification 256

11.2 Optimal International Portfolio
Selection 257
International Portfolio DesignThe Simple
Case of 2 261
International DiversificationAn Extensive
Illustration 262

11.7 International Diversification with Hedge

Funds 271
11.8 Why Home Bias in Portfolio
Holdings? 276
Summary 277
Mini Case: Solving for the Optimal
International Portfolio 281

11.3 International Mutual Funds: Access to the

World 265

Appendix 11A: International Investment with

Exchange Risk Hedging 283

11.4 International Diversification through

Country Funds 267

Appendix 11B: Solving for the Optimal

Portfolio 285

11.5 International Diversification with

ADRs 269

contents

ix

PART THREE Foreign Exchange Exposure and Management 287

Chapter 12

12.1 Three Types of Exposure 291

Management
of Economic
Exposure 288

12.2 How to Measure Economic Exposure 292

R&D Efforts and Product

Differentiation 304

12.3 Operating Exposure: Definition 296

Financial Hedging 304

12.4 Illustration of Operating Exposure 296

How Canadian Firms Deal with Economic

Exposure 304

12.5 Determinants of Operating Exposure 299

Pass-through Canadian Evidence 301
12.6 Managing Operating Exposure 302

Managerial and Strategic Perspectives

on Economic Exposure 305

Selecting Low-Cost Production Sites 302

Illustrated Mini Case: Exchange Rate

Management at Merck 307

Flexible Sourcing Policy 303

Summary 309

Diversification of the Market 303

Mini Case: Economic Exposure of Calais

Computers PLC 311

Chapter 13

13.1 Forward Hedge 314

13.7 Hedging through Invoice Currency 324

Management
of Transaction
Exposure 313

13.2 Money Market Hedge 317

13.8 Hedging via Lead and Lag 325

13.3 Options Hedge 318

13.9 Exposure Netting 325

13.4 Cross-Hedging Minor Currency

Exposure 321

13.10 Should the Firm Hedge? 326

13.5 Hedging Contingent Exposure 322

Chapter 14

Management
of Translation
Exposure 335

13.11 What Risk Management Products Do

Firms Use? 328

13.6 Hedging Recurrent Exposure with Swap

Contracts 323

Summary 330

14.1 Translation Methods 337

14.2 Management of Translation

Exposure 345

Foreign Operations 337

Mini Case: barricks real option on tires 333

Two Approaches to Translation:

Current Rate Method and the Temporal
Approach 337

Hedging Translation Exposure 346

Temporal Method 339

Translation Exposure versus Operating

Exposure 348

Which Method in Canada: Current Rate or

Temporal 339
Illustrated Mini Case: Consolidation of
Accounts According to the CICA Handbook
Section 1650: The Maple Corporation 342

Balance Sheet Hedge 347

Derivatives Hedge 347

14.3 Analysis of a Change in Accounting for

Translation Gains and Losses 349
Summary 349
Mini Case: Sundance Sporting Goods,
Inc. 350

PART FOUR Financial Management of the Multinational Firm 353

Chapter 15

15.1 Global Trends in FDI 357

Foreign Direct
Investment and
Cross-Border
Acquisitions 354

15.2 Why Do Firms Invest Overseas? 360

15.3 Cross-Border Mergers and

Acquisitions 367

Trade Barriers 361

15.4 Political Risk and FDI 374

Imperfect Labour Market 361

Summary 382

Intangible Assets 362

Mini Case 1: Inward and outwards

(FDI)Enhancing the competitiveness
of countries 384

Vertical Integration 364

Product Life Cycle 364
Shareholder Diversification Services 367

Mini Case 2: enron versus bombay

385

politicians

contents

Chapter 16

16.1 Cost of Capital 388

International
Capital Structure
and the Cost of
Capital 387

16.2 Cost of Capital in Segmented versus

Integrated Markets 389
16.3 Adjusting the Cost of Equity to Account
for Country-Specific Risk 391
An Illustration with Date 392

Asset Pricing under Foreign Ownership

Restrictions 406
16.8 The Financial Structure of
Subsidiaries 408

Illustrated Mini Case: Novo Industri 396

Summary 410

16.5 Cross-Border Listings of Shares 398

Appendix 16A: Pricing of Nontradable Assets:

Numerical Simulations 413

Chapter 17

17.1 Review of Capital Budgeting 414

International
Capital
Budgeting 414

17.2 Adjusted Present Value 416

17.3 Capital Budgeting from the Parent Firms
Perspective 417

17.4 Risk Adjustment in Capital

Budgeting 424
17.5 Sensitivity Analysis 425
17.6 Real Options 425

Generality of the APV Model 419

Summary 427

Estimating the Future Expected Exchange

Rate 420

Mini Case 1: Dorchester 428

Illustrated Mini Case: Research In Motion/

Europe 420

Multinational Cash
Management 431

Pricing-to-Market Phenomenon 404

Illustrated Mini Case: Nestl 405

16.4 Does the Cost of Capital Differ Among

Countries? 393

16.6 Capital Asset Pricing under CrossListings 402

Chapter 18

16.7 The Effect of Foreign Equity Ownership

Restrictions 404

18.1 Management of International Cash

Balances 431
Illustrated Mini Case: Teltrexs Cash
Management System 432
18.2 Reduction in Precautionary Cash
Balances 437
18.3 Bilateral Netting of Internal and External
Net Cash Flows 437
18.4 Transfer Pricing and Related Issues 439
Illustrated Mini Case: Mintel Products
Transfer Pricing Strategy 441

Chapter 19

19.1 A Typical Foreign Trade Transaction 453

Exports and
Imports 452

19.2 Export Finance 457

Mini Case 2: Timmins Gold Mining

Company 429

Miscellaneous Factors 446

18.5 Blocked Funds 446
Summary 448
Mini Case 1: Efficient Funds Flow at Eastern
Trading Company 449
Mini Case 2: Eastern Trading Companys
Optimal Transfer Pricing Strategy 450
Mini Case 3: Eastern Trading Companys
New MBA 450

Governing Agreements and CIRR

Rates 462

Buyer Credits and Lines of Credit 457

19.4 Intra-firm International Trade 463

Supplier Credit and Forfaiting 458

19.5 Countertrade 464

Forfait FinanceAn Example 459

Forms of Countertrade 464

International Leasing 460

Some Generalizations about

Countertrade 465

19.3 Government Financial Support of

Exports 460

Summary 466
Mini Case: Manitoba Machine Tools,
Inc. 467

Chapter 20

International Tax
Environment 469

20.1 The Objectives of Taxation 469

Tax Neutrality 469

Taxes and Transfer Pricing 471

20.2 Types of Taxation 472

National Treatment 470

Income Tax 472

The Canadian versus the American Way

of Taxing Multinational Enterprise 470

Withholding Tax 472

Value-Added Tax 474

contents

xi

20.3 National Tax Environments 476

Worldwide Taxation 476

Tax Havens 480

Controlled Foreign Corporation 482

Territorial Taxation 476

Summary 483

Foreign Tax Credits 476

Mini Case 1: Sigma Corp.s Location

Decision 485

20.4 Organizational Structures for Reducing

Tax Liabilities 477
Branch and Subsidiary Income 477

Mini Case 2: Transfer Pricing Cases

Before the Courts 485

Payments to and from Foreign

Affiliates 479

Chapter 21

Corporate
Governance around
the World 486

21.1 Governance of the Public Corporation:

Key Issues 486

21.5 Consequences of Law 498

Ownership and Control Pattern 498

21.2 The Agency Problem 488

Private Benefits of Control 502

21.3 Remedies for the Agency Problem 492

Capital Markets and Valuation 502

Board of Directors 490

21.6 Corporate Governance Reform 503

Incentive Contracts 491

Objectives of Reform 503

Concentrated Ownership 492

Political Dynamics 504

Debt 493

The Cadbury Code of Best Practice 505

Overseas Shares Listings 494

Summary 506

Market for Corporate Control 494

Mini Case: Parmalat: Europes Enron 507

21.4 Law and Corporate Governance 495

Glossary 510
Index 521