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Dividend
Remittance
Exporting & Financing Investing
& Importing & Financing
3
Theories of International Business
1 2
Firm creates Firm exports 3
product to product to Firm
accommodate accommodate establishes
local demand. foreign demand. foreign
subsidiary
to establish
4a or presence in
Firm differentiates 4b foreign
product from Firm’s foreign country and
competitors and/or business declines possibly to
expands product as its competitive reduce
line in foreign advantages are costs.
country. eliminated.
• 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
Purely
Domestic
Firm MNC
Marginal
Return on
Projects MNC
Purely
Marginal Domestic
Cost of Firm
Capital
Appropriate
Size for Purely Appropriate
Domestic Firm Size for MNC
X 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
8
Overview of an MNC’s Cash Flows
9
Overview of an MNC’s Cash Flows
n E CF$, t
Value =
t =1 1 k t
11
Valuation Model for an MNC
m
E CFj , t E ER j , t
n j 1
Value =
t =1 1 k t
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
m
E CFj , t E ER j , t
n j 1
Value =
t =1 1 k t
13
How Chapters Relate to Valuation
Exchange Rate
Behavior Exchange Rate
(Chapters 6-8) Risk Management
(Chapters 9-12)
Background
on Long-Term
International Investment and
Financial Risk and Value and
Financing Return of Stock Price
Markets Decisions
(Chapters MNC of MNC
(Chapters 13-18)
2-5)
Short-Term
Investment and
Financing
Decisions
(Chapters 19-21)
• 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
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
correction methods can be developed.
¤ However, a weak home currency may not necessarily improve a trade deficit
due to: J Curve Effect
- revised pricing policy by foreign competition,
- weakening of some other currencies,
trade prearrangements (J curve effect), and
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.
• Agencies that Facilitate International Flows
¤ International Monetary Fund (IMF)
- 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
¤ 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.
m
n
E CFj , t E ER j , t
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
• 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 ¤ Government Restrictions
- National Income ¤ 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
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 =
of currency B value of currency B in $
• 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
S
Interest Interest
Rate Rate
for $ 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
Improved global image from Cost of borrowing funds in
E (CFj,t ) = expected cash issuing stock in global markets global markets
flows in currency j to be
received by the U.S. parent
m
E CFj , t E ER j , t
at the end of period t
E (ERj,t ) = expected
n j 1
exchange rate at which Value =
currency j can be t =1 1 k t
converted to dollars at the
end of period t
Cost of parent’s equity in global Cost of parent’s
k = the weighted average
markets funds borrowed in
cost of capital of the U.S. global markets
parent
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
37
Exchange Rate Equilibrium
Value of £
S
equilibrium
exchange
rate
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 £ S2
S
r2
r
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 £ S
S2
r
r2
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
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
U.S. demand for foreign
1. Inflation goods, i.e. demand for
Differential foreign currency
2. Income
Differential Foreign demand for U.S.
3. Gov’t Trade goods, i.e. supply of Exchange
Restrictions foreign currency rate
between
foreign
Financial U.S. demand for foreign currency
Factors securities, i.e. demand and the
1. Interest Rate for foreign currency dollar
Differential
2. Capital Flow Foreign demand for U.S.
securities, i.e. supply of
Restrictions
foreign currency
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
How Factors Have Influenced Exchange Rates
140
Persian Gulf War
100
high U.S. large balance of
inflation trade deficit
60
1972 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
Borrows at 7.20%
for 30 days
1. Borrows 4. Holds
$20 million $20,912,320
Returns $20,120,000
Profit of $792,320
Exchange at Exchange at
$0.50/NZ$ $0.52/NZ$
Lends at 6.48%
2. Holds for 30 days 3. Receives
NZ$40 million NZ$40,216,000
47
Speculating on Anticipated Exchange Rates
Borrows at 6.96%
for 30 days
1. Borrows 4. Holds
NZ$40 million NZ$41,900,000
Returns NZ$40,232,000
Profit of NZ$1,668,000
Exchange at or $800,640 Exchange at
$0.50/NZ$ $0.48/NZ$
Lends at 6.72%
2. Holds for 30 days 3. Receives
$20 million $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
n
E CFj , t E ER j , t
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
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
¤ 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 ¤ Marketplace
- Delivery date ¤ Regulation
- Participants ¤ Liquidation
- Security deposit ¤ Transaction costs
- Clearing operation
¤ 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
+$.06 +$.06
+$.04 +$.04
+$.02 +$.02
- $.06 - $.06
57
Contingency Graphs for Put Options
+$.06 +$.06
+$.04 +$.04
+$.02 +$.02
- $.06 - $.06
58
Conditional Currency Options
59
Conditional Currency Options
$1.80
$1.78 Basic Put
$1.76
$1.74
$1.72
Conditional Put
$1.70
$1.68
$1.66
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
63
Part II Exchange Rate Behavior
Existing spot
locational
arbitrage
exchange rates
Existing spot at other locations
exchange rate
triangular Existing cross
arbitrage exchange rates
covered interest arbitrage of currencies
international
Existing interest Fisher effect Future exchange
rate differential rate movements
CHAPTER 6
S S1
S2
Value of £
Value of £
V2 V1
V1 V2
D2
D1 D
Quantity of £ 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
Government
Purchases & Sales
of Currencies
Government Intervention in
Tax Laws, Foreign Exchange Market Quotas,
etc. Tariffs, etc.
72
Impact of Central Bank Intervention
on an MNC’s Value
Direct intervention
Indirect intervention
m
n
E CFj , t E ER j , t
j 1
Value =
t =1 1 k t
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
78
Graphic Analysis of Interest Rate Parity
Forward -3 -1 1 3 Forward
Discount (%) Premium (%)
-2
-4
79
Graphic Analysis of Interest Rate Parity
4
IRP line
Zone of potential
covered interest
arbitrage by
foreign investors 2
Forward
Discount (%) -1
-3 1 3 Forward
Premium (%)
Zone where
covered Zone of potential
interest - 2 covered interest
arbitrage is arbitrage by
not feasible local investors
-4
80
Interest Rate Parity
81
Correlation Between Spot and Forward Rates
Interest Rates
iA
Because of iU.S.
interest rate
parity, a forward
rate will normally
move in tandem t0 t1 time t2
with the spot rate.
Forward Rates
Spot and
This correlation
SpotA
depends on
interest rate ForwardA.
movements.
t0 t1 time t2
82
Impact of Arbitrage on an MNC’s Value
Forces of Arbitrage
m
n
E CFj , t E ER j , t
j 1
Value =
t =1 1 k t
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
87
Graphic Analysis of Purchasing Power Parity
-3 -1 1 3 %D in the
foreign
currency’s
-2 spot rate
-4
88
Graphic Analysis of Purchasing Power Parity
-3 -1 1 3 %D in the
Decreased foreign
purchasing currency’s
-2 power of spot rate
foreign
goods
-4
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
91
International Fisher Effect
92
Graphic Analysis of the International Fisher Effect
-3 -1 1 3 %D in the
foreign
Higher currency’s
-2 returns from spot rate
investing in
foreign
deposits
-4
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
95
Impact of Inflation on an MNC’s Value
Effect of Inflation
m
n
E CFj , t E ER j , t
j 1
Value =
t =1 1 k t
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 Information on existing
economic conditions of and anticipated
various countries and cash flows in
on historical exchange each currency
rate movements at each subsidiary
Forecasting Measuring
exchange exposure to
rates exchange rate
Managing fluctuations
exposure to
exchange rate
fluctuations
CHAPTER 9
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
z Perfect
forecast
line
Region of
downward
bias
Realized Value
Region of
upward bias
x z
Predicted Value
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
10
CHAPTER 10
Measuring Exposure to
Exchange Rate Fluctuations
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
¤ 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
n
E CFj , t E ER j , t
j 1
Value =
t =1 1 k t
12
CHAPTER 12
Hedging decisions on
economic exposure
m
n
E CFj , t E ER j , t
j 1
Value =
t =1 1 k t
12
Chapter Review
12
Part IV
Long-Term Asset and Liability Management
Existing
Host Country
Tax Laws
Potential Estimated
Revision in Cash Flows of
Exchange Multinational
Host Country Rate
Tax Laws or Project
Projections
Other
Provisions
Country Risk Multinational
Analysis Capital
MNC’s Access Budgeting
to Foreign Decisions
Financing
MNC’s Cost
of Capital Required
International
Interest Rates Return on
on Long-Term Multinational
Funds Risk Unique to Project
Multinational
Project
CHAPTER 13
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
=i S poni business
x expected
unit i
return
13
Benefits of International Diversification
Average Variance
of Returns
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
Benefits of International Diversification
Frontier
Expected Return
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
Benefits of International Diversification
Expected Return
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:
13
Impact of Direct Foreign Investment
Decisions on an MNC’s Value
DFI decisions on type
of business and location
m
n
E CFj , t E ER j , t
j 1
Value =
t =1 1 k t
13
CHAPTER 14
14
Remitting Subsidiary Earnings to the Parent
Conversion of Funds
to Parent’s Currency
14
Factors to Consider in Multinational Capital Budgeting
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
Multinational capital
E (CFj,t ) = expected cash budgeting decisions
flows in currency j to be
received by the U.S.
parent at the end of period
t
E (ERj,t ) = expected
m
n
j 1
E CFj , t E ER j , t
exchange rate at which Value =
currency j can be t =1 1 k t
converted to dollars at the
end of period t
k = the weighted average
cost of capital of the U.S.
parent
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
800
600
400 Foreign Acquisitions
200 of U.S. Firms
0
1988 1989 1990 1991 1992 1993 1994 1995 1996 1997
100
(in billions of $)
Acquisitions
80 Foreign Acquisitions
Value of
60 of U.S. Firms
40
U.S. Acquisitions
20 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 salvage
present = _ initial + S in period t + value
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 3. Target’s industrial conditions
4. Target’s currency 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
m
n
E CFj , t E ER j , t
j 1
Value =
t =1 1 k t
15
CHAPTER 16
Acceptable
Political Risk Rating
Zone
Unclear
Zone
Unacceptable
Unstable
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.
E (CFj,t ) = expected
cash flows in currency Exposure of foreign projects
j to be received by the
U.S. parent at the end to country risk
of period t
E (ERj,t ) = expected
exchange rate at which
currency j can be
m
n j 1
E CFj , t E ER j , t
converted to dollars at Value =
the end of period t t =1 1 k t
k = the weighted
average cost of capital
of the U.S. parent
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
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.
8
7 U.S. U.S.
Costs of Debt
Canada
6
Australia
5
Germany
4
3
2 Japan
1
1996 1997 1998
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
m
n
E CFj , t E ER j , t
j 1
Value =
t =1 1 k t
• 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
30
20
10
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 offsetting cash inflows in that currency,
2 forward contracts, or
3 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.
17
Illustration of A Parallel Loan
1
U.S. Parent British Parent
Provision
of Loans
Subsidiary of Subsidiary of
U.S.- based MNC U.K.- based MNC
that is located that is located
2 in the U.S.
in the U.K.
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
as of June 1998
Annualized Yield
Term to Maturity
17
Yield Curves
as of June 1998
Annualized Yield
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 =1
1 k
t
18
Part V
Short-Term Asset and Liability Management
Provision Provision
of Loans of Loans
Purchase
Deposits Securities
Eurobanks in International
Eurocurrency MNC Commercial
Market Parent Paper Market
Borrow Borrow
Funds Funds
Borrow Borrow
Funds Funds
Borrow Funds Subsidiaries Borrow Funds
of MNC with
Deficient Funds
CHAPTER 19
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.
5. Deliver Goods
2. 8. 6. 4.
Request Documents Present Deliver
for Credit & Claim for Documents Letter of
Payment Credit
7. Present Documents
Importer’s Correspondent
Bank 9. Payment 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.
m
E CFj , t E ER j , t
n j 1
Value =
t =1
1 k
t
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
19
Implications of IRP for Financing
m
E CFj , t E ER j , t
n j 1
Value =
t =1 1 k t
19
CHAPTER 21
20
Cash Flow of the Overall MNC
20
Use of the Forward Rate as a Forecast
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 =1 1 k t
20