19 - 1 multinational vs. domestic financial management exchange rates and trading in foreign...

19 - 1

Multinational vs. domestic financial management

Exchange rates and trading in foreign exchange

International monetary systemInternational money and capital

markets

CHAPTER 19Multinational Financial Management

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What is a multinational corporation?

A corporation that operates in two or more countries.

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1. To seek new markets.

2. To seek raw materials.

3. To seek new technology.

4. To seek production efficiency.

5. To avoid political and regulatory hurdles.

6. To diversify.

Why do firms expand into othercountries?

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1. Different currency denominations.

2. Economic and legal ramifications.

3. Language differences.

4. Cultural differences.

5. Role of governments.

6. Political risk.

What are the six major factors that distinguish multinational from

domestic financial management?

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U.S. $ to buy

1 Unit Japanese yen 0.009Australian dollar 0.650Are these currency prices direct or indirect quotations?

Since they are prices of foreign currencies expressed in dollars, they are direct quotations.

Consider the following exchange rates:

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The number of units of foreign currency needed to purchase one U. S. dollar, or the reciprocal of a direct quotation.

What is an indirect quotation?

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Calculate the indirect quotationsfor yen and Australian dollars.

# of Units of Foreign Currency per U.S. $

Japanese yen 111.11Australian dollar 1.5385

Yen: 1/0.009 = 111.11.A. Dollar: 1/0.650 = 1.5385.

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The exchange rate between any two currencies. Cross rates are actually calculated on the basis of various currencies relative to the U. S. dollar.

What is a cross rate?

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Cross rate = x

= 111.11 x 0.650= 72.22 yen/A. dollar.

Cross rate = x

= 1.5385 x 0.009= 0.0138 A. dollars/yen.

Calculate the two cross ratesbetween yen and Australian dollars.

Yen U.S. Dollars U.S. Dollar A. Dollar

A. Dollars U.S. Dollars U.S. Dollar Yen

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The two cross rates are reciprocals of one another.

They can be calculated by dividing either the direct or indirect quotations.

Note:

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Price = (1.75)(1.50)(111.11)

= 291.66 yen.

The firm can produce a liter oforange juice and ship it to Japan for

$1.75. If the firm wants a 50% markupon the product, what should the

juice sell for in Japan?

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250 yen = 250(0.0138) = 3.45 A. dollars.

6 – 3.45 = 2.55 Australian dollar profit.

1.5385 A. dollars = 1 U. S. dollar.

Dollar profit = 2.55/1.5385 = $1.66.

Now the firm begins producing theorange juice in Japan. The product costs 250 yen to produce and shipto Australia, where it can be soldfor 6 Australian dollars. What is

the dollar profit on the sale?

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The risk that the value of a cash flow in one currency translated to another currency will decline due to a change in exchange rates.

For example, in the last slide, a weakening Australian dollar (strengthening dollar) would lower the dollar profit.

What is exchange rate risk?

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The current system is a floating rate system.

Prior to 1971, a fixed exchange rate system was in effect.

The U.S. dollar was tied to gold.

Other currencies were tied to the dollar.

Describe the current and formerinternational monetary systems.

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The European Monetary Union

In 2002, the full implementation of the “euro” is expected to be complete. The national currencies of the 11 participating countries will be phased out in favor of the “euro.” The newly formed European Central Bank will control the monetary policy of the EMU.

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The 11 Member Nations of theEuropean Monetary Union

Austria

Belgium

Finland

France

Germany

Ireland

Italy

Luxembourg

Netherlands

Portugal

Spain

European Union countries not in the EMU: Britain Sweden Denmark Greece

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A currency is convertible when the issuing country promises to redeem the currency at current market rates.

Convertible currencies are traded in world currency markets.

What is a convertible currency?

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It becomes very difficult for multi-national companies to conduct business because there is no easy way to take profits out of the country.

Often, firms will barter for goods to export to their home countries.

What problems arise when a firmoperates in a country whose currency is not convertible?

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Spot rates are the rates to buy currency for immediate delivery.

Forward rates are the rates to buy currency at some agreed-upon date in the future.

What is the difference between spot rates and forward rates?

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When is the forward rate at a premium to the spot rate?

If the U. S. dollar buys fewer units of a foreign currency in the forward than in the spot market, the foreign currency is selling at a premium.

In the opposite situation, the foreign currency is selling at a discount.

The primary determinant of the spot/forward rate relationship is relative interest rates.

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What is interest rate parity?

Interest rate parity holds that investors should expect to earn the same return in all countries after adjusting for risk.

ft = t-period forward exchange rate

e0 = today’s spot rate

kh = periodic interest rate in the home country

kf = periodic interest rate in the foreign country

ft

e0

=1 + kh

1 + kf

.

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Assume 1 yen = $0.0095 in 30-day forward market and kNom for 30-day

risk-free securities in Japan and U. S. = 4%. Does interest rate parity hold?

No.

ft = $0.0095kh = 4%/12 = 0.333%kf = 4%/12 = 0.333%

(More...)

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Therefore, if interest rate parity holds then e0 = $0.0095. However, we were given earlier that e0 = $0.0090.

ft

e0

=1 + kh

1 + kf

=1.00331.0033

$0.0095e0

$0.0095e0

= 1.

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What security offers highest return?

Japanese security.1. Convert $1,000 to yen in spot market. $1,000 x

111.111 = 111,111 yen.2. Invest 111,111 yen in 30-day Japanese security.

In 30 days receive 111,111 yen x 1.00333 = 111,481 yen.

3. Agree today to exchange 111,481 yen 30 days from now at forward rate.111,481/105.2632 = $1,059.07.

4. 30-day return = $59.07/$1,000 = 5.907%, nominal annual return = 12 x 5.907% = 70.88%.

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What is purchasing power parity (PPP)?

Purchasing power parity implies that the level of exchange rates adjusts so that identical goods cost the same amount in different countries.

Ph = Pf(e0) or e0 = Ph/Pf.

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If grapefruit juice costs $2.00/liter in U. S. and PPP holds, what is the price

of grapefruit juice in Australia?

PPP = e0 = Ph/Pf

$0.6500 = $2.00/Pf

Pf = $2.00/$0.6500 = 3.0769 Australian dollars.

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Lower inflation leads to lower interest rates, so borrowing in low-interest countries may appear attractive to multinational firms.

However, currencies in low-inflation countries tend to appreciate against those in high-inflation rate countries, so the effective interest cost increases over the life of the loan.

What impact does relative inflation have on interest rates and

exchange rates?

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Eurodollar marketsa source of dollars outside the U. S.

International bondsForeign bonds: Sold by foreign

borrower, but denominated in the currency of the country of issue.

Eurobonds: Sold in country other than the one in whose currency the bonds are denominated.

Describe the internationalmoney and capital markets.

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To what extent do average capital structures vary across different

countries?

Previous studies suggested that average capital structures vary among the large industrial countries.

However, a recent study, which controlled for differences in accounting practices, suggests that capital structures are more similar across different countries than previously thought.

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Distances are greater.Access to more markets for loans and

for temporary investments.Cash is often denominated in different

currencies.

What is the impact of multinationaloperations on each of the

following topics?

Cash Management

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Foreign operations are taxed locally, and then funds repatriated may be subject to U. S. taxes.

Foreign projects are subject to political risk.

Funds repatriated must be converted to U. S. dollars, so exchange rate risk must be taken into account.

Capital Budgeting Decisions

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Credit is more important, because commerce to lesser-developed countries often relies on credit.

Credit for future payment may be subject to exchange rate risk.

Credit Management

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Inventory decisions can be more complex, especially when inventory can be stored in locations in different countries.

Some factors to consider are shipping times, carrying costs, taxes, import duties, and exchange rates.

Inventory Management

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Capital Budgeting in Foreign Countries

CountrySingapore

India & Thailand

MethodAverageAccounting Return (AAR)

Payback Period

CommentDivides the averageNet Income of aproject by thatproject’s averagebook value of equity.

Preferred by Indianand Thai financialmanagers because of relative simplicity.