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International Financial Management 723G33 LiU yinghong.chen@liu.se

Chapter. 21. International Financial Management 723G33 LiU yinghong.chen@liu.se. Chapter Outline. Multinational corporations Effect of exchange rates on profitability and cash-flow Hedging and reduction of foreign exchange risk Evaluating political risk in foreign investment decisions

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International Financial Management 723G33 LiU yinghong.chen@liu.se

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  1. Chapter 21 International Financial Management 723G33 LiUyinghong.chen@liu.se

  2. Chapter Outline • Multinational corporations • Effect of exchange rates on profitability and cash-flow • Hedging and reduction of foreign exchange risk • Evaluating political risk in foreign investment decisions • Financing international operations

  3. Growing Interdependency • Integrates capital markets • World events such as currency crisis, government defaults, terrorism can cause stock and bond markets to suffer emotional declines well beyond the expected economic impact of a major event • Currency markets • Impact on trade between nations affecting sales and earnings of international companies • The advent of the Euro • Sever impact on earnings of U.S. companies doing significant business in Europe

  4. International Sales of selected U.S.Companies

  5. Cash flowanalysisof a foreign investment

  6. The Multinational Corporation • A firm carrying out its business activities (often 30% or more) outside its national borders • Can take several forms : • Exporter • Licensing agreement • Joint venture • Fully owned foreign subsidiary

  7. Forms of Multinational Corporation • Exporter: • Least risky method • Reaping the benefits of foreign demand • No long-term investment commitment • Licensing agreement: • License granted to a local manufacturer in foreign land to use firm’s technology • Effectively exporting technology • Collects licensing fee or royalty • Joint venture: • Established with a local firm in foreign land • Most preferred by business firms and foreign governments • Least amount of political risk

  8. Forms of Multinational Corporation (cont’d) • Fully owned foreign subsidiary • Higher risks and complexities of operation • Often more profitable than domestic firms • Lowers combined portfolio risk of the parent corporation • Decisive factor in shaping the pattern of trade, investment, and the flow of technology • Exert significant impact on host country’s economic growth, employment, trade, and balance of payments

  9. British Pound and Euro to USD

  10. Exchange Rates to the Dollar • The following figure shows the amount of foreigncurrency for one U.S. dollar

  11. Factors Influencing Exchange Rates • Inflation: • A parity between the purchasing power of two currencies establishes the rate of exchange between the two currencies • Example: it takes $1.00 to buy one apple in New York and 1.25 euros to buy apple in Germany. Then the rate of exchange between the USD and the Euro is €1.25/$1.00 or $.80/euro

  12. Factors Influencing Exchange Rates • Purchasing power parity theory states that: • Currency exchange rates vary inversely with their respective purchasing powers • Exchange rates between two countries adjust to inflation differential between the two countries

  13. Factors Influencing Exchange Rates (cont’d) • Interest rates: • Short-term capital movements from low-yield to high-yield markets • Interest rate parity theory: • The interplay between interest rate differentials and exchange rates • Interest rates and exchange rates adjust until the foreign exchange market and the money market reach equilibrium

  14. Factors Influencing Exchange Rates (cont’d) • Balance of payments: • A system of government accounts that catalog flow of economic transactions between the residents of one country and that of others • Trade surplus or deficit determines strength of currency

  15. Factors Influencing Exchange Rates (cont’d) • Government policies: • Direct or indirect intervention in the foreign exchange market • For maintenance of the undervalued currency • Currency values set by government • Restriction on inflow and outflow of funds • Monetary and fiscal policies • Result in inflation and change in value of currency • Expansionary monetary policies • Excessive government spending

  16. Other Factors Influencing Exchange Rates (cont’d) • Other factors: • Extended stock market rally • Higher capital inflow and increase in currency value • Significant drop in demand for a nation’s principal exports globally • Lower investment potential and decrease in value of currency • Political turmoil in a country • Capital shift to more stable countries and decrease in value of currency • Widespread labor strikes

  17. Spot Rates and Forward Rates • Spot rate • Exchange rate at which the currency is traded for immediate delivery • Forward rates • Trading of currencies for future delivery • Reflects the expectations regarding the future value of a currency • Forward Discount or premium: • Expressed as an annualized percentage deviation from the spot rate

  18. Cross Rates • Not all currencies are actively traded • Value for such currencies determined through a cross rate • Example : Three currencies $, € and ¥ • $ and € are actively traded • $ is 0.8384€ and € is 141.390¥ • Thus $ = 0.8384 × 141.390¥ = 118.541¥

  19. Key Currency Cross Rates

  20. Managing Foreign Exchange Risk • Foreign exchange risk • Possibility of a drop in revenue or an increase in cost in an international transaction due to changes in foreign exchange rates • Shift from fixed exchange rate regime to freely-floating rate regime • Exchange risk of a multinational company: • Accounting or translation exposure • Transaction exposure

  21. Translation Exposure • Consolidated figures of the parent include value of foreign assets and liabilities converted and expressed in home currency • Treatment of such gains and losses depend on the accounting rules established by the government of parent company. • Note: unrealized accounting gains and losses should only be hedged if you are sure it is going to influence the corporate cash flows! Do a value at risk (VaR) analysis.

  22. Translation Exposure (cont’d) • SFAS 52 says: • All foreign currency-denominated assets and liabilities to be converted at the rate of exchange on date of balance sheet preparation • Unrealized gain or loss to be held in equity reserve account and realized gain or loss incorporated in the consolidated income statement of the parent company

  23. Transaction Exposure • Foreign exchange gains or losses resulting from international transactions (from the time of agreement to time of payment) • Volatility of reported earnings per share increases • Strategies to minimize transaction exposure: • Forward exchange market hedge • Money market hedge • Currency futures market hedge

  24. Currencyfutureshedging

  25. Other Forms of Protection Against Foreign Exchange Risk • MNCs have developed foreign asset management programs, involving strategies: • Switching cash and other assets into strong currencies • Piling up debt and other liabilities in depreciating currencies • Quick collection of bills in weak currencies by offering sizable discounts, while extending credit in strong currencies

  26. Foreign Investment Decisions • Factors encouraging foreign affiliates: • Avoid trade barriers • Lower production costs overseas • Superior technology enabled easy access to resources in developing countries • Tax advantage • Motivated by strategic considerations in an oligopolistic industry • Diversification of risks internationally

  27. Risk Reduction from International Diversification

  28. Political Risk in Foreign Investment • Government interference by imposition of unfriendly foreign exchange restrictions • Limitation of foreign ownership to a small percentage • Blocking repatriation of a subsidiary’s profit to the parent firm • Expropriation of foreign subsidiary’s assets by the host government

  29. Guarding Against Political Risk • Establish a joint venture with a local entrepreneur (not totally risk free!) • Establish a joint venture with firms from other countries • Insurance against perceived political-risk level can be obtained • Overseas Private Investment Corporation (OPIC) and other private insurance companies sell insurance policies • Coverage is expensivein troubled countries

  30. Financing International Business Operations • Credit sales are influenced by: • Relationship of the parties involved • Political stability of countries involved • Letter of credit issued by importer’s bank reduces risk of nonpayment • Credit risk to exporter is absorbed by the importer’s bank • Importer’s bank in a good position to evaluate the creditworthiness of the importing firm

  31. Financing International Business Operations (cont’d) • Alternatives to avoid risk of loss of business: • Obtaining export credit insurance • The Foreign Credit Insurance Association (FCIA) provides this kind of insurance • A private association of 60 U.S. insurance firms

  32. Funding of Transactions • Eximbank (Export-Import Bank) • Direct loan program • Discount program • Loans from parent company or sister affiliate • Parallel loans • Fronting loans • Eurodollar loans • US dollars deposited in foreign banks • Lending rates based on London Interbank Offer Rate (LIBOR)

  33. Funding of Transactions (cont’d) • Eurobond market • Issues are sold in several national capital markets • Widely used currency – U.S. dollar • International equity markets • Companies are listed on major stock exchanges • Issue American Depository Receipts (ADRs) • The International Finance Corporation (IFC) • Approached by companies facing issues with raising equity capital in a foreign country

  34. Some Unsettled Issues in International Finance • Nature of financial decisions for an MNC are complex: • Access to more sources of financing than a purely domestic corporation • Decision regarding level of leverage in the foreign affiliate • Dividend policy decisions influenced by foreign government regulations • Differences in interest rates and market conditions between domestic and foreign markets • Differences in corporate financial practices

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