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CHAPTER 15 Multinational Financial Management Factors that make multinational financial management different Exchange rates and trading International monetary system International financial markets Specific features of multinational financial management What is a multinational corporation?

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chapter 15 multinational financial management
CHAPTER 15Multinational Financial Management
  • Factors that make multinational financial management different
  • Exchange rates and trading
  • International monetary system
  • International financial markets
  • Specific features of multinational financial management
slide2

What is a multinational corporation?

  • A multinational corporation is one that operates in two or more countries.
  • At one time, most multinationals produced and sold in just a few countries.
  • Today, many multinationals have world-wide production and sales.
slide3

Why do firms expand into other countries?

  • To seek new markets.
  • To seek new supplies of raw materials.
  • To gain new technologies.
  • To gain production efficiencies.
  • To avoid political and regulatory obstacles.
  • To reduce risk by diversification.
slide4

What are the major factors that distinguish multinational from domestic financial management?

  • Currency differences
  • Economic and legal differences
  • Language differences
  • Cultural differences
  • Government roles
  • Political risk
slide5

Consider the following exchange rates:

U.S. $ to buy

1 Unit

Euro 0.8000

Swedish krona 0.1000

Are these currency prices direct or indirect quotations?

Since they are prices of foreign currencies expressed in U.S. dollars, they are direct quotations (dollars per currency).

slide6

What is an indirect quotation?

  • An indirect quotation gives the amount of a foreign currency required to buy one U.S. dollar (currency per dollar).
  • Note than an indirect quotation is the reciprocal of a direct quotation.
slide7

Calculate the indirect quotations

for euros and kronas.

# of Units of Foreign

Currency per U.S. $

Euro 1.25

Swedish krona 10.00

Euro: 1 / 0.8000 = 1.25.

Krona: 1 / 0.1000 = 10.00.

slide8

What is a cross rate?

  • A cross rate is the exchange rate between any two currencies not involving U.S. dollars.
  • In practice, cross rates are usually calculated from direct or indirect rates. That is, on the basis of U.S. dollar exchange rates.
slide9

Calculate the two cross rates

between euros and kronas.

Euros Dollars Dollar Krona

  • Cross rate = x

= 1.25 x 0.1000 =0.125 euros/krona.

  • Cross rate = x

= 10.00 x 0.8000 = 8.00 kronas/euro.

Kronas Dollars Dollar Euros

slide10

Note:

  • The two cross rates are reciprocals of one another.
  • They can be calculated by dividing either the direct or indirect quotations.
slide11

Assume the firm can produce a liter of

orange juice in the U.S. and ship it to Spain for $1.75. If the firm wants a 50% markup on the product, what should the juice sell for in Spain?

Target price = ($1.75)(1.50)=$2.625

Spanish price = ($2.625)(1.25 euros/$)

=€ 3.28.

slide12

Now the firm begins producing the

orange juice in Spain. The product

costs 2.0 euros to produce and

ship to Sweden, where it can be sold

for 20 kronas. What is the dollar

profit on the sale?

2.0 euros (8.0 kronas/euro) = 16 kronas.

20 - 16 = 4.0 kronas profit.

Dollar profit = 4.0 kronas(0.1000 dollars per krona) = $0.40.

slide13

What is exchange rate risk?

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

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

slide14

Describe the current and former

international monetary systems.

  • 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.
slide15

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.

slide16

The 12 Member Nations of the

European Monetary Union

Austria

Belgium

Finland

France

Germany

Ireland

Italy

Luxembourg

Netherlands

Portugal

Spain

Greece

European Union countries not in the EMU: Britain Sweden Denmark

slide17

What is a convertible currency?

  • 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.
slide18

What problems arise when a firm

operates in a country whose

currency is not convertible?

  • 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.
slide19

What is the difference between

spot rates and forward rates?

  • A spot rate is the rate applied to buy currency for immediate delivery.
  • A forward rate isthe rate applied to buy currency at some agreed-upon future date.
when is the forward rate at a premium to the spot rate
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.
what is interest rate parity

1 + rh

1 + rf

Forward rate

Spot rate

.

=

What is interest rate parity?

Interest rate parity implies that investors should expect to earn the same return on similar-risk securities in all countries:

Forward and spot rates are direct quotations.

rh = periodic interest rate in the home country.

rf = periodic interest rate in the foreign country.

slide22

Assume 1 euro = $0.8100 in the180-day forward market and and 180-day risk-free rate is 6% in the U.S. and 4% in Spain. Does interest rate parity hold?

Spot rate = $0.8000.

rh = 6%/2 = 3%.

rf = 4%/2 = 2%.

(More...)

slide23

1 + rh

1 + rf

Forward rate

Spot rate

=

Forward rate

0.8000

1.03

1.02

=

Forward rate = 0.8078.

If interest rate parity holds, the implied forward rate, 0.8078, would equal the observed forward rate, 0.8100; so parity doesn’t hold.

which 180 day security u s or spanish offers the higher return
Which 180-day security (U.S. or Spanish) offers the higher return?
  • A U.S. investor could directly invest in the U.S. security and earn an annualized rate of 6%.
  • Alternatively, the U.S. investor could convert dollars to euros, invest in the Spanish security, and then convert profit back into dollars. If the return on this strategy is higher than 6%, then the Spanish security has the higher rate.
what is the return to a u s investor in the spanish security
What is the return to a U.S. investor in the Spanish security?
  • Buy $1,000 worth of euros in the spot market:

$1,000(1.25 euros/$) = 1,250 euros.

  • Spanish investment return (in euros):

1,250(1.02)= 1,275 euros.

(More...)

slide26
Buy contract today to exchange 1,275 euros in 180 days at forward rate of 0.8100 dollars/euro.
  • At end of 180 days, convert euro investment to dollars:

€1,275 (0.8100 $/€) = $1,032.75.

  • Calculate the rate of return:

$32.75/$1,000 = 3.275% per 180 days

= 6.55% per year.

(More...)

the spanish security has the highest return even though it has a lower interest rate
The Spanish security has the highest return, even though it has a lower interest rate.
  • U.S. rate is 6%, so Spanish securities at 6.55% offer a higher rate of return to U.S. investors.
  • But could such a situation exist for very long?
arbitrage
Arbitrage
  • Traders could borrow at the U.S. rate, convert to pesetas at the spot rate, and simultaneously lock in the forward rate and invest in Spanish securities.
  • This would produce arbitrage: a positive cash flow, with no risk and none of the traders own money invested.
impact of arbitrage activities
Impact of Arbitrage Activities
  • Traders would recognize the arbitrage opportunity and make huge investments.
  • Their actions would tend to move interest rates, forward rates, and spot rates to parity.
what is purchasing power parity
What is purchasing power parity?

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

Ph = Pf(Spot rate),

or

Spot rate = Ph/Pf.

slide31
If grapefruit juice costs $2.00/liter in the U.S. and purchasing power parity holds, what is price in Spain?

Spot rate = Ph/Pf.

$0.8000 = $2.00/Pf

Pf = $2.00/$0.8000

= 2.5 euros.

  • Do interest rate and purchasing power parity hold exactly at any point in time?
slide32

What impact does relative

inflation have on interest rates

and exchange rates?

  • 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 true interest cost increases over the life of the loan.
slide33

Describe the international money and capital markets.

  • Eurodollar markets
    • Dollars held outside the U.S.
    • Mostly Europe, but also elsewhere
  • International bonds
    • Foreign 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 it is denominated.
to what extent do capital structures vary across different countries
To what extent do capital structures vary across different countries?
  • Early studies suggested that average capital structures varied widely 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.
slide35

What is the impact of multinational

operations on each of the

following topics?

  • Distances are greater.
  • Access to more markets for loans and for temporary investments.
  • Cash is often denominated in different currencies.

Cash Management

slide36

Capital Budgeting Decisions

  • 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.
slide37

Credit Management

  • 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.
slide38

Inventory Management

  • 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.