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CHAPTER 26 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 26 multinational financial management
CHAPTER 26Multinational 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

Spanish peseta 0.0050

Swedish krona 0.0985

Are these currency prices direct or indirect quotations?

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

slide6

What is an indirect quotation?

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

Calculate the indirect quotations

for pesetas and kronas.

# of Units of Foreign

Currency per U.S. $

Spanish peseta 200.00

Swedish krona 10.15

Peseta: 1/0.0050 = 200.00.

Krona: 1/0.0985 = 10.15.

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 pesetas and kronas.

Pesetas Dollars Dollar Krona

  • Cross rate = x

= 200.00 x 0.0985 =19.70 pesetas/krona.

  • Cross rate = x

= 10.15 x 0.0050 = 0.051 kronas/peseta.

Kronas Dollars Dollar Peseta

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 = ($2.625)(200.00 pesetas/$)

=525.00 pesetas.

slide12

Now the firm begins producing the

orange juice in Spain. The product

costs 240 pesetas to produce and

ship to Sweden, where it can be sold

for 20 kronas. What is the dollar

profit on the sale?

240 pesetas = 240(0.051) = 12.24 kronas.

20 - 12.24 = 7.76 kronas profit.

Dollar profit = 7.76 kronas(0.0985 dollars per krona) = $0.76.

exchange rate relationships
Exchange Rate Relationships

Expected difference in inflation rates

  • Basic Relationships

Difference in interest rates

equals

equals

equals

equals

Expected change in spot rate

Difference between forward and spot rate

exchange rate relationships14
Exchange Rate Relationships

1) Interest Rate Parity Theory

  • The ratio between the risk free interest rates in two different countries is equal to the ratio between the forward and spot exchange rates. (Assuming we quote in yen/dollar. If quotes are in $/yen, ratio of interest rates flips over)
exchange rate relationships15
Exchange Rate Relationships

Example - You have the opportunity to invest $1,000,000 for one year. All other things being equal, you have the opportunity to obtain a 1 year Japanese bond (in yen) @ 0.25 % or a 1 year US bond (in dollars) @ 5%. The spot rate is 112.645 yen:$1 The 1 year forward rate is 107.495 yen:$1

Which bond will you prefer and why?

Ignore transaction costs.

exchange rate relationships16
Exchange Rate Relationships

Example - You have the opportunity to invest $1,000,000 for one year. All other things being equal, you have the opportunity to obtain a 1 year Japanese bond (in yen) @ 0.25 % or a 1 year US bond (in dollars) @ 5%. The spot rate is 112.645 yen:$1 The 1 year forward rate is 107.495 yen:$1

Which bond will you prefer and why? Ignore transaction costs

1.0025/1.05 = 107.495/112.645

.954762 > .954281

Value of US = $1,000,000 x 1.05 = $1,050,000

Value of Japan = $1,000,000 x 112.645 = 112,645,000 yen exchange

112,645,000 yen x 1.0025 = 112,927,000 yen bond pmt

112,927,000 yen / 107.495 = $1,050,500 exchange

another example
Another Example

Assume that spot exchange rate for Euros is 1.4631 #/$. The six month forward rate is 1.4570. The US interest rate is 5.5% and the Euro interest rate is 4.5%. If I could invest $1,000,000, are there any arbitrage opportunities in the exchange rate? Assume all interest rates are continuously compounded.

e(.045*.5)/e(.055*.5) = 1.4570/1.4631

.9950122 < .9958308

Lend US = 1,000,000*e(.055*.5) = 1,027,882

Exchange US = 1,000,000*1.4631 = 1,463,100

Lend Euro = 1,463,100*e(.045*.5) = 1,496,393

Exchange Euro in future = 1,496,393/1.4570 = 1,027,037

exchange rate relationships18
Exchange Rate Relationships

2) Expectations Theory of Exchange Rates

Theory that the expected spot exchange rate equals the forward rate.

exchange rate relationships19
Exchange Rate Relationships

3) Purchasing Power Parity

The expected change in the spot rate equals the expected difference in inflation between the two countries.

exchange rate relationships20
Exchange Rate Relationships

Example

If inflation in the US is forecasted at 2.0% this year and Japan is forecasted to fall 2.5%, what do we know about the expected spot rate?

Given a spot rate of 112.645 yen / $1

exchange rate relationships21
Exchange Rate Relationships

Example - If inflation in the US is forecasted at 2.0% this year and Japan is forecasted to fall 2.5%, what do we know about the expected spot rate?

Given a spot rate of 112.645yen:$1

solve for Es

Es = 107.68

exchange rate relationships22
Exchange Rate Relationships

4) International Fisher effect

The expected difference in inflation rates equals the difference in current interest rates.

Also called common real interest rates.

exchange rate relationships23
Exchange Rate Relationships

Example - The real interest rate in each country is about the same.

slide24

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.

exchange rate risk
Exchange Rate Risk
  • Currency Risk can be reduced by using various financial instruments.
  • Currency forward contracts, futures contracts, and even options on these contracts are available to control the risk.
exchange rate risk26
Exchange rate risk
  • The first financial futures to be traded were foreign exchange futures contracts beginning in 1972 on the CME
  • Why did trading begin after 1972? What about pre-1972?
exchange rate risk27
Exchange rate risk
  • Why did trading begin after 1972?
    • Breakdown of Bretton Woods agreement in early 1970’s essentially ended the use of the gold standard
    • This allowed currencies to “float” which gave enough volatility to foreign exchange markets to make derivatives contracts desirable
      • An underlying asset must have variability for a derivative to be written on that asset
exchange rate risk28
Exchange rate risk
  • Types of float
    • Managed float
      • Currency value is allowed to vary with supply and demand forces
      • Central bank may intervene to alter the currency’s value
      • Fed attempted several times during the 80s to depreciate the dollar in order to improve the trade deficit
exchange rate risk29
Exchange rate risk
  • Types of float
    • Joint float
      • Essentially what exists in the EU, unless the Euro becomes more popular
      • Currency floats among non-EU countries but is strictly managed within EU countries
exchange rate risk30
Exchange rate risk
  • Types of float
    • Pegging currency values
      • Allow your currency to be pegged to the value of the currency of a larger country or a basket of currencies
      • Several Central/South American countries peg their currency to the dollar
      • Several African countries peg their currency to the French Franc
exchange rate risk31
Exchange rate risk
  • Types of float
    • Risk in float
      • The different float strategies will make a difference when assessing the risk of a position in a country’s currency
      • This risk level will influence the need to hedge
exchange rate risk32
Exchange rate risk
  • Other determinants of exchange rate risk
    • Money supply changes
    • Real income changes
    • Inflation
    • Interest rates
    • Political environment
currency futures forwards
Currency Futures/Forwards
  • Review of forward contracts
    • Forward is a contract where a good is to be purchased at a specified price at a specified time in the future
    • No marking-to-market with a forward contract
      • Considered more of a hedging instrument
    • Large market for currency forwards
      • Dollar value of forward contracts estimated to be almost 20 times the value of futures contracts
currency futures forwards34
Currency Futures/Forwards
  • Differences between forward and futures contracts
    • Forward contracts are dealer derivatives
      • No active secondary market
    • Speculation encouraged in futures markets, but not forward markets
    • Forwards only available to large, creditworthy customers
      • No margin requirements
currency futures forwards35
Currency Futures/Forwards
  • Differences between forward and futures contracts
    • Most forwards are settled by delivery
    • Forwards may be more appropriate for simple hedging of exchange rate risk
      • Can tailor contract to specific need of company
      • Generally need delivery in hedging of exchange rate risk
currency swaps
Currency Swaps
  • Allows two firms to exchange currencies at recurrent intervals and is usually used in conjunction with debt issues
  • Simplest “plain-vanilla” currency swap involves exchanging principal and fixed-rate payments on a loan in one currency for principal and fixed-rate payments on an approximately equivalent loan in another currency
reasons for engaging in currency swaps
Reasons for engaging in currency swaps
  • 1. Exchange rate risk allocation
    • a. In its simplest form, a currency swap allows a loan in one currency to be transformed to a loan in another currency.
    • b. It may very well be that a company will desire to issue debt in a foreign currency due to its current exchange rate exposure in some other area of the company.
    • c. A currency swap is a quick, cost effective way of transforming the companies obligations.
reasons for engaging in currency swaps38
Reasons for engaging in currency swaps
  • 2. Regulatory barriers to capital flows:
    • a. Companies may be prevented from issuing debt in foreign currencies.
    • b. A currency swap allows the company to circumvent such regulation.
example of a typical currency swap
Example of a typical currency swap
  • The most common type of currency swap involves exchanging fixed-rate loan contracts denominated in different currencies. Thus, companies can exchange loans denominated in one currency for loans denominated in another currency.
example of a typical currency swap40
Example of a typical currency swap
  • 1. The following borrowing rates are available to two companies in the dollar market and the pound market:
    • Company A Dollar: 8% Pound: 11.6%
    • Company B Dollar: 10% Pound: 12.0%
  • 2. The amount that can be saved through a swap is: 2% - .4% = 1.6%.
example of a typical currency swap41
Example of a typical currency swap
  • 3. The swap should be structured so that both firms will share in the profits.
  • 4. In this case, company A will borrow dollars while company B borrows pounds.
  • 5. We assume that the principal, after accounting for differences in exchange rates will be the same. Also, principal amounts are also exchanged at the beginning and the ending of the swap.
example of a typical currency swap42
Example of a typical currency swap
  • 6. The swap occurs when company B pays company A, 9.2% per year in dollars and company A pays B 12% per year in pounds.
  • 7. Company A makes 1.2 % per year on the dollar payments and loses .4% per year on the pound payments.
  • 8. Company B saves .8% per year on its interest payments on the dollar.
  • 9. Company A is now paying a fixed rate on a pound denominated note and company B is paying a fixed rate on a dollar denominated note.
slide43

Assume that the exchange rate is such that the principal amounts are equivalent when $15,000,000 = 10,000,000 pounds. The net payment in this case would be the difference between the 1.2 million pounds and the 1.38 million dollars, after accounting for exchange rates.

hedging with currency futures
Hedging with currency futures
  • The two simplest hedging strategies are the long hedge and the short hedge
    • In both cases the goal is to protect the value of the firm’s cash flows from changes in the expected exchange rate
    • Both the long and short hedges employ the naïve hedge ratio
      • Assumes one-to-one correspondence between spot and futures position
      • Works well for currencies since spot and future exchange rates are very highly correlated
hedging with currency futures45
Hedging with currency futures
  • Long Hedge
    • Employed when a future cash outflow in foreign currency is expected and there is a feeling that the foreign currency relative to the home currency
    • “Long” refers to taking a long position in the futures contract
    • The long positions allows the company to lock in a rate at which the foreign currency can be purchased
hedging with currency futures46
Hedging with currency futures
  • Long Hedge
    • Example
      • A US watch retailer contracts on March 1 to take delivery of 1000 Swiss watches at SF375 each on September 5. The current $/SF exchange rate is $0.6369/SF. The importer can engage in a September futures contract at an exchange rate of $0.6514/SF. How can our position be hedged using the futures contract?
hedging with currency futures47
Hedging with currency futures
  • Long Hedge
    • Example
      • To hedge dollar-for-dollar, the importer will need to match the current dollar value of the watches with the current dollar value of the futures contract
      • The current dollar value of the watches is
        • SF375,000*$0.6369/SF = $238,837.50
      • The current dollar value of the Swiss Franc future is:
        • SF125,000*$0.6514/SF = $81,425
hedging with currency futures48
Hedging with currency futures
  • Long Hedge
    • Example
      • The importer will need to go long in
        • 238,837.50/81,425 = 2.93 = 3 contracts
      • Assume the exchange rate at the time of the transaction is $0.6600/SF and the futures rate is $0.6750/SF
        • The importer will lose 375,000*(0.6600-0.6369)
        • =$8662.50
        • However the importer will have made
        • 3*125,000*(0.6750-0.6514) = $8850
hedging with currency futures49
Hedging with currency futures
  • Short hedge
    • The short hedge is used when a company expects a cash inflow in a foreign currency and expect a depreciation in the foreign currency relative to the home currency
    • “Short” refers to taking a short position in the currency
    • The short position locks in a rate at which the foreign currency can be sold
hedging with currency futures50
Hedging with currency futures
  • Example
    • A US based corporation is expected to earn DM260,000 from its German subsidiary at the end of March. The current spot rate on March 1 is $0.5442/DM. The current June DM futures contract is priced at $0.5498/DM. How can the company hedge its position using the futures contract?
hedging with currency futures51
Hedging with currency futures
  • Example
    • Again, we need to match the dollar value of the inflow with the dollar value of the futures contract
    • Dollar value of inflow:
      • $0.5442/DM*DM260,000 = $141,492
    • Dollar value of futures contract:
      • $0.5498*DM125,000 = $68,725
    • Number of contracts needed
      • $141,492/68,725 = 2.05 = 2
hedging with currency futures52
Hedging with currency futures
  • Example
    • Assume the exchange rate in March is $0.5400/DM and the futures rate is $0.5475
    • The company will lose
      • (0.5442 - 0.5400)*260,000 = $1092 on the exchange
    • The company will gain
      • (0.5498-0.5475)*125,000*2 = $575 on the future
currency options
Currency Options
  • Hedging with currency options
    • Options are a more expensive hedging choice than futures contracts
    • Options are like an insurance position. We pay a premium to insure against currency movements that are detrimental to our position.
    • With options, our downside risk is limited to the premium paid.
currency options54
Currency Options
  • Hedging with currency options
    • One type of situation where options will be superior to futures is in a situation where the firm makes a bid on a foreign project
    • The project bid will either be accepted or rejected in the future.
    • If we hedge our potential exposure with futures contracts and our bid is not accepted, we will be in a naked position in the futures contract and have an unlimited downside
currency options55
Currency Options
  • Hedging with currency options
    • Example
      • Assume we want to make a bid on a Swiss project to be completed in June. Our finance department has determined we need $1,000,000 in revenue for the project to be profitable. There is a put contract with an exercise price of $0.60/SF. The contract is written on 62.500 francs and has a quote price of $0.0021
currency options56
Currency Options
  • Hedging with currency options
    • Example
      • We can effectively lock in an exchange rate of
      • X - Co. Thus, we can determine the bid to make on the project using this exchange rate
      • Our effective exchange rate will be
        • $0.60 - 0.0021 = 0.5979
      • Our bid should be $1,000,000/0.5979 = SF1.672,520
      • We should buy 1,672,500/62,500 = 27 contracts
currency options57
Currency Options
  • Hedging with currency options
    • Example
      • The cost of our hedge is 0.0021*62,500*27 = $3,543.75
      • Even if we do not receive the bid, our exposure is limited to the cost of the hedge, since the worst that will happen is that the option will expire worthless
      • If we win, the bid will be worth $1,000,000 regardless of the exchange rate