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
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.
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.
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
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.
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.
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.
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.
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
Note: • The two cross rates are reciprocals of one another. • They can be calculated by dividing either the direct or indirect quotations.
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.
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 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 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 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 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 = $1,050,500 exchange
Another Example Assume that spot exchange rate for Euros is 1.4631 #/$. 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 Relationships 2) Expectations Theory of Exchange Rates Theory that the expected spot exchange rate equals the forward rate.
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 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 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 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 Relationships Example - The real interest rate in each country is about the same.
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 • 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 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 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 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 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 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 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 risk • Other determinants of exchange rate risk • Money supply changes • Real income changes • Inflation • Interest rates • Political environment
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/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/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 • 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 • 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 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 • 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 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 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 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.
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 • 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 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 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 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 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 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 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?