MGRECON401 Economics of International Business and Multinationals LECTURE 9

1. MGRECON401Economics of International Business and MultinationalsLECTURE 9 Financial Management in Multinationals

2. Lecture Focus • Investment decisions in foreign currency • Hedging Transaction Exposure • Hedging Translation Exposure • Hedging Operating Exposure

3. Discounting Cash Flows in Foreign Currency • Let FCF(t) be the foreign cash flow at time t • Let the d(t) be the risk-adjusted discount factor for discounting cash in domestic currency received in year t • Let f(t) be the forward exchange rate (foreign currency per domestic currency) • Define CF(t) = FCF(t)/f(t) • Then DCF = CF(1)/d(1) + CF(2)/d(2) + …

4. Discounting Cash Flows in Foreign Currency • DCF = CF(1)/d(1) + CF(2)/d(2) + … • Summary: Convert cash flow into domestic currency using the forward exchange rate, and discount using the US discount rate.

5. Covered Interest Rate Parity • Let r(t) be the domestic interest rate at maturity t • Let r*(t) be the foreign interest rate at maturity t • Let s be the spot exchange rate • Let f(t) be the forward rate for delivery of foreign currency in t periods • Then 1+r(t) = [1+r*(t)]*s/f(t)

6. Discounting Cash Flowsin Foreign Currency, part II • Recall DCF = CF(1)/d(1) + CF(2)/d(2) + … • Since CF(t) = FCF(t)/f(t) • Write DCF = FCF(1)/f(1)d(1) + CF(2)/f(2)d(2) + … • Note d*(t)=d(t)*f(t)/s by covered interest parity • So DCF = [FCF(1)/d*(1) + FCF(2)/d*(2) + …]/s

7. Discounting Cash Flowsin Foreign Currency, part II • DCF = [FCF(1)/d*(1) + DCF(2)/d*(2) + …]/s • Summary = DCF equivalent to discounting foreign cash flows using the appropriate foreign discount rate and converting the foreign discounted cash flow into domestic currency using the spot exchange rate.

8. Transaction Exposure Transaction or “contractual” exposure refers to the gains or losses that may be incurred when monetary transactions are to be settled in foreign currencies. • If you are long a foreign currency, the value of your future payment in units of the domestic currency falls as the value of the domestic currency rises.

9. GM’s Foreign Currency Exposure GM’s Largest Currency Exposures (Forecasted Receivables Less Payables) As of 12/31/00 (units are $000) Source: General Motors (Figures have been disguised) Notes: GMNA: GM North America GME: GM Europe GMAP: GM Asian Pacific GMLAAM: GM Latin America, Africa, Middle East

10. Managing Transaction Exposure • Forward Cover • Money-Market Hedge • Options Market Hedge

11. Forward Cover • Suppose GM expects to receive 1,000,000 Euros in 3 months. • Current spot exchange rate is 0.7000 Euros/USD • Current 3 month forward rate is 0.7069 Euros/USD • GM could sell 1,000,000 Euros three months forward at 0.7069 Euros/USD, thereby locking in a payment of 1,414,565 USD.

12. Money-Market Hedge • Suppose GM expects to receive 1,000,000 Euros in 3 months. • Current spot exchange rate is 0.7000 Euros/USD • Current 3 month US interest rate is 1.00% • Current 3 month Euro interest rate is 2.00%. • GM could borrow 980,392 = 1,000,000/1.02 Euros for three months, exchange it for 1,400,560 USD, and invest it in the US for three months. • In three months: receive 1,414,565 USD on US asset. • Use Euro payment to pay off Euro loan.

13. Options Market Hedge • Suppose GM expects to receive 1,000,000 Euros in 3 months. • GM would like to purchase a put option giving it the right to sell Euros for USD at a predetermined price. • Let’s say that GM has to pay 50,000 USD (due to the option premium) for the right to sell 1,000,000 Euros at .7069 (the strike price) in three months. • If the spot exchange rate is higher than .7069 in three months, then GM will execute its put option and receive 1,414,627 USD (minus 50,500 = 50,000*1.01). • If the spot exchange rate is below .7069 then GM will exchange its 1,000,000 Euro on the spot market.

14. Comparison: Volatility Due to the Exchange Rate • Unhedged position • Unlimited gain or loss • Forward or Money-market hedge • No risk • Options-market hedge • Potential for unlimited profit • Pay a fixed sum to limit loss

15. Comparison: Volatility Due to Uncertainty in Future Payment Suppose the future payment went to zero • Unhedged position • No exposure • Forward or Money-market hedge • Exposure in the amount of the contract • Options-market hedge • Upside exposure above the strike price • Paid a fixed sum for no downside exposure

16. Translation Exposure Translation exposure refers to the unrealized gains or losses of foreign assets or liabilities in units of the domestic currency due to fluctuations in the exchange rate. • All current method: All assets and liabilities are translated at the current exchange rate on the balance sheet date. • Balance sheet hedge: equal amounts of assets and liabilities in each currency. Not smart to borrow in one currency and invest to receive payments in another.

17. Operating Exposure Operating exposure refers to the effect of a change in exchange rates on the expected value of a firm’s future operating cash flows. • Changes in the real exchange rate alter relative prices and hence have real consequences for the firm. • Maximizing the value of the firm may involve insurance against some of these shocks.

18. Response of Operating Cash Flowto Changes in the Exchange Rate • Changes price or profit from exports • Changes cost of foreign-sourced inputs • Changes behavior of consumers • Reaction of competitors • Public sector reactions

19. Managing Operating Exposure • Continue to respond internally to maximize the value of the firm. • Use foreign currency (and other contracts) to reduce likelihood of bankruptcy and thereby avoid costs associated with firms in financial distress.