Multinational Financial Management: An Overview

Multinational corporations (MNCs) are firms that engage in some form of international business. Their managers
conduct international financial management, which involves international investing and financing decisions that are
intended to maximize the value of the MNC. The goal of these managers is to maximize their firm’s value, which is the
same goal pursued by managers employed by strictly domestic companies.
Initially, firms may merely attempt to export products to a certain country or import supplies from a foreign manufacturer.
Over time, however, many of these firms recognize additional foreign opportunities and eventually establish subsidiaries
in foreign countries. Some businesses commonly generate more than half of their sales in foreign countries.
International financial management is important even to companies that have no international business. These companies
must recognize how their foreign competitors will be influenced by movements in exchange rates, foreign interest rates,
labor costs, and inflation. Such economic characteristics can affect the foreign competitors’ costs of production and pricing
policies.
Managing the MNC
The commonly accepted goal of an MNC is to maximize shareholder wealth. Managers employed by the MNC are
expected to make decisions that will maximize the stock price, thereby serving the shareholders’ interests. Some publicly
traded MNCs may have additional goals, such as satisfying their respective governments, creditors, or employees.
Nevertheless, these MNCs place greater emphasis on their primary goal of satisfying shareholders; that way, the firm can
more easily obtain funds from them to support its operations. Even in developing countries that have just recently
encouraged the development of business enterprise, managers of firms must serve shareholder interests if they hope to
obtain funding from investors.
How Business Disciplines Are Used to Manage the MNC
Various business disciplines are integrated to manage the MNC in a manner that maximizes shareholder wealth.
Management develops strategies that will motivate and guide employees who work in an MNC and to organize resources
so that they can efficiently produce products or services. Marketing seeks to increase consumer awareness about the
products and to recognize changes in consumer preferences. Accounting and information systems record financial
information about revenue and expenses of the MNC, which can be used to report financial information to investors and to
evaluate the outcomes of various strategies implemented by the MNC. Finance makes investment and financing decisions
for the MNC. Common finance decisions include the following:
 Whether to pursue new business in a particular country
 Whether to expand business in a particular country
 How to finance expansion in a particular country
 Whether to discontinue operations in a particular country
These finance decisions for each MNC are partially influenced by the other business discipline functions. The decision to
pursue new business in a particular country depends on a comparison of the costs and potential benefits of expansion.
The potential benefits of such new business reflect both the expected consumer interest in the products to be sold
(marketing function) and the expected cost of the resources needed to pursue the new business (management
function). Financial managers rely on financial data provided by the accounting and information systems functions.
Agency Problems
Managers of an MNC may sometimes make decisions that conflict with the firm’s goal of maximizing shareholder wealth.
The conflict of goals between a firm’s managers and shareholders is often referred to as the agency problem.
The costs of ensuring that managers maximize shareholder wealth (agency costs) are typically larger for MNCs than
they are for purely domestic firms, for several reasons. First, MNCs with subsidiaries scattered around the world may
experience larger agency problems because monitoring the managers of distant subsidiaries in foreign countries is more
difficult. Second, foreign subsidiary managers who are raised in different cultures may not follow uniform goals. Some of
them may believe that the first priority should be to serve their respective employees. Third, the sheer size of the larger
MNCs can create significant agency problems, because it complicates the monitoring of all managers.
Lack of monitoring can lead to substantial losses for MNCs.
Parent Control of Agency Problems
The parent corporation of an MNC may be able to prevent most agency problems with proper governance. The parent
should clearly communicate the goals for each subsidiary to ensure that all of them focus on maximizing the value of the
MNC, rather than the value of their respective subsidiaries. The parent can oversee subsidiary decisions to check whether
each subsidiary’s managers are satisfying the MNC’s goals. The parent also can implement compensation plans that
reward those managers who satisfy the MNC’s goals. One commonly used incentive is to provide managers with the
MNC’s stock (or options to buy that stock at a fixed price) as part of their compensation; thus, the subsidiary managers
benefit directly from a higher stock price when they make decisions that enhance the MNC’s value.
Corporate Control of Agency Problems
In some cases, agency problems can occur because the goals of the entire management of the MNC are not focused on
maximizing shareholder wealth. Various forms of corporate control can help prevent these agency problems and induce
managers to make decisions that satisfy the MNC’s shareholders. If managers make poor decisions that reduce the
MNC’s value, then another firm might acquire it at this lower price; the new owner would then probably remove the weak
managers. Moreover, institutional investors with large holdings of an MNC’s stock have some influence over management
and may complain to the board of directors if managers are making poor decisions. Institutional investors may seek to
enact changes, including removal of high-level managers or even board members, in a poorly performing MNC. Such
investors may also band together to demand changes in an MNC, as they know that the firm would not want to lose all of
its major shareholders.
How SOX Improved Corporate Governance of MNCs
One limitation of the corporate control process is that investors rely on reports by the firm’s own managers for information.
If managers are serving themselves rather than the investors, they may exaggerate their performance.
Enacted in 2002, the Sarbanes-Oxley Act (SOX) ensures a more transparent process for managers to report on the
productivity and financial condition of their firm. It requires firms to implement an internal reporting process that can be
easily monitored by executives and the board of directors. Methods used by MNCs to improve their internal control
process may include the following:

 Establishing a centralized database of information

 Ensuring that all data are reported consistently among subsidiaries
 Implementing a system that automatically checks data for unusual discrepancies relative to norms
 Speeding the process by which all departments and subsidiaries access needed data
 Making executives more accountable for financial statements by personally verifying their accuracy
These systems make it easier for a firm’s board members to monitor the financial reporting process. In this way, SOX
reduced the likelihood that managers of a firm can manipulate the reporting process and, therefore, improved the
accuracy of financial information for existing and prospective investors.
Management Structure of an MNC

The magnitude of agency costs can vary with the MNC’s management style. A centralized management style can
reduce agency costs because it allows managers of the parent to control foreign subsidiaries, which in turn reduces the
power of subsidiary managers. However, the parent’s managers may make poor decisions for the subsidiary if they are
less informed than the subsidiary’s managers about its specific setting and financial characteristics.
Alternatively, an MNC can use a decentralized management style. This style is more likely to result in higher agency
costs because subsidiary managers may make decisions that fail to maximize the value of the entire MNC. Yet this
management style gives more control to those managers who are closer to the subsidiary’s operations and environment.
To the extent that subsidiary managers recognize the goal of maximizing the value of the overall MNC and are
compensated in accordance with that goal, the decentralized management style may be more effective.
Given the clear trade-offs between centralized and decentralized management styles, some MNCs attempt to achieve the
advantages of both. That is, they allow subsidiary managers to make the key decisions about their respective operations,
but the parent’s management monitors those decisions to ensure they are in the MNC’s best interests.
Why MNCs Pursue International Business
Multinational business has generally increased over time. Three commonly held theories to explain why MNCs are
motivated to expand their business internationally are (1) the theory of comparative advantage, (2) the imperfect markets
theory, and (3) the product cycle theory. These theories overlap to some extent and can complement one another in
developing a rationale for the evolution of international business.
Theory of Comparative Advantage
Specialization by countries can increase production efficiency. Some countries have a technology advantage, whereas
others have an advantage in the cost of basic labor. Because these advantages cannot easily be transported, countries
tend to use their advantages to specialize in the production of goods that can be produced with relative efficiency. This
explains why some countries are large producers of electronic products, whereas other countries are large producers of
agricultural and handmade goods. Multinational corporations have grown substantially in foreign countries because of
their technology advantage.
A country that specializes in some products may not produce other products, so trade between countries is essential. This
is the argument made by the classical theory of comparative advantage. Comparative advantages allow firms to
penetrate foreign markets.
Imperfect Markets Theory
If each country’s markets were closed to all other countries, then there would be no international business. At the other
extreme, if markets were perfect, such that the factors of production were easily transferable, then labor and other
resources would flow wherever they were in demand. Such unrestricted mobility of factors would create equality in both
costs and returns, thereby eliminating the comparative cost advantage, which is the rationale for international trade and
investment. However, the real world suffers from imperfect market conditions where factors of production are somewhat
immobile. Costs and often other restrictions affect the transfer of labor and other resources used for production. In
addition, restrictions may be placed on transferring funds and other resources among countries. Because markets for the
various resources used in production are “imperfect,” MNCs often capitalize on a foreign country’s particular resources by
having many of their products manufactured in countries where labor costs are low. Imperfect markets provide an
incentive for firms to seek out foreign opportunities.
Product Cycle Theory

One of the more popular explanations as to why firms evolve into MNCs is the product cycle theory. According to this
theory, a firm first becomes established in its home market, where information about markets and competition is more
readily available. To the extent that the firm’s product is perceived by foreign consumers to be superior to that available
within their own countries, the firm may accommodate foreign consumers by exporting. As time passes, if the firm’s
product becomes very popular in foreign countries, it may produce the product in foreign markets, thereby reducing its
transportation costs. The firm may also develop strategies to prolong the foreign demand for its product. One frequently
used approach is to differentiate the product so that competitors cannot duplicate it exactly.
Whether the firm’s foreign business diminishes or expands over time will depend on how successful it is at maintaining
some advantage over its competition.
Methods to Conduct International Business
Firms use several methods to conduct international business:

 International trade
 Licensing
 Franchising
 Joint ventures
 Acquisitions of existing operations
 Establishment of new foreign subsidiaries
International Trade
International trade is a relatively conservative approach that can be used by firms to penetrate markets (by exporting) or
to obtain supplies at a low cost (by importing). This approach entails minimal risk because the firm does not place any of
its capital at risk. If the firm experiences a decline in its exporting or importing, it can usually reduce or discontinue that
part of its business at a low cost.
Licensing
Licensing is an arrangement whereby one firm provides its technology (copyrights, patents, trademarks, or trade names)
in exchange for fees or other considerations.
Franchising
Under a franchising arrangement, one firm provides a specialized sales or service strategy, support assistance, and
possibly an initial investment in the franchise in exchange for periodic fees, allowing local residents to own and manage
the specific units. Because franchising by an MNC often requires a direct investment in foreign operations, it is referred to
as a direct foreign investment (DFI).
Joint Ventures
A joint venture is a business that is jointly owned and operated by two or more firms. Many firms enter foreign markets
by engaging in a joint venture with firms that are already established in those markets. Most joint ventures allow two firms
to apply their respective comparative advantages in a given project. These ventures often require some degree of DFI,
while the other parties involved in the joint ventures also participate in the investment.
Acquisitions of Existing Operations
Firms frequently acquire other firms in foreign countries as a means of penetrating foreign markets. Such acquisitions give
firms full control over their foreign businesses and enable the MNC to quickly obtain a large portion of foreign market
share. Acquisitions represent DFI because MNCs directly invest in a foreign country by purchasing the operations of
target companies.
Sometimes, however, the acquisition of an existing corporation may lead to large losses because of the large investment
required. In addition, if the foreign operations perform poorly, it may be difficult to sell them to another company at a
reasonable price.
Some firms engage in partial international acquisitions as a means of obtaining a toehold or stake in foreign operations.
On the one hand, this approach requires a smaller investment than that needed for a full international acquisition, which
limits the potential loss to the firm if the project fails. On the other hand, the firm will not have complete control over
foreign operations that are only partially acquired.
Establishment of New Foreign Subsidiaries
Firms can also penetrate foreign markets by establishing new operations in foreign countries to produce and sell their
products. Like a foreign acquisition, this method requires a large DFI. Establishing new subsidiaries may be preferred to
foreign acquisitions because the operations can be tailored exactly to the firm’s needs. In addition, a smaller investment
may be required than would be needed to purchase existing operations. However, the firm will not reap any rewards from
the investment until the subsidiary is built and a customer base established.
Summary of Methods
The methods of increasing international business extend from the relatively simple approach of international trade to the
more complex approach of acquiring foreign firms or establishing new subsidiaries. International trade and licensing are
usually not viewed as examples of DFI because they do not involve direct investment in foreign operations. Franchising
and joint ventures tend to require some investment in foreign operations but only to a limited degree. Foreign acquisitions
and the establishment of new foreign subsidiaries require substantial investment in foreign operations and account for the
largest portion of DFI.
Many MNCs use a combination of these methods to increase international business.
In general, the cash outflows associated with international business by the parent are used to pay for imports, to comply
with its international arrangements, and/or to support the creation or expansion of foreign subsidiaries. At the same time,
an MNC receives cash flows in the form of payment for its exports, fees for the services it provides within international
arrangements, and remitted funds from the foreign subsidiaries. The MNC’s international cash flows result either from
paying for imported supplies or from receiving payment in exchange for products that it exports.
An MNC engaging in some international arrangements, such as international licensing, franchising, or joint ventures may
require the MNC to have cash outflows in foreign countries to cover the expenses associated with transferring technology
or funding partial investment in a franchise or joint venture. These arrangements generate cash flows for the MNC in the
form of fees for services that it provides.
An MNC engaging in direct foreign investment has one or more foreign subsidiaries. Cash outflows from the parent to its
foreign subsidiaries may take the form of invested funds to help finance the operations of the foreign subsidiaries. In
addition, cash flows from the foreign subsidiaries to the parent occur in the form of remitted earnings and fees for services
provided by the parent; all of these flows can be classified as remitted funds from the foreign subsidiaries.

Valuation Model for an MNC

The value of an MNC is relevant to its shareholders and its debt holders. When managers make decisions that maximize
the firm’s value, they also maximize shareholder wealth.
Domestic Valuation Model
Before modeling an MNC’s value, consider the valuation of a purely domestic firm that does not engage in any foreign
transactions. The value (V) of the purely domestic firm is commonly specified as the present value of its expected cash
flows, where E(CF$,t) denotes expected cash flows to be received at the end of period t; n is the number of future periods
in which cash flows are received; and k represents not only the weighted average cost of capital, but also the required
rate of return by investors and creditors that provide funds to the MNC.:

Domestic Cash Flows

The domestic cash flows in period t comprise funds received by the firm minus funds needed to pay expenses or taxes or
to reinvest in the firm. The expected cash flows are estimated from knowledge about existing projects as well as other
projects that will be implemented in the future. A firm’s decisions about how it should invest funds to expand its business
can affect its expected future cash flows, which in turn can affect the firm’s value. Holding other factors constant, an
increase in expected cash flows over time should increase the value of a firm.
Cost of Capital
The required rate of return (k) in the denominator of the valuation equation represents the cost of capital (including both
the cost of debt and the cost of equity) to the firm and is, in essence, a weighted average of the cost of capital based on
all of the firm’s projects. In making decisions that affect its cost of debt or equity for one or more projects, the firm also
influences the weighted average of its cost of capital and, therefore, the required rate of return. If the firm’s credit rating is
suddenly lowered, then its cost of capital will probably increase, and so will its required rate of return. Holding other
factors constant, an increase in the firm’s required rate of return will reduce the value of the firm because expected cash
flows must be discounted at a higher interest rate. Conversely, a decrease in the firm’s required rate of return will increase
the value of the firm because expected cash flows will be discounted at a lower required rate of return.
Multinational Valuation Model
An MNC’s value can be specified in the same manner as a purely domestic firm’s value. Managers must consider a new
factor, however: the expected cash flows generated by a domestic-based MNC’s parent in period t may be coming from
various countries and may be denominated in different foreign currencies. In this case, the foreign currency cash flows will
be converted into domestic currency. The expected domestic cash flows to be received at the end of period t are then
equal to the sum of the products of cash flows denominated in each currency j multiplied by the expected exchange rate
at which currency j could be converted into dollar cash flows by the MNC at the end of period t, where (CFj,t) represents
the amount of cash flow denominated in a particular foreign currency j at the end of period t, and Sj,t denotes the
exchange rate at which the foreign currency (measured in domestic currency per unit of the foreign currency) can be
converted to domestic currency at the end of period t:

Domestic Cash Flows of an MNC That Uses Two Currencies

An MNC that does business in two currencies could measure its expected domestic cash flows in any period by
multiplying the expected cash flow in each currency by the expected exchange rate at which that currency could be
converted to domestic and then summing those two products.
Consider an MNC’s business transactions as a portfolio of currency cash flows, with one set of cash flows for each
currency in which it conducts business. The expected domestic cash flows derived from each of those currencies can be
combined to determine the total expected domestic cash flows in the given period. It is easier to derive an expected dollar
cash flow value for each currency before combining the cash flows among currencies within a given period, because each
currency’s cash flow amount must be converted to a common unit before combining the amounts.
Dollar Cash Flows of an MNC That Uses Multiple Currencies
The same process just described can be employed to estimate the domestic cash flows an MNC that does business in
many foreign currencies. The general formula for estimating the domestic cash flows to be received by an MNC from
multiple currencies in one period can be written as follows:

Valuation of an MNC’s Cash Flows over Multiple Periods

The process of estimating domestic cash flows for a single period can be adapted to account for multiple periods. First,
apply the same process described for a single period to all future periods in which the MNC will receive cash flows; this
will generate an estimate of total domestic cash flows to be received in every period in the future. Second, discount the
estimated total domestic cash flow for each period at the weighted cost of capital (k). Third, add these discounted cash
flows to estimate the value of this MNC. The process for valuing an MNC receiving multiple currencies over multiple
periods can be expressed formally as follows, where CFj,t is the cash flow denominated in a particular currency and Sj,t
denotes the exchange rate at which the MNC can convert the foreign currency to the domestic currency at the end of
period t. Whereas the previous equation is applied to single-period cash flows, this equation considers cash flows over
multiple periods and then discounts those flows to obtain a present value:
Because the management of an MNC should focus on maximizing its value, the equation for valuing an MNC is extremely
important. According to this equation, the value (V) will increase in response to managerial decisions that increase the
amount of its cash flows in a particular currency (CFj) or to conditions that increase the exchange rate at which that
currency is converted into domestic currency (Sj).
To avoid double counting, cash flows of the MNC’s subsidiaries are considered in the valuation model only when they
reflect transactions with the parent. Therefore, any expected cash flows received by foreign subsidiaries should not be
counted in the valuation equation until they are remitted to the parent.
The denominator of the valuation model for the MNC remains unchanged from the original valuation model for the purely
domestic firm. However, note that the weighted average cost of capital for the MNC is based on funding some projects
involving business in different countries. In consequence, any decision by the MNC’s parent that affects the cost of its
capital for supporting projects in a specific country will also affect its weighted average cost of capital (and required rate of
return) and, therefore, its value.
Uncertainty Surrounding an MNC’s Cash Flows
The MNC’s future cash flows (and therefore its valuation) are subject to uncertainty because of its exposure not only to
domestic economic conditions but also to international economic conditions, political conditions, and exchange rate risk.
Exposure to International Economic Conditions

To the extent that a foreign country’s economic conditions affect an MNC’s cash flows, they also affect the MNC’s
valuation. The cash inflows that an MNC receives from sales in a foreign country during a given period depend on the
demand by that country’s consumers for the MNC’s products, which in turn is affected by that country’s national income in
that period. If economic conditions improve in that country, consumers there may enjoy an increase in their income and
the employment rate may rise. In that case, those consumers will have more money to spend, and their demand for the
MNC’s products will increase.
Conversely, an MNC can be adversely affected by its exposure to declining international economic conditions. If
conditions weaken in the foreign country where the MNC does business, that country’s consumers may suffer a decrease
in their income and the employment rate may decline. Those consumers will then have less money to spend, and their
demand for the MNC’s products will decrease. In this case, the MNC’s cash flows are reduced because of its exposure to
the harsher international economic conditions.
International economic conditions can also affect the MNC’s cash flows indirectly by affecting its home economy. When a
country’s economy strengthens and, in turn, its consumers buy more products from other countries, the firms in those
other countries will experience stronger sales and cash flows. Conversely, if the foreign country’s economy weakens and
its consumers buy fewer products from other countries, then the firms in those countries will experience weaker sales and
cash flows.
The effects on international economic conditions shows the different ways in which weak foreign conditions can affect the
valuations of domestic-based MNCs. The string of effects indicates how weak foreign economic conditions cause a
decline in the demand for the products made by domestic firms. The result is weaker cash flows of the domestic-based
MNCs that sell products either as exports or through their foreign subsidiaries to foreign customers. In addition, the weak
foreign economy can weaken the domestic economy, resulting in a lower domestic demand for products produced by
domestic-based MNCs and domestic firms.
Exposure to International Political Risk
Political risk in any country can affect the level of an MNC’s sales. A foreign government may increase taxes or impose
barriers on the MNC’s subsidiary. Alternatively, consumers in a foreign country may boycott the MNC if friction arises
between the government of their country and the MNC’s home country. These kinds of political actions can, in turn,
reduce the cash flows of an MNC. The term “country risk” is commonly used to reflect an MNC’s exposure to a variety of
country conditions, including political actions such as friction within the government, government policies, and financial
conditions within that country.
Exposure to Exchange Rate Risk
If the foreign currencies to be received by a domestic-based MNC suddenly weaken against the domestic currency, then
the MNC will receive a lower amount of domestic cash flows than expected. Therefore, the MNC’s cash flows will be
reduced.
This conceptual framework can be used to understand how MNCs are affected by exchange rate movements.
Many MNCs have cash outflows in one or more foreign currencies because they import supplies or materials from
companies in other countries. When an MNC anticipates future cash outflows in foreign currencies, it is exposed to
exchange rate movements, but in the opposite direction. That is, if those foreign currencies strengthen, then the MNC will
need more dollars to obtain the foreign currencies to make its payments.
How Uncertainty Affects the MNC’s Cost of Capital
If there is suddenly more uncertainty about an MNC’s future cash flows, then investors would require a higher expected
rate of return, which increases the MNC’s cost of obtaining capital and lowers its valuation.
If the uncertainty surrounding economic conditions that influence cash flows declines, the uncertainty surrounding cash
flows of MNCs also declines and results in a lower required rate of return and cost of capital for MNCs. Consequently, the
valuations of MNCs increase.
 International Flow of Funds
Many multinational corporations (MNCs) are heavily engaged in international business, such as exporting, importing, or
direct foreign investment (DFI) in foreign countries. The transactions arising from international business create money
flows from one country to another. The balance of payments is a measure of the international money flows.
Financial managers of MNCs monitor the balance of payments so that they can determine how the flow of international
transactions is changing over time. The balance of payments can indicate the volume of transactions between specific
countries and may even signal potential shifts in specific exchange rates. In consequence, it can have a major influence
on the long-term planning and management by MNCs.
Balance of Payments
The balance of payments is a summary of transactions between domestic and foreign residents for a specific country
over a specified period of time. It represents an accounting of a country’s international transactions for that period, usually
a quarter or a year. This summary includes transactions by businesses, individuals, and the government.
A balance-of-payments statement is composed of the current account, the capital account, and the financial account.
Current Account
The current account measures the flow of funds between a specific country and all other countries due to purchases of
goods and services or to income generated by assets. The main components of the current account are payments
between two countries for (1) merchandise (goods) and services, (2) primary income, and (3) secondary income.

Payments for Goods and Services

Merchandise exports and imports comprise tangible products that are transported between countries. Service exports and
imports encompass tourism and other services provided for customers based in other countries. Service exports by the
domestic country result in an inflow of funds to the domestic country, whereas service imports by the domestic country
result in an outflow of funds.
The difference between total exports and total imports is referred to as the balance of trade. A deficit in the balance of
trade means that the value of merchandise and services exported is less than the value of merchandise and services that
it imports.
Primary Income Payments
A second component of the current account is primary income (formerly called factor income), which is mostly
composed of income earned by MNCs on their direct foreign investment (investment in fixed assets in foreign countries
that can be used to conduct business operations) as well as income earned by investors on their portfolio investments
(investments in foreign securities). Net primary income represents the difference between the primary income receipts
(inflows) and the primary income payments (outflows).
Secondary Income
The third main component of the current account is secondary income (also known as transfer payments), which
represents aid, grants, and gifts from one country to another. Net secondary income represents the difference between
the secondary income receipts and the secondary income payments.
Financial Account
The financial account measures the flow of funds between countries that are due to (1) direct foreign investment, (2)
portfolio investment, and (3) other capital investment.
Direct Foreign Investment
The financial account keeps track of a country’s payments for new direct foreign investment over a given period.
Payments representing direct foreign investment in the domestic country are recorded as a positive number in the
domestic financial account, because funds are flowing into the domestic country. Conversely, payments representing a
domestic-based MNC’s direct foreign investment in another country are recorded as a negative number because funds
are being sent from the domestic country to another country.
Portfolio Investment
The financial account also keeps track of a country’s payments for new portfolio investment (investment in financial assets
such as stocks or bonds) over a given period.
Other Capital Investment
A third component of the financial account is other capital investment, which represents transactions involving short-term
financial assets between countries. In general, direct foreign investment measures the expansion of firms’ foreign
operations, whereas portfolio investment and other capital investment measure the net flow of funds due to financial asset
transactions between individual or institutional investors.
Capital Account
The capital account measures the flow of funds between one country and all other countries due to financial assets
transferred across country borders by people who move to a different country, or due to sales of patents and trademarks.
In general, the financial account items represent very large cash flows between countries, whereas the capital account
items are relatively minor when compared with the financial account items. Thus, the financial account merits much more
attention than the capital account when attempting to understand how a country’s investment behavior has affected its
flow of funds with other countries during a particular period.
Growth in International Trade
International trade creates some jobs, especially in industries where domestic firms have a technology advantage.
International trade prompts a shift of production to those countries that can produce products more efficiently. In addition,
it ensures more global competition among producers, which forces those firms to keep their prices low. Hence, domestic
consumers have more product choices, and at lower prices, as a result of international trade.
Nevertheless, not all domestic residents have benefited from the expansion of international trade. In particular, workers in
certain industries have experienced job losses as production has shifted from the domestic to foreign countries where
labor costs are lower. As a result, international trade has become a more controversial issue in recent years.
Events That Increased Trade Volume
The development of international trade reflects numerous efforts by governments to remove cross-border restrictions.
Impact of Outsourcing on Trade
Outsourcing refers to the process of subcontracting to a third party. In the context of multinational financial management,
outsourcing involves subcontracting to a third party in another country to provide supplies or services that were previously
produced internally. Under this definition, outsourcing increases international trade activity because it means that MNCs
now purchase products or services from another country.
Outsourcing allows MNCs to operate at a lower cost, because the expenses they incur from paying a third party are less
than the expenses they would incur if they produced the product or service themselves. Many MNCs argue that they
cannot compete globally without outsourcing some of their production or services. Outsourcing by MNCs has created
many jobs in countries where wages are low. However, outsourcing by domestic-based MNCs is sometimes criticized
because it may reduce the number of jobs that these companies provide in the domestic country. These MNCs might
counter that, if they had not outsourced their production or services, they would have shut down some labor-intensive
operations because labor expenses are too high in the domestic country to enable the firms to compete on a global basis.
There are many opinions about outsourcing, but no simple solutions to the dilemma it creates. Often people have opinions
about outsourcing that are inconsistent with their own behavior.
Managerial Decisions about Outsourcing
Managers of domestic-based MNCs may argue that they produce their products in the domestic country with the aim of
creating jobs for domestic workers. However, when the same products can be easily manufactured in foreign markets to
have the same quality but at one-fifth of the cost, shareholders may pressure the managers of the MNC to establish a
foreign subsidiary or to engage in outsourcing. Shareholders could argue that the managers are failing to maximize the
MNC’s value as a result of their commitment to creating domestic jobs. The MNC’s board of directors, which governs all
major managerial decisions, could pressure the managers to move some of the production outside the domestic country.
The board should consider the potential savings that could occur from this strategy, but must also take into account the
possible adverse effects due to bad publicity or to bad morale among its remaining domestic workers. If the MNC’s costs
could be substantially reduced by moving production outside the domestic country without a loss in quality, then a
possible compromise is to rely on outsourcing only to accommodate any growth in the firm’s business. That way, the
outsourcing strategy would not adversely affect the firm’s existing employees in the domestic country.
Trade Volume among Countries
Some countries rely more heavily on international trade than others do.
Trend in Domestic Balance of Trade
Any country’s balance of trade can change substantially over time.
Factors Affecting International Trade Flows
Because international trade can significantly affect a country’s economy, it is important to identify and monitor the factors
that influence it. The following factors are the most influential:
 Cost of labor
 Inflation
 National income
 Credit conditions
 Government policies
 Exchange rates
Cost of Labor
The cost of labor varies substantially among countries. Firms in countries where labor costs are low typically have an
advantage when competing globally, especially in labor-intensive industries.
Inflation
If a country’s inflation rate increases relative to the countries with which it trades, this could cause its exports to decrease
(if foreign customers shift to cheaper alternatives in other countries) and its imports to increase (if local individuals and
firms shift to cheaper alternatives). Consequently, an increase in the country’s inflation may cause its current account to
decrease.
National Income
If a country’s income level (national income) increases by a higher percentage than those of other countries, then its
current account should decrease, other things being equal. As the real income level (adjusted for inflation) rises, so does
consumption of goods. A percentage of that increase in consumption will most likely reflect an increased demand for
foreign goods.
Credit Conditions
When credit conditions become more restrictive, banks are less willing to provide financing to MNCs. MNCs, in turn, may
reduce their corporate spending, which further weakens the economy, and also reduce their demand for imported
supplies.
Government Policies
Theories about the advantages of free trade commonly receive a great deal of attention, but these theories seem less
attractive when the country’s unemployment rate increases in response to a large balance-of-trade deficit. On a practical
level, governments implement many policies that affect their respective balance-of-trade positions.
Restrictions on Imports
Some governments prevent or discourage imports from other countries by imposing trade restrictions. The most
commonly used trade restrictions are tariffs and quotas. When a country’s government imposes a tax on imported goods
(tariff), that tax is commonly passed on from the importer to the consumer. Consequently, consumers pay more to
purchase foreign goods. The underlying idea is that increasing prices through tariffs will compel consumers to purchase
fewer foreign goods and more domestically produced goods. Thus, tariffs are expected to protect domestic industries to
some extent from foreign competition.
In addition to tariffs, a government can reduce its country’s imports by enforcing a maximum limit that can be imported
(quota). Quotas have frequently been applied to a variety of goods imported by the countries, especially when countries
are experiencing weak economic conditions.
Trade restrictions can change over time in response to changing relationships between governments.
Subsidies for Exporters
A government may offer subsidies to its domestic firms to enable them to produce products at a lower cost than their
global competitors. The firms may then be able to price their products lower than competitors’ products, thereby attracting
more demand for their exports. Some subsidies are more obvious than others, and it could be argued that every
government provides subsidies in some form.
In some countries, certain firms receive subsidies from the government provided that their manufactured products are
then exported. These firms may be able to sell their products at a lower price than any of their competitors in other
countries. This practice of exporting of lower-priced products that were produced with the help of government subsidies is
referred to as dumping.
Restrictions on Piracy
A government can also affect international trade flows by its lack of restrictions on piracy. A government that does not act
to minimize piracy may indirectly reduce imports and may even discourage MNCs from exporting to that market.
Environmental Restrictions
When a government imposes environmental restrictions, local firms experience higher costs of production. Those costs
could put local firms at a disadvantage compared with firms (in other countries) that are not subject to the same
restrictions. Some governments have considered loosening or entirely eliminating environmental restrictions as a means
to ensure that local firms can compete globally. Of course, such a policy will be in clear conflict with the objectives of that
country’s environmental groups. A person’s opinion about the appropriate policy is often based in large part on whether
local jobs or a clean environment is considered to be the most important criterion.
Labor Laws
Labor laws vary among countries, which might allow for pronounced differences in the labor expenses incurred by firms
among countries. Some countries have more restrictive laws that protect the rights of workers and more restrictive child
labor laws. Firms based in countries with more restrictive laws will incur higher expenses for labor, other factors being
equal. For this reason, their firms may be at a disadvantage when competing against firms based in other countries.
Business Laws
Some countries have more restrictive laws on bribery than others. Firms based in these countries may not be able to
compete globally in some situations, such as when government officials of an agency soliciting specific services from
MNCs expect to receive bribes from the MNCs attempting to secure that business.
Tax Breaks
In some countries, the government may give tax breaks to firms that operate in specific industries.
Country Trade Requirements
A government may require that MNCs complete various forms or obtain licenses before they can export products to its
country. Such requirements often result in delays simply because the government is inefficient in validating the forms or
licenses. This process might even be purposely inefficient to discourage exporters and thereby, indirectly, protect jobs
within a country.
Bureaucracy (whether international or not) is a strong trade barrier. Furthermore, it is difficult to prove that a country’s
government is purposely trying to prevent trade and, therefore, is violating free trade agreements. Even with the available
advances in technology, many governments still respond slowly as a matter of course to requests by other countries’
exporters to send products to their country. In other cases, government delays may represent a form of retaliation
intended to hinder trade and protect local jobs. Such bureaucratic delays may discourage some MNCs from pursuing
business in other countries.
Government Ownership or Subsidies
Some governments maintain ownership in firms that are major exporters.
Country Security Laws
Some domestic politicians have argued that international trade and foreign ownership should be restricted when domestic
security is threatened. Despite the general support for this opinion, there is disagreement regarding which specific
domestic business and transactions deserve protection from foreign competition.
It is often difficult to distinguish between a trade or investment restriction that enhances national security and one that
unfairly protects a domestic firm from foreign competition. This same dilemma is faced not only by the domestic country,
but also by most other countries.
Policies to Punish Country Governments
International trade policy issues have become even more contentious over time. Whereas some people advocate free
trade without restrictions, many others want their governments to impose new trade restrictions that would punish other
countries that do not enforce environmental laws or child labor laws, or that commit human rights violations. Every
international trade convention now attracts a large number of protesters, all of whom have their own agendas.
Summary of Government Policies
Every government implements some policies that may give its local firms an advantage in the battle for global market
share, so the playing field is probably not level across all countries. Even so, no formula can ensure a completely fair
contest for market share. Most governments are pressured by their constituents to implement trade restrictions that create
local jobs and give local firms an exporting advantage. However, a country’s imposition of new trade restrictions will often
trigger retaliation by its trading partners.
Domestic-based MNCs cannot control the international trade policies implemented by the domestic government, but they
can assess how existing economic, political, and social conditions might affect international trade policies in the future,
and how those policies might affect their international business.
One conclusion is that any government can find an argument for restricting imports if it wants to increase domestic
employment. Some arguments might be justified; others, less so. Naturally, countries that are adversely affected by a
trade policy may retaliate to offset any adverse effects on employment. In consequence, the plan to create jobs by
restricting imports may not be successful. But even when the overall employment situation for both countries is
unchanged due to offsetting effects of trade policies, employment within particular industries may be changed.
Politicians frequently criticize the international trade policy of their government, especially during election campaigns. The
trade policies of any government are easy to criticize because any form of criticism will likely connect with some voters.
Politicians are rarely willing to offer much detail about the international trade policy that their government should
implement, because doing so would expose how their own proposed policy does not serve all voters. Politicians also
frequently criticize the international trade policies of other countries’ governments, whether to gain favor with local voters
or to kickstart negotiations for a new trade agreement between the countries.
Exchange Rates
Each country’s currency is valued in terms of other currencies through the use of exchange rates. Once the necessary
exchange rate is established, currencies can then be exchanged to facilitate international transactions. The values of most
currencies fluctuate over time because of market and government forces. As the value of a country’s currency changes,
the prices of its exported goods will change for the importing countries, as will the demand for those goods.
The demand for an imported product can shift as a result of a change in the exchange rate. The demand for a local firm’s
product can shift as the price of a competitor’s imported product changes due to a change in the exchange rate.
Just as exchange rate movements can affect a domestic firm’s cash flows by changing the domestic demand for imports,
they can also affect the cash flows of a domestic firm that exports its products.
The cumulative effect of all exports would again be much greater. In general, when currencies are strong against the
domestic dollar, domestic imports should be relatively low, and domestic exports should be relatively high. Holding other
factors constant, this suggests that a weak domestic currency should result in a more favorable balance-of-trade situation
for the domestic country. Conversely, when currencies are weak against the domestic currency, domestic imports should
be relatively high, and domestic exports should be relatively low. Holding other factors constant, a strong domestic
currency should result in a less favorable balance-of-trade situation for the domestic currency.
How Exchange Rates May Correct a Balance-of-Trade Deficit
A floating exchange rate could correct any international trade imbalance between two countries in the following way. A
balance-of-trade deficit suggests that the country is spending more funds on foreign products than it is receiving from
exports to foreign countries. This exchange of its currency (to buy foreign goods) in greater volume than the foreign
demand for its currency could place downward pressure on the value of that currency. Once the value of the country’s
home currency declines in response to these forces, the result should be more foreign demand for its products.
Why Exchange Rates May Not Correct a Balance-of-Trade Deficit
A floating exchange rate will not always correct any international trade imbalances. A country may experience positive net
financial flows, which offset the net international trade flows, so that its currency will not necessarily weaken when its
balance-of-trade deficit is large. If the home currency does not weaken, it cannot correct the balance-of-trade deficit.
Even if a country’s home currency weakens, thereby lowering the prices that its MNCs charge to foreign consumers,
many foreign competitors might lower their prices to remain competitive. In addition, a country’s currency might not
weaken against all currencies at the same time. Therefore, its MNCs may still face stiff competition from competitors
based in other countries whose currencies are also weak.
Another reason why a weak currency will not always improve a country’s balance of trade is that many international trade
transactions are prearranged and cannot be adjusted immediately to fluctuating exchange rates. Thus, exporters and
importers are committed to following through on the international transactions that they agreed to complete. The lag time
between weakness in the domestic currency and increased foreign demand for domestic products has been estimated to
be long. The domestic balance-of-trade deficit could deteriorate even further in the short run when the domestic currency
is weak because domestic importers then need more dollars to pay for the imports they have contracted to purchase. This
pattern is referred to as the J-curve effect. The trade balance’s further decline before a reversal is a trend whose plot
resembles the letter J.

Finally, a weak currency is less likely to improve a country’s balance of trade when its international trade involves
importers and exporters under the same ownership. Many firms purchase products that are produced by their subsidiaries
in what is known as intracompany trade. Intracompany trade amounts to more than 50 percent of all international trade.
This type of trade in which the manufacturer is purchasing parts from its foreign subsidiary will usually continue even if its
home currency weakens.
International Friction Caused by Exchange Rate Manipulation
For the many reasons just cited, a weaker home currency is seldom the best way to reduce a balance-of-trade deficit.
Even so, government officials may recommend this approach as a possible solution. Of course, all country governments
cannot simultaneously weaken their home currencies. If the domestic government took actions that caused the domestic
currency to weaken against the foreign currency, this implies that the foreign currency has strengthened against the
domestic currency.
As consumers in the country with the stronger currency are enticed by the new exchange rate to purchase more imports,
more jobs may be created in the country with the weak currency and jobs may be eliminated in the country with the strong
currency. These outcomes can lead to friction between countries.
International Capital Flows
One of the most important types of capital flows is direct foreign investment. Firms commonly pursue DFI so that they can
reach additional consumers or utilize low-cost labor.
The countries that are most heavily involved in pursuing such outside investments also attract considerable DFI.
Factors Affecting Direct Foreign Investment
Capital flows resulting from DFI change whenever conditions in a country change the desire of MNCs to conduct business
operations there.
Changes in Restrictions
Lowering the restrictions on DFI results in more DFI in the country. New opportunities in the countries arise since
government barriers are removed.
Privatization
Several national governments have engaged in privatization, which is the selling of some of their operations to
corporations and other investors. This policy allows for expansion of international business because foreign firms can
acquire operations sold by national governments.
The primary reason that the market value of a firm may increase in response to privatization is the anticipated
improvement in managerial efficiency. Managers in a privately owned firm can focus on the goal of maximizing
shareholder wealth; in contrast, a state-owned business must consider the economic and social ramifications of any
decision. Also, managers of a privately owned enterprise are more motivated to ensure profitability because their careers
may depend on it. The trend toward privatization will undoubtedly create a more competitive global marketplace.
Potential Economic Growth
Countries that have greater potential for economic growth are more likely to attract DFI because firms recognize the
possibility of capitalizing on that growth by establishing more business there.
Tax Rates
Countries that impose relatively low tax rates on corporate earnings are more likely to attract DFI. When assessing the
feasibility of DFI, firms estimate the after-tax cash flows that they expect to earn.
Exchange Rates
Firms typically prefer to pursue DFI in countries where the local currency is expected to strengthen against their own.
Under these conditions, they can invest funds to establish their operations in a country at a time when that country’s
currency is relatively cheap (weak).
Factors Affecting International Portfolio Investment
The amount of funds invested by individual or institutional investors in a specific country is influenced by the following
factors.
Tax Rates on Interest or Dividends
Investors generally prefer to invest in a country where the taxes on interest or dividend income from investments are
relatively low. Investors assess their potential after-tax earnings from investments in foreign securities.
Interest Rates
Money tends to flow to countries with high interest rates as long as the local currencies are not expected to weaken.
Exchange Rates
If a country’s home currency is expected to strengthen, then foreign investors may be willing to invest in that country’s
securities so that they can benefit from the currency movement. Conversely, if a country’s home currency is expected to
weaken, then foreign investors may prefer to purchase securities in other countries.
Impact of International Capital Flows
A domestic country relies heavily on foreign capital in many ways. First, foreign investment is used to build manufacturing
plants, offices, and other buildings. Second, foreign investors purchase debt securities issued by domestic firms, thereby
serving as creditors to these firms. Third, foreign investors purchase Treasury debt securities, thereby serving as creditors
to the domestic government. Foreign investors are especially attracted to domestic financial markets when the interest
rate in their home country is lower than that in the domestic country.

At any time, the long-term interest rate is determined by the interaction between the supply of funds available in credit
markets and the amount of funds demanded there. The supply curve S1 reflects the supply of funds from domestic
sources. If the country relied solely on domestic sources for its supply, its equilibrium interest rate would be i1 and the
level of business investment would be BI1. If the supply curve also includes the supply of funds from foreign sources (S2),
the equilibrium interest rate is i2. Because of the large international capital flows to the credit markets, interest rates are
lower than they would be otherwise. This allows for a lower cost of borrowing and, in turn, a lower cost of using capital. As
a result, the equilibrium level of business investment is BI 2. Because of the lower interest rate, more business
opportunities warrant funding.
The long-term rate may be considered the cost of borrowing for the most creditworthy firms; other firms would pay a
premium above that rate. Without international capital flows, less funding would be available across all risk levels, and the
cost of funding would be higher regardless of a firm’s risk level. This would reduce the number of business opportunities
considered feasible.
 International Financial Markets
The growth in international business over the last 40 years has led to the development of various international financial
markets. Financial managers of multinational corporations (MNCs) must understand the available international financial
markets and be able to use them to facilitate the firm’s international business transactions.
Foreign Exchange Market
Each country in the world has its own currency. An important exception is the eurozone, which consists of the 19
European countries that have adopted the euro as their currency. When MNCs and individuals engage in international
transactions, they commonly need to exchange their local currency for a foreign currency, or exchange a foreign currency
for their local currency. The foreign exchange market allows for the exchange of one currency for another. Large
commercial banks serve this market by holding inventories of each currency so that they can accommodate requests by
individuals or MNCs for currency for various transactions. Individuals rely on the foreign exchange market when they
travel to foreign countries. MNCs also need to exchange their local currency when they make foreign investments.
At any point in time, the exchange rate between any two currencies specifies the rate at which one currency can be
exchanged for another. In essence, the exchange rate represents the price at which one currency can be purchased with
another currency. If the exchange rate was higher, your cost in domestic currency would be higher.
History of Foreign Exchange
The system for establishing exchange rates has changed over time, evolving from the gold standard to an agreement on
fixed exchange rates to a floating rate system.
Gold Standard
From 1876 to 1913, exchange rates were dictated by the gold standard. Each currency was convertible into gold at a
specified rate. Thus, the exchange rate between two currencies was determined by their relative convertibility rates per
ounce of gold. Each country used gold to back its currency.
When World War I began in 1914, the gold standard was suspended. Some countries reverted to the gold standard in the
1920s, but later abandoned it as a result of the U.S. and European banking panic during the Great Depression. In the
1930s, some countries attempted to peg their currency to the dollar or the British pound, but frequent revisions were
required to their currencies’ value. As a result of instability in the foreign exchange market and the severe restrictions on
international transactions during this period, the volume of international trade declined.
Agreements on Fixed Exchange Rates
In 1944, an international agreement among many countries (Bretton Woods Agreement) called for fixed exchange rates
between currencies. An exchange rate was set for each pair of currencies, and each country’s central bank was required
to maintain its respective local currency’s value within 1 percent of the agreed-upon exchange rates. The system
established by the Bretton Woods Agreement lasted until 1971.
By 1971, the U.S. dollar had apparently become overvalued, as U.S. demand for some foreign currencies was
substantially more than the supply of those currencies offered in exchange for dollars. As interventions by central banks
could not effectively offset the large imbalance between demand and supply, representatives from the major nations met
to discuss this dilemma. This conference resulted in the Smithsonian Agreement, whereby the U.S. dollar’s value was
devalued relative to the other major currencies. The degree to which the dollar was devalued varied with each foreign
currency. Not only was the dollar’s value reset, but exchange rates were also allowed to fluctuate by 2.25 percent in either
direction from the newly set rates. These boundaries of 2.25 percent were wider than the previous boundaries, which
enabled exchange rates to move within a wider range.
Floating Exchange Rate System
Even with the wider bands allowed by the Smithsonian Agreement, central banks still had difficulty maintaining exchange
rates within the stated boundaries. By March 1973, the official boundaries imposed by the Smithsonian Agreement had
been eliminated, thereby allowing exchange rates to move more freely. Since that time, the currencies of most countries
have been allowed to fluctuate in accordance with market forces; however, some countries’ central banks still periodically
intervene in the foreign exchange market to influence the market-determined exchange rate or to reduce the volatility in
their respective currency’s exchange rate movements.
Foreign Exchange Transactions
The foreign exchange market should not be thought of as a specific building or location where traders exchange
currencies. Instead, companies typically exchange one currency for another through a commercial bank over a
telecommunications network, which represents an over-the-counter market.
Foreign exchange dealers serve as intermediaries in the foreign exchange market by exchanging currencies desired by
MNCs or individuals. Foreign exchange dealers include large commercial banks. Dealers such as these have branches in
most major cities and also facilitate foreign exchange transactions with an online trading service. Dealers also rely
exclusively on online trading to facilitate such transactions. Customers establish an online account and can interact with
the foreign exchange dealer’s website to transmit their foreign exchange order. In recent years, new trading platforms
have been established that allow some MNCs to engage in foreign exchange transactions directly with other MNCs,
thereby eliminating the need for a foreign exchange dealer.
Most currency transactions between two non-U.S. countries do not involve the U.S. dollar.
Spot Market
The most common type of foreign exchange transaction is for immediate exchange. The market in which these
transactions occur is known as the spot market. The exchange rate at which one currency is traded for another in the
spot market is known as the spot rate.
Spot Market Structure
Commercial transactions in the spot market are often completed electronically, with banks or other financial institutions
serving as intermediaries. The exchange rate at the time determines the amount of funds necessary for the transaction.
If a bank begins to experience a shortage of a particular foreign currency, it can purchase that currency from other banks.
This trading between banks occurs in the interbank market.
Some other financial institutions, such as securities firms, can provide the same services. Most major airports around the
world also have foreign exchange centers where individuals can exchange currencies. Many cities also have retail foreign
exchange offices where tourists and other individuals can exchange their currency.
Use of the Dollar in Spot Markets
The U.S. dollar is accepted as a medium of exchange by merchants in many countries; this is especially true in countries
where the home currency is weak or subject to foreign exchange restrictions. Many merchants accept U.S. dollars
because they can easily use them to purchase goods from other countries.
Spot Market Time Zones
Although foreign exchange trading is conducted only during normal business hours at a given location, such hours vary
among locations because of different time zones. Thus, at any given weekday time, a bank located somewhere in the
world is open and ready to accommodate foreign exchange requests by MNCs.
When the foreign exchange market opens in the United States each morning, the opening exchange rate quotations are
based on the prevailing rates quoted by banks in other locations, where the markets have opened earlier.
Several U.S. banks have established night-trading desks to deal with the issues related to time zone differences. The
largest banks have initiated night-trading to capitalize on overnight foreign exchange movements and to accommodate
corporate requests for currency trades. Even some medium-sized banks now offer night trading as a way of
accommodating their corporate clients.
Spot Market Liquidity
The spot market for each currency is characterized by its liquidity, which reflects the level of trading activity. The more
buyers and sellers there are for a currency, the more liquid the market for that currency is. The spot markets for heavily
traded currencies are extremely liquid. In contrast, the spot markets for currencies of less developed countries are much
less liquid. A currency’s liquidity affects the ease with which it can be bought or sold by an MNC. If a currency is illiquid,
then the number of willing buyers and sellers is limited, so an MNC may be unable to purchase or sell a large amount of
that currency in a timely fashion and at a reasonable exchange rate.
Attributes of Banks That Provide Foreign Exchange
The following characteristics of banks are important to customers in need of foreign exchange:
1. Competitiveness of quote. A savings of $0.01 per unit on an order of 1 million units of currency is worth
$10,000.
 2. Special relationship with the bank. The bank may offer cash management services or be willing to make a
special effort to obtain hard-to-find foreign currencies for the corporation.
3. Speed of execution. Banks may vary in the efficiency with which they handle an order. A corporation needing the
currency will prefer a bank that conducts the transaction promptly and also handles any paperwork properly.
4. Advice about current market conditions. Some banks may provide assessments of foreign economies and
relevant activities in the international financial environment that relate to corporate customers.
5. Forecasting advice. Some banks may provide forecasts of the future state of foreign economies and the future
value of exchange rates.
The list suggests that a corporation in need of a foreign currency should not automatically choose the bank that sells the
currency at the lowest price. Most MNCs that frequently need foreign currencies develop a close relationship with at least
one major bank in case they need various foreign exchange services from a bank.
Bid/Ask Spread of Banks
Commercial banks charge fees for conducting foreign exchange transactions, such that they buy a currency from
customers at a slightly lower price than the price at which they sell it. In other words, a bank’s bid price (buy quote) for a
foreign currency will always be less than its ask price (sell quote). The difference between the bid and ask prices, known
as the bid/ask spread, is meant to cover the costs associated with fulfilling requests to exchange currencies. A larger
bid/ask spread generates more revenue for commercial banks, but represents a higher cost to individuals or MNCs that
engage in foreign exchange transactions. The bid/ask spread is typically expressed as a percentage of the ask quote.
Comparison of Bid/Ask Spread among Currencies
The difference between a bid quote and an ask quote will look much smaller for currencies of lesser value. This
differential can be standardized by measuring the spread as a percentage of the currency’s spot rate.
The bid/ask spread in percentage terms is typically computed as follows:

This formula is used to compute the bid/ask spreads.

The bid/ask spread for retail transactions is usually in the range of 3 to 7 percent. For the larger wholesale transactions
that occur between banks or involve large corporations, the spread is much smaller, commonly in the range of 0.01 to
0.03 percent. The spread is usually larger for illiquid currencies that are traded less frequently. The bid/ask spread
represents the discount in the bid rate as a percentage of the ask rate. An alternative bid/ask spread uses the bid rate as
the denominator, so that it measures the percentage markup of the ask rate above the bid rate. The spread is slightly
higher when using this formula because the bid rate used in the denominator is always less than the ask rate.
The bid/ ask spread will be ignored. That is, only one price will be shown for a given currency, because the bid and ask
prices are assumed to be equal.
To conserve space, some quotations show the entire bid price followed by a slash and then only the last two or three
digits of the ask price.
Factors That Affect the Spread
The spread on currency quotations is influenced by the following factors:

 Order costs. Order costs are the costs of processing orders; these costs include clearing costs and the costs of
recording transactions.
 Inventory costs. Inventory costs are the costs of maintaining an inventory of a particular currency. Holding an
inventory involves an opportunity cost because the funds could have been used for some other purpose. If
interest rates are relatively high, then the opportunity cost of holding an inventory should be relatively high. The
higher the inventory costs, the larger the spread established to cover these costs will be.
 Competition. The more intense the competition, the smaller the spread quoted by intermediaries will be.
Competition is more intense for the more widely traded currencies because more business is conducted in those
currencies. The establishment of trading platforms that allow MNCs to trade directly with each other is a form of
competition against foreign exchange dealers, and it has forced dealers to reduce their spread to remain
competitive.
  Volume. Currencies that are more liquid are less likely to experience a sudden change in price. Currencies that
have a large trading volume are more liquid because numerous buyers and sellers are available at any given
time. In turn, the market has enough depth that a few large transactions are unlikely to cause the currency’s price
to change abruptly.
 Currency risk. Some currencies exhibit more volatility than others because of economic or political conditions
that cause the demand for and supply of the currency to change abruptly. For example, currencies in countries
that experience frequent political crises are subject to sudden price movements. Intermediaries that are willing to
buy or sell these currencies could incur large losses due to such changes in their value.
Like the prices of securities in many financial markets, foreign exchange prices can be subject to manipulation. In
particular, a few financial institutions that serve as the main intermediaries for large foreign exchange transactions might
engage in collusion by agreeing to set wider bid/ask spreads than would normally be possible if they set their quotes
competitively.
Agencies attempt to ensure orderly and fair pricing in the foreign exchange market. The oversight of exchange rate pricing
is challenging, however, because it can be difficult to prove that financial institutions have conspired to widen spreads.
Foreign Exchange Quotations
Exchange rate quotations for widely traded currencies, and even for many currencies that are not widely traded, are
readily available on the Internet.
At any moment in time, the exchange rate between two currencies should be similar across the various banks that provide
foreign exchange services. If a large discrepancy exists, customers could profit from purchasing a large amount of the
currency from the low-quoting bank and immediately selling it to the high-quoting bank. These actions would cause the
low-quoting bank to quickly experience a shortage of that currency, while the high-quoting bank would quickly experience
an excessive amount of that currency because it was willing to pay too much for the currency. As a result, the banks
would rapidly adjust their exchange rate quotations, eliminating any discrepancy between the quotations.
Direct versus Indirect Quotations at One Point in Time
Quoted exchange rates for currencies usually reflect the ask prices for large transactions. Quotations that report the value
of a foreign currency in dollars (number of dollars per unit of other currency) are referred to as direct quotations,
whereas quotations that report the number of units of a foreign currency per dollar are known as indirect quotations.
Websites that provide exchange rates allow you to readily switch between direct and indirect quotations. An indirect
quotation is the reciprocal (inverse) of the corresponding direct quotation.

Direct versus Indirect Exchange Rates over Time

For any currency at any time, the indirect exchange rate is the inverse of the direct exchange rate. According to the
relationship, for each currency, between movements in the direct exchange rate and movements in the indirect exchange
rate, it follows that if a currency’s direct exchange rate is rising over time, then its indirect exchange rate must be declining
over time (and vice versa).
It is important to recognize the difference between direct and indirect exchange rates over time, because both are used in
the presentations by different analysts and firms. When a discussion about depreciation of a currency is illustrated with a
rising trend for that currency, the trend must be based on an indirect exchange rate.
When conducting an extensive analysis of exchange rates, all exchange rates should be converted into direct quotations.
In this way, currencies can be easily compared and are less likely to make a mistake in determining whether a currency is
appreciating or depreciating over a particular period.
Source of Exchange Rate Quotations
Updated currency quotations are provided for several major currencies on various websites. You can select any currency
for which you want an exchange rate quotation, and you can view a trend of the historical exchange rate movements for
any currency. Trends are available for various periods (longer for some currencies). As you review the trend in exchange
rates, note carefully whether the exchange rate quotation is direct or indirect so that you can properly interpret the trend.
The trend indicates not only the exchange rate’s direction, but also the extent to which the currency has changed over
time. In addition, it identifies the range (a measurement of volatility) of exchange rates within a particular period. When a
currency’s exchange rate is extremely sensitive to economic conditions, its movements tend to be more volatile.
Exchange rate quotations are also provided by many other online sources. Most sources provide both direct and indirect
exchange rate quotations, so be sure to check which type of quotation is being provided.
Cross Exchange Rates
Most tables of exchange rate quotations express currencies relative to the U.S. dollar, but in some instances, a firm will be
concerned about the exchange rate between two non-dollar currencies. The type of rate desired here is known as a cross
exchange rate because it reflects the amount of one foreign currency per unit of another foreign currency. Cross
exchange rates can be easily determined with the use of foreign exchange quotations. The relative value of any two non-
dollar currencies is equal to the dollar value of one currency divided by the dollar value of the other.
Cross Exchange Rates over Time
As the exchange rates of two currencies change against the U.S. dollar over time, the cross exchange rate of these
currencies can change as well.
Derivative Contracts in the Foreign Exchange Market
A currency derivative is a contract with a price that is partially derived from the value of the underlying currency that it
represents. Three types of currency derivatives that are often used by MNCs are forward contracts, currency futures
contracts, and currency options contracts.
Forward Contracts
In some cases, an MNC may prefer to lock in an exchange rate at which it can obtain a currency in the future. A forward
contract is an agreement between an MNC and a foreign exchange dealer that specifies the currencies to be exchanged,
the exchange rate, and the date at which the transaction will occur. The forward rate is the exchange rate, specified in
the forward contract, at which the currencies will be exchanged. MNCs commonly request forward contracts to hedge
future payments that they expect to make or receive in a foreign currency. With such arrangements in place, they do not
have to worry about fluctuations in the spot rate until the time of their future payments.
The forward market is the market in which forward contracts are traded. In this over-the-counter market, the main
participants are the foreign exchange dealers and the MNCs that wish to obtain a forward contract. Many MNCs use the
forward market to hedge their payables and receivables.
Many of the large dealers that serve as intermediaries in the spot market also serve the forward market.
The liquidity of the forward market varies among currencies. The forward market for euros is very liquid because many
MNCs take forward positions to hedge their future payments in euros. In contrast, the forward markets for currencies of
countries with less international trade are less liquid, so MNCs take fewer forward positions. There are even some
currencies for which there is no forward market.
Some quotations of exchange rates include forward rates for the most widely traded currencies. Other forward rates are
not quoted on financial websites but are quoted by the banks that offer forward contracts in various currencies.
Currency Futures Contracts
Futures contracts are similar to forward contracts but are sold on an exchange instead of an over-the-counter market. A
currency futures contract specifies a standard volume of a particular currency to be exchanged on a specific settlement
date. Some MNCs involved in international trade use the currency futures markets to hedge their positions. The futures
rate is the exchange rate at which an entity can purchase or sell a specified currency on the settlement date in
accordance with the futures contract. Thus, the futures rate’s role in a futures contract is similar to the forward rate’s role
in a forward contract.
It is important to distinguish between the futures rate and the future spot rate. The future spot rate is the spot rate that
will exist at some future time; hence that rate is uncertain today.
Currency Options Contracts
Currency options contracts can be classified as calls or puts. A currency call option provides the right to buy a specific
currency at a specific price (called the strike price or exercise price) within a specific period of time. It is used to hedge
future payables. A currency put option provides the right to sell a specific currency at a specific price within a specific
period of time. It is used to hedge future receivables.
Currency call and put options can be purchased on an exchange. They offer more flexibility than forward or futures
contracts because they are not obligations: That is, the firm can elect not to exercise the option.
Currency options have become a popular means of hedging. Although most MNCs use forward contracts, many also use
currency options.
International Money Market
Each country has a money market whereby surplus units (individuals or institutions with available short-term funds) can
transfer funds to deficit units (institutions or individuals in need of funds). Financial institutions such as commercial banks
accept short-term deposits from surplus units and redirect those funds toward deficit units.
The international money market developed to accommodate the needs of MNCs. First, many MNCs borrow short-term
funds in different currencies to pay for imports denominated in those currencies. Second, MNCs that need funds to
support local operations may consider borrowing in a nonlocal currency that exhibits lower interest rates. This strategy is
especially appropriate for firms expecting future receivables denominated in that currency. Third, MNCs may consider
borrowing in a currency that they anticipate will depreciate against their home currency, as this would enable them to
repay the short-term loan at a more favorable exchange rate. In this case, the actual cost of borrowing would be less than
the interest rate quoted for that currency.
At the same time, some MNCs and institutional investors have incentives to invest short-term funds in a foreign currency.
First, the interest rate on a short-term investment denominated in a foreign currency might exceed the interest rate on a
short-term investment denominated in their home currency. Second, they may consider investing in a currency that they
expect will appreciate against their home currency so that the return on their investment would be greater than the interest
rate quoted for the foreign investment.
Financial institutions such as commercial banks serve this market by accepting deposits and providing loans in various
currencies. These intermediaries typically also serve as dealers in the foreign exchange market.
Dollar-Denominated Bank Accounts in Europe and Asia
Because the U.S. dollar is sometimes used even by foreign countries as a medium for international trade, there is a
consistent demand for dollars in Europe and elsewhere. Consequently, many MNCs from various countries have
established dollar-denominated bank accounts in Europe. Banks are willing to allow such accounts because they can lend
the dollars to corporate customers based in Europe. These dollar deposits in banks in Europe (and on other continents)
are known as Eurodollars (not to be confused with the euro, the currency used by many European countries).
The Asian money market also accommodates dollar-denominated bank accounts because various businesses in Asia
use dollars as the medium of exchange in international trade. Banks within the Asian money market usually lend to each
other when some banks have excess dollars and other banks need more dollars. The Asian money market is integrated
with the European money market in that banks in Asia lend and borrow dollars from banks in Europe.
Money Market Interest Rates among Currencies
The money market interest rate on short-term deposits or short-term loans in a particular currency in international money
markets depends on the supply of short-term funds provided by surplus units and the demand for short-term funds by
deficit units in that currency. In general, a country that experiences both a high demand for and a small supply of short-
term funds will have relatively high money market interest rates. Conversely, a country with both a low demand for and a
large supply of short-term funds will have relatively low money market interest rates. Money market rates tend to be
higher in developing countries because they experience higher rates of inflation and faster growth, so they need more
funds (relative to the available supply) to finance that growth. The money market interest rate for a particular currency
changes over time in response to changes in the supply of and demand for short-term funds for that currency.
The money market rates vary substantially among some currencies. MNCs based in countries whose local currencies
exhibit low interest rates tend to have lower financing costs.
A currency’s money market is highly influenced by its respective London Interbank Offer Rate (LIBOR), which is the
interest rate most often charged for short-term loans between banks in international money markets. The term LIBOR is
commonly used even though many international interbank transactions do not actually pass through London. When a
currency’s LIBOR rises, money market rates denominated in that currency tend to rise as well, just as U.S. money market
rates tend to move with the federal funds rate (the interest rate charged on loans between U.S. banks).
The LIBOR was historically measured as the average of the rates reported by banks at a particular time. In 2012, country
governments detected that some banks were falsely reporting the interest rate they offered in the interbank market in an
effort to manipulate the LIBOR, thereby boosting the values of their investments that were tied to LIBOR. This scandal
prompted financial markets to devise ways of determining the market interest rate in a manner that does not rely on the
rates reported by participating banks.
Risk of International Money Market Securities
When MNCs and government agencies issue debt securities with a short-term maturity (one year or less) in the
international money market, these instruments are referred to as international money market securities. MNCs typically
pay a slightly higher rate than their local government when borrowing in international money markets because of a small
risk premium that reflects the credit (default) risk involved in the loan. Generally, international money market securities are
perceived to be very safe, especially when they are rated high by rating agencies. Also, because the typical maturity of
these securities is one year or less, investors are less concerned about the issuer’s financial condition deteriorating by the
time of maturity than if the securities had a longer-term maturity. Nevertheless, some international money market
securities have defaulted, so investors in this market need to consider the possible credit (default) risk of the securities
that are issued.
International money market securities are also exposed to exchange rate risk when the currency denominating the
securities differs from the investor’s home currency. Specifically, the return on investment in the international money
market security will decrease when the currency denominating the money market security weakens against the home
currency. Thus, even when they purchase securities without credit risk, investors can lose money because of exchange
rate risk.
International Credit Market
Multinational corporations and domestic firms sometimes obtain medium-term funds via term loans from local financial
institutions or by issuing notes (medium-term debt obligations) in their local markets. In addition, MNCs can access
medium-term funds through banks located in foreign markets. Loans of one year or longer that are extended by banks to
MNCs or government agencies in Europe are commonly called Eurocredits or Eurocredit loans; these transactions
occur in the Eurocredit market. Eurocredit loans can be denominated in dollars or in one of many other currencies, and
their typical maturity is five years.
Borrowers usually prefer that loans be denominated in the currency of the country in which they receive most of their cash
flows, which eliminates the borrower’s exchange rate risk. However, the loan’s interest rate depends on the currency in
which the loan is denominated. The loan rate adjusts over time in accordance with the movement of a market interest
rate.
Syndicated Loans in the Credit Market
Sometimes a single bank is unwilling or unable to lend the amount needed by a particular corporation or government
agency. In this case, a syndicate of banks may be organized, in which each bank participates in the lending. The lead
bank is responsible for first negotiating terms with the borrower; it then organizes a group of banks to underwrite the
loans. For each bank involved, syndicated loans reduce the exposure to default risk to the extent of that individual bank’s
participation.
Borrowers that receive a syndicated loan incur various fees besides the interest on the loan. Front-end management fees
are paid to cover the costs of organizing the syndicate and underwriting the loan. In addition, a commitment fee of
approximately 0.25 to 0.50 percent is charged annually on the unused portion of the available credit extended by the
syndicate.
Syndicated loans can be denominated in a variety of currencies. The interest rate depends on the currency denominating
the loan, the loan’s maturity, and the creditworthiness of the borrower. Interest rates on syndicated loans are usually
adjusted to reflect movements in market interest rates, with such adjustments occurring every six months or every year.
International Bond Market
The international bond market facilitates the flow of funds between borrowers who need long-term funds and investors
who are willing to supply those funds. Major investors in the international bond market include institutional investors such
as commercial banks, mutual funds, insurance companies, and pension funds from many countries. Institutional investors
may prefer to invest in international bond markets, rather than in their respective local markets, when they can earn a
higher return on bonds denominated in foreign currencies. Borrowers in the international bond market include both
national governments and MNCs.
MNCs can obtain long-term debt by issuing bonds in their local markets, and they can also access long-term funds in
foreign markets. They may choose to issue bonds in the international bond markets for three reasons. First, MNCs may
be able to attract a stronger demand by issuing their bonds in a particular foreign country rather than in their home
country. Some countries have a limited investor base, so MNCs in those countries naturally seek financing elsewhere.
Second, MNCs may prefer to finance a specific foreign project in a particular currency and, therefore, may seek funds
where that currency is widely used. Third, an MNC might attempt to finance projects in a foreign currency with a lower
interest rate in an effort to reduce its cost of financing, although doing so would increase its exposure to exchange rate
risk.
An international bond issued by a borrower foreign to the country where the bond is placed is known as a foreign bond.
In some cases, a firm may issue a variety of bonds in various countries. The currency denominating each type of bond is
determined by the country where it is sold. The foreign bonds in these cases are sometimes referred to as parallel
bonds.
Eurobond Market
Eurobonds are bonds that are sold in countries other than the country whose currency is used to denominate the bonds.
The term “Eurobond” can be misleading because the prefix “Euro” refers to external financing, rather than to Europe or
the currency called the euro. There is also potential confusion because some financial market participants use the term
“Eurobonds” when describing bonds issued in Europe that are denominated in euros.
Eurobonds have become popular as a means of attracting funds because they may circumvent registration requirements
and avoid some disclosure requirements. Thus, these bonds can be issued quickly and at a low cost. Eurobonds are
underwritten by a multinational syndicate of investment banks and can be simultaneously placed in many countries,
providing a wide spectrum of fund sources to tap. Those MNCs without a strong credit record may have difficulty obtaining
funds in the Eurobond market because the limited disclosure requirements may discourage investors from trusting issuers
that have not yet established a good reputation.
Features of Eurobonds
Eurobonds have several distinctive features. They are usually issued in bearer form, which means that no records are
kept regarding ownership. Coupon payments are made yearly. Some Eurobonds carry a convertibility clause that allows
for them to be converted into a specified number of shares of common stock. An advantage to the issuer is that
Eurobonds typically have few, if any, protective covenants. Furthermore, even short-maturity Eurobonds include call
provisions. Some Eurobonds, called floating-rate notes (FRNs), have a variable rate provision that adjusts the coupon
rate over time according to prevailing market rates.
Denominations
Eurobonds are denominated in a number of currencies. Because credit conditions and the interest rates for each currency
change constantly, the popularity of particular currencies in the Eurobond market changes over time.
Secondary Market
Eurobonds have a secondary market. In many cases, the market makers for Eurobonds are the same underwriters who
sell the primary issues.
Development of Other Bond Markets
Bond markets have also developed in Asia and South America. Government agencies and MNCs in these regions use
international bond markets to issue bonds when they believe they can reduce their financing costs. Investors in some
countries use international bond markets because they expect their local currency to weaken in the future and prefer to
invest in bonds denominated in a strong foreign currency. The South American bond market has experienced limited
growth because the interest rates in some countries there are usually high. Because MNCs and government agencies in
those countries are unwilling to issue bonds when interest rates are so high, they rely heavily on short-term financing.
Risk of International Bonds
From the perspective of investors, international bonds are subject to four forms of risk: interest rate risk, exchange rate
risk, liquidity risk, and credit (default) risk.
Interest Rate Risk
The interest rate risk of international bonds is the potential for their value to decline in response to rising long-term interest
rates. When long-term interest rates rise, the required rate of return by investors rises. Therefore, the valuations of bonds
decline. Interest rate risk is more pronounced for fixed-rate bonds than for floating-rate bonds because the coupon rate
remains fixed on fixed-rate bonds even when interest rates rise.
Exchange Rate Risk
Exchange rate risk is the potential for a bond’s value to decline (from the investor’s perspective) because the currency
denominating the bond depreciates against the investor’s home currency. As a result, the future expected coupon or
principal payments to be received from the bond may convert to a smaller amount of the investor’s home currency.
Liquidity Risk
Liquidity risk of bonds represents the potential for their prices to be lower at the time they are sold by investors because
no consistently active market exists for them. Thus, investors who wish to sell the bonds may have to lower their price to
attract potential buyers.
Credit Risk
The credit risk of international bonds is the potential for default, whereby interest and/or principal payments to investors
may be suspended either temporarily or permanently. This risk is especially relevant in countries where creditor rights are
limited, because creditors may be unable to require that debtor firms take the actions necessary to enable debt
repayment.
As the credit risk of the issuing firm increases, the risk premium required by investors also increases. Any investors who
want to sell their holdings of the bonds under these conditions must sell the bonds for a lower price to compensate
potential buyers for the credit risk.
International Stock Markets
In recent years, many new stock markets have been developed. Such emerging markets allow foreign firms doing
business in those countries to raise large amounts of capital by issuing stock there.
Issuance of Stock in Foreign Markets
MNCs may issue stock in foreign markets for various reasons. They may more readily attract funds from foreign investors
by issuing stock in international markets. They typically have their stock listed on an exchange in any country where they
issue shares, because investors in a foreign country are only willing to purchase stock if they can later easily sell their
holdings locally in the secondary market. The stock is denominated in the currency of the country where it is placed.
An MNC’s stock offering may be more easily digested when it is issued in several markets. The stocks of some U.S.-
based MNCs are widely traded on numerous stock exchanges around the world, which gives non-U.S. investors easy
access to those stocks and also gives the MNCs global name recognition. Many MNCs issue stock in a country where
they will generate enough future cash flows to cover dividend payments.
Issuance of Foreign Stock in the United States
Non-U.S. corporations that need large amounts of funds sometimes issue stock in the United States (these are called
Yankee stock offerings) because the U.S. new-issues market is so liquid. Because many financial institutions in the
United States purchase non-U.S. stocks as investments, non-U.S. firms may be able to place an entire stock offering in
the United States. By issuing stock in the United States, non-U.S. firms may diversify their shareholder base; this, in turn,
can lessen the share price volatility induced by large investors selling shares. Investment banks and other financial
institutions in the United States often serve as underwriters of stock issues targeted for the U.S. market, for which they
receive underwriting fees of approximately 7 percent of the issued stock’s value.
Non-U.S. firms that issue stock in the United States have their shares listed on a U.S. stock exchange, so that the shares
placed in the United States can be easily traded in the secondary market. Firms that issue stock in the United States are
generally required to satisfy stringent disclosure rules regarding their financial condition.
Effect of the Sarbanes-Oxley Act on Foreign Stock Listings
In 2002, the U.S. Congress passed the Sarbanes-Oxley Act, which required firms whose stock is listed on U.S. stock
exchanges to provide more complete financial disclosure. The high cost of compliance with this act subsequently
prompted many non-U.S. firms to place new issues of their stock in the United Kingdom, rather than the in United States.
Furthermore, some non-U.S. firms listed on U.S. stock exchanges before the Sarbanes-Oxley Act de-registered after its
passage; such withdrawals may be attributed to the high cost of compliance.
American Depository Receipts
Non-U.S. firms also obtain equity financing by issuing American depository receipts (ADRs), which are certificates
representing bundles of the firm’s stock. The use of ADRs circumvents some disclosure requirements imposed on stock
offerings in the United States while enabling non-U.S. firms to still tap the U.S. market for funds.
Because ADR shares can be traded just like shares of a stock, the price of an ADR changes each day in response to
demand and supply conditions. Over time, however, the value of an ADR should move in tandem with the value of the
corresponding stock that is listed on the foreign stock exchange (after exchange rate effects are taken into account). The
formula for calculating the price of an ADR is

where PADR denotes the price of the ADR, PFS is the price of the foreign stock measured in foreign currency, and S is the
spot rate of the foreign currency. Holding the price of the foreign stock constant, the ADR price should move
proportionately (against the dollar) with movement in the currency denominating the foreign stock. ADRs are especially
attractive to U.S. investors who anticipate that the foreign stock will perform well and that the currency in which it is
denominated will appreciate against the dollar. ADR price quotations are provided by various websites.
How Governance Varies among Stock Markets
In general, stock market participation and trading activity are higher in countries where there is strong governance. Some
factors enable stronger governance and, therefore, may increase the trading activity in a stock market.
Rights
Shareholders in some countries have more rights than those in other countries. For example, shareholders have more
voting power in some countries than others, and they can have influence on a wider variety of management issues in
some countries.
Legal Protection
Shareholders in some countries may have more power to sue publicly traded firms if their executives or directors commit
financial fraud. In general, common-law countries allow for more legal protection than civil-law countries. Managers are
more likely to serve shareholder interests when shareholders have more legal protection.
Government Enforcement
A country might have laws to protect shareholders yet not adequately enforce those laws, which means that, in a practical
sense, shareholders are not protected. Some countries also tend to have less corporate corruption than others. In these
countries, shareholders are less susceptible to major losses due to agency problems, whereby managers use shareholder
money for their own benefit.
Accounting Laws
Beginning in 2001, the International Accounting Standards Board issued accounting rules for public companies. Many
countries now require public companies to use these rules in preparing their financial statements. As a result, there is
more uniformity in accounting rules across countries, though some persistent differences might make it difficult to directly
compare financial statements of MNCs across countries. Shareholders are less susceptible to losses stemming from
insufficient information when public companies are required to provide more transparency in their financial reporting.
Impact of Governance Characteristics
In general, stock markets that allow more voting rights for shareholders, more legal protection, more enforcement of the
laws, and more stringent accounting requirements attract more investors who are willing to invest in stocks. Collectively,
these factors produce more confidence in the stock market and greater pricing efficiency, because a large set of investors
monitor each firm. A stock market that does not attract investors will not attract companies in search of funds; in this case,
companies must rely either on stock markets in other countries or on credit markets (bonds and bank loans).
Integration of International Stock Markets and Credit Markets
Because the economies of countries are integrated and because stock market prices reflect the host country’s prevailing
and anticipated economic conditions, stock market prices are integrated across countries. Furthermore, international
credit and stock markets are integrated because both are adversely affected when conditions cause the perceived credit
risk of companies to increase. When economic conditions become unfavorable, more uncertainty surrounds the future
cash flows of firms; hence the risk premium required by investors rises and valuations of debt securities and stocks fall.
International Financial Market Crises
When a country experiences an economic crisis, that event often leads to a financial market crisis. In such a case, a
country that relies on foreign investment (capital inflows) from foreign financial institutions to support its growth is typically
subjected to capital outflows as foreign investors and creditors attempt to withdraw their funds as soon as possible. A
common first response by the government is to raise the local interest rates in an attempt to attract new foreign
investments, which could offset the funds that have been withdrawn by foreign investors. Yet, when a country raises its
interest rates, the market values of existing bonds that it previously issued and denominated in its own currency will
decline (interest rate risk).
As foreign investors sell investments in the struggling country so that they can withdraw their funds, they exchange the
local currency into their respective home currencies. These actions place heavy downward pressure on the value of the
local currency against all the currencies of the foreign investors. In some countries that have experienced massive
withdrawals of foreign funds, the local currencies declined by more than 30 percent against many other currencies in a
single week. Consequently, if the government of the struggling country has issued debt in one of the currencies that has
strengthened substantially against its own, it will need much more of its own currency to repay the debt (exchange rate
risk). The countries that heavily rely on foreign funds are more exposed to the possibility of major withdrawals of foreign
funds in response to any signal that the country is experiencing financial problems.
As foreign investors sell their securities in the secondary market, and no new foreign investment flows in, the local market
suffers from a lack of liquidity. Consequently, the investors may have to sell their securities at a significant discount
(liquidity risk).
When a country’s economy weakens, corporate income declines, personal income declines, and the government receives
less tax revenue. In addition, the government may need to spend more money due to higher unemployment in the
country. Consequently, its budget worsens, and it is more likely to default on its debt (credit risk). It might wish to issue
more debt to get through the crisis, but if the country’s interest rates are now very high and its currency is very weak, this
response could cause debt repayments to be excessive. In addition, foreign investors will be willing to provide new
financing to the government only if the yield contains a very large risk premium to compensate them for accepting the high
credit risk. This is one more reason why the cost of new financing would be very high.
All of these types of risk interact and can even create more fear of a crisis. Even the local investors within the struggling
country may attempt to sell their local investments and move their money into other countries. As foreign investors and
local investors exchange the local currency for currencies of other countries where they wish to move their funds, their
actions place additional downward pressure on the local currency.
Contagion Effects
A financial market crisis in one country can lead to contagion effects in the financial markets of other countries. The
consumers and businesses of the country that is experiencing an economic crisis have less money to spend, which
causes a reduced demand for imported products produced by other countries. This effect is especially pronounced when
the crisis country’s local currency has weakened substantially against other currencies. Thus, any country that relies
heavily on consumers in the crisis country to buy its products could experience its own economic crisis. If many of the
second country’s local financial institutions have major investments in or have provided loans to the crisis country, they
could be subject to large losses or even bankruptcy. If the second country’s government has issued international debt, it
could experience its own financial market crisis, just as the crisis country did. The greater the degree of a country’s
economic integration and financial market integration with the crisis country, the more likely that it will be exposed
(contagious) to the problems of the crisis country.
Even if a country is completely independent of the country experiencing the crisis, it could be subject to contagion effects
if it relies heavily on foreign investors to purchase its international debt. When one country experiences a financial crisis,
foreign investors commonly assess whether other countries that are heavily reliant on their funds might also develop
economic problems, which could lead to severe currency depreciation and debt repayment problems. Some foreign
investors simply stop investing in international securities while one country is experiencing a financial crisis due to fear of
contagion effects. This action by itself can cause contagion effects, because it results in less liquidity in the international
financial markets. Since credit markets are based on trust that credit will be repaid, funds dry up when fear of government
debt defaults increase. Thus, even if a country is not experiencing severe economic problems, it could be cut off from
foreign investors due to a fear that it might experience a crisis.
In recent decades, a number of financial crises have occurred. Some of these events produced substantial contagion
effects, whereas in others those effects were limited.
Asian Crisis
The international debt crisis that occurred in 1997 illustrates all of the potential bad effects just described. This event is
often referred to as the Asian crisis, because the problems affected not only the Asian debt markets but also the Asian
stock markets.
In the mid-1990s, Thailand and many other Asian countries were growing rapidly, but needed foreign funding in the debt
markets and stock markets to finance that growth. Foreign investors (especially large financial institutions) were glad to
oblige because they were earning a higher rate of return in these countries than they could earn elsewhere. However,
Thailand’s economy stalled in 1997, and the country was plagued with political uncertainty. Consequently, foreign
investors sold their investments in Thailand and withdrew their funds. This caused Thailand’s currency (the baht) to
depreciate substantially. The weakened currency reduced the value of the investments that any foreign investors still had
in Thailand, which encouraged any remaining foreign investors to withdraw their funds before the currency weakened
further.
Many foreign investors feared that other emerging countries in Asia that relied heavily on foreign financing could
experience the same problem, so they attempted to withdraw their funds from those countries before a crisis occurred.
Unfortunately, these actions by foreign investors actually expedited the crisis in these other Asian countries: The sudden
massive sale of Asian investments in the secondary markets caused the values of these investments to plummet, and a
massive sale of the local currencies occurred as foreign investors moved their money out of these countries. The crisis
caused stock valuations in Thailand, South Korea, Indonesia, and Malaysia to decline by more than 60 percent from a
U.S. investor’s perspective (when including the effect of their weakened currencies as well).
One of the most important lessons of the Asian crisis was that when a country relies heavily on foreign funding, it exposes
itself to adverse effects if the foreign funding disappears. A second lesson is that foreign funding can disappear quickly in
response to investors’ fear of a potential economic or political problem, even before the problem occurs. Several financial
crises have occurred in emerging markets since the Asian crisis for similar reasons. The Asian crisis is covered in more
detail in the Appendix to Chapter 6.
International Credit Crisis
In 2008, the United States experienced a credit crisis that affected the international financial markets. The credit crisis was
triggered by the substantial defaults on subprime (low-quality) mortgages. Financial institutions in other countries, such as
the United Kingdom, had also offered subprime mortgage loans and experienced high default rates.
Because of the global integration of financial markets, the problems in the U.S. and U.K. financial markets soon spread to
other markets. Some financial institutions based in Asia and Europe were heavy purchasers of subprime mortgages that
had originated in the United States and United Kingdom. Furthermore, the resulting weakness of the U.S. and European
economies reduced their demand for imports from other countries. As a result of all these factors, the U.S. credit crisis
blossomed into an international credit crisis and increased concerns about credit risk in international markets. Creditors
reduced the amount of credit that they were willing to provide, and some MNCs and government agencies were then no
longer able to obtain funds in the international credit markets.
Greek Crisis
In 2010, Greece experienced weak economic conditions and a large increase in the government’s budget deficit.
Investors were concerned that the Greek government would not be able to repay its debt. Furthermore, investors learned
that the government’s reported budget deficits in the previous eight years were understated. A financial crisis erupted in
Greece, as its government became desperate for new financing. As of March 2010, bonds issued by the Greek
government offered a 6.5 percent yield, which reflected a 4 percent annualized premium above bonds issued by other
European governments (such as Germany) that also used the euro as their currency. This implies that borrowing the
equivalent of $10 billion from a bond offering would require Greece to pay an additional $400 million in interest payments
every year because of its higher degree of default risk. These high interest payments created even more concern that
Greece would not be able to repay its debt.
In 2010, governments and banks in the other eurozone countries provided Greece with a bailout loan of €110 billion and
required Greece to meet so-called austerity conditions (such as reducing its public-sector salaries and pensions) that
could reduce the future budget deficit. However, Greece’s budget deficit increased, and it needed another bailout of about
€130 billion from several European governments in 2012. By 2015, the government needed another bailout, the country’s
third in five years. In July of that year, several European governments agreed to provide a new bailout loan of
approximately €85 billion to Greece.
As of August 2018, Greece’s debt level was estimated to be $366 billion. Because some European governments served
as major creditors for Greece, they were subject to potential credit contagion. A default by Greece on its debt could have
had devastating financial effects on the European governments that provided loans, which could have prevented some of
them from repaying their own debt. An important lesson of the Greek crisis is that government debt is not always risk-free.
Creditors now assess the credit risk of countries that have large budget deficits more carefully, and they commonly
require these countries to pay a risk premium on their debt.
Turkish Crisis
In August 2018, as Turkey experienced economic problems, some of its foreign investors began to move their funds
outside of Turkey. The Turkish currency (lira) depreciated by 25 percent against the dollar in just one week, and there was
some concern about Turkey’s ability to repay its international debt. Investors identified some banks in Spain and France
as having possible exposure to credit contagion effects because they had provided a significant amount of loans to
Turkey, and some of their stock valuations declined by 10 percent. However, the threat of contagion to other countries
was limited because many analysts believed that the problems experienced by Turkey were unique to Turkey and not
likely to surface in other countries.
How Financial Markets Serve MNCs
Exhibit 3.6 illustrates the foreign cash flow movements of a typical MNC. These cash flows can be classified into four
corporate functions, all of which generally require use of the foreign exchange markets. The spot market, forward market,
currency futures market, and currency options market are all classified as foreign exchange markets.
The first function is foreign trade with business clients. Exports generate foreign cash inflows, whereas imports require
cash outflows. A second function is direct foreign investment, or the acquisition of foreign real assets. This function
requires cash outflows but generates future inflows either through remitted earnings back to the MNC or through the sale
of these foreign assets. A third function is short-term investment or financing in foreign securities in the international
money market. The fourth function is longer-term financing in the international bond or stock markets. An MNC may use
international money or bond markets to obtain funds at a lower cost than they can be obtained locally.
 Exchange Rate Determination
Financial managers of multinational corporations (MNCs) that conduct international business must continuously monitor
exchange rates because their cash flows are highly dependent on them. They need to understand what factors influence
exchange rates so that they can anticipate how exchange rates may change in response to specific conditions.
Measuring Exchange Rate Movements
Exchange rate movements affect an MNC’s value because they can affect the amount of cash inflows received from
exporting products or services or from a subsidiary; likewise, they can affect the amount of cash outflows needed to pay
for imports of products or services. An exchange rate measures the value of one currency in units of another currency. As
economic conditions change, exchange rates can change substantially. A decline in a currency’s value is known as
depreciation. An increase in currency value is known as appreciation.
When a foreign currency’s spot rates at two different times are compared, the spot rate at the more recent date is denoted
as S and the spot rate at the earlier date is denoted as St-1. The percentage change in the value of the foreign currency
over a specified period is then computed as follows:

A positive percentage change indicates that the foreign currency has appreciated over the period, whereas a negative
percentage change indicates that it has depreciated over the period.
On some days, most foreign currencies appreciate against the domestic currency (albeit by different degrees); on other
days, most currencies depreciate against the domestic currency (again, by different degrees). On still other days, some
currencies appreciate while others depreciate against the domestic currency; the financial media describe this scenario by
stating that “the domestic currency was mixed in trading.”
Foreign exchange rate movements tend to be larger for longer time horizons. Thus, if yearly exchange rate data were
assessed, the movements would be more volatile for each currency, but the foreign currency’s movements would still be
more volatile than the domestic currency’s movements. If daily exchange rate movements were assessed, the movements
would be less volatile for each currency, but the foreign currency’s movements would still be more volatile than the
domestic currency’s movements. A review of daily exchange rate movements is important to an MNC that will need to
obtain a foreign currency in a few days and wants to assess the possible degree of movement over that period. A review
of annual exchange movements would be more appropriate for an MNC that conducts foreign trade once per year and
wants to assess the possible degree of movements on a yearly basis. Many MNCs review exchange rates based on both
short- and long-term horizons because they expect to engage in international transactions in both the near term and the
distant future.
Exchange Rate Equilibrium
Although it is easy to measure the percentage change in a currency’s value, it is more difficult to explain why the value
changed or to forecast how it may change in the future. To achieve either of these objectives, an understanding of the
concept of an equilibrium exchange rate is necessarily, along with recognition of the factors that affect this rate.
Before considering why an exchange rate changes, recall that an exchange rate (at a given time) represents the price of a
currency, or the rate at which one currency can be exchanged for another. The exchange rate always involves two
currencies.
Like any other product sold in markets, the price of a currency is determined by the demand for that currency relative to its
supply. At any given moment, a currency should exhibit the price at which the demand for that currency is equal to supply;
this is the equilibrium exchange rate. Of course, conditions can change over time. These changes induce adjustments in
the supply of or demand for any currency of interest, which in turn creates movement in the currency’s price.
Demand for a Currency
The domestic demand for foreign currency results partly from international trade, as domestic firms obtain foreign pounds
to purchase foreign products. A demand schedule/demand curve for foreign currency represents the quantity of foreign
currency that would be demanded for each of several possible values of the exchange rate that could exist at a specific
point in time. Only one exchange rate exists at any specific point in time. A downward-sloping demand schedule for
foreign currency suggests that if the value of the foreign currency (as shown in the vertical axis) is relatively low, the
domestic demand for foreign currency (as shown in the horizontal axis) is relatively high. The logic behind this relationship
is that corporations and individuals in the domestic country would be expected to purchase more foreign products when
the foreign currency is worth less (because it takes fewer domestic currency to obtain the desired amount of foreign
currency). Conversely, if the foreign currency’s exchange rate is relatively high, then the domestic demand for foreign
currency would be relatively low, as corporations and individuals in the domestic country are less willing to purchase
foreign products (because it takes more domestic currency to obtain the desired amount of foreign currency).
The domestic demand for foreign currency is also affected when domestic investors invest in foreign securities, because
they need foreign currency to buy foreign securities. The behavior of domestic investors should be similar to the behavior
of domestic consumers. When the foreign currency’s value (vertical axis) is low, domestic investors would be more willing
to invest in foreign securities because it takes fewer domestic currency to obtain the desired amount of foreign currency.
Conversely, when the foreign currency’s value is high, domestic investors would be less willing to invest in foreign
securities because it takes more domestic currency to obtain the desired amount of foreign currency. These preferences
reinforce the logic as to why the demand schedule for foreign currency is downward sloping.
Supply of a Currency for Sale

A supply schedule/supply curve of foreign currency for sale in the foreign exchange market can be developed in a
manner similar to the demand schedule for foreign currency. It shows the quantity of foreign currency for sale (supplied to
the foreign exchange market in exchange for domestic currency) corresponding to each possible exchange rate at a given
time. The supply schedule of foreign currency reflects a positive relationship between the value of the foreign currency
and the quantity of foreign currency for sale (supplied) in exchange for domestic currency. When the foreign currency’s
value (shown on the vertical axis) is high, foreign consumers and firms can obtain a desired amount of domestic currency
with fewer foreign currency. Thus, they would be more willing to supply (exchange) their foreign currency for domestic
currency to purchase domestic products. Conversely, when the foreign currency’s value is low, foreign consumers and
firms need a relatively large amount of foreign currency to obtain a desired amount of domestic currency, and would
therefore be less willing to purchase domestic products.
The supply of foreign currency to be exchanged for domestic currency also reflects the funds provided by foreign
investors, who supply foreign currency in exchange for domestic currency to invest in domestic securities. The behavior of
foreign investors should be similar to the behavior of foreign consumers. When the foreign currency’s value (vertical axis)
is high, foreign investors would be more willing to invest in domestic securities because it takes fewer foreign currency to
obtain the desired amount of domestic currency. Conversely, when the foreign currency’s value is low, foreign investors
would be less willing to invest in domestic securities because it takes more foreign currency to obtain the desired amount
of domestic currency. These preferences reinforce the logic as to why the supply schedule of foreign currency is upward
sloping.
Equilibrium Exchange Rate
The demand and supply schedules for foreign currency are combined for a given moment in time. At an exchange rate
below the equilibrium exchange rate, the quantity of foreign currency demanded would exceed the supply of foreign
currency for sale. Consequently, those banks that provide foreign exchange services would experience a shortage of
foreign currency at that exchange rate. At an exchange rate above the equilibrium exchange rate, the quantity of foreign
currency demanded would be less than the supply of foreign currency for sale; in this case, banks providing foreign
exchange services would experience a surplus of foreign currency at that exchange rate. At the equilibrium exchange
rate, the quantity of foreign currency demanded equals the supply of foreign currency for sale.
Change in the Equilibrium Exchange Rate
Changes in the demand and supply schedules of a currency force changes in the equilibrium exchange rate in the foreign
exchange market. Four possible changes in market conditions can affect this rate. The exchange rate varies because the
banks that serve as intermediaries in the foreign exchange market adjust the price at which they are willing to buy or sell a
particular currency in the face of a sudden shortage or excess of that currency. The bid/ask spread quoted by banks is not
needed to explain changes in the equilibrium exchange rate.

Increase in Demand Schedule

The demand schedule for foreign currency can change at any time in response to various conditions. Assume that
conditions cause the demand schedule for foreign currency to shift outward (reflecting a higher quantity of foreign
currency demanded at any possible exchange rate), but the supply schedule of foreign currency for sale has not changed.
At the prevailing exchange rate, the amount of foreign currency demanded in the foreign exchange market will now
exceed the amount of foreign currency for sale in the foreign exchange market, resulting in a shortage of foreign currency.
The banks that serve as intermediaries in the foreign exchange market will not have enough foreign currency to
accommodate the demand for foreign currency at the prevailing exchange rate, so they will raise the price (exchange rate)
of the foreign currency. In turn, the amount of foreign currency demanded in the foreign exchange market will decrease
(reflected by a movement along the new demand schedule and the amount of foreign currency supplied (sold) in the
foreign exchange market will increase (reflected by a movement along the existing supply schedule). The banks will
increase the exchange rate to the level at which the amount of foreign currency demanded equals the amount of foreign
currency supplied in the foreign exchange market.
Decrease in Demand Schedule
Assume that conditions cause the domestic demand schedule for foreign currency to shift inward (reflecting a lower
quantity of foreign currency demanded at any possible exchange rate), while the supply schedule of foreign currency for
sale has not changed. Under these conditions, the amount of foreign currency demanded in the foreign exchange market
will now be less than the amount of foreign currency for sale in the foreign exchange market at the prevailing price
(exchange rate). Those banks that serve as intermediaries in this market will have an excess of foreign currency at the
prevailing exchange rate, so they will lower the price (exchange rate) of the foreign currency. As they reduce the
exchange rate, the amount of foreign currency demanded in the foreign exchange market will increase (reflected by a
movement along the new demand schedule) and the amount of foreign currency supplied (sold) in that market will
decrease (reflected by a movement along the existing supply schedule). The banks will reduce the exchange rate to the
level at which the amount of foreign currency demanded equals the amount supplied in the foreign exchange market.
Increase in Supply Schedule
Start over again with the initial equilibrium situation, and assume that conditions cause an outward shift in the supply
schedule of foreign currency (reflecting a higher quantity of foreign currency supplied at any possible exchange rate),
while the demand schedule for foreign currency has not changed. In this case, the amount of the currency supplied in the
foreign exchange market will exceed the amount of foreign currency demanded in that market at the prevailing price
(exchange rate), resulting in a surplus of foreign currency. The banks that serve as intermediaries in the foreign exchange
market will respond by reducing the price of the foreign currency. As they reduce the exchange rate, the amount of foreign
currency demanded in the foreign exchange market will increase (reflected by a movement along the existing demand
schedule) and the amount of foreign currency supplied will decrease (reflected by a movement in the new supply
schedule). The banks will reduce the exchange rate to the level at which the amount of foreign currency demanded equals
the amount of foreign currency supplied (sold) in the foreign exchange market.
Decrease in Supply Schedule
Assume that conditions cause an inward shift in the supply schedule of foreign currency to be exchanged for domestic
currency in the foreign exchange market (reflecting a lower possible quantity of foreign currency supplied at any possible
exchange rate), while the demand schedule for foreign currency has not changed. In this case, the amount of foreign
currency supplied will be less than the amount demanded in the foreign exchange market at the prevailing price
(exchange rate), resulting in a shortage of foreign currency. Banks that serve as intermediaries in the foreign exchange
market will respond by increasing the price (exchange rate) of the foreign currency. As they increase the exchange rate,
the amount of foreign currency demanded will decrease (reflected by a movement along the existing demand schedule)
and the amount of foreign currency supplied will increase (reflected by a movement along the new supply schedule). The
banks will increase the exchange rate to the level at which the amount of foreign currency demanded equals the amount
of foreign currency supplied (sold) in the foreign exchange market.
Factors That Influence Exchange Rates
The factors that cause currency supply and demand schedules to change are discussed by relating each factor’s
influence to the graphs of the demand and supply schedules. The following equation summarizes the factors that can
influence a currency’s spot rate:

Where

Relative Inflation Rates

Changes in relative inflation rates can affect international trade activity, which influences the demand for and supply of
currencies and therefore affects exchange rates.
In reality, the actual demand and supply schedules, and therefore the true equilibrium exchange rate, account for several
factors simultaneously. A change in a single factor (higher inflation) can affect an exchange rate. Each factor can be
assessed in isolation to determine its effect on exchange rates while holding all other factors constant; then, all factors
can be tied together to fully explain exchange rate movements.
Relative Interest Rates
Changes in relative interest rates affect investment in foreign securities. This investment influences the demand for and
supply of currencies and, therefore, affects the equilibrium exchange rate.
Real Interest Rates
Although a relatively high interest rate may attract foreign inflows (to invest in securities offering high yields), the high rate
may reflect expectations of relatively high inflation. Because high inflation can place downward pressure on the local
currency, some foreign investors may be discouraged from investing in securities denominated in that currency. In such
cases, it is useful to consider the real interest rate, which adjusts the nominal interest rate for inflation:

This relationship is sometimes called the Fisher effect.

The real interest rate is appropriate for international comparisons of exchange rate movements because it incorporates
both the nominal interest rate and inflation, each of which influences exchange rates. Other things held constant, a high
domestic real rate of interest (relative to other countries) tends to boost the domestic currency’s value.
Relative Income Levels
A third factor affecting exchange rates is relative income levels. Because income can affect the amount of imports
demanded, it can also affect exchange rates.

In reality, other factors do not remain constant. An increasing domestic income level likely reflects favorable economic
conditions. Under such conditions, some foreign firms might increase their investment in their domestic operations, which
would require exchanging more foreign currency for domestic currency. In addition, foreign investors might increase their
investment in domestic stocks to capitalize on the domestic economic growth, which would require exchanging more
foreign currency for domestic currency. Thus, the supply schedule of foreign currency could increase (shift outward),
which might more than offset any impact on the demand schedule for foreign currency.
Government Controls
A fourth factor affecting exchange rates is government controls. The governments of foreign countries can influence the
equilibrium exchange rate in the following ways: (1) imposing foreign exchange barriers; (2) imposing foreign trade
barriers; (3) intervening (buying and selling currencies) in the foreign exchange markets; and (4) affecting macro variables
such as inflation, interest rates, and income levels.
Expectations
A fifth factor affecting exchange rates is market expectations about future exchange rates. Like other financial markets,
foreign exchange markets react to any news that may affect future transactions. News of a potential surge in domestic
inflation may cause currency traders to sell domestic currency because they anticipate a future decline in the domestic
currency’s value. This response places immediate downward pressure on the domestic currency even before domestic
inflation occurs.
Impact of Favorable Expectations
Many institutional investors (such as commercial banks and insurance companies) take currency positions based on
anticipated interest rate movements in various countries.
Impact of Unfavorable Expectations
Just as speculators can place upward pressure on a currency’s value when they expect it to appreciate, they can place
downward pressure on a currency when they expect it to depreciate.
Impact of a Currency Crisis
Sometimes a currency depreciates to such an extent that a currency crisis ensues. Many emerging markets have
experienced this type of crisis. Although the specific conditions leading to a currency crisis have varied among countries,
an important factor is usually substantial uncertainty about the country’s future economic or political conditions.
When a country experiences political problems, its appeal to foreign and local investors disappears. Foreign investors will
likely liquidate their investments and move their money out of the country. Local investors may follow the lead of the
foreign investors by liquidating their investments and selling their local currency in exchange for the currencies of other
countries so that they can move their money to a safer (more politically stable) environment.
Any concerns about a potential crisis can trigger money movements out of the country before the crisis fully develops. Yet
such actions can themselves cause a major imbalance in the foreign exchange market and a significant decline in the
local currency’s value. That is, expectations of a crisis trigger actions that can make the crisis worse. The country’s
government might even attempt to impose foreign exchange restrictions in an effort to stabilize the currency situation, but
this may create still more panic as local investors rush to move their money out of the country before those restrictions are
imposed.
Furthermore, some foreign exchange speculators may purposely try to capitalize on a currency crisis by borrowing the
local currency that is expected to weaken and exchanging it for other currencies in the foreign exchange market. Once the
currency crisis occurs and the local currency’s value declines substantially, they buy back that currency at a much lower
price and repay their loans. Such speculation can add to the downward pressure on the currency’s value.
Interaction of Factors
Transactions within foreign exchange markets facilitate either trade or financial flows. Trade-related foreign exchange
transactions generally respond less dramatically to news. In contrast, financial flow transactions are extremely responsive
to news because decisions to hold securities denominated in a particular currency often depend on anticipated changes in
currency values. Sometimes trade-related factors and financial factors interact and simultaneously affect exchange rate
movements.

Over a particular period, some factors may place upward pressure on the value of a foreign currency while other factors
place downward pressure on that value.
The sensitivity of an exchange rate to these factors depends on the volume of international transactions between the two
countries. If the two countries engage in a large volume of international trade but only a small volume of international
capital flows, then the relative inflation rates will likely have a stronger influence on the exchange rate. If the two countries
engage in a large volume of capital flows, however, then interest rate fluctuations may be more influential.
Capital flows around the world have become increasingly larger in recent decades. A significant portion of capital flows
are due to large institutional investors, which commonly make large investments in securities denominated in specific
currencies that may last only a day or two. Because the size of these capital flows can easily overwhelm trade flows, the
relationship between the factors that affect trade and exchange rates is sometimes weaker than expected.
An understanding of exchange rate equilibrium does not guarantee accurate forecasts of future exchange rates, because
that will depend in part on how the factors that affect exchange rates change in the future. Even if analysts fully realize
how factors influence exchange rates, they may still be unable to predict how those factors will change.
Influence of Factors across Multiple Currency Markets
Each exchange rate has its own market, meaning its own demand and supply conditions.
In some periods, most currencies move in the same direction against the domestic currency. This consistency typically
reflects a particular underlying factor in the domestic currency that has a similar impact on the demand and supply
conditions across many currencies in that period.
It is not unusual for foreign currencies to move in the same direction against the domestic currency because their home
countries’ economic conditions tend to change over time in a related manner. However, it is possible for one of the
countries to experience different economic conditions in a particular period, which may cause its currency’s movement
against the domestic currency to deviate from the movements of other foreign currencies.
Impact of Liquidity on Exchange Rate Adjustments
For all currencies, the equilibrium exchange rate is reached through transactions in the foreign exchange market;
however, the adjustment process is more volatile for some currencies than for others. The liquidity of a currency affects
the exchange rate’s sensitivity to specific transactions. If the currency’s spot market is liquid, then its exchange rate will
not be highly sensitive to a single large purchase or sale; in turn, the change in the equilibrium exchange rate will be
relatively small. With many willing buyers and sellers of the currency, transactions can be easily accommodated. In
contrast, if a currency’s spot market is illiquid, then its exchange rate may be highly sensitive to a single large purchase or
sale transaction. In this case, there are not enough buyers or sellers to accommodate a large transaction, which means
that the price of the currency must change to rebalance its supply and demand. Illiquid currencies, such as those in
emerging markets, tend to exhibit more volatile exchange rate movements because the equilibrium prices of their
currencies adjust to even minor changes in supply and demand conditions.
Movements in Cross Exchange Rates
Many international transactions involve the exchange of one non-domestic currency for another non-domestic currency.
This type of activity is sometimes referred to as a cross exchange.
Distinct international trade and financial flows occur between every pair of countries. These flows dictate the unique
supply and demand conditions for these two countries’ currencies, which in turn affect movements in the equilibrium
exchange rate between them. Thus, a change in the equilibrium cross exchange rate between these two currencies is due
to the same types of forces that affect the demand and supply conditions between the two currencies.
The movement in a cross exchange rate over a particular period can be measured as its percentage change in that
period, just as demonstrated previously for any currency’s movement against the dollar. The percentage change in a
cross exchange rate over some time period can be measured, even with the lack of cross exchange rate quotations.
The cross exchange rate changes when either currency’s value changes against the domestic currency.

 If the foreign currencies move by the same percentage against the domestic currency, the cross exchange rate
does not change.
 If the foreign currency A appreciates against the domestic currency by a greater percentage than the foreign
currency B appreciates against the domestic currency, the foreign currency A appreciates against the foreign
currency B.
 If the foreign currency A appreciates against the domestic currency by a smaller percentage than the foreign
currency B appreciates against the domestic currency, the foreign currency A depreciates against the foreign
currency B.
 If the foreign currency A depreciates against the domestic currency and the foreign currency B appreciates
against the domestic currency, the foreign currency A depreciates against the foreign currency B.
Capitalizing on Expected Exchange Rate Movements
If spot exchange rates are priced properly, this implies that the foreign exchange market is efficient, so that speculators
will be unable to profit from their expectations about exchange rate movements. However, if spot exchange rates are not
priced properly, this implies that the foreign exchange market is not efficient, and speculators can potentially capitalize on
the mispricing.
Some large financial institutions attempt to anticipate how the equilibrium exchange rate will change in the near future
based on the conditions identified in this chapter. These institutions may then take a position in that currency in an attempt
to benefit from their expectations.
Institutional Speculation Based on Expected Appreciation
When financial institutions believe that a particular currency is presently valued lower than it should be in the foreign
exchange market, they may consider investing in that currency now, before it appreciates. They hope to liquidate their
investment in that currency after it appreciates, thereby benefiting from selling it for a higher price than they paid.
The computations measure the expected profits from the speculative strategy. The actual outcome may potentially be less
favorable if the currency appreciates to a smaller degree (and much less favorable if it depreciates).
Institutional Speculation Based on Expected Depreciation
If financial institutions believe that a particular currency is valued higher than it should be in the foreign exchange market,
they may borrow funds in that currency now and convert it to their local currency now—that is, before the target currency’s
value declines to its “proper” level. The plan would be to repay the loan in that currency after it depreciates, when the
institutions could buy that currency for a lower price than the one at which it was initially converted to their own currency.
Most money center banks continue to take some speculative positions in foreign currencies. In fact, some banks’ currency
trading profits have exceeded $100 million per quarter.
The potential returns from foreign currency speculation are high for financial institutions that have large borrowing
capacity. Yet because foreign exchange rates are volatile, a poor forecast could result in a large loss. Some MNCs have
suffered losses of more than $1 billion due to speculation in the foreign exchange market.
Speculation by Individuals
Even individuals whose careers have nothing to do with foreign exchange markets can speculate in foreign currencies.
Individuals can take positions in the currency futures market or options market. Alternatively, they can set up an account
at a foreign exchange trading website with a small initial amount, after which they can move their money into one or more
foreign currencies. Individuals can also establish a margin account on some websites; this practice enables them to take
positions in foreign currency while financing a portion of their investment with borrowed funds.
Some speculators in the foreign exchange market have been allowed to maintain a cash amount of only 5 percent of their
investment, while borrowing the remainder. This substantially magnifies the return that the speculators can earn on their
speculative position. Of course, it also substantially magnifies their risk: A currency’s movement on a single day could
wipe out their entire cash position.
Many foreign exchange websites have a demonstration (demo) that allows prospective speculators to simulate the
process of speculating in the foreign exchange market. By using these demos, speculators can determine how much they
would have earned or lost by pretending to take a position with an assumed investment and borrowed funds.
Individual speculators quickly realize that the foreign exchange market remains active even after the financial markets in
their own country close. As a consequence, the value of a currency can change substantially overnight while local
financial markets are closed or support only limited trading. Individuals are naturally attracted by the potential for large
gains, but just as with other forms of gambling, there is the risk of losing the entire investment. In that case, investors
would still be liable for any debt created from borrowing money to support the speculative position.
Carry Trades
One of the strategies most commonly used by institutional and individual investors to speculate in the foreign exchange
market is a carry trade, whereby investors attempt to capitalize on the difference in interest rates between two countries.
Specifically, this strategy involves borrowing a currency with a low interest rate and investing the funds in a currency with
a high interest rate. The investor may execute a carry trade for only a day or for several months. The term “carry trade” is
derived from the phrase “cost of carry,” which in financial markets represents the cost of holding (or carrying) a position in
some asset.
Both institutional and individual investors engage in carry trades. Moreover, some brokers facilitate both the borrowing of
one currency (assuming the investor posts adequate collateral) and the investing in a different currency. Numerous
websites have been established by brokers to support this process.
Before taking any speculative position in a foreign currency, carry traders must consider the prevailing interest rates at
which they can invest or borrow in addition to their expectations about the movement of exchange rates.
Notice the large return to Hampton over a single month, even though the interest rate on its investment is only 0.5 percent
above its borrowing rate. Such a high return on its investment over a one-month period is possible when Hampton
borrows a large portion of the funds used for its investment. This illustrates the power of financial leverage.
At the end of the month, Hampton may roll over (repeat) its position for the next month. Alternatively, it could decide to
execute a new carry trade transaction in which it borrows a different currency and invests in still another currency.
Impact of Appreciation in the Investment Currency
If the British pound had appreciated against both the euro and the dollar during the month, Hampton’s profits would be
even higher, for two reasons. First, if the pound appreciated against the euro, then each British pound at the end of the
month would have converted into more euros; Hampton would have then needed fewer British pounds to repay the funds
borrowed in euros. Second, if the pound also appreciated against the dollar, then the remaining British pounds held (after
repaying the loan) would have converted into more dollars. Thus, the choice of the currencies to borrow and purchase is
influenced not only by prevailing interest rates but also by expected exchange rate movements. Investors prefer to borrow
a currency with a low interest rate that they expect will weaken and to invest in a currency with a high interest rate that
they expect will strengthen.
When many investors executing carry trades share the same expectations about a particular currency, they execute
similar types of transactions, and their trading volume can have a major influence on exchange rate movements over a
short period. Over time, as many carry traders borrow one currency and convert it into another, there is downward
pressure on the currency being converted (sold) and upward pressure on the currency being purchased. This type of
pressure on the exchange rate may enhance investor profits.
Risk of the Carry Trade
The risk associated with the carry trade is that exchange rates may move in the opposite direction of what the investors
expected, which would cause a loss. Just as financial leverage can magnify gains from a carry trade, it can also magnify
losses from a carry trade when the currency that was borrowed appreciates against the investment currency. This
dynamic is illustrated in the following example.
In the preceding example, Hampton’s loss is due to the euro’s appreciation against the pound, which increased the
number of pounds that Hampton needed to repay the euro loan. Consequently, Hampton had fewer pounds to convert
into dollars at the end of the month. Because of its high financial leverage (its high level of borrowed funds relative to its
total investment), Hampton’s losses are magnified.
In periods when changing conditions cause carry traders to question their trade positions, many such traders will attempt
to unwind (reverse) their positions. This activity can have a major impact on the exchange rate.