Chapter 19

Multinational Financial
Management
 Multinational vs. Domestic Financial
Management
 Exchange Rates and Trading in
Foreign Exchange
 International Money and Capital
Markets
What is a multinational corporation?

 A corporation that
operates in an
integrated fashion in
two or more
countries.
What is a multinational corporation?

 Decision making within

the corporation may be
centralized in the home
country, or may be
decentralized across the
countries in which the
corporation does
business.
Why do firms expand into other
countries?

1. To seek production efficiency.

2. To avoid political, trade and
regulatory hurdles.
3. To seek new markets.
4. To protect processes and
products.
5. To diversify.
Why do firms expand into other
countries?

6. To retain customers.
7. To seek raw materials and
new technology.
 Vertically integrated
investment occurs when a
firm undertakes an
investment to secure its input
supply at stable prices.
Managing Multinational Operations

 The complexity of managing

multinational corporations
increases significantly
because of differences that
firms are faced with once
they operate in foreign
countries.
Multinational Financial Management vs.
Domestic Financial Management

1. Different currency
denominations.
2. Political risk
3. Economic and legal
ramifications.
4. Role of governments
5. Language and cultural
differences.
Multinational Financial Management vs.
Domestic Financial Management

 Different currency
denominations
MNCs have to keep track of
the fluctuations in exchange
rates of various currencies
caused by fluctuating
economic factors.
Multinational Financial Management vs.
Domestic Financial Management

 Political risk
Changing attitudes of the
political leadership towards
MNCs resulting in loss of
subsidies or risk of
nationalization.
Multinational Financial Management vs.
Domestic Financial Management

 Economic and legal

ramifications
Different economic and
legal system per country.
Multinational Financial Management vs.
Domestic Financial Management

 Role of governments
Frequently, the terms and
actions to be taken are a
result of direct negotiation
between government and
MNC.
Multinational Financial Management vs.
Domestic Financial Management

 Language and cultural

differences
arises from differences in
customs, social norms,
attitudes, assumptions, and
expectations of the local
society in the host country
International Monetary System

 Every nation has a monetary

system and a monetary
authority.
International Monetary System

 The framework within which

exchange rates are
determined.
 The blueprint for international
trade and capital flows.
International Monetary Terminology

 Exchange rate is the

number of units of a given
currency that can be
purchased for one unit of
another currency.
Tells us how to convert one
currency into another
International Monetary Terminology

 Spot exchange rate is the

quoted price for a unit of
foreign currency to be
delivered “on the spot”.
It is the rate of exchange
between any two currencies
on a given day for an
immediate transaction.
International Monetary Terminology

 Forward exchange rate is

the quoted price for a unit of
foreign currency to be
delivered at a specified date
in the future.
International Monetary Terminology

 Fixed exchange rate for a

currency is set by the
government and is allowed to
fluctuate only slightly around
a desired rate, called the par
value.
International Monetary Terminology

 Floating or flexible
exchange rate is not
regulated by the government.
Supply and demand in the
market determine the
currency’s value.
International Monetary Terminology

 Depreciation or
appreciation of a currency
refers to a decrease or
increase, respectively, in the
foreign exchange value of a
floating currency.
These changes are caused
by market forces.
International Monetary Terminology

 Devaluation or revaluation
of a currency refers to the
decrease or increase in the
stated par value of a
currency whose value is
fixed.
Current Monetary Agreements

 Currency regimes groups

Floating rates
Fixed rates
Floating Monetary Agreements

 Freely floating regime –

Exchange rate is determined
by the market’s supply and
demand for the currency.
 Governments may
occasionally intervene and
buy or sell their currency to
stabilize fluctuations.
Floating Monetary Agreements

 Managed floating regime

– Significant government
intervention manages the
exchange rate by
manipulating the currency’s
supply and demand.
Floating Monetary Agreements

 Managed floating regime

The target exchange rates
are kept secret to prevent
currency speculators from
profiting from it.
Fixed Monetary Agreements

No local currency – The

country uses either another
country’s currency as its legal
tender (like the U.S. dollar in
Ecuador) or else belongs to a
group of countries that share a
currency (like the euro).
Fixed Monetary Agreements

Currency board
arrangement – The country
technically has its own
currency but commits to
exchange it for a specified
foreign currency at a fixed
exchange rate (like Argentina
before its January 2002 crisis).
Fixed Monetary Agreements

Fixed peg arrangement –

The country locks or “pegs” its
currency to another (or a
basket of currencies) at a
fixed exchange rate.
Fixed Monetary Agreements

Fixed peg arrangement

Slight fluctuations are okay,
but the rate must stay within
a desired range.
For example, the Chinese
yuan is pegged to a basket of
currencies.
Foreign Exchange Rate Quotations

Exchange rate quotations can

be expressed in:
direct form – the home
currency price of 1 unit of
the foreign money
indirect form – the foreign
currency price of 1 unit of
the home money
Foreign Exchange Rate Quotations

Exchange rate quotations can

be expressed in:
direct form (amount of
pesos required to buy 1 unit
of foreign money) or
indirect form (amount of
foreign money required to buy
1 peso).
Foreign Exchange Rate Quotations
 Foreign Exchange Rate Quotations

Are these currency prices

direct or indirect quotations?
US $ to Buy 1 Unit
Japanese yen 0.009
Australian dollar 0.650

Since they are prices of

foreign currencies expressed
in dollars, they are direct
quotations.
Using Exchange Rates to
Convert Prices
Suppose you are planning a
trip to England and have
located a hotel on the internet
that lists the price of the
rooms as ₤50 per night. Using
the rates listed in Table 16.1,
how much will these rooms
cost you in US dollars?
Using Exchange Rates to
Convert Prices
To convert from British pounds
(₤) to US dollars ($), multiply
₤ 50 by the direct rate
 Foreign Exchange Rate Quotations

Indirect quotation is the

reciprocal of a direct quotation.
US $ to Buy 1 Unit
Japanese yen 0.009
Australian dollar 0.650
# of Units of Foreign
Currency per US $
Japanese yen 111.11
Australian dollar 1.5385
What is a cross rate?

Cross rate is the exchange

rate between any two
currencies.
Cross rates are used to find
the exchange rate between
two currencies.
What is a cross rate?
What is a cross rate?
What is a cross rate?

A cross rate is computed using

the exchange rates between
the U.S. dollar and the two
other currencies to find the
exchange between those
currencies.
 What is a cross rate?

Cross rate between Australian

dollar and the Japanese yen
US $ to Buy 1 Unit
Japanese yen 0.009
Australian dollar 0.650
# of Units of Foreign
Currency per US $
Japanese yen 111.11
Australian dollar 1.5385
What is a cross rate?

 Cross rate between Australian dollar and the

Japanese yen.
Cross rate = (Yen/US Dollar) x
(US Dollar/A. Dollar)
= 111.11 x 0.650
= 72.22 Yen/A. Dollar
The inverse of this cross rate
yields: 0.0138 A. Dollars/Yen
Orange Juice Project:
Setting the Appropriate Price

 A firm can produce a liter of

orange juice and ship it to
Japan for $1.75 per unit. If
the firm wants a 50% markup
on the project, what should
the juice sell for in Japan?
Price = ($1.75)(1.50)(111.11 yen/$)
= 291.66 yen
Orange Juice Project:
Determining Profitability

 The product will cost 250 yen to

produce and ship to Australia,
where it can be sold for 6
Australian dollars. What is the
U.S. dollar profit on the sale?
Cost in A. dollars  250 yen(0.0138)
 3.45 A. dollars
A. dollar profit  6  3.45  2.55 A. dollars

U.S. dollar profit  2.55/1.5385  $1.66

What is exchange rate risk?

 The risk that the value of a

cash flow in one currency
translated to another currency
will decline due to a change in
exchange rates.
 For example, a weakening
Australian dollar (strong US$)
would lower the dollar profit.
What is exchange rate risk?

 As long as the flow of

currencies between countries
is equal, the exchange rate is
constant.
What is exchange rate risk?

 When the demand for one

currency increases and the
supply of another increases,
the exchange rate adjusts so
that the market for the
currencies reaches
equilibrium.
What is exchange rate risk?

 Although several economic

and political factors influence
foreign exchange rate
movements, by far the most
important explanation for
long-term changes is differing
inflation between two
countries.
What is difference between spot rates
and forward rates?

 Spot rates are the rates to

buy currency for immediate
delivery.
 Forward rates are the rates
to buy currency at some
agreed-upon date in the
future.
Discount/Premium on Forward Rates

 Discount on Forward Rate

– situation when the spot rate
is less than forward rate.
 Premium on Forward Rate
– situation when the spot rate
is greater than forward rate.
Discount on Forward Rates

 Foreign exchange situation

where the domestic current
spot exchange rate is trading
at a higher level than the
current domestic futures spot
rate for a maturity period.
Discount on Forward Rates

 A forward discount is an
indication by the market that
the current domestic
exchange rate is going to
depreciate in value against
another currency.
Premium on Forward Rates

 Foreign exchange situation

where the futures exchange
rate, with respect to the
domestic currency, is trading
at a higher spot exchange
rate than it is currently.
When is the forward rate at a premium
to the spot rate?

 If the U.S. dollar buys fewer

units of a foreign currency in
the forward than in the spot
market, the foreign currency
is selling at a premium.
 In the opposite situation, the
foreign currency is selling at a
discount.
When is the forward rate at a discount
to the spot rate?

 If more units of a foreign

currency is needed in the
forward than in the spot
market for the U.S. dollar, the
foreign currency is selling at a
discount relative to the $.
The U.S. dollar is selling at a
premium.
 Spot and Forward Exchange Rate
Forward Rate *
Spot Rate * 1 Month 3 Months 1 Year
Europe
EMU (euro) 1.2375 1.2364 1.2346 1.2285
Norway (krone) 6.8168 6.8217 6.8292 6.861
Sweden (krona) 7.4509 7.4601 7.4738 7.5284
Switzerland (franc) 1.2559 1.2549 1.2532 1.2451
United Kingdom (pound) 1.8472 1.8421 1.8325 1.7877
Americas:
Canada (dollar_ 1.3276 1.3289 1.3311 1.3388
Mexico (peso) 10.9815 11.0338 11.126 11.5775
Pacific/ Africa:
Hong Kong (dollar) 7.7928 7.7858 7.774 7.739
Japan (yen) 106.83 106.72 106.53 105.505
South Africa (rand) 6.4662 6.5107 6.5917 6.9812
South Korea (won) 1160.5 1163.8 1169.2 1186

* Rates are per $US, other than Euro and UK Pounds

Spot and Forward Exchange Rate

 The primary determinant of

the spot/forward rate
relationship is relative interest
rates.
Interest Rate Parity

 Forces Affecting Foreign

Investments
 Return on Investments
 Change in exchange rates
 If foreign currency
appreciates relative to home
currency, overall return is
higher.
What is interest rate parity?

 Interest rate parity holds

that investors should expect
to earn the same return in
all countries after adjusting
for risk.
What is interest rate parity?

 Interest rate parity refers to

the fundamental equation
that governs the relationship
between interest rates and
currency exchange rates.
What is interest rate parity?

 The basic premise

of interest rate parity is that
hedged returns from
investing in different
currencies should be the
same, regardless of the level
of their interest rates.
 Interest Rate Parity Equation

ft 1  rh

e0 1  rf
ft  t - period forward exchange rate
e0  today' s spot exchange rate
rh  periodic interest rate in home country
rf  periodic interest rate in foreign country
What is interest rate parity?

 It suggests that if interest

rates are higher in one
country than they are in
another, the former’s
currency will sell at a
discount in the forward
market.
What is interest rate parity?

 A currency with lower

interest rates will trade at a
forward premium in relation
to a currency with a higher
interest rate.
Interest Rate Parity Example

The current Euro 90-day

interest rate is 16%.
The current U.S. 90-day
interest rate is 8%.
The current spot rate is .706
Euro per U.S. dollar.
What is the implied 90-day
forward rate?
Interest Rate Parity Example

The implied 90-day forward

rate is:
F 1 + .04
=
.706 1 + .02

F = (1.04) x (.706) / (1.02)

= .720 euro per dollar .
Thus, the implied 90-day
forward rate is .720
 Evaluating Interest Rate Parity

 The relationship can be seen

when you follow two methods
an investor may take to convert
foreign currency into U.S.
dollars.
 Evaluating Interest Rate Parity

 Option A would be to convert

the foreign currency to U.S.
dollars at the spot exchange
rate, then invest the dollars for
a specific time at the local
(U.S.) risk-free rate.
 Evaluating Interest Rate Parity

 Option B would be to invest the

foreign currency locally at the
foreign risk-free rate for the
same amount of time.
 Evaluating Interest Rate Parity

 And simultaneously enter into a

forward rate agreement to
convert the proceeds from the
investment into U.S. dollars,
using a forward exchange rate,
at the end of the investing
period.
 Evaluating Interest Rate Parity

 When no arbitrage
opportunities exist, the cash
flows from both options are
equal.
 Evaluating Interest Rate Parity

 Suppose one yen buys $0.0095

in the 30-day forward exchange
market and rNOM for a 30-day
risk-free security in Japan and
in the U.S. is 4%.
ft  0.0095
rh  4%/12  0.333%
rf  4%/12  0.333%
Does interest rate parity hold?

0.0095 1.0033

e0 1.0033
0.0095
1
e0
e 0  0.0095

 For interest rate parity to hold,

e0 must equal $0.0095, but if
given that e0 = $0.0090,
interest rate parity does not
hold.
Which security offers the highest
return?

 Convert $1,000 to yen in the

spot market.
$1,000 x 111.111
= 111,111 yen.
 Invest 111,111 yen in 30-day
Japanese security.
 In 30 days receive 111,111
yen x 1.00333 = 111,481 yen.
Which security offers the highest
return?

 Agree today to exchange

111,481 yen 30 days from
now at forward rate,
111,481/105.2632
= $1,059.07.
Which security offers the highest
return?

 30-day return
= $59.07/$1,000
= 5.907%
 Nominal annual return
= 12 x 5.907% = 70.88%.
 The Japanese security.
Exchange Rate Relationships

You have $1,000,000 to invest

for one year.
All other things being equal,
you have the opportunity to
obtain a 1 year Mexican bond
(in peso) @ 6.7 % or a 1 year
US bond (in dollars) @ 1.22%.
Exchange Rate Relationships

The spot rate is 10.9815

peso:$1.
The 1 year forward rate is
11.5775 peso:$1
Which bond will you prefer
and why? Ignore transaction
costs.
Exchange Rate Relationships

Value of US bond
= $1,000,000 x 1.0122
= $1,012,200
Value of Mexican bond
= $1,000,000 x 10.9815
= 10,981,500 peso
exchange
Exchange Rate Relationships

 10,981,500 peso x 1.067

= 11,717,261 peso bond
pmt
11,717,261 peso / 11.5775
= $1,012,072 exchange
Exchange Rate Relationships

Suppose you are expecting to

receive ₤1,000,000 in 6
months?
You agree to a forward trade
to exchange your ₤ to $.
Spot rate: ₤1 = $1.9809
180-day forward: ₤1 = $1.9693
 Exchange Rate Relationships

How many $ will you get in 6

months?
$1,969,300
Is the ₤ selling at a discount or
premium relative to the $?
It is selling at a discount relative
to the $ because it is cheaper to
buy a ₤ in the forward.
Purchasing Power Parity (PPP)

 What determines the rate of

change in exchange rates?
 Part of the answer is the PPP,
the idea that the exchange
rate adjusts to keep
purchasing power constant
among currencies.
What is purchasing power parity?

 Foreign exchange quotes in

two different countries must
be in line with each other.
If the exchange rates are out
of line, then a trader could
make a profit by buying in the
market where the currency
was cheaper and selling it in
the other.
What is purchasing power parity?

 The process of buying and

selling in more than one
market to make a riskless
profit is called arbitrage.
 Such opportunities do not
exist for a long time due to
arbitrage process.
What is purchasing power parity?

 In the long run, exchange

rates adjust so that the
purchasing power of each
currency tends to be the
same.
 The exchange rate changes
tend to reflect international
differences in inflation rates.
What is purchasing power parity?

 Countries that experience

high inflation rates will see
their currencies decline in
value (depreciate) relative to
the currencies of countries
with lower inflation rates.
What is purchasing power parity?

 Purchasing power parity is the

relationship in which the same
products cost roughly the
same amount in different
countries after the exchange
rate is taken into account.
What is purchasing power parity?

 Purchasing power parity

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

Ph
Ph  Pf (e0 ) or e0 
Pf
Ph  price of the good in home country
Pf  price of the good in foreign country
What is purchasing power parity?

 PPP is based on the law of one

price – in competitive markets in
which there are no transportation
costs or barriers to trade, the
same goods sold in different
countries sell for the same price
if all the different prices are
expressed in terms of the same
currency.
What is purchasing power parity?

 Thus if Big Mac Costs $2 in

US and the exchange rate
with British Pound is
1 Pound = $2.
 Big Mac should cost 1 Pound
in UK.
What is purchasing power parity?

 For example, the price of

wheat in Canadian and U.S.
markets should trade at the
same price (after adjusting for
the exchange rate).
What is purchasing power parity?

 If the price of wheat is lower

in Canada, then purchasers
will buy wheat in Canada as
long as the price is cheaper
(after accounting for
transportation costs).
What is purchasing power parity?

 Thus, demand will fall in the

U.S. and increase in Canada to
bring prices back into
equilibrium.
 The price elasticity of exports
and imports influences the
relationship between a
country’s exchange rate and its
purchasing-power parity.
What is purchasing power parity?

 Commodity items and

products in mature industries
are more likely to conform to
PPP.
 Frictions such as government
intervention and trade
barriers cause PPP not to
hold.
What is purchasing power parity?

 Arbitrage – Simultaneously
buying and selling equal
amounts of a good so that
you have zero net investment
while earning a return on the
transaction.
What is purchasing power parity?

 Purchasing power
arbitrage – The act of
trading to profit from a
deviation in the law of one
price.
 The guiding rule of arbitrage
is to buy low and sell high.
Purchasing Power Arbitrage
Purchasing Power Arbitrage
 Foreign Exchange Rate Quotations

US $ to Buy 1 Unit
Japanese yen 0.009
Australian dollar 0.650
# of Units of Foreign
Currency per US $
Japanese yen 111.11
Australian dollar 1.5385
If grapefruit juice costs $2.00 per liter in the U.S.
and PPP holds, what is the price of grapefruit juice
in Australia?

e0 = Ph/Pf
$0.6500 = $2.00/Pf
Pf = $2.00/$0.6500
Pf = 3.0769 Aus $
What impact does relative inflation have on
interest rates and exchange rates?

 Lower inflation leads to lower

interest rates, so borrowing in
low-interest countries may
appear attractive to
multinational firms.
What impact does relative inflation have on
interest rates and exchange rates?

 However, currencies in low-

inflation countries tend to
appreciate against those in
high-inflation rate countries,
so the effective interest cost
increases over the life of the
loan.
Capital Markets

 Ways to invest in international

markets
Buy stocks of multinational
corporations that directly
invest in foreign countries,
Purchase foreign securities
How Foreign Investments are Financed

 There are 3 major types of

International Credit Markets.
Euro credits
Eurobonds
Foreign bonds
International Credit Markets

 Euro credits
Fixed term, floating-rate
bank loans with no early
repayment.
An example is a eurodollar
deposit, which is U.S. dollars
deposited in a bank outside
the U.S.
International Credit Markets

 Euro credits
Interest rates are tied to the
London Interbank Offer Rate
(LIBOR).
LIBOR is the rate offered by
the largest and strongest
banks on large deposits.
International Credit Markets

 Eurobonds
Medium- to long-term
international market for
fixed- and floating-rate debt.
Underwritten by an
international bank syndicate.
International Credit Markets

 Eurobonds
Sold to investors in countries
other than the one in whose
currency the bond is
denominated.
US dollar-denominated
eurobonds are not sold in the
US.
International Credit Markets

 Foreign bonds
Issued in a capital market
other than the issuer’s.
Issued in the country in
whose currency the bond is
denominated.
Underwritten by investment
banks in that country.
International Credit Markets

 Foreign bonds
The only thing foreign about
it is the borrower’s
nationality.
The borrower is
headquartered in another
country.
International Credit Markets

 Foreign bonds
Japanese company might
issue a US dollar-
denominated bond in the US
to fund its US operations.
International Credit Markets

 Foreign bonds
Foreign bonds issued in the
US are sometimes called
“Yankee bonds”.
“Samurai bonds” are foreign
bonds issued in Japan.
International Stock Markets

 International markets are a

large source of capital.
 New issues of stocks and
outstanding stocks are sold in
international markets.
International Stock Markets

 US investors can invest in

foreign companies through
American Depository
Receipts (ADRs).
 ADRs are certificates
representing ownership of
foreign stock held in trust.
American Depository Receipts (ADRs)

 ADR is a security issued in the

United States that represents
shares of a foreign stock,
allowing that stock to be
traded in the US.
American Depository Receipts (ADRs)

 Foreign companies use ADRs,

which are issued in US
dollars, to expand the pool of
potential US investors.
American Depository Receipts (ADRs)

 Many ADRs are now available

in the United States, with
most of them traded on the
over-the-counter (OTC)
market.
 However, more and more
ADRs are being listed on the
New York Stock Exchange.
Investing Overseas

 Additional risk factors when

investing overseas:
Country risk
Exchange rate risk
Investing Overseas

 Two bets when investing

overseas:
That foreign stocks will
increase in their local
markets, and
That currencies in which
payment will be received will
rise relative to your currency.
International Capital Budgeting

 Key differences between

international and domestic
operations:
Cash flow estimation is more
complex.
These cash flows must be
converted into the home
currency.
International Capital Budgeting

 Cash flow estimation

considerations
Dividends and royalties tax
treatment.
Repatriation of earnings.
International Capital Budgeting

 Repatriation of earnings
Relevant cash flows are
those expected to be
received.
Subject to political and
exchange rate risks.
International Capital Budgeting

 Political risk
Nationalization
Unstable governments may
seize foreign business assets
Local governments may
impose import and export
duties and tariffs
International Capital Budgeting

 Political risk
Local governments may
choose to tax the income,
property or value added by
the manufacturer.
Ways to Reduce Country Risk

 Keeping critical operations

private.
Maintain key or critical
elements of operations safely
within the firm rendering the
assets useless in case of
nationalization.
Ways to Reduce Country Risk

 Financing operations and

assets with local money
Local creditors can then put
pressure on the host
government not to
nationalize the business.
Ways to Reduce Country Risk

 Receiving primary inputs

outside the local economy:
without which the assets and
operations would not be
valuable
International Capital Budgeting

 When evaluating multinational

capital budgeting projects, the
NPV analysis can be done
using either
Home/domestic currency
approach
Foreign currency approach
International Capital Budgeting

 Home currency approach

Convert all cash flows to
home currency then discount
at required return on home
currency investment of this
sort.
Convert before estimating the
NPV.
International Capital Budgeting

 Foreign currency approach

Determine the required
return on foreign investment
and then discount at that
rate.
Convert after estimating the
NPV.
International Capital Budgeting

 Key problem between

international and domestic
operations:
the use of an appropriate
discount rate which
accounts for the relative
inflation rates.
International Capital Budgeting

 Key problem between

international and domestic
operations:
the conversion of cash flows
using an appropriate
exchange rate.
International Capital Budgeting
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International Capital Budgeting
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International Capital Structures

 Previous studies suggested

that average capital structures
vary among the large
industrial countries.
International Capital Structures

 However, a recent study,

which controlled for
differences in accounting
practices, suggests that capital
structures are more similar
across different countries than
previously thought.