CHAPTER 17
Multinational Financial
Management



Multinational vs. domestic financial management
Exchange rates and trading in foreign exchange
International money and capital markets
17-1
What is a multinational corporation?


A corporation that
operates in two or more
countries.
Decision making within
the corporation may be
centralized in the home
country, or may be
decentralized across the
countries the corporation
does business in.
17-2
Why do firms expand into
other countries?
1.
To seek new markets.
2.
To seek raw materials.
3.
To seek new technology.
4.
To seek production efficiency.
5.
To avoid political and regulatory hurdles.
6.
To diversify.
7.
To retain customers.
8.
To protect processes.
17-3
What factors distinguish multinational
financial management from domestic
financial management?
1.
Different currency denominations.
2.
Political risk
3.
Economic and legal ramifications.
4.
Role of governments
5.
Language and cultural differences.
17-4
Consider the following
exchange rates
US $ to buy 1 unit
Japanese yen
0.009
Australian dollar
0.650

Are these currency prices direct or
indirect quotations?

Since they are prices of foreign currencies
expressed in dollars, they are direct
quotations.
17-5
What is an indirect quotation?


The number of units of a foreign
currency needed to purchase one U.S.
dollar, or the reciprocal of a direct
quotation.
Are you more likely to observe direct or
indirect quotations?


Most exchange rates are stated in terms of
an indirect quotation.
Except the British pound, which is usually in
terms of a direct quotation.
17-6
Calculate the indirect quotations
for yen and Australian dollars
# of units of foreign
currency per US $
Japanese yen
111.11
Australian dollar
1.5385

Simply find the inverse of the direct
quotations.
17-7
What is a cross rate?


The exchange rate between any two currencies.
Cross rates are actually calculated on the basis
of various currencies relative to the U.S. dollar.
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
17-8
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
17-9
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
17-10
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, in the last slide, a weakening
Australian dollar (strengthening dollar)
would lower the dollar profit.
17-11
International monetary system



The framework within which exchange rates
are determined.
The blueprint for international trade and
capital flows.
Exchange rate terminology
 Spot vs. forward exchange rate
 Fixed vs. floating exchange rate
 Devaluation and revaluation
 Depreciation and appreciation
 Soft, or weak, currency
17-12
Floating monetary agreements

Freely floating


Exchange rate determined by the market’s
supply and demand for the currency.
Governments may occasionally intervene and
buy or sell their currency to stabilize
fluctuations.
Managed floating

Significant government intervention manages
the exchange rate by manipulating the
currency’s supply and demand. The target
exchange rates are kept secret to prevent
currency speculators from profiting from it.
17-13
Fixed monetary agreements

No local currency


Currency board arrangement


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).
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 peg arrangement

The country “pegs” its currency to another (or a basket of
currencies) at a fixed rate. 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.
17-14
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.
17-15
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.
The primary determinant of the
spot/forward rate relationship is relative
interest rates.
17-16
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.
ft 1  rh

e 0 1  rf
ft  t - period forward exchange rate
e 0  today' s spot exchange rate
rh  periodic interest rate in home country
rf  periodic interest rate in foreign country
17-17
Evaluating interest rate parity

Suppose one yen buys $0.0095 in the 30day 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%
17-18
Does interest rate parity hold?
0.0095 1.0033

e0
1.0033
0.0095
1
e0

Therefore, for interest rate parity to hold,
e0 must equal $0.0095, but we were given
earlier that e0 = $0.0090.
17-19
Which security offers the
highest return?
The Japanese security.

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.
 Agree today to exchange 111,481 yen 30 days from
now at forward rate, 111,481/105.2632 = $1,059.07.
 30-day return = $59.07/$1,000 = 5.907%, nominal
annual return = 12 x 5.907% = 70.88%.

17-20
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.
Ph = Pf(e0)
-ORe0 = Ph/Pf
17-21
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 =
$0.6500 =
Pf =
=
Ph/Pf
$2.00/Pf
$2.00/$0.6500
3.0769 Australian dollars.
17-22
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.
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.
17-23
International credit markets

Eurocredits



Eurobonds



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.
Medium- to long-term international market for fixed- and
floating-rate debt.
Underwritten by an international bank syndicate and sold to
investors in countries other than the one in whose currency
the bond is denominated.
Foreign bonds


Issued in a capital market other than the issuer’s.
The only thing foreign about it is the borrower’s nationality.
17-24
American Depository Receipts (ADRs)



Certificates representing ownership of foreign
stock held in trust.
About 1,700 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.
17-25
To what extent do average capital
structures vary across different countries?


Previous studies suggested that average
capital structures vary among the large
industrial countries.
However, a recent study, which controlled
for differences in accounting practices,
suggests that capital structures are more
similar across different countries than
previously thought.
17-26
Impact of multinational operations

Cash management



Distances are greater and cash is often
denominated in different currencies.
Access to more markets for loans and for
temporary investments.
Capital budgeting decisions



Foreign operations are taxed locally, then
repatriated funds may be taxed in the U.S.
Foreign projects are subject to political risk.
Repatriated funds must be converted to U.S.
dollars (subject to exchange rate risk).
17-27
Impact of multinational operations

Credit management



Credit is more important, because commerce to
lesser-developed countries often relies on credit.
Credit for future payment may be subject to
exchange rate risk.
Inventory management


Inventory decisions can be more complex,
especially when inventory can be stored in
locations in different countries.
Should consider shipping times, carrying costs,
taxes, import duties, and exchange rates.
17-28