Chapter 18
International
Financial
Management
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Learning Objectives
1. Understand cultural, business, and
political differences in business practices.
2. Calculate exchange rates, cross rates,
and forward rates.
3. Understand transaction exposure,
operating exposure, and translation
exposure.
4. Apply net present value to foreign
projects.
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18-2
18.1 Managing Multinational
Operations
• When a firm goes multinational, the
complexity of the management component
increases significantly because of
differences in host countries’
– cultures
– business practices
– political systems
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18-3
18.1 (A) Cultural Risk
•
•
•
Cultural risk arises from differences in customs, social norms, attitudes,
assumptions, and expectations of the local society in the host country.
Differences in ownership structure:
– a requirement to set up joint ventures in certain countries
– a requirement to increase local participation and ownership
Differences in human resource norms:
– hiring and firing norms
– different cultural attitudes towards women and minorities in the
workplace
– local promotions and reward systems may not be consistent with those
of the home office and may have to be altered to maintain positive
relations with local employees, customers, and government officials
Religious heritage of the host country:
– the way employees dress
– holiday observances
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18-4
18.1 (A) Cultural Risk (continued)
• Nepotism and corrupt practices in the host country:
– a requirement to hire relatives of government officials as
a condition of doing business (Indonesia) and
– bribery of officials to get permits and licenses—
considered to be illegal in the U.S.—may be normal
practices in some foreign countries.
• Intellectual property rights:
– copyrights and patents may not be honored in some
foreign countries (e.g., China)
• Although attempts are being made to alter the
landscape of differences in attitudes towards
intellectual property rights (e.g. 2001 treaty), much
still needs to be done.
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18-5
18.1 (B) Business Risk
• Arises from economic factors such as
–
–
–
–
inflation rates
recessions
interest rate movements
exchange rate fluctuations
• Tend to be more pronounced when
operating in multiple countries.
• Efficient diversification of such risk factors
is key to success.
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18-6
18.1 (C) Political Risk
• Arises from changing attitudes of the political leadership
towards MNCs, resulting in loss of subsidies or risk of
nationalization.
• MNCs can defend against such risks by
– Keeping critical operations private: maintaining key
or critical elements of operations safely within the firm,
thereby rendering the assets useless in case of
nationalization.
– Financing operations and assets with local money
so that local creditors can put pressure on the host
government not to nationalize the business.
– Receiving primary inputs outside the local
economy: it may be that which the assets and
operations of the MNC will not be valuable without such
inputs.
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18-7
18.2 Foreign Exchange
• With each sovereign nation having its own
currency (except of course, the euro which
is the accepted currency in 16 out of 27
countries of the European Union), MNCs
have to keep track of the fluctuations in
exchange rates of various currencies
caused by changing economic factors such
as interest rates, inflation rates, and
productivity.
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18-8
18.2 (A) Purchasing Power Parity
• Purchasing power parity  the price of
similar goods is the same regardless of
which currency one uses to buy the goods.
• Table 18.1 shows how the price of a Big
Mac in various countries can be used to
keep track of relative purchasing power
and exchange rates in countries where
McDonalds operates.
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18-9
18.2 (A) Purchasing Power Parity
(continued)
TABLE 18.1
Big Mac Index
•
•
•
Price in US $ = Price of a Big Mac in Foreign Currency/ HK$/1US$
For Hong Kong, Price in US$  HK$13.3/HK$7.75 = $1.72
Purchasing Power(Hong Kong) = Price in HK$/Price in US$=HK$13.3/$3.543.76
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18-10
18.2 (A) Purchasing Power Parity
(continued)
• In the real world, exchange rates are
based on the prices of a basket of goods
rather than on a single item in different
countries.
• In general, the rate at which we can
exchange money between currencies
should allow us to purchase the same
basket of goods in any country with the
same dollars (except for local tariffs, etc.).
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18-11
18.2 (C) Currency Exchange Rates
• can be expressed in
– direct form (amount of US$ required to buy 1
unit of foreign money). Also known as the
American rate.
– indirect form (amount of foreign money
required to buy 1 US$). Also know as the
European rate.
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18-12
18.2 (C) Currency Exchange Rates
(continued)
TABLE 18.2 Exchange Rates (May 12, 2009)
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18-13
18.2 (C) Currency Exchange Rates
(continued)
Calculation of these rates is as follows:
So, 1 Mexican peso can buy roughly 8 US cents.
If we divide the direct rate into 1, that is, take its
reciprocal, we get the indirect or European rate:
Indirect rate = 1/$0.075513.245 Mexican pesos
So, 1 US$ can buy 13.245 Mexican pesos.
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18-14
18.2 (D) Cross Rates
• Cross rates are used to state the exchange rate between two
non-US currencies,
– for example, the exchange rate between the British pound and
the yen.
We can use a three-step process to determine the rate:
1. We first convert pounds (£) into U.S. dollars. Using the direct
rate from Table 18.2, we see that 1 £ buys $1.5253.
2. We then convert our dollars into yen at the indirect rate of
¥96.16 per dollar. So, $1.5253 times 96.126 buys ¥146.6728.
3. We now have an exchange rate for pounds to yen via the U.S.
dollar. That is, if we start with 1 £, we will end up with
¥146.6728:
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18-15
18.2 (D) Cross Rates (continued)
In Britain, this would be the indirect rate between the British pound
and the Japanese Yen, that is, it would tell us how many units of yen
can be bought with 1 £.
To solve for the direct rate between the £ and the yen, we simply
take the reciprocal of the indirect rate >
1/146.6728 > .0006817 £.
Alternatively, we can solve for the indirect rate between 2 currencies
— for example, the amount of yen that 1 £ can buy. To do so, we
take the direct or American rate of the first foreign currency and
multiply it by the indirect or European rate of the second foreign
currency.
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18-16
18.2 (E) Arbitrage Opportunities
 Arbitrage opportunities exist when cross
rates, as determined by Equation 18.3, do
not hold:
– allows traders the opportunity to exchange
currencies simultaneously and make instant
profits without taking on any additional risk
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18-17
18.2 (E) Arbitrage Opportunities
(continued)
Example 1: Triangular arbitrage
Problem
Let’s say that you see that the direct rate for Euro is 1.2922 and the
indirect rate for the Yen is 96.16. You check the internet and find
that the indirect rate for Yen in Euros is 130 yen. You have
$10,000 and are willing to make quick gains if possible. Is there
an arbitrage opportunity here?
Solution
First, use Equation 18.3 to determine if the indirect rate for yen in
euros is correct.
According to Equation 18.3, the indirect rate for yen per euro =
Direct rate for euros in US$* Indirect rate for yen in US
= $ 1.2922*96.16124.26Y/euro,
which is less than the Indirect Rate so the euro seems to be
overvalued.
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18-18
18.2 (E) Arbitrage Opportunities
(continued)
You would then convert dollars into euros,  buy Yen at the
indirect rate, and  convert yen back to dollars as follows:
Direct rate for euro = 1.2922  $1.2922 = 1 euro or $1 = 1/1.2922
euro  0.773874 euro.
$10,000*0.77387 euros/$  7738.74 euros
7738.74 euros * 130 yen/euro 1006036.22 yen
1006036.22 yen * .0104$/yen=$10,462.77
So make a cool $462.77 before commissions.
YES! THIS WOULD BE AN ARBITRAGE OPPORTUNITY!
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18-19
18.2 (F) Forward Rates
The exchange rates in the future, e.g., one year
from now, depend to a large extent on the current
exchange rate and the relative expected inflation
rates in the 2 countries, as shown in Equation 18.4
Where inff = expected inflation rate in the foreign
country and infh = expected inflation rate in the host
country.
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18-20
18.2 (F) Forward Rates (continued)
If a country’s inflation rate increases relatively higher than that
of another country, then its currency’s exchange rate will get
weaker, that is, it will buy fewer units of the currency of the
country whose inflation rate did not increase as much.
Equation 18.4 applies to a 1-year forward rate. A more general
formula that can be used for predicting forward rates for any
future period is shown in Equation 18.5:
here T is time in years, I.e., 9 months > = T = 9/12 = 0.75
and 3 years would have T = 3
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18-21
18.2 (F) Forward Rates (continued)
Example 2: Calculating
forward rates: Let’s say
that the Australian $ is
currently being quoted at
A$1.3109/US$.
• If inflation is likely to be 8%
in Australia and 4% in the
United States, calculate the
indirect forward rate for the
Australian dollar 3 months
from now.
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Forward indirect rate --3
months = A$ 1.3109 *
(1.08/1.04)3/12  A$1.3233
• So, since inflation is
expected to rise higher in
Australia than in the United
States, the Aussie $ is
expected to get weaker,
that is,1 US$ will buy more
A$ than before.
18-22
18.2 (G) Using Forward Rates
Investors and companies can use forward contracts minimize their risk
of losses arising from having to convert money received in foreign
currencies at lower rates. The forward rate is the rate that is being
committed to today for forward delivery of the currency. So if rates go
down, you still get the forward rate that was agreed upon.
According to the International Fisher Effect, the real interest rates are
equal across all countries, so if we get a higher rate in one country, it
will be offset by a higher inflation in that country and a weakening
exchange rate.
Covered interest arbitrage is an attempt made by some investors to try
to exploit variances in inflation rates and interest rates across countries.
Most often, however, the exchange rate adjusts in such a way that the
arbitrage opportunities do not materialize.
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18-23
18.3 Transaction, Operating, and
Translation Exposure
• Fluctuations in exchange rates cause a
firm’s future cash inflows, to vary
significantly, leading to possible losses and
gains from transaction, operating, and
translation exposure.
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18-24
18.3 (A) Transaction Exposure
This exposure can and must
be hedged by selling the
currency forward, that is, by
entering into selling forward
contract,
whereby
the
forward selling price of the
foreign
currency
to
be
received is agreed upon
today.
is the potential loss in
home currency value of
future foreign currency
payments.
•This loss can occur if the home
currency gets stronger, meaning
that fewer units can be purchased
per unit of the foreign currency.
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18-25
18.3 (B) Operating Exposure
Unfavorable
exchange
rate
movements
Operating Exposure:
threat to the longrun viability of a
foreign operation of
a
multinational
business
Escalating
inflation
rates
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18-26
18.3 (B) Operating Exposure
TABLE 18.4 Dollar Profit per Swedish Bicycle Sale: No Change in
Exchange Rate (inflation the same in both countries)
TABLE 18.5 Dollar Profit per Swedish Bicycle Sale: Increase in
Exchange Rate Due to Different Inflation Rates
Tables 18.4 and 18.5 illustrate the effects of rising inflation rates on a country’s exchange
rate and the consequential negative effect on operating profits of a U.S. firm doing business
in Sweden.
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18-27
18.3 (C) Translation Exposure
Differences in rules for translating foreign financial
statements
Affects the way consolidated statements are
reported.
Leading to a risk of negative effects on a firm’s
financial statements
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18-28
18.4 Foreign Investment Decisions
• When evaluating multinational capital
budgeting projects, the NPV analysis can be
done with either foreign currency cash flows
or with domestic currency cash flows.
• Two main differences between foreign and
domestic investment decisions include:
1. the use of an appropriate discount rate that
accounts for the relative inflation rates in the two
countries
2. the conversion of cash flows using an appropriate
exchange rate
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18-29
18.4 Foreign Investment Decisions
(continued)
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18-30
18.4 Foreign Investment Decisions
(continued)
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18-31
18.4 Foreign Investment Decisions
(continued)
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18-32
18.4 Foreign Investment Decisions
(continued)
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18-33
18.4 Foreign Investment Decisions
(continued)
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18-34
Additional Problems with Answers
Problem 1: Currency Exchange Rates
On the day you arrive in New Zealand, the exchange rate
for U.S. dollars and New Zealand dollars is $1:2.25 NZ$.
– While you remain in New Zealand for the next few
months, the exchange rate falls to $1:$1.75439 NZ$.
– When you entered New Zealand, you converted
US$10,500 to NZ$.
– As you leave New Zealand, you have NZ$ 400.
• How much did you spend in New Zealand in U.S. dollars?
• Did the movement in the exchange rate help or hurt you?
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18-35
Additional Problems with Answers
Problem 1 (Answer)
Convert US$ to NZ$:  $ 10,500 x 2.25 = NZ$23,625
Remaining NZ$ after trip is over = NZ$400;
Amount spent NZ$23,625-NZ$400=NZ$ 23,225
Dollars left after converting: NZ$400 /1.75439 = $
228
Dollars Spent: $10,500 - $228.00 = $10,272
Appreciation of the NZ$ helped you: you bought the
NZ low and sold the NZ high
Initial value of $1.00 = NZ$2.25
Ending value of $ = NZ$2.25/NZ$ 1.75439 = 1.2825
You gained about 28.25 cents per dollar while in
New Zealand.
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18-36
Additional Problems with Answers
Problem 2: Cross-Rates
You plan to travel to South Korea and China on a business
trip.
– You will first stop in Korea, where the current direct
exchange rate is $1:1243.78SK Won.
– You will next stop in China, where the current direct
exchange rate is $1: Yuan 6.83013.
– As you leave South Korea, you have 825,000 Won and
need to convert it to Yuan.
• What is the cross-rate for Yuan, and how many Yuan do
you get for your won?
• Verify by converting won back to dollars and then dollars
to Yuan.
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18-37
Additional Problems with Answers
Problem 2 (Answer)
Direct rate: $0.000804 / Won1.00 & $0.1464101
/Yuan1.00
Cross rate: ($0.000804 / Won1.00) /
($0.1464101/Yuan1.00)
 Yuan0.00549142 / Won1.00
Convert: 125,000 Won to Yuan = Won 825,000 x
(0.00549142)
 Yuan 4,530.42
Verification: 825,000 Won= 825,000*.000804$663.3
$663.3*6.83013Yuan Yuan 4,530.42
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18-38
Additional Problems with Answers
Problem 3: Triangular Arbitrage
On-Line Currency, Inc. is an online currency exchange
company that will immediately convert and credit your bank
account based on its published rates. Being the smart
finance major that you are, you notice that one of the rates
published below is incorrect, and you want to take
advantage of it. Let’s say that you have $20,000 of next
semester’s college funds sitting in your checking account
and decide to take advantage of the error by doing a
triangular arbitrage (we do not advise doing this in reality!).
Explain how you would go about doing the arbitrage by first
identifying the mismatched currency pair:
$ for £
£ for €
€ for $
£ for $
€ for £
$ for €
0.5510
1.5235
1.3046
1.81488203
0.95683
0.7665
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18-39
Additional Problems with Answers
Problem 3 (Answer)
Direct
£0.5510 =
$1.00
€1.5235 =
£1.00
$1.3046 =
€1.00
Indirect
$1.81488203
£1.00
£0.65638333
€1.00
€0.7665
$1.00
Actual Indirect:
$1.81488203
£1.00
£0.95683 = Mismatch
€1.00
€0.7665
$1.00
Arbitrage strategy: Need to use the mismatched Euros to
British Pounds…
1. Convert $ to €: $20,000 x 0.7665 = €15,330
2. Convert € to £: €15,330 x 0.95683 = £14,668.20390
3. Convert £ to $: £14,668.20 x 1.81488203 = $26,621.06
Profit: $ 6,621.06
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18-40
Additional Problems with Answers
Problem 4: Forward Rates
The Wall Street Journal lists forward rates for Euros. Say that
the current listings are:
1-month forward rate (indirect) 0.7025
3-month forward rate (indirect) 0.7145
6-month forward rate (indirect) 0.7245
1) Is the anticipated inflation rate higher or lower in Europe
compared with that in the United States?
2) If the current indirect rate is 0.6994, what do the six-month
rate and the current rate imply about the relative difference
in the anticipated annual inflation rates?
3) Using the current indirect rate and the 6-month forward rate,
determine the annual anticipated inflation rates for Europe if
the U.S. inflation rate is anticipated to be 3.15%.
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18-41
Additional Problems with Answers
Problem 4 (Answer)
Forward indirect rates:
One month €0.7025 / $ 1.00
Three months €07145 / $ 1.00
Six months €0.7245 / $ 1.00
A depreciating € signifies higher inflation in the next
six months for Europe versus the United States.
Inflation: 0.7245 = 0.6994 x [(1 + infEUROPE)/(1 +
infUS)]0.5
[(1 + infEUROPE) / (1 + infUS)] = (.7245 / .6994)2
[(1 + infEUROPE) / (1 + infUS)] = 1.07306375
(1 + infEUROPE) = (1 + infUS) x 1.07306375
Since inflation in US is 3.15%
(1 + infEUROPE) = (1.0315) x 1.073063751.10686526
Inf EUROPE = 10.69%
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18-42
Additional Problems with Answers
Problem 5: Domestic NPV Approach
Kalamazoo Marine wants to expand its operations to New Zealand.
The current indirect exchange rate is 1.75 for U.S. and New
Zealand dollars. The anticipated inflation rate is 3.8% in the United
States, but only 1.75% in New Zealand. The discount rate in the
United States for the expansion project is 16%. If the following
after-tax cash flows have been forecasted for the expansion
project in NZ$, should Kalamazoo Marine expand to New Zealand?
Investment:
NZ$ 60,000,000
Cash Flows: Year 1 – NZ$7,000,000
Year 2 – NZ$10,000,000
Year 3 – NZ$ 25,000,000
Year 4 – NZ$ 19,000,000
Year 5 – NZ$ 17,000,000
Year 6 – NZ$ 5,000,000
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18-43
Additional Problems with Answers
Problem 5 (Answer)
• Anticipated forwards:
• Yr 1. (NZ$1.75/$1.00)
NZ$1.7154/$1.00
• Yr 2. (NZ$1.75/$1.00)
NZ$1.6816/$1.00
• Yr 3. (NZ$1.75/$1.00)
NZ$1.6483/$1.00
• Yr 4. (NZ$1.75/$1.00)
NZ$1.6158/$1.00
• Yr 5. (NZ$1.75/$1.00)
NZ$1.5839/$1.00
• Yr 6. (NZ$1.75/$1.00)
NZ$1.5526/$1.00
x (1.0175/1.038) =
x (1.0175/1.038)2 =
x (1.0175/1.038)3 =
x (1.0175/1.038)4 =
x (1.0175/1.038)5 =
x (1.0175/1.038)6 =
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18-44
Additional Problems with Answers
Problem 5 (Answer continued)
Cash Flows:
$ value
Present Value
NZ$ -60,000,000 / 1.75 = $ -34,285,714.29
$ -34,285,714.29
NZ$ 7,000,000 / 1.7154
= $ 4,080,680.89/ (1.16)
$
3,517,828.35
NZ$ 10,000,000 / 1.6816
= $ 5,946,717.41/ (1.16)2
$
4,419,379.77
NZ$ 25,000,000 / 1.6483
= $ 15,167,141.90/ (1.16)3
$
9,716,945.85
NZ$ 19,000,000 / 1.6158
= $ 11,758,881.05/ (1.16)4
$
6,494,325.32
NZ$ 17,000,000 / 1.5839
= $ 10,733,000.82/ (1.16)5
$
5,110,121.39
NZ$ 5,000,000 / 1.5526
= $ 3,220,404.48/ (1.16)6
$
1,321,790.08
NPV = ∑(PV Column) -$ 3,705,323.53. Do not expand…Negative
NPV!
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18-45