International
Financial Management
9th Edition
by
Jeff Madura
Florida Atlantic University
South-Western/Thomson Learning © 2003
Part I
The International Financial Environment
Multinational Corporation (MNC)
Foreign Exchange Markets
Exporting
& Importing
Product Markets
Dividend
Remittance
& Financing
Subsidiaries
Investing
& Financing
International
Financial
Markets
Chapter
1
Multinational Financial Management:
An Overview
South-Western/Thomson Learning © 2003
Chapter Objectives
• To identify the main goal of the
multinational corporation (MNC) and
conflicts with that goal;
• To describe the key theories that justify
international business; and
• To explain the common methods used to
conduct international business.
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Goal of the MNC
• The commonly accepted goal of an MNC is
to maximize shareholder wealth.
• We will focus on MNCs that are based in
the United States and that wholly own
their foreign subsidiaries.
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Conflicts Against the MNC Goal
• For corporations with shareholders who
differ from their managers, a conflict of
goals can exist - the agency problem.
• Agency costs are normally larger for MNCs
than for purely domestic firms.
¤ The sheer size of the MNC.
¤ The scattering of distant subsidiaries.
¤ The culture of foreign managers.
¤ Subsidiary value versus overall MNC value.
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Impact of Management Control
• The magnitude of agency costs can vary
with the management style of the MNC.
• A centralized management style reduces
agency costs. However, a decentralized
style gives more control to those
managers who are closer to the
subsidiary’s operations and environment.
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Centralized Multinational Financial Management
for an MNC with two subsidiaries, A and B
Cash
Management
at A
Inventory and
Accounts
Receivable
Management at A
Financing at A
Capital Expenditures
at A
Financial
Managers
of Parent
Cash
Management
at B
Inventory and
Accounts
Receivable
Management at B
Financing at B
Capital Expenditures
at B
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Decentralized Multinational Financial Management
for an MNC with two subsidiaries, A and B
Cash
Management
at A
Financial
Managers
of A
Inventory and
Accounts
Receivable
Management at A
Financing at A
Capital Expenditures
at A
Financial
Managers
of B
Cash
Management
at B
Inventory and
Accounts
Receivable
Management at B
Financing at B
Capital Expenditures
at B
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Impact of Management Control
• Some MNCs attempt to strike a balance they allow subsidiary managers to make
the key decisions for their respective
operations, but the decisions are
monitored by the parent’s management.
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Impact of Management Control
• Electronic networks make it easier for the
parent to monitor the actions and
performance of foreign subsidiaries.
• For example, corporate intranet or internet
email facilitates communication. Financial
reports and other documents can be sent
electronically too.
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Impact of Corporate Control
• Various forms of corporate control can
reduce agency costs.
¤ Stock compensation for board members
and executives.
¤ The threat of a hostile takeover.
¤ Monitoring and intervention by large
shareholders.
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Constraints
Interfering with the MNC’s Goal
• As MNC managers attempt to maximize
their firm’s value, they may be confronted
with various constraints.
¤
Environmental constraints.
¤
Regulatory constraints.
¤
Ethical constraints.
C1 - 13
Theories of International Business
Why are firms motivated to expand
their business internationally?
 Theory of Comparative Advantage
¤
Specialization by countries can increase
production efficiency.
 Imperfect Markets Theory
¤
The markets for the various resources
used in production are “imperfect.”
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Theories of International Business
Why are firms motivated to expand
their business internationally?
 Product Cycle Theory
¤
As a firm matures, it may recognize
additional opportunities outside its home
country.
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The International Product Life Cycle
 Firm creates
product to
accommodate
local demand.
a. Firm
differentiates
product from
competitors
and/or expands
product line in
foreign country.
 Firm exports
product to
accommodate
foreign demand.
or
b. Firm’s
foreign
business
declines as its
competitive
advantages are
eliminated.
 Firm
establishes
foreign
subsidiary
to establish
presence in
foreign
country
and
possibly to
reduce
costs.
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International
Business Methods
There are several methods by which firms
can conduct international business.
• International trade is a relatively
conservative approach involving
exporting and/or importing.
¤ The internet facilitates international trade
by enabling firms to advertise and manage
orders through their websites.
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International
Business Methods
• Licensing allows a firm to provide its
technology in exchange for fees or some
other benefits.
• Franchising obligates a firm to provide a
specialized sales or service strategy,
support assistance, and possibly an initial
investment in the franchise in exchange
for periodic fees.
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International
Business Methods
• Firms may also penetrate foreign markets
by engaging in a joint venture (joint
ownership and operation) with firms that
reside in those markets.
• Acquisitions of existing operations in
foreign countries allow firms to quickly
gain control over foreign operations as
well as a share of the foreign market.
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International
Business Methods
• Firms can also penetrate foreign markets
by establishing new foreign subsidiaries.
• In general, any method of conducting
business that requires a direct investment
in foreign operations is referred to as a
direct foreign investment (DFI).
• The optimal international business
method may depend on the characteristics
of the MNC.
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Degree of International Business by MNCs
Foreign Sales as a % of Total Sales
Foreign Assets as a % of Total Assets
70%
62%
60%
46%
50%
66%
58%
50%
40%
33%
40%
30%
20%
47%
26%
12%
10%
0%
Campbell's
Dow
Soup
Chemical
IBM
Motorola
Nike
C1 - 21
Online Application
• Check out the following international trade
promotion sites.
C1 - 22
http://www.tradenet.gov
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http://www.business.gov/busadv/
index.cfm
C1 - 24
http://www.trade.gov
http://www.export.gov
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International Opportunities
• Investment opportunities - The marginal
return on projects for an MNC is above
that of a purely domestic firm because of
the expanded opportunity set of possible
projects from which to select.
• Financing opportunities - An MNC is also
able to obtain capital funding at a lower
cost due to its larger opportunity set of
funding sources around the world.
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International Opportunities
Cost-benefit Evaluation for
Purely Domestic Firms versus MNCs
Purely
Domestic
Firm
Investment
Opportunities
Marginal
Return on
Projects
Marginal
Cost of
Capital
MNC
MNC
Purely
Domestic
Firm
Financing
Opportunities
Appropriate
Size for Purely
Domestic Firm
X
Appropriate
Size for MNC
Y
Asset Level
of Firm
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International Opportunities
• Opportunities in Europe
¤
¤
¤
The Single European Act of 1987.
The removal of the Berlin Wall in 1989.
The inception of the euro in 1999.
• Opportunities in Latin America
¤
¤
The North American Free Trade
Agreement (NAFTA) of 1993.
The General Agreement on Tariffs and
Trade (GATT) accord.
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International Opportunities
• Opportunities in Asia
¤
¤
¤
The reduction of investment restrictions by
many Asian countries during the 1990s.
China’s potential for growth.
The Asian economic crisis in 1997-1998.
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Online Application
• For more information on the Asian crisis,
check out the following sites:
¤ http://www.stern.nyu.edu/~nroubini/asia/Asi
aHomepage.html
¤ http://www.asienhaus.org/navigat/english/a
sienhau.htm
C1 - 30
Exposure to International Risk
International business usually increases an
MNC’s exposure to:
 exchange rate movements
¤ Exchange rate fluctuations affect cash
flows and foreign demand.
 foreign economies
¤ Economic conditions affect demand.
 political risk
¤ Political actions affect cash flows.
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Exposure to International Risk
U.S. Firm’s Cost of Obtaining £100,000
$165,000
$160,000
$155,000
$150,000
$145,000
$140,000
$135,000
$130,000
Jan
2000
Mar
May
Jul
Sep
Nov
Jan
Mar
May
2001
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Online Application
• Visit FRED®, Fed's economic time-series
database, at http://www.stls.frb.org/fred for
numerous economic and financial time
series, e.g., balance of payment statistics,
interest rates, foreign exchange rates.
• Visit http://www.ita.doc.gov/td/industry/otea
(Office of Trade and Economic Analysis)
for an outlook of international trade
conditions for each of several industries.
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Managing for Value
• Like domestic projects, foreign projects
involve an investment decision and a
financing decision.
• When managers make multinational
finance decisions that maximize the
overall present value of future cash flows,
they maximize the firm’s value, and hence
shareholder wealth.
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Valuation Model for an MNC
• Domestic Model
n
Value = 
t =1
E CF$, t 
1 k 
t
E (CF$,t ) = expected cash flows to be received at
the end of period t
n
= the number of periods into the future
in which cash flows are received
k
= the required rate of return by
investors
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Valuation Model for an MNC
• Valuing International Cash Flows
m

E CFj , t  E ER j , t 
n 
 j 1

Value =  

t
1  k 
t =1 



E (CFj,t ) = expected cash flows denominated in currency j
to be received by the U.S. parent at the end of
period t
E (ERj,t ) = expected exchange rate at which currency j can
be converted to dollars at the end of period t
k
= the weighted average cost of capital of the U.S.
parent company
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Valuation Model for an MNC
• An MNC’s financial decisions include how
much business to conduct in each country
and how much financing to obtain in each
currency.
• Its financial decisions determine its
exposure to the international environment.
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Valuation Model for an MNC
Impact of New International Opportunities
on an MNC’s Value
Exposure to
Foreign Economies
Exchange Rate Risk
m

E CFj , t  E ER j , t 
n 
 j 1

Value =  

t
1  k 
t =1 



Political Risk
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How Chapters Relate to Valuation
Exchange Rate
Behavior
(Chapters 6-8)
Background
on
International
Financial
Markets
(Chapters
2-5)
Long-Term
Investment and
Financing
Decisions
(Chapters 13-18)
Short-Term
Investment and
Financing
Decisions
(Chapters 19-21)
Exchange Rate
Risk Management
(Chapters 9-12)
Risk and
Return of
MNC
Value and
Stock Price
of MNC
Chapter Review
• Goal of the MNC
¤
¤
¤
¤
Conflicts Against the MNC Goal
Impact of Management Control
Impact of Corporate Control
Constraints Interfering with the MNC’s
Goal
• Theories of International Business
¤
¤
¤
Theory of Comparative Advantage
Imperfect Markets Theory
Product Cycle Theory
C1 - 40
Chapter Review
• International Business Methods
¤
¤
¤
¤
¤
¤
International Trade
Licensing
Franchising
Joint Ventures
Acquisitions of Existing Operations
Establishing New Foreign Subsidiaries
C1 - 41
Chapter Review
• Exposure to International Risk
¤
¤
¤
Exposure to Exchange Rate Movements
Exposure to Foreign Economies
Exposure to Political Risk
• Managing for Value
C1 - 42
Chapter Review
• Valuation Model for an MNC
¤
¤
¤
¤
Domestic Model
Valuing International Cash Flows
Impact of Financial Management and
International Conditions on Value
How Chapters Relate to Valuation
C1 - 43
Chapter
2
International Flow of Funds
South-Western/Thomson Learning © 2003
C1 - 44
Chapter Objectives
• To explain the key components of the
balance of payments; and
• To explain how the international flow of
funds is influenced by economic factors
and other factors.
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Balance of Payments
• The balance of payments is a
measurement of all transactions between
domestic and foreign residents over a
specified period of time.
• Each transaction is recorded as both a
credit and a debit, i.e. double-entry
bookkeeping.
• The transactions are presented in three
groups – a current account, a capital
account, and a financial account.
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Balance of Payments
• The current account summarizes the flow of
funds between one specified country and all
other countries due to the purchases of
goods or services, the provision of income
on financial assets, or unilateral current
transfers (e.g. government grants and
pensions, private remittances).
• A current account deficit suggests a greater
outflow of funds from the specified country
for its current transactions.
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Summary of U.S. International Transactions
(For the Year of 2000 in Millions of Dollars)
Current Account
Exports of goods and services and income receipts 1418568
Goods, balance of payments basis
772210
Services
293492
Income receipts
352866
Imports of goods and services and income receipts -1809099
Goods, balance of payments basis
-1224417
Services
-217024
Income payments
-367658
Unilateral current transfers, net
Balance on current account
Source: U.S. Bureau of Economic Analysis
-54136
-444667
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Balance of Payments
• The current account is commonly used to
assess the balance of trade, which is simply
the difference between merchandise exports
and merchandise imports.
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Balance of Payments
• The new capital account (as defined in the
1993 System of National Accounts and the
fifth edition of IMF’s Balance of Payments
Manual) is adopted by the U.S. in 1999.
• It includes unilateral current transfers that
are really shifts in assets, not current
income. E.g. debt forgiveness, transfers
by immigrants, the sale or purchase of
rights to natural resources or patents.
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Summary of U.S. International Transactions
(For the Year of 2000 in Millions of Dollars)
Capital Account
Capital account transactions, net
Source: U.S. Bureau of Economic Analysis
705
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Balance of Payments
• The financial account (which was called
the capital account previously)
summarizes the flow of funds resulting
from the sale of assets between one
specified country and all other countries.
• Assets include official reserves, other
government assets, direct foreign
investments, investments in securities,
etc.
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Summary of U.S. International Transactions
(For the Year of 2000 in Millions of Dollars)
Financial Account
U.S.-owned assets abroad, net (increase/financial outflow) -580952
U.S. official reserve assets, net
-290
Other U.S. Gov’t assets, net
-944
U.S. private assets, net
-579718
Foreign-owned assets in the U.S., net (increase/financial inflow)
1024218
Foreign official assets in the U.S., net
37619
Other foreign assets in the U.S., net
986599
Net financial flows
443266
Statistical discrepancy (sum of items in all accounts with sign reversed)
696
Source: U.S. Bureau of Economic Analysis
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Online Application
• The U.S. balance of payments and related
data are disseminated by the Bureau of
Economic Analysis.
Visit the Bureau at http://www.bea.doc.gov.
C1 - 54
Online Application
• For a snapshot of the latest international
trade conditions, visit the White House’s
Economic Statistics Briefing Room at
www.whitehouse.gov/fsbr/international.html.
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International Trade Flows
• Different countries rely on trade to
different extents.
• The trade volume of European countries is
typically between 30 – 40% of their
respective GDP, while the trade volume of
U.S. and Japan is typically between 10 –
20% of their respective GDP.
• Nevertheless, the volume of trade has
grown over time for most countries.
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Canada
(179,231)
Mexico
(111,136)
Guatemala
(2,3)
El Salvador (2,2)
Costa Rica (2,4)
Panama (2,0)
Colombia (4,7)
Peru
Ecuador
(2,2)
(1,2)
Chile
(3,3)
Source: U.S. Census Bureau
Distribution of
U.S. Exports
and Imports
For the Year of 2000
(exports, imports)
Bahamas (1,0)
in Billions of $
Honduras (3,3)
Jamaica (1,1)
Dominican Republic (4,4)
Trinidad and Tobago (1,2)
Venezuela (6,19)
Brazil (15,14)
Argentina (5,3)
C1 - 57
Distribution of U.S. Exports and Imports
(exports, imports) in Billions of $ for the Year of 2000
Sweden Poland
Finland (2,3)
Norway (2,6) (5,10)
(1,1)
Denmark (2,3)
Russia (2,8)
Germany (29,59)
Czech Republic
Netherlands
(1,1)
(22,10)
Austria (3,3)
Ireland (8,16)
Hungary
United Kingdom
(1,3)
(42,43)
Italy
Belgium
(11,25)
(14,10)
Portugal
(1,2) Spain France
Turkey (4,3)
(6,6) (20,30) Switzerland Greece (1,1)
(10,10)
Source: U.S. Census Bureau
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Algeria (1,3)
Egypt (3,1)
Nigeria (1,11)
Gabon (0,2)
Distribution of
U.S. Exports
and Imports
For the Year of 2000
(exports, imports)
in Billions of $
Source: U.S. Census Bureau
Angola
(0,4)
South Africa (3,4)
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Iraq (0,6) Bangladesh (0,2)
Israel (8,13)
Pakistan
(0,2)
Kuwait
(1,3)
China
Saudi Arabia
(16,100)
(6,14)
India
United Arab
(4,11)
Sri Lanka
Emirates
(0,2)
(2,1)
Distribution of
U.S. Exports
and Imports
For the Year of 2000
(exports, imports)
in Billions of $
Source: U.S. Census Bureau
Thailand
(7,16)
Malaysia
(11,26)
Singapore
(18,19)
Japan
(65,146)
South Korea
(28,40)
Taiwan (24,41)
Hong Kong
(15,11)
Macao (0,1)
Philippines
(9,14)
Indonesia
(2,10)
Australia
(12,6)
New Zealand
(2,2)
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Distribution of U.S. Exports and Imports
For the Year of 2000 in Billions of $
Exports
Imports
Australasia
14.8 1.9%
Other Asia
South
Other Asia Australasia
47.4
88.0
23.6 3.0%
East
56.5 4.6%
8.8 0.7%
6.1% Asia 7.2%
Canada
Canada
229.2
148.5
178.8
18.8%
19.0%
22.8%
East Asia
Mexico
340.3
135.9
28.0%
Mexico
11.2%
11.0
111.7
Other
1.4%
14.3%
America
Africa
73.3
27.6
Other
6.0%
2.3%
America
59.3
Eastern Europe 181.3 Western 241.0
Eastern Europe
7.6%
6.1 0.8%
23.2% Europe 19.8%
16.2 1.3%
Source: U.S. Office of Trade and Economic Analysis
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International Trade Flows
• In 1975, the U.S. exported $107.1 billions
in goods, and imported $98.2 billions.
Since then, international trade has grown,
with U.S. exports and imports of goods
valued at $773.3 and $1,222.8 billions
respectively for the year of 2000.
• Since 1976, the value of U.S. imports has
exceeded the value of U.S. exports,
causing a balance of trade deficit.
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U.S. Balance of Trade Trend
1300
Billions of US$
1100
U.S. Imports
900
700
500
300
U.S. Exports
100
-1001960
1965
1970
1975
1980
1985
1990
1995
2000
-300
-500
Source: U.S. Census Bureau
U.S. Balance of Trade
C1 - 63
Factors Affecting
International Trade Flows
• Inflation
¤
A relative increase in a country’s inflation
rate will decrease its current account, as
imports increase and exports decrease.
• National Income
¤
A relative increase in a country’s income
level will decrease its current account, as
imports increase.
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Factors Affecting
International Trade Flows
• Government Restrictions
¤
¤
A government may reduce its country’s
imports by imposing tariffs on imported
goods, or by enforcing a quota. Note that
other countries may retaliate by imposing
their own trade restrictions.
Sometimes though, trade restrictions may
be imposed on certain products for health
and safety reasons.
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Factors Affecting
International Trade Flows
• Exchange Rates
¤
If a country’s currency begins to rise in
value, its current account balance will
decrease as imports increase and exports
decrease.
• Note that the factors are interactive, such
that their simultaneous influence on the
balance of trade is a complex one.
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Correcting
A Balance of Trade Deficit
• By reconsidering the factors that affect
the balance of trade, some common
correction methods can be developed.
• For example, a floating exchange rate
system may correct a trade imbalance
automatically since the trade imbalance
will affect the demand and supply of the
currencies involved.
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Correcting
A Balance of Trade Deficit
• However, a weak home currency may not
necessarily improve a trade deficit.
¤ Foreign companies may lower their prices
to maintain their competitiveness.
¤ Some other currencies may weaken too.
¤ Many trade transactions are prearranged
and cannot be adjusted immediately. This
is known as the J-curve effect.
¤ The impact of exchange rate movements
on intracompany trade is limited.
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U.S. Trade Balance
J-Curve Effect
0
Time
J Curve
C1 - 69
International Capital Flows
• Capital flows usually represent portfolio
investment or direct foreign investment.
• The DFI positions inside and outside the
U.S. have risen substantially over time,
indicating increasing globalization.
• In particular, both DFI positions increased
during periods of strong economic
growth.
C1 - 70
Direct Foreign Investment Positions
of the United States on a Historical Cost basis
1400
Billions of US$
1200
DFI by U.S. Firms
1000
800
600
400
DFI in the U.S.
200
0
1980
1985
Source: U.S. Bureau of Economic Analysis
1990
1995
2000
C1 - 71
Distribution of DFI for the U.S.
For the Year of 2000
DFI by U.S. Firms
DFI in the U.S.
Other Asia
Other Asia
Japan & Pacific Canada Other Western Canada & Pacific
Hemisphere
4.5%
10.2%
8.1%
11.6%
2.5% Japan
19.2% 3.4%
Middle
13.2%
East
France
Middle
1.0%
9.6%
East
Africa
0.7%
Germany
1.3%
9.9%
Other
Other
France
Europe
Europe
3.1%
16.6%
21.5%
Germany
4.3%
United Kingdom
United Kingdom
Netherlands
18.8%
18.5%
9.3% 12.3%
Source: U.S. Bureau of Economic Analysis
C1 - 72
Factors Affecting DFI
• Changes in Restrictions
¤
New opportunities may arise from the
removal of government barriers.
• Privatization
¤
DFI has also been stimulated by the selling
of government operations.
• Potential Economic Growth
¤
Countries with higher potential economic
growth are more likely to attract DFI.
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Factors Affecting DFI
• Tax Rates
¤
Countries that impose relatively low tax
rates on corporate earnings are more likely
to attract DFI.
• Exchange Rates
¤
Firms will typically prefer to invest their
funds in a country when that country’s
currency is expected to strengthen.
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Factors Affecting
International Portfolio Investment
• Tax Rates on Interest or Dividends
¤
Investors will normally prefer countries
where the tax rates are relatively low.
• Interest Rates
¤
Money tends to flow to countries with high
interest rates.
• Exchange Rates
¤
Foreign investors may be attracted if the
local currency is expected to strengthen.
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Agencies that Facilitate
International Flows
International Monetary Fund (IMF)
• The IM F is an organization of 183 member
countries. Established in 1946, it aims
¤ to promote international monetary
cooperation and exchange stability;
¤ to foster economic growth and high levels
of employment; and
¤ to provide temporary financial assistance
to help ease imbalances of payments.
C1 - 76
Agencies that Facilitate
International Flows
International Monetary Fund (IMF)
• Its operations involve surveillance, and
financial and technical assistance.
• In particular, its compensatory financing
facility attempts to reduce the impact of
export instability on country economies.
• The IMF uses a quota system, and its unit
of account is the SDR (special drawing
right).
C1 - 77
Agencies that Facilitate
International Flows
International Monetary Fund (IMF)
• The weights assigned to the currencies in
the SDR basket are as follows:
Currency
2001 Revision 1996 Revision
U.S. dollar
45
39
Euro
29
Deutsche mark
21
French franc
11
Japanese yen
15
18
Pound sterling
11
11
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Online Application
• You may learn more about the IMF at
http://www.imf.org.
C1 - 79
Agencies that Facilitate
International Flows
World Bank Group
• Established in 1944, the Group assists
development with the primary focus of
helping the poorest people and the
poorest countries.
• It has 183 member countries, and is
composed of five organizations - IBRD,
IDA, IFC, MIGA and ICSID.
C1 - 80
Agencies that Facilitate
International Flows
IBRD: International Bank for Reconstruction
and Development
• Better known as the World Bank, the IBRD
provides loans and development
assistance to middle-income countries
and creditworthy poorer countries.
• In particular, its structural adjustment
loans are intended to enhance a country’s
long-term economic growth.
C1 - 81
Agencies that Facilitate
International Flows
IBRD: International Bank for Reconstruction
and Development
• The IBRD is not a profit-maximizing
organization. Nevertheless, it has earned a
net income every year since 1948.
• It may spread its funds by entering into
cofinancing agreements with official aid
agencies, export credit agencies, as well
as commercial banks.
C1 - 82
Agencies that Facilitate
International Flows
IDA: International Development Association
• IDA was set up in 1960 as an agency that
lends to the very poor developing nations
on highly concessional terms.
• IDA lends only to those countries that lack
the financial ability to borrow from IBRD.
• IBRD and IDA are run on the same lines,
sharing the same staff, headquarters and
project evaluation standards.
C1 - 83
Agencies that Facilitate
International Flows
IFC: International Finance Corporation
• The IFC was set up in 1956 to promote
sustainable private sector investment in
developing countries, by
¤ financing private sector projects;
¤ helping to mobilize financing in the
international financial markets; and
¤ providing advice and technical assistance
to businesses and governments.
C1 - 84
Agencies that Facilitate
International Flows
M IGA: Multilateral Investment Guarantee
Agency
• The MIGA was created in 1988 to promote
FDI in emerging economies, by
¤ offering political risk insurance to investors
and lenders; and
¤ helping developing countries attract and
retain private investment.
C1 - 85
Agencies that Facilitate
International Flows
ICSID: International Centre for Settlement of
Investment Disputes
• The ICSID was created in 1966 to facilitate
the settlement of investment disputes
between governments and foreign
investors, thereby helping to promote
increased flows of international
investment.
C1 - 86
Online Application
• To learn more about the World Bank
Group and its organizations, visit:
¤ http://www.worldbank.org
¤ http://www.worldbank.org/ibrd
¤ http://www.worldbank.org/ida
¤ http://www.ifc.org
¤ http://www.miga.org
¤ http://www.worldbank.org/icsid
C1 - 87
Agencies that Facilitate
International Flows
World Trade Organization (WTO)
• Created in 1995, the WTO is the successor
to the General Agreement on Tariffs and
Trade (GATT).
• It deals with the global rules of trade
between nations to ensure that trade flows
smoothly, predictably and freely.
• At the heart of the WTO's multilateral
trading system are its trade agreements.
C1 - 88
Agencies that Facilitate
International Flows
World Trade Organization (WTO)
• Its functions include:
¤
¤
¤
¤
¤
¤
administering WTO trade agreements;
serving as a forum for trade negotiations;
handling trade disputes;
monitoring national trading policies;
providing technical assistance and training
for developing countries; and
cooperating with other international groups.
C1 - 89
Agencies that Facilitate
International Flows
Bank for International Settlements (BIS)
• Set up in 1930, the BIS is an international
organization that fosters cooperation
among central banks and other agencies
in pursuit of monetary and financial
stability.
• It is the “central banks’ central bank” and
“lender of last resort.”
C1 - 90
Agencies that Facilitate
International Flows
Bank for International Settlements (BIS)
• The BIS functions as:
¤
¤
¤
¤
a forum for international monetary and
financial cooperation;
a bank for central banks;
a center for monetary and economic
research; and
an agent or trustee in connection with
international financial operations.
C1 - 91
Online Application
• To learn more about the WTO and the BIS,
visit:
¤ http://www.wto.org
¤ http://www.bis.org
C1 - 92
Impact of International Trade on an MNC’s Value
National Income in Foreign Countries
Trade Agreements
Inflation in Foreign Countries
Exchange Rate Movements
m

E CFj , t  E ER j , t 
n 
 j 1

Value =  

t
1  k 
t =1 



E (CFj,t ) = expected cash flows in currency j to be received
by the U.S. parent at the end of period t
E (ERj,t ) = expected exchange rate at which currency j can
be converted to dollars at the end of period t
k
= weighted average cost of capital of the parent
C1 - 93
Chapter Review
• Balance of Payments
¤
Current, Capital, and Financial Accounts
• International Trade Flows
¤
¤
¤
¤
Distribution of U.S. Exports and Imports
U.S. Balance of Trade Trend
Recent Changes in North American and
European Trade
Trade Agreements Around the World
C1 - 94
Chapter Review
• Factors Affecting International Trade
Flows
¤ Inflation
¤ National Income
¤ Government Restrictions
¤ Exchange Rates
¤ Interaction of Factors
C1 - 95
Chapter Review
• Correcting a Balance of Trade Deficit
¤
Why a Weak Home Currency is Not A
Perfect Solution
• International Capital Flows
¤
¤
¤
¤
Distribution of DFI by U.S. Firms
Distribution of DFI in the U.S.
Factors Affecting DFI
Factors Affecting International Portfolio
Investment
C1 - 96
Chapter Review
• Agencies that Facilitate International
Flows
¤ International Monetary Fund (IMF)
¤ World Bank Group
¤ World Trade Organization (WTO)
¤ Bank for International Settlements (BIS)
¤ Regional Development Agencies
• How International Trade Affects an MNC’s
Value
C1 - 97
3
Chapter
International Financial Markets
South-Western/Thomson Learning © 2003
C1 - 98
Chapter Objectives
• To describe the background and corporate
use of the following international financial
markets:
¤ foreign exchange market,
¤ Eurocurrency market,
¤ Eurocredit market,
¤ Eurobond market, and
¤ international stock markets.
C1 - 99
Motives for Using
International Financial Markets
• The markets for real or financial assets are
prevented from complete integration by
barriers such as tax differentials, tariffs,
quotas, labor immobility, communication
costs, cultural differences, and financial
reporting differences.
• Yet, these barriers can also create unique
opportunities for specific geographic
markets that will attract foreign investors.
C1 - 100
Motives for Using
International Financial Markets
• Investors invest in foreign markets:
¤
¤
¤
to take advantage of favorable economic
conditions;
when they expect foreign currencies to
appreciate against their own; and
to reap the benefits of international
diversification.
C1 - 101
Motives for Using
International Financial Markets
• Creditors provide credit in foreign
markets:
¤ to capitalize on higher foreign interest
rates;
¤ when they expect foreign currencies to
appreciate against their own; and
¤ to reap the benefits of international
diversification.
C1 - 102
Motives for Using
International Financial Markets
• Borrowers borrow in foreign markets:
¤
¤
to capitalize on lower foreign interest rates;
and
when they expect foreign currencies to
depreciate against their own.
C1 - 103
Foreign Exchange Market
• The foreign exchange market allows
currencies to be exchanged in order to
facilitate international trade or financial
transactions.
• The system for establishing exchange
rates has evolved over time.
¤ From 1876 to 1913, each currency was
convertible into gold at a specified rate, as
dictated by the gold standard.
C1 - 104
Foreign Exchange Market
¤
¤
¤
This was followed by a period of instability,
as World War I began and the Great
Depression followed.
The 1944 Bretton Woods Agreement called
for fixed currency exchange rates.
By 1971, the U.S. dollar appeared to be
overvalued. The Smithsonian Agreement
devalued the U.S. dollar and widened the
boundaries for exchange rate fluctuations
from ±1% to ±2%.
C1 - 105
Foreign Exchange Market
¤
Even then, governments still had difficulties
maintaining exchange rates within the
stated boundaries. In 1973, the official
boundaries for the more widely traded
currencies were eliminated and the floating
exchange rate system came into effect.
C1 - 106
Foreign Exchange
Transactions
• There is no specific building or location
where traders exchange currencies.
Trading also occurs around the clock.
• The market for immediate exchange is
known as the spot market.
• The forward market enables an MNC to
lock in the exchange rate at which it will
buy or sell a certain quantity of currency
on a specified future date.
C1 - 107
Foreign Exchange
Transactions
• Hundreds of banks facilitate foreign
exchange transactions, though the top 20
handle about 50% of the transactions.
• At any point in time, arbitrage ensures that
exchange rates are similar across banks.
• Trading between banks occurs in the
interbank market. Within this market,
foreign exchange brokerage firms
sometimes act as middlemen.
C1 - 108
Foreign Exchange
Transactions
• The following attributes of banks are
important to foreign exchange customers:
¤ competitiveness of quote
¤ special relationship between the bank and
its customer
¤ speed of execution
¤ advice about current market conditions
¤ forecasting advice
C1 - 109
Foreign Exchange
Transactions
• Banks provide foreign exchange services
for a fee: the bank’s bid (buy) quote for a
foreign currency will be less than its ask
(sell) quote. This is the bid/ask spread.
• bid/ask % spread = ask rate – bid rate
ask rate
• Example: Suppose bid price for £ = $1.52,
ask price = $1.60.
bid/ask % spread = (1.60–1.52)/1.60 = 5%
C1 - 110
Foreign Exchange
Transactions
• The bid/ask spread is normally larger for
those currencies that are less frequently
traded.
• The spread is also larger for “retail”
transactions than for “wholesale”
transactions between banks or large
corporations.
C1 - 111
Interpreting
Foreign Exchange Quotations
• Exchange rate quotations for widely
traded currencies are frequently listed in
the news media on a daily basis. Forward
rates may be quoted too.
• The quotations normally reflect the ask
prices for large transactions.
C1 - 112
Interpreting
Foreign Exchange Quotations
• Direct quotations represent the value of a
foreign currency in dollars, while indirect
quotations represent the number of units
of a foreign currency per dollar.
• Note that exchange rate quotations
sometimes include IMF’s special drawing
rights (SDRs).
• The same currency may also be used by
more than one country.
C1 - 113
Interpreting
Foreign Exchange Quotations
• A cross exchange rate reflects the amount
of one foreign currency per unit of another
foreign currency.
• Value of 1 unit of currency A in units of
currency B = value of currency A in $
value of currency B in $
C1 - 114
Online Application
• Check out these foreign exchange sites:
¤
http://pacific.commerce.ubc.ca/xr/
¤
http://sonnet-financial.com/rates/full.asp
¤
http://www.oanda.com/
C1 - 115
Currency Futures and Options Market
• A currency futures contract specifies a
standard volume of a particular currency
to be exchanged on a specific settlement
date. Unlike forward contracts however,
futures contracts are sold on exchanges.
• Currency options contracts give the right
to buy or sell a specific currency at a
specific price within a specific period of
time. They are sold on exchanges too.
C1 - 116
Eurocurrency Market
$
• U.S. dollar deposits placed in banks in
Europe and other continents are called
Eurodollars.
• In the 1960s and 70s, the Eurodollar
market, or what is now referred to as the
Eurocurrency market, grew to
accommodate increasing international
business and to bypass stricter U.S.
regulations on banks in the U.S.
C1 - 117
Eurocurrency Market
$
• The Eurocurrency market is made up of
several large banks called Eurobanks that
accept deposits and provide loans in
various currencies.
• For example, the Eurocurrency market has
historically recycled the oil revenues
(petrodollars) from oil-exporting (OPEC)
countries to other countries.
C1 - 118
Eurocurrency Market
$
• Although the Eurocurrency market
focuses on large-volume transactions,
there are times when no single bank is
willing to lend the needed amount.
• A syndicate of Eurobanks may then be
composed to underwrite the loans. Frontend management and commitment fees
are usually charged for such syndicated
Eurocurrency loans.
C1 - 119
Eurocurrency Market
$
• The recent standardization of regulations
around the world has promoted the
globalization of the banking industry.
• In particular, the Single European Act has
opened up the European banking industry.
• The 1988 Basel Accord signed by G-10
central banks outlined common capital
standards, such as the structure of risk
weights, for their banking industries.
C1 - 120
Online Application
• Learn more about the Single European Act
at http://europa.eu.int/abc/treaties_en.htm.
• Details about the 1988 Basel Accord can
be found at
http://www.bis.org/publ/bcbs04a.htm.
Check out the new Basel Capital
Accord (2001) at
http://www.bis.org/publ/bcbsca.htm too.
C1 - 121
Eurocurrency Market
$
• The Eurocurrency market in Asia is
sometimes referred to separately as the
Asian dollar market.
• The primary function of banks in the Asian
dollar market is to channel funds from
depositors to borrowers.
• Another function is interbank lending and
borrowing.
C1 - 122
Eurocredit Market
LOANS
• Loans of one year or longer are extended
by Eurobanks to MNCs or government
agencies in the Eurocredit market. These
loans are known as Eurocredit loans.
• Floating rates are commonly used, since
the banks’ asset and liability maturities
may not match - Eurobanks accept shortterm deposits but sometimes provide
longer term loans.
C1 - 123
Eurobond Market
BONDS
There are two types of international bonds.
 Bonds denominated in the currency of the
country where they are placed but issued
by borrowers foreign to the country are
called foreign bonds or parallel bonds.
 Bonds that are sold in countries other
than the country represented by the
currency denominating them are called
Eurobonds.
C1 - 124
Eurobond Market
BONDS
• The emergence of the Eurobond market is
partially due to the 1963 Interest
Equalization Tax imposed in the U.S.
• The tax discouraged U.S. investors from
investing in foreign securities, so non-U.S.
borrowers looked elsewhere for funds.
• Then in 1984, U.S. corporations were
allowed to issue bearer bonds directly to
non-U.S. investors, and the withholding
tax on bond purchases was abolished.
C1 - 125
Eurobond Market
BONDS
• Eurobonds are underwritten by a multinational syndicate of investment banks
and simultaneously placed in many
countries through second-stage, and in
many cases, third-stage, underwriters.
• Eurobonds are usually issued in bearer
form, pay annual coupons, may be
convertible, may have variable rates, and
typically have few protective covenants.
C1 - 126
Eurobond Market
BONDS
• Interest rates for each currency and credit
conditions in the Eurobond market change
constantly, causing the popularity of the
market to vary among currencies.
• About 70% of the Eurobonds are
denominated in the U.S. dollar.
• In the secondary market, the market
makers are often the same underwriters
who sell the primary issues.
C1 - 127
Comparing Interest Rates
Among Currencies
• Interest rates vary substantially for
different countries, ranging from about 1%
in Japan to about 60% in Russia.
• Interest rates are crucial because they
affect the MNC’s cost of financing.
• The interest rate for a specific currency is
determined by the demand for and supply
of funds in that currency.
C1 - 128
Why U.S. Dollar Interest Rates Differ
from Brazilian Real Interest Rates
Interest
Rate
for $
S
Interest
Rate
for Real
S
D
D
Quantity of $
Quantity of Real
• The curves are further to the right for the
dollar because the U.S. economy is larger.
• The curves are higher for the Brazilian Real
because of the higher inflation in Brazil.
C1 - 129
Comparing Interest Rates
Among Currencies
• As the demand and supply schedules
change over time for a specific currency,
the equilibrium interest rate for that
currency will also change.
• Note that the freedom to transfer funds
across countries causes the demand and
supply conditions for funds to be
somewhat integrated, such that interest
rate movements become integrated too.
C1 - 130
International Stock Markets
• In addition to issuing stock locally, MNCs
can also obtain funds by issuing stock in
international markets.
• This will enhance the firm’s image and
name recognition, and diversify the
shareholder base. The stocks may also be
more easily digested.
• Note that market competition should
increase the efficiency of new issues.
C1 - 131
International Stock Markets
• Stock issued in the U.S. by non-U.S. firms
or governments are called Yankee stock
offerings. Many of such recent stock
offerings resulted from privatization
programs in Latin America and Europe.
• Non-U.S. firms may also issue American
depository receipts (ADRs), which are
certificates representing bundles of stock.
ADRs are less strictly regulated.
C1 - 132
Online Application
• Check out the performance of ADRs at
http://www.adr.com.
C1 - 133
International Stock Markets
• The locations of the MNC’s operations can
influence the decision about where to
place stock, in view of the cash flows
needed to cover dividend payments.
• Market characteristics are important too.
Stock markets may differ in size, trading
activity level, regulatory requirements,
taxation rate, and proportion of individual
versus institutional share ownership.
C1 - 134
Online Application
• For a summary of the performance of
various stock markets, refer to
http://www.worldbank.org/data/wdi2001/pdfs/t
ab5_3.pdf
• Visit the stock exchanges at:
¤
¤
http://dir.yahoo.com/Business_and_Econo
my/Business_to_Business/Financial_Servi
ces/Exchanges/Stock_Exchanges/
http://www.aex.nl/finance/beurzen.html
C1 - 135
International Stock Markets
• Electronic communications networks
(ECNs) have been created to match orders
between buyers and sellers in recent
years.
• As ECNs become more popular over time,
they may ultimately be merged with one
another or with other exchanges to create
a single global stock exchange.
C1 - 136
Comparison of
International Financial Markets
• The foreign cash flow movements of a
typical MNC can be classified into four
corporate functions, all of which generally
require the use of the foreign exchange
markets.
 Foreign trade. Exports generate foreign
cash inflows while imports require cash
outflows.
C1 - 137
Comparison of
International Financial Markets
 Direct foreign investment (DFI). Cash
outflows to acquire foreign assets
generate future inflows.
 Short-term investment or financing in
foreign securities, usually in the
Eurocurrency market.
 Longer-term financing in the Eurocredit,
Eurobond, or international stock markets.
C1 - 138
Foreign Cash Flow Chart of an MNC
MNC Parent
Export/Imp
ort
Foreign
Business
Clients
Export/Imp
ort
Dividend
Remittance
& Financing
Medium- &
Long-Term
Financing
Foreign
Exchange
Transaction
s
Foreign
Exchan
ge
Markets
Long-Term
Financing
ShortTerm
Investmen
t
Eurocurren
Eurocredit
&
Internation
cy Market
&
Financing
al Stock
Short-Term
Eurobond
Foreign
Markets
Markets
Subsidiari Investment & Financing
Medium- & Long-Term Financing
es
Long-Term Financing
C1 - 139
Online Application
• For the latest information from financial
markets around the world, visit:
¤ http://www.bloomberg.com/
¤ http://finance.yahoo.com/
¤ http://money.cnn.com/
¤ http://www.reuters.com/
C1 - 140
Online Application
• Find out how these offices regulate the
U.S. financial markets.
• The Department of the Treasury
http://www.ustreas.gov/
• The Federal Reserve System
http://www.federalreserve.gov/
• The Securities and Exchange
Commission
http://www.sec.gov/
C1 - 141
Impact of Global Financial Markets
on an MNC’s Value
Improved global image
from issuing stock in
global markets
Cost of borrowing
funds in global
markets
m

E CFj , t  E ER j , t 
n 
 j 1

Value =  

t
1  k 
t =1 



Cost of parent’s
Cost of parent’s funds
equity in global
borrowed in global
markets cash flows in currency
marketsj to
E (CFj,t ) = expected
be received by the U.S. parent at the end
of period t
E (ERj,t ) = expected exchange rate at which
C1 - 142
Chapter Review
• Motives for Using International Financial
Markets
¤ Motives for Investing in Foreign Markets
¤ Motives for Providing Credit in Foreign
Markets
¤ Motives for Borrowing in Foreign Markets
C1 - 143
Chapter Review
• Foreign Exchange Market
¤
¤
¤
¤
History of Foreign Exchange
Foreign Exchange Transactions
Interpreting Foreign Exchange Quotations
Currency Futures and Options Markets
C1 - 144
Chapter Review
• Eurocurrency Market
¤
¤
¤
¤
¤
Development of the Eurocurrency Market
Composition of the Eurocurrency Market
Syndicated Eurocurrency Loans
Standardizing Bank Regulations within the
Eurocurrency Market
Asian Dollar Market
• Eurocredit Market
C1 - 145
Chapter Review
• Eurobond Market
¤
¤
¤
Development of the Eurobond Market
Underwriting Process
Features
• Comparing Interest Rates Among
Currencies
¤ Global Integration of Interest Rates
C1 - 146
Chapter Review
• International Stock Markets
¤
¤
Issuance of Foreign Stock in the U.S.
Issuance of Stock in Foreign Markets
• Comparison of International Financial
Markets
• How Financial Markets Affect An MNC’s
Value
C1 - 147
Chapter
4
Exchange Rate Determination
South-Western/Thomson Learning © 2003
C1 - 148
Chapter Objectives
• To explain how exchange rate movements
are measured;
• To explain how the equilibrium exchange
rate is determined; and
• To examine the factors that affect the
equilibrium exchange rate.
C1 - 149
Measuring
Exchange Rate Movements
• An exchange rate measures the value of
one currency in units of another currency.
• When a currency declines in value, it is
said to depreciate. When it increases in
value, it is said to appreciate.
• On the days when some currencies
appreciate while others depreciate against
the dollar, the dollar is said to be “mixed
in trading.”
C1 - 150
Measuring
Exchange Rate Movements
• The percentage change (% D in the value
of a foreign currency is computed as
St – St-1
St-1
where St denotes the spot rate at time t.
• A positive % D represents appreciation of
the foreign currency, while a negative % D
represents depreciation.
C1 - 151
Fluctuation of the British Pound
Over Time
Approximate
Spot Rate of £
$ 1.80
1.75
1.70
1.65
1.60
1.55
1.50
1.45
1.40
1992
1996
Approximate
Annual % D
20 %
15
10
5
0
-5
-10
-15
-20
1992
2000
Approximate £
that could be
Purchased with
$10,000
£ 7000
6800
6600
6400
6200
6000
5800
5600
1996
2000
1992
1996
2000
C1 - 152
Online Application
• For the latest exchange rates, visit:
¤
¤
¤
¤
http://www.bloomberg.com/
http://finance.yahoo.com/
http://money.cnn.com/
http://www.reuters.com/
C1 - 153
Exchange Rate Equilibrium
• An exchange rate represents the price of a
currency, which is determined by the
demand for that currency relative to the
supply for that currency.
Value of £
$1.60
$1.55
$1.50
S: Supply of £
equilibrium
exchange rate
D: Demand for £
Quantity of £
C1 - 154
Factors that Influence
Exchange Rates
Relative Inflation Rates
$/£
r1
r0
S1
S0
D1
D0
Quantity of £
U.S. inflation 
  U.S. demand for
British goods, and
hence £.
  British desire for U.S.
goods, and hence the
supply of £.
C1 - 155
Factors that Influence
Exchange Rates
Relative Interest Rates
$/£
r0
r1
S0
S1
D0
D1
Quantity of £
U.S. interest rates 
  U.S. demand for
British bank deposits,
and hence £.
  British desire for U.S.
bank deposits, and
hence the supply of £.
C1 - 156
Factors that Influence
Exchange Rates
Relative Interest Rates
• A relatively high interest rate may actually
reflect expectations of relatively high
inflation, which discourages foreign
investment.
• It is thus useful to consider real interest
rates, which adjust the nominal interest
rates for inflation.
C1 - 157
Factors that Influence
Exchange Rates
Relative Interest Rates
•
real
nominal
interest  interest – inflation rate
rate
rate
• This relationship is sometimes called the
Fisher effect.
C1 - 158
Factors that Influence
Exchange Rates
Relative Income Levels
$/£
r1
r0
U.S. income level 
  U.S. demand for
S0 ,S1
British goods, and
hence £.
D1
 No expected change for
D0
the supply of £.
Quantity of £
C1 - 159
Factors that Influence
Exchange Rates
Government Controls
• Governments may influence the
equilibrium exchange rate by:
¤ imposing foreign exchange barriers,
¤ imposing foreign trade barriers,
¤ intervening in the foreign exchange market,
and
¤ affecting macro variables such as inflation,
interest rates, and income levels.
C1 - 160
Factors that Influence
Exchange Rates
Expectations
• Foreign exchange markets react to any
news that may have a future effect.
• Institutional investors often take currency
positions based on anticipated interest
rate movements in various countries.
• Because of speculative transactions,
foreign exchange rates can be very
volatile.
C1 - 161
Factors that Influence
Exchange Rates
Expectations
Signal
Poor U.S. economic indicators
Impact on $
Weakened
Fed chairman suggests Fed is
Strengthened
unlikely to cut U.S. interest rates
A possible decline in German
Strengthened
interest rates
Central banks expected to
Weakened
intervene to boost the euro
C1 - 162
Factors that Influence
Exchange Rates
Interaction of Factors
• Trade-related factors and financial factors
sometimes interact. Exchange rate
movements may be simultaneously
affected by these factors.
• For example, an increase in the level of
income sometimes causes expectations of
higher interest rates.
C1 - 163
Factors that Influence
Exchange Rates
Interaction of Factors
• Over a particular period, different factors
may place opposing pressures on the
value of a foreign currency.
• The sensitivity of the exchange rate to
these factors is dependent on the volume
of international transactions between the
two countries.
C1 - 164
How Factors Can Affect Exchange Rates
Trade-Related
Factors
1. Inflation
Differential
2. Income
Differential
3. Gov’t Trade
Restrictions
Financial
Factors
1. Interest Rate
Differential
2. Capital Flow
Restrictions
U.S. demand for foreign
goods, i.e. demand for
foreign currency
Foreign demand for U.S.
goods, i.e. supply of
foreign currency
U.S. demand for foreign
securities, i.e. demand
for foreign currency
Exchange
rate
between
foreign
currency
and the
dollar
Foreign demand for U.S.
securities, i.e. supply of
foreign currency
C1 - 165
Factors that Influence
Exchange Rates
How Factors Have Influenced Exchange Rates
• Because the dollar’s value changes by
different magnitudes relative to each
foreign currency, analysts often measure
the dollar’s strength with an index.
• The weight assigned to each currency is
determined by its relative importance in
international trade and/or finance.
C1 - 166
Value of Foreign Currency Index Over Time
 strengthens $ weakens 
With Respect to the Dollar
large
250
$ due to
balance Persian
relatively high of trade Gulf War
200 U.S. inflation
deficit
& growth
150
U.S. interest rates 
high U.S.
interest rates, a
50 somewhat depressed
U.S. economy, & low
inflation
100
0
1972
Higher
U.S.
interest
rates
1976
1980
1984
relatively high U.S.
interest rates, &
lower balance of
trade deficit
1988
1992
1996
2000
Note: The index reflects equal weights of £, ¥, French franc, German mark, and Swiss franc.C1 - 167
Online Application
• Exchange rate releases and historical data
may be found at the Federal Reserve
website http://www.federalreserve.gov/.
MONETARY
COUNTRY
UNIT
Oct. 1 Oct. 2 Oct. 3 Oct. 4 Oct. 5
*AUSTRALIA
DOLLAR
0.4923 0.4953 0.4971 0.4975 0.5060
BRAZIL
REAL
2.6870 2.7000 2.7290 2.7290 2.7540
CANADA
DOLLAR
1.5794 1.5696 1.5688 1.5680 1.5626
CHINA, P.R. YUAN
8.2768 8.2768 8.2768 8.2768 8.2768
DENMARK
KRONE
8.1151 8.1267 8.0968 8.1339 8.1115
*EMU MEMBERS EURO
0.9159 0.9149 0.9181 0.9141 0.9168
DOLLAR
7.7992 7.7993 7.7995 7.7998 7.7999
RUPEE
48.03
48.03
47.96
48.04
48.05
YEN
120.27 120.78 120.67 120.63 120.37
.8003 3.8003 3.8005
C1 - 168
Speculating on Anticipated Exchange Rates
Chicago Bank expects the exchange rate of the New
Zealand dollar to appreciate from its present level of
$0.50 to $0.52 in 30 days.
1. Borrows
$20 million
Borrows at 7.20%
for 30 days
Returns $20,120,000
Profit of $792,320
Exchange at
$0.52/NZ$
Exchange at
$0.50/NZ$
2. Holds
NZ$40 million
4. Holds
$20,912,320
Lends at 6.48%
for 30 days
3. Receives
NZ$40,216,000
C1 - 169
Speculating on Anticipated Exchange Rates
Chicago Bank expects the exchange rate of the New
Zealand dollar to depreciate from its present level of
$0.50 to $0.48 in 30 days.
1. Borrows
NZ$40 million
Exchange at
$0.50/NZ$
2. Holds
$20 million
Borrows at 6.96%
for 30 days
4. Holds
NZ$41,900,000
Returns NZ$40,232,000
Profit of NZ$1,668,000
Exchange at
or $800,640
$0.48/NZ$
Lends at 6.72%
for 30 days
3. Receives
$20,112,000
C1 - 170
Impact of Exchange Rates on an MNC’s Value
Inflation Rates, Interest Rates,
Income Levels, Government Controls,
Expectations
m

E CFj , t  E ER j , t 
n 
 j 1

Value =  

t
1  k 
t =1 



E (CFj,t ) = expected cash flows in currency j to be received
by the U.S. parent at the end of period t
E (ERj,t ) = expected exchange rate at which currency j can
be converted to dollars at the end of period t
k
= weighted average cost of capital of the parent
C1 - 171
Online Application
• Check out these foreign exchange sites:
¤
http://pacific.commerce.ubc.ca/xr/
¤
http://sonnet-financial.com/rates/full.asp
¤
http://www.oanda.com/
C1 - 172
Chapter Review
• Measuring Exchange Rate Movements
• Exchange Rate Equilibrium
¤
¤
¤
Demand for a Currency
Supply of a Currency for Sale
Equilibrium
C1 - 173
Chapter Review
• Factors that Influence Exchange Rates
¤
¤
¤
¤
¤
¤
¤
Relative Inflation Rates
Relative Interest Rates
Relative Income Levels
Government Controls
Expectations
Interaction of Factors
How Factors Have Influenced Exchange
Rates
C1 - 174
Chapter Review
• Speculating on Anticipated Exchange
Rates
• How Exchange Rates Affect an MNC’s
Value
C1 - 175
Chapter
5
Currency Derivatives
See c5.xls for spreadsheets to
accompany this chapter.
South-Western/Thomson Learning © 2003
C1 - 176
Chapter Objectives
• To explain how forward contracts
are used for hedging based on
anticipated exchange rate movements;
and
• To explain how currency futures contracts
and currency options contracts are used
for hedging or speculation based on
anticipated exchange rate movements.
C1 - 177
Forward Market
• The forward market facilitates the trading
of forward contracts on currencies.
• A forward contract is an agreement
between a corporation and a commercial
bank to exchange a specified amount of a
currency at a specified exchange rate
(called the forward rate) on a specified
date in the future.
C1 - 178
Forward Market
• When MNCs anticipate future need or
future receipt of a foreign currency, they
can set up forward contracts to lock in the
exchange rate.
• Forward contracts are often valued at $1
million or more, and are not normally used
by consumers or small firms.
C1 - 179
Forward Market
• As with the case of spot rates, there is a
bid/ask spread on forward rates.
• Forward rates may also contain a premium
or discount.
¤ If the forward rate exceeds the existing
spot rate, it contains a premium.
¤ If the forward rate is less than the existing
spot rate, it contains a discount.
C1 - 180
Forward Market
• annualized forward premium/discount
= forward rate – spot rate  360
spot rate
n
where n is the number of days to maturity
• Example: Suppose £ spot rate = $1.681,
90-day £ forward rate = $1.677.
$1.677 – $1.681 x 360 = – 0.95%
$1.681
90
So, forward discount = 0.95%
C1 - 181
Forward Market
• The forward premium/discount reflects the
difference between the home interest rate
and the foreign interest rate, so as to
prevent arbitrage.
C1 - 182
Forward Market
• A non-deliverable forward contract (NDF)
is a forward contract whereby there is no
actual exchange of currencies. Instead, a
net payment is made by one party to the
other based on the contracted rate and the
market rate on the day of settlement.
• Although NDFs do not involve actual
delivery, they can effectively hedge
expected foreign currency cash flows.
C1 - 183
Online Application
• Forward rates can be found online at
http://www.bmo.com/economic/regular/fxrates
.html.
C1 - 184
Currency Futures Market
• Currency futures contracts specify a
standard volume of a particular currency to
be exchanged on a specific settlement
date, typically the third Wednesdays in
March, June, September, and December.
• They are used by MNCs to hedge their
currency positions, and by speculators
who hope to capitalize on their
expectations of exchange rate movements.
C1 - 185
Currency Futures Market
• The contracts can be traded by firms or
individuals through brokers on the trading
floor of an exchange (e.g. Chicago
Mercantile Exchange), on automated
trading systems (e.g. GLOBEX), or overthe-counter.
• Participants in the currency futures
market need to establish and maintain a
margin when they take a position.
C1 - 186
Currency Futures Market
Forward Markets
Contract size
Customized.
Delivery date
Customized.
Participants
Banks, brokers,
MNCs. Public
speculation not
encouraged.
Security
Compensating
deposit
bank balances or
credit lines needed.
Futures Markets
Standardized.
Standardized.
Banks, brokers,
MNCs. Qualified
public speculation
encouraged.
Small security
deposit required.
C1 - 187
Currency Futures Market
Clearing
operation
Marketplace
Forward Markets
Futures Markets
Handled by
individual banks
& brokers.
Handled by
exchange
clearinghouse.
Daily settlements
to market prices.
Central exchange
floor with global
communications.
Worldwide
telephone
network.
C1 - 188
Currency Futures Market
Forward Markets
Futures Markets
Regulation
Self-regulating.
Liquidation
Mostly settled by
actual delivery.
Bank’s bid/ask
spread.
Commodity
Futures Trading
Commission,
National Futures
Association.
Mostly settled by
offset.
Negotiated
brokerage fees.
Transaction
Costs
C1 - 189
Currency Futures Market
• Normally, the price of a currency futures
contract is similar to the forward rate for a
given currency and settlement date, but
differs from the spot rate when the interest
rates on the two currencies differ.
• These relationships are enforced by the
potential arbitrage activities that would
occur otherwise.
C1 - 190
Currency Futures Market
• Currency futures contracts have no credit
risk since they are guaranteed by the
exchange clearinghouse.
• To minimize its risk in such a guarantee,
the exchange imposes margin
requirements to cover fluctuations in the
value of the contracts.
C1 - 191
Currency Futures Market
• Speculators often sell currency futures
when they expect the underlying currency
to depreciate, and vice versa.
April 4
June 17
1. Contract to sell
500,000 pesos
@ $.09/peso
($45,000) on
June 17.
2. Buy 500,000 pesos
@ $.08/peso
($40,000) from the
spot market.
3. Sell the pesos to
fulfill contract.
Gain $5,000.
C1 - 192
Currency Futures Market
• Currency futures may be purchased by
MNCs to hedge foreign currency payables,
or sold to hedge receivables.
April 4
June 17
1. Expect to receive
500,000 pesos.
Contract to sell
500,000 pesos
@ $.09/peso on
June 17.
2. Receive 500,000
pesos as expected.
3. Sell the pesos at
the locked-in rate.
C1 - 193
Currency Futures Market
• Holders of futures contracts can close out
their positions by selling similar futures
contracts. Sellers may also close out their
positions by purchasing similar contracts.
January 10
1. Contract to
buy
A$100,000
@ $.53/A$
($53,000) on
March 19.
February 15
2. Contract to
sell
A$100,000
@ $.50/A$
($50,000) on
March 19.
March 19
3. Incurs $3000
loss from
offsetting
positions in
futures
contracts.
C1 - 194
Currency Futures Market
• Most currency futures contracts are
closed out before their settlement dates.
• Brokers who fulfill orders to buy or sell
futures contracts earn a transaction or
brokerage fee in the form of the bid/ask
spread.
C1 - 195
Online Application
•
Visit the Commodity Futures
Trading Commission at
http://www.cftc.gov/.
• Also check out
¤
the National Futures Association at
http://www.nfa.futures.org, and
¤
the Futures Industry Association at
http://futuresindustry.org/.
C1 - 196
Currency Options Market
• A currency option is another type of
contract that can be purchased or sold by
speculators and firms.
• The standard options that are traded on an
exchange through brokers are guaranteed,
but require margin maintenance.
• U.S. option exchanges (e.g. Chicago
Board Options Exchange) are regulated by
the Securities and Exchange Commission.
C1 - 197
Currency Options Market
• In addition to the exchanges, there is an
over-the-counter market where
commercial banks and brokerage firms
offer customized currency options.
• There are no credit guarantees for these
OTC options, so some form of collateral
may be required.
• Currency options are classified as either
calls or puts.
C1 - 198
Currency Call Options
• A currency call option grants the holder
the right to buy a specific currency at a
specific price (called the exercise or strike
price) within a specific period of time.
• A call option is
¤
¤
¤
in the money if spot rate > strike price,
at the money if spot rate = strike price,
out of the money
if spot rate < strike price.
C1 - 199
Currency Call Options
• Option owners can sell or exercise their
options. They can also choose to let their
options expire. At most, they will lose the
premiums they paid for their options.
• Call option premiums will be higher when:
¤
¤
¤
(spot price – strike price) is larger;
the time to expiration date is longer; and
the variability of the currency is greater.
C1 - 200
Currency Call Options
• Firms with open positions in foreign
currencies may use currency call options
to cover those positions.
• They may purchase currency call options
¤
¤
¤
to hedge future payables;
to hedge potential expenses when bidding
on projects; and
to hedge potential costs when attempting
to acquire other firms.
C1 - 201
Currency Call Options
• Speculators who expect a foreign
currency to appreciate can purchase call
options on that currency.
¤ Profit = selling price – buying (strike) price
– option premium
• They may also sell (write) call options on a
currency that they expect to depreciate.
¤ Profit = option premium – buying price
+ selling (strike) price
C1 - 202
Currency Call Options
• The purchaser of a call option will break
even when
selling price = buying (strike) price
+ option premium
• The seller (writer) of a call option will
break even when
buying price = selling (strike) price
+ option premium
C1 - 203
Currency Put Options
• A currency put option grants the holder
the right to sell a specific currency at a
specific price (the strike price) within a
specific period of time.
• A put option is
¤
¤
¤
in the money if spot rate < strike price,
at the money if spot rate = strike price,
out of the money
if spot rate > strike price.
C1 - 204
Currency Put Options
• Put option premiums will be higher when:
¤
¤
¤
(strike price – spot rate) is larger;
the time to expiration date is longer; and
the variability of the currency is greater.
• Corporations with open foreign currency
positions may use currency put options to
cover their positions.
¤ For example, firms may purchase put
options to hedge future receivables.
C1 - 205
Currency Put Options
• Speculators who expect a foreign
currency to depreciate can purchase put
options on that currency.
¤ Profit = selling (strike) price – buying price
– option premium
• They may also sell (write) put options on a
currency that they expect to appreciate.
¤ Profit = option premium + selling price
– buying (strike) price
C1 - 206
Currency Put Options
• One possible speculative strategy for
volatile currencies is to purchase both a
put option and a call option at the same
exercise price. This is called a straddle.
• By purchasing both options, the
speculator may gain if the currency moves
substantially in either direction, or if it
moves in one direction followed by the
other.
C1 - 207
Contingency Graphs for Currency Options
For Buyer of £ Call Option
For Seller of £ Call Option
Strike price = $1.50
Premium
= $ .02
Strike price = $1.50
Premium
= $ .02
Net Profit
per Unit
Net Profit
per Unit
+$.04
+$.04
+$.02
+$.02
0
0
$1.46
- $.02
- $.04
$1.50
$1.54
Future
Spot
Rate
Future
Spot
Rate
$1.46
$1.50
$1.54
- $.02
- $.04
C1 - 208
Contingency Graphs for Currency Options
For Buyer of £ Put Option
For Seller of £ Put Option
Strike price = $1.50
Premium
= $ .03
Strike price = $1.50
Premium
= $ .03
Net Profit
per Unit
Net Profit
per Unit
+$.04
+$.04
Future
Spot
Rate
+$.02
0
+$.02
0
$1.46
$1.50
$1.54
$1.46
- $.02
- $.02
- $.04
- $.04
$1.50
$1.54
Future
Spot
Rate
C1 - 209
Online Application
• The Chicago Mercantile Exchange
provides current and historical futures
and option prices at
http://www.cme.com/prices/index.cfm.
• Also visit
¤
¤
the Chicago Board Options Exchange at
http://www.cboe.com, and
the London International Financial Futures
and Options Exchange at www.liffe.com.
C1 - 210
Online Application
• You may also want to check out
¤
the Options Industry Council at
http://www.optionscentral.com/,
¤
the Options Clearing Corporation at
http://www.optionsclearing.com/, and
¤
the Futures and Options Association at
http://www.foa.co.uk/.
C1 - 211
Conditional Currency Options
• A currency option may be structured such
that the premium is conditioned on the
actual currency movement over the period
of concern.
• Suppose a conditional put option on £ has
an exercise price of $1.70, and a trigger of
$1.74. The premium will have to be paid
only if the £’s value exceeds the trigger
value.
C1 - 212
Conditional Currency Options
Net Amount Received
Option Type Exercise Price
basic put
$1.70
conditional put
$1.70
Trigger
$1.74
Basic
Put
$1.78
$1.76
$1.74
$1.72
Premium
$0.02
$0.04
Conditional
Put
Conditional
Put
$1.70
$1.68
$1.66
$1.66
$1.70
$1.74
$1.78
$1.82
Spot
Rate
C1 - 213
Conditional Currency Options
• Similarly, a conditional call option on £
may specify an exercise price of $1.70,
and a trigger of $1.67. The premium will
have to be paid only if the £’s value falls
below the trigger value.
• In both cases, the payment of the premium
is avoided conditionally at the cost of a
higher premium.
C1 - 214
European Currency Options
• European-style currency options are
similar to American-style options except
that they can only be exercised on the
expiration date.
• For firms that purchase options to hedge
future cash flows, this loss in terms of
flexibility is probably not an issue. Hence,
if their premiums are lower, Europeanstyle currency options may be preferred.
C1 - 215
Efficiency of
Currency Futures and Options
• If foreign exchange markets are efficient,
speculation in the currency futures and
options markets should not consistently
generate abnormally large profits.
• A speculative strategy requires the
speculator to incur risk. On the other
hand, corporations use the futures and
options markets to reduce their exposure
to fluctuating exchange rates.
C1 - 216
Impact of Currency Derivatives on an MNC’s Value
Currency Futures
Currency Options
m

E CFj , t  E ER j , t 
n 
 j 1

Value =  

t
1  k 
t =1 



E (CFj,t ) = expected cash flows in currency j to be received
by the U.S. parent at the end of period t
E (ERj,t ) = expected exchange rate at which currency j can
be converted to dollars at the end of period t
k
= weighted average cost of capital of the parent
C1 - 217
Online Application
• Check out the Futures magazine website
at http://www.futuresmag.com/ for a
discussion of the various aspects of
derivatives trading.
• Also check out http://www.ino.com/.
C1 - 218
Chapter Review
• Forward Market
¤
¤
How MNCs Use Forward Contracts
Non-Deliverable Forward Contracts
C1 - 219
Chapter Review
• Currency Futures Market
¤
¤
¤
¤
¤
¤
¤
¤
Contract Specifications
Comparison of Currency Futures and
Forward Contracts
Pricing Currency Futures
Credit Risk of Currency Futures Contracts
Speculation with Currency Futures
How Firms Use Currency Futures
Closing Out A Futures Position
Transaction Costs of Currency Futures
C1 - 220
Chapter Review
• Currency Options Market
• Currency Call Options
¤
¤
¤
Factors Affecting Currency Call Option
Premiums
How Firms Use Currency Call Options
Speculating with Currency Call Options
C1 - 221
Chapter Review
• Currency Put Options
¤
¤
¤
Factors Affecting Currency Put Option
Premiums
Hedging with Currency Put Options
Speculating with Currency Put Options
• Contingency Graphs for Currency Options
¤
Contingency Graphs for the Buyers and
Sellers of Call and Put Options
C1 - 222
Chapter Review
• Conditional Currency Options
• European Currency Options
• Efficiency of Currency Futures and
Options
• How the Use of Currency Futures and
Options Affects an MNC’s Value
C1 - 223
Part II Exchange Rate Behavior
Existing spot
exchange rate
locational
arbitrage
Existing spot
exchange rates
at other locations
covered interest arbitrage
Existing cross
exchange rates
of currencies
Existing forward
exchange rate
Existing inflation
rate differential
triangular
arbitrage
Fisher
effect
purchasing power parity
covered interest arbitrage
Existing interest
rate differential
international
Fisher effect
Future exchange
rate movements
C1 - 224
Chapter
6
Government Influence
On Exchange Rates
South-Western/Thomson Learning © 2003
C1 - 225
Chapter Objectives
• To describe the exchange rate
systems used by various
governments;
• To explain how governments can use
direct and indirect intervention to
influence exchange rates; and
• To explain how government intervention
in the foreign exchange market can affect
economic conditions.
C1 - 226
Exchange Rate Systems
• Exchange rate systems can be classified
according to the degree to which the rates
are controlled by the government.
• Exchange rate systems normally fall into
one of the following categories:
¤ fixed
¤ freely floating
¤ managed float
¤ pegged
C1 - 227
Fixed
Exchange Rate System
• In a fixed exchange rate system, exchange
rates are either held constant or allowed
to fluctuate only within very narrow bands.
• The Bretton Woods era (1944-1971) fixed
each currency’s value in terms of gold.
• The 1971 Smithsonian Agreement which
followed merely adjusted the exchange
rates and expanded the fluctuation
boundaries. The system was still fixed.
C1 - 228
Online Application
• Find out more about the Bretton Woods
conference and the Smithsonian
Agreement at:
¤
http://www.imfsite.org/origins/confer.html
¤
http://www.mises.org/money.asp
C1 - 229
Fixed
Exchange Rate System
• Pros: Work becomes easier for the MNCs.
• Cons: Governments may revalue their
currencies. In fact, the dollar was
devalued more than once after the U.S.
experienced balance of trade deficits.
• Cons: Each country may become more
vulnerable to the economic conditions in
other countries.
C1 - 230
Freely Floating
Exchange Rate System
• In a freely floating exchange rate system,
exchange rates are determined solely by
market forces.
• Pros: Each country may become more
insulated against the economic problems
in other countries.
• Pros: Central bank interventions that may
affect the economy unfavorably are no
longer needed.
C1 - 231
Freely Floating
Exchange Rate System
• Pros: Governments are not restricted by
exchange rate boundaries when setting
new policies.
• Pros: Less capital flow restrictions are
needed, thus enhancing the efficiency of
the financial market.
C1 - 232
Freely Floating
Exchange Rate System
• Cons: MNCs may need to devote
substantial resources to managing their
exposure to exchange rate fluctuations.
• Cons: The country that initially
experienced economic problems (such as
high inflation, increasing unemployment
rate) may have its problems compounded.
C1 - 233
Managed Float
Exchange Rate System
• In a managed (or “dirty”) float exchange
rate system, exchange rates are allowed to
move freely on a daily basis and no official
boundaries exist. However, governments
may intervene to prevent the rates from
moving too much in a certain direction.
• Cons: A government may manipulate its
exchange rates such that its own country
benefits at the expense of others.
C1 - 234
Pegged
Exchange Rate System
• In a pegged exchange rate system, the
home currency’s value is pegged to a
foreign currency or to some unit of
account, and moves in line with that
currency or unit against other currencies.
• The European Economic Community’s
snake arrangement (1972-1979) pegged
the currencies of member countries within
established limits of each other.
C1 - 235
Pegged
Exchange Rate System
• The European Monetary System which
followed in 1979 held the exchange rates
of member countries together within
specified limits and also pegged them to a
European Currency Unit (ECU) through
the exchange rate mechanism (ERM).
¤
The ERM experienced severe problems in
1992, as economic conditions and goals
varied among member countries.
C1 - 236
Pegged
Exchange Rate System
• In 1994, Mexico’s central bank pegged the
peso to the U.S. dollar, but allowed a band
within which the peso’s value could
fluctuate against the dollar.
¤
By the end of the year, there was
substantial downward pressure on the
peso, and the central bank allowed the
peso to float freely. The Mexican peso
crisis had just began ...
C1 - 237
Online Application
• For more information on the Mexican peso
crisis, visit:
¤
http://www.cfr.org/public/pubs/mexican.htm
l
¤
http://www.frbatlanta.org/publica/ECOREV/REV_ABS/janfeb96.html
¤
http://www.brook.edu/views/papers/lustig/1
14.htm
C1 - 238
Currency Boards
• A currency board is a system for
maintaining the value of the local currency
with respect to some other specified
currency.
• For example, Hong Kong has tied the
value of the Hong Kong dollar to the U.S.
dollar (HK$7.8 = $1) since 1983, while
Argentina has tied the value of its peso to
the U.S. dollar (1 peso = $1) since 1991.
C1 - 239
Currency Boards
• For a currency board to be successful, it
must have credibility in its promise to
maintain the exchange rate.
• It has to intervene to defend its position
against the pressures exerted by
economic conditions, as well as by
speculators who are betting that the board
will not be able to support the specified
exchange rate.
C1 - 240
Online Application
• Find out more about Hong Kong’s
currency board system (and see a chart
showing the resilience of the Hong Kong
dollar against external shocks) at
http://www.info.gov.hk/hkma/eng/currency/link
_ex/index.htm.
C1 - 241
Exposure of a Pegged Currency to
Interest Rate Movements
• A country that uses a currency board does
not have complete control over its local
interest rates, as the rates must be aligned
with the interest rates of the currency to
which the local currency is tied.
• Note that the two interest rates may not be
exactly the same because of different
risks.
C1 - 242
Exposure of a Pegged Currency to
Exchange Rate Movements
• A currency that is pegged to another
currency will have to move in tandem with
that currency against all other currencies.
• So, the value of a pegged currency does
not necessarily reflect the demand and
supply conditions in the foreign exchange
market, and may result in uneven trade or
capital flows.
C1 - 243
Dollarization
• Dollarization refers to the replacement of a
local currency with U.S. dollars.
• Dollarization goes beyond a currency
board, as the country no longer has a
local currency.
• For example, Ecuador implemented
dollarization in 2000.
C1 - 244
Online Application
• A table showing the currencies of the
world and their exchange rate
arrangements can be found at:
¤
http://pacific.commerce.ubc.ca/xr/currency
_table.html
C1 - 245
A Single European Currency
€
• In 1991, the Maastricht treaty called for a
single European currency. On Jan 1, 1999,
the euro was adopted by Austria, Belgium,
Finland, France, Germany, Ireland, Italy,
Luxembourg, Netherlands, Portugal, and
Spain. Greece joined the system in 2001.
• By 2002, the national currencies of the 12
participating countries will be withdrawn
and completely replaced with the euro.
C1 - 246
A Single European Currency
€
• Within the euro-zone, cross-border trade
and capital flows will occur without the
need to convert to another currency.
• European monetary policy is also
consolidated because of the single money
supply. The Frankfurt-based European
Central Bank (ECB) is responsible for
setting the common monetary policy.
C1 - 247
A Single European Currency
€
• The ECB aims to control inflation in the
participating countries and to stabilize the
euro within reasonable boundaries.
• The common monetary policy may
eventually lead to more political harmony.
• Note that each participating country may
have to rely on its own fiscal policy (tax
and government expenditure decisions) to
help solve local economic problems.
C1 - 248
A Single European Currency
€
• As currency movements among the
European countries will be eliminated,
there should be an increase in all types of
business arrangements, more comparable
product pricing, and more trade flows.
• It will also be easier to compare and
conduct valuations of firms across the
participating European countries.
C1 - 249
A Single European Currency
€
• Stock and bond prices will also be more
comparable and there should be more
cross-border investing. However, nonEuropean investors may not achieve as
much diversification as in the past.
• Exchange rate risk and foreign exchange
transaction costs within the euro-zone will
be eliminated, while interest rates will
have to be similar.
C1 - 250
A Single European Currency
€
• Since its introduction in 1999, the euro
has declined against many currencies.
• This weakness was partially attributed to
capital outflows from Europe, which was
in turn partially attributed to a lack of
confidence in the euro.
• Some countries had ignored restraint in
favor of resolving domestic problems,
resulting in a lack of solidarity.
C1 - 251
 strengthens € weakens 
A Single European Currency
€
1.80
1.60
€/£
1.40
1.20
1.00
€/$
€/100¥
0.80
0.60
0.40
Jan-99
€/SwF (Swiss Franc)
Jul-99
Jan-00
Jul-00
Jan-01
Jul-01
C1 - 252
Online Application
• For more information on the euro, visit:
¤
http://www.euro.ecb.int/en.html
¤
http://www.ecb.int/
¤
http://pacific.commerce.ubc.ca/xr/euro/
C1 - 253
Government Intervention
• Each country has a government agency
(called the central bank) that may
intervene in the foreign exchange market
to control the value of the country’s
currency.
• In the United States, the Federal
Reserve System (Fed) is the
central bank.
C1 - 254
Online Application
• To link to the websites of the central
banks around the world, visit
http://www.bis.org/cbanks.htm.
C1 - 255
Government Intervention
• Central banks manage exchange rates
¤
¤
¤
to smooth exchange rate movements,
to establish implicit exchange rate
boundaries, and/or
to respond to temporary disturbances.
• Often, intervention is overwhelmed by
market forces. However, currency
movements may be even more volatile in
the absence of intervention.
C1 - 256
Government Intervention
• Direct intervention refers to the exchange
of currencies that the central bank holds
as reserves for other currencies in the
foreign exchange market.
• Direct intervention is usually most
effective when there is a coordinated
effort among central banks.
C1 - 257
Government Intervention
Fed exchanges $ for £
to strengthen the £
Value
of £
V2
V1
S1
D2
D1
Quantity of £
Fed exchanges £ for $
to weaken the £
Value
of £
V1
V2
S1
S2
D1
Quantity of £
C1 - 258
Online
Application
http://www.federalreserve.gov
Treasury and Federal Reserve Foreign Exchange Operations
During the third quarter of 2000, the dollar appreciated 8.2 percent
against the euro and 2.0 percent against the yen. On a tradeweighted basis, the dollar ended the quarter 4.1 percent stronger
against the currencies of the United States' major trading partners.
On September 22, the U.S. monetary authorities intervened in the
foreign exchange markets, purchasing 1.5 billion euros against the
dollar. The operation, which was divided evenly between the U.S.
Treasury Department's Exchange Stabilization Fund and the
Federal Reserve System, was coordinated with the European
Central Bank and the monetary authorities of Japan, Canada, and
the United Kingdom.
C1 - 259
Government Intervention
• When a central bank intervenes in the
foreign exchange market without
adjusting for the change in money supply,
it is said to engaged in nonsterilized
intervention.
• In a sterilized intervention, Treasury
securities are purchased or sold at the
same time to maintain the money supply.
C1 - 260
Nonsterilized Intervention
Federal Reserve
To
Strengthen
the C$:
$
C$
Banks participating
in the foreign
exchange market
Federal Reserve
To Weaken
the C$:
$
C$
Banks participating
in the foreign
exchange market
C1 - 261
Sterilized Intervention
T- securities
Federal Reserve
To
Strengthen
the C$:
$
C$
$
Banks participating
in the foreign
exchange market
$
Federal Reserve
To Weaken
the C$:
$
C$
Financial
institutions
that invest
in Treasury
securities
T- securities
Banks participating
in the foreign
exchange market
Financial
institutions
that invest
in Treasury
securities
C1 - 262
Government Intervention
• Some speculators attempt to determine
when the central bank is intervening, and
the extent of the intervention, in order to
capitalize on the anticipated results of the
intervention effort.
C1 - 263
Government Intervention
• Central banks can also engage in indirect
intervention by influencing the factors that
determine the value of a currency.
• For example, the Fed may attempt to
increase interest rates (and hence boost
the dollar’s value) by reducing the U.S.
money supply.
¤ Note that high interest rates adversely
affects local borrowers.
C1 - 264
Government Intervention
• Governments may also use foreign
exchange controls (such as restrictions
on currency exchange) as a form of
indirect intervention.
C1 - 265
Online Application
• The Fed’s objective for
open market operations
has gradually shifted
toward attaining a
specified level of the
federal funds rate. Find
out more at
http://www.federalreserve
.gov/fomc/fundsrate.htm.
C1 - 266
Online Application
• During the 1997-98 Asian financial crisis,
some governments intervened in an
attempt to control their exchange rates.
Find out more about the crisis (and the
consequences of the intervention efforts)
at http://www.stern.nyu.edu/globalmacro/.
C1 - 267
Exchange Rate Target Zones
• Many economists have criticized the
present exchange rate system because of
the wide swings in the exchange rates of
major currencies.
• Some have suggested that target zones be
used, whereby an initial exchange rate will
be established with specific boundaries
(that are wider than the bands used in
fixed exchange rate systems).
C1 - 268
Exchange Rate Target Zones
• The ideal target zone should allow rates to
adjust to economic factors without
causing wide swings in international trade
and fear in the financial markets.
• However, the actual result may be a
system no different from what exists
today.
C1 - 269
Intervention as a Policy Tool
• Like tax laws and money supply, the
exchange rate is a tool which a
government can use to achieve its desired
economic objectives.
• A weak home currency can stimulate
foreign demand for products, and hence
local jobs. However, it may also lead to
higher inflation.
C1 - 270
Intervention as a Policy Tool
• A strong currency may cure high inflation,
since the intensified foreign competition
should cause domestic producers to
refrain from increasing prices. However, it
may also lead to higher unemployment.
C1 - 271
Impact of Government Actions on Exchange Rates
Government
Monetary
and Fiscal Policies
Relative Interest
Rates
Relative Inflation
Rates
Relative National
Income Levels
International
Capital Flows
Exchange Rates
International
Trade
Government
Purchases & Sales
of Currencies
Tax Laws,
etc.
Government Intervention
in
Foreign Exchange Market
Quotas,
Tariffs, etc.
C1 - 272
Impact of Central Bank Intervention
on an MNC’s Value
Direct Intervention
Indirect Intervention
m

E CFj , t  E ER j , t 
n 
 j 1

Value =  

t
1  k 
t =1 



E (CFj,t ) = expected cash flows in currency j to be received
by the U.S. parent at the end of period t
E (ERj,t ) = expected exchange rate at which currency j can
be converted to dollars at the end of period t
k
= weighted average cost of capital of the parent
C1 - 273
Chapter Review
• Exchange Rate Systems
¤
¤
¤
¤
¤
¤
¤
Fixed Exchange Rate System
Freely Floating Exchange Rate System
Managed Float Exchange Rate System
Pegged Exchange Rate System
Currency Boards
Exposure of a Pegged Currency to Interest
Rate and Exchange Rate Movements
Dollarization
C1 - 274
Chapter Review
• A Single European Currency
¤
¤
¤
¤
¤
¤
¤
¤
Membership
Euro Transactions
Impact on European Monetary Policy
Impact on Business Within Europe
Impact on the Valuation of Businesses in
Europe
Impact on Financial Flows
Impact on Exchange Rate Risk
Status Report on the Euro
C1 - 275
Chapter Review
• Government Intervention
¤
¤
¤
Reasons for Government Intervention
Direct Intervention
Indirect Intervention
• Exchange Rate Target Zones
C1 - 276
Chapter Review
• Intervention as a Policy Tool
¤
¤
Influence of a Weak Home Currency on the
Economy
Influence of a Strong Home Currency on
the Economy
• How Central Bank Intervention Can Affect
an MNC’s Value
C1 - 277
Chapter
7
International Arbitrage And
Interest Rate Parity
See c7.xls for spreadsheets to
accompany this chapter.
South-Western/Thomson Learning © 2003
C1 - 278
Chapter Objectives
• To explain the conditions that will
result in various forms of international
arbitrage, along with the realignments that
will occur in response; and
• To explain the concept of interest rate
parity, and how it prevents arbitrage
opportunities.
C1 - 279
International Arbitrage
• Arbitrage can be loosely defined as
capitalizing on a discrepancy in quoted
prices. Often, the funds invested are not
tied up and no risk is involved.
• In response to the imbalance in demand
and supply resulting from arbitrage
activity, prices will realign very quickly,
such that no further risk-free profits can
be made.
C1 - 280
International Arbitrage
• Locational arbitrage is possible when a
bank’s buying price (bid price) is higher
than another bank’s selling price (ask
price) for the same currency.
• Example:
Bank C Bid Ask
NZ$ $.635 $.640
Bank D Bid Ask
NZ$ $.645 $.650
Buy NZ$ from Bank C @ $.640, and sell it to
Bank D @ $.645. Profit = $.005/NZ$.
C1 - 281
International Arbitrage
• Triangular arbitrage is possible when a
cross exchange rate quote differs from the
rate calculated from spot rates.
• Example:
Bid
Ask
British pound (£)
$1.60
$1.61
Malaysian ringgit (MYR) $.200
$.202
£
MYR8.1 MYR8.2
Buy £ @ $1.61, convert @ MYR8.1/£, then
sell MYR @ $.200. Profit = $.01/£. (8.1.2=1.62)
C1 - 282
International Arbitrage
$
Value of
£ in $
£
Value of
MYR in $
Value of
£ in MYR
MYR
• When the exchange rates of the currencies
are not in equilibrium, triangular arbitrage will
force them back into equilibrium.
C1 - 283
International Arbitrage
• Covered interest arbitrage is the process
of capitalizing on the interest rate
differential between two countries, while
covering for exchange rate risk.
• Covered interest arbitrage tends to force a
relationship between forward rate
premiums and interest rate differentials.
C1 - 284
International Arbitrage
• Example:
£ spot rate = 90-day forward rate = $1.60
U.S. 90-day interest rate = 2%
U.K. 90-day interest rate = 4%
Borrow $ at 3%, or use existing funds which
are earning interest at 2%. Convert $ to £ at
$1.60/£ and engage in a 90-day forward
contract to sell £ at $1.60/£. Lend £ at 4%.
C1 - 285
Online Application
• Spot exchange rates can be found online
at http://sonnet-financial.com/rates/full.asp,
while forward rates can be found at
http://www.bmo.com/economic/regular/fxrates
.html,
and interest rates at
http://www.federalreserve.gov/releases/H15/u
pdate/.
C1 - 286
International Arbitrage
• Locational arbitrage ensures that quoted
exchange rates are similar across banks
in different locations.
• Triangular arbitrage ensures that cross
exchange rates are set properly.
• Covered interest arbitrage ensures that
forward exchange rates are set properly.
C1 - 287
International Arbitrage
• Any discrepancy will trigger arbitrage,
which will then eliminate the discrepancy.
Arbitrage thus makes the foreign
exchange market more orderly.
C1 - 288
Interest Rate Parity (IRP)
• Market forces cause the forward rate to
differ from the spot rate by an amount that
is sufficient to offset the interest rate
differential between the two currencies.
• Then, covered interest arbitrage is no
longer feasible, and the equilibrium state
achieved is referred to as interest rate
parity (IRP).
C1 - 289
Derivation of IRP
• When IRP exists, the rate of return
achieved from covered interest arbitrage
should equal the rate of return available in
the home country.
• End-value of a $1 investment in covered
interest arbitrage = (1/S) (1+iF)  F
= (1/S) (1+iF)  [S(1+p)]
= (1+iF) (1+p)
where p is the forward premium.
C1 - 290
Derivation of IRP
• End-value of a $1 investment in the home
country = 1 + iH
• Equating the two and rearranging terms:
p = (1+iH) – 1
(1+iF)
i.e.
forward = (1 + home interest rate) – 1
premium
(1 + foreign interest rate)
C1 - 291
Determining the Forward Premium
Example:
• Suppose 6-month ipeso = 6%, i$ = 5%.
• From the U.S. investor’s perspective,
forward premium = 1.05/1.06 – 1  - .0094
• If S = $.10/peso, then
6-month forward rate = S  (1 + p)
_
 .10  (1 .0094)
 $.09906/peso
C1 - 292
Determining the Forward Premium
• Note that the IRP relationship can be
rewritten as follows:
F – S = S(1+p) – S = p = (1+iH) – 1 = (iH–iF)
S
S
(1+iF)
(1+iF)
• The approximated form, p  iH–iF, provides
a reasonable estimate when the interest
rate differential is small.
C1 - 293
Graphic Analysis of Interest Rate Parity
Interest Rate Differential (%)
home interest rate – foreign interest rate
4
IRP line
2
Forward
Discount (%)
-3
-1
1
3 Forward
Premium (%)
-2
-4
C1 - 294
Graphic Analysis of Interest Rate Parity
Interest Rate Differential (%)
home interest rate – foreign interest rate
4
Zone of potential
covered interest
IRP line
arbitrage by
foreign investors 2
Forward
Discount (%)
-3
-1
1
3 Forward
Premium (%)
Zone of potential
- 2 covered interest
arbitrage by
local investors
-4
C1 - 295
Test for the Existence of IRP
• To test whether IRP exists, collect the
actual interest rate differentials and
forward premiums for various currencies.
Pair up data that occur at the same point
in time and that involve the same
currencies, and plot the points on a graph.
• IRP holds when covered interest arbitrage
is not worthwhile.
C1 - 296
Interpretation of IRP
• When IRP exists, it does not mean that
both local and foreign investors will earn
the same returns.
• What it means is that investors cannot use
covered interest arbitrage to achieve
higher returns than those achievable in
their respective home countries.
C1 - 297
Does IRP Hold?
• Various empirical studies indicate that IRP
generally holds.
• While there are deviations from IRP, they
are often not large enough to make
covered interest arbitrage worthwhile.
• This is due to the characteristics of
foreign investments, including transaction
costs, political risk, and differential tax
laws.
C1 - 298
Considerations When Assessing IRP
Transaction Costs
iH – iF
Zone of potential
covered interest
arbitrage by
foreign investors
Zone where
covered interest
arbitrage is not
feasible due to
transaction costs
IRP line
p
Zone of
potential
covered
interest
arbitrage
by local
investors
C1 - 299
Considerations When Assessing IRP
Political Risk
¤ A crisis in the foreign country could cause
its government to restrict any exchange of
the local currency for other currencies.
¤ Investors may also perceive a higher
default risk on foreign investments.
Differential Tax Laws
¤ If tax laws vary, after-tax returns should be
considered instead of before-tax returns.
C1 - 300
Interest Rates
Explaining Changes in Forward Premiums
Spot and
Forward Rates
t0
t0
iA
iU.S.
t1
t2 time
SA
FA
t1
t2 time
Because of IRP,
a forward rate
will normally
move in tandem
with the spot
rate.
This correlation
depends on
interest rate
movements,
i.e. p  iH–iF
C1 - 301
Explaining Changes in Forward Premiums
• During the 1997-98 Asian crisis, the
forward rates offered to U.S. firms on
some Asian currencies were substantially
reduced for two reasons.
 The spot rates of these currencies
declined substantially during the crisis.
 Their interest rates had increased as their
governments attempted to discourage
investors from pulling out their funds.
C1 - 302
Online Application
• Find out more about the 1997-98 Asian
financial crisis by visiting
http://www.stern.nyu.edu/globalmacro/.
C1 - 303
Impact of Arbitrage on an MNC’s Value
Forces of Arbitrage
m

E CFj , t  E ER j , t 
n 
 j 1

Value =  

t
1  k 
t =1 



E (CFj,t ) = expected cash flows in currency j to be received
by the U.S. parent at the end of period t
E (ERj,t ) = expected exchange rate at which currency j can
be converted to dollars at the end of period t
k
= weighted average cost of capital of the parent
C1 - 304
Chapter Review
• International Arbitrage
¤
¤
¤
¤
Locational Arbitrage
Triangular Arbitrage
Covered Interest Arbitrage
Comparison of Arbitrage Effects
C1 - 305
Chapter Review
• Interest Rate Parity (IRP)
¤
¤
¤
¤
¤
¤
¤
Derivation of IRP
Determining the Forward Premium
Graphic Analysis of IRP
Test for the Existence of IRP
Interpretation of IRP
Does IRP Hold?
Considerations When Assessing IRP
C1 - 306
Chapter Review
• Explaining Changes in Forward Premiums
• Impact of Arbitrage on an MNC’s Value
C1 - 307
10
Chapter
Measuring Exposure To
Exchange Rate Fluctuations
See c10.xls for spreadsheets to
accompany this chapter.
South-Western/Thomson Learning © 2003
C1 - 308
Chapter Objectives
• To discuss the relevance of an
MNC’s exposure to exchange rate risk;
• To explain how transaction exposure can
be measured;
• To explain how economic exposure can be
measured; and
• To explain how translation exposure can
be measured.
C1 - 309
Is Exchange Rate Risk Relevant?
Purchasing Power Parity Argument
 Exchange rate movements will be matched
by price movements.
 PPP does not necessarily hold.
C1 - 310
Is Exchange Rate Risk Relevant?
The Investor Hedge Argument
 MNC shareholders can hedge against
exchange rate fluctuations on their own.
 The investors may not have complete
information on corporate exposure. They
may not have the capabilities to correctly
insulate their individual exposure too.
C1 - 311
Is Exchange Rate Risk Relevant?
Currency Diversification Argument
 An MNC that is well diversified should not
be affected by exchange rate movements
because of offsetting effects.
 This is a naive presumption.
C1 - 312
Is Exchange Rate Risk Relevant?
Stakeholder Diversification Argument
 Well diversified stakeholders will be
somewhat insulated against losses
experienced by an MNC due to exchange
rate risk.
 MNCs may be affected in the same way
because of exchange rate risk.
C1 - 313
Is Exchange Rate Risk Relevant?
Response from MNCs
• Many MNCs have attempted to stabilize
their earnings with hedging strategies,
which confirms the view that exchange
rate risk is relevant.
C1 - 314
Online Application
• For current and historic exchange rates,
as well as implied currency volatilities,
visit http://www.ny.frb.org/pihome/statistics/.
11/30/01
Implied Vols 1 Week 1 Month 2 Month 3 Month 6 Month 12 Month 2 Year 3 Year
EUR
10.9
9.9
10.9
11.2
11.7
11.9
11.9
11.8
JPY
9.1
8.9
9.5
9.9
10.4
10.6
10.7
10.7
CHF
11.2
10.3
11.2
11.5
11.9
12.1
12.0
12.0
GBP
9.0
8.1
8.8
9.1
9.4
9.5
9.6
9.7
CAD
6.2
5.9
6.0
6.1
6.1
6.1
6.2
6.1
AUD
10.4
10.3
11.0
11.4
11.8
12.0
12.0
12.0
GBPEUR
8.1
6.9
7.4
7.7
8.4
8.7
8.6
8.5
EURJPY
9.3
9.0
9.7
10.3
10.8
11.3
11.4
11.4
C1 - 315
Types of Exposure
• Although exchange rates cannot be
forecasted with perfect accuracy, firms
can at least measure their exposure to
exchange rate fluctuations.
• Exposure to exchange rate fluctuations
comes in three forms:
¤ Transaction exposure
¤ Economic exposure
¤ Translation exposure
C1 - 316
Transaction Exposure
• The degree to which the value of future
cash transactions can be affected by
exchange rate fluctuations is referred to
as transaction exposure.
• To measure transaction exposure:
 project the net amount of inflows or
outflows in each foreign currency, and
 determine the overall risk of exposure to
those currencies.
C1 - 317
Transaction Exposure
• MNCs can usually anticipate foreign cash
flows for an upcoming short-term period
with reasonable accuracy.
• After the consolidated net currency flows
for the entire MNC has been determined,
each net flow is converted into either a
point estimate or a range of a chosen
currency, so as to standardize the
exposure assessment for each currency.
C1 - 318
Transaction Exposure
• An MNC’s overall exposure can be
assessed by considering each currency
position together with the currency’s
variability and the correlations among the
currencies.
• The standard deviation statistic on
historical data serves as one measure of
currency variability. Note that currency
variability levels may change over time.
C1 - 319
Transaction Exposure
Standard Deviations of Exchange Rate Movements
Based on Monthly Data
Currency
British pound
Canadian dollar
Indian rupee
Japanese yen
New Zealand dollar
Swedish krona
Swiss franc
Singapore dollar
1981-1993
1994-1998
0.0309
0.0100
0.0219
0.0279
0.0289
0.0287
0.0330
0.0111
0.0148
0.0110
0.0168
0.0298
0.0190
0.0195
0.0246
0.0174
C1 - 320
Transaction Exposure
• The correlations among currency
movements can be measured by their
correlation coefficients, which indicate the
degree to which two currencies move in
relation to each other.
perfect positive correlation
no correlation
perfect negative correlation
coefficient
1.00
0.00
-1.00
C1 - 321
Transaction Exposure
Correlations Among Exchange Rate Movements
£
British
pound (£)
1.00
Canadian
dollar (Can$)
.18
Japanese
yen (¥)
.45
New Zealand
dollar (NZ$)
.39
Swedish
krona (Sk)
.62
Swiss franc
(SwF)
.63
Can$
¥
NZ$
Sk
SwF
1.00
.06
1.00
.20
.33
1.00
.16
.46
.33
1.00
.12
.61
.37
.70
1.00
C1 - 322
Transaction Exposure
• The point in considering correlations is to
detect positions that could somewhat
offset each other.
• For example, if currencies X and Y are
highly correlated, the exposures of a net X
inflow and a net Y outflow will offset each
other to a certain degree.
• Note that the corrrelations among
currencies may change over time.
C1 - 323
Movements of Selected Currencies
Against the Dollar
$ per unit
1.40
1.20
$/10 Indian rupees
1.00
$/Canadian$
$/100 ¥
0.80
0.60
0.40
0.20
$/Singapore$ $/5 Swedish krona
$/Chinese yuan
0.00
1981
1986
1991
1996
2001
C1 - 324
Transaction Exposure
• A related method, the value-at-risk (VAR)
method, incorporates currency volatility
and correlations to determine the potential
maximum one-day loss.
• Historical data is used to determine the
potential one-day decline in a particular
currency. This decline is then applied to
the net cash flows in that currency.
C1 - 325
Economic Exposure
• Economic exposure refers to the degree to
which a firm’s present value of future cash
flows can be influenced by exchange rate
fluctuations.
• Cash flows that do not require conversion
of currencies do not reflect transaction
exposure. Yet, these cash flows may also
be influenced significantly by exchange
rate movements.
C1 - 326
Economic Exposure
Transactions that
Influence the Firm’s
Cash Inflows
Impact on Transactions
Local Currency Local Currency
Appreciates
Depreciates
Local sales (relative
Decrease
to foreign competition
in local markets)
Firm’s exports
denominated in local
Decrease
currency
 Firm’s exports
denominated in
Decrease
foreign currency
 Interest received from
Decrease
foreign investments
Transactions reflecting transaction exposure.
Increase
Increase
Increase
Increase
C1 - 327
Economic Exposure
Transactions that
Influence the Firm’s
Cash Outflows
Firm’s imported
supplies denominated
in local currency
 Firm’s imported
supplies denominated
in foreign currency
 Interest owed on
foreign funds
borrowed
Impact on Transactions
Local Currency Local Currency
Appreciates
Depreciates
No Change
No Change
Decrease
Increase
Decrease
Increase
Transactions reflecting transaction exposure.
C1 - 328
Economic Exposure
• Even purely domestic firms may be
affected by economic exposure if there is
foreign competition within the local
markets.
• MNCs are likely to be much more exposed
to exchange rate fluctuations. The impact
varies across MNCs according to their
individual operating characteristics and
net currency positions.
C1 - 329
Economic Exposure
• One measure of economic exposure
involves classifying the firm’s cash flows
into income statement items, and then
reviewing how the earnings forecast in the
income statement changes in response to
alternative exchange rate scenarios.
• In general, firms with more foreign costs
than revenues will be unfavorably affected
by stronger foreign currencies.
C1 - 330
Economic Exposure
• Another method of assessing a firm’s
economic exposure involves applying
regression analysis to historical cash flow
and exchange rate data.
C1 - 331
Economic Exposure
PCFt = a0 + a1et + t
PCFt = % change in inflation-adjusted cash
flows measured in the firm’s home
currency over period t
et = % change in the currency exchange
rate over period t
t = random error term
a0 = intercept
a1 = slope coefficient
C1 - 332
Economic Exposure
• The regression model may be revised to
handle multiple currencies by including
them as additional independent variables,
or by using a currency index (composite).
• By changing the dependent variable, the
impact of exchange rates on the firm’s
value (as measured by its stock price),
earnings, exports, sales, etc. may also be
assessed.
C1 - 333
Translation Exposure
• The exposure of the MNC’s consolidated
financial statements to exchange rate
fluctuations is known as translation
exposure.
• In particular, subsidiary earnings
translated into the reporting currency on
the consolidated income statement are
subject to changing exchange rates.
C1 - 334
Translation Exposure
Does Translation Exposure Matter?
• Cash Flow Perspective - Translating
financial statements for consolidated
reporting purposes does not by itself
affect an MNC’s cash flows.
• However, a weak foreign currency today
may result in a forecast of a weak
exchange rate at the time subsidiary
earnings are actually remitted.
C1 - 335
Translation Exposure
Does Translation Exposure Matter?
• Stock Price Perspective - Since an MNC’s
translation exposure affects its
consolidated earnings and many investors
tend to use earnings when valuing firms,
the MNC’s valuation may be affected.
C1 - 336
Translation Exposure
• In general, translation exposure is relevant
because
some MNC subsidiaries may want to remit
their earnings to their parents now,
the prevailing exchange rates may be used
to forecast the expected cash flows that will
result from future remittances, and
consolidated earnings are used by many
investors to value MNCs.
C1 - 337
Translation Exposure
• An MNC’s degree of translation exposure
is dependent on:
the proportion of its business conducted by
its foreign subsidiaries,
the locations of its foreign subsidiaries, and
the accounting method that it uses.
C1 - 338
Translation Exposure
• According to World Research Advisory
estimates, the translated earnings of U.S.based MNCs in aggregate were reduced
by $20 billion in the third quarter of 1998
alone simply because of the depreciation
of Asian currencies against the dollar.
• In 2000, the weakness of the euro also
caused several U.S.-based MNCs to report
lower earnings than expected.
C1 - 339
Online Application
• The annual reports for many MNCs may be
found at http://www.reportgallery.com.
Review some annual reports and see if
you can find any comments that describe
the MNCs’ transaction, economic, or
translation exposures.
C1 - 340
Impact of Exchange Rate Exposure
on an MNC’s Value
Transaction Exposure
Economic Exposure
m

E CFj , t  E ER j , t 
n 
 j 1

Value =  

t
1  k 
t =1 



E (CFj,t ) = expected cash flows in currency j to be received
by the U.S. parent at the end of period t
E (ERj,t ) = expected exchange rate at which currency j can
be converted to dollars at the end of period t
k
= weighted average cost of capital of the parent
C1 - 341
Chapter Review
• Is Exchange Rate Risk Relevant?
¤
¤
¤
¤
¤
Purchasing Power Parity Argument
The Investor Hedge Argument
Currency Diversification Argument
Stakeholder Diversification Argument
Response from MNCs
• Types of Exposure
¤
Transaction, Economic, and Translation
Exposures
C1 - 342
Chapter Review
• Transaction Exposure
¤
¤
¤
¤
Transaction Exposure to “Net” Cash Flows
Transaction Exposure Based on Currency
Variability
Transaction Exposure Based on Currency
Correlations
Transaction Exposure Based on Value-atRisk
C1 - 343
Chapter Review
• Economic Exposure
¤
¤
¤
Economic Exposure to Local Currency
Appreciation & Depreciation
Economic Exposure of Domestic Firms &
MNCs
Measuring Economic Exposure
- Sensitivity of Earnings & Cash Flows to
Exchange Rates
C1 - 344
Chapter Review
• Translation Exposure
¤
¤
¤
Does Translation Exposure Matter?
- Cash Flow Perspective
- Stock Price Perspective
Determinants of Translation Exposure
Examples of Translation Exposure
• Impact of Exchange Rate Exposure on an
MNC’s Value
C1 - 345
Chapter
11
Managing Transaction Exposure
See c11.xls for spreadsheets to
accompany this chapter.
South-Western/Thomson Learning © 2003
C1 - 346
Chapter Objectives
• To identify the commonly used
techniques for hedging transaction
exposure;
• To explain how each technique can be
used to hedge future payables and
receivables;
• To compare the advantages and
disadvantages of the identified hedging
techniques; and
C1 - 347
Chapter Objectives
• To suggest other methods of
reducing exchange rate risk when
hedging techniques are not available.
C1 - 348
Transaction Exposure
• Transaction exposure exists when the
future cash transactions of a firm are
affected by exchange rate fluctuations.
• When transaction exposure exists, the
firm faces three major tasks:
 Identify its degree of transaction exposure,
 Decide whether to hedge its exposure, and
 Choose among the available hedging
techniques if it decides on hedging.
C1 - 349
Identifying Net Transaction Exposure
• Centralized Approach - A centralized
group consolidates subsidiary reports to
identify, for the MNC as a whole, the
expected net positions in each foreign
currency for the upcoming period(s).
• Note that sometimes, a firm may be able to
reduce its transaction exposure by pricing
some of its exports in the same currency
as that needed to pay for its imports.
C1 - 350
Techniques to Eliminate
Transaction Exposure
• Hedging techniques include:
¤
¤
¤
¤
Futures hedge,
Forward hedge,
Money market hedge, and
Currency option hedge.
• MNCs will normally compare the cash
flows that could be expected from each
hedging technique before determining
which technique to apply.
C1 - 351
Techniques to Eliminate
Transaction Exposure
• A futures hedge involves the use of
currency futures.
• To hedge future payables, the firm may
purchase a currency futures contract for
the currency that it will be needing.
• To hedge future receivables, the firm may
sell a currency futures contract for the
currency that it will be receiving.
C1 - 352
Techniques to Eliminate
Transaction Exposure
• A forward hedge differs from a futures
hedge in that forward contracts are used
instead of futures contract to lock in the
future exchange rate at which the firm will
buy or sell a currency.
• Recall that forward contracts are common
for large transactions, while the
standardized futures contracts involve
smaller amounts.
C1 - 353
Techniques to Eliminate
Transaction Exposure
• An exposure to exchange rate movements
need not necessarily be hedged, despite
the ease of futures and forward hedging.
• Based on the firm’s degree of risk
aversion, the hedge-versus-no-hedge
decision can be made by comparing the
known result of hedging to the possible
results of remaining unhedged.
C1 - 354
Techniques to Eliminate
Transaction Exposure
Real cost of hedging payables (RCHp) =
+ nominal cost of payables with hedging
– nominal cost of payables without
hedging
Real cost of hedging receivables (RCHr) =
+ nominal home currency revenues
received without hedging
– nominal home currency revenues
received with hedging
C1 - 355
Techniques to Eliminate
Transaction Exposure
• If the real cost of hedging is negative, then
hedging is more favorable than not
hedging.
• To compute the expected value of the real
cost of hedging, first develop a probability
distribution for the future spot rate, and
then use it to develop a probability
distribution for the real cost of hedging.
C1 - 356
The Real Cost of Hedging for Each £ in Payables
Probability
5%
10
15
20
20
15
10
5
Nominal Cost
Nominal Cost
Real Cost
With Hedging Without Hedging of Hedging
$1.40
$1.30
$0.10
$1.40
$1.32
$0.08
$1.40
$1.34
$0.06
$1.40
$1.36
$0.04
$1.40
$1.38
$0.02
$1.40
$1.40
$0.00
$1.40
$1.42
- $0.02
$1.40
$1.45
- $0.05
Expected RCHp =  Pi RCHi = $0.0295
C1 - 357
The Real Cost of Hedging for Each £ in Payables
25%
Probability
20%
15%
10%
5%
0%
-$0.05 -$0.02 $0.00 $0.02 $0.04 $0.06 $0.08 $0.10
There is a 15% chance that the real cost of hedging
will be negative.
C1 - 358
Techniques to Eliminate
Transaction Exposure
• If the forward rate is an accurate predictor
of the future spot rate, the real cost of
hedging will be zero.
• If the forward rate is an unbiased predictor
of the future spot rate, the real cost of
hedging will be zero on average.
C1 - 359
0.4
-0.4
0.3
-0.3
0.2
-0.2
0.1
-0.1
0
0
-0.1
0.1
-0.2
0.2
-0.3
1975
0.3
1980
1985
1990
1995
RCH (receivables)
RCH (payables)
The Real Cost of Hedging British Pounds Over Time
2000
C1 - 360
Techniques to Eliminate
Transaction Exposure
• A money market hedge involves taking
one or more money market position to
cover a transaction exposure.
• Often, two positions are required.
¤
¤
Payables: Borrow in the home currency,
and invest in the foreign currency.
Receivables: borrow in the foreign
currency, and invest in the home
currency.
C1 - 361
Techniques to Eliminate
Transaction Exposure
A firm needs to pay NZ$1,000,000 in 30 days.
1. Borrows
$646,766
Borrows at 8.40%
for 30 days
Effective
exchange rate
$0.6513/NZ$
Exchange at
$0.6500/NZ$
2. Holds
NZ$995,025
3. Pays
$651,293
Lends at 6.00%
for 30 days
3. Receives
NZ$1,000,000
C1 - 362
Techniques to Eliminate
Transaction Exposure
A firm expects to receive S$400,000 in 90 days.
1. Borrows
S$392,157
Borrows at 8.00%
for 90 days
Effective
exchange rate
$0.5489/S$
Exchange at
$0.5500/S$
2. Holds
$215,686
3. Pays
S$400,000
Lends at 7.20%
for 90 days
3. Receives
$219,568
C1 - 363
Techniques to Eliminate
Transaction Exposure
• Note that taking just one money market
position may be sufficient.
¤ A firm that has excess cash need not
borrow in the home currency when hedging
payables.
¤ Similarly, a firm that is in need of cash
need not invest in the home currency
money market when hedging receivables.
C1 - 364
Techniques to Eliminate
Transaction Exposure
• For the two examples shown, the known
results of money market hedging can be
compared with the known results of
forward or futures hedging to determine
which the type of hedging that is
preferable.
C1 - 365
Techniques to Eliminate
Transaction Exposure
• If interest rate parity (IRP) holds, and
transaction costs do not exist, a money
market hedge will yield the same result as
a forward hedge.
• This is so because the forward premium
on a forward rate reflects the interest rate
differential between the two currencies.
C1 - 366
Techniques to Eliminate
Transaction Exposure
• A currency option hedge involves the use
of currency call or put options to hedge
transaction exposure.
• Since options need not be exercised, firms
will be insulated from adverse exchange
rate movements, and may still benefit from
favorable movements.
• However, the firm must assess whether
the premium paid is worthwhile.
C1 - 367
Using Currency Call Options for Hedging Payables
British Pound Call Option:
Exercise Price = $1.60, Premium = $.04.
For each £ :
Scenario
1
2
3
Nominal Cost
Nominal Cost
without Hedging
with Hedging
= Spot Rate
= Min(Spot,$1.60)+$.04
$1.58
$1.62
$1.62
$1.64
$1.66
$1.64
C1 - 368
Using Put Options for Hedging Receivables
New Zealand Dollar Put Option:
Exercise Price = $0.50, Premium = $.03.
For each NZ$ :
Nominal Income
Nominal Income
Scenario
without Hedging
with Hedging
= Spot Rate = Max(Spot,$0.50)- $.03
1
$0.44
$0.47
2
$0.46
$0.47
3
$0.51
$0.48
C1 - 369
Techniques to Eliminate
Transaction Exposure
Hedging Payables Hedging Receivables
Futures
hedge
Forward
hedge
Money
market
hedge
Currency
option
Purchase currency
futures contract(s).
Negotiate forward
contract to buy
foreign currency.
Borrow local
currency. Convert
to and then invest
in foreign currency.
Sell currency
futures contract(s).
Negotiate forward
contract to sell
foreign currency.
Borrow foreign
currency. Convert
to and then invest
in local currency.
Purchase currency
call option(s).
Purchase currency
put option(s).
C1 - 370
Techniques to Eliminate
Transaction Exposure
• A comparison of hedging techniques
should focus on minimizing payables, or
maximizing receivables.
• Note that the cash flows associated with
currency option hedging and remaining
unhedged cannot be determined with
certainty.
C1 - 371
Techniques to Eliminate
Transaction Exposure
• In general, hedging policies vary with the
MNC management’s degree of risk
aversion and exchange rate forecasts.
• The hedging policy of an MNC may be to
hedge most of its exposure, none of its
exposure, or to selectively hedge its
exposure.
C1 - 372
Online Application
• Forward rates can be found online at
¤
¤
¤
http://www.ny.frb.org/pihome/statistics/fore
x10.shtml
http://pacific.commerce.ubc.ca/xr/telerate.h
tml
http://www.bmo.com/economic/regular/fxra
tes.html
C1 - 373
Online Application
• The Chicago Mercantile Exchange
provides current and historical futures
and option prices at
http://www.cme.com/prices/index.cfm.
• Also visit
¤
¤
the Chicago Board Options Exchange at
http://www.cboe.com, and
the London International Financial Futures
and Options Exchange at www.liffe.com.
C1 - 374
Limitations of Hedging
• Some international transactions involve
an uncertain amount of foreign currency,
such that overhedging may result.
• One way of avoiding overhedging is to
hedge only the minimum known amount in
the future transaction(s).
C1 - 375
Limitations of Hedging
• In the long run, the continual hedging of
repeated transactions may have limited
effectiveness.
• For example, the forward rate often moves
in tandem with the spot rate. Thus, an
importer who uses one-period forward
contracts continually will have to pay
increasingly higher prices during a strongforeign-currency cycle.
C1 - 376
Limitations of Hedging
Repeated Hedging of Foreign Payables
when the Foreign Currency is Appreciating
Costs are
increasing …
Forward
Rate
Spot
Rate
although there
are savings
from hedging.
Time
C1 - 377
Hedging Long-Term
Transaction Exposure
• MNCs that are certain of having cash
flows denominated in foreign currencies
for several years may attempt to use longterm hedging.
• Three commonly used techniques for
long-term hedging are:
¤ long-term forward contracts,
¤ currency swaps, and
¤ parallel loans.
C1 - 378
Hedging Long-Term
Transaction Exposure
• Long-term forward contracts, or long
forwards, with maturities of ten years or
more, can be set up for very creditworthy
customers.
• Currency swaps can take many forms. In
one form, two parties, with the aid of
brokers, agree to exchange specified
amounts of currencies on specified dates
in the future.
C1 - 379
Hedging Long-Term
Transaction Exposure
• A parallel loan, or back-to-back loan,
involves an exchange of currencies
between two parties, with a promise to reexchange the currencies at a specified
exchange rate and future date.
C1 - 380
Hedging Long-Term
Transaction Exposure
Long-Term Hedging of Foreign Payables
when the Foreign Currency is Appreciating
Spot Rate
Savings from
hedging
3-yr
2-yr
1-yr forward forward
forward
0
1
2
3
Year
C1 - 381
Alternative Hedging Techniques
• Sometimes, a perfect hedge is not
available (or is too expensive) to eliminate
transaction exposure.
• To reduce exposure under such a
condition, the firm can consider:
¤ leading and lagging,
¤ cross-hedging, or
¤ currency diversification.
C1 - 382
Alternative Hedging Techniques
• The act of leading and lagging refers to an
adjustment in the timing of payment
request or disbursement to reflect
expectations about future currency
movements.
• Expediting a payment is referred to as
leading, while deferring a payment is
termed lagging.
C1 - 383
Alternative Hedging Techniques
• When a currency cannot be hedged, a
currency that is highly correlated with the
currency of concern may be hedged
instead.
• The stronger the positive correlation
between the two currencies, the more
effective this cross-hedging strategy will
be.
C1 - 384
Alternative Hedging Techniques
• With currency diversification, the firm
diversifies its business among numerous
countries whose currencies are not highly
positively correlated.
C1 - 385
Online Application
• The annual reports for many MNCs may be
found at http://www.reportgallery.com.
Review some annual reports and see if
you can find any comments that describe
the MNCs’ hedging of transaction
exposures.
C1 - 386
Online Application
• Check out the Futures magazine website
at http://www.futuresmag.com/ for a
discussion of the various aspects of
derivatives trading, such as new products,
strategies, and market analyses.
• Also check out http://www.ino.com/.
C1 - 387
Impact of Hedging Transaction Exposure
on an MNC’s Value
Hedging Decisions on
Transaction Exposure
m

E CFj , t  E ER j , t 
n 
 j 1

Value =  

t
1  k 
t =1 



E (CFj,t ) = expected cash flows in currency j to be received
by the U.S. parent at the end of period t
E (ERj,t ) = expected exchange rate at which currency j can
be converted to dollars at the end of period t
k
= weighted average cost of capital of the parent
C1 - 388
Chapter Review
• Transaction Exposure
• Identifying Net Transaction Exposure
C1 - 389
Chapter Review
• Techniques to Eliminate Transaction
Exposure
¤ Futures Hedge
¤ Forward Hedge
¤ Measuring the Real Cost of Hedging
¤ Money Market Hedge
¤ Currency Option Hedge
¤ Comparison of Hedging Techniques
¤ Hedging Policies of MNCs
C1 - 390
Chapter Review
• Limitations of Hedging
¤
¤
Limitation of Hedging an Uncertain Amount
Limitation of Repeated Short-Term
Hedging
• Hedging Long-Term Transaction Exposure
¤
¤
¤
Long-Term Forward Contract
Currency Swap
Parallel Loan
C1 - 391
Chapter Review
• Alternative Hedging Techniques
¤
¤
¤
Leading and Lagging
Cross-Hedging
Currency Diversification
• How Transaction Exposure Management
Affects an MNC’s Value
C1 - 392