International Financial Management

723G33 LiU yinghong.chen@liu.se

21Chapter

21-2

Chapter Outline

Multinational corporationsEffect of exchange rates on

profitability and cash-flowHedging and reduction of foreign

exchange riskEvaluating political risk in foreign

investment decisionsFinancing international operations

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Growing Interdependency Integrates capital markets

World events such as currency crisis, government defaults, terrorism can cause stock and bond markets to suffer emotional declines well beyond the expected economic impact of a major event

Currency markets Impact on trade between nations affecting

sales and earnings of international companies The advent of the Euro

Sever impact on earnings of U.S. companies doing significant business in Europe

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International Sales of selected U.S.Companies

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Cash flow analysis of a foreign investment

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The Multinational Corporation

A firm carrying out its business activities (often 30% or more) outside its national borders

Can take several forms : Exporter Licensing agreement Joint venture Fully owned foreign subsidiary

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Forms of Multinational Corporation

Exporter: Least risky method Reaping the benefits of foreign demand No long-term investment commitment

Licensing agreement: License granted to a local manufacturer in foreign land

to use firm’s technology Effectively exporting technology Collects licensing fee or royalty

Joint venture: Established with a local firm in foreign land Most preferred by business firms and foreign

governments Least amount of political risk

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Forms of Multinational Corporation (cont’d)

Fully owned foreign subsidiary▪ Higher risks and complexities of operation▪ Often more profitable than domestic firms▪ Lowers combined portfolio risk of the parent

corporation▪ Decisive factor in shaping the pattern of

trade, investment, and the flow of technology▪ Exert significant impact on host country’s

economic growth, employment, trade, and balance of payments

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British Pound and Euro to USD

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Exchange Rates to the DollarThe following figure shows the

amount of foreign currency for one U.S. dollar

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Factors Influencing Exchange Rates

Inflation: A parity between the purchasing power

of two currencies establishes the rate of exchange between the two currencies

Example: it takes $1.00 to buy one apple in New York and 1.25 euros to buy apple in Germany. Then the rate of exchange between the USD and the Euro is €1.25/$1.00 or $.80/euro

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Factors Influencing Exchange Rates

Purchasing power parity theory states that:▪Currency exchange rates vary inversely with their respective purchasing powers▪ Exchange rates between two countries adjust to inflation differential between the two countries

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Factors Influencing Exchange Rates (cont’d)

Interest rates: Short-term capital movements from

low-yield to high-yield markets Interest rate parity theory: ▪ The interplay between interest rate

differentials and exchange rates▪ Interest rates and exchange rates adjust until

the foreign exchange market and the money market reach equilibrium

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Factors Influencing Exchange Rates (cont’d)

Balance of payments: A system of government accounts that

catalog flow of economic transactions between the residents of one country and that of others▪ Trade surplus or deficit determines

strength of currency

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Factors Influencing Exchange Rates (cont’d)

Government policies: Direct or indirect intervention in the

foreign exchange market▪ For maintenance of the undervalued currency

Currency values set by government Restriction on inflow and outflow of

funds Monetary and fiscal policies▪ Result in inflation and change in value of

currency▪ Expansionary monetary policies▪ Excessive government spending

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Other Factors Influencing Exchange Rates (cont’d)

Other factors: Extended stock market rally▪ Higher capital inflow and increase in

currency value Significant drop in demand for a nation’s

principal exports globally▪ Lower investment potential and decrease in

value of currency Political turmoil in a country▪ Capital shift to more stable countries and

decrease in value of currency Widespread labor strikes

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Spot Rates and Forward Rates Spot rate

Exchange rate at which the currency is traded for immediate delivery

Forward rates Trading of currencies for future delivery Reflects the expectations regarding the future value of a currency

Forward Discount or premium: Expressed as an annualized percentage deviation from the spot

rate

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Cross Rates

Not all currencies are actively tradedValue for such currencies determined

through a cross rateExample : Three currencies $, € and

¥ $ and € are actively traded $ is 0.8384€ and € is 141.390¥ Thus $ = 0.8384 × 141.390¥ =

118.541¥

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Key Currency Cross Rates

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Managing Foreign Exchange Risk

Foreign exchange risk Possibility of a drop in revenue or an

increase in cost in an international transaction due to changes in foreign exchange rates

Shift from fixed exchange rate regime to freely-floating rate regime

Exchange risk of a multinational company: Accounting or translation exposure Transaction exposure

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Translation Exposure

Consolidated figures of the parent include value of foreign assets and liabilities converted and expressed in home currency

Treatment of such gains and losses depend on the accounting rules established by the government of parent company.

Note: unrealized accounting gains and losses should only be hedged if you are sure it is going to influence the corporate cash flows! Do a value at risk (VaR) analysis.

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Translation Exposure (cont’d)

SFAS 52 says: All foreign currency-denominated assets

and liabilities to be converted at the rate of exchange on date of balance sheet preparation

Unrealized gain or loss to be held in equity reserve account and realized gain or loss incorporated in the consolidated income statement of the parent company

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Transaction Exposure

Foreign exchange gains or losses resulting from international transactions (from the time of agreement to time of payment) Volatility of reported earnings per share

increases Strategies to minimize transaction

exposure:▪ Forward exchange market hedge▪ Money market hedge▪ Currency futures market hedge

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Currency futures hedging

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Other Forms of Protection Against Foreign Exchange Risk

MNCs have developed foreign asset management programs, involving strategies: Switching cash and other assets

into strong currencies Piling up debt and other liabilities in

depreciating currencies Quick collection of bills in weak

currencies by offering sizable discounts, while extending credit in strong currencies

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Foreign Investment Decisions

Factors encouraging foreign affiliates: Avoid trade barriers Lower production costs overseas Superior technology enabled easy

access to resources in developing countries

Tax advantage Motivated by strategic considerations

in an oligopolistic industry Diversification of risks

internationally

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Risk Reduction from International Diversification

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Political Risk in Foreign Investment

Government interference by imposition of unfriendly foreign exchange restrictions

Limitation of foreign ownership to a small percentage

Blocking repatriation of a subsidiary’s profit to the parent firm

Expropriation of foreign subsidiary’s assets by the host government

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Guarding Against Political RiskEstablish a joint venture with a local

entrepreneur (not totally risk free!)Establish a joint venture with firms

from other countries Insurance against perceived

political-risk level can be obtained Overseas Private Investment Corporation

(OPIC) and other private insurance companies sell insurance policies▪ Coverage is expensive in troubled

countries

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Financing International Business Operations

Credit sales are influenced by: Relationship of the parties involved Political stability of countries involved

Letter of credit issued by importer’s bank reduces risk of nonpayment Credit risk to exporter is absorbed by the

importer’s bank▪ Importer’s bank in a good position to evaluate

the creditworthiness of the importing firm

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Financing International Business Operations (cont’d)

Alternatives to avoid risk of loss of business: Obtaining export credit insurance▪ The Foreign Credit Insurance Association

(FCIA) provides this kind of insurance

▪A private association of 60 U.S. insurance firms

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Funding of Transactions

Eximbank (Export-Import Bank) Direct loan program Discount program

Loans from parent company or sister affiliate Parallel loans Fronting loans

Eurodollar loans US dollars deposited in foreign banks Lending rates based on London

Interbank Offer Rate (LIBOR)

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Funding of Transactions (cont’d)Eurobond market

Issues are sold in several national capital markets

Widely used currency – U.S. dollar International equity markets

Companies are listed on major stock exchanges

Issue American Depository Receipts (ADRs)

The International Finance Corporation (IFC) Approached by companies facing issues

with raising equity capital in a foreign country

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Some Unsettled Issues in International Finance

Nature of financial decisions for an MNC are complex: Access to more sources of financing than a

purely domestic corporation▪ Decision regarding level of leverage in the foreign

affiliate ▪ Dividend policy decisions influenced by foreign

government regulations Differences in interest rates and market

conditions between domestic and foreign markets

Differences in corporate financial practices