introduction to global business chapter 14 global financial management 2017 cengage learning. all...

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Introduction to Global Business

Chapter 14Global Financial Management


1. Explain how foreign exchange risk affects firms and investors.

2. Describe different ways to hedge exchange rate risk.3. Discuss sources of funds to finance international trade

and investment.4. Apply net present value analyses to the capital

budgeting decisions facing firms with international operations.

5. Discuss how exchange rate risk affects firms’ cash flows and its impact on stock returns.

After studying this chapter, you should be able to:


Measuring Foreign Exchange Exposure

• Exchange rate risk– The impact of random change in the value of one currency with

respect to other currencies• Transactions risk

– How short-term changes in exchange rates can affect operating costs and revenues of firms engaged in international business activities

• Translation risk– The short-term effects of currency movements on the consolidated

accounting statements of a firm


Measuring Foreign Exchange Risk (continued)

• Consolidated accounting statements– The income statements and balance sheets of multinational

corporations and of all subsidiaries abroad• Economic risk

– The ways in which long-term exchange rate movements affect firms

• Special drawing right (SDR)– A basket of currencies consisting of dollars, euros, pounds, and

yen created by the International Monetary Fund (IMF)


Hedging Foreign Exchange (Forex) Riskwith Derivatives

• Hedging– Using currency derivatives to reduce potential transaction,

translation, and economic risks of currency movements that could lead to losses for a firm or investor

• Speculators– Trade in currencies and currency derivatives to earn profits and to

help to make currency prices efficient


Futures Contracts

• Currency futures contracts– Standardized agreements to buy or sell a specified amount of

currency at a date in the future at a predetermined price• Long position

– Buying a currency contract and profiting on the increased value of the underlying currency over time

• Short position– Selling a currency contract and profiting on the decreased value of

the currency over time• Organized exchanges

– Trade futures contracts in major currencies and offer price transparency and efficiency in addition to eliminating counterparty risk due to guaranteed payments on contacts


Futures Contracts (continued)

• Common rules in trading currency futures contracts:– Futures contracts are marked-to-market—gains (losses) are

earned (paid) in cash at the end of each trading day.– Contracts can be purchased for a small commitment fee called the

margin.– If losses occur causing a participant’s balance to fall below the

maintenance margin at the end of the trading day, a margin call occurs that requires the customer to replenish the margin account.


Forward Contracts

• Currency forward contracts– Futures contracts in the currencies of emerging-market countries

offered by large banks in the OTC market– Less standardized than future contracts such that they can be

customized by the seller/counterparty to meet the hedging needs of the buyer

– Are not marked-to-market daily• Over-the-counter (OTC) market

– Derivatives market run by large banks


Options Contracts

• Call option– An investor’s right (but not obligation) to buy an asset (e.g., a

currency) at a predetermined (strike) price• Put option

– An investor’s right (but not obligation) to sell an asset (e.g., a currency) at a predetermined price

• Premium– The price paid by the buyer to the seller for an option contract


Swap Contracts

• Currency swaps– Allow firms to exchange currencies at a previously agreed

exchange rate as a way to hedge exchange rate movements• Plain vanilla currency swap

– An interest rate swap, often combined with a currency swap, if the interest being swapped is in different currencies


Financing International Trade and Investment

• Firms finance international operations in a variety of ways.– Short-term financing of goods and services is handled by large

banks.– Long-term financing of capital equipment, land, and buildings is

provided by international bond and stock markets.– Government financing is also available to meet international trade

policy goals in a particular country.


International Banking

• Money center banks– Large global banks

• Clearing House Interbank Payments System (CHIPS)– Provides large, wholesale dollar payments services for

businesses, banks, and governments• Society of Worldwide Interbank Financial

Telecommunications (SWIFT)– Provides secure communications for contracts, invoices, and other

trade documents that accompany cash payments• Syndicate

– A group of banks that collectively make a loan to an international firm


International Payment Methods and Documentation

Payment in Advance• The safest method

for exporters, but it exposes importers to risk related to delivery of goods

Commercial Letter of Credit (LC)• Provides payment

protection to both exporters and importers, as the importer’s bank writes a guarantee of payment

Banker’s Acceptance• When a bank sells

a LC into the financial marketplace as a money market instrument

Open Account• A simple

agreement wherein the exporter sends an invoice with the goods and the exporter pays upon the receipt


International Bond Markets

• Bond ratings– Moody’s and Standard and Poor’s rating services that are

important in assuring foreign investors of the credit quality of bond issues

• Domestic bonds– Debt contracts sold by firms domiciled in a country in the home

currency• Foreign bonds

– Bonds that are issued by foreign firms in another country in the home currency of that country

• Eurobonds– Bonds that are sold in any country outside the home country, but in

the home country’s currency


International Stock Markets

• Diversification– Buying securities in a portfolio with price patterns over time that

are different from one another, which reduces the volatility of the portfolio

• Home bias– Investing most of retirement and other savings in one’s home

country, which reduces diversification• Contagion

– When stock markets in many countries move down in concert with one another and thereby reduce international diversification benefits


Government Financing

• International Monetary Fund (IMF)– Provides “lender-of-last-resort” short-term loans to countries in

financial crisis– Evaluates exchange rate policies– Gives technical assistance to countries

• World Bank– Provides long-term loans for economic reform and infrastructure

development in emerging and developing markets• IMF and World Bank are major suppliers of emergency

and development assistance to poorer countries.


Government Financing (continued)

• Major government-supported international financing institutions include:– Export-Import (Ex-Im) Bank—a U.S. government export finance

agency that supports U.S. firms competing against government-supported exports of other countries

– Bank of International Cooperation (JBIC)—Japanese bank that supports exporters around the world that have at least 30 percent Japanese content


Government Financing (continued)

• Trade finance– Bank and government loans used by exporters to finance working

capital (i.e., labor, materials, inventory, and accounts receivables)• Term financing

– Bank and government loans to importers to cover the cost of major purchases


Parent Firm Capital Budgeting (continued)

• Country risk– The uncertainty in predicting how economic, political, inflation, and

tax risk factors will affect an investment in a country• Sensitivity analysis

– An examination of optimistic, expected, and pessimistic scenarios to give a more complete picture of the risks and returns of investments abroad


The Cost of Capital: Domestic Versus Global

• Cost of capital– The required rate of return demanded by stock and bond investors– Used in net present value capital budgeting analyses as the

discount rate• Weighted average cost of capital

– The sum of the costs of equity and debt weighted by the amount of financing from these two capital sources


The Cost of Capital: Domestic Versus Global (continued)

• The weighted average cost of capital for a firm is:

K = (Equity/Total Market Value) R + (Debt/Total Market Value) (1 – Tax Rate) I

whereEquity = market value of common and preferred stock outstandingDebt = market value of long-term debt outstandingR = cost of equity or required rate of return of equity holdersI = before-tax cost of debt or interest rateTax Rate= marginal tax rate of the firmTotal Market Value = Equity + Debt.



• Cost of debt– The weighted average of different interest rates paid on long-term

borrowings• Cost of equity

– The rate of return on equity required by stockholders as estimated by Capital Asset Pricing Model (CAPM)



• The CAPM is written as follows:

Rit = Rft + i(Rmt – Rft),

whereRit = the one-month return on stock i in month tRmt = the one-month return on a domestic market index (e.g., the S&P 500 index of the 500 largest U.S. firms)Rft = the one-month riskless rate of return (e.g., the U.S. Treasury bill rate)i = the domestic beta risk measure for the stock.



• International CAPM (ICAPM)– An asset pricing model that includes both domestic and global

market factors to estimate the cost of equity or required rate of return on stocks

– The estimated rate of return required by stockholders as estimated by ICAPM) is:

whereRgt = the one-month return on a global market index (e.g., the Dow Jones world index of stocks= the global beta risk measure for the stock and other terms as before.


Currency Risk and Stock Valuation

• Cash flow sensitivity to exchange rate risk– Firms can experience positive and negative fluctuations in cash

flows and profits due to currency movements that strengthen or weaken the value of their products in overseas markets.

– One channel for currency movements to impact MNC cash flows is export sales.

– Another channel for dollar movements to affect companies is through oil imports, normally priced in dollars.


Stock Values and Foreign Exchange Movements

• Measurement of long-run exchange risk (Adler and Dumas):

Rit = Rft + i(Rmt – Rft) + CRCt

whereRCt = the one-month return on local currency relative to a basket of currencies in month tC = the exchange rate risk measure for the stock and other terms are the same as in the CAPM equation.


Stock Values and Foreign Exchange Movements (continued)

• Market factors affecting equity valuations– Exchange rate sensitivity—a stock value measured with the

coefficient obtained by regressing the stock’s return on a currency’s return over time

– Exchange risk beta—the sensitivity of a stock to market risk affected by currency movements


Stock Values and Foreign Exchange Movements (continued)

• Measurement of exchange risk (Armstrong, Knif, Kolari, and Pynnönen):

Rit = Rft + b0(Rmt – Rft) + b1(Rmt – Rft) RCt

whereb0 = the market beta with no exchange riskb1 = the market beta associated with exchange risk


exchange rate risktransactions risktranslation riskconsolidated accounting

statementseconomic riskSpecial Drawing Right (SDR)hedgingspeculatorscurrency futures contractslong positionshort position

organized exchangesmarked-to-marketmarginmargin callcurrency forward contractsover-the-counter (OTC) marketcall optionput optionpremiumcurrency swapsplain vanilla currency swapmoney center banks

Key Terms


CHIPS (Clearing House Interbank Payments System)

SWIFT (Society of Worldwide Interbank Financial Telecommunications)

payment in advancecommercial letter of credit (LC)banker’s acceptanceopen accountsyndicatebond ratingsdomestic bonds

foreign bondseurobondsdiversificationhome biascontagionExport-Import (Ex-Im) Banktrade financeterm financingBank of International

Cooperation (JBIC)net present valuecountry risk

Key Terms (continued)


sensitivity analysiscost of capitalweighted average cost of

capitalcost of debtcost of equity

beta riskinternational CAPM (ICAPM)size factorvalue factorexchange rate sensitivityexchange risk beta

Key Terms (continued)

introduction to global business chapter 14 global financial management 2017 cengage learning. all...

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