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UNIT FIVE (5)

The International Monetary Environment and Financial

Management in the Global Firm

Objectives

Exchange rates and currencies

How exchange rates are determined

The monetary and financial systems

Financial management in the global firm

Managing currency risk

Managing accounting and tax practices

Currencies & Exchange Rates

• International markets for foreign exchange/capital are

much larger than those for goods & services

• Some 150 currencies are in use worldwide

• Exchange rate: Price of one currency expressed in terms

of another

• Changes in exchange rates affect measures such as costs

of inputs, sales performance, which market entry

strategies to use, & more

Recent Exchange Rates Against The U.S. Dollar

The Four Risks of International Business

Foreign Exchange Markets

• Foreign exchange: All forms of internationally traded

monies, including foreign currencies, bank deposits,

checks, and electronic transfers

• Foreign exchange market: The global marketplace for

buying and selling national currencies

• Exchange rates are in constant flux. For example:

• In 2007, the Japanese yen was trading at 116 yen to the U.S.

dollar. By 2009, it was trading at 85 yen to the dollar,

Foreign Exchange Markets Cont’d

an appreciation of over 25 percent.

• This made the yen more expensive for Americans, & the U.S. dollar cheaper for Japanese.

Foreign Exchange Markets Cont’d

Example: The Euro vs. the Dollar

• Suppose that last year the exchange rate was 1 = $1.

• Now, suppose the rate has gone to 1.50 = $1.

• What is the effect of this change on Europeans?

• Effects on European firms:

European firms pay more for inputs from the U.S.

Higher costs reduce profitability; require higher prices.

European firms can increase their exports to the U.S.

European firms can raise their prices to the U.S.

Increased exports to the U.S. lead to higher revenues

What is the effect on European consumers?

• Suppose the euro/dollar exchange rate goes from 1 euro

equals $1 to €1.50 = $1. What are the effects on European

firms and consumers? European firms pay more for

inputs from the United States. Because U.S. products and

services now cost more, consumers demand less of them.

As you can see, a fluctuating exchange rate affects both

sides of international transactions.

What is the effect on European consumers?

Effect on consumers includes:

• Because U.S. products & services now cost more,

European consumers demand fewer of them.

• The cost of living rises for those Europeans who

consume many dollar-denominated imports.

• Fewer European tourists can afford to visit the U.S.

Fewer European students end up studying at U.S.

universities.

How Are Exchange Rates Determined?

In a free market, the “price” of any currency (the exchange

rate) is determined by supply and demand.

The greater the supply of a currency, the lower its price.

The lower the supply of a currency, the higher its price.

The greater the demand for a currency, the higher its price.

The lower the demand for a currency, the lower its price.

Factors that Influence the Supply and Demand for a Currency

induced decline in the value of their Inflation refers to

increases in the prices of goods & services

Some countries (e.g., Argentina, Israel, Russia)

have experienced hyperinflation

High inflation erodes a currency’s purchasing power

Interest rates and inflation are positively related;

high inflation forces banks to pay high interest

In other words, investors expect to be compensated for

inflation induced decline in the value of their money.

Factors that Influence the Supply and Demand for a Currency Cont’d

• Market Psychology refers to non-financial impacts

• Herding – following the crowd; mimicking the

investment patterns of others

• Momentum – buying when prices rise & selling when

they begin to fall

Example

If inflation is 10%, banks must pay more than 10% to attract

deposits.


• Another factor that influences the exchange rate of a

currency is inflation, which reduces the purchasing power

of the currency. Interest rates and inflation are closely

related. In countries with high inflation, interest rates tend

to be high because investors expect to be compensated for

the inflation-induced decline in the value of their money.

If inflation is running at 10 percent, for example, banks

must pay more than 10 percent interest to attract customers

to open savings accounts.


• Inflation occurs when

Demand for money grows more rapidly than supply, or

The central bank increases the nation’s money supply

faster than output. Inflation directly affects the value of

the nation’s currency. If it results from an excessive

increase in the money supply, all else being equal, the

price of that money (expressed in terms of foreign

currencies) will fall.


• The link between interest rates and inflation, and between

inflation and the value of currency, implies that there is a

relationship between real interest rates and the value of

currency. For example, when interest rates in Japan are

high, foreigners seek profits by buying Japan’s interest-

bearing investment opportunities, such as bonds and

deposit certificates. Investment from abroad will have the

effect of increasing demand for the Japanese yen.

Value of the Currency and Trade Surplus vs. Trade Deficit

• Trade surplus: Exports exceed imports; may result when the

exporter’s currency is undervalued, as in China’s official policy

regarding its currency

• Trade deficit: Imports exceed exports; the government may

devalue the nation’s currency to correct a trade deficit

• Balance of trade: the difference between the value of a

nation’s exports and its imports


• The Chinese government regularly intervenes in the

foreign exchange market to keep the renminbi

undervalued, helping to ensure that Chinese exports

remain strong. An undervalued national currency can

result in a trade surplus, which arises when a nation’s

exports exceed its imports for a specific period of time,

causing a net inflow of foreign exchange.


• By contrast, a trade deficit results when a nation’s

imports exceed its exports for a specific period of time,

causing a net outflow of foreign exchange.

• The balance of trade is the difference between the

monetary value of a nation’s exports and that of its

imports over the course of a year. Many economists

believe a persistent trade deficit is harmful to the

national economy.

The Exchange Rate System Today

• Today, advanced economy currencies (dollar, euro, pound,

yen) float according to market forces, their value

determined by supply and demand

• Conversely, most developing and emerging economies use

fixed exchange rate systems

• In fixed regimes, the value of a currency is pegged to the

value of another currency or to a basket of currencies, at a

specified rate

Examples

• China pegs its currency to a basket of currencies.

• Belize pegs its currency to the dollar.


• The exchange rate system today consists of two main

types of foreign exchange management: the floating

system and the fixed system.


• Most advanced economies use the floating exchange

rate system, in which governments refrain from

systematic intervention, and each nation’s currency

floats independently, according to market forces. Major

world currencies—including the Canadian dollar, the

British pound, the euro, the U.S. dollar, and the Japanese

yen—float independently on world exchange markets,

their exchange rates determined daily by supply and

demand.


• The fixed exchange rate system is similar to the system

used under the Bretton Woods agreement and is sometimes

called a pegged exchange rate system. In this system, the

value of a currency is set relative to the value of another (or

to the value of a basket of currencies) at a specified rate. As

this “reference value” rises and falls, so does the currency

pegged to it. Many developing economies and some

emerging markets use the fixed system today. China pegs

its currency to the value of a basket of currencies.

• At times, countries adhere to neither a purely fixed nor a

floating exchange rate system. Rather, they try to hold

the value of their currency within some range against the

U.S. dollar or other important reference currency in a

system often referred to as dirty float. That is, the value of

the currency is determined by market forces, but the

central bank intervenes occasionally in the foreign

exchange market to maintain the value of its currency

within acceptable limits relative to a major reference

currency. Many Western countries resort to this type of

intervention from time to time.

The International Monetary and Financial Systems

• International monetary system: The institutional

framework, rules, and procedures by which national

currencies are exchanged for one another.

• Global financial system: The collection of financial

institutions that facilitate and regulate the flows of

investment and capital funds worldwide. It includes the

national and international banking systems, the

international bond market, & national stock markets.


• The international monetary system consists of the

institutional frameworks, rules, and procedures that

govern how national currencies are exchanged for one

another. By providing a framework for the monetary

and foreign exchange activities of firms and

governments worldwide, the system facilitates

international trade and investment.

• The global financial system consists of the collective

financial institutions that facilitate and regulate flows of

investment and capital funds worldwide. Key players in

the system include finance ministries, national stock

exchanges, commercial banks, central banks, the Bank

for International Settlements, the World Bank, and the

IMF.


Globalization of Financial and Monetary Activities

• Growing integration of financial and monetary global activity

is due to:

• Evolution of monetary and financial

regulations worldwide

• Emergence of new technologies and

payment systems in global finance;

e.g., the Internet

• Increased global and regional

interdependence of financial markets

• Growing role of single-currency

systems, e.g., euro

Globalization of Financial and Monetary Activities

• Capital flows are much more volatile than FDI-type

investments, because it is much easier for investors to

withdraw and reallocate liquid capital funds than FDI

funds, which are directly tied to factories and other

permanent operations that firms establish abroad. The

globalization of financial flows has yielded many

benefits, but it is also associated with increased risk.

• Economic difficulties in one country can quickly spread

to other countries, like a contagion. Financial instability

is worsened when governments fail to adequately

regulate and monitor their banking and financial sectors.

Key Participants and Relationships in the Global Monetary and Financial Systems

Key Participants and Relationships in the Global Monetary and Financial Systems

• Exhibit 6.2: As companies engage in international trade and

are paid by their customers abroad, they typically acquire

large quantities of foreign exchange and must convert them

into the currency of the home country. Firms also engage in

investment, franchising, and licensing activities abroad that

generate revenues they must exchange into their home

currency. These firms use the resources of international and

domestic financial institutions to exchange these currencies.

Key Participants in the Monetary and Financial Systems

• Bank for International Settlements – based in Switzerland,

works to foster cooperation among central banks & other

government agencies

• IMF – based in Washington; provides framework of and code

of behavior for international monetary system. Plays key role

in monetary crises

• World Bank – goal is to reduce world poverty & is active in

various dev. projects to provide good infrastructure (water,

electricity, transport to poor countries.

Key Participants in the Monetary and Financial Systems

• National stock exchanges and bond markets are also key

participants in the international financial system. Many

exchanges are electronic networks not necessarily tied to

a fixed location. Today, MNEs often list themselves on a

number of exchanges worldwide to maximize their

ability to raise capital. Bonds are another type of security

sold through banks and stockbrokers. They are a form of

debt that corporations and governments incur by issuing

interest-bearing certificates to raise capital.

Key Participants in the Monetary and Financial Systems (cont.)

• Commercial Banks: Lend money to finance

business activity, play a key role in nations’ money

supplies, exchange foreign currencies

• Central Banks: Regulate money supply, issue currency,

manage exchange rates, control national reserves

International Financial Management

• It is the acquisition and use of funds for cross-border

trade, investment, and other commercial activities

• Firms access funds from a variety of sources—foreign

bond markets, local stock exchanges, foreign banks,

venture capital firms, and intracorporate financing—

based on wherever in the world capital is cheapest

• In a typical MNE, financial managers must be effective

in 5 key areas

Five Key International Financial Management Tasks

Raise funds for the firm: Acquire equity, debt, or

intracorporate financing for funding activities and

investments

Manage cash flow: Manage funds passing in and out of

the firm’s value-adding activities

Perform capital budgeting: Assess financial

attractiveness of major investment projects (e.g., foreign

market expansion & entry)

Five Key International Financial Management Tasks

Manage currency risk: Manage the multiple-currency

transactions of the firm and its exposure to exchange-

rate fluctuations

Manage accounting & tax practices: Learn to operate

in a global environment with diverse accounting

practices and international tax regimes

Raising Funds

• Global money market: Financial market where firms

and governments raise short-term financing. It is the

meeting point of those who want to invest money and

those who want to raise funds

• Global capital market: Financial market where firms

and governments raise intermediate-term and long-

term financing

Raising Funds

• Participating in the global capital market allows firms

to access funds from a larger pool of capital at

competitive interest rates. International investors access

a much wider range of investment opportunities than

are available in the domestic capital market

Where to Get Funds: Financial Centers

• New York, London, and Tokyo are the major centers

• Frankfurt, Hong Kong, Paris, San Francisco, Sydney,

Singapore, and Zurich are secondary centers

• Firms access major capital suppliers—banks, stock

exchanges, and venture capitalists—at such centers

• Global capital markets have grown rapidly in the past

decade due to a variety of reasons (government

deregulation, innovations in comm. tech., realized cost

savings from efficiencies, more)

Sources of Funding

Equity Financing

• The firm obtains capital by selling shares of stock

• Main advantage is the firm obtains capital without

incurring debt and having to repay funds to providers

• Main disadvantage is the firm’s ownership is diluted

• The global equity market is the worldwide market of

funds for equity financing—the stock exchanges

worldwide where investors and firms meet to buy and

sell shares of stock

Sources of Funding

Debt Financing

• The firm borrows money from a creditor in exchange for

repayment of principal and interest

• The main advantage over equity financing is that the firm

does not sacrifice any ownership interests

• Debt financing is obtained from two sources: Loans

(usually from banks) and the sale of bonds

• The firm may borrow money from banks in its home

market or in foreign markets

• Borrowing internationally is complicated by differences

in banking laws and infrastructure, lack of loanable

funds, and fluctuating exchange rates

The Eurocurrency Market

• The Eurocurrency market, representing money deposited in

banks outside its country of origin, is a key source of loanable

funds. U.S. dollars account for the largest share of such funds

• Eurodollars are U.S. dollars held in banks outside the United

States, including foreign branches of U.S. banks

• Other Eurocurrencies include euros, yen, and British pounds,

as long as they are banked outside their home country

Bonds are the Major Source of Debt Financing

• A bond is a debt instrument that enables the issuer (borrower)

to raise capital by promising to repay the principal along with

the interest on a specified date (maturity)

• Governments, states, and other institutions also sell bonds.

Investors purchase bonds and redeem them at face value in

the future

• The global bond market is the international marketplace in

which bonds are bought and sold, primarily through banks

and stockbrokers

Foreign Bonds and Eurobonds

• Foreign bonds are sold outside the bond issuer’s country and

denominated in the currency of the country in which they are

issued. E.g., when Mexico’s Cemex sells dollar-denominated

bonds in the United States, it is issuing foreign bonds

• Eurobonds are sold outside the bond issuer’s home country

and denominated in its own currency. For example, when

Toyota sells yen-denominated bonds in the United States, it is

issuing Eurobonds

Sources of Funding (cont’d.)

Intracorporate Financing

• Obtaining funds from within firm’s network of

subsidiaries and affiliates

• In firms with extensive international operations, at times

some units are cash rich while others are cash poor

• Usually has little effect on the parent’s balance sheet

because the funds are simply transferred from one area of

the firm to another

• Minimizes transaction costs of borrowing from banks and

avoids the ownership-diluting effects of equity financing

Managing Cash Flow

• Cash flow needs arise from everyday business activities,

such as paying for labor and materials or resources,

servicing interest payments on debt, paying taxes, or

paying dividends to shareholders

• Cash flow management ensures cash is available where

and when it is needed

Managing Cash Flow

• Cash is generated from various sources, and needs to be

transferred from one part of the MNE to another

• International financial managers devise strategies for

transferring funds within the firm’s worldwide

operations to optimize global operations

Methods for Transferring Funds Within the MNE• Through trade credit, a subsidiary defers payment for

goods received from the parent firm

• Dividend remittances are commonly used to transfer

funds from foreign subsidiaries to the parent, but vary

depending on tax levels, currency risks, and other factors

• Royalty payments are compensation paid to owners of

intellectual property. Assuming the subsidiary has licensed

technology, trademarks, or other assets from the parent or

other subsidiaries, royalties can be an efficient way to

transfer funds

Methods for Transferring Funds Within the MNE (cont’d)

• In a fronting loan, the parent deposits a large sum in a

foreign bank, which then transfers the funds to the

subsidiary in the form of a loan

• Fronting allows the parent to circumvent restrictions

that foreign governments impose on direct

intracorporate loans

Methods for Transferring Funds Within the MNE (cont’d)

• Transfer pricing (also known as intracorporate pricing)

refers to prices that subsidiaries and affiliates charge

one another as they transfer goods and services within

the same MNE

• Firms can use transfer pricing to shift profits out of

high-tax countries into low-tax countries, optimizing

cash flows

Multilateral Netting & Central Depositories

Multilateral Netting: Strategic reduction of cash transfers

within the MNE family through the elimination of offsetting

cash flows:

Multilateral netting involves three or more subsidiaries

that hold accounts payable or accounts receivable with

one other.

MNEs with numerous subsidiaries usually establish a

netting center that headquarters supervises.

Multilateral Netting & Central Depositories

• MNEs pool surplus funds into a central depository that

functions either globally or for a region. The funds are

then directed to needful subsidiaries or invested to

generate income

Perform Capital Budgeting

• Managers use capital budgeting to decide which international

projects are economically desirable

• Net present value (NPV) is the difference between the present

value of a project’s incremental cash flows and its initial

investment requirements

• Internationally, such decisions are complex because managers

must consider many variables, each of which can strongly

affect the potential profitability of a venture

Managing Currency Risk

• Currency risk concerns exchange rate fluctuations that

harm business profits

• Transaction exposure is currency risk that firms face

when outstanding accounts receivable or payable are

denominated in foreign currencies

• Translation exposure is currency risk that results when

a firm translates financial statements denominated in a

foreign currency into the functional currency of the

parent firm

• Economic exposure is currency risk that results from

exchange rate fluctuations affecting the pricing of

products, the cost of inputs, and the value of foreign

investments

Foreign Exchange Trading

A relatively limited number of currencies facilitate cross-

border trade and investment, mainly dollars, euros, yen,

and British pounds

In 2010, the daily volume of global trading in foreign

exchange amounted to over $3 trillion - more than 100x

the daily value of global trade in products and services

Large banks are the primary dealers in currency

Currency traders are especially active in major

financial centers such as London, New York, & Tokyo

Trading is increasingly done online

Specialized Terminology in Currency Trading

• Spot rate: Exchange rate based on the current rate of

exchange

• Forward rate: Exchange rate applicable at some future

date, but specified at time of the transaction

• Direct quote: The number of units of the domestic

currency needed to acquire one unit of the foreign

currency; e.g., “It costs $1.42 to acquire one euro.”

• Indirect quote: The number of units of the foreign currency

obtained for one unit of the domestic currency; e.g., “For

$1, I can receive 0.74 euros.”

Types of Currency Traders• Hedgers seek to minimize the risk of exchange rate

fluctuations, often by buying forward or similar financial

instruments. They include MNEs who conduct international

trade

• Speculators are currency traders who seek profits by

investing in currencies with the expectation that they will

rise in value

• Arbitragers are currency traders who buy and sell the same

currency in two or more foreign-exchange markets to profit

from differences in the currency’s exchange rate

Management of Currency Risk Through Hedging• Hedging refers to efforts to compensate for a possible loss

from a bet or investment by making offsetting bets or

investments

• In international business, it refers to using financial

instruments and other measures to reduce or eliminate

exposure to currency risk

• If the hedge is perfect, the firm is protected against the risk

of adverse changes in currency prices

• Banks offer various financial instruments to facilitate

hedging

Hedging Instruments

Forward contract: A financial instrument to buy or sell

a currency at an agreed-upon exchange rate at the

initiation of the contract for future delivery

Futures contract: An agreement to buy or sell a

currency in exchange for another at a pre-specified

price and on a pre-specified date

Hedging Instruments Cont’d

Currency option: Gives the purchaser the right, but not

the obligation, to buy a certain amount of foreign

currency at a set exchange rate within a specified

amount of time

Currency swap: The exchange of one currency for

another currency according to a specified schedule

Managerial Guidelines for Minimizing Currency Risk

Manage Accounting & Tax Practices

Developing accounting systems to identify, measure, &

communicate financial information is especially challenging in

firms with multi-country operations

Dozens of approaches are used to determine cost of goods sold,

return on assets, R&D expenditures, net profits, and other

outcomes in different countries

Balance sheets and income statements vary mainly in language,

currency, format, and underlying accounting principles

Financial statements prepared in one country may be difficult to

compare with those prepared in another

Transparency in Financial Reporting

• Transparency: Degree to which firms regularly and

comprehensively reveal substantial information about

their financial condition and accounting practices

• The more transparent a nation’s accounting systems,

the more regularly and comprehensively its public

firms report their financial results in a reliable manner

• Transparency improves the ability of investors to

accurately evaluate company performance

• In many developing and emerging market economies,

accounting systems have low transparency

Consolidating Financial Statements of Subsidiaries• A key challenge in international accounting is foreign

currency translation, converting foreign currencies into the

firm’s functional currency

• Translation is critical because subsidiaries’ financial

records are normally maintained in the currencies of the

countries where they are located

• When headquarters consolidates financial records, foreign

currencies are translated into the functional currency by

using one of two methods: The current rate method or the

temporal method

Current Rate Method

• Current rate method: All foreign currency balance sheet

& income statement items are translated at current

exchange rate—the spot exchange rate in effect on the

day (in the case of balance sheets), or for the period (in

the case of income statements), when statements are

prepared

• Typically used when translating records of foreign

subsidiaries that are considered separate entities, rather

than part of the parent firm’s operations

Temporal Method

• Temporal method: The choice of exchange rate

depends on the underlying method of valuation

• Assets & liabilities normally valued at historical cost

are translated at historical rates - the rates in effect

when the assets were acquired

Temporal Method Cont’d

• Assets & liabilities normally valued at market cost are

translated at the current exchange rate

• Thus, monetary items, such as cash, receivables, &

payables, are translated at the current exchange rate

• Non-monetary items (inventory, plant, & equipment)

are translated at historical rates

International Taxation

• A direct tax is imposed on income derived from

business profits, intracorporate transactions, capital

gains, and sometimes royalties, interest, and dividends

• An indirect tax applies to firms that license or franchise

products/services, or that charge interest. The

government withholds a percentage of interest charges

as tax

• A sales tax is a flat percentage tax on the value of goods

or services sold, and is paid by the user

International Taxation (cont’d.)

• A value-added tax (VAT) is payable at each stage of

processing in the value chain of a product or service

• VAT is calculated as a percentage of the difference

between the sale and purchase price of a good

• Common in Canada, Europe, & Latin America

• Each business in a product’s value chain is required to

bill the VAT to its customers; the net result is a tax on

the added value of the good

Tax Havens

• Tax havens are countries hospitable to business &

inward investment (with low corporate income taxes)

• The Bahamas, Luxembourg, Monaco, Singapore, &

Switzerland are examples

• Tax havens exist because tax systems vary greatly

worldwide. Thus, MNEs have an incentive to structure

their global activities to minimize taxes

• MNEs take advantage of tax havens either by starting

operations in them or by funneling business

transactions through them

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