Essential of Multinational Business Finance Practical Approach potx

Chapter 1 Financial Goals and Corporate Governance ■ Multinational business enterprise and finance ■ A business having operating subsidiaries, branches, or affiliates located in foreign

Essential of Multinational Business Finance

Practical Approach

Professor M Vaziri

Chapter 1

Financial Goals and Corporate

Governance

■ Multinational business enterprise and finance

■ A business having operating subsidiaries, branches, or affiliates located in foreign countries

■ Can be engaged in virtually every type of business activity, including banking, accounting, consulting, etc

■ Business activities, primarily financing, which reach beyond the domestic markets

■ Major risks include interest rate, exchange rate, and credit risks of foreign markets.

Chapter 1

Financial Goals and Corporate

Governance

■ Goal of management : Shareholder Wealth

Maximization versus Corporate Wealth Maximization

■ Shareholder Wealth Maximization (SWM Model)

■ Is the predominant theory of domestic U.S firms

■ Assumes that the stock market is efficient and all news (public or private) is reflected in the stock price.

■ Risk = added risk that the firm’s share bring to an established investment portfolio

■ Agency Theory Managers and owners may not share the same goals and objectives

Problem arises as shareholders seek effective motivational tools to promote managers

conformity to will of shareholders

Chapter 1

Financial Goals and Corporate

Governance

■ Corporate Wealth Maximization

■ The firm treats shareholders as equals to other groups with interest in the firm (management, labor, local community, supplies, creditors, etc).

■ Risk = total risk = Operational + Financial Risk.

■ Concerned with growing the firm for the benefit of all, not exclusively shareholders.

■ Is the predominant theory of many foreign firms.

Chapter 1

Financial Goals and Corporate

Governance

■ Weaknesses of Corporate Wealth Maximization (CWM)

■ Attempts to satisfy too many parties simultaneously It may be to provide adequate satisfaction to any single party

■ Due to abuses and failures of internal corporate self-governance, government and outside agencies must enact legislation regulating activities One such law is the Sarbanes-Oxley Act of 2002.

■ Corporate boards must have independent auditors.

Chapter 1

Financial Goals and Corporate

Governance

■ Basics of Corporate Governance

■ The way a corporation directs itself is called corporate governance Primarily, corporate governance states the techniques that govern the formation of a corporation’s structure and the laws and customs that affect these techniques

■ A corporation’s structure is composed of three groups:

■ Board of Directors

■ Managers

■ Shareholders

international trade are accommodated & Balance of

Payments Adjustments are made

■ History of IMS: The Gold Standard (1876-1913):

 Gold as a medium of exchange- Pharaohs (3000 PC)

 The Greeks, Romans & Persians Used gold coins & passed through the mercantile era to the 19th

Chapter 2

International Monetary System

(IMS)

■ Mercantilism of 19th Century - Need for IMS :

 Europe adapted the IMS in 1870 & the U.S in 1879

 $20.67/Ounce of Gold, £4.274/Ounce:

 $20.67/£4.2474=£4.8665/$

 Limitation of gold reserve & supply of money

 Limit the flow of goods and gold & suspension of GS

■ Inter War Years: 1914-1944 :

 Free Fluctuating of Exchange Rates with consideration of the gold and par value of other currencies.

 Short sell of week currencies, re-evaluation of £, the

collapse of the Austrian banking system-total abandonment

of GS

Chapter 2

International Monetary System

(IMS)

■ The Bretton Wood Agreement: (1944):

 Dollar based Monetary System (par value based on $)

 Fixed value in term of $, but not required to convert

 Only $ remained convertible to gold: $35/Ounce

 Only 1% of par allowed for fluctuation

 Devaluation was not allowed for purpose of high export

 10% devaluation for week currency or approval of IMF

 IMF & World Bank were created

Chapter 2

International Monetary System

(IMS)

■ International Monetary Fund IMF

■ Mission: Rendering temporary assistance to currencies with cyclical,

seasonal or random fluctuation.

■ Help countries with a structural trade problem

■ IMF is funded based on quota of expected post WWII trade

■ The Original quota were 25% in gold or $ (Gold tranche), & 75% local

■ At the present time, each of the 151 member can borrow up to 150%

annually of its quota or up to 450% during a three years period

■ Cumulative access could be up to 600% of members quota

Chapter 2

International Monetary System

(IMS)

■ International Monetary Fund IMF (Cont’)

■ Distribution of the quota is prelude to distribution of vote

■ U.S Vote:19.1%, UK:6.6%, Germany:5.8%, France:4.8%,

Chapter 2

International Monetary System

(IMS)

■ EFTA (1957) & EEC (1959), rapid increase in world trade

■ U.S deficit of 1959 & International Monetary Reserve dilemma: BOP deficit to create more reserve for LDCs

■ Doubt of convertibility of major reserve currencies

■ "Interest Equalization Tax“ on foreign borrowing & creation of bond

Euro-■ Mandatory control of direct foreign investment ,control of foreign

lending by U.S banks,& high U.S deficit

■ Official Currency Swaps: Group of Ten Industrialized Nations as a interest credit between central banks

Chapter 2

International Monetary System

(IMS)

■ U.S BOT had reached to all-time high in 1971

■ U.S lost one-third of her official gold & president Nixon suspended convertibility of $ to gold

■ U.S imposed 10%surcharge on imports & freezes P&W

■ Most European currencies gained against $

■ Group ten Industrialized Nations signed on Dec, 17 1971

Chapter 2

International Monetary System

(IMS)

■ Floating Rate has been established ( has continued today)

■ Gold was demonetarized as a reserved asset

■ IMF agreed to sell $25 million ounces of gold to its members and used the proceeds to help the poor nations

■ IMF quota increased to $41 and then to $180 billion

■ 10% of the voting power given to OPEC members

■ Non-oil producing countries have more access to IMF

■ Floating Exchange Rate System has officially adopted & continued until present time

Chapter 3

Balance of Payment (BOP)

■ Definition of BOP: Record of transactions between residents of one country & rest of the world

■ Functions of BOP:

■ Helps forecast market potential of a country

■ Helps to understand the currency fluctuation of a country

■ It is a poor description of National Economy

■ Useful in measuring economic performance if there is FER

■ $ was indexed at 100 at 1970: If index is greater than 100,$ gain VS other countries currencies

Chapter 3

Balance of Payment (BOP)

■ Accounts of BOP:

■ Trade Balance : Net balance in merchandise traded

■ Current Account: Trade account + earning & expense on services

■ Basic Balance: Current account +long term capital (such as direct investment)

■ Overall Balance: basic Balance + short term capital +Error &

Omission

Chapter 3

Balance of Payment (BOP)

■ Aggregates Income: Y=C+S, Where,

■ C = Agg Consumption & S = Agg Saving

■ Aggregate Expenditure: E= C+Id, where Id=Domestic investment

Chapter 3

Balance of Payment (BOP)

■ Balance Economy

■ Y-E=0

■ S (Saving) – Id = 0 : Saving Balance

■ G – T (Tax) = 0: Budget Balance

■ Export (X) – Import (M) = 0: Trade Balance.

■ In a balance Economy: Y=E, then S= Id, then G=T, then X=M

* If Y>E, then S> Id (Saving Surplus), then T>G (Budget Surplus), then X>M (Trade Surplus) So If > 0 ( Capital

Chapter 3

Balance of Payment (BOP)

■ Coping with Current Account Deficit (CAD):

■ Relationship between CAD & currency depreciation

■ According to General Equilibrium View : not a simple one

■ 1976-1980: $ depreciate, CAD decreased

■ 1980-1985: $ appreciate, CAD increased

■ Impose high tariffs & quotas:

■ Since S-Id=X-M, (unless S & Id changes), if M decline, X must decline : less import means less demand for foreign currency, less supply of domestic currency, and an increase in value of domestic goods, which mean less export.

Chapter 3

Balance of Payment (BOP)

■ End Foreign ownership of domestic assets

■ No capital account surplus means interest rate will increase & investment & income will decline

■ Stimulate savings: If S is greater than Id,

we will have capital outflow, causing deficit to decrease in both Government

Chapter 4 Foreign Exchange Market (FEM)

 Function of FEM:

 Transfer of Purchasing Power.

 International Credit such as L.C.

 Minimize Exposure to Foreign Exchange Risk

 Market for Hedging & Arbitrageur

 Market for currency Swaps, futures &

 Participants in FEM:

 Banks & Non-banks

 FEM Dealers- benefited from bid-ask spread

 Market Makers-Position on certain Currencies

 FEM Brokers (56%)

 Exporter, Importer, Tourists MNCs, Portfolio Managers

 Speculators & Arbitrageur

 Central Banks

Chapter 4 Foreign Exchange Market

(FEM)

 Types of FEM Transactions:

 Spot Transactions: one day settlement (63% of market)

 Forward Transactions: one, two, six & 12 month (6%)

 Swaps Transactions: Simultaneous purchase or sale of FE, with

two value dates: spot-forward, forward-forward

Swaps Transactions

Example: sell £20 mil forward for $ deliver in two

months at $1.4870/£ & simultaneously

buy back £20 mil forward for delivery in three

Chapter 4 Foreign Exchange Market

(FEM)

 Bid & ask spread:

• Buy (bid) at €0.8474/$ & ask (offer) at €0.8474/$.

• Difference between bid-ask is dealer

• Premium=transaction cost

Chapter 4 Foreign Exchange Market

(FEM)

(FEM)

Triangular Arbitrageur

Buying & selling of one currency for another & returning to the original one.

U.S$ UK £ €

U.S$ 1 S($/£)=1.70 S($/ € )=1.18

The Interest Rate Parity

Theory

 DEF: Except for transaction costs, the differences in

national interest rate, for security of similar risk &

maturity should be equal but opposite in sign, to forward exchange rate discount or premium for foreign currency

 It links National Monetary Market Rate to Foreign

Exchange Rate

 Forward Exchange Rate Discount & Premium:

 (Forward Rate-Spot Rate)/(Spot Rate)*12/n*100

 (Spot Rate-Forward Rate)/(Forward Rate)*12/n*100

 Can$1.319-1.313/1.313*12/3*100=+1.8279 per year:

The operation of Covered

Interest Arbitrageur

Chapter 4

 Test for Parity

 UK 3-Month Interest Rate=12% per year

 U.S 3-month Interest Rate=7% per year

 Transaction Cost=.15% should be calculated at the beginning of

transaction

 Size of Transaction=$2,800,000.00

 Covered Interest Arbitrageur actions:

 Step 1 Borrow $2.8mil at 7%/year for 3-month

 Step 2 Exchange $2.8 mil for £ at spot rate of $1.4000/£ & receive

£2mil.

 Step 3 Invest £2mil for 3-month in UK at 12%/year or 3%/Quarter.

 Step 4 Sell £2.06mil forward at 3-month forward rate of $1.3860/£: which include £2mil principal & £60,000 interest for the 3-month (3%*2mil=$60mil

The operation of Covered

Interest Arbitrageur

 Covered Interest Arbitrageur actions-con :

 Step 5 Pay transaction cost of $4,200 ($2.8*.15)

 Step 6 Three month after, redeem UK investment of £2,06mil

 Step 7 Fulfill forward contract by selling £2060mil at $1.3860/£

forward rate & receive $2.855160.

 Step 8 Repay loan of $2.8mil plus 3-month interest at

1.75%/Quarter ($2.8*1.75%=$49000).

 Profit Calculation:

 Proceed from investment in UK=$2,855,160.

 Principal + interest from borrowing=$2,849,000

Speculation in FEM

Chapter 4

 Spot Market Speculation:

 Spot rate:DG2.9000/$,Forward Rate=DG2.8000/$

 6-month expected spot rate=DG2.700/$

 With $40,000, buy:$40,000*DG2.9=DG116000

 Sell at DG2.7/$ for $42965 (116000/2.7)

 Make profit of 2965 or14.82%/Year

 Forward Market Speculation

 Buy $40,000*DG2.8=DG112000

 Buy back $ at DG2.7=$41,481

 Profit=$1,481

Factors to be considered

in forecasting the ER

1 Expected changes in spot rate,

2 Inflation rate differential,

3 Interest rate differential,

4 BOP problems,

5 Growth of Money supply

6 Business Cycle,

7 Change in International Monetary Reserve,

8 Increase in official-nonofficial rate spread

9 FE policies such as , FE control, ceilings on interest rate,

Interest Rate Parity Theory

Chapter 4

• For given transaction cost, percentage of the forward premium or

discount of foreign currency to home currency is equal but

opposite in sign to interest rate differential between foreign

country and home country.

Forward Premium or Discount of Foreign Currency to Home Currency

Interest Rate Differential between foreign country and home country

IRP Line

Purchasing power Parity

(PPP) Theory

• Def: If the spot rate between two countries

starts in equilibrium, any change in the

difference of rate of inflation between

them tends to be offset over the long run

by equal, but opposite change in spot

exchange rate

• Current Account Balances are very

sensitive to change in inflation Rate

Purchasing power Parity

(PPP)

Chapter 4

• For example: if the inflation rate of US is 2% lower than that of UK,

then the expected rate in US is 2 % higher than that of UK Balance

in current account is very sensitive to change in inflation rate.

Inflation differential of Foreign Currency to Home Currency

Expected spot rate differential of Foreign Currency to Home Currency

PPP line

International Fisher Effect

(Fisher Open) Theory

• Def: Difference in interest rate between two countries is

equal, but opposite in sign to the spot exchange rate of

foreign currency to home currency

International Fisher Effect

(IFE)

Chapter 4

• For example: If the interest rate in U.K has 3% higher than interest rate in the U.S., U.K should be

depreciated by 3% against the $U.S., and at the same time the U.S should be appreciated by 3% (If it

is on the IFE line)

• If the interest rate in U.K is 4% lower than interest rate in the U.S., U.K should be appreciated by 4%

against the $U.S., and at the same time the U.S should be depreciated by 4% (If it is on the IFE line)

Expected Spot Rate difference

of foreign currency to home currency

Interest Rate differences of Foreign Currency to Home Currency

IFE line

Fisher Effect (Irving Fisher)

• Def: Difference in inflation rate between two countries is

equal to the interest rate differential between them

Nominal interest rate is equal to the required real rate of

return plus compensation for expected inflation (i= r + π,

i : the nominal interest rate, r: the real interest rate, π:

expected inflation)

Expected Inflation

Interest Rate Differential

Fisher Parity Line

Foreign Currency Option

(FCO)

Chapter 4

• Def: FCO is a contract that gives buyers the

right to buy or sell a given amount of foreign

exchange at a fixed price (exercise price or

strike price) per unit for a specific period of

time

• Types of FCO: American Option : Right to

exercise on any day before the expiration date,

when you have a loss

Foreign Currency Option

(FCO)

Maturity dates & size of FCO:

• Saturday proceeding the third Wednesday

of expiration Month March, June, September, and December.

• Contract size: Cited as fixed contract per

unit, such as DM62,500/per unit of option: with one mil$ one can buy:$ one

mil/¨DM62,500=16 FCP contract

• Price of FCP: No of cents per unit: