Financial management of multinational firms

TYPES OF EXCHANGE RATE• Exchange rates classified by maturity: – Spot - which means the exchange rate for buying or selling the currency today.. Denote this by St – Forward - which mean

Financial Management of

Multinational Firms

FNGB 7451 MSGF Program Gautam Goswami Graduate School of Business

Fordham University

• Multinational Financial Manager’s function

• Multinational Financial Management Vs Domestic Financial Management

RATIONALE OF THE MULTINATIONAL FIRM

• Theory of Comparative Advantage

– Example

• Economic and business rationale:

– Host country’s perspective

– Multinational business perspective

• Risk management through:

- Geographic diversification

- Currency diversification

INTRODUCTION – Course Overview

1 Foreign Exchange Markets:

• Spot, Forward, Futures, Options

• Arbitrage, Hedging and Speculation

2 Fundamental Theories in Corporate Finance:

- Net Present Value (NPV)

- Adjusted Net Present Value

- Capital Asset Pricing Model (CAPM)

- Cost of Capital (WACC)

- Option Pricing Model (OPM)

- Capital Structure Theory

INTRODUCTION – Course Overview

2 Fundamental Theories in Corporate Finance (Cont.):

- Purchasing Power Parity (PPP)

- Interest Rate Parity (IRP)

- Put-Call Parity (PCP)

- Fisher Effect (FE)

- Generalized Fisher Effect (GFE)

- International Fisher Effect (IFE)

3 Financial Management Issues:

3.1 Valuation:

- Stock / Bond Valuation

- Project Valuation

- Cost of Capital

3.2 Working Capital Management

- Hedging Foreign Currency Cash-Flows

INTRODUCTION – Course Overview

3.3 Measurement and Management of:

» Accounting & Economic Exposure

» Contractual Exposure (Case: Jaguar Plc.)

3.4 Estimating Cost of Capital for Emerging Market Cash

Flows (Case 46 Paginas Amarelas)

3.5 Capital Budgeting and Cross Border Valuation

(Case: Wiley International)

INTRODUCTION – Course Overview

INTRODUCTION – Course Overview

3.6 International Financing:

(Case: Petrolera Zueta (Petrozuata)

- Euro debt Market

- Debt Financing

- Equity Financing

3.7 Valuations for Acquisitions or Large Investments

- Evaluating a Joint Venture (Case 47 Continental Cablevision)

- Evaluating the Equity in Project Financing

(Case: Airbus A3XX)

Benchmark Interest Rates

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INTRODUCTION - Fx Markets

• Why Fx markets are important?

• Who is affected by Fx markets?

National Vs Multinational Companies

FOREIGN EXCHANGE MARKETS

FOREIGN EXCHANGE MARKETS

• Mechanism to:

– Transfer purchasing power

– Obtain or provide credit

– Minimize exposure to risk

• Not an organized physical marketplace

- Over the Counter (OTC)

- Most trades by phone, telex, or SWIFT

(SWIFT: Society for Worldwide Interbank Financial Telecommunication)

• Highly sophisticated telecommunications network

SWIFT

(Society for Worldwide Interbank Financial Telecommunications)

• Connects more than 7,000 banks and broke-dealers in 192

countries

• Processes more than five million transactions a day, representing about $5 trillion in payments

• Its mission is to quickly transmit standard forms to allow its

member banks to automatically process data by computer

FOREIGN EXCHANGE MARKETS

COMPARISION OF SIZE IN 2004

Fx Market US$1.9 trillion/day or US$475 trillion/yearNYSE US$7 trillion/day or US$1750 trillion/yearNYSE (Oct 1987) US$21 billion/day or US$5250 billion/year

US GDP (2004) US$11.686 trillion

FOREIGN EXCHANGE MARKETS

• Structure of Foreign Exchange Market

Tiers: (i) Interbank or wholesale market

(ii) Client or retail market

• Participants:

- Bank/non-bank foreign exchange dealers

- Individuals/firms conducting comm./ investment transactions

- Speculators/arbitrageurs

- Central banks and treasuries

FOREIGN EXCHANGE MARKETS

Clearing System

• Clearing House Interbank Payments System (CHIPS)

- Used in U.S for electronic fund transfers

- Handles about 105,000 interbank transfers daily valued

at $350 billion

• FedWire

- Operated by the Fed

- Used for domestic transfers

Electronic Trading

- Automated trading

FOREIGN EXCHANGE MARKETS

• Size

- Fx Market = The largest financial market in the world

- Most important markets: (daily turnover)

1995 2004

- London $464 billion $753 billion

- NY $244 billion $461 billion

- Tokyo $161 billion $199 billion

- Less important markets:

- Singapore, Hong Kong, Zurich ($90-$115b)

FOREIGN EXCHANGE MARKETS

LEADING FOREIGN EXCHANGE TRADERS IN 2003

FOREIGN EXCHANGE MARKETS

• Markets:

- Spot Market - Forward Market

- Futures Market - Options Market

• Basic Operations:

- Arbitrage: Spot Markets

- Hedging: Forward, Futures, Options Markets

- Speculation

FOREIGN EXCHANGE MARKETS

• Delivery: +1 or 2 business days

– Delivery of FX is not instantaneous When you

exchange bank drafts of western nations, delivery takes place after 2 days

– In the case of a transactions involving the US$ and the Can$ delivery takes place after 1 day

FOREIGN EXCHANGE MARKETS

• Definition: An exchange rate is the number of units of one

currency that one requires in order to purchase one unit of

another currency

• An example of a quote is US$0.8/C$ This means that you can

“exchange” a Can$ for US$0.80 In other words, you can buy a C$ by paying 80 US cents

• Source:

- All major newspapers

- Major currencies have 4 different quotes: (i) spot price, (ii) 30-day, (iii) 90-day, (iv) 180-day

EXCHANGE RATE QUOTATIONS

• Direct Quote: Units of Local Currency (LC) per Foreign

Currency (FC)

- From a U.S Perspective, a Direct Quote is expressed as

Dollars/Unit of Foreign Currency Examples:

• Indirect Quote: Units of Foreign Currency (FC) per Local

Currency (LC) Examples:

0.5727 Pound/$ [Pounds 0.5727 = $1]

1.6250 DM/$ [DM 1.6250 = $ 1]

• To do any exchange rate calculation (appreciation or

depreciation) you must first express the exchange rate as a

direct quote

EXCHANGE RATE QUOTATIONS

WSJ/ FC newspaper copy

• Most currencies on the interbank market are quoted as units of Foreign Currency/Dollar For example:

1.6250 DM/$ [DM 1.6250 = $1]

133.25 Yen/$ [Yen 133.25 = $1]

• From a U.S perspective, these quotes are Indirect To convert

from Indirect to Direct, use the relationship:

Direct = 1 / Indirect

EXCHANGE RATE QUOTATIONS

TYPES OF EXCHANGE RATE

• Exchange rates classified by maturity:

– Spot - which means the exchange rate for buying or selling

the currency today Denote this by S(t)

– Forward - which means the exchange rate for buying or

selling the currency at some future date, say 3 months from now For example, you could ask your bank to quote you an exchange rate to sell dollars for pounds for March S(t+3)

TYPES OF EXCHANGE RATE

• Exchange rates classified by maturity (cont.):

– Future Spot : This is different from the fwd rate because

while the fwd rate is fixed (that is, the bank promises to make the transaction at the rate quoted) the future rate is only an estimate of what the spot rate should be 3 months from now ES(t+3)

• Exchange rates classified by type of transactions:

– Bid-Ask

» The rate that you are quoted at which the bank will buy

a currency from you (and you will sell the currency) is

called the BID rate

» The rate at which the bank will sell a currency to you is

the ASK rate.

(US$/SFr) Bid Ask

Spot 0.3968 0.3978

TYPES OF EXCHANGE RATE

• Exchange rates classified by type of transactions:

– Bid-Ask (cont.)

Example: Convert indirect quote to direct quote

Bid Ask

(Indirect Quote) Spot SFr 2.4027/US$ 2.4051/US$

(Direct Quote) Spot US$ 0.4158/SFr (1) 0.4162/SFr (2)

(1) Bid Rate (US$ per SFr) = 1/Ask Rate (SFr per US$) = 1/2.4051(2) Ask Rate (US$ per SFr) = 1/Bid Rate (SFr per US$) = 1/ 2.4027

Always Ask Rate > Bid Rate

Ask Price – Bid Price

EXCHANGE RATE QUOTATIONS

• Point Quotation or Swap Quotation: Rates quoted on point

basis This is because in a swap transaction the bank will only pay the points, that is, the difference between the spot and the forward quote

Example:

$0.3968/78 15/17 33/38 93/103 per SFr

EXCHANGE RATE QUOTATIONS

• Outright Quotation: The Outright Quote is the same as

quoting spot exchange rates For example the outright forward quote on the 3-month SFr could have been $.4001/.4016 which mean that the bank will buy SFr at $.4001/SFr and sell it at

• Rule of Thumb is that as we move into quotes for

future dates the spread between the bid and the ask

must increase The economic intuition for this is that

as we go further into the future, risk increases and thus the banks charge a higher rate for their services -

thereby widening the spread.

• Cross Rate: Exchange rate involving two currencies other than

the US dollar Generally, cross rates are calculated from US$ rates

For example, given the following dollar exchange rates:

SPOT EXCHANGE MARKET

SPOT EXCHANGE MARKET

• Arbitrage: risk free profit from explicit market disequilibrium

(Bid > Ask):

- Buy cheap in one int’l market, sell at a higher price in another

- The Critical Role of Available Information

• Arbitrage across market-makers

– Two- way arbitrage opportunity

– One – way arbitrage opportunity

SPOT EXCHANGE MARKET

Exchange Risk

• Bankers = middlemen

a Incurring risk of adverse exchange rate moves

b Increased uncertainty about future exchange rate requires

b1) Demand for higher risk premiumb2) Bankers widen bid-ask spread

Example 1: No Transaction Costs

Citibank quotes DM/USD 1.6500

Chemical Bank quotes DM/USD 1.6501

- Two-Way: Buy from Citibank, sell to Chemical Bank

netting USD 0001/DM

- One-Way: All buyers of USD go to Citibank & all sellers

of USD go to Chemical Bank

To avoid arbitrage opportunities, both quote the same price for USD in DM

SPOT EXCHANGE MARKET

Example 2: With Transaction Costs (bid-ask spread)

• Strong arbitrage opportunities between banks X and Y

• Not so between banks Z and Y

SPOT EXCHANGE MARKET

Example 3: 3-Point Arbitrage Opportunity

FORWARD/FUTURE EXCHANGE MARKETS

FORWARD/FUTURE EXCHANGE MARKETS

• Forward Rate: The forward rate is the rate that is contracted

today for the delivery of a a currency at a specified date in the future, at a price agreed upon today

• Forward rate reflects the market’s risk-adjusted

expectations about the future spot rate

• Implications for: - Financial reporting

- Pricing for exports

- Firm’s invoicing and management policies

risk-• Forward Premium/Discount: Difference between a N-day

forward price and the spot price expressed as percent per annum

• Forward or Future Contract: Agreement to buy or sell a

specified quantity of an asset as a specified price at a specified time and place

• How to hedge with Forward Contract:

Spot Rate = $1.6/BP Exporter Sell Forward

Forward Rate = $1.7/BP Importer Buy Forward

CURRENCY FUTURES

• Market History:

1 Background

a Long history

b Extremely volatile due to their information driven nature

c The market plays a Price Discovery Role for other financial markets such as the cash markets

FORWARD/FUTURE EXCHANGE MARKETS

CURRENCY FUTURES (cont.)

• International Monetary Market (IMM) 1972:

- Opened by the Chicago Mercantile Exchange

- Purpose: to provide a stable market for the exchange of

currency futures

FORWARD/FUTURE EXCHANGE MARKETS

- IMM provides: an outlet for hedging currency

risk with futures contracts

- Definition of a Futures Contract:

contracts written requiring a standard quantity of

an available currency at a fixed exchange rate at a set delivery date

FORWARD/FUTURE EXCHANGE MARKETS

FORWARD/FUTURE EXCHANGE MARKETS

• Special Features of Future Markets

- Clearing House: Guarantees contract performance by

taking opposite side of the contract

Independent Corporation member clearing firm

- Margin Requirement: Post margin money with a member

clearing firm with a brokerage house

Reduction of Credit Risk

Initial Margin Vs Maintenance Margin

• Maintenance Margins:

When the account balance falls below the maintenance margin, a margin call may be necessary to maintain the minimum balance

FORWARD/FUTURE EXCHANGE MARKETS

FORWARD/FUTURE EXCHANGE MARKETS

• Special Features of Future Markets (cont.):

- Daily Resettlement: Marking to Market

Traders realize looses or gains daily

Example:

Contract Size = SF125,000 Futures Price = $0.694/SF

Today’s Price = $0.70/SF

Tomorrow = $0.72/SFHolder gains = 125,000 (0.70 - 0.694) = $750

125,000 (0.72 - 0.7) = $2,500

• Maximum price movement rules:

Contracts set daily to a price limit that restricts maximum daily upward and downward

movements.

FORWARD/FUTURE EXCHANGE MARKETS

• Special Features of Future Markets (cont.)

- Daily Price Limit:

Up Limit and Down LimitPosition Limit (# of contracts)

- Delivery Terms:

Cash settlement

ORReversing Trades

FORWARD/FUTURE EXCHANGE MARKETS

• Special Features of Future Markets (cont.)

- Executing Trades: Commission Broker Vs Locals

Locals: Scalpers

Day TradersPosition Traders(client) (own)

• Comparison of Forward and Futures Contract:

Phone/TelexSelf-regulating90% deliveredTailor made (larger)Any date

5% deliveredFixed

Few dates

FORWARD/FUTURE EXCHANGE MARKETS

• Comparison of Forward and Futures Contract (cont.):

FORWARD/FUTURE EXCHANGE MARKETS

Between bank &

customer on any dateEuropean

Bid-Ask spread Not RequiredHigh

RequiredLow

9 Margins

10 Credit Risk

2.) Limited dates of delivery

3.) Rigid contract sizes

• Global futures exchanges:

1.) I.M.M International Monetary Market

2.) L.I.F.F.E.London International Financial Futures Exchange3.) C.B.O.T Chicago Board of Trade

4.) S.I.M.E.X.Singapore International Monetary Exchange

5.) D.T.B Deutsche Termin Bourse

6.) H.K.F.E Hong Kong Futures Exchange

FUTURES CONTRACTS

FORWARD/FUTURE EXCHANGE MARKETS

• Forward and Money Market Relationship:

Buy/Sell in Futures Market

Buy FC spot

1/StSell FC spot

St

FORWARD/FUTURE EXCHANGE MARKETS

• Forward and Money Market Relationship:

Borrow/Invest in Money Market

HCt

HCt

Borrow1/ 1+rt,T

Invest1+rt,T

t = 0

t = T

Invest 1+r*t,T

Borrow 1/ 1+r*t,T

Invest 1+rt,T

FORWARD/FUTURE EXCHANGE MARKETS

• Forward and Money Market Relationship:

FORWARD AND MONEY MARKET RELATIONSHIP

FT So

1 + rf

OPTIONS CURRENCY MARKETS

• Currency options

1 Offer another method to hedge exchange rate risk

2 First offered on Philadelphia Exchange (PHLX)

OPTIONS CURRENCY MARKETS

• Option: Right to buy (Call) or sell (Put) foreign currency or

currency futures

• Call Option: Right to purchase underlying asset (e.g foreign

currency or common stock) at a certain strike price any time prior to or on a specified expiration date

Buy a Call Option Pay a Premium

Write a Call Option Receive a Premium

OPTIONS CURRENCY MARKETS

• Put Option: Right to sell underlying asset (e.g foreign

currency or common stock) at a certain strike price any time prior to or on a specified expiration date

Buy a Put Option Pay a Premium

Write a Put Option Receive a Premium

• European option can be exercised only at maturity

• American option can be exercised at any time

OPTIONS CURRENCY MARKETS

Buyers Sellers = Writers

Right to

Buy

Right to Sell

Must Buy

Must Sell

CALL

PUT

Premium HOW CURRENCY OPTIONS ARE PURCHASED