INTERNATIONAL FINANCIAL MANAGEMENT PEARSON

 Compute domestic equivalents of foreign currencies given the spot or forward exchange rates.. Important Exchange-Rate Terms Currency risk can be thought of as the volatility of the

Chapter 24

International

Financial Management

International

Financial Management

© Pearson Education Limited 2004 Fundamentals of Financial Management, 12/e

After studying Chapter 24, you should be able to:

 Explain why many firms invest in foreign operations.

 Explain why foreign investment is different from domestic

investment

 Describe how capital budgeting, in an international

environment, is similar or dissimilar to that in a domestic environment

 Understand the types of exchange-rate exposure and how to

manage exchange-rate risk exposure

 Compute domestic equivalents of foreign currencies given

the spot or forward exchange rates

 Understand and illustrate the purchasing-power parity (PPP)

and interest rate parity.

 Describe the specific instruments and documents used in

structuring international trade transactions.

Distinguish among countertrade, export factoring, and

International Financial Management

Some Background

 Fill product gaps in foreign markets where

excess returns can be earned.

 To produce products in foreign markets

more efficiently than domestically.

 To secure the necessary raw materials

required for product production.

What is a company’s motivation to

invest capital abroad?

International Capital Budgeting

1 Estimate expected cash flows in the foreign

currency.

2 Compute their U.S.-dollar equivalents at the

expected exchange rate.

3 Determine the NPV of the project using the U.S

required rate of return, with the rate adjusted upward or downward for any risk premium effect How does a firm make an international

capital budgeting decision?

International Capital Budgeting

 Only consider those cash flows that can

be “repatriated” (returned) to the country parent.

home- The exchange rate exchange rate is the number of units

of one currency that may be purchased with one unit of another currency.

 For example, the current exchange rate might be 2.50 Freedonian marks per one U.S dollar.

International Capital Budgeting Example

 A firm is considering an investment in

Freedonia, and the initial cash outlay is 1.5 million marks.

 The project has 4-year project life with cash flows given on the next slide.

 The appropriate required return appropriate required return for

repatriated U.S dollars is 18% is 18%

 The appropriate expected exchange rates expected exchange rates are given on the next slide.

International project details:

International Capital Budgeting Example

Expected Cash Flow (marks)

Expected Cash Flow (U.S dollars)

Present Value

of Cash Flows

at 18%

Exchange Rate (marks

to U.S dollar)

International Capital Budgeting

 International diversification and risk

reduction

 U.S Government taxation

 Taxable income derived from non-domestic operations through a branch or division is taxed under U.S code.

 Foreign subsidiaries are taxed under foreign tax codes until dividends are received by the U.S parent from the foreign subsidiary.

Related issues of concern:

International Capital Budgeting

 Tax codes and policies differ from country to country, but all countries impose income taxes

International Capital Budgeting

 Expropriation is the ultimate political risk.

 Developing countries may provide financial incentives to enhance foreign investment.

 Bottom line: Forecasting political instability Forecasting political instability

 Protect the firm by hiring local nationals, acting responsibly in the eyes of the host government, entering joint ventures, making the subsidiary reliant on the parent company, and/or

purchasing political risk insurance political risk insurance.

 Political Risk

Important Exchange-Rate Terms

 Currency risk can be thought of as the volatility

of the exchange rate of one currency for another (say British pounds per U.S dollar).

Spot Exchange Rate The rate today for exchanging one currency for another for

immediate delivery immediate delivery.

Forward Exchange Rate The rate today for exchanging one currency for another at

a specific future date

a specific future date.

Types of Rate Risk Exposure

Exchange- Translation Exposure Relates to the change in accounting income and balance sheet statements caused by changes in exchange rates

 Transactions Exposure Relates to settling a

particular transaction at one exchange rate when the obligation was originally recorded at another

 Economic Exposure Involves changes in

expected future cash flows, and hence economic value, caused by a change in exchange rates.

Management of Rate Risk Exposure

Exchange- Natural hedges

 Adjusting of intracompany

accounts

 International financing hedges

 Currency market hedges

Natural Hedges

 Both scenarios are natural hedges as any gain (loss) from exchange rate fluctuations in pricing is reduced by an offsetting loss (gain) in costs in

Globally Domestically Determined Determined

Natural Hedges “Not!”

 Both of these scenarios are not natural hedges and thus create a possible firm exposure to events that impact one market and not the other market.

Globally Domestically Determined Determined

Cash Management

 Exchange cash for real assets (inventories) whose value is in their use rather than tied to a currency.

 Reduce or avoid the amount of trade credit that will

be extended as the dollar value that the firm will receive is reduced and reduce any cash that does arrive as quickly as possible.

 Obtain trade credit or borrow in the local currency

What should a firm do if it knew that a local foreign currency was going to fall in value (e.g., drop from

$.70 per peso to $.60 per peso)?

Cash Management

 Generally, one cannot predict the future

exchange rates, and the best policy would be

to balance monetary assets against monetary liabilities to neutralize the effect of exchange- rate fluctuations.

 A reinvoicing center reinvoicing center is a company-owned

financial subsidiary that purchases exported goods from company affiliates and resells

(reinvoices) them to other affiliates or independent customers.

Cash Management

 Generally, the reinvoicing center is billed in the

selling unit’s home currency and bills the purchasing unit in that unit’s home currency.

 Allows better management of intracompany

transactions.

Netting A system in which cross-border purchases among participating subsidiaries of the same company are netted so that each participant pays or receives only the net amount

of its intracompany purchases and sales.

International Financing Hedges

 Foreign commercial banks perform essentially the same financing functions as domestic banks except:

 They allow longer term loans.

 Loans are generally made on an overdraft basis overdraft basis.

 Nearly all major commercial cities have U.S bank branches or offices available for customers.

 The use of “discounting” trade bills is widely utilized

in Europe versus minimal usage in the United States.

1 Commercial Bank Loans and Trade Bills

International Financing Hedges

 Eurodollars are bank deposits denominated in U.S dollars but not subject to U.S banking regulations.

 This market is unregulated Therefore, the differential between the rate paid on deposits and that charged

on loans varies according to the risk of the borrower and current supply and demand forces.

 Rates are typically quoted in terms of the LIBOR.

 It is a major source of short-term financing for the

working capital requirements of the multinational

2 Eurodollar Financing

International Financing Hedges

 A Eurobond Eurobond is a bond issued internationally outside

of the country in whose currency the bond is denominated

 The Eurobond is issued in a single currency, but is placed in multiple countries.

 A foreign bond foreign bond is issued by a foreign government or

corporation in a local market For example, Yankee

bonds, and Samurai bonds.

 Many international debt issues are floating rate notes floating rate notes that carry a variable interest rate.

3 International Bond Financing

International Financing Hedges

 Currency-option bonds provide the holder with the

option to choose the currency in which payment is received For example, a bond might allow you to choose between yen and U.S dollars.

 Currency cocktail bonds provide a degree of rate stability by having principal and interest payments being a weighted average of a “basket” of currencies.

exchange- Dual-currency bonds have their purchase price and

coupon payments denominated in one currency, while a different currency is used to make principal payments.

4 Currency-Option and Multiple-Currency bonds

Currencies and the Euro

 Each country has a representative currency like the $ (dollar) in the United States or the ₤ (pound)

in Britain.

 On January 1, 1999, the “ euro ” started trading.

 The euro is the common currency of the European Monetary Union (EMU), which currently includes the following 12 European Union (EU) countries:

 Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the

Netherlands, Portugal, and Spain.

Euro – The name given to the single European currency Symbol is € (much like the dollar, $).

Currency Market Hedges

 A forward contract forward contract is a contract for the delivery of a

commodity, foreign currency, or financial instrument at a price specified now, with delivery and settlement at a

specified future date.

Spot rate $.168 per EFr

90-day forward rate 166 per EFr

 As shown, the Elbonian franc (EFr) is said to sell at a

forward discount as the forward price is less than the

spot rate.

 If the forward rate is $.171, the EFr is said to sell at a

1 Forward Exchange Market

Currency Market Hedges

 The firm has the option of selling 1 million Elbonian francs forward 90 days The firm will receive

$166,000 in 90 days (1 million Elbonian francs x

$.166).

 Therefore, if the actual spot price in 90 days is less

than 166, the firm benefited from entering into this transaction

 If the rate is greater than 166, the firm would have

benefited from not entering into the transaction.

Fillups Electronics has just sold equipment worth

1 million Elbonian francs with credit terms of “net 90.” How can the firm hedge the currency risk? How can the firm hedge the currency risk?

Currency Market Hedges

 Typical discount or premium ranges for

stable currencies are from 0 to 8%, but may

be as high as 20% for unstable currencies.

How much does this “insurance” cost?

Annualized cost of protection

= ( $.002 )/( $.168 ) X ( 365 days / 90 days)

= 011905 X 4.0556

= 0483 or 4.83% 4.83%

Currency Market Hedges

 A futures contract futures contract is a contract for the delivery of a

commodity, foreign currency, or financial instrument at a specified price on a stipulated future date.

 A currency futures market exists for the major

currencies of the world.

 Futures contracts are traded on organized exchanges.

 The clearinghouse of the exchange interposes itself

between the buyer and the seller Therefore, transactions are not made directly between two parties.

 Very few contracts involve actual delivery at expiration.

2 Currency Futures

Currency Market Hedges

 Sellers (buyers) cancel a contract by purchasing

(selling) another contract This is an offsetting position that closes out the original contract with the

clearinghouse.

 Futures contracts are marked-to-market daily This is different than forward contracts that are settled only at maturity.

 Contracts come in only standard-size contracts (e.g., 12.5 million yen per contract).

2 Currency Futures (continued)

Currency Market Hedges

 A currency option currency option is a contract that gives the holder the right to buy (call) or sell (put) a specific amount of a

foreign currency at some specified price until a certain (expiration) date.

 Currency options hedge only adverse currency

movements (“one-sided” risk) For example, a put option can hedge only downside movements in the currency exchange rate.

 Options exist in both the spot and futures markets.

 The value depends on exchange rate volatility.

3 Currency Options

Currency Market Hedges

 In a currency swap currency swap two parties exchange debt

obligations denominated in different currencies Each party agrees to pay the other’s interest obligation At maturity, principal amounts are exchanged, usually at a rate of exchange agreed to in advance.

 The exchange is notional only the cash flow difference

is paid.

 Swaps are typically arranged through a financial

intermediary, such as a commercial bank.

4 Currency Swaps

Macro Factors Governing Exchange-Rate Behavior

 The idea that a basket of goods should sell for the same price in two countries, after exchange rates are taken into account.

 For example, the price of wheat in Canadian

and U.S markets should trade at the same price (after adjusting for the exchange rate) If the price of wheat is lower in Canada, then

purchasers will buy wheat in Canada as long as the price is cheaper (after accounting for

transportation costs)

Purchasing-Power Parity (PPP)

Macro Factors Governing Exchange-Rate Behavior

 Thus, demand will fall in the U.S and increase in

Canada to bring prices back into equilibrium.

 The price elasticity of exports and imports influences the relationship between a country’s exchange rate and its purchasing-power parity.

 Commodity items and products in mature industries are more likely to conform to PPP.

 Frictions such as government intervention and trade barriers cause PPP not to hold.

Purchasing-Power Parity (PPP continued)

Macro Factors Governing Exchange-Rate Behavior

 It suggests that if interest rates are higher in one

country than they are in another, the former’s currency will sell at a discount in the forward market.

 Remember that the Fisher effect implies that the

nominal rate of interest equals the real rate of interest plus the expected rate of inflation.

 The international Fisher effect suggests that

differences in interest rates between two countries serve as a proxy for differences in expected inflation.

Interest-Rate Parity

Macro Factors Governing Exchange-Rate Behavior

F = current forward exchange-rate in foreign

currency per dollar.

S = current spot exchange-rate in foreign currency

per dollar.

r foreign = foreign interbank Euromarket interest rate

Interest-Rate Parity (continued)

The international Fisher effect suggests:

F

1 + r foreign

1 + r dollar

Interest-Rate Parity Example

 The current German 90-day interest rate is 4%.

 The current U.S 90-day interest rate is 2%.

 The current spot rate is 706 Freedonian marks per U.S dollar ($1.416 per mark).

What is the implied 90-day forward

Interest-Rate Parity Example

F = (1.04) x (.706 706 ) / (1.02)

= 720 720

Thus, the implied 90-day forward implied 90-day forward

The implied 90-day forward rate implied 90-day forward rate is:

F 706 =

1 + 04

1 + 02