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Factors that make multinational financial management different

Exchange rates and tradingInternational monetary systemInternational financial marketsSpecific features of multinational

financial management

CHAPTER 26Multinational Financial Management

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What is a multinational corporation?

A multinational corporation is one that operates in two or more countries.

At one time, most multinationals produced and sold in just a few countries.

Today, many multinationals have world-wide production and sales.

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Why do firms expand into other countries?

To seek new markets.

To seek new supplies of raw materials.

To gain new technologies.

To gain production efficiencies.

To avoid political and regulatory obstacles.

To reduce risk by diversification.

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What are the major factors that distinguish multinational from

domestic financial management?

Currency differences

Economic and legal differences

Language differences

Cultural differences

Government roles

Political risk

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Are these currency prices direct or indirect quotations?

Since they are prices of foreign currencies expressed in U.S. dollars, they are direct quotations (dollars per currency).

Consider the following exchange rates:

U.S. $ to buy 1 Unit

Euro 0.8000Swedish krona 0.1000

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What is an indirect quotation?

An indirect quotation gives the amount of a foreign currency required to buy one U.S. dollar (currency per dollar).

Note than an indirect quotation is the reciprocal of a direct quotation.

Euros and British pounds are normally quoted as direct quotations. All other currencies are quoted as indirect.

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Calculate the indirect quotationsfor euros and kronas.

# of Units of Foreign Currency per U.S. $

Euro 1.25Swedish krona 10.00

Euro: 1 / 0.8000 = 1.25.Krona: 1 / 0.1000 = 10.00.

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What is a cross rate?

A cross rate is the exchange rate between any two currencies not involving U.S. dollars.

In practice, cross rates are usually calculated from direct or indirect rates. That is, on the basis of U.S. dollar exchange rates.

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Cross rate = x

= 1.25 x 0.1000= 0.125 euros/krona.

Cross rate = x

= 10.00 x 0.8000= 8.00 kronas/euro.

Calculate the two cross ratesbetween euros and kronas.

Euros Dollars Dollar Krona

Kronas Dollars Dollar Euros

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The two cross rates are reciprocals of one another.

They can be calculated by dividing either the direct or indirect quotations.

Note:

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Target price = ($1.75)(1.50)=$2.625

Spanish price = ($2.625)(1.25 euros/$)

= € 3.28.

Assume the firm can produce a liter oforange juice in the U.S. and ship it to

Spain for $1.75. If the firm wants a 50% markup on the product, what should the juice sell for in Spain?

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2.0 euros (8.0 kronas/euro) = 16 kronas.

20 - 16 = 4.0 kronas profit.

Dollar profit = 4.0 kronas(0.1000 dollars per krona) = $0.40.

Now the firm begins producing theorange juice in Spain. The product

costs 2.0 euros to produce andship to Sweden, where it can be sold

for 20 kronas. What is the dollarprofit on the sale?

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Exchange rate risk is the risk that the value of a cash flow in one currency translated from another currency will decline due to a change in exchange rates.

What is exchange rate risk?

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Currency Appreciation and Depreciation

Suppose the exchange rate goes from 10 kronas per dollar to 15 kronas per dollar.

A dollar now buys more kronas, so the dollar is appreciating, or strengthening.

The krona is depreciating, or weakening.

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Affect of Dollar Appreciation

Suppose the profit in kronas remains unchanged at 4.0 kronas, but the dollar appreciates, so the exchange rate is now 15 kronas/dollar.

Dollar profit = 4.0 kronas / (15 kronas per dollar) = $0.267.

Strengthening dollar hurts profits from international sales.

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The current system is a floating rate system.

Prior to 1971, a fixed exchange rate system was in effect.

The U.S. dollar was tied to gold.

Other currencies were tied to the dollar.

Describe the current and formerinternational monetary systems.

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The European Monetary Union

In 2002, the full implementation of the “euro” was completed (those still holding former currencies have 10 years to exchange them at a bank). The newly formed European Central Bank now controls the monetary policy of the EMU.

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The 12 Member Nations of theEuropean Monetary Union

Austria

Belgium

Finland

France

Germany

Ireland

Italy

Luxembourg

Netherlands

Portugal

Spain

Greece

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A currency is convertible when the issuing country promises to redeem the currency at current market rates.

Convertible currencies are traded in world currency markets.

What is a convertible currency?

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It becomes very difficult for multi-national companies to conduct business because there is no easy way to take profits out of the country.

Often, firms will barter for goods to export to their home countries.

What problems arise when a firmoperates in a country whose currency is not convertible?

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A spot rate is the rate applied to buy currency for immediate delivery.

A forward rate is the rate applied to buy currency at some agreed-upon future date.

Forward rates are normally reported as indirect quotations.

What is the difference between spot rates and forward rates?

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When is the forward rate at a premium to the spot rate?

If the U.S. dollar buys fewer units of a foreign currency in the forward than in the spot market, the foreign currency is selling at a premium.

For example, suppose the spot rate is 0.7 £/$ and the forward rate is 0.6 £/$.

The dollar is expected to depreciate, because it will buy fewer pounds.

Continued….

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Spot rate = 0.7 £/$Forward rate = 0.6 £/$.

The pound is expected to appreciate, since it will buy more dollars in the future.

So the forward rate for the pound is at a premium.

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When is the forward rate at a discount to the spot rate?

If the U.S. dollar buys more units of a foreign currency in the forward than in the spot market, the foreign currency is selling at a discount.

The primary determinant of the spot/forward rate relationship is the relationship between domestic and foreign interest rates.

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What is interest rate parity?

Interest rate parity implies that investors should expect to earn the same return on similar-risk securities in all countries:

Forward and spot rates are direct quotations.

rh = periodic interest rate in the home country.

rf = periodic interest rate in the foreign country.

Forward rateSpot rate

=1 + rh

1 + rf

.

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Spot rate = $0.8000.rh = 6%/2 = 3%.rf = 4%/2 = 2%.

(More...)

Assume 1 euro = $0.8100 in the180-day forward market and and 180-day risk-free rate is 6% in the U.S. and

4% in Spain.

Does interest rate parity hold?

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Forward rate 0.8000

If interest rate parity holds, the implied forward rate, 0.8078, would equal the observed forward rate, 0.8100; so parity doesn’t hold.

Forward rateSpot rate =

1 + rh

1 + rf

=1.031.02

Forward rate = 0.8078.

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A U.S. investor could directly invest in the U.S. security and earn an annualized rate of 6%.

Alternatively, the U.S. investor could convert dollars to euros, invest in the Spanish security, and then convert profit back into dollars. If the return on this strategy is higher than 6%, then the Spanish security has the higher rate.

Which 180-day security (U.S. or Spanish) offers the higher return?

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What is the return to a U.S. investor in the Spanish security?

Buy $1,000 worth of euros in the spot market:

$1,000(1.25 euros/$) = 1,250 euros.

Spanish investment return (in euros):

1,250(1.02)= 1,275 euros.

(More...)

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Buy contract today to exchange 1,275 euros in 180 days at forward rate of 0.8100 dollars/euro.

At end of 180 days, convert euro investment to dollars:

€1,275 (0.8100 $/€) = $1,032.75.

Calculate the rate of return:

$32.75/$1,000 = 3.275% per 180 days

= 6.55% per year.(More...)

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The Spanish security has the highest return, even though it has a lower

interest rate.

U.S. rate is 6%, so Spanish securities at 6.55% offer a higher rate of return to U.S. investors.

But could such a situation exist for very long?

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Arbitrage

Traders could borrow at the U.S. rate, convert to pesetas at the spot rate, and simultaneously lock in the forward rate and invest in Spanish securities.

This would produce arbitrage: a positive cash flow, with no risk and none of the traders own money invested.

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Impact of Arbitrage Activities

Traders would recognize the arbitrage opportunity and make huge investments.

Their actions would tend to move interest rates, forward rates, and spot rates to parity.

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What is purchasing power parity?

Purchasing power parity implies that the level of exchange rates adjusts so that identical goods cost the same amount in different countries.

Ph = Pf(Spot rate),

or

Spot rate = Ph/Pf.

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If grapefruit juice costs $2.00/liter in the U.S. and purchasing power parity

holds, what is price in Spain?

Spot rate = Ph/Pf. $0.8000= $2.00/Pf

Pf = $2.00/$0.8000 = 2.5 euros.

Do interest rate and purchasing power parity hold exactly at any point in time?

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Lower inflation leads to lower interest rates, so borrowing in low-interest countries may appear attractive to multinational firms.

However, currencies in low-inflation countries tend to appreciate against those in high-inflation rate countries, so the true interest cost increases over the life of the loan.

What impact does relativeinflation have on interest rates

and exchange rates?

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Eurodollar marketsDollars held outside the U.S.Mostly Europe, but also elsewhere

International bondsForeign bonds: Sold by foreign

borrower, but denominated in the currency of the country of issue.

Eurobonds: Sold in country other than the one in whose currency it is denominated.

Describe the international money and capital markets.

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To what extent do capital structures vary across different countries?

Early studies suggested that average capital structures varied widely among the large industrial countries.

However, a recent study, which controlled for differences in accounting practices, suggests that capital structures are more similar across different countries than previously thought.

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International Cash Management

Distances are greater.

Access to more markets for loans and for temporary investments.

Cash is often denominated in different currencies.

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Multinational Capital Budgeting Decisions

Foreign operations are taxed locally, and then funds repatriated may be subject to U.S. taxes.

Foreign projects are subject to political risk.

Funds repatriated must be converted to U.S. dollars, so exchange rate risk must be taken into account.

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Multinational Credit Management

Credit is more important, because commerce to lesser-developed countries often relies on credit.

Credit for future payment may be subject to exchange rate risk.

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Multinational Inventory Management

Inventory decisions can be more complex, especially when inventory can be stored in locations in different countries.

Some factors to consider are shipping times, carrying costs, taxes, import duties, and exchange rates.