9/17/20151 Multinational Corporate Finance (MCF) Dr. Richard Michelfelder Fall 2015.

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Multinational Corporate Finance (MCF)

Dr. Richard Michelfelder

Fall 2015

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MCF Topics1. Introduction to MCF

2. The Balance of Trade, Balance of Payments and International Macroeconomics

3. Foreign Currency Markets: Spot and Forward Markets

4. Exchange Rates, Monetary Theory and Policy: How Changes in the Money Supply Affect Exchange Rates and Forecasting Exchange Rates in the Short Run

5. Inflation, Interest Rates, and Exchange Rates (Purchasing Power Parity, Interest Rate Parity, and Exchange Rate Forecasting in the Long-Run)

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MCF Topics

6. Hedging and Speculating Foreign Exchange Rate Risk: Currency Futures and Options

7. Measuring and Managing Economic Exposure

8. Measuring and Managing Translation and Transaction Exposure

9. International Equity Markets, Portfolio Investment and Diversification

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Outline 1: Introduction to MCF

1. Overview of MCF1.1 Introduction to Multinational Corporate Finance 1.1.1 The Multinational Corporation (MC)1.2 Primer on Foreign Exchange (FX) Rates Determination1.3 The International Monetary System

1.3.1 Fixed v. Floating Exchange Rates

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1. Overview of MCF

• MC’s deal in foreign currency, capital, and goods markets so we need to understand the interactions of these markets:– Inflation (goods markets)– FX rates (currency markets)– Interest rates (bond markets)– Equity markets (stock markets)

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1.1 Introduction to MCF

• 1st Objective: Maximize Shareholder Value– Increase cash flow and reduce risk

– Increase Ps (stock price) by increasing CFt (cash flow in future year t ) with ks (discount rate and price of risk) constant or falling:

P

C F

ks

t

s

tt

11

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• For a firm that does in business in multiple currencies (i.e., multinational firm) CF’s are affected by currency value fluctuations– Therefore Ps (CF’s and k) is affected by FX

(foreign exchange) fluctuations

P

C F

ks

t

s

tt

11

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• Secondary Objectives include the interests of other stakeholders:– Customers

– Employees

– Community (can be any geographic region such as a locale or a nation)

• Harvard “Balanced Scorecard Approach” has management goals related to each stakeholder

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• Functions of Financial Management: involves the acquisition and investment of funds:– Acquisition: internally generate or raise capital

– Investment: apply funds to business endeavors that maximize CF with less than proportionate risk

• Additional risks of MC’s:– Political risk

– Exchange rate risk

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• Globalization:– Financial markets: find lowest cost of capital and

optimal investment opportunities worldwide (more opportunities than US alone)

– Goods markets: find lowest prices for similar goods worldwide

– Financial/goods markets are linked:• Due to lowered costs and advances in transportation,

communications, and information systems

– Worldwide competition

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• Globalization:– Increased diversification opportunities:

• Investing in new stock markets to increase k and decrease of k (standard deviation of k, or, risk)

• Investing in new bond markets

– Buy/sell goods– Arbitrage across countries for lowest price

– Sell goods where demand and price is higher

– World population: 6.7 Billion v. US ~ 304 million

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• Globalization:– Labor diversification (e.g. Engineers in Russia):

• Skills• Cost• Availability

– Capital diversification (e.g. world stock portfolio)

– Land diversification (e.g. Campbells Soup tomato farm diversification to ensure supply)

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• Multinational corporations seek and exploit such diversification for higher profits (k) and risk management () – E.g. tobacco companies market foci shifting to

Asia

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• Economic Basis for International Trade: What is the motivation for trading among countries?– Comparative Advantage Based on Opportunity

Cost:• Cost of one commodity is the amount of a 2nd

commodity that must be given up in order to release enough factors of production (land, labor, capital. entrepreneurship (risk-taking)) to produce 1 additional unit of 1st commodity

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• Comparative Advantage Based on Opportunity Cost (CONTINUED):

– The nation with lower opportunity cost for a commodity has a comparative advantage in that commodity and a comparative disadvantage in other commodity.

– The production possibilities frontier represents the advantage to each country and the gains from trade.

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• Production Possibilities Frontier:

– Assume two goods, wheat and cloth

– In the absence of trade nations can only consume what they produce

– Two country example:

UK US

Wheat (millions bushels/year)

60 160

Cloth (millions of yards/year)

120 80

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1.1 Introduction to MCFProduct. Poss. Frontier: Produce & Consume A, A* In

Absence of Trade

Wheat

Cloth

Wheat

Cloth

UK US

60

120

160

80

40

40

80

40

A

A*

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• Gains from trade:– UK price of cloth in terms of wheat:

P

Pc

w

6 0

1 2 00 5.

– US price of cloth in terms of wheat:

P

Pc

w

1 6 0

8 02

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Mutually advantageous trade is possible if:

0 5 2. P

Pc

w

Set trade price as below and UK specializes in cloth and US in wheat; trade 60 C for 60 W

P

Pc

w

1

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1.1 Introduction to MCFWith Trade, UK Prod. Cloth, US Produces Wheat and Trade at

Pc/Pw = 1, Consume B, B*

Wheat

Cloth

Wheat

Cloth

UK US

60

120

160

80

40

40

80

40

A

A*B*

B

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With International Trade, Both Countries Consume More than They Can Produce Due to the Gains From Trade.

This is the Motivation for Trade Among Countries and a Key Reason Why Different International Monetary Systems Have Been Developed to Attempt to Minimize Volatility of FX Rates – To Encourage More Trade.

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1.1Introduction to MCF

• Theory of international trade is becoming less relevant since MC’s are reducing nations’ trade advantages.

• MC’s enter nations seeking advantages in:– Factors of production (land, natural resources,

labor, and capital)– Markets

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1.1Introduction to MCF

• Trade theory assumed factors were not mobile.

• Differences and advantages remain across countries and give rise to international markets in goods and capital.

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1.1.1Multinational Corporation

• MC is a company engages in producing and selling goods / services in more than one country.

• MC usually has a domestic parent or holding company with foreign divisions or subsidiaries– E.g. Comverge Technologies, Inc. had US,

Middle Eastern / S. America, and Asia (Taiwan, India, Thailand) divisions

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Example Organization Chart of MC

C om verg e Tech n o log ies , In c .

D S I, In c .M id d le E as t, S . A m erica

C om verg e Tech n o log ies , In c .U S

C om verg e Tech n o log ies , In c .A s ia

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1.1.1 Multinational Corporation

• Globally coordinate allocation of resources by a single centralized management

• (time can be allocated due to time differences – keep moving a project around the world for different teams to get done faster – 24 hour workday)

• 3 Types of MC’s:1. Raw material seekers e.g, oil companies

2. Market seekers e.g., Coca Cola, Phillip Morris

3. Cost minimizers e.g., Intel, bank Call Centers, “outsourcing”

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1.1.1 Multinational Corporation

• MC’s are characterized more by their scope in conducting business than in size

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1.2 Primer on FX Rates Determination

• FX rate: price of one nation’s currency in terms of another nation’s currency– Usually expressed as the domestic currency

price of 1 unit of foreign currency:

E = $ / b = $0.025

where b is the symbol for the Thai baht; 1b = $0.025

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• 1/E is the foreign currency price of 1 unit of domestic currency:

1 14 0 0 0

Eb

bb

$ $$ 1.

The price of a US $ is 40 baht. (Review Wall Street Journal FX rates quotes.)

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• Spot FX rate: is the price to purchase or sell one unit of foreign currency to be delivered in 2 business days.

• Forward rate: is the price agreed today to buy or sell a specified quantity of foreign currency for future delivery (30, 60, 90, 180, X days).

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• Where is the FX market:

– Banks are the principal agents (FX desks), currency brokers

• Quote example for Deutche Mark:

Bid (Buy) Ask (Sell)

$/DM $0.4918 $0.4924

The bank or broker earn the bid-ask spread as the fee for

trading FX (0.4924-0.4918/0.4918) x 100 = 0.122%.

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• How are the FX rates determined - by the market (demand and supply)– Supply of £ derived from UK demand for US

goods and $ denominated securities.– Demand for £ derived from US demand for UK

goods and £ denominated securities.

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$/£

Q£

D£

E0

Q£

Demand & Supply for UK £

S£

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– Depreciation: in value of currency in terms of other currency ( in e depreciating foreign currency)

– Appreciation: in value of currency in terms of other currency ( in e appreciating foreign currency)

• E.g. Baht appreciation: E0 = $/b = 0.025, E1 = $/b = 0.03

E E

E1 0

0

0 0 3 0 0 0 2 5

0 0 2 50 2

. .

..

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– Depreciation: in value of currency in terms of other currency ( in e depreciating foreign currency)

– The $ depreciation in this example is 16.7%:

1 1

1

1 0

0

3 3 3 3 4 0

4 00 1 6 7E E

E

..

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$/£

Q£

D£ S£*

E0

Q£

Appreciation of UK £ & Depreciation in $

S£

D£*

E1

Q£*

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• Expectations and FX Rates:– Depend upon expectations about future movements of FX rates– Currencies are financial assets and FX rates the relative price of two

assets, therefore their prices are determined similarly as stocks, bonds, etc.

• FX and Money:– Money provide liquidity, store of value, medium of exchange, facilitates

transactions.– Money supply determined by central banks (e.g. Fed. Res. Sys, European

Central Bank,…)– Money demand depends upon E(inflation), demand for liquidity for

transactions (GDP), demand for assets denominated in that currency (risk-adjusted expected rate of return on assets).

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1.3 The International Monetary System (IMS)

• IMS refers to the system used to determine FX rates among countries:– Policies– Institutions– Practices– Regulations

• IMS was a fixed FX rate system from 1946 to 1971: Bretton Woods System

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• Under Bretton Woods IMS, FX rates were a fixed FX rate system from 1946 to 1971 (System Collapsed in 1971)– Fixed FX rates defined in $ values– International convertibility of $ into gold– Intent was to stabilize FX rates and promote trade and

investment among countries– FX volatility reduces trade & investment due to risk of

losses from FX rate changes, FX transactions costs for hedging FX risk.

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• Post-Bretton Woods: Currently (starting in 1971) the IMS is a floating FX rate system.– I.e., FX rates set by demand and supply– The $ became the benchmark international

currency used to value others.– Became ‘the’ international currency.– The $ has gone through many up and down

cycles in value. It is the currency of safety when funds flee another country.

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1.3 The International Monetary System

Value of $: Trade-Weighted $ Index

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1.3 The International Monetary System

• European Monetary System:– The Euro came into existence and began trading on

1/5/1998 at $1.08, 2001 low $0.82, $1.45 on 9/8/2009, 9/3/2013 $1.3193, now $1.1551

– http://europa.eu/abc/european_countries/index_en.htm5

– Its supply is controlled by the European Central Bank.

– Has 27 members except UK maintains Pound and Switzerland maintains Franc

– Developed to compete with US and currency replace $ as international currency.

http://europa.eu/abc/european_countries/index_en.htm5

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1.3.1 Fixed v. Floating FX Rates

• Free Float: e moves randomly based on demand and supply

• Managed or ‘Dirty Float’: floating E with central bank intervention to smooth volatility

• Target Zones: maintain FX rates near an agreed upon fixed rate

• Fixed-Rate System: each country’s central bank intervenes in the FX market to keep e at target level

9/17/20151 Multinational Corporate Finance (MCF) Dr. Richard Michelfelder Fall 2015.

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Transcript of 9/17/20151 Multinational Corporate Finance (MCF) Dr. Richard Michelfelder Fall 2015.