UNIT FIVE (5) The International Monetary Environment and Financial Management in the Global Firm

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1 UNIT FIVE (5) The International Monetary Environment and Financial Management in the Global Firm

2 Objectives Exchange rates and currencies How exchange rates are determined The monetary and financial systems Financial management in the global firm Managing currency risk Managing accounting and tax practices

3 Currencies & Exchange Rates International markets for foreign exchange/capital are much larger than those for goods & services Some 150 currencies are in use worldwide Exchange rate: Price of one currency expressed in terms of another Changes in exchange rates affect measures such as costs of inputs, sales performance, which market entry strategies to use, & more

4 Recent Exchange Rates Against The U.S. Dollar

5 The Four Risks of International Business

6 Foreign Exchange Markets Foreign exchange: All forms of internationally traded monies, including foreign currencies, bank deposits, checks, and electronic transfers Foreign exchange market: The global marketplace for buying and selling national currencies Exchange rates are in constant flux. For example: In 2007, the Japanese yen was trading at 116 yen to the U.S. dollar. By 2009, it was trading at 85 yen to the dollar,

7 Foreign Exchange Markets Cont d an appreciation of over 25 percent. This made the yen more expensive for Americans, & the U.S. dollar cheaper for Japanese.

8 Foreign Exchange Markets Cont d Example: The Euro vs. the Dollar Suppose that last year the exchange rate was 1 = $1. Now, suppose the rate has gone to 1.50 = $1. What is the effect of this change on Europeans? Effects on European firms: European firms pay more for inputs from the U.S. Higher costs reduce profitability; require higher prices. European firms can increase their exports to the U.S. European firms can raise their prices to the U.S. Increased exports to the U.S. lead to higher revenues

9 What is the effect on European consumers? Suppose the euro/dollar exchange rate goes from 1 euro equals $1 to 1.50 = $1. What are the effects on European firms and consumers? European firms pay more for inputs from the United States. Because U.S. products and services now cost more, consumers demand less of them. As you can see, a fluctuating exchange rate affects both sides of international transactions.

10 What is the effect on European consumers? Effect on consumers includes: Because U.S. products & services now cost more, European consumers demand fewer of them. The cost of living rises for those Europeans who consume many dollar-denominated imports. Fewer European tourists can afford to visit the U.S. Fewer European students end up studying at U.S. universities.

11 How Are Exchange Rates Determined? In a free market, the price of any currency (the exchange rate) is determined by supply and demand. The greater the supply of a currency, the lower its price. The lower the supply of a currency, the higher its price. The greater the demand for a currency, the higher its price. The lower the demand for a currency, the lower its price.

12 Factors that Influence the Supply and Demand for a Currency induced decline in the value of their Inflation refers to increases in the prices of goods & services Some countries (e.g., Argentina, Israel, Russia) have experienced hyperinflation High inflation erodes a currency s purchasing power Interest rates and inflation are positively related; high inflation forces banks to pay high interest In other words, investors expect to be compensated for inflation induced decline in the value of their money.

13 Factors that Influence the Supply and Demand for a Currency Cont d Market Psychology refers to non-financial impacts Herding following the crowd; mimicking the investment patterns of others Momentum buying when prices rise & selling when they begin to fall Example If inflation is 10%, banks must pay more than 10% to attract deposits.

14 Factors that Influence the Supply and Demand for a Currency Another factor that influences the exchange rate of a currency is inflation, which reduces the purchasing power of the currency. Interest rates and inflation are closely related. In countries with high inflation, interest rates tend to be high because investors expect to be compensated for the inflation-induced decline in the value of their money. If inflation is running at 10 percent, for example, banks must pay more than 10 percent interest to attract customers to open savings accounts.

15 Factors that Influence the Supply and Demand for a Currency Inflation occurs when Demand for money grows more rapidly than supply, or The central bank increases the nation s money supply faster than output. Inflation directly affects the value of the nation s currency. If it results from an excessive increase in the money supply, all else being equal, the price of that money (expressed in terms of foreign currencies) will fall.

16 Factors that Influence the Supply and Demand for a Currency The link between interest rates and inflation, and between inflation and the value of currency, implies that there is a relationship between real interest rates and the value of currency. For example, when interest rates in Japan are high, foreigners seek profits by buying Japan s interestbearing investment opportunities, such as bonds and deposit certificates. Investment from abroad will have the effect of increasing demand for the Japanese yen.

17 Value of the Currency and Trade Surplus vs. Trade Deficit Trade surplus: Exports exceed imports; may result when the exporter s currency is undervalued, as in China s official policy regarding its currency Trade deficit: Imports exceed exports; the government may devalue the nation s currency to correct a trade deficit Balance of trade: the difference between the value of a nation s exports and its imports

18 Value of the Currency and Trade Surplus vs. Trade Deficit The Chinese government regularly intervenes in the foreign exchange market to keep the renminbi undervalued, helping to ensure that Chinese exports remain strong. An undervalued national currency can result in a trade surplus, which arises when a nation s exports exceed its imports for a specific period of time, causing a net inflow of foreign exchange.

19 Value of the Currency and Trade Surplus vs. Trade Deficit By contrast, a trade deficit results when a nation s imports exceed its exports for a specific period of time, causing a net outflow of foreign exchange. The balance of trade is the difference between the monetary value of a nation s exports and that of its imports over the course of a year. Many economists believe a persistent trade deficit is harmful to the national economy.

20 The Exchange Rate System Today Today, advanced economy currencies (dollar, euro, pound, yen) float according to market forces, their value determined by supply and demand Conversely, most developing and emerging economies use fixed exchange rate systems In fixed regimes, the value of a currency is pegged to the value of another currency or to a basket of currencies, at a specified rate Examples China pegs its currency to a basket of currencies. Belize pegs its currency to the dollar.

21 The Exchange Rate System Today The exchange rate system today consists of two main types of foreign exchange management: the floating system and the fixed system.

22 The Exchange Rate System Today Most advanced economies use the floating exchange rate system, in which governments refrain from systematic intervention, and each nation s currency floats independently, according to market forces. Major world currencies including the Canadian dollar, the British pound, the euro, the U.S. dollar, and the Japanese yen float independently on world exchange markets, their exchange rates determined daily by supply and demand.

23 The Exchange Rate System Today The fixed exchange rate system is similar to the system used under the Bretton Woods agreement and is sometimes called a pegged exchange rate system. In this system, the value of a currency is set relative to the value of another (or to the value of a basket of currencies) at a specified rate. As this reference value rises and falls, so does the currency pegged to it. Many developing economies and some emerging markets use the fixed system today. China pegs its currency to the value of a basket of currencies.

24 At times, countries adhere to neither a purely fixed nor a floating exchange rate system. Rather, they try to hold the value of their currency within some range against the U.S. dollar or other important reference currency in a system often referred to as dirty float. That is, the value of the currency is determined by market forces, but the central bank intervenes occasionally in the foreign exchange market to maintain the value of its currency within acceptable limits relative to a major reference currency. Many Western countries resort to this type of intervention from time to time.

25 The International Monetary and Financial Systems International monetary system: The institutional framework, rules, and procedures by which national currencies are exchanged for one another. Global financial system: The collection of financial institutions that facilitate and regulate the flows of investment and capital funds worldwide. It includes the national and international banking systems, the international bond market, & national stock markets.

26 The International Monetary and Financial Systems The international monetary system consists of the institutional frameworks, rules, and procedures that govern how national currencies are exchanged for one another. By providing a framework for the monetary and foreign exchange activities of firms and governments worldwide, the system facilitates international trade and investment.

27 The International Monetary and Financial Systems The global financial system consists of the collective financial institutions that facilitate and regulate flows of investment and capital funds worldwide. Key players in the system include finance ministries, national stock exchanges, commercial banks, central banks, the Bank for International Settlements, the World Bank, and the IMF.

28 Globalization of Financial and Monetary Activities Growing integration of financial and monetary global activity is due to: Evolution of monetary and financial regulations worldwide Emergence of new technologies and payment systems in global finance; e.g., the Internet Increased global and regional interdependence of financial markets Growing role of single-currency systems, e.g., euro

29 Globalization of Financial and Monetary Activities Capital flows are much more volatile than FDI-type investments, because it is much easier for investors to withdraw and reallocate liquid capital funds than FDI funds, which are directly tied to factories and other permanent operations that firms establish abroad. The globalization of financial flows has yielded many benefits, but it is also associated with increased risk.

30 Economic difficulties in one country can quickly spread to other countries, like a contagion. Financial instability is worsened when governments fail to adequately regulate and monitor their banking and financial sectors.

31 Key Participants and Relationships in the Global Monetary and Financial Systems

32 Key Participants and Relationships in the Global Monetary and Financial Systems Exhibit 6.2: As companies engage in international trade and are paid by their customers abroad, they typically acquire large quantities of foreign exchange and must convert them into the currency of the home country. Firms also engage in investment, franchising, and licensing activities abroad that generate revenues they must exchange into their home currency. These firms use the resources of international and domestic financial institutions to exchange these currencies.

33 Key Participants in the Monetary and Financial Systems Bank for International Settlements based in Switzerland, works to foster cooperation among central banks & other government agencies IMF based in Washington; provides framework of and code of behavior for international monetary system. Plays key role in monetary crises World Bank goal is to reduce world poverty & is active in various dev. projects to provide good infrastructure (water, electricity, transport to poor countries.

34 Key Participants in the Monetary and Financial Systems National stock exchanges and bond markets are also key participants in the international financial system. Many exchanges are electronic networks not necessarily tied to a fixed location. Today, MNEs often list themselves on a number of exchanges worldwide to maximize their ability to raise capital. Bonds are another type of security sold through banks and stockbrokers. They are a form of debt that corporations and governments incur by issuing interest-bearing certificates to raise capital.

35 Key Participants in the Monetary and Financial Systems (cont.) Commercial Banks: Lend money to finance business activity, play a key role in nations money supplies, exchange foreign currencies Central Banks: Regulate money supply, issue currency, manage exchange rates, control national reserves

36 International Financial Management It is the acquisition and use of funds for cross-border trade, investment, and other commercial activities Firms access funds from a variety of sources foreign bond markets, local stock exchanges, foreign banks, venture capital firms, and intracorporate financing based on wherever in the world capital is cheapest In a typical MNE, financial managers must be effective in 5 key areas

37 Five Key International Financial Management Tasks Raise funds for the firm: Acquire equity, debt, or intracorporate financing for funding activities and investments Manage cash flow: Manage funds passing in and out of the firm s value-adding activities Perform capital budgeting: Assess financial attractiveness of major investment projects (e.g., foreign market expansion & entry)

38 Five Key International Financial Management Tasks Manage currency risk: Manage the multiple-currency transactions of the firm and its exposure to exchangerate fluctuations Manage accounting & tax practices: Learn to operate in a global environment with diverse accounting practices and international tax regimes

39 Raising Funds Global money market: Financial market where firms and governments raise short-term financing. It is the meeting point of those who want to invest money and those who want to raise funds Global capital market: Financial market where firms and governments raise intermediate-term and longterm financing

40 Raising Funds Participating in the global capital market allows firms to access funds from a larger pool of capital at competitive interest rates. International investors access a much wider range of investment opportunities than are available in the domestic capital market

41 Where to Get Funds: Financial Centers New York, London, and Tokyo are the major centers Frankfurt, Hong Kong, Paris, San Francisco, Sydney, Singapore, and Zurich are secondary centers Firms access major capital suppliers banks, stock exchanges, and venture capitalists at such centers Global capital markets have grown rapidly in the past decade due to a variety of reasons (government deregulation, innovations in comm. tech., realized cost savings from efficiencies, more)

42 Sources of Funding Equity Financing The firm obtains capital by selling shares of stock Main advantage is the firm obtains capital without incurring debt and having to repay funds to providers Main disadvantage is the firm s ownership is diluted The global equity market is the worldwide market of funds for equity financing the stock exchanges worldwide where investors and firms meet to buy and sell shares of stock

43 Sources of Funding Debt Financing The firm borrows money from a creditor in exchange for repayment of principal and interest The main advantage over equity financing is that the firm does not sacrifice any ownership interests Debt financing is obtained from two sources: Loans (usually from banks) and the sale of bonds The firm may borrow money from banks in its home market or in foreign markets

44 Borrowing internationally is complicated by differences in banking laws and infrastructure, lack of loanable funds, and fluctuating exchange rates

45 The Eurocurrency Market The Eurocurrency market, representing money deposited in banks outside its country of origin, is a key source of loanable funds. U.S. dollars account for the largest share of such funds Eurodollars are U.S. dollars held in banks outside the United States, including foreign branches of U.S. banks Other Eurocurrencies include euros, yen, and British pounds, as long as they are banked outside their home country

46 Bonds are the Major Source of Debt Financing A bond is a debt instrument that enables the issuer (borrower) to raise capital by promising to repay the principal along with the interest on a specified date (maturity) Governments, states, and other institutions also sell bonds. Investors purchase bonds and redeem them at face value in the future The global bond market is the international marketplace in which bonds are bought and sold, primarily through banks and stockbrokers

47 Foreign Bonds and Eurobonds Foreign bonds are sold outside the bond issuer s country and denominated in the currency of the country in which they are issued. E.g., when Mexico s Cemex sells dollar-denominated bonds in the United States, it is issuing foreign bonds Eurobonds are sold outside the bond issuer s home country and denominated in its own currency. For example, when Toyota sells yen-denominated bonds in the United States, it is issuing Eurobonds

48 Sources of Funding (cont d.) Intracorporate Financing Obtaining funds from within firm s network of subsidiaries and affiliates In firms with extensive international operations, at times some units are cash rich while others are cash poor Usually has little effect on the parent s balance sheet because the funds are simply transferred from one area of the firm to another Minimizes transaction costs of borrowing from banks and avoids the ownership-diluting effects of equity financing

49 Managing Cash Flow Cash flow needs arise from everyday business activities, such as paying for labor and materials or resources, servicing interest payments on debt, paying taxes, or paying dividends to shareholders Cash flow management ensures cash is available where and when it is needed

50 Managing Cash Flow Cash is generated from various sources, and needs to be transferred from one part of the MNE to another International financial managers devise strategies for transferring funds within the firm s worldwide operations to optimize global operations

51 Methods for Transferring Funds Within the MNE Through trade credit, a subsidiary defers payment for goods received from the parent firm Dividend remittances are commonly used to transfer funds from foreign subsidiaries to the parent, but vary depending on tax levels, currency risks, and other factors Royalty payments are compensation paid to owners of intellectual property. Assuming the subsidiary has licensed technology, trademarks, or other assets from the parent or other subsidiaries, royalties can be an efficient way to transfer funds

52 Methods for Transferring Funds Within the MNE (cont d) In a fronting loan, the parent deposits a large sum in a foreign bank, which then transfers the funds to the subsidiary in the form of a loan Fronting allows the parent to circumvent restrictions that foreign governments impose on direct intracorporate loans

53 Methods for Transferring Funds Within the MNE (cont d) Transfer pricing (also known as intracorporate pricing) refers to prices that subsidiaries and affiliates charge one another as they transfer goods and services within the same MNE Firms can use transfer pricing to shift profits out of high-tax countries into low-tax countries, optimizing cash flows

54 Multilateral Netting & Central Depositories Multilateral Netting: Strategic reduction of cash transfers within the MNE family through the elimination of offsetting cash flows: Multilateral netting involves three or more subsidiaries that hold accounts payable or accounts receivable with one other. MNEs with numerous subsidiaries usually establish a netting center that headquarters supervises.

55 Multilateral Netting & Central Depositories MNEs pool surplus funds into a central depository that functions either globally or for a region. The funds are then directed to needful subsidiaries or invested to generate income

56 Perform Capital Budgeting Managers use capital budgeting to decide which international projects are economically desirable Net present value (NPV) is the difference between the present value of a project s incremental cash flows and its initial investment requirements Internationally, such decisions are complex because managers must consider many variables, each of which can strongly affect the potential profitability of a venture

57 Managing Currency Risk Currency risk concerns exchange rate fluctuations that harm business profits Transaction exposure is currency risk that firms face when outstanding accounts receivable or payable are denominated in foreign currencies

58 Translation exposure is currency risk that results when a firm translates financial statements denominated in a foreign currency into the functional currency of the parent firm Economic exposure is currency risk that results from exchange rate fluctuations affecting the pricing of products, the cost of inputs, and the value of foreign investments

59 Foreign Exchange Trading A relatively limited number of currencies facilitate crossborder trade and investment, mainly dollars, euros, yen, and British pounds In 2010, the daily volume of global trading in foreign exchange amounted to over $3 trillion - more than 100x the daily value of global trade in products and services Large banks are the primary dealers in currency Currency traders are especially active in major financial centers such as London, New York, & Tokyo Trading is increasingly done online

60 Specialized Terminology in Currency Trading Spot rate: Exchange rate based on the current rate of exchange Forward rate: Exchange rate applicable at some future date, but specified at time of the transaction Direct quote: The number of units of the domestic currency needed to acquire one unit of the foreign currency; e.g., It costs $1.42 to acquire one euro. Indirect quote: The number of units of the foreign currency obtained for one unit of the domestic currency; e.g., For $1, I can receive 0.74 euros.

61 Types of Currency Traders Hedgers seek to minimize the risk of exchange rate fluctuations, often by buying forward or similar financial instruments. They include MNEs who conduct international trade Speculators are currency traders who seek profits by investing in currencies with the expectation that they will rise in value Arbitragers are currency traders who buy and sell the same currency in two or more foreign-exchange markets to profit from differences in the currency s exchange rate

62 Management of Currency Risk Through Hedging Hedging refers to efforts to compensate for a possible loss from a bet or investment by making offsetting bets or investments In international business, it refers to using financial instruments and other measures to reduce or eliminate exposure to currency risk If the hedge is perfect, the firm is protected against the risk of adverse changes in currency prices Banks offer various financial instruments to facilitate hedging

63 Hedging Instruments Forward contract: A financial instrument to buy or sell a currency at an agreed-upon exchange rate at the initiation of the contract for future delivery Futures contract: An agreement to buy or sell a currency in exchange for another at a pre-specified price and on a pre-specified date

64 Hedging Instruments Cont d Currency option: Gives the purchaser the right, but not the obligation, to buy a certain amount of foreign currency at a set exchange rate within a specified amount of time Currency swap: The exchange of one currency for another currency according to a specified schedule

65 Managerial Guidelines for Minimizing Currency Risk

66 Manage Accounting & Tax Practices Developing accounting systems to identify, measure, & communicate financial information is especially challenging in firms with multi-country operations Dozens of approaches are used to determine cost of goods sold, return on assets, R&D expenditures, net profits, and other outcomes in different countries Balance sheets and income statements vary mainly in language, currency, format, and underlying accounting principles Financial statements prepared in one country may be difficult to compare with those prepared in another

67 Transparency in Financial Reporting Transparency: Degree to which firms regularly and comprehensively reveal substantial information about their financial condition and accounting practices The more transparent a nation s accounting systems, the more regularly and comprehensively its public firms report their financial results in a reliable manner Transparency improves the ability of investors to accurately evaluate company performance In many developing and emerging market economies, accounting systems have low transparency

68 Consolidating Financial Statements of Subsidiaries A key challenge in international accounting is foreign currency translation, converting foreign currencies into the firm s functional currency Translation is critical because subsidiaries financial records are normally maintained in the currencies of the countries where they are located When headquarters consolidates financial records, foreign currencies are translated into the functional currency by using one of two methods: The current rate method or the temporal method

69 Current Rate Method Current rate method: All foreign currency balance sheet & income statement items are translated at current exchange rate the spot exchange rate in effect on the day (in the case of balance sheets), or for the period (in the case of income statements), when statements are prepared Typically used when translating records of foreign subsidiaries that are considered separate entities, rather than part of the parent firm s operations

70 Temporal Method Temporal method: The choice of exchange rate depends on the underlying method of valuation Assets & liabilities normally valued at historical cost are translated at historical rates - the rates in effect when the assets were acquired

71 Temporal Method Cont d Assets & liabilities normally valued at market cost are translated at the current exchange rate Thus, monetary items, such as cash, receivables, & payables, are translated at the current exchange rate Non-monetary items (inventory, plant, & equipment) are translated at historical rates

72 International Taxation A direct tax is imposed on income derived from business profits, intracorporate transactions, capital gains, and sometimes royalties, interest, and dividends An indirect tax applies to firms that license or franchise products/services, or that charge interest. The government withholds a percentage of interest charges as tax A sales tax is a flat percentage tax on the value of goods or services sold, and is paid by the user

73 International Taxation (cont d.) A value-added tax (VAT) is payable at each stage of processing in the value chain of a product or service VAT is calculated as a percentage of the difference between the sale and purchase price of a good Common in Canada, Europe, & Latin America Each business in a product s value chain is required to bill the VAT to its customers; the net result is a tax on the added value of the good

74 Tax Havens Tax havens are countries hospitable to business & inward investment (with low corporate income taxes) The Bahamas, Luxembourg, Monaco, Singapore, & Switzerland are examples Tax havens exist because tax systems vary greatly worldwide. Thus, MNEs have an incentive to structure their global activities to minimize taxes MNEs take advantage of tax havens either by starting operations in them or by funneling business transactions through them

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