Week-7. Dr. Ahmed. Domestic Firms International Firms Multinational Firms Global Firms

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1 FINC 5880 Dr. Ahmed Week-7 Name Domestic Firms International Firms Multinational Firms Global Firms Factors that make multinational financial management different Exchange rates and trading International monetary system International financial markets Specific features of multinational financial management 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. 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 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 Direct and Indirect Quotations A direct quotation gives the price of foreign currencies expressed in U.S. dollars (dollars per currency). U.S. $ to buy 1 Unit of foreign currency Euro $ Swedish krona $

2 An indirect quotation gives the amount of a foreign currency required to buy one U.S. dollar (currency per dollar). An indirect quotation is the reciprocal of a direct quotation. # of Units of Foreign Currency per U.S. dollar Euro 1.25 Swedish krona Euro: 1 / = Krona: 1 / = Euros and British pounds are normally quoted as direct quotations. All other currencies are quoted as indirect. 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. Cross rate = (Euros / Dollar) X (Dollar/ Krona) = 1.25 x = euros/krona. Cross rate = (Krona / Dollar) X (Dollar/ Euros) = x = 8.00 kronas/euro. The two cross rates are reciprocals of one another. They can be calculated by dividing either the direct or indirect quotations. Assume the firm can produce a liter of orange 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? Target price = ($1.75)(1.50)=$2.625 Spanish price = ($2.625)(1.25 euros/$) = Now the firm begins producing the orange juice in Spain. The product costs 2.0 euros to produce and ship to Sweden, where it can be sold for 20 kronas. What is the dollar profit on the sale? 2.0 euros (8.0 kronas/euro) = 16 kronas = 4.0 kronas profit. Dollar profit = 4.0 kronas( dollars per krona) = $0.40.

3 What is exchange rate risk? 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. 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. International monetary systems 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. Convertible 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. Spot Rate and Forward Rate 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. 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 /$. The dollar is expected to depreciate, because it will buy fewer pounds. Spot rate = 0.7 /$ 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. 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. 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:

4 Finance and Economic Theories International Parity Conditions The economic theories that link exchange rates, price levels, and interest rates together are called international parity conditions. Law of One Price If the identical product or service can be: sold in two different markets; and no restrictions exist on the sale; and transportation costs of moving the product between markets are equal, then the products price should be the same in both markets. P $ x S = P Where the product price in US dollars is (P $ ), the spot exchange rate is (S) and the price in Yen is (P ). If the law of one price were true for all goods and services, the purchasing power parity (PPP) exchange rate could be found from any individual set of prices. This is the absolute version of the PPP theory. PPP holds up well over the very long run but poorly for shorter time periods; and, the theory holds better for countries with relatively high rates of inflation and underdeveloped capital markets. Exchange Pass-Through The degree to which the prices of imported and exported goods change as a result of exchange rate changes is termed pass-through. For example, a car manufacturer may or may not adjust pricing of its cars sold in a foreign country if exchange rates alter the manufacturer s cost structure in comparison to the foreign market. Interest Rates and Exchange Rates - The Fisher effect The Fisher Effect states that nominal interest rates in each country are equal to the required real rate of return plus compensation for expected inflation. This equation reduces to (in approximate form): i = r + π Where i = nominal interest rate, r = real interest rate and π = expected inflation. International Fisher effect The relationship between the percentage change in the spot exchange rate over time and the differential between comparable interest rates in different national capital markets is known as the international Fisher effect.

5 Fisher-open, as it is termed, states that the spot exchange rate should change in an equal amount but in the opposite direction to the difference in interest rates between two countries. (S1 S2) / S2 = (i $ - i ) Where i $ and i are the respective national interest rates and S is the spot exchange rate using indirect quotes ( /$). Justification for the international Fisher effect is that investors must be rewarded or penalized to offset the expected change in exchange rates. Forward Exchange Rates A forward rate is an exchange rate quoted for settlement at some future date. A forward exchange agreement between currencies states the rate of exchange at which a foreign currency will be bought forward or sold forward at a specific date in the future. For example, the 90-day forward rate for the Swiss franc/us dollar exchange rate (F SF /$90) is found by multiplying the current spot rate (S SF /$) by the ratio of the 90-day euro-swiss franc deposit rate (i SF ) over the 90-day eurodollar deposit rate (i $ ). Forward Premium F SF/$ 90 = S SF/$ x [1 + (i SF x 90/360)] / [1 + ( i $ x 90/360)] The forward premium or discount is the percentage difference between the spot and forward exchange rate, stated in annual percentage terms. Interest Rate Parity (IRP) f SF = ( Spot Forward / Forward ) X (360/Days) X 100 The theory of Interest Rate Parity (IRP) provides the linkage between the foreign exchange markets and the international money markets. The theory states: The difference in the national interest rates for securities of similar risk and maturity should be equal to, but opposite in sign to, the forward rate discount or premium for the foreign currency, except for transaction costs.

6 Equilibrium between Interest Rates and Exchange Rates The spot and forward exchange rates are not, however, constantly in the state of equilibrium described by interest rate parity. Covered Interest Arbitrage (CIA) When the market is not in equilibrium, the potential for risk-less or arbitrage profit exists. The arbitrager will exploit the imbalance by investing in whichever currency offers the higher return on a covered basis. This is known as covered interest arbitrage (CIA).

7 Eurodollar markets Dollars held outside the U.S. Mostly Europe, but also elsewhere International bonds Foreign 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. To what extent do capital structures vary across different countries? Early studies suggested that average capital structures varied widely among the l 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. International Cash Management Distances are greater. Access to more markets for loans and for temporary investments Cash is often denominated in different currencies.

8 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. 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. 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.