Foundations of Multinational Financial Management, 6th Edition Test Bank

Foundations of Multinational Financial Management, 6th Edition

By Shapiro, Sarin

Shapiro6thTESTBANK Chapter 1

CHAPTER 1 Introduction EASY 1.1

Historically, the primary motive for U.S. multinationals to produce abroad has been to a. lower costs b. respond more quickly to the marketplace c. avoid trade barriers d. gain tax benefits ANSWER: b: evolution of multinational

1.2

The primary objective of the multinational corporation is to a. maximize shareholder wealth b. maximize world production c. minimize debt d. minimize the cost of doing business globally ANSWER: a: Multinational Financial Management: Theory and Practice 1.3

____________ is defined as the purchase of assets or commodities on one market for immediate resale on another in order to profit form a price discrepancy. a. internationalization b. arbitrage c. financing d. total risk ANSWER: b: evolution of multinational 1.4

The value of good financial management is ___________ in the global markets because of the much greater probability of market imperfections and multiple tax rates. a. minimized b. neutralized c. enhanced d. arbitraged away ANSWER: c: role of the financial executive 1.5

When a firm operates globally it offers advantages such as a. greater political power at home b. less taxes on its profits c. greater negotiating power with foreign minority groups d. greater negotiating power with labor unions ANSWER: d: rise of the multinational

Shapiro6thTESTBANK Chapter 1

1.6

The prime transmitter of global competitive forces is the a. public utility firm b. financial management experience of the U.S. markets c. the multinational corporation d. the Federal Reserve System of the U.S. ANSWER: c: rise of the multinational 1.7

___________ were the earliest multinationals. a. raw-material seekers b. market seekers c. cost minimizers d. oil companies.

ANSWER: a: raw material seekers 1.8

The ___________ are the archetype of the modern multinational firm that goes overseas to produce and sell in foreign markets. a. cost minimizers b. market seekers c. raw-material seekers d. whaling companies ANSWER: b: market seekers 1.9

___________ are a recent category of multinationals that seek out and invest in lower cost production sites overseas. a.

Cost minimizers b.

Market seekers c.

Raw-material seekers d.

High tech firms ANSWER: a: cost minimizers 1.10

Which one of the following is a consequence of increased global competition? a. the creation of new steel plants in the old industrial countries b. the end of free-trade agreements between governments of the world c. increased comfort level of trade unions with the consequences d. increased anxiety among workers in the old industrial countries ANSWER: d: Consequences of Global Competition 1.11

The defenders of multinationals believe that __________ are the appropriate reward for efficiently providing the global economy with products and services. a. profits b. subsidies c. tax holidays d. low-interest, government-subsidized loans ANSWER: a: Criticisms of the Multinational Corporation

Shapiro6thTESTBANK Chapter 1

1.12

International ________ can reduce the volatility of an investment portfolio because national financial markets tend to move independently of each other. a. arbitrage b. centralization of the MNC’s cash c. diversification d. investment ANSWER: c: The Importance of Total Risk

MODERATE 1.13

Into which category of multinational is IBM most likely to fall? a. raw materials seeker b. market seeker c. cost minimizer d. all of the above ANSWER: b: market seeker 1.14

Which one of the following did NOT accelerate the growth of the global economy in the past decade? a. the U.S.-Canada-Mexico free-trade pact b. the creation of the European Union c.

China’s entrance into the WTO d.

The Southeast Asia Currency Crisis ANSWER: d: Consequences of Global Competition 1.15

The multinational financial system enables companies to a. avoid currency controls b. reduce taxes c. access lower cost financing sources d. all of the above ANSWER: d: rise of the multinational

1.16

An alternative to the set up of an production facility overseas is to license a local firm to manufacture the company’s products. One disadvantage of this method is a. the establishment of a competitor with loss of future revenues to the licensing firm b. the time to market entry c. the degree of financial and legal risks d. the amount of the investment required ANSWER: a: The Process of Overseas Expansion

Shapiro6thTESTBANK Chapter 1

1.17

Which of the following is an example of reverse foreign investment for the U.S.? a.

Honda builds a factory in Ohio b.

Apple builds a plant in Ireland that exports to the United States c.

British Telecom issues new stock in the United States d.

American investors buy shares in Sony ANSWER: a: market seeker 1.18

Which of the following is NOT a failing of the theory of comparative advantage? a. it ignores the role of uncertainty and economies of scale b. it assumes that factors of production are relatively immobile c. it assumes that there are no differentiated products d. it deals with trade only differentiate rather than undifferentiated products ANSWER: d: rise of the multinational

DIFFICULT 1.19

Which of the following theories identifies specialization as the main reason for international business activity? a. product life cycle theory of international trade b. theory of diversification c. doctrine of comparative advantage d. theory of globalization ANSWER: c: rise of the multinational 1.20

Critics of the multinational corporation would NOT fault its tendency to a. shift production from one location to another in search of lower costs b. avoid taxes c. cause balance of payments difficulties d. engage in environmental protection measures ANSWER: d: criticisms of the MNC

1.21

Multinational firms would most likely be a. riskier than purely domestic firms because of the exposures of operating abroad b. less risky than purely domestic firms because of international diversification c. less risky than domestic firms if the added risks of operating overseas are more than offset by the ability to operate in nations whose economic cycles are not perfectly in phase d. invested in developed countries only and avoid developing economies ANSWER: c: the importance of total risk 1.22

According to the capital asset pricing model

Shapiro6thTESTBANK Chapter 1

a. b.

c. d.

ANSWER:

only the systematic component of risk affects the required return foreign investments whose returns are uncorrelated with the market's return should have a higher required return than comparable domestic investments total risk of the investment is most relevant for small to medium-sized firms diversification is secondary to risk levels of the investment a: capital asset pricing

1.23

The internationalization process most likely tends to a. proceed in a preprogrammed series of steps b. begin by licensing foreign producers c. inevitably involve foreign production d. begin by exporting ANSWER: d: capital asset pricing 1.24

According to the efficient market hypothesis, which one of the following is NOT correct? a. markets place a premium on the future b. today’s stock price is the best predictor of tomorrow’s stock price c. stock prices reflect all available information d. today’s stock price incorporates the past history of prices ANSWER: a: market efficiency

1.25

Which one of the following provides strong evidence that internationalization continues to grow in the world economy? a. import restrictions by the Bush Administration on foreign steel b. efforts suggested by politicians to restrict the sourcing of foreign products by locally headquartered multinationals c. the growing volume of foreign direct investment by U.S. as well as other multinational companies d. pressure on governments to embargo unfriendly nations ANSWER: c: Evolution of the Multinational Corporation 1.26

For the multinational corporation, which one of the following complements to the integration of world wide operations is MOST critical? a. flexibility b. adaptability c. speed d. economies of scale of distribution ANSWER: c: A Behavioral Definition of the Multinational Corporation

Shapiro6thTESTBANK Chapter 1

1.27

According to Shapiro, if you were the CEO of a multinational corporation, which of the following would be MOST important to you in hiring a manager? One that a.

Avoids risk at any price b.

Manages effectively the political environment of the subsidiary country c.

Anticipates every future disturbance related to the supply chain d.

Makes decisions that anticipates problems and provides solutions that enhances the firm’s prospects for growth ANSWER: d: The Global Manager

CHAPTER 2 THE DETERMINATION OF EXCHANGE RATES EASY 2.1

The explanation for the rise of the U.S. dollar during the early 1980s is that a. the U.S. budget deficit lowered U.S. interest rates b. the U.S. trade deficit caused more U.S. inflation c. the U.S. budget deficit raised U.S. interest rates d. the U.S. economy deteriorated dramatically ANSWER: c: Expectations and the Asset Market Model of Exchange Rates 2.2

The U.S. dollar weakened during the 1970s because a. control of Congress changed political parties b. the U.S. economy grew c. foreigners wanted to hold more dollars than before d.

U.S. inflation accelerated ANSWER: d: Expectations and the Asset Market Model of Exchange Rates 2.3

Exchange rates depend on a. relative inflation rates b. relative interest rates c. relative trade deficits d. a and b ANSWER: d: The Nature of Money and Currency Values 2.4

Beginning in 1997, the ruble came under attack by speculators and resulted in accelerating a. stock market prices b. capital flight c. efforts by the Russian government to address the root causes of the crisis d. decontrol by the government on the foreign exchange market ANSWER: b: Illustration The Ruble is Rubble 2.5

During the second half of 1997, currencies and stock market prices plunged in value across Southeast Asia, beginning in a.

Thailand b.

Malaysia c.

Indonesia d.

South Korea ANSWER: a: Asian Currencies Sink in 1997

2.6

The asset market view of exchange rate determination says that the spot rate

a. b. c. d.

ANSWER:

should follow a random walk is affected primarily by a nation's long-run economic prospects both a and b should be strongly affected by a nation's balance of trade c: Expectations and the Asset Market Model of Exchange Rates

2.7

When monetary authorities have not insulated their domestic money supplies from the foreign exchange transactions, it is known as ________ intervention. a. unsterilized b. sterilized c. foreign market d. subsidized ANSWER: a: Sterilized versus Unsterilized Intervention 2.8

When the U.S. Federal Reserve sells or purchases Treasury securities in order to sterilize the impact of their foreign exchange market interventions, it is referred to as a(n) ________ operation. a. floating currency b. spot rate c. revaluation d. open market ANSWER: d: Sterilized versus Unsterilized Intervention 2.9

Under which one of the following systems is there no central bank? a.

Floating exchange rates b.

Currency board c.

Pegged exchange rates d.

Sterilized intervention ANSWER: b: Central Bank Reputations MODERATE 2.10

On Friday, September 13, 1992, the lira was worth DM 0.0013. Over the weekend the lira devalued against the DM to DM 0.0012. By how much had the lira devalued against the DM? a.

7.69% b.

8.33% c.

5.21% d.

9.27% ANSWER: a: Setting the Equilibrium Spot Exchange Rate

2.11

Suppose that the Brazilian real devalues by 40% against the U.S. dollar. By how much will the dollar appreciate against the real? a.

67% b 40% c.

32% d.

28% ANSWER: a: Setting the Equilibrium Spot Exchange Rate

2.12

If the French euro devalued by 17% against the U.S. dollar, this is equivalent to a revaluation of the dollar against the euro by a.

17% b.

16.31% c.

20.48% d.

17.54% ANSWER: c: Setting the Equilibrium Spot Exchange Rate

2.13

If the Australian dollar devalues against the Japanese yen by 10%, the yen will appreciate by a.

33.32% b.

25.55% c.

10.11% d.

11.11% ANSWER: d: Setting the Equilibrium Spot Exchange Rate

2.14

If the euro depreciates against the U.S. dollar by 50%, the dollar appreciates against the euro by a.

55% b.

100% c.

200% d.

1,000% ANSWER: b: Setting the Equilibrium Spot Exchange Rate

2.15

If the U.S. dollar appreciates against the Nigerian naira by 150%, the naira depreciates against the dollar by a.

60% b.

75% c.

125% d.

300% ANSWER: a: Setting the Equilibrium Spot Exchange Rate

2.16

If the dinar devalues against the U.S. dollar by 45%, the U.S. dollar will appreciate against the dinar by a.

45% b.

82% c.

55% d.

32% ANSWER: b: Setting the Equilibrium Spot Exchange Rate

2.17

If the peso depreciates against the U.S dollar by 80%, the US dollar will appreciate against the peso by a.

300% b.

200% c.

250% d.

400% ANSWER: d: Setting the Equilibrium Spot Exchange Rate

2.18

If the U.S. dollar appreciates against the euro by 25%, the euro will depreciate against the U.S. dollar a.

25% b.

20% c.

30% d.

10% ANSWER: b: Setting the Equilibrium Spot Exchange Rate 2.19

If a foreigner purchases a U.S. government security a. the supply of dollars rises b. the federal government deficit declines c. the demand for dollars rises d. the U.S. money supply rises ANSWER: c: Setting the Equilibrium Spot Exchange Rate

2.20

The price of foreign goods in terms of domestic goods is called a. the real exchange rate b. the balance of trade c. the trade-weighted exchange rate d. purchasing parity ANSWER: a: The Fundamentals of Central Bank Intervention 2.21

An increase in the real exchange rate will a. raise national income b. lower national income c. make a country less competitive in international trade

d.

ANSWER:

raise the cost of foreign goods c: The Fundamentals of Central Bank Intervention

2.22

A slowdown in U.S. economic growth will a. boost the value of the dollar because inflation fears will be calmed b. boost the value of the dollar because the Federal Reserve will expand the money supply c. lower the value of the dollar because the U.S. will be a less attractive place to invest in d. lower the value of the dollar because interest rates will rise ANSWER: c: The Fundamentals of Central Bank Intervention 2.23

The willingness of people to hold money a. increases with the interest rate b. rises with price stability c. rises with national income d. b and c only ANSWER: d: The Fundamentals of Central Bank Intervention 2.24

Sound economic policies will a. raise the value of a nation's currency by boosting the economy b. lower the value of a nation's currency by increasing the precautionary demand for money c. lower the value of a nation's currency by leading to lower interest rates d. both b and c ANSWER: a: The Fundamentals of Central Bank Intervention 2.25

Large government budget deficits will a. raise the value of a nation's currency by raising domestic interest rates b. raise the value of a nation's currency by stimulating the domestic economy c. lower the value of a nation's currency by leading to higher inflation d. lower the value of a nation's currency by leading to added political risk e. historical experience shows no correlation between government budget deficits and the value of the nation's currency ANSWER: e: The Nature of Money and Currency Values

DIFFICULT 2.26

Which type of money is MOST likely to see its value fluctuate in the foreign exchange market? a. fiat money

b. c. d.

ANSWER:

commodity money price-indexed money pegged-exchange rate a: Central Bank Reputations and Currency Values

2.27

An increase in the supply of U.S. dollars by the Federal Reserve will a. raise the value of the dollar because it will stimulate U.S. economic growth b. raise the value of the dollar because it will lead to higher U.S. interest rates c. reduce the value of the dollar because of inflation fears in the United States d. decrease the value of the dollar because it will force other countries to raise their interest rates ANSWER: c: The Fundamentals of Central Bank Intervention 2.28

Which one of the following is probably the best advice for governments when it comes to exchange rate arrangements? a.

The complete replacement of the local currency with the U.S. dollar. b.

Currency boards are the next best arrangement after fixed exchange rates. c.

There is no substitute for good macroeconomic policy. d.

Fixed exchange rates are the most completely sound and credible.

ANSWER: c: Central Bank Reputations 2.29

Which of the following is an example of foreign exchange market intervention? a. the U.S. government pays Social Security checks to pensioners living in Poland b.

IBM sells euros it received in international trade c. the Canadian government pays interest to Saudi Arabian investors d. the Japanese central bank sells yen in the foreign exchange market to prop up the value of the yen ANSWER: d: The Fundamentals of Central Bank Intervention

2.30

During 1995, the yen went from $0.0125 to $0.0095238. By how much did the dollar appreciate against the yen? a.

23.81% b.

31.25% c.

15.67% d.

40.78% ANSWER: b: Setting the Equilibrium Spot Exchange Rate 2.31

Which one of the following effects would MOST likely be caused by a government artificially holding its currency value down? a. a massive rise in foreign exchange reserves. b. the value of the nation’s exports rises dramatically

c. d.

ANSWER:

the outsourcing a the nation’s manufacturing jobs to offshore markets a growing trade deficit with foreign economies a: Central Bank reputation

CHAPTER 3 The International Monetary System

EASY 3.1

The ________ is an exchange rate system that is relatively free from central bank and other government interventions. a. managed float b. clean float c. dirty float d. target-zone arrangement ANSWER: b: Free Float 3.2

When government intervention attempts to reduce for exporters and importers the uncertainty caused by disruptive exchange rate changes for the short and medium term, it is referred to as _________. a. smoothing out daily fluctuations b. leaning against the wind c. unofficial pegging d. a dirty float ANSWER: b: Managed Float 3.3

Under a _________, countries adjust their national economic policies to maintain their exchange rates within a specific margin around agreed-upon, fixed central exchange rates. a. managed float b. ‘beggar-thy-neighbor” devaluation c. dirty float d. target-zone agreement ANSWER: d: Target-Zone Agreement 3.4

________ is nonconvertible paper money backed only by faith that the monetary authorities will not issue more money. a.

Specie b.

Fiat money c.

Seignorage d.

Par value ANSWER: b: the classical gold standard 3.5

Under the classic gold standard, if prices began rising in the U.S. a. the dollar value of the pound would rise b. the dollar value of the pound would fall c. the U.S. would begin running a balance of trade surplus d. gold would flow out of the U.S. and the U.S. money supply would drop ANSWER: d: the classical gold standard

3.6

The Bretton Woods system a. ended in 1971 b. ended in 1939 when World War II began c. is currently the basis for the international monetary system d. is currently in use only by the major industrial nations ANSWER: a: introduction 3.7

The current exchange rate system can best be characterized as a a. free float b. managed float c. target-zone arrangement d. fixed-rate system e. hybrid system ANSWER: e: the current system of exchange rate determination 3.8

Managed floats would NOT fall into which of the following categories of central bank intervention? a. smoothing out daily fluctuations b. leaning against the wind c. unofficial pegging d. target-zone arrangements ANSWER: d: managed float 3.9

The European Monetary System is best described as a a. clean float b. target-zone arrangement c. dirty float d. managed float ANSWER: b: the European monetary system

3.9

A weak peso is most likely to cause a. added employment and inflation in Mexico b. less unemployment but more inflation in Mexico c. more unemployment but less inflation in Mexico d. less unemployment and less inflation in Mexico ANSWER: b: emerging market currency crises

3.10

The Bretton Woods system fell apart because a. of the oil crisis b.

U.S. monetary policy was too expansionary c. the United States ran a large trade deficit d. the United States no longer supported a pegged gold standard ANSWER: b: the Bretton Woods System

3.11

The gold standard was dissolved in 1973 because a. the U.S. printed too many dollars to maintain gold at $35/oz b. some countries preferred to hold gold instead of dollars c. high interest rates raised the cost of holding gold d. a and b only ANSWER: d: the post-Bretton Woods System 3.12

The rising dollar in the early 1980s can be attributed to a. high real interest rates in the United States b. improved investment prospects in the United States c. the growing U.S. budget deficit d. a and b only ANSWER: d: the rising dollar: 1980-1985 3.13

The fall of the dollar beginning in 1985 can be attributed to a. the growing U.S. budget deficit b. the large U.S. trade deficit c. rapid U.S. economic growth d. the slowdown in U.S. economic growth relative to growth overseas ANSWER: d: the sinking dollar: 1985-1987

MODERATE 3.14

The characteristic of gold that is most important to the success of a gold standard is that it is a. portable b. storable c. easily standardized d. expensive to produce ANSWER: d: the classical gold standard 3.15

A gold standard ensures a long-run tendency toward price stability because a. gold is desirable b. gold is durable and storable c. the cost of producing an ounce of gold stays relatively constant overtime d. gold supply is directly related to consumer satisfaction ANSWER: c: the classical gold standard 3.16

Calls for a new gold standard reflect a. fundamental distrust of government's willingness to maintain the integrity of fiat money b. a general willingness to accept fiat money c. a short memory of what actually transpired under the gold standard d. the durability and desirability of gold ANSWER: a: the classical gold standard

3.17

Under the gold standard a. price levels rose dramatically b. price levels stayed constant over time c. the long-run stability of the price level includes alternating periods of inflation and deflation d. fiat money is more valuable ANSWER: c: the classical gold standard 3.18

Under a fixed-rate system, a country that followed policies that would lead to a higher rate of inflation than that experienced by its trading partners would a. experience a balance-of-payments deficit as its goods became more expensive b. see a decrease in the supply of its currency on the foreign exchange markets c. find its currency exchange rate subject to upward pressure d. experience a balance-of-payments surplus.

ANSWER: a: fixed-rate system 3.19

Under a fixed-rate system, a country that followed policies leading to a lower inflation rate than that experienced by its trading partners would a. come under pressure to expand its money supply b. restrict the growth of its money supply c. experience a balance-of-payments deficit d. be forced to buy its currency in the foreign exchange market ANSWER: a: fixed-rate system 3.20

Underlying the emerging markets currency crises is a fundamental conflict among policy objectives that the target nations have failed to resolve. Which one of the following is NOT? a.

IMF bailouts b. fixed exchange rates c. independent domestic monetary policy d. free capital movement ANSWER: a: emerging market currency crises DIFFICULT 3.21

In a fixed-rate system, central banks maintain currency values by a. reducing the money supplies of nations with overvalued currencies b. boosting the money supplies of nations with undervalued currencies c. buying up overvalued currencies in the foreign exchange market d. buying undervalued currencies in the foreign exchange market ANSWER: d: fixed-rate system 3.22

Governments intervene in the foreign exchange markets for all of the following except to

a. b. c. d.

ANSWER:

earn foreign exchange reduce economic uncertainty improve the nation's export competitiveness reduce inflation a: managed float

3.23

Under a fixed-rate system, which of the following four alternatives to devaluation is MOST likely to succeed? a. foreign borrowing b. austerity c. wage and price controls d. exchange controls ANSWER: b: fixed-rate system 3.24

In order to boost the value of the euro relative to the dollar a. the Fed should sell dollars for euros and the European central bank should buy DM with dollars b. the Fed should sell dollars for euros and the European central bank should buy dollars with euros c. the Fed should sell euros for dollars and the European central bank should sell dollars for DM d. the Fed should sell DM for dollars and the European central bank should buy euros with dollars ANSWER: a: managed float

CHAPTER 4 Parity Conditions in International Finance and Currency Forecasting EASY 4.1

A currency is said to be at a forward _________ if the forward rate is below the spot rate. a. discount b. premium c. position d. forward ANSWER: a: arbitrage and the law of one price 4.2

The theory of relative purchasing power parity states that, between two nations, the a. inflation rates are unrelated b. exchange rate difference reflects the inflation rate difference c. inflation rate is greater in weaker currencies d. the interest rate is greater than the inflation rate during depreciations ANSWER: b: purchasing power parity 4.3

The Fisher effect states that the _________ rate is made up of a real required rate of return and an inflation premium. a. nominal exchange b. real exchange c. nominal interest rate d. adjusted dividend ANSWER: c: The Fisher Effect 4.4

A rise in the inflation rate in one nation relative to others will be associated with a fall in the first nation’s exchange rate and with a rise of its interest rate relative to foreign interest rates. The two conditions combined result in the _________ Effect. a.

Fisher b.

Herstatt c.

Unbiased forward rate d.

International Fisher ANSWER: d: The Fisher effect 4.5

The purchase of currency on one market for immediate resale in another market in order to profit from the rate discrepancy is known as _________. a. arbitrage b. financial innovation c. a line of credit d. countertrade

4.6

In its absolute version, _______ states that price levels should be equal worldwide when expressed in a common currency. a. interest rate parity b. purchasing power parity c. the international Fisher effect d. covered interest arbitrage

4.7

When there is a relative shortage of capital and high political risk in most developing countries, it is likely to drive real interest rates in these countries to a. decline below real interest rates in developed countries b. exceed nominal interest rates in developed countries c. exceed rate interest rates in developed countries d. parity conditions in all developing countries

MODERATE 4.8

Suppose annual inflation rates in the U.S. and Mexico are expected to be 6% and 80%, respectively, over the next several years. If the current spot rate for the Mexican peso is $.005, then the best estimate of the peso's spot value in 3 years is a. $.00276 b. $.01190 c. $.00321 d. $.00102 ANSWER: d: purchasing power parity 4.9

If the expected inflation rate is 5% and the real required return is 6%, then the Fisher effect says that the nominal interest rate should be a.

1% b.

11.3% c.

11% d.

6% ANSWER: b: The Fisher Effect

4.10

The inflation rates in the U.S. and France are expected to be 4% per annum and 7% per annum, respectively. If the current spot rate is $.1050, then the expected spot rate in three years is a. $.1150 b. $.1112 c. $.0964 d. $.0992 ANSWER: c: purchasing power parity

4.11

If inflation in the U.S. is projected at 5% annually for the next 5 years and at 12% annually in Italy for the same time period, and the lira/$ spot rate is

currently at L2400 = $1, then the PPP estimate of the spot rate five years from now is a.

1738 b.

3314 c.

2560 d.

2250 ANSWER: b: purchasing power parity 4.12

If expected inflation is 20% and the real required return is 10%, then the Fisher effect says that the nominal interest rate should be exactly a.

30% b.

32% c.

22% d.

12% ANSWER: b: The Fisher effect

4.13

Annual inflation rates in the U.S. and Greece are expected to be 3% and 8%, respectively. If the current spot rate for the drachma is $.007, then the expected spot rate in three years is a. $.00607 b. $.00823 c. $.00751 d. $.00694 ANSWER: a: purchasing power parity 4.14

If a country's freely floating currency is undervalued in terms of purchasing power parity, its capital account is likely to be a. in deficit or tending toward a deficit b. in surplus or tending toward a surplus c.

Subsidized by the International Monetary Fund d. a candidate for loans from the World Bank ANSWER: a: purchasing power parity 4.15

If the average rate of inflation in the world rises from 5% to 7%, this will tend to make forward exchange rates move toward a. smaller premiums or larger discounts in relation to the dollar b. larger premiums or smaller discounts in relation to the dollar c. no change on average d. can't tell what will happen ANSWER: c: purchasing power parity 4.16

A 150% real return in Brazil is higher than a 15% dollar return in the U.S. a. because arbitrage opportunities exist b. when the inflation controls are suspended in Brazil c. it depends on whether these are nominal or real returns d. regardless of nominal or real returns

ANSWER:

c: purchasing power parity

4.17

Annual inflation rates in the U.S. and Italy are expected to be 4% and 7%, respectively. If the current spot rate is $1 = L2,000, then the expected spot rate for the lira in three years is a. $.0004591 b. $.0011590 c. $.0009892 d. $.0005471 ANSWER: a: purchasing power parity

4.18

Annual inflation rates in the U.S. and France are expected to be 4% and 6%, respectively. If the current spot rate is $.1250/FF, then the expected spot rate in two years is a. $.1299 b. $.1150 c. $.1203 d. $.1335 ANSWER: c: purchasing power parity 4.19

Suppose five-year deposit rates on Eurodollars and Euromarks are 12% and 8%, respectively. If the current spot rate for the mark is $0.50, then the spot rate for the mark five years from now implied by these interest rates is a. .5997 b. .4169 c. .5185 d. .4821 ANSWER: a: the international Fisher effect 4.20

The direct spot quote for the Canadian dollar is $.76 and the 180-day forward rate is $.74. The difference between the two rates is likely to mean that a. inflation in the U.S. during the past year was lower than in Canada b. interest rates are rising faster in Canada than in the U.S. c. prices in Canada are expected to rise more rapidly than in the U.S. d. the Canadian dollar's spot rate is expected to rise in terms of the U.S. dollar ANSWER: c: interest rate parity theory 4.21

The spot rate on the Dutch guilder is $0.39 and the 180-day forward rate is $0.40. The difference between the spot and forward rates means that a. interest rates are higher in the U.S. than in the Netherlands b. the guilder has risen in relation to the dollar c. the inflation rate in the Netherlands is declining d. the guilder is expected to fall in value relative to the dollar there is a high inflation rate in the U.S.

ANSWER:

a: interest rate parity theory

4.22

Suppose the price indexes in Mexico and the U.S., which both began the year at 100, are at 160 and 103, respectively, by the end of the year. If the exchange rate began the year at Mex$4.5 = $1 and ended the year at Mex$5.9 = $1, then the change in the real value of the peso (a "-" indicates a real devaluation) during the year is a.

0% b.

-5.0% c.

18.5% d.

-8.2% ANSWER: c: purchasing power parity

4.23

Suppose the spot rates for the pound, mark, and Swiss franc are $1.20, $.32, and $.40, respectively. The associated 90-day interest rates (annualized) are 16%, 8%, and 4%, while the U.S. 90-day interest rate is 12%. What is the 90-day forward rate (to the nearest cent) on a TCU (TCU 1 = £1 + DM1 + SFr1) if interest parity holds? a $1.92 b $1.98 c $1.94 d $1.87 ANSWER: a: interest rate parity theory

4.24

The current five-year Euroyen rate is 6% per annum (compounded annually).

The five-year Eurodollar rate is 8.5%. What is the implied forward premium or discount of the yen (over the current spot rate) for a five-year forward contract? a.

4.17% premium b.

18.46% discount c.

11.00% discount d.

12.36% premium ANSWER: d: interest rate parity theory 4.25

Suppose the spot rates for the pound, mark, and Swiss franc are $1.50, $.42, and $.48, respectively. The associated 90-day interest rates (annualized) are 12%, 6%, and 4%, while the U.S. 90-day interest rate (annualized) is 8%. What is the 90-day forward rate on a DCU (DCU 1 = £1 + DM1 + SFr1) if interest parity holds? a. $2.4027 b. $2.3923 c. $2.4196 d. $2.3738

ANSWER:

b: interest rate parity theory

4.26

Suppose that spot pounds are selling at $1.7342, while 90-day forward pounds are selling at $1.7156. At the same time, DM spot and 90-day forward rates are $0.6138 and $0.6014, respectively. According to these quotes the a. pound is selling at a 3.87% forward discount relative to the DM b. pound is selling at a 2.37% forward premium relative to the DM c.

DM is selling at a 0.97% forward discount relative to the pound d.

DM is selling at a 1.54% forward premium relative to the pound ANSWER: a: interest rate parity theory

4.27

If annualized interest rates in the U.S. and France are 9% and 13%, respectively, and the spot value of the franc is $.1109, then at what 180-day forward rate will interest rate parity hold? a. $.1070 b. $.1150 c. $.1088 d. $.1130 ANSWER: c: interest rate parity theory 4.28

If annualized interest rates in the U.S. and Switzerland are 10% and 4%, respectively, and the 90-day forward rate for the Swiss franc is $.3864, at what current spot rate will interest rate parity hold? a. $.3902 b. $.3874 c. $.3807 d. $.3792 ANSWER: c: interest rate parity theory 4.29

The spot rate on the euro is $1.40 and the 180-day forward rate is $1.50. The difference between the two rates means a. interest rates are higher in the U.S. than in the European Union b. the mark has risen in relation to the dollar c. the inflation rate in Germany is declining d. the euro is expected to fall in value relative to the dollar ANSWER: a: interest rate parity theory

4.30

Suppose the spot rates for the pound, mark, and Swiss franc are $1.30, $.35, and $.40, respectively. The associated 90-day interest rates (annualized) are 16%, 8%, and 4%, while the U.S. 90-day interest rate (annualized) is 12%. What is the 90-day forward rate on an ACU (ACU 1 = £1 + DM1 + SFr1) if interest parity holds? a. $2.0512

b. c. d.

ANSWER:

$2.1134 $2.0397 $2.0489 d: interest rate parity theory

4.31

The current five-year Euroyen and Eurodollar rates are 8% and 12.5% per annum, respectively. What is the implied forward premium or discount of the yen (over the current spot rate for a five-year forward contract)? a.

4.17% premium b.

18.46% discount c.

17.74% discount d.

22.64% premium ANSWER: d: interest rate parity theory 4.32

The 90-day interest rates (annualized) in the U.S. and Japan are, respectively, 10% and 7%, while the direct spot quote for the yen in New York is $.004300.

At what 90-day forward rate would interest rate parity hold? a. .004430 b. .004271 c. .004332 d. .004176 ANSWER: c: interest rate parity theory 4.33

If annualized interest rates in the U.S. and France are 9% and 13%, respectively, and the spot value of the franc is $.1109, then at what 180-day forward rate will interest rate parity hold? a. $.1070 b. $.1150 c. $.1088 d. $.1130 ANSWER: c: interest rate parity theory

DIFFICULT 4.34

Suppose the pound devalues from $1.25 at the start of the year to $1.00 at the end of the year. Inflation during the year is 15% in England and 5% in the U.S. What is the real devaluation (-) or real revaluation (+) of the pound during the year? a.

- 12.38% b.

- 20.71% c. + 2.39%

d.

ANSWER:

+ 1.46% a: purchasing power parity

4.35

Suppose the price indexes in Spain and the U.S., which both began the year at 100, are at 117 and 105, respectively, by the end of the year. If the beginning and ending exchange rates, respectively, for the peseta are $.1320 and $.1125, then the change in the real value of the peseta (a "-" indicates a real devaluation) during the year is a.

0% b.

-5.0% c.

2.4% d.

-8.2% ANSWER: b: purchasing power parity

4.36

Suppose the Swiss franc revalues from $0.40 at the beginning of the year to $0.44 at the end of the year. U.S. inflation is 5% and Swiss inflation is 3% during the year. What is the real devaluation (-) or real revaluation (+) of the Swiss franc during the year? a. + 7.9% b.

- 5.3% c. + 8.1% d.

- 1.6% ANSWER: a: purchasing power parity

4.37

Suppose the value of the Polish zloty moves from Z 1000 = $1 at the start of the year to Z 1,800 at the end of the year. At the same time, the Polish price level changes from an index of 100 on January 1 to 134 on December 31. U.S. inflation during the year was 4.5%. If the one-year interest rate on the zloty is 44%, what was the real dollar cost of borrowing the zloty during the year? a.

17.53% b.

27.81% c.

-23.44% d.

-8.76% ANSWER: c: purchasing power parity

4.38

Suppose inflation rates in the U.S. and France are expected to be 4% and 9%, respectively, next year and 6% and 7%, respectively, in the following year. If the current spot rate is $.1050, then the expected spot value of the franc in two years is a. $.1111 b. $.1024

c. d.

ANSWER:

$.0992 $.1074 c: purchasing power parity

4.39

Suppose the Deutsche mark revalues from $.30 at the beginning of the year to $.33 at the end of the year. Inflation during the year is 5% in the U.S. and 3% in Germany. What is the real devaluation (-) or real revaluation (+) of the Deutsche mark during the year? a. + 7.9% b.

- 5.3% c. + 8.1% d.

- 1.6% ANSWER: a: purchasing power parity

4.40

If the U.S. trade balance with Japan is expected to go from a deficit this year to a surplus next year, the forward rate on yen would a. be less than the spot rate b. be higher than the spot rate c. equal the spot rate d. could be either above or below the spot rate ANSWER: d: the relationship between the forward rate and the future spot rate 4.41

The following exchange and interest rate quotations were recently observed: Eurocurrency rates

Exchange rate per $

90-days (% annum) (Discretely-compounded)

90-day forward

Spot

$

DM

£

DM

£

DM

£

Bid:

15 5/8

7 7/8

12 1/4

1.881

.4961

1.801

.4937

Ask:

16

8 1/4

13

1.843

.4902

1.773

.4889

An arbitrage profit can be obtained by a. borrowing pounds and lending dollars b. borrowing dollars and lending DM c. borrowing DM and lending pounds d. there are no arbitrage opportunities ANSWER: a: interest rate and parity theory

CHAPTER 5 The Balance of Payments and International Economic Linkages EASY 5.1

A balance of trade deficit results in a current account a. deficit b. surplus c.

IMF intervention d.

World Bank loan ANSWER: c: current account 5.2

The change in private domestic borrowing or lending required to keep payments in balance without adjusting official reserves is called a. the net liquidity balance b. the balance of payments c. the balance on current account d. the balance on capital account ANSWER: a: balance-of-payment measures 5.3

Tourism shows up on the a. merchandise account b. current account c. capital account d. a and c above ANSWER: b: current account 5.4

The accounting statement that summarizes all the economic transactions between residents of the home country and residents of all other countries is called the a. balance of trade b. current account balance c. balance of payments d. capital account balance ANSWER: c: balance-of-payment categories 5.5

The balance on current account includes the net flow of good, services, income and a. portfolio investments b. changes in reserve assets c. direct investment d. unilateral transfers ANSWER: d: balance of payment categories 5.6

The sale of American computers to the Spanish government shows up as a. a debit on the official reserves account b. a credit on the official reserves account c. a credit on the trade account

d.

ANSWER:

a debit on the current account c: current account

5.7

An overvalued currency acts as a(n) ____ on exports and a(n) _____ to imports. a. subsidy, tax b. increase, reduction c. increase, increase d. tax, subsidy ANSWER: d: coping with the current-account deficit 5.8

The US savings deficit can be attributed, in part, to a. the growing US budget deficit b. high real interest rates abroad c. low American investment in plant and equipment d. rising US taxes on capital accumulation ANSWER: a: the international flow of goods

MODERATE 5.9

In a freely floating exchange rate system, if the capital account surplus for the U.S. rises, what will most likely happen to the real value of the dollar? a. it will decline b. it will rise c. there is no impact on the dollar d. the IMF will step in to adjust rising exchange rates ANSWER: b: the link between the current and the capital accounts 5.10

If a real value of a nation's freely floating currency increases, and the nation's current account is initially zero, its capital account will most likely be a. in deficit b. in surplus c. adjusted for the rate of inflation d. decreased by the amount of increase in the current account ANSWER: b: the link between the current and the capital accounts 5.11

In a freely floating exchange rate system, if the capital account is running a deficit a. the balance of payments must run a deficit b. the balance of payments must be zero c. the current account must run a surplus d. b and c above ANSWER: d: the link between the current and the capital accounts

5.12

As the real value of the dollar rises, the balance on current account is likely to a. increase b. decrease c. stay the same d. move with the capital account adjustments factor ANSWER: b: the link between the current and the capital goods 5.13

In a freely floating exchange rate system, if the current account is running a deficit a. the balance of payments must run a deficit b. the balance of payments must be zero c. the capital account must run a surplus d. b and c above ANSWER: d: the link between the current and the capital goods 5.14

In a freely-floating exchange rate system, the sale of Japanese cars to the United States will be offset by which item on the US balance of payments? a. a credit on the current account b. a credit on the capital account c. a debit on the trade account d. a or b ANSWER: d: the link between the current and the capital goods 5.15

The Japanese current account surplus can best be attributed to a. the high rate of Japanese domestic investment b.

Japanese protectionism c. the high rate of Japanese savings d. government budget deficits ANSWER: c: the link between the current and the capital goods According to the J-curve theory, a country’s trade deficit a. decreases just after its currency depreciates b. increases just after its currency appreciates c. increases just after its currency is pegged to the dollar d. worsens just after its currency depreciatees ANSWER: d: coping with the current-account deficit 5.16

DIFFICULT 5.17

Suppose Lufthansa buys 10 Boeing 747s for $150 million in 1991, financed by a five-year loan from the US Export-Import Bank There is a one year grace period on principal and interest payments The net impact of this sale in 1991 is a. a $150 million reduction in the U.S. trade deficit b. a $150 million increase in the U.S. capital account surplus

c. d.

ANSWER:

positive change in the U.S. balance of payments in 1991 a $500 million reduction in the U.S. trade deficit a: the link between the current and the capital goods

5.18

If a nation's income exceeds its spending, then a. savings will be less than domestic investment b. the nation must run a current-account deficit c. the balance of payments will have deficits for the next two years d. the nation must run a capital-account deficit ANSWER: d: the link between the current and the capital goods 5.19

A nation that is running a savings deficit a. must spend more than it produces b. will invest domestically more than it saves c. must have a net capital outflow d. a and b only ANSWER: d: the link between the current and the capital goods 5.20

In order to reduce its current-account deficit, the United States must do which of the following? a. reduce the federal budget deficit b. lower national product relative to national spending c. reduce savings relative to domestic investment d. reduce the federal budget surplus ANSWER: a: the link between the current and the capital goods

CHAPTER 6 THE FOREIGN EXCHANGE MARKET EASY 6.1

Exports of goods and services by the United States now total more than _________ of gross domestic product. a.

10% d.

20% d.

50% d.

75% ANSWER: a: introduction 6.2

What is the name of the international bank communications network for foreign exchange transactions that connects more than 7,000 banks and broker-dealers? a.

FedWire b.

CHIPS c.

SWIFT d.

UBS ANSWER: c: organization of the foreign exchange market 6.3

The overwhelming majority of foreign exchange transactions involve a. multinational corporations buying and selling foreign exchange b. importers and exporters buying and selling foreign exchange c. banks buying and selling foreign exchange d. governments buying and selling foreign exchange ANSWER: c: the participants 6.4

The world's largest currency trading market is located in the city of a.

New York b.

Frankfurt c.

Tokyo d.

London ANSWER: d: size 6.5

American terms refers to the a. number of U.S. dollars per unit of foreign currency b. number of foreign-currency units per U.S. dollar c. quotation system found in the United States d. bid-ask spread on the U.S. dollar ANSWER: d: spot quotations

6.6

Trading on the foreign exchange market is a. located in a physical headquarters in London b. takes place within an organized exchange c. conducted by licensed brokers from the London stock exchange d. an electronically linked network of banks, brokers, and dealers ANSWER: d: organization 6.7

Traders on the foreign exchange market use ___________ to eliminate or cover the risk of loss on export or import orders denominated in foreign currencies. a. currency options b. forward contracts c. money-market hedges d. currency futures contracts ANSWER: b: the participants 6.8

Hedgers, mostly _____________, engage in forward contracts on the foreign exchange markets to protect the home currency value of various foreign currencydenominated assets and liabilities on their balance sheets. a. commercial banks b. public utilities c. multinational corporations d. speculators ANSWER: c: the participants 6.9

A ___________ between a bank and a customer calls for a fixed delivery date, at a fixed exchange rate for a specified amount of one currency against another currency payment. a. spot quotation b. currency option c. currency swap d. forward contract ANSWER: d: the forward market 6.10

Risk that a central bank will not make the necessary transfer of foreign currency to complete a currency settlement is known as ________ risk. a. exchange rate b.

Herstatt c.

Interest-rate d. settlement ANSWER: b: the mechanics of spot transactions

MODERATE 6.11

The spot and 30-day forward rates for the Dutch guilder are $.3075 and $.3120, respectively. The guilder is said to be selling at a forward a. premium of 16.83% b. premium of 17.56% c. discount of 6.39% d. discount of 15.10% ANSWER: b: forward quotations 6.12

Suppose the spot direct quotes for the pound sterling and French franc are $1.3981-89 and $.1130-33, respectively. What is the direct quote for the pound in Paris? a.

12.3398-3796 b.

12.3469-3726 c. .0808-12 d. .0976-87 ANSWER: a: spot quotations 6.13

Suppose the following direct quotes are received for spot and one- month French francs in New York: .1160-684-6. Then the outright 30- day forward quote for the French franc is: a. .1156-62 b. .1164-74 c. .1166-72 d. .1154-64 ANSWER: b: forward quotations 6.14

Suppose the spot direct quotes for the Swedish krona and French franc are $.1395-99 and $.1130-33, respectively. What is the direct quote for the krona in Paris? a.

1.2312-81 b.

1.2435-37 c. .0806-11 d. .0973-81 ANSWER: a: spot quotations

6.15

Suppose sterling is quoted at $1.4419-36, and the Swiss franc is quoted at $0.6250-67. What is the direct quote for the pound in Zurich? a.

2.3035-70 b.

2.3018- 88 c.

2.3008-98 d.

2.3020-50 ANSWER: c: spot quotations 6.16

Suppose the Brazilian Real is quoted at $0.9455-9510, and the Thai baht is quoted at $25.2513-3986. What is the direct quote for the Real in Bangkok? a.

27.1267-5673 b.

26.7801-9801 c.

25.2597-2700 d.

26.5524-8626 ANSWER: d: spot quotations 6.17

If the direct price of the dollar is 2.5 in Frankfurt and transaction costs are .4% of the amount transacted, then the minimum- maximum direct quotes for the DM in New York are: a. .3968-4032 b.

2.4800-2.5200 c. .3984-.4016 d.

2.4900-2.5100 ANSWER: a: spot quotations 6.18

Suppose the 90-day forward quotes on the DM and the French franc are $.4002-10 and $.1180-90, respectively. What is the direct 90-day forward quote for the franc in Frankfurt? a.

3.3625-54 b.

3.3631-92 c. .2943-74 d. .2949-68 ANSWER: c: forward quotations 6.19

The spot and 180-day forward rates for the DM are $.3310 and $.3402, respectively. The DM is said to be selling at a forward a. discount of 2.8% b. premium of 2.8% c. discount of 5.6% d. premium of 5.6% ANSWER: d: forward quotations

6.20

Suppose the spot direct quotes for the Italian lira and Swedish krone are $.00050-51 and $.1201-10, respectively. What is the direct quote for the Swedish krone in Milan? a. .00413-25 b. .00422-31 c.

235.49-242.00 d.

237.81-245.03 ANSWER: c: forward quotations 6.21

Suppose the direct quote for sterling in New York is 1.3110-5. Then the direct quote for dollars in London is: a. .7110-5 b.

2.6220-30 c. .7625-8 d.

1.3110-5 ANSWER: c: spot quotations 6.22

An American company that imports leather goods from England is most likely to be a. long pounds b. short pounds c. can't tell ANSWER: b: spot quotations

DIFFICULT 6.23

On December 3,2001, spot Japanese yen were sold at $0.008058. Suppose the 180-day forward Japanese yen was selling at a 1.91% annualized premium, what is the 180-day forward rate of the yen? a.

0.008245 b.

0.008135 c.

0.008457 d. can’t tell ANSWER: b: forward quotations 6.24

Suppose the spot rate and forward rate for the British pound are 1.4248 and 1.4179 respectively. Assume the forward pound is selling at a 1.94% annualized discount, what is the number of days of the forward contract? a.

180 days b.

120 days c.

90 days d.

60 days ANSWER: c: forward quotations

6.25

Suppose one observed the following direct spot quotations in New York and London, respectively: 1.2500-60 and .8000-50. Arbitrage profits per $1 million equal a. $637 b. $0 c. $1,268 d. $4,492 ANSWER: b: currency arbitrage 6.26

The $/DM exchange rate is DM1 = $.35 and the DM/FF exchange rate is FF1 = DM.31. What is the FF/$ exchange rate? a.

3.226 French francs per dollar b.

1.129 French francs per dollar c. .886 French francs per dollar d.

9.217 French francs per dollar ANSWER: d: cross rates 6.27

Suppose the following direct quotes are received for spot and one-month French francs in New York: .1260-684-6. Then the outright 30-day forward quote for the French is: a. .1256-62 b. .1264-74 c. .1266-72 d. .1254-64 ANSWER: b: forward quotations 6.28

If the direct price of the dollar is 5 in Copenhagen and transaction costs are .5%, then the minimum-maximum direct quotes for the Danish krone in New York are a.

4.9750-5.0250 b.

4.9500-5.0500 c. .1980-.2020 d. .1990-.2010 ANSWER: c: the spot quotations 6.29

Suppose the pound sterling is selling for $1.62 and the buying rate for the Swiss franc is $0.71. Then the £/SFr cross rate is a. £1 = SFr 0.4383 b.

SFr 1 = £2.2817 c. £1 = SFr 2.2817 d. a or b ANSWER: c: cross rates

6.30

Suppose the quote for DM is DM 2.9865-92. Then the percent spread is a.

2.31% b.

0.97% c.

0.62% d.

0.09% ANSWER: d: transaction costs

CHAPTER 7 Currency Futures and Options Markets EASY 7.1

Which one of the following provides an outlet for currency speculators and hedgers who are looking to reduce their currency risks? a. the Chicago Mercantile Exchange b. the Philadelphia Stock Exchange c. the Clearing House Interbank Payments System d. the over the counter market ANSWER: a: futures contracts 7.2

Which of the following has provided a major inducement for speculators to participate in the futures market? a. low margin requirements b. low bid-ask spreads c. high volume compared to the forward market d. all of the above ANSWER: a: forward contracts versus futures contracts 7.2

With respect to the currency futures market, the number of contracts outstanding at any one time is called the a. bear spread b. currency spread c. open interest d. initial margin ANSWER: c: future contracts 7.4

Major advantages of futures contracts include the a. large number of currencies traded b. extensive delivery dates available c freedom to liquidate the contract at any time before its maturity d. all of the above ANSWER: c: advantages and disadvantages of future contracts 7.5

The major disadvantage of forward and futures contracts relative to options is that the forwards and futures contracts a. cannot protect the holder against the risk of adverse movements in exchange rates b. are more expensive c. are available only for relatively short maturities d. eliminate the possibility of gaining a windfall profit from favorable movements in exchange rates ANSWER: d: advantages and disadvantages of future contracts

7.6

Suppose the current spot rate for the DM is $0.7427. A call option with an exercise price of $0.7550 is said to be a. in-the-money b. out-of-the-money c. at-the-money d. past breakeven ANSWER: b: using currency options 7.7

Suppose the current spot rate for the DM is $0.7427. A put option with an exercise price of $0.7550 is said to be a. in-the-money b. out-of-the-money c. at-the-money d. past breakeven ANSWER: a: using currency options MODERATE 7.8

The basic difference(s between forward and futures contracts is that a. forward contracts are individually tailored while futures contracts are standardized b. forward contracts are negotiated with banks whereas futures contracts are bought and sold on an organized exchange c. forward contracts have no daily limits on price fluctuations whereas futures contracts have a daily limit on price fluctuations d. all of the above ANSWER: d: forward contract versus futures contract 7.9

Suppose the current spot rate for the Australian dollar is U.S.$0.8321. The intrinsic value of an A$50,000 call option with an exercise price of U.S.$0.8195 is a. $0 b. $630 c. $740 d. $2,340 ANSWER: b: option pricing and valuation 7.10

The time value of a European option a is always positive for an out-of-the-money option b is always positive for an in-the-money option c is always positive for an at-the-money option d decreases with the time that remains until the option expires ANSWER: a: option pricing and valuation

7.11

Which one of the following acts to reduce risk in the futures markets? a. the Federal Deposit Insurance Corporation b. the low initial margin c. the number of currencies available as futures contracts d. the practice of marking to market by the CME ANSWER: d: using forward or futures contracts versus options

DIFFICULT 7.12

Suppose you are holding a long position in a French franc futures contract that matures in 76 days. The agreed-upon price is $0.15 for FF 250,000. At the close of trading today, the futures price has risen to $0.155. Under marking to market, you now a. hold a futures contract that has risen in value by $1,250 b. hold a futures contract that has fallen in value by $625 c. will receive $1,250 and a new futures contract priced at $0.155 d. must pay over $1,250 to the seller of the futures contract ANSWER: c: computing gains, losses and maintenance margins 7.13

Suppose that the interbank forward bid for March 20 on Swiss francs is $0.7827 at the same time that the price of IMM Swiss franc futures for delivery on March 20 is $0.7795. How much of an arbitrage profit could a dealer earn per March Swiss franc futures contract of SFr 125,000? a. $400 b. $68 c. $215 d. $58 ANSWER: a: arbitrage between the futures and forward markets 7.14

Suppose the current spot rate for the DM is $0.5925. The call premium on a call option with an exercise price of $0.5675 is $0.0373. What is the time value of one DM 62,500 call option?

a. b. c. d.

ANSWER:

$2,331.25 $1,562.50 $950.00 $768.75 d: option pricing and valuation

7.15

Suppose the current spot rate for the DM is $0.5925. The call premium on a call option with an exercise price of $0.5675 is $0.0373. What is the intrinsic value of one DM 62,500 call option? a. $2,331.25 b. $1,562.50 c. $950.00 d. $768.75 ANSWER: b: option pricing and valuation 7.16

The value of a European option always a. exceeds its intrinsic value b. rises with the time to maturity c. rises with the interest rate d. rises with the volatility of the exchange rate ANSWER: d: option pricing and valuation 7.17

A rise in the domestic interest rate will a. raise the value of foreign-currency call options and reduce the value of foreign-currency put options b. raise the value of foreign-currency put options and reduce the value of foreign-currency call options c. raise the value of both foreign-currency put and call options d. reduce the value of both foreign-currency put and call options ANSWER: a: option pricing and valuation 7.18

A rise in the foreign interest rate will a raise the value of foreign-currency call options and lower the value of foreign-currency put options b raise the value of foreign-currency put options and lower the value of foreign-currency call options c raise the value of both foreign-currency put and call options d reduce the value of both foreign-currency put and call options ANSWER: b: option pricing and valuation 7.19

You can speculate on an appreciation of the Japanese yen by a selling a yen put option and buying a yen call option b selling a yen put option and selling a yen call option c buying a yen put option and selling a yen call option d buying a yen put option and buying a yen call option ANSWER: a: option pricing and valuation

7.20

Fluor Corporation has just made a French franc bid on a major project located in France. It won't find out for 60 days whether it has won the contract. The best way to protect against currency risk on its bid is for Fluor to a. buy a franc futures contract b. sell a franc call option c. sell a franc futures contract d. buy a franc put option ANSWER: d: using forward or futures contracts versus options contracts

CHAPTER 8 Swaps and Interest Rate Derivatives EASY 8.1

An __________ swap is an agreement between two parties to exchange interest payments for a specific maturity in an agreed upon notional amount. a. interest rate b. currency c. bond d. currency bond ANSWER: a: interest rate swaps 8.2

In a __________ swaps, two parties exchange floating interest payments based on different reference rates. a. basis b. coupon c. notional d. forward rate ANSWER: a: interest rate swaps 8.3

The theoretical principal underlying the swap is termed the a. basis amount b. swap differential c. notional principal d. arbitrage principal ANSWER: c: interest rate swaps 8.4

In a _____ swap, one party pays a fixed rate calculated at the time off trade as a spread to a particular Treasury bond, and the other sides pays a floating rate. a. currency b. interest rate c. coupoon d. basis ANSWER: c: interest rate swaps 8.5

In a currency swap, the effective interest rate on the money raised is known as the a. notional principal b. all-in cost c. right of offset d. yield to call ANSWER: b: currency swaps

8.6

Swaps provide a real economic benefit to the counterparties only if a barrier exists to prevent ______ from functioning fully. a. hedging b. factoring c. arbitrage d. forfaiting ANSWER: c: economic advantages of swaps 8.7

A(n) ________ is a cash-settled, over-the-counter forward contract that allows a company to fix an interest rate to be applied to a specified future interest period on a notional principal amount. a. interest rate currency swap b. dual currency bond c. exchange of principal d. forward rate agreement ANSWER: d: forward rate agreement 8.8

A(n) __________ is a contract that fixes an interest rate today on a future loan or deposit a. inverse floater b. step-up c. step-down d. forward forward ANSWER: d: forward forwards 8.9

A _________ future is a cash-settled futures contract for a three-month $1,000,000 eurodollar deposit that pays LIBOR. a. forward b. eurodollar c. forward rate agreement d. currency swap ANSWER: b: eurodollar futures

MODERATE 8.10

Swaps are primarily of value because they permit firms to a. tap new capital markets b. reduce risks c. reduce taxes d. a and b only ANSWER: d: economic advantages of swaps

8.11

A currency swap is equivalent to a a. currency option, with the exercise price equal to the current spot rate b. long-dated forward foreign exchange contract, where the forward rate is the current spot rate. c. interest rate swap, where the basis is the differential between the fixed and floating interest rates d. short-term currency futures contract ANSWER: b: currency swaps 8.12

A currency swap is most similar in economic purpose to a a. basis swap b. parent company loan c. debt-equity swap d. parallel loan ANSWER: d: currency swaps 8.13

Currency swaps are often used to provide long-term financing in foreign currencies because a. long-term capital markets are not well developed b. long-term forward foreign exchange markets are absent c. of high foreign taxes d. a and b only ANSWER: d: currency swaps 8.14

If the world capital market were fully integrated, the incentive to swap would be ____ because ____ arbitrage opportunities would exist. a. increased; more b. reduced; fewer c. increased; fewer d. reduced; more ANSWER: b: economic advantages of swaps DIFFICULT The following statement is to be used in answering questions 15 and 16.

Company X, a low-rated firm, desires a fixed-rate, long-term loan. X presently has access to floating interest rate funds at a margin of 1.25% over LIBOR. Its direct borrowing cost is 11% in the fixed-rate bond market. In contrast, company Y, which prefers a floating-rate loan, has access to fixed-rate funds in the Eurodollar bond market at 9% and floating-rate funds at LIBOR + 1/4%. Suppose they split the cost savings.

8.15

How much would X pay for its fixed-rate funds? a.

9.5% b.

10.0% c.

10.5% d.

10.75% ANSWER: c: interest rate and currency swaps, 8.16

How much would Y pay for its floating-rate funds? a.

LIBOR -.25% b.

LIBOR -.50% c.

LIBOR d.

LIBOR + .5% ANSWER: a: interest rate and currency swaps The following statement is to be used in answering questions 17-19.

Axil Corp. has not tapped the Deutsche mark public debt market because of concern about a likely appreciation of that currency and only wishes to be a floating-rate dollar borrower, which it can be at LIBOR + 1%. Bevel Corp. strongly prefers fixed-rate DM debt, but it must pay 1.5% more than the 6 1/4% coupon that Axil's DM notes would carry. Bevel, however, can obtain Eurodollars at LIBOR + ½%.

8.17

What is the maximum possible cost savings to Axil from engaging in a currency swap with Bevel? a.

1% b.

75% c.

2% d.

1.25% ANSWER: c: interest rate and currency swaps 8.18 What is the maximum possible cost savings to Bevel from engaging in a currency swap with Axil? a.

1% b.

75% c.

2% d.

1.25% ANSWER: c: interest rate and currency swaps 8.19

Suppose a bank charges .8% to arrange the swap and Axil and Bevel split the resulting cost savings. Then Axil will pay --- for its floating-rate money and Bevel will pay ---- for its fixed-rate money. a.

LIBOR - .7%; 7.5% b.

LIBOR + .4%; 7.15% c.

LIBOR; 7.45% d.

LIBOR + .5%; 6.75% ANSWER: b: interest rate and currency swaps

8.20

The economic benefits associated with swaps may derive from a. legal restrictions on spot and forward foreign exchange transactions b. different perceptions by investors of risk and creditworthiness of the two parties to the swap c. appeal or acceptability of one borrower to a certain class of investor d. all of the above ANSWER: d: economic advantages of swaps 8.21

Suppose a U.S. corporation wants to secure fixed-rate funds in pounds in order to reduce its pound exposure, but is hampered in doing so because it is a relatively unknown credit in the British financial market. In contrast, a British company that is well established in its own country may desire floating-rate dollar financing, but is relatively unknown in the U.S. financial market. What is the most appropriate form of swap for these two parties? a. interest rate/currency swap b. currency swap c. interest rate swap d. debt/equity swap ANSWER: a: interest rate and currency swaps,

CHAPTER 9 Measuring and Managing Translation and Transaction Exposure EASY 9.1

Under FASB 52, foreign exchange gains and losses a. flow into a special reserve account b. are usually determined according to the current rate method c. both a and b d. flow directly into the income statement ANSWER: c: alternative measures of foreign exchange exposure 9.2

Translation exposure reflects the exposure of a company's a. foreign operations to currency movements b. foreign sales to currency movements c. financial statements to currency movements d. cash flows to currency movements ANSWER: c: alternative currency translation methods 9.3

The current standard for measuring translation exposure is a. the current/noncurrent method b. the monetary/nonmonetary method c.

FASB 8 d.

FASB 52 ANSWER: d: statement of financial accounting standards No. 52 9.4

Under FASB 52, most financial statements must be translated using the a. monetary/nonmonetary method b. current/noncurrent method c. current rate method d. temporal method ANSWER: c: statement of financial accounting standards No. 52

MODERATE 9.5

The major difference between the temporal method and the monetary/nonmonetary method is that a. under the monetary/nonmonetary method, long-term debt is translated at the historical rate, whereas under the temporal method, long-term debt is translated at the current rate b. under the monetary/nonmonetary method, inventory is always translated at the historical rate, whereas under the temporal method, inventory may be translated at the current rate if the inventory is shown on the balance sheet at market values c. under the monetary/nonmonetary method, fixed assets are translated at the historical rate, whereas under the temporal method, fixed assets may be translated at the current rate d. under the monetary/nonmonetary method, accounts receivable are always translated at the historical rate, whereas under the temporal method, receivables may be translated at the current rate ANSWER: b: alternative currency translation methods 9.6

Under a historical cost accounting system, as the United States now has, most accounting theoreticians would probably argue that the appropriate method for translation is the a. monetary/nonmonetary method b. current/noncurrent method c. current rate method d. temporal method ANSWER: d: statement of financial accounting standards No. 52 9.7

The most important aspect of the FASB-52 is that a. it is consistent with generally accepted accounting practice that requires balance-sheet items to be valued according to their underlying measurement basis b. it disallows all reserves for currency losses c. it mandates a uniform translation standard for all firms d. most translation gains and losses bypass the income statement and are accumulated in a separate equity account on the parent's balance sheet ANSWER: d: statement of financial accounting standards No. 52

9.8

The functional currency of a Colombian manufacturing subsidiary selling exclusively to the U.S. a. depends on where it sources its raw materials b. depends on where it sells the completed product c. will be the Colombian peso d. will be the U.S. dollar ANSWER: d: statement of financial accounting standards No. 52

9.9

The functional currency of a Mexican subsidiary that both manufactures and sells most of its output in Mexico will a. always be the U.S. dollar b. always be the Mexican peso c. be the U.S. dollar unless Mexico has a high rate of inflation d. be the Mexican peso unless Mexico has a high rate of inflation ANSWER: d: statement of financial accounting standards No. 52 9.10

The functional currency of a German subsidiary that both manufactures and sells in Germany and competes primarily against Japanese firms a. will be the U.S. dollar b. will be the Deutsche mark c. may be the Japanese yen d. will be the U.S. dollar unless German inflation is high ANSWER: c: statement of financial accounting standards No. 52 9.11

The functional currency of a Malaysian subsidiary that assembles computers using U.S.-made parts, which it then sells in the United States, would most likely be the a.

U.S. dollar b.

Malaysian ringgit c.

The supplier’s currency d.

The lender’s currency ANSWER: a: statement of financial accounting standards No. 52 The following statement is to be used in answering questions 12 and 13.

Suppose the Swiss subsidiary of a U.S. company owes $1 million. During a recent period, the Swiss franc appreciated from $0.69 to $0.73, with an average exchange rate for the period of $0.71.

9.12

If the functional currency is the U.S. dollar, the net result under FASB-52 would be a a. transaction loss of $40,000 for the U.S. parent b. transaction gain of $56,383 for the U.S. parent c. transaction loss of $32,876 for the Swiss subsidiary d. transaction gain of $3176 for the U.S. parent e. no transaction gain or loss for either the subsidiary or parent ANSWER: e: statement of financial accounting standards No. 52

9.13

If the functional currency is the Swiss franc, the net result under FASB-52 would be a a. transaction loss of $40,000 for the U.S. parent b. transaction gain of $56,383 for the U.S. parent c. transaction loss of $32,876 for the Swiss subsidiary d. transaction gain of $3176 for the U.S. parent ANSWER: b: statement of financial accounting standards No. 52 The following information is to be used in answering questions 14-17.

Ajax Manufacturing's German subsidiary has the following balance sheet: Cash, marketable securities Accounts receivable Inventory (at market.

Fixed Assets

DM 250,000 1,000,000 2,700,000 5,100,000 ----------------DM 9,050,000

Current liabilities Long-term debt Equity

DM 750,000 3,400,000 4,900,000

Total liabilities plus equity

--------------DM 9,050,000

Total assets Suppose the DM appreciates from $0.70 to $0.76 during the period.

9.14

Under the current/noncurrent method, what is Ajax's translation gain (loss).? a. a gain of $294,000 b. a gain of $192,000 c. a loss of $174,000 d. a loss of $12,000 ANSWER: b: current/non current method 9.15

Under the temporal method, what is Ajax's translation gain (loss).? a. a gain of $294,000 b. a gain of $192,000 c. a loss of $174,000 d. a loss of $12,000 ANSWER: d: temporal method 9.16

Under the current rate method, what is Ajax's translation gain (loss).? a. a gain of $294,000 b. a gain of $192,000 c. a loss of $174,000 d. a loss of $12,000 ANSWER: a: current rate method

9.17

Under the monetary/non-monetary method, what is Ajax's translation gain (loss).? a. a gain of $294,000 b. a gain of $192,000 c. a loss of $174,000 d. a loss of $12,000 ANSWER: c: monetary/non-monetary method DIFFICULT 9.18

Suppose the English subsidiary of a U.S. firm had current assets of £1 million, fixed assets of £2 million and current liabilities of 1 million pounds both at the start and at the end of the year. There are no long-term liabilities. If the pound depreciated during that year from $1.50 to $1.30, the translation gain (loss) to be included in the parent company's equity account according to FASB #52 is a.

0 since the current assets and current liabilities cancel b. +$200,000 c.

-$250,000 d.

-$400,000 ANSWER: d: application of FASB No. 52 9.19

Suppose the German subsidiary of a U.S. firm had current assets of DM3 million, fixed assets of DM6 million and current liabilities of DM3 million both at the start and at the end of the year. There are no long-term liabilities. If the DM depreciated during that year from $.48 to $.38, the FASB-52 translation gain (loss. to be included in the parent company's equity account is a.

0, since the current assets and current liabilities cancel b. +$300,000 c.

-$350,000 d.

-$600,000 ANSWER: d: application of FASB No. 52 9.20

Transaction gains and losses that result from adjusting assets and liabilities denominated in a currency other than the functional currency must appear on the foreign unit's income statement unless the gains or losses are attributable to a. foreign currency transactions that are designated as an economic hedge of a net investment in a foreign entity b. intercompany foreign-currency transactions that are of a short- term nature c. foreign-currency transactions that involve currency speculation d. all of the above ANSWER: a: application of FASB No. 52

PART 2 EASY 9.21

Hedging cannot provide protection against ________ exchange rate changes.

a. b. c. d.

ANSWER: 9.22

expected nominal real pegged a: designing a hedging strategy

The basic hedging strategy involves

a. b. c. d.

ANSWER:

reducing hard currency assets and soft currency liabilities increasing hard currency liabilities and soft currency assets reducing soft currency assets and hard currency liabilities converting soft currencies to hard currencies and lending hard currencies c: designing a hedging strategy

9.23

Firms that attempt to reduce risk and beat the market simultaneously may end up with a. more risk, not less b. less risk c. a profit as well as reduced risk d. a loss as well as reduced risk ANSWER: a: designing a hedging strategy 9.24

One argument that favors centralization of foreign risk management is the ability to take advantage of the portfolio effect through ________. a. risk shifting b. risk sharing c. offshore banking d. exposure netting ANSWER: d: centralization versus decentralization 9.25

In a forward market hedge, a company that is long a foreign currency will ____ the foreign currency forward. a. buy b. sell c. borrow d. lend ANSWER: b: centralization versus decentralization

9.26. A ________ involves simultaneously borrowing and lending activities in two different currencies to lock in the currency’s value of a future foreign currency cash flow. a. forward contract b. currency collar c. money-market hedge d. currency option ANSWER: c: money-market hedge 9.27

A __________ involves offsetting exposures in one currency with exposures in the same or another currency, where exchange rates are expected to move in such a way that losses on the first exposed position should be offset by gains on the second currency exposure and vice versa. a. forward contract b. currency collar c. money-market hedge d. currency option ANSWER: b: currency collars MODERATE 9.28

Which of the following is NOT a basic hedging technique during a currency depreciation? a. buy local currency forward b. sell a local currency put option c. reduce levels of local currency cash and marketable securities d. loosen credit (increase local currency receivables) ANSWER: c: costs and benefits of standard hedging techniques 9.29

Compaq Computer has a £1 million receivable that it expects to collect in one year. Suppose the interest rate on pounds is 15%. How could Compaq protect this receivable using a money market hedge?

a. b. c. d.

ANSWER: 9.30

borrow £1 million pounds today lend £1 million pounds today borrow £869,565 pounds today lend £986,754 pounds today c: basic hedging techniques

Suppose PPP holds, markets are efficient, there are no taxes, and relative prices remain constant. In such a world, a. b. c. d.

hedging can not still be of value exchange risk management remains of vital concern markets are always free of inflation exchange risk is nonexistent

ANSWER: 9.31

American Airlines hedges a £2.5 million receivable by selling pounds forward. If the spot rate is £1 = $1.73 and the 90-day forward rate is $1.7158, what is American's cost of hedging?

a. b. c. d.

ANSWER: 9.32

$142,000 $35,500 $8,875 it is unknown at the time American enters into its hedge d: the true cost of hedging

Suppose General Motors uses a money market hedge to protect an Lit 200 million payable due in one year. The U.S. interest rate at the time of the hedge was 9% and the lira interest rate was 14%. If the spot rate moved from Lit 1293 at the start of the year to Lit 1349 at the end of the year, what was GM's cost of the money market hedge?

a. b. c. d.

ANSWER: 9.33

b: managing risk management

$3,647 $414 GM gained $1,069 GM gained $5,631 b: money-market hedge

Suppose PepsiCo hedges a ¥1 billion dividend it expects to receive from its Japanese subsidiary in 90 days with a forward contract. The current spot rate is ¥150/$1 and the 90-day forward rate is ¥149/$1. If the spot rate in 90 days is ¥154/$, how much has this forward market hedge cost PepsiCo?

a. b. c. d.

ANSWER:

$173,160 $44,743 Pepsi gains $173,160 from the forward contract Pepsi gains $217,903 from the forward contract d: money-market hedge

DIFFICULT 9.34

If you fear the dollar will rise against the Spanish peseta, with a resulting adverse change in the dollar value of the equity of your Spanish subsidiary, you can hedge by

a. b. c. d.

ANSWER:

selling pesetas forward in the amount of net assets buying pesetas forward in the amount of net assets reducing the liabilities of the subsidiary selling pesetas forward in the amount of total assets a: forward market hedge

9.35

On March 1, Bechtel submits a franc-denominated bid on a project in France.

Bechtel will not learn until June 1 whether it has won the contract. What is the most appropriate way for Bechtel to manage the exchange risk on this contract?

a. b. c. d.

ANSWER: 9.36

A Japanese firm sells TV sets to an American importer for one billion yen payable in 90 days. To protect against exchange risk, the importer could

a. b. c. d.

ANSWER: 9.37

borrow yen, convert to dollars, and lend dollars for the interim period sell yen on the forward market sell a call option on yen buy a futures contract for yen on the IMM d: cross-hedging

If you fear the dollar will rise against the French franc, with a resulting adverse change in the dollar value of the equity of your French subsidiary, you can hedge by

a. b. c. d.

ANSWER: 9.38

sell the franc amount of the bid forward for U.S. dollars buy French francs forward in the amount of the contract buy a put option on francs in the amount of the franc exposure sell a call option on francs in the amount of franc exposure c: foreign currency options

selling francs forward in the amount of net assets buying francs forward in the amount of net assets reducing the liabilities of the subsidiary selling francs forward in the amount of total assets a: forward market hedge

Suppose that the spot rate and the 90-day forward rate on the pound sterling are $1.35 and $1.30, respectively. Your company, wishing to avoid foreign exchange risk, sells £500,000 forward 90 days. Assuming that the spot rate remains the same 90 days hence, your company would

a. b. c. d.

ANSWER:

receive £500,000 90 days hence receive more than £500,000 in 90 days have been better off not to have sold pounds forward receive nothing c: forward market hedge

9.39

DEC is asked to quote a price in Belgian francs for computer sales to a Belgian company. The computers will be paid for in four equal, quarterly installments, beginning 90 days from now. DEC requires a minimum price of $2.5 million to accept this contract. Suppose the spot and forward rates for the Belgian franc are as follows:

Spot

90-Day

180-Day

270-Day

360-Day

$0.0307

$0.0302

$0.0298

$0.0293

$0.0287

What is the minimum Belgian franc price that DEC should quote for this order? a. b. c. d.

ANSWER: 9.40

Ford simultaneously borrows Spanish pesetas at 13% and invests dollars at 10%, both for one year. At the time Ford enters into these transactions, the spot rate for the peseta is $0.095. If the spot rate is Ptas. 1 = $0.087 in one year, what is the cost to Ford of this money market hedge?

a. b. c. d.

ANSWER: 9.41

BF 82,781,457 BF 87,108,014 BF 81,433,225 BF 84,745,763 d: forward market hedge

2.0% 3.8% 1.3% Ford has a 6.5% gain, not a cost d: forward market hedge

Du Pont has entered into a currency risk sharing arrangement with British Gas. Under the contract, Du Pont agrees to pay British Gas a base price of $10 million for gas purchases, but the parties would share the currency risk equally beyond a neutral zone, specified as a band of exchange rates: $1.67-1.73:£1. Within the neutral zone, Du Pont must pay BG the pound equivalent of $10 million at the base rate of $1.70. Suppose the spot rate at the time of payment is £1 = $1.63.

How much will Du Pont owe British Gas?

a. b. c. d.

ANSWER:

$10 million $9,702,381 $9,588,235 $9,819,277 b: currency risk sharing

The following information is to be used in answering questions 42-44.

U.S. borrowing rate for 1 year = 9.5% U.S. deposit rate for 1 year = 8.7% French borrowing rate for 1 year = 11.3% French deposit rate for 1 year = 10.2% French franc spot quote = $0.1763-78 French franc 1-year forward quote = $0.1729-47 9.42

What value can Alcoa lock in for a receivable of FF 3 million due in one year if it executes a money market hedge today?

a. b. c. d.

ANSWER: 9.43

What value can Alcoa lock in for its FF 3 million receivable if it executes a forward contract today?

a. b. c. d.

ANSWER: 9.44

$525,540 $516,545 $530,012 $520,940 b: money-market hedge

$518,700 $524,100 $528,900 $532,410 a: forward market hedge

Suppose Alcoa has a payable of FF 1 million due in one year. Alcoa's cost of the payable using a money market hedge is ----- and its cost using a forward market hedge is -----.

a. b. c. d.

ANSWER:

$173,900; $177,470 $174,925; $176,300 $176,671; $172,900 $178,937; $174,700 d: money-market hedge

9.45

Goodyear has operations in both Germany and the Netherlands. Because of their membership in the European monetary system, the Dutch guilder and Deutsche mark are highly correlated in their movements against the U.S. dollar. If the Dutch unit has net inflows of guilders and the German unit has net inflows of DM, then Goodyear's combined transaction exposure a. b. c.

d.

ANSWER:

9.46

approximately equals the sum of its guilder and DM exposures is less than the sum of its guilder and DM exposures because the currencies are highly correlated is less than the sum of its guilder and DM exposures because of diversification b and c a: cross-hedging

DEC hedges a FF 3.2 million receivable due in 180 days. The current spot rate is FF 1 = $0.18834 and the 180-day forward rate is FF 1 = $0.18625. If the spot rate at the end of 180 days is $0.18728, how much has the forward market hedge cost DEC?

a. b. c. d.

ANSWER:

$6,688 $3,392 $3,296 DEC gains $6,688 on the hedge c: forward market hedge

CHAPTER 10 MEASURING AND MANAGING ECONOMIC EXPOSURE EASY 10.1

During a home currency appreciation, exporters may pull out of markets that foreign competition makes ________. a. unprofitable b. more competitive c. profitable d. more liquid ANSWER: a: foreign exchange risk and economic exposure 10.2

Economic exposure is based on the extent to which the ______ of the firm will change when exchange rates change. a. value b. current assets c. long-term liabilities d. competitive advantages ANSWER: a: foreign exchange risk and economic exposure _______ exposure arises because currency fluctuations can alter a company’s future revenues and expenses. a.

Transaction b.

Operating c.

Political d.

Translation ANSWER: b: foreign exchange risk and economic exposure 10.3

10.4

With respect to home currency (HC) appreciation, the key issue for a domestic firm is its degree of ____. a. market share b. product differentiation c. marketing plan d. pricing flexibility ANSWER: d: operating Exposure 10.5

In the face of exchange rate volatility, developing a pricing strategy must address two key issues: a. market selection and segmentation b. market share and selection c. market share and profit margin d. market share and segmentation ANSWER: c: pricing strategy

10.6

The _______ the price elasticity of demand, the _____ the incentive to hold down price and thereby expand sales. a. lower, greater b. lower, lower c. greater, lower d. greater, greater ANSWER: d: operating exposure 10.7

During periods of exchange rate volatility, firms dealing in _______ products face more exchange rate risk that the firms selling _________ products. a. low demand, high demand a. low supply, high supply c. undifferentiated, differentiated d. differentiated, undifferentiated ANSWER: c: operating exposure 10.8

With respect to production management of exchange risk, ________ and plant location are the principal variables that companies may change to manage the risk. a. product innovation b. product retirement c. market selection d. product sourcing ANSWER: a: product strategy 10.9

One way an MNC may improve productivity in the face of exchange rate volatility is by revising ________. a. product offerings b. the input mix c. shifting production among plants d. changing the promotional strategy ANSWER: a: product strategy 10.10 The greatest boost to a firm’s competitiveness comes from compressing the time it takes to bring new and improved products to market also known as _________. a. product innovation b. product cycle c. input mix d. market segmentation ANSWER: b: planning for exchange rate changes

10.11 While the strategic marketing and production adjustments occur over the long run, financial management may finance the firm’s operations such that shortfalls in cash flows during the adjustments are offset by a reduction in __________ expenses. a. marketing b. production c. debt-servicing d. hedging ANSWER: c: financial management of exchange rate risk MODERATE 10.12 A weak dollar will a. force American exporters to raise their foreign currency prices b. enable American importers to reduce their dollar costs c. enable American exporters to improve their profit margins d. cost American exporters market share abroad ANSWER: c: real exchange rate changes and exchange rate risk 10.13 A company producing an undifferentiated product and competing with internationally diversified competitors will face a relatively ___ price elasticity of demand for its products and possess a relatively ___ degree of pricing flexibility. a. high, low b. low, low c. low, high d. high, high ANSWER: a: operating exposure 10.14 The appropriate response for a U.S. exporter to appreciation of the dollar would be to a. raise the foreign currency price if the dollar appreciation was expected to be temporary and the cost of regaining market share was minimal b. move some production offshore if the appreciation were expected to persist for an extended period c. keep the foreign currency price constant if demand is quite elastic d. all of the above ANSWER: d: operating exposure 10.15 Which one of the following areas is NOT a way companies often respond to exchange rate risk when they alter their product strategy? a. shifting the firm’s manufacturing base to another country b. the timing of new-product introduction c. changing the size of its product line d. product innovation with advanced technology ANSWER: a: product strategy

10.16 Which of the following strategies assumes that the MNC has already collected a portfolio of different facilities world wide? a. production shifting b. product innovation c. product sourcing d. raising productivity ANSWER: a: shifting production among plants 10.17 When we examine operating exposure, the key issue for a domestic firm is its a. prior import competition b. pricing flexibility c. asset valuation adjustment d. low import content ANSWER: b: operating exposure

DIFFICULT 10.18 Volkswagen almost went bankrupt in 1973 for all of the following EXCEPT a. it failed to offset the exchange risk associated with its cost structure and revenue structure with a suitable liability structure b. it gambled on the value of dollars c. it priced its cars in dollars d. it produced in many locations globally ANSWER: a: financial management of exchange rate risk 10.19 A company producing an undifferentiated product and competing with internationally diversified competitors will face a relatively __ price elasticity of demand for its products and possess a relatively ___ degree of pricing flexibility. a. high, low b. low, low c. low, high d. high, high ANSWER: a: operating exposure 10.20 All of the following are appropriate responses for a U.S. exporter to an appreciation of the dollar EXCEPT a. raise the foreign currency price if the dollar appreciation was expected to be temporary and the cost of regaining market share was minimal b. move some production offshore if the appreciation were expected to persist for an extended period c. keep the foreign currency price constant if demand is highly elastic d. keep the local currency price constant if demand is highly elastic ANSWER: d: characteristic economic effects of exchange rate changes

10.21 Suppose McDonald's charges Ptas. 25 for a burger in Madrid. Its costs are Ptas.

18 per burger and these costs are not expected to change with the exchange rate. If the peseta devalues from $0.107 to $0.096, what price will McDonald's have to charge for its burgers to maintain its dollar profit margin? a.

Ptas. 25.80 b.

Ptas. 27.86 c.

Ptas. 22.43 d.

Ptas. 24 ANSWER: a: calculating economic exposure 10.22 Suppose Apple is selling Macintosh computers in Germany in 1990 for DM 5,500 when the exchange rate was DM 1 = $0.68. If the DM rises to $0.71, what price must Apple charge to maintain its dollar unit revenue? a.

DM 5,147 b.

DM 6,361 c.

DM 5,743 d.

DM 5,268 ANSWER: d: calculating economic exposure 10.23 Following a devaluation of the Greek drachma, which of the following products sold in Greece is most likely to bear a drachma price increase? a.

Fiat automobile, sold to the low end of the market b.

Kentucky Fried Chicken dinner, facing competition from local fast food restaurants c.

IBM mainframe computer, whose only competition comes from other American computer companies d. shirts from Hong Kong, facing competition from local manufacturers ANSWER: c: operating exposure 10.24 In the face of an appreciating yen, Toyota should consider a. investing in U.S. production facilities b. raising its research and development investment c. coming out with new cars targeted at the low end of the market d. a and b only ANSWER: d: operating exposure 10.25 A U.S. exporter that anticipates an appreciation of the dollar should a. sell foreign currencies forward b. borrow foreign currencies c. scout out possible foreign production sites d. consider raising dollar prices on exports ANSWER: c: planning for exchange rate risk

10.26 Which of the following products is most likely to benefit from depreciation of the dollar? a. high-end signal processor from Hewlett-Packard that faces minimal competition b.

Chevrolet automobile with a highly price elastic demand c.

Mercedes-Benz auto facing price inelastic demand d. low-end Japanese machine tool ANSWER: b: foreign exchange risk and economic exposure 10.27 Jet engine manufacturing entails enormous economies of scale. Pratt & Whitney, a large U.S. jet engine producer, faces substantial competition from Rolls-Royce, the British engine manufacturer. What would be the best way for P & W to cope with a dollar that has recently appreciated by 50%? a. accelerate R&D spending and cost-cutting efforts b. shift some of its production abroad c. raise the foreign currency prices of its engines sold abroad d. buy dollars forward ANSWER: a: foreign exchange risk and economic exposure 10.28 Shorter product cycles can improve currency risk management by allowing the firm to a. incorporate more up-to-date technology in its products b. respond more quickly to changing market conditions c. reduce the average price elasticity of demand d. maintain its current line of products ANSWER: d: the economic consequences of exchange rate changes 10.29 Nissan, the Japanese car manufacturer, exports a substantial fraction of its output to the United States. What financial measures would be suitable for Nissan to take to reduce its currency risk? a. borrow only yen to finance its operations b. borrow dollars to finance part of its operations c. sell yen forward in the amount of its annual shipments to the U.S. d. buy yen forward in the amount of its annual shipments to the U.S. ANSWER: b: the economic consequences of exchange rate changes 10.30 Sumitomo Bank wants to expand its lending in the United States, but to do so it needs to raise more long-term debt capital to help finance these loans. Currently, long-term interest rates are 9.5% in the U.S. and 6.3% in Japan. What would you recommend Sumitomo do? a. raise yen in Japan because of the lower cost of money b. raise yen in Japan because Japanese investors are more patient than U.S. investors c. raise dollars in the U.S. to hedge against currency risk d. raise dollars in the U.S. to avoid depressing Tokyo stocks ANSWER: c: the economic consequences of exchange rate changes

CHAPTER 11 Country Risk Analysis EASY 11.1

The degree of political risk faced by a firm operating in a foreign country a. can be determined by using a political risk index b. depends on the benefits provided by the firm c. both a and b d. depends on how the firm has structured its operations ANSWER: d: measuring political risk 11.2

One good indicator of political risk is a. the seriousness of capital flight b. the level of domestic interest rates c. the level of domestic tax rates d. a large middle class population ANSWER: a: capital flight 11.3

Capital flight occurs for several reasons, most of which have to do with a. government regulations on interest rates b. high taxes on domestic investments c. the threat of government seizure of domestic assets d. inappropriate economic policies ANSWER: d: capital flight 11.4

Expropriation or creeping expropriation is most likely in the ------ sector of an economy. a. manufacturing b. agricultural c. construction d. extractive ANSWER: d: market-oriented versus statist policies 11.5

The great economic lesson of the ill-fated, post-World War II experiment in Communism is that _________ work and command economies do not. a. state subsidies b. market forces c. five-year plans d. centralized economic controls ANSWER: d: market-oriented versus statist policies 11.6

A large government deficit relative to GDP, a high rate of money expansion accompanied by fixed exchange rates, along with substantial government expenditures are some of the common characteristics of _________ risk. a. exchange rate b. interest rate c. country d. investment ANSWER: c: indicators of country risk

11.7

A structure of incentives that rewards risk taking in productive ventures is an indicator of long-run _____________ health for a country. a. social b. political c. economic d. spiritual ANSWER: c: key indicators of country risk The state’s best strategy is to provide basic _________ in order to promote economic growth. a. health care services b. lifelong pensions for its workers c. economic and political stability d. natural resources ANSWER: c: key indicators of country risk 11.8

What ultimately determines a nation’s ability to repay foreign loans is its ability to generate ___________. a. hard currencies b. soft currencies c. more employment d. more imports ANSWER: a: key indicators of country risk 11.9

11.10 The economic experiences of Mexico, Chile, and Argentina in the recent past show that they all possessed a_________. a. a political party system of many factions b. a loosely drawn economic plan that is allowed to evolve over time c. a political lead who is more of a manager than a leader d. a head of state who demonstrates strong will and leadership ANSWER: d: lessons from international debt crisis MODERATE 11.11 When investing in a natural resource project, a foreign mining firm can add value to the project by doing all of the following EXCEPT a. taking out political risk insurance from the home government b. using foreign financing c. selling mining resource in advance to customers d. ignoring safety conditions in the local plant ANSWER: d: key indicators of country risk

11.12 During the 1980s many Latin American countries believed in a policy that economic growth was best promoted by extensive state ownership which led to a. capital flight b. increased growth in GDP c. rampant deflations d. import subsidies ANSWER: a: Economic and Political Factors Underlying Country Risk 11.13 Which one of the following is a tough-minded economic policy that may halt capital flight? a. making utilities publicly owned b. granting government subsidies to local firms c. imposing protective tariffs d. removing barriers to investment by foreigners ANSWER: d: capital flight 11.14 An oil company can manage its political risk in Nigeria by all of the following EXCEPT a. taking out political risk insurance b. using foreign non-recourse financing c. selling oil in advance d. siding with the political establishment regardless of public opinion ANSWER: d: capital flight 11.15 Political risk is primarily a function of the following but NOT a. instability in the government b. uncertainty over property rights c. the level of violence in the society d. the degree of centralization practiced by the MNC in country ANSWER: d: measuring political risk

DIFFICULT 11.16 Which one of the following is NOT a form of political risk to the multinational corporation? a. currency controls b. privatization of public utilities c. changes in tax or labor laws d. regulatory restrictions ANSWER: b: measuring political risk 11.17 Which one of the following is NOT a measure of political instability? a. the number of political parties b. frequency of changes of government c. the level of violence d. conflicts with neighboring states ANSWER: a: measuring political risk

11.18 Which of the following foreign investments would be least subject to expropriation? a. b. c. d.

ANSWER:

an oil well in an LDC that is providing needed foreign exchange a coffee plantation that is producing beans for export an assembly plant for automobiles located in an LDC a tire making plant in an LDC that is substituting for tire imports c: key indicators of country risk

11.19 A U.S. company whose foreign property has been expropriated is most likely to receive legal aid and indemnification from a. a host country court b. the U.S. Supreme Court c. the International Center for Settlement of Investment Dispute d. the U.S. Appeals Court e. none of the above will generally prove adequate ANSWER: e: key indicators of country risk 11.20 To halt capital flight, which one of the following would NOT be a measure governments may take? a. cutting budget deficits b. impose comprehensive capital controls c. sell off state-owned enterprises d. allowing for freer trade ANSWER: b: capital flight

CHAPTER 12 INTERNATIONAL FINANCING AND NATIONAL CAPITAL MARKETS EASY 12.1

The most preferred form of securities by U.S. firms for funding is a. debt b. preferred stock c. common stock d. stock derivatives ANSWER: a: corporate sources and uses of funds 12.2

Financial deregulation began in ____ in 1981 and in _____ in 1986. a.

Italy, Germany b.

England, France c. the U.S., Japan d. in the European Union, NAFTA ANSWER: c: financial markets versus financial intermediaries 12.3

The cost of the heavy reliance on banks by Japanese and German companies is a. less freedom of action b. higher interest charges on loans c. lower deposit rates d. more control by the government ANSWER: a: financial systems and corporate governance 12.4

Which one of the following is a consequence of a well-functioning financial market? a. greater capital accumulation b. better projects get financed c. lower cost of capital d. all of the above ANSWER: d: the role and consequences of well-functioning financial markets 12.5

______ is replacing bank loans with securities issued in public markets. a.

A drawdown b.

Securitization c.

Capital productivity d.

Regulatory arbitrage ANSWER: b: financial markets versus financial intermediaries

12.6

The difference between countries in terms of company controls can be categorized into market-oriented and ____________ systems. a. bank-centered b.

Anglo-Saxon c. debt-denominated d. keiretsu ANSWER: a: financial systems and corporate governance

12.7

Brazil is planning to develop a major hydroelectric project in order to replace oil imports and conserve scarce foreign exchange. Which of the following international lending agencies is most likely to provide financing for this project? a. the World Bank b. the International Monetary Fund c. the International Finance Agency d. the International Development Agency ANSWER: a: development banks 12.8

The most important source of funds used by companies around the world is a. internally generated cash b. short-term external funds c. issues of new stock d. public debt securities ANSWER: a: corporate sources and uses of funds 12.9

The most important change in Japanese corporate finance in recent years has been a. the shift from internal funds to bank loans b. the shift from internal funds to stock issues c. the shift from external funds to internal funds d. the dramatic rise in the payment of dividends ANSWER: c: financial markets versus financial intermediaries 12.10 Argentina is seeking balance-of-payments financing from an international lending institution. Which of the following is most likely to provide such funding? a. the World Bank b. the International Monetary Fund c. the International Finance Corporation d. the International Development Agency ANSWER: b: development banks 12.11 Selling stock overseas is attractive to corporations because it a. may raise the price of the company's stock b. improves the company's visibility in local markets c. provides a pool of patient investors who are not focusing exclusively on next quarter's profits d. a and b only

ANSWER:

d: the foreign equity market

12.12 Which of the following banking practice would be found more often under the CEJ model of corporate governance? a. emphasis on shareholder value b. the importance of equity financing c. control by institutional shareholders d. universal banking ANSWER: d: financial systems and corporate governance 12.13 Project finance is distinctive from other financings because the providers of the funding a. look primarily to the cash flow from the project as the source of funds b. use the parent’s assets to secure the funds c. merge the operations of the project with those of the parent d. have no exit plans ANSWER: a: project finance 12.14 The dominant currency of the Eurocurrency markets is the a.

U.S. dollar b.

Euro c.

Yen d.

Pound ANSWER: a: the Eurocurrency market 12.15 Eurodollar deposits represent the liabilities of a.

European non-financial corporations b. the Organization of Petroleum Exporting Countries (OPEC. c.

European banks and U.S. bank branches abroad d.

European banks exclusively ANSWER: c: the eurocurrency market 12.16 The supply of Eurodollar deposits is the result of a.

Federal Reserve Board policy b.

World Bank policy c. a resolution of the member governments of the Organization of Economic Cooperation and Development (OECD) d. none of the above ANSWER: d: modern origins 12.17 In recent years, the Eurocurrency market has grown ___ the Eurobond market. a. more slowly than b. at about the same rate as c. much more rapidly than

d.

ANSWER:

with no clear pattern emerges relative to a: modern origins

12.18 The period over which the borrower may take down a Eurocurrency loan is known as the ______. a. maturity of the loan b.

LIBOR rate c.

Drawdown d.

Margin ANSWER: c: Eurocurrency loans

12.19 Another name for the spread in a Eurocurrency loan is the _______. a. drawdown b. term c.

LIBOR rate d.

Margin ANSWER: d: eurocurrency loans 12.20 Eurocurrency spreads are __________ the domestic money market spreads. a. wider than b. narrower than c. very similar to d. exactly the same as ANSWER: b: interest differentials 12.21 One reason Eurocurrency deposit rates are higher than domestic rates is due to the fact that a. they have no relationship to domestic rates b. they must be higher to attract domestic depositors c. most borrowers are well-known d. a smaller percentage of deposits can be lent out ANSWER: b: Eurocurrency spreads 12.22 The rate of interest paid at which high-quality borrowers can borrow at lower rates in the eurocurency markets is known as the ____ rate. a.

LIBOR b. prime c.

LIBIL d.

LIBID ANSWER: d: euormarket trends 12.23 Historically, most Eurobonds have been ________ denominated. a.

U.S. dollar b. yen c. euro

d.

ANSWER:

pound a: Eurobonds/currency denomination

12.24 The ________ , which resembles the U.S. commercial paper market, allows borrowers to issue their own short-term euronotes. a.

Eurobond market b. eurobank c. note issuance facility d. revolving underwriter facility ANSWER: c: note issuance facilities and euronotes

12.25 Debt denominated in a foreign currency that is launched, priced and traded in Asia is referred to as a _________ bond. a. shogun b. samurai c.

Asian-tiger d. dragon ANSWER: d: the Asiancurrency market

MODERATE 12.26 Which one of the following factors does NOT promote well-functioning financial markets? a. secure property rights b. high tariffs c. contracts that are easily enforced d. transparency in financial statements ANSWER: b: the role and consequences of well-functioning financial markets 12.27 The process of securitization reflects a. new technology that has lowered the costs of compiling, accessing, and manipulating data b. financial deregulation that raised the cost of funds to banks c. lower costs of accessing public markets directly d. all of the above ANSWER: d: financial markets versus financial intermediaries

12.28 The globalization of financial markets reflects a. financial deregulation, which spurs competition among markets b. reductions in currency controls and other government restrictions on cfree flow of capital internationally c. new technology that has lowered the cost of information

d.

ANSWER:

all of the above d: financial markets versus financial intermediaries

12.29 Why are privately placed bonds more difficult to sell than publicly issued bonds? a. they are usually commercial bank loans b. the presence of customized covenants c. funds come from private investors d. underwriting is required ANSWER: b: corporate sources and uses of funds 12.30 Global growth in the financial markets is driven by each of the following EXCEPT: a. freer markets b. widely available information c. government capital controls d. financial deregulation by governments ANSWER: c: globalization of financial markets 12.31 When the overwhelming majority of investors would be willing to pay more for the shares of a well-governed company, ___________ is improved. a. financial innovation b. regulatory arbitrage c. private placement d. capital productivity ANSWER: d: national capital markets as international financial centers 12.32 Which one of the following securities in the foreign bond markets has the least amount of risk to the investor? a. samurai bond b. shogun bond c. convertible bond d. equity warrants ANSWER: c: the foreign bond market 12.33 Which one of the following new issues of stock has the greatest probability of lowering its cost of equity capital? a.

Microsoft in the New York markets b.

Toyota on the Tokyo exchange c.

Apple stock on the London exchange d. all of the above ANSWER: c: the foreign equity market 12.34 Which one of the following banks is considered the most important in the development bank industry? a.

Asian Development Bank b.

World Bank

c. d.

ANSWER:

African Development Bank European Bank for Reconstruction and Development b: development banks

12.35 The process of securitization reflects a. new technology that has lowered the costs of compiling, accessing, and manipulating data b. financial deregulation that raised the cost of funds to banks c. lower costs of accessing public markets directly d. all of the above ANSWER: d: financial markets versus financial intermediaries

12.36 The globalization of financial markets reflects a. financial deregulation, which spurs competition among markets c. reductions in currency controls and other government restrictions on cfree flow of capital internationally c. new technology that has lowered the cost of information d. all of the above ANSWER: d: financial markets versus financial intermediaries 12.37 Which one of the following is the MOST obvious example of the globalization of financial markets? a. the creation of the European Union b. the rise of the Euromarkets c. the end of the Soviet Union d. the Asian currency crisis of 1997 ANSWER: b: globalization 12.38 Suppose the French government imposes an interest rate ceiling on French bank deposits. What is the likely effect of this regulation? a. reduce Eurofranc interest rates b. raise Eurofranc interest rates c. have no effect d. can't tell ANSWER: a: relationship between domestic and eurocurrency money markets 12.39 If the current 180-day inter-bank Eurodollar rate is 15% (all rates are stated on an annualized basis. and next period's LIBOR is 13%, then a Eurocurrency loan priced at LIBOR plus 1% will cost a.

16% this period and 16% next period b.

15% this period and 14% next period c.

16% this period and 14% next period d.

15% this period and 15% next period ANSWER: c: eurocurrency loans

12.40 Suppose that the current 90-day London interbank offer rate is 11% (all rates are stated on an annualized basis..If next period's LIBOR is 10.5%, then a Eurodollar rate priced at LIBOR plus 1% will cost a.

12% this period and 11.5% next period b.

11% this period and 10.5% next period c.

12% this period and 12% next period d.

11% this period and 11% next period ANSWER: a: eurocurrency loans 12.41 One reason for the multicurrency clause in the euro markets is to avoid a. government actions to block funds b. local traders from arbitraging away profits c. exchange rate risk d. political instability ANSWER: c: multicurrency clause DIFFICULT 12.42 As the cost of gathering information on foreign firms continues to come down, ___ should become an increasingly more cost- effective means of raising funds internationally. a. international securitization b. international financial intermediation c. international bank lending d. international portfolio investment ANSWER: a: globalization of financial markets

12.43 A U.S. company has the following choices of financial markets in which to raise capital. Which one will it most often prefer? a. foreign bond b. foreign bank c. a new issue of common stock d. domestic banks ANSWER: a: corporate sources and use of funds 12.44 A multinational corporation attempting to secure an airport construction project involving billions of dollars in cost would be best advised to apply to the _________ for funding. a.

World Bank b.

London banking market c.

New York bond market d.

Tokyo foreign bond market ANSWER: a: development banks 12.45 Which of the following bonds would NOT be found on the foreign bond markets?

a. b. c. d.

ANSWER:

Yankee municipal samurai shogun b: the foreign bond market

12.46 Which one of the following economic policies would the international financial markets tend to reward? a. increased tariffs b. reduced government ownership of private firms c. a system of government currency controls d. more government protection of infant-industries ANSWER: b: globalization of financial markets has its downside 12.47 Suppose the Belgian government imposes added taxes on interest paid on Belgian bank deposits. What is the likely effect of this regulation? a. raise Eurofranc interest rates b. reduce Eurofranc interest rates c. have no effect d. capital flight ANSWER: b: relationship between domestic and eurocurrency money markets

12.48 Which of the following have led to a closer relationship between interest rates in national and Eurocurrency money markets? a. tax treaties that reduce the incidence of double taxation on foreign-source income b. elimination of currency controls c. reduced cost of transatlantic telecommunications d. all of the above ANSWER: d: eurobonds versus eurocurrency loans 12.49 Eurocurrency spreads are narrower than in domestic money markets because a.

Eurobanks don't have to maintain reserves on Eurodollar deposits b.

Eurobanks face lower regulatory expenses c. national banks are often required to lend money to certain borrowers at concessionary rates d. all of the above ANSWER: d: eurobonds versus eurocurrency loans

CHAPTER 13 INTERNATIONAL PORTFOLIO INVESTMENT EASY 13.1

Which one of the following is an advantage of international investing? a. you can invest in industries that don't exist in the United States b. you can invest in companies that have lower price-earnings ratios c. you can invest in companies that are, on average, more profitable than similar U.S. firms d. you can invest in companies with lower market-book value ratios ANSWER: a: international diversification 13.2

While there is systematic risk within a nation, it may be ______ and diversifiable outside the country after constructing a global portfolio. a. temporary b. somewhat temporary c. non-systematic d. permanent ANSWER: c: correlations and the gains from diversification 13.3

The efficient frontier is the set of portfolios that has the ________ standard deviation for its level of expected return. a. smallest possible b. greatest possible c. most feasible d. least correlated ANSWER: a: correlations and the gains from diversification 13.4

The lack of ________ , the ability to buy and sell securities efficiently, is a major obstacle on some overseas exchanges. a. diversification b. foreign ownership c. liquidity d. solvency ANSWER: c: barriers to international diversification 13.5

The total dollar return on a foreign security can be decomposed into a. dividend/interest income b. capital gains (losses). c. currency gains (losses). d. all of the above ANSWER: d: measuring the total return from foreign portfolio investing

13.6

________ are certificates of ownership by a U.S. bank as a convenience to investors in lieu of the underlying shares it holds in custody. a.

Emerging market indexes b.

Regional funds c.

American depository receipts d.

American derivative claims ANSWER: c: barriers to international diversification 13.7

Instead of buying foreign stocks overseas, investors wishing to diversify internationally can buy foreign equities traded in the United States in the form of a. currency futures contracts b. foreign stock options c. interest rate swaps d.

American Depository Receipts ANSWER: d: barriers to international diversification 13.8

In the past investing in emerging markets offered _______ risk and _________ returns. a. the highest, the highest b. the lowest, the highest c. the highest, the lowest d. the lowest, the lowest ANSWER: a: investing in emerging markets 13.9

One of the barriers to international diversification is the lack of information that is not readily __________ nor ___________ for global investors. a. provided, comparable b. accessible, comparable c. comparable, free d. provided, free ANSWER: b: barriers to international diversification 13.10 Recent global market behavior indicates that markets tend to be most ________ when volatility is greatest. a. uncorrelated b. stable c. correlated d. unstable ANSWER: c: recent correlations

MODERATE 13.11 The difference between a global fund and an international fund is the global fund a. invests anywhere in the world excluding the United States b. invests anywhere in the world including the United States c. invests only outside the United States d. invests in individual countries ANSWER: b: barriers to international diversification 13.12 Suppose the initial price of a French bond is FF 850, the coupon income is FF 70, the end-of-period bond price is FF 1,000, and the franc devalues by 6% against the dollar during the period. What was the bond's total dollar return during the period? a.

8.24% b.

18.33% c.

25.88% d.

27.44% ANSWER: b: measuring the total return from foreign portfolio investing 13.13

Suppose an investor buys a Taiwanese bond with a face value of NT20,000, which is priced at NT$19,500 and bears a coupon of NT$1,700. At the end of the year, the investor sells the bond at a price of NT$18,030. During the year, the exchange rate goes from NT$1 = U.S.$0.0375 to NT$1 = U.S.$0.0425. What was the investor's U.S. dollar return on this bond? a.

13.33% b.

4.23% c.

-5.69% d.

14.67% ANSWER: d: measuring the total return from foreign portfolio investing 13.14 A Thai baht bond with a coupon of 9.5% is initially priced at its face value of Bt 1,000. At the end of one year, the bond is selling for Bt 1,050. If the initial spot rate was Bt 25 = $1, at what end- of-year exchange rate will the dollar return on the bond just equal 10%? a.

Bt 1 = $0.0384 b.

Bt 1 = $0.0416 c.

Bt 1 = $0.0482 d.

Bt 1 = $0.0324 ANSWER: a: measuring the total return from foreign portfolio investing

13.15 A Canadian bond is initially priced at its face value of C$1,000. At the end of the year, the bond is selling for C$1,100. If the Canadian dollar appreciates by 10%, with a 5.5% coupon, what will the U.S. dollar return on the bond equal at the end of the year? a.

1.05% b.

27.1% c.

15% d.

20% ANSWER: b: measuring the total return from foreign portfolio investing 13.16 A Hong Kong bond with a coupon of 10% is initially priced at HK$1,000. At the end of the year, the bond is selling for HK$1,200. If the Hong Kong dollar depreciates by 5%, what will the U.S. dollar return on the bond equal at the end of the year? a.

10% b.

13% c.

23.5% d.

31% ANSWER: c: measuring the total return from foreign portfolio investing

13.17 Suppose an investor buys a Japanese bond with a coupon rate of 10% at its price of ¥1,100. The bond’s face value is ¥1,000. At the end of the year, the bond is selling at ¥1,050 and the ¥ has depreciated by 10%. What is the dollar return on the bond at the end of the year? a.

-15.6% b.

-5.91% c.

10.3% d.

15.8% ANSWER: b: measuring the total return from foreign portfolio investing 13.18 A Euro bond with a coupon rate of 10% is initially priced at its face value of €1000. At the end of the year, the bond is selling at €1,070. If the € appreciates by 12% during the year, what is the end- of-year dollar return on the bond? a.

130% b.

105% c.

31.04% d.

95% ANSWER: c: measuring the total return from foreign portfolio investing

13.19 A Brazilian bond with a coupon rate of 20% is initially priced at its face value of R$1,000. At the end of the year, the bond is selling at R$1,050. If the real depreciates by 75%, what is the dollar return at the end of the year? a.

-155% b.

-68.75% c.

9.5% d.

8.5% ANSWER: b: measuring the total return from foreign portfolio investing 13.20 A Brazilian bond with a coupon rate of 15% at is initially priced at its face value of R$1,000. At the end of the year, the bond is selling at R$950. During the year, the exchange rate goes from R$1 = U.S.$0.75 to R$1 = U.S.$0.85. What is the bond's total dollar return during the period? a.

15% b.

10% c.

22.67% d.

31.25% ANSWER: c: measuring the total return from foreign portfolio investing 13.21 What country’s depreciation in 1994 led the stock market tumble by other Latin American stock markets? a.

Mexico b.

Argentina c.

Brazil d.

Columbia ANWER: a: Latin American Stocks Were Hotter than Salsa 13.22 Suppose an investor buys a share of Sony at a price of ¥38,720 at the start of the year. During the year, the investor receives a dividend of ¥500. At the end of the year, the price of Sony is ¥49,560. During the year, the exchange rate goes from ¥150 = $1 to ¥175 = $1. What was the investor's dollar return on Sony? a.

29.29% b.

10.82% c.

-3.24% d.

-8.23% ANSWER: b: measuring the total return from foreign portfolio investing 13.23 Suppose you buy a share of Siemens at a price of DM 83. During the year, you receive a dividend of DM 2 and the DM rises by 8%. If the stock price at yearend is DM 80, what was your total dollar return for the year? a.

10.60% b.

6.70% c.

9.83% d.

8.43% ANSWER: b: measuring the total return from foreign portfolio investing

13.24 Suppose an investor buys a share of British Petroleum at a price of £32 at the start of the year. During the year, the investor receives a dividend of £1.5. At the end of the year, the price of BP is £34. During the year, the exchange rate goes from £1 = $1.78 to £1 = $1.63. What was the investor's dollar return on BP? a.

-2.35% b.

-6.47% c.

1.59% d.

10.94% ANSWER: c: measuring the total return from foreign portfolio investing 13.25 International diversification provides a better risk-return trade-off than does investing solely in U.S. securities primarily because a. many foreign industries don't exist in the U.S. b. there are many more securities to choose from overseas c. the economic cycles of nations may not be perfectly in phase d. the foreign securities may follow U.S. markets in their price movements ANSWER: c: international diversification DIFFICULT 13.26 Assume the standard deviation of the U.S. market portfolio is 18.2%, the standard deviation of the non-U.S. portion of the world portfolio is 17.1%, and the correlation between the U.S. and non-U.S. market portfolios is .47. Suppose you invest 40% of your money in the U.S. stock market and the other 60% in the non-U.S. portfolio. What is the standard deviation of your portfolio? a.

17.7% b.

9.4% c.

15.1% d.

18.3% ANSWER: c: correlations and the gains from diversification 13.27 Assume the standard deviation of the U.S. market portfolio is 18.2%, the standard deviation of the non-U.S. portion of the world portfolio is 17.1%, and the correlation between the U.S. and non-U.S. market portfolios is .47. Suppose you invest 25% of your money in the U.S. stock market and the other 75% in the non-U.S. portfolio. What is the standard deviation of your portfolio? a.

16.7% b.

15.5% c.

17.1% d.

18.6% ANSWER: b: correlations and the gains from diversification

13.28 Which one of the following are NOT a barrier to international diversification. a. lack of foreign market liquidity b. easy convertibility of many currencies c. inadequate information d. lack of international accounting standards ANSWER: b: barriers to international diversification 13.29 Which of the following statements is most CORRECT with respect to international diversification? a. the gains from diversification may be diminished due to combined correlations accompanied by volatility in world markets b. world markets always seem to be most uncorrelated when volatility is present c. world markets have displayed relatively low and fixed correlations over the last five years d. global diversification produces gain even when world markets have correlations value near one.

ANSWER: a: correlations and the gains from diversification 13.30 Suppose an investor buys a UK bond with a coupon rate of 8% at its price of £990. The bond’s face value is £1,000. If the British pound depreciates by 5%, at what end- of-year selling price of this bond will the dollar return on the bond just equal 10%? a.

1062 b.

1100 c.

1000 d.

1300 ANSWER: a: measuring the total return from foreign portfolio investing

CHAPTER 14 CAPITAL BUDGETING FOR THE MULTINATIONAL CORPORATION

EASY 14.1

The _______ is defined as the present value of future cash flows discounted at the project’s cost of capital minus the initial net cash outlay for the project. a. net present value b. equity-adjusted present value c. cost of capital d. value additivity principle ANSWER: a: net present value 14.2

The most desirable properto the the NPV criterion is that it evaluates a. investments in the same way as the company’s subsidiaries b. new market innovations that are simple to identify c. investments the same way as the company’s shareholders d. competitive advantages of the firm realistically ANSWER: c: net present value

When a new product takes sales away from the firm’s existing products, it is known as ______. a. cannibalization b. sales creation c. transfer pricing d. opportunity cost ANSWER: a: cannibalization 14.3

14.4

When evaluating an investment, the MNC should consider the ____________ cash flows generated by the project. a. total b. variable c. incremental d. fixed ANSWER: c: incremental cash flows The ___________ at which the company’s products or inputs are traded internally can significantly cause errors in evaluating the profitability of proposed investments. a. export licenses b. transfer pricing c. opportunity costs d. market prices ANSWER: b: transfer pricing 14.5

14.6

If all funds in a project are expected to be blocked in perpetuity, the value of the project is _____. a. limited b. unlimited c. zero d. difficult to determine ANSWER: c: blocked funds 14.7

____________ such as better quality, faster time to market, and higher customer satisfaction can have a significant impact on corporate cash flows. a.

Intangibles b.

Transfer prices c.

Economies of scale of distribution d.

Value additivity ANSWER: a: accounting for intangible benefits In capital budgeting what matters is not the project’s total cash flow per period, but the ___________ cash flows generated by the project. a. sales-creating b. incremental c. base-case d. parent ANSWER: b: incremental cash flows 14.8

MODERATE 14.9

A foreign project that is _____ when valued on its own can be ________ from the parent firm's standpoint. a. profitable, unprofitable b. unprofitable, profitable c. appreciated, depreciated d. depreciated, appreciated ANSWER: a: issues in foreign investment analysis 14.10 Given the differences that are likely to exist between parent and project cash flows, the relevant cash flows to use in project evaluation are the a. incremental worldwide cash flows received by the parent b. incremental worldwide project cash flows c. incremental worldwide project cash flows that can be repatriated to the parent d. total worldwide cash flows generated by the project ANSWER: a: parent versus project cash flows

14.11 Many multinationals are now making small investments in Eastern Europe. These investments a. may be valued using conventional discounted cash-flow analysis b. will be overvalued using conventional discounted cash-flow analysis because of their high risks c. should be valued using an expanded net present value rule that considers the attendant options d. b and c only ANSWER: d: adjusting the discount rate of payback period 14.12 Which of the following is NOT a method for incorporating the additional political and economic risk into foreign investment analysis? a. shortening the minimum payback period, b. raising the required rate of return of the investment c. adjusting cash flows to reflect the specific impact of a given risk d. hedging the expected risk of currency fluctuations with currency futures ANSWER: d: political and economic risk analysis 14.13 An investment in the Mezzogiorno will receive a subsidized loan of $12 million from the Italian government. The loan bears an interest rate of 7% in contrast to a market rate of 10%. The loan principal must be paid back in 8 years. What is the present value of the interest subsidy? a. $360,000 b. $1.92 million c. $2.31 million d. $870,000 ANSWER: b: net present value 14.14 Walt Disney Company is contemplating a new theme park somewhere in Southeast Asia. However, it is concerned about cannibalizing sales of Tokyo Disneyland.

Walt Disney should a. not be concerned because if it doesn't build another theme park, another competitor will certainly do so b. not be concerned because the odds are that it will generate enough additional sales to offset any cannibalization that does take place c. be concerned because cannibalization is a real threat d. decrease the amount of transfer pricing between its subsidiaries ANSWER: c: cannibalization

DIFFICULT 14.15 Suppose a firm projects cash flows of $2.5 million, $3 million, and $4 million for years 1, 2, and 3, respectively, on an initial investment in Ecuador of $22 million.

The firm projects a perpetuity of $5 million in years 4 and beyond. If the required return on this investment is 17%, how large does the probability of expropriation in year 5 have to be before the investment has a negative NPV? Expected compensation in the event of expropriation is $3 million. a.

31% b.

42% c.

22% d.

49% ANSWER: c: expropriation 14.16 Global Industries (GI. is planning to use some existing equipment from its own facilities in a foreign project. The used equipment has a book value of $2 million but a market value of $6 million. If GI's marginal tax rate is 34%, what is its opportunity cost of using the used equipment in the foreign project? a. $2 million b. $3.25 million c. $6 million d. $4.64 million ANSWER: d: estimation of projected cash flows 14.17 Suppose that a subsidiary operates in a foreign country with a corporate tax rate of 42% and a withholding tax on dividends of 5%. If the U.S. parent has surplus foreign tax credits, what is the marginal rate of tax on remitted profits from the subsidiary? a.

13% b.

34% c.

8% d.

5% ANSWER: d: tax factors 14.18 What is the expected real dollar value of the depreciation tax shield in year 10, assuming that the tax write-off is taken at yearend? a. $1.1 million b. $1.9 million c. $2.3 million d. $1.3 million ANSWER: d: tax factors

14.19 A new project is projected to yield $2.5 million annually in after-tax profit, based on a local corporate profit tax rate of 40%. However, this profit figure depends on the use of a transfer price of $30 per unit on a component bought from the parent. If the project requires 100,000 units of this component annually, the impact on project profitability and on parent profitability of a boost in the transfer price to $35 will be _______ and ________, respectively. The parent's marginal tax rate is 34% and the incremental tax on subsidiary remittances to the parent is -3%. a.

-$500,000, +$500,000 b.

-$300,000, +$330,000 c.

-$300,000, +$321,000 d. +$500,000, -$500,000 ANSWER: c: tax factors 14.20 General Tin (GT. is worried that its mine in Peru will be expropriated during the next 12 months. The Peruvian government has promised, however, to pay compensation of $15 million at the year's end if it expropriates the mine. GT believes that this promise would be kept. If expropriation does not occur this year, it will not occur anytime in the foreseeable future. The mine is expected to be worth $50 million at the end of the year. A wealthy Peruvian has just offered GT $19 million for the mine today. If GT's risk-adjusted discount rate is 22%, what is the probability of expropriation at which GT is just indifferent between selling now or holding on to its mine? a.

71.2% b.

76.6% c.

23.5% d.

18.9% ANSWER: b: expropriation

CHAPTER 15 FOREIGN TRADE AND SHORT-TERM FINANCING EASY 15.1

Which of the following payment methods provides the exporter with the strongest protection against risk? a.

Cash in advance b.

Letter of credit c.

Draft d.

Consignment ANSWER: a: cash in advance 15.2

Which of the following payment methods provides both parties with a strong measure of protection against commercial and political risks? a.

Cash in advance b.

Letter of credit c.

Draft d.

Consignment ANSWER: b: letter of credit 15.3

Most L/Cs issued in connection with commercial transactions are a. documentary b. clean c. revocable d. without discrepancies ANSWER: a: letter of credit 15.4

An exporter shipping goods to a nation that may impose currency controls will seek an L/C that is a. revocable b. clean c. documentary d. confirmed by a domestic bank ANSWER: d: letter of credit 15.5

The party to a draft who signs and sends the draft to the second party is called the a. drawer b. payee c. drawee d. opening bank ANSWER: a: draft

15.6

RJR Nabisco sells its export receivables to a firm that takes responsibility for collecting payment from the importers. RJR has used a. accounts receivable financing b. factoring c. forfaiting d. letter of credit ANSWER: b: factoring 15.7

The only U.S. agency dedicated solely to financing and facilitating U.S. exports is the a.

Ex Im Bank b.

Foreign Credit Insurance Association c.

Bankers' Association for Foreign Trade d.

Agency for International Development ANSWER: a: Export-Import Bank 15.8

Fluor is seeking to bid on a construction project in Turkey. Which Ex Im Bank program will likely be most useful to Fluor? a. "standby" loan commitment b.

Ex Im Bank payment guarantee c. preliminary commitment d.

Ex Im Bank loan guarantee ANSWER: c: Export-Import Bank 15.9

Which one of the following is NOT a condition of the Ex Im Bank before it will issue a commercial and political risk insurance policy to an exporter? a.

Concerning the export more than 25% must be U.S.- made content b.

Concerning the export more than 50% must be U.S.- made content c. the export must be environmentally friendly d. the export must not be military goods ANSWER: a: Export-Import Bank 15.10 Which of the following organizations was created by the Bankers' Association for Foreign Trade to mobilize private capital for financing the export of big-ticket items by U.S. firms? a. the Ex Im Bank b.

Private Export Funding Corporation c.

Foreign Credit Insurance Association d.

Bankers' Export Financing Association ANSWER: b: Private Export Funding Corporation

15.11 When factoring is done on a nonrecourse basis, the ---- has title to the receivables and the ---- is responsible for credit checking and collecting the receivables. a. factor, factor b. factor, borrowing firm c. borrowing firm, factor d. borrowing firm, borrowing firm ANSWER: a: factoring 15.12 Countertrade arrangements may take the form of a. barter b. buyback c. drafts d. both a and b ANSWER: d: Countertrade 15.13 SCI borrows SFr 1.5 million from Credit Suisse for one year at 12% interest.

Interest is prepaid. What is the effective SFr interest rate on SCI's loan? a.

14.52% b.

13.64% c.

16.44% d.

21.22% ANSWER: b: interest rates on bank loans

15.14 Allied Products has been offered a one-year loan of £100,000 at 14%, payable at maturity. What is the effective pound interest rate on Allied's loan? a.

14.0% b.

17.5% c.

15.2% d.

18.3% ANSWER: b: interest rates on bank loans 15.15 Philips N.V. requires Lit 500 million for one year. It can borrow from Banca di Roma at a 15% interest rate. How many lira must Philips borrow to receive this amount if the loan is quoted on a discount basis? a.

Lit 667 million b.

Lit 588 million c.

Lit 435 million d.

Lit 556 million ANSWER: b: interest rates on bank loans 15.16 The Apex Supplies Corporation needs to acquire €100 million in funds to expand their facilities. The bank has offered them a discounted loan at 10% and a compensating balance of 6%. What is the effective interest rate on this loan? a.

5.5% b.

7.8% c.

11.9%

d.

ANSWER:

14.5% c: interest rates on bank loans

15.17 Consolidated Corporation requires C$50 million in funds. The banks has offered them a discounted loan at 8% with a compensating balance of 15%. How much must they borrow in order to net this amount? a.

64,935,165 b.

55,455,700 c.

85, 985,005 d.

35,097,555 ANSWER: a: interest rates on bank loans

MODERATE 15.18 The other name for a draft is a a. bill of exchange b. bankers acceptance c. currency collar d. overdraft ANSWER: a: documents in international trade 15.19 Which one of the following is NOT a disadvantage to open account financing? a. high risk b. seller must finance production c. increased risk from currency controls d. no customer resistance ANSWER: d: collecting overdue accounts 15.20 Why is Ex Im Bank financing often referred to as financing of “last resort?” a. it will not provide financing unless the U.S. exporter is doing business in more than one country b. it will not provide financing unless private capital is unavailable c. fees are extremely high for guarantees and insurance d. the Ex-Im Bank authorizes loans for only the worst credit risks ANSWER: b: Export-Import Bank 15.21 Which one of the following conditions is NOT required for a draft to be negotiable under the U.S. Uniform Commercial Code? a. to be in writing b. signed by the drawer c. an open amount of money d. an unconditional order to pay ANSWER; c: draft 15.22 Which of the following is NOT an advantage to the importer of L/C financing?

a. b. c. d.

ANSWER:

any documents required are carefully inspected by clerks with years of experience an L/C is almost as good as cash in advance the importer using an L/C can usually command better credit terms and/or prices from the exporter L/C financing is always cheaper than the alternative financing methods d: Letter of credit

15.23 Which of the following L/Cs is safest for the exporter? a. revocable, confirmed L/C b. irrevocable, unconfirmed L/C c. irrevocable, confirmed L/C d. revocable L/C ANSWER: c: Letter of credit 15.24 An exporter manufacturing a specialized piece of equipment can hedge the risk that its customer will cancel the contract before shipment by obtaining a a. consignment contract b. open account c. bill of lading d. letter of credit ANSWER: d: Letter of credit 15.25 Which of the following is NOT a function of a draft ? a. to provide written evidence, in clear and simple terms, of a financial obligation b. to enable both parties to potentially reduce their costs of financing c. to provide a negotiable and unconditional instrument d. to insure the exporter is paid on a non-recourse basis ANSWER: d: draft 15.26 A documentary draft is typically accompanied by a a. document verifying the importer’s address b. guarantee to pay from the importer’s bank c. currency futures contract to hedge exchange rate changes d. commercial invoice ANSWER: d: draft 15.27 Which one of the following is NOT an important attribute of a bankers’ acceptance? a. makes an unconditional promise to pay the holder of the draft a stated amount on a specified day b. effectively substitutes its own credit for that of a borrower c. creates a negotiable instrument that may be freely traded

d.

ANSWER:

it allows the bank to hold them on their books as an asset d: bankers’ acceptance

DIFFICULT 15.28 Which of the following is not an advantage to the exporter of L/C financing? a. an L/C eliminates credit risk if the bank that opens it is of undoubted standing b. an L/C reduces the danger that payment will be delayed or withheld due to exchange controls or other political acts c. payment is only in compliance with the L/C's stipulated conditions d. an L/C guards against pre-shipment risk such as order cancellation ANSWER: c: Letter of credit 15.29 Microsoft sells software to a French firm. In return, the French firm's bank, Credit Agricole, acknowledges it will pay Microsoft after the software is delivered to its client. Microsoft has most probably used a. accounts receivable financing b. factoring c. forfaiting d. letter of credit ANSWER: d: Letter of credit 15.30 Caterpillar Tractor sells heavy construction equipment to a Polish firm. In return, the Polish firm issues a promissory note to Caterpillar promising to pay for the equipment over a five-year period. Caterpillar sells the note to Deutsche Bank at a discount. Caterpillar has used a. accounts receivable financing b. factoring c. forfaiting d. letter of credit ANSWER: c: forfaiting

15.31. By shipping goods under documentary time drafts for acceptance a. the exporter is extending credit to the importer b. the exporter is relinquishing control of the goods in return for a signature on the acceptance to assure it of payment c. the importer guarantees that it will pay cash on delivery d. a and b only ANSWER: d: draft 15.32 Which of the following attributes of a bankers’ acceptance greatly enhances its marketability? a. the authenticity of an accepted draft is separated from the underlying commercial transaction

b. c. d.

ANSWER:

the accepted draft may not be dishonored for reason of a dispute between the exporter and importer the accepted draft is automatically guaranteed by the Ex im Bank a and b only d: bankers’ acceptance

15.33 Which of the following is the LEAST important economic rationales for countertrade? a. many Third World countries use countertrade to conserve what little foreign exchange they have b. the goods taken in countertrade are often unattractive and difficult to market c. countertrade enables members of cartels such as OPEC to undercut an agreed-upon price without formally doing so d. it avoids tariff and quota constraints ANSWER: b: countertrade 15.34 Precor sells exercise equipment to thousands of health clubs and sporting goods stores around the world. Its average order size is about $3,500. Which of the following techniques would you recommend to Precor to deal with its credit risk? a. insure the receivables through the FCIA, which will charge a 1.2% fee to cover 90% of the receivables b. use a factor, who will charge a 1.3% export factoring fee c. request letters of credit from customers. The customers will have to pay $75 plus 0.5% for each letter of credit. To remain competitive, Precor will have to reduce its prices to reimburse customers for their L/C costs d. all are about equally acceptable ANSWER: b: factoring 15.35 Which of the following firms would find a factor most useful? a.

Levi Strauss, which has been shipping jeans to the same customers in 120 countries for over 40 years, b.

Brown and Root, which manages major construction projects around the world c.

RC Cola, which periodically ships a small order of soft drinks overseas d.

IBM, which exports mainframes and other expensive equipment to customers in over 100 countries around the world ANSWER: c: factoring

CHAPTER 16 MANAGING THE MULTINATIONAL FINANCIAL SYSTEM EASY 16.1

The value of the multinational financial system is based on the ability to take advantage of a. tax arbitrage b. financial market arbitrage c. regulatory system arbitrage d. all of the above ANSWER: d: the value of the multinational financial system 16.2

Tax arbitrage a. arises when subsidiary profits vary due to local regulations b. occurs when firms move funds to lower tax jurisdictions c. arises when barriers to trade exist d. occurs due to the incidence of capital flight ANSWER: b: the value of the multinational financial system 16.3

MNCs may use _______ arbitrage to resist government price controls or union wage pressures. a. tax b. financial system c. regulatory d. triangular ANSWER: c: the value of the multinational financial system 16.4

Subsidiaries A and B buy from and sell to each other. Suppose that A has excess cash, whereas B is short of cash. How can A funnel money to B? a.

A can lead payments owed to B b.

B can lag payments owed to A c.

A can raise transfer prices on goods sold to B d. a and b only ANSWER: d: leading and lagging 16.5

______ is the pricing of internally traded goods for the purpose of moving profits to a more tax-friendly nation. a.

Transfer pricing b.

Leading and lagging c.

Arm’s length pricing d.

Advanced pricing ANSWER: a: transfer pricing

16.6

Using transfer prices may lead to _____. a. increased local taxes b. reduced ad valorem tariffs c. exchange rate controls d. decreased political risk ANSWER: b: transfer pricing 16.7

Reinvoicing centers are usually set up in __________ jurisdictions. a. economically secure b. politically stable c. high-tax d. low-tax ANSWER: d: reinvoicing centers 16.8

One disadvantage of a reinvoicing center is _______ . a. less chance of local government suspicion b. less communication costs c. more communications costs d. more exchange rate risk ANSWER: c: reinvoicing centers One advantage of the use of fees or royalties to manage the MNC’s cash flow is ____. a. less communications costs b. less exchange rate risk c. more favorable tax treatment by the parent country’s government d. less suspicion by the host government ANSWER: d: fees and royalties 16.9

16.10 Intercompany loans are useful during periods of ______ in the financial markets. a. credit rationing b. hyperinflation c. currency depreciations d. capital flight ANSWER: a: intercompany loans 16.11 ______ from the subsidiary to the parent are still the most important method of transferring funds in the MNC. a.

Parallel loans b.

Leading and laggng c.

Dividends d.

Credit rationing ANSWER: c: dividends

16.12 Which one of the following is a real rather than a financial flow? a. capital goods b. dividends c. equity investment d. credit on goods and services ANSWER: a: mode of transfer 16.13 Which one of the following is an example of a market imperfection in the domestic capital market? a. transactions costs b. costs of obtaining information c. ceilings on interest rates d. restrictions by nationality of investor ANSWER: c: value MODERATE 16.14 Which one of the following would government taxing authorities NOT use to establish arm’s length pricing? a. comparable uncontrolled price method b. resale price method c. cost-plus method d. the marketing department’s best estimate ANSWER: d: transfer pricing 16.15 Leading and lagging is primarily of value because of a. tax regulations b. foreign exchange risk c. expropriation risk d. exchange and capital controls ANSWER: a: leading and lagging 16.16 Suppose a firm earns $2.5 million before-tax in Spain. It pays Spanish tax of $1.3 million and remits the remaining $1.2 million as a dividend to its U.S. parent. The Spanish dividend withholding tax is 5%. Under current U.S. tax law, the parent will owe U.S. tax on this dividend equal to a. $1.15 million b. $552,000 c. nothing. It will also receive a foreign tax credit equal to $1.3 million. d. nothing. It will also receive a foreign tax credit equal to $510,000.

ANSWER: d: tax effects

16.17 Suppose affiliate A sells goods worth $1 million monthly to affiliate B on 30 day credit terms. A switch in credit terms to 120 days will involve a one-time shift in cash of a. $3 million from A to B b. $3 million from B to A c. $4 million from A to B d. $4 million from B to A ANSWER: a: leading and lagging 16.18 The best way(s) to increase the present value of after-tax remittances from overseas is (are) to a. invest parent funds as debt rather than equity b. borrow in the local currency c. hedge exchange risk d. speed up the payment of dividends ANSWER: a: equity versus debt 16.19 A French subsidiary that earns $1 million before-tax pays French tax of $.5 million and remits the remaining $.5 million as a dividend to its U.S. parent. It pays a 10% dividend withholding tax on its remittance. Under current tax law, the parent will owe U.S. tax on this dividend equal to a. $40,000 b. $460,000 c. $207,000 d. nothing. It will also receive a foreign tax credit of $210,000.

ANSWER: d: tax effects 16.20 A firm that earns $1 million before-tax in Brazil pays Brazilian tax of $250,000 and remits the remaining $750,000 as a dividend to its U.S. parent. It pays a 10% dividend withholding tax on its remittance. Under current U.S. tax law, the parent will owe U.S. tax on this dividend of a. $40,000 b. $340,000 c. $15,000 d. nothing. It will also receive a foreign tax credit of $90,000.

ANSWER: c: tax effects 16.21 The extensive system of foreign tax credits allows a.

U.S. MNCs to lower their effective tax rate on foreign-source income to below the U.S. corporate tax rate b. governments to collect more taxes from MNCs c. reduce the amount of taxes they owe the host country d.

MNCs to avoid double taxation on foreign-source income ANSWER: d: tax effects

16.22 Suppose a foreign subsidiary earns $1 million after paying foreign income taxes of $800,000. If the subsidiary pays a dividend of $600,000, what is the amount of the indirect foreign tax credit that its parent will receive? a. $480,000 b. $800,000 c. $400,000 d. it receives no foreign tax credit ANSWER: a: tax effects 16.23 Suppose a foreign subsidiary earns $2 million after paying foreign income taxes of $500,000. If the subsidiary retains all of its earnings, what is the amount of the indirect foreign tax credit that its parent will receive? a. $500,000 b. $250,000 c. $400,000 d. it receives no foreign tax credit ANSWER: d: tax effects 16.24 Which one of the following cash flow mechanisms arouses the least suspicion from a host government concerning a multinationals attempts to avoid additional taxes? a. transfer pricing b. reinvoicing centers c. royalties d. leading and lagging ANSWER: d: intercompany fund-flow mechanisms: costs and benefits 16.25 Leading and lagging strategies have several advantages EXCEPT a. no formal note of indebtedness is needed b. governments are less like to interfere with payments on intercompany accounts c. interest must be charged on all intercompany accounts d. intercompany accounts up to six months are interest free ANSWER: c: leading and lagging

DIFFICULT 16.26 Arco ships 15 million barrels of refined oil monthly from Arco-Canada to Arco-U.S. Arco-U.S. has to pay a U.S. ad valorem tariff of 6%. Tax accountants advise Arco that it can set the transfer price in the range of $15-$18 per barrel of product. The current price is set at $16 a barrel. If Arco-Canada's tax rate is 50% (the U.S. rate is 46%., what is the incremental cash flow per month associated with using the optimal transfer price? a. $236,000 b. $1,343,000 c. $1,086,000 d. $32,670 ANSWER: c: tariffs 16.27 Suppose affiliate A sells 10,000 chips monthly to affiliate B at a unit price of $15.

A's tax rate is 45% and B's tax rate is 55%. In addition, B must pay an ad valorem tariff of 12% on its imports. If the transfer price on chips can be set anywhere between $11 and $18, how much can the total monthly cash flow of A and B be increased by switching to the optimal transfer price? a. $3,000 b. $4,000 c. $1,840 d. $1,380 ANSWER: d: tariffs 16.28 Which of the following is NOT characteristic of a back-to-back loan? a. it is a method to reduce exchange rate risk b. it is know as a fronting loan c. it is a loan channeled through a bank d. it is collateralized by the parent’s deposit ANSWER: a: back-to-back loans 16.29 Which one of the following is NOT a factor in developing a global remittance policy? a. number of financial links b. global investment yields c. ownership patterns d. volume of transactions ANSWER: b: designing a global remittance policy 16.30 Which one of the following is not an information factor in developing a global remittance policy? a. subsidiary financing requirements b. costs of external capital c. financial channels available e. inventory stocking policies

ANSWER:

d: designing a global remittance policy

Chapter 1

Introduction: Multinational Enterprise and Multinational Financial Management

Chapter 1 Outline A. Catalysts for Globalization B. Implications of Globalization for Businesses C. Consequences of Globalization D. Multinational Corporations

E. Rational for Multinational Corporations F. Process of Overseas Expansion by Multinationals G. Appendix

Chapter 1: Introduction: Multinational Enterprise and Multinational Financial Management

1

1.A Catalysts for Globalization ❑

Massive deregulation

❑

Collapse of Communism

❑

Worldwide sale of state-owned firms in privatizations

❑

Revolution in information technologies

❑

Rise in the market for corporate control

❑

Replacement of statist policies by free-market policies in many Third-World economies

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1.B Implications of Globalization for Businesses ❑

Companies must be able to quickly adapt their policies to respond to new global market opportunities and challenges.

❑

The international mobility of capital has provided more financial options while simultaneously increasing complexity.

❑

Global managers need in-depth knowledge of their operations.

– How their products are made

– Their supply chain, alternatives – Where the funds come from – How their changing relative values affect the bottom line. ❑

Global managers must understand the political and economic choices facing key nations and how those choices affect the outcomes of their decisions.

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1.C Consequences of Globalization ❑

The global rationalization of production is driven by global competition.

❑

Free trade allocates resources to their highest valued use.

❑

Globalization fosters creative destruction – continuous change-out with the old, in with the new; i.e.: – Some industries advance, others recede; – Jobs are gained and lost; – Businesses boom and go bust; and – Some workers must change jobs and occupations.

❑

Consumers benefit from lower prices and expanded choices.

❑

Globalization enables nations to get richer together (i.e., expands the economic pie for all parties).

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1.D Multinational Corporations ❑

Multinational corporations (MNCs) produce and sell goods or services in more than one country.

❑

MNCs emphasize group performance over performance of individual parts.

MNC Home Country

Foreign Subsidiary 1

Foreign Subsidiary 2

Foreign Subsidiary 3

Foreign Subsidiary 4

Foreign Subsidiary 5

. . .

High degree of strategic interaction

❑

What differentiates MNCs from other firms engaged in international business is the globally coordinated allocation of resources by a single centralized management.

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1.E Rationale for MNCs (1) ❑

The classical theory of international trade based on comparative advantage states that – Each nation should specialize in the production and export of those goods it can produce with the highest relative efficiency and import those goods that other nations can produce relatively more efficiently; and – Goods and services can move internationally but factors of production, i.e., land, labor, and capital, are relatively immobile.

❑

This theory is becoming increasingly irrelevant as differences among corporations are becoming more important than aggregate differences among countries and countries move their factors of production more rapidly in search of higher returns.

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1.E Rationale for MNCs (2) ❑

The role of natural resources has diminished in national specialization as advanced, knowledge-based societies move rapidly toward artificial materials and genetic engineering.

❑

Capital moves instantaneously around the world.

❑

Labor skills are no longer fundamentally different – i.e., many foreign students attend American universities.

❑

Technology and know-how are rapidly becoming a global pool.

❑

The ability of MNCs to use these globally available factors of production fosters international competitiveness to a far greater degree than macroeconomic differences among countries.

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1.E Rationale for MNCs (3) ❑

Search for raw materials – MNCs aim to exploit raw materials found in foreign countries.

❑

Market Seeking – MNCs’ firm-specific advantages can be profitably applied to foreign markets.

• Products/processes • Technologies • Patents • Specific rights, knowledge, and skills – Exploitation of foreign markets may be possible at considerably lower costs.

– Foreign markets provide opportunities for MNCs to achieve economies of scale and exploit premiums associated with strong brand names.

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1.E Rationale for MNCs (4) ❑

Cost Minimization. Costs can be minimized by combining production shifts with rationalization and integration of the firm’s global manufacturing facilities; i.e., plants specialize in different stages of production.

❑

Knowledge Seeking. Some firms enter foreign markets to gain information and experience to use in other markets.

❑

Keeping Domestic Customers. MNC suppliers follow customers abroad to guarantee them a continuing product flow and reduce the risk that their customers will find an alternative local supplier.

❑

Exploiting Financial Market Imperfections. Operating in numerous countries with different economic cycles reduces systematic risk and risk relating to exchange rate fluctuations, currency controls, expropriation, and other foreign government interventions (“diversification effect”).

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1.F Process of Overseas Expansion by MNCs (1) ❑

Firms become MNCs by degree – globalization does not initially occur through conscious design but is the inevitable outcome of the competitive pressures in oligopolistic industries.

❑

Typical sequence of transitioning from a domestic firm to an MNC 1. Exporting

2. Setting up a foreign sales subsidiary 3. Securing license agreements 4. Establishing foreign production ❑

Each sequence enables firms to move from a low-risk, low-return export strategy to a higher-risk, higher-return strategy emphasizing international production.

Chapter 1: Introduction: Multinational Enterprise and Multinational Financial Management

10

1.F Process of Overseas Expansion by MNCs (2) 1. Exporting – Advantages • Low capital requirements and start-up costs • Low risk • Immediate profits

• Firms learn about present and future market conditions, local competition, distribution channels, payment conventions, financial institutions, and financial techniques.

– Disadvantages • Inability to realize full sales potential – As increased communication with customers reduces uncertainty, the firm might establish its own sales subsidiary.

Chapter 1: Introduction: Multinational Enterprise and Multinational Financial Management

11

1.F Process of Overseas Expansion by MNCs (3) 2. Overseas Production – Advantages • Keep abreast of market conditions and adapt products to changing local tastes and conditions • Faster order fulfillment • Ability to provide more comprehensive after-sales service • Conveys commitment to local market • Ensures certainty of supply – Key Decision – Create own affiliate or acquire going concern • Acquisition: Speedy transfer of parent skills, ready-made marketing network, and local market/technology knowledge; but may be more costly than creating affiliate.

– Generally, the larger and more experienced the firm, the less it relies on acquisitions.

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12

1.F Process of Overseas Expansion by MNCs (4) 3.

Licensing – alternative or precursor to overseas production – Advantages • Minimal investment • Faster market-entry time • Fewer financial and legal risks – Disadvantages • Cash flow relatively low • Risk of product quality problems

• Difficulty controlling exports by the licensee; licensee may become a competitor

Chapter 1: Introduction: Multinational Enterprise and Multinational Financial Management

13

1.F Process of Overseas Expansion by MNCs (5) ❑

General circumstances that drive selection of mode of overseas expansion – If MNC’s intangible capital • Can be incorporated into standardized products: Export • Is a product/process technology that can be codified: License • Is organizational capital that is not easily separable from the firm: Establish overseas production IF the benefits of circumventing market imperfections outweigh the costs of central control.

– Types of overseas investment

• Vertical integration • Horizontal integration

Chapter 1: Introduction: Multinational Enterprise and Multinational Financial Management

14

1.G Appendix (1) ❑

Origins and consequences of international trade – Theory of absolute advantage •

Goods and services are commodities

•

Factors of production cannot move freely across borders

•

Ignores roles of uncertainty, economies of scale, and technology

•

Is static model

– Example using production schedule Commodity Produced (units of production required per ton) Country

Wheat

Coal

U.S.

2 units

1 unit

U.K.

3 units

4 units U.S. has an absolute advantage in producing both wheat and coal

Chapter 1: Introduction: Multinational Enterprise and Multinational Financial Management

15

1.G Appendix (2) ❑

Origins and consequences of international trade, continued – Theory of comparative advantage •

A country has a comparative advantage in producing the commodity that it has less of an absolute disadvantage in producing.

– Example using production schedule with inverted values reflecting output per unit of production Commodity Produced (tons produced per unit of production)

Country

Wheat

Coal

U.S.

2 units/ton = 0.5 tons/unit

1 unit/ton = 1 ton/unit

U.K.

3 units/ton = 0.33 tons/unit

4 units/ton = 0.25 tons/unit

U.K. has an absolute disadvantage in producing both wheat and coal but a comparative advantage in producing wheat

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16

1.G Appendix (3) ❑

Gains from trade using comparative advantage – Profitability of producing each commodity is determined by determining exchange rate, or terms of trade, between wheat and coal in the U.S. and U.K. Commodity Produced (tons produced per unit of production) Country

Wheat

Coal

U.S.

0.5 tons/unit

1 ton/unit

U.K.

0.33 tons/unit

0.25 tons/unit

U.S.: 1 ton wheat = 1 / 0.5 = 2 tons coal

U.K.: 1 ton wheat = 0.25 / 0.33 = 0.75 tons coal

– The U.S. can produce coal more productively and trade with the U.K. for wheat.

– The U.K can consume more coal than if it mined its own.

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17

1.G Appendix (4) ❑

Specialized factors of production – Assuming factors of production are specialized •

Prices of specialized factors used to produce exported goods will increase in home country as demand for exported goods increases.

•

Prices of specialized factors used to produce imported goods will decrease in home country as demand for imported goods increases.

– Computing gains to specialized factors •

Let terms of trade be 1 ton of wheat = 1.95 tons of coal

•

Gains for U.S. in producing coal and trading for wheat – The U.S. can consume 1 / 1.95 = 0.5128 tons of wheat per ton of coal

– The U.S. can produce 0.50 tons of wheat per ton of coal – Gain = (0.5128 / 0.50) - 1 = 2.5% more wheat than if it produced wheat itself

•

Gains for U.K. in producing wheat and trading for coal – The U.K. can consume 1.95 tons of coal per ton of wheat – The U.K. can produce 0.75 tons of coal per ton of wheat

– Gain = (1.95 / 0.75) - 1 = 160% more coal than if it produced coal itself Chapter 1: Introduction: Multinational Enterprise and Multinational Financial Management

18

1.G Appendix (5) ❑

Specialized factors of production, continued – The greater the gains from trade overall, the greater the cost of trade to those factors of production that specialize in producing the imported commodity.

– Thus, losses for factors of production producing coal in the U.K. will be greater than losses for factors of production producing wheat in the U.S. – Computing losses to specialized factors, if countries continue to produce goods for which they have a comparative disadvantage •

Losses for U.S. in producing wheat: Using specialized factors of production to produce wheat will cause a 2.5% loss of income because the wheat produced buys 2.5% less coal ([1.95 tons / 2 tons] – 1).

•

Losses for U.K. in producing coal: Using specialized factors of production to produce coal will cause a 62% loss of income; wheat purchasing power was 1.33 (4 / 3) tons of coal and is now 0.5128 (1 / 1.95) tons of coal. Change in purchasing power is (0.5128 – 1.33) / 1.33 = -62%.

Chapter 1: Introduction: Multinational Enterprise and Multinational Financial Management

19

1.G Appendix (6) ❑

Monetary prices and exchange rates – Substituting unit prices for units of production in the preceding example and assuming each production unit costs $30 in the U.S. and £10 in the U.K.: Commodity Produced (price/ton) Country

Wheat

Coal

U.S.

2 units/ton * $30 = $60

1 unit/ton * $30 = $30

U.K.

3 units/ton * £10 = £30

4 units/ton * £10 = £40

– If the exchange rate is £1 = $3, then dollar-equivalent prices are: Commodity Produced (price/ton) Country

Wheat

Coal

U.S.

$60 * 1 = $60

$30 * 1 = $30

U.K.

$30 * 3 = $90

$40 * 3 = $120

Chapter 1: Introduction: Multinational Enterprise and Multinational Financial Management

20

1.G Appendix (7) ❑

Monetary prices and exchange rates, continued – At dollar-equivalent prices, U.K. will demand both wheat and coal, and the U.S. will demand no U.K. goods.

– Result: trade deficit for U.K. and trade surplus for U.S. – Absent government intervention: •

U.K. demand for dollars increases value of dollar;

•

U.S. goods become more expensive to U.K.; U.K. goods become less expensive to U.S.;

•

Simultaneously, increased demand for U.S. factors raises factor prices and causes inflation;

•

Decreased demand for U.K. factors decreases factor prices and prices of wheat and coal; and

•

U.K. goods become more attractive to consumers.

– Process continues until terms of trade are equal.

Chapter 1: Introduction: Multinational Enterprise and Multinational Financial Management

21

1.G Appendix (8) ❑

Tariffs – Distort prices and reduce the quantity of goods traded.

–

E.g., effects of a $0.15/pound tariff of Mexican tomatoes S1

P

S2 So

PTariff = $0.45 PFinal = $0.35 P0= $0.30

D

QTariff Q QFinal0

Q

–

Mexican farmers must charge $0.45 to maintain their profit margin.

–

American consumers will demand fewer tomatoes at $0.45/pound.

–

Mexican suppliers will lower their prices (and their margins) to $0.35/pound to remain competitive.

–

Tariff harms Mexican farmers, U.S. consumers, and U.S. businesses that use Mexican tomatoes as a factor of production.

Chapter 1: Introduction: Multinational Enterprise and Multinational Financial Management

22

1.G Appendix (9) ❑ Effects of free trade

– Increased competition among businesses – Increased innovation – Higher productivity

– Lower prices and greater choice for consumers – Rising wages for workers – Higher living standards

Chapter 1: Introduction: Multinational Enterprise and Multinational Financial Management

23

Chapter 2

The Determination of Exchange Rates

Chapter 2 Outline A. Introduction to Exchange Rates B. Factors Affecting the Equilibrium Exchange Rate C. Calculating Exchange Rate Changes

D. Asset Market Model of Exchange Rates E. Central Banks and Currency Values F. Central Bank Intervention

Chapter 2: Determination of Exchange Rates

1

2.A Introduction to Exchange Rates (1) ❑

Exchange rate – the price of one nation’s currency in terms of another.

– If $1 buys ¥100, the ¥/$ exchange rate, or yen value of the dollar, = ¥100/$1 – The inverse $/¥ exchange rate, or dollar value of the yen, = $1/ ¥100 and tells how many dollars one yen will buy = $0.01.

❑

Exchange rates are market-clearing prices that equilibrate supplies and demands in the foreign exchange market.

❑

Spot rate e0 – the price at which currencies are traded for immediate delivery.

❑

Forward rate f1 – the price at which currencies are quoted for delivery at a specified future date.

Chapter 2: Determination of Exchange Rates

2

2.A Introduction to Exchange Rates (2) ❑

Demand for a currency – Demand for a currency is a function of the demand for foreign goods denominated in that currency. E.g., U.S. demand for Euroland goods increases demand for euros to pay for those goods.

– As demand for euros increases, the value of the dollar falls against the euro.

– As the value of the dollar falls against the euro, Americans demand fewer Euroland goods, services, and assets.

❑

Supply of a currency – Supply of euros is a function of Euroland demand for U.S. goods.

– Euroland consumers must buy dollars to buy U.S. goods.

– As the value of the euro increases against the dollar, increased Euroland demand for U.S. goods increases demand for dollars, which increases the amount of euros supplied.

Chapter 2: Determination of Exchange Rates

3

2.A Introduction to Exchange Rates (3) ❑

Graphical representation of supply and demand for a currency

e S If supply of a currency exceeds demand, the value will fall relative to another currency until it reaches a new equilibrium.

Surplus

e0 Shortage

If demand for a currency exceeds supply, the value will increase relative to another currency until it reaches a new equilibrium.

D Q Q*

Chapter 2: Determination of Exchange Rates

4

2.B Factors Affecting the Equilibrium Exchange Rate (1) ❑

Factors that influence the supply and demand for one currency in terms of another affect the equilibrium exchange rate.

– Inflation rates – Interest rates – Economic growth

– Political and economic risks

Chapter 2: Determination of Exchange Rates

5

2.B Factors Affecting the Equilibrium Exchange Rate (2) ❑

Inflation rates – e.g., U.S. inflation > Euroland inflation €/$

$ depreciates: fewer euros e0 required to buy $

e1

S

S’

$/€ e1 e0

3

S’

€ appreciates over time in an amount such that Euroland and U.S. prices are again in equilibrium

S 6 4

D’

7

D’

D

D €

$ Q*

Q*

1. U.S. imports become more expensive to Euroland consumers 2. Euroland consumers switch to domestic substitutes 3. Demand for $ decreases 4. Supply of euros decreases (fewer euros needed to buy dollars) 5. U.S. consumers substitute Euroland imports for domestic goods 6. Demand for euros increases 7. Supply of dollars increases Chapter 2: Determination of Exchange Rates

6

2.B Factors Affecting the Equilibrium Exchange Rate (3) ❑

Interest rates – e.g., U.S. interest rates > Euroland interest rates S’

€/$

$/€

S

e1

5

eo

2

S’

€ depreciates: fewer dollars e 0 required to buy €

3

e1

$ appreciates over time in an amount such that U.S. and Euroland prices are again in equilibrium

S

D’

4 D’

D

D €

Qo

Qo

$

1. Capital shifts from Euroland to U.S. to exploit higher returns 2. Demand for dollars increases 3. Supply of euros increases to buy more dollars 4. Demand for euros decreases as demand to buy U.S. assets decreases 5. Supply of dollars decreases

Chapter 2: Determination of Exchange Rates

7

2.B Factors Affecting the Equilibrium Exchange Rate (4) ❑

Economic growth – e.g., U.S. GDP growth > Euroland GDP growth €/$

$/€

S’ S

e0

S

e1 eo

3

2

e1

D’ D

D €

$ Qo

Qo

1. As income increases, U.S. consumers spend more on Euroland imports 2. Demand for euros increases 3. Supply of dollars increases to buy more euros 4. Value of euro increases relative to the dollar

Chapter 2: Determination of Exchange Rates

8

2.B Factors Affecting the Equilibrium Exchange Rate (5) ❑

Political and economic risk – Investors prefer to hold fewer riskier assets.

– Political and economically stable countries have lower-risk currencies.

– Low-risk currencies are more highly valued and high-risk currencies.

Chapter 2: Determination of Exchange Rates

9

2.C Calculating Exchange Rate Changes (1) ❑

Using the $/€ as an example, euro appreciation/depreciation is computed as the fractional increase/decrease in the dollar value of the euro.

❑

General formula for computing currency appreciation/depreciation in dollar terms Currency appreciation/depreciation = (new dollar value of currency – old dollar value of currency) Old dollar value of currency

❑

E.g.: $/€ increases from $1.25/€1.00 to $1.35/€1.00 ($1.35 – $1.25) / $1.25 = 0.08, or 8%

❑

The euro has appreciated 8% against the dollar. That is, the amount of dollars required to buy one euro increased by 8%.

Chapter 2: Determination of Exchange Rates

10

2.C Calculating Exchange Rate Changes (2) ❑

General formula for computing dollar appreciation/depreciation in terms of another currency Dollar appreciation/depreciation = (old dollar value of currency - new dollar value of currency)

New dollar value of currency ❑

Using previous example: $/€ increases from $1.25/€1.00 to $1.35/€1.00 ($1.25 – $1.35) / $1.35 = -0.074, or -7.4%

❑

The dollar has depreciated 7.4% against the euro. That is, the amount of euros required to buy one dollar decreased by 7.4%.

Chapter 2: Determination of Exchange Rates

11

2.D Asset Market Model of Exchange Rate Determination ❑

The exchange rate between two currencies represents the price that just balances the relative supplies of and demand for assets denominated in those currencies.

❑

Shifts in preferences or expectations of future exchange rate movements affect the exchange rate of two currencies.

❑

The desire to hold currency today depends on expectations of the factors that affect the currency’s future value.

❑

Thus, currency values are forward-looking.

Chapter 2: Determination of Exchange Rates

12

2.E Central Banks and Currency Values (1) ❑

Central banks use monetary policy, including creating money, to achieve price stability, low interest rates, or a target currency value.

❑

Before 1971, currencies were linked to a commodity, usually gold.

❑

Fiat money – nonconvertible paper money – Is not linked to a commodity and thus has no “anchor.”

– No standard of value for determining a currency’s future value.

– Central bank determines a currency’s value through its control of the money supply.

– Expectations of central bank behavior affect exchange rates.

Chapter 2: Determination of Exchange Rates

13

2.E Central Banks and Currency Values (2) ❑

A central bank’s reputation for maintaining currency stability is critical.

❑

Investors demand a risk premium to hold low-quality currencies.

❑

Central bank independence and focus is necessary to avoid political influence.

❑

The greater risk of political influence over central banks that do not have a clear mandate to pursue price stability will foster the perception of inflation risk.

❑

Central banks lacking independence must often monetize the deficit – that is, finance the deficit by creating money and buying government debt.

– Releasing more money into an economy leads to inflation and currency devaluation.

Chapter 2: Determination of Exchange Rates

14

2.E Central Banks and Currency Values (3) ❑

Currency boards – Replace central banks – Issue notes and coins that are convertible on demand and at a fixed rate into a foreign reserve currency – Have no discretionary monetary policy – the market determines the money supply – Promote price stability

❑

Without a central bank to monetize a country’s deficit, a currency board compels a government to follow responsible fiscal policy.

❑

HOWEVER, a run on the currency causes a sharp contraction in the money supply and jump in interest rates, slowing economic activity.

Chapter 2: Determination of Exchange Rates

15

2.E Central Banks and Currency Values (4) ❑

Dollarization – A country replaces its currency with the U.S. dollar – Promotes price stability and thus low inflation – Eliminates local currency risk – Results in loss of seignorage, a central bank’s profit on the currency it prints.

Chapter 2: Determination of Exchange Rates

16

2.F Central Bank Intervention (1) ❑

How real exchange rates affect relative national competitiveness – Our previous diagram illustrates how the euro rises over time to fill the inflation differential created by rising U.S. inflation. E.g., if U.S. and Euroland inflation = 1% and U.S inflation increases to 3%, the value of the euro will appreciate by 2% to re-establish price parity. €/$

S’

$/€ e1

S S’

Euro appreciation reflects 2% rise in inflation

S

e0

e0

D’

e1 D’

D

D €

$ Q*

Q*

– Appreciation beyond 2% raises the relative price of Euroland goods, increasing U.S. consumption of domestic goods and stimulating domestic employment. Longer term, U.S. inflation will rise to re-establish price parity.

Chapter 2: Determination of Exchange Rates

17

2.F Central Bank Intervention (2) ❑ Foreign exchange market intervention

– Whether governments prefer an overvalued, undervalued, or correctly valued domestic currency depends on their economic goals.

– Governments may engage in unsterilized intervention, i.e., intervene in the foreign exchange market, to move e0 to a level consistent with their goals by buying or selling foreign currencies to influence the value of their own currencies.

• To reduce the value of the dollar against the euro, the U.S. Central Bank (“the Fed”) will sell dollars and purchase an equivalent amount of euros, releasing dollars into the foreign market and reducing the supply of euros.

• To increase the value of the dollar against the euro, the Fed will buy dollars with euros, releasing euros into the foreign market and reducing the supply of dollars.

• Using unsterilized intervention, monetary authorities have not insulated their domestic money supplies from the foreign exchange transactions.

• Unsterilized intervention leads to increases in inflation as exchange rates move out of equilibrium. Inflation will in turn affect interest rates.

Chapter 2: Determination of Exchange Rates

18

2.F Central Bank Intervention (3) ❑

Foreign exchange market intervention, continued – In sterilized intervention, the Fed will intervene in the foreign exchange market AND simultaneously engage in open market operations, or the sale or purchase of domestic Treasury bills.

– Example • To reduce the value of the dollar relative to the euro, the Fed sells dollars for euros in the foreign exchange market to flood the foreign market with dollars AND sells Treasury bills to reduce the number of dollars in the domestic market.

• Net effect: The value of the dollar relative to the euro decreases without changing the domestic supply of dollars, thereby insulating the U.S. from inflation.

– The effects of sterilized intervention are temporary, because the Fed signals a change in monetary policy to the market, not a change in market fundamentals.

– The effects of unsterilized intervention are permanent, because they create inflation in some countries and deflation in others.

Chapter 2: Determination of Exchange Rates

19

Chapter 3

The International Monetary System

Chapter 3 Outline A. Exchange Rate Systems B. International Monetary System C. European Monetary System and Monetary Union

D. Emerging Market Currency Crises

Chapter 3: The International Monetary System

1

3.A Exchange Rate Systems (1) ❑

Free float

❑

Managed float

❑

Target-zone arrangement

❑

Fixed-rate system

❑

Hybrid system

Chapter 3: The International Monetary System

2

3.A Exchange Rate Systems (2) ❑

Free (“clean”) float – Exchange rates are determined by currency supply and demand with no government intervention.

– As economic parameters change, market participants adjust their current and expected future currency needs.

– Shifts in currency needs in turn shift currency supply and demand schedules, as seen in Chapter 2.

❑

Managed (“dirty”) float – Central banks intervene to reduce economic volatility.

– Three categories of intervention 1. Smoothing out daily fluctuations – central bank buys or sells currency to smooth exchange rate adjustments.

2. Leaning against the wind – measures taken to moderate or prevent short- or medium-term exchange rate fluctuations caused by random events.

3. Unofficial pegging – a country pegs the value of its currency to a foreign currency to protect the value of its exports.

Chapter 3: The International Monetary System

3

3.A Exchange Rate Systems (3) ❑

❑

❑

Target zone arrangement –

Countries agree to adopt economic policies that maintain their exchange rates within a specific range.

–

Designed to minimize exchange rate volatility and enhance economic stability in participating countries.

–

Requires coordination of economic policy objectives and practices.

Fixed-rate system –

Governments maintain target exchange rates.

–

Central banks buy/sell currency to increase (“revalue”)/decrease (“devalue”) exchange rates when exchange rates threaten to deviate from their stated par values by more than an agreed-on percentage.

–

Monetary policy becomes subordinate to exchange rate policy.

Hybrid system – current international system consisting of free-float, managed-float, and pegged currencies.

Chapter 3: The International Monetary System

4

3.B International Monetary System (1) ❑

Gold Standard – participating countries fixed the prices of their currencies in terms of a specified amount of gold.

❑

Because the value of gold is fairly stable over time, the gold standard ensured long-run price stability for both individual countries and groups of countries.

❑

Classical Gold Standard (1821-1914) –

Characterized by price-specie-flow mechanism •

Changes in the price level in one country were offset by an automatic balance of payments (“BOP”) adjustment.

–

As U.S. exchange rate falls, exports rise, causing BOP surplus and inflow of foreign gold.

–

U.S. prices rise, foreign prices fall

–

U.S. exports fall, foreign exports rise

–

BOP equilibrium achieved

Chapter 3: The International Monetary System

5

3.B International Monetary System (2) ❑

Classical Gold Standard (1821-1914), continued –

1821 – England returns to gold standard

–

1821-1880 – other countries join the gold standard

–

1880-1914 •

Rapid expansion of virtually free international trade

•

Stable exchange rates and prices

•

Free flow of labor and capital

•

Rapid economic growth

•

World peace

•

However, some negative economic conditions –

Major depression in 1890s

–

Economic contraction in1907

–

Repeated recessions

Chapter 3: The International Monetary System

6

3.B International Monetary System (3) ❑

❑

Gold Exchange Standard (1925-1931) –

The U.S. and England could hold only gold reserves

–

Other nations could hold both gold and dollars/pounds as reserves.

–

In 1931, England departed from gold given massive gold and capital flows stemming from an unrealistic exchange rate, ending the Gold Exchange Standard.

1931-1944 –

Beggar thy neighbor devaluations – countries devalued their currencies to maintain trade competitiveness, leading to a trade war.

Chapter 3: The International Monetary System

7

3.B International Monetary System (4) ❑

Bretton Woods System (1946-1971) – Bretton Woods Conference, 1944 • New postwar monetary system –

Allied nations pledged to maintain a fixed (pegged) exchange rate in terms of the dollar or gold.

–

1 ounce of gold = $35

–

Exchange rates could fluctuate only within 1% of their stated par values.

–

Fixed rates were maintained by central bank intervention in foreign exchange markets.

Chapter 3: The International Monetary System

8

3.B International Monetary System (5) ❑

Bretton Woods System (1946-1971), continued –

Bretton Woods Conference, 1944, continued •

Two new institutions created –

International Monetary Fund (IMF) – created to promote monetary stability • Role has evolved over time • Oversees exchange rate policies in 182 member countries • Advises developing countries on economic policy • Lender of last resort • Moral hazard – expectation of IMF bailouts leads investors to underestimate risks of lending to governments that pursue irresponsible policies

–

International Bank for Reconstruction and Development (World Bank) – created to lend money to countries to rebuild their war-damaged infrastructures

Chapter 3: The International Monetary System

9

3.B International Monetary System (6) ❑

Bretton Woods System (1946-1971), continued – Fixed rate system in name only.

• Of 21 major industrial countries: – Only the U.S. and Japan maintained their par values – 12 countries devalued their currencies >30% against the dollar – 4 countries revalued their currencies – 4 countries allowed their currencies to float

– Collapse of Bretton Woods system • Inflation in the U.S. stemming from the Johnson Administration printing money instead of raising taxes to finance Viet Nam conflict.

• West Germany, Japan, and Switzerland would not accept the inflation that a fixed exchange rate with the dollar would have imposed on them.

Chapter 3: The International Monetary System

10

3.B International Monetary System (7) ❑

Post-Bretton Woods System (1971-Present) – Smithsonian Agreement • Dollar was devalued to 1/38 of an ounce of gold.

• Other currencies revalued by agreed-on amounts in terms of the dollar.

– Attempts to set new fixed rates unsuccessful.

– International floating exchange rate system instituted in 1973.

• System supposed to reduce economic volatility and facilitate free trade.

– Floating rates would offset international differences in inflation.

– Real exchange rates would stabilize given gradual changes in underlying conditions affecting trade and productivity of capital.

– Nominal exchange rates would stabilize if countries coordinated their monetary policies to achieve inflation rate convergence.

• However, currency volatility has increased due to non-monetary global economic shocks (e.g., changing oil prices).

Chapter 3: The International Monetary System

11

3.C European Monetary System (1) ❑

European Monetary System (EMS) –

Began operating in March 1979.

–

Purpose: Foster monetary stability in the European Community (EC)

–

Members established the European Currency Unit (ECU), a composite currency consisting of fixed amounts of the 12 EC member currencies.

–

The quantity of each currency reflected each country’s relative economic strength within the ECU.

–

In 1992, the EC became the European Union (EU).

–

The EU currently has 27 member states.

Chapter 3: The International Monetary System

12

3.C European Monetary System (2) ❑

Exchange rate mechanism (ERM) –

Target zone system

–

Allowed each EMS member to determine a mutually agreed-on currency exchange rate.

–

Each rate was denominated in central ECU currency units.

–

Central rates established a grid of bilateral cross-exchange rates between currencies.

–

Participating countries pledged to maintain their currencies within a +/-15% margin of cross-exchange rates.

–

By 1993, the ERM created a two-tiered system

–

•

One tier included currencies tightly anchored by the DM

•

One tier included weaker currencies

EMR abandoned in August 1993

Chapter 3: The International Monetary System

13

3.C European Monetary System (3) ❑

European Monetary Union (EMU, or EU) – Maastricht Treaty • Formalized the EC’s moved toward a monetary union • EC nations would establish the European Central Bank with sole power to issue a single currency (euro).

– On January 1, 1999, the euro became a currency and conversion rates for the euro were locked in for member countries.

– On January 1, 2002, member countries’ currencies were replaced by euro bills and coins.

– To join the EU, countries were subjected to the Maastricht criteria • Government debt ≤ 60% of GDP • Budget deficit ≤ 3% of GDP • Inflation ≤ 1.5 percentage points above the average rate of Europe’s three lowest-inflation countries • Long-term interest rates ≤ 2 percentage points above the average interest rate in the three lowest-inflation countries Chapter 3: The International Monetary System

14

3.C European Monetary System (4) ❑

European Monetary Union (EMU, or EU), continued –

Consequences of EU •

Lower cross-border currency conversion costs

•

Eliminated risk of currency fluctuations

•

Facilitated cross-border price comparisons

•

Encouraged flow of trade and investments among member countries

•

Greater integration of Europe’s capital, labor, and commodity markets

•

Increased Europe’s competitiveness

•

Greater coordination of monetary policy

Chapter 3: The International Monetary System

15

3.D Emerging Market Currency Crises (1) ❑

❑

Currency crises spread from one country to another by two means.

–

Trade links – e.g., when Argentina is in crisis, it imports less from Brazil, causing Brazil’s economy to contract and its currency to weaken. Brazil’s contraction will in turn affect other trade partners.

–

The financial system – distress in one emerging market causes investors to exit other countries with similar risk profiles.

Common denominator in promoting currency crises: Countries issue too much short-term debt closely linked to the dollar. When the dollar depreciates, the cost of repaying dollar-linked bonds soars.

Chapter 3: The International Monetary System

16

3.D Emerging Market Currency Crises (2) ❑

Circumventing emerging market crises – Currency controls • Abandoning free capital movement to insulate a country’s currency from speculative attacks.

• However: – Open capital markets channel savings to where they are most productive; – Developing nations need foreign capital and know-how; and – Currency controls have led to corruption.

– Freely floating currency – floating rates absorb the pressures created in emerging countries that simultaneously peg their exchange rates and pursue independent monetary policy.

– Permanently fix the exchange rate – through dollarization, use of a currency board, or a monetary union, a country can permanently fix its exchange rate.

Chapter 3: The International Monetary System

17

Chapter 4

Parity Conditions in International Finance and Currency Forecasting

Chapter 4 Outline A. Arbitrage and the Law of One Price B. Key Terms C. Theoretical Economic Relationships

D. Currency Forecasting

Chapter 4: Parity Conditions in International Finance and Currency Forecasting

1

4.A Arbitrage and the Law of One Price ❑

Arbitrage – the simultaneous purchase and sale of the same assets or commodities on different markets to profit from price discrepancies

❑

Law of One Price – in competitive markets, exchange-adjusted prices of identical tradable goods and financial assets must be within transaction costs of equality worldwide.

❑

Absent market imperfections, arbitrage ensures that exchangeadjusted prices of identical traded goods follow the Law of One Price.

Chapter 4: Parity Conditions in International Finance and Currency Forecasting

2

4.B Key Terms ❑

Spot rate e0 – current exchange rate of currency

❑

Forward rate f1 – exchange rate of currency on a specified future date

❑

Forward discount – the discount applied to a currency if the forward rate is below the spot rate

❑

Forward premium – the premium applied to a currency if the forward rate is above the spot rate

Forward premium/discount =

f1 – e0 e0

x

Chapter 4: Parity Conditions in International Finance and Currency Forecasting

360 Forward contract number of days

3

4.C Theoretical Economic Relationships (1) ❑

In the absence of market imperfections, risk-adjusted expected returns on financial assets in different markets should be equal.

❑

Five key theoretical economic relationships result from arbitrage. i.

Purchasing power parity (PPP) – for prices in two countries to be equal, the exchange rate between the two countries must change by the difference between the domestic and foreign rates of inflation.

ii.

Fisher effect (FE) – If expected real interest rates differ between the home and foreign countries, capital will flow to the country with the higher real rate until the real rates in both countries are equal and equilibrium is reached.

iii. International Fisher effect (IFE) – combines the conditions underlying PPP and FE; if real interest rates differ between the home and foreign countries, capital will flow to the country with the higher real rate until the exchange-adjusted returns are equal in both countries and equilibrium is reached. iv. Interest rate parity (IRP) – in an efficient market with no transaction costs, the interest rate differential between two countries should approximate the forward differential. v.

Forward rates as unbiased predictors of future spot rates (UFR) – Equilibrium is achieved when the forward differential equals the expected change in the spot rate.

Chapter 4: Parity Conditions in International Finance and Currency Forecasting

4

4.C Theoretical Economic Relationships (2) ❑

Note: The equations presented in the discussions of the theoretical economic relationships are “approximations” of formal equations.

For example, in the discussion of purchasing power parity, we present the equilibrium state as achieved when e1 – e0 e0

= ih – if

This equation is a commonly used and accepted approximation of the following formal equation, which is presented and discussed in the textbook. et e0

=

(1 + if)t (1 + ih)t

The approximation equations are used to graphically illustrate each theoretical economic relationship.

Chapter 4: Parity Conditions in International Finance and Currency Forecasting

5

4.C.i

Theoretical Economic Relationships: Purchasing Power Parity (PPP) (1)

❑

Price levels should be equal worldwide when expressed in a common currency.

❑

The exchange rate e0 will adjust to reflect changes in the price levels (inflation) of the two countries.

– Purchasing power disparity occurs when inflation in one country changes, causing goods in that country to become more or less attractive to foreign consumers.

– e0 will change over time until inflation equalizes in the two countries and PPP is once again restored.

– PPP is thus achieved when e1 – e0 e0

= ih – if

where et = home currency/ foreign currency

Chapter 4: Parity Conditions in International Finance and Currency Forecasting

6

4.C.i

Theoretical Economic Relationships: Purchasing Power Parity (PPP) (2)

❑ Graphical example e1 – e0 e0

Parity Line

5

1. At equilibrium E0, U.S. and Japan inflation both = 2% and change in e0 = 0

4 3

2. U.S. inflation increases to 5% (ih – if = 3%), causing disequilibrium, or purchasing power disparity, at (0,3).

E1

2 1 -5

-4

-3

-2

E0 1

-1 -1 -2

-3

ih – if 2

3

4

5

3. $/¥ exchange rate will rise ~3% (e1–e0 / e0 ≈ 3%) to equalize the dollar price of goods in the two countries at a new equilibrium E1.

-4 -5

Chapter 4: Parity Conditions in International Finance and Currency Forecasting

7

4.C.i ❑

Theoretical Economic Relationships: Purchasing Power Parity (PPP) (3)

Nominal exchange rate versus real exchange rate – Nominal exchange rate = actual exchange rate et – Because changes in et offset changes in foreign and domestic price levels (i.e., inflation differentials), changes in et should not affect the relative competitive positions of domestic and foreign competitors.

– et thus does not reveal the true effects of currency changes on a firm or country.

– The real exchange rate indicates the real purchasing power of one currency relative to another.

– Real exchange rate = et adjusted for changes in the relative purchasing power of each currency since a base year* = et’ e t ’ = et

(1 + if)t (1 + ih)t

*In base year, et = et’ Chapter 4: Parity Conditions in International Finance and Currency Forecasting

8

4.C.i ❑

Theoretical Economic Relationships: Purchasing Power Parity (PPP) (4)

Nominal exchange rate versus real exchange rate, continued –

If changes in et are offset by changes in inflation between two countries, et’ remains unchanged.

–

Thus, a change in et’ is equivalent to a deviation from PPP.

–

E.g., compute and compare changes in the real and nominal values of the yen relative to the dollar (i.e., et and et’ = $/¥) from 1982 to 2006 1. et in 1982 (e0 = base year) = $1/¥249.05, et in 2006 (e25) = $1/¥116.34 2. CPIJapan in 1982 = 80.75, CPIJapan in 2006 = 97.72; if = 21% 3. CPIUS in 1982 = 56.06, CPIUS in 2006 = 117.07; ih = 109% e25’ = $1/¥116.34

(1 + 21%)

(1 + 109%)

= $.004981

4. e0’ = $1/¥249.05 = $.004015.

5. Change in et’ = ($.004981 - $.004015) / $.004015 = 24%, meaning the yen appreciated 24% against the dollar in real terms – that is, the real dollar prices of Japanese exports rose by 24%.

Chapter 4: Parity Conditions in International Finance and Currency Forecasting

9

4.C.i ❑

Theoretical Economic Relationships: Purchasing Power Parity (PPP) (5)

Nominal exchange rate versus real exchange rate, continued –

E.g., compute and compare the changes in the real and nominal values of the yen relative to the dollar from 1982 to 2006, continued 6. Change in et = (($1/¥116.34) – ($1/¥249.05)) / ($1/¥249.05) = 114%, meaning the nominal dollar prices of Japanese exports rose by 114% over the period.

7. Difference between et and et’ = 114% - 24% = 90%.

8. Conclusion: Inflation differentials justify only a 90% rise in et . Thus, the increase in et’ causes a deviation from PPP by 24%.

Chapter 4: Parity Conditions in International Finance and Currency Forecasting

10

4.C.ii

Theoretical Economic Relationships: Fisher Effect (FE) (1)

❑

The nominal interest rate compensates lenders for the erosion of future purchasing power of dollars loaned.

❑

Because virtually all financial contracts are stated in nominal terms, the real interest rate a must be adjusted to reflect expected inflation.

❑

FE states that the nominal interest rate r = a required rate of return a and an inflation premium equal to expected inflation i: r = a + i + ai

❑

Real returns are equalized across countries through arbitrage; i.e., over time, ah = af.

❑

If expected ah ≠ af, capital would flow to the country with the higher real rate until ah = af and equilibrium is reached.

❑

In equilibrium with no government interference, rh - rf = ih - if

Chapter 4: Parity Conditions in International Finance and Currency Forecasting

11

4.C.ii

Theoretical Economic Relationships: Fisher Effect (FE) (2)

❑ Graphical example rh – rf Parity Line 5

2. Foreign interest rates increase by 2% (rh – rf = -2%), causing a 2% disequilibrium in real rates at (0,-2) (i.e., the differential in r and i).

4 3 2

1

E0 -5

-4

-3

-2

-1

E1

ih – if 1

-1 -2

-3 -4

1. At equilibrium E0, rh = rf and i h = i f.

2

3

4

5

3. Funds will flow from the home country to the foreign country to equalize the real rates (if will increase by 2%) in the two countries at a new equilibrium E1.

-5

Chapter 4: Parity Conditions in International Finance and Currency Forecasting

12

4.C.ii ❑

Theoretical Economic Relationships: Fisher Effect (FE) (3)

Capital market segmentation – real interest rates are determined by local credit conditions.

– Real interest rate in the U.S. aUS is based on the national supply and demand for credit.

– Real interest rate in the rest of the world arw is based on the rest of the world’s supply and demand for credit.

❑

Capital market integration – real interest rates are determined by global supply and demand for funds.

– If aUS > arw, when U.S. capital markets open up, aUS will fall and arw will rise to the new world rate aw , which is determined by world supply (SUS + Srw) and demand (DUS + Srw).

Chapter 4: Parity Conditions in International Finance and Currency Forecasting

13

4.C.iii Theoretical Economic Relationships: International Fisher Effect (IFE) (1) ❑

IFE combines the conditions underlying PPP and FE.

❑

Thus, in equilibrium, rh – rf =

ē1 – e0

e0

❑

If rh ≠ rf, capital will flow from the country with the lower expected return to the country with the higher expected return, causing e0 to adjust by the interest rate differential such that rh = rf and a new equilibrium is established.

❑

Interest rate differentials are thus unbiased (while not necessarily accurate) predictors of ē1.

Chapter 4: Parity Conditions in International Finance and Currency Forecasting

14

4.C.iii

Theoretical Economic Relationships: International Fisher Effect (IFE) (2)

❑ Graphical example ē1 – e0 e0 Parity Line 5

E1

2. ē1 increases by 4%, causing a 4% disequilibrium in exchange-adjusted interest rates at (4,0).

4 3 2 1

E0 -5

-4

-3

-2

-1

rh – rf 1

-1 -2

-3

2

3

4

1. At equilibrium E0, ih = if and change in e0 = 0.

5

3. Funds will flow from the home country to the foreign country to equalize the exchangeadjusted returns (rh increases by 4%) at a new equilibrium E1.

-4 -5

Chapter 4: Parity Conditions in International Finance and Currency Forecasting

15

4.C.iv Theoretical Economic Relationships: Interest Rate Parity (IRP) (1) ❑

The forward discount or premium is closely related to the interest differential between two currencies.

❑

IRP – in an efficient market with no transaction costs, the interest rate differential between two countries (rh – rf) should approximate the forward differential (f1 – e0)/e0.

❑

Thus, in equilibrium, rh – rf ≈

❑

f1 – e0 e0

IRP ensures that the return on a hedged, or covered, foreign investment will just equal the home interest rate on investments of identical risk.

Chapter 4: Parity Conditions in International Finance and Currency Forecasting

16

4.C.iv Theoretical Economic Relationships: Interest Rate Parity (IRP) (2) ❑

Covered interest arbitrage (CIA) – profiting from interest rate differentials in rh and rf (when IRP does not hold). E.g.: – rUK = 12%, rUS = 7% – e0 = $/£ = $1.95, f1 = $1.88 – rUK – rUS = 5%

– (f1 – e0)/e0 = ($1.88 - $1.95)/$1.95 = -3.6% = forward discount – rUK – rUS ≠ (f1 – e0)/e0 – Funds will flow from U.S. to U.K. to exploit profit opportunity (CIA) – As pounds are bought spot and sold forward, e0 will increase and f1 will decrease, increasing the forward discount – As funds flow from U.S. to U.K., rUS will increase and rUK will decrease.

– CIA will continue until IRP is achieved.

Chapter 4: Parity Conditions in International Finance and Currency Forecasting

17

4.C.iv Theoretical Economic Relationships: Interest Rate Parity (IRP) (3) ❑ Graphical example In this example, let UK be home country

rh – rf CIA

Parity Line

Arbitrage inflow to UK

5 4

1. rh - rf = 5% and forward discount = -3.6%.

3 2 1

-5

-4

-3

-2

-1

-2 -3

– Increasing f1; and

f1 – e0 E 1

-1

2. Funds will flow from the U.S. to the U.K.:

Arbitrage outflow from UK*

2

3

4

5

– Increasing rUS and decreasing rUK until rh - rf = 0

e0

3. CIA continues until IRP is achieved at E.

-4 -5

*Points below the parity line represent points at which the forward premium would negate the favorable UK interest rate differential

Chapter 4: Parity Conditions in International Finance and Currency Forecasting

18

4.C.iv Theoretical Economic Relationships: Interest Rate Parity (IRP) (4) ❑

Transaction costs cause effective rates to be lower than nominal rates, creating a band around the parity line. For CIA to occur, the covered differential must exceed transaction costs. rh – rf Parity Line

5 4 3 2 1 -5

-4

-3

-2

-1

f1 – e0 1

2

3

4

5

-1

e0

-2 -3 -4 -5 Chapter 4: Parity Conditions in International Finance and Currency Forecasting

19

4.C.v

Theoretical Economic Relationships: Forward Rate and Future Spot Rate (1)

❑

Absent government intervention, e0 and f1 are heavily influenced by current expectations of future events.

❑

The two rates move in tandem, linked by interest differentials.

❑

E.g., the pound is expected to depreciate.

– Holders of pounds sell pounds forward.

– Sterling-area dollar earners reduce sales of dollars in the forward market.

– f1 will decrease.

– Banks will sell e0 to offset f1 positions.

– Earners of pounds will accelerate their collection and conversion of pounds. ❑

Thus, pressure from the forward market is transmitted to the spot market, and vice versa.

Chapter 4: Parity Conditions in International Finance and Currency Forecasting

20

4.C.v

Theoretical Economic Relationships: Forward Rate and Future Spot Rate (2)

❑

Equilibrium is achieved when the forward differential equals the expected change in e0 (ē1).

❑

Thus, in equilibrium, f1 – e0 e0

ē1 – e0 = e0

❑

In equilibrium, incentives to buy or sell currency forward do not exist.

❑

ft should reflect ēt on the date of settlement of the forward contract.

❑

Thus, the unbiased forward rate (UFR) condition is ft =

ēt

Chapter 4: Parity Conditions in International Finance and Currency Forecasting

21

4.C.v

Theoretical Economic Relationships: Forward Rate and Future Spot Rate (3)

❑ Graphical example ē1 – e 0 e0

Parity Line

5 4

2. The value of the pound is expected to depreciate by 4%.

3 2 1 -5

-4

-3

-2

-1 -2 -3

E1

f1 – e0 E0 1

-1

1. At equilibrium E0, ē0 = f1 and there is no incentive to buy or sell currency forward.

2

3

4

5

e0

3. Pound holders sell pounds forward, dollar holders delay converting dollars to pounds.

4. f1 decreases over time by 4% to establish a new equilibrium at E1.

-4 -5

Chapter 4: Parity Conditions in International Finance and Currency Forecasting

22

4.D Currency Forecasting (1) ❑

Requirements for successful currency forecasting – Exclusive use of a superior forecasting model – Consistent access to information – Exploiting small, temporary deviations from equilibrium – Predicting the nature of government intervention in the foreign exchange market

❑

Market-based forecasts can be obtained by extracting the predictions embodied in interest and forward rates.

– f1 is an unbiased estimate of ē1 (forecasting usefulness limited to one year given the general absence of longer-term forward contracts) – Interest rate differentials can be used as predictors beyond one year.

Chapter 4: Parity Conditions in International Finance and Currency Forecasting

23

4.D Currency Forecasting (2) ❑

Model-based forecasts are based on technical and/or fundamental analysis – Fundamental analysis involves examining macroeconomic variables and policies likely to influence a currency’s prospects.

– Technical analysis focuses exclusively on past price and volume movements to identify price patterns.

– Model-based forecasts are inconsistent with the efficient market hypothesis – because markets are forward looking, exchange rates will fluctuate randomly as market participants assess and react to news.

❑

Exchange controls and restrictions on imports and capital flows often mask the true pressures on a currency to devalue.

Chapter 4: Parity Conditions in International Finance and Currency Forecasting

24

Chapter 5

The Balance of Payments and International Economic Linkages

Chapter 5 Outline A. Balance of Payments B. The International Flow of Goods, Services, and Capital C. Current Account Deficit

Chapter 5: The Balance of Payments and International Economic Linkages

1

5.A Balance of Payments (1) ❑

Balance of payments (“BOP”) – an accounting statement that summarizes all of the economic transactions between residents of the home country and residents of all other countries.

– Current Account – reflects the net flow of • Goods and services (balance of trade); • Income (interest, dividends, and compensation); and • Unilateral transfers (pensions, remittances, and other transfers for which no services were rendered).

– Capital Account – reflects capital transfers that offset transactions undertaken without exchange in fixed assets or in their financing.

– Financial Account – reflects net purchases of financial assets: • Portfolio investments – financial assets with maturity > one year • Direct investments – financial assets for which management control is exerted (at least 10% equity ownership) • Changes in reserve assets held by official monetary institutions

– Double-entry accounting ensures that the sum of all transactions is zero.

– A “statistical discrepancy” line is included to offset non-zero balances.

Chapter 5: The Balance of Payments and International Economic Linkages

2

5.A Balance of Payments (2) ❑

Basic BOP statement Category

Credit (+)

Debit (-)

Goods (export/import)

$xxx

-$xxx

Services (export/import)

$xxx

-$xxx

Income (receipts/payments)

$xxx

-$xxx

Current Account

Unilateral transfers

Balance of Trade

-$xxx

Capital Account Capital transfers

$xxx

-$xxx

Portfolio investment (in U.S./overseas)

$xxx

-$xxx

Direct investment (in U.S./overseas)

$xxx

-$xxx

Government investment (in U.S./overseas)

$xxx

-$xxx

Changes in reserve assets

$xxx

-$xxx

Financial Account

Surplus/Deficit

Statistical Discrepancy

Chapter 5: The Balance of Payments and International Economic Linkages

3

5.A Balance of Payments (3) ❑

BOP definitions – Basic balance – includes transactions that are fundamental to the economic health of a currency.

– Net liquidity balance – measures change in private domestic borrowing or lending required to keep payments balanced without adjusting official reserves.

– Official reserve transactions balance – measures the adjustment required in official reserves to achieve BOP equilibrium.

Chapter 5: The Balance of Payments and International Economic Linkages

4

5.B ❑

International Flow of Goods, Services, and Capital

Macroeconomic accounting identities –

Link domestic spending and production to savings, consumption, and investment behavior, and thus to Current Account and Financial Account balances.

–

Manipulating accounting identities reveals the nature of the links between U.S. and world economies.

i.

Domestic savings and investment and the Financial Account

ii. Link between Current Account and Financial Account iii. Government budget deficits and the Current Account

Chapter 5: The Balance of Payments and International Economic Linkages

5

5.B.i International Flow of Goods, Services, and Capital: Savings and Investment and the Financial Account ❑

National income* is either spent or saved. Thus: Identity 5.1:

❑

National Income = Consumption + Savings

National expenditures consist of consumption and investment.

Thus: Identity 5.2: National Expenditures = Consumption + Investment

❑

Thus: National Income – National Expenditures = Identity 5.3: (consumption + savings) – (consumption + investment) = Savings – Investment *same as national product

Chapter 5: The Balance of Payments and International Economic Linkages

6

5.B.i International Flow of Goods, Services, and Capital: Savings and Investment and the Financial Account ❑

If income > expenditures, then savings > investment, resulting in a capital surplus (excess savings).

❑

Surplus capital is invested overseas.

❑

Thus, surplus capital becomes net foreign investment.

❑

If positive, net foreign investment equals a Financial Account deficit.

Financial Account

Credit (+)

Debit (-)

Portfolio investment (in U.S./overseas)

$xxx

-$xxx

Direct investment (in U.S./overseas)

$xxx

-$xxx

Government investment (in U.S./overseas)

$xxx

-$xxx

Changes in reserve assets

$xxx

-$xxx

Balance

Chapter 5: The Balance of Payments and International Economic Linkages

-$xxx

7

5.B.i International Flow of Goods, Services, and Capital: Savings and Investment and the Financial Account If a country’s…

Production > Spending

Production < Spending

Domestic Savings > Domestic Investment

Domestic Savings < Domestic Investment

Capital Surplus

Capital Shortage

Net Capital Outflow

Net Capital Inflow

Financial Account Deficit

Financial Account Surplus

Chapter 5: The Balance of Payments and International Economic Linkages

8

5.B.ii International Flow of Goods, Services, and Capital: Link Between Current Account and Financial Account ❑

National income consists of domestic goods and services and exports.

❑

National expenditure consists of spending on domestic goods and services and imports.

❑

Thus: Identity 5.4:

National Income – National Expenditure = (dom. goods/services + exports) – (dom. goods/services + imports) = Exports – Imports ❑

If income > expenditures, then exports > imports, resulting in a Current Account surplus.

Chapter 5: The Balance of Payments and International Economic Linkages

9

5.B.ii International Flow of Goods, Services, and Capital: Link Between Current Account and Financial Account ❑

Combining Identity 5.3 and Identity 5.4: Identity 5.5:

– ❑

Savings – Investment = Exports – Imports

Thus, if savings > investment, net exports are positive and the Current Account will run a surplus.

Because net foreign investment = savings - investment: Identity 5.6:

Net Foreign Investment = Exports – Imports

–

Thus, the Current Account balance = net capital outflow.

–

If savings > investment, net foreign investment is positive and the Current Account will run a surplus.

Chapter 5: The Balance of Payments and International Economic Linkages

10

5.B.ii International Flow of Goods, Services, and Capital: Link Between Current Account and Financial Account ❑

By Identity 5.6, the excess of goods and services bought over goods and services produced domestically must be acquired through foreign trade and financed by an equal amount of borrowing from abroad.

❑

That is, if exports < imports, net foreign investment is negative.

❑

–

When exports < imports, the Current Account will run a deficit.

–

When net foreign investment is negative, the Financial Account will run a surplus.

Thus, the Current Account and Financial Account balances must exactly offset each other.

Chapter 5: The Balance of Payments and International Economic Linkages

11

5.B.ii International Flow of Goods, Services, and Capital: Link Between Current Account and Financial Account ❑

Using identities to assess the efficacy of solutions to improve the Current Account balance

❑

Two conditions must be satisfied to reduce/increase a Current Account deficit/surplus:

❑

–

By Identify 5.3, raise income relative to expenditures; and

–

Bv Identity 5.5, raise savings relative to investment.

However, a Current Account surplus is not necessarily a sign of economic health.

–

Countries that provide good investment opportunities may run trade deficits (investment > savings).

–

Countries that grow rapidly import more goods and services and may thus run trade deficits.

–

Weak economies may reduce their imports, given a positive correlation of income with import consumption, and may thus run trade surpluses.

Chapter 5: The Balance of Payments and International Economic Linkages

12

5.B.iii International Flow of Goods, Services, and Capital: Govt. Budget Deficits and Current Account Deficits ❑

The previous identities include government spending and taxation in national income and expenditures.

❑

Differentiating government from household spending shows the effect of a government budget deficit on the Current Account.

National Expenditures = Household Spending + Private Investment + Govt. Spending Identity 5.7: = (National Income – Private Savings – Taxes) + Private Investment + Govt. Spending

❑

By Identity 5.7, excess spending, or capital surplus is expressed as: Identity 5.8:

National Expenditures – National Income = Private Investment – Private Savings + Govt. Budget Deficit*

*Govt. budget deficit = taxes – govt. spending Chapter 5: The Balance of Payments and International Economic Linkages

13

5.B.iii International Flow of Goods, Services, and Capital: Govt. Budget Deficits and Current Account Deficits ❑

Rearranging and combining Identity 5.4 and Identity 5.8 shows the impact of the government budget deficit on the Current Account balance: Identity 5.9:

–

Current Account Balance = Private Savings Surplus – Govt. Budget Deficit

Thus, a country running a Current Account deficit is not saving enough to finance its private investment and government budget deficit, and a country running a Current Account surplus has excess savings after financing private investment and the government deficit.

Chapter 5: The Balance of Payments and International Economic Linkages

14

5.C. Current Account Deficit (1) ❑

Responses to a Current Account deficit include currency devaluation, protectionism, and increasing savings.

–

Devaluation •

An overvalued currency acts as a tax on exports and a subsidy to imports.

•

Empirical review of currency devaluation and trade deficit – 1976-1980 – dollar depreciated as trade deficit first worsened and then improved.

– 1980-1985 – dollar appreciated as trade deficit steadily worsened.

– 1985-1987 – Dollar began depreciating while trade deficit rose steadily.

– 2002 – Dollar began depreciating as trade deficit reached record levels

Chapter 5: The Balance of Payments and International Economic Linkages

15

5.C. Current Account Deficit (2) ❑

Responses to a Current Account deficit include currency devaluation, protectionism, and increasing savings, continued –

Devaluation, continued •

Conventional explanations for disconnect between changes in currency value and changes in trade deficit –

Lagged effects – time is needed for an exchange rate change to affect trade. Empirical review indicates that changes in the dollar’s value explain less than 5% of the variation in the trade balance between 1970 and 2006.

–

J-Curve theory – as currency depreciates, the trade deficit initially worsens and then improves over time. Consistent with presence of lagged effects. Empirical review indicates that the trade deficit initially worsened in 1985 but did not reach its 1985 level until four years later.

Subsequent Current Account improvements may have been due to budget deficit declines, rendering the J-curve theory inconclusive.

–

The attractive investment climate in the 1980s caused investors to expand holdings of U.S. assets, which bid up the value of the dollar such that Americans changed their assets for foreign goods and services, causing a Financial Account surplus and Current Account deficit.

Chapter 5: The Balance of Payments and International Economic Linkages

16

5.C. Current Account Deficit (3) ❑

Responses to a Current Account deficit include currency devaluation, protectionism, and increasing savings, continued –

Protectionism •

Tariffs increase the prices of imports, causing domestic consumers to opt for domestic substitutes.

•

Quotas restrict supply of imports, thereby raising prices and causing domestic consumers to opt for domestic substitutes.

•

Protectionism thus results in increased domestic prices, erosion in purchasing power, and a decline in living standards.

•

Protectionism does not affect the trade balance, as other imports rise or exports fall.

•

By Identity 5.5, as imports fall, exports will fall by an equal amount absent changes in saving or investment.

Chapter 5: The Balance of Payments and International Economic Linkages

17

5.C. Current Account Deficit (4) ❑

Responses to a Current Account deficit include currency devaluation, protectionism, and increasing savings, continued –

Increasing savings •

The prospect of receiving Social Security benefits may negatively affect American’s saving habits.

•

Increase tax-favored savings vehicles

•

Switch from income tax to consumption tax

•

Reduce the government budget deficit

Chapter 5: The Balance of Payments and International Economic Linkages

18

Chapter 6

The Foreign Exchange Market

Chapter 6 Outline A. Foreign Exchange Market B. Spot Market C. Forward Market

Chapter 6: The Foreign Exchange Market

1

6.A Foreign Exchange Market (1) ❑

Foreign exchange market permits transfers of purchasing power denominated in one currency to another.

❑

Interbank market – wholesale market in which major banks trade with one another. Accounts for ~95% of foreign exchange transactions.

Spot market – where currencies are traded for immediate delivery Forward market – where contracts are made to buy or sell currencies for future delivery Swap transactions – involve a package of a spot and a forward contract

Chapter 6: The Foreign Exchange Market

35% 53% 12%

Spot Transactions Forward Transactions Swap Transactions

2

6.A Foreign Exchange Market (2) ❑

Methods of trading – Telephone – Telex – SWIFT (Society for Worldwide Interbank Financial Telecommunications) system

– Internet-based systems ❑

Market participants – Large commercial banks – Foreign exchange brokers in the interbank market

– Commercial customers (primarily MNCs) – Central banks ❑

The role of human brokers has declined as electronic brokers have significantly increased their share of the foreign exchange market.

Chapter 6: The Foreign Exchange Market

3

6.A Foreign Exchange Market (3) ❑

Quotations – Up to four different foreign exchange quotes are displayed in major newspapers.

• Spot rate • Forward rates, including 30-, 90-, and 180-day forward

– Quotes are for dealers in the interbank market.

– When interbank trades involve dollars, rates are expressed in American terms ($/foreign currency) or European terms (foreign currency/$).

Chapter 6: The Foreign Exchange Market

4

6.A Foreign Exchange Market (4) ❑

Forward market participants – Arbitrageurs – seek to earn risk-free profits by taking advantage of interest rates differentials among countries. Use forward contracts to eliminate the exchange rate risk involved in transferring their funds between countries.

– Traders – use forward contracts to eliminate or cover the risk on export or import orders denominated in foreign currencies.

– Hedgers – use forward contracts to protect the home currency value of various foreign currency-denominated assets and liabilities.

– Speculators – actively expose themselves to exchange risk by buying or selling currencies forward to profit from exchange rate fluctuations.

– Thus, arbitrageurs, traders, and hedgers seek to eliminate or minimize exchange risk while speculators expose themselves to risk through forward market transactions.

Chapter 6: The Foreign Exchange Market

5

6.A Foreign Exchange Market (5) ❑

Clearing System – In the U.S., where all foreign exchange transactions involving dollars are cleared, electronic funds transfers between banks are processed through the Clearing House Interbank Payments System (CHIPS).

– Settlement payments are debited from and credited to a settlement account established by the New York Federal Reserve Bank for member banks.

– Member banks with debit positions deposit funds into their settlement accounts through FedWire to cover their part of a transaction.

Chapter 6: The Foreign Exchange Market

6

6.A Foreign Exchange Market (6) ❑

Example of CHIPS process: Fuji Bank sells $15 million to Citibank for ¥1.5 billion.

Fuji Bank Enters transaction into CHIPS system Approves and releases transaction

Fuji Bank

CHIPS 1 2

3

+ Stores transaction

Makes appropriate debits and credits to Fuji and Citibank settlement accounts 5

-

¥1.5 bil. $15 mil.

4 Citibank + $15 mil. ¥1.5 bil.

Makes permanent record of transaction 6 Issues a settlement report to each member bank

Chapter 6: The Foreign Exchange Market

7

6.A Foreign Exchange Market (7) ❑

Electronic trading systems – First created in 1992 – Enable automatic matching and execution of foreign exchange transactions – Reduce cost of trading by eliminating brokers and reducing the number of transactions traders had to engage in to obtain market prices – Gather and publish information on prices and quantities of currencies as they are traded – FXall largest electronic trading system

Chapter 6: The Foreign Exchange Market

8

6.B Spot Market (1) ❑

Spot Quotations – Direct quote – gives the home currency price of a quantity of the foreign currency quoted. E.g., the price of the euro in Switzerland is SFr1.65, or the price of the franc in Germany is €0.61.

– Indirect quote – the home currency is quoted in terms of the foreign currency. E.g., the price of pounds in terms of dollars is quoted in Great Britain as $1.9721.

– Quotes found in the financial press are for transactions in the interbank market exceeding $1,000,000.

– Quotes are provided in both American and European terms: American Terms

European Terms

• $/foreign currency

• Foreign currency/$

• Direct quote in U.S.

• Direct quote outside of U.S.

• Indirect quote outside of U.S.

• Indirect quote in U.S.

Chapter 6: The Foreign Exchange Market

9

6.B Spot Market (2) ❑

Spot Quotations, continued – Quotes are given in pairs that reflect the bid-ask price.

• E.g., pound sterling is quoted at $1.9719-28.

• $1.9719 is the (bid) rate at which banks will buy pounds

• $1.9728 is the (ask) rate at which banks will sell pounds • The spread equals the dealer’s profit • The bid-ask spread is often quoted by the last two numbers; e.g., 19-28.

– Bid-ask quote expressed in American and European terms and as direct and indirect quotes: American Terms Direct in U.S.

European Terms* Direct outside U.S.

$1.9719-28 Indirect outside U.S.

Indirect in U.S.

(1/$1.9728)-(1/$1.9719) =£0.5069-71

*Note that the bid and ask prices are reversed in quoting in European terms.

Chapter 6: The Foreign Exchange Market

10

6.B Spot Market (3) ❑

Spot quotations, continued – Bid-ask spreads are expressed as a percentage cost of transacting in the foreign exchange market as follows:

Percent Spread =

❑

Ask price – Bid price x 100 Ask price

Cross rates – Most currencies are quoted against the dollar.

– A cross rate is the exchange rate between two non-dollar currencies

Chapter 6: The Foreign Exchange Market

11

6.B Spot Market (4) ❑

Cross rates, continued – Example: Compute direct bid and ask cross rates for the pound in Zurich – Direct quote for pound sterling = $1.9719-36

– Direct quote for SFr = $0.8130-47

Bid cross rate =

Ask cross rate =

Bid rate for £ in $ Ask rate for SFr in $

Ask rate for £ in $ Bid rate for SFr in $

=

=

$1.9719 $0.8147

$1.9736 $0.8130

= SFr2.4204

= SFr2.4227

– Thus, the direct quote for the pound in Zurich is SFr2.4204-27.

Chapter 6: The Foreign Exchange Market

12

6.B Spot Market (5) ❑

Currency arbitrage – Triangular currency arbitrage – traders take advantage of exchange rate inconsistencies in different money markets by buying a currency in one market and simultaneously selling it in another.

– E.g., compute profit given the following exchange rates • $/£ = $1.9724 in New York • $/€ = $1.3450 in Frankfurt • €/£= €1.4655 in London New York

Sell pounds in New York for dollars: £507,332/(1/$1.9724) = $1,000,661

Sell $1,000,000 in Frankfurt for euros: $1,000,000/($1.3450) = €743,494

Profit = $661 London

Frankfurt Sell euros in London for pounds: €743,494/€1.4655 = £507,332

Chapter 6: The Foreign Exchange Market

13

6.B Spot Market (6) ❑

Currency arbitrage, continued – Results of triangular currency arbitrage

New York Selling pounds for dollars, the pound will depreciate against the dollar in New York

London

Selling dollars for euros, the euro will appreciate against the dollar in Frankfurt

Frankfurt Selling euros for pounds, the euro will depreciate against the pound in London

Chapter 6: The Foreign Exchange Market

14

6.B Spot Market (7) ❑

Exchange risk – Bank losses and gains from exchange rate transactions result from the immediate adjustment of quotes in response to new political and economic information affecting exchange rates.

– E.g., given a $/£ exchange rate of $1.9712, a bank buys $985,600 for £500,000 (£500,000/(1/$1.9712) = $985,600) in the foreign exchange market.

– If no offsetting transaction to cover its position is made simultaneously, it is exposed to exchange rate risk.

– If the bank then decides to cover its position in the interbank market, increases or decreases in the exchange rate will affect its exchange loss/gain.

• If the exchange rate increases to $1.9801 before the bank completes its transaction, the bank will pay $990,050 to buy £500,000, thus incurring a loss of $990,050 - $985,600 = $4,450.

• If the exchange rate increases, the bank will realize an exchange gain.

Chapter 6: The Foreign Exchange Market

15

6.C Forward Market (1) ❑

A forward contract between a bank and a customer calls for delivery on a fixed future date of a specified amount of one currency against dollar payment at a fixed exchange rate.

❑

Negotiating a forward contract for payment of a future liability eliminates exchange risk by locking in a known future exchange rate.

❑

E.g., a U.S. company buys textiles from England, with payment of £1 million due in 90 days.

Day

0

e0 = $1.97

90 e90 > $1.98 Exchange risk: If e90 > f90, cost of payable will increase

❑

f90 = $1.98 No exchange risk: £1,000,000 = $1,980,000

Implicit gains/losses on forward positions are related to the difference between ft and et at the forward contract’s maturity.

Chapter 6: The Foreign Exchange Market

16

6.C Forward Market (2) ❑

Forward rate quotations – Actual price of f1 is the outright rate – Swap rate – quoted as the premium on or discount from eo, e.g.: •

eo for yen = $0.008225, f1 for yen = $0.008421

•

Swap rate is 0.008421-0.008225 = 196

– Determining whether swap rate is a premium or discount on f1 •

When forward bid < ask rate, f1 is at a premium.

•

When forward bid > ask rate, f1 is at a discount.

– Converting swap rate to outright rate – add the premium to or subtract the discount from eo

Chapter 6: The Foreign Exchange Market

17

6.C Forward Market (3) ❑

Forward cross rates – Computed in the same way as spot cross rates – Example: Compute the forward cross rates for yen in terms of euros* – f30 for €/$ = €0.81070 - €0.81243 – f30 for ¥/$ = ¥107.347 - ¥107.442

Bid cross rate =

Ask cross rate =

Ask rate for € Bid rate for ¥

=

Bid rate for €

Ask rate for ¥

=

€0.81243 ¥107.347

€0.81170 ¥107.442

= €0.0075683

= €0.0075548

– Forward cross rates for yen in terms of euros are €0.0075683 - €0.0075548. *Note that this example is in European terms, as opposed to previous example computing bid/ask cross rates for pounds in Zurich, which was in American terms. Thus, ask and bid rates are reversed in the cross rate formulas.

Chapter 6: The Foreign Exchange Market

18

6.C Forward Market (4) ❑

Arbitraging between currencies and interest rates – Use arbitrage to take advantage of interest rate and spot/forward rate differentials. E.g., using the following table, compute profits from arbitrage.

Currency

90-day interest rates

e0

f90

£

7 7/16 – 5/16

¥240.9696 - 9912

¥224.5731 - 8692

¥

2 3/8 – 1/4

1. Borrow £1,000,000 for 90 days (repayment = [1+ ((7 7/16)/4] = £1,018,594)

2. Buy £1,000,000 of yen ([£1,000,000 (¥240.9696)] = ¥240,969,600) 3. Invest yen for 90 days (proceeds = [¥240,969,600 (1 + ((2 3/8)/4)] = ¥242,325,054) 4. Sell proceeds forward for pounds (¥242,325,054/ ¥224.8692 = £1,077,627) Profit = £1,077,627 - £1,018,594 = £59,033 Chapter 6: The Foreign Exchange Market

19

Chapter 7

Currency Futures and Options Markets

Chapter 7 Outline A. Forward and Futures Contracts B. Currency Options C. Forward and Futures Contracts versus Currency Options

D. Futures Options E. Reading Currency Futures and Options Prices

Chapter 7: Currency Futures and Options Markets

1

7.A Futures and Forward Contracts (1) ❑

Futures contracts – Contracts to buy or sell standardized quantities of given currencies, with standardized delivery dates, trading on organized exchanges – Contracts are highly leveraged, meaning the contract value responds strongly to small changes in exchange rates.

– Traders make money through commissions rather than from bid-ask spreads.

– Low cost and high leverage attracts speculators.

– Chicago Mercantile Exchange (CME) – the exchange on which most currency futures are traded

– Open interest – the number of contracts outstanding

Chapter 7: Currency Futures and Options Markets

2

7.A Futures and Forward Contracts (2) ❑

Futures contracts, continued – Margin requirements • Initial performance bond (formerly initial margin) – a minimum account balance required to enter into a contract • Maintenance performance bond (formerly maintenance margin) – the balance below which a performance bond call is triggered

• Performance bond call (formerly margin call) – a requirement to add funds when the account balance falls below the maintenance performance bond level to bring the balance in line with the initial performance bond level

– Daily settlement 1. Unrealized profits and losses on a contract resulting from price movements are marked to market (paid daily) 2. The existing contract reflecting the currency’s old price is canceled 3. A new contract reflecting the prevailing price is issued

Chapter 7: Currency Futures and Options Markets

3

7.A Futures and Forward Contracts (3) ❑

Futures contracts, continued – E.g.: Short one CME yen futures contract for ¥12.5 million with initial performance bond of $4,590 and maintenance performance bond of $3,400.

Trading Day

Currency Price

1 (open)

$0.008233

1 (close)

$0.008342

Credit/Debit

Account Balance

Initial performance bond

$4,590.00

$4,590.00

Daily loss marked to market

-$1,362.50

$3,227.50

Performance bond call deposit

$1,362.50

$4,590.00

Action

2 (close)

$0.008381

Daily loss marked to market

-$487.50

$4,102.50

3 (close)

$0.008175

Daily gain marked to market

$2,575.00

$6,677.50

4 (close)

$0.008169

Daily gain marked to market

$75.00

$6,752.50

5 (close)

$0.008194

Daily loss marked to market

-$312.50

$6,440.00

Round-trip commission to close account

-$27.00

$6,413.00

Chapter 7: Currency Futures and Options Markets

4

7.A Futures and Forward Contracts (4) ❑

Arbitrage using forward and futures contracts – Dealers seek to profit from differences in forward and futures bid prices for a currency.

– E.g., Forward bid on £62,500 pounds sterling = $1.9727; futures price = $1.9715.

• Buy futures contract for $123,218.75 (62,500 * $1.9715) • Simultaneously sell an equivalent amount of sterling forward (62,500 * $1.9727) for $123,293.75 • Profit = $75 – Arbitrage transactions will bid up the futures price and bid down the forward price until price equilibrium is restored.

Chapter 7: Currency Futures and Options Markets

5

7.B Currency Options (1) ❑

An option is a financial instrument that gives the holder the right but not the obligation to sell (put) or buy (call) another financial instrument at a set (strike or exercise) price and expiration date.

– Options can be exercised or sold.

• Exercising an option – The buyer of a call exercises an option to buy (take delivery of) the underlying currency at the strike price.

– The buyer of a put exercises an option to sell (deliver) the underlying currency at the strike price.

• Selling an option

– The buyer of a call or put sells an option to collect the difference between the initial option price and the price at the time of sale without taking delivery of/delivering the underlying currency.

Chapter 7: Currency Futures and Options Markets

6

7.B Currency Options (2) ❑

Options are in the money, at the money, or out of the money, depending on the strike price relative to the spot rate.

– The purchaser of a call wants the spot rate to increase above the strike price in order to buy the underlying currency at a profit (to exercise) or see the value of the option increase (to sell).

– The purchaser of a put wants the spot rate to decrease below the strike price in order to sell the underlying currency at a profit (to exercise) or see the value of the option increase (to sell).

Option Description

Strike Price Relative to Spot Rate

Effect of Exercise

Call (buy) Option

Put (sell) Option

In the money

Strike < Spot

Strike > Spot

Profit

At the money

Strike = Spot

Strike = Spot

Indifference

Out of the money

Strike > Spot

Strike < Spot

Loss

Chapter 7: Currency Futures and Options Markets

7

7.B Currency Options (3) ❑

American-style option – can be exercised/sold any time up to expiration

❑

European-style option – can be exercised/sold only at maturity.

❑

Exchange-traded or listed options – standardized contracts with predetermined strike prices and expiration dates

❑

Market structure – Organized exchanges • In U.S.: United Currency Options Market (UCOM) of the Philadelphia Stock Exchange and Chicago Mercantile Exchange • Outside U.S.: European Options Exchange (Amsterdam, Montreal Stock Exchange

– Over-the-counter (OTC) market • Two segments – Retail market – nonbank customers purchase from banks – Wholesale market – composed of commercial banks, investment banks, and specialized trading firms.

• OTC option specifications are generally negotiated in terms of amount, strike price and rights, underlying instrument, and expiration.

Chapter 7: Currency Futures and Options Markets

8

7.B Currency Options (4) ❑

Using currency options – buying and exercising calls – Example: U.S. importer must make a €125,000 payment to a German exporter in 60 days.

• To hedge against an exchange rate increase, buy a European-style call to have euros delivered at a strike price on the due date.

• Strike = $1.34, premium = $0.02 • Option price = $0.02 * 125,000 = $2,500 • At the end of 60 days: – If value of euro has increased to $1.40, net profit = ($1.40 - $1.34) * 125,000 - $2,500 = $5,000. If strike equaled spot when the call was purchased, the implied cost of the importer’s payable increases by $7,500, whereas the actual increase is $2,500 (cost of the call).

– If value of euro has decreased to $1.30, increase in cost of payable is limited to $2,500 because the option would not be exercised. Had the importer locked in a forward or futures rate of $1.34, the cost of the payable would have increased by $5,000.

Chapter 7: Currency Futures and Options Markets

9

7.B Currency Options (5) ❑

Using currency options – buying and exercising calls, continued – Break-even point – a call holder breaks even when Spot – Strike – Premium = Zero

– E.g., profit/loss/break-even for exercising previous call example Profit/ Loss $1.36 - $1.34 - $0.02 = $0

$5,000 $3,750 $2,500 $1,250 0 -$1,250

$1.30

$1.32

$1.34 $1.36 $1.38 Strike Break-even

$1.40

Spot at Expiration

-$2,500 -$3,750

Out of the money At the money

Chapter 7: Currency Futures and Options Markets

In the money

10

7.B Currency Options (6) ❑

Using currency options – buying and exercising puts – Example: German exporter has a €125,000 receivable due from a U.S. importer in 60 days.

• To hedge against an exchange rate decrease, buy a European-style put to have euros delivered at a strike price on the due date • Strike = $1.34, premium = $0.02

• Option price = $0.02 * 125,000 = $2,500 • At the end of 60 days: – If value of euro has decreased to $1.28, net profit = ($1.34 - $1.28) * 125,000 - $2,500 = $5,000. If strike equaled spot when the put was purchased, the implied cost of the importer’s payable decreases by $7,500, whereas the actual decrease is $5,000.

– If value of euro has increased to $1.40, the implied value of the receivable would decrease by $2,500 because the option would not be exercised, but the actual value would increase by $7,500 ($1.40 * 125,000 = $7,500). Thus, the net increase in value to the receivable is $5,000.

Chapter 7: Currency Futures and Options Markets

11

7.B Currency Options (7) ❑

Using currency options – buying and exercising puts, continued – Break-even point – a put holder breaks even when Strike – Spot – Premium = Zero

– E.g., profit/loss/break-even for exercising put example Profit/ Loss $5,000

$1.34 - $1.32 - $0.02 = $0

$3,750 $2,500 $1,250 0 -$1,250

$1.30

$1.32 $1.34 Break-even Strike

$1.36

$1.38

$1.40

Spot at Expiration

-$2,500 -$3,750

In the money

Out of the money At the money

Chapter 7: Currency Futures and Options Markets

12

7.B Currency Options (8) ❑

Using currency options – writing calls and puts – Call and put writers take on exchange risk transferred by call and put buyers.

– Call and put writers keep the premium when options expire out of the money.

– E.g., profit/loss/break-even for written call and put with same terms as previous examples Profit/ Loss $3,750 $2,500 $1,250 0 -$1,250

$1.30

-$2,500 -$3,750

$1.32 Put breakeven

$1.34 Strike

-$5,000 Profit/loss for put writer -$6,250 Chapter 7: Currency Futures and Options Markets

$1.36 Call breakeven

$1.38

$1.40

Spot at Expiration

Profit/loss for call writer 13

7.B Currency Options (9) ❑

Currency spreads – Combine calls or puts to lower the cost of speculating – Limit both downside and upside potential – Bull spread – speculating that the exchange rate will increase: buying a call at one strike price and writing a similar call at a different strike price – Bear spread – speculating that the exchange rate will decrease: buying a put at one strike price and writing a similar put at a different strike price

Profit/ Loss

Profit/ Loss

Bull Spread

Bear Spread

Long call Bear spread Long put

Bull spread

Long call strike

Spot at Exp.

Short call strike Short call

Chapter 7: Currency Futures and Options Markets

Short put strike

Spot at Exp. Long put strike

Short put

14

7.B Currency Options (10) ❑

Knockout (“barrier”) options – Similar to a standard option except it is cancelled if the exchange rate crosses a predefined level (the outstrike) – Less expensive than standard options because of the risk of early cancellation – Types of knockout options • Down and out call – has a positive payoff to the option holder if the underlying currency increases • Down and out put – has a positive payoff to the option holder if the underlying currency decreases • Up and out options – cancelled if the underlying currency increases beyond the outstrike

Chapter 7: Currency Futures and Options Markets

15

7.B Currency Options (11) ❑

Option pricing – Option value Option Value = Intrinsic Value + Time Value where Intrinsic Value (call) = Spot S – Strike X

Intrinsic Value (put) = Strike X – Spot S and Time Value = Option Value – Intrinsic Value

Chapter 7: Currency Futures and Options Markets

16

7.B Currency Options (12) ❑

Option pricing – Time value reflects the probability that an option’s intrinsic value will increase before expiration, which decreases as expiration approaches.

– A currency’s volatility increases the chances of very high or very low currency values at expiration. Thus, the higher the volatility of the underlying currency, the higher the option value.

– The higher the option value, the higher the premium.

– The value of an American option always exceeds its intrinsic value because time value is positive up to the expiration date.

– An out-of-the-money option has only time value.

– Because time value erodes as expiration approaches, an option with a longer expiration will have a higher price than an option with the same strike price but shorter expiration.

Chapter 7: Currency Futures and Options Markets

17

7.C ❑

Forward and Futures Contracts versus Options Contracts (1)

Compute benefits of hedging with futures and options assuming an American firm will collect a €125,000 receivable in 3 months – Spot rate = $1.3425; spot rate 3 months from now = $1.3125 – Futures rate = $1.3456; futures rate 3 months from now = $1.1350 – Put 1 premium = $0.0046; premium in 3 months = $0.0212 Put 2 premium = $0.0138; premium in 3 months = $0.0402

❑

Loss in value of the receivable in 3 months without hedge – ($1.3425 - $1.3125) * 125,000 = $3,750

❑

Hedging with options: Buy a put (to sell) – Profit on put 1 = ($0.0212 - $0.0046) * 125,000 = $2,075 – Profit on put 2 = ($0.0402- $0.0138) * 125,000 = $3,300

❑

Hedging with futures: Sell euros forward – Profit = ($1.3456 - $1.3150) * 125,000 = $3,825

❑

The futures hedge best offsets the loss in the receivable’s value.

Chapter 7: Currency Futures and Options Markets

18

7.C

Forward and Futures Contracts versus Options Contracts (2)

❑

HOWEVER, the currency could have appreciated in 3 months.

❑

Compute losses from hedging given the following assumptions: – Spot rate = $1.3425; spot rate 3 months from now = $1.3761 – Futures rate = $1.3456; futures rate 3 months from now = $1.3796 – Put 1 premium = $0.0046; premium in 3 months = $0.0001 Put 2 premium = $0.0138; premium in 3 months = $0.0001

❑

Gain in value of the receivable in 3 months without hedge – ($1.3761 - $1.3425) * 125,000 = $4,200

❑

Hedging with options: Buy a put (to sell) – Loss on put 1 = ($0.0001 - $0.0046) * 125,000 = -$562.5 – Loss on put 2 = ($0.0001- $0.0138) * 125,000 = -$1,712.5

❑

Hedging with futures: Sell euros forward – Loss = ($1.3456 - $1.3796) * 125,000 = -$4,250

❑

The options hedge minimizes hedging losses.

Chapter 7: Currency Futures and Options Markets

19

7.D Futures Options (1) ❑

Traders purchase and sell puts and calls on a contract calling for delivery of a standard CME currency futures contract, rather than the currency itself.

❑

When a contract is exercised, the holder receives a short or long position in the underlying currency futures contract that is marked to market.

– On exercising a call futures option, the holder receives a long position in the underlying futures contract, plus an amount of cash equal to the current futures price less strike.

– On exercising a put futures option, the holder receives a short position in the futures contract, plus an amount of cash equal to the strike price less the current futures price.

❑

Difference between a futures option contract and a futures contract – Futures contract: Holder must deliver one currency against the other or reverse the contract, regardless of whether doing so is profitable.

– Futures option contract: Holder is protected against an adverse move in the exchange rate and may allow the option to expire unexercised.

Chapter 7: Currency Futures and Options Markets

20

7.D Futures Options (2) ❑

Example: Exercising a pound call futures option contract – An investor holds a June pound call futures option contract for £62,500 – Strike = $1.9565, spot = $1.9663 – At exercise, investor receives: • Long position in the futures contract at a price of $1.9565 • Cash payment of ($1.9663 - $1.9565) * 62,500 = $612.50.

– At exercise, option writer receives a short position in the same contract ❑

Example: Exercising a Swiss franc put futures option contract – An investor holds a June pound put futures option contract for SFr 125,000 – Strike = $0.8132, spot = $0.7950 – At exercise, investor receives: • Short position in the futures contract at a price of $1.9565 • Cash payment of ($0.8132 - $0.7950) * 125,000 = $2,275.

– At exercise, option writer receives a long position in the same contract Chapter 7: Currency Futures and Options Markets

21

7.E Reading Currency Futures and Options Prices

Strike = $1.3600

Cost per euro = $0.0109; 125,000 * $0.109 = $1,362.5 per contract

Chapter 7: Currency Futures and Options Markets

22

Chapter 8

Swaps and Interest Rate Derivatives

Chapter 8 Outline A. Interest Rate Swaps B. Currency Swaps C. Interest Rate/Currency Swaps

D. Interest Rate Forwards E. Interest Rate Futures

Chapter 8: Swaps and Interest Rate Derivatives

1

8.A Interest Rate Swaps (1) ❑

Interest rate swap – an agreement between two parties to exchange U.S. dollar interest payments for a specific maturity on an agreed-on notional, or theoretical, principal amount.

❑

No principal changes hands.

❑

Maturities range from less than one year to greater than 15 years.

❑

Enable a party to convert a floating rate to a fixed rate, and vice versa.

❑

Types of swaps – Coupon swap – one party pays a fixed rate computed at the time of trade as a spread to a particular Treasury bond, and one party pays a floating rate that resets periodically based on a designated index.

– Basis swap – two parties exchange floating interest payments based on different reference rates.

Chapter 8: Swaps and Interest Rate Derivatives

2

8.A Interest Rate Swaps (2) ❑

Classical swap transaction – Counterparties A and B require $100 million for 5 years.

– Based on their credit rating, Counterparties A (BBB rating) and B (AAA rating) have the following borrowing options.

Counterparty

Fixed Rate

Floating Rate

A

8.5%

6-month LIBOR + 0.5%

B

7.0%

6-month LIBOR

– Counterparty A wants to borrow at a fixed rate lower than 8.5%.

– Counterparty B wants to borrow at a floating rate lower than LIBOR. – Counterparty A uses an interest rate swap to convert a floating rate to a more attractive fixed rate, and Counterparty B uses an interest rate swap to convert a fixed rate to a more attractive floating rate.

Chapter 8: Swaps and Interest Rate Derivatives

3

8.A Interest Rate Swaps (3) ❑

Classical swap transaction, continued Pays 7.35% Counterparty A

Receives 7.25% BigBank

Receives LIBOR Borrows $100m at (LIBOR + 0.5%) Floating Rate Lenders Net Cost = 7.35% + (LIBOR + 0.5%) – LIBOR = 7.85% Counterparty A • Pays BigBank 7.35% in return for LIBOR • Borrows $100 million at (LIBOR + 0.5%) • Trades floating rate for fixed rate and reduces 8.5% fixed rate to 7.85%, saving 0.65% Chapter 8: Swaps and Interest Rate Derivatives

Counterparty B Pays LIBOR

Net Gain = 7.35% – 7.25% + LIBOR – LIBOR = 0.10%

Issues $100m at 7.0% Eurobond Net Cost = LIBOR + 7.0% – 7.25% = LIBOR – 0.25%

Counterparty B • Pays BigBank LIBOR in return for 7.25% • Issues $100 million in Eurobonds at 7.0% • Trades fixed rate for floating rate and reduces LIBOR floating rate to (LIBOR – 0.25%), saving 0.25% 4

8.B Currency Swaps (1) ❑

Currency swap – an exchange of debt-service obligations denominated in one currency for the service on an agreed-on principal amount of debt denominated in another currency.

– E.g., a U.S. firm borrows yen and engages in a swap with a company that borrows dollars with parallel interest and principal repayment schedules: Year 0 Principal payment in yen Principal payment in dollars

Company A

Years 1-10 Dollar interest payments

Company B

Yen interest payments Year 10 Principal payment in dollars Principal payment in yen

Chapter 8: Swaps and Interest Rate Derivatives

5

8.B Currency Swaps (2) ❑

Currency swap enables companies to effectively lower their costs of borrowing.

– E.g., Dow Chemical wants to borrow $200 million in euros and Michelin wants to borrow $200 million, both at fixed rates. Borrowing options are: Better for Michelin

Counterparty

DollarDenominated Debt

EuroDenominated Debt

Dow Chemical

7.5%

8.25%

Michelin

7.7%

8.1%

Better for Dow Chemical

– Michelin’s euro-denominated rate is better for Dow Chemical, and Dow Chemical’s dollar-denominated rate is better for Michelin.

– Given a current spot rate of €0.75/$, Michelin would borrow €150 million at 8.1% and Dow Chemical would borrow $200 million at 7.5%.

– By engaging in a currency swap, each company benefits from the other’s borrowing terms (Dow Chemical effectively services €150 million at 8.1% and saves 15 basis points, and Michelin effectively services $200 million at 7.5% and saves 20 basis points).

Chapter 8: Swaps and Interest Rate Derivatives

6

8.B Currency Swaps (3) ❑

Mechanics of Dow Chemical-Michelin currency swap* €150 million

$200 million Borrows at 7.5%

Borrows at 8.1% Year 0 $200 million principal €150 million principal

Dow Chemical

Years 1-10 €12.15 million interest

Michelin

$15 million interest Year 10 €150 million principal $200 million principal

*Actual swaps typically use intermediaries as illustrated in the classical swap transaction and are thus more complex.

Chapter 8: Swaps and Interest Rate Derivatives

7

8.C Interest Rate/Currency Swaps (1) ❑

Interest rate/currency swap – combines the features of both a currency swap and interest rate swap.

❑

Designed to convert a liability in one currency with a stipulated type of interest payment into a liability denominated in another currency with a different type of interest payment.

❑

Types of interest rate/currency swap – Fixed-for-floating swap – most common type of interest rate/currency swap; converts a fixed-rate liability in one currency into a floating rate liability in another currency.

– Dual currency bond swap – a company swaps the foreign-currencydenominated interest payments on its dual currency bond* for dollardenominated payments.

*A dual currency bond has the issue’s proceeds and interest payments stated in a foreign currency and the principal repayment in another currency. The swap effectively converts the dual currency bond to a single currency bond.

Chapter 8: Swaps and Interest Rate Derivatives

8

8.C Interest Rate/Currency Swaps (2) ❑

Example: Fixed-for-floating swap – Dow Chemical wants to borrow floating-rate euros and Michelin wants to borrow fixed-rate dollars. Debt options are:

Better for Michelin

Counterparty

DollarDenominated Debt

EuroDenominated Debt

Dow Chemical

7.5%

LIBOR + 0.35%

Michelin

7.7%

LIBOR + 0.125%

Better for Dow Chemical

– Michelin’s euro-denominated floating rate is better for Dow Chemical, and Dow Chemical’s dollar-denominated fixed rate is better for Michelin.

– Given a current spot rate of €0.75, Michelin would borrow €150 million at LIBOR + 0.125% and Dow Chemical would borrow $200 million at 7.5%.

– By engaging in an interest rate/currency swap, each company benefits from the other’s borrowing terms (Dow Chemical effectively services €150 million at LIBOR + 0.125% and saves 22.5 basis points, and Michelin effectively services $200 million at 7.5% and saves 20 basis points).

Chapter 8: Swaps and Interest Rate Derivatives

9

8.C Interest Rate/Currency Swaps (3) ❑

Mechanics of Dow Chemical-Michelin interest rate/currency swap* €150 million

$200 million

Borrows at LIBOR + 0.125%

Borrows at 7.5% Year 0 $200 million principal €150 million principal

Dow Chemical

Years 1-10 LIBOR + 0.125% interest

Michelin

$15 million interest Year 10 €150 million principal $200 million principal

*Actual swaps typically use intermediaries as illustrated in the classical swap transaction and are thus more complex.

Chapter 8: Swaps and Interest Rate Derivatives

10

8.C Interest Rate/Currency Swaps (4) ❑

Example: Dual currency bond swap – On October 1, 1985, Fanny Mae issues 10-year, 8% dual currency bonds with ¥50 billion in proceeds, ¥4 billion interest payments, and $240,000 principal repayment.

– Fanny Mae enters into a swap with Nomura, exchanging the ¥4 billion interest payments for a fixed schedule of dollar payments at implied exchange rates.* – The swap converts the dual currency bond into a single currency bond.

– Scheduled payments lock in an internal rate of return on dollar payments of 10.67% and eliminate exchange risk associated with the yen over the period.

*The implied exchange rates are computed as ¥4 billion / scheduled dollar payment (see next slide).

Chapter 8: Swaps and Interest Rate Derivatives

11

8.C Interest Rate/Currency Swaps (5) ❑

Dual currency bond swap: Fanny Mae-Nomura swap terms Payment Date (October 1)

Payment on Dual Currency Bond

Dollar Payment Under Swap

Implied Exchange Rate

1985

¥49,687,500,000

$209,468,314

¥237.378

1986

¥4,000,000,000

$18,811,800

¥212.633

1987

¥4,000,000,000

$19,124,381

¥209.157

1988

¥4,000,000,000

$19,464,370

¥205.504

1989

¥4,000,000,000

$19,854,506

¥201.466

1990

¥4,000,000,000

$20,304,259

¥197.003

1991

¥4,000,000,000

$20,942,375

¥191.000

1992

¥4,000,000,000

$21,499,712

¥186.049

1993

¥4,000,000,000

$22,116,872

¥180.857

1994

¥4,000,000,000

$22,718,882

¥176.065

1995

¥4,000,000,000

$23,665,096

¥169.025

1996

$240,400,000

$240,400,000

¥207.987

Swap converts dual currency bond to single currency bond Chapter 8: Swaps and Interest Rate Derivatives

12

8.C Interest Rate/Currency Swaps (6) ❑

Mechanics of Fanny Mae-Nomura dual currency bond swap ¥50 billion in bonds Issues at 8.0% Year 0 ¥50 billion $209 million

Fanny Mae

Years 1-10 Scheduled dollar payments

Nomura

¥4 billion Year 10 $240.4 million $240.4 million

Chapter 8: Swaps and Interest Rate Derivatives

13

8.D Interest Rate Forwards (1) ❑

Forward forward – a contract that fixes an interest rate today on a future loan or deposit – E.g., if a company knows it will need to borrow money in 6 months for a 3-month period, it risks interest rate increases by waiting 3 months to borrow.

– Buying a forward forward with a bank guarantees that 6 months from now, the bank will loan the company its funds at a known fixed rate (forward forward rate).

Chapter 8: Swaps and Interest Rate Derivatives

14

8.D Interest Rate Forwards (2) ❑

Forward forward, continued – Companies can create forward forwards and derive the forward forward rate through arbitrage. E.g.: • LIBOR3 = 6.7%, LIBOR9 = 6.95% • Borrow the present value of $1,000,000 for 3 months and loan the same amount for 9 months.

• Net effect: 6-month transaction to loan $1,000,000 3 months from now and receive $1,034,792 in 9 months.

• Implied 6-month forward forward rate = interest of 3.479% over 6 months, or 6.958% per annum. t=0

3 months

Borrow $983,526

6.7%

Loan $983,526

6.95%

9 months

Repay $1,000,000 Collect $1,034,792 6-month forward forward

Chapter 8: Swaps and Interest Rate Derivatives

15

8.D Interest Rate Forwards (3) ❑

Forward rate agreement (FRA) – a cash-settled, OTC forward contract that allows a company to fix an interest rate to be applied to a specified future period on a notional principal amount.

– Company and bank agree to exchange interest payments, such that, on a LIBOR-based FRA: • If fixed interest rate at time of contract (forward rate) < LIBORt in x months, bank pays company the interest payment differential • If forward rate > LIBORt in x months, company pays bank the interest payment differential

– Interest payment on a LIBOR-based FRA: (LIBOR – forward rate)(

days

)

360

Interest payment = notional principal * 1 + (LIBOR * (

days

))

360 where days = number of days in the future interest period Chapter 8: Swaps and Interest Rate Derivatives

16

8.D Interest Rate Forwards (4) ❑

Forward rate agreement (FRA), continued – E.g., Unilever needs to borrow $50 million for 6 months starting in 2 months – Unilever buys a “2 x 6” FRA on LIBOR at 6.5% from bank for notional principal of $50 million.

– If in 2 months, LIBOR6 > 6.5%, bank pays Unilever the difference in interest expense, and if LIBOR6 < 6.5%, Unilever pays bank the difference.

– In 2 months, LIBOR = 7.2% – Bank owes Unilever the difference in interest between 7.2% and 6.5%, computed as (0.072 – 0.065) (

Interest payment = $50,000,000 * 1 + (0.072 * (

182

)

360

182

= $170,730

))

360 Chapter 8: Swaps and Interest Rate Derivatives

17

8.E Interest Rate Futures (1) ❑

Eurodollar future – a cash-settled contract on a 3-month, $1,000,000 Eurodollar deposit that pays LIBOR. – Act like FRAs by helping to lock in a future interest rate and are settled in cash.

– Like other futures contracts, marked to market – Contract price quoted as an index number equal to (100 – annualized forward rate); e.g., if LIBOR3 = 8.32%, price = 100 – 8.23 = 91.68.

– Initial value of contract Initial value of contract = $1,000,000 * (1 – LIBOR3 at inception) (

90 ) 360

– Settlement value of contract Settlement value of contract = $1,000,000 * (1 – LIBOR3 at settlement) (

Chapter 8: Swaps and Interest Rate Derivatives

90 ) 360

18

8.E Interest Rate Futures (2) ❑

Eurodollar future, continued – If LIBOR3 at settlement > LIBOR3 at inception, buyer will realize a gain.

– Thus, • Borrowers looking to lock in a future cost of funds would sell futures contracts because increases in future interest rates would be offset by gains on the short position in the futures contracts; and • Investors seeking to lock in a forward interest rate would buy futures contracts because declines in future rates would be offset by gains on the long position in the futures contracts.

Chapter 8: Swaps and Interest Rate Derivatives

19

Chapter 9

Foreign Exchange Risk Management

Chapter 9 Outline A. Measures of Foreign Exchange Exposure B. Translation Exposure C. Transaction Exposure

D. Hedging E. Managing Translation Exposure F. Managing Transaction Exposure

Chapter 9: Foreign Exchange Risk Management

1

9.A Measures of Foreign Exchange Exposure (1) ❑

Foreign exchange exposure – the degree to which a company is affected by exchange rate changes

❑

Types of exposure – Translation (accounting) exposure – the extent to which currency fluctuations affect financial statement items denominated in foreign currency.

• A company must convert the financial statements of its foreign operations from local currencies to the home currency.

– Economic exposure – the extent to which the value of the firm, as measured by the present value of its expected cash flows, is affected by exchange rate fluctuations. Includes operating exposure and transaction exposure.

• Operating exposure – the extent to which currency fluctuations can alter a company’s future operating cash flows (revenues and costs) • Transaction exposure – the extent to which currency fluctuations affect contractually binding future foreign-currency-denominated cash inflows and outflows. Has aspects of both translation and operating exposure.

Chapter 9: Foreign Exchange Risk Management

2

9.A Measures of Foreign Exchange Exposure (2) Foreign Exchange Exposure Economic Exposure = Operating Exposure + Transaction Exposure* Operating Exposure Aspects of both operating and transaction exposure

The extent to which revenues and costs are affected by currency fluctuations

Accounting Exposure Translation Exposure The extent to which assets, liabilities, revenues, expenses, gains, and losses denominated in foreign currencies result in foreign exchange gains and losses

Transaction Exposure E.g., contractual sales transactions affect revenues

The extent to which contractually binding transactions that have not been executed will be affected by currency fluctuations at settlement

Aspects of both translation and transaction exposure

E.g., A/R, debt

*Although transaction exposure is properly included as economic exposure, it is often included in accounting exposure because certain contractually binding transactions are included in a firm’s financial statements.

Chapter 9: Foreign Exchange Risk Management

3

9.B Translation Exposure (1) ❑

The financial statements of foreign subsidiaries must be translated from local currency to home currency before consolidation with the parent’s financial statements.

❑

Assets and liabilities translated at the current (postchange) exchange rates are considered to be exposed.

❑

Assets and liabilities translated at historical (prechange) exchange rates maintain their historic home country values and are not exposed.

❑

Four principal methods are used to translate foreign subsidiary financial statements from local currency to home currency.

1. Current/noncurrent method 2. Monetary/nonmonetary method 3. Temporal method 4. Current rate method

Chapter 9: Foreign Exchange Risk Management

4

9.B Translation Exposure (2) 1. Current/noncurrent method – based on the maturity of the financial statement item – Balance sheet items • All of the foreign subsidiary’s current assets and liabilities are translated into home currency at the current exchange rate.

• All noncurrent assets and liabilities are translated at the historical exchange rate (the rate in effect at the time the asset was acquired or the liability was incurred).

– Income statement items – are translated at the average exchange rate of the period, except for revenues and expenses associated with noncurrent assets (e.g., depreciation) or liabilities.

Chapter 9: Foreign Exchange Risk Management

5

9.B Translation Exposure (3) 2. Monetary/nonmonetary method – differentiates between monetary and nonmonetary (i.e., physical) assets and liabilities – Balance sheet items • All of the foreign subsidiary’s monetary assets and liabilities are translated into home currency at the current exchange rate.

• All nonmonetary assets and liabilities are translated at the historical exchange rate (the rate in effect at the time the asset was acquired or the liability was incurred).

– Income statement items – are translated at the average exchange rate of the period, except for revenues and expenses associated with nonmonetary assets (e.g., depreciation, COGS) or liabilities.

Chapter 9: Foreign Exchange Risk Management

6

9.B Translation Exposure (4) 3. Temporal method – modified version of the monetary/nonmonetary method but based on the underlying approach to cost accounting (historical vs. market) rather than on the type of asset and liability.

– Balance sheet items • All of the foreign subsidiary’s monetary assets and liabilities are translated into home currency at the current exchange rate.

• All nonmonetary assets and liabilities are translated at the historical exchange rate (the rate in effect at the time the asset was acquired or the liability was incurred), except inventory, which can be translated at the current exchange rate if included on the balance sheet at market values.

– Income statement items – are translated at the average exchange rate of the period, except for depreciation, amortization, and COGS, which are translated at historical exchange rates.

4. Current rate method – all balance sheet and income statement items are translated at the current rate.

Chapter 9: Foreign Exchange Risk Management

7

9.B Translation Exposure (5) Example: The effects of each translation method on balance sheet items Local Currency

Historical = LC4/$1

Current = LC5/$1

Monetary/ Nonmon.

Temporal

Current/ Noncurrent

Current Rate

Cash, marketable sec., A/R

2,600

650

520

520

520

520

520

Inventories (at market)

3,600

900

720

900

720

720

720

Prepaid Expenses

200

50

40

50

50

40

40

Total Current Assets

6,400

1,600

1,280

1,470

1,290

1,280

1,280

Fixed Assets less Acc. Dep.

3,600

900

720

900

900

900

720

Goodwill

1,000

250

200

250

250

250

200

Total Assets

11,000

2,750

2,200

2,620

2,440

2,430

2,200

Current Liabilities

3,400

850

680

680

680

680

680

Long-term Debt

3,000

750

600

600

600

750

600

500

125

100

100

100

125

100

6,900

1,725

1,380

1,380

1,380

1,555

1,380

Capital Stock

1,500

375

300

375

375

375

375

Retained Earnings

2,600

650

520

865

685

500

445

Total Equity

4,100

1,025

820

1,240

1,060

875

820

215

35

-150

-205

Balance Sheet Item

Current Assets

Deferred Income Taxes

Total Liabilities

Equity Gain/Loss

Chapter 9: Foreign Exchange Risk Management

8

9.C Transaction Exposure ❑ Transaction exposure stems from the possibility of incurring future exchange gains or losses on foreign-currency-denominated transactions already entered into but not settled. ❑ Transaction exposure is measured currency by currency and equals the difference between contractually fixed future cash inflows and outflows in each currency.

❑ Example: Boeing sells five 747s to Air India for Rs 50 billion and agrees to buy Indian parts worth Rs 22 billion.* –

Inflows = Rs 50 billion; outflows = Rs 22 billion

–

Net transaction exposure = inflows – outflows = Rs 28 billion.

–

If e0 = $0.0243, net transaction exposure in dollars = 28 billion * $0.0243 = $680.4 million.

–

If e0 decreases to $0.024255 at settlement, transaction loss = ($0.024255 $0.0243) * 22 billion = $1.4 million.

*This example also shows the effects of operating exposure (recall that transaction exposure overlaps with both operating and translation exposure), because the value of the contract, and thus the effect of currency fluctuations on the contract, directly affects revenues.

Chapter 9: Foreign Exchange Risk Management

9

9.D Hedging (1) ❑ Before using hedging techniques, a firm must decide which exposures to manage and how to manage them. ❑ Clear, detailed objectives must be developed to eliminate the ambiguity inherent in broad or vague objectives (e.g., “eliminate all exposure). ❑ Elements of an exposure management strategy 1. Determine the types of exposure to be monitored.

2. Formulate corporate objectives and guidelines for conflicts of interest.

3. Ensure corporate objectives are consistent with maximizing shareholder value and can be implemented.

4. Clearly specify who is responsible for which exposures and detail the criteria by which each manager will be judged.

5. Make explicit any constraints on the use of exposure-management techniques.

6. Identify the channels by which exchange rate considerations are incorporated into operating decisions that will affect the firm’s exchange risk posture.

7. Develop a system to monitor and evaluate exchange risk management activities.

Chapter 9: Foreign Exchange Risk Management

10

9.D Hedging (2) ❑ Strategy objectives 1. Minimize translation exposure – necessitates protecting foreigncurrency-denominated assets and liabilities from changes in value due to exchange rate fluctuations.

2. Minimize quarter-to-quarter (or year-to-year) earnings fluctuations related to currency fluctuations 3. Minimize transaction exposure 4. Minimize economic exposure 5. Minimize foreign exchange risk management costs

6. Avoid surprises

Chapter 9: Foreign Exchange Risk Management

11

9.D Hedging (3) ❑ Standard hedging techniques Anticipated Currency Change Depreciation

Appreciation

Sell local currency forward

Buy local currency forward

Buy a local currency put option

Buy a local currency call option

Reduce levels of local currency cash and marketable securities

Increase levels of local currency cash and marketable securities

Tighten local currency credit terms

Relax local currency credit terms

Delay collection of hard currency A/R

Accelerate collection of soft currency receivables

Accelerate dividend and fee remittance to parent and other subsidiaries

Delay dividend and fee remittance to parent and other subsidiaries

Accelerate payment of intersubsidiary A/P

Delay payment of intersubsidiary A/P

Delay collection of intersubsidiary A/R

Accelerate collection of intersubsidiary A/R

Invoice exports in foreign currency and imports in local currency

Invoice exports in local currency and imports in foreign currency

Chapter 9: Foreign Exchange Risk Management

12

9.D Hedging (4) ❑ Centralizing versus decentralizing hedging function – Arguments for centralization •

Local treasurers want to optimize their own financial and exposure positions, regardless of the overall corporate situation.

•

Through lack of knowledge or incentive, subsidiaries may engage in hedges that increase rather than decrease overall corporate exposure.

•

Reduces amount of hedging required and associated transaction costs.

•

Optimizes before-tax hedging cost variations that exist among subsidiaries because of market imperfections.

– Arguments for decentralization •

Local knowledge

•

Incentives for local managers to take advantage of situations that only they are familiar with.

Chapter 9: Foreign Exchange Risk Management

13

9.D Hedging (5) ❑ Costs of hedging – If devaluation is unlikely, hedging may be costly and inefficient.

– If devaluation is likely, hedging costs rise to reflect the anticipated devaluation – Because one company’s payable is another company’s receivable, attempting to delay or accelerate payment given anticipated exchange rate changes will not produce a net gain.

– Shifting funds from one country to another is not costless: Accelerating payables and delaying intercompany receivables forces a subsidiary in a devaluation-prone country to increase local currency borrowings at higher interest rates to finance additional working capital requirements.

– Invoicing exports in the foreign currency and imports in the local currency may result in lost sales.

Chapter 9: Foreign Exchange Risk Management

14

9.D Hedging (6) ❑ Costs of hedging relating to currency depreciation Hedging Technique

Cost

Sell local currency forward

Transaction costs; difference between forward and future spot rates

Buy a local currency put option

Put option premium

Reduce levels of local currency cash and marketable securities

Operational problems; opportunity costs (loss of higher interest rates on local currency securities)

Tighten local currency credit terms

Lost sales and profits

Delay collection of hard currency A/R

Cost of financing additional receivables

Increase imports of hard currency goods

Financing and holding costs

Borrow locally

Higher interest rates

Delay payment of A/P

Negatively affect credit rating

Accelerate dividend and fee remittance to parent and other subsidiaries

Borrowing cost if funds not available or loss of higher interest rates if local currency securities are sold

Accelerate payment of intersubsidiary A/P

Opportunity cost of money

Delay collection of intersubsidiary A/R

Opportunity cost of money

Invoice exports in foreign currency and imports in local currency

Lost export sales or lower price; premium price for imports

Chapter 9: Foreign Exchange Risk Management

15

9.D Hedging (7) ❑ Benefits of hedging – A company can benefit from hedging only to the extent that it can forecast future exchange rates more accurately than the market.

•

For a foreign cash inflow, hedge if f1 > ē0

•

For a foreign cash outflow, hedge if f1 < ē0

– The hedger (company) should assume that the market knows as much as it does.

– Using market imperfections or tax asymmetries or both. E.g.: •

If a currency is overvalued and exchange controls are not imposed to prevent capital outflows, and if hard currency can be acquired at the official exchange rate, a subsidiary can accelerate intercompany accounts payable and remittances and make immediate purchases from other subsidiaries.

•

If forward contract losses are treated as a cost of doing business and gains are taxed at lower capital gains, a company can engage in tax arbitrage.

Chapter 9: Foreign Exchange Risk Management

16

9.D Hedging (8) ❑

Accounting for hedging and FASB 133 – FASB 133 establishes accounting and reporting standards for derivatives and hedging activities.

•

A derivative that qualifies as a hedge gets special accounting treatment that matches gains/losses resulting from the changes in value of the derivatives with gains/losses in the value of the underlying transaction or asset, thus removing hedging gains/losses from current income.

•

A change in the value of the derivative not offset by a change in the value of the hedged item is recorded in current income.

– To qualify for hedge accounting, a company must demonstrate a hedging relationship to be highly effective (meaning a correlation ratio of 80% to 125%) in achieving offsetting changes in fair value or cash flows for the risk being hedged.

– A foreign currency derivative that cannot be shown to be effective must be marked to market.

Chapter 9: Foreign Exchange Risk Management

17

9.E Managing Translation Exposure (1) ❑

Basic hedging strategy for translation exposure Currency

Anticipated Movement

Assets

Liabilities

Hard currencies

Appreciate

Increase

Decrease

Soft currencies

Depreciate

Decrease

Increase

Reduce cash

Soft Currency Devaluation

Tighten credit terms to decrease A/R

Increase cash

Increase local currency borrowing

Hard Currency Revaluation

Loosen credit terms to decrease A/R

Chapter 9: Foreign Exchange Risk Management

Decrease local currency borrowing

Sell weak currency forward Delay A/P

Buy weak currency forward Accelerate A/P

18

9.E Managing Translation Exposure (2) ❑

Only if a company’s anticipations differ from the market’s and are also superior to the market’s will hedging lead to reduced costs.

❑

Three methods for managing translation exposure – Adjusting flow funds – Entering into forward contracts – Exposure netting

Chapter 9: Foreign Exchange Risk Management

19

9.E Managing Translation Exposure (3) ❑

Funds adjustment – To reduce translation exposure in anticipation of a local currency devaluation, convert local currency cash into hard currency assets.

– Funds adjustment alters the amounts or currencies or both of the planned cash flows of the parent or its subsidiaries to reduce the firm’s local currency accounting exposure.

• Direct funds adjustment techniques (reverse for revaluation) – Price exports in hard currencies and imports in local currency – Invest in hard currency securities – Replace hard currency loans with local currency loans • Indirect funds adjustment techniques (reverse for revaluation) – Adjust transfer prices on the sale of goods between affiliates – Accelerate payment of dividends, fees, and royalties – Adjust the leads and lags of intersubsidiary A/P and A/R

Chapter 9: Foreign Exchange Risk Management

20

9.E Managing Translation Exposure (4) ❑

Evaluating alternative hedging mechanisms – two-stage process – Stage 1: Compute the profit associated with each funds adjustment technique on a covered after-tax basis.

• Profitable transactions should be undertaken regardless of whether they increase or decrease the company’s translation exposure.

These transactions involve the use of arbitrage and not hedging.

– Stage 2: Any unwanted exposure resulting from stage 1 can be corrected in the forward market.

• Where the forward market is nonexistent or limited, the company must determine both the appropriate techniques and their appropriate levels.

• To determine the appropriate levels, comparing the net cost of a funds adjustment technique with the anticipated currency depreciation will indicate whether the hedging transaction is profitable on an expected-value basis.

Chapter 9: Foreign Exchange Risk Management

21

9.F Managing Transaction Exposure (1) ❑

Measures to protect against transaction exposure – Forward market hedge – Money-market hedge – Risk shifting – invoicing all transactions in dollars to avoid transaction exposure (still leaving the company open to operating exposure)

– Exposure netting – Price adjustment clauses (currency risk sharing) – Currency collars – Cross-hedging

– Currency options

Chapter 9: Foreign Exchange Risk Management

22

9.F Managing Transaction Exposure (2) ❑

Forward market hedge – a company fixes the dollar value of the future foreign currency cash flow by selling or buying currency forward.

Currency Position

❑

Hedging Strategy

Protect Against

Long (receivable)

Sell forward

Currency depreciation

Short (payable)

Buy forward

Currency appreciation

Example –

GE has a €10 million receivable in one year.

–

If e0 = $1.3382 and f1 = $1.28, the market expects a euro devaluation. To protect against currency depreciation, GE sells forward €10 million for delivery in one year.

–

By selling forward, in one year, GE will receive a fixed amount of $12.8 million.

–

If e1 = $1.3382, receivable = $13.382 million and loss on hedge = -$582,000 = $1.28, receivable = $12.8 million and gain/loss on hedge = $0 = $1.25, receivable = $12.5 million and gain on hedge = $300,000

Chapter 9: Foreign Exchange Risk Management

23

9.F Managing Transaction Exposure (3) ❑

True cost of forward hedging – the cost of hedging can be computed only at settlement because it depends on the future spot rate e1.

❑

The traditional method for computing the cost of hedging is f1 – e0 e0

– This method computes only the forward discount or premium. ❑

The true cost of hedging is computed as f1 – e1 e0

– This method computes the opportunity cost of the hedge; that is, the difference between dollars per unit of foreign currency received with hedging (a function of f1) and without hedging (a function of e1).

Chapter 9: Foreign Exchange Risk Management

24

9.F Managing Transaction Exposure (4) ❑

Money-market hedge – borrow and lend two currencies simultaneously to lock in the dollar value of a future foreign currency cash flow.

❑

Example –

GE has a €10 million receivable due in one year

–

rEur = 15%, rUS = 10%

–

If e0 = $1.3382 and f1 = $1.28, the market expects a euro devaluation.

–

To protect against currency depreciation: NOW • •

Borrow PV of €10 million = €(10 million/1.15) = €8.70 million for one year Convert €8.70 million to $11.64 million (€8.70 million * $1.3382)

•

Deposit $11.64 million for one year at 10%

IN ONE YEAR • •

–

Collect $11.64 million * 1.10 = $12.8 million Use proceeds from receivable to repay loan of €8.70 million * 1.15 = €10 million

If e1 = $1.3382, receivable = $13.382 million and loss on hedge = -$582,000 = $1.28, receivable = $12.8 million and gain/loss on hedge = $0

= $1.25, receivable = $12.5 million and gain on hedge = $300,000 Chapter 9: Foreign Exchange Risk Management

25

9.F Managing Transaction Exposure (5) ❑

Comparing forward and money-market hedges with transaction costs

❑

Example: Pepsi has a C$40 million payable due in 90 days – rCan = 4.71%-4.64%, rUS = 5.50%-5.35% – e0 = $0.9422-31, f1 = $0.9440-61, so the market expects a C$ appreciation

– Using money-market hedge to protect against currency appreciation NOW • Borrow [C$40 million/(1+4.64%/4)] * $0.9431 = $37,291,420 at 5.50%/4 = 1.375% • Convert $37,291,420 to C$39,541,321 ($37,291,420/$0.9431)

• Deposit C$39,541,321 for 90 days at 4.64%/4 = 1.16% IN 90 DAYS • Receive C$39,541,321 * 1.0116 = C$40 million • Use proceeds to pay payable • Repay loan of $37,291,420 * 1.01375 = $37,804,177 with cash Chapter 9: Foreign Exchange Risk Management

26

9.F Managing Transaction Exposure (6) ❑

Example, continued: Pepsi has a C$40 million payable due in 90 days – rCan = 4.71%-4.64%, rUS = 5.50%-5.35% – e0 = $0.9422-31, f1 = $0.9440-61, so the market expects a C$ appreciation

– Using forward hedge to protect against currency appreciation • Buy forward C$40 million at f1 = $0.9461 for delivery in 90 days • Pepsi locks in the cost of its payable at C$40 million * 0.9461 = $37,844,000

– In this case, using the money-market hedge instead of the forward hedge saves $37,844,000 - $37,804,177 = $39,823.

Chapter 9: Foreign Exchange Risk Management

27

9.F Managing Transaction Exposure (7) ❑

Risk shifting – Exporter invoices importer in exporter’s local currency, shifting the currency risk to the importer.

– Exporter agrees to invoice importer in importer’s local currency, shifting the currency risk to itself.

– Thus, risk shifting is a zero-sum game – An importer will take on exchange risk (be willing to pay the exporter in the exporter’s currency) only if it expects e1 to be no higher than f1.

Chapter 9: Foreign Exchange Risk Management

28

9.F Managing Transaction Exposure (8) ❑

Pricing decisions – When a company fails to account for anticipated exchange rate changes when making pricing decisions, it may incur losses at the time of the initial transaction unrelated to exchange risk.

– E.g., GE sells turbine blades to Lufthansa •

GE prices blades at $13.382 million

•

Lufthansa demands a quote in euros

•

GE quotes blades at €10 million using e0 = $1.3382

•

The quote is only worth $12.8 million, GE’s risk-free price in using the forward market (f1 = $1.28)

•

Thus, the proper euro quote = €13.382 million/1.28 = €10.455 million.

•

GE loses $582,000 on the sale, not due to exchange risk

– General rule on credit sales overseas – convert between the foreign currency price and the dollar price using f1 and not e0.

Chapter 9: Foreign Exchange Risk Management

29

9.F Managing Transaction Exposure (9) ❑ Exposure netting – Exposures in one currency are offset with exposures in the same or another currency – Only net exposures are hedged, saving on transaction costs – Basic example: Currency

Total Inflow

Total Outflow

Net Exposure

British pound

£15,000,000

£10,000,00

£5,000,000

Canadian dollar

C$8,000,000

C$4,000,000

C$4,000,000

Japanese yen

¥750,000,000

¥500,000,000

¥250,000,000

Mexican peso

MXP 120,000,000

MXP 40,000,000

MXP 80,000,000

Chapter 9: Foreign Exchange Risk Management

30

9.F Managing Transaction Exposure (10) ❑

Exposure netting, continued – Three ways to reduce transaction exposure through exposure netting: 1. Offset a long position in one currency with a short position in the same currency.

2. If the exchange rate movements of two currencies are positively correlated, offset a long position in one currency with a short position in another currency.

3. If the exchange rate movements of two currencies are negatively correlated, short or long positions in both currencies will offset each other.

– Correlation coefficients reflect the degree to which two currencies move in relation to each other and range from -1 to +1.

•

Two currencies with a correlation coefficient of +1 are perfectly positively correlated; both currencies will move in perfect unison.

•

Two currencies with a correlation coefficient of -1 are perfectly negatively correlated; both currencies will move perfectly inversely.

– The stronger the correlations among currencies, the more effective exposure netting.

Chapter 9: Foreign Exchange Risk Management

31

9.F Managing Transaction Exposure (11) ❑

Exposure netting, continued – How would you minimize currency exposure of the following positions?

Currency Exposure (000) Historic positive correlation Historic negative correlation

Currency

Short

Swiss franc

-SFr 8,600

Chapter 9: Foreign Exchange Risk Management

-$6,880 €1,300

Euro Peso

Long

-MXP 15,400

Dollar Conversion (000)

$1,700 -$1,400

32

9.F Managing Transaction Exposure (12) ❑

Exposure netting, continued 1. Offset positively correlated currencies (offset long position with short position), leaving net short position of -$5,180 in SFr

Historic positive correlation

Currency

Dollar Conversion (000)

Offset (000)

Swiss franc

-$6,880

-$5,180

Euro

$1,700

$1,700 + -$6,880 = -$5,180

2. Offset negatively correlated currencies (offset short position with another short position), leaving net short position of -$3,780 in SFr

Historic negative correlation

Currency

Dollar Conversion (000)

Offset (000)

Swiss franc

-$5,180

-$3,780

Peso

-$1,400

-$5,180 – -$1,400 = -$3,780

3. Hedge only residual transaction exposure of -$3,780.

Chapter 9: Foreign Exchange Risk Management

33

9.F Managing Transaction Exposure (13) ❑

Currency risk sharing – Two companies involved in a transaction can agree to share the currency risks associated with their transaction.

– Companies develop a customized hedge contract embedded in the underlying trade transaction.

– The hedge contains a price adjustment clause whereby a base price is adjusted to reflect certain exchange rate changes.

– Within a neutral zone of exchange rates, the importer pays the dollar equivalent of the local currency payable using a base e1 to compute the value of the payable.

– Companies share currency risk beyond the neutral zone.

Chapter 9: Foreign Exchange Risk Management

34

9.F Managing Transaction Exposure (14) ❑

Currency risk sharing, continued –

Sharing currency risk when e1 moves outside of neutral zone •

If e1 < lower bound of neutral zone, the exchange rate used to compute the price at settlement is

Base rate -

Base rate – (lower bound of neutral zone – e1) 2

•

If e1 > upper bound of neutral zone, the exchange rate used to compute the price at settlement is

Base rate +

Base rate + (e1 – upper bound of neutral zone ) 2

Chapter 9: Foreign Exchange Risk Management

35

9.F Managing Transaction Exposure (15) ❑

Currency risk sharing, continued –

Example: currency risk sharing between GE and Lufthansa •

Lufthansa agrees to pay GE the dollar equivalent of €10 million in the neutral zone of $1.30 to $1.36, at a base rate of e1 = $1.33 Neutral Zone

e1

$1.22

$1.30

$1.33

$1.36

$1.44

Base Rate e1 =

Payable =

Payable =

Payable =

e1 =

1.33 – (0.08/2) = $1.29

1.33 * €10 million

1.33 * €10 million

1.33 * €10 million

1.30 = dollar equivalent of €10.231 million = $13.3 million

= $13.3 million

1.36 = dollar equivalent of €9.779 million = $13.3 million

1.33 + (0.08/2) = $1.37

Payable =

1.29 * €10 million = $12.9 million Dollar equivalent of $12.9 million / 1.22 = €10.57 million

Dollar equivalent is set, but euro cost of payable changes

Chapter 9: Foreign Exchange Risk Management

Payable = 1.37 * €10 million = $13.7 million Dollar equivalent of $13.7 million / 1.44 = €9.51 million

36

9.F Managing Transaction Exposure (16) ❑

Currency collar (range forward) – a contract that provides protection against currency movements outside an agreed-on range – Example: GE is willing to accept variations in the value of its euro receivable resulting from fluctuations in e1 ranging from $1.28 to $1.38.

– GE converts it receivable at the range forward rate RF, as follows: •

If e1 < $1.28, RF = $1.28

•

If $1.28 ≤ e1 ≤ $1.38, RF = e1

•

If e1 > $1.38, RF = $1.38 $1.28

e

$1.38

1

RF = $1.28

RF = e1

RF = $1.38

– When e1 > $1.38, GE converts euro proceeds at $1.38, and the bank profits on the RF. – When e1 < $1.38, GE converts euro proceeds at $1.28, and the bank suffers a loss on the RF. Chapter 9: Foreign Exchange Risk Management

37

9.F Managing Transaction Exposure (17) ❑

Cross-hedging – if a firm cannot find a futures/forward contract on the currency for which it has exposure, it will hedge its exposure using a futures/forward contract on a related currency.

–

Use regression to estimate the relationship between the two related currencies.

–

The regression coefficient indicates the sign and approximate size of the futures/forward position to take in the related currency.

–

R2 measures the variation in the exposed currency that is explained by variation in the hedging currency; the greater R2, the better the cross-hedge.

–

Example • An exporter has a receivable due in Danish krone (DK), but there are no DK futures available.

• The exporter can cross-hedge with euro futures.

• Historical exchange rates suggest that every 1¢ change in the value of the euro leads to a 0.8¢ change in the value of the DK. • R2 = .91, indicating 91% of the variation in the DK is explained by variation in the euro; thus, the euro can be confidently used in a cross-hedge.

Chapter 9: Foreign Exchange Risk Management

38

9.F Managing Transaction Exposure (18) ❑

Foreign currency options – hedging mechanism used when future transaction exposure is uncertain.

– Example: GE bids on contract on January 1 but will not know until April 1 if its bid is accepted, making a €10 million receivable on December 31 uncertain. Hedging with forward contracts increases risk: •

•

GE could wait until April 1 when it knows it has won the bid to sell €10 million forward for December delivery.

–

Between January 1 and April 1, f1 for delivery in December may decrease, reducing the value of GE’s receivable should it win the bid.

–

E.g., f1 on January 1 = $1.28 and f1 on April 1 = $1.215. Waiting to sell forward on April 1 results in a loss of -$0.065 * 10,000,000 = -$650,000.

GE could sell €10 million forward in January for December delivery in anticipation of winning the contract.

–

Should it lose the bid, GE must still sell the currency forward on December 31 but will have no receivable to sell. GE must buy currency on the open market to sell on December 31, possibly at a significant loss.

–

E.g., f1 on January 1 = $1.28 and e1 on December 31 = $1.356, GE buys at $1.356 and sells at $1.28, at a loss of -$.076 * 10,000,000 = -$760,000.

Chapter 9: Foreign Exchange Risk Management

39

9.F Managing Transaction Exposure (19) ❑

Foreign currency options, continued – Example: GE bids on contract on January 1 but will not know until April 1 if its bid is accepted, making a €10 million receivable on December 31 uncertain. Hedging with option contracts decreases risk: •

•

On January 1, GE purchases for $100,000 a currency option to sell €10 million on December 31 at strike = $1.28.

–

Should GE lose the bid, its loss is limited to the $100,000 premium.

–

Should GE win the bid and e1 > $1.28 on December 31, GE lets the option expire and converts the €10 million receivable at e1, offsetting the loss of the premium.

On January 1, GE purchases a December currency futures put option expiring in April.

–

If the put is out of the money on April 1, GE’s loss is limited to the premium.

–

If the put is in the money on April 1, GE exercises it and receives a short position in a euro futures contract, plus cash equal to strike minus December futures price as of April.

•

Should GE lose the bid, it keeps the cash and closes its short position.

•

Should GE win the bid, it holds the contract until December 31.

Chapter 9: Foreign Exchange Risk Management

40

Chapter 10

Measuring and Managing Economic Exposure

Chapter 10 Outline A. Foreign Exchange Risk and Economic Exposure B. The Economic Consequences of Exchange Rate Changes C. Identifying Economic Exposure

D. Calculating Economic Exposure E. An Operational Measure of Exchange Risk F. Managing Operating Exposure G. Planning for Exchange Rate Changes H. Financial Management of Exchange Risk

Chapter 10: Measuring and Managing Economic Exposure

1

10.A Foreign Exchange Risk and Economic Exposure (1) ❑

Economic exposure – the degree to which the value of a firm, as measured by the present value of its expected future cash flows, will change when exchange rates change.

❑

Economic exposure comprises both transaction and operating exposure.

❑

Even if a firm prices all contracts in dollars or otherwise hedges its transaction exposure, the residual exposure – operating exposure – remains.

❑

Operating exposure is the degree to which currency fluctuations can alter a firm’s future revenues and costs, that is, its operating cash flows.

Examples: – Euro decline against the dollar increases costs for European distributors of American films because the dollar cost of presale distribution rights has risen.

– Euro increase against the dollar decreases revenues and profits for European manufacturers as dollar sales become less valuable when converted to Euros.

Chapter 10: Measuring and Managing Economic Exposure

2

10.A Foreign Exchange Risk and Economic Exposure (2) ❑

Real exchange rate = the nominal exchange rate adjusted for changes in the relative purchasing power of each currency since a base period.

From Chapter 4 we computed the real exchange rate as et ’ = e t

(1 + if)t (1 + ih)t

– Example: The Danish krone has devalued by 5% this year. Danish and U.S. inflation rates were 3% and 2%, respectively. The real exchange rate is computed as

0.95e0

(1 + 0.03) (1 + 0.02)

= 0.96e0

– In this case, the real exchange rate et’ is 96% of the nominal exchange rate e0. *In base year, et = et’ Chapter 10: Measuring and Managing Economic Exposure

3

10.A Foreign Exchange Risk and Economic Exposure (3) ❑

The change in et’ is computed as Δet’ =

et ’ – e0

e0

– Example: The change in the Dkr/$ et’ is computed as 0.96e0 – e0 e0 ❑

= -4%

The implications for exchange risk between et’ and et are vastly different.

– A change in et accompanied by an equal change in prices should not affect the relative competitive positions of domestic and foreign competitors and will thus not alter real cash flows.

– When et’ = et, relative prices are equal and no operating exchange risk exists.

– A change in et’ affects relative price changes – a reduction in the purchasing power of one currency relative to another – which will alter real cash flows.

Chapter 10: Measuring and Managing Economic Exposure

4

10.A Foreign Exchange Risk and Economic Exposure (4) ❑

Effects of inflation on exchange risk – Without relative price changes, that is, with no change in et’, an MNC faces no real operating exchange risk. Recall example from Chapter 4: e1 – e0 e0

Parity Line

5

1. At equilibrium E0, U.S. and Japan inflation both = 2% and change in e0 = 0

4 3

2. U.S. inflation increases to 5% (ih – if = 3%), causing disequilibrium, or purchasing power disparity, at (0,3).

E1

2 1 -5

-4

-3

-2

E0 1

-1

ih – if 2

3

4

5

-1 -2 -3

3. $/¥ exchange rate will rise ~3% (e1–e0 / e0 ≈ 3%) to equalize the dollar prices of goods in the two countries at a new equilibrium E1.

-4 -5 Chapter 10: Measuring and Managing Economic Exposure

5

10.A Foreign Exchange Risk and Economic Exposure (5) ❑

Also recall from Chapter 4: –

Compute and compare changes in the real and nominal values of the yen relative to the dollar (i.e., et and et’ = $/¥) from 1982 to 2006 1. et in 1982 (e0 = base year) = $1/¥249.05, et in 2006 (e25) = $1/¥116.34 2. CPIJapan in 1982 = 80.75, CPIJapan in 2006 = 97.72; if = 21% 3. CPIUS in 1982 = 56.06, CPIUS in 2006 = 117.07; ih = 109% e25’ = $1/¥116.34

(1 + 21%) (1 + 109%)

= $.004981

4. e0’ = $1/¥249.05 = $.004015.

5. Change in et’ = ($.004981 - $.004015) / $.004015 = 24%, meaning the yen appreciated 24% against the dollar in real terms – that is, the real dollar prices of Japanese exports rose by 24%.

Chapter 10: Measuring and Managing Economic Exposure

6

10.A Foreign Exchange Risk and Economic Exposure (6) ❑

Example from Chapter 4, continued: –

E.g., compute and compare the changes in the real and nominal values of the yen relative to the dollar from 1982 to 2006, continued 6. Change in et = (($1/¥116.34) – ($1/¥249.05)) / ($1/¥249.05) = 114%, meaning the nominal dollar prices of Japanese exports rose by 114% over the period.

7. Difference between et and et’ = 114% - 24% = 90%.

8. Conclusion: Inflation differentials justify only a 90% rise in et .

Thus, the increase in et’ causes a deviation from PPP by 24%.

Chapter 10: Measuring and Managing Economic Exposure

7

10.A Foreign Exchange Risk and Economic Exposure (7) ❑

With relative price changes, that is, a change in et’ (and a deviation from PPP) an MNC faces real operating exchange risk. Graphical depiction of example from Chapter 4: e25 – e0 e0

Inflation justifies only a 90% rise in e25

Parity Line

e25 114% e25’ 24% E0

ih – if 88%

Chapter 10: Measuring and Managing Economic Exposure

Japan’s relative prices have risen by 24% over the period, creating real operating exchange or inflation risk for companies selling yendenominated goods and services

8

10.A Foreign Exchange Risk and Economic Exposure (8) ❑

Example: An appreciation in the real value of the yen makes Japanese television exports less competitive by acting like a tax.

– e0 = ¥240/$, e10 = ¥90/$; U.S. inflation not in line with yen appreciation; cost per television over period = ¥100,000.

– Year 0: Break-even dollar price = $417 (¥100,000/¥240) – Year 10: Break-even dollar price = $1,111 (¥100,000/¥90)

– Dilemma: • Raising dollar prices results in lost sales because U.S. prices have not risen.

• Maintaining dollar prices means cutting yen prices to ¥37,530 (417 * 90).

❑

Example: A depreciation in the real value of the peso makes Mexican exports more competitive by acting like a subsidy.

– As the peso depreciates, the dollar value of Mexican exports increases, while peso-denominated costs stay constant, increasing revenues and profits.

❑

The economic impact of a currency change on a firm depends on whether the exchange rate change is fully offset by the inflation differential or whether et’, and thus relative prices, change.

Chapter 10: Measuring and Managing Economic Exposure

9

10.A Foreign Exchange Risk and Economic Exposure (9) ❑

Fixed exchange rates can create exchange risk.

❑

Example: Brazil’s nominal exchange rate is fixed – e0 and e0’ = $0.50 – Brazil’s inflation over year = 100% but nominal rate does not change – e1 = $0.50, e1’ = $1.00

– Impact on a Brazilian shoe manufacturer’s profits is as follows: Beginning of Year Profit Impact

End of Year

Reais*

Dollars

Reais

Dollars

Price

20.00

10.00

20.00

10.00

Cost of production

8.00

4.00

16.00

8.00

Profit

12.00

6.00

4.00

2.00

Costs double

Profits decrease by two thirds *Reais is plural for the Brazilian currency real Chapter 10: Measuring and Managing Economic Exposure

10

10.A Foreign Exchange Risk and Economic Exposure (10) ❑

Example, continued: Brazil’s nominal exchange rate is fixed – e0 and e0’ = $0.50 – Inflation over year = 100% – e1 = $0.50, e1’ = $1.00 – If shoe manufacturer raises prices to maintain profit margins, it loses competitiveness: Beginning of Year Profit Impact

End of Year

Reais*

Dollars

Reais

Dollars

Price

20.00

10.00

20.00

14.00

Cost of production

8.00

4.00

16.00

8.00

Profit

12.00

6.00

4.00

6.00

Dollar price increases

Profit margin preserved *Reais is plural for the Brazilian currency real Chapter 10: Measuring and Managing Economic Exposure

11

10.B Economic Consequences of Exchange Rate Changes (1) ❑

Transaction exposure –

Arises from various types of transactions that require settlement in a foreign currency.

–

Balance sheet items subject to transaction exposure •

–

Loans and receivables

Off-balance sheet items subject to transaction exposure •

Future sales and purchases

•

Lease payments

•

Forward contracts

•

Loan repayments

•

Other contractual or anticipated foreign currency receipts and disbursements

Chapter 10: Measuring and Managing Economic Exposure

12

10.B Economic Consequences of Exchange Rate Changes (2) ❑

Operating exposure –

Real exchange rates affect numerous aspects of a firm’s operations.

• Pricing flexibility – in light of a dollar appreciation, can the firm maintain its dollar margins in its domestic (to compete against lower-cost imports) and foreign markets?

• Pricing flexibility is a function of price elasticity of demand (i.e., increases/ decreases in demand given changes in price).

– The more sensitive consumers are to price changes, the more elastic their demand will be.

– The more differentiated a product, the less competition it faces, and the less elastic the demand will be. The more commoditized, the greater competition it faces, and the more elastic the demand will be.

Type of Good

Degree of Competition

Demand Elasticity

Pricing Flexibility

Exchange Risk

Differentiated

Lower

Lower

Higher

Lower

Commoditized

Higher

Higher

Lower

Higher

Chapter 10: Measuring and Managing Economic Exposure

13

10.B Economic Consequences of Exchange Rate Changes (3) ❑

Operating exposure, continued –

Real exchange rates affect numerous aspects of a firm’s operations, continued.

• Ability to shift production and sourcing among countries – the greater a company’s flexibility to substitute between domestic and foreign inputs or production, the less exchange risk the company will face.

– All else equal, firms with global production and purchasing networks can manage currency changes by increasing production and purchasing in a country whose currency has been devalued in real terms and decreasing production and purchasing in a country whose currency has been revalued in real terms.

– While prices in the local currency cannot be increased to the full extent of the local currency devaluation (to increase the exchange value), its lower prices will be more competitive, offsetting some revenue declines.

Chapter 10: Measuring and Managing Economic Exposure

14

10.B Economic Consequences of Exchange Rate Changes (4) ❑

Summary of economic effects of exchange rate changes

LC Cash Flow Category

Impact on Parent Company Cash Flows Relevant Economic Factors

LC Deval.

Reason

LC Reval.

Reason

Revenue Export Sales

Local Sales

Elastic demand

Increase (++)

Decrease (- -)

Increase (+)

Units demanded increases

Decrease (-)

Units demanded decreases

Inelastic demand Weak import competition

Decrease (- -)

Demand constant

Increase (++)

Demand constant

Strong import competition

Decrease (-)

Local consumers switch from highercost imports

Increase (+)

Price reductions preserve demand

Low import content

Decrease (- -)

High import content

Costs Local Inputs

Imported inputs

Increase (++)

Decrease (-)

Lowers dollar cost of production to decreasing degrees

Increase (+)

Raises dollar cost of production to decreasing degrees

Small local market

No change

Minimal impact

No change

Minimal impact

Large local market

Decrease (-)

Lowers dollar cost of production

Increase (+)

Raises dollar cost of production

Chapter 10: Measuring and Managing Economic Exposure

15

10.C Identifying Economic Exposure (1) ❑

Three examples illustrate a firm’s susceptibility to exchange risk 1. Aspen Skiing Company – consequences of a domestic company buying and selling only in dollars 2. Petroleos Mexicanos (Pemex) – consequences of a Mexican national company borrowing in dollars 3. Toyota Motor Company – consequences of having a mix of half foreign sales and half domestic sales

Chapter 10: Measuring and Managing Economic Exposure

16

10.C Identifying Economic Exposure (2) 1.

Aspen Skiing Company –

Because Aspen buys and sells only in dollars, no accounting exposure.

–

Economic exposure stems from how changes in the value of the dollar affect its competitive position and thus its future cash flows.

–

–

A dollar appreciation makes foreign ski alternatives attractive to both foreign and domestic customers, causing revenues to decrease and costs to remain constant.

–

A dollar depreciation makes Aspen more attractive to both domestic and foreign skiers, causing revenues to rise and cost to remain constant.

The competitive landscape makes demand for Aspen’s ski venue elastic – that is, consumers will switch to lower-cost alternatives.

Chapter 10: Measuring and Managing Economic Exposure

17

10.C Identifying Economic Exposure (3) 2.

Petroleos Mexicanos (Pemex) –

Pemex exports all its oil, priced in dollars.

–

Costs are denominated in both foreign currency and pesos –

Equipment and services related to oil exploration, drilling, and production denominated in foreign currency.

–

Labor, local supplies, services, and materials are denominated in pesos.

–

Pemex borrows in U.S. dollars

–

Given a peso devaluation: –

Dollar revenues remain unchanged.

–

Dollar costs of foreign currency inputs likely unchanged.

–

Dollar cost of peso-denominated inputs declines

–

Net effect: an increase in dollar cash flow and a decrease in credit risk from borrowing in pesos.

Chapter 10: Measuring and Managing Economic Exposure

18

10.C Identifying Economic Exposure (4) 3.

Toyota Motor Company –

Half of Toyota’s sales are in foreign markets, primarily in U.S.

–

Effect on a yen appreciation on revenues

–

–

•

Keeping yen price constant, dollar prices will rise but sales volume will drop; or

•

Keeping dollar price constant, U.S. market share is preserved but yen value of revenues will drop.

•

Either decision will cause a drop in revenues.

•

If Toyota decides to focus on the local market, it faces the flow-back effect stemming from other Japanese exporters refocus on the local market.

Effect on a yen appreciation on costs •

Most inputs are imported, so the yen cost of inputs will decline

•

Local inputs such as labor will likely remain constant.

•

Net effect: Overall reduction in yen costs

Overall effect of yen appreciation: Reduction in revenues exceeds the reduction in costs.

Chapter 10: Measuring and Managing Economic Exposure

19

10.D Calculating Economic Exposure (1) ❑

Quantitative determination of economic exposure using Spectrum Manufacturing AB, a wholly owned Swedish affiliate of a U.S. MNC. – Cash flow calculation using current exchange rate of SKr 4/$ Income Statement Item

Units

Unit Price (SKr)

Total

Domestic sales (60%)

600,000

20

12,000,000

Export sales (40%)

400,000

20

8,000,000

Total Revenue

20,000,000

Operating Expense

(10,800,000)

Overhead Expense

(3,500,000)

Interest on SKr debt @ 10%

(300,000)

Depreciation

(900,000)

EBT

4,500,000

Tax @ 40%

(1,800,000)

EAT

2,700,000

Add back depreciation

900,000

Net cash flow in SKr

3,600,000

Net cash flow in dollars

Chapter 10: Measuring and Managing Economic Exposure

900,000

20

10.D Calculating Economic Exposure (2) ❑

Given an exchange rate change to SKr 5/$, compute translation loss.

Translation at SKr 5/$

SKr 4/$ Balance Sheet Item

SKr

Dollar

Current Rate

Monetary/ Nonmonetary

Assets

Cash

1,000,000

250,000

200,000

200,000

Accounts Rec.

5,000,000

1,250,000

1,000,000

1,000,000

Inventory

2,700,000

675,000

540,000

675,000

Net Fixed Assets

10,000,000

2,500,000

2,000,000

2,000,000

Total Assets

18,700,000

4,675,000

3,740,000

4,375,000

Accounts Payable

2,000,000

500,000

400,000

400,000

Long-Term Debt

3,000,000

750,000

600,000

600,000

Equity

13,700,000

3,425,000

2,640,000

3,375,000

Total Liabilities + Equity

18,700,000

4,675,000

3,740,000

4,375,000

(935,000)

(300,000)

Liabilities

Translation Loss

Chapter 10: Measuring and Managing Economic Exposure

21

10.D Calculating Economic Exposure (3) ❑

While accounting exposure is measured by balance sheet items (stock items), economic exposure is measured by income statement items (flow items)

❑

Compute and compare gain/loss from economic exposure to loss from accounting exposure

❑

Use 3 scenarios 1. All variables remain the same (inability to raise prices) 2. SKr sales prices and all costs rise; volume remains the same 3. Partial increases in prices, costs, and volume

Chapter 10: Measuring and Managing Economic Exposure

22

10.D Calculating Economic Exposure (4) ❑

Scenario 1: All variables remain the same – – – – –

First-year cash flow at SKr 4/$ = $900,000 First-year cash flow at SKr 5/$ = $720,000 Net loss from devaluation in first year = $180,000 Loss will continue until relative prices adjust Assuming a three-year adjustment period, gain in year 3 = $150,000 from loan repayment ($3,000,000/4 - $3,000,000/5 = $150,000)

–

Present value of loss/gain over the three-year adjustment period = economic loss/gain from SKr devaluation: t

Postdevaluation CF – Predevaluation CF = Change in CF * 15% discount factor = Present Value

1

2

$720,000 $900,000 -$180,000 1/1.15 -$156,600

$720,000 $900,000 -$180,000 1/1.152 -$136,080

3 $720,000 + $150,000 $900,000 -$30,000 1/1.153 -$19,740

Total economic gain/loss from devaluation = -$156,600 + -$136,080 + -$19,740 = -$312,420 Chapter 10: Measuring and Managing Economic Exposure

23

10.D Calculating Economic Exposure (5) ❑

Scenario 2: SKr sales prices and all costs rise; volume remains the same – Cash flows given SKr 5/$ change as follows: Income Statement Item

Units

Unit Price (SKr)

Total

Domestic sales (60%)

600,000

25

15,000,000

Export sales (40%)

400,000

25

10,000,000

Total Revenue

25,000,000

Operating Expense

(13,500,000)

Overhead Expense

(4,375,000)

Interest on SKr debt @ 10%

(300,000)

Depreciation

(900,000)

EBT

5,925,000

Tax @ 40%

(2,370,000)

EAT

3,555,000

Add back depreciation

900,000

Net cash flow in SKr

4,455,000

Net cash flow in dollars

Chapter 10: Measuring and Managing Economic Exposure

891,000

24

10.D Calculating Economic Exposure (6) ❑

Scenario 2: SKr sales prices and all costs rise; volume remains the same, continued – Computing the present value of cash flow loss/gain during the threeyear adjustment period, we derive the total economic loss/gain due to the SKr devaluation. t

Postdevaluation CF – Predevaluation CF = Change in CF * 15% discount factor = Present Value

1

2

$891,000 $900,000 -$9,000 1/1.15 -$7,830

$891,000 $900,000 -$9,000 1/1.152 -$6,800

3 $891,000 + $150,000 $900,000 $141,000 1/1.153 $92,780

Total economic gain/loss from devaluation = -$7,830 + -$6,800 + $92,780 = $78,150

– Net gain stems from gain on loan repayment.

Chapter 10: Measuring and Managing Economic Exposure

25

10.D Calculating Economic Exposure (7) ❑

Scenario 3: Partial increases in prices, costs, and volume – Cash flows given SKr 5/$ change as follows: Income Statement Item

Units

Unit Price (SKr)

Total

Domestic sales (60%)

720,000

22

15,840,000

Export sales (40%)

460,000

24

11,040,000

Total Revenue

26,906,000

Operating Expense

(14,906,000)

Overhead Expense

(3,850,000)

Interest on SKr debt @ 10%

(300,000)

Depreciation

(900,000)

EBT

6,924,000

Tax @ 40%

(2,769,000)

EAT

4,155,000

Add back depreciation

900,000

Net cash flow in SKr

5,055,000

Net cash flow in dollars

1,011,000

Chapter 10: Measuring and Managing Economic Exposure

26

10.D Calculating Economic Exposure (8) ❑

Scenario 3: Partial increases in prices, costs, and volume, continued – Computing the present value of cash flow loss/gain during the threeyear adjustment period, we derive the total economic loss/gain due to the SKr devaluation. t

Postdevaluation CF – Predevaluation CF = Change in CF * 15% discount factor = Present Value

1 $1,011,000 $900,000 $111,000 1/1.15 $96,570

2 $1,011,000 $900,000 $111,000 1/1.152 $83,920

3 $1,011,000 + $150,000 $900,000 $261,000 1/1.153 $171,740

Total economic gain/loss from devaluation = $96,570 + $83,920 + $171,740 = $352,230

– Net gain stems from increase in operating cash flows and gain on loan repayment.

Chapter 10: Measuring and Managing Economic Exposure

27

10.E Operational Measure of Exchange Risk (1) ❑

Determining a firm’s true economic exposure and susceptibility to exchange risk using regression analysis

❑

Regression analysis – Establishes the correlation between the variations in the dollar value of the unit’s cash flows with variations in the nominal exchange rate.

– Changes in dollar-value cash flows from past periods are regressed on changes in the average exchange rate during the corresponding period.

– Regression formula ΔCFt = a + β(ΔEXCHt) + ut

Where ΔCFt = CFt – CFt-1, and CFt = dollar value of parent CF in period t ΔEXCHt = EXCHt – EXCHt-1, and EXCHt = average e0 in period t u = random error Chapter 10: Measuring and Managing Economic Exposure

28

10.E Operational Measure of Exchange Risk (2) ❑

Regression output –

Beta coefficient β measures the sensitivity of dollar cash flows to exchange rate changes.

•

–

t-statistic measures the statistical significance of β.

•

–

❑

The higher β, the greater the impact of a given exchange rate change on the dollar value of cash flows.

The larger the t-statistic, the higher the level of confidence in the value of β

R2 measures the fraction of cash flow variability explained by variation in the exchange rate.

•

The most important parameter

•

Even if β is large and statistically significant as measured by t-statistic, if R2 is 0.01, indicating that only 1% is total cash flow variability is explained by exchange rate changes, the firm should not devote a high level of resources to managing exchange risk.

The validity of regression analysis depends on the sensitivity of future cash flows to exchange rates being similar to their historical sensitivity.

Chapter 10: Measuring and Managing Economic Exposure

29

10.F Managing Operating Exposure (1) ❑

Currency risk affects all areas of a firm’s operations

❑

Competitive exposures arise when competition with firms based in other currencies cannot be managed solely through financial hedging.

❑

Managing competitive exposures 1. Marketing management of exchange risk 2. Production management of exchange risk

Chapter 10: Measuring and Managing Economic Exposure

30

10.F Managing Operating Exposure (2) 1.

Marketing management of exchange risk – a firm’s marketing strategy can provide competitive leverage when the home currency fluctuates.

– Market selection • A strong dollar places dollar-denominated firms at a competitive disadvantage in markets with weaker currencies, while making the U.S an attractive market for foreign companies seeking to gain market share from U.S. rivals.

• A weak dollar makes foreign markets with stronger currencies attractive to U.S firms because of their pricing advantage.

Chapter 10: Measuring and Managing Economic Exposure

31

10.F Managing Operating Exposure (3) 1.

Marketing management of exchange risk, continued – Pricing strategy • Following dollar depreciation, MNCs have a competitive pricing advantage in foreign markets, and domestic firms facing strong import competition may

have a pricing advantage.

– Both MNCs and domestic firms can keep dollar prices constant and expand market share or raise prices to increase profit margins, depending on whether •

Dollar depreciation is likely to persist;

•

The firm can achieve economies of scale;

•

The cost structure of expanding output is viable; and

•

Demand elasticity is conducive to increasing prices.

– Elastic demand and economies of scale favor keeping prices constant and expanding the market.

– Inelastic demand and the absence of economies of scale favor increasing prices and profit margins.

Chapter 10: Measuring and Managing Economic Exposure

32

10.F Managing Operating Exposure (4) 1.

Marketing management of exchange risk, continued – Pricing strategy, continued • Following dollar appreciation, foreign producers have a competitive pricing advantage in foreign and domestic markets.

– At best, firms will be able to raise dollar prices only to the extent of the dollar appreciation.

– At worst, firms will have to absorb a reduction in dollar revenues equal to the percentage decline in the value of the foreign currency.

– Product strategy – firms time new product introductions, product line extensions, and product innovation to optimize exchange rate changes.

• A dollar depreciation creates opportunities for MNCs to develop brand franchises as well as expand their product lines in both the domestic and foreign markets.

• A dollar appreciation enables firms to pursue product innovation through expanded R&D efforts, strengthening their product differentiation and thus making demand less elastic.

Chapter 10: Measuring and Managing Economic Exposure

33

10.F Managing Operating Exposure (5) 2.

Production management of exchange risk – when pricing and other marketing strategies are not sufficient to preserve profit margins in the face of exchange rate fluctuations, firms can trim costs through production management.

– Changing the input mix: Given a dollar appreciation, a firm shifts to foreign suppliers with costs least affected by exchange rate changes.

– Shifting production among plants • MNCs with a global production network can allocate production among their plants to align with changing dollar costs of production – increasing production in countries whose currencies have devalued and decreasing production in countries whose currencies have been revalued.

• Caveat – multiple plants can create manufacturing redundancies and reduce or eliminate economies of scale.

• The value of a global manufacturing network increases with exchange rate volatility. Thus, despite higher unit costs associated with smaller plants and excess capacity, currency risk may justify the use of multiple production facilities.

Chapter 10: Measuring and Managing Economic Exposure

34

10.F Managing Operating Exposure (6) 2.

Production management of exchange risk, continued – Plant location • A firm without foreign facilities may be forced to create new plants abroad if foreign sourcing is not sufficient to maintain unit profitability.

• Caveat – while foreign manufacturing plants can create cost advantages in light of a home currency appreciation, these cost advantages erode in the face of a home currency depreciation.

– Raising productivity • Firms have sought to improve their cost structures by raising productivity.

– Closing inefficient plants,

– Increasing automation, – Negotiating with unions, – Reducing product offerings to include those products that account for the bulk of sales and profits.

Chapter 10: Measuring and Managing Economic Exposure

35

10.G Planning for Exchange Rate Changes ❑

MNCs must plan for exchange rate changes with the understanding that equilibrium rates are constantly changing.

❑

The ability to respond to constantly changing equilibrium rates is critical to maintaining competitive viability.

❑

Competitive options include outsourcing, flexible manufacturing systems, a global network of production facilities, and shorter product cycles.

❑

Shorter product cycles provide the greatest competitive enhancement.

– MNCs can charge a premium for being first to market, incorporate state-of-the-art technology, and respond faster to emerging market niches and changes in consumer tastes.

❑

Competitive options enable MNCs to change their strategies before the impact of a currency change is manifest.

Chapter 10: Measuring and Managing Economic Exposure

36

10.H Financial Management of Exchange Risk (1) ❑

Strategic marketing and production adjustments take time to implement.

❑

Financial management ensures that, while strategic adjustments are effected, any reduction in earnings on assets is matched by a corresponding decrease in the cost of servicing the liabilities that fund those assets.

– A firm with a substantial export market should hold a portion of its liabilities in that country’s currency.

– While an increase in the home currency may decrease revenues, it will also decrease payables.

Chapter 10: Measuring and Managing Economic Exposure

37

10.H Financial Management of Exchange Risk (2) ❑

Example: A devaluation results in increased local currency cash flows but still lower dollar cash flows.

LC 1 - $0.25

LC 1 = $0.20

Cash Flow Component

Units (000)

Unit Price

Total (000)

Units (000)

Unit Price

Total (000)

Domestic Sales

400

20

8,000

300

24

7,000

Export Sales

400

20

8,000

500

24

12,000

Total Revenue

16,000

19,200

Local Labor (hours)

800

10

-8,000

800

12

-9,600

Local Material

800

3

-2,400

1,000

3.5

-3,500

Imported Material

600

4

-2,400

450

5

-2,250

Total Expenditures

-12,800

-15,350

Net Cash Flow from Operations (LC)

3,200

3,850

Net Cash Flow from Operations ($)

$800

$770

$30,000 exchange loss on operating cash flows Chapter 10: Measuring and Managing Economic Exposure

38

10.H Financial Management of Exchange Risk (3) ❑

Example, continued –

The subsidiary requires assets of LC 20 million, or $5 million (converted at LC 1 = $0.25). Assets can be financed with dollars at 8% and converting to local currency, or with local currency at 10%.

–

Structure financing to reduce the cost of servicing debt by $30,000.

•

S = dollar outflow on local debt

•

0.2S = $30,000 (0.2 reflects the 20% devaluation)

•

S = $150,000, or LC 600, which reflects borrowing LC 6 million and the dollar equivalent of LC 14 million ($3.5 million; 8% of $3.5 million = $280,000) LC 1 = $0.25

LC 1 = $0.20

Cash Flow Component

LC

Dollars

LC

Dollars

Net Cash Flow from Operations

3,200

800

3,850

770

Local Currency Debt

600

150

600

120

Dollar Debt

1,120

280

1,400

280

Total Debt Service Outflow

1,720

430

2,000

400

Net Cash Flow

1,480

370

1,850

370

Debt Service Requirements

Chapter 10: Measuring and Managing Economic Exposure

Translated postdevaluation net cash flow remains at predevaluation level 39

Chapter 11

Foreign Markets and Investments

Chapter 11 Outline A. Country Risk B. Measuring Political Risk C. Economic and Political Factors Underlying Country Risk

D. Country Risk Analysis in International Banking

E. Appendix: Managing Political Risk

Chapter 11: Foreign Markets and Investments

1

11.A Country Risk ❑

Country risk analysis – the assessment of the potential risks and rewards associated with making investments and doing business in a country.

– Because economic policies are often a function of political considerations, country risk analysis focuses on both economic and political considerations.

❑

Nonbank MNCs analyze country risk to determine the investment climate in various countries.

❑

Banks analyze country risk to determine which countries to lend to, the currencies in which to denominate their loans, and the interest rates to demand on those loans.

Chapter 11: Foreign Markets and Investments

2

11.B Measuring Political Risk (1) ❑

Political economy – the interaction of politics and economics that creates risks relating to monetary and fiscal policy, currency or trade controls, changes in labor laws, regulatory restrictions, and requirements for additional local production.

❑

The degree of risk is a function of the nature of government intervention in a country.

❑

Two approaches to analyzing political risk – Country-specific perspective – Firm-specific perspective (see Chapter 14)

❑

Common political measures of political stability – Frequency of changes of government – Level of violence – Number of armed insurrections – Extent of conflicts with other states

Chapter 11: Foreign Markets and Investments

3

11.B Measuring Political Risk (2) ❑

MNCs use stability measures to determine how long the current regime will be in power and whether that regime will be willing and able to enforce its foreign investment guarantees.

❑

While many developing countries have the basic foundation of a nation-state (i.e., UN-endorsed borders, armies, foreign ministries, flags, currencies, national airlines), they lack social cohesion, political legitimacy, and the institutional infrastructure necessary for economic growth.

❑

Common economic measures of political stability – Inflation

– Balance of payments deficits/surpluses – Per-capita GDP growth ❑

In general, the better a country’s economic outlook, the less likely it is to face political and social instability that negatively impact MNCs.

Chapter 11: Foreign Markets and Investments

4

11.B Measuring Political Risk (3) ❑

Subjective measures of political stability are based on a general perception of the country’s attitude toward capitalism and MNCs. – Profit Opportunity Recommendation (POR) is an index that rates countries on an aggregation of subjective assessments of a panel of experts.

– Property rights – from an economic standpoint, political risk refers to uncertainty over property rights.

• Risk of expropriation – the degree to which a government can seize legal title to property or the stream of income generated by the property • Risk of constrained use of property

– Capital flight – the export of savings by a country’s citizens because of fears about the safety of their capital.

• Capital flight is difficult to measure because it is not directly observed in most cases.

• Capital flight can be inferred using balance of payments figures.

Chapter 11: Foreign Markets and Investments

5

11.B Measuring Political Risk (4) ❑

Subjective measures of political stability, continued – Capital flight, continued • Reasons for capital flight – Government regulations, controls, and taxes that lower the return on domestic investments – Increases in a country’s external debt that may precede a fiscal crisis – Political risk – in unstable political regimes, wealth is not secure from government seizure

Chapter 11: Foreign Markets and Investments

6

11.C Economic and Political Factors Underlying Country Risk (1) ❑

❑

Country risk is not confined to less developed countries (LDCs).

–

Western European countries have problems with economic stagnation, overregulation, inflexible labor markets, and overly expansive and expensive welfare states.

–

The U.S. business environment is subject to arbitrary changes in employment and environmental laws, and the legal environment opens MNCs to litigation risk.

–

Japan’s highly regulated business system places a preponderance of power with the state, and its banking system has made approximately $1.23 trillion in bad loans.

Determinants of a country’s economic performance and degree of risk 1.

2.

3.

4.

5.

6.

Fiscal irresponsibility Monetary instability Controlled exchange rate system Wasteful government spending Resource base Adjustment to external shocks

Chapter 11: Foreign Markets and Investments

7

11.C Economic and Political Factors Underlying Country Risk (2) 1.

Fiscal irresponsibility – Indiscriminant government spending increases country risk.

– The higher the government deficit as a percentage of GDP, the lower the probability a country can meet its obligations without resorting to expropriations of property, raising taxes, or printing money.

2.

•

Expropriation causes capital flight and a shortage of new investment.

•

Raising taxes adversely affects incentives to work, save, and take risks.

•

Printing money to finance the government deficit (monetizing the deficit) results in monetary instability, high inflation, high interest rates, and currency depreciation.

Monetary instability – an expansion of the money supply in excess of real output growth results in inflation.

Chapter 11: Foreign Markets and Investments

8

11.C Economic and Political Factors Underlying Country Risk (3) 3.

4.

Controlled exchange rate system –

Currency controls are used to fix the exchange rate and result in an overvalued local currency.

–

An overvalued currency effectively taxes exports and subsidizes imports.

–

The risk associated with currency controls encourages capital flight.

–

MNCs repatriate subsidiary profits rather than reinvest them.

–

A controlled exchange rate system exacerbates unfavorable trends in the country’s terms of trade (the exchange rate between exports and imports).

Wasteful government spending –

Unproductive spending results in a government having less money to repay its foreign debts.

–

Funds used to purchase foreign assets will not add to an economy’s dollargenerating capacity unless investors feel safe in repatriating their foreign earnings.

Chapter 11: Foreign Markets and Investments

9

11.C Economic and Political Factors Underlying Country Risk (4) 5.

Resource base – A country’s resources include natural, human, and financial resources.

– All things equal, a country with substantial natural resources is a better economic risk than a country without natural resources.

– However, the quality of human resources and the degree to which those resources are efficiently employed can offset disadvantages of having sparse natural resources.

– Three factors are necessary to ensure the most efficient use of a country’s human resource base: •

A stable political system that encourages hard work and risk-taking by entrepreneurs;

•

A flexible labor market that permits workers to be allocated to those jobs in which they will be most productive; and

•

A free market system that ensures that prices people respond to correctly signal the relative desirability of engaging in different activities.

Chapter 11: Foreign Markets and Investments

10

11.C Economic and Political Factors Underlying Country Risk (5) 6.

Adjustment to external shocks – Domestic policies are critical in determining how effectively a country deals with external shocks.

•

In response to falling commodity prices, rising interest rates, and rising exchange rates in the 1980s: – Asian countries’ policies, characterized by imitation and innovation in the international market, promoted timely internal and external adjustment.

– Latin American countries, with extensive state ownership, controls, and policies to encourage import substitution, exploited their internal markets, fostering long-term inefficiency among Latin American manufacturers and worsening their international competitive positions.

Chapter 11: Foreign Markets and Investments

11

11.C Economic and Political Factors Underlying Country Risk (6) ❑

Market-oriented versus statist policies – Market (capitalist) economy •

Individual decisions makers make economic decisions based on prices of goods, services, capital, labor, land, and other resources.

•

Capitalism works because – Economic decisions are made by those who have the information necessary to determine the trade offs inherent in those decisions; and – People have the incentive to efficiently act on that information.

– Command (socialist) economy •

Top government decides what will be produced, how it is produced, and where it is produced, and commands others to follow the central plan.

•

Command economies don’t work because – All fragments of knowledge existing in different minds must be transferred to the central planner, which is impossible; and – Incentives that foster efficiency are lacking.

Chapter 11: Foreign Markets and Investments

12

11.C Economic and Political Factors Underlying Country Risk (7) ❑

Market-oriented versus statist policies, continued – Most modern economies are a mix of market and command economies.

– Statist policies constrain growth through heavy government intervention, regulations, tax-and-spend policies, and state ownership or control of key industries.

•

Special interest groups lobby for state benefits and oppose reforms to eliminate subsidies.

Chapter 11: Foreign Markets and Investments

13

11.C Economic and Political Factors Underlying Country Risk (8) ❑

Review of common characteristics of high country risk –

A large government deficit relative to GDP

–

High monetary expansion, especially if combined with a fixed exchange rate

–

High government spending yielding low rates of return

–

Price controls, interest rate ceilings, trade restrictions, rigid labor laws, and other barriers that impede a smooth adjustment to changing relative prices

–

High tax rates that destroy incentives to work, save, and invest

–

High level of state-owned firms

–

A citizenry that demands, and a political system that accepts, government responsibility for maintaining and expanding the nation’s standard of living through public-sector spending and regulations

–

Pervasive corruption that impedes development, discourages foreign investment, and breeds distrust of capitalism

–

The absence of basic institutions

Chapter 11: Foreign Markets and Investments

14

11.C Economic and Political Factors Underlying Country Risk (9) ❑

Review of common characteristics of low country risk –

A structure of incentives that rewards risk-taking in productive ventures

–

A legal structure that stimulates the development of free markets

–

Minimal regulations and economic distortions

–

Incentives to save and invest

–

An open economy

–

Stable macroeconomic policies

Chapter 11: Foreign Markets and Investments

15

11.D Country Risk Analysis in International Banking (1) ❑

Country risk from a bank’s perspective stems from the possibility that borrowers in a country will be unable to service their debts to foreign lenders in a timely manner.

❑

Underlying causes of default are internal and include –

Massive corruption;

–

Bureaucracy;

–

Government intervention;

–

Poor macroeconomic policies; and

–

Large budget deficits that have been monetized.

Chapter 11: Foreign Markets and Investments

16

11.D Country Risk Analysis in International Banking (2) ❑

Terms of trade –

When a country’s terms of trade improve, foreign goods become relatively less expensive, the country’s standard of living rises, and consumers and businesses become more dependent on imports.

–

When a country’s terms of trade decline, countries may fix the exchange rate at an artificially high level to maintain the standard of living.

–

Loans made when terms of trade were favorable are now doubly risky: Because the terms of trade have declined and because the government is maintaining an overvalued currency.

Chapter 11: Foreign Markets and Investments

17

11.E Appendix: Managing Political Risk (1) ❑

After analyzing a country’s political environment, assessing its implications for operations, and deciding to invest there, an MNC must determine how to structure its investment to minimize political risk.

❑

Preinvestment planning – four options to manage political risk –

Avoidance • An MNC may screen out investments in politically uncertain countries, but absolute avoidance is impossible because the home country also carries political risk.

• However, avoiding investments with political risk ignores potentially high returns and the extent to which the firm can control the risks.

–

Insurance • Most developed countries sell political risk insurance covering foreign assets of domestic companies.

• Problems with relying only on insurance – If an investment is unprofitable, it is unlikely to be expropriated.

– If an investment is profitable and is expropriated, the firm is compensated only for the value of its assets rather than the economic value of the investment (i.e., present value of future cash flows).

Chapter 11: Foreign Markets and Investments

18

11.E Appendix: Managing Political Risk (2) ❑

Preinvestment planning, continued –

–

Negotiating the environment •

Concession agreements – MNCs negotiate with the host government to define rights and responsibilities of both parties before undertaking the investment.

•

Concession agreements may not be honored in many third-world countries.

Structuring the investment •

Minimize exposure to political risk by increasing the host government’s cost of nationalization (and ability to harm the MNC by seizing a single plant).

–

Keep the subsidiary dependent on sister companies for markets and/or supplies.

–

Concentrate R&D facilities and proprietary technology in the home country.

–

Source production from multiple plants.

–

Raise capital from the host and other governments, international financial institutions, and customers instead of using funds supplied by the MNC.

–

Obtain unconditional host government guarantees for the amount of investment to give creditors legal leverage against transactions between the host country and third parties if a subsequent government repudiates the country’s obligations.

Chapter 11: Foreign Markets and Investments

19

11.E Appendix: Managing Political Risk (3) ❑

Operating policies – Change the benefit/cost ratio of expropriation – an MNC can raise the cost of expropriation by increasing the negative sanctions involved through •

Controlling export markets, transportation, technology, trademarks and brand names, and components manufactured in other countries.

•

When expropriation is inevitable, the MNC should prepare for negotiations to establish a future contract-based relationship.

– Develop local stakeholders – research indicates that having local private investors as partners seems to provide protection against expropriation.

– Adaptation – MNCs pursue a policy of adapting to the inevitability of potential expropriation and try to earn profits on the firm’s resources through licensing and management agreements.

Chapter 11: Foreign Markets and Investments

20

Chapter 12

International Financing and National Capital Markets

Chapter 12 Outline A. Corporate Sources and Uses of Funds B. National Capital Markets as International Financial Centers C. Eurocurrency Market

D. Eurobonds E. Asiacurrency Market F. Project Finance

Chapter 12: International Financing and National Capital Markets

1

12.A Corporate Sources and Uses of Funds (1) ❑

Three general sources of corporate funds – Internally generated cash – Short-term external funds – Long-term external funds

❑

External finance comes from investors and/or lenders.

– Negotiable securities are publicly issued debt or equity.

– Debt accounts for vast majority of external funds.

❑

Investment banker – a financing specialist that designs and underwrites (markets) the securities – Investment bankers buy the securities and resell them to the public.

– Compensation is the spread between the purchase and selling prices. ❑

Financial intermediary – debt financing specialist that makes loans and issues its own securities or deposits in the market.

– Commercial bank loans for short- and medium-term credit – Privately placed bonds for longer-term credit

Chapter 12: International Financing and National Capital Markets

2

12.A Corporate Sources and Uses of Funds (2) ❑

Privately placed bonds – Sold directly to a limited number of sophisticated investors – Generally nonnegotiable – Contain covenants (customized loan agreements) that are regularly renegotiated before maturity

❑

Financial markets vs. financial intermediaries – Globally, bank borrowing is declining.

– Corporate borrowers are increasingly using securitization, i.e., issuing negotiable securities in public markets.

– Financial deregulation has reduced the cost of using financial markets while the cost of bank borrowing has risen.

Chapter 12: International Financing and National Capital Markets

3

12.A Corporate Sources and Uses of Funds (3) ❑

Difference between securitization and intermediation – a Belgian corporation seeks an investment, and a Japanese firm seeks funds

Belgian Corporation

Securitization Deposits funds

Belgian Bank

Redeposits funds

Issues and sells bonds

International Money Center Bank In London Lends funds

Intermediation

Chapter 12: International Financing and National Capital Markets

Japanese Bank Lends funds

Japanese Corporation

4

12.A Corporate Sources and Uses of Funds (4) ❑

Corporate governance – two general models – Anglo-Saxon (“AS” or market-oriented) model used in U.S. and U.K. • Institutional investors play a critical role and exert a high level of corporate control.

• Equity finance is important.

• Corporate objective: maximize shareholder value • High return on capital is stressed

– Continental European and Japanese (“CEJ”) model • Banks play a critical role.

• Share ownership and control are concentrated in banks and other firms.

• Corporate decision-making is influenced heavily by close personal relationships between corporate leaders who sit on each other’s boards of directors.

• Less focus on return on capital

Chapter 12: International Financing and National Capital Markets

5

12.A Corporate Sources and Uses of Funds (5) ❑

Corporate governance, continued – CEJ model, continued • The keiretsu (large industrial groupings often with a bank at the center) form the foundation of corporate Japan.

– Provide financial banking, management advice, favorable contracts, and a safety net for members.

– The main bank has access to information about member companies and strong influence in their management.

– Banks hold industrial shares and have sizable equity stakes in their borrowers.

• Universal banking is practiced in Germany.

– German commercial banks perform investment banking and take major equity positions in companies.

– “Cross-shareholdings” (i.e., banks are both debt and equity holders) has resulted in a loss of competitiveness.

• Heavy reliance on bank debt has resulted in less freedom of action.

• Japanese and German companies are turning more to the AS model.

Chapter 12: International Financing and National Capital Markets

6

12.A Corporate Sources and Uses of Funds (6) ❑

Globalization of financial markets – Advances in communications and technology combined with deregulation have reduced transaction costs and created a global financial market.

– Competition among key financial centers and institutions has skyrocketed and further reduced the cost of issuing new securities.

– Regulatory arbitrage draws users of capital markets to the financial centers with the lowest regulatory standards and thus the lowest costs.

❑

Financial innovation – Enables companies to tap previously inaccessible markets and permits investors and issuers to optimize tax loopholes.

– To the extent that a firm can design a security that appeals to a capital market niche, it can attract funds at a lower cost than the market’s required return on securities of comparable risk.

Chapter 12: International Financing and National Capital Markets

7

12.B National Capital Markets as International Financial Centers (1) ❑

Well-functioning financial markets foster economic growth.

Functions of a Well-Functioning Financial Market

Factors Promoting Well-Functioning Financial Markets • Secure property rights

• Mobilize savings

• Easily enforceable contracts

• Allocate resources based on expected risk-adjusted returns

• Meaningful accounting information • Accountability of borrowers and investors

• Borrowers and investors bear the consequences of their decisions

• Facilitate risk transfer and risk reduction through diversification • Monitor managers through informationgathering • Exert corporate control • Supply liquidity by enabling investors to sell their investments before maturity Consequences

Results • Stronger economic growth • Greater consumer satisfaction

• Greater capital accumulation • More and better projects get financed • More innovation • Managerial accountability • Preferred time pattern of consumption

Chapter 12: International Financing and National Capital Markets

8

12.B National Capital Markets as International Financial Centers (2) ❑

International financial markets – Political stability and minimal government intervention are necessary to become a major international financial center.

– The most important global financial centers are in London, Tokyo, and New York.

– The domestic markets in Switzerland, Luxembourg, Hong Kong, the Bahamas, and Bahrain serve as financial entrepôts (channels through which foreign funds pass).

❑

Foreign access to domestic markets – MNCs have greater latitude in accessing a variety of local money markets than domestic firms.

– Money raised in local markets is often limited to local uses through exchange controls.

– However, MNCs can transfer funds using a variety of financial channels.

Chapter 12: International Financing and National Capital Markets

9

12.B National Capital Markets as International Financial Centers (3) ❑

Foreign access to domestic markets, continued – Foreign bond market • The portion of the domestic bond market that represents issues floated by foreign companies or governments • Foreign bonds are subject to local laws and must be denominated in the local currency.

• Types of bonds – Fixed-rate issue – similar to domestic fixed-rate issues, with a fixed coupon, set maturity date, and full repayment of principal at maturity.

– Floating-rate note (FRN) – variable coupon that is reset at fixed intervals at a margin above a mutually agreed-on reference rate such as the Treasury bill.

– Equity-related issue – combines features of bonds and common stock • Convertible bonds – fixed rate bonds that are convertible into a given number of shares before maturity • Equity warrants – give the holder the right to buy a specified number of shares of common stock at a specified price during a designated period Chapter 12: International Financing and National Capital Markets

10

12.B National Capital Markets as International Financial Centers (4) ❑

Foreign access to domestic markets, continued – Foreign bank market • The portion of domestic bank loans supplied to foreigners for use abroad • Governments often restrict the amounts of bank funds allocated for foreign purposes.

– Foreign equity market • MNCs sell their stocks in foreign markets.

• A pool of funds from a diversified shareholder base insulates a company from the uncertainties of a single national market.

• Selling shares in foreign markets can increase the potential demand for, and thus the price of, the company’s shares.

• Still, foreign listings by U.S. MNCs have trended downward since 2000.

• Investors prefer to trade shares in the market in which they get the best price, which is typically the stock’s home market.

• Companies pay annual fees to list on foreign exchanges and thus have an incentive to delist when trading is light in foreign markets.

Chapter 12: International Financing and National Capital Markets

11

12.B National Capital Markets as International Financial Centers (5) ❑

Foreign access to domestic markets, continued – Foreign equity market, continued • Companies must meet often-stringent accounting and disclosure practices (such as in the U.S.) to be listed on a foreign exchange.

• Rule 144A allows qualified institutional investors to trade in unregistered private placements (equity and debt), attracting foreign companies that would not enter the U.S. market given the reporting requirements.

– Global shares • Shares of a non-U.S. company listed and traded in the same form on any market in the world

• Tracked in a single global registry • Traded in the home currency of each market

Chapter 12: International Financing and National Capital Markets

12

12.C Eurocurrency Market (1) ❑

Eurocurrency – a dollar (Eurodollar) or other freely convertible currency deposited in a bank outside its country of origin. (The prefix euro is not related to the euro currency.)

❑

Eurobank – a foreign bank or foreign branch of a domestic U.S. bank that accepts deposits and makes loans in foreign countries.

❑

The Eurocurrency market enables investors to hold short-term claims on commercial banks, which then act as intermediaries to transform deposits into long-term claims on final borrowers.

❑

By operating in Eurocurrencies, banks and suppliers of funds avoid certain regulatory costs and restrictions, including – Reserve requirements that lower a bank’s earning asset base;

– Special charges and taxes on domestic banking transactions; e.g.,FDIC fees; – Requirements to lend money to certain borrowers at concessionary rates; – Interest rate ceilings on deposits or loans that inhibit competition for funds; – Rules or regulations that restrict competition among banks.

Chapter 12: International Financing and National Capital Markets

13

12.C Eurocurrency Market (2) ❑

Eurodollar creation – Swedish firm Leksell AB receives a $1 million payable from a U.S. hospital 1. Deposits check

Leksell AB 2. Pays Leksell AB 3. To earn higher interest, Leksell deposits funds with Barclays Bank

Citibank New York

4. Loans funds to Ronninger SA

Barclays London

Barclays London

Owes Citibank New York +

Leksell AB +

$1 mil.

Pays

$1 mil.

Owes

Barclays London

$1 mil.

+ $1 mil.

Deposits

$1 mil. + interest

Ronninger SA + $1 mil.

$1 mil. + interest

Loans

1 million Eurodollars created Chapter 12: International Financing and National Capital Markets

14

12.C Eurocurrency Market (3) ❑

Eurocurrency market versus domestic banking operations – The Eurocurrency market involves a chain of deposits and a chain of borrowers and lenders.

• There is a chain of ownership between the original dollar depositor and the U.S. bank.

• There is a changing control over the deposit and the use to which the funds are put.

– Domestic banking operations are typically characterized by an owner of dollars depositing the dollars in a bank, with the bank controlling the use of the funds until they are withdrawn.

– The majority of Eurocurrency transactions involve transferring control of deposits from one Eurobank to another.

Chapter 12: International Financing and National Capital Markets

15

12.C Eurocurrency Market (4) ❑

Eurocurrency loans – Loans are made on a floating-rate basis, typically set at a fixed margin above LIBOR. – The bank’s spread is based on the borrower’s perceived riskiness and can range from 15 to 300 basis points.

– Maturity ranges from 3 to 10 years.

– If a loan is made by a syndicate of banks, a syndication fee of 0.25% to 2% of the loan value is charged.

– The drawdown period and repayment period vary by the borrower’s needs.

– Borrowers are mainly concerned about the effective interest rate (all-in cost) on their loans.

Chapter 12: International Financing and National Capital Markets

16

12.C Eurocurrency Market (5) ❑

Eurocurrency loans, continued – Example: compute the loan proceeds, first semiannual payment, and effective annual cost of a Eurocurrency loan • Loan = €250 million, five-year, euro-denominated Eurocurrency loan with a syndicate of banks and a syndication fee of 2.0% and interest rate of LIBOR6 (initially 5.5%) + 1.75%.

• Proceeds = €250 million – (€250 million * 0.02) = €245 million • First semiannual payment = [(0.055 + 0.0175) / 2] * €250 million = €9,062,500 • Effective annual interest rate for first six months = €9,062,500 / €245,000,000 * 2 * 100 = 7.4%

– Multicurrency clauses – the borrower has the right to switch from one currency to another on any rollover or reset date, enabling the borrower to match currencies on cash inflows and outflows based on expected exchange rate changes.

Chapter 12: International Financing and National Capital Markets

17

12.C Eurocurrency Market (6) ❑

Relationship between domestic and Eurocurrency money markets – The presence of arbitrage activities ensures a close relationship between interest rates in national and international (Eurocurrency) money markets.

– Currency controls or risk explain any substantial differences between domestic and external interest rates.

• If exchange controls are effective, the national money market can be isolated or segmented from its international counterpart.

• If future exchange controls are expected, creating the possibility that the lender or borrower will not be able to transfer funds across a border, interest rate differentials may result.

Chapter 12: International Financing and National Capital Markets

18

12.C Eurocurrency Market (7) ❑

Relationship between domestic and Eurocurrency money markets – Eurocurrency spreads are generally narrower and lower than those in domestic money markets.

• Lending rates can be lower because – Regulatory expenses that raise costs and lower returns on domestic transactions do not exist in the Eurocurrency market; – Most borrowers are well known, reducing the cost of information-gathering and credit analysis; – Eurocurrency lending is characterized by high volumes, resulting in lower margins and transaction costs; and – Eurocurrency lending often takes place out of tax-haven countries, providing higher after-tax returns.

• Deposit rates can be higher because – They must be to attract domestic deposits; – Eurobanks can afford to pay higher rates based on lower regulatory costs; – Eurobanks are not subject to the interest rate ceilings present in many countries; and

– A larger percentage of deposits can be loaned out.

Chapter 12: International Financing and National Capital Markets

19

12.D Eurobonds (1) ❑

Eurobonds are similar to public debt sold in domestic markets.

– Consist largely of fixed-rate, floating-rate, and equity-related debt.

– Self-regulated by the Association of International Bond Dealers.

❑

70% of Eurobonds are swaps

❑

The growing presence of sophisticated investors willing to arbitrage between the domestic dollar and Eurodollar bond markets has eliminated most interest disparity that once existed between domestic bonds and Eurobonds.

❑

Issues are arranged through an underwriting group and often involve more than a hundred banks for an issue as small as $25 million.

❑

About 75% of Eurobonds are dollar denominated.

Chapter 12: International Financing and National Capital Markets

20

12.D Eurobonds (2) ❑

Fixed-rate Eurobonds – Coupons are typically paid annually.

– The interest rate is the internal rate of return on the bond (the discount rate that equates the present value of future interest and principal payments to the net proceeds received).

– Conversion of annual yield to semiannual yield Semiannual yield = (1 + annual yield)1/2 - 1

– Conversion of semiannual yield to annual yield Annual yield = (1 + semiannual yield)2 - 1

Chapter 12: International Financing and National Capital Markets

21

12.D Eurobonds (3) ❑

Floating-rate Eurobonds (FRNs) – The interest rate is a fixed amount above a floating reference rate, typically LIBOR (e.g., LIBOR3 + 0.5%), and is reset at regular intervals equaling the maturity of LIBOR used (e.g., if LIBOR3 is used, interest is reset every 3 months).

– Inverse floaters – FRNs with coupons that move in the opposite direction of the reference rate (e.g., 12% - LIBOR3).

❑

Eurobond retirement – Sinking fund – requires the borrower to retire a fixed amount of bonds annually after a specified number of years.

– Purchase fund – the bonds are retired only if the market price is below the issue price.

– Call provisions give the borrower the option to retire the bonds before maturity if interest rates decline sufficiently. Eurobonds with call provisions typically require a call premium and higher interest rates.

Chapter 12: International Financing and National Capital Markets

22

12.D Eurobonds (4) ❑

Why the Eurobond market exists – The Eurobond market is largely unregulated and untaxed.

• A relatively free flow of capital among countries attracts international investors.

• MNCs can raise funds more quickly and flexibly than at home.

– Eurobonds are issued in bearer, or unregistered, form, meaning the bond owners are anonymous. ❑

The cost advantage of Eurobonds has eroded somewhat since regulatory relaxation in the U.S., Japan, and England.

– In the U.S., the shelf registration procedure enables certain companies to bypass some complex securities laws when issuing new securities.

– Rule 144A enables companies to issue bonds simultaneously in Europe and the U.S., blurring the distinction between the U.S. bond market and its Eurobond equivalent.

Chapter 12: International Financing and National Capital Markets

23

12.D Eurobonds (5) ❑

Eurobonds versus Eurocurrency loans – Cost of borrowing • Eurobonds are issued in both fixed- and floating-rate forms. Fixed-rate bonds are useful for exposure management because long-term currency inflows can be offset with known long-term outflows in the same currency.

• Eurocurrency loan interest rates are variable. When rates decline, borrower costs decline; when rates increase, borrower costs increase.

– Maturity – Eurobonds have longer maturities.

– Size of issue – the volume of Eurobond offerings exceeds that of global bank lending; sizes and prices of Eurobond financings are expanding.

Chapter 12: International Financing and National Capital Markets

24

12.D Eurobonds (6) ❑

Eurobonds versus Eurocurrency loans, continued

– Flexibility • Eurobonds – Funds are drawn down in one sum on a fixed date and repaid on a fixed schedule unless the borrower pays a prepayment penalty.

– Switching the denomination involves a costly refunding and reissuing process.

• Eurocurrency loan – The drawdown can be staggered to fit the borrower’s needs with a fee of about 0.5% per annum paid on the unused portion and can be prepaid without penalty.

– A Eurocurrency loan with a multicurrency clause enables the borrower to switch currencies on any rollover date.

– Speed • Eurocurrency market – funds can be raised in as little as two to three weeks.

• Eurobonds – financing takes more time, but the difference is becoming less significant.

Chapter 12: International Financing and National Capital Markets

25

12.D Eurobonds (7) ❑

Euronotes – Note issuance facility (NIF) – a low-cost substitute for syndicated credits that allows borrowers to issue their own short-term Euronotes.

– NIFs have features of both the U.S. commercial paper market and U.S. commercial lines of credit.

• Like commercial paper, notes under NIFs are unsecured, short-term debt (also known as Euro-commercial paper or Euro-CP) generally issued by MNCs with excellent credit ratings.

• Like lines of credit, NIFs generally include multiple pricing components for various contract features, including a market-based interest rate and participation, facility, and underwriting fees.

– Revolving underwriting facility (RUF) – a NIF that includes underwriting services and gives borrowers long-term continuous access to shortterm money underwritten by banks at a fixed rate.

Chapter 12: International Financing and National Capital Markets

26

12.D Eurobonds (8) ❑

Euronotes, continued – Euronote pricing • In lieu of a coupon rate, Euronotes are sold at a discount from face value.

• The yield is usually quoted on a discount basis from its face value.

– Euro-medium term notes (Euro-MTNs) • Can be offered in small amounts; in different maturities, currencies, seniority, and security; and on a daily basis.

• Issuers can thus take advantage of changes in the yield curve and of changing investor needs.

• Maturities are typically from 5 to 30 years. However, increasing issues with maturities of less than one year are negatively impacting the Euro-CP market.

• Euro-MTNs are typically underwritten in batches of more than $50 million.

Chapter 12: International Financing and National Capital Markets

27

12.E Asiacurrency (Asiadollar) Market ❑

Located in Singapore due to relaxed financial controls and taxes.

❑

Primary economic functions – Channel investment dollars to rapidly growing Southeast Asian countries – Provide deposit facilities for investors with excess funds

❑

Dragon bond – Asiabond counterpart to the Asiadollar market.

– Denominated in a foreign currency, usually dollars, but launched, priced, and traded in Asia.

– The market has slumped because Asian borrowers with good international credit ratings can raise funds with longer maturities and at lower cost in Europe or the U.S.

Chapter 12: International Financing and National Capital Markets

28

12.F Project Finance (1) ❑

Project finance – raising funds to finance an economically separable capital investment project in which the providers of the funds use the cash flow from the project to service their loans and provide the return of and a return on their equity investment in the project

❑

The ownership vehicle for a project is a single-purpose corporation that is legally independent of its sponsors.

❑

Key attributes of project finance – Focuses on the economically separable nature of investment projects suitable for project financing, such as power plants or pipelines.

– Because projects are set up as legally independent entities, nonrecourse lenders have resort only to project assets and cash flows.

– The underlying assets are large, illiquid industrial assets.

– At the end of a project, all debt and equity investors are paid.

Chapter 12: International Financing and National Capital Markets

29

12.F Project Finance (2) ❑

Project finance shields the parent from financial obligations and risks associated with the project, and the project from problems the parent may have.

❑

Lenders factor in a greater degree of risk because the parent is not legally responsible for the project.

❑

Thus, the cost of project financing exceeds the parent’s cost of borrowing.

❑

The net benefit stems from the ability of project finance to resolve agency problems, reduce taxes and the costs of financial distress, and facilitate risk management.

– Credit risk analysis is performed on the project only, and not on the parent.

– The ability to exploit special tax holidays, tax rate reductions, and reduce royalty payments may result in reductions in corporate taxes.

– The careful alignment of risks and returns with those best able to bear them improves incentives and increases the likelihood that the project will be operated with maximum efficiency.

Chapter 12: International Financing and National Capital Markets

30

Chapter 13

International Portfolio Investment

Chapter 13 Outline A. Risks and Benefits of International Equity Investing B. International Bond Investing C. Optimal International Asset Allocation

D. Measuring the Total Return from Foreign Portfolio Investing E. Measuring Exchange Risk on Foreign Securities

Chapter 13: International Portfolio Investment

1

13.A Risks and Benefits of International Equity Investing (1) ❑

Risks to international investing – Changes in currency exchange rate – dividends received on or proceeds from the sale of international investments may be reduced or increased when the dividends or proceeds are converted into dollars.

– Currency controls may restrict or delay an investor’s ability to move currency out of a country.

– Dramatic changes in foreign market value – Political, economic, and social events influence foreign markets.

– Lack of liquidity – foreign markets may have lower trading volumes, fewer listed companies, abbreviated hours of operation, and restrictions on the amount and type of stocks investors may purchase.

– Less information – Disclosure policies are often more lax in foreign countries than in the U.S.

Chapter 13: International Portfolio Investment

2

13.A Risks and Benefits of International Equity Investing (2) ❑

Risk to international investing, continued – Legal recourse – even if investors have legal recourse in the U.S., judgments may not be enforceable in foreign countries. Thus, investors may have to rely on the legal system of the foreign company’s home country.

– Different market operations • Foreign markets may have different periods for clearance and settlement and may not report stock trades as quickly as U.S. markets.

• Shares may not be protected if the custodian bank has credit problems.

❑

Benefit to international investing – International investments offer greater opportunities than domestic investments.

• More than half the world’s market capitalization is in non-U.S. companies.

• Most global manufacturers are overseas.

• More than 80% of all cars, 85% of all stereos, and 99% of 35mm cameras are produced abroad.

Chapter 13: International Portfolio Investment

3

13.A Risks and Benefits of International Equity Investing (3) ❑

International diversification – Basic rule of portfolio diversification – the broader the diversification, the more stable the returns and the more diffuse the risks.

– The expanded universe of international securities implies the possibility of achieving a better risk-return tradeoff than investing solely in U.S. securities.

– While nearly 75% of investment risk can be eliminated in a fully diversified U.S. portfolio, all companies in a country are subject to the same cyclical economic fluctuations (systematic risk), which cannot be diversified out.

– By diversifying across countries whose economic cycles are not perfectly aligned (e.g., an oil price shock that hurts the U.S. economy helps oil-exporting countries), investors may further reduce risk by diversifying out some systematic risk.

Chapter 13: International Portfolio Investment

4

13.A Risks and Benefits of International Equity Investing (4) ❑

International diversification, continued – Annualized returns and standard deviations of returns for various developed and emerging stock markets from 1988 to 2006 indicate that emerging markets generally have higher risks and returns than developed markets.

– The Morgan Stanley Capital International (MSCI) Europe, Australia, Far East (EAFE) Index (reflecting the 20 major stock markets outside the U.S.) has had lower risk than most of its individual country components.

– The MSCI World Index (which combines EAFE countries with North America), has lower risk than any of its components except for the U.S.

Chapter 13: International Portfolio Investment

5

13.A Risks and Benefits of International Equity Investing (5) ❑

International diversification, continued – Domestic diversification reduces unsystematic risk, and international diversification reduces both unsystematic and systematic risk.

Total Risk 100%

U.S. domestic portfolio ~10% difference in risk reduction

International portfolio Number of Stocks 50

Chapter 13: International Portfolio Investment

6

13.A Risks and Benefits of International Equity Investing (6) ❑

Correlations and gains from diversification – Foreign market betas measure market risk relative to the U.S. market (i.e., U.S. market beta = 1.00)

Foreign Market Beta =

Correlation with U.S. market *

Standard deviation of foreign market Standard deviation of U.S. market

– Market risk is also computed from a world perspective, whereby the correlations are computed relative to the world index.

– High correlations (e.g., Canada-U.S. correlation of 0.72) indicate that the markets of the correlated countries move fairly synchronously.

– Low correlations (e.g., Austria-U.S. correlation of 0.19) indicate that markets of the correlated countries move largely independently of each other.

Chapter 13: International Portfolio Investment

7

13.A Risks and Benefits of International Equity Investing (7) ❑

Correlations and gains from diversification, continued – Efficient frontier – the set of portfolios with the smallest possible standard deviations for their levels of expected returns and the maximum expected returns for a given level of risk.

– International diversification pushes out (enhances) the efficient frontier.

Expected Return • Portfolio B has the same expected return as Portfolio A but lower risk • Portfolio C has the same risk as Portfolio A but a higher expected return • Portfolio D has both a higher expected return and lower risk than Portfolio A

Chapter 13: International Portfolio Investment

Efficient frontier for U.S./foreign stock portfolios

C D

Efficient frontier for U.S. stock portfolios

B A

Standard Deviation 8

13.A Risks and Benefits of International Equity Investing (8) ❑

Correlations and gains from diversification, continued – Estimating the benefits of an international portfolio • Let  = fraction invested in U.S. stocks; 1 –  = fraction invested in foreign stocks • rus = expected return on U.S. stocks; rrw = expected return on international stocks • σus = standard deviation on U.S. stocks; σrw = standard deviation on international stocks • and us,rw = correlation between returns on the U.S. and international portfolios

– Return on an international portfolio rp = Rp = rus + (1 – )rrw – Risk on an international portfolio σp = 2

2

σp = [ σus + (1 – )2σrw + 2(1 – a)σusσrwus,rw]1/2 Chapter 13: International Portfolio Investment

9

13.A Risks and Benefits of International Equity Investing (9) ❑

Correlations and gains from diversification, continued – Example • Assume equal weights of U.S. and international stocks ( = 0.5) • Let EAFE Index represent foreign stock portfolio • σus = 15.16%; σrw = 16.43%; us,rw = 0.50

– Risk on an international portfolio σ p = σp = [0.52 (15.16)2 + (1 – 0.5)2 (16.43)2 + 2(0.5)(0.5) * 15.16 * 16.43 * 0.50]1/2

= [187.212]1/2 = 13.68% – Thus, diversifying internationally reduces risk by ~10% ((13.68 - 15.16)/15.16 = -9.8%).

Chapter 13: International Portfolio Investment

10

13.A Risks and Benefits of International Equity Investing (10) ❑

Correlations and gains from diversification, continued – Benefits of diversification depend on relatively low correlations among assets.

• Experts assume that as their underlying economies become more closely integrated and cross-border financial flows accelerate, national capital markets will become more highly correlated, thus reducing the benefits (reductions in systematic risk) of international diversification.

• Empirical evidence supports this assumption.

– The correlations between the U.S. and non-U.S. stock markets are generally higher today than they were during the 1970s.

– The correlation between the EAFE Index and the U.S. market increased from about 0.4 in the mid-1990s to about 0.84 in 2006.

• As markets decline, correlations appear to increase as market volatility increases, reducing the benefits of international diversification.

• Benefits still exist, particularly for long-term investors.

Chapter 13: International Portfolio Investment

11

13.A Risks and Benefits of International Equity Investing (11) ❑

Investing in emerging markets – Emerging markets with volatile economic and political prospects offer the greatest degree of diversification and highest expected returns.

– High returns come with high risk.

– Despite high risk, emerging markets reduce portfolio risk because of their low correlations with returns in developed markets (even though correlations are rising over time).

• Shifting to a portfolio 100% invested in the MSCI World Index to one containing up to 10% invested in the IFC Emerging Markets Index reduces risk while simultaneously increasing expected return.

• Beyond a 10% investment, risk increases.

• Thus, even if emerging markets are not expected to outperform developed country markets, risk reduction would dictate an investment of up to 10% in emerging markets.

– Caveat – the IFC database does not include emerging markets that fail to reach a certain threshold of capitalization. Thus, the IFC Index is biased against low-return markets.

Chapter 13: International Portfolio Investment

12

13.A Risks and Benefits of International Equity Investing (12) ❑

Barriers to international diversification – Benefits of international diversification will be limited because of barriers to investing overseas.

– Barriers include • Lack of liquidity • Currency controls • Tax regulations • Relatively less-developed capital markets abroad • Exchange risk • Lack of readily accessible and comparable information on foreign securities

• Home bias

– Home bias – the vast majority of U.S. investor portfolios consists of domestic stocks. The same bias applies to foreign investors.

Chapter 13: International Portfolio Investment

13

13.A Risks and Benefits of International Equity Investing (13) ❑

Barriers to international diversification, continued – How to diversify into foreign securities • Some foreign firms (< 100) are listed on the New York Stock Exchange or American Stock Exchange.

• Buy U.S.-traded foreign stocks in the form of American depository receipts (ADRs) – Negotiable certificates issued by U.S. banks evidencing ownership of ADSs. – ADS – a dollar-denominated security representing foreign company shares held for the ADS owner by a custodian bank in the issuing company’s home country.

Proof of ownership

Represents

ADR

ADS

Issued by U.S. bank

Held by custodian bank in issuing company’s home country

Shares of foreign stock

– ADR investors absorb handling costs through transfer and handling charges.

– ADRs eliminate custodian safekeeping charges in the issuer’s home country, reduce settlement delays, and facilitate prompt dividend payments.

Chapter 13: International Portfolio Investment

14

13.A Risks and Benefits of International Equity Investing (14) ❑

Barriers to international diversification, continued – How to diversify into foreign securities, continued • Buy global depository receipts (GDRs) – Similar to ADRs but generally traded on two or more markets outside the foreign issuer’s home market.

– Generally structured as a combination of a Rule 144A ADR (which trades in the U.S. private placement market and can be sold only to qualified institutional buyers) and a public offering outside the U.S. – Enable foreign companies to raise capital in two or more markets simultaneously and broaden their shareholder bases.

• Buy global depository shares (GDSs, or global shares) – Similar to an ordinary share but traded on any stock exchange in the world where it is registered and in the local currency.

– Less expensive to trade than ADRs. – Currently only four global share issues – DaimlerChrysler, Celanese, UBS, and Deutsche Bank.

Chapter 13: International Portfolio Investment

15

13.A Risks and Benefits of International Equity Investing (15) ❑

Barriers to international diversification, continued – How to diversify into foreign securities, continued • The easiest way to invest abroad is to buy shares in an internationally diversified mutual fund. Four basic categories: – Global funds – invest anywhere in the world, including the U.S. – International funds – invest only outside the U.S. – Regional funds – focus on specific geographical areas overseas, such as Asia or Europe.

– Single-country funds – invest in individual countries, such as Germany or Taiwan.

• Greater diversification of the global and international funds reduces risk but also reduces the chance of high returns should a single country’s market increase substantially.

Chapter 13: International Portfolio Investment

16

13.B International Bond Investing (1) ❑

Research indicates that bond portfolios benefit from international diversification.

– A portfolio fully invested in U.S. bonds is replaced in increments of 10% with a mixture of foreign bonds from 7 markets.

– Ten portfolios were created over 1973-1983 and risk-returns computed.

– Conclusions • As the proportion of U.S. bonds fell, portfolio returns rose; foreign bonds outperformed U.S. bonds over the period.

• As the proportion of U.S. bonds fell from 100% to 70%, volatility fell; correlation between U.S. and foreign bond returns was low over the period.

• By investing up to 60% in foreign bonds, U.S. investors could have raised their returns substantially while not increasing risk above the level associated with holding only U.S. bonds.

– Other studies have lead to similar findings.

Chapter 13: International Portfolio Investment

17

13.B International Bond Investing (2) ❑

Research indicates that bond portfolios benefit from international diversification, continued.

100% U.S. Bonds

Higher returns

U.S. + Foreign Bonds

100% U.S. Bonds

Lower volatility

70% U.S. Bonds

100% U.S. Bonds

Chapter 13: International Portfolio Investment

Substantially higher returns;

No increase in volatility

Up to 60% Foreign Bonds

18

13.C Optimal International Asset Allocation (1) ❑

Research indicates that expanding investments to include domestic and foreign stocks and bonds provides benefits.

– Performances of various investment strategies were compared over the period 1970-1980.

– Conclusions • International stock diversification yields a substantially better risk-return tradeoff than does holding only domestic stock.

• International diversification combining stock and bond investments results in substantially less risk than international stock diversification alone.

• A substantial improvement in the risk-return tradeoff can be realized by investing in internationally diversified stock and bond portfolios whose weights do not conform to relative market capitalizations (i.e., market indices used to measure world stock and bond portfolios do not lie on the efficient frontier).

Chapter 13: International Portfolio Investment

19

13.C Optimal International Asset Allocation (2) ❑

Research indicates that expanding investments to include domestic and foreign stocks and bonds provides benefits, continued.

100% U.S. Stocks

100% U.S. and Foreign Stocks

Weights conform to market indices that do not lie on the efficient frontier

Chapter 13: International Portfolio Investment

Higher riskreturn tradeoff

Lower volatility

Substantial risk-return improvement

U.S. + Foreign Stocks

U.S. and Foreign Stocks and Bonds

Weights do not conform to market indices that do not lie on the efficient frontier

20

13.D Measuring Total Return from Foreign Portfolio Investing (1) ❑

Total dollar return can be divided into 3 elements: – Dividend/interest income – Capital gains/losses – Currency gains/losses

❑

Bonds – One-period total dollar return R$ is computed as R$ = Foreign Currency Return * Currency Gain/Loss - 1

=

R$ = [1 +

B(1) – B(0) + C

] (1 + g) - 1

B(0)

– Where • B(t) = foreign currency (FC) bond price at time t • C = FC coupon income • g = percent change in dollar value of foreign currency Chapter 13: International Portfolio Investment

21

13.D Measuring Total Return from Foreign Portfolio Investing (2) ❑

Bonds, continued – Example: Compute R$ given the following: • B(0) = 95; C = 8; B(1) = 97 • Local currency appreciates by 3% against the dollar over period

R$ = [1 +

=

97 – 95 + 9

] (1 + 0.03) - 1

95

(1.105) * (1.03) – 1 = 13.8%

FC return Currency gain/loss

Chapter 13: International Portfolio Investment

22

13.D Measuring Total Return from Foreign Portfolio Investing (3) ❑

Stocks – One-period total dollar return R$ is computed as R$ = Foreign Currency Return * Currency Gain/Loss - 1

=

R$ = [1 +

P(1) – P(0) + DIV

] (1 + g) - 1

P(0)

– Where • P(t) = foreign currency (FC) stock price at time t • DIV = FC dividend income • g = percent change in dollar value of foreign currency

Chapter 13: International Portfolio Investment

23

13.D Measuring Total Return from Foreign Portfolio Investing (4) ❑

Stocks, continued – Example: Compute R$ given the following: • P(0) = 50; DIV = 1; P(1) = 48 • Local currency depreciates by 5% against the dollar over period

R$ = [1 +

=

48 – 50 + 1

] (1 + 0.05) - 1

50

(1.98) * (0.95) – 1 = -6.9%

Chapter 13: International Portfolio Investment

24

13.E Measuring Exchange Risk on Foreign Securities (1) ❑

R$ can be approximated as R$ ≈ Rf + g

❑

σ$, the standard deviation of R$, can be written as 2

2

σ$ = [σf + σg + 2σfσgf,g]1/2 – Where •

σf2 = variance of the FC return

• σg2 = variance of the change in the exchange rate

 f,g = correlation between FC return and exchange rate change ❑

Example: Compute σ$ given the following: – σf = 23%; σg = 17%; f,g= 0.31 σ$ = [232 + 172 + 2 * 23 * 17 * 0.31]1/2 = 32.56%

Chapter 13: International Portfolio Investment

25

13.E Measuring Exchange Risk on Foreign Securities (2) ❑

Hedging currency risk – Stock portfolios • During 1980-1985, the dollar was rising, and during 1986-1996, the dollar was generally falling.

• Over the period 1980-1985, risk-adjusted returns on hedged stock portfolios exceeded those on unhedged portfolios.

• Over the period 1986-1996, this result reversed.

• The reversal occurred because of changes over time in the standard deviations and correlation coefficients of national stock market returns expressed in dollars.

– Bond portfolios • The returns on hedged, internationally diversified bond portfolios exhibited lower volatility than the returns on unhedged bond portfolios over both above-discussed periods.

• However, the lower standard deviation of hedged bond returns is generally matched by lower returns.

Chapter 13: International Portfolio Investment

26

Chapter 14

Capital Budgeting for the Multinational Corporation

Chapter 14 Outline A. Capital Budgeting B. Discount Rates for Foreign Investments C. Issues in Foreign Investment Analysis

D. Establishing a Worldwide Capital Structure

Chapter 14: Capital Budgeting for the Multinational Corporation

1

14.A Capital Budgeting (1) ❑

Capital budgeting – the process of selecting the prospective capital investments that maximize an MNC’s shareholder value.

❑

A project’s net present value determines the project’s effect on shareholder value.

❑

Net present value (NPV) – the present value of future cash flows discounted at the project’s cost of capital less the initial investment. n

NPV = -I0 + 

– Where

Xt

t=1 (1 + k)t

• I0 = initial investment • Xt = net cash flow in period t • k = cost of capital (also known as weighted average cost of capital, or WACC) • n = investment horizon

– Only projects with positive NPV should be accepted.

– If two projects are mutually exclusive, the project with the higher NPV should be accepted.

Chapter 14: Capital Budgeting for the Multinational Corporation

2

14.A Capital Budgeting (2) ❑

❑

Example – compute NPV of a plant expansion project. Assume n = 3 and k = 10% t

0

1

2

3

Xt

-$4,000,000

$1,200,000

$2,700,000

$2,700,000

k

1.00

1.10

(1.10)2

(1.10)3

Present Value

-$4,000,000

$1,091,000

$2,231,000

$2,029,000

Cumulative Present Value

-$4,000,000

-$2,909,000

-$678,000

$1,351,000 $1,351,000 NPV

The project has a positive NPV and is thus acceptable.

Chapter 14: Capital Budgeting for the Multinational Corporation

3

14.A Capital Budgeting (3) ❑

Incremental cash flows – incremental cash flows may differ from total cash flows for a number of reasons.

1. Cannibalization 2. Sales creation 3. Opportunity cost

4. Transfer pricing 5. Fees and royalties 6. Getting the base case right 7. Accounting for intangible benefits ❑

The impact of each of these factors on cash flows must be considered in determining the project’s viability.

Chapter 14: Capital Budgeting for the Multinational Corporation

4

14.A Capital Budgeting (4) 1.

2.

Cannibalization –

A company’s new product steals sales from its earlier models.

–

A firm builds a plant overseas and substitutes foreign production for parent company exports.

–

To the extent that sales of a new product or plant replace existing corporate sales, the new project’s estimated profits must be reduced by the earnings on the lost sales.

–

The relevant measure of cannibalism for capital budgeting purposes is the lost profit on lost sales that would not otherwise have been lost had the new project not been undertaken.

Sales creation –

The opposite of cannibalization – a new project creates additional sales for existing products.

–

The new project’s estimated profits must be increased by the additional sales created by the project.

Chapter 14: Capital Budgeting for the Multinational Corporation

5

14.A Capital Budgeting (5) 3.

4.

Opportunity cost –

Project costs must include the true economic cost of any resource required for the project, regardless of whether the firm already owns the resource or acquires it just for the project.

–

The opportunity cost – that is, the maximum amount of cash the asset could generate for the firm should it be sold or put to some other productive use – must be included in computing the value of undertaking the project.

Transfer pricing –

If an MNC’s new domestic plant will supply parts to its foreign subsidiary, it can increase the apparent profitability of the new plant by increasing the transfer price to the subsidiary, and vice versa.

–

Thus, the transfer prices at which goods and services are traded internally can significantly distort the profitability of a proposed investment.

–

Where possible, prices used to evaluate project inputs or outputs should reflect market prices.

Chapter 14: Capital Budgeting for the Multinational Corporation

6

14.A Capital Budgeting (6) 5.

6.

Fees and royalties –

An MNC often charges fees and royalties to a project to cover various items such as legal counsel, power, lighting, heating, rent, R&D, headquarters staff, management costs, etc.

–

While fees and royalties are costs to the project, they are a benefit from the parent’s perspective.

–

The project should be charged only for additional expenses attributable to the project and not for overhead expenses unaffected by the project.

Getting the base case right –

Generally, a project’s incremental cash flows can be found only by subtracting worldwide corporate cash flows without the investment (the base case) from postinvestment corporate cash flows.

–

Getting the base case right requires correctly determining what will happen if the firm does not make the investment.

–

Toward this end, understanding the competitive landscape is critical.

• E.g., a firm may forgo investing in a new product for fear of cannibalization, only to create a profitable niche for another company to exploit.

Chapter 14: Capital Budgeting for the Multinational Corporation

7

14.A Capital Budgeting (7) 7.

Accounting for intangible benefits –

Intangible assets include better quality, faster time to market, quicker and more efficient order processing, learning curve, knowledge, and higher customer satisfaction, among other things.

–

Intangible assets have a very tangible impact on cash flows.

–

Thus, while intangible benefits from a project cannot be measured precisely, they must be included in the capital-budgeting process.

Chapter 14: Capital Budgeting for the Multinational Corporation

8

14.B Discount Rates for Foreign Investments ❑

For capital budgeting purposes, the cost of capital k0 (also known as weighted average cost of capital, or WACC) is the required return for the project. k0 = (1 – L)ke + Lkd(1 – t)

– Where • L = parent’s debt ratio (debt to total assets) • ke= project’s cost of equity capital • kd = project’s cost of debt • t = tax rate

– A project’s estimated cash flows are discounted by k0 to determine its NPV. – Because a project’s risk may be different than the MNC’s risk, the project’s own cost of capital must be used to compute NPV.

Chapter 14: Capital Budgeting for the Multinational Corporation

9

14.B.i Discount Rates for Foreign Investments: Cost of Equity Capital (1) ❑

Cost of equity capital ke – The minimum rate of return necessary to induce investors to buy or hold the firm’s stock, consisting of a basic yield to cover time value and a risk premium to account for the specific risk of the project.

– The rate used to capitalize total corporate cash flows – the conceptually preferred definition, as ke is a function of the riskiness of the activities in which a firm is engaged, rather than of the riskiness of the firm itself. ❑

ke is defined as ri, the expected return on asset i, by the capital asset pricing model (CAPM): ri = rf + βi(rm – rf)

– Where • rf = rate of return on a risk-free asset (usually a U.S. Treasury bill or bond) • βi = the systematic or nondiversifiable risk of the asset • rm = expected return on the market portfolio consisting of all risky assets • rm – rf = the market risk premium (MRP) Chapter 14: Capital Budgeting for the Multinational Corporation

10

14.B.i Discount Rates for Foreign Investments: Cost of Equity Capital (2) ❑

The CAPM is based on the notion that intelligent, risk-averse shareholders will seek to diversify their risks; thus, the only risk that will be rewarded with a risk premium is systematic risk.

❑

A project’s systematic risk is measured by βi: βi =

i,mσi

σm

– Where •

i,m = correlation between returns on project i and the market portfolio

• σi = standard deviation of returns on project i • σm = standard deviation of returns on the market portfolio

Chapter 14: Capital Budgeting for the Multinational Corporation

11

14.B.i Discount Rates for Foreign Investments: Cost of Equity Capital (3) ❑

Much of the systematic risk affecting a company is related to the cyclical nature of the national economy in which the company is domiciled.

❑

The returns on a project located in a foreign country whose economy is not synchronous with the home country’s economy should be less correlated with domestic market returns than the returns on a comparable domestic project.

❑

In this case, a project’s systematic risk may be lower than that of a comparable domestic project.

❑

The project risk premium is represented by βi multiplied by the MRP. Risk premiumi = βi(rm – rf)

❑

When the returns and financial structure of a proposed investment are expected to be similar to those of a firm’s typical investment, the corporate ri may serve as a proxy for the project’s ri.

Chapter 14: Capital Budgeting for the Multinational Corporation

12

14.B.i Discount Rates for Foreign Investments: Cost of Equity Capital (4) ❑

Less developed countries (LDCs) may provide the largest diversification benefits (lower systematic risk) despite high political risk because their economies are less correlated with the U.S. or other Western economy.

❑

Conversely, diversification benefits from investing in developed countries diminish because of their high correlations.

Investment in

Developed Country Investment in

Low correlation increases diversification benefits

LDC

High correlation decreases diversification benefits

Developed Country

Chapter 14: Capital Budgeting for the Multinational Corporation

13

14.B.i Discount Rates for Foreign Investments: Cost of Equity Capital (5) ❑

While the ratio of systematic risk to total risk in LDCs is generally very low, systematic risk in LDCs is probably not significantly lower than that in developed countries.

❑

Even given a low correlation to the world economy, systematic risk for a project located in an LDC could be large.

– E.g., extraction (mining) projects rely on prices set in the world market.

– Worldwide demand is systematically related to the state of the world economy.

❑

Conversely, a market-oriented project in an LDC, whose risk depends largely on the evolution of the local market, will likely have systematic risk that is small in both relative and absolute terms.

Chapter 14: Capital Budgeting for the Multinational Corporation

14

14.B.i Discount Rates for Foreign Investments: Cost of Equity Capital (6) ❑

To the extent an MNC can provide low-cost international diversification, investors may be willing to accept a lower rate of return on shares of MNCs than on shares of single-country firms – i.e., the required return on foreign projects may be less than the required return on comparable domestic projects.

❑

If individual investors can accomplish international portfolio diversification as easily and cheaply, the discount rate would not be reduced further to reflect investors’ willingness to pay a premium for the indirect diversification provided by an MNC’s shares.

Single-Country Firm

Internationally Diversified MNC

Investment choice is singlecountry firm or MNC: Investors may accept a lower return on MNC shares Chapter 14: Capital Budgeting for the Multinational Corporation

Internationally Diversified Portfolio of Stocks

Investment choice is international portfolio or MNC: Investors may not accept a lower return on MNC shares 15

14.B.i Discount Rates for Foreign Investments: Cost of Equity Capital (7) ❑

Key issues in estimating ri – The information needed to estimate βi directly – i.e., a history of past subsidiary returns or future subsidiary returns relative to predicted market returns – does not exist.

– Thus, an MNC must find publicly traded firms that share similar risk characteristics and use the average beta for the portfolio of corporate surrogates to proxy for βi.

– This process requires answering four key questions: 1. Should the proxies be U.S. or local?

•

Local companies provide a better indication of risk but may not exist.

•

U.S. proxies and accessible information exist, but their betas may be very different than those of foreign subsidiaries.

Chapter 14: Capital Budgeting for the Multinational Corporation

16

14.B.i Discount Rates for Foreign Investments: Cost of Equity Capital (8) ❑

Key issues in estimating foreign project discount rates, continued – Four key questions, continued: 2. Is the relevant base portfolio against which the proxy betas are estimated the U.S. market portfolio, the local portfolio, or the world market portfolio?

•

A risk that is systematic in the context of the local market may be diversifiable in the context of the U.S. or world portfolio.

•

In this case, using the local market portfolio will result in a higher required return.

3. Should the MRP be based on the U.S. market or the local market?

•

The local MRP is the MRP demanded by investors on investments in that market.

•

Estimates of the local MRP may be subject to statistical error or irrelevant to the extent that an MNC’s investors are not the same as investors in the local market, and the two sets of investors measure risk differently.

Chapter 14: Capital Budgeting for the Multinational Corporation

17

14.B.i Discount Rates for Foreign Investments: Cost of Equity Capital (9) ❑

Key issues in estimating foreign project discount rates, continued – Four key questions, continued: 4. How, if at all, should country risk be incorporated into the cost of capital estimates?

•

A recently adopted approach is to add a country risk premium to the discount rate.

•

Adding a country risk premium may result in double counting risks.

– Estimating proxy betas – 3 alternatives in order of preference 1. Use local companies – Because the returns on an MNC’s local operations depend on the local economy, the degree of systematic risk for a foreign project may be lower than that of comparable U.S. companies.

– Using U.S companies and their returns to proxy for the returns of a foreign project will likely lead to an upward-biased estimate of the MRP. Chapter 14: Capital Budgeting for the Multinational Corporation

18

14.B.i Discount Rates for Foreign Investments: Cost of Equity Capital (10) ❑

Key issues in estimating foreign project discount rates, continued – Estimating proxy betas – 3 alternatives in order of preference, continued 2. Use an industry in the local market whose U.S. industry beta is similar to that of the project’s U.S. industry beta.

3. Use an adjusted U.S. industry beta – compute the U.S. industry beta for the project and multiply it by the foreign market beta relative to the U.S. index.

– Relevant base portfolio • The relevant base portfolio against which to estimate proxy betas can be the home portfolio or the global market portfolio.

• If capital markets are seen as globally integrated, use the global market portfolio.

• CAPM becomes the global CAPM: ri = rf + βig(rg – rf) • Where – βig = project beta measured relative to the global market – rg = expected return on the global market Chapter 14: Capital Budgeting for the Multinational Corporation

19

14.B.i Discount Rates for Foreign Investments: Cost of Equity Capital (11) ❑

Key issues in estimating foreign project discount rates, continued – Relevant base portfolio, continued • Using the global CAPM, βig is computed as

βig =

i,gσif σg

• Where – i,g = correlation between returns on project i and the global portfolio – σf = standard deviation of returns on foreign project i – σg = standard deviation of returns on the global portfolio

Chapter 14: Capital Budgeting for the Multinational Corporation

20

14.B.i Discount Rates for Foreign Investments: Cost of Equity Capital (12) ❑

Key issues in estimating foreign project discount rates, continued – Relevant base portfolio, continued • If capital markets are not seen as globally integrated, use the home market portfolio.

• For a U.S. MNC, CAPM becomes ri = rf + βius(rus – rf) • Where – βius = project beta measured relative to the U.S. market – rus = expected return on the U.S. market portfolio • Capital markets are now integrated to a great extent and are expected to become more integrated over time. Government regulations and other market imperfections have been barriers to total global integration.

Chapter 14: Capital Budgeting for the Multinational Corporation

21

14.B.i Discount Rates for Foreign Investments: Cost of Equity Capital (13) ❑

Key issues in estimating foreign project discount rates, continued – Relevant base portfolio, continued •

Implications of global CAPM for MNCs – Other things equal, the use of a global CAPM means a lower cost of capital because the MRP will be lower.

• As long as the domestic economy is less than perfectly correlated with the world economy, βig will be less when measured against the global portfolio than when measured against the domestic portfolio.

• Risk that is systematic in the context of the U.S. economy may be unsystematic in the context of the global economy; thus, investors able to diversify internationally will demand a lower risk premium.

• Reducing total risk can increase a firm’s cash flows – by operating in a number of countries, an MNC can trade off negative swings in some countries against positive swings in other countries.

Chapter 14: Capital Budgeting for the Multinational Corporation

22

14.B.i Discount Rates for Foreign Investments: Cost of Equity Capital (14) ❑

Relevant market risk premium –

The U.S. MRP is recommended because • The U.S. MRP is likely to be demanded by a U.S. MNC’s mostly American investors; • The betas for foreign subsidiaries are estimated relative to the U.S. market;

• The quality, quantity, and time span of U.S. capital market data are the best in the world and thus increase the statistical validity of the estimated MRP.

–

Even if the market price per unit of risk is uniform worldwide, the MRP may differ across countries because market risk itself differs across countries.

–

When computing foreign MRPs, adjust the U.S. MRP for differences in risk on a market-by-market basis, as follows: MRPf = MRPus

σf σus

• Where – MRPus = U.S. market risk premium – σf = standard deviation of returns on foreign market portfolio – σus = standard deviation of returns on the U.S. market portfolio Chapter 14: Capital Budgeting for the Multinational Corporation

23

14.B.ii Discount Rates for Foreign Investments: Cost of Debt ❑

Cost of debt kd – the dollar costs of foreign currency debt, which include the interest rate, currency gains/losses, and tax effects, computed as kd = rL(1 + c)(1 – ta) + c

– Where • rL= interest rate on foreign debt • c = exchange gain/loss, computed as (e1 – e0) / e0 • ta = project’s marginal tax rate

– Example: the French subsidiary of a U.S. MNC borrows €10 million for one year • rL = 7% • e0 = $1.34; e1 = $1.30; c = (1.30 – 1.34) / 1.34 = -2.99% • ta = 40% kd = 0.07(1 -0.0299)(1 – 0.40) – 0.0299 = 1.09%

Chapter 14: Capital Budgeting for the Multinational Corporation

24

14.B.iii Discount Rates for Foreign Investments: Weighted Average Cost of Capital (WACC) (1) ❑

Using ke and kd, we compute WACC k0 as k0 = (1 – L)ke + Lkd(1 – t) *

–

Where L = the parent’s debt ratio

❑

The debt ratio must be based on the proportion of the MNC’s capital structure accounted for by each source of capital using market – and not book – values.

❑

The debt ratio to be used must reflect the firm’s target capital structure, and not its historic capital structure.

❑

When project risk and capital structure differ from those of the parent, k0 = k0’. k0’ = (1 – L’)ke’ + Lkd’(1 – t)

*This equation assumes a pretax kd. If kd is computed after taxes, as in the previous slide, we omit (1-t): k0 = (1 – L)ke + Lkd Chapter 14: Capital Budgeting for the Multinational Corporation

25

14.B.iii Discount Rates for Foreign Investments: Weighted Average Cost of Capital (WACC) (2) ❑

Example: Compute and compare k0 and k0’ – An MNC planning for a foreign investment has a 40% debt ratio, ke of 14%, and after-tax kd of 6%. k0 = (1 – 0.40)0.14 + 0.40*0.06 = 10.8%

– The MNC’s foreign investment can support only a 30% debt ratio and, given the project’s high degree of risk, ke of 16% and after-tax kd of 6%. k0’ = (1 – 0.30)0.16 + 0.30*0.08 = 13.6%

Chapter 14: Capital Budgeting for the Multinational Corporation

26

14.C. Issues in Foreign Investment Analysis (1) ❑

Evaluating project cash flows – Tax regulations and exchange controls can create substantial differences in a project’s cash flow and the amount remitted to the parent.

– Project expenses such as management fees and royalties are returns to the parent.

– Incremental revenue contributed to the parent can differ from total project revenue. ❑

Economic theory states that the value of a project is determined by the NPV of future cash flows to the investor.

❑

Thus, the parent should value only those cash flows repatriated net of transfer costs.

Chapter 14: Capital Budgeting for the Multinational Corporation

27

14.C. Issues in Foreign Investment Analysis (2) ❑

Evaluating project cash flows, continued – Three-step approach to project evaluation 1. Estimate project cash flows from the project’s standpoint.

2. Forecast the amounts, timing, and form of transfers, as well as taxes and other expenses incurred in the transfer process, to the parent.

3. Consider the indirect benefits and costs of the project.

– Estimating incremental project cash flows •

Subtract worldwide parent cash flows (without the investment) from postinvestment parent cash flows.

– Adjust for transfer pricing and fees and royalties • Use market costs/prices for goods, services, and transfer prices.

• Add back fees and royalties because they are benefits to the parent.

• Remove the fixed portions of costs such as corporate overhead.

Chapter 14: Capital Budgeting for the Multinational Corporation

28

14.C. Issues in Foreign Investment Analysis (3) ❑

Evaluating project cash flows, continued – Estimating incremental project cash flows, continued •

Adjust for global costs/benefits not reflected in the project’s financial statements:

– Cannibalization – Sales creation – Additional taxes owed when repatriating profits – Foreign tax credits – Diversification of production facilities – Market diversification – Provision of a key link in a global service network – Intangible assets

Chapter 14: Capital Budgeting for the Multinational Corporation

29

14.C. Issues in Foreign Investment Analysis (4) ❑

Evaluating project cash flows, continued – Tax factors •

Only after-tax cash flows are relevant

•

Compute marginal tax rate on project profits

•

Example: A foreign subsidiary remits $150,000 in after-tax earnings to the parent through a dividend.

– Dividend tax = 4% = $6,000 – Foreign tax credits = $50,000 + dividend tax = $56,000

– U.S. tax rate = 35% – Foreign tax rate = 25%.

– Compute marginal tax rate: • Pretax income = $150,000 / 0.75 = $200,000 • U.S. tax owed = $200,000 * 0.35 = $70,000 • Taxes paid to IRS = $70,000 - $50,000 - $6,000 = $14,000 • Marginal tax rate = ($14,000 + $6,000) / $150,000 = 13.33% Chapter 14: Capital Budgeting for the Multinational Corporation

30

14.C. Issues in Foreign Investment Analysis (5) ❑

Political and economic risk analysis – Three primary methods to incorporate political and economic risk into foreign investment analysis •

Shorten the minimum payback period

•

Raise the cost of capital

•

Adjust cash flows to reflect the specific impact of a given risk

– Shortening the payback period and raising the cost of capital do not address the actual impact of a particular risk and may adulterate the analysis.

•

E.g., if expropriation is likely in five years, increasing the cost of capital distorts the meaning of the present value of cash flows.

– Adjusting expected cash flows to reflect the specific impact of a given risk on a project’s cash flows is the recommended approach.

Chapter 14: Capital Budgeting for the Multinational Corporation

31

14.C. Issues in Foreign Investment Analysis (6) ❑

Exchange rate changes and inflation – Assessing the effect of exchange rate changes on expected cash flows from a foreign project involves removing the effect of offsetting inflation and exchange rate changes.

– Each effect should be analyzed separately.

– First adjust cash flows for inflation and then convert the projected cash flows into dollars using the forecasted exchange rate.

– Example: Compute the effects of inflation and currency depreciation on a new project in France.

• Year 1 expected cash flow = €1,000,000, with 4% projected growth • Year 2 expected inflation = 6% • e0 = $1.34; Year 2 expected currency depreciation = 5%; e2 = 1.34 (1 – 0.05)2 = $1.209

• Year 2 forecasted cash flow = €1,000,000 (1.04)2 = €1,081,600 • Year 2 forecasted cash flow in dollars = €1,081,600 (1.209) = $1,307,654 Chapter 14: Capital Budgeting for the Multinational Corporation

32

14.C. Issues in Foreign Investment Analysis (7) ❑

Exchange rate changes and inflation, continued – Alternative approach • Discount the nominal foreign currency cash flows at the nominal foreign currency required rate of return.

• Convert the resulting foreign currency present value to the home currency using e0.

– Both approaches should yield the same results.

Chapter 14: Capital Budgeting for the Multinational Corporation

33

14.D. Establishing a Worldwide Capital Structure (1) ❑

Foreign subsidiary capital structure – MNCs must determine the mix of debt and equity for the parent and all consolidated and unconsolidated subsidiaries that maximizes shareholder wealth (i.e., a worldwide debt ratio).

– MNC options for financing affiliates • The parent raises funds in its own country and makes equity investments in the affiliates – debt ratio = 0% • The parent holds one dollar of share capital in each affiliate and requires all affiliates to borrow on their own – debt ratio ≈ 100% • The parent borrows and relends the funds as intracorporate advances – debt ratio ≈ 100%.

Chapter 14: Capital Budgeting for the Multinational Corporation

34

14.D. Establishing a Worldwide Capital Structure (2) ❑

Foreign subsidiary capital structure, continued – An MNC’s three primary options for financing affiliate operations Equity Investment

Dividend Payments

Subsidiary

Interest and Principal

Parent

Reloan

Loan

Interest and Principal

Interest and Principal

Loan

Bank

Chapter 14: Capital Budgeting for the Multinational Corporation

35

14.D. Establishing a Worldwide Capital Structure (3) ❑

Effect of foreign investment on debt ratios of affiliate and parent Parent Consolidated Debt Ratio Before Foreign Investment Total Investment = $1,000

D = $300 E = $700

D/E = 3:7

Affiliate Debt Ratio After $100 Investment 100% Parent Financed

100% Bank Financed

D = $0 E = $100

D = $50 E = $50

D = $100 E = $0

D = $100 E = $0

D/E = 0

D/E = 1:1

D/E = Infinity

D/E = Infinity

Parent Consolidated Debt Ratio After Foreign Investment Total Investment = $1,100

D = $400 E = $700

Chapter 14: Capital Budgeting for the Multinational Corporation

D/E = 4:7

Whether parent or affiliate raises $100, affiliate’s debt ratio can vary from 0 to infinity

Whether parent or affiliate raises $100, parent’s debt ratio is 4:7 36

14.D. Establishing a Worldwide Capital Structure (4) ❑

Foreign subsidiary capital structure, continued – Political risk management • The use of financing to reduce political risks typically involves mechanisms to avoid or reduce the impact of certain risks, such as those related to exchange controls or expropriation.

– By raising funds locally, if a subsidiary is expropriated, it would default on loans from local financial institutions.

– Because local currency can be used to service local debt, borrowing locally decreases the MNC’s vulnerability to exchange controls.

– Foreign investments may be funded through the host or other governments, international development agencies, overseas banks, and customers, with payment to be provided out of production.

• Repayment is thus tied to the project’ success.

Chapter 14: Capital Budgeting for the Multinational Corporation

37

14.D. Establishing a Worldwide Capital Structure (5) ❑

Foreign subsidiary capital structure, continued – Currency risk management • Basic rule – finance assets that generate foreign currency cash flows with liabilities denominated in those same foreign currencies.

• For contractual cash flows, match net positive positions in each currency with liabilities of similar maturities in the same currency.

• For noncontractual cash flows, match net positive positions in each currency with liabilities in the same currency.

– Leverage and foreign tax credits • Foreign tax credits (FTCs) are credits that home countries grant against domestic income tax for foreign income taxes already paid.

– If the foreign tax on a dollar earned abroad and remitted to the U.S. is less than 35%, additional U.S. taxes will be owed to bring the total tax paid to $0.35.

– If the foreign tax on a dollar earned abroad and remitted to the U.S. is greater than 35%, excess taxes paid will offset U.S. taxes owed.

Chapter 14: Capital Budgeting for the Multinational Corporation

38

14.D. Establishing a Worldwide Capital Structure (6) ❑

Foreign subsidiary capital structure, continued – Leasing and taxes • Leasing an asset is economically equivalent to using borrowed funds to purchase the asset.

• However, tax consequences of leasing versus borrowing vary.

– E.g., an MNC is considering buying or leasing a new asset for use in the U.S. • Under current U.S. tax law, deductible interest expense is a function of the preexisting proportion of assets used abroad versus domestically.

E.g., if 50% of all assets are in the U.S., 50% of the interest expense on the new equipment is deductible.

• Regardless of the location of existing assets, 100% of lease payments is deductible.

– Cost-minimizing approach to global capital structure • MNCs allow subsidiaries with access to low-cost capital markets to exceed the parent capitalization norm, while subsidiaries in higher-cost capital markets would have lower target debt ratios.

Chapter 14: Capital Budgeting for the Multinational Corporation

39

14.D. Establishing a Worldwide Capital Structure (7) ❑

Joint ventures (JVs) – Debt raised by a joint venture may not be equivalent to parent-raised debt in terms of default risk.

– Assessing the effects of leverage in a joint venture requires a qualitative analysis of the partner’s ties to the local financial community.

– Conflicts may result if a JV is not isolated from a partner’s operations.

• Each owner has an incentive to exploit the other through transfer pricing, royalty and licensing fees, and allocating production and markets among plants.

– Lack of complete control leads most MNCs to guarantee JV loans only in proportion to their share of ownership.

Chapter 14: Capital Budgeting for the Multinational Corporation

40

Chapter 15

Financing and Controlling Multinational Corporations

Chapter 15 Outline A. Payment Terms in International Trade B. Documents in International Trade C. Financing Techniques in International Trade

D. Government Sources of Export Financing and Credit Insurance E. Countertrade F. Short-Term Financing

Chapter 15: Financing and Controlling Multinational Corporations

1

15.A Payment Terms in International Trade (1) ❑

Five principal methods of payment in international trade (in order of increasing risk to the exporter) 1. Cash in advance 2. Letter of credit 3. Draft

4. Consignment 5. Open account ❑

Generally, the greater the protection afforded the exporter, the less convenient the terms are for the importer.

Chapter 15: Financing and Controlling Multinational Corporations

2

15.A Payment Terms in International Trade (2) ❑

Five principal means of payment in international trade, continued 1. Cash in advance – provides the exporter the greatest protection because – Payment is received either before shipment or on arrival of the goods; – Exporter’s funds are not tied up in receivables.

Used if importer’s country is politically unstable or importer’s credit is poor.

2. Letter of credit (L/C) – a letter addressed to the seller, written and signed by a bank acting on behalf of the buyer. Satisfies both the exporter and importer because – The importer’s promise of payment is backed by a bank; – The importer may not want to pay for the goods until after receipt and inspection.

The bank promises to honor drafts drawn on itself if the seller conforms to the conditions set forth in the L/C. Chapter 15: Financing and Controlling Multinational Corporations

3

15.A Payment Terms in International Trade (3) ❑

Five principal means of payment in international trade, continued 2. Letter of credit (L/C), continued – Advantages to the exporter – Eliminates credit risk if the issuing bank is of undoubted standing.

– Because countries generally permit local banks to honor L/Cs, reduces the danger of delayed or withheld payment due to exchange controls or other political acts.

– Reduces uncertainty because all requirements are stipulated in the L/C.

– Guards against preshipment cancellations.

– Facilitates financing by ensuring a ready buyer for the exporter’s product.

Chapter 15: Financing and Controlling Multinational Corporations

4

15.A Payment Terms in International Trade (4) ❑

Five principal means of payment in international trade, continued 2. Letter of credit (L/C), continued – Advantages to the importer – The importer can require an inspection certificate and ascertain that the merchandise is shipping on or before the stipulated date by requiring an on-board bill of lading.

– Documents are carefully inspected by experienced clerks.

– An L/C is as good as cash in advance, enabling the importer to secure more advantageous credit terms and/or prices.

– Some exporters will sell only on an L/C. – Because the L/C substitutes for cash in advance, cash is not tied up.

– If prepayment is required, the importer is better off depositing its funds with the bank than with the exporter because funds are easier to recover if the exporter fails to ship the goods.

Chapter 15: Financing and Controlling Multinational Corporations

5

15.A Payment Terms in International Trade (5) ❑

Five principal means of payment in international trade, continued 2. Letter of credit (L/C), continued – Mechanics of an L/C – example: USA importers purchases goods from Japan Exporters 1. Issue purchase order

USA Importers

2. Request L/C

10.

Forward shipping docs

Japan Exporters

5. Ship goods

11. Pay L/C at maturity

4. Notify of L/C

6. Send draft and 9. Send shipping payment docs

3. Deliver L/C

Wells Fargo Bank

7. Send L/C, draft, shipping docs 8. Accept draft, remit funds

Chapter 15: Financing and Controlling Multinational Corporations

Bank of Tokyo

6

15.A Payment Terms in International Trade (6) ❑

Five principal means of payment in international trade, continued 2. Letter of credit (L/C), continued – Types of L/Cs – Documentary – the seller must submit necessary invoices and other documentation with the draft – Nondocumentary (“clean”) – L/C used for noncommercial transactions

– Revocable – L/C does not guarantee payment – Irrevocable – payment cannot be revoked without permission of all parties – Confirmed – issued by one bank and confirmed by another, obligating both banks to honor drafts drawn on the L/C. – Unconfirmed – the obligation of the issuing bank only – Transferable – the beneficiary has the right to instruct the paying bank to make the credit available to one or more secondary beneficiaries – Assignment – assigns part or all of the proceeds to another party but does not transfer the required documents to the party.

Chapter 15: Financing and Controlling Multinational Corporations

7

15.A Payment Terms in International Trade (7) ❑

Five principal means of payment in international trade, continued 3. Draft (bill of exchange) – an unconditional order in writing signed by the exporter ordering the importer or importer’s agent to pay on demand or at a fixed or determinable future date the amount specified.

– Key functions of a draft – Provides written evidence of a financial obligation

– Enables both parties to potentially reduce their costs of financing – Provides a negotiable and unconditional instrument – Enables an exporter to employ its bank as a collection agent (the bank forwards the draft to the importer, collects the funds, and remits the proceeds to the exporter)

– Key parties to a draft – Drawer – the party that signs and sends the draft to the second party – Drawee – the party to whom the draft is addressed – Payee – the party that receives the payment (often the same party as the drawer) Chapter 15: Financing and Controlling Multinational Corporations

8

15.A Payment Terms in International Trade (8) ❑

Five principal means of payment in international trade, continued 3. Draft, continued – Mechanics of a draft – example: USA importers purchases goods from Japan Exporters Japan Exporters Drawer

USA Importers

4. Pays at maturity

Wells Fargo Bank Drawee*

1. Signs and sends draft

2. Makes payment

3. Remits proceeds

Bank of Tokyo Payee

*In this example, in which an L/C is used, the drawee is the confirming bank.

Chapter 15: Financing and Controlling Multinational Corporations

9

15.A Payment Terms in International Trade (9) ❑

Five principal means of payment in international trade, continued 3. Draft, continued – Types of drafts – Sight draft – must be paid on presentation or else dishonored – Time draft – payable at a specified future date

– Usance or tenor – the maturity of a time draft – A time draft becomes an banker’s acceptance after being accepted by the drawee.

– Banker’s acceptance (B/A) – a draft accepted by a bank – Trade acceptance – a draft drawn on and accepted by a commercial enterprise – Clean draft – a draft unaccompanied by other papers, normally used for nontrade remittances – Documentary draft – a draft accompanied by other papers and can be either a sight or time draft Chapter 15: Financing and Controlling Multinational Corporations

10

15.A Payment Terms in International Trade (10) ❑

Five principal means of payment in international trade, continued 4. Consignment – Goods are shipped but not sold to the importer.

– Exporter (consignor) retains title to the goods until the importer (consignee) sells them to a third party.

5. Open account – Goods are shipped and the importer is billed later.

– No specific payment dates are set.

– Fewer bank charges than with other methods of payment.

Chapter 15: Financing and Controlling Multinational Corporations

11

15.A Payment Terms in International Trade (11) ❑

Five principal means of payment in international trade, continued – Summary of payment methods

Payment Method

Risk

Chief Advantage to Exporter

Chief Disadvantage(s) to Exporter

Cash in advance

L

No credit extension required

Can limit sales potential

Sight draft

M/L

Retain control and title; payment before goods are delivered

Unaccepted goods remain at port of entry and no payment is due

Time draft

M/H

Lowers customer resistance by allowing extended payment

Same as sight draft, plus goods are delivered before payment is due

Irrevocable

M

Revocable

M/H

Banks accept responsibility to pay; payment on presentation of papers; costs go to buyer

If revocable, terms can change during contract work

Consignment

M/H

Facilitates delivery; lowers customer resistance

Capital tied up until sale; credit check on distributor; political risk insurance in some countries; increased risk from currency controls

Open account

H

Simplified procedure; no customer resistance

High risk; seller must finance production; increased risk from currency controls

Draft

Letter of credit

Chapter 15: Financing and Controlling Multinational Corporations

12

15.B Documents in International Trade (1) ❑

Bill of lading (B/L) – The most important shipping document – Three primary functions •

Contract between the carrier and shipper (exporter)

•

Shipper’s receipt for the goods

•

Establishes control over the goods

– Types of B/Ls •

Straight – goods are consigned to a specific party, usually the importer, and is not negotiable.

•

Order – goods are consigned to a specific party, usually the exporter.

•

On-board – certifies that the goods have been placed on board the vessel.

•

Received-for-shipment – acknowledges that the carrier has received the goods for shipment.

•

Clean – indicates that the goods were received in good condition.

•

Foul – a clean B/L becomes foul when shipment has been damaged.

Chapter 15: Financing and Controlling Multinational Corporations

13

15.B Documents in International Trade (2) ❑

Commercial invoice – Contains a detailed description of the goods shipped, names and addressees of exporter and importer, number of packages, distinguishing external marks, payment terms, other expenses, fees collectible from the importer, name of vessel, ports of departure and destination.

❑

Insurance certificate – All foreign shipments are insured.

– An open (floating) policy covers all shipments made by the exporter.

– Insurance certificate is evidence of insurance for a shipment under an open policy.

❑

Consular invoice – Presented to the local consul in exchange for a visa

Chapter 15: Financing and Controlling Multinational Corporations

14

15.C Financing Techniques in International Trade (1) ❑

Banker’s acceptance (B/A) – Time draft drawn on a bank – By accepting the draft, the bank makes an unconditional promise to pay the holder of the draft a stated amount on a specified day and creates a B/A. – The bank thus substitutes its own credit for that of the borrower.

– A B/A is a negotiable instrument.

– The accepting bank may either buy (discount) the B/A and hold it in its own portfolio or sell (rediscount) it in the money market.

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15

15.C Financing Techniques in International Trade (2) ❑

Banker’s acceptance, continued 1. Issue purchase order

USA Importers

2. Request L/C

10.

Forward shipping docs

Japan Exporters

5. Ship goods

13. Pay L/C at maturity

4. Notify of L/C

6. Send draft and shipping docs

9. Make payment

3. Deliver L/C

Wells Fargo Bank

7. Send L/C, draft, shipping docs 8. Accept draft (B/A created and discounted) and remit funds

Bank of Tokyo

11. Rediscount B/A 12. Remit payment for B/A 14. Present B/A at maturity 15. Send payment Chapter 15: Financing and Controlling Multinational Corporations

Money Market Investor

16

15.C Financing Techniques in International Trade (3) ❑

Banker’s acceptance, continued –

The accepting bank receives a commission for accepting the draft and an additional fee if an L/C is involved.

–

Evaluating costs of B/A financing – Example: assume a 90-day, $1,000,000 B/A with a 2% annual commission fee and 9.8% 90-day discount rate Option 1: Hold the B/A for 90 days Face amount of B/A = Less 2% commission = $1,000,000 * (.02/4) = Amount received in 90 days =

$1,000,000 -$5,000 $995,000

Option 2: Sell the B/A in the money market Face amount of B/A = Less 2% commission = $1,000,000 * (.02/4) = Less 9.8% annual discount = $1,000,000 * (0.98/4) = Amount received now =

–

$1,000,000 -$5,000 -$24,500 $970,500

To understand options, compute opportunity cost of holding B/A. Example: exporter’s opportunity cost of money is 10.2%: •

PV of holding B/A = $995,000 / [1 + (0.102/4) = $970,258

Chapter 15: Financing and Controlling Multinational Corporations

Proceeds from sale of B/A > PV of holding B/A 17

15.C Financing Techniques in International Trade (4) ❑

Discounting – Even if a draft is not accepted by a bank, the exporter can convert the draft into cash through discounting.

– Exporter places draft with a bank and receives the face value of the draft less interest and commissions.

– If draft is insured against political and commercial risks, the interest rate may be reduced.

– The insurer pays covered losses to exporter or any institution to which the exporter transfers the draft.

– Discounting with recourse – the bank can collect from the exporter if the importer fails to pay the bill when due.

– Discounting without recourse – the bank bears the risk of collection.

– Discounting is most useful for the occasional exporter and for the exporter with a geographically diverse portfolio of receivables.

Chapter 15: Financing and Controlling Multinational Corporations

18

15.C Financing Techniques in International Trade (5) ❑

Factoring – An exporter sells its accounts receivable to a factor at a discount plus fees for nonrecourse financing.

– Because most factoring is nonrecourse (i.e., factor assumes all credit and political risks) factors may insist on purchasing all of an exporter’s receivables to avoid a selection bias (i.e., purchasing only receivables of risky customers).

– Evaluating the cost of factoring – Example: A factor buys an exporter’s receivables at a 2.5% per month discount and 1.75% fee for nonrecourse financing.

1. Compute the amount received by an exporter for factoring $1 million in 90-day receivables without recourse.

Face amount of receivable = $1,000,000 Less 1.75% nonrecourse fee = $1,000,000 * .0175 = -$17,500 Less 2.5% monthly discount = $1,000,000 * (0.025*3) = -$75,000 Amount received now = $907,500

Chapter 15: Financing and Controlling Multinational Corporations

19

15.C Financing Techniques in International Trade (6) ❑

Factoring, continued – Evaluating the cost of factoring – Example: A factor buys an exporter’s receivables at a 2.5% per month discount and 1.75% fee for nonrecourse financing, continued.

2. Compute annualized cost of factoring. $17,500 + $75,000 $1,000,000 - $17,500 - $75,000

•

365

*

= 41.34% 90

Despite the high costs, the cost of bearing credit risk associated with receivables can be substantially lower to a factor than to the exporter, because

– A factor’s greater credit information gives it more knowledge about the actual versus perceived risks involved and thus reduces its risk premium; and – By holding a well-diversified portfolio of receivables, the factor can eliminate some of the risks associated with individual receivables.

Chapter 15: Financing and Controlling Multinational Corporations

20

15.C Financing Techniques in International Trade (7) ❑

Forfaiting – Discounting at a fixed rate without recourse of medium-term export receivables denominated in fully convertible currencies (U.S. dollar, Swiss franc, euro).

– Generally used for capital-goods exports with a five-year maturity and repayment in semiannual installments.

– Fixed-rate discount ≈ 1.25% above local cost of funds.

Chapter 15: Financing and Controlling Multinational Corporations

21

15.D Government Sources of Export Financing and Credit Insurance (1) ❑

Most governments of developed countries provide their domestic exporters with low-cost export financing and concessionary rates on political and economic risk insurance.

❑

Export financing – Programs extending supplier credits •

Supplier passes credit on to the importer.

•

Supplier bears the credit risk.

– Programs extending buyer credits •

Buyer uses credits to pay the supplier.

•

Buyer bears the credit risk.

– Export-Import Bank (Eximbank) •

U.S. government agency dedicated solely to financing and facilitating U.S. exports.

•

Provides competitive, fixed-rate financing for U.S. export sales facing foreign competition backed with subsidized official financing.

Chapter 15: Financing and Controlling Multinational Corporations

22

15.D Government Sources of Export Financing and Credit Insurance (2) ❑

Export financing, continued – Export-Import Bank (Eximbank), continued •

Eximbank operations – Eximbank covers up to 100% of the U.S. component content of exports, provided that the total amount financed does not exceed 85% of the total contract price of the item and the total U.S. content accounts for at least half of the contract price.

– Eximbank provides financing only when private capital is unavailable.

– Loans must have reasonable assurance of repayment and must be for projects that have a favorable impact on the country’s economic and social well being.

– Fees and premiums for guarantees and insurance are based on the risks covered.

– In authorizing loans, Eximbank takes into account any potential adverse effects on the U.S. economy or balance of payments.

Chapter 15: Financing and Controlling Multinational Corporations

23

15.D Government Sources of Export Financing and Credit Insurance (3) ❑

Export financing, continued – Private Export Funding Corporation (PEFCO) •

Purchases medium- to long-term debt obligations of importers of U.S. products at fixed rates.

•

Finances loans through the sale of its own securities.

•

Eximbank guarantees repayment of all PEFCO foreign obligations.

– Trends in public-source export financing •

Shift from supplier to buyer credits

•

Growing emphasis on acting as catalysts to attract private capital

•

Public agencies as a source of refinancing

•

Attempts to limit competition among agencies

Chapter 15: Financing and Controlling Multinational Corporations

24

15.D Government Sources of Export Financing and Credit Insurance (4) ❑

Export-credit insurance – Provides protection against losses from political and commercial risks.

– Results in lowering the cost of borrowing from private institutions because the government agency is bearing those risks set forth in the insurance policy.

– Foreign Credit Insurance Association (FCIA) •

Administers the U.S. export-credit program

•

Cooperative effort of Eximbank and a group of ~50 insurance companies.

•

Short-term insurance available for export credits up to 180 days – Comprehensive coverage covers 90% to 100% of political risks and 90% to 95% of commercial risks.

– Political-only coverage covers 90% to100% of political risks.

•

Medium-term insurance covers big-ticket credits from 181 days to five years.

– Coverage is only for that portion of the value added that originated in the U.S.

Chapter 15: Financing and Controlling Multinational Corporations

25

15.D Government Sources of Export Financing and Credit Insurance (5) ❑

Taking advantage of government-subsidized export financing – Export financing strategy • Foreign countries in which the MNC has plants are both markets AND potential sources of financing exports to Third-World countries.

• E.g., Massey-Ferguson wants to sell 7,200 tractors to Turkey but is unwilling to assume risk of currency inconvertibility. Solution: –

Massey manufactured the tractors at its Brazilian subsidiary and sold them to Brazil’s Interbras.

–

Interbras paid Massey in cruzeiros and sold the tractors to Turkey.

–

Banco do Brazil underwrote all political, commercial, and exchange risks for Interbras’ cruzeiro financing.

– Import financing strategy • Many countries provide credit to foreign purchasers at below-market interest rates and long repayment periods.

• Loans are typically tied to procurement in the agency’s country.

• If an importer can source its needs from many countries, it will have leverage to extract more favorable financing terms from various export-credit agencies.

Chapter 15: Financing and Controlling Multinational Corporations

26

15.E Countertrade ❑

Countertrade – a country requires exporters to purchase local products in order to sell their products in that market.

– Countertrade results in an MNC acquiring goods that a country cannot or will not sell in international markets.

– Goods may be unrelated to goods the MNC sells.

– An MNC must usually sell the goods acquired in countertrade at a discount and thus may sell its exports to the country with which it engages in countertrade at a premium to offset price reductions.

– Forms of countertrade • Barter – a direct exchange of goods between two parties without the use of money. E.g., oil for guns.

• Counterpurchase (parallel barter) – the sale and purchase of goods that are unrelated to each other. E.g., soft drinks for vodka.

• Buyback – repayment of the original purchase price through the sale of a related product. E.g., provide materials for the construction of a gas pipeline in exchange for purchasing a certain amount of gas each year.

Chapter 15: Financing and Controlling Multinational Corporations

27

15.F Short-Term Financing (1) ❑

Four aspects of developing a short-term foreign financing strategy 1. Identify key factors 2. Formulate and evaluate objectives 3. Describe available short-term borrowing options

4. Develop a methodology for calculating and comparing the effective dollar costs of options

Chapter 15: Financing and Controlling Multinational Corporations

28

15.F Short-Term Financing (2) 1.

Identify key factors – the basic determinants of any funding strategy are strongly influenced by six key factors. i.

If forward contracts are unavailable –

Determine whether differences in nominal interest rates among currencies are matched by anticipated exchange changes (i.e., whether IFE holds; see Chapter 4).

–

If there is a deviation in IFE, expected dollar borrowing costs will vary by currency, leading to tradeoffs between the expected borrowing costs and the exchange risks associated with each financing option.

ii. Exchange risk –

Borrowing locally can provide an offsetting liability if currency exposure exists.

–

Borrowing in a local currency in which an MNC has no exposure increases exchange risk.

Chapter 15: Financing and Controlling Multinational Corporations

29

15.F Short-Term Financing (3) 1.

Identify key factors, continued iii. MNC’s degree of risk aversion –

The more risk averse, the higher the price an MNC should be willing to pay to reduce its currency exposure.

iv. If forward contracts are available –

Currency risk should not be a factor in the MNC’s borrowing strategy.

–

Relative borrowing costs are the sole determinant of which currencies to borrow in.

–

–

Determine whether the nominal interest differential equals the forward differential (i.e., whether IRP holds; see Chapter 4).

–

If IRP holds, the currency denomination is irrelevant.

Given the existence or threat of government capital controls, the forward discount or premium may not offset the difference between the interest rate on the local currency loan versus the dollar loan (i.e., IRP will not hold).

Chapter 15: Financing and Controlling Multinational Corporations

30

15.F Short-Term Financing (4) 1.

Identify key factors, continued v. If IRP holds before taxes –

Currency denomination of MNC borrowings does matter when tax asymmetries exist.

–

Tax asymmetries are based on the differential treatment of foreign exchanges gains and losses on forward contracts and loan repayments.

–

Thus, MNCs must compute relative borrowing costs on an after-tax basis.

vi. Political risk –

Even if local financing is not the minimum cost option, MNCs should maximize local borrowings if they believe expropriation or exchange controls are serious possibilities.

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31

15.F Short-Term Financing (5) 2.

Formulate and evaluate objectives – four possible objectives i.

Minimize expected cost and ignore risk – reduces information requirements, allows borrowing options to be evaluated without considering the correlation between loan cash flows and operating cash flows, and facilitates break-even analysis.

ii. Minimize risk without regard to cost – this objective is impractical and contrary to maximizing shareholder value. iii. Trade off expected cost and systematic risk – allows the MNC to evaluate loans without considering the relationship between loan cash flows and operating cash flows. Probably little difference between expected borrowing costs adjusted for systematic risk and unadjusted borrowing costs, because the correlation between currency fluctuations and a well-diversified portfolio is likely to be small. iv. Trade off expected cost and total risk – provides management with greater cash flow stability. Should be used only when forward contracts are unavailable.

Chapter 15: Financing and Controlling Multinational Corporations

32

15.F Short-Term Financing (6) 3.

Describe available short-term borrowing options – three principal short-term financing options i. Intercompany loan – interest rate must fall within set limits. Relevant factors in establishing the interest rate include the lender’s opportunity cost of funds, tax rates and regulations, currency denomination of loan, and expected exchange movements over the term of the loan. ii. Local currency loan – MNCs prefer local currency financing for convenience and exposure management.

– Bank financing – Term loans – straight loans, often unsecured, made for a fixed period – Line of credit (LOC) – an MNC draws down funds when required.

– Overdrafts – LOC against which drafts can be drawn.

– Revolving credit agreement – similar to an LOC except the bank is legally committed to extend credit up to the stated maximum. The MNC pays interest on its outstanding balance, plus a fee on the unused portion of the credit line.

– Discounting

– Nonbank financing – commercial paper and factoring Chapter 15: Financing and Controlling Multinational Corporations

33

15.F Short-Term Financing (7) 3.

Describe available short-term borrowing options, continued ii. Local currency loan, continued –

Determining interest rates

Annual interest paid Effective interest rate = –

Funds received

Example 1 – effective rate = stated rate: an MNC borrows $10,000 for one year at 11%, with interest paid at maturity. $1,100 Effective interest rate =

–

$10,000

= 11%

Example 2 – effective rate ≠ stated rate: an MNC borrows MXP10,000 for one year at 70%, with interest paid in advance.

MXP7,000 Effective interest rate =

Chapter 15: Financing and Controlling Multinational Corporations

MXP3,000

= 233% 34

15.F Short-Term Financing (8) 3.

Describe available short-term borrowing options, continued ii. Local currency loan, continued –

Compensating balance requirement – banks require borrowers to hold 10% to 20% of outstanding loan balances in a non-interest-bearing account.

Annual interest paid Effective interest rate =

–

Usable funds

Example 1 – an MNC borrows $10,000 for one year at 11%, with interest paid at maturity. Compensating balance requirement = 15%. $1,100 Effective interest rate =

–

$8,500

= 12.9%

Example 2 – an MNC borrows $10,000 for one year at 11%, with interest paid in advance. Compensating balance requirement = 15%. $1,100 Effective interest rate =

Chapter 15: Financing and Controlling Multinational Corporations

$7,400

= 14.9% 35

15.F Short-Term Financing (9) 3.

Describe available short-term borrowing options, continued iii. Commercial paper (CP) –

Short-term promissory note generally sold by large corporations on a discount basis to institutional investors and other corporations.

–

A favored alternative to bank borrowing.

–

Average maturities vary from 20 to 25 days.

–

By going directly to the market, MNCs can save as much as 1% in interest costs and avoid SEC registration requirements.

–

Three major non-interest costs –

Backup LOCs – because CP maturities are very short, the issuer may not be able to pay off or roll over maturing paper. Backup LOCs provide insurance against this occurrence.

–

Fees to banks – MNCs must pay fees to commercial and investment banks that act as issuing and paying agents.

–

Rating service fees – credit ratings are not legally required by any country but are often necessary for placing CPs.

Chapter 15: Financing and Controlling Multinational Corporations

36

15.F Short-Term Financing (10) 4.

Develop a methodology for calculating and comparing the effective dollar costs of options –

Break-even analysis determines the effective dollar costs of a local currency loan or dollar loan.

–

Example break-even analysis: an MNC can borrow pesos at 45% or dollars at 11%; peso expected to depreciate by 20% •

Analysis 1 – assume no taxes and forward contracts –

Cost of debt kd = kd = rL(1 + c) + c

1. Compute cost of local currency loan kd = 0.45(1 – 0.20) – 0.20 = 16% 2. Cost of dollar loan – the cost of a dollar loan to the affiliate is the interest rate on the dollar = 11%.

Chapter 15: Financing and Controlling Multinational Corporations

37

15.F Short-Term Financing (11) 4.

Develop a methodology for calculating and comparing the effective dollar costs of options, continued –

Example break-even analysis: an MNC can borrow pesos at 45% or dollars at 11%; peso expected to depreciate by 20%, continued •

Analysis 1 – assume no taxes and forward contracts, continued 3. Set local currency and dollar interest rates equal to determine breakeven rate of currency depreciation (break-even c) at which the dollar cost of peso borrowing is equal to the cost of dollar financing. kd = 0.45(1 + c) + c = 11% •

c = -23.45%

•

Thus, the peso must devalue by 23.45% before it is less expensive to borrow pesos at 45% than dollars at 11%.

•

If c is expected to be -20%, borrow dollars.

Chapter 15: Financing and Controlling Multinational Corporations

38

15.F Short-Term Financing (12) 4.

Develop a methodology for calculating and comparing the effective dollar costs of options, continued –

Example break-even analysis : an MNC can borrow pesos at 45% or dollars at 11%; peso expected to depreciate by 20%, continued • Analysis 2 – assume taxes – Cost of debt kd = kd = 0.45(1 + c) + c = 11% 1. Compute cost of local currency loan given a 40% affiliate tax rate kd = 0.45(1 + c)(1 – 0.40) + c = 0.27 + 1.27c 2. Compute cost of dollar loan – when taxes are considered, the cost of a dollar loan to the affiliate is the after-tax interest less tax gain/loss cta. kd = 0.11(1 – 0.40) – (-0.4c) = 6.6% + 0.4c

Chapter 15: Financing and Controlling Multinational Corporations

39

15.F Short-Term Financing (13) 4.

Develop a methodology for calculating and comparing the effective dollar costs of options, continued –

Example analysis: an MNC can borrow pesos at 45% or dollars at 11%; peso expected to depreciate by 20%, continued •

Analysis 2 – assume taxes, continued 3. Set local currency and dollar interest rates equal to determine breakeven rate of currency depreciation at which the dollar cost of peso borrowing is equal to the cost of dollar financing.

0.066 + 0.4c = 0.27 + 1.27c •

c = -23.45%

•

The break-even exchange rate is the same as in Analysis 1.

•

Thus, although taxes affect the after-tax costs of the dollar and local currency loans, if one loan has a lower cost before tax, it will also be less costly on an after-tax basis.

Chapter 15: Financing and Controlling Multinational Corporations

40

15.F Short-Term Financing (14) 4.

Develop a methodology for calculating and comparing the effective dollar costs of options, continued –

Example analysis: an MNC can borrow pesos at 45% or dollars at 11%; peso expected to depreciate by 20%, continued •

Analysis 2 – assume taxes, continued •

Thus, in general, the break-even rate of currency appreciation or depreciation can be found by equating the dollar costs of local currency and dollar financing and solving for c: rH(1 – ta) + cta = rL(1 + c)(1 – ta) + c

Chapter 15: Financing and Controlling Multinational Corporations

41

Chapter 16

Managing the Multinational Financial System

Chapter 16 Outline A. Multinational Financial System B. Intercompany Fund-Flow Mechanisms: Costs and Benefits C. Designing a Global Remittance Policy

Chapter 16: Managing the Multinational Financial System

1

16.A Multinational Financial System (1) ❑

Financial transactions within the MNC result from the internal transfer of goods, services, technology, and capital.

❑

Mode of transfer – Intermediate to finished goods – transfer pricing facilitates movement of profits and cash from one unit to another.

– Intangibles such as management skills, trademarks, and patents – transfer facilitated by selling outright to affiliate or through fees and royalties

❑

Timing flexibility – Leading and lagging – some internally generated financial claims require a fixed payment schedule while others can be accelerated or delayed.

– Timing of fee and royalty payments can be modified when all parties are related.

– Shipping schedules can be altered so one unit carries additional inventory for a sister affiliate.

Chapter 16: Managing the Multinational Financial System

2

16.A Multinational Financial System (2) ❑

The value of the MNC’s financial network stems from the wide variations in national tax systems and costs and barriers associated with internal financial transfers.

❑

The ability to transfer funds and reallocate profits internally creates arbitrage opportunities for MNCs. – Tax arbitrage – MNCs can reduce their global tax burden by shifting profits from units located in high-tax countries to those in lower-tax countries, or from units in a taxpaying position to those with tax losses.

– Financial market arbitrage – internal funds transfers may enable MNCs to circumvent exchange controls, earn higher risk-adjusted yields on excess funds, reduce risk-adjusted cost of borrowed funds, and access previously unavailable capital sources.

– Regulatory system arbitrage – when affiliate profits are a function of government regulations or union pressure, the ability to disguise profitability by reallocating profits among units may give MNCs a negotiating advantage.

Chapter 16: Managing the Multinational Financial System

3

16.B Intercompany Fund-Flow Mechanisms ❑

Tax factors –

Total tax payments on intercompany fund transfers depend on tax regulations in both the host and recipient countries.

–

Two types of taxes levied by the host country

– ❑

•

Corporate income taxes

•

Withholding taxes on dividend, interest, and fee remittances

Foreign tax credits (FTCs) – credits provided by the recipient country in consideration of foreign taxes paid on repatriated earnings.

Channels available to the MNC for moving money and profits internationally 1. Transfer pricing 2. Fee and royalty adjustments 3. Leading and lagging 4. Intercompany loans 5. Dividend adjustments

6. Investing in the form of debt versus equity Chapter 16: Managing the Multinational Financial System

4

16.B.1 Intercompany Fund-Flow Mechanisms: Transfer Pricing (1) ❑

Home and host governments have policing mechanisms to review the transfer pricing policies of MNCs.

❑

The most important uses of transfer pricing include –

–

–

Reducing taxes – general rule •

If tA > tB, set transfer prices as low as possible

•

If tA < tB, set transfer prices as high as possible

•

If price is too high, tax authorities in Affiliate B’s host country will see revenues forgone.

•

If price is too low, Affiliate A’s government may infer tax evasion through transfer pricing.

Reducing tariffs •

If Affiliate B is subject to ad valoerm tariffs (import duties set as a percentage of the value of the imported goods), increasing the transfer price will increase the duties Affiliate B must pay.

•

In general, the higher the ad valorem tariff relative to the income tax differential, the more likely a low transfer price is desirable.

Avoiding exchange controls

Chapter 16: Managing the Multinational Financial System

5

16.B.1 Intercompany Fund-Flow Mechanisms: Transfer Pricing (2) ❑

Tax effect of increasing transfer pricing Markup Policy

Affiliate A

Affiliate B

Affiliates A + B

Low-markup policy • Affiliate A produces 100 circuit boards at $10/unit

Low-Markup

Revenue

1,500

2,200

2,200

COGS

-1,000

-1,500

-1,000

Gross Profit

500

700

1,200

Other Expenses

-100

-100

-200

EBT

400

600

1,000

Taxes (30% / 50%)

-120

-300

-420

Net Income

280

300

580

• Affiliate B sells circuit boards to customers for $22/unit High-markup policy

High-Markup Revenue

1,800

2,200

2,200

COGS

-1,000

-1,800

-1,000

800

400

1,200

Gross Profit

• Affiliate A sells circuit boards to Affiliate B for $15/unit

Other Expenses

-100

-100

-200

EBT

700

300

1,000

Taxes (30% / 50%)

-210

-150

-360

Net Income

490

150

640

Same EBT Lower taxes Higher net income

• Affiliate A produces 100 circuit boards at $10/unit

• Affiliate A sells circuit boards to Affiliate B for $18/unit • Affiliate B sells circuit boards to customers for $22/unit

Higher transfer pricing shifts more income to lower-tax jurisdiction Chapter 16: Managing the Multinational Financial System

6

16.B.1 Intercompany Fund-Flow Mechanisms: Transfer Pricing (3) ❑

Tariff effect of increasing transfer pricing Markup Policy

Affiliate A

Affiliate B

Affiliates A + B

Revenue

1,500

2,200

2,200

COGS

-1,000

-1,500

-1,000

Tariff (10%)

-0

-150

-150

Gross Profit

500

550

1,050

Other Expenses

-100

-100

-200

EBT

400

450

850

Taxes (30% / 50%)

-120

-225

-345

Net Income

280

225

505

Revenue

1,800

2,200

2,200

COGS

-1,000

-1,800

-1,000

Tariff (10%)

-0

-180

-180

Gross Profit

800

220

1,020

Other Expenses

-100

-100

-200

EBT

700

120

820

Taxes (30% / 50%)

-210

-60

-270

Net Income

490

60

550

Low-Markup

High-Markup

Chapter 16: Managing the Multinational Financial System

Higher transfer pricing increases import duties and decreases EBT, but lower taxes still result in higher, although reduced, net income

Lower gross profit Lower EBT Higher net income

7

16.B.1 Intercompany Fund-Flow Mechanisms: Transfer Pricing (4) ❑

U.S. Revenue Code Section 482 provides for four alternative methods to establish intercompany arm’s length pricing.

– Comparable uncontrolled price method – transfer prices are set by direct reference to market prices charged by the MNC or comparable companies to unrelated parties.

– Resale price method – transfer prices are determined by reducing the price at which a good is resold to an independent purchaser by an appropriate markup.

– Cost-plus method – adds an appropriate profit markup to the seller’s cost to determine arm’s length transfer prices.

– Another appropriate method – in some cases, the use of combinations of the above methods or other methods are appropriate. ❑

Advance pricing agreements – the MNC, IRS, and foreign tax authority agree in advance on a method to compute transfer prices.

Chapter 16: Managing the Multinational Financial System

8

16.B.1 Intercompany Fund-Flow Mechanisms: Transfer Pricing (5) ❑

Exchange controls – Given a U.S. corporate tax rate of 35%, in the absence of offsetting FTCs, a U.S. MNC will net after-tax earnings of $0.65Q0 for each dollar increase in the price at which it sells Q0 units to an affiliate with blocked funds.

– A transfer price increase from P0 to P1 results in an increase of 0.65(P1–P0)Q0 dollars to the parent.

– The affiliate will show a corresponding decrease in its cash balances and taxes due to higher COGS.

❑

Joint ventures – Conflicts over transfer pricing may result when an affiliate is owned jointly by one or more other partners.

– Outside partners may be suspicious that transfer pricing is being used to shift shared profits from the joint venture to a wholly owned subsidiary.

Chapter 16: Managing the Multinational Financial System

9

16.B.1 Intercompany Fund-Flow Mechanisms: Transfer Pricing (6) ❑

Reinvoicing centers – MNCs may use reinvoicing in low-tax countries to disguise profitability.

– The reinvoicing center takes title to all goods sold by one corporate unit to another, while the goods move directly from the factory or warehouse to the purchaser.

– The center pays the seller and is in turn paid by the purchasing unit.

Title to goods

Affiliate A

Pay for goods

Reinvoicing Center t = 10%

Sale/delivery of goods

Affiliate B t = 50%

Chapter 16: Managing the Multinational Financial System

Pay for goods

10

16.B.1 Intercompany Fund-Flow Mechanisms: Transfer Pricing (7) ❑

Reinvoicing centers, continued –

U.S. Revenue Act of 1962 – declared reinvoicing to be Subpart F income.

–

Subpart F income – a category of foreign-source income subject to U.S. taxation immediately, whether or not remitted to the U.S.

–

A 1977 IRS ruling allocated to an MNC’s foreign affiliates certain parent expenses that previously could be written off in the U.S.

–

Additional FTCs are generated that can be utilized only against U.S. taxes owed on foreign-sourced income.

–

Subpart F income generated by reinvoicing centers offsets excess FTCs. Title to goods

Affiliate A Sale/delivery of goods

Payment = $90

Reinvoicing Center t = 10%

Creates $25 tax payment for which FTCs can be used

Affiliate B t = 50% Chapter 16: Managing the Multinational Financial System

Payment = $100

11

16.B.2 Intercompany Fund-Flow Mechanisms: Fees and Royalties ❑

Management services such as headquarters advice, allocated overhead, patents, and trademarks are often unique and thus have no reference market price.

❑

By varying the fees and royalties charged for their use, intangible resources become additional routes for funneling remittances from foreign affiliates.

❑

By setting low transfer prices on intangibles to manufacturing affiliates in low-tax locations, MNCs can receive profits essentially tax free.

❑

To counter such an occurrence, Section 482 provides that the transfer price of an intangible asset must be “commensurate with the income” the intangible generates.

–

A related-party transfer price for an intangible is not arm’s length unless it produces a split in profits between transferor and transferee that falls within the range of profits that unrelated parties realize on similar intangibles in similar circumstances.

Chapter 16: Managing the Multinational Financial System

12

16.B.3 Intercompany Fund-Flow Mechanisms: Leading and Lagging (1) ❑

MNCs shift liquidity among affiliates by accelerating (leading) or delaying (lagging) the payment of interaffiliate accounts. Example: Affiliate A bills Affiliate B $1,000,000 per month

Month

1

2

3

4

5

6

$1,000,000

$1,000,000

$1,000,000 $1,000,000 1

$1,000,000 $1,000,000 2

$1,000,000 $1,000,00 3

$1,000,000 $1,000,000 4

$1,000,000 $1,000,000 1

$1,000,000 $1,000,000 2

$1,000,000 $1,000,000 3

$1,000,000 $1,000,000 4

$1,000,000 $1,000,000 5

$1,000,000 $1,000,000 6

$1,000,000

$1,000,000

90-day (normal) Affiliate A A/R Affiliate B A/P A/P for month 30-day (leading) Affiliate A A/R Affiliate B A/P A/P for month

Creates $2,000,000 of cash flow for A 180-day (lagging)

Affiliate A A/R Affiliate B A/P A/P for month

$1,000,000

$1,000,000

$1,000,000

$1,000,000 $1,000,000 1 Provides $3,000,000 of working capital for B

Chapter 16: Managing the Multinational Financial System

13

16.B.3 Intercompany Fund-Flow Mechanisms: Leading and Lagging (2) ❑

The value of leading and lagging depends on the opportunity cost of funds to both the Affiliate A and Affiliate B. – When an affiliate in a surplus position receives payment, it can invest the additional funds at the prevailing local lending rate or use it to reduce its borrowings at the borrowing rate.

– If the paying unit has excess funds, it loses cash it would have invested at the lending rate, and if in a deficit position, it has to borrow at the borrowing rate.

Chapter 16: Managing the Multinational Financial System

14

16.B.3 Intercompany Fund-Flow Mechanisms: Leading and Lagging (3) ❑

Example – The U.S. and German affiliates of a U.S. MNC face the following effective, after-tax dollar borrowing and lending rates.

Affiliate

Borrowing Rate

Lending Rate

U.S.

3.8%

2.9%

Germany

3.6%

2.7%

– Both units can have either surplus or deficit of funds.

– Four possibilities •

Both units have surplus funds.

•

Both units have a deficit of funds.

•

U.S. has a surplus while Germany has a deficit.

•

Germany has a surplus while U.S. has a deficit.

Chapter 16: Managing the Multinational Financial System

15

16.B.3 Intercompany Fund-Flow Mechanisms: Leading and Lagging (4) ❑

Example, continued –

If both units have excess funds, the opportunity costs of funds are the lending rates for both affiliates.

–

If U.S. requires funds while Germany has a surplus, the opportunity costs of funds are the borrowing rate for U.S. and the lending rate for Germany.

–

Etc. Germany

Affiliate/Cash Position

+

-

+

2.9% / 2.7% (0.2%)

2.9% / 3.6% (-0.7%)

-

3.8% / 2.7% (1.1%)

3.8% / 3.6% (0.2%)

U.S.

–

Based on the interest differentials, all borrowings should be done in Germany, and surplus funds should be invested in the U.S.

–

Only if the U.S. unit has excess cash and the German unit requires funds should money flow into Germany.

Chapter 16: Managing the Multinational Financial System

16

16.B.3 Intercompany Fund-Flow Mechanisms: Leading and Lagging (5) ❑

Example, continued Germany

Affiliate/Cash Position

+

-

+

2.9% / 2.7% (0.2%)

2.9% / 3.6% (-0.7%)

-

3.8% / 2.7% (1.1%)

3.8% / 3.6% (0.2%)

U.S.

–

Let Germany owe $2 million to U.S.

–

The timing of the payment can be changed by up to +/- 90 days.

–

Assume U.S. is borrowing funds and Germany has excess funds.

–

Given the interest differential of 1.1%, Germany should accelerate (lead) its payment to U.S.

–

Net effect: U.S. can reduce its borrowing by $2 million and Germany has $2 million less in cash for 90 days.

–

Net savings = $2,000,000 * 0.011 * 90/360 = $5,500.

Chapter 16: Managing the Multinational Financial System

17

16.B.3 Intercompany Fund-Flow Mechanisms: Leading and Lagging (6) ❑

Advantages of leading and lagging strategy – No formal note is required.

– The amount of credit can be adjusted up or down by adjusting the terms on the accounts.

– Governments are less likely to interfere with payments on intercompany accounts than on direct loans.

– Section 482 allows intercompany accounts up to six months to be interest free while interest must be charged on intercompany loans.

Chapter 16: Managing the Multinational Financial System

18

16.B.4 Intercompany Fund-Flow Mechanisms: Intercompany Loans (1) ❑

Intercompany loans are more valuable than arm’s length transactions only if at least one of the following market distortions exists: – Credit rationing (due to a ceiling on local rates); – Currency controls; – Differential tax rates among countries.

❑

Most important types of intercompany loans 1. Direct loans 2. Back-to-back loans 3. Parallel loans

Chapter 16: Managing the Multinational Financial System

19

16.B.4 Intercompany Fund-Flow Mechanisms: Intercompany Loans (2) ❑

Most important types of intercompany loans, continued 1. Direct loans – straight extensions of credit from the parent to an affiliate or from one affiliate to another.

2. Back-to-back (also called fronting or link) loans – The parent deposits funds with a bank in country A that in turn lends the money to a subsidiary in country B. – Typically used to finance affiliates in countries with high interest rates or restricted capital markets.

Parent in Country A

Intercompany loan

Affiliate in Country B

Deposit

Bank in Country A

Back-to-back loan

Chapter 16: Managing the Multinational Financial System

20

16.B.4 Intercompany Fund-Flow Mechanisms: Intercompany Loans (3) ❑

Most important types of intercompany loans, continued 2. Back-to-back loans, continued – Advantages of back-to-back loans over direct loans – Certain countries apply different withholding tax rates to interest paid to a foreign parent and interest paid to a financial institution. Thus, a back-to-back loan may offer cost savings through lower taxes.

– If currency controls are imposed, the government will typically permit the affiliate to honor bank loan payments while not necessarily authorizing repayment of an intercompany loan.

– Costs are evaluated as follows.

Cost =

Interest cost to parent

-

Interest income to parent

+

Interest cost to affiliate

-

Tax gain on exchange loss

– Example: parent’s opportunity cost of funds = 10%, parent and affiliate tax margins = 34% and 40% respectively, parent lending rate = 8%, affiliate borrowing rate = 9%.

– Cost of loan = 0.10(0.66) - 0.08(0.66) + 0.09(0.6) – 0.40(0.11) = 2.32% Chapter 16: Managing the Multinational Financial System

21

16.B.4 Intercompany Fund-Flow Mechanisms: Intercompany Loans (4) ❑

Most important types of intercompany loans, continued 3. Parallel loan – Consists of two related but separate (i.e., parallel) borrowings and usually involves four parties in at least two countries.

– Used to repatriate blocked funds, circumvent exchange control restrictions, avoid a premium exchange rate for investments abroad, finance foreign affiliates without incurring additional exchange risk, or obtain foreign currency financing at attractive rates.

– Example: a U.S. MNC wishing to invest in Spain lends dollars to the U.S. affiliate of a Spanish MNC wishing to invest in the U.S., which lends euros to the U.S. firm’s Spanish affiliate.

U.S. Parent Direct loan in dollars

Spanish Firm’s U.S. Affiliate

Spanish Parent Direct loan in euros

U.S. Firm’s Spanish Affiliate

Draw downs, interest payments, and principal repayments made simultaneously Chapter 16: Managing the Multinational Financial System

22

16.B.5 Intercompany Fund-Flow Mechanisms: Dividend Adjustments (1) ❑

Dividends are the most important means of transferring funds from foreign affiliates to the parent.

❑

Factors considered when deciding on dividend payments – Taxes – Financial statement effects – Exchange risk – – – –

Currency controls Financing requirements Availability and cost of funds The parent’s dividend payout ratio

Chapter 16: Managing the Multinational Financial System

23

16.B.5 Intercompany Fund-Flow Mechanisms: Dividend Adjustments (2) ❑

Tax effects – by increasing payout ratios for foreign affiliates with the lowest transfer costs, the MNC can reduce its total tax burden.

❑

Example: – U.S. MNC wants to withdraw $1 million from its affiliates through dividends.

– Three affiliates – Germany, Ireland, France –each earn $2 million before tax.

– Germany subject to corporate tax rate of 50% on undistributed gross earnings, 36% on dividends, and10% dividend withholding tax – Ireland grants a 15-year tax holiday on all export profits, so no taxes – France subject to 45% corporate tax rate and 10% dividend withholding tax – U.S. MNC corporate tax rate is 35%; MNC has no excess FTCs (continued next slide) Chapter 16: Managing the Multinational Financial System

24

16.B.5 Intercompany Fund-Flow Mechanisms: Dividend Adjustments (3) ❑

Tax effects example, continued ($ 000) –

Germany: 50% corporate tax on undistributed gross earnings, 36% on dividends, and10% dividend withholding tax

–

Ireland: 15-year tax holiday on all export profits, so no taxes

–

France: 45% corporate tax rate and 10% dividend withholding tax

–

Earnings for each affiliate = $2 million Host Country Income Tax if Dividend Paid

Host Country Dividend Withholding Tax

U.S. Income Tax*

Total Taxes if Dividend Paid

Host Country Income Tax if No Dividend Paid

Worldwide Tax Liability if Dividend Paid

Affiliate

Dividend

Germany

$1,000

$360 $500 $860

$100

$0

$960

$1,000

$1,860**

Ireland

$1,000

$0

$0

$350

$350

$0

$2,250

France

$1,000

$900

$100

$0

$1,000

$900

$2,000

*FTCs applied to Germany and France **$960 + $0 + $900 = $1,860 Chapter 16: Managing the Multinational Financial System

Cheapest to remit dividends from Germany 25

16.B.5 Intercompany Fund-Flow Mechanisms: Dividend Adjustments (4) ❑

Dividend payments lead to liquidity shifts.

❑

The value of moving dividends depends on the different opportunity costs of money among the affiliates.

– An affiliate that must borrow funds will usually have a higher opportunity cost than a unit with excess cash.

– Some subsidiaries will have access to low-cost financing sources, whereas others must borrow at a relatively high interest rate. ❑

All else equal, a parent can increase its value by exploiting yield differences among its affiliates (i.e., setting a high dividend payout rate for affiliates with relatively low opportunity costs of funds, and vice versa).

Chapter 16: Managing the Multinational Financial System

26

16.B.5 Intercompany Fund-Flow Mechanisms: Dividend Adjustments (5) ❑

Effect of exchange controls on dividend decisions – Countries with balance of payments problems may restrict dividend payments to foreign companies.

– An MNC may try to reduce the chance of interference by maintaining a record of consistent dividend payments.

•

Consistent payments imply the existence of an established program rather than an act of speculation against the host country’s currency.

•

Dividend payout ratios may be uniform throughout the MNC to show that all affiliates pay an equivalent percentage dividend.

Chapter 16: Managing the Multinational Financial System

27

16.B.6 Intercompany Fund-Flow Mechanisms: Equity versus Debt (1) ❑

MNCs generally prefer to invest through loans rather than equity.

– An MNC typically has wider latitude to repatriate funds through interest and loan repayments than as dividends or reductions in equity.

– Loans are more likely to create more favorable tax benefits •

Interest paid on a loan is typically tax deductible in the host country, whereas dividend payments are not.

•

Unlike dividends, principal repayments do not normally constitute taxable income to the parent.

– Example: Compare cash flows generated from parent’s $1,000,000 investment in affiliate made as debt and equity •

Additional after-tax sales generated from investment = $200,000 annually

•

10% withholding tax on dividend and interest payments

•

Interest rate on principal = 10%

•

Interest 50% tax deductible

•

Use 15% discounting factor to determine present value of cash flows to parent

(see next two slides) Chapter 16: Managing the Multinational Financial System

28

16.B.6 Intercompany Fund-Flow Mechanisms: Equity versus Debt (2) ❑

Example: Cash flows ($000) to parent over repayment period given $1,000,000 debt investment a

a–b=d

c+d=e

(b+e)(0.10) =f

a+b+e-f Cash Flow to Parent

b

b/2 = c

Funds Remaining

Dividend

Withholding Tax

Year

Principal

Interest

Interest Tax Savings

1

100

100

50

0

50

15.0

235.0

2

100

90

45

10

55

14.5

230.5

3

100

80

40

20

60

14.0

226.0

4

100

70

35

30

65

13.5

221.5

5

100

60

30

40

70

13.0

217.0

6

100

50

25

50

75

12.5

212.5

7

100

40

20

60

80

12.0

208.0

8

100

30

15

70

85

11.5

203.5

9

100

20

10

80

90

11.0

199.0

10

100

10

5

90

95

10.5

194.5

Present Value of Cash Flows to Parent Discounted at 15% Chapter 16: Managing the Multinational Financial System

$1,102.7 29

16.B.6 Intercompany Fund-Flow Mechanisms: Equity versus Debt (3) ❑

Example: Cash flows ($000) to parent given $1,000,000 equity investment; dividend = additional after-tax sales generated a

b

a-b

Year

Dividend

Withholding Tax

Cash Flow to Parent

1

200

20

180

2

200

20

180

3

200

20

180

4

200

20

180

5

200

20

180

6

200

20

180

7

200

20

180

8

200

20

180

9

200

20

180

10

200

20

180

Present Value of Cash Flows to Parent Discounted at 15%

Chapter 16: Managing the Multinational Financial System

903.42

30

16.C Designing a Global Remittance Policy (1) ❑

Coordinating the use of an MNC’s financial linkages in a manner consistent with value maximization requires four interrelated decisions.

– How much money (if any) to remit – When to remit

– Where to transmit remittances – Which transfer method(s) to use

Chapter 16: Managing the Multinational Financial System

31

16.C Designing a Global Remittance Policy (2) ❑

Factors affecting the benefits of an internal financial transfer system – Number of financial linkages – the wider the range of choice, the greater a firm’s ability to achieve specific goals.

– Volume of interaffiliate transactions – more affiliates specializing in different components and stages of production increase interaffiliate trade.

– Foreign-affiliate ownership pattern – 100% ownership removes impediments to efficient worldwide funds allocation.

– Degree of product and services standardization – the more standardization, the less latitude an MNC has to adjust transfer prices, fees, and royalties.

– Government regulations – tax, credit allocation, and exchange control policies can provide incentives for or create impediments to international fund flows.

Chapter 16: Managing the Multinational Financial System

32