Internatioanl Finance

8/8/2019 Internatioanl Finance

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International Financial Markets

Various international financial markets have been developed due to growth in

international business over the last 30 years. Financial Managers of MNCs must

understand the various international financial markets that are available so that

they can use those markets to facilitate their international business transaction.

The following are the international markets -

i. Foreign Exchange Marketsii. Euro currency marketsiii. Euro credit marketiv. Euro bond marketv. International stock markets.

Motives for using international financial markets -

Various barriers prevent the markets for real or financial assets from becoming

completely integrated. These barriers include ten differential tariffs, quotas,

labour immobility cultural differences financial reporting differences and

significant cost of communicating information across countries.

The barriers can also create unique opportunities for specific

geographic markets that will attract foreign creditors and investors. As for

example, barriers such as tariffs, quotas and labour immobility can cause agiven countrys economic conditions to be districtly different from others.

Investors and creditors may want to do business in that country to capitalise on

favourable conditions unique to that country. The existence of imperfect

markets has precipitated the internationalisation of financial markets.

Motives for investing in foreign markets-

1. Economic condition- investors may expect firms in a particular foreigncountry to achieve more favourable performance than those in the

investors home country. For ex- the loosening of restriction in Eastern

European countries create favourable economic condition. These such

conditions attracted foreign investors and creditors.

2. Exchange rate expectations-Some investors purchase financial securities denominated in a currency

that is expected to appreciate against their own. The performance of such


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an investment is highly dependent on the currency movement over the

investment horizon.

3. International diversification- investors may achieve benefits frominternationally diversifying their asset portfolio. When an investor enter

in portfolios does not depend solely on a single countrys economy, cross border differences in economic condition can allow for risk reduction

benefits. A stock portfolio representing firms across European countries

less risky than a stock portfolio representing firms in any single European

country. Further more, access to foreign markets allows investors to

spread their funds across a more diverse group of industries than may be

available domestically. This is especially true for investors residing in

countries these firms are concentrated in a relatively small member of

industries.

Motives for providing credit in foreign markets-

Creditors have one or more of the following motives for providing credits in

foreign markets are-

- High foreign interest rates- Exchange rate expectation- International diversification

Motives for borrowing in foreign markets-

Borrowers may have one or more of the following motives for borrowing in

foreign markets.

- Low interest rates- Exchange rate expectations

The existence of market imperfections prevents markets frombeing completely integrated. Consequently, investors and creditors can attempt

to capitalize on unique characteristics that make foreign markets more attractive

than domestic markets. This motivates the international flow of funds and

results in the development of international financial markets.


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The foreign exchange markets-

It allows currencies to be exchanged in order to facilitate international trade or

financial transaction. Commercial banks saves financial intermediaries in this

markets. They stand ready to exchange currencies on the sp ot or at a future

point in time with the use of forward contracts.

The Eurocurrency markets- is composed of several large banks that accept

deposits and provide short-term loans in various currencies. This market is

primarily used by govt. and large corporations.

The Euro credit markets- is composed of the same commercial banks that serve

the Eurocurrency markets. These banks convert some of the deposits received

into Euro-credit loans (for medium-term periods) to govt. and large

corporations.

The Eurobond markets facilitates international transfers of long-term credit

thereby enabling govt. and large corporations to borrow funds from various

countries. Eurobonds are underwritten by a multinational syndicated

investment banks and are placed in various count ries.

International stock markets enable firms to obtain equity financing in foreign

countries. Thus, these markets have helped MNCs finance their international

expansion.

Currency forward, future and option

Currency forward a forward market facilitates the trading of forward

contract on currencies.

A forward contract is an agreement between a corporation and a commercial

bank to exchange a specific amount of a currency at a specific exchange rate

(forward rate) on a specific date in the future.


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When multinational corporation (MNCs) anticipated a future need for a foyer

receipt of a foreign currency they can set up a forward contract to lock in the

rate at which they can purchase or sell a particular foreign currency. Virtually

all large MNCs use forward contract some MNCs such as TRW have forward

contract outstanding worth more than $100 million to hedge various positionforward contract normally are not used by consumer or small firm.

The most common forward contract are 30, 60, 90, 180 and 360 days although

foyer period (including longer period) are available. The forward rate of a given

currency will typically vary with the length (number of days) of the forward

period. MNCs use forward contract to hedge imports. They can lock in the rate

at which they obtain a currency needed to purchase import.

Currency future - Currency future contract are contract specifying a standardvolume of a particular currency to be exchanged on a specific settlement date.

They are commonly used by MNC:s to hedge their foreign currency position in

addition they are traded by speculations who hope to capitalize on their

expectation of exchange rate movement. A buyer of a currency future contract

locks in the exchanger rate to be paid for a foreign currency at future point in

time.

Alternatively a seller of a currency future contract locks in exchange rate

at which a foreign currency can be exchanged for the home currency. In the USCurrency future contract are purchased to lock in the amount of dollarsneeded

to obtain a specific amount of a particular foreign currency they are sold to lock

in the amount of specified amount of a particular currency. Currency future

contract are available for several widely traded currency at the Chicago

mercantile exchange and the contract for each currency specifies a standardized

number of units.

Currency future contract are sold on a exchange while each forward

contact negocoated between a firm ND a commercial bank over a

telecommunication network. Forward contract can be tailored to the needs of

the firm while the currency future contract isstandardized.

Currency option a Currency option is an alternative type of contract that can

be purchased or sold by speculator and firm.


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A Currency call option grants the right to buy a specific currency at specified

price at specified date the price at which the owner is allotted to exercise price

or strike price and there are monthly expectation dates for each option. Call

option are describe when one wishes to lock in a maximum price to be paid for

a currency in the future. If the spot rate of the currency risk above the strikeprice owners of call option can exercise then option by purchasing the currency

at the stake price which will be cheaper than the prevailing spot rate this

strategy is some what similar to hat used by purchase of future contract but the

future contract require an obligation, which the currency option does not the

owner can choose to let the option expire on the expiration date without even

exercising it owners of expired call option will have lost the premium they

initially paid but that is the most they can lose.

Some option are listed as European style which means that they can b e

exercised only upon expiration.

A currency call option is said to be in the money when the present exchange

rate exceeds the strike price and out of the money when the present exchange

rate is less than the strike price. For a five currency and expiration date an in the

money call option will require a higher premium than option that are at the

money or out of money.

Currency put option the owner of a Currency put option recovers the right to

sell a currency at a specified price within specified time period of time. The

owner of a put option is not obligated to exercise the option therefore the

maximum potential loan to the owner of the put option is the price (or premium)

paid for the option contract.

A Currency put option is said to be in the money when the present

exchanger rate is less than the strike price at the money when the present

exchange rate are equal the strike price and out of the money when the present

exchange rate exceeds the strike price for a given currency and exp iration datean in the money put option will require a higher premium at the money or out of

the money.

Foreign Exchange Markets the Foreign Exchange Markets allow currencies

to be exchanged in order to facilitate international trade or financial transaction


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MNCs rely on the foreign exchange market to exchange their home currency

for a foreign currency that they need to purchase imports or use for direct

foreign investment.Alternatively they may need the foreign exchange market to

exchange a foreign currency that they receive into their home currency. The

system for establishing exchanged rate has exchange time.

Interest rate parity once market forces cause interest rate and exchanged rate

to adjust such that covered interest arbitrage is no longer feasible there is an

equilibrium state referred to as IRP. In equilibrium the forward rate differs from

the spot rate by a sufficient amount to offset the interest rate diffencial between

two currency.

Covered interest arbitrage is the process of capitalizing on the interest rate

differential between two countries while coving your exchange rate risk. The

logic of the term term cover interest rate arbitrage becomes clear.

IRP specifying that the forward premium (or discount) is equal to the interest

rate differential between the two currencies.

Inflation, interest rate and exchange rate changes in relative inflation rate can

effect international trade actively which influence the demand for and supply of

currencies and there fore influence exchange rates

Changes in relative interest rate affect investment in foreign securities

which influence the demand and supply of currencies and therefore influence

Exchange rates the key economic factors that can influen ce exchange rate

movement through their effect on demand and supply condition are relative

influence rates interest rate and income level and as well as Govt. contract.

As these factors cause as change in international trade or financial flow they

affect the demand for a currency or the supply of currency for the sale andtherefore affect the equilibrium exchange rate.

When a countrys inflation rate risk the demand for it currency decline as it

export decline (due to its higher price) consumer and firm in that country tend to

increase their importing.


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Purchasing power parity (PPP) theory attempts to quantity inflation exchange

rate relationship.

Fisher effect nominal risk free interest rates contain a real rate of return andanticipated inflation

International Fisher effect theory (IFE) it uses interest rate rather than

inflation rate differential to explain why exchange rate change overtime but it is

closely related to the PPP theorybecause interest rate are often highly correlated

with inflation rates specifies a precise relation between relative interest rate of

two countries and then exchange rate.

Exchange rate Forecasting MNC need exchange rate forecast to make

decision on hedging payable madreceivable, short term financing and

investment, capital budgeting and long term financing.

The most common forecasting technique can be classified as

(i) Technique(ii) Fundamental (iii) Market based(iv) MixedUnfortunately these technique have generally performed rather poorly

increase years yet due to high variability in exchange rate . It should not be

surprising that forecast are not always accurate.

Forecasting method can be evaluated by comparing the actual value of

currency to the value predicted by the forecasting method. To be meaningful

that comparison should be conducted over several period two criteria used toevaluate performance of a forecast method are bias and accuracy. When

comparing the accuracy of forecast for two currencie s, the absolute forecast

error should be divided by the realized value of the currency to control for

differential in the relative value of currencies.


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Why firms forecast exchange rates virtually every operation of an MNC

can be influenced by changes in exchange rates.

The following are some of the corporate function for which exchange rate

forecast are necessary :

(i) Hedging decision MNCs constantly face the decision of whether tohedge future payment and receivables in foreign currencies whether a

firm hedge may be determined by its forecast of foreign currency

valve.

(ii) Short term financing decision when large corporation borrow, theyhave access to several different currencies the currency they borrow

will ideally (1) exhibit a low interest rate and (2) weaken in value over

the financial period.

(iii) Short term investment decision corporation some times have asubstantial amount of exceedscash available for a short term period.

Large deposit can be established in several currencies the ideal

currency for deposits will (1) exhibit a high interest rate and (2)

strengthen in value over the investment period.

(iv) Capital budgeting decision when an MNCs parent assesses whetherto invest funds in a foreign project may periodically require the

exchange of currencies. The capital budget analysis can be completed

only when all estimated cash flow is measured in the parent local

currency.(v) Long term financial decision corporations that issue bonds to secure

long term funds may consider denominating the bonds in foreign

currency borrowed depreciate over time against the currency they are

receive from sales to estimate the cost of issuing bonds denominated

in a foreign currency, forecasts of exchange rates are required.

(vi) Earning assessment when earning of an MNC are reportedsubsidiary earning are consolidated and translated into the currency

representing the parent firms home country.

Forecasting technique - thenumerousmethods are available for

forecasting exchange rate can be categorized into from general group

(1) technical (2) fundamental (3) market based (4) mixed


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Technical forecasting - Technical forecasting involves the use of

historical exchange rates data to predict future value.

Fundamental analysis it is based on fundamental relationshipbetween economic variable and exchange rates. Given current value of

that variable along with their historical impact on a currencys value

corporations can develop exchange rate projection.

A forecast may arise simply from a subjective assessment of the

degree to which general movement in economic variable in one

country are expected to affect exchange rates. From a statistical

perspective measured impact of factors on exchange rates.

Market based forecasting the process of developing forecast from

market indicators known as market based forecasting is usually based

on either (1) the spot rate or (2) the forward rate.

Use of spot rate todays spot rate may be used as a forecast of the

spot rate that will exist on a future date.

Use of forward rate a forward rate quoted for s specific date in the

future is commonly used as the forecasted spot rate on that future date.

Mixed forecast as on suitable forecasting technique has been formed

to be consistentlysuperior the other some MNCs prefer to use

combination of forecasting technique. Various forecasting for a

particular currency value are developed using several forecasting

technique then technique used are assisted weight in such a way that

weight are 100 per cent with the technique considered more reliable

being assessed higher weights. The actual forecast the currency is a

weighted average of the various forecast developed.

Performance of forecasting service - given the recent vitality in

foreign exchange market it is quite difficult to forecast currency value.

One for a corporation to determine whether a forecasting service is

valuable is to compare the accuracy of its forecast to that of publicly

available and free forecast. The forward rate serves as a benchmark for


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comparison here suite it is quoted in many news paper and

margarines.

Some studies have compared several forecasting service forecast for

different currencies to the forward rate a small percentage of the

forecast for one month ahead were more accurate that the forward rate.The result were similar than assessing forecast for three month ahead,

such result are forecasted for the corporation that have paid substantial

amount for expect opinion.

Forecasting service the corporate need to forecast currency value

has prompedthe evergence of business international currency prede X

and whotson econometric forecasting associats in addition some large

investment investment bank such as Goldman sacls and commercial

bank such as Citibank ofer forecasting servoice. Many consistingservice use atleast two different type of analysis to generate separate

forecast and determine the weighted coverage of the forecast.

Some forecasting servive such capital techniqyue, FX concept, and

preview Economics focus on tecjnoque forecasting, while others

service such as corporate treasury consitants ltd. And WEFA, focus on

fundamental forecasting many services such as forexia Ltd. Use both

forecasting. Forecast is even provided for currencies that are not

widely traded. Firms provides forecast on any currency for time

horizon of interest to their clients ranging from one day to ten yearsfrom now. In addition some firms offer advice on international cash

management assessment of exposure to exchange rate risk and

hedging. Many of the firm provide their client with forexast and

recommendation monthly, or even weekly for an annual fee.

Evaluation of forecast performance an MNC that forecast

exchange rate must monitor its performance overtime to fetermine

whether the forecasting process is satisfy for the porpuse, or

measyrement of the forecast error is requird there are various ways

compleat forecast errors.

Absolute forecast error as a % of realized value

= (forecasted value realized value)/ realized value


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Forecasted accuracy overtime MNCs are likely to have more

confidence in their measurement of the forecast error when they

measure it over each of several periods.

Forecast accuracy among currencies the ability to currencyforecast may vary with the currency concern. The maen forecast error

for major currency may be derived form 90 days forward contarct.

Search for forecast bias the difference between the forecasted and

realized exchange rate for a given point in time is a nominal forecast

error negative error overtime indicate underest mainly while positive

error indicate overestimating if the error are consistentaly positive or

negative overtime then a bias in forecasting procedure does exists.

Statistical test of forecast bias it the forward rate is a biased

predictor of the future spot rate this implies there is a systematic

forecast error, which could be corrected to improve forecast accuracy

if the forward rate is unbiased, it fully reflect all avalible information

about the future spot rate. In any case any forecast error would be the

result of events that covered not has been anticipated from exiting

information at the time of the forecast.

A conventional method of testing for a forecast bias is to apply the

regression model to historical data.

St =a0 +a1Ft-1 +utWhere

St= spot rate at time t

Ft-1= forward rate

Ut = error terma0 = intercept

a1 = regression co efficient

If the forward rate is unbiased the intercept should equal to

zero and the regression co efficient and should equal to 1.


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t = (a1 1)/standard error of a1

if a0 = 0 and a is significantly less that 1 this implies that the forward

rate is systematically overestimating the spot rate. For example if

a0 = 0 and a1 = 0.90 the future spot rate is estimated to be 90% of theforecasted generated by the forecast rate.

Conversely if a0 = 0 and a issignificantly greater than 1 this

implies that the forward rate is systematically underestimating the spot

rate. For example if a = 0 and a1 = 1.1 the future spot rate is

estinmated to be 1.1 times the forecast generated by the forward rate.

When a bias as detected and anticiapated to persist in future forecast

may incorporate that, bias for example if a1 = 1.1 future forecast of

the spot rate may incorporate their inflation by 1.1 to create a forecast

of the future spot rate.By detecting a bias an MNC may be able to adjust for the bias so

that it can improve its forecasting accuracy for example if the errors

are consistacly positive could adjust todays forward rate downward to

reflect the bias overtime a forecasting bias can change (from

underestimstimg to overestimating or vice versa). Any adjustment to

the forward rate used as a forecast would need to reflect the

anticipated bias for the period of concern.

Graphic evaluate of forecast performance forecast performance

can be examised with the use of a graph that campars forecasted value

with the realized valye for various time periods.

Comparision of forecasting technique when an MNC evaluate its

forecasting performanbe, it must realize errors will commonaly occurs

to at least minimize the error it may derive to compare forecasting

errors of the available methods. This can be derived by plotting the

point relating to two methods on graph the points performing to each

method can be distinguise by a particular month of glone.

The performance of two methods can be evaluated by comparing

distance of point from the 45 degree.


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Exchange rate volatility MNCs recognize that it is nearly

inposition to predict future exchange will may specify a range around

their forecast.

Methods of forecasting exchange rate volatility the volatility ofexchange rate movement for a future period can be forecast using

(1)Recent exchange rate volatil ity(2)Historical time series of volatility(3)The implied standard deviation on derived from currency option

prices.

Application of exchange rate forecasting to the Asian crisis just before the

asian crisis the spot rate (in dollor) would have served as a reasonable predictorof the future spot rate because the central bank were maintain a some what

stable value for their respective currency the forward rate of these some what

Asian currency would not have been accurate because it would have exhibits a

discount to reflect the differential between the south east Asian countries

interest rate (based on interest rate parity). The currency depreciated by much

more than would have been predicted according to the forward rate.

Two key factor that led to sustainable decline in currency value were -

1. The large amount of foreign investment prior to the crisis2. Fear of a massive sell off of the currencies which perpetuated the

problem. These 2 factors cannot easily be incorporated in a fundamental

forecasting model in a manner that will precisely identify the timing and

magnitude of a major decline in a currency value.

How exchange rate forecasting affects a MNCs value-

Exchange rate forecasting affects the value of an MNC. The forecasts lead todecisions about whether the firm should remain exposed to exchange rate

fluctuations a hedge its foreign currency position. The forecasts can affect the

expected foreign currency cash flows if those cash flows are partially generated

by foreign subsidiaries from transactions with other countries.


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The forecasts have a direct effect on the expected values of the exc hange rates

at which the foreign currency cash flows will be converted into dollars when

those cash flows are remitted to the U.S. parent suice the forecasts lead to

decision about whether to hedge they influence the actual exchange rate at

which the future foreign currency cash flows will be converted to dollars whenremitted to the U.S parent. Thus, they determine the expected dollars when

remitted to the U.S parent. Thus, they determine the expected dollar cash flows

to be received by the U.S parent.

THE MEASUREMENT OF EXCHANGE RATE RISK

Exchange rate risk can be broadly defined as the risk that a company

performance, will be affected by exchange rate movements. MNC closely

monitor their operations to determine how they are exposed various forms of

exchange rates risk. Financial managers must understand how to measure the

exposure of their MNCs to exchange rate fluctuations. So that, they can

determine whether and how to protect their companies from that exposure.

EXCHANGE RATE RISK IS IRRELEVANT BECAUSE OF-

1. Purchasing power parity argument- According to PPP theory, exchangerate movements are just a response to differentials in price changes

between countries. Therefore, the exchange rate effect is offset by the

changes in price.

2. The investor hedge arguments- Investors in MNCs can hedge this risk ontheir own.

3. Currency diversifications argument- If a US based MNC is welldiversified across numerous countries its value will not be affected by

exchange rate movements because of offsetting effects.

4. Stakeholder diversification argument- If creditors or stockholders arediversified they will be somewhat insulated against losts experienced by

an MNC due to exchange rate risk. In 1988 numerous US based MNCs of

Asian currencies against dollar. In 2000, some MNCs were adversily

affected by the depreciation of European currencies against the dollar.


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5. Response from MNCs- MNCs like colgate Palmolive, Eastman Kodak,have attempted to stabilize their earnings with hedging strategies - an

medication that they believe excha nge rate risk is relevant.

TYPE OF EXPOSURE-

Exposure to exchange rate fluctuations comes in three forms -

1. Transaction exposure2. Economic exposure3. Translation exposure

Transaction Exposure

The degree to which the value of future cash transactions can be affected by

exchange rate fluctuations is referred to as transaction exposure. The value of a

firms cash inflows received in various currencies will be affected by the

respective exchange rates of these currencies when they are converted into the

currency desired. Similarly, the value of a firms cash outflows in various

currencies will be dependent on the respective exchange rate of these

currencies.

Economic Exposure

The degree to which a firms present value of future cash flows can be

influenced by exchange rate fluctuations is referred to as economic exposure to

exchange rates. All type of transactions that cause transaction exposure also

cause economic exposure because these transactions represent cash flows that

can be influenced by exchange rate fluctuations. In addition, other types of

business that do not cause transaction exposure can cause economic exposure.

Measuring Economic Exposure- classify the cash flows into different incomestatement in terms and subsectively predict each income statement item based

on a forecast of exchange rates. There are alternative considered and the

forecasts for the income statement items revised. This procedure is especially

for firms that have more expense than revenue in a particular foreign currency.


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Translation Exposure an MNC creates its financial statements by

consolidated all of its individual subsidiarys financial statement. A subsidiary

financial statement is normally measured in it local cur rency. To be

consolidated each subsidiary financial statement must transfer into currency of

the parent since the exchange rate change over time, the translation of thesubsidiarys financial statement into a different currency is affected by

exchange rate movement the exposure of MNCs consolidated financial to

exchange rate fluctuation is known as translation exposure particular subsidiary

earning translated into the reporting currency on the consolidated income

statement and subject to changing exchange rate.

Cash flow perspective translation of financial statement for consolidated

reporting purpose does not affect an MNCs cash flows. For the reason someanalysis suggest that translation exposure is not relevant.

Stock price perspective many investor tend to use earning when valuing

firm, either by deriving estimate of expected cash flow from previous earning or

by apply a P/E ratio to expected annual earning to derive a value per share of

stock since an MNCs translation exposure affect its consoli dated earning it can

affect the MNCs valuation.

Determining of translation exposure dependent on following

(i) The proportion of its business conducted by foreign subsidiary(ii) The location of its foreign subsidiary(iii) The accounting method that it use

Managing exchange rate risk

Transaction exposure a MNC is exposure to exchanger rate

fluctuation in there ways

(i) transaction exposure(ii) economic exposure


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(iii) translation exposure by managing translation exposure financial manager may be

able to increase cash flows and enhance the value of their

MNCs

transaction exposure exits when the future cash flow transactionof a firm are affected by exchange rate fluctuation.

Technique to eliminate transaction exposure

(i) future hedge(ii) forward hedge(iii) currency option hedge (iv) money market hedge

Future hedge currency future can be used by a firm that desire to hedge

transaction exposure

Purchasing currency system a firm that buy a currency future contract is

entitled to receive a specified amount in specified currency for a stated price on

a specified date.

Selling currency future a firm that sells a current future contract is entitled to

sell a specified amount in a specified currency for a stated price on specified

date.

Forward hedge forward contract can be used it lock in the future exchange

rate at which a MNC can be or buy a currency. A forward contract is very

similar to future contract hedge expect that forward contract are commonly use d

for large transaction, where future contract tend to be used for small amount

MNC;s can request forward contract that specifying the exact number of units

that they desire whereas future contract represent a standardized number of

units for currency.


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Money market hedge - Money market hedge involve taking a money market

position to cover a future payment or receivable position money market

Hedge on payment if a firm has excess cash it can create a short term depositin the foreign currency that it will need in the future Hedging of future

receivables with forward sale is similar to borrowing at the foreign interest rate

interesting at the at the home interest rate

Currency option hedge the currency option has an advantage over the other

hedging in that it does not have to be exercised if the MN would be both off

unhedged. A premium must be paid to purchase the currency option however so

there is a cost for the flexibility they provide.

Hedging payables with currency call option- a currency call option provides

the right to buy a specified amount of a particular currency at a specified price

with a given period of time. The currency call option does not obligate its owner

to buy the currency at that price.

Comparison of techniques to hedge payables- A comparison of hedging

techniques should focus on obtaining a foreign currency at the lowest possible

cost.

Currency swap- A currency swap is a second techniques for hedging long-term

transaction exposure to exchange rate fluctuation. It can take many forms. One

type of currency swap accommodates two firms that have different long-term

needs.

Paralled loan- A paralled loan involves an exchange of currencies between two

parties with a promise to exchange currencies at a specified exchange rates and

future date, it represents two swaps of currencies one swap at the inception of

the loan contract and another swap at the specified future date. A paralled loan


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is interpreted by accountant as a loan and is therefore recorded on financial

statements.

Alternative hedging techniques- When a perfect hedge is not available toeliminate transaction exposure, thefirm should consider methods to at least

reduce exposure, such method include t he following-

- leading and lagging

-cross-hedging

-currency diversification

Ledging and lagging- the act of leading and lagging involves an adjustment in

the timing of a payment request or disbursement to reflect expectation about

future currency if a company expects that the pound will soon depreciate against

foreign, it may attempt to expedite the payment to thundery before the pound

depreciates. This strategy is referred to as leading. If a British subsidiary

expects the pound to appreciate against the forint soon, in that case the british

subsidiary may attempt to all its payment until after the pound appreciates. In

this way, it could use fewer pounds to obtain the forint needed fo r payment, this

strategy is referred to as lagging.

Cross-hedging- cross hedging is a common method of reducing transaction

exposure when the currency cannot be hedged.

Currency diversification- a third method for reducing transaction exposure is

currency diversification, which can limit the potential effect of any single

currencys movements on the value of an MNC. The coca-cola co, pepsi co.,

Philip Morris.


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An MNCs management of transaction exposure can affect its value. Hedging

decision on remitted funds affect the expected value of the exchange rate at

which the funds are converted to dollar and therefore affect the dollar cash

flows. That are ultimately received long the US parent.

Economic Exposure-

Economic exposure represents any impact of exchange rate fluctuation on a

firms future cash flows. Corporate cash flows can be affected by exchange rate

movements in ways not directly associated with foreign transaction. Thus, firms

cannot focus just on hedging their foreign currency payable a receivable but

must also attempt to determine how all their cash flows will be affected by

possible exchange rate movement.

How to assess economic exposure-

An MNC must determine its economic exposure before it can manage its

exposure. It can determine its exposure to each currency informs of its cash

inflows and cash outflows. The income statements for each subsidiary can be

used to derive estimates.

How restructuring can reduce economic exposure -

MNCs may restructure their operations to reduce their economic exposure. The

restructuring involves sniffing the sources of costs or revenue to other locations

in order to match cash inflows and outflows in foreign currencies.

Issues involved in the restricting decision-

Restructuring operations to reduce economic exposure is a more complex task

than hedging any single foreign currency transaction which is why managing

economic exposure is normally perceived to be more different than managing

transaction exposure.


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By managing economic exposure the firm is developing a long term solution

because once the restructuring is complete, it should reduce economic exposure

over the long-run.

When deciding how to restructure operations to reduce economic exposure, one

must address the following questions-

1. should the firm attempt to increase or reduce sales innew or existing foreign markets?

2. Should the firm increase or reduce its dependency onforeign suppliers?

3. Should the firm establish or eliminate productionfacilities in foreign markets?

4. Should the firm increase or reduce its level of debtdenominated in foreign currencies?

MNCs that have production and marketing facilities in various countries may be

able to reduce any adverse impact of economic exposure by shifting the

allocation of then operation.

Nikes economic exposure comes in various forms. First, it is subject to

transaction exposure because of its numerous purchase and sale transactions in

foreign currencies, and thus transaction exposure is a subset of econo micexposure.

TRANSLATION EXPOSURE-

Translation exposure occurs when an MNC translates each subsidiaries

financial data to its home currency for consolidated financial statement.

Some people argue that it is not necessary to hedge or even reduce translat ion

exposure as cash flow is not affected. Some MNCs attempt to avoid translationexposure by matching foreign liabilities with foreign assets. For example, Philip

Morris uses foreign financing to matching its covers of foreign assets.

Use of forward contract to hedge translation exposure-


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MNCs can use forward contracts or futures contracts to hedge translation

exposure. They can sell the currency forward that their foreign subsidiaries

receive as earning. In this, they create a cash outflow in the currency to offset

the earning received in that country. Companys decision to hedge translation

exposure.

Limitations on hedging translation exposure-

There are 4 limitations in hedging translation exposure-

1. In accurate earnings forecasts2. In adequate forward contrasts for some currencies.3. Accounting distribution4. Increased transaction exposure.

Alternative solutions to hedging Translation Exposure- Some MNCs do not

consider hedging translation exposure because they do not perceive this

exposure to be relevant.

How managing exposure affects a MNCs value-

A MNCs management of economic exposure can affect its value. Suice

transaction exposure is a subset of economic exposure, foreign subsidiaries that

exchange their local currencies follows as part of their normally b usiness mustmange their transaction exposure, which affects their expected foreign currency

cash flows.

An MNCs value is also affected by the way it manges other forms of economic

exposure that are unexpected to transaction exposure.

Short term financing in international

Source of Short term financing MNC parent and their subsidiary

typically use various method of obtain short term funds to satisfy their

liquidity needs.

Euro notes these are unsecured on their notes are based on LIBOR

(the interest rate Euro banks change on interbank loan). Euro notes


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typically have maturities of 1, 3 or 6 month commercial bank

underwrite the notes mores.

Euro commercial paper MNCs also issue euro commercial paper

to obtain short term financing .Dealers issue this paper for MNCs without the banking of an

under writing syndicate so a selling price is not guarantee to the issues

matereties can be tailored to the issuer performance.

Dealers makes a secondary market by offering to repurchase euro

commercial paper before maturity.

Euro bank loan direct loan from euro banks which are typically

utilized to maintain a relationship with euro bank & are another

popular source of short term funds for MNCs. if other source of short

term funds become unavailable MNCs rely more heavily on direct

loan from euro banks. Most MNCs maintain credit arrangement with

various banks around the world. Some MNCs have credit

arrangement with more than 100 foreign and domestic banks.

Internal financing by MNCs An MNCs parent or subsidiary in

need of funds search for outside funding it should cheek other

subsidiary cash flow position to determine whether any internal funds

are available.

Foreign financing to offset foreign currency inflows a large firm

may finance in foreign currency to offset a net receivables position inthat foreign currency.

Foreign financing to reduce cost even when an MNC parent or

subsidiary is not attempting to cover foreign net receivable it may still


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consider borrowing foreign currency if the interest rates on those

currencies are attractive financing in foreign currency has become

common as a recent of the development of the euro currency market.

The cost of financing can vary with the currency borrowed in the euro

currency market. A euro currency loan may offer a slight lower rate

than a loan in the same currency through the home currency.

Determining the effective financing rate the value of the currency

borrowed will most likely changed with respect to the borrowers

local currency over time. The actual cost of financing by the debtor

firm will depend on

(i) The interest rate changed by the bank that provided theloan and

(ii) The movement in the borrowed currencys value over thelife of the loan, thus actual or effective financing rate may

differ form the quoted interest rate.

Criteria considered for foreign financing

(i) Interest rate parity(ii) The forward rate as a forecast(iii) Exchange rate forecast

Interest rate paritycovered interest arbitrage was described as a

foreign short term investment with a simultaneous forward sale of the

Foreign currency denominating the foreign investment.

from a financing prospective covered interest arbitrage can be

conducted as follows. First borrow a foreign currency and conceit that

a currency to the home currency of ruse


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also, similarly purchase the foreign currency forward to lack in the

exchange rate of the currency needed to pay off the loan if the foreign

currency interest rate is low this may appear to be a feasible strategy.

However such a currency.

normally will exhibit a forward premium that that offset differential

between is interest tare and home interest rate.

this can be shown by recognizing that the financing firm no

longer will be affected by the percentage change in exchange rate but

instead by percentage differential between the spot rate at which the

foreign currency was converted to the local currency and the forward

rate at which the foreign currency was repurchased the difference

reflects the forward premium (animalized)

The forward rate as a forecast exchange rate forecast

recent movement as a forecasting future movements

Actual Regents from foreign financing

The fact that some firm utilized foreign financing suggest that they

believe reduce financing cost can be achieved.Financing with a portfolio of currencies portfolio diversion effects

Repeated financing with a currency portfolio

The more volatile a portfolios effective financing rate overtime the

more uncertainty (risk)

There is about the effective financing rate that will exist is any period

Impact of short tern financing on the MNCs value

Will enhance the value of MNC


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International cash managementcash flow analysis subsidiaryperspective Subsidiary expenses Subsidiary revenue Subsidiary

dividend payment Subsidiary liquidity management Subsidiary

commonly have access to numerous line of credit and overdraft

facility in various countries, therefore they may maintain adequate

liquidity without substantial cash balances.

Centralized cash management

A centralized cash management group may be need to monitor and

possibly manage, the parent subsidiary and inter subsidiary cash

flows.

Technique to optimize cash flows

(i) Accelerating cash inflows(ii) Minimizing currency conversion cost

(iii) Managing inter subsidiary cash transfersinn the case of acerbating cash flow is to the accelerate cash inflow,

since the more quickly the inflows are received or used for otherpurpose.

the technique for optimizing cash flow movements netting can be

implemented with the joint effort subsidiary or by the Centralized

cashmanagement group the technique optimize can flow by reducing

the administrative and transfer cost that result from currency

conversion.

Cash flow can be affected by a host govt. blockage of funds which

might occur if the government require all funds to remain with the

country in order to create jobs and reduce unemployment. MNC may

instruct subsidiary to set up a research and development division.


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Which incurs cost and possibly generates revenue for other

subsidiaries.

another strategy is to use transfer pricing a manner that will increase

the experts incurred by the Govt. is likely to be more lenient canfunds set to cover expenses than on earning remitted to the parent.

proper management of cash flow can also be financial to a subsidiary

in need of funds.

complication in optimizing cash flow

(i) Company related characteristics(ii) Government restriction

(iii) Characteristic of banking systemif one of the subsidiary delays payment to other subsidiary for

supplies received the other subsidiary may be forced to borrow until

the payment arrive.

The existence of Government restriction can disrupt a cash flow optimizationpolicy. The abilities of banks to facilitate cash transfer for MNC vary among

country bank in the united state are advance the field but banks in some other

countries do not offer service.

Investing excess cash any remaining funds can be invested in domestic or

foreign short term security in some periods, short term security will have higher

interest rate than domestic interest rate.

How to invest excess cash international money markets have grown to

accommodate corporate investment of excess cash. MNCs may use

international money market in an attempt to achieve higher returns that what

they can achieve domestically.

Centralized cash management the function of optimizing cash flow can be

improved by a centralized approcech since all subsidiary cash position can be

monitored simultaneously.


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Centralization when subsidiaries use the same currency the centralized

approach can also facilitate the transfer of funds from subsidiaries with excess

funds to those that need funds.

Determining the effective yield

It is the deposits effective yield not is interest rate, that is mist important to the

cash manager the effective yield of a bank deposit couriers both the interest rate

and the rate of appreciation (or deprecation) of the currency denominating the

deposit and cash therefore be very different from the quoted interest rate on a

deposit denominated in a foreign currency.

Implication of interest rate parity

Covered interest arbitrage is described on a foreign short te rm investment with a

simultaneous forward sale of the foreign currency denominating the foreigninvestment.

uncovered basis (without use of the forward market)

investor cannot lock in a higher return when attempting covered interest

arbitrage if interest rate parity exists.

Use of forward rate a forecast if interest rate parity exists the forward rate can

still be a indicator for the US firm investment decision.

Relation ship with the interest rate and Fisher effect

IFE suggests that the exchange rate of a foreign currency is expected to change

by an amount reflecting the differential between its interest rate and the US

interest rate.

Use of exchange rate forecast

Although MNCs do not know how a currencys value will change over the

investment horizon they use use formulator effective yield and plug in their.

Forecast for the percentage change in the foreign currency's exchange rate since

the interest rate if the foreign currency deposit is known the effective yield on a

foreign deposit can their be comp ared with the yield when investing in the

firms local currency.

Use of probability distribution


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It is something useful to developing a probability distribution instead of

relaying on a single prediction since even expert forecasts are not always

accurate.

Diversifying cash across currencies

An MNC may prefer to diversify cash among securities denominated in

different currencies because it is not sure how exchange rates will

Change over time. Limiting the percentage of excess cash inversed in each

currency will reduce the MNCs exposure to exchange rate risk.

the degree to which a portfolio of investment denominated in various currencies

will reduce risk depends on the currency correlation.

Impact of international cash management on MNCs value

An MNCs international cash management can affect its value. If an MNCs

foreign subsidiary can invest its cash the currencies that offer a higher return

that is available from investing in local securities it can increases the level of its

foreign currency cash flows.

Capital budgeting for international project

Multinational capital budgeting MNCs evaluate international project by using

Multinational capital budgeting which compare the benefit and cost of these

projects.

the most popular method of capital budging involves determine the present

value of project future cash flow and subtracting the initial outlay required for

the project. Multinational capital budgeting typically uses a similar process.

Subsidiary versus parent perspective

capital budgeting may generate different result and a different conclusion

depending on whether it is conducted from the perspective of an MNCs

subsidiary or from the perspective of MNC;s parent. The subsidiary perspective

does not consider possible exchange rate and tan effect on cash flow transferred

by the subsidiary to the parent. When a parent is deciding whether t o implement

an international project it should be determine whether the project is feasible

from its own perspective.

Tan differential


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If the earning due to the project will someday be remitted to the parent, the

MNC needs to be consider how the parents Govt. taxes these earning if the

parents Govt. impose a high tax rate on the remitted funds the project may be

feasible from the subsidiary point of view. Under such a scenario the parent

should not consider implementing the project even through it appe ars feasiblefrom the subsidiary perspective.

Restricted Remittances

Consider a potential project to be implemented in a country where Govt.

restriction require that a percentage of the subsidiary earning remain in the

country. Since the parent may be nev er have access to these funds, the project is

not attractive to the parent. Yet the project may be attractive to the subsidiary,

one possible solution is to let the subsidiary obtain partial financing for the

project within the host country. In this case the portion of funds not allowed tobe sent to the parent can be uses to lover the financing cost over time.

Exassive remittance

A parent changes it subsidiary very high administrative fees because

management is centralized at the headquarters. To the subs idiary the fees

respect an expense to the parent the fees respect revenue that may subsidiary

exceed the actual cost of managing the subsidiary neglecting the parent

perspective will distort the true value of a foreign project.

Exchange rate movement

The amount received by the parent is therefore influenced by the existing

exchange rate if the subsidiary project is assessed from the subsidiary

Perspective the cash flows forecasted for the subsidiary do not have it be

converted to the parent currency.

Impact for multinational capital budgeting

Regard lean(inclined) of the long term project to be considered an MNC willnormally require forecast of the economic and financial characteristic related to

the project.

The characteristic are:


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(i) Initial investment the parent initial investment in a project may constitutethe major source of funds to support a particular project. Working capital

to support the project overtime is also included.

(ii) Consumer demand(iii) Price future inflation on rates must be forecasted(iv) Variable cost hourly labor cost to cost of materials.(v) Fixed cost sensitive to any change in host countrys inflation rate.

(vi) Project life time some project have indefinite lifetime. Political eventsmay force the firm to liquidate the project earliest that p lanned.

(vii) Salvage (liquidation) value host government could take over the project

without adequately compersateeing the MNC

(ix) Tax's laws after tax cash flow are necessary for an adequate capital

budgeting analysis, international tax effects must be determined on any

proposed foreign projects.

(x) Exchange rates most budgeting technique are used to cover short term

position it is possible to hedge over longer periods (with long term forward

contract or currency swap).

(xi) Required rate of return cash flow can be discounted at project required rateof return.

Factors to consider in multinational capital budgeting

(i) Exchange rate fluctuation(ii) Inflation

(iii) Financing arrangement(iv) Blocked funds(v) Uncertain salvage value

(vi) Impact of project on preventing cash flow(vii) Host Govt. incentives


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(viii) Exchange rate will typically change overtime. The difficultly inaccurately forecasting exchange rate is well known.

(ix) inflation - capital budgeting analysis implicitly consider inflation, sin cevariable cost permute and product prices generally have been rising over

time. In some countries inflation can be quite volatile from year to yearand can therefore strongly influence a project net cash flows.

(x) Financing arrangement(xi) Many foreign projects are partially financed by foreign subsidiary. If the

parent provides the endive investment no foreign financing is required

can sequent the subsidiary makes no interest payment and therefore

remits larger cash flow to the parent. Given the larger payment to the

parent, the cash flow ultimately received by the parent are more

susceptible to exchange rate movements. Some foreign projects are

completely financed with retained earning of existing foreign subsidiary.

(xii) A subsidiarys investment in a project as an the opportunity cost isviewed since the funds could be remitted to the parent rather that invested

in the foreign project.

(xiii) Blocked funds(xiv) The host country may block fund that the subsidiary attempts to send to

the parent, some countries require that earn ing shuerated by the

subsidiary be reinvested locally for at least there year before they can be

remitted such restriction can affect the accept/reject decision on a project.

(xv) Uncertain salvage value(xvi) The salvage value of an MNCs project topically has a sig nificant impact

on the projects NPV.

(xvii) if the actual salvage value is expected to equal or exceed the breakeven salvage value (called SVn) can be determine by setting NPV equalto zero.

(xviii) Impact of project on prevailing cash flows(xix) In reality in the new project there may be often be an impact. Some

foreign projects may have favorable impact on prevailing cash flows.


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(xx) If a manufacture of competer components establishes foreign subsidiary(xxi) To manufacture competer the subsidiary might order the component from

the parent. In the case the sale volume of the parent would increase

(xxii)

(xxiii)Host Govt. incentives

A low rate host Govt. loan a reduced tax rate offered to the subsidiary will

enhance periodic cash flows. If the Govt. subsidiary the initial establishment o f

the subsidiary the MNCs initial investment will be reduced.

Adjusting project assessment for risk

3 methods used to adjust evaluate for risk:

(i) Risk adjusted discount rate(ii) Sensitively analysis

(iii) SimulationsRisk adjusted discount rate the greater the uncertainly about a project

forecasted cash flows the larger should be the discount rate applied to cash

flows. This risk adjusted discount rate tends to reduce the worth of a project bya degree that reflects the risk the project exhibits.

The risk adjusted discount rate is a commonly used technique perhaps because

of the case with which it can be arbitrarily adjusted.

Sensitively analysis - Sensitively analysis can be more useful than simple point

estimates because it meassesses the project learned on var ious instances that

may occur.

Simulations - Simulations can be used for a varity of tasks including thegeneration of a probability distribution for NPV based on a range of possible

values for one or more input variables.

Simulations generates a distribution of NPVs for the project the major

advantage of Simulation techniqye does not put all of its empasis on any


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aneparticuler NPV forecast but instead provides a distribution of the possible

outcomes that may occur.

Impavt of multinational capital budgeting on an MNCs value

multinational capital budgeting decision affects the value the MNC. Becausemultinational capital budgeting decision determine the types of operation of the

MNCs they also affect the level of the MNCs risk when the MNCs parent

financially supports the foreign projects it cost of capital is affected, which

influence its requoirsd rate of return on its business and its vaulue.

Internatioanl Finance

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