International Finance and Trade [Emba]5207 2011 Edition

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NATIONAL UNIVERSITY OF SCIENCE

AND TECHNOLOGY

GRADUATE SCHOOL OF BUSINESS

EXECUTIVE MASTER OF BUSINESS

ADMINSTRATION PROGRAMME

INTERNATIONAL FINANCE AND

TRADE EMBA (5207)

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Chapter One: ...................................................................................... page 1.

International Business Finance and Financial markets

Chapter Two......................................................................................page 8.

International Flow of Funds

Chapter Three.......... .........................................................................page 17.

Relationship between Inflation, Interest Rates and Exchange Rates

Chapter Four.....................................................................................page 23.

Government Intervention in the Exchange Foreign Market

Chapter Five.......................................................................................page 29.

Foreign Exchange Exposure Measurement and Management

Chapter Six.........................................................................................page 40.

Country Risk Analysis

Chapter Seven....................................................................................page 46.

International Treasury Management and Financing

Chapter Eight ....................................................................................page 51.

Multinational Cost of Capital and Capital structure

Chapter Nine .....................................................................................page 58.

Foreign Direct Investment

Chapter Ten ......................................................................................page 62.

Multinational Capital Budgeting Decisions

Chapter Eleven..................................................................................page 69.

International Payments

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SYLLABUS

Course Objectives:

• To identify the main goal of the multinational corporation (MNC) and conflicts with that goal;

• To describe the key theories that justify international business;

• To explain the common methods used to conduct international business.

• To describe the background and corporate use of the following international financial markets:

• To identify the commonly used techniques for hedging international exposure;

• To analyze country risk indicators

Course Synopsis:

The major topics and concepts covered in this course module include, Introduction to International

Financial Management ,International Capital Flows ,International Financial Markets, Exchange Rate

Determination and Currency Derivation, Government Influence on Exchange Rate movements,

International Parity and International Parity Theorems ,Forecasting Exchange rates ,Managing

Exposure in International Trade, Foreign Direct Investment and Country Risk Analysis

Delivery Methods:

The course will be delivered through lectures, group discussions and case presentations. Notes and hand outs

will :be provided when ever its necessary.

Course Assessment

The course is assessed through the following three components:

Final Examination 60%

Individual Assignment 20%

Group work (Case Study) 20%

Total 100%

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Module delivery programme

LESSONS START AT 0830 AND END AT 1600HRS EVERYDAY FROM THE ..........................2011 TO

............................. 2011.)

DAY TOPIC S Requirements

DAY ONE Topic 1-

Introduction to International Financial

Management , International Capital Flows

Topic 2-

Exchange Rate Determination

Forecasting Exchange

Notebook, calculator

Read Chapter 1,2 Jeff

Madura (J S. E S)

Eiteman Stonhill (E, S)

DAY TWO Topic 3

Parity Theorems

International Parity Theorems

Read Chapter

Read Chapter 4,

J S , ES, Module

DAY THREE Topic 4

Government Influence on Exchange Rate

Topic 5

Exposure Measurement and Management

Read module

JM, ES

DAY FOUR Topic 6


Topic 7

Treasury Management and Financing

Read Module , J S ES,

case

DAY FIVE Topic 8

Cost of International capital

Topic 9


Read module

J S , E S, Case

DAY SIX Topic 10

Multinational Capital Budgeting

Topic 11


Read

Module, JS, ES, Case

study

DAY SEVEN Case Presentations and Revision

Group Presentations

on case studies

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AIMS of the Module

The module aims to examine the theory and practice of modern international finance and trade.

The rapid growth of MNCs has highlighted the significance of the international finance function in

firms while the greater volatility of exchange rate systems and deregulation of financial markets

accentuate the need for financial managers to cope with complex cash and currency management,

investment and financing decisions.

On completion of the module students should:

1. Critically discuss the strategic role of international finance and the drivers of globalisation of

business.

2. Discuss the theoretical and practical issues of exchange rate determination.

3. Discuss currency and interest rate risks and critically evaluate their management techniques

including derivatives.

4. Critically discuss the various sources of finance for multinational companies and the

complexities of financial markets in which the international finance manager operates.

5. Critically evaluate international capital investment decisions within the context of corporate

objectives and strategies using appropriate financial techniques.

6. Critically discuss the opportunities and constraints in international treasury management

and mobilisation of finance around the globe

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Chapter One:

1.0.International Business Finance and Financial markets

Learning Outcomes:

• To recognize the main goal of the Multinational Corporation (MNC) and the factors that

conflict with that goal.

• To review and examine the key theories that explain the existence of International Business.

• To understand common ways in which International Business is conducted.

• To discuss the Fundamentals of International Finance and Financial Markets.

KEY TERMS

• MULTINATIONAL CORPORATION (MNC) ARBITRAGE

• CAPITAL MARKET FOREIGN EXCHANGED RATE

• SPOT RATE FORWARD RATE

• FLOATING EXCHANGE RATE MANAGED EXCHANGED RATE

1.1. Objectives of Multinational Corporation Financial Management

Financial management in a domestic environment is one of the curious combinations of

mathematics precision with the source of all random behaviour. When financial management is

stretched across geographic, cultural, and political and jurisdiction boundaries, more variables are

introduced and considered as compared to domestic financial management.

The traditional areas of financial management are:

• Capital Structure: Determination of what proportions of debt and equity re necessary for

the firm’s maximum financial health and long-term competitiveness.

• Capital Budgeting: Analysis of investment opportunities and lines of business activity that

are considered by the firm.

• Long term financing: Selection, issuance and management of long term sources of capital

by the firm

• Working capital management: Management of the levels and composition of the firm’s

current assets and their sources of funding.

International Financial Environment will consider issues such as global financial management,

Balance of payments, repositioning of funds, multinational taxation and capital budgeting.

Figure 1.1. International Financial Environment

Why are firms motivated to expand their business internationally?

The commonly accepted goal of an

the Anglo-American approach to business.

theory and thinking has resulted in the development of other internationally accepted goals of

business. The most recent and popular approach

1.2. Theories of International Business

1. Specialization by countries can increase production effi

2. Imperfect Markets Theory

• The markets for the various resources used in production are “imperfect.”

3. Product Cycle Theory

• As a firm matures, it may recognize additional opportunities outside its home

country.

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.1. International Financial Environment

motivated to expand their business internationally?

The commonly accepted goal of any MNC is to maximize shareholder wealth. This is referred to as

American approach to business. However the development of Financial Management

ng has resulted in the development of other internationally accepted goals of

popular approach is the corporate wealth maximization.

Theories of International Business

Specialization by countries can increase production efficiency.

The markets for the various resources used in production are “imperfect.”

As a firm matures, it may recognize additional opportunities outside its home

This is referred to as

However the development of Financial Management

ng has resulted in the development of other internationally accepted goals of

is the corporate wealth maximization.

As a firm matures, it may recognize additional opportunities outside its home

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Figure 1. 2 International Product Life Cycle

� Firm exports product to accommodate foreign demand.

� Firm creates product to accommodate local demand.

The International Product Life Cycle

� Firm establishes foreign subsidiary to establish presence in foreign country and possibly to reduce costs.

�a. Firm differentiates product from competitors and/or expands product line in foreign country.

�b. Firm’s foreign business declines as its competitive advantages are eliminated.

or

The theory of internalisation causes firms to expand into regional and international markets

into order to preserve their technology and other forms of competitive advantages

1.3. Multinational Corporation Decision to go into International Markets

The decision to go into international markets should be premised on the shareholder value addition.

A company should go international if the value of shareholders is increased by the cash flow arising

from the cross border investment.

Figure 1.3 shows the cost and benefit analysis for domestic firms versus MNCs. As the firm’s asset

base increases as a result of investing in international markets, the marginal return for a MNC will

increase at a higher rate than that of a purely domestic firm.

1.4. The Potential For Conflict for a MNC

From an economic perspective, host countries welcome multinational firms because they are viewed

as agents of technology transfer and host-country economic development. From a business

perspective, multinational firms are eager for opportunities to invest in geographic locations where

they can earn a rate of return high enough to compensate them for the perceived level of risk.

National and international market imperfections provide these opportunities.

Although a strong economic and business rationale exists for the success of multinational firms, they

must live within host-country economic, political, social, and religious goals and the potential for

conflict with such goals is imminent. Thus, maximizing the value of the multinational firms for the

benefit of their shareholders may conflict with concepts of national sovereignty, which nearly always

override the rights of individual firms, multinational or domestic. Therefore, in choosing operational

financial goals and marking policy decisions to implement these goals, financial executives of

multinational firms must recognize the institutional, cultural, and political differences among host

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countries, which in turn lead to different national persecutions of the proper goals of a business

entity.

Marginal Return on

Projects

Purely Domestic Firm

MNC

Asset Levelof Firm

InvestmentOpportunities

Fig 1.3. International Opportunities

Cost-benefit Evaluation for Purely Domestic Firms versus MNCs

Appropriate Size for Purely Domestic Firm

Appropriate Size for MNC

X Y

Marginal Cost of Capital

Purely Domestic Firm MNC

FinancingOpportunities

1.5. Multinational Firms and Fluctuating Exchange Rates

An understanding of foreign exchange risk is essential for managers and investors in today’s

environment of volatile foreign exchange rates. The present international monetary system is

characterized by a mix of floating and managed exchange rate policies pursued by each nation in its

own best interest. When a currency increases in relative value, as was the case for the U.S. dollar

between 1981 AND 1985, U.S. exports decline because their prices become too high when converted

to the currency of the foreign importer. Likewise, imports increase because they cost less in local

currency terms. In the U.S. example, the loss of exports hurt gross domestic product and

employment, but low-cost imports benefited consumers and helped keep a lid on inflation. Thus,

any firm that exports or imports, or even a domestic firm that competes against imports, would be

directly affected by changes in the value of the U.S. Dollar. All firms must understand foreign

exchange risk in order to anticipate increased competition from imports or to realize increased

opportunities for exports.

Multinational have the advantage of being geographically diversified. They need to understand

foreign exchange risk in order to shift production to countries with relatively undervalued currencies

and to promote sales in countries with overvalued currencies. They also typically have access to

international sources of funds. The relative cost of these funds, after consideration of exchange rate

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effects, is likely to change, thereby firms giving multinational firms an opportunity to lower their cost

of capital.

1.6. Multinational Firms and Capital Markets

During the past decade an explosive growth has occurred in the use of international capital markets

to lower a firm’s cost of capital. This growth has been fuelled in part by a trend toward liberalizing

securities markets in the most important world capital markets, which has motivated a large net

increase in international portfolio investment. The United States was the first to liberalize.

Subsequently, the European Union countries have adopted rules that should eventually lead to an

integrated money and capital market. The “Big Bang” of October 1986 was the U.K. version of capital

market liberalization. Other EU members followed soon after with their own deregulation initiatives.

Even the Japanese capital market has been slowly liberalized. Foreign firms have been admitted to

the Tokyo Stock Exchange. Restrictions on the use of the yen as an international currency have been

eased and foreign firms may raise capital in Japan.

Although global integration is well started, many restrictions on the free flow of capital still exist,

especially in the newly-emerging capital markets. Furthermore, performances of stock and bond

markets vary widely among countries and over time. Therefore opportunities still exist for both firms

and portfolio investors to benefit from diversifying internationally.

1.7.Multinational Firms and Corporate Governance

Capital market integration has enabled multinational firms to source their equity and debt in global

markets. However, in order to attract global investors, it has become necessary for multinational

firms to become more “shareholder friendly”. The traditional corporate governance norms, which

have fostered both the corporate wealth and shareholder wealth maximization models, depending

on country, are under attack.

In the Anglo-American markets, some politicians, academics, and interest groups have been

espousing changing corporate governance “stakeholder capitalism”. This would be consistent with

moving part-way toward the goal of corporate wealth maximization

In the non-Anglo-American markets, the same political pressures exist to change corporate

governance norms to permit more shareholders’ influence. This means weakening takeover

defences and adopting more of the policies promoted by agency theory in the Anglo-American

markets.

Where will it end? Those firms that need to raise capital globally will need to move part of the way

toward the shareholder wealth maximization model. On the other hand, it does not appear that they

are likely to remove such takeover defences as dual class of stocks. Even the New York Stock

exchange, considered one of the last great bastions of pure shareholder wealth, now accepts listings

from firms with dual classes of stock (If that is the tradition in the firm’s home country). Even if

takeover defences remain in place, however, it is likely that multinational firms might adopt such

“agency theory” incentives as more significant stock option programmes for managers in order to

align their interests with those of the shareholders.

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In the Anglo-American markets, multinational firms are likely to move part of the way toward

“stakeholder” capitalism as a larger share of their markets, production, assets, debt, and investors

are located outside their home countries. Wherever the stakeholder model is the norm, pressure

will increase on multinational firms to consider other interest groups, rather than mainly their home

country shareholder group.

1.8 The Foreign Exchange Market

Foreign exchange markets exist because most countries have their own monetary units in which

business is done within their own borders. Trade between countries in goods and securities

therefore requires the exchange of national moneys. The foreign exchange market is where this

occurs. We define the exchange rate as the domestic currency price of a unit in foreign currency.

Since each country or currency area has an exchange rate with every other currency area, there are

many more exchange rates than there are currencies. Internal consistency of this network of

exchange rates is maintained by arbitrage. The latter is defined as a set of simultaneous transactions

at existing exchange rates from which a sure profit can be made as a result of discrepancies between

those rates. For example, if the exchange rates between the dollar, yen and pound were such that

one could make a profit by converting dollars to yen, yen to pounds, and pounds back into dollars,

foreign exchange traders will make these trades and quickly create market pressures that will

restore consistency between the rates. It is customary for traders to use certain currencies, like the

U.S. dollar, the British Pound, the Euro and the Japanese yen as vehicle currencies or international

moneys. This means that trade between countries other than vehicle-currency countries is

conducted in a vehicle currency with the local moneys being exchanged for the vehicle currency

rather than for each other.

1.9. Reasons for investing in Foreign Markets:

¤ to take advantage of favourable economic conditions;

¤ when they expect foreign currencies to appreciate against their own; and

¤ to reap the benefits of international diversification.

1.10. Borrowers borrow in foreign markets:

¤ to capitalize on lower foreign interest rates and due to international market

fragmentation

¤ when they expect foreign currencies to depreciate against their own.

1.11. Forms of International trade

1.11.1. International Trade - importing and exporting - conservative (often first step) Low barriers to

entry, minimal risk.

1.11.2. Licensing - allows expansion of a firm's technological advantages without major costs of

foreign investment or transportation. Problem of ensuring (enforcing) quality control in foreign

production process.

1.11.3. Franchising - Like licensing, it allows firms to penetrate foreign markets without major

foreign investment (enforcement of quality control can be a complex issue, particularly for consumer

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firms like McDonalds and KFC, where brand uniformity must be weighed against cultural diversity of

tastes).

1.11. 4. Joint Ventures - allows two firms to apply their comparative advantages to a specific joint

actvity in a relatively simple manner. Avoids the entanglements and complications of mergers and

acquisitions.

1.11.5. Acquisition of Existing Operations (Subsidiary) - Opportunity to achieve quick market

penetration (existing customer base). Requires high foreign (capital) investment and is thus riskier.

(FORM OF DIRECT FOREIGN INVESTMENT - DFI)

1.11.6. Establishing New Foreign Subsidiary - Also requires large capital investment (perhaps not as

large as an acquisition) but also risky.

1.12. Barriers to International Market Integration.

The markets for real or financial assets are prevented from complete integration by barriers such as

tax differentials, tariffs, quotas, labour immobility, communication costs, cultural differences, and

financial reporting differences. The formation of regional blocks such as the Southern African

Development Community (SADC), the Common Market for Eastern and Southern Africa (COMESA),

Economic Community of West African States (ECOWAS), European Union (EU) and Southern African

Customs Union (SACU) fragments the operations of a global market.

The common aims for all these economic groupings are to remove barriers to entry and create

bigger markets for their goods and services. Yet, these barriers can also create unique opportunities

for specific geographic markets that will attract foreign investors.

Chapter One Practice Questions

1. Describe constraints that interfere with the MNCs’ finance managers’ objective of attempting to

maximize shareholders’ value.

2. It is always suggested that floating exchange will adjust to reduce or eliminate any current account

deficit. Explain why this adjustment would occur.

3. What are the main objectives of IMF and to what extent are these objectives being achieved?

4. What is the role of a factor in international trade transactions? How can a factor be useful to an

exporter?

5. Explain how the development of foreign trade would be affected if banks did not provide trade-

related services.

6. What is counter trade? Illustrate your answer.

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Chapter Two

Topic: International Flow of Funds

Learning Outcomes:

• To explain the key components of the balance of payments.

• To explain how the international flow of funds is influenced by economic factors and other

factors.

KEY TERMS

• BALANCE OF PAYMENT(BOP) TRADE FLOWS

• TRADE DEFICIT PRIVATE CAPITAL FLOWS

• CAPITAL ACCOUNT BOP DEFICIT

• BOP DEFICIT BOP SURPLUS

• GOVERNMENT RELATED TRANSFERS NET ERRORS AND OMISSIONS

• BELOW THE LINE ITEMS ABOVE THE LINE ITEMS

• J CURVE EFFECT

Comments

2.0. Balance of payments statement:

This is a measurement of all transactions between all the residents of a country vis-a-vis. the

rest of the world over a period of specified time, in most cases one year. Every time

something is sent abroad, something (which may be a cash balance in a bank) is received in

return from abroad. At any time, therefore, the value of what is received must be equal to

the value of what has been given. Because debits must equal credits individually, the inflows

must equal the outflows in the aggregate balance of payments.

2.1.1 Factors Affecting International Trade Flows

Inflation: A relative increase in a country’s inflation rate will decrease its current account, as

imports increase and exports decrease.

National Income: A relative increase in a country’s income level will decrease its current

account, as imports increase.

Government Restrictions: A government may reduce its country’s imports by imposing

tariffs on imported goods, or by enforcing a quota. Note that other countries may retaliate

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•

Fig. 2.1.Foreign Cash Flow Chart of an

MNC

MNC Parent

Foreign Subsidiaries

Foreign Business Clients

Eurocurrency Market

Eurocredit & Eurobond Markets

International

Stock Markets

Foreign Exchange Markets

Export/Import

Export/Import

Short-TermInvestment& Financing

Long-TermFinancing

ForeignExchange

Transactions

Medium- &Long-TermFinancing

DividendRemittance& Financing

Long-Term Financing

Medium- & Long-Term Financing

Short-Term

Investment & Financing

by imposing their own trade restrictions. Sometimes, though, trade restrictions may be

imposed on certain products for health and safety reasons.

Exchange Rates: If a country’s currency begins to rise in value, its current account balance

will decrease as imports increase and exports decrease. Note that the factors are interactive,

such that their simultaneous influence on the balance of trade is a complex one.

2.2. Analytical Arrangement of the BoP:

In any balance of payments presentation, all transactions between residents and non-

residents are conceptually or ideally divided into two analytical categories: current account

and capital account items.

Credits: All transactions leading to inflow of funds or earned foreign exchange are recorded

as credits.

Debits: Are transactions leading to outflow of funds or expended foreign exchange.

The recording of all transactions in the balance of payment statement is done by double

entry bookkeeping: meaning each transaction has both a credit and debit entry. Thus, at any

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given time, the ,total of credits and debits will be identical but opposite in sign for a country’s

balance of payment statement in aggregate.

2.3. The Balance of Payment Deficit:

For a trade deficit to occur (the value of imports exceeding exports) some importers must

have not paid in real goods their imports or there weren’t enough aggregate exports to pay

for all the imports. This means some of the imports were made on credit or through a

depletion of some of the cash or other assets held by exporters abroad or the government

came to their aid by paying for these excess imports.

In either case, we can describe the situation as selling financial assets to foreigners (i.e.,

borrowing from abroad). Selling financial or real assets to foreigner initiates capital inflows;

buying assets from foreigners results in capital outflows.

Therefore unless the government chooses to intervene, private capital inflows must always

be sufficient to cover the trade deficit (Private capital inflows occur when foreigners lend to

us, or invest here, or we draw down on our assets held abroad). More generally, the net

foreign capital inflow must be sufficient to offset the export shortfall in the trade account.

The above argument points out that private exports plus capital inflows must equal private

imports plus capital outflows, unless the government chooses to help the private sector pay

for some of those imports of goods (or financial assets) by drawing down on its international

reserves. When it does so, private purchases of goods and assets from abroad (imports plus

capital flows) exceed private sales of goods and assets to the rest of the world (exports plus

capital inflows), and we say there is a balance of payments deficit

Without the government’s intervention, credit transactions must equal debit transactions

implying there cannot be a balance of payments deficit or surplus. Thus, if there is an overall

surplus or deficit, it can only be to the extent of intervention by the central bank. Therefore,

to the extent that the central bank’s reserves decreased, there was an overall deficit and to

the extent the central bank’s reserves increased, there was a surplus.

2.3. Current Account: (summary of exports and imports)

The current account balance is composed of

a. The trade account

- Export of goods

- Import of goods

b. Payment for Services:

- The net amount of payments of interest to foreign investors and receipts from

foreign investments

- Payments from international tourism; and

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c. Unilateral transfers:

- Private gifts and grant

2.4. Capital Account:

The capital account is composed of all capital investments made between countries and is further

divided into two:

(i) Direct foreign investment, and

(ii) Purchases of securities with maturities exceeding one year.

Other significant sections of BoP statement are the official reserves and government related

transfers together with the net errors and omissions.

2.5. Official Reserve Position:

This section is sometimes referred to as below the line and represents the movements in the

Reserve Position of the Apex Monetary Authority of the country and is always of opposite in

sign to the total balance of all the items above the line.

2.6. Net errors and Omissions:

Quite often the official reserve movement never equals the above the line items and thus a

balancing figure is required which represents a category of unrecorded transactions. This is

the Net Errors and omissions entry.

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Transylvania’s Balance of Payments

‘Billions’

Debits Credits Nature of

Balance

Exports (goods sold to foreigners) 11

Imports (goods bought from

foreigners) -16

Net Balance - 5 Trade

Balance

Services like tourism and

Investments income

(and interest paid or received) -2 3

Aid and Gifts (a plug category) 1

Net Balance -3 Current

Account

Balance

Financial and real assets sold

to foreigners (Capital inflows) 3

Financial and real assets bought

from foreigners (Capital outflows) -2

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Net Balance -2 Overall

Balance

Government’s financial assets sold

(Foreign exchange reserves reduced) 3

Government’s financial assets bought

(Foreign-exchange reserves increased) –

Errors and omissions (plug category) -1

-21 21

2.7. Managerial Significance of BoP Imbalances

The significance of a deficit / surplus in the balance of payments has changed since the

advent of floating exchange rates. Traditionally, under fixed exchange rate regimes, BoP

measures were used as evidence of potential pressure on a country’s foreign exchange rate

(the price of foreign currency in terms of the local currency). The presence of a surplus

indicated potential foreign exchange rate’s appreciation and a deficit signified potential

depreciation.

2.8. Exchange Rate Impact:

The relationship between the BoP and exchange rate can be illustrated by the use of the

following equation:

Current Account Balanc e + [(Capital Account Balance +Financial Account Balance)] + Reserve

Balance

(X-M) + [(CI-CO) + (FI-FO)] + FXB

= Balance of Payments Equilibrium - BOP

Where:

X is exports of goods and services.

M is imports of goods and services.

CI is capital inflow (foreign direct investments)

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CO is capital outflow.

FI is financial inflow.

FO is financial outflow.

2.9. Correcting A Balance of Trade Deficit

By reconsidering the factors that affect the balance of trade, some common correction methods can

be developed. For example, a floating exchange rate system may correct a trade imbalance

automatically since the trade imbalance will affect the demand and supply of the currencies

involved.

However, a weak home currency may not necessarily improve a trade deficit. Foreign companies

may lower their prices to maintain their competitiveness. Some other currencies may weaken too.

Many trade transactions are prearranged and cannot be adjusted immediately. This is known as the

J-curve effect. The impact of exchange rate movements on intra company trade is limited.

Capital flows usually represent portfolio investment or direct foreign investment. The DFI positions

inside and outside the U.S. have risen substantially over time, indicating increasing globalization. In

particular, both DFI positions increased during periods of strong economic growth. Foreign exchange

balance is foreign exchange reserves balance of the country.

2.10 Effects of BOP imbalance on a country

The effect of an imbalance in the balance of payments of a country works differently depending on

whether that country is pursuing a fixed, floating, or a managed exchange rate system.

2.10.1 Fixed Exchange Rate Countries:

In this foreign exchange regime business managers use the balance of payments statistics to

forecast potential devaluation or revaluation of the official exchange rate. A deficit means a

country is a net supplier of its currency to the forex market and therefore should sell some

of its forex reserves to mop up its currency back to maintain a fixed exchange rate. The

reverse is also true in case of a surplus in the balance of payments.

2.10.2. Floating Exchange Rate Countries:

A country running a deficit means it has excess supply of its domestic currency appearing on

foreign exchange markets, and like all goods in excess supply, the market will rid itself of the

imbalance by lowering the price-- thus resulting in a depreciation of the domestic currency

in the foreign exchange market. The reverse case is also true for a country running a surplus

in the balance of payments. Therefore for a country following a floating exchange regime,

BoP deficit/surplus is used to forecast potentials for depreciation/appreciation of the foreign

exchange rate.

2.10.3. Managed Float:

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A country with a managed float that wishes to defend its currency may choose to raise its

domestic interest rate to attract additional capital from abroad or sell excess foreign

exchange to maintain a given level of foreign exchange rate. This action alters market forces

and creates additional market demand for the domestic currency, thus propping the

besieged currency.

2.11. Economic Development Impact

From a national income viewpoint, a deficit on current account might have a negative effect

on GDP and employment if underemployment exists, whereas a surplus could have a

positive effect. A current account’s deficit signifies excess of imports over exports. However,

at full employment capital will be attracted from abroad to enhance capacity leading to

increased employment creation. A surplus in the current account has the reverse impact.

Therefore, generally, a deficit has a negative impact on employment and therefore income

(because it exports jobs), unless such deficits are compensated by capital inflows in the

capital account (importation of capital from abroad).

2.12. Issues in International Capital Flows

The capital account and its subjective financial flow (autonomous) generate equal concern

for both the business firms and governments. Short-term capital flows respond primarily to

interest rate differentials and interest rate expectation changes across countries. No doubt

some countries with deficits in their BoP have always financed such deficits with short-term

capital flows as they fine-tune their domestic interest rates.

2.13. Short-term capital flows are primarily motivated by the interest rate

differentials between the countries.

Long term capital funds: long term capital flows play a significant role in the BoP structure

of many nations. Whereas short- term capital tends to follow interest rate movements, long-

term capital flow is typically attracted to economic and business environment opportunities

expected to provide significant long-term stability and economic growth.

Long-term capital flows are typically attracted to stable economic and business

environmental conditions – Opportunities for economic growth

2.14. Agencies that Promote International Capital Flows

A) International Monetary Fund (IMF)

The main objectives of IMF:

1- Promote co-operation among countries on international monetary issues.

2- Promote stability in exchange rates

3- Provide temporary funds to member countries attempting to correct imbalances of

international payments.

4- Promote free mobility of capital funds across countries, and

5- Promote free-flow of funds and trade.

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B) World Bank (IBRD) and its Associates

Primary objectives are to make loans to countries in order to enhance economic

development and by focusing on Government lending.

C) International Financial Corporation.

This institution was established to promote private enterprise development within the

member countries. In carrying out this function, it focuses on private sector

development and stock markets round the world.

D) International Development Association

Extends loans to less developed countries on concessional interest rates and is one of

the wings of the World Bank

E) Bank for International Settlement:

It facilitates co-operation among countries with regards to international transactions

and settlements.

I. Regional Development Agencies which are extensions of the World Bank as it

owns a substantial share in all of them:

-Asian Development Bank (ADB).

-American Development Bank (ADB).

-African Development Bank (ADB).

-European development bank of recent origin

2.15 International Capital Flows

Factors Affecting DFI :

• Changes in Restrictions

o New opportunities may arise from the removal of government barriers.

• Privatization

o DFI has also been stimulated by the selling of government operations.

• Potential Economic Growth

o Countries with higher potential economic growth are more likely to attract DFI.

• Tax Rates

o Countries that impose relatively low tax rates on corporate earnings are more likely

to attract DFI.

• Exchange Rates

o Firms will typically prefer to invest their funds in a country when that country’s

currency is expected to strengthen.

Factors Affecting International Portfolio Investment

• Tax Rates on Interest or Dividends

o Investors will normally prefer countries where the tax rates are relatively low.

22

• Interest Rates

o Money tends to flow to countries with high interest rates.

• Exchange Rates

o Foreign investors may be attracted if the local currency is expected to strengthen.

Chapter Two Practice Questions

1. What restrictions would prevent the exchange rate not always to adjust to a

Current account deficit?

2.Explain the implications of a Balance of Payment deficit for a country that operates in a fixed exchange

rate market, managed floating exchange rate market and free floating exchange.

3.Discuss the origins and functions of SADC, ECOWAS and COMESA.

Chapter Three

Relationship Between Inflation, Interest Rates and

Exchange Rates and the International Fisher Effect

Learning Outcomes

• To examine foreign exchange rate forecasting techniques.

• To observe the types of exchange rates systems used by different governments

23

• Understand how governments to intervene directly to affect exchange rates

• Understand the theory of Purchasing Power Parity (PPP) and its relationship to exchange rate

changes.

• Understand the theory of the International Fisher Effect (IFE) and its relationship to exchange

rate changes

• To be able to compare and contrast the PPP theory, IFE theory, and Interest Rate Parity (IRP).

• To understand how firms can benefit from forecasting exchange rates

• To review and examine common techniques used for exchange rate forecasting.

• Understand how forecasting performance can be evaluated.

• KEYS TERMS

•

• PURCHASING POWER PARITY (PPP) LAW OF ONE PRICE I

• INTERNATIONAL FISHER EFFECT (IFE) INTEREST RATE PARITY (IRP)

• EXCHANGE RATE FORECASTING LOCATIONAL ARBITRAGE

• TRIANGULAR ARBITRAGE COVERED INTEREST ARBITRAGE

• COVERED INTEREST ARBITRAGE EFFICIENT MARKET CONDITIONS

• EXCHANGE RATE FORECASTING FUNDAMENTAL FORECASTING

• TECHNICAL FORECASTING MARKET BASED FORECASTING

• MIXED FORECASTING.

Figure 3.1. Exchange Rate Behavior

Existing spotexchange rates

at other locations

Existing crossexchange ratesof currencies

Existing inflation rate differential

Future exchangerate movements

Existing spotexchange rate

Existing forward exchange rate

Existing interest rate differential

locationalarbitrage

triangulararbitrage

purchasing power parity

international Fisher effect

covered interest arbitrage

covered interest arbitrage

Fisher effect

24

3.1 Purchasing Power Parity (PPP)

When one country’s inflation rate rises relative to that of another country, decreased exports and

increased imports depress the country’s currency. The theory of purchasing power parity (PPP)

attempts to quantify this inflation-exchange rate relationship. The absolute form of PPP, or the “law

of one price,” suggests that similar products in different countries should be equally priced when

measured in the same currency. The relative form of PPP accounts for market imperfections like

transportation costs, tariffs, and quotas. It states that the rate of price changes should be similar.

Locational Arbitrage - Represents momentary differences in exchange rates between and among

regional markets. Such differences are quickly resolved by actions of investors to take advantage of

differing prices for the same currency.

Triangular Arbitrage - Involves situations where exchange rates for currency A in terms of major

currencies B and C are momentarily inconsistent with the exchange rate existing between B and C.

The result is an opportunity for investors to purchase Currency A using the major currency with the

more favourable rate (say, B) and sell A for the other currency (C).

Covered Interest Arbitrage - Involves opportunities to take advantage of opportunities created by

inconsistencies between the risk free interest rate investment opportunities available for two

different opportunities and the interest rate differential implied by forward exchange rates between

the two currencies based on the theory of interest rate parity

3.1. 1. Relationship Between Spot and Forward Exchange Rates

The forward discount on domestic currency is defined as the excess of the forward price of foreign

currency in terms of domestic currency over its current spot price, taken as a fraction or percentage

of the current spot price.

Φ = (Π − I)/Π (Equation 1)

where I is the spot price of foreign currency in terms of domestic currency, Π is the forward price,

and Φ is the forward discount/premium. A speculator who thinks that the future spot price of

foreign currency at the time a forward contract matures will be less than the forward price, can

expect to gain by selling the foreign currency forward—or taking a short position in it—and then

purchasing it spot for delivery under the contract when the forward contract comes due. This

assumes, of course, that the speculator is willing to bear the risk involved. The possibility of profit

results from a deference between the forward rate and the spot rate expected at the maturity date

in excess of any allowance for risk—the current spot rate is irrelevant. Action by all speculators will

drive the forward price of the foreign currency in terms of domestic currency into equality with their

expected future spot price, plus or minus an allowance for foreign exchange risk. The latter is

defined as the risk of loss through changes in the exchange rate when taking an uncovered position.

If the foreign exchange risk premium is zero, the forward exchange rate will equal the market’s

expectation of the spot rate that will hold on the due date of the forward contract.

Let ˆΠ be the expected future price of foreign currency in terms of domestic currency. Adding and

subtracting it within the brackets in equation (1) and rearranging the terms, we obtain

Φ = (Π − Π + Π − Π)/Π= (Π − Π)/Π + ( ˆΠ − Π)/Π= θT+ EΠ ( Equation 2)

25

where θT is a premium to cover foreign exchange risk and EΠ is the expected rate of change in the

domestic currency price of foreign currency. The condition for Equation (2) to hold is that market

participants form their expectations rationally in the sense that they use all information available to

them in making buy and sell decisions. This also implies that the foreign exchange market is efficient.

Equation (2) can thus be called the efficient markets condition.

3.2. Interest Rate Parity

Ignoring risk considerations, an arbitrage opportunity will exist whenever the domestic interest rate

exceeds the foreign interest rate by more or less than the forward discount on the domestic

currency. If the interest rate deferential is greater than the forward discount it pays to shift funds

from foreign securities to domestic securities and cover oneself by purchasing foreign currency

forward to guarantee return of the funds at the exchange rate indicated by the forward discount. If

the interest rate deferential is less than the forward discount it pays to shift funds in the other

direction, covering oneself by selling foreign currency forward. The widespread attempt to take

advantage of discrepancies between the interest rate deferential and the forward discount will

eliminate them. As a result id− If = Φ(1) where id and if are the domestic and foreign interest rates

and Φ is the forward discount on domestic currency. Since there is no reason to assume that

securities in the two countries are equally risky, this equation has to be modified by including a risk

premium.

id− if = Φ + θX(Equation 3)

where θ X is a premium for political or country- specific risk. Note that this risk is different from

foreign exchange risk because it will exist even if the exchange rate is immutably fixed and Φ is

therefore zero. The condition in equation 3 is called the interest rate parity condition.

3.3. Domestic Interest Rate Determination

The two conditions, efficient markets and interest rate parity can be com-

bined by substituting the efficient markets equation Φ = θT+ EΠ(1)into the interest parity equation

id−if= Φ + θX(3) to obtain id− if= θT+ θX+ EΠ (3) where θT and θX are the foreign exchange and

country-specific risk premium and EΠ is the expected rate of depreciation of the domestic currency

in terms of foreign currency. The two risk premium can be consolidated to express Equation (3) as

I d− if= θ + EΠ(Equation 4)

which can be rearranged to yield an equation determining the domestic interest rate

,id= if+ θ + Π (Equation 5)

This equation reveals a fundamental constraint on domestic macroeconomic policy. The only way

the domestic government can alter the domestic interest rate (assuming that it cannot affect the

interest rate in the rest of the world) is to induce a change in the risk of holding domestic assets or

induce an expected change in the domestic exchange rate. This constraint can be developed further

by introducing the relationship between nominal interest rates and real interest rates developed

further as follows:

r = i − τe(Equation 6)

where τe is the rate of inflation expected during the term of the loan, r is the real interest rate on

which people base their decisions and the nominal interest rate is given by i. Using this relationship,

we can express domestic and foreign interest rates as

rd= id− τed( Equation 7)

rf= if− τef(Equation 8)

26

and then subtract (8) from (7) to obtain rd− rf= (id− if) − (τed− τef) (Equation 9)

which upon substitution of equation (4) gives

rd− rf= θ + EΠ− (τed− τef)= θ − (τed− EΠ− τef) (Equation 10)

The expression (τed−EΠ− τef) equals the expected rate of change of the real exchange rate where

the latter is defined as P d ΠPf= q.( Equation 11) Pd and Pf are the price levels of domestic and

foreign output. The real exchange rate q is the relative price of domestic output in terms of foreign

output where both prices are measured in domestic currency. Equation (10) can thus be rewritten as

rd− rf= θ − Eq (Equation 12) where E q is the expected rate of change in the domestic real exchange

rate.

The domestic real interest rate is thus constrained in relation to the foreign real interest rate by

rd= r f + θ − Eq(Equation 13)

An expected rise in the real exchange rate (increase in the relative price of domestic output in terms

of foreign output) lowers the domestic real interest rate because it implies an increasing value of

domestic output in terms of foreign output and thus a future capital gain on domestic capital

relative to foreign capital. This makes domestically employed capital more valuable as

compared to foreign capital, raising its price and lowering the interest rate at which the future (non-

capital-gains) income from it is discounted. Equation (13) implies a constraint on the real interest

rate similar to the constraint on the nominal interest rate implied by equation (5). This

constraint says that the domestic authorities can affect the domestic real interest rate in two ways—

by inducing a change in the risk of holding domestic capital, or by inducing a change in people’s

expectations about the future course of the real exchange rate. This assumes, of course, that the

domestic authorities have no control over the foreign interest rate. Finally, the relationships

between the nominal and real interest rates in the domestic and foreign economies, given by the

two countries’ Fisher equations,

I d= r d+ τe d (Equation 14)

if= rf+ τef (Equation 15)

obtained by rearranging equations (7) and (8) implies that

I d− if= (rd− rf) + (τed− τef) (Equation 16)

A change in the domestic relative to the foreign expected inflation rate will lead to an equal change

in the domestic relative to the foreign nominal interest rate, assuming that real interest rates are

unaffected.

3.4. Foreign Exchange Rate Forecasting

Technical forecasting - As in other forms of market forecasting, technical forecasting of exchange

rate movements involves statistical analysis of historical data, especially time series analysis as a

means of predicting future exchange rate movements.

Fundamental forecasting - This form of forecasting involves analysis of the fundamental factors

and relationships that affect exchange rate fluctuations: interest rates, inflation, and other

economic variables. Such analysis may employ linear regression and other statistical methods, but

based on an economic theoretical framework which assumes key economic factors affecting

exchange rates.

Market based forecasting - This form of forecasting relies on the expectations as to future

exchange rate movements built into the pricing of market instruments such as foreword and futures

rates for various time periods versus spot rates.

Mixed forecasting - Mixed forecasting simply involves using several of the above types of

forecasting rather than relying on the validity of one approach.

27

Fixed exchange rate system - Rate fixed by government as constant or forced to stay within

defined narrow limits.

Freely floating exchange rate system - Exchange rates determined purely by market forces.

Incidental imbalances efficiently resolved by market forces.

Managed float exchange rate system - Blend of the above that can be termed a not perfectly free

floating rate system.

Pegged exchange rate system - The currency of one country is set equal to or as a fixed percentage

of another country's currency (generally a major stable currency like the US dollar

Practice Questions

1.Consider a world with two countries, domestic and foreign, in both of which five units of output

are produced for every unit of capital stock, broadly defined to include human capital, physical

capital, technology, knowledge, etc. Suppose that the domestic (and foreign) real exchange rate is an

immutable constant equal to 1.0. Suppose, further, that the residents of both the domestic and

foreign economies choose to hold one unit of nominal money balances for every two units of

nominal output, regardless of market interest rates. Finally, assume that no one in either economy

requires any premium to bear risk. What will be the effect on the nominal exchange rate, the

forward discount on the domestic currency and the domestic market interest rate of

a) An unanticipated (by the private sector) one-shot increase in the domestic

nominal money supply of 10 percent, brought about by the actions of the

domestic government?

b) A sudden and not previously predicted increase in the public’s desired ratio

of nominal money to nominal income from 0.5 to 0.6?

c) An increase in the rate of growth of the domestic money supply, brought

about by pre-announced actions of the domestic government, from 0

percent per year to 10 percent per year?

d) How would your answers above change if it were the case that the public’s

desired ratio of money to income falls in both countries when the nominal

interest rate increases?

e) In the above cases, does the forward discount adjust to equal the

domestic/foreign interest rate differential or does the domestic/foreign

interest rate differential adjust to equal the forward discount?

2. Suppose that the exchange rate between U.S. dollars and Swedish krona is $1 = 6.6565 krona.

How many dollars can 10,000 krona be exchanged for?

3. You will be vacationing in Belgium and wish to take with you $500 in Belgian francs. If the

exchange rate is $1 = 29.14 Belgian francs, how many francs will you need?

4. Explain covered interest parity.

5. State the law of one price.

6. How does arbitrage ensure that the law prevails?

7. What is purchasing power parity? Why does PPP not appear to hold in the real world?

28

8. ALKMAR ICE SKATE COMPANY

a) Hans Brinker is Assistant Vice-President for marketing for Alkmar Ice Company. Alkmar does

all of its manufacturing in the Netherlands and then distributes worldwide through its sales

offices. World prices for foreign sales offices are set by the home office. Brinker is now

setting the price list for all U.S. sales offices, and needs prices set for the coming year.

(b) The currency spot rate is HA1.8935/$, with a one-year forward rate HA1.9207/$. The one-

year Eurocurrency deposit rates for Dutch guilders and U.S dollars are 6.0000% and 4.5000%,

respectively. Alkmar’s best selling professional figure skate, the Royal Silver Blade, is currently

priced at $350 to U.S. retailers. Current inflation estimates for the Netherlands and the United

States are both 3.00%. Alkmar’s policy is to try to absorb about 50% of all exchanger rate-

induced price increases, but pass along 100% of all exchange rate price decreases if possible. The

world skate business is competitive.

(c) Brinker phones you on Friday afternoon and explains that he will be on a business trip next

week, and you will therefore be responsible for setting the U.S. dollar prices for the coming year.

Your price list is due Monday morning at 10:00A.M.

9. Explain the concept of covered interest arbitrage, and the scenario necessary for it to be plausible.

(a) Assume the following information:

Quoted Price

Spot rate of Canadian dollar $ .80

90-day forward rate of Can. Dollar $ .79

90-day Canadian Interest rate 4%

90-day U.S interest rate 2.5%

Given the above information, what would be the yield (percentage return on the invested funds) to

a U.S. investor who used a covered interest arbitrage strategy?

Assume the investor had invested $1000, 000

(b) Based on the information in the previous question, what market forces would occur to eliminate any

further possibilities of covered interest arbitrage?

(c) Explain the concept of International Fisher Effect (IFE). What are the implications of IFE to firms with

excess cash that consistently invest in foreign treasury bills?

.

29

Chapter Four

Government Intervention in The Foreign Exchange

Market

Learning Outcomes

• To describe the exchange rate systems used by various governments;

• To explain how governments can use direct and indirect intervention to influence exchange

rates; and

• To explain how government intervention in the foreign exchange market can affect

economic conditions

The foreign market

Figure 4.1. Impact of Government Actions on Exchange Rates

Government Intervention in

Foreign Exchange Market

Government Monetary

and Fiscal Policies

Relative InterestRates

Relative InflationRates

Relative NationalIncome Levels

InternationalCapital Flows

Exchange RatesInternational

Trade

Tax Laws, etc.

Quotas, Tariffs, etc.

Government Purchases & Sales of Currencies

30

Government intervention in the foreign exchange markets comes in a number of ways. This

intervention can either be direct or indirect depending on the particular government

macroeconomic policy focus.

4.1. Exchange Rate Systems

• Exchange rate systems can be classified according to the degree to which the rates are

controlled by the government.

• Exchange rate systems normally fall into one of the following categories:

¤ fixed

¤ freely floating

¤ managed float

¤ pegged

4.1.2. Fixed Exchange system

In a fixed exchange rate system, exchange rates are either held constant or allowed to fluctuate only

within very narrow bands.

• The Bretton Woods era (1944-1971) fixed each currency’s value in terms of gold.

• The 1971 Smithsonian Agreement which followed, merely adjusted the exchange rates and

expanded the fluctuation boundaries. The system was still fixed.

• Pros: Work becomes easier for the MNCs.

• Cons: Governments may revalue their currencies. In fact, the dollar was devalued more than

once after the U.S. experienced balance of trade deficits.

• Cons: Each country may become more vulnerable to the economic conditions in other

countries.

4.1.3. In a freely floating exchange rate system, exchange rates are determined solely by market

forces.

• Pros: Each country may become more insulated against the economic problems in other

countries.

Pros: Central bank interventions that may affect the economy unfavourably are no longer

needed

31

• Pros: Governments are not restricted by exchange rate boundaries when setting new

policies.

• Pros: Less capital flow restrictions are needed, thus enhancing the efficiency of the financial

market.

• Cons: MNCs may need to devote substantial resources to managing their exposure to

exchange rate fluctuations.

• Cons: The country that initially experienced economic problems (such as high inflation,

increasing unemployment rate) may have its problems compounded

4.1.4. In a managed (or “dirty”) float exchange rate system, exchange rates are allowed to move

freely on a daily basis and no official boundaries exist. However, governments may intervene to

prevent the rates from moving too much in a certain direction.

• Cons: A government may manipulate its exchange rates such that its own country benefits at

the expense of others.

4.1.5 In a pegged exchange rate system, the home currency’s value is pegged to a foreign

currency or to some unit of account, and moves in line with that currency or unit against other

currencies.

• The European Economic Community’s snake arrangement (1972-1979) pegged the

currencies of member countries within established limits of each other.

Exposure of a Pegged Currency to Interest Rate Movements

• A country that uses a currency board does not have complete control over its local interest

rates, as the rates must be aligned with the interest rates of the currency to which the local

currency is tied.

• Note that the two interest rates may not be exactly the same because of different risks.

• A currency that is pegged to another currency will have to move in tandem with that

currency against all other currencies.

• So, the value of a pegged currency does not necessarily reflect the demand and supply

conditions in the foreign exchange market, and may result in uneven trade or capital flows

4.2. . Dollarization

• Dollarization refers to the replacement of a local currency with U.S. dollars.

• Dollarization goes beyond a currency board, as the country no longer has a local currency.

32

• For example, Ecuador implemented dollarization in 2000.

• Zimbabwe replaced its Zimbabwe dollar with a cocktail of currencies in 2008.x

4.3. A Single European Currency

• In 1991, the Maastricht Treaty called for a single European currency. On Jan 1, 1999, the

Euro was adopted by Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg,

Netherlands, Portugal, and Spain. Greece joined the system in 2001.

• By 2012, the national currencies of the 12 participating countries will be withdrawn and

completely replaced with the euro.

• Within the euro-zone, cross-border trade and capital flows will occur without the need to

convert to another currency.

• European monetary policy is also consolidated because of the single money supply. The

Frankfurt-based European Central Bank (ECB) is responsible for setting the common

monetary policy.

• The ECB aims to control inflation in the participating countries and to stabilize the euro

within reasonable boundaries.

• The common monetary policy may eventually lead to more political harmony.

• Note that each participating country may have to rely on its own fiscal policy (tax and

government expenditure decisions) to help solve local economic problems.

4.4. Government Intervention

Each country has a government agency (called the central bank) that may intervene in the foreign

exchange market to control the value of the country’s currency. In the United States, the Federal

Reserve System (Fed) is the central bank.

4.5. Central banks manage exchange rates

• to smooth exchange rate movements,

• to establish implicit exchange rate boundaries, and/or

• to respond to temporary disturbances.

• Often, intervention is overwhelmed by market forces. However, currency movements may

be even more volatile in the absence of intervention.

33

• Direct intervention refers to the exchange of currencies that the central bank holds as

reserves for other currencies in the foreign exchange market.

4.6. Direct intervention is usually most effective when there is a coordinated effort among

central banks.

• When a central bank intervenes in the foreign exchange market without adjusting for the

change in money supply, it is said to engaged in nonsterilized intervention.

• In a sterilized intervention, treasury securities are purchased or sold at the same time to

maintain the money supply Central banks can also engage in indirect intervention by

influencing the factors that determine the value of a currency.

• For example, the Fed may attempt to increase interest rates (and hence boost the dollar’s

value) by reducing the U.S. money supply.

¤ Note that high interest rates adversely affect local borrowers.

Governments may also use foreign exchange controls (such as restrictions on currency exchange) as

a form of indirect intervention

4.7. Exchange Rate Target Zones

• Many economists have criticized the present exchange rate system because of the wide

swings in the exchange rates of major currencies.

• Some have suggested that target zones be used, whereby an initial exchange rate will be

established with specific boundaries (that are wider than the bands used in fixed exchange

rate systems).

• The ideal target zone should allow rates to adjust to economic factors without causing wide

swings in international trade and fear in the financial markets.

• However, the actual result may be a system no different from what exists today.

4.8. Intervention as a Policy Tool

• Like tax laws and money supply, the exchange rate is a tool which a government can use to

achieve its desired economic objectives.

• A weak home currency can stimulate foreign demand for products, and hence local jobs.

However, it may also lead to higher inflation.

34

• A strong currency may cure high inflation, since the intensified foreign competition should

cause domestic producers to refrain from increasing prices. However, it may also lead to

higher unemployment.

Figure 4.2. Impact of Central Bank Intervention

on an MNC’s Value

( ) ( )[ ]

( )∑∑

+

×=

n

tt

m

j

tjtj

k1=

1

, ,

1

ER ECF E

= Value

E (CFj,t ) = expected cash flows in currency j to be received by the U.S. parent at the end of period t

E (ERj,t ) = expected exchange rate at which currency j can

be converted to dollars at the end of period tk = weighted average cost of capital of the parent

Direct InterventionIndirect Intervention

Practice Questions

1. State and explain reasons why the Central Bank of Zimbabwe should use indirect intervention to

change the value of the local currency.

2. Should the Government of Zimbabwe allow its currency to float freely? What would be the

advantages of letting it currency float freely? What would be the disadvantages for this approach?

35

Chapter Five

Foreign Exchange Exposure Measurement and Management

Learning Outcomes

• To be able to understand and discuss the MNC’s exposure to exchange rate risk

• To be able to understand the nature of transaction exposure and how it can be

measured

• To be able to understand the nature of economic exposure and how it be measured

• To be able to understand the nature of translation exposure and how it can be

measured.

• To learn about commonly used methods of hedging the firm’s transaction exposure

• To understand the various methods and hedging and their advantages and disadvantages.

KEY TERMS

• EXCHANGE RATE EXPOSURE EXCHANGE RATE RISK

• TRANSACTION EXPOSURE TRANSLATION EXPOSURE

• ECONOMIC EXPOSURE ACCOUNTING EXPOSURE

• OPERATIONAL RISK CURRENCY FUTURES

• MARKET HEDGE FORWARD RATE CONTRACT

• FUTURES CONTRACT

5.1. Risks in International Trade

It is an established argument that a firm can increase its market value by reducing the

variability of its cash flows (operational risk) and which in the case of exchange rate risk

hedging is instrumental.

While exchange rate risk is the major risk in international trade, there are other risks that are

not related to foreign exchange rate risk. These are:

i) Default Risk: The exporter may not ship the goods at all after the sale contract i.e.

fails to perform the contract (performance risk)

ii) Delivery Risk: The goods shipped may not conform to the contract’s specifications.

iii) Credit Risk: The importer may fail to pay, or pay too little or too late.

iv) Transfer risk: The importer’s country may have run out of the foreign exchange

reserves by the time the payment is due and therefore no

remittance

5.1.2. Transaction exposure : is a type of foreign exchange risk faced by companies that

engage in international trade. It is the risk that exchange rate

fluctuations will change the value of a contract before it is settled.

Transaction exposure is also called transaction risk.

Transaction exposure is the risk that foreign exchange rate changes

will adversely affect a cross

A cross

A business contract may extend over a period of months. Foreign

exchange rates can fluctuate instantaneously. Once a cross

contract has be

a specific amount of money, subsequent fluctuations in exchange

rates can change the value of that contract.

Managing Transaction Exposure

This model illustrates the impact of transaction exposure on

cash flows

FIGURE 5.1 Impact of Transaction Exposure on MNC Cashflows.

Transaction exposure exists when the future cash transactions of a firm are affected by exchange

rate fluctuations. When transaction exposure exists, the firm

• Identify its degree of transaction exposure,

• Decide whether to hedge its exposure, and

• Choose among the available hedging techniques if it decides on hedging.

A company that has agreed to but not yet settled a cross

exposure as any change to the exchange rate will impair the

time between the agreement and the settlement of the contrac

associated with exchange rate fluctuation

36


will adversely affect a cross-currency transaction before it is settled.

A cross-currency transaction is one that involves multiple currencies.


exchange rates can fluctuate instantaneously. Once a cross

contract has been agreed upon, for a specific quantity of goods and


rates can change the value of that contract.

Managing Transaction Exposure

This model illustrates the impact of transaction exposure on

cash flows (see Figure 5.1).

Impact of Transaction Exposure on MNC Cashflows.


rate fluctuations. When transaction exposure exists, the firm faces three major tasks:

Identify its degree of transaction exposure,

Decide whether to hedge its exposure, and

Choose among the available hedging techniques if it decides on hedging.

A company that has agreed to but not yet settled a cross-currency contract that has transaction

as any change to the exchange rate will impair the company’s cash flows. The greater the

time between the agreement and the settlement of the contract Equation, the greater the risk

associated with exchange rate fluctuations.


ncy transaction before it is settled.

currency transaction is one that involves multiple currencies.


exchange rates can fluctuate instantaneously. Once a cross-currency

en agreed upon, for a specific quantity of goods and


This model illustrates the impact of transaction exposure on MNC


ct that has transaction

The greater the

, the greater the risk

37

5.1.2.1. Transaction Risk Example

For example, let’s say a domestic company signs a contract with a foreign company. The contract

states that the domestic company will ship 1,000 units of product to the foreign company and the

foreign company will pay for the goods in 3 months with 100 units of foreign currency. Assume the

current exchange rate is: 1 unit of domestic currency equals 1 unit of foreign currency. The money

the foreign company will pay the domestic company is equal to 100 units of domestic currency.

The domestic company, the one that is going to receive payment in a foreign currency, now has

transaction exposure. The value of the contract is exposed to the risk of exchange rate fluctuations.

The next day the exchange rate changes and then remains constant at the new exchange rate for 3

months. Now one unit of domestic currency is worth 2 units of foreign currency. The foreign

currency has devalued against the domestic currency. Now the value of the 100 units of foreign

currency that the foreign company will pay the domestic company has changed – the payment is

now only worth 50 units of domestic currency.

The contract still stands at 100 units of foreign currency, because the contract specified payment in

the foreign currency. However, the domestic firm suffered a 50% loss in value.

5.2. Hedging Transaction Risk

A company engaging in cross-currency transactions can protect against transaction exposure by

hedging. The company can protect against the transaction risk by purchasing foreign currency, by

using currency swaps, by using currency futures, or by using a combination of these hedging

techniques. Any one of these techniques can be used to fix the value of the cross-currency contract

in advance of its settlement.

5.2.1. A forward contract or simply a forward is an agreement between two parties to buy

or sell an asset at a certain future time for a certain price agreed today. This is in

contrast to a spot contract, which is an agreement to buy or sell an asset today. It

costs nothing to enter a forward contract. The party agreeing to buy the underlying

asset in the future assumes a long position, and the party agreeing to sell the asset in

the future assumes a short position. The price agreed upon is called the delivery

price, which is equal to the forward price at the time the contract is entered into.

• The price of the underlying instrument, in whatever form, is paid before control of

the instrument changes. This is one of the many forms of buy/sell orders where the

time of trade is not the time where the securities themselves are exchanged.

• The forward price of such a contract is commonly contrasted with the spot price,

which is the price at which the asset changes hands on the spot date. The difference

between the spot and the forward price is the forward premium or forward

discount, generally considered in the form of a profit, or loss, by the purchasing

party.

• Forwards, like other derivative securities, can be used to hedge risk (typically

currency or exchange rate risk), as a means of speculation, or to allow a party to take

advantage of a quality of the underlying instrument which is time-sensitive.

5.2.2. Money Market Hedges

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Objective: borrow/lend to lock in home currency value of cash flow

1. Expected Inflow of Foreign Currency: Borrow present value of the foreign currency at a

fixed interest and convert it into home currency. Deposit the home currency at a fixed

interest rate. When the foreign currency is received, use it to pay off the foreign

currency loan.

Expected Outflow of Foreign Currency: Determine PV of the foreign currency to be paid

(using foreign currency interest rate as the discount rate). Borrow equivalent amount of

home currency (considering spot exchange rate). Convert the home currency into PV

equivalent of the foreign currency (in the spot market now) and make a foreign currency

deposit on payment day, withdraw the foreign currency deposit (which by the time

equals the payable amount) and make payment.

Example

A US firm is expected to pay A$300,000 to an Australian supplier 3 months from now.

A$ interest rate is 12% and US$ interest rate is 8%. Spot rate is 0.60A$/US$.

PV of A$: 300,000/(1+.12/4) = A$291,262.14 Borrow (291,262.14X0.60) US$174,757.28

and convert it to A$291,262.14 at spot rate (0.60/US$) Use the A$ to make an A$

deposit which will grow to A$300,000 in 3 months. Pay this A$300,000 on due date Pay

{174,757.28X(1+0.8/4)} US$178,252.43 with interest for settling the US$ loan.

5.3. Conditions for Use of Money Market Hedge strategy

Firms have access to money market for different currencies

The dates of expected future cash flows and money market transaction maturity match

offshore currency deposits or Eurocurrency deposits are main money market hedge

instruments.

Comparison: Forward and Money Market Hedge The covered interest parity implies

that a firm cannot be better off using money market hedge compared to forward hedge.

In reality, firms find use of forward contracts more profitable than use of money market

instruments, because firms:

Borrow at a rate> inter-bank offshore lending rate

Put deposits at a rate< inter-bank offshore deposit rate.

A closely related contract is a futures contract; they differ in certain respects. Forward contracts are

very similar to futures contracts, except they are not marked to market, exchange traded, or defined

on standardized assets. Forwards also typically have no interim partial settlements or "true-ups" in

margin requirements like futures - such that the parties do not exchange additional property

securing the party at gain and the entire unrealized gain or loss builds up while the contract is open.

A forward contract arrangement might call for the loss party to pledge collateral or additional

collateral to better secure the party at gain

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5.4. Measuring and Managing Accounting Exposure.

Accounting exposure, also called translation exposure, refers to the change in the value of a

subsidiary, as given by its financial statements in the reporting currency, when these

statements are translated into the currency of the parent firm.

5.4.1. Concept of Accounting Exposure

Exposure = Total unexpected change on Financial Position of a firm, as measured in

home Current, at Time (t)

Unexpected change in St (Spot exchange rate at time, t)

Equivalently, we can say:

Unexpected effect on the financial position of a firm

= Exposure x Unexpected change in St (Spot exchange rate at a time, t)

Two concepts need to be reconciled here.

• Financial position from purely accounting position means Accounting Value Net worth as

given by the financial statements of a firm.

• Whereas from the economic exposure perspective, financial position is interpreted to mean

the present value of a firms’ future cash flows.

In other words, translation exposure measures the impact of exchange rate movement on the

accounting value of a firm’s foreign subsidiary, while economic exposure measures the effect on

the cash flows and consequently its impact on the market value of a firm.

5.4.2. Translating Financial Statements :

If some of the subsidiaries of a firm are located abroad, their financial statements are

typically maintained in terms of the ruling foreign currency.

It therefore becomes necessary to translate these financial statements into the parent’s

financial reporting currency for consolidation purposes.

Reasons:

(i) Taxes in the parents’ home country on income earned by the foreign subsidiary are payable

in home currency. This means that the foreign income has to be translated into the home

currency. Thus, translation exposure, even though it deals with accounting data, can have

an impact on a firm’s CASH FLOWS through its effect on the taxable amounts

(ii) Most countries require consolidation of the parents’ and subsidiary’s financial statements

for financial reporting purposes.

(iii) A firm may also need to translate the financial statements of foreign subsidiaries in order to

consolidate data in order to make investment and financial decisions.

40

(iv) In order to make performance measures comparable, foreign data need to be translated into

a common currency. Decisions to promote or fire managers are also based on performance.

(v) To value the entire firm, one needs far more than just accounting data. Still, valuation is

often partially based on accounting values; i.e. accounting value serves as a reference point.

If the discounted cash flow value of the entire firm turns out to be four times its book value,

one should surely take a closer look at both types of information. This information might

suggest creative accounting.

5.4.3. Different Translation Methods:

Firms would like to hedge translation exposure to eliminate or reduce the swings in reported

profits resulting from translation effects. This exposure depends on the rules used to

translate the accounts of the subsidiary into the currency of the parent firm.

Approaches:

Basically, there are four different translation methods and philosophies. Each method has a

set of rules for translating items in the balance sheet and the income statement. The rules

for translating items in the income statement are quite similar across the different methods.

Hence we shall concentrate on items reported in the Balance Sheets and rules for their

translation.

(i) The Current/Non-Current Method:

According to this method, current assets and liabilities in the balance sheet are translated at

the current exchange rate as on the translation date, while non-current assets (items) i.e.

long term debt are translated at the historical rate (the rate at which they entered the

company’s books)

The logic behind this is that the value of short-term assets and liabilities already reflect

movements in the foreign exchange rate and fluctuate with the exchange rate movements.

Long term assets and liabilities, in contrast, will not be realized in the short-run and by the

time they are realized, the current exchange rate change may turn out to have been undone

by the latter. This is to say the long term realization value of long term assets and liabilities

is very uncertain.

Thus accountants who favour Current/non-current method agree that long term items

should be recorded at the historical exchange rate when they were acquired.

Under the current/non-current method, translation at the current rate is restricted to only

the short term assets and liabilities. This means a measure of the translation exposure is

generally given by the difference between short term assets and liabilities, i.e. Net Working

Capital.

Illustration on Current/Non-Current Method:

41

Historical Historical Current Change

Bal. Sheet Exchange rate Exchange in

Rate Value

(R) (0.333 $/R) (0.300 $/R) ($)

Assets:

Cash & securities 1 000 333 300

A/R 1 000 333 300

Inventory 1 000 333 300

Plant & Equipment 5 000 1 625 1 625

Total (a) 8 000 2 624 2 530 -99

Liabilities:

A/P 500 166.5 150

Short term Debt 2 000 666 600

Long term Debt 2 400 780 780

Total Debts (b) 4 900 1612.5 1 530 -82.5

Net Worth

(a) – (b) 3 100 1 011.5 -16.5

Alternatively, this –16.5 US$ can easily be calculated thus

Effect of exchange rate change under the Current/Non-Current Method

42

= (Exposure) X ∆s

= [Current Assets – Current Liabilities] X ∆s.

= Net Working Capital X ∆s

= 500 X (0.300 – 0.333) = - $16.5

To translate the subsidiary’s income statement, the current/non-current method uses an

average exchange rate over the period, assuming that cash flows come evenly over the

period – except for incomes or costs corresponding to non-current items like depreciation of

assets. These are translated at the same rate as the corresponding balance sheet item to

which they are related.

(ii) The Monetary/Non-Monetary Method:

This method translates monetary items in the Balance sheet using the current exchange

rate. When using this method, the values of claims or liabilities denominated in a dropping

foreign currency drop by the same percentage.

Thus, according to this method, we should adjust only the monetary (not real) assets and

liabilities: items whose values are already fixed by contracts to reflect the changes in

exchange rate.

Effect of Exchange rate Change under the Monetary/Non-Monetary Method: Using the

Previous Example:

= [Exposure] x ∆s

= [Financial Assets – Financial liabilities] X ∆s

= $[2 000 – 4 900] X (0.300 – 0.333) = + $95.7

To translate the subsidiary’s income statement, the monetary/non-monetary method uses

an average exchange rate of the period except for income or costs corresponding to non-

monetary sources like depreciation. These are translated at the same rate as the

corresponding Balance Sheet item.

(iii) The Temporal Method:

The temporal method of translating the financial statements of a foreign subsidiary is similar

to the Monetary/Non-Monetary method. The main difference between the two methods is

that, under the monetary system, inventory is translated at the historical exchange rate,

because it is considered a non-monetary item.

However, under the Temporal Method, inventory may be translated at the current exchange

rate, if it is recorded in the Balance Sheet at the current market prices.

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By making translation movements part of the reported earnings, it does not allow

firms to maintain reserves for currency losses. Thus, if translation gains and losses

are reflected in the income statement of the firm and it can lead to large swings in

reported earnings (incomplete sentence).

(iv) The Current Rate Method:

This so far is the simplest approach for translating financial statements.

According to the current rate method, all balance sheet items are translated at the current

exchange rate.

Typically, exchange gains are reported separately in a special equity account on the

parent’s balance sheet, thus avoiding large variations in reported earnings, and

these unrealized gains are not taxed.

Income statement is translated (all items) at the current exchange rate or the average

exchange rate of the reporting period. The first method is chosen for consistency with the

balance sheet translation.

However, the second method is recommended on the argument that expenses that have

been made gradually over the year should be translated at the average exchange rate.

Profits, are realized gradually over the years, and should be translated at an average

exchange rate.

Illustration Using the Previous figures:

Effect of exchange rate change under the current rate method:

= [Exposure] x ∆s

= [Total Assets – Total Liabilities] x ∆s

= [Net Worth] x ∆s

= 3 100 x (0.300 – 0.333)

= -$102.3

5.3. 0 Conclusion on Translation Accounting:

Many accounting regulating bodies favour the current rate method. The International

Accounting Standards Committee (IFRSC) also has endorsed the current rate method.

However, the IFRSC can only provide recommendations; it has no statutory power to impose

accounting rules anywhere.

- However, this still does not answer our dilemma.

44

Although one can still argue that the choice of the translation method does not

affect reality, except possibly through its effects on taxable profits, so that the whole

issue is, basically, a non-issue.

- Accounting data are already complicated enough, so that the current rate method is

probably a good choice, given its simplicity and internal consistency.

- Accounting exposure is limited by the fact that assets are valued at historical costs.

- Accounting exposure is limited by the fact that it is an incomplete measure of the

risks that a firm faces because accounting exposure ignores operating exposure.

That is, there is no room in the financial statements of a firm to reflect the operating

exposure that a firm faces.

- The translation effect can be part of reported income (and, therefore,

taxable/deductible). If the company records the translation gain or loss in the

income statement, in case of a loss, its durability has to be proved to the tax

authorities, otherwise they are disallowed.

Practice Questions

1.José Corporation is a South African-based firm and needs R600 000 to finance one of its expansion

projects. It has no business in Switzerland but is considering one year financing in Swiss Francs, because

the annual interest rate would be 5% in Switzerland versus 9% in South Africa. The spot rate of the Swiss

Franc is presently R .6200, while the forward rate is R .6436.

(i) Can Jose benefit by borrowing Swiss Francs and simultaneously purchasing Francs one-year forward

to cover the same contract to avoid exchange rate risk? Explain.

(ii) Assume that Jose does not cover its exposure and expects that the Swiss Franc will appreciate by 5%,

3%, 2% and 1% all with an equal probability of occurrence. Use this information to determine the

probability distribution of the effective financing rates. Show how these would appear in a normal

distribution curve.

(iii) Based on your findings above, should Jose finance with Swiss Francs? Explain.

(iv) Assume that Jose does not cover its exposure and uses the forward rate to forecast the future

spot rate. Determine the expected effective financing rate and comment whether Jose’s should

finance with Swiss Francs. Explain.

2. Why would a firm consider hedging net payables or net receivables with currency options rather

than forward contracts? What are the disadvantages of hedging with currency options as

opposed to futures contracts?

3. Explain how a firm trying to reduce its transaction exposure can use currency diversification.

45

4. Carbondale Company expects to receive SF 500, 000 in a year’s time from Switzerland. The existing

spot rate of the Swiss Franc is $.60/1SF. The one-year forward rate of the Swiss franc is $.62/1SF.

Carbondale created a probability distribution for the future spot rate on SF in one year as follows:

Future Spot rate Probability

$.61 20%

$.63 50%

$.67 30%

Assume that a one-year put option (an option to sell) on francs is available, with an exercise price of

$.63/1SF and a premium (price) of $.04 per unit. One-year call option on francs is available with an

exercise price of $.60/1SF and a premium of $.03 per unit. Assume the following money Market

rates.

US SWITZERLAND

Deposit rates 8% 5%

Borrowing rates 9% 6%

Given the above information, determine whether a forward hedge, money market hedge, or a

currency options hedge would be most appropriate (cost effective). Then compare the most

appropriate hedge strategy to an un-hedged strategy, and decide whether Carbondale should hedge

its payables position anyway.

46

Chapter Six


Learning Outcomes

• To identify the common factors used by MNCs to measure a country’s political risk and

financial risk;

• To explain the techniques used to measure country risk; and

• To explain how the assessment of country risk is used by MNCs when making financial

decisions

KEY TERMS

• COUNTRY RISK SOVEREIGN RISK

• POLITICAL RISK TRANSFER RISK

• COUNTRY RISK RATING

6.1. Country risk refers to the risk of investing in a country, dependent on changes in the business

environment that may adversely affect operating profits or the value of assets in a specific country.

For example, financial factors such as currency controls, devaluation or regulatory changes, or

stability factors such as mass riots, civil war and other potential events contribute to companies'

operational risks. This term is also sometimes referred to as political risk; however, country risk is a

more general term, which generally only refers to risks affecting all companies operating within a

particular country.

6.2. Sovereign Risk concerns whether a government will be unwilling or unable to meet its loan

obligations, or is likely to renege on loans it guarantees. Sovereign risk can relate to transfer risk in

that a government may run out of foreign exchange due to unfavourable developments in its

balance of payments. It also relates to political risk in that a government may decide not to honour

its commitments for political reasons. The Country Risk Analysis literature designates sovereign risk

as a separate category because a private lender faces a unique risk in dealing with a sovereign

government. Should the government decide not to meet its obligations, the private lender

realistically cannot sue the foreign government without its permission.

Sovereign-risk measures of a government's ability to pay are similar to transfer-risk measures.

Measures of willingness to pay require an assessment of the history of a government's repayment

performance, an analysis of the potential costs to the borrowing government of debt repudiation,

and a study of the potential for debt rescheduling by consortiums of private lenders or international

institutions. The international setting may further complicate sovereign risk. In a recent example,

IMF guarantees to Brazil in late 1998 were designed to stop the spread of an international financial

crisis. Had Brazil's imbalances developed before the Asian and Russian financial crises, Brazil

probably would not have received the same level of support, and sovereign risk would have been

higher.

47

6.3. Political risk analysis providers and credit rating agencies use different methodologies to

assess and rate countries' comparative risk exposure. Credit rating agencies tend to use quantitative

econometric models and focus on financial analysis, whereas political risk providers tend to use

qualitative methods, focusing on political analysis. However, there is no consensus on methodology

in assessing credit and political risks.

Political Risk concerns risk of a change in political institutions stemming from a change in

government control, social fabric, or other noneconomic factors. This category covers the potential

for internal and external conflicts, expropriation risk and traditional political analysis. Risk

assessment requires analysis of many factors, including the relationships of various groups in a

country, the decision-making process in the government, and the history of the country. Insurance

exists for some political risks, obtainable from a number of government agencies (such as the

Overseas Private Investment Corporation in the United States) and international organizations (such

as the World Bank's Multilateral Investment Guarantee Agency).

Few quantitative measures exist to help assess political risk. Measurement approaches range from

various classification methods (such as type of political structure, range and diversity of ethnic

structure, civil or external strife incidents), to surveys or analyses by political experts. Most services

tend to use country experts who grade or rank multiple socio-political factors and produce a written

analysis to accompany their grades or scales. Company analysts may also develop political risk

estimates for their business through discussions with local country agents or visits to other

companies operating similar businesses in the country. In many risk systems, analysts reduce

political risk to some type of index or relative measure. Unfortunately, little theoretical guidance

exists to help quantify political risk, so many "systems" prove difficult to replicate over time as

various socio-political events ascend or decline in importance in the view of the individual analyst.

6.4. Transfer risk measures typically include the ratio of debt service payments to exports or to

exports plus net foreign direct investment, the amount and structure of foreign debt relative to

income, foreign currency reserves divided by various import categories, and measures related to the

current account status. Trends in these quantitative measures reveal potential imbalances that could

lead a country to restrict certain types of capital flows. For example, a growing current account

deficit as a percent of GDP implies an ever-greater need for foreign exchange to cover that deficit.

The risk of a transfer problem increases if no offsetting changes develop in the capital account.

6.5. Exchange Risk is an unexpected adverse movement in the exchange rate. Exchange risk

includes an unexpected change in currency regime such as a change from a fixed to a floating

exchange rate. Economic theory guides exchange rate risk analysis over longer periods of time (more

than one to two years). Short-term pressures, while influenced by economic fundamentals, tend to

be driven by currency trading momentum best assessed by currency traders. In the short run, risk for

many currencies can be eliminated at an acceptable cost through various hedging mechanisms and

futures arrangements. Currency hedging becomes impractical over the life of the plant or similar

direct investment, so exchange risk rises unless natural hedges (alignment of revenues and costs in

the same currency) can be developed.

Many of the quantitative measures used to identify transfer risk also identify exchange rate risk

since a sharp depreciation of the currency can reduce some of the imbalances that lead to increased

transfer risk. A country's exchange rate policy may help isolate exchange risk. Managed floats, where

the government attempts to control the currency in a narrow trading range, tend to possess higher

risk than fixed or currency board systems. Floating exchange rate systems generally sustain the

lowest risk of producing an unexpected adverse exchange movement. The degree of over- or under-

valuation of a currency also can help isolate exchange rate risk.

48

6.6. Predicting Political Stability

Macro political risk analysis is still an emerging field of study. Political scientists in academia,

industry, and government study country risk for the benefit of multinational firms, government

foreign policy decision makers, and defence planners.

Political risk studies usually include an analysis of the historical stability of the country in question,

evidence of present turmoil or dissatisfaction, indications of economic stability, and trends in

cultural and religious activities. Data are usually assembled by reading local newspapers, monitoring

radio and television broadcasts, reading publications from diplomatic sources, tapping the

knowledge of outstanding expert consultants, contacting other businesspeople who have had recent

experience in the host country, and impressive on site-visits.

Despite this impressive list of activities, the prediction track record of business firms, the diplomatic

service, and the military has been spotty at best. When one analyzes trends, whether in politics or

economics, the tendency is to predict an extension of the same trends. It is a rare forecaster who is

able to predict a cataclysmic change in direction. Who predicted the overthrow of the Shah of Iran

and the ascent of a dogmatic theocratic government there? Who predicted the overthrow of

Ferdinand Marcos in the Philippines? Indeed, who predicted the collapse of communism in the

Soviet Union and its Eastern European satellites? Who predicted the invasion of Kuwait by Iraq in

1990? Who, in early 1997 could have predicted what would happen to Hong Kong after mid-1997?

What does the difference between the Euro-American policy of imposing sanctions on Myanmar

(formerly Burma) and ASEAN’s policy of engagement imply for the continuation of Myanmar’s

military regime or its replacement by the National League for Democracy Party of Aung San Suu Kyi?

The Myanmar military placed Aung San Suu Kyi under house arrest in July 1989, the year before her

party won an open and free election, and kept her there until 1995. Is a confrontation policy more or

less likely than a policy of accommodation to lead to policy and economic liberalization?

6.7 Predicting Firm Specific

From the viewpoint of a multinational firm, assessing the policy stability of a host country is only the

first step, since the real objective is to anticipate the effect of political changes on activities of a

specific firm. Indeed, different foreign firms operating within the same country may have very

different degrees of vulnerability to changes in host country policy or regulations. One does not

expect a Kentucky Fried Chicken franchise to experience the same risk as a Fort manufacturing plant.

The need of firm-specific analyses of political risk has led to a demand for “tailor-made” studies

undertaken in-houseby professional political risk analysis. This demand is heightened by the

observation that outside professional risk analysts rarely even agree on the degree of macro political

risk that exists in any set of countries.

In-house political risk analysts relate the micro-risk attributes of specific countries to the particular

characteristics and vulnerabilities of their client firms. Dan Haendel notes that the framework for

such analysts depends on such attributes as the ratio of a firm’s foreign to domestic investments,

the political sensitivity of the particular industry, and the degree of diversification. Mineral extractive

frims, manufacturing firms, multinational banks, private insurance companies, and worldwide hotel

chains are all exposed in fundamentally different ways to politically inspired restrictions.

49

Even with the best possible firm-specific analysts, multinational firms cannot be sure that the

political or economic situation will not change. Thus it is necessary to plan protective steps in

advance to minimize the risk of damage from unanticipated changes. Possible protective steps can

be divided into two categories, both of which have financial implications although they are not

“finance”

6.7. Establishing operation strategies after the investment is made

6.7.1. Negotiating the Environment prior to investment

The best approach to political risk management is to anticipate problems and negotiate

understandings beforehand. Different cultures apply different ethics to the question of honouring

prior “contracts”, especially when they were negotiated with a previous administration.

Nevertheless, renegotiation of all conceivable areas of conflict provides a better basic for a

successful economic future for both parties than does overlooking the possibility that divergent

objectives will evolve over time.

6.7.2. Negotiating investment agreement

An investment agreement should spell out policies on financial and managerial issues, including the

following:

� The basis on which fund flows, such as dividends, management fees, royalties, patent fees,

and loan repayments, may be remitted.

� The basis for setting transfer prices.

� The right to export to third-country markets.

� Obligations to build, or fund, social and economic overhead projects such as schools,

hospitals, and retirement systems.

� Methods of taxation, including the rate, the type of taxation, and how the rate base is

determined.

� Access to host country capital markets, particularly for long-term borrowing.

� Permission for 100% foreign ownership versus required local ownership (joint venture)

participation.

� Price controls, if any, applicable to sales in the host country markets.

� Requirements for local sourcing versus import of raw materials and components.

� Permission to use expatriate managerial and technical personnel, and to bring them and

their personal possessions into the country free of exorbitant visa charges or import duties.

� Provisions for arbitration of disputes.

� Provisions for planned divestment, should such be required, indicating how the going

concern will be valued and to whom it will be sold.

6.7.3. Investment and Insurance Guarantees.

Multinational firms can sometimes transfer political risk to a home country public agency through an

investment insurance and guarantee programme. Many developed countries have such programmes

to protect investments by their nationals in developing countries.

The U.S investment insurance and guarantee program is managed by the government owned

Overseas Private Investment Corporation (OPIC), organized in 1969 to replace earlier programmes.

OPIC’s stated purpose is to mobilize and facilitate the participating of U.S private capital and skills in

50

the economic and social progress of less developed friendly countries and areas, there by

complementing the developmental assistance of the United States. OPIC offers insurance coverage

for four separate types of political risk, which have their own specific definitions for insurance

purposes:

� Inconvertibility is the risk that the investor will not be able to convert profit, royalties, fees,

or other income, as well as the original capital invested, into dollars.

� Expropriation is the risk that the host government takes a specific step which, for one year,

prevents the investor or the foreign affiliate from exercising effective control over use of

the property.

� War, revolution, insurrection and civil strife coverage applies primarily to the damage of

physical property of the insured, although in some cases inability of a foreign affiliate to

repay a loan because of a war may be covered.

� Business income coverage provides compensation for loss of business income resulting

from events of political violence that directly cause damage to the assets of a foreign

enterprise.

6.7.4. Operating Strategies after investment decision.

Although an investment agreement creates obligations on the part of both the foreign investor and

the host government, conditions change and the agreements are often revised in the light of such

changes. The changed conditions may be economic, or they may result from political changes within

the host government. The firm that sticks rigidly to the legal interpretation of its original agreement

may well find the host government first applies pressure in areas not covered by the agreement and

then possibly reinterprets the agreement to conform to the political reality of that country.

6.9 Techniques of Assessing Country Risk

• A checklist approach involves rating and weighting all the identified factors, and then

consolidating the rates and weights to produce an overall assessment.

• The Delphi Technique involves collecting various independent opinions and then averaging

and measuring the dispersion of those opinions.

• Quantitative analysis techniques like regression analysis can be applied to historical data to

assess the sensitivity of a business to various risk factors.

• Inspection visits involve traveling to a country and meeting with government officials, firm

executives, and/or consumers to clarify uncertainties.

• Often, firms use a variety of techniques for making country risk assessments.

• For example, they may use a checklist approach to develop an overall country risk rating,

and some of the other techniques to assign ratings to the factors considered.

6.10. Developing A Country Risk Rating

A checklist approach will require the following steps:

Assign values and weights to the political risk factors.

• Multiply the factor values with their respective weights, and sum up to give the political risk

rating.

• Derive the financial risk rating similarly.

• Assign weights to the political and financial ratings according to their perceived importance.

• Multiply the ratings with their respective weights, and sum up to give the overall country risk

rating

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Practice Questions

1.Explain how the theory of comparative advantage relates to the need for international

business.

2.Shah’s Corporation of the U.S. owns 100% of Finley of Finland. This year Finley - Finland

earned Fim 102 000 000 equal to US $24 000 000 at the current exchange rate of Fim

4.25/1$. The exchange rate is not expected to change in the near future.

Shah’s U.S. wants to transfer half of the Finnish earnings to the United States and wonders which is the

best way to remit this sum is:

3.By a cash dividend of US $12 000 000, or By a cash dividend of US $6 000 000 and a royalty of US $6 000

000 .

4.Finish income taxes are 28% and 5% withholding tax, while the US income taxes are 34%. Which of

these methods would you recommend for Shah’s to repatriate its earnings?

Give your reasons.

5.Zen Corporation considered establishing a subsidiary in Zenland; it performed a country risk analysis to

help make the decision. It first retrieved a country risk analysis performed about one year earlier, when it

planned to begin a major exporting business to Zenland firms. Then it updated the analysis by

incorporating all current information on the Key variables that were used in that analysis, such as

Zenland's willingness to accept imports, its existing quotas, and existing tariff laws. Is this country risk

analysis adequate? Explain.

6.It was sometimes argued that projects considered for China could be assessed using a higher discount

rate to capture the possibility of new government policies in order to capture this risk when estimating a

project's NPV. Would this method properly distinguish between projects in China that would be

worthwhile and those that will not?

8.Describe the possible errors involved in assessing country risk. In other words, explain why country risk

analysis is always not accurate.

9.Explain an MNC’s strategy of diversifying projects internationally in order to maintain a low level of

overall country risk.

10.Explain some methods of reducing exposure to existing country risk, while maintaining the same

amount of business within a particular country.

11.How could a country risk assessment be used to adjust a project’s required rate of return?

Alternatively, how can such an assessment be used to adjust a project’s estimated cash flow?

52

Chapter Seven

International Treasury Management and Financing

Learning Outcomes

• To explain the difference between a subsidiary perspective and a parent perspective in

analyzing cash flows;

• To explain the various techniques used to optimize cash flows.

• To explain common complications in optimizing cash flows.

• To explain the potential benefits and risks of foreign investments.

• KEY TERMS

•

• CENTRALIZED CASH MANAGEMENT DECENTRALIZED CASH MANAGEMENT

• BLOCKED FUNDS OPTIMIZING CASH FLOWS

• HEDGING STRATEGY TREASURY MANAGEMENT

• INTERNATIONAL WORKING CAPITAL

7.1.0.. Cash Flow Analysis:

The viability of any international transaction should be assessed from both the host perspective and

also the parent company perspective. This chapter analyses treasury management and short term

international financing

7.1.1 Subsidiary Perspective

The management of working capital has a direct influence on the amount and timing of cash flow :

• inventory management

• accounts receivable management

• cash management

• liquidity management

Subsidiary Expenses

• International purchases of raw materials or supplies are more likely to be difficult to manage

because of exchange rate fluctuations, quotas, etc.

• If the sales volume is highly volatile, larger cash balances may need to be maintained in order

to cover unexpected inventory demands.

Subsidiary Revenue

• International sales are more likely to be volatile because of exchange rate fluctuations,

business cycles, etc.

• Looser credit standards may increase sales (accounts receivable), though often at the

expense of slower cash inflows

Subsidiary Dividend Payments

• Forecasting cash flows will be easier

overhead charges) to be sent to the parent are known in advance and denominated in the

subsidiary’s currency.

7.1.2. Centralized Cash Management

• While each subsidiary is managing its own working capital, a

group is needed to monitor, and possibly manage, the parent

cash flows.

• International cash management can be segmented into two functions:

• optimizing cash flow movements, and

• Investing excess cash.

Figure 7.1 shows the movement of cash in an international company.

Figure 7.1 The movement of cash in a multinational

The centralized cash management division of an MNC cannot always accurately forecast the events

that may affect parent- subsidiary or inter

53

Looser credit standards may increase sales (accounts receivable), though often at the

expense of slower cash inflows

Forecasting cash flows will be easier if the dividend payments and fees (royalties and


Centralized Cash Management

While each subsidiary is managing its own working capital, a centralized cash management

group is needed to monitor, and possibly manage, the parent-subsidiary and inter

International cash management can be segmented into two functions:

optimizing cash flow movements, and

Figure 7.1 shows the movement of cash in an international company.

movement of cash in a multinational company.


subsidiary or inter-subsidiary cash flows.

Looser credit standards may increase sales (accounts receivable), though often at the

if the dividend payments and fees (royalties and


centralized cash management

subsidiary and inter-subsidiary


54

It should, however, be ready to react to any event by considering any potential adverse impact on

cash flows, and how to avoid such adverse impacts.

7.2. Techniques to Optimize Cash Flows

7.2.1. Accelerating Cash Inflows o

• The more quickly the cash inflows are received, the more quickly they can be invested or

used for other purposes.

• Common methods include the establishment of lockboxes around the world (to reduce mail

float) and preauthorized payments (direct charging f a customer’s bank account).

7.2.2.Minimizing Currency Conversion Costs

• Netting reduces administrative and transaction costs through the accounting of all

transactions that occur over a period to determine one net payment.

• A bilateral netting system involves transactions between two units, while a multilateral

netting system usually involves more complex interchanges.

7.2.3. Managing Blocked Funds

• A government may require that funds remain within the country in order to create jobs and

reduce unemployment.

• The MNC should then reinvest the excess funds in the host country, adjust the transfer

pricing policy (such that higher fees have to be paid to the parent), borrow locally rather

than from the parent, etc.

7.2.4. Managing Inter-subsidiary Cash Transfers

• A subsidiary with excess funds can provide financing by paying for its supplies earlier than is

necessary. This technique is called leading.

• Alternatively, a subsidiary in need of funds can be allowed to lag its payments. This

technique is called lagging.

7.2.5. Complications in Optimizing Cash Flows

Company-Related Characteristics

• When a subsidiary delays its payments to the other subsidiaries, the other

subsidiaries may be forced to borrow until the payments arrive.

Government Restrictions

• Some governments may prohibit the use of a netting system, or periodically prevent

cash from leaving the country.

Characteristics of Banking Systems

• The abilities of banks to facilitate cash transfers for MNCs may vary among

countries.

• The banking systems in different countries usually differ too.

55

7.2.6. Investing Excess Cash

• Excess funds can be invested in domestic or foreign short-term securities, such as

Eurocurrency deposits, bills, and commercial papers.

• Sometimes, foreign short-term securities have higher interest rates. However, firms must

also account for the possible exchange rate movements.

• Centralized Cash Management

• Centralized cash management allows for more efficient usage of funds and possibly higher

returns.

• When multiple currencies are involved, a separate pool may be formed for each currency.

The investment securities may also be denominated in the currencies that will be needed in

the future.

7.2.7 Implications of Interest Rate Parity (IRP)

• A foreign currency with a high interest rate will normally exhibit a forward discount that

reflects the differential between its interest rate and the investor’s home interest rate.

• However, short-term foreign investing on an uncovered basis may still result in a higher

effective yield.

7.2.8 Use of the Forward Rate as a Forecast

• If IRP exists, the forward rate can be used as a break-even point to assess the short-term

investment decision.

• The effective yield will be higher if the spot rate at maturity is more than the forward rate at

the time the investment is undertaken, and vice versa. Figure 7.2 shows the impact of

international cash management on an MNC’s value.

Figure 7.2. Impact of International Cash Management

on an MNC’s Value

( ) ( )[ ]

( )∑∑

+

×=

n

tt

m

j

tjtj

k1=

1

, ,

1

ER ECF E

= Value

E (CFj,t ) = expected cash flows in currency j to be received

by the U.S. parent at the end of period tE (ERj,t ) = expected exchange rate at which currency j can

be converted to dollars at the end of period t

k = weighted average cost of capital of the parent

Returns on International Cash Management

56

Practice Questions

1.Assume the following information for BIM, a local bank:

Value of Mozambiquean Metical in Rands = R0.2857

Value of Swaziland Emalangeni in Rands = R0.0952

Value of Mozambiquean Metical in Swaziland Emalangeni = R3.300

a. Given the information above, evaluate if triangular arbitrage is possible.

b. If so, explain the steps that would reflect arbitrage , and compute the profit from this strategy if

you had 100 000 Meticals to use.

c. Under what conditions would an MNC subsidiary consider use of a “leading” strategy to reduce

transactions exposure?

d. When is it optimal for an MNC to rely on centralised currency hedge mechanisms?

2. Explain how the following strategies can be used by a Zimbabwean company faced with a

situation of appreciating dollar.

(a) Lagging

(b) Leading

(c) Off setting

3. Discuss the advantages of centralized cash management for a multinational corporation.

57

Chapter Eight

Multinational Cost of Capital & Capital Structure

Learning Outcomes

• To explain how corporate and country characteristics influence an MNC’s cost of capital;

• To explain why there are differences in the costs of capital across countries; and

• To explain how corporate and country characteristics are considered by an MNC when it

establishes its capital structure.

• KEY TERMS

• INTERNATIONAL COST OF CAPITAL INTERNATIONAL CAPITAL MARKETS

• BANKRUPTCY CAPITAL ASSET PRICING MODEL

8.1. Cost of Capital

A firm’s capital consists of equity (retained earnings and funds obtained by issuing stock) and debt

(borrowed funds). The cost of equity reflects an opportunity cost, while the cost of debt is reflected

in interest expenses. Firms want a capital structure that will minimize their cost of capital, and hence

the required rate of return on projects.

A firm’s weighted average cost of capital

kc = ( D ) kd ( 1 _ t ) + ( E ) ke

D + E D + E

where Kc Cost of Capital

D is the amount of debt of the firm

E is the equity of the firm

kd is the before-tax cost of its debt

t is the corporate tax rate

ke is the cost of financing with equity

58

The interest payments on debt are tax deductible. However, as interest expenses increase, the

probability of bankruptcy will increase too. It is favourable to increase the use of debt financing until

the point at which the bankruptcy probability becomes large enough to offset the tax advantage of

using debt. Figure 8.1. shows the trade-off between debt ratio and cost of capital.

Debt’s Tradeoff

Fig 8.1 Cost of Capital

Co

st

of

Cap

ita

l

Debt Ratio

8.2. Determinants of MNC’s Cost of Capital

The cost of capital for MNCs may differ from that for domestic firms because of the following

differences.

8.2.1. Size of Firm. Because of their size, MNCs are often given preferential treatment by creditors.

They can usually achieve smaller per unit flotation costs, too.

8.2.2. Access to International Capital Markets. MNCs are normally able to obtain funds through

international capital markets, where the cost of funds may be lower.

8.2.3. International Diversification. M NCs may have more stable cash inflows due to international

diversification, such that their probability of bankruptcy may be lower.

8.2.4. Exposure to Exchange Rate Risk. MNCs may be more exposed to exchange rate fluctuations,

such that their cash flows may be more uncertain and their probability of bankruptcy higher.

8.2.5. Exposure to Country Risk. MNCs that have a higher percentage of assets invested in foreign

countries are more exposed to country risk.

59

Fig 8.2. Cost of Capital for MNCs

Possible access to low-

cost foreign financing

Preferential treatment from

creditorsGreater access to international capital markets

Larger size

International diversification

Exposure to exchange rate

risk

Exposure to country risk

Cost of capital

Probability of bankruptcy

8.3. Methods of calculating the MNC’s Cost capital

The capital asset pricing model (CAPM) can be used to assess how the required rates of return of

MNCs differ from those of purely domestic firms.

According to CAPM, ke = Rf + b (Rm – Rf )

where ke = the required return on a stock

Rf = risk-free rate of return

Rm = market return

• b = the beta of the stock

A stock’s beta represents the sensitivity of the stock’s returns to market returns, just as a project’s

beta represents the sensitivity of the project’s cash flows to market conditions.

The lower a project’s beta, will be the lower its systematic risk, and its required rate of return, since

its unsystematic risk can be diversified away.

8.4. Costs of Capital across Countries

The cost of capital may vary across countries, such that: MNCs based in some countries may have a

competitive advantage over others; MNCs may be able to adjust their international operations and

sources of funds to capitalize on the differences; and MNCs based in some countries may have a

more debt-intensive capital structure

The cost of debt to a firm is primarily determined by � the prevailing risk-free interest rate of the

borrowed currency and � the risk premium required by creditors.

The risk-free rate is determined by the interaction of the supply and demand for funds. It may vary

due to different tax laws, demographics, monetary policies, and economic conditions.

60

The risk premium compensates creditors for the risk that the borrower may be unable to meet its

payment obligations. The risk premium may vary due to different economic conditions, relationships

between corporations and creditors, government intervention, and degrees of financial leverage.

Although the cost of debt may vary across countries, there is some positive correlation among

country cost-of-debt levels over time.

• A country’s cost of equity represents an opportunity cost – what the shareholders could

have earned on investments with similar risk if the equity funds had been distributed to

them.

• The return on equity can be measured by the risk-free interest rate plus a premium that

reflects the risk of the firm.

• A country’s cost of equity can also be estimated by applying the price/earnings multiple to a

given stream of earnings.

• A high price/earnings multiple implies that the firm receives a high price when selling new

stock for a given level of earnings. So, the cost of equity financing is low.

8.5. Using the Cost of Capital for Assessing Foreign Projects

� Derive NPVs based on the Weighted Average Cost of Capital (WACC.)

¤ The probability distribution of NPVs can be computed to determine the probability

that the foreign project will generate a return that is at least equal to the firm’s

WACC.

� Adjust the WACC for the risk differential.

¤ The MNC may estimate the cost of equity and the after-tax cost of debt of the funds

needed to finance the project.

8.6. The MNC’s Capital Structure Decision

• The overall capital structure of an MNC is essentially a combination of the capital structures

of the parent body and its subsidiaries.

• The capital structure decision involves the choice of debt versus equity financing, and is

influenced by both corporate and country characteristics.

8.6.1. Corporate Characteristics

• Stability of cash flows. MNCs with more stable cash flows can handle more debt.

• Credit risk. MNCs that have lower credit risk have more access to credit.

• Access to retained earnings. Profitable MNCs and MNCs with less growth may be able to

finance most of their investment with retained earnings.

8.6.2. Country Characteristics

• Stock restrictions. MNCs in countries where investors have less investment opportunities

may be able to raise equity at a lower cost.

• Interest rates. MNCs may be able to obtain loanable funds (debt) at a lower cost in some

countries.

• Strength of currencies. MNCs tend to borrow the host country currency if they expect it to

weaken, so as to reduce their exposure to exchange rate risk

61

• Country risk. If the host government is likely to block funds or confiscate assets, the

subsidiary may prefer debt financing.

• Tax laws. MNCs may use more local debt financing if the local tax rates (corporate tax rate,

withholding tax rate, etc.) are higher.

8.6.3 .Interaction Between Subsidiary and Parent Financing Decisions

Increased debt financing by the subsidiary

• A larger amount of internal funds may be available to the parent.

• The need for debt financing by the parent may be reduced.

• The revised composition of debt financing may affect the interest charged on debt as well as

the MNC’s overall exposure to exchange rate risk

Reduced debt financing by the subsidiary

• A smaller amount of internal funds may be available to the parent.

• The need for debt financing by the parent may be increased.

• The revised composition of debt financing may affect the interest charged on debt as well as

the MNC’s overall exposure to exchange rate risk.

Amount of Internal Amount ofLocal Debt Funds Debt

Host Country Financed by Available FinancedConditions Subsidiary to Parent by Parent

Higher Country Risk Higher Higher Lower

Lower Interest Rates Higher Higher Lower

Expected Weakness Higher Higher Lowerof Local Currency

Blockage of Funds Higher Higher Lower

Higher Taxes Higher Higher Lower

Fig 8.3 Interaction Between Subsidiary and Parent Financing

Decisions

8.7. Using a Target Capital Structure on a Local versus Global Basis

• An MNC may deviate from its “local” target capital structure as necessitated by local

conditions.

• However, the proportions of debt and equity financing in one subsidiary may be adjusted to

offset an abnormal degree of financial leverage in another subsidiary.

• Hence, the MNC may still achieve its “global” target capital structure

62

• The volumes of debt and equity issued in financial markets vary across countries, indicating

that firms in some countries (such as Japan) have a higher degree of financial leverage on

average.

• However, conditions may change over time. In Germany for example, firms are shifting from

local bank loans to the use of debt security and equity markets.

Fig 8.4 Impact of Multinational Capital Structure Decisions on an MNC’s Value

( ) ( )[ ]

( )∑∑

+

×=

n

tt

m

j

tjtj

k1=

1

, ,

1

ER ECF E

= Value


by the U.S. parent at the end of period t



Parent’s Capital Structure Decisions

Practice Questions

1.Illustrate the impact on a firm’s financing costs using a potentially stronger vehicle currency, as

against a potentially weaker vehicle currency for a Zimbabwean-based firm in sourcing funds from

abroad.

2.Seminole, Inc., is a US-based company and is considering issuing a Mark-denominated bond at its

present coupon rate of 7%, even though it has no income in Mark cash flows to cover the bond

payments. It has simply been attracted to the low financing rate, since dollar bonds issued in the

United States would have a coupon rate of 12%.

Assume that either bond would have a four-year maturity and could be issued at par value.

Seminole needs to borrow $10 million. Therefore it will issue either dollar bonds with a par value of

$10 million or DM. bonds with a par value of 20 million. The spot rate of the Mark is $.50/1DM.

63

Seminole has forecasted the Mark’s value at the end of each of the next four years, when coupon

payments are to be paid thus.

Year End Exch. Rate of the DM

1 $.52

2 $.56

3 $.58

4 $.53

Determine the expected annual cost of financing with Mark. Should Seminole Corporation issue

bonds denominated in dollars or in Marks? Explain.

64

Chapter Nine


Learning Outcomes

• To describe common motives for initiating direct foreign investment (DFI); and

• To illustrate the benefits of international diversification.

• To explain how DFI can help increase value of an MNC.

• FOREIGN DIRECT INVESTMENT INTERNATIONAL DIVERSIFICATION

• INTERNALISATION LOCAL SOURCING

• FACILITY LOCATION

Foreign direct investment (FDI) is a measure of foreign ownership of productive assets, such as

factories, mines and land. Increasing foreign investment can be used as one measure of growing

economic globalization.

9.1. Motives for DFI

DFI can improve profitability and enhance shareholder wealth, either by boosting revenues or

reducing costs.

9.1.2 Revenue-Related Motives

•••• Attract new sources of demand, especially when the potential for growth in the home country

is limited

•••• . Exploit monopolistic advantages, especially for firms that possess resources or skills not

available to competing firms.

•••• React to trade restrictions.

9.1.3. Cost-Related Motives

•••• Fully benefit from economies of scale, especially for firms that utilize much machinery.

•••• Use cheaper foreign factors of production.

•••• Use foreign raw materials, especially if the MNC plans to sell the finished product back to the

consumers in that country.

•••• React to exchange rate movements, such as when the foreign currency appears to be

undervalued. DFI can also help reduce the MNC’s exposure to exchange rate fluctuations.

65

•••• Diversify sales/production internationally.

•••• The optimal method for a firm to penetrate a foreign market is partially dependent on the

characteristics of the market.

•••• For example, if the consumers are used to buying domestic products, then licensing

arrangements or joint ventures may be more appropriate.

•••• Before investing in a foreign country, the potential benefits must be weighed against the costs

and risks.

•••• As conditions change over time, some countries may become more attractive targets for DFI,

while other countries become less attractive

9.2..Benefits of International Diversification

•••• The key to international diversification is to select foreign projects whose performance levels

are not highly correlated over time.

•••• An MNC may not be insulated from a global crisis, since many countries will be adversely

affected.

•••• However, as can be seen from the 1997-98 Asian crisis, an MNC that had diversified among the

Asian countries might have fared better than if it had focused on one country. Even better

would be diversification among the continents.

•••• As more projects are added to a portfolio, the portfolio variance should decrease on average,

up to a certain point.

•••• However, the degree of risk reduction is greater for a global portfolio than for a domestic

portfolio, due to the lower correlations among the returns of projects implemented in

different economies.

Figure 9.1 shows the benefits of diversification. As the number of projects increase, the project

specific risk is reduced.

Fig 9.1 Portfolio Risk Reduction Effect.

9.3 Incentives for FDI

• Foreign direct investment incentives may take the following forms:

• low corporate tax and income tax

• tax holidays

• other types of tax concessions

• preferential tariffs

• special economic zones

• investment financial subsidies

• soft loan or loan guarantees

• free land or land subsidies

• relocation & expatriation subsidies

• job training & employment subsidies

• infrastructure subsidies

• R&D support

• derogation from regulations (usually for very large projects)

9.4 Host Government View of DFI

• For the government, the ideal DFI solves problems such as unemployment and lack of

technology without taking business away from the local

• The government may provide incentives to encourage the forms of DFI that it desires, and

impose preventive barriers or conditions on the forms of DFI that it does not want.

• The ability of a host government to attract DFI is dependent on the country’

resources, as well as government regulations and incentives.

• Common incentives offered by the host government include tax breaks, discounted rent for

land and buildings, low-interest loans, subsidized energy, and reduced environmental

restrictions.

66

Foreign direct investment incentives may take the following forms:[citation needed

income tax rates

other types of tax concessions

investment financial subsidies

guarantees

relocation & expatriation subsidies

job training & employment subsidies

derogation from regulations (usually for very large projects)

For the government, the ideal DFI solves problems such as unemployment and lack of

technology without taking business away from the local firms.

The government may provide incentives to encourage the forms of DFI that it desires, and


The ability of a host government to attract DFI is dependent on the country’s markets and

resources, as well as government regulations and incentives.

Common incentives offered by the host government include tax breaks, discounted rent for

interest loans, subsidized energy, and reduced environmental

citation needed]

For the government, the ideal DFI solves problems such as unemployment and lack of

The government may provide incentives to encourage the forms of DFI that it desires, and


s markets and

Common incentives offered by the host government include tax breaks, discounted rent for

interest loans, subsidized energy, and reduced environmental

67

• Common barriers imposed by the host government include the power to block a

merger/acquisition, foreign majority ownership restrictions, excessive procedure and

documentation requirements (red tape), and operational conditions

Fig 9.2. Impact of DFI Decisions on an MNC’s

Value

( ) ( )[ ]

( )∑∑

+

×=

n

tt

m

j

tjtj

k1=

1

, ,

1

ER ECF E

= Value


by the U.S. parent at the end of period t



DFI Decisions onType of Business and Location

Practice Questions

1. Describe some potential benefits to the MNC as a result of direct foreign investment (DFI). To

what extent do they apply to FDI investment in Zimbabwe.?

2. Why would the Government of Zimbabwe provide MNCs with incentives to undertake DFI in its

country?

3. Discuss all the components, explaining the impact of foreign direct investment on the value of the

MNC.

4. Why do companies still invest in countries with high risk indicators?

68

Chapter Ten

Multinational Capital Budgeting Decisions

Learning Outcomes

• To compare and understand the capital budgeting analysis of MNCs subsidiary versus that

of a parent.

• To understand how multinational budgeting can be utilised to evaluate the viability of an

international project.

• To understand how to assess project risk in an international context.

• To how the corporate and country characteristics affect an MNC’’s cost of capital.

• To understand the reasons for differing costs of capital in different countries.

• KEY TERMS

•

• MULTINATIONAL CAPITAL BUDGETING DOMESTIC PROJECT

• FOREIGN PROJECT MULTIPLE SOURCE BORROWING

10.1. Capital budgeting theoretical framework.

Capital budgeting for a foreign project uses the same theoretical framework as domestic capital

budgeting. What are the basic steps in domestic capital budgeting? Multinational capital budgeting,

like traditional domestic capital budgeting, focuses on the cash inflows and outflows associated with

prospective long-term investment projects. Multinational capital budgeting techniques are used in

traditional FDI analysis, such as the construction of a manufacturing plant in another country, as well

as in the growing field of international mergers and acquisitions. The MNC uses capital budgeting

analysis to evaluate its international projects by comparing the costs and benefits of projects.

Capital budgeting, which involves the discounting of incremental project cash flows to arrive at the

project's net present value, is more complex in a multinational environment. This is due to such

problems as the difference in perspective between foreign subsidiary and parent and other

problems specific to the differing laws, business and cultural constraints of the countries involved.

The cost of capital of the MNC is important for capital budgeting decisions and as a determiner of

the value of the MNC as a whole. The MNC strives to utilize a capital structure that can minimize its

cost of capital by optimal use of capital funding opportunities (debt and equity) available to the MNC

globally.

Capital budgeting for a foreign project uses the same theoretical framework as domestic capital

budgeting—with a few very important differences. The basic steps are:

1) Identify the initial capital invested or put at risk.

69

2) Estimate cash flows to be derived from the project over time, including an estimate of the

terminal or salvage value of the investment.

3) Identify the appropriate discount rate for determining the present value of the expected cash

flows.

4) Apply traditional capital budgeting decision criteria such as net present value (NPV) and internal

rate of return (IRR) to determine the acceptability of or priority ranking of potential projects.

10.2. Domestic Project Appraissal Versus Foreign Project

Capital budgeting for a foreign project is considerably more complex than the domestic case. Several

factors contribute to this greater complexity:

• Parent cash flows must be distinguished from project cash flows. Each of these two types of

flows contributes to a different view of value.

• Parent cash flows often depend on the form of financing. Thus, we cannot clearly separate

cash flows from financing decisions, as we can in domestic capital budgeting.

• Additional cash flows generated by a new investment in one foreign subsidiary may be in

part or in whole taken away from another subsidiary, with the net result that the project is

favourable from a single subsidiary’s point of view but contributes nothing to worldwide

cash flows.

• The parent must explicitly recognize remittance of funds because of differing tax systems,

legal and political constraints on the movement of funds, local business norms, and

differences in the way financial markets and institutions function.

• An array of nonfinancial payments can generate cash flows from subsidiaries to the parent,

including payment of license fees and payments for imports from the parent.

• Managers must anticipate differing rates of national inflation because of their potential to

cause changes in competitive position, and thus changes in cash flows over a period of time.

• Managers must keep the possibility of unanticipated foreign exchange rate changes in mind

because of possible direct effects on the value of local cash flows, as well as indirect effects

on the competitive position of the foreign subsidiary.

• Use of segmented national capital markets may create an opportunity for financial gains or

may lead to additional financial costs.

• Use of host-government subsidized loans complicates both capital structure and the parent’s

ability to determine an appropriate weighted average cost of capital for discounting

purposes.

• Managers must evaluate political risk because political events can drastically reduce the

value or availabilityof expected cash flows.

• Terminal value is more difficult to estimate because potential purchasers from the host,

parent, or third countries, or from the private or public sector, may have widely divergent

perspectives on the value to them of acquiring the project.

10.3. Project versus parent valuation.

• Why should a foreign project be evaluated both from a project and parent viewpoint? A

strong theoretical argument exists in favour of analyzing any foreign project from the

viewpoint of the parent. Cash flows to the parent are ultimately the basis for dividends to

70

stockholders, reinvestment elsewhere in the world, repayment of corporate-wide debt, and

other purposes that affect the firm’s many interest groups.

• However, since most of a project’s cash flows to its parent, or to sister subsidiaries, are

financial cash flows rather than operating cash flows, the parent viewpoint usually violates a

cardinal concept of capital budgeting, namely, that financial cash flows should not be mixed

with operating cash flows. Often the difference is not important because the two are almost

identical, but in some instances a sharp divergence in these cash flows will exist.

• Evaluation of a project from the local viewpoint serves some useful purposes, but it should

be subordinated to evaluation from the parent’s viewpoint. In evaluating a foreign project’s

performance relative to the potential of a competing project in the same host country, we

must pay attention to the project’s local return.

• Almost any project should at least be able to earn a cash return equal to the yield available

on host government bonds with a maturity the same as the project’s economic life, if a free

market exists for such bonds. Host government bonds ordinarily reflect the local risk-free

rate of return, including a premium equal to the expected rate of inflation. If a project

cannot earn more than such a bond yield, the parent firm should buy host government

bonds rather than invest in a riskier project.

• Host country inflation. How should an MNE factor host country inflation into its evaluation

of an investment proposal? Inflation is factored into the expected cash flows of the project

rate of return. Relative inflation affects the expected exchange rate due to purchasing power

parity.

10.4. Production and Logistics Strategies

Production and logistic policies to enhance bargaining position include local sourcing, location of

facilities, control of transportation, and control of technology.

10.4.1. Local Sourcing

Host governments may require foreign firms to purchase raw materials and components locally as a

way to maximize value-added and increase local employment. From the viewpoint of the foreign

firm trying to adapt to host country goals, local sourcing reduces political risk, albeit at a trade-off

with other factors. Local strikes or other turmoil may shut down the operation: in addition, such

issues as quality control, high local prices because of lack of economies of scale, and unreliable

delivery schedules become important. Often the foreign firm acquires lower political risk only by

increasing financial and commercial risk.

10.4.2. Facility Location

Production facilities may be located so as to minimize risk. The natural location of different stages of

production may be resource-oriented, footloose or market-oriented. Oil, for instance, is drilled in

and around the Persian Gulf, Venezuela, and Indonesia. No choice exists for where this activity takes

place. Refining is footloose, whenever possible, oil companies have built refineries in politically safe

countries, such as Western Europe or small islands (such as Singapore or Curacao), even though

costs might be reduced by refining nearer the oil fields. They have traded reduced political risk and

financial exposure for possibly higher transportation and refining costs.

71

10.4.3. Control of Transportation

Control of transportation has been an important means to reduced political risk. Control of oil

pipelines that cross national frontiers, oil tankers, ore carriers, refrigerated ships, and railroads have

been used at times to influence the bargaining power of both nations and companies.

10.4.4. Control of Technology

Control of key patents and processes is a viable way to reduce political risk. If a host country cannot

operate a plant because it does not have technicians capable of running the process, or of keeping

up with changed technology, abrogation of an investment agreement with a foreign firm is unlikely.

This approach works best when the foreign firm is steadily improving its technology.

10.4.5. Marketing Strategies

Marketing techniques to enhance a firm’s bargaining position include control of markets, brand

names, and trademarks.

Control of markets is a common strategy to enhance a firm’s bargaining position. As effective as the

OPEC cartel was in raising the price received for crude oil by its member countries in the 1970’s,

marketing was still controlled by the international oil companies; OPEC’s need of the oil companies

limited the degree to which its members could dictate terms.

Control of export markets for manufactured goods is also a source of leverage in dealings between

foreign-owned firms and host governments. The multinational firm would prefer to serve world

markets from sources of its own choosing, basing the decision on considerations of production cost,

transportation, tariff barriers, political risk exposure, and competition. The selling pattern that

maximizes long-run profits from the overall viewpoint of the worldwide firm rarely maximizes

exports, or value-added, from the perspective of the host countries. The contrary argument is that

self-standing local firms might never obtain foreign market share because they lack economies of

scale on the production side and are unable to market in foreign countries.

10.4.6. Brand names and trade mark control

Control of a brand name or trademark can have an effect almost identical to that of controlling

technology. It gives the multinational firm a monopoly on something that may or may not have

substantive value but quite likely represents value in the eyes of consumers. Ability to produce for

and market under a world brand name is valuable for local firms, and thus represents an important

bargaining attribute for maintaining an investment position.

10.4.7. Financing Strategies

Financial strategies can be adopted to enhance the continued bargaining position of a multinational

firm. Many of these tactics are covered elsewhere in this module , so for the moment it is sufficient

to list some of the more popular techniques.

Foreign affiliates can be financed with a thin equity base and a large proportion of local debt. If the

debt is borrowed from locally owned banks, host government actions that weaken the financial

viability of the firm also endanger local creditors.

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If the firm must finance with foreign-source debt, it should borrow from banks in countries other

than its own home country. If, for example, debt is owned to banks in Tokyo, Frankfurt, London and

New York, influential institutions in a number of foreign countries have a vested interest in keeping

the borrowing affiliate financially strong. If the multinational is U.S.-owned, a fall out between the

United States and the host government is less likely to cause the local government to move against

the firm if it might lead to a default on creditors in other countries.

Practice Questions

1. Wolverine Corp presently has no existing business in Germany but is considering the establishment of a

subsidiary there. The following information has been gathered to help in the assessment of the project:

(a.) The initial investment required is DM 50 million. Given the existing spot rate of $.50 per Mark, this initial

investment in dollars is $25 million. In addition to the DM50 million initial investment on plant and

equipment, DM 20 million will be needed for working capital and will be borrowed by the subsidiary from a

German bank. The German subsidiary of Wolverine will pay interest only on the loan each year, at an

interest rate of 14% percent. The loan principal is to be paid in 10 years.

(b.) The project will be terminated at the end of year 4, when the subsidiary will be sold as a going concern.

(c.) The price, demand, and variable costs of the product in West Germany are as follows:

Year Price Demand Variable Cost

1 DM 500 35,000 units DM 30

2 DM 511 45,000 units DM 35

3 DM 530 55,000 units DM 40

4 DM 524 50,000 units DM 45

(d.) The fixed costs, such as overhead expenses, are expected to be DM 6 million per year.

(e.) The exchange rate of the Mark is expected to be $ .52 at the end of year 1; $.54 at the end of year 2; $.56

at the end of year 3 and $.59 at the end of the year 4.

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(f.) The US government will impose an income tax of 30 percent while the German corporate tax is 28 percent.

In addition, the German government will impose a withholding tax of 10 percent on earnings remitted by

the subsidiary to the US. The US government currently has entered into an agreement with its German

counterpart aimed at eliminating double taxation and therefore will allow tax credits on the portion of

remitted earnings.

(g.) 80% of cash flows received by the subsidiary are to be sent to the parent at the end of each year. The

subsidiary will use its working capital to support her on-going operations.

(h.) The plant and equipment are to be depreciated over 10 years using the straight-line method.

(i.) In four years, the subsidiary is to be sold. Wolverine Corp. expects to receive DM 70 million after

subtracting capital gains taxes on selling the subsidiary.

(j.) Wolverine requires a 20 percent return on this project.

Required

1. Determine the Net Present Value of the project and comment whether Wolverine should accept this

project.

2. Assume that Wolverine decides to implement the project, using the above-proposed financing

arrangement. Also assume that after one year, a German firm offers Wolverine a price of $27 million

after taxes for the subsidiary and that Wolverine’s original forecasts for years 2, 3 and 4 have not

changed. Should Wolverine divest the subsidiary? Explain

3. Assume Wolverine used the originally proposed financing arrangements and that funds are blocked

until the subsidiary is sold. The funds to be remitted are reinvested at a rate of 6% (after taxes) until the

end of year 4 when the project is to be sold. How is the project’s net present value affected?

4.Illustrate the impact on a firm’s financing costs using a potentially stronger vehicle currency, as against

a potentially weaker vehicle currency for a Zimbabwean-based firm in sourcing funds from abroad.

5.Seminole, Inc. is a US-based company and is considering issuing a Mark-denominated bond at its

present coupon rate of 7%, even though it has no income in Mark cash flows to cover the bond

payments. It has simply been attracted to the low financing rate, since dollar bonds issued in the

United States would have a coupon rate of 12%.

Assume that either bond would have a four-year maturity and could be issued at par value.

Seminole needs to borrow $10 million. Therefore it will issue either dollar bonds with a par value of

$10 million or DM. bonds with a par value of 20 million. The Spot rate of the Mark is $.50/1DM.

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Seminole has forecasted the Mark’s value at the end of each of the next four years, when coupon

payments are to be paid thus.

Year End Exch. Rate of the DM

1 $.52

2 $.56

3 $.58

4 $.53

Determine the expected annual cost of financing with Mark. Should Seminole Corporation issue

bonds denominated in dollars or in Marks? Explain.

4. On September 24, 2001, Smith Chemical Company sold C$2500,000 of agricultural pesticides to

Hindustan Agri Chemical Company, payable in 3 months at, Metropolitan Bank, Manitoba. The sale was

denominated in Indian rupees at a time when the rupee traded at 36.56 rupees per Canadian dollar.

On 22nd October 2001, the Reserve Bank of India announced a 240 billion-rupee budget package

designed to repair its relations with the International Monetary Fund and to end uncertainty over its

ability to service its C$128 billion foreign debt. (At that time, India's foreign exchange reserves were

estimated at C$761 million, worth about four weeks of imports). The Reserve Bank's discount rate was

then raised 3 percentage points to 20%, and the rupee was devalued to 40.22 per C$.

a) What was the percentage amount of devaluation?

b) What was the dollar loss experienced by Smith Chemical Company? When was it experienced?

c) Was the loss described in part (b) of a transaction, translation, or operating nature? Explain your

answer.

d) What precaution should have been taken to ensure that such losses do not get repeated?

5. Why should capital budgeting for subsidiary projects be assessed from the parent’s perspective?

6. What additional factors deserve consideration in a multinational capital budgeting project that is not

normally relevant for a purely domestic project? Explain.

7. What are the limitations of using single-point estimates of exchange rate when carrying out

multinational capital budgeting?

8. Explain briefly how the result of country risk analyses is finally incorporated into a multinational capital

budgeting process.

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Chapter Eleven


Learning Outcomes

• To describe the methods of payment for international trade;

• To explain common trade finance methods; and

• To describe the major agencies that facilitate international trade.

• KEY TERMS

•

• INTERNATIONAL PAYMENTS TRADE BILL

• TRADE ACCEPTANCE TRANSFER RISK

• DOCUMENTARY CREDIT BANKERS ACCEPTANCE

• FACTORING COUNTER TARDE

• COMPENSATION TRADE COUNTER PURCHASE TRADE

• INCOTERMS

Introduction

In any international trade transaction, credit is provided by either the supplier (exporter),

the buyer (importer), one or more financial institutions, or any combination of the above.

The form of credit whereby the supplier funds the entire trade cycle is known as supplier credit.

11.1. Managing the Default and Transfer Risks:

Cash payment after delivery, which in a domestic business transaction is referred to as

“selling goods on account or credit” is a well-known tradition and an established standard

practice.

Internationally, the practice of shipping goods on an open account is also widely

accepted, especially between those parties who have a long-standing and positive business

relationship and when the transfer risk is negligible.

However, if the foreign customer is new and unknown to the exporter or importer, or

if his/her credit standing deteriorates, or if the customer’s country is short of foreign

exchange reserves, the exporter faces default and transfer risks. In these

circumstances, payment after delivery is rated poorly in terms of these risks.

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11.2. Approaches in dealing with default and transfer risks:

11.2.1. Cash payment before shipping:

This is a case when the supplier ships the goods only after receiving payment from

the foreign customer. In contrast to the case where goods are shipped on open

account, now the importer bears the default and delivery risks.

In the same contract the exporter has shifted the following risks to the importer:

i) Delivery risk

ii) Credit risk and

iii) Transfer risk

The above discussed mode of payment is an extreme way in which the risks can be

shifted from the exporter to importer and vice-versa and stifles international trade.

Cash payment method shifts the trading risks from the exporter to the importer.

To reduce the bad sides of the above method of international trade settlement,

its variants are used.

11.2.2.Use of trade Bills:

The use of personal trade bills mitigates the delivery and default risks facing the

importer after making payments, since the importer will honour the bills when the

terms of the export contract are fully met. Similarly, the exporter can discount the

bill immediately and absolve himself from the contract.

A second issue in international trade is the financing of working capital. Normally

the mode of payment determines which party has provided which part of the

financing of exports. Unless one party can obtain financing at a cost below the

regular bank rates, the investment in working capital is usually financed through

short-term bank loans.

Bank loans for international trade are easily obtained, and at attractive interest

rates, if the payment involves a trade bill (Also known as a draft or a bill of

exchange).

A trade bill is like a summary invoice. If it is drawn on and accepted by the

importer, it is called a Trade Acceptance; however, a bill drawn on and

accepted by a bank is called a Banker’s Acceptance.

• In many ways an acceptance payable on sight is similar to a cheque because

it can be cashed in at any moment.

• Further Trade Bills once accepted by the importer can be discounted and

traded. The discounting of the trade bills is done by commercial banks or by

specialized financial institutions (i.e. discount house).

• For all good intentions, banks favour bills--especially export bills, and are

willing to discount them at attractive interest rates.

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Personal trade bills, though extensively used, from the point of view of

credit risk and transfer risk, the instrument remains almost as risky as an

invoice. For instance:

- The drawee might not even accept the bill after taking delivery.

- Might default on it; or

- Might not have a license to remit foreign exchange.

• Normally, the legal redress in case of default by either the exporters or the

importers is slow and costly because the two parties are governed by

different laws; thus, it is wise for the parties to compromise contracts and

sought proactive methods to avert these risks.

Thus credit and transfer risks cannot be solved and this has led to the evolution

of documentary payment modes.

In a bid to improve on the negative sides of the payment through personal bills,

we can improve the situation through documentary payments.

Fig 11.1. Documentary Credit Procedure

Buyer(Importer)

� Sale ContractSeller

(Exporter)� Deliver Goods

�

Requestfor Credit

Importer’s Bank(Issuing Bank)

�

Documents& Claim for

Payment

�

PresentDocuments

�

DeliverLetter ofCredit

PresentDocuments

� Send Credit

Exporter’s Bank(Advising Bank) Payment

11.3. Documentary Payment Modes With Bank Participation

Given the inadequacy of legal redress with personal trade bills, one would wish to

choose a mode of payment in which the risks are shared between (importers,

exporters and at times the intermediating finance institution), and that reduces both

the probability as well as the cost of default.

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Such contracts usually involve at least one financial institution, which acts as a

trustee for the importers and exporters.

The role of banks is, as we shall see, similar to that of a trustee. The arrangement is

that the bank receives a set of documents rather than the goods themselves. The

importer and exporter have to agree on what documents will be required.

11.4. Documents against Payment:

Here the bank receives a set of documents as agreed by the parties and remits the same to

the other party – goods are not involved. This provides a reasonable solution to the default

risk

Under documents against payment (D/P), the bank checks whether all documents listed in

the contract are present. If nothing is missing, the bank remits these documents to the

importer against payment – that is, the importer receives the papers only when the agreed-

up price has been paid to the banker. The importer, being in possession of the documents,

can then claim the merchandise from a designated warehouse.

11.5 Documents against Acceptance:

A D/A is a variant of a D/P, but has a built-in feature to allow the exporter to obtain finance

to process the exports before shipment

From a pure financial angle, the drawback of D/P is that it precludes the use of bills, which in

the domestic commercial transactions are instrumental in financing working capital because

of the possibility of them be discounted and cash got immediately. For that reason, a variant

of D/P is D/A.

Under D/A, the documents will be sent to a remitting bank that will pass them to the

customer after satisfying themselves that everything is in order. The set of documents now

will include a bill drawn by the exporter on the importer.

If the set of documents is complete, the bank will remit the documents to the importer who

would signify his acceptance of the bill. As soon as the latter has accepted (signed) the bill,

the acceptance is sent back to the exporter, who may discount it immediately to get cash.

The main difference between a D/P and D/A is that the importer may still default after

taking possession of the goods in the contract and this becomes the risk of a D/A (see Figure

11.2).

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Fig 11.2. Life Cycle of a Typical Banker’s

Acceptance

8. Pay Discounted Value of BA

1-7 : Prior to BA

1. Purchase OrderImporter Exporter

5. Ship Goods

Importer’sBank

2. Applyfor L/C

11.Shipping

Documents

14. PayFace Value

of BA

10. SignPromissoryNote to Pay

6.Shipping

Documents& TimeDraft

4. L/CNotification

9. PayDiscounted

Value ofBA

7. Shipping Documents &

Time Draft

Exporter’sBank

3. L/C

12. BA

Money Market Investor

13. Pay Discounted Value of BA

16. Pay Face Value of BA

15. Present BA at Maturity

14-16 : When BAmatures

8-13 : When BAis created

11.6. Obtaining a guarantee from the Importers’ Bank: the Letter of Credit.

An LC reduces the credit risk, default risk, transfer risk and delivery risks

involved in the D/P and D/A.

There is an obvious and simple way to resolve the default risk in a D/A arrangement. The

exporter can insist that the importer have the payment or bill guaranteed by his/her bank,

which also acts as the remitting bank. The exporter will insist on evidence to such a

commitment before sending any documents.

If, as is usually the case, the bank’s guarantee is conditional on receiving a set of

conformatory documents, this type of arrangement is called a “documentary credit”. Note

that in contrast to D/P or D/A payments, the receiving bank is now responsible for the

payment as soon as it accepts that the documents conform to the standard contract and

therefore is part and parcel of the export contract.

The L/C arrangement reduces the probability and cost of default. L/C arrangement is still far

from perfect. Occasionally, letters of credit turn out to be counterfeited or issued by banks

that, from their name and logo, look like branches of major international banks but are in

fact just minor local and useless banks. Finally, even if the issuing bank is sound, transfer

risk still exists. In managing all of the problems, the exporter‘s own bank can play a useful

role.

The problem with the above letter of credit is that it can be a counterfeit letter of credit and

further it still does not solve the transfer risk. This problem requires an independent bank to

the importer’s bank to confirm the letter of credit.

11.7. Advised or Confirmed Letters of Credit

There are several ways in which an exporter can further reduce the default risk, even after

obtaining an L/C.

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The exporter can ask the issuing bank to send the L/C to a designated bank trusted

by the exporter, called “advisory bank”. The advisory bank receives the L/C from the

issuing bank; its task is to check whether the bank exists and is in good financial

standing, whether the signatures are legitimate and signed by the bank’s manager

duelly authorized to do so.

- The exporter can also ask the importer to have the L/C confirmed by a bank located in

the exporter’s country, or at least confirmed by a well-known bank trusted by the

exporter. Under such an arrangement, the confirming bank will actually guarantee the

payment; that is, it will pay the exporter if the original issuing bank defaults, or if the

transfer is blocked.

“Thus a confirmed L/C offers insurance against default on behalf of the issuing bank

against transfer risk”

- The exporter can also have a bank-backed bill or the issuing bank accept discounting the

bill “without recourse”. This again shifts the transfer risk and default risks to the issuing

bank. This technique is called “forfeiting” – implying discounting regular commercial

invoices on a non-recovery basis.

11.8. Other standard ways to cope with Default Risk:

A letter of credit is only but one of the many ways to insure against credit risks. Exporters

can also use factor companies, or they can buy insurance from export credit insurance

companies.

11.8.1. Factoring

• This is a pure debt collection contract with recourse to the seller should the customer fail to

pay or without recourse to the client should the customer fail to pay.

• A credit insurance agent is a factor who, over and above credit collection, also guarantees

payments should the customer default.

• Accounts receivable financing; a factor can also finance the invoices, after the deduction of

interest (at the rate applicable on straight loans.)

• Financing of insured invoices also eliminates foreign exchange risk.

Therefore factoring is similar to non-recourse discounting of bills, or forfeiting.

11.8.2.Credit Insurance

Virtually every country has a government agency that insures export credit and / or transfer

risk. Usually, if the exporter’s contract is with a foreign government institution, credit risks

and transfer risks are often not separate and one needs to insure both.

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11.8.3.Export-Backed Financing:

Firms in a country experiencing a temporary shortage of hard currency may find it difficult to

import goods. In such a case, banks may grant advances to firms against the firm’s future

export proceeds. To ensure the safety of the loans, the lending bank typically adds two

clauses to the loan contract:

- The exporting firm must sell its export output forward.

- The buyer of the forward sale must pay the proceeds through the bank

When the payment is received, the bank withholds the amounts required to service its loan,

and pays out the balance to the exporting firm.

Export-backed finance means obtaining finance on the basis of anticipated

export proceeds.

11.8.4. Counter trade:

Counter-trade is viewed as a form of financial engineering, as it involves:

i) Selling;

ii) Buying; and

iii) Cleverly securing financing on such exports; this is because most of these

contracts invariably involve a delay between delivery and receipt of

payment.

The advantages of counter-trade are essentially the components packaged together such as:

- An opportunity to trade;

- Use of trade intermediaries;

- Obtaining finance and

- Risk shifting through forward trade/sub-contracting

There are several techniques / forms of carrying out counter-trade transactions.

11.8.5.Barter trade

Pure barter-trade consists of an exchange of goods for goods simultaneously or

within a short interval of time.

b) Compensation trade

Compensation trade is a type of barter where one of the flows is partly in goods and

partly in cash (hard currency). An L/C may be used to insure the cash component of

the transaction.

c) Counter Purchase trade:

This is closer to a standard trade than is the compensation trade. It consists of an

autonomous contract, i.e.;

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- Purchase of one combine harvester against cash, and a second contract,

which is conditional on the first one.

- Purchase of goods from the first sales proceeds worth a given amount from

the initial contract.

d) Buy-Back

Here the exporting country’s firm builds a turn-key plant (and often also provides

training and management assistance often referred to as technological transfers)

and is paid in stated amounts of the plant’s output at stated intervals.

e) Switch Trade

This is similar to a negotiated counter-purchase contract. For example, a Canadian

exporter delivers a combine harvester and obtains the right to buy C$300, 000 worth

of the importer country’s goods within a stated period. Now, suppose the Canadian

company can utilize only C $200,000 worth of goods and finds it difficult to use the

C$100 000 balance. Under switch trade this balance can be sold to another firm or

to another trader – usually at a discount.

11.8.6. Advantages of Counter trade:

o With asymmetric and proprietary information and bid-offer spreads for

transactions, the drafting, monitoring and implementation of one

contract is probably cheaper and easier than that of three separate but

interlinked contracts like:

� Turnkey project;

� The loan agreement; and

� The long term sales contract;

Camouflaging the deal, a single packaged contract allows one to hide the

true revenues and costs of the component transactions.

Since counter trade involves several contracts in one, they are more

economical to draft. Further, because several contracts are crafted into one

contract, this enables the exporter to hide revenues and costs of individual

contracts components

11.9.. AGENCIES THAT MOTIVATE INTERNATIONAL TRADE:

Due to the inherent risks of international trade, insurance against various forms of

risk is desirable. Some agencies provide insurance or combine it with various loan-

support programmes or guarantees.

In the US, the prominent agencies providing these services are:

11.9.1 Export-Import Bank (Exim Bank)

The programmes of Exim Bank are designed to meet two broad objectives:

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i) Assumes the underlying credit and country risk and encouraging private

lenders to finance export trade; and

ii) Provides direct loans to foreign buyers when private lenders are unwilling

to do so. These goals are broadly achieved through the provision of:

(a) Guarantees;

(b) Loans; and

(c) Insurance.

11.9.2.Export Credit Insurance:

A variety of short term and medium term insurance policies are available to

exporters, banks and other eligible applicants. Basically, all the policies provide

insurance protection against the risk of nonpayment by foreign buyers. Exim Bank

operates these policies.

i. If a foreign buyer fails to pay due to commercial reasons such as cash flow

problems or insolvency, the policy pays between 90 to 100% of the

insurance amount.

ii. If the failure is due to war or political reasons such as foreign exchange

controls, Exim Bank reimburses 100% of the insured amount.

11.9.3 Private Exchange Funding Corporation (PEFCO)

A consortium of commercial banks and industrial companies own this. Working

together with Exim Bank, PEFCO provides medium and long term fixed rate financing

to foreign buyers. Exim Bank guarantees all export loans made by PEFCO.

11.9.4 Overseas Private Investment Corporation (OPIC):

Is a self-sustaining federal agency responsible for insuring the direct US investments

in foreign countries against the risks of currency inconvertibility, expropriation and

other political risks

11.8. INCOTERMS

Language is one of the most complex and important tools of international trade. As in any complex

and sophisticated business, small changes in wording can have a major impact on all aspects of a

business agreement.

Word definitions often differ from industry to industry. This is especially true of global trade where

such fundamental phrases as "delivery" can have a far different meaning in the business than in the

rest of the world.

For business terminology to be effective, phrases must mean the same thing throughout the

industry. That is why the International Chamber of Commerce created "INCOTERMS" in 1936.

INCOTERMS are designed to create a bridge between different members of the industry by acting as

a uniform language they can use.

Each refers to a type of agreement for the purchase and shipping of goods internationally. There are

more than 13 different terms, each of which helps users deal with different situations involving the

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movement of goods. For example, the term FCA is often used with shipments involving Ro/Ro or

container transport; DDU assists with situations found in intermodal or courier service-based

shipments.

INCOTERMS also deal with the documentation required for global trade, specifying which parties are

responsible for which documents. Determining the paperwork required to move a shipment is an

important job, since requirements vary so much between countries. Two items, however, are

standard: the commercial invoice and the packing list.

INCOTERMS were created primarily for people inside the world of global trade. Outsiders frequently

find them difficult to understand. Seemingly common words such as "responsibility" and "delivery"

have different meanings in global trade than they do in other situations.

In global trade, "delivery" refers to the seller fulfilling the obligation of the terms of sale or to

completing a contractual obligation. "Delivery" can occur while the merchandise is on a vessel on the

high seas and the parties involved are thousands of miles from the goods. In the end, however, the

terms wind up boiling down to a few basic specifics:

Costs: who is responsible for the expenses involved in a shipment at a given point in the

shipment's journey?

Control: who owns the goods at a given point in the journey?

Liability: who is responsible for paying damage to goods at a given point in a shipment's transit?

It is essential for shippers to know the exact status of their shipments in terms of ownership and

responsibility. It is also vital for sellers and buyers to arrange insurance on their goods while the

goods are in their "legal" possession. Lack of insurance can result in wasted time, lawsuits, and

broken relationships.

INCOTERMS can thus have a direct financial impact on a company's business. What is important is

not the acronyms, but the business results. Often companies like to be in control of their freight.

That being the case, sellers of goods might choose to sell CIF, which gives them a good grasp of

shipments moving out of their country, and buyers may prefer to purchase FOB, which gives them a

tighter hold on goods moving into their country.

In this glossary, we'll tell you what terms such as CIF and FOB mean and their impact on the trade

process. In addition, since we realize that most international buyers and sellers do not handle goods

themselves, but work through customs brokers and freight forwarders, we'll discuss how both fit

into the terms under discussion.

INCOTERMS are most frequently listed by category. Terms beginning with F refer to shipments

where the primary cost of shipping is not paid for by the seller. Terms beginning with C deal with

shipments where the seller pays for shipping. E-terms occur when a seller's responsibilities are

fulfilled when goods are ready to depart from their facilities. D terms cover shipments where the

shipper/seller's responsibility ends when the goods arrive at some specific point. Because shipments

are moving into a country, D terms usually involve the services of a customs broker and a freight

forwarder. In addition, D terms also deal with the pier or docking charges found at virtually all ports

and determining who is responsible for each charge.

85

Recently (2004) the ICC changed basic aspects of the definitions of a number of INCOTERMS; buyers

and sellers should be aware of this. Terms that have changed have a star alongside them.

• EX-Works

One of the simplest and most basic shipment arrangements, places the minimum

responsibility on the seller with greater responsibility on the buyer. In an EX-Works

transaction, goods are basically made available for pickup at the shipper/seller's factory or

warehouse and "delivery" is accomplished when the merchandise is released to the

consignee's freight forwarder. The buyer is responsible for making arrangements with their

forwarder for insurance, export clearance and handling all other paperwork.

• FOB (Free On Board)

One of the most commonly used-and misused-terms, FOB means that the shipper/seller

uses his freight forwarder to move the merchandise to the port or designated point of origin.

Though frequently used to describe inland movement of cargo, FOB specifically refers to

ocean or inland waterway transportation of goods. "Delivery" is accomplished when the

shipper/seller releases the goods to the buyer's forwarder. The buyer's responsibility for

insurance and transportation begins at the same moment.

• FCA (Free Carrier)

In this type of transaction, the seller is responsible for arranging transportation, but he is

acting at the risk and the expense of the buyer. Where in FOB the freight forwarder or

carrier is the choice of the buyer, in FCA the seller chooses and works with the freight

forwarder or the carrier. "Delivery" is accomplished at a predetermined port or destination

point and the buyer is responsible for Insurance.

• FAS (Free Alongside Ship)*

In these transactions, the buyer bears all the transportation costs and the risk of loss of

goods. FAS requires the shipper/seller to clear goods for export, which is a reversal from

past practices. Companies selling on these terms will ordinarily use their freight forwarder to

clear the goods for export. "Delivery" is accomplished when the goods are turned over to

the Buyers Forwarder for insurance and transportation.

• CFR (Cost and Freight)

This term, formerly known as CNF (C&F), defines two distinct and separate responsibilities-

one is dealing with the actual cost of merchandise "C" and the other "F" refers to the freight

charges to a predetermined destination point. It is the shipper/seller's responsibility to get

goods from their door to the port of destination. "Delivery" is accomplished at this time. It is

the buyer's responsibility to cover insurance from the port of origin or port of shipment to

THE buyer's door. Given that the shipper is responsible for transportation, the shipper also

chooses the forwarder.

• CIF (Cost, Insurance and Freight)

This arrangement is similar to CFR, but instead of the buyer insuring the goods for the

maritime phase of the voyage, the shipper/seller will insure the merchandise. In this

arrangement, the seller usually chooses the forwarder. "Delivery", as above, is accomplished

at the port of destination.

• CPT (Carriage Paid To)

In CPT transactions the shipper/seller has the same obligations found with CIF, with the

addition that the seller has to buy cargo insurance, naming the buyer as the insured while

the goods are in transit.

• CIP (Carriage and Insurance Paid To)

This term is primarily used for multimodal transport. Because it relies on the carrier's

insurance, the shipper/seller is only required to purchase minimum insurance coverage.

When this particular agreement is in force, freight forwarders often act in effect, as carriers.

The buyer's insurance is effective when the goods are turned over to the Forwarder.

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• DAF (Delivered At Frontier)

Here the seller's responsibility is to hire a forwarder to take goods to a named frontier,

which usually is a border crossing point, and clear them for export. "Delivery" occurs at this

time. The buyer's responsibility is to arrange with their forwarder for the pick up of the

goods after they are cleared for export, carry them across the border, clear them for

importation and effect delivery. In most cases, the buyer's forwarder handles the task of

accepting the goods at the border across the foreign soil.

• DES (Delivered Ex Ship)

In this type of transaction, it is the seller's responsibility to get the goods to the port of

destination or to engage the forwarder to move cargo to the port of destination uncleared.

"Delivery" occurs at this time. Any destination charges that occur after the ship is docked are

the buyer's responsibility.

• DEQ (Delivered Ex Quay)*

In this arrangement, the buyer/consignee is responsible for duties and charges and the seller

is responsible for delivering the goods to the quay, wharf or port of destination. In a reversal

of previous practice, the buyer must also arrange for customs clearance.

• DDP (Delivered Duty Paid)

DDP terms tend to be used in intermodal or courier-type shipments, whereby the

shipper/seller is responsible for dealing with all the tasks involved in moving goods from the

manufacturing plant to the buyer/consignee's door. It is the shipper/seller's responsibility to

insure the goods and absorb all costs and risks, including the payment of duty and fees.

• DDU(Delivered Duty Unpaid)

This arrangement is basically the same as with DDP, except for the fact that the buyer is

responsible for the duty, fees and taxes.

1. Practice Questions

Flexi-Bilt, Inc., of South Carolina, has just purchased a Thai company that manufactures plastic

beams and sockets for children’s construction toys. The purchase price is 120.000.000 Thai baht

(symbol B), with payment due to the selling Thai shareholders in six months. The currency spot rate

is B25.60/$, and the six month forward rate is B26.60/$. Additional data rate as follows:

Six-months Thai baht interest rate: 12 00%p.a

Six-months U.S interest rate: 4.00%p.a

Six-months call option on baht at 26.00 3.0%premium

Six-months put option on baht at 26.00 2.4% premium

Assume that Flexi-Bilt can invest at the given interest rates or borrow at 1% per annum above the

interest rates. Flexi-Bilt’s weighted average cost of capital is 20%.

a) Compare alternative ways that Flexi-Bilt might deal with its foreign exchange exposure.

b) What do you recommend and why?

2.ELECTRONIX, INC

Electronix, Inc., of Seattle, Washington, sold an Internet protocol system to Kompu-Deutsche of

Germany for DM2, 000,000 with payment due in three months. The following quotes are available:

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Three-month interest rate (borrowing or investing) 6, 00% per annum

On U.S Dollars.

Three-month interest rate (borrowing or investing) 8.00% per annum

On Deutschemarks:

Spot exchange rate DMI.6000/$

Three-month forward exchange rate: DMI.6120/$

Three-month options from bank of America:

Call option on DM2, 000,000 at exercise price of DM1, 6000/$ and a 1% premium

Put option on DM2, 000,000 at exercise price of DM1.6000/$ and a 3% premium

Electronix’s cost of capital is 10.0%, and it wishes to protect the dollar value of this receivable.

a) What are the costs and benefits of each alternative? Which is the best alternative?

b) What is the break-even reinvestment rate when comparing forward and money market

alternatives?

3.VALDIVIA VINEYARDS

Valdivia Vineyards of Chile were recently acquired by Sauvignon Winery of Napa, California. At

present Valdivia is paying 50% p.a.interest on Ps 100 million of five-year, balloon maturity, and peso

debt. It would be possible to refinance this into dollar debt costing only 10% p.a., saving some 40

percentage points over the cost of peso debt.

All of Valdivia’s wine is exported to the United States, where it is sold for dollars. Valdivia is

allowed by Chilean regulations to use hard currency earned to pay hard currency expenses, including

interest.

The currency exchange rate is Ps32/$, and both Chile and the United States have a rate to drop to

Ps48/$ one year from now, and to continue to deteriorate thereafter at the same rate.

a) As assistant financial manager of Sauvignon Winery in charge of the Latin American

Beverage Division, should you refinance Valdivia’s Chilean peso debt into dollars?

b) Would your answer be different if all of Valdivia’s sales were within Chile? (Explain and

show your calculation.)

4.GAMBOA’S TAX AVERAGING

Gamboa, Incorporated, is a relatively new U.S-Based retailer of specialty fruits and vegetables. The

firm is vertically integrated with fruit and vegetable-sourcing subsidiaries in Central America, and

distribution outlets throughout the southeastern and northeastern region of the United States.

Gamboa’s two Central American subsidiaries are in Belize and Costa Rica.

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Maria Gamboa, the daughter of the firm’s founder, is being groomed to take over the firm’s financial

management in the near future. Like many firms of Gamboa’s size, it has not possessed a very high

degree of sophistication in financial management, simply out of time and cost considerations. Maria,

however, has recently finished her MBA and is now attempting to put some specialized knowledge

of U.S taxation practices to work to save Gamboa money. Her first concern is tax averaging for

foreign tax liabilities arising from the two Central American subsidiaries.

Costa Rican operations are slightly more profitable than Belize, which is particularly good since Costa

Rica is a relatively low-tax country. Costa Rican corporate taxes are a flat 30%, and there are no

withholding taxes imposed on dividends paid by foreign firms with operations there. Belize has a

higher corporate income tax rate of 40%, and imposes a 10% withholding tax on all dividends

distributed to foreign investors. The current U.S. corporate income tax rate is 35%.

Belize Costa Rica

Earnings before taxes $1, 000,000 $1, 500,000

Corporate income tax rate 40% 30%

Dividend withholding tax rate 10% 0%

a. If Maria Gamboa assumes a 50% payout rate from each subsidiary, what are the additional

taxes due on foreign-sourced income from Belize and Costa Rica individually? How much in

additional U.S. taxes would be due if Maria averaged the tax credits/liabilities of the two

units?

b. Keeping the payout rate from the Belize subsidiary at 50%, how should Maria change the

payout rate of the Costa Rican subsidiary in order to most efficiently manage her total

foreign tax bill?

c. What is the minimum effective tax rate which Maria can achieve on her foreign sourced

income? `

5.PRETORIA PRODUCTIONS, LTD

Hollywood Video, Inc., of Los Angeles, California, wants to loan US$6, 000,000 to its new South

African affiliate, Pretoria Productions, Ltd. Pretoria Productions was formed after the election victory

of Nelson Mandela to produce and distribute Hollywood movies in video form throughout South

Africa. Hollywood Video owns a wholly owned finance subsidiary in Malta, which is used to redirect

funds between affiliates in the eastern hemisphere.

Corporate income taxes are 34% in the United States and 48% in South Africa. No taxes are levied in

Malta. Hollywood Video may either (1) have its Maltese finance subsidiary loans $6 million directly

to Pretoria Productions, or (2) have the Maltese subsidiary deposit $6 million in National

Westminster Bank (NatWest), London, at 11.5%. NatWest would then loan the same sum at 12% to

Pretoria Productions. NatWest would charge only 0.5% to act as a financial intermediary because

none of its own funds are at risk, as Malta’s deposit provides 100% collateral. Which option do you

advocate and why?

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Past Final Examination Papers 1

SECTION A (ANSWER ALL QUESTIONS FROM THIS SECTION)

QUESTION ONE

1.(a) Explain the fundamental technique for forecasting exchange rates (5 marks)

1.(b) Explain how the theory of comparative advantage relates to the need for international

business. (5 marks)

1.(c) How is the product life cycle related to the growth of MNCs? (5 Marks)

1.(d) How would a weakening Zimbabwean dollar affect its balance of payment? (10 marks )

QUESTION TWO

2. (a) You are given the following information:

Spot rate USD = 26.50MT

180-day forward rate of USD = 25.60MT

180-day American Interest rate = 15%

180-day Mozambiquean interest rate = 12%

Based on this information, is covered interest arbitrage by a Mozambiquean investor feasible?

Explain. Assume the investor starts with 1 000 000Meticals. (8 marks)

2(b). Assume that the Central Bank of Mozambique believes that the Metical should be weakened

against the United States dollar. Discuss how it would use indirect intervention strategy to

weaken the Metical’s value with respect to the dollar. If the future inflation rate in Mozambique is

expected to be high, why would the Central Bank Of Mozambique attempt to weaken the Metical?

(17 marks)

SECTION 2 (ANSWER ANY TWO QUESTIONS FROM THIS SECTION)

QUESTION THREE

What factors affect a firm’s degree of transaction exposure in a particular currency? For each

factor, explain the desirable characteristics that would reduce exposure. (25 marks)

QUESTION FOUR

Describe some potential benefits to the MNC as a result of direct foreign investment (DFI). To

what extent do they apply to FDI investment in Mozambique? (25 marks)

90

QUESTION FIVE

Identify common political and economic factors for an MNC to consider when assessing country

risk. Briefly explain how each factor can affect the risk to the MNC. (25 Marks)

QUESTION SIX

Discuss the following terms:

6.(a) Interest Parity Theory

(b) Purchasing Power Parity Theory

(c)International Fisher Effect

(d) Interest Covered Arbitrage

(e) Forward Rate agreement

SECTION A (ANSWER ALL QUESTIONS FROM THIS SECTION)

QUESTION ONE

1.(a) Explain the motives for forecasting exchange rates by MNCs. (5 marks)

1.(b) Assume an MNC hires you as a consultant to assess its degree of economic exposure

to exchange rate fluctuations. How would you handle this task? Be brief and specific. (7)

marks)

1.(c) Assume the following information for BIM, a local bank:

Value of Mozambiquean Metical in Rands = R0.2857

Value of Swaziland Emalangeni in Rands = R0.O952

Value of Mozambiquean Metical in Swaziland Emalangeni = R3.300

Given this information, is triangular arbitrage possible? If so, explain the steps that would

reflect arbitrage , and compute the profit from this strategy if you had 100 000 MT to

use.(8 marks)

(d) Under what conditions would an MNC subsidiary consider use of a “leading” strategy

to reduce transaction exposure? (5 marks)

QUESTION TWO

2.(a) A local company, Terminus Hotel, has contracted to purchase 1000 air conditioners at

US$200 each. It has been granted 6 months to settle the account. The company can borrow

at 7% above base rate in either market and invest at 6% below base rate in both markets as

well. The current market rates are 13% in the US market and 22% in Mozambique.

The exchange rates are as follows:

MT per USD

Spot Rates 26.65 – 28.70

I month Forward 29.20 - 30.24

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6 Months Forward 31.24 -33.24

Illustrate possible policies that Terminus Hotel might follow regarding this transaction

and provide a recommendation for which policy Terminus Hotel must follow. (20 marks)

2.(b). Define the terms transaction exposure , economic exposure and translation exposure (5

marks)

SECTION TWO (CHOOSE ANY TWO QUESTIONS FROM THIS SECTION)

QUESTION THREE

Why would the Government of Zimbabwe provide MNCs with incentives to undertake DFI in its

country? (25 marks)

QUESTION FOUR

4(a) How can the Central Bank of Mozambique use indirect intervention to change the value of the

currency? (10 marks)

4(b) Should the Government of Mozambique allow its currency to float freely? What would be the

advantages of letting their currencies float freely? What would be the disadvantages for this

approach? (15 marks)

QUESTION FIVE

5. (a) Explain how diversification can be used by a company to reduce transaction exposure. (15

marks)

5. (b) When is it optimal for an MNC to rely on centralised currency hedge mechanisms. (10 marks)

QUESTION SIX

Discuss reasons advanced by MNCs for foreign investment. To what extent do they apply to FDI

investment in Mozambique? (25 marks)

QUESTION SEVEN

Montclair Company, a United States of America Co., plans to use a money market hedge to hedge

its payment of $3 000 000 for Australian goods in one year. The U.S. interest rate is 7%, while the

Australian interest rate is 12%. The spot exchange rate of the Australian dollar is $0.85, while the

one year forward rate is $0.81.

A) Determine the amount of US$s needed in one year if a money market hedge is used.

B) Determine the amount of US $s needed in one year if a

C)

D)

E) forward market hedge is used?

Reference List

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Buckley, A. (2004) Multinational Finance , 5th

edition, FT Prentice Hall

Eiteman , D.K, Stonehill, A.I. and Moffet, M.H. (2007) Multinational Business Finance , 11th edition,

Addison-Wesley

Eun, C,S. and Rennick, B.G. (2006) International Financial Managaement, 4th

edition, McGraw-Hill.

Madura, J. (2006) International Corporate, 8th edition Fiance on, Thomson

Pilbeam, K. (2006) International Finance , 3rd edition, Palgrave.

Shapiro, A.C. (2006) Multinational Financial Management, 8th

edition, John Wiley & Sons

International Finance and Trade [Emba]5207 2011 Edition

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