Arbitrage:

Arbitrage can be loosely defined as capitalizing on a discrepancy in quoted prices by

making a riskless profit.

Types
 Locational arbitrage
 Triangular arbitrage
 Covered interest arbitrage

Locational arbitrage
It is the process of buying a currency at the location where it is priced cheap and
immediately selling it at another location where it is priced higher.

Commercial banks usually offer similar exchange rates for currencies, so shopping
around doesn’t always get you a better deal. However, if demand and supply for a
specific currency differ between banks, their exchange rates might not match.

This creates an opportunity for locational arbitrage:

1. Buy low: You purchase the currency at the bank offering a cheaper rate.

2. Sell high: You immediately sell the same currency at a bank offering a higher
rate.

3. Profit: The difference between the rates is your risk-free profit.

For example:

 Bank A sells €1 for $1.05.

 Bank B buys €1 for $1.08.

 You buy €1 from Bank A and sell it to Bank B, making $0.03 profit per euro.
Triangular arbitrage
Triangular arbitrage is a strategy used in foreign exchange markets to profit from
discrepancies between three currencies' exchange rates.

In the United States, the term cross exchange rate refers to the relationship between
two non-dollar currencies.

Covered Interest Arbitrage

Covered interest arbitrage is the process of capitalizing on the interest rate differential
between two countries while covering your exchange rate risk with a forward contract.
The logic of the term covered interest arbitrage becomes clear when it is broken into
two parts: “interest arbitrage” refers to the process of capitalizing on the difference
between interest rates between two countries; “covered” refers to hedging your position
against exchange rate risk.

INTEREST RATE PARITY (IRP)

Once market forces cause interest rates and exchange rates to adjust such that
covered interest arbitrage is no longer feasible, there is an equilibrium state referred to
as interest rate parity (IRP)
Interest Rate Parity (IRP) is a theory in international finance that suggests a
relationship between the exchange rates of two currencies and their respective interest
rates. According to IRP, the difference in interest rates between two countries is equal
to the difference in the forward exchange rates and the spot exchange rates of their
currencies. This relationship helps prevent arbitrage opportunities, where investors can
profit from discrepancies in exchange rates and interest rates.

The basic idea is that an investor should not be able to earn a risk-free profit by
borrowing money in one currency with a low interest rate, converting it into another
currency with a higher interest rate, and then converting it back at a future date at the
forward rate.

Mathematically, interest rate parity is expressed as:

Multinational Capital Budgeting:
Capital budgeting is the process of evaluating and selecting long-term investment
projects, such as purchasing equipment, expanding operations, or launching new
products. It involves analyzing potential returns and risks to determine whether an
investment is worth pursuing, using techniques like Net Present Value (NPV), Internal
Rate of Return (IRR), and Payback Period.

Multinational capital budgeting is the process of evaluating and selecting long-term

investment projects for multinational companies, considering additional complexities like
foreign exchange rates, political risk, tax differences, and varying economic conditions
across countries. It adapts traditional capital budgeting techniques (e.g., NPV, IRR) to
account for these international factors.

We compare the present value of that project’s expected future cash flows to the initial
investment.

Factors:
1. Tax Differences: If the parent company faces high taxes on money sent back
from the subsidiary, the project might be good for the subsidiary but not profitable
for the parent.

2. Restrictions on Sending Money: Host countries may limit how much money a
subsidiary can send back. If most earnings must stay in the host country, the
project may not benefit the parent company.

3. Exchange Rate Changes: If the subsidiary's currency weakens, the money sent
back to the parent will lose value, making the project less attractive.

4. Overall Process: The subsidiary’s earnings are reduced by host country taxes,
retained earnings, withholding taxes, and currency conversion before reaching
the parent company. These factors must be considered in multinational capital
budgeting.
Input for multinational capital budgeting:
Here are the key factors multinational corporations (MNCs) consider when
conducting capital budgeting for long-term international projects.

i. Initial Investment: Includes funds to start the project and support ongoing
expenses like wages and inventory until it generates revenue.
ii. Price and Consumer Demand: Forecasts of product prices and demand
depend on market competition and host country inflation, which are uncertain.
iii. Costs: Variable costs depend on production levels and inflation, while fixed costs
(like rent) are more predictable but still influenced by inflation.
iv. Tax Laws: Different countries have varying tax rules for foreign earnings,
affecting cash flow projections.
v. Remitted Funds: Host government restrictions on sending earnings to the
parent can impact cash flow estimates.
vi. Exchange Rates: Currency fluctuations affect project value and are challenging
to predict or hedge.
vii. Salvage Value: The future value of the project depends on success, host
government attitudes, and political risks.
viii. Required Rate of Return: The MNC calculates the project's discount rate based
on its risk and cost of capital. Riskier projects require higher returns.
Hedging:
Hedging is a financial strategy used to reduce or manage the risk of adverse price
movements in an asset. It involves taking an offsetting position in a related asset, such
as using derivatives like options or futures, to protect against potential losses.
Essentially, hedging acts as a form of insurance to mitigate the impact of market
fluctuations.

Hedging Most of the Exposure

Hedging most of the transaction exposure allows MNCs to more accurately forecast
future cash flows (in their home currency) so that they can make better decisions
regarding the amount of financing they will need.

Selective Hedging
Many multinational companies (MNCs) use selective hedging, where they assess each
transaction individually. Diversified MNCs operating in many countries often avoid
hedging unless necessary, as they believe their wide range of operations naturally
reduces the impact of exchange rate changes on their cash flow.

Hedging exposure to payables

 Futures hedge
 Forward hedge
 Money market hedge
 Currency option hedge

Forward or Futures Hedge on Payables

The contract will specify the:

 currency that the firm will pay

 currency that the firm will receive
 amount of currency to be received by the firm
 rate at which the MNC will exchange currencies (called the forward rate)
 future date at which the exchange of currencies will occur
Money Market Hedge on Payables

Call Option Hedge on Payables

A currency call option provides the right to buy a specified amount of a particular
currency at a specified price (called the strike price, or exercise price) within a given
period of time. Yet, unlike a futures or forward contract, the currency call option does
not obligate its owner to buy the currency at that price.
  Call Option: Provides flexibility, allowing the option to expire if the spot rate is
lower than the exercise price. However, it requires paying a premium.
 Forward Contract: Locks in a fixed cost ($1.20 per euro in the example),
regardless of the spot rate, but creates an obligation to execute.

Limitations of Hedging:
Hedging uncertain payments has limitations, especially when the amount involved is
unknown. Overhedging occurs when a company hedges for more than it needs,
creating additional risks. For instance, if the actual amount is less than the hedged
amount, the firm might need to cover the shortfall in the spot market, which could be
costly if the currency appreciates.

To mitigate this, firms can:

1. Hedge only the minimum known payment.

2. Use a combination of hedging methods, such as a money market hedge for the
minimum amount and options for any additional uncertain amount.

Although MNCs cannot fully hedge all transactions due to uncertainty, partial hedging
can still reduce exposure to exchange rate fluctuations and stabilize cash flows.

Additional:
Here are the key limitations of hedging:

1. Cost: Hedging involves costs, such as premiums for options or transaction fees,
which may reduce overall profitability.

2. Incomplete Protection: Hedging may not fully eliminate risk; some residual
exposure often remains.

3. Opportunity Loss: If market movements are favorable, a hedge might prevent

the business from benefiting from those changes.

4. Complexity: Understanding and implementing hedging strategies require

expertise, making it challenging for businesses without financial knowledge.
5. Short-Term Focus: Hedging often addresses immediate risks but may not align
with long-term financial goals.

6. Counterparty Risk: There’s a risk that the other party in a forward or futures
contract might default.

7. Market Dependency: The effectiveness of a hedge depends on the accuracy of

market forecasts, which are inherently uncertain.

8. Over-Hedging: Excessive or improper hedging can lead to unnecessary costs or

additional financial risks.
Direct Foreign Investment
It is investment in real assets (such as land, buildings, or even existing plants) in foreign
countries. MNCs engage in joint ventures with foreign firms, acquire foreign firms, and
form new foreign subsidiaries.

Revenue-Related Motives
MNCs pursue Direct Foreign Investment (DFI) for several key motives:

1. Attract New Sources of Demand: MNCs target countries with economic growth
and rising income levels, as higher income leads to greater consumption,
creating increased demand for their products. Countries like Argentina, Chile,
Mexico, Hungary, and China are popular targets.

2. Enter Profitable Markets: MNCs may enter markets where competitors are
earning high profits or charging excessive prices, aiming to sell at lower prices.
However, established competitors may counteract this by lowering their prices to
defend their market share.

3. Exploit Monopolistic Advantages: Firms with unique resources, skills, or

advanced technology may expand internationally to use their competitive edge in
less developed markets, where their technology is more distinct.

4. Diversify Internationally: By operating in multiple countries, MNCs can reduce

the volatility of their cash flows. This diversification makes financial outcomes
more stable, reducing the risk of liquidity issues and potentially lowering the cost
of capital.

5. React to trade restrictions: MNCs sometimes use DFI defensively to avoid

trade restrictions, such as tariffs or quotas. By establishing operations within the
restricted country, they can bypass these barriers and continue doing business
there.
Cost-Related Motives
MNCs engage in DFI to reduce costs through the following strategies:

1. Fully Benefit from Economies of Scale: Expanding production into new

markets helps MNCs lower average costs per unit, especially for machinery-
intensive firms, increasing earnings and shareholder wealth.
2. Use Foreign Factors of Production: MNCs reduce costs by setting up
operations in countries with cheaper labor and land, leveraging market
imperfections like unequal labor costs across regions.
3. Use Foreign Raw Materials: Producing goods in countries where raw materials
are located avoids high transportation costs, particularly when selling finished
products in the same country.
4. Use Foreign Technology: MNCs establish or acquire foreign plants to access
advanced technologies, improving production efficiency across global operations.
5. React to Exchange Rate Movements: Investing in countries with undervalued
currencies lowers the initial investment cost, making DFI more attractive.
Benefits of international diversification

Barriers to Direct Foreign Investment (DFI):

1. Protective Barriers: Governments may block DFI that threatens local
businesses, fearing layoffs or too much foreign ownership.

2. Red Tape: Complex procedures and documentation requirements in different

countries can slow down or discourage DFI.

3. Industry Barriers: Local industries with government influence may push to block
competition from foreign companies.

4. Environmental Barriers: Countries may impose strict environmental rules,

increasing costs for foreign subsidiaries.

5. Regulatory Barriers: Rules on taxes, currency, employee rights, and other

policies can affect cash flows and may require frequent adjustments.

6. Ethical Differences: Business practices vary globally, with some actions

considered unethical or illegal in one country but acceptable in another, such as
bribery.
7. Political Instability: Political conflicts or unstable governments may discourage
MNCs from investing in certain countries due to risks of abrupt changes.
Measuring Exposure to Exchange Rate Fluctuations
Exchange rate risk can be broadly defined as the risk that a company’s performance will
be affected by exchange rate movements.

Irrelevance of o exchange rate risk

 Investor Hedge Argument:

Investors can hedge exchange rate risks individually if they have full knowledge of
corporate exposure and the ability to hedge effectively. However, corporations may
hedge more efficiently due to lower costs and better information.

 Currency Diversification Argument:

MNCs operating in multiple countries might offset exchange rate impacts across
different currencies. However, many currencies move similarly against the dollar, so
complete offsetting is unlikely.

 Stakeholder Diversification Argument:

Diversified stakeholders (creditors or stockholders) might reduce the impact of

exchange rate losses. However, many MNCs face similar risks, making it hard to create
a fully insulated portfolio.

Exchange rate exposure

 Transaction exposure
 Economic exposure
 Translation exposure

Transaction Exposure Summary:

Transaction Exposure refers to the risk that a company's financial performance will be
affected by changes in exchange rates between the time a transaction is agreed upon
and when it is settled.

MNCs face exchange rate risk through contractual transactions in foreign currencies,
known as transaction exposure. To assess this exposure, an MNC must:
  Estimate its net cash flows in each foreign currency.
 Measure the potential impact of exchange rate movements on those cash flows.

Economic exposure
Economic Exposure (also called operating exposure) refers to the risk that a
company's market value or future cash flows will be affected by changes in exchange
rates over time, beyond just the immediate impact of transactions. Unlike transaction
exposure, which involves specific contracts or transactions, economic exposure is
broader and relates to the long-term effect of currency fluctuations on a company's
overall competitiveness, revenues, and costs in foreign markets.

For example, a company that earns revenue in a foreign currency may see its future
income reduced if its home currency strengthens, even if no immediate transactions are
involved. Similarly, a company that imports raw materials may face higher costs if the
foreign currency strengthens against its home currency. Economic exposure affects the
company's overall strategic positioning and long-term financial performance.

Translation Exposure
Translation Exposure (also known as accounting exposure) refers to the risk that a
company's consolidated financial statements will be affected by changes in exchange
rates when translating the financial results of foreign subsidiaries into the parent
company's currency. This exposure arises from the need to convert the financial
statements of foreign subsidiaries (which are typically in a foreign currency) into the
parent company’s reporting currency for consolidation purposes.

For example, if a U.S.-based company has a subsidiary in Europe, and the euro
weakens relative to the dollar, the revenue and assets of the European subsidiary,
when converted into U.S. dollars, will appear lower on the consolidated financial
statements, even though the actual economic performance of the subsidiary remains
unchanged. Translation exposure affects the reported financial results but does not
directly impact cash flows.
Determinants of Translation Exposure
Some MNCs are subject to a greater degree of translation exposure than others. An
MNC’s degree of translation exposure is dependent on the following:

 The proportion of its business conducted by foreign subsidiaries

 The locations of its foreign subsidiaries
 The accounting methods that it uses