Chapter 17

International
Business
Finance

Copyright © 2011 Pearson Prentice Hall.

All rights reserved.
 1. Globalization of Products
and Financial Markets

 Direct Foreign Investment (DFI) occurs when the

multinational corporation (MNC) has control over the
investment, such as when it builds an offshore
manufacturing facility.
 Capital flows (Portfolio Investment) between
countries has also been increasing motivated by the
possibility of obtaining higher returns and/or reducing
portfolio risk through international diversification.
 The increase in world trade and investment activity is
reflected in the recent globalization of financial
markets.

© 2011 Pearson Prentice Hall. All rights reserved. 17-2

 2. Exchange Rates

 Floating-rate international currency system is

a system in which exchange rates between
different national currencies are allowed to
fluctuate with supply and demand conditions.
 Most major currencies, including US dollars,
fluctuate freely in the market.

© 2011 Pearson Prentice Hall. All rights reserved. 17-3

 Exchange Rates

 A country’s relative economic strengths, trade

balance, level of monetary activity, and
Balance of payments (BOP) are important
determinants of exchange rates.
 Short-term day-to-day fluctuations in
exchange rates are caused by changing
supply and demand conditions in the foreign
exchange market.

© 2011 Pearson Prentice Hall. All rights reserved. 17-4

 The Foreign Exchange Market

 Foreign Exchange Market is organized

as an Over-the-counter market i.e. a
network of telephone and computer
connections among banks, foreign
exchange dealers, and brokers.

© 2011 Pearson Prentice Hall. All rights reserved. 17-5

 3. Levels of FE market

 Level 1: Customers buy and sell foreign

exchange through their banks.
 Level 2: Banks buy and sell foreign exchange
from other banks in the same commercial
center.
 Level 3: Banks buy and sell foreign exchange
from banks in commercial centers in other
countries (i.e. New York, London, Zurich,
Frankfurt, Hong Kong, Singapore, Tokyo).

© 2011 Pearson Prentice Hall. All rights reserved. 17-6

 Example: Multi-level trading

 Importer buys Japanese Yen from a

bank in California for payment to a
Japanese supplier.
 California bank purchases the
Japanese Yen from a bank in New
York.
 The New York buys the Yen from
another bank in New York.

© 2011 Pearson Prentice Hall. All rights reserved. 17-7

 Exchange Rates and Quotes

 Exchange rate
 The price of foreign currency in terms of the
domestic currency.
 Spot Transactions at spot rate
 In a spot transaction, one currency is traded
for another currency today
 Rates are typically “Direct Quotes”

© 2011 Pearson Prentice Hall. All rights reserved. 17-8

 Direct and Indirect Quote

 Direct Quote
 Indicates the number of units of the home currency
required to buy one unit of the foreign currency
 Example: 1.6288 dollars per British pound
 Indirect Quote
 Indicates the number of units of a foreign currency
that can be bought for one unit of the home
currency. It is the reciprocal of direct quote.
 Example: =1/1.6288 = .6139 pounds per dollar

© 2011 Pearson Prentice Hall. All rights reserved. 17-9

 Bid and Ask rates

 Bid: Rate at which bank buys foreign

currency from a customer
 Ask: Rate at which bank sells foreign
currency to a customer
 The difference between the asked quote
and the bid quote is known as bid-
asked spread.

© 2011 Pearson Prentice Hall. All rights reserved. 17-10

 Cross rate

 The computation of an exchange rate

for a currency from the exchange rates
of two other currencies.

© 2011 Pearson Prentice Hall. All rights reserved. 17-11

 Forward rate

 A forward exchange contract requires

delivery, at a specified future date, of one
currency for a specified amount of another
currency.
 The exchange rate for the future is agreed
today and is known as the “forward rate”. The
actual payment of one currency and receipt of
another currency take place at the future
date.

© 2011 Pearson Prentice Hall. All rights reserved. 17-12

 Forward contract example

 Forward contracts are usually quoted

for periods of 30, 90, and 180 days.
 If the 30-day forward quote for Euros
is $1.30, it means that the bank is
contractually bound to deliver Euro at
$1.30 and the customer is bound to buy
Euro at $1.30, regardless of the actual
spot rate.

© 2011 Pearson Prentice Hall. All rights reserved. 17-13

 Exchange Rates and
Arbitrage

 Foreign exchange quotes in two different

countries must be in line with each other.
 If the exchange rates are out of line, then a
trader could make a profit by buying in the
market where the currency was cheaper and
selling it in the other.
 The process of buying and selling in more than
one market to make a riskless profit is called
arbitrage. Such opportunities do not exist for a
long time due to arbitrage process.

© 2011 Pearson Prentice Hall. All rights reserved. 17-14

 Types of Arbitrage

 Simple
 Eliminates exchange rate differentials across the
markets for a single currency
 Triangular
 Eliminates exchange rate differentials across
markets for all currencies
 Covered-Interest
 Eliminates differentials across currency and interest-
rate markets

© 2011 Pearson Prentice Hall. All rights reserved. 17-15

 Exchange Rate Risk

 The risk that tomorrow’s exchange rate

will differ from today’s rate.
 Exchange rate risk affects:
 international trade contracts
 foreign portfolio investments
 direct foreign investment

© 2011 Pearson Prentice Hall. All rights reserved. 17-16

 Exchange Rate Risk in
International Trade Contracts

 Example: You are expecting to receive

1m Euros next year from exports.
 The future value of Euros in dollars is
uncertain and depends on future
exchange rate.
 If Euro = $1.25, you will receive $1.25m
but if the Euro depreciates to $.90, your
contract is worth only $.90m.

© 2011 Pearson Prentice Hall. All rights reserved. 17-17

 Exchange Rate Risk in
Foreign Portfolio Investments

 The future return on portfolio is unknown as

investments in securities is a risky investment.
Thus investing in Euro market securities could
yield –5% or +10%. In addition, investor is
exposed to US $/Euro exchange rate
fluctuation.
 Thus if the Euro investment yields 10% but the
Euro depreciates during the period, the net
return will be less than 10% depending
on the extent of Euro depreciation.

© 2011 Pearson Prentice Hall. All rights reserved. 17-18

 Exchange Rate Risk in Direct
Foreign Investment

 In a DFI, parent company invests in assets

denominated in foreign currency. The US based
parent company receives the repatriated (or
converted) profit stream from the subsidiary in
dollars.
 Thus exchange rate risk arises due to:
 Fluctuations in the dollar value of the assets located
abroad.
 Fluctuations in the home currency-denominated profit
stream.
 May affect future profit stream

© 2011 Pearson Prentice Hall. All rights reserved. 17-19

 3. Interest-Rate Parity Theory

 IRP theory can be used to relate differences

in the interest rates in two countries to the
ratio of spot and forward exchange rates of
the two countries’ currencies. The IRP
condition can be stated as follows:

© 2011 Pearson Prentice Hall. All rights reserved. 17-20

 4. Purchasing Power Parity
Theory (PPP)

 In the long run, exchange rates adjust

so that the purchasing power of each
currency tends to be the same.
 The exchange rate changes tend to
reflect international differences in
inflation rates.Countries with high rates
of inflation tend to experience declines
in the value of their currency.

© 2011 Pearson Prentice Hall. All rights reserved. 17-21

 Purchasing Power Parity
Theory (PPP)

 Thus according to PPP, Expected spot

rate = Current spot rate  expected
difference in inflation rate.
 In other words, according to PPP, a
dollar should have the same purchasing
power anywhere in the world

© 2011 Pearson Prentice Hall. All rights reserved. 17-22

 PPP

© 2011 Pearson Prentice Hall. All rights reserved. 17-23

 Law of One Price

 PPP is based on the law of one price - a

proposition that in competitive markets in
which there are no transportation costs or
barriers to trade, the same goods sold in
different countries sell for the same price if all
the different prices are expressed in terms of
the same currency.
 Thus if Big Mac Costs $2 in US and the
exchange rate with British Pound is 1 Pound =
$2, Big Mac should cost 1 Pound in UK.

© 2011 Pearson Prentice Hall. All rights reserved. 17-24

 The International
Fisher Effect

 International Fisher Effect states that the real

interest rate should be the same all over the
world, with the differences in nominal rate
resulting from differences in expected
inflation rates.
 Thus investing in a foreign bank with highest
interest rate may simply mean investing in a
country with the highest rate of inflation.

© 2011 Pearson Prentice Hall. All rights reserved. 17-25

 5. Exposure to
Exchange Rate Risk

 Three Measures of foreign exchange

exposure:
 Translation Exposure
 Transaction Exposure
 Economic Exposure

© 2011 Pearson Prentice Hall. All rights reserved. 17-26

 Translation Exposure

 Translation exposure risk arises because the

foreign operations of MNCs have financial
statements denominated in the local
currencies of the countries in which the
operations are located. These denominations
must be translated into the MNCs home
currency at the prevailing exchange rate.
 Exchange rate gains or losses due to
translation exposure are not realized, and
have little or no impact on taxable income.

© 2011 Pearson Prentice Hall. All rights reserved. 17-27

 Transaction Exposure

 Transaction exposure refers to the net

contracted foreign currency transactions
(such as receivables, payables, fixed price
sales or purchase contract) for which the
settlement amounts are subject to changing
exchange rates.
 Transaction exposure can be hedged by
using money market hedge, or forward
contracts or futures contracts or options.

© 2011 Pearson Prentice Hall. All rights reserved. 17-28

 Economic Exposure

 Economic exposure refers to the overall impact of

exchange rate changes on the value of the firm. This
change in value may be caused by a rate change-
induced decline in the level of expected cash flows
and/or by an increase in the riskiness of these cash
flows.

© 2011 Pearson Prentice Hall. All rights reserved. 17-29

 Economic Exposure

 Economic exposure to exchange rate changes depends

on the competitive structure of the markets for a firm’s
inputs (purchases/expenses) and outputs (Sales) and
how these markets are influenced by changes in
exchange rates.
 For example, the profits of a Canadian company that
used coal in its production process was influenced
indirectly by the Yen/US$ exchange rate as the price of
coal depended on Japanese demand for coal, which in
turn depended on the Yen/US$ exchange rate.

© 2011 Pearson Prentice Hall. All rights reserved. 17-30

 6. Multinational
Working-Capital Management

 Basic principles of working-capital

management for a multinational
corporation are similar to those of a
domestic firm.
 Tax rate and exchange rates are additional
considerations

© 2011 Pearson Prentice Hall. All rights reserved. 17-31

 Two techniques used for
managing working capital

Leading and Lagging Strategies

 Holding a net asset (long) position in a weak or
potentially depreciating currency is not desirable.
 Lead – To get rid of assets early (i.e. lead) and convert
the assets into a stronger currency
 Lag – To delay the collection against a net asset position
in a strong currency.
 In case of net liability (short) position
 For a weakening currency – delay payment
 For a strengthening currency – lead the payments

© 2011 Pearson Prentice Hall. All rights reserved. 17-32

 2. Cash Management and
Positioning of Funds

 Funds may be transferred from a subsidiary

of the multinational company in country A to
another subsidiary in country B such that the
foreign exchange exposure and the tax
liability is minimized.
 Transfer of funds among subsidiaries and the
parent company is done via royalties, fees,
and transfer pricing.

© 2011 Pearson Prentice Hall. All rights reserved. 17-33

 Transfer Pricing

 Price a subsidiary or a parent company

charges other companies that are part
of the multinational company for its
goods and services.

© 2011 Pearson Prentice Hall. All rights reserved. 17-34

 7. International Financing
Decisions

 MNC has access to both domestic and

foreign markets for financing
 Foreign host countries may often provide low-cost
subsidized financing to attract investments
 Because of its international presence, MNC
can tap into a third country capital markets.
 MNC can also access external currency
markets: Eurodollar, Eurocurrency, or Asian
dollar markets.

© 2011 Pearson Prentice Hall. All rights reserved. 17-35

 Factors to consider before MNC arrive at its
capital structure decisions

 Local norms regarding capital structure

 Corporate attitude towards exchange rate and
political risks
 Local-affiliate capital structure must reflect home
country requirements with regard to the company’s
consolidated capital structure.
 The optimal MNC capital structure should reflects its
wider access to financial markets, its ability to
diversify its economic and political risks, and its other
advantages over domestic companies.

© 2011 Pearson Prentice Hall. All rights reserved. 17-36

 8. Direct Foreign Investment

 The decision process for DFI is similar to

capital budgeting decisions in the domestic
context.
 Risks in domestic capital budgeting arises
from two sources: business risk and financial
risk.
 In international capital budgeting problem, we
also have to incorporate political risk and
exchange rate risk.

© 2011 Pearson Prentice Hall. All rights reserved. 17-37

 Political Risk

 Political risk arises because the foreign subsidiary

conducts business in a political system different from
that of the home country.
 Some examples of such risk include:
 Expropriation of assets without compensation
 Nonconvertibility of the subsidiary’s foreign earnings into the
parent’s currency
 Changes in the laws governing taxation
 Restrictions on sale price, wage rates, local borrowing, extent
of local ownership, hiring of personnel, transfer payments
made to the parent.

© 2011 Pearson Prentice Hall. All rights reserved. 17-38

 Exchange Rate Risk

 As observed before, exchange rate

risks can have significant effect on cash
flows and earnings.

© 2011 Pearson Prentice Hall. All rights reserved. 17-39