Chapter 19

Multinational Financial
Management
Multinational vs. Domestic Financial
Management
Exchange Rates and Trading in
Foreign Exchange
International Money and Capital
Markets
19-1
What is a multinational corporation?

A corporation that operates

in two or more countries.
Decision making within the
corporation may be
centralized in the home
country, or may be
decentralized across the
countries in which the
corporation does business.

19-2
Why do firms expand into other
countries?
1. To seek production efficiency.
2. To avoid political and regulatory hurdles.
3. To seek new markets.
4. To seek raw materials and new technology.
5. To protect processes and products.
6. To diversify.
7. To retain customers.

19-3
Multinational Financial Management vs.
Domestic Financial Management

1. Different currency denominations.

2. Political risk
3. Economic and legal ramifications.
4. Role of governments
5. Language and cultural differences.

19-4
Consider the Following Exchange Rates

US $ to Buy 1 Unit
Japanese yen 0.009
Australian dollar 0.650

Are these currency prices direct or indirect

quotations?
Since they are prices of foreign currencies
expressed in dollars, they are direct quotations.

19-5
What is an indirect quotation?

The number of units of a foreign currency

needed to purchase one U.S. dollar, or the
reciprocal of a direct quotation.

19-6
Calculate the Indirect Quotations for
Yen and Australian Dollars
# of Units of Foreign
Currency per US $
Japanese yen 111.11
Australian dollar 1.5385

Simply find the inverse of the direct

quotations.

19-7
What is a cross rate?

The exchange rate between any two currencies.

Cross rates are actually calculated on the basis
of various currencies relative to the U.S. dollar.
Cross rate between Australian dollar and the
Japanese yen.
Cross rate = (Yen/US Dollar) x (US Dollar/A. Dollar)
= 111.11 x 0.650
= 72.22 Yen/A. Dollar
The inverse of this cross rate yields:
0.0138 A. Dollars/Yen
19-8
Orange Juice Project:
Setting the Appropriate Price
A firm can produce a liter of orange juice and
ship it to Japan for $1.75 per unit. If the firm
wants a 50% markup on the project, what
should the juice sell for in Japan?
Price = ($1.75)(1.50)(111.11 yen/$)
= 291.66 yen

19-9
Orange Juice Project:
Determining Profitability
The product will cost 250 yen to produce and
ship to Australia, where it can be sold for 6
Australian dollars. What is the U.S. dollar
profit on the sale?
Cost in A. dollars 250 yen(0.0138)
3.45 A. dollars

A. dollar profit 6 3.45 2.55 A. dollars

U.S. dollar profit 2.55/1.5385 $1.66

19-10
What is exchange rate risk?

The risk that the value of a cash flow in one

currency translated to another currency will
decline due to a change in exchange rates.
For example, in the last slide, a weakening
Australian dollar (strengthening dollar) would
lower the dollar profit.

19-11
International Monetary System

The framework within which exchange rates

are determined.
The blueprint for international trade and capital
flows.
Exchange rate terminology
Spot vs. forward exchange rate
Fixed vs. floating exchange rate
Devaluation and revaluation
Depreciation and appreciation
19-12
International Monetary System

International monetary systems are

sets of internationally agreed rules,
conventions and supporting institutions,
that facilitate international trade, cross
border investment and generally the
reallocation of capital between nation
states.

19-13
Floating Monetary Agreements

Freely floating
Exchange rate determined by the markets
supply and demand for the currency.
Governments may occasionally intervene and
buy or sell their currency to stabilize
fluctuations.
Managed floating
Significant government intervention manages
the exchange rate by manipulating the
currencys supply and demand. The target
exchange rates are kept secret to prevent
currency speculators from profiting from it.
19-14
Fixed Monetary Agreements

No local currency
The country uses either another countrys
currency as its legal tender (like the U.S. dollar in
Ecuador) or else belongs to a group of countries
that share a currency (like the euro).
Currency board arrangement
The country technically has its own currency but
commits to exchange it for a specified foreign
currency at a fixed exchange rate (like Argentina
before its January 2002 crisis).

19-15
Fixed Monetary Agreements

Fixed peg arrangement

The country pegs its currency to another (or a
basket of currencies) at a fixed rate. Slight
fluctuations are okay, but the rate must stay
within a desired range. For example, the
Chinese yuan is pegged to a basket of
currencies.

19-16
What is difference between spot rates
and forward rates?
Spot rates are the rates to buy currency for
immediate delivery.
Forward rates are the rates to buy currency
at some agreed-upon date in the future.

19-17
When is the forward rate at a premium
to the spot rate?
If the U.S. dollar buys fewer units of a foreign
currency in the forward than in the spot
market, the foreign currency is selling at a
premium.
In the opposite situation, the foreign currency
is selling at a discount.
The primary determinant of the spot/forward
rate relationship is relative interest rates.

19-18
What is interest rate parity?

Interest rate parity holds that investors

should expect to earn the same return in
all countries after adjusting for risk.
ft 1 rh

e0 1 rf
ft t - period forward exchange rate
e0 today' s spot exchange rate
rh periodic interest rate in home country
rf periodic interest rate in foreign country
19-19
Evaluating Interest Rate Parity

Suppose one yen buys $0.0095 in the 30-day

forward exchange market and rNOM for a 30-
day risk-free security in Japan and in the U.S.
is 4%.
ft 0.0095
rh 4%/12 0.333%
rf 4%/12 0.333%

19-20
Does interest rate parity hold?

0.0095 1.0033

e0 1.0033
0.0095
1
e0
e 0 0.0095

For interest rate parity to hold, e0 must

equal $0.0095, but we were given earlier
that e0 = $0.0090, so interest rate parity
does not hold.
19-21
Which security offers the highest
return?
The Japanese security.
Convert $1,000 to yen in the spot market.
$1,000 x 111.111 = 111,111 yen.
Invest 111,111 yen in 30-day Japanese security.
In 30 days receive 111,111 yen x 1.00333 =
111,481 yen.
Agree today to exchange 111,481 yen 30 days
from now at forward rate, 111,481/105.2632 =
$1,059.07.
30-day return = $59.07/$1,000 = 5.907%,
nominal annual return = 12 x 5.907% =
70.88%. 19-22
What is purchasing power parity?

Purchasing power parity implies that the level

of exchange rates adjusts so that identical
goods cost the same amount in different
countries.
Ph Pf (e 0 )
OR
e 0 Ph /Pf
Purchasing power parity (PPP) is a theory which states that exchange
rates between currencies are in equilibrium when their purchasing
power is the same in each of the two countries.
19-23
If grapefruit juice costs $2.00 per liter in the U.S.
and PPP holds, what is the price of grapefruit juice
in Australia?

e0 = Ph/Pf
$0.6500 = $2.00/Pf
Pf = $2.00/$0.6500
Pf = 3.0769 Australian dollars

19-24
What impact does relative inflation have on
interest rates and exchange rates?

Lower inflation leads to lower interest rates,

so borrowing in low-interest countries may
appear attractive to multinational firms.
However, currencies in low-inflation countries
tend to appreciate against those in high-
inflation rate countries, so the effective
interest cost increases over the life of the
loan.

19-25
International Credit Markets

Eurocredits
Fixed term, floating-rate bank loans with no early
repayment.
An example is a eurodollar deposit, which is U.S.
dollars deposited in a bank outside the U.S.

19-26
International Credit Markets

Eurobonds
Medium- to long-term international market for
fixed- and floating-rate debt.
Underwritten by an international bank syndicate
and sold to investors in countries other than the
one in whose currency the bond is denominated.
Foreign bonds
Issued in a capital market other than the issuers.
The only thing foreign about it is the borrowers
nationality.
19-27
American Depository Receipts (ADRs)

Certificates representing ownership of foreign

stock held in trust.
About 1,700 ADRs are now available in the
United States, with most of them traded on
the over-the-counter (OTC) market.
However, more and more ADRs are being
listed on the New York Stock Exchange.

19-28
To what extent do average capital
structures vary across different countries?

Previous studies suggested that average

capital structures vary among the large
industrial countries.
However, a recent study, which controlled for
differences in accounting practices, suggests
that capital structures are more similar across
different countries than previously thought.

19-29
Impact of Multinational Operations on Capital
Budgeting Decisions

Foreign operations are taxed locally, then

repatriated funds may be taxed in the U.S.
Foreign projects are subject to political risk.
Repatriated funds must be converted to U.S.
dollars (subject to exchange rate risk).

19-30