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.

Exchange Rate
 The number of units of a given currency that
can be purchased for one unit of another
currency

19-4
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
19-5
Spot vs. forward exchange rate
 Spot exchange rate is the quoted price
for a unit of foreign currency to be
delivered “on the spot” or within a very
short period of time

 Forward exchange rate is the quoted

price for a unit of foreign currency to be
delivered at a specified date in the
future.

19-6
Fixed vs. floating exchange rate
 Fixed exchange rate is set by the
government and is allowed to fluctuate
only slightly (if at all) around the desired
rate, which is called the par value.

 Floating or flexible exchange rate is not

regulated by the government, thus the
demand and supply in the market
determine the currency’s value.

19-7
Devaluation and revaluation
Depreciation and appreciation
 Devaluation or revaluation is the technical term
referring to the decrease or increase in the
stated par value of a currency whose value is
fixed.
 Depreciation or appreciation refers to a
decrease or increase, respectively, in the
foreign exchange value of a floating currency.
These changes are caused by market forces
rather than by governments.

19-8
Regimes of Currency

Floating Rate Fixed Rate

19-9
 Foreign Exchange Rate Quotations
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.
Japanese Yen: 1/.009 = 111.11
1/111.11 =.009 (indirect)
Interpretation: 1 Japanese yen is worth (or can be
exchanged for) .009 US $
19-10
 Try this.

 Assume that today 1 Japanese yen is worth .01095

US dollar. How many Japanese yen would you
receive for 1 US dollar?
Answer 1 /.01095 = 91.32
 Assume that 1 US dollar can be exchanged for 105
Japanese yen or for .80 euro. What is the euro/yen
exchange rate?
Answer .007619/Japanese yen

19-11
 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.
# of Units of Foreign
Currency per US $
Japanese yen 111.11
Australian dollar 1.5385
 Simply find the inverse of the direct quotations.
1/111.11 =.009 (indirect)
Interpretation: 1 US $ is worth (or can be exchanged
for) 111.11 of Japanese yen
19-12
 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 no. of yen that one A.
dollar could buy)

The inverse of this cross rate yields:

0.0138 A. Dollars/Yen (The no. of A. dollar
that one yen could buy)
19-13
Application:
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

19-14
Application:
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

19-15
Another Illustration
Spot Rate
Euro .6797/$1
Yen 91.3404/$1

 We can cancel the $1, thus

.6797 / 91.3404 = .0074/ Yen

Interpretation:
1 Yen could buy or can be exchanged for .0074 of Euro
Alternatively,
1 Euro could buy or can be exchanged for 134.38 of
Yen
19-16
 Interbank Foreign Currency Quotations

 American Terms: The foreign exchange rate

quotation that represents the number of
American dollars that can be bought with one
unit of local currency.
 European Terms: The foreign exchange rate
quotation that represents the units of local
currency that can be bought with one US dollar
 Direct quotation: The home currency price of
one unit of the foreign currency
 Indirect quotation: The foreign currency
price of one unit of the home currency.
19-17
 Interbank Foreign Currency Quotations

 Spot Rate: The effective exchange rate of a

foreign currency for delivery on (approximately)
the current day.
 Forward Exchange Rate: An agreed-upon
price at which two currencies will be exchanged
at some future date.
 Discount on Forward Rate: The situation
when the spot rate is less than the forward rate
 Premium on Forward Rate: The situation
when the spot rate is greater than the forward
rate.
19-18
 Illustration:

Currency Spot Forward Rates Forward

Rate rate at a
premium
or
discount
30 days 90 days 180 days
British Pound 1.6521 1.6543 1.6558 1.6597 Premium
Canadian Dollar .9387 .9408 .9400 .9377 Discount
Hong Kong Dollar .1290 .1296 .1294 .1299 Premium
Japanese Yen .0109 .01097 .01395 .01852 Premium
Swiss franc .9687 .9708 .9714 .9729 Premium

Note: If the forward rate is more valuable than spot rate = premium
If the forward rate if less valuable than the spot rate = discount

19-19
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.

19-20
Interest Rate Parity

 A concept that specifies that investors should

expect to earn the same return in all
countries after adjusting risk
 A principle that holds the relationship
between spot and forward exchange rates
and interest rates
 Formula:
Forward exchange rate = (1 + rh)
Spot exchange rate = (1 + rf)

19-21
Illustration

ft 1  rh

e 0 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

19-22
Illustration

 Suppose one yen buys $0.0095 in the 30-day

forward exchange market. The 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%
Note:
The annualized rate for 30-day (or 1 month) is divided
into 12 months as there are 12 months in a year
19-23
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 if we were given an e0 = $0.0090,
thus interest rate parity does not hold.

19-24
Exercise 1:

 Suppose in the spot market, 1 U.S. dollar equals 1.75

Canadian dollars. 6-month Canadian securities have an
annualized return of 6% (and thus a 6-month periodic
return of 3%). 6-month U.S. securities have an
annualized return of 6.5% and a periodic return of
3.25%. If interest rate parity holds, what is the U.S.
dollar-Canadian dollar exchange rate in the 180-day
forward market? In other words, how many Canadian
dollars are required to purchase one U.S. dollar in the
180-day forward market?
 Answer

US $.5728/C$ or C$1.7458/ US $
19-25
Exercise 2:

 The nominal annual interest rate on 1 year US

Treasuries is .07%. The spot rate of the British
pound is $1.5246 and the forward rate of the
British pound is $1.4936. If interest rate parity
holds, what is the nominal annual interest rate on
default-free 1 year British bonds?
 Answer

$ .9797 = 1.0007
(1 + rf)
.9797 + .9797rf = 1.0007
rf = .021/.9797
= 2.14%
19-26
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 ) Spot Rate = Ph
 OR  Pf

e 0  Ph /Pf Where:

Ph is the price of the goods in the

home country
Pf is the price of the goods in the
foreign country
19-27
Illustration:

If grapefruit juice costs $2.00 per liter in the

U.S. and PPP holds, what is the price of
grapefruit juice in Australia if in the spot
market, 1 Australian dollar can be exchanged
for $.6500?

e0 = Ph/Pf
$0.6500 = $2.00/Pf
Pf = $2.00/$0.6500
Pf = 3.0769 Australian dollars
19-28
Exercise 1:
A product sells for $750 in the United States.
The spot exchange rate is $1 to 1.65 Swiss
francs. If purchasing power parity (PPP) holds,
what is the price of the product in Switzerland?
Answer
Product price in U.S. $750.00
Spot rate, SF/$ 1.65 SF
​Formula below requires spot rate to be home
currency/foreign currency, so need inverse of spot
rate given.
Ph = Pf × Spot rate, $/SF
$750 = Pf × 0.6061
Pf = 1,237.50
​
19-29
Exercise 2:

Suppose hockey skates sell in Canada for 105

Canadian dollars, and 1 Canadian dollar equals
0.71 U.S. dollar. If purchasing power parity (PPP)
holds, what is the price of hockey skates in the
United States? Answer

Price of skates, C$ 105.00 C$

Spot exchange rate, $/C$ $0.71
​Ph = Pf × Spot rate  =
105.00 × $0.71  Ph =
$74.55
19-30
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 application for determining
profit, a weakening/strengthening Australian
dollar would impact the dollar profit.

19-31
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.

19-32
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.
 Eurodollar
 A US dollar deposited in a bank outside the
United States.

19-33
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 issuer’s.
 The only thing foreign about it is the borrower’s
nationality.
19-34
Floating Monetary Agreements

 Freely floating
 Exchange rate determined by the market’s 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 currency’s
supply and demand. The target exchange rates
are kept secret to prevent currency speculators
from profiting from it.

19-35
Fixed Monetary Agreements

 No local currency
 The country uses either another country’s
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).

19-36
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.

19-37
End of Presentation

19-38
 Other Concepts and Terms

Country Risk
The risk that arises from investing or doing
business in a particular country.
Repatriation of Earnings
The process of sending cash flows from a
foreign subsidiary back to the parent company.
Political Risk
Potential actions by a host government that
would reduce the value of a company’s
investment.
Business Climate
Refers to a country’s social, political and
19-39
economic environment.
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.

19-40
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).

19-41
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%.

19-42