Multinational Finance

Dr. Richard Michelfelder

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 MCF Topics
1. Introduction to MCF

2. The Balance of Trade, Balance of Payments and International

Macroeconomics

3. Foreign Currency Markets: Spot and Forward Markets

4. Exchange Rates, Monetary Theory and Policy: How Changes in the

Money Supply Affect Exchange Rates and Forecasting Exchange Rates
in the Short Run

5. Inflation, Interest Rates, and Exchange Rates (Purchasing Power Parity,

Interest Rate Parity, and Exchange Rate Forecasting in the Long-Run)

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 MCF Topics
6. Hedging and Speculating Foreign Exchange Rate Risk: Currency
Futures and Options

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 Outline 1: Introduction to MCF
1. Overview of MCF
1.1 Introduction to Multinational Corporate Finance
1.1.1 The Multinational Corporation (MC)
1.2 Primer on Foreign Exchange (FX) Rates Determination
1.3 The International Monetary System
1.3.1 Fixed v. Floating Exchange Rates

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 1. Overview of MCF
• MC’s deal in foreign currency, capital, and
goods markets so we need to understand the
interactions of these markets:
– Inflation (goods markets)
– FX rates (currency markets)
– Interest rates (bond markets)
– Equity markets (stock markets)

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 1. Overview of MCF
• Remember this throughout the course:

There is only two things that you can do with any

currency, spend or save!

This will affect the structure of the entire course

and be a main theme.

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 1.1 Introduction to MCF
• 1st Objective: Maximize Shareholder Value
– Increase cash flow and reduce risk
– Increase Ps (stock price) by increasing CFt
(cash flow in future year t ) with ks (discount
rate and price of risk) constant or falling:

C Ft
Ps  
t 1 1  k 
s
t

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 1.1 Introduction to MCF
• For a firm that does in business in multiple
currencies (i.e., multinational firm) CF’s
are affected by currency value fluctuations
– Therefore Ps (CF’s and k) is affected by FX
(foreign exchange) fluctuations

C Ft
Ps  
t 1 1  k 
s
t

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 1.1 Introduction to MCF
• Secondary Objectives include the interests of
other stakeholders:
– Customers
– Employees
– Community (can be any geographic region such as a
locale or a nation)
• Harvard “Balanced Scorecard Approach” has
management goals related to each stakeholder

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 1.1 Introduction to MCF
• Functions of Financial Management: involves the
acquisition and investment of funds:
– Acquisition: internally generate or raise capital
– Investment: apply funds to business endeavors that
maximize CF with less than proportionate risk

• Additional risks of MC’s:

– Political risk
– Exchange rate risk
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 1.1 Introduction to MCF
• Globalization:
– Financial markets: find lowest cost of capital and
optimal investment opportunities worldwide (more
opportunities than US alone)
– Goods markets: find lowest prices for similar goods
worldwide
– Financial/goods markets are linked:
• Due to lowered costs and advances in transportation,
communications, and information systems
– Worldwide competition

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 1.1 Introduction to MCF
• Globalization:
– Increased diversification opportunities:
• Investing in new stock markets to increase k and
decrease risk
• Investing in new bond markets
– Buy/sell goods
– Arbitrage across countries for lowest price
– Sell goods where demand and price is higher
– World population: 7 Billion v. US ~ 335 million

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 1.1 Introduction to MCF
• Globalization:
– Labor diversification (e.g. Engineers in Russia):
• Skills
• Cost
• Availability
– Capital diversification (e.g. world stock portfolio)
– Land diversification (e.g. Campbells Soup tomato
farm diversification to ensure supply)

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 1.1 Introduction to MCF
• Multinational corporations seek and exploit
such diversification for higher profits and
risk management
– E.g. tobacco companies market foci shifting to
Asia

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 1.1 Introduction to MCF
• Economic Basis for International Trade: What
is the motivation for trading among countries?
Both countries are better off w/ greater consumption
– Comparative Advantage Based on Opportunity
Cost:
• Cost of one commodity is the amount of a 2nd
commodity that must be given up in order to release
enough factors of production (land, labor, capital.
entrepreneurship (risk-taking)) to produce 1 additional
unit of 1st commodity

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 1.1 Introduction to MCF
• Comparative Advantage Based on Opportunity Cost
(CONTINUED):
– The nation with lower opportunity cost for a commodity
has a comparative advantage in that commodity and a
comparative disadvantage in other commodity.

– The production possibilities frontier represents the

advantage to each country and the gains from trade.

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 1.1 Introduction to MCF
• Production Possibilities Frontier:

– Assume two goods, wheat and cloth

– In the absence of trade nations can only consume what
they produce
– Two country example:

UK US
Wheat (millions 60 160
bushels/year)
Cloth (millions of 120 80
yards/year)
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 1.1 Introduction to MCF
Product. Poss. Frontier: Produce & Consume A, A* In
Absence of Trade
Wheat
Wheat
UK 160 US
A*
60 80
A
40

40 120 40 80
Cloth Cloth

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 1.1 Introduction to MCF
• Gains from trade:
– UK price of cloth in terms of wheat:
Pc 60
  0 .5
Pw 1 2 0
– US price of cloth in terms of wheat:
Pc 1 6 0
 2
Pw 80
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 1.1 Introduction to MCF
Mutually advantageous trade is possible if:

Pc
0 .5  2
Pw
Set trade price as below and UK specializes
in cloth and US in wheat; trade 60 C for 60
W
Pc
1
Pw
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 1.1 Introduction to MCF
With Trade, UK Prod. Cloth, US Produces Wheat and Trade at
Pc/Pw = 1, Consume B, B*

Wheat UK US
Wheat
160
B*
60 A*
B 80
40 A

40 120 40 80
Cloth Cloth

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 1.1 Introduction to MCF
With International Trade, Both Countries
Consume More than They Can Produce Due to
the Gains From Trade.

This is the Motivation for Trade Among

Countries and a Key Reason Why Different
International Monetary Systems Have Been
Developed to Attempt to Minimize Volatility of
FX Rates – To Encourage More Trade.
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 1.1Introduction to MCF
• Theory of international trade is becoming less
relevant since MC’s are reducing nations’
trade advantages.
– Ex. Building a company in the resourceful country
• MC’s enter nations seeking advantages in:
– Factors of production (land, natural resources,
labor, and capital)
– Markets

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 1.1Introduction to MCF
• Trade theory assumes factors were not
mobile.
• Differences and advantages remain across
countries and give rise to international
markets in goods and capital.

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 1.1.1Multinational Corporation
• MC is a company engages in producing and
selling goods / services in more than one
country.
• MC usually has a domestic parent or
holding company with foreign divisions or
subsidiaries
– E.g. Comverge Technologies, Inc. had US,
Middle Eastern / S. America, and Asia (Taiwan,
India, Thailand) divisions
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 Example Organization Chart of
MC

C om verge Techn ologies, Inc.

D S I, In c. C om verge Techn ologies, Inc. C om verge Technologies, In c.

M idd le E ast, S . A m erica US A sia

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 1.1.1 Multinational Corporation
• Globally coordinate allocation of resources by a
single centralized management
• (time can be allocated due to time differences – keep moving a
project around the world for different teams to get done faster –
24 hour workday)
• 3 Types of MC’s:
1. Raw material seekers e.g, oil companies
2. Market seekers e.g., Coca Cola, Phillip Morris
3. Cost minimizers e.g., Intel, bank Call Centers,
“outsourcing”
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 1.1.1 Multinational Corporation
• MC’s are characterized more by their scope
in conducting business than in size

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 1.2 Primer on FX Rates
Determination
• FX rate: price of one nation’s currency in
terms of another nation’s currency
– Usually expressed as the domestic currency
price of 1 unit of foreign currency:

E = $ / b = $0.025

where b is the symbol for the Thai baht; 1b = $0.025

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 1.2 Primer on FX Rates
Determination
• 1/E is the foreign currency price of 1 unit of
domestic currency:

1 1 b
   40 b  $1.00
E $ $
b
The price of a US $ is 40 baht.
(Review Wall Street Journal FX rates quotes.)
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 1.2 Primer on FX Rates
Determination
• Spot FX rate: is the price to purchase or sell
one unit of foreign currency to be delivered
in 2 business days.
• Forward rate: is the price agreed today to
buy or sell a specified quantity of foreign
currency for future delivery (30, 60, 90,
180, X days).

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 1.2 Primer on FX Rates
Determination
• Where is the FX market:
– Banks are the principal agents (FX desks), currency
brokers
• Quote example for the Euro:

Bid (Buy) Ask (Sell)

$/Euro $1.20 $1.2015

The bank or broker earn the bid-ask spread as the fee for
trading FX ($1.2015 - $1.20/$1.20) x 100 = 0.125%.
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 1.2 Primer on FX Rates
Determination
• How are the FX rates determined - by the
market (demand and supply)
– Supply of £ derived from UK demand for US
goods and $ denominated securities.
– Demand for £ derived from US demand for UK
goods and £ denominated securities.

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 1.2 Primer on FX Rates
Determination
Demand & Supply for UK £
$/£ D£ S£

E0

Q£
Q£
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 1.2 Primer on FX Rates
Determination
– Depreciation:  in value of currency in terms of
other currency ( in e depreciating foreign
currency)
– Appreciation:  in value of currency in terms of
other currency ( in e appreciating foreign
currency)
• E.g. Baht appreciation: E0 = $/b = 0.025, E1 = $/b = 0.03

E 1  E 0 0 .030  0 .025
  0 .2
E0 0 .025
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 1.2 Primer on FX Rates
Determination
– Depreciation:  in value of currency in terms of
other currency ( in e depreciating foreign
currency)
– The $ depreciation in this example is 16.7%:
1
E1  E10 33.33  40
  0 .167
1
E0 40

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 1.2 Primer on FX Rates
Determination
Appreciation of UK £ & Depreciation in $
$/£ D£ S £*
E1
 S£
E0
D£*

Q£
Q£ Q£*
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 1.2 Primer on FX Rates
Determination
• Expectations and FX Rates:
– Depend upon expectations about future movements of FX rates
– Currencies are financial assets and FX rates the relative price of two
assets, therefore their prices are determined similarly as stocks, bonds, etc.

• FX and Money:
– Money provide liquidity, store of value, medium of exchange, facilitates
transactions.
– Money supply determined by central banks (e.g. Fed. Res. Sys, European
Central Bank,…)
– Money demand depends upon E(inflation), demand for liquidity for
transactions (GDP), demand for assets denominated in that currency (risk-
adjusted expected rate of return on assets).

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 1.3 The International Monetary
System (IMS)
• IMS refers to the system used to determine
FX rates among countries:
– Policies
– Institutions
– Practices
– Regulations
• IMS was a fixed FX rate system from 1946
to 1971: Bretton Woods System
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 1.3 The International Monetary
System (IMS)
• Under Bretton Woods IMS, FX rates were a fixed
FX rate system from 1946 to 1971 (System
Collapsed in 1971)
– Fixed FX rates defined in $ values
– International convertibility of $ into gold
– Intent was to stabilize FX rates and promote trade and
investment among countries
– FX volatility reduces trade & investment due to risk of
losses from FX rate changes, FX transactions costs for
hedging FX risk.

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 1.3 The International Monetary
System (IMS)
• Post-Bretton Woods: Currently (starting in
1971) the IMS is a floating FX rate system.
– I.e., FX rates set by demand and supply
– The $ became the benchmark international
currency used to value others.
– Became ‘the’ international currency.
– The $ has gone through many up and down
cycles in value. It is the currency of safety
when funds flee another country.
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1.3 The International Monetary System
Value of $: Trade-Weighted $ Index

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 1.3 The International Monetary
System
• European Monetary System:
– The Euro came into existence and began trading on
1/5/1998 at $1.08, 2001 low $0.82, $1.45 on 9/8/2009,
9/3/2013 $1.3193, recently $1.15
– http://europa.eu/abc/european_countries/index_en.htm5
– Its supply is controlled by the European Central Bank.
– Has 27 members except UK maintains Pound and
Switzerland maintains Franc
– Developed to compete with US and currency replace $ as
international currency.
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 1.3.1 Fixed v. Floating FX Rates
• Free Float: e moves randomly based on demand
and supply
• Managed or ‘Dirty Float’: floating E with central
bank intervention to smooth volatility
• Target Zones: maintain FX rates near an agreed
upon fixed rate
• Fixed-Rate System: each country’s central bank
intervenes in the FX market to keep e at target
level

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