4-2InternationalInternationalFinancial ManagementFinancial ManagementSome BackgroundTypes of Exchange-Rate RiskExposureManagement of Exchange-RateRisk ExposureStructuring International TradeTransactions
4-3Some BackgroundSome BackgroundFill product gaps in foreign markets whereexcess returns can be earned.To produce products in foreign marketsmore efficiently than domestically.To secure the necessary raw materialsrequired for product production.What is a company’s motivation toWhat is a company’s motivation toinvest capital abroad?invest capital abroad?
4-4InternationalInternationalCapital BudgetingCapital Budgeting1. Estimate expected cash flows in the foreigncurrency.2. Compute their U.S.-dollar equivalents at theexpected exchange rate.3. Determine the NPV of the project using the U.S.required rate of return, with the rate adjustedupward or downward for any risk premium effectassociated with the foreign investment.How does a firm make an internationalHow does a firm make an internationalcapital budgeting decision?capital budgeting decision?
4-5InternationalInternationalCapital BudgetingCapital BudgetingOnly consider those cash flows that canbe “repatriated” (returned) to the home-country parent.The exchange rateexchange rate is the number of unitsof one currency that may be purchasedwith one unit of another currency.For example, the current exchange ratemight be 2.50 Freedonian marks per oneU.S. dollar.
4-6International CapitalInternational CapitalBudgeting ExampleBudgeting ExampleA firm is considering an investment inFreedonia, and the initial cash outlay is 1.5million marks.The project has 4-year project life with cashflows given on the next slide.The appropriate required returnappropriate required return forrepatriated U.S. dollars is 18%is 18%.The appropriate expected exchange ratesexpected exchange ratesare given on the next slide.International project detailsInternational project details::
4-8InternationalInternationalCapital BudgetingCapital BudgetingInternational diversification and riskreductionU.S. Government taxationTaxable income derived from non-domesticoperations through a branch or division is taxedunder U.S. code.Foreign subsidiaries are taxed under foreign taxcodes until dividends are received by the U.S.parent from the foreign subsidiary.Related issues of concernRelated issues of concern::
4-9InternationalInternationalCapital BudgetingCapital BudgetingTax codes and policies differ from country tocountry, but all countries impose income taxeson foreign companies.The U.S. government provides a tax credit tocompanies to avoid the double taxationproblem.A credit is provided up to the amount of theforeign tax, but not to exceed the sameproportion of taxable earnings from the foreigncountry.Excess tax credits can be carried forward.Foreign Taxation
4-10InternationalInternationalCapital BudgetingCapital BudgetingExpropriation is the ultimate political risk.Developing countries may provide financialincentives to enhance foreign investment.Bottom line: Forecasting political instabilityForecasting political instability.Protect the firm by hiring local nationals, actingresponsibly in the eyes of the host government,entering joint ventures, making the subsidiaryreliant on the parent company, and/orpurchasing political risk insurancepolitical risk insurance.Political Risk
4-11ImportantImportantExchange-Rate TermsExchange-Rate TermsCurrency riskCurrency risk can be thought of as the volatilityof the exchange rate of one currency foranother (say British pounds per U.S. dollar).Spot Exchange RateSpot Exchange Rate -- The rate today forexchanging one currency for another forforimmediate deliveryimmediate delivery.Forward Exchange RateForward Exchange Rate -- The rate todayfor exchanging one currency for another atata specific future datea specific future date.
4-12Types of Exchange-Types of Exchange-Rate Risk ExposureRate Risk ExposureTranslation ExposureTranslation Exposure -- Relates to the change inaccounting income and balance sheet statementscaused by changes in exchange rates.Transactions ExposureTransactions Exposure -- Relates to settling aparticular transaction at one exchange rate whenthe obligation was originally recorded at another.Economic ExposureEconomic Exposure ---- Involves changes inexpected future cash flows, and hence economicvalue, caused by a change in exchange rates.
4-13Management of Exchange-Management of Exchange-Rate Risk ExposureRate Risk ExposureNatural hedgesCash managementAdjusting of intracompanyaccountsInternational financing hedgesCurrency market hedges
4-14Natural HedgesNatural HedgesBoth scenarios are natural hedges as any gain(loss) from exchange rate fluctuations in pricingis reduced by an offsetting loss (gain) in costs insimilar global markets.Globally DomesticallyDetermined DeterminedScenario 1Scenario 1Pricing XCost XScenario 2Scenario 2Pricing XCost X
4-15Natural Hedges -- “Not!”Natural Hedges -- “Not!”Both of these scenarios are not natural hedges andthus create a possible firm exposure to events thatimpact one market and not the other market.Globally DomesticallyDetermined DeterminedScenario 3Scenario 3Pricing XCost XScenario 4Scenario 4Pricing XCost X
4-16Cash ManagementCash ManagementExchange cash for real assets (inventories) whosevalue is in their use rather than tied to a currency.Reduce or avoid the amount of trade credit that willbe extended as the dollar value that the firm willreceive is reduced and reduce any cash that doesarrive as quickly as possible.Obtain trade credit or borrow in the local currencyso that the money is repaid with fewer dollars.What should a firm do if it knew that a local foreignWhat should a firm do if it knew that a local foreigncurrency was going to fall in value (e.g., drop fromcurrency was going to fall in value (e.g., drop from$.70 per peso to $.60 per peso)?$.70 per peso to $.60 per peso)?
4-17Cash ManagementCash ManagementGenerally, one cannot predict the futureexchange rates, and the best policy would beto balance monetary assets against monetaryliabilities to neutralize the effect of exchange-rate fluctuations.A reinvoicing centerreinvoicing center is a company-ownedfinancial subsidiary that purchases exportedgoods from company affiliates and resells(reinvoices) them to other affiliates orindependent customers.
4-18Cash ManagementCash ManagementGenerally, the reinvoicing center is billed in theselling unit’s home currency and bills the purchasingunit in that unit’s home currency.Allows better management of intracompanytransactions.NettingNetting -- A system in which cross-borderpurchases among participating subsidiaries ofthe same company are netted so that eachparticipant pays or receives only the net amountof its intracompany purchases and sales.
4-19InternationalInternationalFinancing HedgesFinancing HedgesForeign commercial banks perform essentially thesame financing functions as domestic banks except:They allow longer term loans.Loans are generally made on an overdraft basisoverdraft basis.Nearly all major commercial cities have U.S. bankbranches or offices available for customers.The use of “discounting” trade bills is widely utilizedin Europe versus minimal usage in the United States.1. Commercial Bank Loans and Trade Bills1. Commercial Bank Loans and Trade Bills
4-20InternationalInternationalFinancing HedgesFinancing HedgesEurodollars are bank deposits denominated in U.S.dollars but not subject to U.S. banking regulations.This market is unregulated. Therefore, thedifferential between the rate paid on deposits andthat charged on loans varies according to the risk ofthe borrower and current supply and demand forces.Rates are typically quoted in terms of the LIBOR.It is a major source of short-term financing for theworking capital requirements of the multinationalcompany.2. Eurodollar Financing2. Eurodollar Financing
4-21InternationalInternationalFinancing HedgesFinancing HedgesA EurobondEurobond is a bond issued internationally outsideof the country in whose currency the bond isdenominated.The Eurobond is issued in a single currency, but isplaced in multiple countries.A foreign bondforeign bond is issued by a foreign government orcorporation in a local market. For example, Yankeebonds, Samurai bonds, and Rembrandt bonds.Many international debt issues are floating rate notesfloating rate notesthat carry a variable interest rate.3. International Bond Financing3. International Bond Financing
4-22InternationalInternationalFinancing HedgesFinancing HedgesCurrency-option bonds provide the holder with theoption to choose the currency in which payment isreceived. For example, a bond might allow you tochoose between yen and U.S. dollars.Currency cocktail bonds provide a degree of exchange-rate stability by having principal and interest paymentsbeing a weighted average of a “basket” of currencies.Dual-currency bonds have their purchase price andcoupon payments denominated in one currency, whilea different currency is used to make principalpayments.4. Currency-Option and Multiple-Currency bonds4. Currency-Option and Multiple-Currency bonds
4-23Currencies and the EuroCurrencies and the EuroEach country has a representative currency like the $in the United States or the ₤ in Britain.On January 1, 1999, the “euro” started trading.European Monetary Union (EMU) includes Austria,Belgium, Finland, France, Germany, Ireland, Italy,Luxembourg, the Netherlands, Portugal, and Spain.Agreed to issue a common currency, the euro, butcan continue to use their national currencies until2002 when each national currency is retired.EuroEuro – The name given to the single Europeancurrency. Symbol is € (much like the dollar, $).
4-24Currency Market HedgesCurrency Market HedgesA forward contractforward contract is a contract for the delivery of acommodity, foreign currency, or financial instrument at aprice specified now, with delivery and settlement at aspecified future date.Spot rate $.168 per EFr90-day forward rate .166 per EFrAs shown, the Elbonian franc (EFr) is said to sell at aforward discountforward discount as the forward price is less than thespot rate.If the forward rate is $.171, the EFr is said to sell at aforward premiumforward premium.1. Forward Exchange Market1. Forward Exchange Market
4-25Currency Market HedgesCurrency Market HedgesThe firm has the option of selling 1 million Elbonianfrancs forward 90 days. The firm will receive$166,000 in 90 days (1 million Elbonian francs x$.166).Therefore, if the actual spot price in 90 days is lessthan .166, the firm benefited from entering into thistransaction.If the rate is greater than .166, the firm would havebenefited from not entering into the transaction.Fillups Electronics has just sold equipment worth1 million Elbonian francs with credit terms of “net90.” How can the firm hedge the currency risk?How can the firm hedge the currency risk?
4-26Currency Market HedgesCurrency Market HedgesTypical discount or premium ranges forstable currencies are from 0 to 8%, but maybe as high as 20% for unstable currencies.How much does this “insurance” cost?How much does this “insurance” cost?Annualized cost of protectionAnnualized cost of protection= ( $.002 )/( $.168 ) X ( 365 days / 90 days)= .011905 X 4.0556= .0483 or 4.83%4.83%
4-27Currency Market HedgesCurrency Market HedgesA futures contractfutures contract is a contract for the delivery of acommodity, foreign currency, or financial instrument ata specified price on a stipulated future date.A currency futures market exists for the majorcurrencies of the world.Futures contracts are traded on organized exchanges.The clearinghouse of the exchange interposes itselfbetween the buyer and the seller. Therefore,transactions are not made directly between two parties.Very few contracts involve actual delivery at expiration.2. Currency Futures2. Currency Futures
4-28Currency Market HedgesCurrency Market HedgesSellers (buyers) cancel a contract by purchasing(selling) another contract. This is an offsetting positionthat closes out the original contract with theclearinghouse.Futures contracts are marked-to-market daily. This isdifferent than forward contracts that are settled only atmaturity.Contracts come in only standard-size contracts (e.g.,12.5 million yen per contract).2. Currency Futures (continued)2. Currency Futures (continued)
4-29Currency Market HedgesCurrency Market HedgesA currency optioncurrency option is a contract that gives the holderthe right to buy (call) or sell (put) a specific amount of aforeign currency at some specified price until a certain(expiration) date.Currency options hedge only adverse currencymovements (“one-sided” risk). For example, a putoption can hedge only downside movements in thecurrency exchange rate.Options exist in both the spot and futures markets.The value depends on exchange rate volatility.3. Currency Options3. Currency Options
4-30Currency Market HedgesCurrency Market HedgesIn a currency swapcurrency swap two parties exchange debtobligations denominated in different currencies. Eachparty agrees to pay the other’s interest obligation. Atmaturity, principal amounts are exchanged, usually at arate of exchange agreed to in advance.The exchange is notional -- only the cash flowdifference is paid.Swaps are typically arranged through a financialintermediary, such as a commercial bank.A variety of (complex) arrangements are available.4. Currency Swaps4. Currency Swaps
4-31Macro Factors GoverningMacro Factors GoverningExchange-Rate BehaviorExchange-Rate BehaviorThe idea that a basket of goods should sell forthe same price in two countries, after exchangerates are taken into account.For example, the price of wheat in Canadianand U.S. markets should trade at the sameprice (after adjusting for the exchange rate). Ifthe price of wheat is lower in Canada, thenpurchasers will buy wheat in Canada as long asthe price is cheaper (after accounting fortransportation costs).Purchasing-Power Parity (PPP)Purchasing-Power Parity (PPP)
4-32Macro Factors GoverningMacro Factors GoverningExchange-Rate BehaviorExchange-Rate BehaviorThus, demand will fall in the U.S. and increase inCanada to bring prices back into equilibrium.The price elasticity of exports and imports influencesthe relationship between a country’s exchange rate andits purchasing-power parity.Commodity items and products in mature industriesare more likely to conform to PPP.Frictions such as government intervention andtrade barriers cause PPP not to hold.Purchasing-Power Parity (PPP continued)Purchasing-Power Parity (PPP continued)
4-33Macro Factors GoverningMacro Factors GoverningExchange-Rate BehaviorExchange-Rate BehaviorIt suggests that if interest rates are higher in onecountry than they are in another, the former’scurrency will sell at a discount in the forward market.Remember that the Fisher effect implies that thenominal rate of interest equals the real rate ofinterest plus the expected rate of inflation.The international Fisher effect suggests thatdifferences in interest rates between two countriesserve as a proxy for differences in expected inflation.Interest-Rate ParityInterest-Rate Parity
4-34Macro Factors GoverningMacro Factors GoverningExchange-Rate BehaviorExchange-Rate BehaviorF = current forward exchange-rate in foreigncurrency per dollar.S = current spot exchange-rate in foreign currencyper dollar.rforeign = foreign interbank Euromarket interest raterdollar = U.S. interbank Euromarket interest rateInterest-Rate Parity (continuedInterest-Rate Parity (continued))The international Fisher effect suggests:FS=1 + rforeign1 + rdollar
4-35Interest-RateInterest-RateParity ExampleParity ExampleThe current German 90-day interest rate is4%.The current U.S. 90-day interest rate is 2%.The current spot rate is .706 Freedonianmarks per U.S. dollar ($1.416 per mark).What is theWhat is the implied 90-day forwardimplied 90-day forwardraterate??
4-36Interest-RateInterest-RateParity ExampleParity ExampleF = (1.04) x (.706.706) / (1.02)= .720.720Thus, the implied 90-day forwardimplied 90-day forwardraterate is .720 marks per dollar.720 marks per dollar.The implied 90-day forward rateimplied 90-day forward rate is:F.706.706=1 + .041 + .02
4-37Structuring InternationalStructuring InternationalTrade TransactionsTrade TransactionsIn international trade, sellers often havedifficulty obtaining thorough and accuratecredit information on potential buyers.Channels for legal settlement in cases ofdefault are more complicated and costly topursue.Key documents are (1) an order to pay(international trade draft), (2) a bill of lading,and (3) a letter of credit.
4-38International Trade DraftInternational Trade DraftThe international trade draft (bill of exchange)international trade draft (bill of exchange) is awritten statement by the exporter ordering the importerto pay a specific amount of money at a specified time.Sight draftSight draft is payable on presentation to the party(drawee) to whom the draft is addressed.Time draftTime draft is payable at a specified future date aftersight to the party (drawee) to whom the draft isaddressed.
4-39Time Draft FeaturesTime Draft FeaturesAn unconditional order in writing signedby the drawer, the exporter.It specifies an exact amount of moneythat the drawee, the importer, must pay.It specifies the future date when thisamount must be paid.Upon presentation to the drawee, it isacceptedaccepted.
4-40Time Draft FeaturesTime Draft FeaturesThe acceptance can be by either thedraweedrawee or a bankbank.If the drawee accepts the draft, it isacknowledged in writing on the back ofthe draft the obligation to pay the amountso many specified days hence.It is then known as a trade drafttrade draft (banker’sbanker’sacceptanceacceptance if a bank accepts the draft).
4-41Bill of LadingBill of LadingIt serves as a receipt from the transportationcompany to the exporter, showing that specifiedgoods have been received.It serves as a contract between the transportationcompany and the exporter to ship goods and deliverthem to a specific party at a specific destination.It serves as a document of title.Bill of LadingBill of Lading -- A shipping documentindicating the details of the shipment anddelivery of goods and their ownership.
4-42Letter of CreditLetter of CreditA letter of credit is issued by a bank onbehalf of the importer.The bank agrees to honor a draft drawnon the importer, provided the bill oflading and other details are in order.The bank is essentially substituting itscredit for that of the importer.
4-43CountertradeCountertradeUsed effectively when exchange restrictions exist orother difficulties prevent payment in hard currencies.Quality, standardization of goods, and resale ofgoods that are delivered are risks that arise withcountertrade.CountertradeCountertrade -- Generic term for barter andother forms of trade that involve theinternational sale of goods or services that arepaid for -- in whole or in part -- by the transferof goods or services from a foreign country.
4-44ForfaitingForfaitingThe forfaiter assumes the credit risk and collectsthe amount owed from the importer.Most useful when the importer is in a less-developed country or in an Eastern Europeannation.ForfaitingForfaiting -- The selling “without recourse” ofmedium- to long-term export receivables to afinancial institution, the forfaiter. A third party,usually a bank or governmental unit,guarantees the financing.
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