1. C1: MNC Management 1
Agency Theory / Problem / Cost
Conflicting goals owner v managers
Agency Cost: Cost to ensure managers
maximize S/H wealth
MNC Agency Cost Larger & More Complicated
1) Logistics / Geographical
2) Size of Larger MNC
3) Foreign Goal e.g. employees / country
Controls:
1) Corporate Governance
= Protect Stakeholders’ Rights
e.g. Sarbanes-Oxley Act (SOX) – 2002
2) Communicate / align goals for max value
3) Compensation / Reward Plan
4) Stock options, e.g. ESOS
International Risks / Uncertainties
P5F: Micro (Industry)
PESTLE: Macro (Country, International)
1. Political (Policies, Tax, Interest)
2. Economy (ER, Inflation, Financial)
3. Social (Ethics, Culture, Education, Skills)
4. Technology (Infrastructure)
5. Legal (Laws)
6. Environmental (Restrictions)
Other Constraints & Issues:
1. Abuse ER as policy
2. Outsourcing
3. Trade Policies for Political Reasons
Multi-National Companies (MNC)
Goal = Maximize Shareholders Wealth
(Capital Gains & Dividends)
Madura 2012: has operating subsidiaries,
branches & affiliates in foreign countries
Shapiro 2006: has 50% of its operating assets in
foreign countries
Aggrawal 2002: exports its product or services
to foreign countries
Events that increase International Trade
1) General Agreement on Tariffs and Trade
GATT 1947 (125 countries)
• Trade Fairness = Eliminate Trade Restriction
(tariff, subsidies, bail-out quota)
• Enforce Patent, Trademark, Copyright
2) European Union EU 1951 (28 countries)
• Free movement products, services & funds
• Eurodollar = $ deposits in European banks
3) Single European Act 1987
• Uniform Regulation & Remove Tax
4) NAFTA 1993:
• Eliminated trade barrier US & Mexico
• Implicate US Walmart Jobs
International Agencies
1) International Monetary Fund (1944)
• Cooperation between countries
on international monetary issues
• Stability in Exchange Rate
• Temporary funds to correct imbalance in
international payments / financial instability
(Special Drawing Rights SDR)
• Reduce impact of financial instability
2) World Bank (1944)
• Loans for LT Economic Development
• Structural Adjustment Loans (SAL)
• Co-financing agreements
(WB and Investment Banks)
3) World Trade Organization (1995)
• Promote Free Trade (Origin GATT)
• Forum for Multilateral Trade
Negotiations & Settle Disputes
International Credit Market
Syndicated Loan for Large Loans
• Few Banks merge loan facility
EURO Credit Loan >1yr
• Bank to MNCs or Gov’ Agency in Europe
• Based on LIBOR Floating Rate
e.g. reset every 6mths plus 3%
• Immediate ER
LIBOR = Intercontinental Exchange London
Interbank Offered Rate. Benchmark rate for
short-term loans between banks.
Why International
1) Theory of Comparative Advantage
• Adam Smith 1776
• Country Specialization increase Efficiency
e.g. Japan tech, Vietnam labour, Malaysia
rubber, Tax Holiday, Facilities, Special Skills,
Cheaper Commodity, Industry Advantage
2) Theory of Imperfect Market
• Production Resources for Real Market
e.g. labour, raw material, funds, others
• Immobile due to Restriction & Transfer Cost
3) Theory of Product Cycle
• Create Local Demand
Export to accommodate demand
Establish subsidiary presence
Control & Reduce Cost
• Market Expansion: Local & Export Demand
• Product Expansion
• Product Differentiation
2. C3: International Finance Market & C2: Flow of Funds
FOREX: Foreign Exchange Market
1) Competitive Quote
2) Relationship with banks
• Cash management Services
• Source limited Currencies
3) Efficient Order
4) Advice Current Market Condition
5) Advice Forecast: Foreign Economy & ER
Bid / Ask Spread
Ask Price = Sell Price
Bid Price = Buy Price
Spread = Bank Fees to conduct FOREX
Spread =
𝐴𝑠𝑘 − 𝐵𝑖𝑑
𝐵𝑖𝑑
× 100%
Factors to Spread (OICVR)
1) Order Cost
• Clearing + Recording
2) Inventory Cost
• Maintaining / Holding Currency
(Opportunity Cost)
3) Competition
• Competition↑ = Spread↓
4) Volume
• Currency Liquidity↑ = Sudden Change↓
5) Risk
• Volatility due to Economics & Political
Correcting Trade Deficit
Weak Home Currency may not necessarily
improve trade deficit
1) Revised Pricing Policy by foreign competitor
2) Weakening Currencies of trading partners
3) Trade Agreements, e.g. cannot limit parts
4) Intra-Company Trade, e.g. can obtain raw
material from subsidiary located abroad
2
GDP = C + I + G + ( X – M )
Current Account ∝ Inflation ∝ Exchange Rate ∝ Export ∝ (-Imports)
Balance of Payment (BOP)
Summary of Transaction between Domestic &
Foreign Residents over Specific Period of Time
CURRENT ACCOUNT
CA = Export - Import
1) Tangible Goods
2) Financial Services Income
e.g. dividend & interest
3) Services Balance
e.g. royalties, consultation fees
4) Unilateral Transfer
e.g. foreign aid, grant, gifts
CAPITAL ACCOUNT
1) Foreign Investment
e.g. JV, Takeover, Licensing
2) Portfolio Investment
e.g. Stocks, Bonds
3) Other Capital Investment
e.g. transaction currency, bank deposit
Factors to International Trade Flows
1) Inflation: Inflation ↑ ⇒ Price Local Goods ↑
⇒ DD Foreign Goods ↑ ⇒ CA ↓
2) Income: Income ↑ ⇒ Purchasing Power ↑
⇒ DD Foreign Goods ↑ ⇒ CA ↓
3) Exchange Rate: ER ↑ ⇒ DD Foreign Goods ↑
⇒ Imports ↑ ⇒ CA ↓
4) Government Intervention
i. Restriction on Imports
Tariff / Levies ⇒ Price ↑ ⇒ DD ↓
Quota ⇒ Volume of Inputs ↓
ii. Subsidies, government scheme to support
firms reduce costs against competitors
iii. Tax Breaks, government scheme to
support firms to export products
iv. Labour Law, e.g. Less restrictive LL not
applicable globally
v. Business Law, e.g. Bribery Law
vi. Country Security Law, e.g. National
security can affect trade
Factors to FDI
1) Change in Restrictions – removal of Barriers
2) Privatization – movement of Free Enterprise
3) Economic Growth – counters with strong
fundamentals attracts more FDI
4) Tax Rate – country with low Tax Rate
5) Exchange Rate – expected to strengthen
against investor currency
Factors to International Portfolio
1) Tax Rates Hi on Interest & Dividend
2) Interest Rates Hi
3) Exchange Rates expected to strengthen
3. Exchange Rate (ER)
FOREX: Foreign Exchange Market
Value of One Currency expressed in another Currency
Appreciate = ↑ ER ⇒ Imports ↑
Depreciate = ↓ ER ⇒ Exports ↑
ER Equilibrium: Currency Qty Supply = Demand
ER = f(Δinflation, Δinterest, Δincome, Δgovernment, Δexpectation)
Demands Foreign Currency
1. UK Consumers Buy / Import US Foreign Goods
2. UK Investors Invest in US Foreign Assets
3. UK Governments / Central Banks
↑ Demand ⇒ Value ↑ = Appreciate
Supplies for Exchange Currency
1. Foreign Consumers Buy Domestic Goods
2. Foreign Investors Invest in Domestic Assets
3. Foreign Governments / Centrals Banks
↑ Supplier ⇒ Value ↓ = Depreciate
3C4 Exchange Rate | Demand Supply
Value
$ / £
Market for £ in US
S£0
S£1
Qty £
R0: $2.5/£1
R1: $2.0/£1
£ Depreciate
⇒ $ Appreciate
e.g. UK Consumer Buy More Foreign Goods
ERE1
ERE0
D£0
S$0
D$1
D$0
Value
£ / $
Market for $ in UK
Qty $
R1: £0.5/$1
R0: £0.4/$1
$ Appreciate
⇒ £ Depreciate
e.g. UK Consumer Buy More Foreign Goods
ERE0
ERE1
Scenario US Foreign
Euro Tourist to US ↑ DD $↑ = $ App SS ↑ Dep
Recession ↑ in Asia DD $↓ = $ Dep DD ↑ App
↑ Inflation in US SS $↑ = $ Dep DD ↑ App
US Tourist to Taiwan ↑ SS $↑ = $ Dep DD ↑ App
US ↓ Income Tax SS $↑ = $ Dep DD ↑ App
↑ Inflation in Europe DD $↑ = $ App SS ↑ Dep
↑ Interest Rate in UK SS $↑ = $ Dep DD ↑ App
M’sia ↑ Import Tariff DD $↓ = $ Dep SS ↓ App
Recession ↑ in US SS $↑ = $ Dep DD ↓ Dep
4. Inflation = Price Level = Purchasing Power
Rise in US Relative Inflation Rate
US DD ↑ for Cheaper UK goods
UK DD ↓ for Expensive US goods
US DD £ ↑ ⇒ SS £ ↓
UK SS $ ↑ ⇒ DD $ ↓
$ Depreciate = £ Appreciate
Sol: US SS £ ↑ ⇒ DD £ ↓
Inflation Rate Interest Rate Income Level 4
Cost of Capital, Cost of Doing Business
Rise in US Relative Interest Rate
UK Investment ↑ in US
US Investment ↓ in UK
US SS £ ↑ ⇒ DD £ ↓
UK DD $ ↑ ⇒ SS $ ↓
$ Appreciate = £ Depreciate
Recession = Less Income
Rise in US Income Level
US DD ↑ for Superior UK goods
No Effect to People in UK
US DD £ ↑ ⇒ SS £ No Change
UK SS $ ↑ ⇒ DD $ No Change
S1: £ Appreciate = $ Depreciate
S2: Confidence ⇒ $ Appreciate
Value
$ / £
S£1
S£0
D£1
D£0
Qty £
R1: $2.5/£1
R0: $2.0/£1
£ Appreciate
$ Depreciate
ERE0
ERE1
Market for £ in US
Value
£ / $
S$0
S$1
D$0
D$1
Qty $
R0: £0.5/$1
R1: £0.4/$1
$ Depreciate
£ Appreciate
ERE1
ERE0
Market for $ in UK
Value
$ / £
S£0
S£1
D£0
D£1
Qty £
R0: $2.5/£1
R1: $2.0/£1
£ Depreciate
$ Appreciate
ERE1
ERE0
Market for £ in US
Value
£ / $
S$1
S$0
D$1
D$0
Qty $
R1: £0.5/$1
R0: £0.4/$1
$ Appreciate
£ Depreciate
ERE0
ERE1
Market for $ in UK
Value
$ / £
S£0
D£1
D£0
Qty £
R1: $2.5/£1
R0: $2.0/£1
£ Appreciate
$ Depreciate
ERE0
ERE1
Market for £ in US
Value
£ / $
S$0
S$1
D$0
Qty $
R0: £0.5/$1
R1: £0.4/$1
$ Depreciate
£ Appreciate ERE1
ERE0
Market for $ in UK
5. Institutional investors reaction
to anticipated change
Tighter Monetary Policy in UK
High Interest Rate in UK
US Investment ↑ in UK
US DD £ ↑ ⇒ SS £ ↓
UK SS $ ↑ ⇒ DD $ ↓
£ Appreciate = $ Depreciate
Inflation, Money Supply, Interest, Income
High Inflation Rate in the US
US DD ↑ for Cheaper UK goods
UK DD ↓ for Expensive US goods
UK SS $ ↑ ⇒ $ Depreciate
Sol: US Interest Rate ↑
Foreign Investment ↑
UK DD $ ↑ ⇒ $ Appreciate
Trade Barrier / Capital Flow Restriction
Tax/Tariff/Levies/Quota on Imported Goods
US DD ↓ for UK import goods
US DD ↑ for Cheaper US goods
No Effect to People in UK
DD £ ↓ ⇒ SS £ No Change
DD $ No Change ⇒ SS $ ↓
$ Appreciate = £ Depreciate
Expectations Interactions Government Ctrl5
Value
$ / £
S£1
S£0
D£1
D£0
Qty £
R1: $2.5/£1
R0: $2.0/£1
£ Appreciate
$ Depreciate
ERE0
ERE1
Market for £ in US
Value
£ / $
S$0
S$1
D$0
D$1
Qty $
R0: £0.5/$1
R1: £0.4/$1
$ Depreciate
£ Appreciate
ERE1
ERE0
Market for $ in UK Value
$ / £
S£0
S£1
D£0
D£1
Qty £
R0: £2.5/$1
R1: £2.0/$1
£ Depreciate
$ Appreciate
ERE1
ERE0
Market for £ in US
Value
$ / £
S£0
D£0
D£1
Qty £
R1: $2.5/£1
R0: $2.0/£1
£ Depreciate
$ Appreciate
ERE1
ERE0
Market for £ in US
Value
£ / $
S$1
S$0
D$0
Qty $
R0: £0.5/$1
R1: £0.4/$1
$ Appreciate
£ Depreciate ERE0
ERE1
Market for $ in UK
Value
$ / £
S£1
S£0
D£1
D£0
Qty £
R1: $2.5/£1
R0: $2.0/£1
£ Appreciate
$ Depreciate
ERE0
ERE1
Market for £ in US
?
Favourable
Unfavourable
6. Fixed / Constant Pegged Free Float Managed Float
• Bretton Wood (1944-1971)
• US Gold Standard $35/oz; UK,
France, Italy, Japan, Holland
• 1971 US High Inflation
o Vietnam War
o Countries sell US$ for Gold
• Fixed with foreign currency e.g.
trade partner
• Group e.g. Euro Dollar
• Market Forces
• Free Market
• Fluctuate Freely but Dirty as Gov’ Intervenes
(1) Smoothen Disturbance / Volatility
(2) Tackle Inflation
• Beneficial to Country but
at Expense of Other Countries
• Explicit Boundaries:
Floor = Limit to Depreciation
Ceiling = Limit to Appreciation
Pros 1.MNC no ER Risk
2.Managerial Duty↓
• Stabilize Value
Cons Push Inflation
e.g. US Inflation ↑
⇒ US import ↑ cheaper UK Goods
⇒ UK SS Goods ↓ Shortage
⇒ US Push Inflation to UK
1.Interest Rate Movements of
Pegged Currency; i.e. no full
control on local interest rates, &
interest rates must be aligned to
pegged currency.
2.ER Movements of Pegged
Currency; i.e. tandem effects
with other currencies.
3.Recession / weak economy /
politics force break peg.
Currency depreciate drastically.
Intervention usually superficial.
Severe Inflation
e.g. US Inflation ↑
⇒ US import cheaper
UK Goods↑
⇒ US DD £ ↑ ⇒ SS £ ↓
⇒ £ Appreciate
⇒ US import ↓ Expensive
⇒ UK Goods No Shortage
⇒ No Push Inflation to UK
BUT, US Competition ↓
⇒ US Goods Price ↑
⇒ US Inflation ↑
Direct Intervention
Forced appreciation / depreciation
using Central Bank Reserves or
Government Securities
Indirect Intervention
Through intervention influence
1. Interest Rate
2. Income Levels
3. Inflation (Weaken Local Economy)
4. Capital Flow Restriction / Controls
5. FOREX Barriers
6. Trade Restriction on Imports
Tax / Tariff / Levies ⇒ Price ↑ ⇒ DD ↓
Quota ⇒ Volume of Inputs ↓
Stimulate Economy
DI: USD purchase Foreign Currency
⇒ US Dollar ↓ ⇒ US Export ↑
IDI: ↓ Interest Rate
⇒ Financing Cost ↓ + US Dollar ↓
⇒ Borrowing ↑
Decrease Inflation
DI: USD purchase Dollar
⇒ US Dollar ↑ ⇒ Cost Import
+ ↓ Competition
IDI: ↑ Interest Rate
⇒ Financing Cost ↑ + US Dollar ↑
⇒ Borrowing ↓
6
RC: RM4.1/$1
⇒ RM Depreciate
R0: RM3.9/$1
RF: RM3.8/$1
⇒ RM Appreciate
Value
RM / $
Qty
RM
S$0
D$0
Market for $
in Malaysia
D$C
D$F
ER
Floor
ER
Ceiling
Sell
T-Bills
Excess
Funds
Excess
Funds
Financial
Institution
Contraction
Monetary
Policy
Loans ↑
⇒ Economy ↑
⇒ Inflation ↑
Central
Bank
Shortage
Funds
Funds
Buy
T-Bills
Expansion
Monetary
Policy
Loans ↓
⇒ Interest ↑
⇒ Economy ↓
Financial
InstitutionCentral
Bank
C6 Government Influence
STERILIZE INTERVENTION
Level of Domestic Money Supply
Foreign
Currency
Local
Local
Currency
Foreign
7. C19: Country Risk 7
FINANCIAL
def: current/potential state of economy with adverse impact on MNC
1) Financial Distress @ Government Policies
Monetary Controls
Fixed / Pegged / Managed Float Currency
Limit Market Penetration, e.g. Campaign on Local Products
2) Economic Growth influenced by Inflation
Purchasing Power Currency ⇒ Demand for MNC Product
Affects Interest Rate + Currency Exchange Rate
3) Economic Growth influenced by Interest Rate
High Interest Rate discourage economic growth = reduce spending
= reduce demand for expensive imported products
Low Interest Rate encourage economic growth = increase spending =
increase borrowings = increase business competition
4) Economic Growth influenced by Exchange Rate
Import/Export ⇒ Int Trade Flows ⇒ Productivity ⇒ Net Income
Currency↑ ⇒ Export↓ ⇒ Import↑ ⇒ Productivity↓ ⇒ Net Income↓
ASSESSMENT
1) Checklist approach
Judgement call on Political & Financial Factors
From typical experience, public study/survey, e.g. CIA, WorldBank
2) Inspection visits
Qualitative input by travel to country & meet government, company,
business, consumers to clarify specific uncertainties
3) Quantitative analysis
Characteristics that influence country risk
Risk Factors that affect company performance
Regression Analysis y=mx+c.
Coefficient = Slope, m = Relationship between 2 or more variables.
Positive m = Tandem, e.g. GDP & Sales
Negative m = Inverse, e.g. Inflation / Purchase Power & Sales
4) DELPHI technique
Collection of Independent Opinions
Subjective | Expensive Consultant
5) Combination technique
P OLITIC AL
def: events/scenario/system with LR adverse impact on MNC
1) Consumer Attitude in Host Country
Loyalty on local products
Beneficial with Local JV & Market (instead of export)
2) Government Action / Intervention in Host Country
Local Rules / Controls / Standards
Corporate Tax, With-holding Tax (Before Remittance), Exit Tax
3) Fund Transfer Restriction / Blockage
Subsidiary / Employees send money back to home country
Force subsidiary into less optimal project / securities
4) Currency Inconvertibility
Blocked Currency Exchange
5) Government Bureaucracy
Difficulty in Doing Business, Inefficiency, delays, red-tape,
Extra effort / resources / cost
6) Corruption Malaysia #62 at 47pts vs New Zealand #1 89pts
Unfair competition
Increased cost of conducting business
7) War / Unrest – safety, security, business volatility, uncertain cashflow
EXP ROPRIAT ION
1) Short Term Horizon
Recover Investment quickly
Minimize unnecessary expenses, e.g. expansion, maintenance
Sell assets to local investor / government in stages
2) JV / Partnership with Local Entity
3) Unique Suppliers / Technology
Proprietary material / technology that cannot be duplicated
4) Hire Local Labor / Workforce
Locals as stakeholders @ Implication on job security
5) Local Financing
Local Bank / Investors as stakeholder @ Interest on firm’s performance
6) Insurance
Cover risk of appropriation
• Anticipate uncertainties in proposed project
• Avoid countries with excessive risk
• Observe current status of countries
WHY
Incorporated as higher
Required Rate of Return
8. C5&12: Derivatives 8
FORWARD Contract
Forward Contract (FC)
Agreement with commercial bank to exchange
specific amount of specific currency at
specific Forward Rate on specific Future Date
Process: Import / Export Transaction
Lock Forward Rate
Engage Forward Contract with Bank
Exchange at Forward Rate
Non-Delivery FC (NDF)
Agreement where currencies not actually
exchanged. On settlement day, net payment
is made based on contracted rate, and
difference to spot rate is offset by NDF
Process: Import / Export Transaction
Lock Reference Rate
Engage NDF Contract with Bank
Transact at Future Spot Rate
Receive/Pay Offset from/to Bank
Key DIFFERENCE
1.Contract Obligation / Regulation
•Forward: Obligated / Self
•Futures: Obligated / Commodity Futures Trd
Commission / National Future Association
•Option: Optional / Clearinghouse
2.Currencies
•Forward: Almost all currencies
•NDF / Futures / Option: Commonly traded
currencies
3.Size of Contract
•Forward: Tailored to individual needs
•Futures: Standardized, useless if excess
•Option: Matching Concept
FUTURES Contract
Contract traded between firms or individuals
on Trading Floor of Exchange
e.g. Chicago Mercantile Exchange
Standard volume of particular currency
at Future Rate on Settlement Date
3rd Wed @ Mar, Jun, Sep, & Dec
Process:
Lock Future Rate
Order Contract via Broker
Trading Floor of Exchange
Matched order sent to ClearingHouse
Pay initial Margin (10% of total cost)
Delivery of currencies at ClearingHouse
OPTION Contract
Standard Option offered on Trading Floor of
Exchange through brokers and Over Counter
Standard volume of particular currency at
Exercise Price (EP) / Strike Price on Delivery Date
CALL Option
Grants right to BUY specific currency
at Exercise Price within specific time period
Process:
Buy Call Option = Rights to buy foreign
currency at fixed exchange rate
Spot ER increase ⇒ Payable Hedged
Spot ER decrease ⇒ Let contract expire/void
• At the Money: Future Spot Rate > EP+Prem
• On the Money: Future Spot Rate = EP+Prem
• Out the Money: Future Spot Rate < EP+Prem
PUT Option
Grants right to SELL specific currency
at Exercise Price within specific time period
Process:
Buy Put Option = Rights to sell foreign
currency at fixed exchange rate
Spot ER decrease ⇒ Receivable Hedged
Spot ER increases ⇒ Let contract expire/void
• At the Money: Future Spot Rate < EP-Prem
• On the Money: Future Spot Rate = EP-Prem
• Out the Money: Future Spot Rate > EP-Prem
Premium on Call / Put Option
= Service Charge
1. Spot Price relative to EP ∝ Premium
2. Time Period before Expiry Date ∝ Premium
3. Variability of Currency
Translation Fear @ Local Currency Futures Option
Import Payable Depreciate ⇒ Pay More Buy | Long | Take Delivery Call
Export Receivable Appreciate ⇒ Receive Less Sell | Short | Make Delivery Put
Lock future Receivable / Payable
Subject to Amount, Rate and Period
4.Delivery Date (popular with Forward)
•Forward: Tailored to needs
•Futures: Standardized
•Option: : Tailored to needs
5.Market Place / Clearing Operations
•Forward: Major Banks & Brokers
•Futures: Matching @ Central Exchange Floor
•Option: Central Exchange Floor
6.Others
•Forward: Not regulated
•Futures: More complex but least expensive
•Option: Premium charges
•Futures & Option: Opportunity for Speculators
Hedger / Speculator
9. C8: Relationship Inflation, Interest & Exchange Rate 9
Purchasing Power Parity (PPP)
2 countries which trade heavily with one another
Law of one Price: Two similar products in two different
countries should have equal price due to demand
& exchange rate adjustment
Currency with higher INFLATION rate
will experience currency depreciation
%Δf in value of foreign currency =
𝑛 𝑓𝑜𝑟𝑒𝑖𝑔𝑛 =
1 + 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛(ℎ𝑜𝑚𝑒)
1 + 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛(𝑓𝑜𝑟𝑒𝑖𝑔𝑛)
− 1
International Fisher Effect (IFE)
2 countries which trade heavily with one another
Currency with higher NOMINAL INTEREST rates
reflects higher expected INFLATION
and will experience currency depreciation
Investors which hope to capitalize on higher foreign
interest rate would earn a return no higher than what
they would earn domestically.
Δ Inflation Rate ∝ Δ Interest Rate (Positive Correlation)
Nominal Interest Rate = Real Interest Rate + Inflation Rate
RIR: shields deferring current consumption
& not able to enjoy current utility
most of the time same for all countries
IR: shields from inflation fluctuation
NIR: Hi NIR reflect Hi expected INFLATION
%Δf in value of foreign currency =
𝑛 𝑓𝑜𝑟𝑒𝑖𝑔𝑛 =
1 + 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡(ℎ𝑜𝑚𝑒)
1 + 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡(𝑓𝑜𝑟𝑒𝑖𝑔𝑛)
− 1
INTERESTINFLATION
INFLATION
Usually Long Term
Hi Surplus Money
Products prices are inflated / more expensive
Higher Cost of Living
Higher Imports → Higher Currency Outflow
Economist believe solution in Efficiency
by Increase Supply of Goods at Lower Cost &
Reduce Circulation of Money
Exchange Rate Depreciate
Lose on currency exchange
Higher Inflation in Home Country:
1) Product Prices in Home Country are higher
2) Demand ↑ for cheaper Foreign products
3) Demand ↑ for Foreign Currency
4) Buying product in Foreign Currency will offset the
gain from buying in Home Currency by %Δf
5) Foreign Currency will appreciate by +%Δf
to converge to Foreign Currency
(-%Δf = depreciate)
6) Buying Foreign products not worthwhile / stops;
product prices of Home & Foreign are indifferent
Higher Inflation in Foreign Country:
1) Product Prices in Home Country are lower
2) Demand ↑ for cheaper Home products
3) Demand ↑ for Home Currency
4) Buying product in Home Currency will offset the
gain from buying in Foreign Currency by %Δh
5) Home Currency will appreciate by +%Δh
to converge to Foreign Currency
(-%Δh = depreciate)
6) Buying Home products not worthwhile / stops;
product prices of Home & Foreign are indifferent
10. C7: Arbitrage & Interest Rate Parity 10
Arbitrage Pricing Model (APT)
Capitalizing / Exploiting from Discrepancies / Disparity / Abnormal Return
Covered Interest Arbitrage (CIA)
def: Capitalizing from Interest Rate Difference between 2 countries
while covering Exchange Rate Risk
1) Convert to Foreign Currency using current rate
• $100k / $1.60/DM = DM62.5k
2) Establish Forward Contract to sell Accumulated Currency after 90 days
3) Invest Foreign Currency over 90-day interest rate @ 4%
• DM62.5k X 1.04 = DM65k
4) Use Forward Rate to convert accumulated Foreign Currency to Original
• DM65k x $1.60/DM = $104k
5) Investment Profit = Final Amount – Initial Investment = $4k
Realignment:
At Forward Market for DM: DM Supply ↑ ⇒ DM Forward Rate ↓
Interest Rate Parity (IRP)
def: IRP is the equilibrium state caused by market forces
FORWARD RATE differ from SPOT RATE by sufficient premium
which offsets INTEREST RATE differential between 2 countries
With IRP abnormal return from CIA diminish to equate to returns at home
Sometimes, deviations in IRP not large enough for CIA to be worthwhile:
Characteristics of Foreign Investment, Transaction Costs, Political Risk,
Default Risk, Differential Tax Law, With-holding Tax
1) Calculate Forward Premium, changes in Foreign Currency Forward Rate
FP =
1 + Interest(Home)
1 + Interest(Foreign)
− 1
+ve Ef @ Foreign Currency Forward Rate ↑
–ve Ef @ Foreign Currency Forward Rate ↓
Simpler Formula for %Δ Foreign Currency Forward Rate
FP = Interest Home − Interest Foreign
2) Calculate Adjusted Forward Rate
= Spot Rate (1 + FP)
3) Calculate using Covered Interest Arbitrage Step1
4) Compare with Returns at Home
Triangular Arbitrage (TA)
def: Capitalize differences between Intrinsic & Quoted Rate
1) Cross Rate for same denomination as Spot Rate
:
:
=
USD0.90/
USD0.30/
= NZD3.00/CAD
2) Arbitrage Possibility: Spot Rate vs Cross Rate
Spot Rate for CAD > Cross Rate for CAD
CAD Overvalue & NZD Undervalue
3) Convert to Overvalue Currency CAD
• USD10k / USD0.90/CAD = CAD11111
4) Convert to Undervalue Currency NZD
• CAD11111 x NZD3.02/CAD = NZD33555
5) Convert to Original Currency USD using NZD
• NZD33555 x USD0.30/NZD = USD10066
6) Investment Profit = Final Amount – Initial Amount = USD66
Location Arbitrage (LA)
def: Capitalizing from differences between Supply and Demand
1) Buy from Lower Selling / ASK Price
• $10k x £0.64/$ = £15624
2) Sell to Higher Buying / BID Price
• £15624 x $0.645/£ = $10078
3) Profit = Final Amount – Initial Amount = $78
Realignment:
At Selling Location: £ Demand ↑ ⇒ £ Ask Price ↑
At Buying Location: £ Supply ↑ ⇒ £ Bid Price ↓
Discrepancies / Disparity / Abnormal Returns will diminish due to
Realignment / Readjustments by market forces in Forward Market
Over
Value
Original
Under
Value
U
CN
Spot Rate
NZD3.02/CAD
Cross Rate
NZD3.00/CAD
Microsoft Excel
Worksheet
11. Location Arbitrage (LA)
Bank X Bank Y STEPS
Sell / Bid USD/NZD $0.401 $0.398 (1) Buy from Lower ASK PRICE
Buy / Ask USD/NZD $0.404 $0.400 (2) Sell to Higher BID PRICE
(3) Investment Profit
Original Currency 1,000,000.000$
Buy Lower Ask Price 0.400 /NZD$ 2,500,000.000NZD
Sell Higher Bid Price 0.401 /NZD$ 1,002,500.000$
Profit 2,500.000$
Triangular Arbitrage (TA)
STEPS
5,051,035.53$ 5,000,000.00$ Profit= $51,035.525 (1) Cross Rate to Spot Rate denomination
(2) Arbitrage Possibility
SF 1.1806 /€ € 0.7627 /$ (3) Convert to Overvalue Currency
SF Cross Rate € 0.6460 /SF (4) Convert to Undervalue Currency
Undervalue Currency S E Overvalue Currency (5) Convert to Original Currency
SF 5,963,252.54 € 3,813,500.00 (6) Investment Profit
SF Spot Rate € 0.6395 /SF
:: SF Spot Rate < SF Cross Rate
:: SF Spot Rate Undervalue & EUD Spot Rate Overvalue
:: Convert to Overvalue Currency EUD
WRONG
5,000,000.00$ 4,949,480.14$ Loss= -$50,519.864
SF 1.1806 /€ € 0.7627 /$
Cross Rate € 0.6460 /SF
S E
Spot Rate € 0.6395 /SF
Triangular Arbitrage (TA) with Bid-Ask Spread
Spot Rate
USD/EUD
Spot Rate
USD/GBP
Spot Rate
GBP/EUD
Cross Rate
GBP/EUD STEPS
Sell / Bid 1.1779 1.6953 0.6955 0.6948 (1) Cross Rate to Spot Rate denomination
Buy / Ask 1.1776 1.6955 0.6960 0.6945 (2) Arbitrage Possibility
(3) Use Ask Rate if Divide. Use Bid Rate if Multiply.
Or; Ask-Bid-Bid
10,012,577.70$ 10,000,000.00$ Profit= $12,577.700 (4) Convert to Overvalue Currency
Spot Rate (5) Convert to Undervalue Currency
$ 1.6953 /£ $ 1.1776 /€ (6) Convert to Original Currency
EUD Cross Rate £ 0.6948 /€ Investment Profit
Undervalue Currency G E Overvalue Currency
5,906,080.16£ € 8,491,847.83
EUD Spot Rate £ 0.6955 /€
:: EUD Spot Rate > EUD Cross Rate
:: EUD Spot Rate Overvalue & GBP Spot Rate Undervalue
:: Convert to Overvalue Currency EUD
U
U
U
Original Currency
Original Currency
Original Currency
SF 5,903,000.00 € 3,774,968.50
12. C14 Capital Budgeting 11
Pro ConNPV
Easy understand & comms
All cash flows not earnings
Discounts / TVM
Future cashflow is greater than
initial investment
Discount Rate is real market rate
Inconsistent with IRR decision in
Re-Investment / Non-Conventional Cash Flow
(Sign Change in Cashflow)
Mutually Exclusive Projects
(Different initial investment or timing)
IRR
Easy understand & comms
Discount Rate when NPV=0
Discounts / TVM
All CF assumed reinvested at the IRR
IRR Rate is not real nor practical
Does not link to wealth maximization
Do not distinguish between Borrowing & Lending
Scale Problem ⇒ Incremental IRR / NPV
Timing Problem if Mutually Exclusive ⇒ Crossover
Rate
PBP
Easy understand & comms
Biased toward Liquidity
commitments, e.g. bonds, coupon
repayment
Ignores CF after PBP
Ignores TVM
Discriminate long-term projects
Arbitrary acceptance criteria
May not even have NPV>0
Project Evaluation
Necessary to channel resources
into steams which give the
highest return @ maximize
wealth in the long run
Discount Factor
= Interest Rate
= Cost of Capital
derived from Country Risk,
Financial Risk & Political Risk
Factors for MNCs
1. Exchange Rate Fluctuations
2. Financing Arrangement
3. Blocked Funds
4. Impact of New Competitors
on Prevailing Cashflows
5. Uncertain Salvage Value
Input for MNCs
1. Initial Investment
2. Consumer Demand
3. Product Price
4. Variable Cost
5. Fixed Cost
6. Project Lifetime
7. Salvage / Liquidation Value
8. Fund Transfer Restriction
9. Tax Laws
10. Exchange Rate
11. Working Capital
Payback Period PBP
Time to recover initial outlay
Shortest / Minimum PBP or DPBP
Net Present Value, NPV
= -Initial Outlay + Future Cashflows +
Salvage or Terminal Value
Internal Rate of Return, IRR
Multiple Cash Flow CFj
:: i/Yr when NPV = 0
Choose NPV if NPV & IRR conflicts due to
Initial Cost, Project Timing, or Cash Flow.
Mutually
Exclusive
Highest +ve NPV
Highest IRR
Independent
Decision
+ve NPV
IRR > WACC