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International Financial Management
24-1 © Pearson Education Limited 2004 Fundamentals of Financial Management, 12/e Created by: Gregory A. Kuhlemeyer, Ph.D. Carroll College, Waukesha, WI
After studying Chapter 24, you should be able to:
Explain why many firms invest in foreign operations. Explain why foreign investment is different from domestic investment. Describe how capital budgeting, in an international environment, is similar or dissimilar to that in a domestic environment. Understand the types of exchange-rate exposure and how to manage exchange-rate risk exposure. Compute domestic equivalents of foreign currencies given the spot or forward exchange rates. Understand and illustrate the purchasing-power parity (PPP) and interest rate parity. Describe the specific instruments and documents used in structuring international trade transactions. Distinguish among countertrade, export factoring, and forfaiting.
International Financial Management
Some Background Types of Exchange-Rate Risk Exposure Management of Exchange-Rate Risk Exposure Structuring International Trade Transactions
What is a company’s motivation to invest capital abroad?
Fill product gaps in foreign markets where excess returns can be earned. To produce products in foreign markets more efficiently than domestically. To secure the necessary raw materials required for product production.
2. 3. Determine the NPV of the project using the U. required rate of return. 24-5 . Estimate expected cash flows in the foreign currency. Compute their U.S.International Capital Budgeting How does a firm make an international capital budgeting decision? 1.S. with the rate adjusted upward or downward for any risk premium effect associated with the foreign investment.-dollar equivalents at the expected exchange rate.
S. For example. dollar. 24-6 .International Capital Budgeting Only consider those cash flows that can be “repatriated” (returned) to the homecountry parent. the current exchange rate might be 2. The exchange rate is the number of units of one currency that may be purchased with one unit of another currency.50 Freedonian marks per one U.
The appropriate expected exchange rates are given on the next slide.S. 24-7 .International Capital Budgeting Example International project details: A firm is considering an investment in Freedonia. and the initial cash outlay is 1.5 million marks. The project has 4-year project life with cash flows given on the next slide. The appropriate required return for repatriated U. dollars is 18%.
000 196.588 Net Present Value = 113.000 2.International Capital Budgeting Example End of Year 0 1 2 3 Expected Cash Flow (marks) -1.202 24-8 .S.850 308.770 4 600.000 166.000 800.880 264. dollars) -600.72 220.000 700.000 Exchange Rate (marks to U.822 221.833 160.59 2.50 2.151 Present Value of Cash Flows at 18% -600.500.65 Expected Cash Flow (U.000 500. dollar) 2.S.54 2.777 63.
S. Foreign subsidiaries are taxed under foreign tax codes until dividends are received by the U. code.International Capital Budgeting Related issues of concern: International diversification and risk reduction U. parent from the foreign subsidiary.S. 24-9 .S. Government taxation Taxable income derived from non-domestic operations through a branch or division is taxed under U.
government provides a tax credit to companies to avoid the double taxation problem. tax credits can be carried forward. credit is provided up to the amount of the foreign tax. but not to exceed the same proportion of taxable earnings from the foreign country. The A Excess 24-10 . but all countries impose income taxes on foreign companies. U.International Capital Budgeting Foreign Taxation Tax codes and policies differ from country to country.S.
acting responsibly in the eyes of the host government. and/or purchasing political risk insurance. making the subsidiary reliant on the parent company. entering joint ventures. Protect the firm by hiring local nationals. 24-11 . Bottom line: Forecasting political instability. Developing countries may provide financial incentives to enhance foreign investment.International Capital Budgeting Political Risk Expropriation is the ultimate political risk.
dollar).S.Important Exchange-Rate Terms Spot Exchange Rate -. Forward Exchange Rate -. Currency risk can be thought of as the volatility of the exchange rate of one currency for another (say British pounds per U.The rate today for exchanging one currency for another at a specific future date. 24-12 .The rate today for exchanging one currency for another for immediate delivery.
Economic Exposure -. and hence economic value. 24-13 . Transactions Exposure -.Involves changes in expected future cash flows.Relates to the change in accounting income and balance sheet statements caused by changes in exchange rates. caused by a change in exchange rates.Types of ExchangeRate Risk Exposure Translation Exposure -.Relates to settling a particular transaction at one exchange rate when the obligation was originally recorded at another.
Management of ExchangeRate Risk Exposure Natural hedges Cash management Adjusting of intracompany accounts International financing hedges Currency market hedges 24-14 .
Natural Hedges Globally Determined Domestically Determined Scenario 1 Pricing Cost Scenario 2 Pricing Cost X X X X Both scenarios are natural hedges as any gain (loss) from exchange rate fluctuations in pricing is reduced by an offsetting loss (gain) in costs in similar global markets. 24-15 .
24-16 .“Not!” Globally Determined Domestically Determined Scenario 3 Pricing Cost Scenario 4 Pricing Cost X X X X Both of these scenarios are not natural hedges and thus create a possible firm exposure to events that impact one market and not the other market.Natural Hedges -.
. Obtain trade credit or borrow in the local currency so that the money is repaid with fewer dollars.60 per peso)? Exchange cash for real assets (inventories) whose value is in their use rather than tied to a currency. Reduce or avoid the amount of trade credit that will be extended as the dollar value that the firm will receive is reduced and reduce any cash that does arrive as quickly as possible. 24-17 . drop from $.g.70 per peso to $.Cash Management What should a firm do if it knew that a local foreign currency was going to fall in value (e.
A reinvoicing center is a company-owned financial subsidiary that purchases exported goods from company affiliates and resells (reinvoices) them to other affiliates or independent customers. and the best policy would be to balance monetary assets against monetary liabilities to neutralize the effect of exchangerate fluctuations.Cash Management Generally. 24-18 . one cannot predict the future exchange rates.
the reinvoicing center is billed in the selling unit’s home currency and bills the purchasing unit in that unit’s home currency.Cash Management Netting -.A system in which cross-border purchases among participating subsidiaries of the same company are netted so that each participant pays or receives only the net amount of its intracompany purchases and sales. 24-19 . Allows better management of intracompany transactions. Generally.
bank branches or offices available for customers. The use of “discounting” trade bills is widely utilized in Europe versus minimal usage in the United States.S. Commercial Bank Loans and Trade Bills Foreign commercial banks perform essentially the same financing functions as domestic banks except: They allow longer term loans. Loans are generally made on an overdraft basis. Nearly all major commercial cities have U.International Financing Hedges 1. 24-20 .
Therefore. Rates are typically quoted in terms of the LIBOR.International Financing Hedges 2. This market is unregulated. 24-21 . the differential between the rate paid on deposits and that charged on loans varies according to the risk of the borrower and current supply and demand forces. dollars but not subject to U. banking regulations. It is a major source of short-term financing for the working capital requirements of the multinational company. Eurodollar Financing Eurodollars are bank deposits denominated in U.S.S.
and Samurai bonds.International Financing Hedges 3. 24-22 . For example. A foreign bond is issued by a foreign government or corporation in a local market. The Eurobond is issued in a single currency. Yankee bonds. Many international debt issues are floating rate notes that carry a variable interest rate. International Bond Financing A Eurobond is a bond issued internationally outside of the country in whose currency the bond is denominated. but is placed in multiple countries.
S. For example.International Financing Hedges 4. Currency-Option and Multiple-Currency bonds Currency-option bonds provide the holder with the option to choose the currency in which payment is received. a bond might allow you to choose between yen and U. 24-23 . while a different currency is used to make principal payments. dollars. Currency cocktail bonds provide a degree of exchangerate stability by having principal and interest payments being a weighted average of a “basket” of currencies. Dual-currency bonds have their purchase price and coupon payments denominated in one currency.
Each country has a representative currency like the $ (dollar) in the United States or the ₤ (pound) in Britain. Luxembourg. 24-24 . Portugal. $). 1999. Greece. On January 1. and Spain. The euro is the common currency of the European Monetary Union (EMU). Germany. the Netherlands. Symbol is € (much like the dollar.Currencies and the Euro Euro – The name given to the single European currency. Italy. the “euro” started trading. France. which currently includes the following 12 European Union (EU) countries: Austria. Belgium. Ireland. Finland.
foreign currency.171. Spot rate $. If the forward rate is $.Currency Market Hedges 1.166 per EFr As shown. the EFr is said to sell at a forward premium. or financial instrument at a price specified now.168 per EFr 90-day forward rate . with delivery and settlement at a specified future date. Forward Exchange Market A forward contract is a contract for the delivery of a commodity. 24-25 . the Elbonian franc (EFr) is said to sell at a forward discount as the forward price is less than the spot rate.
Therefore.166. The firm will receive $166. if the actual spot price in 90 days is less than . . the firm benefited from entering into this transaction.000 in 90 days (1 million Elbonian francs x $.166). the firm would have benefited from not entering into the transaction.” How can the firm hedge the currency risk? 24-26 The firm has the option of selling 1 million Elbonian francs forward 90 days. If the rate is greater than .Currency Market Hedges Fillups Electronics has just sold equipment worth 1 million Elbonian francs with credit terms of “net 90.166.
83% Typical discount or premium ranges for stable currencies are from 0 to 8%.Currency Market Hedges How much does this “insurance” cost? Annualized cost of protection = ( $.002 )/( $.011905 X 4.0556 = .0483 or 4. 24-27 .168 ) X ( 365 days / 90 days) = . but may be as high as 20% for unstable currencies.
Currency Market Hedges 2. few contracts involve actual delivery at expiration. Therefore. Very 24-28 . or financial instrument at a specified price on a stipulated future date. The clearinghouse of the exchange interposes itself between the buyer and the seller. Futures contracts are traded on organized exchanges. transactions are not made directly between two parties. Currency Futures A futures contract is a contract for the delivery of a commodity. A currency futures market exists for the major currencies of the world. foreign currency.
g. Futures contracts are marked-to-market daily.5 million yen per contract). This is an offsetting position that closes out the original contract with the clearinghouse. Contracts come in only standard-size contracts (e.Currency Market Hedges 2.. This is different than forward contracts that are settled only at maturity. 24-29 . 12. Currency Futures (continued) Sellers (buyers) cancel a contract by purchasing (selling) another contract.
Currency Market Hedges 3. Currency options hedge only adverse currency movements (“one-sided” risk). Currency Options A currency option is a contract that gives the holder the right to buy (call) or sell (put) a specific amount of a foreign currency at some specified price until a certain (expiration) date. a put option can hedge only downside movements in the currency exchange rate. value depends on exchange rate volatility. For example. Options exist in both the spot and futures markets. The 24-30 .
only the cash flow difference is paid. Currency Swaps In a currency swap two parties exchange debt obligations denominated in different currencies. Each party agrees to pay the other’s interest obligation. such as a commercial bank. Swaps are typically arranged through a financial intermediary. At maturity. principal amounts are exchanged. usually at a rate of exchange agreed to in advance.Currency Market Hedges 4. The exchange is notional -. variety of (complex) arrangements are available. A 24-31 .
24-32 . the price of wheat in Canadian and U.S. after exchange rates are taken into account. If the price of wheat is lower in Canada. markets should trade at the same price (after adjusting for the exchange rate). then purchasers will buy wheat in Canada as long as the price is cheaper (after accounting for transportation costs).Macro Factors Governing Exchange-Rate Behavior Purchasing-Power Parity (PPP) The idea that a basket of goods should sell for the same price in two countries. For example.
24-33 .Macro Factors Governing Exchange-Rate Behavior Purchasing-Power Parity (PPP continued) Thus. The price elasticity of exports and imports influences the relationship between a country’s exchange rate and its purchasing-power parity.S. demand will fall in the U. Commodity items and products in mature industries are more likely to conform to PPP. Frictions such as government intervention and trade barriers cause PPP not to hold. and increase in Canada to bring prices back into equilibrium.
the former’s currency will sell at a discount in the forward market.Macro Factors Governing Exchange-Rate Behavior Interest-Rate Parity It suggests that if interest rates are higher in one country than they are in another. The international Fisher effect suggests that differences in interest rates between two countries serve as a proxy for differences in expected inflation. Remember that the Fisher effect implies that the nominal rate of interest equals the real rate of interest plus the expected rate of inflation. 24-34 .
Macro Factors Governing Exchange-Rate Behavior Interest-Rate Parity (continued) The international Fisher effect suggests: F S F= = 1 + rforeign 1 + rdollar current forward exchange-rate in foreign currency per dollar. S= current spot exchange-rate in foreign currency per dollar. interbank Euromarket interest rate 24-35 . rforeign = foreign interbank Euromarket interest rate rdollar = U.S.
706 Freedonian marks per U.S.S. dollar ($1. 90-day interest rate is 2%. The The current spot rate is . 4%.416 per mark). What is the implied 90-day forward rate? 24-36 .Interest-Rate Parity Example The current German 90-day interest rate is current U.
02) = . 24-37 .706) / (1.720 Thus. the implied 90-day forward rate is .02 F = (1.Interest-Rate Parity Example The implied 90-day forward rate is: F .04) x (.706 = 1 + .720 marks per dollar.04 1 + .
Structuring International Trade Transactions In international trade. sellers often have difficulty obtaining thorough and accurate credit information on potential buyers. documents are (1) an order to pay (international trade draft). Channels Key 24-38 . (2) a bill of lading. for legal settlement in cases of default are more complicated and costly to pursue. and (3) a letter of credit.
Time draft is payable at a specified future date after sight to the party (drawee) to whom the draft is addressed. 24-39 .International Trade Draft The international trade draft (bill of exchange) is a written statement by the exporter ordering the importer to pay a specific amount of money at a specified time. Sight draft is payable on presentation to the party (drawee) to whom the draft is addressed.
Time Draft Features An It It unconditional order in writing signed by the drawer. the exporter. must pay. Upon 24-40 . it is accepted. presentation to the drawee. specifies the future date when this amount must be paid. specifies an exact amount of money that the drawee. the importer.
the drawee accepts the draft. It 24-41 is then known as a trade draft (banker’s acceptance if a bank accepts the draft). it is acknowledged in writing on the back of the draft the obligation to pay the amount so many specified days hence.Time Draft Features The If acceptance can be by either the drawee or a bank. .
24-42 It serves as a receipt from the transportation company to the exporter. showing that specified goods have been received.Bill of Lading Bill of Lading -. .A shipping document indicating the details of the shipment and delivery of goods and their ownership. It serves as a document of title. It serves as a contract between the transportation company and the exporter to ship goods and deliver them to a specific party at a specific destination.
24-43 . The bank agrees to honor a draft drawn on the importer. provided the bill of lading and other details are in order.Letter of Credit Letter of Credit .A promise from a third party (usually a bank) for payment in the event that certain conditions are met. A letter of credit is issued by a bank on behalf of the importer. It is frequently used to guarantee payment of an obligation. The bank is essentially substituting its credit for that of the importer.
by the transfer of goods or services from a foreign country. Used effectively when exchange restrictions exist or other difficulties prevent payment in hard currencies. and resale of goods that are delivered are risks that arise with countertrade. Quality. standardization of goods.Generic term for barter and other forms of trade that involve the international sale of goods or services that are paid for -.in whole or in part -.Countertrade Countertrade -. 24-44 .
A third party. the forfaiter. 24-45 .to long-term export receivables to a financial institution. guarantees the financing.Forfaiting Forfaiting -. The forfaiter assumes the credit risk and collects the amount owed from the importer. Most useful when the importer is in a lessdeveloped country or in an Eastern European nation.The selling “without recourse” of medium. usually a bank or governmental unit.
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