International Financial Management

21

Author's Overview
The instructor should stress the importance of international financial management (and
international trade) to the class. Data demonstrating Canada’s exceptional openness to the forces
of trade should be emphasized. Factors leading to a more integrated world economy can be
mentioned. The students can easily appreciate the everyday events that bring the world closer
together.
The nature of the international firm can be described, along with the many forms entry into a
foreign country can take. The increased risks of foreign investment can be identified.
An important point is that international finance has the same elements as domestic financial
management only the issues tend to be more involved. The firm must not only make a profit on a
transaction, but consider currency fluctuations. Inflation, interest rates, balance of payments, and
government policies impact on foreign exchange rates. Spot and forward exchange rates can be
illustrated. The foreign exchange market hedge, the money market hedge, and the currency
futures market hedge are discussed as means to manage foreign exchange risk.
Increasingly students must understand how to conduct business across international borders.
Transferring funds internationally, the Euromarket, government institutions facilitating trade
financing, and international equity markets are all part of international trade.

Chapter Objectives
1.

Describe the purposes and nature of the multinational operations of the corporation.

2.

Discuss the effects of exchange rates on the firm’s profitability and cash flow.

3.

Outline the factors influencing exchange rates.

4.

Define spot and forward rates and compute forward premiums and discounts.

5.

Evaluate techniques to hedge or reduce foreign exchange risk.

6.

Discuss the impact of political risk on the foreign investment decision.

7.

Analyze a foreign investment decision.

8.

Outline potential ways to finance international operations.

Foundations of Fin. Mgt.

1

5/E Cdn. Block, Hirt, Short

Annotated Outline and Strategy I. European Common Market (ECM or EU) c. Canada’s preponderance of merchandise trade is evidenced in Figure 21-4. International flows of capital and technology 4. social and economic changes in Russia 3. Hirt.S. International currency: U. PPT 21-1 World’s leading merchandise exporters. Many factors have contributed to greater economic interaction among the world's nations: 1. Political. 1998 (Figure 21-4) Finance in Action: The Birth of a New Currency – The Euro! In 1999 the Euro came into existence for electronic transactions. 2 5/E Cdn. current account. Mgt. Short . Figure 21-3 demonstrates Canada’s close trading relationship with the United States. risky and require special understanding. II. Dollar 5. Introduction A. Post World War II rebuilding programs b. Interdependence for scarce resources International business operations are complex. In 2002 paper and coin Euros will be available. The Multinational Corporation (MNC) Foundations of Fin. 1997 (Figure 21-1) PPT 21-2 PPT 21-3 World’s leading merchandise importers. Canada and Canadian corporations are particularly dependent on international trade as emphasized by Figures 21-1 and 21-2. B. Block. Adaptation of political systems: a. Advances in communication and transportation 2. 1997 (Figure 21-2) Canada’s 1998 merchandise exports and imports by region (Figure 21-3) PPT 21-4 Canada’s international balance of payments.

the MNC is faced with foreign exchange risk and political risk. however. 3 5/E Cdn.A. Basic forms of MNC: 1. Work habits and wages of laborers 2. Exporter: exportation to foreign markets of domestically produced products Licensing Agreement: the granting of a license to an independent local (in the foreign country) firm to use the "exporting" firm's technology Joint Venture: cooperative business operation with a firm (or firms) in the foreign country Fully Owned Foreign Subsidiary 2. may be reduced if foreign and domestic operations are not correlated Potentially more profitable More complex: the laws. Structure and operation of financial institutions d. Short . The portfolio risk of the parent company. and exporter will usually desire payment in the currency of the home country. To facilitate international trade. Tax rules c. PPT 21-5 B. Mgt. Foreign Exchange Rates A. Financial policies and practices e. 3. Selected currencies and exchange rates (Table 21-1) Factors affecting exchange rates: Foundations of Fin. B. currencies must be exchanged. International Environment versus Domestic Environment: 1. The importer must swap the domestic currency for the currency desired by the exporter in order to pay the bill. More risky: in addition to normal business risks. 3. III. He or she may wish to comment on the declining value of the dollar and give an update on the current value of the dollar. Hirt. 4. Rates of inflation b. and economic environment of the host country may vary in many respects: a. For example. customs. Perspective 21-1: The instructor may wish to use Table 21-1 to illustrate foreign exchange rates and how they change over time. Block.

 Block. Capital market movements b. Forward premium Forward rate . (21-1. D. Political turmoil C. Foundations of Fin. as well as cross rates. Supply of and demand for the currencies of the various countries The degree of central bank intervention Inflation rate differentials (Purchasing Power Parity Theory) Interest rate differentials (Interest Rate Parity Theory). and Cross Rates Perspective 21-2: There are a number of easily understood examples in the text on spot and forward rates. 7. Mgt. 3. Balance of payments Government policies Other factors: a. Although interest rates may look better in another country they turn out to be remarkably similar through the forward covered rate (page 817). Labor disputes d. Many variables affect currency exchange rates. Hirt. 2. Spot Rates. and the integration of world financial markets. Forward Rates. The instructor can use these with students who have little or no international background. interest parity theory. Short . 6.1. 4.Spot rate 12 = x x 100 % Length of forward (discount) Spot rate contract (months) 1. Changes in supply of and demand for the products and services of individual countries c. Spot rate: the exchange rate between currencies with immediate delivery. 5. Forward rate: the rate of exchange between currencies when delivery will occur in the future. 2. Finance in Action: Interest Rate in Other Countries: Are They Any Better? This example taken from the financial pages of a newspaper demonstrates a swap deposit. The importance of each variable or set of variables will change as economics and political conditions change throughout the world. page 820) 4 5/E Cdn.

when foreign funds are converted to Canadian dollars. Block. 1. Accounting or translation exposure: depends upon accounting rules established by CICA accounting recommendations. Hirt. Foreign Investment Decisions A. d. Hedging in the money market: the recipient borrows foreign currency in the amount to be received and then immediately converts to domestic currency. Hedging in the forward exchange market: the recipient (seller) of foreign currency in an international transaction sells a forward contract to assure the amount that will be received in domestic currency. the loan is paid off.3. When the receivable is collected. Transaction exposure: the foreign exchange gains and losses resulting from international transactions. 5 5/E Cdn. primarily by way of direct investment ($240 billion). Mgt. Short . b. Three types of foreign exchange risk exposure: a. Economic exposure identifies market value of net investment subject to change in economic value due to currency fluctuation. Hedging in the currency options market: options contracts on foreign currencies are traded on the CME. IV. Hedging in the currency futures market: futures contracts in foreign currencies began trading in the International Monetary Market (IMM) of the Chicago Mercantile Exchange (CME) on May 16. Foundations of Fin. b. V. 2. c. There are four strategies used to minimize transaction exposure: a. Canada held $647 billion in assets abroad. Cross rate: the exchange rate between currencies such as Danish Krone and British Pounds based on their exchange rate with another currency such as Canadian Dollars. This is often an unrealized gain or loss. Canada invests abroad. Managing Foreign Exchange Risk A. 1. Foreign exchange risk is the possibility of experiencing a drop in revenue or an increase in cost in an international transaction due to a change in foreign exchange rates. 1972. b.

Resources readily available b. Competition 3. Foreign exchange restriction b. Expropriation of foreign subsidiary's assets 2. 1. The primary locale of Canadian investment abroad is the United States. Higher rates of return. Block. Proximity to market c. Strategic considerations: a. Lower production costs particularly with regard to labor costs c. 2. 1998 (assets) (Figure 21-6) B. Blockage of repatriation of earnings d.K. The great foreign control of Canadian assets and industry is a continuing concern.2. Hirt. Safeguards against political risk. Trade Blocs b. International diversification PPT 21-8 C. Risk reduction from international diversification (Figure 21-7) Foreign firms are expanding their investment in Canada. Foreign investment in Canada by region. Foundations of Fin. Foreign investments in Canada reached $971 billion in 1998 with the United States dominating followed by Britain and the EU. Ease of entry because of advanced technology 2. and the EEC. Short . Bond holdings were $410 billion and direct investment was $217 billion. 1998 (Figure 21-5) PPT 21-7 Canada’s investment abroad by region.. Mgt. 1998 (liabilities) (Figure 21-8) Analysis of Political Risk 1. followed by the U. The structure of the foreign government and/or those in control may change many times during the lengthy period necessary to recover an investment. a. PPT 21-9 D. PPT 21-6 Canada’s international investment position. Foreign ownership limitations c. Tax advantages d. 6 5/E Cdn. "Unfriendly" changes may result in: a. Reasons for Canadian firms to invest in foreign countries: 1.

Foundations of Fin. Short .. Loans from the parent company or sister affiliate. b. c. C. Hirt. 3. 7 5/E Cdn. There are many participants in the Eurodollar market from throughout the world particularly the U. d. Eurocurrency loans: loans from foreign banks that are denominated in dollars. Funding of transactions 1. a. 2. A thorough investigation of the country's political stability Joint ventures with local (foreign) companies Joint ventures with multiple companies representing multiple countries Insurance through the federal government agency. Fronting loans: loans from a parent firm to a foreign subsidiary via PPT 21-10 A parallel loan arrangement (Figure 21-9) and A fronting loan arrangement (Figure 21-10) a bank located in the foreign country. Lower borrowing costs and greater credit availability have enabled these markets to become an important source of short-term funding. b. an exporter may require an importer to furnish a letter of credit. The letter of credit is normally issued by the importer's bank and guarantees payment to the exporter upon delivery of the merchandise if the specified conditions are met. the Export Development Corporation (EDC) Finance in Action: Whiskey is Risky! In the mid-1990s Seagram was allowed to enter the liquor business in India. Letters of credit: in order to reduce the risk of non-payment.S. It found the early going tougher than it expected as several unique cultural. a. Parallel loans: an arrangement where two parent firms in different countries each make a loan to the affiliate of the other parent. B. Canada. The procedure eliminates foreign exchange risk. Block.a. Western Europe and Japan. and technical risks were encountered. political. Export Development Corporation: facilitates the financing of Canadian exports through several programs. Financing International Business Operations A. b. Export credit insurance: the Export Development Corporation may provide insurance against non-payment by foreign customers. Mgt. VI.

com VII. Large Euro-currency loans are frequently syndicated and managed by a lead bank. 5. Once the venture is well established. Registration costs are lower. b. Marketing securities internationally requires firms to adjust their procedures. 8 5/E Cdn.moodys. b. www. Global Cash Management A. the IFC frees up its capital by selling its ownership interest. technological constraints. Eurobond market: long-term funds may be secured by issuing Eurobonds. a. volatile interest rates.c. Lending in the Eurodollar market is almost exclusively done by commercial banks. Block. For example. The lending rate is based on the London Interbank Offered Rate (LIBOR). c. These bonds are sold throughout the world but are denominated primarily in U. The IFC decides to participate in the venture on the basis of profitability and the potential benefit to the host country. b. Deutsche marks. Some tax advantages exist. 4. 6. Short . Unsettled Issues in International Finance Foundations of Fin. Mgt. differing inflation rates. and other variables increase the complexity of managing cash globally. A multinational firm may be able to raise equity capital by selling partial ownership to the IFC. d. d. Multinational firms list their shares on major stock exchanges around the world. Hirt. c. Disclosure requirements are less stringent. International equity markets: selling common stock to residents of a foreign country provides financing and also reduces political risk. Swiss francs and Japanese yen. VIII. a. chartered banks have a dominant role in the securities business throughout Europe. Caution must be exercised because of the exposure to foreign exchange risk. dollars. International Finance Corporation (IFC): the IFC was established in 1956 and is unit of the World Bank.S. Finance in Action: Rating the Countries Moody’s Bond Rating Service rates the sovereign debt of countries. a. Government restrictions. Its objective is to promote economic development to member countries of the World Bank.

B. 1. Should a foreign affiliate design a capital structure similar to that of the parent firm or one that fits the acceptable pattern of the host country? 2. 1997 (Figure 21-1) World’s leading merchandise importers.the affiliate management or the parent management? Successful participation in the international business environment requires cohesive. PPT 21-10 Cash flow analysis of a foreign investment (Table 21A-1) Summary Listing of PowerPoint Slides PPT 21-1 PPT 21-2 PPT 21-3 PPT 21-4 PPT 21-5 PPT 21-6 PPT 21-7 PPT 21-8 PPT 21-9 PPT 21-10 PPT 21-11 Foundations of Fin. 1998 (assets) (Figure 21-6) Risk reduction from international diversification (Figure 21-7) Foreign investment in Canada by region. current account. Cash Flow Analysis Tax Factors Foreign Exchange Considerations Present Value Analysis The Risk Factor Perspective 21-3: The appendix represents a reasonably complicated consideration of a foreign investment decision by a corporation. 1998 (Figure 21-5) Canada’s investment abroad by region. C. E. Short . 1998 (Figure 21-4) Selected currencies and exchange rates (Table 21-1) Canada’s international investment position.A. Who should determine the dividend policy of a foreign affiliate . The complexity of the multinational business environment generates questions for which there are no easy answers. World’s leading merchandise exporters. Appendix 21A: Cash Flow Analysis and the Foreign Investment Decision A. Block. IX. Mgt. Hirt. 1997 (Figure 21-2) Canada’s 1998 merchandise exports and imports by region (Figure 21-3) Canada’s international balance of payments. D. coordinated financial management. B. 1998 (liabilities) (Figure 21-8) A parallel loan arrangement (Figure 21-9) and A fronting loan arrangement (Figure 21-10) Cash Flow Analysis of a Foreign Investment (Table 21A-1) 9 5/E Cdn.

Hirt. 10 5/E Cdn. Short . Mgt.Foundations of Fin. Block.