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Internatioanl Finance
Internatioanl Finance
Various barriers prevent the markets for real or financial assets from becoming
completely integrated. These barriers include ten differential tariffs, quotas,
labour immobility cultural differences financial reporting differences and
significant cost of communicating information across countries.
Creditors have one or more of the following motives for providing credits in
foreign markets are-
Borrowers may have one or more of the following motives for borrowing in
foreign markets.
The Euro credit markets- is composed of the same commercial banks that serve
the Eurocurrency markets. These banks convert some of the deposits received
into Euro-credit loans (for medium-term periods) to govt. and large
corporations.
Some option are listed as “European style” which means that they can be
exercised only upon expiration.
A currency call option is said to be in the money when the present exchange
rate exceeds the strike price and out of the money when the present exchange
rate is less than the strike price. For a five currency and expiration date an in the
money call option will require a higher premium than option that are at the
money or out of money.
Currency put option – the owner of a Currency put option recovers the right to
sell a currency at a specified price within specified time period of time. The
owner of a put option is not obligated to exercise the option therefore the
maximum potential loan to the owner of the put option is the price (or premium)
paid for the option contract.
Interest rate parity – once market forces cause interest rate and exchanged rate
to adjust such that covered interest arbitrage is no longer feasible there is an
equilibrium state referred to as IRP. In equilibrium the forward rate differs from
the spot rate by a sufficient amount to offset the interest rate diffencial between
two currency.
IRP specifying that the forward premium (or discount) is equal to the interest
rate differential between the two currencies.
Inflation, interest rate and exchange rate – changes in relative inflation rate can
effect international trade actively which influence the demand for and supply of
currencies and there fore influence exchange rates
Exchange rates – the key economic factors that can influence exchange rate
movement through their effect on demand and supply condition are relative
influence rates interest rate and income level and as well as Govt. contract.
When a country’s inflation rate risk the demand for it currency decline as it
export decline (due to its higher price) consumer and firm in that country tend to
increase their importing.
Purchasing power parity (PPP) theory attempts to quantity inflation exchange
rate relationship.
Fisher effect – nominal risk free interest rates contain a real rate of return and
anticipated inflation
International Fisher effect theory (IFE) – it uses interest rate rather than
inflation rate differential to explain why exchange rate change overtime but it is
closely related to the PPP theorybecause interest rate are often highly correlated
with inflation rates specifies a precise relation between relative interest rate of
two countries and then exchange rate.
(i) Technique
(ii) Fundamental
(iii) Market based
(iv) Mixed
The following are some of the corporate function for which exchange rate
forecast are necessary :
Search for forecast bias – the difference between the forecasted and
realized exchange rate for a given point in time is a nominal forecast
error negative error overtime indicate underest mainly while positive
error indicate overestimating if the error are consistentaly positive or
negative overtime then a bias in forecasting procedure does exists.
Application of exchange rate forecasting to the Asian crisis – just before the
asian crisis the spot rate (in dollor) would have served as a reasonable predictor
of the future spot rate because the central bank were maintain a some what
stable value for their respective currency the forward rate of these some what
Asian currency would not have been accurate because it would have exhibits a
discount to reflect the differential between the south east Asian countries
interest rate (based on interest rate parity). The currency depreciated by much
more than would have been predicted according to the forward rate.
Two key factor that led to sustainable decline in currency value were-
Exchange rate forecasting affects the value of an MNC. The forecasts lead to
decisions about whether the firm should remain exposed to exchange rate
fluctuations a hedge its foreign currency position. The forecasts can affect the
expected foreign currency cash flows if those cash flows are partially generated
by foreign subsidiaries from transactions with other countries.
The forecasts have a direct effect on the expected values of the exchange rates
at which the foreign currency cash flows will be converted into dollars when
those cash flows are remitted to the U.S. parent suice the forecasts lead to
decision about whether to hedge they influence the actual exchange rate at
which the future foreign currency cash flows will be converted to dollars when
remitted to the U.S parent. Thus, they determine the expected dollars when
remitted to the U.S parent. Thus, they determine the expected dollar cash flows
to be received by the U.S parent.
Exchange rate risk can be broadly defined as the risk that a company
performance, will be affected by exchange rate movements. MNC closely
monitor their operations to determine how they are exposed various forms of
exchange rates risk. Financial managers must understand how to measure the
exposure of their MNCs to exchange rate fluctuations. So that, they can
determine whether and how to protect their companies from that exposure.
TYPE OF EXPOSURE-
1. Transaction exposure
2. Economic exposure
3. Translation exposure
Transaction Exposure
The degree to which the value of future cash transactions can be affected by
exchange rate fluctuations is referred to as transaction exposure. The value of a
firms cash inflows received in various currencies will be affected by the
respective exchange rates of these currencies when they are converted into the
currency desired. Similarly, the value of a firms cash outflows in various
currencies will be dependent on the respective exchange rate of these
currencies.
Economic Exposure
The degree to which a firms present value of future cash flows can be
influenced by exchange rate fluctuations is referred to as economic exposure to
exchange rates. All type of transactions that cause transaction exposure also
cause economic exposure because these transactions represent cash flows that
can be influenced by exchange rate fluctuations. In addition, other types of
business that do not cause transaction exposure can cause economic exposure.
Measuring Economic Exposure- classify the cash flows into different income
statement in terms and subsectively predict each income statement item based
on a forecast of exchange rates. There are alternative considered and the
forecasts for the income statement items revised. This procedure is especially
for firms that have more expense than revenue in a particular foreign currency.
Translation Exposure – an MNC creates its financial statements by
consolidated all of its individual subsidiary’s financial statement. A subsidiary
financial statement is normally measured in it local currency. To be
consolidated each subsidiary financial statement must transfer into currency of
the parent since the exchange rate change over time, the translation of the
subsidiary’s financial statement into a different currency is affected by
exchange rate movement the exposure of MNC’s consolidated financial to
exchange rate fluctuation is known as translation exposure particular subsidiary
earning translated into the reporting currency on the consolidated income
statement and subject to changing exchange rate.
Stock price perspective – many investor tend to use earning when valuing
firm, either by deriving estimate of expected cash flow from previous earning or
by apply a P/E ratio to expected annual earning to derive a value per share of
stock since an MNC’s translation exposure affect its consolidated earning it can
affect the MNC’s valuation.
Future hedge – currency future can be used by a firm that desire to hedge
transaction exposure
Selling currency future – a firm that sells a current future contract is entitled to
sell a specified amount in a specified currency for a stated price on specified
date.
Forward hedge – forward contract can be used it lock in the future exchange
rate at which a MNC can be or buy a currency. A forward contract is very
similar to future contract hedge expect that forward contract are commonly used
for large transaction, where future contract tend to be used for small amount
MNC;s can request forward contract that specifying the exact number of units
that they desire whereas future contract represent a standardized number of
units for currency.
Money market hedge - Money market hedge involve taking a money market
position to cover a future payment or receivable position money market
Hedge on payment – if a firm has excess cash it can create a short term deposit
in the foreign currency that it will need in the future Hedging of future
receivables with forward sale is similar to borrowing at the foreign interest rate
interesting at the at the home interest rate
Currency option hedge – the currency option has an advantage over the other
hedging in that it does not have to be exercised if the MN would be both off
unhedged. A premium must be paid to purchase the currency option however so
there is a cost for the flexibility they provide.
Hedging payables with currency call option- a currency call option provides
the right to buy a specified amount of a particular currency at a specified price
with a given period of time. The currency call option does not obligate its owner
to buy the currency at that price.
-cross-hedging
-currency diversification
Ledging and lagging- the act of leading and lagging involves an adjustment in
the timing of a payment request or disbursement to reflect expectation about
future currency if a company expects that the pound will soon depreciate against
foreign, it may attempt to expedite the payment to thundery before the pound
depreciates. This strategy is referred to as leading. If a British subsidiary
expects the pound to appreciate against the forint soon, in that case the british
subsidiary may attempt to all its payment until after the pound appreciates. In
this way, it could use fewer pounds to obtain the forint needed for payment, this
strategy is referred to as lagging.
Economic Exposure-
An MNC must determine its economic exposure before it can manage its
exposure. It can determine its exposure to each currency informs of its cash
inflows and cash outflows. The income statements for each subsidiary can be
used to derive estimates.
MNCs may restructure their operations to reduce their economic exposure. The
restructuring involves sniffing the sources of costs or revenue to other locations
in order to match cash inflows and outflows in foreign currencies.
MNCs that have production and marketing facilities in various countries may be
able to reduce any adverse impact of economic exposure by shifting the
allocation of then operation.
TRANSLATION EXPOSURE-
Some people argue that it is not necessary to hedge or even reduce translation
exposure as cash flow is not affected. Some MNCs attempt to avoid translation
exposure by matching foreign liabilities with foreign assets. For example, Philip
Morris uses foreign financing to matching its covers of foreign assets.
An MNCs value is also affected by the way it mange’s other forms of economic
exposure that are unexpected to transaction exposure.
Euro bank loan – direct loan from euro banks which are typically
utilized to maintain a relationship with euro bank & are another
popular source of short term funds for MNC’s. if other source of short
term funds become unavailable MNC’s rely more heavily on direct
loan from euro banks. Most MNC’s maintain credit arrangement with
various banks around the world. Some MNC’s have credit
arrangement with more than 100 foreign and domestic banks.
Internal financing by MNC’s – An MNC’s parent or subsidiary in
need of funds search for outside funding it should cheek other
subsidiary cash flow position to determine whether any internal funds
are available.
It is the deposits effective yield not is interest rate, that is mist important to the
cash manager the effective yield of a bank deposit couriers both the interest rate
and the rate of appreciation (or deprecation) of the currency denominating the
deposit and cash therefore be very different from the quoted interest rate on a
deposit denominated in a foreign currency.
Use of forward rate a forecast if interest rate parity exists the forward rate can
still be a indicator for the US firm investment decision.
IFE suggests that the exchange rate of a foreign currency is expected to change
by an amount reflecting the differential between its interest rate and the US
interest rate.
Although MNC’s do not know how a currency’s value will change over the
investment horizon they use use formulator effective yield and plug in their.
Forecast for the percentage change in the foreign currency's exchange rate since
the interest rate if the foreign currency deposit is known the effective yield on a
foreign deposit can their be compared with the yield when investing in the
firm’s local currency.
Change over time. Limiting the percentage of excess cash inversed in each
currency will reduce the MNC’s exposure to exchange rate risk.
the most popular method of capital budging involves determine the present
value of project future cash flow and subtracting the initial outlay required for
the project. Multinational capital budgeting typically uses a similar process.
Tan differential
If the earning due to the project will someday be remitted to the parent, the
MNC needs to be consider how the parent’s Govt. taxes these earning if the
parent’s Govt. impose a high tax rate on the remitted funds the project may be
feasible from the subsidiary point of view. Under such a scenario the parent
should not consider implementing the project even through it appears feasible
from the subsidiary perspective.
Restricted Remittances
Exassive remittance
Perspective the cash flows forecasted for the subsidiary do not have it be
converted to the parent currency.
(v) Fixed cost sensitive to any change in host country’s inflation rate.
(vi) Project life time some project have indefinite lifetime. Political events
may force the firm to liquidate the project earliest that planned.
(vii) Salvage (liquidation) value host government could take over the project
without adequately compersateeing the MNC
(ix) Tax's laws after tax cash flow are necessary for an adequate capital
budgeting analysis, international tax effects must be determined on any
proposed foreign projects.
(x) Exchange rates most budgeting technique are used to cover short term
position it is possible to hedge over longer periods (with long term forward
contract or currency swap).
(xi) Required rate of return cash flow can be discounted at project required rate
of return.
(ii) Inflation
(xi) Many foreign projects are partially financed by foreign subsidiary. If the
parent provides the endive investment no foreign financing is required
can sequent the subsidiary makes no interest payment and therefore
remits larger cash flow to the parent. Given the larger payment to the
parent, the cash flow ultimately received by the parent are more
susceptible to exchange rate movements. Some foreign projects are
completely financed with retained earning of existing foreign subsidiary.
(xiv) The host country may block fund that the subsidiary attempts to send to
the parent, some countries require that earning shuerated by the
subsidiary be reinvested locally for at least there year before they can be
remitted such restriction can affect the accept/reject decision on a project.
(xvi) The salvage value of an MNC’s project topically has a significant impact
on the project’s NPV.
(xvii) if the actual salvage value is expected to equal or exceed the break
even salvage value (called SVn) can be determine by setting NPV equal
to zero.
(xix) In reality in the new project there may be often be an impact. Some
foreign projects may have favorable impact on prevailing cash flows.
(xx) If a manufacture of competer components establishes foreign subsidiary
(xxi) To manufacture competer the subsidiary might order the component from
the parent. In the case the sale volume of the parent would increase
(xxii)
(xxiii)
A low rate host Govt. loan a reduced tax rate offered to the subsidiary will
enhance periodic cash flows. If the Govt. subsidiary the initial establishment of
the subsidiary the MNC’s initial investment will be reduced.
(iii) Simulations
Risk adjusted discount rate– the greater the uncertainly about a project
forecasted cash flows the larger should be the discount rate applied to cash
flows. This risk adjusted discount rate tends to reduce the worth of a project by
a degree that reflects the risk the project exhibits.
The risk adjusted discount rate is a commonly used technique perhaps because
of the case with which it can be arbitrarily adjusted.
Sensitively analysis - Sensitively analysis can be more useful than simple point
estimates because it meassesses the project learned on various instances that
may occur.
multinational capital budgeting decision affects the value the MNC. Because
multinational capital budgeting decision determine the types of operation of the
MNC’s they also affect the level of the MNC’s risk when the MNC’s parent
financially supports the foreign projects it cost of capital is affected, which
influence its requoirsd rate of return on its business and its vaulue.