Whats Special about International Finance?

Goals for International Financial Management Globalization of the World Economy Multinational Corporations Organization of the Text Summary Foreign Exchange Risk Political Risk Market Imperfections Expanded Opportunity Set

Foreign Exchange Risk The risk that foreign currency profits may evaporate in dollar terms due to unanticipated unfavorable exchange rate movements. Political Risk Sovereign governments have the right to regulate the movement of goods, capital, and people across their borders. These laws sometimes change in unexpected ways. Market Imperfections Legal restrictions on movement of goods, people, and money Transactions costs Shipping costs Tax arbitrage Expanded Opportunity Set It doesnt make sense to play in only one corner of the sandbox. True for corporations as well as individual investors. The focus of the text is to equip the reader with the intellectual toolbox of an effective global manager but what goal should this effective global manager be working toward? Maximization of shareholder wealth? or Other Goals? Long accepted as a goal in the Anglo-Saxon countries, but complications arise. Who are and where are the shareholders? In what currency should we maximize their wealth? In other countries shareholders are viewed as merely one among many stakeholders of the firm including: Employees Suppliers Customers In Japan, managers have typically sought to maximize the value of the keiretsua family of firms to which the individual firms belongs. No matter what the other goals, they cannot be achieved in the long term if the maximization of shareholder wealth is not given due consideration. Emergence of Globalized Financial Markets Trade Liberalization and Economic Integration Privatization Deregulation of Financial Markets coupled with Advances in Technology have greatly reduced information and transactions costs, which has led to:

 Financial Innovations, such as Currency futures and options Multi-currency bonds Cross-border stock listings International mutual funds Over the past 50 years, international trade increased about twice as fast as world GDP. There has been a sea change in the attitudes of many of the worlds governments who have abandoned mercantilist views and embraced free trade as the surest route to prosperity for their citizenry. The General Agreement on Tariffs and Trade (GATT) a multilateral agreement among member countries has reduced many barriers to trade. The World Trade Organization has the power to enforce the rules of international trade. The North American Free Trade Agreement (NAFTA) calls for phasing out impediments to trade between Canada, Mexico and the United States over a 15-year period. The selling off state-run enterprises to investors is also known as Denationalization. Often seen in socialist economies in transition to market economies. By most estimates this increases the efficiency of the enterprise. Often spurs a tremendous increase in cross-border investment.

A firm that has incorporated on one country and has production and sales operations in other countries. There are about 60,000 MNCs in the world. Many MNCs obtain raw materials from one nation, financial capital from another, produce goods with labor and capital equipment in a third country and sell their output in various other national markets.

In what currency should capital be raised In what currency should capital be raised? How structured: equity, debt? What sources of capital? If capital market, which ones? Are other sources of money available? How much and for how long?

Capital Structure of a firm Retained earnings Debt Offshore financial center specializes in financing nonresidents, low taxes and few banking regulations Equity American depository receipts (ADRs): foreign shares held by a custodian in the issuers home market and traded in dollars on the U.S. exchange

Cash flow management Multilateral Netting Subsidiaries transfer net intra company cash flows through a centralized clearing center Leading and Lagging

Timing payments early (lead) or late (lag), depending on anticipated currency movements, so they have the most favorable impact

Forex Manangement Transaction exposure Change in the value of financial position created by foreign currency changes between establishment and settlement of contract Translation exposure Potential change in value of a companys financial position due to exposure created during consolidation process Economic exposure Potential for value of future cash flows to be affected by unanticipated exchange rate movements

Hedging Hedging process to reduce or eliminate financial risk Forward market hedge Foreign currency contract sold or bought forward in order to protect against foreign currency movement Currency option hedge Option to buy or sell specific amount of foreign currency at specific time to protect against foreign currency risk Money market hedge Method to hedge foreign currency exposure by borrowing and lending in domestic and foreign money markets Transaction Exposure Swap Contract Spot sale/purchase of asset against future purchase/sale of equal amount in order to hedge financial position Bank Swap Swap made between banks to acquire temporary foreign currencies Currency Swap Exchange of debt service of loan or bond in one currency for debt service of loan or bond in another currency Interest Rate Swap Exchange of interest rate flows to manage interest rate exposure Spot and Forward Market Swaps Use spot and forward markets to hedge foreign currency exposure Parallel Loans Matched loans across currencies made to cover risk Current Rate Method Current assets and liabilities are valued at current spot rates and noncurrent assets and liabilities are translated at historic exchange rates Temporal Method Monetary accounts are valued at spot rate and accounts carried at historical cost are translated at historic exchange rates

Derivates Contract whose value is tied to the performance of a financial instrument or commodity

Sales without money Countertrade The trade of goods or services for other goods or services (6 varieties) Counter purchase Goods supplied do not rely on the goods imported Compensation Developing country makes payment in products produced by use of developed country equipment Barter Direct exchange of goods or services for goods or services Switch Trading Use of third party to market products received in countertrade Offset Trade arrangement that requires portion of the inputs be supplied by receiving country Clearing account arrangements Process to settle trading account within specified time

In the last 4 weeks, we have: 1. Developed a number of measures of exposure 2. Constructed measures of the risks associated with 3. Determined how to identify the appropriate exposure to exposures. 4. Reviewed the advantages and disadvantages of a that can aid us in hedging these exposures. The nature of Hedging

these exposures hedge among a portfolio of number of financial instruments

At this point, we want to address some broader concerns in foreign exchange risk management: 1. Why hedge? 2. What kinds of risks should we focus on to hedge? 3. At what horizon should the hedging take place? 4. 5. What can be done from the operational side to manage foreign exchange risks? What is an appropriate overall approach for managing foreign exchange risk at a multinational?

Why Hedge? As we have seen, exposure alone does not justify hedging. However, the risk associated with a particular exposure may be sufficient to justify hedging. But this assumes that companies are risk-averse. When are companies risk-averse? This question must be addressed before a firm undertakes the costs associated with hedging foreign exchange risks. Why do corporations prefer a known home currency amount rather than a gamble with the same expected value involving potential gains or losses? What is the ultimate objective of the firm? To maximize shareholder valueand minimize systematic risks. Relative to the amount of hedging that takes place, the arguments for firm risk-aversion are somewhat scarce. When will risk management improve shareholder wealth and/or reduce their systematic risk? 1. 2. 3. Tax gain/loss treatment asymmetry. High financial distress costs. Internal vs. external capital markets.

4. 5.

Executive compensation / monitoring / transparency. Firms can hedge more efficiently than their shareholders.

The point is that unless a firm can identify one of the above concerns as relevant to a particular exposure, the costs associated with hedging may not be worthwhile. What risk should be hedge? If firms should only concern themselves with risks that have real economic costs associated with them, upon which of our measures of exposure should we focus? 1. Translation exposure Across-the-board changes in the balance sheet will generally have little effect on the ongoing operations of the firm. Cash flows are ignored and balance sheet entries are measured in terms of book values. The only possibility here is the tax gain/loss asymmetry. If the firm operates in a high inflationary environment, it may find the translation adjustment reported to the income statement taxed more when positive than credited when negative. Likewise, a firm may find changes in foreign borrowing subject to asymmetric treatment of capital gains/losses. But this is really part of a larger point. In general, if firms need to worry about the balance sheet, it will be due to an anticipated sale or discontinuation of the firms operations or due to changes in the firms capital structure - when firm value is no longer in NPV of cash flows. If this is the case, the appropriate measure of exposure will generally be net worth exposure - with assets and liabilities recorded at market values. Any balance sheet exposure hedging activities must focus on net worth exposure and be justified from this standpoint. 2. Transaction exposure Transaction exposure is similarly limited as it focuses solely on known, contractual cash flows. Nonetheless, because these cash flows are almost always denominated in pre-determined nominal amounts, hedging them will perfectly insulate the firm against exchange rate changes - nominal or real. Since the cash flows do not change with inflation, they move entirely with nominal rates. Also, because transaction exposure focuses only known, contractual amounts and as such will generally only include cash flows of short horizon, financial instruments for hedging them will be easily available and quite inexpensive. 3. Economic Exposure Economic exposure is ultimately what the firm should be concerned with. For ultimately investors are concerned with the value and riskiness of the firm itself. Indeed, even transaction exposures should be evaluated in terms of whether they are associated with an underlying economic exposure. When considering hedging a know outflow or cost, the firm needs to

evaluate the revenue side operations; and when considering a known inflow or revenue, the firm needs to evaluate the cost side.For whenever the currency movement affects revenues and costs equally, only the profit margin is truly exposed. What risk should be hedge? For treating economic exposure, financial hedges have two main shortcomings: 1. Horizon. Outside of swaps, most financial hedges become quite expensive over longer horizons. While swaps can provide an inexpensive way to construct a series of long-dated forward contracts, they require accurate assessment of future cash flows. For hedging future cash flows are uncertain, long-horizoned futures contracts are unavailable, and the costs of long-horizoned options will be prohibitively large. 2. Real vs. Nominal. Financial hedges can only hedge nominal amounts. If there are real changes in home currency costs and revenues, nominal hedges may be quite ineffective. As we have seen, real and nominal exchange rates coincide reasonably well in developed countries, but the correspondence is usually weak for emerging economies. Economic exposure on the long run? Recall that economic exposure is only concerned with changes in the market value of the firm that result from real exchange rate changes. Hence, if RPPP holds in the long run, changes in the real exchange rate should balance out in the long run. This is what we saw with most of the developing countries that saw large short-term swings in the real exchange rate. Thus, long-term hedging activity may not be entirely needed or productive. Where then is the value in hedging economic exposure? In addition to financial hedges, a number of operational activities exist which can be used to efficiently reduce the risks posed by exchange rate movements. Whereas financial hedges effectively eliminate the exposure of certain cash flows by creating an offsetting position, other activities exist which can mitigate the overall level of cash flow exposures themselves. Essentially these activities fall into two categories: 1. Marketing management. 2. Production management. What else can be done? In addition to financial hedges, a number of operational activities exist which can be used to efficiently reduce the risks posed by exchange rate movements.

Whereas financial hedges effectively eliminate the exposure of certain cash flows by creating an offsetting position, other activities exist which can mitigate the overall level of cash flow exposures themselves. Essentially these activities fall into two categories: 1. Marketing management. 2. Production management. Marketing Management. Marketing management focuses on increasing sales in countries in which the real exchange rate has appreciated and restructuring sales in countries where the real exchange rate has declined. Marketing management has three main dimensions: 1. Promotional strategy. If the marginal cost of promoting a product does not rise as much as the marginal benefit in response to an appreciation, it will make sense to shift promotional resources from undervalued currencies towards overvalued currencies. 2. Product design and development. Although new products will generally be introduced based on long-run competitive merits calculated at the long run real exchange rate, the optimal time to introduce new products may be when the exchange rate is high. When revenues are relatively high in home currency terms, it may be easier to justify high market entry costs - particularly if these costs are partially determined in the home currency. Effectively, having a new product to introduce to a market is like owning a long-dated call option. When the currency becomes sufficiently appreciated, the option should be exercised - the product should be introduced. 3. Pricing strategy. If firms have some flexibility to adjust prices and pass-through the exchange rate effects, they may want to take advantage of this in responding to exchange rate changes. Specifically, firms selling in overvalued currencies will want to lower the local currency price to capture larger market share, while those operating in undervalued currencies will raise prices to maintain profit margins. Certainly firms in more competitive industries face less flexibility in terms of their pricing schedules. Production management Just as marketing activities focus on firms that are overvalued, production activities will focus on countries where currencies are undervalued. Certainly a firm will face less flexibility on the production side than on the sales side. Nonetheless, to the extent possible, a firm has a number of potential production responses to shifts in exchange rates:

1. Since the costs of labor-intensive production activities are most likely to fluctuate with real exchange rate changes, they should be shifted from overvalued to undervalued currencies. In this way, having a flexibility with respect to production sourcing acts as a portfolio of currency options which benefit from exchange rate variability. 2. Similarly, input components can be sourced from countries with depreciated exchange rates at the expense of countries with high exchange rates. This activity is essentially enforcing the law of one price for traded goods, and as such, opportunities may be limited. 3. While expansions of capacity, introductions of new technology, and other efforts to improve productivity should be based on long-run comparative advantage and real exchange rates, again, the optimal time to introduce such changes may be when the currency is depreciated. The investment can be easily justified since its costs are likely to be lower and the facility is already realizing a comparative advantage and operating at high volume. Similar to new product introduction, opportunities to expand capacity or introduce new production technologies behave as a put option on the currency. The option should be exercised when the currency is depreciated and costs are low. Generally, production management will require a high degree of flexibility from the outset. Since this flexibility will generally take the form of excess capacity, it must come at some cost. Nonetheless, the option-like nature of this flexibility adds value to the firm from both risk management and profit maximization standpoints. Forex Management In managing foreign exchange risk several points are worth keeping in mind: 1. Focus attention on risks which have a material impact on the expected value and systematic risk of the firm to shareholders. 2. Measure exposures and risks accurately: recognize any potentially offsetting effects in costs, revenues, quantities, or pass-

through. -

take into account offsetting movements in exposures to other currencies.

apply appropriate measures of risk: RPPP for exposures not linked to interest rates and UIP for those that are interest sensitive (i.e. cash deposits). 3. Use risk management to control risks in the short-run, while relying on firm, manager, and exchange rate fundamentals to dominate in the long-run. 4. Dont ignore opportunities to manage exchange rate risks from the operational side.

5. Recognize that risk management often creates more risk than it eliminates - no firm (or municipality) ever went bankrupt solely due to insufficient risk management, plenty have gone bankrupt as a result of too much. 6. Keep in mind that investment banks make more money when you worry about FX risk than when you dont.