21

International Financial
Management

Block, Hirt, and Danielsen

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 Chapter Outline

• Multinational corporations
• Exchange rates, Cross rates, Forward premium
& discounts
• Hedging and reduction of foreign exchange
risk

21-2
 The Multinational Corporation

• Firm carrying out business activities (often

30% or more) outside its national borders
• Can take several forms
• Exporter
• Licensing agreement
• Joint venture
• Fully-owned foreign subsidiary

21-3
 Forms of Multinational Corporation
• Exporter
• Least risky method
• Reap benefits of foreign demand
• No long-term investment commitment
• Licensing agreement
• License granted to local manufacturer in foreign land to use firm’s
technology
• Effectively exporting technology
• Collects licensing fee or royalty
• Joint venture
• Established with local firm in foreign land
• Most preferred by business firms and foreign governments
• Least political risk

21-4
 Forms of Multinational Corporation
(cont’d)

• Fully-owned foreign subsidiary

• Higher risks and operation complexities
• Often more profitable than domestic firms
• Exert significant impact on host country’s economic
growth, employment, trade, balance of payments

21-5
 Exchange Rates

• Relationship between values of two currencies

• For example, quotation of $2.00 per pound
same as £.50 per dollar (1/$2.00)
• If a Czech crown is equal to $.05, the U.S.
dollar is equal to how many Czech crowns?
• Answer: ____________

21-6
 Spot Rates and Forward Rates

• Spot rate
• Exchange rate at which currency traded for immediate delivery
• Forward rates
• Trading currencies for future delivery
• Expectations regarding future currency value
• Discount or premium
• Expressed as annualized percentage deviation from spot rate

21-7
 Cross Rates

• Suppose that ($/€) = 1.50 (i.e., $1.50 = €1.00) and

that ($/£) = 2.00 (i.e., £1.00 = $2.00).
• What must the €/£ cross rate be?

$1.50 £1.00 £0.75

× =
€1.00 $2.00 €1.00

€1.00 = £0.75

5-8
 Foreign Exchange Risk

• Foreign exchange risk

• Possibility of revenue drop or cost increase in
international transaction due to changes in foreign
exchange rates
• Exchange risk of multinational company
• Accounting or translation exposure
• Transaction exposure

21-9
 Translation Exposure

• Consolidated figures of parent include value of

foreign assets and liabilities converted,
expressed in home currency
• Changing exchange rates result in losses and
gains on translation
• Treatment of gains and losses depends on
accounting rules established by government of
parent company

21-10
 Transaction Exposure

• Foreign exchange gains or losses resulting

from international transactions (from time of
agreement to time of payment)
• Strategies to minimize transaction exposure
(Hedging)
• Forward exchange market hedge
• Money market hedge
• Currency futures market hedge

21-11
 Forward exchange market hedge

• Suppose on Feb 21, 2014 an electric company in France, purchases

equipment from the United States for 822,400 euros and promises to pay
in 90 days (on May 22, 2014) (suppose 822,400 euros = $1,000,000)
• US company is exposed to exchange rate risk
• One simple method is to hedge the exposure in the forward exchange
market with a 90-day forward contract. 
• On February 21, 2014, to establish a forward cover, US Company will book
a forward contract with the bank to deliver the 822,400 euros 90 days
from that date in exchange for $1,000,000.
• On May 22, 2014, US company receives payment from French company
and delivers the 822,400 euros to the bank that signed the contract. In
return, the bank delivers $1,000,000 to US company.
 Money market hedge

• A second way to have eliminated transaction

exposure in the previous example would have
been to borrow money in euros and then
convert it to U.S. dollars immediately. When
the money is collected three months later
from French company, the US company will
clear the loan.
 Currency futures market hedge

• For example, suppose that Company making silver

jewelry knows that in six months it will have to buy
20,000 ounces of silver to fulfill an order.
• Assume the spot price (now) for silver is $12/ounce
and the six-month futures price is $11/ounce. By
buying the futures contract, Company can lock in a
price of $11/ounce.
• This reduces the company's risk because it can buy
20,000 ounces of silver for $11/ounce in six months.