Chapter 24

International
International
Financial
Financial
Management
Management
© Pearson Education Limited 2004
Fundamentals of Financial Management, 12/e
Created by: Gregory A. Kuhlemeyer, Ph.D.
Carroll College, Waukesha, WI
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 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
4-2 forfaiting.
 International
Financial Management
 Some Background
 Types of Exchange-Rate Risk
Exposure
 Management of Exchange-Rate
Risk Exposure
 Structuring International Trade
Transactions
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 Some Background
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.
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 International
Capital Budgeting
How does a firm make an international
capital budgeting decision?
1. Estimate expected cash flows in the foreign
currency.
2. Compute their U.S.-dollar equivalents at the
expected exchange rate.
3. Determine the NPV of the project using the U.S.
required rate of return, with the rate adjusted
upward or downward for any risk premium effect
associated with the foreign investment.
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 International
Capital Budgeting
 Only consider those cash flows that can
be “repatriated” (returned) to the home-
country parent.
 The exchange rate is the number of units
of one currency that may be purchased
with one unit of another currency.
 For example, the current exchange rate
might be 2.50 Freedonian marks per one
U.S. dollar.
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 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.S. dollars is 18%.
18%
 The appropriate expected exchange rates
are given on the next slide.

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 International Capital
Budgeting Example

End Expected Exchange Expected Present Value

of Cash Flow Rate (marks Cash Flow of Cash Flows
Year (marks) to U.S. dollar) (U.S. dollars) at 18%

0 -1,500,000 2.50 -600,000 -600,000

1 500,000 2.54 196,850 166,822
2 800,000 2.59 308,880 221,833
3 700,000 2.65 264,151 160,770
4 600,000 2.72 220,588 113,777
Net Present Value = 63,202

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 International
Capital Budgeting
Related issues of concern:
 International diversification and risk
reduction
 U.S. Government taxation
 Taxable income derived from non-domestic
operations through a branch or division is taxed
under U.S. code.
 Foreign subsidiaries are taxed under foreign tax
codes until dividends are received by the U.S.
parent from the foreign subsidiary.

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 International
Capital Budgeting
 Foreign Taxation
 Tax codes and policies differ from country to
country, but all countries impose income taxes
on foreign companies.
 The U.S. government provides a tax credit to
companies to avoid the double taxation problem.
 A 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.
 Excess tax credits can be carried forward.

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 International
Capital Budgeting
 Political Risk
 Expropriation is the ultimate political risk.
 Developing countries may provide financial
incentives to enhance foreign investment.
 Bottom line: Forecasting political instability.
instability
 Protect the firm by hiring local nationals, acting
responsibly in the eyes of the host government,
entering joint ventures, making the subsidiary
reliant on the parent company, and/or
purchasing political risk insurance.
insurance

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 Important
Exchange-Rate Terms
Spot Exchange Rate -- The rate today for
exchanging one currency for another for
immediate delivery.
delivery
Forward Exchange Rate -- The rate today
for exchanging one currency for another at
a specific future date.
date
 Currency risk can be thought of as the volatility
of the exchange rate of one currency for
another (say British pounds per U.S. dollar).
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 Types of Exchange-
Rate Risk Exposure
 Translation Exposure -- Relates to the change in
accounting income and balance sheet statements
caused by changes in exchange rates.
 Transactions Exposure -- Relates to settling a
particular transaction at one exchange rate when
the obligation was originally recorded at another.
 Economic Exposure -- Involves changes in
expected future cash flows, and hence economic
value, caused by a change in exchange rates.

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 Management of Exchange-
Rate Risk Exposure
 Natural hedges
 Cash management
 Adjusting of intracompany
accounts
 International financing hedges
 Currency market hedges

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 Natural Hedges
Globally Domestically
Determined Determined
Scenario 1
Pricing X
Cost X
Scenario 2
Pricing X
Cost 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.
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 Natural Hedges -- “Not!”
Globally Domestically
Determined Determined
Scenario 3
Pricing X
Cost X
Scenario 4
Pricing X
Cost 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.
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 Cash Management
What should a firm do if it knew that a local foreign
currency was going to fall in value (e.g., drop from
$.70 per peso to $.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.
 Obtain trade credit or borrow in the local currency
so that the money is repaid with fewer dollars.
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 Cash Management
 Generally, one cannot predict the future
exchange rates, and the best policy would be
to balance monetary assets against monetary
liabilities to neutralize the effect of exchange-
rate fluctuations.
 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.
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 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.
 Generally, the reinvoicing center is billed in the
selling unit’s home currency and bills the purchasing
unit in that unit’s home currency.
 Allows better management of intracompany
transactions.
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 International
Financing Hedges
1. 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.

basis
 Nearly all major commercial cities have U.S. 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.

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 International
Financing Hedges
2. Eurodollar Financing
 Eurodollars are bank deposits denominated in U.S.
dollars but not subject to U.S. banking regulations.
 This market is unregulated. Therefore, 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.
 Rates are typically quoted in terms of the LIBOR.
 It is a major source of short-term financing for the
working capital requirements of the multinational
company.
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 International
Financing Hedges
3. International Bond Financing
 A Eurobond is a bond issued internationally outside
of the country in whose currency the bond is
denominated.
 The Eurobond is issued in a single currency, but is
placed in multiple countries.
 A foreign bond is issued by a foreign government or
corporation in a local market. For example, Yankee
bonds, and Samurai bonds.
 Many international debt issues are floating rate notes
that carry a variable interest rate.
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 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. For example, a bond might allow you to
choose between yen and U.S. dollars.
 Currency cocktail bonds provide a degree of exchange-
rate 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, while
a different currency is used to make principal
payments.
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 Currencies and the Euro
Euro – The name given to the single European
currency. Symbol is € (much like the dollar, $).
 Each country has a representative currency like
the $ (dollar) in the United States or the ₤ (pound)
in Britain.
 On January 1, 1999, the “euro” started trading.
 The euro is the common currency of the European
Monetary Union (EMU), which currently includes
the following 12 European Union (EU) countries:
 Austria, Belgium, Finland, France, Germany,
Greece, Ireland, Italy, Luxembourg, the
Netherlands, Portugal, and Spain.
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 Currency Market Hedges
1. Forward Exchange Market
 A forward contract is a contract for the delivery of a
commodity, foreign currency, or financial instrument at a
price specified now, with delivery and settlement at a
specified future date.
Spot rate $.168 per EFr
90-day forward rate .166 per EFr
 As shown, the Elbonian franc (EFr) is said to sell at a
forward discount as the forward price is less than the
spot rate.
 If the forward rate is $.171, the EFr is said to sell at a
forward premium.
premium
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 Currency Market Hedges
Fillups Electronics has just sold equipment worth
1 million Elbonian francs with credit terms of “net
90.” How can the firm hedge the currency risk?
 The firm has the option of selling 1 million Elbonian
francs forward 90 days. The firm will receive
$166,000 in 90 days (1 million Elbonian francs x
$.166).
 Therefore, if the actual spot price in 90 days is less
than .166, the firm benefited from entering into this
transaction.
 If the rate is greater than .166, the firm would have
benefited from not entering into the transaction.
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 Currency Market Hedges
How much does this “insurance” cost?

Annualized cost of protection

= ( $.002 )/( $.168 ) X ( 365 days / 90 days)
= .011905 X 4.0556
= .0483 or 4.83%
 Typical discount or premium ranges for
stable currencies are from 0 to 8%, but may
be as high as 20% for unstable currencies.
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 Currency Market Hedges
2. Currency Futures
 A futures contract is a contract for the delivery of a
commodity, foreign currency, or financial instrument at a
specified price on a stipulated future date.
 A currency futures market exists for the major currencies
of the world.
 Futures contracts are traded on organized exchanges.
 The clearinghouse of the exchange interposes itself
between the buyer and the seller. Therefore,
transactions are not made directly between two parties.
 Very few contracts involve actual delivery at expiration.
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 Currency Market Hedges
2. Currency Futures (continued)
 Sellers (buyers) cancel a contract by purchasing
(selling) another contract. This is an offsetting position
that closes out the original contract with the
clearinghouse.
 Futures contracts are marked-to-market daily. This is
different than forward contracts that are settled only at
maturity.
 Contracts come in only standard-size contracts (e.g.,
12.5 million yen per contract).

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 Currency Market Hedges
3. 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.
 Currency options hedge only adverse currency
movements (“one-sided” risk). For example, a put
option can hedge only downside movements in the
currency exchange rate.
 Options exist in both the spot and futures markets.
 The value depends on exchange rate volatility.
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 Currency Market Hedges
4. 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. At
maturity, principal amounts are exchanged, usually at a
rate of exchange agreed to in advance.
 The exchange is notional -- only the cash flow difference
is paid.
 Swaps are typically arranged through a financial
intermediary, such as a commercial bank.
 A variety of (complex) arrangements are available.
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 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, after exchange
rates are taken into account.
 For example, the price of wheat in Canadian
and U.S. markets should trade at the same
price (after adjusting for the exchange rate). If
the price of wheat is lower in Canada, then
purchasers will buy wheat in Canada as long as
the price is cheaper (after accounting for
transportation costs).
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 Macro Factors Governing
Exchange-Rate Behavior
Purchasing-Power Parity (PPP continued)
 Thus, demand will fall in the U.S. and increase in
Canada to bring prices back into equilibrium.
 The price elasticity of exports and imports influences
the relationship between a country’s exchange rate and
its purchasing-power parity.
 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.

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 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 former’s
currency will sell at a discount in the forward market.
 Remember that the Fisher effect implies that the
nominal rate of interest equals the real rate of
interest plus the expected rate of inflation.
 The international Fisher effect suggests that
differences in interest rates between two countries
serve as a proxy for differences in expected inflation.

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 Macro Factors Governing
Exchange-Rate Behavior
Interest-Rate Parity (continued)
The international Fisher effect suggests:
F 1 + rforeign
=
S 1 + rdollar
F= current forward exchange-rate in foreign
currency per dollar.
S= current spot exchange-rate in foreign currency
per dollar.
rforeign = foreign interbank Euromarket interest rate
rdollar = U.S. interbank Euromarket interest rate
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 Interest-Rate
Parity Example
 The current German 90-day interest rate is
4%.
 The current U.S. 90-day interest rate is 2%.
 The current spot rate is .706 Freedonian
marks per U.S. dollar ($1.416 per mark).

What is the implied 90-day forward rate?

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 Interest-Rate
Parity Example

The implied 90-day forward rate is:

F 1 + .04
=
.706 1 + .02

F = (1.04) x (.706)
.706 / (1.02)
= .720
Thus, the implied 90-day forward
rate is .720 marks per dollar.
dollar
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 Structuring International
Trade Transactions
 In international trade, sellers often have
difficulty obtaining thorough and accurate
credit information on potential buyers.
 Channels for legal settlement in cases of
default are more complicated and costly to
pursue.
 Key documents are (1) an order to pay
(international trade draft), (2) a bill of lading,
and (3) a letter of credit.
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 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 is payable at a specified future date after
sight to the party (drawee) to whom the draft is
addressed.

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 Time Draft Features
 An unconditional order in writing signed
by the drawer, the exporter.
 It specifies an exact amount of money
that the drawee, the importer, must pay.
 It specifies the future date when this
amount must be paid.
 Upon presentation to the drawee, it is
accepted.
accepted
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 Time Draft Features
 The acceptance can be by either the
drawee or a bank.
bank
 If the drawee 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.
 It is then known as a trade draft (banker’s
acceptance if a bank accepts the draft).
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 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 receipt from the transportation
company to the exporter, showing that specified
goods have been received.
 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.
 It serves as a document of title.
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 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. It is frequently used
to guarantee payment of an obligation.
 A letter of credit is issued by a bank on behalf of the
importer.
 The bank agrees to honor a draft drawn on the
importer, provided the bill of lading and other details
are in order.
 The bank is essentially substituting its credit for that
of the importer.
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 Countertrade
Countertrade -- 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 -- 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.
 Quality, standardization of goods, and resale of
goods that are delivered are risks that arise with
countertrade.
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 Forfaiting
Forfaiting -- The selling “without recourse” of
medium- to long-term export receivables to a
financial institution, the forfaiter. A third party,
usually a bank or governmental unit,
guarantees the financing.
 The forfaiter assumes the credit risk and collects
the amount owed from the importer.
 Most useful when the importer is in a less-
developed country or in an Eastern European
nation.
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