1 Financial Goals and Corporate GovernanceChapter 1 Financial Goals and Corporate Governance

2 The Multinational Enterprise (MNE)A multinational enterprise (MNE) is defined as one that has operating subsidiaries, branches or affiliates located in foreign countries. The ownership of some MNEs is so dispersed internationally that they are known as transnational corporations. The transnationals are usually managed from a global perspective rather than from the perspective of any single country. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

3 Multinational Business FinanceWhile multinational business finance emphasizes MNEs, purely domestic firms also often have significant international activities: Import & export of products, components and services Licensing of foreign firms to conduct their foreign business Exposure to foreign competition in the domestic market Indirect exposure to international risks through relationships with customers and suppliers Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

4 Global Financial ManagementThere are significant differences between international and domestic financial management: Cultural issues Corporate governance issues Foreign exchange risks Political Risk Modification of domestic finance theories Modification of domestic financial instruments Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

5 The Goal of Management Maximization of shareholders’ wealth is the dominant goal of management in the Anglo-American world. In the rest of the world, this perspective still holds true (although to a lesser extent in some countries). In Anglo-American markets, this goal is realistic; in many other countries it is not. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

6 The Goal of Management There are basic differences in corporate and investor philosophies globally. In this context, the universal truths of finance become culturally determined norms. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

7 Shareholder Wealth MaximizationIn a Shareholder Wealth Maximization model (SWM), a firm should strive to maximize the return to shareholders, as measured by the sum of capital gains and dividends, for a given level of risk. Alternatively, the firm should minimize the level of risk to shareholders for a given rate of return. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

8 Shareholder Wealth MaximizationThe SWM model assumes as a universal truth that the stock market is efficient. An equity share price is always correct because it captures all the expectations of return and risk as perceived by investors, quickly incorporating new information into the share price. Share prices are, in turn, the best allocators of capital in the macro economy. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

9 Shareholder Wealth MaximizationThe SWM model also treats its definition of risk as a universal truth. Risk is defined as the added risk that a firm’s shares bring to a diversified portfolio. Therefore the unsystematic, or operational risk, should not be of concern to investors (unless bankruptcy becomes a concern) because it can be diversified. Systematic, or market, risk cannot however be eliminated. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

10 Shareholder Wealth MaximizationAgency theory is the study of how shareholders can motivate management to accept the prescriptions of the SWM model. Liberal use of stock options should encourage management to think more like shareholders. If management deviates too extensively from SWM objectives, the board of directors should replace them. If the board of directors is too weak (or not at “arms-length”) the discipline of the capital markets could effect the same outcome through a takeover. This outcome is made more possible in Anglo-American markets due to the one-share one-vote rule. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

11 Shareholder Wealth MaximizationLong-term value maximization can conflict with short-term value maximization as a result of compensation systems focused on quarterly or near-term results. Short-term actions taken by management that are destructive over the long-term have been labeled impatient capitalism. This point of debate is often referred to a firm’s investment horizon (how long it takes for a firm’s actions, investments and operations to result in earnings). Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

12 Shareholder Wealth MaximizationIn contrast to impatient capitalism is patient capitalism. This focuses on long-term SWM. Many investors, such as Warren Buffet, have focused on mainstream firms that grow slowly and steadily, rather than latching on to high-growth but risky sectors. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

13 Corporate Wealth MaximizationIn contrast to the SWM model, continental European and Japanese markets are characterized by a philosophy that a corporation’s objective should be to maximize corporate wealth (the CWM model). In this context, a firm should treat shareholders on a par with other corporate interest groups, such as management, labor, the local community, suppliers, creditors and even the government. This model, also called the stakeholder capitalism model focuses on earning as much as possible in the long-run while retaining enough to increase the corporate wealth for the benefit of all interest groups. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

14 Corporate Wealth MaximizationThe definition of corporate wealth is much broader than just financial wealth (cash, marketable securities and lines of credit). Corporate wealth includes technical, market and human resources. This measure goes beyond financial reports to include the firm’s market position, employee knowledge base and skill sets, manufacturing processes, technological proficiencies, marketing and administration capabilities. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

15 Corporate Wealth MaximizationThe CWM model does not assume that equity markets are either efficient or inefficient. In fact, market efficiency does not matter as the firm’s financial goals are not exclusively shareholder-oriented. This model assumes that long-term “loyal” shareholders should influence corporate strategy, not transient portfolio investors. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

16 Corporate Wealth MaximizationThe CWM model assumes that total risk, operating and financial risk, does count. In the CWM model, it is a corporate objective to generate growing earnings and dividends over the long run with as much certainty as possible given the firm’s mission statement and goals. Risk is measured more by product market variability than by short-term variation in earnings and share price. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

17 Corporate Wealth MaximizationAlthough the CWM model avoids the impatient capitalism as seen in the SWM, it has its own flaw in that management is tasked with meeting the demands of multiple stakeholders. This leaves management without a clear signal about the tradeoffs, which management tries to influence through written and oral disclosures and complex compensation systems. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

18 Corporate Wealth MaximizationIn contrast to the CWM model, the SWM model requires a single goal of value maximization. While both forms of wealth maximization have their strengths and weaknesses, two trends in recent years have led to a focus on the SWM model. As non Anglo-American markets privatize their industries the SWM model becomes more important in the overall effort to attract foreign capital Many analysts believe that shareholder-based MNEs are increasingly dominating their global industry segments Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

19 Failures in Corporate GovernanceThere are clear examples of the failure of Corporate Governance in the United States: Enron – lack of full disclosure of off-B/S debt WorldCom – capitalizing costs that should have been expensed Global Crossing – hiding its overinvestment in operating losses Adelphia – management looting of the firm Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

20 Failures in Corporate GovernanceIn each case, prestigious auditing firms missed the violations or minimized them, presumably because of lucrative consulting relationships or other conflicts of interest. In addition, security analysts urged investors to buy the shares of firms they knew to be highly risky (or even close to bankruptcy). Top executives themselves were responsible for mismanagement and still received overly generous compensation while destroying their firms. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

21 Regulation of Corporate GovernanceThe corporate regulatory “pyramid” in the United States is as follows: US Congress Securities and Exchange Commission (SEC) New York Stock Exchange (NYSE) Individual Brokerage Firms Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

22 The Sarbanes-Oxley ActThis act was passed by the US Congress, and signed by President George W. Bush during 2002 and has three major requirements: CEOs of publicly traded companies must vouch for the veracity of published financial statements Corporate boards must have audit committees drawn from independent directors Companies can no longer make loans to corporate directors Penalties have been spelled out for various levels of failure. Most of its terms are appropriate for the US situation, but some terms do conflict with practices in other countries. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

23 Governance, Rights, and the FutureClearly, there has been substantial reflection on business in the early days of the 21st century. Issues such as sustainable development, environmentalism and corporate social responsibility are emerging as concerns for society, and of course management as businesses look toward the future. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

24 The International Monetary SystemChapter 2 The International Monetary System

25 The International Monetary SystemThe increased volatility of exchange rates is one of the main economic developments of the past 40 years. Policies for forecasting and reacting to exchange rate fluctuations are still evolving. Although volatile exchange rates increase risk, they also create profit opportunities for firms and investors. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

26 The International Monetary SystemThe international monetary system is the structure within which foreign exchange rates are determined, international trade and capital flows are accommodated, and the balance-of-payments adjustments made. All of the instruments, institutions, and agreements that link together the world’s currency, money markets, securities, real estate, and commodity markets are also encompassed within that term. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

27 Currency Terminology Foreign Currency Exchange Rate – the price of one country’s currency in units of another currency of commodity. Can be fixed or floating Spot Exchange Rate – the quoted price for foreign exchange to be delivered at once, or in two days for interbank transactions. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

28 Currency Terminology Forward Rate – the quoted price for foreign exchange to be delivered at a specified date in the future. Can be guaranteed with a forward exchange contract Forward Premium or Discount – the percentage difference between the spot and forward exchange rate. Calculated as Spot – Forward 100 n Forward x Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

29 Currency Terminology Devaluation of a Currency – refers to a drop in foreign exchange value of a currency that is pegged to gold or another currency. The opposite is revaluation Weakening, deterioration, or depreciation of a Currency – refers to a drop in the foreign exchange value of a floating currency. The opposite is strengthening or appreciation Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

30 Currency Terminology Soft or Weak – describes a currency that is expected to devalue or depreciate relative to major currencies. Also refers to currencies being artificially sustained by their governments Hard or Strong – describes a currency that is expected to revalue or appreciate relative to major trading currencies. Eurocurrencies – are domestic currencies of one country on deposit in a bank in a second country. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

31 History of the International Monetary SystemThe Gold Standard (1876 – 1913) Gold has been a medium of exchange since 3000 BC “Rules of the game” were simple, each country set the rate at which its currency unit could be converted to a weight of gold Currency exchange rates were in effect “fixed” Expansionary monetary policy was limited to a government’s supply of gold Was in effect until the outbreak of WWI as the free movement of gold was interrupted Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

32 History of the International Monetary SystemThe Inter-War Years & WWII ( ) During this period, currencies were allowed to fluctuate over a fairly wide range in terms of gold and each other Increasing fluctuations in currency values became realized as speculators sold short weak currencies The US adopted a modified gold standard in 1934 During WWII and its chaotic aftermath the US dollar was the only major trading currency that continued to be convertible Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

33 History of the International Monetary SystemBretton Woods and the International Monetary Fund (IMF) (1944) As WWII drew to a close, the Allied Powers met at Bretton Woods, New Hampshire to create a post-war international monetary system The Bretton Woods Agreement established a US dollar based international monetary system and created two new institutions the International Monetary Fund (IMF) and the World Bank Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

34 History of the International Monetary SystemThe International Monetary Fund is a key institution in the new international monetary system and was created to: Help countries defend their currencies against cyclical, seasonal, or random occurrences Assist countries having structural trade problems if they promise to take adequate steps to correct these problems The International Bank for Reconstruction and Development (World Bank) helped fund post-war reconstruction and has since then supported general economic development Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

35 History of the International Monetary SystemFixed Exchange Rates ( ) The currency arrangement negotiated at Bretton Woods and monitored by the IMF worked fairly well during the post-WWII era of reconstruction and growth in world trade However, widely diverging monetary and fiscal policies, differential rates of inflation and various currency shocks resulted in the system’s demise The US dollar became the main reserve currency held by central banks, resulting in a consistent and growing balance of payments deficit which required a heavy capital outflow of dollars to finance these deficits and meet the growing demand for dollars from investors and businesses Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

36 History of the International Monetary SystemEventually, the heavy overhang of dollars held by foreigners resulted in a lack of confidence in the ability of the US to met its commitment to convert dollars to gold The lack of confidence forced President Richard Nixon to suspend official purchases or sales of gold by the US Treasury on August 15, 1971 This resulted in subsequent devaluations of the dollar Most currencies were allowed to float to levels determined by market forces as of March, 1973 Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

37 History of the International Monetary SystemAn Eclectic Currency Arrangement (1973 – Present) Since March 1973, exchange rates have become much more volatile and less predictable than they were during the “fixed” period There have been numerous, significant world currency events over the past 30 years Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

38 The IMF’s Exchange Rate Regime ClassificationsThe International Monetary Fund classifies all exchange rate regimes into eight specific categories. There are eight categories that span the spectrum of exchange rate regimes from rigidly fixed to independently floating. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

39 Fixed Versus Flexible Exchange RatesA nation’s choice as to which currency regime to follow reflects national priorities about all facets of the economy, including inflation, unemployment, interest rate levels, trade balances, and economic growth. The choice between fixed and flexible rates may change over time as priorities change. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

40 Fixed Versus Flexible Exchange RatesCountries would prefer a fixed rate regime for the following reasons: stability in international prices inherent anti-inflationary nature of fixed prices However, a fixed rate regime has the following problems: Need for central banks to maintain large quantities of hard currencies and gold to defend the fixed rate Fixed rates can be maintained at rates that are inconsistent with economic fundamentals Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

41 Attributes of the “Ideal” CurrencyPossesses three attributes, often referred to as the Impossible Trinity: Exchange rate stability Full financial integration Monetary independence The forces of economics to not allow the simultaneous achievement of all three Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

42 Emerging Markets and Regime ChoicesA currency board exists when a country’s central bank commits to back its monetary base – its money supply – entirely with foreign reserves at all times. This means that a unit of domestic currency cannot be introduced into the economy without an additional unit of foreign exchange reserves being obtained first. Argentina moved from a managed exchange rate to a currency board in 1991 In 2002, the country ended the currency board as a result of substantial economic and political turmoil Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

43 Emerging Markets and Regime ChoicesDollarization is the use of the US dollar as the official currency of the country. One attraction of dollarization is that sound monetary and exchange-rate policies no longer depend on the intelligence and discipline of domestic policymakers. Panama has used the dollar as its official currency since 1907 Ecuador replaced its domestic currency with the US dollar in September, 2000 Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

44 The Euro: Birth of a European CurrencyIn December 1991, the members of the European Union met at Maastricht, the Netherlands to finalize a treaty that changed Europe’s currency future. This treaty set out a timetable and a plan to replace all individual ECU currencies with a single currency called the euro. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

45 The Euro: Birth of a European CurrencyTo prepare for the EMU, a convergence criteria was laid out whereby each member country was responsible for managing the following to a specific level: Nominal inflation rates Long-term interest rates Fiscal deficits Government debt In addition, a strong central bank, called the European Central Bank (ECB), was established in Frankfurt, Germany. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

46 Effects of the Euro The euro affects markets in three ways:Cheaper transactions costs in the Euro Zone Currency risks and costs related to uncertainty are reduced All consumers and businesses both inside and outside the Euro Zone enjoy price transparency and increased price-based competition Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

47 Achieving Monetary UnificationIf the euro is to be successful, it must have a solid economic foundation. The primary driver of a currency’s value is its ability to maintain its purchasing power. The single largest threat to maintaining purchasing power is inflation, so the job of the EU has been to prevent inflationary forces from undermining the euro. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

48 Exchange Rate Regimes: The FutureAll exchange rate regimes must deal with the tradeoff between rules and discretion (vertical), as well as between cooperation and independence (horizontal). The pre WWI Gold Standard required adherence to rules and allowed independence. The Bretton Woods agreement (and to a certain extent the EMS) also required adherence to rules in addition to cooperation. The present system is characterized by no rules, with varying degrees of cooperation. Many believe that a new international monetary system could succeed only if it combined cooperation among nations with individual discretion to pursue domestic social, economic, and financial goals. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

49 The Balance of PaymentsChapter 3 The Balance of Payments

50 The Balance of PaymentsInternational business transactions occur in many different forms over the course of a year. The measurement of all international economic transactions between the residents of a country and foreign residents is called the balance of payments (BOP). Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

51 The Balance of PaymentsBOP data is important for government policymakers and MNEs as it is a gauge of a nations competitiveness or health (domestic and/or foreign). For a MNE both home and host country BOP data is important as: An indication of pressure on a country’s foreign exchange rate A signal of the imposition or removal of controls in various sorts of payments (dividends, interest, license fees, royalties and other cash disbursements) A forecast of a country’s market potential (especially in the short run) Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

52 Typical BOP TransactionsEach of the following represents an international economic transaction that is counted in and captured in the US BOP: A US subsidiary of a foreign MNE acts as a distributor for the MNEs products in the US market A US based firm, manages the construction of a major water treatment facility in a foreign country The US subsidiary of a foreign firm pays profits (dividends) back to a parent in its home (foreign) country The US government finances the purchase of military equipment for a foreign military ally Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

53 Fundamentals of BOP AccountingThe BOP must balance. It cannot be in disequilibrium unless something has not been counted or has been counted improperly. Therefore it is incorrect to state that the BOP is in disequilibrium. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

54 Fundamentals of BOP AccountingThere are three main elements of the actual process of measuring international economic activity: Identifying what is and is not an international economic transaction Understanding how the flow of goods, services, assets, and money create debits and credits to the overall BOP Understanding the bookkeeping procedures for BOP accounting It is a daunting task to measure all international transactions that take place in and out of a country over a year. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

55 The BOP as a Flow StatementThe BOP is often misunderstood as many people infer from its name that it is a balance sheet, whereas in fact it is a cash flow statement. By recording all international transactions over a period of time such as a year, it tracks the continuing flows of purchases and payments between a country and all other countries. It does not add up the value of all assets and liabilities of a country on a specific date (as an individual firm’s balance sheet would do). Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

56 The BOP as a Flow StatementTwo types of business transactions dominate the balance of payments: Exchange of Real Assets Exchange of Financial Assets Although assets can be identified as belonging to distinct groups, it is easier to think of all assets simply as goods that can be bought or sold (a clock versus a bond). Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

57 The Accounts of the BOP The BOP is composed of two primary sub accounts, the Current Account and the Capital/Financial Account. In addition, the Official Reserves account tracks government currency transactions. A fourth account, the Net Errors and Omissions account is produced to preserve the balance of the BOP. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

58 The Current Account The Current Account includes all international economic transactions with income or payment flows occurring within one year, the current period. It consists of the following four subcategories: Goods trade and import of goods Services trade Income Current transfers The Current Account is typically dominated by the first component which is known as the Balance of Trade (BOT) even though it excludes service trade. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

59 Exhibit 3.3 U.S. Trade Balance & Balance on Services & Income, 1985-2000 (billions of US$)Source: International Monetary Fund, Balance of Payments Statistics Yearbook, 2001. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

60 The Current Account The deficits in the BOT of the past decade have been an area of considerable concern for the United States, in both the public and private sectors. The goods trade deficit saw the decline of heavy traditional industries in the US (steel, automobiles, automotive parts, textiles) Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

61 The Capital/Financial AccountThe Capital Account of the balance of payments measures all international economic transactions of financial assets. It is divided into two major components: The Capital Account The Financial Account The Capital Account is minor (in magnitude), while the Financial Account is significant. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

62 The Financial Account Financial assets can be classified in a number of different ways including the length of the life of the asset (maturity) and the nature of the ownership (public or private). The Financial Account, however, uses a third method. This focuses on the degree of investor control over the assets or operations. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

63 The Financial Account The Financial Account consists of three components; Direct Investment – in which the investor exerts some explicit degree of control over the assets Portfolio Investment – in which the investor has no control over the assets Other Investment – consists of various short-term and long-term trade credits, cross-border loans, currency deposits, bank deposits and other A/R and A/P related to cross-border trade Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

64 Direct Investment This is the net balance of capital dispersed from and into the US for the purpose of exerting control over assets. Foreign direct investment arises from 10% ownership of voting shares in a domestic firm by foreign investors. The source of concern over foreign investment in any country focuses on two topics: control and profit. Some countries possess restrictions on foreigners may own in their country. The general rule or premise is that domestic land, assets and industry should be owned by residents of the country. Concerns over profit stem from the same argument. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

65 Portfolio Investment This is the net balance of capital that flows in and out of the US but does not reach the 10% threshold of direct investment. The purchase of debt securities across borders is classified as portfolio investment because debt securities by definition do not provide the buyer with ownership or control. Portfolio investment is motivated by a search for returns rather than to control or manage the investment. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

66 Exhibit 3.6 Current and Financial/Capital Account Balances for the United States, (billions of US$) Source: International Monetary Fund, Balance of Payments Statistics Yearbook, 2001. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

67 Net Errors & Omissions/Official Reserves AccountsThe Net Errors and Omissions account ensures that the BOP actually balances. The Official Reserves Account is the total reserves held by official monetary authorities within the country. These reserves are normally composed of the major currencies used in international trade and financial transactions (hard currencies). The significance of official reserves depends generally on whether the country is operating under a fixed exchange rate regime or a floating exchange rate system. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

68 The BOP in Total — SurplusA surplus in the BOP implies that the demand for the country’s currency exceeded the supply and that the government should allow the currency value to increase – in value – or intervene and accumulate additional foreign currency reserves in the Official Reserves Account. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

69 The BOP in Total — DeficitA deficit in the BOP implies an excess supply of the country’s currency on world markets, and the government should then either devalue the currency or expend its official reserves to support its value. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

70 Capital Mobility The degree to which capital moves freely across borders is critically important to a country’s balance of payments. While capital has not always been free to move in and out of a country, it clearly has increased over the past 40 years (exhibit 3.8). Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

71 Exhibit 3.8 A Stylized View of Capital Mobility in Modern History• 2000 Gold Standard • 1914 High • 1900 Float 1929 • • • Bretton Woods 1880 1980 • • • 1960 Low 1860 • • 1918 1925 • 1971 Interwar, 1945 1860 1880 1900 1920 1940 1960 1980 2000 Source: “Globalization and Capital Markets,” Maurice Obstfeld and Alan M. Taylor, NBER Conference Paper, May 4-5, 2001, p. 6.

72 Capital Mobility The authors argue that the post-1860 era can be subdivided into four distinct periods with regard to capital mobility. – continuously increasing capital mobility as the gold standard was adopted and international trade relations were expanded – global economic destruction, isolationist economic policies, negative effect on capital movement between countries – Bretton Woods era say a great expansion of international trade – floating exchange rates, economic volatility, rapidly expanding cross-border capital flows Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

73 Capital Flight Although no single definition of capital flight exists, it has been characterized as occurring when capital transfers by residents conflict with political objectives. Many heavily indebted countries have suffered capital flight, compounding their debt service problems. Capital can be moved via international transfers, with physical currency, collectables or precious metals, money laundering or false invoicing of international trade transactions. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

74 The Foreign Exchange MarketChapter 4 The Foreign Exchange Market

75 The Foreign Exchange MarketThe Foreign Exchange Market provides: The physical and institutional structure through which the money of one country is exchanged for that of another country The determination rate of exchange between currencies Is where foreign exchange transactions are physically completed Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

76 The Foreign Exchange MarketForeign exchange means the money of a foreign country; that is, foreign currency bank balances, banknotes, checks and drafts. A foreign exchange transaction is an agreement between a buyer and a seller that a fixed amount of one currency will be delivered for some other currency at a specified date. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

77 Geography The foreign exchange market spans the globe, with prices moving and currencies trading somewhere every hour of every business day. As the next exhibit will illustrate, the volume of currency transactions ebbs and flows across the globe as the major currency trading centers open and close throughout the day. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

78 Exhibit 4.1 Measuring Foreign Exchange Market Activity: Average Electronic Conversations Per HourGreenwich Mean Time Tokyo opens Asia closing 10 AM In Tokyo Afternoon in America London 6 pm In NY Americas open Europe opening Lunch Source: Federal Reserve Bank of New York, “The Foreign Exchange Market in the United States,” 2001, Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

79 Functions of the Foreign Exchange MarketThe foreign exchange Market is the mechanism by which participants: Transfer purchasing power between countries Obtain or provide credit for international trade transactions Minimize exposure to the risks of exchange rate changes Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

80 Market Participants The foreign exchange market consists of two tiers:The interbank or wholesale market (multiples of $1MM US or equivalent in transaction size) The client or retail market (specific, smaller amounts) Five broad categories of participants operate within these two tiers; bank and nonbank foreign exchange dealers, individuals and firms, speculators and arbitragers, central banks and treasuries, and foreign exchange brokers.

81 Bank and Nonbank Foreign Exchange DealersBanks and a few nonbank foreign exchange dealers operate in both the interbank and client markets. The profit from buying foreign exchange at a “bid” price and reselling it at a slightly higher “offer” or “ask” price. Dealers in the foreign exchange department of large international banks often function as “market makers.” These dealers stand willing at all times to buy and sell those currencies in which they specialize and thus maintain an “inventory” position in those currencies. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

82 Individuals and Firms Individuals (such as tourists) and firms (such as importers, exporters and MNEs) conduct commercial and investment transactions in the foreign exchange market. Their use of the foreign exchange market is necessary but nevertheless incidental to their underlying commercial or investment purpose. Some of the participants use the market to “hedge” foreign exchange risk. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

83 Speculators and ArbitragersSpeculators and arbitragers seek to profit from trading in the market itself. They operate in their own interest, without a need or obligation to serve clients or ensure a continuous market. While dealers seek the bid/ask spread, speculators seek all the profit from exchange rate changes and arbitragers try to profit from simultaneous exchange rate differences in different markets. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

84 Central Banks and TreasuriesCentral banks and treasuries use the market to acquire or spend their country’s foreign exchange reserves as well as to influence the price at which their own currency is traded. They may act to support the value of their own currency because of policies adopted at the national level or because of commitments entered into through membership in joint agreements such as the European Monetary System. The motive is not to earn a profit as such, but rather to influence the foreign exchange value of their currency in a manner that will benefit the interests of their citicizens. As willing loss takers, central banks and treasuries differ in motive from all other market participants. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

85 Foreign Exchange BrokersForeign exchange brokers are agents who facilitate trading between dealers without themselves becoming principals in the transaction. For this service, they charge a commission. It is a brokers business to know at any moment exactly which dealers want to buy or sell any currency. Dealers use brokers for their speed, and because they want to remain anonymous since the identity of the participants may influence short term quotes. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

86 Transactions in the Interbank MarketA Spot transaction in the interbank market is the purchase of foreign exchange, with delivery and payment between banks to take place, normally, on the second following business day. The date of settlement is referred to as the value date. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

87 Transactions in the Interbank MarketAn outright forward transaction (usually called just “forward”) requires delivery at a future value date of a specified amount of one currency for a specified amount of another currency. The exchange rate is established at the time of the agreement, but payment and delivery are not required until maturity. Forward exchange rates are usually quoted for value dates of one, two, three, six and twelve months. Buying Forward and Selling Forward describe the same transaction (the only difference is the order in which currencies are referenced.) Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

88 Transactions in the Interbank MarketA swap transaction in the interbank market is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates. Both purchase and sale are conducted with the same counterparty. Some different types of swaps are: Spot against forward Forward-Forward Nondeliverable Forwards (NDF) Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

89 Market Size In April 2001, a survey conducted by the Bank for International Settlements (BIS) estimated the daily global net turnover in traditional foreign exchange market activity to be $1,210 billion. This was the first decline observed by the BIS since it began surveying banks on foreign currency trading in the 1980s. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

90 Exhibit 4.2 Global Foreign Exchange Market Turnover (daily averages in April, billions of US dollars) Source: Bank for International Settlements, “Central Bank Survey of Foreign Exchange and Derivatives Market Activity in April 2001,” October 2001, Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

91 Exhibit 4.3 Geographic Distribution of Foreign Exchange Market Turnover (daily averages in April, billions of US dollars) Source: Bank for International Settlements, “Central Bank Survey of Foreign Exchange and Derivatives Market Activity in April 2001,” October 2001,

92 Exhibit 4.4 Currency Distribution of Global Foreign Exchange Market Turnover (percentage shares of average daily turnover in April) Because all exchange transactions involve two currencies, percentage shares total to 200% Source: Bank for International Settlements, “Central Bank Survey of Foreign Exchange and Derivatives Market Activity in April 2001,” October 2001,

93 Foreign Exchange Rates and QuotationsA foreign exchange rate is the price of one currency expressed in terms of another currency. A foreign exchange quotation (or quote) is a statement of willingness to buy or sell at an announced rate. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

94 Foreign Exchange Rates and QuotationsMost foreign exchange transactions involve the US dollar. Professional dealers and brokers may state foreign exchange quotations in one of two ways: The foreign currency price of one dollar The dollar price of a unit of foreign currency Most foreign currencies in the world are stated in terms of the number of units of foreign currency needed to buy one dollar. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

95 Foreign Exchange Rates and QuotationsFor example, the exchange rate between US dollars and the Swiss franc is normally stated: SF /$ (European terms) However, this rate can also be stated as: $0.6250/SF (American terms) Excluding two important exceptions, most interbank quotations around the world are stated in European terms. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

96 Foreign Exchange Rates and QuotationsAs mentioned, several exceptions exist to the use of European terms quotes. The two most important are quotes for the euro and U.K. pound sterling which are both normally quoted in American terms. American terms are also utilized in quoting rates for most foreign currency options and futures, as well as in retail markets that deal with toursists. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

97 Foreign Exchange Rates and QuotationsForeign exchange quotes are at times described as either direct or indirect. In this pair of definitions, the home or base country of the currencies being discussed is critical. A direct quote is a home currency price of a unit of foreign currency. An indirect quote is a foreign currency price of a unit of home currency. The form of the quote depends on what the speaker regard as “home.” Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

98 Foreign Exchange Rates and QuotationsInterbank quotations are given as a bid and ask (also referred to as offer). A bid is the price (i.e. exchange rate) in one currency at which a dealer will buy another currency. An ask is the price (i.e. exchange rate) at which a dealer will sell the other currency. Dealers bid (buy) at one price and ask (sell) at a slightly higher price, making their profit from the spread between the buying and selling prices. A bid for one currency is also the offer for the opposite currency. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

99 Foreign Exchange Rates and QuotesForward rates are typically quoted in terms of points. A forward quotation is expressed in points is not a foreign exchange rate as such. Rather, it is the difference between the forward rate and the spot rate. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

100 Foreign Exchange Rates and QuotesForward quotations may also be expressed as the percent-per-annum deviation from the spot rate. This method of quotation facilitates comparing premiums or discounts in the forward market with interest rate differentials. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

101 Foreign Exchange Rates and QuotesFor quotations expressed in foreign currency terms (Indirect quotations) the formula becomes: f ¥ = Spot – Forward For quotations expressed in home currency terms (Direct quotations) the formula becomes: f ¥ = Forward – Spot 100 n Forward x 100 n Spot x Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

102 Foreign Exchange Rates and QuotesMany currency pairs are only inactively traded, so their exchange rate is determined through their relationship to a widely traded third currency (cross rate). Cross rates can be used to check on opportunities for intermarket arbitrage. This situation arose because one bank’s (Dresdner) quotation on €/£ is not the same a calculated cross rate between $/£ (Barclay’s) and $/€ (Citibank). Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

103 Foreign Exchange Rates and QuotesCitibank quote - $/€ $0.9045/€ Barclays quote - $/£ $1.4443/£ Dresdner quote - €/£ €1.6200/£ Cross rate calculation: $1.4443/£ = = € /£ $0.9045/€ Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

104 Exhibit 4.9A Triangular ArbitrageCitibank End with $1,014,533 Start with $1,000,000 (6) Receive $1,014,533 (1) Sell $1,000,000 to Barclays Bank at $1.4443/£ Dresdner Bank Barclays Bank (5) Sell €1,121,651 to Citibank at $0.9045/€ (2) Receive £692,377 (4) (3) Sell £692,377 to Dresnder Bank at €1.6200/£ Receive €1,121,651

105 Foreign Exchange Rates and QuotesMeasuring a change in the spot rate for quotations expressed in home currency terms (direct quotations): %∆ = Ending rate – Beginning Rate Quotations expressed in foreign currency terms (indirect quotations): %∆ = Beginning Rate – Ending Rate Beginning Rate x 100 Ending Rate x 100 Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

106 Foreign Currency DerivativesChapter 5 Foreign Currency Derivatives

107 Foreign Currency DerivativesFinancial management of the MNE in the 21st century involves financial derivatives. These derivatives, so named because their values are derived from underlying assets, are a powerful tool used in business today. These instruments can be used for two very distinct management objectives: Speculation – use of derivative instruments to take a position in the expectation of a profit Hedging – use of derivative instruments to reduce the risks associated with the everyday management of corporate cash flow Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

108 Foreign Currency FuturesA foreign currency futures contract is an alternative to a forward contract that calls for future delivery of a standard amount of foreign exchange at a fixed time, place and price. It is similar to futures contracts that exist for commodities such as cattle, lumber, interest-bearing deposits, gold, etc. In the US, the most important market for foreign currency futures is the International Monetary Market (IMM), a division of the Chicago Mercantile Exchange. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

109 Foreign Currency FuturesContract specifications are established by the exchange on which futures are traded. Major features that are standardized are: Contract size Method of stating exchange rates Maturity date Last trading day Collateral and maintenance margins Settlement Commissions Use of a clearinghouse as a counterparty Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

110 Foreign Currency FuturesForeign currency futures contracts differ from forward contracts in a number of important ways: Futures are standardized in terms of size while forwards can be customized Futures have fixed maturities while forwards can have any maturity (both typically have maturities of one year or less) Trading on futures occurs on organized exchanges while forwards are traded between individuals and banks Futures have an initial margin that is market to market on a daily basis while only a bank relationship is needed for a forward Futures are rarely delivered upon (settled) while forwards are normally delivered upon (settled) Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

111 Foreign Currency OptionsA foreign currency option is a contract giving the option purchaser (the buyer) the right, but not the obligation, to buy or sell a given amount of foreign exchange at a fixed price per unit for a specified time period (until the maturity date). There are two basic types of options, puts and calls. A call is an option to buy foreign currency A put is an option to sell foreign currency Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

112 Foreign Currency OptionsThe buyer of an option is termed the holder, while the seller of the option is referred to as the writer or grantor. Every option has three different price elements: The exercise or strike price – the exchange rate at which the foreign currency can be purchased (call) or sold (put) The premium – the cost, price, or value of the option itself The underlying or actual spot exchange rate in the market Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

113 Foreign Currency OptionsAn American option gives the buyer the right to exercise the option at any time between the date of writing and the expiration or maturity date. A European option can be exercised only on its expiration date, not before. The premium, or option price, is the cost of the option. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

114 Foreign Currency OptionsAn option whose exercise price is the same as the spot price of the underlying currency is said to be at-the-money (ATM). An option the would be profitable, excluding the cost of the premium, if exercised immediately is said to be in-the-money (ITM). An option that would not be profitable, again excluding the cost of the premium, if exercised immediately is referred to as out-of-the money (OTM) Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

115 Foreign Currency OptionsIn the past three decades, the use of foreign currency options as a hedging tool and for speculative purposes has blossomed into a major foreign exchange activity. Options on the over-the-counter (OTC) market can be tailored to the specific needs of the firm but can expose the firm to counterparty risk. Options on organized exchanges are standardized, but counterparty risk is substantially reduced. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

116 Foreign Currency SpeculationSpeculation is an attempt to profit by trading on expectations about prices in the future. Speculators can attempt to profit in the: Spot market – when the speculator believes the foreign currency will appreciate in value Forward market – when the speculator believes the spot price at some future date will differ from today’s forward price for the same date Options markets – extensive differences in risk patters produced depending on purchase or sale of put and/or call Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

117 Option Market SpeculationBuyer of a call: Assume purchase of August call option on Swiss francs with strike price of 58½ ($0.5850/SF), and a premium of $0.005/SF At all spot rates below the strike price of 58.5, the purchase of the option would choose not to exercise because it would be cheaper to purchase SF on the open market At all spot rates above the strike price, the option purchaser would exercise the option, purchase SF at the strike price and sell them into the market netting a profit (less the option premium) Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

118 Exhibit 5.4 Profit and Loss for the Buyer of a Call Option on Swiss francs“Out of the money” “In the money” “At the money” Profit (US cents/SF) Strike price + 1.00 Limited loss Unlimited profit + 0.50 Spot price (US cents/SF) 57.5 58.0 58.5 59.0 59.5 Break-even price - 0.50 - 1.00 Loss The buyer of a call option on SF, with a strike price of 58.5 cents/SF, has a limited loss of 0.50 cents/SF at spot rates less than 58.5 (“out of the money”), and an unlimited profit potential at spot rates above 58.5 cents/SF (“in the money”).

119 Option Market SpeculationWriter of a call: What the holder, or buyer of an option loses, the writer gains The maximum profit that the writer of the call option can make is limited to the premium If the writer wrote the option naked, that is without owning the currency, the writer would now have to buy the currency at the spot and take the loss delivering at the strike price The amount of such a loss is unlimited and increases as the underlying currency rises Even if the writer already owns the currency, the writer will experience an opportunity loss Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

120 Exhibit 5.5 Profit and Loss for the Writer of a Call Option on Swiss francs“At the money” Profit (US cents/SF) Strike price + 1.00 + 0.50 Break-even price Limited profit Unlimited loss Spot price (US cents/SF) 57.5 58.0 58.5 59.0 59.5 - 0.50 - 1.00 Loss The writer of a call option on SF, with a strike price of 58.5 cents/SF, has a limited profit of 0.50 cents/SF at spot rates less than 58.5, and an unlimited loss potential at spot rates above (to the right of) 59.0 cents/SF.

121 Option Market SpeculationBuyer of a Put: The basic terms of this example are similar to those just illustrated with the call The buyer of a put option, however, wants to be able to sell the underlying currency at the exercise price when the market price of that currency drops (not rises as in the case of the call option) If the spot price drops to $0.575/SF, the buyer of the put will deliver francs to the writer and receive $0.585/SF At any exchange rate above the strike price of 58.5, the buyer of the put would not exercise the option, and would lose only the $0.05/SF premium The buyer of a put (like the buyer of the call) can never lose more than the premium paid up front Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

122 Exhibit 5.6 Profit and Loss for the Buyer of a Put Option on Swiss francs“In the money” “Out of the money” “At the money” Profit (US cents/SF) Strike price + 1.00 Limited loss Profit up to 58.0 + 0.50 Spot price (US cents/SF) 57.5 58.0 58.5 59.0 59.5 Break-even price - 0.50 - 1.00 Loss The buyer of a put option on SF, with a strike price of 58.5 cents/SF, has a limited loss of 0.50 cents/SF at spot rates greater than 58.5 (“out of the money”), and an unlimited profit potential at spot rates less than 58.5 cents/SF (“in the money”) up to 58.0 cents.

123 Option Market SpeculationSeller (writer) of a put: In this case, if the spot price of francs drops below 58.5 cents per franc, the option will be exercised Below a price of 58.5 cents per franc, the writer will lose more than the premium received fro writing the option (falling below break-even) If the spot price is above $0.585/SF, the option will not be exercised and the option writer will pocket the entire premium Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

124 Exhibit 5.7 Profit and Loss for the Writer of a Put Option on Swiss francs“At the money” Profit (US cents/SF) Strike price + 1.00 Break-even price + 0.50 Unlimited loss up to 58.0 Limited profit Spot price (US cents/SF) 57.5 58.0 58.5 59.0 59.5 - 0.50 - 1.00 Loss The writer of a put option on SF, with a strike price of 58.5 cents/SF, has a limited profit of 0.50 cents/SF at spot rates greater than 58.5, and an unlimited loss potential at spot rates less than 58.5 cents/SF up to 58.0 cents.

125 Option Pricing and ValuationThe pricing of any currency option combines six elements: Present spot rate Time to maturity Forward rate for matching maturity US dollar interest rate Foreign currency interest rate Volatility (standard deviation of daily spot price movements) Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

126 Option Pricing and ValuationThe total value (premium) of an option is equal to the intrinsic value plus time value. Intrinsic value is the financial gain if the option is exercised immediately. For a call option, intrinsic value is zero when the strike price is above the market price When the spot price rises above the strike price, the intrinsic value become positive Put options behave in the opposite manner On the date of maturity, an option will have a value equal to its intrinsic value (zero time remaining means zero time value) The time value of an option exists because the price of the underlying currency, the spot rate, can potentially move further and further into the money between the present time and the option’s expiration date. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

127 Exhibit 5.8 Intrinsic Value, Time Value & Total Value for a Call Option on British Pounds with a Strike Price of $1.70/£ Option Premium (US cents/£) -- Valuation on first day of 90-day maturity -- 6.0 5.67 Total value 5.0 4.0 4.00 3.30 3.0 2.0 1.67 Time value Intrinsic value 1.0 0.0 1.66 1.67 1.68 1.69 1.70 1.71 1.72 1.73 1.74 Spot rate ($/£)

128 Currency Option Pricing SensitivityIf currency options are to be used effectively, either for the purposes of speculation or risk management, the individual trader needs to know how option values – premiums – react to their various components. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

129 Currency Option Pricing SensitivityForward rate sensitivity: Standard foreign currency options are priced around the forward rate because the current spot rate and both the domestic and foreign interest rates are included in the option premium calculation The option-pricing formula calculates a subjective probability distribution centered on the forward rate This approach does not mean that the market expects the forward rate to be equal to the future spot rate, it is simply a result of the arbitrage-pricing structure of options Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

130 Currency Option Pricing SensitivitySpot rate sensitivity (delta): The sensitivity of the option premium to a small change in the spot exchange rate is called the delta delta = Δ premium The higher the delta, the greater the probability of the option expiring in-the-money Δ spot rate Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

131 Currency Option Pricing SensitivityTime to maturity – value and deterioration (theta): Option values increase with the length of time to maturity theta = Δ premium A trader will normally find longer-maturity option better values, giving the trader the ability to alter an option position without suffering significant time value deterioration Δ time Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

132 Exhibit 5.11 Theta: Option Premium Time Value Deterioration(US cents/£) A Call Option on British Pounds: Spot Rate = $1.70/£ 7.0 In-the-money (ITM) call ($1.65 strike price) 6.0 5.0 4.0 At-the-money (ATM) call ($1.70 strike price) 3.0 2.0 Out-of-the-money (OTM) call ($1.75 strike price) 1.0 0.0 90 80 70 60 50 40 30 20 10 Days remaining to maturity

133 Currency Option Pricing SensitivitySensitivity to volatility (lambda): Option volatility is defined as the standard deviation of daily percentage changes in the underlying exchange rate Volatility is important to option value because of an exchange rate’s perceived likelihood to move either into or out of the range in which the option will be exercised lambda = Δ premium Δ volatility Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

134 Currency Option Pricing SensitivityVolatility is viewed in three ways: Historic Forward-looking Implied Because volatilities are the only judgmental component that the option writer contributes, they play a critical role in the pricing of options. All currency pairs have historical series that contribute to the formation of the expectations of option writers. In the end, the truly talented option writers are those with the intuition and insight to price the future effectively. Traders who believe that volatilities will fall significantly in the near-term will sell (write) options now, hoping to buy them back for a profit immediately volatilities fall, causing option premiums to fall. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

135 Currency Option Pricing SensitivitySensitivity to changing interest rate differentials (rho and phi): Currency option prices and values are focused on the forward rate The forward rate is in turn based on the theory of Interest Rate Parity Interest rate changes in either currency will alter the forward rate, which in turn will alter the option’s premium or value A trader who is purchasing a call option on foreign currency should do so before the domestic interest rate rises. This timing will allow the trader to purchase the option before its price increases. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

136 Currency Option Pricing SensitivityThe expected change in the option premium from a small change in the domestic interest rate (home currency) is the term rho. rho = Δ premium The expected change in the option premium from a small change in the foreign interest rate (foreign currency) is termed phi. phi = Δ premium Δ US $ interest rate Δ foreign interest rate Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

137 Exhibit 5.13 Interest Differentials and Call Option PremiumsOption Premium (US cents/£) 8.0 A Call Option on British Pounds: Spot Rate = $1.70/£ 7.0 ITM call ($1.65 strike price) 6.0 5.0 4.0 ATM call ($1.70 strike price) 3.0 2.0 OTM call ($1.75 strike price) 1.0 0.0 -4.0 -3.0 -2.0 -1.0 1.0 2.0 3.0 4.0 5.0 Interest differential: iUS$ - i £ (percentage)

138 Currency Option Pricing SensitivityThe sixth and final element that is important to option valuation is the selection of the actual strike price. A firm must make a choice as per the strike price it wishes to use in constructing an option (OTC market). Consideration must be given to the tradeoff between strike prices and premiums. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

139 Exhibit 5.14 Option Premiums for Alternative Strike Rates(US cents/£) 7.0 Current spot rate = $1.70/£ 6.0 5.0 OTM Strike rates 4.0 3.0 ITM Strike rates 2.0 1.0 0.0 1.66 1.67 1.68 1.69 1.70 1.71 1.72 1.73 1.74 1.75 Call strike price (U.S. dollars/£)

140 International Parity ConditionsChapter 6 International Parity Conditions

141 International Parity ConditionsSome fundamental questions managers of MNEs, international portfolio investors, importers, exporters and government officials must deal with every day are: What are the determinants of exchange rates? Are changes in exchange rates predictable? The economic theories that link exchange rates, price levels, and interest rates together are called international parity conditions. These international parity conditions form the core of the financial theory that is unique to international finance. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

142 Prices and Exchange RatesIf the identical product or service can be sold in two different markets, and no restrictions exist on the sale or transportation costs of moving the product between markets, the products price should be the same in both markets. This is called the law of one price. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

143 Prices and Exchange RatesA primary principle of competitive markets is that prices will equalize across markets if frictions (transportation costs) do not exist. Comparing prices then, would require only a conversion from one currency to the other: P$ x S = P¥ Where the product price in US dollars is (P$), the spot exchange rate is (S) and the price in Yen is (P¥). Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

144 Prices and Exchange RatesIf the law of one price were true for all goods and services, the purchasing power parity (PPP) exchange rate could be found from any individual set of prices. By comparing the prices of identical products denominated in different currencies, we could determine the “real” or PPP exchange rate that should exist if markets were efficient. This is the absolute version of the PPP theory. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

145 Exhibit 6.2 Purchasing Power Parity (PPP)PPP line Percent change in the spot exchange rate for foreign currency 4 P 3 2 1 -6 -5 -4 -3 -2 -1 1 2 3 4 5 6 -1 Percent difference in expected rates of inflation (foreign relative to home country) -2 -3 -4 Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

146 Prices and Exchange RatesIf the assumptions of the absolute version of the PPP theory are relaxed a bit more, we observe what is termed relative purchasing power parity (RPPP). RPPP holds that PPP is not particularly helpful in determining what the spot rate is today, but that the relative change in prices between two countries over a period of time determines the change in the exchange rate over that period. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

147 Prices and Exchange RatesMore specifically, with regard to RPPP, if the spot exchange rate between two countries starts in equilibrium, any change in the differential rate of inflation between them tends to be offset over the long run by an equal but opposite change in the spot exchange rate. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

148 Prices and Exchange RatesEmpirical testing of PPP and the law of one price has been done, but has not proved PPP to be accurate in predicting future exchange rates. Two general conclusions can be made from these tests: PPP holds up well over the very long run but poorly for shorter time periods The theory holds better for countries with relatively high rates of inflation and underdeveloped capital markets Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

149 Prices and Exchange RatesIndividual national currencies often need to be evaluated against other currency values to determine relative purchasing power. The objective is to discover whether a nation’s exchange rate is “overvalued” or “undervalued” in terms of PPP. This problem is often dealt with through the calculation of exchange rate indices such as the nominal effective exchange rate index. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

150 Exhibit 6.3 IMF’s Real Effective Exchange Rate Indexes for the United States & Japan (1995 = 100)Source: International Financial Statistics, International Monetary Fund, monthly, 1995=100. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

151 Prices and Exchange RatesThe degree to which the prices of imported and exported goods change as a result of exchange rate changes is termed pass-through. Although PPP implies that all exchange rate changes are passed through by equivalent changes in prices to trading partners, empirical research in the 1980s questioned this long-held assumption. For example, a car manufacturer may or may not adjust pricing of its cars sold in a foreign country if exchange rates alter the manufacturer’s cost structure in comparison to the foreign market. Pass-through can also be partial as there are many mechanisms by which companies can compartmentalize or absorb the impact of exchange rate changes. Price elasticity of demand is an important factor when determining pass-through levels. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

152 Interest Rates and Exchange RatesThe Fisher Effect states that nominal interest rates in each country are equal to the required real rate of return plus compensation for expected inflation. This equation reduces to (in approximate form): i = r + π Where i = nominal interest rate, r = real interest rate and π = expected inflation. Empirical tests (using ex-post) national inflation rates have shown the Fisher effect usually exists for short-maturity government securities (treasury bills and notes). Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

153 Interest Rates and Exchange RatesThe relationship between the percentage change in the spot exchange rate over time and the differential between comparable interest rates in different national capital markets is known as the international Fisher effect. “Fisher-open”, as it is termed, states that the spot exchange rate should change in an equal amount but in the opposite direction to the difference in interest rates between two countries. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

154 Interest Rates and Exchange RatesMore formally: S1 – S2 Where i$ and i¥ are the respective national interest rates and S is the spot exchange rate using indirect quotes (¥/$). Justification for the international Fisher effect is that investors must be rewarded or penalized to offset the expected change in exchange rates. S2 x 100 = i$ - i¥ Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

155 Interest Rates and Exchange RatesA forward rate is an exchange rate quoted for settlement at some future date. A forward exchange agreement between currencies states the rate of exchange at which a foreign currency will be bought forward or sold forward at a specific date in the future. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

156 Interest Rates and Exchange RatesThe forward rate is calculated for any specific maturity by adjusting the current spot exchange rate by the ratio of eurocurrency interest rates of the same maturity for the two subject currencies. For example, the 90-day forward rate for the Swiss franc/US dollar exchange rate (FSF/$90) is found by multiplying the current spot rate (SSF/$) by the ratio of the 90-day euro-Swiss franc deposit rate (iSF) over the 90-day eurodollar deposit rate (i$). Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

157 Interest Rates and Exchange RatesFormulaic representation of the forward rate: FSF/$90 = SSF/$ x [1 + (iSF x 90/360)] [1 + (i$ x 90/360)] Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

158 Interest Rates and Exchange RatesThe forward premium or discount is the percentage difference between the spot and forward exchange rate, stated in annual percentage terms. f SF = Spot – Forward This is the case when the foreign currency price of the home currency is used (SF/$). 360 x x 100 Forward days Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

159 Interest Rates and Exchange RatesThe theory of Interest Rate Parity (IRP) provides the linkage between the foreign exchange markets and the international money markets. The theory states: The difference in the national interest rates for securities of similar risk and maturity should be equal to, but opposite in sign to, the forward rate discount or premium for the foreign currency, except for transaction costs. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

160 Exhibit 6.5 Currency Yield Curves & The Forward PremiumInterest yield Eurodollar yield curve 10.0 % 9.0 % 8.0 % 7.0 % Forward premium is the percentage difference of 3.96% 6.0 % 5.0 % Euro Swiss franc yield curve 4.0 % 3.0 % 2.0 % 1.0 % 30 60 90 120 150 180 Copyright © 2004 Pearson Addison-Wesley. All rights reserved. Days Forward

161 Exhibit 6.6 Interest Rate Parity (IRP)i $ = 8.00 % per annum (2.00 % per 90 days) Start End $1,000,000 x 1.02 $1,020,000 $1,019,993* Dollar money market 90 days S = SF /$ F90 = SF /$ Swiss franc money market SF 1,480,000 x 1.01 SF 1,494,800 i SF = 4.00 % per annum (1.00 % per 90 days) Note that the Swiss franc investment yields $1,019,993, $7 less on a $1 million investment. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

162 Interest Rates and Exchange RatesThe spot and forward exchange rates are not, however, constantly in the state of equilibrium described by interest rate parity. When the market is not in equilibrium, the potential for “risk-less” or arbitrage profit exists. The arbitrager will exploit the imbalance by investing in whichever currency offers the higher return on a covered basis. This is known as covered interest arbitrage (CIA). Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

163 Eurodollar rate = 8.00 % per annum Euroyen rate = 4.00 % per annumExhibit 6.7 Covered Interest Arbitrage (CIA) Eurodollar rate = 8.00 % per annum Start End $1,000,000 x 1.04 $1,040,000 $1,044,638 Arbitrage Potential Dollar money market 180 days S =¥ /$ F180 = ¥ /$ Yen money market ¥ 106,000,000 x 1.02 ¥ 108,120,000 Euroyen rate = 4.00 % per annum Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

164 Interest Rates and Exchange RatesA deviation from covered interest arbitrage is uncovered interest arbitrage (UIA). In this case, investors borrow in countries and currencies exhibiting relatively low interest rates and convert the proceed into currencies that offer much higher interest rates. The transaction is “uncovered” because the investor does no sell the higher yielding currency proceeds forward, choosing to remain uncovered and accept the currency risk of exchanging the higher yield currency into the lower yielding currency at the end of the period. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

165 Exhibit 6.8 Uncovered Interest Arbitrage (UIA): The Yen Carry TradeInvestors borrow yen at 0.40% per annum Start End ¥ 10,000,000 x ¥ 10,040,000 Repay ¥ 10,500,000 Earn ¥ ,000 Profit Japanese yen money market 360 days S =¥ /$ S360 = ¥ /$ US dollar money market $ 83,333,333 x 1.05 $ 87,500,000 Invest dollars at 5.00% per annum In the yen carry trade, the investor borrows Japanese yen at relatively low interest rates, converts the proceeds to another currency such as the U.S. dollar where the funds are invested at a higher interest rate for a term. At the end of the period, the investor exchanges the dollars back to yen to repay the loan, pocketing the difference as arbitrage profit. If the spot rate at the end of the period is roughly the same as at the start, or the yen has fallen in value against the dollar, the investor profits. If, however, the yen were to appreciate versus the dollar over the period, the investment may result in significant loss.

166 Interest Rates and Exchange RatesThe following exhibit illustrates the conditions necessary for equilibrium between interest rates and exchange rates. The disequilibrium situation, denoted by point U, is located off the interest rate parity line. However, the situation represented by point U is unstable because all investors have an incentive to execute the same covered interest arbitrage, which is virtually risk-free. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

167 Exhibit 6.9 Interest Rate Parity (IRP) and Equilibrium4 3 2 Percentage premium on foreign currency (¥) 1 4.83 -6 -5 -4 -3 -2 -1 1 2 3 4 5 6 -1 -2 -3 Percent difference between foreign (¥) and domestic ($) interest rates X U -4 Y Z Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

168 Exhibit 6.11 International Parity Conditions in Equilibrium (Approximate Form)Forecast change in spot exchange rate + 4 % (yen strengthens) Forward rate as an unbiased predictor ( E ) Purchasing power parity ( A ) Forward premium on foreign currency + 4 % (yen strengthens) Forecast difference in rates of inflation - 4 % (less in Japan) International Fisher Effect ( C ) Interest rate parity ( D ) Difference in nominal interest rates - 4 % (less in Japan) Fisher effect ( B )

169 Interest Rates and Exchange RatesSome forecasters believe that forward exchange rates are unbiased predictors of future spot exchange rates. Intuitively this means that the distribution of possible actual spot rates in the future is centered on the forward rate. Unbiased prediction simply means that the forward rate will, on average, overestimate and underestimate the actual future spot rate in equal frequency and degree. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

170 Exhibit 6.10 Forward Rate as an Unbiased Predictor for Future Spot RateExchange rate t 2 t 3 t 4 t 1 S2 F2 Error F3 S1 Error Error F1 S3 S4 Time t 2 t 3 t 4 t 1 The forward rate available today (Ft,t+1), time t, for delivery at future time t+1, is used as a “predictor” of the spot rate that will exist at that day in the future. Therefore, the forecast spot rate for time St2 is F1; the actual spot rate turns out to be S2. The vertical distance between the prediction and the actual spot rate is the forecast error. When the forward rate is termed an “unbiased predictor of the future spot rate,” it means that the forward rate over or underestimates the future spot rate with relatively equal frequency and amount. It therefore “misses the mark” in a regular and orderly manner. The sum of the errors equals zero. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

171 Foreign Exchange Rate DeterminationChapter 7 Foreign Exchange Rate Determination

172 Foreign Exchange Rate DeterminationChapter 6 described the international parity conditions that integrate exchange rates with inflation and interest rates. This chapter extends the discussion of exchange rate determination to the other two major schools of thought on the determination of exchange rates: The balance of payments approach The asset market approach Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

173 Exhibit 7.1 The Determinants of Foreign Exchange RatesParity Conditions 1. Relative inflation rates 2. Relative interest rates 3. Forward exchange rates 4. Interest rate parity Spot Exchange Rate Is there a sound and secure banking system in-place to support currency trading activities? Is there a well-developed and liquid money and capital market in that currency? Asset Approach 1. Relative real interest rates 2. Prospects for economic growth 3. Supply & demand for assets 4. Outlook for political stability 5. Speculation & liquidity 6. Political risks & controls Balance of Payments 1. Current account balances 2. Portfolio investment 3. Foreign direct investment 4. Exchange rate regimes 5. Official monetary reserves

174 Foreign Exchange Rate DeterminationIt is important to remember that these three theories are not competing, but rather are complementary to each other. Without the depth and breadth of the various approaches combined, our ability to capture the complexity of the global market for currencies is lost. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

175 Foreign Exchange Rate DeterminationIn addition to gaining an understanding of the basic theories, it is equally important to gain a working knowledge of how the complexities of international political economy; societal and economic infrastructures; and random political, economic, or social events affect the exchange rate markets. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

176 The Balance of Payments (BOP) ApproachThe relationship between the BOP and exchange rates can be illustrated by the use of a simplified equation that summarizes BOP data: (X – M) + (CI – CO) + (FI – FO) + FXB = BOP Where X = exports of goods and services, M = imports of goods and services, CI = capital inflows, CO = capital outflows, FI = financial inflows, FO = financial outflows and FXB = official monetary reserves. Current Account Balance Capital Account Balance Financial Account Balance Reserve Balance Balance of Payments Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

177 The Balance of Payments (BOP) ApproachFixed Exchange Rate Countries: Under a fixed exchange rate system, the government bears the responsibility to ensure a BOP near zero. To ensure a fixed exchange rate, the government must intervene in the foreign exchange market and buy or sell domestic currencies (or sell gold) to bring the BOP back to near zero. It is very important for a government to maintain significant foreign exchange reserve balances to allow it to intervene in the foreign exchange market effectively. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

178 Exhibit 7.3 Thailand’s Deteriorating Balance of Payments, 1991-1998Source: International Financial Statistics, International Monetary Fund, Washington DC, monthly.

179 The Balance of Payments (BOP) ApproachFloating Exchange Rate Countries: Under a floating exchange rate system, the government of a country has no responsibility to peg its foreign exchange rate. The fact that current and capital account balances do not sum to zero will automatically (in theory) alter the exchange rate in the direction necessary to obtain a BOP near zero. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

180 The Balance of Payments (BOP) ApproachManaged Floats: Countries operating with managed floats, while still relying on market conditions for day-to-day exchange rate determination, often find it necessary to take action to maintain their desired exchange rate values. They seek to alter the market’s valuation of a specific exchange rate by influencing the motivators of market activity, rather through direct intervention in the foreign exchange markets. The primary action taken by such governments is to change relative interest rates. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

181 The Asset Market Approach to ForecastingThe asset market approach assumes that whether foreigners are willing to hold claims in monetary form depends on an extensive set of investment considerations or drivers (among others): Relative real interest rates Prospects for economic growth Capital market liquidity A country’s economic and social infrastructure Political safety Corporate governance practices Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

182 The Asset Market Approach to ForecastingForeign investors are willing to hold securities and undertake foreign direct investment in highly developed countries based primarily on relative real interest rates and the outlook for economic growth and profitability. The asset market approach is also applicable to emerging markets, however in these cases a number of additional variables contribute to exchange rate determination (previous slide). Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

183 Disequilibrium: Exchange Rates in Emerging MarketsAlthough the three different schools of thought on exchange rate determination (parity conditions, balance of payments approach, asset approach) make understanding exchange rates appear to be straightforward, that it rarely the case. The large and liquid capital and currency markets follow many of the principles outlined so far relatively well in the medium to long term. The smaller and less liquid markets, however, frequently demonstrate behaviors that seemingly contradict the theory. The problem lies not in the theory, but in the relevance of the assumptions underlying the theory. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

184 Illustrative Case: The Asian CrisisThe roots of the Asian currency crisis extended from a fundamental change in the economics of the region, the transition of many Asian nations from being net exporters to net importers. The most visible roots of the crisis were the excess capital inflows into Thailand in 1996 and early 1997. As the investment “bubble” expanded, some market participants questioned the ability of the economy to repay the rising amount of debt and the Thai bhat came under attack. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

185 Illustrative Case: The Asian CrisisThe Thai government intervened directly (using foreign currency reserves) and indirectly by raising interest rates in support of the currency. Soon thereafter, the Thai investment markets ground to a halt and the Thai central bank allowed the bhat to float. The bhat fell dramatically and soon other Asian currencies (Philippine peso, Malaysian ringgit and the Indonesian rupiah) came under speculative attack. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

186 Illustrative Case: The Asian CrisisThe Asian economic crisis (which was much more than just a currency collapse) had many roots besides traditional balance of payments difficulties: Corporate socialism Corporate governance Banking liquidity and management What started as a currency crisis became a region-wide recession. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

187 Illustrative Case: The Russian Crisis of 1998The crisis of August 1998 was the culmination of a continuing deterioration in general economic conditions in Russia. From 1995 to 1998, Russian borrowers (both government and non-governmental) had gone to the international capital markets for large quantities of capital. Servicing this debt soon became an increasing problem, as it was dollar denominated and required dollar denominated debt service. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

188 Illustrative Case: The Russian Crisis of 1998The Russian current account (while a healthy surplus of $15 - $20 billion per year) was not finding its way into internal investment and external debt service. Capital flight began to accelerate, and hard currency earnings flowed out of the country. As the Russian rouble operated under a managed float, the Central Bank had to intervene in foreign exchange markets to support the currency if it came under pressure. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

189 Illustrative Case: The Russian Crisis of 1998During the month of August, 1998, the Russian government continued to drain its reserves and had increasing difficulties in raising additional capital in support of its reserves on the international markets. By mid-August, the Russian Central Bank announced it would allow the rouble to fall, postponed short-term domestic debt service and initiated a moratorium on all repayment of foreign debt owed by Russian banks and private borrowers to avert a banking collapse. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

190 Illustrative Case: The Argentine Crisis of 2002In 1991 the Argentine peso had been fixed to the US dollar at a one-to-one rate of exchange. A currency board structure was implemented in an effort eliminate the source inflation that had devastated the nation’s standard of living in the past. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

191 Illustrative Case: The Argentine Crisis of 2002By 2001, after three years of recession, three important problems with the Argentine economy became apparent: The Argentine Peso was overvalued The currency board regime had eliminated monetary policy alternatives for macroeconomic policy The Argentine government budget deficit – and deficit spending – was out of control Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

192 Illustrative Case: The Argentine Crisis of 2002In January 2002, the peso was devalued as a result of enormous social pressures resulting from deteriorating economic conditions and substantial runs on banks. However, the economic pain continued and the banking system remained insolvent. Social unrest continued as the economic and political systems within the country collapsed; certain government actions set the stage for a constitutional crisis. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

193 Forecasting in PracticeNumerous foreign exchange forecasting services exist, many of which are provided by banks and independent consultants. Some multinational firms have their own in-house forecasting capabilities. Predictions can be based on elaborate econometric models, technical analysis of charts and trends, intuition, and a certain measure of gall. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

194 Forecasting in PracticeTechnical analysts, traditionally referred to as chartists, focus on price and volume data to determine past trends that are expected to continue into the future. The single most important element of technical analysis is that future exchange rates are based on the current exchange rate. Exchange rate movements can be subdivided into three periods: Day-to-day Short-term (several days to several months) Long-term Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

195 Forecasting in PracticeThe longer the time horizon of the forecast, the more inaccurate the forecast is likely to be. Whereas forecasting for the long run must depend on the economic fundamentals of exchange rate determination, many of the forecast needs of the firm are short to medium term in their time horizon and can be addressed with less theoretical approaches. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

196 Exhibit 7.12 Differentiating Short-Term Noise from Long-Term TrendsForeign currency per unit of domestic currency Fundamental Equilibrium Path Technical or random events may drive the exchange rate from the long-term path Time

197 Chapter 8 Transaction Exposure

198 Transaction Exposure Foreign exchange exposure is a measure of the potential for a firm’s profitability, net cash flow, and market value to change because of a change in exchange rates. An important task of the financial manager is to measure foreign exchange exposure and to manage it so as to maximize the profitability, net cash flow, and market value of the firm. The effect on a firm when foreign exchange rates change can be measured in several ways. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

199 Accounting exposure Operating exposure Transaction exposureExhibit 8.1 Conceptual Comparison of Transaction, Operating and Accounting Foreign Exchange Exposure Moment in time when exchange rate changes Accounting exposure Operating exposure Changes in reported owners’ equity in consolidated financial statements caused by a change in exchange rates Change in expected future cash flows arising from an unexpected change in exchange rates Transaction exposure Impact of settling outstanding obligations entered into before change in exchange rates but to be settled after change in exchange rates Time

200 Types of Foreign Exchange ExposureTransaction exposure measures changes in the value of outstanding financial obligations incurred prior to a change in exchange rates but not due to be settled until after the exchange rates change. Thus, this type of exposure deals with changes in cash flows the result from existing contractual obligations. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

201 Types of Foreign Exchange ExposureOperating exposure, also called economic exposure, competitive exposure, or strategic exposure, measures the change in the present value of the firm resulting from any change in future operating cash flows of the firm caused by an unexpected change in exchange rates. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

202 Types of Foreign Exchange ExposureTransaction exposure and operating exposure exist because of unexpected changes in future cash flows. The difference between the two is that transaction exposure is concerned with future cash flows already contracted for, while operating exposure focuses on expected (not yet contracted for) future cash flows that might change because a change in exchange rates has altered international competitiveness. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

203 Types of Foreign Exchange ExposureAccounting exposure, also called translation exposure, is the potential for accounting-derived changes in owner’s equity to occur because of the need to “translate” foreign currency financial statements of foreign subsidiaries into a single reporting currency to prepare worldwide consolidated financial statements. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

204 Types of Foreign Exchange ExposureThe tax consequence of foreign exchange exposure varies by country. As a general rule, however, only realized foreign exchange losses are deductible for purposes of calculating income taxes. Similarly, only realized gains create taxable income. “Realized” means that the loss or gain involves cash flows. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

205 Why Hedge? MNEs possess a multitude of cash flows that are sensitive to changes in exchange rates, interest rates, and commodity prices. These three financial price risks are the subject of the growing field of financial risk management. Many firms attempt to manage their currency exposures through hedging. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

206 Why Hedge? Hedging is the taking of a position, acquiring either a cash flow, an asset, or a contract (including a forward contract) that will rise (fall) in value and offset a fall (rise) in the value of an existing position. While hedging can protect the owner of an asset from a loss, it also eliminates any gain from an increase in the value of the asset hedged against. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

207 Why Hedge? The value of a firm, according to financial theory, is the net present value of all expected future cash flows. The fact that these cash flows are expected emphasizes that nothing about the future is certain. Currency risk is defined roughly as the variance in expected cash flows arising from unexpected exchange rate changes. A firm that hedges these exposures reduces some of the variance in the value of its future expected cash flows. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

208 Exhibit 8.2 Impact of Hedging on the Expected Cash Flows of the FirmHedged Unhedged NCF Net Cash Flow (NCF) Expected Value, E(V) Hedging reduces the variability of expected cash flows about the mean of the distribution. This reduction of distribution variance is a reduction of risk.

209 Why Hedge? However, is a reduction in the variability of cash flows sufficient reason for currency risk management? Opponents of hedging state (among other things): Shareholders are much more capable of diversifying currency risk than the management of the firm Currency risk management does not increase the expected cash flows of the firm Management often conducts hedging activities that benefit management at the expense of the shareholders (agency conflict) Managers cannot outguess the market Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

210 Why Hedge? Proponents of hedging cite:Reduction in risk in future cash flows improves the planning capability of the firm Reduction of risk in future cash flows reduces the likelihood that the firm’s cash flows will fall below a necessary minimum (the point of financial distress) Management has a comparative advantage over the individual shareholder in knowing the actual currency risk of the firm Management is in better position to take advantage of disequilibrium conditions in the market Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

211 Measurement of Transaction ExposureTransaction exposure measures gains or losses that arise from the settlement of existing financial obligations whose terms are stated in a foreign currency. The most common example of transaction exposure arises when a firm has a receivable or payable denominated in a foreign currency. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

212 Exhibit 8.3 The Life Span of a Transaction ExposureTime and Events t1 t2 t3 t4 Seller quotes a price to buyer (in verbal or written form) Buyer places firm order with seller at price offered at time t1 Seller ships product and bills buyer (becomes A/R) Buyer settles A/R with cash in amount of currency quoted at time t1 Quotation Exposure Backlog Exposure Billing Exposure Time between quoting a price and reaching a contractual sale Time it takes to fill the order after contract is signed Time it takes to get paid in cash after A/R is issued Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

213 Measurement of Transaction ExposureForeign exchange transaction exposure can be managed by contractual, operating, and financial hedges. The main contractual hedges employ the forward, money, futures, and options markets. Operating and financial hedges employ the use of risk-sharing agreements, leads and lags in payment terms, swaps, and other strategies. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

214 Measurement of Transaction ExposureThe term natural hedge refers to an off-setting operating cash flow, a payable arising from the conduct of business. A financial hedge refers to either an off-setting debt obligation (such as a loan) or some type of financial derivative such as an interest rate swap. Care should be taken to distinguish operating hedges from financing hedges. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

215 Dayton Manufacturing’s Transaction ExposureWith reference to Dayton Manufacturing’s Transaction Exposure, the CFO, Scout Finch, has four alternatives: Remain unhedged Hedge in the forward market Hedge in the money market Hedge in the options market These choices apply to an account receivable and/or an account payable Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

216 Dayton Manufacturing’s Transaction ExposureA forward hedge involves a forward (or futures) contract and a source of funds to fulfill the contract. In some situations, funds to fulfill the forward exchange contract are not already available or due to be received later, but must be purchased in the spot market at some future date. This type of hedge is “open” or “uncovered” and involves considerable risk because the hedge must take a chance on the uncertain future spot rate to fulfill the forward contract. The purchase of such funds at a later date is referred to as covering. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

217 Dayton Manufacturing’s Transaction ExposureA money market hedge also involves a contract and a source of funds to fulfill that contract. In this instance, the contract is a loan agreement. The firm seeking the money market hedge borrows in one currency and exchanges the proceeds for another currency. Funds to fulfill the contract – to repay the loan – may be generated from business operations, in which case the money market hedge is covered. Alternatively, funds to repay the loan may be purchased in the foreign exchange spot market when the loan matures (uncovered or open money market hedge). Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

218 Dayton Manufacturing’s Transaction ExposureHedging with options allows for participation in any upside potential associated with the position while limiting downside risk. The choice of option strike prices is a very important aspect of utilizing options as option premiums, and payoff patterns will differ accordingly. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

219 Forward contract hedgeExhibit 8.5 Valuation of Cash Flows Under Hedging Alternatives for Dayton Value in US dollars of Dayton’s £1,000,000 A/R Uncovered Put option strike price of $1.75/£ OTM put option hedge 1.84 1.82 Put option strike price of $1.71/£ ATM put option hedge 1.80 1.78 Money market hedge 1.76 1.74 Forward contract hedge 1.72 1.70 1.68 1.68 1.70 1.72 1.74 1.76 1.78 1.80 1.82 1.84 1.86 Ending spot exchange rate (US$/£)

220 Forward contract hedgeExhibit 8.6 Valuation of Hedging Alternatives for an Account Payable 1.68 1.70 1.74 1.76 1.72 1.82 1.80 1.78 1.86 1.84 Cost in US dollars of Dayton’s £1,000,000 A/P Ending spot exchange rate (US$/£) Call option strike price of $1.75/£ Uncovered costs whatever the ending spot rate is in 90 days Forward rate is $1.7540/£ Money market hedge Locks in a cost of $1,781,294 Forward contract hedge locks in a cost of $1,754,000 Call option hedge

221 Risk Management in PracticeThe treasury function of most private firms, the group typically responsible for transaction exposure management, is usually considered a cost center. The treasury function is not expected to add profit to the firm’s bottom line. Currency risk managers are expected to err on the conservative side when managing the firm’s money. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

222 Risk Management in PracticeFirms must decide which exposures to hedge: Many firms do not allow the hedging of quotation exposure or backlog exposure as a matter of policy Many firms feel that until the transaction exists on the accounting books of the firm, the probability of the exposure actually occurring is considered to be less than 100% An increasing number of firms, however, are actively hedging not only backlog exposures, but also selectively hedging quotation and anticipated exposures. Anticipated exposures are transactions for which there are – at present – no contracts or agreements between parties Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

223 Risk Management in PracticeAs might be expected, transaction exposure management programs are generally divided along an “option-line”; those that use options and those that do not. Firms that do not use currency options rely almost exclusively on forward contracts and money market hedges. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

224 Risk Management in PracticeMany MNEs have established rather rigid transaction exposure risk management policies that mandate proportional hedging. These contracts generally require the use of forward contract hedges on a percentage of existing transaction exposures. The remaining portion of the exposure is then selectively hedged on the basis of the firm’s risk tolerance, view of exchange rate movements, and confidence level. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

225 Risk Management in PracticeIn addition to having required minimum forward-cover percentages, many firms also require full forward-cover when forward rates “pay them the points.” The points on the forward rate is the forward rate’s premium or discount. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

226 Risk Management in PracticeA further distinction in practice can be made between those firms that buy currency options (buy a put or buy a call) and those that both buy and write currency options. Those firms that do use currency options are generally more aggressive in their tolerance of currency risk. However, in many cases firms that are extremely risk-intolerant will utilize options to hedge backlog and/or anticipated exposures. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

227 Risk Management in PracticeSince the writer of an option has a limited profit potential with unlimited loss potential, the risks associated with writing options can be substantial. Firms that write options usually do so to finance the purchase of a second option. The most frequently used complex options are range forwards, participating forwards, break forwards, and average rate options. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

228 Chapter 9 Operating Exposure

229 Operating Exposure Operating exposure, also called economic exposure, competitive exposure, and even strategic exposure on occasion, measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

230 Attributes of Operating ExposureMeasuring the operating exposure of a firm requires forecasting and analyzing all the firm’s future individual transaction exposures together with the future exposures of all the firm’s competitors and potential competitors worldwide. From a broader perspective, operating exposure is not just the sensitivity of a firm’s future cash flows to unexpected changes in foreign exchange rates, but also to its sensitivity to other key macroeconomic variables. This factor has been labeled macroeconomic uncertainty. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

231 Attributes of Operating ExposureThe cash flows of the MNE can be divided into operating cash flows and financing cash flows. Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables, rent and lease payments, royalty and license fees and assorted management fees. Financing cash flows are payments for loans (principal and interest), equity injections and dividends of an inter and intracompany nature Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

232 Operational Cash FlowsExhibit 9.1 Financial & Operating Cash Flows Between Parent & Subsidiary Financial Cash Flows Dividend paid to parent Parent invested equity capital Interest on intrafirm lending Intrafirm principal payments Parent Subsidiary Payment for goods & services Rent and lease payments Royalties and license fees Management fees & distributed overhead Operational Cash Flows Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

233 Attributes of Operating ExposureOperating exposure is far more important for the long-run health of a business than changes caused by transaction or accounting exposure. Operating exposure is inevitably subjective, because it depends on estimates of future cash flow changes over an arbitrary time horizon. Planning for operating exposure is a total management responsibility because it depends on the interaction of strategies in finance, marketing, purchasing, and production. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

234 Attributes of Operating ExposureAn expected change in foreign exchange rates is not included in the definition of operating exposure, because both management and investors should have factored this information into their evaluation of anticipated operating results and market value. From an investor’s perspective, if the foreign exchange market is efficient, information about expected changes in exchange rates should be reflected in a firm’s market value. Only unexpected changes in exchange rates, or an inefficient foreign exchange market, should cause market value to change. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

235 Measuring the Impact of Operating ExposureAn unexpected change in exchange rates impacts a firm’s expected cash flows at four levels, depending on the time horizon used: Short run Medium run: Equilibrium case Medium run: Disequilibrium case Long run Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

236 Measuring the Impact of Operating ExposureThe following slide presents the dilemma facing Carlton, Inc. as a result of an unexpected change in the value of the euro, the currency of economic consequence for the German subsidiary. There is concern over how the subsidiaries revenues (price and volumes in euro terms), costs (input costs in euro terms), and competitive landscape will change with a fall in the value of the euro. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

237 Exhibit 9.2 Carlton, Inc. and Carlton Germany(Palo Alto, CA, USA) Will the altered profits of the German subsidiary, in euro, translate into more or less in US dollars? US$ Reporting Environment US$/€ Carlton Germany (Munich, Germany) Euro Competitive Environment How will the sales, costs, and profits of the German subsidiary change? Carlton’s Suppliers Carlton’s Customers Will costs change? Will prices and sales volume change? How much? An unexpected depreciation in the value of the euro alters both the competitiveness of the subsidiary and the financial results which are consolidated with the parent company. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

238 Strategic Management of Operating ExposureThe objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firm’s future cash flows, rather than merely hoping for the best. To meet this objective, management can diversify the firm’s operating and financing base. Management can also change the firm’s operating and financing policies. A diversification strategy does not require management to predict disequilibrium, only to recognize it when it occurs. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

239 Strategic Management of Operating ExposureIf a firm’s operations are diversified internationally, management is prepositioned both to recognize disequilibrium when it occurs and to react competitively. Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies. Domestic firms may be subject to the full impact of foreign exchange operating exposure and do not have the option to react in the same manner as an MNE. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

240 Strategic Management of Operating ExposureIf a firm’s financing sources are diversified, it will be prepositioned to take advantage of temporary deviations from the international Fisher effect. However, to switch financing sources a firm must already be well-known in the international investment community. Again, this would not be an option for a domestic firm (if it has limited its financing to one capital market). Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

241 Proactive Management of Operating ExposureOperating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures. The four most commonly employed proactive policies are: Matching currency cash flows Risk-sharing agreements Back-to-back or parallel loans Currency swaps Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

242 Proactive Management of Operating ExposureIn this example, a US firm has continuing export sales to Canada. In order to compete effectively in Canadian markets, the firm invoices all export sales in Canadian dollars. This policy results in a continuing receipt of Canadian dollars month after month. This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

243 Principal and interestExhibit 9.4 Matching: Debt Financing as a Financial Hedge Canadian Corporation (buyer of goods) Exports goods to Canada Canadian Bank (loans funds) US Corp borrows Canadian dollar debt from Canadian Bank Payment for goods in Canadian dollars Principal and interest payments on debt in Canadian dollars U.S. Corporation Exposure: The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollars Hedge: The Canadian dollar debt payments act as a financial hedge by requiring debt service, an outflow of Canadian dollars Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

244 Proactive Management of Operating ExposureMatching currency cash flows. One way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching). Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms. In addition, the company could engage in currency switching, in which the company would pay foreign suppliers with Canadian dollars. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

245 Proactive Management of Operating ExposureCurrency Clauses: Risk-Sharing: An alternate method for managing a long-term cash flow exposure between firms is risk sharing. This is a contractual arrangement in which the buyer and seller agree to “share” or split currency movement impacts on payments between them. This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

246 Proactive Management of Operating ExposureBack-to-Back Loans: A back-to-back loan, also referred to as a parallel loan or credit swap, occurs when two business firms in separate countries arrange to borrow each other’s currency for a specific period of time. At an agreed terminal date they return the borrowed currencies. Such a swap creates a covered hedge against exchange loss, since each company, on its own books, borrows the same currency it repays. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

247 Exhibit 9.5 Using a Back-to-Back Loan for Currency Hedging1. British firm wishes to invest funds in its Dutch subsidiary 2. British firm identifies a Dutch firm wishing to invest funds in its British subsidiary British parent firm Dutch parent firm Indirect Financing Direct loan in pounds Direct loan in euros Dutch firm’s British subsidiary British firm’s Dutch subsidiary 3. British firm loans British pounds directly to the Dutch firm’s British subsidiary 4. British firm’s Dutch subsidiary loans euros to the Dutch parent The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

248 Proactive Management of Operating ExposureThere are two fundamental impediments to widespread use of the back-to-back loan: It is difficult for a firm to find a partner, termed a counterparty for the currency amount and timing desired. A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity – although each party has 100% collateral (denominated in a different currency). Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

249 Proactive Management of Operating ExposureCurrency Swaps: A currency swap resembles a back-to-back loan except that it does not appear on a firm’s balance sheet. In a currency swap, a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

250 Exhibit 9.6 Using a Cross Currency Swap to Hedge Currency ExposureBoth the Japanese corporation and the U.S. corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt. Japanese Corporation United States Corporation Assets Liabilities & Equity Assets Liabilities & Equity Inflow of US$ Inflow of yen Sales to US Debt in yen Sales to Japan Debt in US$ Receive yen Pay yen Pay dollars Receive dollars Swap Dealer Wishes to enter into a swap to “pay dollars” and “receive yen” Wishes to enter into a swap to “pay yen” and “receive dollars”

251 Proactive Management of Operating ExposureSome MNEs now attempt to hedge their operating exposure with contractual hedges. Merck and Eastman Kodak have undertaken long-term currency option positions hedges designed to offset lost earnings from adverse exchange rate changes. The ability to hedge the “unhedgeable” is dependent upon: Predictability of the firm’s future cash flows Predictability of the firm’s competitor’s responses to exchange rate changes Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

252 Chapter 10 Accounting Exposure

253 Overview of TranslationAccounting exposure, also called translation exposure, arises because financial statements of foreign subsidiaries – which are stated in foreign currency – must be restated in the parent’s reporting currency for the firm to prepare consolidated financial statements. The accounting process of translation, involves converting these foreign subsidiaries financial statements into US dollar-denominated statements. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

254 Overview of TranslationTranslation exposure is the potential for an increase or decrease in the parent’s net worth and reported net income caused by a change in exchange rates since the last translation. While the main purpose of translation is to prepare consolidated statements, management uses translated statements to assess performance (facilitation of comparisons across many geographically distributed subsidiaries). Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

255 Overview of TranslationTranslation in principle is simple: Foreign currency financial statements must be restated in the parent company’s reporting currency If the same exchange rate were used to remeasure each and every line item on the individual statement (I/S and B/S), there would be no imbalances resulting from the remeasurement What if a different exchange rate were used for different line items on an individual statement (I/S and B/S)? An imbalance would reslult Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

256 Overview of TranslationWhy would we use a different exchange rate in remeasuring different line items? Translation principles in many countries are often a complex compromise between historical and current market valuation Historical exchange rates can be used for certain equity accounts, fixed assets, and inventory items, while current exchange rates can be used for current assets, current liabilities, income, and expense items. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

257 Overview of TranslationMost countries today specify the translation method used by a foreign subsidiary based on the subsidiary’s business operations (subsidiary characterization). For example, a foreign subsidiary’s business can be categorized as either an integrated foreign entity or a self-sustaining foreign entity. An integrated foreign entity is one that operates as an extension of the parent, with cash flows and business lines that are highly interrelated. A self-sustaining foreign entity is one that operates in the local economic environment independent of the parent company. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

258 Overview of TranslationA foreign subsidiary’s functional currency is the currency of the primary economic environment in which the subsidiary operates and in which it generates cash flows. In other words, it is the dominant currency used by that foreign subsidiary in its day-to-day operations. The US, requires that the functional currency of the foreign subsidiary be determined based on the nature and purpose of the subsidiary. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

259 Overview of TranslationTwo basic methods for the translation of foreign subsidiary financial statements are employed worldwide: The current rate method The temporal method Regardless of which method is employed, a translation method must not only designate at what exchange rate individual balance sheet and income statement items are remeasured, but also designate where any imbalance is to be recorded (current income or an equity reserve account). Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

260 Overview of TranslationThe current rate method is the most prevalent in the world today. Assets and liabilities are translated at the current rate of exchange Income statement items are translated at the exchange rate on the dates they were recorded or an appropriately weighted average rate for the period Dividends (distributions) are translated at the rate in effect on the date of payment Common stock and paid-in capital accounts are translated at historical rates Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

261 Overview of TranslationGains or losses caused by translation adjustments are not included in the calculation of consolidated net income. Rather, translation gains or losses are reported separately and accumulated in a separate equity reserve account (on the B/S) with a title such as cumulative translation adjustment (CTA). The biggest advantage of the current rate method is that the gain or loss on translation does not pass through the income statement but goes directly to a reserve account (reducing variability of reported earnings). Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

262 Overview of TranslationUnder the temporal method, specific assets are translated at exchange rates consistent with the timing of the item’s creation. This method assumes that a number of individual line item assets such as inventory and net plant and equipment are restated regularly to reflect market value. Gains or losses resulting from remeasurement are carried directly to current consolidated income, and not to equity reserves (increased variability of consolidated earnings). Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

263 Overview of TranslationIf these items were not restated but were instead carried at historical cost, the temporal method becomes the monetary/nonmonetary method of translation. Monetary assets and liabilities are translated at current exchange rates Nonmonetary assets and liabilities are translated at historical rates Income statement items are translated at the average exchange rate for the period Dividends (distributions) are translated at the exchange rate on the date of payment Equity items are translated at historical rates Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

264 Overview of TranslationThe US differentiates foreign subsidiaries on the basis of functional currency, not subsidiary characterization. If the financial statements of the foreign subsidiary are maintained in US dollars, translation is not required If the statements are maintained in the local currency, and the local currency is the functional currency, they are translated by the current rate method If the statements are maintained in local currency, and the US dollar is the functional currency, they are remeasured by the temporal method If the statements are in local currency and neither the local currency or the US dollar is the functional currency, the statements must first be remeasured into the functional currency by the temporal method, and then translated into US dollars by the current rate method Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

265 Exhibit 10.2 Procedure Flow Chart for United States Translation PracticesPurpose: Foreign currency financial statements must be translated into U.S. dollars If the financial statements of the foreign subsidiary are expressed in a foreign currency, the following determinations need to be made. Is the local currency the functional currency? No Yes Is the dollar the functional currency? Translated to dollars (current rate method) Remeasure from foreign currency to functional (temporal method) and translate to dollars (current rate method) No Yes Remeasure to dollars (temporal method) * The term “remeasure” means to translate, as to change the unit of measure, from a foreign currency to the functional currency.

266 Overview of TranslationMany of the world’s largest industrial countries – as well as the relatively newly formed International Accounting Standards Committee (IASC) follow the same basic translation procedure: A foreign subsidiary is an integrated foreign entity or a self-sustaining foreign entity Integrated foreign entities are typically remeasured using the temporal method Self-sustaining foreign entities are translated at the current rate method, also termed the closing-rate method. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

267 Managing Translation ExposureThe main technique to minimize translation exposure is called a balance sheet hedge. A balance sheet hedge requires an equal amount of exposed foreign currency assets and liabilities on a firm’s consolidated balance sheet. If this can be achieved for each foreign currency, net translation exposure will be zero. If a firm translates by the temporal method, a zero net exposed position is called monetary balance. Complete monetary balance cannot be achieved under the current rate method. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

268 Managing Translation ExposureThe cost of a balance sheet hedge depends on relative borrowing costs. These hedges are a compromise in which the denomination of balance sheet accounts is altered, perhaps at a cost in terms of interest expense or operating efficiency, to achieve some degree of foreign exchange protection. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

269 Managing Translation ExposureIf a firm’s subsidiary is using the local currency as the functional currency, the following circumstances could justify when to use a balance sheet hedge: The foreign subsidiary is about to be liquidated, so that the value of its CTA would be realized The firm has debt covenants or bank agreements that state the firm’s debt/equity ratios will be maintained within specific limits Management is evaluated on the basis of certain income statement and balance sheet measures that are affected by translation losses or gains The foreign subsidiary is operating in a hyperinflationary environment Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

270 Managing Translation ExposureManagement will find it almost impossible to offset both translation and transaction exposure at the same time. As a general matter, firms seeking to reduce both types of exposure usually reduce transaction exposure first. Taxes complicate the decision to seek protection against transaction or translation exposure. Transaction losses are considered “realized” and are deductible from pre-tax income while translation losses are only “paper” losses and are not deductible from pre-tax income. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

271 Evaluation of PerformanceAn MNE must be able to set specific financial goal, monitor progress by all units of the enterprise towards those goals, and evaluate results. An MNE must be able to measure the performance of each of its subsidiaries on a consistent basis, and managers of subsidiaries must be given unambiguous objectives against which they will be judged. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

272 Evaluation of PerformanceThe MNE must determine for itself the proper balance between three operating financial objectives: Maximization of consolidated after-tax income Minimization of the firm’s effective global tax burden Correct positioning of the firm’s income, cash flows, and available funds These goals are frequently inconsistent. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

273 Evaluation of PerformanceManagers of foreign subsidiaries must be able to run their own operations efficiently according to achievable objectives. All firms expand and modify their domestic profitability measures when applying them to foreign subsidiaries. In addition, some firms establish foreign subsidiaries for objectives not related to normal corporate profit-oriented goals. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

274 Evaluation of PerformanceThere are four purposes of an internal evaluation system: To ensure adequate profitability To have an early warning system if something is wrong To have a basis for allocating resources To evaluate individual managers Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

275 Evaluation of PerformanceInternational financial evaluation of foreign subsidiaries is both unique and difficult. Use of one foreign exchange translation method, in an attempt to measure results in the home currency, will present a different measure of success or of compliance with predetermined goals than use of some other translation method. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

276 Evaluation of PerformanceThe results of any control system must be judged against distortions of performance caused by widely differing national business environments. International measurement systems are distorted by decisions to benefit the world system (MNE) at the expense of a specific local subsidiary. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

277 Evaluation of PerformanceThe impact of exchange rate movements on the measured performance of foreign subsidiaries is one of the single largest dilemmas facing management of the MNE. The evaluation of the performance of an MNE subsidiary involves three different evaluation dimensions: Management evaluation Subsidiary evaluation Strategic evaluation Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

278 Global Cost and Availability of CapitalChapter 11 Global Cost and Availability of Capital

279 Global Cost and Availability of CapitalGlobal integration of capital markets has given many firms access to new and cheaper sources of funds beyond those available in their home markets. If a firm is located in a country with illiquid and/or segmented capital markets, it can achieve this lower global cost and greater availability of capital by a properly designed and implemented strategy. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

280 Exhibit 11.1 Dimensions of the Cost and Availability of Capital StrategyLocal Market Access Global Market Access Firm-Specific Characteristics Firm’s securities appeal only to domestic investors Firm’s securities appeal to international portfolio investors Market Liquidity for Firm’s Securities Illiquid domestic securities market and limited international liquidity Highly liquid domestic market and broad international participation Effect of Market Segmentation on Firm’s Securities and Cost of Capital Segmented domestic securities market that prices shares according to domestic standards Access to global securities market that prices shares according to international standards

281 Global Cost and Availability of CapitalA firm that must source its long-term debt and equity in a highly illiquid domestic securities market will probably have a relatively high cost of capital and will face limited availability of such capital which will, in turn, damage the overall competitiveness of the firm. Firms resident in industrial countries with small capital markets may enjoy an improved availability of funds at a lower cost, but would also benefit from access to highly liquid global markets. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

282 Global Cost and Availability of CapitalFirms resident in countries with segmented capital markets must devise a strategy to escape dependence on that market for their long-term debt and equity needs. A national capital market is segmented if the required rate of return on securities in that market differs from the required rate of return on securities of comparable expected return and risk traded on other securities markets. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

283 Weighted Average Cost of CapitalA firm normally finds its weighted average cost of capital (WACC) by combining the cost of equity with the cost of debt in proportion to the relative weight of each in the firm’s optimal long-term financial structure: kWACC = keE + kd(1-t)D V V Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

284 Weighted Average Cost of CapitalkWACC = weighted average after-tax cost of capital ke = risk-adjusted cost of equity kd = before-tax cost of debt t = marginal tax rate E = market value of the firm’s equity D = market value of the firm’s debt V = total market value of the firm’s securities (D+E) Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

285 Weighted Average Cost of CapitalThe capital asset pricing model (CAPM) approach is to define the cost of equity for a firm by the following formula: ke = krf + βj(km – krf) Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

286 Weighted Average Cost of Capitalke = expected (required) rate of return on equity krf = rate of interest on risk-free bonds (Treasury bonds, for example) βj = coefficient of systematic risk for the firm km = expected (required) rate of return on the market portfolio of stocks Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

287 Weighted Average Cost of CapitalThe normal procedure for measuring the cost of debt requires a forecast of interest rates for the next few years, the proportions of various classes of debt the firm expects to use, and the corporate income tax rate. The interest costs of different debt components are then averaged (according to their proportion). The before-tax average, kd, is then adjusted for corporate income taxes by multiplying it by the expression (1-tax rate), to obtain kd(1-t), the weighted average after-tax cost of debt. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

288 Weighted Average Cost of CapitalThe weighted average cost of capital is normally used as the risk-adjusted discount rate whenever a firm’s new projects are in the same general risk class as its existing projects. On the other hand, a project-specific required rate of return should be used as the discount rate if a new project differs from existing projects in business or financial risk. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

289 Weighted Average Cost of CapitalIn practice, calculating a firm’s equity risk premium is quite controversial. While the CAPM is widely accepted as the preferred method of calculating the cost of equity for a firm, there is rising debate over what numerical values should be used in its application (especially the equity risk premium). This risk premium is the average annual return of the market expected by investors over and above riskless debt, the term (km – krf). Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

290 Weighted Average Cost of CapitalWhile the field of finance does agree that a cost of equity calculation should be forward-looking, practitioners typically use historical evidence as a basis for their forward-looking projections. The current debate begins with a debate over what actually happened in the past. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

291 The Demand for Foreign Securities: The Role of International Portfolio InvestorsGradual deregulation of equity markets during the past three decades not only elicited increased competition from domestic players but also opened up markets to foreign competitors. To understand the motivation of portfolio investors to purchase and hold foreign securities requires an understanding of the principals of: Portfolio risk reduction Portfolio rate of return Foreign currency risk Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

292 The Demand for Foreign Securities: The Role of International Portfolio InvestorsBoth domestic and international portfolio managers are asset allocators whose objective is to maximize a portfolio’s rate of return for a given level of risk, or to minimize risk for a given rate of return. Since international portfolio managers can choose from a larger bundle of assets than domestic portfolio managers, internationally diversified portfolios often have a higher expected rate of return, and nearly always have a lower level of portfolio risk since national securities markets are imperfectly correlated with one another. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

293 The Demand for Foreign Securities: The Role of International Portfolio InvestorsMarket liquidity (observed by noting the degree to which a firm can issue a new security without depressing the existing market price) can affect a firm’s cost of capital. In the domestic case, a firm’s marginal cost of capital will eventually increase as suppliers of capital become saturated with the firm’s securities. In the multinational case, a firm is able to tap many capital markets above and beyond what would have been available in a domestic capital market only. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

294 The Demand for Foreign Securities: The Role of International Portfolio InvestorsCapital market segmentation is caused mainly by government constraints, institutional practices and investor perceptions. While there are many imperfections that can affect the efficiency of a national market, these markets can still be relatively efficient in a national context but segmented in an international context (recall the finance definition of efficiency). Some capital market imperfections include: Lack of transparency Political risks Corporate governance issues Regulatory barriers Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

295 The Demand for Foreign Securities: The Role of International Portfolio InvestorsThe degree to which capital markets are illiquid or segmented has an important influence on a firm’s marginal cost of capital (and thus on its weighted average cost of capital). In the following exhibit, the marginal return on capital at different budget levels is denoted as MRR. If the firm is limited to raising funds in its domestic market, the line MCCD shows the marginal domestic cost of capital. If the firm has additional sources of capital outside the domestic (illiquid) capital market the marginal cost of capital shifts right to MCCF. If the MNE is located in a capital market that is both illiquid and segmented, the line MCCU represents the decreased marginal cost of capital if it gains access to other equity markets. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

296 Exhibit 11.6 Market Liquidity, Segmentation, and the Marginal Cost of Capitaland rate of return (percentage) MCCF MCCU MCCD kD 20% kF 15% kU 13% MRR 10% Budget (millions of $) 10 20 30 40 50 60 Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

297 Illustrative Case: Novo Industri A/S (Novo)Novo is a Danish multinational firm. The company’s management decided to “internationalize” the firm’s capital structure and sources of funds. This was based on the observation that the Danish securities market was both illiquid and segmented from other capital markets (at the time). Management realized that the company’s projected growth opportunities required raising capital beyond what could be raised in the domestic market alone. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

298 Illustrative Case: Novo Industri A/S (Novo)Six characteristics of the Danish equity market were responsible for market segmentation: Asymmetric information base of Danish and foreign investors Taxation Alternative sets of feasible portfolios Financial risk Foreign exchange risk Political risk Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

299 Illustrative Case: Novo Industri A/S (Novo)Although Novo’s management wished to escape from the shackles of Denmark’s segmented and illiquid capital market, many barriers had to be overcome. These barriers included closing the information gap between the capital markets and the company itself and executing a share offering in the US (which required resolving additional barriers imposed by the government of Denmark on securities issuances). Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

300 Exhibit 11.7 Novo’s B-Share Prices Compared with Stock Market IndicesDow Jones Industrial Average (NYSE) Novo B-Shares Financial Times (London) Danish Industry Index Source: Arthur I. Stonehill and Kåre B. Dullum, Internationalizing the Cost of Capital: The Novo Experience and National Policy Implications, London: John Wiley, 1982, p. 73. Reprinted with permission.

301 The Cost of Capital for MNEs Compared to Domestic FirmsDetermining whether a MNEs cost of capital is higher or lower than a domestic counterpart is a function of the marginal cost of capital, the relative after-tax cost of debt, the optimal debt ratio and the relative cost of equity. While the MNE is supposed to have a lower marginal cost of capital (MCC) than a domestic firm, empirical studies show the opposite (as a result of the additional risks and complexities associated with foreign operations). Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

302 The Cost of Capital for MNEs Compared to Domestic FirmsThis relationship lies in the link between the cost of capital, its availability, and the opportunity set of projects. As the opportunity set of projects increases, the firm will eventually need to increase its capital budget to the point where its marginal cost of capital is increasing. The optimal capital budget would still be at the point where the rising marginal cost of capital equals the declining rate of return on the opportunity set of projects. This would be at a higher weighted average cost of capital than would have occurred for a lower level of the optimal capital budget. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

303 Exhibit 11.8 The Cost of Capital for MNE & Domestic Counterpart ComparedMarginal cost of capital and rate of return (percentage) MCCDC 20% 15% MCCMNE 10% MRRMNE 5% MRRDC Budget (millions of $) 100 140 300 350 400 Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

304 The Cost of Capital for MNEs Compared to Domestic FirmsIn conclusion, if both MNEs and domestic firms do actually limit their capital budgets to what can be financed without increasing their MCC, then the empirical findings that MNEs have higher WACC stands. If the domestic firm has such good growth opportunities that it chooses to undertake growth despite and increasing marginal cost of capital, then the MNE would have a lower WACC. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

305 Sourcing Equity GloballyChapter 12 Sourcing Equity Globally

306 Sourcing Equity GloballyTo implement the goal of gaining access to global capital markets a firm must begin by designing a strategy that will ultimately attract international investors. This would mean identifying and choosing alternative paths to access global markets. This would also require some restructuring of the firm, improving the quality and level of its disclosure, and making its accounting and reporting standards more transparent to potential foreign investors. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

307 Designing a Strategy to Source Equity GloballyDesigning a capital sourcing strategy requires that management agree upon a long-run financial objective and then choose among the various alternative paths to get there. Often, this decision making process is aided by an early appointment of an investment bank as an official advisor to the firm. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

308 Designing a Strategy to Source Equity GloballyMost firms raise their initial capital in their own domestic market. However, most firms that have only raised capital in their domestic market are not well known enough to attract foreign investors. Incremental steps to bridge this gap include conducting an international bond offering and/or cross-listing equity shares on more highly liquid foreign stock exchanges. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

309 Designing a Strategy to Source Equity GloballyDepositary receipts (depositary shares) are negotiable certificates issued by a bank to represent the underlying shares of stock, which are held in trust at a foreign custodian bank. American depository receipts (ADRs) are certificates traded in the United States and denominated in US dollars. ADRs are sold, registered, and transferred in the US in the same manner as any share of stock with each ADR representing some multiple of the underlying foreign share (allowing for ADR pricing to resemble conventional US share pricing between $20 and $50 per share). Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

310 Exhibit 12.2 Mechanics of American Depositary Receipts (ADRs)issued by a bank representing underlying shares held by a custodial bank Shares Receipts (ADRs) Publicly traded firm outside the U.S. Receipts for shares listed on U.S. exchange Traded by U.S. investors Shares traded on local stock exchange Shares Arbitrage Activity Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

311 Designing a Strategy to Source Equity GloballyADRs can be exchanged for the underlying foreign shares, or vice versa, so arbitrage keeps foreign and US prices of any given share the same after adjusting for transfer costs. ADRs also convey certain technical advantages to US shareholders. While ADRs are quoted only in US dollars and traded only in the US, Global Registered Shares (GRSs) can be traded on equity exchanges around the globe in a variety of currencies. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

312 Foreign Equity Listing and IssuanceA firm must choose one or more stock markets on which to cross-list its shares and sell new equity. Just where to go depends mainly on the firm’s specific motives and the willingness of the host stock market to accept the firm. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

313 Foreign Equity Listing and IssuanceCross-listing attempts to accomplish one or more of many objectives: Improve the liquidity of its existing shares and support a liquid secondary market for new equity issues in foreign markets Increase its share price by overcoming mis-pricing in a segmented and illiquid home capital market Increase the firms visibility Establish a secondary market for shares used to acquire other firms Create a secondary market for shares that can be used to compensate local management and employees in foreign subsidiaries Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

314 Effect of Cross-Listing and Equity Issuance on Share PriceCross-listing may have a favorable impact on share price if the new market values the firm or its industry more than the home market does. It is well known that the combined impact of a new equity issue undertaken simultaneously with a cross-listing has a more favorable impact on stock price than cross-listing alone. Even US firms can benefit by issuing equity abroad as increased investor recognition and participation in the primary and secondary markets results. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

315 Barriers to Cross-Listing and Selling Equity AbroadThere are certainly barriers to cross-listing and/or selling equity abroad. The most serious of these includes the future commitment to providing full and transparent disclosure of operating results and balance sheets as well as a continuous program of investor relations. The US school of thought is that the worldwide trend toward requiring fuller, more transparent, and more standardized financial disclosure of operating results and balance sheet positions may have the desirable effect of lowering the cost of equity capital. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

316 Alternative Instruments to Source Equity in Global MarketsAlternative instruments to source equity in global markets include the following: Sale of a directed public share issue to investors in a target market Sale of a Euroequity public issue to investors in more than one market (foreign and domestic markets) Private placements under SEC Rule 144A Sale of shares to private equity funds Sale of shares to a foreign firm as part of a strategic alliance Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

317 Alternative Instruments to Source Equity in Global MarketsA directed public share issue is defined as one that is targeted at investors in a single country and underwritten in whole or in part by investment institutions from that country. The issue might or might not be denominated in the currency of the target market. The shares might or might not be cross-listed on a stock exchange in the target market. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

318 Alternative Instruments to Source Equity in Global MarketsThe gradual integration of the world’s capital markets and increased international portfolio investment has spawned the emergence of a very viable Euroequity market. A firm can now issue equity underwritten and distributed in multiple foreign equity markets, sometimes simultaneously with distribution in the domestic market. The “Euro” market (a generic term for international securities issues originating and being sold anywhere in the world), was created by the same financial institutions that had previously created an infrastructure for the Euronote and Eurobond markets. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

319 Alternative Instruments to Source Equity in Global MarketsOne type of directed issue with a long history as a source of both equity and debt is the private placement market. A private placement is the sale of a security to a small set of qualified institutional buyers. Since the securities are not registered for sale to the public, investors have typically followed a “buy and hold” policy. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

320 Alternative Instruments to Source Equity in Global MarketsPrivate equity funds are usually limited partnerships of institutional and wealthy individual investors that raise their capital in the most liquid capital markets. These investors then invest the private equity fund in mature, family-owned firms located in emerging markets. The investment objective is to help these firms to restructure and modernize in order to face increasing competition and the growth of new technologies. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

321 Alternative Instruments to Source Equity in Global MarketsStrategic alliances are normally formed by firms that expect to gain synergies from one or more of the following joint efforts: Sharing the cost of developing technology Gaining economies of scale or scope Financial assistance (lowering of cost of capital through attractively priced debt or equity financing) Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

322 Financial Structure and International DebtChapter 13 Financial Structure and International Debt

323 Optimal Financial StructureThe domestic theory of optimal financial structure must be modified considerably to encompass the multinational firm. Most finance theorists are now in agreement about whether an optimal financial structure exists for a firm, and if so, how it can be determined. When taxes and bankruptcy costs are considered, a firm has an optimal financial structure determined by that particular mix of debt and equity that minimizes the firm’s cost of capital for a given level of business risk. As the business risk of new projects differs from the risk of existing projects, the optimal mix of debt and equity would change to recognize tradeoffs between business and financial risks. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

324 Optimal Financial StructureThe following exhibit illustrates how the cost of capital varies with the amount of debt employed. As the debt ratio increases, the overall cost of capital (kWACC) decreases because of the heavier weight of low-cost (due to tax-deductability) debt ([kd(1-t)] compared to high cost equity (ke). Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

325 Exhibit 13.1 The Cost of Capital and Financial Structureke = cost of equity Exhibit The Cost of Capital and Financial Structure Debt Ratio (%) = Total Debt (D) Total Assets (V) 30 28 26 24 22 20 18 16 14 12 10 8 6 4 2 Cost of Capital (%) 40 60 80 100 Minimum cost of capital range kWACC = weighted average after-tax cost of capital kd (1-tx) = after-tax cost of debt Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

326 Optimal Financial Structure and the MNEThe domestic theory of optimal financial structures needs to be modified by four more variables in order to accommodate the case of the MNE. These variables include: Availability of capital Diversification of cash flows Foreign exchange risk Expectations of international portfolio investors Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

327 Optimal Financial Structure and the MNEAvailability of capital: A multinational firm’s marginal cost of capital is constant for considerable ranges of its capital budget This statement is not true for most small domestic firms (as they do not have equal access to capital markets), nor for MNEs located in countries that have illiquid capital markets (unless they have gained a global cost and availability of capital) Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

328 Optimal Financial Structure and the MNEDiversification of cash flows: The theoretical possibility exists that multinational firms are in a better position than domestic firms to support higher debt ratios because their cash flows are diversified internationally As returns are not perfectly correlated between countries, an MNE might be able to achieve a reduction in cash flow variability (much in the same way as portfolio investors who diversify their security holdings globally) Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

329 Optimal Financial Structure and the MNEForeign exchange risk: When a firm issues foreign currency denominated debt, its effective cost equals the after-tax cost of repaying the principal and interest in terms of the firm’s own currency This amount includes the nominal cost of principal and interest in foreign currency terms, adjusted for any foreign exchange gains or losses Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

330 Optimal Financial Structure and the MNEExpectations of International Portfolio Investors: The key to gaining a global cost and availability of capital is attracting and retaining international portfolio investors If a firm wants to raise capital in global markets, it must adopt global norms that are close to the US and UK norms as these markets represent the most liquid and unsegmented markets Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

331 Financial Structure of Foreign SubsidiariesIf the theory that minimizing the cost of capital for a given level of business risk and capital budget is an objective that should be implemented from the perspective of the consolidated MNE, then the financial structure of each subsidiary is relevant only to the extent that it affects this overall goal. In other words, an individual subsidiary does not really have an independent cost of capital; therefore its financial structure should not be based on an objective of minimizing it. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

332 Financial Structure of Foreign SubsidiariesAdvantages to implementing a financing structure that conforms to local norms: Reduction in criticisms Improvement in the ability of management to evaluate ROE relative to local competitors Determination as to whether or not resources are being misallocated (cost of local debt financing versus returns generated by the assets financed) Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

333 Financial Structure of Foreign SubsidiariesDisadvantages to localization: MNEs are expected to have a competitive advantage over local firms in overcoming imperfections in national capital markets; there would then be no need to dispose of this competitive advantage and conform Consolidated balance sheet structure may not conform t any country’s norm (increasing perceived financial risk and cost of capital to the parent) Local debt ratios are really only cosmetic as lenders will ultimately look to the parent, and its consolidated worldwide cash flow as the source of debt repayment Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

334 Financial Structure of Foreign SubsidiariesIn addition to choosing an appropriate financial structure for foreign subsidiaries, financial managers of MNEs must choose among alternative sources of funds to finance the foreign subsidiary. These funds can be either internal to the MNE or external to the MNE. Ideally the choice should minimize the cost of external funds (after adjusting for foreign exchange risk) and should choose internal sources in order to minimize worldwide taxes and political risk. Simultaneously, the firm should ensure that managerial motivation in the foreign subsidiaries is geared toward minimizing the firm’s worldwide cost of capital Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

335 Exhibit 13.3 Internal Financing of the Foreign SubsidiaryFunds From Within the Multinational Enterprise (MNE) Funds from parent company Equity Cash Real goods Debt -- cash loans Leads & lags on intra-firm payables Funds from sister subsidiaries Debt -- cash loans Leads & lags on intra-firm payables Subsidiary borrowing with parent guarantee Funds Generated Internally by the Foreign Subsidiary Depreciation & non-cash charges Retained earnings Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

336 Exhibit 13.4 External Financing of the Foreign SubsidiaryFunds External to the Multinational Enterprise (MNE) Borrowing from sources in parent country Banks & other financial institutions Security or money markets Borrowing from sources outside of parent country Local currency debt Third-country currency debt Eurocurrency debt Local equity Individual local shareholders Joint venture partners Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

337 The Eurocurrency MarketsThe Eurocurrency markets are one of the truly significant innovations in international finance of the past 50 years. These markets have provided a foundation for a series of innovations in both the structure of and choices in financing the MNE. Eurocurrencies are domestic currencies of one country on deposit in a second country. Any convertible currency can exist in “Euro” form (not to be confused with the European currency called the euro). These markets serve two valuable purposes: Eurocurrency deposits are an efficient and convenient money market device for holding excess corporate liquidity The Eurocurrency market is a major source of short-term bank loans to finance corporate working capital needs (including imports and exports) Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

338 International Debt MarketsThe international debt market offers the borrower a wide variety of different maturities, repayment structures, and currencies of denomination. The markets and their many different instruments vary by source of funding, pricing structure, maturity, and subordination or linkage to other debt and equity instruments. The three major sources of debt funding on the international markets are depicted in the following exhibit. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

339 short-to-medium term) short-to-medium term) (fixed & floating-rate,Exhibit International Debt Markets & Instruments Bank Loans & Syndications (floating-rate, short-to-medium term) International Bank Loans Eurocredits Syndicated Credits Euronote Market (floating-rate, short-to-medium term) Euronotes & Euronote Facilities Eurocommercial Paper (ECP) Euro Medium Term Notes (EMTNs) International Bond Market (fixed & floating-rate, medium-to-long term) Eurobond * straight fixed-rate issue * floating-rate note (FRN) * equity-related issue Foreign Bond Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

340 International Debt MarketsBank loans and syndications: International bank loans have traditionally been sourced in the Eurocurrency markets, there is a narrow interest rate spread between deposit and loan rates of less than 1%. Eurocredits are bank loans to MNEs, sovereign governments, international institutions, and banks denominated in Eurocurrencies and extended by banks in countries other than the country in whose currency the loan is denominated. The syndication of loans has enabled banks to spread the risk of very large loans among a number of banks (this is significant for MNEs as they usually need credit in an amount larger than a single bank’s loan limit). Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

341 Exhibit 13.7 Comparative Spreads Between Lending and Deposit Rates in the Eurodollar MarketInterest Rate Domestic Loan Rate 7.000 % 4.625 % Eurodollar Loan Rate Domestic Spread of 4.000% Eurodollar Spread of 0.500% 4.125 % Eurodollar Deposit Rate Domestic Deposit Rate 3.000 % Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

342 International Debt MarketsThe Euronote market: Euronotes and Euronote facilities are short to medium in term and are either underwritten and non-underwritten Euro-commercial paper is a short-term debt obligation of a corporation or bank (usually denominated in US dollars) Euro medium-term notes is a new entrant to the world’s debt markets, which bridges the gap between Euro-commercial paper and a longer-term and less flexible international bond Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

343 International Debt MarketsThe International Bond Market: A Eurobond is underwritten by an international syndicate of banks and other securities firms and is sold exclusively in countries other than the country in whose currency the issue is denominated A foreign bond is underwritten by a syndicate composed of members from a single country, sold principally within that country, and denominated in the currency of that country The Eurobond markets differ from the Eurodollar markets in that there is an absence of regulatory interference, less stringent disclosure rules and favorable tax treatments for these bonds Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

344 Project Financing Project finance is the arrangement of financing for long-term capital projects, large in scale, long in life, and generally high in risk. Project finance is used widely today by MNEs in the development of large-scale infrastructure projects in China, India, and many other emerging markets. Most of these transactions are highly leveraged, with debt making up more than 60% of the total financing. Equity is a small component of project financing for two reasons; first, the scale of investment projects is often too large for an investor or group of investors to fund and second, many projects involve subjects traditionally funded by governments Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

345 Project Financing Since project financing usually utilizes a substantial amount of debt financing, additional levels of risk reduction are needed in order to create an environment whereby lenders feel comfortable lending: Separability of the project from its investors Long-lived and capital-intensive singular projects Cash flow predictability from third-party commitments Finite projects with finite lives Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

346 Interest Rate and Currency SwapsChapter 14 Interest Rate and Currency Swaps

347 Interest Rate Risk All firms – domestic or multinational, small or large, leveraged, or unleveraged – are sensitive to interest rate movements in one way or another. The single largest interest rate risk of the nonfinancial firm (our focus in this discussion) is debt service; the multicurrency dimension of interest rate risk for the MNE is of serious concern. The second most prevalent source of interest rate risk for the MNE lies in its holdings of interest-sensitive securities. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

348 Management of Interest Rate RiskBefore they can manage interest rate risk, treasurers and financial managers of all types must resolve a basic management dilemma: the balance between risk and return. Treasury has traditionally been considered a service center (cost center) and is therefore not expected to take positions that incur risk in the expectation of profit (treasury management practices are rarely evaluated as profit centers). Treasury management practices are therefore predominantly conservative, but opportunities to reduce costs or actually earn profits are not to be ignored. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

349 Management of Interest Rate RiskBoth foreign exchange and interest rate risk management must focus on managing existing or anticipated cash flow exposures of the firm. As in foreign exchange management exposure, the firm cannot undertake informed management or hedging strategies without forming expectations – a directional and/or volatility view – of interest rate movements. Fortunately, interest rate movements have historically shown more stability and less volatility than foreign exchange rate movements. Once management has formed expectations about future interest rate levels and movements, it must choose the appropriate implementation, a path that includes the selective use of various techniques and instruments. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

350 Management of Interest Rate RiskPrior to describing the management of the most common interest rate pricing risks, it is important to distinguish between credit risk and repricing risk. Credit risk, sometimes termed roll-over risk, is the possibility that a borrower’s credit worthiness, at the time of renewing a credit, is reclassified by the lender (resulting in changes to fees, interest rates, credit line commitments or even denial of credit). Repricing risk is the risk of changes in interest rates charged (earned) at the time a financial contract’s rate is reset. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

351 Management of Interest Rate RiskAs an example, Carlton Corporation has taken out a three-year, floating-rate loan in the amount of US$10 million (annual interest payments). Some alternatives available to management as a means to manage interest rate risk are as follows: Refinancing Forward rate agreements Interest rate futures Interest rate swaps Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

352 Management of Interest Rate RiskA forward rate agreement (FRA) is an interbank-traded contract to buy or sell interest rate payments on a notional principal. These contracts are settled in cash. The buyer of an FRA obtains the right to lock in an interest rate for a desired term that begins at a future date. The contract specifies that the seller of the FRA will pay the buyer the increased interest expense on a nominal sum (the notional principal) of money if interest rates rise above the agreed rate, but the buyer will pay the seller the differential interest expense if interest rates fall below the agreed rate. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

353 Management of Interest Rate RiskUnlike foreign currency futures, interest rate futures are relatively widely used by financial managers and treasurers of nonfinancial companies. Their popularity stems from the relatively high liquidity of the interest rate futures markets, their simplicity in use, and the rather standardized interest-rate exposures most firms possess. The two most widely used futures contracts are the Eurodollar futures traded on the Chicago Mercantile Exchange (CME) and the US Treasury Bond Futures of the Chicago Board of Trade (CBOT). Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

354 Management of Interest Rate RiskInterest rate futures strategies for common exposures: Paying interest on a future date (sell a futures contract/short position) If rates go up, the futures price falls and the short earns a profit (offsets loss on interest expense) If rates go down, the futures price rises and the short earns a loss Earning interest on a future date (buy a futures contract/long position) If rates go up, the futures price falls and the short earns a loss If rates go down, the futures price rises and the long earns a profit Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

355 Management of Interest Rate RiskSwaps are contractual agreements to exchange or swap a series of cash flows. These cash flows are most commonly the interest payments associated with debt service, such as the floating-rate loan described earlier. If the agreement is for one party to swap its fixed interest rate payments for the floating interest rate payments of another, it is termed an interest rate swap If the agreement is to swap currencies of debt service obligation, it is termed a currency swap A single swap may combine elements of both interest rate and currency swaps Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

356 Management of Interest Rate RiskThe swap itself is not a source of capital, but rather an alteration of the cash flows associated with payment. What is often termed the plain vanilla swap is an agreement between two parties to exchange fixed-rate for floating-rate financial obligations. This type of swap forms the largest single financial derivative market in the world. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

357 Management of Interest Rate RiskSince all swap rates are derived from the yield curve in each major currency, the fixed- to floating-rate interest rate swap existing in each currency allow firms to swap across currencies. The usual motivation for a currency swap is to replace cash flows scheduled in an undesired currency with flows in a desired currency. The desired currency is probably the currency in which the firm’s future operating revenues (inflows) will be generated. Firms often raise capital in currencies in which they do not possess significant revenues or other natural cash flows (a significant reason for this being cost). Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

358 Carlton Corporation: Swapping to Fixed RatesCarlton Corporation’s existing floating-rate loan is now the source of some concern. Recent events have led management to believe that interest rates, specifically LIBOR, may be rising in the three years ahead. As the loan is relatively new, refinancing is considered too expensive but management believes that a pay fixed/receive floating interest rate swap may be the better alternative for fixing future interest rates now. This swap agreement does not replace the existing loan agreement; it supplements it. Note that the swap agreement applies only to the interest payments on the loan and not the principal payments. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

359 Carlton Corporation: Swapping Floating Dollars into Fixed-Rate Swiss FrancsAfter raising US$10 million in floating-rate debt, and subsequently swapping into fixed-rate payments, management decides it would prefer to make its payments in Swiss francs. Since the company has a natural inflow of Swiss francs (sales contract) it may decide to match the currency of its debt denomination to its cash flows with a currency swap. Carlton now enters into a three-year pay Swiss francs and receive US dollars currency swap. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

360 Carlton Corporation: Swapping Floating Dollars into Fixed-Rate Swiss FrancsThe three-year currency swap entered into by Carlton is different from the plain vanilla interest rate swap described in two important ways: The spot exchange rate in effect on the date of the agreement establishes what the notional principal is in the target currency. The notional principal itself is part of the swap agreement (because in a currency swap the notional principals are denoted in two currencies, the exchange rate between which is likely to change over the life of the swap). Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

361 Carlton Corporation: Unwinding SwapsAs with all original loan agreements, it may happen that at some future date the partners to a swap may wish to terminate the agreement before it matures. Unwinding a currency swap requires the discounting of the remaining cash flows under the swap agreement at current interest rates, then converting the target currency (Swiss francs) back to the home currency (US dollars) of the firm. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

362 Counterparty Risk Counterparty risk is the potential exposure any individual firm bears that the second party to any financial contract will be unable to fulfill its obligations under the contract’s specifications. Counterparty risk has long been one of the major factors that favor the use of exchange-traded rather than over-the-counter derivatives. Most exchanges, like the Philadelphia Stock Exchange or Chicago Mercantile Exchange are themselves counterparty to all transactions. The real exposure of an interest or currency swap is not the total notional principal, but the mark-to-market values of differentials in interest of currency interest payments. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

363 Illustrative Case: A Three-Way Back-to-Back Cross-Currency SwapIndividual firms often find special demands for their debt in select markets, allowing them to raise capital at several points lower there than in other markets. Thus, a growing number of firms are confronted with debt service in currencies that are not normal for their operations. The result has been a use of debt issuances coupled with swap agreements from inception. The following exhibit depicts a three-way borrowing plus swap structure between a Canadian province, a Finnish export agency, and a multilateral development bank. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

364 Exhibit 14.10 A Three-way Back-to-Back Cross-Currency SwapProvince of Ontario (Canada) C$300 million C$150 million $260 million $130 million Borrows $390 million at US Treasury + 48 basis points Finish Export Credit (Finland) Inter-American Development Bank Borrows C$300 million at Canadian Treasury + 47 basis points Borrows C$150 million at Canadian Treasury + 44 basis points Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

365 Chapter 14 Appendix: Advanced Topics in Interest Rate ManagementAn interest rate cap is an option to fix a ceiling or maximum short-term interest-rate payment. The contract is written such that the buyer of the cap will receive a cash payment equal to the difference between the actual market interest rate and the cap strike rate on the notional principal, if the market rate rises above the strike rate. Like any option, the buyer of the cap pays a premium to the seller of the cap up front for this right. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

366 Chapter 14 Appendix: Advanced Topics in Interest Rate ManagementAn interest rate floor gives the buyer the right to receive the compensating payment (cash settlement) when the reference interest rate falls below the strike rate of the floor. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

367 Chapter 14 Appendix: Advanced Topics in Interest Rate ManagementNo theoretical limit exists to the specification of caps and floors. Most currency cap markets are liquid for up to ten years in the over-the-counter market, though the majority of trading falls between one and five years. An added distinction that is important to understanding cap maturity has to do with the number of interest rate resets involved. A common interest rate cap would be a two-year cap on three-month LIBOR. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

368 Chapter 14 Appendix: Advanced Topics in Interest Rate ManagementThe value of a capped interest payment is composed of three different elements (3-year, 3-month LIBOR reference rate cap): The actual three-month payment The amount of the cap payment to the cap buyer if the reference rate rises above the cap rate The annualized cost of the cap Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

369 Chapter 14 Appendix: Advanced Topics in Interest Rate ManagementInterest rate floors are basically call options on an interest rate, and equivalently, interest rate floors are put options on an interest rate. A floor guarantees the buyer of the floor option a minimum interest rate to be received (rate of return on notional principal invested) for a specified reinvestment period or series of periods. The pricing and valuation of a floor is the same as that of an interest rate cap. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

370 Exhibit 14A.2 Profile of an Interest Rate CapPayment (%) 7.50 Uncovered interest rate payment 7.00 6.50 The effective “cap” 6.00 Capped interest rate payment 5.50 5.00 5.50 6.00 6.50 7.00 7.50 8.00 Actual 3-month LIBOR on reset date (%)

371 German firm’s effectiveExhibit 14A.3 Profile of an Interest Rate Floor German firm’s effective investment rate (%) 6.50 Uncovered interest earnings 6.00 5.50 The effective “floor” Interest earnings with floor 5.00 4.50 4.00 4.50 5.00 5.50 6.00 6.50 7.00 6-month DM LIBOR on reset date (%)

372 Chapter 14 Appendix: Advanced Topics in Interest Rate ManagementAn interest rate collar is the simultaneous purchase (sale) of a cap and a sale (purchase) of a floor. The firm constructing the collar earns a premium from the sale of one side to cover in part of in full the premium expense of purchasing the other side of the collar. If the two premiums are equal, the position is often referred to as a zero-premium collar. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

373 Exhibit 14A.4 Profile of an Interest Rate CollarFirm’s interest rate payment (%) Uncovered interest rate payment 9.00 Floor strike rate Cap strike rate 8.00 7.00 6.00 5.00 Interest rate floor 4.00 Interest rate cap 3.00 2.00 1.00 0.00 0.5 1.5 2.5 3.5 4.5 5.5 6.5 Copyright © 2004 Pearson Addison-Wesley. All rights reserved. Actual market interest rate (%)

374 Chapter 14 Appendix: Advanced Topics in Interest Rate ManagementThe purchase of a swap option, a swaption, gives the firm the right but not the obligation to enter into a swap on a pre-determined notional principal at some defined future date at a specified strike rate. A firm’s treasurer would typically purchase a payer’s swaption, giving the treasurer the right to enter a swap in which they pay the fixed rate and receive the floating rate. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

375 Foreign Direct Investment Theory and StrategyChapter 15 Foreign Direct Investment Theory and Strategy

376 The Theory of Comparative AdvantageThe theory of comparative advantage provides a basis for explaining and justifying international trade in a model world assumed to enjoy free trade, perfect competition, no uncertainty, costless information, and no government interference. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

377 The Theory of Comparative AdvantageThe theory contains the following features: Exporters in Country A sell goods or services to unrelated importers in Country B Firms in Country A specialize in making products that can be produced relatively efficiently, given Country A’s endowment of factors of production, that is, land, labor, capital, and technology Firms in Country B do likewise, given the factors of production found in Country B In this way the total combined output of A and B is maximized Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

378 The Theory of Comparative AdvantageBecause the factors of production cannot be moved freely from Country A to Country B, the benefits of specialization are realized through international trade The way the benefits of the extra production are shared depends on the terms of trade, the ratio at which quantities of the physical goods are traded Each country’s share is determined by supply and demand in perfectly competitive markets in the two countries Neither Country A nor Country B is worse off than before trade, and typically both are better off, albeit perhaps unequally Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

379 The Theory of Comparative AdvantageAlthough international trade might have approached the comparative advantage model during the nineteenth century, it certainly does not today, for the following reasons: Countries do not appear to specialize only in those products that could be most efficiently produced by that country’s particular factors of production (as a result of government interference and ulterior motivations) At least two factors of production – capital and technology – now flow directly and easily between countries Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

380 The Theory of Comparative AdvantageModern factors of production are more numerous than in this simple model Although the terms of trade are ultimately determined by supply and demand, the process by which the terms are set is different from that visualized in traditional trade theory Comparative advantage shifts over time, as less developed countries become developed and realize their latent opportunities The classical model of comparative advantage did not really address certain other issues, such as the effect of uncertainty and information costs, the role of differentiated products in imperfectly competitive markets, and economies of scale Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

381 The Theory of Comparative AdvantageComparative advantage is however still a relevant theory to explain why particular countries are most suitable for exports of goods and services that support the global supply chain of both MNEs and domestic firms. The comparative advantage of the 21st century, however, is one based more on services, and thier cross-border facilitation by telecommunications and the Internet. The source of a nations comparative advantage is still created from the mixture of its own labor skills, access to capital, and technology. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

382 The Theory of Comparative AdvantageMany locations for supply chain outsourcing exist today (see the following exhibit). It takes a relative advantage in costs, not just an absolute advantage, to create comparative advantage. Clearly, the extent of global outsourcing is reaching out to every corner of the globe. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

383 Exhibit 15.5 Global Outsourcing of Comparative AdvantageCHINA BUDAPEST LONDON BERLIN EAST. EUROPE PARIS SHANGHAI RUSSIA PHILIPPINES UNITED STATES MANILA MOSCOW MEXICO MONTERREY SAN JOSE JOHANNESBURG GUADALAJARA BOMBAY HYDERABAD BANGALORE INDIA COSTA RICA S. AFRICA MNEs based in many of the major industrial countries are outsourcing many of their intellectual functions to providers based in many of the traditional emerging market countries. Data: Gartner, McKinsey, BW Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

384 Market Imperfections: A Rationale for the Existence of the Multinational FirmMNEs strive to take advantage of imperfections in national markets for products, factors of production, and financial assets. Imperfections in the market for products translate into market opportunities for MNEs. Large international firms are better able to exploit such competitive factors as economies of scale, managerial and technological expertise, product differentiation, and financial strength than are their local competitors. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

385 Market Imperfections: A Rationale for the Existence of the Multinational FirmStrategic motives drive the decision to invest abroad and become a MNE and can be summarized under the following categories: Market seekers Raw material seekers Production efficiency seekers Knowledge seekers Political safety seekers These categories are not mutually exclusive. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

386 Sustaining and Transferring Competitive AdvantageIn deciding whether to invest abroad, management must first determine whether the firm has a sustainable competitive advantage that enables it to compete effectively in the home market. The competitive advantage must be firm-specific, transferable, and powerful enough to compensate the firm for the potential disadvantages of operating abroad (foreign exchange risks, political risks, and increased agency costs). There are several competitive advantages enjoyed by MNEs. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

387 Sustaining and Transferring Competitive AdvantageEconomies of scale and scope: Can be developed in production, marketing, finance, research and development, transportation, and purchasing Large size is a major contributing factor (due to international and/or domestic operations) Managerial and marketing expertise: Includes skill in managing large industrial organizations (human capital and technology) Also encompasses knowledge of modern analytical techniques and their application in functional areas of business Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

388 Sustaining and Transferring Competitive AdvantageAdvanced technology: Includes both scientific and engineering skills Financial strength: Demonstrated financial strength by achieving and maintaining a global cost and availability of capital This is a critical competitive cost variable that enables them to fund FDI and other foreign activities Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

389 Sustaining and Transferring Competitive AdvantageDifferentiated products: Firms create their own firm-specific advantages by producing and marketing differentiated products Such products originate from research-based innovations or heavy marketing expenditures to gain brand identification Competitiveness of the home market: A strongly competitive home market can sharpen a firm’s competitive advantage relative to firms located in less competitive ones This phenomenon is known as the diamond of national advantage and has four components Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

390 supporting IndustriesExhibit Determinants of National Competitive Advantage: Porter’s Diamond (1) Factor conditions (4) Firm strategy, structure, & rivalry (2) Demand conditions (3) Related and supporting Industries Source: Michael Porter, “The Competitive Advantage of Nations,” Harvard Business Review, March-April 1990.

391 The OLI Paradigm and InternalizationThe OLI Paradigm is an attempt to create an overall framework to explain why MNEs choose FDI rather than serve foreign markets through alternative models such as licensing, joint ventures, strategic alliances, management contracts, and exporting. “O” owner-specific (competitive advantage in the home market that can be transferred abroad) “L” location-specific (specific characteristics of the foreign market allow the firm to exploit its competitive advantage) “I” internalization (maintenance of its competitive position by attempting to control the entire value chain in its industry) Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

392 Where to Invest? The decision about where to invest abroad is influenced by behavioral factors. The decision about where to invest abroad for the first time is not the same as the decision about where to reinvest abroad. In theory, a firm should identify its competitive advantages, and then search worldwide for market imperfections and comparative advantage until it finds a country where it expects to enjoy a competitive advantage large enough to generate a risk-adjusted return above the firm’s hurdle rate. In practice, firms have been observed to follow a sequential search pattern as described in the behavioral theory of the firm. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

393 Where to Invest? The decision to invest abroad is often a stage in the firm’s development process. Eventually the firm experiences a stimulus from the external environment, which leads it to consider production abroad. Some important external stimuli are: An outside proposal, from a quality source Fear of losing a market The “bandwagon” effect Strong competition from abroad in the home market Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

394 How to Invest Abroad: Modes of Foreign InvolvementThe globalization process includes a sequence of decisions regarding where production is to occur, who is to own or control intellectual property, and who is to own the actual production facilities. The following exhibit provides a roadmap to explain this FDI sequence. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

395 Exhibit 15.9 The FDI Sequence: Foreign Presence & Foreign InvestmentThe Firm and its Competitive Advantage Greater Foreign Presence Change Competitive Advantage Exploit Existing Competitive Advantage Abroad Greater Foreign Investment Production at Home: Exporting Production Abroad Licensing Management Contract Control Assets Abroad Joint Venture Wholly-Owned Affiliate Greenfield Investment Acquisition of a Foreign Enterprise

396 How to Invest Abroad: Modes of Foreign InvestmentExporting versus production abroad: There are several advantages to limiting a firm’s activities to exports as it has none of the unique risks facing FDI, Joint Ventures, strategic alliances and licensing with minimal political risks The amount of front-end investment is typically lower than other modes of foreign involvement Some disadvantages include the risks of losing markets to imitators and global competitors Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

397 How to Invest Abroad: Modes of Foreign InvestmentLicensing and management contracts versus control of assets abroad: Licensing is a popular method for domestic firms to profit from foreign markets without the need to commit sizeable funds However, there are disadvantages which include: License fees are lower than FDI profits Possible loss of quality control Establishment of a potential competitor in third-country markets Risk that technology will be stolen Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

398 How to Invest Abroad: Modes of Foreign InvestmentManagement contracts are similar to licensing, insofar as they provide for some cash flow from a foreign source without significant foreign investment or exposure Management contracts probably lessen political risk because the repatriation of managers is easy Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

399 How to Invest Abroad: Modes of Foreign InvestmentJoint venture versus wholly owned subsidiary: A joint venture is here defined as shared ownership in a foreign business Some advantages of a MNE working with a local joint venture partner are: Better understanding of local customs, mores and institutions of government Providing for capable mid-level management Some countries do not allow 100% foreign ownership Local partners have their own contacts and reputation which aids in business Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

400 How to Invest Abroad: Modes of Foreign InvestmentHowever, joint ventures are not as common as 100%-owned foreign subsidiaries as a result of potential conflicts or difficulties including: Increased political risk if the wrong partner is chosen Divergent views about the need for cash dividends, or the best source of funds for growth (new financing versus internally generated funds) Transfer pricing issues Difficulties in the ability to rationalize production on a worldwide basis Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

401 How to Invest Abroad: Modes of Foreign InvestmentGreenfield investment versus acquisition: A greenfield investment is defined as establishing a production or service facility starting from the ground up Compared to a greenfield investment, a cross-border acquisition is clearly much quicker and can also be a cost effective way to obtain technology and/or brand names Cross-border acquisitions are however, not without pitfalls, as firms often pay too high a price or utilize expensive financing to complete a transaction Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

402 How to Invest Abroad: Modes of Foreign InvestmentThe term strategic alliance conveys different meanings to different observers. In one form of cross-border strategic alliance, two firms exchange a share of ownership with one another. A more comprehensive strategic alliance, partners exchange a share of ownership in addition to creating a separate joint venture to develop and manufacture a product or service Another level of cooperation might include joint marketing and servicing agreements in which each partner represents the other in certain markets. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

403 Political Risk Assessment and ManagementChapter 16 Political Risk Assessment and Management

404 Defining Political RiskIn order for an MNE to identify, measure, and manage its political risks, it must define and classify these risks. This text classifies these risks as: Firm-specific Country-specific Global-specific This method of risk classification differs from the traditional method that classifies risks according to the disciplines of economics, finance, political science, sociology and law. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

405 Exhibit 16.1 Classification of Political RisksFirm-Specific Risks Country-Specific Risks Global-Specific Risks • Business risks • Terrorism & War • Foreign-exchange risks • Anti-globalization movement Transfer Risk Cultural and Institutional Risk • Governance risks • Environmental concerns • Poverty • Blocked funds • Ownership structure • Cyberattacks • Human resource norms • Religious heritage • Nepotism & corruption • Intellectual property rights Copyright © 2004 Pearson Addison-Wesley. All rights reserved. • Protectionism

406 Assessing Political RiskAt the macro level, firms attempt to assess a host country’s political stability and attitude toward foreign investors. At the micro level, firms analyze whether their firm-specific activities are likely to conflict with host-country goals as evidenced by existing regulations. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

407 Assessing Political RiskPredicting firm-specific risk (micro risk): Assessing the political stability of a country is only a first step The real objective is to anticipate the effect of political changes on activities of a specific firm Clearly, different foreign firms operating within the same country may have very different degrees of vulnerability to changes in host-country policy or regulations Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

408 Assessing Political RiskPredicting country-specific risk (macro risk): Political risk studies usually include an analysis of the historical stability of the country in question, evidence of present turmoil or dissatisfaction, indications of economic stability, and trends in cultural and religious activities Analysis of trends in these metrics leads many to speculate that the future will resemble the past, which is often not the case Despite this difficulty, the MNE must conduct adequate analysis in preparation for the unknown Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

409 Assessing Political RiskPredicting global-specific risk: Global-specific risk is clearly quite difficult to predict (i.e. September 11th) There are many groups interested in disrupting MNEs operations for the cause of religion, anti-globalization, environmental protection, and even anarchy We can expect to see a number of new indices, similar to country-specific indices, but devoted to ranking different types of terrorist threats, their locations, and potential targets Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

410 Firm-Specific Risks The firm-specific risks that confront MNEs include: Business risk Foreign exchange risk Governance risks Governance risk is the ability to exercise effective control over an MNE’s operations within a country’s legal and political environment For an MNE, it must be addressed for the individual business unit as well as for the MNE as a whole Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

411 Firm-Specific Risks Corporate governance principles include:Accountability (transparent ownership, appropriate board size, defined board accountability, and ownership neutrality) Disclosure and transparency (broad, timely and accurate disclosure, use of proper accounting standards) Independence (dispersed ownership, independent audits and oversight, independent directors) Shareholder equity (one share, one vote) Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

412 Firm-Specific Risks Negotiating investment agreements:An investment agreement spells out specific rights and responsibilities of both the foreign firm and host government The presence of MNEs is as often sought by development-seeking host governments as a particular foreign location is sought by an MNE An investment agreement should spell out policies on many areas including (among others): The basis of fund flows (fees, royalties, dividends) The basis for setting transfer prices The right to export to third-country markets Methods of taxation Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

413 Firm-Specific Risks Investment insurance and guarantees: OPICMNEs can sometimes transfer political risk to a home-country public agency through an investment insurance and guarantee program The US investment insurance and guarantee program is managed by the government-owned Overseas Private Investment Corporation (OPIC) OPIC offers insurance for four separate types of political risk: Inconvertibility Expropriation War, revolution, insurrection, and civil strife Business income (resulting from political violence) Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

414 Firm-Specific Risks Operating strategies after the FDI decision:Although an investment agreement creates obligations on the part of both foreign investor and host government, conditions change and agreements are often revised in the light of such changes Most MNEs, in their own self-interest, follow a policy of adapting to changing host-country priorities whenever possible The essence of such adaptation is anticipating host-country priorities and making the activities of the firm of continued value to the host country Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

415 Firm-Specific Risks Host countries may look for control of:Local sourcing of raw materials and components Facility location Transportation Technology Markets Brand names and trademarks Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

416 Country-Specific Risks: Transfer RiskTransfer risk is defined as limitations on the MNE’s ability to transfer funds into and out of a host country without restrictions. When a government runs short of foreign exchange and cannot obtain additional funds through borrowing or attracting new foreign investment, it usually limits transfers of foreign exchange out of the country, a restriction known as blocked funds. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

417 Exhibit 16.4 Management Strategies for Country-Specific RisksTransfer Risk Cultural and Institutional Risk Blocked Funds Ownership Structure Human Resource Norms • Preinvestment strategy to anticipate blocked funds • Joint venture • Local management & staffing • Fronting loans Religious Heritage Intellectual Property • Creating unrelated exports • Understand and respect host country religious heritage • Legal action in host country courts • Obtaining special dispensation • Forced reinvestment • Support worldwide treaty to protect intellectual property rights Nepotism and Corruption • Disclose bribery policy to both employees and clients Protectionism • Retain a local legal advisor • Support government actions to create regional markets Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

418 Country-Specific Risks: Transfer RiskMNEs can react to the potential for blocked funds at three stages: Prior to making an investment, a firm can analyze the effect of blocked funds on return on investment, the desired local financial structure etc. During operations a firm can attempt to move funds through a variety of repositioning techniques Funds that cannot be moved must be reinvested in the local country in a manner that avoids deterioration in their real value because of inflation or exchange depreciation Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

419 Country-Specific Risks: Cultural and Institutional RisksWhen investing in some of the emerging markets, MNEs that are resident in the most industrialized countries face serious risks because of cultural and institutional differences: Differences in allowable ownership structures Differences in human resource norms Differences in religious heritage Nepotism and corruption in the host country Protection of intellectual property rights Protectionism Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

420 Country-Specific Risks: Cultural and Institutional RisksOwnership structure: Many countries have required that MNEs share ownership of their foreign subsidiaries with local firms or citizens This requirement has been eased in most countries in recent years Human resource norms: MNEs are often required by host countries to employ a certain proportion of host country citizens rather than staffing mainly with foreign expatriates It is often very difficult to fire local employees due to host country labor laws and union contracts Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

421 Country-Specific Risks: Cultural and Institutional RisksReligious heritage: Despite religious differences, MNEs have operated successfully in emerging markets, especially in extractive and natural resource industries such as oil, natural gas, minerals and forest products Nepotism and corruption: There is clearly endemic nepotism and corruption in many important foreign investment locations Bribery is not limited to emerging markets, as it is also a problem in industrialized nations such as the US and Japan Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

422 Country-Specific Risks: Cultural and Institutional RisksIntellectual property rights: Intellectual property rights grant the exclusive use of patented technology and copyrighted creative materials Courts in some countries have historically not done a fair job of protecting these rights Protectionism: Protectionism is defined as the attempt by a national government to protect certain of its designated industries from foreign competition Industries that are usually protected are defense, agriculture, and infant (emerging) industries Protectionism occurs through the use of tariff and non-tariff barriers Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

423 Global-Specific RisksGlobal-specific risks faced by MNEs have come to the forefront in recent years: Terrorism and war Poverty Anti-globalization Cyber attacks Environmental concerns Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

424 MNE movement towards multiple primary objectives:Exhibit Management Strategies for Global-Specific Risks Terrorism & War Anti-Globalization Environmental Concerns • Support government efforts to flight terrorism and war • Support government efforts to reduce trade barriers • Show sensitivity to environmental concerns • Crisis planning • Recognize that MNEs are the targets • Support government efforts to maintain a level playing field for pollution controls Poverty Cyber Attacks • Provide stable, relatively well-paying jobs • No effective strategy except internet security efforts • Establish the strictest of occupational safety standards • Support government anti-cyber attack efforts MNE movement towards multiple primary objectives: Profitability, Sustainable Development, Corporate Social Responsibility Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

425 Illustration of Global-Specific Risks: The Case of StarbucksStarbucks found itself an early target of the anti-globalist movement. The company appeared to be yet another American cultural imperialist. As global prices for coffee plummeted in the late 1990’s, companies like Starbucks were criticized as being unwilling to help improve the economic conditions of the coffee growers themselves Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

426 Exhibit 16.8 Arabica Bean Coffee Prices, 1981-2001US cents/pound Source: International Coffee Organization (ICO), Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

427 Illustration of Global-Specific Risks: The Case of StarbucksMuch of the growing pressure on all multinational companies for sustainable development and social responsibility arose directly from consumer segments. In response, the company introduced in 1998 coffee that was cultivated under the canopy of shade trees in host countries (a practice considered ecologically sound). In addition, in 2000, the company introduced “Fair Trade” coffee in an effort to improve the living standards of coffee growers Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

428 Starbucks’ coffee buyers work with coffee wholesalers and directly with small farmers and farm cooperatives in procurement Infrastructure, including schools, clinics, and coffee processing facilities Supplemental funding for farm credit programs to support farm capital needs Contributions to CARE, the non-profit international relief organization Shade Grown Mexico Brand Partnership formed in 1998, encourages production of shade-grown coffee using ecologically sound growing practices to promote bio-diversity and to financially support farms employing these practices (with Conservation International, CI) Fair Trade Certified Brand Partnership in which Starbucks promises consumers that the farmers who produced the coffee beans were paid a guaranteed minimum price that helps support a better life for farm families (with TransFair USA) Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

429 Multinational Tax ManagementChapter 17 Multinational Tax Management

430 Multinational Tax ManagementTax planning for multinational operations is an extremely complex but vitally important aspect of international business. To plan effectively, MNEs must understand not only the intricacies of their own operations worldwide, but also the different structures and interpretations of tax liabilities across countries. The primary objective of multinational tax planning is the minimization of the firm’s worldwide tax burden. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

431 Multinational Tax ManagementTaxes have a major impact on corporate net income and cash flow through their influence on foreign investment decisions, financial structure, determination of the cost of capital, foreign exchange management, working capital management, and financial control. Management must not pursue the objective of minimizing the firm’s worldwide tax burden without full recognition that decision making within the firm must always be based on the economic fundamentals of the firm’s line of business. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

432 Tax Principles Tax morality:In many countries taxpayers, corporate or individual, do not voluntarily comply with the tax laws The MNE must decide whether to follow a practice of full disclosure to tax authorities or adopt the philosophy “When in Rome, do as the Romans do” Most MNEs follow the full disclosure practice Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

433 Tax Principles Tax neutrality:When a government decides to levy a tax, it must consider not only the potential revenue from the tax, or how effectively it can be collected, but also the effect the proposed tax can have on private economic behavior For example, the US government’s policy on taxation of foreign-source income has multiple objectives: Neutralizing tax incentives that favor or disfavor US private investment in developed countries Providing an incentive for US private investment in developing countries Improving the US BOP Raising revenue Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

434 Tax Principles One way to view neutrality is to require that the burden of taxation on each dollar, euro, pound, or yen of profit earned in home country operations by a MNE be equal to the burden of taxation on each currency equivalent of profit earned by the same firm in its foreign operations (domestic neutrality). A second way to view neutrality is to require that the tax burden on each foreign subsidiary of the firm be equal to the tax burden on its competitors in the am country (foreign neutrality). In theory, an equitable tax is one that imposes the same total tax burden on all taxpayers who are similarly situated and located in the same tax jurisdiction. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

435 Tax Principles Despite the fundamental objectives of national tax authorities, it is widely agreed that taxes do affect economic decisions made by MNEs. Tax treaties between nations and differential tax structures, rates, and practices all result in a less than level playing field for the MNEs competing on world markets. Nations typically structure their tax systems along one of two basic approaches: The worldwide approach The territorial approach Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

436 Tax Principles The worldwide approach, also referred to as the residential or national approach, levies taxes on the income earned by firms that are incorporated in the host country, regardless of where the income was earned (domestically or abroad). A MNE earning income both at home and abroad would therefore find its worldwide income taxed by its home country tax authorities. For example, a country like the US taxes the income earned by firms based in the US regardless of whether the income earned by the firm is domestic or foreign in origin. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

437 Tax Principles The territorial approach, also termed the source approach, focuses on the income earned by the firms within the legal jurisdiction of the host country, not on the country of firm incorporation. Countries like Germany follow this approach and apply taxes equally to foreign or domestic firms on income earned within the country, but in principle not on income earned outside the country. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

438 Tax Principles A network of bilateral tax treaties, many of which are modeled after one proposed by the Organization for Economic Cooperation and Development (OECD), provides a means of reducing double taxation. Tax treaties normally define whether taxes are to be imposed on income earned in one country by the nationals of another, and if so, how. Tax treaties are bilateral, with the two signatories specifying what rates are applicable to which types of income between themselves alone. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

439 Tax Principles Taxes are classified on the basis of whether they are applied directly to income, called direct taxes, or to some other measurable performance characteristic of the firm, called indirect taxes. Some categories include: Income tax Withholding tax Value-added tax Other national taxes Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

440 Tax Principles To prevent double taxation on the same income, most countries grant a foreign tax credit for income taxes paid to the host country. A tax credit is a direct reduction of taxes that would otherwise be due and payable. If there were no credits for foreign taxes paid, sequential taxation by the host government and then by the home government would result in a very high cumulative tax rate. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

441 US Taxation of Foreign Source IncomeAs discussed, the US applies the worldwide approach to international taxation to US MNEs operating globally, but the territorial approach to foreign firms operating within its borders. Dividends received from US corporate subsidiaries are fully taxable in the US at US tax rates but with credit allowed for direct taxes paid on income in a foreign country. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

442 US Taxation of Foreign Source IncomeThe amount of foreign tax allowed as a credit depends on five tax parameters: Foreign corporate income tax rate US corporate income tax rate Foreign corporate dividend withholding tax rate for nonresidents (per the applicable bilateral tax treaty) Proportion of ownership held by the US corporation in the foreign firm Proportion of net income distributed (payout rate) Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

443 US Taxation of Foreign Source IncomeIf a US based MNE receives income from a foreign country that imposes higher corporate income taxes than the US (or combined income and withholding tax), total creditable taxes will exceed US taxes on that foreign income. The result is excess foreign tax credits. The proper management of global taxes is not simple, and combines three different components: Foreign tax credit limitations Tax credit carry-forward/carry-back Foreign tax averaging Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

444 US Taxation of Foreign Source IncomeCarlton Corporation is considering acquiring a profitable telecommunications manufacturing company in Brazil. The due diligence process includes an examination of the tax implications of paying dividends to Carlton from its existing subsidiary, Carlton Germany, and simultaneously paying dividends to Carlton from Carlton Brazil. The following exhibit summarizes the key tax management issue for Carlton. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

445 Pays corporate income taxes Pays corporate income taxesExhibit Carlton’s Tax Management of Foreign-Source Income Carlton Brazil Pays corporate income taxes in Brazil of 25% Dividend remitted after-tax Has paid less than US tax requirement of 35% on income Declares a dividend to its US parent Withholding taxes are deducted from the dividend before leaving Brazil of an additional 5% Carlton Germany Pays corporate income taxes in Germany of 40% Withholding taxes are deducted from the dividend before leaving Germany of an additional 10% Dividend remitted after-tax Has paid more than US tax requirement of 35% on income Declares a dividend to its US parent Efficient management of Carlton’s foreign tax position requires it to try and balance Deficit Foreign Tax Credits against Excess Foreign Tax Credits Carlton Pays corporate income taxes in the United States of 35% Deficit Foreign Tax Credit Excess Foreign Tax Credit Pays taxes to US government separately on domestic-source income & foreign-source income

446 US Taxation of Foreign Source IncomeThe rule that US shareholders do not pay US taxes on foreign-source income until that income is remitted to the US was amended in 1962 by the creation of special Subpart F income. The revision was designed to prevent the use of arrangements between operating companies and base companies located in tax havens as a means of deferring US taxes and to encourage greater repatriation of foreign incomes. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

447 US Taxation of Foreign Source IncomeSubpart F income is subject to immediate US taxation even when not remitted. It is income of a type otherwise easily shifted offshore to avoid current taxation and includes: Passive income received by the foreign corporation such as dividends, interest, rents, royalties, net foreign currency gains, net commodities gains, and income from the sale of non-income-producing property Income from the issuance of US risks Financial service income Shipping income Oil-related income Certain related-party sales and service income Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

448 US Taxation of Foreign Source IncomeA MNE normally has a choice whether to organize a foreign subsidiary as a branch of the parent or as a local corporation. Both tax and nontax consequences must be considered. Nontax factors include the locus of legal liability, public image in the host country, managerial incentive considerations, and local legal and political requirements. A major tax consideration is whether the foreign subsidiary is expected to run at a loss for several years after start-up. A second tax consideration is the net tax burden after paying withholding taxes on dividends. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

449 US Taxation of Foreign Source IncomeOver the years, the US has introduced into US tax laws special incentives dealing with international operations. To benefit from these incentives, a firm may have to form separate corporations for qualifying and nonqualifying activities. The most important US special corporation is a foreign sales corporation (FSC). Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

450 US Manufacturer European BuyerExhibit Foreign Sales Corporations (FSCs) US Manufacturer European Buyer Physical goods Goods are sold on paper to its Foreign Sales Corporation located in the U.S. Virgin Islands Foreign Sales Corporation completes the sale by re-selling the goods to the European Buyer. Foreign Sales Corporation (U.S. Virgin Islands) 1. The payment by the European Buyer is routed through the FSC. The FSC may charge the U.S. parent a commission, or simply pass the full payment on. 2. The tax benefits arise from the fact that up to 34% of the paper “profits” of the resale are excluded from U.S. taxation. 3. When the FSC pays a dividend to its parent on its profits, the dividend is not taxed by the U.S. tax authorities. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

451 US Taxation of Foreign Source IncomeThe primary tax issues facing a US-based MNE are: Domestic-source income and foreign-source income are separated Foreign-source income is separated into active and passive categories If the remittance of active income from one subsidiary results in an excess foreign tax credit, and the remittance from a second subsidiary results in a foreign tax deficit, the credit may be applied to the deficit if the incomes are of the same “basket” under US tax law Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

452 Tax-Haven Subsidiaries and International Offshore Financial CentersMany MNEs have foreign subsidiaries that act as tax havens for corporate funds awaiting reinvestment or repatriation. Tax-haven subsidiaries, categorically referred to as international offshore financial centers, are partially a result of tax-deferral features on earned foreign income allowed by some of the parent countries. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

453 Tax-Haven Subsidiaries and International Offshore Financial CentersTax-haven subsidiaries are typically established in a country that can meet the following requirements: A low tax on foreign investment or sales income earned by resident corporations and a low dividend withholding tax on dividends paid to the parent firm A stable currency to permit easy conversion of funds into and out of the local currency The facilities to support financial services activity A stable government that encourages the establishment of foreign-owned financial and service facilities within its borders Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

454 Exhibit 17.9 International Offshore Financial CentersCopyright © 2004 Pearson Addison-Wesley. All rights reserved.

455 Multinational Capital BudgetingChapter 18 Multinational Capital Budgeting

456 Multinational Capital BudgetingAlthough the original decision to undertake an investment in a particular foreign country may be determined by a mix of strategic, behavioral, and economic decisions – as well as reinvestment decisions – it should be justified by traditional financial analysis. Multinational capital budgeting, like traditional domestic capital budgeting, focuses on the cash inflows and outflows associated with prospective long-term investment projects. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

457 Multinational Capital BudgetingCapital budgeting for a foreign project uses the same theoretical framework as domestic capital budgeting. The basic steps are: Identify the initial capital invested or put at risk Estimate cash flows to be derived from the project over time, including an estimate of the terminal or salvage value of the investment Identify the appropriate discount rate to use in valuation Apply traditional capital budgeting decision criteria such as NPV and IRR Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

458 Complexities of Budgeting for a Foreign ProjectCapital budgeting for a foreign project is considerably more complex than the domestic case: Parent cash flows must be distinguished from project cash flows Parent cash flows often depend on the form of financing Additional cash flows generated by a new investment in one foreign subsidiary may be in part or in whole taken away from another subsidiary Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

459 Complexities of Budgeting for a Foreign ProjectThe parent must explicitly recognize remittance of funds because of differing tax systems, legal and political constraints on the movement of funds, local business norms, and differences in the way financial markets and institutions function An array of nonfinancial payments can generate cash flows from subsidiaries to the parent Managers must keep the possibility of unanticipated foreign exchange rate changes in mind because of possible direct effects on cash flows as well as indirect effects on competitiveness Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

460 Project Versus Parent ValuationA strong theoretical argument exists in favor of analyzing any foreign project from the viewpoint of the parent. Cash flows to the parent are ultimately the basis for dividends to stockholders, reinvestment elsewhere in the world, repayment of corporate-wide debt, and other purposes that affect the firm’s many interest groups. However, this viewpoint violates a cardinal concept of capital budgeting – that financial cash flows should not be mixed with operating cash flows. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

461 Project Versus Parent ValuationEvaluation of a project from the local viewpoint serves some useful purposes, but is should be subordinated to evaluation from the parent’s viewpoint. In evaluating a foreign project’s performance relative to the potential of a competing project in the same host country, we must pay attention to the project’s local return. Almost any project should at least be able to earn a cash return equal to the yield available on host government bonds (with the same maturity as the project’s economic life). Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

462 Project Versus Parent ValuationMultinational firms should invest only if they can earn a risk-adjusted return greater than locally based competitors can earn on the same project. If they are unable to earn superior returns on foreign projects, their stockholders would be better of buying shares in local firms, where possible, and letting those companies carry out the local projects. Most firms appear to evaluate foreign projects from both parent and project viewpoints (to obtain perspectives on NPV and the overall effect on consolidated earnings of the firm). Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

463 Illustrative Case: Cemex Enters IndonesiaIt is early 1998, Cementos Mexicanos is considering the construction of a cement manufacturing facility on the Indonesian island of Sumatra. This project would be a wholly-owned greenfield investment. The company has three main reasons for the project: Initiate a productive presence in Southeast Asia To position Cemex to benefit from infrastructural development in the region The positive prospects for Indonesia to act as a produce-for-export site Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

464 Illustrative Case: Cemex Enters IndonesiaThe following exhibit details the complete multinational capital budgeting analysis for Cemex in Indonesia. Essentially, the parent company will invest US dollar-denominated capital, which flows through the creation and operation of the Indonesian subsidiary which subsequently generates cash flows that are returned to the parent in various forms (in US dollars). Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

465 Is the project investmentExhibit A Road-Map to the Construction of Semen Indonesia’s Capital Budget START Cementos Mexicanos (Mexico) Semen Indonesia (Sumatra, Indonesia) US$ invested in Indonesia cement manufacturing firm END Is the project investment Justified (NPV > 0)? Estimated cash flows of project Parent viewpoint Capital Budget (U.S. dollars) Project Viewpoint Capital Budget (Indonesian rupiah) Cash flows remitted to Cemex (Rp to US$) Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

466 Illustrative Case: Cemex Enters IndonesiaThe first step is to construct a set of pro forma financial statements for Semen Indonesia (in Indonesian Rupiah). The next step is to create two capital budgets, the project viewpoint and parent viewpoint. Financial assumptions are then made about: Capital investment Method of financing Revenue/cost forecasts Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

467 Illustrative Case: Cemex Enters IndonesiaThe project viewpoint capital budget indicates a negative NPV and an IRR of only 15.4% compared to the 33.3% cost of capital. These are the returns the project would yield to a local or Indonesian investor in Indonesian rupiah. The project, from this viewpoint, is not acceptable. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

468 Illustrative Case: Cemex Enters IndonesiaA foreign investor’s assessment of a project’s returns depends on the actual cash flows that are returned to it, in its own currency. For Cemex, this means that the investment must be analyzed in terms of US dollar cash inflows and outflows associated with the investment over the life of the project, after-tax, discounted at the appropriate cost of capital. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

469 Illustrative Case: Cemex Enters IndonesiaWe build this parent viewpoint capital budget in two steps. First, we isolate the individual cash flows, adjusted for any withholding taxes imposed by the Indonesian government and converted to US dollars. The second step, that actual parent viewpoint capital budget, combines these US dollar after-tax cash flows with the initial investment to determine the NPV of the proposed Indonesian subsidiary in the eyes (and pocketbook) of Cemex. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

470 Illustrative Case: Cemex Enters IndonesiaMost corporations require that the new investments more than cover the cost of the capital employed in their undertaking. It is therefore not unusual for the firm to require a hurdle rate of 3% over the cost of capital for domestic investments, and 6% more for international projects. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

471 Illustrative Case: Cemex Enters IndonesiaAt this point sensitivity analyses are run from both the project and parent viewpoints. This would include analyzing (for the project): Political risks Foreign exchange risks Other business specific potentialities And analyzing (for the parent): A range of discount rates Varying cash flow patterns Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

472 Real Options Analysis The discounted cash flow (DCF) analysis used in the valuation of Semen Indonesia, and in capital budgeting and valuation in general, has long had its critics. Importantly, when MNEs evaluate competitive projects, traditional cash flow analysis is typically unable to capture the strategic options that an individual invest option may offer. This has led to the development of real options analysis. Real options analysis is the application of the option theory to capital budgeting decisions. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

473 Real Options Analysis Real options is a different way of thinking about investment values. At its core, it is a cross between decision-tree analysis and pure option-based valuation. Real option valuation also allows us to analyze a number of managerial decisions that in practice characterize many major capital investment projects: The option to defer The option to abandon The option to alter capacity The option to start up or shut down Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

474 Cross-Border Mergers, Acquisitions, and ValuationChapter 19 Cross-Border Mergers, Acquisitions, and Valuation

475 Cross-Border Mergers, Acquisitions, and ValuationAlthough there are many pieces to the puzzle of building shareholder value, ultimately it comes down to growth. An increasingly popular route to “going global” in search of new markets, resources, productive advantages, and other elements of competition and profit is through cross-border mergers and acquisitions. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

476 Cross-Border Mergers, Acquisitions, and ValuationCross-border mergers, acquisitions, and strategic alliances all face similar challenges: they must value the target enterprise on the basis of its projected performance in its market. An enterprise’s potential value is a combination of the intended strategic plan and the expected operational effectiveness to be implemented post-acquisition. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

477 Cross-Border Mergers and AcquisitionsThe number and dollar value of cross-border mergers and acquisitions (M&A) have grown rapidly in recent years, but the growth and magnitude of activity are taking place in the developed countries, not developing countries. The following exhibit illustrates that the growth in M&A within developed countries has been torrid in recent years (particularly within the EU and US). Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

478 Exhibit 19.1 Cross-Border Mergers & Acquisitions: Developed Countries (billions of US dollars)Source: United Nations Center for Trade and Development (UNCTAD).

479 Cross-Border Mergers and AcquisitionsThe next slide, presents evidence of cross-border M&A activity among the developing countries. While the growth and magnitude looks impressive, it is clear that the total M&A activity in developing countries was only a fraction (at 8%) of the total. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

480 Exhibit 19.2 Cross-Border Mergers & Acquisitions: Developing Countries (billions of US dollars)Source: United Nations Center for Trade and Development (UNCTAD).

481 Cross-Border Mergers and AcquisitionsAmong the developing regions of the world, cross-border M&A activity has been focused nearly exclusively on Latin America and Asia. West Asia, Eastern Europe and Africa have largely been bypassed in the international rush to acquire. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

482 Cross-Border Mergers and AcquisitionsThe true motivation for cross-border mergers and acquisitions is a traditional one: to build shareholder value. The following exhibit justifies this global expansion as a result of the following: Publicly traded MNEs live and die, in the eyes of the shareholders, by their share price If the MNE’s share price is a combination of the earnings of the firm and the market’s opinion of those earnings and the price-to-earnings multiple, management must strive to grow both Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

483 Cross-Border Mergers and AcquisitionsManagement’s problem is that it does not directly influence the market’s opinion of its earnings Although management’s responsibility is to increase the P/E ratio, this is a difficult, indirect, and long-term process of communication and promise fulfillment However, management does control EPS and often must look outward to build value The global marketplace can offer greater growth potential or “bang for the buck” when compared to struggling within a domestic market for market share and profits Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

484 Exhibit 19.3 Building Shareholder Value Means Building EarningsThe Goal: Increase the share price of the firm P E Price = EPS x Increasing the share price means increasing earnings. Management, directly controls through its efforts the earnings per share of the firm. Management only indirectly influences the market’s opinion of the company’s earnings as reflected in the P/E. So building “value” means growing the firm to grow earnings. The largest growth potential is global.

485 Cross-Border Mergers and AcquisitionsIn addition to the desire to grow, MNEs are motivated to undertake cross-border mergers and acquisitions by a number of other factors. The United Nations Conference on Trade and Development (UNCTAD), has summarized the M&A drivers in the following exhibit. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

486 Exhibit 19.4 Driving Forces Behind Cross Border M&ACross - border M & A activity Changes in the Global Environment • Technology • Regulatory frameworks • Capital market changes New business opportunities and risks Firms Undertake M&As to: • Access strategic proprietary assets • Gain market power & dominance • Achieve synergies • Become larger • Diversify & spread risks • Exploit financial opportunities Strategic responses by firms to defend and enhance their competitive positions in a changing environment. time Source: UNCTAD, World Development Report 2000: Cross-border Mergers and Acquisitions and Development, figure V.1., p. 154.

487 Cross-Border Mergers and AcquisitionsThe drivers of M&A activity are both macro in scope (the global competitive environment) and micro in scope (the variety of industry and firm-level forces and actions driving individual firm value). The primary forces of change in the global competitive environment – technological change, regulatory change, and capital markets change – create new business opportunities for MNEs. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

488 Cross-Border Mergers and AcquisitionsAs shown in exhibit 19.4, MNEs undertake cross-border M&A for a variety of reasons. The drivers are strategic responses by MNEs to defend and enhance their global competitiveness by: Gaining access to strategic proprietary assets Gaining market power and dominance Achieving synergies in local/global operations across different industries Becoming larger, and then reaping the benefits of size in competition and negotiation Diversifying and spreading their risks wider Exploiting financial opportunities they may possess Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

489 Cross-Border Mergers and AcquisitionsAs opposed to a greenfield investment, a cross-border acquisition has a number of significant advantages. First, it is quicker (shortening the time required to gain a presence and facilitate competitive entry into the market). Second, acquisition may be a cost-effective way of gaining competitive advantages such as technology, brand names, and/or logistic/distribution capabilities while eliminating a local competitor. Third, specific to cross-border acquisitions, international economic, political, and foreign exchange conditions may result in market imperfections, allowing target firms to be undervalued. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

490 Cross-Border Mergers and AcquisitionsCross-border acquisitions are not, however, without their pitfalls. There are still problems with paying too much or suffering excessive financing costs. Melding corporate cultures can also be traumatic. In addition, management of the post-acquisition process is extremely difficult to do successfully. Internationally, additional difficulties arise from host governments intervening in pricing, financing, employment guarantees, market segmentation, and general nationalism and favoritism. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

491 The Cross-Border Acquisition StrategyThe process of acquiring an enterprise anywhere in the world has three common elements: Identification and valuation of the target Completion of the ownership change transaction (the tender) Management of the post-acquisition transition Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

492 transition; integrationExhibit The Cross-Border Acquisition Process Stage I Stage II Stage III Identification & valuation of the target Completion of the ownership change transaction (the tender) Management of the post-acquisition transition; integration of business and culture Strategy & Management Valuation & negotiation Financial settlement & compensation Rationalization of operations; integration of financial goals; achieving synergies Financial Analysis & Strategy

493 The Cross-Border Acquisition StrategyStage I – Involves the identification task for firms that have promising market opportunities and may be amenable to suitors in addition to valuation using traditional (DCF) and multiples (earnings and cash flows) analysis. Stage II – Requires gaining the approval of the target company (target company management support), regulatory approval and the appropriate compensation settlement for target shareholders. Stage III – This critical process requires the realization of the motivations for the transaction itself and can be extremely difficult for a variety of reasons. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

494 Corporate Governance and Shareholder RightsOne of the most controversial issues in shareholder rights is at what point in the accumulation of shares is the bidder required to make all shareholders a tender offer. While every country possesses a different set of rules and regulations for the transfer of control, the market for corporate control has been the subject of enormous debate in recent years. There are many elements involved in the regulation of cross-border takeovers. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

495 Cross-Border ValuationIllustrative case: The potential acquisition of Tsingtao brewery Company, Ltd., China In January 2001, Anheuser Busch (AB) was considering acquiring a larger minority interest in Tsingtao Brewery Company Ltd., China AB had originally acquired a 5% equity interest in 1993 when Tsingtao had first been partly privatized Since AB had already identified the target (Phase I), it would only need to value the target’s shares (Phase II) and to assess its prospects for post acquisition influence on Tsingtao’s operations Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

496 Cross-Border ValuationIn 1999, negotiations had broken down between AB and Tsingtao because Tsingtao would not offer AB a voice in its operations. However, by 2001, Tsingtao needed an equity infusion to grow its business. Key questions for AB were: The valuation of Tsingtao shares in an illiquid Chinese market The percentage of Tsingtao’s total equity to be purchased The terms of the transaction The prospects for AB to contribute management skills to Tsingtao The degree of future compatibility between the two corporate cultures The potential for future rationalization of operations Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

497 Cross-Border ValuationAs a fundamental metric in the determination of value, free cash flow (FCF) is a critical input in the valuation of any enterprise. FCF = NOPAT + D&A – Δ in NWC – CAPEX Where: NOPAT = net operating profit after tax D&A = depreciation and amortization NWC = net working capital CAPEX = capital expenditures Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

498 Cross-Border ValuationAnalyzing Tsingtao’s FCF for 2000 shows a healthy operating cash flow (OCF) but a negative FCF due to enormous capital expenditures. For valuation purposes, this (and previous years) detailed financial data is utilized in forecasting expected future free cash flows (in this example in local currency). These free cash flows are valued using a risk-adjusted discount rate; in this methodology the Tsingtao (local currency) WACC is used. In addition, the terminal value of the firm, beyond the FCF projection period, is also added to the value of the FCF to determine the entity value. Equity value is determined by subtracting the PV of debt capital. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

499 Cross-Border ValuationIn addition to the DCF exercise, a multiples analysis is performed by analyzing (in this case): Price/Earnings Ratio (P/E) - an indication of what the market is willing to pay for a currency unit of earnings Market/Book Ratio (M/B) - provides some measure of the market’s assessment of the employed capital per share versus what the capital cost Other multiples – including (in this case) price/sales or entity/enterprise value to EBTIDA (business earnings) Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

500 International Portfolio Theory and DiversificationChapter 20 International Portfolio Theory and Diversification

501 International Diversification and RiskThe case for international diversification of portfolios can be decomposed into two components, the first of which is the potential risk reduction benefits of holding international securities. This initial focus is on risk. The risk of a portfolio is measured by the ratio of the variance of a portfolio’s return relative to the variance of the market return (portfolio beta). As an investor increases the number of securities in a portfolio, the portfolio’s risk declines rapidly at first, then asymptotically approaches the level of systematic risk of the market. A domestic portfolio that is fully diversified would have a beta of 1.0. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

502 Variance of portfolio return Variance of market returnExhibit Portfolio Risk Reduction Through Diversification Variance of portfolio return Variance of market return Percent risk = 100 80 Total Risk = Diversifiable Risk Market Risk (unsystematic) (systematic) 60 40 Portfolio of U.S. stocks 27% 20 Total risk Systematic risk 1 10 20 30 40 50 Number of stocks in portfolio By diversifying the portfolio, the variance of the portfolio’s return relative to the variance of the market’s return (beta) is reduced to the level of systematic risk -- the risk of the market itself.

503 International Diversification and RiskThe total risk of any portfolio is therefore composed of systematic risk (the market) and unsystematic risk (the individual securities). Increasing the number of securities in the portfolio reduces the unsystematic risk component leaving the systematic risk component unchanged. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

504 International Diversification and RiskThe second component of the case for international diversification addresses foreign exchange risk. The foreign exchange risks of a portfolio, whether it be a securities portfolio or the general portfolio of activities of the MNE, are reduced through international diversification. Purchasing assets in foreign markets, in foreign currencies may alter the correlations associated with securities in different countries (and currencies). This provides portfolio composition and diversification possibilities that domestic investment and portfolio construction may not provide. The risk associated with international diversification, when it includes currency risk, is very complicated when compared to domestic investments. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

505 International Diversification and RiskInternational diversification benefits induce investors to demand foreign securities (the so called buy-side). If the addition of a foreign security to the portfolio of the investor aids in the reduction of risk for a given level of return, or if it increases the expected return for a given level of risk, then the security adds value to the portfolio. A security that adds value will be demanded by investors, bidding up the price of that security, resulting in a lower cost of capital for the issuing firm. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

506 Internationalizing the Domestic PortfolioClassic portfolio theory assumes a typical investor is risk-averse. This means an investor is willing to accept some risk but is not willing to bear unnecessary risk. The typical investor is therefore in search of a portfolio that maximizes expected portfolio return per unit of expected portfolio risk. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

507 Internationalizing the Domestic PortfolioThe domestic investor may choose among a set of individual securities in the domestic market. The near-infinite set of portfolio combinations of domestic securities form the domestic portfolio opportunity set (next exhibit). The set of portfolios along the extreme left edge of the set is termed the efficient frontier. This efficient frontier represents the optimal portfolios of securities that possess the minimum expected risk for each level of expected portfolio return. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

508 Internationalizing the Domestic PortfolioThe portfolio with the minimum risk along all those possible is the minimum risk domestic portfolio (MRDP). The individual investor will search out the optimal domestic portfolio (DP), which combines the risk-free asset and a portfolio of domestic securities found on the efficient frontier. He or she begins with the risk-free asset (Rf) and moves out along the security market line until reaching portfolio DP. This portfolio is defined as the optimal domestic portfolio because it moves out into risky space at the steepest slope. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

509 • • Exhibit 20.3 Optimal Domestic Portfolio Construction R DP Rf  DPCapital Market Line (Domestic) Optimal domestic portfolio (DP) Expected Return of Portfolio, Rp • DP R DP Minimum risk (MRDP ) domestic portfolio • MRDP Rf Domestic portfolio opportunity set Expected Risk of Portfolio,p  DP An investor may choose a portfolio of assets enclosed by the Domestic portfolio opportunity set. The optimal domestic portfolio is found at DP, where the Security Market Line is tangent to the domestic portfolio opportunity set. The domestic portfolio with the minimum risk is designated MRDP.

510 International Diversification and RiskThe next exhibit illustrates the impact of allowing the investor to choose among an internationally diversified set of potential portfolios. The internationally diversified portfolio opportunity set shifts leftward of the purely domestic opportunity set. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

511 Exhibit 20.4 The Internationally-Diversified Portfolio Opportunity SetExpected Return of Portfolio, Rp • DP R DP Internationally diversified portfolio opportunity set Domestic portfolio opportunity set Rf Expected Risk of Portfolio,p  DP The addition of internationally-diversified portfolios to the total opportunity set available to the investor shifts the total portfolio opportunity set left, providing lower expected risk portfolios for each level of expected portfolio return.

512 International Diversification and RiskIt is critical to be clear as to exactly why the internationally diversified portfolio opportunity set is of lower expected risk than comparable domestic portfolios. The gains arise directly from the introduction of additional securities and/or portfolios that are of less than perfect correlation with the securities and portfolios within the domestic opportunity set. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

513 International Diversification and RiskThe investor can now choose an optimal portfolio that combines the same risk-free asset as before with a portfolio from the efficient frontier of the internationally diversified portfolio opportunity set. The optimal international portfolio, IP, is again found by locating that point on the capital market line (internationally diversified) which extends from the risk-free asset return of Rf to a point of tangency along the internationally diversified efficient frontier. The benefits are obvious in that a higher expected portfolio return with a lower portfolio risk can be obtained when compared to the domestic portfolio alone. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

514 • • Exhibit 20.5 The Gains from InternationalPortfolio Diversification Capital Market Line (International) Optimal international portfolio Capital Market Line (Domestic) Expected Return of Portfolio, Rp Increased return of optimal portfolio • R IP IP • DP R DP Internationally diversified portfolio opportunity set Domestic portfolio opportunity set Rf Expected Risk of Portfolio,p  IP  DP Risk reduction of optimal portfolio

515 International Diversification and RiskAn investor can reduce investment risk by holding risky assets in a portfolio. As long as the asset returns are not perfectly positively correlated, the investor can reduce risk, because some of the fluctuations of the asset returns will offset each other. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

516 • • • • Exhibit 20.5 Alternative Portfolio ProfilesUnder Varying Asset Weights Expected Portfolio Return (%) • 18 17 • Maximum return & maximum risk (100% GER) Initial portfolio (40% US & 60% GER) 16 • Minimum risk combination (70% US & 30% GER) 15 • Domestic only portfolio (100% US) 14 13 12 Expected Portfolio Risk ( ) 11 12 13 14 15 16 17 18 19 20

517 National Markets and Asset PerformanceAsset portfolios are traditionally constructed using both interest bearing risk-free assets and risky assets. For the 100 year period ending in 2000, the risk of investing in equity assets has been rewarded with substantial returns. The true benefits of global diversification, however, arise from the fact that the returns of different stock markets around the world are not perfectly positively correlated. This is because the are different industrial structures in different countries, and because different economies do not exactly follow the same business cycle. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

518 National Markets and Asset PerformanceInterestingly, markets that are contiguous or near-contiguous (geographically) seemingly demonstrate the higher correlation coefficients for the past century. It is often said that as capital markets around the world become more and more integrated over time, the benefits of diversification will be reduced. Analysis of market data supports this idea (although the correlation coefficients between markets are still far from 1.0). Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

519 The International Capital Asset Pricing ModelThe use of an international portfolio could have implications on an MNE’s cost of capital. The capital asset pricing model (CAPM) states that the expected return on an equity by an investor is the sum of two components, a risk-free rate of interest and a risk-premium component (which is based on the perceived riskiness of the individual security relative to the market). Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

520 The International Capital Asset Pricing ModelThe CAPM formula is as follows: ke = krf + βi(km – krf) Where: ke = expected (required) rate of return on equity i krf = rate of interest on risk-free bonds (Treasury bonds, for example) βi = coefficient of systematic risk for the firm km = expected (required) rate of return on the market portfolio of stocks Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

521 The International Capital Asset Pricing ModelThe measure of risk, beta (β), is a measure of how the returns of the individual security, i, are expected to vary and covary with that of the market. Specifically, beta is calculated as: βi = ρim σi σm Where rho (ρim) is the correlation between security i and the market, and σi and σm are the standard deviations of security i and the market, respectively. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

522 The International Capital Asset Pricing ModelIn theory, the primary distinction in the estimation of the cost of equity for an individual firm using an internationalized version of the CAPM is the definition of the “market” and a recalculation of the firm’s beta for the market. This is very significant as one must address what sort of portfolio investors hold (domestic or internationally diversified) in determining the expected market return component of the CAPM as well as beta (β). Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

523 Chapter 21 Repositioning Funds

524 Repositioning Funds An MNE is constantly striving to create shareholder value by maximizing the after-tax profitability of the firm. One dimension of this task is to reposition the profits of the firm, as legally and practically as possible, in low-tax environments. Repositioning allows an MNE to increase after-tax profits by lowering its tax liabilities with the same amount of sales. Repositioning is also useful when a MNE wishes to redeploy cash flows or funds to more value-creating activities or to minimize exposure to a potential currency collapse, or political or economic crises. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

525 Cascade Pharmaceutical, Inc. (Cascade)Cascade is a US-based MNE specializing in the manufacture and distribution of generic drugs worldwide. Cascade’s three foreign subsidiaries each present a unique set of concerns for management: Cascade Europe – High-tax environment, mature business (few growth opportunities), stable currency Cascade Mexico – Medium-tax environment, solid growth opportunities, volatile currency Cascade China – 50%-owned joint-venture, low-tax environment, capital restrictions, significant long-term growth potential Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

526 Cascade Pharmaceutical, Inc.Exhibit Cascade Pharamceutical’s Subsidiaries & Their Growth Potentials Cascade Pharmaceutical, Inc. (Boston, USA) Currency: the dollar (US$) Tax rate: 35% Capital restrictions: None US Manufacturing Facility Subsidiary status: Business: mature Cascade China (Shanghai, China) Cascade Mexico (Monterrey, Mexico) Cascade Europe (Frankfurt, Germany) Greenfield Investment Acquisition Investment Joint Venture Investment Currency: the euro (€) Tax rate: 45% Capital restrictions: None Country: Currency: the peso (Ps) Tax rate: 34% Capital restrictions: None Country: Currency: the renminbi (Rmb) Tax rate: 30% Capital restrictions: Many Country: Subsidiary status: Business: mature Subsidiary status: Business: immediate growth potential Subsidiary status: Business: long-term growth potential

527 Cascade Pharmaceutical, Inc. (Cascade)In practice Cascade’s senior management in the parent company (corporate) will first determine its strategic objectives for each subsidiary and then design for each a financial management plan for repositioning of profits, cash flows and capital. The following are repositioning objectives by subsidiary: Cascade Europe – Reposition profits from Germany to the US Cascade Mexico – Reposition (or manage) foreign exchange risks while maintaining capital for growth Cascade China – Reposition funds enough to protect against blocked funds (transfer risk), while balancing the needs of the JV partner Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

528 Cascade Pharmaceutical, Inc. (Cascade)Funds flows between units of a domestic business are generally unimpeded, but that is not the case in a multinational business. A firm operating globally faces a variety of political, tax, foreign exchange, and liquidity considerations that limit its ability to move funds easily and without cost from one country or currency to another. These constraints are the reason multinational financial managers must plan ahead for repositioning funds within the MNE. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

529 Cascade Pharmaceutical, Inc. (Cascade)Political constraints: Political constraints can block the transfer of funds either overtly or covertly Overt blockage occurs when a currency becomes incontrovertible or is subject to government exchange controls that prevent its transfer at reasonable exchange rates Covert blockage occurs when dividends or other forms of fund remittances are severely limited, heavily taxed, or excessively delayed by the need for bureaucratic approval Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

530 Cascade Pharmaceutical, Inc. (Cascade)Tax constraints: Tax constraints arise because of the complex and possibly contradictory tax structures of various national governments through whose jurisdictions funds may pass A firm does not want funds eroded by a sequence of nibbling tax collectors in every jurisdiction through which funds might flow Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

531 Cascade Pharmaceutical, Inc. (Cascade)Transaction costs: Foreign currency transaction costs are incurred when one currency is exchanged for another These costs, in the form of fees and/or the difference between bid and ask quotations, are revenue for the banks and Fx dealers that operate the Fx markets Large or frequent transfers can have significant transaction costs (requiring that firms avoid unnecessary back-and-forth transfers) Liquidity needs: Needs in each individual location must be satisfied and good local banking relationships maintained Clearly, local needs constrain a pure-optimization approach to worldwide cash positioning Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

532 Conduits for Moving FundsMultinational firms often unbundle their transfer of funds into separate flows for specific purposes. Unbundling allows a multinational firm to recover funds from subsidiaries without piquing host country sensitivities over large dividend drains. The following exhibit illustrates conduits separated into before-tax ad after-tax groups in the host country. Tax goals frequently are a critical determinant for many foreign subsidiary tax structures (making the before-tax, after-tax conduit distinction of importance). Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

533 Foreign Subsidiary’s Income Statement Payment to Parent CompanyExhibit Potential Conduits for Moving Funds From Subsidiary to Parent Foreign Subsidiary’s Income Statement Payment to Parent Company Sales Cost of goods sold Gross profit General & administrative expenses License fees Royalties Management fees Operating profit (EBITDA) Depreciation & amortization Earnings before interest & taxes (EBIT) Foreign exchange gains (losses) Interest expenses Earnings before tax (EBT) Corporate income tax Net income (NI) Dividends Retained earnings Payments to parent for goods or services Payments for technology, trademarks, copyrights, management or other shared services Before-Tax in the Host Country Payments of interest to parent for intra- firm debt After-Tax in the Host Country Distribution of dividends to parent

534 Transfer Pricing The pricing of goods, services, and technology transferred to a foreign subsidiary from a related company, transfer pricing, is the first and foremost method of transferring funds out of a foreign subsidiary. There are significant effects of transfer pricing policies: Fund positioning effect – Transferring funds out of a particular country can be accomplished through transfer pricing (charging higher prices on goods sold to a subsidiary in that country) Income tax effect – MNEs can influence their worldwide corporate profits by setting transfer prices to minimize taxable income in a country with a high income tax rate (and vice versa) Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

535 Transfer Pricing IRS regulations provide three methods to establish arm’s length prices (the “correct” transfer price): Comparable uncontrolled price method – Although ideal, this is difficult to apply in practice because of variations in quality, quantity, timing of sale and proprietary trademarks Resale price method – starts with the final selling price to an independent purchaser and subtracts an appropriate markup for the distribution subsidiary Cost-plus method – Sets the allowable transfer price by adding an appropriate profit markup to the seller’s full cost, where full cost is the accounting definition of direct costs plus overhead allocation Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

536 Transfer Pricing When a firm is organized with decentralized profit centers, transfer pricing between centers can disrupt evaluation of managerial performance. In the case of Cascade, transferring profit from high-tax Cascade Europe to low-tax Cascade USA changes the following for one or both companies: Import tariffs paid Measurements of Fx exposure Liquidity tests Operating efficiency Income tax payments Profitability Dividend payout ratio Internal growth rate Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

537 Transfer Pricing Although all governments have an interest in monitoring transfer pricing by MNEs, not all governments use these powers to regulate transfer prices to the detriment of MNEs. Most foreign governments realize the need of foreign investors to repatriate a reasonable profit by their own standards, even if it seems unreasonable locally. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

538 License Fees, Royalty Fees, and Shared ServicesLicense fees are remuneration paid to the owners of technology, patents, trade names, and copyrighted material. License fees are usually paid on a percentage of the value of the product or on the volume of production. As such they are calculated independently of the volume of sales. Royalty fees are similar compensation for the use of intellectual property. Royalty fees are, however, usually a stated percentage of sales revenue (compensation to the owner for sales volume). Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

539 License Fees, Royalty Fees, and Shared ServicesThese types of fees can also function as a means to reposition funds between subsidiaries and parent. These intracompany licensing and royalty fees can be further differentiated into management fees for general expertise and advice, technical assistance fees, and license fees for use of patented products or processes. Shared services charges (often referred to as distributed charges or distributed overhead) compensate the parent for costs incurred in the general management of international operations and for other corporate services provided to foreign subsidiaries by the parent. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

540 License Fees, Royalty Fees, and Shared ServicesAn MNE must be careful to preserve its rights to receive funds from subsidiaries as royalties, fees, or shared services. The contracts or agreements that establish the terms and amount of payment must be structured carefully and clearly and should address: Sales price definitions Coverage Time and currency of payment Reports Monitoring costs Non-financial issues (exclusiveness and limitations) Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

541 International Dividend RemittancesPayment of dividends is the classical method by which firms transfer profit back to owners, be they individual shareholders or parent corporations. Clearly, host country tax laws influence the dividend decision. Dividends remain the most tax-inefficient method for repatriating funds because they are distributed on an after-tax basis (generating excess foreign tax credits on the dividend for the MNE). Royalty fees or license fees, on the contrary, are pre-tax and are usually only subject to a smaller (relative) withholding tax. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

542 International Dividend RemittancesHowever, political risk may motivate parent firms to require foreign subsidiaries to remit all locally generated funds (not required to finance growth in sales or to support working capital needs). Clearly, foreign exchange risks (or anticipated losses for example) would lead the MNE to speed up the transfer of funds out of the country via dividends. Speeding up or slowing down payments is referred to as leads and lags. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

543 Leads and Lags: Retiming the Transfer of FundsFirms can reduce both operating and transaction exposure by accelerating or decelerating the timing of payments that must be made or received in foreign currencies. To lead is to pay early. To lag is to pay late. Leading and lagging is more feasible between related firms, because they presumably embrace a common set of goals for the consolidated group. This device is readily more applicable if the MNE operates on an integrated worldwide basis. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

544 Leads and Lags: Retiming the Transfer of FundsBecause the use of leads and lags is an obvious technique for minimizing foreign exchange exposure and for shifting the burden of financing, many governments impose limits on the allowed range. Leading or lagging between independent firms requires the time preference of one firm to be imposed to the detriment of the other firm. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

545 Re-Invoicing Centers A re-invoicing center is a separate corporate subsidiary that serves as a type of middle-man between the parent or related unit in one location and all foreign subsidiaries in a geographic region. As depicted in the following exhibit, the US manufacturing unit of Cascade USA invoices the firm’s re-invoicing center – in US dollars. The re-invoicing center in turn resells to Cascade Mexico in Mexican pesos. Consequently, all operating units deal only in their own currency, and all transaction exposure lies with the re-invoicing center. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

546 Exhibit 21.4 Use of a Reinvoicing CenterCascade USA (Manufactures unfinished switches) Cascade Mexico (Finishes for local sales) Physical goods Goods are re-sold by reinvoicing center to Mexican sales affiliate in Mexican pesos (Ps) Goods are sold by Cascade USA to reinvoicing center in U.S. dollars Reinvoicing Center 1. Cascade USA ships goods directly to the Mexican subsidiary. 2. The invoice by Cascade USA, which is denominated in U.S. dollars, is passed to the reinvoicing center. 3. The reinvoicing center takes legal title to the goods. 4. The reinvoicing center invoices Cascade Mexico in Mexican pesos, repositioning the currency exposure from both operating units to the reinvoicing center. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

547 Re-Invoicing Centers The three main benefits of such a strategy are:Managing foreign exchange exposure in one place Guaranteeing the exchange rate for future orders Managing intra-subsidiary cash flows The main disadvantage is that the benefits may not justify the agency cost (an additional corporate unit with its own set of books). The establishment of such a center is also likely to bring increased scrutiny by tax authorities. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

548 Working Capital Management in the MNEChapter 22 Working Capital Management in the MNE

549 Working Capital Management in the MNEWorking capital management in a multinational enterprise requires managing current assets (cash balances, accounts receivable, and inventory) and current liabilities (accounts payable and short-term debt) when faced with political, foreign exchange, tax, and liquidity constraints. The overall goal is to reduce funds tied up in working capital while simultaneously providing sufficient funding and liquidity for the conduct of global business. Working capital management should enhance return on assets and return on equity and should also improve efficiency ratios and other performance measures. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

550 Working Capital ManagementThe operating cycle of a business generates funding needs, cash inflows and outflows (the cash conversion cycle) and foreign exchange rate and credit risks. The funding needs generated by the operating cycle of the firm constitute working capital. The cash conversion cycle, a subcomponent of the operating cycle (working capital cycle), is that period of time extending between cash outflow for purchased inputs and materials and cash inflow from cash settlement. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

551 Working Capital ManagementThe operating and cash conversion cycles for Cascade Mexico is illustrated in the following exhibit. This is decomposed into five different periods (each with business, accounting, and potential cash flow implications): Quotation period Input sourcing period Inventory period Accounts payable period Accounts receivable period Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

552 Exhibit 22.1 Operating and Cash Cycles for Cascade MexicoOperating Cycle Accounts Payable Period Accounts Receivable Period Input Sourcing Period Quotation Period Inventory Period Price Quote Order Placed Inputs Received Order Shipped Payment Received Cascade Mexico time t0 t1 t2 t3 t4 t5 Cash Outflow Cash Intflow Cash Payment for Inputs Cash Settlement Received Cash Conversion Cycle Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

553 Working Capital ManagementIf Cascade Mexico’s business continues to expand, it will continually add to inventories and accounts payable (A/P) in order to fill increased sales in the form of accounts receivable (A/R). These components make up net working capital (NWC): NWC = (A/R + inventory) – (A/P) Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

554 Exhibit 22.2 Cascade Mexico’s Net Working Capital RequirementsNet Working Capital (NWC) is the net investment required of the firm to support on-going sales. NWC components typically grow as the firm buys inputs, produces product, and sells finished goods. Cascade Mexico’s Balance Sheet Assets Liabilities & Net Worth Cash Accounts payable (A/P) Accounts receivable (A/R) Short-term debt Inventory Current assets Current liabilities NWC = ( A/R + Inventory ) - A/P Note that NWC is not the same as Current assets & Current liabilities.

555 Working Capital ManagementThe previous exhibit illustrates one of the key managerial decisions for any subsidiary: Should A/P be paid off early, taking discounts offered by suppliers? The alternate form of financing for NWC balances is short-term debt In our example, Cascade Mexico’s CFO must decide which is the lower cost (short-term Mexican peso borrowings or the effective annual interest cost of supplier financing – cost of carry). Clearly, there are issues such as access to local currency debt, or various intra-company financing alternatives that complicate the decision. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

556 Working Capital ManagementA common method of benchmarking financial management practice is to calculate the NWC of the firm on a “days sales” basis. An analysis of this metric in a global context shows that US firms have a typical days sales of 29, while the European group has a days sales of 75. Clearly, European-based (technology firms in this example) are carrying a significantly higher level of net working capital in their financial structures. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

557 Working Capital ManagementThe MNE itself poses some unique challenges in the management of working capital. Many multinationals manufacture goods in a few specific countries and then ship the intermediate products to other facilities globally for completion and distribution. The payables, receivables, and inventory levels of the various units are a combination of intra-firm and inter-firm. The varying business practices observed globally regarding payment terms – both days and discounts – create severe mismatches in some cases. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

558 Exhibit 22.4 Cascade’s Multinational Working Capital SequenceCash inflows to Cascade Mexico arise from local market sales. These cash flows are used to repay both intra-firm payables (to Cascade USA) and local suppliers. Cascade Mexico Balance Sheet Cascade USA Balance Sheet Intra-firm: 30 days 60 days 30 days A/R Inventory A/P A/R Inventory A/P A/P Local-sourcing: 60 days Mexican Business Practices Payment terms in Mexico are longer than those typical of the United States. Cascade Mexico must offer 60-day terms to local customers to be competitive with other firms in the local market. United States Business Practices Payment terms used by Cascade USA are typical of the United States, 30 days. Cascade USA’s local customers will expect to be paid in 30 days. Cascade USA may consider extending longer terms to Mexico to reduce the squeeze. Result: Cascade Mexico is squeezed in terms of cash flow. It receives inflows in 60 days but must pay Cascade USA in 30 days.

559 Working Capital ManagementA firm’s operating cash inflow is derived primarily from the collection of accounts receivable. Multinational accounts receivable are created by two separate types of transactions: Sales to related subsidiaries Sales to independent or unrelated buyers Management of accounts receivable form independent customers requires two types of decisions: What currency should the transaction be denominated? What should be the terms of payment? Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

560 Working Capital ManagementOperations in inflationary, devaluation-prone economies sometimes force management to modify its normal approach to inventory management. In some cases, management may choose to maintain inventory and reorder levels far in excess of what would be called for in an economic order-quantity model. It is important to anticipate: Devaluation Price freezes The implications of various forms of free-trade zones Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

561 International Cash ManagementInternational cash management is the set of activities determining the levels of cash balances held throughout the MNE (cash management) and the facilitation of its movement cross-border (settlements and processing). These activities are typically handled by the international treasury of the MNE. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

562 International Cash ManagementThe level of cash maintained by an individual subsidiary is determined independent of the working capital management decisions we have discussed. Cash balances, including marketable securities, are held partly to enable normal day-to-day cash disbursements and partly to protect against unanticipated variations from budgeted cash flows. These two motives are called the transaction motive and the precautionary motive. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

563 International Cash ManagementCash disbursed for operations is replenished from two sources: Internal working capital turnover External sourcing, traditionally short-term borrowing Efficient cash management aims to reduce cash tied up unnecessarily in the system, without diminishing profit or increasing risk, so as to increase the rate of return on invested assets. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

564 International Cash ManagementAll firms, both domestic and international, engage in some form of the following fundamental steps: Planning Collection Repositioning Disbursement Covering cash shortages Investing surplus cash Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

565 International Cash ManagementMultinational business increases the complexity of making payments and settling cash flows between related and unrelated firms. Over time a number of techniques and services have evolved that simplify and reduce the costs of making these cross-border payments. Four such techniques include: Wire transfers (exhibit 22.5) Cash pooling Payment netting (exhibit 22.7) Electronic fund transfers Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

566 Exhibit 22.5 Average Daily Dollar Amount Handled by CHIPS (billions of US dollars) Source: Clearing House Interbank Payment System, (April 2002).

567 The Four European Affiliates of Quad CorporationExhibit Multilateral Matrix Before Netting (thousands of US dollars) The Four European Affiliates of Quad Corporation $4,000 Quad United Kingdom Quad de France $3,000 $3,000 $5,000 $5,000 $5,000 $6,000 $4,000 $3,000 $2,000 $2,000 Quad Belgium Deutscheland Quad $1,000 Prior to netting, the four sister affiliates of Quad Corporation have numerous intra-firm payments between them. Each payment results in transfer charges.

568 Financing Working CapitalAll firms need to finance working capital. The normal sources of funds for financing short-term working capital are accounts payable to suppliers and loans against bank credit lines. In some countries, such as the United States, borrowing is done by the firm issuing notes payable to banks and other creditors. In many other countries, short term borrowing is done on an “overdraft” basis. In all cases, permanent working capital requirements, as opposed to seasonal needs, are at least partially financed with long-term debt and equity. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

569 The Four European Subsidiaries of Quad CorporationExhibit Multilateral Matrix After Netting (thousands of US dollars) The Four European Subsidiaries of Quad Corporation Quad United Kingdom Quad de France Pays $1,000 Pays $3,000 Pays $1,000 Quad Belgium Deutscheland Quad After netting, the four sister subsidiaries of Quad Corporation have only three net payments to make among themselves to settle all intra-firm obligations

570 Financing Working CapitalSome MNEs have found that their financial resources and needs are either too large or too sophisticated for the financial services available in may locations where they operate. One solution to this has been the establishment of an in-house or internal bank within the firm. Such an in-house bank is not a separate corporation; rather, it is a set of functions performed by the existing treasury department. The following exhibit, illustrates how the in-house bank of Cascade Pharmaceuticals, Inc., could work. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

571 Financing Working CapitalCascade Mexico sells all its receivables to the in-house bank as they arise, reducing some of the domestic working capital needs. Additional working capital needs are supplied by the in-house bank directly to Cascade Mexico. Because the in-house bank is part of the same company, the interest rates it charges may be significantly lower than what Cascade Mexico could obtain on its own. In addition to providing financing benefits, in-house banks allow for more effective currency risk management. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

572 Exhibit 22.10 Cascade’s In-House BankCascade Europe deposits excess cash balances with the in-house bank. Cash flow Cascade Europe Cascade’s In-House Bank Cascade’s in-house bank reallocates cash and capital within the MNE network. Cascade Mexico Cash flow Cascade Mexico sells its receivables to the in-house bank, receiving cash and receiving working capital financing.

573 Financing Working CapitalMNEs depend on their commercial banks to handle most of the trade financing needs, such as letters of credit, and to provide advice on government support, country risk assessment, introductions to foreign firms and banks, and general financing availability. The main points of bank contacts are correspondent banks, representative offices, branch banks, subsidiaries, and affiliates. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

574 International Trade FinanceChapter 23 International Trade Finance

575 The Trade RelationshipTrade financing shares a number of common characteristics with the traditional value chain activities conducted by all firms. All companies must search out suppliers for the many goods and services required as inputs to their own goods production or service provision processes. Issues to consider in this process include the capability of suppliers to produce the product to adequate specifications, deliver said products in a timely fashion, and to work in conjunction on product enhancements and continuous process improvement. All of the above must also be at an acceptable price and payment terms. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

576 The Trade RelationshipThe nature of the relationship between the exporter and the importer is critical to understanding the methods for import-export financing utilized in industry. There are three categories of relationships (see next exhibit): Unaffiliated unknown Unaffiliated known Affiliated (sometimes referred to as intra-firm trade) The composition of global trade has changed dramatically over the past few decades, moving from transactions between unaffiliated parties to affiliated transactions. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

577 Exhibit 23.1 Alternative International Trade RelationshipsExporter Unaffiliated Unknown Party A new customer which with exporter has no historical business relationship Unaffiliated Known Party A long-term customer with which there is an established relationship of trust and performance Affiliated Party A foreign subsidiary or affiliate of exporter Importer is …. Requires: 1. A contract 2. Protection against non-payment Requires: 1. A contract 2. Possibly some protection against non-payment Requires: 1. No contract 2. No protection against non-payment

578 The Trade Dilemma International trade (i.e. between and importer and exporter) must work around a fundamental dilemma: They live far apart They speak different languages They operate in different political environments They have different religions They have different standards for honoring obligations In essence, there could be distrust, and clearly the importer and exporter would prefer two different arrangements for payment/goods transfer (next exhibit) Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

579 Importer Exporter Importer ExporterExhibit The Mechanics of Import and Export 1st: Exporter ships the goods Importer Importer Preference Exporter 2nd: Importer pays after goods received 1st: Importer pays for goods Importer Exporter Exporter Preference 2nd: Exporter ships the goods after being paid

580 The Trade Dilemma The fundamental dilemma of being unwilling to trust a stranger in a foreign land is solved by using a highly respected bank as an intermediary. The following exhibit is a simplified view involving a letter of credit (a bank’s promise to pay) on behalf of the importer. Two other significant documents are an order bill of lading and a sight draft. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

581 Importer Bank ExporterExhibit The Bank as the Import/Export Intermediary 1st: Importer obtains bank’s promise to pay on importer’s behalf. Importer 6th: Importer pays the bank. 2nd: Bank promises exporter to pay on behalf of importer. Bank 5th: Bank ‘gives’ merchandise to the importer. 4th: Bank pays the exporter. Exporter 3rd: Exporter ships ‘to the bank’ trusting bank’s promise.

582 Benefits of the System The system (including the three documents discussed) has been developed and modified over centuries to protect both importer and exporter from: The risk of noncompletion Foreign exchange risk To provide a means of financing Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

583 Elements of an Import/Export TransactionEach individual trade transaction must cover three basic elements: description of goods, prices, and documents regarding shipping and delivery instructions. Contracts: An import or export transaction is by definition a contractual exchange between parties in two countries that may have different legal systems, currencies, languages, religions or units of measure All contracts should include definitions and specifications for the quality, grade, quantity, and price of the goods in question Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

584 Elements of an Import/Export TransactionPrices: Price quotations can be a major source of confusion Price terms in the contract should conform to published catalogs, specify whether quantity discounts or early payment discounts are in effect, and state whether finance charges are relevant in the case of deferred payment, and should address other relevant fees or charges Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

585 Elements of an Import/Export TransactionDocuments: Bill of lading – issued to the exporter by a common carrier transporting the merchandise Commercial invoice – issued by the exporter and contains a precise description of the merchandise (also indicates unit prices, financial terms of the sale etc.) Insurance documents – specified in the contract of sale and issued by insurance companies (or their agents) Consular invoices – issued in the exporting country by the consulate of the importing country Packing lists Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

586 International Trade RisksThe following exhibit illustrates the sequence of events in a single export transaction. From a financial management perspective, the two primary risks associated with an international trade transaction are currency risk (currency denomination of payment) and risk of non-completion (timely and complete payment). The risk of default on the part of the importer is present as soon as the financing period begins. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

587 Exhibit 23.4 The Trade Transaction Time-Line and StructureTime and Events Price quote request Export contract signed Goods are shipped Documents are accepted Goods are received Cash settlement of the transaction Negotiations Backlog Documents Are Presented Copyright © 2004 Pearson Addison-Wesley. All rights reserved. Financing Period

588 Letter of Credit (L/C) A letter of credit (L/C) is a bank’s conditional promise to pay issued by a bank at the request of an importer, in which the bank promises to pay an exporter upon presentation of documents specified in the L/C. An L/C reduces the risk of noncompletion because the bank agrees to pay against documents rather than actual merchandise. The following exhibit shows the relationship between the three parties. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

589 Beneficiary ApplicantExhibit Parties to a Letter of Credit (L/C) Issuing Bank The relationship between the importer and the issuing bank is governed by the terms of the application and agreement for the letter of credit (L/C). The relationship between the issuing bank and the exporter is governed by the terms of the letter of credit, as issued by that bank. Beneficiary (exporter) Applicant (importer) The relationship between the importer and the exporter is governed by the sales contract.

590 Letter of Credit (L/C) The essence of the L/C is the promise of the issuing bank to pay against specified documents, which must accompany any draft drawn against the credit. To constitute a true L/C transaction, all of the following five elements must be present with respect to the issuing bank: Must receive a fee or other valid business consideration for issuing the L/C The L/C must contain a specified expiration date or definite maturity The bank’s commitment must have a stated maximum amount of money The bank’s obligation to pay must arise only on the presentation of specific documents The bank’s customer must have an unqualified obligation to reimburse the bank on the same condition as the bank has paid Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

591 Letter of Credit (L/C) Commercial letters of credit are also classified: Irrevocable versus revocable Confirmed versus unconfirmed The primary advantage of an L/C is that it reduces risk – the exporter can sell against a bank’s promise to pay rather than against the promise of a commercial firm. The major advantage of an L/C to an importer is that the importer need not pay out funds until the documents have arrived at the bank that issued the L/C and after all conditions stated in the credit have been fulfilled. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

592 Exhibit 23.6 Essence of a Letter of Credit (L/C)Bank of the East, Ltd. [Name of Issuing Bank] Date: September 18, 2003 L/C Number Bank of the East, Ltd. hereby issues this irrevocable documentary Letter of Credit to Jones Company [name of exporter] for US$500,000, payable 90 days after sight by a draft drawn against Bank of the East, Ltd., in accordance with Letter of Credit number The draft is to be accompanied by the following documents: 1. Commercial invoice in triplicate 2. Packing list 3. Clean on board order bill of lading 4. Insurance documents, paid for by buyer At maturity Bank of the East, Ltd. will pay the face amount of the draft to the bearer of that draft. Authorized Signature Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

593 Draft A draft, sometimes called a bill of exchange (B/E), is the instrument normally used in international commerce to effect payment. A draft is simply an order written by an exporter (seller) instructing and importer (buyer) or its agent to pay a specified amount of money at a specified time. The person or business initiating the draft is known as the maker, drawer, or originator. Normally this is the exporter who sells and ships the merchandise. The party to whom the draft is addressed is the drawee. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

594 Draft If properly drawn, drafts can become negotiable instruments.As such, they provide a convenient instrument for financing the international movement of merchandise (freely bought and sold). To become a negotiable instrument, a draft must conform to the following four requirements: It must be in writing and signed by the maker or drawer It must contain an unconditional promise or order to pay a definite sum of money It must be payable on demand or at a fixed or determinable future date It must be payable to order or to bearer There are time drafts and sight drafts. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

595 Name of Exporter Signature of ExporterExhibit Essence of a Time Draft Name of Exporter Date: October 10, 2003 Draft number 7890 Ninety (90) days after sight of this First of Exchange, pay to the order of Bank of the West [name of exporter’s bank] the sum of Five-hundred thousand U.S. dollars for value received under Bank of the East, Ltd. letter of credit number Signature of Exporter Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

596 Bill of Lading (B/L) The third key document for financing international trade is the bill of lading or B/L. The bill of lading is issued to the exporter by a common carrier transporting the merchandise. It serves three purposes: a receipt, a contract, and a document of title. Bills of lading are either straight or to order. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

597 Documentation in a Typical Trade TransactionA trade transaction could conceivably be handled in many ways. The transaction that would best illustrate the interactions of the various documents would be an export financed under a documentary commercial letter of credit, requiring an order bill of lading, with the exporter collecting via a time draft accepted by the importer’s bank. The following exhibit illustrates such a transaction. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

598 Exhibit 23.8 Steps in a Typical Trade Transaction3. Importer arranges L/C with its bank 1. Importer orders goods 2. Exporter agrees to fill order Exporter Importer 5. Bank X advises exporter of L/C 6. Exporter ships goods to Importer 7. Exporter presents draft and documents to its bank, Bank X 13. Importer pays its bank 12. Bank I obtains importer’s note and releases shipment 11. Bank X pays exporter 8. Bank X presents draft and documents to Bank I Bank X Bank I 9. Bank I accepts draft, promising to pay in 60 days, and returns accepted draft to Bank X 10. Bank X sells acceptance to investor 4. Bank I sends L/C to Bank X 14. Investor presents acceptance and is paid by Bank I Public Investor

599 Government Programs to Help Finance ExportsGovernments of most export-oriented industrialized countries have special financial institutions that provide some form of subsidized credit to their own national exporters. These export finance institutions offer terms that are better than those generally available from the competitive private sector. Thus domestic taxpayers are subsidizing lower financial costs for foreign buyers in order to create employment and maintain a technological edge. The most important institutions usually offer export credit insurance and a government-supported bank for export financing. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

600 Trade Financing AlternativesIn order to finance international trade receivables, firms use the same financing instruments as they use for domestic trade receivables, plus a few specialized instruments that are only available for financing international trade. There are short-term financing instruments and longer-term instruments in addition to the use of various types of barter to substitute for these instruments. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

601 Forfaiting Forfaiting is a specialized technique to eliminate the risk of nonpayment by importers in instances where the importing firm and/or its government is perceived by the exporter to be too risky for open account credit. The following exhibit illustrates a typical forfaiting transaction (involving five parties – importer, exporter, forfaiter, investor and the importers bank). The essence of forfaiting is the non-recourse sale by an exporter of bank-guaranteed promissory notes, bills of exchange, or similar documents received from an importer in another country. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

602 Exhibit 23.10 Typical Forfaiting TransactionStep 1 Importer (private firm or government purchaser in emerging market) Exporter (private industrial firm) Step 2 Step 4 FORFAITER (subsidiary of a European bank) Step 3 Step 5 Step 6 Investor (institutional or individual) Importer’s Bank (usually a private bank in the importer’s country Step 7

603 Countertrade The word countertrade refers to a variety of international trade arrangements in which goods and services are exported by a manufacturer with compensation linked to that manufacturer accepting imports of other goods and services. In other words, an export sale is tied by contract to an import. The countertrade may take place at the same time as the original export, in which case credit is not an issue; or the countertrade may take place later, in which case financing becomes important. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

604 Advanced Topics in International FinanceChapter 24 Advanced Topics in International Finance

605 The Currency Hedge RatioThe hedge ratio, frequently termed beta (β), is the percentage of an individual exposure’s nominal amount covered by a financial instrument such as a forward contract of currency option. Beta is then defined as follows: β = value of currency hedge value of currency exposure Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

606 The Currency Hedge RatioThe value of an individual currency position can be expressed as a portfolio of two assets: A spot asset (the exposure) A hedge asset (a forward, future, or option) The hedge is constructed so that whatever spot value is lost as a result of adverse exchange rate movements (Δ spot) is replaced by an equal but opposite change in the value of the hedge asset, the futures position (Δ futures): Δ position value = Δ spot – Δ futures ≈ 0 Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

607 The Currency Hedge RatioThe optimal currency hedge can be found by minimizing the terminal (end-of-period) variance of the two asset portfolio. The hedge asset amount as a percentage of the exposure is altered to minimize the terminal portfolio variance. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

608 The Currency Hedge RatioSometimes there are no available futures or forward markets for currencies. In these cases the risk manager may substitute a proxy for the underlying currency in a proxy-hedge or a cross-hedge. The cross-hedger would likely go through a simple two-step process to determine the optimal cross-hedge: First, find the currency futures most highly correlated with the actual currency of exposure Second, find the optimal hedge ratio using the covariance between the proxy futures and the actual currency as in the previous model Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

609 The Currency Hedge RatioA slightly more sophisticated currency hedging strategy than the traditional one demonstrated in Chapter 6 is called delta hedging. The objective of delta hedging is to construct a position – the combined exposure of the hedging instrument – whose market values (not terminal values) will change in opposite directions with changes in the spot exchange rate; it is the value of the position at all times which is being managed, not the value of the position only at termination. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

610 The Currency Hedge RatioReturning to the basis position valuation principle introduced at the beginning of this chapter: if the hedge is constructed so that the changes in the spot position and hedge position are equal and opposite in currency value at all times in the life-span of the exposure, it is termed delta-neutral. Δ position value = Δ spot – Δ futures Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

611 Financial Engineering and Risk ManagementFinancial engineering has come to mean very different things to different people. We use it here to describe the use of basic financial building blocks (spot positions, forwards, options) to construct positions that provide the user with desired risk and return characteristics. The number of combinations and deviations is indeed infinite. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

612 Financial Engineering and Risk ManagementThe following problem is utilized for the remainder of the chapter: A US-based firm, Dayton Manufacturing, possesses a long £1,000,000 exposure – an account receivable – to be settled in 90 days The firm believes that the exchange rate will move in its favor over the 90-day period (the British pound will appreciate versus the US dollar) Despite having this directional view or currency expectation, the firm wishes downside protection for the event that the pound were to depreciate instead Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

613 Financial Engineering and Risk ManagementClearly, Dayton could sell the receivable forward at the forward rate, yielding $1,470,000. In addition, Dayton could construct a synthetic forward in which the company would buy a put and sell a call (at the forward rate), again yielding $1,470,000. A firm would undertake this relatively complex position if it altered the strike prices from the forward-ATM (at the money) and was able to make a slight premium (net) on the purchase and sale of the options. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

614 Exhibit 24.3 Construction of a Synthetic Forward for a Long FX PositionInstruments Strike Rates Premium Notional Principal Buy a put Sell a call $1.4700/£ $0.0318/£ £ 1,000,000 US dollar value of A/R (millions) $1.47 strike Uncovered 1.56 1.54 Sell a call: $1.47 strike 1.52 1.50 1.48 1.46 Forward 1.44 Buy a put: $1.47 strike 1.42 1.40 1.40 1.42 1.44 1.46 1.48 1.50 1.52 1.54 1.56 End-of-period spot rate (US$/£)

615 Second-Generation Currency Risk Management ProductsSecond-generation risk-management products are constructed from the two basic derivatives used throughout this book; the forward and the option. We will subdivide them into two groups: The zero-premium option products (which focus on pricing in and around the forward rate) The exotic option products (which focus on alternative pricing targets) Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

616 Second-Generation Currency Risk Management ProductsThe primary “problem” with the use of options for risk management in the eyes of many firms is the up-front premium payment. Although the premium payment is only a portion of the total payoff profile of the hedge, many firms view the expenditure of substantial funds for the purchase of a financial derivative as prohibitively expensive. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

617 Second-Generation Currency Risk Management ProductsZero-premium option products are designed to require no out-of-pocket premium payment at the initiation of the hedge. This set of products includes what are most frequently labeled the range forward and the participating forward. Both of these products: Are priced on the basis of the forward rate Are constructed to provide a zero-premium payment up front Allow the hedger to take advantage of expectations of the direction of exchange rate movements Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

618 Second-Generation Currency Risk Management ProductsThe basic range forward is constructed by: Buying a put option with a strike rate below the forward rate, for the full amount of long currency exposure (100% coverage) Selling a call option with a strike rate above the forward rate, for the full amount of the long currency exposure (100% coverage) The hedger chooses one side of the “range” or spread, normally the downside (put strike rate), which then dictates the strike rate at which the call option will be sold. The call option strike rate must be chosen at an equal distance from the forward rate as the put option strike price from the forward rate. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

619 Exhibit 24.4 The Range Forward: Hedging a £1,000,000 Long PositionInstruments Strike Rates Premium Notional Principal Buy a put Sell a call $1.4500/£ $1.4900/£ $0.0226/£ $0.0231/£ £ 1,000,000 US dollar value of A/R (millions) Uncovered 1.56 $1.45 strike $1.49 strike 1.54 1.52 Sell a call: $1.49 strike 1.50 1.48 1.46 Forward 1.44 Buy a put: $1.45 strike 1.42 1.40 1.40 1.42 1.44 1.46 1.48 1.50 1.52 1.54 1.56 End-of-period spot rate (US$/£)

620 Second-Generation Currency Risk Management ProductsThe participating forward, is an option combination that allows the hedger to take a position that will share in potential upside movements in the exchange rate, while providing option-based downside protection, all at a zero-net premium. The participating forward is constructed in two steps: Buy a put with a strike price below the forward rate for the full amount of the long exposure (100%) coverage Sell a call option with a strike price that is the same as the put, for a portion of the total exposure (less than 100% coverage) Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

621 Exhibit 24.5 The Participating Forward: Hedging a £1,000,000 Long PositionInstruments Strike Rates Premium Notional Principal Buy a put Sell a call $1.4500/£ $0.0226/£ $0.0425/£ £ 1,000,000 £ 531,765 US dollar value of A/R (millions) 1.56 Uncovered $1.45 strike 1.54 1.52 1.50 1.48 1.46 Forward 1.44 Participating Forward 1.42 1.40 1.40 1.42 1.44 1.46 1.48 1.50 1.52 1.54 1.56 End-of-period spot rate (US$/£)

622 Exotic Options This second set of instruments offers alternative pricing, timing, or exercise provisions of the product. All of these in some way have altered the valuation principles of the basis option-pricing model; hence the term exotic. These products are therefore products only, and not easily reproducible (though generally possible) by the corporate risk manager. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

623 Exotic Options The knock-out option, differs markedly from previous products covered. The knock-out option is designed to behave like any option, offering downside protection, but to offer only a limited upside range before crossing a previously specified barrier or knock-out level, at which it automatically expires. The automatic expiration of the option would occur only after the exchange rate has moved in the expected direction of the hedger (a favorable movement). In return for giving up the full maturity period coverage, the premium of the option – being a shorter-term option – is smaller. Copyright © 2004 Pearson Addison-Wesley. All rights reserved.

624 Exhibit 24.6 The Knock-Out Option: Hedging a £1,000,000 Long PositionInstruments Strike Rates Premium Notional Principal Buy a put $1.4700/£ Barrier: $1.49/£ $0.0103/£ £ 1,000,000 US dollar value of A/R (millions) 1.56 Uncovered $1.49 Barrier 1.54 1.52 $1.47 Strike 1.50 Knock-out option 1.48 1.46 Forward 1.44 Put option 1.42 1.40 1.40 1.42 1.44 1.46 1.48 1.50 1.52 1.54 1.56 Copyright © 2004 Pearson Addison-Wesley. All rights reserved. End-of-period spot rate (US$/£)

625 Exotic Options In addition, there are more recent second-generation (possibly third generation) currency derivatives: Average rate option (ARO) Average strike option (ASO) Compound option Chooser option Copyright © 2004 Pearson Addison-Wesley. All rights reserved.