1 International Financial ManagementType of assessment Weight% Duration /words) Assignment 50% 2500 words Examination 3 hours The International Perspective Globalisation and the multinational firm International monetary system Balance of payments The market for foreign exchange International parity relationships International Financial Markets The derivative market and hedging strategies Foreign direct investment International capital budgeting International portfolio investment and diversification Financial Management and the Multinational Firm Multinational treasury management Current topics Your Participation: Mini case study Discussion point Analysis check 1
2 International Financial Management PART 1The International Perspective Madura & Fox Academic Papers Academic Papers background 1.Globalisation and the MNC Ch 1 Ramamurti Feinberg/Gabriel/ Stoever 2.International monetary system Ch 2 Eichengreen/ Cyr/ Woods 3.Balance of payments Mann 4.The market for foreign exchange Ch 3 Issing 5.International parity relationships Chs 4,6,7,8
3 International Financial Management PART 2International Financial Markets Madura & Fox Academic Papers Academic Papers background The derivative market and hedging strategies Ch 5,11 Foreign direct investment Ch 13, 15,16 Stoever International capital budgeting Ch 14 International portfolio investment and diversification Chs 10,
4 International Financial Management Module Part 2The International Perspective International Financial Markets Financial Management and the Multinational Firm Madura & Fox Academic Papers Academic Papers background Multinational treasury management Ch 17 to 19 Current topics 4
5 International Financial Management PART 2International Financial Markets Madura & Fox Academic Papers Academic Papers background The derivative market and hedging strategies Ch 5,11 Foreign direct investment Ch 13, 15,16 Stoever International capital budgeting Ch 14 International portfolio investment and diversification Chs 10, 5
6 The derivative market and hedging strategiesThe Derivative market is trading on promises about prices in the future The “promise” is a derivative because its value is derived from the price of the asset (the underlying asset) that it is making promises about.
7 The derivative market and hedging strategiesHedging strategy concerns MNC’s decisions about what price changes they want to “insure” against The “promises” or financial instruments are Futures, Options & Swaps.
8 The derivative market and hedging strategiesDerivative exchanges 2008, annual number of contracts traded in millions
9 The derivative market and hedging strategiesTurnover of futures contracts traded on international exchanges (numbers of contracts in millions)
10 The derivative market and hedging strategies- The Forward market An agreed price for an underlying asset (often currency) at a future date… the forward contract 1) Contracts between Companies and Banks. 2) 1,3,6 and 12 month forward rates quoted by banks. 3) Personal contracts of 2 to 5 years. 4) Speculation not encouraged. 5) Companies usually relate forwards to specific transactions. 6) All contracts fulfilled ~ no closing out! ~ no speculation
11 The derivative market and hedging strategies- The Futures market traded on exchanges unlike the forward contract on restricted set of assets currency, bonds, stick indices, corn, soy, beans, wheat, meat An agreed price and delivery date and terms set contract sizes (eg £'s is £62,500 ) and settlement dates (March, May , June , July, September and December ) easy to reverse the position ie close out credit risk eliminated by clearing house margin system and daily settlement A person to person contract: a writer or seller of a futures and a buyer of a futures contract. tick size of 1/32 of 1% of the contract size All contracts have delivery conditions that are often poor (expensive) – few contracts result in actual delivery
12 The derivative market and hedging strategies- The Futures market 12
13 The derivative market and hedging strategies- The Futures market 2 common management features with all derivative type contracts: Daily settlement: Ensuring that any potential shortfall is paid immediately Closing out: Reversing your position
14 The derivative market and hedging strategies
15 The derivative market and hedging strategies - managing futuresDaily Settlement minimizes credit risk Seller pays buyer Nb the “sufferer” receives Buyer pays seller Price of underlying asset Buyer pays Buyer receives TIME
16 The derivative market and hedging strategies - managing futuresDaily Settlement minimizes credit risk FuturesPrice* of Oil $114 $112 $111 $108 $115 $113 Buyer ($2) ($1) ($3) $4 $3 Seller $2 $1 ($4) Price of underlying asset Buyer pays Buyer receives TIME *daily closing price
17 Closing out terminates whenever – a stop order at $108The derivative market and hedging strategies - managing futures default risk Closing out terminates whenever – a stop order at $108 17 *daily closing price
18 The derivative market and hedging strategies - managing futuresFutures price over the life of the contract Price of underlying asset Maturity date and spot price – law of one price, same service Carry cost TIME 18 *daily closing price
19 The derivative market and hedging strategies - managing futuresPricing a Futures Price of Futures Price of underlying asset Price of Futures and Asset Maturity date and spot price – law of one price, same service Carry cost 19 TIME *daily closing price
20 The derivative market and hedging strategies - managing futuresClosing out terminates whenever – a stop order at $108 Price* of Oil $114 $112 $111 $108 $115 $113 Buyer (Jim) ($2) ($1) ($3) $4 $3 Seller (Jim) Closes out ($4) $2 Daily NET position JIM $0 Seller (Linda) $1 Buyer (Eric) *daily closing price
21 The derivative market and hedging strategies - managing futuresFutures on Bonds: Protection against interest rate changes Futures on the stock market index: Protection against systematic risk Futures on exchange rates: Protection against exchange rate volatility Futures on commodities: Protection against price change Partial hedging: reduction but not elimination of exposure Futures management: no up front payment apart from a deposit margin
22 The derivative market and hedging strategies - managing futuresAnalysis check End of day1 day2 day3 day4 Day5 day6 day7 Futures Price of wood £ 37 £ 38 £ 40 £ 36 Buyer Jim Seller Linda What businesses would want to: a) sell wood futures or b) buy wood futures? What would be the daily settlement payments and receipts – fill in the blank squares? How could Jim end the contract on day 5? 22
23 The derivative market and hedging strategies – Options the basic ideaProtection if price falls (guaranteed minimum selling price) Options as a Hedging Tool probability density Put type protection future spot Density Call type protection future spot Strike or exercise price Protection if price rises (guaranteed maximum buying price)
24 The derivative market and hedging strategies – CALL Options
25 The derivative market and hedging strategies –Option premiums
26 The derivative market and hedging strategies –Option premiumsThree factors influence the option premium (referred to as C): C = f(S – X, T, r, σ ) Where: S − X = the difference between the spot exchange rate (S) and the strike or exercise price (X), T = the time to maturity, r = risk free interest rate σ = the volatility of the underlying asset, as measured by the standard deviation of the movements in the underlying asset.
27 The derivative market and hedging strategies –OptionsCALL strike profit 3 Possible future prices of xyz loss 63 Possible Maturity prices 60 63 66 69 70 Claim? N Y Claim amount 3 6 7 Premium paid on purchase (3) Net 4 Contingency table
28 The derivative market and hedging strategies –Options financial managementPUT Plain Vanilla CALL strike strike profit profit Pfp* Pfp* loss loss strike strike profit profit Pfp* Pfp* loss loss premium *Pfp = possible future price
29 The derivative market and hedging strategies –Options financial managementPUT Plain Vanilla CALL strike strike profit profit Pfp* Pfp* loss loss Suggest 3 scenarios each for puts and calls: remember it can be on assets, currency, bonds and the stock market index Discussion point premium *Pfp = possible future price
30 The derivative market and hedging strategies –Options financial managementPlain Vanilla CALL strike Using the diagram, complete the following table… profit 5 Pfp* loss 53 Possible Maturity prices 50 53 56 59 60 Claim? Claim amount Premium paid on purchase Net premium *Pfp = possible future price 30
31 The derivative market and hedging strategies –Options financial managementStraddle strike profit Pfp* loss Strangle strike profit Pfp* loss *Pfp = possible future price
32 Range forward or cylinder contract e.g. Mr W a UK investor is expecting ¥ revenues... UK purchase put on ¥’s desired rate & UK sell ¥’s call on higher rate Often same premium so...no net cost. future spot £’s:¥ £ £0.006 Gains protection against ¥ selling less than £0.005 with put in return for sacrificing ¥ selling more than £0.006 32
33 Range forward or cylinder contract e.g. Mr W a UK investor is expecting ¥ costs... UK purchase call on ¥’s at desired rate & UK sell ¥’s put on lower rate Often same premium so...no net cost. future spot £’s:¥ £ £0.006 Gains protection against ¥ costing more than £0.006 with call in return for sacrificing ¥ paying less than £0.005 33
34 The derivative market and hedging strategies –Options financial managementRange Forward profit loss Pfp* *Pfp = possible future price = strike
35 The derivative market and hedging strategies –Options financial managementprofit Range Forward on CALL strike 63 and 66 loss Pfp* Possible Maturity prices 57 60 63 64 66 69 70 Claim on call? N Y Claim on put? CALL Claim received 1 4 5 Premium paid on CALL (3) Premium earned on PUT 3 PUT claim paid (6) Asset price purchased (57) (60) (63) (64) (66) (69) (70) NET COST (65) *Pfp = possible future price = strike
36 The derivative market and hedging strategies –Options financial managementRange Forward on PUT strike 63 and 66 Possible Maturity prices 57 60 63 64 66 69 70 Claim on call? N Y Claim on put? CALL Claim paid (1) (4) (5) Premium paid on PUT (3) Premium earned on CALL 3 PUT claim received 6 Asset price sold NET Receipt 65 36
37 The derivative market and hedging strategies –Options financial managementprofit Range Forward loss Pfp* Implied Range Forward Call S2 S1 In return I pay you IF the price goes below S2 You pay me IF the price goes above S1 Pfp* *Pfp = possible future price = strike
38 The derivative market and hedging strategies –Options financial managementprofit Range Forward loss Pfp* Implied Range Forward Put S2 S1 You pay me IF the price goes below S2 In return I pay you IF the price goes above S1 Pfp* *Pfp = possible future price = strike 38
39 The derivative market and hedging strategies – derivatives managementABC ltd sells wheat at 66 and an option with a premium of 4 and for the same spot price Analysis check Possible Maturity prices 60 63 66 76 86 Claim? Claim amount Premium paid on purchase Cost of wheat Net cost Complete the table and comment on its role in financial management 39
40 The derivative market and hedging strategies – Swaps definitionAn exchange of financial terms or assets Originated to evade government controls eg if you cannot borrow in dollars then borrow in £s and swap with a US borrower who wants to borrow in £s You need NOT ACTUALLY SWAP the loans but simply pay or receive depending on the movement of the currencies e.g. if $ increases in value by 5% by the end of the loan then the UK “borrower” will have to pay 5% of the loan in $s to the US borrower. Another example:A parallel loan UK MNC lends to French MNC (UK)ltd and in return French MNC lends to UK MNC (France) s.a. thus avoiding having to lend abroad yet in effect doing just that!
41 The derivative market and hedging strategies – Swaps absolute advantageBorrowing rates $ £ Quality corporation 5% 8% Risky plc 9% 4% Scenario: Risky wants to borrow in $s and Quality in £s. Risky borrows in £s Quality borrows in $s They then swap repayment terms Risky borrows at 5% instead of 9% Quality borrows at 4% instead of 8% So is the market inefficient??? Risky better than Quality in £s and Quality better in $s
42 The derivative market and hedging strategies – Swaps comparative advantageBorrowing rates $ £ Quality corporation 5% 6% Risky plc 9% 8% Scenario: Risky wants to borrow in $s and Quality in £s. One solution involving swaps is… Risky borrows in £s…Quality borrows in $s… then they SWAP Quality lends $s to Risky at +2½% i.e. 7½% Risky lends £s to Quality at 8% so makes no profit or loss Quality pays 8% less its profit, so: 8% - 2½ %= 5½% instead of 6% Risky borrows at 7½% but makes no profit so 7½% instead of 9% So is the market inefficient??? Risky plc worse on both counts surprisingly there is still value in swapping!
43 The derivative market and hedging strategies – derivatives managementmotive Strategy* Leading concepts Make a profit Futures Market efficiency Avoid most risk Futures, swaps Random walk, Avoid large losses Options Random walk, fat tails
44 Foreign direct investment - definitionAn investment of at least 10% made by a company based in one country into a company based in another country Often need to buy into or set up a legal entity e.g. Renault (UK) ltd, Spar (UK) ltd These companies pay UK taxes Their exports count as UK exports Their purchases as UK purchases Their imports as UK imports Renault and Spar receive dividends (France and Holland respectively) Totals appear on the Balance of payments (see next slide) Not the same as portfolio investment 44
45 Foreign direct investment - definition45
46 Foreign direct investment – motives, Dunning’s eclectic modeladvantages of internationalization Firm specific advantages: i) proprietary technology ii) managerial/ marketing skills iii) trademarks iv) economies of scale v) large capital requirements Internalization advantages: i) High enforcement costs ii) Buyer uncertainty over value iii) Need to control production iv) Tax Foreign direct investment – motives, Dunning’s eclectic model 3) Country Specific Advantages: i) Natural resources ii) Labour force iii) Trade barriers Plus: Greater profits, monopolistic advantages Reducing exchange rate exposure …. 46
47 Foreign direct investment – reducing exchange rate exposureIncrease in value BPs Scenario 1 Decrease in value foreign sales cost $s BPs cost foreign profits Increase in value Scenario 2 foreign profits Decrease in value $s foreign profits cost
48 Foreign direct investment – reducing exchange rate exposureUK $1.5:£1 UK $1.9:£1 US $1.5:£1 US $1.9:£1 Sales £1,000 £789 $1,500 Costs £800 profit £200 (£11) $1,200 £158 $300 Scenario 1 Scenario 2 Foreign factories The variation of UK profits is less in scenario 2 as less is converted 48
49 Foreign direct investment – barriersRestrict ownership Red tape Local links with government Political instability Government requirements - local content 49
50 Foreign direct investment – country risk analysisProblems: Blocked funds Currency inconvertibility War Corruption New Zealand / Denmark / Singapore / Sweden /Switzerland…Japan / UK / US / …France / …Venezuela…Iran… Sudan… Somalia 50
51 Foreign direct investment – country risk analysis51
52 ✔ Foreign direct investment – country risk analysis debt crisesActually reschedules Does not reschedule Predict reschedule ✔ Type II error Predict not reschedule Type I error reduce Type II by decreasing reschedule predictions reduce Type I by increasing reschedule predictions Which is the more expensive error? 52
53 Foreign direct investment – country risk analysis significant factors (p.516 M&F)Most critical risk factor % respondents (2004) Govt regulations / legal decisions 64 Country financial risk 60 Currency interest rate volatility 51 Political and social disturbances 46 Corporate governance 30 Absence of the rule of law 29 Theft of intellectual property 28 53
54 Foreign direct investment – is FDI the new foreign aid…discussAT Kearney FDI confidence index forecasts EMs to rise relative to developed countries December 15, 2011 Thursday LENGTH: 1054 words A foreign direct investment (FDI) rebound will be slow at best and the focus of corporate investments is increasingly on developing markets, according to the 2011 A T Kearney Foreign Direct Investment Confidence Index, a regular measure of senior executive sentiment at the world`s largest companies. Conducted regularly over the last 13 years by global management consulting firm A T Kearney, the index provides a look at the present and future prospects for international direct investment flows. While 55% of corporate investors surveyed said their FDI budgets had returned to the levels they were prior to the economic crisis, more than one-fifth said they don`t expect their FDI to return to pre-crisis levels until 2014 or later. 54
55 International capital budgetingForeign production and real investment planning 55
56 International capital budgetingDifferences of international budgeting: Foreign currency Foreign inflation Foreign interest rates 56
57 International capital budgetingIllustration only not examined International capital budgeting Illustrative problem: ABC plc has the following budget UK sales 5,000 Foreign sales 6,000 Variable costs (UK) (3,000) (Euro) (4,000) Fixed costs (UK) (1,000) (Euro) (2,000) Net 1,000 Budget prepared on the basis of 1.2€:£1 Revise the budget assuming an exchange rate of 1.3€:£1 and a 5% increase in euro prices. 57
58 International capital budgetingIllustration only not examined International capital budgeting Budget prepared on the basis of 1.2€:£1 Revise the budget assuming an exchange rate of 1.3€:£1 and a 5% increase in euro prices and a 1% volume increase. Illustrative problem: ABC plc has the following budget £ £ € UK sales 5, ,000 Foreign sales 6, ,636 (6K x 1.2 x 1.05 x 1.01) Total Sales ,000 Variable costs (UK) (3,000) (3,016) (3K x (1 + 6/11 x 0.01) (Euro) (4,000) (4,826) (4K x 1.2 x (1 + 6/11 x 0.01) Fixed costs (UK) (1,000) (1,000) (Euro) (2,000) (2,400) (2K x 1.2) Net 1,000 58
59 International capital budgetingIllustration only not examined International capital budgeting Budget prepared on the basis of 1.2€:£1 Revise the budget assuming an exchange rate of 1.3€:£1 and a 5% increase in euro prices and a 1% volume increase. Illustrative problem: ABC plc has the following budget £ £ € £ UK sales 5, , ,000 Foreign sales 6, , ,873 Variable costs (UK) (3,000) (3,016) (3,016) (Euro) (4,000) (4,826) (3,712) Fixed costs (UK) (1,000) (1,000) (1,000) (Euro) (2,000) (2,400) (1,846) Net 1, ,299 Note that the euro value falls by 7.69% 59
60 International portfolio investment and diversificationportfolio investment - buying shares for investment purposes only <10% ownership RETURN …. R£ = R$ + e$ RISK….. var (R£) = var (R$) + var (e$)+ 2 cov (R$, e$) Eg STDEV of (R$) & (e$) = 0.15 or 15% and 0 cov = >> STDEV (R£) = (SQRT(0.045)) = 21% NOT 30%) Eun and Resnick study: US investing in varR$ vare$ cov (R$, e$) UK % 32% 17% France % 30% 8% R$= local stock market return in this case the US stock market E$ = % change in value of foreign currency 60
61 International portfolio investment and diversificationDo more diversified firms have lower betas? alternative approach: Jacquillat and Solnick study: 1) Looked at betas of multinational companies based on domestic index. beta i = cov(R i,R M) var(R M) 2) Recalculated betas based on foreign indexes. Think of it as Risk relative to the market 61
62 International portfolio investment and diversificationDo more diversified firms have lower betas? alternative approach: Jacquillat and Solnik study: 2) Recalculated betas based on foreign indexes. multinationals betas US Germany France UK US Germany France UK no relationship with foreign markets – the market does not value diversification!! "International Pricing of Risk, An Empirical Investigation of the World Capital Market Structure," Journal of Finance, May 1974. 62
63 International portfolio investment and diversificationDo more diversified firms have lower betas? ►tests group shares into portfolios according to sales abroad. ►do shares with higher sales abroad have lower betas? Madura quotes: Portfolio %sales abroad beta no clear indication 63
64 International portfolio investment size64
65 International Financial Management Module SummaryThe International Perspective International Financial Markets Financial Management and the Multinational Firm Madura & Fox Academic Papers Academic Papers background Multinational treasury management Ch 17 to 19 Current topics 65
66 International Financial Management Treasury management66
67 International Financial Management Treasury managementExample of an Irrevocable Letter of Credit If you present the right documents we will pay the amount on this letter 67
68 International Financial Management Treasury managementDocumentary Credit Procedure Buyer (Importer) 1. Sale Contract Seller (Exporter) 5. Deliver Goods 2. Request for Credit Importer’s Bank (Issuing Bank) 8. Documents & Claim for Payment 6. Present Documents 4. Deliver Letter of Credit 7. Present Documents 3. Send Credit Exporter’s Bank (Advising Bank) 9. Payment 68
69 International Financial Management Treasury management69
70 International Financial Management Treasury management foreign borrowingBorrowing from abroad Year 1 Year 2 Year 3 Swiss interest rate 4% 3% 5% Change in value of Swiss franc 2% (4%) 1% total 6% (1%) Home (US) cost 70
71 International Financial Management Treasury management foreign borrowing71
72 International Financial Management Treasury management foreign borrowing multicurrency riskinvestA invest B invest C Invest D invest E invest A wA2 x Var(A) wA x wB x Cov(A,B) wA x wC x Cov(A,C) wA x wD x Cov(A,D) wA x wE x Cov(A,E) WB2 x Var(B) wB x wC x Cov(B,C) wB x wD x Cov(B,D) wB x wE x Cov(B,E) WC2 x Var(C) wC x wD x Cov(C,D) wC x wD x Cov(C,E) invest D WD2 x Var(D) wD x wE x Cov(D,E) WE2 x Var(E) 72
73 International Financial Management Treasury managementLoans or Investment Interest &/or Principal Short-Term Securities Long-Term Projects Purchase Investment Subsidiary Funds for Supplies Sale Return on Investment Fees & Earnings Excess Cash Parent Sources of Debt Stock- holders Loans New Issues Cash Dividends Repayment 73
74 International Financial Management Treasury management non market methodsminimising currency conversion costs (cash flows) payments netting owed to >> Canada France UK by: ΠCanada l 40 80 France 60 l 40 UK l - Π= bilateral netting owed to >> Canada France UK by Canada l France 20 l 20 UK l
75 International Financial Management Treasury management non market methodsleading and lagging – speculation(?) matching foreign revenues with costs in the same currency Parallel loans and other swap type transactions Invoicing policy - in home currency
76 International Financial Management conclusionThe International Perspective Globalisation and the multinational firm International monetary system Balance of payments The market for foreign exchange International parity relationships International Financial Markets The derivative market and hedging strategies Foreign direct investment International portfolio investment and diversification Financial Management and the Multinational Firm Multinational treasury management International capital budgeting
77 International Financial Management post script
78 International Financial Management post script