copyright © 2010 pearson prentice hall. all rights reserved. chapter 18 international financial...

Copyright © 2010 Pearson Prentice Hall. All rights reserved.

Chapter 18

International Financial Management


18-2

Learning Objectives

1. Understand cultural, business, and political differences in business practices.

2. Calculate exchange rates, cross rates, and forward rates.

3. Understand transaction exposure, operating exposure, and translation exposure.

4. Apply net present value to foreign projects.


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18.1 Managing Multinational Operations

• When a firm goes multinational, the complexity of the management component increases significantly because of differences in host countries’– cultures – business practices – political systems


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18.1 (A) Cultural Risk

Cultural risk arises from differences in customs, social norms, attitudes, assumptions, and expectations of the local society in the host country.

• Differences in ownership structure: – a requirement to set up joint ventures in certain countries – a requirement to increase local participation and ownership

• Differences in human resource norms: – hiring and firing norms– different cultural attitudes towards women and minorities in

the workplace– local promotions and reward systems may not be consistent

with those of the home office and may have to be altered to maintain positive relations with local employees, customers, and government officials

• Religious heritage of the host country: – the way employees dress – holiday observances


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18.1 (A) Cultural Risk (continued)

• Nepotism and corrupt practices in the host country: – a requirement to hire relatives of government officials as a condition of doing business (Indonesia) and

– bribery of officials to get permits and licenses—considered to be illegal in the U.S.—may be normal practices in some foreign countries.

• Intellectual property rights: – copyrights and patents may not be honored in some foreign countries (e.g., China)

• Although attempts are being made to alter the landscape of differences in attitudes towards intellectual property rights (e.g. 2001 treaty), much still needs to be done.


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18.1 (B) Business Risk

• Arises from economic factors such as – inflation rates – recessions – interest rate movements – exchange rate fluctuations

• Tend to be more pronounced when operating in multiple countries.

• Efficient diversification of such risk factors is key to success.


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18.1 (C) Political Risk

• Arises from changing attitudes of the political leadership towards MNCs, resulting in loss of subsidies or risk of nationalization.

• MNCs can defend against such risks by– Keeping critical operations private: maintaining key or critical elements of operations safely within the firm, thereby rendering the assets useless in case of nationalization.

– Financing operations and assets with local money so that local creditors can put pressure on the host government not to nationalize the business.

– Receiving primary inputs outside the local economy: it may be that which the assets and operations of the MNC will not be valuable without such inputs.


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18.2 Foreign Exchange

• With each sovereign nation having its own currency (except of course, the euro which is the accepted currency in 16 out of 27 countries of the European Union), MNCs have to keep track of the fluctuations in exchange rates of various currencies caused by changing economic factors such as interest rates, inflation rates, and productivity.


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18.2 (A) Purchasing Power Parity

• Purchasing power parity the price of similar goods is the same regardless of which currency one uses to buy the goods.

• Table 18.1 shows how the price of a Big Mac in various countries can be used to keep track of relative purchasing power and exchange rates in countries where McDonalds operates.


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• Price in US $ = Price of a Big Mac in Foreign Currency/ HK$/1US$Price in US $ = Price of a Big Mac in Foreign Currency/ HK$/1US$• For Hong Kong, Price in US$ For Hong Kong, Price in US$ HK$13.3/HK$7.75 = $1.72 HK$13.3/HK$7.75 = $1.72• Purchasing Power(Hong Kong) = Price in HK$/Price in US$=HK$13.3/$3.54Purchasing Power(Hong Kong) = Price in HK$/Price in US$=HK$13.3/$3.543.763.76

18.2 (A) Purchasing Power Parity (continued)

TABLE 18.1 Big Mac Index


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18.2 (A) Purchasing Power Parity (continued)

• In the real world, exchange rates are based on the prices of a basket of goods rather than on a single item in different countries.

• In general, the rate at which we can exchange money between currencies should allow us to purchase the same the same basket of goods basket of goods in any country with the same dollars (except for local tariffs, etc.).


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18.2 (C) Currency Exchange Rates

can be expressed in – direct form (amount of US$ required to buy 1 unit of foreign money). Also known as the American rate.

– indirect form (amount of foreign money required to buy 1 US$). Also know as the European rate.


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18.2 (C) Currency Exchange Rates (continued)

TABLE 18.2 Exchange Rates (May 12, 2009)


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18.2 (C) Currency Exchange Rates (continued)

Calculation of these rates is as follows:

So, 1 Mexican peso can buy roughly 8 US cents.

If we divide the direct rate into 1, that is, take its reciprocal, we get the indirect or European rate:

Indirect rate = 1/$0.075513.245 Mexican pesos

So, 1 US$ can buy 13.245 Mexican pesos.


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18.2 (D) Cross Rates

Cross rates are used to state the exchange rate between two non-US currencies, – for example, the exchange rate between the British

pound and the yen.We can use a three-step process to determine the rate:1.We first convert pounds (£) into U.S. dollars. Using

the direct rate from Table 18.2, we see that 1 £ buys $1.5253.

2.We then convert our dollars into yen at the indirect rate of ¥96.16 per dollar. So, $1.5253 times 96.126 buys ¥146.6728.

3.We now have an exchange rate for pounds to yen via the U.S. dollar. That is, if we start with 1 £, we will end up with ¥146.6728:


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18.2 (D) Cross Rates (continued)

In Britain, this would be the indirect rate between the British pound and the Japanese Yen, that is, it would tell us how many units of yen can be bought with 1 £.

To solve for the direct rate between the £ and the yen, we simply take the reciprocal of the indirect rate >1/146.6728 > .0006817 £.

Alternatively, we can solve for the indirect rate between 2 currencies — for example, the amount of yen that 1 £ can buy. To do so, we take the direct or American rate of the first foreign currency and multiply it by the indirect or European rate of the second foreign currency.


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18.2 (E) Arbitrage Opportunities

Arbitrage opportunities exist when cross rates, as determined by Equation 18.3, do not hold: – allows traders the opportunity to exchange currencies simultaneously and make instant profits without taking on any additional risk


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Example 1: Triangular arbitrageProblem Let’s say that you see that the direct rate for Euro is

1.2922 and the indirect rate for the Yen is 96.16. You check the internet and find that the indirect rate for Yen in Euros is 130 yen. You have $10,000 and are willing to make quick gains if possible. Is there an arbitrage opportunity here?

SolutionFirst, use Equation 18.3 to determine if the indirect rate for yen in euros is correct.According to Equation 18.3, the indirect rate for yen per euro = Direct rate for euros in US$* Indirect rate for yen in US= $ 1.2922*96.16124.26Y/euro, which is less than the Indirect Rate so the euro seems to be overvalued.

18.2 (E) Arbitrage Opportunities (continued)


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You would then convert dollars into euros, buy Yen at the indirect rate, and convert yen back to dollars as follows:

Direct rate for euro = 1.2922 $1.2922 = 1 euro or $1 = $1.2922 = 1 euro or $1 = 1/1.2922 euro 1/1.2922 euro 0.773874 euro. 0.773874 euro.

$10,000*0.77387 euros/$ $10,000*0.77387 euros/$ 7738.74 euros 7738.74 euros7738.74 euros * 130 yen/euro 7738.74 euros * 130 yen/euro 1006036.22 yen1006036.22 yen1006036.22 yen * .0104$/yen=$10,462.771006036.22 yen * .0104$/yen=$10,462.77

So make a cool $462.77 before commissions.

YES! THIS WOULD BE AN ARBITRAGE OPPORTUNITY!

18.2 (E) Arbitrage Opportunities (continued)


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18.2 (F) Forward Rates

The exchange rates in the future, e.g., one year from now, depend to a large extent on the current exchange rate and the relative expected inflation rates in the 2 countries, as shown in Equation 18.4

Where inff = expected inflation rate in the foreign country and infh = expected inflation rate in the host country.


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18.2 (F) Forward Rates (continued)

If a country’s inflation rate increases relatively higher than that of another country, then its currency’s exchange rate will get weaker, that is, it will buy fewer units of the currency of the country whose inflation rate did not increase as much.

Equation 18.4 applies to a 1-year forward rate. A more general formula that can be used for predicting forward rates for any future period is shown in Equation 18.5:

here T is time in years, I.e., 9 months > = T = 9/12 = 0.75 and 3 years would have T = 3


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18.2 (F) Forward Rates (continued)


18-23

18.2 (G) Using Forward Rates


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18.3 Transaction, Operating, and Translation Exposure

• Fluctuations in exchange rates cause a firm’s future cash inflows, to vary significantly, leading to possible losses and gains from transaction, operating, and translation exposure.


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18.3 (A) Transaction Exposure


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18.3 (B) Operating Exposure


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18.3 (B) Operating Exposure

Tables 18.4 and 18.5 illustrate the effects of rising inflation rates on a country’s exchange rate and the consequential negative effect on operating profits of a U.S. firm doing business in Sweden.

TABLE 18.4 Dollar Profit per Swedish Bicycle Sale: No Change in Exchange Rate (inflation the same in both countries)

TABLE 18.5 Dollar Profit per Swedish Bicycle Sale: Increase in Exchange Rate Due to Different Inflation Rates


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18.3 (C) Translation Exposure


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18.4 Foreign Investment Decisions

• When evaluating multinational capital budgeting projects, the NPV analysis can be done with either foreign currency cash flows or with domestic currency cash flows.

• Two main differences between foreign and domestic investment decisions include: 1. the use of an appropriate discount rate discount rate

that accounts for the relative inflation rates in the two countries

2. the conversion of cash flows using an appropriate exchange rateexchange rate


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18.4 Foreign Investment Decisions (continued)


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18-32



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18-35

Additional Problems with Answers

Problem 1: Currency Exchange Rates On the day you arrive in New Zealand, the exchange

rate for U.S. dollars and New Zealand dollars is $1:2.25 NZ$. – While you remain in New Zealand for the next few months, the exchange rate falls to $1:$1.75439 NZ$.

– When you entered New Zealand, you converted US$10,500 to NZ$.

– As you leave New Zealand, you have NZ$ 400. • How much did you spend in New Zealand in U.S.

dollars? • Did the movement in the exchange rate help or

hurt you?


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Additional Problems with AnswersProblem 1 (Answer)

Convert US$ to NZ$: $ 10,500 x 2.25 = NZ$23,625 Remaining NZ$ after trip is over = NZ$400; Amount spent NZ$23,625-NZ$400=NZ$ 23,225Dollars left after converting: NZ$400 /1.75439 = $

228Dollars Spent: $10,500 - $228.00 = $10,272Appreciation of the NZ$ helped you: you bought

the NZ low and sold the NZ highInitial value of $1.00 = NZ$2.25 Ending value of $ = NZ$2.25/NZ$ 1.75439 = 1.2825

You gained about 28.25 cents per dollar while in New Zealand.


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Problem 2: Cross-Rates You plan to travel to South Korea and China on a

business trip.– You will first stop in Korea, where the current direct exchange rate is $1:1243.78SK Won.

– You will next stop in China, where the current direct exchange rate is $1: Yuan 6.83013.

– As you leave South Korea, you have 825,000 Won and need to convert it to Yuan.

• What is the cross-rate for Yuan, and how many Yuan do you get for your won?

• Verify by converting won back to dollars and then dollars to Yuan.


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Direct rate: $0.000804 / Won1.00 & $0.1464101 /Yuan1.00

Cross rate: ($0.000804 / Won1.00) / ($0.1464101/Yuan1.00)

Yuan0.00549142 / Won1.00

Convert: 125,000 Won to Yuan = Won 825,000 x Convert: 125,000 Won to Yuan = Won 825,000 x (0.00549142) (0.00549142)

Yuan 4,530.42Verification: 825,000 Won= 825,000*.000804$663.3$663.3*6.83013Yuan Yuan 4,530.42


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Problem 3: Triangular ArbitrageOn-Line Currency, Inc. is an online currency exchange company that will immediately convert and credit your bank account based on its published rates. Being the smart finance major that you are, you notice that one of the rates published below is incorrect, and you want to take advantage of it. Let’s say that you have $20,000 of next semester’s college funds sitting in your checking account and decide to take advantage of the error by doing a triangular arbitrage (we do not advise doing this in reality!). Explain how you would go about doing the arbitrage by first identifying the mismatched currency pair:$ for £ £ for € € for $ £ for $ € for £ $ for €

0.5510 1.5235 1.3046 1.81488203 0.95683 0.7665


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Direct Indirect Actual Indirect: £0.5510 = $1.81488203 $1.81488203 $1.00 £1.00 £1.00 €1.5235 = £0.65638333 £0.95683 = Mismatch £1.00 €1.00 €1.00 $1.3046 = €0.7665 €0.7665 €1.00 $1.00 $1.00

Arbitrage strategy: Need to use the mismatched Euros to British Pounds…

1. Convert $ to €: $20,000 x 0.7665 = €15,3302. Convert € to £: €15,330 x 0.95683 = £14,668.203903. Convert £ to $: £14,668.20 x 1.81488203 = $26,621.06Profit: $ 6,621.06


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Problem 4: Forward RatesThe Wall Street Journal lists forward rates for

Euros. Say that the current listings are:1-month forward rate (indirect) 0.70253-month forward rate (indirect) 0.71456-month forward rate (indirect) 0.7245

1) Is the anticipated inflation rate higher or lower in Europe compared with that in the United States?

2) If the current indirect rate is 0.6994, what do the six-month rate and the current rate imply about the relative difference in the anticipated annual inflation rates?

3) Using the current indirect rate and the 6-month forward rate, determine the annual anticipated inflation rates for Europe if the U.S. inflation rate is anticipated to be 3.15%.


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Forward indirect rates:One month €0.7025 / $ 1.00Three months €07145 / $ 1.00Six months €0.7245 / $ 1.00 A depreciating € signifies higher inflation in the

next six months for Europe versus the United States.

Inflation: 0.7245 = 0.6994 x [(1 + infEUROPE)/(1 + infUS)]0.5

[(1 + infEUROPE) / (1 + infUS)] = (.7245 / .6994)2

[(1 + infEUROPE) / (1 + infUS)] = 1.07306375 (1 + infEUROPE) = (1 + infUS) x 1.07306375Since inflation in US is 3.15% (1 + infEUROPE) = (1.0315) x 1.073063751.10686526 Inf EUROPE = 10.69%


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Problem 5: Domestic NPV ApproachKalamazoo Marine wants to expand its operations to New

Zealand. The current indirect exchange rate is 1.75 for U.S. and New Zealand dollars. The anticipated inflation rate is 3.8% in the United States, but only 1.75% in New Zealand. The discount rate in the United States for the expansion project is 16%. If the following after-tax cash flows have been forecasted for the expansion project in NZ$, should Kalamazoo Marine expand to New Zealand?

Investment: NZ$ 60,000,000Cash Flows: Year 1 – NZ$7,000,000

Year 2 – NZ$10,000,000Year 3 – NZ$ 25,000,000Year 4 – NZ$ 19,000,000Year 5 – NZ$ 17,000,000Year 6 – NZ$ 5,000,000


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• Anticipated forwards:• Yr 1. (NZ$1.75/$1.00) x (1.0175/1.038) =

NZ$1.7154/$1.00• Yr 2. (NZ$1.75/$1.00) x (1.0175/1.038)2 =

NZ$1.6816/$1.00• Yr 3. (NZ$1.75/$1.00) x (1.0175/1.038)3 =

NZ$1.6483/$1.00• Yr 4. (NZ$1.75/$1.00) x (1.0175/1.038)4 =

NZ$1.6158/$1.00• Yr 5. (NZ$1.75/$1.00) x (1.0175/1.038)5 =

NZ$1.5839/$1.00• Yr 6. (NZ$1.75/$1.00) x (1.0175/1.038)6 =

NZ$1.5526/$1.00


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Additional Problems with AnswersProblem 5 (Answer continued)

Cash Flows: $ value Present

Value NZ$ -60,000,000 / 1.75 = $ -34,285,714.29 $ -34,285,714.29NZ$ 7,000,000 / 1.7154 = $ 4,080,680.89/ (1.16) $

3,517,828.35NZ$ 10,000,000 / 1.6816 = $ 5,946,717.41/ (1.16)2 $

4,419,379.77NZ$ 25,000,000 / 1.6483 = $ 15,167,141.90/ (1.16)3 $

9,716,945.85NZ$ 19,000,000 / 1.6158 = $ 11,758,881.05/ (1.16)4 $

6,494,325.32NZ$ 17,000,000 / 1.5839 = $ 10,733,000.82/ (1.16)5 $

5,110,121.39NZ$ 5,000,000 / 1.5526 = $ 3,220,404.48/ (1.16)6 $

1,321,790.08 NPV = ∑(PV Column) -$ 3,705,323.53. Do not expand…Negative NPV!

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