essential of multinational business finance practical approach professor m. vaziri

Essential of Essential of Multinational Business Multinational Business FinanceFinancePractical ApproachPractical Approach

Professor M. VaziriProfessor M. Vaziri

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Chapter 1Chapter 1 Chapter 2Chapter 2 Chapter 3Chapter 3 Chapter 4Chapter 4 Chapter 5Chapter 5 Chapter 6Chapter 6 Chapter 23Chapter 23

Chapter 14Chapter 14 Chapter 18Chapter 18 Chapter 15Chapter 15 Chapter 20Chapter 20 Chapter 11Chapter 11 Chapter 22Chapter 22 International BankingInternational Banking International Financial MaInternational Financial Ma

rketrket

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Chapter 1 Chapter 1 Financial Goals and Corporate Financial Goals and Corporate GovernanceGovernance

Multinational business enterprise and finance A business having operating subsidiaries,

branches, or affiliates located in foreign countries.

Can be engaged in virtually every type of business activity, including banking, accounting, consulting, etc.

Business activities, primarily financing, which reach beyond the domestic markets.

Major risks include interest rate, exchange rate, and credit risks of foreign markets.

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Goal of management : Shareholder Wealth Maximization versus Corporate Wealth Maximization

Shareholder Wealth Maximization (SWM Model) Is the predominant theory of domestic U.S. firms Assumes that the stock market is efficient and all news

(public or private) is reflected in the stock price. Risk = added risk that the firm’s share bring to an

established investment portfolio. Systematic Risk = the non-diversifiable risk inherent in

the market, therefore it cannot be eliminated. Unsystematic Risk = the diversifiable risk of an

individual.

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Weaknesses of Shareholder Wealth Maximization (SWM) Short-term gains vs. long-term gains – Some

managers attempt to maximize short-term shareholder wealth at the expense of the long-term profitability of the company.

Agency Theory -- Managers and owners may not share the same goals and objectives. Problem arises as shareholders seek effective motivational tools to promote managers conformity to will of shareholders.

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Corporate Wealth Maximization The firm treats shareholders as equals to other

groups with interest in the firm (management, labor, local community, supplies, creditors, etc).

Risk = total risk = Operational + Financial Risk. Concerned with growing the firm for the benefit

of all, not exclusively shareholders. Is the predominant theory of many foreign

firms. A few foreign firms are adopting the SWM

model.

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Weaknesses of Corporate Wealth Maximization (CWM) Attempts to satisfy too many parties simultaneously. It may

be to provide adequate satisfaction to any single party.

Corporate Governance Relationship among firm’s stakeholders to control the

objectives and strategic direction of the firm. U.S. and similar markets use the “one share = one vote”

voting system. While many foreign firms issues separate classes of voting, limited voting, and non-voting shares.

Due to abuses and failures of internal corporate self-governance, government and outside agencies must enact legislation regulating activities. One such law is the Sarbanes-Oxley Act of 2002.

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Three major characteristics of Sarbanes-Oxley CEO’s of publicly traded firms must

personally certify company’s public financial statements.

Corporate boards must have independent auditors.

Companies cannot make loans to company directors.

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Basics of Corporate Governance The way a corporation directs itself is called corporate

governance. Primarily, corporate governance states the techniques that govern the formation of a corporation’s structure and the laws and customs that affect these techniques.

A corporation’s structure is composed of three groups: Board of Directors Managers Shareholders

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Chapter 2 Chapter 2 International Monetary System International Monetary System (IMS)(IMS)

Structure of IMS: Framework within which the foreign Exchange rates are determined, capital flows & international trade are accommodated & Balance of Payments Adjustments are made

History of IMS: The Gold Standard (1876-1913): Gold as a medium of exchange- Pharaohs (3000

PC) The Greeks, Romans & Persians Used gold coins

& passed through the mercantile era to the 19th century

No multinational agreement, but each country declared a par value for its currency in terms of gold based on rule of games or "Gold Standard"

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Mercantilism of 19th Century - Need for IMS: Europe adapted the IMS in 1870 & the U.S.. in 1879 $20.67/Ounce of Gold, £4.274/Ounce: $20.67/£4.2474=£4.8665/$ Limitation of gold reserve & supply of money Limit the flow of goods and gold & suspension of GS

Inter War Years: 1914-1944: Free Fluctuating of Exchange Rates with consideration

of the gold and par value of other currencies. Short sell of week currencies, re-evaluation of £, the

collapse of the Austrian banking system-total abandonment of GS

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The Bretton Wood Agreement: (1944): Dollar based Monetary System (par value based on $) Fixed value in term of $, but not required to convert Only $ remained convertible to gold: $35/Ounce Only 1% of par allowed for fluctuation Devaluation was not allowed for purpose of high export 10% devaluation for week currency or approval of IMF IMF & World Bank were created Former Soviet Union did participate at Bretton Wood but

chose not to join IMF or World Bank

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International Monetary Fund IMF Mission: Rendering temporary assistance to currencies with cyclical, Mission: Rendering temporary assistance to currencies with cyclical,

seasonal or random fluctuation.seasonal or random fluctuation. Help countries with a structural trade problemHelp countries with a structural trade problem IMF is funded based on quota of expected post WWII tradeIMF is funded based on quota of expected post WWII trade The Original quota were 25% in gold or $ (Gold tranche), & 75% local The Original quota were 25% in gold or $ (Gold tranche), & 75% local

currency.currency. A member country can borrow up to its original 25% in gold or A member country can borrow up to its original 25% in gold or

convertible currencies in any 12 month plus 100% of its total quota. convertible currencies in any 12 month plus 100% of its total quota. A member country can also borrow up to 120% of its quota in A member country can also borrow up to 120% of its quota in convertible currency or gold, even through it only paid 25% in convertible currency or gold, even through it only paid 25% in convertible currency or gold.convertible currency or gold.

At the present time, each of the 151 member can borrow up to 150% annually of its quota or up to 450% during a three years period

Cumulative access could be up to 600% of members quota

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International Monetary Fund IMF (Cont’) Distribution of the quota is prelude to distribution of voteDistribution of the quota is prelude to distribution of vote U.S. Vote:19.1%, UK:6.6%, Germany:5.8%, France:4.8%, U.S. Vote:19.1%, UK:6.6%, Germany:5.8%, France:4.8%,

Japan:4.5%, Canada:3.2%Japan:4.5%, Canada:3.2% General Agreement to Borrow: IMF ability to borrow from General Agreement to Borrow: IMF ability to borrow from

member countries, currently more than $180 billion.member countries, currently more than $180 billion. Special Drawing Rights (SDR): created according to Rio de Special Drawing Rights (SDR): created according to Rio de

Janeiro agreement (1967) to help increase the global trade Janeiro agreement (1967) to help increase the global trade between nationsbetween nations

SDR is distributed based on members quota and valued based SDR is distributed based on members quota and valued based on 16 then 5 currencyon 16 then 5 currency

First $/SDR determined then value of other currencies are First $/SDR determined then value of other currencies are measured measured

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Monetary Development: (1944-1971) EFTA (1957) & EEC (1959), rapid increase in world tradeEFTA (1957) & EEC (1959), rapid increase in world trade U.S.. deficit of 1959 & International Monetary Reserve U.S.. deficit of 1959 & International Monetary Reserve

dilemma: BOP deficit to create more reserve for LDCsdilemma: BOP deficit to create more reserve for LDCs Doubt of convertibility of major reserve currenciesDoubt of convertibility of major reserve currencies "Interest Equalization Tax“ on foreign borrowing & creation of "Interest Equalization Tax“ on foreign borrowing & creation of

Euro-bondEuro-bond Mandatory control of direct foreign investment ,control of Mandatory control of direct foreign investment ,control of

foreign lending by U.S banks,& high U.S deficitforeign lending by U.S banks,& high U.S deficit Official Currency Swaps: Group of Ten Industrialized Nations Official Currency Swaps: Group of Ten Industrialized Nations

as a interest credit between central banksas a interest credit between central banks

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Monetary Development: (1944-1971) U.S. BOT had reached to all-time high in 1971U.S. BOT had reached to all-time high in 1971 U.S lost one-third of her official gold & president Nixon U.S lost one-third of her official gold & president Nixon

suspended convertibility of $ to goldsuspended convertibility of $ to gold U.S. imposed 10%surcharge on imports & freezes P&WU.S. imposed 10%surcharge on imports & freezes P&W Most European currencies gained against $Most European currencies gained against $

Smithsonian agreement: December of 1971: Group ten Industrialized Nations signed on Dec, 17 1971Group ten Industrialized Nations signed on Dec, 17 1971 $ devaluated to $38/Ounce, Yen evaluated against $ :16.9%, $ devaluated to $38/Ounce, Yen evaluated against $ :16.9%,

Canada 7.4%Canada 7.4% Floatation of 2.25% (Max 4.5%) is allowedFloatation of 2.25% (Max 4.5%) is allowed $ lost its value sharply: $42.22 in free market, $70 in official $ lost its value sharply: $42.22 in free market, $70 in official

London marketLondon market

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Jamaican Agreement: January 1976: Floating Rate has been established ( has continued today)Floating Rate has been established ( has continued today) Gold was demonetarized as a reserved assetGold was demonetarized as a reserved asset IMF agreed to sell $25 million ounces of gold to its members IMF agreed to sell $25 million ounces of gold to its members

and used the proceeds to help the poor nationsand used the proceeds to help the poor nations IMF quota increased to $41 and then to $180 billionIMF quota increased to $41 and then to $180 billion 10% of the voting power given to OPEC members10% of the voting power given to OPEC members Non-oil producing countries have more access to IMFNon-oil producing countries have more access to IMF Floating Exchange Rate System has officially adopted & Floating Exchange Rate System has officially adopted &

continued until present timecontinued until present time

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Plaza Agreement

Louvre Agreement

http://www.econ.iastate.edu/classes/econ355/choi/cur.htm

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Chapter 3Chapter 3Balance of Payment (BOP)Balance of Payment (BOP)

Definition of BOP: Record of transactions between residents of one country & rest of the world

Functions of BOP: Helps forecast market potential of a country Helps to understand the currency fluctuation of a country It is a poor description of National Economy Useful in measuring economic performance if there is

FER

$ was indexed at 100 at 1970: If index is greater than 100,$ gain VS other countries currencies.

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Chapter 3Chapter 3Balance of Payment (BOP)Balance of Payment (BOP) Accounts of BOP:

Trade Balance : Net balance in merchandise traded Current Account: Trade account + earning & expense on

services Performed service: travel, shipping, banking, insurance, etc Debt service: interest, dividend received or paid abroad.

Basic Balance: Current account +long term capital (such as direct investment)

Overall Balance: basic Balance + short term capital +Error & Omission

Unilateral Transfer: no corresponding flow of G&S-non military goods, grants, foreign aids, donation, inheritance

Capital account: record of investment & payments

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Chapter 3Chapter 3Balance of Payment (BOP)Balance of Payment (BOP) Macro Modeling of BOP:

Aggregates Income: Y=C+S, Where, C = Agg. Consumption & S = Agg. Saving Aggregate Expenditure: E= C+Id, where Id=Domestic

investment Y-E=S-Id If Y is greater than E, S is greater than Id

Sector of Economy Consumer Sector (C) Business Sector (Investment): - Id and If Government Sector (G) Foreign Sector = Export (X) – Import (M)

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Chapter 3Chapter 3Balance of Payment (BOP)Balance of Payment (BOP) Balance Economy

Y-E=0 S (Saving) – Id = 0 : Saving Balance G – T (Tax) = 0: Budget Balance Export (X) – Import (M) = 0: Trade Balance. In a balance Economy: Y=E, then S= Id, then G=T, then X=M

* If Y>E, then S> Id (Saving Surplus), then T>G (Budget Surplus), then X>M (Trade Surplus). So If > 0 (Capital Outflow)

* If Y<E, then S< Id (Saving Deficit), then T<G (Budget Deficit), then X<M (Trade Deficit). So If < 0 (Capital Inflow)

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Chapter 3Chapter 3Balance of Payment (BOP)Balance of Payment (BOP) Coping with Current Account Deficit

(CAD): Relationship between CAD & currency depreciation According to General Equilibrium View : not a

simple one 1976-1980: $ depreciate, CAD decreased 1980-1985: $ appreciate, CAD increased

Impose high tariffs & quotas: Since S-Id=X-M, (unless S & Id changes), if M decline, X

must decline : less import means less demand for foreign currency, less supply of domestic currency, and an increase in value of domestic goods, which mean less export.

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Chapter 3Chapter 3Balance of Payment (BOP)Balance of Payment (BOP)

End Foreign ownership of domestic assets No capital account surplus means interest

rate will increase & investment & income will decline

Stimulate savings: If S is greater than Id, we will have capital outflow, causing deficit to decrease in both Government budget & Current Account.

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Foreign Exchange Foreign Exchange MarketMarket

Euro €

£Can$SFranc

¥

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Chapter 4Foreign Exchange Market (FEM)

Function of FEM:Function of FEM: Transfer of Purchasing Power.Transfer of Purchasing Power. International Credit such as L.C.International Credit such as L.C. Minimize Exposure to Foreign Exchange Minimize Exposure to Foreign Exchange

Risk Risk Market for Hedging & Arbitrageur Market for Hedging & Arbitrageur Market for currency Swaps, futures & Market for currency Swaps, futures &

forward/Spot Transactionsforward/Spot Transactions

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Participants in FEM:Participants in FEM: Banks & Non-banksBanks & Non-banks FEM Dealers- benefited from bid-ask spreadFEM Dealers- benefited from bid-ask spread Market Makers-Position on certain CurrenciesMarket Makers-Position on certain Currencies FEM Brokers (56%)FEM Brokers (56%) Exporter, Importer, Tourists MNCs, Portfolio Exporter, Importer, Tourists MNCs, Portfolio

ManagersManagers Speculators & ArbitrageurSpeculators & Arbitrageur Central BanksCentral Banks

Chapter 4Foreign Exchange Market

(FEM)

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Types of FEM Transactions:Types of FEM Transactions: Spot Transactions: one day settlement (63% of market)Spot Transactions: one day settlement (63% of market) Forward Transactions: one, two, six & 12 month (6%)Forward Transactions: one, two, six & 12 month (6%) Swaps Transactions: Simultaneous purchase or sale of FE, Swaps Transactions: Simultaneous purchase or sale of FE,

with two value dates: spot-forward, forward-forwardwith two value dates: spot-forward, forward-forward

Spot Transactions

Forward Transactions

Swaps TransactionsExample: sell £20 mil forward for $ deliver in two months at $1.4870/£ & simultaneouslybuy back £20 mil forward for delivery in three month at $1.4820/£.


(FEM)

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Types of Quotations:Types of Quotations: Direct Quotation : Direct Quotation :

• Home currency in terms of foreign currency.Home currency in terms of foreign currency.

• $/€ =$1.18/€: American Way$/€ =$1.18/€: American Way

Indirect Quotation:Indirect Quotation:• Foreign currency in terms of home currencyForeign currency in terms of home currency

• €€/$= €0.8474/$./$= €0.8474/$.

Bid & ask spread:Bid & ask spread:• Buy (bid) at €0.8474/$. & ask (offer) at €0.8474/$.Buy (bid) at €0.8474/$. & ask (offer) at €0.8474/$.

• Difference between bid-ask is dealerDifference between bid-ask is dealer

• Premium=transaction costPremium=transaction cost


(FEM)

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Types of Quotations:Types of Quotations:Cross Rates:Cross Rates:

• Swiss Franc (CHB)/$ over Danish Krone (DKK) , Swiss Franc (CHB)/$ over Danish Krone (DKK) ,

• So,CHB1.32/DKK6.30 = CHB0.2095/DKKSo,CHB1.32/DKK6.30 = CHB0.2095/DKK

Point Quotation:Point Quotation:• Difference between forward rate & spot rate (swap Difference between forward rate & spot rate (swap

rate).rate).


(FEM)

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Triangular Arbitrageur

Buying & selling of one currency for another & returning to the original one.

U.S$U.S$ UK £UK £ €€

U.S$U.S$ 11 S($/£)=1.70 S($/£)=1.70 S($/S($/€€)=1.18 )=1.18

££ S(£/$)=0.5883 1 0.6943 S(£/$)=0.5883 1 0.6943

€€ 0.8474 1.44 10.8474 1.44 1

If S(€ /$)*S(£/ €)*S($/£) is greater than one, successful arbitrageur.

(0.8474*0.6943*1.7)=$1.00019, is successful arbitrageur

Chapter 4

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The Interest Rate Parity Theory

Chapter 4

DEF: Except for transaction costs, the differences in national interest rate, for security of similar risk & maturity should be equal but opposite in sign, to forward exchange rate discount or premium for foreign currency.

It links National Monetary Market Rate to Foreign Exchange Rate.

Forward Exchange Rate Discount & Premium: (Forward Rate-Spot Rate)/(Spot Rate)*12/n*100 (Spot Rate-Forward Rate)/(Forward Rate)*12/n*100

Can$1.319-1.313/1.313*12/3*100=+1.8279 per year: It means CAN $ is in 1.8279%, 3-month forward premium or the

U.S. $ is in 1.8279%, 3-month forward discount.

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The operation of Covered Interest Arbitrageur

Chapter 4

Test for Parity UK 3-Month Interest Rate=12% per year U.S. 3-month Interest Rate=7% per year Transaction Cost=.15% should be calculated at the

beginning of transaction Size of Transaction=$2,800,000.00

Covered Interest Arbitrageur actions: Step 1. Borrow $2.8mil at 7%/year for 3-month Step 2. Exchange $2.8 mil for £ at spot rate of $1.4000/£ &

receive £2mil. Step 3. Invest £2mil for 3-month in UK at 12%/year or

3%/Quarter. Step 4. Sell £2.06mil forward at 3-month forward rate of

$1.3860/£: which include £2mil principal & £60,000 interest for the 3-month (3%*2mil=$60mil

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The operation of Covered Interest Arbitrageur

Chapter 4

Covered Interest Arbitrageur actions-con..: Step 5. Pay transaction cost of $4,200 ($2.8*.15) Step 6. Three month after, redeem UK investment of

£2,06mil Step 7. Fulfill forward contract by selling £2060mil at

$1.3860/£ forward rate & receive $2.855160. Step 8. Repay loan of $2.8mil plus 3-month interest at

1.75%/Quarter ($2.8*1.75%=$49000). Profit Calculation:

Proceed from investment in UK=$2,855,160. Principal + interest from borrowing=$2,849,000 Transaction cost=$4200 Net profit=$2,855160-2,849000-4200=$1,950.00

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Speculation in FEM

Chapter 4

Spot Market Speculation: Spot rate:DG2.9000/$,Forward Rate=DG2.8000/$

6-month expected spot rate=DG2.700/$

With $40,000, buy:$40,000*DG2.9=DG116000

Sell at DG2.7/$ for $42965 (116000/2.7)

Make profit of 2965 or14.82%/Year

Forward Market Speculation Buy $40,000*DG2.8=DG112000

Buy back $ at DG2.7=$41,481

Profit=$1,481

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Factors to be considered in forecasting the ER

Chapter 4

1.1. Expected changes in spot rate,Expected changes in spot rate,

2.2. Inflation rate differential,Inflation rate differential,

3.3. Interest rate differential, Interest rate differential,

4.4. BOP problems,BOP problems,

5.5. Growth of Money supplyGrowth of Money supply

6.6. Business Cycle,Business Cycle,

7.7. Change in International Monetary Reserve,Change in International Monetary Reserve,

8.8. Increase in official-nonofficial rate spreadIncrease in official-nonofficial rate spread

9.9. FE policies such as , FE. control, ceilings on interest rate, FE policies such as , FE. control, ceilings on interest rate, high import duties, export subsidies, excess G-Spending,high import duties, export subsidies, excess G-Spending,

10.10. Elasticity of demand for exchange rate, Forward rate Elasticity of demand for exchange rate, Forward rate discount or premiumdiscount or premium

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Interest Rate Parity Theory

Chapter 4

• For given transaction cost, percentage of the forward premium or For given transaction cost, percentage of the forward premium or discount of foreign currency to home currency is equal but opposite discount of foreign currency to home currency is equal but opposite in sign to interest rate differential between foreign country and in sign to interest rate differential between foreign country and home country.home country.

Forward Premium or Discount of Foreign Currency to Home Currency

Interest Rate Differential between foreign country and home country

IRP Line

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Purchasing power Parity (PPP) Theory

Chapter 4

• Def: If the spot rate between two countries Def: If the spot rate between two countries starts in equilibrium, any change in the starts in equilibrium, any change in the difference of rate of inflation between them difference of rate of inflation between them tends to be offset over the long run by tends to be offset over the long run by equal, but opposite change in spot equal, but opposite change in spot exchange rate. exchange rate.

• Current Account Balances are very sensitive Current Account Balances are very sensitive to change in inflation Rateto change in inflation Rate

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Purchasing power Parity (PPP)

Chapter 4

• For example: if the inflation rate of US is 2% lower than that of UK, For example: if the inflation rate of US is 2% lower than that of UK, then the expected rate in US is 2 % higher than that of UK. Balance in then the expected rate in US is 2 % higher than that of UK. Balance in current account is very sensitive to change in inflation rate.current account is very sensitive to change in inflation rate.

Inflation differential of Foreign Currency to Home Currency

Expected spot rate differential of Foreign Currency to Home Currency

PPP line

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International Fisher Effect (Fisher Open) Theory

Chapter 4

• Def: Difference in interest rate between Def: Difference in interest rate between two countries is equal, but opposite in two countries is equal, but opposite in sign to the spot exchange rate of sign to the spot exchange rate of foreign currency to home currencyforeign currency to home currency

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International Fisher Effect (IFE)

Chapter 4

• For example: If the interest rate in U.K. has 3% higher than interest rate in the U.S., U.K. should be For example: If the interest rate in U.K. has 3% higher than interest rate in the U.S., U.K. should be depreciated by 3% against the $U.S., and at the same time the U.S. should be appreciated by 3%. (If it depreciated by 3% against the $U.S., and at the same time the U.S. should be appreciated by 3%. (If it is on the IFE line)is on the IFE line)

• If the interest rate in U.K. is 4% lower than interest rate in the U.S., U.K. should be appreciated by 4% If the interest rate in U.K. is 4% lower than interest rate in the U.S., U.K. should be appreciated by 4% against the $U.S., and at the same time the U.S. should be depreciated by 4%. (If it is on the IFE line)against the $U.S., and at the same time the U.S. should be depreciated by 4%. (If it is on the IFE line)

Expected Spot Rate difference of foreign currency to home currency

Interest Rate differences of Foreign Currency to Home Currency

IFE line

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Fisher Effect (Irving Fisher)

Chapter 4

• Def: Difference in inflation rate between two countries is Def: Difference in inflation rate between two countries is equal to the interest rate differential between them. Nominal equal to the interest rate differential between them. Nominal interest rate is equal to the required real rate of return plus interest rate is equal to the required real rate of return plus compensation for expected inflation. (i= r + π, i : the nominal compensation for expected inflation. (i= r + π, i : the nominal interest rate, r: the real interest rate, π: expected inflation)interest rate, r: the real interest rate, π: expected inflation)

Expected Inflation

Interest Rate Differential

Fisher Parity Line

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Foreign Currency Option (FCO)

Chapter 4

• Def: FCO is a contract that gives buyers the Def: FCO is a contract that gives buyers the right to buy or sell a given amount of foreign right to buy or sell a given amount of foreign exchange at a fixed price (exercise price or exchange at a fixed price (exercise price or strike price) per unit for a specific period of strike price) per unit for a specific period of time.. time..

• Types of FCO: Types of FCO: American OptionAmerican Option: Right to : Right to exercise on any day before the expiration date, exercise on any day before the expiration date, European OptionEuropean Option: only on the expiration date.: only on the expiration date.

• In-the-moneyIn-the-money: When you make profit, : When you make profit, At-the-At-the-moneymoney: when profit is zero, and : when profit is zero, and Out-of-moneyOut-of-money: : when you have a losswhen you have a loss

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Foreign Currency Option (FCO)

Chapter 4

Maturity dates & size of FCO:Maturity dates & size of FCO:• Saturday proceeding the third Wednesday Saturday proceeding the third Wednesday

of expiration Month March, June, of expiration Month March, June, September, and December.September, and December.

• Contract size: Cited as fixed contract per Contract size: Cited as fixed contract per unit, such as DM62,500/per unit of option: unit, such as DM62,500/per unit of option: with one mil$ one can buy:$ one with one mil$ one can buy:$ one mil/¨DM62,500=16 FCP contractmil/¨DM62,500=16 FCP contract

• Price of FCP: No of cents per unit: Price of FCP: No of cents per unit: £12,500*.02=$250.£12,500*.02=$250.

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Foreign Currency Premium (FCP)

Chapter 4

• FCP is a flexible transaction of over 1 mil in major FCP is a flexible transaction of over 1 mil in major trading currencies for any time period up to one trading currencies for any time period up to one year, tailored to the customer's need. year, tailored to the customer's need.

• This is a good alternative to the forward market.This is a good alternative to the forward market.

• A Percentage of TransactionA Percentage of Transaction, , Paid advance & Paid advance & according to following factors:according to following factors:

1.1. Strike price relative to spot rateStrike price relative to spot rate

2.2. Supply & demand for optionSupply & demand for option

3.3. Relative interest rate between countriesRelative interest rate between countries

4.4. Relative currency risk, andRelative currency risk, and

5.5. Maturity of the option.Maturity of the option.

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Foreign Currency Premium (FCP)

Chapter 4

An Exercise on FCPAn Exercise on FCP::• March $1.45 call option payees $.02 per £ ( March $1.45 call option payees $.02 per £ (

purchase £12,500 at $1.45 option with purchase £12,500 at $1.45 option with expiration date of March.expiration date of March.

• If price of £ increase to $1.5100, buy £ at If price of £ increase to $1.5100, buy £ at £1.4500 & sell £ 1.5000 & make $1.5100-£1.4500 & sell £ 1.5000 & make $1.5100-1.4500=.06 per £ or 12500*.06=$750. 1.4500=.06 per £ or 12500*.06=$750.

• Subtract transaction cost of 250, & make a Subtract transaction cost of 250, & make a net profit of $750-250=$500.net profit of $750-250=$500.

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Currency Future Market (CFM)

Chapter 4

• Def of CFM: CF are contract between the Def of CFM: CF are contract between the future dealers & client.future dealers & client.

• It does not involve commercial banks & It does not involve commercial banks & traderstraders

• Difference between CFM & Forward Difference between CFM & Forward Exchange Market, as inflation, contract is Exchange Market, as inflation, contract is drawn up between banks & client;drawn up between banks & client;

• Major Participants in CFM are: Importer & Major Participants in CFM are: Importer & Exporter, Speculators & Arbitrageur, and Exporter, Speculators & Arbitrageur, and those who invest abroad. those who invest abroad.

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Future Contracts

Chapter 5

Currency futures contracts, patterned after Currency futures contracts, patterned after grain and commodity contracts, are traded at grain and commodity contracts, are traded at the International Monetary Market (IMM) and the International Monetary Market (IMM) and the Chicago Mercantile Exchange (CME)the Chicago Mercantile Exchange (CME)

1. Futures contracts are written for a specific quantity of a given currency. The exchange rate is fixed at the time the contract is entered into, and delivery date is set by the IMM or CME.

2. Contract sizes are standardized for a currency. 3. Transactions in futures market require payment of a

commission to trader rather than the bid/ask spreads of the forward market.

4. Futures contracts are “marked to market” daily. In other words, at the end of each day, the contracts are settled and the resulting profits and losses are paid.

5. Market participants are required to maintain a margin or security deposit with a broker.

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Forward Contracts

Chapter 5

Forward contracts can be written for any quantity mutually agreed upon by the two parties.

Contract sizes are not standardized. Transactions in forwards are usually conducted on

a bank-to-client basis Since forward contracts are custom tailored for

each agreement, there is no daily “marking to market” because there is no centralized market

No requirement for margin or security deposit.

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Currency Options

Chapter 5

Currency options give the holder the right, but not the Currency options give the holder the right, but not the obligation to buy or sell a given amount of a particular obligation to buy or sell a given amount of a particular currency at a fixed price per unit for a specific time period.currency at a fixed price per unit for a specific time period.Call OptionCall Option

A call option is the right to BUY foreign currencyA call option is the right to BUY foreign currency

Put OptionPut Option A put option is the right to SELL foreign currencyA put option is the right to SELL foreign currency

American OptionAmerican Option A holder has the right to exercise the option at any time up to the A holder has the right to exercise the option at any time up to the

expiration dateexpiration date

European OptionEuropean Option A holder has the right to exercise the option A holder has the right to exercise the option ONLYONLY on the expiration date on the expiration date

Exercise / Strike PriceExercise / Strike Price The price at which the option holder can buy or sell the contracted The price at which the option holder can buy or sell the contracted

currencycurrency

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Currency Options

Chapter 5

In-the-moneyIn-the-money

An option that would be profitable to exercise.An option that would be profitable to exercise.

Put: The spot exchange rate is less than the strike pricePut: The spot exchange rate is less than the strike price

Call: The spot exchange rate is greater than the strike priceCall: The spot exchange rate is greater than the strike price

Out-of-the-moneyOut-of-the-money

An option that would not be profitable to exerciseAn option that would not be profitable to exercise

Call: The spot exchange rate is less than the strike priceCall: The spot exchange rate is less than the strike price

Put: The spot exchange rate is greater than the strike pricePut: The spot exchange rate is greater than the strike price

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Currency Options

Chapter 5

Currency options can be used by Currency options can be used by hedgers and speculators:hedgers and speculators: With a call option, the owner can profit (hedge) from With a call option, the owner can profit (hedge) from (against) increases in the spot exchange rate.(against) increases in the spot exchange rate. With a put option, the owner can profit (hedge) from With a put option, the owner can profit (hedge) from (against) decreases in the spot exchange rate.(against) decreases in the spot exchange rate. Currency options are most appropriate when hedging Currency options are most appropriate when hedging currency transactions that are possible but not certain currency transactions that are possible but not certain to occur.to occur.

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Currency Options

Chapter 5

Currency Option ValuationCurrency Option Valuation

Theoretical value = Intrinsic Value + Time Theoretical value = Intrinsic Value + Time ValueValue Intrinsic Value = The amount by which the Intrinsic Value = The amount by which the option ‘In-the-money’option ‘In-the-money’ Time Value = The amount by which the option Time Value = The amount by which the option exceeds the Intrinsic Valueexceeds the Intrinsic Value

Value of an option increases with longer time Value of an option increases with longer time expiration and greater variability in exchange expiration and greater variability in exchange ratesrates

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Currency Options

Chapter 5

Comparison between a put option Comparison between a put option and call option:and call option:

Put option is an option with the holder of a security to Put option is an option with the holder of a security to sell the security to the issuer or to the person who sell the security to the issuer or to the person who wrote the put option. wrote the put option.

Call Option which is a contract whereby the purchaser, Call Option which is a contract whereby the purchaser, owner or holder is given the right but is not obligated owner or holder is given the right but is not obligated to purchase the underlying security or commodity at a to purchase the underlying security or commodity at a fixed strike price within a limited time frame. fixed strike price within a limited time frame.

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INTERNATIONAL PARITY CONDITIONS

Chapter 6

Five key international parity Five key international parity relationships result from these relationships result from these arbitrage activitiesarbitrage activities

Purchasing power parityPurchasing power parity Fisher effectFisher effect International Fisher effectInternational Fisher effect Interest Rate ParityInterest Rate Parity Unbiased Forward RatesUnbiased Forward Rates

These parity conditions are linked by the following:These parity conditions are linked by the following: The adjustment of various rates and prices to inflationThe adjustment of various rates and prices to inflation The notion that money should have no effect on real variablesThe notion that money should have no effect on real variables

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Purchasing Power Parity (PPP)

Chapter 6

Absolute – By examining the cost of goods in various Absolute – By examining the cost of goods in various countries using the spot exchange rate, we are able to countries using the spot exchange rate, we are able to determine the “real” or (PPP) exchange that should determine the “real” or (PPP) exchange that should exist (assuming markets are completely efficient). In exist (assuming markets are completely efficient). In other words, price levels adjusted for exchange rates other words, price levels adjusted for exchange rates should be equal across countries.should be equal across countries.

Relative – This theory states that the spot exchange Relative – This theory states that the spot exchange rate is not a good determinant of (PPP), but that the rate is not a good determinant of (PPP), but that the change of the exchange rate is a more accurate change of the exchange rate is a more accurate measure. In other words, the exchange rate of one measure. In other words, the exchange rate of one currency to another will adjust to reflect changes in currency to another will adjust to reflect changes in price levels.price levels.

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Fisher Effect

Chapter 6

A theory by Irving Fisher which states the A theory by Irving Fisher which states the following:following:

Interest Rates = Required Rate of Return + Interest Rates = Required Rate of Return + Compensation for possible InflationCompensation for possible Inflation

Inflation and home currency depreciation are Inflation and home currency depreciation are jointly determined by the growth of domestic jointly determined by the growth of domestic money supply relative to the growth of money supply relative to the growth of domestic money demand.domestic money demand.

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International Fisher Effect

Chapter 6

The spot exchange rate should change in The spot exchange rate should change in equal amount but in opposite direction to the equal amount but in opposite direction to the difference in interest rates between two difference in interest rates between two countries. countries. Investors holding foreign securities must be Investors holding foreign securities must be rewarded with higher interest rates to be rewarded with higher interest rates to be willing to hold securities denominated in willing to hold securities denominated in currencies expected to depreciate against the currencies expected to depreciate against the investor’s home currency.investor’s home currency.

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Interest Rate Parity (IRP)

Chapter 6

Interest Rate Parity(IRP)

START FINISH

Exchanged for S

wiss F

rancs @S

F 1.48 / $

Exc

hang

ed u

sing

our

forw

ard

cont

ract

@S

F 1

.465

5 / $

SF 1,480,000 SF 1,494,800

U.S. DollarMoney Market

X 1.02Interest Rate

Swiss Franc Money Market

X 1.01Interest Rate

Time period = 90 days

Time period = 90 days$ 1,000,000 $ 1,020,000

$ 1,000,000 $ 1,019,993

This parity theorem states that spot exchange rate and This parity theorem states that spot exchange rate and future exchange rate already take into account the different future exchange rate already take into account the different in interest rates, therefore no real profit can be made.in interest rates, therefore no real profit can be made.

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Covered Interest Arbitrage

Chapter 6

A portfolio manager invests dollars in an A portfolio manager invests dollars in an instrument denominated in a foreign currency and instrument denominated in a foreign currency and hedges his resulting foreign exchange risk by hedges his resulting foreign exchange risk by selling the proceeds of the investment forward for selling the proceeds of the investment forward for dollars.dollars.

Unlike the previous example, there are times when Unlike the previous example, there are times when the market IS NOT in a state of equilibrium. When the market IS NOT in a state of equilibrium. When the market is in this state, the potential for the market is in this state, the potential for arbitrage exists. The requirement for profit is that arbitrage exists. The requirement for profit is that Interest Rate Parity is not holding.Interest Rate Parity is not holding.

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Covered Interest Arbitrage

Chapter 6

Covered InterestArbitrage

START FINISH

Exchanged for Japanese Y

en @ ¥106.00 / $

Exc

hang

ed u

sing

our

forw

ard

cont

ract

@¥

103.

50 /

$

¥ 106,000,000 ¥ 108,120,000

U.S. DollarMoney Market

X 1.04Interest Rate

Japanese Yen Money Market

X 1.02Interest Rate


Time period = 90 days$ 1,000,000 $ 1,040,000

$ 1,000,000 $ 1,044,638

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Uncovered Interest Arbitrage

Chapter 6

Uncovered Interest Arbitrage is similar to Covered Uncovered Interest Arbitrage is similar to Covered Interest Arbitrage, however, in this example, we Interest Arbitrage, however, in this example, we do not have a forward contract exchange rate at do not have a forward contract exchange rate at the end of our investment period. Instead, we the end of our investment period. Instead, we rely upon the spot rate today and the spot rate at rely upon the spot rate today and the spot rate at DAY 360 to determine our exchange rates.DAY 360 to determine our exchange rates.

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Uncovered Interest Arbitrage

Chapter 6

Uncovered InterestArbitrage

START FINISH

Spot R

ate Exchanged for $U

.S. @

¥120.00 / $E

xcha

nged

spo

t rat

e (D

ay 3

60)@

¥ 12

0.00

/ $

$ 83,333,333.33 87,500,000

Japanese YenMoney Market

X 1.004Interest Rate

U.S. Dollar Money Market

X 1.05Interest Rate


Time period = 360 days ¥10,000,000 ¥10,040,000

¥10,000,000 ¥10,500,000

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Law of One Price

Chapter 6

The basis for PPP is the "law of one price". In the The basis for PPP is the "law of one price". In the absence of transportation and other transaction costs, absence of transportation and other transaction costs, competitive markets will equalize the price of an competitive markets will equalize the price of an identical good in two countries when the prices are identical good in two countries when the prices are expressed in the same currency. expressed in the same currency.

There are three caveats with this law of one price. There are three caveats with this law of one price.

(1)(1) As mentioned above, transportation costs, barriers to As mentioned above, transportation costs, barriers to trade, and other transaction costs, can be significant.trade, and other transaction costs, can be significant.

(2)(2)There must be competitive markets for the goods and There must be competitive markets for the goods and services in both countries. services in both countries.

(3)(3)The law of one price only applies to tradable goods; The law of one price only applies to tradable goods; immobile goods such as houses, and many services that immobile goods such as houses, and many services that are local, are of course not traded between countries. are local, are of course not traded between countries.

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The Fisher effect & The International Fisher

effect

Chapter 6

The Fisher effect is a theory describing the long-run The Fisher effect is a theory describing the long-run relationship between inflation and interest rates. relationship between inflation and interest rates. This equation tells us that, all things being equal, a This equation tells us that, all things being equal, a rise in a country's expected inflation rate will rise in a country's expected inflation rate will eventually cause an equal rise in the interest rate eventually cause an equal rise in the interest rate (and vice versa).(and vice versa).

Nominal rate of interest = real rate of interest + Nominal rate of interest = real rate of interest + inflation (Econ terms)inflation (Econ terms)

The International Fisher effect states that the The International Fisher effect states that the Interest rate differential between two countries Interest rate differential between two countries should be an unbiased predictor of the Future should be an unbiased predictor of the Future change in the spot rate.change in the spot rate.

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International Trade Finance

Chapter 23

The Trade RelationshipNature of relationship between exporter and importer is important to understand for import/export financing.

Unaffiliated Unknown – A foreign importer which an exporter has not previously conducted business. In this case, the two parties would need to create a detailed sales contract.

Unaffiliated Known - A foreign importer which an exporter has previously conducted business. Specific terms may still require negotiation; however, the requirements may be less strict

Affiliated Known - A foreign importer that is a subsidiary part of the exporter, also known as intra-firm trade.

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International Trade Finance

Chapter 23

The Trade DilemmaInternational trade must work around a fundamental dilemma. TRUST! Each party wants a guarantee: The Seller wants payment before shipment of goods

The Buyer wants shipment of goods before payment

What do you do?Hire a 3rd party to verify each stage of the transaction. Just like an escrow service, a bank can serve to verify and guarantee payment, exchange rate, receipt of goods, and provide protection against the following risks:

Risk of Non-completion of the transaction

Protection against foreign exchange risk

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Elements of the Import/Export Transaction

Chapter 23

Pricing Documentation Bill of lading (B/L) Straight = Provides that the carrier deliver the merchandise

to the designated consignee only. Order = directs the carrier to deliver goods to the shipper. Commercial Invoice – description of items, unit price,

financial terms, amount due, and shipping conditions. Insurance Documents Consular Invoices – Issue in exporting country by consulate

of importing country to provide customs stats and information.

Packing lists and Export Declaration

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Chapter 23

Shipping Deadline – Time horizon for shipment of goods.

Payment Instructions - determines whether exporter or importer will pay freight, insurance, and other transaction related charges.

Letter of Credit - A bank’s conditional promise to pay. Issued by a bank at the request of an importer, in which the bank promises to pay the exporter upon documents specified in the Letter of Credit (L/C). A Letter of Credit reduces the risk of transaction non-completion. A disadvantage is the fees charged for the guarantee of payment.

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Chapter 23

Draft – Also known as a bill of exchange, A draft is a written order by and exporter (seller) instructing a buyer to pay a specified amount of money at a predetermine time. A sight draft is a payable upon presentation. A time draft promises to pay at a certain time.

Bankers’ Acceptance Notes - When a bank accepts a draft it becomes a bankers’ acceptance note. It is a unconditional promise of that bank to make payment on the draft when it matures.

Trade Financing Alternatives - In order to trade international trade receivables, firms use the same financing instruments as for domestic trade receivables.

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Chapter 23

Bill of Lading

The document issued on behalf of the carrier describing the kind and quantity of goods being shipped, the shipper, the consignee, the ports of loading and discharge and the carrying vessel.

A memorandum or acknowledgment in writing, signed by the captain or master of a ship or other vessel, that he has received in good order, on board of his ship or vessel, therein named, at the place therein mentioned, certain goods therein specified, which he promises to deliver in like good order, (the dangers of the seas excepted,) at the place therein appointed for the delivery of the same, to the consignee therein named or to his assigns, he or they paying freight for the same.

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Chapter 23

Bill of Lading (Cont.)

Ought to contain the name of the consignor; the name of the consignee the name of the master of the vessel; the name of the vessel; the place of departure and destination; the price of the freight; and in the margin, the marks and numbers of the things shipped.

It is usually made in three originals, or parts. One of them is commonly sent to the consignee on board with the goods; another is sent to him by mail or some other conveyance; and the merchant or shipper retains the third. The master should also take care to have another part for his own use. The bill of lading is assignable, and the assignee is entitled to the goods, subject, however, to the shipper's right, in some cases, of stoppage in transition

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Chapter 23

StraightThe most common form, which is widely used in the U.S., is the multi-part, non-negotiable UNIFORM DOMESTIC STRAIGHT BILL OF LADING.

Because it has been in use for many years, shippers have a stock of preprinted forms, which often contain not only a description of their commodities, and applicable classes but, in addition, reference to the carrier's filed tariff.

These forms were mandated by the National Motor Freight Classification (NMFC), a filed tariff in which virtually all motor carriers participated, which contained not only the classification of commodities and rules regarding the details of their transportation, but in addition, the contract terms and conditions for the uniform domestic straight bill of lading.

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Chapter 23

Straight (Cont.)And the law, commonly called the “filed rate doctrine”, required strict adherence to the carrier’s tariff. On August 26, 1994, the filed rate requirement in the federal law governing interstate transportation was repealed.

Effective January 1, 1996, it was abolished for intrastate shipments when federal preemption prohibited the states from regulating the rates, routes and services provided by motor carriers for intrastate transportation.

Shippers and carriers have since had the opportunity to negotiate the terms and conditions of the bill of lading contracts since this deregulation took place. Individual shippers and carriers as well as shipper and carrier trade organizations are now debating the issue.

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Chapter 23

Insurance

Export shipments are usually insured against loss, damage, and delay in transit by cargo insurance.

For international shipments, the carrier's liability is frequently limited by international agreements and the coverage is substantially different from domestic coverage.

Either the buyer or the seller, depending on the terms of sale, may make arrangements for cargo insurance. Exporters are advised to consult with international insurance carriers or freight forwarders for more information.

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Chapter 23

Packing lists and export declaration

Export packing list. Considerably more detailed and informative than a standard domestic packing list, an export packing list itemizes the material in each individual package and indicates the type of package: box, crate, drum, carton, and so on.

It shows the individual net, legal, tare, and gross weights and measurements for each package (in both U.S. and metric systems). Package markings should be shown along with the shipper's and buyer's references.

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Chapter 23

Packing lists and export declaration (Cont.)

The packing list should be attached to the outside of a package in a waterproof envelope marked "packing list enclosed." The list is used by the shipper or forwarding agent to determine

(1) The total shipment weight and volume and

(2) Whether the correct cargo is being shipped. In addition, customs officials (both U.S. and foreign) may use the list to check the cargo.

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Interest Rate & Currency Swap

Chapter 14

The following areas are where firms can experience interest rate risk

1. Debt Service – MNE will have differing debt, interest rates, and different currency denominations. Each country has its own interest rate yield curve and credit spreads.

2. Marketable Securities – This represents potential earnings or cash inflows to the firm. These also are subject to interest rate risk for the MNE.

3. Reference Rate – The interest rate used as a baseline for debt service payment and marketable securities. LIBOR (London Inter-bank Rate) and Prime Rate are two examples of baseline lending standards upon which lending agreements are built.

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Chapter 14

Credit RiskAlso known as roll-over risk, this is the possibility that a borrower’s credit worthiness has been reduced from the 1st credit request to the 2nd credit request. A change in credit worthiness can result in changing fees, interest rates, and possibly rejection.

Re-pricing RiskA negative change in interest rates at the time of reapplication of credit by a borrower.

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Chapter 14

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Chapter 14

Strategy #1The firm will enjoy the safety and comfort of a known, fixed interest rate throughout the 3-year period. However, should the interest rates fall during the 3-year period; the firm will not be able to take advantage of the new rates. On the other hand, the firm will be protected from any future interest rate increases.

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Chapter 14

Strategy #2 This protects the firm from both re-pricing risk and credit or roll-ever risk. The firm may enjoy reductions in interest rates but also experience increased interest rates.

Strategy #3 The firm is able to enjoy freedom from re-pricing risk, however, due to annual reapplication, the firm now experiences credit or roll-over risk

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Chapter 14

Managing a Floating Rate Loan There are several instruments, which that can be used to manage any interest rate risk the firm may experience through floating interest rates.

Forward Rate Agreement – The buyer obtains the right to lock in an interest rate for a desired term, which begins in a future date. If interest rates rise during the contract, the seller will pay the buyer the difference. Should interest rates fall; the buyer will pay the seller the difference. Typically come in 1,3,6,9, and 12-month increments. These are very similar to forward currency contracts.

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Chapter 14

Managing a Floating Rate Loan (Cont’)

Interest Rate Futures – Traded on the Chicago Mercantile Exchange and the Chicago Board of Trade. Allows firm to hedge a floating-rate interest payment.

Interest Rate Swaps – Swaps are contractual agreements to exchange or swap a series of cash flows. In the case of interest rate swaps, one party trades a series of fixed interest rate payments for the floating interest rate payments of another.

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Chapter 14

Debt service:Cash required over a given period for the repayment of interest and principal on a debt. Your monthly mortgage payments are a good example of debt service.

As the debt services industry encompasses a wide range of companies, you'll need to learn about company types in order to determine the best possible debt services company for you.

One thing that universal is the general agreement of the fact that your ability to become debt free is as good as the determination you have in you to accomplish this.

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Chapter 14

Reference Rate

A reference rate is any publicly available quoted number or value that is used by the parties to a financial contract

It is often some form of LIBOR index, but can be anything, such as a consumer price index, house prices, unemployment rate

A reference rate must be independent and outside the control of either of the parties who reference it, otherwise there will be a conflict of interest. (If either party has the ability to alter the rate, it is safe to assume that they will do so in their favor)

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Chapter 14

Interest rate future

An interest bearing instrument as the underlying assets. Examples include Treasury-bill futures, Treasury-bond futures, and Eurodollar futures.They are essentially over-the-counter contracts traded on a one to one basis among the parties involved, for settlement on a future date. The parties decide the terms of these contracts mutually at the time of their initiation. If a forward contract is entered into through an exchange, traded on an exchange and settled through the Clearing Corporation/ House of the exchange, it becomes a futures contract.

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Users and Uses of Interest Rate Swaps

Chapter 14

Interest rate swaps are used for one or more of the following reasons:

To obtain lower cost funding To hedge interest rate exposure To obtain higher yielding investment assets To create types of investment asset not otherwise

obtainable To implement overall asset or liability management

strategies To take speculative positions in relation to future

movements in interest rates.

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Users and Uses of Interest Rate Swaps

Chapter 14

The advantages of interest rate swaps include the following:

A floating-to-fixed swap increases the certainty of an issuer's future obligations.

Swapping from fixed-to-floating rate may save the issuer money if interest rates decline.

Swapping allows issuers to revise their debt profile to take advantage of current or expected future market conditions.

Interest rate swaps are a financial tool that potentially can help issuers lower the amount of debt service.

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Multinational Capital Budgeting

Chapter 18

Capital BudgetingEssentially uses the same approach as domestic capital budgeting by identifying the following

Identifying the initial capital invested or put at risk

Estimating cash flows stemming from the project Identifying the appropriate discount rate to

calculate the present value The use of NPV and IRR to determine the

acceptability of potential prospects

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Chapter 18

Special Considerations

• The primary difference is the firm must work to distinguish between parent cash flow and subsidiary cash flow.

• Must take into account inflationary differences

• Must also take into account political and taxation difference

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Chapter 18

Capital Budgeting

• The process of determining which potential long-term projects are worth undertaking, by comparing their expected discounted cash flows with their internal rates of return.

• Payback, Discounted Payback, NPV, Profitability Index, IRR and MIRR are all capital budgeting decision methods.

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Payback

Chapter 18

Year Cash flowRunning

Total

0 -15,000 -15,000

1 +7,000 -8,000So after the 1st year,the project has not yet broken even

2 +6,000 -2,000So after the 2nd year,the project has not yet broken even

3 +3,000 +1,000So the project breaks evensometime in the 3rd year

Negative Balance / Cash flow from the Break Even Year

=When in the final year

we break even

-2,000 / 3,000 = 0.666

When: At the beginning of the year we had still had a -2,000 balance. So do this.When: At the beginning of the year we had still had a -2,000 balance. So do this.

So we broke even 2/3 of the way through the 3rd year. So the total time required to payback the So we broke even 2/3 of the way through the 3rd year. So the total time required to payback the money we borrowed was 2.66 years. money we borrowed was 2.66 years.

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Discounted Payback

Chapter 18

Negative Balance / Cash flow from the Break Even Year

=When in the final year

we break even

-58 / 621 = 0.093

So we break even sometime in the 5th year. When?So we break even sometime in the 5th year. When?

So using the Discounted Payback Method we break even after 4.093 years.So using the Discounted Payback Method we break even after 4.093 years.

Year Cash flow Discounted Cash flow Running Total

0 -15,000 -15,000 -15,000

1 7,000 6,363 -8,637

2 6,000 4,959 -3,678

3 3,000 2,254 -1,424

4 2,000 1,366 -58

5 1,000 621 563

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Net Present Value (NPV)

Chapter 18

Once you understand discounted payback, NPV is so easy! NPV is the final running total number. That's it. In the example above the NPV is 563. That's all.

Basically NPV and Discounted Payback are the same idea, with slightly different answers. Discounted Payback is a period of time, and NPV is the final dollar amount you get by adding all the discounted cash flows together. If the NPV is positive, then approve the project.

It shows that you are making more money on the investment than you are spending on your cost of capital. If NPV is negative, then do not approve the project because you are paying more in interest on the borrowed money than you are making from the project.

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Profitability Index (PI)

So in example, the PI = 1.0375. For every dollar borrowed and invested we get back $1.0375, or one dollar and 3 and one-third cents. This profit is above and beyond our cost of capital

Profitability Index

Equals NPVDivided

byTotal

InvestmentPlus 1

PI = 563 / 15,000 + 1

Chapter 18

Year Cash flow

0 -15,000

1 +7,000

2 +6,000

3 +3,000

4 +2,000

5 +1,000

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Internal Rate of Return (IRR)

Chapter 18

IRR is the amount of profit you get by investing in a certain project. It is a percentage. An IRR of 10% means you make 10% profits per year on the money invested in the project.

To determine the IRR, you need the financial calculator.

-15000 G CFo

7000 G CFj

6000 G CFj

3000 G CFj

2000 G CFj

1000 G CFj

F IRR

After you enter these numbers the calculator will entertain you by blinking for a few seconds as it determines the IRR, in this case 12.02%

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Internal Rate of Return (IRR)

Chapter 18

But there are problems!!!

Sometimes it gets confusing putting all the numbers in, especially if you have alternate between a lot of negative and positive numbers.

IRR assumes that the all cash flows from the project are invested back into the project. Sometimes, that simply isn't possible. Let's say you have a sailboat that you give rides on, and you charge people money for it. Well you have a large initial expense (the cost of the boat) but after that, you have almost no expenses, so there is no way to re-invest the money back into the project. Fortunately for you, there is the MIRR.

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Modified Internal Rate of Return (MIRR)

Chapter 18

Basically the same as the IRR, except it assumes that the revenue (cash flows) from the project are reinvested back into the company, and are compounded by the company's cost of capital, but are not directly invested back into the project from which they came.

MIRR assumes that the revenue is not invested back into the same project, but is put back into the general "money fund" for the company, where it earns interest. We don't know exactly how much interest it will earn, so we use the company's cost of capital as a good guess.

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Terminal value: Assume, again, that the company's cost of capital is 10%

Chapter 18

Cash Flow

Times

=Future Value of that year’s cash

flow.Note

7000 X(1+.1) ^

4= 10249 Compounded for 4 years

6000 X(1+.1) ^


3000 X(1+.1) ^


2000 X(1+.1) ^


1000 X(1+.1) ^

0= 1000

Not compounded at all because

this is the final cash flow

TOTAL = 25065This is the Terminal

Value

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Now Calculating

Chapter 18

-15000 G CFo

0 G CFj

0 G CFj

0 G CFj

0 G CFj

25065 G CFj

F IRR

Why All Those Zeros?

Because the calculator needs to know how many years go by. But you don't enter the money from the sum of the cash flows until the end, until the last year. You have to understand that the cash flows are received from the project, and then get used by the company, and increase because the company makes profit on them, and then, in the end, all that money gets 'credited' back to the project. Anyhow, the final MIRR is 10.81%

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Now Decision Time!!

Chapter 18

Decision Method Result

Approve?

Why?

Payback2.66 years

Yes Well, cause we get our money back

Discounted Payback

4.195 years

YesBecause we get our money back, even after discounting our cost of capital.

NPV $500 YesBecause NPV is positive (reject the project if NPV is negative)

Profitability Index

1.003 Yes Cause we make money

IRR 12.02% Yesbecause the IRR is more than the cost of capital

MIRR 10.81% Yesbecause the MIRR is more than the cost of capital

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Difference between Parent Cash Flow and Subsidiary Cash Flow

1. Parent cash flow must be distinguished from project cash flow. It is the parent cash flow that matters. The parent cash flow is the cash flow that can be reinvested into other projects and can be used to pay dividends and can be used to reduce debt. So parent cash flow then is the important cash flow and the parent cash flow must have the positive net present value to be a viable project.

Chapter 18

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2. Parent cash flow can be different from project cash flow for the following reasons:

1. Parent can arrange special financing that differs from project to project.

2. New projects may cause existing projects in other parts of the world to reduce their cash flow. This is a concept known as cannibalism.

3. Parent cash flow may be affected by political reasons established by the host country. These are usually known as "repatriation" restrictions.

4. Tax consequences may be different in different countries. 5. Royalty may affect parent cash flow and management fees

charged by the parent or license fees charged by the parent and finally the parent cash flow may be affected by a concept known as "transfer pricing".

6. Inflation rates may be different in different countries. 7. Exchange rates will change and will affect annual cash flows.

Chapter 18

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Similarities between financial options and real options

Chapter 18

Financial Options Real Options

S Stock Price PV of Expected Cash Flows

X Exercise Price PV of Fixed Costs

sStock Price Movement

UncertaintyUncertainty of Expected Cash

Flows

T-t

Time to Expiry Time to Expiry

d DividendsValue lost over Duration of

Option

r Risk-Free Interest Rate Risk-Free Interest Rate

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International Financial MarketInternational Financial Market

Sources of CapitalSources of Capital International Market: business operationInternational Market: business operationExternal Market:External Market:

A. Domestic Market: domestic funds for domestic use.A. Domestic Market: domestic funds for domestic use.

B. International Market: domestic funds for foreign use.B. International Market: domestic funds for foreign use.

C. International Market: foreign funds for domestic use.C. International Market: foreign funds for domestic use.

D. Offshore Market: foreign funds for foreign use ie. D. Offshore Market: foreign funds for foreign use ie. London, N.Y., Tokyo, Zurich, Singapore, Bahrain, London, N.Y., Tokyo, Zurich, Singapore, Bahrain, Bahamas.Bahamas.

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U.S. Dollar time deposits in a bank outside the U.S.A.U.S. Dollar time deposits in a bank outside the U.S.A. Bank may be foreign bank or overseas branch of a Bank may be foreign bank or overseas branch of a

U.S. bank.U.S. bank. Deposits could be in: Call Money, Overnight Draft, 3-Deposits could be in: Call Money, Overnight Draft, 3-

month CD.month CD. Eurodollar deposits are not demand deposit and can’t Eurodollar deposits are not demand deposit and can’t

be transferred by a check drawn on the bank having be transferred by a check drawn on the bank having the deposit. It can be transferred by a wire or cable the deposit. It can be transferred by a wire or cable from a balance-hold in a corresponding bank located from a balance-hold in a corresponding bank located in the U.S.in the U.S.

Banks in which Eurodollar or Eurocurrencies are Banks in which Eurodollar or Eurocurrencies are deposited are generally called Euro-banks.deposited are generally called Euro-banks.

Eurodollar Eurodollar vsvs Eurocurrencies Market Eurocurrencies Market

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1.1. Convenient money marketConvenient money market

2.2. Major source of short-term bank loansMajor source of short-term bank loans

3.3. Arbitrage purposeArbitrage purpose

4.4. U.S. long-time trade deficitU.S. long-time trade deficit

5.5. Money regulation in the U.S.Money regulation in the U.S.

6.6. Military expenses of the 1960’s and 1970’sMilitary expenses of the 1960’s and 1970’s

7.7. Freezing of foreign assets in the U.S. in the 1970’s Freezing of foreign assets in the U.S. in the 1970’s and 1980’sand 1980’s

Reasons for Existence of Reasons for Existence of Eurodollar MarketEurodollar Market

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Size of the MarketSize of the Market

According to the report by According to the report by Bank for International SettlementBank for International Settlement, the size of the , the size of the market has increased 4 times since the 1970’s market has increased 4 times since the 1970’s to $2,056 billion.to $2,056 billion.

A Majority of the dollar deposits are in Europe A Majority of the dollar deposits are in Europe (60%), and the rest are in Asia -- mainly in Japan (60%), and the rest are in Asia -- mainly in Japan and Singapore.and Singapore.

The Expansion of the market is very similar to The Expansion of the market is very similar to the money creation principle of a commercial the money creation principle of a commercial bank.bank.

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Money Market (Euro-Line of Credit, Revolving Credit, Money Market (Euro-Line of Credit, Revolving Credit, Syndicated Short-term and Medium-term loans) Syndicated Short-term and Medium-term loans)

Euro-CD, such as Spot Rate CD, Roll-over Credit where Euro-CD, such as Spot Rate CD, Roll-over Credit where the interest is paid in floating rate and TAPS, CD’s for less the interest is paid in floating rate and TAPS, CD’s for less than a year with min $25,000 denomination which could than a year with min $25,000 denomination which could be in a series of identical CD’s (Tranche) or single issue, be in a series of identical CD’s (Tranche) or single issue, and Five-currency CD (denominated in a basket of five and Five-currency CD (denominated in a basket of five different currencies).different currencies).

Euro-Capital MarketEuro-Capital Market

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EurobondsEurobonds

1.1. The Euro-note Market: short to medium-The Euro-note Market: short to medium-term debt instruments (negotiable term debt instruments (negotiable promissory notes) sold in the Eurocurrency promissory notes) sold in the Eurocurrency market.market.

They are underwritten by different They are underwritten by different facilities, such as Revolving Underwriting facilities, such as Revolving Underwriting Facilities (RUF), Note Insurance Facilities Facilities (RUF), Note Insurance Facilities (NIF) and Standby Note Issuance Facilities (NIF) and Standby Note Issuance Facilities (SNIF).(SNIF).

2.2. Euro-commercial Papers (ECP) - one, three Euro-commercial Papers (ECP) - one, three and six-month maturities.and six-month maturities.

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EurobondsEurobonds

3.3. Euro Medium-term Notes (EMTN): bridges Euro Medium-term Notes (EMTN): bridges maturity gap between ECP and Eurobond.maturity gap between ECP and Eurobond.

4.4. Euro-bond MarketEuro-bond Market Straight Fixed Rate Issue -fixed CR, specified Straight Fixed Rate Issue -fixed CR, specified

maturity date and full principal repayment maturity date and full principal repayment upon final maturity.upon final maturity.

Floating Rate Notes (FRN) - semiannual coupon, Floating Rate Notes (FRN) - semiannual coupon, variable rate, fixed maturity or perpetuities.variable rate, fixed maturity or perpetuities.

Euro-Equity Convertibles - similar to straight Euro-Equity Convertibles - similar to straight bond with added feature to convert to a certain bond with added feature to convert to a certain number of stocks prior to maturity.number of stocks prior to maturity.

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EurobondsEurobonds

4.4. Euro-bond Market (Cont’)Euro-bond Market (Cont’) Dual currency Bonds - purchase price and

coupon denominated in one currency and the principal redemption value fixed in a second currency.

Currency Cocktail Bond - denominated in one of several currency baskets such as SDR or ECU; stable interest and principal payments.

Stripped Bond - deep discounted bond issued in bearer form in order to sell them to non-residents; Certificate of Accrual on Treasury Securities (CATS).

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EurobondsEurobonds

5.5. Yankee Bond - issued by non-residents in U.S. Yankee Bond - issued by non-residents in U.S. Dollars sold in the U.S.Dollars sold in the U.S.

6.6. Foreign Bond - issued by non-residents in non-Foreign Bond - issued by non-residents in non-Dollars sold in the U.S.Dollars sold in the U.S.

7.7. Treasury Bond - long-term obligation of federal Treasury Bond - long-term obligation of federal government (U.S.)government (U.S.)

8.8. Corporate Bond (General, Debenture, Jr, Corporate Bond (General, Debenture, Jr, Subordinate) - long-term obligation of corporation.Subordinate) - long-term obligation of corporation.

9.9. Municipal Bond - long-term obligation of state and Municipal Bond - long-term obligation of state and local government.local government.

10.10. Interest and Currency SwapsInterest and Currency Swaps

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Foreign Direct Investment

Chapter 15

The Theory of Comparative Advantage provides a basis for understanding world trade.

PRODUCTION Waffle Irons Tennis Rackets Country A: 12 6 Country B: 10 2

Country “A” has a comparative advantage of production over Country “B”. Country “A” has an absolute advantage over Country “B” in both columns; however, the relative advantage is greater in Tennis Rackets. For ever 2 units made by Country “B”, Country “A” can make 6. Therefore, Country “A” should specialize in Tennis Rackets and Country “B” should specialize in Waffle Irons.If each country specializes, then total production should increase because of specialization.

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Chapter 15

Limitations of Comparative AdvantageBecause of the “givens” of the theory, the reality is that governments do interfere and pure free trade does not exist in all areas. There are more factors of production than listed within the theory. Geographical restrictions, labor disputes, management practices, taxes, raw material availability, etc … all serve to influence production.Comparative advantage shifts over time. Less developed countries have increased their production capacity and technological advantages.

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Chapter 15

The OLI Paradigm and InternalizationFor a MNE to receive foreign direct investment (FDI), it must enjoy one or more of the following:

Owner-Specific Advantages = These must be firm specific, not easily copied, and in a form that can be transferred to foreign subsidiaries.

Location-Specific Advantages = Includes factors like low-cost productive labor force, sources of raw materials, large domestic market, or technological superiority

Internalization = A proprietary technology or human capital that is capable of continuing to create new expertise.

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Strategy and Management (one approach to execute acquisition

process)

Chapter 15

IdentificationThe key document in an international shipment under an L/C is the bill of lading (B/L). The usual provisions contained in a B/L include the following:

A description of the merchandise Identification marks on the merchandise Evidence of loading (receiving) ports Name of the exporter (shipper) Name of the importer Status of freight charges (prepaid or collect) Date of shipment

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process)

Chapter 15

Completion of ownership changeBanker’s Acceptance (BA)This is a time draft that is drawn on and accepted by a bank (the importer’s bank). The accepting bank is obliged to pay the holder of the draft at maturity. If the exporter does not want to wait for payment, it can request that the BA be sold in the money market. Trade financing is provided by the holder of the BA.

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process)

Chapter 15

Completion of ownership changeLetters of Credit (L/C)

These are issued by a bank on behalf of the importer promising to pay the exporter upon presentation of the shipping documents.

The importer pays the issuing bank the amount of the L/C plus associated fees.

Commercial or import/export L/Cs are usually irrevocable.

Accounts Receivable Financing An exporter that needs funds immediately may obtain a bank

loan that is secured by an assignment of the account receivable.

Factoring (Cross-Border Factoring) The accounts receivable are sold to a third party (the factor), that

then assumes all the responsibilities and exposure associated with collecting from the buyer.

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process)

Chapter 15

Management of acquired target and integration of business and culture

Traditionally most small and medium-size Emerging Market projects are unable to penetrate the international debt and/or equity market for cost-efficient financing for reasons related to: lack of resources to pursue opportunities abroad, concern over political risks, high exchange rate volatility, language barriers, inadequate loan guarantees and a lack of quality representation services.

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Financial Analysis and Strategy (another approach to

execute acquisition process)

Chapter 15

Valuation (DCF, NPV, IRR) and negotiationDiscounted Cash Flow: method of ranking investment proposals that employ time value of money concepts.

(1) Find the present value of each cash flow, including both inflows and outflows, discounted at the project’s cost of capital.

(2) Sum these discounted cash flows; this sum is defined as the project’s NPV.

(3) If the NPV is positive, the project should be accepted, while if the NPV is negative, it should be rejected. If two projects with positive NPVs are mutually exclusive, the one with the higher NPV should be chosen.

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Chapter 15

Financial settlement and compensation Internal Rate of Return (IRR) method: Accounts

Receivable Financing

Factoring

Letters of Credit

Banker’s Acceptances

Working Capital Financing

Medium-Term Capital Goods Financing (Forfeiting)

Counter-trade

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Chapter 15

Rationalization of operations, integration of financial goals and synergies

Synergy: The condition wherein the whole is greater than the sum of its parts; in a synergistic merger, the post merger value exceeds the sum of the separate companies’ pre-merger values.

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International Portfolio Theory and Diversification

Chapter 20

As an MNE examines international portfolio risk, a firm must evaluate the following factors:

Portfolio Risk - The ratio of the variance of the portfolio’s return relative to the market’s return. Also known as the portfolio beta.

Total Risk = Systematic Risk (Market or Diversifiable) + Unsystematic (Individual or non-diversifiable) Risk

Foreign Exchange Risk - As stated in earlier chapters, this is the risk that foreign exchange rates may cause a loss of investment value.

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Portfolio Measurements:

Sharpe Measure = Ri – Rf σi

Treynor Measure = Ri – Rf β i

Capital Asset Pricing Model = Ke = krf + βi (km - krf)


Chapter 20

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Chapter 20

Portfolio risk Portfolio risk takes into consideration the time period or length of time required to return one’s original investment. Portfolio diversification means not placing all your eggs into one carton. If the carton breaks, you do not loose all your eggs. Having your investments in different cartons minimizes total loss of the investment. MNC’s diversify their portfolios by spreading their exposure to loss globally, across many countries, thereby helping to hedge against events such as exchange rate fluctuations, political upheaval or war in one country, which help to lower total risk. Forecasting portfolio risk has become an art in managing investment risk and the amount of return necessary to compensate for the risks taken.

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Chapter 20

Total risk It involves all of an investment portfolio’s potential for loss. Total risk encompasses diversifiable risk (unsystematic risk) as well as market risk (systematic risk). Investors seek to be risk adverse, and try to minimize their exposure to total risk of their investment and potential loss of their investment. Systematic risk even with diversification cannot totally be removed. Some element of risk will always remain. MNC’s raise capital in foreign markets, because interest rates are more favorable than in their home country. This will lower their cost of capital and maximize their shareholders wealth position. They will take the borrowed funds by paying the operating costs of their foreign subsidiary, without ever converting it back to their home currency.

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Chapter 20

Total risk (Cont.) Foreign exchange rates are based upon many different factors within the economy of each country, causing fluctuations in this market. When the exchange rate appreciates or depreciates beyond the current rate paid by the investor, the investor will either lose or win accordingly. Most large corporations hedge their risk in foreign exchange by purchasing spots and forwards. The total dollar return on an investment can be divided into three separate elements: Capital gain or loss, currency gain or loss, and dividend interest income.

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Chapter 20

Optimal international portfolios It benefits both investors and MNC’s because it allows for a maximum return on one’s investment or lower capital costs depending on the forecasted perceptions of a particular foreign currency market. By calculating the effective cost of capital and applying weighted average cost of capital models, standard deviations and betas along with ratios, an optimum portfolio can be achieved. The optimal international portfolio allows the investor to maximize return per unit of risk more so than would be received with just a domestic portfolio.

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Chapter 20

Optimal international portfolios (Cont.) Portfolio theory was developed by Harry Markowitz (Nobel Prize 1990). It can be used to determine optimal international. portfolio, taking into account risk-return trade off. World Beta is given for each country, measures the co-movement between the returns in a country's stock market with the returns for the world stock market returns.

Beta = % Change in a Country's Stock Market % Change in World Stock Market

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Chapter 20

Sharp RatioThis ratio measures the return earned in excess of the risk free rate (normally Treasury instruments) on a portfolio to the portfolio's total risk as measured by the standard deviation in its returns over the measurement period. Or how much better did you do for the risk assumed.

S = Return portfolio- Return of Risk free investment

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Chapter 20

Treynor RatioThis ratio is similar to the above except it uses beta instead of standard deviation. It's also known as the Reward to Volatility Ratio, it is the ratio of a fund's average excess return to the fund's beta. It measures the returns earned in excess of those that could have been earned on the risks investment per unit of market risk assumed.

T = Return of Portfolio - Return of Risk Free Investment

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Global Cost and Availability of Capital

Chapter 11

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Chapter 11

Our cost of equity can be calculated as follows:

Ke = Krf + β (Km – Krf)

Krf = Risk Free rate of interest estimated by the U.S. Treasury bond rate

Km = The expected rate of return for the market

β = The systematic risk using the correlation of the firm’s returns with that of the market

Our cost of debt is as follows:

Kd = The pre tax yield of a firm’s combined debt payments

t = The firm’s corporate tax rate

Our weighted average cost of capital is calculated as follows:

KWACC = Ke (E / V) + Kd (1 – t) (D / V)

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Chapter 11

Interrelation between the opportunity cost of capital, capital rationing, and capital investment options are, and the constraints they can place on a firm:

Opportunity Cost of Capital

The return that is sacrificed by investing finance in one way rather than investing in an alternative of the same risk class, e.g. financial security.

Cost of capital

The opportunity cost of an investment, i.e. the rate of return that a company would otherwise be able to earn at the same risk level as the investment that has been selected.

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Reasons for Capital Rationing

Chapter 11

External Reasons: These arise when a firm is unable to borrow from the

outside. For example if the firm is under financial distress, tight credit conditions, firm has a new unproven product. Borrowing limits are imposed by banks particularly in relation to smaller firms and individuals.

Internal Reasons: Private owned company: Owners might decide that

expansion is a trouble not worth taking. For example, there may that management fear to lose their control in the company.

Divisional Constraints: Upper management allocates a fixed amount for each division as part of the overall corporate strategy. This arises from a point of view of a department, cost center or wholly owned subsidiary, the budgetary constraints determined by senior management or head office.

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Reasons for Capital Rationing

Chapter 11

Internal Reasons: Human Resource Limitations: Company does not have

enough middle management to manage the new expansions

Dilution: For example, there may be a reluctance to issue further equity by management fearful of losing control of the company.

Debt Constraints: Earlier debt issues might prohibit the increase in the firm’s debt beyond a certain level, as stipulated in previous debt contracts. For example bondholders requiring in the bond contract, that they would accept a maximum Debt-to-Asset ratio = 40%.

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Working Capital Management in the MNE

Chapter 22

The operating cycle of any business creates funding needs, cash inflows, and cash outflows.Working Capital – The funding needed by the operating cycle of the firmCash conversion cycle – The time period between the purchase of input goods (cash outflow) and payment for the sale of the finished goods (cash inflow).Net Working Capital (NWC) = (Accts Receivable + Inventory) – (Accts Payable)The MNE will have to decide whether to use short-term debt or take advantage of discounts offered by suppliers. Many times, the effective annualized cost of not taking discounts from suppliers is significantly higher than the annualized cost of short term borrowing from lending institutions.

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Chapter 22

Days Working Capital

A common method of benchmarking financial management is to calculate the Net Working Capital based upon the Days Sales Method.

(Accts Receivable + Inventory) – (Accts Payable)

365 days

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Chapter 22

Managing Receivables

Independent Customers - What currency should out transactions be in? What should be the terms of payment?

Self-Liquidating Bills – Using the “Code Napoleon” No good company should wait for cash when selling to a good customer. Banks will lend money based upon sales receipts (accounts receivable) of MNEs.

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Chapter 22

Inventory ManagementAnticipating Devaluation – If local currency is expected to significantly devalue, management may decide to build up significant levels of inventory, while the currency still has purchasing power.

Anticipating Price Freezes – A firm may properly anticipate a price freeze and take corrective measures against it. Management can create a local currency high price and then discount actual sales from it.

Free Trade and Industrial Zones - A free trade zone provides an area, which eliminates customers or duties. Income taxes may also be reduced. A free industrial zone allows for the manufacture of goods tax and duty-free.

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Chapter 22

The Working Capital Working Capital is a valuation metric that is calculated as current assets minus current liabilities. If a company's current assets do not exceed its current liabilities, then it may run into trouble paying back creditors that want their money quickly. Working capital refers to the cash a business requires for day-to-day operations, or, more specifically, for financing the conversion of raw materials into finished goods, which the company sells for payment. Among the most important items of working capital are levels of inventory, accounts receivable, and accounts payable. Analysts look at these items for signs of a company's efficiency and financial strength.

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Chapter 22

The Working Capital (Cont.) Working capital measures how much in liquid assets a company has available to build its business. The number can be positive or negative; depending on how much debt the company is carrying. In general, companies that have a lot of working capital will be more successful since they can expand and improve their operations. Companies with negative working capital may lack the funds necessary for growth. Working capital is also called net current assets or current capital.

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Chapter 22

Cash Conversion Cycle The cash conversion cycle is the duration between the purchase of a firm's inventory and the collection of accounts receivable for the sale of that inventory. Also known as cash cycle. Cash is therefore not involved until the company pays the accounts payable and collects accounts receivable. So the cash conversion cycle measures the time between outlay of cash and the cash recovery. This cycle is extremely important for companies whose focus is the retail sector. This measure illustrates how quickly a company can convert its products into cash through sales.

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Chapter 22

Cash Conversion Cycle (Cont.)The cash conversion cycle, or net operating cycle, simply indicates the duration of time it takes the firm to convert its activities requiring cash into cash returns. As highlighted earlier, this ratio is vital since it represents the number of days a firm's cash is occupied with its operations. Naturally, a firm wants this cycle to be as short as possible. Therefore, a downward trend in this cycle is a positive signal while an upward trend is a negative signal. When the cash conversion cycle shortens, cash becomes free for other uses such as investing in new capital, spending on equipment and infrastructure, as well as preparing for possible share buy-backs down the road.

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Chapter 22

The Net Working Capital Working capital is sometimes used to refer only to current assets, while net working capital is defined to be the difference between current assets and current liabilities. To understand net working capital better, it helps to look at each word individually. Net: This means we look at cash tied up in short term operating assets such as accounts receivable and inventory, offset by non-interest bearing current liabilities such as accounts payable.

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Chapter 22

The Net Working Capital (Cont.) Working: This means that we want to focus on cash tied up in short term operating assets. Thus, working capital excludes long-term capital required for, say, investment in Plant, Property and Equipment (PP&E). Capital: This means that we want to calculate the amount of cash that a company has to tie up in working capital in order to run its business. More specifically, for industrial companies, "net working capital" equals cash tied up by a company's short term operating assets, netted against short term operating liabilities.

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International BankingInternational Banking International BankingInternational BankingMotivations: Access to dollar and Eurocurrency Motivations: Access to dollar and Eurocurrency

deposits and international saving markets.deposits and international saving markets. Tasks of International Banking:Tasks of International Banking:

• Financing exports and importsFinancing exports and imports• Trading foreign exchangeTrading foreign exchange• Underwriting both Euro-bonds and foreign bondsUnderwriting both Euro-bonds and foreign bonds• Borrowing and lending in Euro-currency marketBorrowing and lending in Euro-currency market• Participate and organize foreign exchange marketParticipate and organize foreign exchange market• Project financingProject financing• International cash flow management & fund transferInternational cash flow management & fund transfer• Solicitation for local currency deposits to operate as full-service banksSolicitation for local currency deposits to operate as full-service banks• Serve as consultant for MNCServe as consultant for MNC

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Risks in International BankingRisks in International Banking

1. Commercial Risk•Facing difficulties in receiving the repayments of principal and interest on due date.•Lack of financial and economic information about the clients and host countries and differences in accounting disclosure practices and legal procedures.

2. Country Risk•Sovereign Risk: political, jurisdictional and cultural differences.•Exchange Rate Risk: shortage of foreign exchange reserves; change in repayment schedules.

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Advantages and Disadvantages of Advantages and Disadvantages of International BankingInternational Banking

AdvantagesAdvantages• High rate of return for investment and High rate of return for investment and

relatively low loss ratiorelatively low loss ratio• Ability to diversify loan portfolio.Ability to diversify loan portfolio.• Excess demand for international loans, Excess demand for international loans,

especially for development programs.especially for development programs.• Usually international loans are safeguarded Usually international loans are safeguarded

by official and non-official insurance by official and non-official insurance agencies, such as export credit insurance.agencies, such as export credit insurance.

MENU

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Advantages and Disadvantages of Advantages and Disadvantages of International BankingInternational Banking

DisadvantagesDisadvantages• Unfamiliar political and social environments and Unfamiliar political and social environments and

rapidly changing macroeconomic and financial rapidly changing macroeconomic and financial variables.variables.

• Unexpected events and regulators.Unexpected events and regulators.• Weak demand for domestic loans has relaxed Weak demand for domestic loans has relaxed

standards for international loans.standards for international loans.• Only a few credit-worthy countries are available.Only a few credit-worthy countries are available.• External debt problems of many foreign External debt problems of many foreign

international countries, especially Latin international countries, especially Latin American countries and major international loan American countries and major international loan loss by many international banks.loss by many international banks.

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Types of International Bank OfficesTypes of International Bank Offices

Correspondent BankingCorrespondent Banking Two way link between banks (home and foreign bank); Two way link between banks (home and foreign bank);

services offered include, but not limited to: accepting services offered include, but not limited to: accepting drafts, honoring L/C, and furnishing credit information.drafts, honoring L/C, and furnishing credit information.

Representative OfficesRepresentative Offices• Cannot accept deposits, make loans, accept L/C or Cannot accept deposits, make loans, accept L/C or

cash checks; just help and advise parent bank clients cash checks; just help and advise parent bank clients when they are doing business in host country.when they are doing business in host country.

Agencies RelationshipAgencies Relationship• Like branch banking without having authority to Like branch banking without having authority to

accept deposit from the public; may accept deposits accept deposit from the public; may accept deposits from other banks; can arrange loans, L/C and trade from other banks; can arrange loans, L/C and trade foreign exchange.foreign exchange.

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Types of International Bank OfficesTypes of International Bank Offices Bank Subsidiaries and AffiliatesBank Subsidiaries and Affiliates

• Can be a separately incorporated bank or owned and control by bank Can be a separately incorporated bank or owned and control by bank (partially-owned or entirely-owned subsidiaries).(partially-owned or entirely-owned subsidiaries).

Branch BankingBranch Banking Extension of parent bank; can be full-service bank.Extension of parent bank; can be full-service bank.

International Banking Facilities (IBF)International Banking Facilities (IBF)• An accounting entity as well as a legal entity of a bank to An accounting entity as well as a legal entity of a bank to

capture a segment of the Euro Market.capture a segment of the Euro Market.• They are not subject to FDIC rules or Fed’s Required Rate Ratio.They are not subject to FDIC rules or Fed’s Required Rate Ratio.• Deposits limited to non-residents only and size limitation.Deposits limited to non-residents only and size limitation.• They are exempt from state and local tax.They are exempt from state and local tax.• They could be U.S.-owned IBF (exempt from federal tax) or They could be U.S.-owned IBF (exempt from federal tax) or

foreign-owned IBF, such as Japanese IBF and Italian IBF.foreign-owned IBF, such as Japanese IBF and Italian IBF.

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Types of International Bank OfficesTypes of International Bank Offices(Cont.)(Cont.)

Bank Subsidiaries and AffiliatesBank Subsidiaries and Affiliates• Can be a separately incorporated bank or owned and control by bank Can be a separately incorporated bank or owned and control by bank

(partially-owned or entirely-owned subsidiaries).(partially-owned or entirely-owned subsidiaries).

Branch BankingBranch Banking Extension of parent bank; can be full-service bank.Extension of parent bank; can be full-service bank.

International Banking Facilities (IBF)International Banking Facilities (IBF)• An accounting entity as well as a legal entity of a bank to An accounting entity as well as a legal entity of a bank to

capture a segment of the Euro Market.capture a segment of the Euro Market.• They are not subject to FDIC rules or Fed’s Required Rate Ratio.They are not subject to FDIC rules or Fed’s Required Rate Ratio.• Deposits limited to non-residents only and size limitation.Deposits limited to non-residents only and size limitation.• They are exempt from state and local tax.They are exempt from state and local tax.• They could be U.S.-owned IBF (exempt from federal tax) or They could be U.S.-owned IBF (exempt from federal tax) or

foreign-owned IBF, such as Japanese IBF and Italian IBF.foreign-owned IBF, such as Japanese IBF and Italian IBF.

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Types of International Bank Offices Types of International Bank Offices (cont...)(cont...)

Edged Act BanksEdged Act Banks• Subsidiary of U.S. bank incorporated in U.S. under Subsidiary of U.S. bank incorporated in U.S. under

section 25 of federal banking law to engage in section 25 of federal banking law to engage in international banking functions and finance all international banking functions and finance all types of the loans in the world.types of the loans in the world.

• They are physically located in states other than They are physically located in states other than their own within the U.S. (inter-state banking).their own within the U.S. (inter-state banking).

• If they are state chartered - called Agreement If they are state chartered - called Agreement Corporation, if nationally chartered - called Edged Corporation, if nationally chartered - called Edged Act Bank.Act Bank.

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Good Luck!!Good Luck!!

essential of multinational business finance practical approach professor m. vaziri

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