International Business

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Introduction to Global Business

Chapter 14 Global Financial Management

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Explain how foreign exchange risk affects firms and investors.

Describe different ways to hedge exchange rate risk.

Discuss sources of funds to finance international trade and investment.

Apply net present value analyses to the capital budgeting decisions facing firms with international operations.

Discuss how exchange rate risk affects firms’ cash flows and its impact on stock returns.

After studying this chapter, you should be able to:

EXHIBIT 14.1 THE PRICE IN DOLLARS OF ONE BARREL OF CRUDE OIL, MARCH 2007 TO MARCH 2009

Measuring Foreign Exchange Exposure

Exchange rate risk

The impact of random change in the value of one currency with respect to other currencies

Transactions risk

How short-term changes in exchange rates can affect operating costs and revenues of firms engaged in international business activities

Translation risk

The short-term effects of currency movements on the consolidated accounting statements of a firm

Measuring Foreign Exchange Risk (continued)

Consolidated accounting statements

The income statements and balance sheets of multinational corporations and of all subsidiaries abroad

Economic risk

The ways in which long-term exchange rate movements affect firms

Special drawing right (SDR)

A basket of currencies consisting of dollars, euros, pounds, and yen created by the International Monetary Fund (IMF)

Hedging Foreign Exchange (Forex) Risk with Derivatives

Hedging

Using currency derivatives to reduce potential transaction, translation, and economic risks of currency movements that could lead to losses for a firm or investor

Speculators

Trade in currencies and currency derivatives to earn profits and to help to make currency prices efficient

Futures Contracts

Currency futures contracts

Standardized agreements to buy or sell a specified amount of currency at a date in the future at a predetermined price

Long position

Buying a currency contract and profiting on the increased value of the underlying currency over time

Short position

Selling a currency contract and profiting on the decreased value of the currency over time

Organized exchanges

Trade futures contracts in major currencies and offer price transparency and efficiency in addition to eliminating counterparty risk due to guaranteed payments on contacts

EXHIBIT 14.2 PAYOFFS FOR FUTURES CONTRACTS

Futures Contracts (continued)

Common rules in trading currency futures contracts:

Futures contracts are marked-to-market—gains (losses) are earned (paid) in cash at the end of each trading day.

Contracts can be purchased for a small commitment fee called the margin.

If losses occur causing a participant’s balance to fall below the maintenance margin at the end of the trading day, a margin call occurs that requires the customer to replenish the margin account.

Forward Contracts

Currency forward contracts

Futures contracts in the currencies of emerging-market countries offered by large banks in the OTC market

Less standardized than future contracts such that they can be customized by the seller/counterparty to meet the hedging needs of the buyer

Are not marked-to-market daily

Over-the-counter (OTC) market

Derivatives market run by large banks

Options Contracts

Call option

An investor’s right (but not obligation) to buy an asset (e.g., a currency) at a predetermined (strike) price

Put option

An investor’s right (but not obligation) to sell an asset (e.g., a currency) at a predetermined price

Premium

The price paid by the buyer to the seller for an option contract

EXHIBIT 14.3 PAYOFFS FOR CALL AND PUT OPTIONS CONTRACTS

Swap Contracts

Currency swaps

Allow firms to exchange currencies at a previously agreed exchange rate as a way to hedge exchange rate movements

Plain vanilla currency swap

An interest rate swap, often combined with a currency swap, if the interest being swapped is in different currencies

EXHIBIT 14.4 VANILLA CURRENCY SWAP

Financing International Trade and Investment

Firms finance international operations in a variety of ways.

Short-term financing of goods and services is handled by large banks.

Long-term financing of capital equipment, land, and buildings is provided by international bond and stock markets.

Government financing is also available to meet international trade policy goals in a particular country.

International Banking

Money center banks

Large global banks

Clearing House Interbank Payments System (CHIPS)

Provides large, wholesale dollar payments services for businesses, banks, and governments

Society of Worldwide Interbank Financial Telecommunications (SWIFT)

Provides secure communications for contracts, invoices, and other trade documents that accompany cash payments

Syndicate

A group of banks that collectively make a loan to an international firm

International Payment Methods and Documentation

Payment in Advance

The safest method for exporters, but it exposes importers to risk related to delivery of goods

Commercial Letter of Credit (LC)

Provides payment protection to both exporters and importers, as the importer’s bank writes a guarantee of payment

Banker’s Acceptance

When a bank sells a LC into the financial marketplace as a money market instrument

Open Account

A simple agreement wherein the exporter sends an invoice with the goods and the exporter pays upon the receipt

International Bond Markets

Bond ratings

Moody’s and Standard and Poor’s rating services that are important in assuring foreign investors of the credit quality of bond issues

Domestic bonds

Debt contracts sold by firms domiciled in a country in the home currency

Foreign bonds

Bonds that are issued by foreign firms in another country in the home currency of that country

Eurobonds

Bonds that are sold in any country outside the home country, but in the home country’s currency

EXHIBIT 14.5 INTERNATIONAL BONDS AND NOTES BY CURRENCY AND ISSUER

EXHIBIT 14.5 INTERNATIONAL BONDS AND NOTES BY CURRENCY AND ISSUER (CONTINUED)

International Stock Markets

Diversification

Buying securities in a portfolio with price patterns over time that are different from one another, which reduces the volatility of the portfolio

Home bias

Investing most of retirement and other savings in one’s home country, which reduces diversification

Contagion

When stock markets in many countries move down in concert with one another and thereby reduce international diversification benefits

EXHIBIT 14.6 DIVERSIFICATION CAN REDUCE RISK FOR INVESTORS

International Stock Markets (continued)

Increasing consolidation of international stock exchanges include these recent mergers:

New York Stock Exchange (NYSE) and Euronext, which comprises a group of European countries’ exchanges

NASDAQ (National Association of Securities Dealers Automated Quotation system) and American Stock Exchange (AMEX)

London Stock Exchange and Italy’s Borsa Italiana

Chicago Mercantile Exchange (CME) and Chicago Board of Trade

Government Financing

International Monetary Fund (IMF)

Provides “lender-of-last-resort” short-term loans to countries in financial crisis

Evaluates exchange rate policies

Gives technical assistance to countries

World Bank

Provides long-term loans for economic reform and infrastructure development in emerging and developing markets

IMF and World Bank are major suppliers of emergency and development assistance to poorer countries.

Government Financing (continued)

Major government-supported international financing institutions include:

Export-Import (Ex-Im) Bank—a U.S. government export finance agency that supports U.S. firms competing against government-supported exports of other countries

Bank of International Cooperation (JBIC)—Japanese bank that supports exporters around the world that have at least 30 percent Japanese content

Government Financing (continued)

Trade finance

Bank and government loans used by exporters to finance working capital (i.e., labor, materials, inventory, and accounts receivables)

Term financing

Bank and government loans to importers to cover the cost of major purchases

Parent Firm Capital Budgeting

Net present value (NPV)

The difference between present value of future profits on an investment project minus the initial investment cost

To calculate the NPV of capital investments in a foreign subsidiary:

where

CFt = cash flow in period t

Salvagen = salvage value at the end of the investment’s life at time n

k = the required rate of return on investment by the conglomerate firm

Investment = the initial capital investment at time 0 (now)

Parent Firm Capital Budgeting (continued)

Country risk

The uncertainty in predicting how economic, political, inflation, and tax risk factors will affect an investment in a country

Sensitivity analysis

An examination of optimistic, expected, and pessimistic scenarios to give a more complete picture of the risks and returns of investments abroad

EXHIBIT 14.7 SELECTING ACCEPTABLE CAPITAL BUDGETING PROJECTS

The Cost of Capital: Domestic Versus Global

Cost of capital

The required rate of return demanded by stock and bond investors

Used in net present value capital budgeting analyses as the discount rate

Weighted average cost of capital

The sum of the costs of equity and debt weighted by the amount of financing from these two capital sources

The Cost of Capital: Domestic Versus Global (continued)

The weighted average cost of capital for a firm is:

K = (Equity/Total Market Value) R + (Debt/Total Market Value) (1 – Tax Rate) I

where

Equity = market value of common and preferred stock outstanding

Debt = market value of long-term debt outstanding

R = cost of equity or required rate of return of equity holders

I = before-tax cost of debt or interest rate

Tax Rate = marginal tax rate of the firm

Total Market Value = Equity + Debt.

The Cost of Capital: Domestic Versus Global (continued)

Cost of debt

The weighted average of different interest rates paid on long-term borrowings

Cost of equity

The rate of return on equity required by stockholders as estimated by Capital Asset Pricing Model (CAPM)

The Cost of Capital: Domestic Versus Global (continued)

The CAPM is written as follows:

Rit = Rft + i(Rmt – Rft),

where

Rit = the one-month return on stock i in month t

Rmt = the one-month return on a domestic market index (e.g., the S&P 500 index of the 500 largest U.S. firms)

Rft = the one-month riskless rate of return (e.g., the U.S. Treasury bill rate)

i = the domestic beta risk measure for the stock.

The Cost of Capital: Domestic Versus Global (continued)

International CAPM (ICAPM)

An asset pricing model that includes both domestic and global market factors to estimate the cost of equity or required rate of return on stocks

The estimated rate of return required by stockholders as estimated by ICAPM) is:

where

Rgt = the one-month return on a global market index (e.g., the Dow Jones world index of stocks

= the global beta risk measure for the stock and other terms as before.

Currency Risk and Stock Valuation

Cash flow sensitivity to exchange rate risk

Firms can experience positive and negative fluctuations in cash flows and profits due to currency movements that strengthen or weaken the value of their products in overseas markets.

One channel for currency movements to impact MNC cash flows is export sales.

Another channel for dollar movements to affect companies is through oil imports, normally priced in dollars.

Stock Values and Foreign Exchange Movements

Measurement of long-run exchange risk (Adler and Dumas):

Rit = Rft + i(Rmt – Rft) + CRCt

where

RCt = the one-month return on local currency relative to a basket of currencies in month t

C = the exchange rate risk measure for the stock and other terms are the same as in the CAPM equation.

Stock Values and Foreign Exchange Movements (continued)

Market factors affecting equity valuations

Exchange rate sensitivity—a stock value measured with the coefficient obtained by regressing the stock’s return on a currency’s return over time

Exchange risk beta—the sensitivity of a stock to market risk affected by currency movements

Stock Values and Foreign Exchange Movements (continued)

Measurement of exchange risk (Armstrong, Knif, Kolari, and Pynnönen):

Rit = Rft + b0(Rmt – Rft) + b1(Rmt – Rft) RCt

where

b0 = the market beta with no exchange risk

b1 = the market beta associated with exchange risk

exchange rate risk

transactions risk

translation risk

consolidated accounting statements

economic risk

Special Drawing Right (SDR)

hedging

speculators

currency futures contracts

long position

short position

organized exchanges

marked-to-market

margin

margin call

currency forward contracts

over-the-counter (OTC) market

call option

put option

premium

currency swaps

plain vanilla currency swap

money center banks

Key Terms

CHIPS (Clearing House Interbank Payments System)

SWIFT (Society of Worldwide Interbank Financial Telecommunications)

payment in advance

commercial letter of credit (LC)

banker’s acceptance

open account

syndicate

bond ratings

domestic bonds

foreign bonds

eurobonds

diversification

home bias

contagion

Export-Import (Ex-Im) Bank

trade finance

term financing

Bank of International Cooperation (JBIC)

net present value

country risk

Key Terms (continued)

sensitivity analysis

cost of capital

weighted average cost of capital

cost of debt

cost of equity

beta risk

international CAPM (ICAPM)

size factor

value factor

exchange rate sensitivity

exchange risk beta

Key Terms (continued)