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Instructor’s Resource Manual

For

Multinational Business Finance Fourteenth Edition

David K. Eiteman University of California, Los Angeles

Arthur I. Stonehill Oregon State University and University of Hawaii at Manoa

Michael H. Moffett Thunderbird School of Global Management

at Arizona State University

Vice President, Product Management: Donna Battista Acquisitions Editor: Kate Fernandes Program Manager: Kathryn Dinovo Team Lead, Project Management: Jeff Holcomb Project Manager: Meredith Gertz

Copyright © 2016, 2013, 2010 Pearson Education, Inc., or its affiliates. All Rights Reserved. Manufactured in the United States of America. This publication is protected by copyright, and permission should be obtained from the publisher prior to any prohibited reproduction, storage in a retrieval system, or transmission in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise. For information regarding permissions, request forms, and the appropriate contacts within the Pearson Education Global Rights and Permissions department, please visit www.pearsoned.com/permissions/.

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ISBN-13: 978-0-13-387987-2 ISBN-10: 0-13-387987-9

Contents

Chapter 1 Multinational Financial Management: Opportunities and Challenges .......................... 1

Chapter 2 The International Monetary System .............................................................................. 7

Chapter 3 The Balance of Payments ............................................................................................ 12

Chapter 4 Financial Goals and Corporate Governance ................................................................ 20

Chapter 5 The Foreign Exchange Market .................................................................................... 25

Chapter 6 International Parity Conditions ................................................................................... 31

Chapter 7 Foreign Currency Derivatives: Futures and Options ................................................... 38

Chapter 8 Interest Rate Risk and Swaps ...................................................................................... 43

Chapter 9 Foreign Exchange Rate Determination ....................................................................... 48

Chapter 10 Transaction Exposure ................................................................................................ 55

Chapter 11 Translation Exposure ................................................................................................. 60

Chapter 12 Operating Exposure .................................................................................................... 64

Chapter 13 The Global Cost and Availability of Capital ............................................................. 68

Chapter 14 Raising Equity and Debt Globally ............................................................................. 72

Chapter 15 Multinational Tax Management ................................................................................ 79

Chapter 16 International Trade Finance ....................................................................................... 85

Chapter 17 Foreign Direct Investment and Political Risk ........................................................... 89

Chapter 18 Multinational Capital Budgeting and Cross-Border Acquisitions ........................... 101

CHAPTER 1

MULTINATIONAL FINANCIAL MANAGEMENT: OPPORTUNITIES AND CHALLENGES

1. Globalization Risks in Business. What are some of the risks that come with the growing

globalization of business?

Exchange rates. The international monetary system, an eclectic mix of floating and managed fixed exchange rates, is constantly changing. For example, the growth of the Chinese yuan is now changing the global currency landscape.

Interest rates. Large fiscal deficits, including the current eurozone crisis, plague most of the major

trading countries of the world, complicating fiscal and monetary policies, and ultimately, interest rates and exchange rates.

Many countries experience continuing balance of payments imbalances, and in some cases,

dangerously large deficits and surpluses, all will inevitably move exchange rates.

Ownership, control, and governance vary radically across the world. The publicly traded company is not the dominant global business organization—the privately held or family-owned business is the prevalent structure—and their goals and measures of performance vary dramatically.

Global capital markets that normally provide the means to lower a firm’s cost of capital, and even

more critically, increase the availability of capital, have in many ways shrunk in size and have become less open and accessible to many of the world’s organizations.

Financial globalization has resulted in the ebb and flow of capital in and out of both industrial and

emerging markets, greatly complicating financial management (Chapters 5 and 8). 2. Globalization and the MNE. The term globalization has become widely used in recent years. How

would you define it? Narayana Murthy’s quote is a good place to start any discussion of globalization:

“I define globalization as producing where it is most cost-effective, selling where it is most profitable, and sourcing capital where it is cheapest, without worrying about national boundaries.”

Narayana Murthy, President and CEO, Infosys 3. Assets, Institutions, and Linkages. Which assets play the most critical role in linking the major

institutions that make up the global financial marketplace?

The debt securities issued by governments. These low risk or risk-free assets form the foundation for the creation, trading, and pricing of other financial assets like bank loans, corporate bonds, and equities (stock). In recent years, a number of additional securities have been created from the existing

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securities—derivatives, whose value is based on market value changes in the underlying securities. The health and security of the global financial system relies on the quality of these assets.

4. Currencies and Symbols. What technological change is even changing the symbols we use in the

representation of different country currencies?

As currency trading has shifted from verbal telephone conversations to electronic and digital trading, currency symbols (many of which were not common across alphabetic platforms, like the British pound, £) have been replaced with the ISO-4217 codes, three-letter currency codes like USD, EUR, and GBP.

5. Eurocurrencies and LIBOR. Why have eurocurrencies and LIBOR remained the centerpiece of the

global financial marketplace for so long?

Eurocurrencies and LIBOR (and there are LIBOR rates for all eurocurrencies) reflect the “purest” of market-driven currencies and instrument rates. They are largely unregulated and, therefore, reflect freely traded assets whose value is set by the daily global marketplace.

6. Theory of Comparative Advantage. Define and explain the theory of comparative advantage.

The theory of comparative advantage provides a basis for explaining and justifying international trade in a model world assumed to enjoy free trade, perfect competition, no uncertainty, costless information, and no government interference. The theory contains the following features:

Exporters in Country A sell goods or services to unrelated importers in Country B.

Firms in Country A specialize in making products that can be produced relatively efficiently,

given Country A’s endowment of factors of production: that is, land, labor, capital, and technology. Firms in Country B do likewise, given the factors of production found in Country B. In this way, the total combined output of A and B is maximized.

Because the factors of production cannot be moved freely from Country A to Country B, the

benefits of specialization are realized through international trade.

The way the benefits of the extra production are shared depends on the terms of trade, the ratio at which quantities of the physical goods are traded. Each country’s share is determined by supply and demand in perfectly competitive markets in the two countries. Neither Country A nor Country B is worse off than before trade, and typically both are better off, albeit perhaps unequally.

7. Limitations of Comparative Advantage. Key to understanding most theories is what they say and

what they don’t. Name four or five key limitations to the theory of comparative advantage.

Although international trade might have approached the comparative advantage model during the nineteenth century, it certainly does not today, for the following reasons:

Countries do not appear to specialize only in those products that could be most efficiently

produced by that country’s particular factors of production. Instead, governments interfere with comparative advantage for a variety of economic and political reasons, such as to achieve full employment, economic development, national self-sufficiency in defense-related industries, and

Chapter 1 Multinational Financial Management: Opportunities and Challenges 3

protection of an agricultural sector’s way of life. Government interference takes the form of tariffs, quotas, and other non-tariff restrictions.

At least two of the factors of production, capital and technology, now flow directly and easily

between countries, rather than only indirectly through traded goods and services. This direct flow occurs between related subsidiaries and affiliates of multinational firms, as well as between unrelated firms via loans and license and management contracts. Even labor flows between countries, such as immigrants into the United States (legal and illegal), immigrants within the European Union and other unions.

Modern factors of production are more numerous than in this simple model. Factors considered in

the location of production facilities worldwide include local and managerial skills, a dependable legal structure for settling contract disputes, research and development competence, educational levels of available workers, energy resources, consumer demand for brand name goods, mineral and raw material availability, access to capital, tax differentials, supporting infrastructure (roads, ports, communication facilities), and possibly others.

Although the terms of trade are ultimately determined by supply and demand, the process by

which the terms are set is different from that visualized in traditional trade theory. They are determined partly by administered pricing in oligopolistic markets.

Comparative advantage shifts over time as less developed countries become more developed and

realize their latent opportunities. For example, during the past 150 years, comparative advantage in producing cotton textiles has shifted from the United Kingdom to the United States to Japan to Hong Kong to Taiwan and to China.

The classical model of comparative advantage did not really address certain other issues, such as

the effect of uncertainty and information costs, the role of differentiated products in imperfectly competitive markets, and economies of scale.

Nevertheless, although the world is a long way from the classical trade model, the general principle of comparative advantage is still valid. The closer the world gets to true international specialization, the more world production and consumption can be increased, provided the problem of equitable distribution of the benefits can be solved to the satisfaction of consumers, producers, and political leaders. Complete specialization, however, remains an unrealistic limiting case, just as perfect competition is a limiting case in microeconomic theory.

8. International Financial Management. What is different about international financial management?

Multinational financial management requires an understanding of cultural, historical, and institutional differences, such as those affecting corporate governance. Although both domestic firms and MNEs are exposed to foreign exchange risks, MNEs alone face certain unique risks, such as political risks, that are not normally a threat to domestic operations.

MNEs also face other risks that can be classified as extensions of domestic finance theory. For example, the normal domestic approach to the cost of capital, sourcing debt and equity, capital budgeting, working capital management, taxation, and credit analysis needs to be modified to accommodate foreign complexities. Moreover, a number of financial instruments that are used in domestic financial management have been modified for use in international financial management. Examples are foreign currency options and futures, interest rate and currency swaps, and letters of credit.

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9. Ganado’s Globalization. After reading the chapter’s description of Ganado’s globalization process,

how would you explain the distinctions between international, multinational, and global companies?

The difference in definitions for these three terms is subjective, with different writers using different terms at different times. No single definition can be considered definitive, although as a general matter the following probably reflect general usage.

International simply means that the company has some form of business interest in more than one country. That international business interest may be no more than exporting and importing, or it may include having branches or incorporated subsidiaries in other countries. International trade is usually the first step in becoming “international,” but the term also encompasses foreign subsidiaries created for the single purpose of marketing, distribution, or financing. The term international is also used to encompass what are defined as multinational and global in the following two paragraphs.

Multinational is usually taken to mean a company that has operating subsidiaries and performs a full set of its major operations in a number of countries, i.e., in “many nations.” “Operations” in this context includes both manufacturing and selling, as well as other corporate functions, and a multinational company is often presumed to operate in a greater number of countries than simply an international company. A multinational company is presumed to operate with each foreign unit “standing on its own,” although that term does not preclude specialization by country or supplying parts from one country operation to another.

Global is a newer term that essentially means about the same as “multinational,” i.e., operating around the globe. Global has tended to replace other terms because of its use by demonstrators at the international meetings (“global forums?”) of the International Monetary Fund and World Bank that took place in Seattle in 1999 and Rome in 2001. Terrorist attacks on the World Trade Center and the Pentagon in 2001 led politicians to refer to the need to eliminate “global terrorism.”

10. Ganado, the MNE. At what point in the globalization process did Ganado become a multinational

enterprise (MNE)?

Ganado became a multinational enterprise (MNE) when it began to establish foreign sales and service subsidiaries, followed by creation of manufacturing operations abroad or by licensing foreign firms to produce and service Trident’s products. This multinational phase usually follows the international phase, which involved the import and/or export of goods and/or services.

11. Role of Market Imperfections. What is the role of market imperfections in the creation of

opportunities for the multinational firm?

MNEs strive to take advantage of imperfections in national markets for products, factors of production, and financial assets.

Imperfections in the market for products translate into market opportunities for MNEs. Large

international firms are better able to exploit such competitive factors as economies of scale, managerial and technological expertise, product differentiation, and financial strength than their local competitors are.

MNEs thrive best in markets characterized by international oligopolistic competition, where these

factors are particularly critical.

Chapter 1 Multinational Financial Management: Opportunities and Challenges 5

Once MNEs have established a physical presence abroad, they are in a better position than purely domestic firms are to identify and implement market opportunities through their own internal information network.

12. Why Go. What do firms become multinational?

1. Entry into new markets, not currently served by the firm, which in turn allow the firm to grow and possibly to acquire economies of scale

2. Acquisition of raw materials, not available elsewhere

3. Achievement of greater efficiency, by producing in countries where one or more of the factors of production are underpriced relative to other locations

4. Acquisition of knowledge and expertise centered primarily in the foreign location

5. Location of the firms’ foreign operations in countries deemed politically safe 13. Multinational Versus International. What is the difference between an international firm and a

multinational firm?

A multinational firm goes beyond simply selling to or trading with firms in foreign countries (international), by expanding its intellectual capital and acquiring a physical presence in foreign countries. This allows the firm to expand and deepen its core competitiveness and global reach to more markets, customers, suppliers, and partners.

14. Ganado’s Phases. What are the main phases that Ganado passed through as it evolved into a truly

global firm? What are the advantages and disadvantages of each?

a. International trade. Two advantages are finding out if the firms’ products are desired in the foreign country and learning about the foreign market. Two disadvantages are lack of control over the final sale and service to final customer (many exports are to distributors or other types of firms that in turn resell to the final customer) and the possibility that costs and thus final customer sales prices will be greater than those of competitors that manufacture locally.

b. Foreign sales and service offices. The greatest advantage is that the firm has a physical presence

in the country, allowing it great control over sales and service as well as allowing it to learn more about the local market. The disadvantage is the final local sales prices, based on home country plus transportation costs, may be greater than competitors that manufacture locally.

c. Licensing a foreign firm to manufacture and sell. The advantages are that product costs are based

on local costs and that the local licensed firm has the knowledge and expertise to operate efficiently in the foreign country. The major disadvantages are that the firm might lose control of valuable proprietary technology and that the goals of the foreign partner might differ from those of the home country firm. Two common problems in the latter category are whether the foreign firm (that is manufacturing the product under license) is a shareholder wealth or corporate wealth maximizer, which in turn often leads to disagreements about reinvesting earning to achieve greater future growth versus making larger current dividends to owners and payments to other stakeholders.

d. Part ownership of a foreign, incorporated, subsidiary, i.e., a joint venture. The advantages and

disadvantages are similar to those for licensing: Product costs are based on local costs and that the local joint owner presumably has the knowledge and expertise to operate efficiently in the foreign

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country. The major disadvantages are that the firm might lose control of valuable proprietary technology to its joint venture partner, and that the goals of the foreign owners might differ from those of the home country firm.

e. Direct ownership of a foreign, incorporated, subsidiary. If fully owned, the advantage is that the

foreign operations may be fully integrated into the global activities of the parent firm, with products resold to other units in the global corporate family without questions as to fair transfer prices or too great specialization. (Example: the Ford transmission factory in Spain is of little use as a self-standing operation; it depends on its integration into Ford’s European operations.) The disadvantage is that the firm may come to be identified as a “foreign exploiter” because politicians find it advantageous to attack foreign-owned businesses.

15. Financial Globalization. How do the motivations of individuals, both inside and outside the

organization or business, define the limits of financial globalization?

If influential insiders in corporations and sovereign states continue to pursue the increase in firm value, there will be a definite and continuing growth in financial globalization. But if these same influential insiders pursue their own personal agendas, which may increase their personal power, influence, or wealth, then capital will not flow into these sovereign states and corporations. The result is the growth of financial inefficiency and the segmentation of globalization outcomes creating winners and losers.

The three fundamental elements—financial theory, global business, management beliefs and actions—combine to present either the problem or the solution to the growing debate over the benefits of globalization to countries and cultures worldwide.

CHAPTER 2

THE INTERNATIONAL MONETARY SYSTEM

1. The Rules of the Game. Under the gold standard, all national governments promised to follow the

“rules of the game.” What did this mean?

A country’s money supply was limited to the amount of gold held by its central bank or treasury. For example, if a country had 1,000,000 ounces of gold and its fixed rate of exchange was 100 local currency units per ounce of gold, that country could have 100,000,000 local currency units outstanding. Any change in its holdings of gold needed to be matched by a change in the number of local currency units outstanding.

2. Defending a Fixed Exchange Rate. What did it mean under the gold standard to “defend a fixed

exchange rate,” and what did this imply about a country’s money supply?

Under the gold standard, a country’s central bank was responsible for preserving the exchange value of the country’s currency by being willing and able to exchange its currency for gold reserves upon the demand by a foreign central bank. This required the country to restrict the rate of growth in its money supply to a rate that would prevent inflationary forces from undermining the country’s own currency value.

3. Bretton Woods. What was the foundation of the Bretton Woods international monetary system, and

why did it eventually fail?

Bretton Woods, the fixed exchange rate regime of 1945–73, failed because of widely diverging national monetary and fiscal policies, differential rates of inflation, and various unexpected external shocks. The U.S. dollar was the main reserve currency held by central banks and was the key to the web of exchange rate values. The United States ran persistent and growing deficits in its balance of payments requiring a heavy outflow of dollars to finance the deficits. Eventually the heavy overhang of dollars held by foreigners forced the United States to devalue the dollar because it was no longer able to guarantee conversion of dollars into its diminishing store of gold.

4. Technical Float. What specifically does a floating rate of exchange mean? What is the role of

government?

A truly floating currency value means that the government does not set the currency’s value or intervene in the marketplace, allowing the supply and demand of the market for its currency to determine the exchange value.

5. Fixed versus Flexible. What are the advantages and disadvantages of fixed exchange rates?

Fixed rates provide stability in international prices for the conduct of trade. Stable prices aid in the growth of international trade and lessen risks for all businesses.

Fixed exchange rates are inherently anti-inflationary, requiring the country to follow restrictive

monetary and fiscal policies. This restrictiveness, however, can often be a burden to a country

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wishing to pursue policies that alleviate continuing internal economic problems, such as high unemployment or slow economic growth.

Fixed exchange rate regimes necessitate that central banks maintain large quantities of

international reserves (hard currencies and gold) for use in the occasional defense of the fixed rate. As international currency markets have grown rapidly in size and volume, increasing reserve holdings has become a significant burden to many nations.

Fixed rates, once in place, may be maintained at rates that are inconsistent with economic

fundamentals. As the structure of a nation’s economy changes, and as its trade relationships and balances evolve, the exchange rate itself should change. Flexible exchange rates allow this to happen gradually and efficiently, but fixed rates must be changed administratively—usually too late, too highly publicized, and at too large a one-time cost to the nation’s economic health.

6. De facto and de jure. What do the terms de facto and de jure mean in reference to the International

Monetary Fund’s use of the terms?

A country’s actual exchange rate practices is the de facto system. This may or may not be what the “official” or publicly and officially system commitment, the de jure system.

7. Crawling Peg. How does a crawling peg fundamentally differ from a pegged exchange rate?

In a crawling peg system, the government will make occasional small adjustments in its fixed rate of exchange in response to changes in a variety of quantitative indicators, such as inflation rates or economic growth. In a truly pegged exchange rate regime, no such changes or adjustments are made to the official fixed rate of exchange.

8. Global Eclectic. What does it mean to say the international monetary system today is a global

eclectic?

The current global market in currency is dominated by two major currencies, the U.S. dollar and the European euro, and after that, a multitude of systems, arrangements, currency areas, and zones.

9. The Impossible Trinity. Explain what is meant by the term impossible trinity and why it is in fact

“impossible.”

Countries with floating rate regimes can maintain monetary independence and financial integration but must sacrifice exchange rate stability.

Countries with tight control over capital inflows and outflows can retain their monetary independence and stable exchange rate but surrender being integrated with the world’s capital markets.

Countries that maintain exchange rate stability by having fixed rates give up the ability to have an independent monetary policy.

10. The Euro. Why is the formation and use of the euro considered to be of such a great

accomplishment? Was it really needed? Has it been successful?

The creation of the euro required a near-Herculean effort to merge the monetary institutions of separate sovereign states. This required highly disparate cultures and countries to agree to combine,

Chapter 2 The International Monetary System 9

giving up a large part of what defines an independent state. Member states were so highly integrated in terms of trade and commerce that maintaining separate currencies and monetary policies was an increasing burden on both business and consumers, adding cost and complexity, which added sizable burdens to global competitiveness. The euro is widely considered to have been extremely successful since its launch.

11. Currency Board or Dollarization. Fixed exchange rate regimes are sometimes implemented through

a currency board (Hong Kong) or dollarization (Ecuador). What is the difference between the two approaches?

In a currency board arrangement, the country issues its own currency but that currency is backed 100% by foreign exchange holdings of a hard foreign currency—usually the U.S. dollar. In dollarization, the country abolishes its own currency and uses a foreign currency, such as the U.S. dollar, for all domestic transactions.

12. Argentine Currency Board. How did the Argentine currency board function from 1991 to January

2002, and why did it collapse?

Argentina’s currency board exchange regime of fixing the value of its peso on a one-to-one basis with the U.S. dollar ended for several reasons:

As the U.S. dollar strengthened against other major world currencies, including the euro, during

the 1990s, Argentine export prices rose vis-à-vis the currencies of its major trading partners.

This problem was aggravated by the devaluation of the Brazilian real in the late 1990s.

These two problems, in turn, led to continued trade deficits and a loss of foreign exchange reserves by the Argentine central bank.

This problem, in turn, led Argentine residents to flee from the peso and into the dollar, further worsening Argentina’s ability to maintain its one-to-one peg.

13. Special Drawing Rights. What are Special Drawing Rights?

The Special Drawing Right (SDR) is an international reserve asset created by the IMF to supplement existing foreign exchange reserves. It serves as a unit of account for the IMF and other international and regional organizations and is also the base against which some countries peg the exchange rate for their currencies.

Defined initially in terms of a fixed quantity of gold, the SDR has been redefined several times. It is currently the weighted value of currencies of the five IMF members that have the largest exports of goods and services. Individual countries hold SDRs in the form of deposits in the IMF. These holdings are part of each country’s international monetary reserves, along with official holdings of gold, foreign exchange, and its reserve position at the IMF. Members may settle transactions among themselves by transferring SDRs.

14. The Ideal Currency. What are the attributes of the ideal currency?

If the ideal currency existed in today’s world, it would possess three attributes, often referred to as the Impossible Trinity:

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1. Exchange rate stability. The value of the currency would be fixed in relationship to other major currencies so that traders and investors could be relatively certain of the foreign exchange value of each currency in the present and into the near future.

2. Full financial integration. Complete freedom of monetary flows would be allowed; thus, traders

and investors could willingly and easily move funds from one country and currency to another in response to perceived economic opportunities or risks.

3. Monetary independence. Domestic monetary and interest rate policies would be set by each

individual country to pursue desired national economic policies, especially as they might relate to limiting inflation, combating recessions, and fostering prosperity and full employment.

The reason that it is termed the Impossible Trinity is that a country must give up one of the three goals described by the sides of the triangle, monetary independence, exchange rate stability, or full financial integration. The forces of economics do not allow the simultaneous achievement of all three.

15. Emerging Market Regimes. High capital mobility is forcing emerging market nations to choose

between free-floating regimes and currency board or dollarization regimes. What are the main outcomes of each of these regimes from the perspective of emerging market nations?

Highly restrictive regimes like currency boards and dollarization require a country to give up the majority of its discretionary ability over its own currency’s value. Currency boards, like that used by Argentina in the 1990s, restricted the rate of growth in the country’s monetary policy in order to preserve a fixed exchange rate regime. This proved to be a very high price for Argentine society to pay and, in the end, could not be maintained. Dollarization, an even more radical extreme in the adoption of another country’s currency for all exchange, removes one of a government’s major attributes of sovereignty.

A free-floating rate of exchange is, however, in many ways not that different from the highly restrictive choices just mentioned. In a free-floating regime, the government allows the foreign currency markets to determine the currency’s value, although the government does maintain sovereignty over its own monetary policy, which in turn has significant direct impacts on the currency’s value.

16. Globalizing the Yuan. What are the major changes and developments that must occur for the

Chinese yuan to be considered “globalized”?

First, the yuan must become readily accessible for trade transaction purposes. This is the fundamental and historical use of currency. Secondly, it then needs to mature toward a currency easily and openly useable for international investment purposes. The third and final stage of currency globalization is when the currency itself takes on a role as a reserve currency, currency held by central banks of other countries as a store of value and a medium of exchange for their own currencies.

17. Triffin Dilemma. What is the Triffin Dilemma? How does it apply to the development of the Chinese

yuan as a true global currency?

The Triffin Dilemma is the potential conflict in objectives that may arise between domestic monetary and currency policy objectives and external or international policy objectives when a country’s currency is used as a reserve currency. Domestic monetary and economic policies may on occasion require both contraction and the creation of a current account surplus (balance on trade surplus).

Chapter 2 The International Monetary System 11

18. China and the Impossible Trinity. What choices do you believe that China will make in terms of the Impossible Trinity as it continues to develop global trading and use of the Chinese yuan?

This is purely speculative opinion, but many believe China will continue to move the yuan toward globalization rapidly. As Chinese financial institutions and policies become more mature, and policies more consistent with those of other major country financial markets, the yuan will grow as a medium of exchange for both commercial trade and capital investment transactions. The gradual opening of the Chinese economy to foreign investment is a critical component of this process.

CHAPTER 3

THE BALANCE OF PAYMENTS

1. Balance of Payments Defined. What is the balance of payments?

The measurement of all international economic transactions between the residents of a country and foreign residents is called the balance of payments (BOP).

2. BOP Data. What institution provides the primary source of similar statistics for balance of payments

and economic performance worldwide?

The primary source of similar statistics for balance of payments and economic performance worldwide is the International Monetary Fund, Balance of Payments Statistics.

3. Importance of BOP. Business managers and investors need BOP data to anticipate changes in host

country economic policies that might be driven by BOP events. From the perspective of business managers and investors, list three specific signals that a country’s BOP data can provide.

The BOP is an important indicator of pressure on a country’s foreign exchange rate and thus on

the potential for a firm trading with or investing in that country to experience foreign exchange gains or losses. Changes in the BOP may predict the imposition or removal of foreign exchange controls.

Changes in a country’s BOP may signal the imposition or removal of controls over payment of

dividends and interest, license fees, royalty fees, or other cash disbursements to foreign firms or investors.

The BOP helps to forecast a country’s market potential, especially in the short run. A country

experiencing a serious trade deficit is not likely to expand imports as it would if running a surplus. It may, however, welcome investments that increase its exports.

4. Flow Statement. What does it mean to describe the balance of payments as a flow statement?

The BOP is often misunderstood because many people infer from its name that it is a balance sheet, whereas in fact it is a cash flow statement. By recording all international transactions over a period such as a year, the BOP tracks the continuing flows of purchases and payments between a country and all other countries. It does not add up the value of all assets and liabilities of a country on a specific date like a balance sheet does for an individual firm.

5. Economic Activity. What are the two main types of economic activity measured by a country’s

BOP?

Current transactions having cash flows completed within one year, such as for the import or export of goods and services.

Capital and financial transactions, in which investors acquire ownership of a foreign asset, such

as a company, or a portfolio investment, such as bonds or shares of common stock.

Chapter 3 The Balance of Payments 13

6. Balance. Why does the BOP always “balance”?

The algebraic sum of all flows accounted for in the current account and the capital and financial accounts should, in theory, equal changes in a country’s monetary reserves. Because data for the balance of payments are collected on a single entry basis and some data are missed, the equalization usually does not occur. The imbalance is plugged by an entry called “errors and omissions” that makes the accounts balance.

7. BOP Accounting. If the BOP were viewed as an accounting statement, would it be a balance sheet of

the country’s wealth, an income statement of the country’s earnings, or a funds flow statement of money into and out of the country?

A country’s balance of payments is similar to a corporation’s funds flow statement in that the balance of payments records events that cause the receipt (earnings) and disbursement (expenditures) into and out of the country.

8. Current Account. What are the main component accounts of the current account? Give one debit and

one credit example for each component account for the United States. The main components and possible examples are: Trade in goods Debit: U.S. firm purchases German machine tools. Credit: Singapore Air Lines buys a Boeing jet. Trade in services Debit: An American takes a cruise on a Dutch cruise line. Credit: The Brazilian tourist agency places an ad in The New York Times. Income payments and receipts Debit: The U.S. subsidiary of a Taiwan computer manufacturer pays dividends to its parent. Credit: A British company pays the salary of its executive stationed in New York. Unilateral current transactions Debit: The U.S.-based International Rescue Committee pays for an American working on the

Afghan border. Credit: A Spanish company pays tuition for an employee to study for an MBA in the United

States. 9. Real versus Financial Assets. What is the difference between a “real” asset and a “financial” asset?

Real assets are goods (merchandise) and useful services. Financial assets are financial claims, such as shares of stock or bonds.

10. Direct versus Portfolio Investments. What is the difference between a direct foreign investment and

a portfolio foreign investment? Give an example of each. Which type of investment is a multinational industrial company more likely to make?

A direct investment is made with the intent that the investor will have a degree of control over the asset acquired. Typical examples are the building of a factory in a foreign country by the subsidiary

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of a multinational enterprise or the acquisition of more than 10% of the voting shares of a foreign corporation. A portfolio investment is the purchase of less than 10% of the voting shares of a foreign corporation or the purchase of debt instruments. Multinational enterprises are more likely to engage in direct foreign investment than in portfolio investment.

11. Net International Investment Position. What is a country’s net international investment position,

and how does it differ from the balance of payments?

The net international investment position (NIIP) of a country is an annual measure of the assets owned abroad by its citizens, its companies, and its government, less the assets owned by foreigners public and private in their country. Whereas a country’s balance of payments is often described as a country’s international cash flow statement, the NIIP may be interpreted as the country’s international balance sheet. NIIP is a country’s stock of foreign assets minus its stock of foreign liabilities.

12. The Financial Account. What are the primary sub-components of the financial account?

Analytically, what would cause net deficits or surpluses in these individual components?

The main components and possible examples follow: Direct investment

Debit: Ford Motor Company builds a factory in Australia. Credit: Ford Motor Company sells its factory in Britain to British investors. Portfolio investment Debit: An American buys shares of stock of a European food chain on the Frankfurt Stock

Exchange. Credit: The government of Korea buys U.S. treasury bills to hold as part of its foreign exchange

reserves. Net financial derivatives Debit: A U.S. firm purchases a financial derivative, like a currency swap, in London Credit: A U.S. firm sells a financial derivative, like a forward contract on the dollar versus the

pound, to a London buyer Other investment. Debit: A U.S. firm deposits $1 million in a bank balance in London. Credit: A U.S. firm generates an account receivable for exports to Canada. 13. Classifying Transactions. Classify the following as a transaction reported in a sub-component of the

current account or the capital and financial accounts of the two countries involved: a. A U.S. food chain imports wine from Chile. Debit to U.S. goods part of current account, credit to

Chilean goods part of current account. b. A U.S. resident purchases a euro-denominated bond from a German company. Debit to U.S.

portfolio part of financial account; credit to German portfolio of financial account. c. Singaporean parents pay for their daughter to study at a U.S. university. Credit to U.S. current

transfers in current account; debit to Singapore current transfers in current account.

Chapter 3 The Balance of Payments 15

d. A U.S. university gives a tuition grant to a foreign student from Singapore. If the student is already in the United States, no entry will appear in the balance of payments because payment is between U.S. residents. (A student already in the United States becomes a resident for balance of payments purposes.)

e. A British Company imports Spanish oranges, paying with eurodollars on deposit in London. A

debit to the goods part of Britain’s current account; a credit to the goods part of Spain’s current account.

f. The Spanish orchard deposits half the proceeds in a eurodollar account in London. No recording

in the U.S. balance of payments, as the transaction was between foreigners using dollars already deposited abroad. A debit to the income receipts/payments of the British current account; a credit to the income receipts/payments of the Spanish current account.

g. A London-based insurance company buys U.S. corporate bonds for its investment portfolio. A

debit to the portfolio investment section of the British financial accounts; a credit to the portfolio investment section of the U.S. balance of payments.

h. An American multinational enterprise buys insurance from a London insurance broker. A debit to

the services part of the U.S. current account; a credit to the services part of the British current account.

i. A London insurance firm pays for losses incurred in the United States because of an international

terrorist attack. A debit to the services part of the British current account; a credit to the services part of the U.S. current account.

j. Cathay Pacific Airlines buys jet fuel at Los Angeles International Airport so it can fly the return

segment of a flight back to Hong Kong. Hong Kong keeps its balance of payments separate from those of the People’s Republic of China. Hence a debit to the goods part of Hong Kong’s current account; a credit to the goods part of the U.S. current account.

k. A California-based mutual fund buys shares of stock on the Tokyo and London stock exchanges.

A debit to the portfolio investment section of the U.S. financial account; a credit to the portfolio investment section of the Japanese and British financial accounts.

l. The U.S. army buys food for its troops in South Asia from vendors in Thailand. A debit to the

goods part of the U.S. current account; a credit to the goods part of the Thai current account. m. A Yale graduate gets a job with the International Committee of the Red Cross working in Bosnia

and is paid in Swiss francs. A debit to the income part of the Swiss current account; a credit to the income part of the Bosnia current account. This assumes the Yale graduate spends her earnings within Bosnia; should she deposit the sum in the United States, then the credit would be to the income part of the U.S. current account.

n. The Russian government hires a Dutch salvage firm to raise a sunken submarine. A debit to the

service part of Russia’s current account; a credit to the service part of the Netherlands’s current account.

o. A Colombian drug cartel smuggles cocaine into the United States, receives a suitcase of cash, and

flies back to Colombia with that cash. This would not get captured in the goods part of the U.S. or Colombian current accounts. Assuming the cash was “laundered” appropriately, from the point of

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view of the smugglers, bank accounts in the United States or somewhere else (probably not Colombia, possibly Switzerland) would be credited. This imbalance would end up in the errors and omissions part of the U.S. balance of payments.

p. The U.S. government pays the salary of a Foreign Service Officer working in the U.S. embassy in

Beirut. Diplomats serving in a foreign country are regarded as residents of their home country, so this payment would not be recorded in any balance of payments accounts. If or when the diplomat spent the money in Beirut, at that time a debit should be incurred in the goods or services part of the U.S. current account and a contrary entry in the Lebanon balance of payments. It is doubtful that the goods or services transaction would get reported or recorded, although on a net basis changes in bank balances would reflect half of the transaction.

q. A Norwegian shipping firm pays U.S. dollars to the Egyptian government for passage of a ship

through the Suez Canal. If the Norwegian firm paid with dollar balances held in the United States and the Suez Canal Authority of Egypt redeposited the proceeds in the United States, no entry would appear in the U.S. balance of payments. Norway would debit a purchase of services, and Egypt would credit a sale of services.

r. A German automobile firm pays the salary of its executive working for a subsidiary in Detroit.

Germany would record a debit in the income payments/receipts in its current account; the U.S. would record a credit in the income payments/receipts in its current account.

s. An American tourist pays for a hotel in Paris with his American Express card. A debit would be

recorded in the services part of the U.S. current account; a credit would be recorded in the services part of the French current account.

t. A French tourist from the provinces pays for a hotel in Paris with his American Express card. A

French resident most likely has a French-issued credit card, issued by the French subsidiary of American Express. In this instance, no entry would appear in either country’s balance of payments. If, later, the French subsidiary of American Express paid a dividend back to the United States, that would be recorded in the income part of the current accounts.

u. A U.S. professor goes abroad for a year and lives on a Fulbright grant. The current transfers

section of the U.S. current account would be debited for the salary paid to a foreign resident. (Even though an American, the professor is a foreign resident during the time he lives abroad.) The current transfers section of the host country’s current account would be credited.

14. The Balance. What are the main summary statements of the balance of payments accounts, and what

do they measure?

The balance on goods (also called the balance of trade) measures the balance on imports and exports of merchandise.

The balance on current account expands the balance on goods to include receipts and expenses

for services, income flows, and unilateral transfers.

The basic balance measures all of the international transactions (current, capital, and financial) that come about because of market forces,that is, the balance resulting from all decisions made for private motives. (This includes international operating expenses of the government.)

Chapter 3 The Balance of Payments 17

The overall balance (also called the official settlements balance) is the total change in a country’s foreign exchange reserves caused by the basic balance plus any governmental action to influence foreign exchange reserves.

15. Twin Surpluses. Why is China’s twin surpluses—a surplus in both the current and financial

accounts—considered unusual?

China’s surpluses in both the current and financial accounts—termed the twin surplus in the business press—is highly unusual. Ordinarily, countries experiencing large current account deficits fund these deficits through equally large surpluses in the financial account, and vice versa.

China has experienced a massive current account surplus and a sometimes sizable financial account surplus simultaneously. This is rare and an indicator of just how exceptional the growth of the Chinese economy has been. Although current account surpluses of this magnitude would ordinarily create a financial account deficit, the positive prospects of the Chinese economy have drawn such massive capital inflows into China in recent years that the financial account too is in surplus.

16. Capital Mobility—United States. The U.S. dollar has maintained or increased its value over the past

20 years despite running a gradually increasing current account deficit. Why has this phenomenon occurred?

The U.S. dollar has maintained or increased its value during the past 20 years despite running a gradually increasing current account deficit because the current account deficit has been more than offset by an inflow of dollars on capital and financial accounts.

17. Capital Mobility—Brazil. Brazil has experienced periodic depreciation of its currency over the past

20 years despite occasionally running a current account surplus. Why has this phenomenon occurred?

Brazil has experienced periodic depreciation of its currency because of speculative flights of capital out of Brazil in response to political and/or economic shocks, including periods of hyperinflation.

18. BOP Transactions. Identify the correct BOP account for each of the following transactions. a. A German-based pension fund buys U.S. government 30-year bonds for its investment portfolio. Financial account: portfolio investment liabilities

b. Scandinavian Airlines System (SAS) buys jet fuel at Newark Airport for its flight to Copenhagen. Current account: Goods: Exports FOB

c. Hong Kong students pay tuition to the University of California, Berkeley. Current account: Services: credit

d. The U.S. Air Force buys food in South Korea to supply is air crews. Current account: Goods: Imports

e. A Japanese auto company pays the salaries of its executives working for its U.S. subsidiaries. Current account: Services: credit

f. A U.S. tourist pays for a restaurant meal in Bangkok. Current account: Services: debit

g. A Colombian citizen smuggles cocaine into the United States, receives cash, and smuggles the dollars back into Colombia.

Unrecorded but should be a current account item.

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h. A U.K. corporation purchases a euro-denominated bond from an Italian MNE. Does not enter the U.S. balance of payments 19. BOP and Exchange Rates. What is the relationship between the balance of payments and a fixed or

floating exchange rate regime?

Fixed Exchange Rate System. Under a fixed exchange rate system, the government bears the responsibility to ensure that the BOP is near zero. If the sum of the current and capital accounts do not approximate zero, the government is expected to intervene in the foreign exchange market by buying or selling official foreign exchange reserves. If the sum of the first two accounts is greater than zero, a surplus demand for the domestic currency exists in the world. To preserve the fixed exchange rate, the government must then intervene in the foreign exchange market and sell domestic currency for foreign currencies or gold in order to bring the BOP back to near zero.

Floating Exchange Rate System. Under a floating exchange rate system, the government of a country has no responsibility to peg its foreign exchange rate. The fact that the current and capital account balances do not sum to zero will automatically—in theory—alter the exchange rate in the direction necessary to obtain a BOP near zero. For example, a country running a sizable current account deficit and a capital and financial accounts balance of zero will have a net BOP deficit. An excess supply of the domestic currency will appear on world markets. Like all goods in excess supply, the market will rid itself of the imbalance by lowering the price. Thus, the domestic currency will fall in value, and the BOP will move back toward zero.

20. J-Curve Dynamics. What is the J-Curve adjustment path?

A country’s trade balance may change as a result of an exchange rate change in the shape of a flattened “j.” International economic analysis characterizes the trade balance adjustment process as occurring in three stages: (1) the currency contract period, (2) the pass-through period, and (3) the quantity adjustment period. Assuming that the trade balance is already in deficit prior to the devaluation, a devaluation may actually result in the trade balance first worsening before improving as a result of the three distinct commercial periods.

21. Evolution of Capital Mobility. Has capital mobility improved steadily over the past 50 years?

The magnitude of capital movements globally has increased dramatically during the past 50 years. Capital inflows and outflows for major industrial countries now dwarf the transaction values of current account activities. These massive capital movements, if allowed to move without restriction, may cause increasing instability in economies, however, like that of Iceland in recent years. So to ask if “capital mobility has improved” is a bit of tricky question; capital mobility has definitely increased, if that is what is meant by “improved.”

22. Restrictions on Capital Mobility. What factors seem to play a role in a government’s choice to

restrict capital mobility?

There is a spectrum of motivations for capital controls, with most associated with either insulating the domestic monetary and financial economy from outside markets or political motivations over ownership and access interests. Capital controls are just as likely to occur over capital inflows as they are over capital outflows. Although there is a tendency for a negative connotation to accompany capital controls (possibly the bias of the word “control” itself), the impossible trinity requires that capital flows be controlled if a country wishes to maintain a fixed exchange rate and an independent monetary policy.

Chapter 3 The Balance of Payments 19

23. Capital Controls. Which do most countries control, capital inflows or capital outflows? Why?

Although the fear of major government policy makers is often the flight of capital, capital outflows, massive capital inflows are often considered potentially more disruptive if not managed correctly. As a result, most countries are slow and careful to deregulate capital inflows, allowing them more control over what kinds of capital over what periods of time enter the country. If regulated on entry, they are typically easier to regulate on exit.

24. Globalization and Capital Mobility. How does capital mobility typically differ between

industrialized countries and emerging market countries?

Emerging market countries, by definition, have relatively small and undeveloped financial systems and sectors. Outside of some potential foreign direct investment opportunities, they offer few choices for capital to flow in of substance. Industrialized countries, however, typically have large and sophisticated financial sectors that offer a multitude of financial investment options and assets, which on occasion may attract large capital inflows (and in other periods, may suffer large capital outflows).

CHAPTER 4

FINANCIAL GOALS AND CORPORATE GOVERNANCE

1. Business Ownership. What are the predominant ownership forms in global business?

Business ownership can first be divided between state ownership and private ownership. State ownership, public ownership, is probably the largest globally. Private ownership, where a business is owned by an individual, partners, a family, or a collection of private investors, is business that is owned generally for more singular purposes like profit.

2. Business Control. How does ownership alter the control of a business organization? Is the control of

a private firm that different from a publicly traded company?

Privately controlled companies—a single individual or family—is often characterized by top-down control, where the owner is active in more of the daily strategic and operational decisions made in the firm. The publicly traded firm, where management acts as an agent of the owner, often has more decentralized decision making and may use more consensus based direction.

3. Separation of Ownership and Management. Why is this separation so critical to the understanding

of how businesses are structured and led?

The field of agency theory is the study of how shareholders can motivate management to accept the prescriptions of the Shareholder Wealth Maximization (SWM) model. For example, liberal use of stock options should encourage management to think like shareholders. Whether these inducements succeed is open to debate. However, if management deviates too much from SWM objectives of working to maximize the returns to the shareholders, the board of directors should replace them. In cases where the board is too weak or ingrown to take this action, the discipline of the equity markets could do it through a takeover. This discipline is made possible by the one-share, one-vote rule that exists in most Anglo-American markets.

4. Corporate Goals: Shareholder Wealth Maximization. Explain the assumptions and objectives of

the shareholder wealth maximization model.

The Anglo-American markets are characterized by a philosophy that a firm’s objective should be to maximize shareholder wealth. Anglo-American is defined to mean the United States, United Kingdom, Canada, Australia, and New Zealand. This theory assumes that the firm should strive to maximize the return to shareholders—those individuals owning equity shares in the firm, as measured by the sum of capital gains and dividends, for a given level of risk. This in turn implies that management should always attempt to minimize the risk to shareholders for a given rate of return.

5. Corporate Goals: Stakeholder Capitalism Maximization (SCM). Explain the assumptions and

objectives of the stakeholder capitalization model.

Continental European and Japanese markets are characterized by a philosophy that all of a corporation’s stakeholders should be considered and the objective should be to maximize corporate wealth. Thus, a firm should treat shareholders on a par with other corporate stakeholders, such as management, labor, the local community, suppliers, creditors, and even the government. The goal is

Chapter 4 Financial Goals and Corporate Governance 21

to earn as much as possible in the long run, but to retain enough to increase the corporate wealth for the benefit of all. This model has also been labeled the stakeholder capitalism model.

6. Management’s Time Horizon. Do shareholder wealth maximization and stakeholder capitalism have

the same time-horizon for the strategic, managerial, and financial objectives of the firm? How do they differ?

Companies pursuing shareholder returns, particularly publicly traded firms, have a very short time horizon for financial results. The 90-day time interval, the quarterly result, is a very short period for companies to continually demonstrate the success or failure of corporate strategy and operational execution. Stakeholder capitalist firms, firms pursuing a complex combination of goals and services for a variety of stakeholders, may have a consistently longer time horizon.

7. Operational Goals. What should be the primary operational goal of an MNE?

Financial goals differ from strategic goals in that the former focus on money and wealth (such as the present value of expected future cash flows). Strategic goals are more qualitative-operating objectives, such as growth rates and/or share-of-market goals.

Trident’s strategic goals are the setting of such objectives as degree of global scope and depth of operations. In what countries should the firm operate? What products should be made in each country? Should the firm integrate its international operations or have each foreign subsidiary operate more or less on its own? Should it manufacture abroad through wholly owned subsidiaries, through joint ventures, or through licensing other companies to make its products? Of course, successful implementation of these several strategic goals is undertaken as a means to benefit shareholders and/or other stakeholders.

Trident’s financial goals are to maximize shareholder wealth relative to a risk constraint and in consideration of the long-term life of the firm and the long-term wealth of shareholders. In other words, wealth maximization does not mean short-term pushing up share prices so executives can execute their options before the company crashes—a consideration that must be made in the light of the Enron scandals.

8. Financial Returns. How do shareholders in a publicly traded firm actually reap cash flow returns

from their ownership? Who has control over which of these returns?

The return to a shareholder in a publicly traded firm combines current income in the form of dividends and capital gains from the appreciation of share price:

2 2 1

1 1

ShareholderReturn −

= + D P P P P

where the initial price, P1, is equivalent to the initial investment by the shareholder, and P2 is the price of the share at the end of period. The shareholder theoretically receives income from both components. For example, duirng the past 60 years in the U.S. marketplace, a diversified investor may have received a total average annual return of 14%, split roughly between dividends, 2%, and capital gains, 12%.

Management generally believes it has the most direct influence over the first component, the dividend yield. Management makes strategic and operational decisions, which grow sales and generate profits,

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and then distributes those profits to ownership in the form of dividends. Capital gains, the change in the share price as traded in the equity markets, is much more complex and reflects many forces that are not in the direct control of management. Despite growing market share, profits, or any other traditional measure of business success, the market may not reward these actions directly with share price appreciation.

A privately held firm has a much simpler shareholder return objective function: maximize current and sustainable income. The privately held firm does not have a share price (it does have a value, but this is not a definitive market-determined value in the way in which we believe markets work). It therefore simply focuses on generating current income, dividend income, to generate the returns to its ownership. If the privately held ownership is a family, the family may also place a great emphasis on the ability to sustain those earnings over time while maintaining a slower rate of growth that can be managed by the family itself.

9. Dividend Returns. Are dividends really all that important to investors in publicly traded companies?

Aren’t capital gains really the point or objective of the investor?

Although on average over the past century in the U.S. capital markets capital gains are larger than dividend income, dividend income is considered much more stable and more reliable than capital gains. As a result, different investors view dividends versus capital gains differently. Investors looking for regular current period income may be attracted to high dividend yielding equities.

10. Ownership Hybrids. What is a hybrid? How may it be managed differently?

Many firms around the world are both publicly traded but privately controlled. This is typical of family-owned businesses that have gone public but the family retains controlling interest in the firm. Because private/family ownership generally has a longer time horizon than publicly traded firms, these firms may behave more like private firms, being more “patient” in terms of seeing the financial and operational results of corporate investment and strategy.

11. Corporate Governance. Define corporate governance and the various stakeholders involved in

corporate governance. What is the difference between internal and external governance?

Corporate governance is the control of the firm. It is a broad operation concerned with choosing the board of directors and with setting the long run objectives of the firm. This means managing the relationship between various stakeholders in the context of determining and controlling the strategic direction and performance of the organization. Corporate governance is the process of ensuring that managers make decisions in line with the stated objectives of the firm.

Management of the firm concerns implementation of the stated objectives of the firm by professional managers employed by the firm. In theory, managers are the employees of the shareholders and can be hired or fired as the shareholders, acting through their elected board, may decide. Ownership of the firm is that group of individuals and institutions that own shares of stock and that elected the board of directors.

The governance of all firms is a combination of internal and external. Internal governance comes from the corporate board and the senior executive management team. External governance is exercised by all external stakeholders of the firm—the equity markets, debt markets, exchanges, regulatory bodies of all kinds, auditors, and legal service providers.

12. Governance Regimes. What are the four major types of governance regimes and how do they differ?

Chapter 4 Financial Goals and Corporate Governance 23

The four major corporate governance regimes are (1) market-based, characterized by dispersed ownership and a separation of ownership from management; (2) family-based, where ownership and management are often combined; (3) bank-based, where government frequently controls bank lending practices, restricting the growth rate of industry, and sometimes combined control between family and government; and (4) government affiliated, where government exclusively directs business activity with little minority interest or influence. Exhibit 4.6 details the four regimes as well as providing a sampling of representative countries characterized by these regimes.

13. Governance Development Drivers. What are the primary drivers of corporate governance across the

globe? Is the relative weight or importance of some drivers increasing over others?

Changes in corporate governance principles and practices globally have had four major drivers: (1) the financial market development; (2) the degree of separation between management and ownership; (3) the concept of disclosure and transparency; and (4) the historical development of the legal system.

14. Good Governance Value. Does good governance have a “value” in the marketplace? Do investors

really reward good governance, or does good governance just attract a specific segment of investors?

This is basically a rhetorical question for student discussion. There have been a number of studies, for example by McKinsey, as to what premium—if any—that institutional investors would be willing to pay for companies with good governance within specific country-markets. The results indicate in certain circumstances the market may be willing to pay a small premium, but in general, the results to date have been unconvincing.

15. Shareholder Dissatisfaction. What alternative actions can shareholders take if they are dissatisfied

with their company? Disgruntled shareholders may do the following:

a. Remain quietly disgruntled. This puts no pressure on management to change its ways under both the Shareholder Wealth Maximization (SWM) model and the Corporate Wealth Maximization (CWM) model.

b. Sell their shares. Under the SWM model, this action (if undertaken by a significant number of

shareholders) drives down share prices, making the firm an easier candidate for takeover and the probable loss of jobs among the former managers. Under the CWM model, management can more easily ignore any drop in share prices.

c. Change management. Under the one-share, one-vote procedures of the SWM model, a concerted

group of shareholders can vote out existing board members if they fail to change management practices. This usually takes the form of the board firing the firm’s president or chief operating officer. Cumulative voting, which is a common attribute of SWM firms, facilitates the placing of minority stockholder representation on the board. If, under the CWM model, different groups of shareholders have voting power greater than their proportionate ownership of the company, ousting of directors and managers is more difficult.

d. Initiate a takeover. Under the SWM model, it is possible to accumulate sufficient shares to take

control of a company. This is usually done by a firm seeking to acquire the target firm making a tender offer for a sufficient number of shares to acquire a majority position on the board of directors. Under the CWM model, acquisition of sufficient shares to bring about a takeover is

24 Eiteman/Stonehill/Moffett | Multinational Business Finance, 14th Edition

much more difficult, in part because nonshareholder stakeholder wishes are considered in any board action. (One can argue as to whether the long-run interests of nonshareholding stakeholders are served by near-term avoidance of unsettling actions.) Moreover, many firms have disproportionate voting rights because of multiple classes of stock, thus allowing entrenched management to remain.

16. Emerging Markets Corporate Governance Failures. It has been claimed that failures in corporate

governance have hampered the growth and profitability of some prominent firms located in emerging markets. What are some typical causes of these failures in corporate governance?

Causes include lack of transparency, poor auditing standards, cronyism, insider boards of directors (especially among family-owned and operated firms), and weak judicial systems.

17. Emerging Markets Corporate Governance Improvements. In recent years, emerging-market

MNEs have improved their corporate governance policies and become more shareholder-friendly. What do you think is driving this phenomenon?

It is driven by the need to access global capital markets. The depth and breadth of capital markets is critical to growth. Country markets that have had relatively slow growth or have industrialized rapidly utilizing neighboring capital markets, may not form large public equity market systems. Without significant public trading of ownership shares, high concentrations of ownership are preserved and few disciplined processes of governance developed.

CHAPTER 5

THE FOREIGN EXCHANGE MARKET

1. Definitions. Define the following terms:

a. Foreign exchange market. The foreign exchange market provides the physical and institutional structure through which the money of one country is exchanged for that of another country, the rate of exchange between currencies is determined, and foreign exchange transactions are physically completed .

b. Foreign exchange transaction. A foreign exchange transaction is an agreement between a buyer

and seller that a fixed amount of one currency will be delivered for some other currency at a specified rate.

c. Foreign exchange. Foreign exchange means the money of a foreign country; that is, foreign

currency bank balances, bank notes, checks, and drafts. 2. Functions of the Foreign Exchange Market. What are the three major functions of the foreign

exchange market?

To transfer purchasing power from one country and its currency to another. Typical parties would be importers and exporters, investors in foreign securities, and tourists.

To finance goods in transit. Typical parties would be importers and exporters.

To provide hedging facilities. Typical parties would be importers, exporters, and creditors and

debtors with short-term monetary obligations. 3. Structure of the FX Market. How is the global foreign exchange market structured? Is digital

telecommunications replacing people?

One of the biggest changes in the foreign exchange market in the past decade has been its shift from a two-tier market (the interbank or wholesale market and the client or retail market) to a single-tier market. Electronic platforms and the development of sophisticated trading algorithms have facilitated market access by traders of all kinds and sizes.

Participants in the foreign exchange market can be simplistically divided into two major groups: those trading currency for commercial purposes, liquidity seekers, and those trading for profit, profit seekers. Although the foreign exchange market began as a market for liquidity purposes, facilitating the exchange of currency for the conduct of commercial trade and investment purposes, the exceptional growth in the market has been largely based on the expansion of profit-seeking agents. As might be expected, the profit seekers are typically much better informed about the market, looking to profit from its future movements, while liquidity seekers simply wish to secure currency for transactions. As a result, the profit seekers generally profit from the liquidity seekers.

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4. Market Participants. For each of the foreign exchange market participants, identify their motive for buying or selling foreign exchange.

Foreign exchange dealers are banks and a few nonbank institutions that “make a market” in

foreign exchange. They buy and sell foreign exchange in the wholesale market and resell or rebuy it from customers at a slight change from the wholesale price.

Foreign exchange brokers (not to be confused with dealers) act as intermediaries in bringing

dealers together, either because the dealers do not want their identity revealed until after the transaction or because the dealers find that brokers and “shop the market,” i.e., scan the bid and offer prices of many dealers very quickly.

Individuals and firms conducting international business consist primarily of three categories:

importers and exporters, companies making direct foreign investments, and securities investors buying or selling debt or equity investments for their portfolios.

Speculators and arbitragers buy and sell foreign exchange for profit. Speculators and arbitragers

buy or sell foreign exchange on the basis of which direction they believe a currency’s value will change in the immediate or speculative horizon.

Central banks and treasuries buy and sell foreign exchange for several purposes, but most

importantly, for intervention in the marketplace. Direct intervention, in which the central bank will buy (sell) its own currency in the market with its foreign exchange reserves to push its value up (down), is a very common activity by government treasuries and central banking authorities.

5. Foreign Exchange Transaction. Define each of the following types of foreign exchange

transactions: a. Spot. A spot transaction is an agreement between two parties to exchange one currency for

another, with the transaction being carried out at once for commercial customers and on the second following business day for most interbank (i.e., wholesale) trades.

b. Outright forward. A forward transaction is an agreement made today to exchange one currency

for another, with the date of the exchange being a specified time in the future—often one month, two months, or some other definitive calendar interval. The rate at which the two currencies will be exchanged is set today.

c. Forward-forward swaps. A more sophisticated swap transaction is called a “forward-forward”

swap. A dealer sells £20,000,000 forward for dollars for delivery in, say, two months at $1.6870/£ and simultaneously buys £20,000,000 forward for delivery in three months at $1.6820/£. The difference between the buying price and the selling price is equivalent to the interest rate differential, i.e., interest rate parity, between the two currencies. Thus, a swap can be viewed as a technique for borrowing another currency on a fully collateralized basis.

6. Swap Transactions. Define and differentiate the different type of swap transactions in the foreign

exchange markets.

A swap transaction in the interbank market is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates. Both purchase and sale are conducted with the same counterparty. There are several types of swap transactions.

Chapter 5 The Foreign Exchange Market 27

Spot Against Forward. The most common type of swap is a “spot against forward.” The dealer buys a currency in the spot market (at the spot rate) and simultaneously sells the same amount back to the same bank in the forward market (at the forward exchange rate). Because this is executed as a single transaction, with just one counterparty, the dealer incurs no unexpected foreign exchange risk. Swap transactions and outright forwards combined made up more than half of all foreign exchange market activity in recent years.

Forward-Forward Swaps. A more sophisticated swap transaction is called a forward-forward swap. For example, a dealer sells £20,000,000 forward for dollars for delivery in, say, two months at $1.8420/£ and simultaneously buys £20,000,000 forward for delivery in three months at $1.8400/£. The difference between the buying price and the selling price is equivalent to the interest rate differential, which is the interest rate parity described in Chapter 6, between the two currencies. Thus, a swap can be viewed as a technique for borrowing another currency on a fully collateralized basis.

Nondeliverable Forwards (NDFs). Created in the early 1990s, the nondeliverable forward (NDF) is now a relatively common derivative offered by the largest providers of foreign exchange derivatives. NDFs possess the same characteristics and documentation requirements as traditional forward contracts, except that they are settled only in U.S. dollars; the foreign currency being sold forward or bought forward is not delivered.

7. Nondeliverable Forward. What is a nondeliverable forward, and why does it exist?

The nondeliverable forward (NDF) is now a relatively common derivative offered by the largest providers of foreign exchange derivatives. NDFs possess the same characteristics and documentation requirements as traditional forward contracts, except that they are settled only in U.S. dollars; the foreign currency being sold forward or bought forward is not delivered.

The dollar-settlement feature reflects the fact that NDFs are contracted offshore, for example in New York for a Mexican investor, and so are beyond the reach and regulatory frameworks of the home country governments (Mexico in this case). NDFs are traded internationally using standards set by the International Swaps and Derivatives Association (ISDA). Although originally envisioned to be a method of currency hedging, it is now estimated that more than 70% of all NDF trading is for speculation purposes.

8. Foreign Exchange Market Characteristics. With reference to foreign exchange turnover in 2010: a. Rank the relative size of spot, forwards, and swaps as of 2007. Ranking: 1. Swaps; 2. Spot;

3. Forwards b. Rank the five most important geographic locations for foreign exchange turnover. Ranking:

1. United Kingdom; 2. United States; 3. Singapore (just barely passing Japan); 4. Japan (used to be third); 5. Hong Kong (rising rapidly)

c. Rank the three most important currencies of denomination. Ranking: 1. U.S. dollar; 2. European

euro; 3. Japanese yen 9. Foreign Exchange Rate Quotations. Define and give an example of each of the following quotes: a. Bid rate quote. b. Ask rate quote.

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Interbank quotations are given as a bid and ask (also referred to as offer). A bid is the price (i.e., exchange rate) in one currency at which a dealer will buy another currency. An ask is the price (i.e., exchange rate) at which a dealer will sell the other currency. Dealers bid (buy) at one price and ask (sell) at a slightly higher price, making their profit from the spread between the buying and selling prices.

Bid and ask quotations in the foreign exchange markets are superficially complicated by the fact that the bid for one currency is also the offer for the opposite currency. A trader seeking to buy dollars with Swiss francs is simultaneously offering to sell Swiss francs for dollars. Assume a bank makes the quotations shown in the top half of Exhibit 6.5 for the Japanese yen. The spot quotations on the first line indicate that the bank’s foreign exchange trader will buy dollars (i.e., sell Japanese yen) at the bid price of ¥118.27 per dollar. The trader will sell dollars (i.e., buy Japanese yen) at the ask price of ¥118.37 per dollar.

10. Reciprocals. Convert the following indirect quotes to direct quotes and direct quotes to indirect

quotes: a. Euro: €1.22/$ (indirect quote); 1/1.22 = $0.8197/€ (direct) b. Russia: Rub 30/$ (indirect quote); 1/30 = $0.0333/Rub (direct) c. Canada: $0.72/C$ (direct quote); 1/0.72 = C$1.3889/$ (indirect) d. Denmark: $0.1644/DKr (direct quote); 1/0.1644 = Dkr 6.0827/$ (indirect) 11. Geographical Extent of the Foreign Exchange Market. a. What is the geographical location? All countries. b. What are the two main types of trading systems? (1) Trading on an exchange or exchange floor

and (2) telecommunications linkages. c. How are foreign exchange markets connected for trading activities? Telecommunications

linkages. 12. American and European Terms. With reference to interbank quotations, what is the difference

between American terms and European terms?

Most foreign currencies in the world are stated in terms of the number of units of foreign currency needed to buy one dollar. For example, the exchange rate between U.S. dollars and Swiss franc is normally stated

SF1.6000/$, read as “1.6000 Swiss francs per dollar”

This method, called European terms, expresses the rate as the foreign currency price of one U.S. dollar. An alternative method is called American terms. The same exchange rate above expressed in American terms is

$0.6250/SF, read as “0.6250 dollars per Swiss franc”

Chapter 5 The Foreign Exchange Market 29

Under American terms, foreign exchange rates are stated as the U.S. dollar price of one unit of foreign currency. Note that European terms and American terms are reciprocals:

1 USD 0.6250 / SF

SF1.60000 / USD =

With several exceptions, including two important ones, most interbank quotations around the world

are stated in European terms. Thus, throughout the world the normal way of quoting the relationship between the Swiss franc and U.S. dollar is SF1.6000/$; this method may also be called “Swiss terms.” A Japanese yen quote of ¥118.32/$ is called “Japanese terms,” although the expression “European terms” is often used as the generic name for Asian as well as European currency prices of the dollar. European terms were adopted as the universal way of expressing foreign exchange rates for most (but not all) currencies in 1978 to facilitate worldwide trading through telecommunications

13. Direct and Indirect Quotes. Define and give an example of the following: a. An example of a direct quote between the U.S. dollar and the Mexican peso, where the United

States is designated as the home country.

A direct quote is a home currency price of a unit of foreign currency. An example, using Mexico and the United States (home country) is $0.1050/Peso.

b. An example of an indirect quote between the Japanese yen and the Chinese renminbi (yuan),

where China is designated as the home country.

An indirect quote is a foreign currency price of a unit of home currency. An example, using Japan and China (home country) is ¥14.75/Rmb.

14. Base and Price Currency. Define base currency, unit currency, price currency, and quote currency.

Foreign exchange quotations follow a number of principles, which at first may seem a bit confusing or nonintuitive. Every currency exchange involves two currencies, currency 1 (CUR1) and currency 2 (CUR2):

CUR1/CUR2

The currency to the left of the slash is called the base currency or the unit currency. The currency to the right of the slash is called the price currency or quote currency. The quotation always indicates the number of units of the price currency, CUR2, required in exchange for receiving one unit of the base currency, CUR1.

For example, the most commonly quoted currency exchange is that between the U.S. dollar and the European euro. For example, a quotation of

EUR/USD 1.2174

designates the euro (EUR) as the base currency, the dollar (USD) as the price currency, and the exchange rate is If you can remember that the currency quoted on the left of the slash is always the base currency, and always a single unit, you can avoid confusion. Exhibit 5.6 provides a brief

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overview of the multitude of terms often used around the world to quote currencies through an example using the European euro and U.S. dollar.

15. Cross Rates and Intermarket Arbitrage. Why are cross currency rates of special interest when

discussing intermarket arbitrage?

Because many currencies are traded in volume against a single other currency, cross rates can be used to check on opportunities for intermarket arbitrage. These arbitrage opportunities arise when a currency like the Mexican peso, which is traded heavily against the U.S. dollar, may have profit opportunities arise when the dollar rises or falls against a third currency like the Brazilian real or the Chilean peso, which are also traded against the Mexican peso.

16. Percentage Change in Exchange Rates. Why do percentage change calculations end up being rather

confusing on occasion?

Unlike the price of a share of stock or an orange, an exchange rate is the price of one money in terms of a second money. Confusion occasionally arises when looking at a commonly quoted exchange rate like the number of Mexican pesos to exchange for one dollar. If that rate has changed from 10 to 11, the percentage change can be calculated either of two ways.

Foreign Currency Terms. When the foreign currency price (the price, Ps) of the home currency (the unit, $) is used, Mexican pesos per U.S. dollar in this case, the formula for the percent change (%Δ) in the foreign currency becomes

Beginning Rate Ending Rate 10.00 / $ 11.00 / $ % 100 100 9.09%

Ending Rate 11.00 / $ − =

Δ = × = × = − Ps Ps

The Mexican peso fell in value 9.09% against the dollar. Note that it takes more pesos per dollar,

and the calculation resulted in a negative value, both characteristics of a fall in value.

Home Currency Terms. When the home currency price (the price) for a foreign currency (the unit) is used – the reciprocals of the numbers above – the formula for the percent change in the foreign currency is:

Beginning Rate Ending Rate $0.09091 / $0.1000 / % 100 100 9.09%

Ending Rate $0.1000 / − =

Δ = × = × = − Ps Ps

The calculation yields the identical percentage change, a fall in the value of the peso by 9.09%.

Although many people find the second calculation, the home currency term calculation, to be the more “intuitive” because it reminds them of many percentage change calculations, one must be careful to remember that these are exchanges of currency for currency, and the currency that is designated as home currency is significant.

CHAPTER 6

INTERNATIONAL PARITY CONDITIONS

1. Law of One Price. Define the law of one price carefully, noting its fundamental assumptions. Why are these assumptions so difficult to find in the real world in order to apply the theory?

If identical products or services can be sold in two different markets, and no restrictions exist on the sale or transportation of product between markets, the product’s price should be the same in both markets. This is called the law of one price.

A primary principle of competitive markets is that prices will equalize across markets if frictions or costs of moving the products or services between markets do not exist. If the two markets are in two different countries, the product’s price may be stated in different currency terms, but the price of the product should still be the same. Comparing prices would require only a conversion from one currency to the other. For example,

$ ¥ ,× =P S P

where the price of the product in U.S. dollars, P$, multiplied by the spot exchange rate (S, yen per U.S. dollar), equals the price of the product in Japanese yen, P¥. Conversely, if the prices of the two products were stated in local currencies, and markets were efficient at competing away a higher price in one market relative to the other, the exchange rate could be deduced from the relative local product prices:

$= P

S P

The challenge in applying the theory in the real world is that few products exist that are truly identical

across markets, and if they are identical, are truly “transportable” across markets with nearly zero transportation costs and fees.

2. Purchasing Power Parity. Define the following terms: a. The law of one price. The law of one prices states that producers’ prices for goods or services of

identical quality should be the same in different markets; i.e., different countries (assuming no restrictions on the sale and allowing for transportation costs). If a country has higher inflation than other countries, its currency should devalue or depreciate so that the real price remains the same as in all countries. Application of this law results in the theory of purchasing power parity (PPP).

b. Absolute purchasing power parity. If the law of one price were true for all goods and services,

the purchasing power parity (PPP) exchange rate could be found from any individual set of prices. By comparing the prices of identical products denominated in different currencies, one could determine the “real” or PPP exchange rate which should exist if markets were efficient. This is the absolute version of the theory of purchasing power parity. Absolute PPP states that the spot exchange rate is determined by the relative prices of similar baskets of goods.

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c. Relative purchasing power parity. If the assumptions of the absolute version of PPP theory are

relaxed a bit more, we observe what is termed relative purchasing power parity. This more general idea is that PPP is not particularly helpful in determining what the spot rate is today, but that the relative change in prices between two countries over a period of time determines the change in the exchange rate over that period. More specifically, if the spot exchange rate between two countries starts in equilibrium, any change in the differential rate of inflation between them tends to be offset over the long run by an equal but opposite change in the spot exchange rate.

3. Big Mac Index. How close does the Big Mac Index conform to the theoretical requirements for a one

price measurement of purchasing power parity?

The Big Mac may be a good candidate for the application of the law of one price and measurement of under or overvaluation for a number of reasons. First, the product itself is nearly identical in each market. This is the result of product consistency, process excellence, and McDonald’s brand image and pride. Second, and just as important, the product is a result of predominantly local materials and input costs. This means that its price in each country is representative of domestic costs and prices and not imported ones, which would be influenced by exchange rates themselves. The index, however, still possesses limitations. Big Macs cannot be traded across borders, and costs and prices are influenced by a variety of other factors in each country market, such as real estate rental rates and taxes.

4. Undervaluation and Purchasing Power Parity. According to the theory of purchasing power parity,

what should happen to a currency which is undervalued?

Theoretically, if the currency is undervalued then market participants, in search of potential profits, will continue to purchase the currency until they drive its price up eliminating the undervaluation.

5. Nominal Effective Exchange Rate Index. Explain how a nominal effective exchange rate index is

constructed.

An exchange rate index is an index that measures the value of a given country’s exchange rate against all other exchange rates in order to determine if that currency is overvalued or undervalued. A nominal effective exchange rate index is based on a weighted average of actual exchange rates over a period of time. It is unrelated to PPP and simply measures changes in the exchange rate (i.e., currency value) relative to some arbitrary base period. It is used in calculating the real effective exchange rate index.

6. Real Effective Exchange Rate Index. What formula is used to convert a nominal effective exchange

rate index into a real effective exchange rate index?

A real effective exchange rate index adjusts the nominal effective exchange rate index to reflect differences in inflation. The adjustment is achieved by multiplying the nominal index by the ratio of domestic costs to foreign costs. The real index measures deviation from purchasing power parity and, consequently, pressures on a country’s current account and foreign exchange rate.

Chapter 6 International Parity Conditions 33

The real effective exchange rate index for the U.S. dollar, E$R, is found by multiplying the nominal effective exchange rate index, E$N, by the ratio of U.S. dollar costs, C$, over foreign currency costs, CFC, both in index form:

$ $ $= ×R N FC

C E E

7. Exchange Rate Pass-Through. Incomplete exchange rate pass-through is one reason that a

country’s real effective exchange rate can deviate for lengthy periods from its purchasing power equilibrium level of 100. What is meant by the term exchange rate pass-through?

Incomplete exchange rate pass-through is one reason that a country’s real effective exchange rate index can deviate for lengthy periods from its PPP-equilibrium level of 100. The degree to which the prices of imported and exported goods change as a result of exchange rate changes is termed pass- through. Although PPP implies that all exchange rate changes are passed through by equivalent changes in prices to trading partners, empirical research in the 1980s questioned this long-held assumption. For example, sizable current account deficits of the United States in the 1980s and 1990s did not respond to changes in the value of the dollar.

8. Partial Exchange Rate Pass-Through. What is partial exchange rate pass-through, and how can it

occur in efficient global markets?

Partial pass-through is when prices of imported products rise by less than the full percentage change in the imported product’s currency. Many times an exporter that finds its price has risen in target foreign markets as a result of the exporter’s currency appreciating will attempt to keep the price from rising in the target market by as much as the exchange rate change, wishing to not lose sales as a result of the price increase. This means that the exporter, if not changing their cost structure, is earning a smaller margin on the sale.

9. Price Elasticity of Demand. How is the price elasticity of demand relevant to exchange rate pass-

through?

The concept of price elasticity of demand is useful when determining the desired level of pass- through. Recall that the price elasticity of demand for any good is the percentage change in quantity of the good demanded as a result of the percentage change in the good’s price:

% Price elasticity of demand

% Δ

= = Δ

d p

Q e

where Qd is quantity demanded and P is product price. If the absolute value of ep is less than 1.0, then

the good is relatively “inelastic.” If it is greater than 1.0, the good is relatively “elastic.”

A German product that is relatively price-inelastic, meaning that the quantity demanded is relatively unresponsive to price changes, may often demonstrate a high degree of pass-through. This is because a higher dollar price in the U.S. market would have little noticeable effect on the quantity of the product demanded by consumers. Dollar revenue would increase, but euro revenue would remain the same.

However, products that are relatively price-elastic would respond in the opposite way. If the 20% euro appreciation resulted in 20% higher dollar prices, U.S. consumers would decrease the number of

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BMWs purchased. If the price elasticity of demand for BMWs in the United States were greater than one, total dollar sales revenue of BMWs would decline.

10. The Fisher Effect. Define the Fisher effect. To what extent do empirical test confirm that the Fisher

effect exists in practice?

The Fisher effect, named after economist Irving Fisher, states that nominal interest rates in each country are equal to the required real rate of return plus compensation for expected inflation. More formally, this is derived from (1 + r)(1 + π) – 1:

π π= + +i r r where i is the nominal rate of interest, r is the real rate of interest, and π is the expected rate of

inflation over the period of time for which funds are to be lent. 11. Approximate Form of Fisher Effect.

The final compound term, r times π, is frequently dropped from consideration due to its relatively minor value. The Fisher effect then reduces to (approximate form):

π= +i r The Fisher effect applied to two different countries like the United States and Japan would be:

$ $ $ ¥ ¥ ¥;π π= + = +i r i r where the superscripts $ and ¥ pertain to the respective nominal (i), real (r), and expected inflation (π)

components of financial instruments denominated in dollars and yen, respectively. We need to forecast the future rate of inflation, not what inflation has been. Predicting the future can be difficult.

12. The International Fisher Effect. Define the international Fisher effect. To what extent do empirical

tests confirm that the international Fisher effect exists in practice?

Irving Fisher stated that the spot exchange rate should change in an equal amount but opposite in direction to the difference in nominal interest rates. Stated differently, the real return in different countries should be the same, so that if one country has a higher nominal interest rate, the gain from investing in that currency will be lost by a deterioration of its exchange rate.

The relationship between the percentage change in the spot exchange rate over time and the differential between comparable interest rates in different national capital markets is known as the international Fisher effect. “Fisher-open,” as it is often termed, states that the spot exchange rate should change in an equal amount but in the opposite direction to the difference in interest rates between two countries. More formally:

$ ¥1 2

100 −

× = − S S

i i S

where i$ and i¥ are the respective national interest rates, and S is the spot exchange rate using indirect

quotes (an indirect quote on the dollar is, for example, ¥/$) at the beginning of the period (S1) and the

Chapter 6 International Parity Conditions 35

end of the period (S2). This is the approximation form commonly used in industry. The precise formulation is:

$ ¥

1 2 ¥

2 1 − −

= +

S S i i S i

Empirical tests using ex-post national inflation rates have shown the Fisher effect usually exists for

short-maturity government securities, such as treasury bills and notes. Comparisons based on longer maturities suffer from the increased financial risk inherent in fluctuations of the market value of the bonds prior to maturity. Comparisons of private sector securities are influenced by unequal creditworthiness of the issuers. All the tests are inconclusive to the extent that recent past rates of inflation are not a correct measure of future expected inflation.

13. Interest Rate Parity. Define interest rate parity. What is the relationship between interest rate parity

and forward rates?

The theory of interest rate parity (IRP) provides the linkage between the foreign exchange markets and the international money markets. The theory states: The difference in the national interest rates for securities of similar risk and maturity should be equal to, but opposite in sign to, the forward rate discount or premium for the foreign currency, except for transaction costs.

14. Covered Interest Arbitrage. Define the terms covered interest arbitrage and uncovered interest

arbitrage. What is the difference between these two transactions?

The spot and forward exchange markets are not, however, constantly in the state of equilibrium described by interest rate parity. When the market is not in equilibrium, the potential for “riskless” or arbitrage profit exists. The arbitrager who recognizes such an imbalance will move to take advantage of the disequilibrium by investing in whichever currency offers the higher return on a covered basis. This is called covered interest arbitrage (CIA).

15. Uncovered Interest Arbitrage. Define uncovered interest arbitrage and explain what expectations an

investor or speculator would need to undertake an uncovered interest arbitrage investment?

A deviation from covered interest arbitrage is uncovered interest arbitrage (UIA), wherein investors borrow in countries and currencies exhibiting relatively low interest rates and convert the proceeds into currencies that offer much higher interest rates. The transaction is “uncovered” because the investor does not sell the higher yielding currency proceeds forward, choosing to remain uncovered and accept the currency risk of exchanging the higher yield currency into the lower yielding currency at the end of the period. Exhibit 6.8 demonstrates the steps an uncovered interest arbitrager takes when undertaking what is termed the yen carry trade. Borrowing in the Japanese yen market has always been desirable as yen interest rates are frequently very low, Japanese banks— which are large—are frequently interested in lending to multinational companies, and the yen itself may hold its value for long periods of time.

16. Forward Rate Calculation. If someone you were working with argued that the current forward rate

quoted on a currency pair is the market’s expectation of where the future spot rate will end up, what would you say?

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This is a common misconception. The forward rate is a calculation, using three observable market rates: the spot exchange rate, the domestic interest rate, and the foreign interest rate. It is technically categorized as a foreign currency loan agreement by the financial institution, and the rate makes that evident. There is no “predictive” element in its calculation, although many people in the market commonly use it as a forecast. In fact, the forward rate has been repeatedly tested over time as to its forecasting accuracy, and it generally performs pretty well when forecasting out 30 to 90 days.

17. Forward Rate as an Unbiased Predictor of the Future Spot Rate. Some forecasters believe that

foreign exchange markets for the major floating currencies are “efficient” and forward exchange rates are unbiased predictors of future spot exchange rates. What is meant by “unbiased predictor” in terms of how the forward rate performs in estimating future spot exchange rates?

Some forecasters believe that foreign exchange markets for the major floating currencies are “efficient” and forward exchange rates are unbiased predictors of future spot exchange rates.

Exhibit 6.10 demonstrates the meaning of “unbiased prediction” in terms of how the forward rate performs in estimating future spot exchange rates. If the forward rate is an unbiased predictor of the future spot rate, the expected value of the future spot rate at time 2 equals the present forward rate for time 2 delivery, available now, E(S2) = F1.

Intuitively this means that the distribution of possible actual spot rates in the future is centered on the forward rate. The fact that it is an unbiased predictor, however, does not mean that the future spot rate will actually be equal to what the forward rate predicts. Unbiased prediction simply means that the forward rate will, on average, overestimate and underestimate the actual future spot rate in equal frequency and degree. The forward rate may, in fact, never actually equal the future spot rate.

The rationale for this relationship is based on the hypothesis that the foreign exchange market is reasonably efficient. Market efficiency assumes that (1) all relevant information is quickly reflected in both the spot and forward exchange markets, (2) transaction costs are low, and (3) instruments denominated in different currencies are perfect substitutes for one another.

18. Transaction Costs. If transaction costs for undertaking covered or uncovered interest arbitrage were

large, how do you think it would influence arbitrage activity?

It would result in large discrepancies between market rates and quotes, as a higher transaction cost would dissuade many arbitragers from making the trades for small amounts.

19. Carry Trade. The term carry trade is used quite frequently in the business press. What does it mean,

and what conditions and expectations do investors need to hold to undertake carry trade transactions?

The carry trade refers to borrowing in a low interest rate environment, for example Japan, and then investing the proceeds in a higher rate environment, say the Australian dollar, to earn the differential. It is a risky position in that if the debt currency (the yen in this case) were to appreciate in value during the period, the exchange rate change can easily wipe out all interest earnings returns. The borrower therefore needs to expect the borrowing currency’s value to remain relatively unchanged over the period (or even fall in value against the currency of the investment).

Chapter 6 International Parity Conditions 37

20. Market Efficiency. Many academics and professionals have tested the foreign exchange and interest rate markets to determine their efficiency. What have they concluded?

Tests of foreign exchange market efficiency conclude that either exchange market efficiency is untestable or, if it is testable, that the market is not efficient. The existence and success of foreign exchange forecasting services suggest that managers are willing to pay a price for forecast information even though they can use the forward rate as a forecast at no cost. The “cost” of buying this information is, in many circumstances, an “insurance premium” for financial managers who might get fired for using their own forecast, including forward rates, when that forecast proves incorrect.

CHAPTER 7

FOREIGN CURRENCY DERIVATIVES: FUTURES AND OPTIONS

1. Foreign Currency Futures. What is a foreign currency future?

A future is an exchange-traded contract calling for future delivery of a standard amount of foreign currency at a fixed time, place, and price. A future requires a mandatory delivery. The future is a standardized exchange-traded contract often used as an alternative to a forward foreign exchange agreement.

2. Futures Terminology. Explain the meaning and probable significance for international business of

the following contract specifications:

Specific-sized contract: Trading may be conducted only in preestablished multiples of currency units. This means that a firm wishing to hedge some aspect of its foreign exchange risk is not able to match the contract size with the size of the risk.

Standard method of stating exchange rates. Rates are stated in “American terms,” meaning the U.S. dollar value of the foreign currency, rather than in the more generally accepted “European terms,” meaning the foreign currency price of a U.S. dollar. This has no conceptual significance, although financial managers used to viewing exposure in European terms will find it necessary to convert to reciprocals.

Standard maturity date. All contracts mature at a preestablished date, being on the third Wednesday of eight specified months. This means that a firm wishing to use foreign exchange futures to cover exchange risk will not be able to match the contract maturity with the risk maturity.

Collateral and maintenance margins. An initial “margin,” meaning a cash deposit made at the time a futures contract is purchased, is required. This is an inconvenience to most firms doing international business because it means some of their cash is tied up in a unproductive manner. Forward contracts made through banks for existing business clients do not normally require an initial margin. A maintenance margin is also required, meaning that if the value of the contract is marked to market every day and if the existing margin on deposit falls below a mandatory percentage of the contract, additional margin must be deposited. This constitutes a big nuisance to a business firm because it must be prepared for a daily outflow of cash than cannot be anticipated. (Of course, on some days the cash flow would be in to the firm.)

Counterparty. All futures contracts are with the clearinghouse of the exchange where they are traded. Consequently a firm or individual engaged in buying or selling futures contracts need not worry about the credit risk of the opposite party.

3. Long and a Short. How do you use foreign currency futures to speculate on the exchange rate

movements, and what role do long and short positions play in that speculation?

Chapter 7 Foreign Currency Derivatives: Futures and Options 39

Short Positions. If a currency speculator believes that a foreign currency will fall in value versus the U.S. dollar (home currency) by a specific date, she could sell that date futures contract, taking a short position. By selling that date contract, the speculator locks in the right to sell the foreign currency at a set price—a price that the speculator believes would be higher than the spot rate in the market on that future date. Long Positions. If a currency speculator believes that a foreign currency will rise in value versus the home currency by a specific date, she should buy a specific future date future on the foreign currency. By buying a currency future, the speculator is locking in the price to buy the foreign currency, which the speculator expects to be higher in value at that date, therefore generating a profit.

4. Futures and Forwards. How do foreign currency futures and foreign currency forwards compare?

Foreign currency futures contracts differ from forward contracts in a number of important ways. Individuals find futures contracts useful for speculation because they usually do not have access to forward contracts. For businesses, futures contracts are often considered inefficient and burdensome because the futures position is marked to market on a daily basis over the life of the contract. Although this does not require the business to pay or receive cash daily, it does result in more frequent margin calls from its financial service providers than the business typically wants.

5. Puts and Calls. Define a put and call on the British pound sterling.

A put option on the British pound would give the holder—the buyer of the put option—the right but not the obligation to sell British pounds at a future date at a specific rate.

A call option on the British pound would give the holder—the buyer of the call option—the right

but not the obligation to buy British pounds at a future date at a specific rate. 6. Options versus Futures. Explain the difference between foreign currency options and futures and

when either might be most appropriately used.

An option is a contract giving the buyer the right but not the obligation to buy or sell a given amount of foreign exchange at a fixed price for a specified time period. A future is an exchange-traded contract calling for future delivery of a standard amount of foreign currency at a fixed time, place, and price.

The essence of the difference is that an option leaves the buyer with the choice of exercising or not exercising. The future requires a mandatory delivery. The future is a standardized exchange-traded contract often used as an alternative to a forward foreign exchange agreement.

7. Call Option Contract. You read that exchange-traded American call options on pounds sterling

having a strike price of 1.460 and a maturity of next March are now quoted at 3.67. What does this mean if you are a potential buyer?

If you buy such an option, you may, if you wish, order the writer (opposite party) of the option to deliver pounds sterling to you, and you will pay $1.460 for each pound. $1.460/£ is called the “strike price.” You have this right (this “option”) until next March, and for this right you will pay 3.67¢ per pound.

The information provided to you does not tell you the size of each option contract, which you would have to know from general experience or from asking your broker. The contract size for pounds

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sterling on the IMM is £62,500 per contract, meaning that the option will cost you £62,500 × $0.0367 = $2,293.75.

8. Premiums, Prices & Costs. What is the difference between the price of an option, the value of an

option, the premium on an option, and the cost of a foreign currency option?

They all mean the same thing. The price of an option is its premium, its cost, and its value. 9. Three Prices. What are the three different prices or “rates” integral to every foreign currency option

contract?

All currency options have three fundamental prices or rates: (1) the current spot rate;( 2) the chosen strike rate; and (3) the option premium.

10. Writing Options. Why would anyone write an option, knowing that the gain from receiving the

option premium is fixed but the loss if the underlying price goes in the wrong direction can be extremely large?

As with all options, what the holder gains, the writer loses, and vice versa. If the writer of a call option already owns the currency, the writer would be effectively “covered” if the option ends up being call against the writer. The writer, however, will still experience an opportunity loss, surrendering against the option the same currency that could have been sold for more in the open market.

From the option writer’s point of view, only two events can take place:

The option is not exercised. In this case, the writer gains the option premium and still has the

underlying stock.

The option is exercised. If the option writer owns the stock and the option is exercised, the option writer (1) gains the premium and (2) experiences only an opportunity cost loss. In other words, the loss is not a cash loss, but rather the opportunity cost loss of having foregone the potential of making even more profit had the underlying shares been sold at a more advantageous price. This is somewhat equivalent of having sold (call option writer) or bought (put option writer) at a price better than current market, only to have the market price move even further in a beneficial direction.

If the option writer does not own the underlying shares, the option is written “naked.” Only in this instance can the cash loss to the option writer be unlimited.

11. Decision Prices. Once an option has been purchased, only two prices or rates are part of the holder’s

decision making process. Which two and why?

Once an option has been purchased, the option premium is essentially a sunk cost that no longer drives any decision making. What matters after purchase is how the option strike rate is positioned in regard to the current spot rate. Then, depending on the expectations of the investor and the kind of option purchased, the option will be exercised if in-the-money.

12. Option Cash Flows and Time. The cash flows associated with a call option on euros by a U.S. dollar

based investor occur at different points in time. What are they and how much does the time element matter?

Chapter 7 Foreign Currency Derivatives: Futures and Options 41

The U.S. dollar investor purchases the option up-front. This is the initial up-front cash outlay for the option “right,” but also represents the total maximum loss. The buyer of an option cannot lose more than the cost of the option, the premium. Upon expiration or exercise, if the option is in the money the investor will exercise the option for profit and a cash settlement on the option. If the option is allowed to expire out-of-the-money, there is no secondary cash flow associated with the option. There is no cash exchange with expiration. The time between option purchase and maturity can be very short or very long, but the time value does not alter the value proposition or decision principles followed by the investor.

13. Option Valuation. The value of an option is stated to be the sum of its intrinsic value and its time

value. Explain what is meant by these terms.

Intrinsic value for a call option is the amount of gain that would be made today if the option were exercised today and the underlying shares sold immediately. For a put, intrinsic value is the amount of gain that would be made if the underlying shares were purchased today and delivered immediately against the option. Intrinsic value can be zero, as when the option is not worth exercising today. However, if a gain could be made by exercising the option today, the intrinsic value is positive because intrinsic value can never be less than what can be gained from an immediate exercise of the option. Note that gain is not the same as net profit because in all cases the option buyer has already paid the premium.

Time value of an option is related to what one will pay above intrinsic value because of the chance that between today and the maturity of the option intrinsic value will become positive (option with no intrinsic value) or greater than today (option having some positive intrinsic value today). In effect, intrinsic value is the worth of the speculative component of the option.

14. Time Value Deterioration. An option’s value declines over time, but it does not do it evenly.

Explain what that means for option valuation.

Option premiums deteriorate at an increasing rate as they approach expiration; they do not deteriorate linearly. In fact, the majority of the option premium— depending on the individual option— may be lost in the final one-third of the option’s life prior to maturity/expiration.

15. Option Values and Money. Options are often described as in-the-money, at-the-money, or out-of-

the-money. What does that mean and how is it determined?

If an option could currently be exercised for a profit it is in-the-money. If the current spot rate is the same as the option’s strike rate, it is at-the-money. If the option is not currently exercisable for a profit it is out-of-the-money.

16. Option Pricing and the Forward Rate. What is the relationship or link between the forward rate and

the foreign currency option premium?

Because foreign currency option premiums using the current spot exchange rate and both the domestic and foreign interest rate in their pricing, and those same three elements are the necessary components for calculation of the forward rate, foreign currency options have an implicit forward rate embedded in their pricing and valuation.

17. Option Deltas. What is an option delta? How does it change when the option is in-the-money, at-the-

money, or out-of-the-money?

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18. Historic Versus Implied Volatility. What is the difference between a historic volatility and an implied volatility?

Historic volatility is the standard deviation of daily spot rates as calculated over a historical period of time. It is observable, historical, data. Implied volatility is the estimation of the volatility that is “back-out” of an option price (premium) as a result of trading in the market.

CHAPTER 8

INTEREST RATE RISK AND SWAPS

1. Reference Rates. What is an interest “reference rate,” and how is it used to set rates for individual

borrowers?

A reference rate—for example, U.S. dollar LIBOR—is the rate of interest used in a standardized quotation, loan agreement, or financial derivative valuation. LIBOR, the London Interbank Offered Rate, is by far the most widely used and quoted.

2. My Word is My LIBOR. Why has LIBOR played such a central role in international business and

financial contracts? Why has this been questioned in recent debates over its value reported?

No single interest rate is more fundamental to the operation of the global financial markets than the London Interbank Offered Rate (LIBOR). But beginning as early as 2007, a number of participants in the interbank market on both sides of the Atlantic suspected that there was trouble with LIBOR. The three-month and six-month maturities are the most significant maturities due to their widespread use in various loan and derivative agreements, with the dollar and the euro being the most widely used currencies. The issues related to LIBOR have been increasingly complicated in recent years—beginning with the origin of the rates submitted by banks. First, rates are based on “estimated borrowing rates” to avoid reporting only actual transactions, as many banks may not conduct actual transactions in all maturities and currencies each day. As a result, the origin of the rate submitted by each bank becomes, to some degree, discretionary. Secondly, banks—specifically money-market and derivative traders within the banks—have a number of interests that may be impacted by borrowing costs reported by the bank that day. One such example can be found in the concerns of banks in the interbank market in September 2008, when the credit crisis was in full bloom. A bank reporting that other banks were demanding it pay a higher rate that day would, in effect, be self-reporting the market’s assessment that it was increasingly risky. In the words of one analyst, akin “to hanging a sign around one’s neck that I am carrying a contagious disease.” Market analysts are now estimating that many of the banks in the LIBOR panel were reporting borrowing rates that were anywhere from 30 to 40 basis points lower than actual rates throughout the financial crisis.

3. Credit Risk Premium. What is a credit risk premium?

The cost of debt for any individual borrower will therefore possess two components, the risk-free rate of interest (kUS$), plus a credit risk premium (RPM$Rating) reflecting the assessed credit quality of the individual borrower. For an individual borrower in the United States, the cost of debt (kDebt$) would be:

kDebt$ = kUS$ + RPM$Rating

The credit risk premium represents the credit risk of the individual borrower. In credit markets, this assignment is typically based on the borrower’s credit rating as designated by one of the major credit

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rating agencies, Moody’s, Standard & Poors, and Fitch. An overview of those credit ratings is presented in Exhibit 8.3. Although each agency utilizes different methodologies, all include the industry in which the firm operates, its current level of indebtedness, its past, present, and prospective operating performance, among a multitude of other factors.

4. Credit and Repricing Risk. From the point of view of a borrowing corporation, what are credit and

repricing risks? Explain steps a company might take to minimize both.

For a corporate borrower, it is especially important to distinguish between credit risk and repricing risk. Credit risk, sometimes termed roll-over risk, is the possibility that a borrower’s creditworthiness at the time of renewing a credit—its credit rating—is reclassified by the lender. This can result in changing fees, changing interest rates, altered credit line commitments, or even denial. Repricing risk is the risk of changes in interest rates charged (earned) at the time a financial contract’s rate is reset. A borrower that is renewing a credit will face current market conditions on the base rate used for financing, a true floating-rate.

5. Credit Spreads. What is a credit spread? What credit rating changes have the most profound impact

on the credit spread paid by corporate borrowers?

The cost of debt changes with credit quality, as a credit spread is added to the basic Treasury rate for the maturity in question. The costs of credit quality—credit spreads—are quite minor for borrowers of investment grade but rise dramatically for speculative grade borrowers.

6. Investment Grade Versus Speculative Grade. What do the general categories of investment grade

and speculative grade represent?

Although there is obviously a wide spectrum of credit ratings, the designation of investment grade versus speculative grade is extremely important. An investment grade borrower (Baa3, BBB-, and above) is considered a high-quality borrower that is expected to be able to repay a new debt obligation in a timely manner regardless of market events or business performance. A speculative grade borrower (Ba1 or BB+ and below) is believed to be a riskier borrower and, depending on the nature of a market downturn or business shock, may have difficulty servicing new debt.

7. Sovereign Debt. What is sovereign debt? What specific characteristic of sovereign debt constitutes

the greatest risk to a sovereign issuer?

Debt issued by governments—sovereign debt—is historically considered debt of the highest quality, higher than that of non-government borrowers within that same country. This quality preference stems from the ability of a government to tax its people and, if need be, print more money. Although the first may cause significant economic harm in the form of unemployment and the second significant financial harm in the form of inflation, they are both tools available to the sovereign. The government therefore has the ability to service its own debt, one way or another, when that debt is denominated in its own currency. When that debt is denominated in a foreign currency, however, servicing that debt can potentially pose a great risk to the sovereign issuer.

8. Floating Rate Loan Risk. Why do borrowers of lower credit quality often find their access limited to

floating-rate loans?

As opposed to fixed rate loans, where the lender accepts both the risk of changing interest rates and changing credit quality of the borrower on loan origination, a floating-rate loan shifts interest rate risk

Chapter 8 Interest Rate Risk and Swaps 45

to the borrower. Lenders are not generally willing to accept both risks when lending to lower credit quality borrowers.

9. Interest Rate Futures. What is an interest rate future? How can they be used to reduce interest rate

risk by a borrower?

Interest rate futures are relatively widely used by financial managers and treasurers of nonfinancial companies. Their popularity stems from the high liquidity of the interest rate futures markets, their simplicity in use, and the rather standardized interest rate exposures most firms possess.

If a financial manager were interested in hedging a floating-rate interest payment due at a short-term future date, she would need to sell a future to take a short position. This strategy is referred to as a short position because the manager is selling something she does not own (as in shorting common stock). If interest rates rise by March, as the manager fears, the futures price will fall, and she will be able to close the position at a profit. This profit will roughly offset the losses associated with rising interest payments on her debt. If the manager is wrong, however, and interest rates actually fall by the maturity date, causing the futures price to rise, she will suffer a loss that will wipe out the “savings” derived from making a lower floating-rate interest payment than she expected. So by selling the futures contract, the manager locks-in an interest rate.

10. Interest Rate Futures Strategies. What would be the preferred strategy for a borrower paying

interest on a future date if they expected interest rates to rise?

They should sell an interest rate futures—take a short position. 11. Forward Rate Agreement. How can a business firm that has borrowed on a floating-rate basis use a

forward rate agreement to reduce interest rate risk?

A forward rate agreement (FRA) is an interbank-traded contract to buy or sell interest rate payments on a notional principal. These contracts are settled in cash. The buyer of an FRA obtains the right to lock in an interest rate for a desired term that begins at a future date. The contract specifies that the seller of the FRA will pay the buyer the increased interest expense on a nominal sum (the notional principal) of money if interest rates rise above the agreed rate, but the buyer will pay the seller the differential interest expense if interest rates fall below the agreed rate. Maturities available are typically 1, 3, 6, 9, and 12 months, much like traditional forward contracts for currencies.

12. Plain Vanilla. What is a plain vanilla interest rate swap? Are swaps a significant source of capital for

multinational firms?

A plain vanilla interest rate swap is a swap to pay fixed/receive floating, or alternatively, pay floating/receive fixed. The plain vanilla interest rate swap is not a source of capital; it only alters the interest rate price on repayment of a theoretical—notional—debt principal.

13. Swaps and Credit Quality. If interest rate swaps are not the cost of government borrowing, what

credit quality do they represent?

Although in principle the swap market does not “price” or “trade” credit quality, the fundamental fixed rates of interest used by the swap market are based on AA credit quality borrowers.

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14. LIBOR Flat. Why do fixed for floating interest rate swaps never swap the credit spread component on a floating rate loan?

Interest rate swaps are not sources of capital and, therefore, are not intended to price debt as a market or banker would in assessing a borrower’s credit quality. Instead, the swap market only alters the repayment mechanism of existing debt. Because floating-rate loans are priced at LIBOR + a credit risk premium, and the market is not assessing credit risk, the credit risk premium adjustment to LIBOR on interest rate swaps is zero or flat.

15. Debt Structure Swap Strategies. How can interest rate swaps be used by a multinational firm to

manage its debt structure?

All companies will pursue a target debt structure that combines maturity, currency of composition, and fixed/floating pricing. The fixed/floating objective is one of the most difficult for many companies to determine with any confidence, and they often just try to replicate industry averages.

Companies that have very high credit quality and therefore advantaged access to the fixed-rate debt markets, companies of A or AA like WalMart or IBM, often raise large amounts of debt in long maturities at fixed rates. They then use the plain vanilla swap market to alter selective amounts of their fixed-rate debt into floating-rate debt to achieve their desired objective. Swaps allow them to alter the fixed/floating composition quickly and easily without the origination and registration fees of the direct debt markets.

Companies of lower credit quality, sometimes those of less than investment grade, often find the fixed-rate debt market not open to them. Getting fixed-rate debt is either impossible or too costly. They will generally raise their debt at floating-rates and then periodically evaluate whether the plain vanilla swap market offers any attractive alternatives to swap from paying-floating to paying-fixed. The plain vanilla swap market is of course also frequently used by many firms to alter their fixed/floating debt structure to changing interest rate expectations.

16. Cost-Based Swap Strategies. How do corporate borrowers use interest rate or cross currency swaps

to reduce the costs of their debt?

All firms are always interested in opportunities to lower the cost of their debt. The plain vanilla swap market is one highly accessible and low cost method of doing so.

These lower costs achieved through the plain vanilla swap market may simply reflect short-term market imperfections and inefficiencies or the comparative advantage some borrowers have in selected markets via selective financial service providers. The savings may be large—30, 40, or even 50 basis points on occasion—or quite small. It is up to the management of the firm and its corporate treasury to determine how much savings is needed to spend the time and effort in executing the swaps. Banks promote the swap market and will regularly market deals to corporate treasuries. A corporate treasurer once remarked to the author that “unless the proposed structure or deal can save me 15 or 20 basis points, at a minimum, do not bother calling me to push the deal.”

17. Cross-Currency Swaps. Why would one company with interest payments due in pounds sterling

want to swap those payments for interest payments due in U.S. dollars?

It might be that the company in its continuing business received regular cash inflows in U.S. dollars and would prefer to match the currency inflows with a same-currency cash outflow. Swapping pounds sterling interest payments for dollar interest payments would fulfill that objective.

Chapter 8 Interest Rate Risk and Swaps 47

18. Value Swings in Cross-Currency Swaps. Why are there significantly larger swings in the value of a cross-currency swap than there is in a plain vanilla interest rate swap?

Cross-currency swaps are subject to both changes in interest rates and changes in exchange rates. The two risks together combine to cause potentially large swings in the relative legs of the swap structure.

19. Unwinding a Swap. How does a company cancel or unwind a swap?

Unwinding a currency swap requires the discounting of the remaining cash flows under the swap agreement at current interest rates, then converting the target currency back to the home currency of the firm.

20. Counterparty Risk. How does organized exchange trading in swaps remove any risk that the

counterparty in a swap agreement will not complete the agreement?

Counterparty risk is the potential exposure any individual firm bears that the second party to any financial contract will be unable to fulfill its obligations under the contract’s specifications. Concern over counterparty risk has risen in the interest rate and currency swap markets as a result of a few large and well-publicized swap defaults. The rapid growth in the currency and interest rate financial derivatives markets has actually been accompanied by a surprisingly low default rate to date, particularly in a global market that is, in principle, unregulated.

Counterparty risk has long been one of the major factors that favor the use of exchange-traded rather than over-the-counter derivatives. Most exchanges, like the Philadelphia Stock Exchange for currency options or the Chicago Mercantile Exchange for Eurodollar futures, are themselves the counterparty to all transactions. This allows all firms a high degree of confidence that they can buy or sell exchange-traded products quickly and with little concern over the credit quality of the exchange itself. Financial exchanges typically require a small fee of all traders on the exchanges, to fund insurance funds created expressly to protect all parties. Over-the-counter products, however, are direct credit exposures to the firm because the contract is generally between the buying firm and the selling financial institution. Most financial derivatives in today’s world financial centers are sold or brokered only by the largest and soundest financial institutions. This structure does not mean, however, that firms can enter continuing agreements with these institutions without some degree of real financial risk and concern.

CHAPTER 9

FOREIGN EXCHANGE RATE DETERMINATION

1. Exchange Rate Determination. What are the three basic theoretical approaches to exchange rate

determination?

The three major schools of thought are (1) purchasing power parity, (2) balance of payments approach, and (3) asset market approach.

Purchasing Power Parity Approach. The most widely accepted of all exchange rate determination theories, the theory of purchasing power parity (PPP) states that the long-run equilibrium exchange rate is determined by the ratio of domestic prices relative to foreign prices, as explained in Chapter 6. PPP is both the oldest and most widely followed of the exchange rate theories, and most theories of exchange rate determination have PPP elements embedded within their frameworks.

Balance of Payments Approach. After PPP, the most frequently used theoretical approach to exchange rate determination is probably that involving the supply and demand for currencies in the foreign exchange market. These exchange rate flows reflect current account and financial account transactions recorded in a nation’s balance of payments, as described in Chapter 3. The basic balance of payments approach argues that the equilibrium exchange rate is found when the net inflow (outflow) of foreign exchange arising from current account activities matches the net outflow (inflow) of foreign exchange arising from financial account activities.

Asset Market Approach. The asset market approach, sometimes called the relative price of bonds or portfolio balance approach, argues that exchange rates are determined by the supply and demand for financial assets of a wide variety. Shifts in the supply and demand for financial assets alter exchange rates. Changes in monetary and fiscal policy alter expected returns and perceived relative risks of financial assets, which in turn alter rates.

2. PPP Inadequacy. The most widely accepted theory of foreign exchange rate determination is

purchasing power parity, yet it has proven to quit poor at forecasting future spot exchange rates. Why?

Although PPP seems to possess a core element of common sense, it has proven to be quite poor at forecasting exchange rates (at least in the short to medium term). The problems are both theoretical and empirical. The theoretical problems lie primarily with its basic assumption that the only thing that matters is relative price changes. Yet many currency supply and demand forces are driven by other forces, including investment incentives, economic growth, and political change. The empirical issues are primarily in deciding which measures or indexes of prices to use across countries, in addition to the ability to provide a “predicted change in prices” with the chosen indexes.

3. Data and the Balance of Payments Approach. Statistics on a country’s balance of payments are

used by the business press and business itself often in terms of predicting exchange rates, but the academic profession is highly critical of it. Why?

Criticisms of the balance of payments approach arise from the theory’s emphasis on flows of currency and capital rather than on stocks of money or financial assets. Relative stocks of money or financial

Chapter 9 Foreign Exchange Rate Determination 49

assets play no role in exchange rate determination in this theory, a weakness explored in the following discussion of monetary and asset market approaches. Curiously, while the balance of payments approach is largely dismissed by the academic community today, the practitioner public-market participants, including currency traders themselves, still rely on different variations of this theory for much of their decision making.

4. Supply and Demand. Which of the three major theoretical approaches seems to put the most weight

into arguments on the supply and demand for currency? What is its primary weakness?

The monetary approach focuses on changes in the supply and demand for money as the primary determinant of inflation. Changes in relative inflation rates in turn are expected to alter exchange rates through a purchasing power parity effect. The monetary approach then assumes that prices are flexible in the short run as well as the long run, so that the transmission mechanism of inflationary pressure is immediate in impact.

A weakness of monetary models of exchange rate determination is that real economic activity is relegated to a role in which it only influences exchange rates through changes in the demand for money. The monetary approach is also criticized for its omission of a number of factors that are generally agreed upon by area experts as important to exchange rate determination, including (1) the failure of PPP to hold in the short to medium term; (2) money demand appears to be relatively unstable over time; and (3) the level of economic activity and the money supply appear to be interdependent, not independent.

5. Asset Market Approach to Forecasting. Explain how the asset market approach can be used to

forecast future spot exchange rates. How does the asset market approach differ from the BOP approach to forecasting?

The asset market approach assumes that whether foreigners are willing to hold claims in monetary form depends on an extensive set of investment considerations or drivers. These drivers include the following:

Relative real interest rates are a major consideration for investors in foreign bonds and short-term

money market instruments. Prospects for economic growth and profitability are an important determinant of cross-border

equity investment in both securities and foreign direct investment. Capital market liquidity is particularly important to foreign institutional investors. Cross-border

investors are not only interested in the ease of buying assets, but also in the ease of selling those assets quickly for fair market value if desired.

A country’s economic and social infrastructure is an important indicator of that country’s ability to survive unexpected external shocks and to prosper in a rapidly changing world economic environment.

Political safety is exceptionally important to both foreign portfolio and direct investors. The outlook for political safety is usually reflected in political risk premiums for a country’s securities and for purposes of evaluating foreign direct investment in that country.

The credibility of corporate governance practices is important to cross-border portfolio investors. A firm’s poor corporate governance practices can reduce foreign investors’ influence and cause subsequent loss of the firm’s focus on shareholder wealth objectives.

Contagion is defined as the spread of a crisis in one country to its neighboring countries and other countries that have similar characteristics—at least in the eyes of cross-border investors. Contagion can cause an “innocent” country to experience capital flight with a resulting depreciation of its currency.

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Speculation can cause a foreign exchange crisis, make an existing crisis worse, or both. We will observe this effect through the three illustrative cases that follow shortly.

6. Technical Analysis. Explain how technical analysis can be used to forecast future spot exchange

rates. How does technical analysis differ from the BOP and asset market approaches to forecasting?

Technical analysts, traditionally referred to as chartists, focus on price and volume data to determine past trends that are expected to continue into the future. The single most important element of technical analysis is that future exchange rates are based on the current exchange rate. Exchange rate movements, similar to equity price movements, can be subdivided into three periods: (1) day-to-day movement, which is seemingly random; (2) short-term movements extending from several days to trends lasting several months; and (3) long-term movements, which are characterized by up and down long-term trends. Long-term technical analysis has gained new popularity as a result of recent research into the possibility that long-term “waves” in currency movements exist under floating exchange rates.

7. Intervention. What is foreign currency intervention? How is it accomplished?

Foreign currency intervention is the active management, manipulation, or intervention in the market’s valuation of a country’s currency. A short list of the intervention methods would include direct intervention, indirect intervention, and capital controls.

Direct Intervention. This is the active buying and selling of the domestic currency against foreign currencies. This traditionally required a central bank to act like any other trader in the currency market—albeit a big one. If the goal were to increase the value of the domestic currency, the central bank would purchase its own currency using its foreign exchange reserves, at least to the acceptable limits that it could endure depleting its reserves.

Indirect Intervention. This is the alteration of economic or financial fundamentals that are thought to be drivers of capital to flow in and out of specific currencies. This was a logical development for market manipulation given the growth in size of the global currency markets relative to the financial resources of central banks.

8. Intervention Motivation. Why do governments and central banks intervene in the foreign exchange

markets? If markets are efficient, why not let them determine the value of a currency?

Historically, a primary motive for a government to pursue currency value change was to keep the country’s currency cheap so that foreign buyers would find its exports cheap. This policy, long referred to as “beggar-thy-neighbor,” gave rise to many competitive devaluations over the years. It has not, however, fallen out of fashion.

Alternatively, the fall in the value of the domestic currency will sharply reduce the purchasing power of its people. If the economy is forced, for a variety of reasons, to continue to purchase imported products (e.g., petroleum imports because of no domestic substitute), a currency devaluation or depreciation may prove highly inflationary and, in the extreme, impoverish the country’s people (as in the case of Venezuela).

It is frequently noted that most countries would like to see stable exchange rates and to avoid the entanglements associated with manipulating currency values. Unfortunately, that would also imply that they are also happy with the current exchange rate’s impact on country-level competitiveness.

Chapter 9 Foreign Exchange Rate Determination 51

9. Direct Intervention Usefulness. When is direct intervention likely to be the most successful? And when is it likely to be the least successful?

Direct intervention was the primary method used for many years, but beginning in the 1970s, the world’s currency markets grew enough that any individual player, even a central bank, could find itself with insufficient resources to move the market.

10. Intervention Downside. What is the downside of both direct and indirect intervention?

It is important to remember that intervention may—and often does—fail. The Turkish currency crisis of 2014 is a classic example of a drastic indirect intervention that ultimately only slowed the rate of capital flight and currency collapse. Turkey had enjoyed some degree of currency stability throughout 2012 and 2013, but the Turkish economy (one of the so-called “Fragile Five” countries, along with South Africa, India, Indonesia, and Brazil) suffered a widening current account deficit and rising inflation in late 2013. With the increasing anxieties in emerging markets in the fourth quarter of 2013 over the U.S. Federal Reserve’s announcement that it would be slowing its bond purchasing (the Taper Program, essentially a tighter monetary policy), capital began exiting Turkey. The lira came under increasing downward pressure.

11. Capital Controls. Are capital controls really a method of currency market intervention, or more of a

denial of activity? How does this fit with the concept of the impossible trinity?

This is the restriction of access to foreign currency by government. This involves limiting the ability to exchange domestic currency for foreign currency. When access and exchange is permitted, trading takes place only with official designees of the government or central bank, and only at dictated exchange rates.

Often, governments will limit access to foreign currencies to commercial trade: for example, allowing access to hard currency for the purchase of imports only. Access for investment purposes— particularly for short-term portfolios in which investors are moving in and out of interest-bearing accounts, purchasing or selling securities or other funds—is often prohibited or limited. The Chinese regulation of access and trading of the Chinese yuan is a prime example of the use of capital controls over currency value—a choice within the framework of the Impossible Trinity. In addition to the government’s setting the daily rate of exchange, access to the exchange is limited by a difficult and timely bureaucratic process for approval and is limited to commercial trade transactions.

12. Asian Crisis of 1997 and Disequilibrium. What was the primary disequilibrium at work in Asia in

1997 that likely caused the Asian financial crisis? Do you think it could have been avoided?

The roots of the Asian currency crisis extended from a fundamental change in the economics of the region, the transition of many Asian nations from being net exporters to net importers. Starting as early as 1990 in Thailand, the rapidly expanding economies of the Far East began importing more than they exported, requiring major net capital inflows to support their currencies. As long as the capital continued to flow in—capital for manufacturing plants, dam projects, infrastructure development, and even real estate speculation—the pegged exchange rates of the region could be maintained. When the investment capital inflows stopped, however, crisis was inevitable.

Many analysts argue that if the governments of these Far East nations had given up their pegged exchange rates earlier, the market adjustment would have been made gradually over time as their economies changed. Expecting governments to give up on pegged exchange rates, particularly when they still viewed their economic life-blood to be exports, is not, however, very realistic.

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13. Fundamental Equilibrium. What is meant by the term “fundamental equilibrium path” for a currency value? What is “noise”?

It appears from decades of theoretical and empirical studies that exchange rates do adhere to the fundamental theories outlined in this chapter (namely purchasing power parity and interest rate parity). Fundamentals do apply in the long term. There is, therefore, something of a fundamental equilibrium path for a currency’s value.

It also seems that in the short term, a variety of random events, institutional frictions, and technical factors may cause currency values to deviate significantly from their long-term fundamental path. This is sometimes referred to as noise. Clearly, therefore, we might expect deviations from the long- term path not only to occur, but to occur with some regularity and relative longevity.

14. Argentina’s Failure. What was the basis of the Argentine Currency Board, and why did it fail in

2002?

By 2001, crisis conditions had revealed three very important underlying problems with Argentina’s economy: (1) the Argentine peso was overvalued; (2) the currency board regime had eliminated monetary policy alternatives for macroeconomic policy; and (3) the Argentine government budget deficit, and deficit spending, was out of control.

The peso had indeed been stabilized. But inflation had not been eliminated, and the other factors that are important in the global market’s evaluation of a currency’s value—economic growth, corporate profitability, etc.—had not necessarily always been positive. The inability of the peso’s value to change with market forces led many to believe increasingly that it was overvalued and that the overvaluation gap was rising as time passed.

Argentina’s large neighbor to the north, Brazil, had also suffered many of the economic ills of hyperinflation and international indebtedness in the 1980s and early 1990s. Brazil’s response, the Real Plan, was introduced in July 1994. The real plan worked, for a while, but eventually collapsed in January 1999 as a result of the rising gap between the real’s official value and the market’s assessment of its true value.

Brazil was by far Argentina’s largest trading partner. With the fall of the Brazilian real, however, Brazilian consumers could no longer afford Argentine exports. It simply took too many real to purchase a peso. In fact, Argentine exports became some of the most expensive in all of South America as other countries saw their currencies slide marginally against the dollar over the decade but the Argentine peso did not slide.

15. Term Forecasting. What are the major differences between short-term and long-term forecasts for a

fixed exchange rate versus a floating exchange rate?

Long-run forecasts may be motivated by a multinational firm’s desire to initiate a foreign investment in Japan, or perhaps to raise long-term funds denominated in Japanese yen. Or a portfolio manager may be considering diversifying for the long term in Japanese securities. The longer the time horizon of the forecast, the more inaccurate but also the less critical the forecast is likely to be. The forecaster will typically use annual data to display long-run trends in such economic fundamentals as Japanese inflation, growth, and the BOP.

Short-term forecasts are typically motivated by a desire to hedge a receivable, payable, or dividend for perhaps a period of three months. In this case, the long-run economic fundamentals may not be as

Chapter 9 Foreign Exchange Rate Determination 53

important as technical factors in the marketplace, government intervention, news, and passing whims of traders and investors. Accuracy of the forecast is critical because most of the exchange rate changes are relatively small even though the day-to-day volatility may be high.

Forecasting services normally undertake fundamental economic analysis for long-term forecasts, and some base their short-term forecasts on the same basic model. Others base their short-term forecasts on technical analysis similar to that conducted in security analysis. They attempt to correlate exchange rate changes with various other variables, regardless of whether there is any economic rationale for the correlation. The chances of these forecasts being consistently useful or profitable depends on whether one believes the foreign exchange market is efficient. The more efficient the market is, the more likely it is that exchange rates are “random walks,” with past price behavior providing no clues to the future. The less efficient the foreign exchange market is, the better the chance that forecasters may get lucky and find a key relationship that holds, at least for the short run. If the relationship is really consistent, however, others will soon discover it, and the market will become efficient again with respect to that piece of information. Exhibit 9.9 summarizes the various forecasting periods, regimes, and the authors’ opinions on the preferred methodologies.

16. Exchange Rate Dynamics. What is meant by the term “overshooting”? What causes it, and how is it

corrected?

Assume that the current spot rate between the dollar and the euro, as illustrated in Exhibit 9.9 in the text, is S0. The U.S. Federal Reserve announces an expansionary monetary policy that cuts U.S. dollar interest rates. If euro-denominated interest rates remain unchanged, the new spot rate expected by the exchange markets on the basis of interest differentials is S1. This immediate change in the exchange rate is typical of how the markets react to news, distinct economic and political events that are observable. The immediate change in the value of the dollar/euro is therefore based on interest differentials.

As time passes, however, the price impacts of the monetary policy change start working their way through the economy. As price changes occur over the medium to long term, purchasing power parity forces drive the market dynamics, and the spot rate moves from S1 toward S2. Although both S1 and S2 were rates determined by the market, they reflected the dominance of different theoretical principles. As a result, the initial lower value of the dollar of S1 is often explained as an overshooting of the longer-term equilibrium value of S2.

17. Foreign Currency Speculation. The emerging market crises of 1997–2002 were worsened because

of rampant speculation. Do speculators cause such crisis or do they simply respond to market signals of weakness? How can a government manage foreign exchange speculation?

“Hot money” is a term used to describe funds held in one currency (country) that will move very quickly to another currency as soon as it is deemed weak. Such a quick flow will create severe short- term pressures on the exchange rate, forcing depreciation or a devaluation. This run on the currency may cause others to also try to exchange their local currency holdings for foreign money, aggravating the already apparent weakness.

If a currency is fundamentally weak, a speculator such as George Soros may lead a flight from that currency. He will succeed if he is correct in his assessment of the fundamentals, but if he is in error, he will lose on the speculation. In the Malaysian situation, Soros correctly assessed the situation and, by moving first ,was probably instrumental in setting in motion underlying factors that would have influenced exchange rates in any case—possibly at a later date. In other words, Soros did not cause

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the currency crisis in a fundamental sense, but he may well have caused (and advanced) the timing of what would have occurred eventually in any case.

18. Cross-Rate Consistency in Forecasting. Explain the meaning of “cross-rate consistency” as used by

MNEs. How do MNEs use a check of cross-rate consistency in practice?

International financial managers must often forecast their home currency exchange rates for the set of countries in which the firm operates, not only to decide whether to hedge or to make an investment, but also as an integral part of preparing multi-country operating budgets in the home country’s currency. These are the operating budgets against which the performance of foreign subsidiary managers will be judged. Checking the reasonableness of the cross rates implicit in individual forecasts acts as a reality check to the original forecasts.

19. Stabilizing Versus Destabilizing Expectations. Define stabilizing and destabilizing expectations,

and describe how they play a role in the long-term determination of exchange rates.

If market participants have stabilizing expectations, when forces drive the currency’s value below the long-term fundamental equilibrium path, they will buy the currency driving its value back toward the fundamental equilibrium path. If market participants have destabilizing expectations and forces drive the currency’s value away from the fundamental path, participants may not move immediately or in significant volume to push the currency’s value back toward the fundamental equilibrium path for an extended period of time (or possibly establish a new long-term fundamental path).

20. Currency Forecasting Services. Many multinational firms use forecasting services regularly. If

forecasting is essentially “foretelling the future,” and that is theoretically impossible, why would these firms spend money on these services?

If nothing else, a variety of opinions is generally useful when attempting to predict the future. Most forecasting services also provide added discipline to the forecasting process often missing within smaller corporate finance units. For example, the need to focus on the likely movement of an exchange rate within a specific time interval is typically stressed within a forecasting unit while not within a business unit’s planning horizon. A treasurer might also use a forecasting service because “it exists.” If the treasurer does not use it, and guesses wrong on an exchange rate, the treasurer could be criticized for not using available “expert advice.”

CHAPTER 10

TRANSACTION EXPOSURE

1. Foreign Exchange Exposure. Define the three types of foreign exchange exposure.

The three main types of foreign exchange exposure are transaction, translation, and operating:

Transaction exposure measures changes in the value of outstanding financial obligations incurred prior to a change in exchange rates but not due to be settled until after the exchange rates change. Thus, it deals with changes in cash flows that result from existing contractual obligations.

Translation exposure is the potential for accounting-derived changes in owner’s equity to occur

because of the need to “translate” foreign currency financial statements of foreign subsidiaries into a single reporting currency to prepare worldwide consolidated financial statements.

Operating exposure, also called economic exposure, competitive exposure, or strategic exposure,

measures the change in the present value of the firm resulting from any change in future operating cash flows of the firm caused by an unexpected change in exchange rates. The change in value depends on the effect of the exchange rate change on future sales volume, prices, and costs.

2. Currency Exposure and Contracting. Which of the three currency exposures relate to cash flows

already contracted for, and which of the exposures do not?

Transaction exposures are existing exposures of the firm, resulting from identifiable transaction. Operating exposures are exposures that are likely—anticipated—but not yet existing or contracted.

3. Currency Risk. Define currency risk.

Currency risk is the variance in expected cash flows arising from unexpected exchange rate changes. 4. Hedging. What is a hedge? How does that differ from speculation?

A hedge is the acquisition of a contract or a physical asset that will offset a change in value of some other contract or physical asset. Hedges are entered into to reduce or eliminate risk, as opposed to speculation, which is the taking of a position for the purposes of potential profit.

5. Value of the Firm. What—according to financial theory—is the value of a firm?

According to financial theory, the value of a firm is the net present value of all expected future cash flows.

6. Cash Flow Variability. How does currency hedging theoretically change the expected cash flows of

the firm?

Hedging reduces the variability of expected cash flows. In some cases hedging may also bound or limit the variability of expected cash flows on an absolute basis.

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7. Arguments for Currency Hedging. Describe four arguments in favor of a firm pursuing an active currency risk management program?

1. Reduction in risk of future cash flows improves the planning capability of the firm. If the firm can

more accurately predict future cash flows, it may be able to undertake specific investments or activities that it might otherwise not consider.

2. Reduction of risk in future cash flows reduces the likelihood that the firm’s cash flows will fall

below a level sufficient to make debt-service payments in order for it to continue to operate. This minimum cash flow point, often referred to as the point of financial distress, lies left of the center of the distribution of expected cash flows. Hedging reduces the likelihood of the firm’s cash flows falling to this level.

3. Management has a comparative advantage over the individual shareholder in knowing the actual

currency risk of the firm. Regardless of the level of disclosure provided by the firm to the public, management always possesses an advantage in the depth and breadth of knowledge concerning the real risks.

4. Markets are usually in disequilibrium because of structural and institutional imperfections, as

well as unexpected external shocks (such as an oil crisis or war). Management is in a better position than shareholders are to recognize disequilibrium conditions and to take advantage of opportunities to enhance firm value through selective hedging (the hedging of exceptional exposures or the occasional use of hedging when management has a definite expectation of the direction of rates).

8. Arguments Against Currency Hedging. Describe six arguments against a firm pursuing an active

currency risk management program? 1. Shareholders are more capable of diversifying currency risk than the management of the firm are.

If stockholders do not wish to accept the currency risk of any specific firm, they can diversify their portfolios to manage the risk in a way that satisfies their individual preferences and risk tolerance.

2. Currency risk management does not increase the expected cash flows of the firm. Currency risk

management does, however, consume firm resources and so reduces cash flow. The impact on value is a combination of the reduction of cash flow (which lowers value) and the reduction in variance (which increases value).

3. Management often conducts hedging activities that benefit management at the expense of the

shareholders. The field of finance called agency theory frequently argues that management is generally more risk-averse than shareholders are.

4. Managers cannot outguess the market. If and when markets are in equilibrium with respect to

parity conditions, the expected net present value of hedging should be zero. 5. Management’s motivation to reduce variability is sometimes driven by accounting reasons.

Management may believe that it will be criticized more severely for incurring foreign exchange losses than for incurring similar or even higher cash costs in avoiding the foreign exchange loss. Foreign exchange losses appear in the income statement as a highly visible separate line item or as a footnote, but the higher costs of protection are buried in operating or interest expenses.

Chapter 10 Transaction Exposure 57

6. Efficient market theorists believe that investors can see through the “accounting veil” and therefore have already factored the foreign exchange effect into a firm’s market valuation. Hedging would only add cost.

9. Transaction Exposure. What are the four main types of transactions from which transaction

exposure arises?

Transaction exposure measures gains or losses that arise from the settlement of existing financial obligations whose terms are stated in a foreign currency. Transaction exposure arises from any of the following:

1. Purchasing or selling on credit, on open account, goods or services when prices are stated in

foreign currencies

2. Borrowing or lending funds when repayment is to be made in a foreign currency

3. Being a party to an unperformed foreign exchange forward contract

4. Otherwise acquiring assets or incurring liabilities denominated in foreign currencies 10. Life Span of a Transaction Exposure. Diagram the life span of an exposure arising from selling a

product on open account. On the diagram define and show quotation, backlog, and billing exposures.

See chapter Exhibit 10.3 for the entire life span. 11. Unperformed Contracts. Which contract is more likely not to be performed: a payment due from a

customer in foreign currency (a currency exposure) or a forward contract with a bank to exchange the foreign currency for the firm’s domestic currency at a contracted rate (the currency hedge)?

The forward contract agreement with a financial service provider—a bank—is much more “certain” than is the receipt of cash in payment on an outstanding receivable.

12. Cash Balances. Why do foreign currency cash balances not cause transaction exposure?

A transaction exposure is defined as a foreign currency denominated cash flow occurring at a future date in time. Because cash balances are in the present, not a future cash flow, they are not defined as transaction exposures.

13. Contractual Currency Hedges. What are the four main contractual instruments used to hedge

transaction exposure?

The four main contractual instruments or hedges used to hedge transaction exposure are foreign currency forwards, foreign currency futures, money market derivatives, and foreign currency options.

14. Money Market Hedges. How does a money market hedge differ for an account receivable versus

that of an account payable? Is it really a meaningful difference?

A money market hedge for an account receivable is the use of the A/R as collateral against a foreign currency loan (the A/R is not being sold, only posted as collateral for a loan). This creates a short- term loan or debt obligation on the hedger’s balance sheet that “matches” the foreign currency receivable.

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A money market hedge for an account payable requires the company to exchange money now to be placed on deposit in a foreign currency financial account in an amount which, upon maturity, will satisfy the account payable in full.

Whether there is a meaningful difference between the two is debatable and somewhat situational. A heavily indebted firm will not find taking on additional debt obligations (hedging the A/R) because that will increase all debt-based financial metrics and ratios. A firm that does not enjoy ready access to affordable capital will find the foreign currency deposit (hedging the A/P) difficult, as it means putting scarce capital into an account for earning nothing but interest when capital is hard to come by.

15. Balance Sheet Hedging. What is the difference between a balance sheet hedge, a financing hedge,

and a money market hedge?

A balance sheet hedge is any foreign currency denominated asset or liability created to offset a similar foreign currency denominated liability or asset.

A financing or financial hedge is any financial position, a deposit or loan obligation, created to

offset a matching foreign currency denominated exposure.

A money market hedge is one type of financial hedge, where a foreign currency loan is acquired to hedge a foreign currency denominated account receivable, or a foreign currency deposit is created to hedge a foreign currency denominated account payable.

16. Forward versus Money Market Hedging. Theoretically, shouldn’t forward contract hedges and

money market hedges have the same identical outcome? Don’t they both use the same three specific inputs—the initial spot rate, the domestic cost of funds, and the foreign cost of funds?

On a theoretical basis, both structures do indeed include the same three basic components. What differs, however, is the rates of interest utilized in constructing the positions. The forward contract uses eurocurrency deposit rates (effectively the same as LIBOR rates) in the construction of the forward rate.

The money market hedge, however, uses a deposit rate (for an A/P) or a borrowing rates (for an A/R) for the execution of the structure. Borrowing rates will include the lender’s credit assessment of the borrower. In both cases, the firm’s weighted average cost of capital, which will obviously differ across firms, is needed for the estimation of the time value of money either used or accessed as part of the money market hedge.

17. Foreign Currency Option Premia. Why do many firms object to paying for foreign currency option

hedges? Do firms pay for forward contract hedges? How do forwards and options differ if at all?

Consider the traditional alternative to the option—the forward contract. A firm does not exchange any cash flow up-front for a forward. It does, however, have its available line of credit with the financial institution reduced by the amount of the forward, but that is not an out-of-pocket cash obligation.

An option, however, is purchased—the option premium—and that is an explicit cost of acquiring the derivative whether it is used or not in the end. (Option premiums are not necessarily settled up-front, as many banks will simply combine the option premium settlement with the regular clearing of the firm’s settlements with the bank, or combine it with the final settlement on the over-the-counter option at option maturity.)

Chapter 10 Transaction Exposure 59

Option premiums may also be significant in size. If a firm is purchasing a number of large options, this may require a larger amount of capital than the firm has budgeted for treasury and currency operations. Many firms simply object to spending money, option premiums, for a risk product that may or may not be ultimately used.

18. Decision Criteria. Ultimately, a treasurer must choose among alternative strategies to manage transaction exposure. Explain the two main decision criteria that must be used.

A treasurer must select based on two decision criteria: (1) the risk tolerance of the firm, as expressed in its stated policies; and (2) the treasurer’s own view, or expectation of the direction (and distance) the exchange rate will move over the exposure period.

19. Risk Management Hedging Practices. According to surveys of corporate practices, which currency

exposures do most firms regularly hedge?

Transaction exposures, once booked (recorded on the financial statements as an account receivable or payable), are the most frequently hedged exposure. Conservative hedging policies dictate that contractual hedges be placed only on existing exposures.

20. Hedge Ratio. What is the hedge ratio? Why would the hedge ratio ever be less than one?

The hedge ratio is basically what proportion or percentage of the total expected currency exposure is hedged by the firm. Many firms regularly hedge 80% or 90% of their expected exposures as a precaution of not receiving the total amount expected (as is often the case when firms deduct penalties or fees associated with sale or payment settlement).

CHAPTER 11

TRANSLATION EXPOSURE 1. Translation. What does the word translation mean? Why is translation exposure called an

accounting exposure?

Translation exposure arises because financial statements of foreign subsidiaries—which are stated in foreign currency—must be restated in the parent’s reporting currency for the firm to prepare consolidated financial statements.

Because translation occurs as a result of the accounting process, the restatement is most often called “accounting.” Because exchange rates change from one period to another, imbalances occur. These imbalances may cause an accounting-derived gain or loss, which is taken into the equity section of the parent’s consolidated statement. The possibility of gain or loss gives rise to the word “exposure.”

2. Causation. What activity gives rise to translation exposure?

Consolidation of financial results for a multinational company. Although the exposure arises for all firms with foreign subsidiaries, publicly traded firms, which report consolidated financial results regularly, are thought to be “exposed” in terms of potential market reactions to changes in their consolidated results arising from translation.

3. Converting Financial Assets. In the context of preparing consolidated financial statements, are the

words translate and convert synonyms?

They are not synonyms. To translate is to express the value of a financial account (assets, liability, revenue, or expense) originally measured in one currency in another currency. Translation is pure measurement; no transaction is involved.

To convert is to engage in a transaction in which an asset or liability originally measured in one currency is physically exchanged for as asset or liability measured in another currency. Exchanging pounds sterling for dollars in the foreign exchange market is converting sterling into dollars. Swapping yen-denominated debt for dollar-denominated debt is converting the debt from once currency to another.

4. Subsidiary Characterization. What is the difference between a self-sustaining foreign subsidiary

and an integrated foreign subsidiary?

An integrated foreign entity is one that operates as an extension of the parent company, with cash flows and general business lines that are highly interrelated with those of the parent. A self-sustaining foreign entity is one that operates in the local economic environment independent of the parent company. The differentiation is important to the logic of translation. A foreign subsidiary should be valued principally in terms of the currency that is the basis of its economic viability.

Chapter 11 Translation Exposure 61

5. Functional Currency. What is a functional currency? What do you think a “non-functional currency” would be?

A foreign subsidiary’s functional currency is the currency of the primary economic environment in which the subsidiary operates and in which it generates cash flows. In other words, it is the dominant currency used by that foreign subsidiary in its day-to-day operations.

6. Functional Currency Designation. Can or should a company change the functional currency designation of a foreign subsidiary from year to year? If so, when would it be justified?

The functional currency of an individual foreign subsidiary will rarely change on a year-to-year basis. Because the functional currency designation arises from the fundamental economic principles of the subsidiary’s business, this will not change frequently and is justified only when the dominant currency of its operations changes.

7. Translation Methods. What are the two basic methods for translation used globally?

Two basic methods for translation are employed worldwide: the current rate method and the temporal method. Regardless of which method is employed, a translation method must not only designate at what exchange rate individual balance sheet and income statement items are remeasured, but also designate where any imbalance is to be recorded, either in current income or in an equity reserve account in the balance sheet.

8. Current versus Historical. One of the major differences between translation methods is which

balance sheet components are translated at which exchange rates, current or historical. Why would accounting practices ever use historical exchange rates?

Equity investments in subsidiaries (initially and when added equity investments are made using retained earnings) are generally recorded at the exchange rates in effect on their execution. This is based on establishing the “cost basis” of those investments.

9. Translating Assets. What are the major differences in translating assets between the current rate

method and the temporal method?

Under the current rate method, all assets are translated at the current period (end of period) exchange rate. Under the temporal method, inventories and fixed assets are translated at the exchange rate in effect at the time of their acquisition/creation.

10. Translating Liabilities. What are the major differences in translating liabilities between the current

rate method and the temporal method?

Under both the current rate and temporal methods, all liabilities are translated or remeasured using the current rate, while all equity account entries are translated at historical rates.

11. Earnings or Equity. Where do you believe that most company’s would prefer currency translation

imbalances or adjustments to go, to earnings or consolidated equity? Why?

Publicly traded companies are highly sensitive to changes in consolidated earnings. Earnings, earnings per share, and changes in earnings per share are known to be extremely important to market assessment of firm performance. Therefore, if the firm were publicly traded and had a choice as to

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where currency translation adjustments were to go, it would generally prefer consolidated equity, an item of significantly lower market inspection.

12. Translation Exposure Management. What are the primary options firms have to manage

translation exposure?

The main technique to minimize translation exposure is called a balance sheet hedge. A balance sheet hedge requires an equal amount of exposed foreign currency assets and liabilities on a firm’s consolidated balance sheet. If this can be achieved for each foreign currency, net translation exposure will be zero.

Some firms have attempted to hedge translation exposure in the forward market—with forward contracts. Such action amounts to speculating in the forward market in the hope that a cash profit will be realized to offset the noncash loss from translation. Success depends on a precise prediction of future exchange rates, for such a hedge will not work over a range of possible future spot rates. In addition, the profit from the forward “hedge” (i.e., speculation) is taxable, but the translation loss does not reduce taxable income.

13. Accounting or Cash Flow. If a U.S.-based multinational company generates more than 80% of its

profits (earnings) outside the U.S. in the euro zone and Japan, and both the euro and the yen fall significantly in value versus the dollar as occurred in the second half of 2014, is the impact on the firm only accounting or does it alter cash flow, or both?

The impact would clearly be accounting at a minimum. Because consolidated income (earnings reported to Wall Street) is formed by consolidating earnings from all affiliates from all over the world, consolidated earnings would in this case be significantly reduced by translation. Corporate cash flows may be reduced as well if the company remits some portion of its foreign earnings back to the U.S. parent.

14. Balance Sheet Hedge Justification. When is a balance sheet hedge justified?

If a firm’s subsidiary is using the local currency as the functional currency, the following circumstances could justify when to use a balance sheet hedge:

The foreign subsidiary is about to be liquidated, so that value of its CTA would be realized. The firm has debt covenants or bank agreements that state the firm’s debt/equity ratios will be

maintained within specific limits. Management is evaluated based on certain income statement and balance sheet measures that are

affected by translation losses or gains. The foreign subsidiary is operating in a hyperinflationary environment.

If a firm is using the parent’s home currency as the functional currency of the foreign subsidiary, all transaction gains/losses are passed through to the income statement. Hedging this consolidated income to reduce its variability may be important to investors and bond rating agencies.

15. Realization and Recognition. When would a multinational firm, if ever, realize and recognize the

cumulative translation losses recorded over time associated with a subsidiary?

A U.S.-based multinational firm will realize and recognize in current income the cumulative translation gains and losses associated with an individual foreign affiliate when that affiliate is sold or closed. Also, if a foreign affiliate is operating in an economic environment which experiences a

Chapter 11 Translation Exposure 63

cumulative rate of inflation of 100% or greater over a three-year period, it must use the temporal method of translation and recognize and realize translation gains or losses in consolidated income in the current period.

16. Tax Obligations. How does translation alter the global tax liabilities of a firm? If a multinational

firm’s consolidated earnings increase as a result of consolidation and translation, what is the impact on tax liabilities?

This is in effect a trick question. Translation does not alter taxable income. Multinational companies do not pay taxes on a consolidated basis. They pay taxes in the legal and jurisdictional countries in which they operate, and in the case of the United States, on earnings from abroad when repatriated to the parent company. Consolidation and translation alter none of these.

17. Hyperinflation. What is hyperinflation, and what are the consequences for translating foreign

financial statements in countries experiencing hyperinflation?

Hyperinflation is, by definition, a “very high and rapid monetary inflation, or the period during which this occurs” (Encarta World English Dictionary). The prefix, hyper, means “over, beyond, over much, above measure” (The Shorter Oxford English Dictionary on Historical Principles). In the context of practical international accounting for multinational companies, hyperinflation is deemed to exist when accumulated inflation is 100% or more over a three-year period.

18. Transaction versus Translation Losses. What are the main differences between losses from

transaction exposure and translation exposure?

Losses from transaction exposure are cash losses incurred in the near term because of a change in the amount of cash to be received or paid on account of already-existing receivables or payables. The focus is on a loss from an already-existing balance sheet account. These are “realized” losses and therefore can be deducted from income for tax purposes.

Losses from translation exposure are changes in the size of the equity section of a parent company issuing consolidated financial statements that result from a change in how foreign subsidiary financial statements are measured for translation purposes. As such, losses from translation exposure are not cash losses. The focus is on translation (“remeasurement, if you prefer) of both balance sheet and income statement accounts.

CHAPTER 12

OPERATING EXPOSURE

1. Exposure Definitions. Define operating exposure, economic exposure, and competitive exposure.

Can you provide any insights into what may be behind the use of the different terms?

All are names for the same exposure. If they are different, it must be only in a subtlety of meaning by the user. Operating exposure, also referred to as economic exposure, competitive exposure, or strategic exposure, measures any change in the present value of a firm resulting from changes in future operating cash flows caused by any unexpected change in exchange rates. Economic exposure emphasizes that the exposure is created by the economic consequences of an unexpected exchange rate change. Economic consequences, in turn, suggests that the impact is due to the response of external forces in the economy, rather than, say, something directly under the control of management. Competitive exposure suggests that the consequences of an unexpected exchange rate change are due to a shift in the competitive position of a firm, vis-á-vis its competitors.

2. Operating Exposure versus Translation Exposure. What do you see as the primary difference

between operating exposure and translation exposure? Would this have the same meaning to a private firm as a publicly traded firm?

Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure. However, operating exposure is inevitably subjective because it depends on estimates of future cash flow changes over an arbitrary time horizon. Thus, it does not spring from the accounting process but rather from operating analysis. Planning for operating exposure is a total management responsibility depending upon the interaction of strategies in finance, marketing, purchasing, and production.

3. Unexpected Exchange Rate Changes. Why do unexpected exchange rate changes contribute to

operating exposure, but expected exchange rate changes do not?

Expected changes in foreign exchange rates should be incorporated in all financial plans of an MNE, including both operating and financial budgets. Hence, the arrival of an expected exchange rate change should not be a surprise requiring alteration of existing plans and procedures. Unexpected exchange rate changes are those that could not have been anticipated or built into existing plans. Hence, a reevaluation of existing plans and procedures must be considered.

One must note that because budgets are built around expected exchange rate changes, the unexpected exchange rate is the deviation from the expected exchange rate, rather than the deviation from the actual exchange rate at the time a budget was prepared.

4. Time Horizon. Explain the time horizons used to analyze and measure unexpected changes in

exchange rates.

Operating exposure is inevitably subjective because it depends on estimates of future cash flow changes over an arbitrary time horizon. Thus, it does not spring from the accounting process but rather from operating analysis. Planning for operating exposure is a total management responsibility depending upon the interaction of strategies in finance, marketing, purchasing, and production.

Chapter 12 Operating Exposure 65

5. Static versus Dynamic. What are examples of static exposures versus dynamic exposures?

Measuring the operating exposure of a firm requires forecasting and analyzing all the firm’s future individual transaction exposures together with the future exposures of all the firm’s competitors and potential competitors worldwide. Exchange rate changes in the short term affect current and immediate contracts, generally termed transactions—static in nature. But over the longer term, as prices change and competitors react, the more fundamental economic and competitive drivers of the business may alter all cash flows of all units—dynamic in scope.

6. Operating versus Financing Cash Flows. According to financial theory, which is more important

to the value of the firm, financing or operating cash flows?

The cash flows of the MNE can be divided into operating cash flows and financing cash flows. Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables, rent and lease payments for the use of facilities and equipment, royalty and license fees for the use of technology and intellectual property, and assorted management fees for services provided. These are the cash flows associated with the conduct of business—and therefore are the source of value. Financing cash flows, such as the cash flows associated with debt and equity, are according to financial theory not associated with value and therefore of only secondary importance.

7. Macroeconomic Uncertainty. Explain how the concept of macroeconomic uncertainty expands the

scope of analyzing operating exposure.

Macroeconomic uncertainty is the sensitivity of the firm’s future cash flows to macroeconomic variables in addition to foreign exchange, such as changes in interest rates and inflation rates.

8. Strategic Response. The objective of both operating and transaction exposure management is to

anticipate and influence the effect of unexpected changes in exchange rates on a firm’s future cash flows. What strategic alternative policies exist to enable management to manage these exposures?

The key to effective preparations for an unexpected devaluation is anticipation. Major changes to protect a firm after an unexpected devaluation are minimally effective. Possibilities include diversifying operations and diversifying financing.

9. Managing Operating Exposure. The key to managing operating exposure at the strategic level is for

management to recognize a disequilibrium in parity conditions when it occurs and to be pre- positioned to react most appropriately. How can this task best be accomplished?

If a firm’s operations are diversified internationally, management is pre-positioned both to recognize disequilibrium when it occurs and to react competitively. Consider the case where purchasing power parity is temporarily in disequilibrium. Although the disequilibrium may have been unpredictable, management can often recognize its symptoms as soon as they occur. For example, management might notice a change in comparative costs in the firm’s own plants located in different countries. It might also observe changed profit margins or sales volume in one area compared to another, depending on price and income elasticities of demand and competitors’ reactions.

Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies. Management might make marginal shifts in sourcing raw materials, components, or finished products. If spare capacity exists, production runs can be lengthened in one

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country and reduced in another. The marketing effort can be strengthened in export markets where the firm’s products have become more price competitive because of the disequilibrium condition.

10. Diversification. How can a multinational firm diversify operations? How can it diversify its

financing? Do you believe these are effective ways of managing operating exposure?

Worldwide diversification in effect prepositions a firm to make a quick response to any loss from operating exposure. The firm’s own internal cost control system and the alertness of its foreign staff should give the firm an edge in anticipating countries where the currency is weak. Recognizing a weak currency is different from being able to predict the time or amount of a devaluation, but it does allow some defensive planning.

If the firm is already diversified, it should be able to shift sourcing, production, or sales effort from one country or currency to another in order to benefit from the change in the post-devaluation economic situation. Such shifts could be marginal or major.

Unexpected devaluations change the cost of the several components of capital—in particular, the cost of debt in one market relative to another. If a firm has already diversified its sources of financing, that is, established itself as a known and reputable factor in several capital markets, it can quickly move to take advantage of any temporary deviations from the international Fisher effect by changing the country or currency where borrowings are made.

11. Proactive Management. Operating exposures can be partially managed by adopting operating or

financing policies that offset anticipated foreign exchange exposures. What are four of the most commonly employed proactive policies?

The four most common proactive policies and a brief explanation are matching currency cash flows, risk-sharing agreements, back-to-back loans, and currency swaps.

12. Matching Currency Exposure. Explain how matching currency cash flows can offset operating

exposure.

The essence of this approach is to create operating or financial foreign currency cash outflows to match equivalent foreign currency inflows. Often debt is incurred in the same foreign currency in which operating cash flows are received.

13. Risk Sharing. An alternative arrangement for managing operating exposure between firms with a

continuing buyer-supplier relationship is risk sharing. Explain how risk sharing works.

Contracts, including sales and purchasing contracts, between parties operating in different currency areas can be written such that any gain or loss caused by a change in the exchange rate will be shared by the two parties.

14. Back-to-Back Loans. Explain how back-to-back loans can hedge foreign exchange operating

exposure. Would firms have any specific worries about their partner in a back-to-back loan arrangement?

Two firms in different countries lend their home currency to each other and agree to repay each other the same amount at a later date. This can be viewed as a loan between two companies (independent entities or subsidiaries in the same corporate family) with each participant both making a loan and receiving 100% collateral in the other’s currency. A back-to-back loan appears as both a debt

Chapter 12 Operating Exposure 67

(liability side of the balance sheet) and an amount to be received (asset side of the balance sheet) on the financial statements of each firm.

15. Currency Swaps. Explain how currency swaps can hedge foreign exchange operating exposure.

What are the accounting advantages of currency swaps?

In terms of financial flows, the currency swap is almost identical to the back-to-back loan. However, in a currency swap, each participant gives some of its currency to the other participant and receives in return an equivalent amount of the other participant’s currency. No debt or receivable shows on the financial statements as this is in essence a foreign exchange transaction. The swap allows the participants to use foreign currency operating inflows to unwind the swap at a later date.

16. Hedging the Unhedgeable. How do some firms attempt to hedge their long-term operation exposure

with contractual hedges? What assumptions do they make in order to justify contractual hedging of their operating exposure? How effective is such contractual hedging in your opinion?

The ability of firms to hedge the “unhedgeable” depends on predictability: (1) the predictability of the firm’s future cash flows and (2) the predictability of the firm’s competitor’s responses to exchange rate changes. Although the management of many firms may believe they are capable of predicting their own cash flows, in practice few feel capable of accurately predicting competitor response. Many firms still find timely measurement of exposure challenging.

A significant question remains as to the true effectiveness of hedging operating exposure with contractual hedges. The fact remains that even after feared exchange rate movements and put option position payoffs have occurred, the firm is competitively disadvantaged. The capital outlay required for the purchase of such sizeable put option positions is capital not used for the potential diversification of operations, which in the long run might have more effectively maintained the firm’s global market share and international competitiveness.

CHAPTER 13

THE GLOBAL COST AND AVAILABILITY OF CAPITAL

1. Segmented Market. What are the most common challenges a firm resident in a segmented market faces in regards to its access to capital?

An illiquid market is one in which it is difficult to buy or sell shares, and especially an abnormally large number of shares, without a major change in price. From a company perspective, an illiquid market is one in which it is difficult to raise new capital because there are insufficient buyers for a reasonably sized offering. From an investor’s perspective, an illiquid market means that the investor will have difficulty selling any shares owned without a major drop in price.

2. Dimensions of Capital. Global integration has given many firms access to new and cheaper sources

of funds beyond those available in their home markets. What are the dimensions of a strategy to capture this lower cost and greater availability of capital?

Global integration of capital markets has given many firms access to new and cheaper sources of funds beyond those available in their home markets. These firms can then accept more long-term projects and invest more in capital improvements and expansion. If a firm resides in a country with illiquid or segmented capital markets, it can achieve this lower global cost and greater availability of capital by a properly designed and implemented strategy.

3. Cost of Capital Benefits. What are the benefits of achieving a lower cost and greater availability of

capital?

A firm can accept more long-term projects and invest more in capital improvements and expansion because of the lower hurdle rate in capital budgeting and the lower marginal cost of capital as more funds are raised.

4. Equity Cost and Risk. What are the classifications used in defining risk in the estimation of a firm’s

cost of equity?

Systematic risk. Systematic risk is the risk of share price changes that cannot be avoided by diversification. In other words, it is the risk that the stock market as a whole will rise or fall, and the price of shares of an individual company will rise and fall with the market. Systematic risk is sometimes called market risk.

Beta (in the Capital Asset Pricing Model). Beta is a measure of the systematic risk of a firm, where “systematic risk” means that risk that cannot be diversified away. Beta measures the amount of fluctuation expected in a firm’s share price, relative to the stock market as a whole. Thus a beta of 0.8 would indicate an expectation that the share price of a given company would rise or fall at 80% of the rise or fall in the stock market in general. The stock is expected to be less volatile than the market as a whole. A beta of 1.6 would indicate an expectation that the share price of a given company would rise or fall at 60% more that the rise or fall in the market. If the market rose, say, 20% during a year, a stock with a beta of 1.6 would be expected to rise (0.20)(1.6) = 0.32, or 32%.

Chapter 13 The Global Cost and Availability of Capital 69

5. Equity Risk Premiums. What is an equity risk premium? For an equity risk premium to be truly useful, what need it do?

The equity risk premium is the average annual return of the market expected by investors over and above riskless debt, the term (km – krf). To be useful, it must be a relatively accurate forecast of what market returns will be in the near- to medium-term future.

6. Portfolio Investors. Both domestic and international portfolio managers are asset allocators. What is

their portfolio management objective?

Their objective is to maximize a portfolio’s rate of return for a given level of risk or to minimize risk for a given rate of return. International portfolio managers can choose from a larger bundle of assets than portfolio managers limited to domestic-only asset allocations.

7. International Portfolio Management. What is the main advantage that international portfolio

managers have compared to portfolio managers limited to domestic-only asset allocation?

Internationally diversified portfolios often have a higher expected rate of return, and they nearly always have a lower level of portfolio risk because national securities markets are imperfectly correlated with one another.

8. International CAPM. What are the fundamental distinctions that the international CAPM tries to

capture which traditional domestic CAPM does not?

In theory, the primary distinction in the estimation of the cost of equity for an individual firm using an internationalized version of the CAPM is the definition of the “market” and a recalculation of the firm’s beta for that market. International CAPM (ICAPM) assumes that there is a global market in which the firm’s equity trades, and estimates of the firm’s beta (βjg) and the market risk premium (kmg – krfg) must then reflect this global portfolio.

9. Dimensions of Asset Allocation. Portfolio asset allocation can be accomplished along many

dimensions depending on the investment objective of the portfolio manager. Identify the various dimensions.

Portfolio asset allocation can be accomplished along many dimensions depending on the investment objective of the portfolio manager. For example, portfolios can be diversified according to the type of securities. They can be composed of stocks only, bonds only, or a combination of both. They also can be diversified by industry or by size of capitalization (small-cap, mid-cap, and large-cap stock portfolios).

10. Market Liquidity. What is meant by the term market liquidity? What are the main disadvantages for

a firm to be located in an illiquid market?

Although no consensus exists about the definition of market liquidity, we can observe market liquidity by noting the degree to which a firm can issue a new security without depressing the existing market price, as well as the degree to which a change in price of its securities elicits a substantial order flow.

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11. Market Segmentation. What is market segmentation, and what are the six main causes of market segmentation?

Capital market segmentation is a financial market imperfection caused mainly by government constraints, institutional practices, and investor perceptions. The most important imperfections are the following:

Asymmetric information between domestic and foreign-based investors

Lack of transparency

High securities transaction costs

Foreign exchange risks

Political risks

Corporate governance differences

Regulatory barriers 12. Market Liquidity. What is the effect of market liquidity and segmentation on a firm’s cost of

capital?

Firms located in an illiquid and segmented capital market will usually have a higher marginal cost of capital.

13. Emerging Markets. Firms located in illiquid and segmented emerging markets would benefit from

nationalizing their own cost of capital. What do they need to do, and what conditions must exist for their efforts to succeed?

Multinational firms based in emerging markets often face barriers and lack of visibility similar to what Novo faced. They could benefit by following Novo’s proactive strategy employed to attract international portfolio investors. However, a word of caution is advised. Novo had an excellent operating track record and a very strong worldwide market niche in two important industry sectors, insulin and industrial enzymes. This record continues to attract investors in Denmark and abroad. Other companies would also need to have such a favorable track record to attract foreign investors.

14. Cost of Capital for MNEs. Do multinational firms have a higher or lower cost of capital than their

domestic counterparts? Is this surprising?

Theoretically, MNEs should be in a better position than their domestic counterparts to support higher debt ratios because their cash flows are diversified internationally. However, recent empirical studies have come to the opposite conclusion. These studies also concluded that MNEs have higher betas than their domestic counterparts.

15. Multinational Use of Debt. Do multinational firms use relatively more or less debt than their

domestic counterparts? Why?

According to empirical studies, multinational firms appear to use less debt than their domestic counterparts. We believe it results from a variety of factors. First, despite the favorable effect of international diversification of cash flows, bankruptcy risk was only about the same for MNEs as for domestic firms. However, MNEs faced higher agency costs, political risk, foreign exchange risk, and asymmetric information. These have all been identified as the factors leading to lower debt ratios and

Chapter 13 The Global Cost and Availability of Capital 71

even a higher cost of long-term debt for MNEs. Domestic firms rely much more heavily on short and intermediate debt, which lie at the low cost end of the yield curve.

16. Multinationals and Beta. Do multinational firms have higher lower betas than their domestic

counterparts?

A number of studies have found that MNEs have a higher level of systematic risk than their domestic counterparts. The same factors caused this phenomenon that caused the lower debt ratios for MNEs. In general, the increased standard deviation of cash flows from internationalization more than offset the lower correlation from diversification.

17. The “Riddle.” What is the riddle?

The riddle is an attempt to explain under what conditions an MNE would have a higher or lower debt ratio and beta than its domestic counterpart does. The answer to this riddle lies in the link between the cost of capital, its availability, and the opportunity set of projects. As the opportunity set of projects increases, eventually the firm needs to increase its capital budget to the point where its marginal cost of capital is increasing. The optimal capital budget would still be at the point where the rising marginal cost of capital equals the declining rate of return on the opportunity set of projects. However, this would be at a higher weighted average cost of capital than would have occurred for a lower level of the optimal capital budget.

To illustrate this linkage, Exhibit 13.8 in the chapter shows the marginal cost of capital given different optimal capital budgets. Assume that there are two different demand schedules based on the opportunity set of projects for both the multinational enterprise (MNE) and domestic counterpart (DC).

18. Emerging Market Listings. Why might emerging market multinationals list their shares abroad?

First, to improve liquidity and escape from a segmented home market.

Secondly, internationalization may actually allow emerging market MNEs to carry a higher level of debt and lower their systematic risk. This may occur because the emerging market MNEs are investing in more stable economies abroad, a strategy that lowers their operating, financial, foreign exchange, and political risks. The reduction in risk more than offsets their increased agency costs and allows the emerging market MNEs to enjoy higher leverage and lower systematic risk than their U.S.–based MNE counterparts.

CHAPTER 14

RAISING EQUITY AND DEBT GLOBALLY

1. Equity Sourcing Strategy. Why does the strategic path to sourcing equity start with debt?

Most firms should start sourcing abroad with an international bond issue to gain name recognition in the global financial markets. This could be followed by an international bond issue in a target market or in the eurobond market. The next step might be to cross-list and issue equity in one of the less prestigious markets in order to attract the attention of international investors.

2. Optimal Financial Structure. If the cost of debt is less than the cost of equity, why doesn’t the

firm’s cost of capital continue to decrease with the use of more and more debt?

When taxes and bankruptcy costs are considered, a firm has an optimal financial structure determined by that particular mix of debt and equity that minimizes the firm’s cost of capital for a given level of business risk. If the business risk of new projects differs from the risk of existing projects, the optimal mix of debt and equity would change to recognize trade-offs between business and financial risks. As more and more debt is taken on, the firm’s perceived ability to service those cash flow obligations worsens and its riskiness rises as does its cost of equity.

3. Multinationals and Cash Flow Diversification. How does the multinational’s ability to diversify its

cash flows alter its ability to use greater amounts of debt?

Multinational firms are in a better position than domestic firms to support higher debt ratios because their cash flows are diversified internationally. The probability of a firm covering fixed charges under varying conditions in product, financial, and foreign exchange markets should increase if the variability of its cash flows is minimized.

By diversifying cash flows internationally, the MNE might be able to achieve the same kind of reduction in cash flow variability as portfolio investors receive from diversifying their security holdings internationally. Returns are not perfectly correlated between countries. In contrast, a domestic firm would not enjoy the benefit of international cash flow diversification. Instead, it would need to rely entirely on its own net cash inflow from domestic operations.

4. Foreign Currency Denominated Debt. How does borrowing in a foreign currency change the risk

associated with debt?

Changes in foreign exchange rates caused the ex post cost of borrowing to increase or decrease from what was originally expected. Management can only guess at future foreign exchange risk. Therefore, they could either borrow only in their functional currency or diversify by currency their sources of borrowing.

5. Three Keys to Global Equity. What are the three key elements related to raising equity capital in the

global marketplace?

Equity issuance, equity listing, and private placement.

Chapter 14 Raising Equity and Debt Globally 73

6. Global Equity Alternatives. What are the alternative structures available for raising equity capital on the global market?

1. Sale of a directed public share issue to investors in a target market

2. Sale of a euroequity public issue to investors in more than one market, including both foreign and domestic markets

3. Private placements under SEC Rule 144A

4. Sale of shares to private equity funds

5. Sale of shares to a foreign firm as part of a strategic alliance 7. Directed Public Issues. What is a directed public issue? What is the purpose of this kind of an

international equity issuance?

A directed public share issue is defined as one that is targeted at investors in a single country and underwritten in whole or in part by investment institutions from that country. The issue might or might not be denominated in the currency of the target market. The shares might or might not be cross-listed on a stock exchange in the target market.

8. Depositary Receipts. What is a depositary receipt? What are equity shares listed and issued in

foreign equity markets in this form?

Depositary receipts (depositary shares) are negotiable certificates issued by a bank to represent the underlying shares of stock, which are held in trust at a foreign custodian bank. American depositary receipts (ADRs) are certificates traded in the United States and denominated in U.S. dollars. ADRs are sold, registered, and transferred in the United States in the same manner as any share of stock, with each ADR representing some multiple of the underlying foreign share.

9. GDRs, ADRs, and GRSs. What is the difference between a GDR, ADR, and GRS? How are these

differences significant?

Similar to ordinary shares, GDRs have the added benefit of being able to be traded on equity exchanges around the globe in a variety of currencies. ADRs, however, are quoted only in U.S. dollars and are traded only in the United States. GDRs can, theoretically, be traded with the sun, following markets as they open and close around the globe around the clock. The shares are traded electronically, thereby eliminating the specialized forms and depositaries required by share forms like ADRs.

10. Sponsored and Unsponsored. ADRs and GDRs can be sponsored or unsponsored. What does it

mean and will it matter to the investors purchasing the shares?

Sponsored depositary receipts. Sponsored ADRs are created at the request of a foreign firm wanting its shares traded in the United States. The firm applies to the Securities and Exchange Commission (SEC) and a U.S. bank for registration and issuance of ADRs.

Unsponsored depositary receipts. If a foreign firm does not seek to have its shares traded in the United States but U.S. investors are interested, a U.S. securities firm may initiate creation of the ADRs. Such an ADR would be unsponsored, but the SEC still requires that all new ADR programs must have approval of the firm itself even if it is not a sponsored ADR.

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11. ADR Levels. Distinguish between the three levels of commitment for ADRs traded in the United States.

Level I (“over the counter” or pink sheets) is the easiest to satisfy. It facilitates trading in foreign securities that have been acquired by U.S. investors but are not registered with the SEC. It is the least costly approach but might have a minimal impact on liquidity. Level II applies to firms that want to list existing shares on the NYSE, AMEX, or NASDAQ markets. They must meet the full registration requirements of the SEC. This means reconciling their financial accounts with those used under U.S. GAAP, which raises the cost considerably. Level III applies to the sale of a new equity issued in the United States. It too requires full registration with the SEC and an elaborate stock prospectus. This is the most expensive alternative but the most likely to improve the stock’s liquidity and escape from home market segmentation.

12. IPOs and FOs. What is the significance of IPOs versus FOs?

An IPO, an initial public offering, is when a firm first raises capital by listing its shares in a public market. The FO or follow-on offerings is when the company over time issues additional shares in the public market in order to raise additional equity.

13. Foreign Equity Listing and Issuance. Give five reasons why a firm might cross-list and sell its

shares on a very liquid stock exchange. 1. Improve the liquidity of its existing shares and support a liquid secondary market for new equity

issues in foreign markets.

2. Increase its share price by overcoming mispricing in a segmented and illiquid home capital market.

3. Increase the firm’s visibility and political acceptance to its customers, suppliers, creditors, and host governments.

4. Establish a secondary market for shares used to acquire other firms in the host market.

5. Create a secondary market for shares that can be used to compensate local management and employees in foreign subsidiaries.

14. Cross-Listing Abroad. What are the main reasons causing firms to cross-list abroad?

A recent study of U.S. firms that issued equity abroad concluded that increased name recognition and accessibility from global equity issues leads to increased investor recognition and participation in both the primary and secondary markets. Moreover, the ability to issue global shares can validate firm quality by reducing the information asymmetry between insiders and investors. Another conclusion was that U.S. firms may seize a window of opportunity to switch to global offerings when domestic demand for their shares is weak. Finally, the study found that U.S. firms announcing global equity offerings have significantly less negative market reactions by about one percentage point than what would have been expected had they limited their issues to the domestic market.

15. Barriers to Cross-Listing. What are the main barriers to cross-listing abroad?

A decision to cross-list must be balanced against the implied increased commitment to full disclosure and a continuing investor relations program. For firms resident in the Anglo-American markets, listing abroad might not appear to be much of a barrier. For example, the SEC’s disclosure rules for listing in the United States are so stringent and costly that any other market’s rules are mere child’s

Chapter 14 Raising Equity and Debt Globally 75

play. Reversing the logic, however, non–U.S. firms must really think twice before cross-listing in the United States. Not only are the disclosure requirements breathtaking, but a continuous timely quarterly information is required by U.S. regulators and investors. As a result, the foreign firm must provide a costly continuous investor relations program for its U.S. shareholders, including frequent “road shows” and the time-consuming personal involvement of top management.

16. Private Placement. What is a private placement? What are the comparative pros and cons of private

placement versus a pubic issue?

A firm, public or private, can place an issue with private investors, a private placement. (Note that private placement may refer to either equity or debt.) Private placements can take a variety of different forms, and the intent of investors may be passive (e.g., Rule 144A investors) or active (e.g., private equity, where the investor intends to control and change the firm).

17. Private Equity. What is private equity, and how do private equity funds differ from traditional

venture capital firms?

Private equity funds are usually limited partnerships of institutional and wealthy individual investors that raise their capital in the most liquid capital markets, especially the United States. They then invest the private equity fund in mature, family-owned firms located in emerging markets. The investment objective is to help these firms to restructure and modernize in order to face increasing competition and the growth of new technologies.

Private equity funds differ from traditional venture capital funds. The latter usually operate mainly in highly developed countries. They typically invest in high technology start-ups with the goal of exiting the investment with an initial public offering (IPO) placed in those same highly liquid markets. Very little venture capital is available in emerging markets, partly because it would be difficult to exit with an IPO in an illiquid market. The same exiting problem faces the private equity funds, but they appear to have a longer time horizon, they invest in already mature and profitable companies, and they are content with growing companies through better management and mergers with other firms.

18. Bank Loans versus Securitized Debt. What is the advantage of securitized debt instruments sold on

a market versus bank borrowing for multinational corporations?

If a multinational firm is widely known in the global capital markets, it generally prefers to issue securitized debt over the use of bank loans. Purchasers of eurobonds do not rely only on bond-rating services or on detailed analyses of financial statements. The general reputation of the issuing corporation and its underwriters has been a major factor in obtaining favorable terms. For this reason, larger and better known MNEs, state enterprises, and sovereign governments are able to obtain the lowest interest rates. Firms whose names are better known to the general public, possibly because they manufacture consumer goods, are often believed to have an advantage over equally qualified firms whose products are less widely known.

19. International Debt Instruments. What are the primary alternative instruments available for raising

debt on the international marketplace?

Syndicated loans. Syndication allows many different investors to “participate” in the funding of the loan, thereby allowing them to diversify their risk or exposure to the individual borrower. The result is the borrower gains access to a greater availability of capital at a lower cost of funds.

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Euronotes. A major development in international money markets was the establishment of facilities for sales of short-term, negotiable, promissory notes—euronotes. Among the facilities for their issuance were revolving underwriting facilities (rufs), note issuance facilities (nifs), and standby note issuance facilities (snifs). These facilities were provided by international investment and commercial banks. The euronote was a substantially cheaper source of short-term funds than syndicated loans because the notes were placed directly with the investor public, and the securitized and underwritten form allowed the ready establishment of liquid secondary markets. The banks received substantial fees initially for their underwriting and placement services.

Euro-commercial paper. Euro-commercial paper (ECP), like commercial paper issued in domestic markets around the world, is a short-term debt obligation of a corporation or bank. Maturities are typically one, three, and six months. The paper is sold normally at a discount or occasionally with a stated coupon. Although the market is capable of supporting issues in any major currency, more than 90% of issues outstanding are denominated in U.S. dollars.

Euro-medium term notes. The EMTN’s basic characteristics are similar to those of a bond, with principal, maturity, and coupon structures and rates being comparable. The EMTN’s typical maturities range from as little as nine months to a maximum of 10 years. Coupons are typically paid semiannually, and coupon rates are comparable to similar bond issues. The EMTN does, however, have three unique characteristics. First, the EMTN is a facility, allowing continuous issuance over a period, unlike a bond issue, which is essentially sold all at once. Second, because EMTNs are sold continuously, in order to make debt service (coupon redemption) manageable, coupons are paid on set calendar dates regardless of the date of issuance. Finally, EMTNs are issued in relatively small denominations, from $2 million to $5 million, making medium-term debt acquisition much more flexible than the large minimums customarily needed in the international bond markets.

International bonds. The international bond market sports a rich array of innovative instruments created by imaginative investment bankers who are unfettered by the usual controls and regulations governing domestic capital markets. Indeed, the international bond market rivals the international banking market in terms of the quantity and cost of funds provided to international borrowers. All international bonds fall within two generic classifications, eurobonds and foreign bonds. The distinction between categories is based on whether the borrower is a domestic or a foreign resident and whether the issue is denominated in the local currency or a foreign currency.

20. Eurobond versus Foreign Bonds. What is the difference between a eurobond and a foreign bond,

and why do two types of international bonds exist?

All international bonds fall within two generic classifications, eurobonds and foreign bonds. The distinction between categories is based on whether the borrower is a domestic or a foreign resident, and whether the issue is denominated in the local currency or a foreign currency.

A eurobond is underwritten by an international syndicate of banks and other securities firms and

is sold exclusively in countries other than the country in whose currency the issue is denominated. For example, a bond issued by a firm resident in the United States, denominated in U.S. dollars but sold to investors in Europe and Japan (not to investors in the United States), would be a eurobond.

A foreign bond is underwritten by a syndicate composed of members from a single country, sold

principally within that country, and denominated in the currency of that country. The issuer, however, is from another country. A bond issued by a firm resident in Sweden, denominated in dollars, and sold in the United States to U.S. investors by U.S. investment bankers, would be a

Chapter 14 Raising Equity and Debt Globally 77

foreign bond. Foreign bonds have nicknames: foreign bonds sold in the United States are “Yankee bonds”; foreign bonds sold in the United Kingdom are “bulldogs.”

A firm can now issue equity underwritten and distributed in multiple foreign equity markets, sometimes simultaneously with distribution in the domestic market. The same financial institutions that had previously created an infrastructure for the euronote and eurobond markets (described in detail in Chapter 16) were responsible for the euroequity market. The term “euro” does not imply that the issuers or investors are located in Europe nor does it mean the shares are sold in the currency “euro.” It is a generic term for international securities issues originating and being sold anywhere in the world.

21. Funding Foreign Subsidiaries. What are the primary methods of funding foreign subsidiaries, and

how do host government concerns affect those choices?

In general, although a minimum amount of equity capital from the parent company is required, multinationals often strive to minimize the amount of equity in foreign subsidiaries in order to limit risks of losing that capital. Equity investment can take the form of either cash or real goods (machinery, equipment, inventory, etc.).

Although debt is the preferable form of subsidiary financing, access to local host country debt is limited in the early stages of a foreign subsidiary’s life. Without a history of proven operational capability and debt service capability, the foreign subsidiary may need to acquire its debt from the parent company or from unrelated parties with a parental guarantee (after operations have been initiated). Once the operational and financial capabilities of the subsidiary have been established, it may then actually enjoy preferred access to debt locally.

22. Local Norms. Should foreign subsidiaries of multinational firms conform to the capital structure

norms of the host country or to the norms of their parent’s country?

Main advantages of localization. The main advantages of a finance structure for foreign subsidiaries that conforms to local debt norms are as follows:

A localized financial structure reduces criticism of foreign subsidiaries that have been operating

with too high a proportion of debt (judged by local standards), often resulting in the accusation that they are not contributing a fair share of risk capital to the host country. At the other end of the spectrum, a localized financial structure would improve the image of foreign subsidiaries that have been operating with too little debt and thus appear to be insensitive to local monetary policy.

A localized financial structure helps management evaluate return on equity investment relative to

local competitors in the same industry. In economies where interest rates are relatively high as an offset to inflation, the penalty paid reminds management of the need to consider price level changes when evaluating investment performance.

In economies where interest rates are relatively high because of a scarcity of capital, and real

resources are fully utilized (full employment), the penalty paid for borrowing local funds reminds management that unless return on assets is greater than the local price of capital—that is, negative leverage—they are probably misallocating scarce domestic real resources such as land and labor. This factor may not appear relevant to management decisions, but it will certainly be considered by the host country in making decisions with respect to the firm.

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Main disadvantages of localization. The main disadvantages of localized financial structures are as follows:

An MNE is expected to have a comparative advantage over local firms in overcoming

imperfections in national capital markets through better availability of capital and the ability to diversify risk. Why should it throw away these important competitive advantages to conform to local norms established in response to imperfect local capital markets, historical precedent, and institutional constraints that do not apply to the MNE?

If each foreign subsidiary of an MNE localizes its financial structure, the resulting consolidated

balance sheet might show a financial structure that does not conform to any particular country’s norm. The debt ratio would be a simple weighted average of the corresponding ratio of each country in which the firm operates. This feature could increase perceived financial risk and thus the cost of capital for the parent, but only if two additional conditions are present:

1. The consolidated debt ratio is pushed completely out of the discretionary range of acceptable

debt ratios in the flat area of the cost of capital curve, shown previously in Exhibit 16.1.

2. The MNE is unable to offset high debt in one foreign subsidiary with low debt in other foreign or domestic subsidiaries at the same cost. If the International Fisher effect is working, replacement of debt should be possible at an equal after-tax cost after adjusting for foreign exchange risk. On the other hand, if market imperfections preclude this type of replacement, the possibility exists that the overall cost of debt, and thus the cost of capital, could increase if the MNE attempts to conform to local norms.

The debt ratio of a foreign subsidiary only cosmetic because lenders ultimately look to the parent

and its consolidated worldwide cash flow as the source of repayment. In many cases, debt of subsidiaries must be guaranteed by the parent firm. Even if no formal guarantee exists, an implied guarantee usually exists because almost no parent firm would dare to allow an affiliate to default on a loan. If it did, repercussions would surely be felt with respect to the parent’s own financial standing, with a resulting increase in its cost of capital.

23. Internal Financing of Foreign Subsidiaries. What is the difference between “internal” financing

and “external” financing for a subsidiary?

“Internal sourcing” means the funds come from related firms. “External sourcing” means the funds come from unrelated firms or investors. Internal financing types include (1) funds from the parent company, (2) funds from sister subsidiaries, and (3) subsidiary borrowing with parent guarantees.

24. External Financing of Foreign Subsidiaries. What are the primary alternatives for the external

financing of a foreign subsidiary?

External financing types include (1) borrowing from sources in the parent country, (2) borrowing from sources outside the parent country, and (3) raising equity locally.

CHAPTER 15

MULTINATIONAL TAX MANAGEMENT

1. Primary Objective. What is the primary objective of multinational tax planning?

The primary objective of multinational tax planning is to pay the lowest global effective tax rate. 2. Tax Morality. What is meant by the term “tax morality”? If for example, your company has a

subsidiary in Russia where some believe tax evasion is a fine art, should you comply with Russian tax laws or violate the laws as do your local competitors?

The MNE faces not only a morass of foreign taxes but also an ethical question. In many countries, taxpayers, corporate or individual, do not voluntarily comply with the tax laws. Smaller domestic firms and individuals are the chief violators. The MNE must decide whether to follow a practice of full disclosure to tax authorities or adopt the philosophy, “When in Rome, do as the Romans do.” Given the local prominence of most foreign subsidiaries and the political sensitivity of their position, most MNEs follow the full disclosure practice. Some firms, however, believe that their competitive position would be eroded if they did not avoid taxes to the same extent as their domestic competitors. There is obviously no prescriptive answer to the problem because business ethics are partly a function of cultural heritage and historical development.

3. Tax Neutrality. What is tax neutrality? What is the difference between domestic neutrality and

foreign neutrality?

When a government decides to levy a tax, it must consider not only the potential revenue from the tax, or how efficiently it can be collected, but also the effect the proposed tax can have on private economic behavior. For example, the U.S. government’s policy on taxation of foreign-source income does not have as single objective, the raising of revenue.

One way to view neutrality is to require that the burden of taxation on each dollar, euro, pound, or yen of profit earned in home country operations by an MNE be equal to the burden of taxation on each currency equivalent of profit earned by the same firm in its foreign operations. This is called domestic neutrality. A second way to view neutrality is to require that the tax burden on each foreign subsidiary of the firm be equal to the tax burden on its competitors in the same country. This is called foreign neutrality. The latter policy is often supported by MNEs because it focuses more on the competitiveness of the individual firm in individual country markets.

4. Worldwide versus Territorial. What is the difference between the worldwide and territorial

approaches to taxation?

The worldwide approach, also referred to as the residential or national approach, levies taxes on the income earned by firms that are incorporated in the host country, regardless of where the income was earned (domestically or abroad). An MNE earning income both at home and abroad would therefore find its worldwide income taxed by its home country tax authorities. For example, a country like the United States taxes the income earned by firms based in the United States regardless of whether the income earned by the firm is domestic or foreign in origin. In the case of the United States, ordinary foreign-sourced income is taxed only as remitted to the parent firm. As with all questions of tax, however, numerous conditions and exceptions exist. The primary problem is that this approach does

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not address the income earned by foreign firms operating within the United States. Countries like the United States then apply the principle of territorial taxation to foreign firms within their legal jurisdiction, taxing all income earned by foreign firms in their borders as well.

The territorial approach, also termed the source approach, focuses on the income earned by firms within the legal jurisdiction of the host country, not on the country of firm incorporation. Countries like Germany that follow the territorial approach apply taxes equally to foreign or domestic firms on income earned within the country, but in principle not on income earned outside the country. The territorial approach, like the worldwide approach, results in a major gap in coverage if resident firms earn income outside the country but are not taxed by the country in which the profits are earned. In this case, tax authorities extend tax coverage to income earned abroad if it is not currently covered by foreign tax jurisdictions. Once again, a mix of the two tax approaches is necessary for full coverage of income.

5. Direct or Indirect. What is the difference between a direct tax and an indirect tax?

Taxes are classified on whether they are applied directly to income, called direct taxes, or to some other measurable performance characteristic of the firm, called indirect taxes.

6. Tax Deferral. What is meant by tax deferral in the U.S. system of taxation? What is the deferral

privilege?

If the worldwide approach to international taxation were followed to the letter, it would end the tax- deferral privilege for many MNEs. Foreign subsidiaries of MNEs pay host country corporate income taxes, but many parent countries defer claiming additional income taxes on that foreign-source income until it is remitted to the parent firm.

For example, U.S. corporate income taxes on some types of foreign-source income of U.S.-owned subsidiaries incorporated abroad are deferred until the earnings are remitted to the U.S. parent. However, the ability to defer corporate income taxes is highly restricted and has been the subject of many tax law changes in the past three decades.

7. Value-Added Tax. What is a value-added tax, and how does it differ from an income tax?

The value added tax is in effect a sales tax on the value added at every step of the production and distribution process, adjusted so that the tax is not cumulative; i.e., a later stage of production does not pay tax on taxes already levied at earlier stages.

The advantages of the value-added tax include (1) it is probably more neutral in its effect on economic decisions, (2) the populace is generally more aware that they are paying the tax, and (3) it can be rebated in the case of exports. The latter “advantage” puts countries using the value-added tax at an advantage over those that rely on income taxes on the profit from exports because income taxes cannot be rebated.

8. Withholding Tax. What is a withholding tax, and why do governments impose them?

Withholding taxes are a minimum tax payment due government prior to remittance, in this case, outside the country. The reason for the institution of withholding taxes is that governments recognize that most international investors will not file a tax return in each country in which they invest. The government, therefore, wishes to ensure that a minimum tax payment is received. As the term “withholding” implies, taxes are withheld by the corporation from the payment made to the investor,

Chapter 15 Multinational Tax Management 81

and the taxes withheld are then turned over to government authorities. Withholding taxes are a major subject of bilateral tax treaties and generally range between 0% and 25%.

9. Tax Treaty. What is usually included within a tax treaty?

Tax treaties normally define whether taxes are to be imposed on income earned in one country by the nationals of another, and if so, how. Tax treaties are bilateral, with the two signatories specifying what rates are applicable to which types of income between the two countries alone.

The individual bilateral tax jurisdictions as specified through tax treaties are particularly important for firms that are primarily exporting to another country rather than doing business there through a “permanent establishment.” The latter would be the case for manufacturing operations. A firm that only exports would not want any of its other worldwide income taxed by the importing country. Tax treaties define what is a “permanent establishment” and what constitutes a limited presence for tax purposes.

Tax treaties typically result in reduced withholding tax rates between the two signatory countries, the negotiation of the treaty itself serving as a forum for opening and expanding business relationships between the two countries. This practice is important both to MNEs operating through foreign subsidiaries, earning active income, and to individual portfolio investors who are simply receiving passive income in the form of dividends, interest, or royalties.

10. Active versus Passive. What do the terms active and passive mean in the context of U.S. taxation of

foreign source income?

Active income, the income arising from manufacturing or provision of services, is difficult to shift across borders by ownership. Passive income, however, is more easily shifted and therefore may gain undue deferral of U.S. taxation. Subpart F income is active income, subject to immediate U.S. taxation even when not remitted, and is otherwise easily shifted offshore to avoid current taxation. It includes (1) passive income received by the foreign corporation such as dividends, interest, rents, royalties, net foreign currency gains, net commodities gains, and income from the sale of non- income-producing property, (2) income from the insurance of U.S. risks, (3) financial service income, (4) shipping income, (5) oil-related income, and (6) certain related-party sales and service income.

One type of passive income would simply be the distributed profits of another company, dividends, if the foreign company owned it. Without the differential treatment, it would only make sense for most U.S. multinationals to create a holding company in a tax haven, which would then own all the foreign subsidiaries of the company. Then, all the profits earned by the holding company would be retained in low tax environment without incurring any U.S. tax liabilities. An undesired outcome by the U.S. tax authorities!

11. Tax Types. Taxes are classified based on whether they are applied directly to income, called direct

taxes, or to some other measurable performance characteristic of the firm, called indirect taxes. Identify each of the following as a “direct tax,” an “indirect tax,” or something else:

a. Corporate income tax paid by a Japanese subsidiary on its operating income—Direct tax

b. Royalties paid to Saudi Arabia for oil extracted and shipped to world markets—Technically not a tax, but in fact similar to a direct tax.

c. Interest received by a U.S. parent on bank deposits held in London—Any tax on such interest would be a direct tax.

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d. Interest received by a U.S. parent on a loan to a subsidiary in Mexico—Direct tax

e. Principal repayment received by U.S. parent from Belgium on a loan to a wholly owned subsidiary in Belgium—Not a tax

f. Excise tax paid on cigarettes manufactured and sold within the United States—Indirect tax

g. Property taxes paid on the corporate headquarters building in Seattle—Indirect tax

h. A direct contribution to the International Committee of the Red Cross for refugee relief—Not a tax

i. Deferred income tax, shown as a deduction on the U.S. parent’s consolidated income tax—Direct tax

j. Withholding taxes withheld by Germany on dividends paid to a United Kingdom parent corporation—Direct tax

12. Foreign Tax Credit. What is a foreign tax credit? Why do countries give credit for taxes paid on

foreign source income?

To prevent double taxation of the same income, most countries grant a foreign tax credit for income taxes paid to the host country. Countries differ on how they calculate the foreign tax credit and what kinds of limitations they place on the total amount claimed. Normally foreign tax credits are also available for withholding taxes paid to other countries on dividends, royalties, interest, and other income remitted to the parent. The value-added tax and other sales taxes are not eligible for a foreign tax credit but are typically deductible from pretax income as an expense.

A tax credit is a direct reduction of taxes that would otherwise be due and payable. It differs from a deductible expense, which is an expense the taxpayer uses to reduce taxable income before the tax rate is applied. A $100 tax credit reduces taxes payable by the full $100, whereas a $100 deductible expense reduces taxable income by $100 and taxes payable by $100 × t, where t is the tax rate. Tax credits are more valuable on a dollar-for-dollar basis than are deductible expenses.

13. Earnings Stripping. What is earnings stripping, and what are some examples of how multinational

firms pursue it?

A multinational firm may allocate debt differently across its various foreign subsidiaries to reduce tax liabilities in high tax environments. Units in high tax environments may be assigned very high debt obligations in an attempt to maximize the interest deductibility provisions offered in that country. Often termed earnings stripping, this method is typically limited by host government requirements for minimum equity capitalizations—thin capitalization rules.

14. Controlled Foreign Corporation. What is a controlled foreign corporation and what is its

significance in global tax management?

A controlled foreign corporation (CFC) is any foreign corporation in which U.S. shareholders, including corporate parents, own more than 50% of the combined voting power or total value. Its significance in global tax management arises from the fundamental assumption by U.S. tax authorities that all income earned by a CFC is under the full control of the U.S. parent company, and any choice to delay repatriation of passive income is made only to gain deferral of U.S. taxation.

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15. Transfer Pricing. What is a transfer price and can a government regulate it? What difficulties and motives does a parent multinational firm face in setting transfer prices?

A transfer price is the amount paid by one unit of a company (domestic or international) for goods or services purchased from another unit of the same firm. As such, a transfer price is needed for every intrafirm transaction. Where buyer and seller are in different tax jurisdictions (i.e., countries), governments are concerned with the possibility that transfer prices are raised or lowered from a “normal” or “appropriate” level in order to avoid taxes.

In most countries, tax authorities have the right to declare a given international transfer price as a tax avoidance device. Such countries have the right to reset taxable income to a higher level. The motives for the parent MNE are to minimize taxes, and the difficulty is that the burden of proof is on the MNE, not the tax collector, to show proof as to why a given transfer price is reasonable.

16. Fund Positioning. What is fund positioning?

Fund positioning is the use of prices or transactions of different kinds to move taxable profits out of high-tax environments and into low-tax environments. A parent firm wishing to transfer funds out of a particular country can charge higher prices on goods sold to its subsidiary in that country—to the degree that government regulations allow. A foreign subsidiary can be financed by the reverse technique, a lowering of transfer prices. Payment by the subsidiary for imports from its parent or sister subsidiary transfers funds out of the subsidiary. A higher transfer price permits funds to be accumulated in the selling country. Multiple sourcing of component parts on a worldwide basis allows the act of switching between suppliers from within the corporate family to function as a device to transfer funds.

17. Income Tax Effect. What is the income tax effect, and how may a multinational firm alter transfer

prices as a result of the income tax effect?

A major consideration in setting a transfer price is the income tax effect. Worldwide corporate profits may be influenced by setting transfer prices to minimize taxable income in a country with a high income tax rate and to maximize taxable income in a country with a low income tax rate. A parent wishing to reduce the taxable profits of a subsidiary in a high-tax environment may set transfer prices at a higher rate to increase the costs of the subsidiary, thereby reducing taxable income.

18. Correct Pricing. What is Section 482 of the U.S. Internal Revenue Code, and what guidelines does it

recommend when setting transfer prices?

Most transfer pricing regulations require the use of a correct or arms-length price on a transaction that is similar to the price that would be seen in the open market on a similar product or service and therefore not constructed to pursue some type of fund positioning or other tax reduction or deferral objective by the company.

19. Cross-Crediting. Define cross-crediting and explain why it may or may not be consistent with a

worldwide tax regime.

Cross-crediting is the ability to cross-credit foreign tax credits with foreign tax deficits in the same period. If a U.S. multinational remits profits from two different countries, one in a high-tax environment (relative to the United States) and the other in low-tax environment (relative to the United States), if the income is from one of the two major “baskets” of foreign source income (active

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or passive), the excess foreign tax credits from one can be cross-credited against the foreign tax deficits of the other.

20. Check-the-Box. Explain how the check-the-box regulatory change altered the effectiveness of

Subpart F income regulations.

In 1997, the U.S. Treasury attempted to simplify U.S. taxes by introducing what is called check-the- box subsidiary characterization. The U.S. Treasury changed its required filing practices to allow multinational firms to categorize subsidiaries for taxation purposes by simply “checking-the-box” on a single form.

One of the box choices offered, a disregarded entity, allowed the unit to “disappear” for tax purposes because its results would be consolidated with those of its parent company. These combined units are termed hybrid entities. In the end, it allowed U.S. multinationals that have tiered ownership of offshore units to once again begin repositioning profits in low-tax environments and gain essentially permanent deferral for those earnings. In 2007, the U.S. Treasury codified this process in what is now referred to as the look-through-rules on this tax treatment of disregarded entities.

21. Measuring Managerial Performance. What role does transfer pricing have within multinational

companies when measuring management performance? How can transfer pricing practices within a firm conflict with performance measurement?

When a firm is organized with decentralized profit centers, transfer pricing between centers can disrupt evaluation of managerial performance. Transfer prices that are set high or low for various tax management purposes also alter the profitability of the unit performance for evaluation of management. Although not within the control of local unit management, prices are set for the “greater good” of the entire MNE. In cases such as these, allowances or alternative measures of price or performance need to be used to adequately evaluate individual unit management performance.

22. Tax Haven Subsidiary. What is a tax haven? Is it the same thing as an international offshore

financial center? What is the purpose of a multinational creating and operating a financial subsidiary in a tax haven?

A wholly owned subsidiary located in a low-tax environment can act as a tax haven for corporate funds awaiting reinvestment or repatriation. Tax-haven subsidiaries, categorically referred to as International Offshore Financial Centers, are partially a result of tax-deferral features on earned foreign income allowed by some of the parent countries. Tax-haven subsidiaries are typically established in a country characterized as a low tax on foreign investment or sales income earned by resident corporations and a low dividend withholding tax on dividends paid to the parent firm.

23. Corporate Inversion. What is a corporate inversion, and why do many U.S. corporations want to

pursue it although it is highly criticized by public and private parties alike?

Corporate inversion is the changing of a company’s country of incorporation. Its purpose is to reduce its effective global tax liabilities by reincorporating in a lower tax jurisdiction, typically a country using a territorial tax regime. Although the company’s operations may be completely unchanged and its corporate headquarters remaining in the original country of incorporation, it would now have a new corporate home, and its old country of incorporation would now be only one of many other countries in which the firm operates foreign subsidiaries. A number of U.S. companies have pursued corporate inversion in recent years in order to lower their effective global tax rates. Politically, in the United States, it is often seen as unpatriotic and not consistent with being a good corporate citizen.

CHAPTER 16

INTERNATIONAL TRADE FINANCE

1. Unaffiliated Buyers. Why might different documentation be used for an export to a nonaffiliated foreign buyer who is a new customer, as compared with an export to a nonaffiliated foreign buyer to whom the exporter has been selling for many years?

A new nonaffiliated buyer presents a credit risk for the exporter because the exporter may be unable to assess the credit worthiness of that importer due to geographic distance, language, culture, or lack of a record of payments to other suppliers. A letter of credit, accompanied by other documents, allows the exporter to rely on the credit standing of a bank, which is presumed to be of greater credit worthiness than just an unknown manufacturing firm.

After successful trade goes on for some time, the importer becomes a known entity, in which case the exporter will have more faith in the importer’s willingness and ability to pay. Because the letter of credit and other documents have both a financial cost and a cost for the time and energy involved in handling the documents, direct billing for exports is easier, faster, and lowers the final end-cost to the ultimate customer.

2. Affiliated Buyers. For what reason might an exporter use standard international trade documentation

(letter of credit, draft, order bill of lading) on an intrafirm export to its parent or sister subsidiary?

An export to a parent or sister subsidiary has no credit risk because both exporter and importer are part of the same corporate unit. Nonpayment to an exporter in this situation is just a matter of keeping the firm’s cash in another corporate account. In fact, very late payment for an export to an affiliated importer might be desirable because the firm wants to keep cash in one location and not in another. (This is referred to as “leads and lags.”) Nevertheless, an export to an affiliated buyer might pass through the standard documentation as a way to obtain financing that is easy to obtain, is possibly cheaper than alternative sources of short-term financing, or provides some protection against political or country-based interruption to payment for the transaction.

3. Related Party Trade. What reasons can you give for the observation that intrafirm trade is now

greater than trade between non-affiliated exporters and importers?

The globalization of world business means that multinational firms manufacture as well as sell in many international markets simultaneously. Firms that move part of their manufacturing operation abroad to lower costs and thus enable them to compete more effectively in the home and other markets find themselves specializing in certain products or components in one location and then exporting those items to sister subsidiaries in other countries. The globalization of enterprise means that an ever-greater portion of a firms’ products are produced in one country and sold in another. (This is no different than large domestic U.S. firms manufacturing in one state and selling in another.)

4. Documents. Explain the difference between a letter of credit (L/C) and a draft. How are they linked?

A letter of credit (L/C) is a document issued by a bank promising to pay if certain documents are delivered to that bank A draft is an order sent to that bank written by a business firm ordering the bank to make payment. (A personal check is a simple form of a bank draft.) L/Cs and drafts are linked because the L/C states the conditions under which the bank promises to honor a draft drawn on (e.g.,

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directed to) that bank. 5. Risks. What is the major difference between currency risk and risk of noncompletion? How are these

risks handled in a typical international trade transaction?

Currency risk is the risk that the currency designated for payment of the import changes in value relative to the other currency. A U.S. firm exporting to France wants dollars, while the French importer wants to pay euros. If the sale contract specifies payment in dollars, the French importer has a currency risk—more euros than expected might be needed when payment is due. If the sales contract specifies payment in euros, the U.S. exporter has a currency risk—fewer dollars than expected might be received when the euros are exchanged for dollars.

Risk of noncompletion is the risk that one of the parties fails to fulfill its obligations. The importer may refuse to pay for the goods, or the exporter may fail to ship the goods. Events not under the control of the parties to the trade, such as major storms, disease epidemics, terrorist acts, or war, may make completion of the trade impossible. The several documents involved in international trade are intended to reduce financial loss from noncompletion.

6. Letter of Credit. Identify each party to a letter of credit (L/C) and indicate its responsibility.

A bank issues a letter of credit, promising to pay for an international trade transaction if certain documents are presented to the bank. The applicant for the letter of credit (usually the importer) applies to the bank for the letter of credit. The beneficiary of the letter of credit (usually the exporter) is to receive payment under a set of conditions specified in the letter of credit.

7. Confirmined Letter of Credit. Why would an exporter insist on a confirmed letter of credit?

Most letters of credit are unconfirmed, meaning the exporter relies on the credit quality of the issuing bank, rather than the importer. However, the exporter may be uncertain of the quality of the issuing bank, especially if that bank is in a remote country about which the importer knows little. The confirmation of the letter of credit is by a better-known bank in a major country. For example, a U.S. exporter with an order from Morocco accompanied by an L/C from a Casablanca bank may not know if the bank in Casablanca is dependable. The exporter may then ask a Paris bank to guarantee (i.e., “confirm”) the L/C of the Casablanca bank. The confirming bank may be acquainted with the Casablanca bank because it has had long-standing correspondent banking relationships going back to earlier French control of parts of Morocco, and so be willing—for a fee—to guarantee the L/C of the Casablanca bank.

8. Documenting an Export of Hard Drives. List the steps involved in the export of computer hard disk

drives from Penang, Malaysia, to San Jose, California, using an unconfirmed letter of credit authorizing payment on sight.

1. The San Jose importer applies for a letter of credit (L/C) from its California bank.

2. California bank issues an L/C in favor of the San Jose importer and sends the L/C to the exporter’s Malaysian bank.

3. Malaysian bank advises the Penang exporter of the opening of the L/C.

4. Penang exporter ships the hard drives to the San Jose importer, shipping on an order bill of lading made deliverable to itself; i.e., deliverable to the exporter itself so that the exporter retains legal title to the merchandise at this stage of the transaction.

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5. The Penang exporter draws a sight draft against the California bank in accordance with the terms of the L/C and presents the draft, along with any other required documents, to its own Malaysian bank.

6. Malaysian bank forwards the draft, accompanied by the order bill of lading and any other required documents, to the California bank.

7. California bank pays the Malaysian bank for the sight draft, receiving the order bill of lading, now endorsed by the Malaysian bank. At this point, the California bank has legal title to the merchandise.

8. Malaysian bank, having received the proceeds from the sale (via the sight draft paid by the California bank), pays the Penang exporter (less any fees).

9. California bank collects the proceeds of the sale from the San Jose importer and endorses the order bill of lading over to the importer so the importer, in turn, can collect the merchandise from the shipper. (The California bank could endorse the order bill of lading over to the San Jose importer without collecting at that time. In such an instance, the California bank is making an unsecured loan to the importer, a lending transaction entirely separate from the import/export transaction.)

9. Documenting an Export of Lumber from Portland to Yokohama. List the steps involved in the

export of lumber from Portland, Oregon, to Yokohama, Japan, using a confirmed letter of credit, payment to be made in 120 days.

1. Yokohama importer applies for a letter of credit (L/C) from its Japanese bank.

2. Japanese bank issues an L/C in favor of the Yokohama importer and sends the L/C to exporter’s Oregon bank, asking the Oregon back to confirm (i.e., guarantee) the letter of credit.

3. Oregon bank confirms the L/A and advises Portland exporter of the opening of the L/C.

4. Portland exporter ships the lumber to the Yokohama importer, shipping on an order bill of lading made deliverable to itself; i.e., deliverable to the exporter itself so that the exporter retains legal title to the merchandise at this stage of the transaction.

5. The Portland exporter draws a 120-day time draft against the Yokohama bank in accordance with the terms of the L/C and presents the draft, along with any required documents, to its own Oregon bank.

6. The Oregon bank endorses (i.e., applies its own guarantee) to the 120-day draft and forwards it, accompanied by the order bill of lading and any other required documents, to the Japanese bank.

7. The Japanese bank accepts the time draft, which at this point becomes a banker’s acceptance, and returns the accepted time draft to the exporter. The exporter may (1) hold the acceptance to maturity or (2) discount it in the acceptance market. At this point, the Japanese bank has legal title to the lumber.

8. The Japanese bank retains the order bill of lading and other documents for the moment. The Japanese bank collects the funds from the Yokohama importer, and then gives the order bill of lading to the importer so the importer may obtain both legal title and physical possession of the shipment of lumber. Several other possibilities exist, depending on the security arrangements between the Japanese bank and the Yokohama importer.

9. At maturity (120 days after the Japanese bank accepted the time draft), the holder of the acceptance presents it to the Japanese bank. The holder might be the exporter or it might be an investor in banker’s acceptances. If the acceptance is still held by the Portland exporter, that

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exporter presents it to its Oregon bank, which in turn forwards it to the Japanese bank for collection. When the Oregon bank receives funds, it credits the account of the Portland exporter.

10. Governmentally Supplied Credit. Various governments have established agencies to insure against

nonpayment for exports and/or to provide export credit. This shifts credit risk away from private banks and to the citizen taxpayers of the country whose government created and backs the agency. Why would such an arrangement be of benefit to the citizens of that country?

The cost to local taxpayers is a contingent loss, to be covered by the government’s tax revenues in case the foreign importer fails to pay the exporter. Failure could be deliberate by the importer, but it could also be imposed because of wars, natural disasters, or other international events. The benefits to the exporting country are the current jobs created by the manufacturing process and any future jobs that might follow from recurring exports by the same firm. The government has determined that the benefits outweigh the possibility of loss.

CHAPTER 17

FOREIGN DIRECT INVESTMENT AND POLITICAL RISK

1. Evolving into Multinationalism. As a firm evolves from purely domestic into a true multinational enterprise, it must consider (1) its competitive advantages, (2) its production location, (3) the type of control it wants to have over any foreign operations, and (4) how much monetary capital to invest abroad. Explain how each of these considerations is important to the success of foreign operations.

If a firm lacks sufficient competitive advantage to compete effectively in its home market, it is unlikely to have sufficient advantages of any type to be successful in a foreign market. This is because the competitive advantages of the home market must be enduring, transferable, and sufficiently powerful to enable the firm to overcome the assorted difficulties of operating in a foreign environment. Foreign operations must be located where market imperfections are such that the firm can take advantage of its competitive advantages to the degree necessary to earn a risk-adjusted rate of return above the firm’s cost of capital.

The firm must decide upon the degree of control it will need over the foreign operation, recognizing that greater control usually involves both greater risk and a greater investment. Viewing a spectrum of degrees of control, licensing, and management contracts provides a low level of control (along with a low level of financial investment); joint ventures necessitate a somewhat higher level of control; and greenfield direct investments and/or acquisition of an existing foreign firm require the highest degree of control (along with a higher level of financial investment).

The spectrum of investment approaches (licensing, management contracts, joint ventures, and direct investment) require in that order ever-increasing investment of more monetary capital. The firm must decide if the benefits of greater investment (presumably greater profits, plus possibly acquiring market share or forestalling competitors from gaining a greater market share) are worth the differing amounts of monetary capital needed.

2. Market Imperfections. MNEs strive to take advantage of market imperfections in national markets

for products, factors of production, and financial assets. Large international firms are better able to exploit such imperfections. What are their main competitive advantages?

MNEs strive to take advantage of imperfections in national markets for products, factors of production, and financial assets. Imperfections in the market for products translate into market opportunities for MNEs. Large international firms are better able to exploit such competitive factors as economies of scale, managerial and technological expertise, product differentiation, and financial strength than are their local competitors. In fact, MNEs thrive best in markets characterized by international oligopolistic competition, where these factors are particularly critical. In addition, once MNEs have established a physical presence abroad, they are in a better position compared to purely domestic firms to identify and implement market opportunities through their own internal information network.

3. Competitive Advantage. In deciding whether to invest abroad, management must first determine

whether the firm has a sustainable competitive advantage that enables it to compete effectively in the home market. What are the necessary characteristics of this competitive advantage?

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In deciding whether to invest abroad, management must first determine whether the firm has a sustainable competitive advantage that enables it to compete effectively in the home market. The competitive advantage must be firm-specific, transferable, and powerful enough to compensate the firm for the potential disadvantages of operating abroad (foreign exchange risks, political risks, and increased agency costs).

Based on observations of firms that have successfully invested abroad, we can conclude that some of the competitive advantages enjoyed by MNEs are (1) economies of scale and scope arising from their large size, (2) managerial and marketing expertise, (3) superior technology owing to their heavy emphasis on research, (4) financial strength, (5) differentiated products, and sometimes (6) competitiveness of their home markets.

4. Economies of Scale and Scope. Explain briefly how economies of scale and scope can be developed

in production, marketing, finance, research and development, transportation, and purchasing.

Economies of scale and scope can be developed in production, marketing, finance, research and development, transportation, and purchasing. In each of these areas, being large has significant competitive advantages, whether size is due to international or domestic operations. Production economies can come from the use of large-scale automated plant and equipment or from an ability to rationalize production through worldwide specialization. For example, some automobile manufacturers, such as Ford, rationalize manufacturing by producing engines in one country, transmissions in another, and bodies in another and assembling still elsewhere, with the location often being dictated by comparative advantage.

Marketing economies occur when firms are large enough to use the most efficient advertising media to create worldwide brand identification, as well as to establish worldwide distribution, warehousing, and servicing systems. Financial economies derive from access to the full range of financial instruments and sources of funds, such as the eurocurrency, euroequity, and eurobond markets. In- house research and development programs are typically restricted to large firms because of the minimum-size threshold for establishing a laboratory and scientific staff. Transportation economies accrue to firms that can ship in carload or shipload lots. Purchasing economies come from quantity discounts and market power.

5. Competitiveness of the Home Market. A strongly competitive home market can sharpen a firm’s

competitive advantage relative to firms located in less competitive markets. This phenomenon is known as Porter’s “diamond of national advantage.” Explain what is meant by the “diamond of national advantage.”

A strongly competitive home market can sharpen a firm’s competitive advantage relative to firms located in less competitive home markets. This phenomenon is known as the “diamond of national advantage” (Porter). The diamond has four components. A firm’s success in competing in a particular industry depends partly on the availability of factors of production (land, labor, capital, and technology) appropriate for that industry. Countries that are either naturally endowed with the appropriate factors or able to create them will probably spawn firms that are both competitive at home and potentially so abroad. For example, a well-educated work force in the home market creates a competitive advantage for firms in certain high-tech industries.

Firms facing sophisticated and demanding customers in the home market are able to hone their marketing, production, and quality control skills. Japan is such a market.

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Firms in industries that are surrounded by a critical mass of related industries and suppliers will be more competitive because of this supporting cast. For example, electronic firms located in centers of excellence, such as in the San Francisco Bay area, are surrounded by efficient, creative suppliers and enjoy access to educational institutions at the forefront of knowledge.

A competitive home market forces firms to fine-tune their operational and control strategies for their specific industry and country environment. Japanese firms learned how to organize to implement their famous “just-in-time” inventory control system. One key was to use numerous subcontractors and suppliers that were encouraged to locate near the final assembly plants.

In some cases, home country markets have not been large or competitive, but MNEs located there have nevertheless developed global niche markets served by foreign subsidiaries. Global competition in oligopolistic industries substitutes for domestic competition. For example, a number of MNEs resident in Scandinavia, Switzerland, and the Netherlands fall in this category. Some of these are Novo Nordisk (Denmark), Norske Hydro (Norway), Nokia (Finland), L.M. Ericsson (Sweden), Astra (Sweden), ABB (Sweden/Switzerland), Roche Holding (Switzerland), Royal Dutch Shell (the Netherlands), Unilever (the Netherlands), and Philips (the Netherlands).

6. OLI Paradigm. The OLI Paradigm is an attempt to create an overall framework to explain why

MNEs choose FDI rather than serve foreign markets through alternative modes.

The OLI Paradigm states that a firm must first have some competitive advantage in its home market—“O” or owner-specific—that can be transferred abroad if the firm is to be successful in foreign direct investment. Second, the firm must be attracted by specific characteristics of the foreign market—“L” or location-specific—that will allow it to exploit its competitive advantages in that market. Third, the firm will maintain its competitive position by attempting to control the entire value chain in its industry—“I” or internalization. This leads it to foreign direct investment rather than licensing or outsourcing.

7. Financial Links to OLI. Financial strategies are directly related to the OLI Paradigm. a. Explain how proactive financial strategies are related to OLI. Proactive financial strategies

can be controlled in advance by the MNE’s financial managers. These include strategies necessary to gain an advantage from lower global cost and greater availability of capital. Other proactive financial strategies are negotiating financial subsidies and/or reduced taxation to increase free cash flows, reducing financial agency costs through FDI, and reducing operating and transaction exposure through FDI.

b. Explain how reactive financial strategies are related to OLI. Reactive financial strategies

depend on discovering market imperfections. For example, the MNE can exploit misaligned exchange rates and stock prices. It also needs to react to capital controls that prevent the free movement of funds and react to opportunities to minimize worldwide taxation.

8. Where to Invest. The decision about where to invest abroad is influenced by behavioral factors. a. Explain the behavioral approach to FDI. The behavioral approach to analyzing the FDI decision

is typified by the so-called Swedish School of economists. The Swedish School has rather successfully explained not just the initial decision to invest abroad but also later decisions to reinvest elsewhere and to change the structure of a firm’s international involvement over time. Based on the internationalization process of a sample of Swedish MNEs, the economists observed that these firms tended to invest first in countries that were not too far distant in psychic terms.

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Close psychic distance defined countries with a cultural, legal, and institutional environment similar to Sweden’s, such as Norway, Denmark, Finland, Germany, and the United Kingdom. The initial investments were modest in size to minimize the risk of an uncertain foreign environment. As the Swedish firms learned from their initial investments, they became willing to take greater risks with respect to both the psychic distance of the countries and the size of the investments.

b. Explain the international network theory explanation of FDI. As the Swedish MNEs grew and

matured, so did the nature of their international involvement. Today each MNE is perceived as being a member of an international network, with nodes based in each of the foreign subsidiaries, as well as the parent firm itself. Centralized (hierarchical) control has given way to decentralized (heterarchical) control. Foreign subsidiaries compete with each other and with the parent for expanded resource commitments, thus influencing the strategy and reinvestment decisions. Many of these MNEs have become political coalitions with competing internal and external networks. Each subsidiary (and the parent) is embedded in its host country’s network of suppliers and customers. It is also a member of a worldwide network based on its industry. Finally, it is a member of an organizational network under the nominal control of the parent firm. Complicating matters still further is the possibility that the parent itself may have evolved into a transnational firm, one that is owned by a coalition of investors located in different countries.

9. Exporting versus Producing Abroad. What are the advantages and disadvantages of limiting a

firm’s activities to exporting compared to producing abroad?

There are several advantages to limiting a firm’s activities to exports. Exporting has none of the unique risks facing FDI, joint ventures, strategic alliances, and licensing. Political risks are minimal. Agency costs, such as monitoring and evaluating foreign units, are avoided. The amount of front-end investment is typically lower than in other modes of foreign involvement. Foreign exchange risks remain, however.

The fact that a significant share of exports (and imports) are executed between MNEs and their foreign subsidiaries and affiliates further reduces the risk of exports compared to other modes of involvement.

There are also disadvantages. A firm is not able to internalize and exploit the results of its research and development as effectively as if it invested directly. The firm also risks losing markets to imitators and global competitors that might be more cost efficient in production abroad and distribution. As these firms capture foreign markets, they might become so strong that they can export back into the domestic exporter’s own market. Remember that defensive FDI is often motivated by the need to prevent this kind of predatory behavior as well as to preempt foreign markets before competitors can get started

10. Licensing and Management Contracts Versus Producing Abroad. What are the advantages and

disadvantages of licensing and management contracts compared to producing abroad?

Licensing is a popular method for domestic firms to profit from foreign markets without the need to commit sizable funds. Because the foreign producer is typically wholly owned locally, political risk is minimized. In recent years, a number of host countries have demanded that MNEs sell their services in “unbundled form” rather than only through FDI. Such countries would like their local firms to purchase managerial expertise and knowledge of product and factor markets through management contracts, and purchase technology through licensing agreements.

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The main disadvantage of licensing is that license fees are likely to be lower than FDI profits, although the return on the marginal investment might be higher. Other disadvantages include the following:

Possible loss of quality control

Establishment of a potential competitor in third-country markets

Possible improvement of the technology by the local licensee, which then enters the original firm’s home market

Possible loss of opportunity to enter the licensee’s market with FDI later

Risk that technology will be stolen

High agency costs

MNEs have not typically used licensing of independent firms. On the contrary, most licensing arrangements have been with their own foreign subsidiaries or joint ventures. License fees are a way to spread the corporate research and development cost among all operating units and a means of repatriating profits in a form more acceptable to some host countries than dividends.

Management contracts are similar to licensing insofar as they provide for some cash flow from a foreign source without significant foreign investment or exposure. Management contracts probably lessen political risk because repatriation of managers is easy. International consulting and engineering firms traditionally conduct their foreign business on the basis of a management contract.

Whether licensing and management contracts are cost effective compared to FDI depends on the price host countries will pay for the unbundled services. If the price were high enough, many firms would prefer to take advantage of market imperfections in an unbundled way, particularly in view of the lower political, foreign exchange, and business risks. Because we observe MNEs continuing to prefer FDI, we must assume that the price for selling unbundled services is still too low.

11. Joint Venture versus Wholly Owned Production Subsidiary. What are the advantages and

disadvantages of forming a joint venture to serve a foreign market compared to serving that market with a wholly owned production subsidiary?

A joint venture is here defined as shared ownership in a foreign business. A foreign business unit that is partially owned by the parent company is typically termed a foreign affiliate. A foreign business unit that is 50% or more owned (and therefore controlled) by the parent company is typically designated a foreign subsidiary. A joint venture would therefore typically fall into the categorization of being a foreign affiliate but not a foreign subsidiary.

A joint venture between an MNE and a host country partner is a viable strategy if, and only if, the MNE finds the right local partner. Some of the obvious advantages of having a compatible local partner are as follows:

a. The local partner understands the customs, mores, and institutions of the local environment. An

MNE might need years to acquire such knowledge on its own with a 100%-owned greenfield subsidiary.

b. The local partner can provide competent management, not just at the top but also at the middle levels of management.

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c. If the host country requires that foreign firms share ownership with local firms or investors, 100% foreign ownership is not a realistic alternative to a joint venture.

d. The local partner’s contacts and reputation enhance access to the host country’s capital markets.

e. The local partner may possess technology that is appropriate for the local environment or perhaps can be used worldwide.

f. The public image of a firm that is partially locally owned may improve its sales possibilities if the purpose of the investment is to serve the local market.

Despite this impressive list of advantages, joint ventures are not as common as 100%-owned foreign subsidiaries because MNEs fear interference by the local partner in certain critical decision areas. Indeed, what is optimal from the viewpoint of the local venture may be suboptimal for the multinational operation as a whole. The most important potential conflicts or difficulties are these:

a. Political risk is increased rather than reduced if the wrong partner is chosen. Imagine the standing

of joint ventures undertaken with the family or associates of Suharto in Indonesia or Slobodan Milosevic in Serbia just before their overthrow. The local partner must be credible and ethical, or the venture is worse off for being a joint venture.

b. Local and foreign partners may have divergent views about the need for cash dividends or about the desirability of growth financed from retained earnings versus new financing.

c. Transfer pricing on products or components bought from or sold to related companies creates a potential for conflict of interest.

d. Control of financing is another problem area. An MNE cannot justify its use of cheap or available funds raised in one country to finance joint venture operations in another country.

e. Ability of a firm to rationalize production on a worldwide basis can be jeopardized if such rationalization would act to the disadvantage of local joint venture partners.

f. Financial disclosure of local results might be necessary with locally traded shares, whereas if the firm is wholly owned from abroad such disclosure is not needed. Disclosure gives nondisclosing competitors an advantage in setting strategy.

12. Greenfield Investment versus Acquisition. What are the advantages and disadvantages of serving a

foreign market through a greenfield foreign direct investment compared to an acquisition of a local firm in the target market?

A greenfield investment is defined as establishing a production or service facility starting from the ground up, i.e., from a green field. Compared to greenfield investment, a cross-border acquisition has a number of significant advantages. First and foremost, it is quicker. Greenfield investment frequently requires extended periods of physical construction and organizational development. By acquiring an existing firm, the MNE can shorten the time required to gain a presence and facilitate competitive entry into the market. Second, acquisition may be a cost-effective way of gaining competitive advantages such as technology, brand names valued in the target market, and logistical and distribution advantages, while simultaneously eliminating a local competitor. Third, international economic, political, and foreign exchange conditions may result in market imperfections allowing target firms to be undervalued. Many enterprises throughout Asia have been the target of acquisition as a result of the Asian economic crisis’ impact on their financial health. Many enterprises were in dire need of capital injections for competitive survival.

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Cross-border acquisitions are not, however, without their pitfalls. As with all acquisitions—domestic or international—there are the frequent problems of paying too high a price or suffering a method of financing that is too costly. Meshing different corporate cultures can be traumatic. Managing the post- acquisition process is frequently characterized by downsizing to gain economies of scale and scope in overhead functions. This results in nonproductive impacts on the firm as individuals attempt to save their own jobs. Internationally, additional difficulties arise from host governments intervening in pricing, financing, employment guarantees, market segmentation, and general nationalism and favoritism. In fact, the ability to complete international acquisitions successfully may itself be a test of the MNE’s competence in the twenty-first century.

13. Cross-Border Strategic Alliance. The term “cross-border strategic alliance” conveys different meanings to different observers. What are the meanings?

The term strategic alliance conveys different meanings to different observers. In one form of cross- border strategic alliance, two firms exchange a share of ownership with one another. A strategic alliance can be a takeover defense if the prime purpose is for a firm to place some of its stock in stable and friendly hands. If that is all that occurs, it is just another form of portfolio investment.

In a more comprehensive strategic alliance, in addition to exchanging stock, the partners establish a separate joint venture to develop and manufacture a product or service. Numerous examples of such strategic alliances can be found in the automotive, electronics, telecommunications, and aircraft industries. Such alliances are particularly suited to high-tech industries where the cost of research and development is high and timely introduction of improvements is important.

A third level of cooperation might include joint marketing and servicing agreements in which each partner represents the other in certain markets. Some observers believe such arrangements begin to resemble the cartels prevalent in the 1920s and 1930s. Because they reduce competition, cartels have been banned by international agreements and many national laws.

14. Governance Risk. a. Define what is meant by the term “governance risk.” Governance risk is the ability to exercise

effective control over an MNE’s operations within a country’s legal and political environment. For an MNE, however, governance is a subject similar in structure to consolidated profitability— it must be addressed for the individual business unit and subsidiary, as well as for the MNE as a whole.

b. What is the most important type of governance risk? The most important type of governance

risk for the MNE on the subsidiary level arises from a goal conflict between bona fide objectives of host governments and the private firms operating within their spheres of influence. Governments are normally responsive to a constituency consisting of their citizens. Firms are responsive to a constituency consisting of their owners and other stakeholders. The valid needs of these two separate sets of constituents need not be the same, but governments set the rules. Consequently, governments impose constraints on the activities of private firms as part of their normal administrative and legislative functioning.

15. Investment Agreement. An investment agreement spells out specific rights and responsibilities of

both the foreign firm and the host government. What are the main financial policies that should be included in an investment agreement?

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An investment agreement spells out specific rights and responsibilities of both the foreign firm and the host government. The presence of MNEs is as often sought by development-seeking host governments as a particular foreign location sought by an MNE. All parties have alternatives and so bargaining is appropriate.

An investment agreement should spell out policies on financial and managerial issues, including the following:

The basis on which fund flows, such as dividends, management fees, royalties, patent fees, and

loan repayments, may be remitted

The basis for setting transfer prices

The right to export to third-country markets

Obligations to build, or fund, social and economic overhead projects, such as schools, hospitals, and retirement systems

Methods of taxation, including the rate, the type of taxation, and means by which the rate base is determined

Access to host-country capital markets, particularly for long-term borrowing

Permission for 100% foreign ownership versus required local ownership (joint venture) participation

Price controls, if any, applicable to sales in the host-country markets

Requirements for local sourcing versus import of raw materials and components

Permission to use expatriate managerial and technical personnel, and to bring them and their personal possessions into the country free of exorbitant charges or import duties

Provision for arbitration of disputes

Provisions for planned divestment, should such be required, indicating how the going concern will be valued and to whom it will be sold

16. Investment Insurance and Guarantees (OPIC). a. What is OPIC? The U.S. investment insurance and guarantee program is managed by the

government-owned Overseas Private Investment Corporation (OPIC). OPIC’s stated purpose is to mobilize and facilitate the participation of U.S. private capital and skills in the economic and social progress of less developed friendly countries and areas, thereby complementing the developmental assistance of the United States.

b. What types of political risks can OPIC insure against? OPIC offers insurance coverage for

four separate types of political risk, which have their own specific definitions for insurance purposes:

Inconvertibility is the risk that the investor will not be able to convert profits, royalties, fees, or other income, as well as the original capital invested, into dollars.

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Expropriation is the risk that the host government takes a specific step that for one year prevents the investor or the foreign subsidiary from exercising effective control over use of the property.

War, revolution, insurrection, and civil strife coverage applies primarily to the damage of physical property of the insured, although in some cases inability of a foreign subsidiary to repay a loan because of a war may be covered.

Business income coverage provides compensation for loss of business income resulting from events of political violence that directly cause damage to the assets of a foreign enterprise.

17. Operating Strategies after the FDI Decision. The following operating strategies, among others, are

expected to reduce damage from political risk. Explain each one and how it reduces damage. a. Local sourcing. Host governments may require foreign firms to purchase raw material and

components locally as a way to maximize value added benefits and to increase local employment. From the viewpoint of the foreign firm trying to adapt to host-country goals, local sourcing reduces political risk, albeit at a trade-off with other factors. Local strikes or other turmoil may shut down the operation and such issues as quality control, high local prices because of lack of economies of scale, and unreliable delivery schedules become important. Often the MNE lowers political risk only by increasing its financial and commercial risk.

b. Facility location. Production facilities may be located so as to minimize risk. The natural

location of different stages of production may be resource-oriented, footloose, or market-oriented. Oil, for instance, is drilled in and around the Persian Gulf, Russia, Venezuela, and Indonesia. No choice exists for where this activity takes place. Refining is footloose; a refining facility can be moved easily to another location or country. Whenever possible, oil companies have built refineries in politically safe countries, such as Western Europe, or small islands (such as Singapore or Curaçao), even though costs might be reduced by refining nearer the oil fields. They have traded reduced political risk and financial exposure for possibly higher transportation and refining costs.

c. Control of technology. Control of key patents and processes is a viable way to reduce political

risk. If a host country cannot operate a plant because it does not have technicians capable of running the process, or of keeping up with changed technology, abrogation of an investment agreement with a foreign firm is unlikely. Control of technology works best when the foreign firm is steadily improving its technology.

d. Thin equity base. Foreign subsidiaries can be financed with a thin equity base and a large

proportion of local debt. If the debt is borrowed from locally owned banks, host-government actions that weaken the financial viability of the firm also endanger local creditors.

e. Multiple-source borrowing. If the firm must finance with foreign source debt, it may borrow

from banks in a number of countries rather than just from home country banks. If, for example, debt is owed to banks in Tokyo, Frankfurt, London, and New York, nationals in a number of foreign countries have a vested interest in keeping the borrowing subsidiary financially strong. If the multinational is U.S.-owned, a fallout between the United States and the host government is less likely to cause the local government to move against the firm if it also owes funds to these other countries.

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18. Country-Specific Risk. Define the following terms: a. Transfer risk. Transfer risk is defined as limitations on the MNE’s ability to transfer funds into

and out of a host country without restrictions. b. Blocked funds. When a government runs short of foreign exchange and cannot obtain additional

funds through borrowing or attracting new foreign investment, it usually limits transfers of foreign exchange out of the country, a restriction known as blocked funds. In theory this does not discriminate against foreign-owned firms because it applies to everyone; in practice, foreign firms have more at stake because of their foreign ownership. Depending on the size of a foreign exchange shortage, the host government might simply require approval of all transfers of funds abroad, thus reserving the right to set a priority on the use of scarce foreign exchange in favor of necessities rather than luxuries. In very severe cases, the government might make its currency nonconvertible into other currencies, thereby fully blocking transfers of funds abroad. In between these positions are policies that restrict the size and timing of dividends, debt amortization, royalties, and service fees.

19. Blocked Funds. Explain the strategies used by an MNE to counter blocked funds.

To transfer funds out of countries having exchange or remittance restrictions, at least six popular strategies are used by multinational firms:

1. Providing alternative conduits for repatriating funds

2. Transfer pricing goods and services between related units of the MNE

3. Leading and lagging payments

4. Using fronting loans

5. Creating unrelated exports

6. Obtaining special dispensation 20. Cultural and Institutional Risks. Identify and explain the main types of cultural and institutional

risks, except protectionism.

When investing in some of the emerging markets, MNEs that are resident in the most industrialized countries face serious risks because of cultural and institutional differences. Among many such differences are the following:

Differences in allowable ownership structures

Differences in human resource norms

Differences in religious heritage

Nepotism and corruption in the host country

Protection of intellectual property rights

Protectionism 21. Strategies to Manage Cultural and Institutional Risks. Explain the strategies that a MNE can use

to manage each of the cultural and institutional risks that you identified in question 9, except protectionism.

Chapter 17 Foreign Direct Investment and Political Risk 99

Lengthy and detailed descriptions are provided in the chapter. 22. Protectionism Defined. a. Define protectionism and identify the industries that are typically protected. Protectionism is

defined as the attempt by a national government to protect certain of its designated industries from foreign competition. Industries that are protected are usually related to defense, agriculture, and “infant” industries.

b. Explain the “infant industry” argument for protectionism. The traditional protectionist

argument is that newly emerging, “infant” industries need protection from foreign competition until they can get firmly established. The infant industry argument is usually directed at limiting imports but not necessarily MNEs. In fact, most host countries encourage MNEs to establish operations in new industries that do not presently exist in the host country. Sometimes the host country offers foreign MNEs “infant industry” status for a limited number of years. This status could lead to tax subsidies, construction of infrastructure, employee training, and other aids to help the MNE get started. Host countries are especially interested in attracting MNEs that promise to export, either to their own foreign subsidiaries elsewhere or to unrelated parties.

23. Managing Protectionism. a. What are the traditional methods for countries to implement protectionism? Tariff and

nontariff barriers. b. What are some typical non-tariff barriers to trade? Non-tariff barriers, which restrict imports

by something other than a financial cost, are often difficult to identify because they are promulgated as health, safety, or sanitation requirements. A list of the major types of non-tariff barriers would include those shown in Exhibit 15.6.

c. How can MNEs overcome host country protectionism? MNEs have only a very limited ability

to overcome host country protectionism. However, MNEs do enthusiastically support efforts to reduce protectionism by joining together in regional markets. The best examples of regional markets are the European Union (EU), the North American Free Trade Association (NAFTA), and the Latin American Free Trade Association (MERCOSUR). Among the objectives of regional markets are elimination of internal trade barriers, such as tariffs and non-tariff barriers, as well as the free movement of citizens for employment purposes. External trade barriers still exist.

24. Global-Specific Risks. What are the main types of political risks that are global in origin?

Terrorism and war, anti-globalization efforts, environmental concerns. 25. Managing Global-Specific Risks. What are the main strategies used by MNEs to manage the global-

specific risks you have identified in question 13?

Exhibit 15.6 in the chapter provides a short synthesis of the multitude of strategies applicable to global-specific risks.

26. U.S. Anti-Bribery Law. The United States has a law prohibiting U.S. firms from bribing foreign

officials and business persons, even in countries where bribery is a normal practice. Some U.S. firms claim this places the United States at a disadvantage compared to host-country firms and other foreign

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firms that are not hampered by such a law. Discuss the ethics and practicality of the U.S. anti-bribery law.

MNEs are caught in a dilemma. Should they employ bribery if their local competitors use this strategy? Alternative strategies are as follows:

Refuse bribery outright, or else demands will quickly multiply.

Retain a local adviser to diffuse demands by local officials, customs agents, and other business partners.

Do not count on the justice system in many emerging markets because Western-oriented contract law may not agree with local norms.

Educate both management and local employees about whatever bribery policy the firm intends to follow.

Chapter 18

MULTINATIONAL CAPITAL BUDGETING AND CROSS-BORDER ACQUISITIONS

1. Capital Budgeting Theoretical Framework. Capital budgeting for a foreign project uses the same

theoretical framework as domestic capital budgeting. What are the basic steps in domestic capital budgeting?

Multinational capital budgeting, like traditional domestic capital budgeting, focuses on the cash inflows and outflows associated with prospective long-term investment projects. Multinational capital budgeting techniques are used in traditional FDI analysis, such as the construction of a manufacturing plant in another country, as well as in the growing field of international mergers and acquisitions.

Capital budgeting for a foreign project uses the same theoretical framework as domestic capital budgeting—with a few very important differences. The basic steps are as follows:

1. Identify the initial capital invested or put at risk.

2. Estimate cash flows to be derived from the project over time, including an estimate of the terminal or salvage value of the investment.

3. Identify the appropriate discount rate for determining the present value of the expected cash flows.

4. Apply traditional capital budgeting decision criteria such as net present value (NPV) and internal rate of return (IRR) to determine the acceptability of or priority ranking of potential projects

2. Foreign Complexities. Capital budgeting for a foreign project is considerably more complex than the

domestic case. What are the factors that add complexity?

Capital budgeting for a foreign project is considerably more complex than the domestic case. Several factors contribute to this greater complexity:

Parent cash flows must be distinguished from project cash flows. Each of these two types of

flows contributes to a different view of value.

Parent cash flows often depend on the form of financing. Thus we cannot clearly separate cash flows from financing decisions, as we can in domestic capital budgeting.

Additional cash flows generated by a new investment in one foreign subsidiary may be in part or

in whole taken away from another subsidiary, with the net result that the project is favorable from a single subsidiary’s point of view but contributes nothing to worldwide cash flows.

The parent must explicitly recognize remittance of funds because of differing tax systems, legal

and political constraints on the movement of funds, local business norms, and differences in the way financial markets and institutions function.

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An array of nonfinancial payments can generate cash flows from subsidiaries to the parent, including payment of license fees and payments for imports from the parent.

Managers must anticipate differing rates of national inflation because of their potential to cause

changes in competitive position, and thus changes in cash flows over time.

Managers must keep the possibility of unanticipated foreign exchange rate changes in mind because of possible direct effects on the value of local cash flows, as well as indirect effects on the competitive position of the foreign subsidiary.

Use of segmented national capital markets may create an opportunity for financial gains or may

lead to additional financial costs.

Use of host-government subsidized loans complicates both capital structure and the parent’s ability to determine an appropriate weighted average cost of capital for discounting purposes.

Managers must evaluate political risk because political events can drastically reduce the value or

availability of expected cash flows.

Terminal value is more difficult to estimate because potential purchasers from the host, parent, or third countries, or from the private or public sector, may have widely divergent perspectives on the value to them of acquiring the project.

3. Project versus Parent Valuation. Why should a foreign project be evaluated both from a project and

parent viewpoint?

A strong theoretical argument exists in favor of analyzing any foreign project from the viewpoint of the parent. Cash flows to the parent are ultimately the basis for dividends to stockholders, reinvestment elsewhere in the world, repayment of corporate-wide debt, and other purposes that affect the firm’s many interest groups. However, because most of a project’s cash flows to its parent or to sister subsidiaries are financial cash flows rather than operating cash flows, the parent viewpoint usually violates a cardinal concept of capital budgeting, namely, that financial cash flows should not be mixed with operating cash flows. Often the difference is not important because the two are almost identical, but in some instances, a sharp divergence in these cash flows will exist.

Evaluation of a project from the local viewpoint serves some useful purposes, but it should be subordinated to evaluation from the parent’s viewpoint. In evaluating a foreign project’s performance relative to the potential of a competing project in the same host country, we must pay attention to the project’s local return. Almost any project should at least be able to earn a cash return equal to the yield available on host government bonds with a maturity the same as the project’s economic life, if a free market exists for such bonds. Host government bonds ordinarily reflect the local risk-free rate of return, including a premium equal to the expected rate of inflation. If a project cannot earn more than such a bond yield, the parent firm should buy host government bonds rather than invest in a riskier project.

4. Viewpoint and NPV. Which viewpoint, project or parent, gives results closer to the traditional

meaning of net present value in capital budgeting?

Multinational firms should invest only if they can earn a risk-adjusted return greater than locally based competitors can earn on the same project. If they are unable to earn superior returns on foreign projects, their stockholders would be better off buying shares in local firms, where possible, and

Chapter 18 Multinational Capital Budgeting and Cross-Border Acquisitions 103

letting those companies carry out the local projects. Apart from these theoretical arguments, surveys during the past 35 years show that in practice multinational firms continue to evaluate foreign investments from both the parent and project viewpoint.

5. Viewpoint and Consolidated Earnings. Which viewpoint gives results closer to the effect on

consolidated earnings per share?

The attention paid to project returns in various surveys probably reflects emphasis on maximizing reported consolidated net earnings per share as a corporate financial goal. As long as foreign earnings are not blocked, they can be consolidated with the earnings of both the remaining subsidiaries and the parent. As mentioned previously, U.S. firms must consolidate foreign subsidiaries that are more than 50% owned. If a firm is owned between 20% and 49% by a parent, it is called an affiliate. Affiliates are consolidated with the parent owner on a pro rata basis. Subsidiaries less than 20% owned are normally carried as unconsolidated investments. Even in the case of temporarily blocked funds, some of the most mature MNEs do not necessarily eliminate a project from financial consideration. They take a very long-run view of world business opportunities.

6. Operating and Financing Cash Flows. Capital projects provide both operating cash flows and

financial cash flows. Why are operating cash flows preferred for domestic capital budgeting but financial cash flows given major consideration in international projects?

If reinvestment opportunities in the country where funds are blocked are at least equal to the parent firm’s required rate of return (after adjusting for anticipated exchange rate changes), temporary blockage of transfer may have little practical effect on the capital budgeting outcome because future project cash flows will be increased by the returns on forced reinvestment. Because large multinationals hold a portfolio of domestic and foreign projects, corporate liquidity is not impaired if a few projects have blocked funds; alternate sources of funds are available to meet all planned uses of funds. Furthermore, a long-run historical perspective on blocked funds does indeed lend support to the belief that funds are almost never permanently blocked. However, waiting for the release of such funds can be frustrating, and sometimes the blocked funds lose value while blocked because of inflation or unexpected exchange rate deterioration, even though they have been reinvested in the host country to protect at least part of their value in real terms.

7. Risk-Adjusted Return. Should the anticipated internal rate of return (IRR) for a proposed foreign

project be compared to (a) alternative home country proposals, (b) returns earned by local companies in the same industry and/or risk class, or (c) both? Justify your answer.

The key to distinction is “risk-adjusted.” Foreign projects will, by most methodologies, be of higher risk than a domestic or home country project. The anticipated returns should therefore take this into consideration. At the same time, comparing expected returns with those earned by local companies in the target markets will not capture the cross-border risks (such as blocked funds) which a foreign investor may experience. In the end, the answer is (c), both—and more.

8. Blocked Cash Flows. In the evaluation of a potential foreign investment, how should a multinational

firm evaluate cash flows in the host foreign country that are blocked from being repatriated to the firm’s home country?

The impact of blocked funds on the rate of return from the investor’s perspective would depend on when the blockage occurs, what reinvestment opportunities exist for the blocked funds in the captive country, and when the blocked funds would eventually be released to the investor. As with all cash

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flow-based financial analyses, the critical element is when the parent investor will regain the ability to move the blocked funds freely.

9. Host Country Inflation. How should an MNE factor host country inflation into its evaluation of an

investment proposal?

Inflation is factored into the expected cash flows of the project rate of return. Relative inflation affects the expected exchange rate due to purchasing power parity.

10. Cost of Equity. A foreign subsidiary does not have an independent cost of capital. However, in order

to estimate the discount rate for a comparable host-country firm, the analyst should try to calculate a hypothetical cost of capital. How is this done?

As part of this process, the analyst can estimate the subsidiary’s proxy cost of equity by using the traditional equation: ke = krf +β (km – krf). Define each variable in this equation and explain how the variable might be different for a proxy host country firm compared to the parent MNE.

The cost of capital and equity of a specific project or subsidiary such as this would be expressed in local currency terms, while the parent company will ultimately measure the project’s expected returns and risks based on its own parent currency terms. Therefore, the risk-free rate would be a local currency government bond. The market return would be the expected return on the market portfolio in the local market (typically based on recent historical returns). The local project’s beta would be first based on other like firms in the local market and their historical covariance with the variance of the market.

11. Viewpoint Cash Flows. What are the differences in the cash flows used in a project point of view

analysis and a parent point of view analysis?

The project viewpoint focuses on the cash flows that are traditionally isolated and analyzed by any prospective investment—the operational cash flows of the proposed project (initial investment, operating cash flows, terminal value). The parent viewpoint analysis must, however, focus on those cash flows that flow between the parent and the project of any kind—including operating cash flows (operating returns, intra-firm sales and margins, etc.) as well as financing cash flows (dividends as distributed to the parent from the project).

12. Foreign Exchange Risk and Capital Budgeting. How is foreign exchange risk sensitivity factored

into the capital budgeting analysis of a foreign project?

In the chapter problem, the project team assumed that the Indonesian rupiah would depreciate versus the U.S. dollar at the purchasing power parity “rate” (approximately 20.767% per year in the baseline analysis). What if the rate of rupiah depreciation were greater? Although this event would make the assumed cash flows to Cemex worth less in dollars, operating exposure analysis would be necessary to determine whether the cheaper rupiah made Semen Indonesia more competitive.

For example, because Semen Indonesia’s exports to Taiwan are denominated in U.S. dollars, a weakening of the rupiah versus the dollar could result in greater rupiah earnings from those export sales. This serves to somewhat offset the imported components that Semen Indonesia purchases from the parent company that are also denominated in U.S. dollars. Semen Indonesia is representative of firms today which have both cash inflows and outflows denominated in foreign currencies, providing a partial natural hedge against currency movements.

Chapter 18 Multinational Capital Budgeting and Cross-Border Acquisitions 105

What if the rupiah should appreciate against the dollar? The same kind of economic exposure analysis is needed. In this particular case, we might guess that the effect would be positive on both local sales in Indonesia and the value in dollars of dividends and license fees paid to Cemex by Semen Indonesia. Note, however, that an appreciation of the rupiah might lead to more competition within Indonesia from firms in other countries with now lower cost structures, lessening Semen Indonesia’s sales.

13. Expropriation Risk. How is expropriation risk factored into the capital budgeting analysis of a

foreign project?

This is typical of the complexity of capturing political risk and its repercussions on financial performance in a prospective project analysis. Again, if expropriation risk is considered highly possible, the risk-adjusted return must capture it in some manner.

Many expropriations eventually result in some form of compensation to the former owners. This compensation can come from a negotiated settlement with the host government or from payment of political risk insurance by the parent government. Negotiating a settlement takes time, and the eventual compensation is sometimes paid in installments over a further period. Thus the present value of the compensation is often much lower than its nominal value. Furthermore, most settlements are based on book value of the firm at the time of expropriation rather than the firm’s market value.

14. Real Option Analysis. What is real option analysis? How is it a better method of making investment

decisions than traditional capital budgeting analysis?

Real options is a different way of thinking about investment values. At its core, it is a cross between decision-tree analysis and pure option-based valuation. It is particularly useful when analyzing investment projects that will follow very different value paths at decision points in time where management decisions are made regarding project pursuit. This wide range of potential outcomes is at the heart of real option theory. Real option valuation also allows us to analyze a number of managerial decisions that in practice characterize many major capital investment projects:

1. The option to defer

2. The option to abandon

3. The option to alter capacity

4. The option to start up or shut down (switching)

Real option analysis treats cash flows in terms of future value in a positive sense, whereas DCF treats future cash flows negatively (on a discounted basis). Real option analysis is a particularly powerful device when addressing potential investment projects with extremely long life spans or investments that do not commence until future dates. Real option analysis acknowledges the way information is gathered over time to support decision making. Management learns from both active (searching it out) and passive (observing market conditions) knowledge gathering and then uses this knowledge to make better decisions.

15. M&A Business Drivers. What are the primary driving forces that motivate cross-border mergers and

acquisitions?

The drivers of M&A activity are both macro in scope—the global competitive environment—and micro in scope—the variety of industry and firm-level forces and actions driving individual firm

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value. The primary forces of change in the global competitive environment—technological change, regulatory change, and capital market change—create new business opportunities for MNEs, which they pursue aggressively.

As opposed to greenfield investment, a cross-border acquisition has a number of significant advantages. First and foremost, it is quicker. Greenfield investment frequently requires extended periods of physical construction and organizational development. By acquiring an existing firm, the MNE shortens the time required to gain a presence and facilitate competitive entry into the market. Second, acquisition may be a cost-effective way of gaining competitive advantages, such as technology, brand names valued in the target market, and logistical and distribution advantages, while simultaneously eliminating a local competitor. Third, specific to cross-border acquisitions, international economic, political, and foreign exchange conditions may result in market imperfections, allowing target firms to be undervalued.

16. Three Stages of Cross-Border Acquisitions. What are the three stages of a cross-border acquisition?

What are the core financial elements integral to each stage?

The process of acquiring an enterprise anywhere in the world has three common elements: (1) identification and valuation of the target, (2) execution of the acquisition offer and purchase—the tender, and (3) management of the post-acquisition transition.

17. Currency Risks in Cross-Border Acquisitions. What are the currency risks that arise in the process

of making a cross-border acquisition?

The pursuit and execution of a cross-border acquisition poses a number of challenging foreign currency risks and exposures for an MNE. The nature of the currency exposure related to any specific cross-border acquisition evolves as the bidding and negotiating process itself evolves across the bidding, financing, transaction (settlement), and operating stages. The assorted risks, both in the timing and information related to the various stages of a cross-border acquisition, make the management of the currency exposures difficult. The uncertainty related to the multitude of stages declines over time as stages are completed and contracts and agreements reached.

18. Contingent Currency Exposure. What are the largest contingent currency exposures that arise in the

process of pursuing and executing a cross-border acquisition?

The initial bid, if denominated in a foreign currency, creates a contingent foreign currency exposure for the bidder. This contingent exposure grows in certainty of occurrence over time as negotiations continue, regulatory requests and approvals are gained, and competitive bidders emerge. Although a variety of hedging strategies might be employed, the use of a purchased currency call option is the simplest. The option’s notional principal would be for the estimated purchase price, but the maturity, for the sake of conservatism, might possibly be significantly longer than probably needed to allow for extended bidding, regulatory, and negotiation delays.

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