Multinational Business Finance 13th Edi Eiteman David
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MULTINATIONAL BUSINESS FINANCE THIRTEENTH EDIT ION
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MULTINATIONAL BUSINESS FINANCE THIRTEENTH EDIT ION
David K. EITEMAN
University of California, Los Angeles
Arthur I. STONEHILL
Oregon State University and the University
of Hawaii at Manoa
Michael H. MOFFETT
Thunderbird School of Global Management
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Library of Congress Cataloging-in-Publication Data
Copyright © 2013, 2010, 2007, 2004 by Pearson Education, Inc.
Multina- tional Business Finance
! Organizations of all kinds.
! Emerging markets.
! Financial leadership.
Audience Multinational Business Finance
Global Finance in Practice
Organization Multinational Business Finance
Preface
Preface
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New in the Thirteenth Edition
new normal
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Global Finance in Practice
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Preface
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A Rich Array of Support Materials
! Instructor’s Manual.
! Test Bank.
! Computerized Test Bank.
! PowerPoint Presentation.
! Companion Web Site.
International Editions Multinational Business Finance
Preface
Acknowledgments
Multinational Business Finance
Yong-Cheol Kim University of Wisconsin-Milwaukee
Yen-Sheng Lee Bellevue University
Robert Mefford University of San Francisco John Petersen George Mason University Rahul Verma University of Houston-Downtown
Otto Adleberger Essen University, Germany
Alan Alford Northeastern University
Stephen Archer Willamette University
Bala Arshanapalli Indiana University Northwest
Hossein G. Askari George Washington University
Robert T. Aubey University of Wisconsin at Madison
David Babbel University of Pennsylvania
James Baker Kent State University
Morten Balling Arhus School of Business, Denmark
Arindam Bandopadhyaya University of Massachusetts at Boston
Ari Beenhakker University of South Florida
Carl Beidleman Lehigh University
Robert Boatler Texas Christian University
Gordon M. Bodnar John Hopkins University
Nancy Bord University of Hartford
Finbarr Bradley University of Dublin, Ireland
Tom Brewer Georgetown University
Michael Brooke University of Manchester, England
Robert Carlson Assumption University, Thailand
Kam C. Chan University of Dayton
Chun Chang University of Minnesota
Sam Chee Boston University Metropolitan College
Kevin Cheng New York University
It-Keong Chew University of Kentucky
Frederick D. S. Choi New York University
Jay Choi Temple University
Nikolai Chuvakhin Pepperdine University
Mark Ciechon University of California, Los Angeles
J. Markham Collins University of Tulsa
Alan N. Cook Baylor University
Kerry Cooper Texas A&M University
Robert Cornu Cranfield School of Management, U.K.
Roy Crum University of Florida
Steven Dawson University of Hawaii at Manoa
David Distad University of California, Berkeley
Gunter Dufey University of Michigan, Ann Arbor
Mark Eaker Duke University
Rodney Eldridge George Washington University
Imad A. Elhah University of Louisville
Vihang Errunza McGill University
Cheol S. Eun Georgia Tech University
Mara Faccio University of Notre Dame
Larry Fauver University of Tennessee
Joseph Finnerty University of Illinois at Urbana- Champaign
William R. Folks, Jr. University of South Carolina
Lewis Freitas University of Hawaii at Manoa
Preface
Anne Fremault Boston University
Fariborg Ghadar George Washington University
Ian Giddy New York University
Martin Glaum Justus-Lievig-Universitat Giessen, Germany
Deborah Gregory University of Georgia
Robert Grosse Thunderbird
Christine Hekman Georgia Tech University
Steven Heston University of Maryland
James Hodder University of Wisconsin, Madison
Alfred Hofflander University of California, Los Angeles
Janice Jadlow Oklahoma State University
Veikko Jaaskelainen Helsinki School of Economics and Business Administration
Benjamas Jirasakuldech University of the Pacific
Ronald A. Johnson Northeastern University
John Kallianiotis University of Scranton
Fred Kaen University of New Hampshire
Charles Kane Boston College
Robert Kemp University of Virginia
W. Carl Kester Harvard Business School
Seung Kim St. Louis University
Yong Kim University of Cincinnati
Gordon Klein University of California, Los Angeles
Steven Kobrin University of Pennsylvania
Paul Korsvold Norwegian School of Management
Chris Korth University of South Carolina
Chuck C. Y. Kwok University of South Carolina
John P. Lajaunie Nicholls State University
Sarah Lane Boston University
Martin Laurence William Patterson College
Eric Y. Lee Fairleigh Dickinson University
Donald Lessard Massachusetts Institute of Technology
Arvind Mahajan Texas A&M University
Rita Maldonado-Baer New York University
Anthony Matias Palm Beach Atlantic College
Charles Maxwell Murray State University
Sam McCord Auburn University
Jeanette Medewitz University of Nebraska at Omaha
Robert Mefford University of San Francisco
Paritash Mehta Temple University
Antonio Mello University of Wisconsin at Madison
Eloy Mestre American University
Kenneth Moon Suffolk University
Gregory Noronha Arizona State University
Edmund Outslay Michigan State University
Lars Oxelheim Lund University, Sweden
Jacob Park Green Mountain College
Yoon Shik Park George Washington University
Harvey Poniachek New York University
Yash Puri University of Massachusetts at Lowell
R. Ravichandrarn University of Colorado at Boulder
Scheherazade Rehman George Washington University
Jeff Rosenlog Emory University
David Rubinstein University of Houston
Alan Rugman Oxford University, U.K.
R. J. Rummel University of Hawaii at Manoa
Mehdi Salehizadeh San Diego State University
Michael Salt San Jose State University
Roland Schmidt Erasmus University, the Netherlands
Lemma Senbet University of Maryland
Alan Shapiro University of Southern California
Hany Shawky State University of New York, Albany
Hamid Shomali Golden Gate University
Vijay Singal Virginia Tech University
Preface
Sheryl Winston Smith University of Minnesota
Luc Soenen California Polytechnic State University
Marjorie Stanley Texas Christian University
Joseph Stokes University of Massachusetts- Amherst
Jahangir Sultan Bentley College
Lawrence Tai Loyola Marymount University
Kishore Tandon CUNY—Bernard Baruch College
Russell Taussig University of Hawaii at Manoa
Lee Tavis University of Notre Dame
Sean Toohey University of Western Sydney, Australia
Norman Toy Columbia University
Joseph Ueng University of St. Thomas
Gwinyai Utete Auburn University
Harald Vestergaard Copenhagen Business School
K. G. Viswanathan Hofstra University
Joseph D. Vu University of Illinois, Chicago
Mahmoud Wahab University of Hartford
Masahiro Watanabe Rice University
Michael Williams University of Texas at Austin
Brent Wilson Brigham Young University
Bob Wood Tennessee Technological University
Alexander Zamperion Bentley College
Emilio Zarruk Florida Atlantic University
Tom Zwirlein University of Colorado, Colorado Springs
Industry (present or former affiliation)
Paul Adaire Philadelphia Stock Exchange
Barbara Block Tektronix, Inc.
Holly Bowman Bankers Trust
Payson Cha HKR International, Hong Kong
John A. Deuchler Private Export Funding Corporation
Kåre Dullum Gudme Raaschou Investment Bank, Denmark
Steven Ford Hewlett Packard
David Heenan Campbell Estate, Hawaii
Sharyn H. Hess Foreign Credit Insurance Association
Aage Jacobsen Gudme Raaschou Investment Bank, Denmark
Ira G. Kawaller Chicago Mercantile Exchange
Kenneth Knox Tektronix, Inc.
Arthur J. Obesler Eximbank
I. Barry Thompson Continental Bank
Gerald T. West Overseas Private Investment Corporation
Willem Winter First Interstate Bank of Oregon
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Preface
!
Arthur I. Stonehill
Financial Management, Journal of International Business Studies California Management Review Journal of Financial and Quantitative Analysis Journal of International Financial Management and Accounting International Business Review Euro- pean Management Journal The Investment Analyst (U.K.) Nationaløkonomisk Tidskrift (Denmark) Sosialøkonomen (Norway) Journal of Financial Education
David K. Eiteman
The Journal of Finance The International Trade Journal Financial Analysts Journal Journal of World Business Management International Business Horizons MSU Business Topics Public Utilities Fortnightly,
Michael H. Moffett
About the Authors
About the Authors
Journal of Financial and Quantitative Analysis Journal of Applied Corporate Finance Journal of International Money and Finance Journal of Interna- tional Financial Management and Accounting Contemporary Policy Issues Brookings Dis- cussion Papers in International Economics
Handbook of Modern Finance International Accounting and Finance Handbook Encyclopedia of International Business
International Business Global Business
PART I Global Financial Environment 1
PART II Foreign Exchange Theory and Markets 157
PART III Foreign Exchange Exposure 245
PART IV Financing the Global Firm 349
PART V Foreign Investment Decisions 439
PART VI Managing Multinational Operations 527
Brief Contents
PART I Global Financial Environment 1
Chapter 1 Current Multinational Challenges and the Global Economy 2
Summary Points 17 MINI-CASE: Nine Dragons Paper and the 2009 Credit Crisis 17 Questions ! Problems ! Internet Exercises 24
Chapter 2 Corporate Ownership, Goals, and Governance 27
Summary Points 49 MINI-CASE: Luxury Wars—LVMH vs. Hermès 49 Questions ! Problems ! Internet Exercises 54
Chapter 3 The International Monetary System 59
Summary Points 78 MINI-CASE: The Yuan Goes Global 79 Questions ! Problems ! Internet Exercises 84
Chapter 4 The Balance of Payments 87
Summary Points 112 MINI-CASE: Global Remittances 113 Questions ! Problems ! Internet Exercises 117
Contents
Contents
Chapter 5 The Continuing Global Financial Crisis 122
Summary Points 150 MINI-CASE: Letting Go of Lehman Brothers 151 Questions ! Problems ! Internet Exercises 153
PART II Foreign Exchange Theory and Markets 157
Chapter 6 The Foreign Exchange Market 158
Summary Points 177 MINI-CASE: The Saga of the Venezuelan Bolivar Fuerte 178 Questions ! Problems ! Internet Exercises 180
Chapter 7 International Parity Conditions 185
Summary Points 204 MINI-CASE: Emerging Market Carry Trades 205 Questions ! Problems ! Internet Exercises 206 Appendix: An Algebraic Primer to International Parity Conditions 212
Chapter 8 Foreign Currency Derivatives and Swaps 216
Summary Points 235 MINI-CASE: McDonald’s Corporation’s British Pound Exposure 236 Questions ! Problems ! Internet Exercises 237
PART III Foreign Exchange Exposure 245
Chapter 9 Foreign Exchange Rate Determination and Forecasting 246
Summary Points 268 MINI-CASE: The Japanese Yen Intervention of 2010 269 Questions ! Problems ! Internet Exercises 271
Contents
Chapter 10 Transaction Exposure 275
Summary Points 290 MINI-CASE: Banbury Impex (India) 291 Questions ! Problems ! Internet Exercises 295 Appendix: Complex Option Hedges 301
Chapter 11 Translation Exposure 309
Summary Points 320 MINI-CASE: LaJolla Engineering Services 320 Questions ! Problems 323
Chapter 12 Operating Exposure 326
Summary Points 343 MINI-CASE: Toyota’s European Operating Exposure 343 Questions ! Problems ! Internet Exercises 346
PART IV Financing the Global Firm 349
Chapter 13 The Global Cost and Availability of Capital 350
Summary Points 366 MINI-CASE: Novo Industri A/S (Novo) 367 Questions ! Problems ! Internet Exercises 371
Chapter 14 Raising Equity and Debt Globally 376
Summary Points 400 MINI-CASE: Korres Natural Products and the Greek Crisis 401 Questions ! Problems ! Internet Exercises 406 Appendix: Financial Structure of Foreign Subsidiaries 411
Contents
Chapter 15 Multinational Tax Management 415
Summary Points 430 MINI-CASE: The U.S. Corporate Income Tax Conundrum 430 Questions ! Problems ! Internet Exercises 434
PART V Foreign Investment Decisions 439
Chapter 16 International Portfolio Theory and Diversification 440
Summary Points 453 MINI-CASE: Portfolio Theory, Black Swans, and [Avoiding] Being the Turkey 454 Questions ! Problems ! Internet Exercises 456
Chapter 17 Foreign Direct Investment and Political Risk 460
Summary Points 485 MINI-CASE: Corporate Competition from the Emerging Markets 486 Questions ! Internet Exercises 487
Chapter 18 Multinational Capital Budgeting and Cross-Border Acquisitions 490
Summary Points 513 MINI-CASE: Yanzhou (China) Bids for Felix Resources (Australia) 514 Questions ! Problems ! Internet Exercises 521
PART VI Managing Multinational Operations 527
Chapter 19 Working Capital Management 528
Summary Points 549 MINI-CASE: Honeywell and Pakistan International Airways 549 Questions ! Problems ! Internet Exercises 552
Contents
Chapter 20 International Trade Finance 556
Summary Points 574 MINI-CASE: Crosswell International and Brazil 575 Questions ! Problems ! Internet Exercises 579
Answers to Selected End-of-Chapter Problems 582
Glossary 586
Index 603
Credits 626
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Global Financial Environment
CHAPTER 1 Current Multinational Challenges and the Global Economy
CHAPTER 2 Corporate Ownership, Goals, and Governance
CHAPTER 3 The International Monetary System
CHAPTER 4 The Balance of Payments
CHAPTER 5 The Continuing Global Financial Crisis
PART I
1
Current Multinational Challenges and the Global Economy
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.
The subject of this book is the financial management of multinational enterprises (MNEs). MNEs are firms—both for profit companies and not-for-profit organizations—that have operations in more than one country, and conduct their business through foreign subsidiar- ies, branches, or joint ventures with host country firms.
MNEs are struggling to survive and prosper in a very different world than in the past. Today’s MNEs depend not only on the emerging markets for cheaper labor, raw materials, and outsourced manufacturing, but also increasingly on those same emerging markets for sales and profits. These markets—whether they are emerging, less developed, developing, or BRICs (Brazil, Russia, India, and China)—represent the majority of the earth’s population, and therefore, customers. And adding market complexity to this changing global landscape is the risky and challenging international macroeconomic environment, both from a long- term and short-term perspective, following the global financial crisis of 2007–2009. How to identify and navigate these risks is the focus of this book.
Financial Globalization and Risk
Back in the halcyon pre-crisis days of the late 20th and early 21st centuries, it was taken as self evident that financial globalisation was a good thing. But the subprime crisis and eurozone dramas are shaking that belief. Never mind the fact that imbalances amid globalisation can stoke up bubbles; what is the bigger risk now—particularly in the eurozone—is that financial globalisation has created a system that is interconnected in some dangerous ways.
—“Crisis Fears Fuel Debate on Capital Controls,” Gillian Tett, The Financial Times, December 15, 2011.
2
CHAPTER 1
3Current Multinational Challenges and the Global Economy CHAPTER 1
The theme dominating global financial markets today is the complexity of risks associated with financial globalization—far beyond whether it is simply good or bad, but how to lead and manage multinational firms in the rapidly moving marketplace.
! The international monetary system, an eclectic mix of floating and managed fixed exchange rates today, is under constant scrutiny. The rise of the Chinese renminbi is changing much of the world’s outlook for currency exchange, reserve currencies, and the roles of the dollar and the euro (see Chapter 3).
! Large fiscal deficits plague most of the major trading countries of the world, including the current eurozone crisis, complicating fiscal and monetary policies, and ultimately, interest rates and exchange rates (see Chapters 4 and 5).
! Many countries experience continuing balance of payments imbalances, and in some cases, dangerously large deficits and surpluses—whether it be the twin surpluses enjoyed by China, the current account surplus of Germany amidst a sea of eurozone deficits, or the continuing current account deficit of the United States, all will inevi- tably move exchange rates (see Chapters 4 and 5).
! Ownership, control, and governance changes 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 differ dramatically (see Chapter 2).
! 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, openness, and accessibility by many of the world’s organizations (see Chapters 1 and 5).
! Today’s emerging markets are confronted with a new dilemma: the problem of being the recipients of too much capital—sometimes. Financial globalization has resulted in the flow of massive quantities of capital into and out of many emerging markets, complicating financial management (Chapters 6 and 9).
These are but a sampling of the complexity of topics. The Mini-Case at the end of this chapter, Nine Dragons Paper and the 2009 Credit Crisis, highlights many of these MNE issues in emerging markets today. As described in Global Finance in Practice 1.1, the global credit crisis and its aftermath has damaged the world’s largest banks and reduced the rate of eco- nomic growth worldwide, leading to higher rates of unemployment and putting critical pres- sures on government budgets from Greece to Ireland to Portugal to Mexico.
The Global Financial Marketplace Business—domestic, international, global—involves the interaction of individuals and indi- vidual organizations for the exchange of products, services, and capital through markets. The global capital markets are critical for the conduct of this exchange. The global financial crisis of 2008–2009 served as an illustration and a warning of how tightly integrated and fragile this marketplace can be.
Assets, Institutions, and Linkages Exhibit 1.1 provides a map to the global capital markets. One way to characterize the global financial marketplace is through its assets, institutions, and linkages.
4 CHAPTER 1 Current Multinational Challenges and the Global Economy
GLOBAL FINANCE IN PRACTICE 1.1
Global Capital Markets: Entering a New Era
The current financial crisis and worldwide recession have abruptly halted a nearly three-decade-long expansion of global capital markets. From 1980 through 2007, the world’s financial assets—including equities, private and public debt, and bank deposits—nearly quadrupled in size relative to global GDP. Global capital flows similarly surged. This growth reflected numerous interrelated trends, including advances in information and communication technology, financial market liberalization, and innovations in financial products and ser- vices. The result was financial globalization.
But the upheaval in financial markets in late 2008 marked a break in this trend. The total value of the world’s financial assets fell by $16 trillion to $178 trillion, the largest setback on record. Although equity markets have bounced back from their recent lows, they remain well below their peaks. Credit markets have healed somewhat but are still impaired.
Going forward, our research suggests that global capi- tal markets are entering a new era in which the forces fueling growth have changed. For the past 30 years, most of the overall increase in financial depth—the ratio of assets to GDP—was driven by the rapid growth of equities and private debt in mature markets. Looking ahead, these asset classes in mature mar- kets are likely to grow more slowly, more in line with GDP, while government debt will rise sharply. An increasing share of global asset growth will occur in emerging markets, where GDP is ris- ing faster and all asset classes have abundant room to expand.
Source: Excerpted from “Global Capital Markets: Entering a New Era,” McKinsey Global Institute, Charles Rosburgh, Susan Lund, Charles Atkins, Stanislas Belot, Wayne W. Hu, and Moira S. Pierce, McKinsey & Company, September 2009, p. 7.
Assets. The assets—the financial assets—which are at the heart of the global capital markets are the debt securities issued by governments (e.g., U.S. Treasury Bonds). These low-risk or risk-free assets then form the foundation for the creating, trading, and pricing of other finan- cial assets like bank loans, corporate bonds, and equities (stock). In recent years, a number of
EXHIBIT 1.1
Bank
Mortgage Loan
Corporate Loan
Corporate Bond
Bank
Interbank Market (LIBOR )
Bank
Public Debt
Private Debt
Private Equity
Central Banks Institutions
Currency Currency Currency
The global capital market is a collection of institutions (central banks, commercial banks, investment banks, not for profit financial institutions like the IMF and World Bank) and securities (bonds, mortgages, derivatives, loans, etc.), which are all linked via a global network—the Interbank Market. This interbank market, in which securities of all kinds are traded, is the critical pipeline system for the movement of capital.
The exchange of securities—the movement of capital in the global financial system—must all take place through a vehicle—currency. The exchange of currencies is itself the largest of the financial markets. The interbank market, which must pass-through and exchange securities using currencies, bases all of its pricing through the single most widely quoted interest rate in the world—LIBOR (the London Interbank Offered Rate).
Global Capital Markets
5Current Multinational Challenges and the Global Economy CHAPTER 1
additional securities have been created from the existing 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.
Institutions. The institutions of global finance are the central banks, which create and control each country’s money supply; the commercial banks, which take deposits and extend loans to businesses, both local and global; and the multitude of other financial institutions created to trade securities and derivatives. These institutions take many shapes and are subject to many different regulatory frameworks. The health and security of the global financial system relies on the stability of these financial institutions.
Linkages. The links between the financial institutions, the actual fluid or medium for exchange, are the interbank networks using currency. The ready exchange of currencies in the global marketplace is the first and foremost necessary element for the conduct of financial trading, and the global currency markets are the largest markets in the world. The exchange of currencies, and the subsequent exchange of all other securities globally via currency, is the international interbank network. This network, whose primary price is the London Interbank Offered Rate (LIBOR), is the core component of the global financial system.
The movement of capital across borders and continents for the conduct of business has existed in many different forms for thousands of years. Yet, it is only within the past 50 years that these capital movements have started to move at the pace of an electron, either via a phone call or an email. And it is only within the past 20 years that this market has been able to reach the most distant corners of the earth at any moment of the day. This market has seen an explosion of innovative products and services in the past decade, some of which proved, as in the case of the 2008–2009 crisis, somewhat toxic to the touch.
The Market for Currencies The price of any one country’s currency in terms of another country’s currency is called a foreign currency exchange rate. For example, the exchange rate between the U.S. dollar ($ or USD) and the European euro (€ or EUR) may be stated as “1.4565 dollar per euro” or simply abbreviated as $1.4565/€. This is the same exchange rate as when stated “EUR1.00 = USD1.4565.” Since most international business activities require at least one of the two parties in a business transaction to either pay or receive payment in a currency, which is dif- ferent from their own, an understanding of exchange rates is critical to the conduct of global business.
A quick word about currency symbols. As noted, USD and EUR are often used as the symbols for the U.S. dollar and the European Union’s euro. These are the computer sym- bols (ISO-4217 codes) used today on the world’s digital networks. The field of international finance, however, has a rich history of using a variety of different symbols in the financial press, and a variety of different abbreviations are commonly used. For example, the British pound sterling may be £ (the pound symbol), GBP (Great Britain pound), STG (British pound sterling), ST£ (pound sterling), or UKL (United Kingdom pound). This book will also use the simpler common symbols—the $ (dollar), the € (euro), the ¥ (yen), the £ (pound)—but be warned and watchful when reading the business press!
Exchange Rate Quotations and Terminology. Exhibit 1.2 lists currency exchange rates for Thursday, January 12, 2012, as would be quoted in New York or London. The exchange rate listed is for a specific country’s currency—for example, the Argentina peso against the U.S. dollar—Peso 3.9713/$, the European euro—Peso $5.1767/€, and the British pound—Peso 6.1473/£. The rate listed is termed a “mid-rate” because it is the middle or average of the rates currency traders buy currency (bid rate) and sell currency (offer rate).
EXHIBIT 1.2 Selected Global Currency Exchange Rates
January 12, 2012 Country Currency Symbol Code
Currency to equal 1 Dollar
Currency to equal 1 Euro
Currency to equal 1 Pound
Argentina peso Ps ARS 4.3090 5.5143 6.6010
Australia dollar A$ AUD 0.9689 1.2413 1.4859
Bahrain dinar — BHD 0.3770 0.4825 0.5776
Bolivia boliviano Bs BOB 6.9100 8.8428 10.5855
Brazil real R$ BRL 1.7874 2.2873 2.7380
Canada dollar C$ CAD 1.0206 1.3061 1.5635
Chile peso $ CLP 502.050 642.473 769.090
China yuan ¥ CNY 6.3178 8.0849 9.6783
Colombia peso Col$ COP 1,843.30 2,358.87 2,823.75
Costa Rica colon C// CRC 508.610 650.869 779.141
Czech Republic koruna Kc CZK 20.0024 25.5970 30.6416
Denmark krone Dkr DKK 5.8114 7.4368 8.9024
Egypt pound £ EGP 6.0395 7.7288 9.2519
Hong Kong dollar HK$ HKD 7.7679 9.9405 11.8996
Hungary forint Ft HUF 241.393 308.910 369.789
India rupee Rs INR 51.6050 66.0389 79.0537
Indonesia rupiah Rp IDR 9,160.0 11,722.1 14,032.2
Iran rial — IRR 84.5000 231.8950 89.1256
Israel shekel Shk ILS 3.8312 4.9027 5.8690
Japan yen ¥ JPY 76.7550 98.2234 117.581
Kenya shilling KSh KES 87.6000 112.102 134.195
Kuwait dinar — KWD 0.2793 0.3574 0.4278
Malaysia ringgit RM MYR 3.1415 4.0202 4.8125
Mexico new peso $ MXN 13.5964 17.3993 20.8283
New Zealand dollar NZ$ NZD 1.2616 1.6145 1.9327
Nigeria naira N NGN 162.050 207.375 248.244
Norway krone NKr NOK 6.0033 7.6824 9.1965
Pakistan rupee Rs. PKR 90.1050 115.3070 138.0320
Peru new sol S/. PEN 2.6925 3.4456 4.1247
Phillippines peso P PHP 44.0550 56.3772 67.4879
Poland zloty — PLN 3.4543 4.4204 5.2916
Romania new leu L RON 3.3924 4.3425 5.1983
Russia ruble R RUB 31.6182 40.4618 48.4360
Saudi Arabia riyal SR SAR 3.7504 4.7994 5.7452
Singapore dollar S$ SGD 1.2909 1.6520 1.9775
South Africa rand R ZAR 8.0743 10.3326 12.3690
South Korea won W KRW 1,158.10 1,482.02 1,774.09
Sweden krona SKr SEK 6.9311 8.8698 10.6178
Switzerland franc Fr. CHF 0.9460 1.2106 1.4492
Taiwan dollar T$ TWD 29.9535 38.3315 45.8858
Thailand baht B THB 31.8300 40.7329 48.7604
Tunisia dinar DT TND 1.5184 1.9431 2.3261
Turkey lira YTL TRY 1.8524 2.3706 2.8377
United Arab Emirates
dirham — AED 3.6733 4.7007 5.6271
United Kingdom pound £ GBP 1.5319 0.8354
Ukraine hrywnja — UAH 8.0400 10.2888 12.3165
Uruguay peso $U UYU 19.4500 24.8902 29.7955
United States dollar $ USD 1.2797 1.5319
Venezuela bolivar fuerte Bs VEB 4.2947 5.4959 6.5790
Vietnam dong d VND 21,035.0 26,918.5 32,223.5
Euro euro € EUR 1.2797 1.1971
Special Drawing Right
— — SDR 0.6541 0.8370 1.0019
Note that a number of different currencies use the same symbol (for example both China and Japan have traditionally used the ¥ symbol, yen or yuan, meaning round or circle). That is one of the reasons why most of the world’s currency markets today use the three-digit currency code for clarity of quo- tation. All quotes are mid-rates, and are drawn from the Financial Times, January 12, 2012.
6
7Current Multinational Challenges and the Global Economy CHAPTER 1
The U.S. dollar has been the focal point of most currency trading since the 1940s. As a result, most of the world’s currencies have been quoted against the dollar—Mexican pesos per dollar, Brazilian real per dollar, Hong Kong dollars per dollar, etc. This quotation convention is also followed against the world’s major currencies as listed in Exhibit 1.2. For example, the Japanese yen is commonly quoted as ¥83.2200/$, ¥108.481/€, and ¥128.820/£.
Quotation Conventions. Several of the world’s major currency exchange rates, however, fol- low a specific quotation convention that is the result of tradition and history. The exchange rate between the U.S. dollar and the euro is always quoted as “dollars per euro” ($/€), $1.3036/€ as listed in Exhibit 1.2. Similarly, the exchange rate between the U.S. dollar and the British pound is always quoted as $/£, for example, the $1.5480/£ listed under “United States” in Exhibit 1.2. Many countries that were formerly members of the British Commonwealth will commonly be quoted against the dollar as U.S. dollars per currency (e.g., the Australian or Canadian dollars).
Eurocurrencies and LIBOR One of the major linkages of global money and capital markets is the Eurocurrency market and its interest rate known as LIBOR. Eurocurrencies are domestic currencies of one country on deposit in a second country. Eurodollar time deposit maturities range from call money and overnight funds to longer periods. Certificates of deposit are usually for three months or more and in million-dollar increments. A Eurodollar deposit is not a demand deposit; it is not created on the bank’s books by writing loans against required fractional reserves, and it can- not be transferred by a check drawn on the bank having the deposit. Eurodollar deposits are transferred by wire or cable transfer of an underlying balance held in a correspondent bank located within the United States. In most countries, a domestic analogy would be the transfer of deposits held in nonbank savings associations. These are transferred by the association writing its own check on a commercial bank.
Any convertible currency can exist in “Euro-” form. Note that this use of “Euro-” should not be confused with the new common European currency called the euro. The Eurocur- rency market includes Eurosterling (British pounds deposited outside the United Kingdom); Euroeuros (euros on deposit outside the euro zone); Euroyen (Japanese yen deposited outside Japan) and Eurodollars (U.S. dollars deposited outside the United States). The exact size of the Eurocurrency market is difficult to measure because it varies with daily decisions made by depositors about where to hold readily transferable liquid funds, and particularly on whether to deposit dollars within or outside the United States.
Eurocurrency markets serve two valuable purposes: 1) Eurocurrency deposits are an effi- cient and convenient money market device for holding excess corporate liquidity; and 2) the Eurocurrency market is a major source of short-term bank loans to finance corporate working capital needs, including the financing of imports and exports.
Banks in which Eurocurrencies are deposited are called Eurobanks. A Eurobank is a financial intermediary that simultaneously bids for time deposits and makes loans in a currency other than that of the currency in which it is located. Eurobanks are major world banks that conduct a Eurocurrency business in addition to all other banking functions. Thus, the Eurocurrency operation that qualifies a bank for the name Eurobank is in fact a department of a large commercial bank, and the name springs from the performance of this function.
The modern Eurocurrency market was born shortly after World War II. Eastern Euro- pean holders of dollars, including the various state trading banks of the Soviet Union, were afraid to deposit their dollar holdings in the United States because these deposits might be attached by U.S. residents with claims against communist governments. Therefore, Eastern
8 CHAPTER 1 Current Multinational Challenges and the Global Economy
European holders deposited their dollars in Western Europe, particularly with two Soviet banks: the Moscow Narodny Bank in London, and the Banque Commerciale pour l’Europe du Nord in Paris. These banks redeposited the funds in other Western banks, especially in London. Additional dollar deposits were received from various central banks in Western Europe, which elected to hold part of their dollar reserves in this form to obtain a higher yield. Commercial banks also placed their dollar balances in the market because specific maturities could be negotiated in the Eurodollar market. Such companies found it financially advanta- geous to keep their dollar reserves in the higher-yielding Eurodollar market. Various holders of international refugee funds also supplied funds.
Although the basic causes of the growth of the Eurocurrency market are economic effi- ciencies, many unique institutional events during the 1950s and 1960s helped its growth.
! In 1957, British monetary authorities responded to a weakening of the pound by imposing tight controls on U.K. bank lending in sterling to nonresidents of the United Kingdom. Encouraged by the Bank of England, U.K. banks turned to dollar lending as the only alternative that would allow them to maintain their leading position in world finance. For this they needed dollar deposits.
! Although New York was “home base” for the dollar and had a large domestic money and capital market, international trading in the dollar centered in London because of that city’s expertise in international monetary matters and its proximity in time and distance to major customers.
! Additional support for a European-based dollar market came from the balance of payments difficulties of the U.S. during the 1960s, which temporarily segmented the U.S. domestic capital market.
Ultimately, however, the Eurocurrency market continues to thrive because it is a large international money market relatively free from governmental regulation and interference.
Eurocurrency Interest Rates: LIBOR. In the Eurocurrency market, the reference rate of interest is LIBOR—the London Interbank Offered Rate. LIBOR is now the most widely accepted rate of interest used in standardized quotations, loan agreements or financial deriva- tives valuations. LIBOR is officially defined by the British Bankers Association (BBA). For example, U.S. dollar LIBOR is the mean of 16 multinational banks’ interbank offered rates as sampled by the BBA at 11 A.M. London time in London. Similarly, the BBA calculates the Japanese yen LIBOR, euro LIBOR, and other currency LIBOR rates at the same time in London from samples of banks.
The interbank interest rate is not, however, confined to London. Most major domes- tic financial centers construct their own interbank offered rates for local loan agreements. These rates include PIBOR (Paris Interbank Offered Rate), MIBOR (Madrid Interbank Offered Rate), SIBOR (Singapore Interbank Offered Rate), and FIBOR (Frankfurt Inter- bank Offered Rate), to name but a few.
The key factor attracting both depositors and borrowers to the Eurocurrency loan market is the narrow interest rate spread within that market. The difference between deposit and loan rates is often less than 1%. Interest spreads in the Eurocurrency market are small for many reasons. Low lending rates exist because the Eurocurrency market is a wholesale market, where deposits and loans are made in amounts of $500,000 or more on an unsecured basis. Borrowers are usually large corporations or government entities that qualify for low rates because of their credit standing and because the transaction size is large. In addition, overhead assigned to the Eurocurrency operation by participating banks is small.
Deposit rates are higher in the Eurocurrency markets than in most domestic currency markets because the financial institutions offering Eurocurrency activities are not subject to
9Current Multinational Challenges and the Global Economy CHAPTER 1
many of the regulations and reserve requirements imposed on traditional domestic banks and banking activities. With these costs removed, rates are subject to more competitive pressures, deposit rates are higher, and loan rates are lower. A second major area of cost avoided in the Eurocurrency markets is the payment of deposit insurance fees (such as the Federal Deposit Insurance Corporation, FDIC, and assessments paid on deposits in the United States).
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, cost- less information, and no government interference. The theory’s origins lie in the work of Adam Smith, and particularly with his seminal book The Wealth of Nations published in 1776. Smith sought to explain why the division of labor in productive activities, and subsequently inter- national trade of those goods, increased the quality of life for all citizens. Smith based his work on the concept of absolute advantage, where every country should specialize in the production of that good it was uniquely suited for. More would be produced for less. Thus, by each country specializing in products for which it possessed absolute advantage, countries could produce more in total and exchange products—trade—for goods that were cheaper in price than those produced at home.
David Ricardo, in his work On the Principles of Political Economy and Taxation pub- lished in 1817, sought to take the basic ideas set down by Adam Smith a few logical steps further. Ricardo noted that even if a country possessed absolute advantage in the produc- tion of two products, it might still be relatively more efficient than the other country in one good’s product than the other. Ricardo termed this comparative advantage. Each country would then possess comparative advantage in the production of one of the two products, and both countries would then benefit by specializing completely in one product and trad- ing for the other.
Although international trade might have approached the comparative advantage model during the nineteenth century, it certainly does not today, for a variety of 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 com- parative 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 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, and 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.
10 CHAPTER 1 Current Multinational Challenges and the Global Economy
Comparative advantage shifts over time as less developed countries become more devel- oped and realize their latent opportunities. For example, over 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 also 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 consum- ers, producers, and political leaders. Complete specialization, however, remains an unrealistic limiting case, just as perfect competition is a limiting case in microeconomic theory.
Global Outsourcing of Comparative Advantage Comparative advantage is still a relevant theory to explain why particular countries are most suitable for exports of goods and services that support the global supply chain of both MNEs and domestic firms. The comparative advantage of the twenty-first century, however, is one that is based more on services, and their cross border facilitation by telecommunications and the Internet. The source of a nation’s comparative advantage, however, still is created from the mixture of its own labor skills, access to capital, and technology. Many locations for supply chain outsourcing exist today.
Exhibit 1.3 presents a geographical overview of this modern reincarnation of trade-based comparative advantage. To prove that these countries should specialize in the activities shown you would need to know how costly the same activities would be in the countries that are
China
Eastern Europe
Russia Philippines
Mexico
Costa Rica South Africa
United States
IndiaMonterrey
Guadalajara
Shanghai
London
Paris
Berlin Budapest
Moscow
San Jose
Johannesburg Bombay Hyderabad Bangalore
Manila
MNEs based in many industrial countries are outsourcing intellectual functions to providers based in traditional emerging market countries.
EXHIBIT 1.3 Global Outsourcing of Comparative Advantage
11Current Multinational Challenges and the Global Economy CHAPTER 1
importing these services compared to their own other industries. Remember that it takes a relative advantage in costs, not just an absolute advantage, to create comparative advantage.
For example, India has developed a highly efficient and low-cost software industry. This industry supplies not only the creation of custom software, but also call centers for customer support, and other information technology services. The Indian software industry is composed of subsidiaries of MNEs and independent companies. If you own a Hewlett-Packard computer and call the customer support center number for help, you are likely to reach a call center in India. Answering your call will be a knowledgeable Indian software engineer or program- mer who will “walk you through” your problem. India has a large number of well-educated, English-speaking technical experts who are paid only a fraction of the salary and overhead earned by their U.S. counterparts. The overcapacity and low cost of international telecom- munication networks today further enhances the comparative advantage of an Indian location.
The extent of global outsourcing is already reaching out to every corner of the globe. From financial back-offices in Manila, to information technology engineers in Hungary, modern telecommunications now take business activities to labor rather than moving labor to the places of business.
What Is Different About International Financial Management? Exhibit 1.4 details some of the main differences between international and domestic financial management. These component differences include institutions, foreign exchange and political risks, and the modifications required of financial theory and financial instruments.
International 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,
EXHIBIT 1.4
Concept International Domestic
Culture, history and institutions Each foreign country is unique and not always understood by MNE management
Each country has a known base case
Corporate governance Foreign countries’ regulations and institutional practices are all uniquely different
Regulations and institutions are well known
Foreign exchange risk MNEs face foreign exchange risks due to their subsidiaries, as well as import/export and foreign competitors
Foreign exchange risks from import/export and foreign competition (no subsidiaires)
Political risk MNEs face political risk because of their foreign subsidiaries and high profile
Negligible political risks
Modification of domestic finance theories MNEs must modify finance theories like capital budgeting and the cost of capital because of foreign complexities
Traditional financial theory applies
Modification of domestic financial instruments
MNEs utilize modified financial instruments such as options, forwards, swaps, and letters of credit
Limited use of financial instruments and derivatives because of few foreign exchange and political risks
What Is Different About International Financial Management?
12 CHAPTER 1 Current Multinational Challenges and the Global Economy
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.
The main theme of this book is to analyze how an MNE’s financial management evolves as it pursues global strategic opportunities and new constraints emerge. In this chapter, we will take a brief look at the challenges and risks associated with Trident Corporation (Trident), a company evolving from domestic in scope to being truly multinational. The discussion will include the constraints that a company will face in terms of managerial goals and governance as it becomes increasingly involved in multinational operations. But first we need to clarify the unique value proposition and advantages that the MNE was created to exploit. And as noted by Global Finance in Practice 1.2, the objectives and responsibilities of the modern multinational have grown significantly more complex in the twenty-first century.
Market Imperfections: A Rationale for the Existence of 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 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 than purely domestic firms to identify and implement market opportunities through their own internal information network.
GLOBAL FINANCE IN PRACTICE 1.2
Corporate Responsibility and Corporate Sustainability
Sustainable development is development that meets the needs of the present without compromising the ability of future generations to meet their own needs.
—Brundtland Report, 1987, p. 54.
What is the purpose of the corporation? It is increasingly accepted that the purpose of the corporation is to certainly create profits and value for its stakeholders, but the respon- sibility of the corporation is to do so in a way that inflicts no costs on society, including the environment. As a result of globalization, this growing responsibility and role of the corpo- ration in society has added a level of complexity to the leader- ship challenges faced by the twenty-first century firm.
This developing debate has been somewhat hampered to date by conflicting terms and labels—corporate goodness, corporate responsibility, corporate social responsibility (CSR),
corporate philanthropy, and corporate sustainability, to list but a few. Much of the confusion can be reduced by using a guiding principle—that sustainability is a goal, while responsibility is an obligation. It follows that the obligation of leadership in the mod- ern multinational is to pursue profit, social development, and the environment, all along sustainable principles.
The term sustainable has evolved greatly within the con- text of global business in the past decade. A traditional primary objective of the family-owned business has been the “sustain- ability of the organization”—the long-term ability of the company to remain commercially viable and provide security and income for future generations. Although narrower in scope than the con- cept of environmental sustainability, there is a common core thread—the ability of a company, a culture, or even the earth, to survive and renew over time.
13Current Multinational Challenges and the Global Economy CHAPTER 1
Why Do Firms become Multinational? Strategic motives drive the decision to invest abroad and become an MNE. These motives can be summarized under the following categories:
1. Market seekers produce in foreign markets either to satisfy local demand or to export to markets other than their home market. U.S. automobile firms manufacturing in Europe for local consumption are an example of market-seeking motivation.
2. Raw material seekers extract raw materials wherever they can be found, either for export or for further processing and sale in the country in which they are found—the host country. Firms in the oil, mining, plantation, and forest industries fall into this category.
3. Production efficiency seekers produce in countries where one or more of the factors of production are underpriced relative to their productivity. Labor-intensive produc- tion of electronic components in Taiwan, Malaysia, and Mexico is an example of this motivation.
4. Knowledge seekers operate in foreign countries to gain access to technology or man- agerial expertise. For example, German, Dutch, and Japanese firms have purchased U.S.-located electronics firms for their technology.
5. Political safety seekers acquire or establish new operations in countries that are considered unlikely to expropriate or interfere with private enterprise. For example, Hong Kong firms invested heavily in the United States, United Kingdom, Canada, and Australia in anticipation of the consequences of China’s 1997 takeover of the British colony.
These five types of strategic considerations are not mutually exclusive. Forest products firms seeking wood fiber in Brazil, for example, may also find a large Brazilian market for a portion of their output.
In industries characterized by worldwide oligopolistic competition, each of the above strategic motives should be subdivided into proactive and defensive investments. Proactive investments are designed to enhance the growth and profitability of the firm itself. Defensive investments are designed to deny growth and profitability to the firm’s competitors. Examples of the latter are investments that try to preempt a market before competitors can get estab- lished in it, or capture raw material sources and deny them to competitors.
The Globalization Process Trident is a hypothetical U.S.-based firm that will be used as an illustrative example through- out the book to demonstrate the globalization process—the structural and managerial changes and challenges experienced by a firm as it moves its operations from domestic to global.
Global Transition I: Trident Moves from the Domestic Phase to the International Trade Phase Trident is a young firm that manufactures and distributes an array of telecommunication devices. Its initial strategy is to develop a sustainable competitive advantage in the U.S. mar- ket. Like many other young firms, it is constrained by its small size, competitors, and lack of access to cheap and plentiful sources of capital. The top half of Exhibit 1.5 shows Trident in its early domestic phase.
Trident sells its products in U.S. dollars to U.S. customers and buys its manufacturing and service inputs from U.S. suppliers, paying U.S. dollars. The creditworth of all suppliers
14 CHAPTER 1 Current Multinational Challenges and the Global Economy
and buyers is established under domestic U.S. practices and procedures. A potential issue for Trident at this time is that although Trident is not international or global in its operations, some of its competitors, suppliers, or buyers may be. This is often the impetus to push a firm like Trident into the first transition of the globalization process, into international trade. Trident was founded by James Winston in Los Angeles in 1948 to make telecommunications equipment. The family-owned business expanded slowly but steadily over the following 40 years. The demands of continual technological investment in the 1980s, however, required that the firm raise additional equity capital in order to compete. This need led to its initial public offering (IPO) in 1988. As a U.S.-based publicly traded company on the New York Stock Exchange, Trident’s management sought to create value for its shareholders.
As Trident became a visible and viable competitor in the U.S. market, strategic opportuni- ties arose to expand the firm’s market reach by exporting product and services to one or more foreign markets. The North American Free Trade Area (NAFTA) made trade with Mexico and Canada attractive. This second phase of the globalization process is shown in the lower half of Exhibit 1.5. Trident responded to these globalization forces by importing inputs from Mexican suppliers and making export sales to Canadian buyers. We define this stage of the globalization process as the International Trade Phase.
Exporting and importing products and services increases the demands of financial man- agement over and above the traditional requirements of the domestic-only business. First, direct foreign exchange risks are now borne by the firm. Trident may now need to quote prices in foreign currencies, accept payment in foreign currencies, or pay suppliers in foreign cur- rencies. As the value of currencies change from minute to minute in the global marketplace, Trident will now experience significant risks from the changing values associated with these foreign currency payments and receipts.
Second, the evaluation of the credit quality of foreign buyers and sellers is now more important than ever. Reducing the possibility of non-payment for exports and non-delivery of imports becomes one of two main financial management tasks during the international trade
EXHIBIT 1.5
Mexican Suppliers Canadian Buyers
Are Mexican suppliers dependable? Will Trident pay US$ or Mexican pesos?
All payments in U.S. dollars. All credit risk under U.S. law.
Are Canadian buyers creditworthy? Will payment be made in US$ or C$?
Trident Corporation (Los Angeles, USA)
Phase Two: Expansion into International Trade
U.S. Suppliers (domestic)
U.S. Buyers (domestic)
Phase One: Domestic Operations
Trident Corp: Initiation of the Globalization Process
15Current Multinational Challenges and the Global Economy CHAPTER 1
phase. This credit risk management task is much more difficult in international business, as buyers and suppliers are new, subject to differing business practices and legal systems, and generally more challenging to assess.
Global Transition II: The International Trade Phase to the Multinational Phase If Trident is successful in its international trade activities, the time will come when the global- ization process will progress to the next phase. Trident will soon need to establish foreign sales and service affiliates. This step is often followed by establishing manufacturing operations abroad or by licensing foreign firms to produce and service Trident’s products. The multitude of issues and activities associated with this second larger global transition is the real focus of this book.
Trident’s continued globalization will require it to identify the sources of its competitive advantage, and with that knowledge, expand its intellectual capital and physical presence globally. A variety of strategic alternatives are available to Trident—the foreign direct invest- ment sequence—as shown in Exhibit 1.6. These alternatives include the creation of foreign sales offices, the licensing of the company name and everything associated with it, and the manufacturing and distribution of its products to other firms in foreign markets.
As Trident moves farther down and to the right in Exhibit 1.6, the degree of its physical presence in foreign markets increases. It may now own its own distribution and production facilities, and ultimately, may want to acquire other companies. Once Trident owns assets and enterprises in foreign countries it has entered the multinational phase of its globalization.
EXHIBIT 1.6
Greater Foreign Investment
Greater Foreign Presence
Production Abroad
Control Assets Abroad
Exploit Existing Competitive Advantage Abroad
Production at Home: Exporting
Licensing Management Contract
Change Competitive Advantage
Trident and Its Competitive Advantage
Wholly Owned SubsidiaryJoint Venture
Acquisition of a Foreign Enterprise
Acquisition of a Foreign Enterprise
Greenfield Investment
Trident’s Foreign Direct Investment Sequence
16 CHAPTER 1 Current Multinational Challenges and the Global Economy
The Limits to Financial Globalization The theories of international business and international finance introduced in this chapter have long argued that with an increasingly open and transparent global marketplace in which capital may flow freely, capital will increasingly flow and support countries and companies based on the theory of comparative advantage. Since the mid-twentieth century, this has indeed been the case as more and more countries have pursued more open and competitive markets. But the past decade has seen the growth of a new kind of limit or impediment to financial globalization: the growth in the influence and self-enrichment of organizational insiders.
One possible representation of this process can be seen in Exhibit 1.7. If influential insid- ers 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 and influence or personal wealth, or both, 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. As we will see throughout this book, this barrier to international finance may indeed be increasingly troublesome.
This growing dilemma is also something of a composite of what this book is about. The three fundamental elements—financial theory, global business, and 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. The Mini-Case sets the stage for our debate and discussion. Are the controlling family members of this company creating value for themselves or their shareholders?
We close this chapter—and open this book—with the simple words of one of our colleagues in a recent conference on the outlook for global finance and global financial management.
Welcome to the future. This will be a constant struggle. We need leadership, citizenship, and dialogue.
—Donald Lessard, in Global Risk, New Perspectives and Opportunities, 2011, p. 33.
EXHIBIT 1.7
The Twin Agency Problems Limiting
Financial Globalization
Actions of Rulers of Sovereign States
Higher Firm Value (possibly lower insider value)
Lower Firm Value (possibly higher insider value)
Actions of Corporate Insiders
There is a growing debate over whether many of the insiders and rulers of organizations with enterprises globally are taking actions consistent with creating firm value or consistent with increasing their own personal stakes and power.
If these influential insiders are building personal wealth over that of the firm, it will indeed result in preventing the flow of capital across borders, currencies, and institutions to create a more open and integrated global financial community.
Source : Constructed by authors based on “The Limits of Financial Globalization,” Rene M. Stulz, Journal of Applied Corporate Finance, Volume 19 Number 1, Winter 2007, pp. 8–15.
The Potential Limits of Financial Globalization
17Current Multinational Challenges and the Global Economy CHAPTER 1
SUMMARY POINTS
! The creation of value requires combining three critical elements: 1) an open marketplace; 2) high-quality stra- tegic management; and 3) access to capital.
! The theory of comparative advantage provides a basis for explaining and justifying international trade in a model world assumed to enjoy free trade, perfect com- petition, no uncertainty, costless information, and no government interference.
! International financial management requires an understanding of cultural, historical, and institu- tional 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 nor- mally a threat to domestic operations.
! MNEs strive to take advantage of imperfections in national markets for products, factors of production, and financial assets.
! 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.
! A firm may first enter into international trade trans- actions, then international contractual arrangements, such as sales offices and franchising, and ultimately the acquisition of foreign subsidiaries. At this final stage it truly becomes a multinational enterprise (MNE).
! The decision whether or not to invest abroad is driven by strategic motives, and may require the MNE to enter into global licensing agreements, joint ventures, cross- border acquisitions, or greenfield investments.
! If influential insiders in corporations and sovereign states pursue their own personal agendas which may increase their personal power, influence, or wealth, then capital will not flow into these sovereign states and cor- porations. This will, in turn, create limitations to global- ization in finance.
Rumors about this relatively secret company abound. Share prices fell below $1 in November. Following some action on the stock, and at the request of the Hong Kong stock market, the company had to issue a number of press releases denying rumors of acquisitions or other agreements. It also denied rumors that its Chinese mills had taken market-related downtime. Finally, a spokes- man said the company had no “liquidity problems.”
—“Five Companies to Watch,” G. Rodden, M. Rushton, F. Willis, PPI, January 2009, p. 21.
“This time is really different. Large and small are all affected. In the past, the big waves would only wash away the sand and leave the rocks. Now the waves are so big, even some rocks are being washed away.”
—Cheung Yan, Chairwoman of Nine Dragons Paper, “Wastepaper Queen: Letter from China,”
New Yorker, 30 March 2009, p. 8.
Incorporated in Hong Kong in 1995, Nine Dragons Paper (Holdings) Limited had become an international power- house in the paper industry. The company produced a port- folio of paperboard products used in consumer product packaging. The company had expanded rapidly, its capital expenditure growing at an average annual rate of 120% for the past five years.
But in January 2009, the company had been forced to issue a profit warning (Exhibit 1). Squeezed by market con- ditions and burdened by debt, Nine Dragons Paper (NDP), the largest paperboard manufacturer in Asia and second largest in the world, had seen its share price plummet. As the economic crisis of 2008 had bled into 2009, NDP’s sales had fallen. Rumors had been buzzing since October that NDP was on the very edge of bankruptcy. Now, in April 2009, more than one analyst was asking “Will they go bust?”
MINI-CASE Nine Dragons Paper and the 2009 Credit Crisis1
1Copyright 2011 © Thunderbird School of Global Management. All rights reserved. This case was prepared by Professor Michael Mof- fett and Brenda Adelson, MBA ’08, for the purpose of classroom discussion only, and not to indicate either effective or ineffective management.
18 CHAPTER 1 Current Multinational Challenges and the Global Economy
The Wastepaper Queen Cheung Yan, or Mrs. Cheung as she preferred, was the visionary force behind NDP’s success. Her empire was built from trash—discarded cardboard cartons to be precise. The cartons were collected in the United States and Europe, shipped to China, then pulped and remanu- factured into paperboard. NDP customers then used the paperboard to package goods for shipment back to the United States and Europe, returning them to their origins. Born in 1957, Mrs. Cheung came from a modest family background. She had started as an accountant for a Chi- nese trading company in Hong Kong, and then started her own company after her employer went under. Her com- pany was a scrap paper dealer, purchasing scrap paper in Hong Kong and mainland China and selling it to Chinese paper manufacturers. Paper in China was of generally poor quality, made from bamboo stalk, rice stalk, and grass. The locally collected wastepaper didn’t meet the needs of paper manufacturers as a raw input. In Europe and the United States, however, paper was made from wood pulp, which produced a higher quality paper (United States companies use a higher percentage of pulp, while Chinese companies use more recovered paper). Realizing that by capturing the wastepaper stream in the United States and Europe she could provide a higher quality product to her customers in China, Mrs. Cheung moved to the United States in 1990 to start another company, American Chung Nam Incor- porated (ACN).
One of the first companies to export wastepaper from the United States to China, ACN started by collecting
wastepaper from dumps, then expanded its network to include waste haulers and wastepaper collectors. Mrs. Cheung negotiated favorable contracts with shipping com- panies whose ships were returning to China empty. ACN soon expanded abroad and became a leading exporter of recovered paper from Europe to China as well. By 2001, ACN had become the largest exporter, by volume, of freight from the United States. In other words, nobody in America was shipping more of anything each year any- where in the world.
The Chinese economic miracle that began in the late 1990s rose through exports of consumer goods which needed a massive amount of packaging material. Within a few years, the demands for packaging far outgrew what domestic suppliers could provide. In 1995, Mrs. Cheung founded Nine Dragons Paper Industries Company in Dongguan, China. By 1998, the first papermaking machine was installed, a second in 2000, and a third in 2003. By 2008, NDP had 22 paperboard manufacturing machines at six locations in China and Vietnam. As illustrated by Exhibit 2, sales and profits soared.
NDP’s Products Containerboard is used for exactly what it sounds like: con- taining products in shipping between manufacturing and market. As illustrated in Exhibit 3, the containerboard value chain is a consumer-driven market, with consumer purchases of products driving the demand for packaging and containers and insulation worldwide. Companies like NDP purchase recovered pulp paper from a variety of raw
EXHIBIT 1
(Incorporated in Bermuda with limited liability) (Stock Code: 2689)
ANNOUNCEMENT
PROFIT WARNING
The Board wishes to inform the shareholders of the Company and potential investors that it is expected the Group will record a substantial reduction in its unaudited consolidated net profit arising from normal operations for the six months ended 31 December 2008 as compared to that for the corresponding period in 2007 due to the substantial decrease in the selling prices of the Group’s products and the rising cost of raw materials.
Shareholders of the Company and potential investors are advised to exercise caution in dealing in shares of the Company.
NPD’s Profit Warning (14 January 2009)
19Current Multinational Challenges and the Global Economy CHAPTER 1
EXHIBIT 2
0
2,000,000
4,000,000
6,000,000
8,000,000
10,000,000
12,000,000
14,000,000
16,000,000
2003 2004 2005 2006 2007 2008 0%
5%
10%
15%
20%
25%
Sales (000s Rmb) Return on Sales (%)
Return on Sales = Net Income
Sales
Source: Nine Dragons Paper.
NPD’s Growing Sales and Profitability
EXHIBIT 3
Raw Material Suppliers
OCC (old corrugated cardboard) or recovered paper makes up 90% of volume
Pulp paper about 10% of volume
Input prices have been very volatile in recent years
NDP sources 60% of its OCC from American Chung Nam (ACN) owned by Mrs. Cheung
Raw material costs make up 60% of cost of goods sold
Large quantities of water and electricity required in manufacture
Containerboard Manufacturers
Containerboard co’s typically pass along cost changes due to highly fragmented box manufacturers
NDP & Lee & Man control roughly 25% of the total Chinese market
Sales mix has shifted to domestic market in recent years (78% domestic in 2008, only 49% in 2005)
Companies:
Shandong Huatai Paper Company Ltd.
Kith Holdings Limited
Samson Paper Holdings Limited
Lee & Man Paper Manufacturing Limited
Box Manufacturers
Also able to pass along prices to customers as container costs make up a relatively small percentage of total product cost of final customer
Manufacturing needs to occur near customers due to high cost of transport of low value goods
Companies:
Hop Fung supplies manufacturing sector in Hong Kong and the Pearl River Delta
D&B Database returns 3892 paperboard box manufacturers (NAICS 32221) in China
Consumer Product Companies
Highly cyclical with consumer spending
Market in China has been shifting to a domestic orientation as Chinese incomes and consumption patterns grow
Chinese economy, domestic economy, recovered rapidly from the 2008 recession suffered by most nations globally
Nine Dragons Paper
Chinese Containerboard Value Chain
CHAPTER 1 Current Multinational Challenges and the Global Economy20
material suppliers (e.g., American Chung Nam, ACN, Mrs. Cheung’s own company), to manufacture container- board. The containerboard is then sold to a variety of box manufacturers, most of which are located near the final customer, the consumer product companies.
NDP produced three different types of containerboard: linerboard (47% of 2008 sales), corrugated medium (28% of sales), and corrugated duplex (23% of sales). Linerboard, light brown or white in color, is the flat exterior surface of boxes used to absorb external pressures during transport. Corrugated containerboard is the wavy fluted interior used to protect products in shipment. Corrugated medium, also light brown in color, has a high stack strength and is light- weight, saving shippers significant shipping costs. Corru- gated duplex is glossy on one side, high in printability, and is used in packaging of electronics, cosmetics, and a variety of food and beverages. These three products made up 98% of sales in 2008, with pulp and specialty paper making up the final 2% of sales.
Expansion
The market waits for no one. If I don’t develop today, if I wait for a year, or two or three years, to develop, I will have nothing for the market, and I will miss the opportunity.
—Cheung Yan, Chairwoman of Nine Dragons Paper, “Wastepaper Queen: Letter from China,”
New Yorker, 30 March 2009, p. 2.
Since its founding in 1995, the company had continuously expanded production capacity. By 2008, NDP had three paperboard manufacturing plants in China: Dongguan, in Guangdong Province in the Pearl River Delta; Taicang, in Jiangsu Province in the Yangtze River Delta region; and Chongqing, in Sichuan Province in western China. All three were strategically located close to consumer goods manufacturers and shipping ports. NDP also had three other major investments in parallel with paperboard man- ufacturing, buying a specialty board producer in Sichuan Province, a pulp manufacturer in Inner Mongolia, and a joint venture in a pulp manufacturer and paper mill in Binh Duong Province, Vietnam.
Even with NDP and competitor expansions, the demand for paperboard in China surpassed production. In 2005, Chinese manufacturers produced nearly 28 million tonnes of containerboard, yet consumption equaled 30 mil- lion tonnes. Domestic manufacturers had been narrowing the output gap, yet there was still an unmet need. Despite being the largest containerboard manufacturing country in the world, China remained a net importer. By 2008, NDP was the largest paperboard manufacturer in Asia.
Expansion came at a cost. A paper-making machine can cost anywhere from $100 to $200 million to purchase and set up, and then take up to two years before reaching optimal productivity. NDP operated its own electrical power plants, loading, and transportation services, had entered into sev- eral joint ventures to supply wood pulp, and held long-term agreements for wastepaper supply. Though registered in Bermuda, corporate offices remained in Hong Kong.
Containerboard manufacturing is both energy intensive and water use intensive. To secure power supplies, NDP constructed coal-fired co-generation power plants to sup- ply its plants in Dongguan, Taicang, and Chongqing. With these plants, the cost of generating power was approxi- mately one-third less than electricity purchased from the regional power grid.
The company owned and operated its own transporta- tion infrastructure, including piers and unloading facilities, railway spurs, and truck fleets. The company received ship- ments of raw materials, including recovered paper, chemi- cals, and coal, at its own piers in Taicang and Chongqing, and at the Xinsha Port in Dongguan. These facilities took advantage of ocean and inland waterway transportation, reducing port loading and unloading charges and allowing the company to avoid transportation bottlenecks.
From the beginning, the company invested in the most advanced equipment available, importing papermaking machines from the U.S. and Italy. Each plant was con- structed with multiple production lines, allowing flexible configuration. This allowed NDP to respond to changing customer demands, offering a diversified product portfolio with options including product types, sizes, grades, burst indices, stacking strengths, basis weights, and printability. NDP had become an innovation leader in the industry, with equipment utilization rates consistently averaging 94%, far surpassing the industry average.
Although now publicly traded, the family still controlled the business. Mrs. Cheung and her husband held 72% of the company’s stock, with family members holding a number of the executive positions in the company: Mrs. Cheung was Chairman; her husband, Ming Chung Liu, was Chief Execu- tive Officer; her brother Zhang Cheng Fei was a general man- ager; and her son, Lau Chun Shun, was an executive director.
Financing Expansion
Why are we in debt? she asked. . . . I took a high level of risk because that is the preparation for the future, so that we will be first in the market when things change.
—Cheung Yan, Chairwoman of Nine Dragons Paper, “Wastepaper Queen: Letter from China,” New
Yorker, 30 March 2009, p. 2.
21Current Multinational Challenges and the Global Economy CHAPTER 1
Although sometimes difficult, NDP had historically been able to fund its growing capital expenditures with a com- bination of operating cash flow and debt. But as the rate of expansion grew even faster, and the company’s capital expenditures ballooned as illustrated in Exhibit 4, it became obvious that the company would need to restructure its financial base. Mrs. Cheung devised a second strategic plan.
Initial Public Offering. The first step was an initial pub- lic offering (IPO). In March 2006, NDP offered 25% of the company’s equity, one billion shares, at an offer price of HK$3.40 per share. The official offering was oversub- scribed as a result of intense investor interest. The company then exercised an over-allotment option through its joint underwriters, Merrill Lynch and BNP Paribas Peregrine, issuing an additional 150 million shares in a private place- ment to a select set of Hong Kong-based investors. The added shares raised an additional HK$490 million ($63.2 million) after fees, raising the total issuance to HK$3.9 bil- lion ($504 million), representing 27.7% of the company’s ownership.
NDP’s shares (HK:2689) began trading on the Hong Kong stock exchange in March 2006 and within six months were a constituent stock of the Hang Seng Composite Index. Following the highly successful IPO, Mrs. Cheung was now the richest woman in China.
Raising Debt. The proceeds from the IPO allowed NDP to retire a large portion of its accumulated debt. But the respite from debt concerns was short-lived. As
Mrs. Cheung increased the rate of asset growth, the company’s debt again began to grow. NDP once again generated a negative free cash flow (operating cash flow less capex as illustrated in Exhibit 4). In April 2008, NDP issued $300 million in senior unsecured notes, notes which Fitch initially rated BBB–, the very edge of investment grade. Fitch cited a multitude of factors in its rating: the current economy, raw material price increases, supply risk, and the company’s aggressive capital expenditure program.
When global financial markets ground to a halt in September and October 2008 and the economic crisis spread around the globe, consumers stopped buying, Chinese exports slowed, and sales of containerboard plummeted. NDP’s export orders declined 50%, sales revenue dropped, and the burden of debt grew notice- ably heavier. Analysts became increasingly nervous. As price pressure from raw materials continued and NDP’s margins fell, final customers started fighting higher con- tainerboard and box prices. On October 13, Fitch down- graded NDP to BB+. NDP was now speculative grade, junk bond status.
NDP’s Chinese New Year 2009
We understand that all NDP’s banks have postponed for one year all earnings-based debt covenant ratios. We see this as a significant positive for shareholders as it should allow management enough time to restore confidence
EXHIBIT 4
0
1,000,000
2,000,000
3,000,000
4,000,000
5,000,000
6,000,000
7,000,000
8,000,000
9,000,000
10,000,000
6/30/2003 6/30/2004 6/30/2005 6/30/2006 6/30/2007 6/30/2008
Rmb (000s)
Capital Expenditure
Operating Cash Flow
NDP’s Capex and Operating Cash Flow
CHAPTER 1 Current Multinational Challenges and the Global Economy22
and restructure its Rmb14.7 bn in debt, of which half is due in two years.
—“Nine Dragons Paper,” Morgan Stanley, January 29, 2009, p. 1.
Following new rumors of the company’s possible bank- ruptcy, on December 29, 2008, NDP announced that it would delay Rmb1.5 billion in capital expenditure planned for the 2009 fiscal year. The company reassured analysts and shareholders that by late 2010 or early 2011 the paperboard markets would rebound. NDP also moved quickly to repur- chase $16 million of its own notes and reported it would prepay $100 million of an existing $350 million syndicated loan and HK$720 million of a HK$2.3 billion credit line.
The debt restructuring had mixed results for NDP’s outlook. The partial repayment on the two loan facilities convinced NDP’s bankers to allow the debt covenants on the loan facilities to be relaxed for one year. In turn, NDP’s costs under the loan facilities would reflect new higher spreads commensurate with its fallen credit rating. Its actions quelled the tempest somewhat, but not much, and not for long. NDP’s share price, after recovering a bit in December 2008, started falling once again in January 2009, as shown in Exhibit 5. Two days later on January 15, NDP issued a profit warning, revising sales and profit forecasts downward (see Exhibit 1). The ratings agencies responded with another downgrade, Fitch pushing NDP’s outstanding notes down to BB–. Rumors of the company’s potential bankruptcy were widespread.
By mid-February, many investment analysts were start- ing to reverse their recommendations on NDP shares. A few argued that the company’s share price had over- reacted, and the company simply “had to be worth more” than what it was currently trading at. As more and more analysts endorsed the strategic and financial changes announced and implemented by management, the share price gradually rose. There were early signs that the Chi- nese economy was recovering from the recession quickly, margins were stabilizing, and that boded well for NDP’s earnings and cash flows.
In mid-March, however, the analysts were stunned once again. In a briefing held by Mrs. Cheung, NDP announced it was re-instituting capex plans which had been shelved only three months before.
. . . we are concerned about the heavy reliance on bank borrowing in its current capital structure. Whilst the US$165 mn buyback of its senior notes and the relax- ation of loan covenants in its syndicated term loans were positive catalysts for shareholders, in our view, we believe investors today are now asking what the company is doing to cut total debt, and at the meeting management failed to provide any new strategies.
—Morgan Stanley, March 18, 2009.
Estimates of earnings for the year would once again have to be revised downward (as seen in the March 18, 2009 revision in Exhibit 6). The higher capital expenditures
EXHIBIT 5
HK$0
HK$4
HK$8
HK$12
HK$16
HK$20
HK$24
HK$28 NDP Share Price (HK$)
3/3 /20
06
5/3 /20
06
7/3 /20
06
9/3 /20
06
11 /3/
20 06
1/3 /20
07
3/3 /20
07
5/3 /20
07
7/3 /20
07
9/3 /20
07
11 /3/
20 07
1/3 /20
08
3/3 /20
08
5/3 /20
08
7/3 /20
08
9/3 /20
08
11 /3/
20 08
1/3 /20
09
3/3 /20
09
NDP’s IPO March 2006 Rumors of
potential bankruptcy increase
October 2008
NDP’s record high of HK$26 in September 2007
NDP’s Share Price (ending April 30, 2009; weekly)
23Current Multinational Challenges and the Global Economy CHAPTER 1
EXHIBIT 6 The Evolution of Earnings, Cash Flow, and Debt Analysis of Nine Dragons Paper
Rmb (millions) 2007 2008
Maintain Sept 17,
2008 2009e
Downgrade Dec 16,
2008 2009e
Upgrade Jan 29,
2009 2009e
Downgrade Feb 19, 2009 2009e
Debt Concern Mar 18,
2009 2009e
INCOME
Net sales 9,838 14,114 20,837 14,691 14,691 14,522 14,517 Cost of goods manufacturing (7,201) (11,341) (16,849) (12,886) (12,779) (12,482) (12,468)
EBITDA 2,637 2,773 3,988 1,805 1,912 2,040 2,049 Percent of sales 26.8% 19.6% 19.1% 12.3% 13.0% 14.0% 14.1%
Depreciation & amoritization (370) (507) (914) (800) (807) (848) (829)
EBIT 2,267 2,266 3,074 1,005 1,105 1,192 1,220 Percent of sales 23.0% 16.1% 14.8% 6.8% 7.5% 8.2% 8.4%
Interest (105) (102) (795) (887) (887) (556) (480)
Pre-tax Profit (EBT) 2,162 2,164 2,279 118 218 636 740 Percent of sales 22.0% 15.3% 10.9% 0.8% 1.5% 4.4% 5.1%
CASH FLOW
EBITDA 2,637 2,773 3,988 1,805 1,912 2,040 2,049 Less taxes paid (93) (263) (296) (15) (28) (44) (22) Less net financial (272) (102) (814) (918) (918) (588) (1,057) Less working capital (1,517) (1,012) (1,202) (691) 1,500 602 599
Operating Cash Flow 755 1,396 1,676 181 2,466 2,010 1,569
Capex (5,345) (9,601) (2,950) (1,500) (1,700) (2,800) (4,450) Acquisitions (208) (208) (208) (208) — — — Disposals & other 28 — 20 31 31 31 31
Investing Cash Flow (5,525) (9,809) (3,138) (1,677) (1,669) (2,769) (4,419)
Equity raised 2,011 — — — — — — Debt raised 1,795 8,594 2,950 1,350 (1,000) (500) 2,000 Dividends (199) (495) (495) (224) (224) (224) (224) Other 119 171 — (452) (12) (17) (17)
Financing Cash Flow 3,726 8,270 2,455 674 (1,236) (741) 1,759
Net Changes in Cash (1,044) (143) 993 (822) (439) (1,500) (1,091)
FREE CASH FLOW
Operating Cash Flow 755 1,396 1,676 181 2,466 2,010 1,569 Less capex (5,345) (9,601) (2,950) (1,500) (1,700) (2,800) (4,450)
Free Cash Flow (FCF) (4,590) (8,205) (1,274) (1,319) 766 (790) (2,881)
CAPITAL STRUCTURE
Payables 1,767 3,839 2,941 2,280 4,316 4,232 4,221 Borrowings 6,632 14,685 14,865 16,265 13,915 13,575 16,369 Other liabilities 328 544 39 91 532 527 527
Total Liabilities 8,727 19,068 17,845 18,636 18,763 18,334 21,117
Shareholders equity 11,513 13,272 14,426 13,090 13,178 14,419 13,706 Minority interest 123 274 243 334 334 334 334
Total Liabilities and Equity 20,363 32,614 32,514 32,060 32,275 33,087 35,157
Net Debt 5,007 13,396 13,458 15,858 13,124 13,845 16,231 Net Debt / Equity 43.5% 100.9% 93.3% 121.1% 99.6% 96.0% 118.4% Interest Cover (EBITDA x) 9.7 27.2 4.9 2.0 2.1 3.5 1.9 Gearing (Debt/Equity) 58% 111% 103% 124% 106% 94% 119% Debt / EBITDA (5x or less) 2.51 5.30 3.73 9.01 7.28 6.65 7.99 EBIT / Interest (4x or more) 21.59 22.22 3.87 1.13 1.25 2.14 2.54
Source: Compiled by authors from “Nine Dragons Paper,” Morgan Stanley, September 17, 2008, December 16, 2008, January 29, 2009, February 10, 2009, February 19, 2009, and March 18, 2009.
24 CHAPTER 1 Current Multinational Challenges and the Global Economy
would now result in both higher depreciation charges and higher interest expenses for their funding.
Cash Flow Concerns
Nine Dragon’s earnings are very sensitive to prices of both recycled paper and containerboard. Fluctuations in these prices could lead to material changes in earn- ings. With current net debt to equity close to 100%, the company relies on bank borrowings to finance part of its working capital and capex. Should the banks unex- pectedly withdraw their facilities, the company may encounter liquidity problems. In addition, the company’s earnings growth is based on expansion plans. If the com- pany is unable to obtain sufficient funding, the expansion may fall short of the company’s target.
—Morgan Stanley, January 29, 2009, p. 6.
The focus of analyst concerns over NDP’s prospects was the impact of declining sales and margin on its ability to service its large debt burden. Morgan Stanley’s frequent revision and reevaluation of NDP’s key cash flow drivers and drains over the first quarter of 2009 is illustrated in Exhibit 5. Key issues included the following:
! Earnings. NDP’s primary source of ongoing cash flow was earnings, and as measured by EBITDA (Earnings before interest, taxes, depreciation and amortization), margins and earnings would be negatively impacted by the current paperboard market decline and higher input costs.
! Interest Expenses. Debt costs in the form of interest expenses were clearly rising rapidly as a result of con- tinued high-debt levels and the higher interest rates which followed from credit downgrades.
! Capex. NDP’s massive asset expansion had brought about both its market dominance and its never-ending need for debt. Initially, management had announced postponement of capital expenditure plans in an attempt to calm bankruptcy fears.
QUESTIONS 1. Globalization and the MNE. The term globalization
has become widely used in recent years. How would you define it?
2. Assets, Institutions, and Linkages. Which assets play the most critical role in linking the major institutions that make up the global financial marketplace?
3. Eurocurrencies and LIBOR. Why have eurocurrencies and LIBOR remained the centerpiece of the global financial marketplace for so long?
4. Theory of Comparative Advantage. Define and explain the theory of comparative advantage.
5. Limitations of Comparative Advantage. Key to understanding most theories is what they say and what
! Debt. The debt-carrying capacity of NDP was the primary source of debate in the current recession- ary environment. The company’s debt/equity ratio, its gearing, was extremely high and potentially lethal in a recessionary environment amid a global finan- cial crisis, with credit so tight that many banks had stopped answering the phone. Analysts agreed across the board that NDP needed to reduce debt—now.
The March announcement of higher capex, now revised upward to Rmb 4.45 bn, would result in both higher depre- ciation charges and higher interest expenses. It would again commit the company to a large negative free cash flow for the 2009 year, and would probably result in NDP carrying higher debt levels well into 2010 and 2011 while the world economic environment was predicted to remain fragile. As the global economic crisis continued in 2009, many of NDP’s customers had simply disappeared. More than 670,000 Chinese businesses had failed in 2008, and early 2009 had been just as bad. Could NDP be next?
Our future path of development may remain thorny ahead, but armed with the shared confidence and cour- age throughout the Group to overcome and conquer, we are poised to act even more diligently and powerfully to prepare for the next global economic recovery . . .
—“Chairlady’s Statement,” 2008/09 Interim Report, Nine Dragons Paper (Holdings) Limited.
Case Questions
1. How does Mrs. Cheung think? What does she believe in when it comes to building her business?
2. How would you summarize the company’s financial status? How does it reflect the business development goals and strategies employed by Mrs. Cheung?
3. Is NDP in trouble? How would your answer differ if you were an existing shareholder, a potential investor, or an analyst?
25Current Multinational Challenges and the Global Economy CHAPTER 1
4. Trade at France’s Domestic Price. France’s domestic price is 2 containers of toys equals 7 cases of wine. Assume China produces 10,000 containers of toys and exports 400 containers to France. Assume France in turn produces 7,000 cases of wine and exports 1,400 cases to China. What happens to total production and consumption?
5. Trade at Negotiated Mid-Price. The mid-price for exchange between France and China can be calculated as follows. What happens to total production and consumption?
they don’t. Name four or five key limitations to the theory of comparative advantage.
6. Trident’s Globalization. After reading the chapter’s description of Trident’s globalization process, how would you explain the distinctions between international, multinational, and global companies?
7. Trident, the MNE. At what point in the globalization process did Trident become a multinational enterprise (MNE)?
8. Trident’s Advantages. What are the main advantages that Trident gains by developing a multinational presence?
9. Trident’s Phases. What are the main phases that Trident passed through as it evolved into a truly global firm? What are the advantages and disadvantages of each?
10. Financial Globalization. How do the motivations of individuals, both inside and outside the organization or business, define the limits of financial globalization?
PROBLEMS Comparative Advantage Problems 1–5 illustrate an example of trade induced by comparative advantage. They assume that China and France each have 1,000 production units. With one unit of produc- tion (a mix of land, labor, capital, and technology), China can produce either 10 containers of toys or 7 cases of wine. France can produce either 2 cases of toys or 7 cases of wine. Thus, a production unit in China is five times as efficient compared to France when producing toys, but equally effi- cient when producing wine. Assume at first that no trade takes place. China allocates 800 production units to building toys and 200 production units to producing wine. France allocates 200 production units to building toys and 800 pro- duction units to producing wine.
1. Production and Consumption. What is the production and consumption of China and France without trade?
2. Specialization. Assume complete specialization, where China produces only toys and France produces only wine. What would be the effect on total production?
3. Trade at China’s Domestic Price. China’s domestic price is 10 containers of toys equals 7 cases of wine. Assume China produces 10,000 containers of toys and exports 2,000 containers to France. Assume France produces 7,000 cases of wine and exports 1,400 cases to China. What happens to total production and consumption?
Assumptions
Toys (containers/ unit) Wine (cases/unit)
China—output per unit of production input
10 7
France—output per unit of production input
2 7
China—total production inputs
1,000
France—total production inputs
1,000
Americo Industries—2010 Problems 6 through 10 are based on Americo Industries. Americo is a U.S.-based multinational manufacturing firm, with wholly owned subsidiaries in Brazil, Germany, and China, in addition to domestic operations in the United States. Americo is traded on the NASDAQ. Americo cur- rently has 650,000 shares outstanding. The basic operating characteristics of the various business units are as follows:
Business Performance (000s, local currency)
U.S. Parent Company (US$)
Brazilian Subsidiary (reais, R$)
German Subsidiary (euros, €)
Chinese Subsidiary (yuan, ¥)
Earnings before taxes (EBT)
$4,500 R$6,250 4,500 ¥2,500
Corporate income tax rate
35% 25% 40% 30%
Average exchange rate for the period
— R$1.80/$ €0.7018/$ ¥7.750/$
6. Americo Industries’ Consolidate Earnings. Americo must pay corporate income tax in each country in which it currently has operations.
26 CHAPTER 1 Current Multinational Challenges and the Global Economy
INTERNET EXERCISES 1. International Capital Flows: Public and Private. Major
multinational organizations (some of which are listed below) attempt to track the relative movements and magnitudes of global capital investment. Using these Web pages and others you may find, prepare a two- page executive briefing on the question of whether capital generated in the industrialized countries is finding its way to and from emerging markets. Is there some critical distinction between “less developed” and “emerging”?
The World Bank www.worldbank.org
OECD www.oecd.org
European Bank www.ebrd.org for Reconstruction and Development
2. External Debt. The World Bank regularly compiles and analyzes the external debt of all countries globally. As part of their annual publication on World Development Indicators (WDI), they provide summaries of the long-term and short-term external debt obligations of selected countries online like that of Poland shown here. Go to their Web site and find the decomposition of external debt for Brazil, Mexico, and the Russian Federation.
The World Bank/data www.worldbank.org/data
3. World Economic Outlook. The International Monetary Fund (IMF) regularly publishes its assessment of the prospects for the world economy. Choose a country of interest and use the IMF’s current analysis to form your own expectations of its immediate economic prospects.
IMF Economic Outlook www.imf.org/external/ index.htm
4. Financial Times Currency Global Macromaps. The Financial Times provides a very helpful real-time global map of currency values and movements online. Use it to track the movements in currency.
Financial Times http://markets.ft.com/ft/ markets/currencies.asp
a. After deducting taxes in each country, what are Americo’s consolidated earnings and consolidated earnings per share in U.S. dollars?
b. What proportion of Americo’s consolidated earn- ings arise from each individual country?
c. What proportion of Americo’s consolidated earn- ings arise from outside the United States?
7. Americo’s EPS Sensitivity to Exchange Rates (A). Assume a major political crisis wracks Brazil, first affecting the value of the Brazilian reais and, subsequently, inducing an economic recession within the country. What would be the impact on Americo’s consolidated EPS if the Brazilian reais were to fall in value to R$3.00/$, with all other earnings and exchange rates remaining the same?
8. Americo’s EPS Sensitivity to Exchange Rates (B). Assume a major political crisis wracks Brazil, first affecting the value of the Brazilian reais and, subsequently, inducing an economic recession within the country. What would be the impact on Americo’s consolidated EPS if, in addition to the fall in the value of the reais to R$3.00/$, earnings before taxes in Brazil fell as a result of the recession to R$5,8000,000?
9. Americo’s Earnings and the Fall of the Dollar. The dollar has experienced significant swings in value against most of the world’s currencies in recent years. a. What would be the impact on Americo’s consoli-
dated EPS if all foreign currencies were to appreci- ate 20% against the U.S. dollar?
b. What would be the impact on Americo’s consoli- dated EPS if all foreign currencies were to depreci- ate 20% against the U.S. dollar?
10. Americo’s Earnings and Global Taxation. All MNEs attempt to minimize their global tax liabilities. Return to the original set of baseline assumptions and answer the following questions regarding Americo’s global tax liabilities: a. What is the total amount—in U.S. dollars—which
Americo is paying across its global business in cor- porate income taxes?
b. What is Americo’s effective tax rate (total taxes paid as a proportion of pre-tax profit)?
c. What would be the impact on Americo’s EPS and global effective tax rate if Germany instituted a cor- porate tax reduction to 28%, and Americo’s earn- ings before tax in Germany rose to €5,000,000?
27
CHAPTER 2
Corporate Ownership, Goals, and Governance
Gerald L. Storch, CEO of Toys ‘R’ Us, says all CEOs share the same fundamental goals: enhance the value for the customer, maximize return to the shareholders, and develop a sustainable competitive advantage. “Largely, I believe that the differences are more subtle than what I’ve read in many articles. On a day-to-day basis, I do the same thing. I get to work every morning. I try to make the company better.”
—“Public Vs. Private,” Forbes, September 1, 2006.
This chapter examines how legal, cultural, political, and institutional differences affect a firm’s choice of financial goals and corporate governance. The owner of a commercial enter- prise, and his or her specific personal and professional interests, has a significant impact on the goals of the corporation and its governance. We therefore examine ownership, goals, and governance in turn. The chapter concludes with the Mini-Case, Luxury Wars—LVMH vs. Hermès, the recent struggle by Hermès of France to remain family controlled.
Who Owns the Business? We begin our discussion of corporate financial goals by asking two basic questions: 1) Who owns the business? and 2) Do the owners of the business manage the business themselves?
Exhibit 2.1 provides a type of taxonomy of commercial enterprises— highlighting the sometimes rather confusing nomenclature used in ownership identity. The exhibit expressly concerns commercial enterprises, those organizations created for the conduct of business. The first distinction is between public ownership, where the state, government, or civil society owns the organization, and private ownership, which includes individuals, partners, families, or the modern publicly traded widely held organization.
It is important to reconfirm that public ownership is ownership of organizations that are created distinctly for the purpose of commercial activities, rather than the multitude of other social, civil, and regulatory activities of government. Those for business, often termed State Owned Enterprises (SOEs), are today in many countries, the dominant form of busi- ness entity. One example is the Saudi Arabian Oil Company, Saudi Aramco, the national oil company of Saudi Arabia and the world’s largest oil and gas company. Saudi Aramco is owned by the Saudi Arabian government.
28 CHAPTER 2 Corporate Ownership, Goals, and Governance
The common assumption made by people when discussing a “company” or a “business” is that of the privately owned enterprise presented in Exhibit 2.1. These companies are created by entrepreneurs who are typically either individuals or a small set of partners. In either case, they may be members of a family. (Do not forget that even Microsoft started as the brainchild of two partners, Bill Gates and Paul Allen.)
Publicly Traded Shares Regardless of core origins—public or private—today’s global marketplace has both organiza- tional forms traded in the public market. In addition to the usual suspects such as ExxonMobil and IBM, widely publicly traded and held private enterprises, there are many other SOEs that are also publicly traded. For example, China National Petroleum Corporation (CNPC), the government parent company of PetroChina, has shares listed and traded on stock exchanges in Shanghai, Hong Kong, and New York.
Some firms, either initially private or public, may choose in time to go public via an initial public offering, or IPO. Typically, only a relatively small percentage of the company is initially sold to the public, anywhere from 10% to 20%, resulting in a company that may still be con- trolled by a small number of private investors or SOEs, but now with public shares outstand- ing. Over time, some companies may sell more and more of their equity interests into the public marketplace, possibly eventually becoming totally publicly traded. Alternatively, the private owner or family may choose to retain a major share but does not have explicit control. Possibly, as has been the case in recent years, a firm reverses direction, reducing the shares outstanding; or in the case of an acquisition, being taken completely private once again. For example, in 2005 a very large private firm, Koch Industries (U.S.), purchased all outstanding shares of Georgia-Pacific (U.S.), a very large publicly traded forest products company. Koch took Georgia-Pacific private. An added consideration is that even when the firm’s ownership is publicly traded, it may still be controlled by a single investor or a small group of investors, including major institutional investors. This means that the control of the company is much like the privately held company, and therefore reflects the interests and goals of the individual investor or family. A continuing characteristic of many emerging markets is the dominance
EXHIBIT 2.1
Wholly state-owned
Purpose is not for profit, but for civil services
Purpose is hybrid of profit and civil services
Purpose is for profit
Partially publicly traded
Publicly traded
Private company Partnership
Family-owned
PrivatePublic
Commercial Enterprises
A Taxonomy of Commercial Enterprises
29Corporate Ownership, Goals, and Governance CHAPTER 2
of family-controlled firms, although many are simultaneously publicly traded. And as shown in Global Finance in Practice 2.1, family-controlled firms all over the world, including France, may outperform publicly traded firms. The Mini-Case at the end of this chapter highlights another of these family-based enterprises.
As discussed later in this chapter, something else of significance results from the initial sale of shares to the public: The firm becomes subject to many of the increased legal, regulatory, and reporting requirements in most countries surrounding the sale and trading of securities. In the United States, for example, going public means the firm will now have to disclose a sizable degree of financial and operational detail, publish this information at least quarterly, comply with Securities and Exchange Commission (SEC) rules and regulations, and comply with all the specific operating and reporting requirements of the specific exchange on which it is traded.
Separation of Ownership from Management One of the most complex issues in global financial management of the enterprise, be it public or private, is the separation of ownership from management. Hired or professional manage- ment may be characteristic of any ownership structure, but is most often observed in SOEs and widely held publicly traded companies. This separation of ownership from management raises the possibility that the two entities will not be aligned in their business and financial objectives. This is the so-called agency problem.
The United States and United Kingdom have been two country markets characterized by widespread ownership of shares. Management may own some small proportion of stock in their firms, but largely management is a hired agent of widely held firms. In contrast, many firms in many other global markets are characterized by controlling shareholders such as
GLOBAL FINANCE IN PRACTICE 2.1
Family-Controlled Firms in France Outperform the Public Sector
Translation: “Why do family firms outperform the CAC 40 index?”
Among the major industrial countries, France has the high- est number of family businesses (about 65% of the CAC 40 firms are family owned versus only about 24% in the U.K.). This includes Bouygues, Dassault, Michelin and Peugeot. Over the 1990–2006 period, French family firms generated a 639% return to their owners, whereas the major French index, the
CAC 40, returned only 292%. This family-owned firm domi- nance is attributed to three factors: 1) they focus on the long- term; 2) they stick to their core business; and 3) because the owners are closer to management, fewer conflicts arise between management and ownership (fewer agency problems in the terminology of Finance).
Source: Le Figaro, June 2007.
30 CHAPTER 2 Corporate Ownership, Goals, and Governance
government, institutions (e.g., banks in Germany), family (e.g., in France, Italy, and through- out Asia and Latin America), and consortiums of interests (e.g., keiretsus in Japan and chae- bols in South Korea).
In many of these cases, control is enhanced by ownership of shares with dual voting rights, interlocking directorates, staggered election of the board of directors, takeover safeguards, and other techniques not used in the Anglo-American markets. However, the recent emer- gence of huge equity funds and hedge funds in the United States and the United Kingdom has led to the privatization of some very prominent publicly traded firms.
The Goal of Management As companies become more deeply committed to multinational operations, a new constraint develops—one that springs from divergent worldwide opinions and practices as to just what the firms’ overall goal should be from the perspective of top management, as well as the role of corporate governance.
What do investors want? First, of course, investors want performance: strong predict- able earnings and sustainable growth. Second, they want transparency, accountability, open communications and effective corporate governance. Companies that fail to move toward international standards in each of these areas will fail to attract and retain inter- national capital.
—“The Brave New World of Corporate Governance,” LatinFinance, May 2001.
An introductory course in finance is usually taught within the framework of maximizing share- holders’ wealth as the goal of management. In fact, every business student memorizes the concept of maximizing shareholder value sometime during his or her college education. This rather rote memorization, however, has at least two major challenges: 1) It is not necessarily the accepted goal of management across countries to maximize the wealth of shareholders— other stakeholders may carry substantial weight and 2) It is extremely difficult to carry out. Creating value is—like so many lofty goals—much easier said than done.
Although the idea of maximizing shareholder wealth is probably realistic both in theory and in practice in the Anglo-American markets, it is not always exclusive elsewhere. Some basic differences in corporate and investor philosophies exist between the Anglo-American markets and those in the rest of the world. Therefore, one must realize that the so-called uni- versal truths taught in basic finance courses are actually culturally determined norms.
Shareholder Wealth Maximization Model The Anglo-American markets have a philosophy that a firm’s objective should follow the shareholder wealth maximization (SWM) model. More specifically, the firm should strive to maximize the return to shareholders, as measured by the sum of capital gains and dividends, for a given level of risk. Alternatively, the firm should minimize the risk to shareholders for a given rate of return.
The SWM theoretical model assumes as a universal truth that the stock market is efficient. This means that the share price is always correct because it captures all the expectations of return and risk as perceived by investors. It quickly incorporates new information into the share price. Share prices, in turn, are deemed the best allocators of capital in the macro economy.
The SWM model also treats its definition of risk as a universal truth. Risk is defined as the added risk that the firm’s shares bring to a diversified portfolio. The total operational risk of the firm can be eliminated through portfolio diversification by the investors. Therefore, this unsystematic risk, the risk of the individual security, should not be a prime concern for
31Corporate Ownership, Goals, and Governance CHAPTER 2
management unless it increases the prospect of bankruptcy. Systematic risk, the risk of the market in general, cannot be eliminated. This reflects risk that the share price will be a func- tion of the stock market.
Agency Theory. The field of agency theory is the study of how shareholders can motivate management to accept the prescriptions of the SWM model.1 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, then the board of directors should replace them. In cases where the board is too weak or ingrown to take this action, the disci- pline 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.
Long-Term Versus Short-Term Value Maximization. During the 1990s, the economic boom and rising stock prices in the United States and abroad exposed a flaw in the SWM model, especially in the United States. Instead of seeking long-term value maximization, several large U.S. corporations sought short-term value maximization (e.g., the continuing debate about meeting the market’s expected quarterly earnings). This strategy was partly motivated by the overly generous use of stock options to motivate top management.
This sometimes created distorted managerial incentives. In order to maximize growth in short-term earnings and to meet inflated expectations by investors, firms such as Enron, Global Crossing, Health South, Adelphia, Tyco, Parmalat, and WorldCom undertook risky, decep- tive, and sometimes dishonest practices for the recording of earnings and/or obfuscation of liabilities, which ultimately led to their demise. It also led to highly visible prosecutions of their CEOs, CFOs, accounting firms, legal advisers, and other related parties. This destructive short- term focus by both management and investors has been correctly labeled impatient capitalism. This point of debate is also sometimes referred to as the firm’s investment horizon in reference to how long it takes the firm’s actions, its investments and operations, to result in earnings.
In contrast to impatient capitalism is patient capitalism, which focuses on long-term shareholder wealth maximization. Legendary investor Warren Buffett, through his invest- ment vehicle Berkshire Hathaway, represents one of the best of the patient capitalists. Buf- fett has become a billionaire by focusing his portfolio on mainstream firms that grow slowly but steadily with the economy such as Coca Cola. He was not lured into investing in the high growth but risky dot-coms of 2000 or the “high tech” sector that eventually imploded in 2001.
Stakeholder Capitalism Model In the non–Anglo-American markets, controlling shareholders also strive to maximize long- term returns to equity. However, they are more constrained by powerful other stakeholders. In particular, labor unions are more powerful than in the Anglo-American markets. Govern- ments interfere more in the marketplace to protect important stakeholder groups, such as local communities, the environment, and employment. Banks and other financial institutions are more important creditors than securities markets. This model has been labeled the stakeholder capitalism model (SCM).
Market Efficiency. The SCM model does not assume that equity markets are either efficient or inefficient. It does not really matter because the firm’s financial goals are not exclusively shareholder-oriented since they are constrained by the other stakeholders. In any case, the
1Michael Jensen and W. Meckling, “Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure,” Journal of Financial Economics, No. 3, 1976, and Michael C. Jensen, “Agency Cost of Free Cash Flow, Corporate Finance and Takeovers,” American Economic Review, 76, 1986, pp. 323–329.
32 CHAPTER 2 Corporate Ownership, Goals, and Governance
SCM model assumes that long-term “loyal” shareholders, typically controlling shareholders, should influence corporate strategy rather than the transient portfolio investor.
Risk. The SCM model assumes that total risk, that is, operating and financial risk, does count. It is a specific-corporate objective to generate growing earnings and dividends over the long run with as much certainty as possible, given the firm’s mission statement and goals. Risk is measured more by product market variability than by short-term variation in earnings and share price.
Single Versus Multiple Goals. Although the SCM model typically avoids a flaw of the SWM model, namely, impatient capital that is short-run oriented, it has its own flaw. Trying to meet the desires of multiple stakeholders leaves management without a clear signal about the trade- offs. Instead, management tries to influence the trade-offs through written and oral disclosures and complex compensation systems.
The Score Card. In contrast to the SCM model, the SWM model requires a single goal of value maximization with a well-defined score card. According to the theoretical model of SWM described by Michael Jensen, the objective of management is to maximize the total market value of the firm.2 This means that corporate leadership should be willing to spend or invest more money or capital if each additional dollar creates more than one dollar in the market value of the company’s equity, debt, or any other contingent claims on the firm.
Although both models have their strengths and weaknesses, in recent years two trends have led to an increasing focus on the shareholder wealth form. First, as more of the non– Anglo-American markets have increasingly privatized their industries, the shareholder wealth focus is seemingly needed to attract international capital from outside investors, many of whom are from other countries. Second, and still quite controversial, many analysts believe that shareholder-based MNEs are increasingly dominating their global industry segments. Nothing attracts followers like success.
Operational Goals It is one thing to say maximize value, but it is another to actually do it. The management objective of maximizing profit is not as simple as it sounds, because the measure of profit used by ownership/ management differs between the privately held firm and the publicly traded firm. In other words, is management attempting to maximize current income, capital appreciation, or both?
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:
Shareholder return = P2 - P1 + D2
P1 =
P2 - P1 P1
+ D2 P1
.
where the initial price, P1 is equivalent to the initial investment by the shareholder, P2 is the price of the share at the end of period, and D2 is the dividend paid at the end of the period. The shareholder theoretically receives income from both components. For example, over the past 50 or 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 that grow sales and generate profits. Then it distributes those profits to ownership in the form of dividends. Capital
2Michael C. Jensen, “Value Maximization, Stakeholder Theory, and the Corporate Objective Function,” Journal of Applied Corporate Finance, Fall 2001, Volume 14, No. 3, pp. 8–21, p. 12.
33Corporate Ownership, Goals, and Governance CHAPTER 2
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. Many top executives believe that stock markets move in mysterious ways and are not always consistent in their valuations. In the end, leadership in the publicly traded firm typically concludes that it is its own growth—growth in top-line sales and bottom-line profits—that is its great hope for driving share price upwards.
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, which can be managed by the family itself. Without a share price, ‘growth’ is not of the same significance in strategic importance in the privately held firm. It is therefore critical that ownership and ownership’s specific financial interests be understood from the very start if we are to understand the strategic and financial goals and objectives of management. Exhibit 2.2 provides an overview of the variety of distinctive financial and managerial differences between publicly traded and privately held firms.
The privately held firm may also be less aggressive (take fewer risks) than the publicly traded firm. Without a public share price, and therefore the ability of outside investors to specu- late on the risks and returns associated with company business developments, the privately held firm—its owners and operators—may choose to take fewer risks. This may mean that it will not attempt to grow sales and profits as rapidly, and therefore may not require the capital (equity and debt) needed for rapid growth. One recent study by McKinsey found that private firms not only consistently used lower levels of financial leverage (averaging 5% less debt-to-equity) over the past decade, they also enjoyed a lower cost of debt (the average yield spread on corporate bonds being a full 32 basis points lower for family-owned firms).3
Operational Goals for MNEs. The MNE must be guided by operational goals suitable for vari- ous levels of the firm. Even if the firm’s goal is to maximize shareholder value, the manner in which investors value the firm is not always obvious to the firm’s top management. Therefore, most firms hope to receive a favorable investor response to the achievement of operational
3“The five attributes of enduring family businesses,” Christian Caspar, Ana Karina Dias, and Heinz-Peter Elstrodt, McKinsey Quarterly, January 2010, p. 6.
Limited in the past but increasingly available
Publicly Traded Privately HeldOrganizational Characteristic
Entrepreneurial No; stick to core competencies
Short-term focus on quarterly earnings
Yes; growth in earnings is critical
Good access to capital and capital markets
Professional; hiring from both inside & outside
Earnings to signal the equity markets
Minimal interests; some have stock options
Long-term or short-term focus
Focused on profitable growth
Quality of leadership
Adequately financed
Role of Earnings (Profits)
Leadership are owners
Yes; do anything the owners wish
Long-term focus
No; needs defined by owners earnings need
Highly variable; family run firms are lacking
Earnings to support owners and family
Yes; ownership and mgmt often one and the same
EXHIBIT 2.2 Public Versus Private Ownership
34 CHAPTER 2 Corporate Ownership, Goals, and Governance
goals that can be controlled by the way in which the firm performs, and then hope—if we can use that term—that the market will reward their results.
The MNE must determine the proper balance between three common operational finan- cial objectives:
1. Maximization of consolidated after-tax income 2. Minimization of the firm’s effective global tax burden 3. Correct positioning of the firm’s income, cash flows, and available funds as to country
and currency
These goals are frequently incompatible, in that the pursuit of one may result in a less desirable outcome of another. Management must make decisions about the proper trade-offs between goals (which is why managers are people and not computers).
Consolidated Profits. The primary operational goal of the MNE is to maximize consolidated profits, after-tax. Consolidated profits are the profits of all the individual units of the firm originating in many different currencies expressed in the currency of the parent company. This is not to say that management is not striving to maximize the present value of all future cash flows. It is simply the case that most of the day-to-day decision-making in global management is about current earnings. The leaders of the MNE, the management team who are implement- ing the firm’s strategy, must think far beyond current earnings.
For example, foreign subsidiaries have their own set of traditional financial statements: 1) a statement of income, summarizing the revenues and expenses experienced by the firm over the year; 2) a balance sheet, summarizing the assets employed in generating the unit’s revenues, and the financing of those assets; and 3) a statement of cash flows, summarizing those activities of the firm that generate and then use cash flows over the year. These finan- cial statements are expressed initially in the local currency of the unit for tax and reporting purposes to the local government, but they must be consolidated with the parent company’s financial statements for reporting to shareholders.
Public/Private Hybrids. The global business environment is, as one analyst termed it, “a messy place,” and the ownership of companies of all kinds, including MNEs, is not necessarily purely public or purely private. According to McKinsey’s recent study of global businesses:4
One-third of all companies in the S&P 500 index and 40 percent of the 250 largest com- panies in France and Germany are defined as family businesses, meaning that a family owns a significant share and can influence important decisions, particularly the election of the chairman and CEO.
In other words, the firm may be publicly traded, but a family still wields substantial power over the strategic and operational decisions of the firm. This may prove to be a good thing. As illustrated in Exhibit 2.3, the financial performance of family-based businesses (as measured by total returns to shareholders) in five different regions of the globe were superior to their nonfamily publicly traded counterparts.
Why do family-influenced businesses seemingly outperform the truly independents? The answer appears to be the same as that noted by Le Figaro in Global Finance in Practice 2.1. According to Credit Suisse, there are three key catalysts for the performance of stocks with significant family influence (SSFI): 1) management with a longer-term focus; 2) better
4“The five attributes of enduring family businesses,” Christian Caspar, Ana Karina Dias, and Heinz-Peter Elstrodt, McKinsey Quarterly, January 2010, p. 6.
35Corporate Ownership, Goals, and Governance CHAPTER 2
alignment between management and shareholder interests; and 3) stronger focus on the core business of the firm.
Publicly Traded Versus Privately Held: The Global Shift
Today, the public company is in trouble: the organisation that has been at the heart of capitalism for the past 150 years faces a loss of confidence in its Anglo-Saxon heartland and the rise of powerful challengers abroad. The number of companies listed on the major American stock exchanges has been declining relentlessly in recent years … America needs 360 new listings a year merely to maintain a steady state. But it has averaged only 170 a year since 2000—and even a Facebook-fueled IPO boom is not going to make up the difference.
—“Varied Company,” The World in 2012,The Economist, December 2011, p. 31.
Is the future of the publicly traded firm really in risk, or is it just that the U.S.-based publicly traded shares are on the decline? Exhibit 2.4 provides a broad overview of global equity list- ings, separating the number of listings between those on U.S. exchanges and all others.
Exhibit 2.4, based on listings data from the World Federation of Exchanges, raises a num- ber of questions about trends and tendencies across the global equity markets:
! Although global equity listings grew significantly over the past 20 years, they peaked in 2008. Although the true residual impact of the 2008–2009 global financial crisis is yet unknown, it is clear that the crisis, amid other factors, has stopped the growth of public share listings. At least for now.
10-year average total returns to shareholders by region
Source: Author presentation based on data presented in “The Five Attributes of Enduring Family Businesses,” Christian Caspar, Ana Karina Dias, and Heinz-Peter Elstrodt, McKinsey Quarterly, January 2010, p. 7. Index of public companies by region: France, SBF120; Western Europe, MSCI Europe; United States, S&P500; Germany, HDAX.
0
1
2
3
4
5
6
7
France Western Europe United States Germany
Percent
Family businesses Public company indexes
EXHIBIT 2.3 The Superior Performance of Family
36 CHAPTER 2 Corporate Ownership, Goals, and Governance
! The U.S. share of global equity listings has declined dramatically and steadily since the mid-1990s. At the end of 2010, of the 45,508 equities listed on 54 stock exchanges globally, U.S. listings comprised 5,016 of the total, or 11.0%. That was a dramatic decline from 1996, the peak year of total U.S. listings, when the U.S. comprised 8,783 of the global total of 26,368 listings, or 33.3%.
! U.S. public share listings fell by 3,767 (from 8,783 in 1996 to 5,016 in 2010), 42.9% over the 14-year period since its peak. Clearly, the attraction of being a publicly traded firm on a U.S. equity exchange had declined dramatically.
Listings Measurement New listings is the net change in equities listed on an exchange or exchanges. It is therefore the net result of exchange listing additions and delistings.
Listing Additions. Exchange listing additions arise from four sources: 1) initial public offerings (IPOs); 2) movements of share listings from one exchange to another; 3) spinouts from larger firms; and 4) new listings from smaller nonexchanges such as bulletin boards. Since movements between exchanges typically are a zero sum within a country, and spinouts and bulletin board movements are few in number, real growth in listings comes from IPOs.
Delistings. Delisted shares fall into three categories: 1) forced delistings, in which the equity no longer meets exchange requirements on share price or financial valuation; 2) mergers—in which two firms combine eliminating a listing; and 3) acquisitions, where the purchase results in the reduction of a listing. Companies entering into bankruptcy, or being major acquisition targets, make up a great proportion of delisting activity. Companies that are delisted are not necessarily bankrupt, and may continue trading over the counter.
0
19 90
19 91
19 92
19 93
19 94
19 95
19 96
19 97
19 98
19 99
20 00
20 01
20 02
20 03
20 04
20 05
20 06
20 07
20 08
20 09
20 10
5,000
10,000
15,000
20,000
25,000
30,000
35,000
40,000
45,000
50,000
U.S. listings peaked in 1996
U.S. Listings
Non-U.S. Listings
Global Non-U.S. listings peaked in 2008
Global listings peaked in 2007
Source : Derived by author from statistics collected by the World Federation of Exchanges (WFE), www.world-exchanges.org.
EXHIBIT 2.4 The Superior Performance of Family
37Corporate Ownership, Goals, and Governance CHAPTER 2
Possible Causes in the Decline of Publicly Traded Shares The decline of share listings in the United States has led to considerable debate over whether these trends represent a fundamental global business shift away from the publicly traded corporate form, or something that is more U.S.-centric combined with the economic times.
The U.S. market itself may reflect a host of country specific factors. The cost and anti- competitive effects of Sarbanes-Oxley are now well documented and well known. Compli- ance with it and a variety of additional restrictions and requirements on public issuances in the United States have reduced the attractiveness of public listings. This, combined with the continued development and growth of the private equity markets, where companies may find other forms of equity capital without a public listing, are likely major contributors to the fall in U.S. listings over the last decade.
One recent study, which has garnered much attention, argued that it was not really the increasingly burdensome U.S. regulatory environment that was to blame, but rather a prolifera- tion of factors that caused the decline in market making, sales, and research support for small and medium-sized equities.5 Beginning with the introduction of online brokerage in 1996 and online trading rules in 1997, more and more equity trading in the United States shifted to ECNs, elec- tronic communication networks, which allowed all market participants to trade directly with the exchange order books, and not through brokers or brokerage houses. Although this increased competition reduced transaction costs dramatically, it also undermined the profitability of the retail brokerage institutions, which had always supported research, market making, and sales and promotion of the small- to medium-sized equities. Without this financial support, the smaller stocks were no longer covered (and possibly promoted) by the major equity houses. Without that research, marketing, promotion and coverage, their trading volumes and values fell.
Corporate Governance Although the governance structure of any company, domestic, international, or multinational, is fundamental to its very existence, this subject has become the lightning rod of political and business debate in the past few years as failures in governance in a variety of forms has led to corporate fraud and failure. Abuses and failures in corporate governance have dominated global business news in recent years. Beginning with the accounting fraud and questionable ethics of business conduct at Enron culminating in its bankruptcy in the fall of 2001, failures in corporate governance have raised issues about the very ethics and culture of business conduct.
The Goal of Corporate Governance The single overriding objective of corporate governance in the Anglo-American markets is the optimization over time of the returns to shareholders. In order to achieve this, good gov- ernance practices should focus the attention of the board of directors of the corporation on this objective by developing and implementing a strategy for the corporation, which ensures corporate growth and improvement in the value of the corporation’s equity.6 At the same time, it should ensure an effective relationship with stakeholders. A variety of organizations includ- ing the Organization for Economic Cooperation and Development (OECD) have continued to refine their recommendations about five primary areas of governance:
1. Shareholder rights. Shareholders are the owners of the firm, and their interests should take precedence over other stakeholders.
5“A Wake-Up Call for America,” by David Weild and Edward Kim, Grant Thornton, November 2009. 6This definition of the corporate objective is based on that supported by the International Corporate Governance Network (ICGN), a nonprofit organization committed to improving corporate governance practices globally.
38 CHAPTER 2 Corporate Ownership, Goals, and Governance
2. Board responsibilities. The board of the company is recognized as the individual entity with final full legal responsibility for the firm, including proper oversight of management.
3. Equitable treatment of shareholders. Equitable treatment is specifically targeted toward domestic versus foreign residents as shareholders, as well as majority and minority interests.
4. Stakeholder rights. Governance practices should formally acknowledge the interests of other stakeholders—employees, creditors, community, and government.
5. Transparency and disclosure. Public and equitable reporting of firm operating and financial results and parameters should be done in a timely manner, and available to all interests equitably.
These principles obviously focus on several key areas—shareholder rights and roles, disclosure and transparency, and the responsibilities of boards—which we will discuss in more detail.
The Structure of Corporate Governance Our first challenge is to understand what people mean when they use the expression “cor- porate governance.” Exhibit 2.5 provides an overview of the various parties and their responsibilities associated with the governance of the modern corporation. The modern corporation’s actions and behaviors are directed and controlled by both internal forces and external forces.
The internal forces, the officers of the corporation (such as the chief executive officer or CEO) and the board of directors of the corporation (including the chairman of the board), are
Equity Markets Analysts and other market agents
evaluate the performance of the firm on a daily basis
Board of Directors Chairman of the Board and members are accountable
for the organization
Management Chief Executive Officer (CEO) and his team run
the company
Debt Markets Ratings agencies and other analysts review the ability of
the firm to service debt
Auditors and Legal Advisers Provide an external opinion
as to the legality and fairness of presentation and conformity to
standards of financial statements
Regulators SEC, the NYSE, or other
regulatory bodies by country
The Corporation (internal)
The Marketplace (external)
Corporate governance represents the relationship among stakeholders that is used to determine and control the strategic direction and performance of the organization.
EXHIBIT 2.5 The Structure of Corporate Governance
39Corporate Ownership, Goals, and Governance CHAPTER 2
those directly responsible for determining both the strategic direction and the execution of the company’s future. But they are not acting within a vacuum; they are subject to the constant prying eyes of the external forces in the marketplace who question the validity and soundness of their decisions and performance. These include the equity markets in which the shares are traded, the analysts who critique their investment prospects, the creditors and credit agencies who lend them money, the auditors and legal advisers who testify to the fairness and legality of their reporting, and the multitude of regulators who oversee their actions in order to protect the investment public.
The Board of Directors. The legal body that is accountable for the governance of the corporation is its board of directors. The board is composed of both employees of the organization (inside members) and senior and influential nonemployees (outside members). Areas of debate surrounding boards include the following: 1) the proper balance between inside and outside members; 2) the means by which board members are compensated for their service; and 3) the actual ability of a board to monitor and manage a corporation adequately when board members are spending sometimes less than five days a year in board activities. Outside members, often the current or retired chief executives of other major companies, may bring with them a healthy sense of distance and impartiality, which although refreshing, may also result in limited understanding of the true issues and events within the company.
Officers and Management. The senior officers of the corporation, the chief executive officer (CEO), the chief financial officer (CFO), and the chief operating officer (COO), are not only the most knowledgeable of the business, but also the creators and directors of its strategic and operational direction. The management of the firm is, according to theory, acting as a contractor—as an agent—of shareholders to pursue value creation. They are positively motivated by salary, bonuses, and stock options or negatively motivated by the risk of losing their jobs. They may, however, have biases of self-enrichment or personal agendas, which the board and other corporate stakeholders are responsible for overseeing and policing. Interestingly, in more than 80% of the companies in the Fortune 500, the CEO is also the chairman of the board. This is, in the opinion of many, a conflict of interest and not in the best interests of the company and its shareholders.
Equity Markets. The publicly traded company, regardless of country of residence, is highly susceptible to the changing opinion of the marketplace. The equity markets themselves, whether they are the New York Stock Exchange/Euronext, London Stock Exchange, or Mexico City Bolsa, should reflect the market’s constant evaluation of the promise and performance of the individual company. The analysts are those self-described experts employed by the many investment banking firms who also trade in the client company shares. They are expected (sometimes naïvely) to evaluate the strategies, plans for execution of the strategies, and financial performance of the firms on a real-time basis. Analysts depend on the financial statements and other public disclosures of the firm for their information.
Debt Markets. Although the debt markets (banks and other financial institutions providing loans and various forms of securitized debt like corporate bonds), are not specifically interested in building shareholder value, they are indeed interested in the financial health of the company. Their interest, specifically, is in the company’s ability to repay its debt in a timely manner. Like equity markets, they must rely on the financial statements and other disclosures (public and private in this case) of the companies with which they work.
Auditors and Legal Advisers. Auditors and legal advisers are responsible for providing an external professional opinion as to the fairness, legality, and accuracy of corporate financial statements. In this process, they attempt to determine whether the firm’s financial records and
40 CHAPTER 2 Corporate Ownership, Goals, and Governance
practices follow what in the United States is termed generally accepted accounting principles (GAAP) in regard to accounting procedures. But auditors and legal advisers are hired by the firms they are auditing, leading to a rather unique practice of policing their employers. The additional difficulty that has arisen in recent years is that the major accounting firms pursued the development of large consulting practices, often leading to a conflict of interest. An auditor not giving a clean bill of health to a client could not expect to gain many lucrative consulting contracts from that same firm in the near future.
Regulators. Publicly traded firms in the United States and elsewhere are subject to the regulatory oversight of both governmental organizations and nongovernmental organizations. In the United States, the Securities and Exchange Commission (SEC) is a careful watchdog of the publicly traded equity markets, both of the behavior of the companies themselves in those markets and of the various investors participating in those markets. The SEC and other similar authorities outside of the United States require a regular and orderly disclosure process of corporate performance in order that all investors may evaluate the company’s investment value with adequate, accurate, and fairly distributed information. This regulatory oversight is often focused on when and what information is released by the company, and to whom.
A publicly traded firm in the United States is also subject to the rules and regulations of the exchange upon which they are traded (New York Stock Exchange/Euronext, American Stock Exchange, and NASDAQ are the largest). These organizations, typically categorized as self-regulatory in nature, construct and enforce standards of conduct for both their member companies and themselves in the conduct of share trading.
Comparative Corporate Governance The origins of the need for a corporate governance process arise from the separation of ownership from management, and from the varying views by culture of who the stakeholders are and their significance.7 This assures that corporate governance practices will differ across countries, economies, and cultures. As described in Exhibit 2.6, though, the various corporate governance regimes may be classified by regime. The regimes in turn reflect the evolution of business ownership and direction within the countries over time.
7For a summary of comparative corporate governance, see R. La Porta, F. Lopez-de-Silanes, and A. Schleifer, “Corporate Ownership Around the World,” Journal of Finance, 54, 1999, pp. 471–517. See also A. Schleifer and R. Vishny, “A Survey of Corporate Governance,” Journal of Finance, 52, 1997, pp. 737–783, and the winter 2007 issue, Volume 19 Number 1, of the Journal of Applied Corporate Finance.
Regime Basis Characteristics Examples
Market-based Efficient equity markets; Dispersed ownership
United States, United Kingdom, Canada, Australia
Family-based Management and ownership is combined; Family/majority and minority shareholders
Hong Kong, Indonesia, Malaysia, Singapore, Taiwan, France
Bank-based Government influence in bank lending; Lack of transparency; Family control
Korea, Germany
Government-affiliated State ownership of enterprise; Lack of transparency; No minority influence
China, Russia
Source: Based on “Corporate Governance in Emerging Markets: An Asian Perspective,” by J. Tsui and T. Shieh, in International Finance and Accounting Handbook, Third Edition, Frederick D.S. Choi, editor, Wiley, 2004, pp. 24.4–24.6.
EXHIBIT 2.6 Comparative Corporate Governance Regimes
41Corporate Ownership, Goals, and Governance CHAPTER 2
Market-based regimes, like that of the United States, Canada, and the United Kingdom, are characterized by relatively efficient capital markets in which the ownership of publicly traded companies is widely dispersed. Family-based systems, like those characterized in many of the emerging markets, Asian markets, and Latin American markets, not only started with strong concentrations of family ownership (as opposed to partnerships or small investment groups which are not family-based), but also have continued to be largely controlled by f amilies even after going public. Bank-based and government-based regimes are those reflecting markets in which government ownership of property and industry has been the constant force over time, resulting in only marginal “public ownership” of enterprise, and even then, subject to significant restrictions on business practices.
These regimes are therefore a function of at least four major factors in the evolution of corporate governance principles and practices globally: 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.
Financial Market Development. The depth and breadth of capital markets is critical to the evolution of corporate governance practices. Country markets that have had relatively slow growth, as in the emerging markets, or have industrialized rapidly utilizing neighboring capital markets (for example, Western Europe), 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 are developed.
Separation of Management and Ownership. In countries and cultures in which the ownership of the firm has continued to be an integral part of management, agency issues and failures have been less problematic. In countries like the United States, in which ownership has become largely separated from management (and widely dispersed), aligning the goals of management and ownership is much more difficult.
Disclosure and Transparency. The extent of disclosure regarding the operations and financial results of a company vary dramatically across countries. Disclosure practices reflect a wide range of cultural and social forces, including the degree to which ownership is public, the degree to which government feels the need to protect investor’s rights versus owner- ship rights, and the extent to which family-based and government-based business remains central to the culture. Transparency, a parallel concept to disclosure, reflects the visibility of decision-making processes within the business organization.
Historical Development of the Legal System. Investor protection is typically better in countries in which English common law is the basis of the legal system, compared to the codified civil law that is typical in France and Germany (the so-called Code Napoleon). English common law is typically the basis of the legal systems in the United Kingdom and former colonies of the United Kingdom, including the United States and Canada. The Code Napoleon is typically the basis of the legal systems in former French colonies and the European countries that Napoleon once ruled, such as Belgium, Spain, and Italy. In countries with weak investor protection, controlling shareholder ownership is often a substitute for a lack of legal protection.
Note that we have not mentioned ethics. All of the principles and practices described so far have assumed that the individuals in roles of responsibility and leadership pursue them truly and fairly. That, however, has not always been the case.
Family Ownership and Corporate Governance Although much of the discussion about corporate governance concentrates on the market- based regimes (see Exhibit 2.6), family-based regimes are arguably more common and more
42 CHAPTER 2 Corporate Ownership, Goals, and Governance
important worldwide, including the United States and Western Europe. For example, in a study of 5,232 corporations in 13 Western European countries, family-controlled firms represented 44% of the sample compared to 37% that were widely held.8
Recent research indicates that, as opposed to popular belief, family-owned firms in some highly developed economies typically outperform publicly owned firms. This is true not only in Western Europe but also in the United States. A recent study of firms included in the S&P500 found that families are present in fully one-third of the S&P500 and account for 18% of their outstanding equity. (An added insight is that firms possessing a CEO from the family also perform better than those with outside CEOs.) Interestingly, it seems that minority shareholders are actually better off, according to this study, when a member of the dominant family influences the firm’s direction.9
Another study based on 120 Norwegian, founding family-controlled and nonfounding family-controlled firms, concluded that founding family control was associated with higher firm value. Furthermore, the impact of founding family directors on firm value is not affected by corporate governance conditions such as firm age, board independence, and number of share classes. The authors also found that the positive relation between founding family ownership and firm value is greater among older firms, firms with larger boards, and particularly when these firms have multiple classes of stock.10 It is common for Norwegian firms (and firms based in many European and Latin American countries) to have dual classes of stock with differential voting rights.
Failures in Corporate Governance Failures in corporate governance have become increasingly visible in recent years. The Enron scandal in the United States is well known. In addition to Enron, other firms that have revealed major accounting and disclosure failures, as well as executive looting, are WorldCom, Parmalat, Global Crossing, Tyco, Adelphia, and HealthSouth.
In each case, prestigious auditing firms, such as Arthur Andersen, missed the violations or minimized them possibly because of lucrative consulting relationships or other conflicts of interest. Moreover, security analysts and banks urged investors to buy the shares and debt issues of these and other firms that they knew to be highly risky or even close to bankruptcy. Even more egregious, most of the top executives who were responsible for the mismanagement that destroyed their firms, walked away (initially) with huge gains on shares sold before the downfall, and even overly generous severance packages.
It appears that the day of reckoning has come. The first to fall (due to its involvement with Enron) was Arthur Andersen, one of the former “Big Five” U.S. accounting firms. However, many more legal actions against former executives are underway. Although the corruption scandals were first revealed in the United States, they have spread to Canada and the European Union countries.
8Mara Faccio and Larry H.P. Lang, “The Ultimate Ownership of Western European Corporations,” Journal of Financial Economics, 65 (2002), p. 365. See also: Torben Pedersen and Steen Thomsen, “European Pat- terns of Corporate Ownership,” Journal of International Business Studies, Vol. 28, No. 4, Fourth Quarter, 1997, pp. 759–778. 9Ronald C. Anderson and David M. Reeb, “Founding Family Ownership and Firm Performance from the S&P500,” The Journal of Finance, June 2003, p. 1301. 10Chandra S. Mishra, Trond Randøy, and Jan Inge Jenssen, “The Effect of Founding Family Influence on Firm Value and Corporate Governance,” Journal of International Financial Management and Accounting, Volume 12, Number 3, Autumn 2001, pp. 235–259.
43Corporate Ownership, Goals, and Governance CHAPTER 2
Good Governance and Corporate Reputation Does good corporate governance matter? This is actually a difficult question, and the realistic answer has been largely dependent on outcomes historically. For example, as long as Enron’s share price continued to rise, questions over transparency, accounting propriety, and even financial facts were largely overlooked by all of the stakeholders of the corporation. Yet, eventually, the fraud, deceit, and failure of the multitude of corporate governance practices resulted in the bankruptcy of the firm. It not only destroyed the wealth of investors, but the careers, incomes, and savings of so many of its basic stakeholders—its own employees. Ultimately, good governance should matter.
One way in which companies may signal good governance to the investor markets is to adopt and publicize a fundamental set of governance policies and practices. Nearly all publicly traded firms have adopted this approach, as is obvious when visiting their corporate Web sites. This has also led to a standardized set of common principles, as described in Exhibit 2.7, which might be considered a growing consensus on good governance practices. Those practices—board composition, management compensation structure and oversight, corporate auditing practices, and public disclosure—have been accepted by a growing stakeholder audience.
Good corporate governance depends on a variety of factors, one of which is the general governance reputation of the country of incorporation and registration. As concern over the quality of corporate governance rose in the years following Enron and other failures, a number of governance ranking services and indexes developed. These services, including ISS/RiskMet- rics, Audit Integrity, Governance Metrics International (GMI), and The Corporate Library (TCL), to name but a few, use a multitude of quantitative and nonquantitative disclosures by publicly traded firms to rank firms on their corporate governance. Exhibit 2.8 presents selected recent rankings by another such firm, IR Global.
In principle, the idea is that good governance (at both the country and corporate levels) is linked to cost of capital (lower), returns to shareholders (higher), and corporate profitability (higher). An added dimension of interest is the role of country governance as it may influence
EXHIBIT 2.7 The Growing Consensus on Good Corporate Governance
Although there are many different cultural and legal approaches used to corporate governance worldwide, there is a growing consensus on what constitutes good corporate governance.
! Composition of the Board of Directors. The Board should have both internal and external members. More importantly, it should be staffed by individuals of real experience and knowledge, not only of their own rules and responsibilities, but also of the nature and conduct of the corporate business.
! Management Compensation. There should be a management compensation system aligned with corporate performance (financial and otherwise), with significant oversight by the board and open disclosure to shareholders and investors.
! Corporate Auditing. There should be independent auditing of corporate financial results on a meaningful real-time basis. An audit process with oversight by a Board committee composed primarily of external members would be an additional significant plus.
! Public Reporting and Disclosure. Timely public reporting of both financial and nonfinancial operating results may be used by investors to assess the investment outlook.
This should also include transparency and reporting around potentially significant liabilities. A final international note of caution: The quality and credibility of all internal corporate practices on good governance, however, are still subject to the quality of a country’s corporate law, its protection of both creditor and investor rights, including minority shareholders, and the country’s ability to provide adequate and appropriate enforcement.
44 CHAPTER 2 Corporate Ownership, Goals, and Governance
EXHIBIT 2.8 IR Global Rankings: The Top 30
Company Country Industry Score Company Country Industry Score
Danske Bank Denmark Financials 92.50 PHILIPS Netherlands Industrials 80.00
América Latina Logística
Brazil Industrials 91.75 Cameco Canada Basic Materials 79.75
BASF Germany Basic Materials 89.75 Grupo Pão de Açúcar
Brazil Consumer Services
79.75
Homex Mexico Consumer Services 89.50 Cielo Brazil Technology 79.50
Bayer AG Germany Health Care 87.25 JSL S.A. Brazil Industrials 79.50
GOL Linhas Aéreas Inteligentes
Brazil Consumer Services 87.25 Microsoft USA Technology 79.50
ThyssenKrupp Germany Basic Materials 85.50 SulAmérica S.A. Brazil Financials 79.40
Marfrig Brazil Consumer Goods 85.00 Land Securities UK Financials 79.25
TURK TELEKOM Turkey Telecommunications 83.75 METRO GROUP USA Consumer Services
78.75
Life Technologies USA Health Care 82.00 Rossi Residencial Brazil Industrials 78.75
PotashCorp Canada Basic Materials 81.75 Petrobras Brazil Oil & Gas 78.25
Royal DSM N.V. Netherlands Basic Materials 81.25 Energisa Brazil Utilities 78.00
adidas AG Germany Consumer Goods 80.50 Infosys Technologies
India Technology 77.75
Intel USA Technology 80.35 EMC USA Technology 77.50
Norsk Hydro ASA Norway Basic Materials 80.25 General Electric USA Industrials 77.50
Note: The evaluations performed for the IR Web site ranking are based on the information publicly available on the respective participant Web site at the time of the evaluation date. Neither IR Global Rankings nor any of its supporting entities are liable for any changes that may occur on such Web sites after the evaluation date and that may affect the original scores and opinions provided. IR Global Rankings (“IRGR”) is a comprehensive ranking system for investor relations Web sites, online annual reports, corporate governance practices and financial disclosure procedures. The ranking system is based on extensive technical proprietary research of publicly traded companies based on a clear and transparent methodology that is supported and backed by key global institutions, including Arnold & Porter; KPMG; MZ; and Sodali.
Source: http://www.irglobalrankings.com/irgr2010.
the country in which international investors may choose to invest. Curiously, however, not only have corporate rankings been highly uncorrelated across ranking firms, but a number of academic studies have also indicated little linkage between a firm’s corporate governance ranking and its future likelihood of restating earnings, shareholder lawsuits, return on assets, and a variety of measures of stock price performance.11
An additional way to signal good corporate governance, in non–Anglo-American firms, is to elect one or more Anglo-American board members. An additional way to signal good corporate governance, in non–Anglo-American firms, is to elect one or more Anglo-American
11Robert Daines, Ian D. Gow, and David F. Larcker, “Rating the Ratings: How Good Are Commercial Gover- nance Ratings?” Journal of Financial Economics (2010); John E. Core, Wayne R. Guay, and Tjomme O. Rusticus, “Does Weak Governance Cause Weak Stock Returns? An Examination of Firm Operating Performance and Investors’ Expectations,” Journal of Finance (2006); and Shane A. Johnson, Theodore C. Moorman, and Sorin Sorescu, “A Reexamination of Corporate Governance and Equity Prices,” Review of Financial Studies (2009).
45Corporate Ownership, Goals, and Governance CHAPTER 2
board members. This was shown to be true for a select group of Norwegian and Swedish firms in a study by Oxelheim and Randøy.12 The firms had superior market values. The Anglo- American board members suggested a governance system that would show better monitoring opportunities and enhanced investor recognition.
A follow-up study of the same firms found that CEO pay increased because of the perceived reduction in tolerance for bad performance and increased monitoring required.13
Corporate Governance Reform Within the United States and the United Kingdom, the main corporate governance problem is the one treated by agency theory: With widespread share ownership, how can a firm align management’s interest with that of the shareholders? Since individual shareholders do not have the resources or the power to monitor management, the U.S. and U.K. markets rely on regulators to assist in the agency theory monitoring task. Outside the United States and the United Kingdom, large controlling shareholders (including Canada) are in the majority. They are able to monitor management in some ways better than regulators. However, controlling shareholders pose a different agency problem. How can minority shareholders be protected against the controlling shareholders?
In recent years, reform in the United States and Canada has been largely regulatory. Reform elsewhere has been largely adoption of principles rather than stricter legal regulations. The principles approach is softer, less costly, and less likely to conflict with other existing regulations.
Sarbanes-Oxley Act. The U.S. Congress passed the Sarbanes-Oxley Act (SOX) in July 2002. Named after its two primary congressional sponsors, SOX had four major requirements: 1) CEOs and CFOs of publicly traded firms must vouch for the veracity of the firm’s published financial statements; 2) corporate boards must have audit and compensation committees drawn from independent (outside) directors; and 3) companies are prohibited from making loans to corporate officers and directors; and 4) companies must test their internal financial controls against fraud.
The first provision—the so-called signature clause, has already had significant impacts on the way in which companies prepare their financial statements. The provision was intended to instill a sense of responsibility and accountability in senior management (and therefore fewer explanations of “the auditors signed off on it”). The companies themselves have pushed the same procedure downward in their organizations, often requiring business unit managers and directors at lower levels to sign their financial statements. Severe penalties were enacted in case of noncompliance.
SOX has been much more expensive to implement than was originally expected during the debate in the U.S. Congress. Apart from the obvious costs of filling out more forms, many critics argue that too much time is consumed in meeting the new regulations, modify- ing internal controls to combat fraud, and restating past earnings, rather than running the operations of the firms. This cost may be disproportionately high for small firms that must meet the same regulatory requirements as large firms. In particular, auditing and legal fees have skyrocketed.
12Lars Oxelheim and Trond Randøy, “The Impact of Foreign Board Membership on Firm Value,” Journal of Banking and Finance, Vol. 27, No. 12, 2003, pp. 2369–2392. 13Lars Oxelheim and Trond Randøy, “The Anglo-American Financial Influence on CEO Compensation in Non- Anglo-American Firms,” Journal of International Business Studies, Vol. 36, No. 4, July 2005, pp. 470–483.
46 CHAPTER 2 Corporate Ownership, Goals, and Governance
Everyone is afraid of following in the footsteps of Arthur Andersen that collapsed as a result of the Enron scandal. (The “Big Five” accounting firms became the “Big Four” over- night!) The net result may lead to more small but growing firms choosing to sell out to larger firms instead of going the initial public offering (IPO) route. Other firms may simply choose to stay private, feeling that the costs of public offerings outweigh the benefits. Moreover, many firms may become more risk averse. Lower level employees might pass all risky decisions up the line to a more central risk assessment level. Such an action would slow down decision-making, and potentially, growth.
SOX has been quite controversial internationally. Its “one size fits all” style conflicts with a number of the corporate governance practices already in place in markets that view themselves as having better governance records than the United States. A foreign firm wishing to list or continue listing their shares on a U.S. exchange must comply with the law. Some companies, such as Porsche, withdrew plans for a U.S. listing specifically in opposition to SOX. Other companies, however, including many of the largest foreign companies traded on U.S. exchanges such as Unilever, Siemens, and ST Microelectronics, have stated their willingness to comply—if they can find acceptable compromises between U.S. law and the governance requirements and principles in their own countries. One example is Germany, where supervisory board audit committees must include employee representatives. But according to U.S. law, employees are not independent. Many of these listed firms have concluded that they need access to the U.S. capital market and therefore must comply, others have not. As Global Finance in Practice 2.2 indicates, good governance is a global issue of considerable debate.
GLOBAL FINANCE IN PRACTICE 2.2
Is Good Governance Good Business Globally?
The term “good governance” is, in many instances, a highly politically charged term. When talking to the press, many directors and executives argue that the pursuit of good gov- ernance practices is good for business globally. However, those same officials may also argue that stringent report- ing and disclosure requirements, like those imposed by the United States under Sarbanes-Oxley, harm business competition and growth and ultimately, the attractiveness of listing and trading their securities in the United States. In the end, the devil may indeed be in the detail. A number of examples from around the world are helpful in understanding the complexity of finding common ground in “good” corpo- rate governance.
! Siemens (Germany) has implemented a company-wide trans- formation program containing two significant mindset changes: seeing integrity and performance as not mutually exclusive (clean business always and everywhere), and defining corpo- rate governance in a way that provides space for entrepreneur- ial behavior, focused on long-term sustainable value creation for all stakeholders. It believes that this will generate ever- greater transparency and higher-quality business and financial reporting.1
1“Good Governance and Sustainability Fundamental for Improved Business Reporting,” International Federation of Accountants, Project on Business Reporting, June 2010.
! Western governance practices are only now starting to take hold in the Gulf region of the Middle East. Sabic, the Saudi Basic Industries Corporation, widely considered a leader in good governance practices in the region, is helping to promote board structures that separate audit, remuneration, and other director functions. The growing influence of the Gulf Cooperation Council Board Directors Institute, a nonprofit organization for the sharing of gov- ernance practices in the Gulf, has been instrumental in promoting transparency and disclosure.2
! Neeraj Bhargava, CEO of WNS Global Services, an India- based outsourcing firm, has adamantly argued that the stringent demands of Western governance practices like those of Sarbanes-Oxley have helped both investors and clients “view our organization as a trusted, well-run, and compliant company.” In a global marketplace in which it is ever harder to raise capital critical for corporate growth and development, Bhargava argues that listing in the United States and therefore complying with U.S. corpo- rate governance requirements has gained his firm credi- bility, global visibility, shareholder value, and liquidity. According to Bhargava “Sarbanes-Oxley compliance
2“Making Good Governance Good Business in the Gulf,” Arabic Knowledge@Wharton, April 6, 2010; “Building Better Boards: A Review of Board Effectiveness in the Gulf,” GCC Board Directors Institute, 2009.
47Corporate Ownership, Goals, and Governance CHAPTER 2
Board Structure and Compensation. Many critics have argued for the United States to move more toward structural reforms more consistent with European standards (e.g., prohibiting CEOs from also being chairmen). Although this is increasingly common, there is no regulatory or other legal requirement to force the issue. Secondly, and more radically, would be to move toward the two-tiered structure of countries like Germany, in which there is a supervisory board (largely outsiders, and typically large—Siemens has 18 members) and a management board (predominantly insiders, and small—Siemens has eight members).
Although SOX addresses the agency theory problem of transparency, it does not address the agency theory problem of aligning the goals of boards and managers with the interests of shareholders. In the past, the United States was characterized by compensation schemes to reward directors and management with a combination of an annual stipend or salary with significant stock options. However, when stock options go underwater (become essentially valueless because they are so far out-of-the-money), it does not cost the recipient anything directly, only the loss of a potential future benefit. Indeed, some firms simply rewrite the options so that they have higher values immediately. It now appears that many firms are changing their compensation schemes to replace options with restricted stock. Restricted stock cannot be sold publicly for some specified period. If the price of the firm’s shares falls, the recipient has actually lost money and is normally not recompensated by receiving more restricted shares.
Transparency, Accounting, and Auditing. The concept of transparency is also one that has been raised in a variety of different markets and contexts. Transparency is a rather common term used to describe the degree to which an investor—either existing or potential—can discern the true activities and value drivers of a company from the disclosures and financial results reported. For example, Enron was often considered a “black box” when it came to what the actual operational and financial results and risks were for its multitude of business lines. The consensus of corporate governance experts is that all firms, globally, should work toward increasing the transparency of the firm’s risk-return profile.
The term “good governance” is, in many instances, a highly politically charged term. When talking to the press, many directors and executives argue that the pursuit of good gov- ernance practices is good for business globally. However, those same officials may also argue that stringent report- ing and disclosure requirements, like those imposed by the United States under Sarbanes-Oxley, harm business competition and growth and ultimately, the attractiveness of listing and trading their securities in the United States. In the end, the devil may indeed be in the detail. A number of examples from around the world are helpful in understanding the complexity of finding common ground in “good” corpo- rate governance.
! Siemens (Germany) has implemented a company-wide trans- formation program containing two significant mindset changes: seeing integrity and performance as not mutually exclusive (clean business always and everywhere), and defining corpo- rate governance in a way that provides space for entrepreneur- ial behavior, focused on long-term sustainable value creation for all stakeholders. It believes that this will generate ever- greater transparency and higher-quality business and financial reporting.1
1“Good Governance and Sustainability Fundamental for Improved Business Reporting,” International Federation of Accountants, Project on Business Reporting, June 2010.
! Western governance practices are only now starting to take hold in the Gulf region of the Middle East. Sabic, the Saudi Basic Industries Corporation, widely considered a leader in good governance practices in the region, is helping to promote board structures that separate audit, remuneration, and other director functions. The growing influence of the Gulf Cooperation Council Board Directors Institute, a nonprofit organization for the sharing of gov- ernance practices in the Gulf, has been instrumental in promoting transparency and disclosure.2
! Neeraj Bhargava, CEO of WNS Global Services, an India- based outsourcing firm, has adamantly argued that the stringent demands of Western governance practices like those of Sarbanes-Oxley have helped both investors and clients “view our organization as a trusted, well-run, and compliant company.” In a global marketplace in which it is ever harder to raise capital critical for corporate growth and development, Bhargava argues that listing in the United States and therefore complying with U.S. corpo- rate governance requirements has gained his firm credi- bility, global visibility, shareholder value, and liquidity. According to Bhargava “Sarbanes-Oxley compliance
2“Making Good Governance Good Business in the Gulf,” Arabic Knowledge@Wharton, April 6, 2010; “Building Better Boards: A Review of Board Effectiveness in the Gulf,” GCC Board Directors Institute, 2009.
[has] benefits: Business processes are better defined, vetted by experts and made more efficient.”3
! One size may not fit all, however. Culture has an enormous impact on business conduct, and many countries are finding their own way without necessarily following U.S. or European practices. For example, a number of Japanese leaders note that the Japanese corporate governance system differs from the Western system, but has evolved while preserving Japanese culture and history. They argue that cultural background and history should not be ignored when developing and implementing global standards, regulations, and oversight.
! Concerns over “governance shopping,” however, continue. In January 2011, the U.S. Securities and Exchange Commission noted growing concerns over Chinese firms that were choosing to list in the United States rather than at home, frequently using a “network of professionals” who
3“Good Governance Is Good Business,” Neeraj Bhargava, Wall Street Journal, August 28, 2006.
were facilitating the listing with questionable financial reports.4 This is partly aided by the continuing evidence that listing in the United States provides a share premium from the umbrella of perceived U.S. good governance.5
4“U.S. Gets Tough on China Listings,” Isabella Steger, Wall Street Journal, December 22, 2010.
5“Has New York Become Less Competitive in Global Markets? Evaluating Foreign Listing Choices over Time,” Craig Doidge, George Andrew Karolyi, and Rene M. Stulz, National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI), July 2007.
48 CHAPTER 2 Corporate Ownership, Goals, and Governance
The accounting process itself has now come under debate. The U.S. system is characterized as strictly rule based, rather than conceptually based, as is common in Western Europe. Many critics of U.S. corporate governance practices point to this as a fundamental flaw, in which clever accountants find ways to follow the rules, yet not meet the underlying purpose for which the rules were intended. An extension of the accounting process debate is that of the role and remuneration associated with auditing. This is the process of using third parties, paid by the firm, to vet their reporting practices as being consistent with generally accepted accounting principles. As the collapse of Arthur Andersen illustrated, serious questions remain.
Minority Shareholder Rights. Finally, the issue of minority shareholder rights continues to rage in many of the world’s largest markets. Many of the emerging markets are still characterized by the family-based corporate governance regime, where the family remains in control even after the firm has gone public. But what of the interests and voices of the other shareholders? How are their interests preserved in organizations where families or controlling investors make all true decisions, including the boards?
Poor performance of management usually requires changes to management, ownership, or both. Exhibit 2.9 illustrates some of the alternative paths available to shareholders when they are dissatisfied with firm performance. Depending on the culture and accepted practices, it is not unusual for many investors to—for an extended time—remain quietly disgruntled regarding share price performance. If more active in response, they may sell their shares. It is the third and fourth responses, shareholder activist responses, in which management hears a much louder dissatisfied shareholder voice.
Popular Term
The Past
Walk-Away
Shareholder Activism
Maximum Threat
What counts is that the management of a publicly quoted company, and its board of directors, know that the company can become the subject of a hostile takeover bid if they fail to perform. The growth of equity and hedge funds in the United States and elsewhere in recent years has strengthened this threat as leveraged buyouts are once again common.
Remain Quietly Disgruntled
Sell the Shares
Change Management
Initiate a Takeover
Shareholder Dissatisfaction
Possible Action
EXHIBIT 2.9 Potential Responses to Shareholder Dissatisfaction
49Corporate Ownership, Goals, and Governance CHAPTER 2
SUMMARY POINTS
! Most commercial enterprises have their origins with either entrepreneurs (private entities) or governments (public entities). Regardless of origin, if they remain commercial in focus, they may over time choose to go public via an initial public offering (IPO).
! The U.S. and U.K. stock markets are characterized by widespread ownership of shares. In the rest of the world, ownership is usually characterized by control- ling shareholders. Typical controlling shareholders are government, institutions, families, and consortiums.
! When a firm becomes widely owned, typically it is man- aged by hired professionals. Professional managers’ interests may not be aligned with the interests of own- ers, thus creating an agency problem.
! The Anglo-American markets have a philosophy that a firm’s objective should follow the shareholder wealth maximization (SWM) model. More specifically, the firm should strive to maximize the return to shareholders, as measured by the sum of capital gains and dividends, for a given level of risk.
! In the non–Anglo-American markets, controlling shareholders also strive to maximize long-term returns to equity. However, they also consider the interests of other stakeholders, including employees, customers, suppliers, creditors, government and community. This is known as stakeholder capitalism.
! 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. A privately held firm tries to maximize current and sus- tainable income since it has no share price.
! The MNE must determine for itself the proper balance between three common operational objectives: maximi- zation of consolidated after-tax income; minimization of the firm’s effective global tax burden; and correct positioning of the firm’s income, cash flows, and avail- able funds as to country and currency.
! The relationship among stakeholders used to determine the strategic direction and performance of an organi- zation is termed corporate governance. Dimensions of corporate governance include agency theory; compo- sition and control of boards of directors; and cultural, historical and institutional variables.
! As MNEs become more dependent on global capital markets for financing, they may need to modify their policies of corporate governance. A trend exists for firms resident in non–Anglo-American markets to move toward being more “shareholder friendly.” Simultaneously, firms from the Anglo- American markets may be moving toward being more “stakeholder friendly.”
! A number of initiatives in governance practices in the United States, the United Kingdom, and the European Union, including board structure and compensation, transparency, auditing, and minority shareholder rights, are spreading to a number of today’s major emerging markets.
! These governance practices are seen by some, in some countries and cultures, as overly intrusive and occasion- ally are viewed as damaging to the competitive capabil- ity of the firm. The result is an increasing reluctance to go public in selective markets.
The basic rule is to be there at the right moment, at the right place, to seize a promising opportunity in an environment guaranteeing sufficient longer-term growth.
—Bernard Arnault, Chairman and CEO, LVMH.
Patrick Thomas focused intently on not letting his hands shake as he quietly closed the phone. He had been riding his bicycle in rural Auvergne, in south-central France, when his cell phone had buzzed. He took a long deep breath, closed his eyes and tried to think. He had spent most of his
Luxury Wars—LVMH vs. Hermès1
1Copyright 2011 © Thunderbird School of Global Management. All rights reserved. This case was prepared by Joe Kleinberg, MBA 2011 and Peter Macy, MBA 2011, under the direction of Professor Michael Moffett for the purpose of classroom discussion only, and not to indicate either effective or ineffective management.
MINI-CASE
50 CHAPTER 2 Corporate Ownership, Goals, and Governance
professional life working at Hermès International, SA and had assumed the position of CEO in 2006 after the retire- ment of Gean-Louis Dumas. The first nonfamily CEO to run the company was now facing the biggest threat to the family controlled company in its 173-year history.
The LVMH Position The man on the other end of the phone had been none other than Bernard Arnault, Chairman and CEO of LVMH (Moët Hennessy Louis Vuitton), the world’s larg- est luxury brand company, and the richest man in France. Arnault was calling to inform him that LVMH would be announcing in two hours that they had acquired a 17.1% interest in Hermès. Thomas had simply not believed Arnault for the first few minutes, thinking it impossible that they could have gained control of that significant a stake without him knowing about it. Arnault assured him it was no joke and that he looked forward to participating in the company’s continued success as a shareholder before repeating again that the press release would be made in two hours (Exhibit 1). Thomas snapped out of his stupor and snatched up the phone; he needed to call Hermès’ Executive Chairman, Bertrand Puech, and begin assessing the potential threat, if it was indeed a threat.
Hermès International. Hermès International, SA is a mul- tibillion-dollar French company that makes and sells luxury goods across a number of different product categories includ- ing women’s and men’s apparel, watches, leather goods, jewelry and perfume. Thierry Hermès, who was known for making the best saddles and harnesses in Paris, founded the company in 1837. The company’s reputation soared as it began to provide its high-end products to nobility throughout Europe, North Africa, Russia, Asia and The Americas. As the years wore on, the company began to expand its product line to include the finest leather bags and the most luxurious silk scarves on the market, all while passing the company down through generations and maintaining family control.
Despite going public in 1993, roughly 60 direct descendants of Thierry Hermès, comprising the 5th and 6th generations, still controlled approximately 73% of the company. In 2006, the job of CEO had been passed, for the first time, to a nonfamily member, Patrick Thomas.
Bernard Arnault
Arnault is a shrewd man. He has reviewed his portfolio and sees what he is missing—a company that still pro- duces true luxury—and he is going after it.
—Anonymous luxury brand CEO speaking on the LVMH announcement.
Bernard Arnault had made a very profitable career out of his penchant for taking over vulnerable family-owned busi- nesses (earning him the colorful nickname of “the wolf in cashmere”). Originally born in Roubaix, France, to an upper class family, Arnault excelled as a student and graduated from France’s prestigious engineering school, Ecole Polytechnique, before working as an engineer and taking over his family’s construction business. When the French government began looking for someone to acquire the bankrupt company, Bous- sac (and its luxury line, Christian Dior), Arnault promptly bought the company. It proved the first step in building what would eventually become the luxury titan, LVMH, and pro- pel Arnault to the title of France’s wealthiest man.
From that point on, Arnault began assembling what his competitors referred to as “the evil empire,” by preying on susceptible family-owned companies with premium names. His takeover of Louis Vuitton was said to have gotten so personal and vicious that, after the last board meeting, the Vuitton family packed their belongings and left the building in tears. In addition to Louis Vuitton, Arnault had spent the last three decades forcibly adding such family-owned luxury brands as Krug (champagne), Pucci (fashion), Chateau d’Yquem (vineyard), and Celine (fashion), among others.
EXHIBIT 1 LVMH Becomes a Shareholder of Hermès International
LVMH Moët Hennessy Louis Vuitton, the world’s leading luxury products group, announces that it holds 15 016 000 shares of Hermès International, representing 14.2% of the share capital of the company. The objective of LVMH is to be a long-term shareholder of Hermès and to contribute to the preservation of the family and French attributes which are at the heart of the global success of this iconic brand.
LVMH fully supports the strategy implemented by the founding family and the management team, who have made the brand one of the jewels of the luxury industry. LVMH has no intention of launching a tender offer, taking control of Hermès nor seeking Board representation. LVMH holds derivative instruments over 3 001 246 Hermès International shares and intends to request their conversion.
LVMH would then hold a total of 18 017 246 Hermès International shares, or 17.1% of its capital. The total cost of this shareholding would, in this case, be €1.45 billion.
Source: Press Release, October 23, 2010, LVMH.com.
51Corporate Ownership, Goals, and Governance CHAPTER 2
Arnault had nothing but success in his takeover attempts until 1999, when his attempted takeover of Gucci was stymied by Francois Pinault, whose company PPR served as the white knight for Gucci and effectively stole the deal out from under Arnault. It marked the one time in LVMH’s history that it had failed in a takeover bid. It remained a bitter memory for Arnault.
Autorité des Marchés Financiers (AMF). Arnault’s announcement of LVMH’s ownership stake in Hermès came as a shock to both the fashion industry and the fam- ily shareholders of Hermès. Exhibit 2 is Hermès public response to LVMH’s initiative. The French stock market regulator, the Autorité des Marchés Financiers (AMF), required any investor gaining a 5% or greater stake in a publicly traded company to file their ownership percentage publicly, as well as a document of intent. But no such notice had been filed, and Patrick Thomas was livid.
In the days following the October 23 press release, LVMH confirmed through additional announcements that the company had complied with all current rules and regu- lations in the transactions, and that it would file all the nec- essary documentation within the allotted time. The AMF announced that it would be opening up a formal investiga- tion of LVMH’s acquisition of the Hermès stock, but this was little consolation to Thomas and the Hermès family, since even if the AMF found LVMH in violation, the only penalty would be a loss of voting rights for two years.
Equity Swaps. In the days following LVMH’s announce- ment, new reports and evidence came to light documenting how the company had attained such a large ownership position under the radar of the Hermès family, com- pany management, and industry analysts. The culprit was equity swaps.
Equity Swaps are derivative contracts whereby two parties enter into a contract to swap future cash flows at a preset date. The cash flows are referred to as “legs” of the swap. In most equity swaps, one leg is tied to a floating rate like LIBOR (the floating leg), and the other leg is tied to the performance of a stock or stock index (the equity leg). It is also possible for an equity swap to have two equity legs. Under current French law, a company must acknowledge when they attain a 5% or more equity stake in another company, or the rights to pur- chase a 5% or more stake via derivatives like equity swaps.
However, equity swaps can be structured in such a way that only their value is tied to the equity instrument; at closeout the contract may be settled in cash, not shares. Using this structure, the swap holder is not required to file with the AMF, since they will never actually own the stock.
The LVMH Purchase. It was widely known that Arnault had long coveted Hermès as a brand. In fact, Mr. Arnault had previously owned 15% of Hermès when he first took over LVMH in the 1990s. At the time, Mr. Arnault had his hands full with reorganizing and redirecting LVMH after his takeover of the company, so he agreed to sell the shares to then Hermès CEO Jean-Louis Dumas when he wanted to take the company public.
But things had changed for LVMH and Arnault since 1990. Mr. Arnault had grown his company to the largest luxury conglomerate in the world, with over $55 billion in annual sales. He accomplished this through organic growth of brands and strategic purchases. Known for his patience and shrewd business acumen, when he saw an opportunity to target a long coveted prize, he took advantage.
The attack on Hermès shares was one of Arnault’s most closely kept secrets, with only three people in his empire aware of the equity swap contracts. Arnault began
EXHIBIT 2 Hermès Response via Press Release: October 24, 2010
Hermès has been informed that LVMH has acquired a 17% stake in the Company. In 1993, the shareholders of Hermès International, all descendants from Emile Hermès, decided to enlist the Company on the Paris stock exchange. This decision was made with two objectives in mind:
! support the long term development of the Company ! make shares easier to trade for the shareholders.
Over the last 10 years, the Hermès group has delivered an average annual growth rate of 10% of its net result and currently holds a very strong financial position with over M € 700 of free cash. Today, Hermès Family shareholders have a strong majority control of nearly 3/4 of the shares. They are fully united around a common business vision. Their long term control of Hermès International is guaranteed by its financial status as limited partnership by shares and the family shareholders have confirmed that they are not contemplating any significant selling of shares. The public listing of shares, allows investors who want to become minority share- holders to do so. As a Family Company Hermès has treated and will always treat its shareholders with utmost respect.
The Executive Management, Sunday October 24, 2010
Source: Hermes.com.
52 CHAPTER 2 Corporate Ownership, Goals, and Governance
making his move in 2008 when three blocks of Hermès shares—totaling 12.8 million shares—were quietly placed on the market by three separate French banks. The origins of these shares are still unknown, but with such a large number of shares in question, many suspected they had come from Hermès family members.
It is believed that Arnault was contacted by the banks and was given 24 hours to decide whether he would like to purchase them or not. At the time, Arnault was hesitant to take such a large ownership stake in Hermès, particularly one requiring registration with the AMF. Arnault and the banks then developed the strategy whereby he would hold rights to the shares via equity swaps, but only as long as he put up the cash. At contract maturity, LVMH would realize the profit/loss on any movement in the share price. As part of the agreement with the banks, however, LVMH would have the option to take the shares instead. Had the contracts required share settlement, under French law LVMH would have to acknowledge its potential equity position in Hermès publicly.
The design of these contracts prevented LVMH from actually holding the shares until October 2010, when they publicly announced their ownership stake in Hermès. During the period the swap contracts were in place, Hermès share price floated between €60 and €102. This explained how LVMH was able to acquire its shares in Hermès at an average price of €80 per share, nearly a 54% discount on the closing price of €176.2 on Friday, October 22.
LVMH could have actually held its swap contracts longer and postponed settlement and therefore disclosure, but the rapid rise in Hermès share price over the previous months forced the decision last year (which many analysts attributed to market speculations of an LVMH takeover plot). If LVMH had postponed settlement, it would have had to account for €2 billion in paper profit, or more, earned on the contracts when publishing their year-end accounts in February 2011.
The Battle Goes Public Although the original press release by LVMH made it very clear that the company had no greater designs on controlling Hermès, Hermès management did not believe it, and moved quickly. After a quick conference call amongst Hermès leadership, Patrick Thomas and Puech gave an uncharacteristic interview with Le Figaro on October 27.
It’s clear his [Mr. Arnault] intention is to take over the company and the family will resist that.
—Patrick Thomas, CEO Hermès, Le Figaro, October 27, 2010.
We would like to convince him [Mr. Arnault] that this is not the right way to operate and that it’s not friendly. If he entered in a friendly way, then we would like him to leave in a friendly way.
—Mr. Puech, Executive Chairman of Emile Hermès SARL, Le Figaro, October 27, 2010.
Arnault wasted no time in responding in an interview given to the same newspaper the following day:
I do not see how the head of a listed company can be qualified to ask a shareholder to sell his shares. On the contrary he is supposed to defend the interests of all shareholders.
—Bernard Arnault, CEO LVMH, Le Figaro, October 28, 2010.
Pierre Godé, Vice President LVMH. On November 10, after much speculation regarding LVMH’s intent, Pierre Godé, an LVMH Vice President, gave an interview with Les Echos newspaper (itself owned by LVMH) to discuss how and why the transactions took place the way they did, as well as to dispel media speculation about a potential hostile takeover attempt from LVMH. In the interview, Godé was questioned about why LVMH chose to purchase the equity swap contracts against Hermès in the first place, and why LVMH chose to close those contracts in Hermès shares rather than in cash.
Godé confided that LVMH had begun looking at Hermès in 2007 when the financial crisis started and the stock exchange began to fall. LVMH was looking for financial investments in the luxury industry—as that is where their expertise lies—and took the position that Hermès would weather the financial crisis better than other potential investments. It was for this reason alone that LVMH chose to purchase equity swaps with Hermès shares as the equity leg.
Godé argued that equity swaps with cash payment and settlement were trendy at that time, and virtually every bank offered this derivative. Even though LVMH already had just under a 5% stake of Hermès stock at the time the derivatives were being set up, Godé stated that LVMH never even considered the possibility of closing out the swaps in shares. For one thing, it was something they could not do contractually (according to Godé), nor did LVMH want to ask the banks for equity settlements. But by 2010, the situa- tion had changed, prompting LVMH to reassess their Her- mès equity swap contracts. The contracts themselves were running out, and LVMH had a premium of nearly €1 billion on them. According to Godé, the banks that had covered their contracts with LVMH were now tempted to sell the shares, which represented 12% of Hermès’ capital.
52 CHAPTER 2 Corporate Ownership, Goals, and Governance
53Corporate Ownership, Goals, and Governance CHAPTER 2
Godé explained that the selling of the shares in and of itself did not concern LVMH. What they did worry about however, was where the shares might end up. Godé stressed that at that time there were rumors that a “pow- erful group from another industry,” and Chinese invest- ment funds were interested in the Hermès shares. LVMH management felt the rising share price of Hermès lent sup- port to these rumors. Additionally, the market had been improving and LVMH had the financial means to be able to pay for the contracts and settle in shares. As a result, LVMH spoke with the banks to assess their position, and after several weeks of talks LVMH reached an agreement with them in October for part of the shares.
At this time, “the Board had to choose between receiv- ing a considerable amount on the equity swaps or take a minority participation in this promising group but where our power would be very limited as the family controlled everything. There was an intense debate and finally the Board chose to have share payments.” Godé completed the interview by stating that LVMH was surprised by the strong negative response from Hermès, especially consid- ering that LVMH had owned a 15% stake in the company in the early 1990s.
Evolution of Hermès International and Its Control. Hermès was structured as a Société en Commandite, the French version of a limited partnership in the United States. In the case of Hermès, this structure concentrates power in the hands of a ruling committee, which is con- trolled by the family.
In addition to the Société en Commandite structure of the company, former Hermès CEO Jean-Louis Dumas established a partner company, Hermès SARL, in 1989. This company represented the interests of family share- holders (only direct Hermès descendants could be owners), and was the sole authority to appoint management and
set company strategy. This unusual structure allowed the Hermès family the ability to retain decision-making power even if only one family member were to remain a shareholder. The structure had been adopted as protec- tion against a hostile takeover after Dumas saw the way Bernard Arnault had dealt with the Vuitton family when he acquired their company.
In a further attempt to placate family members and minimize family infighting, Dumas listed 25% of Hermès SA on the French stock market in 1993. This was done to provide family members with a means to value their stake in the company as well as partially cash out if they felt their family dividends were not enough (several family mem- bers were known to live large, and Dumas feared their lifestyles might exceed their means). Dumas believed—at least at that time—that his two-tier structure would insu- late Hermès from a potential hostile takeover.
However, analysts were now speculating that Hermès SARL may only provide protection through the 6th gener- ation, and that with just a 0.1% stake in the company being worth approximately 18 million at current market prices, there was reason to fear some family members “defecting.” This concern was made all the more real when it became known through AMF filings that Laurent Mommeja, brother to Hermès supervisory board member Renaud fe, sold €1.8 million worth of shares on October 25, at a share price of €189 per share.
After considerable debate, the Hermès family decided to consolidate their shares into a trust in the form of a hold- ing company that would insure that their 73% ownership stake would always vote as one voice and ultimately secure the family’s continued control of the company (Exhibit 3). On December 21, LVMH announced that it had raised its total stake in Hermès to 20.21%, and had filed all required documents with AMF once passing the 20% threshold. LVMH also reiterated that it had no intention of taking
EXHIBIT 3 Hermès Family Confirms Its Long-Term Commitment
Creation of a holding company owning over 50% of Hermès International’s share capital Paris, 5 December 2010—Following a meeting on 3 December 2010, members of the Hermès family reasserted their unity and their confidence in the solidity of their current control of Hermès International, partly via the Emile Hermès family company, sole general partner responsible for determining the company’s strategy and management, and via its shareholding.
The family has decided to confirm its long-term unity by creating a family holding company separate from Emile Hermès SARL, which will hold the shares transferred by family members representing over 50% of Hermès International’s share capital. The family’s commitment to create this majority holding company is irrevocable. The new family-owned company will benefit from preferential rights to shares still directly owned by the family.
This internal reclassification of shares will not impact the family’s stake in Hermès International or the powers of the general partner. The plan will be submitted to the Autorité des Marchés Financiers for definitive approval before it is implemented.
Source: Press Release, December 5, 2010, Hermes.com.
54 CHAPTER 2 Corporate Ownership, Goals, and Governance
control of Hermès or making a public offer for its shares. Under French law, once LVMH reached one-third share ownership it would have to make a public tender for all remaining shares. Hermès share price, as illustrated in Exhibit 4, continued to calm—at least for the moment— following the extended fight for corporate control.
Case Questions 1. Hermès International was a family-owned business for
many years. Why did it then list its shares on a public market? What risks and rewards come from a public listing?
2. Bernard Arnault and LVMH acquired a large position in Hermès shares without anyone knowing. How did they do it and how did they avoid the French regulations requiring disclosure of such positions?
3. The Hermès family defended themselves by forming a holding company of their family shares. How will this work and how long do you think it will last?
54 CHAPTER 2 Corporate Ownership, Goals, and Governance
EXHIBIT 4
100
110
120
130
140
150
160
170
180
190
7/ 1
7/ 8
7/ 15
7/ 22
7/ 29 8/
5 8/
12 8/
19 8/
26 9/ 2
9/ 9
9/ 16
9/ 23
9/ 30
10 /7
10 /1
4 10
/2 1
10 /2
8 11
/4 11
/1 1
11 /1
8 11
/2 5
12 /2
12 /9
12 /1
6 12
/2 3
Oct 25, price peaks at 178.84
Eu ro
s (
) p er
s ha
re
Hermès International Share Price (July–Dec 2010)
55Corporate Ownership, Goals, and Governance CHAPTER 2
QUESTIONS 1. Ownership of the Business. How does ownership
alter the goals and governance of a business?
2. Separation of Ownership and Management. Why is this separation so critical to the understanding of how businesses are structured and led?
3. Corporate Goals: Shareholder Wealth Maximiza- tion. Explain the assumptions and objectives of the shareholder wealth maximization model.
4. Corporate Goals: Stakeholder Wealth Maximiza- tion. Explain the assumptions and objectives of the stakeholder wealth maximization model.
5. Corporate Governance. Define the following terms: a. Corporate governance b. The market for corporate control c. Agency theory d. Stakeholder capitalism
6. Operational Goals. What should be the primary operational goal of an MNE?
7. Knowledge Assets. “Knowledge assets” are a firm’s intangible assets, the sources and uses of its intellec- tual talent—its competitive advantage. What are some of the most important “knowledge assets” that create shareholder value?
8. Labor Unions. In Germany and Scandinavia, among others, labor unions have representation on boards of directors or supervisory boards. How might such union representation be viewed under the shareholder wealth maximization model compared to the corpo- rate wealth maximization model?
9. Interlocking Directorates. In an interlocking director- ate, members of the board of directors of one firm also sit on the board of directors of other firms. How would interlocking directorates be viewed by the shareholder wealth maximization model compared to the corpo- rate wealth maximization model?
10. Leveraged Buyouts. A leveraged buyout is a finan- cial strategy in which a group of investors gains voting control of a firm and then liquidates its assets in order to repay the loans used to purchase the firm’s shares. How would leveraged buyouts be viewed by the share- holder wealth maximization model compared to the corporate wealth maximization model?
11. High Leverage. How would a high degree of lever- age (debt/assets) be viewed by the shareholder wealth maximization model compared to the corporate wealth maximization model?
12. Conglomerates. Conglomerates are firms that have diversified into unrelated fields. How would a policy of conglomeration be viewed by the shareholder wealth maximization model compared to the corpo- rate wealth maximization model?
13. Risk. How is risk defined in the shareholder wealth maximization model compared to the corporate wealth maximization model?
14. Stock Options. How would stock options granted to a firm’s management and employees be viewed by the shareholder wealth maximization model compared to the corporate wealth maximization model?
15. Shareholder Dissatisfaction. What alternative actions can shareholders take if they are dissatisfied with their company?
16. Dual Classes of Common Stock. In many countries, it is common for a firm to have two or more classes of common stock with differential voting rights. In the United States, the norm is for a firm to have one class of common stock with one-share-one-vote. What are the advantages and disadvantages of each system?
17. 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?
18. Emerging Markets Corporate Governance Improve- ments. 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?
19. Developed Markets Corporate Governance Fail- ures. What have been the main causes of recent cor- porate governance failures in the United States and Europe?
20. Family Ownership. What are the key differences in the goals and motivations of family business ownership as opposed to the widely held publicly traded business?
56 CHAPTER 2 Corporate Ownership, Goals, and Governance
21. Value of Good Governance. Do markets appear to be willing to pay for good governance?
22. Corporate Governance Reform. What are the pri- mary principles behind corporate governance reform today? In your opinion, are these culturally specific?
PROBLEMS Use the following formula for shareholder returns to answer questions 1 through 4, where Pt is the share price at time t, and Dt is the dividend paid at time t.
Shareholder return = P2 - P1
P1 +
D2 P1
.
1. Emaline Returns. If the share price of Emaline, a New Orleans-based shipping firm, rises from $12 to $15 over a one-year period, what is the rate of return to the shareholder if the following: a. The company paid no dividends b. The company paid a dividend of $1 per share c. The company paid the dividend and the total return
to the shareholder is separated into the dividend yield and the capital gain
2. Carty’s Choices. Brian Carty, a prominent investor, is evaluating investment alternatives. If he believes an individual equity will rise in price from $59 to $71 in the coming one-year period, and the share is expected to pay a dividend of $1.75 per share, and he expects at least a 15% rate of return on an invest- ment of this type, should he invest in this particular equity?
3. Vaniteux’s Returns (A). Spencer Grant is a New York-based investor. He has been closely following his investment in 100 shares of Vaniteux, a French firm that went public in February 2010. When he pur- chased his 100 shares, at €17.25 per share, the euro was trading at $1.360/ €. Currently, the share is trad- ing at €28.33 per share, and the dollar has fallen to $1.4170/ €. a. If Spencer sells his shares today, what percentage
change in the share price would he receive? b. What is the percentage change in the value of euro
versus the dollar over this same period? c. What would be the total return Spencer would earn
on his shares if he sold them at these rates?
4. Vaniteux’s Returns (B). Spencer Grant chooses not to sell his shares at the time described in problem 3. He waits, expecting the share price to rise further after the announcement of quarterly earnings. His expec- tations are correct; the share price rises to €31.14 per share after the announcement. He now wishes to recalculate his returns. The current spot exchange rate is $1.3110/ €.
5. Vaniteux’s Returns (C). Using the same prices and exchange rates as in problem 4, Vaniteux (B), what would be the total return on the Vaniteux investment by Laurent Vuagnoux, a Paris-based investor?
6. Microsoft’s Dividend. In January 2003, Microsoft announced that it would begin paying a dividend of $0.16 per share. Given the following share prices for Microsoft stock in the recent past, how would a constant dividend of $0.16 per share per year have changed the company’s return to its shareholders over this period?
First Trading Day
Closing Share Price
First Trading Day
Closing Share Price
1998 (Jan 2) $131.13 2001 (Jan 2) $43.38
1999 (Jan 4) $141.00 2002 (Jan 2) $67.04
2000 (Jan 3) $116.56 2003 (Jan 2) $53.72
7. Fashion Acquisitions. During the 1960s, many con- glomerates were created by a firm enjoying a high price/earnings ratio (P/E). They then used their highly valued stock to acquire other firms that had lower P/E ratios, usually in unrelated domestic industries. These conglomerates went out of fashion during the 1980s when they lost their high P/E ratios, thus making it more difficult to find other firms with lower P/E ratios to acquire.
During the 1990s, the same acquisition strategy was possible for firms located in countries where high P/E ratios were common compared to firms in other coun- tries where low P/E ratios were common. Consider the hypothetical firms in the pharmaceutical industry shown in the table at the top of the next page.
Modern American wants to acquire ModoUnico. It offers 5,500,000 shares of Modern American, with a current market value of $220,000,000 and a 10% pre- mium on ModoUnico’s shares, for all of ModoUnico’s shares.
57Corporate Ownership, Goals, and Governance CHAPTER 2
2008 2009 2010
Total net sales, HK$ 171,275 187,500 244,900
Percent of total sales from Europe
48% 44% 39%
Total European sales, HK$ _______ _______ _______
Average exchange rate, HK$/ € 11.5 11.7 10.3
Total European sales, euros _______ _______ _______
Growth rate of European sales _______ _______ _______
2008 2009 2010
Annual yen payments on debt agreement (¥)
12,000,000 12,000,000 12,000,000
Average exchange rate, ¥/HK$
12.3 12.1 11.4
Annual yen debt service, HK$
__________ ___________ ___________
Problem 7.
Company P/E ratio Number of shares Market value per share Earnings EPS Total market value
ModoUnico 20 10,000,000 $20.00 $10,000,000 $1.00 $200,000,000
Modern American 40 10,000,000 $40.00 $10,000,000 $1.00 $400,000,000
Bertrand Manufacturing Local Currency
(millions)
Long-term debt 200
Retained earnings 300
Paid-in common stock: 1 million A-shares 100
Paid-in common stock: 4 million B-shares 400
Total long-term capital 1,000
8. Corporate Governance: Overstating Earnings. A number of firms, especially in the United States, have had to lower their previously reported earnings due to accounting errors or fraud. Assume that Modern American (problem 7) had to lower its earnings to $5,000,000 from the previously reported $10,000,000. What might be its new market value prior to the acqui- sition? Could it still do the acquisition?
9. Bertrand Manufacturing (A). Dual classes of common stock are common in a number of countries. Assume that Bertrand Manufacturing has the following capital structure at book value. The A-shares each have ten votes and the B-shares each have one vote per share.
12. Kingdom Enterprises (B): Japanese Yen Debt. King- dom Enterprises of Hong Kong borrowed Japanese yen under a long-term loan agreement several years ago. The company’s new CFO believes, however, that what was originally thought to have been relatively “cheap debt” is no longer true. What do you think?
13. Chinese Sourcing and the Yuan. Harrison Equipment of Denver, Colorado, purchases all of its hydraulic tubing from manufacturers in mainland China. The company has recently completed a corporate-wide initiative in six sigma/lean manufacturing. Completed oil field hydraulic system costs were reduced 4% over a one-year period, from $880,000 to $844,800. The company is now worried that all of the hydraulic tubing that goes into the systems (making up 20% of their total costs) will be hit by the potential revaluation of the Chinese yuan—if some in Washington get their way. How would a 12% revaluation of the yuan against the dollar impact total system costs?
14. Mattel’s Global Performance. Mattel (U.S.) achieved significant sales growth in its major international regions between 2001 and 2004. In its filings with the United States Security and Exchange Commission
10. Bertrand Manufacturing (B). Assuming all of the same debt and equity values for Bertrand Manufac- turing in problem 9, with the sole exception that both A-shares and B-shares have the same voting rights, one vote per share. a. What proportion of the total long-term capital has
been raised by A-shares? b. What proportion of voting rights is represented by
A-shares? c. What proportion of the dividends should the
A-shares receive?
11. Kingdom Enterprises (A): European Sales. Kingdom Enterprises is a Hong Kong-based exporter of con- sumer electronics and files all of its financial state- ments in Hong Kong dollars (HK$). The company’s European sales director, Phillipp Bosse, has been crit- icized for his performance. He disagrees, arguing that sales in Europe have grown steadily in recent years. Who is correct?
58 CHAPTER 2 Corporate Ownership, Goals, and Governance
(SEC), it reported both the amount of regional sales and what percentage change in regional sales occurred because of exchange rate changes. a. What was the percentage change in sales, in U.S.
dollars, by region? b. What was the percentage change in sales by region
net of currency change impacts? c. What relative impact did currency changes have on
the level and growth of Mattel’s consolidated sales between 2001 and 2004?
INTERNET EXERCISES 1. Multinational Firms and Global Assets/Income. The
differences across MNEs are striking. Using a sample of firms such as the following, pull from their individual Web pages the proportions of their incomes that are earned outside their country of incorporation. (Note how Nestlé calls itself a “transnational company.”)
Walt Disney disney.go.com
Nestlé S.A. www.nestle.com
Intel www.intel.com
Mitsubishi Motors www.mitsubishi.com
Nokia www.nokia.com
Royal Dutch/Shell www.shell.com
Also, note the way in which international business is now conducted via the Internet. Several home pages of the above sites allow the user to choose the language of the presentation viewed.
2. Corporate Governance. There is no hotter topic in business today than corporate governance. Use the following sites to view recent research, current events and news items, and other information related to the relationships between a business and its stakeholders.
Corporate Governance Net www.corpgov.net
3. Fortune Global 500. Fortune magazine is relatively famous for its listing of the Fortune 500 firms in the global marketplace. Use Fortune’s Web site to find the most recent listing of the global firms in this dis- tinguished club.
Fortune www.fortune.com/fortune
4. Financial Times. The Financial Times, based in London—the global center of international finance— has a Web site with a wealth of information. After going to the home page, go to the Markets Data & Tools page, and examine the recent stock market activity around the globe. Note the similarity in movement on a daily basis among the world’s major equity markets.
Financial Times www.ft.com
Problem 14. Mattel’s Global Sales
(thousands of US$) 2001 Sales ($) 2002 Sales ($) 2003 Sales ($) 2004 Sales ($)
Europe $ 933,450 $ 1,126,177 $ 1,356,131 $ 1,410,525
Latin America 471,301 466,349 462,167 524,481
Canada 155,791 161,469 185,831 197,655
Asia Pacific 119,749 136,944 171,580 203,575
Total International $ 1,680,291 $ 1,890,939 $ 2,175,709 $ 2,336,236
United States 3,392,284 3,422,405 3,203,814 3,209,862
Sales Adjustments (384,651) (428,004) (419,423) (443,312)
Total Net Sales $ 4,687,924 $ 4,885,340 $ 4,960,100 $ 5,102,786
Impact of Change in Currency Rates
Region 2001–2002 2002–2003 2003–2004
Europe 7.0% 15.0% 8.0%
Latin America -9.0% -6.0% -2.0%
Canada 0.0% 11.0% 5.0%
Asia Pacific 3.0% 13.0% 6.0%
Source: Mattel, Annual Report, 2002, 2003, 2004.
59
The International Monetary System
The price of every thing rises and falls from time to time and place to place; and with every such change the purchasing power of money changes so far as that thing goes.
—Alfred Marshall.
This chapter begins with a brief history of the international monetary system from the days of the classical gold standard to the present time. The next section describes contemporary currency regimes and their construction and classification, fixed versus flexible exchange rate principles, and what we would consider the theoretical core of the chapter—the attributes of the ideal currency. The following section describes the introduction of the euro and the path toward monetary unification, including the continuing expansion of the European Union. This is followed by a section that analyzes the regime choices of emerging markets. The final section analyzes the trade-offs between exchange rate regimes based on rules, discre- tion, cooperation, and independence. The chapter concludes with the Mini-Case, The Yuan Goes Global, which details the evolution of the Chinese yuan from a purely domestic to an increasingly global currency.
History of the International Monetary System Over the ages currencies have been defined in terms of gold and other items of value, and the international monetary system has been subject to a variety of international agreements. A review of the evolution of these systems—or eras as we refer to them in Exhibit 3.1—pro- vides a useful perspective against which to understand today’s rather eclectic system of fixed rates, floating rates, crawling pegs, and others, and to evaluate weaknesses and challenges for governments and business enterprises conducting global business.
The Gold Standard, 1876–1913 Since the days of the pharaohs (about 3000 B.C.), gold has served as a medium of exchange and a store of value. The Greeks and Romans used gold coins and passed on this tradition through the mercantile era to the nineteenth century. The great increase in trade during the free-trade period of the late nineteenth century led to a need for a more formalized system for settling international trade balances. One country after another set a par value for its currency in terms
CHAPTER 3
of gold and then tried to adhere to the so-called rules of the game. This later came to be known as the classical gold standard. The gold standard as an international monetary system gained acceptance in Western Europe in the 1870s. The United States was something of a latecomer to the system, not officially adopting the standard until 1879.
Under the gold standard, the “rules of the game” were clear and simple. Each country set the rate at which its currency unit (paper or coin) could be converted to a weight of gold. The United States, for example, declared the dollar to be convertible to gold at a rate of $20.67 per ounce (a rate in effect until the beginning of World War I). The British pound was pegged at £4.2474 per ounce of gold. As long as both currencies were freely convertible into gold, the dollar/pound exchange rate was
$ 20.67/ounce of gold £4.2474/ounce of gold
= $ 4.8665/£
Because the government of each country on the gold standard agreed to buy or sell gold on demand with anyone at its own fixed parity rate, the value of each individual currency in terms of gold, and therefore exchange rates between currencies, was fixed. Maintaining adequate reserves of gold to back its currency’s value was very important for a country under this system. The system also had the effect of implicitly limiting the rate at which any individual country could expand its money supply. Any growth in the amount of money was limited to the rate at which official authorities could acquire additional gold.
The gold standard worked adequately until the outbreak of World War I interrupted trade flows and the free movement of gold. This event caused the main trading nations to suspend operation of the gold standard.
Exchange Rate Era
Cross- Border Political Economy
Implication
1860 1914 1945 1971 1997
The last 150 years has seen periods of increasing and decreasing political and economic openness between countries. Beginning with the Bretton Woods Era, global markets have moved toward increasing open exchange of goods and capital, making it increasingly difficult to maintain fixed or even stable rates of exchange between currencies. The most recent era, characterized by the growth and development of emerging economies is likely to be even more challenging.
The Gold Standard
The Inter-War Years
The Bretton Woods Era
The Floating Era
The Emerging Era
Growing openness in trade, with growing, but
limited, capital mobility
Trade dominates capital in total
influence on exchange rates
Protectionism & isolationism
Growing belief in the benefits
of open economies
Trade increasingly dominated by
capital; era ends as capital flows
Rising barriers to the movement
of both trade & capital
Industrialized (primary) nations open; emerging
states (secondary) restrict capital
flows to maintain economic control
Capital flows dominate trade;
emerging nations suffer devaluations
More and more emerging nations
open their markets to capital at the
expense of reduced economic
independence
Capital flows increasingly
drive economic growth and health
present
60 CHAPTER 3 The International Monetary System
EXHIBIT 3.1 The Evolution of Capital Mobility
61The International Monetary System CHAPTER 3
The Interwar Years and World War II, 1914–1944 During World War I and the early 1920s, currencies were allowed to fluctuate over fairly wide ranges in terms of gold and in relation to each other. Theoretically, supply and demand for a country’s exports and imports caused moderate changes in an exchange rate about a central equilibrium value. This was the same function that gold had performed under the previous gold standard. Unfortunately, such flexible exchange rates did not work in an equilibrating manner. On the contrary: international speculators sold the weak currencies short, causing them to fall further in value than warranted by real economic factors. Selling short is a specu- lation technique in which an individual speculator sells an asset such as a currency to another party for delivery at a future date. The speculator, however, does not yet own the asset, and expects the price of the asset to fall by the date when the asset must be purchased in the open market by the speculator for delivery.
The reverse happened with strong currencies. Fluctuations in currency values could not be offset by the relatively illiquid forward exchange market except at exorbitant cost. The net result was that the volume of world trade did not grow in the 1920s in proportion to world gross domestic product but instead declined to a very low level with the advent of the Great Depression in the 1930s.
The United States adopted a modified gold standard in 1934 when the U.S. dollar was devalued to $35 per ounce of gold from the $20.67 per ounce price in effect prior to World War I. Contrary to previous practice, the U.S. Treasury traded gold only with foreign central banks, not private citizens. From 1934 to the end of World War II, exchange rates were theo- retically determined by each currency’s value in terms of gold. During World War II and its chaotic aftermath, however, many of the main trading currencies lost their convertibility into other currencies. The dollar was one of the few currencies that continued to be convertible.
Bretton Woods and the International Monetary Fund, 1944 As World War II drew to a close in 1944, the Allied Powers met at Bretton Woods, New Hampshire, to create a new postwar international monetary system. The Bretton Woods Agreement established a U.S. dollar-based international monetary system and provided for two new institutions: the International Monetary Fund and the World Bank. The International Monetary Fund (IMF) aids countries with balance of payments and exchange rate problems. The International Bank for Reconstruction and Development (World Bank) helped fund postwar reconstruction and since then has supported general economic development. Global Finance in Practice 3.1 provides some insight into the debates at Bretton Woods.
The IMF was the key institution in the new international monetary system, and it has remained so to the present. The IMF was established to render temporary assistance to member countries trying to defend their currencies against cyclical, seasonal, or random occurrences. It also assists countries having structural trade problems if they promise to take adequate steps to correct their problems. If persistent deficits occur, however, the IMF cannot save a country from eventual devaluation. In recent years, it has attempted to help countries facing financial crises. It has provided massive loans as well as advice to Russia and other former Russian republics, Brazil, Indonesia, and South Korea, to name but a few.
Under the original provisions of the Bretton Woods Agreement, all countries fixed the value of their currencies in terms of gold but were not required to exchange their currencies for gold. Only the dollar remained convertible into gold (at $35 per ounce). Therefore, each country established its exchange rate vis-à-vis the dollar, and then calculated the gold par value of its currency to create the desired dollar exchange rate. Participating countries agreed to try to maintain the value of their currencies within 1% (later expanded to 2.25%) of par by buying or selling foreign exchange or gold as needed. Devaluation was not to be used as
62 CHAPTER 3 The International Monetary System
a competitive trade policy, but if a currency became too weak to defend, a devaluation of up to 10% was allowed without formal approval by the IMF. Larger devaluations required IMF approval. This became known as the gold-exchange standard.
The Special Drawing Right (SDR) is an international reserve asset created by the IMF at this time 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. Initially defined in terms of a fixed quantity of gold, the SDR is currently the weighted average of four major currencies: the U.S. dollar, the euro, the Japanese yen, and the British pound. The weights are updated every five years by the IMF. 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.
Fixed Exchange Rates, 1945–1973 The currency arrangement negotiated at Bretton Woods and monitored by the IMF worked fairly well during the post-World War II period of reconstruction and rapid growth in world trade. However, widely diverging national monetary and fiscal policies, differential rates of inflation, and various unexpected external shocks eventually resulted in the system’s demise.
GLOBAL FINANCE IN PRACTICE 3.1
Hammering Out an Agreement at Bretton Woods
The governments of the Allied powers knew that the dev- astating impacts of World War II would require swift and decisive policies. A full year before the end of the war, repre- sentatives of all 45 allied nations met in the summer of 1944 (July 1–22) at Bretton Woods, New Hampshire, for the United Nations Monetary and Financial Conference. Their purpose was to plan the postwar international monetary system. It was a difficult process, and the final synthesis was shaded by pragmatism.
The leading policy makers at Bretton Woods were the British and the Americans. The British delegation was led by Lord John Maynard Keynes, termed “Britain’s economic heavy- weight.” The British argued for a postwar system that would be decidedly more flexible than the various gold standards used before the war. Keynes argued, as he had after World War I, that attempts to tie currency values to gold would create pressures for deflation in many of the war-ravaged economies. And these economies were faced with enormous re-industrialization needs that would likely cause inflation, not deflation.
The American delegation was led by the director of the U.S. Treasury’s monetary research department, Harry D. White, and the U.S. Secretary of the Treasury, Henry Morgenthau, Jr. The Americans argued for stability (fixed exchange rates) but not a return to the gold standard itself. In fact, although the U.S. at that time held most of the gold of the Allied powers, the U.S. delegates argued that currencies should be fixed in parities,
but redemption of the gold should occur only between official authorities (central banks of governments).
On the more pragmatic side, all parties agreed that a post- war system would be stable and sustainable only if there was sufficient credit available for countries to defend their currencies in the event of payment imbalances, which they knew to be inevitable in a reconstructing world order.
The conference divided into three commissions for weeks of negotiation. One commission, led by U.S. Treasury Secretary Morgenthau, was charged with the organization of a fund of capi- tal to be used for exchange rate stabilization. A second commis- sion, chaired by Lord Keynes, was charged with the organization of a second “bank” whose purpose would be for long-term recon- struction and development. A third commission was to hammer out details such as what role silver would have in any new system.
After weeks of meetings the participants came to a three- part agreement—the Bretton Woods Agreement. The plan called for: 1) fixed exchange rates, termed an “adjustable peg” among members; 2) a fund of gold and constituent currencies available to members for stabilization of their respective curren- cies, called the International Monetary Fund (IMF); and 3) a bank for financing long-term development projects (eventually known as the World Bank). One proposal resulting from the meetings, which was not ratified by the United States, was the establish- ment of an international trade organization to promote free trade. That would take many years and conferences to come.
63The International Monetary System CHAPTER 3
The U.S. dollar was the main reserve currency held by central banks and was the key to the web of exchange rate values. Unfortunately, the United States ran persistent and growing deficits in its balance of payments. A heavy capital outflow of dollars was required to finance these deficits and to meet the growing demand for dollars from investors and businesses. Eventually, the heavy overhang of dollars held by foreigners resulted in a lack of confidence in the ability of the United States to meet its commitment to convert dollars to gold.
This lack of confidence forced President Richard Nixon to suspend official purchases or sales of gold by the U.S. Treasury on August 15, 1971, after the United States suffered out- flows of roughly one-third of its official gold reserves in the first seven months of the year. Exchange rates of most of the leading trading countries were allowed to float in relation to the dollar and thus indirectly in relation to gold. A year and a half later, the U.S. dollar once again came under attack, thereby forcing a second devaluation on February 12, 1973; this time by 10% to $42.22 per ounce of gold. By late February 1973, a fixed-rate system no lon- ger appeared feasible given the speculative flows of currencies. The major foreign exchange markets were actually closed for several weeks in March 1973. When they reopened, most currencies were allowed to float to levels determined by market forces. Par values were left unchanged. The dollar floated downward an average of another 10% by June 1973.
The Floating Era of Eclectic Arrangements, 1973–1997 Since March 1973, exchange rates have become much more volatile and less predictable than they were during the “fixed” exchange rate period, when changes occurred infrequently. Exhibit 3.2 illustrates the wide swings exhibited by the IMF’s nominal exchange rate index of the U.S. dollar since 1957. Clearly, volatility has increased for this currency measure since 1973.
19 58
80
90
100
110
120
130
140
150
160 Dollar peaks on Feb 28, 1985
Bretton Woods Period ends Aug 1971 Jamaica
Agreement Jan 1976
US dollar devalued Feb 1973
EMS Created March 1979
EMS Crisis of Sept 1992 Dollar reaches new
low on index basis
Euro Peaks at $1.60/ April 2008
Euro, launched Jan 1999
Asian Crisis June 1997
Louvre Accords Feb 1987
19 60
19 62
19 64
19 66
19 68
19 70
19 72
19 74
19 76
19 78
19 80
19 82
19 84
19 86
19 88
19 90
19 92
19 94
19 96
19 98
20 00
20 02
20 04
20 06
20 08
20 10
Source: International Monetary Fund, International Financial Statistics, www. imfstatistics.org. 2005=100.
EXHIBIT 3.2 The IMF’s Exchange Rate Index of the Dollar
64 CHAPTER 3 The International Monetary System
Date Event Impact
August 1971 Dollar floated Nixon closes the U.S. gold window, suspending purchases or sales of gold by U.S. Treasury; temporary imposition of 10% import surcharge
December 1971 Smithsonian Agreement
Group of Ten reaches compromise whereby the US$ is devalued to $38/oz. of gold; most other major currencies are appreciated versus US$
February 1973 U.S. dollar devalued Devaluation pressure increases on US$, forcing further devaluation to $42.22/oz. of gold
February–March 1973
Currency markets in crisis
Fixed exchange rates no longer considered defensible; speculative pressures force closure of international foreign exchange markets for nearly two weeks; markets reopen on floating rates for major industrial currencies
June 1973 U.S. dollar depreciation
Floating rates continue to drive the now freely floating US$ down by about 10% by June
Fall 1973–1974 OPEC oil embargo Organization of Petroleum Exporting Countries (OPEC) impose oil embargo, eventually quadrupling the world price of oil; because world oil prices are stated in US$, value of US$ recovers some former strength
January 1976 Jamaica Agreement IMF meeting in Jamaica results in the “legalization” of the floating exchange rate system already in effect; gold is demonetized as a reserve asset
1977–1978 U.S. inflation rate rises
Carter administration reduces unemployment at the expense of inflation increases; rising U.S. inflation causes continued depreciation of the US$
March 1979 EMS created The European Monetary System (EMS) is created, establishing a cooperative exchange rate system for participating members of the European Economic Community (EEC)
Summer 1979 OPEC raises prices OPEC nations raise price of oil again
Spring 1980 U.S. dollar begins rise
Worldwide inflation and early signs of recession coupled with real interest differential advantages for dollar-denominated assets contribute to increased demand for dollars
August 1982 Latin American debt crisis
Mexico informs U.S. Treasury on Friday 13, 1982, that it will be unable to make debt service payments; Brazil and Argentina follow within months
February 1985 U.S. dollar peaks The U.S. dollar peaks against most major industrial currencies, hitting record highs against the deutsche mark and other European currencies
September 1985 Plaza Agreement Group of Ten members meet at the Plaza Hotel in New York City to sign an international cooperative agreement to control the volatility of world currency markets and to establish target zones
February 1987 Louvre Accords Group of Six members state they will “intensify” economic policy coordination to promote growth and reduce external imbalances
December 1991 Maastricht Treaty European Union concludes a treaty to replace all individual currencies with a single currency—the euro
September 1992 EMS crisis High German interest rates induce massive capital flows into deutsche mark- denominated assets, causing the withdrawal of the Italian lira and British pound from the EMS’s common float
July 1993 EMS realignment EMS adjusts allowable deviation band to for all member countries (except the Dutch guilder); U.S. dollar continues to weaken; Japanese yen reaches ¥100.25/$
1994 EMI founded European Monetary Institute (EMI), the predecessor to the European Central Bank, is founded in Frankfurt, Germany
EXHIBIT 3.3 World Currency Events, 1971–2011
(Continued)
Exhibit 3.3 summarizes the key events and external shocks that have affected currency values since March 1973. The most important shocks in recent years have been the European Monetary System (EMS) restructuring in 1992 and 1993; the emerging market currency crises, including that of Mexico in 1994, Thailand (and a number of other Asian currencies) in 1997,
65The International Monetary System CHAPTER 3
Russia in 1998, and Brazil in 1999; the introduction of the euro in 1999; and the currency crises and changes in Argentina and Venezuela in 2002.
The Emerging Era, 1997–Present The post-Asian Crisis of 1997 period has seen the growth in both breadth and depth of emerging market economies and currencies. We may end up being proven wrong on this count, but the final section of this chapter argues that the global monetary system is already more than a decade into the embracement of a number of major emerging market currencies—beginning with the Chinese renminbi. Feel free to disagree.
Date Event Impact
December 1994 Peso collapse Mexican peso suffers major devaluation as a result of increasing pressure on the managed devaluation policy; peso falls from Ps3.46/$ to Ps5.50/$ within days; the peso’s collapse results in a fall in most major Latin American exchanges in a contagion process—the “tequila effect”
August 1995 Yen peaks Japanese yen reaches an all-time high versus the U.S. dollar of ¥79/$; yen slowly depreciates over the following two-year period, rising to over ¥130/$
June 1997 Asian crisis The Thai baht is devalued in July, followed soon after by the Indonesian rupiah, Korean won, Malaysian ringgit, and Philippine peso; following the initial exchange rate devaluations, the Asian economy plummets into recession
August 1998 Russian crisis On Monday, August 17, the Russian Central Bank devalues the ruble by 34%; the ruble continues to deteriorate in the following days, sending the already weak Russian economy into recession
January 1999 Euro launched Official launch date for the euro, the single European currency; 11 European Union member states elect to participate in the system, which irrevocably locks their individual currencies rates among them
January 1999 Brazilian reais crisis The reais, initially devalued 8.3% by the Brazilian government on January 12, is allowed to float against the world’s currencies
January 2002 Euro coinage Euro coins and notes are introduced in parallel with home currencies; national currencies are phased out during the six-month period beginning January 1
January 8, 2002 Argentine peso crisis The Argentine peso, its value fixed to the U.S. dollar at 1:1 since 1991 through a currency board, is devalued to Ps1.4/$, then floated
February 13, 2002 Venezuelan bolivar floated
The Venezuelan bolivar, fixed to the dollar since 1996, is floated as a result of increasing economic crisis
February 14, 2004 Venezuelan bolivar devalued
Venezuela devalues the bolivar by 17% versus the U.S. dollar, to deal with its growing fiscal deficit
May 2004 EU enlargement Ten more countries join the European Union, thereby enlarging it to 25 members; in the future, when they qualify, most of these countries are expected to adopt the euro
July 21, 2005 Yuan reform The Chinese government and the People’s Bank of China abandon the peg of the Chinese yuan (renminbi) to the U.S. dollar, announcing that it will be instantly revalued from Yuan8.28/$ to Yuan8.11/$, and reform the exchange rate regime to a managed float in the future; Malaysia announces a similar change to its exchange rate regime
April 2008 Euro peaks The euro peaks in strength against the U.S. dollar at $1.60/€ . In the following months the euro falls substantially, hitting $1.25/€ by late 2008
Fall 2011 Greek/EU debt crisis Rising fears over the future of the euro revolve around the mounting public debt levels of Greece, Portugal, and Ireland
EXHIBIT 3.3 World Currency Events, 1971–2011
66 CHAPTER 3 The International Monetary System
IMF Classification of Currency Regimes The global monetary system—if there is indeed a singular “system”—is an eclectic combination of exchange rate regimes and arrangements. Although there is no single governing body, the International Monetary Fund (IMF) has at least played the role of “town crier” since World War II. We present its current classification system of currency regimes here.
Brief Classification History The IMF was for many years the central clearinghouse for exchange rate classifications. Member states submitted their exchange rate policies to the IMF, and those submissions were the basis for its categorization of exchange rate regimes. However, that all changed in 1997– 1998 with the Asian Financial Crisis. One of the clear outcomes of that crisis was that what many countries claimed as their regime structure, the de jure system, differed dramatically from what they practiced during the crisis, their de facto systems.
Beginning in 1998 the IMF adopted a practice of no longer collecting regime classification submissions from member states, but confining its regime classifications and reports to analysis performed in-house.1 As a global institution which is in principle apolitical, the IMF’s analysis today is focused on classifying currencies on the basis of an ex post analysis of how the currency’s value was based in the recent past, one which focuses on observed behavior, not on official government policy pronouncements.
The IMF’s 2009 de facto System The IMF’s methodology of classifying exchange rate regimes today, in effect since January 2009, is presented in Exhibit 3.4. It is based on actual observed behavior, de facto results, and not the official policy statements of the respective governments—de jure classification.2 The classification process begins with the determination of whether the exchange rate of the country’s currency is dominated by markets or by official action. Although the classification system is a bit challenging, there are four basic categories.
Category 1: Hard Pegs. These countries have given up their own sovereignty over monetary policy. This category includes countries that have adopted other country currencies (e.g., Zimbabwe’s adoption of the U.S. dollar, dollarization), and countries utilizing a currency board structure which limits monetary expansion to the accumulation of foreign exchange.
Category 2: Soft Pegs. This general category is colloquially referred to as fixed exchange rates. The five subcategories of soft peg regimes are differentiated on the basis of what the currency is fixed to, whether that fix is allowed to change—and if so under what conditions, what types, magnitudes, and frequencies of intervention are allowed/used, and the degree of variance about the fixed rate.
Category 3: Floating Arrangements. Currencies that are predominantly market-driven are further subdivided into free floating, values determined by open market forces without governmental influence or intervention, and simple floating or floating with intervention, where government occasionally does intervene in the market in pursuit of some rate goals or objectives.
1This included the cessation of publishing its Annual Report on Exchange Arrangements and Exchange Restrictions, a document which much of the financial industry depended upon for decades. 2“Revised System for the Classification of Exchange Rate Arrangements,” by Karl Habermeier, Annamaria Koke- nyne, Romain Veyrune, and Harald Anderson, Monetary and Capital Markets Department, IMF Working Paper 09/211, November 17, 2009. The system presented is a revision of the IMF’s 1998 revision to a de facto system.
67The International Monetary System CHAPTER 3
Rate Classification 2009 de facto System Description and Requirements Confirmation Required? Countries
Hard Pegs Arrangement with no separate legal tender
The currency of another country circulates as the sole legal tender (formal dollarization), as well as members of a monetary or currency union in which the same legal tender is shared by the members.
Yes 10
Currency board arrangement
A monetary arrangement based on an explicit legislative commitment to exchange domestic currency for a specific foreign currency at a fixed exchange rate, combined with restrictions on the issuing authority. Restrictions imply that domestic currency will be issued only against foreign exchange and that it remains fully backed by foreign assets.
Yes 13
Soft Pegs Conventional pegged arrangement
A country formally pegs its currency at a fixed rate to another currency or a basket of currencies of major financial or trading partners. Country authorities stand ready to maintain the fixed parity through direct or indirect intervention. The exchange rate may vary ±1% around a central rate, or may vary no more than 2% for a six-month period.
Notify IMF 45
Stabilized arrangement
A spot market rate that remains within a margin of 2% for six months or more and is not floating. Margin stability can be met by either a single currency or basket of currencies (assuming statistical measurement). Exchange rate remains stable as a result of official action.
— 22
Intermediate pegs:
Crawling peg Currency is adjusted in small amounts at a fixed rate or in response to changes in quantitative indicators (e.g., inflation differentials).
Yes 5
Crawl-like arrangement
Exchange rate must remain with a narrow margin of 2% relative to a statistically defined trend for six months or more. Exchange rate cannot be considered floating. Minimum rate of change is greater than allowed under a stabilized arrangement.
— 3
Pegged exchange rate within horizontal bands
Value of the currency is maintained within 1% of a fixed central rate, or the margin between the maximum and minimum value exceeds 2%. This includes countries which are today members of the ERM II system
Yes 3
Floating Arrangements
Floating Exchange rate is largely market determined without an ascertainable or predictable path. Market intervention may be direct or indirect, and serves to moderate the rate of change (but not targeting). Rate may exhibit more or less volatility.
— 39
Free floating A floating rate is freely floating if intervention occurs only exceptionally, and confirmation of intervention is limited to at most three instances in a six-month period, each lasting no more than three business days.
— 36
Residual Other Managed Arrangements
This category is residual, and is used when the exchange rate does not meet the criteria for any other category. Arrangements characterized by frequent shifts in policies fall into this category.
— 12
Source: “Revised System for the Classification of Exchange Rate Arrangements,” by Karl Habermeier, Anamaria Kokenyne, Romain Veyrune, and Harald Anderson, IMF Working Paper WP/09/211, International Monetary Fund, November 17, 2009. Classification includes 188 countries at the time of publication.
EXHIBIT 3.4 IMF Exchange Rate Classifications
68 CHAPTER 3 The International Monetary System
Category 4: Residual. As one would suspect, this category includes all exchange rate arrangements that do not meet the criteria of the previous three categories. Country systems demonstrating frequent shifts in policy typically make up the bulk of this category.
A Global Eclectic Despite the IMF’s attempt to lend rigor to regime classifications, the global monetary system today is indeed a global eclectic in any sense of the term. As Chapter 6 will describe in detail, 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.
The euro itself is an example of a rigidly fixed system, acting as a single currency for its member countries. However, the euro itself is an independently floating currency against all other currencies. Other examples of rigidly fixed exchange regimes include Ecuador, Panama, and Zimbabwe, which use the U.S. dollar as their official currency; the Central African Franc (CFA) zone, in which countries such as Mali, Niger, Senegal, Cameroon, and Chad among others use a single common currency (the franc, tied to the euro) and the Eastern Caribbean Currency Union (ECCU), a set of small countries that use a common currency, the Eastern Caribbean dollar.
At the other extreme are countries with independently floating currencies. These include many of the most developed countries, such as Japan, the United States, the United Kingdom, Canada, Australia, New Zealand, Sweden, and Switzerland. However, this category also includes a number of unwilling participants—emerging market countries that tried to maintain fixed rates but were forced by the marketplace to let them float. Among these are Korea, the Philippines, Brazil, Indonesia, Mexico, and Thailand.
It is important to note that only the last two categories, including roughly half of the 188 countries covered, are actually “floating” to any real degree. Although the contemporary international monetary system is typically referred to as a “floating regime,” it is clearly not the case for the majority of the world’s nations. And as illustrated by Global Finance in Practice 3.2 on the Swiss franc, even the world’s most stable currencies have to “manage” their values on occasion.
Fixed Versus Flexible Exchange Rates A nation’s choice as to which currency regime to follow reflects national priorities about all facets of the economy, including inflation, unemployment, interest rate levels, trade balances, and economic growth. The choice between fixed and flexible rates may change over time as priorities change.
At the risk of overgeneralizing, the following points partly explain why countries pursue certain exchange rate regimes. They are based on the premise that, other things being equal, countries would prefer 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 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
69The International Monetary System CHAPTER 3
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 levels 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 onetime cost to the nation’s economic health.
The Impossible Trinity If the ideal currency existed in today’s world, it would possess three attributes (illustrated in Exhibit 3.5), often referred to as the “impossible trinity”:
1. Exchange rate stability. The value of the currency would be fixed in relationship to other major currencies, so 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, so 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.
These qualities are termed the impossible trinity (also referred to as the trilemma of inter- national finance) because 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.
For example, a country with a pure float exchange rate regime can have monetary independence and a high degree of financial integration with the outside capital markets, but the result must be a loss of exchange rate stability (the case of the United States). Similarly, a country that maintains very tight controls over the inflow and outflow of capital will retain its monetary independence and a stable exchange rate, but at the loss of being integrated with global financial and capital markets (the case of Malaysia in the 1998–2002 period).
As described in Exhibit 3.5, the consensus of many experts is that the force of increased capital mobility has been pushing more and more countries toward full financial integration
GLOBAL FINANCE IN PRACTICE 3.2
Swiss National Bank Sets Minimum Exchange Rate for the Franc
The current massive overvaluation of the Swiss franc poses an acute threat to the Swiss economy and carries the risk of a deflationary development. The Swiss National Bank (SNB) is therefore aiming for a substantial and sustained weakening of the Swiss franc. With immediate effect, it will no longer tolerate a EUR/ CHF exchange rate below the minimum rate of CHF 1.20. The SNG will enforce this minimum rate with the utmost determination and is prepared to buy foreign currency in unlimited quantities.
Even at a rate of CHF 1.20 per euro, the Swiss franc is still high and should continue to weaken over time. If the economic outlook and deflationary risks so require, the SNG will take further measures.
Source: “Swiss National Bank sets minimum exchange rate at CHF 1.20 per euro,” Communications Press Release, Swiss National Bank, Zurich, 6 September 2011.
70 CHAPTER 3 The International Monetary System
EXHIBIT 3.5 The Impossible Trinity
in an attempt to stimulate their domestic economies and feed the capital appetites of their own MNEs. As a result, their currency regimes are being “cornered” into being either purely floating (like the United States) or integrated with other countries in monetary unions (like the European Union). Global Finance in Practice 3.3 drives this debate home.
A Single Currency for Europe: The Euro Beginning with the Treaty of Rome in 1957 and continuing with the Single European Act of 1987, the Maastricht Treaty of 1991–1992, and the Treaty of Amsterdam of 1997, a core set of European countries worked steadily toward integrating their individual countries into one larger, more efficient, domestic market. Even after the launch of the 1992 Single Europe program, however, a number of barriers to true openness remained, including the use of different currencies. The use of different currencies required both consumers and companies to treat the individual markets separately. Currency risk of cross-border commerce still persisted. The creation of a single currency was seen as the way to move beyond these last vestiges of separated markets.
The original 15 members of the European Union (EU) were also members of the European Monetary System (EMS). The EMS formed a system of fixed exchange rates amongst the member currencies, with deviations maintained through bilateral responsibility to maintain rates at ±2.5% of an established central rate. This system of fixed exchange rates, with some adjustments along the way, remained in effect from 1979 to 1999. Its resiliency was seriously tested with exchange rate crises in 1992 and 1993, but it withstood the challenges and moved onward.
The Maastricht Treaty and Monetary Union In December 1991, the members of the EU met at Maastricht, the Netherlands, and concluded a treaty that changed Europe’s currency future. The Maastricht Treaty specified a timetable
Trinity Element: The Ultimate Objective
Monetary Independence (an independent monetary policy)
Full Financial Integration (the free movement of capital)
An independent monetary policy, or allowing the free movement of capital in and out of its country
All countries must implicitly decide which of the Trinity Elements they wish to pursue, and therefore which element they must give up (you can’t have all three).
Must Give Up Either:
A stable exchange rate, or allowing the free movement of capital in and out of its country
A stable exchange rate, or an independent monetary policy
Exchange Rate Stability (a managed or fixed exchange rate)
In recent years, with the increasing deregulation of capital markets and capital controls around the globe, more countries are opting to pursue Full Financial Integration. The results are as theory would predict: more currency volatility and less independence in the conduct of monetary policy.
71The International Monetary System CHAPTER 3
and a plan to replace all individual EMS member currencies with a single currency— eventually named the euro. Other aspects of the treaty were also adopted that would lead to a full European Economic and Monetary Union (EMU). According to the EU, the EMU is a single- currency area within the EU single market, now known informally as the eurozone, in which people, goods, services, and capital are supposed to move without restrictions.
The integration of separate country monetary systems is not, however, a minor task. To prepare for the EMU, the Maastricht Treaty called for the integration and coordination of the member countries’ monetary and fiscal policies. The EMU would be implemented by a process called convergence. Before becoming a full member of the EMU, each member country was expected to meet the following convergence criteria in order to integrate systems which were at the same relative performance levels:
! Nominal inflation should be no more than 1.5% above the average for the three members of the EU with the lowest inflation rates during the previous year.
! Long-term interest rates should be no more than 2% above the average for the three members with the lowest interest rates.
! The individual government budget deficits, fiscal deficits, should be no more than 3% of gross domestic product.
! Government debt outstanding should be no more than 60% of gross domestic product.
The convergence criteria were so tough that few, if any, of the members could satisfy them at that time, but 11 countries managed to do so just prior to 1999 (Greece was added two years later).
GLOBAL FINANCE IN PRACTICE 3.3
Who Is Choosing What in the Trinity/Trilemma?
The global recession of 2009/2010 sparked much debate over the value of currencies-in some cases invoking what one academic termed “currency wars.” With most of the non- Chinese world suffering very slow economic growth, and under heavy pressure to stimulate their economies and alleviate high unemployment rates, there have been
more and more arguments and efforts for a weak or undervalued currency. Although that sounds logical, the “impossible trinity” makes it very clear that each economy must choose its own medicine. Here is what many argue are the choices of three of the major global economic players:
Choice #1 Choice #2 Therefore
United States Independent monetary policy Free movement of capital Currency value floats
China Independent monetary policy Fixed value of currency Restricted movement of capital
Europe (EU) Free movement of capital Fixed rate of currency exchange between countries
Integrated monetary policy
The choices made by the EU are clearly the more complex. As a combination of different sovereign states, the EU has pursued integration of a common currency, the euro, and free movement of labor and capital. The result, according to the impossible trinity, is that it has had to give up an independent
monetary policy in the form of the European Central Bank (ECB). Although many may argue this, the recent fiscal deficits and near- collapses of government debt issuances in Greece, Portugal, and Ireland for example, may provide strong arguments for belief in the trinity.
72 CHAPTER 3 The International Monetary System
The European Central Bank (ECB) The cornerstone of any monetary system is a strong, disciplined, central bank. The Maastricht Treaty established this single institution for the EMU, the European Central Bank (ECB), which was established in 1998.3 The ECB’s structure and functions were modeled after the German Bundesbank, which in turn had been modeled after the U.S. Federal Reserve System. This independent central bank dominates the activities of the individual countries’ central banks. The individual central banks would continue to regulate banks resident within their borders, but all financial market intervention and the issuance of the single currency would be the sole responsibility of the ECB. The single most important mandate of the ECB was its charge to promote price stability within the European Union.
The Launch of the Euro On January 4, 1999, 11 member states of the EU initiated the EMU. They established a single currency, the euro, which replaced the individual currencies of the participating member states. The 11 countries were Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain. Greece did not qualify for EMU participation at this time, but joined the euro group later, in 2001. On December 31, 1998, the final fixed rates between the 11 participating currencies and the euro were put into place. On January 4, 1999, the euro was officially launched.
The United Kingdom, Sweden, and Denmark chose to maintain their individual currencies. The United Kingdom has been skeptical of increasing EU infringement on its sovereignty, and has opted not to participate. Sweden, which has failed to see significant benefits from EU membership (although it is one of the newest members), has also been skeptical of EMU participation. Denmark, like the United Kingdom, Sweden, and Norway has so far opted not to participate.4
The official abbreviation of the euro, EUR, has been registered with the International Standards Organization (letter abbreviations are needed for computer-based worldwide trading). This is similar to the three-letter computer symbols used for the U.S. dollar, USD, and the British pound sterling, GBP. The official symbol of the euro is €. According to the EU, the € symbol was inspired by the Greek letter epsilon (ε) simultaneously referring to Greece’s ancient role as the source of European civilization and recalling the first letter of the word Europe.
The euro would generate a number of benefits for the participating states: 1) Countries within the euro zone enjoy cheaper transaction costs; 2) Currency risks and costs related to exchange rate uncertainty are reduced; and 3) All consumers and businesses both inside and outside the euro zone enjoy price transparency and increased price-based competition. The primary “cost” of participating in the use of the euro, the loss of monetary independence, would be a continuing challenge for the members for years to come.
On January 4, 1999, the euro began trading on world currency markets. Its introduction was a smooth one. The euro’s value slid steadily following its introduction, however, primarily as a result of the robustness of the U.S. economy and U.S. dollar, and continuing sluggish economic sectors in the EMU countries. Exhibit 3.6 illustrates the euro’s value since its introduction. After declining in value against the U.S. dollar in the early years, the euro then
3The EU created the European Monetary Institute (EMI) in 1994 as a transitional step in establishing the European Central Bank. 4Denmark is, however, a member of ERM II (the Exchange Rate Mechanism II) which effectively allows Denmark to keep its own currency and monetary sovereignty, but fixes the value of its currency, the krone, to the euro.
73The International Monetary System CHAPTER 3
EXHIBIT 3.6 The U.S. Dollar/Euro Spot Exchange Rate, 1999–2011
strengthened versus the dollar and has maintained that relative strength over the past decade. It has, however, demonstrated significant volatility as seen in Exhibit 3.6.
The use of the euro has continued to expand since its introduction. As of January 2012, the euro was the official currency for 17 of the 27 member countries in the European Union, as well as five other countries (Montenegro, Andorra, Monaco, San Marino, and the Vatican) which may eventually join the EU. The 17 countries that currently use the euro—the so-called eurozone—include Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia, and Spain. Although all members of the EU are expected eventually to replace their currencies with the euro, recent years have seen growing debates and continual postponements by new members in moving toward full euro adoption.
The Greek/EU Debt Crisis The European Monetary Union is a complex organism compared to the customary country structure of fiscal and monetary policy institutions and policies described in a typical economics 101 course. The members of the EU do have relative freedom to set their own fiscal policies— government spending, taxation, and the creation of government surpluses or deficits. They are expected to keep deficit spending within limits.
What the members of the EU do not have, however, is the ability to conduct independent monetary policy. When the EU moved to a single currency with the adoption of the euro,
0.80
Source: Data drawn from the International Monetary Fund’s International Financial Statistics, imf.org, monthly average rate.
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74 CHAPTER 3 The International Monetary System
its member states agreed to use a single currency (exchange rate stability), allow the free movement of capital in and out of their economies (financial integration), but give up individual control of their own money supply (monetary independence). Once again, a choice was made among the three competing dimensions of the Impossible Trinity, in this case, to form a single monetary policy body—the European Central Bank (ECB)—to conduct monetary policy on behalf of all EU members.
But fiscal and monetary policies are still somewhat intertwined. Government deficits which are funded by issuing debt to the international financial markets still impact monetary policy. The proliferation of sovereign debt, debt issued by Greece, Portugal, Ireland, for example, may all be euro-denominated, but are debt obligations of the individual governments. But if one or more of these governments flood the market with debt, they may impact the cost (raise it) and availability (decrease it) of capital to all other member states. In the end, if monetary independence is not preserved, then one or both of the other elements of the Trinity may fail—capital mobility or exchange rate stability. We will explore this current crisis, and what it may mean for the future of the euro, in Chapter 5.
Emerging Markets and Regime Choices The 1997–2005 period saw increasing pressures on emerging market countries to choose among more extreme types of exchange rate regimes. The increased capital mobility pressures noted in the previous section have driven a number of countries to choose between either a free-floating exchange rate (as in Turkey in 2002) or the opposite extreme, a fixed-rate regime—such as a currency board (as in Argentina throughout the 1990s and detailed in the following section) or even dollarization (as in Ecuador in 2000). These systems deserve a bit more time and depth in our discussions.
Currency Boards A currency board exists when a country’s central bank commits to back its monetary base—its money supply—entirely with foreign reserves at all times. This commitment means that a unit of domestic currency cannot be introduced into the economy without an additional unit of foreign exchange reserves being obtained first. Eight countries, including Hong Kong, utilize currency boards as a means of fixing their exchange rates.
Argentina. In 1991, Argentina moved from its previous managed exchange rate of the Argentine peso to a currency board structure. The currency board structure fixed the Argentine peso’s value to the U.S. dollar on a one-to-one basis. The Argentine government preserved the fixed rate of exchange by requiring that every peso issued through the Argentine banking system be backed by either gold or U.S. dollars held on account in banks in Argentina. This 100% reserve system made the monetary policy of Argentina dependent on the country’s ability to obtain U.S. dollars through trade or investment. Only after Argentina had earned these dollars through trade could its money supply be expanded. This requirement eliminated the possibility of the nation’s money supply growing too rapidly and causing inflation.
An additional feature of the Argentine currency board system was the ability of all Argentines and foreigners to hold dollar-denominated accounts in Argentine banks. These accounts were in actuality Eurodollar accounts—dollar-denominated deposits in non-U.S. banks. These accounts provided savers and investors with the ability to choose whether or not to hold pesos.
From the very beginning there was substantial doubt in the market that the Argentine government could maintain the fixed exchange rate. Argentine banks regularly paid slightly higher interest rates on peso-denominated accounts than on dollar-denominated accounts. This interest differential represented the market’s assessment of the risk inherent in the
75The International Monetary System CHAPTER 3
Argentine financial system. Depositors were rewarded for accepting risk—for keeping their money in peso-denominated accounts. This was an explicit signal by the marketplace that there was a perceived possibility that what was then “fixed” would not always be so.
The market proved to be correct. In January 2002, after months of economic and political turmoil and nearly three years of economic recession, the Argentine currency board was ended. The peso was first devalued from Peso1.00/$ to Peso1.40/$, then floated completely. It fell in value dramatically within days. The Argentine decade-long experiment with a rigidly fixed exchange rate was over. The devaluation followed months of turmoil, including continuing bank holidays and riots in the streets of Buenos Aires. The Argentina crisis is presented in detail in Chapter 7.
Dollarization Several countries have suffered currency devaluation for many years, primarily as a result of inflation, and have taken steps toward dollarization. Dollarization is the use of the U.S. dollar as the official currency of the country. Panama has used the dollar as its official currency since 1907. Ecuador, after suffering a severe banking and inflationary crisis in 1998 and 1999, adopted the U.S. dollar as its official currency in January 2000. One of the primary attributes of dollarization was summarized well by BusinessWeek in a December 11, 2000, article entitled “The Dollar Club”:
One attraction of dollarization is that sound monetary and exchange-rate policies no longer depend on the intelligence and discipline of domestic policymakers. Their monetary policy becomes essentially the one followed by the U.S., and the exchange rate is fixed forever.
The arguments for dollarization follow logically from the previous discussion of the impossible trinity.
A country that dollarizes removes any currency volatility (against the dollar) and would theoretically eliminate the possibility of future currency crises. Additional benefits are expectations of greater economic integration with other dollar-based markets, both product and financial. This last point has led many to argue in favor of regional dollarization, in which several countries that are highly economically integrated may benefit significantly from dollarizing together.
Three major arguments exist against dollarization. The first is the loss of sovereignty over monetary policy. This is, however, the point of dollarization. Second, the country loses the power of seignorage, the ability to profit from its ability to print its own money. Third, the central bank of the country, because it no longer has the ability to create money within its economic and financial system, can no longer serve the role of lender of last resort. This role carries with it the ability to provide liquidity to save financial institutions that may be on the brink of failure during times of financial crisis.
Ecuador. Ecuador officially completed the replacement of the Ecuadorian sucre with the U.S. dollar as legal tender on September 9, 2000. This step made Ecuador the largest national adopter of the U.S. dollar, and in many ways set it up as a test case of dollarization for other emerging market countries to watch closely. As shown in Exhibit 3.7, this was the last stage of a massive depreciation of the sucre in a brief two-year period.
During 1999, Ecuador suffered a rising rate of inflation and a falling level of economic output. In March 1999, the Ecuadorian banking sector was hit with a series of devastating “bank runs,” financial panics in which all depositors attempted to withdraw all of their funds simultaneously. Although there were severe problems in the Ecuadorian banking system, the truth was that even the healthiest financial institution would fail under the strain of this
76 CHAPTER 3 The International Monetary System
EXHIBIT 3.7 The Ecuadorian Sucre/U.S. Dollar Exchange Rate, November 1998–March 2000
financial drain. Ecuador’s president at that time, Jamil Mahuad, immediately froze all deposits (this was termed a bank holiday in the United States in the 1930s, in which banks closed their doors). The Ecuadorian sucre, which in January 1999 was trading at roughly Sucre7,400/$, plummeted in early March to Sucre12,500/$. Ecuador defaulted on more than $13.6 billion in foreign debt in 1999 alone. President Mahuad moved quickly to propose dollarization to save the failing Ecuadorian economy.
By January 2000, when the next president took office (after a rather complicated military coup and subsequent withdrawal), the sucre had fallen in value to Sucre25,000/$. The new president, Gustavo Naboa, continued the dollarization initiative. Although unsupported by the U.S. government and the IMF, Ecuador completed its replacement of its own currency with the dollar over the next nine months.
The results of dollarization in Ecuador are still unknown. Ecuadorian residents immedi- ately returned over $600 million into the banking system, money that they had withheld from the banks in fear of bank failure. This added capital infusion, along with new IMF loans and economic restructurings, aided economic recovery in the short-term. But today, many years later, Ecuador continues to struggle to find both economic and political balance with its new currency regime.
Currency Regime Choices for Emerging Markets There is no doubt that for many emerging markets the choice of a currency regime may be between extremes, a hard peg (a currency board or dollarization) or free-floating. In fact, many experts have argued for years that the global financial marketplace will drive more and more emerging market nations toward one of these extremes. As shown in Exhibit 3.8, there is a distinct lack of middle ground between rigidly fixed and free-floating extremes. But is the so-called “bi-polar choice” inevitable? Many have argued for years that three common features of emerging market countries make any specific currency regime choice difficult: 1) weak fiscal, financial, and monetary institu- tions; 2) tendencies for commerce to allow currency substitution and the denomination of
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77The International Monetary System CHAPTER 3
liabilities in dollars; and 3) the emerging market’s vulnerability to sudden stoppages of outside capital flows. Calvo and Mishkin may have said it best:5
Indeed, we believe that the choice of exchange rate regime is likely to be one second order importance to the development of good fiscal, financial and monetary institutions in producing macroeconomic success in emerging market countries. Rather than treating the exchange rate regime as a primary choice, we would encourage a greater focus on institutional reforms like improved bank and financial sector regulation, fiscal restraint, building consensus for a sustainable and predictable monetary policy and increasing openness to trade.
In anecdotal support of this argument, a poll of the general population in Mexico in 1999 indicated that 9 out of 10 people would prefer dollarization over a floating-rate peso. Clearly, many in the emerging markets of the world have little faith in their leadership and institutions to implement an effective exchange rate policy.
Exchange Rate Regimes: What Lies Ahead? All exchange rate regimes must deal with the trade-off between rules and discretion, as well as between cooperation and independence. Exhibit 3.9 illustrates the trade-offs between exchange rate regimes based on rules, discretion, cooperation, and independence.
1. Vertically, different exchange rate arrangements may dictate whether a country’s government has strict intervention requirements—rules—or whether it may
5“The Mirage of Exchange Rate Regimes for Emerging Market Countries,” Guillermo A. Calvo and Frederic S. Mishkin, The Journal of Economic Perspectives, Vol. 17, No. 4, Autumn 2003, pp. 99–118.
Currency Board or Dollarization
High capital mobility is forcing emerging market nations to choose between two extremes
Free-Floating Regime Currency value is free to float up and down with international market forces
Independent monetary policy and free movement of capital allowed, but at the loss of stability
Increased volatility may be more than what a small country with a small financial market can withstand
Currency board fixes the value of local currency to another currency or basket; dollarization replaces the currency with the U.S. dollar
Independent monetary policy is lost; political influence on monetary policy is eliminated Seignorage, the benefits accruing to a government from the ability to print its own money, is lost
Emerging Market Country
EXHIBIT 3.8 The Currency Regime Choices for Emerging Markets
78 CHAPTER 3 The International Monetary System
choose whether, when, and to what degree to intervene in the foreign exchange markets—discretion.
2. Horizontally, the trade-off for countries participating in a specific system is between consulting and acting in unison with other countries—cooperation—or operating as a member of the system, but acting on their own—independence.
Regime structures like the gold standard required no cooperative policies among countries, only the assurance that all would abide by the “rules of the game.” Under the gold standard in effect prior to World War II, this assurance translated into the willingness of governments to buy or sell gold at parity rates on demand. The Bretton Woods Agreement, the system in place between 1944 and 1973, required more in the way of cooperation, in that gold was no longer the “rule,” and countries were required to cooperate to a higher degree to maintain the dollar-based system. Exchange rate systems, like the European Monetary System’s fixed exchange rate band system used from 1979 to 1999, were hybrids of these cooperative and rule regimes.
The present international monetary system is characterized by no rules, with varying degrees of cooperation. Although there is no present solution to the continuing debate over what form a new international monetary system should take, many believe that it could succeed only if it combines cooperation among nations with individual discretion to pursue domestic social, economic, and financial goals.
SUMMARY POINTS
! Under the gold standard (1876–1913), the “rules of the game” were that each country set the rate at which its currency unit could be converted to a weight of gold.
! During the inter-war years (1914–1944) currencies were allowed to fluctuate over fairly wide ranges in terms of gold and each other. Supply and demand forces determined exchange rate values.
EXHIBIT 3.9 The Trade-Offs Between Exchange Rate Regimes
Discretionary Policy
Policy Rules
Non-Cooperation Between Countries
Cooperation Between Countries
Pre-WWII Gold Standard
Bretton Woods
European Monetary
System 1979–1999
The Future?
U.S. Dollar, 1981–1985
79The International Monetary System CHAPTER 3
! The Bretton Woods Agreement (1944) established a U.S. dollar-based international monetary system. Under the original provisions of the Bretton Woods Agree- ment, all countries fixed the value of their currencies in terms of gold but were not required to exchange their currencies for gold. Only the dollar remained convertible into gold ($35 per ounce).
! A variety of economic forces led to the suspension of the convertibility of the dollar into gold in August 1971. Exchange rates of most of the leading trading countries were then allowed to float in relation to the dollar and thus indirectly in relation to gold. After a series of continuing crises in 1972 and 1973, the U.S. dollar and the other leading currencies of the world have floated in value since that time.
! If the ideal currency existed in today’s world, it would possess three attributes: a fixed value, convertibility, and independent monetary policy.
! Emerging market countries must often choose between two extreme exchange rate regimes, either a free- floating regime or an extremely fixed regime such as a currency board or dollarization.
! The members of the European Union are also members of the European Monetary System (EMS). This group has tried to form an island of fixed exchange rates among themselves in a sea of major floating currencies. Members of the EMS rely heavily on trade with each other, so the day-to-day benefits of fixed exchange rates between them are perceived to be great.
! The euro affects markets in three ways: 1) Countries within the euro zone enjoy cheaper transaction costs; 2) Currency risks and costs related to exchange rate uncertainty are reduced; and 3) All consumers and businesses both inside and outside the euro zone enjoy price transparency and increase price-based competition.
The Chinese renminbi (RMB) or yuan (CNY) is going global.2 Trading in the RMB is closely controlled by the People’s Republic of China (PRC), the Chinese government, with all trading inside China between the RMB and foreign currencies, primarily the U.S. dollar, being conducted only according to Chinese regulations. Its value, as illustrated in Exhibit 1, has been carefully controlled. Although it has been allowed to revalue gradually against the dollar over time, most indicators and analysts believe it to still be grossly undervalued. The Chinese government, however, is now starting to relax restrictions, releasing the yuan to move toward prominence as a truly global currency.
The first and foremost traditional role for currency trading is through its use in the settlement of trade transactions—the denomination of exports (which generate foreign currency inflows traditionally) and imports (which use up foreign currency reserves traditionally) in the currency—and that is already changing rapidly. In 2009, of
2The People’s Republic of China officially recognizes the terms renminbi (RMB) and yuan (CNY) as names of its official currency. Formally, the term yuan is used in reference to the unit of account, while the physical currency itself is termed the renminbi. This Mini-Case will follow that usage, using RMB to refer to the currency of China and CNY and other forms to reflect its trading in different markets.
the $1.2 trillion of Chinese exports only about 1% were denominated in RMB. By the end of the first quarter of 2011, in a little more than one year, that percentage had risen to 7%.3 The Chinese government had now reversed its policy and was now encouraging exporters to convert to RMB invoicing.
A Chinese exporter is typically paid in U.S. dollars, and has historically not been allowed to keep the dollar pro- ceeds in any bank account. Exporters are required to exchange all foreign currencies for RMB at the official exchange rate set by the PRC. All hard-currency earnings from massive Chinese exports are therefore turned over to the Chinese government. The result has been a gross accu- mulation of foreign currency ($3.2 trillion at end-of-year 2011) not seen in global business history.4 But now, with RMB denomination of exports, foreign buyers are now being pushed to the exchange markets to acquire RMB for purchases, increasing trade-related currency trading.
3“Get Ready: Here Comes the Yuan,” The Wall Street Journal, June 2, 2011. 4“Offshore Trading in Yuan Takes Off,” The Wall Street Journal, December 13, 2010.
The Yuan Goes Global1
1Copyright © 2012 Thunderbird School of Global Management. All rights reserved. This case was prepared by Professor Michael Moffett for the purpose of classroom discussion only and not to indicate either effective or ineffective management.
MINI-CASE
80 CHAPTER 3 The International Monetary System
But Hong Kong has a preferred access to yuan under PRC rules. Beginning in January 2004, Hong Kong residents were allowed to hold RMB in cash and bank deposits. They were allowed to obtain these balances through limited trading; daily transfers were limited to RMB 20,000 (roughly $2,400 at the exchange rate of RMB 8.27/USD at the time). Although this did allow a legal conduit for the movement of RMB out of the onshore market, its volume was so small it was inconsequential. This currency, however small in volume, is now referred to as CNH (as shown in Exhibit 2), Hong Kong-based trading in RMB.5 It has been the basis for some limited financial product development, but has been significantly lacking in trading volume until recently. This market is now starting to boom, with RMB deposits in Hong Kong banks recently estimated at end-of-year 2011 at nearly $90 billion.
This has not, however, sated the thirst for RMB by a multitude of different traders outside of mainland China. As a result, a market has grown over the past decade for
5CNY is the official ISO code for the Chinese currency. Although CNH is in increasingly common usage, it is not at this time an offi- cially recognized code.
Inevitably, the currency of an economy of the size and scope of China’s will result in more and more of its currency leaving China. Although it has restricted the flow of yuan out of China for many years, ultimately more and more will find its way beyond the reach of the onshore authorities. Once out of the reach of Chinese authorities, the yuan will be traded freely without government intervention. China knows this all too well, and has therefore adopted a gradual policy of developing the trad- ing in the yuan—but through its own onshore offshore market, Hong Kong.
Offshore (Hong Kong) Trading Hong Kong is a product of the “one country two systems” development of the PRC. Although a possession of the PRC, Hong Kong (as well as Macau) has been allowed to continue to operate and develop along its traditional free-market ways, but for currency purposes, Hong Kong was offshore. Hong Kong’s own currency, the Hong Kong dollar (HKD), has long floated in value against the world’s currencies.
RMB/USD
Value fixed at RMB 8.28 = USD 1.0
People ’s Bank of China announces that it is abandoning its peg to the U.S. dollar on July 21, 2005
Continuation of a “managed floating exchange rate regime” translating into a gradual revaluation of the RMB against the dollar
Jan -94
Jul -94
Jan -95
Jul -95
Jan -96
Jul -96
Jan -97
Jul -97
Jan -98
Jul -98
Jan -99
Jul -99
Jan -00
Jul -00
Jan -01
Jul -01
Jan -02
Jul -02
Jan -03
Jul -03
Jan -04
Jul -04
Jan -05
Jul -05
Jan -06
Jul -06
Jan -07
Jul -07
Jan -08
Jul -08
Jan -09
Jul -09
Jan -10
Jul -10
Jan -11
Jul -11
Jan -12
6.0
6.5
7.0
7.5
8.0
8.5
9.0
EXHIBIT 1 The Gradual Revaluation of the RMB (1994–2010)
81The International Monetary System CHAPTER 3
mainland China—the market will still be limited in its growth potential.
Charles Li, Chief Executive of HKEx (Hong Kong Exchanges and Clearing Limited), had a unique way of explaining why the accumulating RMB in Hong Kong needs greater backflow ability to China (followed by Morgan Stanley’s graphical depiction of the fish process in Exhibit 3):6
To understand the different challenges in these three stages, the following analogy might be of some help. If we see RMB flows as water and RMB products as fish, the logic will be clear. Fish do not exist where there is no water and they cannot survive if the water is stagnant. Without nutrients in the water, fish don’t grow. The nutrients, representing returns on RMB products, can only come from the home market. That’s why the off- shore RMB must be allowed to flow back, at least at the initial stage.
As Mr. Li (and Morgan Stanley) make so vividly clear, for the RMB market in Hong Kong to grow and sustain it needs the ability to return to the Chinese mainland freely to have a “purpose”—to gain returns from RMB- based trading and commercial purposes. The RMB can only be used in China, and China’s State Administration of Foreign Exchange (SAFE) must approve all transfers
6“Six Questions Regarding the Internationalisation of the Renminbi,” HKEx Chief Executive Charles Li, 21 Sept. 2010.
CNY-NDFs, nondeliverable forwards (NDFs) based on the officially cited value of the CNY by the Chinese govern- ment. These are forward contracts whose value is deter- mined by the PRC-posted exchange value of the CNY, but are nondeliverable, meaning they are settled in a cur- rency like the dollar or euro, not the CNY itself (because that would take access to physical volumes or deposits of RMB).
The flow of RMB into the Hong Kong market, however, boomed in 2010 and 2011 as a result of a series of regulatory changes by the PRC. In July 2010, the PRC began allowing unlimited exchange and flow of RMB into Hong Kong for trade-related transactions—payments for imports denominated in Chinese RMB.
The Question of Backflow The challenge to the growth of the Hong Kong offshore market is what to do with the growing balances of RMB. Although the RMB may flow from the onshore Chinese mainland into Hong Kong for import purchases, the receivers of the RMB will recycle these flows into the Hong Kong market upon receipt as the currency has no real trading use outside of Hong Kong or China as a whole. According to a variety of Hong Kong-based currency analysts, unless the holders of these RMB balances in Hong Kong can gain access to the onshore market—
Chinese Renminbi (RMB)
CNY-NDFCNY
Trading of RMB-based forward contracts
in the offshore market.
Trading of RMB in the regulated onshore
Chinese market.
Trading of RMB in the Hong Kong offshore market.
Chinese yuan (unit of account) and renminbi (physical currency)
CNH
EXHIBIT 2 Evolution of Trading in the Chinese Renminbi
CHAPTER 3 The International Monetary System 82
RMB 200 million 3% notes due September 2013, was targeted at institutional investors.
The bonds—colloquially termed Panda Bonds or the Dim Sum Bond Market—was the first issue denominated in RMB by a nonfinancial non-Chinese firm in the global market. Although small in size, roughly $30 million, the issue was something of a sign of what the future might hold for multinational enterprises operating in the world’s second largest economy: the ability to both operate and fund their business growth in Chinese RMB. The McDonald’s issuance was followed by a larger $150 million RMB-bond by Caterpillar Corporation (U.S.), and in January 2011 by a CNY 500 million ($75.9 million) issuance by the World Bank.9
Are the Tides Turning? The year 2011 saw a number of rather surprising changes in markets and regulations which may fore- tell the true globalization of the yuan. It is important to remember that one of the ongoing concerns of the Chinese government over the globalization of the yuan is that deregulation could result in a flood of capital into the Chinese market—into RMB accounts—driving the currency’s value up over time and damaging export competitiveness.
9“World Bank Issues Yuan Bond,” The Wall Street Journal, January 5, 2011.
of RMB into the country on a case-by-case basis, even from Hong Kong.7
Breadth and Depth of RMB Trading Although the quotation of CNH deposit rates are listed on the counters of most Hong Kong banks today, side-by- side with U.S. dollar and Hong Kong dollar rates, there will continue to be a limited demand for these funds by the institutions themselves in the near future unless the PRC allows greater backflow into the onshore market. The offshore Hong Kong market took a highly visible step forward in August 2010 with the launch of an RMB- denominated corporate bond issue for McDonald’s Corporation (U.S.):8
19 August 2010, Hong Kong-Standard Chartered Bank (Hong Kong) Limited proudly announces the launch of a RMB corporate bond for the Bank’s Multinational Corporate Client McDonald’s Corporation. It is the first ever RMB bond launched for a foreign Multinational Corporate in the Hong Kong debt capital market signifying the commencement of a new funding channel for international companies to raise working capital for their China operations. It is also a significant contribution to the development of the off- shore RMB debt capital market in Hong Kong. The
7Deregulation of the onshore market is progressing as well. Beginning in April 2011 the Chinese government allowed the initiation of trading in yuan currency options amongst a select set of major banks in the Shanghai market. 8“Standard Chartered Launches RMB Corporate Bond in Hong Kong for McDonald’s Corporation,” Press Release, Standard Char- tered, August 19, 2010, Hong Kong.
“Backflow”
“Mainland”
“Water”: Offshore RMB Flows
“Nutrients”: CNH Returns
“Fish”: CNH Products
Source: FX Pulse, Morgan Stanley. December 2, 2010, p. 14.
EXHIBIT 3 Necessary Medium for the Growth of the RMB
83The International Monetary System CHAPTER 3
economic policies may on occasion require both contraction and the creation of a current account surplus (balance on trade surplus). But if a currency is to be used as a reserve currency, other countries will require the country to run current account deficits, essentially dumping growing quantities of the currency on global markets. This means that a country like the United States needs to become inter- nationally indebted as part of its role as a reserve currency country. In short, when the world adopts a currency as a reserve currency, demands are placed on the use and avail- ability of that currency which many countries would prefer not to deal with. In fact, both Japan and Switzerland had both worked for decades to prevent their currencies from gaining wider international use, partially as a result of these complex issues.
Outside of reserve currency status, there are a multi- tude of other factors and levels of trade and capital market developments related to a currency which could determine the degree to which it could be considered “international” in character. Exhibit 4 provides a very recent assessment across currencies by the IMF as to which currencies are more international/global than others. Note the relatively low ranking for the RMB—at this time—in the first three categories of being widely used as a reserve currency, in international trade and capital payments, and currency trading.
Many experts have speculated for years that it would take nearly a generation before the yuan might find its way into the international marketplace. Those forecasts had now changed. It was globalizing, and fast. The growth of the offshore yuan market in Hong Kong represented only the first step on that journey—but an obviously important one for the RMB.
Case Questions 1. How does the Chinese government limit the use of the
Chinese currency, the RMB, on the global currency markets?
2. What are the differences between the RMB, the CNY, the CNH, and the CNY-NDF?
3. Why was the McDonald’s bond issue so significant? 4. Will—if ever—the RMB become a truly global currency?
11The theory is the namesake of its originator, Belgian-American economist Robert Triffin (1911–1963), who was an outspoken critic of the Bretton Woods Agreement, as well as a strong advocate and collaborated in the development of the European Monetary Sys- tem (EMS).
! The Chinese economy’s rate of growth slowed in 2011, and may have slowed dramatically in the last quarter of the year. Chinese factory activity showed declines, as a multitude of economic factors, including rising wage rates in the coastal provinces, hampered Chinese export competitiveness. A number of other major emerging markets, including India, also showed sluggish growth.
! A number of analysts and sources (including the Economist’s own Big Mac Index) began noting that the exchange value of the yuan may be approaching parity in the latter half of 2011. This would mean that the Chinese government’s management of the currency’s trading has found a “resting spot” in terms of value.
! Many market analysts and economists are predicting that the RMB will globalize rapidly, taking on the role of a reserve currency within the next decade. Forecasts of its share of global reserves vary between 15% and 50% by the year 2002.10
Global Currency The globalization of the Chinese yuan could quickly go far beyond being widely traded. The growing debate was whether the yuan could potentially become a reserve currency (also commonly referred to as an anchor currency)—a currency that much of the world’s governments and central banks would acquire and hold and use as part of their foreign currency reserves. The con- tinued fiscal deficits dilemmas in the United States and among European Union members had both resulted in a growing unease in the world’s central banks over the ability of the dollar and the euro to maintain their value over time. Could, or should, the yuan serve as such a replacement?
One theoretical concern about becoming a reserve currency was the Triffin Dilemma (or sometimes called the Triffin Paradox). The Triffin Dilemma is the potential conflict in objectives which 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.11 Domestic monetary and
10“Deutsche Bank: The Renminbi Will Be the World’s Next Major Reserve Currency,” Businessinsider.com, December 5, 2011.
84 CHAPTER 3 The International Monetary System
of each of these regimes from the perspective of emerging market nations?
7. Argentine Currency Board. How did the Argentine currency board function from 1991 to January 2002 and why did it collapse?
8. The Euro. On January 4, 1999, 11 member states of the European Union initiated the European Monetary Union (EMU) and established a single currency, the euro, which replaced the individual currencies of participating member states. Describe three of the main ways that the euro affects the members of the EMU.
9. Mavericks. The United Kingdom, Denmark, and Sweden have chosen not to adopt the euro but rather maintain their individual currencies. What are the motivations of each of these countries that are also members of the European Union?
10. International Monetary Fund (IMF). The IMF was established by the Bretton Woods Agreement (1944). What were its original objectives?
11. Special Drawing Rights. What are Special Drawing Rights?
12. Exchange Rate Regime Classifications. The IMF classifies all exchange rate regimes into four specific
QUESTIONS 1. The Gold Standard and the Money Supply. Under the
gold standard all national governments promised to follow the “rules of the game.” This meant defending a fixed exchange rate. What did this promise imply about a country’s money supply?
2. Causes of Devaluation. If a country follows a fixed exchange rate regime, what macroeconomic variables could cause the fixed exchange rate to be devalued?
3. Fixed Versus Flexible. What are the advantages and disadvantages of fixed exchange rates?
4. The Impossible Trinity. Explain what is meant by the term Impossible Trinity and why it is true.
5. 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?
6. 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
EXHIBIT 4 A Score Board of International Currency Status
• Criteria fully met " Criteria partially met ° Criteria not met
Advanced Economy Currencies USD Euro Yen Pound SWF AUD CAD NZD
Widely used as international reserves • • • • " ° ° ° Widely used in capital and trade payments • • " " ° ° ° ° Widely traded in FX markets • • • • " " " " Economic size • • • • " " " ° Trade network • • • • " " " " Investability • • • • • • • • Capital account openness • • • • • � • • Financial depth index • • • • " " " °
Emerging Market Currencies HKD Won SGD RMB Real Rupee Ruble Rand
Widely used as international reserves ° ° ° ° ° ° ° ° Widely used in capital and trade payments ° ° ° ° ° ° ° ° Widely traded in FX markets • " " ° ° ° ° ° Economic size ° " ° • " " " " Trade network " " " • " " " " Investability • • • • " " " •
Capital account openness • " • ° " ° " ° Financial depth index " " " • " " " "
Source: “Internationalization of Emerging Market Currencies: A Balance Between Risks and Rewards,” Samar Maziad, Pascal Farahmand, Shegzu Wang, Stephanie Segal, and Faisal Ahmed, IMF Staff Discussion Note SDN/11/17, October 19, 2011, p.14. Investability • based on sovereign risk ratings of ‘A’ or above by Moody’s and S&P. Capital account openness based on Chinn and Ito Capital Account Openness Indicator, 2008. Financial depth index based on country contributions to global financial depth, where • is reserved for the top five contributors.
84 CHAPTER 3 The International Monetary System
85The International Monetary System CHAPTER 3
8. Ranbaxy (India) in Brazil. Ranbaxy, an India-based pharmaceutical firm, has continuing problems with its cholesterol reduction product’s price in one of its rapidly growing markets, Brazil. All product is produced in India, with costs and pricing initially stated in Indian rupees (Rps), but converted to Brazilian reais (R$) for distribution and sale in Brazil. In 2009, the unit volume was priced at Rps21,900, with a Brazilian reais price set at R$895. But in 2010, the reais appreciated in value versus the rupee, averaging Rps26.15/R$. In order to preserve the reais price and product profit margin in rupees, what should the new rupee price be set at?
9. Toyota Exports to the United Kingdom. Toyota manufactures most of the vehicles it sells in the United Kingdom in Japan. The base platform for the Toyota Tundra truck line is ¥1,650,000. The spot rate of the Japanese yen against the British pound has recently moved from ¥197/£ to ¥190/£. How does this change the price of the Tundra to Toyota’s British subsidiary in British pounds?
10. Vietnamese Coffee Coyote. Many people were surprised when Vietnam became the second largest coffee producing country in the world in recent years, second only to Brazil. The Vietnamese dong, VND or d, is managed against the U.S. dollar but is not widely traded. If you were a traveling coffee buyer for the wholesale market (a “coyote” by industry terminology), which of the following currency rates and exchange commission fees would be in your best interest if traveling to Vietnam on a buying trip with an initial $10,000 for exchange?
categories that are summarized in this chapter. Under which exchange rate regime would you classify the fol- lowing countries? a. France b. The United States c. Japan d. Thailand
13. The Ideal Currency. What are the attributes of the ideal currency?
14. Bretton Woods Failure. Why did the fixed exchange rate regime of 1945–1973 eventually fail?
PROBLEMS 1. Gilded Question. Before World War I, $20.67 was
needed to buy one ounce of gold. If, at the same time one ounce of gold could be purchased in France for FF410.00, what was the exchange rate between French francs and U.S. dollars?
2. Worth Its Weight in Gold. Under the gold standard, the price of an ounce of gold in U.S. dollars was $20.67, while the price of that same ounce in British pounds was £3.7683. What would be the exchange rate between the dollar and the pound if the U.S. dollar price had been $42.00 per ounce?
3. DuBois and Keller. Chantal DuBois lives in Brussels. She can buy a U.S. dollar for €0.7600. Christopher Keller, living in New York City, can buy a euro for $1.3200. What is the foreign exchange rate between the dollar and the euro?
4. Mexican Peso Changes. In December 1994, the government of Mexico officially changed the value of the Mexican peso from 3.2 pesos per dollar to 5.5 pesos per dollar. What was the percentage change in its value? Was this a depreciation, devaluation, appreciation, or revaluation? Explain.
5. Amazing Incorporated. The spot rate for Mexican pesos is Ps12.42/$. If U.S.-based company Amazing Inc. buys Ps500,000 spot from its bank on Monday, how much must Amazing Inc. pay and on what date?
6. Loonie Parity. If the price of former Chairman of the U.S. Federal Reserve Alan Greenspan’s memoir, The Age of Turbulence, is listed on Amazon.ca as C$26.33, but costs just US$23.10 on Amazon.com, what exchange rate does that imply between the two currencies?
7. Hong Kong Dollar and the Chinese Yuan. The Hong Kong dollar has long been pegged to the U.S. dollar at HK$7.80/$. When the Chinese yuan was revalued in July 2005 against the U.S. dollar from Yuan8.28/$ to Yuan8.11/$, how did the value of the Hong Kong dollar change against the yuan?
Currency Exchange Rate Commission
Vietnamese bank rate d19,800 2.50%
Saigon Airport exchange bureau rate d19,500 2.00%
Hotel exchange bureau rate d19,400 1.50%
11. Chinese Yuan Revaluation. Many experts believe that the Chinese currency should not only be revalued against the U.S. dollar as it was in July 2005, but also be revalued by 20% or 30%. What would be the new exchange rate value if the yuan was revalued an additional 20% or 30% from its initial post- revaluation rate of Yuan 8.11/$?
12. Middle East Exports. Oriol Díez Miguel S.R.L., a manufacturer of heavy duty machine tools near Barcelona, ships an order to a buyer in Jordan. The purchase price is €425,000. Jordan imposes a 13% import duty on all products purchased from
86 CHAPTER 3 The International Monetary System
INTERNET EXERCISES 1. International Monetary Fund’s Special Drawing
Rights. The Special Drawing Right (SDR) is a composite index of six key participant currencies. Use the IMF’s Web site to find the current weights and valuation of the SDR.
the European Union. The Jordanian importer then re-exports the product to a Saudi Arabian importer, but only after imposing their own resale fee of 28%. Given the following spot exchange rates on April 11, 2010, what is the total cost to the Saudi Arabian importer in Saudi Arabian riyal, and what is the U.S. dollar equivalent of that price?
Date of Spot Rate British Pound Spot Rate (£/$) Euro Spot Rate (€/$)
Monday 0.5702 0.8304
Tuesday 0.5712 0.8293
Wednesday 0.5756 0.8340
Currency Crossrate Spot Rate
Jordanian dinar (JD) per euro (€) JD 0.96/€
Jordanian dinar (JD) per U.S. dollar ($) JD 0.711/$
Saudi Arabian riyal (SRI) per U.S. dollar ($) SRI 3.751/$
International Monetary Fund
www.imf.org/external/np/ tre/sdr/sdrbasket.htm
2. Malaysian Currency Controls. The institution of currency controls by the Malaysian government in the aftermath of the Asian currency crisis is a classic response by government to unstable currency conditions. Use the following Web site to increase your knowledge of how currency controls work.
EconEdLink www.econedlink.org/lessons/ index.cfm?lesson=EM25
3. Personal Transfers. As anyone who has traveled internationally learns, the exchange rates available to private retail customers are not always as attractive as those accessed by companies. The OzForex Web site possesses a section on “customer rates” which illustrates the difference. Use the site to calculate what the percentage difference between Australian dollar/U.S. dollar spot exchange rates are for retail customers versus interbank rates.
OzForex www.ozforex.com.au/exchange-rate
4. Exchange Rate History. Use the Pacific Exchange Rate database and plot capability to track the British pound’s, the U.S. dollar’s, and the Japanese yen’s value changes against each other over the past 15 years.
Pacific Exchange fx.sauder.ubc.ca Rate Service
13. Chunnel Choices. The Channel Tunnel or “Chunnel” passes underneath the English Channel between Great Britain and France, a land-link between the Continent and the British Isles. One side is therefore an economy of British pounds, the other euros. If you were to check the Chunnel’s rail ticket Internet rates you would find that they would be denominated in U.S. dollars (USD). For example, a first class round trip fare for a single adult from London to Paris via the Chunnel through RailEurope may cost USD170.00. This currency neutrality, however, means that customers on both ends of the Chunnel pay differing rates in their home currencies from day to day. What is the British pound and euro denominated prices for the USD170.00 round trip fare in local currency if purchased on the following dates at the accompanying spot rates drawn from the Financial Times?
87
The Balance of Payments
The sort of dependence that results from exchange, i.e., from commercial transactions, is a reciprocal dependence. We cannot be dependent upon a foreigner without his being dependent on us. Now, this is what constitutes the very essence of society. To sever natural interrelations is not to make oneself independent, but to isolate oneself completely.
—Frederic Bastiat.
International business transactions occur in many different forms over the course of a year. The measurement of all international economic transactions between the residents of a coun- try and foreign residents is called the balance of payments (BOP). This chapter provides a type of navigational map to the understanding of balance of payments and the multitude of economic, political, and business issues which it involves. But our emphasis is far from descriptive, as a deep understanding of trade and capital flows is integral to the manage- ment of multinational enterprises. In fact, the second half of the chapter emphasizes a more detailed analysis of how elements of the balance of payments affect trade prices and market volumes, as well as how capital flows, capital controls, and capital flight alter the cost and ability to do business internationally. The chapter concludes with the Mini-Case, Global Remittances, an element of the current account in the balance of payments and the subject of significant controversy globally.
The official terminology used throughout this chapter is that of the International Mon- etary Fund, or IMF. Because the IMF is the primary source of similar statistics for balance of payments and economic performance by nations worldwide, its language is more general than other terminology such as that employed by the U.S. Department of Commerce. Govern- ment policy makers need such measures of economic activity in order to evaluate the general competitiveness of domestic industry, to set exchange rate or interest rate policies or goals, and for many other purposes. MNEs use various BOP measures to gauge the growth and health of specific types of trade or financial transactions by country and regions of the world.
Home-country and host-country BOP data are important to business managers, inves- tors, consumers, and government officials because the data influences and is influenced by other key macroeconomic variables such as gross domestic product, employment levels, price levels, exchange rates, and interest rates. Monetary and fiscal policy must take the BOP
CHAPTER 4
88 CHAPTER 4 The Balance of Payments
into account at the national level. Business managers and investors need BOP data to antici- pate changes in host-country economic policies that might be driven by BOP events. BOP data is also important for the following reasons:
! The BOP is an important indicator of pressure on a country’s foreign exchange rate, and thus of the potential for a firm trading with or investing in that country to experi- ence foreign exchange gains or losses. Changes in the BOP may predict the imposi- tion 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 disburse- ments 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 as likely to expand imports as it would be if running a surplus. It may, however, welcome investments that increase its exports.
Typical Balance of Payments Transactions International transactions take many forms. Each of the following examples is an international economic transaction that is counted and captured in the U.S. balance of payments:
! Honda U.S. is the U.S. distributor of automobiles manufactured in Japan by its parent company, Honda of Japan.
! A U.S.-based firm, Fluor Corporation, manages the construction of a major water treat- ment facility in Bangkok, Thailand.
! The U.S. subsidiary of a French firm, Saint Gobain, pays profits (dividends) back to its parent firm in Paris.
! An American tourist purchases a small Lapponia necklace in Finland. ! The U.S. government finances the purchase of military equipment for its NATO (North
Atlantic Treaty Organization) military ally, Norway. ! A Mexican lawyer purchases a U.S. corporate bond through an investment broker in
Cleveland.
This is a small sample of the hundreds of thousands of international transactions that occur each year. The balance of payments provides a systematic method for classifying these transactions. One rule of thumb always aids the understanding of BOP accounting: “Follow the cash flow.”
The BOP is composed of a number of subaccounts that are watched quite closely by groups as diverse as investment bankers, farmers, politicians, and corporate executives. These groups track and analyze the major subaccounts, the current account, the capital account, and the financial account, continually. Exhibit 4.1 provides an overview of these major subaccounts of the BOP.
Fundamentals of Balance of Payments Accounting The BOP must balance. If it does not, something has not been counted or has been counted improperly. Therefore, it is incorrect to state that the BOP is in disequilibrium. It cannot be. The supply and demand for a country’s currency may be imbalanced, but supply and demand are not the same thing as the BOP. A subaccount of the BOP, such as the merchandise trade balance, may be imbalanced, but the entire BOP of a single country is always balanced.
89The Balance of Payments CHAPTER 4
There are three main elements of the actual process of measuring international economic activity: 1) identifying what is and is not an international economic transaction; 2) understand- ing how the flow of goods, services, assets, and money creates debits and credits to the overall BOP; and 3) understanding the bookkeeping procedures for BOP accounting.
Defining International Economic Transactions Identifying international transactions is ordinarily not difficult. The export of merchandise— goods such as trucks, machinery, computers, telecommunications equipment and so forth—is obviously an international transaction. Imports such as French wine, Japanese cameras, and German automobiles are also clearly international transactions. But this merchandise trade is only a portion of the thousands of different international transactions that occur in the United States and other countries each year.
Many other international transactions are not so obvious. The purchase of a glass figure in Venice, Italy, by a U.S. tourist is classified as a U.S. merchandise import. In fact, all expenditures made by U.S. tourists around the globe for services (e.g., restaurants and hotels), but not for goods, are recorded in the U.S. balance of payments as imports of travel services in the current account. The purchase of a U.S. Treasury bill by a foreign resident is an international financial transaction and is duly recorded in the financial account of the U.S. balance of payments.
The BOP 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 of time 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.
Two types of business transactions dominate the balance of payments:
1. Exchange of real assets. The exchange of goods (e.g., automobiles, computers, watches, and textiles) and services (e.g., banking, consulting, and travel services) for other goods and services (barter) or for money
2. Exchange of financial assets. The exchange of financial claims (e.g., stocks, bonds, loans, and purchases or sales of companies) for other financial claims or money
A. Current Account
1. Net exports/imports of goods (balance of trade)
2. Net exports/imports of services
3. Net income (investment income from direct and portfolio investment plus employee compensation)
4. Net transfers (sums sent home by migrants and permanent workers abroad, gifts, grants, and pensions)
A(1 - 4) = Current Account Balance
B. Capital Account
Capital transfers related to the purchase and sale of fixed assets such as real estate
C. Financial Account
1. Net foreign direct investment
2. Net portfolio investment
3. Other financial items A + B + C = Basic Balance
D. Net Errors and Omissions
1. Missing data such as illegal transfers A + B + C + D = Overall Balance
E. Reserves and Related Items
Changes in official monetary reserves including gold, foreign exchange, and IMF position
EXHIBIT 4.1 Generic Balance of Payments
90 CHAPTER 4 The Balance of Payments
Although assets can be identified as real or financial, it is often easier simply to think of all assets as goods that can be bought and sold. The purchase of a hand-woven area rug in a shop in Bangkok by a U.S. tourist is not all that different from a Wall Street banker buying a British government bond for investment purposes.
BOP Accounting The measurement of all international transactions in and out of a country over a year is a daunting task. Mistakes, errors, and statistical discrepancies will occur. The primary problem is that double-entry bookkeeping is employed in theory, but not in practice. Individual purchase and sale transactions should—in theory—result in financing entries in the balance of payments that match. In reality, the entries are recorded independently. Current, financial, and capital account entries are recorded independently of one another, not together as double-entry bookkeeping would prescribe. Thus, there will be serious discrepancies (to use a nice term for it) between debits and credits.
The Accounts of the Balance of Payments The balance of payments is composed of three primary subaccounts: the current account, the financial account, and the capital account. In addition, the official reserves account tracks government currency transactions, and a fifth statistical subaccount, the net errors and omissions account, is produced to preserve the balance in the BOP. The international economic relationships between countries, however, continue to evolve, as the recent revision of the major accounts within the BOP discussed in the following sections indicates.
The Current Account The current account includes all international economic transactions with income or payment flows occurring within the year, the current period. The current account consists of four subcategories:
1. Goods trade. The export and import of goods is known as the goods trade. Merchan- dise trade is the oldest and most traditional form of international economic activity. Although many countries depend on imports of goods (as they should, according to the theory of comparative advantage), they also normally work to preserve either a balance of goods trade or even a surplus.
2. Services trade. The export and import of services is known as the services trade. Common international services are financial services provided by banks to foreign importers and exporters, travel services of airlines, and construction services of domestic firms in other countries. For the major industrial countries, this subaccount has shown the fastest growth in the past decade.
3. Income. This is predominantly current income associated with investments that were made in previous periods. If a U.S. firm created a subsidiary in South Korea to pro- duce metal parts in a previous year, the proportion of net income that is paid back to the parent company in the current year (the dividend) constitutes current invest- ment income. Additionally, wages and salaries paid to nonresident workers are also included in this category.
4. Current transfers. The financial settlements associated with the change in ownership of real resources or financial items are called current transfers. Any transfer between countries that is one-way—a gift or grant—is termed a current transfer. For example, funds provided by the U.S. government to aid in the development of a less-developed nation would be a current transfer. Transfers associated with the transfer of fixed assets are included in a separate account, the capital account.
91The Balance of Payments CHAPTER 4
All countries possess some amount of trade, most of which is merchandise. Many smaller and less-developed countries have little in the way of service trade, or items that fall under the income or transfers subaccounts.
The current account is typically dominated by the first component described, the export and import of merchandise. For this reason, the balance of trade (BOT), which is so widely quoted in the business press in most countries, refers to the balance of exports and imports of goods trade only. If the country is a larger industrialized country, however, the BOT is somewhat misleading, in that service trade is not included. Exhibit 4.2 summarizes the current account and its components for the United States for the 2002–2010 period. As illustrated, the U.S. goods trade balance has been consistently negative, but has been partially offset by the continuing surplus in services trade balance.
Goods Trade Exhibit 4.3 places the current account values of Exhibit 4.2 in perspective over time by dividing the current account into its two major components: 1) goods trade and 2) services trade and investment income. The first and most striking message is the magnitude of the goods trade deficit in the period shown (a continuation of a position created in the early 1980s). The balance on services and income, although not large in comparison to net goods trade, has with few exceptions run a surplus over the past two decades.
The deficits in the BOT of the past decade have been an area of considerable concern for the United States, in both the public and private sectors. Merchandise trade is the original core of international trade. The manufacturing of goods was the basis of the industrial revolution and the focus of the theory of comparative advantage in international trade. Manufacturing is traditionally the sector of the economy that employs most of a country’s workers. The goods trade deficit of the 1980s saw the decline of traditional heavy industries in the United States, industries that through history employed many U.S. workers. Declines in the BOT in areas such as steel, automobiles, automotive parts, textiles, and shoe manufacturing caused massive economic and social disruption.
EXHIBIT 4.2 The United States Current Account, 2002–2010 (billions of U.S. dollars)
2002 2003 2004 2005 2006 2007 2008 2009 2010
Goods exports 686 733 825 916 1043 1168 1312 1074 1293
Goods imports -1167 -1271 -1486 -1693 -1876 -1984 -2139 -1576 -1936
Goods trade balance (BOT) -481 -538 -661 -778 -833 -816 -827 -503 -642
Services trade credits 289 290 338 372 417 487 531 501 544
Services trade debits -231 -243 -282 -303 -337 -367 -402 -380 -402
Services trade balance 58 47 55 69 80 119 129 121 142
Income receipts 281 322 416 537 685 834 814 600 663
Income payments -254 -279 -351 -469 -640 -732 -667 -472 -498
Income balance 27 44 65 69 44 101 147 128 165
Current transfers, credits 12 15 20 19 27 25 26 22 16
Current transfers, debits -77 -87 -109 -125 -118 -140 -152 -145 -152
Net transfers -65 -72 -88 -106 -92 -115 -126 -123 -136
Current Account Balance -461 -519 -629 -746 -801 -710 -677 -377 -471
Source: Derived from Balance of Payments Statistics Yearbook, International Monetary Fund, December 2011, p. 1101.
92 CHAPTER 4 The Balance of Payments
Understanding merchandise import and export performance is much like understanding the market for any single product. The demand factors that drive both are income, the economic growth rate of the buyer, and price of the product in the eyes of the consumer after passing through an exchange rate. For example, U.S. merchandise imports reflect the income level of U.S. consumers and growth of industry. As income rises, so does the demand for imports. Exports follow the same principles, but in the reverse. U.S. manufacturing exports depend not on the incomes of U.S. residents, but on the incomes of buyers of U.S. products in all other coun- tries around the world. When these economies are growing, the demand for U.S. products rises.
The service component of the U.S. current account is a mystery to many. As illustrated in Exhibits 4.2 and 4.3, the United States has consistently run a surplus in services trade income. The major categories of services include travel and passenger fares; transportation services; expenditures by U.S. students abroad and foreign students pursuing studies in the United States; telecommunications services; and financial services. But there are many mysteries in current account numbers, as noted by Global Finance in Practice 4.1.
The Capital and Financial Accounts The capital and financial accounts of the balance of payments measure all international eco- nomic transactions of financial assets.
The capital account is made up of transfers of financial assets and the acquisition and disposal of nonproduced/nonfinancial assets. This account has been introduced as a sepa- rate component in the IMF’s balance of payments only recently. The magnitude of capital
EXHIBIT 4.3
19 85
19 86
19 87
19 88
19 89
19 90
19 91
19 92
19 93
19 94
19 95
19 96
19 97
19 98
19 99
20 00
20 01
20 02
20 03
20 04
20 05
20 06
20 07
20 08
20 09
20 10
–$900
–$800
–$700
–$600
–$500
–$400
–$300
–$200
–$100
$0
$100
$200
Balance on goods Balance on services
Source : Balance of Payments Statistics Yearbook, International Monetary Fund, December 2011, p. 1101.
U.S. Trade Balances on Goods and Services, 1985–2010
93The Balance of Payments CHAPTER 4
transactions covered is relatively minor, and we will include it in principle in all of the following discussion of the financial account.
Financial Account Components The financial account consists of four components: direct investment, portfolio investment, net financial derivatives, and other asset investment (discussed in detail below). Financial assets can be classified in a number of different ways, including by the length of the life of the asset (its maturity) and the nature of the ownership (public or private). The financial account, however, uses a third method, the degree of control over assets or operations, as in portfolio investment, where the investor has no control, or direct investment, where the investor exerts some explicit degree of control over the assets.
Direct Investment. This investment measure is the net balance of capital dispersed from and into the United States for the purpose of exerting control over assets. If a U.S. firm builds a new automotive parts facility in another country or actually purchases a company in another country, this is a direct investment in the U.S. balance of payments accounts. When the capital flows out of the U.S., it enters the balance of payments as a negative cash flow. If, however, a foreign firm purchases a firm in the U.S., it is a capital inflow and enters the balance of payments positively.1
The 1980s boom in foreign investment into the United States, or foreign resident pur- chases of assets in the United States, was extremely controversial. The source of concern over
1Whenever 10% or more of the voting shares in a U.S. company are held by foreign investors, the company is clas- sified as the U.S. affiliate of a foreign company, and as a foreign direct investment. Similarly, if U.S. investors hold 10% or more of the control in a company outside the United States, that company is considered the foreign affili- ate of a U.S. company.
There are three kinds of lies: lies, damned lies and statistics. —Author unknown, though frequently attributed to Lord
Courtney, Sir Charles Dilke, or Mark Twain.
One country’s surplus is another country’s deficit. That is, indi- vidual countries may and do run current account deficits and surpluses, but it should be, theoretically, a zero sum game. But according to the IMF’s most recent World Economic Out- look, however, the world is running a current account surplus. At least that is what the statistics say.*
The rational explanation is that the statistics as reported to the IMF by its member countries are in error. Those errors are most likely both accidental and intentional. The IMF believed for many years that the most likely explanation was under-reporting of foreign investment income by residents of the wealthier indus- trialized countries, as well as under-reporting of transportation
*World Economic Outlook: Slowing Growth, Rising Risks, International Monetary Fund, September 2011.
and freight charges. In more recent years when the imbalance has shifted from deficit to surplus, several studies have argued that it is most likely the result of improved data collection and reporting on trade in international services.
Many alternative explanations focus on intentional mis- reporting of international current account activities. Over or under-invoicing has long been a ploy used in interna- tional trade to avoid taxes, capital controls, or purchasing restrictions. Other arguments, like under-reporting of foreign income for tax avoidance and the complexity of intra- company transactions and transfer prices, are all potential partial explanations.
But in the end the theory says it can’t be, but the numbers says it is. As noted by the Economist, planet Earth appears to be running a current account surplus in its trade with extraterrestrials (“Are aliens buying Louis Vuitton handbags?”).**
**Economics Focus, Exports to Mars,” The Economist, November 12, 2011, p. 90.
GLOBAL FINANCE IN PRACTICE 4.1
The Global Current Account Surplus
94 CHAPTER 4 The Balance of Payments
foreign investment in any country, including the United States, focuses on two topics: control and profit. Some countries place restrictions on what foreigners may own in their country. This rule is based on the premise that domestic land, assets, and industry in general should be owned by residents of the country. On the other hand, the U.S. has traditionally had few restrictions on what foreign residents or firms can own or control; most restrictions remain- ing today relate to national security concerns. Unlike the case in the traditional debates over whether international trade should be free, there is no consensus that international investment should necessarily be free. This question is still very much a domestic political concern first, and an international economic issue second.
The second major source of concern over foreign direct investment is who receives the profits from the enterprise. Foreign companies owning firms in the U.S. will ultimately profit from the activities of the firms, or put another way, from the efforts of U.S. workers. In spite of evidence that indicates foreign firms in the United States reinvest most of their profits in their U.S. businesses (in fact, at a higher rate than domestic firms), the debate on possible profit drains has continued. Regardless of the actual choices made, workers of any nation feel that the profits of their work should remain in their own hands. Once again, this is in many ways a political and emotional concern more than an economic one.
The choice of words used to describe foreign investment can also influence public opinion. If these massive capital inflows are described as “capital investments from all over the world showing their faith in the future of U.S. industry,” the net capital surplus is represented as decidedly positive. If, however, the net capital surplus is described as resulting in “the United States being the world’s largest debtor nation,” the negative connotation is obvious. Both are essentially spins on the economic principles at work.
Capital, whether short-term or long-term, flows to where the investor believes it can earn the greatest return for the level of risk. And although in an accounting sense this is “inter- national debt,” when the majority of the capital inflow is in the form of direct investment, a long-term commitment to jobs, production, services, technological, and other competitive investments, the impact on the competitiveness of industry located within the U.S. is increased. When the “net debtor” label is applied to equity investment, it is misleading, in that it invites comparison with large debt crisis conditions suffered by many countries in the past.
Portfolio Investment. This is net balance of capital that flows in and out of the United States but does not reach the 10% ownership threshold of direct investment. If a U.S. resident purchases shares in a Japanese firm but does not attain the 10% threshold, we define the purchase as a portfolio investment (and in this case an outflow of capital). The purchase or sale of debt securi- ties (like U.S. Treasury bills) across borders is also classified as portfolio investment, because debt securities by definition do not provide the buyer with ownership or control.
Portfolio investment is capital invested in activities that are purely profit-motivated (return), rather than ones made to control or manage the investment. Purchases of debt secu- rities, bonds, interest-bearing bank accounts, and the like are intended only to earn a return. They provide no vote or control over the party issuing the debt. Purchases of debt issued by the U.S. government (U.S. Treasury bills, notes, and bonds) by foreign investors constitutes net portfolio investment in the United States. It is worth noting that most U.S. debt purchased by foreigners is U.S. dollar-denominated in the currency of the issuing country. Most foreign debt issued by countries such as Russia, Mexico, Brazil, and Southeast Asian countries is also U.S. dollar- denominated-in this case, the currency of a foreign country. The foreign country must earn dollars to repay its foreign-held debt. The United States need not earn any foreign currency to repay its foreign debt.
As illustrated in Exhibit 4.4, portfolio investment has shown much more volatile behavior than net foreign direct investment has over the past decade. Many U.S. debt securities, such
95The Balance of Payments CHAPTER 4
as U.S. Treasury securities and corporate bonds, were in high demand in the late 1980s, while surging emerging markets in both debt and equities caused a reversal in direction in the 1990s. The motivating forces for portfolio investment flows are always the same-return and risk. This fact, however, does not make the flows any more predictable.
Other Investment Assets/Liabilities. This final category consists of various short-term and long- term trade credits, cross-border loans from all types of financial institutions, currency deposits and bank deposits, and other accounts receivable and payable related to cross-border trade. Exhibit 4.5 shows the major subcategories of the U.S. financial account balance from 1985 to 2009: direct investment, portfolio investment, and other long-term and short-term capital investment.
Current and Financial Account Balance Relationships Exhibit 4.6 illustrates the current and financial account balances for the United States over recent years. The exhibit shows one of the basic economic and accounting relationships of the balance of payments: the inverse relation between the current and financial accounts. This inverse relationship is not accidental. The methodology of the balance of payments, double-entry bookkeeping in theory, requires that the current and financial accounts be offsetting, unless the country’s exchange rate is being highly manipulated or controlled by governmental authorities. The following section on China describes one very high profile case in which government policy has thwarted economics—the twin surpluses of China. Countries experiencing large current account deficits “finance” these purchases through equally large surpluses in the financial account, and vice versa.
Net Errors and Omissions. As previously noted, because current and financial account entries are collected and recorded separately, errors or statistical discrepancies will occur. The net errors and omissions account ensures that the BOP actually balances.
EXHIBIT 4.4 The United States Financial Accounts and Components, 2002–2010 (billions of U.S. dollars)
2002 2003 2004 2005 2006 2007 2008 2009 2010
Direct Investment
Direct investment abroad -154 -150 -316 -36 -245 -414 -329 -304 -351
Direct investment in the US 84 64 146 113 243 221 310 159 236
Net direct investment -70 -86 -170 76 -2 -193 -19 -145 -115
Portfolio Investment
Assets, net -49 -123 -177 -258 -499 -391 280 -360 -166
Liabilities, net 428 550 867 832 1127 1157 524 360 707
Net portfolio investment 379 427 690 575 628 766 804 0 541
Financial Derivatives, net 30 6 -33 49 14
Other Investment
Other investment assets -88 -54 -510 -267 -544 -649 386 576 -486
Other investment liabilities 283 244 520 303 695 687 -402 -183 303
Net other investment 195 190 10 36 151 38 -17 393 -184
Net Financial Account Balance 504 531 530 687 807 617 735 298 256
Source: Derived from Balance of Payments Statistics Yearbook, International Monetary Fund, December 2011, p. 1101.
96 CHAPTER 4 The Balance of Payments
19 85
19 87
19 89
19 91
19 93
19 95
19 97
19 99
20 01
20 03
20 05
20 07
20 09
–$200
–$100
$0
$100
$200
$300
$400
$500
$600
$700
$800
$900
Source : Balance of Payments Statistics Yearbook, International Monetary Fund, December 2011, p. 1101.
Net portfolio investmentNet direct investment Net other investment
EXHIBIT 4.5 The United States Financial Account, 1985–2010 (billions of U.S. dollars)
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 –$1,000
–$800
–$600
–$400
–$200
$0
$200
$400
$600
$800
$1,000
Source : Balance of Payments Statistics Yearbook, International Monetary Fund, December 2011, p. 1101.
Current account Financial/capital account
EXHIBIT 4.6 Current and Combined Financial/Capital Account Balances for the United States, 1992–2010 (billions of U.S. dollars)
97The Balance of Payments CHAPTER 4
Official Reserves Account. The Official Reserves Account is the total reserves held by official monetary authorities within a country. These reserves are normally composed of the major currencies used in international trade and financial transactions (so-called “hard currencies” like the U.S. dollar, European euro, and Japanese yen; gold; and special drawing rights, SDRs).
The significance of official reserves depends generally on whether a country is operating under a fixed exchange rate regime or a floating exchange rate system. If a country’s currency is fixed, the government of the country officially declares that the currency is convertible into a fixed amount of some other currency. For example, the Chinese yuan was fixed to the U.S. dollar for many years. It was the Chinese government’s responsibility to maintain this fixed rate, also called parity rate. If for some reason there was an excess supply of Chinese yuan on the currency market, to prevent the value of the yuan from falling, the Chinese government would have to support the yuan’s value by purchasing yuan on the open market (by spending its hard currency reserves, its official reserves) until the excess supply was eliminated. Under a floating rate system, the Chinese government possesses no such responsibility and the role of official reserves is diminished. But as described in the following section, the Chinese government’s foreign exchange reserves are now the largest in the world, and if need be, it probably possesses sufficient reserves to manage the yuan’s value for years to come.
Breaking the Rules: China’s Twin Surpluses Exhibit 4.7 illustrates the current and financial account balances for China over recent years. China’s surpluses in both the current and financial accounts—termed the Twin Surplus in the business press, is highly unusual. Ordinarily, for example, in the cases of the United States, Germany, and Great Britain, a country will demonstrate an inverse relationship between the
EXHIBIT 4.7 China’s Twin Surplus, 1998–2010 (billions of U.S. dollars)
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 –$50
$0
$50
$100
$150
$200
$250
$300
$350
$400
$450
Source : Balance of Payments Statistics Yearbook, International Monetary Fund, December 2011, p. 224.
Current account Financial/capital account
98 CHAPTER 4 The Balance of Payments
two accounts. This inverse relationship is not accidental, and typically illustrates that most large, mature, industrial countries “finance” their current account deficits through equally large surpluses in the financial account. For some countries like Japan, it is the inverse; a current account surplus is matched against a financial account deficit.
China, however, has experienced a massive current account surplus and a marginal finan- cial account surplus simultaneously. This is highly unusual, and an indicator of just how excep- tional the growth of the Chinese economy is. Although current account surpluses of this magnitude would ordinarily always 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.
The rise of the Chinese economy has been accompanied by a rise in its current account surplus, and subsequently, its accumulation of foreign exchange reserves. As illustrated in Exhibit 4.8, China’s foreign exchange reserves increased by a factor of 10 from 2001 to 2010— from $200 billion to nearly $2,500 billion. There is no real precedent for this build-up in foreign exchange reserves in global financial history. These reserves allow the Chinese government to manage the value of the Chinese yuan (also referred to as the renminbi) and its impact on Chinese competitiveness in the world economy. The magnitude of these reserves will allow the Chinese government to maintain a relatively stable managed fixed rate of the yuan against other major currencies like the U.S. dollar as long as it chooses.
The sheer size and magnitude of China’s official reserves (excluding gold) is illustrated by Exhibit 4.9, which shows the 20 largest countries in terms of their reserve holdings in 2009. China’s reserves are more than double those of the second largest country reserves, those of
EXHIBIT 4.8
19 90
19 91
19 92
19 93
19 94
19 95
19 96
19 97
19 98
19 99
20 00
20 01
20 02
20 03
20 04
20 05
20 06
20 07
20 08
20 09
20 11
20 10
$0
$250
$500
$750
$1,000
$1,250
$1,500
$1,750
$2,000
$2,500
$2,250
$3,000
$2,750
$3,250
Source: Data drawn from State Administration of Foreign Exchange, People's Republic of China, as quoted by Chinability, http://www.chinability.com/Reserves.htm. 2011 is as end-of-month September.
China’s Foreign Exchange Reserves (billions of U.S. dollars)
99The Balance of Payments CHAPTER 4
Japan. Note that only eight countries even have reserves that exceed $130 billion. The United States, with roughly $130 billion in reserves, pales in comparison to the growing caches of the booming Asian economies.
There have been a variety of suggestions made as to what China could do with its growing reserves. Most of the proposals—stockpiling oil or other commodities for example—would only result in pushing up the price of these other critical global commodities, while not really stopping the accumulation of official reserves. The only real solution to this “problem,” if it is a problem, is to reduce the Chinese current account surplus or allow the yuan to float to a stronger value. Both solutions, however, are not in-line with China’s current political plan.
The Balance of Payments in Total Exhibit 4.10 provides the official balance of payments for the United States as presented by the IMF, which collects these statistics for more than 160 different countries around the globe. Now that the individual accounts and the relationships among the accounts have been discussed, Exhibit 4.10 provides a comprehensive overview of how the individual accounts are combined to create some of the most useful summary measures for multinational business managers.
The current account (line A in Exhibit 4.10), the capital account (line B), and the financial account (line C) combine to form the basic balance (Total, Groups A through C). This balance is one of the most frequently used summary measures of the BOP. It describes the international eco- nomic activity of the nation, which is determined by market forces, not by government decisions
EXHIBIT 4.9 Largest Foreign Exchange Reserves (billions of U.S. dollars)
Ch ina
Jap an
Ru ssi
a
Sa ud
i A rab
ia Tai
wa n
So uth
Ko rea Bra
zil Ind
ia
Sw itze
rla nd
Ho ng
Ko ng
Sin ga
po re
Ge rm
an y
Th aila
nd Fra
nc e
Alg eri
a Ita
ly
Un ite
d S tat
es
Ma lay
sia Me
xic o
$0
$250
$500
$750
$1,000
$1,250
$1,500
$1,750
$2,000
$2,500
$2,250
$3,000
$2,750
Source: Data drawn from “The World Factbook,” www.cia.gov, 2010. Data is for December 31, 2010.
100 CHAPTER 4 The Balance of Payments
EXHIBIT 4.10 The United States Balance of Payments, Analytic Presentation, 2000–2010 (billions of U.S. dollars)
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
A. Current Account -417 -385 -461 -523 -625 -729 -804 -718 -677 -377 -471 Goods: exports fob 775 722 686 717 811 898 1020 1164 1312 1074 1293 Goods: imports fob -1227 -1148 -1167 -1264 -1477 -1682 -1863 -1985 -2139 -1576 -1936
Balance on Goods -452 -426 -481 -548 -666 -783 -844 -820 -827 -503 -642 Services: credit 296 283 289 301 350 385 432 484 531 501 544 Services: debit -224 -222 -231 -250 -291 -314 -349 -366 -402 -380 -402
Balance on Goods & Services -380 -365 -424 -497 -608 -712 -760 -702 -698 -381 -500 Income: credit 351 291 281 320 414 535 682 830 814 600 663 Income: debit -330 -259 -254 -275 -347 -463 -634 -730 -667 -472 -498
Balance on Goods, Services & Income
-359 -333 -396 -452 -541 -639 -712 -603 -551 -253 -335
Current transfers: credit 11 9 12 15 20 19 26 24 26 22 16 Current transfers: debit -69 -60 -77 -87 -105 -109 -117 -140 -152 -145 -152
B. Capital Account -1 -1 -1 -3 -2 -4 -4 0 6 0 0 Capital account: credit 1 1 1 1 1 1 1 0 6 0 0 Capital account: debit -2 -2 -2 -4 -3 -5 -5 0 0 0 0 Total, Groups A Plus B —418 —386 —463 —527 —627 —733 —807 —718 —671 —377 —471
C. Financial Account 478 405 504 532 530 687 807 638 735 298 256 Direct investment 162 25 -70 -86 -170 76 -2 -143 -19 -145 -115
Direct investment abroad -159 -142 -154 -150 -316 -36 -245 -414 -329 -304 -351 Direct investment in United States
321 167 84 64 146 113 243 271 310 159 236
Portfolio investment assets -128 -91 -49 -123 -177 -258 -499 -391 280 -360 -166 Equity securities -107 -109 -17 -118 -85 -187 -137 -148 39 -64 -79 Debt securities -21 18 -32 -5 -93 -71 -362 -243 242 -296 -86
Portfolio investment liabilities 437 428 428 550 867 832 1127 1157 524 360 707 Equity securities 194 121 54 34 62 89 145 276 127 221 172 Debt securities 243 307 374 516 806 743 981 881 397 139 535
Financial derivatives, net 0 0 0 0 0 0 30 6 —33 49 14 Other investment assets -273 -145 -88 -54 -510 -267 -544 -671 386 576 -486
Monetary authorities 0 0 0 0 0 0 0 -24 -530 543 10 General government -1 0 0 1 2 6 5 2 0 -2 -3 Banks -133 -136 -38 -26 -359 -151 -343 -500 456 -192 -427 Other sectors -139 -9 -50 -29 -153 -121 -207 -148 460 226 -67
Other investment liabilities 280 187 283 244 520 303 695 680 -402 -183 303 Monetary authorities -11 35 70 11 13 8 2 -11 29 60 28 General government -2 -2 0 -1 0 0 3 5 9 11 12 Banks 123 88 118 136 347 232 344 468 -357 -257 207 OtherWsectors 171 66 96 98 160 62 346 217 -83 4 55
Total, Groups A Through C 60 19 41 5 —98 46 —1 —79 64 —79 —215 D. Net Errors and Omissions -59 -14 -38 -6 95 32 -2 80 85 163 217
Total, Groups A Through D 0.31 4.88 3.71 —1.33 —2.80 —14.10 —2 0 149 84 2 E. Reserves and Related Items 0 -5 -4 2 3 14 2 0 -5 -52 -2 Source: International Monetary Fund, Balance of Payments Statistics Yearbook, December 2011, p. 1101. Note: Totals may not match original source due to rounding.
(such as currency market intervention). The U.S. basic balance totaled a deficit of $215 billion in 2010. A second frequently used measure, the overall balance, also called the official settlements balance (Total, Groups A through D in Exhibit 4.10), was at a surplus of $2 billion in 2010.
101The Balance of Payments CHAPTER 4
The meaning of the BOP has changed over the past 40 years. As long as most of the major industrial countries were still operating under fixed exchange rates, the interpretation of the BOP was relatively straightforward:
! A surplus in the BOP implied that the demand for the country’s currency exceeded the supply and that the government should allow the currency value to increase— in value—or intervene and accumulate additional foreign currency reserves in the official reserves account. This intervention would occur as the government sold its own currency in exchange for other currencies, thus building up its stores of hard currencies.
! A deficit in the BOP implied an excess supply of the country’s currency on world markets, and the government would then either devalue the currency or expend its official reserves to support its value.
The transition to floating exchange rate regimes in the 1970s (described in Chapter 3) changed the focus from the total BOP to its various subaccounts like the current and financial account balances. These subaccounts are the indicators of economic activities and currency repercussions to come.
The Balance of Payments Interaction with Key Macroeconomic Variables A nation’s balance of payments interacts with nearly all of its key macroeconomic variables. Interacts means that the balance of payments affects and is affected by such key macroeconomic factors as the following:
! Gross domestic product (GDP) ! Exchange rate ! Interest rates ! Inflation rates
The BOP and GDP In a static (accounting) sense, a nation’s GDP can be represented by the following equation:
GDP = C + I + G + X - M
C = consumption spending I = capital investment spending
G = government spending X = exports of goods and services M = imports of goods and services
X9M = the balance on current account (when including current income and transfers)
Thus, a positive current account balance (surplus) contributes directly to increasing the measure of GDP, but a negative current account balance (deficit) decreases GDP.
In a dynamic (cash flow) sense, an increase or decrease in GDP contributes to the current account deficit or surplus. As GDP grows, so does disposable income and capital investment. Increased disposable income leads to more consumption, a portion of which is supplied by
102 CHAPTER 4 The Balance of Payments
more imports. Increased consumption eventually leads to more capital investment. Growth in GDP also should eventually lead to higher rates of employment. However, some of that theoretical increase in employment may be blunted by foreign sourcing (that is, the purchase of goods and services from other enterprises located in other countries).
Supply chain management has increasingly focused on cost reduction through imports from less costly (lower wages) foreign locations. These imports can be from foreign-owned firms or from foreign subsidiaries of the parent firm. In the latter case, foreign subsidiaries tend to buy components and intellectual property from their parent firms, thus increasing exports. Although outsourcing has always been a factor in determining where to locate or procure manufactured goods and commodities, as mentioned in Chapter 1, during the past decade, an increasing amount of high-tech goods and services have been sourced from abroad. Foreign sourcing from the United States and Western Europe has been to countries such as India (software and call centers), China, Eastern Europe, Mexico, and the Philippines. This pattern has caused a loss of some white-collar jobs in the United States and Western Europe and a corresponding increase elsewhere.
The BOP and Exchange Rates A country’s BOP can have a significant impact on the level of its exchange rate and vice versa, depending on that country’s exchange rate regime. The relationship between the BOP and exchange rates can be illustrated by using a simplified equation that summarizes BOP data:
Current Account Balance
Capital Account Balance
Financial Account Balance
Reserve Balance
Balance of Payments
(X - M) + (CI - CO) + (FI - FO) + FXB = BOP
X = is exports of goods and services, M = is imports of goods and services, CI = is capital inflows,
CO = is capital outflows, FI = is financial inflows,
FO = is financial outflows, FXB = is official monetary reserves such as foreign exchange and gold.
The effect of an imbalance in the BOP of a country works somewhat differently depending on whether that country has fixed exchange rates, floating exchange rates, or a managed exchange rate system.
Fixed Exchange Rate Countries. 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 so as to bring the BOP back near zero.
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If the sum of the current and capital accounts is negative, an excess supply of the domestic currency exists in world markets. Then the government must intervene by buying the domestic currency with its reserves of foreign currencies and gold. It is obviously important for a government to maintain significant foreign exchange reserve balances, sufficient to allow it to intervene effectively. If the country runs out of foreign exchange reserves, it will be unable to buy back its domestic currency and will be forced to devalue.
Floating Exchange Rate Countries. 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, with 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. Exchange rate markets do not always follow this theory, particularly in the short to interm ediate term. This delay is known as the J-curve effect (see the next section “Trade Balances and Exchange Rates”). The deficit gets worse in the short run, but moves back toward equilibrium in the long run.
Managed Floats. Although still relying on market conditions for day-to-day exchange rate determination, countries operating with managed floats often find it necessary to take action to maintain their desired exchange rate values. Therefore, they seek to alter the market’s valuation of a specific exchange rate by influencing the motivations of market activity, rather than through direct intervention in the foreign exchange markets.
The primary action taken by such governments is to change relative interest rates, thus influencing the economic fundamentals of exchange rate determination. In the context of the equation discussed, a change in domestic interest rates is an attempt to alter the term (CI-CO), especially the short-term portfolio component of these capital flows, in order to restore an imbalance caused by the deficit in the current account. The power of interest rate changes on international capital and exchange rate movements can be substantial. A country with a managed float that wishes to defend its currency may choose to raise domestic interest rates to attract additional capital from abroad. This step will alter market forces and create additional market demand for the domestic currency. In this process, the government signals to exchange market participants that it intends to take measures to preserve the currency’s value within certain ranges. The process also raises the cost of local borrowing for businesses, however, so the policy is seldom without domestic critics.
The BOP and Interest Rates Apart from the use of interest rates to intervene in the foreign exchange market, the overall level of a country’s interest rates compared to other countries has an impact on the financial account of the balance of payments. Relatively low real interest rates should normally stimulate an outflow of capital seeking higher interest rates in other country currencies. However, in the case of the United States, the opposite effect has occurred. Despite relatively low real interest rates and large BOP deficits on current account, the U.S. BOP financial account has experienced offsetting financial inflows due to relatively attractive U.S. growth rate prospects, high levels of productive innovation, and perceived political safety. Thus, the financial account inflows have helped the United States to maintain its lower interest rates and to finance its exceptionally large fiscal deficit. However, it is beginning to appear that the favorable inflow on the financial account is diminishing while the U.S. balance on current account is worsening.
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The BOP and Inflation Rates Imports have the potential to lower a country’s inflation rate. In particular, imports of lower- priced goods and services place a limit on what domestic competitors charge for comparable goods and services. Thus, foreign competition substitutes for domestic competition to maintain a lower rate of inflation than might have been the case without imports.
On the other hand, to the extent that lower-priced imports substitute for domestic production and employment, gross domestic product will be lower and the balance on current account will be more negative.
Trade Balances and Exchange Rates A country’s import and export of goods and services is affected by changes in exchange rates. The transmission mechanism is in principle quite simple: changes in exchange rates change relative prices of imports and exports, and changing prices in turn result in changes in quantities demanded through the price elasticity of demand. Although the theoretical economics appear straightforward, the reality of global business is more complex.
Trade and Devaluation Countries occasionally devalue their own currencies as a result of persistent and sizable trade deficits. Many countries in the not-too-distant past have intentionally devalued their currencies in an effort to make their exports more price-competitive on world markets. The devaluation of the New Taiwan dollar in 1997 during the Asian financial crisis is believed by many to have been one such competitive devaluation. These competitive devaluations are often considered self-destructive, however, as they also make imports relatively more expensive. So what is the logic and likely results of intentionally devaluing the domestic currency to improve the trade balance?
The J-Curve Adjustment Path 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. These three stages, and the resulting time-adjustment path of the trade balance in whole, is illustrated in Exhibit 4.11. Assuming that the trade balance is already in deficit prior to the devaluation, a devaluation at time t1 results initially in a further deterioration in the trade balance before an eventual improvement—the path of adjustment taking on the shape of a flattened “j.”
In the first period, the currency contract period, a sudden unexpected devaluation of the domestic currency has a somewhat uncertain impact, simply because all of the contracts for exports and imports are already in effect. Firms operating under these agreements are required to fulfill their obligations, regardless of whether they profit or suffer losses. Assume that the United States experienced a sudden fall in the value of the U.S. dollar. Most exports were priced in U.S. dollars but most imports were contracts denominated in foreign currency. The result of a sudden depreciation would be an increase in the size of the trade deficit at time t1 because the cost to U.S. importers of paying their import bills would rise as they spent more and more dollars to buy the foreign currency they needed, while the revenues earned by U.S. exporters would remain unchanged. Although this is the commonly cited scenario regarding trade balance adjustment, there is little reason to believe that most U.S. imports are denominated in foreign currency and most exports in U.S. dollars.
The second period of the trade balance adjustment process is termed the pass-through period. As exchange rates change, importers and exporters eventually must pass these exchange
105The Balance of Payments CHAPTER 4
rate changes through to their own product prices. For example, a foreign producer selling to the U.S. market after a major fall in the value of the U.S. dollar will have to cover its own domestic costs of production. This need will require that the firm charge higher dollar prices in order to earn its own local currency in large enough quantities. The firm must raise its prices in the U.S. market. U.S. import prices rise substantially, eventually passing through the full exchange rate changes into prices. American consumers see higher import-product prices on the shelf. Similarly, the U.S. export prices are now cheaper compared to foreign competitors’ because the dollar is cheaper. Unfortunately for U.S. exporters, many of the inputs for their final products may actually be imported, causing them also to suffer from rising prices after the fall of the dollar.
The third and final period, the quantity adjustment period, achieves the balance of trade adjustment that is expected from a domestic currency devaluation or depreciation. As the import and export prices change as a result of the pass-through period, consumers both in the United States and in the U.S. export markets adjust their demands to the new prices. Imports are relatively more expensive; therefore the quantity demanded decreases. Exports are relatively cheaper; therefore the quantity demanded increases. The balance of trade—the expenditures on exports less the expenditures on imports—improves.
Unfortunately, these three adjustment periods do not occur overnight. Countries like the United States that have experienced major exchange rate changes, also have seen this adjust- ment take place over a prolonged period. Empirical studies have concluded that for industrial countries, the total time elapsing between time t1 and t2 can vary from 3 to 12 months—sometimes longer. To complicate the process, new exchange rate changes often occur before the adjustment is completed. Trade adjustment to exchange rate changes does not occur in a sterile laboratory environment, but in the messy and complex world of international business and economic events.
Trade Balance (Domestic Currency)
Time (Months)
Initial Trade Balance Position
(Typically in Deficit) t1 t2
Currency Contract Period
Exchange Rate Pass-Through
Period
Quantity Adjustment
Period
If export products are predominantly priced and invoiced in domestic currency, and imports are predominantly priced and invoiced in foreign currency, a sudden devaluation of the domestic currency can possibly result—initially—in a deterioration of the balance on trade. After exchange rate changes are passed-through to product prices, and markets have time to respond to price changes by altering market demands, the trade balance will improve. The currency contract period may last from three to six months, with pass-through and quality adjustment following for an additional three to six months.
Trade Balance
EXHIBIT 4.11 Trade Balance Adjustment to Exchange Rate Changes: The J-Curve
106 CHAPTER 4 The Balance of Payments
Trade Balance Adjustment Path: The Equation A country’s trade balance is essentially the net of import and export revenues, where each is a multiple of prices:PX $ and PM fc:the prices of exports and imports, respectively. Export prices are assumed to be denominated in U.S. dollars, and import prices are denominated in foreign currency. The quantity of exports and the quantity of imports are denoted as QX and QM, respectively. Import expenditures are then expressed in U.S. dollars by multiplying the foreign currency denominated expenditures by the spot exchange rate, S$/fc. The U.S. trade balance, expressed in U.S. dollars, is then expressed as follows:
U.S. trade balance = (PX$ Qx) - (S$/fcPMfc QM)
The immediate impact of a devaluation of the domestic currency is to increase the value of the spot exchange rate S, resulting in an immediate deterioration in the trade balance (currency contract period). Only after a period in which the current contracts have matured, and new prices reflecting partial to full pass-through have been instituted, would improvement in the trade balance been evident (pass-through period). In the final stage, in which the price elasticity of demand has time to take effect (quantity adjustment period), is the actual trade balance—in theory—which is expected to rise above where it started in Exhibit 4.8.
Capital Mobility The degree to which capital moves freely cross-border is critically important to a country’s balance of payments. We have already seen how the U.S. has suffered a deficit in its current account balance over the past 20 years while running a surplus in the financial account, and how China has enjoyed a surplus in both the current and financial accounts over the last decade. But these are only two country cases, and may not reflect the challenges that changing balances in trade and capital may mean for many countries, particularly smaller ones or emerging markets.
Current Account Versus Financial Account Capital Flows Capital inflows can contribute significantly to an economy’s development. Capital inflows can increase the availability of capital for new projects, new infrastructure development, and productivity improvements. All of which may stimulate general economic growth and job creation. For domestic holders of capital, the ability to invest outside the domestic economy may reap greater investment returns, portfolio diversification, and extend the commercial development of domestic enterprises.
That said, the free flow of capital in and out of an economy can potentially destabilize eco- nomic activity. Although the benefits of free capital flows have been known for centuries, so have the negatives. For this very reason, the creators of the Bretton Woods system were very careful to promote and require the free movement of capital for current account t ransactions— foreign exchange, bank deposits, money market instruments—but not require such free transit for capital account transactions—foreign direct investment and equity investments.
Experience has shown that current account-related capital flows can be more volatile, with capital flowing in and out of an economy and a currency on the basis of short-term interest rate differentials and exchange rate expectations. But in some ways this same volatility is somewhat compartmentalized, not directly impacting real asset investments, employment, or long-term economic growth. Longer-term capital flows often reflect more fundamental economic expectations, including growth prospects and perceptions of political stability.
The complexity of issues, however, is apparent when you consider the plight of many emerg- ing market countries. Recall the Impossible Trinity from Chapter 3—the theoretical structure
107The Balance of Payments CHAPTER 4
which states that no country can maintain fixed exchange rates, capital mobility, and independent monetary policy simultaneously. Many emerging market countries have continued to develop by maintaining a near-fixed (soft peg) exchange rate regime, a strictly independent monetary policy, while restricting capital inflows and outflows. With the growth of current account business activity (exports and imports of goods and services), more and more current account-related capital flows are deregulated. If, however, the country experiences significant volatility in these short-term capital movements, capital flows potentially impacting either exchange rate pegs or monetary policy objectives, authorities are often quick to re-institute capital controls.
The growth in capital openness in the 1970s, 1980s, and first half of the 1990s resulted in a significant increase in political pressures for more countries to open up more of their financial account sectors to international capital. But the devastation of the Asian Financial Crisis of 1997/1998 brought much of that to a halt.2 Smaller economies, no matter how successful their growth and development may have been under export-oriented trade strategies, found themselves still subject to sudden and destructive capital outflows in times of economic crisis and financial contagion.
Historical Patterns of Capital Mobility Before leaving our discussion of the balance of payments, we need to gain additional insights into the history of capital mobility and the contribution of capital outflows—capital flight—to balance of payments crises. Has capital always been free to move in and out of a country? Definitely not. The ability of foreign investors to own property, buy businesses, or purchase stocks and bonds in other countries has been controversial.
Exhibit 4.12, first presented in Chapter 3, is helpful once again in categorizing the last 150 years of economic history into five distinct exchange rate eras and their associated implications for capital mobility (or lack thereof). These exchange rate eras obviously reflect the exchange rate regimes we discussed and detailed in Chapter 3, but also reflect the evolution of cross-border political economy beliefs and policies of both industrialized and emerging market nations over this period.
The Gold Standard (1860–1914). Although an era of growing capital openness in which trade and capital began to flow more freely, it was an era dominated by industrialized nation economies that were dependent on gold convertibility to maintain confidence in the system.
The Inter-War Years (1914–1945). An era of retrenchment, in which major economic powers returned to policies of isolationism and protectionism, restricting trade and nearly eliminating capital mobility. The devastating results included financial crisis, a global depression, and rising international political and economic disputes which drove nations into a second world war.
The Bretton Woods Era (1945–1971). The dollar-based fixed exchange rate system under Bretton Woods gave rise to a long period of economic recovery and growing openness of both international trade and capital flows in and out of more and more countries. Many r esearchers (for example Obstfeld and Taylor, 2001) believe it was the rapid growth in the speed and volume of capital flows that ultimately led to the failure of Bretton Woods—global capital could no longer be held in check.
The Floating Era (1971–1997). The Floating Era, saw the rise of a growing schism between the industrialized and the emerging market nations. The industrialized nations (primary currencies) moved to—or were driven to—floating exchange rates by capital mobility. The emerging markets (secondary currencies), in an attempt to both promote economic development but maintain control over their economies and currencies, opened trade but
2The Asian Financial Crisis of 1997 is examined in detail in Chapter 9.
108 CHAPTER 4 The Balance of Payments
maintained restrictions on capital flows. Despite these restrictions, the era ended with the onslaught of the Asian Financial Crisis in 1997.
The Emerging Era (1997–Present). The emerging economies, led by China and India, attempt to gradually open their markets to global capital. But, as the Impossible Trinity taught the industrial nations in previous years, the increasing mobility of capital now requires that they give up either the ability to manage their currency values or conduct independent monetary policies. By 2011 and 2012 more and more emerging market currencies “suffer” appreciation (or fight appreciation) as capital flows grow in magnitude and speed.
The 2008–2011 period reinforced what some call the double-edged sword of global capital movements. The credit crisis of 2008, beginning in the United States, quickly spread to the global economy, pulling and pushing down industrial and emerging market economies alike. But in the post credit crisis period, global capital now flowed toward the emerging markets. Although funding and fueling their rapid economic recoveries, it came—in the words of one journalist—“with luggage.” The increasing pressure on emerging market currencies to appreciate is partially undermining their export competitiveness.
Capital Controls
Back in the halcyon pre-crisis days of the late 20th and early 21st centuries, it was taken as self evident that financial globalisation was a good thing. But the subprime crisis and eurozone dramas are shaking that belief. Never mind the fact that imbalances amid globalisation can stoke up bubbles; what is the bigger risk now—particularly in the eurozone—is that financial globalisation has created a system that is interconnected in some dangerous ways.
—“Crisis Fears Fuel Debate on Capital Controls,” Gillian Tett, The Financial Times, December 15, 2011.
EXHIBIT 4.12 The Evolution of Capital Mobility
Exchange Rate Era
Cross- Border Political Economy
Implication
1860 1914 1945 1971 1997
The last 150 years has seen periods of increasing and decreasing political and economic openness between countries. Beginning with the Bretton Woods Era, global markets have moved toward increasing open exchange of goods and capital, making it increasingly difficult to maintain fixed or even stable rates of exchange between currencies. The most recent era, characterized by the growth and development of emerging economies is likely to be even more challenging.
The Gold Standard
The Inter-War Years
The Bretton Woods Era
The Floating Era
The Emerging Era
Growing openness in trade, with growing, but
limited, capital mobility
Trade dominates capital in total
influence on exchange rates
Protectionism & isolationism
Growing belief in the benefits
of open economies
Trade increasingly dominated by
capital; era ends as capital flows
Rising barriers to the movement
of both trade & capital
Industrialized (primary) nations open; emerging
states (secondary) restrict capital
flows to maintain economic control
Capital flows dominate trade;
emerging nations suffer devaluations
More and more emerging nations
open their markets to capital at the
expense of reduced economic
independence
Capital flows increasingly
drive economic growth and health
present
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A capital control is any restriction that limits or alters the rate or direction of capital movement into or out of a country. Capital controls may take many forms, sometimes which parties may undertake which types of capital transactions for which purposes—the who, what, when, where, and why of investment.3 As noted in the previous section, there was a large scale reduction of capital controls in the years leading up to the 1997 Asian Crisis, but that in no way means they had gone away or were minor in nature. It is in many ways the bias of the journalistic and academic press that believes that capital has been able to move freely across boundaries. Free movement of capital, either in the pre- or post-1997 environment, is more the exception than the rule. When it comes to moving capital, the world is full of requirements, restrictions, taxes, and documentation approvals.
There is a wide 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. As illustrated in Exhibit 4.13, capital controls are just as likely to occur over capital inflows as they are 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.
Capital controls may take a variety of forms which mirror restrictions on trade. They may simply be a tax on a specific transaction, may limit the quantity or magnitudes of specific capital transactions, or may prohibit them altogether. The controls themselves have tended to follow the basic dichotomy of the balance of payments—current account-related transactions versus financial account transactions.
In some cases capital controls are intended to stop or thwart capital outflows and currency devaluation or depreciation. The case of Malaysia during the Asian Crisis of 1997–1998 helps explain both the logic of the controls, the forms of implementation, and the relationship between capital controls and currency controls in a falling currency case. As the Malaysian currency came under attack and capital started to exit the Malaysian economy, the government imposed a series of capital controls that were intended to stop short-term capital movements, in or out, but not hinder trade and not restrict long-term inward investment. All trade-related requests for access to foreign exchange were granted, allowing current account-related capital flows to continue. But access to foreign exchange for inward or outward money market or capital market investments were restricted. Foreign residents wishing to invest in Malaysian assets—real assets not financial assets—had ready access to exchange and capital movements.
Capital controls can be implemented in the opposite case, in which the primary fear is that large rapid capital inflows will both cause currency appreciation (and therefore harm export competitiveness) and complicate monetary policy (capital inflows flooding money markets and bank deposits). Chile in the 1990s is one such case, in which a new-found political and economic soundness started attracting international capital. The Chilean government responded with its encaje program, which imposed taxes and restrictions on short-term (less than one year) capital inflows, as well as restrictions on the ability of domestic financial institutions to extend credits or loans in foreign currency.4 Although credited with achieving its goals of maintaining domestic monetary policy and preventing a rapid appreciation in the Chilean peso, it came at substantial cost to Chilean firms, particularly smaller ones.
3“Capital Inflows: The Role of Controls,” Jonathan D. Ostry, Atish R. Ghosh, Karl Habermeier, Marcos Chamon, Mahvash S. Qureshi, and Dennis B.S. Reinhardt, IMF Staff Position Note, SPN/10/04, February 19, 2010. 4Encaje is a bit difficult to translate into English, but roughly means “slotting together” or “adjusting to circumstances.”
110 CHAPTER 4 The Balance of Payments
sectors in recent years, including oil and gas development in Azerbaijan, Kazakhstan, and Nigeria, or copper in Chile or Ghana, to name but a few.
Capital Flight. An extreme problem which has raised its ugly head a number of times in international financial history is capital flight, one of the extremes which capital controls hope to control. Although no single accepted definition of capital flight exists, Ingo Walter’s description is quite useful:6
International flows of direct and portfolio investments under ordinary circumstances are rarely associated with the capital flight phenomenon. Rather, it is when capital transfers by residents conflict with political objectives that the term “flight” comes into general usage.
Although it is not limited to heavily indebted countries, the rapid and sometimes illegal transfer of convertible currencies out of a country poses significant economic and political problems. Many heavily indebted countries have suffered significant capital flight, which has compounded their problems of debt service.
There are a number of mechanisms used for moving money from one country to another— some legal, some not. Transfers via the usual international payments mechanisms (regular bank transfers) are obviously the easiest and lowest cost, and are legal. Most economically healthy countries allow free exchange of their currencies, but of course for such countries “capital flight” is not a problem. The opposite, transfer of physical currency by bearer (the proverbial smuggling out of cash in the false bottom of a suitcase) is more costly and, for transfers out of many countries, illegal. Such transfers may be deemed illegal for balance of payments reasons or to make difficult the movement of money from the drug trade or other illegal activities.
There are a number of more creative solutions. One is to move cash via collectibles or precious metals, which are then transferred across borders. Money laundering is the cross- border purchase of assets that are then managed in a way that hides the movement of money and its ownership. And finally, false invoicing of international trade transactions occurs when capital is moved through the under invoicing of exports or the over invoicing of imports, where the difference between the invoiced amount and the actual agreed upon payment is deposited in banking institutions in a country of choice.
Globalization of Capital Flows
Notwithstanding these benefits, many EMEs [emerging market economies] are concerned that the recent surge in capital inflows could cause problems for their economies. Many of the flows are perceived to be temporary, reflecting interest rate differentials, which may be at least partially reversed when policy interest rates in advanced economies return to more normal levels. Against this backdrop, capital controls are again in the news.
A concern has been that massive inflows can lead to exchange rate overshooting (or merely strong appreciations that significantly complicate economic management) or inflate asset price bubbles, which can amplify financial fragility and crisis risk. More broadly, following the crisis, policymakers are again reconsidering the view that unfet- tered capital flows are a fundamentally benign phenomenon and that all financial flows are the result of rational investing/borrowing/lending decisions. Concerns that foreign
5Interestingly, the term was coined by The Economist in its analysis of the growing Dutch debate.
6Ingo Walter, “The Mechanisms of Capital Flight,” in Capital Flight and Third World Debt, edited by Donald R. Lessard and John Williamson, Institute for International Economics, Washington, D.C., 1987, p. 104.
Control Purpose Method Capital Flow Controlled Example
General Revenue/Finance War Effort Controls on capital outflows permit a country to run higher inflation with a given fixed-exchange rate and also hold down domestic interest rates.
Outflows Most belligerents in WWI and WWII
Financial Repression/Credit Allocation Governments that use the financial system to reward favored industries or to raise revenue, may use capital controls to prevent capital from going abroad to seek higher returns.
Outflows Common in developing countries
Correct a Balance of Payments Deficit Controls on outflows reduce demand for foreign assets without contractionary monetary policy or devaluation. This allows a higher rate of inflation than otherwise would be possible.
Outflows US interest equalization tax 1963–1974
Correct a Balance of Payments Surplus Controls on inflows reduce foreign demand for domestic assets without expansionary monetary policy or revaluation. This allows a lower rate of inflation than would otherwise be possible.
Inflows German Bardepot Scheme 1972–1974
Prevent Potentially Volatile Inflows Restricting inflows enhances macroeconomic stability by reducing the pool of capital that can leave a country during a crisis.
Inflows Chilean encaje 1991–1998
Prevent Financial Destabilization Capital controls can restrict or change the composition of international capital flows that can exacerbate distorted incentives in the domestic financial system.
Inflows Chilean encaje 1991–1998
Prevent Real Appreciation Restricting inflows prevents the necessity of monetary expansion and greater domestic inflation that would cause a real appreciation of the currency.
Inflows Chilean encaje 1991–1998
Restrict Foreign Ownership of Domestic Assets
Foreign ownership of certain domestic assets— especially natural resources—can generate resentment.
Inflows Article 27 of the Mexican Constitution
Preserve Savings for Domestic Use The benefits of investing in the domestic economy may not fully accrue to savers so the economy as a whole can be made better off by restricting the outflow of capital.
Outflows —
Protect Domestic Financial Firms Controls that temporarily segregate domestic financial sectors from the rest of the world may permit domestic firms to attain economies of scale to compete in world markets.
Inflows and Outflows
—
Source: “An Introduction to Capital Controls,” Christopher J. Neely, Federal Reserve Bank of St. Louis Review, November/December 1999, p. 16.
EXHIBIT 4.13 Purposes of Capital Controls
A similar use of capital controls to prevent domestic currency appreciation is the so-called case of Dutch Disease.5 With the rapid growth of the natural gas industry in the Netherlands in the 1970s, there was growing fear that massive capital inflows would drive up the demand for the Dutch guilder and cause a substantial currency appreciation. A more expensive guilder would then reduce the international competitiveness of other Dutch manufacturing industries, causing their relative decline to that of the natural resource industry. This is a challenge faced by a number of resource-rich economies of relatively modest size and relatively small export
111The Balance of Payments CHAPTER 4
sectors in recent years, including oil and gas development in Azerbaijan, Kazakhstan, and Nigeria, or copper in Chile or Ghana, to name but a few.
Capital Flight. An extreme problem which has raised its ugly head a number of times in international financial history is capital flight, one of the extremes which capital controls hope to control. Although no single accepted definition of capital flight exists, Ingo Walter’s description is quite useful:6
International flows of direct and portfolio investments under ordinary circumstances are rarely associated with the capital flight phenomenon. Rather, it is when capital transfers by residents conflict with political objectives that the term “flight” comes into general usage.
Although it is not limited to heavily indebted countries, the rapid and sometimes illegal transfer of convertible currencies out of a country poses significant economic and political problems. Many heavily indebted countries have suffered significant capital flight, which has compounded their problems of debt service.
There are a number of mechanisms used for moving money from one country to another— some legal, some not. Transfers via the usual international payments mechanisms (regular bank transfers) are obviously the easiest and lowest cost, and are legal. Most economically healthy countries allow free exchange of their currencies, but of course for such countries “capital flight” is not a problem. The opposite, transfer of physical currency by bearer (the proverbial smuggling out of cash in the false bottom of a suitcase) is more costly and, for transfers out of many countries, illegal. Such transfers may be deemed illegal for balance of payments reasons or to make difficult the movement of money from the drug trade or other illegal activities.
There are a number of more creative solutions. One is to move cash via collectibles or precious metals, which are then transferred across borders. Money laundering is the cross- border purchase of assets that are then managed in a way that hides the movement of money and its ownership. And finally, false invoicing of international trade transactions occurs when capital is moved through the under invoicing of exports or the over invoicing of imports, where the difference between the invoiced amount and the actual agreed upon payment is deposited in banking institutions in a country of choice.
Globalization of Capital Flows
Notwithstanding these benefits, many EMEs [emerging market economies] are concerned that the recent surge in capital inflows could cause problems for their economies. Many of the flows are perceived to be temporary, reflecting interest rate differentials, which may be at least partially reversed when policy interest rates in advanced economies return to more normal levels. Against this backdrop, capital controls are again in the news.
A concern has been that massive inflows can lead to exchange rate overshooting (or merely strong appreciations that significantly complicate economic management) or inflate asset price bubbles, which can amplify financial fragility and crisis risk. More broadly, following the crisis, policymakers are again reconsidering the view that unfet- tered capital flows are a fundamentally benign phenomenon and that all financial flows are the result of rational investing/borrowing/lending decisions. Concerns that foreign
5Interestingly, the term was coined by The Economist in its analysis of the growing Dutch debate.
6Ingo Walter, “The Mechanisms of Capital Flight,” in Capital Flight and Third World Debt, edited by Donald R. Lessard and John Williamson, Institute for International Economics, Washington, D.C., 1987, p. 104.
112 CHAPTER 4 The Balance of Payments
investors may be subject to herd behavior, and suffer from excessive optimism, have grown stronger; and even when flows are fundamentally sound, it is recognized that they may contribute to collateral damage, including bubbles and asset booms and busts.
—“Capital Inflows: The Role of Controls,” Jonathan D. Ostry, Atish R. Ghosh, Karl Habermeier, Marcos Chamon, Mahvash S. Qureshi, and Dennis B.S. Reinhardt, IMF Staff Position Note,
SPN/10/04, February 19, 2010, p. 4.
Traditionally, the primary concern over the inflow of capital inflows is that they are short- term in duration, may flow out with short notice, and are characteristics of the politically and economically unstable emerging markets. But as described in the quote above, two of the largest capital flow crises in recent years have occurred within the largest, most highly developed, mature capital markets—the United States and Western Europe.
The 2008 global credit crisis which had the United States as its core, and the current 2011–2012 Greece/European Union sovereign debt crisis, both occurred within the markets which have long been considered the most mature, the most sophisticated, and the “safest.” Chapter 5 will explore the causes and implications these recent financial crises have caused for the structure and operations of the world’s multinational enterprises.
SUMMARY POINTS
! Monitoring of the various subaccounts of a country’s balance of payment activity is helpful to decision- makers and policy makers on all levels of government and industry in detecting the underlying trends and movements of fundamental economic forces driving a country’s international economic activity.
! Changes in exchange rates change relative prices of imports and exports, and changing prices in turn result in changes in quantities demanded through the price elasticity of demand.
! A devaluation results initially in a further deterioration in the trade balance before an eventual improvement— the path of adjustment taking on the shape of a flattened “j.”
! The ability of capital to move instantaneously and massively cross-border has been one of the major factors in the severity of recent currency crises. In cases such as Malaysia in 1997 and Argentina in 2001, the national governments concluded that they had no choice but to impose drastic restrictions on the ability of capital to flow.
! Although not limited to heavily indebted countries, the rapid and sometimes illegal transfer of convertible currencies out of a country poses significant economic and political problems. Many heavily indebted countries have suffered significant capital flight, which has compounded their problems of debt service.
! The BOP is the summary statement of all international transactions between one country and all other countries.
! The BOP is a flow statement, summarizing all the inter- national transactions that occur across the geographic boundaries of the nation over a period of time, typically a year.
! Although in theory the BOP must always balance, in practice there are substantial imbalances as a result of statistical errors and mis-reporting of current account and financial/capital account flows.
! The two major subaccounts of the balance of payments, the current account and the financial/capital account, summarize the current trade and international capital flows of the country respectively.
! The current account and financial/capital account are typically inverse on balance, one in surplus and the other in deficit.
! Although most nations strive for current account surpluses, it is not clear that a balance on current or capital account, or a surplus on current account, is either sustainable or desirable.
! Although merchandise trade is more easily observed (e.g., goods flowing through ports of entry), today, the growth of services trade is more significant to the balance of payments for many of the world’s largest industrialized countries.
113The Balance of Payments CHAPTER 4
“Remittances are a vital source of financial support that directly increases the income of migrants’ families,” said Hans Timmer, director of development prospects at the World Bank. “Remittances lead to more investments in health, education, and small business. With better track- ing of migration and remittance trends, policy makers can make informed decisions to protect and leverage this massive capital inflow which is triple the size of official aid flows,” Timmer said.
—“Remittances to Developing Countries Resilient in the Recent Crisis,” Press Release No.
2011/168DEC, The World Bank, November 8, 2010.
One area within the balance of payments that has received intense interest in the past decade is that of remittances. The term remittance is a bit tricky. According to the Inter- national Monetary Fund (IMF), remittances are interna- tional transfers of funds sent by migrant workers from the country where they are working to people, typically family
members, in the country from which they originated.2 According to the IMF, a migrant is a person who comes to a country and stays, or intends to stay, for a year or more. As shown in Exhibit 1, a brief overview of global remittances would include the following:
! The World Bank estimates that $414 billion was remitted in 2009, with $316 billion of that going to developing countries. These remittance transactions were made by more than 190 million people, roughly 3% of the world’s population.
! The top remittance sending countries in 2009 were the United States, Saudi Arabia, Switzerland, Russia, and Germany. Worldwide, the top recipient countries in 2009 were India, China, Mexico, the Philippines, and France.
! Remittances make up a very small, often negligible cash outflow from sending countries like the United States. They do, however, represent a more significant
2“Remittances: International Payments by Migrants,” Congressional Budget Office, May 2005.
Global Remittances1
1Copyright © 2012 Michael H. Moffett. All rights reserved. This case was prepared from public sources for the purpose of classroom discussion only, and not to indicate effective or ineffective management.
MINI-CASE:
EXHIBIT 1 A Sample of Remittance Flows Across Countries
Residents of these recipient countries received the following total estimated amounts through formal channels
Greater than $15 Billion $5 to $15 Billion $1 to $5 Billion Less than $1 Billion
China Australia Algeria Angola France Belarus Bolivia Argentina India Egypt Brazil Chad Mexico Germany Colombia Chile
Indonesia Ecuador Finland Italy Iran Ghana Morroco Japan Mali Pakistan Kenya Mozambique Poland Malaysia Namibia Russia Peru Norway Spain South Africa Paraguay Ukraine Sudan Sudan United Kingdom United States Sweden Vietnam Yemen Tunisia
Uruguay
Source: “Global Remittances: Formal Remittances Inflow in 2010 by Migrants’ Origin Countries,” Migration Policy Institute, www.migrationinformation.org, based on data collected by the World Bank Development Prospects Group. These are gross estimates, and do not include informal remittances which are thought to be very large and very common. These would then be gross underestimates of actual transfers.
114 CHAPTER 4 The Balance of Payments
50,000
100,000
150,000
200,000
250,000
300,000
350,000
400,000
450,000
Average annual growth of 15.6% from 1970 to 2010e.
After peaking at $443 billion in 2008, 2009 showed the first decline since 1985.
Source: The World Bank.
19 70
19 72
19 74
19 76
19 78
19 80
19 82
19 84
19 86
19 88
19 90
19 92
19 94
19 96
19 98
20 00
20 02
20 04
20 06
20 08
20 10
e
EXHIBIT 2 Global Remittances—World Inflows
volume, for example as a percent of GDP, for smaller receiving countries, developing countries, sometimes more than 25%. In many cases, this is greater than all development capital and aid flowing to these same countries.
The historical record on global remittances is short. As illustrated in Exhibit 2, it has shown dramatic growth in the post-2000 period, until suffering its first real decline since 1985 in the 2009 global economic slowdown.
Remittances largely reflect the income which is earned by migrant or guest workers in one country (source coun- try) and then returned to families or related parties in their home countries (receiving countries). Therefore, it is not surprising that although there are more migrant worker flows between developing countries, the high-income developed economies remain the main source of remit- tances. The global economic recession of 2009 resulted in reduced economic activities like construction and manufac- turing in the major source countries; as a result, remittance cash flows fell in 2009 but rebounded slightly in 2010.
Most remittances are frequent small payments made through wire transfers or a variety of informal channels (some even carried by hand). The United States Bureau of Economic Analysis (BEA), which is responsible for the compilation and reporting of U.S. balance of payments
statistics, classifies migrant remittances as “current trans- fers” in the current account. Wider definitions of remit- tances may also include capital assets which migrants take with them to host countries, and similar assets which they bring back with them to their home countries. These values, when compiled, are generally reported under the capital account of the balance of payments exactly who a “migrant” is, is also an area of some debate. Transfers back to their home country made by individuals who may be working in a country (for example, an expat working for an MNE) but not considered “residents,” may also be considered global remittances under current transfers in the current account.
Remittance Prices
Given the development impact of remittance flows, we will facilitate a more efficient transfer and improved use of remittances and enhance cooperation between national and international organizations, in order to implement the recommendations of the 2007 Berlin G8 Conference and of the Global Remittances Working Group estab- lished in 2009 and coordinated by the World Bank. We will aim to make financial services more accessible to migrants and to those who receive remittances in the developing world. We will work to achieve in particular
conducted along a variety of country corridors globally (country pairs). The most recent survey conducted in the second half of 2010 covered 200 individual corridors— remittances originating in 29 countries and received in 86 countries. The average cost of a migrant remittance transaction was 8.89% for all corridors surveyed for the third quarter of 2010 (most recent data available). The most recent survey found, assuming $200 per transfer, that the highest cost was that of the Tanzania-Kenya corridor (a remittance from Tanzania to Kenya) at $47.27 per $200 transaction, a 23.6% charge.
The cost of remittances is a combination of the fees charged at any stage of the transaction and the exchange rate used to convert the local currency into the currency of the destination country.5 Fees charged may occur at the ori- gin (for transactions, transaction size, currency conversion), while fees at the destination may include many of the same. One relatively simple example is that presented in Exhibit 3, a transaction described by a major RSP (remittance service provider) in Mexico. In this case, the transfer cost comprises two components, a transaction fee which differs by RSP, and a calculated foreign exchange charge based on the exchange rate used in the transaction compared to an official refer- ence rate for that date. In this case—as opposed to the rates quoted globally in the World Bank project—the full cost percentage of remittance is quite small and competitive.
4Remittance Prices Worldwide, The World Bank, Issue No. 2, November 2010, remittanceprices.worldbank.org. 5“Remittance Price Comparison Databases: Minimum Requirements and Overall Policy Strategy, Guidance and Special Purpose Note,” Remittances Working Group, The World Bank Group, p. 2.
the objective of a reduction of the global average costs of transferring remittances from the present 10% to 5% in five years through enhanced information, transparency, competition and cooperation with partners, generating a significant net increase in income for migrants and their families in the developing world.
—The G8 Final Declaration on Responsible Leadership for a Sustainable Future, paragraph 134.
Some organizations have focused on the costs borne by migrants in transferring funds back to their home coun- tries. The primary concern has been excessive remittance charges-the imposition of what many consider exploitive charges related to the transfer of these frequent small pay- ments. The G8 countries, in an initiative entitled ;5 * 5<:the reduction of transfer costs from an average of 10% to 5% in five years—seek to use a variety of market forces such as transparency to improve the efficiency and reduce remittance prices globally.3 Remittance Prices Worldwide (RPW), initiated by the World Bank in September 2008, is the primary body that is creating and sustaining a global database which monitors remittance price activity across geographic regions.
Little was known of global remittance costs until the World Bank began collecting data in the Remittance Prices Worldwide (RPW) database.4 The database, updated twice yearly collects data on the average cost of transactions
3“Rome Roadmap for Remittances,” G8 Summit, The World Bank, November 9, 2009.
EXHIBIT 3 Remittances from the United States to Mexico: A Price Comparison
Gross Remittance Remittance Cost
(1) (2) (3) (4) (5) (6) (7) (8)
Service Provider
Amount Remitted
(US$) RSP’s FX Rate (Pesos/US$)
Amount Received (pesos)
Amount Received
(US$ equivalent) Transfer Fee
(US$) FX Cost (US$)
Full Cost (US$)
Full Cost (percent)
A $300 10.53 3,159 $299.43 $5.00 $0.57 $5.57 1.9%
B $300 10.55 3,165 $300.00 $8.00 $0.00 $8.00 2.7%
C $300 10.50 3,150 $298.58 $8.00 $1.42 $9.42 3.1%
Reference Rate 10.55
Source: Based on published reports from PROFECO, the Federal Consumer Protection Commission of Mexico, as presented in “General Principles for International Remittance Services,” Bank for International Settlements and The World Bank, January 2007, p. 32. Note that the official reference exchange rate, Peso 1055/US$, is the same as the rate used by remittance service provider (RSP) “B.”
Notes: (3) = (1) * (2); (4) = (3)/Reference FX Rate; (6) = (1) - (4); (7) = (5) + (6):(8) = (7)/(1).
115The Balance of Payments CHAPTER 4
116 CHAPTER 4 The Balance of Payments
of payments, and in some ways, a “plug” to replace declining export competition and dropping foreign direct investment. But there is also growing evidence that remittances flow to those who need it most, the lowest income component of the Mexican population, and therefore mitigate poverty and support consumer spending. (Former President Vicente Fox was quoted as saying that Mexico’s workers in other countries remitting income home to Mexico are “heroes.”) Mexico’s own statistical agencies also disagree on both the size of the funds remittances received, as well as to whom the income is returning (family or nonfamily interests).
Case Questions
1. Where are remittances across borders included within the balance of payments? Are they current or finan- cial account components?
2. Under what conditions—for example, for which coun- tries currently—are remittances significant contribu- tors to the economy and overall balance of payments?
3. Why is the cost of remittances the subject of such intense international scrutiny?
As opposed to the remittance costs quoted by PROFECO in Exhibit 3, the World Bank’s survey of global remittances across multiple corridors unveiled a number of individual transfer corridors where the costs were by all indications, exploitive. The most expensive are noted in Exhibit 4.
Growing Controversies With the growth in global remittances has come a grow- ing debate as to what role they do or should play in a country’s balance of payments, and more importantly, economic development. In some cases, like India, there is growing resistance from the central bank and other banking institutions to allow online payment services like PayPal to process remittances. In other countries, like Honduras, Guatemala, and Mexico, there is growing debate on whether the remittances flow to families or are actually payments made to a variety of Central American smugglers—human trafficking smugglers.
In Mexico for example, remittances now make up the sec- ond largest source of foreign exchange earnings, second only to oil exports. The Mexican government has increasingly viewed remittances as an integral component of its balance
Ta nza
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Au str
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Jap an
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Ko rea
Ge rm
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Gh an
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Ca na
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Af ric
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s-T urk
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Fra nc
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0%
5%
10%
15%
20%
25%
Source: The World Bank.
EXHIBIT 4 Highest Cost Corridors for Remittances
117The Balance of Payments CHAPTER 4
d. A U.S. university gives a tuition grant to a foreign student from Singapore.
e. A British company imports Spanish oranges, paying with Eurodollars on deposit in London.
f. The Spanish orchard deposits half the proceeds in a Eurodollar account in London.
g. A London-based insurance company buys U.S. corporate bonds for its investment portfolio.
h. An American multinational enterprise buys insurance from a London insurance broker.
i. A London insurance firm pays for losses incurred in the United States because of an international terrorist attack.
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.
k. A California-based mutual fund buys shares of stock on the Tokyo and London stock exchanges.
l. The U.S. army buys food for its troops in South Asia from local venders. A California-based mutual fund buys shares of stock on the Tokyo and London stock exchanges.
m. A Yale graduate gets a job with the International Committee of the Red Cross in Bosnia and is paid in Swiss francs.
n. The Russian government hires a Norwegian salvage firm to raise a sunken submarine.
o. A Colombian drug cartel smuggles cocaine into the United States, receives a suitcase of cash, and flies back to Colombia with that cash.
p. The U.S. government pays the salary of a foreign service officer working in the U.S. embassy in Beirut.
q. A Norwegian shipping firm pays U.S. dollars to the Egyptian government for passage of a ship through the Suez Canal.
r. A German automobile firm pays the salary of its executive working for a subsidiary in Detroit.
s. An American tourist pays for a hotel in Paris with his American Express card.
t. A French tourist from the provinces pays for a hotel in Paris with his American Express card.
u. A U.S. professor goes abroad for a year on a Fulbright grant.
11. The Balance. What are the main summary statements of the balance of payments accounts and what do they measure?
12. Drugs and Terrorists. Where in the balance of payments accounts do the flows of “laundered” money by drug dealers and international terrorist organizations flow?
QUESTIONS 1. Balance of Payments Defined. The measurement of
all international economic transactions between the residents of a country and foreign residents is called the balance of payments (BOP). What institution provides the primary source of similar statistics for balance of payments and economic performance worldwide?
2. 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.
3. Economic Activity. What are the two main types of economic activity measured by a country’s BOP?
4. Balance. Why does the BOP always “balance”?
5. 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?
6. 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.
7. Real Versus Financial Assets. What is the difference between a “real” asset and a “financial” asset?
8. 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?
9. Capital and Financial Accounts. What are the main components of the financial accounts? Give one debit and one credit example for each component account for the United States.
10. Classifying Transactions. Classify the following as a transaction reported in a subcomponent 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. b. A U.S. resident purchases a euro-denominated
bond from a German company. c. Singaporean parents pay for their daughter to
study at a U.S. university.
118 CHAPTER 4 The Balance of Payments
b. Scandinavian Airlines System (SAS) buys jet fuel at Newark Airport for its flight to Copenhagen.
c. Hong Kong students pay tuition to the University of California, Berkeley.
d. The U.S. Air Force buys food in South Korea to supply its air crews.
e. A Japanese auto company pays the salaries of its executives working for its U.S. subsidiaries.
f. A U.S. tourist pays for a restaurant meal in Bangkok. g. A Colombian citizen smuggles cocaine into the
United States, receives cash, and smuggles the dollars back into Colombia.
h. A U.K. corporation purchases a euro-denominated bond from an Italian MNE.
13. 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?
14. 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?
15. 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.
Brazil’s Current Account (millions of US$) 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Goods: exports 55,086 58,223 60,362 73,084 96,475 118,308 137,807 160,649 197,942 152,995 201,915
Goods: imports -55,783 -55,572 -47,241 -48,290 -62,809 -73,606 -91,350 -120,617 -173,107 -127,705 -181,694 Services: credit 9,498 9,322 9,551 10,447 12,584 16,048 19,462 23,954 30,451 27,728 31,821
Services: debit -16,660 -17,081 -14,509 -15,378 -17,260 -24,356 -29,116 -37,173 -47,140 -46,974 -62,628 Income: credit 3,621 3,280 3,295 3,339 3,199 3,194 6,438 11,493 12,511 8,826 7,353
Income: debit -21,507 -23,023 -21,486 -21,891 -23,719 -29,162 -33,927 -40,784 -53,073 -42,510 -46,919 Current transfers: credit
1,828 1,934 2,627 3,132 3,582 4,050 4,846 4,972 5,317 4,736 4,661
Current transfers: debit
-307 -296 -237 -265 -314 -493 -541 -943 -1,093 -1,398 -1,873
PROBLEMS Brazil’s Current Account. Use the following Brazilian balance of payments data from the IMF (all items are for the current account) to answer questions 1 through 5.
1. What is Brazil’s balance on goods? 2. What is Brazil’s balance on services? 3. What is Brazil’s balance on goods and services?
4. What is Brazil’s balance on goods, services, and income?
5. What is Brazil’s current account balance?
Russia’s Balance of Payments. Use the following Russian (Russian Federation) balance of payments data from the IMF to answer questions 6 through 9.
6. Is Russia experiencing a net capital inflow? 7. What is Russia’s total for Groups A and B?
8. What is Russia’s total for Groups A through C? 9. What is Russia’s total for Groups A through D?
119The Balance of Payments CHAPTER 4
15. Is China experiencing a net capital inflow or outflow? 16. What is China’s total for Groups A and B?
Russia’s (Russian Federation’s) Balance of Payments (millions US$) 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
A. Current account balance 46,839 33,935 29,116 35,410 59,512 84,602 94,686 77,768 103,661 48,605 70,253
B. Capital account balance 10,676 -9,378 -12,396 -993 -1,624 -12,764 191 -10,224 496 -11,869
C. Financial account balance -34,295 -3,732 921 3,024 -5,128 1,025 3,071 94,730 -131,807 -31,648 -25,956
D. Net errors and omissions -9,297 -9,558 -6,078 -9,179 -5,870 -7,895 9,518 -13,347 -11,271 -1,724 -7,621
E. Reserves and related items -13,923 -11,266 -11,563 -28,262 -46,890 -64,968 -107,466 -148,928 38,919 -3,363 -36,749
India’s Current Account. Use the following India balance of payments data from the IMF (all items are for the current account) to answer questions 10 through 14.
10. What is India’s balance on goods? 11. What is India’s balance on services? 12. What is India’s balance on goods and services?
13. What is India’s balance on goods, services, and income?
14. What is India’s current account balance?
India’s Current Account (millions of US$) 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Goods: exports 43,247 44,793 51,141 60,893 77,939 102,175 123,768 153,784 198,598 168,223 225,502
Goods: imports -53,887 -51,212 -54,702 -68,081 -95,539 -134,692 -166,572 -208,611 -290,959 -247,040 -323,435 Services: credit 16,684 17,337 19,478 23,902 38,281 52,527 69,730 86,929 104,215 90,598 123,762
Services: debit -19,187 -20,099 -21,039 -24,878 -35,641 -47,287 -58,696 -70,805 -88,261 -80,996 -116,842 Income: credit 2,521 3,524 3,188 3,491 4,690 5,646 8,199 12,650 15,593 13,734 9,612
Income: debit -7,414 -7,666 -7,097 -8,386 -8,742 -12,296 -14,445 -19,166 -18,891 -20,248 -22,538 Current transfers: credit 13,548 15,140 16,789 22,401 20,615 24,512 30,015 38,885 52,065 51,197 55,046
Current transfers: debit -114 -407 -698 -570 -822 -869 -1,299 -1,742 -3,313 -2,095 -2,889
China’s (Mainland) Balance of Payments. Use the following Chinese (Mainland) balance of payments data from the IMF to answer questions 15 through 18.
17. What is China’s total for Groups A through C? 18. What is China’s total for Groups A through D?
China’s (Mainland) Balance of Payments (millions US$) 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
A. Current account balance 20,518 17,401 35,422 45,875 68,659 134,082 232,746 353,996 412,364 261,120 305,374
B. Capital account balance -35 -54 -50 -48 -69 4,102 4,020 3,099 3,051 3,958 4,630
C. Financial account balance 1,958 34.832 32,341 52,774 110,729 96,944 48,629 92,049 43,270 176,855 221,414
D. Net errors and omissions -11,748 -4,732 7,504 17,985 10,531 15,847 -745 11,507 20,868 -41,425 -59,760 E. Reserves and related items -10,693 -47,447 -75,217 -116,586 -189,849 -250,975 -284,651 -460,651 -479,553 -400,508 -471,659
Euro Area Balance of Payments. Use the following Euro Area balance of payments data from the IMF to answer questions 19 through 22.
19. Is the Euro Area experiencing a net capital inflow? 20. What is the Euro Area’s total for Groups A and B?
21. What is the Euro Area’s total for Groups A through C? 22. What is the Euro Area’s total for Groups A through D?
120 CHAPTER 4 The Balance of Payments
Euro Area Balance of Payments (billions US$) 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
A. Current account balance -81.8 -19.7 44.5 24.9 81.2 19.2 -0.3 24.9 -198.2 -31.3 -53.6
B. Capital account balance 8.4 5.6 10.3 14.3 20.5 14.2 11.7 5.4 13.2 8.5 8.2
C. Financial account balance 50.9 -41.2 -15.3 -47.6 -122.9 -71.4 -27.9 -1.9 204.4 70.3 77.3
D. Net errors and omissions 6.4 38.8 -36.5 -24.4 5.6 15.0 19.0 -22.7 -4.5 12.4 -18.3
E. Reserves and related items 16.2 16.4 -3.0 32.8 15.6 23.0 -2.6 -5.7 -4.9 -59.8 -13.6
Australia’s Current Account (millions US$) 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Goods: exports 64,052 63,676 65,099 70,577 87,207 107,011 124,913 142,421 189,057 154,788 212,850
Goods: imports -68,865 -61,890 -70,530 -85,946 -105,238 -120,383 -134,509 -160,205 -193,972 -159,003 -194,670
Services: credit 18,677 16,689 17,906 21,205 26,362 31,047 33,088 40,496 45,240 41,589 48,490
Services: debit -18,388 -16,948 -18,107 -21,638 -27,040 -30,505 -32,219 -39,908 -48,338 -42,121 -51,470
Income: credit 8,984 8,063 8,194 9,457 13,969 16,445 21,748 32,655 37,320 27,923 38,587
Income: debit -19,516 -18,332 -19,884 -24,245 -35,057 -44,166 -54,131 -73,202 -76,719 -65,998 -84,390
Current transfers: credit
2,622 2,242 2,310 2,767 3,145 3,333 3,698 4,402 4,431 5,069 6,063
Current transfers: debit
-2,669 -2,221 -2,373 -2,851 -3,414 -3,813 -4,092 -4,690 -4,805 -6,138 -7,451
Australia’s Current Account. Use the following data from the IMF to answer questions 23 through 26.
25. What is Australia’s balance on goods and services? 26. What is Australia’s current account balance?
23. What is Australia’s balance on goods? 24. What is Australia’s balance on services?
27. Trade Deficits and J-Curve Adjustment Paths. Assume the United States has the following import/export volumes and prices. It undertakes a major “devaluation” of the dollar, say 18% on average against all major trading partner currencies. What is the pre-devaluation and post-devaluation trade balance?
Initial spot exchange rate ($/fc) 2.00 Price of exports, dollars ($) 20.0000 Price of imports, foreign currency (fc) 12.0000 Quantity of exports, units 100 Quantity of imports, units 120 Percentage devaluation of the dollar 18.00% Price elasticity of demand, imports -0.90
INTERNET EXERCISES 1. World Organizations and the Economic Outlook.
The IMF, World Bank, and United Nations are only a few of the major world organizations that track,
report, and aid international economic and financial development. Using these Web sites and others which may be linked, briefly summarize the economic outlook for the developed and emerging nations of the world. For example, Chapter 1 of the World Economic Outlook published annually by the World Bank is available through the IMF’s Web page.
International Monetary Fund www.imf.org/
United Nations www.unsystem.org/
The World Bank Group www.worldbank.org/
Europa (EU) Homepage europa.eu/
Bank for International Settlements www.bis.org/
2. St. Louis Federal Reserve. The Federal Reserve Bank of St. Louis provides a large amount of recent open-economy macroeconomic data online. Use the following addresses to track down recent BOP and GDP data for the major industrial countries.
Recent international economic data
research.stlouisfed.org/ publications/iet/
121The Balance of Payments CHAPTER 4
3. U.S. Bureau of Economic Analysis. Use the following Bureau of Economic Analysis (U.S. government) and the Ministry of Finance (Japanese government) Web sites to find the most recent balance of payments statistics for both countries.
presented by the WTO on the progress of talks on issues including international trade in services and international recognition of intellectual property at the WTO.
World Trade Organization www.wto.org
5. Global Remittances Worldwide. The World Bank’s Web site on global remittances is a valuable source for new and developing studies and statistics on cross- border remittance activity.
World Bank http://remittanceprices. worldbank.org/
Bureau of Economic Analysis
www.bea.gov/ international/
Ministry of Finance www.mof.go.jp/
4. World Trade Organization and Doha. Visit the WTO’s Web site and find the most recent evidence
Balance of payments statistics
research.stlouisfed.org/ fred2/categories/125
122
CHAPTER 5
The Continuing Global Financial Crisis
Confidence in markets and institutions, it’s a lot like oxygen. When you have it, you don’t even think about it. Indispensable. You can go years without thinking about it. When it’s gone for five minutes, it’s the only thing you think about. The confidence has been sucked out of the credit markets and institutions.
—Warren Buffett, October 1, 2008.
Beginning in the summer of 2007, first the United States, followed by the European and Asian financial markets, incurred financial crises. The global credit crisis, which erupted in September 2008, was just winding down in the fall of 2009 when sovereign debt burdens began to reach crisis conditions in Greece and then Ireland within the European Union. This chapter provides an overview of the origins, dissemination, and repercussions of these finan- cial crises on the conduct of global business. The impacts on the multinational enterprise are likely to be both significant and lasting. No student of multinational business should be without a clear understanding of the causes and consequences of this breakdown in global financial markets. The Mini-Case at the end of this chapter, Letting Go of Lehman Brothers, highlights an example of the crisis.
The Credit Crisis of 2008–2009 As the so-called dot-com bubble collapsed in 2000 and 2001, capital flowed toward the real estate sectors in the United States. Although corporate lending was still relatively slow, the U.S. banking sector found mortgage lending a highly profitable and rapidly expanding mar- ket. The following years saw investment and speculation in the real estate sector increase rapidly. As prices rose and speculation increased, a growing number of the borrowers were of lower and lower credit quality. These borrowers and their associated mortgage agree- ments, the infamous subprime debt, now carried higher debt service obligations with lower and lower income and cash flow capabilities. In traditional financial management terms, debt-service coverage was increasingly inadequate.
Financial Sector Deregulation A number of deregulation efforts in the United States in 1999 and 2000 had opened up the real estate financing marketplace to more financial organizations and institutions than
123The Continuing Global Financial Crisis CHAPTER 5
ever before. One of the major openings was the U.S. Congress’ passage of the Gramm- Leach-Bliley Financial Services Modernization Act of 1999, which repealed the last vestiges of the Glass-Steagall Act of 1933, eliminating the last barriers between commercial and investment banks. The Act now allowed commercial banks to enter into more areas of risk, including underwriting and proprietary dealing. One key result was that the banks now competed aggressively for the loan business of customers of all kinds, offering borrowers more and more creative mortgage forms at lower and lower interest rates—at least initial interest rates.
These new and open markets added significant pressure on the existing financial sector regulators. The Federal Deposit Insurance Corporation (FDIC), established in 1933, insured the deposits of customers in commercial banks. The FDIC’s main tools were to require an adequate capital base for each bank and to conduct periodic inspections to assure the credit quality of the banks’ loans. By most measures it had worked well for the period leading up to 1999.
Investment banks and stock brokerage firms were regulated separately, by the Securities and Exchange Commission (SEC). These banks and brokerage firms dealt in much riskier activities than the commercial banks. These activities included stock and bond underwriting, active participation in derivatives and insurance markets and investments in subprime debt and other mortgages, using their own equity and debt capital—not the deposits of consumers. The two sets of institutions and regulators now found themselves operating in a much more complex combined market.
Mortgage Lending One of the key outcomes of this new market openness and competitiveness was that many borrowers who in previous times could not have qualified for mortgages now could. New—and in many cases lower quality borrowers—borrowed at floating rates, priced at LIBOR plus an interest rate spread, with loans resetting at much higher fixed rates within two to five years. Other forms included loan agreements that were interest only in the early years, requiring a subsequent step up in payments with principal reduction or complete refinancing at later dates. In some cases, loans were at initial rates that were far below market rates.
Credit Quality. Mortgage loans in the U.S. marketplace are normally categorized as prime (or A-paper), Alt-A (Alternative-A paper), and subprime, in increasing order of riskiness. A prime mortgage would be categorized as conforming (also referred to as a conventional loan), meaning it would meet the guarantee requirements and resale to Government-Sponsored Enterprises (GSEs), Fannie Mae and Freddie Mac.
Alt-A mortgages, however, were considered a relatively low risk loan and the borrower creditworthy, but for some reason were not initially conforming. As the housing and real estate markets boomed in 2003 and 2004, more and more mortgages were originated by lenders who were in the Alt-A category, the preferred loan for many non–owner-occupied proper- ties. Investors wishing to buy homes for resale purposes, flipping, would typically qualify for an Alt-A mortgage, but not a prime. By the end of 2008, there was more than $1.3 trillion in Alt-A debt outstanding.
The third category of mortgage loans, subprime, is difficult to define. In principle, it reflects borrowers who do not meet underwriting criteria. Subprime borrowers have a higher perceived risk of default, normally as a result of some credit history elements, which may include bankruptcy, loan delinquency, default, or simply limited experience or history of debt. They are nearly exclusively floating-rate structures, and carry significantly higher interest rate spreads over the floating bases like LIBOR.
124 CHAPTER 5 The Continuing Global Financial Crisis
Subprime lending was itself the result of deregulation. Until 1980, most states in the U.S. had stringent interest rate caps on lenders/borrowers. Even if a lender was willing to extend a mortgage to a subprime borrower—at a higher interest rate, and the borrower was willing to pay it, state law prohibited it. With the passage of the 1980 Depository Institutions Deregulation and Monetary Control Act (DIDMCA) federal law superseded state law. But it wasn’t until the passage of the Tax Reform Act of 1986 that subprime debt became a viable market. The TRA of 1986 eliminated tax deductibility of consumer loans, but allowed tax deductibility on interest charges associated with both a primary residence and a second mortgage loan.
The growing demand for loans or mortgages by these borrowers led more and more origi- nators to provide the loans at above market rates beginning in the late 1990s. By the 2003–2005 period, these subprime loans were a growing segment of the market.1 As illustrated in Exhibit 5.1, the growth in both total domestic borrowing and mortgage-based borrowing in the United States in the post-2000 period was rapid. However, the collapse in mortgage borrowing as a result of the 2008 credit crisis was even more dramatic.
Asset Values. One of the key financial elements of this growing debt was the value of the assets collateralizing the mortgages—the houses and real estate itself. As the market demands pushed up prices, housing assets rose in market value. The increased values were then used as collateral in refinancing, and in some cases, additional debt in the form of second mortgages based on the rising equity value of the home.
1Subprime mortgages may have never exceeded 7% to 8% of all outstanding mortgage obligations by 2007, but by the end of 2008, they were the source of more than 65% of bankruptcy filings by homeowners in the United States.
EXHIBIT 5.1
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 –$500
$0
$500
$1,000
$1,500
$2,000
$2,500
Billions of U.S. dollars
Total Domestic Mortgage Debt
Source: Flow of Funds Accounts of the United States, Annual Flows and Outstandings, Board of Governors of the Federal Reserve System, Washington, D.C. FFA 1995–2004 and FFA, 2005–2010, March 10, 2011, p. 2.
U.S. Credit Market Borrowing, 1995–2010
125The Continuing Global Financial Crisis CHAPTER 5
Unfortunately, as existing homes rose in value, many homeowners were motivated to refinance existing mortgages. As a result, many mortgage holders who were previously stable became more indebted and were participants in more aggressively constructed loan agree- ments. The mortgage brokers and loan originators themselves also provided fuel to the fire, as the continuing prospects for refinancing generated additional fee income, a staple of the industry’s returns. The industry provided the feedstock for its own growth.
Mortgage debt as a percentage of household disposable income continued to climb in the United States rapidly in the post-2000 business environment. But it was not a uniquely American issue, as debt obligations were rising in a variety of countries including Great Brit- ain, France, Germany, and Australia. Exhibit 5.2 illustrates the rising household debt levels for three selected countries through mid-2008. In the end, Great Britain was significantly more indebted in mortgage debt than even the United States.
The U.S. Federal Reserve, at the same time, intentionally aided the debt growth mecha- nism by continuing to lower interest rates. The Fed’s monetary policy actions were predictably to lower interest rates to aid the U.S. economy in its recovery from the 2000–2001 recession. These lower rates provided additional incentive and aid for borrowers of all kinds to raise new and ever cheaper debt.
The Transmission Mechanisms If subprime debt was malaria, then securitization was the mosquito carrier. The vehicle for the growing lower quality debt was the securitization and repackaging provided by a series of new financial derivatives.
Securitization. Securitization has long been a force of change in global financial markets. Securitization is the process of turning an illiquid asset into a liquid salable asset. The key ele- ment was liquidity. Liquid, in the field of finance, is the ability to exchange an asset for cash, instantly, at fair market value.
EXHIBIT 5.2
19 90
19 91
19 92
19 93
19 94
19 95
19 96
19 97
19 98
19 99
20 00
20 01
20 02
20 03
20 04
20 05
20 06
20 07
20 08
180
160
140
120
100
80
60
Great Britain
United States
Germany
Source: Deutsche Bundesbank, UK Statistics Authority, U.S. Federal Reserve, The Economist.
Household Debt as a Percent of Disposable Income, 1990–2008
126 CHAPTER 5 The Continuing Global Financial Crisis
Although a multitude of countries had used securitization as a method of creating liquid markets for debt and equity funding since World War II, the United States had been one of the last major industrial countries to introduce securitization in its savings and loan and commer- cial banking systems, finally doing so in the 1980s. In its purest form, securitization essentially bypasses the traditional financial intermediaries, typically banks, to go directly to investors in the marketplace in order to be sold and raise funds. As a result, it may often reduce the costs of lending and borrowing, while possibly increasing the returns to investors.
The growth in subprime lending and Alt-A lending in the post-2000 U.S. debt markets depended upon this securitization force. Financial institutions extended more loans of all kinds—mortgage, corporate, industrial, and asset-backed—and then moved these loan and bond agreements off their balance sheets to special-purpose vehicles using securitization. The securitized assets took two major forms, mortgage-backed securities (MBSs) and asset-backed securities (ABSs). ABSs included second mortgages and home-equity loans based on mort- gages, in addition to credit card receivables, auto loans, and a variety of others.
Growth was rapid. As illustrated in Exhibit 5.3, mortgage-backed securities (MBS) issu- ances rose dramatically in the post-2000 period. By end of year 2007, just prior to the crisis, MBS totaled $27 trillion and represented 39% of all loans outstanding in the U.S. marketplace. Of the $1.3 trillion in Alt-A debt outstanding at the end of 2008, more than $600 billion of it had been securitized. By securitizing the debt, portfolios of loans and other debt instruments were now packaged and resold into a more liquid market, freeing up the originating institu- tions to make more loans of, in some cases, dubious quality.
An added problem was that securitization itself may degrade credit quality. As long as the lender, the originator, was “stuck” with the loan, the lender was keen to assure the quality of the loan and the capability of the borrower to repay in a timely manner. The lender had a stake
EXHIBIT 5.3
$3,500
$3,000
$2,500
$2,000
$1,000
$1,500
$500
$0
Mortgage-Backed Securities (MBS) issuance growth reflected both greater origination of real estate mortgage debt and the rising use of securitization to “move” mortgages.
Although issuances slowed post-2003, the accumulation of MBS debt was a rising burden on borrowers and the economy.
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Source: Fannie Mae, Freddie Mac, and the Federal Role in the Secondary Mortgage Market, Congressional Budget Office, December 2010, p. 11.
Billions of 2009 U.S. dollars
Annual Issuances of MBSs, 1995–2009
127The Continuing Global Financial Crisis CHAPTER 5
in continuing to monitor borrower behavior over the life of the debt. Securitization, however, severed that link. Now the originator could originate and sell, not being held accountable for the repayment of the loan obligation. Originators could now focus on generating more and more fees through more loans, origination, while not being concerned over the actual loan performance. The originate-to-distribute (OTD) model was now fragmenting traditional banking risks and returns.
Proponents of securitization acknowledge that it did allow more subprime mortgages to be written. But those same credits allowed more and more home buyers and commercial operators lower-cost financing, making home ownership and small business activities more affordable and more accessible. Moreover, although there was clearly abuse in the origination of subprime mortgages, many believe that the U.S. system was particularly vulnerable, not having sufficient requirements or principles in place over key credit quality criteria. Proponents of securitiza- tion argue that if these errors are corrected, it could have the ability to reach its objectives of creating more liquid and efficient markets without degrading the quality of the obligations.
Structured Investment Vehicles. The financial organism that filled the niche of buyer of much of the securitized nonconforming debt was the structured investment vehicle (SIV). This was the ultimate financial intermediation device: it borrowed short and invested long. The SIV was an off-balance sheet entity, first created by Citigroup, to allow a bank to invest in long-term and higher yielding assets such as speculative grade bonds, mortgage-backed securities (MBSs), and collateralized debt obligations (CDOs, described in the following section), while funding itself through commercial paper (CP) issuances. CP has long been one of the lowest-cost funding sources for any business. The problem, of course, is that the buyers of CP issuances must have full faith in the credit quality of the business unit. And that, in the end, was the demise of the SIV.
The funding of the typical SIV was fairly simple: using minimal equity, the SIV borrowed very short—commercial paper, interbank, or medium-term-notes. Sponsoring banks provided backup lines of credit to assure the highest credit ratings for CP issuances. The SIV then used the proceeds to purchase portfolios of higher yielding securities that held investment grade credit ratings. The SIV then generated an interest margin, roughly 0.25% on average, acting as a middleman in the shadow banking process.
It is the credit quality of many of the purchased assets—for example, collateralized debt obligations (CDOs), as described in the following section, which has been the subject of much ex post debate. A portfolio of subprime mortgages not of investment grade quality was often awarded investment grade quality because of the belief in portfolio theory. The theory held that whereas a single large subprime borrower constituted significant risk, a portfolio of sub- prime borrowers which was securitized (chopped up pieces in a sense), represented signifi- cantly less risk of credit default and could therefore be awarded investment grade status.
The theory proved false, however. As the housing boom collapsed in 2007, the subprime mortgages underlying these CDOs failed, causing the value of the SIV’s asset portfolios to be instantly written down in value (mark-to-market accounting required real-time revaluation of the assets). As the asset values fell, buyers of SIV-based CP disappeared. By October 2008, SIVs were a thing of the past.
Collateralized Debt Obligations (CDOs). One of the key instruments in this new growing securitization was the collateralized debt obligation, or CDO. Banks originating mortgage loans and corporate loans could now create a portfolio of these debt instruments and package them as an asset-backed security. Once packaged, the bank passed the security to a special purpose vehicle (SPV) (not to be confused with the previously described SIV), often located in an offshore financial center like the Cayman Islands for legal and tax advantages. SPVs offered a number of distinct advantages, such as the ability to remain off-balance sheet if financed and operated properly. From there the CDO was sold into a growing market through underwriters. The collateral in the CDO was the real estate or other property the loan was used to purchase.
128 CHAPTER 5 The Continuing Global Financial Crisis
These CDOs were sold to the market in categories representing the credit quality of the borrowers in the mortgages—senior tranches (rated AAA), mezzanine or middle tranches (AA down to BB), and equity tranches (below BB, junk bond status, many of which were unrated). The actual marketing and sales of the CDOs was done by the major investment banking houses, which now found the fee income easy and profitable.
The problem with CDOs in practice was the complexity of assigning credit quality. A col- lection of corporate bonds or subprime mortgages would be combined into a portfolio—the CDO. The CDO would then be passed to a ratings firm, firms such as Moody’s, S&P, and Fitch, for a rating. The rating firms were paid for their rating, and were often under severe pressure to complete their rating quickly. As a result, it was common practice to use the ratings informa- tion provided by the underwriter, rather than doing ground-up credit analysis on their own. A second, and somewhat confounding issue, was that it was also possible for a collection of bonds, say BB bonds, to be rated above BB when combined into a CDO. In the end, the ratings provided by the ratings firms were critical for the underwriter to be able to market the CDOs.
By 2007, the CDO market had reached a record level of $600 billion. CDOs now moved globally, being passed along to institutions like Freddie Mac in the U.S., or banking organiza- tions in London, Paris, Hong Kong, or Tokyo.2 Of course, the actual value of the CDO was no better or worse than its two primary value drivers. The first was the performance of the debt collateral it held, the ongoing payments made by borrowers; the second was the willing- ness of institutions to make a market in CDOs. By 2007, the CDO had become a mainstay of investment banking activity globally. The beginning of the end was the collapse of two Bear Stearns’ hedge funds in July 2007, both funds consisting nearly entirely of CDOs. Within a month the market for CDOs was completely illiquid—prices of cents on the dollar. The CDO market collapsed, as seen in Exhibit 5.4.
2A stranger development was the synthetic CDO which was constructed purely of derivative contracts combined to “mimic” the cash flows of other CDOs. The Mantoloking CDO offered by Merrill Lynch was one such CDO-squared. The subprime components that were unacceptable to investors were grouped into dumping grounds like Mantoloking.
EXHIBIT 5.4
Source : Data drawn from “Global CDO Market Issuance Data,” Securities Industry and Financial Markets Association (SIFMA), sigma.org.
$200
$180
$160
$140
$120
$100
$80
$60
$40
$20
$0 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 Quarter
Year2004 2005 2006 2007 2008
4 1 2 3 4
Global CDO Issuance, 2004–2008 (billions of U.S. dollars)
129The Continuing Global Financial Crisis CHAPTER 5
Credit Default Swaps (CDSs). The second derivative of increasing note—or concern—was the credit default swap (CDS). The credit default swap was a contract, a derivative, which derived its value from the credit quality and performance of any specified asset. The CDS was new, invented by a team at J.P. Morgan in 1997, and designed to shift the risk of default to a third party. In short, it was a way to bet whether a specific mortgage or security would either fail to pay on time or fail to pay at all. In some cases, for hedging, it provided insurance against the possibility that a borrower might not pay. In other instances, it was a way in which a speculator could bet against the increasingly risky securities (like the CDO), to hold their value. And uniquely, you could make the bet without ever holding or being directly exposed to the credit instrument itself.
Despite its forbidding name, the CDS is a simple idea: it allows an investor to buy insurance against a company defaulting on its debt payments. When it was invented, the CDS was a use- ful concept because more people felt comfortable owning corporate debt if they could elimi- nate the risk of the issuer failing. The extra appetite for debt helped lower the cost of capital.
—“Derivatives: Giving Credit Where It Is Due,” The Economist, November 6, 2008.
The CDS was completely outside regulatory boundaries, having obtained unique protec- tion as a result of the Commodity Futures Modernization Act of 2000. The CDS was in fact a position or play which had been outlawed for more than a century (the bucket shop)—that is, until major financial market deregulatory steps were taken in 1999 and 2000. A bucket shop was a type of gambling house in which one could speculate on stocks rising or falling in price— without owning the stock.3 In order to write or sell a CDS one needed only to find a counter- party willing to take the opposite position, as opposed to actually owning the shares. The CDS market boomed as seen in Exhibit 5.5, growing to a size many times the size of the underlying
3Note that this is different from shorting, where a speculator bets on a security to fall in price, and agrees to sell an actual share to a second party at a future date at a specified price. The speculator is hoping that the share price does fall, so that it can be purchased on the open market at a lower price.
$60
$50
$40
$30
$20
$10
0
2000 2001 2002 2003 2004 2005 2006 2007 2008
Source : Data drawn from Table 19: Amounts Outstanding of Over-the-Counter-Derivatives, by Risk Category and Instrument, BIS Quarterly Review, June 2009, bis.org.
Amount outstanding in trillions of U.S. dollars
EXHIBIT 5.5 Credit Default Swap Market Growth
130 CHAPTER 5 The Continuing Global Financial Crisis
credit instruments it was created to protect. The market was unregulated—there was no reg- istry of issuances, no requirements on sellers that they had adequate capital to assure contrac- tual fulfillment, and no real market for assuring liquidity—depending on one-to-one counterparty settlement.
Critics of regulation argue that the market has weathered many challenges, such as the failures of Bear Stearns and Lehman Brothers (at one time estimated to have been a seller of 10% of global CDS obligations), the near failure of AIG, and the defaults of Freddie Mac and Fannie Mae. Despite these challenges, the CDS market continues to function and may have learned its lessons. Proponents argue that increased transparency of activity alone might provide sufficient information for growing market resiliency and liquidity.
The collapse of Lehman Brothers, an investment bank, and other financial disasters, raise fears that the sellers of these products, namely banks and insurance firms, will not honour their commitments. A cascade of defaults could be multiplied many times through deriva- tives, blowing yet another hole in the financial system. Once considered a marvelous tool of risk management, CDSs now look as though they will magnify, not mitigate, risk.
—“Dirty Words: Derivatives, Defaults, Disaster . . . ” by Henry Tricks, The World, November 19, 2008.
A final element quietly at work in credit markets beginning in the late 1990s was the pro- cess of credit enhancement. Credit enhancement is the method of making investments more attractive to prospective buyers by reducing their perceived risk. In the mid-1990s, under- writers of a variety of asset-backed securities (ABSs) often used bond insurance agencies to make their products “safer” for both them and the prospective buyers. These bond insurance agencies were third parties, not a direct part of the underwriting and sale, but a guarantor in the case of default. The practice was widely used in the underwriting of home equity loan ABSs, and as illustrated in Global Finance in Practice 5.1, by some well-known entrepreneurs.
Credit Crisis The housing market burst in the spring of 2007, with the U.S. market falling— plummeting— first, followed by housing markets in the United Kingdom and Australia. What followed was a literal domino effect of collapsing loans and securities, followed by the funds and institutions
The type of fallacy involved in projecting loss experience from a universe of noninsured bonds onto a deceptively similar universe in which many bonds are insured pops up in other areas of finance. “Back-tested” models of many kinds are sus- ceptible to this sort of error. Nevertheless, they are frequently touted in financial markets as guides to future action. (If merely looking up past financial data would tell you what the future holds, the Forbes 400 would consist of librarians.)
Indeed, the stupefying losses in mortgage-related secu- rities came in large part because of flawed, history-based models used by salesmen, rating agencies, and investors. These parties looked at loss experience over periods when home prices rose only moderately and speculation in houses was negligible. They then made this experience a yardstick for evaluating future losses. They blissfully ignored the fact
that house prices had recently skyrocketed, loan practices had deteriorated and many buyers had opted for houses they couldn’t afford. In short, universe “past” and universe “current” had very different characteristics. But lenders, government and media largely failed to recognize this all-important fact.
Investors should be skeptical of history-based models. Constructed by a nerdy sounding priesthood using esoteric terms such as beta, gamma, sigma, and the like, these mod- els tend to look impressive. Too often, though, investors forget to examine the assumptions behind the symbols. Our advice: Beware of geeks bearing formulas.
Source: Berkshire Hathaway Annual Report, 2008, Letter to Shareholders, pp. 14–15.
GLOBAL FINANCE IN PRACTICE 5.1
Warren Buffett on the Credit Crisis
131The Continuing Global Financial Crisis CHAPTER 5
that were their holders. In July 2007, two hedge funds at Bear Stearns holding a variety of CDOs and other mortgage-based assets failed. Soon thereafter, Northern Rock, a major British banking organization, was rescued from the brink of collapse by the Bank of England. Financial institutions on several continents suffered bank runs. Interest rates rose, equity markets fell, and the first stages of crisis rolled through the global economy.
2008 proved even more volatile than 2007. Crude oil prices—as well as nearly every other commodity price—rose at astronomical rates in the first half of the year. The massive growth in the Chinese and Indian economies, and in fact in many emerging markets globally, continued unabated. And just as suddenly, it stopped. Crude oil peaked at $147/barrel in July, then plummeted, as did nearly every other commodity price including coal, copper, nickel, timber, concrete, and steel. As mortgage markets faltered, the U.S. Federal Reserve stepped in. On August 10, 2008, the Fed purchased $38 billion in mortgage-backed securities in an attempt to inject liquidity into the credit markets. On September 7, 2008, the U.S. government announced that it was placing Fannie Mae (the Federal National Mortgage Association) and Freddie Mac (the Federal Home Loan Mortgage Corporation) into conservatorship—the government was taking over the institutions as result of their near insolvency. The following week, Lehman Brothers, one of the oldest investment banks on Wall Street, struggled to survive. Finally, on September 14, Lehman filed for bankruptcy. As described in the Mini-Case at the end of this chapter, it was the largest bankruptcy in American history.
On Monday, September 15, the markets reacted. Equity markets plunged. In many ways much more important for the financial security of multinational enterprises, U.S. dollar LIBOR rates shot skyward, as illustrated in Exhibit 5.6, as a result of the growing international perception of financial collapse by U.S. banking institutions. The following day, American
EXHIBIT 5.6
Source :British Bankers Association (BBA). Overnight lending rates.
8.00
7.00
6.00
5.00
4.00
3.00
2.00
1.00
0.00
10 /0
3/ 09
10 /0
1/ 09
10 /0
5/ 09
10 /0
7/ 09
10 /0
9/ 09
10 /1
1/ 09
10 /1
5/ 09
10 /1
3/ 09
10 /2
1/ 09
10 /2
5/ 09
10 /1
7/ 09
10 /1
9/ 09
10 /2
7/ 09
10 /2
3/ 09
10 /2
9/ 09
10 /3
1/ 09
9/ 01
/0 9
9/ 03
/0 9
9/ 05
/0 9
9/ 07
/0 9
9/ 09
/0 9
9/ 13
/0 9
9/ 11
/0 9
9/ 19
/0 9
9/ 23
/0 9
9/ 15
/0 9
9/ 17
/0 9
9/ 25
/0 9
9/ 21
/0 9
9/ 27
/0 9
9/ 29
/0 9
Pe rc
en t
Tuesday, September 16 AIG suffers liquidity crisis following its credit downgrading; USD LIBOR hits 6.4375%
USD LIBOR hits 6.875% September 30, the day following the sale of Wachovia to Bank of America and the fall of the Dow 777 points
USD LIBOR hits 5.375% October 8 following: 1. Federal Reserve’s announcement of a Commercial Paper Facility 2. record drop in the FTSE 3. Icelandic turmoil
Monday, September 15 markets react to Sunday’s announcement of Lehman bankruptcy
USD LIBOR
JPY LIBOR
USD and JPY LIBOR Rates, September–October 2008
132 CHAPTER 5 The Continuing Global Financial Crisis
International Group (AIG), the U.S. insurance conglomerate with extensive CDS exposure, received an $85 billion injection from the U.S. Federal Reserve in exchange for an 80% equity interest. The following weeks saw renewed periods of collapse and calm as more and more financial institutions failed, merged, or were bailed out.
The credit crisis now began in full. Beginning in September 2008 and extending into the spring of 2009, the world’s credit markets—lending of all kinds—nearly stopped. The global credit markets were in shock.
! The risky investment banking activities undertaken post-deregulation, especially in the mortgage market, overwhelmed the banks’ commercial banking activities.
! The indebtedness of the corporate sector was tiered, with the biggest firms actually being well positioned to withstand the crisis. The middle and lower tier companies by size, however, were heavily dependent on short-term debt for working capital financing. Many were now having trouble in both servicing existing debt and gaining access to new debt to stave off declining business conditions.
! The Fortune 500 companies had two balance sheet characteristics that seemed to have predicted the crisis. First, the right-hand side of their balance sheets was extremely clean, paying down debt over the previous five-year period. Second, the left-hand-side of their balance sheets was healthy, with record-high levels of cash and marketable securities. This gave them ready cash even if the banks did not answer the phone.
! Many corporate treasurers in the Fortune 500 now discovered that much of their marketable security portfolio, invested so carefully with high-quality mutual funds and banks, had actually been invested in a variety of securities, derivatives, and funds now failing, despite all policies and guarantees in place.
! Banks stopped lending. Companies that did not have preexisting lines of credit could not gain access to funds at any price. Companies with preexisting lines of credit were now receiving notification that their lines were being reduced. (This was particularly heavy in London, but also seen in New York.) As a result, many companies, although not needing the funds, chose to draw down their existing lines of credit before they could be reduced—a classic panic response, reducing credit availability for all.
! The commercial paper market essentially ceased to operate in September and October. Although the market had always been a short-term money market, more than 90% of all issuances in September 2008 were overnight. The markets no longer trusted the credit quality of any counterparty—whether they be hedge funds, money market funds, mutual funds, investment banks, commercial banks, or corporations. The U.S. Federal Reserve stepped in quickly, buying billions in CP to add liquidity into the system.
! Traditional commercial bank lending for working capital financing, automobile loans, student loans, and credit card debt were squeezed out by the huge losses from the investment banking activities. Thus began the credit squeeze worldwide, a decline of asset prices, increased unemployment, burgeoning real estate foreclosures, and a general global economic malaise.
Global Contagion Although it is difficult to ascribe causality, the rapid collapse of the mortgage-backed securi- ties markets in the United States definitely spread to the global marketplace. Capital invested in equity and debt instruments in all major financial markets fled not only for cash, but for cash in traditional safe-haven countries, and in the process, fleeing many of the world’s most
133The Continuing Global Financial Crisis CHAPTER 5
promising emerging markets. Exhibit 5.7 illustrates clearly how markets fell in September and October 2008, and how they remained volatile in the months that followed.
The impact was felt immediately in the currencies of a multitude of open emerging markets. Many currencies now fell against the traditional three safe-haven currencies, the dollar, the euro, and the yen: the Icelandic krona, Hungarian forint, Indian rupee, Korean won, Mexican peso, Brazilian real, to name a few.
The spring of 2009, saw a mortgage marketplace that continued to deteriorate. Alt-A mortgages were now reaching record delinquency levels, higher than even subprime mortgages. It was now apparent that many of the mortgages that were pumped into the system near the end of the housing boom as Alt-A or “near-prime” mortgages were in fact subprime. Although possessing an historical average delinquency rate of less than 1%, the Alt-A mortgage debt originated in 2006 was now above 11%. Moody’s, for example, downgraded more than $59 billion in Alt-A securities in a three-day period alone in January 2009, most of which fell instantly to speculative grade. More than 25% of all Alt-A mortgage debt was expected to fail.
By January 2009, the credit crisis was having additionally complex impacts on global markets and global firms. As financial institutions and markets faltered in many industrial countries, pressure increased to focus on the needs of “their own.” A new form of antiglobal- ization force arose, the differentiation of the domestic from the multinational. This new form of financial mercantilism focused on supporting the home-country financial and nonfinancial firms first, all others second. Multinational companies, even in emerging markets, now saw
EXHIBIT 5.7
140
120
100
80
60
40
20
31 /O
ct/ 07
30 /N
ov /07
31 /D
ec /07
31 /Ja
n/0 8
29 /Fe
b/0 8
31 /M
ar/ 08
30 /A
pr/ 08
30 /M
ay /08
30 /Ju
n/0 8
31 /Ju
l/0 8
29 /A
ug /08
30 /Se
p/0 8
31 /O
ct/ 08
28 /N
ov /08
31 /D
ec /08
27 /Ja
n/0 9
Stock Market Indices (1 October 2007 = 100)
Source : “The U.S. Financial Crisis: The Global Dimension with Implications for U.S. Policy,” Dick K. Nanto, Congressional Research Service, Washington, D.C., January 29, 2009, p.11.
Russian RTS UK FTSEDow Jones Industrials Japan Nikkei 225
Severe Global
ContagionRussian RTS
UK FTSE
Dow Jones IndustrialsJapan Nikkei 225
Mild Global Contagion
Selected Stock Markets During the Crisis
134 CHAPTER 5 The Continuing Global Financial Crisis
increasing indicators that they were being assessed higher credit risks and lower credit quali- ties, even though they theoretically had greater business diversity and the wherewithal to with- stand the onslaught. The financial press categorized the credit dynamics as homeward flow. Credit conditions and a variety of new government bailout plans were underway in Australia, Belgium, Canada, France, Germany, Iceland, Ireland, Italy, Luxembourg, Spain, Sweden, the United Kingdom, and the United States.
The credit crisis now moved to a third stage. The first stage had been the failure of specific mortgage-backed securities. These had caused the fall of specific funds and instruments. The second stage had seen the crisis spread to the very foundations of the organizations at the core of the global financial system, the commercial and investment banks on all continents. This third new stage had been feared from the beginning—a credit-induced global recession of potential depression-like depths. Not only had lending stopped, but also in many cases, investing ceased. Although interest rates in U.S. dollar markets hovered little above zero, the price was not the issue. The prospects for investment returns of all types were now dim. The economies of the industrial world retrenched, and the seeds of the European debt crisis sown.
What’s Wrong with LIBOR?
Today’s failure of confidence is based on three related issues: the solvency of banks, their ability to fund themselves in illiquid markets and the health of the real economy.
—“The Credit Crunch: Saving the System,” The Economist, October 9, 2008.
The global financial markets have always depended upon commercial banks for their core business activity. In turn, the banks have always depended on the interbank market for the liquid linkage to all of their nonbank activity, their loans and financing of multinational busi- ness. But throughout 2008 and early 2009, the interbank market was, in one analyst’s words, “behaving badly.” LIBOR was clearly the culprit.
The interbank market has historically operated, on its highest levels, as a “no-name” market. This meant that for the banks at the highest level of international credit quality inter- bank transactions could be conducted without discriminating by name; they traded among themselves at no differential credit risk premiums. A major money center bank trading on such a level was said to be trading on the run. Banks that were considered to be of slightly less credit quality, sometimes reflecting more country risk than credit risk, paid slightly higher to borrow in the market. The market preferred not to price on an individual basis, often catego- rizing many banks by tier. As individual financial institutions, commercial and investment banks alike, started suffering more and more losses related to bad loans and credits, the banks themselves became the object of much debate.
LIBOR’s Role In the spring of 2008, the British Bankers Association (BBA), the organization charged with the daily tabulation and publication of LIBOR Rates, became worried about the validity of its own published rate. The growing stress in the financial markets had actually created incentives for banks surveyed for LIBOR calculation to report lower rates than they were actually paying. A bank that had historically been considered to be on the run, but now suddenly reported having to pay higher rates in the interbank market, would be raising concerns that it was no longer safe.
The BBA collects quotes from 16 banks of seven different countries daily, including the United States, Switzerland, and Germany. Rate quotes are collected for 15 different maturities, ranging from one day to one year across 10 different currencies.4 But the BBA has become
4After collecting the 16 quotes by maturity and currency, the BBA eliminates the four highest and four lowest rates reported, and averages the remaining ones to determine various published LIBOR rates.
135The Continuing Global Financial Crisis CHAPTER 5
concerned that even its survey wording—“at what rate could the bank borrow a reasonable amount?”—was leading to some reporting irregularities. There were increasing differences in the interpretation of “reasonable.”
As the crisis deepened in September and October 2008, many corporate borrowers began to argue publicly that LIBOR rates published were in fact understating their problems. Many loan agreements with banks have market disruption clauses that allow banks to actually charge corporate borrowers their “real cost of funds,” not just the published LIBOR. When markets are under stress and banks have to pay more and more to fund themselves, they need to pass the higher costs on to their corporate clients. Corporate borrowers attempting to arrange new loans were being quoted ever-higher prices at considerable spreads over LIBOR.
LIBOR, although only one of several key interest rates in the global marketplace, has been the focus of much attention and anxiety of late. In addition to its critical role in the interbank market, it has become widely used as the basis for all floating rate debt instruments of all kinds. This includes mortgages, corporate loans, industrial development loans, and the multitudes of financial derivatives sold throughout the global marketplace. The BBA recently estimated that LIBOR was used in the pricing of more than $360 trillion in assets globally. LIBOR’s central role in the markets is illustrated in Exhibit 5.8. It was therefore a source of much concern when LIBOR rates literally skyrocketed in September 2008.
In principle, central banks around the world set the level of interest rates in their curren- cies and economies. But these rates are for lending between the central bank and their com- mercial banks. The result is that although the central bank sets the rate it lends at, it does not dictate the rate at which banks lend either between themselves or to nonbank borrowers. As illustrated in Exhibit 5.9, in the months prior to the September crises, three-month LIBOR was averaging 80 basis points higher than the three-month interest rate swap index, the difference being termed the TED Spread. TED is an acronym for T-bill and ED (the ticker symbol for the Eurodollar futures contract). In September and October 2008, the spread rose to more
EXHIBIT 5.8
Bank Bank
Mortgage Loan
Corporate Loan
Corporate Bond
Corporate Borrowers
Commercial Paper (CP) Market
Mutual Funds
Interbank Market
Bank debt began to dry up
Step 1. As the loans and investments made by banks began to fail, the banks were forced to write off the losses under mark-to-market regulatory requirements. The banks then needed to draw upon new funds, like the interbank market.
( L IBOR)
Step 2. Since banks no longer could “trust” the credit quality of other banks, Interbank lending, priced on LIBOR, became a focal point of anxiety.
Step 3. Corporate borrowers who found bank lending shut off, now went directly to the market, issuing commercial paper. After only a few weeks, however, that market too shut down.
Step 4. Mutual Funds and other nonbank investors were no longer willing to invest in CP as corporate borrowers began to suffer from falling business conditions and failure to pay.
LIBOR and the Crisis in Lending
136 CHAPTER 5 The Continuing Global Financial Crisis
EXHIBIT 5.9
5.00
4.50
4.00
3.50
3.00
2.50
2.00
1.50
1.00
0.50
0.00
Source: British Bankers Association, Bloomberg.
Pe rc
en t
3-month USD LIBOR
TED Spread
3-month Interest Rate Swap Index
The TED Spread is the difference between LIBOR and some measure of risk-less interest (either the U.S. Treasury Bill rate or in this case, the Interest Rate Swap Index rate).
11 /4/
20 08
10 /28
/20 08
11 /11
/20 08
11 /18
/20 08
11 /25
/20 08
12 /2/
20 08
12 /16
/20 08
12 /9/
20 08
1/6 /20
09 1/2
0/2 00
9
12 /23
/20 08
12 /30
/20 08
1/2 7/2
00 9
1/1 3/2
00 9
7/8 /20
08
7/1 /20
08 7/1
5/2 00
8 7/2
2/2 00
8 7/2
9/2 00
8 8/5
/20 08
8/2 6/2
00 8
8/1 2/2
00 8
9/1 6/2
00 8
9/3 0/2
00 8
9/2 /20
08 9/9
/20 08
10 /7/
20 08
9/2 3/2
00 8
10 /14
/20 08
10 /21
/20 08
8/1 9/2
00 8
than 350 basis points as the crisis caused many banks to question the credit quality of other banks. Even this spread proved misleading. The fact was that many banks were completely “locked-out” of the interbank market at any price.
What is also apparent from Exhibit 5.9 is the impact of the various U.S. Treasury and Federal Reserve actions to “re-float” the market. As banks stopped lending in mid- to late- September, and many interbank markets became illiquid, the U.S. financial authorities worked feverishly to inject funds into the market. The result was the rapid reduction in the 3-month Interest Rate Swap Index. The TED Spread remained relatively wide only a short period, with LIBOR actually falling to under 1.5% by the end of 2008. In January 2009, the TED Spread returned to a more common spread of under 80 basis points.5
Of course, the larger, more creditworthy companies use the commercial paper market instead of borrowing from banks. In September 2008, however, the commercial paper mar- ket also shutdown as many of the market’s traditional buyers of commercial paper—other commercial banks, hedge funds, and private equity funds shied away from buying the paper. Even CP sold by the traditionally secure General Electric jumped 40 basis points. Many of the buyers of CP now worried that the declining economy would result in an increasing default rate by CP issuers. The corporate sector saw another door to capital close. As illustrated by Global Finance in Practice 5.2, credit itself remained a continuing problem.
The credit crisis was worsened by the destabilizing effects of speculators, in a variety of different institutions, betting that particular instruments or markets or securities would fail. Although legal suits like these will most likely wind their way through the American court system for many years, the basic question of fiduciary responsibility—the responsibility to act in the best interests of the client, to carry out their responsibilities with good faith, honesty,
5The TED Spread is often calculated using the maturity equivalent to LIBOR in U.S. Treasuries, in this case, the 3-month U.S. Treasury Bill yield. In fact, in late 2008 the U.S. 3-month Treasury Bill yield hovered near zero.
The U.S. Dollar TED Spread, July 2008–January 2009
137The Continuing Global Financial Crisis CHAPTER 5
integrity, loyalty and undivided service—versus individual profit motives, is in many ways at the heart of the dilemma.
U.S. Credit Crisis Resolution Starting as early as August 10, 2008, the U.S. Federal Reserve purchased billions of dollars of mortgage-backed securities, CDOs, in an attempt to inject liquidity into the credit market. Although liquidity was indeed a major portion of the problem, massive write-offs of failed mortgages by the largest banks were equally serious. The write-offs weakened the equity capital positions of these institutions. It would, therefore, be necessary for the private sector or the government to inject new equity capital into the riskiest banks and insurers—insolvency in addition to illiquidity.
The U.S. Federal Reserve and U.S. Treasury both encouraged the private sector banks to solve their own problems. This could be done by new equity issues, conversion of investment banks to commercial banks to get direct access to the Fed, and depositors’ funds and mergers. But the market for new equity issues for these weakened banks was unfavorable at this time; as a result, mergers were the strongest remaining alternative. The largest stock brokerage in the United States, Merrill Lynch, was merged into Bank of America. Morgan Stanley, a leading investment bank, sold a 20% equity interest to Mitsubishi Bank of Tokyo. Wachovia Bank was merged into Wells Fargo. Lehman Brothers was courted by Barclays Bank (U.K.) but failed to reach a timely agreement, forcing it into bankruptcy. Lehman’s failure had many of the ripple effects feared, as its role in the commercial paper market could not be replaced. The Mini-Case at the end of this chapter chronicles the demise of Lehman Brothers.
The bailout included governmental institutions as well as private institutions. On September 7, 2008, the government announced it was placing Fannie Mae (the Federal National Mortgage Asso- ciation) and Freddie Mac (the Federal Home Loan Mortgage Corporation) into conservatorship. In essence, the government was taking over the institutions as a result of their near insolvencies.
Troubled Asset Recovery Plan (TARP). After a difficult debate and several failed attempts, the U.S. Congress passed the Troubled Asset Recovery Plan (TARP). It was signed by Presi- dent G.W. Bush in October 2008. TARP authorized the U.S. government to use up to $700
One of the more unusual outcomes of the credit crisis in the fall of 2008 was the opportunity for many companies to buy back their own debt at fractions of face value. The crisis had driven secondary market prices of debt, particularly specula- tive grade debt, extremely low. In some cases, outstanding debt was trading at 30% of face value. Now, if the issuing company had available cash, or access to new lower cost sources of debt, it could repurchase its outstanding debt at fire sale prices. The actual repurchase could be from the public market, or via a debt tender, where an offer would be extended directly to all current debt holders.
A multitude of companies including FreeScale, First Data, GenTek, and Weyerhauser have taken advantage of the oppor- tunity to retire more costly debt at discount prices. Many compa- nies currently held by private equity investors, who have access
to additional financial resources, have moved aggressively to repurchase. Firms have focused particularly on debt issuances that are coming due in the short-term, particularly if they feared difficulty in refinancing.
There have been a number of unintended consequences, however. A number of the distressed financial institutions have used some of the government funds provided under bailout lending to repurchase their own debt. Morgan Stanley reported earnings of more than $2.1 billion in the fourth quarter of 2008 from just buying back $12 billion of its own debt. Although this does indeed shore up the balance sheets, the primary intent of the government-backed capital had been to renew lending and financing to the nonbank financial sector—commercial businesses—in hopes of restarting general business activity, not to generate bank profits from the refinancing of its own portfolio.
GLOBAL FINANCE IN PRACTICE 5.2
Refinancing Opportunities and the Credit Crisis
138 CHAPTER 5 The Continuing Global Financial Crisis
billion to support—bail-out—the riskiest large banks. At that time, the U.S. stock market was at its lowest level in four years.
The bailout was especially useful in shoring up the largest banks and their insurers, such as AIG, that were deemed too big to fail.6 For example, AIG gained access to $85 billion of federal bailout funds because it was the largest issuer of CDSs. If these had been allowed to fail, they would have clearly caused the failure of a number of other major financial institutions. The U.S. government received an 80% equity interest in AIG in return for its capital injection.
Financial Reform 2010. The most recent response by the U.S. government to the excesses revealed by the credit crisis of 2007–2009 was the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.7 Some key features follow:
! An Office of Financial Research was established. Financial firms must release con- fidential information that could help spot future potential market crises. The office can demand all the data necessary from financial firms, including banks, hedge funds, private equity funds, and brokerages.
! Regulatory reach expanded. The Federal Deposit Insurance Corporation (FDIC) would permanently increase its protection of bank deposit accounts from the previ- ous $100,000 to $250,000 per account. The SEC could now sue lawyers, accountants, and other professionals, who know about a deceptive act, even if they weren’t the wrongdoer. The Treasury would set up an office to monitor and modernize state regulation of insurance.
! Institutions must disclose the amount of short selling in each stock. Brokers must notify investors that they can stop their shares from being borrowed for a short sale.
The European Debt Crisis of 2009–2012
The Eurozone is facing a serious sovereign debt crisis. Several Eurozone member countries have high, potentially unsustainable levels of public debt. Three—Greece, Ireland, and Portugal—have borrowed money from other European countries and the International Monetary Fund (IMF) in order to avoid default. With the largest public debt and one of the largest budget deficits in the Eurozone, Greece is at the center of the crisis.
—“Greece’s Debt Crisis: Overview, Policy Responses, and Implications,” Rebecca M. Nelson, Paul Belkin, and Derek E. Mix,
Congressional Research Service, August 18, 2011, p. 1.
Like most governments globally today, most of the European Union member countries enjoy government spending which is beyond their tax revenues and other incomes—they run government budget deficits. Governmental deficits are financed by the sale of government securities—bills, notes, bonds, all forms of public debt—whatever their name, denomination,
6The too big to fail tag goes far back in financial history, and indicates that if these large institutions were allowed to collapse, they would take a multitude of smaller institutions with them, both financial and nonfinancial. A failure ripple-effect of this magnitude is simply considered unacceptable by most governments. The Continental Illinois Bank failure of 1984 was the last such large exposure in U.S. financial history.
7For a detailed evaluation of Dodd-Frank see “The Dodd-Frank Wall Street Reform and Consumer Protection Act: Accomplishments and Limitations,” Viral v. Acharya, Thomas Cooley, Matthew Richardson, Richard Sylla, and Ingo Walter, Journal of Applied Corporate Finance, Volume 23, Number 1, Winter 2011, pp. 43–56.
139The Continuing Global Financial Crisis CHAPTER 5
or maturity. But government budgets and deficits do not exist in an economic and financial vacuum. Their levels, obligations, and directions reflect current business cycles, financial mar- kets, and political trends. Europe was now a microcosm of these major forces.
Beginning in late 2009, the global credit crisis was starting to wind down. But the credit crisis which the United States had largely fostered, had left the world—and Europe—with two very fundamental legacies. First was a monetary environment in which interest rates in all major global currencies—dollars, euros, and yen—were all at historically extremely low levels across the length of the yield curve. Money had been cheap and cheaper for several years, at least for those who could get debt. This led to the second legacy, a global financial marketplace in which banks in the major industrial country markets had reduced lending, slowing business of all kinds in nearly all markets. The result was recession or near-recession economic conditions. A number of major EU members with growing debt levels now faced slowing economies, increasing deficit spending, reduced tax revenues, and intensifying growing debt servicing burdens.
Sovereign Debt Debt issued by government—sovereign debt—is historically considered debt of the highest quality (of debt issued by organizations from within that country). This quality preference stems from the ability of a government to both 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.
But the European Union is a complex organism compared to the customary structure of fiscal and monetary policy institutions described in a typical economics 101 course. With the adoption of a common currency, the EU members participating in the euro gave up exclusive rights over the second instrument above, the ability to print money (to service debt). As a com- mon currency, no one EU member has the right to simply print more euros; that is policy realm of the European Central Bank (ECB). The members of the EU do have relative freedom to set their own fiscal policies—government spending, taxation, and the creation of government surpluses or deficits. They are, however, expected to keep deficit spending within limits.
Eurozone Complexity What the members of the EU’s eurozone (euro participants) do not have is the ability to con- duct independent monetary policy. When the EU moved to a single currency with the adop- tion of the euro, its member states agreed to use a single currency (exchange rate stability), allow the free movement of capital in and out of their economies ( financial integration), but give up individual control of their own money supply (monetary independence). Once again, a choice was made among the three competing dimensions of the Impossible Trinity, in this case, to form a single monetary policy body—the European Central Bank (ECB)—to conduct monetary policy on behalf of all EU members.
But fiscal and monetary policy are still intertwined. Government deficits funded by issu- ing debt to the financial markets still impact monetary policy. The proliferation of sovereign debt, debt issued by Greece, Portugal, Ireland, may all be euro-denominated, but are still debt obligations of the individual governments. But if these governments flood the market with debt, they may impact the cost (raise it) and availability (decrease it) of capital to other member states. In the end, if monetary independence is not preserved, then one or both of the other elements of the Trinity may fail, capital mobility or exchange rate stability.
There are a number of ways to portray the size of government deficits and accumulating debt, and Exhibit 5.10 presents two of the most common. The vertical bars show the total
140 CHAPTER 5 The Continuing Global Financial Crisis
EXHIBIT 5.10
GRCTotal Debt
0
Source: Debt-to-GDP ratios from “Sovereign Default in the Eurozone: Greece and Beyond,” UBS Research Focus, October 2011, p. 10. Total public debt, in billions of U.S. dollars, from the World Bank Group’s Joint External Debt Hub (JEDH).
20
40
60
80
100
120
140
160
180 166.0
120.6 110.1
99.6 96.2 87.1 83.0
73.0 68.7 66.6
Eurozone average = 90%
49.2 43.9 43.4
17.7 6.6
Debt / GDP Ratio (%)
ITA IRL POR BLG FRA GER AST SPA NTH FIN SLV SLO LUX EST $259 $1,192 $142 $136 $301 $1,526 $1,645 $247 $454 $342 $161 $17 $16 $3.5 $1.2
level of public debt outstanding as a percentage of gross domestic product (GDP). This is the relative measure, where the seriousness of the sovereign debt burdens of a few EU countries— Greece, Portugal, Ireland—is readily apparent.
Greece at 166% debt-to-GDP is the highest by far, followed by Italy, Ireland, and Portugal. The eurozone (the 17 countries participating in the single currency, the euro) average in 2011 was 90%, which even including Greece in the calculation, is not high by global standards. The IMF calculated the average debt-to-GDP ratio for “advanced” economies as 109.5% and 36.9% for “emerging” economies in 2011.8
Exhibit 5.10 also lists, by country, the total public debt outstanding in 2011 (the numerical figures listed horizontally below the three-letter country codes). These absolute values are often disregarded as “irrelevant” because they do not reflect the sheer size of the economies in question. However, as we will see in the upcoming discussions of financial resources and sovereign bailouts, although a country like Ireland may have a high debt/GDP ratio (110.1%), the absolute magnitude of its outstanding public debt ($142 billion) is in many ways much more manageable in the context of the resources and capabilities of the EU or IMF.
Greece, Ireland, and Portugal
“Bringing owls to Athens”—in other words, doing something useless. In 414 B.C., when Aristophanes coined this expression in his comedy The Birds, people commonly referred to Athens’ self-minted silver drachmas as “owls” since they had a picture of the bird on
8Fiscal Monitor, International Monetary Fund, September 2011, p. 70. For comparison purposes, it is also interest- ing to note that this same ratio was 100.0% for the United States and 233.1% for Japan (the highest in the world).
European Sovereign Debt in 2011
141The Continuing Global Financial Crisis CHAPTER 5
their reverse side. Athens’ wealth at the time was legendary—and hence it was pointless to bring any more money to the city-state. Yet, only a few decades later, the situation had changed dramatically. Expensive wars had wrecked the budget, and 10 out of 13 Athenian communities eventually defaulted on loans that they had taken out from the temple of Delos—the first recorded sovereign debt defaults in history.
—“Sovereign Default in the Eurozone: Greece and Beyond,” UBS Research Focus, 29 September 2011, p. 14.
Most analysts choose October 2009 as the official “launch” of the European debt crisis. In Greece, a newly elected Socialist government took office under the leadership of Prime Min- ister George A. Papandreou. One of the new government’s rather unsavory discoveries was that the previous Greek government had systematically underestimated or under-reported the actual size of Greece’s growing government deficit. The new government estimated the size of the 2009 government budget deficit as 12.7% of GDP rather than the previously published 6.7%. As with all crises, picking a specific point in time in which the crisis began is arbitrary. Greece’s fiscal deficit had been a growing problem for years, averaging 5% of GDP a year since 2001, when it joined the euro, as opposed to the EU membership’s average of 2%.9
All major credit rating agencies immediately downgraded Greece and its outstanding obligations. Analysts both inside and outside of Greece immediately questioned whether Greece’s economy and government could continue to function and service its rising debt. As a member of the European Union, Greece used the euro, and in turn, sold euro-denominated government debt to the international markets.
Greece’s economy was now falling. Inside Greece, various political factions argued that the government needed to increase spending, not cut government spending, to aid the plum- meting economy, rising unemployment, and struggling Greek people. Outside Greece, fears grew that the ever-increasing amount of Greek debt would not be timely serviced and could ultimately fail. Greece needed outside help soon if it was to avoid defaulting on its sovereign debt and possibly undermining the entire financial structure of the EU and the euro. As with all borrowers in decline, the market’s assessment of Greece’s creditworthiness resulted in skyrocketing costs of financing—if it could get more loans.
In March of 2010, the EU, in conjunction with the IMF, began protracted discussions and negotiations with Greece on a bailout. After weeks of debate and turmoil in which rising demands for austerity measures and assurances be made by the Greek government, a bailout totaling €110 billion (€80 billion from the EU, €30 billion from the IMF) was finally arranged in early May. This allowed Greece to narrowly avoid defaulting on major debt service obliga- tions due May 19. Greece now pledged to cut its government budget deficit from a current 13.6% of GDP (it was still increasing) to under 3% by 2014.
The European Financial Stability Facility (EFSF)
The EFSF’s mandate is to safeguard financial stability in Europe by providing financial assistance to euro area Member States.
—European Financial Stability Facility, www.efsf.europa.eu
A simultaneous achievement with the Greek bailout was the formation of the European Financial Stability Facility (EFSF) by the euro area member states in May of 2010. The EFSF
9Note that the Treaty on European Union, the Maastricht Treaty, required members to limit budget deficits to 3% of GDP and cumulative external debt to 60% of GDP. Of course, in 2010, only two of the 27 EU members were in compliance with these requirements.
142 CHAPTER 5 The Continuing Global Financial Crisis
was a borrowing facility constructed by the EU to collectively raise capital with roughly €500 billion in combined credit capability, using the creditworthiness and access of the EU whole, which could then extend a variety of financial assistance packages to member states under financial distress in the future.
The specific tools and activities available to the EFSF included the ability to extend loans to member States, to intervene in the primary and secondary debt markets (in the presence of exceptional financial market circumstances posing risks to financial stability), and to finance re-capitalizations of financial institutions through loans to member governments. The forma- tion of the EFSF and its capabilities was seen as a major accomplishment in filling a void in financial assistance within the eurozone framework.
The EFSF was created in anticipation of deteriorating debt service conditions in other EU countries as well. Although the EU and IMF made it very clear that they did not believe (or hope) that the larger fund would ever be necessary, it was hoped that the creation of the larger capital fund would serve to calm growing market concern that Greece’s problems could spread. The €500 billion in EFSF capability, combined with another €250 million in IMF guarantees, was hoped to placate market fears.10 Stock and bond markets responded instantly, positively, globally to the EFSF’s creation. There was renewed hope that the sovereign debt contagion could be stopped.11
Ireland Is Different Although Ireland also possessed growing sovereign debt obligations, its economy and circum- stances differed from that of Greece. Ireland did not suffer from an overly profligate govern- ment, but rather a series of failures reminiscent of the United States. After years of financial deregulation, the economy had contracted severely with the credit crisis, also suffering enor- mous losses in a property sector bubble. The Irish government had then been forced to bailout the six largest Irish banks, all of which had incurred massive property-related losses (nearly €100 billion). These same banks now suffered market confidence failures, capital flight, at the same time as the U.S. credit crisis. Although financial stress was temporarily reduced in May 2010 with the Greek solution, problems returned and intensified for Irish banks over the summer and early fall of 2010.
In November 2010, a complex combination of EU, IMF, and governmental assistance (the governments of the U.K., Denmark, and Sweden contributed directly) resulted in a €85 billion bailout for the Irish government and its struggling financial sector. As we will see later, Ireland’s recovery has continued.
Portuguese Contagion Portugal was yet a different story. Portugal’s economy had long been dominated by the State via strong Socialist and Communist party leadership. This relatively complex political envi- ronment had often led to a strong schism between the prime minister and parliament, often undermining the government budget process, including the fulfillment of austerity obliga- tions which had been agreed to with the EU in recent years. With declining economic and budgetary performance in 2009 and 2010, the country’s debt burden—much of it acquired via state-controlled companies—had risen to more than €40 billion.
10Although the EFSF had €440 billion in resources, in order to maintain its AAA credit rating it had to hold roughly 40% in cash reserves, reducing actual lending capability severely. EFSF was downgraded by S&P in January 2012 when it downgraded France and Austria from their triple-A credit status. 11The EFSF’s charter expires in 2013, at which point it is proposed that it be replaced by a new organization, the European Stability Mechanism (ESM). The ESM has yet to be fully ratified.
143The Continuing Global Financial Crisis CHAPTER 5
Portugal’s situation continued to worsen until a bailout plan was approved in May 2011. A total of €78 billion in three-year loans were packaged by the EU (largely through the EFSF) and the IMF to prevent default on sovereign debt obligations. The second major bailout of an EU eurozone member was complete.
Many market analysts have argued that Portugal was the first step of true market conta- gion. They argue that the actual sovereign debt burden Portugal carried into late 2010 was not of the same severity as that of Greece or Ireland, that the country would have been able to service this debt in a timely manner if the market had not focused such negative attention— contagion—on Portugal. Portugal, according to this line of thought, had simply staggered into the market’s cross-hairs.
Market contagion and rating downgrades, starting when the magnitude of Greece’s difficulties surfaced in early 2010, have become a self-fulfilling prophecy: by raising Portugal’s borrowing costs to unsustainable levels, the rating agencies forced it to seek a bailout. The bailout has empowered those “rescuing” Portugal to push for unpopular austerity policies affecting recipients of student loans, retirement pensions, poverty relief and public salaries of all kinds.
The crisis is not of Portugal’s doing. Its accumulated debt is well below the level of nations like Italy that have not been subject to such devastating assessments.
—“Portugal’s Unnecessary Bailout,” Robert M. Fishman, The New York Times, April 12, 2011.
The argument that the market’s own focus and degradation of eurozone sovereign debt increased the severity of the crisis is of course partially true. Whenever any borrower’s credit quality comes into question, the ability of that borrower to gain new access to sufficient quanti- ties of affordable capital is often destroyed.
Transmission As with the global credit crisis which began in the United States, the instrument of contagion of financial crisis in the EU was the debt security. A bond issued by the Greek, Irish, or Portuguese government ultimately found its way into the hands (and onto the balance sheet) of a buyer. The buyer of that asset could then face serious loss if the debt was not serviced as promised.
The sovereign debt issued by Greece, Portugal and Ireland in recent years was now an asset on the balance sheet of investors, many of which were banks throughout Europe. And as is always the case of economic and financial crises, whether it be Asia in 1997 or the United States in 2008, major banking institutions cannot be allowed to fail. This too big to fail epithet arises from the very real fear that the failure of some banks may take many other institutions, both financial and nonfinancial, down with them. Business failures can then possibly spiral rapidly into economic collapse and financial ruin. The extension of credit is critical for the ongoing activities and operations of firms of all kinds in all economies. Whether it be General Electric during the height of the September 2008 credit crisis or exporters in Greece in 2011, ready access to short-term debt is critical for their businesses.
The summer and fall of 2011 saw a renewed level of market financial distress over the state of European sovereign debt. As the international financial markets continued to fear default, the different sovereign debt issuances were trading at ever-larger discounts, driving the yields on this debt skyward. It now appeared that Greece would need a second bailout, as the Greek economy contracted. Other countries with relatively high debt levels, Italy, Spain and even Belgium, now came under increasing financial scrutiny and market pressure.
As illustrated in Exhibit 5.11, the international financial markets continued to question the ability of specific eurozone members to service their debt, and the ability of the EU itself
144 CHAPTER 5 The Continuing Global Financial Crisis
EXHIBIT 5.11
Greece
Germany
Italy
Ireland
Portugal
Percent (euros)
By the end of 2011, the government of Greece was paying 1900 basis points — 19% — more to borrow euros than was the government of Germany.
0
Source: Long-term interest rate statistics for EU member states, European Central Bank, www.ecb.int/stats/money/long. 10-year maturities.
5
10
Jan -09
Fe b-0
9
Ma r-0
9 Ap
r-0 9
Ju n-0
9
Ma y-0
9 Ju
l-0 9
Au g-0
9
Se p-0
9 Oc
t-0 9
No v-0
9
De c-0
9 Jan
-10
Fe b-1
0
Ma r-1
0 Ap
r-1 0
Ma y-1
0 Ju
n-1 0 Ju
l-1 0
Au g-1
0
Se p-1
0 Oc
t-1 0
No v-1
0
De c-1
0 Jan
-11
Fe b-1
1
Ma r-1
1 Ap
r-1 1
Ma y-1
1 Ju
n-1 1 Ju
l-1 1
Au g-1
1
Se p-1
1 Oc
t-1 1
No v-1
1
De c-1
1
15
20
25
to resolve internal conflict and create a system-wide solution in the near future. Ireland and Portugal saw more than a doubling in their cost of funds between early 2010 and mid-2011. But Greece, the focal point of much of the crisis, saw its cost of funds rise from 6% in 2009 to more than 21% in December 2011.12
The bailouts of both Portugal and Ireland were having mixed results. New issuance costs for Ireland had stabilized, but Portuguese public debts were once again on the rise. At the least, new issuances of debt were being brought to the market and finding buyers.
Exhibit 5.12 provides some insight into who or what it was that was exposed to specific sovereign risks. For the three major eurozone debtors who had undergone bailouts, Greece, Portugal, and Ireland, it is clear that most of their debt was now in the hands of their bene- factors, the “foreign official holdings” representing the IMF and the EFSF. Second to the international institutions’ holdings were the banks. Greece also had a significant share of its debt held by insurance companies and pension funds. The growing fear was that the holdings of debt like this by banks in the EU would—again similar to that in the U.S. in 2008—require extraordinary measures by governments to keep them in turn from failing.
The public debt of three other major sovereign debtors, all outside the eurozone—Japan, the U.K., and the U.S.—were more widely held across interests and institutions. Japan’s public
12It should be noted that although these are the prices of debt which was either newly issued or currently trading, the graphic does not really portray the whole story, which was the lack of timely access to new debt, at any price, by these debtors at different points in time.
European Sovereign Debt and Interest Rates
145The Continuing Global Financial Crisis CHAPTER 5
Select Eurozone Members Major Industrial Countries
Holders of Sovereign Debt Greece Ireland Portugal Japan U.K. U.S.
Intragovernmental holdings 0.0% 1.1% 0.0% 10.6% 0.2% 35.0%
Banks 18.3% 13.8% 22.4% 24.6% 10.8% 2.3%
Insurance companies and pension funds 11.8% 2.1% 5.8% 24.0% 29.0% 12.0%
Other domestic investors 2.3% 0.3% 7.8% 27.5% 10.0% 7.6%
Central bank 2.8% 0.0% 0.8% 8.3% 19.7% 11.9%
Foreign official holdings 64.8% 82.7% 63.3% 2.2% 6.2% 22.1%
Other nonresidents 0.0% 0.0% 0.0% 2.8% 24.3% 9.1%
Total 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
Source: IMF. Data as of Q2, 2011 for Greece; Ireland, and the United States. Q1, 2011, for Japan and the United Kingdom; Q4, 2010, for Portugal. “Other domestic investors” includes the Post Bank for Japan.
debt was nearly equally held by banks, insurance and pension funds, and domestic investors, while U.K.’s debt was largely held by insurance and pension firms, non-resident investors, and the central bank (Bank of England). The U.S.’s public debt was an even stranger mix, with huge proportions held by foreign governments.
How Much Money Is Needed? Debt management is also a game of numbers. Although the analysis begins with the total debt magnitudes and their respective sizes to other measures like GDP (as seen in Exhibit 5.10), the more practical demands of debt workouts require estimating actual debt servicing and debt raising needs per unit of time. In other words, how much capital do the eurozone’s indebted members need to get through the coming years?
Exhibit 5.13 presents one estimate of the financing needs of the indebted eurozone members for the 2012–2014 period. This analysis, by Citigroup, tries to estimate the funding needed to get the governments through these crisis years. The top three debtors, Greece, Ireland, and Portu- gal, will need collectively €114 billion in 2012, and another €70 billion in both 2013 and 2014.
However, what Exhibit 5.13 also shows, chillingly, is the magnitude of new financing needed by Spain and Italy—nearly €600 billion in 2012 alone. If for any reason conditions should worsen making it difficult for them to renew financing on schedule, the magnitude of their losses would indeed spark a greater zone of default.
Alternative Solutions Throughout the 2009–2011 period, the EU and other international institutions like the IMF attempted to construct solutions to the growing EU debt crisis. Debt crisis management plans needed to combine remedies for both the symptoms and the causes. The most immediate short-term symptoms needing to be addressed fell into two broad categories: 1) Greece needed access to large quantities of capital immediately for continuing the operations of its government and for making the most immediate of debt service commitments; and 2) Euro- pean banks holding large quantities of eurozone sovereign debt needed some way to preserve their liquidity and solvency against plummeting market values.
EXHIBIT 5.12 Holders of Sovereign Debt
146 CHAPTER 5 The Continuing Global Financial Crisis
The longer term causes of the crisis, the rising levels of fiscal deficits amongst eurozone members, required changes to either the structure of the EU, the requirements of continued membership within the EU, or both. Most long-term proposals linked direct loans to govern- ment or subsidized write-downs of existing public debt to severe cuts in government spending (very unpopular cuts)—austerity measures.
The Brussels Agreement. In September and October 2011 a number of major initiatives were put forward within the EU to attempt to resolve the possible failure of banks, specifi- cally Italian, which held large quantities of sovereign debt which were being pummeled by the global markets. The Brussels Agreement of October 26, 2011 was one such effort which eventually failed. Leaders of the 17 eurozone members, meeting in Brussels, agreed to a 50% write-off of Greek sovereign debt held by banks in the eurozone, a fourfold increase in the funds available through the EFSF, and an increase in the required equity capital of banks to 9%. But the combined package and write-off were contingent on Greece’s commitment to a set of austerity measures which all agreed were rigorous, costly, but needed.
Three days after the announcement of the Brussels Agreement, Prime Minister Papandreou of Greece announced that his country would hold a referendum on whether to accept the austerity measures required. This was perceived as a lack of Greek willingness to work with the EU, and even after Papandreou withdrew the planned referendum days later, the political momentum behind the agreement collapsed.
Debt to Equity Swaps. Those focusing on the solvency of the banks holding sovereign debt proposed the conversion of large quantities of bank debt to equity, debt to equity swaps. Under these proposals, the debt would be converted to an equity position, reducing the outstanding public sector debt and simultaneously increasing the bank’s equity. Stronger equity bases
EXHIBIT 5.13 Selective Eurozone Financing Needs
(billion EUR) 2012 2013 2014 2012–2014
Austria 29.1 24.8 32.5 86.4
Belgium 73.9 40.4 34.3 148.6
Cyprus 4.9 3.0 1.6 9.5
Finland 13.9 5.6 6.1 25.6
Greece 65.6 41.9 38.3 145.8
Ireland 14.0 10.7 14.4 39.1
Italy 373.4 202.5 171.9 747.8
Netherlands 76.5 45.7 42.0 164.2
Spain 216.8 138.2 123.3 478.3
Portugal 34.4 18.3 22.2 74.9
France 356.6 202.1 156.3 715.0
Germany 319.2 258.8 194.7 772.7
Greece + Ireland + Portugal 114.0 70.9 74.9 259.8
Spain + Italy 590.2 340.7 295.2 1,226.1
Source: Author calculations based on “Global Economic Outlook and Strategy,” Citigroup Global Markets , November 28, 2011, p. 4. Values are for general government gross financing requirements.
147The Continuing Global Financial Crisis CHAPTER 5
would increase investor confidence in the banks, hopefully freeing up more funds for the credit markets. The burden on taxpayers might then be minimized.
One of the issues in debt to equity swaps would be the size of the haircuts suffered by the banks. A haircut is the amount of loss on a security’s value. For example, a €100 million obliga- tion which was valued at €60 million would represent a 40% haircut. The €60 million would, however, add substantially to bank equity as well as reducing the outstanding debt of the bank.
Stability Bonds. In November 2011 a new proposal was put forward by the European Com- mission for the issuance of European Bonds (also called E-bonds, eurobonds or stability bonds). These would be bonds issued by the collective 17 eurozone countries. The proceeds of the issuances would then be transferred to eurozone members in danger of sovereign debt default. The program would essentially allow a weak member state to substitute the higher creditworthiness of healthier member states when approaching the international markets. Regardless of actual borrowing in the early stages, like the EFSF hopes the previous year, the simple acceptance and launch of the program was hoped to stem the market tides thrashing sovereign debt values.
This proposal was met with strong opposition from several member states and groups, particularly Germany. The primary opposition was based on the grounds that it made fiscally responsible eurozone members bear the cost and burdens of the irresponsible states which had not maintained fiscal discipline. A second argument was that it would create an environ- ment of increased moral hazard, in principle allowing states that had not exercised the fiscal discipline to actually be rewarded or encouraged to continue to spend and borrow beyond their means. This might lead to a number of banks becoming zombie banks, a rather colorful term used to argue that some financial institutions might become theoretically addicted to these low-cost subsidized sources of capital.
Currency Confusion
There are a number of factors that affect the euro-dollar exchange rate (including U.S. policies, such as quantitative easing), and there has not been a clear, sustained deprecia- tion in the euro against the dollar since the start of the crisis.
—“Greece’s Debt Crisis: Overview, Policy Responses, and Implications,” Rebecca M. Nelson, Paul Belkin, and Derek E. Mix, Congressional Research Service, August 18, 2011, p. 14.
Did the growing levels of sovereign debt issued by Greece, Portugal, Ireland, Italy, Spain and other EU members pose a threat to the euro itself? We will take a rather academic “out” to this question and answer it both yes and no.
Yes. As noted previously, the flood of euro-denominated sovereign debt on the global capi- tal markets could seriously raise the cost of financing for all EU members. Too much debt chasing too few investors. And the failure of individual EU members to conform to common economic and financial principals and expectations could in the near-future threaten the actual continuation of the EU’s structure itself. And that would obviously undermine the market’s ability to believe in the euro.
No. The debt was indeed denominated in the common currency, the euro, but the potential default on specific sovereign obligations would impact the access to the capital markets by the individual governments far more than the collateral damage to other euro-denominated borrowers. Looking at the actual value of the euro on global markets, as noted by the U.S. Congressional Research Service, there is no clear indication that the crisis has had a material impact on the value of the euro.
148 CHAPTER 5 The Continuing Global Financial Crisis
This was not unlike the debt crises suffered by Brazil, Mexico, and Argentina in the 1980s and 1990s when it was their difficulty in servicing dollar-denominated debt which was at the core of the crisis. The risks and damage of failures to repay properly were costs suffered pre- dominantly by the countries, not the dollar. As illustrated in Exhibit 5.11, the markets were clearly differentiating between sovereign borrowers, and did not appear to be dwelling on the common currency of debt denomination.
Sovereign Default What if a country like Greece defaulted? Sovereign defaults do happen, and the global finan- cial markets have significant experience in both absorbing their losses and repairing the dam- age. In a seminal study on the history of defaults, Reinhart and Rogoff found some rather frightening similarities to the continuing eurozone sovereign debt dilemma:13
We find that serial default is a nearly universal phenomenon as countries struggle to transform themselves from emerging markets to advanced economies. Major default episodes are typically spaced some years (or decades) apart, creating an illusion that “this time is different” among policymakers and investors. A recent example of the “this time is different” syndrome is the false belief that domestic debt is a novel feature of the modern financial landscape. We also confirm that crises frequently emanate from the financial centers with transmission through interest rate shocks and commodity price collapses.
Exhibit 5.14 provides a brief history of sovereign defaults since 1983, and their relative outcomes. Of course it will be some time before the market knows whether ‘this time is dif- ferent.’ When a sovereign borrower misses timely payment on outstanding international obli- gations, either domestic currency or foreign currency in denomination, it is technically in default.14 Most loan agreements have short grace periods, in which the borrower may either resolve the payment or offer a restructure or replacement payment program to lenders before technically defaulting.
Resolving Crises
Moreover, private-sector indebtedness across the euro area as a whole is markedly lower than in the highly leveraged Anglo-Saxon economies. Why, then, have financial markets lost confidence in the euro area? The short answer is: because the euro is a currency without a state . . .
The crisis, it follows, is as much political as economic: the question facing the euro area is whether the governments will take the political steps necessary to address the eco- nomic strains within it. The answer to that question partly turns on money. Who should pick up the bill for all the capital that was wasted in the peripheral countries: feckless borrowers or reckless lenders? Creditor countries, unsurprisingly, believe that the bill should fall largely on deficit countries.
—“State of the Union—Can the eurozone survive its debt crisis?” The Economist Intelligent Unit, March 2011.
13“This Time is Different: A Panoramic View of Eight Centuries of Financial Crises,” by Carmen M. Reinhart and Kenneth S. Rogoff, unpublished manuscript, April 16, 2008. 14Note that although the period covered extended begins in 1983, there were technically no sovereign defaults recorded between 1983 and 1998 by Moody’s. This is especially noteworthy given that, although the Asian Finan- cial Crisis roiled the global markets throughout 1997–1998, no individual Asian country technically defaulted as a result of the crisis.
149The Continuing Global Financial Crisis CHAPTER 5
EXHIBIT 5.14 Selected Significant Sovereign Defaults
Country Debt Description
Argentina 2001 $82 billion Argentina’s decade-long adoption of a currency board, in which the value of the Argentine peso was tied to the U.S. dollar in a one-to-one relationship, ended in a massive default of record proportions in the last months of 2001. A number of factors, including the relative appreciation of the dollar (and attaached peso) to other regional currencies, rising indebtedness from the Argentine government’s international borrowing, and the deteriorating relationship between the IMF and the government of Argentina, resulted in a massive default and subsequent economic crisis.
Russia 1998 $73 billion Although Russia enjoyed an extended period of rapid and healthy economic growth following the introduction of perestroika in 1991 and 1992, by late 1997 and early 1998 the Russian economy was suffering a multitude of ills including balance of payments deficits (declining oil prices reduced export earnings) and rapidly increasing inflation from continued government borrowing and rising interest costs. With the continuing Asian financial crisis expanding to more and more of the world’s economy, the Russian economy worsened. Beginning in late August 1998, the Russian ruble rapidly declined in value, falling from Rbl8/$ to Rbl 26/$ in a matter of three weeks.
Ecuador 1999 $6.6 billion Ecuador first defaulted and then completed an extensive renegotiation and refinancing of its foreign debt obligations in late 1999. The majority of the debt was composed of Brady Bonds. Brady Bonds, named after U.S. Treasury Secretary Nicholas Brady, were dollar-denominated debt instruments created in the late 1980s to convert loan debt of Latin Ameircan countries, debt of the sovereign states, into tradeable securities in order to foster the development of a market for emerging market debt.
Uruguay 2003 $5.7 billion Uruguay’s economy is intricately connected to that of Argentina. The Uruguayan financial distress largely resulted from contagion from Argentina’s crisis in 1999, but did not reach crisis stages of default until 2002 and 2003.
Peru 2000 $5 billion More of a technical default, resulting in a late by fulfilled debt commitment, Peru defaulted on outstanding Brady Bonds in late 2000. Peru’s decision to default in 2000 was largely a part of a strategy to allow a debt service obligation to avoid being attached by a legal suit again Peru in U.S. courts.
Source:This selective list draws upon a number of different sources including “This Time is Different: Eight Centuries of Financial Folly,” Carmen M. Reinhart and Kenneth S. Rogoff, Princeton University Press, 2009; “Costs of Sovereign Default,” by Bianca De Paoli, Glenn Hoggarth, and Victoria Saporta, Bank of England Financial Stability Paper No. 1, July 2006; “The Forgotten History of Domestic Debt,” Carmen M. Reinhart and Kenneht S. Rogoff, NBER Working Paper 13946, April 2008; “Sovereign Default and Recovery Rates, 1983-2007,” Moody’s Global Credit Research, March 2008.
The United States resolution to the credit crisis of 2008–2009, in which most of the bad debt ended up on the balance sheets of financial institutions, was to combine 1) write-offs by the holders of debt-based securities, 2) government purchases of debt securities, and 3) govern- ment capital injections into the financial institutions to both preserve their liquidity and make it possible for them to both hold the questionable debt and continue commercial lending. A primary determinant of this set of solutions was the role played by the U.S. Federal Reserve as a lender-of-last-resort.
The EU or ECB, to date (early 2012), has chosen not to write-down debt or step in as a buyer of debt. The EU solution to date has focused on a version of number 3 above—in which funds have been made available to European banks to allow them the ability to increase their capital bases and, hopefully, buy more of the eurozone sovereign debt which is coming to the market. Unfortunately, so far, the banks are not choosing to buy that much of the new sovereign debt issuances, and instead in some cases, not lending or buying significantly.
150 CHAPTER 5 The Continuing Global Financial Crisis
Many proposals coming out of Germany emphasize that both private institutions and individual governments should shoulder the burden of their issuance or purchase of sov- ereign debt. The German finance minister has adamantly opposed the concept of having the EFSF act as a central bank itself, borrowing on the global market to, in-turn, purchase sovereign debt and act as a lender-of-last-resort. In the end much of the debate will be who (the EU, the ECB, the EFSF/EMS) acts as a lender of last resort for who (sovereign states or private banks).
The EU and eurozone continue to be highly complex political-economic-social integra- tions. There are strong differences in beliefs when it comes to reconciling who shall bear the cost of these sovereign debt obligations. For example, Article 125 of the Treaty of Lisbon makes it illegal for one eurozone member country to assume the debts of another member. Although the Treaty was only signed in 2009, the current fear is that German courts may read the treaty and find the current bailout plans in the eurozone as illegal.
The outlook for the eurozone is a challenging one. This sovereign debt crisis is not a single event or single point in time, but a complex combination of nationalist economies, cultures, politics, and economic conditions. The fiscal deficits and their financing will take years to resolve, as many sovereign borrowers will have to continue to come to the market for new issuances and new funds on a continuing basis. With continuing weak economic conditions in a large part of Europe, and the impacts of new and harsher austerity mea- sures, positive economic growth alone will be a challenge, much less stronger growth. And as economic conditions change—possibly for the worse—the need for more funding will only grow.
SUMMARY POINTS
! The seeds of the Global credit crisis of 2008 and at least part of the European sovereign debt crisis of 2010–2012 were sown in the deregulation of the commercial and investment banking sectors in the 1990s.
! The flow of capital into the real estate sector in the post-2000 period reflected changes in social and economic forces in a number of major economies, particularly that of the United States. These capital flows drove asset values up, and combined with very aggressive mortgage creation, lending, and securi- tization practices, created a mountain of debt that could not be serviced when these same asset values collapsed.
! Securitization allowed the re-packaging of different combinations of credit-quality mortgages in order to make them more attractive for resale to other finan- cial institutions; derivative construction increased the liquidity in the market for these securities.
! The SIV was an investment entity created to invest in long-term and higher yielding assets such as speculative grade bonds, mortgage-backed securities (MBSs) and
collateralized debt obligations (CDOs), while funding itself through commercial paper (CP) issuances.
! LIBOR plays a critical role in the interbank market as the basis for all floating rate debt instruments of all kinds. With the onset of the credit crisis in September 2008, LIBOR rates skyrocketed between major inter- national banks, indicating a growing fear of default in a market historically considered the highest quality and most liquid in the world.
! The U.S. Congress passed the Troubled Asset Recovery Plan (TARP), which authorized the use of up to $700 billion to bail out the riskiest banks. As a result of the massive write-offs of failed mortgages, the banks suf- fered weakened equity capital positions, making it necessary for the private sector and the government to inject new equity capital.
! The eurozone sovereign debt crisis, born partially out of the global credit crisis, is a complex combination of failed sovereign state funding, global economic condi- tions, and a single currency structure without all of the attributes and capabilities of a single currency country.
151The Continuing Global Financial Crisis CHAPTER 5
! Beginning with Greece in 2009 and 2010, followed by Ireland and Portugal (and possibly Spain and Italy in the coming years), members of the eurozone have found themselves on the edge of sovereign default as their euro-denominated debt far exceeded their debt servicing capabilities.
! Unlike traditional economic and financial structures, the sovereign states of the eurozone do not have the ability to individually print more money or use other monetary policy approaches to debt repayment or cur- rency devaluation (to increase export competitiveness and alleviate current account deficits).
! Although Greece has been the recipient of several bailout packages, and Ireland and Portugal have also
managed to get by to date, continuing deterioration in economic growth has resulted in ever-larger fiscal deficits, increased sovereign debt financing needs, and deteriorating credit quality. The international financial markets priced some sovereign debt on levels indicating expected default.
! The EU has yet to gain agreement and clarity on which of a variety of strategies and approaches to take in attempting to prevent sovereign default by a eurozone member. It is also unclear if sovereign default would necessarily result in the country, for example Greece, leaving the single currency euro.
There are other things the Treasury might do when a major financial firm assumed to be “too big to fail” comes knocking, asking for free money. Here’s one: Let it fail.
Not as chaotically as Lehman Brothers was allowed to fail. If a failing firm is deemed “too big” for that honor, then it should be explicitly nationalized, both to limit its effect on other firms and to protect the guts of the system. Its shareholders should be wiped out, and its management replaced. Its valuable parts should be sold off as functioning businesses to the highest bidders— perhaps to some bank that was not swept up in the credit bubble. The rest should be liquidated, in calm markets. Do this and, for everyone except the firms that invented the mess, the pain will likely subside.
—“How to Repair a Broken Financial World,” by Michael Lewis and David Einhorn,
The New York Times, January 4, 2009.
Should Lehman Brothers have been allowed to fail? This is one of the lasting debates over the U.S. government’s actions, or in this case inaction, in its attempts to fix the failing U.S. financial system in late 2008. Allowing Lehman to fail—it filed for bankruptcy on September 15, 2008— was in the eyes of many in the global financial markets the individual event that caused the global credit crisis which followed.
Lehman Brothers was founded in 1850 in Alabama by a pair of enterprising brothers. After moving the firm to New York following the American Civil War, the firm had long been considered one of the highest return, highest risk small investment banking firms on Wall Street. Although it had lived and nearly died by the sword many times over the years, by 2008 the firm was holding an enormous port- folio of failing mortgage-backed securities and the future was not bright.
Lehman’s demise was not a shock, but a slow and pain- ful downward spiral. After two major Bear Stearn’s hedge funds collapsed in July 2007, Lehman was the constant focus of much speculation over its holdings of many of the distressed securities behind the credit crisis—the collater- alized debt obligations and credit default swaps that had flooded the market as a result of the real estate and mort- gage lending boom of the 2000 to 2007 period.
Too Big to Fail The “too big to fail” doctrine has long been a mainstay of the U.S. financial system. The U.S. Federal Reserve has long held the responsibility as the lender of last resort, the institution that is charged with assuring the financial stabil- ity and viability of the U.S. financial system. Although it has exercised its powers only rarely in history, the Fed, in conjunction with the Comptroller of the Currency and the Federal Deposit Insurance Corporation (FDIC), has on a
Letting Go of Lehman Brothers1
1Copyright © 2009 Michael H. Moffett. All rights reserved. This case was prepared from public sources for the purpose of classroom discussion only, and not to indicate either effective or ineffective management.
MINI-CASE
152 CHAPTER 5 The Continuing Global Financial Crisis
had put forward when arranging the sale of Bear Stearns.2 The Fed has successfully arranged the sale of Bear Stearns to J.P. Morgan Chase only after the Fed agreed to cover $29 billion in losses. In fact, in August 2008, just weeks prior to its failure, Lehman believed it had found two suit- ors, Bank of America and Barclays, that would quickly step up if the Federal Reserve would guarantee $65 billion in potential bad loans on Lehman’s books. The Fed declined.
Another proposal that had shown promise had been a self-insurance approach by Wall Street. Lehman would be split into a “good bank” and a “bad bank.” The good bank would be composed of the higher quality assets and securi- ties, and would be purchased by either Bank of America or Barclays. The bad bank would be a dumping ground of failing mortgage-backed securities which would be pur- chased by a consortium of 12 to 15 Wall Street financial institutions, not requiring any government funding or tax- payer dollars. The plan ultimately failed when the potential bad bank borrowers could not face their own losses and acquire Lehman’s losses, while either Bank of America or Barclays walked away with high quality assets at the price of a song. In the end, only one day after Lehman’s collapse, Barclays announced that it would buy Lehman’s United States capital markets division for $1.75 billion, a “steal” according to one analyst.
Secretary Paulson has argued that in fact his hands were tied. The Federal Reserve is required by law only to lend to, and is limited by, the amount of asset collateral any specific institution has to offer against rescue loans. (This is in fact the defining principle behind the Fed’s discount window operations.) But many critics have argued that it was not possible to determine the collateral value of the securities held by Lehman or AIG or Fannie Mae and Freddie Mac accurately at this time because of the credit crisis and the illiquidity of markets. Secretary Paulson had never been heard to make the argument before the time of the bankruptcy.
It also became readily apparent that following the AIG rescue the U.S. authorities moved quickly to try to create a systemic solution, rather than continuing to be bounced from one individual institutional crisis to another. Secre- tary Paulson has noted that it was increasingly clear that a larger solution was required, and that saving Lehman would not have stopped the larger crisis. Others have noted, however, that Lehman was one of the largest com- mercial paper issuers in the world. In the days following Lehman’s collapse, the commercial paper market literally locked up. The seizing of the commercial paper market in
2Fuld’s own wealth and compensation had been the subject of much criticism. It has been estimated that Fuld’s total compensation by Lehman over the previous five years was more than $500 million, and that his personal wealth was more than $1 billion early in 2008 (prior to the fall in Lehman’s share price).
few occasions determined that an individual large bank’s failure would threaten the health and functioning of the financial system. In those cases, for example Continental Illinois of Chicago in 1984, the three organizations had stepped in to effectively nationalize the institution and arrange for its continued operation to prevent what were believed to be disastrous results.
The doctrine, however, had largely been confined to commercial banks, not investment banks who made their money by intentionally taking on riskier classes of secu- rities and positions on behalf of their investors—who expected greater returns. Lehman was clearly a risk taker. But the distinction between commercial and investment banking was largely gone, as more and more deregulation efforts had successfully reduced the barriers between tak- ing deposits and making consumer and commercial loans, with traditional investment banking activities of underwrit- ing riskier debt and equity issuances with a lessened fidu- ciary responsibility.
Many critics have argued that for some reason Lehman was singled out for failure. One week prior to Lehman’s bankruptcy, the Federal Reserve and U.S. Treasury under Secretary of the Treasury Hank Paulson, Jr., had bailed out both Fannie Mae and Freddie Mac, putting them into U.S. government receivership. Two days following Lehman’s bankruptcy filings, the Federal Reserve had extended AIG, an insurance conglomerate, an $85 billion loan package to prevent its failure. So why not Lehman?
Why Not Lehman? Lehman had already survived one near miss. When Bear Stearns had failed in March 2008 and its sale arranged by the U.S. government, Lehman had been clearly in the cross-hairs of the financial speculators, particularly the short sellers. Its longtime CEO, Richard Fuld Jr., had been a vocal critic of the short sellers who continued to pound Lehman in the summer of 2008. But CEO Fuld had been encouraged by investors, regulators, and critics to find a way out of its mess following the close call in March. Sec- retary Paulson had gone on record following Lehman’s June earnings reports (which showed massive losses) that if Lehman had not arranged a sale by the end of the third quarter there would likely be a crisis.
But repeated efforts by Fuld at finding buyers for dif- ferent parts of the company failed, from Wall Street to the Middle East to Asia. Fuld has since argued that one of the reasons he wasn’t able to arrange a sale was the U.S. gov- ernment was not offering the same attractive guarantees it
153The Continuing Global Financial Crisis CHAPTER 5
—“The Reckoning: Struggling to Keep Up as the Crisis Raced On,” by Joe Nocera and Edmund L.
Andrews, The New York Times, October 22, 2008.
Case Questions 1. Do you think that the U.S. government treated some
financial institutions differently during the crisis? Was that appropriate?
2. Many experts argue that when the government bails out a private financial institution it creates a problem called “moral hazard,” meaning that if the institution knows it will be saved, it actually has an incentive to take on more risk, not less. What do you think?
3. Do you think that the U.S. government should have allowed Lehman Brothers to fail?
turn eliminated the primary source of liquid funds between mutual banks, hedge funds, and banks of all kinds. The crisis was now in full bloom.
Executives on Wall Street and officials in Euro- pean financial capitals have criticized Mr. Paulson and Mr. Bernanke for allowing Lehman to fail, an event that sent shock waves through the banking system, turning a financial tremor into a tsunami.
“For the equilibrium of the world financial system, this was a genuine error,” Christine Lagarde, France’s finance minister, said recently. Frederic Oudea, chief executive of Société Générale, one of France’s biggest banks, called the failure of Lehman “a trigger” for events leading to the global crash. Willem Sels, a credit strategist with Dres- dner Kleinwort, said that “it is clear that when Lehman defaulted, that is the date your money markets freaked out. It is difficult to not find a causal relationship.”
QUESTIONS
1. Three Forces. What were the three major forces behind the credit crisis of 2007 and 2008?
2. MBS. What is a mortgage-backed security (MBS)?
3. SIV. What is a structured investment vehicle (SIV)?
4. CDO. What is a collateralized debt obligation (CDO)?
5. CDS. What is a credit default swap (CDS)?
6. LIBOR’s Role. Why does LIBOR receive so much attention in the global financial markets?
7. Interbank Market. Why do you think it is impor- tant for many of the world’s largest commercial and investment banks to be considered on-the-run in the interbank market?
8. LIBOR Treasury Spread. Why were LIBOR rates so much higher than Treasury yields in 2007 and 2008? What is needed to return LIBOR rates to the lower, more stable levels of the past?
9. U.S. Crisis Resolution. What were the three key ele- ments of the package used by the U.S. government to resolve the 2008–2009 credit crisis?
10. Eurozone Sovereign Debtors. Why are the sovereign debtors of the eurozone considered to have a prob- lem that is different from any other heavily indebted country, like the United States?
11. EFSF. What is the European Financial Stability Facility (EFSF), and what role might it play in the resolution of the eurozone debt crisis?
12. Contagion. Why has the case of Portugal been termed a “case of contagion” rather than a sovereign debt crisis?
13. Holders of EU Sovereign Debt. What organizations appear to be the most exposed to the declining value of eurozone sovereign debt?
14. Default. Technically, what is a sovereign default?
15. Eurozone Debt Solutions. What are the three pri- mary methods which might be used individually or in combination to resolve the debt crisis?
PROBLEMS 1. U.S. Treasury Bill Auction Rates—March 2009. The
interest yields on U.S. Treasury securities in early 2009 fell to very low levels as a result of the com- bined events surrounding the global financial crisis. Calculate the simple and annualized yields for the 3-month and 6-month Treasury bills auctioned on March 9, 2009, listed here.
3-Month T-Bill 6-Month T-Bill
Treasury bill, face value $10,000.00 $10,000.00
Price at sale $9,993.93 $9,976.74
Discount $6.07 $23.26
154 CHAPTER 5 The Continuing Global Financial Crisis
2. The Living Yield Curve. SmartMoney magazine has what they term a Living Yield Curve graphic on their Internet page. This yield curve graphic simulates the U.S. dollar Treasury yield curve from 1977 through the current day. Using this graphic at www.smartmoney.com (then go to investing/bonds/ living-yield-curve), answer the following questions: a. After checking the box labeled “Average,” what is
the average 90-day Treasury bill rate for the 1977 to current day time interval?
b. In what year does the U.S. Treasury yield curve appear to have reached its highest levels for the 1977 to 2009 or 2010 period?
c. In what year does the U.S. Treasury yield curve appear to have reached its lowest levels for the 1977 to 2009 or 2010 period?
3. Credit Crisis, 2008. During financial crises, short-term interest rates, will often change quickly (typically up) as indications that markets are under severe stress. The interest rates shown in the table below are for selected dates in September–October 2008. Different publications define the TED Spread different ways, but one measure is the differential between the overnight LIBOR interest rate and the 3-month U.S. Treasury bill rate. a. Calculate the spread between the two market rates
shown in the table below in September and Octo- ber 2008.
b. On what date is the spread the narrowest? The widest?
c. When the spread widens dramatically, presumably demonstrating some form of financial anxiety or crisis, which of the rates moves the most and why?
4. U.S. Treasury Bill Auction Rates—May 2009. The interest yields on U.S. Treasury securities continued to fall in the spring of 2009. Calculate the discount, and then the simple and annualized yields for the 3-month and 6-month Treasury bills auctioned on May 4, 2009, listed here:
5. Underwater Mortgages. Bernie Ponzi pays $240,000 for a new four-bedroom 2,400-square-foot home out- side Tonopah, Nevada. He plans to make a 20% down payment, but is having trouble deciding whether he wants a 15-year fixed rate (6.400%) or a 30-year fixed rate (6.875%) mortgage. a. What is the monthly payment for both the 15- and
30-year mortgages, assuming a fully amortizing loan of equal payments for the life of the mortgage? Use a spreadsheet calculator for the payments.
b. Assume that instead of making a 20% down pay- ment, he makes a 10% down payment, and finances the remainder at 7.125% fixed interest for 15 years. What is his monthly payment?
Date Overnight USD
LIBOR 3-Month U.S.
Treasury TED
Spread
9/8/2008 2.15% 1.70% _____
9/9/2008 2.14% 1.65% _____
9/10/2008 2.13% 1.65% _____
9/11/2008 2.14% 1.60% _____
9/12/2008 2.15% 1.49% _____
9/15/2008 3.11% 0.83% _____
9/16/2008 6.44% 0.79% _____
9/17/2008 5.03% 0.04% _____
9/18/2008 3.84% 0.07% _____
9/19/2008 3.25% 0.97% _____
9/22/2008 2.97% 0.85% _____
9/23/2008 2.95% 0.81% _____
9/24/2008 2.69% 0.45% _____
9/25/2008 2.56% 0.72% _____
9/26/2008 2.31% 0.85% _____
Date Overnight USD
LIBOR 3-Month U.S.
Treasury TED
Spread
9/29/2008 2.57% 0.41% _____
9/30/2008 6.88% 0.89% _____
10/1/2008 3.79% 0.81% _____
10/2/2008 2.68% 0.60% _____
10/3/2008 2.00% 0.48% _____
10/6/2008 2.37% 0.48% _____
10/7/2008 3.94% 0.79% _____
10/8/2008 5.38% 0.65% _____
10/9/2008 5.09% 0.55% _____
10/10/2008 2.47% 0.18% _____
10/13/2008 2.47% 0.18% _____
10/14/2008 2.18% 0.27% _____
10/15/2008 2.14% 0.20% _____
10/16/2008 1.94% 0.44% _____
10/17/2008 1.67% 0.79% _____
3-Month T-Bill 6-Month T-Bill
Treasury bill, face value $10,000.00 $10,000.00
Price at sale $9,995.07 $9,983.32
155The Continuing Global Financial Crisis CHAPTER 5
c. Assume that the home’s total value falls by 25%. If the homeowner is able to sell the house, but now at the new home value, what would be his gain or loss on the home and mortgage assuming all of the mortgage principal remains? Use the same assump- tions as in part a.
6. TED Spread, 2009. If we use the same definition of the TED Spread noted in problem 3, the differential between the overnight LIBOR rate and the 3-month U.S. Treasury bill rate, we can see how the market may have calmed by the spring of 2009. Use the fol- lowing data to answer the questions.
Date Overnight USD
LIBOR 3-Month U.S.
Treasury TED
Spread
3/12/2009 0.33% 0.19% _____
3/13/2009 0.33% 0.18% _____
3/16/2009 0.33% 0.22% _____
3/17/2009 0.31% 0.23% _____
3/18/2009 0.31% 0.21% _____
3/19/2009 0.30% 0.19% _____
3/20/2009 0.28% 0.20% _____
3/23/2009 0.29% 0.19% _____
3/24/2009 0.29% 0.21% _____
3/25/2009 0.29% 0.18% _____
3/26/2009 0.29% 0.14% _____
3/27/2009 0.28% 0.13% _____
3/30/2009 0.29% 0.12% _____
3/31/2009 0.51% 0.20% _____
4/1/2009 0.30% 0.21% _____
4/2/2009 0.29% 0.20% _____
4/3/2009 0.27% 0.20% _____
4/6/2009 0.28% 0.19% _____
4/7/2009 0.28% 0.19% _____
4/8/2009 0.26% 0.18% _____
4/9/2009 0.26% 0.18% _____
4/14/2009 0.27% 0.17% _____
Problem 7. Loan 0
Principal €100.00
Interest rate 0.10
Maturity (years) 4.0
a. Calculate the TED Spread for the dates shown. b. On which dates is the spread the narrowest and the
widest? c. Looking at both the spread and the underlying data
series, how would you compare these values with the rates and spreads in problem 3?
7. Negotiating the Rate. A sovereign borrower is con- sidering a $100 million loan for a four-year matu- rity. It will be an amortizing loan, meaning that the interest and principal payments will total, annually, to a constant amount over the maturity of the loan. There is, however, a debate over the appropriate interest rate. The borrower believes the appropri- ate rate for its current credit standing in the mar- ket today is 10%, but a number of the international banks which it is negotiating with are arguing that it is most likely 12%, at the minimum 10%. Refer to the data at the top of this page. What impact do these different interest rates have on the prospective annual payments?
8. Saharan Debt Negotiations. The country of Sahara is negotiating a new loan agreement with a consor- tium of international banks. Both sides have a tenta- tive agreement on the principal—$220 million. But there are still wide differences of opinion on the final interest rate and maturity. The banks would like a shorter loan, four years in length, while Sahara would prefer a long maturity of six years. The banks also believe the interest rate will need to be 12.250% per annum, but Sahara believes that is too high, arguing for 11.750%. Use the data at the top of the next page to answer the questions below. a. What would the annual amortizing loan payments
be for the bank consortium’s proposal? b. What would the annual amortizing loan payments
be for Sahara’s loan preferences? c. How much would annual payments drop on the
bank consortium’s proposal if the same loan was stretched from four to six years?
9. Delos Debt Renegotiations (A). Delos borrowed €80 million two years ago. The loan agreement, an amor- tizing loan, was for six years at 8.625% interest per annum. Delos has successfully completed two years
Payments 1 2 3 4
Interest (10.00) (7.85) (5.48) (2.87)
Principal (21.55) (23.70) (26.07) (28.68)
Total (31.55) (31.55) (31.55) (31.55)
156 CHAPTER 5 The Continuing Global Financial Crisis
of debt-service, but now wishes to renegotiate the terms of the loan with the lender to reduce its annual payments. a. What were Delos’s annual principal and interest
payments under the original loan agreement? b. After two years debt-service, how much of the
principal is still outstanding? c. If the loan was restructured to extend another two
years, what would the annual payments—principal and interest—be? Is this a significant reduction from the original agreement’s annual payments?
10. Delos Debt Renegotiations (B). Delos is continuing to renegotiate its prior loan agreement (€80 million for 6 years at 8.625% per annum), two years into the agreement. Delos is now facing serious tax revenue shortfalls, and fears for its ability to service its debt obligations. So it has decided to get more aggressive, and has gone back to its lenders with a request for a haircut, a reduction in the remaining loan amount. The banks have, so far, only agreed to restructure the loan agreement for another two years (new loan of six years on the remaining principal balance) but at an interest rate a full 200 basis points higher, 10.625%. a. If Delos accepts the current bank proposal of the
remaining principal for six years (extending the loan an additional two years since two of the origi- nal six years have already passed), but at the new interest rate, what are its annual payments going to be? How much relief does this provide Delos on annual debt-service?
b. Delos’s demands for a haircut are based on get- ting the new annual debt service payments down. If Delos does agree to the new loan terms, what size of haircut should it try to get from its lenders to get its payments down to €10 million per year?
INTERNET EXERCISES 1. The New York Times and Times Topics. The online
version of the The New York Times has a special sec- tion entitled “Times Topics”—issues of continuing interest and coverage by the publication. The current financial crisis is covered and updated regularly here.
The New York Times topics.nytimes.com/topics/ and Times Topics reference/timestopics/ subjects/c/credit_crisis/
2. British Bankers Association and LIBOR. The British Bankers Association (BBA), the author of LIBOR, provides both current data for LIBOR of varying maturities as well as timely studies of interbank mar- ket behavior and practices.
British Bankers www.bbalibor.com Association and LIBOR
3. Bank for International Settlements. The Bank for International Settlements (BIS) publishes regular assessments of international banking activity. Use the BIS Web site to find up-to-date analysis of the ongo- ing credit crisis.
Bank for International www.bis.org/ Settlements
4. Federal Reserve Bank of New York. The New York Fed maintains an interactive map of mortgage and credit card delinquencies for the United States. Use the following Web site to view the latest in default rates according to the Fed.
Federal Reserve Bank data.newyorkfed.org/ of New York creditconditionsmap/
Problem 8. Loan 0 Payments 1 2 3 4 5 6
Principal $220 Interest (26.950) (23.650) (19.946) (15.788) (11.120) (5.881)
Interest rate 12.250% Principal (26.939) (30.239) (33.943) (38.101) (42.769) (48.008)
Maturity (years) 6.0 Total (53.889) (53.889) (53.889) (53.889) (53.889) (53.889)
Foreign Exchange Theory and Markets
CHAPTER 6 The Foreign Exchange Market
CHAPTER 7 International Parity Conditions
CHAPTER 8 Foreign Currency Derivatives and Swaps
PART II
157
The Foreign Exchange Market
The best way to destroy the capitalist system is to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.
—John Maynard Keynes.
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. Foreign exchange means the money of a foreign country; that is, foreign currency bank balances, banknotes, checks, and drafts. 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. This chapter describes the following features of the foreign exchange market:
! Its geographical extent ! Its three main functions ! Its participants ! Its immense daily transaction volume ! Types of transactions, including spot, forward, and swap transactions ! Methods of stating exchange rates, quotations, and changes in exchange rates
The chapter concludes with the Mini-Case, The Saga of the Venezuelan Bolivar Fuerte, which details the continuing devaluation of the Venezuelan currency in 2011.
Geographical Extent of the Foreign Exchange Market The foreign exchange market spans the globe, with prices moving and currencies trading somewhere every hour of every business day. Major world trading starts each morning in Sydney and Tokyo, moves west to Hong Kong and Singapore, passes on to Bahrain, shifts to the main European markets of Frankfurt, Zurich, and London, jumps the Atlantic to New York, goes west to Chicago, and ends in San Francisco and Los Angeles. Many large inter- national banks operate foreign exchange trading rooms in each major geographic trading center in order to serve important commercial accounts on a 24-hour-a-day basis. Global currency trading is indeed a 24-hour-a-day process. As shown in Exhibit 6.1, the volume of currency transactions ebbs and flows across the globe as the major currency trading centers of London, New York, and Tokyo open and close throughout the day. Exhibit 6.2 provides
158
CHAPTER 6
159The Foreign Exchange Market CHAPTER 6
EXHIBIT 6.1 Measuring Foreign Exchange Market Activity: Average Electronic Conversations per Hour
10 A.M. in Tokyo
Lunch in Tokyo
Europe Opening
Asia Closing
Americas Open
London Closing
Afternoon in Americas
6 P.M. in New York
Tokyo Opens
Greenwich Mean Time
25,000
20,000
15,000
10,000
5,000
0 3 41 2 5 6 7 8 9 10 13 1411 12 23 2421 2215 16 17 18 19 20
Source: Federal Reserve Bank of New York, “The Foreign Exchange Market in the United States,” 2001, www.ny.frb.org.
EXHIBIT 6.2 Global Currency Trading: The Trading Day
San Francisco
Chicago
New York
London
Frankfurt
Singapore
Bahrain
Tokyo and Sydney
Hong Kong
HKG
Foreign Exchange Dealing Times: GMT
Greenwich Mean Time
The currency trading day literally extends 24 hours per day. The busiest time of the day, however, is when New York and London overlap, the world’s most liquid time of day.
24 00
23 00
22 00
21 00
20 00
19 00
18 00
17 00
16 00
15 00
14 00
13 00
12 00
11 00
10 00
09 00
08 00
07 00
06 00
05 00
04 00
03 00
02 00
01 00
160 CHAPTER 6 The Foreign Exchange Market
a general mapping of which trading centers are open when, and which centers do and do not overlap with other city markets.
In some countries, a portion of foreign exchange trading is conducted on an official trading floor by open bidding. Closing prices are published as the official price, or “fixing,” for the day, and certain commercial and investment transactions are based on this official price. Business firms in countries with exchange controls, for example, China (mainland), often must surrender foreign exchange earned from exports to the central bank at the daily fixing price.
Banks engaged in foreign exchange trading are connected by highly sophisticated telecommunications networks, with dealers and brokers exchanging currency quotes instantaneously. The foreign exchange departments of many nonbank business firms also use Internet-based networks, but often access trading through the major bank trading rooms. Reuters, Telerate, and Bloomberg are the leading suppliers of foreign exchange rate information and trading systems. A growing part of the industry is automated trading, in which corporate buyers and sellers trade currencies through Internet-based platforms provided or hosted by major money center banks. Although the largest currency transactions are still handled by humans via telephone, the use of computer trading has grown dramatically in recent years.
Functions of the Foreign Exchange Market The foreign exchange market is the mechanism by which participants transfer purchasing power between countries, obtain or provide credit for international trade transactions, and minimize exposure to the risks of exchange rate changes.
! Transfer of purchasing power is necessary because international trade and capital transactions normally involve parties living in countries with different national currencies. Usually each party, wants to deal in its own currency, but the trade or capital transaction can be invoiced in only one currency. Hence, one party must deal in a foreign currency.
! Because the movement of goods between countries takes time, inventory in transit must be financed. The foreign exchange market provides a source of credit. Specialized instruments, such as bankers’ acceptances and letters of credit, discussed in detail in Chapter 20, are available to finance international trade.
! The foreign exchange market provides “hedging” facilities for transferring foreign exchange risk to someone else more willing to carry risk. These facilities are explained in Chapter 10.
Market Participants The foreign exchange market consists of two tiers: the interbank or wholesale market, and the client or retail market. Individual transactions in the interbank market are usually for large sums that are multiples of a million U.S. dollars or the equivalent value in other currencies. By contrast, contracts between a bank and its clients are usually for specific amounts.
Five broad categories of participants operate within these two tiers: 1) bank and non- bank foreign exchange dealers; 2) individuals and firms conducting commercial or investment transactions; 3) speculators and arbitragers; 4) central banks and treasuries; and 5) foreign exchange brokers.
161The Foreign Exchange Market CHAPTER 6
Bank and Nonbank Foreign Exchange Dealers Banks, and a few nonbank foreign exchange dealers, operate in both the interbank and client markets. They profit from buying foreign exchange at a “bid” price and reselling it at a slightly higher “offer” (also called an “ask”) price. Competition among dealers worldwide narrows the spread between bids and offers and so contributes to making the foreign exchange market “efficient” in the same sense as in securities markets.
Dealers in the foreign exchange departments of large international banks often function as “market makers.” Such dealers stand willing at all times to buy and sell those currencies in which they specialize and thus maintain an “inventory” position in those currencies. They trade with other banks in their own monetary centers and with other centers around the world in order to maintain inventories within the trading limits set by bank policy. Trading limits are important because foreign exchange departments of many banks operate as profit centers, and individual dealers are compensated on a profit incentive basis.
Currency trading is quite profitable for commercial and investment banks. Many of the major currency-trading banks in the United States derive between 10% and 20% on average of their annual net income from currency trading. But currency trading is also very profitable for the bank’s traders who typically earn a bonus based on the profitability to the bank of their individual trading activities.
Small- to medium-size banks are likely to participate but not be market makers in the interbank market. Instead of maintaining significant inventory positions, they buy from and sell to larger banks to offset retail transactions with their own customers. Of course, even market-making banks do not make markets in every currency. They trade for their own account in those currencies of most interest to their customers and become participants when filling customer needs in less important currencies. Global Finance in Practice 6.1 describes a typical foreign exchange dealer’s day on the job.
How do foreign exchange dealers prepare for their working day? Foreign exchange dealing in Europe is officially opened at 8 A.M., but the dealer’s work starts at least one hour earlier. Every morning, the chief dealers give their staff guidelines for their dealing activities. They will reassess their strategy on the basis of their estimation of the market over the next few months. They will also decide their tactics for the day, based on the following factors:
! Trading Activities in the Past Few Hours in New York and the Far East. Because of the time difference, banks in New York will have continued trading for several hours longer than the banks in Europe, while in the Far East the working day is already closing when the European day begins.
! New Economic and Political Developments. Following the theoretical forces that determine exchange rates, changes in interest rates, economic indicators, and monetary aggre- gates are the fundamental factors influencing exchange rates. Political events such as military conflicts, social unrest,
the fall of a government, and so on, can also influence and sometimes even dominate the market scene.
! The Bank’s Own Foreign Exchange Position. Early in the morning, market makers use electronic information systems to catch up on any events of the past night which might impact exchange rates. Charts (graphic presentations of rate movements) and screen-based rate boards allow dealers to study the latest developments in foreign exchange rates in New York and the Far East. As soon as this preparatory work is completed, the dealers will be ready for international trades (between 8 A.M. and 5 P.M.). The day starts with a series of telephone calls between the key market players, the aim being to sound out what intentions are. Until recently, brokers also acted as intermediaries in foreign exchange and money market operations.
Source: Foreign Exchange and Money Market Transactions, UBS Investment Bank, undated, pp. 54–55.
GLOBAL FINANCE IN PRACTICE 6.1
The Foreign Exchange Dealer’s Day
162 CHAPTER 6 The Foreign Exchange Market
Individuals and Firms Conducting Commercial and Investment Transactions Importers and exporters, international portfolio investors, MNEs, tourists, and others use the foreign exchange market to facilitate execution of commercial or investment transactions. Their use of the foreign exchange market is necessary, but incidental, to their underlying commercial or investment purpose. Some of these participants use the market to hedge foreign exchange risk as well.
Speculators and Arbitragers Speculators and arbitragers seek to profit from trading in the market itself. They operate in their own interest, without a need or obligation to serve clients or to ensure a continuous market. Whereas dealers seek profit from the spread between bids and offers in addition to what they might gain from changes in exchange rates, speculators seek all of their profit from exchange rate changes. Arbitragers try to profit from simultaneous exchange rate differences in different markets.
Traders employed by those banks conduct a large proportion of speculation and arbitrage on behalf of major banks. Thus, banks act both as exchange dealers and as speculators and arbitragers. (However, banks seldom admit to speculating; they characterize themselves as “taking an aggressive position”!) As described in Global Finance in Practice 6.2, however, trading is not for the weak of heart.
For my internship I was working for the Treasury Front and Back Office of a major investment bank’s New York branch on Wall Street. I was, for the first half of my internship, responsible for the timely input and verification of all foreign exchange, money market, securities, and derivative products. My job consisted of the input of all types of trades into the back office systems, the verification through confirmation or documentation of trade details, the verification and payment/receipt of funds regarding variation margins on future transactions, interest rate swaps, caps, floors, FRAs and options, and the maintenance of U.S. dollar positions for the end of day settlement. That was the boring part of my internship.
The second half was much more interesting. I received training in currency trading. I started on the spot desk, worked there for two weeks, and then moved to the swap desk for the remaining three weeks of my internship. From the first day of training in the front office I knew I would have to stay on my toes. The first two weeks of my training I was assigned to the spot desk where my supervisor was a senior trader, female, 23 years old, blonde, blue eyes, and extremely ambitious.
On the very first day, about 11 A.M., she bet on the rise of the Japanese yen after the elections of the new Japanese Prime Minister. She had a long position on the yen and was short on the dollar. Unfortunately she lost $700,000 in less than 10 minutes. It is still unclear for me why she made such
a bet. The Wall Street Journal and the Financial Times (both papers were used heavily in the trading room) were very nega- tive regarding the new Prime Minister’s ability to reverse the financial crisis in Japan. It was clear that her position was based purely on emotions, instinct, savvy—anything but fundamentals.
To understand the impact of a $700,000 loss that my blonde alien made, you must understand that every trader on a spot desk has to make eight times his or her wage in commission. Let’s say that my supervisor was making $80,000 a year. She would then need to make $640,000 in commission on spreads during that year to keep her job. A loss of $700,000 put her in a very bad position, and she knew it. But to her credit, she remained quite confident and did not appear shaken.
But after my first day I was pretty shaken. I understood after this that being a trader was not my cup of tea. It is not because of the stress of the job—and it is obviously very stressful. It was more that most of the skills of the job had nothing to do with what I had been learning in school for many years. And when I saw and experienced how hard these people partied up and down the streets of New York many nights—and then traded hundreds of millions of dollars in minutes the following day, well, I just did not see this as my career track.
Source: Reminiscences of an anonymous intern.
GLOBAL FINANCE IN PRACTICE 6.2
My First Day of Foreign Exchange Trading
163The Foreign Exchange Market CHAPTER 6
Central Banks and Treasuries Central banks and treasuries use the market to acquire or spend their country’s foreign exchange reserves as well as to influence the price at which their own currency is traded. They may act to support the value of their own currency because of policies adopted at the national level or because of commitments entered into through membership in joint float agreements, such as that of the European Monetary System (EMS) central banks that preceded introduction of the euro. Consequently, motive is not to earn a profit as such, but rather to influence the foreign exchange value of their currency in a manner that will benefit the interests of their citizens. In many instances, they do their job best when they willingly take a loss on their foreign exchange transactions. As willing loss takers, central banks and treasuries differ in motive and behavior from all other market participants.
Foreign Exchange Brokers Foreign exchange brokers are agents who facilitate trading between dealers without themselves becoming principals in the transaction. They charge a small commission for this service. They maintain instant access to hundreds of dealers worldwide via open telephone lines. At times, a broker may maintain a dozen or more such lines to a single client bank, with separate lines for different currencies and for spot and forward markets.
It is a broker’s business to know at any moment exactly which dealers want to buy or sell any currency. This knowledge enables the broker to find an opposite party for a client without revealing the identity of either party until after a transaction has been agreed upon. Dealers use brokers to expedite the transaction and to remain anonymous, since the identity of participants may influence short-term quotes.
Continuous Linked Settlement and Fraud In 2002, the Continuous Linked Settlement (CLS) system was introduced. The CLS system eliminates losses if either party of a foreign exchange transaction is unable to settle with the other party. It links the Real-Time Gross Settlement (RTGS) systems in seven major currencies. It is expected eventually to result in a same-day settlement, which will replace the traditional two-day transaction period.
The CLS system should help counteract fraud in the foreign exchange markets as well. In the United States, the Commodity Futures Modernization Act of 2000 gives the responsibility for regulating foreign exchange trading fraud to the U.S. Commodity Futures Trading Commission (CFTC).
Transactions in the Foreign Exchange Market Transactions in the foreign exchange market can be executed on a spot, forward, or swap basis. A broader definition of the foreign exchange market includes foreign currency options, futures, and swaps, which are covered in Chapter 8. A spot transaction requires almost immediate delivery of foreign exchange. A forward transaction requires delivery of foreign exchange at some future date, either on an “outright” basis or through a “futures” contract. A swap transaction is the simultaneous exchange of one foreign currency for another.
Spot Transactions A spot transaction in the interbank market is the purchase of foreign exchange, with delivery and payment between banks to take place, normally, on the second following business day. The Canadian dollar settles with the U.S. dollar on the first following business day. Exhibit 6.3 provides a structured map of when settlement occurs within the European market.
164 CHAPTER 6 The Foreign Exchange Market
The date of settlement is referred to as the “value date.” On the value date, most dollar transactions in the world are settled through the computerized Clearing House Interbank Payments System (CHIPS) in New York, which provides for calculation of net balances owed by any one bank to another and for payment by 6:00 P.M. that same day in Federal Reserve Bank of New York funds. Other central banks and settlement services providers operate similarly in other currencies around the world.
A typical spot transaction in the interbank market might involve a U.S. bank contracting on a Monday for the transfer of £10,000,000 to the account of a London bank. If the spot exchange rate were $1.8420/£, the U.S. bank would transfer £10,000,000 to the London bank on Wednesday, and the London bank would transfer $18,420,000 to the U.S. bank at the same time. A spot transaction between a bank and its commercial customer would not necessarily involve a wait of two days for settlement.
Outright Forward Transactions An outright forward transaction (usually called just “forward”) requires delivery at a future value date of a specified amount of one currency for a specified amount of another currency.
EXHIBIT 6.3 Foreign Exchange Settlement in Europe
Outright Purchase/sale on a specific date
Spot purchase Forward sale
Swap Spot sale Forward purchase
Currency swap on two different dates
Today Tomorrow Day after tomorrow
Two days after tomorrow
Later
Spot Beyond spotPrior to spot
Foreign Exchange Operations
Overnight—tomorrow/next Before the spot date
(today/tomorrow) (tomorrow/day after tomorrow)
Forward Beyond spot
Spot Two working
days previously
Source: Foreign Exchange and Money Market Transactions, UBS Investment Bank, p. 58.
165The Foreign Exchange Market CHAPTER 6
The exchange rate is established at the time of the agreement, but payment and delivery are not required until maturity. Forward exchange rates are normally quoted for value dates of one, two, three, six, and twelve months. Actual contracts can be arranged for other numbers of months or, on occasion, for periods of more than one year. Payment is on the second business day after the even- month anniversary of the trade. Thus, a two-month forward transaction entered into on March 18 will be for a value date of May 20, or the next business day if May 20 falls on a weekend or holiday.
Note that as a matter of terminology we can speak of “buying forward” or “selling forward” to describe the same transaction. A contract to deliver dollars for euros in six months is both “buying euros forward for dollars” and “selling dollars forward for euros.”
Swap Transactions 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. A common type of swap is a “spot against forward.” The dealer buys a currency in the spot market and simultaneously sells the same amount back to the same bank in the forward market. Since this is executed as a single transaction with one counterparty, the dealer incurs no unexpected foreign exchange risk. Swap transactions and outright forwards combined made up 57% of all foreign exchange market activity in April 2010.
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 $1.8420/£ and simultaneously buys £20,000,000 forward for delivery in three months at $1.8400/£. The dif- ference between the buying price and the selling price is equivalent to the interest rate differen- tial, which is the interest rate parity described in Chapter 7, 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 deriv- atives. 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.
NDFs are used primarily for emerging market currencies, currencies that typically do not have open spot market currency trading, liquid money markets, or quoted Eurocurrency interest rates. Although most NDF trading focused on Latin America in the 1990s, many Asian currencies have been very widely traded in the post-1997 Asian crisis era. In general, NDF markets normally develop for country currencies having large cross-border capital movements, but still being subject to convertibility restrictions. Trading in recent years has been dominated by the Chilean peso, Taiwanese dollar, Brazilian reais, and Chinese renminbi.
Pricing of NDFs reflects basic interest differentials, as with regular forward contracts, plus some additional premium charged by the bank for dollar settlement. If, however, there is no accessible or developed money market for interest rate setting, the pricing of the NDF takes on a much more speculative element. Without true interest rates, traders often price based on what they believe spot rates may be at the time of settlement.
NDFs are traded and settled outside the country of the subject currency, and therefore are beyond the control of the country’s government. In the past, this has created a difficult situation, in which the NDF market then serves as something of a gray market in the trading of
166 CHAPTER 6 The Foreign Exchange Market
that currency. For example, in late 2001, Argentina was under increasing pressure to abandon its fixed exchange rate regime of one peso equaling one U.S. dollar. The NDF market began quoting rates of ARS1.05/USD and ARS1.10/USD, in effect a devalued peso, for NDFs settling within the next year. This led to increasing speculative pressure against the peso (and to the ire of the Argentine government).
NDFs, however, have proven to be something of an imperfect replacement for traditional forward contracts. The problems with NDFs typically involve its “fixing of spot rate on the fixing date,” the spot rate at the end of the contract used to calculate the settlement. In times of financial crisis, for example, with the Venezuelan bolivar in 2003, the government of the subject currency may suspend foreign exchange trading in the spot market for an extended period. Without an official fixing rate, the NDF cannot be settled. In the case of Venezuela, the problem was compounded when a new official “devalued bolivar” was announced, but still not traded.
Size of the Foreign Exchange Market The Bank for International Settlements (BIS), in conjunction with central banks around the world, conducts a survey of currency trading activity every three years. The most recent survey, conducted in April 2010, estimated daily global net turnover in the foreign exchange market to be $3.2 trillion. The BIS data for surveys between 1989 and 2010 is shown in Exhibit 6.4.
Global foreign exchange turnover in Exhibit 6.4 is divided into three categories of currency instruments: spot transactions, forward transactions, and swap transactions. While spot market growth between 2007 and 2010 was dramatic, rising from $1.005 trillion to $1.495 trillion (48% growth in only three years), outright forwards rose from $0.362 trillion to $0.475 trillion (30% growth), with
EXHIBIT 6.4 Global Foreign Exchange Market Turnover, 1989–2010 (average daily turnover in April, billions of U.S. dollars)
$1,800
$1,600
$1,400
$1,200
$1,000
$800
$600
$400
$200
$0 1998 2001 2004 2007 20101989 1992 1995
Spot Forwards Swaps
Source: Bank for International Settlements, “Triennial Central Bank Survey: Foreign Exchange and Derivatives Market Activity in April 2010: Preliminary Results,” September 2010, www.bis.org.
167The Foreign Exchange Market CHAPTER 6
swaps growing only marginally, from $1.714 to $1.765 trillion. As we will discuss in Chapter 8, the low level of interest rates around the globe in recent years, combined with slowing economic growth and new debt issuances, has obviously had a dampening impact on the swap market.
Geographical Distribution Exhibit 6.5 shows the proportionate share of foreign exchange trading for the most important national markets in the world between 1992 and 2010. (Note that although the data is collected and reported on a national basis, “United States” should largely be interpreted as “New York” because the majority of foreign exchange trading takes place in the major financial city. This is most true for “United Kingdom” and “London.”)
The United Kingdom (London) continues to be the world’s major foreign exchange market in traditional foreign exchange market activity with $1,854 billion in average daily turnover, 36.7% of the global market. The United Kingdom is followed by the United States with 17.9%, Japan (Tokyo) with 6.2%, Singapore with 5.3%, Switzerland with 5.2%, and Hong Kong now reaching 4.7% of global trading. Indeed, the United Kingdom and United States together make up nearly 55% of daily currency trading. The relative growth of currency trading in Asia versus Europe over the past 15 years is pronounced, as the growth of the Asian economies and markets has combined with the introduction of the euro to shift currency exchange activity.
EXHIBIT 6.5 Top 10 Geographic Trading Centers in the Foreign Exchange Market, 1992–2010 (average daily turnover in April)
$1,400
$1,600
$1,800
$1,200
Bi lli
on s
of U
.S . D
ol la
rs
$1,000
$800
$600
$400
$200
$0 1992 1995 1998 2001 2004 2007 2010
United Kingdom SwitzerlandUnited States Japan
Hong KongSingapore Austraila
DenmarkGermany
France
Source: Bank for International Settlements, “Triennial Central Bank Survey: Foreign Exchange and Derivatives Market Activity in April 2010: Preliminary Results,” September 2010, www.bis.org.
168 CHAPTER 6 The Foreign Exchange Market
EXHIBIT 6.6 Foreign Exchange Market Turnover by Currency Pair (daily average in April)
30
25
20
15
10
5
0 20042001 2007 2010
Pe rc
en t
Euro Pound SterlingJapanese Yen
Canadian DollarSwiss Franc Australian Dollar
Source: Bank for International Settlements, “Triennial Central Bank Survey: Foreign Exchange and Derivatives Market Activity in April 2010: Preliminary Results,” September 2010, www.bis.org.
Currency Composition The currency composition of trading, as shown in Exhibit 6.6, also indicates significant global shifts. Because all currencies are traded against some other currency-pairs, all percentages shown in Exhibit 6.6 are for that currency versus another; in this case, the U.S. dollar. The dollar/euro cross along with the dollar/yen cross continue to dominate global trading. Although the “big three” (dollar, euro, and yen) continue to dominate global trades, it will probably not be long before a fourth, not yet on the map—the Chinese renminbi—will move into greater prominence.
Foreign Exchange Rates and Quotations A foreign exchange rate is the price of one currency expressed in terms of another currency. A foreign exchange quotation (or quote) is a statement of willingness to buy or sell at an announced rate. As we delve into the terminology of currency trading, keep in mind basic pricing, say the price of an orange. If the price is $1.20/orange, the “price” is $1.20, the “unit” is the orange.
Currency Symbols Quotations may be designated by traditional currency symbols or by ISO 4217 codes. The codes were developed for use in electronic communications. Both traditional symbols and currency codes are given in full at the end of this book, but the major ones used throughout this chapter are the following:
Currency Traditional Symbol ISO 4217 Code
U.S. dollar $ USD
European euro € EUR
Great Britain pound £ GBP
Japanese yen ¥ JPY
Mexican peso Ps MXN
169The Foreign Exchange Market CHAPTER 6
Today, all wholesale trading, that is, the trading of currencies between major banks in the global marketplace, uses the three-letter ISO codes. Although there are no hard and fast rules in the retail markets and in business periodicals, European and American periodicals have a tendency to use the traditional currency symbols, while many publications in Asia and the Middle East have embraced the use of ISO codes. The paper currency (banknotes) of most countries continue to use the country’s traditional currency symbol.
Exchange Rate Quotes 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. 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 USD 1.2174 = EUR 1.00. 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 6.7 provides a brief overview of the multitude of terms often used around the world to quote currencies, in this case, focusing on the European euro and U.S. dollar.
Market Conventions The international currency market, although the largest financial market in the world, is steeped in history and convention.
European Terms. European terms, the quoting of the quantity of a specific currency per one U.S. dollar, has been market practice for most of the past 60 years or more. Globally, the base
EXHIBIT 6.7 Foreign Currency Quotations
USD/EUR 0.8214 or
USD 1.00 = EUR 0.8214
USD is the base or unit currency EUR is the quote or price currency
EUR/USD 1.2174 or
EUR 1.00 = USD 1.2174
EUR is the base or unit currency USD is the quote or price currency
EUR 0.8214 / USD = USD 1.2714 / EUR
1
European terms Foreign currency price of one dollar (USD)
American terms U.S. dollar price of one euro (EUR)
170 CHAPTER 6 The Foreign Exchange Market
currency used to quote a currency’s value has typically been the U.S. dollar. Termed European terms, this means that whenever a currency’s value is quoted, it is quoted in terms of number of units of currency to equal one U.S. dollar.
For example, if a trader in Zurich, whose home currency is the Swiss franc (CHF), were to request a quote from an Oslo-based trader on the Norwegian krone (NOK), the Norwegian trader would quote the value of the NOK against the USD, not the CHF. The result is that most currencies are quoted per U.S. dollar—Japanese yen per U.S. dollar, Norwegian krone per U.S. dollar, Mexican pesos per U.S. dollar, Brazilian real per U.S. dollar, Malaysian ringgit per U.S. dollar, Chinese renminbi per U.S. dollar, and so on.
There are two major exceptions to this rule of using European terms: the euro and the U.K. pound sterling. Both are normally quoted in American terms; the U.S. dollar price of one euro and the U.S. dollar price of one pound sterling. Additionally, Australian dollars and New Zealand dollars are normally quoted on American terms. Sterling is quoted as the foreign currency price of one pound for historical reasons. For centuries, the British pound sterling consisted of 20 shillings, each of which equaled 12 pence. Multiplication and division with the nondecimal currency were difficult. The custom evolved for foreign exchange prices in London, then the undisputed financial capital of the world, to be stated in foreign currency units per pound. This practice remained even after sterling changed to decimals in 1971.
The euro was first introduced as a substitute or replacement for domestic currencies like the Deutsche mark and French franc. To make the transition simple for residents and users of these historical currencies, all quotes were made on a “domestic currency per euro” basis. This held true for its quotation against the U.S. dollar; hence, “U.S. dollars per euro” is the common quotation used today.
American Terms. American terms are used in quoting rates for most foreign currency options and futures, as well as in retail markets that deal with tourists and personal remittances. Again, this is largely a result of established practices which have been perpetuated, not some basic law of nature or finance.
Foreign exchange traders may also use nicknames for major currencies. “Cable” means the exchange rate between U.S. dollars and U.K. pounds sterling, the name dating from the time when transactions in dollars and pounds were carried out over the Transatlantic telegraph cable. A Canadian dollar is a “loonie,” named after the water fowl on Canada’s one-dollar coin. “Kiwi” stands for the New Zealand dollar, “Aussie” for the Australian dollar, “Swissie” for Swiss francs, and “Sing dollar” for the Singapore dollar.
Direct and Indirect Quotations. A direct quote is the price of a foreign currency in domestic currency units. An indirect quote is the price of the domestic currency in foreign currency units.
In retail exchange in many countries (such as currency exchanged in hotels or airports) it is common practice to quote the home currency as the price and the foreign currency as the unit. A woman walking down the Avenue des Champs-Elysèes in Paris might see the following quote:
EUR 0.8214=USD 1.00
In France, the home currency is the euro and the foreign currency is the dollar. This quotation in France is termed a direct quote on the dollar or a price quote on the dollar. Verbally, she might say to herself “0.8214 euros per dollar,” or “it will cost me 0.8214 euros to get one dollar.”
At the same time a man walking down Broadway in New York City may see the following quote in a bank window:
USD 1.2174=EUR 1.00
171The Foreign Exchange Market CHAPTER 6
The home currency is the dollar (the price) and the foreign currency is the euro (the unit). In New York, this would be a direct quote on the euro (the home currency price of one unit of foreign currency) and an indirect quote on the dollar (the foreign currency price of one unit of home currency). Again, he would probably say “I will pay $1.2174 dollars per euro.” These are American terms.
The two quotes are obviously equivalent (at least to four decimal places), one being the reciprocal of the other:
1 EUR 0.8214/USD
= USD 1. 2174/EUR
Bid and Ask Rates. Although a newspaper or magazine article will state an exchange rate as a single value, the market for buying and selling currencies, whether it be retail or wholesale, uses two different rates, one for buying and one for selling. Exhibit 6.8 provides a sample of how these quotations may be seen in the market for the dollar/euro.
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. The bid-ask spread may be quite large for currencies that are traded infrequently, in small volumes, or both.
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 euros is simultaneously offering to sell euros for dollars.
As illustrated in Exhibit 6.8, however, the full outright quotation (the full price to all of its decimal points) is typically shown only for the bid rate. Traders, however, tend to
EXHIBIT 6.8 Bid, Ask, and Mid-Point Quotation
EUR/USD 1.2170/1.2178 or 1.2170/78
Quote Currency
Base Currency
You can sell 1 euro for $1.2170
“Bid”
You can buy 1 euro for $1.2178
“Ask”
Traders may quote only the last two digits on a rate
In text documents of any kind, the exchange rate may be stated as mid-point quote, the average of bid and ask, of $1.2174/ .
For example, the Wall Street Journal would quote the following currencies as follows:
Last Bid Last Bid
Euro (EUR/USD) 1.2170 Brazilian Real (USD/BRL) 1.6827
Japanese Yen (USD/JPY) 83.16 Canadian Dollar (USD/CAD) 0.9930
U.K. Pound (GBP/USD) 1.5552 Mexican Peso (USD/MXN) 12.2365
172 CHAPTER 6 The Foreign Exchange Market
abbreviate when talking on the phone or putting quotations on a video screen. The first term, the bid, of a spot quotation may be given in full: that is, “1.2170.” However, the second term, the ask, will probably be expressed only as the digits that differ from the bid. Hence, the bid and ask for spot euros would probably be shown “1.2170/78” on a video screen. In some cases between professional traders, they may only quote the last two digits of both the bid and ask, “70-78”, because they know what the other figures are. Closing rates for 47 currencies (plus the SDR) as quoted by the Wall Street Journal are presented in Exhibit 6.9.
The Wall Street Journal gives American terms quotes under the heading “USD equivalent” and European terms quotes under the heading “Currency per USD.” Quotes are given on an outright basis for spot, with forwards of one, three, and six months provided for a few select currencies. Quotes are for trading among banks in amounts of $1 million or more, as quoted at 4 P.M. EST by Reuters. The Journal does not state whether these are bid, ask, or mid-rate quotations.
A final note. The order of currencies in quotations used by traders can be quite confusing (at least the authors of this book think so). As noted by one major international banking publication: The notation EUR/USD is the system used by traders, although mathematically it would be more correct to express the exchange rate the other way around, as it shows how many USD have to be paid to obtain EUR 1.
This is why the currency quotes in Exhibit 6.8—EUR/USD, USD/JPY, or GBP/USD—are quoted and used in business and the rest of this text as $1.2170/€, ¥83.16/$, and $1.5552/£. International finance is not for the weak of heart!
Cross Rates Many currency pairs are only inactively traded, so their exchange rate is determined through their relationship to a widely traded third currency. For example, a Mexican importer needs Japanese yen to pay for purchases in Tokyo. Both the Mexican peso (MXN) and the Japanese yen (JPY) are commonly quoted against the U.S. dollar (USD). Using the following quotes from Exhibit 6.9:
Japanese yen JPY76.73/USD Mexican peso MXN13.6455/USD
the Mexican importer can buy one U.S. dollar for MXN13.6455, and with that dollar can buy JPY 76.73. The cross rate calculation would be as follows:
Japanese yen/U.S. dollar Mexican pesos/U.S. dollar
= JPY76.73/USD
MXN13.6455/USD = JPY5.6231/MXN
The cross rate could also be calculated as the reciprocal:
Mexican peso/U.S. dollar Japanese yen/U.S. dollar
= MXN13.6455/USD
JPY76.73/USD = MXN0.17784/JPY
Cross rates often appear in various financial publications in the form of a matrix to simplify the math for many readers. Exhibit 6.10 calculates a number of key cross rates from the quotes presented in the previous Exhibit 6.9, including the Mexican peso/Japanese yen calculation just described.
173The Foreign Exchange Market CHAPTER 6
EXHIBIT 6.9 Exchange Rates: New York Closing Snapshot
U.S.-dollar foreign-exchange rates in late New York trading, Tuesday, January 3, 2012
Country Currency Symbol Code USD equivalent Currency per USD Americas Argentina* peso Ps ARS 0.2321 4.3085 Brazil real R$ BRL 0.5338 1.8733 Canada dollar C$ CAD 0.9895 1.0107 Chile peso $ CLP 0.001932 517.5 Colombia peso Col$ COP 0.0005158 1938.85 Ecuador US dollar $ USD 1 1 Mexico* new peso $ MXN 0.0733 13.6455 Peru new sol S/. PEN 0.3708 2.697 Uruguay† peso $U UYU 0.05024 19.904 Venezuela boliviar fuerte Bs VND 0.22988506 4.35 Asia-Pacific Australia dollar A$ AUD 1.0378 0.9636 1-month forward 1.03415886 0.97 3-months forward 1.02711686 0.97 6-months forward 1.01881586 0.98 China yuan ¥ CNY 0.1589 6.294 Hong Kong dollar HK$ HKG 0.1288 7.7668 India rupee Rs INR 0.01876 53.30545 Indonesia rupiah Rp IDR 0.0001101 9082 Japan yen ¥ JPY 0.01303271 76.73 1-month forward 0.01303863 76.7 3-months forward 0.01305577 76.59 6-months forward 0.01308558 76.42 Malaysia § ringgit RM MYR 0.3173 3.1513 New Zealand dollar NZ$ NZD 0.79 1.2658 Pakistan rupee Rs. PKR 0.01112 89.9 Philippines peso P PHP 0.0228 43.954 Singapore dollar S$ SGD 0.779 1.2837 South Korea won W KRW 0.0008725 1146.15 Taiwan dollar T$ TWD 0.03298 30.317 Thailand baht B THB 0.03188 31.369 Vietnam dong d VND 0.00005 21032 Europe Czech Republic** koruna Kc CZK 0.05076 19.7 Denmark krone Dkr DKK 0.1755 5.6977 Euro area euro € EUR 1.3051 0.7662 Hungary forint Ft HUF 0.00412594 242.37 Norway krone NKr NOK 0.1691 5.9124 Poland zloty — PLN 0.2919 3.426 Romania leu L RON 0.2987 3.3475 Russia ‡ ruble R RUB 0.03147 31.78 Sweden krona SKr SEK 0.1465 6.8246 Switzerland franc Fr. CHF 1.0728 0.9321 1-month forward 1.0734 0.9316 3-months forward 1.0749 0.9303 6-months forward 1.0775 0.928
Turkey ** lira YTL TRY 0.5338 1.8735 United Kingdom pound £ GBP 1.5651 0.6389 1-month forward 1.5647 0.6391 3-months forward 1.5638 0.6395 6-months forward 1.5622 0.6401 Middle East/Africa Bahrain dinar — BHD 2.6526 0.377 Eqypt* pound £ EGP 0.1657 6.0348 Israel shekel Shk ILS 0.2615 3.8236 Jordan dinar — JOD 1.4084 0.7101 Kenya shilling KSh KES 0.01177 84.989 Kuwait dinar — KWD 3.5891 0.2786 Lebanon pound — LBP 0.0006642 1505.65 Saudi Arabia riyal SR SAR 0.2667 3.7499 South Africa rand R ZAR 0.124 8.0627 United Arab Emirates dirham — AED 0.2722 3.6732
Note: *Floating rate †Financial §Government rate and ‡Russian Central Bank rate **Commercial rate ‡ Special Drawing Rights (SDR); from the Interna- tional Monetary Fund; based on exchange rates for U.S., British and Japanese currencies.Note: Based on trading among banks of $1 million and more, as quoted at 4 P.M. ET by Reuters. Rates are drawn from The Wall Street Journal for January 4, 2012.
174 CHAPTER 6 The Foreign Exchange Market
Intermarket Arbitrage Cross rates can be used to check on opportunities for intermarket arbitrage. Suppose the following exchange rates are quoted:
Citibank quotes U.S. dollars per euro USD1.3297/EUR Barclays Bank quotes U.S. dollars per pound sterling USD1.5585/GBP Dresdner Bank quotes euros per pound sterling EUR1.1722/GBP
The cross rate between Citibank and Barclays Bank is
USD1.5585/GBP USD1.3297/EUR
= EUR1.1721/GBP
This cross rate is not the same as Dresdner Bank’s quotation of EUR1.1722/GBP, so an opportunity exists to profit from arbitrage between the three markets. Exhibit 6.11 shows the steps in what is called triangular arbitrage.
A market trader at Citibank New York, with USD1,000,000, can sell that sum spot to Barclays Bank for USD1,000,000 , USD1.5585/GBP = GBP641,643. Simultaneously, these pounds can be sold to Dresdner Bank for GBP641,643 * EUR1.1722/GBP = EUR752,133, and the trader can then immediately sell these euros to Citibank for dollars: EUR752,133 * USD1.3297/EUR = USD1,000,112.
The profit on one such “turn” is a risk-free USD112 (not much, but it’s digital!). Such triangular arbitrage can continue until exchange rate equilibrium is reestablished; that is, until the calculated cross rate equals the actual quotation, less any tiny margin for transaction costs.
Percentage Change in Spot Rates Assume that the Mexican peso has recently changed in value from MXP10.00/USD to MXP11.00/USD. Your home currency is the U.S. dollar. What is the percent change in the value of the Mexican peso? The calculation depends upon the designated home currency.
Foreign Currency Terms. When the foreign currency price (the price) of the home currency (the unit) is used, Mexican pesos per U.S. dollar in this case, the formula for the percent change in the foreign currency becomes
EXHIBIT 6.10 Key Currency Rate Calculations for January 3, 2012
Calculated
Dollar Euro Pound SFranc Peso Yen CdnDlr
Canada 1.0107 1.3191 1.5819 1.0843 0.07407 0.01317 . . . Japan 76.73 100.144 120.10 82.32 5.6231 . . . 75.918 Mexico 13.646 17.809 21.358 14.6395 . . . 0.17784 13.501 Switzerland 0.9321 1.2165 1.4589 . . . 0.06831 0.01215 0.92223 U.K. 0.6389 0.8339 . . . 0.6854 0.04682 0.00833 0.63214 Euro 0.7662 . . . 1.1992 0.8220 0.05615 0.00999 0.75809 U.S. . . . 1.3051 1.5652 1.0728 0.07328 0.01303 0.9894
Note: Cross rates are calculated from quotes presented in Exhibit 6.9.
175The Foreign Exchange Market CHAPTER 6
%! = Beginning rate - Ending rate
Ending rate * 100 = MXP10.00/USD - MXP11.00/USD
MXP11.00/USD * 100 = -9.09%
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, therefore the reciprocals of the numbers used above, the formula for the percent change in the foreign currency is
%! = Ending rate - Beginning rate
Beginning rate * 100 = USD0.09091/MXP - USD0.1000/MXP
USD0.1000/MXP * 100 = -9.09%
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, as 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 which currency is designated as home currency matters.
Forward Quotations Although spot rates are typically quoted on an outright basis, meaning all digits expressed, forward rates are typically quoted in terms of points or pips, the last digits of a currency quotation, depending on currency. Forward rates of one year or less maturity are termed cash rates, longer than one-year swap rates. A forward quotation expressed in points is not a foreign exchange rate as such. Rather it is the difference between the forward rate and the spot rate. Consequently, the spot rate itself can never be given on a points basis.
Consider the spot and forward point quotes in Exhibit 6.12. The bid and ask spot quotes are outright quotes, but the forwards are stated as points from the spot rate. The
EXHIBIT 6.11 Triangular Arbitrage by a Market Trader
Dresdner Bank Barclays Bank, London
Citibank New York
End with USD1,000,112 Start with USD1,000,000
(1) Trader sells USD1,000,000 to Barclays Bank at USD1.5585/GBP
(6) Trader receives USD1,000,112
(2) Trader receives GBP641,643
(3) Trader sells GBP641,643 to Dresdner Bank at EUR1.1722/GBP
(5) Trader sells EUR752,133 to Citibank at USD1.3297/EUR
(4) Trader receives EUR752,133 from Dresdner Bank
176 CHAPTER 6 The Foreign Exchange Market
three-month points quotations for the Japanese yen in Exhibit 6.12 are “-143” bid and “-140” ask. The first number (“-143”) refers to points away from the spot bid, and the second number (“-140”) to points away from the spot ask. Given the outright quotes of 118.27 bid and 118.37 ask, the outright three-month forward rates are calculated as follows:
Bid Ask
Outright spot JPY118.27 JPY118.37
Plus points (3 months) -1.43 -1.40
Outright forward JPY116.84 JPY116.97
EXHIBIT 6.12 Spot and Forward Quotations for the Euro and Japanese Yen
Euro: Spot and Forward ($/€) Japanese yen: Spot and Forward (¥/$)
Bid Ask Bid Ask
Term Points Rate Points Rate Points Rate Points Rate
Spot 1.0897 1.0901 118.27 118.37
Cash rates 1 week 3 1.0900 4 1.0905 -10 118.17 -9 118.28
1 month 17 1.0914 19 1.0920 -51 117.76 -50 117.87
2 months 35 1.0932 36 1.0937 -95 117.32 -93 117.44
3 months 53 1.0950 54 1.0955 -143 116.84 -140 116.97
4 months 72 1.0969 76 1.0977 -195 116.32 -190 116.47
5 months 90 1.0987 95 1.0996 -240 115.87 -237 116.00
6 months 112 1.1009 113 1.1014 -288 115.39 -287 115.50
9 months 175 1.1072 177 1.1078 -435 113.92 -429 114.08
1 year 242 1.1139 245 1.1146 -584 112.43 -581 112.56
Swap rates 2 years 481 1.1378 522 1.1423 -1150 106.77 -1129 107.08
3 years 750 1.1647 810 1.1711 -1748 100.79 -1698 101.39
4 years 960 1.1857 1039 1.1940 -2185 96.42 -2115 97.22
5 years 1129 1.2026 1276 1.2177 -2592 92.35 -2490 93.47
The forward bid and ask quotations in Exhibit 6.12 longer than two years are called swap rates. As mentioned earlier, many forward exchange transactions in the interbank market involve a simultaneous purchase for one date and sale (reversing the transaction) for another date. This “swap” is a way to borrow one currency for a limited time while giving up the use of another currency for the same time. In other words, it is a short-term borrowing of one currency combined with a short-term loan of an equivalent amount of another currency. The two parties could, if they wanted, charge each other interest at the going rate for each of the currencies. However, it is easier for the party with the higher-interest currency to simply pay the net interest differential to the other. The swap rate expresses this net interest differential on a points basis rather than as an interest rate.
177The Foreign Exchange Market CHAPTER 6
Forward Quotations in Percentage Terms The percent per annum deviation of the forward from the spot rate is termed the forward premium. However, the forward premium—which may be either a positive (a premium) or negative value (a discount)—depends on which currency is the home, or base currency as with the calculation of percentage changes in spot rates. Assume the following spot rate for our discussion of foreign currency terms and home currency terms.
Foreign currency (price)/ home currency (unit)
Home currency (price)/ foreign currency (unit)
Spot rate ¥118.27/$ USD0.0084552/JPY
3-month forward ¥116.84/$ USD0.0085587/JPY
Foreign Currency Terms. When the foreign currency is used as the price of the home currency (the unit), and substituting JPY/USD spot and forward rates, as well as the number of days forward (90), the forward premium on the yen is calculated as follows:
f JPY = Spot - Forward
Forward * 360
90 * 100 = 118.27 - 116.84
116.84 * 360
90 * 100 = +4.90%
The sign is positive indicating that the Japanese yen is selling forward at a premium of 4.90% against the U.S. dollar.
Home Currency Terms. When the home currency (the dollar) is used as the price for the foreign currency (the yen), the reciprocals of the spot and forward rates used in the previous calculation, the calculation of the forward premium on the yen (f JPY) is
f JPY = Forward - Spot
Spot * 360
90 * 100 = 0.0084552 - 0.0085587
0.0085587 * 360
90 * 100 = +4.90%
Again, the result is identical to the previous premium calculation: a positive 4.90% premium of the yen against the dollar.
SUMMARY POINTS
! The three functions of the foreign exchange market are to transfer purchasing power, provide credit, and minimize foreign exchange risk.
! The foreign exchange market is composed of two tiers: the interbank market and the client market. Participants within these tiers include bank and nonbank foreign exchange dealers, individuals and firms conducting commercial and investment transactions, speculators and arbitragers, central banks and treasuries, and foreign exchange brokers.
! Geographically the foreign exchange market spans the globe, with prices moving and currencies traded somewhere every hour of every business day.
! A foreign exchange rate is the price of one currency expressed in terms of another currency. A foreign exchange quotation is a statement of willingness to buy or sell currency at an announced price.
! Transactions within the foreign exchange market are executed either on a spot basis, requiring settlement two days after the transaction, or on a forward or swap basis, which requires settlement at some designated future date.
! European terms quotations are the foreign currency price of a U.S. dollar. American terms quotations are the dollar price of a foreign currency.
! Quotations can also be direct or indirect. A direct quote is the home currency price of a unit of foreign currency,
CHAPTER 6 The Foreign Exchange Market178
while an indirect quote is the foreign currency price of a unit of home currency.
! Direct and indirect are not synonyms for American and European terms, because the home currency will change depending on who is doing the calculation, while European terms are always the foreign currency price of a dollar.
! A cross rate is an exchange rate between two curren- cies, calculated from their common relationships with a third currency. When cross rates differ from the direct rates between two currencies, intermarket arbitrage is possible.
Una economía fuerte, un bolívar fuerte, un país fuerte. Translation: A strong economy, a strong bolívar, a
strong country.
The Venezuelan bolivar dropped in the country’s parallel currency market Monday after the government’s official devaluation late last week. The value of the bolivar fell to VEF9.25 to the dollar, according to LechugaVerde.com, a website widely used by locals to track the rate of the Venezuelan currency in the black market.
—“Venezuela Bolivar Falls in Parallel Market After Devaluation,” by Kejal Vyas,
Wall Street Journal, January 3, 2011.
Unfortunately for the Venezuelan people, their currency, the Venezuelan bolivar fuerte, had proven anything but strong. On January 1, 2011, President Hugo Chávez devalued the bolivar fuerte—the “strong bolivar”—again, the fifth time in the past decade. The bolivar’s history is detailed in Exhibit 1.
Current Regime This last devaluation was more of an adjustment. The previous devaluation, January 1, 2008, had fixed the bolivar fuerte (BsF) at BsF4.30/$ for general economic and exchange purposes, but a preferred rate of BsF2.60/$ for food, medi- cine, and heavy machinery imports considered essential.2 The 2011 devaluation eliminated the preferred rate, moving all import transactions to BsF4.30/$.This was not a minor elimination, as many analysts believed that in 2010 alone roughly 40% of all dollar-transactions were at the 2.6 rate. Even with this magnitude of change the bolivar fuerte is still considered overvalued; the black market rate of BsF8/$ was the current exchange as the devaluation occurred.
Even this fixed exchange rate was subject to significant restrictions. CADIVI (Comisión de Administración de
2“Venezuela to Devalue Currency,” by Kejal Vyas and David Luhnow, Wall Street Journal, December 31, 2010.
Divisas), the official government agency for the exchange of currency, limited Venezuelan residents to an annual total of $3,000 when traveling abroad, and $400 for Internet- based purchases. Although the country had managed to go a number of years between devaluations, the 2008 and 2010 devaluations were clear losses for the purchasing power of the richest oil exporting country in South America.
The fight by the Venezuelan government and the Venezuelan Central Bank (BCV) to assert its independence from the manipulation of the outside world, specifically the United States, knew few bounds. When Hugo Chávez signed into law the currency reform measures in May 2010 to stop speculation of any kind, including foreign currency bonds in the form of equity securities on the Venezuelan stock exchange, it was made very clear what the objective was:3
Whoever, in one or multiple transactions, within one calendar year, without intervention of the BCV, buys, sells, or in any way offers, transfers, or receives foreign currency between an amount of 10,000 dollars to 20,000 dollars, of the United States of America or their equivalent will be sanctioned with a fine valued at double the amount of the operation, in bolivars.
Chávez had repeatedly devalued the bolivar during his reign in office. In 2003, after the imposition of currency controls, the bolivar was fixed at Bs1,600/$. In February 2004, the bolivar was devalued from Bs1,600/$ to Bs1,920/$. In 2005, it experienced another devaluation, to Bs2,150/$. In January 2008, the bolivar was replaced with the bolivar fuerte (BsF) and re-denominated, knocking off three zeros from the currency value, from Bs2,150/$ to BsF2.15/$. All bank accounts and business agreements and contracts were instantly re-denominated into bolivar fuertes by decree. January 1, 2010, a full five years later, saw the bolivar devalued massively, from BsF2.15/$ to BsF4.3/$.
3“Venezuela Temporarily Closes Parallel Currency Market,” by Tamara Pearson, Venezuelanalysis.com, May 18, 2010.
The Saga of the Venezuelan Bolivar Fuerte1
1Copyright © 2011 Thunderbird School of Global Management. All rights reserved. This case was prepared by Professor Michael Moffett for the purpose of classroom discussion only and not to indicate either effective or ineffective management.
MINI-CASE
179The Foreign Exchange Market CHAPTER 6
The black market for bolivars, quoted in newspapers until recently, served a major purpose. Although the govern- ment set the official exchange rate, it still did not meet all of the demand for dollars even at that rate. As a result, the black market rate became the key indicator of value changes from supply and demand. Grocery stores, restaurants, mer- chants of all kinds used the black market rates to base their prices and price changes. When the black market rate started rising rapidly, business owners started increasing prices to make up for the loss in value of receiving what they consid- ered discounted bolivars. Chávez and the Venezuelan gov- ernment then, repeatedly, chastised business and threatened business owners raising prices with losing their companies. Despite all official efforts, black market trading was esti- mated at an astounding $100 million per day.4
One of the most innovative developments in this dys- functional marketplace had been the selective use of
4“Currency Woes Dog Venezuelans After Devaluation,” by Darcy Crowe, The Wall Street Journal, May 10, 2010.
Of course this did not eliminate a third exchange rate in effect, the Transaction System for Foreign Currency Denomi- nated Securities (SITME), another government organization established to set the rate used by businesses to gain access to critical hard currency like the U.S. dollar in order to pay for inputs and other imported components. That rate, set at an even more costly BsF5.30/$, allowed commercial business to gain limited access to foreign currency—at a very high price.
Alternative Markets The Venezuelan people had struggled so long with an arti- ficially valued currency that they had become some of the most adept in the world at working through black markets and alternative markets. The “black” or parallel market was a semi-legal market that used brokered desk trading, yet was still not formally authorized much less regulated by the Venezuelan government.
EXHIBIT 1 The Venezuelan Bolivar’s Decline
0.00
0.50
1.00
1.50
2.00
2.50
3.00
3.50
4.00
4.50
Venezuelan Bolivars fuertes/U.S. dollar (VEF/USD)
January 1, 2010 devaluation to BsF4.30/$
January 1, 2011 elimination of preferred rate for import essentials
Ja n-9
6
Ju n-9
6
No v-9
6 Ap
r-9 7
Se p-9
7
Fe b-9
8 Ju
l-9 8
De c-9
8
Ma y-9
9 Oc
t-9 9
Ma r-0
0
Au g-0
0
Ja n-0
1
Ja n-0
6
Ju n-0
1
No v-0
1 Ap
r-0 2
Se p-0
2
Fe b-0
3 Ju
l-0 3
De c-0
3
Ma y-0
4 Oc
t-0 4
Ma r-0
5
Au g-0
5
Ju n-0
6
No v-0
6 Ap
r-0 7
Se p-0
7
Fe b-0
8 Ju
l-0 8
De c-0
8
Ma y-0
9 Oc
t-0 9
Ma r-1
0
Au g-1
0
March 2008 bolivar renamed bolivar fuerte and 3 zeros eliminated to BsF2.15/$
March 2005 devaluation to Bs2,150/$
Two weeks of capital controls in January 2003, creation of CADIVI, and fixing of bolivar at Bs1,600/$
February 2004 devaluation to Bs1,920/$
Hugo Chávez takes office as President of Venezuela in February 1999
180 CHAPTER 6 The Foreign Exchange Market
The Chávez regime, however, has repeatedly used the devaluation of the bolivar to increase the domestic mon- etary resources it earns from its oil exports. Oil, priced in dollars on the world market, generates U.S. dollar earnings. After each devaluation, each dollar of oil export revenue generates more bolivars or bolivar fuerte for government spending within Venezuela.
South America’s largest oil-producing nation will devalue its currency by weakening the exchange rate used in the central bank-administered bond trading market, or Sitme, by 18.5 percent to 6.50 bolivars per U.S. dollar from 5.30 at present, according to the median estimate of eight analysts surveyed by Bloomberg. Five of the ana- lysts said the adjustment, which helps boost government revenue from oil exports, will occur by March 31.
—“Venezuela to Devalue Bolivar for Second Time This Quarter,” By Charlie Devereux and Dominic
Carey, Bloomberg, January 7, 2011.
Case Questions 1. Why must a country’s currency be devalued? What is
failing in the economy? 2. What benefit did the Venezuelan regime in power
gain from the repeated devaluation of the bolivar? 3. By the time you read this you will know whether the
analysts predicting the future of the bolivar were correct. How did they do?
alternative currencies throughout Venezuela. One such example was the cimarón, a round piece of stamped card- board, introduced in a number of rural markets in exchange for goods. The principle was that someone coming to the country markets with goods for barter could exchange them for cimarón, then the cimarón for other goods. What the cimarón could not be exchanged for was bolivar fuertes. According to José Guerra, the former head of research at the country’s Central Bank, the cimarón was a relic from Venezuela’s past in which landowners paid their peasant workers, their serfs, in tokens which could only be used for goods on their own estates.5 Although promoted by the government as another step in being “freed” from capitalist ways, the alternative currencies had seen only limited use.
The Chávez Objective Venezuela’s constant battle with inflation has been the underlying economic force driving official devaluation and black market depreciation. Averaging anywhere between 20% and 35% per year over the past decade, inflation has undermined all attempts by the government to reign in the value of its own currency. The devaluations alone contrib- ute to inflation, as more and more domestic currency must then be used to buy the same—or fewer goods— following devaluation. The poor typically suffer the brunt of the devaluation, as they spend the greatest percentages of their incomes on basic necessities, the majority of which are imported.
5“Venezuela’s Alternative Currencies,” The Economist, December 18, 2008, print edition.
QUESTIONS 1. Definitions. Define the following terms:
a. Foreign exchange market b. Foreign exchange transaction c. Foreign exchange
2. Functions of the Foreign Exchange Market. What are the three major functions of the foreign exchange market?
3. Market Participants. For each of the foreign exchange market participants, identify their motive for buying or selling foreign exchange.
4. Transaction. Define each of the following types of foreign exchange transactions: a. Spot b. Outright forward c. Forward-forward swaps
5. Foreign Exchange Market Characteristics. With reference to foreign exchange turnover in 2001 rank the following: a. The relative size of spot, forwards, and swaps as of 2001 b. The five most important geographic locations for
foreign exchange turnover c. The three most important currencies of
denomination
6. Foreign Exchange Rate Quotations. Define and give an example of the following: a. Bid quote b. Ask quote
7. Reciprocals. Convert the following indirect quotes to direct quotes and direct quotes to indirect quotes: a. Euro: €1.22/$ (indirect quote) b. Russia: Rbl30/$ (indirect quote) c. Canada: $0.72/C$ (direct quote) d. Denmark: $0.1644/DKr (direct quote)
180 CHAPTER 6 The Foreign Exchange Market
181The Foreign Exchange Market CHAPTER 6
a. What is the mid-rate for each maturity? b. What is the annual forward premium for all
maturities? c. Which maturities have the smallest and largest
forward premiums?
3. Munich to Moscow. On your post-graduation celebratory trip you decide to travel from Munich, Germany to Moscow, Russia. You leave Munich with 15,000 euros in your wallet. Wanting to exchange all of them for Russian rubles, you obtain the following quotes:
Spot rate on the dollar/euro cross rate $1.3214/€
Spot rate on the ruble/dollar cross rate Rbl30.96/$
a. What is the Russian ruble/euro cross rate? b. How many rubles will you obtain for your
euros?
4. Jumping to Japan. After spending a week in Moscow you get an email from your friend in Japan. He can get you a very good deal on a plane ticket and wants you to meet him in Osaka next week to continue your post-graduation celebratory trip. You have 450,000 rubles left in your money pouch. In preparation for the trip you want to exchange your Russian rubles for Japanese yen so you get the following quotes:
Spot rate on the rubles/dollar cross rate Rbl30.96/$
Spot rate on the yen/dollar cross rate ¥84.02/$
a. What is the Russian ruble/euro cross rate? b. How many rubles will you obtain for your
euros?
5. Vancouver Exports. A Canadian exporter, Vancouver Exports, will be receiving six payments of €12,000, ranging from now to 12 months in the future. Since the company keeps cash balances in both Canadian dollars and U.S. dollars, it can choose which currency to change the euros to at the end of the various periods. Which currency appears to offer the better rates in the forward market?
8. Geographical Extent of the Foreign Exchange Market. Answer the following: a. What is the geographical location of the foreign
exchange market? b. What are the two main types of trading systems for
foreign exchange? c. How are foreign exchange markets connected for
trading activities?
9. American and European Terms. With reference to interbank quotations, what is the difference between American terms and European terms?
10. Direct and Indirect Quotes. Define and give an example of the following: a. Direct quote between the U.S. dollar and the Mexi-
can peso, where the United States is designated as the home country.
b. Indirect quote between the Japanese yen and the Chinese renminbi (yuan), where China is desig- nated as the home country.
PROBLEMS 1. Visiting Guatemala. Isaac Díez Peris lives in Rio de
Janeiro. While attending school in Spain he meets Juan Carlos Cordero from Guatemala. Over the sum- mer holiday Isaac decides to visit Juan Carlos in Gua- temala City for a couple of weeks. Isaac’s parents give him some spending money, R$4,500. Isaac wants to exchange it for Guatemalan quetzals (GTQ). He col- lects the following rates:
Spot rate on the GTQ/€ cross rate GTQ 10.5799/€
Spot rate on the €/reais cross rate €0.4462/R$
a. What is the Brazilian reais/Guatemalan quetzal cross rate?
b. How many quetzals will Isaac get for his reais?
2. Forward Premiums on the Japanese Yen. Use the following spot and forward bid-ask rates for the Japanese yen/U.S. dollar (¥/$) exchange rate from September 16, 2010, to answer the following questions:
Period ¥/$ Bid Rate ¥/$ Ask Rate
spot 85.41 85.46
1 month 85.02 85.05
2 months 84.86 84.90
3 months 84.37 84.42
6 months 83.17 83.20
12 months 82.87 82.91
24 months 81.79 81.82
Period Days Forward C$/euro US$/euro
spot — 1.3360 1.3221
1 month 30 1.3368 1.3230
2 months 60 1.3376 1.3228
3 months 90 1.3382 1.3224
6 months 180 1.3406 1.3215
12 months 360 1.3462 1.3194
CHAPTER 6 The Foreign Exchange Market182
l. U.S. dollars per British pound? m. U.S. dollars per Swiss franc? n. Swiss francs per U.S. dollar?
8. Forward Premiums on the Dollar/Euro ($/€). Use the spot and forward bid-ask rates for the U.S. dollar/ euro (US$/€) exchange rate from December 10, 2010 below, to answer the following questions: a. What is the mid-rate for each maturity? b. What is the annual forward premium for all
maturities? c. Which maturities have the smallest and largest for-
ward premiums?
6. Crisis in the Pacific. The Asian financial crisis which began in July 1997 wreaked havoc throughout the currency markets of East Asia. a. Which of the following currencies had the largest
depreciations or devaluations during the July to November period?
b. Which seemingly survived the first five months of the crisis with the least impact on their currencies?
Country Currency July 1997 (per US$)
November 1997 (per US$)
China yuan 8.40 8.40
Hong Kong dollar 7.75 7.73
Indonesia rupiah 2,400 3,600
Korea won 900 1,100
Malaysia ringgit 2.50 3.50
Philippines peso 27 34
Singapore dollar 1.43 1.60
Taiwan dollar 27.80 32.70
Thailand baht 25.0 40.0
Currency USD EUR JPY GBP CHF CAD AUD HKD
HKD 7.7736 10.2976 0.0928 12.2853 7.9165 7.6987 7.6584 —
AUD 1.015 1.3446 0.0121 1.6042 1.0337 1.0053 — 0.1306
CAD 1.0097 1.3376 0.0121 1.5958 1.0283 — 0.9948 0.1299
CHF 0.9819 1.3008 0.0117 1.5519 — 0.9725 0.9674 0.1263
GBP 0.6328 0.8382 0.0076 — 0.6444 0.6267 0.6234 0.0814
JPY 83.735 110.9238 — 132.3348 85.2751 82.9281 82.4949 10.7718
EUR 0.7549 — 0.009 1.193 0.7688 0.7476 0.7437 0.0971
USD — 1.3247 0.0119 1.5804 1.0184 0.9904 0.9852 0.1286
7. Bloomberg Currency Cross Rates. Use the cross rate table from Bloomberg below to answer the following questions. a. Japanese yen per U.S. dollar? b. U.S. dollars per Japanese yen? c. U.S. dollars per euro? d. Euros per U.S. dollar? e. Japanese yen per euro? f. Euros per Japanese yen? g. Canadian dollars per U.S. dollar? h. U.S. dollars per Canadian dollar? i. Australian dollars per U.S. dollar? j. U.S. dollars per Australian dollar? k. British pounds per U.S. dollar?
Period US$/€ Bid Rate US$/€ Ask Rate
spot 1.3231 1.3232
1 month 1.3230 1.3231
2 months 1.3228 1.3229
3 months 1.3224 1.3227
6 months 1.3215 1.3218
12 months 1.3194 1.3198
24 months 1.3147 1.3176
9. Trading in Zurich. Andreas Broszio just started as an analyst for Credit Suisse in Zurich, Switzerland. He receives the following quotes for Swiss francs against the dollar for spot, one-month forward, three-months forward, and six-months forward.
Spot exchange rate:
Bid rate SF 1.2575/$ Ask rate SF 1.2585/S One-month forward 10 to 15 Three-months forward 14 to 22 Six-months forward 20 to 30
183The Foreign Exchange Market CHAPTER 6
13. Venezuelan Bolivar (A). The Venezuelan government officially floated the Venezuelan bolivar (Bs) in February 2002. Within weeks, its value had moved from the pre-float fix of Bs778/$ to Bs1025/$. a. Is this a devaluation or depreciation? b. By what percentage did its value change?
14. Venezuelan Bolivar (B). The Venezuelan political and economic crisis deepened in late 2002 and early 2003. On January 1, 2003, the bolivar was trading at Bs1400/$. By February 1, its value had fallen to Bs1950/$. Many currency analysts and forecasters were predicting that the bolivar would fall an additional 40% from its February 1 value by early summer 2003.
a. What was the percentage change in January?
b. Its forecast value for June 2003?
15. Indirect Quotation on the Dollar. Calculate the forward premium on the dollar (the dollar is the home currency) if the spot rate is €1.3300/$ and the three- month forward rate is €1.3400/$.
16. Direct Quotation on the Dollar. Calculate the forward discount on the dollar (the dollar is the home currency) if the spot rate is $1.5800/£ and the six- month forward rate is $1.5550/£.
17. Mexican Peso - European Euro Cross Rate. Calculate the cross rate between the Mexican peso (Ps) and the euro (€) from the following spot rates: Ps12.45/$ and €0.7550/$.
18. Pura Vida. Calculate the cross rate between the Costa Rican colón (C//) and the Canadian dollar (C$) from the following spot rates: C500.29/$ and C$1.02/$.
19. Around the Horn. Assuming the following quotes, calculate how a market trader at Citibank with $1,000,000 can make an intermarket arbitrage profit.
Citibank quotes U.S. dollar per pound $1.5900/£ National Westminster quotes euros per pound €1.2000/£ Deutschebank quotes U.S. dollar per euro $0.7550/€
20. Great Pyramids. Inspired by his recent trip to the Great Pyramids, Citibank trader Ruminder Dhillon wonders if he can make an intermarket arbitrage profit using Libyan dinars and Saudi riyals. He has $1,000,000 to work with so he gathers the following quotes:
Citibank quotes U.S. dollar per Libyan dinar $1.9324/LYD
National Bank of Kuwait quotes Saudi riyal per Libyan dinar SAR1.9405/LYD
Barclay quotes U.S. dollar per Saudi riyal $0.2667/SAR
a. Calculate outright quotes for bid and ask, and the number of points spread between each.
b. What do you notice about the spread as quotes evolve from spot toward six months?
c. What is the six-month Swiss bill rate?
10. Triangular Arbitrage Using the Swiss Franc. The following exchange rates are available to you. (You can buy or sell at the stated rates.) Assume you have an initial SF12,000,000. Can you make a profit via triangular arbitrage? If so, show the steps and calculate the amount of profit in Swiss francs.
Mt. Fuji Bank ¥ 92.00/$
Mt. Rushmore Bank SF1.02/$
Mt Blanc Bank ¥ 90.00/SF
11. Forward Premiums on the Australian Dollar. Use the spot and forward bid-ask rates for the U.S. dollar/ Australian dollar (US$/A$) exchange rate from December 10, 2010, below, to answer the following questions: a. What is the mid-rate for each maturity? b. What is the annual forward premium for all
maturities? c. Which maturities have the smallest and largest for-
ward premiums?
Period US$/A$ Bid Rate US$/A$ Ask Rate
spot 0.98510 0.98540
1 month 0.98131 0.98165
2 months 0.97745 0.97786
3 months 0.97397 0.97441
6 months 0.96241 0.96295
12 months 0.93960 0.94045
24 months 0.89770 0.89900
Citibank NYC Barclays London
$0.7551-61/€ $0.7545-75/€
12. Transatlantic Arbitrage. A corporate treasury working out of Vienna with operations in New York simultaneously calls Citibank in New York City and Barclays in London. The banks give the following quotes on the euro simultaneously.
Using $1 million or its euro equivalent, show how the corporate treasury could make geographic arbitrage profit with the two different exchange rate quotes.
184 CHAPTER 6 The Foreign Exchange Market
INTERNET EXERCISES 1. Bank for International Settlements. The Bank for
International Settlements (BIS) publishes a wealth of effective exchange rate indices. Use its database and analyses to determine the degree to which the dollar, the euro, and the yen (the “big three currencies”) are currently overvalued or undervalued.
Bank for International bis.org/statistics/eer/ index.htmSettlements
Bank of Canada exchange rates
www.bankofcanada.ca/en/ rates/ceri.html
2. Bank of Canada Exchange Rate Index (CERI). The Bank of Canada regularly publishes an index of the Canadian dollar’s value, the CERI. The CERI is a multilateral trade-weighted index of the Canadian dollar’s value against other major global currencies relevant to the Canadian economy and business landscape. Use the CERI from the Bank of Canada’s Web site to evaluate the relative strength of the loonie in recent years.
3. Forward Quotes. OzForex Foreign Exchange Services provides representative forward rates on a multitude of currencies online. Use the following Web site to search out forward exchange rate quotations on a variety of currencies. (Note the London, New York, and Sydney times listed on the quotation screen.)
Federal Reserve www.federalreserve.gov/ releases/h10/update/
GCI Financial Ltd. www.gcitrading.com/ fxnews/
Oanda.com oanda.com
Pacific Exchange fx.sauder.ubc.ca/ plot.htmlRate Service
Forex-Markets.com www.forex-markets.com/ quotes_exotic.htm
OzForex ozforex.com.au/ forex-tools/ fx-options-calculator
4. Federal Reserve Statistical Release. The United States Federal Reserve provides daily updates of the value of the major currencies traded against the U.S. dollar on its Web site. Use the Fed’s Web site to determine the relative weights used by the Fed to determine the index of the dollar’s value.
5. Exotic Currencies. Although major currencies like the U.S. dollar and the Japanese yen dominate the headlines, there are nearly as many currencies as countries in the world. Many of these currencies are traded in extremely thin and highly regulated markets, making their convertibility suspect. Finding quotations for these currencies is sometimes very difficult. Use the following Web pages to see how many African currency quotes you can find.
6. Daily Market Commentary. Many different online currency trading and consulting services provide daily assessments of global currency market activity. Use the following GCI site to find the market’s current assessment of how the euro is trading against both the U.S. dollar and the Canadian dollar.
7. Pacific Exchange Rate Service. The Pacific Exchange Rate Service Web site, managed by Professor Werner Antweiler of the University of British Columbia, possesses a wealth of current information on currency exchange rates and related statistics. Use the service to plot the recent performance of currencies which have recently suffered significant devaluations or depreciations, such as the Argentine peso, the Venezuelan bolivar, the Turkish lira, and the Egyptian pound.
185
CHAPTER 7
International Parity Conditions
. . . if capital freely flowed towards those countries where it could be most profitably employed, there could be no difference in the rate of profit, and no other difference in the real or labour price of commodities, than the additional quantity of labour required to convey them to the various markets where they were to be sold.
—David Ricardo, On the Principles of Political Economy and Taxation, 1817, Chapter 7.
What are the determinants of exchange rates? Are changes in exchange rates predictable? Managers of MNEs, international portfolio investors, importers and exporters, and govern- ment officials must deal with these fundamental questions every day. This chapter describes the core financial theories surrounding the determination of exchange rates. Chapter 9 will introduce two other major theoretical schools of thought regarding currency valuation, and combine the three different theories in a variety of real-world applications.
The economic theories that link exchange rates, price levels, and interest rates are called international parity conditions. In the eyes of many, these international parity conditions form the core of the financial theory that is considered unique to the field of international finance. These theories do not always work out to be “true” when compared to what students and practitioners observe in the real world, but they are central to any understanding of how multinational business is conducted and funded in the world today. And, as is often the case, the mistake is not always in the theory itself, but in the way it is interpreted or applied in practice. This chapter concludes with a Mini-Case, Emerging Market Carry Trades, which demonstrates how both the theory and practice of international parity conditions sometimes combine to form unusual opportunities for profit.
Prices and Exchange Rates If identical products or services can be sold in two different markets, and no restrictions exist on the sale or transportation costs of moving the 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,
186 CHAPTER 7 International Parity Conditions
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:
S = P ¥
P $
Purchasing Power Parity and the Law of One Price 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 that 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.
The “Big Mac Index,” as it has been christened by the Economist (see Exhibit 7.1) and calculated regularly since 1986, is a prime example of the law of one price. Assuming that the Big Mac is indeed identical in all countries listed, it serves as one form of comparison of whether currencies are currently trading at market rates that are close to the exchange rate implied by Big Macs in local currencies.
EXHIBIT 7.1 Selected Rates from the Big Mac Index
Country and Currency
(1) Big Mac
Price in Local Currency
(2) Actual Dollar
Exchange Rate on July 25th
(3) Big Mac
Price in Dollars
(4) Implied PPP of the Dollar
(5) Under/Over
Valuation Against Dollar**
United States $ 4.07 — 4.07 — —
Britain £ 2.39 1.63 3.90* 1.70* -4%
Canada C$ 4.73 0.95 4.98 1.16 22%
China Yuan 14.7 6.45 2.28 3.61 -44%
Denmark DK 28.5 5.20 5.48 7.00 35%
Euro area € 3.44 1.43 4.92* 1.18* 21%
Japan ¥ 320 78.4 4.08 78.6 0%
Peru Sol 10.0 2.74 3.65 2.46 -10%
Russia Ruble 75.0 27.8 2.70 18.4 -34%
Switzerland SFr 6.50 0.81 8.02 1.60 97%
Thailand Baht 70.0 29.8 2.35 17.2 -42%
* These exchange rates are stated in US$ per unit of local currency, $/£ and $/€. ** Percentage under/over valuation against the dollar is calculated as (Implied − Actual)/(Actual), except for the Britain and Euro area calculations, which are (Actual-Implied)/(Implied)
Source: Data for columns (1) and (2) drawn from “The Big Mac Index,” The Economist, July 28, 2011.
187International Parity Conditions CHAPTER 7
For example, using Exhibit 7.1, in China a Big Mac costs Yuan 14.7 (local currency), while in the United States the same Big Mac costs $4.07. The actual spot exchange rate was Yuan 6.45/$ at this time. The price of a Big Mac in China in U.S. dollar terms was therefore
Price of Big Mac in China in Yuan Yuan/$ spot rate
= Yuan 14.7
Yuan 6.45/$ = $2.28
This is the value in column 3 of Exhibit 7.1 for China. We then calculate the implied pur- chasing power parity rate of exchange using the actual price of the Big Mac in China (Yuan 14.7) over the price of the Big Mac in the United States in U.S. dollars ($4.07):
Price of Big Mac in China in Yuan Price of Big Mac in the U.S. in $
= Yuan 14.7
$4.07 = Yuan 3.61/$
This is the value in column 4 of Exhibit 7.1 for China. In principle, this is what the Big Mac Index is saying the exchange rate between the Yuan and the dollar should be according to the theory.
Now comparing this implied PPP rate of exchange, Yuan 3.61/$, with the actual market rate of exchange at that time, Yuan 6.45/$, the degree to which the yuan is either undervalued (-%) or overvalued (+%) versus the U.S. dollar is calculated as follows:
Implied Rate - Actual Rate Actual Rate
= Yuan 3.61/$ - Yuan 6.45/$
Yuan 6.45/$ = -44%
In this case, the Big Mac Index indicates that the Chinese yuan is undervalued by 44% versus the U.S. dollar as indicated in column 5 for China in Exhibit 7.1. The Economist is also quick to note that although this indicates a sizable undervaluation of the managed value of the Chinese yuan versus the dollar, the theory of purchasing power parity is supposed to indicate where the value of currencies should go over the long-term, and not necessarily its value today.
It is important to understand why the Big Mac may be a good candidate for the applica- tion of the law of one price and measurement of under or overvaluation. First, the product itself is nearly identical in each market. This is the result of product consistency, process excel- lence, 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.
A less extreme form of this principle would be that in relatively efficient markets the price of a basket of goods would be the same in each market. Replacing the price of a single product with a price index allows the PPP exchange rate between two countries to be stated as
S = PI ¥
PI $ where PI ¥ and PI $ are price indices expressed in local currency for Japan and the United States, respectively. For example, if the identical basket of goods cost ¥1,000 in Japan and $10 in the United States, the PPP exchange rate would be
¥1000 $10
= ¥100/$.
Just in case you are starting to believe that PPP is just about numbers, Global Finance in Practice 7.1 reminds you of the human side of the equation.
188 CHAPTER 7 International Parity Conditions
Relative Purchasing Power Parity If the assumptions of the absolute version of PPP theory are relaxed a bit, we observe what is termed relative purchasing power parity. Relative PPP holds that PPP is not particularly help- ful 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.
Exhibit 7.2 shows a general case of relative PPP. The vertical axis shows the percentage change in the spot exchange rate for foreign currency, and the horizontal axis shows the percentage difference in expected rates of inflation (foreign relative to home country). The diagonal parity line shows the equilibrium position between a change in the exchange rate and relative inflation rates. For instance, point P represents an equilibrium point where inflation in the foreign country, Japan, is 4% lower than in the home country, the United States. Therefore, relative PPP would predict that the yen would appreciate by 4% per annum with respect to the U.S. dollar.
The main justification for purchasing power parity is that if a country experiences inflation rates higher than those of its main trading partners, and its exchange rate does not change, its exports of goods and services become less competitive with comparable products produced elsewhere. Imports from abroad become more price-competitive with higher-priced domestic products. These price changes lead to a deficit on current account in the balance of payments unless offset by capital and financial flows.
The principles of purchasing power are not just a theoretical principle, they can also capture the problems, poverty, and misery of a people. The devaluation of the North Korean won (KPW) in November 2009 was one such case.
The North Korean government has been trying to stop the growth and activity in the street markets of its country for decades. For many years the street markets have been the lone opportunity for most of the Korean people to earn a living. Under the communist state’s stewardship, the quality of life for its 24 million people has continued to deteriorate. Between 1990 and 2008, the country’s infant mortality rate had increased 30%, and life expectancy had fallen by three years. The United Nations estimated that one in three children under the age of five suffered malnutrition. Although most of the working population worked officially for the government, many were underpaid (or in many cases not paid). They often bribed their bosses to allow them to leave work early to try to scrape out a living in the street markets of the underground economy.
But it was this very basic market economy which President Kim Jong-il (now deceased) and the governing regime wished to stamp out. On November 30, 2009, the Korean government
made a surprise announcement to its people: a new, more valu- able Korean won would replace the old one. “You have until the end of the day to exchange your old won for new won.” All old 1,000 won notes would be replaced with 10 won notes, knocking off two zeros from the officially recognized value of the currency. This meant that everyone holding old won, their cash and savings, would now officially be worth 1/100th of what it was previously. Exchange was limited to 100,000 old won. People who had worked and saved for decades to accumulate what was roughly $200 or $300 in savings outside of North Korea were wiped out; their total life savings were essentially worthless. By officially denouncing the old currency, the North Korean people would be forced to exchange their holdings for new won. The government would indeed undermine the under- ground economy.
The results were devastating. After days of street protests, the government raised the 100,000 ceiling to 150,000. By late January 2010, inflation was rising so rapidly that Kim Jong-il apologized to the people for the revaluation’s impact on their lives. The government administrator who had led the revaluation was arrested, and in February 2010, executed “for his treason.”
GLOBAL FINANCE IN PRACTICE 7.1
The Immiseration of the North Korean People— The “Revaluation” of the North Korean Won
189International Parity Conditions CHAPTER 7
Empirical Tests of Purchasing Power Parity Extensive testing of both the absolute and relative versions of purchasing power parity and the law of one price has been done.1 These tests have, for the most part, not proved PPP to be accurate in predicting future exchange rates. Goods and services do not in reality move at zero cost between countries, and in fact many services are not “tradable”—for example, haircuts. Many goods and services are not of the same quality across countries, reflecting differences in the tastes and resources of the countries of their manufacture and consumption.
Two general conclusions can be made from these tests: 1) PPP holds up well over the very long run but poorly for shorter time periods and 2) The theory holds better for countries with relatively high rates of inflation and underdeveloped capital markets.
Exchange Rate Indices: Real and Nominal Because any single country trades with numerous partners, we need to track and evaluate its individual currency value against all other currency values in order to determine relative purchasing power. The objective is to discover whether its exchange rate is “overvalued” or “undervalued” in terms of PPP. One of the primary methods of dealing with this problem is the calculation of exchange rate indices. These indices are formed by trade-weighting the bilateral exchange rates between the home country and its trading partners.
The nominal effective exchange rate index uses actual exchange rates to create an index, on a weighted average basis, of the value of the subject currency over time. It does not really indicate anything about the “true value” of the currency, or anything related to PPP. The
1See for example, Kenneth Rogoff, “The Purchasing Power Parity Puzzle,” Journal of Economic Literature, Volume 34, Number 2, June 1996, 647–668; and Barry K. Goodwin, Thomas Greenes, and Michael K. Wohlgenant, “Testing the Law of One Price When Trade Takes Time,” Journal of International Money and Finance, March 1990, 21–40.
EXHIBIT 7.2
P Percentage change in the spot exchange rate for foreign currency
Percentage difference in expected rates of inflation (foreign relative to home country)
–5
–4
–1
–3 –1–4 –2
–2
–3
1
4
3
2
–6 2 4 63 51
PPP Line
Relative Purchasing Power Parity (PPP)
190 CHAPTER 7 International Parity Conditions
nominal index simply calculates how the currency value relates to some arbitrarily chosen base period, but it is used in the formation of the real effective exchange rate index. The real effective exchange rate index indicates how the weighted average purchasing power of the currency has changed relative to some arbitrarily selected base period. Exhibit 7.3 plots the real effective exchange rate indexes for Japan, the euro area, and the United States for the 1994–2011 period.
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 $, over foreign currency costs, C FC, both in index form:
E R$ = E N$ * C $
C FC .
If changes in exchange rates just offset differential inflation rates—if purchasing power parity holds—all the real effective exchange rate indices would stay at 100. If an exchange rate strengthened more than was justified by differential inflation, its index would rise above 100. If the real effective exchange rate index is above 100, the currency would be considered “overvalued” from a competitive perspective. An index value below 100 would suggest an “undervalued” currency.
Exhibit 7.3 shows that the real effective exchange rate of the dollar, yen, and euro have changed over the past three decades. The dollar’s index value was substantially above 100 in the 1980s (overvalued), but has remained below 100 (undervalued) since the late 1980s (it did
Source: International Financial Statistics, IMF, annual, CPI-weighted real effective exchange rates, series RECZF.
70
80
90
100
110
120
130
140 United States
Japan
Euro Area
19 80
19 81
19 82
19 83
19 84
19 85
19 86
19 87
19 88
19 89
19 90
19 91
19 92
19 83
19 94
19 95
19 96
19 97
19 98
19 99
20 00
20 01
20 02
20 03
20 04
20 05
20 06
20 07
20 08
20 09
20 10
2005 = 100
EXHIBIT 7.3 IMF’s Real Effective Exchange Rate Indexes for the United States, Japan, and the Euro Area
191International Parity Conditions CHAPTER 7
rise slightly above 100 briefly in 1995–1996 and again in 2001–2002). The Japanese yen’s real effective rate has remained above 100 for nearly the entire 1980 to 2006 period (overvalued). The euro, whose value has been back-calculated for the years prior to its introduction in 1999, has been largely below 100 and undervalued in its real lifetime.
Apart from measuring deviations from PPP, a country’s real effective exchange rate is an important tool for management when predicting upward or downward pressure on a country’s balance of payments and exchange rate, as well as an indicator of the desirability to produce for export from that country. Global Finance in Practice 7.2 shows deviations from PPP in the twentieth century.
The seminal work by Dimson, Marsh, and Staunton (2002) found that for the 1900–2000 period, relative purchasing power parity generally held. They did, however, note that significant short run deviations from PPP did occur. “When deviations from PPP appear to be present it is likely that exchange rates are respond- ing not only to relative inflation but also to other economic and political factors. Changes in productivity differentials, such as Japan’s post-war productivity growth in the traded-goods sector, can bring similar wealth effects, with domestic inflation that does not endanger the country’s exchange rate.”
“While real exchange rates do not appear to exhibit a long term upward or downward trend, they are clearly volatile, and on year-to-year basis, PPP explains little of the fluctuations
in foreign exchange rates. Some of the extreme changes [in the table below] reflect exchange rates or inflation indexes that are not representative, typically (as in Germany) because of wartime controls, and this may amplify the volatility of real exchange rates changes. Given the potential measurement error in inflation indexes, and the fact that real exchange rates involve a ratio of two different price index series, it is all the more striking that, with the exception of South Africa, all real exchange rates appreciate or depreciate annually by no more than a fraction of one percentage point.”
Source: Elroy Dimson, Paul Marsh, and Mike Staunton, Triumph of the Optimists, 101 Years of Global Investment Returns, Princeton University Press, 2002, pp. 97–98.
Real Exchange Rate Changes Against the U.S. Dollar, Annually 1900–2000
Country Geometric Mean (%)
Arithmetic Mean(%)
Standard Deviation (%)
Change (Year, %)
Change (Year, %)
Australia -0.6 -0.1 10.7 1931: -39.0 1933: 54.2
Belgium 0.2 1.0 13.3 1919: -32.1 1933: 54.2
Canada -0.5 -0.4 4.6 1931: -18.1 1933: 12.9
Denmark 0.1 1.0 12.7 1946: -50.3 1933: 37.2
France -0.4 2.5 24.0 1946: -78.3 1943: 141.5
Germany -0.1 15.1 134.8 1945: -75.0 1948: 1302.0
Ireland -0.1 0.5 11.2 1946: -37.0 1933: 56.6
Italy -0.2 4.0 39.5 1946: -64.9 1944: 335.2
Japan 0.2 3.2 29.5 1945: -78.3 1946: 253.0
The Netherlands -0.1 0.8 12.6 1946: -61.6 1933: 55.7
South Africa -1.3 -0.7 10.5 1946: -35.3 1986: 37.3
Spain -0.4 1.1 18.8 1946: -56.4 1939: 128.7
Sweden -0.4 0.2 10.7 1919: -38.0 1933: 43.5
Switzerland 0.2 0.8 11.2 1936: -29.0 1933: 53.3
United Kingdom -0.3 0.3 11.7 1946: -36.7 1933: 55.2
GLOBAL FINANCE IN PRACTICE 7.2
Deviations from Purchasing Power Parity in the Twentieth Century
192 CHAPTER 7 International Parity Conditions
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.
To illustrate exchange rate pass-through, assume that BMW produces an automobile in Germany and pays all production expenses in euros. When the firm exports the auto to the United States, the price of the BMW in the U.S. market should simply be the euro value converted to dollars at the spot exchange rate:
P BMW$ = P BMW: * S,
where P BMW$ is the BMW price in dollars, P BMW: is the BMW price in euros, and S is the number of dollars per euro. If the euro appreciated 10% versus the U.S. dollar, the new spot exchange rate should result in the price of the BMW in the United States rising a proportional 10%. If the price in dollars increases by the same percentage change as the exchange rate, the pass-through of exchange rate changes is complete (or 100%).
However, if the price in dollars rises by less than the percentage change in exchange rates (as is often the case in international trade), the pass-through is partial, as illustrated in Exhibit 7.4. The 71% pass-through (U.S. dollar prices rose only 14.29% when the euro appre- ciated 20%) implies that BMW is absorbing a portion of the adverse exchange rate change. This absorption could result from smaller profit margins, cost reductions, or both.
For example, components and raw materials imported to Germany cost less in euros when the euro appreciates. It is also likely that some time may pass before all exchange rate changes are finally reflected in the prices of traded goods, including the period over which
EXHIBIT 7.4 Exchange Rate Pass-Through
Pass-through is the measure of response of imported and exported product prices to exchange rate changes. Assume that the price in dollars and euros of a BMW automobile produced in Germany and sold in the United States at the spot exchange rate is
If the euro were to appreciate 20% versus the U.S. dollar, from $1.0000/ to $1.2000/ , the price of the BMW in the U.S. market should theoretically be $42,000. But if the price of the BMW in the U.S. does not rise by 20%—for example, it rises only to $40,000—then the degree of pass-through is partial:
The degree of pass-through is measured by the proportion of the exchange rate change reflected in dollar prices. In this example, the dollar price of the BMW rose only 14.29%, while the euro appreciated 20% against the U.S. dollar. The degree of pass-through is partial: 14.29% ÷ 20.00%, or approximately 0.71. Only 71% of the exchange rate change was passed through to the U.S. dollar price. The remaining 29% of the exchange rate change has been absorbed by BMW.
P
P BMW
BMW
or a , $
, $
$ , $ ,
. ,2
1
40 000 35 000
1 1429− = 114.29% increase.
P P BMW BMW $ ($ / ) , $ , / $ ,= × = × =35 000 1000 35 000
193International Parity Conditions CHAPTER 7
previously signed contracts are delivered upon. It is obviously in the interest of BMW to keep the appreciation of the euro from raising the price of its automobiles in major export markets.
The concept of price elasticity of demand is useful when determining the desired level of pass-through. Recall that the own-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 own price:
Price elasticity of demand = ep = %!Qd %!P
,
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, it is a relatively “elastic” good.
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 United States 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 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.
Interest Rates and Exchange Rates We have already seen how prices of goods in different countries should be related through exchange rates. We now consider how interest rates are linked to exchange rates.
The Fisher Effect 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 + p) - 1:
i = r + p + rp,
where i is the nominal rate of interest, r is the real rate of interest, and p is the expected rate of inflation over the period of time for which funds are to be lent. The final compound term, rp is frequently dropped from consideration due to its relatively minor value. The Fisher effect then reduces to (approximate form):
i = r + p.
The Fisher effect applied to the United States and Japan would be as follows:
i$ = r$ + p$; i¥ = r¥ + p¥,
where the superscripts $ and ¥ pertain to the respective nominal (i), real (r), and expected inflation (p) 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 is, well, difficult.
Empirical tests using ex-post national inflation rates have shown that 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
194 CHAPTER 7 International Parity Conditions
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.
The International Fisher Effect 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,
S1 - S2 S2
= i $ - i ¥,
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 end of the period S2 This is the approximation form commonly used in industry. The precise formulation is as follows:
S1 - S2 S2
= i $ - i ¥
1 + i ¥ .
Justification for the international Fisher effect is that investors must be rewarded or penalized to offset the expected change in exchange rates. For example, if a dollar-based investor buys a 10-year yen bond earning 4% interest, instead of a 10-year dollar bond earning 6% interest, the investor must be expecting the yen to appreciate vis-à-vis the dollar by at least 2% per year during the 10 years. If not, the dollar-based investor would be better off remaining in dollars. If the yen appreciates 3% during the 10-year period, the dollar-based investor would earn a bonus of 1% higher return. However, the international Fisher effect predicts that with unrestricted capital flows, an investor should be indifferent to whether his bond is in dollars or yen, because investors worldwide would see the same opportunity and compete it away.
Empirical tests lend some support to the relationship postulated by the international Fisher effect, although considerable short-run deviations occur. A more serious criticism has been posed, however, by recent studies that suggest the existence of a foreign exchange risk premium for most major currencies. Also, speculation in uncovered interest arbitrage creates distortions in currency markets. Thus, the expected change in exchange rates might consistently be more than the difference in interest rates.
The Forward Rate A forward rate is an exchange rate quoted today for settlement at some future date. A forward exchange agreement between currencies states the rate of exchange at which a foreign currency will be bought forward or sold forward at a specific date in the future (typically after 30, 60, 90, 180, 270, or 360 days).
The forward rate is calculated for any specific maturity by adjusting the current spot exchange rate by the ratio of euro currency interest rates of the same maturity for the two subject currencies. For example, the 90-day forward rate for the Swiss franc/U.S. dollar exchange rate (F 90SF/$) is found by multiplying the current spot rate (S SF/$) by the ratio of the 90-day euro-Swiss franc deposit rate (i SF) over the 90-day Eurodollar deposit rate (i $):
195International Parity Conditions CHAPTER 7
F 90SF/$ = S SF/$ * J1 + ¢ i SF * 90
360 ≤ RJ1 + ¢ i $ * 90
360 ≤ R .
Assuming a spot rate of SF1.4800/$, a 90-day euro Swiss franc deposit rate of 4.00% per annum, and a 90-day Eurodollar deposit rate of 8.00% per annum, the 90-day forward rate is SF1.4655/$:
F 90SF/$ = SF1.4800/$ * J1 + ¢0.0400 * 90
360 ≤ RJ1 + a0.0800 * 90
360 ≤ R = SF1.4800/$ * 1.011.02 = SF1.4655/$.
The forward premium or discount is the percentage difference between the spot and forward exchange rate, stated in annual percentage terms. When the foreign currency price of the home currency is used, as in this case of SF/$, the formula for the percent-per-annum premium or discount becomes:
f SF = Spot - Forward
Forward * 360
days * 100.
Substituting the SF/$ spot and forward rates, as well as the number of days forward (90),
f SF = SF1.4800/$ - SF1.4655/$
SF1.4655/$ * 360
90 * 100 = +3.96%per annum.
The sign is positive, indicating that the Swiss franc is selling forward at a 3.96% per annum premium over the dollar (it takes 3.96% more dollars to get a franc at the 90-day forward rate).
As illustrated in Exhibit 7.5, the forward premium on the Eurodollar forward exchange rate series arises from the differential between Eurodollar interest rates and Swiss franc interest rates. Because the forward rate for any particular maturity utilizes the specific interest rates for that term, the forward premium or discount on a currency is visually obvious—the currency with the higher interest rate (in this case the U.S. dollar) will sell forward at a discount, and the currency with the lower interest rate (in this case the Swiss franc) will sell forward at a premium.
The forward rate is calculated from three observable data items—the spot rate, the foreign currency deposit rate, and the home currency deposit rate—and is not a forecast of the future spot exchange. It is, however, frequently used by managers as a forecast, with mixed results, as the following section describes.
Interest Rate Parity (IRP) The theory of interest rate parity (IRP) provides the link 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.
Exhibit 7.6 shows how the theory of interest rate parity works. Assume that an investor has $1,000,000 and several alternative but comparable Swiss franc (SF) monetary investments. If the investor chooses to invest in a dollar money market instrument, the investor would earn the dollar rate of interest. This results in (1 + i$) at the end of the period, where i$ is the dollar rate
196 CHAPTER 7 International Parity Conditions
of interest in decimal form. The investor may, however, choose to invest in a Swiss franc money market instrument of identical risk and maturity for the same period. This action would require that the investor exchange the dollars for francs at the spot rate of exchange, invest the francs in a money market instrument, sell the francs forward (in order to avoid any risk that the exchange rate would change), and at the end of the period convert the resulting proceeds back to dollars.
EXHIBIT 7.6 Interest Rate Parity (IRP)
Dollar Money Market
Swiss Franc Money Market
$1,000,000 $1,020,000
$1,019,993*
S = SF1.4800/$
SF1,480,000 SF1,494,800
F90 = SF1.4655/$
! 1.01
! 1.02
Start End
i S F= 4.0% per annum (1.00% per 90 days)
i $ = 8.00% per annum (2.00% per 90 days)
90 Days
*Note that the Swiss franc investment yields $1,019,993, $7 less on a $1 million investment.
EXHIBIT 7.5 Currency Yield Curves and the Forward Premium
10.0%
In te
re st
Y ie
ld
Days Forward
60 12030 90 150 180
Eurodollar yield curve
Euro-Swiss franc yield curve
Forward premium is the percentage difference of 3.96%
4.0%
9.0%
8.0%
7.0%
6.0%
5.0%
2.0%
1.0%
3.0%
197International Parity Conditions CHAPTER 7
A dollar-based investor would evaluate the relative returns of starting in the top-left corner and investing in the dollar market (straight across the top of the box) compared to investing in the Swiss franc market (going down and then around the box to the top-right corner). The comparison of returns would be as follows:
(1 + i $) = S SF/$ * (1 + i SF) * 1 F SF/$
,
where S = the spot rate of exchange and F = forward rate of exchange. Substituting in the spot rate (SF1.4800/$) and forward rate (SF1.4655/$) and respective interest rates from Exhibit 7.6, the interest rate parity condition is as follows:
(1 + 0.02) = 1.4800 * (1 + 0.01) * 1 1.4655
.
The left-hand side of the equation is the gross return the investor would earn by investing in dollars. The right-hand side is the gross return the investor would earn by exchanging dollars for Swiss francs at the spot rate, investing the franc proceeds in the Swiss franc money market, and simultaneously selling the principal plus interest in Swiss francs forward for dollars at the current 90-day forward rate.
Ignoring transaction costs, if the returns in dollars are equal between the two alternative money market investments, the spot and forward rates are considered to be at IRP. The transaction is “covered,” because the exchange rate back to dollars is guaranteed at the end of the 90-day period. Therefore, as shown in Exhibit 7.6, in order for the two alternatives to be equal, any differences in interest rates must be offset by the difference between the spot and forward exchange rates (in approximate form):
F S
= (1 + i SF) (1 + i $)
or SF1.4655/$ SF1.4800/$
= 1.01 1.02
= 0.9902 ! 1%.
Covered Interest Arbitrage (CIA) The spot and forward exchange markets are not 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).
Exhibit 7.7 describes the steps that a currency trader, most likely working in the arbi- trage division of a large international bank, would implement to perform a CIA transaction. The currency trader, Fye Hong, may utilize any of a number of major Eurocurrencies that his bank holds to conduct arbitrage investments. The morning conditions indicate to Fye Hong that a CIA transaction that exchanges 1 million U.S. dollars for Japanese yen, invested in a six month euroyen account and sold forward back to dollars, will yield a profit of $4,638 ($1,044,638–$1,040,000) over and above that available from a Eurodollar investment. Con- ditions in the exchange markets and euromarkets change rapidly however, so if Fye Hong waits even a few minutes, the profit opportunity may disappear. Fye Hong executes the following transaction:
Step 1 : Convert $1,000,000 at the spot rate of ¥106.00/$ to ¥106,000,000 (see “Start” in Exhibit 7.7).
Step 2 : Invest the proceeds, ¥106,000,000, in a euroyen account for six months, earning 4.00% per annum, or 2% for 180 days.
198 CHAPTER 7 International Parity Conditions
Step 3 : Simultaneously sell the future yen proceeds (¥108,120,000) forward for dollars at the 180-day forward rate of ¥103.50/$. This action “locks in” gross dollar revenues of $1,044,638 (see “End” in Exhibit 7.7).
Step 4 : Calculate the cost (opportunity cost) of funds used at the Eurodollar rate of 8.00% per annum, or 4% for 180 days, with principal and interest then totaling $1,040,000. Profit on CIA (“End”) is $4,638 ($1,044,638–$1,040,000).
Note that all profits are stated in terms of the currency in which the transaction was initialized, but that a trader may conduct investments denominated in U.S. dollars, Japanese yen, or any other major currency.
Rule of Thumb. All that is required to make a covered interest arbitrage profit is for interest rate parity not to hold. Depending on the relative interest rates and forward premium, Fye Hong would have started in Japanese yen, invested in U.S. dollars, and sold the dollars forward for yen. The profit would then end up denominated in yen. But how would Fye Hong decide in which direction to go around the box in Exhibit 7.7?
The key to determining whether to start in dollars or yen is to compare the differences in interest rates to the forward premium on the yen (the cost of cover). For example, in Exhibit 7.7, the difference in 180-day interest rates is 2.00% (dollar interest rates are higher by 2.00%). The premium on the yen for 180 days forward is as follows:
f ¥ = Spot - Forward
Forward * 360
180 * 100 = ¥106.00/$ - ¥103.50/$
¥103.50/$ * 200 = 4.8309%.
In other words, by investing in yen and selling the yen proceeds forward at the forward rate, Fye Hong earns 4.83% per annum, whereas he would earn only 4% per annum if he continues to invest in dollars.
EXHIBIT 7.7 Covered Interest Arbitrage (CIA)
Dollar Money Market
Yen Money Market
$1,000,000 $1,040,000
$1,044,638
S = ¥106.00/$
¥106,000,000 ¥108,120,000
F180 = ¥103.50/$
! 1.02
! 1.04
Start End
Euroyen Rate = 4.00% per annum
Eurodollar rate = 8.00% per annum
Arbitrage potential
180 Days
199International Parity Conditions CHAPTER 7
Arbitrage Rule of Thumb: If the difference in interest rates is greater than the forward premium (or expected change in the spot rate), invest in the higher interest yielding currency. If the difference in interest rates is less than the forward premium (or expected change in the spot rate), invest in the lower interest yielding currency.
Using this rule of thumb should enable Fye Hong to choose in which direction to go around the box in Exhibit 7.7. It also guarantees that he will always make a profit if he goes in the right direction. This rule assumes that the profit is greater than any transaction costs incurred.
This process of CIA drives the international currency and money markets toward the equilibrium described by interest rate parity. Slight deviations from equilibrium provide opportunities for arbitragers to make small riskless profits. Such deviations provide the supply and demand forces that will move the market back toward parity (equilibrium).
Covered interest arbitrage opportunities continue until interest rate parity is reestablished, because the arbitragers are able to earn risk-free profits by repeating the cycle as often as possible. Their actions, however, nudge the foreign exchange and money markets back toward equilibrium for the following reasons:
1. The purchase of yen in the spot market and the sale of yen in the forward market narrows the premium on the forward yen. This is because the spot yen strengthens from the extra demand and the forward yen weakens because of the extra sales. A narrower premium on the forward yen reduces the foreign exchange gain previously captured by investing in yen.
2. The demand for yen-denominated securities causes yen interest rates to fall, and the higher level of borrowing in the United States causes dollar interest rates to rise. The net result is a wider interest differential in favor of investing in the dollar.
Uncovered Interest Arbitrage (UIA) 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 for- ward, 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 7.8 demon- strates the steps an uncovered interest arbitrager takes when undertaking what is termed the “yen carry-trade.”
The “yen carry-trade” is an age-old application of UIA. Investors, from both inside and outside Japan, take advantage of extremely low interest rates in Japanese yen (0.40% per annum) to raise capital. Investors exchange the capital they raise for other currencies like U.S. dollars or euros. Then they reinvest these dollar or euro proceeds in dollar or euro money markets where the funds earn substantially higher rates of return (5.00% per annum in Exhibit 7.8). At the end of the period—a year, in this case—they convert the dollar proceeds back into Japanese yen in the spot market. The result is a tidy profit over what it costs to repay the initial loan.
The trick, however, is that the spot exchange rate at the end of the year must not change significantly from what it was at the beginning of the year. If the yen were to appreciate significantly against the dollar, as it did in late 1999, moving from ¥120/$ to ¥105/$, these “uncovered” investors would suffer sizable losses when they convert their dollars into yen to repay the yen they borrowed. Higher return at higher risk.
200 CHAPTER 7 International Parity Conditions
EXHIBIT 7.8 Uncovered Interest Arbitrage (UIA): The Yen Carry-Trade
Japanese Yen Money Market
U.S. Dollar Money Market
! 1.05
! 1.004¥10,000,000
S = ¥120.00/$
$83,333.33 $87,500.00
S360= ¥120.00/$
Start End
Invest dollars at 5.00% per annum
Investors borrow yen at 0.40% per annum
¥10,040,000 Repay ¥10,500,000 Earn ¥ 460,000 Profit
360 Days
Equilibrium Between Interest Rates and Exchange Rates Exhibit 7.9 illustrates the conditions necessary for equilibrium between interest rates and exchange rates. The vertical axis shows the difference in interest rates in favor of the foreign currency, and the horizontal axis shows the forward premium or discount on that currency. The interest rate parity line shows the equilibrium state, but transaction costs cause the line to be a band rather than a thin line. Transaction costs arise from foreign exchange and investment brokerage costs on buying and selling securities. Typical transaction costs in recent years have been in the range of 0.18% to 0.25% on an annual basis. For individual transactions like Fye Hong’s arbitrage activities in the previous example on covered interest arbitrage (CIA), there is no explicit transaction cost per trade; rather, the costs of the bank in supporting Fye Hong’s activities are the transaction costs. Point X shows one possible equilibrium position, where a 4% lower rate of interest on yen securities would be offset by a 4% premium on the forward yen.
The disequilibrium situation, which encouraged the interest rate arbitrage in the previous CIA example, is illustrated by point U. It is located off the interest rate parity line because the lower interest on the yen is 4% (annual basis), whereas the premium on the forward yen is slightly over 4.8% (annual basis). Using the formula for forward premium presented earlier, we find the premium on the yen thus:
¥106.00/$ - 103.50/$ ¥103.50/$
* 360 days 180 days
* 100 = 4.83%.
The situation depicted by point U is unstable, because all investors have an incentive to execute the same covered interest arbitrage. Except for a bank failure, the arbitrage gain is virtually risk-free.
Some observers have suggested that political risk does exist, because one of the governments might apply capital controls that would prevent execution of the forward contract. This risk is fairly remote for covered interest arbitrage between major financial centers of the world, especially because a large portion of funds used for covered interest
201International Parity Conditions CHAPTER 7
arbitrage is in Eurodollars. The concern may be valid for pairings with countries not noted for political and fiscal stability.
The net result of the disequilibrium is that fund flows will narrow the gap in interest rates and/or decrease the premium on the forward yen. In other words, market pressures will cause point U in Exhibit 7.9 to move toward the interest rate parity band. Equilibrium might be reached at point Y, or at any other locus between X and Z, depending on whether forward market premiums are more or less easily shifted than interest rate differentials.
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.
Exhibit 7.10 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, E1(S2) = F1,2.
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.
Empirical studies of the efficient foreign exchange market hypothesis have yielded conflicting results. Nevertheless, a consensus is developing that rejects the efficient market
–5
–4
–1
–3 –1–4 –2
–2
–3
1
4
3
2
–6 2 4 63 51
4.83
Percentage premium on foreign currency (¥)
Percentage difference between foreign (¥) and domestic ($) interest rates
UX
Z Y
EXHIBIT 7.9 Interest Rate Parity (IRP) and Equilibrium
202 CHAPTER 7 International Parity Conditions
EXHIBIT 7.10
Exchange Rate
Time
Error
Error
ErrorS1
F1
S2 F2
S3
S4
F3
t1 t2 t3 t4
t1 t2 t3 t4
The forward rate available today (Ft, t + 1), time t, for delivery at future time t + 1, is used as a “predictor” of the spot rate that will exist at that day in the future. Therefore, the forecast spot rate for time St2 is F1 ; the actual spot rate turns out to be S2. The vertical distance between the prediction and the actual spot rate is the forecast error. When the forward rate is termed an “unbiased predictor of the future spot rate,” it means that the forward rate overestimates or underestimates the future spot rate with relatively equal frequency and amount. It therefore “misses the mark” in a regular and orderly manner. The sum of the errors equals zero.
Forward Rate as an Unbiased Predictor for Future Spot Rate
hypothesis. It appears that the forward rate is not an unbiased predictor of the future spot rate and that it does pay to use resources to attempt to forecast exchange rates.
If the efficient market hypothesis is correct, a financial executive cannot expect to profit in any consistent manner from forecasting future exchange rates, because current quotations in the forward market reflect all that is presently known about likely future rates. Although future exchange rates may well differ from the expectation implicit in the present forward market quotation, we cannot know today which way actual future quotations will differ from today’s forward rate. The expected mean value of deviations is zero. The forward rate is therefore an “unbiased” estimator of the future spot rate.
Tests of foreign exchange market efficiency, using longer time periods of analysis, conclude that either exchange market efficiency is untestable or, if it is testable, that the market is not efficient. Furthermore, 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. If they “bought” professional advice that turned out wrong, the fault was not in their forecast!
If the exchange market is not efficient, it would be sensible for a firm to spend resources on forecasting exchange rates. This is the opposite conclusion to the one in which exchange markets are deemed efficient.
Prices, Interest Rates, and Exchange Rates in Equilibrium Exhibit 7.11 illustrates all of the fundamental parity relations simultaneously, in equilibrium, using the U.S. dollar and the Japanese yen. The forecasted inflation rates for Japan and the United States are 1% and 5%, respectively; a 4% differential. The nominal interest rate in
203International Parity Conditions CHAPTER 7
the U.S. dollar market (1-year government security) is 8%, a differential of 4% over the Japanese nominal interest rate of 4%. The spot rate S1 is ¥104/$, and the 1-year forward rate is ¥100/$.
Relation A: Purchasing Power Parity (PPP). According to the relative version of purchasing power parity, the spot exchange rate one year from now, S2 is expected to be ¥100/$:
S2 = S1 * 1 + p ¥
1 + p $ = ¥104/$ * 1.01
1.05 = ¥100/$.
This is a 4% change and equal, but opposite in sign, to the difference in expected rates of inflation (1% – 5%, or 4%).
Relation B: The Fisher Effect. The real rate of return is the nominal rate of interest less the expected rate of inflation. Assuming efficient and open markets, the real rates of return should be equal across currencies. Here, the real rate is 3% in U.S. dollar markets (r = i - p = 8% - 5%) and in Japanese yen markets (4%–1%). Note that the 3% real rate of return is not in Exhibit 7.11, but rather the Fisher effect’s relationship—that nominal inter- est rate differentials equal the difference in expected rates of inflation, -4%.
Relation C: International Fisher Effect. The forecast change in the spot exchange rate, in this case 4%, is equal to, but opposite in sign to, the differential between nominal interest rates:
S1 - S2 S2
* 100 = i ¥ - i $ = 4% - 8% = -4%.
Forecast Change in Spot Exchange Rate
+ 4% (Yen Strengthens)
Forward Premium on Foreign Currency
+ 4% (Yen Strengthens)
Forecast Difference in Rates of Inflation
– 4% (Less in Japan)
Difference in Nominal Interest Rates
– 4% (Less in Japan)
Forward Rate as an Unbiased
Predictor (E)
Interest Rate Parity (D)
International Fisher Effect (C)
Purchasing Power
Parity (A)
Fisher Effect (B)
EXHIBIT 7.11 International Parity Conditions in Equilibrium (Approximate Form)
CHAPTER 7 International Parity Conditions204
Relation D: Interest Rate Parity (IRP). According to the theory of interest rate parity, the difference in nominal interest rates is equal to, but opposite in sign to, the forward premium. For this numerical example, the nominal yen interest rate (4%) is 4% less than the nominal dollar interest rate (8%):
i ¥ - i $ = 4% - 8% = -4%.
and the forward premium is a positive 4%:
f ¥ = S1 - F
F * 100 = ¥104/$ - ¥100/$
¥100/$ * 100 = 4%.
Relation E: Forward Rate as an Unbiased Predictor. Finally, the 1-year forward rate on the Japanese yen, ¥100/$, if assumed to be an unbiased predictor of the future spot rate, also forecasts ¥100/$.
SUMMARY POINTS
! Parity conditions have traditionally been used by econo- mists to help explain the long-run trend in an exchange rate.
! Under conditions of freely floating rates, the expected rate of change in the spot exchange rate, differential rates of national inflation and interest, and the forward discount or premium are all directly proportional to each other and mutually determined. A change in one of these variables has a tendency to change all of them with a feedback on the variable that changes first.
! If the identical product or service can be sold in two different markets, and there are no restrictions on its sale or transportation costs of moving the product between markets, the product’s price should be the same in both markets. This is called the law of one price.
! The absolute version of the theory of purchasing power parity states that the spot exchange rate is determined by the relative prices of similar baskets of goods.
! The relative version of the theory of purchasing power parity states that 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.
! 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 compensa- tion for expected inflation.
! 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.
! The theory of interest rate parity (IRP) states that 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.
! When the spot and forward exchange markets are not in equilibrium as described by interest rate parity, the potential for “riskless” or arbitrage profit exists. This is called covered interest arbitrage (CIA).
! Some forecasters believe that for the major floating currencies, foreign exchange markets are “efficient” and forward exchange rates are unbiased predictors of future spot exchange rates.
205International Parity Conditions CHAPTER 7
The weak economic outlook for the euro zone is the pri- mary factor driving the change in that trade. Minor dif- ferences in interest rates between the euro and either the dollar or the Japanese yen are less important right now, strategists said. Rates in the U.S. and Japan are near 0%, while they are at 1% in Europe.
—“Euro Becomes Increasingly Popular Choice to Fund Carry Trades,” The Wall Street Journal,
December 21, 2010.
Incredibly low interest rates in both the United States and Europe, accompanied by dim economic performance and continuing concern over fiscal deficits, has led to a most unexpected outcome: a new form of carry trade which shorts the dollar and euro.
The carry trade has long been associated with Japan and the relatively low interest rates which its financial community has made available to multinational investors. A form of uncovered interest rate arbitrage (UIA), the Japanese carry trade was based on an investor raising funds in Japan at low interest rates and then exchanging the proceeds for a foreign currency in which the interest rates promised higher relative returns. Then, at the end
of the term, the investor could potentially exchange the foreign currency returns, plus interest, back to Japanese yen to settle the obligation and also, hopefully, a profit. The entire risk-return profile of the strategy, however, was based on the exchange rate at the end of the period being relatively unchanged from the initial spot rate.
The global financial crisis of 2007–2009 has left a mar- ketplace in which the U.S. Federal Reserve and the Euro- pean Central Bank have pursued easy money policies. Both central banks, in an effort to maintain high levels of liquidity and support fragile commercial banking systems, have kept interest rates at near-zero levels. Now global investors, those who see opportunities for profit in an ane- mic global economy, are using those same low-cost funds in the U.S. and Europe to fund uncovered interest arbitrage activities. But what is making this “emerging market carry trade” so unique is not the interest rates, but the fact that investors are shorting two of the world’s core currencies: the dollar and the euro.
Consider the strategy outlined in Exhibit 1. An inves- tor borrows EUR 20 million at an incredibly low rate, say 1.00% per annum or 0.50% for 180 days. The EUR 20 million are then exchanged for Indian rupees (INR),
MINI-CASE Emerging Market Carry Trades
EXHIBIT 1
1.00% per annum or 1.005 for 180 days
Investor borrows EUR 20,000,000 at 1.00% interest
INR 60.4672/EUR
INR 1,209,344,000 2.50% per annum or 1.0125 for 180 days
INR 1,224,460,800
EUR 20,000,000
180-day period
EUR 1,765,371
21,865,371
EndStart
INR 56.00/EUR
The Euro/Indian Rupee Carry Trade
206 CHAPTER 7 International Parity Conditions
The State Bank of India, India’s central bank, was expected to tighten monetary growth to fight inflationary pressures, sending rupee interest rates—and the rupee itself, higher on world markets. In the exhibit the investor is shown expect- ing a spot rate at the end of the 180-day arbitrage position at INR 56.00/EUR. The expected yield on position, a whop- ping 8.83% (EUR 1,765,371 profit on an initial investment of EUR 20 million). An extremely attractive rate of return in a global marketplace of sub-5% investment yields.
Case Questions
1. Why are interest rates so low in the traditional core markets of USD and EUR?
2. What makes this “emerging market carry trade” so different from traditional forms of uncovered interest arbitrage?
3. Why are many investors shorting the dollar and the euro?
the current spot rate being INR 60.4672 = EUR 1.00. The resulting INR 1,209,344,000 are put into an interest bear- ing deposit with any of a number of Indian banks attempt- ing to attract capital. The rate of interest offered, 2.50%, is not particularly high, but is greater than that available in the dollar, euro, or even yen markets. But the critical component of the strategy is not to earn the higher rupee interest (although that does help), it is the expectations of the investor over the direction of the INR per EUR exchange rate.
The European economy yielded very weak economic growth in 2010, and all indications were that 2011 would not be much better. Low interest rates, although expected to persist, had not done much to support the euro’s value. Like the dollar, many forecasts were for the euro to fall against many of the world’s currencies—including the Indian rupee. The Indian economy, however, had been growing rapidly; in fact, nearly too fast. Inflationary pres- sures had kept inflation for 2010 at just under 10%, and it was expected to remain at 7% or higher throughout 2011.
QUESTIONS 1. Purchasing Power Parity. Define the following terms:
a. The law of one price b. Absolute purchasing power parity c. Relative purchasing power parity
2. Nominal Effective Exchange Rate Index. Explain how a nominal effective exchange rate index is constructed.
3. Real Effective Exchange Rate Index. What formula is used to convert a nominal effective exchange rate index into a real effective exchange rate index?
4. Real Effective Exchange Rates: Japan and the United States. Exhibit 7.3 compares the real effective exchange rates for the United States and Japan. If the comparative real effective exchange rate was the main determinant, does the United States or Japan have a competitive advantage in exporting? Which of the two has an advantage in importing? Explain why.
5. 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?
6. The Fisher Effect. Define the Fisher effect. To what extent do empirical tests confirm that the Fisher effect exists in practice?
7. The International Fisher Effect. Define the interna- tional Fisher effect. To what extent do empirical tests confirm that the international Fisher effect exists in practice?
8. Interest Rate Parity. Define interest rate parity. What is the relationship between interest rate parity and for- ward rates?
9. Covered Interest Arbitrage. Define the terms cov- ered interest arbitrage and uncovered interest arbi- trage. What is the difference between these two transactions?
10. 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 unbi- ased 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?
206 CHAPTER 7 International Parity Conditions
207International Parity Conditions CHAPTER 7
Arbitrage funds available $5,000,000
Spot rate (¥/$) 118.60
180-day forward rate (¥/$) 117.80
180-day U.S. dollar interest rate 4.800%
180-day Japanese yen interest rate 3.400%
PROBLEMS 1. Traveling Down Under. Terry Lamoreaux owns
homes in Sydney, Australia and Phoenix, Arizona. He travels between the two cities at least twice a year. Because of his frequent trips he wants to buy some new, high-quality luggage. He’s done his research and has decided to purchase a Briggs and Riley three- piece luggage set. There are retail stores in Phoenix and Sydney. Terry was a finance major and wants to use purchasing power parity to determine if he is pay- ing the same price regardless of where he makes his purchase. a. If the price of the three-piece luggage set in Phoe-
nix is $850 and the price of the same three-piece set in Sydney is $930, using purchasing power parity, is the price of the luggage truly equal if the spot rate is A$1.0941/$?
b. If the price of the luggage remains the same in Phoenix one year from now, determine the price of the luggage in Sydney in one year’s time if PPP holds true. The U.S. Inflation rate is 1.15% and the Australian inflation rate is 3.13%.
2. Pulau Penang Island Resort. Theresa Nunn is plan- ning a 30-day vacation on Pulau Penang, Malaysia, one year from now. The present charge for a luxury suite plus meals in Malaysian ringgit (RM) is RM1,045/day. The Malaysian ringgit presently trades at RM3.1350/$. She determines that the dollar cost today for a 30-day stay would be $10,000. The hotel informs her that any increase in its room charges will be limited to any increase in the Malaysian cost of living. Malaysian inflation is expected to be 2.75% per annum, while U.S. inflation is expected to be 1.25%. a. How many dollars might Theresa expect to need
one year hence to pay for her 30-day vacation? b. By what percent will the dollar cost have gone up?
Why?
3. Starbucks in Croatia. Starbucks opened its first store in Zagreb, Croatia in October 2010. In Zagreb, the price of a tall vanilla latte is 25.70kn. In New York City, the price of a tall vanilla latte is $2.65. The exchange rate between Croatian kunas (kn) and U.S. dollars is kn5.6288/$. According to purchasing power parity, is the Croatian kuna overvalued or undervalued?
4. Japanese/United States Parity Conditions. Derek Tosh is attempting to determine whether U.S./Japa- nese financial conditions are at parity. The current spot rate is a flat ¥89.00/$, while the 360-day forward rate is ¥84.90/$. Forecast inflation is 1.100% for Japan,
and 5.900% for the United States. The 360-day euro yen deposit rate is 4.700%, and the 360-day euro dol- lar deposit rate is 9.500%. a. Diagram and calculate whether international parity
conditions hold between Japan and the United States. b. Find the forecasted change in the Japanese yen/
U.S. dollar (¥/$) exchange rate one year from now.
5. Crisis at the Heart of Carnaval. The Argentine peso was fixed through a currency board at Ps1.00/$ throughout the 1990s. In January 2002, the Argentine peso was floated. On January 29, 2003, it was trading at Ps3.20/$. During that one-year period, Argentina’s inflation rate was 20% on an annualized basis. Infla- tion in the United States during that same period was 2.2% annualized. a. What should have been the exchange rate in
January 2003 if PPP held? b. By what percentage was the Argentine peso under-
valued on an annualized basis? c. What were the probable causes of undervaluation?
6. Corolla Exports and Pass-Through. Assume that the export price of a Toyota Corolla from Osaka, Japan is ¥2,150,000. The exchange rate is ¥87.60/$. The forecast rate of inflation in the United States is 2.2% per year and in Japan is 0.0% per year. Use this data to answer the following questions on exchange rate pass-through. a. What was the export price for the Corolla at the
beginning of the year expressed in U.S. dollars? b. Assuming purchasing power parity holds, what
should be the exchange rate at the end of the year? c. Assuming 100% pass-through of exchange rate,
what will be the dollar price of a Corolla at the end of the year?
d. Assuming 75% pass-through, what will be the dol- lar price of a Corolla at the end of the year?
7. Takeshi Kamada—CIA Japan. Takeshi Kamada, a foreign exchange trader at Credit Suisse (Tokyo), is exploring covered interest arbitrage possibilities. He wants to invest $5,000,000 or its yen equivalent, in a covered interest arbitrage between U.S. dollars and Japanese yen. He faced the following exchange rate and interest rate quotes.
208 CHAPTER 7 International Parity Conditions
12. Casper Landsten—CIA. Casper Landsten is a foreign exchange trader for a bank in New York. He has $1 million (or its Swiss franc equivalent) for a short-term money market investment and wonders if he should invest in U.S. dollars for three months, or make a CIA investment in the Swiss franc. He faces the following quotes:
8. Takeshi Kamada—UIA Japan. Takeshi Kamada, Credit Suisse (Tokyo), observes that the ¥/$ spot rate has been holding steady, and both dollar and yen interest rates have remained relatively fixed over the past week. Takeshi wonders if he should try an uncovered interest arbitrage (UIA) and thereby save the cost of forward cover. Many of Takeshi’s research associates—and their computer models-are predicting the spot rate to remain close to ¥118.00/$ for the com- ing 180 days. Using the same data as in problem 7, analyze the UIA potential.
9. Copenhagen Covered (A). Heidi Høi Jensen, a for- eign exchange trader at JPMorgan Chase, can invest $5 million, or the foreign currency equivalent of the bank’s short-term funds, in a covered interest arbi- trage with Denmark. Using the following quotes, can Heidi make a covered interest arbitrage (CIA) profit?
Arbitrage funds available $5,000,000
Spot exchange rate (kr/$) 6.1720
3-month forward rate (kr/$) 6.1980
U.S. dollar 3-month interest rate 3.000%
Danish kroner 3-month interest rate 5.000%
Arbitrage funds available $5,000,000
Spot exchange rate (kr/$) 6.1720
3-month forward rate (kr/$) 6.1980
U.S. dollar 3-month interest rate 4.000%
Danish kroner 3-month interest rate 5.000%
10. Copenhagen Covered (B)—Part a. Heidi Høi Jensen is now evaluating the arbitrage profit potential in the same market after interest rates change. (Note that any time the difference in interest rates does not exactly equal the forward premium, it must be pos- sible to make a CIA profit one way or another.)
15. Statoil of Norway’s Arbitrage. Statoil, the national oil company of Norway, is a large, sophisticated, and active participant in both the currency and
13. Casper Landsten—UIA. Casper Landsten, using the same values and assumptions as in problem 12, decides to seek the full 4.800% return available in U.S. dollars by not covering his forward dollar receipts—an uncov- ered interest arbitrage (UIA) transaction. Assess this decision.
14. Casper Landsten—Thirty Days Later. One month after the events described in problems 12 and 13, Casper Landsten once again has $1 million (or its Swiss franc equivalent) to invest for three months. He now faces the following rates. Should he again enter into a covered interest arbitrage (CIA) investment?
11. Copenhagen Covered (B)—Part b. Heidi Høi Jen- sen is now evaluating the arbitrage profit potential in the same market after interest rates change. (Note that any time the difference in interest rates does not exactly equal the forward premium, it must be pos- sible to make a CIA profit one way or another.)
Arbitrage funds available $5,000,000
Spot exchange rate (kr/$) 6.1720
3-month forward rate (kr/$) 6.1980
U.S. dollar 3-month interest rate 3.000%
Danish kroner 3-month interest rate 6.000%
Arbitrage funds available $1,000,000
Spot exchange rate (SFr/$) 1.2810
3-month forward rate (SFr/$) 1.2740
U.S. dollar 3-month interest rate 4.800%
Swiss franc 3-month interest rate 3.200%
Arbitrage funds available $1,000,000
Spot exchange rate (SFr/$) 1.3392
3-month forward rate (SFr/$) 1.3286
U.S. dollar 3-month interest rate 4.750%
Swiss franc 3-month interest rate 3.625%
209International Parity Conditions CHAPTER 7
18. East Asiatic Company—Thailand. The East Asiatic Company (EAC), a Danish company with subsidiaries throughout Asia, has been funding its Bangkok sub- sidiary primarily with U.S. dollar debt because of the cost and availability of dollar capital as opposed to Thai baht-denominated (B) debt. The treasurer of EAC-Thailand is considering a one-year bank loan for $250,000. The current spot rate is B32.06/$, and the dollar-based interest is 6.75% for the one-year period. One-year loans are 12.00% in baht. a. Assuming expected inflation rates of 4.3% and
1.25% in Thailand and the United States, respec- tively, for the coming year, according to purchase power parity, what would be the effective cost of funds in Thai baht terms?
b. If EAC’s foreign exchange advisers believe strongly that the Thai government wants to push the value of the baht down against the dollar by 5% over the coming year (to promote its export competitiveness in dollar markets), what might be the effective cost of funds in baht terms?
c. If EAC could borrow Thai baht at 13% per annum, would this be cheaper than either part (a) or part (b)?
19. Maltese Falcon. The infamous solid gold falcon, ini- tially intended as a tribute by the Knights of Rhodes to the King of Spain in appreciation for his gift of the island of Malta to the order in 1530, has recently been recovered. The falcon is 14 inches high and solid gold, weighing approximately 48 pounds. Assume that gold prices have risen to $440/ounce, primarily as a result of increasing political tensions. The falcon is currently held by a private investor in Istanbul, who is actively negotiating with the Maltese govern- ment on its purchase and prospective return to its island home. The sale and payment are to take place in March 2004, and the parties are negotiating over the price and currency of payment. The investor has decided, in a show of goodwill, to base the sales price only on the falcon’s specie value—its gold value.
The current spot exchange rate is 0.39 Maltese lira (ML) per U.S. dollar. Maltese inflation is expected to be about 8.5% for the coming year, while U.S.
petrochemical markets. Although it is a Norwegian company, because it operates within the global oil market, it considers the U.S. dollar as its functional currency, not the Norwegian krone. Ari Karlsen is a currency trader for Statoil, and has immediate use of either $3 million (or the Norwegian krone equivalent). He is faced with the following market rates, and won- ders whether he can make some arbitrage profits in the coming 90 days.
a. What do the financial markets suggest for inflation in Europe next year?
b. Estimate today’s 1-year forward exchange rate between the dollar and the euro?
17. Chamonix Chateau Rentals. You are planning a ski vacation to Mt. Blanc in Chamonix, France, one year from now. You are negotiating the rental of a chateau. The chateau’s owner wishes to preserve his real income against both inflation and exchange rate changes, and so the present weekly rent of €9,800 (Christmas season) will be adjusted upward or down- ward for any change in the French cost of living between now and then. You are basing your budgeting on purchasing power parity (PPP). French inflation is expected to average 3.5% for the coming year, while U.S. dollar inflation is expected to be 2.5%. The cur- rent spot rate is $1.3620/€. What should you budget as the U.S. dollar cost of the one-week rental?
16. Separated by the Atlantic. Separated by more than 3,000 nautical miles and five time zones, money and foreign exchange markets in both London and New York are very efficient. The following information has been collected from the respective areas:
Arbitrage funds available $3,000,000
Spot exchange rate (Nok/$) 6.0312
3-month forward rate (Nok/$) 6.0186
U.S. dollar 3-month interest rate 5.000%
Norwegian krone 3-month interest rate 4.450%
Assumptions London New York
Spot exchange rate ($/€) 1.3264 1.3264
1-year Treasury bill rate 3.900% 4.500%
Expected inflation rate Unknown 1.250%
Spot exchange rate ($/€) $1.3620
Expected U.S. inflation for coming year 2.500%
Expected French inflation for coming year 3.500%
Current chateau nominal weekly rent (€) €9,800.00
210 CHAPTER 7 International Parity Conditions
and beer met most of the same product and market characteristics required for the construction of a proper currency index. Investec, a South African investment banking firm, has replicated the process of creating a measure of purchasing power parity (PPP) like that of the Big Mac Index of the Economist, for Africa.
The index compares the cost of a 375 milliliter bottle of clear lager beer across Sub-Sahara Africa. As a measure of PPP, the beer needs to be relatively homo- geneous in quality across countries, and must possess substantial elements of local manufacturing, inputs, distribution, and service, in order to actually provide a measure of relative purchasing power. The beer is first priced in local currency (purchased in the taverns of the locals, and not in the high-priced tourist centers), then converted to South African rand. The price of the beer in rand is then compared to form one measure of whether the local currency is undervalued -% or overvalued +% versus the South African rand. Use the data in the table and complete the calculation of whether the individual currencies are undervalued or overvalued.
INTERNET EXERCISES
1. Big Mac Index Updated. Use the Economist’s Web site to find the latest edition of the Big Mac Index of currency overvaluation and undervaluation. (You will need to do a search for “Big Mac Currencies.”) Create a worksheet to compare how the British pound, the euro, the Swiss franc, and the Canadian dollar have changed from the version presented in this chapter.
The Economist www.economist.com/markets-data
inflation, on the heels of a double-dip recession, is expected to come in at only 1.5%. If the investor bases value in the U.S. dollar, would he be better off receiving Maltese lira in one year-assuming purchas- ing power parity, or receiving a guaranteed dollar pay- ment assuming a gold price of $420 per ounce.
20. Malaysian Risk. Clayton Moore is the manager of an international money market fund managed out of London. Unlike many money funds that guaran- tee their investors a near risk-free investment with variable interest earnings, Clayton Moore’s fund is a very aggressive fund that searches out relatively high interest earnings around the globe, but at some risk. The fund is pound-denominated. Clayton is cur- rently evaluating a rather interesting opportunity in Malaysia. Since the Asian Crisis of 1997, the Malay- sian government enforced a number of currency and capital restrictions to protect and preserve the value of the Malaysian ringgit. The ringgit was fixed to the U.S. dollar at RM3.80/$ for seven years. In 2005, the Malay- sian government allowed the currency to float against several major currencies. The current spot rate today is RM3.13485/$. Local currency time deposits of 180- day maturities are earning 8.900% per annum. The London Eurocurrency market for pounds is yielding 4.200% per annum on similar 180-day maturities. The current spot rate on the British pound is $1.5820/£, and the 180-day forward rate is $1.5561/£.
21. The Beer Standard. In 1999, the Economist reported the creation of an index, or standard, for the evalua- tion of African currency values using the local prices of beer. Beer, instead of Big Macs, was chosen as the product for comparison because McDonald’s had not penetrated the African continent beyond South Africa,
Beer Prices
Country Beer Local Currency
Local Currency In rand
Implied PPP Rate
Spot Rate (3/15/99)
South Africa Castle Rand 2.30 — — —
Botswana Castle Pula 2.20 2.94 0.96 0.75
Ghana Star Cedi 1,200.00 3.17 521.74 379.10
Kenya Tusker Shilling 41.25 4.02 17.93 10.27
Malawi Carlsberg Kwacha 18.50 2.66 8.04 6.96
Mauritius Phoenix Rupee 15.00 3.72 6.52 4.03
Namibia Windhoek N$ 2.50 2.50 1.09 1.00
Zambia Castle Kwacha 1,200.00 3.52 521.74 340.68
Zimbabwe Castle Z$ 9.00 1.46 3.91 6.15
211International Parity Conditions CHAPTER 7
Note which countries actually have lower 10-year government bond rates than the United States and the euro? Check.
! Benchmark government bonds (sampling of representative government issuances by major countries and recent price movements). Note which countries are showing longer maturity benchmark rates.
! Emerging market bonds (government issuances, Brady bonds, etc.)
! Eurozone rates (miscellaneous bond rates for assorted European-based companies; includes debt ratings by Moodys and S&P)
4. World Bank’s International Comparison Program. The World Bank has an ongoing research program that focuses on the relative purchasing power of 107 different economies globally, specifically in terms of household consumption. Download the latest data tables and high- light which economies seem to be showing the greatest growth in recent years in relative purchasing power.
World Bank International Comparison Program
2. Purchasing Power Parity Statistics. The Organiza- tion for Economic Cooperation and Development (OECD) publishes detailed measures of prices and purchasing power for its member countries. Go to the OECD’s Web site and download the spreadsheet file with the historical data for purchasing power for the member countries.
web.worldbank.org/ WBSITE/EXTERNAL/ DATASTATISTICS/ ICPEXT/
OECD Purchasing Power
www.oecd.org/department/ 0,3355,en_2649_34357_1_1_1_ 1_1,00.html
3. International Interest Rates. A number of Web sites publish current interest rates by currency and matu- rity. Use the Financial Times Web site listed here to isolate the interest rate differentials between the U.S. dollar, the British pound, and the euro for all maturi- ties up to and including one year.
Financial Times Market Data www.ft.com/intnl/markets
Data Listed by the Financial Times:
! International money rates (bank call rates for major currency deposits)
! Money rates (LIBOR and CD rates, etc.)
! 10-year spreads (individual country spreads versus the euro and U.S. 10-year treasuries).
212
An Algebraic Primer to International Parity Conditions
The following is a purely algebraic presentation of the parity conditions explained in this chapter. It is offered to provide those who wish additional theoretical detail and definition ready access to the step-by-step derivation of the various conditions.
The Law of One Price The law of one price refers to the state in which, in the presence of free trade, perfect sub- stitutability of goods, and costless transactions, the equilibrium exchange rate between two currencies is determined by the ratio of the price of any commodity i denominated in two different currencies. For example,
St = P i,t$
P i,tSF
where P i$ and P iSF refer to the prices of the same commodity i, at time t, denominated in U.S. dollars and Swiss francs, respectively. The spot exchange rate, St, is simply the ratio of the two currency prices.
Purchasing Power Parity The more general form in which the exchange rate is determined by the ratio of two price indexes is termed the absolute version of purchasing power parity (PPP). Each price index reflects the currency cost of the identical “basket” of goods across countries. The exchange rate that equates purchasing power for the identical collection of goods is then stated as follows:
St = P t$
P tSF
where P t$ and P tSF are the price index values in U.S. dollars and Swiss francs at time t, respec- tively. It represents the rate of inflation in each country, the spot exchange rate at time t + 1 would be
APPENDIX
213An Algebraic Primer to International Parity Conditions APPENDIX
St+ 1 = P t $ (1 + p $)
P tSF(1 + p SF) = St J (1 + p $)(1 + p SF) R
The change from period t to t + 1 is then
St+ 1 St
=
P t$(1 + p $) P tSF(1 + p SF)
P t$
P tSF
= St J (1 + p $)(1 + p SF) R
St =
(1 + p $) (1 + p SF)
Isolating the percentage change in the spot exchange rate between periods t and t + 1 is then
St+ 1 - St St
= St J (1 + p $)(1 + p SF) R - St
St =
(1 + p $) - (1 + p SF) (1 + p SF)
This equation is often approximated by dropping the denominator of the right-hand side if it is considered to be relatively small. It is then stated as
St+ 1 - St St
= (1 + p $) - (1 + p SF) = p $ - p SF
Forward Rates The forward exchange rate is that contractual rate which is available to private agents through banking institutions and other financial intermediaries who deal in foreign currencies and debt instruments. The annualized percentage difference between the forward rate and the spot rate is termed the forward premium,
f SF = JFt, t+ 1 - St St
R * J 360 nt, t+ 1
R where f SF is the forward premium on the Swiss franc, Ft, t+ 1 is the forward rate contracted at time t for delivery at time t + 1, St is the current spot rate, and nt, t+ 1 is the number of days between the contract date (t) and the delivery date (t + 1).
Covered Interest Arbitrage (CIA) and Interest Rate Parity (IRP) The process of covered interest arbitrage is when an investor exchanges domestic currency for foreign currency in the spot market, invests that currency in an interest-bearing instru- ment, and signs a forward contract to “lock in” a future exchange rate at which to convert the foreign currency proceeds (gross) back to domestic currency. The net return on CIA is
Net return = J (1 + i SF)Ft, t+ 1 St
R - (1 + i $)
214 APPENDIX An Algebraic Primer to International Parity Conditions
where St and Ft, t+ 1 are the spot and forward rates ($/SF), i SF is the nominal interest rate (or yield) on a Swiss franc-denominated monetary instrument, and i $ is the nominal return on a similar dollar-denominated instrument.
If they possess exactly equal rates of return—that is, if CIA results in zero riskless profit— interest rate parity (IRP) holds, and appears as
(1 + i $) = J (1 + i SF)Ft, t+ 1 St
R or alternatively as
(1 + i $) (1 + i SF)
= Ft, t+ 1
St
If the percent difference of both sides of this equation is found (the percentage difference between the spot and forward rate is the forward premium), then the relationship between the forward premium and relative interest rate differentials is
Ft, t+ 1 - St St
= f SF = i $ - i SF
i $ + i SF
If these values are not equal (thus, the markets are not in equilibrium), there exists a potential for riskless profit. The market will then be driven back to equilibrium through CIA by agents attempting to exploit such arbitrage potential, until CIA yields no positive return.
Fisher Effect The Fisher effect states that all nominal interest rates can be decomposed into an implied real rate of interest (return) and an expected rate of inflation:
i $ = [(1 + r $)(1 + p $)] - 1
where r $ is the real rate of return, and p $ is the expected rate of inflation, for dollar- denominated assets. The subcomponents are then identifiable:
i $ = r $ + p $ + r $p $
As with PPP, there is an approximation of this function that has gained wide acceptance. The cross-product term of r $ p $ is often very small and therefore dropped altogether:
i $ = r $ + p $
International Fisher Effect The international Fisher effect is the extension of this domestic interest rate relationship to the international currency markets. If capital, by way of covered interest arbitrage (CIA), attempts to find higher rates of return internationally resulting from current interest rate dif- ferentials, the real rates of return between currencies are equalized (e.g., r $ = r SF):
St+ 1 - St St
= (1 + i $) - (1 + i SF)
(1 + i SF) =
i $ - i SF
(1 + i SF)
215An Algebraic Primer to International Parity Conditions APPENDIX
If the nominal interest rates are then decomposed into their respective real and expected inflation components, the percentage change in the spot exchange rate is
St+ 1 - St St
= (r $ + p $ + r $ p $) - (r SF + pSF + r SFp SF)
1 + r SF + p SF + r SFp SF
The international Fisher effect has a number of additional implications, if the following requirements are met: (1) Capital markets can be freely entered and exited; (2) Capital mar- kets possess investment opportunities that are acceptable substitutes; and (3) Market agents have complete and equal information regarding these possibilities.
Given these conditions, international arbitragers are capable of exploiting all poten- tial riskless profit opportunities, until real rates of return between markets are equalized (r $ = r SF). Thus, the expected rate of change in the spot exchange rate reduces to the dif- ferential in the expected rates of inflation:
St+ 1 - St St
= p $ + r $p $ - p SF - r SFp SF
1 + r SF + p SF + r SFp SF
If the approximation forms are combined (through the elimination of the denominator and the elimination of the interactive terms of r and p), the change in the spot rate is simply
St+ 1 - St St
= p $ - p SF
Note the similarity (identical in equation form) of the approximate form of the international Fisher effect to purchasing power parity, discussed previously (the only potential difference is that between ex post and ex ante (expected), inflation.
216
CHAPTER 8
Foreign Currency Derivatives and Swaps
Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counterparties to them. In the meantime, though, before a contract is settled, the counterparties record profits and losses—often huge in amount—in their current earnings statements without so much as a penny changing hands. The range of derivatives contracts is limited only by the imagination of man (or sometimes, so it seems, madmen).
—Warren Buffett, Berkshire Hathaway Annual Report, 2002.
Financial management of the multinational enterprise in the twenty-first century will certainly include the use of financial derivatives. These derivatives, so named because their values are derived from an underlying asset like a stock or a currency, are powerful tools used in business today for two very distinct management objectives, speculation and hedging. The financial manager of an MNE may purchase these financial derivatives in order to take positions in the expectation of profit, speculation, or may use these instruments to reduce the risks associated with the everyday management of corporate cash flow, hedging. Before these financial instruments can be used effectively, however, the financial manager must understand certain basics about their structure and pricing.
In this chapter, we cover the primary foreign currency financial derivatives used today in multinational financial management: foreign currency futures, foreign currency options, interest rate swaps, and cross currency interest rate swaps. We focus on the fundamentals of their valuation and their use for speculative purposes. Chapter 10 will describe how these foreign currency derivatives can be used to hedge commercial transactions, hedging. The Mini-Case at the end of this chapter, McDonald’s Corporation British Pound Exposure illustrates how one major multinational company, McDonald’s, has used currency derivatives quite successfully over time.
A word of caution—of reservation—before proceeding further. Financial derivatives are powerful tools in the hands of careful and competent financial managers. They can also be destructive devices when used recklessly and carelessly. The history of finance is littered with cases in which financial managers—either intentionally or unintentionally—took huge positions resulting in significant losses for their companies, and occasionally, their outright collapse. In the right hands and with the proper controls, however, financial derivatives may provide management with opportunities to enhance and protect their corporate financial performance. User beware.
217Foreign Currency Derivatives and Swaps CHAPTER 8
Foreign Currency Futures A foreign currency futures contract is an alternative to a forward contract that calls for future delivery of a standard amount of foreign exchange at a fixed time, place, and price. It is similar to futures contracts that exist for commodities (hogs, cattle, lumber, etc.), interest-bearing deposits, and gold.
Most world money centers have established foreign currency futures markets. In the United States, the most important market for foreign currency futures is the International Monetary Market (IMM) of Chicago, a division of the Chicago Mercantile Exchange.
Contract Specifications Contract specifications are established by the exchange on which futures are traded. Using the Chicago IMM as an example, the major features of standardized futures trading are illustrated by the Mexican peso futures traded on the Chicago Mercantile Exchange (CME), as shown in Exhibit 8.1.
Each futures contract is for 500,000 Mexican pesos. This is the notional principal. Trading in each currency must be done in an even multiple of currency units. The method of stating exchange rates is in American terms, the U.S. dollar cost (price) of a foreign currency (unit), $/MXN, where the CME is mixing the old dollar symbol with the ISO 4217 code for the peso, MXN. In Exhibit 8.1 this is U.S. dollars per Mexican peso. Contracts mature on the third Wednesday of January, March, April, June, July, September, October, or December. Contracts may be traded through the second business day prior to the Wednesday on which they mature. Unless holidays interfere, the last trading day is the Monday preceding the maturity date.
One of the defining characteristics of futures is the requirement that the purchaser deposits a sum as an initial margin or collateral. This requirement is similar to requiring a performance bond, and it can be met by a letter of credit from a bank, Treasury bills, or cash. In addition, a maintenance margin is required. The value of the contract is marked to market daily, and all changes in value are paid in cash daily. Marked to market means that the value of the contract is revalued using the closing price for the day. The amount to be paid is called the variation margin.
Only about 5% of all futures contracts are settled by the physical delivery of foreign exchange between buyer and seller. Most often, buyers and sellers offset their original position prior to delivery date by taking an opposite position. That is, an investor will normally close out a futures position by selling a futures contract for the same delivery date. The complete buy/sell or sell/buy is called a “round turn.”
Lifetime
Maturity Open High Low Settle High Low Open Interest
Mar .10953 .10988 .10930 .10958 .11000 .09770 34,481
June .10790 .10795 .10778 .10773 .10800 .09730 3,405
Sept .10615 .10615 .10610 .10573 .10615 .09930 1,481
All contracts are for 500,000 Mexican pesos. “Open” means the opening price on the day. “High” means the high price on the day. “Low” indicates the lowest price on the day. “Settle” is the closing price on the day. “Change” indicates the change in the settle price from the previous day’s close. “High” and “Low” to the right of Change indicate the highest and lowest prices this specific contract (as defined by its maturity) has experienced over its trading history. “Open Interest” indicates the number of contracts outstanding.
EXHIBIT 8.1 Mexican Peso (CME)—MXN 500,000; $ per 10MXN
218 CHAPTER 8 Foreign Currency Derivatives and Swaps
Customers pay a commission to their broker to execute a round turn and a single price is quoted. This practice differs from that of the interbank market, where dealers quote a bid and an offer and do not charge a commission. All contracts are agreements between the client and the exchange clearinghouse, rather than between the two clients involved. Consequently, clients need not worry that a specific counterparty in the market will fail to honor an agreement (counterparty risk). The clearinghouse is owned and guaranteed by all members of the exchange.
Using Foreign Currency Futures Any investor wishing to speculate on the movement of the Mexican peso versus the U.S. dollar could pursue one of the following strategies. Keep in mind the principle of a futures contract: If a speculator buys a futures contract, they are locking in the price at which they must buy that currency on the specified future date. If a speculator sells a futures contract, they are locking in the price at which they must sell that currency on that future date.
Short Positions. If Amber McClain, a speculator working for International Currency Traders, believes that the Mexican peso will fall in value versus the U.S. dollar by March, she could sell a March futures contract, taking a short position. By selling a March contract, Amber locks in the right to sell 500,000 Mexican pesos at a set price. If the price of the peso falls by the maturity date as she expects, Amber has a contract to sell pesos at a price above their current price on the spot market. Hence, she makes a profit.
Using the quotes on Mexican peso (MXN) futures in Exhibit 8.1, Amber sells one March futures contract for 500,000 pesos at the closing price, termed the settle price, of $.10958/MXN. The value of her position at maturity—at the expiration of the futures contract in March—is then
Value at maturity (Short position) = -Notional principal * (Spot - Futures)
Note that the short position is entered into the valuation as a negative notional principal. If the spot exchange rate at maturity is $.09500/MXN, the value of her position on settlement is
Value = -MXN 500,000 * ($.09500/MXN - $.10958/MXN) = $7,290
Amber’s expectation proved correct; the Mexican peso fell in value versus the U.S. dollar. We could say that “Amber ends up buying at $.09500 and sells at $.10958 per peso.”
All that was really required of Amber to speculate on the Mexican peso’s value was that she formed an opinion on the Mexican peso’s future exchange value versus the U.S. dollar. In this case, she opined that it would fall in value by the March maturity date of the futures contract.
Long Positions. If Amber McClain expected the peso to rise in value versus the dollar in the near term, she could take a long position, by buying a March future on the Mexican peso. Buying a March future means that Amber is locking in the price at which she must buy Mexican pesos at the future’s maturity date. Amber’s futures contract at maturity would have the following value:
Value at maturity (Long position) = Notional principal * (Spot - Futures)
Again using the March settle price on Mexican peso futures in Exhibit 8.1, $.10958/MXN, if the spot exchange rate at maturity is $.1100/MXN, Amber has indeed guessed right. The value of her position on settlement is then
Value = MXN 500,000 * ($.11000/MXN - $.10958/MXN) = $210
219Foreign Currency Derivatives and Swaps CHAPTER 8
In this case, Amber makes a profit in a matter of months of $210 on the single futures contract. We could say that “Amber buys at $.10958 and sells at $.11000 per peso.”
But what happens if Amber’s expectation about the future value of the Mexican peso proves wrong? For example, if the Mexican government announces that the rate of inflation in Mexico has suddenly risen dramatically, and the peso falls to $.08000/MXN by the March maturity date, the value of Amber’s futures contract on settlement is
Value = MXN 500,000 * ($.08000/MXN - $.10958/MXN) = ($14,790)
In this case, Amber McClain suffers a speculative loss. Futures contracts could obviously be used in combinations to form a variety of
more complex positions. When we are combining contracts, however, valuation is fairly straightforward and additive in character.
Foreign Currency Futures Versus Forward Contracts 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.
Currency Options A foreign currency option is a contract that gives the option purchaser (the buyer) the right, but not the obligation, to buy or sell a given amount of foreign exchange at a fixed price per unit for a specified time period (until the maturity date). The most important phrase in this definition is “but not the obligation”; this means that the owner of an option possesses a valuable choice.
In many ways, buying an option is like buying a ticket to a benefit concert. The buyer has the right to attend the concert, but is not obliged to. The buyer of the concert ticket risks nothing more than what she pays for the ticket. Similarly, the buyer of an option cannot lose more than what he pays for the option. If the buyer of the ticket decides later not to attend the concert— prior to the day of the concert, the ticket can be sold to someone else who wishes to go.
! There are two basic types of options, calls and puts. A call is an option to buy foreign currency, and a put is an option to sell foreign currency.
! The buyer of an option is termed the holder, while the seller of an option is referred to as the writer or grantor.
Every option has three different price elements: 1) the exercise or strike price, the exchange rate at which the foreign currency can be purchased (call) or sold (put); 2) the premium, the cost, price, or value of the option itself; and 3) the underlying or actual spot exchange rate in the market.
An American option gives the buyer the right to exercise the option at any time between the date of writing and the expiration or maturity date. A European option can be exercised only on its expiration date, not before. Nevertheless, American and European options are priced almost the same because the option holder would normally sell the option itself before maturity. The option would then still have some “time value” above its “intrinsic value” if exercised (explained later in this chapter).
220 CHAPTER 8 Foreign Currency Derivatives and Swaps
! The premium or option price is the cost of the option, usually paid in advance by the buyer to the seller. In the over-the-counter market (options offered by banks), premiums are quoted as a percentage of the transaction amount. Premiums on exchange-traded options are quoted as a domestic currency amount per unit of foreign currency.
! An option whose exercise price is the same as the spot price of the underlying currency is said to be at-the-money (ATM). An option that would be profitable, excluding the cost of the premium, if exercised immediately is said to be in-the- money (ITM). An option that would not be profitable, again excluding the cost of the premium, if exercised immediately is referred to as out-of-the-money (OTM).
Foreign Currency Options Markets In the past three decades, the use of foreign currency options as a hedging tool and for speculative purposes has blossomed into a major foreign exchange activity. A number of banks in the United States and other capital markets offer flexible foreign currency options on transactions of $1 million or more. The bank market, or over-the-counter market as it is called, offers custom-tailored options on all major trading currencies for any period up to one year, and in some cases, two to three years.
The Philadelphia Stock Exchange introduced trading in standardized foreign currency option contracts in the United States in 1982. The Chicago Mercantile Exchange and other exchanges in the U.S. and abroad have followed suit. Exchange-traded contracts are particularly appealing to speculators and individuals who do not normally have access to the over-the-counter market. Banks also trade on the exchanges because it is one of several ways they can offset the risk of options they have transacted with clients or other banks.
Increased use of foreign currency options is a reflection of the explosive growth in the use of other kinds of options and the resultant improvements in option pricing models. The original option-pricing model developed by Black and Scholes in 1973 has been expanded, adapted, and commercialized in hundreds of forms since that time. One wonders if they truly appreciated what a monster they may have created!
Options on the Over-the-Counter Market. Over-the-counter (OTC) options are most frequently written by banks for U.S. dollars against British pounds sterling, Canadian dollars, Japanese yen, Swiss francs, and the euro.
The main advantage of over-the-counter options is that they are tailored to the specific needs of the firm. Financial institutions are willing to write or buy options that vary by amount (notional principal), strike price, and maturity. Although the over-the-counter markets were relatively illiquid in the early years, the market has grown to such proportions that liquidity is now quite good. On the other hand, the buyer must assess the writing bank’s ability to fulfill the option contract. Termed counterparty risk, the financial risk associated with the counterparty is an increasing issue in international markets as a result of the increasing use of financial contracts like options and swaps by MNE management. Exchange-traded options are more the territory of individuals and financial institutions themselves than of business firms.
If an investor wishes to purchase an option in the over-the-counter market, the investor will normally place a call to the currency option desk of a major money center bank, specify the currencies, maturity, strike rate(s), and ask for an indication—a bid-offer quote. The bank will normally take a few minutes to a few hours to price the option and return the call.
Options on Organized Exchanges. Options on the physical (underlying) currency are traded on a number of organized exchanges worldwide, including the Philadelphia Stock Exchange (PHLX) and the Chicago Mercantile Exchange. Exchange-traded options are settled through
221Foreign Currency Derivatives and Swaps CHAPTER 8
a clearinghouse, so that buyers do not deal directly with sellers. The clearinghouse is the counterparty to every option contract and it guarantees fulfillment. Clearinghouse obligations are in turn the obligation of all members of the exchange, including a large number of banks. In the case of the Philadelphia Stock Exchange, clearinghouse services are provided by the Options Clearing Corporation (OCC).
Currency Option Quotations and Prices Typical quotes in the Wall Street Journal for options on Swiss francs are shown in Exhibit 8.2. The Journal’s quotes refer to transactions completed on the Philadelphia Stock Exchange on the previous day. Quotations are available for more combinations of strike prices and expiration dates than were actually traded and thus reported in the newspaper. Currency option strike prices and premiums on the U.S. dollar are typically quoted as direct quotations on the U.S. dollar and indirect quotations on the foreign currency ($/SF, $/¥, etc.).
Exhibit 8.2 illustrates the three different prices that characterize any foreign currency option. The three prices that characterize an “August 58.5 call option” (highlighted in Exhibit 8.2) are the following:
1. Spot rate. In Exhibit 8.2, “Option and Underlying” means that 58.51 cents, or $0.5851, was the spot dollar price of one Swiss franc at the close of trading on the preceding day.
2. Exercise price. The exercise price, or “Strike price” listed in Exhibit 8.2, means the price per franc that must be paid if the option is exercised. The August call option on francs of 58.5 means $0.5850/SF. Exhibit 8.2 lists nine different strike prices, ranging from $0.5600/ SF to $0.6000/SF, although more were available on that date than are listed here.
3. Premium. The premium is the cost or price of the option. The price of the August 58.5 call option on Swiss francs was 0.50 U.S. cents per franc, or $0.0050/SF. There was no trading of the September and December 58.5 call on that day. The premium is the market value of the option, and therefore the terms premium, cost, price, and value are all interchangeable when referring to an option.
Calls—Last Puts—Last
Option and Underlying Strike Price Aug Sep Dec Aug Sep Dec
58.51 56.0 — — 2.76 0.04 0.22 1.16
58.51 56.5 — — — 0.06 0.30 —
58.51 57.0 1.13 — 1.74 0.10 0.38 1.27
58.51 57.5 0.75 — — 0.17 0.55 —
58.51 58.0 0.71 1.05 1.28 0.27 0.89 1.81
58.51 58.5 0.50 — — 0.50 0.99 —
58.51 59.0 0.30 0.66 1.21 0.90 1.36 —
58.51 59.5 0.15 0.40 — 2.32 — —
58.51 60.0 — 0.31 — 2.32 2.62 3.30
Each option = 62,500 Swiss francs. The August, September, and December listings are the option maturities or expiration dates.
EXHIBIT 8.2 Swiss Franc Option Quotations (U.S. cents/SF)
222 CHAPTER 8 Foreign Currency Derivatives and Swaps
The August 58.5 call option premium is 0.50 cents per franc, and in this case, the August 58.5 put’s premium is also 0.50 cents per franc. Since one option contract on the Philadelphia Stock Exchange consists of 62,500 francs, the total cost of one option contract for the call (or put in this case) is SF62,500 * $0.0050/SF = $312.50.
Buyer of a Call Options differ from all other types of financial instruments in the patterns of risk they produce. The option owner, the holder, has the choice of exercising the option or allowing it to expire unused. The owner will exercise it only when exercising is profitable, which means only when the option is in the money. In the case of a call option, as the spot price of the underlying currency moves up, the holder has the possibility of unlimited profit. On the down side, however, the holder can abandon the option and walk away with a loss never greater than the premium paid.
Hans Schmidt is a currency speculator in Zurich. The position of Hans as a buyer of a call is illustrated in Exhibit 8.3. Assume he purchases the August call option on Swiss francs described previously, the one with a strike price of 58.5 ($0.5850/SF), and a premium of $0.005/ SF. The vertical axis measures profit or loss for the option buyer at each of several different spot prices for the franc up to the time of maturity.
At all spot rates below the strike price of 58.5, Hans would choose not to exercise his option. This is obvious because at a spot rate of 58.0 for example, he would prefer to buy a Swiss franc for $.580 on the spot market rather than exercising his option to buy a franc at $0.585. If the spot rate remains below 58.0 until August when the option expired, Hans would not exercise the option. His total loss would be limited to only what he paid for the option, the $0.005/SF purchase price. At any lower price for the franc, his loss would similarly be limited to the original $0.005/SF cost.
EXHIBIT 8.3 Profit and Loss for the Buyer of a Call Option
Loss
Profit (U.S. cents/SF)
Limited Loss
Unlimited Profit
Break-even Price
“Out of the Money” “In the Money”
“At the Money” Strike Price
Spot Price (U.S. cents/SF)58.0 59.057.5 58.5 59.5
+1.00
+0.50
0
–1.00
–0.50
The buyer of a call option on SF, with a strike price of 58.5 cents/SF, has a limited loss of 0.50 cents/SF at spot rates less than 58.5 (“out of the money”), and an unlimited profit potential at spot rates above 58.5 cents/SF (“in the money”).
223Foreign Currency Derivatives and Swaps CHAPTER 8
Alternatively, at all spot rates above the strike price of 58.5, Hans would exercise the option, paying only the strike price for each Swiss franc. For example, if the spot rate were 59.5 cents per franc at maturity, he would exercise his call option, buying Swiss francs for $0.585 each instead of purchasing them on the spot market at $0.595 each. He could sell the Swiss francs immediately in the spot market for $0.595 each, pocketing a gross profit of $0.010/SF, or a net profit of $0.005/SF after deducting the original cost of the option of $0.005/SF. Hans’s profit, if the spot rate is greater than the strike price, with strike price $0.585, a premium of $0.005, and a spot rate of $0.595, is
Profit = Spot Rate - (Strike Price + Premium) = $0.595/SF - ($0.585/SF + $0.005/SF) = $0.005/SF
More likely, Hans would realize the profit through executing an offsetting contract on the options exchange rather than taking delivery of the currency. Because the dollar price of a franc could rise to an infinite level (off the upper right-hand side of Exhibit 8.3), maximum profit is unlimited. The buyer of a call option thus possesses an attractive combination of outcomes: limited loss and unlimited profit potential.
Note that break-even price of $0.590/SF is the price at which Hans neither gains nor loses on exercising the option. The premium cost of $0.005, combined with the cost of exercising the option of $0.585, is exactly equal to the proceeds from selling the francs in the spot market at $0.590. Note that he will still exercise the call option at the break-even price. This is because by exercising it he at least recoups the premium paid for the option. At any spot price above the exercise price but below the break-even price, the gross profit earned on exercising the option and selling the underlying currency covers part (but not all) of the premium cost.
Writer of a Call The position of the writer (seller) of the same call option is illustrated in Exhibit 8.4. If the option expires when the spot price of the underlying currency is below the exercise price of 58.5, the option holder does not exercise. What the holder loses, the writer gains. The writer keeps as profit the entire premium paid of $0.005/SF. Above the exercise price of 58.5, the writer of the call must deliver the underlying currency for $0.585/SF at a time when the value of the franc is above $0.585. If the writer wrote the option “naked,” that is, without owning the currency, that writer will now have to buy the currency at spot and take the loss. The amount of such a loss is unlimited and increases as the price of the underlying currency rises. Once again, what the holder gains, the writer loses, and vice versa. Even if the writer already owns the currency, the writer will experience an opportunity loss, surrendering against the option the same currency that could have been sold for more in the open market.
For example, the profit to the writer of a call option of strike price $0.585, premium $0.005, a spot rate of $0.595/SF is
Profit = Premium - (Spot Rate - Strike Price) = $0.005/SF - ($0.595/SF - $0.585/SF) = -$0.005/SF
but only if the spot rate is greater than or equal to the strike rate. At spot rates less than the strike price, the option will expire worthless and the writer of the call option will keep the premium earned. The maximum profit that the writer of the call option can make is limited to the premium. The writer of a call option would have a rather unattractive combination of potential outcomes: limited profit potential and unlimited loss potential, but there are ways to limit such losses through other offsetting techniques.
224 CHAPTER 8 Foreign Currency Derivatives and Swaps
Buyer of a Put Hans’s position as buyer of a put is illustrated in Exhibit 8.5. The basic terms of this put are similar to those we just used to illustrate a call. The buyer of a put option, however, wants to be able to sell the underlying currency at the exercise price when the market price of that currency drops (not rises as in the case of a call option). If the spot price of a franc drops to, say, $0.575/SF, Hans will deliver francs to the writer and receive $0.585/SF. The francs can now be purchased on the spot market for $0.575 each and the cost of the option was $0.005/ SF, so he will have a net gain of $0.005/SF.
Explicitly, the profit to the holder of a put option if the spot rate is less than the strike price, with a strike price $0.585/SF, premium of $0.005/SF, and a spot rate of $0.575/SF, is
Profit = Strike Price - (Spot Rate + Premium) = $0.585/SF - ($0.575/SF + $0.005/SF) = $0.005/SF
The break-even price for the put option is the strike price less the premium, or $0.580/ SF in this case. As the spot rate falls further and further below the strike price, the profit potential would continually increase, and Hans’s profit could be unlimited (up to a maxi- mum of $0.580/SF, when the price of a franc would be zero). At any exchange rate above the strike price of 58.5, Hans would not exercise the option, and so would lose only the $0.005/SF premium paid for the put option. The buyer of a put option has an almost unlimited profit potential with a limited loss potential. Like the buyer of a call, the buyer of a put can never lose more than the premium paid up front.
The writer of a call option on SF, with a strike price of 58.5 cents/SF, has a limited profit of 0.50 cents/SF at spot rates less than 58.5, and an unlimited loss potential at spot rates above (to the right of) 59.0 cents/SF.
Loss
Profit (U.S. cents/SF)
Limited Profit
Unlimited Loss
Break-even Price
“At the Money” Strike Price
Spot Price (U.S. cents/SF)
58.0 59.057.5 58.5 59.5
+1.00
+0.50
0
–1.00
–0.50
EXHIBIT 8.4 Profit and Loss for the Writer of a Call Option
225Foreign Currency Derivatives and Swaps CHAPTER 8
EXHIBIT 8.5 Profit and Loss for the Buyer of a Put Option
The buyer of a put option on SF, with a strike price of 58.5 cents/SF, has a limited loss of 0.50 cents/SF at spot rates greater than 58.5 (“out of the money”), and an unlimited profit potential at spot rates less than 58.5 cents/SF (“in the money”) up to 58.0 cents.
Loss
Profit (U.S. cents/SF)
Profit Up to 58.0
Limited Loss Break-even Price
“Out of the Money”“In the Money”
“At the Money” Strike Price
Spot Price (U.S. cents/SF)58.0 59.057.5 58.5 59.5
+1.00
+0.50
0
–1.00
–0.50
Writer of a Put The position of the writer who sold the put to Hans is shown in Exhibit 8.6. Note the sym- metry of profit/loss, strike price, and break-even prices between the buyer and the writer of the put. If the spot price of francs drops below 58.5 cents per franc, Hans will exercise the option. Below a price of 58.5 cents per franc, the writer will lose more than the premium received from writing the option ($0.005/SF), falling below break-even. Between $0.580/SF and $0.585/SF the writer will lose part, but not all, of the premium received. If the spot price is above $0.585/SF, Hans will not exercise the option, and the option writer will pocket the entire premium of $0.005/SF.
The profit (loss) earned by the writer of a $0.585 strike price put, premium $0.005, at a spot rate of $0.575, is
Profit (loss) = Premium - (Strike Price - Spot Rate) = $0.005/SF - ($0.585/SF - $0.575/SF) = -$0.005/SF
but only for spot rates that are less than or equal to the strike price. At spot rates greater than the strike price, the option expires out-of-the-money and the writer keeps the premium. The writer of the put option has the same basic combination of outcomes available to the writer of a call: limited profit potential and unlimited loss potential. Global Finance in Practice 8.1 describes one of the largest, and most successful, currency option speculations ever made—that by Andrew Krieger against the New Zealand kiwi.
226 CHAPTER 8 Foreign Currency Derivatives and Swaps
What has long been considered one of the most dramatic currency plays in history has moved back into the lime- light. New Zealand elected Mr. John Key as its new Prime Minister in November 2008. Key’s career has been a long and storied one, a large part of it involving speculation on foreign currencies. Strangely enough, Key had at one time worked with another currency speculator, Andrew Krieger, who is believed to have single-handedly caused the fall of the New Zealand dollar, the kiwi, in 1987.
Then, Andrew Krieger was a 31-year-old currency trader for Bankers Trust of New York (BT). Following the U.S. stock market crash in October 1987, the world’s currency markets moved rapidly to exit the dollar. Many of the world’s other currencies—including small ones which were in stable, open, industrialized markets like that of New Zealand—became the subject of interest. As the world’s currency traders dumped dollars and bought kiwis, the value of the kiwi rose rapidly.
Krieger believed that the markets were overreacting, and would overvalue the kiwi. So he took a short position
on the kiwi, betting on its eventual fall. And he did so in a big way, not limiting his positions to simple spot or for- ward market positions, but through currency options as well. (Krieger supposedly had approval for positions rising to nearly $700 million in size, while all other BT traders were restricted to $50 million.) Krieger, on behalf of BT, is purported to have shorted 200 million kiwi—more than the entire New Zealand money supply at the time. His view proved correct. The kiwi fell, and Krieger was able to earn millions in currency gains for BT. Ironically, only months later, Krieger resigned from BT when annual bonuses were announced and he reportedly earned only $3 million on the more than $300 million he had made for the bank.
Eventually, the New Zealand central bank lodged complaints with BT, in which the CEO at the time, Charles S. Sanford Jr., seemingly added insult to injury when he report- edly remarked “We didn’t take too big a position for Bank- ers Trust, but we may have taken too big a position for that market.”
GLOBAL FINANCE IN PRACTICE 8.1
The New Zealand Kiwi, Key, and Krieger
EXHIBIT 8.6 Profit and Loss for the Writer of a Put Option
The writer of a put option on SF, with a strike price of 58.5 cents/SF, has a limited profit of 0.50 cents/SF at spot rates greater than 58.5, and an unlimited loss potential at spot rates less than 58.5 cents/SF up to 58.0 cents.
Loss
Profit (U.S. cents/SF)
Unlimited Loss Up to 58.0
Limited Profit Break-even Price
“At the Money” Strike Price
Spot Price (U.S. cents/SF)58.0 59.057.5 58.5 59.5
+1.00
+0.50
0
–1.00
–0.50
227Foreign Currency Derivatives and Swaps CHAPTER 8
Option Pricing and Valuation Exhibit 8.7 illustrates the profit/loss profile of a European-style call option on British pounds. The call option allows the holder to buy British pounds at a strike price of $1.70/£. It has a 90-day maturity. The value of this call option is actually the sum of two components:
Total Value (premium) = Intrinsic Value + Time Value
The pricing of any currency option combines six elements. For example, this European style call option on British pounds has a premium of $0.033/£ (3.3 cents per pound) at a spot rate of $1.70/£. This premium is calculated using the following assumptions: a spot rate of $1.70/£, a 90-day maturity, a $1.70/£ forward rate, both U.S. dollar and British pound interest rates of 8.00% per annum, and an option volatility for the 90-day period of 10.00% per annum.
Intrinsic value is the financial gain if the option is exercised immediately. It is shown by the solid line in Exhibit 8.7, which is zero until it reaches the strike price, then rises linearly (1 cent for each 1-cent increase in the spot rate). Intrinsic value will be zero when the option is out-of-the- money—that is, when the strike price is above the market price—as no gain can be derived from exercising the option. When the spot rate rises above the strike price, the intrinsic value becomes positive because the option is always worth at least this value if exercised. On the date of maturity, an option will have a value equal to its intrinsic value (zero time remaining means zero time value).
! When the spot rate is $1.74/£, the option is in-the-money and has an intrinsic value of $1.74–$1.70/£, or 4 cents per pound.
! When the spot rate is $1.70/£, the option is at-the-money and has an intrinsic value of $1.70-$1.70/£, or zero cents per pound.
! When the spot rate is $1.66/£, the option is out-of-the-money and has no intrinsic value. This is shown by the intrinsic value lying on the horizontal axis. Only a fool would exercise this call option at this spot rate instead of buying pounds more cheaply on the spot market.
EXHIBIT 8.7 Option Intrinsic Value, Time Value, and Total Value
3.30
5.67
4.00
1.67
Total Value
Intrinsic Value
Time Value
Call Option on British Pounds with a Strike price of $1.70/£ Valuation on first day of 90-day maturity
Option Premium (U.S. cents/£)
Spot Rate ($/£) 1.66 1.67 1.68 1.69 1.70 1.71 1.72 1.73 1.74
0.0
1.0
2.0
3.0
4.0
5.0
6.0
228 CHAPTER 8 Foreign Currency Derivatives and Swaps
The time value of an option exists because the price of the underlying currency, the spot rate, can potentially move further and further into the money before the option’s expiration. Time value is shown in Exhibit 8.7 as the area between the total value of the option and its intrinsic value. An investor will pay something today for an out-of-the-money option (i.e., zero intrinsic value) on the chance that the spot rate will move far enough before maturity to move the option in-the-money. Consequently, the price of an option is always somewhat greater than its intrinsic value, since there is always some chance that the intrinsic value will rise between the present and the expiration date.
If currency options are to be used effectively, either for the purposes of speculation or risk management (covered in Chapters 10 and 11), the individual trader needs to know how option values—premiums—react to their various components. Exhibit 8.8 summarizes six basic sensitivities.
Although rarely noted, standard foreign currency options are priced around the for- ward rate because the current spot rate and both the domestic and foreign interest rates (home currency and foreign currency rates) are included in the option premium calcula- tion. Regardless of the specific strike rate chosen and priced, the forward rate is central to valuation. The option-pricing formula calculates a subjective probability distribution centered on the forward rate. This approach does not mean that the market expects the forward rate to be equal to the future spot rate, it is simply a result of the arbitrage-pricing structure of options.
The forward rate focus also provides helpful information for the trader managing a position. When the market prices a foreign currency option, it does so without any bull- ish or bearish sentiment on the direction of the foreign currency’s value relative to the domestic currency. If the trader has specific expectations about the future spot rate’s direction, those expectations can be put to work. A trader will not be inherently betting against the market.
Interest Rate Risk All firms—domestic or multinational, small or large, leveraged or unleveraged—are sensitive to interest rate movements in one way or another. Although a variety of interest rate risks exist in theory and industry, this book focuses on the financial management of the nonfinancial firm. Hence, our discussion is limited to the interest rate risks associated with the multinational firm. The interest rate risks of financial firms, such as banks, are not covered here.
Greek Definition Interpretation
Delta Expected change in the option premium for a small change in the spot rate
The higher the delta, the more likely the option will move in-the-money
Theta Expected change in the option premium for a small change in time to expiration
Premiums are relatively insensitive until the final 30 or so days
Lambda Expected change in the option premium for a small change in volatility
Premiums rise with increases in volatility
Rho Expected change in the option premium for a small change in the domestic interest rate
Increases in domestic interest rates cause increasing call option premiums
Phi Expected change in the option premium for a small change in the foreign interest rate
Increases in foreign interest rates cause decreasing call option premiums
EXHIBIT 8.8 Summary of Option Premium Components
229Foreign Currency Derivatives and Swaps CHAPTER 8
The single largest interest rate risk of the nonfinancial firm is debt service. The debt structure of the MNE will possess differing maturities of debt, different interest rate struc- tures (such as fixed versus floating-rate), and different currencies of denomination. Interest rates are currency-specific. Each currency has its own interest rate yield curve and credit spreads for borrowers. Therefore, the multicurrency dimension of interest rate risk for the MNE is a serious concern. As illustrated in Exhibit 8.9, even the interest rate calcu- lations vary on occasion across currencies and countries. Global Finance in Practice 8.2 provides additional evidence on the use of fixed versus floating-rate instruments in today’s marketplace.
The second most prevalent source of interest rate risk for the MNE lies in its holdings of interest-sensitive securities. Unlike debt, which is recorded on the right-hand side of the firm’s balance sheet, the marketable securities portfolio of the firm appears on the left-hand side. Marketable securities represent potential earnings or interest inflows to the firm. Ever- increasing competitive pressures have pushed financial managers to tighten their management of both the left and right sides of the firm’s balance sheet.
Credit Risk and Repricing Risk Prior to describing the management of the most common interest rate pricing risks, it is important to distinguish between credit risk and repricing risk. Credit risk, sometimes termed roll-over risk, is the possibility that a borrower’s creditworth, at the time of renewing a credit, 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.
Consider the following debt strategies being considered by a corporate borrower. Each is intended to provide $1 million in financing for a three-year period.
Strategy 1 : Borrow $1 million for three years at a fixed rate of interest. Strategy 2 : Borrow $1 million for three years at a floating rate, LIBOR + 2% to be
reset annually. Strategy 3 : Borrow $1 million for one year at a fixed rate, then renew the credit
annually.
EXHIBIT 8.9 International Interest Rate Calculations
International interest rate calculations differ by the number of days used in the period’s calculation and their definition of how many days there are in a year (for financial purposes). The following example highlights how the different methods result in different 1-month payments of interest on a $10 million loan, 5.500% per annum interest, for an exact period of 28 days.
$10 million @ 5.500% per annum
Practice Day Count in Period Days/Year Days Used Interest Payment
International Exact number of days 360 28 $42,777.78
British Exact number of days 365 28 $42,191.78
Swiss (Eurobond) Assumed 30 days/month 360 30 $45,833.33
230 CHAPTER 8 Foreign Currency Derivatives and Swaps
Although the lowest cost of funds is always a major selection criterion, it is not the only one. If the firm chooses strategy 1, it assures itself of the funding for the full three years at a known interest rate. It has maximized the predictability of cash flows for the debt obligation. What it has sacrificed, to some degree, is the ability to enjoy a lower interest rate in the event that interest rates fall over the period. Of course, it has also eliminated the risk that interest rates could rise over the period, increasing debt servicing costs.
Strategy 2 offers what strategy 1 did not, flexibility (repricing risk). It too assures the firm of full funding for the three-year period. This eliminates credit risk. Repricing risk is, however, alive and well in strategy 2. If LIBOR changes dramatically by the second or third year, the LIBOR rate change is passed through fully to the borrower. The spread, however, remains fixed (reflecting the credit standing that has been locked in for the full three years). Flexibility comes at a cost in this case, the risk that interest rates could go up as well as down.
Strategy 3 offers more flexibility and more risk. First, the firm is borrowing at the shorter end of the yield curve. If the yield curve is positively sloped, as is commonly the case in major industrial markets, the base interest rate should be lower. But the short end of the yield curve is also the more volatile. It responds to short-term events in a much more pronounced fashion than longer-term rates. The strategy also exposes the firm to the possibility that its credit rating may change dramatically by the time for credit renewal, for better or worse. Noting that credit ratings in general are established on the premise that a firm can meet its debt-service obliga- tions under worsening economic conditions, firms that are highly creditworthy (investment- rated grades) may view strategy 3 as a more relevant alternative than do firms of lower quality (speculative grades). This is not a strategy for financially weak firms.
The BIS Quarterly Review of March 2009 provides a detailed statistical breakdown of the types of international notes and bonds newly issued and outstanding, by issuer, by type of instrument, and by currency of denomination. The data provides some interesting insights into the international securities market.
! At the end of year 2008, there were $22.7 trillion outstanding in international notes and bonds issued by all types of institutions.
! The market continues to be dominated by issuances of financial institutions. The issuers by dollar value were as follows: financial institutions, $17.9 trillion or 79%; gov- ernments, $1.8 trillion or 8%; international organizations, $0.6 trillion or 3%; and corporate issuers, $2.4 trillion or 10% of the total outstanding.
! The instruments are still largely fixed-rate issuances, with 64% of all outstanding issuances being fixed-rate, 34% floating-rate, and roughly 2% equity-related.
! The euro continues to dominate international note and bond issuances, making up more than 48% of the total.
The euro is followed by the dollar, 36%, the pound ster- ling, 8%, the Japanese yen, 3%, and the Swiss franc, just under 2%.
The data continues to support two long-standing fundamental properties of the international debt markets.
! First, that the euro’s domination reflects the long-term use of the international security markets by the institutions in the countries constituting the euro—Western Europe.
! Second, that fixed-rate issuances are still the foundation of the market. Although floating-rate issuances did rise marginally in the 2003–2006 period, the international credit crisis of 2008–2009 and the response by central banks to push interest rates downward created new opportunities for the issuance of longer-term fixed-rate issuances by issuers of all kinds.
Source: Data drawn from Table 13B, BIS Quarterly Review, March 2009, p. 91, www.bis.org/statistics/secstats.htm.
GLOBAL FINANCE IN PRACTICE 8.2
A Fixed-Rate or Floating-Rate World?
231Foreign Currency Derivatives and Swaps CHAPTER 8
Although the previous example gives only a partial picture of the complexity of funding decisions within the firm, it demonstrates the many ways credit risks and repricing risks are inextricably intertwined. The expression interest rate exposure is a complex concept, and the proper measurement of the exposure prior to its management is critical. We now proceed to describe the interest rate risk of the most common form of corporate debt, floating-rate loans.
Interest Rate Derivatives Like foreign currency, interest rates have derivatives in the form of futures, forwards, and options. In addition, and likely of more importance, is the interest rate swap.
Interest Rate Futures Unlike foreign currency futures, interest rate futures are relatively widely used by financial managers and treasurers of nonfinancial companies. Their popularity stems from the relatively high liquidity of the interest rate futures markets, their simplicity in use, and the rather standardized interest rate exposures most firms possess. The two most widely used futures contracts are the Eurodollar futures traded on the Chicago Mercantile Exchange (CME) and the U.S. Treasury Bond Futures of the Chicago Board of Trade (CBOT). Interestingly, the third-largest volume of a traded futures contract in the latter 1990s was the U.S. dollar/Brazilian real currency futures contract traded on the Bolsa de Mercadorias y Futuros in Brazil.
To illustrate the use of futures for managing interest rate risks we will focus on the three- month Eurodollar futures contracts. Exhibit 8.10 presents Eurodollar futures for two years (they actually trade 10 years into the future).
The yield of a futures contract is calculated from the settlement price, which is the closing price for that trading day. For example, a financial manager examining the Eurodollar quotes in Exhibit 8.10 for a March 2011 contract would see that the settlement price on the previous day was 94.76, an annual yield of 5.24%:
Yield = (100.00 - 94.76) = 5.24%
Since each contract is for a three-month period (quarter) and a notional principal of $1 million, each basis point is actually worth $2,500 (.01 * $1,000,000 * 90/360).
EXHIBIT 8.10 Eurodollar Futures Prices
Maturity Open High Low Settle Yield Open Interest
June 10 94.99 95.01 94.98 95.01 4.99 455,763
Sept 94.87 94.97 94.87 94.96 5.04 535,932
Dec 94.60 94.70 94.60 94.68 5.32 367,036
Mar 11 94.67 94.77 94.66 94.76 5.24 299,993
June 94.55 94.68 94.54 94.63 5.37 208,949
Sept 94.43 94.54 94.43 94.53 5.47 168,961
Dec 94.27 94.38 94.27 94.36 5.64 130,824
Typical presentation by the Wall Street Journal. Only regular quarterly maturities shown. All contracts are for $1 million; points of 100%. Open interest is number of contracts outstanding.
232 CHAPTER 8 Foreign Currency Derivatives and Swaps
If a financial manager were interested in hedging a floating-rate interest payment due in March 2011, 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 short- ing 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 by making a lower floating-rate interest payment than she expected. So by selling the March 2011 futures contract, the manager will be locking in an interest rate of 5.24%.
Obviously, interest rate futures positions could be—and are on a regular basis—purchased purely for speculative purposes. Although that is not the focus of the managerial context here, the example shows how any speculator with a directional view on interest rates could take positions in expectations of profit.
As mentioned previously, the most common interest rate exposure of the nonfinancial firm is interest payable on debt. Such exposure is not, however, the only interest rate risk. As more and more firms aggressively manage their entire balance sheet, the interest earnings from the left-hand side are under increasing scrutiny. If financial managers are expected to earn higher interest on interest-bearing securities, they may well find a second use of the inter- est rate futures market: to lock in future interest earnings. Exhibit 8.11 provides an overview of these two basic interest rate exposures and the strategies needed to manage interest rate futures.
Forward Rate Agreements 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.
Like foreign currency forward contracts, FRAs are useful on individual exposures. They are contractual commitments of the firm that allow little flexibility to enjoy favorable
EXHIBIT 8.11 Interest Rate Futures Strategies for Common Exposures
Exposure or Position Futures Action Interest Rates Position Outcome
Paying interest on future date Sell a Futures (short position) If rates go up Futures price falls; short earns a profit
If rates go down Futures price rises; short earns a loss
Earning interest on future date Buy a Futures (long position) If rates go up Futures price falls; long earns a loss
If rates go down Futures price rises; long earns a profit
233Foreign Currency Derivatives and Swaps CHAPTER 8
movements, such as when LIBOR is falling as described in the previous section. Firms also use FRAs if they plan to invest in securities at future dates but fear that interest rates might fall prior to the investment date. Because of the limited maturities and currencies available, however, FRAs are not widely used outside the largest industrial economies and currencies.
Interest Rate Swaps Swaps are contractual agreements to exchange or swap a series of cash flows. These cash flows are most commonly the interest payments associated with debt service, such as the floating-rate loan described in the previous section.
! If the agreement is for one party to swap its fixed interest rate payment for the floating interest rate payments of another, it is termed an interest rate swap.
! If the agreement is to swap currencies of debt service obligation—for example, Swiss franc interest payments in exchange for U.S. dollar interest payments—it is termed a currency swap.
! A single swap may combine elements of both interest rate and currency swaps.
In any case, however, the swap serves to alter the firm’s cash flow obligations, as in changing floating-rate payments into fixed-rate payments associated with an existing debt obligation. The swap itself is not a source of capital, but rather an alteration of the cash flows associated with payment. What is often termed the plain vanilla swap is an agreement between two parties to exchange fixed-rate for floating-rate financial obligations. This type of swap forms the largest single financial derivative market in the world.
The two parties may have various motivations for entering into the agreement. For example, a very common position is as follows. A corporate borrower of good credit standing has existing floating-rate debt service payments. The borrower, after reviewing current market conditions and forming expectations about the future, may conclude that interest rates are about to rise. In order to protect the firm against rising debt-service payments, the company’s treasury may enter into a swap agreement to pay fixed/receive floating. This means the firm will now make fixed interest rate payments and receive from the swap counterparty floating interest rate payments. The floating-rate payments that the firm receives are used to service the debt obligation of the firm, so the firm, on a net basis, is now making fixed interest rate payments. Using derivatives it has synthetically changed floating-rate debt into fixed-rate debt. It has done so without going through the costs and intricacies of refinancing existing debt obligations.
Similarly, a firm with fixed-rate debt that expects interest rates to fall can change fixed- rate debt to floating-rate debt. In this case, the firm would enter into a pay floating/receive fixed interest rate swap. Exhibit 8.12 presents a summary table of the recommended interest rate swap strategies for firms holding either fixed-rate debt or floating-rate debt.
The cash flows of an interest rate swap are interest rates applied to a set amount of capital (notional principal). For this reason, they are also referred to as coupon swaps. Firms entering into interest rate swaps set the notional principal so that the cash flows resulting from the interest rate swap cover their interest rate management needs.
Interest rate swaps are contractual commitments between a firm and a swap dealer and are completely independent of the interest rate exposure of the firm. That is, the firm may enter into a swap for any reason it sees fit and then swap a notional principal that is less than, equal to, or even greater than the total position being managed. For example, a firm with a variety of floating-rate loans on its books may enter into interest rate swaps for only 70% of the existing principal, if it wishes. The reason for entering into a swap, and the swap position the firm enters into, is purely at management’s discretion. It should also be noted that the interest rate swap market is filling a gap in market efficiency. If all firms had free and equal
234 CHAPTER 8 Foreign Currency Derivatives and Swaps
access to capital markets, regardless of interest rate structure or currency of denomination, the swap market would most likely not exist. The fact that the swap market not only exists but also flourishes and provides benefits to all parties is in some ways the proverbial “free lunch.”
Currency Swaps Since all swap rates are derived from the yield curve in each major currency, the fixed-to- floating-rate interest rate swap existing in each currency allows firms to swap across currencies. Exhibit 8.13 lists typical swap rates for the euro, the U.S. dollar, the Japanese yen, and the Swiss franc. These swap rates are based on the government security yields in each of the individual currency markets, plus a credit spread applicable to investment grade borrowers in the respective markets.
Note that the swap rates in Exhibit 8.13 are not rated or categorized by credit ratings. This is because the swap market itself does not carry the credit risk associated with individual borrowers. Individual borrowers with obligations priced at LIBOR plus a spread will keep the spread. The fixed spread, a credit risk premium, is still borne by the firm itself. For example, lower-rated firms may pay spreads of 3% or 4% over LIBOR, while some of the world’s largest and most financially sound MNEs may actually raise capital at rates of LIBOR -0.40% The swap market does not differentiate the rate by the participant; all swap at fixed rates versus LIBOR in the respective currency.
The usual motivation for a currency swap is to replace cash flows scheduled in an undesired currency with flows in a desired currency. The desired currency is probably the currency in which the firm’s future operating revenues will be generated. Firms often raise capital in currencies in which they do not possess significant revenues or other natural cash flows. The reason they do so is cost; specific firms may find capital costs in specific currencies attractively priced to them under special conditions. Having raised the capital, however, the firm may wish to swap its repayment into a currency in which it has future operating revenues.
The utility of the currency swap market to an MNE is significant. An MNE wishing to swap a 10-year fixed 6.04% U.S. dollar cash flow stream could swap to 4.46% fixed in euro, 3.30% fixed in Swiss francs, or 2.07% fixed in Japanese yen. It could swap from fixed dollars not only to fixed rates, but also to floating LIBOR rates in the various currencies as well. All are possible at the rates quoted in Exhibit 8.13.
Prudence in Practice In the following chapters we will illustrate how derivatives can be used to reduce the risks associated with the conduct of multinational financial management. It is critical, however, that the user of any financial tool or technique—including financial derivatives—follow sound principles and practices. Many a firm has been ruined as a result of the misuse of derivatives. A word to the wise: Do not fall victim to what many refer to as the gambler’s dilemma— confusing luck with talent.
Position Expectation Interest Rate Swap Strategy
Fixed-Rate Debt Rates to go up Do nothing
Rates to go down Pay floating/Receive fixed
Floating-Rate Debt Rates to go up Pay fixed/Receive floating
Rates to go down Do nothing
EXHIBIT 8.12 Interest Rate Swap Strategies
235Foreign Currency Derivatives and Swaps CHAPTER 8
Major corporate financial disasters related to financial derivatives continue to be a problem in global business. As is the case with so many issues in modern society, technology is not at fault, rather human error in its use.
EXHIBIT 8.13 Interest Rate and Currency Swap Quotes
Euro-E Swiss franc U.S. dollar Japanese yen
Years Bid Ask Bid Ask Bid Ask Bid Ask
1 2.99 3.02 1.43 1.47 5.24 5.26 0.23 0.26
2 3.08 3.12 1.68 1.76 5.43 5.46 0.36 0.39
3 3.24 3.28 1.93 2.01 5.56 5.59 0.56 0.59
4 3.44 3.48 2.15 2.23 5.65 5.68 0.82 0.85
5 3.63 3.67 2.35 2.43 5.73 5.76 1.09 1.12
6 3.83 3.87 2.54 2.62 5.80 5.83 1.33 1.36
7 4.01 4.05 2.73 2.81 5.86 5.89 1.55 1.58
8 4.18 4.22 2.91 2.99 5.92 5.95 1.75 1.78
9 4.32 4.36 3.08 3.16 5.96 5.99 1.90 1.93
10 4.42 4.46 3.22 3.30 6.01 6.04 2.04 2.07
12 4.58 4.62 3.45 3.55 6.10 6.13 2.28 2.32
15 4.78 4.82 3.71 3.81 6.20 6.23 2.51 2.56
20 5.00 5.04 3.96 4.06 6.29 6.32 2.71 2.76
25 5.13 5.17 4.07 4.17 6.29 6.32 2.77 2.82
30 5.19 5.23 4.16 4.26 6.28 6.31 2.82 2.88
LIBOR 3.0313 3.0938 1.3125 1.4375 4.9375 5.0625 0.1250 0.2188
Typical presentation by the Financial Times. Bid and ask spreads as of close of London business. US$ is quoted against 3-month LIBOR; Japanese yen against 6-month LIBOR; Euro and Swiss franc against 6-month LIBOR.
SUMMARY POINTS
a specified amount of foreign exchange at a predeter- mined price on or before a specified maturity date.
! The use of a currency option as a speculative device for the buyer of an option arises from the fact that an option gains in value as the underlying currency rises (for calls) or falls (for puts). The amount of loss when the underlying currency moves opposite to the desired direction is limited to the option premium.
! The use of a currency option as a speculative device for the writer (seller) of an option arises from the option premium. If the option—either a put or call— expires out-of-the-money (valueless), the writer of the option has earned, and retains, the entire premium.
! Foreign currency futures contracts are standardized forward contracts. Unlike forward contracts, however, trading occurs on the floor of an organized exchange rather than between banks and customers. Futures also require collateral and are normally settled through the purchase of an offsetting position.
! Corporate financial managers typically prefer foreign currency forwards over futures out of simplicity of use and position maintenance. Financial speculators typically prefer foreign currency futures over forwards because of the liquidity of the futures markets.
! Foreign currency options are financial contracts that give the holder the right, but not the obligation, to buy (in the case of calls) or sell (in the case of puts)
236 CHAPTER 8 Foreign Currency Derivatives and Swaps
! Speculation is an attempt to profit by trading on expectations about prices in the future. In the foreign exchange market, one speculates by taking a position in a foreign currency and then closing that position afterwards; a profit results only if the rate moves in the direction that the speculator expected.
! Currency option valuation, the determination of the option’s premium, is a complex combination of the cur- rent spot rate, the specific strike rate, the forward rate (which itself is dependent on the current spot rate and interest differentials), currency volatility, and time to maturity.
! The total value of an option is the sum of its intrinsic value and time value. Intrinsic value depends on the relationship between the option’s strike price and the current spot rate at any single point in time, whereas time value estimates how intrinsic value may change— for the better—prior to maturity.
! The single largest interest rate risk of the nonfinancial firm is debt-service. The debt structure of the MNE will possess differing maturities of debt, different inter- est rate structures (such as fixed versus floating-rate), and different currencies of denomination.
! The increasing volatility of world interest rates, combined with the increasing use of short-term and variable-rate debt by firms worldwide, has led many firms to actively manage their interest rate risks.
! The primary sources of interest rate risk to a multi- national nonfinancial firm are short-term borrowing, short-term investing, and long-term debt service.
! The techniques and instruments used in interest rate risk management in many ways resemble those used in currency risk management. The primary instruments used for interest rate risk management include forward rate agreements (FRAs), forward swaps, interest rate futures, and interest rate swaps.
! The interest rate and currency swap markets allow firms that have limited access to specific currencies and interest rate structures to gain access at relatively low costs. This in turn allows these firms to manage their currency and interest rate risks more effectively.
! A cross-currency interest rate swap allows a firm to alter both the currency of denomination of cash flows in debt service, but also to alter the fixed-to-floating or floating-to-fixed interest rate structure.
McDonald’s Corporation has investments in more than 100 countries. It considers its equity investment in foreign affiliates capital which is at risk, subject to hedging depend- ing on the individual country, currency, and market.
British Subsidiary as an Exposure McDonald’s parent company has three different pound- denominated exposures arising from its ownership and operation of its British subsidiary.
1. The British subsidiary has equity capital, which is a pound-denominated asset of the parent company.
2. In addition to the equity capital invested in the British affiliate, the parent company provides intra-company debt in the form of a four-year £125 million loan. The loan is denominated in British pounds and carries a fixed 5.30% per annum interest payment.
3. The British subsidiary pays a fixed percentage of gross sales in royalties to the parent company. This too is pound-denominated. The three different exposures sum to a significant exposure problem for McDonald’s.
An additional technical detail further complicates the situation. When the parent company makes an intra- company loan as that to the British subsidiary, it must designate—according to U.S. accounting and tax law practices—whether the loan is considered to be perma- nently invested in that country. (Although on the surface it seems illogical to consider four years “permanent,” the loan itself could simply be continually rolled-over by the parent company and never actually be repaid.) If not con- sidered permanent, the foreign exchange gains and losses related to the loan flow directly to the parent company’s profit and loss statement (P&L), according to FAS # 52. If, however, the loan is designated as permanent, the foreign exchange gains and losses related to the intracompany loan would flow only to the CTA (cumulative translation adjust- ment) on the consolidated balance sheet. To date, McDon- ald’s has chosen to designate the loan as permanent. The functional currency of the British affiliate for consolidation purposes is the local currency, the British pound.
Anka Gopi is both the Manager for Financial Markets/ Treasury and a McDonald’s shareholder. She is currently
MINI-CASE McDonald’s Corporation’s British Pound Exposure
237Foreign Currency Derivatives and Swaps CHAPTER 8
the Financial Accounting Standards Board to delay FAS #133’s mandatory implementation date indefinitely.
Issues for Discussion Anka Gopi, however, still wishes to consider the impact of FAS #133 on the hedging strategy currently employed. Under FAS #133, the firm will have to mark-to-market the entire cross-currency swap position, including principal, and carry this to other comprehensive income (OCI). OCI, how- ever, is actually a form of income required under U.S. GAAP and reported in the footnotes to the financial statements, but not the income measure used in reported earnings per share. Although McDonald’s has been carrying the interest pay- ments on the swap to income, it has not previously had to carry the present value of the swap principal to OCI. In Anka Gopi’s eyes, this poses a substantial material risk to OCI.
Anka Gopi also wished to reconsider the current strategy. She began by listing the pros and cons of the current strategy, comparing these to alternative strategies, and then deciding what if anything should be done about it at this time.
Case Questions
1. How does the cross-currency swap effectively hedge the three primary exposures McDonald’s has relative to its British subsidiary?
2. How does the cross-currency swap hedge the long- term equity position in the foreign subsidiary?
3. Should Anka—and McDonald’s—worry about OCI?
reviewing the existing hedging strategy employed by McDonald’s against the pound exposure. The company has been hedging the pound exposure by entering into a cross-currency U.S. dollar/British pound sterling swap. The current swap is a seven-year swap to receive dol- lars and pay pounds. Like all cross-currency swaps, the agreement requires McDonald’s (U.S.) to make regular pound-denominated interest payments and a bullet prin- cipal repayment (notional principal) at the end of the swap agreement. McDonald’s considers the large notional prin- cipal payment a hedge against the equity investment in its British affiliate.
According to accounting practice, a company may elect to take the interest associated with a foreign currency-denominated loan and carry that directly to the parent company’s P&L This has been done in the past, and McDonald’s has benefited from the inclusion of this interest payment.
FAS #133, Accounting for Derivative Instruments and Hedging Activities, issued in June 1998, was originally intended to be effective for all fiscal quarters within fiscal years beginning after June 15, 1999 (for most firms this meant January 1, 2000). The new standard, however, was so complex and potentially of such material influence to U.S.-based MNEs, that the Financial Accounting Stan- dards Board has been approached by dozens of major firms and asked to postpone mandatory implementation. The standard’s complexity, combined with the workloads associated with Y2K (year 2000) risk controls, persuaded
QUESTIONS 1. Options Versus Futures. Explain the difference
between foreign currency options and futures and when either might be most appropriately used.
2. Trading Location for Futures. Check the Wall Street Journal to find where in the United States foreign exchange future contracts are traded.
3. Futures Terminology. Explain the meaning and prob- able significance for international business of the fol- lowing contract specifications: a. Specific-sized contract b. Standard method of stating exchange rates c. Standard maturity date d. Collateral and maintenance margins e. Counterparty
4. A Futures Trade. A newspaper shows the prices below for the previous day’s trading in U.S. dollar-euro currency futures. What do the terms shown indicate?
Month: December
Open: 0.9124
Settlement: 0.9136
Change: +0.0027
High: 0.9147
Low: 0.9098
Estimated volume 29,763
Open interest: 111,360
Contract size: €125,000
5. Puts and Calls. What is the basic difference between a put on British pounds sterling and a call on sterling?
6. Call Contract Elements. You read that exchange- traded American call options on pounds sterling hav- ing 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?
Foreign Currency Derivatives and Swaps CHAPTER 8 237
238 CHAPTER 8 Foreign Currency Derivatives and Swaps
7. The Option Cost. What happens to the premium you paid for the above option in the event you decide to let the option expire unexercised? What happens to this amount in the event you do decide to exercise the option?
8. Buying a European Option. You have the same infor- mation as in question 4, except that the pricing is for a European option. What is different?
9. 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?
10. Option Valuation. The value of an option is stated to be the sum of its intrinsic value and its time value. What is meant by these terms?
11. 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 mini- mize both.
12. Forward Rate Agreement. How can a business firm that has borrowed on a floating-rate basis use a for- ward rate agreement to reduce interest rate risk?
13. Eurodollar Futures. A newspaper reports that a given June Eurodollar futures settled at 93.55. What was the annual yield? How many dollars does this represent?
14. Defaulting on an Interest Rate Swap. Smith Company and Jones Company enter into an interest rate swap, with Smith paying fixed interest to Jones, and Jones paying floating interest to Smith. Smith now goes bank- rupt and so defaults on its remaining interest payments. What is the financial damage to Jones Company?
15. 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?
16. Counterparty Risk. How does exchange trading in swaps remove any risk that the counterparty in a swap agreement will not complete the agreement?
PROBLEMS 1. Amber McClain. Amber McClain, the currency spec-
ulator we met in the chapter, sells eight June futures contracts for 500,000 pesos at the closing price quoted in Exhibit 8.1. a. What is the value of her position at maturity if the
ending spot rate is $0.12000/Ps? b. What is the value of her position at maturity if the
ending spot rate is $0.09800/Ps? c. What is the value of her position at maturity if the
ending spot rate is $0.11000/Ps?
2. Peleh’s Puts. Peleh writes a put option on Japanese yen with a strike price of $0.008000/¥ (¥125.00/$) at a premium of 0.0080¢ per yen and with an expi- ration date six months from now. The option is for ¥12,500,000. What is Peleh’s profit or loss at matu- rity if the ending spot rates are ¥110/$, ¥115/$, ¥120/$, ¥125/$, ¥130/$, ¥135/$, and ¥140/$?
3. Ventosa Investments. Jamie Rodriguez, a currency trader for Chicago-based Ventosa Investments, uses the futures quotes (shown at the bottom of the page) on the British pound (£) to speculate on the value of the pound. a. If Jamie buys 5 June pound futures, and the spot
rate at maturity is $1.3980/£, what is the value of her position?
b. If Jamie sells 12 March pound futures, and the spot rate at maturity is $1.4560/£, what is the value of her position?
c. If Jamie buys 3 March pound futures, and the spot rate at maturity is $1.4560/£, what is the value of her position?
d. If Jamie sells 12 June pound futures, and the spot rate at maturity is $1.3980/£, what is the value of her position?
4. Sallie Schnudel. Sallie Schnudel trades currencies for Keystone Funds in Jakarta. She focuses nearly all of her time and attention on the U.S. dollar/ Singapore dollar ($/S$) cross-rate. The current spot rate is $0.6000/S$. After considerable study, she has concluded that the Singapore dollar will appreciate
Problem 3. British Pound Futures, US$/pound (CME) Contract = 62,500 pounds
Maturity Open High Low Settle Change High Open Interest
March 1.4246 1.4268 1.4214 1.4228 0.0032 1.4700 25,605
June 1.4164 1.4188 1.4146 1.4162 0.0030 1.4550 809
239Foreign Currency Derivatives and Swaps CHAPTER 8
versus the U.S. dollar in the coming 90 days, probably to about $0.7000/S$. She has the following options on the Singapore dollar to choose from:
Swiss-Eurobond definitions of interest (day count con- ventions). From which source should Chavez borrow?
8. Botany Bay Corporation. Botany Bay Corporation of Australia seeks to borrow US$30,000,000 in the Eurodollar market. Funding is needed for two years. Investigation leads to three possibilities. Compare the alternatives and make a recommendation. 1. Botany Bay could borrow the US$30,000,000 for
two years at a fixed 5% rate of interest. 2. Botany Bay could borrow the US$30,000,000 at
LIBOR + 1.5%. LIBOR is currently 3.5%, and the rate would be reset every six months.
3. Botany Bay could borrow the US$30,000,000 for one year only at 4.5%. At the end of the first year Botany Bay Corporation would have to negotiate for a new one-year loan.
9. Vatic Capital. Cachita Haynes works as a currency speculator for Vatic Capital of Los Angeles. Her latest speculative position is to profit from her expectation that the U.S. dollar will rise significantly against the Japanese yen. The current spot rate is ¥120.00/$. She must choose between the following 90-day options on the Japanese yen:
a. Should Sallie buy a put on Singapore dollars or a call on Singapore dollars?
b. What is Sallie’s break-even price on the option pur- chased in part (a)?
c. Using your answer from part (a), what is Sallie’s gross profit and net profit (including premium) if the spot rate at the end of 90 days is indeed $0.7000/S$?
d. Using your answer from part (a), what is Sallie’s gross profit and net profit (including premium) if the spot rate at the end of 90 days is $0.8000/S$?
5. Blade Capital (A). Christoph Hoffeman trades cur- rency for Blade Capital of Geneva. Christoph has $10 million to begin with, and he must state all profits at the end of any speculation in U.S. dollars. The spot rate on the euro is $1.3358/€, while the 30-day forward rate is $1.3350/€. a. If Christoph believes the euro will continue to rise
in value against the U.S. dollar, so that he expects the spot rate to be $1.3600/€ at the end of 30 days, what should he do?
b. If Christoph believes the euro will depreciate in value against the U.S. dollar, so that he expects the spot rate to be $1.2800/€ at the end of 30 days, what should he do?
6. Blade Capital (B). Christoph Hoffeman of Blade Capital now believes the Swiss franc will appreciate versus the U.S. dollar in the coming three-month period. He has $100,000 to invest. The current spot rate is $0.5820/SF, the three-month forward rate is $0.5640/SF, and he expects the spot rates to reach $0.6250/SF in three months. a. Calculate Christoph’s expected profit assuming a
pure spot market speculation strategy. b. Calculate Christoph’s expected profit assuming he
buys or sells SF three months forward.
7. Chavez S.A. Chavez S.A., a Venezuelan com- pany, wishes to borrow $8,000,000 for eight weeks. A rate of 6.250% per annum is quoted by potential lenders in New York, Great Britain, and Switzerland using, respectively, international, British, and the
Option Strike Price Premium
Put on Sing $ $0.6500/S$ $0.00003/S$
Call on Sing $ $0.6500/S$ $0.00046/S$
Option Strike Price Premium
Put on yen ¥125/$ $0.00003/S$
Call on yen ¥125/$ $0.00046/S$
a. Should Cachita buy a put on yen or a call on yen? b. What is Cachita’s break-even price on the option
purchased in part (a)? c. Using your answer from part (a), what is Cachita’s
gross profit and net profit (including premium) if the spot rate at the end of 90 days is ¥140/$?
10. Calling All Profits. Assume a call option on euros is written with a strike price of $1.2500/€ at a premium of 3.80¢ per euro ($0.0380/€) and with an expiration date three months from now. The option is for €100,000. Cal- culate your profit or loss should you exercise before matu- rity at a time when the euro is traded spot at the following:
a. $1.10/€ b. $1.15/€ c. $1.20/€ d. $1.25/€ e. $1.30/€ f. $1.35/€ g. $1.40/€
240 CHAPTER 8 Foreign Currency Derivatives and Swaps
11. Mystery at Baker Street. Arthur Doyle is a currency trader for Baker Street, a private investment house in London. Baker Street’s clients are a collection of wealthy private investors who, with a minimum stake of £250,000 each, wish to speculate on the movement of currencies. The investors expect annual returns in excess of 25%. Although residing in London, all accounts and expectations are based in U.S. dollars.
Arthur is convinced that the British pound will slide significantly—possibly to $1.3200/£—in the com- ing 30 to 60 days. The current spot rate is $1.4260/£. Arthur wishes to buy a put on pounds which will yield the 25% return expected by his investors. Which of the following put options would you recommend he pur- chase? Prove your choice is the preferable combination of strike price, maturity, and up-front premium expense.
d. Using your answer from part (a), what is Calandra’s gross profit and net profit (including premium) if the spot rate at the end of 90 days is $0.8250?
13. Raid Gauloises. Raid Gauloises is a rapidly growing French sporting goods and adventure racing outfitter. The company has decided to borrow €20,000,000 via a euro-euro floating-rate loan for four years. Raid must decide between two competing loan offers from two of its banks.
Banque de Paris has offered the four-year debt at euro@LIBOR + 2.00% with an up-front initiation fee of 1.8%. Banque de Sorbonne, however, has offered euro@LIBOR + 2.5% a higher spread, but with no loan initiation fees up front, for the same term and principal. Both banks reset the interest rate at the end of each year.
Euro-LIBOR is currently 4.00%. Raid’s econ- omist forecasts that LIBOR will rise by 0.5 per- centage points each year. Banque de Sorbonne, however, officially forecasts euro-LIBOR to begin trending upward at the rate of 0.25 percentage points per year. Raid Gauloises’s cost of capital is 11%. Which loan proposal do you recommend for Raid Gauloises?
14. Schifano Motors. Schifano Motors of Italy recently took out a four-year €5 million loan on a floating-rate basis. It is now worried, however, about rising interest costs. Although it had initially believed interest rates in the Euro-zone would be trending downward when taking out the loan, recent economic indicators show growing inflationary pressures. Analysts are predict- ing that the European Central Bank will slow mon- etary growth driving interest rates up.
Schifano is now considering whether to seek some protection against a rise in euro-LIBOR, and is consid- ering a forward rate agreement (FRA) with an insur- ance company. According to the agreement, Schifano would pay to the insurance company at the end of each year the difference between its initial interest cost at LIBOR + 2.50% (6.50%) and any fall in interest cost due to a fall in LIBOR. Conversely, the insurance company would pay to Schifano 70% of the differ- ence between Schifano’s initial interest cost and any increase in interest costs caused by a rise in LIBOR.
Purchase of the floating-rate agreement will cost €100,000, paid at the time of the initial loan. What are Schifano’s annual financing costs now if LIBOR rises and if LIBOR falls? Schifano uses 12% as its weighted average cost of capital. Do you recommend that Schi- fano purchase the FRA?
a. Should Calandra buy a put on Canadian dollars or a call on Canadian dollars?
b. What is Calandra’s break-even price on the option purchased in part (a)?
c. Using your answer from part (a), what is Calandra’s gross profit and net profit (including premium) if the spot rate at the end of 90 days is indeed $0.7600?
12. Contrarious Calandra. Calandra Panagakos works for CIBC Currency Funds in Toronto. Calandra is something of a contrarian—as opposed to most of the forecasts, she believes the Canadian dollar (C$) will appreciate versus the U.S. dollar over the coming 90 days. The current spot rate is $0.6750/C$. Calandra may choose between the following options on the Canadian dollar.
Strike Price Maturity Premium
$1.36/£ 30 days $0.00081/£
$1.34/£ 30 days $0.00021/£
$1.32/£ 30 days $0.00004/£
$1.36/£ 60 days $0.00333/£
$1.34/£ 60 days $0.00150/£
$1.32/£ 60 days $0.00060/£
Option Strike Price Premium
Put on C$ $0.7000 $0.00003/S$
Call on C$ $0.7000 $0.00049/S$
241Foreign Currency Derivatives and Swaps CHAPTER 8
15. Chrysler LLC. Chrysler LLC, the now privately held company sold off by DaimlerChrysler, must pay floating-rate interest three months from now. It wants to lock in these interest payments by buying an interest rate futures contract. Interest rate futures for three months from now settled at 93.07, for a yield of 6.93% per annum. a. If the floating-rate interest three months from now
is 6.00%, what did Chrysler gain or lose? b. If the floating-rate interest three months from now
is 8.00%, what did Chrysler gain or lose?
16. CB Solutions. Heather O’Reilly, the treasurer of CB Solutions, believes interest rates are going to rise, so she wants to swap her future floating-rate inter- est payments for fixed rates. Presently, she is paying LIBOR + 2% per annum on $5,000,000 of debt for the next two years, with payments due semiannually. LIBOR is currently 4.00% per annum. Heather has just made an interest payment today, so the next pay- ment is due six months from today.
company. They face the following rate structure. Llu- via, with the better credit rating, has lower borrowing costs in both types of borrowing.
Lluvia wants floating-rate debt, so it could bor- row at LIBOR + 1%. However, it could borrow fixed at 8% and swap for floating-rate debt. Paraguas wants fixed rate debt, so it could borrow fixed at 12%. How- ever, it could borrow floating at LIBOR + 2% and swap for fixed rate debt. What should they do?
18. Trident’s Cross-Currency Swap: SFr for US$. Trident Corporation entered into a three-year cross-currency interest rate swap to receive U.S. dollars and pay Swiss francs. Trident, however, decided to unwind the swap after one year—thereby having two years left on the settlement costs of unwinding the swap after one year. Use the following rates to create and than unwind the swap.
Assumptions Values
Notional principal $ 10,000,000
Original Spot exchange rate, SFr/$ 1.5000
New (1-year later) spot exchange rate, SFr./$
1.5560
New fixed US dollar interest 5.20%
New fixed Swiss franc interest 2.20%
Swap Rates 3-Year Bid 3-Year Ask
Original: US dollar 5.56% 5.59%
Original: Swiss franc 1.93% 2.01%
19. Trident’s Cross-Currency Swap: Yen for Euros. Use the table of swap rates in the chapter (Exhibit 8.13), and assume Trident enters into a swap agreement to receive euros and pay Japanese yen, on a notional principal of €5,000,000. The spot exchange rate at the time of the swap is ¥104/€. a. Calculate all principal and interest payments, in
both euros and Swiss francs, for the life of the swap agreement.
b. Assume that one year into the swap agreement Trident decides it wants to unwind the swap agreement and settle it in euros. Assuming that a two-year fixed rate of interest on the Japanese yen is now 0.80%, and a two-year fixed rate of interest on the euro is now 3.60%, and the spot rate of exchange is now ¥114/€, what is the net present value of the swap agreement? Who pays whom what?
Assumptions Values
Notional principal $ 10,000,000
Spot exchange rate, SFr/$ 1.5000
Spot exchange rate, $/euro 1.1200
Swap Rates 3-year Bid 3-year Ask
U.S. dollar 5.56% 5.59%
Swiss franc—SFr 1.93% 2.01%
Heather finds that she can swap her current floating-rate payments for fixed payments of 7.00% per annum. (CB Solution’s weighted average cost of capital is 12%, which Heather calculates to be 6% per six-month period, compounded semiannually). a. If LIBOR rises at the rate of 50 basis points per six-
month period, starting tomorrow, how much does Heather save or cost her company by making this swap?
b. If LIBOR falls at the rate of 25 basis points per six- month period, starting tomorrow, how much does Heather save or cost her company by making this swap?
17. Lluvia and Paraguas. Lluvia Manufacturing and Para- guas Products both seek funding at the lowest possible cost. Lluvia would prefer the flexibility of floating- rate borrowing, while Paraguas wants the security of fixed rate borrowing. Lluvia is the more creditworthy
242 CHAPTER 8 Foreign Currency Derivatives and Swaps
20. Falcor. Falcor is the U.S.-based automotive parts sup- plier that was spun-off from General Motors in 2000. With annual sales of over $26 billion, the company has expanded its markets far beyond traditional automobile manufacturers in the pursuit of a more diversified sales base. As part of the general diversification effort, the company wishes to diversify the currency of denomina- tion of its debt portfolio as well. Assume Falcor enters into a $50 million seven-year cross-currency interest rate swap to do just that—pay euros and receive dol- lars. Using the data in Exhibit 8.13, solve the following: a. Calculate all principal and interest payments in
both currencies for the life of the swap. b. Assume that three years later Falcor decides to
unwind the swap agreement. If four-year fixed rates of interest in euros have now risen to 5.35%, four-year fixed rate dollars have fallen to 4.40%, and the current spot exchange rate is $1.02/€, what is the net present value of the swap agreement? Who pays whom what?
Pricing Your Own Options An Excel workbook entitled FX Option Pricing is down- loadable from the book’s Web site. The workbook has five spreadsheets constructed for pricing currency options for the following five currency pairs: U.S. dollar/euro, U.S. dollar/ Japanese yen, euro/Japanese yen, U.S. dollar/ British pound, and euro/British pound. The dollar/euro pair is shown in the table at the top of the next page. Use the appropriate spreadsheet from the workbook to answer problems 21–25.
21. U.S. Dollar/Euro. The table above indicates that a one-year call option on euros at a strike rate of $1.25/€ will cost the buyer $0.0632/€, or 4.99%. But that assumed a volatility of 12.000% when the spot rate was $1.2674/€. What would that same call option cost if the volatility was reduced to 10.500% when the spot rate fell to $1.2480/€?
22. U.S. Dollar/Japanese Yen. What would be the pre- mium expense, in home currency, for a Japanese firm to purchase an option to sell 750,000 U.S. dollars, assuming the initial values listed in the FX Option Pricing workbook?
23. Euro/Japanese Yen. A French firm is expecting to receive JPY 10.4 million in 90 days as a result of an export sale to a Japanese semiconductor firm. What will it cost, in total, to purchase an option to sell the yen at €0.0072/JPY?
24. U.S. Dollar/British Pound. Assuming the same ini- tial values for the dollar/pound cross rate in the FX Option Pricing workbook, how much more would a call option on pounds be if the maturity was doubled from 90 to 180 days? What percentage increase is this for twice the length of maturity?
25. Euro/British Pound. How would the call option pre- mium change on the right to buy pounds with euros if the euro interest rate changed to 4.000% from the initial values listed in the FX Option Pricing workbook?
Pricing Currency Options on the Euro
A U.S.-based firm wishing to buy or sell euros (the foreign currency)
A European firm wishing to buy or sell dollars (the foreign currency)
Variable Value Variable Value
Spot rate (domestic/foreign) S0 $1.2480 S0 €0.8013
Strike rate (domestic/foreign) X $1.2500 X €0.8000
Domestic interest rate (%p.a.) rd 1.453% rd 2.187%
Foreign interest rate (%p.a.) rf 2.187% rf 1.453%
Time (years, 365 days) T 1.000 T 1.000
Days equivalent 365.00 365.00
Volatility (%p.a.) s 10.500% s 10.500%
Call option premium (per unt fc) c $0.0461 c €0.0366
Put option premium (per unit fc) (European pricing)
p $0.0570 p €0.0295
Call option premium (%) c 3.69% c 4.56%
Put option premium (%) p 4.57% p 3.68%
243Foreign Currency Derivatives and Swaps CHAPTER 8
INTERNET EXERCISES 1. Financial Derivatives and the ISDA. The Interna-
tional Swaps and Derivatives Association (ISDA) publishes a wealth of information about financial derivatives, their valuation and their use, in addition to providing master documents for their contractual use between parties. Use the following ISDA Internet site to find the definitions to 31 basic financial deriva- tive questions and terms:
ISDA www.isda.org/educat/faqs.html
2. Risk Management of Financial Derivatives. If you think this book is long, take a look at the freely down- loadable U.S. Comptroller of the Currency’s hand- book on risk management related to the care and use of financial derivatives!
Garman-Kohlhagen option formulation used widely in business and finance today.
Riskglossary.com www.riskglossary.com/link/ garman_kohlhagen_1983.htm
5. Chicago Mercantile Exchange. The Chicago Mercantile Exchange trades futures and options on a variety of cur- rencies, including the Brazilian real. Use the following site to evaluate the uses of these currency derivatives:
Chicago Mercantile Exchange www.cmegroup.com
6. Implied Currency Volatilities. The single unob- servable variable in currency option pricing is the volatility, since volatility inputs are the expected stan- dard deviation of the daily spot rate for the coming period of the option’s maturity. Use the New York Federal Reserve’s Web site to obtain current implied currency volatilities for major trading cross-rate pairs.
Federal Reserve Bank of New York
www.ny.frb.org/markets/ impliedvolatility.html
7. Montreal Exchange. The Montreal Exchange is a Canadian exchange devoted to the support of finan- cial derivatives in Canada. Use its Web site to view the latest on MV volatility—the volatility of the Montreal Exchange Index itself—in recent trading hours and days.
Montreal Exchange www.m-x.ca/marc_options_en.php
Comptroller of the Currency
www.occ.gov/publications/ publications-by-type/ comptrollers-handbook/deriv.pdf
3. Option Pricing. OzForex Foreign Exchange Services is a private firm with an enormously powerful foreign currency derivative-enabled Web site. Use the follow- ing site to evaluate the various “Greeks” related to currency option pricing.
OzForex www.ozforex.com.au/guides/currency-options
4. Garman-Kohlhagen Option Formulation. For those brave of heart and quantitatively adept, check out the following Internet site’s detailed presentation of the
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CHAPTER 9 Foreign Exchange Rate Determination and Forecasting
CHAPTER 10 Transaction Exposure
CHAPTER 11 Translation Exposure
CHAPTER 12 Operating Exposure
245
Foreign Exchange Exposure
PART II I
Foreign Exchange Rate Determination and Forecasting
The herd instinct among forecasters makes sheep look like independent thinkers.
—Edgar R. Fiedler.
What determines the exchange rate between currencies? This has proven to be a very dif- ficult question to answer. Companies and agents need foreign currency for buying imports, or may earn foreign currency by exporting. Investors, investing in interest-bearing instru- ments in foreign countries and currencies, fixed-income securities like bonds, shares in pub- licly traded companies, or other new types of hybrid instruments in foreign markets, all need foreign currency. Tourists, migrant workers, speculators on currency movements—all of these economic agents buy and sell and supply and demand currencies every day. This chapter offers some basic theoretical frameworks to try to organize these elements, forces, and principles.
Chapter 7 described the international parity conditions that integrate exchange rates with inflation and interest rates and provided a theoretical framework for both the global financial markets and the management of international financial business. Chapter 4 pro- vided a detailed analysis of how an individual country’s international economic activity, its balance of payments, can impact exchange rates. This chapter extends those discussions of exchange rate determination to the third school, the asset market approach.
Exhibit 9.1 provides an overview of the many determinants of exchange rates. This road map is first organized by the three major schools of thought (parity conditions, bal- ance of payments approach, asset market approach), and second by the individual drivers within those approaches. At first glance, the idea that there are three sets of theories may appear daunting, but it is important to remember that these are not competing theories, but rather complementary theories. Without the depth and breadth of the various approaches combined, our ability to capture the complexity of the global market for currencies is lost. The chapter concludes with the Mini-Case, The Japanese Yen Intervention of 2010, detailing Japan’s return to its guidance of market value.
In addition to gaining an understanding of the basic theories, it is equally important to gain a working knowledge of how the complexities of international political economy,
246
CHAPTER 9
247Foreign Exchange Rate Determination and Forecasting CHAPTER 9
societal and economic infrastructures, and random political, economic, or social events affect the exchange rate markets. Here are a few examples:
! Infrastructure weaknesses were among the major causes of the exchange rate col- lapses in emerging markets in the late 1990s. On the other hand, infrastructure strengths help explain why the U.S. dollar continued to be strong, at least until the September 11, 2001 terrorist attack on the United States, despite record balance of payments deficits on current account.
! Speculation contributed greatly to the emerging market crises. Some characteris- tics of speculation are hot money flowing into and out of currencies, securities, real estate, and commodities. Uncovered interest arbitrage caused by exceptionally low borrowing interest rates in Japan coupled with high real interest rates in the United States was a problem in much of the 1990s. Borrowing yen to invest in safe U.S. government securities, hoping that the exchange rate did not change, was popular.
! Cross-border foreign direct investment and international portfolio investment into the emerging markets dried up during the recent crises. This has proven to be a very serious issue both for MNEs from the industrialized countries operating in emerg- ing markets, and even more serious for the multinationals that call these emerging market countries home.
! Foreign political risks were much reduced in recent years as capital markets became less segmented from each other and more liquid. More countries adopted democratic forms of government. However, recent occurrences of terrorism within the U.S. may be changing perceptions of political risk.
Parity Conditions
1. Relative inflation rates 2. Relative interest rates 3. Forward exchange rates 4. Interest rate parity
Asset Approach
1. Relative real interest rates 2. Prospects for economic growth 3. Supply and demand for assets 4. Outlook for political stability 5. Speculation and liquidity 6. Political risks and controls
Is there a well-developed and liquid money and capital market in that currency?
Balance of Payments
1. Current account balances 2. Portfolio investment 3. Foreign direct investment 4. Exchange rate regimes 5. Official monetary reserves
Is there a sound and secure banking system in place to support currency trading activities?
Spot Exchange
Rate
EXHIBIT 9.1 The Determinants of Foreign Exchange Rates
248 CHAPTER 9 Foreign Exchange Rate Determination and Forecasting
Finally, note that most determinants of the spot exchange rate are also in turn affected by changes in the spot rate. In other words, they are not only linked but also mutually determined.
Exchange Rate Determination: The Theoretical Thread
Under the skin of an international economist lies a deep-seated belief in some variant of the PPP theory of the exchange rate.
—Paul Krugman, 1976.
There are basically three views of the exchange rate. The first takes the exchange rate as the relative price of monies (the monetary approach); the second, as the relative price of goods (the purchasing-power-parity approach); and the third, the relative price of bonds.
—Rudiger Dornbusch, “Exchange Rate Economics: Where Do We Stand?, Brookings Papers on Economic Activity 1, 1980, pp. 143–194.
Professor Dornbusch’s tripartite categorization of exchange rate theory is a good starting point, but in some ways not robust enough—in our humble opinion—to capture the multi- tude of theories and approaches. So, in the spirit of both tradition and completeness, we have amended Dornbusch’s three categories with several additional streams of thought in the fol- lowing discussion. The next section will provide a brief overview of the many different, but related, theories of exchange rate determination, and their relative usefulness in forecasting for business purposes.
Purchasing Power Parity Approaches The most widely accepted for all exchange rate determination theories, the theory of purchas- ing 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 7. PPP is both the oldest and most widely followed of the exchange rate theories, as most theories of exchange rate determination have PPP elements embedded within their frameworks.
There are a number of different versions of PPP, the Law of One Price, Absolute Purchas- ing Power Parity, and Relative Purchasing Power Parity (discussed in detail in Chapter 7). The latter of the three theories, Relative Purchasing Power Parity, is thought to be the most relevant to possibly explaining what drives exchange rate values. In essence, it states that changes in relative prices between countries drive the change in exchange rates over time.
If, for example, the current spot exchange rate between the Japanese yen and U.S. dollar was ¥90.0 = $1.00, and Japanese and U.S. prices were to change at 2% and 1% over the com- ing period, respectively, the spot exchange rate next period would be ¥90.89/$.
St+ 1 = St * 1 + ! in Japanese prices
1 + ! in U.S. prices = ¥90.00/$ * 1.02 1.01
= ¥90.89/$.
Although PPP seems to possess a core element of common sense, it has proven to be quite poor at forecasting exchange rates. 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 and economic growth. 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.
249Foreign Exchange Rate Determination and Forecasting CHAPTER 9
Balance of Payments (Flows) Approaches After purchasing power parity, 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 trans- actions recorded in a nation’s balance of payments, as described in Chapter 4. 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.
The balance of payments approach continues to enjoy a wide degree of appeal as the balance of payments transactions are one of the most frequently captured and reported of international economic activity. Trade surpluses and deficits, current account growth in service activity, and recently the growth and significance of international capital flows continue to fuel this theoretical fire.
Criticisms of the balance of payments approach arise from the theory’s emphasis on flows of currency and capital rather than stocks of money or financial assets. Relative stocks of money or financial assets play no role in exchange rate determination in this theory, a weak- ness explored in the following monetary and asset market approaches.
Curiously, the balance of payments approach is largely dismissed by the academic com- munity today, while the practitioner public—market participants including currency traders themselves—still rely on different variations of the theory for much of their decision making.
Monetary Approaches The monetary approach in its simplest form states that the exchange rate is determined by the supply and demand for national monetary stocks, as well as the expected future levels and rates of growth of monetary stocks. Other financial assets, such as bonds, are not considered relevant for exchange rate determination as both domestic and foreign bonds are viewed as perfect substitutes. It is all about money stocks.
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 affect. 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.
In monetary models of exchange rate determination, real economic activity is relegated to a role in which it only influences exchange rates through any alterations to the demand for money. The theory is also criticized on its omission of a number of factors which gener- ally are agreed 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.
Asset Market Approach (Relative Price of Bonds) 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.
Many of the macroeconomic theoretical developments in the 1980s and 1990s focused on how monetary and fiscal policy changes altered the relative perceptions of return and risk to the stocks of financial assets driving exchange rate changes. The frequently cited works of
250 CHAPTER 9 Foreign Exchange Rate Determination and Forecasting
Mundell-Fleming are in this genre. Theories of currency substitution, the ability of individual and commercial investors to alter the composition of their monetary holdings in their portfo- lios, follow the same basic premises of the portfolio balance and re-balance framework.
Unfortunately, for all of the good work and research over the past 50 years, the ability to forecast exchange rate values in the short term to long term is—in the words of the authors below—sorry. Although academics and practitioners alike agree that in the long-run funda- mental principles such as purchasing power and external balances drive currency values, none of the fundamental theories has proven that useful in the short to medium term.
. . . the case for macroeconomic determinants of exchange rates is in a sorry state [The] results indicate that no model based on such standard fundamentals like money supplies, real income, interest rates, inflation rates and current account balances will ever succeed in explaining or predicting a high percentage of the variation in the exchange rate, at least at short- or medium-term frequencies.
—Jeffrey A. Frankel and Andrew K. Rose, “A Survey of Empirical Research on Nominal Exchange Rates,” NBER Working Paper no. 4865, 1994.
Technical Analysis The forecasting inadequacies of fundamental theories has led to the growth and popularity of technical analysis, the belief that the study of past price behavior provides insights into future price movements. The primary feature of technical analysis is the assumption that exchange rates, or for that matter any market-driven price, follows trends. And those trends may be analyzed and projected to provide insights into short-term and medium-term price movements in the future.
Most theories of technical analysis differentiate fair value from market value. Fair value is the true long-term value that the price will eventually retain. The market value is subject to a multitude of changes and behaviors arising from widespread market participant perceptions and beliefs.
The Asset Market Approach to Forecasting The asset market approach assumes that whether foreigners are willing to hold claims in mon- etary form depends on an extensive set of investment considerations or drivers. These drivers, as previously depicted in Exhibit 9.1, include the following elements:
! 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 its 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 inves- tors. 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.
251Foreign Exchange Rate Determination and Forecasting CHAPTER 9
! The credibility of corporate governance practices is important to cross-border port- folio 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 coun- tries and other countries with 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.
! Speculation can either cause a foreign exchange crisis or make an existing crisis worse. We will observe this effect through the three illustrative cases that follow shortly.
Foreign investors are willing to hold securities and undertake foreign direct investment in highly developed countries based primarily on relative real interest rates and the outlook for economic growth and profitability. All the other drivers described in Exhibit 9.1 are assumed to be satisfied.
For example, during the 1981–1985 period, the U.S. dollar strengthened despite grow- ing current account deficits. This strength was due partly to relatively high real interest rates in the United States. Another factor, however, was the heavy inflow of foreign capital into the U.S. stock market and real estate, motivated by good long-run prospects for growth and profitability in the United States.
The same cycle was repeated in the United States in the period between 1990 and 2000. Despite continued worsening balances on current account, the U.S. dollar strengthened in both nominal and real terms due to foreign capital inflow motivated by rising stock and real estate prices, a low rate of inflation, high real interest returns, and a seemingly endless “irrational exuberance” about future economic prospects. This time the “bubble” burst following the September 11, 2001, terrorist attacks on the United States. The attack and its aftermath caused a negative reassessment of long-term growth and profitability prospects in the United States (as well as a newly formed level of political risk for the United States itself). This negative outlook was reinforced by a very sharp drop in the U.S. stock markets based on lower expected earnings. Further damage to the economy was caused by a series of revelations about failures in corporate governance of several large corporations (including overstatement of earnings, insider trading, and self-serving executives).
Loss of confidence in the U.S. economy led to a large withdrawal of foreign capital from U.S. security markets. As would be predicted by both the balance of payments and asset market approaches, the U.S. dollar depreciated. Indeed, its nominal rate depreciated by 18% between mid-January and mid-July 2002 relative to the euro alone.
The experience of the United States, as well as other highly developed countries, illus- trates why some forecasters believe that exchange rates are more heavily influenced by eco- nomic prospects than by the current account. One scholar summarizes this belief using an interesting anecdote.
Many economists reject the view that the short-term behavior of exchange rates is determined in flow markets. Exchange rates are asset prices traded in an efficient financial market. Indeed, an exchange rate is the relative price of two currencies and therefore is determined by the willingness to hold each currency. Like other asset prices, the exchange rate is determined by expectations about the future, not current trade flows.
A parallel with other asset prices may illustrate the approach. Let’s consider the stock price of a winery traded on the Bordeaux stock exchange. A frost in late spring results in a poor
252 CHAPTER 9 Foreign Exchange Rate Determination and Forecasting
harvest, in terms of both quantity and quality. After the harvest the wine is finally sold, and the income is much less than the previous year. On the day of the final sale there is no reason for the stock price to be influenced by this flow. First, the poor income has already been discounted for several months in the winery stock price. Second, the stock price is affected by future, in addition to current, prospects. The stock price is based on expectations of future earnings, and the major cause for a change in stock price is a revision of these expectations.
A similar reasoning applies to exchange rates: Contemporaneous international flows should have little effect on exchange rates to the extent they have already been expected. Only news about future economic prospects will affect exchange rates. Since economic expectations are potentially volatile and influenced by many variables, especially variables of a political nature, the short-run behavior of exchange rates is volatile.
—Bruno Solnik, International Investments, 3rd Edition, Reading, MA: Addison Wesley, 1996, p. 58. Reprinted with permission of Pearson Education, Inc.
The asset market approach to forecasting is also applicable to emerging markets. In this case, however, a number of additional variables contribute to exchange rate determination. These variables, as described previously, are illiquid capital markets, weak economic and social infrastructure, political instability, corporate governance, contagion effects, and specula- tion. These variables will be illustrated in the sections on crises that follow.
Currency Market Intervention
A fundamental problem with exchange rates is that no commonly accepted method exists to estimate the effectiveness of official intervention into foreign exchange markets. Many interrelated factors affect the exchange rate at any given time, and no quantitative model exists that is able to provide the magnitude of any causal relationship between intervention and an exchange rate when so many interdependent variables are acting simultaneously.
—“Japan’s Currency Intervention: Policy Issues,” Dick K. Nanto, CRS Report to Congress, July 13, 2007, CRS-7.
The value of a country’s currency is of significant interest to an individual government’s eco- nomic and political policies and objectives. Those interests sometimes extend beyond the individual country, but may actually reflect some form of collective country interest. Although many countries have moved from fixed exchange rate values long ago, the governments and central bank authorities of the multitude of floating rate currencies still privately and publicly profess what value their currency “should hold” in their eyes, regardless of whether the market for that currency agrees at that time. Foreign currency intervention, the active management, manipulation, or intervention in the market’s valuation of a country’s currency, is a component of currency valuation and forecast that cannot be overlooked.
Motivations for Intervention There is a long-standing saying that “what worries bankers is inflation, but what worries elected officials is unemployment.” The principle is actually quite useful in understanding the various motives for currency market intervention. Depending upon whether a country’s central bank is an independent institution (e.g., the U.S. Federal Reserve), or a subsidiary of its elected government (as the Bank of England was for many years), the bank’s policies may either fight inflation or fight slow economic growth.
253Foreign Exchange Rate Determination and Forecasting CHAPTER 9
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 several competitive devalua- tions over the years. It has not, however, fallen out of fashion. The Asian financial crisis of 1997 (discussed in detail in the following section), resulted in a number of countries devaluing their currency when they did not have to; they devalued their currencies intentionally to remain competitive with neighboring countries with competing export products. The slow economic growth and continuing employment problems in many countries in 2010 and 2011 led to some countries, the United States and the European Union being prime examples, working to hold their currency values down.
Alternatively, the fall in the value of the domestic currency will sharply reduce the pur- chasing 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. This was a partial outcome of the Argentine crisis of 1999 discussed in the following section, and a result of the multitude of devaluations which Presi- dent Hugo Chavez of Venezuela has directed over the past decade.
It is frequently noted that most countries would like to see stable exchange rates, to not get into the entanglements associated with manipulating currency values. Unfortunately, that would also imply that not only are they happy with the current level, but also that the level or rate of exchange is existing within a global economy which itself is not changing. One must look no further than the continuing highly public debate between the United States and China over the value of the yuan. The U.S. believes it is undervalued, making Chinese exports to the United States overly cheap, which in turn, results in a growing current account deficit of the United States and current account surplus of China.
The International Monetary Fund, as one of its basic principles (Article IV), encourages members to avoid pursuing “currency manipulation” to gain competitive advantages over other members. The IMF defines manipulation as “protracted large-scale intervention in one direction in the exchange market.”
Intervention Methods There are many ways in which an individual or collective set of governments and central banks can alter the value of their currencies. It should be noted, however, that the methods of market intervention used are very much determined by the size of the country’s economy, the magni- tude of global trading in its currency, and the depth and breadth of development in its domestic financial markets. A short list of the intervention methods would include the following:
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 cur- rency, the central bank would purchase its own currency using its foreign exchange reserves, at least to the acceptable limits of depleting its reserves that it could endure.
If the goal were to decrease the value of its currency—to fight an appreciation of its cur- rency’s value on the foreign exchange market—it would sell its own currency in exchange for foreign currency, typically major hard currencies like the dollar and euro. Although there are no physical limits to its ability to sell its own currency (it could theoretically continue to “print money” endlessly), central banks are cautious to the degree to which they may potentially change their monetary supplies through intervention.
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
254 CHAPTER 9 Foreign Exchange Rate Determination and Forecasting
bank, may find itself insufficient in resources to move the market. As one trader stated a number of years ago, “We at the bank found ourselves little more than a grain of sand on the beach of the market.” Global Finance in Practice 9.1 provides one suggested strategy for this lack of market-weight.
One solution to the market size challenge has been the occasional use of coordinated intervention, in which several major countries, or a collective such as the G8 of industrialized countries, agree that a specific currency’s value is out of alignment with their collective inter- ests. In that situation, they may work collectively, to intervene and push a currency’s value in a desired direction. The September 1985 Plaza Agreement, an agreement signed at the Plaza Hotel in New York City by the members of the Group of Ten, was one such coordinated intervention agreement. The members, collectively, had concluded that currency values had become too volatile or too extreme in movement for sound economic policy management. The problem with coordinated intervention is, of course, reaching agreement between nations. This has proven to be a major sticking point in the principle’s use.
Indirect Intervention. This is the alteration of economic or financial fundamentals which 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.
The most obvious and widely used factor here is interest rates. Following the financial principles outlined previously in parity conditions, higher real rates of interest attract capital. If a central bank wishes to “defend its currency” for example, it might follow a restrictive monetary policy, which would drive real rates of interest up. The method is therefore no longer limited to the quantity of foreign exchange reserves held by the country, but only by its willingness to suffer the domestic impacts of higher real interest rates in order to attract capital inflows and therefore drive up the demand for its currency.
Alternatively, a country wishing for its currency to fall in value, particularly when con- fronted with a continual appreciation of its value against major trading partner currencies, the central bank may work to lower real interest rates, reducing the returns to capital.
There are a number of factors, features, and tactics, according to many currency traders that determine the effectiveness of an intervention effort.
! Don’t Lean into the Wind. Markets that are moving signifi- cantly in one direction, like the strengthening of the Japa- nese yen in the fall of 2010, are very tough to turn. Termed “leaning into the wind,” intervention during a strong market movement will most likely result in a very expensive failure. Currency traders argue that central banks should time their intervention very carefully, choosing moments when trading volumes are light and direction nearly flat. Don’t lean into the wind, read it.
! Coordinate Timing and Activity. Use traders or asso- ciates in a variety of geographic markets and trading centers, possibly other central banks, if possible. The markets are much more likely to be influenced if they
believe the intervention activity is reflecting a grass-roots movement, and not the singular activity of a single trading entity or bank.
! Use Good News. Particularly when trying to quell a cur- rency fall, time the intervention to coincide with positive economic, financial, or business news closely associated with a country’s currency market. Traders often argue that ‘markets wish to celebrate good news,’ and curren- cies may be no different.
! Don’t Be Cheap. Overwhelm them. Traders fear missing the moment, and a large, coordinated, well-timed inter- vention can make them fear they are leaning in the wrong direction. A successful intervention is in many ways a bat- tle of psychology; play on their insecurities. If it appears the intervention is gradually having the desired impact, throw ever-increasing assets into the battle. Don’t get cheap.
GLOBAL FINANCE IN PRACTICE 9.1
Rules of Thumb for Effective Intervention
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Because indirect intervention uses tools of monetary policy, a fundamental dimension of economic policy, the magnitude and extent of impacts may reach far beyond currency value. Overly stimulating economic activity, or increasing money supply growth beyond real eco- nomic activity, may prove inflationary. The use of such broad-based tools like interest rates to manipulate currency values requires a determination of importance, in many cases the choice to pursue international economic goals at the expense of domestic economic policy goals.
It is also important to remember that intervention may fail. One very real example of intervention failure occurred in 1992 when the United Kingdom attempted to defend the value of the British pound against a rapidly rising Deutsche Mark. As a member of the Euro- pean Exchange Rate Mechanism (ERM) of the EMS of the time, the pound’s value against the Deutsche Mark had to be maintained within a narrow band. The Bank of England, after increasing key interest rates three times in six hours on one day, pulled the currency from the ERM. (A global currency speculator of significance at the time, George Soros, is reported to have made millions of dollars betting against the pound.) The United Kingdom was said to have suffered a “humiliating defeat,” although it was a currency war, not a military one.
Capital Controls. 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 often takes place only with official designees of the govern- ment or central bank, and only at dictated exchange rates.
Often, governments will limit access to foreign currencies to commercial trade: for exam- ple, allowing access to hard currency for the purchase of imports “of import” only. Access for investment purposes, particularly short-term portfolio purposes in which investors are investing in and out of interest-bearing accounts, purchasing or selling fixed income or equity securities or other funds, is often prohibited or limited. The Chinese regulation of access and trading of the Chinese yuan is a prime example over the use of capital controls over currency value. In addition to the government’s setting of 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 alone.
Understanding the motivations and methods for currency market intervention are critical to any analysis of the determination of future exchange rates. And although it is often impos- sible to determine, in the end, whether subtle intervention was successful, it appears to be an area of growing market activity, particularly for countries trying to “emerge” to higher levels of economic income and wealth.
Disequilibrium: Exchange Rates in Emerging Markets Although the three different schools of thought on exchange rate determination (parity condi- tions, balance of payments approach, and asset approach) described earlier make understand- ing exchange rates appear to be straightforward, that is rarely the case. The large and liquid capital and currency markets follow many of the principles outlined so far relatively well in the medium to long term. The smaller and less liquid markets, however, frequently demon- strate behaviors that seemingly contradict theory. The problem lies not in the theory, but in the relevance of the assumptions underlying the theory. An analysis of the emerging market crises illustrates a number of these seeming contradictions.
After a number of years of relative global economic tranquility, the second half of the 1990s was racked by a series of currency crises that shook all emerging markets. The devalu- ation of the Mexican peso in December 1994 was a harbinger. The Asian crisis of July 1997, the Russian ruble’s collapse in August 1998, and the fall of the Argentine peso in 2002 pro- vide a spectrum of emerging market economic failures, each with its own complex causes and
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unknown outlooks. These crises also illustrated the growing problem of capital flight and short-run international speculation in currency and securities markets. We will use each of the individual crises to focus on a specific dimension of the causes and consequences.
The Asian Crisis of 1997 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 cur- rencies. 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, how- ever, crisis was inevitable.
The most visible roots of the crisis were in the excesses of capital inflows into Thailand in 1996 and early 1997. With rapid economic growth and rising profits forming the backdrop, Thai firms, banks, and finance companies had ready access to capital on the international markets, finding U.S. dollar debt cheap offshore. Thai banks continued to raise capital internationally, extending credit to a variety of domestic investments and enterprises beyond what the Thai economy could support. As capital flows into the Thai market hit record rates, financial flows poured into investments of all kinds, including manufacturing, real estate, and even equity market margin-lending. As the investment “bubble” expanded, some participants raised ques- tions about the economy’s ability to repay the rising debt. The baht came under attack.
Currency Collapse. In May and June 1997, more and more rumors circulated throughout the globe’s currency traders that the Thai baht was weak, and that a number of major investors were now speculating on its fall. The Thai government and central bank quickly intervened in the foreign exchange markets directly (using up precious hard currency reserves) and indi- rectly (by raising interest rates to attempt to stop the continual outflow). Thai investment ground quickly to a halt. Foreign capital, which had flowed into Thailand freely in the months and years previous, stopped.
A second round of speculative attacks in late June and early July proved too much for the Thai authorities. On July 2, 1997, the Thai central bank finally allowed the baht to float (or sink in this case). The baht fell 17% against the U.S. dollar and more than 12% against the Japanese yen in a matter of hours. By November, the baht had fallen from THB25/USD to nearly THB40/USD, a fall of about 38%, as illustrated in Exhibit 9.2.
Within days, in Asia’s own version of what is called the tequila effect, a number of neigh- boring Asian nations, some with and some without similar characteristics to Thailand, came under speculative attack by currency traders and capital markets. (“Tequila effect” is the term used to describe how the Mexican peso crisis of December 1994 quickly spread to other Latin American currency and equity markets, a form of financial panic termed contagion.) The Philippine peso, the Malaysian ringgit, and the Indonesian rupiah all fell in the months following the July baht devaluation.
In late October 1997, Taiwan caught the markets off balance with a surprise competitive devaluation of 15%. The Taiwanese devaluation seemed only to renew the momentum of the crisis. Although the Hong Kong dollar survived (at great expense to the central bank’s foreign exchange reserves), the Korean won (KRW) was not so lucky. In November 1997, the histori- cally stable won also fell victim, falling from KRW900/USD to more than KRW1100. The only currency that had not fallen besides the Hong Kong dollar was the Chinese renminbi, which was not freely convertible. Although the renminbi was not devalued, there was rising specula- tion that the Chinese government would soon devalue it for competitive reasons. It did not.
257Foreign Exchange Rate Determination and Forecasting CHAPTER 9
Causal Complexities. The Asian economic crisis—for it was more than just a currency collapse—had many roots besides traditional balance of payments difficulties. The causes were different in each country, yet, there are specific underlying similarities, which allow comparison: corporate socialism, corporate governance, banking stability, and management.
Although Western markets have long known the volatility of the free market, the coun- tries of the post-World War II Asia have largely known only stability. Because of the influence of government and politics in the business arena, even in the event of failure, it was believed that government would not allow firms to fail, workers to lose their jobs, or banks to close. Practices that had persisted for decades without challenge, such as lifetime employment, were now no longer sustainable.
Little doubt exists that many local firms operating within the Far Eastern business envi- ronments were often largely controlled either by families or by groups related to the governing party or body of the country. This tendency has been labeled cronyism. Cronyism means that the interests of minority stockholders and creditors are often secondary at best to the primary motivations of corporate management. When management did not focus on “the bottom line,” the bottom line deteriorated.
The banking sector has fallen behind. Bank regulatory structures and markets have been deregulated nearly without exception across the globe. The central role played by banks in the conduct of business, however, had largely been ignored and underestimated. As firms across Asia collapsed, government coffers were emptied and speculative investments made by the banks themselves failed. Without banks, the “plumbing” of business conduct was shut down.
The Asian economic crisis had global impacts. What started as a currency crisis quickly became a region-wide recession. (The magnitude of economic devastation in Asia is still largely unappreciated by Westerners. At a 1998 conference sponsored by the Milken Institute,
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Thai baht officially floated on July 2, falling from THB25 to THB29 = USD1 in hours
Thai govt intervenes heavily in May and June to thwart rumors of the baht’s potential fall
As more Asian currencies fall in July and August the baht continues to fall under market pressure
The Asian crisis and fall of the Thai baht demonstrate how myopic the international markets can become, having ignored serious current account deficits in Thailand for years.
EXHIBIT 9.2 The Thai Baht and the Asian Crisis
258 CHAPTER 9 Foreign Exchange Rate Determination and Forecasting
a speaker noted that the world’s preoccupation with the economic problems of Indonesia was incomprehensible because “the total gross domestic product of Indonesia is roughly the size of North Carolina.” The following speaker observed, however, that the last time he had checked, “North Carolina did not have a population of 220 million people.”) The slowed economies of the region quickly caused major reductions in world demands for many products, especially commodities. World oil, metal, and agricultural products markets all saw severe price falls as demand fell. These price drops were immediately noticeable in declining earnings and growth prospects for other emerging economies. The problems of Russia in 1998 were reflections of those declines. In the aftermath, the international speculator and philanthropist George Soros was the object of much criticism, primarily by the Prime Minister of Malaysia, Dr. Mahathir Mohamad, for being the cause of the crisis because of massive speculation by his and other hedge funds. Soros, however, was likely only the messenger. Global Finance in Practice 9.2 details the Soros debate.
The Russian Crisis of 1998 The crisis of August 1998 was the culmination of a continuing deterioration in general eco- nomic conditions in Russia. During the period from 1995 to 1998, Russian borrowers—both governmental and nongovernmental—had borrowed heavily on the international capital mar- kets. Servicing this debt soon became a growing problem, as servicing dollar debt requires earn- ing dollars. The Russian current account, a surprisingly healthy surplus, was not finding its way into internal investment and external debt service. Capital flight accelerated, as hard-currency earnings flowed out as fast as they found their way in. Finally, in the spring of 1998, even
For Thailand to blame Mr Soros for its plight is rather like condemning an undertaker for burying a suicide.
—The Economist, August 2, 1997, p. 57.
In the weeks following the start of the Asian Crisis in July 1997, officials from a number of countries including Thailand and Malaysia blamed the international financier George Soros for causing the crisis. Particularly vocal was Prime Minister Datuk Seri Dr. Mahathir Mohamad of Malaysia, who repeat- edly implied that Soros had a political agenda associated with Burma’s prospective joining of the Association of Southeast Asian Nations (ASEAN). Mahathir noted in a number of pub- lic speeches that Soros might have had been out to make a political statement, and not just make money speculating against currency values. Mahathir argued that the poor people of Malaysia, Thailand, the Phillippines, and Indonesia would pay a great price for Soros’s attacks on Asian currencies.
George Soros is probably the most famous currency speculator—and possibly the most successful—in global history. Admittedly responsible for much of the European financial crisis of 1992 and the fall of the French franc in 1993, he once again was the recipient of critical attention in 1997 following the fall of the Thai baht and Malaysian ringgit.
Nine years later, in 2006, Mahathir and Soros met for the first time. Mahathir apologized and withdrew his previous accu- sations. In Soros’s book published in 1998, The Crisis of Global Capitalism: Open Society Endangered (pp. 208–209), Soros explained his role in the crisis as follows:
The financial crisis that originated in Thailand in 1997 was particularly unnerving because of its scope and severity. . . . By the beginning of 1997, it was clear to Soros Fund Management that the discrepancy between the trade account and the capital account was becoming untenable. We sold short the Thai baht and the Malaysian ringgit early in 1997 with maturities ranging from six months to a year. (That is, we entered into contracts to deliver at future dates Thai Baht and Malaysian ringgit that we did not currently hold.) Subsequently Prime Minister Mahathir of Malaysia accused me of causing the crisis, a wholly unfounded accu- sation. We were not sellers of the currency during or several months before the crisis; on the contrary, we were buyers when the currencies began to decline—we were purchas- ing ringgit to realize the profits on our earlier speculation. (Much too soon, as it turned out. We left most of the poten- tial gain on the table because we were afraid that Mahathir would impose capital controls. He did so, but much later.)
GLOBAL FINANCE IN PRACTICE 9.2
Was George Soros to Blame for the Asian Crisis?
259Foreign Exchange Rate Determination and Forecasting CHAPTER 9
Russian export earnings began to decline. Russian exports were predominantly commodity- based, and global commodity prices had been falling since the start of the Asian crisis in 1997.
The Russian currency, the ruble (RUB), operated under a managed float. This meant that the Central Bank of Russia allowed the ruble to trade within a band. The exchange rate band had been adjusted continually throughout 1996, 1997, and the first half of 1998. Theoretically, the Central Bank allowed the exchange rate and associated band to slide daily at a 1.5% per month rate. Automatically, the Central Bank announced an official exchange rate each day at which it was willing to buy and sell rubles, always within the official band. In the event that the ruble’s rate came under pressure at the limits of the band, the Central Bank intervened in the market by buying and selling rubles, usually buying, using the country’s foreign exchange reserves.
The August Collapse. On August 7, 1998, the Russian Central Bank announced that its cur- rency reserves had fallen by $800 million in the last week of July. Prime Minister Kiriyenko said that Russia would issue an additional $3 billion in foreign bonds to help pay its rising debt, a full $1 billion more than had been previously scheduled. The ruble, however, continued to trade within a very narrow range.
On August 10, Russian stocks fell more than 5% as investors feared a Chinese currency (renminbi) devaluation. The Chinese currency was the only Asian currency of size not deval- ued in 1997 and 1998. Devaluation would aid Chinese exports in cutting into Russian export sales. Analysts worldwide speculated that international markets were waiting to see if the Russian government would increase its tax revenues as it had promised the IMF throughout the year. Russian oil companies were publicly warned by the Russian government to pay past due taxes. (Russian tax collections averaged $1 billion per month in 1998, less than those of New York City.) By Wednesday of that week, Russian financing choices narrowed further as the government canceled the government debt auction for the third week in a row.
The following days saw a continuing series of press releases assuring the markets and general population that the government had everything under control. The government stated that the “panic” was psychological, not fiscal, and repeated, as it had in recent days, that it had money to meet its obligations through the fall of the year. The Russian Central Bank contin- ued to trade rubles throughout Friday at RUB6.30/USD, but at many unofficial exchanges throughout Moscow the rate was RUB7.00/USD or more. President Boris Yeltsin, in a speech in the ancient city of Novgorode, stated
“There will be no devaluation—that’s firm and definite.”
He went on to add,
“That would signify that there was a disaster and that everything was collapsing. On the contrary, everything is going as it should.”
“As it should” turned out to mean devaluation. On Monday, August 17, the floodgates were released. The Russian Central Bank announced that the ruble would be allowed to fall by 34% this year, from RUB6.30/USD to about RUB9.50. The government then announced a 90-day moratorium on all repayment of foreign debt, debt owed by Russian banks and all private borrowers, in order to avert a banking collapse. The currency’s fall continued into the following week, as illustrated in Exhibit 9.3. On Thursday, August 27, Acting Prime Minister Viktor Chernomyrdin traveled to the Ukraine to meet with the visiting head of the IMF, Michael Camdessus. A sense of urgency was felt after the ruble fell from RUB10.0/USD to RUB13.0 the previous day alone. In related matters, the Central Bank of Russia, in an attempt to defray criticism of its management of the ruble’s devaluation, disclosed that it had expended $8.8 billion in the preceding eight weeks defending the ruble’s value. On August 28, the Moscow currency exchange closed after 10 minutes of trading as the ruble continued to fall.
260 CHAPTER 9 Foreign Exchange Rate Determination and Forecasting
The Aftermath. It is hard to say when a crisis begins or ends, but for the Russian people and the Russian economy, the deterioration of the economic conditions continued. What is likely of more substantial concern is the toll the crisis has taken on Russian society. For many, the collapse of the ruble and the loss of Russia’s access to the international capital markets brought into question the benefits of a free-market economy, long championed by the advo- cates of Western-style democracy.
The Argentine Crisis of 2002
Now, most Argentines are blaming corrupt politicians and foreign devils for their ills. But few are looking inward, at mainstream societal concepts such as viveza criolla, an Argentine cultural quirk that applauds anyone sly enough to get away with a fast one. It is one reason behind massive tax evasion here: One of every three Argentines does so—and many like to brag about it.
—“Once-Haughty Nation’s Swagger Loses Its Currency,” Anthony Faiola, The Washington Post, March 13, 2002.
Argentina’s economic ups and downs have historically been tied to the health of the Argentine peso. South America’s southernmost resident—which oftentimes considered itself more Euro- pean than Latin American—had been wracked by hyperinflation, international indebtedness, and economic collapse in the 1980s. By early 1991, the people of Argentina had had enough. Economic reform in the early 1990s was a common goal of the Argentine people. They were not interested in quick fixes, but lasting change and a stable future. They nearly got it.
The Currency Board. In 1991, the Argentine peso had been fixed to the U.S. dollar at a one-to-one rate of exchange. The policy was a radical departure from traditional methods of fixing the rate of a currency’s value. Argentina adopted a currency board, a structure—rather
Russian rubles/U.S. dollar
0
5
10
15
20
25
30
8/4 /98
8/1 8/9
8 9/1
/98
9/1 5/9
8
9/2 9/9
8
10 /13
/98
10 /27
/98
11 /10
/98
11 /24
/98
12 /8/
98
12 /22
/98 1/5
/99
1/1 9/9
9 2/2
/99
2/1 6/9
9 3/2
/99
3/1 6/9
9
3/3 0/9
9
4/1 3/9
9
4/2 7/9
9
5/1 1/9
9
5/2 5/9
9 6/8
/99
6/2 2/9
9 7/6
/99
7/2 0/9
9
Govt announces the ruble will be allowed to fall marginally, but then cannot stop its continual decline throughout Aug and early Sept
Ruble’s value continues to deteriorate for months until settling at roughly RUB25 = USD1.00
After only eight years of a market economy, Russia’s accumulation of extreme levels of international debt and rapid rates of inflation combine to undermine the ruble and the Russian people’s purchasing power
Russia spends $8.8 billion defending the ruble the previous two months
EXHIBIT 9.3 The Fall of the Russian Ruble
261Foreign Exchange Rate Determination and Forecasting CHAPTER 9
than merely a commitment—to limiting the growth of money in the economy. Under a cur- rency board, the central bank may increase the money supply in the banking system only with increases in its holdings of hard currency reserves. The reserves were in this case U.S. dollars. By removing the ability of government to expand the rate of growth of the money supply, Argentina believed it was eliminating the source of inflation which had devastated its standard of living.
The idea was simple: limit the rate of growth in the country’s money supply to the rate at which the country receives net inflows of U.S. dollars as a result of trade growth and general surplus. It was both a recipe for conservative and prudent financial management, and a deci- sion to eliminate the power of politicians, elected and unelected, to exercise judgment both good and bad. It was an automatic and unbendable rule. And from the beginning, it had shown the costs and benefits of its rigor.
Although hyperinflation had indeed been the problem, the “cure” was a restrictive mon- etary policy which slowed economic growth. The first and foremost cost of the slower eco- nomic growth had been in unemployment. Beginning with a decade low unemployment rate in 1991, unemployment rose to double-digit levels in 1994 and stayed there. The real GDP growth rate, which opened the decade with booming levels over 10%, settled into recession in late 1998. GDP growth “shrank” in 1999 (-3.5%) and 2000 (-0.4%).
As part of the continuing governmental commitment to the currency board’s fixed exchange rate for the peso, Argentine banks allowed depositors to hold their money in either form—pesos or dollars. This was intended to provide a market-based discipline to the bank- ing and political systems, and to demonstrate the government’s unwavering commitment to maintaining the peso’s value parity with the dollar. Although intended to build confidence in the system, in the end it proved disastrous to the Argentine banking system.
Economic Crisis of 2001. The 1998 recession proved to be unending. Three-and-a-half years later, Argentina was still in recession. 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 which 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. 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. With the fall of the Brazilian real, however, Brazilian consumers could no longer afford Argentine exports. 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 not the Argentine peso.
The Currency Board and Monetary Policy. The increasingly sluggish economic growth in Argentina warranted expansionary economic policies argued many policy makers in and out of the country. But the currency board’s basic premise was that the money supply to the financial system could not be expanded any further or faster than the ability of the economy to capture dollar reserves. This eliminated monetary policy as an avenue for macroeconomic policy formulation, leaving only fiscal policy for economic stimulation.
262 CHAPTER 9 Foreign Exchange Rate Determination and Forecasting
Government spending was not slowing, however. As the unemployment rate grew higher, as poverty and social unrest grew, government—both in the civil center of Argentina, Buenos Aires, and in the outer provinces—was faced with growing expansionary spending needs to close the economic and social gaps. Government spending continued to increase, but tax receipts did not. Lower income led to lower taxes on income. Argentina turned to the inter- national markets to aid in the financing of its government’s deficit spending. The total foreign debt of the country began rising dramatically. Only a number of IMF capital injections pre- vented the total foreign debt of the country from skyrocketing. When the decade was over, however, total foreign debt had effectively doubled, and the economy’s earning power had not.
Social Repercussions. As economic conditions continued to deteriorate, banks suffered increasing runs. Depositors, fearing that the peso would be devalued, lined up to withdraw their money, both Argentine peso cash balances and U.S. dollar cash balances. Pesos were converted to dollars, once again adding fuel to the growing fire of currency collapse. The government, fearing that the increasing financial drain on banks would cause their collapse, closed the banks. Consumers, unable to withdraw more than $250 per week, were instructed to use debit cards and credit cards to make purchases and conduct the everyday transactions required by society.
Riots in the streets of Buenos Aires in December 2001 intensified the need for rapid change. As the new year of 2002 arrived, the second president in two weeks, Fernando de la Rua, was driven from office. He was succeeded by a Peronist, President Adolfo Rodriguez Saa, who lasted all of one week as president before he too was driven from office. President Saa did, however, leave his legacy. In his one week as President of Argentina, President Adolfo Rodriguez Saa declared the largest sovereign debt default in history. Argentina announced it would not be able to make interest payments due on $155 billion in government debt.
Devaluation. On Sunday, January 6, 2002, in the first act of his presidency, President Eduardo Duhalde devalued the peso from ARS1.00/USD to ARS1.40. But the economic pain contin- ued. Two weeks after the devaluation, the banks were still closed. Most of the state govern- ments outside of Buenos Aires, basically broke and without access to financing resources, began printing their own money—script—promissory notes of the provincial governments. The provincial governments were left with little choice as the economy of Argentina was nearing complete collapse as people and businesses could not obtain money to conduct the day-to-day commercial transactions of life.
On February 3, 2002, the Argentine government announced that the peso would be floated, as seen in Exhibit 9.4. The government would no longer attempt to fix or manage its value to any specific level, allowing the market to find or set the exchange rate. The value of the peso now began a slow but gradual depreciation.1 As the year wore on the country was confronted with issue after issue of social, political, and economic collapse.
A former Harvard professor and member of the U.S. President’s Council of Economic Advisors summed up the hard lessons of the Argentine story.2
In reality, the Argentines understood the risk that they were taking at least as well as the IMF staff did. Theirs was a calculated risk that might have produced good results. It is true, however, that the IMF staff did encourage Argentina to continue with the fixed exchange rate and currency board. Although the IMF and virtually all outside
1When a currency that is under a fixed exchange rate regime is officially altered in its value—downward—it is termed a devaluation. When a currency which is freely floated on exchange markets moves downward in value it is termed depreciation. 2“Argentina’s Fall,” Martin Feldstein, Foreign Affairs, March/April 2002.
263Foreign Exchange Rate Determination and Forecasting CHAPTER 9
economists believe that a floating exchange rate is preferable to a “fixed but adjustable” system, in which the government recognizes that it will have to devalue occasionally, the IMF (as well as some outside economists) came to believe that the currency board system of a firmly fixed exchange rate (a “hard peg” in the jargon of international finance) is a viable long-term policy for an economy. Argentina’s experience has proved that wrong.
Forecasting in Practice Numerous foreign exchange forecasting services exist, many of which are provided by banks and independent consultants. In addition, some multinational firms have their own in-house forecasting capabilities. Predictions can be based on elaborate econometric models, technical analysis of charts and trends, intuition, and a certain measure of gall.
Whether any of the forecasting services are worth their cost depends partly on our motive for forecasting as well as the required accuracy of the forecast. For example, 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 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 important as technical factors in the marketplace, government intervention, news, and passing whims of traders and investors. Accuracy of the forecast is critical, since most of the exchange rate changes are relatively small even though the day-to-day volatility may be high.
EXHIBIT 9.4
0.00
0.50
1.00
1.50
2.00
2.50
3.00
3.50
4.00
Argentine pesos/U.S. dollar
Roughly six months pass before stabilization
Currency Board fix ARS1.00 = USD1.00
Feb 3 the government officially announces the flotation of the peso
Jan 6 devaluation from 1.00/$ to 1.40/$ but banks closed, so no trading
11 /2
/0 1
11 /9
/0 1
11 /1
6/ 01
11 /2
3/ 01
11 /3
0/ 01
12 /7
/0 1
12 /1
4/ 01
12 /2
1/ 01
12 /2
8/ 01
1/ 4/
02 1/
11 /0
2 1/
18 /0
2 1/
25 /0
2 2/
1/ 02
2/ 8/
02 2/
15 /0
2 2/
22 /0
2 3/
1/ 02
3/ 8/
02 3/
15 /0
2 3/
22 /0
2 3/
29 /0
2 4/
5/ 02
4/ 12
/0 2
4/ 19
/0 2
4/ 26
/0 2
5/ 3/
02 5/
10 /0
2 5/
17 /0
2 5/
24 /0
2 5/
31 /0
2 6/
7/ 02
6/ 14
/0 2
6/ 21
/0 2
6/ 28
/0 2
7/ 5/
02 7/
12 /0
2 7/
19 /0
2 7/
26 /0
2
Argentina’s Currency Board was an extreme system designed to eliminate the ability of government to conduct independent monetary policy. It was the result of years of disastrous inflationary suffering from poor policy control.
The Collapse of the Argentine Peso
264 CHAPTER 9 Foreign Exchange Rate Determination and Forecasting
Forecasting services normally undertake fundamental economic analysis for long-term fore- casts, 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 depend 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 consistent, however, others will soon dis- cover it and the market will become efficient again with respect to that piece of information.
Exhibit 9.5 summarizes the various forecasting periods, regimes, and the authors’ suggested methodologies. Opinions, however, are subject to change without notice! (And remember, if authors could predict the movement of exchange rates with regularity, we surely wouldn’t write books.)
Technical Analysis 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
EXHIBIT 9.5 Exchange Rate Forecasting in Practice
Forecast Period Regime Recommended Forecast Methods
SHORT-RUN Fixed-Rate 1. Assume the fixed rate is maintained
2. Indications of stress on fixed rate?
3. Capital controls; black market rates
4. Indicators of government’s capability to maintain fixed-rate?
5. Changes in official foreign currency reserves
Floating-Rate 1. Technical methods which capture trend
2. Forward rates as forecasts
(a) 6 30 days, assume a random walk
(b) 30–90 days, forward rates
3. 90–360 days, combine trend with fundamental analysis
4. Fundamental analysis of inflationary concerns
5. Government declarations and agreements regarding exchange rate goals
6. Cooperative agreements with other countries
LONG-RUN Fixed-Rate 1. Fundamental analysis
2. BOP management
3. Ability to control domestic inflation
4. Ability to generate hard currency reserves to use for intervention
5. Ability to run trade surpluses
Floating-Rate 1. Focus on inflationary fundamentals and PPP
2. Indicators of general economic health such as economic growth and stability
3. Technical analysis of long-term trends; new research indicates possibility of long- term technical “waves”
265Foreign Exchange Rate Determination and Forecasting CHAPTER 9
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; 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.
The longer the time horizon of the forecast, the more inaccurate the forecast is likely to be. Whereas forecasting for the long run must depend on economic fundamentals of exchange rate determination, many of the forecast needs of the firm are short-to medium-term in their time horizon and can be addressed with less theoretical approaches. Time series techniques infer no theory or causality but simply predict future values from the recent past. Forecasters freely mix fundamental and technical analysis, presumably because forecasting is like playing
There are many different foreign exchange forecasting services and service providers. JPMorgan Chase (JPMC) is one of the most prestigious and widely used. A review of JPMC’s fore- casting accuracy for the U.S. dollar/euro spot exchange rate ($/€) for the 2002 to 2005 period, in 90-day increments, is presented in the exhibit. The graph shows the actual spot exchange rate for the period and JPMC’s forecast for the spot exchange rate for the same period.
There is good news and there is bad news. The good news is that JPMC hit the actual spot rate dead-on in both May and November 2002. The bad news is that after that, they missed. Somewhat worrisome is when the forecast got the
direction wrong. For example, in February 2004, JPMC had forecast the spot rate to move from the current rate of $1.27/€ to $1.32/€, but in fact, the dollar had appreciated dramatically in the following three-month period to close at $1.19/€. This was in fact a massive difference. Again, in November 2004, JPMC had forecast the spot rate to move from the current spot rate of $1.30/€ to $1.23/€, but in fact, the actual spot rate proved to be $1.32/€. The lesson learned is probably that regardless of how professional and prestigious a forecaster may be, and how accurate they may have been in the past, forecasting the future–by anyone for anything–is challenging to say the least.
GLOBAL FINANCE IN PRACTICE 9.3
JPMorgan Chase Forecast of the Dollar/Euro
* This analysis uses exchange rate data as published in the print edition of The Economist, appearing quarterly. The source of the exchange rate forecasts, as noted in The Economist, is JPMorgan Chase.
2/1 4/0
2 5/1
6/0 2
8/0 8/0
2 11
/07 /02
2/1 3/0
3 5/1
5/0 3
8/1 4/0
3 11
/13 /03
2/1 2/0
4 5/1
3/0 4
8/1 9/0
4 11
/20 /04
3/0 1/0
5 5/2
4/0 5
$1.40
$1.30
$1.20
$1.10
$1.00
$0.90
$0.80
1.38
1.26
1.32 1.30
1.23 1.23
1.23
1.191.19
1.27
1.32
1.22 1.21
1.16 1.17
1.13 1.15
1.07
1.02 1.011.000.98
0.91 0.90
0.87
Actual Spot Rate
JPMC’s forecast of the spot rate 90 days into the future
266 CHAPTER 9 Foreign Exchange Rate Determination and Forecasting
horseshoes—getting close counts. Global Finance in Practice 9.3 provides a short analysis of how accurate one very prestigious currency forecaster was over a three-year period.
Cross-Rate Consistency in Forecasting 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 part of preparing multicountry 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.
Forecasting: What to Think? Obviously, with the variety of theories and practices, forecasting exchange rates into the future is a daunting task. Here is a synthesis of our thoughts and experience:
! It appears from decades of theoretical and empirical studies that exchange rates do adhere to the fundamental principles and theories outlined in the previous sections. Fundamentals do apply in the long term. There is, therefore, something of a funda- mental 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 also to occur with some regularity and relative longevity.
Exhibit 9.6 illustrates this synthesis of forecasting thought. The long-term equilibrium path of the currency—although relatively well-defined in retrospect—is not always apparent in the short term. The exchange rate itself may deviate in something of a cycle or wave about the long-term path.
If market participants both agree on the general long-term path and possess stabilizing expectations, the currency’s value will periodically return to the long-term path. It is critical, however, that when the currency’s value rises above the long-term path, most market par- ticipants see it as being overvalued and respond by selling the currency—causing its price to fall. Similarly, when the currency’s value falls below the long-term path, market participants respond by buying the currency driving its value up. This is what is meant by stabilizing expec- tations: Market participants continually respond to deviations from the long-term path by buying or selling to drive the currency back to the long-term path.
If, for some reason, the market becomes unstable, as illustrated by the dotted deviation path in Exhibit 9.6, the exchange rate may move significantly away from the long-term path for longer periods of time. Causes of these destabilizing markets, weak infrastructure (such as the banking system), and political or social events that dictate economic behaviors, are often the actions of speculators and inefficient markets.
Exchange Rate Dynamics: Making Sense of Market Movements Although the various theories surrounding exchange rate determination are clear and sound, it may appear on a day-to-day basis that the currency markets do not pay much attention to the theories, they don’t read the books! The difficulty is understanding which fundamentals are driving markets at which points in time.
One example of this relative confusion over exchange rate dynamics is the phenomenon known as overshooting. Assume that the current spot rate between the dollar and the euro,
267Foreign Exchange Rate Determination and Forecasting CHAPTER 9
Foreign currency per unit of domestic currency Technical or random
events may drive the exchange rate from the long-term path Fundamentalequilibrium
path
Time
Short-term forces may induce noise — short-term volatility around the long-term path
EXHIBIT 9.6 Short-Term Noise Versus Long-Term Trends
If the U.S. Federal Reserve were to announce a change in monetary policy, an expansion in money supply growth, it could potentially result in an “overshooting” exchange rate change.
The Fed announces a monetary expansion at a time t1. This results immediately in lower dollar interest rates. The foreign exchange markets immediately respond to the lower dollar interest rates by driving the value of the dollar down from S0 to S1. This new rate is based on interest differentials. However, in the coming days and weeks, as the fundamental price effects of the monetary policy actions work their way through the economy, purchasing power parity takes hold and the market moves toward a longer-term valuation of the dollar—by time t2—of S2, a weaker dollar than S0, but not as weak as initially set at S1.
Spot Exchange Rate, $/
Overshooting
Time
S0
S1
S2
t1 t2
EXHIBIT 9.7 Exchange Rate Dynamics: Overshooting
268 CHAPTER 9 Foreign Exchange Rate Determination and Forecasting
as illustrated in Exhibit 9.7, is S0. The U.S. Federal Reserve announces an expansionary monetary policy which cuts U.S. dollar interest rates. If euro- denominated interest rates remain unchanged, the new spot rate expected by the exchange markets based on interest differentials is S1. This immedi- ate change in the exchange rate is typical of how the markets react to news, distinct economic and political events which are observable. The immedi- ate 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 dif- ferent 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.
This is of course only one possible series of events and market reactions. Currency markets are subject to new news every hour of every day, making it very difficult to forecast exchange rate movements in short periods of time. In the longer term, as shown here, the markets do customarily return to funda- mentals of exchange rate determination.
SUMMARY POINTS
! The asset approach to forecasting suggests that whether foreigners are willing to hold claims in monetary form depends partly on relative real interest rates and partly on a country’s outlook for economic growth and profitability.
! Longer-term forecasting, over one year, requires a return to the basic analysis of exchange rate fundamentals such as BOP, relative inflation rates, relative interest rates, and the long-run properties of purchasing power parity.
! Technical analysts (chartists) focus on price and volume data to determine past trends that are expected to con- tinue into the future.
! The Asian currency crisis was primarily a balance of payments crisis in its origins and impacts on exchange rate determination. A weak economic and financial infrastructure, corporate governance problems and speculation were also contributing factors.
! The Russian ruble crisis of 1998 was a complex combi- nation of speculative pressures best explained by the asset approach to exchange rate determination.
! The Argentine crisis of 2002 was probably a combina- tion of a disequilibrium in international parity condi- tions (differential rates of inflation) and balance of payments disequilibrium (current account deficits com- bined with financial account outflows).
! In the long term, it does appear that exchange rates follow a fundamental equilibrium path, one consis- tent with the fundamental theories of exchange rate determination.
! In the short term, a variety of random events, institu- tional frictions, and technical factors may cause currency values to deviate significantly from their long-term fun- damental path.
269Foreign Exchange Rate Determination and Forecasting CHAPTER 9
MINI-CASE The Japanese Yen Intervention of 20101
1Copyright © 2011 Thunderbird School of Global Management. All rights reserved. This case was prepared by Professor Michael Moffett for the purpose of classroom discussion only, and not to indicate effective or ineffective management. This Mini-Case draws from a number of sources including “Japan’s Currency Intervention: Policy Issues,” Dick K. Nanto, CRS Report for Congress, July 13, 2007; IMF Country Report No. 05/273, Japan: 2005 Article IV Consultation Staff Report, August 2005; “Interventions and the Japa- nese Economic Recovery,” Takatoshi Ito, paper presented at the University of Michigan Conference on Policy Options for Japan and the United States, October 2004; “Towards a New Era of Currency Intervention,” Mansoor Mohi-Uddin, Financial Times, September 22, 2010; “Currency Intervention’s Mixed Record of Success,” Russell Hotten, BBC News, September 16, 2010.
We will take decisive steps if necessary, including inter- vention, while continuing to closely watch currency mar- ket moves from now on.
—Yoshihiko Noda, Finance Minister of Japan, September 13, 2010.
Japan has been the subject of continued criticism for nearly two decades over its frequent intervention in the foreign exchange markets. Trading partners have accused it of mar- ket manipulation, while Japan has argued that it is a coun- try and economy which is inherently global in its economic structure, relying on its international competitiveness for its livelihood, and currency stability is its only desire.
The debate was renewed in September 2010 when Japan intervened in the foreign exchange markets for the first time in nearly six years. Japan reportedly bought nearly 20 billion U.S. dollars in exchange for Japanese yen in an attempt to
stop the continuing appreciation of the yen. Finance Min- istry officials had stated publicly that 82 yen per dollar was probably the limit of their tolerance for yen appreciation.
As illustrated in Exhibit 1, the Bank of Japan intervened on September 13 as the yen approached 82 yen per dollar. (The Bank of Japan is independent in its ability to conduct Japanese monetary policy, but as the organizational subsidiary of the Japanese Ministry of Finance, it must conduct foreign exchange operations on behalf of the Japanese government.) Japanese officials reportedly notified authorities in both the United States and the European Union of their activity, but noted that they had not asked for permission or support.
The intervention resulted in public outcry from Bei- jing to Washington to London over the “new era of cur- rency intervention.” Although market intervention is always looked down upon by free market proponents, the move by Japan was seen as particularly frustrating as it
Japanese yen/U.S. dollar (¥/$)—Daily
80
82
84
86
88
90
92
94
96 ¥94.71/$
¥80.67/$
Bank of Japan intervention Sept 13 as yen hits 15-year high
1/4 /10
2/1 /10
1/1 8/1
0
2/1 5/1
0 3/1
/10
3/1 5/1
0
3/2 9/1
0
4/1 2/1
0
4/2 6/1
0
5/1 0/1
0
5/2 4/1
0 6/7
/10
6/2 1/1
0 7/5
/10
7/1 9/1
0 8/2
/10
8/1 6/1
0
8/3 0/1
0
9/1 3/1
0
9/2 7/1
0
10 /11
/10
10 /25
/10
11 /8/
10
11 /22
/10
12 /6/
10
12 /20
/10
EXHIBIT 1 Intervention and the Japanese Yen, 2010
270 CHAPTER 9 Foreign Exchange Rate Determination and Forecasting
came at a time when the United States was continuing to pressure China to revalue its currency, the renminbi. As noted by economist Nouriel Roubini, “We are in a world where everyone wants a weak currency,” a marketplace in which all countries are looking to stimulate their domes- tic economies through exceptionally low interest rates and corresponding weak currency values—“a global race to the bottom.”
Ironically, as illustrated in Exhibit 1, it appears that the intervention was largely unsuccessful. When the Bank of Japan started buying dollars in an appreciating yen market— the so-called “leaning into the wind” strategy—it was hoping to either stop the appreciation, change the direction of the spot rate movement, or both. In either pursuit, it appears to have failed. As one analyst commented, it turned out to be a “short- term fix to a long-term problem.” Although the yen spiked downward (more yen per dollar) for a few days, it returned once again to an appreciating path within a week.
Japan’s frequent interventions, described in Exhibit 2, have been the subject of much study. In an August 2005 study by the IMF, it was noted that between 1991 and 2005, the Bank of Japan had intervened on 340 days, the European Central Bank on 4 days (since its inception in 1998), and the U.S. Federal Reserve on 22 days. Although the IMF has never found Japa- nese intervention to be officially “currency manipulation,” an analysis by Takatoshi Ito in 2004 concluded that there was on average a one-yen per dollar change in market rates, roughly 1%, as a result of Japanese intervention over time.
It is not clear at this time whether or not Japan will “steril- ize” the intervention, meaning neutralize the additional yen impact on the money supply by buying bonds domestically. Although this has been the tendency historically, given the current deflation forces in Japan, it may not be necessary.
Japan’s interventions are not, however, a lone example of attempted market manipulation. The Swiss National Bank repeatedly intervened in 2009 to stop the appreciation of the Swiss franc against both the dollar and the euro, and recently, in January 2011, Chile had aggressively sold Chilean pesos against the U.S. dollar to stop its continued appreciation.
There is no historical case in which [yen] selling interven- tion succeeded in immediately stopping the pre-existing long term uptrend in the Japanese yen.
—Tohru Sasaki, Currency Strategist, JPMorgan.
Case Questions 1. Could the Bank of Japan continually intervene to try
to stop the appreciation of the yen? Is there any limit to its ability to intervene?
2. Why is a stronger yen such a bad thing for Japan? Isn’t a stronger currency value an indication of confidence by the global markets in the economy and policies of a country?
3. If currency intervention has such a poor record, why do you think countries like Japan or Switzerland or Chile continue to do it?
EXHIBIT 2 The History of Japanese Intervention
40
80
120
160
200
240
280
Japanese yen/U.S. dollar (¥/$)
Intervention
It is not clear that Japanese intervention over the past two decades has had the desired impact on preventing yen appreciation.
Ja n-8
0
Se p-8
2
Ma y-8
1
Ja n-8
4
Ma y-8
5
Se p-8
6
Ja n-8
8
Ma y-8
9
Se p-9
0
Ja n-9
2
Ma y-9
3
Se p-9
4
Ja n-9
6
Ma y-9
7
Se p-9
8
Ja n-0
0
Ma y-0
1
Se p-0
2
Ja n-0
4
Ma y-0
5
Se p-0
6
Ja n-0
8
Ma y-0
9
Se p-1
0
Intervention
CHAPTER 9 Foreign Exchange Rate Determination and Forecasting 270
271Foreign Exchange Rate Determination and Forecasting CHAPTER 9
11. Foreign Direct Investment. Swings in foreign direct investment flows into and out of emerging markets contribute to exchange rate volatility. Describe one concrete historical example of this phenomenon dur- ing the last 10 years.
12. Thailand’s Crisis of 1997. What were the main causes of Thailand’s crisis of 1997? What lessons were learned and what steps were eventually taken to nor- malize Thailand’s economy?
13. Russia’s Crisis of 1998. What were the main causes of Russia’s crisis of 1998? What lessons were learned and what steps were taken to normalize Russia’s economy?
14. Argentina’s Crisis of 2001–2002. What were the main causes of Argentina’s crisis of 2001–2002? What les- sons were learned and what steps were taken to nor- malize Argentina’s economy?
PROBLEMS 1. Trepak (The Russian Dance). The Russian ruble
(RUB) traded at RUB 29.00/USD on January 2, 2009. On December 11, 2010, its value had fallen to RUB 31.45/USD. What was the percentage change in its value?
2. Center of the World. The Ecuadorian sucre (S) suf- fered from hyper-inflationary forces throughout 1999. Its value moved from S5,000/$ to S25,000/$. What was the percentage change in its value?
3. Reais Reality. The Brazilian reais (R$) value was R$1.80/$ on Thursday, January 24, 2008. Its value fell to R$2.39/$ on Monday, January 26, 2009. What was the percentage change in its value?
4. That’s Loonie. The Canadian dollar’s value against the U.S. dollar has seen some significant changes over recent history. Use the following graph of the C$/US$ exchange rate for the 30-year period between 1980 and end-of-year 2010 to estimate the percentage change in the Canadian dollar’s value (it’s affection- ately known as the “loonie”) versus the dollar for the following periods. a. January 1980–December 1985 b. January 1986–December 1991 c. January 1992–December 2001 d. January 2002–December 2006 e. January 2007–December 2008 f. January 2009–December 2010
QUESTIONS 1. Term Forecasting. What are the major differences
between short-term and long-term forecasts for a fixed exchange rate versus a floating exchange rate?
2. Exchange Rate Dynamics. What is meant by the term “overshooting”? What causes it and how is it corrected?
3. Fundamental Equilibrium. What is meant by the term “fundamental equilibrium path” for a currency value? What is “noise”?
4. Asset Market Approach to Forecasting. Explain how the asset market approach can be used to forecast spot exchange rates. How does the asset market approach differ from the BOP approach to forecasting?
5. 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?
6. Forecasting Services. Numerous exchange rate fore- casting services exist. Trident’s CFO Maria Gonzalez is considering whether to subscribe to one of these ser- vices at a cost of $20,000 per year. The price includes online access to the forecasting services’ computerized econometric exchange rate prediction model. What factors should Maria consider when deciding whether or not to subscribe?
7. Cross-Rate Consistency in Forecasting. Explain the meaning of “cross-rate consistency” as used by MNEs. How do MNEs use a check of cross-rate consistency in practice?
8. Infrastructure Weakness. Infrastructure weakness was one of the causes of the emerging market crisis in Thailand in 1997. Define infrastructure weakness and explain how it could affect a country’s exchange rate.
9. Infrastructure Strength. Explain why infrastructure strengths have helped to offset the large BOP deficits on current account in the United States.
10. Speculation. The emerging market crises of 1997– 2002 were worsened because of rampant specula- tion. Do speculators cause such crisis or do they simply respond to market signals of weakness? How can a government manage foreign exchange speculation?
272 CHAPTER 9 Foreign Exchange Rate Determination and Forecasting
6. Lowering the Lira. The Turkish lira (TL) was officially devalued by the Turkish government in February 2001 during a severe political and economic crisis. The Turkish government announced on Febru- ary 21 that the lira would be devalued by 20%. The spot exchange rate on February 20 was TL68,000/$. a. What was the exchange rate after devaluation? b. What was the percentage change after falling to
TL100,000/$?
5. Paris to Tokyo. The Japanese yen-euro cross rate is one of the more significant currency values for global trade and commerce. The graph below shows this cross rate from when the euro was launched in Janu- ary 1999 through the end-of-year 2010. Estimate the change in the value of the yen over the following three periods of change. a. Jan 1999–Aug 2001 b. Sep 2001–June 2008 c. July 2008–Dec 2010
170
160
150
140
130
120
110
100
90
Monthly Average Exchange Rates: Japanese Yen/European Euro
Source: PACIFIC Exchange Rates © 2010 by Prof. Werner Antweiler, University of British Columbia, Vancouver BC, Canada.
00 02 04 06 08 10
1.7
1.6
1.5
1.4
1.3
1.2
1.1
1.0
0.9
Monthly Average Exchange Rates: Canadian Dollars/U.S. Dollar
Source: PACIFIC Exchange Rates © 2010 by Prof. Werner Antweiler, University of British Columbia, Vancouver BC, Canada.
80 85 90 95 00 05 10
273Foreign Exchange Rate Determination and Forecasting CHAPTER 9
7. Cada Seis Años. Mexico was famous—or infamous— for many years in having two things every six years (cada seis años in Spanish): a presidential election and a currency devaluation. This was the case in 1976, 1982, 1988, and 1994. In its last devaluation on December 20, 1994, the value of the Mexican peso (Ps) was offi- cially changed from Ps3.30/$ to Ps5.50/$. What was the percentage devaluation?
8. Brokedown Palace. The Thai baht (THB) was devalued by the Thai government from THB25/$ to
THB29/$ on July 2, 1997. What was the percentage devaluation of the baht?
9. Forecasting the Argentine Peso. As illustrated in the graph on the next page, the Argentine peso moved from its fixed exchange rate of Ps1.00/$ to over Ps2.00/$ in a matter of days in early January 2002. After a brief period of high volatility, the peso’s value appeared to settle down into a range varying between 2.0 and 2.5 pesos per dollar. If you were forecasting the Argentine peso fur- ther into the future, how would you use the information
2.25
2.00
1.75
1.50
1.25
1.00
0.75
Daily Exchange Rates: Argentine Pesos/U.S. Dollar
26 2 9 16
Jan 2002 Feb 2002 23 30 6 13 20 27
Forecasting the Pan-Pacific Pyramid Using the table below containing economic, financial, and business indicators from October 20, 2007, issue of the Economist (print edition) to answer problems 10 through 15.
Gross Domestic Product Industrial Production Unemployment Rate Country
Latest Qtr
Qtr*
Forecast 2007e
Forecast 2008e
Recent Qtr
Latest
Australia 4.3% 3.8% 4.1% 3.5% 4.6% 4.2% Japan 1.6% -1.2% 2.0% 1.9% 4.3% 3.8% United States 1.9% 3.8% 2.0% 2.2% 1.9% 4.7%
Consumer Prices Interest Rates Country Year Ago Latest Forecast 2007e 3-Month Latest 1-Yr Govt Latest Australia 4.0% 2.1% 2.4% 6.90% 6.23% Japan 0.9% -0.2% 0.0% 0.73% 1.65% United States 2.1% 2.8% 2.8% 4.72% 4.54%
Trade Balance Current Account Current Units (per US$)
Country Last 12 Mos
(billion $) Last 12 Mos
(billion $) Forecast 07 (% of GDP) Oct 17th Year Ago
Australia -13.0 -$47.0 -5.7% 1.12 1.33 Japan 98.1 $197.5 4.6% 117 119 United States -810.7 -$793.2 -5.6% 1.00 1.00
Source: Data abstracted from The Economist, October 20, 2007, print edition. Unless otherwise noted, percentages are percentage changes over one year. Rec Qtr = recent quarter. Values for 2007e are estimates or forecasts.
274 CHAPTER 9 Foreign Exchange Rate Determination and Forecasting
INTERNET EXERCISES 1. Recent Economic and Financial Data. Use the
following Web sites to obtain recent economic and financial data used for all approaches to forecasting presented in this chapter.
Economist.com www.economist.com/ markets-data
FT.com www.ft.com
EconEdLink www.econedlink.org/ economic-resources/ focus-on-economic-data.php
2. OzForex Weekly Comment. The OzForex For- eign Exchange Services Web site provides a weekly commentary on major political and economic factors and events that move current markets. Using their Web site, see what they expect to happen in the com- ing week on the three major global currencies—the dollar, yen, and euro.
OzForex www.ozforex.com.au/ marketwatch.htm
3. Exchange Rates, Interest Rates, and Global Markets. The magnitude of market data can seem over- whelming on occasion. Use the following Bloom- berg markets page to organize your mind and your global data.
Bloomberg Financial News www.bloomberg.com/markets
4. National Bank of Slovakia and the Slovakia Koruna. The National Bank of Slovakia has been pub- lishing spot and forward rates of selected currencies versus the Slovakia koruna for several years. Using the following Web site, compile spot rates, three- month forward rates, and six-month forward rates for a recent two-year period. After graphing the data, does it appear that the forward rate has predicted the future direction of the spot rate?
National Bank of Slovakia URLwww.nbs.sk/en/ statistics/exchange-rates/ en-kurzovy-listok
5. Banque Canada and the Canadian Dollar Forward Market. Using the following Web site to find the latest spot and forward quotes of the Canadian dollar against the Bahamian dollar and the Brazilian real.
Banque Canada www.bankofcanada.ca/rates/ exchange/
in the graphic—the value of the peso freely floating in the weeks following devaluation—to forecast its future value?
10. Current Spot Rates. What are the current spot exchange rates for the following cross rates? a. Japanese yen/U.S. dollar exchange rate b. Japanese yen/Australian dollar exchange rate c. Australian dollar/U.S. dollar exchange rate
11. Purchasing Power Parity Forecasts. Assuming pur- chasing power parity, and assuming that the fore- casted change in consumer prices is a good proxy of predicted inflation, forecast the following cross rates: a. Japanese yen/U.S. dollar in one year b. Japanese yen/Australian dollar in one year c. Australian dollar/U.S. dollar in one year
12. International Fischer Forecasts. Assuming Interna- tional Fisher applies to the coming year, forecast the following future spot exchange rates using the govern- ment bond rates for the respective country currencies: a. Japanese yen/U.S. dollar in one year b. Japanese yen/Australian dollar in one year c. Australian dollar/U.S. dollar in one year
13. Implied Real Interest Rates. If the nominal interest rate is the government bond rate, and the current change in consumer prices is used as expected infla- tion, calculate the implied “real” rates of interest by currency. a. Australian dollar “real” rate b. Japanese yen “real” rate c. U.S. dollar “real” rate
14. Forward Rates. Using the spot rates and three-month interest rates above, calculate the 90-day forward rates for the following: a. Japanese yen/U.S. dollar exchange rate b. Japanese yen/Australian dollar exchange rate c. Australian dollar/U.S. dollar exchange rate
15. Real Economic Activity and Misery. Calculate the country’s Misery Index (unemployment + inflation) and then use it like interest differentials to forecast the future spot exchange rate, one year into the future. a. Japanese yen/U.S. dollar exchange rate in one year b. Japanese yen/Australian dollar exchange rate in
one year c. Australian dollar/U.S. dollar exchange rate in one
year
275
CHAPTER 10
Transaction Exposure
There are two times in a man’s life when he should not speculate: when he can’t afford it and when he can.
—“Following the Equator,” Pudd’nhead Wilson’s New Calendar, Mark Twain.
Foreign exchange exposure is a measure of the potential for a firm’s profitability, net cash flow, and market value to change because of a change in exchange rates. An important task of the financial manager is to measure foreign exchange exposure and to manage it to maximize the profitability, net cash flow, and market value of the firm. This chapter intro- duces the three types of corporate foreign exchange exposure—transaction exposure, trans- lation exposure, and operating exposure—and then analyzes transaction exposure in depth. The chapter concludes with a Mini-Case, Banbury Impex (India), which involves a recent exposure management problem in India.
Types of Foreign Exchange Exposure What happens to a firm when foreign exchange rates change? There are two distinct categories of foreign exchange exposure for the firm, those that are based in accounting and those that arise from economic competitiveness. The accounting exposures, specifically described as transaction exposure and translation exposure, arise from contracts and accounts being denominated in foreign currency. Economic exposure, which we will describe as operating exposure, is the potential change in the value of the firm from its changing global competi- tiveness as determined by exchange rates. Exhibit 10.1 shows schematically the three main types of foreign exchange exposure: transaction, translation, and operating.
Transaction Exposure 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 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.
276 CHAPTER 10 Transaction Exposure
Operating Exposure 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.
Transaction exposure and operating exposure exist because of unexpected changes in future cash flows. The difference between the two is that transaction exposure is concerned with future cash flows already contracted for, while operating exposure focuses on expected (not yet contracted for) future cash flows that might change because a change in exchange rates has altered international competitiveness.
Why Hedge? MNEs possess a multitude of cash flows that are sensitive to changes in exchange rates, interest rates, and commodity prices. Chapters 10, 11, and 12 focus exclusively on the sensitivity of the individual firm’s value and future cash flows to exchange rates. We begin by exploring the question of whether exchange rate risk should or should not be managed.
Hedging Defined Many firms attempt to manage their currency exposures through hedging, which is the taking of a position, either acquiring a cash flow, an asset, or a contract that will rise (fall) in value and offset a fall (rise) in the value of an existing position. Hedging protects the owner of the existing asset from loss. However, it also eliminates any gain from an increase in the value of the asset hedged. The question remains: What is to be gained by the firm from hedging?
According to financial theory, the value of a firm is the net present value of all expected future cash flows. The fact that these cash flows are expected emphasizes that nothing about the future is certain. If the reporting currency value of many of these cash flows is altered by exchange rates changes, a firm that hedges its currency exposures reduces the variance in the value of its future expected cash flows. Currency risk can then be defined as the variance in expected cash flows arising from unexpected exchange rate changes.
EXHIBIT 10.1 Corporate Foreign Exchange Exposure
Translation Exposure
Transaction Exposure Operating Exposure
Time and Exchange Rate Changes
Changes in income and owners’ equity in consolidated financial statements caused by a change in exchange rates
Change in expected future cash flows arising from an unexpected change in exchange rates
Changes in future cash flows arising from firm and competitor firm responses
Impact of settling outstanding obligations entered into before change in exchange rates but to be settled after change in exchange rates
Resulting from Accounting Resulting from Economics
277Transaction Exposure CHAPTER 10
Exhibit 10.2 illustrates the distribution of expected net cash flows of the individual firm. Hedging these cash flows narrows the distribution of the cash flows about the mean of the distribution. Currency hedging reduces risk. Reduction of risk is not, however, the same as adding value or return. The value of the firm depicted in Exhibit 10.2 would be increased only if hedging actually shifted the mean of the distribution to the right. In fact, if hedging is not “free,” meaning that the firm must expend resources to hedge, then hedging will add value only if the rightward shift is sufficiently large to compensate for the cost of hedging.
The Pros and Cons of Hedging Is a reduction in the variability of cash flows sufficient reason for currency risk management? Opponents of currency hedging commonly make the following arguments:
! Shareholders are more capable of diversifying currency risk than is the management of the firm. 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.
! Currency hedging 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).
! 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 are shareholders.
! 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.
EXHIBIT 10.2 Hedging’s Impact on the Expected Cash Flows of the Firm
Hedging reduces the variability of expected cash flows about the mean of the distribution. This reduction of distribution variance is a reduction of risk.
Hedged
Unhedged
Net Cash Flow (NCF)NCF Expected Value E(V)
278 CHAPTER 10 Transaction Exposure
! Management’s motivation to reduce variability is sometimes driven by accounting reasons. Management may believe that it will be criticized more severely for incur- ring foreign exchange losses than for incurring even higher cash costs by hedging. 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.
! 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.
Proponents of hedging cite the following arguments:
! 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.
! 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 its continued operation. 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.
! 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.
! 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 to recognize disequilibrium conditions and to take advantage of single 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 exchange rates).
Measurement of Transaction Exposure Transaction exposure measures gains or losses that arise from the settlement of existing finan- cial obligations whose terms are stated in a foreign currency. Transaction exposure arises from any of the following:
! Purchasing or selling on credit goods or services when prices are stated in foreign currencies
! Borrowing or lending funds when repayment is to be made in a foreign currency ! Being a party to an unperformed foreign exchange forward contract ! Otherwise acquiring assets or incurring liabilities denominated in foreign currencies
The most common example of transaction exposure arises when a firm has a receivable or payable denominated in a foreign currency. Exhibit 10.3 demonstrates how this exposure is born. The total transaction exposure consists of quotation, backlog, and billing exposures.
A transaction exposure is created at the first moment the seller quotes a price in foreign currency terms to a potential buyer (t1). The quote can be either verbal, as in a telephone quote, or, as in written bid or a printed price list. With the placing of an order (t2), the potential exposure created at the time of the quotation (t1) is converted into actual exposure, called
279Transaction Exposure CHAPTER 10
backlog exposure, because the product has not yet been shipped or billed. Backlog exposure lasts until the goods are shipped and billed (t3), at which time it becomes billing exposure. Billing exposure remains until payment is received by the seller (t4).
Purchasing or Selling on Open Account. Suppose that Trident Corporation, a U.S. firm, sells merchandise on open account to a Belgian buyer for €1,800,000, with payment to be made in 60 days. The spot exchange rate on the date of the sale is $1.1200/€, and the seller expects to exchange the euros received for :1,800,000 * $1.1200/: = $2,016,000 when payment is received. The $2,016,000 is the value of the sale which is posted to the firm’s books. Accounting practices stipulate that the foreign currency transaction be listed at the spot exchange rate in effect on the date of the transaction.
Transaction exposure arises because of the risk that Trident will receive something other than the $2,016,000 expected and booked. For example, if the euro weakens to $1.1000/€ when payment is received, the U.S. seller will receive only :1,800,000 * $1.1000/: = $1,980,000, or some $180,000 less.
Transaction settlement: :1,800,000 * $1.1000/: = $1,980,000 Transaction booked: :1,800,000 * $1.1200/: = $2,016,000 Foreign exchange gain (loss) on sale = ($180,000)
If the euro should strengthen to $1.3000/€, however, Trident receives :1,800,000 * $1.3000/: = $2,340,000, an increase of $180,000 over the amount expected. Thus, exposure is the chance of either a loss or a gain on the resulting dollar settlement versus what the sale was booked at.
The U.S. seller might have avoided transaction exposure by invoicing the Belgian buyer in dollars. Of course, if the U.S. company attempted to sell only in dollars it might not have obtained the sale in the first place. Even if the Belgian buyer agrees to pay in dollars, transaction exposure is not eliminated. Instead, it is transferred to the Belgian buyer, whose dollar account payable has an unknown cost—to it—60 days hence.
EXHIBIT 10.3 The Life Span of Transaction Exposure
Time and Events
Seller quotes a price to buyer (verbal or written form)
Buyer settles A/R with cash in amount of currency quoted at time t1
Seller ships product and bills buyer (becomes A/R)
Buyer places firm order with seller at price offered at time t1
Quotation Exposure
Backlog Exposure
Billing Exposure
Time between quoting a price and reaching a contractual sale
Time it takes to fill the order after contract is signed
Time it takes to get paid in cash after A/R is issued
t1 t2 t3 t4
280 CHAPTER 10 Transaction Exposure
Borrowing and Lending. A second example of transaction exposure arises when funds are borrowed or loaned, and the amount involved is denominated in a foreign currency. For example, in 1994, PepsiCo’s largest bottler outside of the United States was Grupo Embotellador de Mexico (Gemex). In mid-December 1994, Gemex, a Mexican company, had U.S. dollar debt of $264 million. At that time, Mexico’s new peso (“Ps”) was traded at Ps3.45/US$, a pegged rate that had been maintained with minor variations since January 1, 1993, when the new currency unit had been created. On December 22, 1994, the peso was allowed to float because of economic and political events within Mexico, and in one day it sank to Ps4.65/US$. For most of the following January it traded in a range near Ps5.50/US$.
Dollar debt in mid@December 1994: US$264,000,000 * Ps 3.45/US$ = Ps910,800,000 Dollar debt in mid@January 1995: US$264,000,000 * Ps 5.50/US$ = Ps1,452,000,000 Dollar debt increase measure in Mexican pesos Ps541,200,000
The number of pesos needed to repay the dollar debt increased by 59%! In U.S. dollar terms, the drop in the value of the pesos caused Gemex of Mexico to need the peso-equivalent of an additional US$98,400,000 to repay its debt.
Other Causes of Transaction Exposure. When a firm enters into a forward exchange contract, it deliberately creates transaction exposure. This risk is usually incurred to hedge an existing transaction exposure. For example, a U.S. firm might want to offset an existing obligation to purchase ¥100 million to pay for an import from Japan in 90 days. One way to offset this payment is to purchase ¥100 million in the forward market today for delivery in 90 days. In this manner, any change in value of the Japanese yen relative to the dollar is neutralized. Thus, the potential transaction loss (or gain) on the account payable is offset by the transaction gain (or loss) on the forward contract.
Note that foreign currency cash balances do not create transaction exposure, even though their home currency value changes immediately with a change in exchange rates. No legal obliga- tion exists to move the cash from one country and currency to another at a future date. If such an obligation did exist, it would show on the books as a payable (e.g., dividends declared and payable) or receivable and then be counted as part of transaction exposure. Nevertheless, the foreign exchange value of cash balances does change when exchange rates change. Such a change is reflected in the consolidated statement of cash flows and the consolidated balance sheet.
Contractual Hedges. Foreign exchange transaction exposure can be managed by contractual, operating, and financial hedges. The main contractual hedges employ the forward, money, futures, and options markets. Operating and financial hedges employ the use of risk-sharing agreements, leads and lags in payment terms, swaps, and other strategies to be discussed in later chapters.
The term natural hedge refers to an offsetting operating cash flow, a payable arising from the conduct of business. A financial hedge refers to either an offsetting debt obligation (such as a loan) or some type of financial derivative such as an interest rate swap. Care should be taken to distinguish hedges in the same way finance distinguishes cash flows—operating from financing. The following case illustrates how contractual hedging techniques may be used to protect against transaction exposure.
Trident’s Transaction Exposure Maria Gonzalez is the chief financial officer of Trident. She has just concluded negotiations for the sale of a turbine generator to Regency, a British firm, for £1,000,000. This single sale
281Transaction Exposure CHAPTER 10
is quite large in relation to Trident’s present business. Trident has no other current foreign customers, so the currency risk of this sale is of particular concern. The sale is made in March with payment due three months later in June. Exhibit 10.4 summarizes the financial and market information Maria has collected for the analysis of her currency exposure problem. The unknown—the transaction exposure—is the actual realized value of the receivable in U.S. dollars at the end of 90 days.
Trident operates on relatively narrow margins. Although Maria and Trident would be very happy if the pound appreciated versus the dollar, concerns center on the possibility that the pound will fall. When Trident had priced and budgeted this contract, it had set a very slim minimum acceptable margin at a sales price of $1,700,000; Trident wanted the deal for both financial and strategic purposes. The budget rate, the lowest acceptable dollar per pound exchange rate, was therefore established at $1.70/£. Any exchange rate below this budget rate would result in Trident realizing no profit on the deal.
Four alternatives are available to Trident to manage the exposure: 1) remain unhedged; 2) hedge in the forward market; 3) hedge in the money market; or 4) hedge in the options market.
Unhedged Position Maria may decide to accept the transaction risk. If she believes the foreign exchange advi- sor, she expects to receive £1,000,000 * $1.76 = $1,760,000 in three months. However, that amount is at risk. If the pound should fall to, say, $1.65/£, she will receive only $1,650,000. Exchange risk is not one-sided, however; if the transaction is left uncovered and the pound strengthened even more than forecast by the advisor, Trident will receive considerably more than $1,760,000.
EXHIBIT 10.4 Trident’s Transaction Exposure
Trident’s weighted average cost of capital = 12.00% (3.00% for 90 days) US$ 3-month borrowing rate = 8.00% per annum (2.00% for 90 days) US$ 3-month investment rate = 6.00% per annum (1.50% for 90 days)
90 days
U.S. Dollar Market
British Pound Market
Spot rate = $1.7640/£
A/R = £1,000,000
Sale = $1,764,000
UK£ 3-month investment rate = 8.00% per annum (2.00% for 90 days) UK£ 3-month borrowing rate = 10.00% per annum (2.50% for 90 days)
A/R = $ ?,???,???
June (3-month) put option for £1,000,000 with a strike rate of $1.75/£; premium of 1.5%
90-day Forward rate F90 = $1.7540/£
Se90 = $1.7600/£ Foreign exchange advisors forecast
282 CHAPTER 10 Transaction Exposure
The essence of an unhedged approach is as follows:
Today
Do nothing.
Three months from today
Receive £1,000,000. Sell £1,000,000 spot and receive dollars at that day’s spot rate.
Forward Market Hedge A forward hedge involves a forward (or futures) contract and a source of funds to fulfill that contract. The forward contract is entered into at the time the transaction exposure is created. In Trident’s case, that would be in March, when the sale to Regency was booked as an account receivable.
When a foreign currency denominated sale such as this is made, it is booked at the spot rate of exchange existing on the booking date. In this case, the spot rate on the date of sale was $1.7640/£, so the receivable was booked as $1,764,000. Funds to fulfill the forward contract will be available in June, when Regency pays £1,000,000 to Trident. If funds to fulfill the for- ward contract are on hand or are due because of a business operation, the hedge is considered covered, perfect, or square because no residual foreign exchange risk exists. Funds on hand or to be received are matched by funds to be paid.
In some situations, funds to fulfill the forward exchange contract are not already available or due to be received later, but must be purchased in the spot market at some future date. Such a hedge is open or uncovered. It involves considerable risk because the hedger must take a chance on purchasing foreign exchange at an uncertain future spot rate in order to fulfill the forward contract. Purchase of such funds at a later date is referred to as covering.
Should Trident wish to hedge its transaction exposure with a forward, it will sell £1,000,000 forward today at the 3-month forward rate of $1.7540/£. This is a covered transaction in which the firm no longer has any foreign exchange risk. In three months the firm will receive £1,000,000 from the British buyer, deliver that sum to the bank against its forward sale, and receive $1,754,000. This would be recorded on Trident’s income statement as a foreign exchange loss of $10,000 ($1,764,000 as booked, $1,754,000 as settled).
The essence of a forward hedge is as follows:
Today
Sell £1,000,000 forward @ $1.7540/£.
Three months from today
Receive £1,000,000. Deliver £1,000,000 against forward sale. Receive $1,754,000.
If Maria’s forecast of future rates was identical to that implicit in the forward quotation, that is, $1.7540/£, expected receipts would be the same whether or not the firm hedges. How- ever, realized receipts under the unhedged alternative could vary considerably from the certain receipts when the transaction is hedged. Never underestimate the value of predictability of outcomes (and 90 nights of solid sleep).
283Transaction Exposure CHAPTER 10
Money Market Hedge Like a forward market hedge, a money market hedge also involves a contract and a source of funds to fulfill that contract. In this instance, the contract is a loan agreement. The firm seeking the money market hedge borrows in one currency and exchanges the proceeds for another currency. Funds to fulfill the contract—that is, to repay the loan—are generated from business operations, in this case, the account receivable.
A money market hedge can cover a single transaction, such as Trident’s £1,000,000 receivable, or repeated transactions. Hedging repeated transactions is called matching. It requires the firm to match the expected foreign currency cash inflows and outflows by cur- rency and maturity. For example, if Trident had numerous sales denominated in pounds to British customers over a long period, it would have somewhat predictable U.K. pound cash inflows. The appropriate money market hedge technique here would be to borrow U.K. pounds in an amount matching the typical size and maturity of expected pound inflows. Then, if the pound depreciated or appreciated, the foreign exchange effect on cash inflows in pounds would be offset by the effect on cash outflows in pounds from repaying the pound loan plus interest.
The structure of a money market hedge resembles that of a forward hedge. The difference is that the cost of the money market hedge is determined by different interest rates than the interest rates used in the formation of the forward rate. The difference in interest rates facing a private firm borrowing in two separate country markets may be different from the difference in risk-free government bill rates or Eurocurrency interest rates in these same markets. In efficient markets interest rate parity should ensure that these costs are nearly the same, but not all markets are efficient at all times.
To hedge in the money market, Maria will borrow pounds in London at once, immediately convert the borrowed pounds into dollars, and repay the pound loan in three months with the proceeds from the sale of the generator. She will need to borrow just enough to repay both the principal and interest with the sale proceeds. The borrowing interest rate will be 10% per annum, or 2.5% for three months. Therefore, the amount to borrow now for repayment in three months is
£1,000,000 1 + 0.025 = £975,610
Maria would borrow £975,610 now, and in three months repay that amount plus £24,390 of interest with the account receivable. Trident would exchange the £975,610 loan proceeds for dollars at the current spot exchange rate of $1.7640/£, receiving $1,720,976 at once.
The money-market hedge, if selected by Trident, creates a pound-denominated liability, the pound loan, to offset the pound-denominated asset, the account receivable. The money market hedge works as a hedge by matching assets and liabilities according to their currency of denomination. Using a simple T-account illustrating Trident’s balance sheet, the loan in British pounds is seen to offset the pound-denominated account receivable:
Assets Liabilities and Net Worth
Account receivable £1,000,000 Bank loan (principal) £975,610
__________ Interest payable 24,390
£1,000,000 £1,000,000
The loan acts as a balance sheet hedge against the pound-denominated account receivable.
284 CHAPTER 10 Transaction Exposure
To compare the forward hedge with the money market hedge one must analyze how Trident’s loan proceeds will be utilized for the next three months. Remember that the loan proceeds are received today but the forward contract proceeds are received in three months. For comparison purposes, one must calculate either the future value of the loan proceeds or the present value of the forward contract proceeds. Since the primary uncertainty here is the dollar value in three months, we will use future value here.
As both the forward contract proceeds and the loan proceeds are relatively certain, it is possible to make a clear choice between the two alternatives based on the one that yields the higher dollar receipts. This result, in turn, depends on the assumed rate of investment or use of the loan proceeds.
At least three logical choices exist for an assumed investment rate for the loan proceeds for the next three months. First, if Trident is cash rich, the loan proceeds might be invested in U.S. dollar money market instruments that yield 6% per annum. Second, Maria might simply use the pound loan proceeds to pay down dollar loans that currently cost Trident 8% per annum. Third, Maria might invest the loan proceeds in the general operations of the firm, in which case the cost of capital of 12% per annum would be the appropriate rate. The field of finance generally uses the company’s cost of capital to move capital forward and backward in time, and we will therefore use the WACC of 12% (3% for the 90-day period here) to calculate the future value of proceeds under the money market hedge:
$1,720,976 * 1.03 = $1,772,605
A break-even rate can now be calculated between the forward hedge and the money market hedge. Assume that r is the unknown 3-month investment rate, expressed as a decimal, that would equalize the proceeds from the forward and money market hedges. We have
(Loan proceeds) * (1 + rate) = (forward proceeds)
$1,720,976 * (1 + r) = $1,754,000
r = 0.0192
One can convert this 3-month (90 days) investment rate to an annual whole percentage equiva- lent, assuming a 360-day financial year, as follows:
0.0192 * 360 90
* 100 = 7.68%
In other words, if Maria Gonzalez can invest the loan proceeds at a rate higher than 7.68% per annum, she would prefer the money market hedge. If she can invest only at a rate lower than 7.68%, she would prefer the forward hedge.
The essence of a money market hedge is as follows:
Today
Borrow £975,610. Exchange £975,610 for dollars @ $1.7640/£. Receive $1,720,976 cash.
Three months from today
Receive £1,000,000. Repay £975,610 loan plus £24,390 interest, for a total of £1,000,000.
285Transaction Exposure CHAPTER 10
The money market hedge therefore results in cash received up front (at the start of the period), which can then be carried forward in time for comparison with the other hedging alternatives.
Options Market Hedge Maria Gonzalez could also cover her £1,000,000 exposure by purchasing a put option. This technique allows her to speculate on the upside potential for appreciation of the pound while limiting downside risk to a known amount. Maria could purchase from her bank a 3-month put option on £1,000,000 at an at-the-money (ATM) strike price of $1.75/£ with a premium cost of 1.50%. The cost of the option—the premium—is
(Size of option) * (premium) * (spot rate) = cost of option, £1,000,000 * 0.015 * $1.7640 = $26,460.
Because we are using future value to compare the various hedging alternatives, it is necessary to project the premium cost of the option forward three months. We will use the cost of capital of 12% per annum or 3% per quarter. Therefore, the premium cost of the put option as of June would be $26,460(1.03) = $27,254. This is equal to $0.0273 per pound ($27,254 , £1,000,000).
When the £1,000,000 is received in June, the value in dollars depends on the spot rate at that time. The upside potential is unlimited, the same as in the unhedged alternative. At any exchange rate above $1.75/£, Trident would allow its option to expire unexercised and would exchange the pounds for dollars at the spot rate. If the expected rate of $1.76/£ materializes, Trident would exchange the £1,000,000 in the spot market for $1,760,000. Net proceeds would be $1,760,000 minus the $27,254 cost of the option, or $1,732,746.
In contrast to the unhedged alternative, downside risk is limited with an option. If the pound depreciates below $1.75/£, Maria would exercise her option to sell (put) £1,000,000 at $1.75/£, receiving $1,750,000 gross, but $1,722,746 net of the $27,254 cost of the option. Although this downside result is worse than the downside of the forward or money market hedges, the upside potential is unlimited.
The essence of the at-the-money (ATM) put option market hedge is as follows:
Today
Buy put option to sell pounds @ $1.75/£. Pay $26,460 for put option.
Three months from today
Receive £1,000,000. Either deliver £1,000,000 against put, receiving $1,750,000; or sell £1,000,000 spot if current spot rate is > $1.75/£.
We can calculate a trading range for the pound that defines the break-even points for the option compared with the other strategies. The upper bound of the range is determined by comparison with the forward rate. The pound must appreciate enough above the $1.7540 forward rate to cover the $0.0273/£ cost of the option. Therefore, the break-even upside spot price of the pound must be $1.7540 + $0.0273 = $1.7813. If the spot pound appreciates above $1.7813, proceeds under the option strategy will be greater than under the forward hedge. If the spot pound ends up below $1.7813, the forward hedge would be superior in retrospect.
286 CHAPTER 10 Transaction Exposure
The lower bound of the range is determined by the unhedged strategy. If the spot price falls below $1.75/£, Maria will exercise her put and sell the proceeds at $1.75/£. The net proceeds will be $1.75/£ less the $0.0273 cost of the option, or $1.7221/£. If the spot rate falls below $1.7221/£, the net proceeds from exercising the option will be greater than the net proceeds from selling the unhedged pounds in the spot market. At any spot rate above $1.7221/£, the spot proceeds from remaining unhedged will be greater.
Foreign currency options have a variety of hedging uses. A put option is useful to construction firms or other exporters when they must submit a fixed price bid in a foreign currency without knowing until some later date whether their bid is successful. Similarly, a call option is useful to hedge a bid for a foreign business or firm if a potential future foreign currency payment may be required. In either case, if the bid is rejected, the loss is limited to the cost of the option.
Comparison of Alternatives Exhibit 10.5 shows the value of Trident’s £1,000,000 account receivable over a range of possible ending spot exchange rates and hedging alternatives. This exhibit makes it clear that the firm’s view of likely exchange rate changes aids in the hedging choice.
! If the exchange rate is expected to move against Trident—to the left of $1.76/£, the money market hedge is the clearly preferred alternative—a guaranteed value of $1,772,605.
! If the exchange rate is expected to move in Trident’s favor, to the right of $1.76/£, the choice of the hedge is more complex, and lies between remaining unhedged, the money market hedge, or the put option.
Remaining unhedged is most likely an unacceptable choice. If Maria’s expectations regarding the future spot rate proved wrong, and the spot rate fell below $1.70/£, she would not
EXHIBIT 10.5 Valuation of Cash Flows Under Hedging Alternatives for Trident with Option
1.68 1.781.72 1.76 1.82 1.841.70 1.801.74 1.86
1.84
1.82
1.80
1.78
1.76
1.74
1.72
1.70
1.68
Ending Spot Exchange Rate (US$/£)
Value in U.S. dollars of Trident’s £1,000,000 A/R
Put option strike price of $1.75/£
Forward rate is $1.7540/£
Uncovered yields whatever the ending spot rate is in 90 days
Put option guarantees minimum of $1,722,746 with unlimited upside
Forward yields $1,754,000
Money market yields $1,772,605
287Transaction Exposure CHAPTER 10
reach her budget rate. The put option offers a unique alternative. If the exchange rate moves in Trident’s favor, the put option offers nearly the same upside potential as the unhedged alternative except for the up-front costs. If, however, the exchange rate moves against Trident, the put option limits the downside risk to $1,722,746.
Strategy Choice and Outcome Trident, like all firms attempting to hedge transaction exposure, must decide on a strategy before the exchange rate changes occur. How will Maria Gonzalez choose among the alternative hedging strategies? She must select based on two decision criteria: 1) the risk tolerance of Trident, as expressed in its stated policies; and 2) her own view, or expectation of the direction (and distance) the exchange rate will move over the coming 90-day period.
Trident’s risk tolerance is a combination of management’s philosophy toward transaction exposure and the specific goals of treasury activities. Many firms believe that currency risk is simply a part of doing business internationally, and therefore, start their analysis from an unhedged baseline. Other firms, however, view currency risk as unacceptable, and either start their analysis from a full forward contract cover baseline, or simply mandate that all transaction exposures be fully covered by forward contracts regardless of the value of other hedging alternatives. The treasury in most firms operates as a cost or service center for the firm. On the other hand, if the treasury operates as a profit center, it might tolerate taking more risk.
The final choice among hedges—if Maria Gonzalez does expect the pound to appreciate— combines both the firm’s risk tolerance, its view, and its confidence in its view. Transaction exposure management with contractual hedges requires managerial judgment.
Management of an Account Payable The management of an account payable, where the firm would be required to make a foreign currency payment at a future date, is similar but not identical in form. If Trident had a £1,000,000 account payable in 90 days, the hedging choices would appear as follows:
Remain Unhedged. Trident could wait 90 days, exchange dollars for pounds at that time, and make its payment. If Trident expects the spot rate in 90 days to be $1.7600/£, the payment would be expected to cost $1,760,000. This amount is, however, uncertain; the spot exchange rate in 90 days could be very different from that expected.
Forward Market Hedge. Trident could buy £1,000,000 forward, locking in a rate of $1.7540/£, and a total dollar cost of $1,754,000. This is $6,000 less than the expected cost of remaining unhedged, and therefore clearly preferable to the first alternative.
Money Market Hedge. The money market hedge is distinctly different for a payable as opposed to a receivable. To implement a money market hedge in this case, Trident would exchange U.S. dollars spot and invest them for 90 days in a pound-denominated interest- bearing account. The principal and interest in British pounds at the end of the 90-day period would be used to pay the £1,000,000 account payable.
In order to assure that the principal and interest exactly equal the £1,000,000 due in 90 days, Trident would discount the £1,000,000 by the pound investment interest rate of 8% for 90 days in order to determine the pounds needed today:
£1,000,000
1 + ¢ .08 * 90 360
≤ = £980,392.16
288 CHAPTER 10 Transaction Exposure
This £980,392.16 needed today would require $1,729,411.77 at the current spot rate of $1.7640/£:
£980,392.16 * $1.7640/£ = $1,729,411.77.
Finally, in order to compare the money market hedge outcome with the other hedging alternatives, the $1,729,411.77 cost today must be carried forward 90 days to the same future date as the other hedge choices. If the current dollar cost is carried forward at Trident’s WACC of 12%, the total cost of the money market hedge is $1,781,294.12. This is higher than the forward hedge and therefore unattractive.
$1,729,411.77 * J1 + ¢ .12 * 90 360
≤ R = $1,781,294.12 Option Hedge. Trident could cover its £1,000,000 account payable by purchasing a call option on £1,000,000. A June call option on British pounds with a near at-the-money strike price of $1.75/£ would cost 1.5% (premium) or
£1,000,000 * 0.015 * $1.7640/£ = $26,460.
This premium, regardless of whether the call option is exercised or not, will be paid up front. Its value carried forward 90 days at the WACC of 12%, would raise its end of period cost to $27,254.
If the spot rate in 90 days is less than $1.75/£, the option would be allowed to expire and the £1,000,000 for the payable purchased on the spot market. The total cost of the call option hedge if the option is not exercised is theoretically smaller than any other alternative (with the exception of remaining unhedged, because the option premium is still paid and lost). If the spot rate in 90 days exceeds $1.75/£, the call option would be exercised. The total cost of the call option hedge if exercised is as follows:
Exercise call option ([£1,000,000 * $1.75/£) $1,750,000
Call option premium (carried forward 90 days) 27,254
Total maximum expense of call option hedge $1,777,254
The four hedging methods of managing a £1,000,000 account payable for Trident are summarized in Exhibit 10.6. The costs of the forward hedge and money market hedge are certain. The cost using the call option hedge is calculated as a maximum, and the cost of remaining unhedged is highly uncertain.
As with Trident’s account receivable, the final hedging choice depends on the confidence of Maria’s exchange rate expectations, and her willingness to bear risk. The forward hedge provides the lowest cost of making the account payable payment that is certain. If the dollar strengthens against the pound, ending up at a spot rate less than $1.75/£, the call option could potentially be the lowest cost hedge. Given an expected spot rate of $1.76/£, however, the forward hedge appears the preferred alternative.
Risk Management in Practice As many different approaches to exposure management exist as there are firms. A variety of surveys of corporate risk management practices in recent years in the United States, the United Kingdom, Finland, Australia, and Germany indicate no real consensus exists regarding the best approach. The following is our attempt to assimilate the basic results of these surveys and combine them with our own personal experiences.
289Transaction Exposure CHAPTER 10
Which Goals? The treasury function of most private firms, the group typically responsible for transaction exposure management, is usually considered a cost center. It is not expected to add profit to the firm’s bottom line (which is not the same thing as saying it is not expected to add value to the firm). Currency risk managers are expected to err on the conservative side when managing the firm’s money.
Which Exposures? Transaction exposures exist before they are actually booked as foreign currency-denominated receivables and payables. However, many firms do not allow the hedging of quotation exposure or backlog exposure as a matter of policy. The reasoning is straightforward: Until the transaction exists on the accounting books of the firm, the probability of the exposure actually occurring is considered to be less than 100%. Conservative hedging policies dictate that contractual hedges be placed only on existing exposures.
An increasing number of firms, however, are actively hedging not only backlog exposures, but also selectively hedging quotation and anticipated exposures. Anticipated exposures are transactions for which there are—presently—no contracts or agreements between parties, but are anticipated based on historical trends and continuing business relationships. Although this may appear to be overly speculative on the part of these firms, it may be that hedging expected foreign-currency payables and receivables for future periods is the most conservative approach to protect the firm’s future operating revenues.
Which Contractual Hedges? As might be expected, transaction exposure management programs are generally divided along an “option-line,” those that use options and those that do not. Firms that do not use currency options rely almost exclusively on forward contracts and money market hedges. Global Finance in Practice 10.1 demonstrates how market condition may change firm hedging choices.
Many MNEs have established rather rigid transaction exposure risk management poli- cies which mandate proportional hedging. These policies generally require the use of forward contract hedges on a percentage (e.g., 50, 60, or 70%) of existing transaction exposures. As
EXHIBIT 10.6 Valuation of Hedging Alternatives for an Account Payable
1.68 1.781.72 1.76 1.82 1.841.70 1.801.74 1.86
1.84
1.82
1.80
1.78
1.76
1.74
1.72
1.70
1.68
Ending Spot Exchange Rate (US$/£)
Co st
in M
ill io
ns o
f U .S
. D ol
la rs
o f
Tr id
en t's
£ 1,
00 0,
00 0
A/ P
Call option strike price of $1.75/£
Forward rate is $1.7540/£
Call option hedge
Uncovered costs whatever the ending
spot rate is in 90 days
Money market hedge locks in a cost of $1,781,294
Forward contract hedge locks in a cost of $1,754,000
290 CHAPTER 10 Transaction Exposure
the maturity of the exposures lengthens, the percentage forward-cover required decreases. The remaining portion of the exposure is then selectively hedged on the basis of the firm’s risk tolerance, view of exchange rate movements, and confidence level. Although rarely acknowledged by the firms themselves, selective hedging is essentially speculation. Significant question remains as to whether a firm or a financial manager can consistently predict the future direction of exchange rates.
SUMMARY POINTS
! MNEs encounter three types of currency exposure: transaction exposure; translation exposure, and oper- ating exposure.
! Transaction exposure measures gains or losses that arise from the settlement of financial obligations whose terms are stated in a foreign currency.
! Operating exposure, also called economic 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.
! 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 affiliates into a single reporting currency to prepare worldwide consolidated financial statements.
! Considerable theoretical debate exists as to whether firms should hedge currency risk. Theoretically, hedging reduces the variability of the cash flows to the firm. It does not increase the cash flows to the firm. In fact, the costs of hedging may potentially lower them.
! Transaction exposure can be managed by contractual techniques and certain operating strategies. Contractual
hedging techniques include forward, futures, money market, and option hedges.
! The choice of which contractual hedge to use depends on the individual firm’s currency risk tolerance and its expectation of the probable movement of exchange rates over the transaction exposure period.
! In general, if an exchange rate is expected to move in a firm’s favor, the preferred contractual hedges are probably those that allow it to participate in some up- side potential, but protect it against significant adverse exchange rate movements.
! In general, if the exchange rate is expected to move against the firm, the preferred contractual hedge is one that locks in an exchange rate, such as the forward con- tract hedge or money market hedge.
! Risk management in practice requires a firm’s treasury department to identify its goals. Is treasury a cost center or profit center?
! Treasury must also choose which contractual hedges it wishes to use and what proportion of the currency risk should be hedged. Additionally, treasury must deter- mine whether the firm should buy and/or sell currency options, a strategy that has historically been risky for some firms and banks.
The global credit crisis had a number of lasting impacts on corporate foreign exchange hedging practices in late 2008 and early 2009. Currency volatilities rose to some of the highest levels seen in years, and stayed there. This caused option premiums to rise so dramatically that many companies were much more selective in their use of currency options in their risk management programs.
The dollar-euro volatility was a prime example. As recently as July 2007, the implied volatility for the most widely traded currency cross was below 7% for maturities from one week to three years.
By October 31, 2008, the 1-month implied volatility had reached 29%. Although this was seemingly the peak, 1-month implied volatilities were still over 20% on January 30, 2009.
This makes options very expensive. For example, the premium on a 1-month call option on the euro with a strike rate forward-at-the-money at the end of January 2009 rose from $0.0096/ to $0.0286/ when volatility is 20%, not 7%. For a notional principal of 1 million, that is an increase in price from $9,580 to $28,640. That will put a hole in any treasury department’s budget.
GLOBAL FINANCE IN PRACTICE 10.1
The Credit Crisis and Option Volatilities in 2009
291Transaction Exposure CHAPTER 10
As November 2010 came to a close, CEO Aadesh Lapura of Banbury Impex Private Limited, a textile company in India, sat in his office in solitude looking over his com- pany’s financial statements. It looked like 2010 would close with a small growth in sales and a small drop in profits. Although Banbury’s profits were positive, the prospects of about 1.5% return on sales were simply not good enough moving forward. He now had two problems: negotiating a short-term prospective sale to a Turkish company, and increasing his overall profitability, which was a larger, long- term problem.
Lapura concluded that overall profitability—or lack thereof—was a result of two price forces. The first was the rapid rise in the price of cotton. A major cost driver in the textiles industry, cotton prices had risen dramatically in 2010. The second issue was clearly the rising value of the Indian rupee (INR) against the U.S. dollar (USD). Ban- bury’s sales were all invoiced in U.S. dollars, and the dollar was falling. Profit margins were down, and he needed to move quickly.
Banbury Fabrics Founded in 1997, Banbury Impex Private Ltd. was a family-owned enterprise that manufactured and exported apparel fabrics. The company expected sales close to INR 25.6 crores or USD 5.4 million (a crore, cr, is a unit in the Indian numbering system equal to 10 million) in 2010 as illustrated in Exhibit 1. Sales were flat, operating income was declining, and—to be honest—prospects bleak.
Banbury’s sales were nearly all exported, mainly to the Middle East (50%), South America (30%), and Europe (10%). Banbury’s products included a range of blended woven fabrics made from viscose, cotton, and wool. The company operated two weaving units based in India.
The company’s sales growth had been slow over the past five years, averaging about 2.5% per year. However, management had been satisfied with 5% margins in 2006 and 2007 in a highly competitive business environment. Cash flows had remained relatively predictable, as Lapura had managed foreign exchange risks by using forward contracts. Choosing to invoice all international sales in
Banbury Impex (India)1
1Copyright © 2010 Thunderbird, School of Global Management. All rights reserved. This case was prepared by Kyle Mineo, MBA’ 10, Saurabh Goyal, MBA’ 10, and Tim Erion, MBA’ 10, under the direction of Professor Michael Moffett for the purpose of classroom discussion only, and not to indicate either effective or ineffective management.
MINI-CASE
2006 2007 2008 2009 Expected
2010 Forecast
2011
Sales (USD) 5,000,000 5,100,000 5,202,000 5,306,040 5,412,161 5,520,404
Average rate (INR/USD) 44.6443 41.7548 43.6976 46.8997 44.8624 45.2500
Sales (INR) 223,221,500 212,949,480 227,314,915 248,851,684 242,802,523 249,798,282
Cost of goods sold (INR) 151,790,620 144,805,646 159,120,441 216,500,965 235,518,447 242,304,333
Cotton Costs 57,680,436 55,026,146 60,465,767 84,435,376 124,824,777 128,421,297
Direct Labor 19,732,781 28,961,129 38,188,906 47,630,212 49,458,874 48,460,867
Weaving Charges 44,019,280 40,545,581 31,824,088 47,630,212 32,972,583 33,922,607
Variable Overhead 30,358,124 20,272,790 28,641,679 36,805,164 28,262,214 31,499,563
Operating Income 71,430,880 68,143,834 68,194,475 32,350,719 7,284,076 7,493,948
Net Income 11,161,075 10,647,474 11,365,746 7,465,551 3,642,038 3,746,974
Return on Sales (% of sales) 5.0% 5.0% 5.0% 3.0% 1.5% 1.5%
COGS (% of Sales) 68% 68% 70% 87% 97% 97%
Cotton Costs (% of COGS) 38% 38% 38% 39% 53% 53%
Direct Labor (% of COGS) 13% 20% 24% 22% 21% 20%
EXHIBIT 1 Banbury Impex Private Ltd—Sales and Income
292 CHAPTER 10 Transaction Exposure
farmers to plant more cotton to meet the heightened demand. But, despite growing production, cotton prices had skyrocketed in the past year, reaching $1.50/lb, as illus- trated in Exhibit 2. The increased demand from China and the reduced inventories in the United States had driven the price up.
Although most market analysts continued to argue that cotton prices were abnormally high—and must fall sooner rather than later—they remained high and only seemed to go higher as the soothsayers predicted their fall. What frightened Lapura even more, were the market analysts who were now arguing that cotton prices had moved to a higher level, permanently.
Lapura was considering the use of cotton futures, a practice some of his competitors were already using. A recent check of futures prices had provided him some data on what prices he may be able to lock in now for cotton in the coming year, in U.S. cents per pound: March 2011: 113.09; July 2011: 102.06/; October 2011: 95.03. Although futures would eliminate the risk of further increases in cot- ton prices, he was still afraid he would be locking in the price at the top.
Currency of Invoice As an Indian textile exporter, Lapura had never had a choice about the currency of invoice—it would be the U.S. dollar. But maybe times had changed? The dollar had been falling against the rupee for some time now (as seen in Exhibit 3), and as a result, the rupees generated from export sales were less and less. The problem was that as an exporter from what the world called an “emerging mar- ket,” his hard currency choices were the U.S. dollar, the European euro, and the Japanese yen. And the rupee had been strengthening against all of them!
But what might the future bring? All three hard cur- rencies were at record low rates of return—nominal interest rate yields—and not expected to change much in the immediate future. They were under careful watch by their central banks, with all three central banks pumping liquidity into the respective monetary systems following the credit crisis of 2008–2009. The immediate likelihood was the rise of inflation in all three markets. Unfortu- nately, that would not help, as a rise in inflation would probably only drive their values down further against the rupee.
The Turkish Sale Lapura’s immediate problem was a $250,000 textile sale he had made to a Turkish customer. The contract allowed him to change the currency of invoice from the Turkish lira to the dollar or euro if he wished, but he had to decide by close of business day.
USD helped provide further stability in mitigating raw material costs as international cotton prices were priced in USD. All things considered, Banbury’s profit projections for 2011 looked disastrously low.
The Indian Textile Industry The Indian textile industry has been a major contributor to Indian GDP over the past several years. After dismantling the quota regime in 2005, the government had hoped for textile exports to hit USD 50 billion by 2012, but as of 2010, they were only USD 22 billion.
The industry was both capital and labor intensive, as well as highly regulated. Companies operated on small margins in a highly competitive marketplace, and the global recession of 2008–2009 had battered the Indian industry even further. Challenges faced by the Indian textile industry included the following:
Rising Raw Material and Labor Costs. The chief raw materials used in textiles were cotton and other natural and poly-based yarn. Erratic monsoons, coupled with increased exports of cotton in the recent years, had caused the price of cotton to rise dramatically. During the past 12 months, cotton prices had increased more than 75%. A variety of government programs and restrictions had also contributed to a growing scarcity of skilled labor in the textile industry.
Competition from China and Other Asian Countries. India and China account for the majority of global textile produc- tion. Due to low labor costs and strong government support and infrastructure, China had been able to stay ahead in competing with the BRIC (Brazil, Russia, India, and China) countries. Consequently, Chinese textile products were priced more competitively in the global market, and prevented Indian companies from pushing through any price increases. Indian companies were now suffering falling margins and losing orders to other countries. Much of the Indian low-value market had already shifted to Bangladesh, as costs there were 50% cheaper than in India.
Appreciation of the Rupee. The rupee had grown increas- ingly volatile in recent years against the dollar, and over the past two years, appreciated by nearly 20%. This appre- ciation had made countries like Bangladesh and Vietnam more competitive on the global front. In early November, the rupee had risen to INR44/USD, the strongest in more than three years. It now hovered at 45. Further strengthen- ing of the rupee against the dollar would most likely put many Indian textile companies out of business.
The Curious Case of High Cotton Prices The cotton market had been nothing other than “crazy” recently. The monsoons in India had prompted many
293Transaction Exposure CHAPTER 10
his bankers. But his bankers also told him that as a small foreign business, the Turkish market would charge him an additional 300 basis point credit spread. But if he did indeed get the money sooner rather than later, domestic Indian deposit rates were averaging a healthy 10.4%.
Currency options had recently become a hedging alter- native in India. The National Stock Exchange of India in Mumbai had opened a currency options market in October 2010. With no experience with options, Lapura wondered if an option would provide better protection than a forward contract. The options market, at least for now, was limited to INR/USD options. Although Mr. Lapura could see the upside potential that an options contract might provide, he wondered how much the contract would hurt his slim margins if he had to exercise his contract. Put and call option quotes on the dollar, considered by Mr. Lapura, are listed in Exhibit 5.
Out of Time Aadesh Lapura picked up his notes and knew it was time to call a family meeting. Times were tough and the family’s
Expected settlement on the invoice was January 30, 2011. But regardless of which currency he chose (the rupee not being one of the choices), he still had to decide how to hedge it.
Lapura had collected a variety of forward rates from his local bank for the dollar, euro, and Turkish lira, as listed in Exhibit 4. He eyed the dollar quotes the closest. The forwards would lock him into a rupee rate, which was slightly better than the current spot rate. Of course, if the forwards were considered indicators of likely rate move- ment, they did indicate what he had long hoped for—a rise in the dollar.
He had also considered some form of money mar- ket hedge-borrowing Turkish lira against the receivable. Although he had been selling in Turkey for over five years, he had never borrowed there, and only had one bank rela- tionship in Ankara. If he provided sales history to the Turk- ish bank, he may be able to use his $250,000 receivable as collateral. Domestic loan rates in Turkey for companies with similar credit quality were about 14% according to
EXHIBIT 2 Curious Case of Rising Cotton Prices
0
20
M 1
20 00
M 4
20 00
M 7
20 00
M 10
2 00
0 M
1 20
01 M
4 20
01 M
7 20
01 M
10 2
00 1
M 1
20 02
M 4
20 02
M 7
20 02
M 10
2 00
2 M
1 20
03 M
4 20
03 M
7 20
03 M
10 2
00 3
M 1
20 04
M 4
20 04
M 7
20 04
M 10
2 00
4 M
1 20
05 M
4 20
05 M
7 20
05 M
10 2
00 5
M 1
20 06
M 4
20 06
M 7
20 06
M 10
2 00
6 M
1 20
07 M
4 20
07 M
7 20
07 M
10 2
00 7
M 1
20 08
M 4
20 08
M 7
20 08
M 10
2 00
8 M
1 20
09 M
4 20
09 M
7 20
09 M
10 2
00 9
M 1
20 10
M 4
20 10
M 7
20 10
M 10
2 01
0
40
60
80
100
120
140
160
Prices reaching $1.50/lb in November and December 2010
U.S. cents per pound (lb)
Average monthly price of $0.63/lb
294 CHAPTER 10 Transaction Exposure
EXHIBIT 3 Indian Rupee/U.S. Dollar Spot Rate
30
32
34
36
38
40
42
44
46
48
50
52
Rp/US$ (monthly average)
Jan -94
Au g-9
4
Ma r-9
5 Oc
t-9 5
Ma y-9
6
De c-9
6 Ju
l-9 7
Fe b-9
8
Se p-9
8 Ap
r-9 9
No v-9
9 Ju
n-0 0 Jan
-01
Au g-0
1
Ma r-0
2 Oc
t-0 2
Ma y-0
3
De c-0
3 Ju
l-0 4
Fe b-0
5
Se p-0
5 Ap
r-0 6
No v-0
6
Ju n-0
7
Jan -08
Au g-0
8
Ma r-0
9 Oc
t-0 9
Ma y-1
0
De c-1
0
livelihood was being threatened. Two things needed to be sorted out and quickly. With the last major sale of 2010 on the books—the Turkish sale—he knew he needed to protect the value of this sale from currency losses. Also, he needed to find a sustainable path to protecting the business over the long term. With India’s continued
economic growth, many analysts are forecasting a stronger Indian Rupee versus USD exchange rate into the near future. Competition was fierce. Lapura wondered how much longer his Indian operations—the livelihood of the family—would be profitable.
EXHIBIT 4 Forward Rate Quotes
Bank Quotes on Forward Rates
Currency Cross Symbols Spot 30 days 60 days 90 days
Indian rupees per U.S. dollar USD/INR 45.8300 46.12 46.70 46.11
Indian rupees per euro EURO/INR 60.9611 61.70 61.90 62.20
Japanese yen per rupee INR/JPY 1.8250 1.81 1.81 1.80
Indian rupees per Turkish lira TRY/INR 30.7192 30.96 30.95 30.87
Turkish lira per U.S. dollar USD/LIRA 1.4793 1.49 1.48 1.48
295Transaction Exposure CHAPTER 10
9. Contractual Hedges. Name the four main contractual instruments used to hedge transaction exposure.
10. Decision Criteria. Ultimately, a treasurer must choose among alternative strategies to manage transaction exposure. Explain the two main decision criteria that must be used.
11. Proportional Hedge. Many MNEs have established transaction exposure risk management policies that mandate proportional hedging. Explain and give an example of how proportional hedging can be implemented.
PROBLEMS 1. P & G India. Proctor and Gamble’s affiliate in India,
P & G India, procures much of its toiletries product line from a Japanese company. Because of the short- age of working capital in India, payment terms by Indian importers are typically 180 days or longer. P & G India wishes to hedge an 8.5 million Japanese yen payable. Although options are not available on the Indian rupee (Rs), forward rates are available against the yen. Additionally, a common practice in India is for companies like P & G India to work with a currency agent who will, in this case, lock in the current spot exchange rate in exchange for a 4.85% fee. Using the following exchange rate and interest rate data, recommend a hedging strategy.
QUE STIONS 1. Foreign Exchange. Define the following terms:
a. Foreign exchange exposure b. The three types of foreign exchange exposure
2. Hedging and Currency Risk. Define the following terms: a. Hedging b. Currency risk
3. Arguments Against Currency Risk Manage- ment. Describe six arguments against a firm pursuing an active currency risk management program.
4. Arguments for Currency Risk Management. Describe four arguments in favor of a firm pursuing an active currency risk management program.
5. Transaction Exposure. Name the four main types of transactions from which transaction exposure arises.
6. 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.
7. Borrowing Exposure. Give an example of a transac- tion exposure that arises from borrowing in a foreign currency.
8. Cash Balances. Explain why foreign currency cash balances do not cause transaction exposure.
Case Questions
1. Which factor do you think is more threatening to Banbury’s profitability, cotton prices or the rising value of the rupee?
2. Do you think that Lapura should hedge his cotton costs with cotton futures? What would you recommend?
3. Which currency of invoice do you think Lapura should choose for the Turkish sale?
4. What recommendation would you make in terms of hedging the Turkish sale receipts?
Transaction Exposure CHAPTER 10 295
EXHIBIT 5 Currency Option Quotes on the USD
Strike Rate (Rupee/USD) Put Premium (Rupee/USD) Call Premium (Rupee/USD)
44.00 0.005 1.890
45.25 0.035 0.440
Quotes for 60-day maturity, USD 1000 per contract.
Source: National Stock Exchange of India, nseindia.com.
296 CHAPTER 10 Transaction Exposure
produced by Airbus and Boeing, seating between 50 and 100 people on average. Embraer has con- cluded an agreement with a regional U.S. airline to produce and deliver four aircraft one year from now for $80 million. Although Embraer will be paid in U.S. dollars, it also possesses a currency exposure of inputs—it must pay foreign suppliers 20 mil- lion for inputs one year from now (but they will be delivering the subcomponents throughout the year). The current spot rate on the Brazilian real (R$) is R$1.8240/$, but it has been steadily appreciating against the U.S. dollar over the past three years. Forward contracts are difficult to acquire and con- sidered expensive. Citibank Brasil has not explicitly provided Embraer a forward rate quote, but has stated that it will probably be pricing a forward off the current 4.00% U.S. dollar Eurocurrency rate and the 10.50% Brazilian government deposit note.
5. Vizor Pharmaceuticals. Vizor Pharmaceuticals, a U.S.-based multinational pharmaceutical company, is evaluating an export sale of its cholesterol-reduction drug with a prospective Indonesian distributor. The purchase would be for 1,650 million Indonesian rupiah (Rp), which at the current spot exchange rate of Rp9,450/$, translates into nearly $175,000. Although not a big sale by company standards, company policy dictates that sales must be settled for at least a minimum gross margin, in this case, a cash settle- ment of $168,000. The current 90-day forward rate is Rp9,950/$. Although this rate appeared unattractive, Vizor had to contact several major banks before even finding a forward quote on the rupiah. The consensus of currency forecasters at the moment, however, is that the rupiah will hold relatively steady, possibly falling to Rp9,400/$ over the coming 90 to 120 days. Analyze the prospective sale and make a hedging recommendation.
6. Mattel Toys. Mattel is a U.S.-based company whose sales are roughly two-thirds in dollars (Asia and the Americas) and one-third in euros (Europe). In September, Mattel delivers a large shipment of toys (primarily Barbies and Hot Wheels) to a major distributor in Antwerp. The receivable, €30 million, is due in 90 days, standard terms for the toy industry in Europe. Mattel’s treasury team has collected the following currency and market quotes. The company’s foreign exchange advisors believe the euro will be at about $1.4200/€ in 90 days. Mattel’s management does not use currency options in currency risk management activities. Advise Mattel on which hedging alternative is probably preferable.
2. Siam Cement. Siam Cement, the Bangkok-based cement manufacturer, suffered enormous losses with the coming of the Asian crisis in 1997. The company had been pursuing a very aggressive growth strategy in the mid-1990s, taking on massive quantities of foreign- currency-denominated debt (primarily U.S. dollars). When the Thai baht (B) was devalued from its pegged rate of B25.0/$ in July 1997, Siam’s interest payments alone were over $900 million on its outstanding dol- lar debt (with an average interest rate of 8.40% on its U.S. dollar debt at that time). Assuming Siam Cement took out $50 million in debt in June 1997 at 8.40% interest, and had to repay it in one year when the spot exchange rate had stabilized at B42.0/$, what was the foreign exchange loss incurred on the transaction?
3. BioTron Medical, Inc. Brent Bush, CFO of a medical device distributor, BioTron Medical, Inc., was approached by a Japanese customer, Numata, with a proposal to pay cash (in yen) for its typical orders of ¥12,500,000 every other month if it were given a 4.5% discount. Numata’s current terms are 30 days with no discounts. Using the following quotes and estimated cost of capital for Numata, Bush will compare the proposal with covering yen payments with forward contracts.
Spot rate: ¥111.40/$
30-day forward rate: ¥111.00/$
90-day forward rate: ¥110.40/$
180-day forward rate: ¥109.20/$
Numata’s WACC 8.850%
BioTron’s WACC 9.200%
4. Embraer of Brazil. Embraer of Brazil is one of the two leading global manufacturers of regional jets (Bombardier of Canada is the other). Regional jets are smaller than the traditional civilian airliners
180-day account payable, Japanese yen (¥) 8,500,000
Spot rate (¥/$) 120.60
Spot rate, rupees/dollar (Rs/$) 47.75
180-day forward rate (¥/Rs) 2.4000
Expected spot rate in 180 days (¥/Rs) 2.6000
180-day Indian rupee investing rate 8.000%
180-day Japanese yen investing rate 1.500%
Currency agent’s exchange rate fee 4.850%
P & G India’s cost of capital 12.00%
297Transaction Exposure CHAPTER 10
Note: The interest rate differentials vary slightly from the forward discounts on the yen because of time differences for the quotes. The spot ¥118.255/$, for example, is a mid-point range. On April 11, the spot yen traded in London from ¥118.30/$ to ¥117.550/$.
Current spot rate ($/€) $1.4158
Credit Suisse 90-day forward rate ($/€) $1.4172
Barclays 90-day forward rate ($/€) $1.4195
Mattel Toys WACC ($) 9.600%
90-day Eurodollar interest rate 4.000%
90-day euro interest rate 3.885%
90-day Eurodollar borrowing rate 5.000%
90-day euro borrowing rate 5.000%
7. Bobcat Company. Bobcat Company, U.S.-based manufacturer of industrial equipment, just purchased a Korean company that produces plastic nuts and bolts for heavy equipment. The purchase price was Won7,500 million. Won1,000 million has already been paid, and the remaining Won6,500 million is due in six months. The current spot rate is Won1,110/$, and the 6-month forward rate is Won1,175/$. The 6-month Korean won interest rate is 16% per annum, the 6-month U.S. dol- lar rate is 4% per annum. Bobcat can invest at these interest rates, or borrow at 2% per annum above those rates. A 6-month call option on won with a 1200/$ strike rate has a 3.0% premium, while the 6-month put option at the same strike rate has a 2.4% premium.
Bobcat can invest at the rates given above, or borrow at 2% per annum above those rates. Bobcat’s weighted average cost of capital is 10%. Compare alternate ways that Bobcat might deal with its foreign exchange exposure. What do you recommend and why?
8. Aquatech. Aquatech is a U.S.-based company that manufactures, sells, and installs water purification equipment. On April 11, the company sold a system to the City of Nagasaki, Japan, for installation in Nagasaki’s famous Glover Gardens (where Puccini’s Madame Butterfly waited for the return of Lt. Pinker- ton). The sale was priced in yen at ¥20,000,000, with payment due in three months.
Spot exchange rate: ¥118.255/$ (closing mid-rates)
1-month forward: ¥117.760/$, a 5.04% p.a. premium
3-month forward: ¥116.830/$, a 4.88% p.a. premium
1-year forward: ¥112.450/$, a 5.16% p.a. premium
Additional information: Aquatech’s Japanese com- petitors are currently borrowing yen from Japanese banks at a spread of two percentage points above the Japanese money rate. Aquatech’s weighted average cost of capital is 16%, and the company wishes to pro- tect the dollar value of this receivable.
Money Rates United States Japan Differential
1 month 4.8750% 0.09375% 4.78125%
3 months 4.9375% 0.09375% 4.84375%
1 year 5.1875% 0.31250% 4.87500%
Three-month options from Kyushu Bank:
! Call option on ¥20,000,000 at exercise price of ¥118.00/$: a 1% premium.
! Put option on ¥20,000,000, at exercise price of ¥118.00/$: a 3% premium. a. What are the costs and benefits of alternative
hedges? Which would you recommend, and why? b. What is the break-even reinvestment rate when com-
paring forward and money market alternatives?
9. Compass Rose. Compass Rose, Ltd., a Canadian manufacturer of raincoats, does not selectively hedge its transaction exposure. Instead, if the date of the transaction is known with certainty, all foreign currency-denominated cash flows must utilize the following mandatory forward cover formula:
Compass Rose’s Mandatory Forward Cover
0–90 days
91–180 days
180 days
Paying the points forward 75% 60% 50%
Receiving the points forward 100% 90% 50%
Compass Rose expects to receive multiple payments in Danish kroner over the next year. DKr 3,000,000 is due in 90 days; DKr 2,000,000 is due in 180 days; and DKr 1,000,000 is due in one year. Using the following spot and forward exchange rates, what would be the amount of forward cover required by company policy by period?
Spot rate, Dkr/C$ 4.70
3-month forward rate, Dkr/C$ 4.71
6-month forward rate, Dkr/C$ 4.72
12-month forward rate, Dkr/C$ 4.74
10. Pupule Travel. Pupule Travel, a Honolulu, Hawaii- based 100% privately owned travel company, has signed an agreement to acquire a 50% ownership
298 CHAPTER 10 Transaction Exposure
share of Taichung Travel, a Taiwan-based privately owned travel agency specializing in servicing inbound customers from the United States and Canada. The acquisition price is 7 million Taiwan dollars (T$7,000,000) payable in cash in three months.
Thomas Carson, Pupule Travel’s owner, believes the Taiwan dollar will either remain stable or decline a little over the next three months. At the present spot rate of T$35/$, the amount of cash required is only $200,000, but even this relatively modest amount will need to be borrowed personally by Thomas Carson. Taiwanese interest-bearing deposits by nonresidents are regulated by the government, and are currently set at 1.5% per year. He has a credit line with Bank of Hawaii for $200,000 with a current borrowing interest rate of 8% per year. He does not believe that he can calculate a credible weighted average cost of capital since he has no stock outstanding and his competi- tors are all privately owned without disclosure of their financial results. Since the acquisition would use up all his available credit, he wonders if he should hedge this transaction exposure. He has quotes from Bank of Hawaii shown in the following table:
Spot rate (T$/$) 33.40
3-month forward rate (T$/$) 32.40
3-month Taiwan dollar deposit rate 1.500%
3-month dollar borrowing rate 6.500%
3-month call option on T$ not available
Analyze the costs and risks of each alternative, and then make a recommendation as to which alternative Thomas Carson should choose.
11. Chronos Time Pieces. Chronos Time Pieces of Bos- ton exports watches to many countries, selling in local currencies to stores and distributors. Chronos prides itself on being financially conservative. At least 70% of each individual transaction exposure is hedged, mostly in the forward market, but occasionally with options. Chronos’s foreign exchange policy is such that the 70% hedge may be increased up to a 120% hedge if devaluation or depreciation appears imminent. Chronos has just shipped to its major North American distributor. It has issued a 90-day invoice to its buyer for €1,560,000. The current spot rate is $1.2224/€, the 90-day forward rate is $1.2270/€. Chronos’s treasurer, Manny Hernandez, has a very good track record in predicting exchange rate movements. He currently
believes the euro will weaken against the dollar in the coming 90 to 120 days, possibly to around $1.16/€.
12. Lucky 13. Lucky 13 Jeans of San Antonio, Texas, is completing a new assembly plant near Guatemala City. A final construction payment of Q8,400,000 is due in six months. (“Q” is the symbol for Guatema- lan quetzals.) Lucky 13 uses 20% per annum as its weighted average cost of capital. Today’s foreign exchange and interest rate quotations are as follows:
U.S. dollar 6-month interest rate (per annum)
Lucky 13’s weighted average cost of capital (WACC)
Guatemalan 6-month interest rate (per annum)
6-month forward rate (quetzals/$)
Present spot rate (quetzals/$)
Construction payment due in 6-months (A/P, quetzals)
6.000%
20.000%
14.000%
7.1000
7.0000
8,400,000
8.0000
7.3000
6.4000
Highest expected rate (reflecting a significant devaluation)
Lucky 13’s treasury manager, concerned about the Guatemalan economy, wonders if Lucky 13 should be hedging its foreign exchange risk. The manager’s own forecast is as follows:
Expected spot rate in 6 months (quetzals/$):
Expected rate
Lowest expected rate (reflecting a strengthening of the quetzal)
What realistic alternatives are available to Lucky 13 for making payments? Which method would you select and why?
13. Burton Manufacturing. Jason Stedman is the direc- tor of finance for Burton Manufacturing, a U.S.-based manufacturer of handheld computer systems inven- tory management. Burton’s system combines a low- cost active bar code used on inventory (the bar code tags emit an extremely low-grade radio frequency) with custom designed hardware and software which tracks the low-grade emissions for inventory control. Burton has completed the sale of a bar code system to a British firm, Pegg Metropolitan (UK), for a total
299Transaction Exposure CHAPTER 10
payment of £1,000,000. The exchange rates shown at the top of this page were available to Burton on dates corresponding to the events of this specific export sale. Assume each month is 30 days.
14. Micca Metals, Inc. Micca Metals, Inc. is a specialty materials and metals company located in Detroit, Michigan. The company specializes in specific precious metals and materials, which are used in a variety of pig- ment applications in many other industries including cosmetics, appliances, and a variety of high tinsel metal fabricating equipment. Micca just purchased a shipment of phosphates from Morocco for 6,000,000, dirhams, payable in six months. Micca’s cost of capital is 8.600%.
Assumptions Values
Shipment of phosphates from Morocco, Moroccan dirhams
6,000,000
Micca’s cost of capital (WACC) 14.000%
Spot exchange rate, dirhams/$ 10.00
6-month forward rate, dirhams/$ 10.40
6-month interest rate for borrowing, Morocco (per annum)
8.000%
6-month interest rate for investing, Morocco (per annum)
7.000%
6-month interest rate for borrowing, U.S. (per annum)
6.000%
6-month interest rate for investing, U.S. (per annum)
5.000%
Date Event Spot Rate ($/£) Forward Rate ($/£) Days Forward
February 1 Price quotation for Pegg 1.7850 1.7771 210
March 1 Contract signed for sale 1.7465 1.7381 180
Contract amount, pounds £1,000,000
June 1 Product shipped to Pegg 1.7689 1.7602 90
August 1 Product received by Pegg 1.7840 1.7811 30
September 1 Grand Met makes payment 1.7290 – –
Assumptions Value
90-day A/R in pounds £3,000,000.00
Spot rate, US$ per pound ($/£) $1.7620
90-day forward rate, US$ per pound ($/£) $1.7550
Three-month U.S. dollar investment rate 6.000%
Three-month U.S. dollar borrowing rate 8.000%
Three-month U.K. investment interest rate 8.000%
Three-month U.K. borrowing interest rate 14.000%
Put options on the British pound: Strike rates, US$/pound ($/£)
Strike rate ($/£) $1.75
Put option premium 1.500%
Strike rate ($/£) $1.71
Put option premium 1.000%
Trident’s WACC 12.000%
Maria Gonzalez’s expected spot rate in 90-day, US$ per pound ($/£)
$1.7850
15. Maria Gonzalez and Trident. Trident—the U.S.- based company discussed in this chapter, has con- cluded a second larger sale of telecommunications equipment to Regency (U.K.). Total payment of £3,000,000 is due in 90 days. Maria Gonzalez has also learned that Trident will only be able to bor- row in the United Kingdom at 14% per annum (due to credit concerns of the British banks). Given the following exchange rates and interest rates, what transaction exposure hedge is now in Trident’s best interest?
Six-month call options on 6,000,000 dirhams at an exercise price of 10.00 dirhams per dollar are avail- able from Bank Al-Maghrub at a premium of 2%. Six- month put options on 6,000,000 dirhams at an exercise price of 10.00 dirhams per dollar are available at a pre- mium of 3%. Compare and contrast alternative ways that Micca might hedge its foreign exchange transac- tion exposure. What is your recommendation?
16. Larkin Hydraulics. On May 1, Larkin Hydraulics, a wholly owned subsidiary of Caterpillar (U.S.), sold a 12-megawatt compression turbine to Rebecke- Terwilleger Company of the Netherlands for €4,000,000, payable €2,000,000 on August 1 and
300 CHAPTER 10 Transaction Exposure
INTERNET EXERCISES 1. Current Volatilities. You wish to price your own
options, but you need current volatilities on the euro, British pound, and Japanese yen. Using the following Web sites, collect spot rates and volatilities in order to price forward at-the-money put options for your option pricing analysis.
€2,000,000 on November 1. Larkin derived its price quote of €4,000,000 on April 1 by dividing its normal U.S. dollar sales price of $4.320,000 by the then cur- rent spot rate of $1.0800/€.
By the time the order was received and booked on May 1, the euro had strengthened to $1.1000/€, so the sale was in fact worth 4,000,000 * $1.1000/: = $4,400,000. Larkin had already gained an extra $80,000 from favorable exchange rate movements. Neverthe- less, Larkin’s director of finance now wondered if the firm should hedge against a reversal of the recent trend of the euro. Four approaches were possible:
1. Hedge in the forward market: The 3-month for- ward exchange quote was $1.1060/€ and the 6-month forward quote was $1.1130/€.
2. Hedge in the money market: Larkin could borrow euros from the Frankfurt branch of its U.S. bank at 8.00% per annum.
3. Hedge with foreign currency options: August put options were available at strike price of $1.1000/€ for a premium of 2.0% per contract, and Novem- ber put options were available at $1.1000/€ for a premium of 1.2%. August call options at $1.1000/€ could be purchased for a premium of 3.0%, and November call options at $1.1000/€ were available at a 2.6% premium.
4. Do nothing: Larkin could wait until the sales pro- ceeds were received in August and November, hope the recent strengthening of the euro would continue, and sell the euros received for dollars in the spot market.
Larkin estimates the cost of equity capital to be 12% per annum. As a small firm, Larkin Hydrau- lics is unable to raise funds with long-term debt. U.S. T-bills yield 3.6% per annum. What should Larkin do?
Federal Reserve Bank of New York
www.newyorkfed.org/ markets/foreignex.html
RatesFX.com www.ratesfx.com/
2. Hedging Objectives. All multinational companies will state the goals and objectives of their currency risk management activities in their annual reports. Begin- ning with the following firms, collect samples of cor- porate “why hedge?” discussions for a contrast and comparison discussion.
Nestlé www.nestle.com
Disney www.disney.com
Nokia www.nokia.com
BP www.bp.com
3. Changing Translation Practices: FASB. The Financial Accounting Standards Board promulgates standard practices for the reporting of financial results by com- panies in the United States. It also, however, often leads the way in the development of new practices and emerg- ing issues around the world. One major issue today is the valuation and reporting of financial derivatives and derivative agreements by firms. Use the FASB’s home page and the Web pages of several of the major accounting firms and other interest groups around the world to see current proposed accounting standards and the current state of reaction to the proposed standards.
FASB home page raw.rutgers.edu/
Treasury Management of NY www.tmany.org/
301
APPENDIX
Complex Option Hedges
Trident, the same U.S.-based firm used throughout the chapter, still possesses a long £1,000,000 exposure—an account receivable—to be settled in 90 days. Exhibit 10A.1 sum- marizes the assumptions, exposure, and traditional option alternatives to be used throughout this appendix. The firm believes that the exchange rate will move in its favor over the 90-day period (the British pound will appreciate versus the U.S. dollar). Despite having this direc- tional view or currency expectation, the firm wishes downside protection in the event the pound were to depreciate instead.
The exposure management zones that are of most interest to the firm are the two oppos- ing triangles formed by the uncovered and forward rate profiles. The firm would like to retain all potential area in the upper-right triangle, but minimize its own potential exposure to the bottom-left triangle. The put option’s “kinked-profile” is consistent with what the firm wishes if it believes the pound will appreciate.
The firm could consider any number of different put option strike prices, depending on what minimum assured value—degree of self-insurance—the firm is willing to accept. Exhibit 10A.1 illustrates two different put option alternatives: a forward-ATM put of strike price $1.4700/£, and a forward-OTM put with strike price $1.4400/£. Because foreign currency options are actually priced about the forward rate (see Chapter 8), not the spot rate, the correct specification of whether an option, put or call, is ITM, ATM, or OTM is in reference to the same maturity forward rate. The forward-OTM put provides protection at lower cost, but also at a lower level of protection.
The Synthetic Forward At a forward rate of $1.4700/£, the proceeds of the forward contract in 90 days will yield $1,470,000. A second alternative for the firm would be to construct a synthetic forward using options. The synthetic forward requires the firm to combine two options, of equal size and maturity, both with strike rates at the forward rate:
1. Buy a put option on £ bought at a strike price of $1.4700/£, paying a premium of $0.0318/£
2. Sell a call option on £ at a strike price of $1.4700/£, earning a premium of $0.0318/£
The purchase of the put option requires a premium payment, and the sale of the call option earns the firm a premium payment. If both options are struck at the forward rate ( forward-ATM), the premiums should be identical and the net premium payment should have a value of zero.
Exhibit 10A.2 illustrates the uncovered position, the basic forward rate hedge, and the individual profiles of the put and call options for the possible construction of a synthetic
302 APPENDIX Complex Option Hedges
EXHIBIT 10A.1 Trident’s Exposure and Put Option Hedges
US $
(m ill
io ns
)
1.40 1.40
1.42
1.42
1.44
1.44
1.46
1.46
1.48
1.48
1.50
1.50
1.52
1.52
1.54
1.54
1.56
1.56 Uncovered
OTM put Forward ATM put
Forward
End-of-Period Spot Rate (US$/£)
$1.47 Strike
$1.44 Strike
U.S. dollar value of 90-day £1,000,000 A/R
Put Option
Forward ATM put OTM put
Spot rate 90-day forward rate 90-day euro-$ interest rate 90-day euro-£ interest rate 90-day $/£ volatility
$1.4790/£ $1.4700/£
3.250% 5.720%
11.000%
Strike Rates
$1.4700/£ $1.4400/£
Premium
$0.0318/£ $0.0188/£
EXHIBIT 10A.2 Synthetic Forward for a Long FX Exposure
U. S.
D ol
la r V
al ue
o f
A/ R
(m ill
io ns
)
1.40 1.40
1.42
1.42
1.44
1.44
1.46
1.46
1.48
1.48
1.50
1.50
1.52
1.52
1.54
1.54
1.56
1.56 Uncovered
Forward
End-of-Period Spot Rate (US$/£)
Sell a call: $1.47 strike
Buy a put: $1.47 strike
$1.47 strike
Instruments Strike Rates Premium Notional Principal
Buy a put Sell a call
$1.4700/£ $1.4700/£
$0.0318/£ $0.0318/£
£1,000,000 £1,000,000
303Complex Option Hedges APPENDIX
forward. The outcome of the combined position is easily confirmed by simply tracing what would happen at all exchange rates to the left of $1.4700/£, and what would happen to the right of $1.4700/£.
At all exchange rates to the left of $1.4700/£:
1. The firm would receive £1,000,000 in 90 days.
2. The call option on pounds sold by the firm would expire out-of-the-money. 3. The firm would exercise the put option on pounds to sell the pounds received at
$1.4700/£.
At all exchange rates below $1.4700/£, the U.S.-based firm would earn $1,470,000 from the receivable. At all exchange rates to the right of $1.4700/£,
1. The firm would receive £1,000,000 in 90 days.
2. The put option on pounds purchased by the firm would expire out-of-the-money. 3. The firm would turnover the £1,000,000 received to the buyer of the call, who now exercises
the call option against the firm. The firm receives $1.4700/£ from the call option buyer.
Thus, at all exchange rates above or below $1.4700/£, the U.S.-based firm nets $1,470,000 in domestic currency. The combined spot-option position has behaved identically to that of a forward contract. A firm with the exact opposite position, a £1,000,00 payable 90 days in the future, could similarly construct a synthetic forward using options.1
But why would a firm undertake this relatively complex position in order to simply create a forward contract? The answer is found by looking at the option premiums earned and paid. We have assumed that the option strike prices used were precisely forward-ATM rates, and the resulting option premiums paid and earned were exactly equal. But this need not be the case. If the option strike prices (remember that they must be identical for both options, bought and sold) are not precisely on the forward-ATM, the two premiums may differ by a slight amount. The net premium position may then end up as a net premium earning or a net premium pay- ment. If positive, this amount would be added to the proceeds from the receivable to result in a higher total dollar value received than with a traditional forward contract. A second possibility is that the firm, by querying a number of different financial service providers offering options, finds attractive pricing which “beats” the forward. Although this means that theoretically the options market is out of equilibrium, it happens quite frequently.
Second-Generation Currency Risk Management Products Second-generation risk management products are constructed from the two basic derivatives used throughout this book: the forward and the option. We will subdivide them into two groups: 1) the zero-premium option products, which focus on pricing in and around the for- ward rate; and 2) the exotic option products (for want of a better name), which focus on alter- native pricing targets. Although all of the following derivatives are sold as financial products by risk management firms, we will present each as the construction of the position from com- mon building blocks, or LEGO®s, as they have been termed, used in traditional currency risk management, forwards and options. As a group, they are collectively referred to as complex options.
1A U.S.-based firm possessing a future foreign currency denominated payment of £1 million could construct a synthetic forward hedge by 1) buying a call option on £1 million at a strike price of $1.4700/£; and 2) selling a put option on £1 million at the same strike price of $1.4700/£, when 1.47 is the forward rate.
304 APPENDIX Complex Option Hedges
Zero-Premium Option Products The primary problem with the use of options for risk management in the eyes of the firms is the up-front premium payment. Although the premium payment is only a portion of the total payoff profile of the hedge, many firms view the expenditure of substantial funds for the pur- chase of a financial derivative as prohibitively expensive. In comparison, the forward contract that eliminates currency risk requires no out-of-pocket expenditure by the firm (and requires no real specification of expectations regarding exchange rate movements).
Zero-premium option products (or financially engineered derivative combinations) are designed to require no out-of-pocket premium payment at the initiation of the hedge. This set of products includes what are most frequently labeled the range forward or collar and the participating forward. Both of these products 1) are priced based on the forward rate; 2) are constructed to provide a zero-premium payment up-front; and 3) allow the hedger to take advantage of expectations of the direction of exchange rate movements. For the case problem at hand, this means that all of the following products are applicable to an expectation that the U.S. dollar will depreciate versus the pound. If the hedger has no such view, they should turn back now (and buy a forward, or nothing at all)!
The Range Forward or Collar The basic range forward has been marketed under a variety of other names, including the collar, flexible forward, cylinder option, option fence or simply fence, mini-max, or zero-cost tunnel. Regardless of which alias it trades under, it is constructed via two steps:
1. Buying a put option with a strike rate below the forward rate, for the full amount of the long currency exposure (100% coverage)
2. Selling a call option with a strike rate above the forward rate, for the full amount of the long currency exposure (100% coverage), with the same maturity as the purchased put
The hedger chooses one side of the “range” or spread, normally the downside (put strike rate), which then dictates the strike rate at which the call option will be sold. The call option must be chosen at an equal distance from the forward rate as the put option strike price from the forward rate. The distance from the forward rate for the two strike prices should be calculated in percentage, as in {3% from the forward rate.
If the hedger believes there is a significant possibility that the currency will move in the firm’s favor, and by a sizable degree, the put-floor rate may be set relatively low in order for the ceiling to be higher or further out from the forward rate and still enjoy a zero net premium. How far down the downside protection is set is a difficult issue for the firm to determine. Often the firm’s treasurer will determine at what bottom exchange rate the firm would be able to recover the minimum necessary margin on the business underlying the cash flow exposure, sometimes called the budget rate.
Exhibit 10A.3 illustrates the outcome of a range forward constructed by buying a put with strike price $1.4500/£, paying a premium of $0.0226/£, with selling a call option with strike price $1.4900/£, earning a premium of $0.0231/£. The hedger has bounded the range over which the firm’s A/R value moves as an uncovered position, with a put option floor and a sold call option ceiling. Although the put and call option premiums are in this case not identical, they are close enough to result in a near-zero net premium (in this case, a premium expense of $500):
Net premium = ($0.0226/£ - $0.0231/£) * £1,000,000 = -$500
305Complex Option Hedges APPENDIX
The benefits of the combined position are readily observable, given that the put option premium alone amounts to $22,600. If the strike rates of the options are selected independently of the desire for an exact zero-net premium up front (still bracketing the forward rate), it is termed an option collar or cylinder option.
The Participating Forward The participating forward, also called a zero-cost ratio option and forward participation agree- ment, is an option combination that allows the hedger to share in—or participate—in potential upside movements while providing option-based downside protection, all at a zero net pre- mium. The participating forward is constructed via two steps:
1. Buying a put option with a strike price below the forward rate, for the full amount of the long currency exposure (100% coverage)
2. Selling a call option with a strike price that is the same as the put option, for a portion of the total currency exposure (less than 100% coverage)
Similar to the range forward, the buyer of a participating forward will choose the put option strike rate first. Because the call option strike rate is the same as the put, all that remains is to determine the participation rate, the proportion of the exposure sold as a call option.
Exhibit 10A.4 illustrates the construction of a participating forward for the chapter problem. The firm first chooses the put option protection level, in this case $1.4500/£, with a premium of $0.0226/£. A call option sold with the same strike rate of $1.4500/£ would earn the firm $0.0425/£. The call premium is substantially higher than the put premium because the call option is already
EXHIBIT 10A.3 Range Forward or Collar Hedge for a £1,000,000 Long Position
U. S.
D ol
la r V
al ue
o f
A/ R
(m ill
io ns
)
1.40 1.40
1.42
1.42
1.44
1.44
1.46
1.46
1.48
1.48
1.50
1.50
1.52
1.52
1.54
1.54
1.56
1.56 Uncovered
Forward
End-of-Period Spot Rate (US$/£)
Sell a call: $1.49 strike
Buy a put: $1.45 strike
$1.45 strike $1.49 strike
Instruments Strike Rates Premium Notional Principal
Buy a put Sell a call
$1.4500/£ $1.4900/£
$0.0226/£ $0.0231/£
£1,000,000 £1,000,000
306 APPENDIX Complex Option Hedges
EXHIBIT 10A.4 Participating Forward or Zero Cost Ratio Option for a £1,000,000 Long Position
U. S.
D ol
la r V
al ue
o f
A/ R
(m ill
io ns
)
1.40 1.40
1.42
1.42
1.44
1.44
1.46
1.46
1.48
1.48
1.50
1.50
1.52
1.52
1.54
1.54
1.56
1.56 Uncovered
Participating Forward
Forward
End-of-Period Spot Rate (US$/£)
$1.45 strike
Instruments Strike Rates Premium Notional Principal
Buy a put Sell a call
$1.4500/£ $1.4500/£
$0.0226/£ $0.0425/£
£1,000,000 £531,765
in-the-money (ITM). The firm’s objective is to sell a call option only on the number of pounds needed to fund the purchase of the put option. The total put option premium is
Total put premium = $0.0226/£ * £1,000,000 = $22,600
which is then used to determine the size of the call option that is needed to exactly offset the purchase of the put:
$22,600 = $0.0425/£ * call principal
Solving for the call principal:
Call principal = $22,600
$0.0425/£ = £531,765.
The firm must therefore sell a call option on £531,765 with a strike rate of $1.4500/£ to cover the purchase of the put option. This mismatch in option principals is what gives the participating forward its unique shape. The ratio of option premiums, as well as the ratio of option principals, is termed the percent cover:
Percent cover = $0.026/£ $0.0425/£
= £531,765
£1,000,000 = 0.5318 = 53.18%.
The participation rate is the residual percentage of the exposure that is not covered by the sale of the call option. For example, if the percent cover is 53.18%, the participation rate would be 1 – the percent cover, or 46.82%. This means that for all favorable exchange rate movements (those above $1.4500/£), the hedger would “participate” or enjoy 46.8% of the differential. However, like all option-based hedges, downside exposure is bounded by the put option strike rate.
307Complex Option Hedges APPENDIX
The expectations of the buyer are similar to the range forward; only the degree of foreign currency bullishness is greater. For the participating forward to be superior in outcome to the range forward, it is necessary for the exchange rate to move further in the favorable direction.
Ratio Spreads One of the older methods of obtaining a zero-premium option combination, and one of the most dangerous from a hedger’s perspective, is the ratio spread. This structure leaves the hedger with a large uncovered exposure.
Let us assume that Trident decides that it wishes to establish a floor level of protection by pur- chasing a $1.4700/£ put option (forward-ATM) at a cost of $0.0318/£ (total cost of $31,800). This is a substantial outlay of up-front capital for the option premium, and the firm’s risk management division has no budget funding for this magnitude of expenditures. The firm, feeling strongly that the dollar will depreciate against the pound, decides to “finance” the purchase of the put with the sale of an OTM call option. The firm reviews market conditions and considers a number of call option strike prices that are significantly OTM, strike prices of $1.5200/£, $1.5400/£, or further out.
It is decided that the $1.5400/£ call option, with a premium of $0.0089/£, is to be written and sold to earn the premium and finance the put purchase. However, because the premium on the OTM call is so much smaller than the forward-ATM put premium, the size of the call option written must be larger. The firm determines the amount of the call by solving the simple problem of premium equivalency as follows:
Cost of put premium = Earnings call premium
Substituting in the put and call option premiums yields
$0.0318/£ * £1,000,000 = $0.0089/£ * £ call
Solving for the size of the call option to be written as follows:
$31,800 $0.0089/£
= £3,573,034.
The reason that this strategy is called a ratio spread is that the final position, call option size to put option size, is a ratio greater than 1 (in this case, £3,573,034 , £1,000,000, or a ratio of about 3.57).
An alternative form of the ratio spread is the calendar spread. The calendar spread would combine the 90-day put option with the sale of an OTM call option with a maturity that is longer; for example, 120 or 180 days. The longer maturity of the call option written earns the firm larger premium earnings requiring a smaller “ratio.” As a number of firms using this strategy have learned the hard way, however, if the expectations of the hedger prove incorrect, and the spot rate moves past the strike price of the call option written, the firm is faced with delivering a foreign currency that it does not have. In this example, if the spot rate moved above $1.5400/£, the firm would have to cover a position of £2,573,034.
The Average Rate Option These options are normally classified as “path-dependent” currency options because their values depend on averages of spot rates over some pre-specified period. Here, we describe two examples of path-dependent options: the average rate option and the average strike option:
1. Average rate option (ARO), also known as an Asian Option, sets the option strike rate up front, and is exercised at maturity if the average spot rate over the period (as observed by scheduled sampling) is less than the preset option strike rate.
308 APPENDIX Complex Option Hedges
2. Average strike option (ASO) establishes the option strike rate as the average of the spot rate experienced over the option’s life, and is exercised if the strike rate is greater than the end of period spot rate.
Like the knock-out option, the average rate option is difficult to depict because its value depends not on the ending spot rate, but rather the path the spot rate takes over its specified life span. For example, an average rate option with strike price $1.4700/£ would have a premium of only $0.0186/£. The average rate would be calculated by weekly observations (12 full weeks, the first observation occurring 13 days from purchase) of the spot rate. Numerous different averages or paths of spot rate movement obviously exist. A few different scenarios aid in understanding how the ARO differs in valuation.
1. The spot rate moves very little over the first 70 to 80 days of the period, with a sudden movement in the spot rate below $1.4700/£ in the days prior to expiration. Although the final spot rate is below $1.4700/£, the average for the period is above $1.4700, so the option cannot be exercised. The receivable is exchanged at the spot rate (below $1.4700/£) and the cost of the option premium is still incurred.
2. The dollar slowly and steadily depreciates versus the pound, the rate rising from $1.4790/£ to $1.48, $1.49, and on up. At the end of the 90 days the option expires out of the money, the receivable is exchanged at the favorable spot rate, and the firm has enjoyed average rate option protection at substantially lower premium expense.
A variation on the average rate is the lookback option, with strike and without strike. A lookback option with strike is a European-style option with a preset strike rate that on maturity is valued versus the highest or lowest spot rate reached over the option life. A look- back option without strike is typically a European-style option that sets the strike rate at maturity as the lowest exchange rate achieved over the period for a call option, or the highest exchange rate experienced over the period for a put option, and is exercised on the basis of this strike rate versus the ending spot rate.
A variety of different types of average rate currency option products are sold by financial institutions, each having a distinct pay-off structure. Because of the intricacy of the path- dependent option’s value, care must be taken in the use of these instruments. As is always the case with more and more complex financial derivatives, caveat emptor.
309
Translation Exposure
The pen is mightier than the sword, but no match for the accountant.
—Jonathan Glancey.
Translation exposure, the second category of accounting exposures, 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. Foreign subsidiaries of U.S. companies, for example, must restate local euro, pound, yen, etc., statements into U.S. dollars so the foreign values can be added to the parent’s U.S. dollar-denominated balance sheet and income statement. This accounting process is called “translation.” Translation exposure is the potential for an increase or decrease in the parent’s net worth and reported net income caused by a change in exchange rates since the last translation.
Although the main purpose of translation is to prepare consolidated statements, trans- lated statements are also used by management to assess the performance of foreign subsid- iaries. Although such assessment might be performed from the local currency statements, restatement of all subsidiary statements into the single “common denominator” of one currency facilitates management comparison.
This chapter reviews the predominate methods used in translation today, and concludes with the Mini-Case, LaJolla Engineering Services, illustrating how translation may arise and affect a multinational’s financial performance.
Overview of Translation There are two financial statements for each subsidiary which must be translated for consolidation: the income statement and the balance sheet. (Statements of cash flow are not translated from the foreign subsidiaries.) The consolidated statement of cash flow is constructed from the consolidated statement of income and consolidated balance sheet. Because the consolidated results for any multinational firm are constructed from all of its subsidiary operations, including foreign subsidiaries, the possibility of a change in consoli- dated net income or consolidated net worth from period to period, as a result of a change in exchange rates, is high.
For any individual financial statement, internally, if the same exchange rate were used to remeasure each and every line item on the individual statement, the income statement, and balance sheet, there would be no imbalances resulting from the remeasurement. But if a different exchange rate were used for different line items on an individual statement, an imbalance would result. Different exchange rates are used in remeasuring different line items because translation principles are a complex compromise between historical and current values. The question, then, is what is to be done with the imbalance?
CHAPTER 11
310 CHAPTER 11 Translation Exposure
Subsidiary Characterization Most countries specify the translation method to be used by a foreign subsidiary based on its business operations. For example, a foreign subsidiary’s business can be categorized as either an integrated foreign entity or a self-sustaining foreign entity. 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.
It is not unusual for a single company to have both types of foreign subsidiaries, integrated and self-sustaining. For example, a U.S.-based manufacturer that produces subassemblies in the United States which are then shipped to a Spanish subsidiary for finishing and resale in the European Union would likely characterize the Spanish subsidiary as an integrated foreign entity. The dominant currency of economic operation is likely the U.S. dollar. That same U.S. parent may also own an agricultural marketing business in Venezuela that has few cash flows or operations related to the U.S. parent company or U.S. dollar. The Venezuelan subsidiary may source all inputs and sell all products in Venezuelan bolivar. Because the Venezuelan subsidiary’s operations are independent of its parent, and its functional currency is the Venezuelan bolivar, it would be classified as a self-sustaining foreign entity.
Functional Currency A foreign subsidiary’s functional currency is the currency of the primary economic environ- ment 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. It is impor- tant to note that the geographic location of a foreign subsidiary and its functional currency may be different. The Singapore subsidiary of a U.S. firm may find that its functional currency is the U.S. dollar (integrated subsidiary), the Singapore dollar (self-sustaining subsidiary), or a third currency such as the British pound (also a self-sustaining subsidiary). The United States, rather than distinguishing a foreign subsidiary as either integrated or self-sustaining, requires that the functional currency of the subsidiary be determined.
Management must evaluate the nature and purpose of each of its individual foreign subsidiaries to determine the appropriate functional currency for each. If a foreign subsidiary of a U.S.-based company is determined to have the U.S. dollar as its functional currency, it is essentially an extension of the parent company (equivalent to the integrated foreign entity designation used by most countries). If, however, the functional currency of the foreign subsid- iary is determined to be different from the U.S. dollar, the subsidiary is considered a separate entity from the parent (equivalent to the self-sustaining entity designation).
Translation Methods 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.
Current Rate Method The current rate method is the most prevalent in the world today. Under this method, all finan- cial statement line items are translated at the “current” exchange rate with few exceptions.
311Translation Exposure CHAPTER 11
! Assets and liabilities. All assets and liabilities are translated at the current rate of exchange; that is, at the rate of exchange in effect on the balance sheet date.
! Income statement items. All items, including depreciation and cost of goods sold, are translated at either the actual exchange rate on the dates the various revenues, expenses, gains, and losses were incurred or at an appropriately weighted average exchange rate for the period.
! Distributions. Dividends paid are translated at the exchange rate in effect on the date of payment.
! Equity items. Common stock and paid-in capital accounts are translated at historical rates. Year-end retained earnings consist of the original year—beginning retained earnings plus or minus any income or loss for the year.
Gains or losses caused by translation adjustments are not included in the calculation of consolidated net income. Rather, translation gains or losses are reported separately and accumulated in a separate equity reserve account (on the consolidated balance sheet) with a title such as “cumulative translation adjustment” (CTA), but it depends on the country. If a foreign subsidiary is later sold or liquidated, translation gains or losses of past years accumu- lated in the CTA account are reported as one component of the total gain or loss on sale or liquidation. The total gain or loss is reported as part of the net income or loss for the period in which the sale or liquidation occurs.
Temporal Method Under the temporal method, specific assets and liabilities are translated at exchange rates consistent with the timing of the item’s creation. The temporal method assumes that a num- ber of individual line item assets such as inventory and net plant and equipment are restated regularly to reflect market value. If these items were not restated but were instead carried at historical cost, the temporal method becomes the monetary/nonmonetary method of transla- tion, a form of translation that is still used by a number of countries today. Line items include the following:
! Monetary assets (primarily cash, marketable securities, accounts receivable, and long-term receivables) and monetary liabilities (primarily current liabilities and long- term debt). These are translated at current exchange rates. Nonmonetary assets and liabilities (primarily inventory and fixed assets) are translated at historical rates.
! Income statement items. These are translated at the average exchange rate for the period, except for items such as depreciation and cost of goods sold that are directly associated with nonmonetary assets or liabilities. These accounts are translated at their historical rate.
! Distributions. Dividends paid are translated at the exchange rate in effect on the date of payment.
! Equity items. Common stock and paid-in capital accounts are translated at historical rates. Year-end retained earnings consist of the original year-beginning retained earnings plus or minus any income or loss for the year, plus or minus any imbalance from translation.
Under the temporal method, gains or losses resulting from remeasurement are carried directly to current consolidated income, and not to equity reserves. Hence, foreign exchange gains and losses arising from the translation process do introduce volatility to consolidated earnings.
312 CHAPTER 11 Translation Exposure
U.S. Translation Procedures The United States differentiates foreign subsidiaries based on functional currency, not subsid- iary characterization. A note on terminology: Under U.S. accounting and translation practices, use of the current rate method is termed “translation” while use of the temporal method is termed “remeasurement.” The primary principles of U.S. translation are summarized as follows:
! If the financial statements of the foreign subsidiary of a U.S. company are maintained in U.S. dollars, translation is not required.
! If the financial statements of the foreign subsidiary are maintained in the local currency and the local currency is the functional currency, they are translated by the current rate method.
! If the financial statements of the foreign subsidiary are maintained in the local currency and the U.S. dollar is the functional currency, they are remeasured by the temporal method.
! If the financial statements of foreign subsidiaries are in the local currency and neither the local currency nor the dollar is the functional currency, then the statements must first be remeasured into the functional currency by the temporal method, and then translated into dollars by the current rate method.
! U.S. translation practices, summarized in Exhibit 11.1, have a special provision for translating statements of foreign subsidiaries operating in hyperinflation countries. These are countries where cumulative inflation has been 100% or more over a three- year period. In this case, the subsidiary must use the temporal method.
Purpose: Foreign currency financial statements must be translated into U.S. dollars
If the financial statements of the foreign subsidiary are expressed in a foreign currency, the following
determinations need to be made.
Is the local currency the functional currency?
Is the dollar the functional currency?
Remeasure from foreign currency to functional
(temporal method) and translate to dollars (current rate method)
* The term “remeasure” means to translate, as to change the unit of measure, from a foreign currency to the functional currency.
Translated to dollars (current rate method)
Remeasure to dollars (temporal method)
YesNo
No Yes
EXHIBIT 11.1 Flow Chart for U.S. Translation Practices
313Translation Exposure CHAPTER 11
A final note: The selection of the functional currency is determined by the economic reali- ties of the subsidiary’s operations, and is not a discretionary management decision on pre- ferred procedures or elective outcomes. Since many U.S.-based multinationals have numerous foreign subsidiaries, some dollar-functional and some foreign currency-functional, currency gains and losses may be passing through both current consolidated income and/or accruing in equity reserves.
International Translation Practices Many of the world’s largest industrial countries use International Accounting Standards Com- mittee (IASC), and therefore the same basic translation procedure. A foreign subsidiary is an integrated foreign entity or a self-sustaining foreign entity; integrated foreign entities are typically remeasured using the temporal method (or some slight variation thereof); and self- sustaining foreign entities are translated at the current rate method, also termed the closing- rate method.
Trident Corporation’s Translation Exposure Trident Corporation, first introduced in Chapter 1 and shown in Exhibit 11.2, is a U.S.-based corporation, with a U.S. business unit, as well as foreign subsidiaries in both Europe and China. The company is publicly traded and its shares are traded on the New York Stock Exchange (NYSE).
Each subsidiary of Trident—the United States, Europe, and China—will have its own financial statement. Each set of financials will be constructed in the local currency (renminbi,
Trident USA
(dollars, $)
Trident China
(yuan, YUN)
Income Statement
Balance Sheet
Statement of Cash Flow
Consolidated Financials
Trident Corporation (dollars, $)
Trident Corporation will have a complete set of financial results for each subsidiary as well as for the consolidated company. Consolidated results are reported to Wall Street.
Income Statement
Balance Sheet
Statement of Cash Flow
Income Statement
Balance Sheet
Statement of Cash Flow
Income Statement
Balance Sheet
Statement of Cash Flow
Trident Europe
(euros, )
EXHIBIT 11.2 Trident Corporation: U.S. Multinational
314 CHAPTER 11 Translation Exposure
dollar, euro), but the subsidiary income statements and balance sheets will also be translated into U.S. dollars, the reporting currency of the company, for consolidation and reporting. As a U.S.-based corporation whose shares are traded on the NYSE, it will report all of its final results in U.S. dollars.
Trident Corporation’s Translation Exposure: Income Trident Corporation’s sales and earnings by operating unit for 2009 and 2010 are described in Exhibit 11.3.
! Consolidated sales. For 2010, the company generated $300 million in sales in its U.S. unit, $158.4 million in its European subsidiary (120 million at $1.32/€), and $89.6 million in its Chinese subsidiary (Rmb600 million at Rmb6.70/$). Total global sales for 2010 were $548.0 million. This constituted sales growth of 2.8% over 2009.
! Consolidated earnings. The company’s earnings (profits) fell in 2010, dropping to $53.1 million from $53.2 million in 2009. Although not a large fall, Wall Street would not react favorably to a fall in consolidated earnings.
A closer look at the sales and earnings by country, however, yields some interesting insights. Sales and earnings in the U.S. unit rose, sales growing 7.1% and earnings growing 1.4%. Since the U.S. unit makes up more than half of the total company’s sales and profits, this is very important. The Chinese subsidiary’s sales and earnings were identical in 2009 and 2010 when measured in local currency, Chinese renminbi. The Chinese renminbi, however, was revalued against the U.S. dollar by the Chinese government, from Rmb6.83/$ to Rmb6.70/$. The result was the dollar value of both Chinese sales and profits rose.
The European subsidiary’s financial results are even more striking. Sales and earnings in Europe in euros grew from 2009 to 2010. Sales grew 1.7% while earnings increased 1.0%. But the euro depreciated against the dollar, falling from $1.40/€ to $1.32/€. This depreciation
EXHIBIT 11.3 Trident Corporation, Selected Financial Results, 2009–2010
Sales (millions, local currency)
Average Exchange Rate ($/€ and Rmb/$)
Sales (millions of US$)
2009 2010 % Change 2009 2010 % Change 2009 2010 % Change
United States
$280 $300 7.1% — — $280.0 $300.0 7.1%
Europe €118 €120 1.7% 1.4000 1.3200 -5.71% $165.2 $158.4 – 4.1%
China Rmb600 Rmb600 0.0% 6.8300 6.7000 1.94% $87.8 $89.6 1.9%
Total $533.0 $548.0 2.8%
Earnings (millions, local currency)
Average Exchange Rate ($/€ and Rmb/$)
Earnings (millions of US$)
2009 2010 % Change 2009 2010 % Change 2009 2010 % Change
United States
$28.2 $28.6 1.4% — — $28.2 $28.6 1.4%
Europe €10.4 €10.5 1.0% 1.4000 1.3200 -5.71% $14.6 $13.9 – 4.8%
China Rmb71.4 Rmb71.4 0.0% 6.8300 6.7000 1.94% $10.5 $10.7 1.9%
Total $53.2 $53.1 – 0.2%
315Translation Exposure CHAPTER 11
of 5.7% resulted in the financial results of European operations falling in dollar terms. As a result, Trident’s consolidated earnings, as reported dollars, fell in 2010. One can imagine the discussion and debate within Trident, and with the analysts who follow the firm, of the fall in earnings reported to Wall Street.
Translation Exposure: Balance Sheet Let us continue the example of Trident focusing here on the balance sheet of its European subsidiary. We will illustrate translation by both the temporal method and the current rate method, to show the arbitrary nature of a translation gain or loss. The functional currency of Trident Europe is the euro, and the reporting currency of its parent, Trident Corporation, is the U.S. dollar.
Our analysis assumes that plant and equipment and long-term debt were acquired, and common stock issued, by Trident Europe sometime in the past when the exchange rate was $1.2760/€. Inventory currently on hand was purchased or manufactured during the immedi- ately prior quarter when the average exchange rate was $1.2180/€. At the close of business on Monday, December 31, 2010, the current spot exchange rate was $1.2000/€. When busi- ness reopened on January 3, 2011, after the New Year holiday, the euro had dropped in value versus the dollar to $1.0000/€.
Current Rate Method. Exhibit 11.4 illustrates translation loss using the current rate method. Assets and liabilities on the predepreciation balance sheet are translated at the current exchange rate of $1.2000/€. Capital stock is translated at the historical rate of $1.2760/€, and retained earnings are translated at a composite rate that is equivalent to having each past year’s addition to retained earnings translated at the exchange rate in effect that year.
The sum of retained earnings and the CTA account must “balance” the liabilities and net worth section of the balance sheet with the asset side. For this example, we have assumed the two amounts used for the December 31 balance sheet. As shown in Exhibit 11.4, the “just before depreciation” dollar translation reports an accumulated translation loss from prior periods of $136,800. This balance is the cumulative gain or loss from translating euro state- ments into dollars in prior years.
After the depreciation, Trident Corporation translates assets and liabilities at the new exchange rate of $1.0000/€. Equity accounts, including retained earnings, are translated just as they were before depreciation, and as a result, the cumulative translation loss increases to $1,736,800. The increase of $1,600,000 in this account (from a cumulative loss of $136,800 to a new cumulative loss of $1,736,800) is the translation loss measured by the current rate method.
This translation loss is a decrease in equity, measured in the parent’s reporting currency, of “net exposed assets.” An “exposed asset” is an asset whose value drops with the deprecia- tion of the functional currency and rises with an appreciation of that currency. “Net” exposed assets in this context means exposed assets minus exposed liabilities. Net exposed assets are positive (“long”) if exposed assets exceed exposed liabilities. They are negative (“short”) if exposed assets are smaller than exposed liabilities.
Temporal Method. Translation of the same accounts under the temporal method shows the arbitrary nature of any gain or loss from translation. This is illustrated in Exhibit 11.5. Monetary assets and monetary liabilities in the predepreciation euro balance sheet are trans- lated at the current rate of exchange, but other assets and the equity accounts are translated at their historic rates. For Trident Europe, the historical rate for inventory differs from that for net plant and equipment because inventory was acquired more recently.
316 CHAPTER 11 Translation Exposure
Under the temporal method, translation losses are not accumulated in a separate equity account but passed directly through each quarter’s income statement. Thus, in the dollar bal- ance sheet translated before depreciation, retained earnings were the cumulative result of earnings from all prior years translated at historical rates in effect each year, plus translation gains or losses from all prior years. In Exhibit 11.5, no translation loss appears in the predepreciation dollar balance sheet because any losses would have been closed to retained earnings.
The effect of the depreciation is to create an immediate translation loss of $160,000. This amount is shown as a separate line item in Exhibit 11.5 to focus attention on it for this example. Under the temporal method, this translation loss of $160,000 would pass through the income statement, reduc- ing reported net income and reducing retained earnings. Ending retained earnings would in fact be $7,711,200 minus $160,000, or $7,551,200. Whether gains and losses pass through the income statement under the temporal method depends upon the country.
Managerial Implications In the case of Trident, the translation gain or loss is larger under the current rate method because inventory and net plant and equipment, as well as all monetary assets, are deemed exposed. When net exposed assets are larger, gains or losses from translation are also larger. If management expects a foreign currency to depreciate, it could minimize translation exposure by reducing net exposed assets. If management anticipates an appreciation of the foreign currency, it should increase net exposed assets to benefit from a gain.
Depending on the accounting method, management might select different assets and liabilities for reduction or increase. Thus, “real” decisions about investing and financing might be dictated by which accounting technique is used, when in fact, accounting impacts should be neutral.
December 31, 2010 January 2, 2011
Assets In Euros (€) Exchange Rate
(US$/euro) Translated
Accounts (US$) Exchange Rate
(US$/euro) Translated
Accounts (US$)
Cash 1,600,000 1.2000 $ 1,920,000 1.0000 $ 1,600,000
Accounts receivable 3,200,000 1.2000 3,840,000 1.0000 3,200,000
Inventory 2,400,000 1.2000 2,880,000 1.0000 2,400,000
Net plant and equipment 4,800,000 1.2000 5,760,000 1.0000 4,800,000
Total 12,000,000 $ 14,400,000 $ 12,000,000
Liabilities and Net Worth
Accounts payable 800,000 1.2000 $ 960,000 1.0000 $ 800,000
Short-term bank debt 1,600,000 1.2000 1,920,000 1.0000 1,600,000
Long-term debt 1,600,000 1.2000 1,920,000 1.0000 1,600,000
Common stock 1,800,000 1.2760 2,296,800 1.2760 2,296,800
Retained earnings 6,200,000 1.2000 (a) 7,440,000 1.2000 (b) 7,440,000
Translation adjustment (CTA) — $ (136,800) $ (1,736,800)
Total 12,000,000 $14,400,000 $ 12,000,000
(a) Dollar retained earnings before depreciation are the cumulative sum of additions to retained earnings of all prior years, translated at exchange rates in each year. (b) Translated into dollars at the same rate as before depreciation of the euro.
EXHIBIT 11.4 Trident Europe’s Translation Loss After Depreciation of the Euro: Current Rate Method
317Translation Exposure CHAPTER 11
The value contribution of a subsidiary of a multinational to the multinational as a whole is a topic of increasing debate in global financial management. Most multinational companies report the earnings contribution of foreign operations either individually or by region when significant to the total earnings of the consolidated firm.
Changes in the value of a subsidiary as a result of the change in an exchange rate can be decomposed into those specific to the income and the assets of the subsidiary:
! Value of = ! Value of + ! Value of Subsidiary Assets Earnings
Subsidiary Earnings The earnings of the subsidiary, once remeasured into the home currency of the parent company, contributes directly to the consolidated income of the firm. An exchange rate change results in fluctuations in the value of the subsidiary’s income to
the global corporation. If the individual subsidiary in question constitutes a relatively significant or material component of consolidated income, the multinational firm’s reported income (and earnings per share, EPS) may be seen to change purely as a result of translation.
Subsidiary Assets Changes in the reporting currency value of the net assets of the subsidiary is passed into consolidated income or equity.
! If the foreign subsidiary was designated as “dollar functional,” remeasurement results in a transaction exposure, which is passed through current consolidated income.
! If the foreign subsidiary was designated as “local currency functional,” translation results in a translation adjustment and is reported in consolidated equity as a translation adjustment. It does not alter reported consolidated net income in the current period.
GLOBAL FINANCE IN PRACTICE 11.1
Foreign Subsidiary Valuation
EXHIBIT 11.5 Trident Europe’s Translation Loss After Depreciation of the Euro: Temporal Method
December 31, 2010 January 2, 2011
Assets In Euros (€) Exchange Rate
(US$/euro) Translated
Accounts (US$) Exchange Rate
(US$/euro) Translated
Accounts (US$)
Cash 1,600,000 1.2000 $ 1,920,000 1.0000 $ 1,600,000
Accounts receivable 3,200,000 1.2000 3,840,000 1.0000 3,200,000
Inventory 2,400,000 1.2180 2,923,200 1.2180 2,923,200
Net plant and equipment 4,800,000 1.2760 6,124,800 1.2760 6,124,800
Total 12,000,000 $14,808,000 $13,848,000
Liabilities and Net Worth
Accounts payable 800,000 1.2000 $ 960,000 1.0000 $ 800,000
Short-term bank debt 1,600,000 1.2000 1,920,000 1.0000 1,600,000
Long-term debt 1,600,000 1.2000 1,920,000 1.0000 1,600,000
Common stock 1,800,000 1.2760 2,296,800 1.2760 2,296,800
Retained earnings 6,200,000 1.2437 (a) 7,711,200 1.2437 (b) 7,711,200
Translation gain (loss) — (c) $ (160,000)
Total 12,000,000 $14,808,000 $13,848,000
(a) Dollar retained earnings before depreciation are the cumulative sum of additions to retained earnings of all prior years, translated at exchange rates in each year. (b) Translated into dollars at the same rate as before depreciation of the euro. (c) Under the temporal method, the translation loss of $160,000 would be closed into retained earnings through the income statement rather than left as a separate line item as shown here. Ending retained earnings would actually be $7,711,200 - $160,000 = $7,551,200.
318 CHAPTER 11 Translation Exposure
As illustrated in Global Finance in Practice 11.1, transaction, translation, and operating exposures can become intertwined in the valuation of business units—in this case, the valua- tion of a foreign subsidiary.
Managing Translation Exposure The main technique to minimize translation exposure is called a balance sheet hedge. At times, some firms have attempted to hedge translation exposure in the forward market. 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.
Balance Sheet Hedge Defined. 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. A change in exchange rates will change the value of exposed liabilities in an equal amount but in a direction oppo- site to the change in value of exposed assets. If a firm translates by the temporal method, a zero net exposed position is called monetary balance. Complete monetary balance cannot be achieved under the current rate method because total assets would have to be matched by an equal amount of debt, but the equity section of the balance sheet must still be translated at historic exchange rates.
The cost of a balance sheet hedge depends on relative borrowing costs. If foreign currency borrowing costs, after adjusting for foreign exchange risk, are higher than parent currency borrowing costs, the balance sheet hedge is costly, and vice versa. Normal operations, how- ever, already require decisions about the magnitude and currency denomination of specific balance sheet accounts. Thus, balance sheet hedges are a compromise in which the denomi- nation of balance sheet accounts is altered, perhaps at a cost in terms of interest expense or operating efficiency, to achieve some degree of foreign exchange protection.
To achieve a balance sheet hedge, Trident Corporation must either 1) reduce exposed euro assets without simultaneously reducing euro liabilities, or 2) increase euro liabilities without simultaneously increasing euro assets. One way to do this is to exchange existing euro cash for dollars. If Trident Europe does not have large euro cash balances, it can borrow euros and exchange the borrowed euros for dollars. Another subsidiary could borrow euros and exchange them for dollars. That is, the essence of the hedge is for the parent or any of its subsidiaries to create euro debt and exchange the proceeds for dollars.
Current Rate Method. Under the current rate method, Trident should borrow as much as €8,000,000. The initial effect of this first step is to increase both an exposed asset (cash) and an exposed liability (notes payable) on the balance sheet of Trident Europe, with no immedi- ate effect on net exposed assets. The required follow-up step can take two forms: 1) Trident Europe could exchange the acquired euros for U.S. dollars and hold those dollars itself, or 2) it could transfer the borrowed euros to Trident Corporation, perhaps as a euro dividend or as repayment of intracompany debt. Trident Corporation could then exchange the euros for dollars. In some countries, local monetary authorities will not allow their currency to be so freely exchanged.
Another possibility would be for Trident Corporation or a sister subsidiary to borrow the euros, thus keeping the euro debt entirely off Trident’s books. However, the second step is still essential to eliminate euro exposure; the borrowing entity must exchange the euros for dollars or other unexposed assets. Any such borrowing should be coordinated with all other euro borrowings to avoid the possibility that one subsidiary is borrowing euros to reduce
319Translation Exposure CHAPTER 11
translation exposure at the same time as another subsidiary is repaying euro debt. (Note that euros can be “borrowed,” by simply delaying repayment of existing euro debt; the goal is to increase euro debt, not borrow in a literal sense.)
Temporal Method. If translation is by the temporal method, the much smaller amount of only €800,000 need be borrowed. As before, Trident Europe could use the proceeds of the loan to acquire U.S. dollars. However, Trident Europe could also use the proceeds to acquire inven- tory or fixed assets in Europe. Under the temporal method, these assets are not regarded as exposed and do not drop in dollar value when the euro depreciates.
When Is a Balance Sheet Hedge Justified? If a firm’s subsidiary is using the local currency as the functional currency, the following cir- cumstances 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 mea- sures 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 sub- sidiary, 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.
In the end, accounting exposure is a topic of great concern and complex choices for all multinationals. As demonstrated by Global Finance in Practice 11.2, despite the best of inten- tions and structures, business itself may dictate hedging outcomes.
GM Asia, a regional subsidiary of GM Corporation, U.S., held major corporate interests in a variety of countries and companies, including Daewoo Auto. GM had acquired control of Daewoo of South Korea’s automobile operations in 2001. The following years had been very good for the Daewoo unit, and by 2009, GM Daewoo was selling automobile compo- nents and vehicles to more than 100 countries.
Daewoo’s success meant that it had expected sales (receivables) from buyers all over the world. What was even more remarkable was that the global automobile industry now used the U.S. dollar more than ever as its currency of contract for cross-border transactions. This meant that Daewoo did not really have dozens of foreign currencies to manage, just one, the U.S. dollar. So Daewoo of Korea had, in late 2007 and early 2008, entered into a series of forward exchange contracts. These currency contracts locked in the Korean won value of the
many dollar-denominated receivables the company expected to receive from international automobile sales in the coming year. In the eyes of many, this was a conservative and responsible currency hedging policy; that is, until the global financial crisis and the following collapse of global automobile sales.
The problem for Daewoo was not that the Korean won per U.S. dollar exchange rate had moved dramatically; it had not. The problem was that Daewoo’s sales, like all other automobile industry participants, had collapsed. The sales had not taken place, and therefore the underlying exposures, the expected receivables in dollars by Daewoo, had not happened. But GM still had to contractually deliver on the forward contracts. It would cost GM Daewoo Won2,300 billion. GM’s Daewoo unit was now broke, its equity wiped out by currency hedging gone bad. GM Asia needed money, quickly, and selling interests in its highly successful Chinese and Indian businesses was the only solution.
GLOBAL FINANCE IN PRACTICE 11.2
When Business Dictates Hedging Results
320 CHAPTER 11 Translation Exposure
SUMMARY POINTS ! Translation exposure results from translating
foreign-currency-denominated statements of foreign subsidiaries into the parent’s reporting currency so the parent can prepare consolidated financial statements. Translation exposure is the potential for loss or gain from this translation process.
! 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.
! The two basic procedures for translation used in most countries today are the current rate method and the temporal method.
! Technical aspects of translation include questions about when to recognize gains or losses in the income state- ment, the distinction between functional and reporting
currency, and the treatment of subsidiaries in hyperin- flation countries.
! Translation gains and losses can be quite different from operating gains and losses, not only in magnitude but also in sign. Management may need to determine which is of greater significance prior to deciding which expo- sure is to be managed first.
! The main technique for managing translation expo- sure is a balance sheet hedge. This calls for having an equal amount of exposed foreign currency assets and liabilities.
! Even if management chooses to follow an active policy of hedging translation exposure, it is nearly impossible to offset both transaction and translation exposure simulta- neously. If forced to choose, most managers will protect against transaction losses because these are realized cash losses, rather than protect against translation losses.
MINI-CASE LaJolla Engineering Services
Meaghan O’Connor had inherited a larger set of problems in the Engineering Equipment Division than she had ever expected.1 After taking over as the CFO of the Division in March 2004, Meaghan had discovered that LaJolla’s Engi- neering Equipment Division’s Latin American subsidiaries were the source of recent losses and growing income threats. The rather unusual part of the growing problem was that both the losses and the threats were arising from currency translation.
Latin American Subsidiaries LaJolla was a multinational engineering services company with an established reputation in electrical power system design and construction. Although most of LaJolla’s busi- ness was usually described as “services,” and therefore using or owning few real assets, that was not the case with the Engineering Equipment Division. This specific busi- ness unit was charged with owning and operating the very high-cost and specialized heavy equipment involved in cer- tain electrical power transmission and distribution system
1Copyright © 2010 Thunderbird School of Global Management. All rights reserved. This case was prepared by Professor Michael Moffett for the purpose of classroom discussion only, and not to indicate either effective or ineffective management. This case con- cerns a real company. The names and countries have been changed to preserve confidentiality.
construction. In Meaghan’s terminology, she was in charge of the “Big Iron” in a company of consultants.
LaJolla’s recent activity had been focused in four coun- tries: Argentina, Jamaica, Venezuela, and Mexico. And unfortunately, the last few years had not been kind to the value of these currencies—particularly against the U.S. dollar. Each of LaJolla’s subsidiaries in these countries was local currency functional. Each subsidiary generated the majority of its revenues from local service contracts, and many of the operating expenses were also local. But each of the units had invested in some of the specialized equipment—the so-called Big Iron—which had led to net exposed assets when LaJolla had completed its consolida- tion of foreign activities each year for financial reporting purposes. The translation gains and losses (mostly losses in recent years as the Argentine peso, Jamaican dollar, Ven- ezuelan bolivar, and Mexican peso had weakened against the U.S. dollar), had accumulated in the cumulative trans- lation adjustment line item on the company’s consolidated books. But the problem had become more real of late.
321Translation Exposure CHAPTER 11
various business units worldwide. Once again, the company’s Latin American operations were the focal point, as collec- tively many of the Latin currencies had weakened recently against the dollar, although the dollar itself was quite weak against the euro. Jamaica, Venezuela, and Mexico each posed their individual problems and challenges, but all posed translation adjustment threats to LaJolla.
Jamaica The company had been fairly concerned about the Jamai- can business and its contracts from the very beginning. The company had initially agreed to take all revenues in Jamai- can dollars (sealing the local currency functional currency designation), but after the fall of the Jamaican dollar in early 2003 had renegotiated a risk-sharing agreement. The agree- ment restructured the relationship to one where, although LaJolla would continue to be paid in local currency, the two companies would share any changes in the exchange rate beginning in the fourth quarter of 2003 when establishing the charges as invoiced. Regardless, the continuing decline of the Jamaican dollar (as seen in Exhibit 1) had created substantial translation losses for LaJolla in Jamaica.
Ordinarily, these translation losses would not have been a large managerial issue for LaJolla and Meaghan, except for a minor document filing error in Argentina in the fall of 2003. LaJolla, like many multinational companies operating in Argentina in recent years, had simply given up on conduct- ing any real business of promise in the severely depressed post-crisis Argentina. It had essentially closed up shop there in the summer of 2003. But its legal counsel in Buenos Aires had made a mistake. Instead of ceasing current operations and “mothballing” the existing assets of LaJolla Engineer- ing Argentina, the local counsel had filed papers stating that LaJolla was liquidating the business. Although a minor issue in terms of distinction, according to U.S. GAAP and FAS 52, LaJolla would now have to realize in current earnings the cumulative translation losses that had grown over the years from the Argentine business. And they were substantial. It had resulted in the recognition of $7 million in losses in the fourth quarter of 2003; LaJolla’s management had not been happy.
LaJolla 2004 As a result of this recent experience, LaJolla was taking a close look at all of the translation gains and losses of its
Jan -00
Ma y-0
0
Ma r-0
0 Jul
-00
Se p-0
0 No
v-0 0
Jan -01
Ma r-0
1
Ma y-0
1 Jul
-01
Se p-0
1 No
v-0 1
Jan -02
Ma r-0
2
Ma y-0
2 Jul
-02
Se p-0
2 No
v-0 2
Jan -03
Ma r-0
3
Ma y-0
3 Jul
-03
Se p-0
3 No
v-0 3
Ma r-0
4 Jan
-04 40
44
48
52
56
60
64 JMD/USD, monthly average
EXHIBIT 1 Jamaican Dollars per U.S. Dollar
322 CHAPTER 11 Translation Exposure
Venezuela The continuing political crisis in Venezuela surrounding the presidency of Hugo Chavez had taken its toll on the Ven- ezuelan bolivar, as seen in Exhibit 3. Not only was LaJolla suffering declining U.S. dollar proceeds from its Venezuelan operations, but also it had continued to suffer severe late payments from the various government agencies to which the company was exclusively providing services. The aver- age invoice was now taking more than 180 days to be settled, and the bolivar’s decline had added to the losses. Translation losses were accumulating here, again from a subsidiary whose functional currency was the local currency. The LaJolla con- troller in Venezuela had faxed a proposal which would involve changing the currency used for the books in Venezuela to U.S. dollars, as well as a suggestion that they consider moving the subsidiary offshore (out of Venezuela) for accounting and consolidation purposes. He had suggested either the Cayman Islands or the Netherlands Antilles just off the coast.
All in all, Meaghan was beginning to think she made a big mistake when she had accepted the promotion to CFO of this division. She turned her eyes once more to look out over the Pacific to ponder what alternatives she might have to manage these exposures, and what—if anything—she should do immediately.
Mexico Although the Mexican peso had been quite stable for a number of years, it clearly had started to slide against the dollar in 2002 and 2003, as illustrated in Exhibit 2. Meaghan had become particularly frustrated with the Mexican situation the deeper she looked into it. LaJolla had only initiated the subsidiary’s operations in Mexico in early 2000, yet the reported translation losses from Mexico had grown much more rapidly than what she would have expected.
She had also become quite agitated when she real- ized that the financial reports coming from her Mexican offices were seemingly “writing-up” the translation losses every quarter. When she had asked questions, first by phone and then later in person, her local financial con- troller simply stopped talking (she was working through an interpreter), claiming they simply did not understand her questions. Meaghan was no beginner in international finance, and also knew that Mexican financial state- ments did regularly index foreign currency denominated accounts in line with government published indexes of asset values related to currencies. She wondered if the indexing could be at the source of the rapid growth in translation losses.
Jan -00
Ma y-0
0
Ma r-0
0 Jul
-00
Se p-0
0 No
v-0 0
Jan -01
Ma r-0
1
Ma y-0
1 Jul
-01
Se p-0
1 No
v-0 1
Jan -02
Ma r-0
2
Ma y-0
2 Jul
-02
Se p-0
2 No
v-0 2
Jan -03
Ma r-0
3
Ma y-0
3 Jul
-03
Se p-0
3 No
v-0 3
Ma r-0
4 Jan
-04
MXN/USD, monthly average
9.00
9.50
10.00
10.50
11.00
9.25
9.75
10.25
10.75
11.25
11.50
EXHIBIT 2 Mexican Pesos per U.S. Dollar
323Translation Exposure CHAPTER 11
LaJolla? What specific features of their individual problems seem to be intertwined with currency issues?
3. What would you recommend that Meaghan do?
Case Questions
1. Do you think Meaghan should spend time and resources attempting to manage translation losses, what many consider purely an accounting phenomenon?
2. How would you characterize or structure your analysis of each of the individual country threats to
QUESTIONS 1. By Any Other Name. What does the word translation
mean? Why is translation exposure sometimes called accounting exposure?
2. Converting Financial Assets. In the context of prepar- ing consolidated financial statements, are the words translate and convert synonyms?
3. The Central Problem. What is the central problem involved in consolidating the financial statements of a foreign subsidiary?
4. Self-Sustaining Subsidiaries. What is the difference between a self-sustaining foreign subsidiary and an integrated foreign subsidiary?
5. Functional Currency. What is a functional currency? What is a nonfunctional currency?
6. Translating Assets. What are the major differences in translating assets between the current rate method and the temporal method?
7. Translating Liabilities. What are the major differ- ences in translating liabilities between the current rate method and the temporal method?
Translation Exposure CHAPTER 11 323
Jan -00
Ma y-0
0
Ma r-0
0 Jul
-00
Se p-0
0 No
v-0 0
Jan -01
Ma r-0
1
Ma y-0
1 Jul
-01
Se p-0
1 No
v-0 1
Jan -02
Ma r-0
2
Ma y-0
2 Jul
-02
Se p-0
2 No
v-0 2
Jan -03
Ma r-0
3
Ma y-0
3 Jul
-03
Se p-0
3 No
v-0 3
Ma r-0
4 Jan
-04
VEB/USD, monthly average
600
1,000
1,400
1,800
800
1,200
1,600
2,000
EXHIBIT 3 Venezuelan Bolivars per U.S. Dollar
324 CHAPTER 11 Translation Exposure
5. Tristan Narvaja, S.A. (A). Tristan Narvaja, S.A., is the Uruguayan subsidiary of a U.S. manufacturing company. Its balance sheet for January 1 follows. The January 1 exchange rate between the U.S. dollar and the peso Uruguayo ($U) is $U20/$. Determine Tristan Narvaja’s contribution to the translation exposure of its parent on January 1, using the current rate method.
8. Hyperinflation. What is hyperinflation and what are the consequences for translating foreign financial statements?
9. Foreign Exchange Losses by Any Other Name. What is the primary difference between losses from trans- action exposure, operating exposure, and translation exposure?
PROBLEMS 1. Trident Europe (A). Using facts in the chapter for
Trident Europe, assume the exchange rate on Janu- ary 2, 2006, in Exhibit 11.4 dropped in value from $1.2000/€ to $0.9000/€ rather than to $1.0000/€. Recalculate Trident Europe’s translated balance sheet for January 2, 2006, with the new exchange rate using the current rate method. a. What is the amount of translation gain or loss? b. Where should it appear in the financial statements?
2. Trident Europe (B). Using facts in the chapter for Trident Europe, assume as in problem 1 that the exchange rate on January 2, 2006, in Exhibit 11.4 dropped in value from $1.2000/€ to $0.9000/€ rather than to $1.0000/€. Recalculate Trident Europe’s translated balance sheet for January 2, 2006, with the new exchange rate using the temporal rate method. a. What is the amount of translation gain or loss? b. Where should it appear in the financial statements? c. Why does the translation loss or gain under the
temporal method differ from the loss or gain under the current rate method?
3. Trident Europe (C). Using facts in the chapter for Trident Europe, assume the exchange rate on Janu- ary 2, 2006, in Exhibit 11.4 appreciated from $1.2000/€ to $1.500/€. Calculate Trident Europe’s translated balance sheet for January 2, 2006, with the new exchange rate using the current rate method. a. What is the amount of translation gain or loss? b. Where should it appear in the financial statements?
4. Trident Europe (D). Using facts in the chapter for Trident Europe, assume as in problem 3 that the exchange rate on January 2, 2006, in Exhibit 11.4 appreciated from $1.2000/€ to $1.5000/€. Calculate Trident Europe’s translated balance sheet for January 2, 2006, with the new exchange rate using the temporal method. a. What is the amount of translation gain or loss? b. Where should it appear in the financial statements?
Balance Sheet (thousands of pesos Uruguayo, $U)
Assets Liabilities & Net Worth
Cash $U 60,000 Current liabilities
$U 30,000
Accounts receivable
120,000 Long-term debt
90,000
Inventory 120,000 Capital stock 300,000
Net plant & equipment
240,000 Retained earnings
120,000
$U 540,000 $U 540,000
a. Determine Tristan Narvaja’s contribution to the translation exposure of its parent on January 1, using the current rate method.
b. Calculate Tristan Narvaja’s contribution to its parent’s translation loss if the exchange rate on December 31 is $U20/US$. Assume all peso Uruguayo accounts remain as they were at the beginning of the year.
6. Tristan Narvaja, S.A. (B). Using the same balance sheet as in problem 5, calculate Tristan Narvaja’s contribution to its parent’s translation loss if the exchange rate on December 31 is $U22/$. Assume all peso accounts remain as they were at the beginning of the year.
7. Tristan Narvaja, S.A. (C). Calculate Tristan Narvaja’s contribution to its parent’s translation gain or loss using the current rate method if the exchange rate on December 31 is $U12/$. Assume all peso accounts remain as they were at the beginning of the year.
8. Bangkok Instruments, Ltd (A). Bangkok Instruments, Ltd., the Thai subsidiary of a U.S. corporation, is a seis- mic instrument manufacturer. Bangkok Instruments manufactures the instruments primarily for the oil and gas industry globally, though with recent commod- ity price increases of all kinds—including copper—its business has begun to grow rapidly. Sales are primarily to multinational companies based in the United States and Europe. Bangkok Instruments’ balance sheet in thousands of Thai bahts (B) as of March 31 is as follows:
325Translation Exposure CHAPTER 11
between March 31 and April 1. Assuming no change in balance sheet accounts between those two days, calculate the gain or loss from translation by both the current rate method and the temporal method. Explain the translation gain or loss in terms of changes in the value of exposed accounts.
10. Cairo Ingot, Ltd. Cairo Ingot, Ltd. is the Egyptian sub- sidiary of Trans-Mediterranean Aluminum, a British multinational that fashions automobile engine blocks from aluminum. Trans-Mediterranean’s home reporting currency is the British pound. Cairo Ingot’s December 31 balance sheet is shown below. At the date of this bal- ance sheet the exchange rate between Egyptian pounds and British pounds sterling was £E5.50/UK£.
Exchange rates for translating Bangkok’s balance sheet into U.S. dollars are as follows:
B40.00/$ April 1 exchange rate after 25% devaluation.
B30.00/$ March 31 exchange rate, before 25% devaluation. All inventory was acquired at this rate.
B20.00/$ Historic exchange rate at which plant and equipment were acquired.
The Thai baht dropped in value from B30/$ to B40/$ between March 31 and April 1. Assuming no change in balance sheet accounts between these two days, calculate the gain or loss from translation by both the current rate method and the temporal method. Explain the translation gain or loss in terms of changes in the value of exposed accounts.
9. Bangkok Instruments, Ltd (B). Using the original data provided for Bangkok Instruments, assume that the Thai baht appreciated in value from B30/$ to B25/$
Bangkok Instruments, Ltd. Balance Sheet, March 1, thousands of Thai bahts
Assets Liabilities & Net Worth
Cash B 24,000 Accounts payable
B 18,000
Accounts receivable
36,000 Bank loans 60,000
Inventory 48,000 Common stock
18,000
Net plant & equipment
60,000 Retained earnings
72,000
B 168,000 B 168,000
Assets Liabilities & New Worth
Cash £E 16,500,000 Accounts payable
£E 24,750,000
Accounts receivable
33,000,000 Long-term debt
49,500,000
Inventory 49,500,000 Invested capital
90,750,000
Net plant and equipment
66,000,000
£E 165,000,000 £E 165,000,000
What is Cairo Ingot’s contribution to the translation exposure of Trans-Mediterranean on December 31, using the current rate method? Calculate the translation exposure loss to Trans-Mediterranean if the exchange rate at the end of the following quarter is £E6.00/£. Assume all balance sheet accounts are the same at the end of the quarter as they were at the beginning.
326
Operating Exposure
The essence of risk management lies in maximizing the areas where we have some control over the outcome while minimizing the areas where we have absolutely no control over the outcome and the linkage between effect and cause is hidden from us.
—Peter Bernstein, Against the Gods, 1996.
This chapter examines the economic exposure of a firm over time, what we term operating exposure. 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. Operating exposure analysis assesses the impact of changing exchange rates on a firm’s own operations over coming months and years and on its competitive position vis-à-vis other firms. The goal is to identify strategic moves or operating techniques the firm might wish to adopt to enhance its value in the face of unexpected exchange rate changes.
Operating exposure and transaction exposure are related in that they both deal with future cash flows. They differ in terms of which cash flows management considers and why those cash flows change when exchange rates change. We begin by revisiting the structure of our firm, Trident Corporation, and how its structure dictates its likely operating exposure. The chapter continues with a series of strategies and structures used in the management of operating exposure, and concludes with a Mini-Case, Toyota’s European Operating Exposure.
Trident Corporation: A Multinational’s Operating Exposure
The structure and operations of a multinational company determine the nature of its operat- ing exposure. Trident Corporation’s basic structure and currencies of operation are described in Exhibit 12.1. As a U.S.-based publicly traded company, ultimately all financial metrics and values have to be consolidated and expressed in U.S. dollars. That accounting exposure of the firm was described in Chapter 11. Operationally, however, the functional currencies of the individual subsidiaries in combination determine the overall operating exposure of the firm in total.
CHAPTER 12
327Operating Exposure CHAPTER 12
The net operating cash flow of any individual business reflects the cash inflows and cash outflows of its competitive position in the market:
Net operating cash flow = Accounts receivable over time - Accounts payable over time
Accounts receivable are the cash flow proceeds from sales, and accounts payable are all ongo- ing operating costs associated with the purchase of labor, materials, and other inputs. The net result, net operating cash flow, is in essence the lifeblood of any business—the source of value created by the firm over time.
For example, Trident Germany sells locally and exports, but all sales are invoiced in euros. All operating cash inflows are therefore in its home currency, the euro. On the cost side, labor costs are local and in euros, as well as many of its material input purchases being local and in euros. It also purchases components from Trident China, but those too are invoiced in euros. Trident Germany is clearly euro-functional, with all cash inflows and outflows in euros.
Trident Corporation U.S. is similar in structure to Trident Germany. All cash inflows from sales, domestic and international, are in U.S. dollars. All costs, labor and materials, sourced domestically and internationally, are invoiced in U.S. dollars. This includes purchases from Trident China. Trident U.S. is therefore obviously dollar functional.
Trident China is more complex. Cash outflows, labor and materials, are all domestic and paid in Chinese renminbi. Cash inflows, however, are generated across three different currencies as the company sells locally in renminbi, as well as exporting to both Germany in euros and the United States in dollars. On net, although having some cash inflows in both dollars and euros, the dominant currency cash flow is the renminbi.
Static Versus Dynamic Operating Exposure Measuring the operating exposure of a firm like Trident 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
Trident U.S.
(U.S. dollars, $)
Trident China
(Renminbi, Rmb)
Chinese components to U.S. in $
Trident Germany (euros, )
Chinese components to Germany in
China and Germany are subsidiaries of Trident U.S.
Sells domestically in Rmb
Sells domestically and exports in $
Trident China
Trident Germany
Trident U.S.
Material and labor costs are in renminbi (Rmb). Sales are 50% domestic (Rmb) and 50% export ($ and ). Material and labor costs are in euros ( ). Sales are 50% domestic ( ) and 50% export ( ).
Sells in the EU in
Material and labor costs are in dollars ($). Sales are 50% domestic ($) and 50% export ($).
Rmb functional
functional
$ functional
Trident Corporation: Structure and OperationsEXHIBIT 12.1
328 CHAPTER 12 Operating Exposure
term affect current and immediate contracts, generally termed transactions. 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. A simple example will clarify the point.
Assume Trident’s three business units are roughly equal in size. In 2012, the dollar starts depreciating in the market against the euro at the same time the Chinese government con- tinues the gradual revaluation of the renminbi. The operating exposure of each individual business unit then needs to be examined statically (transaction exposures) and dynamically (future business transactions not yet contracted for).
! Trident China. Sales in U.S. dollars will result in fewer renminbi proceeds in the immediate period. Sales in euros may stay roughly the same in renminbi proceeds depending on the relative movement of the Rmb against the euro. General profit- ability will fall in the short run. In the longer term, depending on the markets for its products and the nature of competition, it may need to raise the price it sells its export products for, even to its U.S. parent company.
! Trident Germany. Since this business unit’s cash inflows and outflows are all in euros, there is no immediate transaction exposure or change. It may suffer some rising input costs in the future if Trident China does indeed eventually push through price increases of component sales. Profitability is unaffected in the short term.
! Trident U.S. Like Trident Germany, Trident U.S. has all local currency cash inflows and outflows. A fall in the value of the dollar will have no immediate (transaction exposure) impact, but may change over the medium to long term as input costs from China may rise over time as the Chinese subsidiary tries to regain prior profit margins. But, like Germany, short-term profitability is unaffected.
The net result for Trident is possibly a fall in the total profitability of the firm in the short term, primarily from the fall in profits of the Chinese subsidiary; that is, the short-term trans- action/operating exposure impact. The fall in the dollar in the short term, however, is likely to have a positive impact on translation exposure, as profits and earnings in renminbi and euros translate into more and more dollars. Wall Street would likely like the results in the immediate quarter or two.
Operating and Financing 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 intracom- pany (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.
Financing cash flows are payments for the use of intercompany and intracompany loans (principal and interest) and stockholder equity (new equity investments and dividends). Each of these cash flows can occur at different time intervals, in different amounts, and in different currencies of denomination, and each has a different predictability of occurrence. We summarize cash flow possibilities in Exhibit 12.2 for Trident China and Trident U.S.
Expected Versus Unexpected Changes in Cash Flow 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
329Operating Exposure CHAPTER 12
analysis. Planning for operating exposure is a total management responsibility depending upon the interaction of strategies in finance, marketing, purchasing, and production.
An expected change in foreign exchange rates is not included in the definition of operating exposure, because both management and investors should have factored this information into their evaluation of anticipated operating results and market value.
! From a management perspective, budgeted financial statements already reflect infor- mation about the effect of an expected change in exchange rates.
! From a debt service perspective, expected cash flow to amortize debt should already reflect the international Fisher effect. The level of expected interest and principal repayment should be a function of expected ex-change rates rather than existing spot rates.
! From an investor’s perspective, if the foreign exchange market is efficient, information about expected changes in exchange rates should be widely known and thus reflected in a firm’s market value. Only unexpected changes in exchange rates, or an inefficient foreign exchange market, should cause market value to change.
! From a broader macroeconomic perspective, operating exposure is not just the sen- sitivity of a firm’s future cash flows to unexpected changes in foreign exchange rates, but also its sensitivity to other key macroeconomic variables. This factor has been labeled as macroeconomic uncertainty.
Chapter 7 described the parity relationships among exchange rates, interest rates, and infla- tion rates. However, these variables are often in disequilibrium with one another. Therefore, unexpected changes in interest rates and inflation rates could also have a simultaneous but differential impact on future cash flows. As discussed in Global Finance in Practice 12.1, fixed exchange rates obviously add an additional complexity to managing future cash flows and general corporate currency risk.
Measuring Operating Exposure An unexpected change in exchange rates impacts a firm’s expected cash flows at four levels, depending on the time horizon used, as summarized in Exhibit 12.3.
Trident China (foreign subsidiary)
Trident U.S. (parent company)
A/P
Payments for Components
Liabilities and EquityAssets
Liabilities and EquityAssets
A/R
Debt Service and Dividends
Cash flows related to the financing of the subsidiary are Financial Cash Flows Cash flows related to the business activities of the subsidiary are Operating Cash Flows
Loan to Sub Invest in Sub
Debt Equity
Financial and Operating Cash Flows Between Parent and SubsidiaryEXHIBIT 12.2
330 CHAPTER 12 Operating Exposure
Short Run. The first level impact is on expected cash flows in the one-year operating budget. The gain or loss depends on the currency of denomination of expected cash flows. These are both existing transaction exposures and anticipated exposures. The currency of denomination cannot be changed for existing obligations, or even for implied obligations such as purchase or sales commitments. Apart from real or implied obligations, in the short run it is difficult to change sales prices or renegotiate factor costs. Therefore, realized cash flows will differ from those expected in the budget. However, as time passes, prices and costs can be changed to reflect the new competitive realities caused by a change in exchange rates.
It has long been argued that when firms know the exchange rate cannot or will not change, they will conduct their business as if currency exposure—at least against the major currency(s) which their home currency is fixed—will not occur. As one study of currency risk in India noted: “These results support the hypothesis that pegged exchange rates induce moral hazard and increase financial fragility.”*
Moral hazard is the concept that a party, an agent, an indi- vidual, or a firm will take on more risk when it either knows or believes that a second party will handle, accommodate, or insure the negative repercussions of the firm’s risk-taking decisions. In other words, a firm may take more risk when it knows that some- one else will pick up the tab. In a fixed or managed exchange rate regime, that party is represented by the central bank which tells all those undertaking cross-currency contractual obligations and exposures that the exchange rate will not change.
Although there is still scant research on this specific practice for most of the emerging markets, it could prove to
*“Does the currency regime shape unhedged currency exposure?,” by Ila Patnaik and Ajay Shah, Journal of International Money and Finance, 29, 2010, pp. 760–769. See also “Moral Hazard, Financial Crises, and the Choice of Exchange Rate Regimes,” Apanard Angkinand and Thomas Wil- lett, June 2006; and “Exchange-Rate Regimes for Emerging Markets: Moral Hazard and International Borrowing,” by Ronald I. McKinnon and Huw Pill, Oxford Review of Economic Policy, Vol. 15, No. 3, 1999.
be a significant issue in the years to come as many emerg- ing markets become the object of major new international capital flows—the so-called globalization of finance. If com- mercial firms in those markets are not aware of the risk which the country itself may be taking in opening the door to international capital flows, both in and out of the country, and the impact they may have on the country’s exchange rate, they may be in for a wild ride in the immediate years to come.
GLOBAL FINANCE IN PRACTICE 12.1
Do Fixed Exchange Rates Increase Corporate Currency Risk in Emerging Markets?
EXHIBIT 12.3 Operating Exposure’s Phases of Adjustment and Response
Phase Time Price Changes Volume Changes Structural Changes
Short Run Less than one year Prices are fixed/contracted Volumes are contracted No competitive market changes
Medium Run: Equilibrium
Two to five years Complete pass-through of exchange rate changes
Volumes begin a partial response to prices
Existing competitors begin partial responses
Medium Run: Disequilibrium
Two to five years Partial pass-through of exchange rate changes
Volumes begin a partial response to prices
Existing competitors begin partial responses
Long Run More than five years Completely flexible Completely flexible Threat of new entrants and changing competitor responses
331Operating Exposure CHAPTER 12
Medium Run: Equilibrium. The second level impact is on expected medium-run cash flows, such as those expressed in two- to five-year budgets, assuming parity conditions hold among foreign exchange rates, national inflation rates, and national interest rates. Under equilibrium conditions, the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows. In this case, the currency of denomination of expected cash flows is not as important as the countries in which cash flows originate. National monetary, fiscal, and balance of payments policies determine whether equilibrium conditions will exist and whether firms will be allowed to adjust prices and costs.
If equilibrium exists continuously, and a firm is free to adjust its prices and costs to main- tain its expected competitive position, its operating exposure may be zero. Its expected cash flows would be realized and therefore its market value unchanged since the exchange rate change was anticipated. However, it is also possible that equilibrium conditions exist but the firm is unwilling or unable to adjust operations to the new competitive environment. In such a case, the firm would experience operating exposure because its realized cash flows would differ from expected cash flows. As a result, its market value might also be altered.
Medium Run: Disequilibrium. The third level impact is on expected medium-run cash flows assuming disequilibrium conditions. In this case, the firm may not be able to adjust prices and costs to reflect the new competitive realities caused by a change in exchange rates. The primary problem may be the reactions of existing competitors. The firm’s realized cash flows will differ from its expected cash flows. The firm’s market value may change because of the unanticipated results.
Long Run. The fourth level impact is on expected long-run cash flows, meaning those beyond five years. At this strategic level, a firm’s cash flows will be influenced by the reactions of both existing and potential competitors, possible new entrants, to exchange rate changes under dis- equilibrium conditions. In fact, all firms that are subject to international competition, whether they are purely domestic or multinational, are exposed to foreign exchange operating exposure in the long run whenever foreign exchange markets are not continuously in equilibrium.
Measuring Operating Exposure: Trident Germany Exhibit 12.4 presents the dilemma facing Trident as a result of an unexpected change in the value of the euro, the currency of economic consequence for the German subsidiary. Trident derives much of its reported profits—the earnings and earnings per share (EPS) as reported to Wall Street—from its European subsidiary. If the euro were to unexpectedly fall in value, how would the value of Trident Germany’s business change?
Value in the world of finance is generated by operating cash flow. If Trident wished to attempt to measure the operating exposure of Trident Germany to an unexpected exchange rate change, it would do so by evaluating the likely impact of that exchange rate on the oper- ating cash flows of Trident Germany. Specifically, how would prices, costs, and volume sales change? How would competitors and their respective prices, costs, and volumes change? The following section illustrates how those very values might respond in the short run and medium run to a fall in the value of the euro against Trident’s home currency, the dollar.
Trident Germany: The Base Case Trident Germany manufactures in Germany, sells domestically and exports, and all sales are invoiced in euros. Exhibit 12.5 summarizes the current baseline forecast for Trident Germany income and operating cash flows for the 2014–2018 period (assume it is currently 2013). Sales volume is assumed to be a constant 1 million units per year, with a per unit sales price of
332 CHAPTER 12 Operating Exposure
Trident Europe (Hamburg, Germany)
Trident’s CustomersTrident’s Suppliers
Trident Corporation (Los Angeles)
Will the altered profits of the German subsidiary, in euro, translate into more or less in U.S. dollars?
How will the sales, costs, and profits of the German subsidiary change?
US$ Reporting Environment
Euro Competitive Environment
US$/
Will costs change? Will prices and sales volume change? How much?
An unexpected depreciation in the value of the euro alters both the competitiveness of the subsidiary and the financial results, which are consolidated with the parent company.
EXHIBIT 12.4 Trident and Trident Germany
€12.80 and a per unit direct cost of €9.60. The corporate income tax rate in Germany is 29.5%, and the exchange rate is $1.20/€.1
These assumptions generate sales of €12, 800,000, and €1,205,550 in net income. Adding net income to depreciation and changes in net working capital (which are zero in the base case) generates €1,805,550 or $2,166,660 in operating cash flow at $1.20/€.2 Trident’s manage- ment values its subsidiaries by finding the present value of net operating cash flow over the coming five-year period, in U.S. dollars, assuming a 15% discount rate. The baseline analysis finds a present value of Trident Germany of $7,262,980.
On January 1, 2014, before any commercial activity begins, the euro unexpectedly drops from $1.2000/€ to $1.0000/€. Operating exposure depends on whether an unexpected change in exchange rates causes unanticipated changes in sales volume, sales prices, or operating costs.
Following a euro depreciation, Trident Germany might choose to maintain its domestic sales prices constant in euro terms, or it might try to raise domestic prices because competing imports are now priced higher in Europe. The firm might choose to keep export prices constant in terms of foreign currencies, in terms of euros, or somewhere in between (partial pass-through). The strategy undertaken depends to a large measure on management’s opinion about the price elasticity of demand, which would also include management’s assessment of competitor response.
1Assuming that Trident Germany’s sales price, cost per unit, and sales volume are all constant over the five- year period is obviously simplistic. For the purposes of our basic operating exposure measurement, however, it will allow us to show a series of mechanical changes clearly. In a real business analysis case, you would want to obviously complicate the analysis with a wealth of projections to key business values. 2Net working capital (NWC) = accounts receivable + inventory - accounts payable. This analysis assumes the firm maintains 45 days of sales in accounts receivables, 10 days of cost of goods sold expenses in inventory, and 38 days of sales in accounts payable. Initial baseline total for NWC is €508,493.
333Operating Exposure CHAPTER 12
On the cost side, Trident Germany might raise prices because of more expensive imported raw material or components, or perhaps because all domestic prices in Germany have risen and labor is now demanding higher wages to compensate for domestic inflation.
Trident Germany’s domestic sales and costs might also be partly determined by the effect of the euro depreciation on demand. To the extent that the depreciation, by making prices of German goods initially more competitive, stimulates purchases of European goods in import- competing sectors of the economy as well as exports of German goods, German national income should increase. This assumes that the favorable effect of a euro depreciation on comparative prices is not immediately offset by higher domestic inflation. Thus, Trident Ger- many might be able to sell more goods domestically because of price and income effects and internationally because of price effects.
To illustrate the effect of various post-depreciation scenarios on Trident Germany’s operating exposure, consider four simple cases.
Case 1: Depreciation, no change in any variable Case 2: Increase in sales volume, other variables remain constant Case 3: Increase in sales price, other variables remain constant Case 4: Sales price, cost, and volume increase
EXHIBIT 12.5 Trident Germany’s Baseline Valuation
Assumptions 2014 2015 2016 2017 2018
Sales volume (units) 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000
Sales price per unit € 12.80 € 12.80 € 12.80 € 12.80 € 12.80
Direct cost per unit € 9.60 € 9.60 € 9.60 € 9.60 € 9.60
German corporate tax rate 29.5% 29.5% 29.5% 29.5% 29.5%
Exchange rate ($/€) 1.2000 1.2000 1.2000 1.2000 1.2000
Income Statement 2014 2015 2016 2017 2018
Sales revenue € 12,800,000 € 12,800,000 € 12,800,000 € 12,800,000 € 12,800,000
Direct cost of goods sold -9,600,000 -9,600,000 -9,600,000 -9,600,000 -9,600,000
Cash operating expenses (fixed) -890,000 -890,000 -890,000 -890,000 -890,000
Depreciation -600,000 -600,000 -600,000 -600,000 -600,000
Pretax profit € 1,710,000 € 1,710,000 € 1,710,000 € 1,710,000 € 1,710,000
Income tax expense -504,450 -504,450 -504,450 -504,450 -504,450
Net income € 1,205,550 € 1,205,550 € 1,205,550 € 1,205,550 € 1,205,550
Operating Cash Flows
Net income € 1,205,550 € 1,205,550 € 1,205,550 € 1,205,550 € 1,205,550
Add back depreciation 600,000 600,000 600,000 600,000 600,000
Changes in net working capital 0 0 0 0 0
Cash flow from operations € 1,805,550 € 1,805,550 € 1,805,550 € 1,805,550 € 1,805,550
Cash flow from operations, in dollars $2,166,660 $2,166,660 $2,166,660 $2,166,660 $2,166,660
Present Value @ 15% $7,262,980
334 CHAPTER 12 Operating Exposure
To calculate the changes in value under each of the scenarios, we will use the same five-year horizon for any change in cash flow induced by the change in the dollar/euro exchange rate.
Case 1: Depreciation; No Change in Any Variable. Assume that in the five years ahead no changes occur in sales volume, sales price, or operating costs. Profits for the coming year in euros will be as expected, and cash flow from operations will still be €1,805,550. There is no change in NWC because all results in euros remain the same. The exchange rate change, however, means that operating cash flows measured in U.S. dollars decline to $1,805,550. The present value of this series of operating cash flows is $6,052,483, a fall in Trident Germany’s value—when measured in U.S. dollars—by $1,210,497.
Case 2: Volume Increases; Other Variables Remain Constant. Assume that following the depreciation in the euro sales within Europe increase by 40%, to 1,400,000 units. The depre- ciation has now made German-made telecom components more competitive with imports. Additionally, export volume increases because German-made components are now cheaper in countries whose currencies have not weakened. The sales price is kept constant in euro terms because management of Trident Germany has not observed any change in local German operating costs and because it sees an opportunity to increase market share.
Trident Germany’s net income rises to €2,107,950, and operating cash flow the first year to €2,504,553, after a one-time increase in net working capital of €203,397 (using a portion of the increased cash flows). Operating cash flow is €2,707,950 per year for the following four years. The present value of Trident Germany has risen by $1,637,621 over baseline to $8,900,601.
Case 3: Sales Price Increases, Other Variables Remain Constant. Assume the euro sales price is raised from €12.80 to €15.36 per unit to maintain the same U.S. dollar-equivalent price (the change offsets the depreciation of the euro).
Before After
Price in euro €12.80 €15.36
Exchange rate $1.20/€ $1.00/€
Price in US$ $15.36 $15.36
Also assume that volume remains constant (the baseline 1,000,000 units) in spite of this price increase; that is, customers expect to pay the same dollar-equivalent price, and local costs do not change.
Trident Germany is now better off following the depreciation than it was before because the sales price, which is pegged to the international price level, increased. And volume did not drop. Net income rises to €3,010,350 per year, with operating cash flow rising to €3,561,254 in 2014 (after a working capital increase of €49,096) and €3,610,350 per year in the following four years. Trident Germany has now increased in value to $12,059,761.
Case 4: Price, Cost, and Volume Increases. The final case we examine, illustrated in Exhibit 12.6, is a combination of possible outcomes. Price increases by 10% to €14.08, direct cost per unit increases by 5% to €10.00, and volume rises by 10% to 1,100,000 units. Revenues clearly rise by more than costs, and net income for Trident Germany rises to 2,113,590. Operating cash flow rises to 2,623,683 in 2014 (after NWC increase), and 2,713,590 for each of the fol- lowing four years. Trident Germany’s present value is now $9,018,195.
Other Possibilities. If any portion of sales revenues were incurred in other currencies, the situation would be different. Trident Germany might leave the foreign sales price unchanged, in
335Operating Exposure CHAPTER 12
Assumptions 2014 2015 2016 2017 2018
Sales volume (units) 1,100,000 1,100,000 1,100,000 1,100,000 1,100,000
Sales price per unit € 14.08 € 14.08 € 14.08 € 14.08 € 14.08
Direct cost per unit € 10.00 € 10.00 € 10.00 € 10.00 € 10.00
German corporate tax rate 29.5% 29.5% 29.5% 29.5% 29.5%
Exchange rate ($/€) 1.0000 1.0000 1.0000 1.0000 1.0000
Income Statement 2014 2015 2016 2017 2018
Sales revenue € 15,488,000 € 15,488,000 € 15,488,000 € 15,488,000 € 15,488,000
Direct cost of goods sold -11,000,000 -11,000,000 -11,000,000 -11,000,000 -11,000,000
Cash operating expenses (fixed) -890,000 -890,000 -890,000 -890,000 -890,000
Depreciation -600,000 -600,000 -600,000 -600,000 -600,000
Pretax profit € 2,998,000 € 2,998,000 € 2,998,000 € 2,998,000 € 2,998,000
Income tax expense -884,410 -884,410 -884,410 -884,410 -884,410
Net income € 2,113,590 € 2,113,590 € 2,113,590 € 2,113,590 € 2,113,590
Operating Cash Flows
Net income € 2,113,590 € 2,113,590 € 2,113,590 € 2,113,590 € 2,113,590
Add back depreciation 600,000 600,000 600,000 600,000 600,000
Changes in net working capital -89,907 0 0 0 0
Cash flow from operations € 2,623,683 € 2,713,590 € 2,713,590 € 2,713,590 € 2,713,590
Cash flow from operations, in dollars
$2,623,683 $2,713,590 $2,713,590 $2,713,590 $2,713,590
Present Value @ 15% $9,018,195
EXHIBIT 12.6 Trident Germany’s Valuation (Case 4)
effect raising the euro-equivalent price. Alternatively, it might leave the euro-equivalent price unchanged, thus lowering the foreign sales price in an attempt to gain volume. Of course, it could also position itself between these two extremes. Depending on elasticities and the proportion of foreign to domestic sales, total sales revenue might rise or fall.
If some or all raw material or components were imported and paid for in hard currencies, euro operating costs would increase after the depreciation of the euro. Another possibility is that local (not imported) euro costs would rise after a depreciation.
Measurement of Loss. Exhibit 12.7 summarizes the change in Trident’s German subsidiary value across our small set of simple cases from an instantaneous and permanent change in the value of the euro from $1.20/€ to $1.00/€. These cases estimate Trident Germany’s operating exposure by measuring the change in the subsidiary’s value as measured by the present value of its operating cash flows over the coming five-year period.
In Case 1, in which nothing changes after the euro depreciates, Trident’s German subsid- iary’s value falls by the percent change in the exchange rate, -16.7%. In Case 2, in which vol- ume increased by 40% as a result of increasing price competitiveness, the German subsidiary’s value increased 22.5%. In Case 3, in which the change in the exchange rate was completely passed-through to a higher sales price resulted in a massive 66% increase in subsidiary value.
336 CHAPTER 12 Operating Exposure
The final case, Case 4, combined increases in all three income-drivers. The resulting change in subsidiary valuation of +24.2%, may be creeping toward a “realistic outcome,” but there are obviously an infinite number of possibilities which subsidiary management should be able to narrow. In the end, although the measurement of operating exposure is indeed difficult, it is not impossible—and maybe worth the time and effort—in progressive financial management.
Strategic Management of Operating Exposure 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, rather than merely hoping for the best. To meet this objective, management can diversify the firm’s operating and financing base. Management can also change the firm’s operating and financing policies.
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. This task can best be accomplished if a firm diversifies internation- ally both its operating and its financing bases. Diversifying operations means diversifying sales, location of production facilities, and raw material sources. Diversifying the financing base means raising funds in more than one capital market and in more than one currency.
A diversification strategy permits the firm to react either actively or passively, depend- ing on management’s risk preference, to opportunities presented by disequilibrium condi- tions in the foreign exchange, capital, and product markets. Such a strategy does not require management to predict disequilibrium but only to recognize it when it occurs. It does require management to consider how competitors are prepositioned with respect to their own operating exposures. This knowledge should reveal which firms would be helped or hurt competitively by alternative disequilibrium scenarios.
Diversifying Operations If a firm’s operations are diversified internationally, management is pre-positioned both to recog- nize disequilibrium when it occurs and to react competitively. Consider the case where purchas- ing 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 differ- ent 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 manage- ment to make changes in operating strategies. Management might make marginal shifts in
Case Exchange Rate Price Volume Cost Valuation Change in Value
Percent Change in Value
Baseline $1.20/€ € 12.80 1,000,000 € 9.60 $ 7,262,980 –
1: No variable changes $1.00/€ € 12.80 1,000,000 € 9.60 $ 6,052,483 ($1,210,497) – 16.7%
2: Volume increases $1.00/€ € 12.80 1,400,000 € 9.60 $ 8,900,601 $ 1,637,621 22.5%
3: Sales price increases $1.00/€ € 15.60 1,000,000 € 9.60 $12,059,761 $ 4,796,781 66.0%
4: Price, cost, volume increase $1.00/€ € 14.08 1,100,000 € 10.00 $ 9,018,195 $ 1,755,215 24.2%
EXHIBIT 12.7 Summary of Trident Germany Value Changes to Depreciation of the Euro
337Operating Exposure CHAPTER 12
sourcing raw materials, components, or finished products. If spare capacity exists, produc- tion runs can be lengthened in one 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.
Even if management does not actively alter normal operations when exchange rates change, the firm should experience some beneficial portfolio effects. The variability of its cash flows is probably reduced by international diversification of its production, sourcing, and sales because exchange rate changes under disequilibrium conditions are likely to increase the firm’s competitiveness in some markets while reducing it in others. In that case, operating exposure would be neutralized.
In contrast to the internationally diversified MNE, a purely domestic firm might be sub- ject to the full impact of foreign exchange operating exposure even though it does not have foreign currency cash flows. For example, it could experience intense import competition in its domestic market from competing firms producing in countries with undervalued currencies.
A purely domestic firm does not have the option to react to an international disequilib- rium condition in the same manner as an MNE. In fact, a purely domestic firm will not be positioned to recognize that a disequilibrium exists because it lacks comparative data from its own internal sources. By the time external data are available, it is often too late to react. Even if a domestic firm recognizes the disequilibrium, it cannot quickly shift production and sales into foreign markets in which it has had no previous presence.
Constraints exist that may limit the feasibility of diversifying production locations. The technology of a particular industry may require large economies of scale. High-tech firms, such as Intel, prefer to locate in places where they have easy access to other high-tech suppliers, a highly educated workforce, and one or more leading universities. Their R&D efforts are closely tied to initial production and sales activities.
Diversifying Financing If a firm diversifies its financing sources, it will be pre-positioned to take advantage of tempo- rary deviations from the international Fisher effect. If interest rate differentials do not equal expected changes in exchange rates, opportunities to lower a firm’s cost of capital will exist. However, to be able to switch financing sources, a firm must already be well known in the international investment community, with banking contacts firmly established. Again, this is not typically an option for a domestic firm.
As we will demonstrate in Chapter 13, diversifying sources of financing, regardless of the currency of denomination, can lower a firm’s cost of capital and increase its availability of capi- tal. The ability to source capital from outside of a segmented market is especially important for firms resident in emerging markets.
Proactive Management of Operating Exposure Operating and transaction exposures can be partially managed by adopting operating or financ- ing policies that offset anticipated foreign exchange exposures. Four of the most commonly employed proactive policies are 1) matching currency cash flows; 2) risk-sharing agreements; 3) back-to-back or parallel loans; and 4) cross-currency swaps.
Matching Currency Cash Flows One way to offset an anticipated continuous long exposure to a particular currency is to acquire debt denominated in that currency. Exhibit 12.8 depicts the exposure of a U.S. firm with con- tinuing export sales to Canada. In order to compete effectively in Canadian markets, the firm
338 CHAPTER 12 Operating Exposure
invoices all export sales in Canadian dollars. This policy results in a continuing receipt of Cana- dian dollars month after month. If the export sales are part of a continuing supplier relationship, the long Canadian dollar position is relatively predictable and constant. This endless series of transaction exposures could of course be continually hedged with forward contracts or other contractual hedges, as discussed in Chapter 10.
But what if the firm sought out a continual use, an outflow, for its continual inflow of Canadian dollars? If the U.S. firm were to acquire part of its debt-capital in the Canadian dollar markets, it could use the relatively predictable Canadian dollar cash inflows from export sales to service the principal and interest payments on Canadian dollar debt and be cash flow matched. The U.S.- based firm has hedged an operational cash inflow by creating a financial cash outflow, and so it does not have to actively manage the exposure with contractual financial instruments such as for- ward contracts. This form of hedging, sometimes referred to as matching, is effective in eliminating currency exposure when the exposure cash flow is relatively constant and predictable over time.
The list of potential matching strategies is nearly endless. A second alternative would be for the U.S. firm to seek out potential suppliers of raw materials or components in Canada as a substitute for U.S. or other foreign firms. The firm would then possess not only an operational Canadian dollar cash inflow, the receivable, but also a Canadian dollar operational cash out- flow, a payable. If the cash flows were roughly the same in magnitude and timing, the strategy would be a natural hedge. The term “natural” refers to operating-based activities of the firm.
A third alternative, often referred to as currency switching, would be to pay foreign sup- pliers with Canadian dollars. For example, if the U.S. firm imported components from Mexico, the Mexican firms themselves might welcome payment in Canadian dollars because they are short Canadian dollars in their multinational cash flow network.
Currency Clauses: Risk-Sharing An alternative arrangement for managing a long-term cash flow exposure between firms with a continuing buyer-supplier relationship is risk-sharing. Risk-sharing is a contractual
U.S. Corporation
Canadian Corporation
(buyer of goods)
Canadian Bank
(loans funds)
Payment for goods in Canadian dollars
Principal and interest payments on debt in Canadian dollars
U.S. corp. borrows Canadian dollar debt from Canadian bank
Exports goods to Canada
Exposure: The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollars.
Hedge: The Canadian dollar debt payments act as a financial hedge by requiring debt service, an outflow of Canadian dollars.
EXHIBIT 12.8 Debt Financing as a Financial Hedge
339Operating Exposure CHAPTER 12
arrangement in which the buyer and seller agree to “share” or split currency movement impacts on payments between them. If the two firms are interested in a long-term relationship based on product quality and supplier reliability and not on the whims of the currency markets, a cooperative agreement to share the burden of currency risk management may be in order.
If Ford’s North American operations import automotive parts from Mazda (Japan) every month, year after year, major swings in exchange rates can benefit one party at the expense of the other. (Ford is a major stockholder of Mazda, but it does not exert control over its opera- tions. Therefore, the risk-sharing agreement is particularly appropriate; transactions between the two are both intercompany and intracompany. A risk-sharing agreement solidifies the partnership.) One potential solution would be for Ford and Mazda to agree that all purchases by Ford will be made in Japanese yen at the current exchange rate, as long as the spot rate on the date of invoice is between, say, ¥115/$ and ¥125/$. If the exchange rate is between these values on the payment dates, Ford agrees to accept whatever transaction exposure exists (because it is paying in a foreign currency). If, however, the exchange rate falls outside this range on the payment date, Ford and Mazda will share the difference equally.
For example, Ford has an account payable of ¥25,000,000 for the month of March. If the spot rate on the date of invoice is ¥110/$, the Japanese yen would have appreciated versus the dollar, causing Ford’s costs of purchasing automotive parts to rise. Since this rate falls outside the contractual range, Mazda would agree to accept a total payment in Japanese yen which would result from a difference of ¥5/$ (i.e., ¥115 – ¥110). Ford’s payment would be as follows:D ¥25,000,000
¥115.00/$ - ¢ ¥5.00/$ 2
≤ T = ¥25,000,000¥112.50/$ = $222,222.22. Ford’s total payment in Japanese yen would be calculated using an exchange rate of ¥112.50/$, and saves Ford $5,050.51. At a spot rate of ¥110/$, Ford’s costs for March would be $227,272.73. The risk-sharing agreement between Ford and Mazda allows Ford to pay $222,222.22, a sav- ings of $5,050.51 over the cost without risk sharing (this “savings” is a reduction in an increased cost, not a true cost reduction). Both parties therefore incur costs and benefits from exchange rate movements outside the specified band. Note that the movement could just as easily have been in Mazda’s favor if the spot rate had moved to ¥130/$.
The risk-sharing arrangement is intended to smooth the impact on both parties of vola- tile and unpredictable exchange rate movements. Of course, a sustained appreciation of one currency versus the other would require the negotiation of a new sharing agreement, but the ultimate goal of the agreement is to alleviate currency pressures on the continuing business relationship. Risk-sharing agreements like these have been in use for nearly 50 years on world markets. They became something of a rarity during the 1960s when exchange rates were rela- tively stable under the Bretton Woods Agreement. But with the return to floating exchange rates in the 1970s, firms with long-term customer-supplier relationships across borders have returned to some old ways of maintaining mutually beneficial long-term trade.
Back-to-Back Loans A back-to-back loan, also referred to as a parallel loan or credit swap, occurs when two business firms in separate countries arrange to borrow each other’s currency for a specific period of time. At an agreed terminal date they return the borrowed currencies. The operation is conducted outside the foreign exchange markets, although spot quotations may be used as the reference point for determining the amount of funds to be swapped. Such a swap creates a covered hedge against exchange loss, since each company, on its own books, borrows the
340 CHAPTER 12 Operating Exposure
same currency it repays. Back-to-back loans are also used at a time of actual or anticipated legal limitations on the transfer of investment funds to or from either country.
The structure of a typical back-to-back loan is illustrated in Exhibit 12.9. A British parent firm wanting to invest funds in its Dutch subsidiary locates a Dutch parent firm that wants to invest funds in the United Kingdom. Avoiding the exchange markets entirely, the British parent lends pounds to the Dutch subsidiary in the United Kingdom, while the Dutch parent lends euros to the British subsidiary in the Netherlands. The two loans would be for equal values at the current spot rate and for a specified maturity. At maturity, the two separate loans would each be repaid to the original lender, again without any need to use the foreign exchange markets. Neither loan carries any foreign exchange risk, and neither loan normally needs the approval of any governmental body regulating the availability of foreign exchange for investment purposes.
Parent company guarantees are not needed on the back-to-back loans because each loan carries the right of offset in the event of default of the other loan. A further agreement can provide for maintenance of principal parity in case of changes in the spot rate between the two countries. For example, if the pound dropped by more than, say, 6% for as long as 30 days, the British parent might have to advance additional pounds to the Dutch subsidiary to bring the principal value of the two loans back to parity. A similar provision would protect the British if the euro should weaken. Although this parity provision might lead to changes in the amount of home currency each party must lend during the period of the agreement, it does not increase foreign exchange risk, because at maturity all loans are repaid in the same currency loaned.
There are two fundamental impediments to widespread use of the back-to-back loan. First, it is difficult for a firm to find a partner, termed a counterparty, for the currency, amount, and timing desired. Second, a risk exists that one of the parties will fail to return the borrowed funds at the designated maturity—although this risk is minimized because each party to the loan
British Parent Firm
Dutch Firm’s British Subsidiary
1. British firm wishes to invest funds in its Dutch subsidiary.
3. British firm loans British pounds directly to the Dutch firm’s British subsidiary.
Direct loan in pounds
Dutch Parent Firm
British Firm’s Dutch Subsidiary
2. British firm identifies a Dutch firm wishing to invest funds in its British subsidiary.
4. British firm’s Dutch subsidiary borrows euros from the Dutch parent.
The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure.
Direct loan in euros
Indirect Financing
EXHIBIT 12.9 Back-to-Back Loans for Currency Hedging
341Operating Exposure CHAPTER 12
has, in effect, 100% collateral, albeit in a different currency. These disadvantages have led to the rapid development and wide use of the currency swap.
Cross-Currency Swaps A cross-currency swap resembles a back-to-back loan except that it does not appear on a firm’s balance sheet. As we noted briefly in Chapter 6, the term swap is widely used to describe a foreign exchange agreement between two parties to exchange a specified amount of one currency for another at one point in time, and then give back the original amounts swapped at a future date. Care should be taken to clarify which of the many different swaps is being referred to in a specific case.
In a currency swap, a firm and a swap dealer or swap bank agree to exchange an equiva- lent amount of two different currencies for a specified period of time. Currency swaps can be negotiated for a wide range of maturities up to 30 years in some cases. The swap dealer or swap bank acts as a middleman in setting up the swap agreement. Currency swap structures are covered in detail in Chapter 8.
A typical currency swap first requires two firms to borrow funds in the markets and cur- rencies in which they are best known. For example, a Japanese firm would typically borrow yen on a regular basis in its home market. If, however, the Japanese firm were exporting to the United States and earning U.S. dollars, it might wish to construct a matching cash flow hedge which would allow it to use the U.S. dollars earned to make regular debt-service payments on U.S. dollar debt. If, however, the Japanese firm is not well known in the U.S. financial markets, it may have no ready access to U.S. dollar debt.
One way in which it could, in effect, borrow dollars, is to participate in a cross-currency swap as see in Exhibit 12.10. The Japanese firm could swap its yen-denominated debt service payments with another firm that has U.S. dollar-debt service payments. This swap would have the Japanese firm “paying dollars” and “receiving yen.” The Japanese firm would then have
Both the Japanese corporation and the U.S. corporation would like to enter into a cross-currency swap that would allow them to use foreign currency cash inflows to service debt.
Wishes to enter into a swap to “pay dollars” and “receive yen.”
Wishes to enter into a swap to “pay yen” and “receive dollars.”
Swap Dealer
Sales to U.S. Debt in yen
Receive yen
Pay yen
Inflow
of US$ Sales to Japan Debt in US$
Inflow
of yen
Pay dollars
Receive dollars
Assets Liabilities and Equity Assets
Liabilities and Equity
Japanese Corporation
United States Corporation
EXHIBIT 12.10 Using Cross-Currency Swaps
342 CHAPTER 12 Operating Exposure
dollar-debt service without actually borrowing U.S. dollars. Simultaneously, a U.S. corpora- tion could actually be entering into a cross-currency swap in the opposite direction—“paying yen” and “receiving dollars.” The swap dealer is taking the role of a middleman. Swap dealers arrange most swaps on a “blind basis,” meaning that the initiating firm does not know who is on the other side of the swap arrangement—the counterparty. The firm views the dealer or bank as its counterparty. Because the swap markets are dominated by the major money center banks worldwide, the counterparty risk is acceptable. Because the swap dealer’s business is arranging swaps, the dealer can generally arrange for the currency, amount, and timing of the desired swap.
Accountants in the United States treat the currency swap as a foreign exchange transac- tion rather than as debt and treat the obligation to reverse the swap at some later date as a forward exchange contract. Forward exchange contracts can be matched against assets, but they are entered in a firm’s footnotes rather than as balance sheet items. The result is that both translation and operating exposures are avoided, and neither a long-term receivable nor a long-term debt is created on the balance sheet.
Contractual Approaches: Hedging the Unhedgeable Some MNEs now attempt to hedge their operating exposure with contractual strategies. A number of firms like Merck (U.S.) have undertaken long-term currency option positions, hedges designed to offset lost earnings from adverse exchange rate changes. This hedging of what many of these firms refer to as strategic exposure or competitive exposure seems to fly in the face of traditional theory.
The ability of firms to hedge the “unhedgeable” is dependent upon 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 accu- rately predicting competitor response. Many firms still find timely measurement of exposure challenging.
Merck is an example of a firm whose management feels capable of both. The company possesses relatively predictable long-run revenue streams due to the product-niche nature of the pharmaceuticals industry. As a U.S.-based exporter to foreign markets, markets in which sales levels by product are relatively predictable and prices are often regulated by government, Merck can accurately predict net long-term cash flows in foreign currencies five and ten years into the future. Merck has a relatively undiversified operating structure. It is highly centralized in terms of where research, development, and production costs are located. Merck’s managers feel Merck has no real alternatives but contractual hedging if it is to weather long-term unex- pected exchange rate changes. Merck has purchased over-the-counter (OTC) long-term put options on foreign currencies versus the U.S. dollar as insurance against potential lost earnings from exchange rate changes. In Merck’s case, the predictability of competitor response to exchange rate changes is less pertinent given the niche-market nature of pharmaceutical products.
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 disad- vantaged. The capital outlay required for the purchase of such sizable 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.
343Operating Exposure CHAPTER 12
! Foreign exchange exposure is a measure of the potential for a firm’s profitability, net cash flow, and market value to change because of a change in exchange rates. The three main types of foreign exchange risk are operating, transaction, and translation exposures.
! Operating exposure measures the change in value of the firm that results from changes in future operating cash flows caused by an unexpected change in exchange rates.
! An unexpected change in exchange rates impacts a firm’s expected cash flow at four levels: 1) short run; 2) medium run, equilibrium case; 3) medium run, disequi- librium case; and 4) long run.
! Operating strategies for the management of operating exposure emphasize the structuring of firm operations in order to create matching streams of cash flows by currency. This is termed natural hedging.
! The objective of operating exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firm’s future cash flow, rather than being forced into passive reaction to such changes as was described in the Trident Europe case. This task can best be accomplished if a firm diversifies internationally both its operations and its financing base.
! Proactive policies include matching currency of cash flow, currency risk sharing clauses, back-to-back loan structures, and cross-currency swap agreements.
! Strategies to change financing policies include matching currency cash flows, back-to-back loans and currency swaps.
! Contractual approaches (i.e., options and forwards) have occasionally been used to hedge operating exposure but are costly and possibly ineffectual.
SUMMARY POINTS
It was January 2002, and Toyota Motor Europe Manu- facturing (TMEM) had a problem. More specifically, Mr. Toyoda Shuhei, the new President of TMEM, had a problem. He was on his way to Toyota Motor Company’s (Japan) corporate offices outside Tokyo to explain the continuing losses of the European manufacturing and sales operations. The CEO of Toyota Motor Company, Mr. Hiroshi Okuda, was expecting a proposal from Mr. Shuhei to reduce and eventually eliminate the European losses. The situation was intense given that TMEM was the only major Toyota subsidiary suffering losses.
Toyota and Auto Manufacturing Toyota Motor Company was the number one automobile manufacturer in Japan, the third largest manufacturer in the world by unit sales (5.5 million units or one auto every six seconds), but number eight in sales in Continental Europe. The global automobile manufacturing industry had been experiencing, like many industries, continued consolidation in recent years as margins were squeezed, economies of scale and scope pursued, and global sales slowed.
Toyota was no different. It had continued to rational- ize its manufacturing along regional lines. Toyota had continued to increase the amount of local manufacturing
in North America. In 2001, over 60% of Toyota’s North American sales were locally manufactured. But Toyota’s European sales were nowhere close to this yet. Most of Toyota’s automobile and truck manufacturing for Europe was still done in Japan. In 2001, only 24% of the autos sold in Europe were manufactured in Europe (including the United Kingdom), the remainder were imported from Japan (see Exhibit 1).
Toyota Motor Europe sold 634,000 automobiles in 2000. This was the second largest foreign market for Toyota, second only to North America. TMEM expected significant growth in European sales, and was planning to expand European manufacturing and sales to 800,000 units by 2005. But for fiscal 2001, the unit reported operating losses of ¥9.897 billion ($82.5 million at ¥120/$). TMEM had three assembly plants in the United Kingdom, one plant in Turkey, and one plant in Portugal. In November 2000, Toyota Motor Europe announced publicly that it would not generate positive profits for the next two years due to the weakness of the euro.
Toyota had recently introduced a new model to the European market, the Yaris, which was proving very suc- cessful. The Yaris, a super-small vehicle with a 1,000cc engine, had sold more than 180,000 units in 2000. Although
Toyota’s European Operating ExposureMINI-CASE
344 CHAPTER 12 Operating Exposure
the Yaris had been specifically designed for the Euro- pean market, the decision had been made early on to manufacture it in Japan.
Currency Exposure The primary source of the continuing operating losses suffered by TMEM was the falling value of the euro. Over the recent two-year period, the euro had fallen in value against both the Japanese yen and the British pound. As demonstrated in Exhibit 1, the cost base for most of the autos sold within the Continental European market was the Japanese yen. Exhibit 2 illustrates the slide of the euro against the Japanese yen.
As the yen rose against the euro, costs increased signifi- cantly when measured in euro terms. If Toyota wished to preserve its price competitiveness in the European market, it had to absorb most of the exchange rate changes and suffer reduced or negative margins on both completed cars and key subcomponents shipped to its European manufac- turing centers. Deciding to manufacture the Yaris in Japan had only exacerbated the situation.
Management Response Toyota management was not sitting passively by. In 2001, they had initiated some assembly operations in Valenci- ennes, France. Although a relatively small percentage of total European sales as of January 2002, Toyota planned to continue to expand its capacity and capabilities to source about 25% of European sales by 2004. Assembly
of the Yaris was scheduled to be moved to Valenciennes in 2002. The continuing problem, however, was that it was an assembly facility, meaning that much of the expensive value-added content of the autos being assembled was still based in either Japan or the United Kingdom.
Mr. Shuhei, with the approval of Mr. Okuda, had also initiated a local sourcing and procurement program for the United Kingdom manufacturing operations. TMEM wished to decrease the number of key components imported from Toyota Japan to reduce the currency expo- sure of the U.K. unit. But again, the continuing problem of the British pound’s value against the euro, as shown in Exhibit 3, reduced even the effectiveness of this solution.
Case Questions
1. Why do you think Toyota waited so long to move much of its manufacturing for European sales to Europe?
2. If the British pound were to join the European Monetary Union would the problem be resolved? How likely do you think this is?
3. If you were Mr. Shuhei, how would you categorize your problems and solutions? What was a short-term problem? What was a long-term problem?
4. What measures would you recommend that Toyota Europe take to resolve the continuing operating losses?
Toyota Motor Europe Manufacturing
Continental European Sales ( )
United Kingdom (£)
Portugal ( )
Turkey (Lira)
Toyota Japan Manufacturing
The problem: The euro had been falling continuously against both the Japanese yen and the British pound.
26% of total sales in Europe
74% of total sales in Europe
Key subcomponents (¥)
Complete autos (¥)
EXHIBIT 1 Toyota Motor’s European Currency Operating Structure
345Operating Exposure CHAPTER 12
0.56
0.58
0.60
0.62
0.64
0.66
0.68
0.70
0.72
1/6 /19
99
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99
3/6 /19
99
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99
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99
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19 99
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19 99
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00
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20 01
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20 01
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20 01
British pounds per euro (£/ )
EXHIBIT 3 British Pounds per Euro Spot Rate (weekly, 1999–2001)
80
90
100
110
120
130
140
Japanese yen per euro (¥/ )
1/6 /19
99
2/6 /19
99
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99
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99
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99
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19 99
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19 99
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19 99
1/6 /20
00
2/6 /20
00
3/6 /20
00
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00
5/6 /20
00
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00
7/6 /20
00
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20 00
11 /6/
20 00
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20 00
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01
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01
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01
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01
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01
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01
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01
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01
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20 01
11 /6/
20 01
12 /6/
20 01
EXHIBIT 2 Japanese Yen per Euro Spot Rate (weekly, 1999–2001)
346 CHAPTER 12 Operating Exposure
11. Currency Swaps. Explain how currency swaps can hedge foreign exchange operating exposure. What are the accounting advantages of currency swaps?
12. Contractual Hedging. Merck is an MNE that has undertaken contractual hedging of its operating exposure. a. How do they accomplish this task? b. What assumptions do they make in order to justify
contractual hedging of their operating exposure? c. How effective is such contractual hedging in your
opinion? Explain your reasoning.
PROBLEMS 1. DeMagistris Fashion Company. DeMagistris Fashion
Company, based in New York City, imports leather coats from Acuña Leather Goods, a reliable and longtime supplier, based in Buenos Aires, Argentina. Payment is in Argentine pesos. When the peso lost its parity with the U.S. dollar in January 2002, it collapsed in value to Ps4.0/$ by October 2002. The outlook was for a further decline in the peso’s value. Since both DeMagistris and Acuña wanted to continue their longtime relationship, they agreed on a risk-sharing arrangement. As long as the spot rate on the date of an invoice is between Ps3.5/$ and Ps4.5/$ DeMagistris will pay based on the spot rate. If the exchange rate falls outside this range, they will share the difference equally with Acuña Leather Goods. The risk-sharing agreement will last for six months, at which time the exchange rate limits will be reevaluated. DeMagis- tris contracts to import leather coats from Acuña for Ps8,000,000 or $2,000,000 at the current spot rate of Ps4.0/$ during the next six months. a. If the exchange rate changes immediately to
Ps6.00/$, what will be the dollar cost of six months of imports to DeMagistris?
b. At Ps6.00/$, what will be the peso export sales in Acuña Leather Goods to DeMagistris Fashion Company?
2. Mauna Loa. Mauna Loa, a macadamia nut subsidiary of Hershey’s with plantations on the slopes of its name- sake volcano in Hilo, Hawaii, exports macadamia nuts worldwide. The Japanese market is its biggest export market, with average annual sales invoiced in yen to Japanese customers of ¥1,200,000,000. At the present exchange rate of ¥125/$, this is equivalent to $9,600,000. Sales are relatively equally distributed during the year. They show up as a ¥250,00,000 account receiv- able on Mauna Loa’s balance sheet. Credit terms to
QUESTIONS 1. Definitions. Define the following terms:
a. Operating exposure b. Economic exposure c. Competitive exposure
2. Unexpected Exchange Rate Changes. Answer the following: a. Why do unexpected exchange rate changes contrib-
ute to operating exposure, but expected exchange rate changes do not?
b. Explain the time horizons used to analyze unex- pected changes in exchange rates.
3. Macroeconomic Uncertainty. Explain how the con- cept of macroeconomic uncertainty expands the scope of analyzing operating exposure.
4. Strategic Response. The objective of both operating and transaction exposure management is to antici- pate and influence the effect of unexpected changes in exchange rates on a firm’s future cash flows. What strategic alternative policies exist to enable manage- ment to manage these exposures?
5. Managing Operating Exposure. The key to manag- ing operating exposure at the strategic level is for management to recognize a disequilibrium in parity conditions when it occurs and to be prepositioned to react most appropriately. How can this task best be accomplished?
6. Diversifying Operations. Answer the following: a. How can an MNE diversify operations? b. How can an MNE diversify financing?
7. Proactive Management of Operating Exposure. Oper- ating and transaction exposures can be partially man- aged by adopting operating or financing policies that offset anticipated foreign exchange exposures. What are four of the most commonly employed proactive policies?
8. Matching Currency Exposure. Answer the following: a. Explain how matching currency cash flows can off-
set operating exposure. b. Give an example of matching currency cash flows.
9. Risk Sharing. An alternative arrangement for manag- ing operating exposure between firms with a continu- ing buyer-supplier relationship is risk sharing. Explain how risk sharing works.
10. Back-to-Back Loans. Explain how back-to-back loans can hedge foreign exchange operating exposure.
347Operating Exposure CHAPTER 12
are exported to New Zealand for payment in pounds sterling. The distributor sells the sports cars in New Zealand for New Zealand dollars. The New Zea- land distributor is unable to carry all of the foreign exchange risk, and would not sell MacLoren models unless MacLoren could share some of the foreign exchange risk. MacLoren has agreed that sales for a given model year will initially be priced at a “base” spot rate between the New Zealand dollar and pound sterling set to be the spot mid-rate at the beginning of that model year. As long as the actual exchange rate is within 5% of that base rate, payment will be made in pounds sterling. That is, the New Zealand distributor assumes all foreign exchange risk. However, if the spot rate at time of shipment falls outside of this 5% range, MacLoren will share equally (i.e., 50/50) the difference between the actual spot rate and the base rate. For the current model year the base rate is NZ$1.6400/£. a. What are the outside ranges within which the New
Zealand importer must pay at the then current spot rate?
b. If MacLoren ships 10 sports cars to the New Zea- land distributor at a time when the spot exchange rate is NZ$1.7000/£, and each car has an invoice cost £32,000, what will be the cost to the distribu- tor in New Zealand dollars? How many pounds will MacLoren receive, and how does this compare with McLoren’s expected sales receipt of £32,000 per car?
c. If MacLoren Automotive ships the same 10 cars to New Zealand at a time when the spot exchange rate is NZ$1.6500/£, how many New Zealand dol- lars will the distributor pay? How many pounds will MacLoren Automotive receive?
d. Does a risk-sharing agreement such as this one shift the currency exposure from one party of the transaction to the other?
e. Why is such a risk-sharing agreement of benefit to MacLoren? To the New Zealand distributor?
6. Trident Germany–All Domestic Competitors. Using the Trident Germany analysis in Exhibits 12.5 and 12.6, where the euro depreciates, how would prices, costs, and volumes change if Trident Germany was operating in a nearly purely domestic, mature market, with major domestic competitors?
7. Trident Germany–All Foreign Competitors. Trident Germany is now competing in a number of interna- tional (export) markets, growth markets, in which most of its competitors are foreign. Now how would you expect Trident Germany’s operating exposure to respond to the depreciation of the euro?
each customer allow for 60 days before payment is due. Monthly cash collections are typically ¥100,000,000.
Mauna Loa would like to hedge its yen receipts, but it has too many customers and transactions to make it practical to sell each receivable forward. It does not want to use options because they are consid- ered to be too expensive for this particular purpose. Therefore, they have decided to use a “matching” hedge by borrowing yen. a. How much should Mauna Loa borrow in yen? b. What should be the terms of payment on the yen
loan?
3. Murray Exports (A). Murray Exports (U.S.) exports heavy crane equipment to several Chinese dock facili- ties. Sales are currently 10,000 units per year at the yuan equivalent of $24,000 each. The Chinese yuan (renminbi) has been trading at Yuan8.20/$, but a Hong Kong advisory service predicts the renminbi will drop in value next week to Yuan9.00/$, after which it will remain unchanged for at least a decade. Accepting this forecast as given, Murray Exports faces a pricing deci- sion in the face of the impending devaluation. It may either 1) maintain the same yuan price and in effect sell for fewer dollars, in which case Chinese volume will not change; or 2) maintain the same dollar price, raise the yuan price in China to offset the devaluation, and experience a 10% drop in unit volume. Direct costs are 75% of the U.S. sales price. a. What would be the short-run (one year) implica-
tion of each pricing strategy? b. Which do you recommend?
4. Murray Exports (B). Assume the same facts as in Murray Exports (A). Additionally, financial manage- ment believes that if it maintains the same yuan sales price, volume will increase at 12% per annum for eight years. Dollar costs will not change. At the end of 10 years, Murray Exports’s patent expires and it will no longer export to China. After the yuan is devalued to Yuan9.20/$, no further devaluations are expected. If Murray Exports raises the yuan price so as to maintain its dollar price, volume will increase at only 1% per annum for eight years, starting from the lower initial base of 9,000 units. Again, dollar costs will not change, and at the end of eight years Murray Exports will stop exporting to China. Murray Exports’s weighted aver- age cost of capital is 10%. Given these considerations, what should be Murray Exports’s pricing policy?
5. MacLoren Automotive. MacLoren Automotive manufactures British sports cars, a number of which
348 CHAPTER 12 Operating Exposure
10. Hurte-Paroxysm Products, Inc. (B). Assume the same facts as in Hurte-Paroxysm Products, Inc. (A). HP also believes that if it maintains the same price in Brazil- ian reais as a permanent policy, volume will increase at 10% per annum for six years, costs will not change. At the end of six years, HP’s patent expires and it will no longer export to Brazil. After the reais is devalued to R$4.00/US$, no further devaluation is expected. If HP raises the price in reais so as to maintain its dollar price, volume will increase at only 4% per annum for six years, starting from the lower initial base of 40,000 units. Again, dollar costs will not change, and at the end of six years, HP will stop exporting to Brazil. HP’s weighted average cost of capital is 12%. Given these considerations, what do you recommend for HP’s pric- ing policy? Justify your recommendation.
INTERNET EXERCISES 1. Operating Exposure: Recent Examples. Using the
following major periodicals as starting points, find a current example of a firm with a substantial oper- ating exposure problem. To aid in your search, you might focus on businesses having major operations in countries with recent currency crises, either through depreciation or major home currency appreciation.
Financial Times www.ft.com/
The Economist www.economist.com/
The Wall Street Journal www.wsj.com/
2. SEC Edgar Files.To analyze an individual firm’s operating exposure more carefully, it is necessary to have more detailed information available than in the normal annual report. Choose a specific firm with substantial international operations, for example, Coca-Cola or PepsiCo, and search the Security and Exchange Commission’s Edgar Files for more detailed financial reports of their international operations.
Search SEC EDGAR Archives www.sec.gov/cgi-bin/ srch-edgar
8. Risk-Sharing at Harley Davidson. Harley-Davidson (U.S.) reportedly uses risk-sharing agreements with its own foreign subsidiaries and with independent foreign distributors. Because these foreign units typically sell to their local markets and earn local currency, Harley would like to ease their individual currency exposure problems by allowing them to pay for merchandise from Harley (U.S.) in their local functional currency.
The spot rate between the U.S. dollar and the Australian dollar on January 1 is A$1.3052/US$. Assume that Harley uses this rate as the basis for set- ting its central rate or base exchange rate for the year at A$1.3000/US$. Harley agrees to price all contracts to Australian distributors at this exact exchange rate as long as the current spot rate on the order date is within {2.5% of this rate. If the spot rate falls outside of this range, but is still within {5% of the central rate, Harley will “share” equally (i.e., “50/50”) the difference between the new spot rate and the neutral boundary with the distributor.
9. Hurte-Paroxysm Products, Inc. (A). Hurte- Paroxysm Products, Inc. (HP) of the United States, exports computer printers to Brazil, whose currency, the reais (symbol R$) has been trading at R$3.40/US$. Exports to Brazil are currently 50,000 printers per year at the reais equivalent of $200 each. A strong rumor exists that the reais will be devalued to R$4.00/$ within two weeks by the Brazilian government. Should the devaluation take place, the reais is expected to remain unchanged for another decade. Accepting this forecast as given, HP faces a pricing decision which must be made before any actual devaluation: HP may either 1) maintain the same reais price and in effect sell for fewer dollars, in which case Brazilian volume will not change, or 2) maintain the same dollar price, raise the reais price in Brazil to compensate for the devaluation, and experience a 20% drop in volume. Direct costs in the United States are 60% of the U.S. sales price. What would be the short-run (one year) implication of each pricing strategy? Which do you recommend?
Financing the Global Firm
CHAPTER 13 The Global Cost and Availability of Capital
CHAPTER 14 Raising Equity and Debt Globally
CHAPTER 15 Multinational Tax Management
PART IV
349
The Global Cost and Availability of Capital
Capital must be propelled by self-interest; it cannot be enticed by benevolence.
—Walter Bagehot, 1826-1877.
How can firms tap global capital markets for the purpose of minimizing their cost of capital and maximizing capital’s availability? Is global capital cheaper? Why should they do so? This chapter explores these questions, concluding with a Mini-Case that details one of the most influential corporate financial strategies ever executed, Novo Industri A/S (Novo).
Financial Globalization and Strategy 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 is located in a country with illiquid and/or segmented capital markets, it can achieve this lower global cost and greater availability of capital by a properly designed and implemented strategy. The dimensions of the cost and availability of capital are presented in Exhibit 13.1. The impact of firm-specific characteristics, market liquidity for the firm’s securities, and the definition and effect of market segmentation on the prices of a firm’s capital are the focus of most of this chapter.
A firm that must source its long-term debt and equity in a highly illiquid domestic securities market will probably have a relatively high cost of capital and will face limited availability of such capital, which in turn will lower its competitiveness both internationally and vis-à-vis foreign firms entering its home market. This category of firms includes both firms resident in emerging countries, where the capital market remains undeveloped, and firms too small to gain access to their own national securities markets. Many family-owned firms find themselves in this category because they choose not to utilize securities markets to source their long-term capital needs.
Firms resident in industrial countries with small capital markets often source their long- term debt and equity at home in these partially liquid domestic securities markets. The firms’ cost and availability of capital is better than that of firms in countries with illiquid capital markets. However, if these firms can tap the highly liquid global markets, they can also strengthen their competitive advantage in sourcing capital.
Firms resident in countries with segmented capital markets must devise a strategy to escape dependence on that market for their long-term debt and equity needs. A national
350
CHAPTER 13
351The Global Cost and Availability of Capital CHAPTER 13
capital market is segmented if the required rate of return on securities in that market differs from the required rate of return on securities of comparable expected return and risk traded on other securities markets. Capital markets become segmented because of such factors as excessive regulatory control, perceived political risk, anticipated foreign exchange risk, lack of transparency, asymmetric availability of information, cronyism, insider trading, and many other market imperfections. Firms constrained by any of these conditions must develop a strategy to escape their own limited capital markets and source some of their long-term capital abroad.
The Cost of Capital A domestic firm normally finds its cost of capital by evaluating where and from whom it will raise its capital. The cost will obviously differ on the mix of investors interested in the firm, investors willing and able to buy its equity shares, and the debt available to the firm, raised from the domestic bank and debt market.
The firm then calculates its weighted average cost of capital (WACC) by combining the cost of equity with the cost of debt in proportion to the relative weight of each in the firm’s optimal long-term financial structure. More specifically,
kWACC = ke E V
+ kd (1 - t) D V
EXHIBIT 13.1 Dimensions of the Cost and Availability of Capital Strategy
Segmented domestic securities market that prices shares
according to domestic standards
Access to global securities market that prices shares according to
international standards
Firm's securities appeal only to domestic investors
Firm's securities appeal to international portfolio investors
Local Market Access Global Market Access
Illiquid domestic securities market and limited international liquidity
Highly liquid domestic market and broad international participation
Firm-Specific Characteristics
Market Liquidity for Firm's Securities
Effect of Market Segmentation on Firm's Securities and Cost of Capital
352 CHAPTER 13 The Global Cost and Availability of Capital
where kwacc = weighted average after-tax cost of capital ke = risk@adjusted cost of equity kd = before@tax cost of debt t = marginal tax rate E = market value of the firm’s equity D = market value of the firm’s debt V = market value of the firm’s securities (D + E)
Cost of Equity. The most widely accepted and used method of calculating the cost of equity for a firm today is the capital asset pricing model (CAPM). CAPM defines the cost of equity to be the sum of a risk-free interest component and a firm-specific spread over and above that risk-free component, as seen in the following formula:
ke = krf + bj (km - krf)
where ke = expected (required) rate of return on equity krf = rate of interest on risk-free bonds (Treasury bonds, for example) bj = coefficient of systematic risk for the firm km = expected (required) rate of return on the market portfolio of stocks
The key component of CAPM is beta, the measure of systematic risk. Systematic risk is a measure of how the firm’s returns vary with those of the market in which it trades. Beta is calculated as a function of the total variability of expected returns of the firm’s stock relative to the market index (km) and the degree to which the variability of expected returns of the firm is correlated to the expected returns on the market index. More formally,
bj = rjmsj
sm
where bj (beta) = measure of systematic risk for security j r (rho) = correlation between security j and the market sj (sigma) = standard deviation of the return on firm j sm (sigma) = standard deviation of the market return
Beta will have a value of less than 1.0 if the firm’s returns are less volatile than the market, 1.0 if the same as the market, or greater than 1.0 if more volatile-or risky-than the market. CAPM analysis assumes that the required return estimated is an indication of what more is necessary to keep an investor’s capital invested in the equity considered. If the equity’s return does not reach the expected return, CAPM assumes that individual investors will liquidate their holdings.
CAPM’s biggest challenge is that the beta used needs to be for the future and not the past. A prospective investor is interested in how the individual firm’s returns will vary in the coming periods. Unfortunately, since the future is not known, the beta used in any firm’s estimate of equity cost is typically based on evidence from the recent past.
Cost of Debt. Firms acquire debt in either the form of loans from commercial banks—the most common form of debt, or as securities sold to the debt markets, instruments like notes and bonds. The normal procedure for measuring the cost of debt requires a forecast of interest rates for the next few years, the proportions of various classes of debt the firm expects to use, and the corporate income tax rate. The interest costs of the different debt components are
353The Global Cost and Availability of Capital CHAPTER 13
then averaged according to their proportion in the debt structure. This before-tax average, kd, is then adjusted for corporate income taxes by multiplying it by the expression (1 - tax rate), to obtain kd (1 - t) the weighted average after-tax cost of debt.
The weighted average cost of capital is normally used as the risk-adjusted discount rate whenever a firm’s new projects are in the same general risk class as its existing projects. On the other hand, a project-specific required rate of return should be used as the discount rate if a new project differs from existing projects in business or financial risk.
International CAPM (ICAPM) The traditional form of CAPM, the domestic CAPM used in the previous section, assumes the firm’s equity trades in a purely domestic market. The beta and market risk premium (km - krf) therefore used in the cost of equity calculation were based on a purely domestic market of securities and choices. But what if globalization has opened up the global markets, integrating them, allowing investors to choose among stocks of a global portfolio?
International CAPM (ICAPM) assumes that there is a global market in which the firm’s equity trades, and estimates of the firm’s beta, bjg and the market risk premium, (km g - krf g), must then reflect this global portfolio.
ke global = krf g + bjg (km g - krf g)
The value of the risk-free rate, krf g, may not change (so that krf g = krf ), as a U.S. Treasury note may be the risk-free rate for a U.S.-based investor regardless of the domestic or international portfolio. The market return, km g, will change, reflecting average expected global market returns for the coming periods. The firm’s beta, bjg will most assuredly change as it now will reflect the expected variations against a greater global portfolio. How that beta will change, however, depends.
Sample Calculation: Trident’s Cost of Capital Maria Gonzalez, Trident’s Chief Financial Officer, wants to calculate the company’s weighted average cost of capital in both forms, the traditional CAPM and then ICAPM.
Maria assumes the risk-free rate of interest (krf) as 4%, using the U.S. government 10-year Treasury bond rate. The expected rate of return of the market portfolio (km) is assumed to be 9%, the expected rate of return on the market portfolio held by a well-diversified domestic investor. Trident’s estimate of its own systematic risk, its beta, against the domestic portfolio is 1.2. Trident’s cost of equity is then
ke = krf + b (km - krf) = 4.00% + 1.2 (9.00% - 5.00%) = 10.00%.
Trident’s cost of debt (kd ) the before tax cost of debt estimated by observing the cur- rent yield on Trident’s outstanding bonds combined with bank debt, is 8%. Using 35% as the corporate income tax rate for the United States, Trident’s after-tax cost of debt is then
kd (1 - t) = 8.00 (1 - 0.35) = 8.00 (0.65) = 5.20%.
Trident’s long-term capital structure is 60% equity (E/V) and 40% debt (D/V), where V is Trident’s total market value. Trident’s weighted average cost of capital kWACC is then
kWACC = ke K V
+ kd (1 - t) D V
= 10.00% (.60) + 5.20% (.40) = 8.08%
This is Trident’s cost of capital using the traditional domestic CAPM estimate of the cost of equity.
But Maria Gonzalez wonders if this is the proper approach for Trident. As Trident has globalized its own business activities, the investor base that owns Trident’s shares has also
354 CHAPTER 13 The Global Cost and Availability of Capital
globally diversified. Trident’s shares are now listed in London and Tokyo, in addition to their home listing on the New York Stock Exchange. Over 40% of Trident’s stock is now held by foreign portfolio investors, as part of their globally diversified portfolios, while Trident’s U.S. investors also typically hold globally diversified portfolios.
A second calculation of Trident’s cost of equity, this time using the ICAPM, yields different results. Trident’s beta, when calculated against a larger global equity market index which includes these foreign markets and their investors, is lower, 0.90. The expected market return for a larger globally integrated equity market is a lower value as well, 8.00%. The ICAPM cost of equity is a much lower value of 7.60%.
ke global = krf g + bjg (km g - krf g) = 4.00% + 0.90 (8.00% - 4.00%) = 7.60%
Maria now recalculates Trident’s WACC using the ICAPM estimate of equity costs, assuming the same debt and equity proportions and the same cost of current debt. Trident’s WACC is now estimated at a lower cost of 6.64%.
kWACCICAPM = ke global E V
+ kd (1 - t) D V
= 7.60% (.60) + 5.20% (.40) = 6.64%
Maria believes that this is a more appropriate estimate of Trident’s cost of capital. It is fully competitive with Trident’s main rivals in the telecommunications hardware industry segment worldwide, which are mainly headquartered in the United States, the United King- dom, Canada, Finland, Sweden, Germany, Japan, and the Netherlands. The key to Trident’s favorable global cost and availability of capital going forward is its ability to attract and hold the international portfolio investors that own its stock.
ICAPM Considerations 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 recal- culation of the firm’s beta for that market. The three basic components of the CAPM model must then be reconsidered.
Nestlé, the Swiss-based multinational firm that produces and distributes a variety of confectionery products, serves as an excellent example of how the international investor may view the global cost of capital differently from a domestic investor, and what that means for Nestlé’s estimate of its own cost of equity.1 The numerical example for Nestlé is summarized in Exhibit 13.2.
In the case of Nestlé, a prospective Swiss investor might assume a risk-free return of 3.3%, an index of Swiss government bond issues, in Swiss francs. That same Swiss investor may also consider the expected market return might be an average return on a portfolio of Swiss equities, the Financial Times Swiss index, in Swiss francs, estimated at 10.2%. Assuming a risk-free rate of 3.30%, an expected market return of 10.2%, and a bNestlé of 0.885, a Swiss investor would expect Nestlé to yield 9.4065% for the coming year.
keNestlé = kRF + (kM - kRF) bNestlé = 3.3 + (10.2 - 3.3) 0.885 = 9.4065%
But what if Swiss investors held internationally diversified portfolios instead? Both the expected market return and the beta estimate for Nestlé itself would be defined and deter- mined differently. For the same period as before, a global portfolio index such as the Financial Times index in Swiss francs (FTA-Swiss) would show a market return of 13.7% (as opposed to the domestic Swiss index return of 10.2%). In addition, a beta for Nestlé estimated on
1René Stulz, “The Cost of Capital in Internationally Integrated Markets: The Case of Nestlé,” European Financial Management, Volume 1, Number 1, March 1995, 11–22.
355The Global Cost and Availability of Capital CHAPTER 13
Nestlé’s returns versus the global portfolio index would be much smaller, 0.585 (as opposed to the 0.885 found previously). An internationally diversified Swiss investor would expect the following return on Nestlé:
keNestlé = kRF + (kM - kRF) bNestlé = 3.3 + (13.7 - 3.3) 0.585 = 9.3840%
Admittedly, this is not a lot of difference in the end. However, given the magnitude of change in both the values of the market return average and the beta for the firm, it is obvious that the result could easily have varied by several hundred basis points. The proper construction of the investor’s portfolio and the proper portrayal of the investor’s perceptions of risk and opportunity cost are clearly important to identifying the global cost of a company’s equity capital. In the end, it all depends on the specific case—which firm, which country market, which global portfolio.
We follow the practice here of describing the internationally diversified portfolio as the global portfolio rather than the world portfolio. The distinction is important. The world portfolio is an index of all securities in the world. However, even with the increasing trend of deregulation and financial integration, a number of securities markets still remain segmented or restricted in their access. Those securities actually available to an investor are the global portfolio.
There are, in fact, a multitude of different proposed formulations for calculating the inter- national cost of capital. The problems with both formulation and data expand dramatically as the analysis is extended to rapidly developing or emerging markets. Harvey (2005) serves as a first place to start if you wish to expand your reading and research.2
Global Betas International portfolio theory, covered in detail in Chapter 16, typically concludes that adding international securities to a domestic portfolio will reduce the portfolio’s risks. Although this is fundamental to much of international financial theory, it still depends on individual firms in individual markets. Nestlé’s beta went down when calculated using a global portfolio of equities, but that may not always be the case. Depending on the firm and its business line, the country in which it calls home, and the industry domestically and globally in which it competes, the global beta may go up or down.
2“12 Ways to Calculate the International Cost of Capital,” Campbell R. Harvey, Duke University, unpublished, October 14, 2005.
Nestlè’s estimate of its cost of equity will depend upon whether a Swiss investor is thought to hold a domestic portfolio of equity securities or a global portfolio.
Domestic Portfolio for Swiss Investor Global Portfolio for Swiss Investor
kRF = 3.3% (Swiss bond index yield) kRF = 3.3% (Swiss bond index yield)
kM = 10.2% (Swiss market portfolio in SF) kM = 13.7% (Financial Times Global index in SF)
bNestlé = 0.885 (Nestlé versus Swiss market portfolio) bNestlé = 0.585 (Nestlé versus FTA-Swiss index)
kNestlé ! kRF " BNestlé (kM # kRF)
Required return on Nestlé:
ke Nestlé = 9.4065%
Required return on Nestlé:
ke Nestlé = 9.3840%
Source: All values are taken from René Stulz, “The Cost of Capital in Internationally Integrated Markets: The Case of Nestlé,” European Financial Management, Volume 1, Number 1, March 1995, 11–22.
EXHIBIT 13.2 The Cost of Equity for Nestlé of Switzerland
356 CHAPTER 13 The Global Cost and Availability of Capital
One company often noted by researchers is Petrobrás, the national oil company of Brazil. Although government controlled, the company is publicly traded. Its shares are listed in São Paulo and New York. It operates in a global oil market in which prices and values are set in U.S. dollars. As a result, its domestic or home beta has been estimated at 1.3, but its global beta higher, at 1.7.3 This is only one example of many.
Although it seems obvious to some that the returns to the individual firm should become less correlated to those of the market as the market is redefined ever-larger, it turns out to be more of a case of empirical analysis, not preconceived notions of correlation and covariance.
Equity Risk Premiums In practice, calculating a firm’s equity risk premium is much more controversial. Although the capital asset pricing model (CAPM) has now become very widely accepted in global business as the preferred method of calculating the cost of equity for a firm, there is rising debate over what numerical values should be used in its application, especially the equity risk premium. The equity risk premium is the average annual return of the market expected by investors over and above riskless debt, the term (km - krf).
Equity Risk Premium History. The field of finance does agree that a cost of equity calculation should be forward looking, meaning that the inputs to the equation should represent what is expected to happen over the relevant future time horizon. As is typically the case, however, practitioners use historical evidence as the basis for their forward-looking projections. The current debate begins with a debate over what has happened in the past.
In a large study completed in 2001 by Dimson, Marsh, and Stanton (updated in 2003), the authors estimated the equity risk premium in 16 different developed countries for the 1900–2002 period. The study found significant differences in equity returns over bill and bond returns (proxies for the risk-free rate) over time by country.
! Comparing arithmetic returns over bills, Italy clearly had the highest equity risk premium (10.3%) with Germany (9.4%) and Japan (9.3%) following. Denmark, with an average arithmetic return of only 3.8%, had the lowest. The United States had an average arithmetic equity premium of 7.2%, while the United Kingdom had 5.9%. The average equity premium for the 16 listed countries was 6.9%. The world, as defined by the authors of the study, had an arithmetic premium of 5.7%.
! Comparing geometric returns, the authors found the highest equity risk premium relative to bills in Australia (6.8%) and France (6.4%), with Belgium and Denmark the lowest (2.2%). The average equity premium for the same 16 countries was 4.5%, the world, 4.4%.
There is little debate regarding the use of arithmetic returns over geometric returns. The mean arithmetic return is simply the average of the annual percentage changes in capital appre- ciation plus dividend distributions. This is a rate of return calculation with which every business student is familiar. The mean geometric return, however, is a more specialized calculation, which takes into account only the beginning and ending values over an extended period of his- tory. It then calculates the annual average rate of compounded growth to get from the begin- ning to the end, without paying attention to the specific path taken in between. Exhibit 13.3 provides a simple example of how the two methods would differ for a very short historical series of stock prices.
3The Real Cost of Capital, Tim Ogier, John Rugman, and Lucinda Spicer, Prentice Hall Financial Times, Pearson Publishing, 2005, p. 139.
357The Global Cost and Availability of Capital CHAPTER 13
Arithmetic returns capture the year-to-year volatility in markets, which geometric returns do not. For this reason, most practitioners prefer the arithmetic, as it embodies more of the volatility so often characteristic of equity markets globally. Note that the geometric change will, in all but a few extreme circumstances, yield a smaller mean return.
The debate over which equity risk premium to use in practice was highlighted in this same study by looking at what equity risk premiums are being recommended for the United States by a variety of different sources. As illustrated in Exhibit 13.4, a hypothetical firm with a beta of 1.0 (estimated market risk equal to that of the market) might have a cost of equity as low as 9.000% and as high as 12.800% using this set of alternative values. Note that here the authors used geometric returns, not arithmetic returns. Fernandez and del Campo (2010), in their annual survey of market risk premiums used by analysts and academics, most recently found the average risk premium used by U.S. and Canadian analysts is 5.1%, European analysts 5.0%, and British analysts 5.6%.4
How important is it for a company to accurately predict its cost of equity? The corporation must annually determine which potential investments it will accept and reject due to its limited capital resources. If the company is not accurately estimating its cost of equity—and there- fore its general cost of capital—it will not be accurately estimating the net present value of potential investments if it uses its own cost of capital as the basis for discounting expected cash flows.
4“Market Risk Premium used in 2010 by Analysts and Companies: a survey with 2,400 answers,” Pablo Fernandez and Javier del Campo, IESE Business School, May 17, 2010.
EXHIBIT 13.3 Arithmetic Versus Geometric Returns: A Sample Calculation
Year 1 2 3 4 5 Mean
Share price 10 12 10 12 14
Arithmetic change +20.00% -16.67% +20.00% +16.67% +10.00%
Geometric change +8.78% +8.78% +8.78% +8.78% +8.78%
Arithmetic change is calculated year-by-year as (P2/P1 - 1). The simple average of the series is the mean. The geometric change is calculated using only the beginning and ending values, 10 and 14, and the geometric root of [(14/10)1/4 - 1] is found (the 1/4 is in reference to four periods of change). The geometric change assumes reinvested compounding, whereas the arithmetic mean only assumes point-to-point investment.
Source Equity Risk Premium
(km - krf) Cost of Equity
krf + b (km - krf) Differential
Ibbotson 8.800% 12.800% 3.800%
Finance textbooks 8.500% 12.500% 3.500%
Investor surveys 7.100% 11.100% 2.100%
Dimson, et. al. 5.000% 9.000% Baseline
Source: Equity risk premium quotes from “Stockmarket Valuations: Great Expectations,” The Economist, January 31, 2002.
EXHIBIT 13.4 Alternative Estimates of Cost of Equity for a Hypothetical U.S. Firm Assuming b ! 1 and krf ! 4%
358 CHAPTER 13 The Global Cost and Availability of Capital
A final note on the cost of equity and the selection of betas. For many years there has been a significant gulf between academia and industry on the importance of cost of equity and capital estimations (see Exhibit 13.5). We won’t take a stand ourselves here—taking the easy way out-but the reader should be well aware of the debate.
The Demand for Foreign Securities: The Role of International Portfolio Investors Gradual deregulation of equity markets during the past three decades not only elicited increased competition from domestic players but also opened up markets to foreign competitors. International portfolio investment and cross-listing of equity shares on foreign markets have become commonplace.
What motivates portfolio investors to purchase and hold foreign securities in their port- folio? The answer lies in an understanding of “domestic” portfolio theory and how it has been extended to handle the possibility of global portfolios. More specifically, it requires an understanding of the principles of portfolio risk reduction, portfolio rate of return, and foreign currency risk.
Both domestic and international portfolio managers are asset allocators. 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 port- folio managers limited to domestic-only asset allocations. As a result, internationally diversified portfolios often have a higher expected rate of return, and they nearly always have a lower level of portfolio risk, since national securities markets are imperfectly correlated with one another.
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 or bonds only or
EXHIBIT 13.5 Corporate Cost of Equity and Capital Estimation
What gets measured, gets managed. —Anonymous.
Financial academics love the details and debates associated with the calculation of a company’s cost of equity and ultimately the cost of capital. Instability of betas, whether or not domestic or international cost of capital estimations are appropriate or executed correctly, the source and size of the equity risk premium used, the measure of the risk-free rate, the time period for estimation and forecast—the issues go on and on. Even where the estimates come from is under debate. One famous academic recently went on in-length in his blog that the cost of equity and the equity risk premium is too important to the future of the firm to leave to external service providers like Ibbotson, Duff, and Phelps, or an investment banking firm like CreditSuisse.
But in industry, one is very likely to encounter a near-indifference to the topic. In most com- panies today, either domestic or multinational, the cost of equity and its calculation is only revisited annually. Then, often executed with key inputs gathered from consultants or other third-party data providers, the company calculates the cost of equity and capital and carves it into stone for the year. In many cases, it then only provides a foundation for the establishment of a hurdle rate, the required return the company will post as the minimum necessary for investment consideration. As one former student working in corporate treasury relayed to us, when he asked how the cost of equity was calculated and had there been an update recently, he was told “It’s 12%. End of discussion.”
359The Global Cost and Availability of Capital CHAPTER 13
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).
For our purposes, the most relevant dimensions are diversification by country, geographic region, stage of development, or a combination of these (global). An example of diversification by country is the Korea Fund. It was at one time the only vehicle for foreign investors to hold South Korean securities, but foreign ownership restrictions have more recently been liberalized. A typical regional diversification would be one of the many Asian funds. These performed exceptionally well until the “bubble” burst in Japan and Southeast Asia during the second half of the 1990s. Portfolios composed of emerging market securities are examples of diversification by stage of development. They are composed of securities from different countries, geographic regions, and stage of development.
The Link Between Cost and Availability of Capital Trident’s weighted average cost of capital (WACC) was calculated assuming that equity and debt capital would always be available at the same required rate of return even if Trident’s capital budget expands. This is a reasonable assumption considering Trident’s excellent access through the NYSE to international portfolio investors in global capital markets. It is a bad assumption, however, for firms resident in illiquid or segmented capi- tal markets, small domestic firms, and family-owned firms resident in any capital market. We will now examine how market liquidity and market segmentation can affect a firm’s cost of capital.
Improving Market Liquidity 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.
In the domestic case, an underlying assumption is that total availability of capital to a firm at any time is determined by supply and demand in the domestic capital markets. A firm should always expand its capital budget by raising funds in the same proportion as its optimal financial structure. As its budget expands in absolute terms, however, its marginal cost of capital will eventually increase. In other words, a firm can only tap the capital market for some limited amount in the short run before suppliers of capital balk at providing further funds, even if the same optimal financial structure is preserved. In the long run, this may not be a limitation, depending on market liquidity.
In the multinational case, a firm is able to improve market liquidity by raising funds in the euromarkets (money, bond, and equity), by selling security issues abroad, and by tapping local capital markets through foreign subsidiaries. Such activity should logically expand the capacity of an MNE to raise funds in the short run over what might have been raised if the firm were limited to its home capital market. This situation assumes that the firm preserves its optimal financial structure.
Market Segmentation If all capital markets are fully integrated, securities of comparable expected return and risk should have the same required rate of return in each national market after adjust- ing for foreign exchange risk and political risk. This definition applies to both equity and debt, although it often happens that one or the other may be more integrated than its counterpart.
360 CHAPTER 13 The Global Cost and Availability of Capital
Capital market segmentation is a financial market imperfection caused mainly by government constraints, institutional practices, and investor perceptions. The following are the most important imperfections:
! 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
Market imperfections do not necessarily imply that national securities markets are inefficient. A national securities market can be efficient in a domestic context and yet segmented in an international context. According to finance theory, a market is efficient if security prices in that market reflect all available relevant information and adjust quickly to any new relevant information. Therefore, the price of an individual security reflects its “intrinsic value” and any price fluctuations will be “random walks” around this value. Market efficiency assumes that transaction costs are low, that many participants are in the market, and that these participants have sufficient financial strength to move security prices. Empirical tests of market efficiency show that most major national markets are reasonably efficient.
An efficient national securities market might very well correctly price all securities traded in that market on the basis of information available to the investors who participate in that market. However, if that market is segmented, foreign investors would not be participants. Thus, securities in the segmented market would be priced based on domestic rather than international standards.
In the rest of this chapter and in Chapter 14, we will use the term MNE to describe all firms that have access to a global cost and availability of capital. This includes qualifying MNEs, whether they are located in highly developed or emerging markets. It also includes large firms that are not multinational but have access to global capital markets. They too could be located in highly developed or emerging capital markets. We will use the term domestic firm (DF) for all firms that do not have access to a global cost and availability of capital, no matter where they are located.
Availability of capital depends on whether a firm can gain liquidity for its debt and equity securities and a price for those securities based on international rather than national standards. In practice, this means that the firm must define a strategy to attract international portfolio investors and thereby escape the constraints of its own illiquid or segmented national market.
The Effect of Market Liquidity and Segmentation The degree to which capital markets are illiquid or segmented has an important influence on a firm’s marginal cost of capital and thus on its weighted average cost of capital. The marginal cost of capital is the weighted average cost of the next currency unit raised. This is illustrated in Exhibit 13.6, which shows the transition from a domestic to a global marginal cost of capital.
Exhibit 13.6 shows that the MNE has a given marginal return on capital at different budget levels, represented in the line MRR. This demand is determined by ranking potential projects according to net present value or internal rate of return. Percentage rate of return to both users and suppliers of capital is shown on the vertical scale. If the firm is limited to raising funds in its domes- tic market, the line MCCD shows the marginal domestic cost of capital (vertical axis) at various budget levels (horizontal axis). Remember that the firm continues to maintain the same debt ratio as it expands its budget, so that financial risk does not change. The optimal budget in the domestic case is $40 million, where the marginal return on capital (MRR) just equals the marginal cost of capital (MCCD). At this budget, the marginal domestic cost of capital, kD, would be equal to 20%.
361The Global Cost and Availability of Capital CHAPTER 13
If the MNE has access to additional sources of capital outside an illiquid domestic capital market, the marginal cost of capital should shift to the right (the line MCCF). In other words, foreign markets can be tapped for long-term funds at times when the domestic market is saturated because of heavy use by other borrowers or equity issuers, or when it is unable to absorb another issue of the MNE in the short run. Exhibit 13.6 shows that by a tap of foreign capital markets the firm has reduced its marginal international cost of capital, to 15%, even while it raises an additional $10 million. This statement assumes that about $20 million is raised abroad, since only about $30 million could be raised domestically at a 15% marginal cost of capital.
If the MNE is located in a capital market that is both illiquid and segmented, the line MCCU represents the decreased marginal cost of capital if it gains access to other equity markets. As a result of the combined effects of greater availability of capital and international pricing of the firm’s securities, the marginal cost of capital, kU, declines to 13% and the optimal capital budget climbs to $60 million.
Most of the tests of market segmentation suffer from the usual problem for models— namely, the need to abstract from reality in order to have a testable model. In our opinion, a realistic test would be to observe what happens to a single security’s price when it has been traded only in a domestic market, is “discovered” by foreign investors, and then is traded in a foreign market. Arbitrage should keep the market price equal in both markets. However, if during the transition we observe a significant change in the security’s price uncorrelated with price movements in either of the underlying securities markets, we can infer that the domestic market was segmented.
In academic circles, tests based on case studies are often considered to be “casual empiricism,” since no theory or model exists to explain what is being observed. Nevertheless, something may be learned from such cases, just as scientists learn from observing nature in an uncontrolled environment. Furthermore, case studies that preserve real-world complications may illustrate specific kinds of barriers to market integration and ways in which they might be overcome.
EXHIBIT 13.6 Market Liquidity, Segmentation, and the Marginal Cost of Capital
10 6030 5020 40
MCCD
MCCF MCCU
MRR
kD
kF kU
20%
15% 13% 10%
Budget (millions of US$)
Marginal Cost of Capital and Rate of Return (percentage)
362 CHAPTER 13 The Global Cost and Availability of Capital
Unfortunately, few case studies have been documented in which a firm has “escaped” from a segmented capital market. In practice, escape usually means being listed on a foreign stock market such as New York or London, and/or selling securities in foreign capital markets. We will illustrate something more specific by using the example of Novo, the Mini-Case at the end of the chapter.
Globalization of Securities Markets During the 1980s, numerous other Nordic and other European firms cross-listed on major foreign exchanges such as London and New York. They placed equity and debt issues in major securities markets. In most cases, they were successful in lowering their WACC and increasing its availability. This is the subject of this chapter’s Mini-Case.
During the 1990s, national restrictions on cross-border portfolio investment were gradually eased under pressure from the Organization for Economic Cooperation and Development (OECD), a consortium of most of the world’s most industrialized countries. Liberalization of European securities markets was accelerated because of the European Union’s efforts to develop a single European market without barriers. Emerging nation markets followed suit, as did the former Eastern Bloc countries after the breakup of the Soviet Union. Emerging national markets have often been motivated by the need to source foreign capital to finance large-scale privatization.
Now, market segmentation has been significantly reduced, although the liquidity of individual national markets remains limited. Most observers believe that for better or for worse, we have achieved a global market for securities. The good news is that many firms have been assisted to become MNEs because they now have access to a global cost and availability of capital. The bad news is that the correlation among securities markets has increased, thereby reducing, but not eliminating, the benefits of international portfolio diversification. Globalization of securities markets has also led to more volatility and speculative behavior as shown by the emerging market crises of the 1995–2001 period, and the 2008–2009 global credit crisis.
Corporate Governance and the Cost of Capital. Would global investors be willing to pay a premium for a share in a good corporate governance company? A recent study of Norwegian and Swedish firms measured the impact of foreign board membership (Anglo-American) on firm value. They summarized their findings as follows:
Using a sample of firms with headquarters in Norway or Sweden the study indicates a significantly higher value for firms that have outsider Anglo-American board member(s), after a variety of firm-specific and corporate governance related factors have been controlled for. We argue that this superior performance reflects the fact that these companies have successfully broken away from a partly segmented domestic capital market by “importing” an Anglo-American corporate governance system. Such an “import” signals a willingness on the part of the firm to expose itself to improved corporate governance and enhances its reputation in the financial market.5
Strategic Alliances Strategic alliances are normally formed by firms that expect to gain synergies from one or more of the following joint efforts. They might share the cost of developing technology, or pursue complementary marketing activities. They might gain economies of scale or scope or a variety of other commercial advantages. However, one synergy that may sometimes by overlooked is
5Lars Oxelheim and Trond Randøy, “The impact of foreign board membership on firm value,” Journal of Banking and Finance, Vol. 27, No. 12, 2003, p. 2369.
363The Global Cost and Availability of Capital CHAPTER 13
the possibility for a financially strong firm to help a financially weak firm to lower its cost of capital by providing attractively priced equity or debt financing. This is illustrated in the Global Finance in Practice 13.1 on the strategic alliance between Bang and Olufsen and Philips.
The Cost of Capital for MNEs Compared to Domestic Firms Is the weighted average cost of capital for MNEs higher or lower than for their domestic counterparts? The answer is a function of the marginal cost of capital, the relative after-tax cost of debt, the optimal debt ratio, and the relative cost of equity.
Availability of Capital Earlier in this chapter, we saw that international availability of capital to MNEs, or to other large firms that can attract international portfolio investors, may allow them to lower their cost of equity and debt compared with most domestic firms. In addition, international availability
One excellent example of financial synergy that lowered a firm’s cost of capital was provided by the cross-border strategic alliance of Philips N.V. of the Netherlands and Bang & Olufsen (B & O) of Denmark in 1990. Philips N.V. is one of the largest multinational firms in the world and the leading consumer electronics firm in Europe. B & O is a small European competitor but with a nice market niche at the high end of the audiovisual market.
Philips was a major supplier of components to B & O, a situation it wished to continue. It also wished to join forces with B & O in the upscale consumer electronics market where Philips did not have the quality image enjoyed by B & O. Philips was concerned that financial pressure might force B & O to choose a Japanese competitor for a partner. That would be very unfortunate. B & O had always supported Philips’ political efforts to gain EU support to make the few remaining European-owned consumer electronics firms more competitive than their strong Japanese competitors.
B & O’s Motivation B & O was interested in an alliance with Philips to gain more rapid access to its new technology and assistance in converting that technology into B & O product applications. B & O wanted assurance of timely delivery of components at large volume discounts from Philips itself, as well as access to Philip’s large network of suppliers under terms enjoyed by Philips. Equally important, B & O wanted to get an equity infusion from Philips to strengthen its own shaky financial position. Despite its commercial artistry, in recent years
B & O had been only marginally profitable, and its publicly traded shares were considered too risky to justify a new public equity issue either in Denmark or abroad. It had no excess borrowing capacity.
The Strategic Alliance A strategic alliance was agreed upon that would give each partner what it desired commercially. Philips agreed to invest DKK342 million (about $50 million) to increase the equity of B & O’s main operating subsidiary. In return, it received a 25% ownership of the expanded company.
When B & O’s strategic alliance was announced to the public on May 3, 1990, the share price of B & O Holding, the listed company on the Copenhagen Stock Exchange, jumped by 35% during the next two days. It remained at that level until the Gulf War crisis temporarily depressed B & O’s share price. The share price has since recovered and the expected synergies eventually materialized. B & O eventually bought back its shares from Philips at a price that had been predetermined at the start.
In evaluating what happened, we recognize that an industrial purchaser might be willing to pay a higher price for a firm that will provide it some synergies than would a portfolio investor who does not receive these synergies. Portfolio inves- tors are only pricing a firm’s shares based on the normal risk versus return trade-off. They cannot normally anticipate the value of synergies that might accrue to the firm from an unexpected strategic alliance partner. The same conclusion should hold for a purely domestic strategic alliance but this example happens to be a cross-border alliance.
GLOBAL FINANCE IN PRACTICE 13.1
Bang & Olufsen and Philips N.V.
364 CHAPTER 13 The Global Cost and Availability of Capital
permits an MNE to maintain its desired debt ratio, even when significant amounts of new funds must be raised. In other words, an MNE’s marginal cost of capital is constant for con- siderable ranges of its capital budget. This statement is not true for most domestic firms. They must either rely on internally generated funds or borrow in the short and medium term from commercial banks.
Financial Structure, Systematic Risk, and the Cost of Capital for MNEs Theoretically, MNEs should be in a better position than their domestic counterparts to sup- port higher debt ratios because their cash flows are diversified internationally. The probability of a firm’s covering fixed charges under varying conditions in product, financial, and foreign exchange markets should improve 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. The same argument applies—namely, that returns are not perfectly correlated between countries. For example, in 2000 Japan was in recession but the United States was experiencing rapid growth. Therefore, we might have expected returns, on either a cash flow or an earnings basis, to be depressed in Japan and favorable in the United States. An MNE with operations located in both these countries could rely on its strong U.S. cash inflow to cover debt obligations, even if its Japanese subsidiary produced weak net cash inflows.
Despite the theoretical elegance of this hypothesis, empirical studies have come to the opposite conclusion.6 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 been identified as the factors leading to lower debt ratios and even a higher cost of long-term debt for MNEs. Domestic firms rely much more heavily on short and intermedi- ate debt, which lie at the low cost end of the yield curve.
Even more surprising, one study found that MNEs have a higher level of systematic risk than their domestic counterparts.7 The same factors caused this phenomenon as caused the lower debt ratios for MNEs. The study concluded that the increased standard deviation of cash flows from internationalization more than offset the lower correlation from diversification.
As we stated earlier, the systematic risk term, bj, is defined as
bj = rjmsj
sm ,
where rjm is the correlation coefficient between security j and the market; sj is the standard deviation of the return on firm j; and sm is the standard deviation of the market return. The MNE’s systematic risk could increase if the decrease in the correlation coefficient, rjm, due to international diversification, is more than offset by an increase in sj the standard deviation due to the aforementioned risk factors. This conclusion is consistent with the observation that many MNEs use a higher hurdle rate to discount expected foreign project cash flows. In essence, they are accepting projects they consider to be riskier than domestic projects, thus
6Lee, Kwang Chul, and Chuck C.Y. Kwok, “Multinational Corporations vs. Domestic Corporations: International Environmental Factors and Determinants of Capital Structure,” Journal of International Business Studies, Summer 1988, pp. 195–217. 7Reeb, David M., Chuck C.Y. Kwok, and H. Young Baek, “Systematic Risk of the Multinational Corporation, Journal of International Business Studies, Second Quarter 1998, pp. 263–279.
365The Global Cost and Availability of Capital CHAPTER 13
potentially skewing upward their perceived systematic risk. At the least, MNEs need to earn a higher rate of return than their domestic equivalents in order to maintain their market value.
Other studies have found that internationalization actually allows emerging market MNEs to carry a higher level of debt and lowered their systematic risk.8 This occurs 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 firms to enjoy higher leverage and lower systematic risk than their U.S.-based MNE counterparts.
The Riddle: Is the Cost of Capital Higher for MNEs? The riddle is that the MNE is supposed to have a lower marginal cost of capital (MCC) than a domestic firm because of the MNE’s access to a global cost and availability of capital. On the other hand, the empirical studies we mentioned show that the MNE’s weighted average cost of capital (WACC) is actually higher than for a comparable domestic firm because of agency costs, foreign exchange risk, political risk, asymmetric information, and other complexities of foreign operations.
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 13.7 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).
The line MRRDC depicts a modest set of potential projects. It intersects the line MCCMNE at 15% and a $100 million budget level. It intersects the MCCDC at 10% and a $140 million budget level. At these low budget levels the MCCMNE has a higher MCC and probably weighted average cost of capital than its domestic counterpart (DC), as discovered in the recent empirical studies.
The line MRRMNE depicts a more ambitious set of projects for both the MNE and its domes- tic counterpart. It intersects the line MCCMNE still at 15% and a $350 million budget. However, it intersects the MCCDC at 20% and a budget level of $300 million. At these higher budget levels, the MCCMNE has a lower MCC and probably weighted average cost of capital than its domestic counterpart, as predicted earlier in this chapter. In order to generalize this conclusion, we would need to know under what conditions a domestic firm would be willing to undertake the optimal capital budget despite its increasing the firm’s marginal cost of capital. At some point, the MNE might also have an optimal capital budget at the point where its MCC is rising.
Empirical studies show that neither mature domestic firms nor MNEs are typically willing to assume the higher agency costs or bankruptcy risk associated with higher MCCs and capital budgets. In fact, most mature firms demonstrate some degree of corporate wealth maximizing behavior. They are somewhat risk averse and tend to avoid returning to the market to raise fresh equity. They prefer to limit their capital budgets to what can be financed with free cash flows.
8Kwok, Chuck C.Y., and David M. Reeb, “Internationalization and Firm Risk: An Upstream-Downstream Hypothesis,” Journal of International Business Studies, Vol. 31, Issue 4, 2000, pp. 611–630.
366 CHAPTER 13 The Global Cost and Availability of Capital
Indeed, they have a so-called pecking order that determines the priority of which sources of funds they tap and in what order. This behavior motivates shareholders to monitor management more closely. They tie management’s compensation to stock performance (options). They may also require other types of contractual arrangements that are collectively part of agency costs.
In conclusion, if both MNEs and domestic firms do actually limit their capital budgets to what can be financed without increasing their MCC, then the empirical findings that MNEs have higher WACC stands. If the domestic firm has such good growth opportunities that it chooses to undertake growth despite an increasing marginal cost of capital, then the MNE would have a lower WACC. Exhibit 13.8 summarizes these conclusions.
EXHIBIT 13.7
Budget (millions of US$)
Marginal Cost of Capital and Rate of Return (percentage)
100 140 300 350 400
20%
15%
10%
5%
MCCDC
MRRMNE MRRDC
MCCMNE
The Cost of Capital for MNE and Domestic Counterpart Compared
! Gaining access to global capital markets should allow a firm to lower its cost of capital. This can be achieved by increasing the market liquidity of its shares and by escaping from segmentation of its home capital market.
! The cost and availability of capital is directly linked to the degree of market liquidity and segmentation. Firms having access to markets with high liquidity and a low level of segmentation should have a lower cost of capi- tal and greater ability to raise new capital.
! A firm is able to increase its market liquidity by raising debt in the Euromarket, by selling security issues in individual national capital markets and as Euroequi- ties, and tapping local capital markets through foreign subsidiaries. Increased market liquidity causes the mar- ginal cost of capital line to “flatten out to the right.”
This results in the firm being able to raise more capital at the same low marginal cost of capital, and thereby justify investing in more capital projects. The key is to attract international portfolio investors.
! A national capital market is segmented if the required rate of return on securities in that market differs from the required rate of return on securities of compara- ble expected return and risk that are traded on other national securities markets. Capital market segmen- tation is a financial market imperfection caused by government constraints and investor perceptions. The most important imperfections are 1) asymmetric infor- mation; 2) transaction costs; 3) foreign exchange risk; 4) corporate governance differences; 5) political risk; and 6) regulatory barriers.
SUMMARY POINTS
367The Global Cost and Availability of Capital CHAPTER 13
EXHIBIT 13.8
Is MNEWACC > or < DomesticWACC ?
Empirical studies indicate that MNEs have a lower debt/capital ratio than domestic counterparts, indicating that MNEs have a higher cost of capital.
And indications are that MNEs have a lower average cost of debt than domestic counterparts, indicating that MNEs have a lower cost of capital.
The cost of equity required by investors is higher for multinational firms than for domestic firms. Possible explanations are higher levels of political risk, foreign exchange risk, and higher agency costs of doing business in a multinational managerial environment. However, at relatively high levels of the optimal capital budget, the MNE would have a lower cost of capital.
kWACC = ke Equity Value + kd (1–t )
Debt Value
Do MNEs Have a Higher or Lower Cost of Capital Than Their Domestic Counterparts?
! Segmentation results in a higher cost of capital and less availability of capital.
! If a firm is resident in a segmented capital market, it can still escape from this market by sourcing its debt and equity abroad. The result should be a lower marginal cost of capital, improved liquidity for its shares, and a larger capital budget. The experience of Novo was
suggested as a possible model for firms resident in small or emerging markets that are partially segmented and illiquid.
! Whether or not MNEs have a lower cost of capital than their domestic counterparts depends on their optimal financial structures, systematic risk, availability of capital, and the level of the optimal capital budget.
Novo is a Danish multinational firm which produces indus- trial enzymes and pharmaceuticals (mostly insulin). In 1977, Novo’s management decided to “internationalize” its capital structure and sources of funds. This decision was based on the observation that the Danish securities market was both illiquid and segmented from other capi- tal markets. In particular, the lack of availability and high cost of equity capital in Denmark resulted in Novo hav- ing a higher cost of capital than its main multinational
competitors, such as Eli Lilly (U.S.), Miles Laboratories (U.S.—a subsidiary of Bayer, Germany), and Gist Bro- cades (The Netherlands).
Apart from the cost of capital, Novo’s projected growth opportunities signaled the eventual need to raise new long- term capital beyond what could be raised in the illiquid Danish market. Since Novo is a technology leader in its specialties, planned capital investments in plant, equipment, and research could not be postponed until internal financing
MINI-CASE Novo Industri A/S (Novo)1
1This is a condensed version of Arthur Stonehill and Kåre B. Dullum, Internationalizing the Cost of Capital in Theory and Practice: The Novo Experience and National Policy Implications (Copenhagen: Nyt Nordisk Forlag Arnold Busck, 1982; and New York: Wiley, 1982). Reprinted with permission.
368 CHAPTER 13 The Global Cost and Availability of Capital
Almost no foreign security analysts followed Danish secu- rities because they had no product to sell and the Danish market was too small (small-country bias). Other informa- tion barriers included language and accounting principles. Naturally, financial information was normally published in Danish, using Danish accounting principles. A few firms, such as Novo, published English versions, but almost none used U.S. or British accounting principles or attempted to show any reconciliation with such principles.
Taxation Danish taxation policy had all but eliminated investment in common stock by individuals. Until a tax law change in July 1981, capital gains on shares held for over two years were taxed at a 50% rate. Shares held for less than two years, or for “speculative” purposes, were taxed at per- sonal income tax rates, with the top marginal rate being 75%. In contrast, capital gains on bonds were tax free. This situation resulted in bonds being issued at deep discounts because the redemption at par at maturity was considered a capital gain. Thus, most individual investors held bonds rather than stocks. This factor reduced the liquidity of the stock market and increased the required rate of return on stocks if they were to compete with bonds.
Feasible Set of Portfolios Because of the prohibition on foreign security ownership, Danish investors had a very limited set of securities from which to choose a portfolio. In practice, Danish institu- tional portfolios were composed of Danish stocks, govern- ment bonds, and mortgage bonds. Since Danish stock price movements are closely correlated with each other, Danish portfolios possessed a rather high level of systematic risk. In addition, government policy had been to provide a rela- tively high real rate of return on government bonds after adjusting for inflation. The net result of taxation policies on individuals, and attractive real yields on government bonds was that required rates of return on stocks were relatively high by international standards.
From a portfolio perspective, Danish stocks provided an opportunity for foreign investors to diversify interna- tionally. If Danish stock price movements were not closely correlated with world stock price movements, inclusion of Danish stocks in foreign portfolios should reduce these portfolios’ systematic risk. Furthermore, foreign inves- tors were not subject to the high Danish income tax rates because they are normally protected by tax treaties that typically limit their tax to 15% on dividends and capital gains. As a result of the international diversification poten- tial, foreign investors might have required a lower rate of return on Danish stocks than Danish investors, other
from cash flow became available. Novo’s competitors would preempt any markets not served by Novo.
Even if an equity issue of the size required could have been raised in Denmark, the required rate of return would have been unacceptably high. For example, Novo’s price/earnings ratio was typically around 5; that of its foreign competitors was well over 10. Yet Novo’s business and financial risk appeared to be about equal to that of its competitors. A price/earnings ratio of 5 appeared appropriate for Novo only within a domestic Danish context when Novo was compared with other domestic firms of comparable business and financial risk.
If Denmark’s securities markets were integrated with world markets, one would expect foreign investors to rush in and buy “undervalued” Danish securities. In that case, firms like Novo would enjoy an international cost of capital comparable to that of their foreign competitors. Strangely enough, no Danish governmental restrictions existed that would have prevented foreign investors from holding Danish securities. Therefore, one must look for investor perception as the main cause of market segmentation in Denmark at that time.
At least six characteristics of the Danish equity market were responsible for market segmentation: 1) asymmetric information base of Danish and foreign investors; 2) taxa- tion; 3) alternative sets of feasible portfolios; 4) financial risk; 5) foreign exchange risk; and 6) political risk.
Asymmetric Information Certain institutional characteristics of Denmark caused Danish and foreign investors to be uninformed about each other’s equity securities. The most important information barrier was a Danish regulation that prohibited Danish investors from holding foreign private sector securities. Therefore, Danish investors had no incentive to follow developments in foreign securities markets or to factor such information into their evaluation of Danish securities. As a result, Danish securities might have been priced correctly in the efficient market sense relative to one another, consid- ering the Danish information base, but priced incorrectly considering the combined foreign and Danish information base. Another detrimental effect of this regulation was that foreign securities firms did not locate offices or personnel in Denmark, since they had no product to sell. Lack of a physical presence in Denmark reduced the ability of foreign security analysts to follow Danish securities.
A second information barrier was lack of enough Danish security analysts following Danish securities. Only one pro- fessional Danish securities analysis service was published (Børsinformation), and that was in the Danish language. A few Danish institutional investors employed in-house analysts, but their findings were not available to the public.
369The Global Cost and Availability of Capital CHAPTER 13
financial and technical disclosure in both Danish and English versions.
The information gap was further closed when Morgan Grenfell successfully organized a syndicate to underwrite and sell a $20 million convertible Eurobond issue for Novo in 1978. In connection with this offering, Novo listed its shares on the London Stock Exchange to facilitate conver- sion and to gain visibility. These twin actions were the key to dissolving the information barrier and, of course, they also raised a large amount of long-term capital on favorable terms, which would have been unavailable in Denmark.
Despite the favorable impact of the Eurobond issue on availability of capital, Novo’s cost of capital actually increased when Danish investors reacted negatively to the potential dilution effect of the conversion right. During 1979, Novo’s share price declined from around Dkr300 per share to around Dkr220 per share.
The Biotechnology Boom. During 1979, a fortuitous event occurred. Biotechnology began to attract the interest of the U.S. investment community, with several sensationally over- subscribed stock issues by such start-up firms as Genentech and Cetus. Thanks to the aforementioned domestic infor- mation gap, Danish investors were unaware of these events and continued to value Novo at a low price/earnings ratio of 5, compared with over 10 for its established competitors and 30 or more for these new potential competitors.
In order to profile itself as a biotechnology firm with a proven track record, Novo organized a seminar in New York City on April 30, 1980. Soon after the seminar a few sophisticated individual U.S. investors began buying Novo’s shares and convertibles through the London Stock Exchange. Danish investors were only too happy to supply this foreign demand. Therefore, despite relatively strong demand from U.S. and British investors, Novo’s share price increased only gradually, climbing back to the Dkr300 level by midsummer. However, during the following months, foreign interest began to snowball, and by the end of 1980 Novo’s stock price had reached the Dkr600 level. More- over, foreign investors had increased their proportion of share ownership from virtually nothing to around 30%. Novo’s price/earnings ratio had risen to around 16, which was now in line with that of its international competitors but not with the Danish market. At this point one must conclude that Novo had succeeded in internationalizing its cost of capital. Other Danish securities remained locked in a segmented capital market.
Directed Share Issue in the United States. During the first half of 1981, under the guidance of Goldman Sachs and with the assistance of Morgan Grenfell and Copenha- gen Handelsbank, Novo prepared a prospectus for SEC registration of a U.S. share offering and eventual listing on
things being equal. However, other things were not equal because foreign investors perceived Danish stocks to carry more financial, foreign exchange, and political risk than their own domestic securities.
Financial, Foreign Exchange, and Political Risks Financial leverage utilized by Danish firms was relatively high by U.S. and U.K. standards but not abnormal for Scandinavia, Germany, Italy, or Japan. In addition, most of the debt was short term with variable interest rates. Just how foreign investors viewed financial risk in Danish firms depended on what norms they follow in their home countries. We know from Novo’s experience in tapping the Eurobond market in 1978, that Morgan Grenfell, its British investment banker, advised Novo to maintain a debt ratio (debt/total capitalization) closer to 50% rather than the traditional Danish 65% to 70%.
Foreign investors in Danish securities are subject to foreign exchange risk. Whether this is a plus or minus factor depends on the investor’s home currency, percep- tion about the future strength of the Danish krone, and its impact on a firm’s operating exposure. Through personal contacts with foreign investors and bankers, Novo’s man- agement did not believe foreign exchange risk was a factor in Novo’s stock price because its operations were perceived as being well diversified internationally. Over 90% of its sales were to customers located outside of Denmark.
With respect to political risk, Denmark was perceived as a stable Western democracy but with the potential to cause periodic problems for foreign investors. In particular, Denmark’s national debt was regarded as too high for com- fort, although this judgment had not yet shown up in the form of risk premiums on Denmark’s Eurocurrency syn- dicated loans.
The Road to Globalization Although Novo’s management in 1977 wished to escape from the shackles of Denmark’s segmented and illiquid cap- ital market, many barriers had to be overcome. It is worth- while to describe some of these obstacles, because they typify the barriers faced by other firms from segmented markets that wish to internationalize their capital sources.
Closing the Information Gap. Novo had been a family- owned firm from its founding in the 1920s by the two Pedersen brothers until 1974, when it went public and listed its “B” shares on the Copenhagen Stock Exchange. The “A” shares were held by the Novo Foundation; the “A” shares were sufficient to maintain voting control. However, Novo was essentially unknown in investment circles outside of Denmark. To overcome this disparity in the information base, Novo increased the level of its
370 CHAPTER 13 The Global Cost and Availability of Capital
Effect on Novo’s Weighted Average Cost of Capital. During most of 1981 and the years thereafter Novo’s share price was driven by international portfolio investors trans- acting on the New York, London, and Copenhagen stock exchanges. This reduced Novo’s weighted average cost of capital and lowered its marginal cost of capital. Novo’s systematic risk was reduced from its previous level, which was determined by nondiversified (internationally) Dan- ish institutional investors and the Novo Foundation. How- ever, its appropriate debt ratio level was also reduced to match the standards expected by international portfolio investors trading in the United States, United Kingdom, and other important markets. In essence, the U.S. dollar became Novo’s functional currency when being evalu- ated by international investors. Theoretically, its revised weighted average cost of capital should have become a new reference hurdle rate when evaluating new capital invest- ments in Denmark or abroad.
Other firms that follow Novo’s strategy are also likely to have their weighted average cost of capital become a function of the requirements of international portfolio investors. Firms resident in some of the emerging mar- ket countries have already experienced “dollarization” of trade and financing for working capital. This phenom- enon might be extended to long-term financing and the weighted average cost of capital. The Novo experience has been described in hopes that it can be a model for other firms wishing to escape from segmented and illiquid home equity markets. In particular, MNEs 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 portfo- lio 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.
Globalization of Securities Markets. During the 1980s, numerous other Nordic and other European firms fol- lowed Novo’s example. They cross-listed on major foreign exchanges such as London and New York. They placed equity and debt issues in major securities markets. In most cases, they were successful in lowering their WACC and increasing its availability.
During the 1980s and 1990s, national restrictions on cross-border portfolio investment were gradually eased under pressure from the Organization for Economic Coop- eration and Development (OECD), a consortium of most of the world’s most industrialized countries. Liberalization of European securities markets was accelerated because
the New York Stock Exchange. The main barriers encoun- tered in this effort, which would have general applicability, were connected with preparing financial statements that could be reconciled with U.S. accounting principles and the higher level of disclosure required by the SEC. In particu- lar, industry segment reporting was a problem both from a disclosure perspective and an accounting perspective because the accounting data were not available internally in that format. As it turned out, the investment barriers in the U.S. were relatively tractable, although expensive and time consuming to overcome.
The more serious barriers were caused by a variety of institutional and governmental regulations in Denmark. The latter were never designed so that firms could issue shares at market value, since Danish firms typically issued stock at par value with preemptive rights. By this time, how- ever, Novo’s share price, driven by continued foreign buy- ing, was so high that virtually nobody in Denmark thought it was worth the price which foreigners were willing to pay. In fact, prior to the time of the share issue in July 1981 Novo’s share price had risen to over Dkr1500, before set- tling down to a level around Dkr1400. Foreign ownership had increased to over 50% of Novo’s shares outstanding!
Stock Market Reactions. One final piece of evidence on market segmentation can be gleaned from the way Danish and foreign investors reacted to the announcement of the proposed $61 million U.S. share issue on May 29, 1981. Novo’s share price dropped 156 points the next trading day in Copenhagen, equal to about 10% of its market value. As soon as trading started in New York, the stock price imme- diately recovered all of its loss. The Copenhagen reaction was typical for an illiquid market. Investors worried about the dilution effect of the new share issue, because it would increase the number of shares outstanding by about 8%. They did not believe that Novo could invest the new funds at a rate of return which would not dilute future earnings per share. They also feared that the U.S. shares would eventu- ally flow back to Copenhagen if biotechnology lost its glitter.
The U.S. reaction to the announcement of the new share issue was consistent with what one would expect in a liq- uid and integrated market. U.S. investors viewed the new issue as creating additional demand for the shares as Novo became more visible due to the selling efforts of a large aggressive syndicate. Furthermore, the marketing effort was directed at institutional investors who were previously underrepresented among Novo’s U.S. investors. They had been underrepresented because U.S. institutional investors want to be assured of a liquid market in a stock in order to be able to get out, if desired, without depressing the share price. The wide distribution effected by the new issue, plus SEC registration and a New York Stock Exchange listing, all added up to more liquidity and a global cost of capital.
securities. The good news is that many firms have been assisted to become MNEs because they now have access to a global cost and availability of capital. The bad news is that the correlation among securities markets has increased, thereby reducing, but not eliminating, the ben- efits of international portfolio diversification. Globaliza- tion of securities markets has also led to more volatility and speculative behavior as shown by the emerging market crises of the 1995–2001 period.
of the European Union’s efforts to develop a single Euro- pean market without barriers. Emerging nation markets followed suit, as did the former Eastern Bloc countries after the breakup of the Soviet Union. Emerging national markets have often been motivated by the need to source foreign capital to finance large-scale privatization.
Now, market segmentation has been significantly reduced, although the liquidity of individual national markets remains limited. Most observers believe that for better or for worse, we have achieved a global market for
The Global Cost and Availability of Capital CHAPTER 13 371
QUESTIONS 1. Dimensions of the Cost and Availability 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 avail- ability of capital?
2. Benefits. What are the benefits of achieving a lower cost and greater availability of capital?
3. Definitions. Define the following terms: a. Systematic risk b. Beta (in the Capital Asset Pricing Model)
4. Equity Risk Premiums. Answer the following questions: a. What is an equity risk premium? b. What is the difference between calculating an
equity risk premium using arithmetic returns com- pared to geometric returns?
c. In Exhibit 13.3, why are arithmetic mean risk pre- miums always higher than geometric mean risk premiums?
5. Portfolio Investors. Both domestic and international portfolio managers are asset allocators. a. What is their portfolio management objective? b. What is the main advantage that international
portfolio managers have compared to portfolio managers limited to domestic-only asset allocation?
6. Dimensions of Asset Allocation. Portfolio asset allo- cation can be accomplished along many dimensions depending on the investment objective of the portfolio manager. Identify the various dimensions.
7. Market Liquidity. Answer the following questions: a. Define what is meant by the term market liquidity. b. What are the main disadvantages for a firm to be
located in an illiquid market?
c. If a firm is limited to raising funds in its domestic capital market, what happens to its marginal cost of capital as it expands?
d. If a firm can raise funds abroad what happens to its marginal cost of capital as it expands?
8. Market Segmentation. Answer the following questions: a. Define market segmentation. b. What are the six main causes of market
segmentation? c. What are the main disadvantages for a firm to be
located in a segmented market?
9. Market Liquidity and Segmentation Effects. What is the effect of market liquidity and segmentation on a firm’s cost of capital?
10. Novo Industri (A). Why did Novo believe its cost of capital was too high compared to its competitors? Why did Novo’s relatively high cost of capital create a competitive disadvantage?
11. Novo Industri (B). Novo believed that the Danish capital market was segmented from world capi- tal markets. Explain the six characteristics of the Danish equity market that were responsible for its segmentation.
12. Novo Industri A/S. Answer the following questions: a. What was Novo’s strategy to internationalize its
cost of capital? b. What is the evidence that Novo’s strategy
succeeded?
13. Emerging Markets. It has been suggested that firms located in illiquid and segmented emerging markets could follow Novo’s proactive strategy to internation- alize their own cost of capital. What are the precon- ditions that would be necessary to succeed in such a proactive strategy?
372 CHAPTER 13 The Global Cost and Availability of Capital
A London bank advises Deming that U.S. dollars could be raised in Europe at the following costs, also in multiples of $20 million, while maintaining the 50/50 capi- tal structure.
Each increment of cost would be influenced by the total amount of capital raised. That is, if Deming first borrowed $20 million in the European market at 6% and matched this with an additional $20 million of equity, additional debt beyond this amount would cost 12% in the United States and 10% in Europe. The same relationship holds for equity financing. a. Calculate the lowest average cost of capital for
each increment of $40 million of new capital, where Deming raises $20 million in the equity market and an additional $20 in the debt market at the same time.
b. If Deming plans an expansion of only $60 million, how should that expansion be financed? What will be the weighted average cost of capital for the expansion?
3. Trident’s Cost of Capital. Market conditions have changed. Maria Gonzalez now estimates the risk-free rate to be 3.60%, the company’s credit risk premium is 4.40%, the domestic beta is estimated at 1.05, the international beta at .85, and the company’s capital structure is now 30% debt. All other values remain the same. For both the domestic CAPM and ICAPM, calculate the following: a. Trident’s cost of equity b. Trident’s cost of debt c. Trident’s weighted average cost of capital
4. Trident and Equity Risk Premiums. Using the origi- nal cost of capital data for Trident used in the chapter, calculate both the CAPM and ICAPM costs of capital for the following equity risk premium estimates. a. 8.00% b. 7.00% c. 5.00% d. 4.00%
5. Kashmiri’s Cost of Capital. Kashmiri is the largest and most successful specialty goods company based in Bangalore, India. It has not entered the North Ameri- can marketplace yet, but is considering establishing both manufacturing and distribution facilities in the United States through a wholly owned subsidiary. It has approached two different investment banking advisors, Goldman Sachs and Bank of New York, for estimates of what its costs of capital would be several
14. Cost of Capital for MNEs Compared to Domestic Firms. Theoretically, MNEs should be in a better position than their domestic counterparts to support higher debt ratios because their cash flows are diversi- fied internationally. However, recent empirical studies have come to the opposite conclusion. These studies also concluded that MNEs have higher betas than their domestic counterparts. a. According to these empirical studies, why do
MNEs have lower debt ratios than their domestic counterparts?
b. According to these empirical studies, why do MNEs have higher betas than their domestic counterparts?
15. 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 counter- part. Explain and diagram what are these conditions.
16. Emerging Market MNEs. Apart from improving liquidity and escaping from a segmented home market, why might emerging market MNEs further lower their cost of capital by listing and selling equity abroad?
PROBLEMS 1. Corcovado Pharmaceuticals. Corcovado Pharmaceu-
tical’s cost of debt is 7%. The risk-free rate of interest is 3%. The expected return on the market portfolio is 8%. After effective taxes, Corcovado’s effective tax rate is 25%. Its optimal capital structure is 60% debt and 40% equity. a. If Corcovado’s beta is estimated at 1.1, what is its
weighted average cost of capital? b. If Corcovado’s beta is estimated at 0.8, significantly
lower because of the continuing profit prospects in the global energy sector, what is its weighted aver- age cost of capital?
2. Colton Conveyance, Inc. Colton Conveyance, Inc. is a large U.S. natural gas pipeline company that wants to raise $120 million to finance expansion. Deming wants a capital structure that is 50% debt and 50% equity. Its corporate combined federal and state income tax rate is 40%. Deming finds that it can finance in the domestic U.S. capital market at the rates listed below. Both debt and equity would have to be sold in multiples of $20 million, and these cost figures show the component costs, each, of debt and equity if raised half by equity and half by debt.
373The Global Cost and Availability of Capital CHAPTER 13
years into the future when it planned to list its Ameri- can subsidiary on a U.S. stock exchange. Using the assumptions by the two different advisors, , calculate the prospective costs of debt, equity, and the WACC for Kashmiri (U.S.):
Assumptions Symbol Goldman
Sachs Bank of New
York
Estimate of correlation between security and market
b 0.90 0.85
Estimate of standard deviation of Tata’s returns
rjm 24.0% 30.0%
Estimate of standard deviation of market’s return
sj 18.0% 22.0%
Risk-free rate of interest krf 3.0% 3.0%
Estimate of Tata’s cost of debt in U.S. market
kd 7.5% 7.8%
Estimate of market return, forward-looking
km 9.0% 12.0%
Corporate tax rate t 35.0% 35.0%
Proportion of debt D/V 35% 40%
Proportion of equity E/V 65% 60%
Company A Company B Cargill
Company sales $10.5 billion
$45 billion $113 billion
Company’s beta 0.83 0.68 ??
Credit rating AA A AA
Weighted average cost of debt
6.885% 7.125% 6.820%
Debt to total capital 34% 41% 28%
International sales/ Sales
11% 34% 54%
Brazilian Economic Performance 1995 1996 1997 1998 1999
Inflation rate (IPC) 23.20% 10.00% 4.80% 1.00% 10.50%
Bank lending rate 53.10% 27.10% 24.70% 29.20% 30.70%
Exchange rate (reais/$) 0.972 1.039 1.117 1.207 1.700
Equity returns (São Paulo Bovespa) 16.0% 28.0% 30.2% 33.5% 151.9%
7. The Tombs. You have joined your friends at the local watering hole, The Tombs, for your weekly debate on international finance. The topic this week is whether the cost of equity can ever be cheaper than the cost of debt. The group has chosen Brazil in the mid-1990s as the subject of the debate. One of the group members has torn a table of data out of a book (shown at the bottom of this page), which is then the subject of the analysis.
Larry argues that “it’s all about expected versus delivered. You can talk about what equity investors expect, but they often find that what is delivered for years at a time is so small—even sometimes negative— that in effect, the cost of equity is cheaper than the cost of debt.”
Moe interrupts: “But you’re missing the point. The cost of capital is what the investor requires in compensation for the risk taken going into the invest- ment. If he doesn’t end up getting it, and that was hap- pening here, then he pulls his capital out and walks.”
Curly is the theoretician. “Ladies, this is not about empirical results; it is about the fundamental concept of risk-adjusted returns. An investor in equities knows he will reap returns only after all compensation has been made to debt providers. He is therefore always subject to a higher level of risk to his return than debt
6. Cargill’s Cost of Capital. Cargill is generally consid- ered to be the largest privately held company in the world. Headquartered in Minneapolis, Minnesota, the company has been averaging sales of over $113 billion per year over the past five-year period. Although the company does not have publicly traded shares, it is still extremely important for it to calculate its weighted average cost of capital properly in order to make ratio- nal decisions on new investment proposals. Refer to the table at the at the top right. Assuming a risk-free rate of 4.50%, an effective tax rate of 48%, and a mar- ket risk premium of 5.50%, estimate the weighted average cost of capital first for companies A and B, and then make a “guesstimate” of what you believe a comparable WACC would be for Cargill.
374 CHAPTER 13 The Global Cost and Availability of Capital
risk premium for “going international” to the basic CAPM cost of equity. Calculate Genedak-Hogan’s cost of equity before and after international diversi- fication of its operations, with and without the hypo- thetical additional risk premium, and comment on the discussion.
9. Genedak-Hogan’s WACC. Calculate the weighted average cost of capital for Genedak-Hogan for before and after international diversification. a. Did the reduction in debt costs reduce the firm’s
weighted average cost of capital? How would you describe the impact of international diversification on its costs of capital?
b. Adding the hypothetical risk premium to the cost of equity introduced in problem 8 (an added 3.0% to the cost of equity because of international diver- sification), what is the firm’s WACC?
10. Genedak-Hogan’s WACC and Effective Tax Rate. Many MNEs have greater ability to control and reduce their effective tax rates when expanding international operations. If Genedak-Hogan was able to reduce its consolidated effective tax rate from 35% to 32%, what would be the impact on its WACC?
instruments, and as the capital asset pricing model states, equity investors set their expected returns as a risk-adjusted factor over and above the returns to risk- free instruments.”
At this point, Larry and Moe simply stare at Curly—pause—and order more beer. Using the Brazilian data at the bottom of the previous page, comment on this week’s debate at the Tombs.
Genedak-Hogan Use the data at the bottom of this page to answer prob- lems 8 through 10. Genedak-Hogan is an American conglomerate which is actively debating the impacts of international diversification of its operations on its capital structure and cost of capital. The firm is plan- ning to reduce consolidated debt after diversification.
8. Genedak-Hogan Cost of Equity. Senior manage- ment at Genedak-Hogan is actively debating the implications of diversification on its cost of equity. Although both parties agree that the company’s returns will be less correlated with the reference market return in the future, the financial advisors believe that the market will assess an additional 3.0%
Assumptions Symbol Before
Diversification After
Diversification
Correlation between G-H and the market r jm 0.88 0.76
Standard deviation of G-H’s returns sj 28.0% 26.0%
Standard deviation of market’s returns sm 18.0% 18.0%
Risk-free rate of interest krf 3.0% 3.0%
Additional equity risk premium for internationalization RPM 0.0% 3.0%
Estimate of G-H’s cost of debt in U.S. market kd 7.2% 7.0%
Market risk premium km9krf 5.5% 5.5%
Corporate tax rate t 35.0% 35.0%
Proportion of debt D/V 38% 32%
Proportion of equity E/V 62% 68%
375The Global Cost and Availability of Capital CHAPTER 13
producer of insulin worldwide. Its main competitor is Eli Lilly of the United States. Using standard inves- tor information, and the Web sites for Novo Nordisk and Eli Lilly, determine whether during the most recent five years, Novo Nordisk has maintained a cost of capital competitive with Eli Lilly. In particu- lar, examine the P/E ratios, share prices, debt ratios, and betas. Try to calculate each firm’s actual cost of capital.
Novo Nordisk www.novonordisk.com
Eli Lilly and Company www.lilly.com
BigCharts.com www.bigcharts.marketwatch.com
3. Cost of Capital Calculator. Ibbotson and Associates, a unit of Morningstar, is one of the leading providers of quantitative estimates of the cost of capital across markets. Use the following Web site— specifically the Cost of Capital Center—to prepare an overview of the major theoretical approaches and the numeri- cal estimates they yield for cross-border costs of capital.
Ibbotson and Associates corporate.morningstar.com
INTERNET EXERCISES 1. International Diversification via Mutual Funds. All
major mutual fund companies now offer a variety of internationally diversified mutual funds. The degree of international composition across funds, however, differs significantly. Use the Web sites listed, and oth- ers of interest, to answer the following: a. Distinguish between international funds, global
funds, worldwide funds, and overseas funds b. Determine how international funds have been per-
forming, in U.S. dollar terms, relative to mutual funds offering purely domestic portfolios
Fidelity www.fidelity.com/funds/
T.Rowe Price www.troweprice.com/
Merrill Lynch www.ml.com/
Scudder www.scudder.com/
Kemper www.kempercorporation.com/
2. Novo Industri. Novo Industri A/S merged with Nor- disk Gentofte in 1989. Nordisk Gentofte was Novo’s main European competitor. The combined company, now called Novo Nordisk, has become the leading
376
CHAPTER 14
Raising Equity and Debt Globally
Do what you will, the capital is at hazard. All that can be required of a trustee to invest, is, that he shall conduct himself faithfully and exercise a sound discretion. He is to observe how men of prudence, discretion, and intelligence manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income, as well as the probable safety of the capital to be invested.
—Prudent Man Rule, Justice Samuel Putnam, 1830.
Chapter 13 analyzed why gaining access to global capital markets should lower a firm’s cost of capital, increase its access to capital, and improve the liquidity of its shares by overcoming market segmentation. A firm pursuing this lofty goal, particularly a firm from a segmented or emerging market, must first design a financial strategy that will attract international investors. This involves choosing among alternative paths to access global capital markets.
This chapter focuses on firms resident in less liquid, segmented, or emerging markets. They are the ones that need to tap liquid and unsegmented markets in order to attain the global cost and availability of capital. Firms resident in large and highly industrialized countries already have access to their own domestic, liquid, and unsegmented markets. Although they too source equity and debt abroad, it is unlikely to have as favorable an impact on their cost and availability of capital. In fact, sourcing funds abroad is often motivated only by the need to fund large foreign acquisitions rather than existing operations.
This chapter begins with the design of a financial strategy to source both equity and debt globally. It then analyzes the optimal financial structure for an MNE and its subsidiaries, one that minimizes its cost of capital. Then we explore the alternative paths which a firm may follow in raising capital in global markets. The chapter concludes with a very real and current Mini-Case, Korres Natural Products and the Greek Crisis, which presents a Greek multinational company exploring its alternatives of expanding its access to capital for growth and competitiveness in 2012.
Designing a Strategy to Source Capital Globally Designing a capital sourcing strategy requires management to agree upon a long-run financial objective and then choose among the various alternative paths to get there. Exhibit 14.1 is a visual presentation of alternative paths to the ultimate objective of attaining a global cost and availability of capital.
377Raising Equity and Debt Globally CHAPTER 14
Normally, the choice of paths and implementation is aided by an early appointment of an investment bank as official advisor to the firm. Investment bankers are in touch with the potential foreign investors and their current requirements. They can also help navigate the various institutional requirements and barriers that must be satisfied. Their services include advising if, when, and where a cross-listing should be initiated. They usually prepare the required prospectus if an equity or debt issue is desired, help to price the issue, and maintain an aftermarket to prevent the share price from falling below its initial price.
Alternative Paths Most firms raise their initial capital in their own domestic market (see Exhibit 14.1). Next, they are tempted to skip all the intermediate steps and drop to the bottom line, a Euroequity issue in global markets. This is the time when a good investment bank advisor will offer a “reality check.” Most firms that have only raised capital in their domestic market are not known well enough to attract foreign investors. Remember from Chapter 13 that Novo was advised by its investment bankers to start with a convertible Eurobond issue and simultaneously cross-list their shares and their bonds in London. This was despite the fact that Novo had an outstanding track record of financial and business performance.
Exhibit 14.1 shows that most firms should start sourcing abroad with an international bond issue. It could be placed on a less prestigious foreign market. This could be followed by an international bond issue in a target market or in the Eurobond market. The next step might
EXHIBIT 14.1 Alternative Paths to Globalize the Cost and Availability of Capital
Domestic Financial Market Operations
Euroequity Issue — Global Markets
International Bond Issue — Less Prestigious Markets
International Bond Issue — Target Market or Eurobond Market
Equity Listings — Less Prestigious Markets
Equity Issue — Less Prestigious Markets
Equity Listing — Target Market
Source :Oxelhiem, Stonehill, Randøy, Vikkula, Dullum, and Modén, Corporate Strategies in Internationalizing the Cost of Capital, Copenhagen: Copenhagen Business School Press, 1998, p. 119.
378 CHAPTER 14 Raising Equity and Debt Globally
be to cross-list and issue equity in one of the less prestigious markets to attract international investor attention. The next step could be to cross-list shares on a highly liquid prestigious foreign stock exchange such as London (LSE), NYSE-Euronext, or NASDAQ. The ultimate step would be to place a directed equity issue in a prestigious target market or a Euroequity issue in global equity markets.
Optimal Financial Structure After many years of debate, finance theorists now agree that there does exist an optimal financial structure for a firm, and practically, how it is determined. The great debate between the so-called traditionalists and the Modigliani and Miller school of thought has ended in compromise: 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.
Exhibit 14.2 illustrates how the cost of capital varies with the amount of debt employed. As the debt ratio, defined as total debt divided by total assets at market values, increases, the overall cost of capital (kWACC) decreases because of the heavier weight of low-cost debt [kd(1 - t)] compared to high-cost equity (ke). The low cost of debt is, of course, due to the tax deductibility of interest shown by the term (1 - t).
Partly offsetting the favorable effect of more debt is an increase in the cost of equity (ke), because investors perceive greater financial risk. Nevertheless, the overall weighted average cost of capital (kWACC) continues to decline as the debt ratio increases, until financial risk becomes so serious that investors and management alike perceive a real danger of insolvency. This result causes a sharp increase in the cost of new debt and equity, increasing the weighted
EXHIBIT 14.2 The Cost of Capital and Financial Structure
200 6040 80 100
30 28 26 24 22 20 18 16 14 12 10 8 6 4 2
Cost of Capital (%)
ke = cost of equity
kWACC = weighted average after-tax cost of capital
kd (1 ! x ) = after-tax cost of debt
Debt Ratio (%) = Total Debt (D )
Total Assets (V )
Minimum cost of capital range
379Raising Equity and Debt Globally CHAPTER 14
average cost of capital. The low point on the resulting U-shaped cost of capital curve, 14% in Exhibit 14.2, defines the debt ratio range in which the cost of capital is minimized.
Most theorists believe that the low point is actually a rather broad flat area encompassing a wide range of debt ratios, 30% to 60% in Exhibit 14.2, where little difference exists in the cost of capital. They also believe that, at least in the United States, the range of the flat area and the location of a particular firm’s debt ratio within that range are determined by such variables as 1) the industry in which it competes; 2) the volatility of its sales and operating income; and 3) the collateral value of its assets.
Optimal Financial Structure and the MNE The domestic theory of optimal financial structures needs to be modified by four more variables in order to accommodate the case of the MNE. These variables, in order of appearance, are 1) availability of capital; 2) diversification of cash flows; 3) foreign exchange risk; and 4) expectations of international portfolio investors.1
Availability of Capital. Chapter 13 demonstrated that access to capital in global markets allows an MNE to lower its cost of equity and debt compared with most domestic firms. It also permits an MNE to maintain its desired debt ratio, even when significant amounts of new funds must be raised. In other words, a multinational firm’s marginal cost of capital is constant for considerable ranges of its capital budget. This statement is not true for most small domestic firms because they do not have access to the national equity or debt markets. They must either rely on internally generated funds or borrow for the short and medium terms from commercial banks.
Multinational firms domiciled in countries that have illiquid capital markets are in almost the same situation as small domestic firms unless they have gained a global cost and availability of capital. They must rely on internally generated funds and bank borrowing. If they need to raise significant amounts of new funds to finance growth opportunities, they may need to borrow more than would be optimal from the viewpoint of minimizing their cost of capital. This is equivalent to saying that their marginal cost of capital is increasing at higher budget levels.
Diversification of Cash Flows. As explained in Chapter 13, the theoretical possibility exists that 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’s 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 German firm would not enjoy the benefit of cash flow international diversification but would have to rely entirely on its own net cash inflow from domestic operations. Perceived financial risk for the German firm would be greater than for a multinational firm because the variability of its German domestic cash flows could not be offset by positive cash flows elsewhere in the world.
As discussed in Chapter 13, the diversification argument has been challenged by empirical research findings that MNEs in the United States actually have lower debt ratios than their domestic counterparts. The agency costs of debt were higher for the MNEs, as were political risks, foreign exchange risks, and asymmetric information.
1An excellent recent study on the practical dimensions of optimal capital structure can be found in “An Empirical Model of Optimal Capital Structure,” Jules H. Binsbergn, John R. Graham, and Jie Yang, Journal of Applied Corporate Finance, Volume 23, Number 4, Fall 2011, pp. 34–59.
380 CHAPTER 14 Raising Equity and Debt Globally
Foreign Exchange Risk and the Cost of Debt. When a firm issues foreign currency denominated debt, its effective cost equals the after-tax cost of repaying the principal and interest in terms of the firm’s own currency. This amount includes the nominal cost of principal and interest in foreign currency terms, adjusted for any foreign exchange gains or losses.
For example, if a U.S.-based firm borrows Sfr1,500,000 for one year at 5.00% interest, and during the year the Swiss franc appreciates from an initial rate of Sfr1.5000/$ to Sfr1.4400/$, what is the dollar cost of this debt (kd $)? The dollar proceeds of the initial borrowing are calculated at the current spot rate of Sfr1.5000/$:
Sfr1,500,000 Sfr1.5000/$
= $1,000,000
At the end of one year the U.S.-based firm is responsible for repaying the Sfr1,500,000 principal plus 5.00% interest, or a total of Sfr1,575,000. This repayment, however, must be made at an ending spot rate of Sfr1.4400/$:
Sfr1,500,000 * 1.05 Sfr1.4400/$
= $1,093,750
The actual dollar cost of the loan’s repayment is not the nominal 5.00% paid in Swiss franc interest, but 9.375%: J$1,093,750
$1,000,000 R - 1 = 0.09375 ! 9.375%
The dollar cost is higher than expected due to appreciation of the Swiss franc against the U.S. dollar. This total home-currency cost is actually the result of the combined percentage cost of debt and percentage change in the foreign currency’s value. We can find the total cost of borrowing Swiss francs by a U.S.-dollar based firm, kd $, by multiplying one plus the Swiss franc interest expense, kd Sfr, by one plus the percentage change in the Sfr/$ exchange rate, s:
kd $ = [(1 + kd Sfr) * (1 + s)] - 1
where kd Sfr = 5.00% and s = 4.1667%. The percentage change in the value of the Swiss franc versus the U.S. dollar, when the home currency is the U.S. dollar, is
S1 - S2 S2
* 100 = Sfr1.5000/$ - Sfr1.4400/$ Sfr1.4400/$
* 100 = +4.1667%
The total expense, combining the nominal interest rate and the percentage change in the exchange rate, is
kd $ = [(1 + .0500) * (1 + .041667)] - 1 = .09375 ! 9.375%
The total percentage cost of capital is 9.375%, not simply the foreign currency interest payment of 5%. The after-tax cost of this Swiss franc denominated debt, when the U.S. income tax rate is 34%, is
kd $(1 - t) = 9.375% * 0.66 = 6.1875%
The firm would report the added 4.1667% cost of this debt in terms of U.S. dollars as a foreign exchange transaction loss, and it would be deductible for tax purposes.
Expectations of International Portfolio Investors. Chapter 13 highlighted the fact that the key to gaining a global cost and availability of capital is attracting and retaining international portfolio investors. Their expectations for a firm’s debt ratio and overall financial structures
381Raising Equity and Debt Globally CHAPTER 14
are based on global norms that have developed over the past 30 years. Because a large proportion of international portfolio investors are based in the most liquid and unsegmented capital markets, such as the United States and the United Kingdom, their expectations tend to predominate and override individual national norms. Therefore, regardless of other factors, if a firm wants to raise capital in global markets, it must adopt global norms that are close to the U.S. and U.K. norms. Debt ratios up to 60% appear to be acceptable. Any higher debt ratio is more difficult to sell to international portfolio investors.
Raising Equity Globally Once a multinational firm has established its financial strategy and considered its desired and target capital structure, it then proceeds to raise capital outside of its domestic market—both debt and equity—using a variety of capital raising paths and instruments.
Exhibit 14.3 describes three key critical elements to understanding the issues that any firm must confront when seeking to raise equity capital. Although the business press does not often
EXHIBIT 14.3 Equity Avenues, Activities, and Attributes
Equity Issuance
! Initial Public Offering (IPO)—the initial sale of shares to the public of a private company. IPOs raise capital and typically use underwriters.
! Seasoned Public Offering (SPO)—a subsequent sale of additional shares in the publicly traded company, raising additional equity capital.
! Euroequity—the initial sale of shares in two or more markets and countries simultaneously.
! Directed Issue—the sale of shares by a publicly traded company to a specific target investor or market, public or private, often in a different country.
Equity Listing
! Shares of a publicly traded firm are listed for purchase or sale on an exchange. An investment banking firm is typically retained to make a market in the shares.
! Cross-listing is the listing of a company’s shares on an exchange in a different country market. It is intended to expand the potential market for the firm’s shares to a larger universe of investors.
! Depositary receipt (DR)—a certificate of ownership in the shares of a company issued by a bank, representing a claim on underlying foreign securities. In the United States they are termed American Depositary Receipts (ADRs), and when sold globally, Global Depositary Receipts (GDRs).
Private Placement
! The sale of a security (equity or debt) to a private investor. The private investors are typically institutions such as pension funds, insurance companies, or high net-worth private entities.
! Rule 144A private placement sales are sales of securities to qualified institutional buyers (QIBs) in the United States without SEC registration. QIBs are nonbank firms that own and invest in $100 million or more on a discretionary basis.
! Private Equity—equity investments in firms by large limited partnerships, institutional investors, or wealthy private investors, with the intention of taking the subject firms private, revitalizing their businesses, and then selling them publicly or privately in one to five years.
382 CHAPTER 14 Raising Equity and Debt Globally
make a clear distinction, there is a fundamental distinction between an equity issuance and an equity listing. A firm seeking to raise equity capital is ultimately in search of an issuance—the IPO or SPO described in Exhibit 14.3. This generates cash proceeds to then be used to fund and execute the business. But often issuances must be preceded by listings, in which the shares are traded on an exchange and therefore in a specific country market, gaining name recogni- tion, visibility, and hopefully preparing the market for an issuance.
That said, issuance need not be public. A firm, a public or private one, can place an issue with private investors, the 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).
Equity Pathways Equity strategy is as much art as it is science. Although the ultimate objective is to raise more equity capital at lower cost, the differing characteristics of firm ownership may also dictate which equity path is preferable.
Publicly traded companies, in addition to raising equity capital, are also in pursuit of greater market visibility and reaching ever-larger potential investor audiences. This greater audience is hoped to result in higher share prices over time—increasing the returns to owners. Privately held companies are more singular in their objective, to raise greater quantities of equity at the lowest possible cost—privately. As discussed in Chapter 2, own- ership trends in the industrialized markets have tended toward more private ownership, while many multinational firms from emerging market countries have shown growing inter- est in going public.
We begin by looking at the alternative equity pathways, described in Exhibit 14.4, available to multinational firms today. A firm wishing to raise equity capital outside of its home market may take a public pathway or a private one. The public pathway includes a directed public
EXHIBIT 14.4 Equity Alternatives in the Global Market
Raise Equity Capital
Private placement of public shares Private placement of private interest Private equity Strategic Partner/Alliance
Private Placement Directed Public/Private Issue
Shares sold to a specific market or exchange Shares sold to a specific set of private interests
Euroequity Issue
Shares issued on two or more exchanges, in two or more countries, simultaneously
Initial Public Offering (IPO)
Shares of a private company sold to the public market for the first time Seasoned offering – additional shares issued later Depositary receipts – foreign corporate issuance
383Raising Equity and Debt Globally CHAPTER 14
share issue or a Euroequity issue. Alternatively, and one which has been used with greater frequency over the past decade, is a private pathway—private placements, private equity, or a private share sale under strategic alliance.
Initial Public Offering (IPO). A private firm initiates public ownership of the company through an initial public offering, or IPO. Most IPOs begin with the organization of an underwriting and syndication group comprised of investment banking service providers, which then assist the company in preparation of the regulatory filings and disclosures required, depending on the country and stock exchange the firm is using. The firm will, in the months preceding the IPO date, publish a prospectus. The prospectus will provide a description of the company’s history, business, operating and financing results, associated business, financial, or political risks detailed, and the company’s business plan for the future, all to aid prospective buyers in their assessment of the firm.
The initial issuance of shares by a company typically represents somewhere between 15% and 25% of the ownership in the firm (although a number in recent years have been as little as 6% to 8%). The company may follow the IPO with additional share sales, seasoned offerings, in which more and more of the firm’s ownership is sold in the public market. The total shares or proportion of shares traded in the public market is often referred to as the public float or free float.
Once a firm has “gone public,” it is open to a considerably higher level of public scrutiny. This scrutiny arises from the detailed public disclosures and financial filings it must continually make as required by government security regulators and individual stock exchanges. This continuous disclosure is not trivial in either cost or competitive implications. Public firm financial disclosures can be seen as divulging a tremendous amount of information, which customers, suppliers, partners, and competitors may use in their relationship with the firm. Private firms have a distinct competitive advantage in this arena.2
An added distinction about the publicly traded firm’s shares is that they only raise capital for the firm on issuance. Although the daily rise and fall of share prices drives the returns to the owners of those shares, that daily price movement does not change the capital of the company.
Euroequity Issue. A Euroequity or Euroequity issue is an initial public offering on multiple exchanges in multiple countries at the same time. Almost all Euroequity issues are underwritten by an international syndicate. 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. The Euroequity seeks to raise more capital in its issuance by reaching as many different investors as possible. Two examples of high-profile Euroequity issues would be those of British Telecommunications, and the famous Italian luxury goods producer, Gucci.
The largest and most spectacular issues have been made in conjunction with a wave of privatizations of state-owned enterprises (SOEs). The Thatcher government in the United Kingdom created the model when it privatized British Telecom in December 1984. That issue was so large that it was necessary and desirable to sell tranches to foreign investors in addition to the sale to domestic investors. (A tranche means an allocation of shares, typically to under- writers that are expected to sell to investors in their designated geographic markets.) The objective is both to raise the funds and to ensure post-issue worldwide liquidity.
2A publicly traded firm like Wal-Mart will produce hundreds of pages of operational details, financial results, and management discussion on a quarterly basis. That is in comparison to large private firms like Cargill or Koch, where finding a full single page of financial results would be an achievement.
384 CHAPTER 14 Raising Equity and Debt Globally
Euroequity privatization issues have been particularly popular with international portfolio investors because most of the firms are very large, with excellent credit ratings and profitable quasi-government monopolies at the time of privatization. The British privatization model has been so successful that numerous others have followed like the Deutsche Telecom initial public offering of $13 billion in 1996.
State-owned-enterprises (SOEs), government-owned firms from emerging markets, have successfully implemented large-scale privatization programs with these foreign tranches. Tele- fonos de Mexico, the giant Mexican telephone company, completed a $2 billion Euroequity issue in 1991, and has continued to have an extremely liquid listing on the NYSE.
One of the largest Euroequity offerings by a firm resident in an illiquid market was the 1993 sale of $3 billion in shares by YPF Sociedad Anónima, Argentina’s state-owned oil company. About 75% of its shares were placed in tranches outside Argentina, with 46% in the United States alone. Its underwriting syndicate represented a virtual “who’s who” of the world’s leading investment banks. Global Finance in Practice 14.1 offers another example of a directed issue, in this case, a publicly traded firm in Norway issuing a Euroequity to partially fund the development of a recent acquisition.
Directed Public Share Issues. 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. They are typically combined with a cross-listing on a stock exchange in the target market.3
A directed share issue might be motivated by a need to fund acquisitions or major capital investments in a target foreign market. This is an especially important source of equity for firms that reside in smaller capital markets and that have outgrown that market. A foreign share issue, plus cross-listing, can provide it with improved liquidity for its shares and the means to use those shares to pay for acquisitions.
3The share issue by Novo in 1981 (Chapter 13) was a good example of a successful directed share issue that both improved the liquidity of Novo’s shares and lowered its cost of capital.
PA Resources ASA (PAR) has appointed Carnegie ASA as a Lead-Manager, Pareto Securities ASA and Handelsbanken Markets as Co-Lead Manager in connection with a potential private placement of up to 7 million shares. The private place- ment will be marketed toward professional Norwegian and international investors in the period starting from 16.30 CET on Wednesday June 22, 2005.
The closing price of PAR on the Oslo Stock Exchange on Wednesday 22 June was NOK 89.50 per share. The subscription price in the private placement will be NOK 87.50.
The proceeds from the private placement will be used to partly finance the recently announced acquisition of a 10% interest in the Volve Field, and all outstanding ownership
interests in the Didon Field and in the Zarat permit situated offshore Tunisia in the Gulf of Gabes, including production and other related assets from the company M.P. Zarat. The Equity issue was heavily over-subscribed at the end of the subscription period.
This document does not constitute an offer of securities for sale in the United States. The securities may not be offered or sold in the United States absent registration or an exemption from registration under the US Securities Act of 1933. The securities have not been and will not be registered under the US Securities Act of 1933.
Press release (not for distribution in the United States, Canada, Australia, South Africa or Japan).
GLOBAL FINANCE IN PRACTICE 14.1
Planned Directed Equity Issue: PA Resources ASA—Completed 23/06/2005
385Raising Equity and Debt Globally CHAPTER 14
Nycomed, a small but well-respected Norwegian pharmaceutical firm, was an example of this type of motivation for a directed share issue combined with cross-listing. Its commercial strategy for growth was to leverage its sophisticated knowledge of certain market niches and technologies within the pharmaceutical field by acquiring other promising firms— primarily firms in Europe and the United Sates—that possess relevant technologies, personnel, or market niches. The acquisitions were paid for partly with cash and partly with shares. The company funded its acquisition strategy by selling two directed share issues abroad. In 1989, it cross-listed on the London Stock Exchange (LSE) and raised $100 million in equity from foreign investors. It followed its LSE listing and issuance with a cross-listing and issuance on the NYSE in 1992, raising another $75 million with a share issue directed at U.S. investors.
Depositary Receipts Depositary receipts (DRs) are negotiable certificates issued by a bank to represent the under- lying shares of stock, which are held in trust at a foreign custodian bank. Global depositary receipts refer to certificates traded outside of the United States, and American depositary receipts refer to certificates traded in the United States and denominated in U.S. dollars. If you are a company incorporated outside the United States, and you wish to be listed on a U.S. stock exchange, the primary way of listing is through an American Depositary Receipt
EXHIBIT 14.5 TelMex’s American Depository Receipt (Sample)
386 CHAPTER 14 Raising Equity and Debt Globally
program. If you are a company incorporated anywhere in the world and wish to be listed in any foreign market, you do so via GDRs. If you do so in the United States, and you are a foreign company, it is termed an ADR.
American depositary receipts (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. This multiple allows the ADRs to carry a price per share appropriate for the U.S. market (typically under $20 per share), even if the price of the foreign share is inappropriate when converted to U.S. dollars directly. A number of ADRs, like that of Telefonos de Mexico (TelMex) of Mexico shown in Exhibit 14.5, have been some of the most active shares on U.S. exchanges for many years.
The first ADR program was created for a British company, Selfridges Provincial Stores Limited, a famous British retailer, in 1927. Created by J.P. Morgan, the shares were listed on the New York Curb Exchange, which in later years was transformed into the American Stock Exchange. As with many financial innovations, depositary receipts were created to defeat a regulatory restriction. In this case, the British government had prohibited British companies from registering their shares on foreign markets without British transfer agents. The deposi- tary receipts in essence create a synthetic share abroad, therefore not requiring the actual registration of shares outside Britain.
Depositary Receipt Mechanics Exhibit 14.6 illustrates the issuance process of a DR program, in this case a U.S.-based investor purchasing shares in a publicly traded Brazilian company, therefore an American Depositary Receipt program.
1. The U.S. investor instructs his broker to make a purchase of shares in the publicly traded Brazilian company.
2. The U.S. broker contacts a local broker in Brazil (either through the broker’s inter- national offices or directly), placing the order.
3. The Brazilian broker purchases the desired ordinary shares and delivers them to a custodian bank in Brazil.
4. The U.S. broker converts the U.S. dollars received from the investor into Brazilian reais to pay the Brazilian broker for the shares purchased.
5. On the same day that the shares are delivered to the Brazilian custodian bank, the custodian notifies the U.S. depositary bank of their deposit.
6. Upon notification, the U.S. depositary bank issues and delivers Depositary Receipts for the Brazilian company shares to the U.S. broker.
7. The U.S. broker then delivers the DRs to the U.S. investor.
The DRs are now held and tradable like any other common stock share in the United States. In addition to the process just described, it is possible for the U.S. broker to obtain the DRs for the U.S. investor by purchasing existing DRs, not requiring a new issuance. Exhibit 14.6 also describes the alternative process mechanics of a sale or cancellation of ADRs.
Once the ADRs are created, they are tradable in the U.S. market like any other U.S. security. ADRs can be sold to other U.S. investors by simply transferring them from the existing ADR holder (the seller) to another DR holder (the buyer). This is termed intra- market trading. This transaction would be settled in the same manner as any other U.S. transaction, with settlement in U.S. dollars on the third business day after the trade date and typically using The Depository Trust Company (DTC). Intra-market trading accounts for nearly 95% of all DR trading today.
387Raising Equity and Debt Globally CHAPTER 14
ADRs can be exchanged for the underlying foreign shares, or vice versa, so arbitrage keeps foreign and U.S. prices of any given share the same after adjusting for transfer costs. For example, investor demand in one market will cause a price rise there, which will cause an arbitrage rise in the other market even when investors there are not as bullish on the stock.
ADRs convey certain technical advantages to U.S. shareholders. Dividends paid by a foreign firm are passed to its custodial bank and then to the bank that issued the ADR. The issuing bank exchanges the foreign currency dividends for U.S. dollars and sends the dollar dividend to the ADR holders. ADRs are in registered form, rather than in bearer form. Transfer of ownership is facilitated because it is done in the United States in accordance with U.S. laws and procedures. Normally, trading costs are lower than when buying or selling the underlying shares in their home market, and settlement faster. Withholding taxes are simpler because they are handled by the depositary bank.
ADR Program Structures The previous section described the issuance of a DR (ADR in that case) on a Brazilian company’s shares resulting from the desire of a U.S.-based investor to buy shares in a Brazilian company. But DR programs can also be viewed from the perspective of the Brazilian company—as part of its financial strategy to reach investors in the United States. Exhibit 14.7 summarizes the types of ADR programs used in the U.S. today.
EXHIBIT 14.6 The Structural Execution of ADRs
Instruction Confirmation
U.S. Market
Release Shares
Deposit Shares
Buy Shares
Issue ADRs
Cancel ADRs
Sell Shares
Sell Shares Buy Shares
Sell ADRsBuy ADRs
U.S. Market
Brazilian Market
Local Custodian
Depositary Bank
Source: Based on Depositary Receipts Reference Guide, JPMorgan, 2005, p.33.
U.S. Broker
Local Broker
Local Market
Local Broker
U.S. Broker
Standard Issuance U.S. Investor
Standard Cancellation U.S. Investor
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ADR programs differ by whether they are sponsored and their certification level. Sponsored ADRs are created at the request of a foreign firm wanting its shares listed or traded in the United States. The firm applies to the U.S. SEC and a U.S. bank for registration and issuance of ADRs. The foreign firm pays all costs of creating such sponsored ADRs. If a foreign firm does not seek to have its shares listed in the United States but U.S. investors are interested, a U.S. securities firm may initiate creation of the ADRs—an unsponsored program. Unsponsored ADRs are still required by the SEC to obtain approval of the firms whose shares are to be listed. Unsponsored programs represent a relatively small portion of all DR programs.
The three levels of commitment are distinguished by degree of disclosure, listing alternatives, whether they may be used to raise capital (issue new shares), and the time typically taken to implement the programs.
Level I (over-the-counter or pink sheets) Programs. Level I programs are the easiest and fastest programs to execute. A Level I program allows the foreign securities to be purchased and held by U.S. investors without being registered with the SEC. It is the least costly approach but might have a minimal impact on liquidity.
Level II Programs. Level II applies to firms that want to list existing shares on a U.S. stock exchange. They must meet the full registration requirements of the SEC and the rules of the specific exchange. This also means reconciling their financial accounts with those used under U.S. GAAP, raising the cost considerably.
Level III Programs. Level III applies to the sale of a new equity—raising equity capital— issued in the United States. It requires full registration with the SEC and an elaborate stock prospectus. This is the most expensive alternative, but is the most fruitful for foreign firms wishing to raise capital in the world’s largest capital markets and possibly generate greater returns for all shareholders.
EXHIBIT 14.7 American Depository Receipt (ADR) Programs by Level
Type Description Degree of Disclosure
Listing Alternatives
Ability to Raise Capital
Implementation Timetable
Level I Over-the- Counter ADR Program
None: home country standards apply
Over-the-counter (OTC)
— 6 weeks
Level I GDR Rule 144A/ Reg. S GDR Program
None Not listed Yes, available only to QIBs
3 weeks
Level II U.S.-Listed ADR Program
Detailed Sarbanes Oxley
U.S. stock exchange listings
— 13 weeks
Level II GDR Rule 144A/ Reg. S GDR Program
None DIFX None 2 weeks
Level III U.S.-Listed ADR Program
Rigorous Sarbanes Oxley
U.S. stock exchange listings
Yes, public offering
14 weeks
Level III GDR Rule 144A/ Reg. S GDR Program
EU Prospectus Directive and/or US Rule 144A
London, Luxembourg, U.S. Portal
Yes, available to QIBs
2 weeks
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DR Markets Today: Who, What, and Where The rapid growth in emerging markets in recent years has been partly a result of the ability of companies from these countries to both list their shares and issue new shares on global equity markets. Their desire to access greater pools of affordable capital, as well as the desire for many of their owners to monetize existing value, has led to an influx of emerging market companies into the DR market.
The Who. The Who of global DR programs today is quite clear—the rapidly developing com- panies from the world’s leading emerging markets. Of the top 10 capital raising DR programs of 2011, one was Brazilian, four were Russian, two were Chinese, one was Argentine, one was Taiwanese, and one was South Korean. The largest issue by far was a follow-on program by VTB Bank of Russia, raising $2.78 billion on the London Stock Exchange. Note that there was not a single OECD country company among this top 10.
The What. The What of the global DR market today is a fairly even split between IPO and follow-on offerings. During the last few years, 2008–2011, it does appear that (Exhibit 14.8) IPOs are larger than the follow-on offerings in terms of value.
The Where. Given the dominance of emerging market companies in the DR markets today, it is not surprising that the Where of the DR market is dominated by New York and London. By end-of-year 2011, there were nearly 2,300 sponsored DR programs operating globally. Of those 2,300, 54% were US-ADR programs, and 30% were GDR programs on the London/ Luxembourg stock exchanges.
EXHIBIT 14.8 Equity Capital Raised Through Depositary Receipts
$0
$10
$20
$30
$40
$50
$60
Billions of US$
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
IPOFollow-On
Source: “Depositary Receipts, Year in Review 2011,” JPMorgan, p. 9. Data derived by JPMorgan from other depositary banks, Bloomberg, and stock exchanges, January 2012.
19.4
2.6 2.8 6.1 6.4
8.5
27.6
35.8
4.7 8.6 7.9 7.1
11.2
5.7 4.9 4.1 3.2
12.8
15
21.5
10 9.5
14
8.1
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Even more importantly, than the number of programs operating is the capital which has been raised by companies via the DR programs globally. Exhibit 14.8 distinguishes between equity capital raised through initial equity share offerings (IPOs) and seasoned offerings (follow-on). The DR market has periodically proved very fruitful for firm capital-raising needs. It is also obvious which years have been better for equity issuances—for example, 2000 and 2006–2007.
Global Registered Shares (GRS). A global registered share is a share of equity that is traded across borders and markets without conversion, where one share on the home exchange equals one share on the foreign exchange. The identical share is listed on different stock exchanges, but listed in the currency of the exchange. GRSs can theoretically be traded with the sun, following markets as they open and close around the globe and around the clock. The shares are traded electronically, eliminating the specialized forms and depositaries required by share forms like DRs.
The differences between GRSs and GDRs can be seen in the following example. Assume a German multinational has shares listed on the Frankfurt Stock Exchange, and those shares are currently trading at €4.00 per share. If the current spot rate is $1.20/€, those same shares would be listed on the NYSE at $4.80 per share.
:4.00 * $1.20/: = $4.80 This would be a standard GRS. But at $4.80 per share, that is an extremely “small” price for the NYSE and the U.S. equity market.
If, however, the German firm’s shares were listed in New York as ADRs, they would be converted to a value which was strategically priced for the target market—the United States. Strategic pricing in the United States means having share prices which are generally between $10 and $20 per share, a price range long thought to maximize buyer interest and liquidity. The ADR would then be constructed so that each ADR represented four shares in the company on the home market, or:
$4.80 * 4 = $19.20 per share
Does this distinction matter? Clearly, the GRS is more similar to ordinary shares than depositary receipts, and allows easier comparison and analysis. But if target pricing is important in key markets like that of the United States, then the ADR offers better opportunities for a foreign firm to gain greater presence and activity.4
The arguments in support of the GRS over the ADR/GDR are best described by UBS of Switzerland in its public explanation of why it had changed its listing in New York from an ADR to a GRS:
UBS is pioneering the Global Registered Share (GRS), which allows for cross-market portability at minimized cost to investors. The concept behind American Depository Receipts (ADRs) is the creation of tailor-made securities for individual unlinked markets, following local regulations. UBS believes that, with the globalization of financial markets, this concept is becoming less valid for securities, which will increasingly be traded in multiple markets. UBS believes that a global fungible security can best track liquidity across the globe. UBS also believes that regulatory structures of
4GRSs are not an innovation, as they are identical to the structure used for cross-border trading of Canadian equities in the United States for many years. More than 70 Canadian firms are listed on the NYSE-Euronext. Of course, one could argue that has been facilitated by near-parity of the U.S. and Canadian dollar for years as well.
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different markets will continue to align, reducing the need to have individual securities in each market to comply with different local regulations.5
All argument aside, at least to date, the GRS has not replaced the ADR or GDR. As one colleague noted—“institutionalism rules.”
Private Placement Raising equity through private placement is increasingly common across the globe. Publicly traded and private firms alike raise private equity capital on occasion. A private placement is the sale of a security to a small set of qualified institutional buyers. The investors are traditionally insurance companies and investment companies. Since the securities are not registered for sale to the public, investors have typically followed a “buy and hold” policy. In the case of debt, terms are often custom designed on a negotiated basis. Private placement markets now exist in most countries.
SEC Rule 144A In 1990, the SEC approved Rule 144A. It permits qualified institutional buyers (QIBs) to trade privately placed securities without the previous holding period restrictions and without requiring SEC registration.
A qualified institutional buyer (QIB) is an entity (except a bank or a savings and loan) that owns and invests on a discretionary basis $100 million in securities of nonaffiliates. Banks and savings and loans must meet this test but also must have a minimum net worth of $25 million. The SEC has estimated that about 4,000 QIBs exist, mainly investment advisors, investment companies, insurance companies, pension funds, and charitable institutions. Simultaneously, the SEC modified its Regulation S to permit foreign issuers to tap the U.S. private placement market through an SEC Rule 144A issue, also without SEC registration. A trading system called PORTAL was established by the National Association of Securities Dealers (NASD) to support the distribution of primary issues and to create a liquid secondary market for these issues.
Since SEC registration has been identified as the main barrier to foreign firms wishing to raise funds in the United States, SEC Rule 144A placements are proving attractive to foreign issuers of both equity and debt securities. Atlas Copco, the Swedish multinational engineering firm, was the first foreign firm to take advantage of SEC Rule 144A. It raised $49 million in the United States through an ADR equity placement as part of its larger $214 million Euroequity issue in 1990. Since then, several billion dollars a year have been raised by foreign issuers with private equity placements in the United States. However, it does not appear that such placements have a favorable effect on either liquidity or stock price.
Private Equity Private equity funds are usually limited partnerships of institutional and wealthy investors, such as college endowment funds, that raise capital in the most liquid capital markets. They are best known for buying control of publicly owned firms, taking them private, improving management, and then reselling them after one to three years. They are resold in a variety of ways including selling the firms to other firms, other private equity funds, or taking them back public. The private equity funds themselves are frequently very large, but may also utilize a large amount of debt to fund their takeovers. These “alternatives” as they are called, demand
5UBS GRSs, Frequently Asked Questions, www.ubs.com/global/en/about_ubs/investor_relations/faq.
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fees of 2% of assets plus 20% of profits. In addition, in the United States their gains are taxed at the capital gains rate of 15% on “carried interest” instead of the usual 35% rate on ordinary income. Equity funds have had some highly visible successes.
Many mature family-owned firms resident in emerging markets are unlikely to qualify for a global cost and availability of capital even if they follow the strategy suggested in this chapter. Although they might be consistently profitable and growing, they are still too small, too invisible to foreign investors, lacking in managerial depth, and unable to fund the up-front costs of a globalization strategy. For these firms, private equity funds may be a solution.
Private equity funds differ from traditional venture capital funds. The latter usually operate mainly in highly developed countries. They typically invest in start-up firms 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. They are content with growing companies through better management and mergers with other firms.
Foreign Equity Listing and Issuance According to the alternative paths depicted earlier, a firm needs to choose one or more stock markets on which to cross-list its shares and sell new equity. Just where to go depends mainly on the firm’s specific motives and the willingness of the host stock market to accept the firm. By cross-listing and selling its shares on a foreign exchange a firm typically tries to accomplish one or more of the following objectives:
! Improve the liquidity of its existing shares and support a liquid secondary market for new equity issues in foreign markets
! Increase its share price by overcoming mis-pricing in a segmented and illiquid home capital market
! Increase the firm’s visibility and political acceptance to its customers, suppliers, creditors, and host governments
! Establish a secondary market for shares used to acquire other firms in the host market
! Create a secondary market for shares that can be used to compensate local management and employees in foreign subsidiaries6
Improving Liquidity. Quite often foreign investors have acquired a firm’s shares through normal brokerage channels, even though the shares are not listed in the investor’s home market or not traded in the investor’s preferred currency. Cross-listing is a way to encourage such investors to continue to hold and trade these shares, thus marginally improving secondary market liquidity. It is usually done through ADRs.
Firms domiciled in countries with small illiquid capital markets often outgrow those markets and are forced to raise new equity abroad. Listing on a stock exchange in the market in which these funds are to be raised is typically required by the underwriters to ensure post-issue liquidity in the shares.
6A recent example of this trading expansion opportunity is Kosmos Energy. Following the company’s IPO in the United States in May 2011 (NYSE: KOS), the company listed its shares on the Ghanaian Stock Exchange. Ghana was the country in which the oil company had made its major discoveries and generated nearly all of its income.
393Raising Equity and Debt Globally CHAPTER 14
The first section of this chapter suggested that firms start by cross-listing in a less liquid market, followed by having an equity issue in that market (see Exhibit 14.1). In order to maximize liquidity, however, the firm ideally should cross-list and issue equity in a more liquid market and eventually offer a global equity issue.
In order to maximize liquidity, it is desirable to cross-list and/or sell equity in the most liquid markets. Stock markets have, however, been subject to two major forces in recent years, which are changing their very behavior and liquidity—demutualization and diversification.
Demutualization is the ongoing process by which the small controlling seat owners on a number of exchanges have been giving up their exclusive powers. As a result, the actual ownership of the exchanges has become increasingly public. Diversification represents the growing diversity of both products (derivatives, currencies, etc.) and foreign companies/ shares being listed. This has increased the activities and profitability of many exchanges while simultaneously offering a more global mix for reduced cost and increased service.
Stock Exchanges. With respect to stock exchanges, New York and London are clearly the most liquid. The recent merger of the New York Stock Exchange (NYSE) and Euronext, which itself was a merger of stock exchanges in Amsterdam, Brussels, and Paris, has extended the NYSE lead over NASDAQ (New York) and the London Stock Exchange (LSE). Tokyo has fallen on hard times in recent years in terms of trading value, as many foreign firms have chosen to de-list from the Tokyo exchange in recent years. Few foreign firms remain cross-listed now in Tokyo. Deutsche Börse (Germany) has a fairly liquid market for domestic shares but a much lower level of liquidity for trading foreign shares. On the other hand, it is an appropriate target market for firms resident in the European Union, especially those that have adopted the euro. It is also used as a supplementary cross-listing location for firms that are already cross-listed on the LSE, NYSE, or NASDAQ.
Why are New York and London so dominant? They offer what global financial firms are looking for: plenty of skilled people, ready access to capital, good infrastructure, attractive regulatory and tax environments, and low levels of corruption. Location and the use of English, increasingly acknowledged as the language of global finance, are also important factors.
Electronic Trading. Most exchanges have moved heavily into electronic trading in recent years. For example, the role of the specialist on the floor of the NYSE has been greatly reduced with a corresponding reduction in employment by specialist firms. They are no longer responsible for ensuring an orderly movement for their stocks, but are still important in making more liquid markets for the less-traded shares. The same fate has reduced the importance of market makers on the London Stock Exchange. Now the U.S. stock market is actually a network of 50 different venues connected by an electronic system of published quotes and sales prices.
Hedge funds and other high frequency traders dominate the market. High frequency traders now account for 60% of daily volumes. Equity volume controlled by the NYSE fell from 80% in 2005 to 25% in 2010. Trades are executed immediately by computer. Spreads between buy and sell orders are in decimal points as low as a penny a share instead of an eighth of a point. Liquidity has greatly increased but so has the risk of unexpected swings in prices. For example, on May 6, 2010, the Dow Jones Average fell 9.2% at one point but eventually recovered by the end of the day. Nineteen billion shares were bought and sold.
Impacts on Share Price Although cross-listing and equity issuance can occur together, their impacts are separable and significant in and of themselves.
394 CHAPTER 14 Raising Equity and Debt Globally
Cross-Listing. Does merely cross-listing on a foreign stock exchange have a favorable impact on share prices? It depends on the degree to which markets are segmented.
If a firm’s home capital market is segmented, the firm could theoretically benefit by cross- listing in a foreign market if that market values the firm or its industry more than does the home market. This was certainly the situation experienced by Novo when it listed on the NYSE in 1981 (see Chapter 13). However, most capital markets are becoming more integrated with global markets. Even emerging markets are less segmented than they were just a few years ago.
A more comprehensive study consisted of 181 firms from 35 countries that instituted their first ADR program in the United States over the period from 1985 to 1995. The author measured the stock price impact of the announcement of a cross-listing in the United States and found significant positive abnormal returns around the announcement date. These were retained in the immediate following period. As expected, the study showed that the abnormal returns were greater for firms resident in emerging markets with a low level of legal barriers to capital flows, than for firms resident in developed markets. Firms resident in emerging markets with heavy restrictions on capital flows received some abnormal returns, but not as high as firms resident in the other markets. This was due to the perceived limited liquidity of firms resident in markets with too many restrictions on capital flows.
Equity Issuance. It is well known that the combined impact of a new equity issue undertaken simultaneously with a cross-listing has a more favorable impact on stock price than cross- listing alone. This occurs because the new issue creates an instantly enlarged shareholder base. Marketing efforts by the underwriters prior to the issue engender higher levels of visibility. Post-issue efforts by the underwriters to support at least the initial offering price also reduce investor risk.
Increasing Visibility and Political Acceptance. MNEs list in markets where they have sub- stantial physical operations. Commercial objectives are to enhance corporate image, advertise trademarks and products, get better local press coverage, and become more familiar with the local financial community in order to raise working capital locally.
Political objectives might include the need to meet local ownership requirements for a multinational firm’s foreign joint venture. Local ownership of the parent firm’s shares might provide a forum for publicizing the firm’s activities and how they support the host country. This objective is the most important one for Japanese firms. The Japanese domestic market has both low-cost capital and high availability. Therefore, Japanese firms are not trying to increase the stock price, the liquidity of their shares, or the availability of capital.
Increasing Potential for Share Swaps with Acquisitions. Firms that follow a strategy of growth by acquisition are always looking for creative ways to fund these acquisitions rather than paying cash. Offering their shares as partial payment is considerably more attractive if those shares have a liquid secondary market. In that case, the target’s shareholders have an easy way to convert their acquired shares to cash if they do not prefer a share swap. However, a share swap is often attractive as a tax-free exchange.
Compensating Management and Employees. If an MNE wishes to use stock options and share purchase compensation plans for local management and employees, local listing would enhance the perceived value of such plans. It should reduce transaction and foreign exchange costs for the local beneficiaries.
Barriers to Cross-Listing and Selling Equity Abroad Although a firm may decide to cross-list and/or sell equity abroad, certain barriers exist. The most serious barriers are the future commitment to providing full and transparent disclosure of operating results and balance sheets as well as a continuous program of investor relations.
395Raising Equity and Debt Globally CHAPTER 14
The Commitment to Disclosure and Investor Relations. 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 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 also 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. share- holders, including frequent “road shows” and the time-consuming personal involvement of top management.
Disclosure Is a Double-Edged Sword. The U.S. school of thought is that the worldwide trend toward requiring fuller, more transparent, and more standardized financial disclosure of operating results and financial positions may have the desirable effect of lowering the cost of equity capital. As we observed in 2002 and 2008, lack of full and accurate disclosure, and poor transparency worsened the U.S. stock market decline as investors fled to safer securities such as U.S. government bonds. This action increased the equity cost of capital for all firms. The other school of thought is that the U.S. level of required disclosure is an onerous, costly burden. It chases away many potential listers, thereby narrowing the choice of securities available to U.S. investors at reasonable transaction costs.
Raising Debt Globally The international debt markets offer the borrower a variety of different maturities, repayment structures, and currencies of denomination. The markets and their many different instruments vary by source of funding, pricing structure, maturity, and subordination or linkage to other debt and equity instruments.
Exhibit 14.9 provides an overview of the three basic categories described in the following sections, along with their primary components as issued or traded in the international debt markets today. The three major sources of debt funding on the international markets are international bank loans and syndicated credits, the Euronote market, and the international bond market.
Bank Loans and Syndicated Credits International bank loans are one of the largest and oldest of sources of international debt capital for MNEs. In recent years, however, international bank loans have been increasingly supplanted by the expansion of Eurocredits and Syndicated Credits.
International Bank Loans. International bank loans have traditionally been sourced in the Eurocurrency markets. Eurodollar bank loans are also called “Eurodollar credits” or simply “Eurocredits.” The latter title is broader because it encompasses nondollar loans in the Eurocurrency market. The key factor attracting both depositors and borrowers to the Eurocurrency loan market is the narrow interest rate spread within that market. The difference between deposit and loan rates is often less than 1%.
Eurocredits. Eurocredits are bank loans to MNEs, sovereign governments, international institutions, and banks denominated in Eurocurrencies and extended by banks in countries other than the country in whose currency the loan is denominated. The basic borrowing interest rate for Eurodollar loans has long been tied to the London Interbank Offered Rate (LIBOR), which is the deposit rate applicable to interbank loans within London. Eurodollars
396 CHAPTER 14 Raising Equity and Debt Globally
are lent for both short- and medium-term maturities, with transactions for six months or less regarded as routine. Most Eurodollar loans are for a fixed term with no provision for early repayment.
Syndicated Credits. The syndication of loans has enabled banks to spread the risk of very large loans among a number of banks. Syndication is particularly important because many large MNEs need credit in excess of a single bank’s loan limit. A syndicated bank credit is arranged by a lead bank on behalf of its client. Before finalizing the loan agreement, the lead bank seeks the participation of a group of banks, with each participant providing a portion of the total funds needed. The lead manager bank will work with the borrower to determine the amount of the total credit, the floating-rate base and spread over the base rate, maturity, and fee structure for managing the participating banks. The periodic expenses of the syndicated credit are composed of two elements:
1. The actual interest expense of the loan, normally stated as a spread in basis points over a variable-rate base such as LIBOR.
2. The commitment fees paid on any unused portions of the credit. The spread paid over LIBOR by the borrower is considered the risk premium, reflecting the general business and financial risk applicable to the borrower’s repayment capability.
Euronote Market The Euronote market is the collective term used to describe short- to medium-term debt instruments sourced in the Eurocurrency markets. Although a multitude of differentiated financial products exists, they can be divided into two major groups—underwritten facilities and nonunderwritten facilities. Underwritten facilities are used for the sale of Euronotes in a number of different forms. Nonunderwritten facilities are used for the sale and distribution of Euro-commercial paper (ECP) and Euro medium-term notes (EMTNs).
EXHIBIT 14.9 International Debt Markets and Instruments
International Bank Loans
Eurocredits
Syndicated Credits
Euronotes and Euronote Facilities
Eurocommercial Paper (ECP)
Euro Medium-Term Notes (EMTNs)
Eurobond straight fixed-rate issue floating-rate note (FRN) equity-related issue Foreign Bond
Bank Loans and Syndications (floating-rate,
short- to medium-term)
Euronote Market
(floating-rate, short- to medium-term)
International Bond Market
(fixed and floating-rate medium- to long-term)
397Raising Equity and Debt Globally CHAPTER 14
Euronote Facilities. 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 were 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 (ECP). 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, over 90% of issues outstanding are denominated in U.S. dollars.
Euro Medium-Term Notes (EMTNs). The Euro medium-term note (EMTN) market effectively bridges the maturity gap between ECP and the longer-term and less flexible international bond. Although many of the notes were initially underwritten, most EMTNs are now nonunderwritten.
The rapid initial growth of the EMTN market followed directly on the heels of the same basic instrument that began in the U.S. domestic market when the U.S. Securities and Exchange Commission (SEC) instituted Rule #415, allowing companies to obtain shelf registrations for debt issues. What this meant was that once the registration was obtained, the corporation could issue notes on a continuous basis without having to obtain new registrations for each additional issue. This, in turn, allowed a firm to sell short- and medium-term notes through a much cheaper and more flexible issuance facility than ordinary bonds.
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. 1) the EMTN is a facility, allowing continuous issuance over a period of time, unlike a bond issue which is essentially sold all at once; 2) because EMTNs are sold con- tinuously, in order to make debt service (coupon redemption) manageable, coupons are paid on set calendar dates regardless of the date of issuance; 3) 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 Bond Market 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.
Eurobonds. 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,
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denominated in U.S. dollars, but sold to investors in Europe and Japan (not to investors in the United States), is a Eurobond.
Eurobonds are issued by MNEs, large domestic corporations, sovereign governments, governmental enterprises, and international institutions. They are offered simultaneously in a number of different national capital markets, but not in the capital market or to residents of the country in whose currency the bond is denominated. Almost all Eurobonds are in bearer form with call provisions and sinking funds.
The syndicate that offers a new issue of Eurobonds might be composed of underwriters from a number of countries, including European banks, foreign branches of U.S. banks, banks from offshore financial centers, investment and merchant banks, and nonbank securities firms.
! The straight fixed-rate issue. The straight fixed-rate issue is structured like most domestic bonds, with a fixed coupon, set maturity date, and full principal repayment upon final maturity. Coupons are normally paid annually, rather than semiannually, primarily because the bonds are bearer bonds and annual coupon redemption is more convenient for the holders.
! The floating-rate note. The floating-rate note (FRN) normally pays a semiannual coupon which is determined using a variable-rate base. A typical coupon would be set at some fixed spread over LIBOR. This structure, like most variable-rate interest- bearing instruments, was designed to allow investors to shift more of the interest-rate risk of a financial investment to the borrower. Although many FRNs have fixed maturities, a number of major issues since 1985 are perpetuities. The principal will never be repaid. Thus, they provide many of the same financial functions as equity.
! The equity-related issue. The equity-related international bond resembles the straight fixed-rate issue in practically all price and payment characteristics, with the added feature that it is convertible to stock prior to maturity at a specified price per share (or alternatively, number of shares per bond). The borrower is able to issue debt with lower coupon payments due to the added value of the equity conversion feature.
Foreign Bonds. 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 resi- dent in Sweden, denominated in dollars, and sold in the United States to U.S. investors by U.S. investment bankers, is a foreign bond. Foreign bonds have nicknames: foreign bonds sold in the United States are Yankee bonds; foreign bonds sold in Japan are Samurai bonds; and foreign bonds sold in the United Kingdom are Bulldogs.
Unique Characteristics of Eurobond Markets Although the Eurobond market evolved at about the same time as the Eurodollar market, the two markets exist for different reasons, and each could exist independently of the other. The Eurobond market owes its existence to several unique factors. They are the absence of regulatory interference, less stringent disclosure practices, and favorable tax treatment.
Absence of Regulatory Interference. National governments often impose tight controls on foreign issuers of securities denominated in the local currency and sold within their national boundaries. However, governments in general have less stringent limitations for securities denominated in foreign currencies and sold within their markets to holders of those foreign currencies. In effect, Eurobond sales fall outside the regulatory domain of any single nation.
Less Stringent Disclosure. Disclosure requirements in the Eurobond market are much less stringent than those of the Securities and Exchange Commission (SEC) for sales within
399Raising Equity and Debt Globally CHAPTER 14
the United States. U.S. firms often find that the registration costs of a Eurobond offering are less than those of a domestic issue and that less time is needed to bring a new issue to market. Non-U.S. firms often prefer Eurodollar bonds over bonds sold within the United States because they do not wish to undergo the costs, and disclosure, needed to register with the SEC. However, the SEC has relaxed disclosure requirements for certain private place- ments (Rule #144A), which has improved the attractiveness of the U.S. domestic bond and equity markets.
Favorable Tax Status. Eurobonds offer tax anonymity and flexibility. Interest paid on Eurobonds is generally not subject to an income withholding tax. As one might expect, Eurobond interest is not always reported to tax authorities. Eurobonds are usually issued in bearer form, meaning that the name and country of residence of the owner is not on the certificate. To receive interest, the bearer cuts an interest coupon from the bond and turns it in at a banking institution listed on the issue as a paying agent. European investors are accustomed to the privacy provided by bearer bonds and are very reluctant to purchase registered bonds, which require holders to reveal their names before they receive interest. Bearer bond status, of course, is also tied to tax avoidance.
Access to debt capital is obviously impacted by everything from law to tax to basic societal norms. Religion itself, may play a part in the use and availability of debt capital. Global Finance in Practice 14.2, Islamic Finance, illustrates one area rarely seen by Westerners.
Muslims, the followers of Islam, now make up roughly one- fourth of the world’s population. The countries of the world which are predominantly Muslim create roughly 10% of global GDP, and comprise a large share of the emerging marketplace. Islamic law reaches into many dimensions of the individual and organizational behaviors for its practitioners—including busi- ness. Islamic finance, the specific area of our interest, imposes a number of restrictions on Muslims, which dramatically alter the funding and structure of Muslim businesses.
Under Islam, the shari’ah lays down a series of fundamen- tal beliefs—restrictions in practice—regarding business and finance.
! Making money from money is not permissible
! Earning interest is prohibited ! Profit and loss should be shared ! Speculation, gambling, is prohibited ! Investments should support only halal activities
For the conduct of business, the key to understanding the prohibition on earning interest is to understand that profitability from investment should arise from the returns associated with carrying risk. For example, a traditional Western bank may extend a loan to a business. The bank is to receive its principal and interest in repayment and return regardless of the ultimate
profitability of the business. In fact, the debt is paid off first. Similarly, an individual who deposits their money in a Western bank will receive an interest earning on their deposit regard- less of the profitability of the bank and the bank’s associated investments.
An Islamic bank, however, cannot pay interest to depositors—who are Muslims—under Islamic law. Therefore, the depositors in an Islamic bank are actually shareholders (much like credit unions in the West), and the returns they receive are a function of the profitability of the bank’s investments. Their returns cannot be fixed or guaranteed, because that would break the principle of profit and loss being shared.
Recently, however, a number of Islamic banking institutions have opened in Europe and North America. A Muslim now can enter into a sequence of purchases which allows them to purchase a home without departing from Islamic principles. The buyer selects the property, which is then purchased by the Islamic bank. The bank in turn resells the house to the pro- spective buyer at a higher price. The buyer is allowed to pay off the purchase over a series of years. Although the difference in purchase prices is, by Western thinking, implicit interest, this structure does conform to the shari’ah. Unfortunately, in both the United States and the United Kingdom, the difference is not a tax deductible expense for the homeowner as interest would be.
GLOBAL FINANCE IN PRACTICE 14.2
Islamic Finance
400 CHAPTER 14 Raising Equity and Debt Globally
Ratings. 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.
Rating agencies, such as Moody’s and Standard and Poor’s (S&Ps), provide ratings for selected international bonds for a fee. Moody’s ratings for international bonds imply the same creditworthi- ness as for domestic bonds of U.S. issuers. Moody’s limits its evaluation to the issuer’s ability to obtain the necessary currency to repay the issue according to the original terms of the bond. The agency excludes any assessment of risk to the investor caused by changing exchange rates.
Moody’s rates international bonds upon request of the issuer. Based on supporting financial statements and other material obtained from the issuer, it makes a preliminary rating and then informs the issuer who has an opportunity to comment. After Moody’s determines its final rating, the issuer may decide not to have the rating published. Consequently, a disproportionately large number of published international ratings fall into the highest categories, since issuers about to receive a lower rating do not allow publication.
SUMMARY POINTS
! Designing a capital sourcing strategy requires management to design a long-run financial strategy. The firm must then choose among the various alternative paths to get there, including where to cross-list its shares, and where to issue new equity, and in what form.
! The domestic theory of optimal financial structures needs to be modified by four variables in order to accommodate the case of the MNE: 1) availability of capital; 2) diversification of cash flows; 3) foreign exchange risk; and 4) expectations of international portfolio investors.
! A multinational firm’s marginal cost of capital is constant for considerable ranges of its capital budget. This state- ment is not true for most small domestic firms because they do not have access to the national equity or debt markets.
! By diversifying cash flows internationally, the MNE may be able to achieve the same kind of reduction in cash flow variability as portfolio investors receive from diversifying their security holdings internationally.
! When a firm issues foreign currency-denominated debt, its effective cost equals the after-tax cost of repaying the principal and interest in terms of the firm’s own currency. This amount includes the nominal cost of principal and interest in foreign currency terms, adjusted for any foreign exchange gains or losses.
! There are a variety of different equity pathways firms may choose between when pursuing global sources of equity,
including Euroequity issues, direct foreign issuances, depositary receipt programs, and private placements.
! Depositary receipt programs, either American or global, provide an extremely effective way for firms from out- side of the established industrial country markets to improve the liquidity of their existing shares, or issue new shares.
! Private placement is a growing segment of the market, allowing firms from emerging markets to raise capital in the largest of capital markets with limited disclosure and cost.
! The international debt markets offer the borrower a variety of different maturities, repayment structures, and currencies of denomination. The markets and their many different instruments vary by source of funding, pricing structure, maturity, and subordination or linkage to other debt and equity instruments.
! The three major sources of debt funding on the inter- national markets are international bank loans and syndicated credits, the Euronote market, and the international bond market.
! Eurocurrency markets serve two valuable purposes: 1) Eurocurrency deposits are an efficient and convenient money market device for holding excess corporate liquid- ity, and 2) the Eurocurrency market is a major source of short-term bank loans to finance corporate working capital needs, including the financing of imports and exports.
401Raising Equity and Debt Globally CHAPTER 14
“Bringing owls to Athens”—in other words, doing some- thing useless. In 414 B.C., when Aristophanes coined this expression in his comedy The Birds, people commonly referred to Athens’ self-minted silver drachmas as “owls” since they had a picture of the bird on their reverse side. Athens’ wealth at the time was legendary—and hence it was pointless to bring any more money to the city-state. Yet, only a few decades later, the situation had changed dra- matically. Expensive wars had wrecked the budget, and 10 out of 13 Athenian communities eventually defaulted on loans that they had taken out from the temple of Delos— the first recorded sovereign debt defaults in history.
—“Sovereign Default in the Eurozone: Greece and Beyond,” UBS Research Focus, 29 September 2011, p. 14.
It was January 2012 and Georgios Korres looked out his window—he could literally see the Acropolis from his office in Athens. Like the Acropolis, the Greek economy was in dire need of capital. But Mr. Korres’s immediate challenge in this negative economic environment was not how to fund Greece, only how to fund the growth needs of his own firm, Korres Natural Products. Before the Greek debt crisis, Korres had faced little trouble securing funding for Korres’s rapidly expanding global business. But financ- ing was increasingly hard to find for Greek firms, and Kor- res needed new capital soon if it was going to be able to put its business growth opportunities to work.
The Cosmetics Industry Cosmetics is a $170 billion global industry consisting of five major categories of products: fragrances and perfumes, decorative cosmetics, skin care, hair care, and toiletries. Skin care was the largest segment, followed by hair care and decorative cosmetics. Products are distributed through larger retail stores, specialized and branded retail stores, as well as pharmacies, salons, and spas.
Recent years had been hard on the industry. Although sales were down in 2008 and 2009, the market had turned upward again in 2010 and 2011. The cosmetics market was one which rewarded innovation, with continuous reformulation of products and inputs the norm. Manufacturing costs are generally higher relative to other
industries due to specialized machinery and chemical compounds. Consumers have shown a growing willingness to try new products in all subcategories with performance and ingredients being the most important considerations when making purchasing decisions. And products based on all-natural ingredients were a true growth category.
With its emphasis on creating natural products from organic sources, Korres was well positioned to compete in the global market. Consumer consciousness in sustainable products and a growing backlash against animal testing had helped drive demand. This same consciousness stimulated new regulations on ingredients, component and product testing, and manufacturing. Consumers now demanded more information about the source of ingredients used in the products they purchased. Combined with a renewed emphasis on healthy living, natural product producers— like Korres—were well positioned for the future.
Korres Natural Products Georgios Korres founded Korres Natural Products in 1996. The company focused on utilizing pharmaceutical experience in more than 3,000 herbs to create natural products for use in skin care, hair care, and other cosmetics. Using pharmacies as their main means of distribution (5,600 in Greece alone), Korres had expanded rapidly from 2003 to 2008, and now claimed a presence in 30 countries. The company had gone public in 2007 (Athens: Korres). In 2012, Korres had 28 dedicated stores, five in Greece and 23 throughout Europe, North America, South America, and Asia. The company now employed more than 300 people within Greece, and had over 400 natural and certified organic products.
But Korres itself had been changing as illustrated by Exhibit 1. Group sales had actually peaked in 2008 at €53.7 million, falling the next two years in-step with the Greek economy, to €50.4 million in 2009 and €44.1 million in 2010. Profits had followed sales down, with net income falling from €4.0 million (2008) to €3.4 million (2009) and €1.6 million (2010). All things considered, the company’s profitability had remained surprisingly healthy given the deteriorating economic conditions in Greece, but the company’s share price still continued to slide. Now trad- ing around €3/share, less than a third of its peak of €9.66.
Korres Natural Products and the Greek Crisis1
1Copyright © 2012 Thunderbird School of Global Management. All rights reserved. This case was prepared by Noah Emergy, Maria Iliopoulou, and Jones Dias under the direction of Professor Michael Moffett for the purpose of classroom discussion only, and not to indicate either effective or ineffective management.
MINI-CASE
402 CHAPTER 14 Raising Equity and Debt Globally
were to default on its debt it could threaten the very basis of the euro itself. EU policy makers suggested a combination of Greek government spending restrictions (austerity measures), as well as some form of debt reduction or bailout. The following year, 2010, Greece received a series of additional loans and funds that allowed it to meet its debt service obligations. Exhibit 2 lists other key Greek bailout events.
However, help from the IMF and EU came with strings attached. Besides new higher rates of interest, Greece was forced to implement a series of austerity measures. These austerity measures included privatization of several sectors of the economy, cuts in government spending on health care, pensions and other social programs, and increases in taxes. The unpopularity of these measures amongst the Greek people was widespread, as many took to the streets in protest, including frequent and crippling strikes. But this had still not been nearly enough. In January 2012, the Greek government had entered into intense negotiations with both the private banks and EU members holding Greek sovereign debt. Greece wanted a 70% haircut on existing privately held debt, restructuring of the debt to more than 20-year maturities, new lower interest rates, and additional bailout totaling more than €100 billion.
But despite the growing Greek economic and financial crisis, Korres had found a way to grow. International sales had continued to increase as a proportion of total sales. By 2010, international sales made up more than 35% of total sales. At the same time, Korres had entered into a key distribution agreement with Johnson & Johnson (U.S.), under which J&J would be the sole distributor of Korres products throughout North and South America.
Greek Debt Crisis The Greek government, like many governments, had been running large budget deficits for years. Although the Greek economy had enjoyed healthy growth for many years, the government’s finances had continued to deteriorate. The country’s two largest industrial sectors, shipping and tourism, were highly cyclical and had been hard hit by the financial crisis of 2008–2009. As the global economy continued to slow, Greece’s sovereign debt to GDP ratio continued to rise.
In late 2009, Greece’s slowing economy and burdensome debt raised concern throughout the eurozone (the set of countries within the European Union which use the euro as their single currency). Eurozone authorities, including the European Central Bank (ECB), worried that if Greece
EXHIBIT 1 Korres’s Sales: Domestic and Foreign
2000199919981997 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Foreign salesGreek sales
328 701 1,434 1,879 3,856 7,066
8,874 12,099
13,907
22,960
28,100
34,941 35,095
28,296
230 475
673
2,679 3,158
3,954
7,900
18,765 15,271
15,817
0
10,000
20,000
30,000
40,000
50,000
60,000
Source: Korres Natural Products.
403Raising Equity and Debt Globally CHAPTER 14
growth. The initial public offering in 2007 had contrib- uted significant equity capital. A more recent addition to equity capital was made by a private Greek investor, Alexia David, who took a 14.1% interest in the firm as a
Funding Growth The growth and development of the company’s capital structure is illustrated in Exhibit 3. Korres had been care- ful and constructive in funding its rapid corporate
EXHIBIT 2 Greek Bailout—Key Events and Timeline
May 9, 2010 IMF approves an immediate loan equaling €5.5 billion
May 18, 2010 Greece receives €14.5 billion from the EU to repay immediate debt
August 5, 2010 EU and IMF give Greece €9 billion tranche from bailout
June 13, 2011 S&P downgrades Greece’s credit rating to CCC
July 8, 2011 IMF approves disbursement of an additional €3.2 billion
July 21, 2011 Second rescue package agreed by Eurozone leaders totaling €109 billion
2007 2008 2009 2010
Equity
Share capital, including own shares € 2,310,000 € 4,416,964 € 4,504,500 € 4,504,500
Share premium 10,110,000 7,873,819 7,882,538 7,882,538
Reserves and reserves carried forward 6,441,021 9,041,190 11,140,912 11,793,648
Equity attributable to parent co-owners 18,861,021 21,331,973 23,527,950 24,180,686
Non-controlling interests 7,654 (307,927) 5,017,927 58,103
Total Equity € 18,868,675 € 21,024,046 € 28,545,877 € 24,238,789
Payables
Deferred tax liabilities 515,415 1,373,243 1,228,844 1,559,701
Liabilities for staff retirement indemnities 272,523 403,383 482,577 557,122
Loan 8,079,431 8,608,322 34,518,351 32,041,009
Total Long-Term Liabilities € 8,867,369 € 10,384,948 € 36,229,772 € 34,157,832
Suppliers and other liabilities 15,199,268 21,665,736 22,202,301 20,202,014
Current tax liabilities 1,325,756 949,568 2,104,666 81,135
Loan liabilities 5,326,428 37,624,615 5,446,688 11,328,314
Total Short-Term Liabilities € 21,851,452 € 60,239,919 € 29,753,654 € 31,611,463
Total liabilities € 30,718,821 € 70,624,867 € 65,983,426 € 65,769,295
Total equity and liabilities € 49,587,495 € 91,648,913 € 94,529,303 € 90,008,084
Short-term liabilities (% of total) 44.1% 65.7% 31.5% 35.1%
Long-term liabilities (% of total) 17.9% 11.3% 38.3% 37.9%
Debt (% of total) 61.9% 77.1% 69.8% 73.1%
Source: Korres Natural Products and author calculations.
EXHIBIT 3 Korres Natural Product’s Financial Structure (Euros)
404 CHAPTER 14 Raising Equity and Debt Globally
strategic partner in June 2011 with an injection of €9.5 million.2
Like all firms funding rapid growth, the company had increased the amount of bank debt very rapidly beginning in 2008. Total loan debt jumped from €13.4 million in 2007 to €46.2 million in 2008. The following year Korres had replaced much of the short-term debt with new long-term bank debt agreements, guaranteeing greater control and access over debt financing further into the future.
The cost of bank loans had also risen. Before the crisis, Korres was borrowing long term at about 5%, and short- term funds ranged between 3% and 4%. After the onset of the sovereign debt crisis, the company had managed to retain the same rate on long-term loans (an achievement in and of itself) but short-term interest rates had risen close to 8%. The Greek banking sector was now under severe financial duress. With the onset of the crisis, available credit of all maturities in Greece had declined.
It is estimated that the Greek banking industry will need at least 30 billion to survive the widening debt crisis. Banks
2Alexia David is the niece of the powerful George David, Chairman of the Board of Directors of Coca-Cola Hellenic Bottling Com- pany S.A., the world’s second largest Coca-Cola anchor bottler. The private equity placement was an issuance of 1,900,000 new shares at €5 per share, a capital injection of €9.5 million. This was a price below market at the time of the investment.
are undergoing a debt haircut, i.e., writing off 50% to 70% of the Greek debt and are being forced into accordance with a new law, which requires banks in the EU to have a minimum of 9% capitalization by June 2012. In order for banks to reach this target, there has been a general freeze in issuing new loans. Banks are also trying to terminate some of the existing long-term loans.
Working Capital Korres’s capital needs were compounded by the net working capital cycle of the company. As opposed to the typical 30-day terms and 45 days in receivables one might see in North America, Korres was holding about 200 days sales in receivables. This meant waiting on average 200 days to receive cash settlement on sales, thus depriving the firm of the cash flow to fund its inventory and pay its suppliers. As illustrated by Exhibit 4, Korres typically held over 300 days in inventory and paid its suppliers in 160 days. All told, a net working capital cycle of over 350 days in 2010 was very large, and in this capital-short environment, costly.
CHAPTER 14 Raising Equity and Debt Globally404
EXHIBIT 4 Korres Net Working Capital (NWC) Analysis
Component 2007 2008 2009 2010
Accounts receivable € 20,026,370 € 36,525,168 € 28,692,493 € 24,537,600
Inventory 9,609,320 18,003,937 20,512,616 15,881,777
Accounts payable -15,199,268 -21,665,736 -22,202,301 -20,202,014
Net working capital (NWC) € 14,436,422 € 32,863,369 € 27,002,809 € 20,217,363
Sales € 35,977,891 € 53,736,392 € 50,365,734 € 44,114,726
Day of Sales 98,570 147,223 137,988 120,862
COGS € 12,891,586 € 21,036,470 € 20,127,331 € 18,038,186
Day of COGS 35,319 57,634 55,143 49,420
Days of Sales NWC Analysis 2007 2008 2009 2010
Days sales outstanding 203.2 248.1 207.9 203.0
Days inventory @ COGS 272.1 312.4 372.0 321.4
Days payables -154.2 -147.2 -160.9 -167.1
Days NWC 321.0 413.3 419.0 357.2
Source: Korres Natural Products and author calculations.
405Raising Equity and Debt Globally CHAPTER 14
just as the underlying shares. The difference is that the dividends are paid in the foreign currency. Normally each DR represents a multiple of the underlying share, which helps the instrument be priced correctly in the foreign market. Arbitrage makes the DR and the underlying share end up having similar prices after transfer costs are taken into account.
By cross-listing, Korres would be looking into decreasing its cost of capital, improving its liquidity of existing shares, and increasing its visibility to investors out- side Greece. This last advantage would help the company gain political acceptability to its major stakeholders, being its customers, suppliers, creditors, and investors. However, cross-listing has its disadvantages as well. Because the company will be selling equity abroad, it will have to adapt to regulations in the foreign country. These regulations can include more disclosure requirements and investor relations programs. If Korres decides to cross-list, the countries that the firm would most likely issue DRs would be Germany and the U.K.
Private Equity. Korres is also considering private equity.3 In return, the private equity investor would receive a minority share. Because of the size of the company, its location, and with projected earnings growth of 150% within three years, Korres believes a number of private equity firms would be interested. The downside of private equity, however, was high expected returns (averaging 14% in recent years) as well as some expectation of influ- ence over management. Korres could potentially fill all its funding needs from this one source, but at higher expected returns (higher capital costs) and possible loss of some control.
Bond Issuance. Instead of issuing equity, the company could also issue debt in the form of bonds. Although this would not require giving up ownership control, it would seemingly add more debt to an already highly leveraged firm. Because the company’s credit rating is currently not investment grade, the debt would have to be issued as floating rates. Due to Greece’s bad political and economic environment, those floating rates could be extremely burdensome.
Private Placement. Another option was private place- ment, possibly in the United States. Private placement is the direct sale of securities to an individual or niche group of investors to raise capital. Common examples of
3Private equity investments are generally categorized into leveraged buyouts, venture capital, growth capital, distressed investments, and mezzanine capital. Korres would fall under the category of growth investment and would seek to target firms that specialize in this form of investment.
The Crisis and Korres The company’s strategy is to continuously grow both locally and globally.
! Revenue growth. The revenue goal for the next three to four years is 30% local/70% international, a massive shift from the current 65% local/35% international. Georgios Korres believed that brand awareness is key, and the company may be able to gain €15–€20 million in sales in each of the big European markets of Germany, the United Kingdom, Russia, and Spain.
! The capital needs to support growth is estimated at €20 million. This assumes strong royalty earn- ings from the Americas and realized sales gains and margins from Europe within three years to contribute to funding demands.
! The company also has the goal of decreasing debt-to- equity ratio to reach a 40–60 split. Mr. Korres believes the company will need to reach total revenues of more than €100 million in 2014 before pursuing any major plans for new partnerships in new markets. That means doubling sales in the next three years.
For the coming two years, 2012 and 2013, the recent equity injection combined with the maintenance of existing bank loans should provide adequate funding. However, for 2014 the company needs to have access to additional capital—roughly €15 million to €20 million—in order to achieve targeted international growth. The pressure will be less if their target for their bigger markets comes true and the J&J royalties pay off. However, the company cannot be reassured that these goals will be achieved in just two years and they will seek additional funding in order to support their growth strategy.
Financing Options Georgios Korres was considering a number of different financial strategies to fund the company’s growth.
Cross-Listing. Korres is considering cross-listing its shares on another exchange beyond that of Athens. Cross-listing is when a company sources their equity capital in foreign countries by listing their stock abroad. A company can cross-list by issuing depository receipts (certificates) to a bank in a given country, and the bank will in-turn issue certificates to investors. Basically, the investors own the shares in the home country, which are represented by the DRs. These instruments are quoted and paid dividends
such investors are large banks, mutual and pension funds, and insurance companies. The investors would have very limited ability to sell or trade their positions prior to maturity. As a result, most markets for private placement like that in the U.S. limited buyers to a selected and sophisticated qualified investor audience.
A major benefit of this alternative for Korres is that the placement would not have to be registered with the Securities and Exchange Commission (SEC) and thus the credit rating of the company is not a determinant to the deal. The average investor is notified of such a place- ment usually after it has taken place. Since the private placement does not require the assistance of brokers or underwriters, and the company is also exempt from the usual reporting requirements, this option is often faster and more cost-effective for smaller businesses. Numer- ous Greek companies have chosen this financing option in the past. Georgios Korres favored this option; there were a number of major insurance and pension funds which may have a strong interest. He believes that this is a great channel for smaller companies that are doing well that would otherwise need to pay very high interest rates.
The continuing frustration for Korres’s leadership team was that the company was performing well—growing sales globally in 2011, including Greece, despite the debt crisis wracking Europe and Greece. Leadership believed that the company should be rewarded for its performance, and not punished by the struggling Greek economy or plummeting Athens stock exchange. That meant raising equity in the private placement markets, markets that focused more on firm performance than credit ratings.
Korres seems like a very good candidate for a private debt offering. However, finding the right investor with ample funding, especially in the midst of a major financial
crisis, is difficult to say the least. Investors continue to show a lack of trust in Greek companies, and this could mean a deal based on an undervaluation of the firm. In that environment, the discount demanded by private investors may be greatly exaggerated. That meant least capital at higher cost.
Decision
Some firms are finding ways round the stigma of being a Greek enterprise and the credit troubles that brings. The headquarters of Aquis, a firm that runs hotels and resorts of Greece, was recently moved to London by its founder, Ioannis Kent. It is now a UK holding company with a British bank account into which the firm’s rev- enues are paid.
—“Greece and the Euro: An Economy Crumbles,” The Economist, January 28, 2012, p. 70.
Georgios Korres sat and pondered which financing option would be best for Korres to pursue. He hopes that the royalties from the Johnson and Johnson deal will be enough to fund future expansion but in order to feel safe he will try to secure additional financing to ensure Korres’s future prosperity.
Case Questions 1. How has the financial structure of Korres changed
over recent years? How would you assess its financial health?
2. How has the sovereign debt crisis in Europe, and most importantly in Greece, affected Korres’s business and financial results?
3. What do you think Georgios Korres should do to secure the capital he needs to grow Korres Natural Products?
406 CHAPTER 14 Raising Equity and Debt Globally
QUESTIONS 1. Designing a Strategy to Source Equity
Globally. Exhibit 14.1 illustrates alternative paths to globalizing the cost and availability of capital. Identify the specific steps in Exhibit 14.1 that were taken by Novo Industri (Chapter 13) in chronological order to gain an international cost and availability of capital.
2. Depositary Receipts—Definitions. Define the following terms: a. ADRs b. GDRs c. Sponsored depositary receipts d. Unsponsored depositary receipts
3. ADRs. Distinguish between the three levels of commitment for ADRs traded in the United States.
4. Foreign Equity Listing and Issuance. Give five reasons why a firm might cross-list and sell its shares on a very liquid stock exchange.
5. Cross-Listing Abroad. What are the main reasons causing U.S. firms to cross-list abroad?
6. Barriers to Cross-Listing. What are the main barriers to cross-listing abroad?
7. Alternative Instruments. What are five alternative instruments that can be used to source equity in global markets?
407Raising Equity and Debt Globally CHAPTER 14
to be very different. For example, Deutsche Bank recently borrowed at a nominal cost of 9.59% per annum, but later that debt was selling to yield 7.24%. At the same time, the Kingdom of Thailand borrowed at a nominal cost of 8.70% but later found the debt was sold in the market at a yield of 11.87%. What caused these changes, and what might management do to benefit (as Deutsche Bank did) rather than suf- fer (as the Kingdom of Thailand did)?
19. Local Norms. Should foreign subsidiaries of multi- national firms conform to the capital structure norms of the host country or to the norms of their parent’s country? Discuss.
20. Argentina. In January 2002, the government of Argentina broke away from its currency board system that had tied the peso to the U.S. dollar and devalued the peso from APs1.0000/$ to APs1.40000. This caused some Argentine firms with dollar-denominated debt to go bankrupt. Should a U.S. or European parent in good financial health “rescue” its Argentine subsidiary that would otherwise go bankrupt because of the inept nature of Argentine political and economic manage- ment in the four or five years prior to January 2002? Assume the parent has not entered into a formal agree- ment to guarantee the debt of its Argentine subsidiary.
21. Internal Financing. What is the difference between “internal” financing and “external” financing for a subsidiary? List three types of internal financing and three types of external financing available to a foreign subsidiary.
22. Eurodollar Deposits. Why would anyone, individual or corporation, want to deposit U.S. dollars in a bank out- side of the United States when the natural location for such deposits would be a bank within the United States?
23. Euro-Euros. Define the following term: a. Euro-euro
24. International Debt Instruments. Bank borrowing has been the long-time manner by which corporations and governments borrowed funds for short periods. What then, is the advantage over bank borrowing for each of the following? a. Syndicated loans b. Euronotes c. Euro-Commercial Paper d. Euro-Medium-Term Notes e. International bonds
25. Euro Versus Foreign Bonds. What is the difference between a “eurobond” and a “foreign bond” and why do two types of international bonds exist?
8. Directed Public Share Issue. Answer the following questions: a. Define what is meant by a “directed public share
issue.” b. Why did Novo choose to make a $61 million directed
public share issue in the United States in 1981?
9. Euroequity Public Share Issue. Define the following term: a. Euroequity public share issue
10. Private Placement Under SEC Rule 144A. Answer the following questions: a. What is SEC Rule 144A? b. Why might a foreign firm choose to sell its equity
in the United States under SEC Rule 144A?
11. Private Equity Funds. Answer the following questions: a. What is a private equity fund? b. How do they differ from traditional venture capital
firms? c. How do private equity funds raise their own capital,
and how does this action give them a competitive advantage over local banks and investment funds?
12. Optimal Capital Structure Objective. What, in simple wording, is the objective sought by finding an optimal capital structure?
13. Capital Cost Definitions. Answer the following questions: a. What is the “cost of debt” and how is it determined? b. What is the “cost of equity” and how is it
determined?
14. Varying Debt Proportions. As debt in a firm’s capi- tal structure is increased from no debt to a significant proportion of debt (say, 60%), what tends to happen to the cost of debt, to the cost of equity, and to the overall weighted average cost of capital?
15. Availability of Capital. How does the availability of capital influence the theory of optimal capital struc- ture for a multinational enterprise?
16. Marginal Cost. Define the following term: a. Marginal weighted average cost of capital
17. Diversified Cash Flows. If a multinational firm is able to diversify its sources of cash inflow so as to receive those flows from several countries and in several cur- rencies, do you think that tends to increase or decrease its weighted average cost of capital?
18. Ex-Post Cost of Borrowing. Many firms in many countries borrow at nominal costs that later prove
408 CHAPTER 14 Raising Equity and Debt Globally
PROBLEMS 1. JPMorgan: Petrobrás’s WACC. JPMorgan’s Latin
American Equity Research department produced the following WACC calculation for Petrobrás of Brazil versus Lukoil of Russia in their June 18, 2004, report. Evaluate the methodology and assumptions used in the calculation. Assume a 28% tax rate for both companies.
July 28, 2005 March 8, 2005
Capital Cost Components 2003A 2004E 2003A 2004E
Risk-free rate 9.400% 9.400% 9.000% 9.000%
Levered beta 1.07 1.09 1.08 1.10
Risk premium 5.500% 5.500% 5.500% 5.500%
Cost of equity 15.285% 15.395% 14.940% 15.050%
Cost of debt 8.400% 8.400% 9.000% 9.000%
Tax rate 28.500% 27.100% 28.500% 27.100%
Cost of debt, after-tax
6.006% 6.124% 6.435% 6.561%
Debt/capital ratio 32.700% 32.400% 32.700% 32.400%
Equity/capital ratio 67.300% 67.600% 67.300% 67.600%
WACC 12.20% 12.30% 12.10% 12.30%
Risk-free rate (Brazilian C-Bond) 9.90%
Petrobrás levered beta 1.40
Market risk premium 5.50%
Cost of equity 17.60%
Cost of debt 10.00%
Brazilian corporate tax rate 34.00%
Long-term debt ratio (% of capital) 50.60%
WACC (R$) 12.00%
Petrobrás Lukoil
Risk-free rate 4.8% 4.8%
Sovereign risk 7.0% 3.0%
Equity risk premium 4.5% 5.7%
Market cost of equity 16.3% 13.5%
Beta (relevered) 0.87 1.04
Cost of debt 8.4% 6.8%
Debt/capital ratio 0.333 0.475
WACC 14.7% 12.3%
2. UNIBANCO: Petrobrás’s WACC. UNIBANCO estimated the weighted average cost of capital for Petrobrás to be 13.2% in Brazilian reais in August of 2004. Evaluate the methodology and assumptions used in the calculation.
Risk-free rate 4.5% Cost of debt (after-tax) 5.7%
Beta 0.99 Tax rate 34%
Market premium 6.0% Debt/total capital 40%
Country risk premium
5.5% WACC (R$) 13.2%
Cost of equity (US$)
15.9%
3. Citigroup SmithBarney (Dollar): Petrobrás’s WACC. Citigroup regularly performs a U.S. dollar-based discount cash flow (DCF) valuation of Petrobrás in its coverage. That DCF analysis requires the use of a discount rate, which they base on the company’s weighted average cost of capital. Evaluate the methodology and assumptions used in the 2003 Actual and 2004 Estimates of Petrobrás’s WACC, shown at the top of the next column.
4. Citigroup SmithBarney (Reais). In a report dated June 17, 2003, Citigroup SmithBarney calculated a WACC for Petrobrás denominated in Brazilian reais (R$). Evaluate the methodology and assumptions used in this cost of capital calculation.
5. BBVA Investment Bank: Petrobrás’s WACC. BBVA utilized a rather innovative approach to dealing with both country and currency risk in their December 20, 2004, report on Petrobrás. Evaluate the methodology and assumptions used in the cost of capital calcula- tion, shown on the following page.
409Raising Equity and Debt Globally CHAPTER 14
Cost of Capital Component 2003
Estimate 2004
Estimate
U.S. 10-year risk-free rate (in US$) 4.10% 4.40%
Country risk premium (in US$) 6.00% 4.00%
Petrobrás premium “adjustment” -1.00% -1.00%
Petrobrás risk-free rate (in US$) 9.10% 7.40%
Market risk premium (in US$) 6.00% 6.00%
Petrobrás beta (b) 0.80 0.80
Cost of equity (in US$) 13.90% 12.20%
Projected 10-year currency devaluation 2.50% 2.50%
Cost of equity (in R$) 16.75% 14.44%
Petrobrás cost of debt after-tax (in R$) 5.50% 5.50%
Long-term equity ratio (% of capital) 69% 72%
Long-term debt ratio (% of capital) 31% 28%
WACC (in R$) 13.30% 12.00%
6. Petrobrás’s WACC Comparison. The various estimates of the cost of capital for Petrobrás of Brazil appear to be very different, but are they? Reorganize your answers to problems, 1 through 5 into those costs of capital which are in U.S. dollars versus Brazilian reais. Use the estimates for 2004 as the basis of comparison.
7. Copper Mountain Group (USA). The Copper Mountain Group, a private equity firm headquartered in Boulder, Colorado (U.S.), borrows £5,000,000 for one year at 7.375% interest. a. What is the dollar cost of this debt if the pound depre-
ciates from $2.0260/£ to $1.9460/£ over the year? b. What is the dollar cost of this debt if the pound appre-
ciates from $2.0260/£ to $2.1640/£ over the year?
8. McDougan Associates (USA). McDougan Associates, a U.S.-based investment partnership, borrows €80,000,000 at a time when the exchange rate is $1.3460/€. The entire principal is to be repaid in three years, and interest is 6.250% per annum, paid annually in euros. The euro is expected to depreciate vis à vis the dollar at 3% per annum. What is the effective cost of this loan for McDougan?
9. Sunrise Manufacturing, Inc. Sunrise Manufacturing, Inc., a U.S. multinational company, has the following debt components in its consolidated capital section. Sunrise’s finance staff estimates their cost of equity to be 20%. Current exchange rates are also listed below. Income taxes are 30% around the world after allowing for credits. Calculate Sunrise’s weighted average cost of capital. Are any assumptions implicit in your calculation?
Assumption Value
Tax rate 30.00%
10-year euro bonds (euros) €6,000,000
20-year yen bonds (yen) 750,000,000
Spot rate ($/euro) 1.2400
Spot rate ($/pound) 1.8600
Spot rate (yen/$) 109.00
10. Grupo Modelo S.A.B. de C.V. Grupo Modelo, a brewery out of Mexico that exports such well-known varieties as Corona, Modelo, and Pacifico, is Mexican by incorporation. However, the company evaluates all business results, including financing costs, in U.S. dollars. The company needs to borrow $10,000,000 or the foreign currency equivalent for four years. For all issues, interest is payable once per year, at the end of the year. Available alternatives are as follows: a. Sell Japanese yen bonds at par yielding 3% per
annum. The current exchange rate is ¥106/$, and the yen is expected to strengthen against the dollar by 2% per annum.
b. Sell euro-denominated bonds at par yielding 7% per annum. The current exchange rate is $1.1960/€, and the euro is expected to weaken against the dollar by 2% per annum.
c. Sell U.S. dollar bonds at par yielding 5% per annum.
Which course of action do you recommend Grupo Modelo take and why?
A-Malaysia (accounts in ringgits) A-Mexico (accounts in pesos)
Long-term debt
RM11,400,000 Long-term debt
PS20,000,000
Shareholders’ equity
RM15,200,000 Shareholders’ equity
PS60,000,000
Adamantine Architectonics
(Nonconsolidated Balance Sheet—Selected Items Only)
Investment in subsidiaries
Parent long-term debt
$12,000,000
In A-Malaysia $4,000,000 Common stock 5,000,000
In A-Mexico 6,000,000 Retained earnings 20,000,000
Current exchange rates: Malaysia RM3.80/$ Mexico PS10/$
410 CHAPTER 14 Raising Equity and Debt Globally
15. Westminster Insurance Company. Westminster Insurance Company plans to sell $2,000,000 of euro-commercial paper with a 60-day maturity and discounted to yield 4.60% per annum. What will be the immediate proceeds to Westminster Insurance?
INTERNET EXERCISES 1. Global Equities. Bloomberg provides extensive
coverage of the global equity markets 24 hours a day. Using the Bloomberg site listed here, note how different the performance indices are on the same equity markets at the same point in time all around the world.
Bloomberg www.bloomberg.com/ markets/stocks/world-indexes/
2. JPMorgan and Bank of New York Mellon. JP Morgan and Bank of New York Mellon provide up to the minute performance of American Depositary Receipts in the U.S. marketplace. The site highlights the high-performing equities of the day. a. Prepare a briefing for senior management in your
firm encouraging them to consider internationally diversifying the firm’s liquid asset portfolio with ADRs.
b. Identify whether the ADR program level (I, II, III, 144A) has any significance to which securities you believe the firm should consider.
JPMorgan ADRs www.adr.com
Bank of New York Mellon www.adrbnymellon.com
4. London Stock Exchange. The London Stock Exchange (LSE) lists many different global depository receipts among its active equities. Use the LSE’s Internet site to track the performance of the largest GDRs active today.
London Stock Exchange www.londonstockexchange .com/traders-and-brokers/ security-types/gdrs/gdrs.htm
11. Petrol Ibérico. Petrol Ibérico, a European gas company, is borrowing US$650,000,000 via a syndicated eurocredit for six years at 80 basis points over LIBOR. LIBOR for the loan will be reset every six months. The funds will be provided by a syndicate of eight leading investment bankers, which will charge up-front fees totaling 1.2% of the principal amount. What is the effective interest cost for the first year if LIBOR is 4.00% for the first six months and 4.20% for the second six months?
12. Adamantine Architectonics . Adamantine Architectonics consists of a U.S. parent and wholly owned subsidiaries in Malaysia (A-Malaysia) and Mexico (A-Mexico). Selected portions of their non-consolidated balance sheets, translated into U.S. dollars, are shown in the table at the top of this page. What are the debt and equity proportions in Adamantine’s consolidated balance sheet?
13. Morning Star Air (China). Morning Star Air, head- quartered in Kunming, China, needs US$25,000,000 for one year to finance working capital. The airline has two alternatives for borrowing: a. Borrow US$25,000,000 in Eurodollars in London
at 7.250% per annum. b. Borrow HK$39,000,000 in Hong Kong at 7.00% per
annum, and exchange these Hong Kong dollars at the present exchange rate of HK$7.8/US$ for U.S. dollars.
At what ending exchange rate would Morning Star Air be indifferent between borrowing U.S. dollars and borrowing Hong Kong dollars?
14. Pantheon Capital, S.A. If Pantheon Capital, S.A. is raising funds via a euro-medium-term note with the following characteristics, how much in dollars will Pantheon receive for each $1,000 note sold?
Coupon rate: 8.00% payable semiannually on June 30 and December 31
Date of issuance: February 28, 2011 Maturity: August 31, 2011
411
APPENDIX
Financial Structure of Foreign Subsidiaries
If we accept the theory that minimizing the cost of capital for a given level of business risk and capital budget is an objective that should be implemented from the perspective of the consolidated MNE, then the financial structure of each subsidiary is relevant only to the extent that it affects this overall goal. In other words, an individual subsidiary does not really have an independent cost of capital. Therefore, its financial structure should not be based on an objective of minimizing it.
Financial structure norms for firms vary widely from one country to another but clus- ter for firms domiciled in the same country. This statement is the conclusion of a long line of empirical studies that have investigated the question, from 1969 to the present. Most of these international studies concluded that country-specific environmental variables are key determinants of debt ratios. Among these variables are historical development, taxation, corporate governance, bank influence, existence of a viable corporate bond market, attitude toward risk, government regulation, availability of capital, and agency costs.
Many other institutional differences also influence debt ratios in national capital markets, but firms trying to attract international portfolio investors must pay attention to debt ratio norms those investors expect. Since many international portfolio investors are influenced by the debt ratios that exist in the Anglo- American markets, there is a trend toward more global confor- mity. MNEs and other large firms dependent on attracting international portfolio investors are beginning to adopt similar debt ratio standards, even if domestic firms continue to use national standards.
Local Norms and the Financial Structure of Local Subsidiaries
Within the constraint of minimizing its consolidated worldwide cost of capital, should an MNE take differing country debt ratio norms into consideration when determining its desired debt ratio for foreign subsidiaries? For definition purposes, the debt considered here should be only that borrowed from sources outside the MNE. This debt would include local and foreign currency loans as well as Eurocurrency loans. The reason for this definition is that parent loans to foreign subsidiaries are often regarded as equivalent to equity investment both by host countries and by investing firms. A parent loan is usually subordinated to other debt and does not create the same threat of insolvency as an external loan. Furthermore, the choice of debt or equity investment is often arbitrary and subject to negotiation between host country and parent firm.
412 APPENDIX Financial Structure of Foreign Subsidiaries
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 invest- ment 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.
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 advan- tages 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 14.2; or 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 is 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.
413Financial Structure of Foreign Subsidiaries APPENDIX
Compromise Solution. In our opinion, a compromise position is possible. Both multinational and domestic firms should try to minimize their overall weighted average cost of capital for a given level of business risk and capital budget, as finance theory suggests. However, if debt is available to a foreign subsidiary at equal cost to that which could be raised elsewhere, after adjusting for foreign exchange risk, then localizing the foreign subsidiary’s financial structure should incur no cost penalty and yet would also enjoy the advantages listed above.
Financing the Foreign Subsidiary In addition to choosing an appropriate financial structure for foreign subsidiaries, financial managers of multinational firms need to choose among alternative sources of funds to finance foreign subsidiaries. Sources of funds available to foreign subsidiaries can be classified as internal to the MNE and external to the MNE.
Ideally, the choice among the sources of funds should minimize the cost of external funds after adjusting for foreign exchange risk. The firm should choose internal sources in order to minimize worldwide taxes and political risk. Simultaneously, the firm should ensure that managerial motiva- tion in the foreign subsidiaries is geared toward minimizing the firm’s consolidated worldwide cost of capital, rather than the foreign subsidiary’s cost of capital. Needless to say, this task is difficult if not impossible, and the tendency is to place more emphasis on one variable at the expense of others.
Internal Sources of Funding. Exhibit 14A.1 provides an overview of the internal sources of financing for foreign subsidiaries. In general, although the equity provided by the parent is required, it is frequently kept to legal and operational minimums to reduce
EXHIBIT 14A.1 Internal Financing of the Foreign Subsidiary
Funds from
within the
Multinational Enterprise
(MNE)
Funds Generated Internally by the Foreign Subsidiary
Funds from parent company
Funds from sister subsidiaries
Subsidiary borrowing with parent guarantee
Depreciation and noncash charges
Retained earnings
Leads and lags on intrafirm payables
Debt—cash loans
Leads and lags on intrafirm payables
Debt—cash loans
Equity Cash
Real goods
414 APPENDIX Financial Structure of Foreign Subsidiaries
risk of invested capital. Equity investment can take the form of either cash or real goods (machinery, equipment, inventory, etc.).
Debt is the preferable form of subsidiary financing, but 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 must acquire its debt from the parent company or sister subsidiaries (initially) and from unrelated parties with a parental guarantee (after operations have been initiated).
Once the operational and financial capabilities of the foreign subsidiary have been established, its ability to generate funds internally may become critical for the subsidiary’s growth. In special cases in which the subsidiary may be operating in a highly segmented market, such as an emerging market nation considered to be risky by the international investment and banking communities, the subsidiary’s ability to generate its own funds (retained earnings, depreciation, etc.) from internal sources is important.
External Sources of Funding. Exhibit 14A.2 provides an overview of the sources of foreign subsidiary financing external to the MNE. The sources are first decomposed into three categories: 1) debt from the parent’s country; 2) debt from countries outside the parent’s country; and 3) local equity.
Debt acquired from external parties in the parent’s country reflects the lenders’ familiarity with and confidence in the parent company itself, although the parent is in this case not providing explicit guarantees for the repayment of the debt.
Local currency debt, debt acquired in the host country of the foreign subsidiary’s residence, is particularly valuable to the foreign subsidiary that has substantial local currency cash inflows arising from its business activities. Local currency debt provides a foreign exchange financial hedge, matching currency of inflow with currency of outflow. Gaining access to local currency debt often takes time and patience by foreign subsidiary management in establishing operations and developing a local market credit profile. And in the case of many emerging markets, local currency debt is in short supply for all borrowers, local or foreign.
EXHIBIT 14A.2 External Financing of the Foreign Subsidiary
Funds external
to the Multinational
Enterprise (MNE)
Local equity
Borrowing from sources in
parent country
Borrowing from sources outside of
parent country
Individual local shareholders
Joint venture partners
Local currency debt
Banks and other financial institutions
Security or money markets
Eurocurrency debt
Third-country currency debt
415
CHAPTER 15
Multinational Tax Management
Over and over again courts have said that there is nothing sinister in so arranging one’s affairs as to keep taxes as low as possible. Everybody does so, rich and poor, and all do right, for nobody owes any public duty to pay more than the law demands: taxes are enforced extractions, not voluntary contributions. To demand more in the name of morals is mere cant.
—Judge Learned Hand, Commissioner v. Newman, 159 F.2d 848 (CA-2, 1947).
Tax planning for multinational operations is an extremely complex but vitally important aspect of international business. To plan effectively, MNEs must understand not only the intricacies of their own operations worldwide, but also the different structures and interpreta- tions of tax liabilities across countries. The primary objective of multinational tax planning is the minimization of the firm’s worldwide tax burden. This objective, however, must not be pursued without full recognition that decision-making within the firm must always be based on the economic fundamentals of the firm’s line of business, and not on convoluted policies undertaken purely for the reduction of tax liability. As evident from previous chapters, taxes have a major impact on corporate net income and cash flow through their influence on for- eign investment decisions, financial structure, determination of the cost of capital, foreign exchange management, working capital management, and financial control.
This chapter provides an overview of how taxes are applied to MNEs globally; how the United States taxes the global earnings of U.S.-based MNEs; and how U.S.-based multina- tionals manage their global tax liabilities. We do this in four parts. The first section acquaints the reader with the overall international tax environment. This includes a brief overview of the different tax environments which an MNE is likely to encounter globally, and the basics of most intercountry tax treaties. The second part examines transfer pricing. The third part describes how the United States taxes income of MNEs. Although we use U.S. taxes as illustrations, our intention is not to make this chapter or this book U.S.-centric. Most of the U.S. practices that we describe have close parallels in other countries, albeit modified to fit their specific national overall tax systems. The fourth part of the chapter examines the use of tax-haven subsidiaries and international offshore financial centers. The chapter concludes with a Mini-Case, The U.S. Corporate Income Tax Conundrum, which discusses the U.S. corporate tax structure.
416 CHAPTER 15 Multinational Tax Management
Tax Principles The sections that follow explain the most important aspects of the international tax environ- ments and specific features that affect MNEs. Before we explain the specifics of multinational taxation in practice, however, it is necessary to introduce two areas of fundamental importance: tax morality and tax neutrality.
Tax Morality 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 of “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, since business ethics are partly a function of cultural heritage and historical development.
Some countries have imposed what seem to be arbitrary punitive tax penalties on MNEs for presumed violations of local tax laws. Property or wealth tax assessments are sometimes perceived by the foreign firm to be excessively large when compared with those levied on locally owned firms. The problem is then how to respond to tax penalties that are punitive or discriminatory.
Tax 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 its sole objective the raising of revenue; rather it has multiple objectives, including the following:
! Neutralizing tax incentives that might favor (or disfavor) U.S. private investment in developed countries
! Providing an incentive for U.S. private investment in developing countries ! Improving the U.S. balance of payments by removing the advantages of artificial tax
havens and encouraging repatriation of funds ! Raising revenue
The ideal tax should not only raise revenue efficiently but also have as few negative effects on economic behavior as possible. Some theorists argue that the ideal tax should be completely neutral in its effect on private decisions and completely equitable among taxpayers. However, other theorists claim that national policy objectives such as balance of payments or investment in developing countries should be encouraged through an active tax incentive policy rather than requiring taxes to be neutral and equitable. Most tax systems compromise between these two viewpoints.
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 bur- den 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
417Multinational Tax Management CHAPTER 15
competitors in the same country. This is called foreign neutrality. The latter interpretation is often supported by MNEs because it focuses more on the competitiveness of the individual firm in individual country-markets.
The issue of tax equity is also difficult to define and measure. In theory, an equitable tax is one that imposes the same total tax burden on all taxpayers who are similarly situated and located in the same tax jurisdiction. In the case of foreign investment income, the U.S. Trea- sury argues that since the United States uses the nationality principle to claim tax jurisdiction, U.S.-owned foreign subsidiaries are in the same tax jurisdiction as U.S. domestic subsidiaries. Therefore, a dollar earned in foreign operations should be taxed at the same rate and paid at the same time as a dollar earned in domestic operations.
National Tax Environments Despite the fundamental objectives of national tax authorities, it is widely agreed that taxes do affect economic decisions made by MNEs. Tax treaties between nations, and differential tax structures, rates, and practices all result in a less than level playing field for the MNEs competing on world markets. Different countries use different categorizations of income (e.g., distributed versus undistributed profits), use different tax rates, and have radically different tax regimes, all of which drive different global tax management strategies by multinational firms.
Nations structure their tax systems along two basic approaches: the worldwide approach or the territorial approach. Both approaches are attempts to determine which firms, foreign or domestic by incorporation, or which incomes, foreign or domestic in origin, are subject to the taxation of host-country tax authorities.
Worldwide Approach. 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 coun- try, 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 host-country tax authorities.
For example, a country such as the United States taxes the income earned by firms based in the United States regardless of whether the income earned by the firm is domestically sourced or foreign sourced. 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 does 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 the United States.
Territorial Approach. 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.
As illustrated by Exhibit 15.1, the United States is one of only five Organization for Eco- nomic Cooperation and Development (OECD) countries that utilizes a worldwide system. The predominance of territorial systems has grown rapidly, as more than half of these same
418 CHAPTER 15 Multinational Tax Management
OECD countries used worldwide systems only 10 years ago.1 In 2009 alone, both Japan and the United Kingdom switched from worldwide to territorial.
Tax Deferral. If the worldwide approach to international taxation is 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 of the tax law changes in the past three decades.
The deferral privilege has been challenged a number of times in recent U.S. presidential elec- tions. A number of different candidates have argued that tax deferrals create an incentive for out- sourcing abroad—so called offshoring—of certain manufacturing and service activities by U.S. firms. The added concern to the potential loss of American jobs was the potential reduction in tax collections in the United States, enlarging the already sizable U.S. government’s fiscal deficit.
Tax Treaties A network of bilateral tax treaties, many of which are modeled after one proposed by the OECD, provides a means of reducing double taxation. 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 themselves 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 also 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.
1“Special Report: The Importance of Tax Deferral and a Lower Corporate Tax Rate,” Tax Foundation, February 2010, No. 174, p. 4.
Territorial Taxation Worldwide Taxation
Australia France Japan Slovak Republic Ireland
Austria Germany Luxembourg Spain Korea
Belgium Greece Netherlands Sweden Mexico
Canada Hungary New Zealand Switzerland Poland
Czech Republic Iceland Norway Turkey United States
Denmark Italy Portugal United Kingdom
Finland
Source: “Special Report: The Importance of Tax Deferral and a Lower Corporate Tax Rate,” Tax Foundation, February 2010, No. 174, p. 4.
EXHIBIT 15.1 Tax Regimes of the OECD 30
419Multinational Tax Management CHAPTER 15
Tax Types Taxes are classified based on whether they are applied directly to income, called direct taxes, or based on some other measurable performance characteristic of the firm, called indirect taxes. Exhibit 15.2 illustrates the wide range of corporate income taxes in the world today.
Income Tax. Most governments rely on income taxes, both personal and corporate, for their primary revenue source. Corporate income tax rates differ widely globally, and take a variety of different forms. Some countries, for example, impose different corporate tax rates on dis- tributed income (often lower) versus undistributed income (often higher), in an attempt to motivate companies to distribute greater portions of their income to their owners. In 2011, as shown in Exhibit 15.2, corporate taxes vary from 0% in a number of offshore tax havens like the Bahamas, Cayman Islands, Guernsey, Isle of Man, and Vanuatu; 10% in Paraguay and Qatar; 19% in Poland; to as high as 40% in the United States and 40.69% in Japan.
These differences reflect a rapidly changing global tax environment. Corporate income taxes have been falling rapidly and widely over the past decade, and as illustrated in Exhibit 15.3, the lower rates today are predominantly in the non-OECD countries. The highly indus- trialized world, for better or worse, has been reluctant to reduce corporate income tax rates as aggressively as many emerging market nations. Corporate income tax rates, like any burden on the profitability of commercial enterprise, has become a competitive element used by many countries to attempt to promote inward investment from abroad. In 2011, for the first time in the past 50 years, the global average corporate income tax rate fell below 23%.
Withholding Tax. Passive income (dividends, interest, royalties), earned by a resident of one country within the tax jurisdiction of a second country, are normally subject to a withhold- ing tax in the second country. The reason for the institution of withholding taxes is actually quite simple: governments recognize that most international investors will not file a tax return in each country in which they invest, and the government therefore wishes to assure that a minimum tax payment is received. As the term “withholding” implies, the taxes are withheld by the corporation from the payment made to the investor, 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%.
Value-Added Tax. One type of tax that has achieved great prominence is the value-added tax. The value-added tax is a type of national sales tax collected at each stage of production or sale of consumption goods in proportion to the value added during that stage. In general, produc- tion goods such as plant and equipment have not been subject to the value-added tax. Cer- tain necessities, such as medicines and other health-related expenses, education and religious activities, and the postal service are usually exempt or taxed at lower rates. The value-added tax has been adopted as the main source of revenue from indirect taxation by all members of the European Union, most other countries in Western Europe, a number of Latin American countries, Canada, and scattered other countries. A numerical example of a value-added tax computation is shown in Exhibit 15.4.
Other National Taxes. There are a variety of other national taxes, which vary in importance from country to country. The turnover tax (tax on the purchase or sale of securities in some country stock markets) and the tax on undistributed profits were mentioned before. Property and inheritance taxes, also termed transfer taxes, are imposed in a variety of ways to achieve intended social redistribution of income and wealth as much as to raise revenue. There are a number of red-tape charges for public services that are in reality user taxes. Sometimes foreign exchange purchases or sales are in effect hidden taxes inasmuch as the government earns revenue rather than just regulates imports and exports for balance of payments reasons.
420 CHAPTER 15 Multinational Tax Management
Country Rate Country Rate Country Rate
Afghanistan 20% Guatemala 31% Paraguay 10%
Albania 10% Guernsey 0% Peru 30%
Angola 35% Honduras 35% Philippines 30%
Argentina 35% Hong Kong 16.5% Poland 19%
Armenia 20% Hungary 19% Portugal 25%
Aruba 28% Iceland 20% Qatar 10%
Australia 30% India 33.22% Romania 16%
Austria 25% Indonesia 25% Russia 20%
Bahamas 0% Iran 25% St. Maarten 34%
Bahrain 0% Ireland 12.5% Samoa 27%
Bangladesh 27.5% Isle of Man 0% Saudi Arabia 20%
Barbados 25% Israel 24% Serbia 10%
Belarus 24% Italy 31.4% Singapore 17%
Belgium 33.99% Jamaica 33.33% Slovak Republic 19%
Bermuda 0% Japan 40.69% Slovenia 20%
Bosnia and Herzegovina 10% Jordan 14/24/30 South Africa 34.55%
Botswana 25% Kazakhstan 20% Spain 30%
Brazil 34% Korea, Republic of 24.2% Sri Lanka 35%
Bulgaria 10% Kuwait 15% Sudan 10/15/30/35
Canada 28.3% Latvia 15% Sweden 26.3%
Cayman Islands 0% Libya 20% Switzerland 11.6–24.4
Chile 20% Lithuania 15/5/0 Syria 28%
China 25% Luxembourg 28.80% Taiwan 17%
Colombia 33% Macau 12% Tanzania 30%
Costa Rica 30% Macedonia 10% Thailand 30%
Croatia 20% Malaysia 25% Tunisia 30%
Cyprus 10% Malta 35% Turkey 20%
Czech Republic 19% Mauritius 15% Ukraine 23%
Denmark 25% Mexico 30% United Arab Emirates 0/20/55
Dominican Republic 25% Montenegro 9% United Kingdom 28%
Ecuador 24% Mozambique 32% United States 40%
Egypt 20% Netherlands 20/25 Uruguay 25%
Estonia 21% New Zealand 28% Vanuatu 0%
Fiji 28% Nigeria 30% Venezuela 34%
Finland 26% Norway 28% Vietnam 25%
France 33.33% Oman 12% Yemen 20%
Germany 29.37% Pakistan 35% Zambia 35%
Gibraltar 10% Panama 0% Zimbabwe 25.75%
Greece 24% Papua New Guinea 30%
Source: KPMG’s Corporate and Indirect Tax Rate Survey, 2011. The Netherlands Antilles tax regime has been dismantled.
EXHIBIT 15.2 Corporate Income Tax Rates for Selected Countries, 2011
421Multinational Tax Management CHAPTER 15
20%
21%
22%
23%
24%
25%
26%
27%
28%
29%
2006 2007 2008 2009 2010 2011
Global AverageOCED
Source: KPMG Corporate and Indirect Tax Survey, 2011, p. 23.
EXHIBIT 15.3 Worldwide Corporate Tax Rates, 2006–2011
EXHIBIT 15.4 Value-Added Tax Applied to the Sale of a Wooden Fence Post
This is an example of how a wooden fence post would be assessed for value-added taxes in the course of its production and subsequent sale. A value-added tax of 10% is assumed.
Step 1 The original tree owner sells to the lumber mill, for $0.20, that part of a tree that ultimately becomes the fence post. The grower has added $0.20 in value up to this point by planting and raising the tree. While collecting $0.20 from the lumber mill, the grower must set aside $0.02 to pay the value-added tax to the government.
Step 2 The lumber mill processes the tree into fence posts and sells each post for $0.40 to the lumber wholesaler. The lumber mill has added $0.20 in value ($0.40 less $0.20) through its processing activities. Therefore, the lumber mill owner must set aside $0.02 to pay the mill’s value-added tax to the government. In practice, the owner would probably calculate the mill’s tax liability as 10% of $0.40, or $0.04, with a tax credit of $0.02 for the value-added tax already paid by the tree owner.
Steps 3 and 4 The lumber wholesaler and retailer also add value to the fence post through their selling and distribution activities. They are assessed $0.01 and $0.03 respectively, making the cumulative value-added tax collected by the govern- ment $0.08, or 10% of the final sales price.
Stage of Production Sales Price Value Added Value-Added Tax at 10% Cumulative Value-Added Tax
Tree owner $0.20 $0.20 $0.02 $0.02
Lumber mill $0.40 $0.20 $0.02 $0.04
Lumber wholesaler $0.50 $0.10 $0.01 $0.05
Lumber retailer $0.80 $0.30 $0.03 $0.08
422 CHAPTER 15 Multinational Tax Management
Foreign Tax Credits. 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 pre-tax 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 used to reduce taxable income before the tax rate is applied. A $100 tax credit reduces taxes payable by the full $100, whereas a $100 deduct- ible 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.
If there were no credits for foreign taxes paid, sequential taxation by the host govern- ment and then by the home government would result in a very high cumulative tax rate. For example, assume the wholly owned foreign subsidiary of an MNE earns $10,000 before local income taxes and pays a dividend equal to all of its after-tax income. The host-country income tax rate is 30%, and the home country of the parent tax rate is 35%, assuming no withholding taxes. Total taxation with and without tax credits is shown in Exhibit 15.5.
If tax credits are not allowed, sequential levying of both a 30% host-country tax and then a 35% home-country tax on the income that remains results in an effective 54.5% tax, a cumulative rate that would make many MNEs uncompetitive with local firms. The effect of allowing tax credits is to limit total taxation on the original before-tax income to no more than the highest single rate among jurisdictions. In the case depicted in Exhibit 15.4, the effective overall tax rate of 35% with foreign tax credits is equivalent to the higher tax rate of the home country (and is the tax rate payable if the income had been earned at home).
The $500 of additional home-country tax under the tax credit system in Exhibit 15.5 is the amount needed to bring total taxation ($3,000 already paid plus the additional $500) up to but not beyond 35% of the original $10,000 of before-tax foreign income.
The problem, however, is that if this company repatriates the profits of its foreign busi- nesses to the parent company it owes more taxes. Period. If it leaves those profits in that for- eign country, it enjoys what is referred to as deferral—it is able to defer incurring additional parent—country taxes on the foreign-source income until it does repatriate those earnings. As shown in Global Finance in Practice 15.1, this has motivated some countries like the United States to try periodicallyto provide tax incentives for repatriating profits.
EXHIBIT 15.5 Foreign Tax Credits
Without foreign tax credits With foreign tax credits
Before-tax foreign income $10,000 $10,000
Less foreign tax @ 30% -3,000 -3,000
Available to parent and paid as dividend $7,000 $ 7,000
Less additional parent-country tax at 35% -2,450
Less incremental tax (after credits) -500
Profit after all taxes $4,550 $6,500
Total taxes, both jurisdictions $5,450 $3,500
Effective overall tax rate (total taxes paid , foreign income) 54.5% 35.0%
423Multinational Tax Management CHAPTER 15
It is estimated that U.S.-based multinationals have one trillion dollars in un-repatriated profits offshore. Repatriating those profits, given the relatively higher effective corporate income tax rate in the U.S. compared to many other countries, would trig- ger significant additional tax charges in the U.S. In an effort to facilitate repatriation of those profits in 2004, the U.S. govern- ment passed the Homeland Investment Act of 2004. The Act
provided a window of opportunity in 2005 in which profits could be repatriated with only an additional tax obligation of 5.25%.
The temporary tax law change clearly had the desired impact of stimulating the repatriation of profits, as illustrated in the exhibit. Dividend repatriations skyrocketed in 2005 to over $360 billion from $60 billion the previous year. After the tempo- rary tax revision expired, repatriated dividends returned to trend.
$0
$50
$100
$150
$200
$250
$300
$350
$400
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Source: Bureau of Economic Analysis, Joint Committee on Taxation, Congressional Research Service.
Homeland Investment Act of 2004 provided an 85% deduction of US tax on qualified repatriations of foreign income to US parent companies
U.S. Dividend Repatriations, 1994–2010 (billions of US dollars)
GLOBAL FINANCE IN PRACTICE 15.1
Offshore Profits and Dividend Repatriation
Unfortunately, the political motivations behind the origi- nal tax holiday were focused on jobs creation in the United States by U.S. companies. All evidence has indicated that U.S. parent companies used the repatriated profits for a variety of uses, predominantly in returning money to
shareholders via dividends and share repurchases, and not in creating new jobs. As discussions arise once again on a new tax holiday, in search of those one trillion dollars in cor- porate profits held offshore, these same debates are rising once again.
Transfer Pricing The pricing of goods, services, and technology transferred to a foreign subsidiary from an affiliated company, transfer pricing, is the first and foremost method of transferring funds out of a foreign subsidiary. These costs enter directly into the cost of goods sold component of the subsidiary’s income statement. This is a particularly sensitive problem for MNEs. Even purely domestic firms find it difficult to reach agreement on the best method for setting prices on transactions between related units. In the multinational case, managers must balance conflicting considerations. These include fund positioning and income taxes.
Fund Positioning Effect. A parent 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
424 CHAPTER 15 Multinational Tax Management
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. Transfer pricing may also be used to transfer funds between sister subsidiaries. Multiple sourcing of component parts on a worldwide basis allows switching between suppliers from within the corporate family to function as a device to transfer funds.
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 maximize 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.
The income tax effect is illustrated in the hypothetical example presented in Exhibit 15.6. Trident Europe is operating in a relatively high-tax environment, assuming German corporate income taxes of 45%. Trident U.S. is in a significantly lower tax environment, assuming a U.S. corporate income tax rate of 35%, motivating Trident to charge Trident Europe a higher transfer price on goods produced in the United States and sold to Trident Europe.2
2Note that this hypothetical situation assumes a U.S. corporate income tax rate that is lower than Germany’s. Actual corporate income tax rates for both countries were presented earlier in Exhibit 15.2, in which the current combined federal and state burden is 40% in the U.S. and 29% in Germany.
Trident USA (subsidiary)
Trident Europe (subsidiary)
Europe and USA Combined
Low-Markup Policy
Sales $1,400 $2,000 $2,000
Less cost of goods sold* (1,000) (1,400) (1,000)
Gross profit $ 400 $ 600 $1,000
Less operating expenses (100) (100) (200)
Taxable income $ 300 $ 500 $ 800
Less income taxes 35% (105) 45% (225) (330)
Net income $ 195 $ 275 $ 470
High-Markup Policy
Sales $1,700 $2,000 $2,000
Less cost of goods sold* (1,000) (1,700) (1,000)
Gross profit $ 700 $ 300 $1,000
Less operating expenses (100) (100) (200)
Taxable income $ 600 $ 200 $ 800
Less income taxes 35% (210) 45% (90) (300)
Net income $ 390 $ 110 $ 500
*Trident USA’s sales price becomes cost of goods sold for Trident Europe.
EXHIBIT 15.6 Effect of Low Versus High Transfer Price on Trident Europe’s Net Income (thousands of U.S. dollars)
425Multinational Tax Management CHAPTER 15
If Trident Corporation adopts a high-markup policy by “selling” its merchandise at an intracompany sales price of $1,700,000, the same $800,000 of pre-tax consolidated income is allocated more heavily to low-tax Trident U.S.A. and less heavily to high-tax Trident Europe. (Note that it is Trident Corporation, the corporate parent, which must adopt a transfer pric- ing policy that directly alters the profitability of each of the individual subsidiaries.) As a consequence, total taxes drop by $30,000 and consolidated net income increases by $30,000 to $500,000. All while total sales remain constant.
Trident would naturally prefer the high-markup policy for sales from the United States to Europe (Germany in this case). Needless to say, government tax authorities are aware of the potential income distortion from transfer price manipulation. A variety of regulations and court cases exist on the reasonableness of transfer prices, including fees and royalties as well as prices set for merchandise. If a government taxing authority does not accept a transfer price, taxable income will be deemed larger than was calculated by the firm, and taxes will be increased.
Section 482 of the U.S. Internal Revenue Code is typical of laws circumscribing freedom to set transfer prices. Under this authority, the IRS can reallocate gross income, deductions, credits, or allowances between related corporations in order to prevent tax evasion or to reflect more clearly a proper allocation of income. Under these guidelines, the burden of proof is on the taxpaying firm to show that the IRS has been arbitrary or unreasonable in real- locating income. This “guilty until proved innocent” approach means that MNEs must keep good documentation of the logic and costs behind their transfer prices. The “correct price” according to the guidelines is the one that reflects an arm’s length price, that is, a sale of the same goods or service to a comparable unrelated customer.
IRS regulations provide three methods to establish arm’s length prices: comparable uncontrolled prices, resale prices, and cost-plus calculations. All three of these methods are recommended for use in member countries by the Organization for Economic Cooperation and Development (OECD) Committee on Fiscal Affairs. In some cases, combinations of these three methods are used.
Managerial Incentives and Evaluation When a firm is organized with decentralized profit centers, transfer pricing between centers can disrupt evaluation of managerial performance. This problem is not unique to MNEs; it is also a controversial issue in the “centralization versus decentralization” debate in domestic circles. In the domestic case, however, a modicum of coordination at the corporate level can alleviate some of the distortion that occurs when any profit center suboptimizes its profit for the corporate good. Also, in most domestic cases, the company can file a single (for that country) consolidated tax return, so the issue of cost allocation between affiliates is not critical from a tax-payment point of view.
In the multinational case, coordination is often hindered by longer and less efficient chan- nels of communication, the need to consider the unique variables that influence international pricing, and separate taxation. Even with the best of intent, a manager in one country finds it difficult to know what is best for the firm as a whole when buying at a negotiated price from related companies in another country. If corporate headquarters establishes transfer prices and sourcing alternatives, one of the main advantages of a decentralized profit center system disappears: local management loses the incentive to act for its own benefit.
To illustrate, refer to Exhibit 15.6, where an increase in the transfer price led to a world- wide income gain: Trident Corporation’s income rose by $195,000 (from $195,000 to $390,000) while Trident Europe’s income fell by only $165,000 (from $275,000 to $110,000), for a net gain of $30,000. Should the managers of the European subsidiary lose their bonuses (or their jobs) because of their “sub-par” performance? Bonuses are usually determined by a company-wide
426 CHAPTER 15 Multinational Tax Management
formula based in part on the profitability of individual subsidiaries, but in this case, Trident Europe “sacrificed” for the greater good of the whole. Arbitrarily changing transfer prices can create measurement problems.
Specifically, transferring profit from high-tax Trident Europe to low-tax Trident Corporation in the United States changes the following for one or both companies:
! Import tariffs paid (importer only) and hence profit levels ! Measurements of foreign exchange exposure, such as the amount of net exposed
assets, because of changes in amounts of cash and receivables ! Liquidity tests, such as the current ratio, receivables turnover, and inventory turnover ! Operating efficiency, as measured by the ratio of gross profit to either sales or to total
assets ! Income tax payments ! Profitability, as measured by the ratio of net income to either sales or capital invested ! Dividend payout ratio, in that a constant dividend will show as a varied payout ratio
as net income changes (alternatively, if the payout ratio is kept constant the amount of dividend is changed by a change in transfer price)
! Internal growth rate, as measured by the ratio of retained earnings to existing ownership equity.
Effect on Joint-Venture Partners Joint ventures pose a special problem in transfer pricing, because serving the interest of local stockholders by maximizing local profit may be suboptimal from the overall viewpoint of the MNE. Often, the conflicting interests are irreconcilable. Indeed, the local joint venture partner could be viewed as a potential “Trojan horse” if they complain to local authorities about the MNE’s transfer pricing policy.
Tax Management at Trident Exhibit 15.7 summarizes the key tax management issue for Trident when remitting dividend income back to the United States from Trident Germany and Trident Brazil.
! Because corporate income tax rates in Germany (40%) are higher than those in the United States (35%), dividends remitted to the U.S. parent result in excess foreign tax credits. Any applicable withholding taxes on dividends between Germany and the U.S. only increase the amount of the excess credit.
! Because corporate income tax rates in Brazil (25%) are lower than those in the United States (35%), dividends remitted to the U.S. parent result in deficit foreign tax credits. If there are withholding taxes applied to the dividends by Brazil on remittances to the United States, this will reduce the size of the deficit, but not eliminate it.
Trident’s management would like to manage the two dividend remittances in order to match the deficits with the credits. The most straightforward method of doing this would be to adjust the amount of dividend distributed from each foreign subsidiary so that, after all applicable income and withholding taxes have been applied, Trident’s excess foreign tax credits from Trident Germany exactly match the excess foreign tax deficits from Trident Brazil. There are a number of other methods of managing the global tax liabilities of Trident, so-called repositioning of funds, which is examined in detail in Chapter 19.
427Multinational Tax Management CHAPTER 15
Tax-Haven Subsidiaries and International Offshore Financial Centers Many MNEs have foreign subsidiaries that act as tax havens 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 estab- lished in a country that can meet the following requirements:
! 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.
! A stable currency to permit easy conversion of funds into and out of the local currency. This requirement can be met by permitting and facilitating the use of Eurocurrencies.
! The facilities to support financial services; for example, good communications, pro- fessional qualified office workers, and reputable banking services.
! A stable government that encourages the establishment of foreign-owned financial and service facilities within its borders.
Exhibit 15.8 provides a map of most of the world’s major offshore financial centers. The typi- cal tax-haven subsidiary owns the common stock of its related operating foreign subsidiaries. There might be several tax-haven subsidiaries scattered around the world. The tax-haven subsidiary’s equity is typically 100% owned by the parent firm. All transfers of funds might go through the tax-haven subsidiaries, including dividends and equity financing. Thus, the par- ent country’s tax on foreign-source income, which might normally be paid when a dividend is
Trident Brazil pays corporate income taxes
in Brazil of 25%
Trident U.S. pays corporate income taxes in the United States of 35%
Declares a dividend to its U.S. parent
Efficient management of Trident’s foreign tax position requires it to
try to balance Deficit Foreign Tax
Credits against Excess Foreign Tax Credits
Pays taxes to U.S. government separately on domestic-source income and foreign-source income
Withholding taxes are deducted from the dividend before leaving
Brazil of an additional 5%
Dividend remitted after-tax
Trident Germany pays corporate income taxes
in Germany of 40%
Declares a dividend to its U.S. parent
Withholding taxes are deducted from the dividend before leaving Germany of an additional 10%
Dividend remitted after-tax
Has paid less than U.S. tax requirement of 35% on income
Deficit foreign tax credit
Has paid more than U.S. tax requirement of 35% on income
Excess foreign tax credit
EXHIBIT 15.7 Trident’s Tax Management of Foreign-Source Income
428 CHAPTER 15 Multinational Tax Management
declared by a foreign subsidiary, could continue to be deferred until the tax-haven subsidiary itself pays a dividend to the parent firm. This event can be postponed indefinitely if foreign operations continue to grow and require new internal financing from the tax-haven subsidiary. Thus, MNEs are able to operate a corporate pool of funds for foreign operations without hav- ing to repatriate foreign earnings through the parent country’s tax machine.
For U.S. MNEs, the tax-deferral privilege operating through a foreign subsidiary was not originally a tax loophole. On the contrary, it was granted by the U.S. government to allow U.S. firms to expand overseas and place them on a par with foreign competitors, that also enjoy similar types of tax deferral and export subsidies of one type or another. Exhibit 15.9 provides a categorization of the primary activities of offshore financial centers.
Unfortunately, some U.S. firms distorted the original intent of tax deferral into tax avoid- ance. Transfer prices on goods and services bought from or sold to related subsidiaries were artificially rigged to leave all the income from the transaction in the tax-haven subsidiary. This manipulation could be done by routing the legal title to the goods or services through the tax-haven subsidiary, even though physically the goods or services never entered the tax- haven country. Needless to say, tax authorities of both exporting and importing countries were dismayed by the lack of taxable income in such transactions.
One purpose of the U.S. Internal Revenue Act of 1962 was to eliminate the tax advantages of these “paper” foreign corporations without destroying the tax-deferral privilege for those foreign manufacturing and sales subsidiaries that were established for business and economic motives rather than tax motives. Although the tax motive has been removed, some firms have found these subsidiaries useful as finance control centers for foreign operations, as illustrated by Global Finance in Practice 15.2.
DublinBermuda
Bahamas
Belize
Panama
Cayman Isles
Aruba
Netherlands Antilles
Luxembourg
Liechtenstein
Switzerland Cyprus
Dubai
Bahrain
Hong Kong
Labuan
Vanuatu
Cook Islands
Mauritius
Singapore
Alderney
Turks and Caicos Virgin Isles
Montserrat
Barbados Antigua
Anguilla
Jersey and Guernsey
Isle of Man
Western Samoa
Monaco
Malta
Gibraltar
EXHIBIT 15.8 International Offshore Financial Centers
429Multinational Tax Management CHAPTER 15
Google, the dominant Internet search engine which is famous for encouraging all employees to Do no evil in the company code of conduct, has been the subject of much scrutiny over its global tax strategy in recent years. Google’s effective over- seas tax rate (average effective tax on all foreign income) was
2.4% in 2010 on more than $13 billion in sales. Google’s overall tax rate, taxes paid in total globally on pre-tax earn- ings, has averaged roughly 22% in recent years. Google’s tax strategy is executed through a complex structure shown in the exhibit.
Google’s Global Tax Strategy: The Double Irish and Dutch Sandwich
Google Ireland Ltd.
Google Ireland Holdings
Google Bermuda
Double Irish. Google books nearly 90% of its non-US sales through Google Ireland, which then pays billions in royalties to Google Ireland Holdings – which has its effective management center in Bermuda.
Dutch Sandwich. To avoid withholding taxes on the payments by Ireland to Bermuda, the money is first passed through the Netherlands, taking advantage of intra-European tax treaties. Bermuda does not impose a corporate income tax on foreign-source income as earned by Google Bermuda here.
Google Netherlands
Offshore financial centers provide financial management services to foreign users in exchange for foreign exchange earnings. There are several comparative advantages for clients, including very low tax rates, minimal administrative formalities, and confidentiality and discre- tion. This environment allows wealthy international clients to minimize potential tax liability while protecting income and assets from politi- cal, fiscal, and legal risks. There are many vehicles through which offshore financial services can be provided. They include the following:
! Offshore banking, which can handle foreign exchange operations for corporations or banks. These operations are not subject to capital, corporate, capital gains, dividend, or interest taxes or to exchange controls.
! International business corporations, which are often tax-exempt, limited-liability companies used to operate businesses or raise capital through issuing shares, bonds, or other instruments.
! Offshore insurance companies, which are established to minimize taxes and manage risk.
! Asset management and protection, which allows individuals and corporations in countries with fragile banking systems or unstable political regimes to keep assets offshore to protect against the collapse of domestic currencies and banks.
! Tax planning, which means multinationals may route transactions through offshore centers to minimize taxes through transfer pricing. Individuals can make use of favorable tax regimes offered by offshore centers through trusts and foundations.
The tax concessions and secrecy offered by offshore financial centers can be used for many legitimate purposes, but they have also been used for illegitimate ends, including money laundering and tax evasion.
EXHIBIT 15.9 The Activities of Offshore Financial Centers
GLOBAL FINANCE IN PRACTICE 15.2
Google’s Double Irish/Dutch Sandwich Global Tax Strategy
Continues next page
430 CHAPTER 15 Multinational Tax Management
Google’s structure is one used by a multitude of U.S. mul- tinationals today. It is based on repositioning the ownership of many of its patents, copyrights, and other intellectual property to a subsidiary in a low-tax environment like Ireland, and then establishing high transfer prices on various forms of services and overheads to other units, leaving most of the profits in a near- zero tax environment like Bermuda.
There is nothing illegal about Google’s tax strategy. The company negotiated with the U.S. tax authority, the Internal Rev- enue Service (IRS) for years, eventually gaining IRS consent in what is known as an advanced pricing agreement. The agree- ment, as yet undisclosed, established allowable transfer prices and practices between the various Google-owned units used to minimize global taxes.
SUMMARY POINTS
! Nations typically structure their tax systems along one of two basic approaches: the worldwide approach or the territorial approach. Both approaches are attempts to determine which firms, foreign or domestic by incor- poration, or which incomes, foreign or domestic in origin, are subject to the taxation of host-country tax authorities.
! A network of bilateral tax treaties, many of which are modeled after one proposed by the Organiza- tion for Economic Cooperation and Development (OECD), provides a means of reducing double taxation.
! 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 them- selves alone.
! The value-added tax is a type of national sales tax col- lected at each stage of production or sale of consump- tion goods in proportion to the value added during that stage.
! Transfer pricing is the pricing of goods, services, and technology between related companies. High- or low- transfer prices have an effect on income taxes, fund positioning, managerial incentives and evaluation, and joint venture partners.
! The United States differentiates foreign source income from domestic source income. Each is taxed separately, and tax deficits/credits in one category may not be used against deficits/credits in the other category. If a U.S.- based MNE receives income from a foreign country that imposes higher corporate income taxes than does the United States (or combined income and withholding tax), total creditable taxes will exceed U.S. taxes on that foreign income. The result is excess foreign tax credits.
! All firms wish to manage their tax liabilities globally so that they do not end up paying more on foreign-sourced income than they do on domestically sourced income.
! MNEs have foreign subsidiaries that act as tax havens for corporate funds awaiting reinvestment or repatria- tion. Tax havens are typically located in countries that have a low corporate tax rate, a stable currency, facilities to support financial services, and a stable government.
So tonight, I’m asking Democrats and Republicans to simplify the system. Get rid of the loopholes. Level the playing field. And use the savings to lower the corporate tax rate for the first time in 25 years—without adding to our deficit. It can be done.
—President Barack Obama, State of the Union Address, January 25, 2011.
The United States had been debating its corporate income tax rates for years. It was an issue in the 2008 U.S. presi- dential election, and it continued to be an issue of much debate in the following years. In January 2011, it once again moved into the spotlight of political debate.
But measuring corporate income tax rates and burdens turns out to be quite tricky. The difference lies between
The U.S. Corporate Income Tax Conundrum 1
1Copyright © 2011 Michael H. Moffett. All rights reserved. This case was prepared by Professor Michael Moffett for the purpose of class- room discussion only and not to indicate either effective or ineffective management.
MINI-CASE
431Multinational Tax Management CHAPTER 15
active corporate earnings on one of two basic approaches, a territorial system or a worldwide system.2 Under a territorial system, taxes are paid by a firm only on income where it is earned—by territory or country. But under a worldwide system, the firm is taxed on its earnings worldwide, regardless of where they are earned.
What has made the U.S. worldwide tax system “toler- able to date” (to use the phrasing of the Tax Foundation) is that the United States does not tax the active earnings from outside the United States until they are repatriated. This is a tax deferral on foreign source income. A pure world- wide system would tax all earnings everywhere as earned, regardless of when the profits were repatriated to the home country. This means that U.S. corporations can defer pay- ing U.S. taxes on foreign earnings by not repatriating the profits.
The relatively high U.S. corporate tax rate, when combined with worldwide taxation, creates a significant problem in principle for the United States today. For exam- ple, a U.S. multinational has a subsidiary in Hong Kong. That subsidiary pays corporate income taxes in Hong Kong of 16.5%. But the U.S. company knows that if it repatriates those profits to the United States, it will owe the tax differ- ential, the U.S. effective tax rate less credit for Hong Kong taxes already paid (39.2%–16.5%). It therefore chooses not to bring the profits back home. In previous years in which the tax differential was not as great, the incentive for U.S. companies to leave profits abroad was less. It is on this basis that many in the United States argue it is way past time to revise—to lower—the U.S. corporate income tax.
2Active earnings are profits generated from producing products or providing services. Passive earnings are profits derived from the owner- ship of an asset, business, or technology.
statutory tax rates and effective tax rates. Statutory tax rates are the rates, by law, that companies are required to pay on taxable income. Effective tax rates are the actual tax rates paid by companies on all consolidated income— globally, after taking into account differences across countries and all available tax deductions.
Statutory Tax Rates In 2010, the United States had some of the highest corporate income tax rates in the world. In fact, among the OECD countries—the 31 largest industrialized econo- mies—the U.S. tax rate at 39.2% shown in Exhibit 1 was second highest, only Japan higher at 39.5%. The average of the non-U.S. OECD countries was 25.5%. U.S. corporate income tax rates were now believed to be an increasing impediment to investment in the United States, by both non-U.S. and U.S. corporations.
It had not always been this way. As illustrated by Exhibit 2, the combined federal and state U.S. tax rate had actually been significantly lower than most of the industrial countries for a period during the 1980s. But outside of the 1986 Tax Reform Act in the United States, U.S. rates had largely remained unchanged for 25 years. The rest of the industrial world, however, had continuously cut its com- bined statutory corporate income tax rate in a continuing effort to attract foreign investment.
Tax Regimes and Tax Deferral The statutory tax rate, however, is only one element of a country’s tax regime. Countries structure their taxation of
Country Rate Country Rate Country Rate
Australia 30.0% Hungary 19.0% Poland 19.0%
Austria 25.0% Iceland 15.0% Portugal 26.5%
Belgium 34.0% Ireland 12.5% Slovak Republic 19.0%
Canada 29.5% Italy 27.5% Spain 30.0%
Chile 17.0% Japan 39.5% Sweden 26.3%
Czech Republic 19.0% Korea 24.2% Switzerland 21.2%
Denmark 25.0% Luxembourg 28.6% Turkey 20.0%
Finland 26.0% Mexico 30.0% United Kingdom 28.0%
France 34.4% Netherlands 25.5% United States 39.2%
Germany 30.2% New Zealand 30.0%
Greece 24.0% Norway 28.0%
Source: Center for Tax Policy and Administration, OECD.org. Central government corporate income tax rate adjusted for subcentral rates.
EXHIBIT 1 Corporate Combined Tax Rates, OECD Countries, 2010
432 CHAPTER 15 Multinational Tax Management
(GE paying an average effective tax rate of only 3.6%). It is interesting to note that none of the biggest losers according to the study had an effective tax rate as high as the statu- tory rate noted by the OECD.
I’m asking Congress to eliminate the billions in taxpayer dollars we currently give to oil companies. For example, over the years, a parade of lobbyists has rigged the tax code to benefit particular companies and industries. Those with accountants or lawyers to work the system can end up paying no taxes at all. But all the rest are hit with one of the highest corporate tax rates in the world. It makes no sense, and it has to change.
—President Barack Obama, excerpts from the State of the Union Address, January 2011.
But Exhibit 3 was an analysis of only U.S.-based multi- nationals. A following exposé, this time by Business Week, presented in Exhibit 4, suggested that when you looked at a variety of multinational companies by industry across the globe, the differences were not that significant—at least by country of incorporation. It was clear, however, that global multinationals in specific industries were clearly paying higher rates than in other industry segments.
But it was not the energy or oil companies that were paying the lowest effective tax rates. In fact, they appeared to be paying some of the highest effective tax rates in the world. The lowest rate segment reported was pharmaceu- ticals, with financial services and some heavy equipment firms also enjoying relatively lower effective rates.
Effective Tax Rates
There are big companies that consider their tax depart- ments to be profit centers.
—National Public Radio, January 29, 2011.
But there is a big difference between statutory rates and what a company actually pays after all tax incen- tives, deductions, and differences across country tax environments, are taken into account. Because all gov- ernments attempt to direct corporate investment and activity toward specific public policy goals, a variety of incentives and deductions are available across the globe. Many multinational companies, for example, General Electric (U.S.), excel at taking advantage of these tax-lowering opportunities to pay a much lower effective tax.
They make money by moving income overseas or in dif- ferent kinds of activities or adjusting their accounting in such a way that they can pay less taxes than their com- petitors do.
—Martin Sullivan, tax expert, testimony before the HouseWays and Means Committee, January 20, 2011.
Exhibit 3 lists a number of U.S. multinationals, which in the eyes of one tax expert, were some of the biggest winners and losers over recent years. In expert testimony before the U.S. Congress, Martin Sullivan listed a few com- panies like General Electric that had clearly managed to pay a very low effective tax rate over a three-year period
Combined Federal and State U.S. corporate income tax rate
Non-U.S. OECD country average combined corporate income tax rate
20%
19 80
19 81
19 82
19 83
19 84
19 85
19 86
19 87
19 88
19 89
19 90
19 91
19 92
19 93
19 94
19 95
19 96
19 97
19 98
19 99
20 00
20 01
20 02
20 03
20 04
20 05
20 06
20 07
20 08
20 09
20 10
25%
30%
35%
40%
45%
50%
55%
Source: TaxFoundation.org.
EXHIBIT 2 U.S. and OECD Corporate Tax Rates
433Multinational Tax Management CHAPTER 15
EXHIBIT 3 Effective Tax Rates for Selected U.S. Multinationals
Winners Effective Rate Losers Effective Rate
General Electric 3.6% CVS Caremark 38.8%
Merck 12.5% Target 37.2%
Pfizer 17.1% Disney 36.5%
Medtronic 19.7% Home Depot 35.4%
Cisco Systems 19.8% United Health Group 35.4%
Hewlett-Packard 20.0% Aetna 34.6%
Johnson and Johnson 22.0% Wal-Mart 33.6%
Source: Testimony of Martin A. Sullivan before the Committee on Ways and Means, U.S. House of Representatives, January 20, 2011. Data is for most recent company annual reports. Tax rates shown here are average of three years presented in most recent report.
EXHIBIT 4 Effective Tax Rates for Selected Multinational Firms
Industrial and Heavy Machinery Rate Pharmaceuticals Rate
Siemens, Germany 29.0% AstraZeneca, Britain 29.5%
United Technologies, U.S. 27.5% Johnson and Johnson, U.S. 22.8%
Caterpillar, U.S. 24.7% Bayer, Germany 20.0%
Hyundai Industries, Korea 24.2% Pfizer, U.S. 18.7%
General Electric, U.S. 11.5% Sanofi-Aventis, France 18.2%
Technology Rate% Financial Services Rate
SAP, Germany 31.0% Wells Fargo, U.S. 30.9%
Apple, U.S. 28.5% Royal Bank of Canada, Canada 24.7%
Microsoft, U.S. 26.7% Bank of America, U.S. 24.7%
Nokia, Finland 23.9% Deutsche Bank, Germany 24.2%
Cisco Systems, U.S. 21.6% HSBC, Britain 20.6%
Retailers Rate Energy Rate
Gap, U.S. 38.6% Chevron, U.S. 43.9%
Home Depot, U.S. 36.7% ExxonMobil, U.S. 41.7%
Costco, U.S. 36.3% BP, Britain 33.8%
Carrefour, France 32.0% Petrobrás, Brazil 30.2%
Inditex, Spain 23.5% Petrochina, China 24.7%
Source: “The Multinational Tax Advantage,” by Peter Cohn and MathrewConniti, BusinessWeek Magazine, January 20, 2011. Effective tax rates, in percent- ages, averaged over 2005–2009.
434 CHAPTER 15 Multinational Tax Management
! A 2004 GAO study found that the average effective tax rate on the domestic income of large corporations was 25.2%.5
! That same GAO study found that the average effec- tive tax rate on foreign-source income of large corpo- rations was about 4%. This low rate was driven by the fact that the United States only taxes foreign source income (active earnings) upon repatriation, and then it is a residual tax reflecting the credits given on foreign taxes paid on that same income.
In short, U.S. multinationals were not bringing their active foreign earnings back home. They knew if they did, they would be paying more taxes. GE, for example, is esti- mated to have deferred tax on a cumulative $75 billion in foreign active earnings over the past decade by choosing not to bring the profits back home. Given GE’s demon- strated track record in paying such low U.S. taxes, it is prob- ably a good thing that GE’s Chief Executive Officer Jeffrey Immelt was named by President Barack Obama to lead an economic advisory group on corporate tax reform!
Case Questions
1. Do you think the United States needs to cut its corpo- rate income tax rates, change to a territorial system, or both?
2. Do you believe that lower tax rates attract foreign investment?
3. Many public policy experts argue that tax codes should be revised and simplified, so that all firms pay a basic flat rate regardless of who they are or where they do business. What do you think?
5“U.S. Multinational Corporations: Effective Tax Rates Are Correlated with Where Income Is Reported,” General Accounting Office, GAO-08-950, August 2008, p. 3.
Retailers, like the Gap and Home Depot, were also paying relatively higher rates. In fact, of the 30 firms listed in Exhibit 4, the only two firms that were paying at or above the U.S. combined statutory corporate income tax rate of 39.2% were ExxonMobil and Chevron, the two largest American oil companies.3
Of course, what was missing from much of the debate and a lot of the tables or exhibits was how much discre- tion or choice multinational companies have in terms of where they make their taxable profits. A firm, as a result of corporate strategy and history, making more and more of its consolidated profits in a low-tax environ- ment—for example, in Ireland (12.5%), Iceland (15%), or Chile (17%), would have a lower effective tax rate. But companies do not always get to choose where they do business or make profits. If you are a copper mining company, Chile is where you want to be. If, however, you were shopping for a country in which to locate a regional service center for the EU, Ireland would be a very attrac- tive tax choice.
U.S. Tax Revenues From the U.S. government’s perspective, it’s about collect- ing taxes—and it seems to be collecting fewer and fewer taxes from U.S. multinational companies. Consider the fol- lowing statistics:
! Corporate income taxes in the United States have fallen from 6% of GDP in the 1950s to just 2.1% in 2008.4
! Corporate income taxes today make up only 12% of all tax revenues collected by the U.S. government.
3Oil and gas companies like ExxonMobil and Chevron produce their oil and gas in countries all over the world—from Chad to Kazakhstan—and most of those host countries today tax the profits in their countries at rates often above 65%, the result of added special added income and production taxes on oil and gas production. 4“Outsourcing Jobs and Taxes,” by Roya Wolverson, CFR.org, February 11, 2011, p. 2.
QUESTIONS 1. Tax Morality. Answer the following questions:
a. What is meant by the term “tax morality”? b. Your company has a subsidiary in Russia, where
tax evasion is a fine art. Discuss whether you should comply with Russian tax laws or violate the laws as do your local competitors.
2. Tax Neutrality. Answer the following questions:
a. Define the term “tax neutrality.” b. What is the difference between domestic neutrality
and foreign neutrality? c. What are a country’s objectives when determining
tax policy on foreign source income?
3. Worldwide Versus Territorial Approach. Nations typically structure their tax systems along one of two basic approaches: the worldwide approach or the
435Multinational Tax Management CHAPTER 15
and motives does a parent multinational firm face in setting transfer prices?
10. Sister Subsidiaries. Subsidiary Alpha in Country Able faces a 40% income tax rate. Subsidiary Beta in Coun- try Baker faces only a 20% income tax rate. Presently, each subsidiary imports from the other an amount of goods and services exactly equal in monetary value to what each exports to the other. This method of balancing intracompany trade was imposed by a man- agement keen to reduce all costs, including the costs (spread between bid and ask) of foreign exchange transactions. Both subsidiaries are profitable, and both could purchase all components domestically at approximately the same prices as they are paying to their foreign sister subsidiary. Does this seem like an optimal situation?
11. Correct Pricing. Section 482 of the U.S. Internal Rev- enue Code specifies use of a “correct” transfer price, and the burden of proof that the transfer price is “cor- rect” lies with the company. What guidelines exist for determining the proper transfer price?
12. Tax-Haven Subsidiary. Answer the following questions: a. What is meant by the term “tax haven”? b. What are the desired characteristics for a country
if it expects to be used as a tax haven? c. Identify five tax havens. d. What are the advantages leading an MNE to use a
tax-haven subsidiary? e. What are the potential distortions of an MNE’s
taxable income that are opposed by tax authorities in non–tax-haven countries?
13. Tax Treaties. How do tax treaties affect the opera- tions and structure of MNEs?
14. Passive. Why do the U.S. tax authorities tax passive income generated offshore differently from active income?
PROBLEMS 1. Avon’s Foreign-Source Income. Avon is a U.S.-based
direct seller of a wide array of products. Avon markets leading beauty, fashion, and home products in more than 100 countries. As part of the training in its corpo- rate treasury offices, it has its interns build a spread- sheet analysis of the following hypothetical subsidiary earnings/distribution analysis. Use the spreadsheet presented in Exhibit 15.6 for your basic structure. a. What is the total tax payment, foreign and domes-
tic combined, for this income?
territorial approach. Explain these approaches and how they differ from each other.
4. Tax Deferral. Answer the following questions: a. What is meant by the term “tax deferral”? b. Why do countries allow tax deferral on foreign
source income?
5. Tax Treaties. Answer the following questions: a. What is a bilateral tax treaty? b. What is the purpose of a bilateral tax treaty? c. What policies do most tax treaties cover?
6. 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 fol- lowing as a “direct tax,” an “indirect tax,” or something else: a. Corporate income tax paid by a Japanese subsid-
iary on its operating income b. Royalties paid to Saudi Arabia for oil extracted
and shipped to world markets c. Interest received by a U.S. parent on bank deposits
held in London d. Interest received by a U.S. parent on a loan to a
subsidiary in Mexico e. Principal repayment received by U.S. parent from
Belgium on a loan to a wholly owned subsidiary in Belgium
f. Excise tax paid on cigarettes manufactured and sold within the United States
g. Property taxes paid on the corporate headquarters building in Seattle
h. A direct contribution to the International Commit- tee of the Red Cross for refugee relief
i. Deferred income tax, shown as a deduction on the U.S. parent’s consolidated income tax
j. Withholding taxes withheld by Germany on dividends paid to a United Kingdom parent corporation
7. Foreign Tax Credit. What is a foreign tax credit? Why do countries give credit for taxes paid on foreign source income?
8. Value-Added Tax. Answer the following questions: a. What is a value-added tax? b. Although the value-added tax has been proposed
numerous times, the United States has never adopted one. Why do you think the United States is so negative on it when the value-added tax is widely used outside the United States?
9. Transfer Pricing Motivation. What is a transfer price and can a government regulate it? What difficulties
436 CHAPTER 15 Multinational Tax Management
3. Kraftstoff of Germany. Kraftstoff is a German-based company that manufactures electronic fuel-injection carburetor assemblies for several large automobile companies in Germany, including Mercedes, BMW, and Opel. The firm, like many firms in Germany today, is revising its financial policies in line with the increasing degree of disclosure required by firms if they wish to list their shares publicly in or out of Germany.
Kraftstoff’s primary problem is that the Ger- man corporate income tax code applies a different income tax rate to income depending on whether it is retained (45%) or distributed to stockholders (30%). a. If Kraftstoff planned to distribute 50% of its net
income, what would be its total net income and total corporate tax bills?
b. If Kraftstoff was attempting to choose between a 40% and 60% payout rate to stockholders, what arguments and values would management use in order to convince stockholders which of the two payouts is in everyone’s best interest?
Chinglish Dirk Use the following company case to answer questions 4 through 6. Chinglish Dirk Company (Hong Kong) exports razor blades to its wholly owned parent com- pany, Torrington Edge (Great Britain). Hong Kong tax rates are 16% and British tax rates are 30%. Chinglish calculates its profit per container as follows (all values in British pounds).
b. What is the effective tax rate paid on this income by the U.S.-based parent company?
c. What would be the total tax payment and effective tax rate if the foreign corporate tax rate was 45% and there were no withholding taxes on dividends?
d. What would be the total tax payment and effective tax rate if the income was earned by a branch of the U.S. corporation?
2. Pacific Jewel Airlines (Hong Kong). Pacific Jewel Airlines is a U.S.-based air freight firm with a wholly owned subsidiary in Hong Kong. The subsidiary, Jewel Hong Kong, has just completed a long-term planning report for the parent company in San Fran- cisco, in which it has estimated the following expected earnings and payout rates for the years 2011–2014.
Baseline Values Case 1 Case 2
a. Foreign corporate income tax rate 28% 45%
b. U.S. corporate income tax rate 35% 35%
c. Foreign dividend withholding tax rate 15% 0%
d. U.S. ownership in foreign firm 100% 100%
e. Dividend payout rate of foreign firm 100% 100%
Jewel Hong Kong Income Items (millions US$) 2011 2012 2013 2014
Earnings before interest and taxes (EBIT)
8,000 10,000 12,000 14,000
Less interest expenses (800) (1,000) (1,200) (1,400)
Earnings before taxes (EBT) 7,200 9,000 10,800 12,600
The current Hong Kong corporate tax rate on this category of income is 16.5%. Hong Kong imposes no withholding taxes on dividends remitted to U.S. inves- tors (per the Hong Kong-United States bilateral tax treaty). The U.S. corporate income tax rate is 35%. The parent company wants to repatriate 75% of net income as dividends annually. a. Calculate the net income available for distribu-
tion by the Hong Kong subsidiary for the years 2004–2007.
b. What is the amount of the dividend expected to be remitted to the U.S. parent each year?
c. After gross-up for U.S. tax liability purposes, what is the total dividend after tax (all Hong Kong and U.S. taxes) expected each year?
d. What is the effective tax rate on this foreign- sourced income per year?
Constructing Transfer (Sales) Price per Unit
Chinglish Dirk (British pounds)
Torrington Edge (British pounds)
Direct costs £10,000 £16,100
Overhead 4,000 1,000
Total costs £14,000 £17,100
Desired markup 2,100 2,565
Transfer price (sales price)
£16,100 £19,665
Income Statement
Sales price £16,100,000 £19,665,000
Less total costs (14,000,000) (17,100,000)
Taxable income £2,100,000 £2,565,000
Less taxes (336,000) (769,500)
Profit, after-tax £1,764,000 £1,795,500
437Multinational Tax Management CHAPTER 15
2. International Taxpayer. The United States Internal Revenue Service (IRS) provides detailed support and document requirements for international taxpayers. Use the IRS site to find the legal rules and regulations and definitions for international residents tax liabili- ties when earning income and profits in the United States.
U.S. IRS Taxpayer www.irs.gov/businesses/small/ international/index.html
3. Official Government Tax Authorities. Tax laws are constantly changing, and an MNE’s tax planning and management processes must therefore include a con- tinual updating of tax practices by country. Use the following government tax sites to address specific issues related to those countries:
4. Chinglish Dirk (A). Corporate management of Torrington Edge is considering repositioning profits within the multinational company. What happens to the profits of Chinglish Dirk and Torrington Edge, and the consolidated results of both, if the markup at Chinglish was increased to 20% and the markup at Torrington was reduced to 10%? What is the impact of this repositioning on consolidated tax payments?
5. Chinglish Dirk (B). Encouraged by the results from the previous problem’s analysis, corporate man- agement of Torrington Edge wishes to continue to r eposition profit in Hong Kong. It is, however, facing two constraints. First, the final sales price in Great Britain must be £20,000 or less to remain competitive. Secondly, the British tax authorities—in working with Torrington Edge’s cost accounting staff—has estab- lished a maximum transfer price allowed (from Hong Kong) of £17,800. What combination of markups do you recommend for Torrington Edge to institute? What is the impact of this repositioning on consoli- dated profits on after-tax and total tax payments?
6. Chinglish Dirk (C). Not to leave any potential tax repositioning opportunities unexplored, Torrington Edge wants to combine the components of problem 4 with a redistribution of overhead costs. If overhead costs could be reallocated between the two units, but still total £5,000 per unit, and maintain a minimum of £1,750 per unit in Hong Kong, what is the impact of this repositioning on consolidated profits after-tax and total tax payments?
INTERNET EXERCISES 1. Global Taxes. Sites like TaxWorld provide detailed
insights into the conduct of business and the associated tax and accounting requirements of doing business in a variety of countries.
International Tax www.taxworld.org/ OtherSites/ Resources International/international.htm
www.gov.hk/en/business/ taxes/profittax/
Hong Kong’s ownership change to China
Czech Republic’s tax incentives for investment
www.revenue.ie/Ireland’s international financial services center
www.czech.cz/homepage/ busin.htm
4. Tax Practices for International Business. Many of the major accounting firms provide online informa- tion and advisory services for international business activities as related to tax and accounting practices. Use the following Web sites to find current informa- tion on tax law changes and practices.
Ernst and Young www.ey.com/tax/
Deloitte &Touche www.deloitte.com/view/ en_US/us/Services/tax/index .htm
KPMG www.kpmg.com/
Price Waterhouse Coopers www.pwc.com/us/en/ tax-services/ index.jhtml
Ernst & Young www.eyi.com/
5. International Tax Blog. Follow the latest changes in global tax rules and treaties on the following blog:
International Tax Blog blogs.cbh.com/international/
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CHAPTER 16 International Portfolio Theory and Diversification
CHAPTER 17 Foreign Direct Investment and Political Risk
CHAPTER 18 Multinational Capital Budgeting and Cross-Border Acquisitions
Foreign Investment Decisions
PART V
439
International Portfolio Theory and Diversification
It is not a case of choosing those which, to the best of one’s judgement, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be.
—John Maynard Keynes, The General Theory of Employment, Interest, and Money, 1936.
This chapter explores how application of portfolio theory can reduce risks of asset portfolios held by MNEs, and risks incurred by MNEs in general from internationally diversified activities. In the first part of the chapter, we extend portfolio theory from the domestic to the international business environment. Then, we show how the risk of a portfolio, whether it be a securities portfolio or the general portfolio of activities of the MNE, is reduced through international diversification. The second part of the chapter details the theory and application of international portfolio theory and presents recent empirical results of the risk-return trade-offs of internationally diversified portfolios. The third and final section explores inter- national diversification’s impact on the cost of capital for the MNE. The chapter concludes with the Mini-Case, Portfolio Theory, Black Swans, and [Avoiding] Being the Turkey.
International Diversification and Risk The case for international diversification of portfolios can be decomposed into two components: 1) the potential risk reduction benefits of holding international securities and 2) the potential added foreign exchange risk.
Portfolio Risk Reduction We focus first on risk. The risk of a portfolio is measured by the ratio of the variance of the portfolio’s return relative to the variance of the market return. This is the beta of the portfolio. As an investor increases the number of securities in a portfolio, the portfolio’s risk declines rapidly at first, then asymptotically approaches the level of systematic risk of the market. A fully diversified domestic portfolio would have a beta of 1.0, as shown in Exhibit 16.1.
Exhibit 16.1 illustrates portfolio risk reduction for the U.S. economy. It shows that a fully diversified U.S. portfolio is only about 27% as risky as a typical individual stock. This relationship implies that about 73% of the risk associated with investing in a single stock is diversifiable in a fully diversified U.S. portfolio. Although we can reduce risk substantially through portfolio diversification, it is not possible to eliminate it totally, because security returns are affected by a common set of factors—a set we characterize as the market.
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441International Portfolio Theory and Diversification CHAPTER 16
The total risk of any portfolio is therefore composed of systematic risk (the market) and unsystematic risk (the individual securities). Increasing the number of securities in the portfolio reduces the unsystematic risk component leaving the systematic risk component unchanged.
Exhibit 16.2 illustrates the incremental gains of diversifying both domestically and inter- nationally. The lowest line in Exhibit 16.2 (portfolio of international stocks) represents a portfolio in which foreign securities have been added. It has the same overall risk shape as the U.S. stock portfolio, but it has a lower portfolio beta. This means that the international portfolio’s market risk is lower than that of a domestic portfolio. This situation arises because the returns on the foreign stocks are closely correlated not with returns on U.S. stocks, but rather with a global beta. We will return to this concept in the section National Markets and Asset Performance later in this chapter.
Foreign Exchange Risk The foreign exchange risks of a portfolio, whether it be a securities portfolio or the general portfolio of activities of the MNE, are reduced through international diversification. The construction of internationally diversified portfolios is both the same as and different from creating a traditional domestic portfolio. Internationally diversified portfolios are the same in principle because the investor is attempting to combine assets that are less than perfectly correlated, reducing the total risk of the portfolio. In addition, by adding assets outside the home market, assets that previously were not available to be averaged into the portfolio’s expected returns and risks, the investor has now tapped into a larger pool of potential investments.
But international portfolio construction is also different in that when the investor acquires assets or securities outside the investor’s host-country market, the investor may also be
EXHIBIT 16.1 Portfolio Risk Reduction Through Diversification
1 5020 4010 30
100
80
60
40
20
27%
Total Risk = Diversifiable Risk (unsystematic)
+ Market Risk (systematic)
Portfolio of U.S. Stocks
Total Risk
When the portfolio is diversified, the variance of the portfolio’s return relative to the variance of the market’s return (beta) is reduced to the level of systematic risk—the risk of the market itself.
Number of Stocks in Portfolio
Percent Risk
Variance of Portfolio Return Variance of Market Return
=
Systematic Risk
442 CHAPTER 16 International Portfolio Theory and Diversification
acquiring a foreign currency denominated asset. This is not always the case. For example, many U.S.-based investors routinely purchase and hold Eurodollar bonds (on the secondary market only; it is illegal during primary issuance), which would not pose currency risk to the U.S.-based investor for they are denominated in the investor’s home currency. Thus, the inves- tor has actually acquired two additional assets—the currency of denomination and the asset subsequently purchased with the currency—one asset in principle, but two in expected returns and risks.
Japanese Equity Example. A numerical example can illustrate the difficulties associated with international portfolio diversification and currency risk. A U.S.-based investor takes US$1,000,000 on January 1, and invests in shares traded on the Tokyo Stock Exchange (TSE). The spot exchange rate on January 1 is ¥130.00/$. The $1 million therefore yields ¥130,000,000. The investor uses ¥130,000,000 to acquire shares on the Tokyo Stock Exchange at ¥20,000 per share, acquiring 6,500 shares, and holds the shares for one year. At the end of one year, the investor sells the 6,500 shares at the market price, which is now ¥25,000 per share; the shares have risen ¥5,000 per share in price. The 6,500 shares at ¥25,000 per share yield proceeds of ¥162,500,000.
The Japanese yen are then changed back into the investor’s home currency, the U.S. dollar, at the spot rate of ¥125.00/$ now in effect. This results in total U.S. dollar proceeds of $1,300,000.00. The total return on the investment is then
US$1,300,000 - US$1,000,000 US$1,000,000
= 30.00%
EXHIBIT 16.2 Portfolio Risk Reduction Through International Diversification
1 5020 4010 30
100
80
60
40
20
27%
12%
When the portfolio is diversified internationally, the portfolio’s beta—the level of systematic risk that cannot be diversified away—is lowered.
Number of Stocks in Portfolio
Percent Risk
Variance of Portfolio Return Variance of Market Return
=
Portfolio of U.S. Stocks
Portfolio of International Stocks
443International Portfolio Theory and Diversification CHAPTER 16
The total U.S. dollar return is actually a combination of the return on the Japanese yen (which in this case was positive) and the return on the shares listed on the Tokyo Stock Exchange (which was also positive). This value is expressed by isolating the percentage change in the share price (rshares) in combination with the percentage change in the currency value (r¥/$):
R$ = [(1 + r¥/$)(1 + rshares, ¥)] - 1.
In this case, the value of the Japanese yen, in the eyes of a U.S.-based investor, rose 4.00% (from ¥130/$ to ¥125/$), while the shares traded on the Tokyo Stock Exchange rose 25.00%. The total investment return in U.S. dollars is therefore
R$ = [(1 + .0400)(1 + .2500)] - 1 = .3000 or 30.00%.
Obviously, the risk associated with international diversification, when it includes currency risk, is inherently more complex than that of domestic investments. You should also see, however, that the presence of currency risk may alter the correlations associated with securities in different countries and currencies, providing portfolio composition and diversification possibilities that domestic investment and portfolio construction may not. In conclusion:
! International diversification benefits induce investors to demand foreign securities (the so-called buy-side).
! If the addition of a foreign security to the portfolio of the investor aids in the reduction of risk for a given level of return, or if it increases the expected return for a given level of risk, then the security adds value to the portfolio.
! A security that adds value will be demanded by investors. Given the limits of the potential supply of securities, increased demand will bid up the price of the security, resulting in a lower cost of capital for the firm. The firm issuing the security, the sell-side, is therefore able to raise capital at a lower cost.
Internationalizing the Domestic Portfolio First, we review the basic principles of traditional domestic portfolio theory to aid in our identification of the incremental changes introduced through international diversification. We then illustrate how diversifying the portfolio internationally alters the potential set of portfolios available to the investor.
The Optimal Domestic Portfolio Classic portfolio theory assumes a typical investor is risk-averse. This means that an investor is willing to accept some risk but is not willing to bear unnecessary risk. The typical investor is therefore in search of a portfolio that maximizes expected portfolio return per unit of expected portfolio risk.
The domestic investor may choose among a set of individual securities in the domestic market. The near infinite set of portfolio combinations of domestic securities form the domestic portfolio opportunity set shown in Exhibit 16.3. The set of portfolios formed along the extreme left edge of the domestic portfolio opportunity set is termed the efficient frontier. It represents the optimal portfolios of securities that possess the minimum expected risk for each level of expected portfolio return. The portfolio with the minimum risk among all those possible is the minimum risk domestic portfolio (MRDP).
444 CHAPTER 16 International Portfolio Theory and Diversification
EXHIBIT 16.3 Optimal Domestic Portfolio Construction
Expected Return of Portfolio, Rp
σDP
RDP
Rf
Minimum risk domestic portfolio (MRDP )
Domestic portfolio opportunity set
An investor may choose a portfolio of assets enclosed by the domestic portfolio opportunity set. The optimal domestic portfolio is found at DP, where the capital market line is tangent to the domestic portfolio opportunity set. The domestic portfolio with the minimum risk is designated MRDP.
Capital market line (domestic)
DP
Optimal domestic portfolio (DP )
MRDP
Expected Risk of Portfolio, σp
The individual investor will search out the optimal domestic portfolio (DP) which combines the risk-free asset and a portfolio of domestic securities found on the efficient frontier. He or she begins with the risk-free asset with return of Rf (and zero expected risk), and moves out along the security market line until reaching portfolio DP. This portfolio is defined as the optimal domestic portfolio because it moves out into risky space at the steepest slope—maximizing the slope of expected portfolio return over expected risk—while still touching the opportunity set of domestic portfolios. This line is called the capital market line, and portfolio theory assumes an investor who can borrow and invest at the risk-free rate can move to any point along this line.
Note that the optimal domestic portfolio is not the portfolio of minimum risk (MRDP). A line stretching from the risk-free asset to the minimum risk domestic portfolio would have a lower slope than the capital market line, and the investor would not be receiving as great an expected return (vertical distance) per unit of expected risk (horizontal distance) as that found at DP.
International Diversification Exhibit 16.4 illustrates the impact of allowing the investor to choose among an internationally diversified set of potential portfolios. The internationally diversified portfolio opportunity set shifts leftward of the purely domestic opportunity set. At any point on the efficient frontier of the internationally diversified portfolio opportunity set, the investor can find a portfolio of lower expected risk for each level of expected return.
It is critical to be clear as to exactly why the internationally diversified portfolio opportunity set is of lower expected risk than comparable domestic portfolios. The gains arise directly from the introduction of additional securities and/or portfolios, which are of less than perfect correlation with the securities and portfolios within the domestic opportunity set.
445International Portfolio Theory and Diversification CHAPTER 16
For example, Sony Corporation is listed on the Tokyo Stock Exchange. Sony’s share price derives its value from both the individual business results of the firm and the market in which it trades. If either or both are not perfectly positively correlated to the securities and markets available to a U.S.-based investor, then that investor would observe the opportunity set shift shown in Exhibit 16.4.
The Optimal International Portfolio The investor can now choose an optimal portfolio that combines the same risk-free asset as before with a portfolio from the efficient frontier of the internationally diversified portfolio opportunity set. The optimal international portfolio, IP, is again found by locating that point on the capital market line (internationally diversified) which extends from the risk-free asset return of Rf to a point of tangency along the internationally diversified efficient frontier. We illustrate this in Exhibit 16.5.
The benefits of international diversification are now obvious. The investor’s optimal international portfolio, IP, possesses both higher expected portfolio return (RIP 7 RDP), and lower expected portfolio risk (sIP 6 sDP), than the purely domestic optimal portfolio. The optimal international portfolio is superior to the optimal domestic portfolio.
The Calculation of Portfolio Risk and Return An investor may reduce investment risk by holding risky assets in a portfolio. As long as the asset returns are not perfectly positively correlated, the investor can reduce risk because some of the fluctuations of the asset returns will offset each other.
EXHIBIT 16.4 The Internationally Diversified Portfolio Opportunity Set
Expected Return of Portfolio, Rp
σDP
RDP
Rf
Internationally diversified portfolio opportunity set
Domestic portfolio opportunity set
The addition of internationally diversified portfolios to the total opportunity set available to the investor shifts the total portfolio opportunity set left, providing lower expected risk portfolios for each level of expected portfolio return.
DP
Expected Risk of Portfolio, σp
446 CHAPTER 16 International Portfolio Theory and Diversification
Expected Return of Portfolio, Rp
Expected Risk of Portfolio, σp σDP σIP
RDP
RIP
Rf
Internationally diversified portfolio opportunity set
Domestic portfolio opportunity set
DP
IP
Capital market line (domestic)
Capital market line (international)Optimal
international portfolio
Risk reduction of optimal portfolio
Increased return of optimal portfolio
EXHIBIT 16.5 The Gains from International Portfolio Diversification
Two-Asset Model. Let us assume Trident’s CFO Maria Gonzalez is considering investing Trident’s marketable securities in two different risky assets, an index of the U.S. equity markets and an index of the German equity markets. The two equities are characterized by the following expected returns (the mean of recent returns) and expected risks (the standard deviation of recent returns):
Expected Return Expected Risk (S)
United States equity index (US) 14% 15%
German equity index (GER) 18% 20%
Correlation coefficient (rUS- GER) 0.34
If the weights of investment in the two assets wUS and wGER respectively, and wUS + wGER = 1, and the risk of the portfolio (sp), usually expressed in terms of the standard devia- tion of the portfolio’s expected return, is given by the following equation:
sp = 2wUS2 sUS2 + wGER2 sGER2 + 2wUSwGERrUS - GERsUSsGER, where sUS 2 and sGER 2 are the squared standard deviations of the expected returns of risky assets in the United States and Germany (the variances), respectively. The Greek letter rho, rUS - GER, is the correlation coefficient between the two market returns over time.
We now plug in the values for the standard deviations of the United States (15%) and Germany (20%), and the correlation coefficient of 0.34. Assuming that Maria initially wishes
447International Portfolio Theory and Diversification CHAPTER 16
to invest 40% of her funds in the United States (0.40), and 60% of her funds in German equities (0.60), the expected risk of the portfolio will be
sp = 2(0.40)2(0.15)2 + (0.60)2(0.20)2 + 2(0.40)(0.60)(0.34)(0.15)(0.20), which, when reduced, is
= 20.0036 + 0.0144 + 0.0049 = 0.151 ! 15.1%. Note that the portfolio risk is not the weighted average of the risks of the individual
assets. As long as the correlation coefficient (r) is smaller than 1.0, some of the fluctuations of the asset returns will offset each other, resulting in risk reduction. The lower the correlation coefficient, the greater the opportunity for risk diversification.
We obtain the expected return of the portfolio with the following equation:
E(Rp) = wUSE(RUS) + wGERE(RGER),
where E(Rp), E(RUS), and E(RGER) are the expected returns of the portfolio, the United States equity index, and the German equity index, respectively. Using the expected returns for the U.S. (14%) and German (18%) equity indexes above, we find the expected return of the portfolio to be
E(Rp) = (0.4)(0.14) + (0.6)(0.18) = 0.164 ! 16.4%.
Altering the Weights. Before Maria finalizes the desired portfolio, she wishes to evaluate the impact of changing the weights between the two equity indexes on the expected risk and expected returns of the portfolio. Using weight increments of 0.5, she graphs the alternative portfolios in the customary portfolio risk-return graphic. Exhibit 16.6 illustrates the result.
The different portfolios possible using different weights with the two equity assets provides Maria some interesting choices. The two extremes, the greatest expected return and the minimum expected risks, call for very different weight structures. The greatest expected return is, as we would expect from the original asset expectations, 100% German in composition. The minimum expected risk portfolio, with approximately 15.2% expected risk, comprises approximately 70% U.S. and 30% German securities.
Multiple Asset Model. We can generalize the above equations to a portfolio consisting of multiple assets. The portfolio risk is
sp = CaNi=1wi2sj2 + aN - 1i=1 aNj= i+ 1wiwjrijsisj, and the portfolio expected return is
E(Rp) = a N
i=1 wiE(Ri),
where N stands for the total number of assets included in the portfolio. By allowing investors to hold foreign assets, we substantially enlarge the feasible set of investments; higher return can be obtained at a given level of risk, or lower risk can be attained at the same level of return.
448 CHAPTER 16 International Portfolio Theory and Diversification
National Markets and Asset Performance As demonstrated in the previous section, international portfolio construction allows the investor to gather in different expected returns—sometimes higher, sometimes lower—with the real gains arising from reduction in the expected risk of the portfolio.
A multitude of studies have analyzed historical returns from the world’s various equity markets. One of the longest historical time period coverage is that of Dimson, Marsh, and Staunton (2002), who analyzed a century of equity returns over 16 different markets. They found that U.S. equities delivered an inflation-adjusted mean return of 8.7% versus mean returns of 2.1% on Treasury bonds. But they also concluded that the U.S. market was not exceptional, with equity markets in Australia, Germany, Japan, South Africa, and Sweden all exhibiting higher mean returns for the century. Importantly, they also found that equity returns for all 16 countries exhibited positive mean returns, the lowest being 4.8% in Belgium, and the highest being 9.9% in Sweden.
The true benefits of global diversification do indeed arise from the fact that the returns of different stock markets around the world are not perfectly positively correlated. (Exhibit 16.7 describes U.S. equity market correlations with select global equity markets in recent years.) Because there are different industrial structures in different countries and because different economies follow very different business cycles, we expect smaller return correlations between investments in different countries than between investments within a given country. And in fact, that is what most of the empirical studies indicate.
As demonstrated by Global Finance in Practice 16.1, however, average performances over extended periods may be misleading when it comes to assessing market movements and
EXHIBIT 16.6 Alternative Portfolio Profiles Under Varying Asset Weights
Expected Portfolio Return (%)
Expected Portfolio Risk (σ)
Initial portfolio (40% U.S. and 60% GER)
Maximum return and maximum risk (100% GER)
Minimum risk combination (70% U.S. and 30% GER)
Domestic-only portfolio (100% U.S.)
18
17
16
15
14
13
12
110 12 19 2017 1815 1613 14
449International Portfolio Theory and Diversification CHAPTER 16
EXHIBIT 16.7 Major Equity Market Correlations with the United States Equity Market
0.00
0.10
0.20
0.30
0.50
0.70
0.40
0.60
0.80
Au str
alia
Be lgiu
m Ca
na da
De nm
ark Fra
nc e
Ge rm
an y
Ho ng
Ko ng
Jap an
Ne the
rla nd
as
Sw ed
en
Sw itze
rla nd
Un ite
d K ing
do m
Source: Author estimates for the 1970–2010 period.
Market correlation studies focus on market movements over segments of time, such as monthly average returns over years or blocks of years. But correlation coefficients between mar- kets on singular events, such as major global crises, disasters, or events of global profile, often show near-perfect correla- tions, with all markets moving identically.
In most cases, the identification of the event (for example the terrorist attacks of September 11, 2001) is relatively easy. In other instances, however, such as the stock market crash of October 19, 1987; the crash of October 13, 1989; or the collapse of the Thai baht on July 2, 1997, instigating the Asian Crisis of 1997; finding a smoking gun is difficult. Whether it be the madness of crowds or unknown forces, the causal event is difficult to find even after the fact. (Michael Mussa often recites a television news story in which the governor of Ohio claimed that a major prison riot was the work of “outside agitators.”)
In some cases in history, however, the correlation in equity market movements displays an interesting twist. On January 17, 1991, the U.S. initiated its counterattack on Iraqi forces which had occupied Kuwait. The date had been watched with intense interest for months as then President George Bush had warned Iraq that it had until that date to withdraw. When no withdrawal occurred, the U.S. attack began on January 17. Nineteen global equity markets all closed up that day, with percentage increases ranging from 1.17% in Toronto to 7.56% in Frankfurt (the DAX). But there was one market that closed down that day—the Johannes- burg exchange index. The reason? That is the one equity mar- ket in the world, at least at that time, that was dominated by the value of gold—that substance to which many investors run when the world is at risk (as in the spring of 2011), or flee when all seems to be returning to calm.
GLOBAL FINANCE IN PRACTICE 16.1
Market Correlations and Extraordinary Events
correlations as a result of singular events. A low average correlation over a series of years may prove to be little comfort for those suffering a highly correlated market decline from a singular global disaster.
450 CHAPTER 16 International Portfolio Theory and Diversification
Exhibit 16.8 presents a comparison of correlation coefficients between major global equity markets over a variety of different periods. The comparison yields a number of conclusions and questions:
! The correlation between equity markets for the full twentieth century shows quite low levels of correlation between some of the largest markets (for example, .55 between the U.S. and U.K.).
! That same century of data, however, yields a high correlation between the U.S. and Canada (.80) which is relatively high compared to other pairs, but not as high as one might suspect for such highly integrated economies.
! The correlation coefficients between those same equity markets for selected sub- periods over the last quarter of the twentieth century, however, show significantly different correlation coefficients. For example, the 1977–1986 period finds five of the seven market pairs with lower correlations than the century averages.
! When moving from the 1977–1986 period to the 1987–1996 period, six of the seven pairs show higher correlations. This tendency continues when moving from the 1987–1996 period to the 1996–2000 period, when six of the seven pair correlations once again increase.
So what does the future hold for market correlations? Many equity market futurists believe that the digitally integrated global marketplace, combined with the spread of equity cross-listings will probably cause a significant increase in market correlations. Only time—and data—will tell.
Market Performance Adjusted for Risk: The Sharpe and Treynor Performance Measures Although Exhibits 16.7 and 16.8 provided some insights into the long-term historical performance of individual national markets and key assets, they do not provide a complete picture of how returns and risks must be considered in combination. Exhibit 16.9 presents
EXHIBIT 16.8 Equity Market Correlations Over Time
Correlation Estimates for Selected Subperiods
Correlation Between Dimson et al*
1900–2000 Authors’ MSCI**
1977–1986 Authors’ MSCI**
1987–1996 Dimson et al*
1996–2000
U.S. and Canada 0.80 0.66 0.77 0.78
U.S. and Denmark 0.38 0.26 0.18 0.46
U.S. and France 0.36 0.37 0.55 0.56
U.S. and Germany 0.12 0.24 0.42 0.56
U.S. and Japan 0.21 0.16 0.26 0.49
U.S. and Switzerland 0.50 0.38 0.47 0.44
U.S. and U.K. 0.55 0.40 0.67 0.67
Average 0.42 0.35 0.47 0.57
Sources: *Coefficients drawn from Triumph of the Optimists, 101 Years of Global Investment Returns, by Dimson, March, and Staunton, Princeton University Press, 2002, p. 15; **Authors calculations using data extracted over multiple issues of Morgan Stanley Capital International.
451International Portfolio Theory and Diversification CHAPTER 16
EXHIBIT 16.9 Summary Statistics of the Monthly Returns for 18 Major Stock Markets, 1977–1996 (all returns converted into U.S. dollars and include all dividends paid)
Mean Return (%)
Standard Deviation (%) Beta (Bi)
Sharpe M. (SHPi)
Treynor M. (TRNi)
Australia 1.00 7.44 1.02 0.078 0.0057
Austria 0.77 6.52 0.54 0.055 0.0066
Belgium 1.19 5.53 0.86 0.141 0.0091
Canada 0.82 5.34 0.93 0.076 0.0044
Denmark 0.99 6.25 0.68 0.092 0.0085
France 1.18 6.76 1.08 0.113 0.0071
Germany 0.97 6.17 0.84 0.089 0.0065
Hong Kong 1.50 9.61 1.09 0.113 0.0100
Italy 0.96 7.57 0.89 0.071 0.0061
Japan 1.08 6.66 1.21 0.099 0.0055
Netherlands 1.39 4.93 0.89 0.197 0.0109
Norway 1.00 7.94 1.02 0.073 0.0057
Singapore 1.09 7.50 1.01 0.090 0.0057
Spain 0.83 6.81 0.94 0.060 0.0044
Sweden 1.37 6.67 0.97 0.143 0.0099
Switzerland 1.10 5.39 0.86 0.127 0.0080
United Kingdom 1.35 5.79 1.06 0.162 0.0089
United States 1.01 4.16 0.82 0.143 0.0072
Average 1.09 6.51 0.93 0.107 0.0073
The results are computed with stock market data from Morgan Stanley’s Capital International Perspectives, monthly.
summary statistics for the monthly returns across 18 major equity markets for the 1977–1996 period. In addition to the traditional measures of individual market performance of mean return and standard deviation (for risk), the individual national market’s beta to the global portfolio is reported as well as two measures of risk-adjusted returns, the Sharpe and Treynor measures.
Investors should examine returns by the amount of return per unit of risk accepted, rather than in isolation (as in simply mean risks and returns). For example, in Exhibit 16.9, the Hong Kong market had the highest average monthly return at 1.50%, but also the highest risk, a standard deviation of 9.61%. (A major contributing factor to its high volatility was, perhaps, the political uncertainty about the future of the British colony after 1997.)
To consider both risk and return in evaluating portfolio performance, we introduce two measures in Exhibit 16.9, the Sharpe measure (SHP) and the Treynor measure (TRN). The Sharpe measure calculates the average return over and above the risk-free rate of return per unit of portfolio risk:
Sharpe Measure = SHPi = Ri - Rf
si ,
452 CHAPTER 16 International Portfolio Theory and Diversification
where Ri is the average return for portfolio i during a specified time period, Rf is the average risk-free rate of return, and si is the risk of portfolio i. The Treynor measure is very similar, but instead of using the standard deviation of the portfolio’s total return as the measure of risk, it utilizes the portfolio’s beta, bi, the systematic risk of the portfolio, as measured against the world market portfolio:
Treynor Measure = TRNi = Ri - Rf
bi .
The Sharpe measure indicates on average how much excess return (above risk-free rate) an investor is rewarded per unit of portfolio risk the investor bears.
Though the equations of the Sharpe and Treynor measures look similar, the difference between them is important. If a portfolio is perfectly diversified (without any unsystematic risk), the two measures give similar rankings because the total portfolio risk is equivalent to the systematic risk. If a portfolio is poorly diversified, it is possible for it to show a high ranking based on the Treynor measure, but a lower ranking based on the Sharpe measure. The difference is attributable to the low level of portfolio diversification. The two measures, therefore, provide complementary but different information.
Hong Kong Example. The mean return for Hong Kong in Exhibit 16.9 was 1.5%. If we assume the average risk-free rate was 5% per year during this period (or 0.42% per month), the Sharpe measure would be calculated as follows:
SHPHKG = Ri - Rf
si =
0.015 - 0.0042 0.0961
= 0.113.
For each unit (%) of portfolio total risk an investor bore, the Hong Kong market rewarded the investor with a monthly excess return of 0.113% in 1977–1996.
Alternatively, the Treynor measure was
TRNHKG = Ri - Rf
bi =
0.015 - 0.0042 1.09
= 0.0100.
Although the Hong Kong market had the second highest Treynor measure, its Sharpe measure was ranked eighth, indicating that the Hong Kong market portfolio was not very well diversified from the world market perspective. Instead, the highest ranking belonged to the Netherlands market, which had the highest Sharpe (0.197) and Treynor (0.0109) measures.
Does this mean that a U.S. investor would have been best rewarded by investing in the Netherlands market over this period? The answer is yes if the investor were allowed to invest in only one of these markets. It would definitely have been better than staying home in the U.S. market, which had a Sharpe measure of 0.143 for the period. However, if the investor were willing to combine these markets in a portfolio, the performance would have been even better. Since these market returns were not perfectly positively correlated, further risk reduc- tion was possible through diversification across markets.
Are Markets Increasingly Integrated? It is often said that as capital markets around the world become more and more integrated over time, the benefits of diversification will be reduced. To examine this question, we break the 20-year sample period of 1977–1996 into halves: 1977–1986 and 1987–1996. Dividing the periods at 1986, the date coincides with the official movement toward a single Europe. At this time, most European Union countries deregulated their securities markets—or at least began the process of removing remaining restrictions on the free flow of capital across the borders.
453International Portfolio Theory and Diversification CHAPTER 16
Exhibit 16.10 reports selected stock markets’ correlation coefficients with the United States for each subperiod. Only the Danish-U.S. market correlation actually fell from the first to the second period. The Canadian-U.S. correlation rose from an already high 0.66 to 0.77 in the latter period. Similarly, the correlations between the United States and both Singapore and the United Kingdom rose to 0.66 and 0.67, respectively.
The overall picture is that the correlations have increased over time. The answer to the question, “Are markets increasingly integrated?” is most likely “yes.” However, although capital market integration has decreased some benefits of international portfolio diversification, the correlation coefficients between markets are still far from 1.0. There are still plenty of risk-reducing opportunities for international portfolio diversification.
EXHIBIT 16.10 Comparison of Selected Correlation Coefficients Between Stock Markets for Two Different Time Periods (dollar returns)
Correlation to United States 1977–1986 1987–1996 Change
Canada 0.66 0.77 +0.11
Denmark 0.26 0.18 -0.08
France 0.37 0.55 +0.18
Germany 0.24 0.42 +0.18
Hong Kong 0.13 0.61 +0.48
Japan 0.16 0.26 +0.10
Singapore 0.31 0.66 +0.35
Switzerland 0.38 0.47 +0.09
United Kingdom 0.40 0.67 +0.27 Correlation coefficients are computed from data from Morgan Stanley’s Capital International Perspectives.
SUMMARY POINTS
! The total risk of any portfolio is composed of systematic (the market) and unsystematic (the individual securi- ties) risk. Increasing the number of securities in the portfolio reduces the unsystematic risk component but cannot change the systematic risk component.
! An internationally diversified portfolio has a lower portfolio beta. This means that the portfolio’s market risk is lower than that of a domestic portfolio. This situ- ation arises because the returns on the foreign stocks are not closely correlated with returns on U.S. stocks, but rather with a global beta.
! Investors construct internationally diversified portfolios in an attempt to combine assets which are less than per- fectly correlated, reducing the total risk of the portfolio. In addition, by adding assets outside the home market,
the investor has now tapped into a larger pool of poten- tial investments.
! The international investor has actually acquired two additional assets—the currency of denomination and the asset subsequently purchased with the currency— two assets in one in principle, but two in expected returns and risks.
! The foreign exchange risks of a portfolio, whether it be a securities portfolio or the general portfolio of activi- ties of the MNE, are reduced through international diversification.
! The individual investor will search out the optimal domestic portfolio (DP) which combines the risk-free asset and a portfolio of domestic securities found on the efficient frontier. The investor begins with the risk-free asset with
454 CHAPTER 16 International Portfolio Theory and Diversification
return of (and zero expected risk), and moves out along the security market line until reaching portfolio DP.
! This portfolio is defined as the optimal domestic portfolio because it moves out into risky space at the steepest slope—maximizing the slope of expected port- folio return over expected risk—while still touching the opportunity set of domestic portfolios.
! The optimal international portfolio, IP, is found by finding that point on the capital market line (internationally diversified) which extends from the risk-free asset return of Rf to a point of tangency along the internationally diversified efficient frontier.
! The investor’s optimal international portfolio, IP, possesses both higher expected portfolio return and lower expected portfolio risk than the purely domestic optimal portfolio. The optimal international portfolio is superior to the optimal domestic portfolio.
! Risk reduction is possible through international diversification because the returns of different stock
markets around the world are not perfectly positively correlated.
! Because of different industrial structures in different countries and because different economies do not exactly follow the same business cycle, smaller return correlations are expected between investments in different countries than investments within a given country.
! The overall picture is that the correlations have increased over time. Nevertheless, 91 of the 153 correlations (59%) and the overall mean (0.46) were still below 0.5 in 1987–1996. The answer to the question of “are markets increasingly integrated?” is Yes.
! However, although capital market integration has decreased some benefits of international portfolio diversification, the correlation coefficients between markets are still far from 1.0. There are still plenty of risk-reducing opportunities for international portfolio diversification.
Put another way, investors are more volatile than invest- ments. Economic reality governs the returns earned by our businesses, and Black Swans are unlikely. But emotions and perceptions—the swings of hope, greed, and fear among the participants in our financial system— govern the returns earned in our markets. Emotional factors magnify or minimize this central core of economic reality, and Black Swans can appear at any time.
—John C. Bogle, Founder of The Vanguard Group.2
Modern Portfolio Theory (MPT), like all theories, has been subject to much criticism. Most of that criticism is focused either on the failings of the theory’s fundamental assumptions, or in the way the theory and its assumptions have been applied. Ultimately, it has been accused of failing to predict the major financial crises of our time, like Black Monday in 1987, the credit crisis in the United States in 2008, and the current financial crisis over sovereign debt in Europe.
2“Black Monday and Black Swans,” Remarks by John C. Bogle, Founder and Former Chief Executive, The Vanguard Group, before the Risk Management Association, Boca Raton, Florida, October 11, 2007, p. 6.
Criticisms of Modern Portfolio Theory Modern portfolio theory was the creation of Harry Markowitz in which he applied principles of linear programming to the creation of asset portfolios.3 Markowitz demonstrated that an investor could reduce the standard deviation of portfolio returns by combining assets which were less than perfectly correlated in their returns. The theory assumes that all inves- tors have access to the same information at the same time. It assumes all investors are rational and risk averse, and will take on additional risk only if compensated by higher expected returns. It assumes all investors are similarly ratio- nal, although different investors will have different trade-offs between risk and return based on their own risk aversion characteristics. The usual measure of risk used in portfolio theory is the standard deviation of returns, assuming a normal distribution of returns over time.
As one would expect, the criticisms of portfolio theory are pointed at each and every assumption behind the
3H.M. Markowitz, “Portfolio Selection,” Journal of Finance, volume 7, March 1952, pp. 77–91.
Portfolio Theory, Black Swans, and [Avoiding] Being the Turkey1
1Copyright © 2012 Thunderbird School of Global Management. All rights reserved. This case was prepared by Professor Michael H. Moffett for the purpose of classroom discussion only and not to indicate either effective or ineffective management.
MINI-CASE
455International Portfolio Theory and Diversification CHAPTER 16
the discovery of Australia and the existence of black swans, all swans were thought to be white. Black swans did not exist because no one had ever seen one. But that did not mean they did not exist. Taleb then applied this premise to financial markets, arguing that simply because a specific event had never occurred did not mean it couldn’t.
Taleb argued that a black swan event is characterized by three fundamentals, in order: rarity, extremeness, and retrospective predictability:
1. Rarity: The event is a shock or surprise to the observer.
2. Extremeness: The event has a major impact.
3. Retrospective Predictability: After the event has occurred, the event is rationalized by hindsight, and found to have been predictable.
Although the third argument is a characteristic of human intellectual nature, it is the first element that is fundamental to the debate. If an event has not been recorded, does that mean it cannot occur? Portfolio theory is a mathematical analysis of provided inputs. Its outcomes are no better than its inputs. The theory itself does not predict price movements. It simply allows the identification of portfolios in which the risk is at a minimum for an expected level of return.
Taleb does not argue that he has some secret ability to predict the future when historical data cannot. Rather, he argues that investors should structure their portfolios, their investments, to protect against the extremes, the improbable events rather than the probable ones. He argues for what many call “investment humility,” to acknowledge that the world we live in is not always the one we think we live in, and to understand how much we will never understand.
What Drives the Improbable? So what causes the “random jumps” noted by Mandelbrot and Taleb? A number of investment theorists, including John Maynard Keynes and John Bogle, have argued over the past century that equity returns are driven by two fundamental forces, enterprise (economic or business returns over time) and speculation (the psychology or emotions of the individuals in the market). First Keynes and then Bogle eventually concluded that speculation would win out over enterprise, very much akin to arguing that hope will win out over logic. This is what Bogle means
6Nassim Nicholas Taleb, Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets, Random House, 2001. He later extended his premise to many other fields beyond finance in The Black Swan: The Impact of the Highly Improbable, Random House, 2007.
theory. For example, the field of behavioral economics argues that investors are not necessarily rational—that in some cases, gamblers buy risk. All investors do not have access to the same information, insider trading persists, some investors are biased, and some investors regu- larly beat the market through market timing. Even the mathematics comes under attack, as to whether standard deviations are the appropriate measure of risk to minimize, or whether the standard normal distribution is appropriate.
Many of the major stock market collapses in recent history, like that of Black Monday’s crash on October 19, 1987, when the Dow fell 23%, were “missed” by the purveyors of portfolio strategy. Statistical studies of markets and their returns over time often show returns that are not normally distributed, but are subject to greater deviation from the mean than traditional normal distributions—evidence of so-called fat tails. Much of the work of Benoit Mandelbrot, the father of fractal geometry, revolved around the possibility that financial markets exhibited fat-tail distributions. Mandelbrot’s analysis in fact showed that the Black Monday event was a 20-sigma event, one which according to normal distributions (bell curve or Gaussian model), was so improbable as not likely to ever occur.4 And if something has not happened in the past, portfolio theory assumes it cannot happen in the future. Yet it did.
The argument and criticism which has been deployed with the greatest traction seems to be that portfolio theory is typically executed using historical data—the numbers from the past—assuming a distribution which the data does not fit.
Any attempts to refine the tools of modern portfolio theory by relaxing the bell curve assumptions, or by “fudging” and adding the occasional “jumps” will not be sufficient. We live in a world primarily driven by random jumps, and tools designed for random walks address the wrong problem. It would be like tinkering with models of gases in an attempt to characterize them as solids and call them “a good approximation”5
Black Swan Theory Nassim Nicholas Taleb published a book in 2001 entitled Fooled by Randomness in which he introduced the analogy of the black swan.6 The argument is quite simple: prior to
4For a more detailed discussion see Richard L. Hudson and Benoit B. Mandelbrot, The (Mis)Behavior of Markets: A Fractal View of Risk, Ruin, and Reward, Basic Books, 2004. 5Benoit Mandelbrot and Nassim Taleb, “A focus on the exceptions that prove the rule,” Financial Times, March 23, 2006.
if it is generally based on the past. Kenneth Arrow, a famed economist and Nobel Prize winner relayed the following story of how during the Second World War a group of statisticians were tasked with forecasting weather patterns.
The statisticians subjected these forecasts to verification and found they differed in no way from chance. The forecasters themselves were convinced and requested that the forecasts be discontinued. The reply read approxi- mately like this: “The Commanding General is well aware that the forecasts are no good. However, he needs them for planning purposes.”7
Taleb, in a recent edition of Black Swan Theory, notes that the event is a surprise to the specific observer, and that what is a surprise to the turkey is not a surprise to the butcher. The challenge is “to avoid being the turkey.”
Case Questions 1. What are the primary assumptions behind modern
portfolio theory?
2. What do many of MPT’s critics believe are the funda- mental problems with the theory?
3. How would you suggest MPT be used in investing your own money?
7“I Know a Hawk from a Handsaw,” Eminent Economists: Their Life Philosophies, edited by Michael Szenberg, Cambridge University Press, 1992, p. 47.
in the opening quotation when he states that “investors are more volatile than investments.”
All agree that the behavior of the speculators (in the words of Keynes) or the jumps of market returns (in the words of Mandelbrot) are largely unpredictable. And all that one can do is try to protect against the unpredictable by building more robust systems and portfolios than can hopefully withstand the improbable. But most also agree that the “jumps” are exceedingly rare, and depending upon the holding period, the market may return to more fundamental values, if given the time. But the event does indeed have a lasting impact.
Portfolio theory remains a valuable tool. It allows inves- tors to gain approximate values over the risk and expected returns they are likely to see in their total positions. But it is fraught with failings, although it is not at all clear what would be better. Even some of history’s greatest market timers have noted that they have followed modern port- folio theory, but have used subjective inputs on what is to be expected in the future. Even Harry Markowitz, on the last page of the same article which started it all, Portfolio Selection, noted that “… in the selection of securities we must have procedures for finding reasonable ri and sij. These procedures, I believe, should combine statistical techniques and the judgment of practical men.”
But the judgment of practical men is—well— difficult to validate. We need predictions of what may come, even
456 CHAPTER 16 International Portfolio Theory and Diversification
QUESTIONS 1. Diversification Benefits. How does the diversification
of a portfolio change its expected returns and expected risks? Is this in principle any different for internationally diversified portfolios?
2. Risk Reduction. What types of risk are present in a diversified portfolio? Which type of risk remains after the portfolio has been diversified?
3. Measurement of Risk. How, according to portfolio theory, is the risk of the portfolio measured exactly?
4. Market Risk. If all national markets have market risk, is all market risk the same?
5. Currency Risk. The currency risk associated with international diversification is a serious concern for portfolio managers. Is it possible for currency risk ever to benefit the portfolio’s return?
6. Optimal Domestic Portfolio. Define in words (without graphics) how the optimal domestic portfolio is constructed.
7. Minimum Risk Portfolios. If the primary benefit of portfolio diversification is risk reduction, is the investor always better off choosing the portfolio with the lowest expected risk?
8. International Risk. Many portfolio managers, when asked why they do not internationally diversify their portfolios, answer that “the risks are not worth the expected returns.” Using the theory of international diversification, how would you evaluate this statement?
9. Correlation Coefficients. The benefits of portfolio construction, domestically or internationally, arise from the lack of correlation among assets and markets. The increasing globalization of business is expected
457International Portfolio Theory and Diversification CHAPTER 16
the three Baltic republics. Calculate the Sharpe and Treynor measures of market performance.
to change these correlations over time. How do you believe they will change and why?
10. Relative Risk and Return. Conceptually, how do the Sharpe and Treynor performance measures define risk differently? Which do you believe is a more use- ful measure in an internationally diversified portfolio?
11. International Equities and Currencies. As the newest member of the asset allocation team in your firm, you constantly find yourself being quizzed by your fellow group members. The topic is international diversification. One analyst asks you the following question:
Security prices are driven by a variety of factors, but corporate earnings are clearly one of the primary drivers. And corporate earnings—on average— follow business cycles. Exchange rates, as you learned in college, reflect the market’s assessment of the growth prospects for the economy behind the currency. So if securities go up with the business cycle, and currencies go up with the business cycle, why do we see currencies and securities prices across the globe not going up and down together?
What is the answer?
12. Are MNEs Global Investments? Firms with opera- tions and assets across the globe, true MNEs, are in many ways as international in composition as the most internationally diversified portfolio of unre- lated securities. Why do investors not simply invest in MNEs traded on their local exchanges and forgo the complexity of purchasing securities traded on foreign exchanges?
13. ADRs Versus Direct Holdings. When you are con- structing your portfolio, you know you want to include Cementos de Mexico (Mexico), but you cannot decide whether you wish to hold it in the form of ADRs traded on the NYSE or directly through purchases on the Mexico City Bolsa. a. Does it make any difference in regard to currency
risk? b. List the pros and cons of ADRs and direct
purchases. c. What would you recommend if you were an asset
investor for a corporation with no international operations or internationally diversified holdings?
PROBLEMS 1. The Baltic Sea. Assume the U.S. dollar returns
(monthly averages) shown in the following table for
Market Mean
Return (R ) Risk-Free Rate (R f )
Standard Deviation (S)
Country Beta ( B)
Estonia 1.12% 0.42% 16.00% 1.65
Latvia 0.75% 0.42% 22.80% 1.53
Lithuania 1.60% 0.42% 13.50% 1.20
Assumptions Expected
Return Expected Risk (S)
Correlation (R)
Google (U.S) 18.60% 22.80% 0.60
Vodafone (U.K.) 16.00% 24.00%
2. Google and Vodafone. An investor is evaluating a two-asset portfolio of the following securities:
a. If the two securities have a correlation of +0.6, what is the expected risk and return for a portfolio that is equally weighted?
b. If the two securities have a correlation of +0.6, what is the expected risk and return for a portfolio that is 70% Google and 30% Vodafone?
c. If the two securities have a correlation of +0.6, what is the expected risk and return for a portfolio that has the minimum combined risk.
3. Tutti-Frutti Equity Fund. An investor is evaluating a two-asset portfolio of the following securities:
Security Expected
Return Expected Risk
(S) Correlation
(R)
Tutti Equities 12.50% 26.40% 0.72
Frutti Equities 10.80% 22.50%
a. If the two equity funds have a correlation of +0.72, what is the expected risk and return for the following portfolio weightings?
Portfolio A: 75% Tutti, 25% Frutti Portfolio B: 50% Tutti, 50% Frutti Portfolio C: 25% Tutti, 75% Frutti b. Which of the portfolios is preferable? On what
basis?
4. Spiegel Chemikalie. Oriol Almenara is a Euro- pean analyst and strategist for Mirror Funds, a New York-based mutual fund company. Oriol is currently
458 CHAPTER 16 International Portfolio Theory and Diversification
7. Bastion Technology: Euro-Based Investors (B). Using the same data—but assume an exchange rate which began at €1.4844/£ in June 2008, and then consis- tently appreciated versus the euro 1.50% per year for the entire period. Calculate the annual average total return (including dividends) to a euro-based investor holding the shares for the entire period shown. What is the average return, including dividend distributions, to a euro-based investor for the period shown?
8. Bastion Technology: U.S. Dollar-Based Investors (A). Using the same data, calculate the annual average total return (including dividends) to a U.S. dollar- based investor holding the shares for the entire period shown. Assume an investment of $100,000. What is the average return, including dividend distributions, to a U.S. dollar-based investor for the period shown?
9. Bastion Technology: U.S. Dollar-Based Investors (B). Use the same data, but assume an exchange rate which began at $1.8160/£ in June 2008, and then consistently appreciated versus the U.S. dollar 3.0% per year for the entire period. Calculate the annual average total return (including dividends) to a U.S. dollar-based investor holding the shares for the entire period shown. What is the average return, including dividend distributions, to a U.S. dollar-based investor for the period shown?
10. Kamchatka-Common Equity Portfolio (A). An investor is evaluating a two-asset portfolio that combines a U.S. equity fund with a Russian equity fund. The expected returns, risks, and correlation coefficients for the coming one-year period are as follows:
evaluating the recent performance of shares in Spie- gel Chemikalie, a publicly traded specialty chemical company in Germany listed on the Frankfurt DAX. The baseline investment amount used by Mirror is $200,000.
Element Jan 1
Purchase Dec 31
Sale Distributions
Share price, euros €135.00 €157.60 €15.00
Exchange rate, US$/euro
$1.3460 $1.4250
a. What was the return on the security in local currency terms?
b. What was the return on the security in U.S. dollar terms?
c. Does this mean it was a good investment for a local investor, a U.S.-based investor, or both?
Bastion Technology is an information technology services provider. It currently operates primarily within the European marketplace, and therefore is not active or traded on any North American Stock Exchange. The company’s share price and dividend distributions have been as follows in recent years:
Assumptions 6/30/2008 6/30/2009 6/30/2010 6/30/2011
Share price (£) 37.40 42.88 40.15 44.60
Dividend (£) 1.50 1.60 1.70 1.80
Spot rate ($/£) 1.8160 1.7855 1.8482 2.0164
Spot rate (€/£) 1.4844 1.4812 1.4472 1.4845
5. Bastion Technology: British Pound-Based Investors. Using the data above, calculate the annual average capital appreciation rate on Bastion shares, as well as the average total return (including dividends) to a British pound-based investor holding the shares for the entire period shown.
6. Bastion Technology: Euro-Based investors (A). Using the same data, calculate the annual average total return (including dividends) to a euro-based investor holding the shares for the entire period shown. Assume an investment of €100,000. What is the average return, including dividend distributions, to a euro-based investor for the period shown?
Assumptions Expected
Return Expected Risk
(S) Correlation
(R)
Common equity fund (United States)
10.50% 18.60% 0.52
Kamchatka equity fund (Russia)
16.80% 36.00%
Assuming the expected correlation coefficient is 0.52 for the coming year, which weights (use increments of 5% such as 95/5, 90/10) result in the best trade-off between expected risk and expected return?
11. Kamchatka-Common Equity Portfolio (B). Rework problem 10, but assume that you have reduced the expected correlation coefficient from 0.52 to 0.38.
459International Portfolio Theory and Diversification CHAPTER 16
differs significantly. Use the Web sites of any of the major mutual fund providers (Fidelity, Scudder, Merrill Lynch, Kemper, etc.) and any others of interest, to do the following: a. Distinguish between international funds, global
funds, worldwide funds, and overseas funds b. Determine how international funds have been
performing, in U.S. dollar terms, relative to mutual funds offering purely domestic portfolios
c. Use the Security and Exchange Commission’s Web site, www.sec.gov/pdf/ininvest.pdf, to review the risk-return issues related to international investing
2. Yahoo! Finance Investment Learning Center. Yahoo! Finance provides detailed current basic and advanced research and reading materials related to all aspects of investing, including portfolio management. Use its Web site to refresh your memory on the benefits—and risks—of portfolio diversification.
Yahoo! Finance Learning biz.yahoo.com/edu/ ed_begin.html
3. FT.com Beyond BRICs. The Financial Times center on the performance of emerging market securities provides a wealth of information on current market developments in a wide span of emerging market financial instruments and markets. Use it to review new equity and fixed income opportunities in this growing investment sector.
FT.com beyondbrics http://blogs.ft.com/ beyond-brics/
Which weights (use increments of 5% such as 95/5, 90/10) result in the best trade-off between expected risk and expected return?
12. Brazilian Investors Diversify. The Brazilian econ- omy in 2001 and 2002 had gone up and down. The Brazilian reais (R$) had also been declining since 1999 (when it was floated). Investors wished to diversify internationally—into U.S. dollars for the most part— to protect themselves against the domestic economy and currency. A large private investor had, in April 2002, invested R$500,000 in Standard and Poor’s 500 Indexes, which are traded on the American Stock Exchange (AMSE: SPY). The beginning and ending index prices and exchange rates between the reais and the dollar were as follows:
Element April 10, 2002
Purchase April 10, 2003
Sale
Share price of SPYDERS (U.S. dollars)
$112.60 $87.50
Exchange rate (Reais/$) 2.27 3.22
a. What was the return on the index fund for the year to a U.S.-based investor?
b. What was the return to the Brazilian investor for the one-year holding period? If the Brazilian investor could have invested locally in Brazil in an interest-bearing account guaranteeing 12%, would that have been better than the American diversification strategy?
INTERNET EXERCISES 1. International Diversification via Mutual Funds. All
major mutual fund companies now offer a variety of internationally diversified mutual funds. The degree of international composition across funds, however,
460
Foreign Direct Investment and Political Risk
People don’t want a quarter-inch drill. They want a quarter-inch hole.
—Theodore Levitt, Harvard Business School.
The strategic decision to undertake foreign direct investment (FDI), and thus become an MNE, starts with a self-evaluation. This self-evaluation combines a series of questions including the nature of the firm’s competitive advantage, what business form and commensurate risks the firm should use and accept upon entry, and what political risks—both macro and micro in context—the firm will be facing. This chapter explores this sequence of self-evaluation, as well as methods for both measuring and managing the political risks confronting MNEs today in both the established industrial markets and the most promising emerging markets. The Mini-Case at the end of this chapter, Corporate Competition from the Emerging Markets, highlights the growing complexity of emerging market competitiveness in the global economy, and how many of tomorrow’s most competitive MNEs may be arising from the emerging markets themselves.
Sustaining and Transferring 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. 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 tech- nology owing to their heavy emphasis on research; 4) financial strength; 5) differentiated products; and sometimes 6) competitiveness of their home markets.
Economies of Scale and Scope Economies of scale and scope can be developed in production, marketing, finance, research and development, transportation, and purchasing. All of these areas have sig- nificant competitive advantages of being large, whether size is due to international or domestic operations. Production economies can come from the use of large-scale auto- mated plant and equipment or from an ability to rationalize production through global specialization.
CHAPTER 17
461Foreign Direct Investment and Political Risk CHAPTER 17
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 global brand identification, as well as to establish global distribution, ware- housing, and servicing systems. Financial economies derive from access to the full range of financial instruments and sources of funds, such as the 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.
Managerial and Marketing Expertise Managerial expertise includes skill in managing large industrial organizations from both a human and a technical viewpoint. It also encompasses knowledge of modern analytical tech- niques and their application in functional areas of business. Managerial expertise can be devel- oped through prior experience in foreign markets. In most empirical studies, multinational firms have been observed to export to a market before establishing a production facility there. Likewise, they have prior experience sourcing raw materials and human capital in other for- eign countries either through imports, licensing, or FDI. In this manner, the MNEs can partially overcome the supposed superior local knowledge of host-country firms.
Advanced Technology Advanced technology includes both scientific and engineering skills. It is not limited to MNEs, but firms in the most industrialized countries have had an advantage in terms of access to continuing new technology spin-offs from the military and space programs. Empirical studies have supported the importance of technology as a characteristic of MNEs.
Financial Strength Companies demonstrate financial strength by achieving and maintaining a global cost and availability of capital. This is a critical competitive cost variable that enables them to fund FDI and other foreign activities. MNEs that are resident in liquid and unsegmented capital markets are normally blessed with this attribute. However, MNEs that are resident in small industrial or emerging market countries can still follow a proactive strategy of seeking foreign portfolio and corporate investors.
Small- and medium-size firms often lack the characteristics that attract foreign (and maybe domestic) investors. They are too small or unattractive to achieve a global cost of capital. This limits their ability to fund FDI, and their higher marginal cost of capital reduces the number of foreign projects that can generate the higher required rate of return.
Differentiated Products Firms create their own firm-specific advantages by producing and marketing differentiated products. Such products originate from research-based innovations or heavy marketing expen- ditures to gain brand identification. Furthermore, the research and marketing process con- tinues to produce a steady stream of new differentiated products. It is difficult and costly for competitors to copy such products, and they always face a time lag if they try. Having devel- oped differentiated products for the domestic home market, the firm may decide to market them worldwide, a decision consistent with the desire to maximize return on heavy research and marketing expenditures.
462 CHAPTER 17 Foreign Direct Investment and Political Risk
Competitiveness of the Home Market 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 “competi- tive advantage of nations,” a concept originated by Michael Porter of Harvard, and summarized in Exhibit 17.1.1
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.
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 who enjoy access to educational institutions at the forefront of knowledge.
A competitive home market forces firms to fine-tune their operational and control strate- gies 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.
1Michael Porter, The Competitive Advantage of Nations, London: Macmillan Press, 1990.
Factor Conditions
Demand Conditions
Related Industries
Firm Strategy, Structure and Rivalry
Source: Based on concepts described by Michael Porter in “The Competitive Advantage of Nations,” Harvard Business Review, March–April 1990.
A firm’s competitiveness can be significantly strengthened based on its having competed in a highly competitive home market. Home country competitive advantage must be based on at least one of four critical components.
The nature of local customers—customers that are demanding, diligent, sophisticated, focused on specific issues of quality or safety—all build competitiveness.
A firm that has competed successfully in a local market, which requires an integration of related suppliers and partner firms, including government, is advantaged.
Many of the world’s most competitive firms have learned to adapt to local markets in different ways, altering strategy and structure to find the best fit for profitable growth.
The factors of production—land, labor, capital, technology— that are core to the specific industry might include specific labor skill sets or complex technology support.
EXHIBIT 17.1 Determinants of National Competitive Advantage: Porter’s Diamond
463Foreign Direct Investment and Political Risk CHAPTER 17
In some cases, host-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 into this category. They include 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).
Emerging market countries have also spawned aspiring global MNEs in niche markets even though they lack competitive home-country markets. Some of these are traditional exporters in natural resource fields such as oil, agriculture, and minerals, but they are in transition to becoming MNEs. They typically start with foreign sales subsidiaries, joint ven- tures, and strategic alliances. Examples are Petrobrás (Brazil), YPF (Argentina), and Cemex (Mexico). Another category is firms that have been recently privatized in the telecommunica- tions industry. Examples are Telefonos de Mexico and Telebrás (Brazil). Still others started as electronic component manufacturers but are making the transition to manufacturing abroad. Examples are Samsung Electronics (Korea) and Acer Computer (Taiwan).
The OLI Paradigm and Internalization The OLI Paradigm (Buckley and Casson, 1976; Dunning, 1977) is an attempt to create an overall framework to explain why MNEs choose FDI rather than serve foreign markets through alternative modes such as licensing, joint ventures, strategic alliances, management contracts, and exporting.2
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 char- acteristics 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.
Definitions. The “O” in OLI stands for owner-specific advantages. As described earlier, a firm must have competitive advantages in its home market. These must be firm-specific, not easily copied, and in a form that allows them to be transferred to foreign subsidiaries. For example, economies of scale and financial strength are not necessarily firm-specific because they can be achieved by many other firms. Certain kinds of technology can be purchased, licensed, or copied. Even differentiated products can lose their advantage to slightly altered versions, given enough marketing effort and the right price.
The “L” in OLI stands for location-specific advantages. These factors are typically market imperfections or genuine comparative advantages that attract FDI to particular locations. These factors might include a low-cost but productive labor force, unique sources of raw materials, a large domestic market, defensive investments to counter other competitors, or centers of technological excellence.
The “I” in OLI stands for internalization. According to the theory, the key ingredient for maintaining a firm-specific competitive advantage is possession of proprietary information
2Peter J. Buckley and Mark Casson, The Future of the Multinational Enterprise, London: Macmillan, 1976; and John H. Dunning, “Trade Location of Economic Activity and the MNE: A Search for an Eclectic Approach,” in The International Allocation of Economic Activity, Bertil Ohlin, Per-Ove Hesselborn, and Per Magnus Wijkman, eds., New York: Holmes and Meier, 1977, pp. 395–418.
464 CHAPTER 17 Foreign Direct Investment and Political Risk
and control of the human capital that can generate new information through expertise in research. Needless to say, once again, large research-intensive firms are most likely to fit this description.
Minimizing transactions costs is the key factor in determining the success of an internalization strategy. Wholly owned FDI reduces the agency costs that arise from asym- metric information, lack of trust, and the need to monitor foreign partners, suppliers, and financial institutions. Self-financing eliminates the need to observe specific debt covenants on foreign subsidiaries that are financed locally or by joint venture partners. If a multi- national firm has a low global cost and high availability of capital, why share it with joint venture partners, distributors, licensees, and local banks, all of which probably have a higher cost of capital?
The Financial Strategy Financial strategies are directly related to the OLI Paradigm in explaining FDI, as shown in Exhibit 17.2. 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.
Reactive financial strategies, as illustrated in Exhibit 17.2, 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.
Ownership Advantages
Location Advantages
Internationalization Advantages
Source: Constructed by authors based on “On the Treatment of Finance-Specific Factors Within the OLI Paradigm,” by Lars Oxelheim, Arthur Stonehill, and Trond Randøy, International Business Review 10, 2001, pp. 381-398.
Competitive sourcing of capital globally Strategic cross-listing Accounting & disclosure transparency Maintaining financial relationships Maintaining competitive credit rating
Competitive sourcing of capital globally Maintaining competitive credit rating Negotiating tax & financial subsidies
Exploiting exchange rates Exploiting stock prices Reacting to capital controls Minimizing taxation
Minimizing taxation Maintaining competitive credit rating Reducing agency costs through FDI
Reactive Financial Strategies
Proactive Financial Strategies
EXHIBIT 17.2 Finance-Specific Factors and the OLI Paradigm
465Foreign Direct Investment and Political Risk CHAPTER 17
Deciding Where to Invest The decision about where to invest abroad is influenced by behavioral factors. The decision about where to invest abroad for the first time is not the same as the decision about where to reinvest abroad. A firm learns from its first few investments abroad and what it learns influences subsequent investments.
In theory, a firm should identify its competitive advantages. Then it should search world- wide for market imperfections and comparative advantage until it finds a country where it expects to enjoy a competitive advantage large enough to generate a risk-adjusted return above the firm’s hurdle rate.
In practice, firms have been observed to follow a sequential search pattern as described in the behavioral theory of the firm. Human rationality is bounded by one’s ability to gather and process all the information that would be needed to make a perfectly rational decision based on all the facts. This observation lies behind two behavioral theories of FDI described next—the behavioral approach and the international network theory.
The Behavioral Approach to FDI The behavioral approach to analyzing the FDI decision is typified by the so-called Swedish School of economists.3 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. 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 invest- ments 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.
MNEs in a Network Perspective 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 (hierar- chical) control has given way to decentralized (heterarchical) control. Foreign subsidiaries compete with each other and with the parent for expanded resource commitments, thus influ- encing 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 coali- tion of investors located in different countries.4
3Johansen, John, and F. Wiedersheim-Paul, “The Internationalization of the Firm: Four Swedish Case Studies,” Journal of Management Studies, Vol. 12, No. 3, 1975; and John Johansen and Jan Erik Vahlne, “The International- ization of the Firm: A Model of Knowledge Development and Increasing Foreign Market Commitments,” Journal of International Business Studies, Vol. 8, No. 1, 1977. 4Forsgren, Mats, Managing the Internationalization Process: The Swedish Case, London: Routledge, 1989.
466 CHAPTER 17 Foreign Direct Investment and Political Risk
Asea Brown Boveri (ABB) is an example of a Swedish-Swiss firm that has passed through the international evolutionary process all the way to being a transnational firm. ABB was formed through a merger of Sweden-based ASEA and Switzerland-based Brown Boveri in 1991. Both firms were already dominant players internationally in the electrotechnical and engineering industries. ABB has literally hundreds of foreign subsidiaries, which are managed on a very decentralized basis. ABB’s “flat” organization structure and transnational owner- ship encourage local initiative, quick response, and decentralized FDI decisions. Although overall strategic direction is the legal responsibility of the parent firm, foreign subsidiaries play a major role in all decision-making. Their input in turn is strongly influenced by their own membership in their local and worldwide industry networks. Despite all the planning and analysis that goes with FDI, MNEs are still often confronted with unexpected challenges.
How to Invest Abroad: Modes of Foreign Involvement The globalization process includes a sequence of decisions regarding where production is to occur, who is to own or control intellectual property, and who is to own the actual production facilities. Exhibit 17.3 provides a road map to explain this FDI sequence.
The Firm and Its Competitive Advantage
Greater Foreign Investment
Greater Foreign Presence
Production Abroad
Control Assets Abroad
Wholly Owned Subsidiary
Acquisition of a Foreign Enterprise
Exploit Existing Competitive Advantage Abroad
Production at Home: Exporting
Licensing Management Contract
Joint Venture
Greenfield Investment
Change Competitive Advantage
Source : Adapted from Gunter Dufey and R. Mirus, “Foreign Direct Investment: Theory and Strategic Considerations,” unpublished, University of Michigan, 1985. Reprinted with permission from the authors. All rights reserved.
EXHIBIT 17.3 The FDI Sequence: Foreign Presence and Investment
467Foreign Direct Investment and Political Risk CHAPTER 17
Exporting Versus Production 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 involve- ment. 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 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.
Licensing and Management Contracts Versus Control of Assets Abroad Licensing is a popular method for domestic firms to profit from foreign markets without the need to commit sizable funds. Since 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.
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
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 licens- ing 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 prob- ably lessen political risk because repatriation of managers is easy. International consulting and engineering firms traditionally conduct their foreign business based on 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 con- tinuing to prefer FDI, we must assume that the price for selling unbundled services is still too low.
468 CHAPTER 17 Foreign Direct Investment and Political Risk
Why is the price of unbundled services too low? The answer may lie in the synergy created when services are bundled as FDI in the first place. Managerial expertise is often dependent on a delicate mix of organizational support factors that cannot be transferred abroad effi- ciently. Technology is a continuous process, but licensing usually captures only the technology at a particular time. Most important of all, however, economies of scale cannot be sold or transferred in small bundles. By definition, they require large-scale operations. A relatively large operation in a small market can hardly achieve the same economies of scale as a large operation in a large market.
Despite the handicaps, some MNEs have successfully sold unbundled services. An example is sales of managerial expertise and technology to the OPEC countries. In this case, however, the OPEC countries are both willing and able to pay a price high enough to approach the returns on FDI (bundled services) while receiving only the lesser benefits of the unbundled services.
Joint Venture Versus Wholly Owned Subsidiary A joint venture (JV) is defined here as shared ownership in a foreign business. A foreign busi- ness 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 par- ent company is typically designated a foreign subsidiary. A JV would therefore typically be described as 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 partner. Some of the obvious advantages of having a compatible local partner are as follows:
! 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. (Greenfield projects are started with a clean slate, having no prior history of development.)
! The local partner can provide competent management, not just at the top but also at the middle levels of management.
! 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.
! The local partner’s contacts and reputation enhance access to the host-country’s capital markets.
! The local partner may possess technology that is appropriate for the local environment or perhaps can be used worldwide.
! 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 sub- optimal for the multinational operation as a whole. The most important potential conflicts or difficulties are these:
! Political risk is increased rather than reduced if the wrong partner is chosen. The local partner must be credible and ethical or the venture is worse off for being a joint venture.
! 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.
469Foreign Direct Investment and Political Risk CHAPTER 17
! Transfer pricing on products or components bought from or sold to related compa- nies creates a potential for conflict of interest.
! 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.
! 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.
! 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.
Valuation of equity shares is difficult. How much should the local partner pay for its share? What is the value of contributed technology, or of contributed land in a country where all land is state owned? It is highly unlikely that foreign and host-country partners have similar opportunity costs of capital, expectations about the required rate of return, or similar percep- tions of appropriate premiums for business, foreign exchange, and political risks. Insofar as the venture is a component of the portfolio of each investor, its contribution to portfolio return and variance may be quite different for each.
Strategic Alliances 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, telecommu- nications, 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.
Political Risk In addition to business and foreign exchange risks, foreign direct investment faces politi- cal risks. How can multinational firms anticipate government regulations that, from the firm’s perspective, are discriminatory or wealth depriving? Normally a twofold approach is utilized.
At the macro level, firms attempt to assess a host country’s political stability and atti- tude toward foreign investors. At the micro level, firms analyze whether their firm-specific activities are likely to conflict with host-country goals as evidenced by existing regulations. The most difficult task, however, is to anticipate changes in host-country goal priorities, new regulations to implement reordered priorities, and the likely impact of such changes on the firm’s operations.
470 CHAPTER 17 Foreign Direct Investment and Political Risk
Defining and Classifying Political Risk In order for an MNE to identify, measure, and manage its political risks, it needs to define and classify these risks. Exhibit 17.4 classifies the political risks facing MNEs as being firm-specific, country-specific, or global-specific.
! Firm-specific risks, also known as micro risks, are those that affect the MNE at the project or corporate level. Governance risk due to goal conflict between an MNE and its host government is the main political firm-specific risk.
! Country-specific-risks, also known as macro risks, are those that affect the MNE at the project or corporate level but originate at the country level. The two main political risk categories at the country level are transfer risk and cultural and institu- tional risks. Cultural and institutional risks spring from ownership structure, human resource norms, religious heritage, nepotism and corruption, intellectual property rights, and protectionism.
! Global-specific risks are those that affect the MNE at the project or corporate level but originate at the global level. Examples are terrorism, the antiglobalization movement, environmental concerns, poverty, and cyber attacks.
This method of classification differs sharply from the traditional method that classifies risks according to the disciplines of economics, finance, political science, sociology, and law. We prefer our classification system because it is easier to relate the identified political risks to existing and recommended strategies to manage these risks.
Predicting Firm-Specific Risk (Micro Risk) From the viewpoint of a multinational firm, assessing the political stability of a host country is only the first step, since the real objective is to anticipate the effect of political changes on activities of a specific firm. Indeed, different foreign firms operating within the same country may have very different degrees of vulnerability to changes in host-country policy or regula- tions. One does not expect a Kentucky Fried Chicken franchise to experience the same risk as a Ford manufacturing plant.
Global-Specific Risks
Country-Specific Risks
Transfer Risk Cultural and Institutional Risk
Firm-Specific Risks
Governance risks
Blocked funds Ownership structure Human resource norms Religious heritage Nepotism and corruption Intellectual property rights Protectionism
Terrorism and war Antiglobalization
movement Environmental
concerns Poverty Cyber attacks
EXHIBIT 17.4 Classification of Political Risks
471Foreign Direct Investment and Political Risk CHAPTER 17
The need for firm-specific analyses of political risk has led to a demand for “tailor-made” studies undertaken in-house by professional political risk analysts. This demand is heightened by the observation that outside professional risk analysts rarely even agree on the degree of macro-political risk which exists in any set of countries.
In-house political risk analysts relate the macro risk attributes of specific countries to the particular characteristics and vulnerabilities of their client firms. Mineral extractive firms, man- ufacturing firms, multinational banks, private insurance carriers, and worldwide hotel chains are all exposed in fundamentally different ways to politically inspired restrictions. Even with the best possible firm-specific analysis, MNEs cannot be sure that the political or economic situation will not change. Thus, it is necessary to plan protective steps in advance to minimize the risk of damage from unanticipated changes.
Predicting Country-Specific Risk (Macro Risk) Macro political risk analysis is still an emerging field of study. Political scientists in academia, industry, and government study country risk for the benefit of multinational firms, government foreign policy decision-makers, and defense planners.
Political risk studies usually include an analysis of the historical stability of the country in question, evidence of present turmoil or dissatisfaction, indications of economic stability, and trends in cultural and religious activities. Data are usually assembled by reading local newspa- pers, monitoring radio and television broadcasts, reading publications from diplomatic sources, tapping the knowledge of outstanding expert consultants, contacting other businesspeople who have had recent experience in the host country, and finally conducting on-site visits.
Despite this impressive list of activities, the prediction track record of business firms, the diplomatic service, and the military has been spotty at best. When one analyzes trends, whether in politics or economics, the tendency is to predict an extension of the same trends into the future. It is a rare forecaster who is able to predict a cataclysmic change in direction. Who predicted the overthrow of Ferdinand Marcos in the Philippines? Indeed, who predicted the collapse of communism in the Soviet Union and the Eastern European satellites? Who predicted the fall of President Suharto in Indonesia in 1998? As illustrated by Global Finance in Practice 17.1, the 2011 public protests in Egypt serve as one corporate reminder of risk and the reaction of markets to perceived vulnerability.
Despite the difficulty of predicting country risk, the MNE must still attempt to do so in order to prepare itself for the unknown. A number of institutional services provide updated country risk ratings on a regular basis.
Predicting Global-Specific Risk Predicting global-specific risk is even more difficult than the other two types of political risk. Nobody predicted the surprise attacks on the World Trade Center and the Pentagon in the United States on September 11, 2001. On the other hand, the aftermath of this attack, that is, the war on global terrorism, increased U.S. homeland security, and the destruction of part of the terrorist net- work in Afghanistan was predictable. Nevertheless, we have come to expect future surprise ter- rorist attacks. U.S.-based MNEs are particularly exposed not only to Al-Qaeda but also to other unpredictable interest groups willing to use terror or mob action to promote such diverse causes as antiglobalization, environmental protection, and even anarchy. Since there is a great need to predict terrorism, we can expect to see a number of new indices, similar to country-specific indices, but devoted to ranking different types of terrorist threats, their locations, and potential targets.
Firm-Specific Risks The firm-specific risks which confront MNEs include foreign exchange risks and governance risks. The various business and foreign exchange risks were detailed in Chapters 10 and 11. We focus our discussion here on governance risks.
472 CHAPTER 17 Foreign Direct Investment and Political Risk
Governance Risks. 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, gover- nance 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.
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 constitu- ency consisting of their citizens. Firms are responsive to a constituency consisting of their own- ers 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.
Historically, conflicts between objectives of MNEs and host governments have arisen over such issues as the firm’s impact on economic development, perceived infringement on national sovereignty, foreign control of key industries, sharing or nonsharing of ownership and control with local interests, impact on a host-country’s balance of payments, influence on the foreign exchange value of its currency, control over export markets, use of domestic versus foreign executives and workers, and exploitation of national resources. Attitudes about conflicts are often colored by views about free enterprise versus state socialism, the degree of national- ism or internationalism present, or the place of religious views in determining appropriate economic and financial behavior.
The January and February 2011 protests in Egypt took billions of dollars of value away from Apache Corporation (NYSE: APA). The U.S.-based oil exploration and production company has sig- nificant holdings and operations in Egypt, and the political turmoil that engulfed the country in early 2011 caused the investment
public to start dumping Apache’s shares. Although actual oil and gas production was not disrupted during this period, Apache did evacuate all expatriate workers from Egypt. Egypt made up roughly 30% of Apache’s revenue in 2011, 26% of total produc- tion, and 13% of its estimated proved reserves of oil and gas.
Apache Corporation’s Share Price (NYSE: APA) $128
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With 464.4 million shares outstanding, Apache’s market value dropped $4.6 billion in 11 days—10% of the company’s total value.
$127.56/share on January 17
Price falls to $114.84/share on January 28
GLOBAL FINANCE IN PRACTICE 17.1
Apache Takes a Hit from Egyptian Protests
473Foreign Direct Investment and Political Risk CHAPTER 17
The best approach to goal conflict management is to anticipate problems and negotiate understandings ahead of time. Different cultures apply different ethics to the question of hon- oring prior “contracts,” especially when they were negotiated with a previous administration. Nevertheless, prenegotiation of all conceivable areas of conflict provides a better basis for a successful future for both parties than does overlooking the possibility that divergent objec- tives will evolve over time. Prenegotiation often includes negotiating investment agreements, buying investment insurance and guarantees, and designing risk-reducing operating strategies to be used after the foreign investment decision has been made.
Investment Agreements. An investment agreement spells out specific rights and responsi- bilities 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 ven-
ture) 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 ! Provision for planned divestment, should such be required, indicating how the going
concern will be valued and to whom it will be sold
Investment Insurance and Guarantees: OPIC. MNEs can sometimes transfer political risk to a host-country public agency through an investment insurance and guarantee program. Many developed countries have such programs to protect investments by their nationals in developing countries.
The U.S. investment insurance and guarantee program is managed by the government- owned Overseas Private Investment Corporation (OPIC). OPIC’s 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. OPIC offers insurance coverage for four separate types of political risk, which have their own specific definitions for insurance purposes:
1. 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.
474 CHAPTER 17 Foreign Direct Investment and Political Risk
2. 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.
3. 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.
4. Business income coverage provides compensation for loss of business income result- ing from events of political violence that directly cause damage to the assets of a foreign enterprise.
Operating Strategies After the FDI Decision. Although an investment agreement creates obligations on the part of both foreign investor and host government, conditions change and agreements are often revised in the light of such changes. The changed conditions may be economic, or they may be the result of political changes within the host government. The firm that sticks rigidly to the legal interpretation of its original agreement may well find that the host government first applies pressure in areas not covered by the agreement and then possibly reinterprets the agreement to conform to the political reality of that country. Most MNEs, in their own self-interest, follow a policy of adapting to changing host-country priori- ties whenever possible. The essence of such adaptation is anticipating host-country priorities and making the activities of the firm of continued value to the host country. Such an approach assumes the host government acts rationally in seeking its country’s self-interest and is based on the idea that the firm should initiate reductions in goal conflict. Future bargaining posi- tion can be enhanced by careful consideration of policies in production, logistics, marketing, finance, organization, and personnel.
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 employ- ment. From the viewpoint of the foreign firm trying to adapt to host-country goals, local sourc- ing 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.
Facility Location. Production facilities may be located 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 transporta- tion and refining costs.
Control of Transportation. Control of transportation has been an important means to reduce political risk. Oil pipelines that cross national frontiers, oil tankers, ore carriers, refrigerated ships, and railroads have all been controlled at times to influence the bargaining power of both nations and companies.
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 changing technology, abrogation of an
475Foreign Direct Investment and Political Risk CHAPTER 17
investment agreement with a foreign firm is unlikely. Control of technology works best when the foreign firm is steadily improving its technology.
Control of Markets. Control of markets is a common strategy to enhance a firm’s bargain- ing position. As effective as the OPEC cartel was in raising the price received for crude oil by its member countries in the 1970s, marketing was still controlled by the international oil companies. OPEC’s need for the oil companies limited the degree to which its members could dictate terms. In more recent years, OPEC members have established some marketing outlets of their own, such as Kuwait’s extensive chain of Q8 gas stations in Europe.
Control of export markets for manufactured goods is also a source of leverage in deal- ings between MNEs and host governments. The MNE would prefer to serve world markets from sources of its own choosing, basing the decision on considerations of production cost, transportation, tariff barriers, political risk exposure, and competition. The selling pattern that maximizes long-run profits from the viewpoint of the worldwide firm rarely maximizes exports, or value added, from the perspective of the host countries. Some will argue that if the same plants were owned by local nationals and were not part of a worldwide integrated system, more goods would be exported by the host country. The contrary argument is that self- contained local firms might never obtain foreign market share because they lack economies of scale on the production side and are unable to market in foreign countries.
Brand Name and Trademark Control. Control of a brand name or trademark can have an effect almost identical to that of controlling technology. It gives the MNE a monopoly on something that may or may not have substantive value but quite likely represents value in the eyes of consumers. Ability to market under a world brand name is valuable for local firms and thus represents an important bargaining attribute for maintaining an investment position.
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.
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 host-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 govern- ment is less likely to cause the local government to move against the firm if it also owes funds to these other countries.
Country-Specific Risks: Transfer Risk Country-specific risks affect all firms, domestic and foreign, that are resident in a host country. Exhibit 17.5 presents a taxonomy of most of the contemporary political risks that emanate from a specific country location. The main country-specific political risks are transfer risk, cultural risk, and institutional risk.
Blocked Funds Transfer risk is defined as limitations on the MNE’s ability to transfer funds into and out of a host country without restrictions. 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
476 CHAPTER 17 Foreign Direct Investment and Political Risk
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. MNEs can react to the potential for blocked funds at three stages:
1. Prior to investing a firm can analyze the effect of blocked funds on expected return on investment, the desired local financial structure, and optimal links with subsidiaries.
2. During operations a firm can attempt to move funds through a variety of reposition- ing techniques.
3. Funds that cannot be moved must be reinvested in the local country in a manner that avoids deterioration in their real value because of inflation or exchange depreciation.
Preinvestment Strategy to Anticipate Blocked Funds. Management can consider blocked funds in their capital budgeting analysis. Temporary blockage of funds normally reduces the expected net present value and internal rate of return on a proposed investment. Whether the investment should nevertheless be undertaken depends on whether the expected rate of return, even with blocked funds, exceeds the required rate of return on investments of the same risk class. Preinvestment analysis also includes the potential to minimize the effect of blocked funds by financing with local borrowing instead of parent equity, swap agreements, and other techniques to reduce local currency exposure and thus the need to repatriate funds. Sourcing and sales links with subsidiaries can be predetermined to maximize the potential for moving blocked funds.
Moving Blocked Funds What can a multinational firm do to transfer funds out of countries having exchange or remittance restrictions? At least six popular strategies are used:
Transfer Risk
Blocked Funds
Preinvestment strategy to anticipate blocked funds
Fronting loans Creating unrelated exports Obtaining special dispensation Forced reinvestment
Ownership Structure
Joint venture
Religious Heritage
Understand and respect host country religious heritage
Nepotism and Corruption
Disclose bribery policy to both employees and clients
Retain a local legal adviser
Human Resource Norms
Local management and staffing
Intellectual Property
Legal action in host country courts
Support worldwide treaty to protect intellectual property rights
Protectionism
Support government actions to create regional markets
Cultural and Institutional Risk
EXHIBIT 17.5 Management Strategies for Country-Specific Risks
477Foreign Direct Investment and Political Risk CHAPTER 17
1. Providing alternative conduits for repatriating funds (discussed in Chapter 19)
2. Transferring pricing goods and services between related units of the MNE (analyzed in Chapter 19)
3. Leading and lagging payments (described previously in Chapter 12) 4. Signing fronting loans 5. Creating unrelated exports 6. Obtaining special dispensation
Fronting Loans. A fronting loan is a parent-to-subsidiary loan channeled through a finan- cial intermediary, usually a large international bank. Fronting loans differ from “parallel” or “back-to-back” loans, discussed in Chapter 11. The latter are offsetting loans between commercial businesses arranged outside the banking system. Fronting loans are sometimes referred to as link financing.
In a direct intracompany loan, a parent or sister subsidiary loans directly to the bor- rowing subsidiary, and later, the borrowing subsidiary repays the principal and interest. In a fronting loan, by contrast, the “lending” parent or subsidiary deposits funds in, say, a London bank, and that bank loans the same amount to the borrowing subsidiary in the host country. From the London bank’s point of view, the loan is risk-free, because the bank has 100% collateral in the form of the parent’s deposit. In effect, the bank “fronts” for the parent—hence the name. Interest paid by the borrowing subsidiary to the bank is usually slightly higher than the rate paid by the bank to the parent, allowing the bank a margin for expenses and profit.
The bank chosen for the fronting loan is usually in a neutral country, away from both the lender’s and the borrower’s legal jurisdiction. Use of fronting loans increases the chances for repayment should political turmoil occur between the home and host countries. Government authorities are more likely to allow a local subsidiary to repay a loan to a large international bank in a neutral country than to allow the same subsidiary to repay a loan directly to its par- ent. To stop payment to the international bank would hurt the international credit image of the country, whereas to stop payment to the parent corporation would have minimal impact on that image and might even provide some domestic political advantage.
Creating Unrelated Exports. Another approach to blocked funds that benefits both the sub- sidiary and host country is the creation of unrelated exports. Because the main reason for stringent exchange controls is usually a host country’s persistent inability to earn hard curren- cies, anything an MNE can do to create new exports from the host country helps the situation and provides a potential means to transfer funds out.
Some new exports can often be created from present productive capacity with little or no additional investment, especially if they are in product lines related to existing operations. Other new exports may require reinvestment or new funds, although if the funds reinvested consist of those already blocked, little is lost in the way of opportunity costs.
Special Dispensation. If all else fails and the multinational firm is investing in an industry that is important to the economic development of the host country, the firm may bargain for special dispensation to repatriate some portion of the funds that otherwise would be blocked. Firms in “desirable” industries such as telecommunications, semiconductor manufacturing, instru- mentation, pharmaceuticals, or other research and high-tech industries may receive preference over firms in mature industries. The amount of preference received depends on bargaining among the informed parties, the government and the business firm, either of which is free to back away from the proposed investment if unsatisfied with the terms.
478 CHAPTER 17 Foreign Direct Investment and Political Risk
Self-Fulfilling Prophecies. In seeking “escape routes” for blocked funds—or for that matter in trying to position funds through any of the techniques discussed in this chapter—the MNE may increase political risk and cause a change from partial blockage to full blockage. The possibility of such a self-fulfilling cycle exists any time a firm takes action that, no matter how legal, thwarts the underlying intent of politically motivated controls. In the statehouses of the world, as in the editorial offices of the local press and TV, MNEs and their subsidiaries are always potential scapegoats.
Forced Reinvestment. If funds are indeed blocked from transfer into foreign exchange, they are by definition “reinvested.” Under such a situation, the firm must find local opportunities that will maximize the rate of return for a given acceptable level of risk.
If blockage is expected to be temporary, the most obvious alternative is to invest in local money market instruments. Unfortunately, in many countries, such instruments are not avail- able in sufficient quantity or with adequate liquidity. In some cases, government Treasury bills, bank deposits, and other short-term instruments have yields that are kept artificially low relative to local rates of inflation or probable changes in exchange rates. Thus, the firm often loses real value during the period of blockage.
If short- or intermediate-term portfolio investments, such as bonds, bank time deposits, or direct loans to other companies, are not possible, investment in additional production facilities may be the only alternative. Often, this investment is what the host country is seeking by its exchange controls, even if the existence of exchange controls is by itself counterproductive to the idea of additional foreign investment. Examples of forced direct reinvestment can be cited for Peru, where an airline invested in hotels and in maintenance facilities for other airlines; for Turkey, where a fish canning company constructed a plant to manufacture cans needed for packing the catch; and for Argentina, where an automobile company integrated vertically by acquiring a transmission manufacturing plant previously owned by a supplier.
If investment opportunities in additional production facilities are not available, funds may simply be used to acquire other assets expected to increase in value with local inflation. Typical purchases might be land, office buildings, or commodities that are exported to global markets. Even inventory stockpiling might be a reasonable investment, given the low opportunity cost of the blocked funds.
Country-Specific Risks: Cultural and Institutional Risks When investing in some of the emerging markets, MNEs that are resident in the most indus- trialized countries face serious risks because of cultural and institutional differences. Many such differences include 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 ! Legal liabilities
Ownership Structure. Historically, many countries have required that MNEs share owner- ship of their foreign subsidiaries with local firms or citizens. Thus, joint ventures were the only way an MNE could operate in some host countries. Prominent countries that used to require majority local ownership were Japan, Mexico, China, India, and Korea. This
479Foreign Direct Investment and Political Risk CHAPTER 17
requirement has been eliminated or modified in more recent years by these countries and most others. However, firms in certain industries are still either excluded from ownership com- pletely or must accept being a minority owner. These industries are typically related to national defense, agriculture, banking, or other sectors that are deemed critical for the host nation.
Human Resource Norms. MNEs are often required by host countries to employ a certain pro- portion of host-country citizens rather than staffing mainly with foreign expatriates. It is often very difficult to fire local employees due to host-country labor laws and union contracts. This lack of flexibility to downsize in response to business cycles affects both MNEs and their local com- petitors. It also qualifies as a country-specific risk. Cultural differences can also inhibit an MNE’s staffing policies. For example, it is somewhat difficult for a woman manager to be accepted by local employees and managers in many Middle Eastern countries. The most extreme example of discrimination against women has been highlighted in Afghanistan when the Taliban were in power. Since the Taliban’s downfall in late 2001, several women have been suggested for important government roles. It is expected that the private sector in Afghanistan will also reintegrate women into the workforce.
Religious Heritage. The current hostile environment for MNEs in some Middle Eastern countries such as Iran, Iraq, and Syria is being fed by some extremist Muslim clerics who are enraged about the continuing violence in Israel and the occupied Arab territories. However, the root cause of these conflicts is a mixture of religious fervor for some and politics for others. Although it is popular to blame the Muslim religion for its part in fomenting the conflict, a number of Middle Eastern countries, such as Egypt, Saudi Arabia, and Jordan, are relatively passive when it comes to Jihads. Jihads are calls for Muslims to attack the infidels (Jews and Christians). Osama Bin Laden’s call for Jihad against the United States has not generated any great interest on the part of moderate Muslims. Indeed one Muslim country, Turkey, has had a secular government for many decades. It strongly supported efforts to rid the world of Bin Laden, which was finally accomplished in May 2011.
Despite religious differences, MNEs have operated successfully in emerging markets, especially in extractive and natural resource industries, such as oil, natural gas, minerals, and forest products. The main MNE strategy is to understand and respect the host country’s religious traditions.
Nepotism and Corruption. MNEs must deal with endemic nepotism and corruption in a number of important foreign investment locations. Indonesia was famous for nepotism and corruption under the now-deposed Suharto government. Nigeria, Kenya, Uganda, and a num- ber of other African countries have a history of nepotism and corruption after they threw out their colonial governments after World War II. China and Russia have recently launched well-publicized crackdowns on those evils.
Bribery is not limited to emerging markets. It is also a problem in even the most indus- trialized countries, including the United States and Japan. In fact, the United States has an antibribery law that would imprison any U.S. business executive found guilty of bribing a for- eign government official. This law was passed in reaction to an attempt by Lockheed Aircraft to bribe a Japanese Prime Minister.
MNEs are caught in a dilemma. Should they employ bribery if their local competitors use this strategy? There are alternative strategies:
! Refuse bribery outright, or else demands will quickly multiply. ! Retain a local advisor 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.
480 CHAPTER 17 Foreign Direct Investment and Political Risk
! Educate both management and local employees about the bribery policy the firm intends to follow.
Intellectual Property Rights. Rogue businesses in some host countries have historically infringed on the intellectual property rights of both MNEs and individuals. Intellectual prop- erty rights grant the exclusive use of patented technology and copyrighted creative materials. Examples of patented technology are unique manufactured products, processing techniques, and prescription pharmaceutical drugs. Examples of copyrighted creative materials are software programs, educational materials (textbooks), and entertainment products (e.g., music, film, art).
MNEs and individuals need to protect their intellectual property rights through the legal process. However, in some countries, courts have historically not done a fair job of protecting intellectual property rights of anyone, much less of foreign MNEs. In those countries, the legal process is costly and subject to bribery.
The agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPS) to pro- tect intellectual property rights has recently been ratified by most major countries. It remains to be seen whether host governments are strong enough to enforce their official efforts to stamp out intellectual piracy. Complicating this task is the thin line that exists between the real item being protected and look-alikes or generic versions of the same item.
Protectionism. Protectionism is defined as the attempt by a national government to protect certain of its designated industries from foreign competition. Protected industriesare usually related to defense, agriculture, and “infant” industries.
Defense. Even though the U.S. is a vocal proponent of open markets, a foreign firm propos- ing to buy a U.S. critical defense supplier would not be welcome. The same attitude exists in many other countries, such as France, which has always wanted to maintain an independent defense capability.
Agriculture. Agriculture is another sensitive industry. No MNE would be foolish enough as to attempt to buy agricultural properties, such as rice operations, in Japan. Japan has desperately tried to maintain an independent ability to feed its own population. Agriculture is the typical “Mother Earth” industry that most countries want to protect for their own citizens.
Infant Industries. The traditional protectionist argument is that newly emerging, “infant” industries need protection from foreign competition until they are 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.
Tariff Barriers. The traditional methods for countries to implement protectionist barriers were through tariff and non-tariff regulations. Negotiations under the General Agreements on Tariffs and Trade (GATT) have greatly reduced the general level of tariffs over the past decades. This process continues today under the auspices of the World Trade Organization (WTO). However, many non-tariff barriers remain.
Non-Tariff Barriers. 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 include those shown in Exhibit 17.6.
481Foreign Direct Investment and Political Risk CHAPTER 17
Strategies to Manage Protectionism. MNEs have only a very limited ability to overcome host country protectionism. However, MNEs do enthusiastically support efforts to reduce protectionism by joining 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.
The EU is trying to become a “United States of Europe,” with a single internal market without barriers. It is not quite there, although the European Monetary Union and the euro have almost eliminated monetary policy differences. The EU still tolerates differences in fis- cal policies, legal systems, and cultural identities. In any case, the movement toward regional markets is very favorable for MNEs serving those markets with foreign subsidiaries.
Legal Liabilities. Despite good intentions, MNEs are often confronted with unexpected legal liabilities. Global Finance in Practice 17.2 illustrates why Hospira, a U.S.-based pharmaceuti- cal manufacturer, decided to cancel an FDI project in Italy as a result of potential legal and associated financial liabilities.
Global-Specific Risks Global-specific risks faced by MNEs have come to the forefront in recent years. Exhibit 17.6 summarizes some of these risks, and strategies that can be used to manage them. The most visible recent risk was, of course, the attack by terrorists on the twin towers of the World Trade Center in New York on September 11, 2001. Many MNEs had major operations in the World Trade Center and suffered heavy casualties among their employees. In addition to terrorism, other global-specific risks include the antiglobalization movement, environmental concerns, poverty in emerging markets, and cyber attacks on computer information systems.
Terrorism and War. Although the World Trade Center attack and its aftermath, the war in Afghanistan, have affected nearly everyone worldwide, many other acts of terrorism have been committed in recent years. More terrorist acts are expected to occur in the future. Particularly
EXHIBIT 17.6 Management Strategies for Global-Specific Risks
Terrorism and War
Support government efforts to fight terrorism and war
Crisis planning Cross-border supply chain
integration
Environmental Concerns
Show sensitivity to environmental concerns
Support government efforts to maintain a level playing field for pollution controls
Antiglobalization
Support government efforts to reduce trade barriers
Recognize that MNEs are the targets
Cyber Attacks
No effective strategy except Internet security efforts
Support government anti-cyber attack efforts
Poverty
Provide stable, relatively well-paying jobs
Establish the strictest of occupational safety standards
MNE movement toward multiple primary objectives: Profitability, Sustainable Development, Corporate Social Responsibility
482 CHAPTER 17 Foreign Direct Investment and Political Risk
exposed are the foreign subsidiaries of MNEs and their employees. As mentioned earlier, foreign subsidiaries are especially exposed to war, ethnic strife, and terrorism because they are symbols of their respective parent countries.
Crisis Planning. No MNE has the tools to avert terrorism. Hedging, diversification, insur- ance, and the like are not suited to the task. Therefore, MNEs must depend on govern- ments to fight terrorism and protect their foreign subsidiaries (and now even the parent firm). In return, governments expect financial, material, and verbal support from MNEs to support antiterrorist legislation and proactive initiatives to destroy terrorist cells wherever they exist.
MNEs can be subject to damage by being in harm’s way. Nearly every year one or more host countries experience some form of ethnic strife, outright war with other countries, or terrorism. It seems that foreign MNEs are often singled out as symbols of “oppression” because they represent their parent country, especially if it is the United States.
Cross-Border Supply Chain Integration. The drive to increase efficiency in manufacturing has driven many MNEs to adopt just-in-time (JIT) near-zero inventory systems. Focusing on so-called inventory velocity, the speed at which inventory moves through a manufacturing process, arriving only as needed and not before, has allowed these MNEs to generate increas- ing profits and cash flows with less capital being bottled-up in the production cycle itself. This finely tuned supply chain system, however, is subject to significant political risk if the supply chain itself extends across borders.
Foreign direct investment can be a very tricky thing. Just ask Hospira, a U.S.-based pharmaceutical manufacturer. Hospira, of Lake Forest, Illinois (U.S.), stopped manufacturing of Pento- thal (sodium thiopental) in North Carolina in the United States in mid-2009. It intended to shift all production to Italy. Hospi- ra’s press release read as follows:
Hospira Statement Regarding Pentothal™ (Sodium Thiopental) Market Exit LAKE FOREST, Ill., Jan. 21, 2011—Hospira announced today it will exit the sodium thiopental market and no longer attempt to resume production of its product, Pentothal™.
Hospira had intended to produce Pentothal at its Italian plant. In the last month, we’ve had ongoing dialogue with the Italian authorities concerning the use of Pentothal in capital pun- ishment procedures in the United States—a use Hospira has never condoned. Italy’s intent is that we control the product all the way to the ultimate end user to prevent use in capital pun- ishment. These discussions and internal deliberation, as well as conversations with wholesalers—the primary distributors of the product to customers—led us to believe we could not prevent the drug from being diverted to departments of corrections for use in capital punishment procedures.
Based on this understanding, we cannot take the risk that we will be held liable by the Italian authorities if the prod- uct is diverted for use in capital punishment. Exposing our employees or facilities to liability is not a risk we are prepared to take.
Given the issues surrounding the product, including the government’s requirements and challenges bringing the drug back to market, Hospira has decided to exit the market. We regret that issues outside of our control forced Hospira’s deci- sion to exit the market, and that our many hospital customers who use the drug for its well-established medical benefits will not be able to obtain the product from Hospira.
Source: Hospira.com
The news was met with dismay by the medical industry. Pen- tothal, at one time a widely used anesthetic, is today only used in a variety of special cases. The drug is preferred in specific cases because it does not cause blood pressure to drop severely, including the care of the elderly, patients with heart disease, or expecting mothers requiring emerging C-sections in which the possibility of low blood pressure is threatening. Second-best solutions would now have to be good enough.
GLOBAL FINANCE IN PRACTICE 17.2
Drugs, Public Policy, and the Death Penalty in 2011
483Foreign Direct Investment and Political Risk CHAPTER 17
Supply Chain Interruptions. Consider the cases of Dell Computer, Ford Motor Company, Dairy Queen, Apple Computer, Herman Miller, and The Limited in the days following the terrorist attacks of September 11, 2001. An immediate result of the attacks of the morning of September 11 was the grounding of all aircraft into or out of the United States. Similarly, the land (Mexico and Canada) and sea borders of the United States were also shut down and not reopened for several days in some specific sites. Ford Motor Company shut down five of its manufacturing plants in the days following September 11 because of inadequate inventories of critical automotive inputs supplied from Canada. Dairy Queen experienced such significant delays in key confectionary ingredients that many of its stores were also temporarily closed.
Dell Computer, with one of the most highly acclaimed and admired virtually integrated supply chains, depends on computer parts and subassembly suppliers and manufacturers in both Mexico and Canada to fulfill its everyday assembly and sales needs. In recent years, Dell has carried less than three full days sales of total inventory—by cost of goods value. Suppliers are integrated electronically with Dell’s order fulfillment system, and deliver required com- ponents and subassemblies as sales demands require. But with the closure of borders and grounding of air freight, the company was literally brought to a near standstill because of its supply chain’s reliance on the ability to treat business units and suppliers in different countries as if they were all part of a single seamless political unit. Unfortunately, that proved not to be the case with this particular unpredictable catastrophic terrorist event.
As a result of these newly learned lessons, many MNEs are now evaluating the degree of exposure their own supply chains possess in regard to cross-border stoppages or other cross-border political events. These companies are not, however, about to abandon JIT. It is estimated that many U.S. companies alone have saved more than $1 billion a year in inven- tory carrying costs by using JIT methods over the past decade. This substantial benefit is now being weighed against the costs and risks associated with the post-September 11 supply chain interruptions.
To avoid suffering a similar fate in the future, manufacturers, retailers, and suppliers are now employing a range of tactics:
Inventory Management. Manufacturers and assemblers are now considering carrying more buffer inventory in order to hedge against supply and production-line disruptions. Retailers, meanwhile, should think about the timing and frequency of their replenishment. Rather than stocking up across the board, companies are focusing on the most critical parts to the product or service, and those components which are uniquely available from international sources.
Sourcing. Manufacturers are now being more selective about where the critical inputs to their products come from. Although sourcing strategies will have to vary by location (those involving Mexico for example will differ dramatically from Canada), firms are attempting to work more closely with existing suppliers to minimize cross-border exposures and reduce the potential costs with future stoppages.
Transportation. Retailers and manufacturers alike are reassessing their cross-border shipping arrangements. Although the mode of transportation employed is a function of value, volume, and weight, many firms are now reassessing whether higher costs for faster shipment balance out the more tenuous delivery under airline stoppages from either labor, terrorist, or even bankruptcy disruptions in the future.
Antiglobalization Movement. During the past decade, there has been a growing negative reaction by some groups to reduced trade barriers and efforts to create regional markets, particularly to NAFTA and the European Union. NAFTA has been vigorously opposed by those sectors of the labor movement that could lose jobs to Mexico. Opposition within the
484 CHAPTER 17 Foreign Direct Investment and Political Risk
European Union centers on loss of cultural identity, dilution of individual national control as new members are admitted, over-centralization of power in a large bureaucracy in Brussels, and most recently, the disappearance of individual national currencies in mid-2002, when the euro became the only currency in 12 of the 15 member nations.
The antiglobalization movement has become more visible following riots in Seattle during the 2001 annual meeting of the World Trade Organization. However, antiglobalization forces were not solely responsible for these riots, or for subsequent riots in Quebec and Prague in 2001. Other disaffected groups, such as environmentalists and even anarchists, joined in to make their causes more visible.
MNEs do not have the tools to combat antiglobalism. Indeed they are blamed for foster- ing the problem in the first place. Once again, MNEs must rely on governments and crisis planning to manage these risks.
Environmental Concerns. MNEs have been accused of “exporting” their environmental problems to other countries. The accusation is that MNEs frustrated by pollution controls in their home country have relocated these activities to countries with weaker pollution controls. Another accusation is that MNEs contribute to the problem of global warming. However, that accusation applies to all firms in all countries. It is based on the manufacturing methods employed by specific industries and on consumers’ desire for certain products such as large automobiles and sport vehicles that are not fuel efficient.
Once again, solving environmental problems is dependent on governments passing leg- islation and implementing pollution control standards. In 2001, a treaty attempting to reduce global warming was ratified by most nations, with the notable exception of the United States. However, the United States has promised to combat global warming using its own strate- gies. The United States objected to provisions in the worldwide treaty that allowed emerging nations to follow less restrictive standards, while the economic burden would fall on the most industrialized countries, particularly the United States.
Poverty. MNEs have located foreign subsidiaries in countries plagued by extremely uneven income distribution. At one end of the spectrum is an elite class of well-educated, well- connected, and productive persons. At the other end is a very large class of persons living at or below the poverty level. They lack education, social and economic infrastructure, and political power.
MNEs might be contributing to this disparity by employing the elite class to manage their operations. On the other hand, MNEs are creating relatively stable and well-paying jobs for those who would be otherwise unemployed and living below the poverty level. Despite being accused of supporting “sweat shop” conditions, MNEs usually compare favorably to their local competitors. For example, Nike, one of the targeted MNEs, usually pays better, provides more fringe benefits, maintains higher safety standards, and educates their workforce to allow personnel to advance up the career ladder. Of course, Nike cannot manage a country’s poverty problems overall, but it can improve conditions for some persons.
Cyber Attacks. The rapid growth of the Internet has fostered a whole new generation of scam artists and cranks that disrupt the usefulness of the World Wide Web. This is both a domestic and an international problem. MNEs can face costly cyber attacks by disaffected persons with a grudge because of their visibility and the complexity of their internal infor- mation systems.
At this time, we know of no uniquely international strategies that MNEs can use to com- bat cyber attacks. MNEs are using the same strategies to manage foreign cyber attacks as they use for domestic attacks. Once again, they must rely on governments to control cyber attacks.
485Foreign Direct Investment and Political Risk CHAPTER 17
SUMMARY POINTS
! In order to invest abroad a firm must have a sustainable competitive advantage in the home market. This must be strong enough and transferable enough to overcome the disadvantages of operating abroad.
! Competitive advantages stem from economies of scale and scope arising from large size; managerial and marketing expertise; superior technology; financial strength; differentiated products; and competitiveness of the home market.
! 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, such as licensing, joint ventures, strategic alliances, management contracts, and exporting.
! Finance-specific strategies are directly related to the OLI Paradigm, including both proactive and reactive financial strategies.
! The decision about where to invest is influenced by eco- nomic and behavioral factors, as well as the stage of a firm’s historical development.
! The most internationalized firms can be viewed from a network perspective. The parent firm and each of the foreign subsidiaries are members of networks. The net- works are composed of relationships within a world- wide industry, within the host countries with suppliers and customers, and within the multinational firm itself.
! Exporting avoids political risk but not foreign exchange risk. It requires the least up-front investment but it might eventually lose markets to imitators and global competitors that might be more cost efficient in produc- tion abroad and distribution.
! Alternative (to wholly owned foreign subsidiaries) modes of foreign involvement exist. They include joint venture, strategic alliances, licensing, management con- tracts, and traditional exporting.
! The success of a joint venture depends primarily on the right choice of a partner. For this reason and a number of issues related to possible conflicts in decision mak- ing between a joint venture and a multinational parent, the 100%-owned foreign subsidiary approach is more common.
! The completion of the European Internal Market at end-of-year 1992 induced a surge in cross-border entry through strategic alliances. Although some forms of strategic alliances share the same characteristics as joint ventures, they often also include an exchange of stock.
! There are six major strategies employed by emerging market MNEs: take brands global; engineer to inno- vation; leverage natural resources; develop an export business model; acquire offshore assets; target a market niche.
! Political risks can be defined by classifying them on three levels: firm-specific, country-specific, or global- specific. Firm-specific risks, also known as micro risks, affect the MNE at the project or corporate level. Country-specific risks, also known as macro risks, affect the MNE at the project or corporate level but originate at the country level. Global-specific risks affect the MNE at the project or corporate level but originate at the global level.
! The main tools used to manage goal conflict are to nego- tiate an investment agreement; to purchase investment insurance and guarantees; and to modify operating strategies in production, logistics, marketing, finance, organization, and personnel.
! The main country-specific risks are transfer risk, known as blocked funds, and certain cultural and institutional risks.
! Blocked funds can be managed by at least five different strategies: 1) considering blocked funds in the original capital budgeting analysis; 2) fronting loans; 3) creat- ing unrelated exports; 4) obtaining special dispensation; and 5) planning on forced reinvestment.
! Cultural and institutional risks emanate from host- country policies with respect to ownership structure, human resource norms, religious heritage, nepotism and corruption, intellectual property rights, protection- ism, and legal liabilities.
! Managing cultural and institutional risks requires the MNE to understand the differences, take legal actions in host-country courts, support worldwide treaties to protect intellectual property rights, and support gov- ernment efforts to create regional markets.
! The main global-specific risks are currently caused by terrorism and war, the antiglobalization move- ment, environmental concerns, poverty, and cyber attacks.
! In order to manage global-specific risks, MNEs should adopt a crisis plan to protect its employees and property. However, the main reliance remains on governments to protect its citizens and firms from these global-specific threats.
486 CHAPTER 17 Foreign Direct Investment and Political Risk
BCG [Boston Consulting Group] argues that this is because they have managed to resolve three trade-offs that are usually associated with corporate growth: of vol- ume against margin; rapid expansion against low lever- age (debt); and growth against dividends. On average the challengers have increased their sales three times faster than their established global peers since 2005. Yet they have also reduced their debt-to-equity ratio by three per- centage points and achieved a higher ratio of dividends to share price in every year but one.
—“Nipping at Their Heels: Firms from the Developing World Are Rapidly Catching Up with
Their Old-World Competitors,” The Economist, January 22, 2011, p. 80.
Leadership in all companies, public and private, new and old, start-ups and maturing, have all heard the same threat in recent years: the emerging market competitors are com- ing. Despite the threat, there have been other forces at work which would prevent their advancing—too fast: the ability to raise sufficient capital at a reasonable cost; the ability to reach the larger and more profitable markets; the competition in markets which value name recognition and brand identity; global reach. But a number of market prognosticators—the gurus and consultants—are now con- tending that these new competitors are already here.
One such analysis was recently published by BCG, the Boston Consulting Group.1 BCG labels these firms the global challengers, companies based in rapidly developing economies that are “shaking up” the established economic order. Their list of 100 global companies, most of which are from Brazil (13), Russia (6), India (20), and China (33) (the so-called BRICs), and Mexico (7), are all innovative and aggressive, but have also proven to be financially fit.
The value created by these firms for their shareholders is very convincing. The total shareholder return (TSR) for the global challengers between 2005 and 2009 was 22%; the same TSR for their global peers, public companies in comparable business lines from the industrialized econo- mies, a mere 5%. They have, according to BCG, been able to achieve these results by resolving three classic trade-offs confronting emerging players. These strategic trade-offs turn out to be uniquely financial in character.
1“Companies on the Move, Rising Stars from Rapidly Developing Economies Are Reshaping Global Industries,” Boston Consulting Group, January 2011.
The Three Trade-Offs The three trade-offs could also be characterized as three financial dimensions of competitiveness—the market, the financing, the offered return.
Trade-Off #1: Volume Versus Margin. Traditional busi- ness thinking assumes that large-scale, large-market sales, like that of Wal-Mart, requires incredibly low prices, which in turn impose low margin returns to the scale competitors. Higher margin products and services are usually reserved for specialty market segments, which may be much more expensive to service, but are found justifiable by the higher prices and higher margins they offer. BCG argues that the global challengers have been able to have both volume and margin, relying on exceptionally low direct costs of materi- als and labor, combined with the latest in technology and execution found in the developed country markets.
Trade-Off #2: Rapid Expansion Versus Low Leverage. One of the key advantages always held by the world’s largest companies is their preferred access to capital. The advantages afforded companies in large market economies, capitalist economies, is access to plentiful and affordable capital. Companies arising from the emerging markets have often been held back in their expansion efforts, not having the capital to exercise their ambitions. Only after gaining access to the world’s largest capital markets, providers of both debt and equity, can these firms pose a serious threat beyond their immediate country market or region. In the past, access meant higher levels of debt and the associated risks and burdens of higher leverage.
But the global challengers have again fought off the trade-off, finding ways to increase both equity and debt in proportion, and therefore to grow without taking on a riskier financial structure. The obvious solution has been to gain increasing access to affordable equity, often in Lon- don and New York.
Trade-Off #3: Growth Versus Dividends. Financial theory has always emphasized the critical distinctions between what opportunities and threats growth firms and value firms offer investors. Growth firms are typically smaller firms, start-ups, companies with unique business models based on new technologies or services. They have
Corporate Competition from the Emerging MarketsMINI-CASE
487Foreign Direct Investment and Political Risk CHAPTER 17
QUESTIONS 1. Evolving into Multinationalism. As a firm evolves
from purely domestic into a true multinational enter- prise, 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 suc- cess of foreign operations.
firms from so many markets flailed against before them? As the Economist notes, “All this is impressive, but it seems implausible that these trade-offs have been ‘resolved.’”2
Many emerging market or rapidly developing economy analysts argue that these firms not only understand emerg- ing markets, but also they have demonstrated sustained innovation and remained financially healthy. Others argue that these three factors are likely to be more simultaneous than causal. It is clear, however, that most of these new global players are arising from large underdeveloped and underserved markets, markets that are providing large bases for their rapid development.
One strategy being rapidly deployed by many of these firms is the use of strategic partnerships, joint ventures, or share swap agreements.3 In each of these forms, the com- panies are gaining a competitive reach, a global partner, and access to technology and markets without major growth on their part.
Not to mention one of the biggest continuing debates, whether they may be able to continue to grow as suc- cessfully while being conglomerates—diversified global conglomerates. That is an organizational and strategic structure enjoyed by few in the highly industrialized economies today.
Case Questions
1. How are the three trade-offs interconnected according to financial principles?
2. Do you believe these firms have truly resolved or con- quered these trade-offs, or have they benefited from some other competitive advantages at this stage of their development?
2“Nipping at Their Heels: Firms from the Developing World Are Rapidly Catching Up with Their Old-World Competitors,” The Economist, January 22, 2011, p. 80. 3“Big Emerging Market Mergers Create Global Competitors,” by Gordon Platt, Global Finance, July/August 2009.
enormous upside potential, but need more time, more experience, more breadth, and most importantly, more capital. Investors in these companies know the risks are high, and as a result, accept those risks in focusing on pro- spective returns from capital gains, not dividend distribu- tions. Investors also know that these firms, often very small firms, will show large share price movements quickly with commensurate business developments. For that, the firm needs to be nimble, quick, and not laden with debt.
Value companies, a polite term for mature or older, larger, well-established global competitors, are of a size in which new business developments, new markets or new technologies, are rarely large enough to move share prices significantly and quickly. Investors in these companies, according to agency theory, do not “trust management” to take sufficient risks to generate returns. Therefore, they prefer the firm to bear some artificial financial burdens to assure diligence. Those financial burdens are typically higher levels of debt and growing distributions of profit as dividends. Both elements serve as financial disciplines, requiring vmanagement to maintain watchfulness over costs and cash flows to service debt, and generate sufficient profitability over time to supply dividends.
The global challengers have arguably thwarted this trade-off as well, paying dividends at growing rates and similar dividend yields to more mature firms with stronger and sustained cash flows. This may actually be the easiest of the three to accomplish given their already substantial sizes and strong profitability.
Continuing Questions Many still have doubts. If these global challengers can defeat these traditional financial trade-offs, can they over- come the corporate strategic challenges that so many
2. Theory of Comparative Advantage. What is the essence of the theory of comparative advantage?
3. Market Imperfections. MNEs strive to take advantage of market imperfections in national markets for prod- ucts, factors of production, and financial assets. Large international firms are better able to exploit such imper- fections. What are their main competitive advantages?
Foreign Direct Investment and Political Risk CHAPTER 17 487
488 CHAPTER 17 Foreign Direct Investment and Political Risk
4. 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 competi- tive advantage?
5. Economies of Scale and Scope. Explain briefly how economies of scale and scope can be developed in pro- duction, marketing, finance, research and development, transportation, and purchasing.
6. Competitiveness of the Home Market. A strongly competitive home market can sharpen a firm’s com- petitive advantage relative to firms located in less competitive markets. Explain what is meant by the “competitive advantage of nations.”
7. 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. Explain what is meant by the O, the L, and the I of the paradigm.
8. Financial Links to OLI. Financial strategies are directly related to the OLI Paradigm. a. Explain how proactive financial strategies are
related to OLI. b. Explain how reactive financial strategies are related
to OLI.
9. Where to Invest. The decision about where to invest abroad is influenced by behavioral factors. a. Explain the behavioral approach to FDI. b. Explain the international network theory explana-
tion of FDI.
10. Exporting Versus Producing Abroad. What are the advantages and disadvantages of limiting a firm’s activities to exporting compared to producing abroad?
11. Licensing and Management Contracts Versus Produc- ing Abroad. What are the advantages and disadvan- tages of licensing and management contracts compared to producing abroad?
12. Joint Venture Versus Wholly Owned Production Subsidiary. What are the advantages and disadvan- tages of forming a joint venture to serve a foreign market compared to serving that market with a wholly owned production subsidiary?
13. 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?
14. Cross-Border Strategic Alliance. The term “cross-bor- der strategic alliance” conveys different meanings to different observers. What are the meanings?
15. Governance Risk. Answer the following questions: a. What is meant by the term “governance risk?” b. What is the most important type of governance
risk?
16. 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?
17. Investment Insurance and Guarantees (OPIC). Answer the following questions: a. What is OPIC? b. What types of political risks can OPIC insure
against?
18. Operating Strategies After the FDI Decision. The fol- lowing operating strategies, among others, are expected to reduce damage from political risk. Explain each and how it reduces damage. a. Local sourcing b. Facility location c. Control of technology d. Thin equity base e. Multiple-source borrowing
19. Country-Specific Risk. Define the following terms: a. Transfer risk b. Blocked funds
20. Blocked Funds. Explain the strategies used by an MNE to counter blocked funds.
21. Cultural and Institutional Risks. Identify and explain the main types of cultural and institutional risks, except protectionism.
22. Strategies to Manage Cultural and Institutional Risks. Explain the strategies that an MNE can use to manage each of the cultural and institutional risks that you identified in question 21, except protectionism.
23. Protectionism Defined. Respond to the following: a. Define protectionism and identify the industries
that are typically protected. b. Explain the “infant industry” argument for
protectionism.
24. Managing Protectionism. Answer the following questions: a. What are the traditional methods for countries to
implement protectionism?
489Foreign Direct Investment and Political Risk CHAPTER 17
b. What are some typical non-tariff barriers to trade? c. How can MNEs overcome host country protectionism?
25. Global-Specific Risks. What are the main types of political risks that are global in origin?
26. Managing Global-Specific Risks. What are the main strategies used by MNEs to manage the global-specific risks you have identified in question 25?
27. U.S. Antibribery 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 firms that are not ham- pered by such a law. Discuss the ethics and practicality of the U.S. antibribery law.
INTERNET EXERCISES 1. The World Bank. The World Bank provides a growing
set of informational and analytical resources to aid in the assessment and management of cross-border risk. The Risk Management Support Group has a variety of political risk assessment tools, which are under constant development. Visit the following site and compose an executive briefing (one page or less) of what the political risk insurance provided by the World Bank will and will not cover.
World Bank Risk Management www.worldbank.org/ WBSITE/EXTERNAL/ OPPORTUNITIES/
2. Global Corruption Report. Transparency Interna- tional (TI) is considered by many to be the leading nongovernmental anticorruption organization in the world today. Recently, it has introduced its own annual survey analyzing current developments, identifying ongoing challenges, and offering potential solutions to individuals and organizations. One dimension of this analysis is the Bribe Payers Index. Visit TI’s Web site to view the latest edition of the Bribe Payers Index.
Corruption Index www.transparency.org/ policy_research/ surveys_indices/cpi
Bribe Payers Index www.transparency.org/ policy_research/ surveys_indices/bpi
3. Sovereign Credit Ratings Criteria. The evaluation of credit risk and all other relevant risks associated with the multitude of borrowers on world debt mar- kets requires a structured approach to international risk assessment. Use Standard and Poor’s criteria, described in depth on their Web page, to differentiate the various risks (local currency risk, default risk, cur- rency risk, transfer risk, etc.) contained in major sov- ereign ratings worldwide. (You may need to complete a free login for this site.)
Standard and Poor’s www.standardandpoors.com/ ratings/criteria/en/us/
4. Milken Capital Access Index. The Milken Institute’s Capital Access Index (CAI) is one of the most recent informational indices that aids in the evaluation of how accessible world capital markets are to MNEs and gov- ernments of many emerging market countries. Accord- ing to the CAI, which countries have seen the largest deterioration in their access to capital in the last two years?
Milken Institute www.milken-inst.org/
5. Overseas Private Investment Corporation. The Over- seas Private Investment Corporation (OPIC) provides long-term political risk insurance and limited recourse project financing aid to U.S.-based firms investing abroad. Using the organization’s Web page, answer the following questions: a. Exactly what types of risk will OPIC insure against? b. What financial limits and restrictions are there on
this insurance protection? c. How should a project be structured to aid in its
approval for OPIC coverage?
Overseas Private Investment Corp. www.opic.gov/
6. Political Risk and Emerging Markets. Check the World Bank’s political risk insurance blog for current issues and topics in emerging markets.
Political Insurance Blog blogs.worldbank.org/ miga/category/tags/ political-risk-insurance
490
CHAPTER 18
Multinational Capital Budgeting and Cross-Border Acquisitions
Whales only get harpooned when they come to the surface, and turtles can only move forward when they stick their neck out, but investors face risk no matter what they do.
—Charles A. Jaffe.
This chapter describes in detail the issues and principles related to the investment in real productive assets in foreign countries, generally referred to as multinational capital budgeting. The chapter first describes the complexities of budgeting for a foreign proj- ect. Second, we describe the insights gained by valuing a project from both the project’s viewpoint and the parent’s viewpoint using a hypothetical investment by Cemex of Mexico in Indonesia. The chapter then discusses both real option analysis and the use of project financing today. The following section describes the stages involved in affecting cross- border acquisitions. We conclude the chapter with the Mini-Case, Yanzhou (China) Bids for Felix Resources (Australia).
Although the original decision to undertake an investment in a particular foreign country may be determined by a mix of strategic, behavioral, and economic decisions, the specific project, as well as all reinvestment decisions, should be justified by traditional financial analysis. For example, a production efficiency opportunity may exist for a U.S. firm to invest abroad, but the type of plant, mix of labor and capital, kinds of equipment, method of financ- ing, and other project variables must be analyzed within the traditional financial framework of discounted cash flows. It must also consider the impact of the proposed foreign project on consolidated net earnings, cash flows from subsidiaries in other countries, and on the market value of the parent firm.
Multinational 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:
! Identify the initial capital invested or put at risk. ! Estimate cash flows to be derived from the project over time, including an estimate
of the terminal or salvage value of the investment.
491Multinational Capital Budgeting and Cross-Border Acquisitions CHAPTER 18
! Identify the appropriate discount rate for determining the present value of the expected cash flows.
! 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.
Complexities of Budgeting for a Foreign Project 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.
! 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 poten- tial to cause changes in competitive position, and thus changes in cash flows over a period of 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.
Since the same theoretical capital budgeting framework is used to choose among com- peting foreign and domestic projects, it is critical that we have a common standard. Thus, all foreign complexities must be quantified as modifications to either expected cash flow or the rate of discount. Although in practice many firms make such modifications arbitrarily, readily available information, theoretical deduction, or just plain common sense can be used to make less arbitrary and more reasonable choices.
492 CHAPTER 18 Multinational Capital Budgeting and Cross-Border Acquisitions
Project Versus Parent Valuation 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, since most of a project’s cash flows to its parent, or to sister subsidiaries, are financial cash flows rather than operat- ing 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. For example, funds that are permanently blocked from repatriation, or “forcibly reinvested,” are not available for dividends to the stockhold- ers or for repayment of parent corporate debt. Therefore, shareholders will not perceive the blocked earnings as contributing to the value of the firm, and creditors will not count on them in calculating interest coverage ratios and other evidence of ability to service debt.
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—or, better yet, invest somewhere else!
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 letting those companies carry out the local projects. Apart from these theoretical arguments, surveys over the past 35 years show that in practice mul- tinational firms continue to evaluate foreign investments from both the parent and project viewpoint.
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 over 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 neces- sarily eliminate a project from financial consideration. They take a very long-run view of world business opportunities.
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 bud- geting outcome, because future project cash flows will be increased by the returns on forced reinvestment. Since 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
493Multinational Capital Budgeting and Cross-Border Acquisitions CHAPTER 18
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.
In conclusion, most firms appear to evaluate foreign projects from both parent and proj- ect viewpoints. The parent’s viewpoint gives results closer to the traditional meaning of net present value in capital budgeting. Project valuation provides a closer approximation of the effect on consolidated earnings per share, which all surveys indicate is of major concern to practicing managers. To illustrate the foreign complexities of multinational capital budgeting, we analyze a hypothetical market-seeking foreign direct investment by Cemex in Indonesia.
Illustrative Case: Cemex Enters Indonesia1
Cementos Mexicanos, Cemex, is considering the construction of a cement manufacturing facility on the Indonesian island of Sumatra. The project, Semen Indonesia (the Indonesian word for “cement” is semen), would be a wholly owned greenfield investment with a total installed capacity of 20 million metric tonnes per year (mmt/y). Although that is large by Asian production standards, Cemex believes that its latest cement manufacturing technology would be most efficiently utilized with a production facility of this scale.
Cemex has three driving reasons for the project: 1) The firm wishes to initiate a productive presence of its own in Southeast Asia, a relatively new market for Cemex; 2) The long-term prospects for Asian infrastructure development and growth appear very good over the longer term; and 3) There are positive prospects for Indonesia to act as a produce-for-export site as a result of the depreciation of the Indonesian rupiah (Rp) in recent years.
Cemex, the world’s third-largest cement manufacturer, is an MNE headquartered in an emerging market but competing in a global arena. The firm competes in the global market- place for both market share and capital. The international cement market, like markets in other commodities such as oil, is a dollar-based market. For this reason, and for comparisons against its major competitors in both Germany and Switzerland, Cemex considers the U.S. dollar its functional currency.
Cemex’s shares are listed in both Mexico City and New York (OTC: CMXSY). The firm has successfully raised capital—both debt and equity—outside Mexico in U.S. dollars. Its investor base is increasingly global, with the U.S. share turnover rising rapidly as a per- centage of total trading. As a result, its cost and availability of capital are internationalized and dominated by U.S. dollar investors. Ultimately, the Semen Indonesia project will be evaluated—in both cash flows and capital cost—in U.S. dollars.
Overview A road map of the complete multinational capital budgeting analysis for Cemex in Indonesia is illustrated in Exhibit 18.1. Starting at the top left, the parent company invests U.S. dollar denominated capital, which flows clockwise through the creation and operation of an Indo- nesian subsidiary, which then generates cash flows that are eventually returned in a variety of forms to the parent company—in U.S. dollars. The first step is to construct a set of pro forma financial statements for Semen Indonesia, all in Indonesian rupiah (Rp). The next step is to create two capital budgets, the project viewpoint and parent viewpoint.
1Cemex is a real company. However, the greenfield investment described here is hypothetical.
494 CHAPTER 18 Multinational Capital Budgeting and Cross-Border Acquisitions
Semen Indonesia will take only one year to build the plant, with actual operations commencing in year 1. The Indonesian government has only recently deregulated the heavier industries to allow foreign ownership. The following analysis is conducted assuming that pur- chasing power parity (PPP) holds for the Rp/US$ exchange rate for the life of the Indonesian project. This is a standard financial assumption made by Cemex for its foreign investments. The projected inflation rates for Indonesia and the United States are 30% per annum and 3% per annum, respectively.
If we assume an initial spot rate of Rp10,000/US$, and Indonesian and U.S. inflation rates of 30% and 3% per annum, respectively, for the life of the project, forecasted spot exchange rates follow the usual PPP calculation. For example, the forecasted exchange rate for year 1 of the project would be as follows:
Spot rate (year 1) = Rp10,000/US$ * 1 + .30 1 + .03 = Rp12,621/US$
The following series of financial statements are based on these assumptions.
Capital Investment. Although the cost of building new cement manufacturing capacity anywhere in the industrial countries is now estimated at roughly $150/tonne of installed capacity, Cemex believed that it could build a state-of-the-art production and shipment facil- ity in Sumatra at roughly $110/tonne (see Exhibit 18.2). Assuming a 20 million metric ton per year (mmt/y) capacity, and a year 0 average exchange rate of Rp10,000/$, this cost will constitute an investment of Rp22 trillion ($2.2 billion). This figure includes an investment of Rp17.6 trillion in plant and equipment, giving rise to an annual depreciation charge of Rp1.76 trillion if we assume a 10-year straight-line depreciation schedule. The relatively short depreciation schedule is one of the policies of the Indonesian tax authorities meant to attract foreign investment.
Financing. This massive investment would be financed with 50% equity, all from Cemex, and 50% debt, 75% from Cemex and 25% from a bank consortium arranged by the Indonesian
Semen Indonesia (Sumatra, Indonesia)
Cementos Mexicanos (Mexico)
US$ invested in Indonesia
cement manufacturing firm
Cash flows remitted
to Cemex (Rp to US$)
Estimated cash flows of project
END Is the project investment
justified (NPV > O)?
START
Parent Viewpoint Capital Budget (U.S. Dollars)
Project Viewpoint Capital Budget
(Indonesian Rupiah)
EXHIBIT 18.1 A Road Map to the Construction of Semen Indonesia’s Capital Budget
495Multinational Capital Budgeting and Cross-Border Acquisitions CHAPTER 18
EXHIBIT 18.2
Investment Financing
Average exchange rate, Rp/$ 10,000 Equity 11,000,000,000
Cost of installed capacity ($/tonne) $110 Debt: 11,000,000,000
Installed capacity 20,000 Rupiah debt 2,750,000,000
Investment in US$ $2,200,000 US$ debt in rupiah 8,250,000,000
Investment in rupiah 22,000,000,000 Total 22,000,000,000
Percentage of investment in plant & equip 80%
Plant and equipment (000s Rp) 17,600,000,000 Note: US$ debt principal $825,000
Depreciation of capital equipment (years) 10.00
Annual depreciation (millions) (1,760,000)
Costs of Capital: Cemex
Risk-free rate 6.000% Cemex beta 1.50
Credit premium 2.000% Equity risk premium 7.000%
Cost of debt 8.000% Cost of equity 16.500%
Corporate income tax rate 35.000% Percent equity 60.0%
Cost of debt after-tax 5.200% WACC 11.980%
Percent debt 40.0%
Cost of Capital: Semen Indonesia
Risk-free rate 33.000% Semen Indonesia beta 1.000
Credit premium 2.000% Equity risk premium 6.000%
Cost of rupiah debt 35.000% Cost of equity 40.000%
Indonesia corporate income tax rate 30.000% Percent equity 50.0%
Cost of US$ debt, after-tax 5.200% WACC 33.257%
Cost of US$ debt, (rupiah equivalent) 38.835%
Cost of US$ debt, after-tax (rupiah eq) 27.184%
Percent debt 50.0%
The cost of the US$ loan is stated in rupiah terms assuming purchasing power parity and U.S. dollar and Indonesian inflation rates of 3% and 30% per annum, respectively, throughout the subject period.
Semen Indonesia (Rp) Amount Financing Proportion Cost After-Tax Cost Component Cost
Rupiah loan 2,750,000,000 12.5% 35.000% 24.500% 3.063%
Cemex loan 8,250,000,000 37.5% 38.835% 27.184% 10.194%
Total debt 11,000,000,000 50.0%
Equity 11,000,000,000 50.0% 40.000% 40.000% 20.000%
Total financing 22,000,000,000 100.0% WACC 33.257%
Investment and Financing of the Semen Indonesia Project (all values in 000s unless otherwise noted)
government. Cemex’s own U.S. dollar-based weighted average cost of capital (WACC) was currently estimated at 11.98%. The WACC on a local Indonesian level in rupiah terms, for the project itself, was estimated at 33.257%. The details of this calculation are discussed later in this chapter.
496 CHAPTER 18 Multinational Capital Budgeting and Cross-Border Acquisitions
The cost of the US$ loan is stated in rupiah terms assuming purchasing power parity and U.S. dollar and Indonesian inflation rates of 3% and 30% per annum, respectively, throughout the subject period.
The explicit debt structures, including repayment schedules, are presented in Exhibit 18.3. The loan arranged by the Indonesian government, part of the government’s economic development incentive program, is an eight-year loan, in rupiah, at 35% annual interest, fully amortizing. The interest payments are fully deductible against corporate tax liabilities.
The majority of the debt, however, is being provided by the parent company, Cemex. After raising the capital from its financing subsidiary, Cemex will relend the capital to Semen Indonesia. The loan is denominated in U.S. dollars, five years maturity, with an annual interest rate of 10%. Because the debt will have to be repaid from the rupiah earnings of the Indone- sian enterprise, the pro forma financial statements are constructed so that the expected costs of servicing the dollar debt are included in the firm’s pro forma income statement. The dollar loan, if the rupiah follows the purchasing power parity forecast, will have an effective interest expense in rupiah terms of 38.835% before taxes. We find this rate by determining the internal rate of return of repaying the dollar loan in full in rupiah (see Exhibit 18.3).
The loan by Cemex to the Indonesian subsidiary is denominated in U.S. dollars. Therefore, the loan will have to be repaid in U.S. dollars, not rupiah. At the time of the loan agree- ment, the spot exchange rate is Rp10,000/$. This is the assumption used in calculating the “scheduled” repaying of principal and interest in rupiah. The rupiah, however, is expected to depreciate in line with purchasing power parity. As it is repaid, the “actual” exchange rate will therefore give rise to a foreign exchange loss as it takes more and more rupiah to acquire U.S. dollars for debt service, both principal and interest. The foreign exchange losses on this debt service will be recognized on the Indonesian income statement.
Revenues. Given the current existing cement manufacturing in Indonesia, and its currently depressed state as a result of the Asian crisis, all sales are based on export. The 20 mmt/y facility is expected to operate at only 40% capacity (producing 8 million metric tonnes). Cement produced will be sold in the export market at $58/tonne (delivered). Note also that, at least for the conservative baseline analysis, we assume no increase in the price received over time.
Costs. The cash costs of cement manufacturing (labor, materials, power, etc.) are estimated at Rp115,000 per tonne for 1999, rising at about the rate of inflation, 30% per year. Additional production costs of Rp20,000 per tonne for year 1 are also assumed to rise at the rate of infla- tion. As a result of all production being exported, loading costs of $2.00/tonne and shipping of $10.00/tonne must also be included. Note that these costs are originally stated in U.S. dol- lars, and for the purposes of Semen Indonesia’s income statement, they must be converted to rupiah terms. This is the case because both shiploading and shipping costs are international services governed by contracts denominated in dollars. As a result, they are expected to rise over time only at the U.S. dollar rate of inflation (3%).
Semen Indonesia’s pro forma income statement is illustrated in Exhibit 18.4. This is the typical financial statement measurement of the profitability of any business, whether domestic or international. The baseline analysis assumes a capacity utilization rate of only 40% (year 1), 50% (year 2), and 60% in the following years. Management believes this is necessary since existing in-country cement manufacturers are averaging only 40% of capacity at this time.
Additional expenses in the pro forma financial analysis include license fees paid by the subsidiary to the parent company of 2.0% of sales, and general and administrative expenses for Indonesian operations of 8.0% per year (and growing an additional 1% per year). Foreign exchange gains and losses are those related to the servicing of the U.S. dollar-denominated
497Multinational Capital Budgeting and Cross-Border Acquisitions CHAPTER 18
EXHIBIT 18.3 Semen Indonesia’s Debt Service Schedules and Foreign Exchange Gains/Losses
Spot rate (Rp/$) 10,000 12,621 15,930 20,106 25,376 32,028
Project Year 0 1 2 3 4 5
Indonesian loan @ 35% for 8 years (millions of rupiah)
Loan principal 2,750,000
Interest payment (962,500) (928,921) (883,590) (822,393) (739,777)
Principal payment (95,939) (129,518) (174,849) (236,046) (318,662)
Total payment (1,058,439) (1,058,439) (1,058,439) (1,058,439) (1,058,439)
Cemex loan @ 10% for 5 years (millions of U.S. dollars)
Loan principal 825
Interest payment ($82.50) ($68.99) ($54.12) ($37.77) ($19.78)
Principal payment ($135.13) ($148.65) ($163.51) ($179.86) ($197.85)
Total payment ($217.63) ($217.63) ($217.63) ($217.63) ($217.63)
Cemex loan converted to Rp at scheduled and current spot rates (millions of Rp):
Scheduled at Rp10,000/$:
Interest payment (825,000) (689,867) (541,221) (377,710) (197,848)
Principal payment (1,351,329) (1,486,462) (1,635,108) (1,798,619) (1,978,481)
Total payment (2,176,329) (2,176,329) (2,176,329) (2,176,329) (2,176,329)
Actual (at current spot rate):
Interest payment (1,041,262) (1,098,949) (1,088,160) (958,480) (633,669)
Principal payment (1,705,561) (2,367,915) (3,287,494) (4,564,190) (6,336,691)
Total payment (2,746,823) (3,466,864) (4,375,654) (5,522,670) (6,970,360)
Cash flows in Rp on Cemex loan (millions of Rp):
Total actual cash flows 8,250,000 (2,746,823) (3,466,864) (4,375,654) (5,522,670) (6,970,360)
IRR of cash flows 38.835%
Foreign exchange gains (losses) on Cemex loan (millions of Rp):
Foreign exchange gains (losses) on interest (216,262) (409,082) (546,940) (580,770) (435,821)
Foreign exchange gains (losses) on principal (354,232) (881,453) (1,652,385) (2,765,571) (4,358,210)
Total foreign exchange losses on debt (570,494) (1,290,535) (2,199,325) (3,346,341) (4,794,031)
The loan by Cemex to the Indonesian subsidiary is denominated in U.S. dollars. Therefore, the loan will have to be repaid in U.S. dollars, not rupiah. At the time of the loan agreement, the spot exchanage rate is Rp10,000/$. This is the assumption used in calculating the “scheduled” repaying of principal and interest in rupiah. The rupiah, however, is expected to depreciate in line with purchasing power parity. As it is repaid, the “actual” exchange rate will therefore give rise to a foreign exchange loss as it takes more and more rupiah to acquire U.S. dollars for debt service, both principal and interest. The foreign exchange losses on this debt service will be recognized on the Indonesian income statement.
debt provided by the parent and are drawn from the bottom of Exhibit 18.3. In summary, the subsidiary operation is expected to begin turning an accounting profit in its fourth year of operations (2000), with profits rising as capacity utilization increases over time.
Project Viewpoint Capital Budget The capital budget for the Semen Indonesia project from a project viewpoint is shown in Exhibit 18.5. We find the net cash flow, or free cash flow as it is often labeled, by summing
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EBITDA (earnings before interest, taxes, depreciation, and amortization), recalculated taxes, changes in net working capital (the sum of the net additions to receivables, inventories, and payables necessary to support sales growth), and capital investment.
Note that EBIT, not EBT, is used in the capital budget, which contains both depreciation and interest expense. Depreciation and amortization are noncash expenses of the firm and therefore contribute positive cash flow. Because the capital budget creates cash flows that will
EXHIBIT 18.4 Semen Indonesia’s Pro Forma Income Statement (millions of rupiah)
Exchange rate (Rp/US$) 10,000 12,621 15,930 20,106 25,376 32,028
Project Year 0 1 2 3 4 5
Sales volume 8.00 10.00 12.00 12.00 12.00
Sales price (US$) 58.00 58.00 58.00 58.00 58.00
Sales price (Rp) 732,039 923,933 1,166,128 1,471,813 1,857,627
Total revenue 5,856,311 9,239,325 13,993,541 17,661,751 22,291,530
Less cash costs (920,000) (1,495,000) (2,332,200) (3,031,860) (3,941,418)
Less other production costs (160,000) (260,000) (405,600) (527,280) (685,464)
Less loading costs (201,942) (328,155) (511,922) (665,499) (865,149)
Less shipping costs (1,009,709) (1,640,777) (2,559,612) (3,327,495) (4,325,744)
Total production costs (2,291,650) (3,723,932) (5,809,334) (7,552,134) (9,817,774)
Gross profit 3,564,660 5,515,393 8,184,207 10,109,617 12,473,756
Gross margin 60.9% 59.7% 58.5% 57.2% 56.0%
Less license fees (117,126) (184,787) (279,871) (353,235) (445,831)
Less general & administrative (468,505) (831,539) (1,399,354) (1,942,793) (2,674,984)
EBITDA 2,979,029 4,499,067 6,504,982 7,813,589 9,352,941
Less depreciation & amortization (1,760,000) (1,760,000) (1,760,000) (1,760,000) (1,760,000)
EBIT 1,219,029 2,739,067 4,744,982 6,053,589 7,592,941
Less interest on Cemex debt (825,000) (689,867) (541,221) (377,710) (197,848)
Foreign exchange losses on debt (570,494) (1,290,535) (2,199,325) (3,346,341) (4,794,031)
Less interest on local debt (962,500) (928,921) (883,590) (822,393) (739,777)
EBT (1,138,965) (170,256) 1,120,846 1,507,145 1,861,285
Less income taxes (30%) – – – (395,631) (558,386)
Net income (1,138,965) (170,256) 1,120,846 1,111,514 1,302,900
Net income (millions of US$) (90) (11) 56 44 41
Return on sales -19.4% -1.8% 8.0% 6.3% 5.8%
Dividends distributed – – 560,423 555,757 651,450
Retained (1,138,965) (170,256) 560,423 555,757 651,450
EBITDA = earnings before interest, taxes, depreciation, and amortization. EBIT = earnings before interest and taxes; EBT = earnings before taxes. Tax credits resulting from current period losses are carried forward toward next year’s tax liabilities. Dividends are not distributed in the first year of opera- tions as a result of losses, and are distributed as a 50% rate in years 2000–2003. All calculations are exact, but may appear not to add due to reported decimal places. The tax payment for year 3 is zero, and year 4 is less than 30%, as a result of tax loss carry-forwards from previous years.
499Multinational Capital Budgeting and Cross-Border Acquisitions CHAPTER 18
be discounted to present value with a discount rate, and the discount rate includes the cost of debt-interest—we do not wish to subtract interest twice. Therefore, taxes are recalculated on the basis of EBITDA. (This highlights the distinction between an income statement and a capital budget. The project’s income statement shows losses the first two years of operations as a result of interest expenses and forecast foreign exchange losses, so it is not expected to pay taxes. But the capital budget, constructed on the basis of EBITDA, before these financing and foreign exchange expenses, calculates a positive tax payment.) The firm’s cost of capital used in discounting also includes the deductibility of debt interest in its calculation.
The initial investment of Rp22 trillion is the total capital invested to support these earnings. Although receivables average 50 to 55 days sales outstanding (DSO) and inventories 65 to 70 DSO, payables and trade credit are also relatively long at 114 DSO in the Indonesian cement industry. Semen Indonesia expects to add approximately 15 net DSO to its investment with sales growth. The remaining elements to complete the project viewpoint’s capital budget are the terminal value (discussed below) and the discount rate of 33.257% (the firm’s weighted average cost of capital).
Terminal Value. The terminal value (TV) of the project represents the continuing value of the cement manufacturing facility in the years after year 5, the last year of the detailed pro forma financial analysis shown here. This value, like all asset values according to financial theory, is the present value of all future free cash flows that the asset is expected to yield. We calculate the TV as the present value of a perpetual net operating cash flow (NOCF) generated in the fifth year by Semen Indonesia, the growth rate assumed for that net operating cash flow (g), and the firm’s weighted average cost of capital (kwacc):
Terminal value = NOCF5 (1 + g)
kwacc - g =
7,075,059 (1 + 0) .33257 - 0 = Rp 21,274,102
EXHIBIT 18.5 Semen Indonesia Capital Budget: Project Viewpoint (millions of rupiah)
Exchange rate (Rp/US$) 10,000 12,621 15,930 20,106 25,376 32,028
Project Year 0 1 2 3 4 5
EBIT 1,219,029 2,739,067 4,744,982 6,053,589 7,592,941
Less recalculated taxes @ 30% (365,709) (821,720) (1,423,495) (1,816,077) (2,277,882)
Add back depreciation 1,760,000 1,760,000 1,760,000 1,760,000 1,760,000
Net operating cash flow 2,613,320 3,677,347 5,081,487 5,997,512 7,075,059
Less changes to NWC (240,670) (139,028) (436,049) (289,776) (626,314)
Initial investment (22,000,000)
Terminal value 21,274,102
Free cash flow (FCF) (22,000,000) 2,372,650 3,538,319 4,645,438 5,707,736 27,722,847
NPV @ 33.257% (7,855,886)
IRR 18.6%
NWC = net working capital. NPV = net present value. Discount rate is Semen Indonesia’s WACC of 33.257%. IRR = internal rate of return, the rate
of discount yielding an NPV of exactly zero. Values in exhibit are exact and are rounded to the nearest million.
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or Rp21,274,102 trillion. The assumption is that net operating cash flows will not grow past year 5 is probably not true, but it is a prudent assumption for Cemex to make when estimating future cash flows. The results of the capital budget from the project viewpoint indicate a negative net present value (NPV) and an internal rate of return (IRR) of only 18.6% compared to the 33.257% cost of capital. These are the returns the project would yield to a local or Indonesian investor in Indonesian rupiah. The project, from this viewpoint, is not acceptable.
Repatriating Cash Flows to Cemex Exhibit 18.6 now collects all incremental earnings to Cemex from the prospective investment project in Indonesia. As described in the section preceding the case, a foreign investor’s assess- ment of a project’s returns depends on the actual cash flows that are returned to it, in its own currency. For Cemex, this means that the investment must be analyzed in terms of U.S. dollar cash inflows and outflows associated with the investment over the life of the project, after-tax, discounted at its appropriate cost of capital.
The parent viewpoint capital budget is constructed in two steps:
1. First, we isolate the individual cash flows, adjusted for any withholding taxes imposed by the Indonesian government and converted to U.S. dollars. (Statutory withholding taxes on international transfers are set by bilateral tax treaties, but individual firms may negotiate lower rates with governmental tax authorities. In the case of Semen Indonesia, dividends will be charged a 15% withholding tax, 10% on interest payments, and 5% license fees.) Mexico does not tax repatriated earnings since they have already been taxed in Indonesia. (The United States does levy a contingent tax on repatriated earnings of foreign source income, as discussed in Chapter 15.)
2. The second step, the actual parent viewpoint capital budget, combines these U.S. dollar after-tax cash flows with the initial investment to determine the net present value of the proposed Semen Indonesia subsidiary in the eyes (and pocketbook) of Cemex. This is illustrated in Exhibit 18.6, which shows all incremental earnings to Cemex from the prospective investment project. A specific peculiarity of this parent view- point capital budget is that only the capital invested into the project by Cemex itself, $1,925 million, is included in the initial investment (the $1,100 million in equity and the $825 million loan). The Indonesian debt of Rp2.75 billion ($275 million) is not included in the Cemex parent viewpoint capital budget.
Parent Viewpoint Capital Budget Finally, all cash flow estimates are now constructed to form the parent viewpoint’s capital budget, detailed in the bottom of Exhibit 18.6. The cash flows generated by Semen Indonesia from its Indonesian operations, dividends, license fees, debt service, and terminal value are now valued in U.S. dollar terms after-tax. In order to evaluate the project’s cash flows that are returned to the parent company, Cemex must discount these at the corporate cost of capital. Remembering that Cemex considers its functional currency to be the U.S. dollar, it calculates its cost of capital in U.S. dollars. As described in Chapter 13, the customary weighted average cost of capital formula is as follows:
kwacc = ke E V
+ kd (1 - t) D V
,
501Multinational Capital Budgeting and Cross-Border Acquisitions CHAPTER 18
ke = risk@adjusted cost of equity kd = before@tax cost of debt t = marginal tax rate E = market value of the firm’s equity D = market value of the firm’s debt V = total market value of the firm’s securities (E + D)
EXHIBIT 18.6
Exchange rate (Rp/US$) 10,000 12,621 15,930 20,106 25,376 32,028
Project Year 0 1 2 3 4 5
Dividend Remittance
Dividends paid (Rp) – – 560,423 555,757 651,450
Less Indonesian withholding taxes – – (84,063) (83,364) (97,717)
Net dividend remitted (Rp) – – 476,360 472,393 553,732
Net dividend remitted (US$) – – 23.69 18.62 17.29
License Fees Remittance
License fees remitted (Rmb) 117,126 184,787 279,871 353,235 445,831
Less Indonesian withholding taxes (5,856) (9,239) (13,994) (17,662) (22,292)
Net license fees remitted (Rmb) 111,270 175,547 265,877 335,573 423,539
Net license fees remitted (US$) 8.82 11.02 13.22 13.22 13.22
Debt Service Remittance
Promised interest paid (US$) 82.50 68.99 54.12 37.77 19.78
Less Indonesian withholding tax @ 10% (8.25) (6.90) (5.41) (3.78) (1.98)
Net interest remitted (US$) 74.25 62.09 48.71 33.99 17.81
Principal payments remitted (US$) 135.13 148.65 163.51 179.86 197.85
Total principal and interest remitted $209.38 $210.73 $212.22 $213.86 $215.65
Capital Budget: Parent Viewpoint (millions of U.S. dollars)
Dividends – – 23.7 18.6 17.3
License fees 8.8 11.0 13.2 13.2 13.2
Debt service 209.4 210.7 212.2 213.9 215.7
Total earnings 218.2 221.8 249.1 245.7 246.2
Initial investment (1,925.0)
Terminal value 664.2
Net cash flows (1,925.0) 218.2 221.8 249.1 245.7 910.4
NPV @ 17.98% (903.9)
IRR !1.12%
NPV calculated using a company-determined discount rate of WACC + foreign investment premium, or 11.98% + 6.00% = 17.98%.
Semen Indonesia’s Remittance of Income to Parent Company (millions of rupiah and US$)
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Cemex’s cost of equity is calculated using the capital asset pricing model (CAPM):
ke = krf + (km - krf)bCemex = 6.00% + (13.00% - 6.00%)1.5 = 16.50%
ke = risk@adjusted cost of equity krf = risk@free rate of interest (U.S. Treasury intermediate bond yield) km = expected rate of return in U.S. equity markets (large stock) bCemex = measure of Cemex’s individual risk relative to the market
The calculation assumes the current risk-free rate is 6.00%, the expected return on U.S. equities is 13.00%, and Cemex’s beta is 1.5. The result is a cost of equity—required rate of return on equity investment in Cemex—of 16.50%.
The investment will be funded internally by the parent company, roughly in the same debt/ equity proportions as the consolidated firm, 40% debt (D/V) and 60% equity (E/V). The cur- rent cost of debt for Cemex is 8.00%, and the effective tax rate is 35%. The cost of equity, when combined with the other components, results in a weighted average cost of capital for Cemex of
kwacc = ke E V
+ kd (1 - t) D V
= (16.50%)(.60) + (8.00%)(1 - .35)(.40) = 11.98%
Cemex customarily uses this weighted average cost of capital of 11.98% to discount prospective investment cash flows for project ranking purposes. The Indonesian investment poses a variety of risks, however, which the typical domestic investment does not.
If Cemex were undertaking an investment of the same relative degree of risk as the firm itself, a simple discount rate of 11.980% might be adequate. Cemex, however, gener- ally requires new investments to yield an additional 3% over the cost of capital for domestic investments, and 6% more for international projects (these are company-required spreads, and will differ dramatically across companies). The discount rate for Semen Indonesia’s cash flows repatriated to Cemex will therefore be discounted at 11.98% + 6.00%, or 17.98%. The project’s baseline analysis indicates a negative NPV with an IRR of -1.12% which means that it is an unacceptable investment from the parent’s viewpoint.
Most corporations require that new investments more than cover the cost of the capital employed in their undertaking. It is therefore not unusual for the firm to require a hurdle rate of 3% to 6% above its cost of capital in order to identify potential investments that will liter- ally add value to stockholder wealth. An NPV of zero means the investment is “acceptable,” but NPV values that exceed zero are literally the present value of wealth that is expected to be added to that of the firm and its shareholders. For foreign projects, as discussed previously, we must adjust for agency costs and foreign exchange risks and costs.
Sensitivity Analysis: Project Viewpoint So far, the project investigation team has used a set of “most likely” assumptions to forecast rates of return. It is now time to subject the most likely outcome to sensitivity analyses. The same proba- bilistic techniques are available to test the sensitivity of results to political and foreign exchange risks as are used to test sensitivity to business and financial risks. Many decision makers feel more uncomfortable about the necessity to guess probabilities for unfamiliar political and foreign exchange events than they do about guessing their own more familiar business or financial risks. Therefore, it is more common to test sensitivity to political and foreign exchange risk by simulat- ing what would happen to net present value and earnings under a variety of “what if” scenarios.
Political Risk. What if Indonesia should impose controls on the payment of dividends or license fees to Cemex? The impact of blocked funds on the rate of return from Cemex’s per- spective would depend on when the blockage occurs, what reinvestment opportunities exist
503Multinational Capital Budgeting and Cross-Border Acquisitions CHAPTER 18
for the blocked funds in Indonesia, and when the blocked funds would eventually be released to Cemex. We could simulate various scenarios for blocked funds and rerun the cash flow analysis in Exhibit 18.6 to estimate the effect on Cemex’s rate of return.
What if Indonesia should expropriate Semen Indonesia? The effect of expropriation would depend on the following factors:
1. When the expropriation occurs, in terms of number of years after the business began operation
2. How much compensation the Indonesian government will pay, and how long after expropriation the payment will be made
3. How much debt is still outstanding to Indonesian lenders, and whether the parent, Cemex, will have to pay this debt because of its parental guarantee
4. The tax consequences of the expropriation 5. Whether the future cash flows are forgone
Many expropriations eventually result in some form of compensation to the former own- ers. 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.
The tax consequences of expropriation would depend on the timing and amount of capital loss recognized by Mexico. This loss would usually be based on the uncompensated book value of the Indonesian investment. The problem is that there is often some doubt as to when a write-off is appropriate for tax purposes, particularly if negotiations for a settlement drag on. In some ways, a nice clear expropriation without hope of compensation, such as occurred in Cuba in the early 1960s, is preferred to a slow “bleeding death” in protracted negotiations. The former leads to an earlier use of the tax shield and a one-shot write-off against earnings, whereas the latter tends to depress earnings for years, as legal and other costs continue and no tax shelter is achieved.
Foreign Exchange Risk. The project team assumed that the Indonesian rupiah would depre- ciate 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, since 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 compo- nents 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.
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.
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Other Sensitivity Variables. The project rate of return to Cemex would also be sensitive to a change in the assumed terminal value, the capacity utilization rate, the size of the license fee paid by Semen Indonesia, the size of the initial project cost, the amount of working capital financed locally, and the tax rates in Indonesia and Mexico. Since some of these variables are within control of Cemex, it is still possible that the Semen Indonesia project could be improved in its value to the firm and become acceptable.
Sensitivity Analysis: Parent Viewpoint Measurement When a foreign project is analyzed from the parent’s point of view, the additional risk that stems from its “foreign” location can be measured in at least two ways, adjusting the discount rates or adjusting the cash flows.
Adjusting Discount Rates. The first method is to treat all foreign risk as a single problem, by adjusting the discount rate applicable to foreign projects relative to the rate used for domestic projects to reflect the greater foreign exchange risk, political risk, agency costs, asymmetric information, and other uncertainties perceived in foreign operations. However, adjusting the discount rate applied to a foreign project’s cash flow to reflect these uncertainties does not penalize net present value in proportion either to the actual amount at risk or to possible variations in the nature of that risk over time. Combining all risks into a single discount rate may thus cause us to discard much information about the uncertainties of the future.
In the case of foreign exchange risk, changes in exchange rates have a potential effect on future cash flows because of operating exposure. The direction of the effect, however, can either decrease or increase net cash inflows, depending on where the products are sold and where inputs are sourced. To increase the discount rate applicable to a foreign project, on the assumption that the foreign currency might depreciate more than expected, ignores the possible favorable effect of a foreign currency depreciation on the project’s competitive position. Increased sales volume might more than offset a lower value of the local currency. Such an increase in the discount rate also ignores the possibility that the foreign currency may appreciate (two-sided risk).
Adjusting Cash Flows. In the second method, we incorporate foreign risks in adjustments to forecasted cash flows of the project. The discount rate for the foreign project is risk-adjusted only for overall business and financial risk, in the same manner as for domestic projects. Simulation-based assessment utilizes scenario development to estimate cash flows to the parent arising from the project over time under different alternative economic futures.
Certainty regarding the quantity and timing of cash flows in a prospective foreign invest- ment is, to quote Shakespeare, “the stuff that dreams are made of.” Due to the complexity of economic forces at work in major investment projects, it is paramount that the analyst realizes the subjectivity of the forecast cash flows. Humility in analysis is a valuable trait.
Shortcomings of Each. In many cases, however, neither adjusting the discount rate nor adjusting cash flows is optimal. For example, political uncertainties are a threat to the entire investment, not just the annual cash flows. Potential loss depends partly on the terminal value of the unrecovered parent investment, which will vary depending on how the project was financed, whether political risk insurance was obtained, and what invest- ment horizon is contemplated. Furthermore, if the political climate were expected to be unfavorable in the near future, any investment would probably be unacceptable. Political uncertainty usually relates to possible adverse events that might occur in the more distant future, but that cannot be foreseen at the present. Adjusting the discount rate for politi- cal risk thus penalizes early cash flows too heavily while not penalizing distant cash flows enough.
505Multinational Capital Budgeting and Cross-Border Acquisitions CHAPTER 18
Repercussions to the Investor. Apart from anticipated political and foreign exchange risks, MNEs sometimes worry that taking on foreign projects may increase the firm’s overall cost of capital because of investors’ perceptions of foreign risk. This worry seemed reasonable if a firm had significant investments in Iraq, Iran, Russia, Serbia, or Afghanistan in the 1990s. However, the argument loses persuasiveness when applied to diversified foreign investments with a heavy balance in the industrial countries of Canada, Western Europe, Australia, Latin America, and Asia where, in fact, the bulk of FDI is located. These countries have a reputa- tion for treating foreign investments by consistent standards, and empirical evidence confirms that a foreign presence in these countries may not increase the cost of capital. In fact, some studies indicate that required returns on foreign projects may even be lower than those for domestic projects.
MNE Practices. Surveys of MNEs over the past 35 years have shown that about half of them adjust the discount rate and half adjust the cash flows. One recent survey indicated a rising use of adjusting discount rates over adjusting cash flows. However, the survey also indicated an increasing use of multifactor methods—discount rate adjustment, cash flow adjustment, real options analysis, and qualitative criteria—in evaluating foreign investments.2
Portfolio Risk Measurement The field of finance has distinguished two different definitions of risk: 1) the risk of the individ- ual security (standard deviation of expected return) and 2) the risk of the individual security as a component of a portfolio (beta). A foreign investment undertaken in order to enter a local or regional market—market seeking—will have returns that are more or less correlated with those of the local market. A portfolio-based assessment of the investment’s prospects would then seem appropriate. A foreign investment undertaken for resource-seeking or production- seeking purposes may have returns related to those of the parent company or units located somewhere else in the world and have little to do with local markets. Cemex’s proposed investment in Semen Indonesia is both market seeking and production seeking (for export). The decision about which approach is to be used by the MNE in evaluating prospective foreign investments may be the single most important analytical decision it makes. An investment’s acceptability may change dramatically across criteria.
For comparisons within the local host country, we should overlook a project’s actual financing or parent-influenced debt capacity, since these would probably be different for local investors than they are for a multinational owner. In addition, the risks of the project to local investors might differ from those perceived by a foreign multinational owner because of the opportunities an MNE has to take advantage of market imperfections. Moreover, the local project may be only one out of an internationally diversified portfolio of projects for the multinational owner; if undertaken by local investors it might have to stand alone without international diversification. Since diversification reduces risk, the MNE can require a lower rate of return than is required by local investors.
Thus, the discount rate used locally must be a hypothetical rate based on a judgment as to what independent local investors would probably demand were they to own the business. Consequently, application of the local discount rate to local cash flows provides only a rough measure of the value of the project as a stand-alone local venture, rather than an absolute valuation.
2Tom Keck, Eric Levengood, and Al Longield, “Using Discounted Cash Flow Analysis in an International Setting: A Survey of Issues in Modeling the Cost of Capital,” Journal of Applied Corporate Finance, Volume 11, No. 3, Fall 1998, pp. 82–99.
506 CHAPTER 18 Multinational Capital Budgeting and Cross-Border Acquisitions
Real Option Analysis The discounted cash flow (DCF) approach used in the valuation of Semen Indonesia—and capital budgeting and valuation in general—has long had its critics. Investments that have long lives, cash flow returns in later years, or higher levels of risk than those typical of the firm’s current business activities are often rejected by traditional DCF financial analysis. More importantly, when MNEs evaluate competitive projects, traditional discounted cash flow anal- ysis is typically unable to capture the strategic options that an individual investment option may offer. This has led to the development of real option analysis. Real option analysis is the application of option theory to capital budgeting decisions.
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. These wide ranges of value are vola- tilities, the basic element of option pricing theory described previously. Real option valuation also allows us to analyze a number of managerial decisions, which in practice, characterize many major capital investment projects:
! The option to defer ! The option to abandon ! The option to alter capacity ! 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. Man- agement learns from both active (searching it out) and passive (observing market conditions) knowledge gathering and then uses this knowledge to make better decisions.
Project Financing One of the hottest topics in international finance today is project finance, which refers to the arrangement of financing for long-term capital projects, large in scale, long in life, and gener- ally high in risk. This is a very general definition, however, because many different forms and structures fall under this generic heading.
Project finance is not new. Examples of project finance go back centuries, and include many famous early international businesses such as the Dutch East India Company and the British East India Company. These entrepreneurial importers financed their trade ventures to Asia on a voyage-by-voyage basis, with each voyage’s financing being like venture capital; investors would be repaid when the shipper returned and the fruits of the Asian marketplace were sold at the docks to Mediterranean and European merchants. If all went well, the indi- vidual shareholders of the voyage were paid in full.
Today, project finance is used widely in the development of large-scale infrastructure projects in China, India, and many other emerging markets. Although each individual proj- ect has unique characteristics, most are highly leveraged transactions, with debt making up more than 60% of the total financing. Equity is a small component of project financing for two reasons: 1) The simple scale of the investment project often precludes a single investor
507Multinational Capital Budgeting and Cross-Border Acquisitions CHAPTER 18
or even a collection of private investors from being able to fund it; 2) Many of these projects involve subjects traditionally funded by governments—such as electrical power generation, dam building, highway construction, energy exploration, production, and distribution.
This level of debt, however, places an enormous burden on cash flow for debt service. Therefore, project financing usually requires a number of additional levels of risk reduc- tion. The lenders involved in these investments must feel secure that they will be repaid; bankers are not by nature entrepreneurs, and do not enjoy entrepreneurial returns from project finance. Project finance has a number of basic properties which are critical to its success.
Separability of the Project from Its Investors. The project is established as an individual legal entity, separate from the legal and financial responsibilities of its individual investors. This not only serves to protect the assets of equity investors, but also provides a controlled platform upon which creditors can evaluate the risks associated with the singular project, have the ability of the project’s cash flows to service debt, and be confident that the debt service payments will be automatically allocated by and from the project itself (and not from a decision by management within an MNE).
Long-Lived and Capital-Intensive Singular Projects. Not only must the individual project be separable and large in proportion to the financial resources of its owners, but also its busi- ness line must be singular in its construction, operation, and size (capacity). The size is set at inception, and is seldom, if ever, changed over the project’s life.
Cash Flow Predictability from Third-Party Commitments. An oil field or electric power plant produces a homogeneous commodity product which can produce predictable cash flows if third-party commitments to take and pay can be established. In addition to revenue pre- dictability, nonfinancial costs of production need to be controlled over time, usually through long-term supplier contracts with price adjustment clauses based on inflation. The predict- ability of net cash inflows to long-term contracts eliminates much of the individual project’s business risk, allowing the financial structure to be heavily debt-financed and still safe from financial distress.
The predictability of the projects revenue stream is essential in securing project financing. Typical contract provisions which are intended to assure adequate cash flow normally include the following clauses: quantity and quality of the project’s output; a pricing formula that enhances the predictability of adequate margin to cover operating costs and debt service pay- ments; a clear statement of the circumstances that permits significant changes in the contract such as force majeure or adverse business conditions.
Finite Projects with Finite Lives. Even with a longer-term investment, it is critical that the project have a definite ending point at which all debt and equity has been repaid. Because the project is a stand-alone investment in which its cash flows go directly to the servicing of its capital structure, and not to reinvestment for growth or other investment alternatives, inves- tors of all kinds need assurances that the project’s returns will be attained in a finite period. There is no capital appreciation, but only cash flow.
Examples of project finance include some of the largest individual investments undertaken in the past three decades, such as British Petroleum’s financing of its interest in the North Sea, and the Trans-Alaska Pipeline. The Trans-Alaska Pipeline was a joint venture between Standard Oil of Ohio, Atlantic Richfield, Exxon, British Petroleum, Mobil Oil, Philips Petro- leum, Union Oil, and Amerada Hess. Each of these projects was at or above $1 billion, and represented capital expenditures which no single firm would or could attempt to finance. Yet, through a joint venture arrangement, the higher than normal risk absorbed by the capital employed could be managed.
508 CHAPTER 18 Multinational Capital Budgeting and Cross-Border Acquisitions
Cross-Border Mergers and Acquisitions The drivers of M&A activity, summarized in Exhibit 18.7, 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 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.
But the global competitive environment is really just the playing field, the ground upon which the individual players compete. MNEs undertake cross-border mergers and acquisitions for a variety of reasons. As shown in Exhibit 18.7, the drivers are strategic responses by MNEs to defend and enhance their global competitiveness by the following:
! Gaining access to strategic proprietary assets ! Gaining market power and dominance ! Achieving synergies in local/global operations and across different industries ! Becoming larger, and then reaping the benefits of size in competition and
negotiation ! Diversifying and spreading their risks wider ! Exploiting financial opportunities they may possess and others desire
As opposed to greenfield investment, a cross-border acquisition has a number of signifi- cant 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 gain- ing competitive advantages such as technology, brand names valued in the target market, and logistical and distribution advantages, while simultaneously eliminating a local com- petitor. Third, specific to cross-border acquisitions, international economic, political, and
Changes in the Global Business Environment
Create business opportunities for select firms to both enhance and defend their competitive positions in global markets
Gaining access to strategic proprietary assets Gaining market power and dominance Achieving synergies in local/global operations and across different industries Becoming larger, and then reaping the benefits of size in competition and negotiation Diversifying and spreading their risks wider Exploiting financial opportunities they may possess and others desire
EXHIBIT 18.7 Driving Forces Behind Cross Border Mergers and Acquisitions
509Multinational Capital Budgeting and Cross-Border Acquisitions CHAPTER 18
foreign exchange conditions may result in market imperfections, allowing target firms to be undervalued.
Cross-border acquisitions are not, however, without their pitfalls. As with all acquisitions—domestic or cross-border—there are problems of paying too much or suf- fering excessive financing costs. Melding 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 cross- border acquisitions successfully may itself be a test of competency of the MNE when enter- ing emerging markets.
The Cross-Border Acquisition Process Although the field of finance has sometimes viewed acquisition as mainly an issue of valua- tion, it is a much more complex and rich process than simply determining what price to pay. As depicted in Exhibit 18.8, the process begins with the strategic drivers discussed in the previous section.
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.
Stage 1: Identification and Valuation. Identification of potential acquisition targets requires a well-defined corporate strategy and focus.
The identification of the target market typically precedes the identification of the target firm. Entering a highly developed market offers the widest choice of publicly traded firms with relatively well-defined markets and publicly disclosed financial and operational data. In this case, the tender offer is made publicly, although target company management may openly recommend that its shareholders reject the offer. If enough shareholders take the offer, the
Strategy and Management
Financial Analysis and Strategy
Stage I Stage II Stage III
Identification and valuation of the target
Completion of the ownership change transaction (the tender)
Management of the post-acquisition transition; integration of business and culture
Valuation and negotiation
Financial settlement and compensation
Rationalization of operations; integration of finanical goals; achieving synergies
EXHIBIT 18.8 The Cross-Border Acquisition Process
510 CHAPTER 18 Multinational Capital Budgeting and Cross-Border Acquisitions
acquiring company may gain sufficient ownership influence or control to change manage- ment. During this rather confrontational process, it is up to the board of the target company to continue to take actions consistent with protecting the rights of shareholders. The board may need to provide rather strong oversight of management during this process, to ensure that management does not take actions consistent with its own perspective but not with protecting and building shareholder value.
Once identification has been completed, the process of valuing the target begins. A variety of valuation techniques are widely used in global business today, each with its relative merits. In addition to the fundamental methodologies of discounted cash flow (DCF) and multiples (earnings and cash flows), there are also a variety of industry-specific measures that focus on the most significant elements of value in business lines. The completion of a variety of alter- native valuations for the target firm aids not only in gaining a more complete picture of what price must be paid to complete the transaction, but also in determining whether the price is attractive.
Stage 2: Execution of the Acquisition. Once an acquisition target has been identified and valued, the process of gaining approval from management and ownership of the target, getting approvals from government regulatory bodies, and finally determining method of compensation—the complete execution of the acquisition strategy—can be time-consuming and complex.
Gaining the approval of the target company has itself been the subject of some of the most historic acquisitions. The critical distinction here is whether the acquisition is supported or not by the target company’s management.
Although there is probably no “typical transaction,” many acquisitions flow relatively smoothly through a friendly process. The acquiring firm will approach the management of the target company and attempt to convince them of the business logic of the acquisition. (Gain- ing their support is sometimes difficult, but assuring target company management that it will not be replaced is often quite convincing!) If the target’s management is supportive, they may then recommend to stockholders that they accept the offer of the acquiring company. One problem that occasionally surfaces at this stage is that influential shareholders may object to the offer, either in principle or based on price, and therefore feel that management is not taking appropriate steps to protect and build their shareholder value.
The process takes on a very different dynamic when the acquisition is not supported by target company management—the so-called hostile takeover. The acquiring company may choose to pursue the acquisition without the target’s support and go directly to the target shareholders. In this case, the tender offer is made publicly, although target company manage- ment may openly recommend that its shareholders reject the offer. If enough shareholders take the offer, the acquiring company may gain sufficient ownership influence or control to change management. During this rather confrontational process, it is up to the board of the target company to continue to take actions consistent with protecting the rights of share- holders. The board may need to provide rather strong oversight of management during this process, to ensure that management does not take actions consistent with its own perspective but not with protecting and building shareholder value.
Regulatory approval alone may prove a major hurdle in the execution of the deal. An acquisition may be subject to significant regulatory approval if it involves a company in an industry considered fundamental to national security, or if there may be concern over major concentration and anticompetitive results from consolidation.
The proposed acquisition of Honeywell International (itself the result of a merger of Honeywell U.S. and Allied-Signal U.S.) by General Electric (U.S.) in 2001 was something of a watershed event in the field of regulatory approval. General Electric’s acquisition of
511Multinational Capital Budgeting and Cross-Border Acquisitions CHAPTER 18
Honeywell had been approved by management, ownership, and U.S. regulatory bodies, when it then sought approval within the European Union. Jack Welch, the charismatic chief execu- tive officer and president of GE did not anticipate the degree of opposition that the merger would face from EU authorities. After a continuing series of demands by the EU that specific businesses within the combined companies be sold off to reduce anticompetitive effects, Welch withdrew the request for acquisition approval, arguing that the liquidations would destroy most of the value-enhancing benefits of the acquisition. The acquisition was canceled. This case may have far-reaching effects on cross-border M&A for years to come, as the power of regulatory authorities within strong economic zones like the EU to block the combination of two MNEs, may foretell a change in regulatory strength and breadth.
The last act within this second stage of cross-border acquisition, compensation settlement, is the payment to shareholders of the target company. Shareholders of the target company are typically paid either in shares of the acquiring company or in cash. If a share exchange occurs, which exchange may be defined by some ratio of acquiring company shares to target company shares (say, two shares of acquirer in exchange for three shares of target), the stockholder is typically not taxed. The shareholder’s shares of ownership have simply been replaced by other shares in a nontaxable transaction.
If cash is paid to the target company shareholder, it is the same as if the shareholder has sold the shares on the open market, resulting in a capital gain or loss (a gain, it is hoped, in the case of an acquisition) with tax liabilities. Because of the tax ramifications, shareholders are typically more receptive to share exchanges so that they may choose whether and when tax liabilities will arise.
A variety of factors go into the determination of type of settlement. The availability of cash, the size of the acquisition, the friendliness of the takeover, and the relative valuations of both acquiring firm and target firm affect the decision. One of the most destructive forces that sometimes arise at this stage is regulatory delay and its impact on the share prices of the two firms. If regulatory body approval drags out over time, the possibility of a drop in share price increases and can change the attractiveness of the share swap.
Stage 3: Post-Acquisition Management. Although the headlines and flash of investment banking activities are typically focused on the valuation and bidding process in an acquisition transaction, post transaction management is probably the most critical of the three stages in determining an acquisition’s success or failure. An acquiring firm can pay too little or too much, but if the post transaction is not managed effectively, the entire return on the invest- ment is squandered. Post-acquisition management is the stage in which the motivations for the transaction must be realized. Those reasons, such as more effective management, syner- gies arising from the new combination, or the injection of capital at a cost and availability previously out of the reach of the acquisition target, must be effectively implemented after the transaction. The biggest problem, however, is nearly always melding corporate cultures.
The clash of corporate cultures and personalities pose both the biggest risk and the biggest potential gain from cross-border mergers and acquisitions. Although not readily measurable like price/earnings ratios or share price premiums, in the end, the value is either gained or lost in the hearts and minds of the stakeholders.
Currency Risks in Cross-Border Acquisitions The pursuit and execution of a cross-border acquisition poses a number of challenging foreign currency risks and exposures for an MNE. As illustrated by Exhibit 18.9, 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.
512 CHAPTER 18 Multinational Capital Budgeting and Cross-Border Acquisitions
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. As illus- trated in Exhibit 18.9, the uncertainty related to the multitude of stages declines over time as stages are completed and contracts and agreements reached.
The initial bid, if denominated in a foreign currency, creates a contingent foreign cur- rency exposure for the bidder. This contingent exposure grows in certainty of occurrence over time as negotiations continue, regulatory requests and approvals are gained, and competi- tive bidders exit. 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.
Once the bidder has successfully won the acquisition, the exposure evolves from a contin- gent exposure to a transaction exposure. Although a variety of uncertainties remain as to the exact timing of the transaction settlement, the certainty over the occurrence of the currency exposure is largely eliminated. Some combination of forward contracts and purchased cur- rency options may then be used to manage the currency risks associated with the completion of the cross-border acquisition.
EXHIBIT 18.9 Currency Risks in Cross-Border Acquisitions
Operational Stage
What are the operational cash flows?
What are the currency exposures associated with cash flows?
Transaction Stage
What will be the precise timing and execution?
Financing Stage
How will it be financed?
What is the form of payment?
Bidding Stage
Will it happen? When will it happen?
Uncertainty
High
Low
What is the final price?
Moderate
513Multinational Capital Budgeting and Cross-Border Acquisitions CHAPTER 18
Statoil’s acquisition of Svenska Esso (Exxon’s wholly owned subsidiary operating in Sweden) in 1986 was one of the more uniquely challenging cross-border acquisitions ever com- pleted. First, Statoil was the national oil company of Norway, and therefore a government-owned and operated business bidding for a private company in another country. Second, if completed, the acquisition’s financing as proposed would increase the financial obligations of Svenska Esso (debt lev- els and therefore debt-service), reducing the company’s tax liabilities to Sweden for many years to come. The proposed cross-border transaction was characterized as a value transfer from the Swedish government to the Norwegian government.
As a result of the extended period of bidding, negotiation, and regulatory approvals, the currency risk of the transaction was both large and extensive. Statoil, being a Norwegian oil company, was a Norwegian kroner (NOK)-based company with the U.S. dollar as its functional currency as a result of the global oil industry being dollar-denominated. Svenska Esso, although
Swedish by incorporation, was the wholly owned subsidiary of a U.S.-based MNE, Exxon, and the final bid and cash settlement on the sale was therefore U.S. dollar-denominated.
On March 26, 1985, Statoil and Exxon agreed upon the sale of Svenska Esso for $260 million, or NOK2.47 billion at the current exchange rate of NOK9.50/$. (This was by all modern standards the weakest the Norwegian krone had ever been against the dollar, and many currency analysts believed the dol- lar to be significantly overvalued at the time.) The sale could not be consummated without the approval of the Swedish govern- ment. That approval process—eventually requiring the approval of Swedish Prime Minister Olaf Palme—took nine months. Because Statoil considered the U.S. dollar as its true operating currency, it chose not to hedge the purchase price currency exposure. At the time of settlement the krone had appreciated to NOK7.65/$, for a final acquisition cost in Norwegian kroner of NOK1.989 billion. Statoil saved nearly 20% on the purchase price, NOK0.481 billion, as a result of not hedging the exposure.
GLOBAL FINANCE IN PRACTICE 18.1
Statoil of Norway’s Acquisition of Esso of Sweden
Once consummated, the currency risks and exposures of the cross-border acquisition, now a property and foreign subsidiary of the MNE, changes from being a transaction-based cash flow exposure to the MNE to part of its multinational structure and therefore part of its operating exposure from that time forward. Time, as is always the case involving cur- rency exposure management in multinational business, is the greatest enemy to the MNE. As illustrated by Global Finance in Practice 18.1, however, things do not always work out for the worst.
SUMMARY POINTS
! The proposed greenfield investment in Indonesia by Cemex was analyzed within the traditional capital bud- geting framework (base case).
! The foreign complications were introduced to the analy- sis, including foreign exchange and political risks.
! 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, cash flows cannot be clearly separated from financ- ing decisions, as is done in domestic capital budgeting.
! Remittance of funds to the parent must be explicitly recognized because of differing tax systems, legal and political constraints on the movement of funds, local
business norms, and differences in how financial mar- kets and institutions function.
! Cash flows from subsidiaries to parent can be generated by an array of nonfinancial payments, including pay- ment of license fees and payments for imports from the parent.
! Differing rates of national inflation must be antici- pated because of their importance in causing changes in competitive position, and thus in cash flows over time.
! When a foreign project is analyzed from the project’s point of view, risk analysis focuses on the use of sensi- tivities, as well as consideration of foreign exchange and political risks associated with the project’s execution over time.
514 CHAPTER 18 Multinational Capital Budgeting and Cross-Border Acquisitions
! When a foreign project is analyzed from the parent’s point of view, the additional risk that stems from its “foreign” location can be measured in at least two ways, adjusting the discount rates or adjusting the cash flows.
! Real option analysis 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.
! Real option valuation allows us to evaluate the option to defer, the option to abandon, the option to alter size or capacity, and the option to start up or shut down a project.
! Project finance is used widely today in the development of large-scale infrastructure projects in many emerging markets. Although each individual project has unique characteristics, most are highly leveraged transac- tions, with debt making up more than 60% of the total financing.
! Equity is a small component of project financing for two reasons: first, the simple scale of the investment project often precludes a single investor or even a collection
of private investors from being able to fund it; second, many of these projects involve subjects traditionally funded by governments—such as electrical power gen- eration, dam building, highway construction, energy exploration, production, and distribution.
! The process of acquiring an enterprise anywhere in the world has three common elements: 1) identifica- tion and valuation of the target; 2) completion of the ownership change transaction (the tender); and 3) the management of the post-acquisition transition.
! The settlement stage of a cross-border merger or acqui- sition requires gaining the approval and cooperation of management, shareholders, and eventually regulatory authorities.
! Cross-border mergers, acquisitions, and strategic alli- ances, all face similar challenges: They must value the target enterprise based on its projected performance in its market. This process of enterprise valuation combines elements of strategy, management, and finance.
On 13 August 2009, the Felix Board announced it had entered into a Scheme Implementation Agreement for an all cash offer by Yanzhou Coal (through its Wholly Owned Subsidiary Austar) to acquire all the issued shares of Felix (the Transaction) to be implemented by way of a scheme of arrangement (the Scheme).
—Felix Resources, Scheme Booklet, 30 September 2009, p. 6.
While we continue to believe the emergence of a counter- bidder is likely, the short list has diminished thus reduc- ing the probability of such an outcome. That said, we would not recommend shareholders accept the $18ps offer for now.
—“Felix Resources: A New Year, A New Mine,” Macquarie Equities, 1 September 2009, p. 1.
It was late October 2009, and Quillan and his fellow inves- tors were debating on what to do about their shares in Felix
Resources (FLX AU), an Australian coal mining company. Yanzhou Coal Company of China had been courting Felix for nearly a year, and had made a formal offer on August 13 worth AUD18 per share—the Scheme, which Felix’s Board and management team had endorsed.2 But many stockholders were not sure the offer was a good one. When Yanzhou had first approached Felix in December 2008, the offer had been AUD20 per share. But a lot had changed since then, including the price of coal, the value of the Aus- tralian dollar, and concerns over Chinese acquisitions of Australian mineral producers. Shareholders were now being pressured to accept the Scheme.
China, Coal, and Yanzhou Coal Company The Chinese economy consumed massive quantities of coal. The rapid economic growth of China drove the demand for both thermal or steam coal (for electrical power produc- tion) and coking coal (for steel production) ever skyward.
2The Australian dollar, depending on the source cited, may be shown as AUD, A$, or $.
Yanzhou (China) Bids for Felix Resources (Australia)1
1Copyright © 2011 Thunderbird School of Global Management. All rights reserved. This case was prepared by Natsuki Baba, Katerina Dankova, and Jeanine Divis under the direction of Professor Michael H. Moffett for the purpose of classroom discussion only, and not to indicate either effective or ineffective management.
MINI-CASE
515Multinational Capital Budgeting and Cross-Border Acquisitions CHAPTER 18
the country, far from the coastal markets and not readily accessible, China has been looking more and more to for- eign markets to fulfill its growing coal demands.
Thus, Chinese coal companies have been looking to purchase more coal from outside China. Because of its proximity, high level of development and abundant natural resources, Australia had been the target of a number of these Chinese acquisition efforts. One such purchase attempt had generated negative press and strained relationships between the two governments. In June 2009, Australian-based Rio Tinto rejected China’s Chinalco’s bid to purchase its major mining assets and partnered with rival BHP Billiton in a shocking last-minute effort. Despite the tensions, Chinese companies continued to buy overseas assets.
Coal Prices. As illustrated in Exhibit 1, Australian thermal coal prices had long been relatively flat—at least until 2008. Strong demand from countries such as Japan, South Korea,
Coal-fired electric power provided roughly 80% of China’s electricity, and was expected to stay at that level for a num- ber of years. In 2008 alone, China, accounted for 43% of global coal consumption. Chinese Coal. China was rich in coal itself, with reserves of its own estimated at 14% of global reserves. Although a global commodity, most of the world’s countries consume coal in the country where it is produced, with one large exception—Australia. Austra- lia exports 75% of its production, mostly to Japan, South Korea, and China.
But the Chinese coal market had grown increasingly complex. The Chinese government had imposed a freeze on all new coal exports in February 2008 and increased its export tax to 13% on existing export commitments. At the same time, China had ordered more than 15,000 small coal mines closed in recent years, primarily a result of unsafe working conditions and continued mine accidents. With much of China’s coal reserves in the far north and west of
EXHIBIT 1 Australian Thermal Coal Price (January 2001–October 2009)
USD/metric tonne
Source: International Monetary Fund. 12,000 BTU/pound, less than 1% sulfur, 14% ash. FOB Newcastle/Port Kembla.
0
20
40
60
80
100
120
140
160
200
180
Ja n-0
1
Ma y-0
1
Se p-0
1
Ja n-0
2
Ma y-0
2
Se p-0
2
Ja n-0
3
Ma y-0
3
Se p-0
3
Ja n-0
4
Ma y-0
4
Se p-0
4
Ja n-0
5
Ma y-0
5
Se p-0
5
Ja n-0
6
Ma y-0
6
Se p-0
6
Ja n-0
7
Ma y-0
7
Se p-0
7
Ja n-0
8
Ma y-0
8
Se p-0
8
Ja n-0
9
Ma y-0
9
Se p-0
9
516 CHAPTER 18 Multinational Capital Budgeting and Cross-Border Acquisitions
Bids and Negotiations In July 2008, as coal prices started to rise, Felix reported that a number of companies were interested in acquiring the firm. Felix’s share price trended upward. In Decem- ber 2008, Felix reported that Yanzhou had surpassed all competitive bidders, with an “indicative offer of AUD20/ share.” At AUD20/share and 196,325,038 shares outstand- ing, the offer was AUD3,926,500,760. At that same time, the Australian dollar was trading at roughly AUD1.50/USD, making the “indicative offer” worth USD2.62 billion.
The debate over price was in many ways personal. Felix Resources was closely held, with the CEO Brian Flannery holding 15% interest, Chairman Travers Duncan 15%, American Metals and Coal International 19.2%—largely controlled by Hans Mende, and former Felix CFO David Knappick another 7.4%. Four people controlled 56.6% of Felix’s shares.
Meetings between the two companies were held in China in February, but little progress was made. By March, the two companies were still negotiating price. The fall in coal prices and coal company share prices had changed the negotiating range.
Yanzhou was now offering only AUD12 per share. Both Felix and Yanzhou were feeling the effects of lower share prices. Because of the scope of the deal, both Chinese and Australian regulatory authorities continued to review the proposed transaction, although the parties appeared to be far apart on price.
The following months saw a number of Chinese acquisi- tions of Australian mineral producers.
Yanzhou is the latest in a long line of Chinese suitors to consider buying Australian mining assets—not all of which have been successful. This month, Chinalco’s $19.5bn tie-up with Rio Tinto collapsed. However, Oz Minerals shareholders recently accepted an offer from Minmetals to purchase the company’s mining assets after the Chinese group raised its offer in a pre-emptive move to head off opposition. Felix indicated on Wednesday that its own discussions with interested parties regarding a takeover deal were ongoing.
—“Linc Energy ends talks with Yanzhou over sale,” Financial Times, June 24, 2009.
In August 2009, after intensive discussions, Yanzhou made an all-cash offer totaling AUD18 per share. The offer combined AUD16.95 per share cash, plus an AUD1.00 per share fully franked dividend (AUD0.50 immediately, with
and China, and limited supply due to inclement weather and undersized ports in Australia, had induced a price run-up in mid-2008.3
But just as quickly as they had gone up, coal prices col- lapsed. The global recession caused coal demand and prices to fall in late 2008. But they did not stay down for long, as the Chinese and Indian economies recovered relatively quickly, once again stoking the demand for coal. Yanzhou, as part of its valuation of Felix, believes that coal prices are likely to stay between USD88 and USD104 per tonne for several years.
Yanzhou Coal Company. With expected 2009 revenues and after-tax profits of HKD19 billion and HKD6.1 bil- lion, respectively, Yanzhou Coal Company was China’s fourth largest coal producer. The company was also repre- sentative of much of China’s new industry, as it was both government-controlled but publicly traded. Yanzhou was listed on the Hong Kong Stock Exchange, the New York Stock Exchange, and the Shanghai Stock Exchange. Its total market capitalization was RMB70.1 billion (USD10.3 billion) on September 30, 2009.
Yanzhou had begun its investment in Australian coal in 2004 when it acquired the Austar coal mine. But since that time, Yanzhou had failed to increase production from Austar significantly, the company falling behind its strate- gic plan. Additionally, because of stricter safety require- ments, production had fallen at six of its mines in Shandong Province, China. Therefore, without the purchase of Felix, Yanzhou’s production would plateau and it risked falling behind its competitors.
Felix Resources Limited (Australia). Felix Resources Limited of Australia (FLX.AU) was Australia’s 12th larg- est coal mining firm. Felix was expected to close 2009 with more than AUD260 million in profits on more than AUD680 million in sales. The company owned four under- ground and open cut mines in New South Wales and Queensland, and was expanding its mining operations at Moolarben in New South Wales. Felix sold the majority of its production to the export market—to South Korea, Japan, and now China.
Felix also owned 15% interest in the Newcastle Coal Infrastructure Group port under construction, and Ultra Clean Coal (UCC), a technology for producing a cleaner coal. Felix’s coal was also low in sulphur content, an added feature given China’s commitment to both coal-fired elec- trical power and the simultaneous commitment to reduce carbon emissions by 40% by 2020.
3Note that Australian coal prices are quoted in U.S. dollars. This is in-line with global practice of pricing coal in U.S. dollars, similar in industry practice to that of oil or other major global commodities.
517Multinational Capital Budgeting and Cross-Border Acquisitions CHAPTER 18
first forecasts the firm’s net operating cash flows, then dis- counts them to present value using the firm’s cost of capital. Financial technicals aside, the true driver of value for the DCF or any other valuation analysis was still what the price of coal would do in the short-to-medium term. Forecasting coal prices added up to “sophisticated guesswork” in the words of one analyst.
One DCF valuation of Felix presented in Exhibit 3 indi- cates a value of AUD10.74 per share (baseline analysis), a much lower value than the current market price and pro- spective bid price. A variety of sensitivities and scenarios established a range between AUD9 and AUD14 per share.
Control Premium. One feature often overlooked in acqui- sition valuations is an added “boost” or premium to the offered share price reflecting a change in control of the company. This is additional compensation to investors who had invested by choice, but who would now be removed without their individual approval. This control premium may vary between 5% and 10% in many cases.
another AUD0.50 per share on approval of the acquisi- tion), and an AUD0.05 share distribution of a startup firm, SACC. (A franking credit represents taxes already paid on the dividend. Although the stockholder receives in cash only the dividend, the tax authorities record stock- holder income as dividend plus credit, eliminating most of the double taxation for small investors on dividend income.) On August 13, 2009, Felix announced that it had received—and the board had unanimously supported—the offer. As illustrated in Exhibit 2, Felix’s share price rose to about AUD17 per share where it had remained.
Valuation Throughout the deal’s discussions, Yanzhou, Felix, and a host of analysts used a variety of different methods to value the company, including discounted cash flow (DCF), reserve valuation, and market comparables.
DCF. The most widely used traditional financial valuation technique for firms is discounted cash flow (DCF). DCF
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Share price peaks June 2, 2008 at AUD 22.49 as speculation rises on acquisition
Yanzhou gains final Chinese and Australian approvals October 23, 2009
Yanzhou makes formal offer of AUD 18 on August 13th
Yanzhou makes indicative offer of AUD 20/share December 2008
Two parties reportedly far apart on price, March 2009
Share price rises as coal prices rise
Share price falls as coal prices fall and no offers
EXHIBIT 2 Felix Resources Share Price (January 2008–October 2009)
518 CHAPTER 18 Multinational Capital Budgeting and Cross-Border Acquisitions
EXHIBIT 3 Discounted Cash Flow Valuation of Felix Resources
Forecast
Thousands of AUD Years 09-12 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Net sales 75,068 117,357 208,536 236,318 420,506 462,557 508,812 559,693 615,663 677,229
Sales growth % 10% 56% 78% 13% 78%
Cost of goods sold 40,481 47,329 80,685 107,275 57,093 62,908 69,198 76,118 83,730 92,103
% of sales 13.6% 54% 40% 39% 45% 14%
Gross profit 34,587 70,028 127,851 129,043 363,413 399,649 439,614 483,575 531,933 585,126
Selling, general and admininstrative
31,791 59,213 95,191 114,783 227,503 245,155 269,670 296,638 326,301 358,931
% of sales 53% 42% 50% 46% 49% 54%
Operating profit (EBITDA) 2,796 10,815 32,660 14,260 135,910 154,494 169,943 186,938 205,631 226,195
Depreciation and amortization
1,547 5,501 11,381 17,469 28,639 31,454 34,599 38,059 41,865 46,052
% of sales 6.8% 2.1% 4.7% 5.5% 7.4% 6.8%
EBIT 1,249 5,314 21,279 (3,209) 107,271 123,040 135,344 148,878 163,766 180,143
NWC 1,199 10,742 14,277 (2,770) 53,775 46,256 50,881 55,969 61,566 67,723
% of sales 10% 1.6% 9.2% 6.8% -1.2% 12.8%
DCF Valuation 2004 2005 2006 2007 2008 2009 2010 2011t 2012 2013
EBIT 123,040 135,344 148,878 163,766 180,143
Less taxes 30% 36,912 40,603 44,664 49,130 54,043
EBITDA after tax 159,952 175,947 193,542 212,896 234,186
Add back depreciation and amortization
31,454 34,599 38,059 41,865 46,052
Less ANWC 7,519 (4,626) (5,088) (5,597) (6,157)
Less Capex (31,454) (34,599) (38,059) (41,865) (46,052)
Free Cash Flow (FCF) 167,471 171,322 188,454 207,299 228,029
Terminal Value (FCF growth rate, %)
1.0% 2,303,095
FCF including terminal value
167,471 171,322 188,454 207,299 2,531,124
Enterprise value (NPV) 11.00% 2,293,674
Less debt 188,031
Market value (AUD) 2,105,643
Shares outstanding 196,000,000
Value per share, Felix (AUD)
10.74
Notes: Felix has an estimated weighted average cost of capital of 11.07%, assuming a risk-free rate of 5.44% (10-year Australian government bond), an expected market return of 9.94%, a beta of 1.63, a cost of debt of 8.50%, a corporate income tax rate of 30%, and a financial structure which is 30% debt and 70% equity. Discount rate rounded to 11%.
Reserve Valuation. All industries use a variety of industry specific valuation techniques which focus on value drivers in that specific industry. In mining, production today is impor- tant, but reserves to support production tomorrow is critical.
When buying a coal, copper, or oil company, the buyer is also buying both proved and probable reserves (often referred to in the minerals industries as 2P). Exhibit 4 provides one ana- lyst’s overview of a reserve-based valuation on Felix.
519Multinational Capital Budgeting and Cross-Border Acquisitions CHAPTER 18
! Felix’s employees and management would be 100% retained
! Yancoal Australia, a mine operating company, incor- porated and headquartered in Australia would be created
! Yancoal would be managed primarily by Australian managers and sales staff
! Yancoal’s CEO and CFO would maintain their primary residences in Australia
! The coal would be marketed on an arm’s-length basis consistent with international benchmarks and practices
! Yancoal would be listed on the Australian Securities Exchange by the end of 2012 and over 30% of the shares would be available for sale
Although the analysts continued to counsel investors to hold out for a competing bid, the share price had stabi- lized and no other bidders had come forward. Quillan and his fellow investors wondered if they should tender their shares now or hold out for a higher offer.
Case Questions
1. When should stockholders doubt their own company’s support of a friendly acquisition?
2. What is your assessment of the stipulations placed on the acquisition by the Australian government?
3. Which of the various valuation techniques do you find the most and least useful?
4. Do you think the offer is a good one? Should Quillan take it?
Comparables. Again, the analysts and interested parties looked at a multitude of other valuation ratios of other regional and Chinese peer companies. Comparables on peers, presented in Exhibit 5, generally showed Felix to be valued on par with other major publicly traded coal com- panies, if not on the high side.
Contracted Valuation. Felix’s management, after announcing their support for the Yanzhou offer, commis- sioned an independent valuation study by a consultant, Deloitte. On September 30, Felix reported that Deloitte’s study concluded that “the proposed scheme is fair,” and that the estimated fair market value of Felix Resources was likely between AUD16.70 and AUD18.70 per share.
Currency-Based Valuation. One final valuation note by one consultant had caught Quillan’s eye. That analysis, pre- sented in Exhibit 6, argued that once the U.S. dollar-based value of coal was translated into the currency of the inves- tor (Chinese yuan for Yanzhou), and that CNY value used to calculate an Australian dollar (AUD) value, the value of a pound of Australian coal assets had dropped from December 2008 to October 2009. This was, hypothetically, the “cost” of Australian coal assets to a Chinese buyer. This change was a combination of changing coal prices and the appreciation of the Australian dollar against the yuan.
Government Approval The Assistant Treasurer of the Government of Australia and the Foreign Investment Review Board (FIRB) gave final approval to the deal on October 23. But the govern- ment’s approval was conditional on all of the following stipulations, which Yanzhou thought acceptable:
EXHIBIT 4 Reserve Valuation Analysis
Coal Company Stock Yanzhou Coal Shenhua Energy Bumi Resources Banpu Felix Resources
Bloomberg Reference 1171 HK 1088 HK Bumi IJ BANPU TB FLX AU
Share price currency HKD HKD IDR THB AUD
Share price 13 August 2009 12.40 31.95 3,175.00 422.00 16.95
Spot exchange rate 7.75 7.75 9,950.00 34.06 1.19
(HKD/USD) (HKD/USD) (IDR/USD) (THB/USD) (AUD/USD)
Shares outstanding 4,918,000,000 19,900,000,000 19,400,000,000 300,000,000 196,325,000
Total market capitalization $7,868,800,000 $82,039,354,839 $6,190,452,261 $3,716,970,053 $2,803,461,457
Proved and probable reserves (equity, t) 1,866,000,000 7,320,000,000 1,100,000,000 288,000,000 386,000,000
Market cap/Coal reserve (USD/t) 4.22 11.21 5.63 12.91 7.26
Source: Bloomberg, DBS Vickers. Analysis revised by authors based on “Hong Kong/China Flash Notes: Yanzhou Coal,” DBS Group Research Equity, 14 August 2009, p. 2. t = tonne. Proved and probable reserves are on an equity ownership basis.
EXHIBIT 5 Valuation Based on Comparables of Peers
Company Name Code Currency Market Capitalization
(million USD) PE P/CF P/Book EV/EBITDA
Bumi Resources BUMI IJ IDR 6,186 13.3 9.7 3.2 6.7
Straits Asia SAR SP SGD 1,761 5.5 7.8 3.2 5.6
Banpu BANPU TB THB 3,356 9.4 8.7 2.3 7.7
Centennial Coal CEY AU AUD 1,083 17.5 8.3 2.1 6.7
Coal and Allied CAN AU AUD 6,123 16.4 13.8 5.2 12.0
Arch Coal ACI US USD 2,970 53.3 7.5 1.4 10.2
Consol Energy CNX US USD 7,476 12.6 7.8 3.7 6.3
Felix Resources FLX AU AUD 2,911 12.6 10.6 4.8 8.3
Weighted Average: Regional 16.7 9.7 3.6 8.1
China Shenhua 1088 HK HKD 14,316 19.1 14.1 3.8 10.8
Yanzhou Coal 1171 HK HKD 3,133 13.6 11.8 1.9 7.0
China Coal 1898 HK HKD 5,638 17.1 15.2 1.9 10.0
Hidili Industry 1393 HK HKD 2,041 24. 2 18.7 2.2 20.5
Weighted Average: H-shares (Hong Kong)
18.4 14.4 3.0 10.9
Source: “Yanzhou Coal,” Flash Notes, DBS Group Research, 14 August 2009. PE is price to earnings; P/CF is price to cash flow; P/Book is price to book value; EV/EBITDA is enterprise value to earnings before interest, taxes, depreciation and amortization. Enterprise value is the market value of all debt and equity less cash and cash equivalents. All ratios are for forecasts for 2009.
EXHIBIT 6 The Price of Australian Thermal Coal to a Chinese Buyer
(1) (2) (3) (4) (5) (6)
Date Price of Coal
(USD) Spot Rate (CNY/USD)
Translated Price of Coal in CNY
Spot Rate (CNY/AUD)
Translated Price of Coal in AUD
Jan 2008 98.30 7.25 712.68 6.25 114.03
July 2008 192.86 6.83 1,317.23 6.67 197.59
Dec 2008 84.27 6.85 577.25 4.55 126.99
March 2009 65.36 6.84 447.06 4.55 98.35
August 2009 77.68 6.83 530.55 5.56 95.50
October 2009 76.15 6.83 520.10 6.25 83.22
Coal is priced globally in USD (column 2). Starting with the market price of Australian thermal coal, the price of coal in USD is translated into Chinese yuan (CNY) at official yuan exchange rate to the dollar (column 3). This value in the eyes of a Chinese investor like Yanzhou is then translated into Austra- lian dollars (AUD) at the current spot rate of exchange (column 5). Column 6 is, in theory, the coal-based cost of acquiring an Australian coal producer.
520 CHAPTER 18 Multinational Capital Budgeting and Cross-Border Acquisitions
521Multinational Capital Budgeting and Cross-Border Acquisitions CHAPTER 18
10. Foreign Exchange Risk. How is foreign exchange risk sensitivity factored into the capital budgeting analysis of a foreign project?
11. Expropriation Risk. How is expropriation risk factored into the capital budgeting analysis of a foreign project?
12. Real Option Analysis. What is real option analy- sis? How is it a better method of making investment decisions than traditional capital budgeting analysis?
PROBLEMS 1. Natural Mosaic. Natural Mosaic Company (U.S.) is
considering investing Rs50,000,000 in India to create a wholly owned tile manufacturing plant to export to the European market. After five years, the subsidiary would be sold to Indian investors for Rs100,000,000. A pro forma income statement for the Indian operation predicts the generation of Rs7,000,000 of annual cash flow, is listed in the following table.
QUESTIONS 1. Capital Budgeting Theoretical Framework. Capital
budgeting for a foreign project uses the same theo- retical framework as domestic capital budgeting. What are the basic steps in domestic capital budgeting?
2. Foreign Complexities. Capital budgeting for a foreign project is considerably more complex than the domes- tic case. What are the factors that add complexity?
3. Project Versus Parent Valuation. a. Why should a foreign project be evaluated both
from a project and parent viewpoint? b. Which viewpoint, project or parent, gives results
closer to the traditional meaning of net present value in capital budgeting?
c. Which viewpoint gives results closer to the effect on consolidated earnings per share?
4. Which Cash Flows? Capital projects provide both operating cash flows and financial cash flows. Why are operating cash flows preferred for domestic capi- tal budgeting but financial cash flows given major consideration in international projects?
5. Risk-Adjusted Return. Should the anticipated internal rate of return (IRR) for a proposed foreign project be compared to 1) alternative home country proposals, 2) returns earned by local companies in the same industry and/or risk class, or 3) both? Justify your answer.
6. Blocked Cash Flows. In the context of evaluating foreign investment proposals, how should a multi- national firm evaluate cash flows in the host foreign country that are blocked from being repatriated to the firm’s home country?
7. Host-Country Inflation. How should an MNE factor host-country inflation into its evaluation of an invest- ment proposal?
8. Cost of Equity. A foreign subsidiary does not have an independent cost of capital. However, in order to esti- mate the discount rate for a comparable host-country firm, the analyst should try to calculate a hypotheti- cal cost of capital. As part of this process, the analyst can estimate the subsidiary’s proxy cost of equity by using the traditional equation: ke = krf + (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.
9. Viewpoints. What are the differences in the cash flows used in a project point of view analysis and a parent point of view analysis?
Sales revenue 30,000,000
Less cash operating expenses (17,000,000)
Gross income 13,000,000
Less depreciation expenses (1,000,000)
Earnings before interest and taxes 12,000,000
Less Indian taxes at 50% (6,000,000)
Net income 6,000,000
Add back depreciation 1,000,000
Annual cash flow 7,000,000
The initial investment will be made on December 31, 2011, and cash flows will occur on December 31 of each succeeding year. Annual cash dividends to Philadelphia Composite from India will equal 75% of accounting income.
The U.S. corporate tax rate is 40% and the Indian cor- porate tax rate is 50%. Because the Indian tax rate is greater than the U.S. tax rate, annual dividends paid to Natural Mosaic will not be subject to additional taxes in the United States. There are no capital gains taxes on the final sale. Natural Mosaic uses a weighted aver- age cost of capital of 14% on domestic investments, but will add six percentage points for the Indian invest- ment because of perceived greater risk. Natural Mosaic forecasts the rupee/dollar exchange rate for December 31 on the next six years are listed on the next page.
What is the net present value and internal rate of return on this investment?
522 CHAPTER 18 Multinational Capital Budgeting and Cross-Border Acquisitions
moving some of its manufacturing operations to south- ern California. Operations in California would begin in year 1 and have the following attributes.
2. Grenouille Properties. Grenouille Properties (U.S.) expects to receive cash dividends from a French joint venture over the coming three years. The first divi- dend, to be paid December 31, 2011, is expected to be €720,000. The dividend is then expected to grow 10.0% per year over the following two years. The cur- rent exchange rate (December 30, 2010) is $1.3603/€. Grenouille’s weighted average cost of capital is 12%. a. What is the present value of the expected euro divi-
dend stream if the euro is expected to appreciate 4.00% per annum against the dollar?
b. What is the present value of the expected dividend stream if the euro were to depreciate 3.00% per annum against the dollar?
3. Carambola de Honduras. Slinger Wayne, a U.S.- based private equity firm, is trying to determine what it should pay for a tool manufacturing firm in Hondu- ras named Carambola. Slinger Wayne estimates that Carambola will generate a free cash flow of 13 million Honduran lempiras (Lp) next year (2012), and that this free cash flow will continue to grow at a constant rate of 8.0% per annum indefinitely.
A private equity firm like Slinger Wayne, however, is not interested in owning a company for long, and plans to sell Carambola at the end of three years for approximately 10 times Carambola’s free cash flow in that year. The current spot exchange rate is Lp14.80/$, but the Honduran inflation rate is expected to remain at a relatively high rate of 16.0% per annum com- pared to the U.S. dollar inflation rate of only 2.0% per annum. Slinger Wayne expects to earn at least a 20% annual rate of return on international investments like Carambola. a. What is Carambola worth if the Honduran lem-
pira were to remain fixed over the three-year investment period?
b. What is Carambola worth if the Honduran lempira were to change in value over time according to purchasing power parity?
4. Finisterra, S.A. Finisterra, S.A., located in the state of Baja California, Mexico, manufactures frozen Mexi- can food which enjoys a large following in the U.S. states of California and Arizona to the north. In order to be closer to its U.S. market, Finisterra is considering
Assumptions Value
Sales price per unit, year 1 (US$) $ 5.00
Sales price increase, per year 3.00%
Initial sales volume, year 1, units 1,000,000
Sales volume increase, per year 10.00%
Production costs per unit, year 1 $ 4.00
Production cost per unit increase, per year 4.00%
General and administrative expenses per year $100,000
Depreciation expenses per year $ 80,000
Finisterra’s WACC (pesos) 16.00%
Terminal value discount rate 20.00%
R$/$ R$/$
2011 50 2014 62
2012 54 2015 66
2013 58 2016 70
The peso/dollar exchange rate (Ps/$) is expected to be 8.00 (Year 0), 9.00 (Year 1), 10.00 (Year 2) and 11.00 (Year 3).
The operations in California will pay 80% of its accounting profit to Finisterra as an annual cash dividend. Mexican taxes are calculated on grossed up dividends from foreign countries, with a credit for host-country taxes already paid. What is the maximum U.S. dollar price Finisterra should offer in year 1 for the investment?
5. Doohicky Devices. Doohickey Devices, Inc., manu- factures design components for personal computers. Until the present, manufacturing has been subcon- tracted to other companies, but for reasons of quality control Doohicky has decided to manufacture itself in Asia. Analysis has narrowed the choice to two pos- sibilities, Penang, Malaysia, and Manila, the Philip- pines. At the moment only the summary of expected, after-tax, cash flows displayed at the bottom of this page is available. Although most operating outflows would be in Malaysian ringgit or Philippine pesos, some additional U.S. dollar cash outflows would be necessary, as shown in the table at the top of this page.
The Malaysia ringgit currently trades at RM3.80/$ and the Philippine peso trades at Ps50.00/$. Doohicky expects the Malaysian ringgit to appreciate 2.0% per year against the dollar, and the Philippine peso to depreciate 5.0% per year against the dollar. If the weighted average cost of capital for Doohicky Devices is 14.0%, which project looks most promising?
523Multinational Capital Budgeting and Cross-Border Acquisitions CHAPTER 18
6. Wenceslas Refining Company. Privately owned Wenceslas Refining Company is considering investing in the Czech Republic so as to have a refinery source closer to its European customers. The original invest- ment in Czech korunas would amount to K250 million, or $5,000,000 at the current spot rate of K32.50/$, all in fixed assets, which will be depreciated over 10 years by the straight-line method. An additional K100,000,000 will be needed for working capital.
For capital budgeting purposes, Wenceslas assumes sale as a going concern at the end of the third year at a price, after all taxes, equal to the net book value of fixed assets alone (not including working capital). All free cash flow will be repatriated to the United States as soon as possible. In evaluating the venture, the U.S. dollar forecasts are shown in the table below.
Variable manufacturing costs are expected to be 50% of sales. No additional funds need be invested in the U.S. subsidiary during the period under consideration. The Czech Republic imposes no restrictions on repa- triation of any funds of any sort. The Czech corporate tax rate is 25% and the United States rate is 40%. Both countries allow a tax credit for taxes paid in other coun- tries. Wenceslas uses 18% as its weighted average cost of capital, and its objective is to maximize present value. Is the investment attractive to Wenceslas Refining?
Doohicky in Penang (after-tax) 2012 2013 2014 2015 2016 2017
Net ringgit cash flows (26,000) 8,000 6,800 7,400 9,200 10,000
Dollar cash outflows _ (100) (120) (150) (150) _
Doohicky in Manila (after-tax)
Net peso cash flows (560,000) 190,000 180,000 200,000 210,000 200,000
Dollar cash outflows _ (100) (200) (300) (400) _
Assumptions 0 1 2 3
Original investment (Czech korunas, K) 250,000,000
Spot exchange rate (K/$) 32.50 30.00 27.50 25.00
Unit demand 700,000 900,000 1,000,000
Unit sales price $10.00 $10.30 $10.60
Fixed cash operating expenses $1,000,000 $1,030,000 $1,060,000
Depreciation $ 500,000 $ 500,000 $ 500,000
Investment in working capital (K) 100,000,000
Hermosa Beach Components (U.S.) Use the following information and assumptions to answer problems 7–10.
Hermosa Beach Components, Inc., of California exports 24,000 sets of low-density light bulbs per year to Argentina under an import license that expires in five years. In Argentina, the bulbs are sold for the Argentine peso equivalent of $60 per set. Direct manufacturing costs in the United States and shipping together amount to $40 per set. The market for this type of bulb in Argentina is stable, neither growing nor shrinking, and Hermosa holds the major portion of the market.
The Argentine government has invited Hermosa to open a manufacturing plant so imported bulbs can be replaced by local production. If Hermosa makes the investment, it will operate the plant for five years and then sell the building and equipment to Argen- tine investors at net book value at the time of sale plus the value of any net working capital. (Net work- ing capital is the amount of current assets less any portion financed by local debt.) Hermosa will be allowed to repatriate all net income and deprecia- tion funds to the United States each year. Hermosa traditionally evaluates all foreign investments in U.S. dollar terms.
524 CHAPTER 18 Multinational Capital Budgeting and Cross-Border Acquisitions
All investment outlays will be made in 2012, and all operating cash flows will occur at the end of years 2013 through 2017.
! Depreciation and investment recovery. Building and equipment will be depreciated over five years on a straight-line basis. At the end of the fifth year, the $1,000,000 of net working capital may also be repatri- ated to the United States, as may the remaining net book value of the plant.
! Sales price of bulbs. Locally manufactured bulbs will be sold for the Argentine peso equivalent of $60 per set.
! Operating expenses per set of bulbs. Material purchases are as follows:
the baseline analysis to be performed in U.S. dol- lars (and implicitly also assumes the exchange rate remains fixed throughout the life of the project). Cre- ate a project viewpoint capital budget and a parent viewpoint capital budget. What do you conclude from your analysis?
8. Hermosa Components: Revenue Growth Scenario. As a result of their analysis in problem 7, Hermosa wishes to explore the implications of being able to grow sales volume by 4% per year. Argentine inflation is expected to average 5% per year, so sales price and material cost increases of 7% and 6% per year, respectively, are thought reasonable. Although material costs in Argentina are expected to rise, U.S.- based costs are not expected to change over the 5-year period. Evaluate this scenario for both the project and parent viewpoints. Is the project under this revenue growth scenario acceptable?
9. Hermosa Components: Revenue Growth and Sales Price Scenario. In addition to the assumptions employed in problem 8, Hermosa now wishes to eval- uate the prospect of being able to sell the Argentine subsidiary at the end of year 5 at a multiple of the busi- ness’s earnings in that year. Hermosa believes that a multiple of six is a conservative estimate of the market value of the firm at that time. Evaluate the project and parent viewpoint capital budgets.
10. Hermosa Components: Revenue Growth, Sales Price, and Currency Risk Scenario. Melinda Deane, a new analyst at Hermosa and a recent MBA gradu- ate, believes that it is a fundamental error to evalu- ate the Argentine project’s prospective earnings and cash flows in dollars, rather than first estimating their Argentine peso (Ps) value and then converting cash flow returns to the United States in dollars. She believes the correct method is to use the end-of-year spot rate in 2012 of Ps3.50/$ and assume it will change in relation to purchasing power. (She is assuming U.S. inflation to be 1% per annum and Argentine infla- tion to be 5% per annum). She also believes that Hermosa should use a risk-adjusted discount rate in Argentina which reflects Argentine capital costs (20% is her estimate) and a risk-adjusted discount rate for the parent viewpoint capital budget (18%) on the assumption that international projects in a risky cur- rency environment should require a higher expected return than other lower-risk projects. How do these assumptions and changes alter Hermosa’s perspective on the proposed investment?
! Investment. Hermosa’s anticipated cash outlay in U.S. dollars in 2012 would be as follows:
Materials purchased in Argentina (U.S. dollar equivalent)
$20 per set
Materials imported from Hermosa Beach-USA $10 per set
Total variable costs $30 per set
! Transfer prices. The $10 transfer price per set for raw material sold by the parent consists of $5 of direct and indirect costs incurred in the United States on their manufacture, creating $5 of pre-tax profit to Hermosa Beach.
! Taxes. The corporate income tax rate is 40% in both Argentina and the United States (combined federal and state/province). There are no capital gains taxes on the future sale of the Argentine subsidiary, either in Argentina or the United States.
! Discount rate. Hermosa Components uses a 15% discount rate to evaluate all domestic and foreign projects.
7. Hermosa Components: Baseline Analysis. Evaluate the proposed investment in Argentina by Hermosa Components (U.S.). Hermosa’s management wishes
Building and equipment $1,000,000
Net working capital 1,000,000
Total investment $2,000,000
525Multinational Capital Budgeting and Cross-Border Acquisitions CHAPTER 18
might start with the Web sites listed below), build a database on doing business in China, and prepare an update of many of the factors discussed in this chapter.
Ministry of Foreign Trade english.mofcom.gov.cn/ and Economic Cooperation, PRC
China Investment Trust and Investment Corporation www.citic.com/wps/portal/
enlimited
ChinaNet Investment Pages www.chinanet-online.com/ relations-end.html
3. BeyondBrics: The Financial Times’s Emerging Mar- ket Hub. Check the FT ’s blog on emerging markets for the latest debates and guest editorials.
Financial Times Blog blogs.ft.com/beyond-brics/ on Emerging Markets
INTERNET EXERCISES
1. Capital Projects and the EBRD. The European Bank for Reconstruction and Development (EBRD) was established to foster market-oriented business devel- opment in the former Soviet Bloc. Use the EBRD Web site to determine which projects and companies EBRD is currently undertaking.
European Bank for Reconstruction www.ebrd.com and Development
2. Emerging Markets: China. Long-term investment projects such as electrical power generation require a thorough understanding of all attributes of doing business in that country. China is currently the focus of investment and market penetration strategies of multinational firms worldwide. Using the Web (you
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PART VI
Managing Multinational Operations
CHAPTER 19 Working Capital Management
CHAPTER 20 International Trade Finance
527
Working Capital Management
Morality is all right, but what about dividends?
—Kaiser Wilhelm II.
Working capital management in an MNE requires managing the repositioning of cash flows, as well as managing current assets and liabilities, when faced with political, foreign exchange, tax and liquidity constraints. The overall goal is to reduce funds tied up in working capital while simultaneously providing sufficient funding and liquidity for the conduct of global business. This should enhance return on assets and return on equity. It also should improve efficiency ratios and other evaluation of performance parameters.
This chapter examines the multitude of cash flow activities and objectives that Trident must confront within its multinational operations. We begin with Trident’s operating cycle and possible strategies and constraints to the repositioning of profits and funds globally. This is followed by a discussion of alternative methods for moving funds, and how the manage- ment of key working capital components can be used to both move, position, and ultimately finance global operations internally and externally, including international cash manage- ment. The chapter concludes with the Mini-Case, Honeywell and Pakistan International Air- ways, which demonstrates the complexity of working capital management for multinational firms operating in emerging markets.
Trident Brazil’s Operating Cycle The operating and cash conversion cycles for Trident Brazil are illustrated in Exhibit 19.1. The operating cycle can be separated into five different periods, each with business, accounting, and potential cash flow implications.
Quotation Period First noted in Chapter 10 when we explored transaction exposure, the quotation period extends from the time of price quotation, t0, to the point when the customer places an order, t1. If the customer is requesting a price quote in foreign currency terms, say Chilean pesos, Trident Brazil would now have a potential but uncertain foreign exchange transaction exposure during this period. The quotation itself is not listed on any of the traditional financial statements of the firm, although a firm like Trident Brazil would keep a worksheet of quotations extended and their time periods.
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529Working Capital Management CHAPTER 19
Input Sourcing Period Once a quotation has been accepted by the customer, the order is placed at time t1. At this point, a contract is signed between the buyer and seller, describing the product to be delivered, likely timing of delivery, conditions of delivery, and price and financing terms. At this time, Trident Brazil would order those material inputs that it requires for the manufacture of the product which it does not currently hold in inventory. Depending on the individual sale, a cash deposit or down payment from the buyer is made at this point. If so, this would constitute the first actual cash flow associated with the order, a cash inflow to Trident Brazil, and that would initiate the cash conversion cycle for this transaction.
Inventory Period As inputs are received, Trident Brazil assembles and manufactures the goods. The length of time during this inventory-manufacturing period, from t1 to t2 depends on the type of product (off-the-shelf versus custom built-to-specification), the supply-chain integration of Trident Brazil with its various internal and external suppliers, and the technology employed by Trident itself.
Accounts Payable Period As inputs arrive during this period they are listed as material and component inventories on the left-hand side of Trident Brazil’s balance sheet, with corresponding accounts payable entries on the right-hand side of the balance sheet. If the inputs are invoiced in foreign currencies, either from Trident USA, a sister subsidiary, or from external suppliers, they constitute foreign currency transaction exposures to Trident Brazil.
Note that the accounts payable period shown in Exhibit 19.1 begins at the same time as the inventory period, t2 but may extend in time to t4 after the inventory period ends. If Trident
EXHIBIT 19.1 Operating and Cash Cycles for Trident Brazil
Operating Cycle
Time
Accounts Payable Period Accounts
Receivable Period
Payment Received
Cash Inflow
Cash Outflow
Cash Settlement ReceivedCash
Conversion Cycle
Cash Payment for Inputs
Price Quote
Order Placed
Inputs Received
Order Shipped
Quotation Period
Input Sourcing Period
Inventory Period
t0 t1 t2 t3 t4 t5
530 CHAPTER 19 Working Capital Management
Brazil’s suppliers extend trade credit, Trident Brazil would have the ability to postpone paying for the inventory for an extended period. Of course, if Trident Brazil chooses not to accept trade credit, it may pay for the inputs as delivered. In this case, the accounts payable period would end before the inventory period—the manufacturing period—ends at time t3. At what- ever point in time Trident Brazil chooses to settle its outstanding accounts payables, it incurs a cash outflow.
Accounts Receivable Period When the goods are finished and shipped, Trident Brazil records the transaction as a sale on its income statement, and books the transaction on its balance sheet as an account receivable. If it is a foreign currency-denominated invoice, the spot exchange rate on that date, t4 is used to record the sale value in local currency. The exchange rate in effect on the date of cash settlement, t5 would then be used in the calculation of any foreign exchange gains and losses associated with the transaction—the transaction exposure.
The length of the accounts receivable period depends on the credit terms offered by Trident Brazil, the choice made by the buyer to either accept trade credit or pay in cash, and country-specific and industry-specific payments practices. At cash settlement, Trident Brazil receives a cash inflow (finally) in payment for goods delivered. At time t5 the transaction is concluded and all accounting entries—inventory items, accounts payable, and accounts receivable—are eliminated.
Trident’s Repositioning Decisions Next, we describe the variety of goals and constraints on the repositioning of funds within Trident Corporation. Exhibit 19.2 depicts Trident, its wholly owned subsidiaries, the currency and tax rates applicable to each unit, and management’s present conclusions regarding each subsidiary’s growth prospects. Trident’s three foreign subsidiaries each present a unique set of concerns.
! Trident Europe, the oldest of the three, is operating in a relatively high-tax environment (compared in principle to the tax rate in the parent country, the United States). It is operating in a relatively stable currency—the euro, and is free to move capital in and out of the country with few restrictions. The business itself is mature, with few significant growth prospects in the near future.
! Trident Brazil, the result of a recent acquisition, is operating in a low-tax environment, but historically a volatile currency environment. It is subject to only a few current capital restrictions. Trident believes the business has very good growth prospects in the short-to-medium term if it is able to inject additional capital and managerial expertise into the business.
! Trident China, a new joint venture with a local partner that is a former unit of the Chinese government, is operating in a relatively low-tax environment, with a fixed exchange rate (the renminbi is managed within a very narrow band relative to the U.S. dollar). It is subject to a number of restrictions on capital. The business is believed to have the greatest potential—in the long run.
In practice, Trident’s senior management in the parent company (corporate) will first determine its strategic objectives regarding the business developments in each subsidiary, and then design a financial management plan for the repositioning of profits, cash flows, and capital for each subsidiary. As a result of this process, Trident will now attempt to pursue the following repositioning objectives by subsidiary:
531Working Capital Management CHAPTER 19
! Trident Europe: reposition profits from Germany to the United States while maintaining the value of the European market’s maturity to Trident Corporation
! Trident Brazil: reposition or in some way manage the capital at risk in Brazil subject to foreign exchange rate risk while providing adequate capital for immediate growth prospects
! Trident China: reposition the quantity of funds in and out of China to protect against blocked funds (transfer risk), while balancing the needs of the joint venture partner
Constraints on Repositioning Funds Fund flows between units of a domestic business are generally unimpeded, but that is not the case in a multinational business. A firm operating globally faces a variety of political, tax, foreign exchange, and liquidity considerations, which limit its ability to move funds easily and without cost from one country or currency to another. These constraints are why multinational financial managers must plan for repositioning funds within the MNE. Advance planning is essential even when constraints do not exist, for at some future date political events may lead to unexpected restrictions.
Political Constraints Political constraints can block the transfer of funds either overtly or covertly. Overt blockage occurs when a currency becomes inconvertible or is subject to government exchange controls that prevent its transfer at reasonable exchange rates. Covert blockage occurs when dividends or other forms of fund remittances are severely limited, heavily taxed, or excessively delayed by the need for bureaucratic approval.
EXHIBIT 19.2 Trident’s Foreign Subsidiaries
Trident Europe (Hamburg, Germany)
Trident China (Shanghai, China)
Trident Brazil (São Paulo, Brazil)
Country Currency: Dollar (US$) Tax rate: 35% Capital restrictions: None
Country Currency: Euro ( ) Tax rate: 45% Capital restrictions: None
Subsidiary Status Business: Mature
Trident Corporation (Los Angeles, USA)
Greenfield Investment
Country Currency: Reais (R$) Tax rate: 25% Capital restrictions: Some
Subsidiary Status Business: Immediate growth potential
Acquisition Investment
Country Currency: Renminbi (Rmb) (or Yuan) Tax rate: 30% Capital restrictions: Many
Subsidiary Status Business: Long-term growth potential
Joint Venture Investment
532 CHAPTER 19 Working Capital Management
Tax Constraints Tax constraints arise because of the complex and possibly contradictory tax structures of various national governments through whose jurisdictions funds might pass. A firm does not want funds in transit eroded by a sequence of nibbling tax collectors in every jurisdiction through which such funds might flow.
Transaction Costs Foreign exchange transaction costs are incurred when one currency is exchanged for another. These costs, in the form of fees and/or the difference between bid and offer quotations, are revenue for the commercial banks and dealers that operate the foreign exchange market. Although usually a small percentage of the amount of money exchanged, such costs become significant for large or frequent transfers. Transaction costs are sufficiently large enough to warrant planning to avoid unnecessary back-and-forth transfers such as would occur if a subsidiary remitted a cash dividend to its parent at approximately the same time as the parent paid the subsidiary for goods purchased. Sending foreign exchange simultaneously in two directions is obviously a sheer waste of corporate resources, but it sometimes occurs when one part of a firm is not coordinated with another.
Liquidity Needs Despite the overall advantage of worldwide cash handling, liquidity needs in each individual location must be satisfied and good local banking relationships maintained. The size of appropriate balances is in part a judgmental decision not easily measurable. Nevertheless, such needs constrain a pure optimization approach to worldwide cash positioning.
Conduits for Moving Funds by Unbundling Them Multinational firms often unbundle their transfer of funds into separate flows for specific purposes. Host countries are then more likely to perceive that a portion of what might other- wise be called remittance of profits constitutes an essential purchase of specific benefits that command worldwide values and benefit the host country. Unbundling allows a multinational firm to recover funds from subsidiaries without piquing host country sensitivities over large dividend drains. For example, Trident might transfer funds from its foreign subsidiaries to the parent, Trident Corporation, by any of the conduits shown in Exhibit 19.3.
The conduits are separable into those which are before-tax and after-tax in the host country. Although not always the focus of intra-unit fund movement, tax goals frequently make this a critical distinction for many foreign subsidiary financial structures. An increase in the funds flow (charges) in any of the before-tax categories reduces the taxable profits of the foreign subsidiary if the host-country tax authorities acknowledge the charge as a legitimate expense. The before-tax/after-tax distinction is also quite significant to a parent company attempting to repatriate funds in the most tax-efficient method if it is attempting to manage its own foreign tax credit/deficits between foreign units.
An item-by-item matching of remittance to input, such as royalties for intellectual property, and fees for patents and advice, is equitable to the host country and foreign investor alike. It allows each party to see the reason for each remittance and to judge its acceptance independently. If all investment inputs are unbundled, part of what might have been classified as residual profits may turn out to be tax-deductible expenses related to a specific purchased benefit. Unbundling also facilitates allocation of overhead from a parent’s inter- national division, so-called shared services, to each operating subsidiary in accordance with a predetermined formula. Predetermination of the allocation method means a host country is
533Working Capital Management CHAPTER 19
less likely to view a given remittance as capricious and thus inappropriate. Finally, unbundling facilitates the entry of local capital into joint venture projects, because total remuneration to different owners can be in proportion to the value of the varied contributions of each, rather than only in proportion to the amount of monetary capital they have invested.
International Dividend Remittances Payment of dividends is the classical method by which firms transfer profit back to owners, be those owners individual shareholders or parent corporations. International dividend policy now incorporates tax considerations, political risk, and foreign exchange risk, as well as a return for business guidance and technology.
Tax Implications Host-country tax laws influence the dividend decision. Countries such as Germany tax retained earnings at one rate while taxing distributed earnings at a lower rate. Most countries levy with- holding taxes on dividends paid to foreign parent firms and investors. Again, most (but not all) parent countries levy a tax on foreign dividends received, but allow a tax credit for foreign taxes already paid on that income stream. That said, dividends remain the most tax inefficient method for repatriating funds because they are distributed on an after-tax basis. This means that the parent company will frequently be faced with the generation of excess foreign tax credits on a dividend. Remittance of license or royalty fees is on a pre-tax basis in the foreign subsidiary; the only tax which is typically applied is that of withholding, a rate considerably below that of corporate income taxes.
EXHIBIT 19.3 Moving Funds from Subsidiary to Parent
Foreign Subsidiary’s Income Statement
Sales Cost of goods sold Gross profit
General and administrative expenses License fees Royalties Management fees Operating profit (EBITDA)
Depreciation and amortization Earnings before interest and taxes (EBIT)
Foreign exchange gains (losses) Interest expenses Earnings before tax (EBT)
Corporate income tax Net income (NI) Dividends Retained earnings
Payment to Parent Company
Payments to parent for goods or services
Payments for technology, trademarks, copyrights, management, or other shared services
Payments of interest to parent for intrafirm debt
Distribution of dividends to parent
Before tax in the host country
After tax in the host country
534 CHAPTER 19 Working Capital Management
Political Risk Political risk may motivate parent firms to require foreign subsidiaries to remit all locally generated funds above that required to internally finance growth in sales (working capital requirements) and planned capital expansions (CAPEX or capital expenditures). Such policies, however, are not universal.
One strategy employed by MNEs in response to potential government restrictions may be to maintain a constant dividend payout ratio to demonstrate that an established policy is being consistently carried out. This establishes a precedent for remittance of dividends and removes the perception of some host-country governments that dividend distributions are by managerial election. (Note that even the terminology, “declare a dividend,” implies managerial discretion.)
Foreign Exchange Risk If a foreign exchange loss is anticipated, an MNE may speed up the transfer of funds out of the country via dividends. This “lead” is usually part of a larger strategy of moving from weak currencies to strong currencies, and can include speeding up intrafirm payments on accounts receivable and payable. However, decisions to accelerate dividend payments ahead of what might be normal must take into account interest rate differences and the negative impact on host-country relations.
Distributions and Cash Flows Dividends are a cash payment to owners equal to all or a portion of earnings of a prior period. To pay dividends, a subsidiary needs both past earnings and available cash. Subsidiaries some- times have earnings without cash because earnings are measured at the time of a sale but cash is received later when the receivable is collected (a typical distinction between accounting profits and cash flow). Profits of rapidly growing subsidiaries are often tied up in ever- increasing receivables and inventory (working capital). Hence, rapidly growing foreign subsidiaries may lack the cash to remit a dividend equal to even a portion of earnings.
The reverse may also be true; firms may be receiving cash from the collection of old receivables even when profits are down because current sales have fallen off or current expenses have risen relative to current sales prices. Such firms might want to declare a dividend in order to remove a bountiful supply of cash from a country, but lack the earnings against which to charge such payments. For either of these reasons, a firm must look at both measured earnings and available cash before settling upon a cash dividend policy.
Joint Venture Factors Existence of joint venture partners or local stockholders also influences dividend policy. Optimal positioning of funds internationally cannot dominate the valid claims of independent partners or local stockholders for dividends. The latter do not benefit from the worldwide success of the MNE parent, but only from the success of the particular joint venture in which they own a share. Firms might hesitate to reduce dividends when earnings falter. They also might hesitate to increase dividends following a spurt in earnings because of possible adverse reaction to reducing dividends later should earnings decline. Many MNEs insist on 100% ownership of subsidiaries in order to avoid possible conflicts of interest with outside shareholders.
Net Working Capital If Trident Brazil’s business continues to expand it will continually add to inventories and accounts payable (A/P) in order to fill increased sales in the form of accounts receivable
535Working Capital Management CHAPTER 19
(A/R). These three components make up net working capital (NWC). The combination is “net” as a result of the spontaneous funding capability of accounts payable; accounts payable provide part of the funding for increased levels of inventory and accounts receivable.
Net Working Capital (NWC) = (A/R + Inventory) - (A/P)
Because both A/R and inventory are components of current assets on the left-hand side of the balance sheet, as they grow they must be financed by additional liabilities of some form on the right-hand side of the balance sheet. A/P may provide a part of the funding. Exhibit 19.4 illustrates Trident Brazil’s net working capital. Note that we do not include cash or short-term debt as part of net working capital. Although they are part of current assets and current liabilities, respectively, they are the result of management discretion, and do not spontaneously change with operations. Their determinates are discussed later in this chapter.
In principle, Trident attempts to minimize its net working capital balance. A/R is reduced if collections are accelerated. Inventories held by the firm are reduced by carrying lower levels of both unfinished and finished goods, and by speeding the rate at which goods are manufactured—reducing so-called cycle-time. All of these measures must be balanced with their customer costs. Sales could be reduced if inventories are not on hand, or if credit sales are reduced. On the other side of the balance sheet, NWC can be reduced by stretching A/P out. Again, if not done carefully, this could potentially damage the company’s relationship with its key suppliers, thereby reducing reliability and supply-chain partnerships.
A/P Versus Short-Term Debt Exhibit 19.4 also depicts one of the key managerial decisions for any subsidiary: should A/P be paid off early, taking discounts if offered by suppliers. The alternative financing for NWC balances is short-term debt.
EXHIBIT 19.4 Trident Brazil’s Net Working Capital Requirements
Trident’s Balance Sheet
Assets Liabilities and Net Worth
Accounts payable (A/P)
Short-term debt
Current liabilities
Cash
Accounts receivable (A/R) Inventory
Current assets
NWC = (A/R + Inventory) – A/P
Note that NWC is not the same as current assets and current liabilities.
Net working capital (NWC) is the net inestment required of the firm to support ongoing sales. NWC components typically grow as the firm buys inputs, produces products, and sells finished goods.
536 CHAPTER 19 Working Capital Management
For example, in Brazil payment terms are quite long by global standards, often extending 60 to 90 days. Paraña Electronics is one of Trident Brazil’s key suppliers. It delivers a ship- ment of electronic components and invoices Trident Brazil R$180,000. Paraña Electronics offers credit terms of 5/10 net 60. This means that the entire amount of the A/P, R$180,000, is due in 60 days. Alternatively, if Trident Brazil wishes to pay within the first 10 days, a 5% discount is given:
R$180,000 * (1 - .05) = R$171,000.
Trident Brazil’s financial manager, Maria Gonzalez, must decide which method is the lower cost of financing her NWC. Short-term debt in Brazilian real, because of the relatively higher inflationary conditions common in Brazil, costs 24% per annum.
What is the annual cost of the discount offered by Paraña Electronics? Trident Brazil is effectively paid 5% for giving up 50 days of financing (60 days less the 10-day period for discounts). Assuming a 365-day count for interest calculation,
365 days 50 days
= 7.30.
To calculate the effective annual interest cost of supplier financing, the 5% discount for 50 days must be compounded 7.30 times, yielding a cost of carry provided by Paraña Electronics of
(1 + .05)7.3 = 1.428, or 42.8% per annum.
Paraña Electronics is therefore charging Trident Brazil 42.8% per annum for financing. Alternatively, Trident Brazil could borrow real from local banks in São Paulo for 24% per annum, use the funds to pay Paraña Electronics early, and take the discounts offered. The latter is the obvious choice in this case.
The choice between taking supplier-provided financing and short-term debt is not always purely a matter of comparing interest costs. In many countries, the foreign sub- sidiaries of foreign MNEs have limited access to local currency debt. In other cases, the subsidiary may be offered funds from the parent company at competitive rates. We will return to this topic, internal banking, in the last section of this chapter, Financing Work- ing Capital.
Days Working Capital A common method of benchmarking working capital management practices is to calculate the NWC of the firm on a “days sales” basis. If the value of A/R, inventories, and A/P on the balance sheet are divided by the annual daily sales (annual sales/365 days), the firm’s NWC can be summarized in the number of days of sales NWC constitutes. Exhibit 19.5 provides the results of a recent survey of computer and peripheral firm working capital performance for a selected set of companies in both the United States and Europe for 2010. We must use care in viewing the survey results. Because the days sales values are for the consolidated companies, not specific country-level subsidiaries, the averages could reflect very different working capital structures for individual subsidiaries of the firms listed.
There are some clear differences between the U.S. and European averages, as well as between individual firms. The days working capital average for the selected U.S. firms of 38 days is a full 30 days less than the average of the European sample. A closer look at the subcategories indicates a radically sparse attitude toward inventory among the U.S. firms, averaging 31 days sales. Days sales held in accounts receivable at 46 days on average is nearly 34 days less than the European average of 80. Payables are also substantially less in the U.S. than Europe, 39 days to 55. Clearly, European-based computer equipment firms are carrying
537Working Capital Management CHAPTER 19
a significantly higher level of working capital in their financial structures to support the same level of sales compared to that for comparable U.S.-based firms.
Among individual firms, Dell Computer Corporation lives up to its popular billing as one of the most aggressive working capital managers across all industries. Dell’s net working capital level of a negative two days indicates exactly what it says—a level of A/P which surpasses the sum of receivables and inventory. Even with that accomplishment, its inventory days of six is still three times that of Apple Computer’s two days in inventory.
Intrafirm Working Capital The MNE itself poses some unique challenges in the management of working capital. Many multinationals manufacture goods in a few specific countries and then ship the intermediate products to other facilities globally for completion and distribution. The payables, receivables, and inventory levels of the various units are a combination of intrafirm and interfirm. The varying business practices observed globally regarding payment terms—both days and discounts—create severe mismatches in some cases.
For example, Exhibit 19.6 illustrates the challenges in working capital management faced by Trident Brazil. Because Trident Brazil purchases inputs from Trident U.S., and then uses additional local material input to finish the products for local distribution, it must manage two different sets of payables. Trident U.S. sells intrafirm on common U.S. payment terms, net 30 days. Local suppliers in Brazil, however, use payment terms closer to Brazilian norms of 60 days net (although this is in many cases still quite short for Brazilian practices that have been known to extend to as long as 180 days). Similarly, since the customers of Trident Brazil
EXHIBIT 19.5 Days Working Capital for Selected U.S. and European Computers and Peripherals Equipment Firms, 2010 (days of sales)
Company Country Receivables Inventory Payables Net Working
Capital
Intel Corporation US 24.0 31.4 19.2 36.2
Hewlett-Packard US 53.5 18.7 41.6 30.6
Dell Computer US 38.5 7.7 67.0 -20.8
NCR Corporation US 65.5 56.1 37.8 83.8
Texas Instruments US 39.7 39.7 16.2 63.2
Applied Materials US 70.0 59.1 25.2 103.9
Apple Computer US 30.8 5.9 67.2 -30.5
Average US 46.0 31.2 39.2 38.1
Nokia Finland 65.1 21.7 52.5 34.3
Philips Electronics Netherlands 59.2 55.5 53.0 61.7
GN Store Nord Denmark 78.7 33.4 27.5 84.6
Ericsson Sweden 118.6 53.7 44.8 127.5
Alcatel-Lucent France 79.8 52.4 98.7 33.5
Average Europe 80.3 43.3 55.3 68.3
Note: Net working capital = receivables + inventory - payables. Source: REL Cash Flow Delivered, The Hackett Group, CFO Magazine, 2011.
538 CHAPTER 19 Working Capital Management
are Brazilian, they expect the same common payment terms of 60 days. Trident Brazil is then “squeezed,” having to pay Trident U.S. much faster than it pays other local suppliers and long before it receives cash settlement from its customers.
In addition to Trident’s need to determine intrafirm payment practices that do not burden their foreign subsidiaries, the question of currency of invoice will also be extremely important. If Trident Brazil sells only domestically, it does not have natural inflows of U.S. dollars or other hard currencies. It earns only Brazilian real. If Trident U.S. then invoices it for inputs in U.S. dollars, Trident Brazil will be constantly short dollars and will incur continuing currency management costs. Trident U.S. should invoice in Brazilian real and manage the currency exposure centrally (possibly through a reinvoicing center as discussed in Chapter 8).
Managing Receivables A firm’s operating cash inflow is derived primarily from collecting its accounts receivable. Multinational accounts receivable are created by two separate types of transactions: sales to related subsidiaries and sales to independent or unrelated buyers.
Independent Customers. Management of accounts receivable from independent customers involves two types of decisions: In what currency should the transaction be denominated, and what should be the terms of payment? Domestic sales are almost always denominated in the local currency. At issue is whether export sales should be denominated in the currency of the exporter, the currency of the buyer, or a third-country currency. Competition or custom will often dictate the answer, but if negotiating room exists the seller prefers to price and to invoice in the strongest currency. However, an informed buyer prefers to pay in the weakest currency.
Payment Terms. Terms of payment are another bargaining factor. Considered by themselves, receivables from sales in weak currencies should be collected as soon as possible to minimize loss of exchange value between sales date and collection date. Accounts receivable resulting from sales in hard currencies may be allowed to remain outstanding longer. In fact, if the
EXHIBIT 19.6 Trident’s Multinational Working Capital Sequence
Trident Brazil Balance Sheet
60 days A/R inventory
A/P A/P
Local sourcing: 60 days
Cash inflows to Trident Brazil arise from local market sales. These cash flows are used to repay both intrafirm payables (to Trident USA) and local suppliers.
Result: Trident Brazil is squeezed in terms of cash flow. It receives inflows in 60 days but must pay Trident USA in 30 days.
30 days Intrafirm: 30 days
Trident USA Balance Sheet
A/R inventory
A/P
Payment terms in Brazil are longer than those typical of North America. Trident Brazil must offer 60-day terms to local customers to be competitive with other firms in the local market.
Brazilian Business Practices
Payment terms used by Trident USA are typical of North America, 30 days. Trident USA‘s local customers will expect to be paid in 30 days. Trident USA may consider extending longer terms to Brazil to reduce the squeeze.
U.S. Business Practices
539Working Capital Management CHAPTER 19
seller is expecting an imminent devaluation of its home currency, it might want to encourage slow payment of its hard currency receivables, especially if the home government requires immediate exchange of foreign currency receipts into the home currency. An alternative, if legal, would be for the seller to accept the proceeds abroad and keep them on deposit abroad rather than return them to the home country.
In inflationary economies, the demand for credit usually exceeds the supply. Often, how- ever, a large business (be it multinational or a large local concern) has better access to the limited, cheaper credit that is available locally than do smaller domestic businesses, such as local distributors, retail merchants, or smaller manufacturers.
Self-Liquidating Bills. Some banking systems, often for reasons of tradition, have a predilection for self-liquidating, discountable bills. In many European countries, it is easier to borrow from a bank on the security of bills (receivables in negotiable form) generated from sales than on the security of physical inventory. Napoleon is alleged to have had a philosophy that no good French merchant should be required to wait for funds if good merchandise has been sold to good people, provided a document exists showing sales of the items. The document must have the signature of the buyer and the endorsement of the seller and the re-discounting bank. Thus, in France, it is often possible to reduce net investment in receivables to zero by selling entirely on trade acceptances that can be discounted at the bank.
The European use of discountable bills has a very real rationale behind it. According to European commercial law, based on the “Code Napoleon,” the claim certified by the signature of the buyer on the bill is separated from the claim based on the underlying transaction. For example, a bill is easily negotiable because objections about the quality of the merchandise by the buyer do not affect the claim of the bill holder. In addition, defaulted bills can be collected through a particularly speedy judicial process that is much faster than the collection of normal receivables.
Other Terms. In many countries, government bodies facilitate inventory financing in the guise of receivable financing by extending export credit or by guaranteeing export credit from banks at advantageous interest rates. When the term of the special export financing can be extended to match the payment of the foreign purchaser, the foreign purchaser is in effect able to finance its inventory through the courtesy of the exporter’s government.
In some environments, credit terms extended by manufacturers to retailers are of such long maturities as to constitute “purchase” of the retailer, such “purchase” being necessary to build an operational distribution system between manufacturer and ultimate customer. In Japan, for example, customer payment terms of 120 days are fairly common, and a manufacturer’s sales effort is not competitive unless sufficient financial aid is provided to retailers to make it possible or beneficial for them to buy the manufacturer’s product. Financial aid is reported to take the form of outright purchase of the retailer’s capital stock, working capital loans, equipment purchase, subsidy or loan, and consideration of payment terms. Such manufacturer-supplied financing is a normal way of doing business in Japan—and contributes to the lack of domestic competition prevalent in that country.
Inventory Management Operations in inflationary, devaluation-prone economies sometimes force management to modify its normal approach to inventory management. In some cases, management may choose to maintain inventory and reorder levels far in excess of what would be called for in an economic order quantity model.
Under conditions where local currency devaluation is likely, management must decide whether to build up inventory of imported items in anticipation of the expected devaluation.
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After the devaluation, imported inventory will cost more in local currency terms. One trade- off is a higher holding cost because of the bloated level of inventory and high local interest rates that normally reflect the expected devaluation. A less obvious trade-off is the possibility that local government will enforce a price freeze following devaluation. This freeze would prevent the imported inventory from being sold for an appropriate markup above its now- higher replacement value. Still worse, the devaluation may not occur as anticipated, leaving management holding an excessive level of inventory until it can be worked down. Disposing of excessive inventory will be particularly painful if competitors have followed the same strategy of speculating on imported inventory.
Free-Trade Zones and Free Industrial Zones A free-trade zone combines the old idea of duty-free ports with legislation that reduces or eliminates customs duties to retailers or manufacturers who structure their operations to benefit from the technique. Income taxes may also be reduced for operations in a free-trade zone. The old duty-free ports were typically in the dock area of major seaports, where goods were held, duty free, until the owner was ready to deliver them within the country. Modern free-trade zones, by comparison, are often located away from a port area. For example, the Italian firm of Olivetti has such a zone in Harrisburg, Pennsylvania.
Free-trade zones function in several ways. As mentioned, they may be a place to off-load merchandise for subsequent sale within the country where the zone is located. An example of such a zone would be a storage area for imported Toyota automobiles in the Port of Los Angeles. A large quantity of differentiated models can be held until sold by a dealer, at which time the cars are “imported” into the United States from the free-trade zone. The advantage of such an arrangement is that a variety of models can be kept near the point of sale for quick delivery, but import duties need be paid only when the merchandise passes from the zone into California.
A second type of zone involves the assembly of components for subsequent sale within the country where the zone is located. An example would be the Mercedes assembly line in Alabama. Components are imported into the free-trade zone where assembly work is finished. The import duty is paid only when the finished car is removed from the zone. Furthermore, the duty is lower than it would be for a finished car because the charges on components are less than the charge on a finished vehicle.
A third type of zone is a full-fledged manufacturing center with a major portion of its output re-exported out of the country. Two examples are Penang, Malaysia, and Madagascar, where such zones are officially designated “Free Industrial Zones.” In Penang, companies as diverse as Dell Computers, National Semiconductor, Sony, Bosch, and Trane Air Conditioning manufacture final products. A major portion of production is re-exported, avoiding Malaysian customs altogether but providing jobs for Malaysian workers and engineers. The portion of production sold in Malaysia is assessed duties only on the components originally imported. However, the variety of firms permits one to buy from another; Dell buys Pentium chips from Intel and disk drives from Seagate, both of which are located less than a mile from the Dell plant.
International Cash Management International cash management is the set of activities which determine the levels of cash balances held throughout the MNE, and the facilitation of its movement cross border. These activities are typically handled by the international treasury of the MNE.
541Working Capital Management CHAPTER 19
Motives for Holding Cash The level of cash maintained by an individual subsidiary is determined independently of the working capital management decisions discussed previously. Cash balances, including marketable securities, are held partly to enable normal day-to-day cash disbursements and partly to protect against unanticipated variations from budgeted cash flows. These two motives are called the transaction motive and the precautionary motive.
Cash disbursed for operations is replenished from two sources: 1) internal working capital turnover and 2) external sourcing, traditionally short-term borrowing. Short-term borrowing can also be “negative” as when excess cash is used to repay outstanding short-term loans. In general, individual subsidiaries of MNEs typically maintain only minimal cash balances necessary to meet the transaction purposes. Efficient cash management aims to reduce cash tied up unnecessarily in the system, without diminishing profit or increasing risk, to increase the rate of return on invested assets. All firms, both domestic and multinational, engage in some form of the following fundamental steps.
International Cash Settlements and Processing Multinational business increases the complexity of making payments and settling cash flows between related and unrelated firms. Over time, a number of techniques and services have evolved which simplify and reduce the costs of making these cross-border payments. We focus here on three such techniques: wire transfers, cash pooling, and payment netting.
Wire Transfers Although there are a variety of computer-based networks used for effecting international transactions and settlements, two have come to dominate the international financial sector, CHIPS and SWIFT. The primary distinction among systems is whether they are for secure communications alone, or for actual transfer and settlement.
CHIPS. The Clearing House Interbank Payment System, CHIPS, is a computerized network which connects major banks globally. CHIPS is owned and operated by its member banks, mak- ing it the single largest privately operated and final payments system in the world. Developed in 1970 when international currency transactions were dominated by the U.S. dollar, CHIPS has continued to dominate the transfer and settlement of U.S. dollar transactions for more than 34 years.
CHIPS is actually a subsidiary of the New York Clearing House, the oldest and largest payments processor of bank transactions. The New York Clearing House was first established in 1853 to provide a central place—a clearinghouse—where all banks in New York City could daily settle transactions, such as the many personal checks written by private individuals and corporations, among themselves. CHIPS itself is simply a computer-based evolutionary result of this need. Because banks are still the primary financial service provider for MNEs, busi- nesses transferring payments both interfirm and intrafirm globally use banks for effecting the payments and the banks in turn utilize CHIPS.
SWIFT. The Society for Worldwide Interbank Financial Telecommunications, SWIFT, also facilitates the wire transfer settlement process globally. Whereas CHIPS actually clears financial transactions, SWIFT is purely a communications system. By providing a secure and standardized transfer process, SWIFT has greatly reduced the errors and associated costs of effecting international cash transfers.
In recent years, SWIFT has expanded its messaging services beyond banks to broker- dealers and investment managers. In the mid-1990s, its services gained wider breadth as
542 CHAPTER 19 Working Capital Management
SWIFT expanded market infrastructure to payments in treasury, derivatives, and securities and trade services. It is now in the forefront of the evolution of Internet-based products and services for e-payments, expanding beyond banks to nonfinancial sector customers conducting business-to-business electronic commerce.
Cash Pooling and Centralized Depositories Any business with widely dispersed operating subsidiaries can gain operational benefits by centralizing cash management. Internationally, the procedure calls for each subsidiary to hold minimum cash for its own transactions and no cash for precautionary purposes. However, the central pool has authority to override this general rule. All excess funds are remitted to a central cash depository, where a single authority invests the funds in such currencies and money market instruments as best serve the worldwide firm. A central depository provides an MNE with at least four advantages:
1. Obtaining information 2. Holding precautionary cash balances 3. Reducing interest rate costs 4. Locating cost in desirable financial centers
Information Advantage. A central depository’s size gives it an advantage in obtaining information. It should be located in one of the world’s major financial centers so information needed for opinions about the relative strengths and weaknesses of various currencies can easily be obtained. Rate of return and risk information on alternative investments in each currency and facilities for executing orders must also be available. The information logic of centralization is that an office that specializes and operates with larger sums of money can get better information from banks, brokers, and other financial institutions, as well as better service in executing orders.
Precautionary Balance Advantage. A second reason for holding all precautionary balances in a central pool is that the total pool, if centralized, can be reduced in size without any loss in the level of protection. Trident U.S., for example, has subsidiaries in Europe, Brazil, and China. Assume each of these subsidiaries maintains its own precautionary cash balance equal to its expected cash needs plus a safety margin of three standard deviations of historical variability of actual cash demands. Cash needs are assumed to be normally distributed in each country, and the needs are independent from one country to another. Three standard deviations means there exists a 99.87% chance that actual cash needs will be met; that is, only a 0.13% chance that any European subsidiary will run out of cash.
Cash needs of the individual subsidiaries, and the total precautionary cash balances held, are shown in Exhibit 19.7. Total precautionary cash balances held by Trident Europe, Brazil, and China, equal $46,000,000, consisting of $28,000,000 in expected cash needs, and $18,000,000 in idle cash balances (the sum of three standard deviations of individual expected cash balances) held as a safety margin.
What would happen if the three Trident subsidiaries maintained all precautionary balances in a single account with Trident U.S.? Because variances are additive when probability distributions are independent (see footnote b in Exhibit 19.7), cash needed would drop from $46,000,000 to $39,224,972, calculated as follows:
Centralized cash = Sum of expected cash needs + Three standard deviations balance of expected sum
= $28,000,000 + (3 * $3,741,657) = $28,000,000 + $11,224,972 = $39,224,972
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EXHIBIT 19.7 Decentralized Versus Centralized Cash Depostiories
Decentralized Cash Depository
Subsidiary Expected Cash Need
(A) One Standard Deviation
(B)
Cash Balance Budgeted for Adequate Protection a
(A + 3B)
Trident Europe $10,000,000 $1,000,000 $13,000,000
Trident Brazil 6,000,000 2,000,000 12,000,000
Trident China 12,000,000 3,000,000 21,000,000
Total $ 28,000,000 $ 6,000,000 $46,000,000
Centralized Cash Depository
Subsidiary Expected Cash Need
(A) One Standard Deviation
(B)
Cash Balance Budgeted for Adequate Protectiona
(A + 3B)
Trident Europe $10,000,000
Trident Brazil 6,000,000
Trident China 12,000,000
Total $28,000,000 $ 3,741,657b $39,224,972
a Adequate protection is defined as the expected cash balance plus three standard deviations, assuming that the cash flows of all three individual affiliates are normally distributed.
b The standard deviation of the expected cash balance of the centralized depository is calculated as follows:
Standard deviation = 2(1,000,000)2 + (2,000,000)2 + (3,000,000)2 = $3,741,657. A budgeted cash balance three standard deviations above the aggregate expected cash
need requires only $11,224,972 in potentially idle cash, as opposed to the previous cash balance of $18,000,000. Trident saves $6,755,028 in cash balances without reducing its safety.
Interest Rate Advantage. A third advantage of centralized cash management is that one subsidiary will not borrow at high rates at the same time that another holds surplus funds idle or invests them at low rates. Managers of the central pool can locate the least expensive locations to borrow and the most advantageous returns to be earned on excess funds. When additional cash is needed, the central pool manager determines the location of such borrowing. A local subsidiary manager can avoid borrowing at a rate above the minimum available to the pool manager. If the firm has a worldwide cash surplus, the central pool manager can evaluate comparative rates of return in various markets, transaction costs, exchange risks, and tax effects.
Location. Central money pools are usually maintained in major money centers such as London, New York, Zurich, Singapore, and Tokyo. Additional popular locations for money pools include Liechtenstein, Luxembourg, the Bahamas, and Bermuda. Although these countries do not have strong diversified economies, they offer most of the other prerequisites for a corporate financial center: freely convertible currency, political and economic stability, access to international communications, and clearly defined legal procedures. Their additional advantage as a so-called tax haven is desirable.
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The need for a centralized depository system means that multinational banks have an advantage over single-country banks in designing and offering competitive services. How- ever, single-country banks can be incorporated into the system if the desired results can still be achieved, for the essence of the operation is centralized information and decisions. MNEs can place actual funds in as many banks as they desire.
Multilateral Netting Multilateral netting is defined as the process that cancels via offset, all, or part, of the debt owed by one entity to another related entity. Multilateral netting is useful primarily when a large number of separate foreign exchange transactions occur between subsidiaries in the normal course of business. Netting reduces the settlement cost of what would otherwise be a large number of crossing spot transactions.
Multilateral netting is an extension of bilateral netting. Assume Trident Brazil owes Trident China $5,000,000 and Trident China simultaneously owes Trident Brazil $3,000,000, a bilateral settlement calls for a single payment of $2,000,000 from Brazil to China and the cancellation, of the remainder of the debt.
A multilateral system is an expanded version of this simple bilateral concept. Assume that payments are due between Trident’s operations at the end of each month. Each obligation reflects the accumulated transactions of the prior month. These obligations for a particular month might be as shown in Exhibit 19.8.
Without netting, Trident Brazil makes three separate payments and receives three separate receipts at the end of the month. If Trident Brazil paid its intracompany obligations daily, or even weekly, rather than accumulating a balance to settle at the end of the month, it would generate a multitude of costly small bank transactions. The daily totals would equal the monthly accumulated balances shown in the exhibit.
In order to reduce bank transaction costs, such as the spread between foreign exchange bid and ask quotations and transfer fees, some MNEs such as Trident establish in-house
EXHIBIT 19.8 Multilateral Matrix Before Netting (thousands of U.S. dollars)
Prior to netting, the four sister Trident companies have numerous intrafirm payments between them. Each payment results in transfer charges.
Trident USA
Trident Europe
Trident China
Trident Brazil
$4,000
$3,000
$2,000
$2,000
$1,000
$3,000
$6,000
$5,000
$3,000
$5,000 $5,000
$4,000
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multilateral netting centers. Other firms contract with banks to manage their netting system. Assume that Trident’s net intracompany obligations for a given month can be summarized as shown in Exhibit 19.9.
Note that payment obligations and expected receipts both add up to $43,000,000 because one subsidiary’s debts are another’s receivable. If the cost of foreign exchange transactions and transfer fees were 0.5%, the total cost of settlement would be $205,000. Using information from the netting matrix in Exhibit 19.9, the netting center at Trident U.S. can order three payments to settle the entire set of obligations. Trident U.S. will itself remit $3,000,000 to China, and Europe will be instructed to send $1,000,000 each to Brazil and China. Total foreign exchange transfers are reduced to $5,000,000, and transaction costs at 0.5% are reduced to $25,000. This is shown in Exhibit 19.10.
Some countries limit or prohibit netting, while others permit netting on a “gross payment” basis only. For a single settlement period, all payments may be combined into a single payment, and all receipts will be received as a single transfer. However, these two may not be netted. Thus, two large payments must pass through the local banking system.
EXHIBIT 19.9 Calculation of Trident Intra-Subsidiary Net Obligations (thousands of U.S. dollars)
Paying Subsidiary
Receiving Subsidiary USA Brazil Europe China Receipts Net Receipts (payments)
USA — $4,000 $3,000 $5,000 $12,000 ($3,000)
Brazil 5,000 — 3,000 1,000 9,000 $1,000
Europe 4,000 2,000 — 3,000 9,000 ($2,000)
China 6,000 2,000 5,000 — 13,000 $4,000
Total Payments $15,000 $8,000 $11,000 $9,000 $43,000 —
EXHIBIT 19.10 Multilateral Matrix After Netting (thousands of U.S. dollars)
Trident USA
Trident Europe
Trident China
Trident Brazil
After netting, the four sister Trident companies have only three net payments to make among themselves to settle all intrafirm obligations.
Pays $1,000Pays $3,000Pays $1,000
546 CHAPTER 19 Working Capital Management
Financing Working Capital The MNE enjoys a much greater choice of banking sources to fund its working capital needs than do domestic firms. Banking sources available to MNEs include in-house banks funded by unrepatriated capital, international banks, and local banks where subsidiaries are located. In-house banks and the various types of external commercial banking offices are described in the remainder of this chapter.
In-House Banks Some MNEs have found that their financial resources and needs are either too large or too sophisticated for the financial services available in many locations where they operate. One solution to this has been the establishment of an in-house or internal bank within the firm. Such an in-house bank is not a separate corporation; rather, it is a set of functions performed by the existing treasury department. Acting as an independent entity, the central treasury of the firm transacts with the various business units of the firm on an arm’s-length basis. The purpose of the in-house bank is to provide banking-like services to the various units of the firm. The in-house bank may be able to provide services not available in many countries, and do so at lower cost when they are available. In addition to traditional banking activities, the in-house bank may be able to offer services to units of the firm, which aid in the management of ongoing transaction exposures. Lastly, because it is “in-house,” credit analysis is not a part of the decision-making.
For example, the in-house bank of Trident Corporation could work with Trident Europe and Trident Brazil. Trident Brazil sells all its receivables to the in-house bank as they arise, reducing some of its domestic working capital needs. Additional working capital needs are supplied by the in-house bank directly to Trident Brazil. Because the in-house bank is part of the same company, interest rates it charges may be significantly lower than what Trident Brazil could obtain on its own. The source of funds for the in- house bank may arise from the deposits of excess cash balances from Trident Europe. If the in-house bank can pay Trident Europe a higher deposit rate than it can obtain on its own, and if the in-house bank can lend these funds to Trident Brazil at an interest rate lower than it can obtain on its own in Brazil, then both operating units benefit. Assuming the loan rate is greater than the deposit rate, the in-house bank profits by the margin between the two, but this margin or spread must be smaller than would be available from a commercial bank.
How can the in-house bank operate with a smaller spread than a regular commercial bank? First, its costs are lower because it does not have to conform to the stringent capital requirements imposed on commercial banks worldwide. Second, in-house banks do not have the overhead costs of supporting large dealing rooms, branch networks, retail “store fronts,” and other services required for commercial bank competitiveness. Third, they need not assess the creditworthiness of the corporate units with which they deal, since the units are all in the same family. Nor need they provide for credit losses.
In addition to providing financing benefits, in-house banks allow for more effective currency risk management. In the case of Trident Brazil, the sale of foreign currency receivables to the in-house bank shifts transaction exposure to the bank. The in-house bank is better equipped to deal with currency exposures and has a greater volume of international cash flows allowing Trident Corporation overall to gain from more effective use of netting and matching. This frees the units of the firm from struggling to manage transaction exposures and allows them to focus on their primary business activities.
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Commercial Banking Offices MNEs depend on their commercial banks not only to handle most of their trade financing needs, such as letters of credit, but also to provide advice on government support, country risk assessment, introductions to foreign firms and banks, and general financing availability. MNEs interface with their banks through a variety of different types of banking offices, many of which perform specialized functions. Therefore, it is important for financial managers to understand which bank offices provide which kinds of activities. The main points of bank contact are with correspondent banks, representative offices, branch banks, and subsidiaries. In the United States, a more specialized banking facility is available: the Edge Act corporation, defined in the following section.
Correspondent Banks. Most major banks of the world maintain correspondent banking relationships with local banks in each of the important foreign cities of the world. The two- way link between banks is essentially one of “correspondence,” via fax, cable, and mail, and a mutual deposit relationship. For example, a U.S. bank may have a correspondent bank in Kuala Lumpur, Malaysia, and the U.S. bank will in turn be the correspondent bank for the Malaysian bank. Each will maintain a deposit in the other in local currency.
Correspondent services include accepting drafts, honoring letters of credit, and furnishing credit information. Services are centered around collecting or paying foreign funds, often because of import or export transactions. However, a visiting businessperson can use the home bank’s introduction to meet local bankers. Under a correspondent banking relationship, neither of the correspondent banks maintains its own personnel in the other country. Direct contact between the banks is usually limited to periodic visits between members of the banks’ management.
For the businessperson, the main advantage of banking at home with a bank having a large number of foreign correspondent relationships is the ability to handle financial matters in a large number of foreign countries through local bankers whose knowledge of local customs should be extensive. The disadvantages are the lack of ability to deposit in, borrow from, or disburse from a branch of one’s own home bank. There is a possibility that correspondents will put a lower priority on serving the foreign banks’ customer than on serving their own permanent customers.
Representative Offices. A bank establishes a representative office in a foreign country primarily to help parent bank clients when they are doing business in that country or in neighboring countries. It also functions as a geographically convenient location from which to visit correspondent banks in its region rather than sending bankers from the parent bank at greater financial and physical cost. A representative office is not a “banking office.” It cannot accept deposits, make loans, commit the parent bank to a loan, or deal in drafts, letters of credit, or the Eurocurrency market. Indeed, a tourist cannot even cash a traveler’s check from the parent bank in the representative office.
If the parent bank eventually decides to open a local general banking office, the existence of a representative office for some prior period usually provides a valuable base of contacts and expertise to facilitate the change. However, representative offices are not necessarily a prelude to a general banking office, nor need an eventual general banking office be the major reason for opening a representative office.
Branch Banks. A foreign branch bank is a legal and operational part of the parent bank, with the full resources of that parent behind the local office. A branch bank does not have its own corporate charter, its own board of directors, or any shares of stock outstanding. Although
548 CHAPTER 19 Working Capital Management
for managerial and regulatory purposes it will maintain its own set of books, its assets and liabilities are in fact those of the parent bank. However, branch deposits are not subject to reserve requirements or FDIC insurance, in the case of U.S. banks, unless the deposits are reloaned to the U.S. parent bank.
Branch banks are subject to two sets of banking regulations. As part of the parent, they are subject to home-country regulations. However, they are also subject to regulations of the host country, which may provide any of a variety of restrictions on their operations.
The major advantage to a business of using a branch bank is that the branch will conduct a full range of banking services under the name and legal obligation of the parent. A deposit in a branch is a legal obligation of the parent. Services to customers are based on the worldwide value of the client relationship rather than just on the relationship to the local office. Legal loan limits are a function of the size of the parent, not of the branch.
From the point of view of a banker, the profits of a foreign branch are subject to immediate taxation at home, and losses of a foreign branch are deductible against tax- able income at home. A new office expected to have losses in its early years creates a tax advantage if it is initially organized as a branch, even if eventually the intent is to change it to a separately incorporated subsidiary. From an organizational point of view, a foreign branch is usually simpler to create and staff than is a separately incorporated subsidiary.
The major disadvantage of a branch bank is one that accrues to the bank rather than to its customers. The parent bank (not just the branch) may be sued at the local level for debts or other activities of the branch.
Banking Subsidiaries. A subsidiary bank is a separately incorporated bank, owned entirely or mostly by a foreign parent, that conducts a general banking business. As a separate corporation, the banking subsidiary must comply with all the laws of the host country. Its lending limit is based on its own equity capital rather than that of the parent bank. This limits its ability to service large borrowers, but local incorporation also limits the liability of the parent bank to its equity investment in the subsidiary.
A foreign banking subsidiary often appears as a local bank in the eyes of potential customers in host countries and is thus often able to attract additional local deposits. This especially is true if the bank is independent prior to being purchased by the foreign parent. Management may well be local, giving the bank greater access to the local business community. A foreign-owned bank subsidiary is more likely to be involved in both domestic and international business than is a foreign branch, which is more likely to appeal to the foreign business community but may well encounter difficulty in attracting banking business from local firms.
Edge Act Corporations. Edge Act corporations are subsidiaries of U.S. banks, incorporated in the United States under Section 25 of the Federal Reserve Act as amended, to engage in international banking and financing operations. Not only may such subsidiaries engage in general international banking, but also they may finance commercial, industrial, or financial projects in foreign countries through long-term loans or equity participation. Such participation, however, is subject to the day-to-day practices and policies of the Federal Reserve System.
Edge Act corporations generally engage in two types of activities: direct international banking, including acting as a holding company for the stock of one or more foreign banking subsidiaries, and financing development activities not closely related to traditional banking operations.
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SUMMARY POINTS
! The operating cycle of a business generates funding needs, cash inflows and outflows—the cash conversion cycle— and potentially foreign exchange rate and credit risks.
! The funding needs generated by the operating cycle of the firm constitute working capital. The operating cycle of a business extends along a timeline from the first point at which a customer requests a price quotation to the final point in time at which payment is received from the customer for goods delivered.
! The cash conversion cycle, a subcomponent of the operating cycle, is the time extending between cash outflows for purchased inputs and materials and when cash inflow is received from cash settlement.
! The MNE is constantly striving to create shareholder value by maximizing the after-tax profitability of the firm. One dimension of this task is to reposition the profits of the firm, as legally and practically as possible, in low-tax environments.
! Repositioning profits will allow the firm to increase the after-tax profits of the firm by lowering the tax liabilities of the firm with the same amount of sales.
! In addition to tax management, repositioning is useful when an MNE wishes to move cash flows or funds in general from where they are not needed to where they may redeployed in more value-creating activities, or to minimize exposure to a potential currency collapse or potential political or economic crisis.
! Royalties are compensation for the use of intellectual property belonging to some other party. Royalties are usually a stated percentage of sales revenue (price times volume) so that the owner is compensated in proportion to the volume of sales.
! License fees are remuneration paid to the owners of technology, patents, trade names, and copyrighted material (including moving pictures, video tapes,
compact disks, software, and books). License fees are usually based on a percentage of the value of the product or on the volume of production. As such, they are calculated independently of the amount of sales.
! International dividend policy now incorporates tax considerations, political risk, and foreign exchange risk, as well as a return for business guidance and technology.
! Dividends are the most tax inefficient method for repatriating funds because they are distributed on an after-tax basis. This means that the parent company will frequently be faced with the generation of excess foreign tax credits on a dividend.
! Remittance of license or royalty fees is on a pre-tax basis in the foreign subsidiary, the only tax which is typically applied is that of withholding, a rate considerably below that of corporate income taxes.
! In principle, firms attempt to minimize their net working capital balance. A/R is reduced if collections are accelerated. Inventories held by the firm are reduced by carrying lower levels of both unfinished and finished goods, and by speeding the rate at which goods are manufactured, reducing so-called cycle-time.
! All firms must determine whether A/P be paid off early, taking discounts if offered by suppliers, and finance these payments with short-term debt. Note that short-term debt is not included within NWC itself because it does not spontaneously increase with operations, but must be acquired as part of management’s financing choices.
! MNEs can finance working capital needs through in- house banks, international banks, and local banks where subsidiaries are located.
! International banks finance MNEs and service these accounts through representative offices, correspondent banking relationships, branch banks, banking subsidiaries, affiliates, and Edge Act corporations (U.S. only).
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The Space and Avionics Control Group (SAC) of Honey- well, Incorporated (U.S.) was quite frustrated in June 1997. The cockpit retrofit proposal with Pakistan International Airlines had been under negotiations for seven months, and over the past weekend a new request had been thrown in—to accept payment in Pakistan rupee. This was against corporate policy at Honeywell, and if an exception was not made, the deal—worth $23.7 million—was most likely dead.
Pakistan International Airlines (PIA) Pakistan International Airlines Corporation (PIA) was the national flag carrier of the Islamic Republic of Pakistan. Founded in 1954, PIA operated both scheduled passenger and cargo services. The firm was 57% state owned, with the remaining 43% held by private investors internal to Pakistan.
PIA’s fleet was aging. Although the airline had planned a significant modernization program, recent restrictions placed on government spending by the International Monetary Fund (IMF) had killed the program. With the cancellation of the fleet modernization program, PIA now had to move fast to ensure compliance with U.S. Federal Aviation Administration (FAA) safety mandates. If it did not comply with the FAA mandates for quieter engines and upgraded avionics by June 30, 1998, PIA would be locked out of its very profitable U.S. gates. PIA would first retrofit the aircraft utilized on the long-haul flights to the United States, primarily the Boeing 747 classics. Due to SAC’s extensive experience with a variety of control systems for Boeing and its recent work on cockpit retro- fit for McDonnell Douglas aircraft, SAC felt it was the preferred supplier for PIA. However, SAC had not under- taken Boeing cockpit retrofits to date (no one had), and looked to the PIA deal as an opportunity to build a new competitive base. PIA’s insistence on payment in local currency terms was now thought to be a tactic to extract better concessions from SAC and their agent, Makran.
Ibrahim Makran Pvt. LTD In countries like Pakistan, the use of an agent is often considered a necessary evil. The agent can often help to bridge two business cultures and provide invaluable information, but at some cost. Honeywell’s agent, Ibrahim Makran Pvt. LTD., based in Hyderabad, was considered one of the most reliable and well-connected in Pakistan. Makran traced its roots back to a long association with the Sperry Aerospace and Marine Group, the precursor to Honeywell’s SAC unit (Sperry was acquired in 1986). Makran was also one of the largest import/export trading houses in Pakistan. It was 100% family-owned and managed.
Standard practice in the avionics business was to provide the agent with a 10% commission, although this was negotiable. The 10% was based on the final sales, and was paid after all payments were received. Typically, it was the agent who spotted the business opportunity and submitted a proposal to SAC Marketing. After PIA contacted Makran regarding their latest demand, Makran knew that SAC would want to maintain the deal in U.S. dollars. Makran had therefore inquired as to the avail- ability of dollar funds for a deal of this size from its own finance department. The finance department confirmed that they had the necessary dollar funds to pay SAC, but warned that policy was to charge 5% for services rendered and currency risks.
Makran advised SAC that it would be willing to purchase the receivable for an additional 5% (in addition to the 10% commission). Makran’s U.S. subsidiary in Los Angeles would credit SAC within 30 days of SAC invoicing Makran. PIA advised Makran that if SAC accepted pay- ment in Pakistan rupees, then local (Pakistan) payment terms would apply. This meant 180 days in principle, but often was much longer in practice. The agent also advised SAC that the Pakistan rupee was due for another devaluation. When pressed for more information, Makran simply replied that the company president, the elder Ibrahim Makran, had “good connections.”
Pakistan Rupee A central part of the IMF’s austerity program was a devaluation of the Pakistan rupee by 7.86% against the U.S. dollar on October 22, 1996. Now, roughly six months later, there was renewed speculation that another devaluation was imminent in order to limit imports and help the export sector earn badly needed hard currency. Another recent economic setback had been the ruling by the European Union that Pakistan was guilty of dumping cotton, and had imposed antidumping fines on Pakistani cotton. This was a painful blow to the export sector. The current exchange rate of 40.4795 Pakistan rupee (Rp) per dollar was maintained by the Pakistani Central Bank. The parallel market rate—black market rate—was approaching Rp50/US$. At present, there was no forward market for the Pakistan rupee.
Honeywell’s Working Capital Honeywell’s finance department was attempting to reduce net working capital and just concluded a thorough review of existing payment terms and worldwide days sales receivable (DSR) rates. The department’s goal was to reduce world- wide DSR rates from 55 to 45 days in the current fiscal year.
Honeywell and Pakistan International AirwaysMINI-CASE
was signed. The invoice for the full amount outstanding would be issued at that time. If the expected improvements to the DSR were made in the meantime, maybe the high DSR rate on the PIA deal could be averaged with the rest of Asia. The 20% advance would be used to fund the front- end engineering work.
Global treasury at Honeywell was headquartered along with corporate in Minneapolis, Minnesota. Corpo- rate treasury was a profit center and charged 1% com- mission on all sales. Treasury, however, passed on the currency risk to the business unit. If a local subsidiary required local currency, treasury would try to match those requirements by accepting the A/R in the local currency. They had advised SAC that for many developing coun- tries where Honeywell had little or no activities such as Pakistan, this was done only on an exception basis. Global treasury also evaluated all deals in present value terms given the extended payment periods, and the corporate cost of capital was set at 12%.
Negotiations Honeywell now speculated that the local currency request was a result of the 20% advance payment clause. The project was considered one of the riskiest SAC had under- taken, and the 20% advance payment would help reach the group’s DSR goals. The DSR was being watched daily by division management. This project had already been forced to secure group-level approval because it fell below the minimum return on sales target. SAC’s management had
The Pay for Performance target for the current year (the annual performance bonus system at Honeywell) included net working capital goals. There was concern in the orga- nization that the net working capital goal could prove the obstacle to achieving a bonus despite excellent sales growth. The latest DSR report is shown in Exhibit 1.
Honeywell payment terms were net 30 from date of invoice. However, payment terms and practices var- ied dramatically across country and region. Payment terms were generally not published, with the exception of some private reports by credit rating agencies. In the past Honeywell had not enforced stringent credit terms on many customers. For example, neither contracts nor invoices stated any penalties for late payment. Many air- lines did pay on time, but others availed themselves of Honeywell’s cheap financing.
A review of PIA’s account receivable history indicated that they consistently paid their invoices late. The current average DSR was 264 days. PIA had been repeatedly put on hold by the collections department, forcing marketing staff representatives to press the agent who in turn pressed PIA for payment. Honeywell was very concerned about this deal. It had, in fact, asked for guarantees that PIA would pay promptly. Honeywell’s concern was also reflected in the 20% advance payment clause in the contract. Although marketing took the high DSR rate up with PIA and the agent, the cur- rent proposed deal was expected to be the same if not worse.
One positive attribute of the proposed contract was that delivery would not occur until one year after the contract
EXHIBIT 1 SAC Control Systems’ Average Days Sales Receivables (DSR) by Region
Region Actual Target Amount
North America 44 40 $31 million
South America 129 70 $2.1 million
Europe 55 45 $5.7 million
Middle East 93 60 $3.2 million
Asia 75 55 $11 million
PIA 264 180 $0.7 million
Boeing 39 30 $41 million
McDonnell Douglas 35 30 $18 million
Airbus Industrie 70 45 $13 million
Notes: 1. U.S.-based airline trading companies distort the actual local payment terms. 2. The spread between individual customers within regions can be extremely large. 3. Some collection activity is assumed. Specific customers are periodically targeted. 4. Disputed invoices are included. Amount is for all products, services, and exchanges. 5. One of the criteria for granting “preferred” pricing is a 30-day DSR. The 10% reduction can be substantial but typically only moti-
vates the larger customers.
551Working Capital Management CHAPTER 19
U.S. dollar value which would, in the end, be received?
2. Do you think the services offered by Makran are worth the costs?
3. What would you do if you were heading the Honey- well SAC group negotiating the deal?
counted on the deal to make its annual sales targets, and that now seemed in jeopardy. It would need to act soon if it was to reach its targets.
Case Questions 1. Estimate what cash flows in which currencies the
proposal would probably yield. What is the expected
CHAPTER 19 Working Capital Management552
QUESTIONS 1. Constraints on Positioning Funds. Each of the
following factors is sometimes a constraint on the free movement of funds internationally. Why would a government impose such a constraint? How might the management of a multinational argue that such a constraint is not in the best interests of the government that has imposed it? a. Government-mandated restrictions on moving
funds out of the country b. Withholding taxes on dividend distributions to
foreign owners c. Dual currency regimes, with one rate for imports
and another rate for exports d. Refusal to allow foreign firms in the country to net
cash inflows and outflows into a single payment
2. Unbundling. What does this term mean? Why would unbundling be needed for international cash flows from foreign subsidiaries, but not for domestic cash flows between related domestic subsidiaries and their parent?
3. Conduits. In the context of unbundling cash flows from subsidiary to parent, explain how each of the following creates a conduit. What are the tax consequences of each? a. Imports of components from the parent b. Payment to cover overhead expenses of parent
managers temporarily assigned to the subsidiary c. Payment of royalties for the use of proprietary
technology d. Subsidiary borrowing of funds on an intermediate
or long-term maturity from the parent e. Payment of dividends to the parent
4. Sister Subsidiaries. Subsidiary Alpha in Country Able faces a 40% income tax rate. Subsidiary Beta in Coun- try Baker faces only a 20% income tax rate. Presently each subsidiary imports from the other an amount of
goods and services exactly equal in monetary value to what each exports to the other. This method of balancing intracompany trade was imposed by a man- agement keen to reduce all costs, including the costs (spread between bid and ask) of foreign exchange transactions. Both subsidiaries are profitable, and both could purchase all components domestically at approximately the same prices as they are paying to their foreign sister subsidiary. Is this an optimal situation?
5. Allocated Fees—1. What is the difference between a “license fee” and a “royalty fee?” Do you think license and royalty fees should be covered by the tax rules that regulate transfer pricing? Why?
6. Allocated Fees—2. What is the difference between a “management fee,” a “technical assistance fee,” and a “license fee for patent usage?” Should they be treated differently for income tax purposes?
7. Distributed Overhead. What methods might the U.S. Internal Revenue Service use to determine if allocations of distributed overhead are being fairly allocated to foreign subsidiaries?
8. Fee Treatment. In the context of unbundling cash flows from subsidiary to parent, why might a host government be more lenient in its treatment of fees than its treatment of dividends? What difference does it make to the subsidiary and to the parent?
9. The Cycle. The operating cycle of a firm, domestic or multinational, consists of the following time periods: a. Quotation b. Input sourcing c. Inventory d. Accounts receivable
For each of these, explain whether a cash outflow or a cash inflow is associated with the beginning and the end of the period.
553Working Capital Management CHAPTER 19
19. Devaluation Risk. Merlin Corporation of the United States imports raw material from Indonesia on terms of 2/10, net 30. Merlin expects a 36% devaluation of the Indonesian rupiah at any moment. Should Merlin take the discount? Discuss aspects of the problem.
20. Free-Trade Zones. What are the advantages of a Free-Trade Zone? Are there any disadvantages?
21. Motives. Explain the difference between the “transaction motive” and the “precautionary motive” for holding cash.
22. Cash Cycle. The operating cash cycle of a multinational firm goes from cash collection from customers, cash holding for anticipated transaction needs (the transaction motive for holding cash), possible cash repositioning into another currency, and eventual cash disbursements to pay operating expenses. Assuming the initial cash collection is in one currency and the eventual cash disbursement is in another currency, what can a multinational firm do to shorten its cash cycle and what risks are involved?
23. Electro-Beam Company. Electro-Beam Company generates and disburses cash in the currencies of four countries, Singapore, Malaysia, Thailand, and Vietnam. What would be the characteristics you might consider if charged with designing a centralized cash depository system for Electro-Beam Company’s Southeast Asian subsidiaries?
24. France. During the era of the French franc, France imposed a rule on its banks and subsidiaries of international companies operating in France that precluded those subsidiaries from netting cash flow obligations between France and non-French related entities. Why do you suppose the French government imposed such a rule, and what if anything could subsidiaries in France have done about it?
25. Foreign Bank Office. What is the difference between a foreign branch and a foreign subsidiary of a home-country bank?
PROBLEMS 1. Frozen Vapor. Frozen Vapor of Toulouse, France,
manufactures and sells skis and snowboards in France, Switzerland, and Italy, and also maintains a corporate account in Frankfurt, Germany. Frozen Vapor has been setting separate operating cash balances in each country at a level equal to expected cash needs plus
10. Accounts Payable Period. Exhibit 19.1 shows the accounts payable period to be longer than the inventory period. Could this be otherwise, and what would be the cash implications?
11. Payables and Receivables. As a financial manager, would you prefer that the accounts payable period end before, at the same time, or after the beginning of the accounts receivable period? Explain.
12. Transaction Exposure. Assuming the flow illustrated in Exhibit 19.1, where does transaction exposure begin and end if inputs are purchased with one currency at t1 and proceeds from the sale are received at t5 Is there more than one interval of transaction exposure?
13. Operating Exposure. Is any operating exposure created during the course of a firm’s operating Cycle?
14. Accounting Exposure. Is any accounting exposure created during the course of a firm’s operating Cycle?
15. Reducing NWC. Assume a firm purchases inventory with one foreign currency and sells it for another foreign currency, neither currency being the home currency of the parent or subsidiary where the manufacturing process takes place. What can the firm do to reduce the amount of net working capital?
16. Trade Terms. Roberts and Sons, Inc., of Great Britain has just purchased inventory items costing Kronor 1,000,000 from a Swedish supplier. The supplier has quoted terms 3/15, net 45. Under what conditions might Roberts and Sons reasonably take the discount, and when might it be a reasonable idea to wait the full 45 days to pay?
17. Inventory Turnover. Japanese industry is often praised for its “just-in-time” inventory practice between industrial buyers and industrial sellers. In the context of the “Day’s Receivables” turnover in Exhibit 19.3, what is the comparative impact of the “just-in-time” system in Japan? Are there any risks associated with this system? Do you think this applies equally to Japanese manufacturing firms sourcing raw material and components in Japan and those sourcing similar items from Thailand and Malaysia?
18. Receivables Turnover. Why might the time lag for intramultinational firm accounts receivable and payable (i.e., all received or paid to a parent or sister subsidiary) differ substantially from the time lags reported for transactions with nonaffiliated companies?
554 CHAPTER 19 Working Capital Management
a. What would be the net interest earnings (i.e., interest earned less interest paid, before administrative expenses), of Dalziel’s in-house bank for April?
b. If parent Dalziel Publishing subsidized the in- house for all of its operating expenses, how much more could the in-house bank loan at the beginning of April?
4. Tierra Technology, Inc. Tierra Technology, Inc., manufactures basic farm equipment in China, Spain, and Iowa. Each subsidiary has monthly unsettled balances due to or from other subsidiaries. At the end of December, unsettled intracompany debts in U.S. dollars were as follows:
two standard deviations above those needs, based on a statistical analysis of cash flow volatility. Expected operating cash needs and one standard deviation of those needs are as follows:
Amount Transaction Costs
Tierra Technology China:
Owes to Spanish subsidiary $8,000,000 $32,000
Owes to Iowa parent $9,000,000 $36,000
Tierra Technology Spain:
Owes to Chinese subsidiary $5,000,000 $20,000
Owes to Iowa parent $6,000,000 $24,000
Tierra Technology Iowa:
Owes to Chinese subsidiary $4,000,000 $16,000
Owes to Spanish subsidiary $10,000,000 $40,000
Country of Subsidiary Expected Cash
Need One Standard
Deviation
Switzerland €5,000,000 €1,000,000
Italy 3,000,000 400,000
France 2,000,000 300,000
Germany 800,000 40,000
Total €10,800,000 €1,740,000
Frozen Vapor’s Frankfurt bank suggests that the same level of safety could be maintained if all precautionary balances were combined in a central account at the Frankfurt headquarters. a. How much lower would Frozen Vapor’s total cash
balances be if all precautionary balances were combined? Assume cash needs in each country are normally distributed and are independent of each other.
b. What other advantages might accrue to Frozen Vapor from centralizing its cash holdings? Are these advantages realistic?
2. Atsushi Japan. Atsushi Japan, the Japanese sub- sidiary of a U.S. company has ¥100,000,000 in accounts receivable for sales billed to customers on terms of 2/30 n/60. Customers usually pay in 30 days. Atsushi also has ¥60,000,000 of accounts payable billed to it on terms of 3/10 n/60. Atsushi delays payment until the last minute because it is normally short of cash. Atsushi normally carries an average cash balance for transactions of ¥30,000,000. How much cash could Atsushi save by taking the discount?
3. Dalziel Publishing Company. Dalziel Publishing Company publishes books in Europe through separate subsidiaries in several countries. On a Europe-wide basis, Dalziel publishing experiences uneven cash flows. Any given book creates a cash outflow during the period of writing and publishing, followed by a cash inflow in subsequent months and years as the book is sold. To handle these imbalances, Dalziel decided to create an in- house bank.
Assumptions Per Annum Monthly
Interest paid on deposits 4.800% 0.400%
Interest charged on advances 5.400% 0.450%
Spot exchange rate, euros/pound 1.6000
a. How could Tierra Technology net these intra- company debts? How much would be saved in transaction expenses over the no-netting alternative?
b. Before settling the above accounts, Tierra Technol- ogy decides to invest $6,000,000 of parent funds in a new farm equipment manufacturing plant in the new Free Industrial Zone at Subic Bay, The Philip- pines. How can this decision be incorporated into the settlement process? What would be total bank charges? Explain.
555Working Capital Management CHAPTER 19
the first full year of operations. Ozark MediSurge’s CFO is pondering these approaches: a. Declare a dividend of Won362,340,000, equal to
50% of profit after taxes. The dividend would be taxable in the United States after a gross-up for Korean taxes already paid.
b. Add a license fee of Won362,340,000 to the above expenses, and remit that amount annually. The license fee would be fully taxable in the United States.
INTERNET EXERCISES 1. Working Capital Management. Using the Web sites of
a variety of these cross-border banks, search for which banks offer multinational cash management services that would combine banking with foreign exchange management. Which banks provide specific services through regional or geographic service centers?
Bank of America www.bankamerica.com/ corporate/
Bank of Montreal www.bmocm.com/sitemap/ default.aspx
2. New Zealand Working Capital. Use the New Zealand government’s definition and analysis of working capital and compare that presented in this chapter. How does the New Zealand definition result in different management practices?
5. Paignton Company (France). Consider the following series of business events:
March 1: Paignton Company seeks a sale at a price of €10,000,000 for items to be sold to a long-standing cli- ent in Poland. To achieve the order, Paignton offered to denominate the order in zlotys (Z), Poland’s cur- rency, for Z20,000,000. This price was arrived at by multiplying the euro price by Z2.00/€, the exchange rate on the day of the quote. The zloty is expected to fall in value by 0.5% per month versus the euro.
April 1: Paignton receives an order worth Z20,000,000 from the customer. On the same day, Paignton places orders with its vendors for €4,000,000 of components needed to complete the sale.
May 1: Paignton receives the components and is billed €4,000,000 by the vendor on terms of 2/20, net 60. During the next two months, Paignton assigns direct labor to work on the project. The expense of direct labor was €5,000,000.
July 1: Paignton ships the order to the customer and bills the customer Z20,000,000. On its corporate books, Paignton debits accounts receivable and credits sales.
Sept 1: Paignton’s customer pays Z20,000,000 to Paignton. a. Draw a cash flow diagram for this transaction in the
style of Exhibit 19.1 and explain the steps involved. b. What working capital management techniques
might Paignton use to better its position vis-à-vis this particular customer?
6. Ozark MediSurge, Inc. Ozark MediSurge, Inc. of Missouri wants to set up a regular procedure for transferring funds from its newly opened manufacturing subsidiary in Korea to the United States. The precedent set by the transfer method or methods is likely to prevail over any government objections that might otherwise arise in the future. The Korean subsidiary manufactures surgical tools for export to all Asian countries. The following pro forma financial information portrays the results expected in
New Zealand Government Working Capital
www.treasury.govt.nz/ publications/guidance/mgmt/ workingcapital
3. Clearinghouse Associations. Use the following Web sites to prepare an executive briefing on the role of clearinghouses in history and in contemporary finance. Use the Web site for the Clearing House Interbank Payments System (CHIPS) to estimate the volume of international financial transactions.
New York Clearinghouse Association
www.theclearinghouse.org/
Clearing House Interbank Payments System
www.chips.org/
556
International Trade Finance
Financial statements are like fine perfume: to be sniffed but not swallowed.
—Abraham Brilloff.
The purpose of this chapter is to explain how international trade, exports and imports, is financed. The contents are of direct practical relevance to both domestic firms that just import and export and to multinational firms that trade with related and unrelated entities.
The chapter begins by explaining the types of trade relationships that exist. Next, we explain the trade dilemma: exporters want to be paid before they export and importers do not want to pay until they receive the goods. The next section explains the benefits of the current international trade protocols. This is followed by a section describing the elements of a trade transaction and the various documents that are used to facilitate the trade’s completion and financing. The next section identifies international trade risks, namely, currency risk and noncompletion risk. The following sections describe the key trade documents, including letter of credit, draft, and bill of lading. The next section summarizes the documentation of a typical trade transaction. This is followed by a description of government programs to help finance exports, including export credit insurance and specialized banks such as the U.S. Export-Import Bank. Next, we compare the various types of short-term receivables financing and then the use of forfaiting for longer term receivables. The Mini-Case at the end of the chapter, Crosswell International and Brazil, illustrates how an export requires the integration of management, marketing, and finance.
The Trade Relationship As we saw in Chapter 1, the first significant global activity by a domestic firm is the importing and exporting of goods and services. The purpose of this chapter is to analyze the international trade phase for a domestic firm that begins to import goods and services from foreign suppliers and to export to foreign buyers. In the case of Trident, this trade phase began with suppliers from Mexico and buyers from Canada.
Trade financing shares a number of common characteristics with the traditional value chain activities conducted by all firms. All companies must search out suppliers for the many goods and services required as inputs to their own goods production or service provision processes. Trident’s Purchasing and Procurement Department must determine whether each potential supplier is capable of producing the product to required quality specifications, producing and delivering in a timely and reliable manner, and continuing to work with Trident in the ongoing process of product and process improvement for continued competitiveness. All must be at an acceptable price
CHAPTER 20
557International Trade Finance CHAPTER 20
and payment terms. As illustrated in Exhibit 20.1, this same series of issues applies to potential customers, as their continued business is equally as critical to Trident’s operations and success.
The nature of the relationship between the exporter and the importer is critical to under- standing the methods for import-export financing utilized in industry. Exhibit 20.2 provides an overview of the three categories of relationships: unaffiliated unknown, unaffiliated known, and affiliated.
! A foreign importer with which Trident has not previously conducted business would be considered unaffiliated unknown. In this case, the two parties would need to enter into a detailed sales contract, outlining the specific responsibilities and expectations of the business agreement. Trident would also need to seek out protection against the possibility that the importer would not make payment in full in a timely fashion.
! A foreign importer with which Trident has previously conducted business success- fully would be considered unaffiliated known. In this case, the two parties may still enter into a detailed sales contract, but specific terms and shipments or provisions of services may be significantly looser in definition. Depending on the depth of the relationship, Trident may seek some third-party protection against noncompletion or conduct the business on an open account basis.
! A foreign importer which is a subsidiary business unit of Trident, such as Trident Brazil, would be an affiliated party (sometime referred to as intrafirm trade). Because both businesses are part of the same MNE, the most common practice would be to conduct the trade transaction without a contract or protection against nonpayment. This is not, however, always the case. In a variety of international business situations it may still be in Trident’s best inter- est to detail the conditions for the business transaction, and to possibly protect against any political or country-based interruption to the completion of the trade transaction.
EXHIBIT 20.1 Financing Trade: The Flow of Goods and Funds
Domestic Buyer (United States)
Canadian Buyers (Calgary, Alberta)
Goods and services flow from supplier to Trident to buyer
Goods and services flow from supplier to Trident to buyer
US$ Mexican pesos
Canadian $US$
Trident USA (Los Angeles)
Domestic Supplier (United States)
Mexican Suppliers (Monterey, Mexico)
558 CHAPTER 20 International Trade Finance
The Trade Dilemma International trade must work around a fundamental dilemma. Imagine an importer and an exporter who would like to do business with one another. Because of the distance between the two, it is not possible to simultaneously hand over goods with one hand and accept payment with the other. The importer would prefer the arrangement shown at the top of Exhibit 20.3, while the exporter’s preference is shown at the bottom.
EXHIBIT 20.3 The Mechanics of Import and Export
Importer Exporter
1. Exporter ships the goods.
2. Importer pays after goods received.
Importer Preference
Importer Exporter
1. Importer pays for goods.
2. Exporter ships the goods after being paid.
Exporter Preference
EXHIBIT 20.2 Alternative International Trade Relationships
Trident as an Exporter
A new customer that Trident has no historical business relationship with
Requires: A contract Protection against nonpayment
Requires: A contract Possibly some protection against nonpayment
Requires: No contract No protection against nonpayment
A long-term customer with which there is an established relationship of trust and performance
A foreign subsidiary of Trident, a business unit of Trident corporation
Unaffiliated Unknown Party
Unaffiliated Known Party
Affiliated Party
Importer is. . .
1. 2.
1. 2.
1. 2.
559International Trade Finance CHAPTER 20
The fundamental dilemma of being unwilling to trust a stranger in a foreign land is solved by using a highly respected bank as intermediary. A greatly simplified view is described in Exhibit 20.4. In this simplified view, the importer obtains the bank’s promise to pay on its behalf, knowing that the exporter will trust the bank. The bank’s promise to pay is called a letter of credit.
The exporter ships the merchandise to the importer’s country. Title to the merchandise is given to the bank on a document called an order bill of lading. The exporter asks the bank to pay for the goods, and the bank does so. The document to request payment is a sight draft. The bank, having paid for the goods, now passes title to the importer, whom the bank trusts. At that time or later, depending on their agreement, the importer reimburses the bank.
Financial managers of MNEs must understand these three basic documents. It is because their firms will often trade with unaffiliated parties, but also because the system of documentation provides a source of short-term capital that can be drawn upon even when shipments are to sister subsidiaries.
Benefits of the System The three key documents and their interaction are described later in this chapter. They constitute a system developed and modified over centuries to protect both importer and exporter from the risk of noncompletion and foreign exchange risk, as well as to provide a means of financing.
Protection Against Risk of Noncompletion As stated above, once importer and exporter agree on terms, the seller usually prefers to maintain legal title to the goods until paid, or at least until assured of payment. The buyer, however, will be reluctant to pay before receiving the goods, or at least before receiving title to them. Each wants assurance that the other party will complete its portion of the transaction. The letter of credit, sight draft, and bill of lading are part of a system carefully constructed to determine who bears the financial loss if one of the parties defaults at any time.
EXHIBIT 20.4 The Bank as the Import/Export Intermediary
Importer
Bank
1. Importer obtains bank’s promise to pay on importer’s behalf.
2. Bank promises exporter to pay on behalf of importer.
6. Importer pays the bank.
5. Bank “gives” merchandise to the importer.
4. Bank pays the exporter.
3. Exporter ships “to the bank“ trusting bank’s promise.
Exporter
560 CHAPTER 20 International Trade Finance
Protection Against Foreign Exchange Risk In international trade, foreign exchange risk arises from transaction exposure. If the transaction requires payment in the exporter’s currency, the importer carries the foreign exchange risk. If the transaction calls for payment in the importer’s currency, the exporter has the foreign exchange risk.
Transaction exposure can be hedged by the techniques described in Chapter 10, but in order to hedge, the exposed party must be certain that payment of a specified amount will be made on or near a particular date. The three key documents described in this chapter ensure both amount and time of payment and thus lay the groundwork for effective hedging.
The risk of noncompletion and foreign exchange risk are most important when the inter- national trade is episodic, with no outstanding agreement for recurring shipments and no sustained relationship between buyer and seller. When the import/export relationship is recurring, as in the case of manufactured goods shipped weekly or monthly to a final assembly or retail outlet in another country, and when it is between countries whose currencies are considered strong, the exporter may well bill the importer on open account after a normal credit check. Banks provide credit information and collection services outside of the system of processing drafts drawn against letters of credit.
Financing the Trade Most international trade involves a time lag during which funds are tied up while the merchandise is in transit. Once the risks of noncompletion and of exchange rate changes are disposed of, banks are willing to finance goods in transit. A bank can finance goods in transit, as well as goods held for sale, based on the key documents, without exposing itself to questions about the quality of merchandise or aspects of shipment.
International Trade: Timeline and Structure In order to understand the risks associated with international trade transactions, it is helpful to understand the sequence of events in any such transaction. Exhibit 20.5 illustrates, in principle, the series of events associated with a single export transaction.
From a financial management perspective, the two primary risks associated with an inter- national trade transaction are currency risk and risk of noncompletion. Exhibit 20.5 illustrates the traditional business problem of credit management: the exporter quotes a price, finalizes a contract, and ships the goods, losing physical control over the goods based on trust of the buyer or the promise of a bank to pay based on documents presented. The risk of default on the part of the importer is present as soon as the financing period begins, as depicted in Exhibit 20.5.
In many cases, the initial task of analyzing the creditworth of foreign customers is similar to procedures for analyzing domestic customers. If Trident has had no experience with a foreign customer but that customer is a large, well-known firm in its home country, Trident may simply ask for a bank credit report on that firm. Trident may also talk to other firms that have had dealings with the foreign customer. If these investigations show the foreign customer (and country) to be completely trustworthy, Trident would likely ship to them on open account, with a credit limit, just as they would for a domestic customer. This is the least costly method of handling exports because there are no heavy documentation or bank charges. However, before a regular trading relationship has been established with a new or unknown firm, Trident must face the possibility of nonpayment for its exports or noncompletion of its imports. The risk of nonpayment can be eliminated through the use of a letter of credit issued by a creditworthy bank.
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Key Documents The three key documents described in the following pages—the letter of credit, draft, and bill of lading—constitute a system developed and modified over centuries to protect both importer and exporter from the risk of noncompletion of the trade transaction as well as to provide a means of financing. The three key trade documents are part of a carefully constructed system to determine who bears the financial loss if one of the parties defaults at any time.
Letter of Credit (L/C) A letter of credit, (L/C), is a bank’s promise to pay issued by a bank at the request of an importer (the applicant/buyer), in which the bank promises to pay an exporter (the beneficiary of the letter) upon presentation of documents specified in the L/C. An L/C reduces the risk of noncompletion, because the bank agrees to pay against documents rather than actual merchandise. The relationship between the three parties is shown in Exhibit 20.6.
An importer (buyer) and exporter (seller) agree on a transaction and the importer then applies to its local bank for the issuance of an L/C. The importer’s bank issues an L/C and cuts a sales contract based on its assessment of the importer’s creditworthiness, or the bank might require a cash deposit or other collateral from the importer in advance. The importer’s bank will want to know the type of transaction, the amount of money involved, and what documents must accompany the draft that will be drawn against the L/C.
If the importer’s bank is satisfied with the credit standing of the applicant, it will issue an L/C guaranteeing to pay for the merchandise if shipped in accordance with the instructions and conditions contained in the L/C.
The essence of an L/C is the promise of the issuing bank to pay against specified documents, which must accompany any draft drawn against the credit. The L/C is not a guarantee of the underlying commercial transaction. Indeed, the L/C is a separate transaction from any sales or
EXHIBIT 20.5 The Trade Transaction Timeline and Structure
Time and Events
Goods are
shipped
Export contract signed
Price quote
request
Financing Period
Documents Are Presented
BacklogNegotiations
Documents are
accepted
Goods are
received
Cash settlement
of the transaction
562 CHAPTER 20 International Trade Finance
other contracts on which it might be based. To constitute a true L/C transaction, the following elements must be present with respect to the issuing bank:
1. The issuing bank must receive a fee or other valid business consideration for issuing the L/C.
2. The bank’s L/C must contain a specified expiration date or a definite maturity. 3. The bank’s commitment must have a stated maximum amount of money. 4. The bank’s obligation to pay must arise only on the presentation of specific documents,
and the bank must not be called on to determine disputed questions of fact or law. 5. The bank’s customer must have an unqualified obligation to reimburse the bank on
the same condition as the bank has paid.
Commercial letters of credit are also classified as follows:
Irrevocable Versus Revocable. An irrevocable L/C obligates the issuing bank to honor drafts drawn in compliance with the credit and can be neither canceled nor modified without the consent of all parties, including in particular the beneficiary (exporter). A revocable L/C can be canceled or amended at any time before payment; it is intended to serve as a means of arranging payment but not as a guarantee of payment.
Confirmed Versus Unconfirmed. An L/C issued by one bank can be confirmed by another, in which case the confirming bank undertakes to honor drafts drawn in compliance with the credit. An unconfirmed L/C is the obligation only of the issuing bank. An exporter is likely to want a foreign bank’s L/C confirmed by a domestic bank when the exporter has doubts about the foreign bank’s ability to pay. Such doubts can arise when the exporter is unsure of the financial standing of the foreign bank, or if political or economic conditions in the foreign country are unstable. The essence of an L/C is shown in Exhibit 20.7.
Most commercial letters of credit are documentary, meaning that certain documents must be included with drafts drawn under their terms. Required documents usually include an order bill of lading (discussed in more detail later in the chapter), a commercial invoice, and any of the following: consular invoice, insurance certificate or policy, and packing list.
EXHIBIT 20.6 Parties to a Letter of Credit (L/C)
Issuing Bank
Beneficiary (exporter)
Applicant (importer)
The relationship between the issuing bank and the exporter is governed by the terms of the letter of credit, as issued by that bank.
The relationship between the importer and the issuing bank is governed by the terms of the application and agreement for the letter of credit (L/C).
The relationship between the importer and the exporter is governed by the sales contract.
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Advantages and Disadvantages of Letters of Credit The primary advantage of an L/C is that it reduces risk—the exporter can sell against a bank’s promise to pay rather than against the promise of a commercial firm. The exporter is also in a more secure position as to the availability of foreign exchange to pay for the sale, since banks are more likely to be aware of foreign exchange conditions and rules than is the importing firm itself. If the importing country should change its foreign exchange rules during the course of a transaction, the government is likely to allow already outstanding bank letters of credit to be honored for fear of throwing its own domestic banks into international disrepute. Of course, if the L/C is confirmed by a bank in the exporter’s country, the exporter avoids any problem of blocked foreign exchange.
An exporter may find that an order backed by an irrevocable L/C will facilitate obtaining pre-export financing in the home country. If the exporter’s reputation for delivery is good, a local bank may lend funds to process and prepare the merchandise for shipment. Once the merchandise is shipped in compliance with the terms and conditions of the credit, payment for the business transaction is made and funds will be generated to repay the pre-export loan.
The major advantage of an L/C to the importer is that the importer need not pay out funds until the documents have arrived at a local port or airfield and unless all conditions stated in the credit have been fulfilled. The main disadvantages are the fee charged by the importer’s bank for issuing its L/C, and the possibility that the L/C reduces the importer’s borrowing line of credit with its bank. It may, in fact, be a competitive disadvantage for the exporter to demand automatically an L/C from an importer, especially if the importer has a good credit record and there is no concern regarding the economic or political conditions of the importer’s country. The value of the L/C has been known since the beginning of commerce, as detailed in Global Finance in Practice 20.1.
EXHIBIT 20.7 Essence of a Letter of Credit (L/C)
Bank of the East, Ltd. [Name of Issuing Bank]
Date: September 18, 2012 L/C Number 123456
Bank of the East, Ltd. hereby issues this irrevocable documentary Letter of Credit to Jones Company [name of exporter] for US$500,000, payable 90 days after sight by a draft drawn against Bank of the East, Ltd., in accordance with Letter of Credit number 123456.
The draft is to be accompanied by the following documents: 1. Commercial invoice in triplicate 2. Packing list 3. Clean on board order bill of lading 4. Insurance documents, paid for by buyer
At maturity Bank of the East, Ltd. will pay the face amount of the draft to the bearer of that draft.
Authorized Signature
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Merchant banking for international trade largely began in a landlocked city, Florence, Italy. In the late 13th and early 14th century as commerce grew throughout Europe and the Mediterranean, banking began to develop in both Venice and Florence.
It was a time in which commerce was still in its infancy, with the Catholic Church not approving of many aspects of commerce, including the loaning of money in return for interest— usury. Although usury has come to mean the illegal activity of charging excessive rates of interest, the term’s original meaning was the charging of interest of any kind.
The florin, a small gold coin first minted in Florence in 1252, may have been largely to blame for this series of disreputable activities. Named after the city, the florin flourished as a means of transacting trade across Europe in the following century. Merchants conducted their trade on a bench—a banco—which
eventually gave rise to the term for the safe place in which one kept their money.
But the coins were heavy, and if a merchant were traveling from one city or country to another to conduct trade, the weight was substantial, as was the chance of being robbed. The merchants then created the first financial derivative, a draft on the banco—a letter of exchange—which could be carried from one city to another and recognized as a credit for florins on account at their home banco. Payment was guaranteed within three months. Of course with the creation of banks came the first failures, bankruptcies.
From the very beginning, whether it was the loaning of money, the validity of a letter of exchange, or even the value of a currency, all were instruments or activities which may have unfortunate or undesirable outcomes, risque in the Italian of the time, or risk today.
Draft A draft, sometimes called a bill of exchange (B/E), is the instrument normally used in international commerce to effect payment. A draft is simply an order written by an exporter (seller) instructing an importer (buyer) or its agent to pay a specified amount of money at a specified time. Thus, it is the exporter’s formal demand for payment from the importer.
The person or business initiating the draft is known as the maker, drawer, or originator. Normally, this is the exporter who sells and ships the merchandise. The party to whom the draft is addressed is the drawee. The drawee is asked to honor the draft, that is, to pay the amount requested according to the stated terms. In commercial transactions, the drawee is either the buyer, in which case the draft is called a trade draft, or the buyer’s bank, in which case the draft is called a bank draft. Bank drafts are usually drawn according to the terms of an L/C. A draft may be drawn as a bearer instrument, or it may designate a person to whom payment is to be made. This person, known as the payee, may be the drawer itself or it may be some other party such as the drawer’s bank.
Negotiable Instruments If properly drawn, drafts can become negotiable instruments. As such, they provide a convenient instrument for financing the international movement of the merchandise. To become a negotiable instrument, a draft must conform to the following requirements (Uniform Commercial Code, Section 3104(1)):
1. It must be in writing and signed by the maker or drawer. 2. It must contain an unconditional promise or order to pay a definite sum of money. 3. It must be payable on demand or at a fixed or determinable future date. 4. It must be payable to order or to bearer.
GLOBAL FINANCE IN PRACTICE 20.1
Florence—The Birthplace of Trade Financing
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If a draft is drawn in conformity with the above requirements, a person receiving it with proper endorsements becomes a “holder in due course.” This is a privileged legal status that enables the holder to receive payment despite any personal disagreements between drawee and maker because of controversy over the underlying transaction. If the drawee dishonors the draft, payment must be made to any holder in due course by any prior endorser or by the maker. This clear definition of the rights of parties who hold a negotiable instrument as a holder in due course has contributed significantly to the widespread acceptance of various forms of drafts, including personal checks.
Types of Drafts Drafts are of two types: sight drafts and time drafts. A sight draft is payable on presentation to the drawee; the drawee must pay at once or dishonor the draft. A time draft, also called a usance draft, allows a delay in payment. It is presented to the drawee, who accepts it by writing or stamping a notice of acceptance on its face. Once accepted, the time draft becomes a promise to pay by the accepting party (the buyer). When a time draft is drawn on and accepted by a bank, it becomes a banker’s acceptance; when drawn on and accepted by a business firm, a trade acceptance.
The time period of a draft is referred to as its tenor. To qualify as a negotiable instrument, and so be attractive to a holder in due course, a draft must be payable on a fixed or determinable future date. For example, “60 days after sight” is a fixed date, which is established precisely at the time the draft is accepted. However, payment “on arrival of goods” is not determinable since the date of arrival cannot be known in advance. Indeed, there is no assurance that the goods will arrive at all.
Banker’s Acceptances When a draft is accepted by a bank, it becomes a banker’s acceptance. As such, it is the unconditional promise of that bank to make payment on the draft when it matures. In quality, the banker’s acceptance is practically identical to a marketable bank certificate of deposit (CD). The holder of a banker’s acceptance need not wait until maturity to liquidate the investment, but may sell the acceptance in the money market, where constant trading in such instruments occurs. The amount of the discount depends entirely on the credit rating of the bank that signs the acceptance, or another bank that reconfirmed the banker’s acceptance, for a fee. The all-in cost of using a banker’s acceptance compared to other short-term financing instruments is analyzed later in this chapter.
Bill of Lading (B/L) The third key document for financing international trade is the bill of lading (B/L). The bill of lading is issued to the exporter by a common carrier transporting the merchandise. It serves three purposes: a receipt, a contract, and a document of title.
As a receipt, the bill of lading indicates that the carrier has received the merchandise described on the face of the document. The carrier is not responsible for ascertaining that the containers hold what is alleged to be their contents, so descriptions of merchandise on bills of lading are usually short and simple. If shipping charges are paid in advance, the bill of lading will usually be stamped “freight paid” or “freight prepaid.” If merchandise is shipped collect—a less common procedure internationally than domestically—the carrier maintains a lien on the goods until freight is paid.
As a contract, the bill of lading indicates the obligation of the carrier to provide certain transportation in return for certain charges. Common carriers cannot disclaim responsibility for their negligence through inserting special clauses in a bill of lading. The bill of lading may
566 CHAPTER 20 International Trade Finance
specify alternative ports in the event that delivery cannot be made to the designated port, or it may specify that the goods will be returned to the exporter at the exporter’s expense.
As a document of title, the bill of lading is used to obtain payment or a written promise of payment before the merchandise is released to the importer. The bill of lading can also function as collateral against which funds may be advanced to the exporter by its local bank prior to or during shipment and before final payment by the importer.
Characteristics of the Bill of Lading The bill of lading is typically made payable to the order of the exporter, who thus retains title to the goods after they have been handed to the carrier. Title to the merchandise remains with the exporter until payment is received, at which time the exporter endorses the order bill of lading (which is negotiable) in blank or to the party making the payment, usually a bank. The most common procedure would be for payment to be advanced against a documentary draft accom- panied by the endorsed order bill of lading. After paying the draft, the exporter’s bank forwards the documents through bank clearing channels to the bank of the importer. The importer’s bank, in turn, releases the documents to the importer after payment (sight drafts); after acceptance (time drafts addressed to the importer and marked D/A); or after payment terms have been agreed upon (drafts drawn on the importer’s bank under provisions of an L/C).
Example: Documentation in a Typical Trade Transaction Although a trade transaction could conceivably be handled in many ways, we shall now turn to a hypothetical example that illustrates the interaction of the various documents. Assume that Trident U.S. receives an order from a Canadian Buyer. For Trident, this will be an export financed under an L/C requiring a bill of lading, with the exporter collecting via a time draft accepted by the Canadian Buyer’s bank. Such a transaction is illustrated in Exhibit 20.8.
1. The Canadian Buyer (the Importer in Exhibit 20.8) places an order with Trident (the Exporter in Exhibit 20.8), asking if Trident is willing to ship under an L/C.
2. Trident agrees to ship under an L/C and specifies relevant information such as prices and terms.
3. The Canadian Buyer applies to its bank, Northland Bank, for an L/C to be issued in favor of Trident for the merchandise it wishes to buy.
4. Northland Bank issues the L/C in favor of Trident and sends it to the Southland Bank (Trident’s bank).
5. Southland Bank advises Trident of the opening of an L/C in Trident’s favor. South- land Bank may or may not confirm the L/C to add its own guarantee to the document.
6. Trident ships the goods to the Canadian Buyer. 7. Trident prepares a time draft and presents it to Southland Bank (Trident’s bank).
The draft is drawn (i.e., addressed to) Northland Bank in accordance with Northland Bank’s L/C and accompanied by other documents as required, including the bill of lading. Trident endorses the bill of lading in blank (making it a bearer instrument) so that title to the goods goes with the holder of the documents—Southland Bank at this point in the transaction.
8. Southland Bank presents the draft and documents to Northland Bank for acceptance. Northland Bank accepts the draft by stamping and signing it making it a banker’s acceptance, takes possession of the documents, and promises to pay the now-accepted draft at maturity—say, 60 days.
567International Trade Finance CHAPTER 20
9. Northland Bank returns the accepted draft to Southland Bank. Alternatively, South- land Bank might ask Northland Bank to accept and discount the draft. Should this occur, Northland Bank would remit the cash less a discount fee rather than return the accepted draft to Southland Bank.
10. Southland Bank, having received back the accepted draft, now a banker’s acceptance, may choose between several alternatives. Southland Bank may sell the acceptance in the open market at a discount to an investor, typically a corporation or financial institution with excess cash it wants to invest for a short period. Southland Bank may also hold the acceptance in its own portfolio.
11. If Southland Bank discounted the acceptance with Northland Bank (mentioned in step 9) or discounted it in the local money market, Southland Bank will transfer the proceeds less any fees and discount to Trident. Another possibility would be for Trident itself to take possession of the acceptance, hold it for 60 days, and present it for collection. Normally, however, exporters prefer to receive the discounted cash value of the acceptance at once rather than wait for the acceptance to mature and receive a slightly greater amount of cash later.
12. Northland Bank notifies the Canadian Buyer of the arrival of the documents. The Canadian Buyer signs a note or makes some other agreed upon plan to pay North- land Bank for the merchandise in 60 days, Northland Bank releases the underly- ing documents so that the Canadian Buyer can obtain physical possession of the shipment at once.
EXHIBIT 20.8 Steps in a Typical Trade Transaction
7. Exporter presents draft and documents to its bank, Bank X
11. Bank X pays exporter
13. Importer pays its bank
12. Bank I obtains importer’s note and releases shipment
Exporter Importer
Bank X Bank I
1. Importer orders goods
2. Exporter agrees to fill order 3. Importer arranges L/C with its bank
6. Exporter ships goods to importer
8. Bank X presents draft and documents to Bank I
9. Bank I accepts draft, promising to pay in 60 days, and returns accepted draft to Bank X
4. Bank I sends L/C to Bank X
10. Bank X sells acceptance to investor
14. Investor presents acceptance and is paid by Bank I
5. Bank X advises exporter of L/C
Public Investor
568 CHAPTER 20 International Trade Finance
13. After 60 days, Northland Bank receives from the Canadian Buyer funds to pay the maturing acceptance.
14. On the same day, the 60th day after acceptance, the holder of the matured acceptance presents it for payment and receives its face value. The holder may present it directly to Northland Bank, or return it to Southland Bank and have Southland Bank collect it through normal banking channels.
Although this is a typical transaction involving an L/C, few international trade transactions are probably ever truly typical. Business, and more specifically international business, requires flexibility and creativity by management at all times. The Mini-Case at the end of this chapter presents an application of the mechanics of a real business situation. The result is a classic challenge to management: when and on what basis do you compromise typical procedure in order to accomplish strategic goals?
Government Programs to Help Finance Exports Governments of most export-oriented industrialized countries have special financial institutions that provide some form of subsidized credit to their own national exporters. These export finance institutions offer terms that are better than those generally available from the private sector. Thus, domestic taxpayers are subsidizing sales to foreign buyers in order to create employment and maintain a technological edge. The most important institutions usually offer export credit insurance and a government-supported bank for export financing.
Export Credit Insurance The exporter who insists on cash or an L/C payment for foreign shipments is likely to lose orders to competitors from other countries that provide more favorable credit terms. Better credit terms are often made possible by means of export credit insurance, which provides assurance to the exporter or the exporter’s bank that, should the foreign customer default on payment, the insurance company will pay for a major portion of the loss. Because of the availability of export credit insurance, commercial banks are willing to provide medium- to long-term financing (five to seven years) for exports. Importers prefer that the exporter purchase export credit insurance to pay for nonperformance risk by the importer. In this way, the importer does not need to pay to have an L/C issued and does not reduce its credit line.
Competition between nations to increase exports by lengthening the period for which credit transactions can be insured may lead to a credit war and to unsound credit decisions. To prevent such an unhealthy development, a number of leading trading nations joined in 1934 to create the Berne Union (officially, the Union d’Assureurs des Credits Internationaux) for the purpose of establishing a voluntary international understanding on export credit terms. The Berne Union recommends maximum credit terms for many items including, for example, heavy capital goods (five years), light capital goods (three years), and consumer durable goods (one year).
Export Credit Insurance in the United States In the United States, export credit insurance is provided by the Foreign Credit Insurance Association (FCIA). This is an unincorporated association of private commercial insurance companies operating in cooperation with the Export-Import Bank (see next page).
569International Trade Finance CHAPTER 20
The FCIA provides policies protecting U.S. exporters against the risk of nonpayment by foreign debtors as a result of commercial and political risks. Losses due to commercial risk are those that result from the insolvency or protracted payment default of the buyer. Political losses arise from actions of governments beyond the control of buyer or seller.
Export-Import Bank and Export Financing The Export-Import Bank (also called Eximbank) is another independent agency of the U.S. government, established in 1934 to stimulate and facilitate the foreign trade of the United States. Interestingly, the Eximbank was originally created primarily to facilitate exports to the Soviet Union. In 1945, the Eximbank was re-chartered “to aid in financing and to facilitate exports and imports and the exchange of commodities between the United States and any foreign country or the agencies or nationals thereof.”
The Eximbank facilitates the financing of U.S. exports through various loan guarantee and insurance programs. The Eximbank guarantees repayment of medium-term (181 days to five years) and long-term (five years to ten years) export loans extended by U.S. banks to foreign bor- rowers. The Eximbank’s medium- and long-term, direct-lending operation is based on participa- tion with private sources of funds. Essentially, the Eximbank lends dollars to borrowers outside the United States for the purchase of U.S. goods and services. Proceeds of such loans are paid to U.S. suppliers. The loans themselves are repaid with interest in dollars to the Eximbank. The Eximbank requires private participation in these direct loans in order to: 1) ensure that it comple- ments rather than competes with private sources of export financing; 2) spread its resources more broadly; and 3) ensure that private financial institutions will continue to provide export credit.
The Eximbank also guarantees lease transactions; finances the costs involved in the preparation by U.S. firms of engineering, planning, and feasibility studies for non-U.S. clients on large capital projects; and supplies counseling for exporters, banks, or others needing help in finding financing for U.S. goods.
Trade Financing Alternatives In order to finance international trade receivables, firms use the same financing instruments as they use for domestic trade receivables, plus a few specialized instruments that are only available for financing international trade. Exhibit 20.9 identifies the main short-term financing instruments and their approximate costs. The last section describes a longer term instrument called forfaiting.
Banker’s Acceptances. Banker’s acceptances, described earlier in this chapter can be used to finance both domestic and international trade receivables. Exhibit 20.9 shows that banker’s acceptances earn a yield comparable to other money market instruments, especially marketable bank certificates of deposit. However, the all-in cost to a firm of creating and discounting a banker’s acceptance also depends upon the commission charged by the bank that accepts the firm’s draft.
The first owner of the banker’s acceptance created from an international trade transaction will be the exporter, who receives the accepted draft back after the bank has stamped it “accepted.” The exporter may hold the acceptance until maturity and then collect. On an acceptance of, say, $100,000 for three months the exporter would receive the face amount less the bank’s acceptance commission of 1.5% per annum:
Face amount of the acceptance $100,000
Less 1.5% per annum commission for three months − 375 (.015 * 3/12 * $100,000)
Amount received by exporter in three months $ 99,625
570 CHAPTER 20 International Trade Finance
Face amount of the acceptance $100,000
Less 1.5% per annum commission for three months − 375 (.015 * 3/12 * $100,000)
Less 1.14% per annum discount rate for three months − 285 (.0114 * 3/12 * $100,000)
Amount received by exporter at once $ 99,340
Alternatively, the exporter may “discount”—that is, sell at a reduced price—the acceptance to its bank in order to receive funds at once. The exporter will then receive the face amount of the acceptance less both the acceptance fee and the going market rate of discount for banker’s acceptances. If the discount rate were 1.14% per annum as shown in Exhibit 20.9, the exporter would receive the following:
EXHIBIT 20.9 Instruments for Financing Short-Term Domestic and International Trade Receivables
Instrument Cost or Yield for 3-month Maturity
Banker’s acceptances* 1.14% yield annualized
Trade acceptances* 1.17% yield annualized
Factoring Variable rate but much higher cost than bank credit lines
Securitization Variable rate but competitive with bank credit lines
Bank credit lines 4.25% plus points (fewer points if covered by export credit insurance)
Commercial paper* 1.15% yield annualized
*These instruments compete with 3-month marketable bank time certificates of deposit that yield 1.17%.
Therefore, the annualized all-in cost of financing this banker’s acceptance is as follows:
Commission + Discount Proceeds
* 360 90
= $375 + $285
$99,340 * 360
90 = .0266 or 2.66%.
The discounting bank may hold the acceptance in its own portfolio, earning for itself the 1.14% per annum discount rate, or the acceptance may be resold in the acceptance market to portfolio investors. Investors buying banker’s acceptances provide the funds that finance the transaction.
Trade Acceptances. Trade acceptances are similar to banker’s acceptances except that the accepting entity is a commercial firm, like General Motors Acceptance Corporation (GMAC), rather than a bank. The cost of a trade acceptance depends on the credit rating of the accepting firm plus the commission it charges. Like banker’s acceptances, trade acceptances are sold at a discount to banks and other investors at a rate that is competitive with other money market instruments (see Exhibit 20.9).
Factoring. Specialized firms, known as factors, purchase receivables at a discount on either a non-recourse or recourse basis. Non-recourse means that the factor assumes the credit, political, and foreign exchange risk of the receivables it purchases. Recourse means that the factor can give back receivables that are not collectable. Since the factor must bear the cost and risk of assessing the creditworth of each receivable, the cost of factoring is usually quite high. It is more than borrowing at the prime rate plus points.
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The all-in cost of factoring non-recourse receivables is similar in structure to acceptances. The factor charges a commission to cover the non-recourse risk, typically 1.5%–2.5%, plus interest deducted as a discount from the initial proceeds. On the other hand, the firm selling the non-recourse receivables avoids the cost of determining creditworth of its customers. It also does not have to show debt borrowed to finance these receivables on its balance sheet. Furthermore, the firm avoids both foreign exchange and political risk on these non-recourse receivables. Global Finance in Practice 20.2 provides an example of the costs.
Securitization. The securitization of export receivables for financing trade is an attractive supplement to banker’s acceptance financing and factoring. A firm can securitize its export receivables by selling them to a legal entity established to create marketable securities based on a package of individual export receivables. An advantage of this technique is to remove the export receivables from the exporter’s balance sheet because they have been sold without recourse.
The receivables are normally sold at a discount. The size of the discount depends on four factors:
1. The historic collection risk of the exporter 2. The cost of credit insurance 3. The cost of securing the desirable cash flow stream to the investors 4. The size of the financing and services fees
Securitization is more cost effective if there is a large value of transactions with a known credit history and default probability. A large exporter could establish its own securitization entity. While the initial setup cost is high, the entity can be used on an ongoing basis. As an alternative, smaller exporters could use a common securitization entity provided by a financial institution, thereby saving the expensive setup costs.
A U.S.-based manufacturer that may have suffered significant losses during first the global credit crisis and the following global recession is cash-short. Sales, profits, and cash flows, have fallen. The company is now struggling to service its high levels of debt. It does, however, have a
number of new sales agreements. It is considering factor- ing one of its biggest new sales, a sale for $5 million to a Japanese company. The receivable is due in 90 days. After contacting a factoring agent, it is quoted the following numbers.
Face amount of receivable $5,000,000
Non-recourse fee (1.5%) − 75,000
Factoring fee (2.5% per month * 3 months) − 375,000
Net proceeds on sale (received now) $4,550,000
GLOBAL FINANCE IN PRACTICE 20.2
Factoring in Practice
If the company wishes to factor its receivable it will net $4.55 million, 91% of the face amount. Although this may at first sight appear expensive, the firm would net the proceeds in cash up-front, not having to wait 90 days for payment. And it would
not be responsible for collecting on the receivable. If the firm were able to “factor-in” the cost of factoring in the initial sale, all the better. Alternatively, it might offer a discount for cash paid in the first 10 days after shipment.
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Bank Credit Line Covered by Export Credit Insurance. A firm’s bank credit line can typically be used to finance up to a fixed upper limit, say 80%, of accounts receivable. Export receivables can be eligible for inclusion in bank credit line financing. However, credit information on foreign customers may be more difficult to collect and assess. If a firm covers its export receivables with export credit insurance, it can greatly reduce the credit risk of those receivables. This insurance enables the bank credit line to cover more export receivables and lower the interest rate for that coverage. Of course, any foreign exchange risk must be handled by the transaction exposure techniques described in Chapter 10.
The cost of using a bank credit line is usually the prime rate of interest plus points to reflect a particular firm’s credit risk. As usual, 100 points is equal to 1%. In the United States, borrowers are also expected to maintain a compensating deposit balance at the lending institution. In Europe and many other places, lending is done on an overdraft basis. An over- draft agreement allows a firm to overdraw its bank account up to the limit of its credit line. Interest at prime plus points is based only on the amount of overdraft borrowed. In either case, the all-in cost of bank borrowing using a credit line is higher than acceptance financing, as shown in Exhibit 20.9.
Commercial Paper. A firm can issue commercial paper—unsecured promissory notes—to fund its short-term financing needs, including both domestic and export receivables. However, it is only the large well-known firms with favorable credit ratings that have access to either the domestic or euro commercial paper market. As shown in Exhibit 20.9, commercial paper interest rates lie at the low end of the yield curve and compete directly with marketable bank time certificates of deposit.
Forfaiting: Medium- and Long-Term Financing Forfaiting is a specialized technique to eliminate the risk of nonpayment by importers in instances where the importing firm and/or its government is perceived by the exporter to be too risky for open account credit. The name of the technique comes from the French à forfait, a term that implies “to forfeit or surrender a right.”
Role of the Forfaiter The essence of forfaiting is the non-recourse sale by an exporter of bank-guaranteed promissory notes, bills of exchange, or similar documents received from an importer in another country. The exporter receives cash at the time of the transaction by selling the notes or bills at a discount from their face value to a specialized finance firm called a forfaiter. The forfaiter arranges the entire operation prior to the actual transaction taking place. Although the exporting firm is responsible for the quality of delivered goods, it receives a clear and unconditional cash payment at the time of the transaction. All political and commercial risk of nonpayment by the importer is carried by the guaranteeing bank. Small exporters who trust their clients to pay find the forfaiting technique invaluable because it eases cash flow problems.
During the Soviet era expertise in the technique was centered in German and Austrian banks, which used forfaiting to finance sales of capital equipment to eastern European, “Soviet Bloc,” countries. British, Scandinavian, Italian, Spanish, and French exporters have now adopted the technique, but U.S. and Canadian exporters are reported to be slow to use forfaiting, possibly because they are suspicious of its simplicity and lack of complex documentation. Nevertheless, some American firms now specialize in the technique, and the Association of Forfaiters in the Americas (AFIA) has more than 20 members. Major export destinations financed via the forfaiting technique are Asia, Eastern Europe, the Middle East, and Latin America.
573International Trade Finance CHAPTER 20
A Typical Forfaiting Transaction A typical forfaiting transaction involves five parties, as shown in Exhibit 20.10. The steps in the process are as follows:
Step 1: Agreement. Importer and exporter agree on a series of imports to be paid for over a period of time, typically three to five years. However, periods up to 10 years or as short as 180 days have been financed by this approach. The normal minimum size for a transaction is $100,000. The importer agrees to make periodic payments, often against progress on delivery or completion of a project.
Step 2: Commitment. The forfaiter promises to finance the transaction at a fixed discount rate, with payment to be made when the exporter delivers to the forfaiter the appropriate promissory notes or other specified paper. The agreed-upon discount rate is based on the cost of funds in the Euromarket, usually on LIBOR for the average life of the transaction, plus a margin over LIBOR to reflect the perceived risk in the deal. This risk premium is influenced by the size and tenor of the deal, country risk, and the quality of the guarantor institution. On a five-year deal, for example, with 10 semiannual payments, the rate used would be based on the 21/4 year LIBOR rate. This discount rate is normally added to the invoice value of the transaction so that the cost of financing is ultimately borne by the importer. The forfaiter charges an additional commitment fee of from 0.5% per annum to as high as 6.0% per annum from the date of its commitment to finance until receipt of the actual discount paper issued in accordance with the finance contract. This fee is also normally added to the invoice cost and passed on to the importer.
Step 3: Aval or Guarantee. The importer obligates itself to pay for its purchases by issuing a series of promissory notes, usually maturing every six or twelve months, against progress on delivery or completion of the project. These promissory notes are first delivered to the importer’s bank where they are endorsed (that is, guaranteed) by that bank. In Europe, this unconditional guarantee is referred to as an aval, which translates into English as “backing.” At this point, the importer’s bank becomes the primary obligor in the eyes of all subsequent holders of the notes. The bank’s aval or guarantee must be irrevocable, unconditional, divisible,
EXHIBIT 20.10 Typical Fortaiting Transaction
Exporter (private industrial firm)
Investor ( institutional or individual)
Importer’s Bank (usually a private bank in the importer’s country)
Importer (private firm or government
purchaser in emerging market)
Step 1
Step 7
Step 5 Step 3Step 4
Step 6
Step 2 Forfaiter
(subsidiary of a European bank)
574 CHAPTER 20 International Trade Finance
and assignable. Because U.S. banks do not issue avals, U.S. transactions are guaranteed by a standby letter of credit (L/C), which is functionally similar to an aval but more cumbersome. For example, L/Cs can normally be transferred only once.
Step 4: Delivery of Notes. The now-endorsed promissory notes are delivered to the exporter.
Step 5: Discounting. The exporter endorses the notes “without recourse” and discounts them with the forfaiter, receiving the agreed-upon proceeds. Proceeds are usually received two days after the documents are presented. By endorsing the notes “without recourse,” the exporter frees itself from any liability for future payment on the notes and thus receives the discounted proceeds without having to worry about any further payment difficulties.
Step 6: Investment. The forfaiting bank either holds the notes until full maturity as an invest- ment or endorses and rediscounts them in the international money market. Such subsequent sale by the forfaiter is usually without recourse. The major rediscount markets are in London and Switzerland, plus New York for notes issued in conjunction with Latin American business.
Step 7: Maturity. At maturity, the investor holding the notes presents them for collection to the importer or to the importer’s bank. The promise of the importer’s bank is what gives the documents their value.
In effect, the forfaiter functions both as a money market firm and a specialist in packaging financial deals involving country risk. As a money market firm, the forfaiter divides the discounted notes into appropriately sized packages and resells them to various investors having different maturity preferences. As a country risk specialist, the forfaiter assesses the risk that the notes will eventually be paid by the importer or the importer’s bank and puts together a deal that satisfies the needs of both exporter and importer.
Success of the forfaiting technique springs from the belief that the aval or guarantee of a commercial bank can be depended on. Although commercial banks are the normal and preferred guarantors, guarantees by government banks or government ministries of finance are accepted in some cases. On occasion, large commercial enterprises have been accepted as debtors without a bank guarantee. An additional aspect of the technique is that the endorsing bank’s aval is perceived to be an “off balance sheet” obligation, the debt is presumably not considered by others in assessing the financial structure of the commercial banks.
SUMMARY POINTS
! International trade takes place between three categories of relationships: unaffiliated unknown parties, unaffiliated known parties, and affiliated parties.
! International trade transactions between affiliated parties typically do not require contractual arrange- ments or external financing. Trade transactions between unaffiliated parties typically require contracts and some type of external financing, such as that available through letters of credit.
! Over many years, established procedures have arisen to finance international trade. The basic procedure rests on the interrelationship between three key documents, the L/C, the draft, and the bill of lading.
! In the L/C, the bank substitutes its credit for that of the importer and promises to pay if certain documents are
submitted to the bank. The exporter may now rely on the promise of the bank rather than on the promise of the importer.
! The exporter typically ships on an order bill of lading, attaches the order bill of lading to a draft ordering pay- ment from the importer’s bank, and presents these doc- uments, plus any of a number of additional documents, through its own bank to the importer’s bank.
! If the documents are in order, the importer’s bank either pays the draft (a sight draft) or accepts the draft (a time draft). In the latter case, the bank promises to pay in the future. At this step, the importer’s bank acquires title to the merchandise through the bill of lading and releases the merchan- dise to the importer.
575International Trade Finance CHAPTER 20
! If a sight draft is used, the exporter is paid at once. If a time draft is used, the exporter receives the accepted draft, now a banker’s acceptance, back from the bank. The exporter may hold the banker’s acceptance until maturity or sell it at a discount in the money market.
! The total costs of an exporter entering a foreign market include the transaction costs of the trade financing, the import and export duties and tariffs applied by exporting and importing nations, and the costs of foreign market penetration, which include distribution expenses, inven- tory costs, and transportation expenses.
! Export credit insurance provides assurance to exporters (or exporters’ banks) that should the foreign customer default on payment, the insurance company will pay for a major portion of the loss.
! Trade financing uses the same financing instruments as in domestic receivables financing, plus some specialized instruments that are only available for financing international trade. A popular instrument for short-term financing is a banker’s acceptance. Its all-in cost is comparable to other money market instruments, such as marketable bank certificates of deposit.
! Other short-term financing instruments with a domestic counterpart are trade acceptances, factoring, securitization, bank credit lines (usually covered by export credit insurance), and commercial paper.
! Forfaiting is an international trade technique that can provide medium- and long-term financing.
Crosswell International is a U.S.-based manufacturer and distributor of health care products, including children’s diapers. Crosswell has been approached by Leonardo Sousa, the president of Material Hospitalar, a distributor of health care products throughout Brazil. Sousa is interested in distributing Crosswell’s major diaper product, Precious, but only if an acceptable arrangement regarding pricing and payment terms can be reached.
Exporting to Brazil Crosswell’s manager for export operations, Geoff Mathieux, followed up the preliminary discussions by putting together an estimate of export costs and pricing for discussion purposes with Sousa. Crosswell needs to know all of the costs and pricing assumptions for the entire supply and value chain as it reaches the consumer. Mathieux believes it critical that any arrangement that Crosswell enters into results in a price to consumers in the Brazilian marketplace that is both fair to all parties involved and competitive, given the market niche Crosswell hopes to penetrate. This first cut on pricing Precious diapers into Brazil is presented in Exhibit 1.
Crosswell proposes to sell the basic diaper line to the Brazilian distributor for $34.00 per case, FAS (free alongside ship) Miami docks. This means that the seller, Crosswell, agrees to cover all costs associated with getting the diapers to the Miami docks. The cost of loading the diapers aboard ship, the actual cost of shipping (freight), and associated documents is $4.32 per case. The running subtotal, $38.32 per case, is termed CFR (cost and freight). Finally, the insurance expenses related to the potential loss of the goods while in transit to final port of destination, export insurance, are $0.86 per case. The total CIF (cost, insurance, and freight) is $39.18 per case, or 97.95 Brazilian real per case, assuming an exchange rate of 2.50 Brazilian real (R$) per U.S. dollar ($). In summary, the CIF cost of R$97.95 is the price charged by the exporter to the importer on arrival in Brazil, and is calculated as follows:
CIF = FAS + freight + export insurance
= ($34.00 + $4.32 + $0.86) * R$2.50/$
= R$97.95.
Crosswell International and Brazil1
1Copyright © 1996, Thunderbird School of Global Management. All rights reserved. This case was prepared by Doug Mathieux and Geoff Mathieux under the direction of Professors Michael H. Moffett and James L. Mills for the purpose of classroom discussion, and not to indicate either effective or ineffective management.
MINI-CASE
576 CHAPTER 20 International Trade Finance
EXHIBIT 1 Export Pricing for the Precious Diaper Line to Brazil
The Precious Ultra-Thin Diaper will be shipped via container. Each container will hold 968 cases of diapers. The costs and prices below are calculated on a per case basis, although some costs and fees are assessed by container.
Exports Costs & Pricing to Brazil Per Case Rates & Calculation
FAS price per case, Miami $34.00
Freight, loading & documentation 4.32 $4180 per container/968 = $4.32
CFR price per case, Brazilian port (Santos) $38.32
Export insurance 0.86 2.25% of CIF
CIF to Brazilian port $39.18
CIF to Brazilian port, in Brazilian real R$ 97.95 2.50 Real/US$ * $39.18
Brazilian Importation Costs
Import duties 1.96 2.00% of CIF
Merchant marine renovation fee 2.70 25.00% of freight
Port storage fees 1.27 1.30% of CIF
Port handling fees 0.01 R$12 per container
Additional handling fees 0.26 20.00% of storage & handling
Customs brokerage fees 1.96 2.00% of CIF
Import license fee 0.05 R$50 per container
Local transportation charges 1.47 1.50% of CIF
Total cost to distributor in real R$ 107.63
Distributor’s Costs & Pricing
Storage cost 1.47 1.50% of CIF * months
Cost of financing diaper inventory 6.86 7.00% of CIF * months
Distributor’s margin 23.19 20.00% of Price + storage + financing
Price to retailer in real R$ 139.15
Brazilian Retailer Costs & Pricing
Industrial product tax (IPT) 20.87 15.00% of price to retailer
Mercantile circulation services tax (MCS) 28.80 18.00% of price + IPT
Retailer costs and markup 56.65 30.00% of price + IPT + MCS
Price to consumer in real R$ 245.48
Diaper Prices to Consumers Diapers Per Case Price Per Diaper
Small size 352 R$ 0.70
Medium size 256 R$ 0.96
Large size 192 R$ 1.28
The actual cost to the distributor in getting the diapers through the port and customs warehouses must also be calculated in terms of what Leonardo Sousa’s costs are in reality. The various fees and taxes detailed in Exhibit 1 raise the fully landed cost of the Precious diapers to R$107.63 per case. The distributor would now bear storage
and inventory costs totaling R$8.33 per case, which would bring the costs to R$115.96. The distributor then adds a margin for distribution services of 20% (R$23.19), raising the price as sold to the final retailer to R$139.15 per case.
Finally, the retailer (a supermarket or other retailer of consumer health care products) would include its expenses,
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Hospitalar’s ability to be a dependable, creditworthy, and capable long-term partner and representative of the firm in the Brazilian marketplace. The discussions that follow focus on finding acceptable common ground between the two parties and working to increase the competitiveness of the Precious diaper in the Brazilian marketplace.
Crosswell’s Proposal. The proposed sale by Crosswell to Material Hospitalar, at least in the initial shipment, is for 10 containers of 968 cases of diapers at $39.18 per case, CIF Brazil, payable in U.S. dollars. This is a total invoice amount of $379,262.40. Payment terms are that a confirmed L/C will be required of Material Hospitalar on a U.S. bank. The payment will be based on a time draft of 60 days, presentation to the bank for acceptance with other documents on the date of shipment. Both the exporter and the exporter’s bank will expect payment from the importer or importer’s bank 60 days from this date of shipment.
What Should Crosswell Expect? Assuming Material Hospitalar acquires the L/C and it is confirmed by Cross- well’s bank in the United States, Crosswell will ship the goods after the initial agreement, say 15 days, as illustrated in Exhibit 2.
taxes, and markup to reach the final shelf price to the cus- tomer of R$245.48 per case. This final retail price estimate now allows both Crosswell and Material Hospitalar to eval- uate the price competitiveness of the Precious Ultra-Thin Diaper in the Brazilian marketplace, and provides a basis for further negotiations between the two parties.
The Precious Ultra-Thin Diaper will be shipped via con- tainer. Each container will hold 968 cases of diapers. The costs and prices below are calculated on a per case basis, although some costs and fees are assessed by container.
Mathieux provides the above export price quotation, an outline of a potential representation agreement (for Sousa to represent Crosswell’s product lines in the Brazilian marketplace), and payment and credit terms to Leonardo Sousa. Crosswell’s payment and credit terms are that Sousa either pay in full in cash in advance, or with a confirmed irrevocable documentary L/C with a time draft specifying a tenor of 60 days.
Crosswell also requests from Sousa financial state- ments, banking references, foreign commercial references, descriptions of regional sales forces, and sales forecasts for the Precious diaper line. These last requests by Crosswell are very important for Crosswell to be able to assess Material
EXHIBIT 2 Export Payment Terms on Crosswell’s Export to Brazil
Time (day count) and Events
Crosswell’s bank confirms L/C and notifies CrosswellMaterial
Hospitalar applies to its bank in Sao Paulo for an L/C
Crosswell agrees to ship under an L/C
0 3 10 15 30 60 90
Period of outstanding account receivable (60-day time draft)
Brazilian bank approves L/C and issues in favor of Crosswell; L/C sent to Crosswell’s bank
Crosswell ships goods
Crosswell presents documents to its bank for acceptance and payment of $379,262 (today is “sight”)
Crosswell’s bank pays discounted value of acceptance of $375,507
Goods arrive at Brazilian port
Material Hospitalar makes payment to its bank of $379,262
60-day time draft and an L/C from its Brazilian bank, total payment of $379,262.40 is due on day 90 (shipment and presentation of documents was on day 30 + 60 day time draft) to the Brazilian bank. Material Hospitalar, because it is a Brazilian-based company and has agreed to make payment in U.S. dollars (foreign currency), carries the currency risk of the transaction.
Crosswell/Material Hospitalar’s Concern The concern the two companies hold, however, is that the total price to the consumer in Brazil, R$245.48 per case, or R$0.70/diaper (small size), is too high. The major competitors in the Brazilian market for premium quality diapers, Kenko do Brasil (Japan), Johnson and Johnson (U.S.), and Procter and Gamble (U.S.), are cheaper (see Exhibit 3). The com- petitors all manufacture in-country, thus avoiding the series of import duties and tariffs, which, have added significantly to Crosswell’s landed prices in the Brazilian marketplace.
Case Questions 1. How are pricing, currency of denomination, and
financing interrelated in the value-chain for Cross- well’s penetration of the Brazilian market? Summarize them using Exhibit 2.
2. How important is Sosa to the value-chain of Cross- well? What worries might Crosswell have regarding Sosa’s ability to fulfill his obligations?
3. If Crosswell is to penetrate the market, some way of reducing its prices will be required. What do you suggest?
Simultaneous with the shipment, in which Crosswell has lost physical control over the goods, Crosswell will present the bill of lading acquired at the time of shipment with the other needed documents to its bank requesting payment. Because the export is under a confirmed L/C, assuming all documents are in order, Crosswell’s bank will give Crosswell two choices:
1. Wait the full time period of the time draft of 60 days and receive the entire payment in full ($379,262.40).
2. Receive the discounted value of this amount today. The discounted amount, assuming U.S. dollar interest rate of 6.00% per annum (1.00% per 60 days):
$379,262.40 (1 + 0.01) =
$379,262.40 1.01
= $375,507.33.
Because the invoice is denominated in U.S. dollars, Crosswell need not worry about currency value changes (currency risk). And because its bank has confirmed the L/C, it is protected against changes or deteriora- tions in Material Hospitalar’s ability to pay on the future date.
What Should Material Hospitalar Expect? Material Hospitalar will receive the goods on or before day 60. It will then move the goods through its distribution system to retailers. Depending on the payment terms between Material Hospitalar and its buyers (retailers), it could either receive cash or terms for payment for the goods. Because Material Hospitalar purchased the goods via the
EXHIBIT 3 Competitive Diaper Prices in the Brazilian Market (in Brazilian Real)
Price per diaper by size
Company (Country) Brand Small Medium Large
Kenko (Japan) Monica Plus 0.68 0.85 1.18
Procter & Gamble (USA) Pampers Uni 0.65 0.80 1.08
Johnson & Johnson (USA) Sempre Seca Plus 0.65 0.80 1.08
Crosswell (USA) Precious 0.70 0.96 1.40
578 CHAPTER 20 International Trade Finance
579International Trade Finance CHAPTER 20
estimate its weighted average cost of capital to be 20% per annum. The commission for selling a bank- er’s acceptance in the discount market is 1.2% of the face amount.
How much cash will Inca Breweries receive from the sale if it holds the acceptance until maturity? Do you recommend that Inca Breweries hold the acceptance until maturity or discount it at once in the U.S. banker’s acceptance market?
11. Swishing Shoe Company. Swishing Shoe Company of Durham, North Carolina, has received an order for 50,000 cartons of athletic shoes from Southampton Footware, Ltd., of England, payment to be in British pounds sterling. The shoes will be shipped to South- ampton Footware under the terms of a letter of credit issued by a London Bank on behalf of Southampton Footware. The letter of credit specifies that the face value of the shipment, £400,000, will be paid 120 days after the London bank accepts a draft drawn by South- ampton Footware in accordance with the terms of the letter of credit.
The current discount rate in London on 120-day banker’s acceptances is 12% per annum, and South- ampton Footware estimates its weighted average cost of capital to be 18% per annum. The commission for selling a banker’s acceptance in the discount market is 2.0% of the face amount. a. Would Swishing Shoe Company gain by holding the
acceptance to maturity, as compared to discounting the banker’s acceptance at once?
b. Does Swishing Shoe Company incur any other risks in this transaction?
12. Going Abroad. Assume that Great Britain charges an import duty of 10% on shoes imported into the United Kingdom. Swishing Shoe Company, in question 11, discovers that it can manufacture shoes in Ireland and import them into Britain free of any import duty. What factors should Swishing consider in deciding to continue to export shoes from North Carolina versus manufacture them in Ireland?
13. 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 benefit the citizens of that country?
QUESTIONS 1. Unaffiliated Buyers. Why might different documenta-
tion be used for an export to a nonaffiliated foreign buyer who is a new customer as compared to an export to a nonaffiliated foreign buyer to whom the exporter has been selling for many years?
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?
3. Related Party Trade. What reasons can you give for the observation that intrafirm trade is now greater than trade between nonaffiliated exporters and importers?
4. Documents. Explain the difference between a letter of credit (L/C) and a draft. How are they linked?
5. Risks. What is the major difference between “cur- rency risk” and “risk of noncompletion?” How are these risks handled in a typical international trade transaction?
6. Letter of Credit. Identify each party to a letter of credit (L/C) and indicate its responsibility.
7. Confirming a Letter of Credit. Why would an exporter insist on a confirmed letter of credit?
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.
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.
10. Inca Breweries of Peru. Inca Breweries of Lima, Peru, has received an order for 10,000 cartons of beer from Alicante Importers of Alicante, Spain. The beer will be exported to Spain under the terms of a letter of credit issued by a Madrid bank on behalf of Alicante Importers. The letter of credit specifies that the face value of the shipment, $720,000 U.S. dollars, will be paid 90 days after the Madrid bank accepts a draft drawn by Inca Breweries in accordance with the terms of the letter of credit.
The current discount rate on a 3-month banker’s acceptance is 8% per annum, and Inca Breweries
580 CHAPTER 20 International Trade Finance
customers. One of its customers is EcoHire, a car rental firm that buys cars from Nakatomi Toyota at a wholesale price. Final payment is due to Nakatomi Toyota in six months. EcoHire has bought $200,000 worth of cars from Nakatomi, with a cash down pay- ment of $40,000 and the balance due in six months without any interest charged as a sales incentive. Nakatomi Toyota will have the EcoHire receivable accepted by Alliance Acceptance for a 2% fee, and then sell it at a 3% per annum discount to Wells Fargo Bank. a. What is the annualized percentage all-in cost to
Nakatomi Toyota? b. What are Nakatomi’s net cash proceeds, including
the cash down payment?
6. Forfaiting at Umaru Oil (Nigeria). Umaru Oil of Nigeria has purchased $1,000,000 of oil drilling equipment from Gunslinger Drilling of Houston, Texas. Umaru Oil must pay for this purchase over the next five years at a rate of $200,000 per year due on March 1 of each year.
Bank of Zurich, a Swiss forfaiter, has agreed to buy the five notes of $200,000 each at a discount. The discount rate would be approximately 8% per annum based on the expected 3-year LIBOR rate plus 200 basis points, paid by Umaru Oil. Bank of Zurich also would charge Umaru Oil an additional commitment fee of 2% per annum from the date of its commitment to finance until receipt of the actual discounted notes issued in accordance with the financing contract. The $200,000 promissory notes will come due on March 1 in successive years.
The promissory notes issued by Umaru Oil will be endorsed by their bank, Lagos City Bank, for a 1% fee and delivered to Gunslinger Drilling. At this point, Gunslinger Drilling will endorse the notes without recourse and discount them with the forfaiter, Bank of Zurich, receiving the full $200,000 principal amount. Bank of Zurich will sell the notes by re-discounting them to investors in the international money market without recourse. At maturity, the investors holding the notes will present them for collection at Lagos City Bank. If Lagos City Bank defaults on payment, the investors will collect on the notes from Bank of Zurich. a. What is the annualized percentage all-in cost to
Umaru Oil of financing the first $200,000 note due March 1, 2011?
b. What might motivate Umaru Oil to use this relatively expensive alternative for financing?
PROBLEMS 1. Nikken Microsystems (A). Assume Nikken Microsys-
tems has sold Internet servers to Telecom España for €700,000. Payment is due in three months and will be made with a trade acceptance from Telecom España Acceptance. The acceptance fee is 1.0% per annum of the face amount of the note. This acceptance will be sold at a 4% per annum discount. What is the annualized percentage all-in cost in euros of this method of trade financing?
2. Nikken Microsystems (B). Assume that Nikken Microsystems prefers to receive U.S. dollars rather than euros for the trade transaction described in problem 2. It is considering two options: 1) sell the acceptance for euros at once and convert the euros immediately to U.S. dollars at the spot rate of exchange of $1.00/€ or 2) hold the euro acceptance until maturity but at the start sell the expected euro proceeds forward for dollars at the 3-month forward rate of $1.02/€. a. What are the U.S. dollar net proceeds received
at once from the discounted trade acceptance in option 1?
b. What are the U.S. dollar net proceeds received in three months in option 2?
c. What is the break-even investment rate that would equalize the net U.S. dollar proceeds from both options?
d. Which option should Nikken Microsystems choose?
3. Motoguzzie (A). Motoguzzie exports large-engine motorcycles (greater than 700cc) to Australia and invoices its customers in U.S. dollars. Sydney Whole- sale Imports has purchased $3,000,000 of merchandise from Motoguzzie, with payment due in six months. The payment will be made with a banker’s acceptance issued by Charter Bank of Sydney at a fee of 1.75% per annum. Motoguzzie has a weighted average cost of capital of 10%. If Motoguzzie holds this accep- tance to maturity, what is its annualized percentage all-in-cost?
4. Motoguzzie (B). Assuming the facts in problem 1, Bank of America is now willing to buy Motoguzzie’s banker’s acceptance for a discount of 6% per annum. What would be Motoguzzie’s annualized percentage all-in cost of financing its $3,000,000 Australian receivable?
5. Nakatomi Toyota. Nakatomi Toyota buys its cars from Toyota Motors (U.S.), and sells them to U.S.
581International Trade Finance CHAPTER 20
fee would cost Whatchamacallit $500, plus reduce Phang’s available credit line by $100,000. The banker’s acceptance note of $100,000 would be sold at a 2% per annum discount in the money market. What is the annualized percentage all-in cost to Whatchamacallit of this banker’s acceptance financing?
10. Whatchamacallit Sports (B). Whatchamacallit could also buy export credit insurance from FCIA for a 1.5% premium. It finances the $100,000 receivable from Phang from its credit line at 6% per annum interest. No compensating bank balance would be required. a. What is Whatchamacallit’s annualized percentage
all-in cost of financing? b. What are Phang’s costs? c. What are the advantages and disadvantages of this
alternative compared to the banker’s acceptance financing in Whatchamacallit (A)? Which option would you recommend?
INTERNET EXERCISES 1. Letter of Credit Services. Commercial banks world-
wide provide a variety of services to aid in the financing of foreign trade. Contact any of the many major multinational banks (a few are listed below) and determine what types of letter of credit services and other trade financing services they provide.
Bank of America www.bankamerica.com
Barclays www.barclays.com
Deutsche Bank www.deutschebank.com
Union Bank of Switzerland www.unionbank.com
Swiss Bank Corporation www.swissbank.com
2. Finance 3.0. The Finance 3.0 Web site is the equivalent of a social networking site for those interested in discussing a multitude of financial issues in greater depth. There is no limit to the breadth of finance and financial management topics that are posted and discussed.
Finance 3.0 www.finance30.com/
7. Sunny Coast Enterprises (A). Sunny Coast Enter- prises has sold a combination of films and DVDs to Hong Kong Media Incorporated for US$100,000, with payment due in six months. Sunny Coast Enterprises has the following options for financing this receivable: 1) Use its bank credit line. Interest would be at the prime rate of 5% plus 150 basis points per annum. Sunny Coast Enterprises would need to maintain a compensating balance of 20% of the loan’s face amount. No interest will be paid on the compensating balance by the bank or 2) Use its bank credit line but purchase export credit insurance for a 1% fee. Because of the reduced risk, the bank interest rate would be reduced to 5% per annum without any points. a. What are the annualized percentage all-in costs of
each option? b. What are the advantages and disadvantages of each
option? c. Which option would you recommend?
8. Sunny Coast Enterprises (B). Sunny Coast Enter- prises has been approached by a factor that offers to purchase the Hong Kong Media Imports receivable at a 16% per annum discount plus a 2% charge for a nonrecourse clause. a. What is the annualized percentage all-in cost of this
factoring option? b. What are the advantages and disadvantages of the
factoring option compared to the options in Sunny Coast Enterprises (A)?
9. Whatchamacallit Sports (A). Whatchamacallit Sports (Whatchamacallit) is considering bidding to sell $100,000 of ski equipment to Phang Family Enter- prises of Seoul, Korea. Payment would be due in six months. Since Whatchamacallit cannot find good credit information on Phang, Whatchamacallit wants to protect its credit risk. It is considering the following financing solution.
Phang’s bank issues a letter of credit on behalf of Phang and agrees to accept Whatchamacallit’s draft for $100,000 due in six months. The acceptance
582
Answers to Selected End-of-Chapter Problems
Chapter 1: Current Multinational Challenges and the Global Economy 6. a. $14.77
b. US = 30.5%, Brazil = 27.1%, Germany = 40.1%, China = 2.4% c. 69.5%
9. Appreciation case: +13.9% Depreciation case: -13.9%
Chapter 2: Financial Goals and Corporate Governance 1. a. 25.000%
b. 33.333%
c. Dividend yield = 8.333%, capital gains = 25.00%, total shareholder return = 33.333%
3. a. 64.23%
b. 4.19%
c. 71.12%
Chapter 3: The International Monetary System 4. -41.82% 6. 1.1398
11. If 20%, 6.76; if 30%, 6.24
Chapter 4: The Balance of Payments Questions 2005 2006 2007 2008 2009 2010
4.1 What is Brazil’s balance on goods? 44,703 46,457 40,032 24,835 25,290 20,221
4.2 What is Brazil’s balance on services? -8,309 -9,654 -13,219 -16,690 -19,245 -30,807 4.3 What is Brazil’s balance on goods and services? 36,394 36,804 26,813 8,145 6,045 -10,586 4.4 What is the Brazil on goods, services and income? 10,427 9,315 -2,478 -32,417 -27,640 -50,152 4.5 What is Brazil’s current account balance? 13,984 13,619 1,551 -28,193 -24,302 -47,364
Chapter 5: The Continuing Global Financial Crisis 3-month 6-month
1. a. $6.07 $23.26
b. 0.0607% 0.2331%
c. 0.2432% 0.4668%
583Answers to Selected End-of-Chapter Problems
7. 10%: $31,550,000
11%: $32,230,000
12%: $32,920,000
Chapter 6: The Foreign Exchange Market 1. a. 4.72
b. 21,243
10. a. Profit of 26,143.79
b. Loss of (26,086.96)
Chapter 7: International Parity Conditions 1. a. 1.0941
b. 1.1155, and 948.19.
7. A CIA profit potential of -0.042% tells Takeshi he should borrow Japanese yen and invest in the higher yielding currency, the U.S. dollar, to earn a CIA profit of 55,000.
Chapter 8: Foreign Currency Derivatives and Swaps 1. a. ($49,080.00)
b. $38,920.00
c. ($9,080.00)
4. a. Sallie should buy a call on Singapore dollars
b. $0.65046
c. Gross profit = $0.05000 Net profit = $0.04954 d. Gross profit = $0.15000 Net profit = $0.14954
Chapter 9: Foreign Exchange Rate Determination and Forecasting 1. -7.79%
6. a. 85,000
b. -32.0% and -15.0%
8. -13.79%
Chapter 10: Transaction Exposure 2. Foreign exchange loss of $921,400,000
10. Do nothing: Could be anything
Forward: $216,049.38
Money market: $212,190.81
Forward is preferable choice if bank allows an expanded line
584 Answers to Selected End-of-Chapter Problems
Chapter 11: Translation Exposure 1. a. Translation loss is ($2,400,000)
b. Loss is accumulated on the consolidated balance sheet, and does not pass through the consolidated income if the subsidiary is foreign currency functional
5. Net exposure is $21,000
Chapter 12: Operating Exposure 3. Case 1: Same yuan price: $33,913,043
Case 2: Same dollar price: $54,000,000 (better)
7. $8,900,601
Chapter 13: The Global Cost and Availability of Capital 1. a. 6.550%
b. 5.950%
8. Before diversification: 10.529%
After diversification: 12.038%
Chapter 14: Raising Equity and Debt Globally 1. Petrobras: 14.674%
Lukoil: 12.286%
15. $990,099.01
Chapter 15: Multinational Tax Management 1. Case 1: 38.8%
Case 2: 45.0%
4. Change in consolidated tax payments of -11.17%
Chapter 16: International Portfolio Theory and Diversification Expected Return Expected Risk
2. a. Equally weighted portfolio 17.30% 20.93%
b. 70% Boeing, 30% Unilever 17.82% 21.08%
c. Min Risk is 55% Boeing, 45% Unilever 17.43% 20.89%
5. Share price appreciation = 6.456% Annual return, including dividends = 10.698%
Chapter 17: Foreign Direct Investment and Political Risk No quantitative problems in this chapter.
585Answers to Selected End-of-Chapter Problems
Chapter 18: Multinational Capital Budgeting and Cross Border Acquisitions 1. NPV of investment (project viewpoint): 11,122,042
NPV of investment (parent viewpoint): (201,847)
4. Ps 28,442771 or $3,555,346
Chapter 19: Working Capital Management 2. a. 19.41%
b. 1,800,000
6. Dividend Only: Total return, after@tax = $247,500 License Fee Only: Total return, after@tax = $178,200
Chapter 20: International Trade Finance 3. 11.765%
5. a. 5.128%
b. $196,000.00
586
the United States as a tax base for determining import duties. The ASP is generally higher than the actual foreign price, so its use is a protectionist technique.
American terms. Foreign exchange quotations for the U.S. dollar, expressed as the number of U.S. dollars per unit of non-U.S. currency.
Anchor currency. See Reserve currency Anticipated exposure. A foreign exchange exposure that
is believed by management to have a very high like- lihood of occurring, but is not yet contractual, and is therefore not yet certain.
Appreciation. In the context of exchange rate changes, a rise in the foreign exchange value of a currency that is pegged to other currencies or to gold. Also called revaluation.
Arbitrage. A trading strategy based on the purchase of a commodity, including foreign exchange, in one market at one price while simultaneously selling it in another market at a more advantageous price, in order to obtain a risk-free profit on the price differential.
Arbitrageur. An individual or company that practices arbitrage.
Arithmetic return. A calculation in which the mean equals the average of the annual percentage changes in capital appreciation plus dividend distributions.
Arm’s-length price. The price at which a willing buyer and a willing unrelated seller freely agree to carry out a transaction. In effect, a free market price. Applied by tax authorities in judging the appropriateness of transfer prices between related companies.
Asian currency unit. A trading department within a Sin- gaporean bank that deals in foreign (non-Singaporean) currency deposits and loans.
Ask. The price at which a dealer is willing to sell foreign exchange, securities or commodities. Also called offer price.
Asset Backed Security (ABS). A derivative security that typically includes second mortgages and home-equity loans based on mortgages, in addition to credit card receivables and auto loans.
Asset market approach. A strategy that determines whether foreigners are willing to hold claims in mone- tary form, depending on an extensive set of investment considerations or drivers.
At-the-money (ATM). An option whose exercise price is the same as the spot price of the underlying currency.
Backlog exposure. The period of time between contract initiation and fulfillment through delivery of services or shipping of goods.
A/P. In international trade documentation, an abbrevia- tion for authority to purchase or authority to pay. In accounting, an abbreviation for accounts payable.
Absolute advantage. The ability of an individual party or country to produce more of a product or service with the same inputs as another party. It is therefore possible for a country to have no absolute advantage in any inter- national trade activity. See also Comparative advantage.
Accounting exposure. Another name for translation expo- sure. See Translation exposure.
Ad valorem duty. A customs duty levied as a percentage of the assessed value of goods entering a country.
ADB. Asian Development Bank. Adjusted present value. A type of present value analysis
in capital budgeting in which operating cash flows are discounted separately from (1) the various tax shields provided by the deductibility of interest and other financial charges, and (2) the benefits of project- specific concessional financing. Each component cash flow is discounted at a rate appropriate for the risk involved.
ADR. See American Depositary Receipt. AfDB. African Development Bank. Affiliate. A foreign enterprise in which the parent com-
pany owns a minority interest. Agency for International Development (AID). A unit of
the U.S. government dealing with foreign aid. Agency theory. The costs and risks of aligning interests
between shareholders of the firm and their agents, management, in the conduct of firm business and strat- egy. Also referred to as the agency problem or agency issue.
All-equity discount rate. A discount rate in capital budget- ing that would be appropriate for discounting operat- ing cash flows if the project were financed entirely with owners’ equity.
Alt-A Mortgage. A mortgage type that, although not prime, is considered a relatively low-risk loan to a cred- itworthy borrower, but lacks some technical qualifica- tions to be categorized as “conforming.”
American Depositary Receipt (ADR). A certificate of ownership, issued by a U.S. bank, representing a claim on underlying foreign securities. ADRs may be traded in lieu of trading in the actual underlying shares.
American option. An option that can be exercised at any time up to and including the expiration date.
American selling price (ASP). For customs purposes, the use of the domestic price of competing merchandise in
Glossary
587Glossary
Bid. The price that a dealer is willing to pay to purchase foreign exchange or a security.
Bid-ask spread. The difference between a bid and an ask quotation.
Big Bang. The October 1986 liberalization of the London capital markets.
Bill of exchange (B/E). A written order requesting one party (such as an importer) to pay a specified amount of money at a specified time to the writer of the bill. Also called a draft. See Sight draft.
Bill of lading (B/L). A contract between a common carrier and a shipper to transport goods to a named destina- tion. The bill of lading is also a receipt for the goods. Bills of lading are usually negotiable, meaning they are made to the order of a particular party and can be endorsed to transfer title to another party.
Black market. An illegal foreign exchange market. Blocked funds. Funds in one country’s currency that may
not be exchanged freely for foreign currencies because of exchange controls.
Border tax adjustments. The fiscal practice, under the General Agreement on Tariffs and Trade, by which imported goods are subject to some or all of the tax charged in the importing country and re-exported goods are exempt from some or all of the tax charged in the exporting country.
Branch. A foreign operation not incorporated in the host country, in contrast to a subsidiary.
Bretton Woods Conference. An international conference in 1944 that established the international monetary system—the Bretton Woods Agreement—that was in effect from 1945 to 1971. The conference was held in Bretton Woods, New Hampshire, United States.
BRIC. A frequently used acronym for the four largest emerging market countries–Brazil, Russia, India, and China.
Bridge financing. Short-term financing from a bank, used while a borrower obtains medium- or long-term fixed- rate financing from capital markets.
Bulldogs. British pound-denominated bonds issued within the United Kingdom by a foreign borrower.
Cable. The U.S. dollar per British pound cross rate. CAD. Cash against documents. International trade term. Call. An option with the right, but not the obligation, to
buy foreign exchange or another financial contract at a specified price within a specified time. See Option.
Capex. Capital expenditures. Capital account. A section of the balance of payments
accounts. Under the revised format of the International Monetary Fund, the capital account measures capital transfers and the acquisition and disposal of nonpro- duced, nonfinancial assets. Under traditional defini- tions, still used by many countries, the capital account measures public and private international lending and
Back-to-back loan. A loan in which two companies in separate countries borrow each other’s currency for a specific period of time and repay the other’s currency at an agreed maturity. Sometimes the two loans are channeled through an intermediate bank. Back-to- back financing is also called link financing.
Balance of payments (BOP). A financial statement sum- marizing the flow of goods, services, and investment funds between residents of a given country and resi- dents of the rest of the world.
Balance of trade (BOT). An entry in the balance of pay- ments measuring the difference between the monetary value of merchandise exports and merchandise imports.
Balance sheet hedge. An accounting strategy that requires an equal amount of exposed foreign currency assets and liabilities on a firm’s consolidated balance sheet.
Bank for International Settlements (BIS). A bank in Basel, Switzerland, that functions as a bank for Euro- pean central banks.
Bank rate. The interest rate at which central banks for var- ious countries lend to their own monetary institutions.
Banker’s acceptance. An unconditional promise by a bank to make payment on a draft when it matures. This comes in the form of the bank’s endorsement (accep- tance) of a draft drawn against that bank in accordance with the terms of a letter of credit issued by the bank.
Barter. International trade conducted by the direct exchange of physical goods, rather than by separate purchases and sales at prices and exchange rates set by a free market.
Basic balance. In a country’s balance of payments, the net of exports and imports of goods and services, unilateral transfers, and long-term capital flows.
Basis point. One one-hundredth of one percentage point, often used in quotations of spreads between interest rates or to describe changes in yields in securities.
Basis risk. A type of interest rate risk in which the interest rate base is mismatched.
Bearer bond. Corporate or governmental debt in bond form that is not registered to any owner. Possession of the bond implies ownership, and interest is obtained by clipping a coupon attached to the bond. The advantage of the bearer form is easy transfer at the time of a sale, easy use as collateral for a debt, and what some cyn- ics call taxpayer anonymity, meaning that governments find it hard to trace interest payments in order to collect income taxes. Bearer bonds are common in Europe, but are seldom issued any more in the United States. The alternate form to a bearer bond is a registered bond.
Beta. Second letter of the Greek alphabet, used as a statis- tical measure of risk in the Capital Asset Pricing Model. Beta is the covariance between returns on a given asset and returns on the market portfolio, divided by the var- iance of returns on the market portfolio.
588 Glossary
Collar option. The simultaneous purchase of a put option and sale of a call option, or vice versa, resulting in a form of hybrid option.
Collateralized Debt Obligation (CDO). A portfolio of debt instruments of varying credit qualities created and packaged for resale as an asset-backed security. The collateral in the CDO is the real estate, aircraft, heavy equipment, or other property the loan was used to purchase.
COMECON. Acronym for Council for Mutual Eco- nomic Assistance. An association of the former Soviet Union and Eastern European governments formed to facilitate international trade among European Com- munist countries. COMECON ceased to exist after the breakup of the Soviet Union.
Commercial risk. In banking, the likelihood that a for- eign debtor will be unable to repay its debts because of business events, as distinct from political ones.
Common market. An association through treaty of two or more countries that agree to remove all trade barriers between themselves. The best known is the European Common Market, now called the European Union.
Comparative advantage. A theory that everyone gains if each nation specializes in the production of those goods that it produces relatively most efficiently and imports those goods that other countries produce rela- tively most efficiently. The theory supports free trade arguments.
Competitive exposure. See Operating exposure. Concession agreement. An understanding or contract
between a foreign corporation and a host government defining the rules under which the corporation may operate in that country.
Consolidated financial statement. A corporate financial statement in which accounts of a parent company and its subsidiaries are added together to produce a statement which reports the status of the worldwide enterprise as if it were a single corporation. Internal obligations are eliminated in consolidated statements.
Consolidation. In the context of accounting for multina- tional corporations, the process of preparing a single reporting currency financial statement, which com- bines financial statements of subsidiaries that are in fact measured in different currencies.
Contagion. The spread of a crisis in one country to its neighboring countries and other countries with simi- lar characteristics—at least in the eyes of cross-border investors.
Contingent foreign currency exposure. The final deter- mination of the exposure is contingent upon another firm’s decision, such as a decision to invest or the winning of a business or construction bid.
Controlled foreign corporation (CFC). A foreign corpo- ration in which U.S. shareholders own more than 50%
investment. Most of the traditional definition of the capital account is now incorporated into IMF state- ments as the financial account.
Capital Asset Pricing Model (CAPM). A theoretical model that relates the return on an asset to its risk, where risk is the contribution of the asset to the volatility of a port- folio. Risk and return are presumed to be determined in competitive and efficient financial markets.
Capital budgeting. The analytical approach used to determine whether investment in long-lived assets or projects is viable.
Capital control. Restrictions, requirements, taxes or prohi- bitions on the movements of capital across borders as imposed and enforced by governments.
Capital flight. Movement of funds out of a country because of political risk.
Capital markets. The financial markets of various coun- tries in which various types of long-term debt and/or ownership securities, or claims on those securities, are purchased and sold.
Capital mobility. The degree to which private capital moves freely from country to country in search of the most promising investment opportunities.
Carry trade. The strategy of borrowing in a low interest rate currency to fund investing in higher yielding cur- rencies. Also termed currency carry trade, the strategy is speculative in that currency risk is present and not managed or hedged.
Cash budgeting. Planning for future receipts and disburse- ments of cash.
Cash flow return on investment (CFROI). A measure of corporate performance in which the numerator equals profit from continuing operations less cash taxes and depreciation. This is divided by cash investment, which is taken to mean the replacement cost of capital employed.
Caveat emptor. Latin for “buyer beware.” Certificate of Deposit (CD). A negotiable receipt issued
by a bank for funds deposited for a certain period of time. CDs can be purchased or sold prior to their matu- rity in a secondary market, making them an interest- earning marketable security.
CFR. Cost and freight charges included. CIF (cost, insurance, and freight). See Cost, insurance, and
freight. CKD. Completely knocked down. International trade
term for components shipped into a country for assem- bly there. Often used in the automobile industry.
Clearinghouse. An institution through which financial obligations are cleared by the process of settling the obligations of various members.
Clearinghouse Interbank Payments System (CHIPS). A New York-based computerized clearing system used by banks to settle interbank foreign exchange obligations (mostly U.S. dollars) between members.
589Glossary
Covered interest arbitrage (CIA). The process whereby an investor earns a risk-free profit by (1) borrowing funds in one currency, (2) exchanging those funds in the spot market for a foreign currency, (3) investing the foreign currency at interest rates in a foreign country, (4) selling forward, at the time of original investment, the invest- ment proceeds to be received at maturity, (5) using the proceeds of the forward sale to repay the original loan, and (6) sustaining a remaining profit balance.
Covering. A transaction in the forward foreign exchange market or money market that protects the value of future cash flows. Covering is another term for hedging. See Hedge.
Crawling peg. A foreign exchange rate system in which the exchange rate is adjusted very frequently to reflect prevailing rate of inflation.
Credit Default Swap (CDS). A derivative contract that derives its value from the credit quality and perfor- mance of any specified asset. The CDS was invented by a team at JPMorgan in 1997, and designed to shift the risk of default to a third party. It is a way to bet whether a specific mortgage or security will either fail to pay on time or fail to pay at all.
Credit enhancement. A process of restructuring or recom- bining assets of different risk profiles in order to obtain a higher credit rating for the combined product.
Credit risk. The possibility that a borrower’s credit worth, at the time of renewing a credit, is reclassified by the lender.
Crisis planning. The process of educating management and other employees about how to react to various scenarios of violence or other disruptive events.
Cross-border acquisition. A purchase in which one firm acquires another firm located in a different country.
Cross-currency interest rate swap. See Currency swap. Cross-currency swap. See Currency swap. Cross-listing. The listing of shares of common stock on two
or more stock exchanges. Cross rate. An exchange rate between two currencies
derived by dividing each currency’s exchange rate with a third currency. Colloquially, it is often used to refer to a specific currency pair such as the euro/yen cross rate, as the yen/dollar and dollar/euro are the more common currency quotations.
Cumulative translation adjustment (CTA) account. An entry in a translated balance sheet in which gains and/ or losses from translation have been accumulated over a period of years.
Currency basket. The value of a portfolio of specific amounts of individual currencies, used as the basis for setting the market value of another currency. Also called currency cocktail.
Currency board structure. A currency board exists when a country’s central bank commits to back its money supply entirely with foreign reserves at all times.
of the combined voting power or total value. Under U.S. tax law, U.S. shareholders may be liable for taxes on undistributed earnings of the controlled foreign corporation.
Convertible bond. A bond or other fixed-income secu- rity that may be exchanged for a number of shares of common stock.
Convertible currency. A currency that can be exchanged freely for any other currency without government restrictions.
Corporate governance. The relationship among stake- holders used to determine and control the strategic direction and performance of an organization.
Corporate wealth maximization. The corporate goal of maximizing the total wealth of the corporation rather than just the shareholders’ wealth. Wealth is defined to include not just financial wealth but also the technical, marketing and human resources of the corporation.
Correspondent bank. A bank that holds deposits for and provides services to another bank, located in another geographic area, on a reciprocal basis.
Cost and freight (CFR). Price, quoted by an exporter, that includes the cost of transportation to the named port of destination.
Cost, insurance, and freight (CIF). Exporter’s quoted price including the cost of packaging, freight or car- riage, insurance premium, and other charges paid in respect of the goods from the time of loading in the country of export to their arrival at the named port of destination or place of transshipment.
Cost of carry. The financing costs, primarily interest expense, of funding an asset such as inventory.
Cost of cover. The cost of hedging. Counterparty. The opposite party in a double transaction,
which involves an exchange of financial instruments or obligations now and a reversal of that same transaction at an agreed-upon later date.
Counterparty risk. The potential exposure any individual firm bears that the second party to any financial con- tract may be unable to fulfill its obligations under the contract’s specifications.
Countertrade. A type of international trade in which par- ties exchange goods directly rather than for money, a type of barter.
Countervailing duty. An import duty charged to offset an export subsidy by another country.
Country risk. In banking, the likelihood that unexpected events within a host country will influence a client’s or a government’s ability to repay a loan. Country risk is often divided into sovereign (political) risk and foreign exchange (currency) risk.
Country-specific-risks. Political risks that affect the MNE at the country level, such as transfer risk (blocked funds) and cultural and institutional risks.
590 Glossary
Dim Sum Bond Market. The market for Chinese renminbi (yuan) denominated securities as issued in Hong Kong.
Direct quote. The price of a unit of foreign exchange expressed in the home country’s currency. The term has meaning only when the home country is specified.
Directed public share issue. An issue that is targeted at investors in a single country and underwritten in whole or in part by investment institutions from that country.
Dirty float. A system of floating (i.e., market-determined) exchange rates in which the government intervenes from time to time to influence the foreign exchange value of its currency.
Discount. In the foreign exchange market, the amount by which a currency is cheaper for future delivery than for spot (immediate) delivery. The opposite of discount is premium.
Dividend yield. The current period dividend distribution as a percentage of the beginning of period share price.
Dollarization. The use of the U.S. dollar as the official cur- rency of a country.
Domestic International Sales Corporation (DISC). Under the U.S. tax code, a type of subsidiary formed to reduce taxes on exported U.S.-produced goods. It has been ruled illegal by the World Trade Organization.
Draft. An unconditional written order requesting one party (such as an importer) to pay a specified amount of money at a specified time to the order of the writer of the draft. Also called a bill of exchange. Personal checks are one type of draft.
Dragon bond. A U.S. dollar-denominated bond sold in the so-called Dragon economies of Asia, such as Hong Kong, Taiwan, and Singapore.
Dumping. The practice of offering goods for sale in a for- eign market at a price that is lower than that of the same product in the home market or a third country. As used in GATT, a special case of differential pricing.
Economic exposure. Another name for operating expo- sure. See Operating exposure.
Economic Value Added (EVA). A widely used measure of corporate financial performance. It is calculated as the difference between net operating profits after tax for the business and the cost of capital invested (both debt and equity). EVA is a registered trademark of Stern Stewart & Company.
Edge Act and Agreement Corporation. Subsidiary of a U.S. bank incorporated under federal law to engage in various international banking and financing oper- ations, including equity participations that are not allowed to regular domestic banks. The Edge Act sub- sidiary may be located in a state other than that of the parent bank.
Effective exchange rate. An index measuring the change in value of a foreign currency determined by calculat- ing a weighted average of bilateral exchange rates. The
Currency swap. A transaction in which two counterparties exchange specific amounts of two different currencies at the outset, and then repay over time according to an agreed-upon contract that reflects interest payments and possibly amortization of principal. In a currency swap, the cash flows are similar to those in a spot and forward foreign exchange transaction. See also Swap.
Current account transactions. In the balance of payments, the net flow of goods, services, and unilateral trans- fers (such as gifts) between a country and all foreign countries.
Current rate method. A method of translating the finan- cial statements of foreign subsidiaries into the parent’s reporting currency. All assets and liabilities are trans- lated at the current exchange rate.
Current/noncurrent method. A method of translating the financial statements of foreign subsidiaries into the parent’s reporting currency. All current assets and cur- rent liabilities are translated at the current rate, and all noncurrent accounts at their historical rates.
D/A. Documents against acceptance. International trade term.
D/P. Documents against payment. International trade term.
D/S. Days after sight. International trade term. Deductible expense. A business expense which is recog-
nized by tax officials as deductible toward the firm’s income tax liabilities.
Deemed-paid tax. That portion of taxes paid to a foreign government that is allowed as a credit (reduction) in taxes due to a home government.
Delta. The change in an option’s price divided by the change in the price of the underlying instrument. Hedging strategies are based on delta ratios.
Demand deposit. A bank deposit that can be withdrawn or transferred at any time without notice, in contrast to a time deposit where (theoretically) the bank may require a waiting period before the deposit can be withdrawn. Demand deposits may or may not earn interest. A time deposit is the opposite of a demand deposit.
Depositary receipt (DR). See American Depositary Receipt.
Depreciate. In the context of foreign exchange rates, a drop in the spot foreign exchange value of a floating currency, i.e., a currency whose value is determined by open market transactions.
Depreciation. A market-driven change in the value of a currency that results in reduced value or purchasing power.
Derivative. An asset that derives all changes in value on a separate underlying asset.
Devaluation. The action of a government or central bank authority to drop the spot foreign exchange value of a currency that is pegged to another currency or to gold.
591Glossary
Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain, and the United Kingdom. Officially renamed the Euro- pean Union (EU) January 1, 1994.
European Free Trade Association (EFTA). European countries not part of the European Union but having no internal tariffs.
European Monetary System (EMS). A monetary alliance of fifteen European countries (same members as the European Union).
European option. An option that can be exercised only on the day on which it expires.
European terms. Foreign exchange quotations for the U.S. dollar, expressed as the number of non-U.S. currency units per U.S. dollar.
European Union (EU). The official name of the former European Economic Community (EEC) as of January 1, 1994.
Eurozone. The countries that officially use the euro as their currency.
Ex dock. Followed by the name of a port of import. International trade term in which seller agrees to pay for the costs (shipping, insurance, customs duties, etc.) of placing the goods on the dock at the named port.
Exchange rate. The price of a unit of one country’s cur- rency expressed in terms of the currency of some other country.
Exchange Rate Mechanism (ERM). The means by which members of the EMS formerly maintained their cur- rency exchange rates within an agreed-upon range with respect to the other member currencies.
Exchange rate pass-through. The degree to which the prices of imported and exported goods change as a result of exchange rate changes.
Exercise price. Same as the strike price; the agreed upon rate of exchange within an option contract to buy or sell the underlying asset.
Export credit insurance. Provides assurance to the exporter or the exporter’s bank that, should the foreign customer default on payment, the insurance company will pay for a major portion of the loss. See also Foreign Credit Insurance Association (FCIA).
Export-Import Bank (Eximbank). A U.S. government agency created to finance and otherwise facilitate imports and exports.
Expropriation. Official government seizure of private property, recognized by international law as the right of any sovereign state provided expropriated owners are given prompt compensation and fair market value in convertible currencies.
Factoring. Specialized firms, known as factors, purchase receivables at a discount on either a non-recourse or recourse basis.
FAF. Fly away free. International trade term.
weighting reflects the importance of each foreign coun- try’s trade with the home country.
Effective tax rate. Actual taxes paid as a percentage of actual income before tax.
Efficient market. A market in which all relevant informa- tion is already reflected in market prices. The term is most frequently applied to foreign exchange markets and securities markets.
EOM. End of month. International trade term. Equity issuance. The issuance to the public market of
shares of ownership in a publicly traded company. Equity listing. The listing of a company’s shares on a public
stock exchange. Equity risk premium. The average annual return of the mar-
ket expected by investors over and above riskless debt. Euro. A new currency unit that replaced the individual
currencies of 12 European countries that belong to the European Union.
Eurobank. A bank, or bank department, that bids for time deposits and makes loans in currencies other than that of the country where the bank is located.
Eurobond. A bond originally offered outside the country in whose currency it is denominated. For example, a dollar-denominated bond originally offered for sale to investors outside the United States.
Euro-commercial paper (ECP). Short-term notes (30, 60, 90, 120, 180, 270, and 360 days) sold in international money markets.
Eurocredit. Bank loans to MNEs, sovereign governments, international institutions, and banks denominated in Eurocurrencies and extended by banks in countries other than the country in whose currency the loan is denominated.
Eurocurrency. A currency deposited in a bank located in a country other than the country issuing the currency.
Eurodollar. A U.S. dollar deposited in a bank outside the United States. A Eurodollar is a type of Eurocurrency.
Euro equity public issue. A new in the domestic equity issue that is underwritten and distributed in multiple foreign equity markets, sometimes simultaneously with distribution market.
Euronote. Short- to medium-term debt instruments sold in the Eurocurrency market.
European Central Bank (ECB). Conducts monetary pol- icy of the European Monetary Union. Its goal is to safe- guard the stability of the euro and minimize inflation.
European Currency Unit (ECU). A composite currency created by the European Monetary System prior to the euro, which was designed to function as a reserve cur- rency numeraire. The ECU was used as the numeraire for denominating a number of financial instruments and obligations.
European Economic Community (EEC). The Euro- pean common market composed of Austria, Belgium,
592 Glossary
by the country’s monetary authorities in accordance with their judgment and/or an external set of economic indicators.
Floating exchange rates. Foreign exchange rates deter- mined by demand and supply in an open market that is presumably free of government interference.
Floating-rate note (FRN). Medium-term securities with interest rates pegged to LIBOR and adjusted quarterly or semiannually.
FOB. Free on board. International trade term in which exporter’s quoted price includes the cost of loading goods into transport vessels at a named point.
Forced delistings. The requirement by a stock exchange for a publicly traded share on that exchange to be delisted from active trading, typically from failure to maintain a minimum level of market capitalization.
Foreign affiliate. A foreign business unit that is less than 50% owned by the parent company.
Foreign bond. A bond issued by a foreign corporation or government for sale in the domestic capital market of another country, and denominated in the currency of that country.
Foreign Corrupt Practices Act of 1977. A U.S. law that punishes companies and their executives if they pay bribes or make other improper payments to foreigners.
Foreign Credit Insurance Association (FCIA). An unin- corporated association of private commercial insurance companies, in cooperation with the Export-Import Bank of the United States, that provides export credit insurance to U.S. firms.
Foreign currency intervention. Any activity or policy ini- tiative by a government or central bank with the intent of changing a currency value on the open market. They may include both direct intervention, in which the cen- tral bank may buy or sell its own currency, or indirect intervention, in which it may change interest rates in order to change the attractiveness of domestic currency obligations in the eyes of foreign investors.
Foreign currency translation. The process of restating for- eign currency accounts of subsidiaries into the report- ing currency of the parent company in order to prepare a consolidated financial statement.
Foreign direct investment (FDI). Purchase of physical assets, such as plant and equipment, in a foreign coun- try, to be managed by the parent corporation. FDI is distinguished from foreign portfolio investment.
Foreign exchange broker. An individual or firm that arranges foreign exchange transactions between two parties, but is not itself a principal in the trade. For- eign exchange brokers earn a commission for their efforts.
Foreign exchange dealer (or trader). An individual or firm that buys foreign exchange from one party (at a bid price), and then sells it (at an ask price) to another
FAQ. Free at quay. International trade term. FAS (free alongside ship). An international trade term in
which the seller’s quoted price for goods includes all costs of delivery of the goods alongside a vessel at the port of embarkation.
FASB 8. A regulation of the Financial Accounting Stan- dards Board requiring U.S. companies to translate foreign affiliate financial statements by the temporal method. FASB 8 was in effect from 1976 to 1981. It is still used under specific circumstances.
FASB 52. A regulation of the Financial Accounting Standards Board requiring U.S. companies to translate foreign subsidiary financial statements by the current rate (closing rate) method. FASB 52 became effective in 1981.
FI. Free in. International trade term meaning that all expenses for loading into the hold of a vessel apply to the account of the consignee.
Financial account. A section of the balance of payments accounts. Under the revised format of the International Monetary Fund, the financial account measures long- term financial flows including direct foreign investment, portfolio investments, and other long-term movements. Under the traditional definition, which is still used by many countries, items in the financial account were included in the capital account.
Financial derivative. A financial instrument, such as a futures contract or option, whose value is derived from an underlying asset like a stock or currency.
Financial engineering. Those basic building blocks, such as spot positions, forwards, and options, used to construct positions that provide the user with desired risk and return characteristics.
Financing cash flow. Cash flows originating from financing activities of the firm, including interest payments and dividend distributions.
Firm-specific risks. Political risks that affect the MNE at the project or corporate level. Governance risk due to goal conflict between an MNE and its host government is the main political firm-specific risk.
First in, first out (FIFO). An inventory valuation approach in which the cost of the earliest inventory purchases is charged against current sales. The opposite is LIFO, or last in, first out.
Fisher Effect. A theory that nominal interest rates in two or more countries should be equal to the required real rate of return to investors plus compensation for the expected amount of inflation in each country.
Fixed exchange rates. Foreign exchange rates tied to the currency of a major country (such as the United States), to gold, or to a basket of currencies such as Special Drawing Rights.
Flexible exchange rates. The opposite of fixed exchange rates. The foreign exchange rate is adjusted periodically
593Glossary
Fronting loan. A parent-to-subsidiary loan that is chan- neled through a financial intermediary such as a large international bank in order to reduce politi- cal risk. Presumably government authorities are less likely to prevent a foreign subsidiary repaying an established bank than repaying the subsidiary’s cor- porate parent.
Functional currency. In the context of translating financial statements, the currency of the primary economic envi- ronment in which a foreign subsidiary operates and in which it generates cash flows.
Futures, or futures contracts. Exchange-traded agree- ments calling for future delivery of a standard amount of any good, e.g., foreign exchange, at a fixed time, place, and price.
Gamma. A measure of the sensitivity of an option’s delta ratio to small unit changes in the price of the underly- ing security.
Gap risk. A type of interest rate risk in which the timing of maturities is mismatched.
General Agreement on Tariffs and Trade (GATT). A framework of rules for nations to manage their trade policies, negotiate lower international tariff barriers, and settle trade disputes.
Generally Accepted Accounting Principles (GAAP). Approved accounting principles for U.S. firms, defined by the Financial Accounting Standards Board (FASB).
Geometric return. A calculation that uses the beginning and ending returns to calculate the annual average rate of compounded growth, similar to an internal rate of return.
Global depositary receipt (GDR). Similar to American Depositary Receipts (ADRs), it is a bank certificate issued in multiple countries for shares in a foreign company. Actual company shares are held by a foreign branch of an international bank. The shares are traded as domestic shares, but are offered for sale globally by sponsoring banks.
Global registered shares. Similar to ordinary shares, global registered shares have the added benefit of being trad- able on equity exchanges around the globe in a variety of currencies.
Global-specific risks. Political risks that originate at the global level, such as terrorism, the anti-globalization movement, environmental concerns, poverty, and cyber attacks.
Gold standard. A monetary system in which currencies are defined in terms of their gold content, and payment imbalances between countries are settled in gold.
Greenfield investment. An initial investment in a new for- eign subsidiary with no predecessor operation in that location. This is in contrast to a new subsidiary created by the purchase of an already existing operation. An investment which starts, conceptually if not literally, with an undeveloped “green field.”
party. The dealer is a principal in two transactions and profits via the spread between the bid and ask prices.
Foreign exchange rate. The price of one country’s currency in terms of another currency, or in terms of a commod- ity such as gold or silver. See also Exchange rate.
Foreign exchange risk. The likelihood that an unexpected change in exchange rates will alter the home currency value of foreign currency cash payments expected from a foreign source. Also, the likelihood that an unex- pected change in exchange rates will alter the amount of home currency needed to repay a debt denominated in a foreign currency.
Foreign sales corporation (FSC). Under U.S. tax code, a type of foreign corporation that provides tax-exempt or tax-deferred income for U.S. persons or corporations having export-oriented activities.
Foreign tax credit. The amount by which a domestic firm may reduce (credit) domestic income taxes for income tax payments to a foreign government.
Forfaiting (forfeiting). A technique for arranging non- recourse medium-term export financing, used most frequently to finance imports into Eastern Europe. A third party, usually a specialized financial institution, guarantees the financing.
Forward-ATM. The strike rate or exercise price of a for- eign exchange derivative set equivalent to the forward exchange rate.
Forward contract. An agreement to exchange currencies of different countries at a specified future date and at a specified forward rate.
Forward differential. The difference between spot and forward rates, expressed as an annual percentage.
Forward discount or premium. The same as forward differential.
Forward exchange rate. An exchange rate quoted for set- tlement at some future date. The rate used in a forward transaction.
Forward premium. See Forward differential. Forward rate agreement (FRA). An interbank-traded
contract to buy or sell interest rate payments on a notional principal.
Forward transaction. An agreed-upon foreign exchange transaction to be settled at a specified future date, often one, two, or three months after the transaction date.
Free cash flow. Operating cash flow less capital expendi- tures (capex).
Free-trade zone. An area within a country into which foreign goods may be brought duty free, often for purposes of additional manufacture, inventory storage, or packaging. Such goods are subject to duty only when they leave the duty-free zone to enter other parts of the country.
Freely floating exchange rates. Exchange rates determined in a free market without government interference, in contrast to dirty float.
594 Glossary
general business lines that are highly interrelated with those of the parent.
Intellectual property rights. Legislation that grants the exclusive use of patented technology and copyrighted creative materials. A worldwide treaty to protect intel- lectual property rights has been ratified by most major countries, including most recently by China.
Interest rate futures. See Futures, or futures contracts. Interest rate parity (IRP). A theory that the differences in
national interest rates for securities of similar risk and maturity should be equal to but opposite in sign (posi- tive or negative) to the forward exchange rate discount or premium for the foreign currency.
Interest rate risk. The risk to the organization arising from interest bearing debt obligations, either fixed or float- ing rate obligations. It is typically used to refer to the changing interest rates which a company may incur by borrowing at floating rates of interest.
Interest rate swap. A transaction in which two counter- parties exchange interest payment streams of differ- ent character (such as floating vs. fixed), based on an underlying notional principal amount.
Internal bank. The use of an internal unit of the cor- poration to act as a bank for exchanges of capital, currencies, or obligations between various units of the company.
Internal rate of return (IRR). A capital budgeting approach in which a discount rate is found that matches the present value of expected future cash inflows with the present value of outflows.
Internalization. A theory that the key ingredient for main- taining a firm-specific competitive advantage in inter- national competition is the possession of proprietary information and control of human capital that can gen- erate new information through expertise in research, management, marketing, or technology.
International Bank for Reconstruction and Development (IBRD, or World Bank). International development bank owned by member nations that makes develop- ment loans to member countries.
International Banking Facility (IBF). A department within a U.S. bank that may accept foreign deposits and make loans to foreign borrowers as if it were a foreign subsidiary. IBFs are free of U.S. reserve requirements, deposit insurance, and interest rate regulations.
International CAPM (ICAPM). A strategy in which the primary distinction in the estimation of the cost of equity for an individual firm using an internationalized version of the domestic capital asset pricing model is the definition of the “market” and a recalculation of the firm’s beta for that market.
International Fisher effect. A theory that the spot exchange rate should change by an amount equal to the difference in interest rates between two countries.
Gross up. See Deemed-paid tax. Haircut. The percentage of the market value of a financial
asset recognized as the collateral value or redeemed value of the asset.
Hard currency. A freely convertible currency that is not expected to depreciate in value in the foreseeable future.
Hedge accounting. An accounting procedure that speci- fies that gains and losses on hedging instruments be recognized in earnings at the same time that the effects of changes in the value of the items being hedged are recognized.
Hedging. Purchasing a contract (including forward foreign exchange) or tangible good that will rise in value and offset a drop in value of another contract or tangible good. Hedges are undertaken to reduce risk by protect- ing an owner from loss.
Historical exchange rate. In accounting, the exchange rate in effect when an asset or liability was acquired.
Hot money. Money that moves internationally from one currency and/or country to another in response to interest rate differences, and moves away immediately when the interest advantage disappears.
Hybrid foreign currency options. Purchase of a put option and the simultaneous sale of a call (or vice versa) so that the overall cost is less than the cost of a straight option.
Hyperinflation countries. Countries with a very high rate of inflation. Under United States FASB 52, these are defined as countries where the cumulative three-year inflation amounts to 100% or more.
IMM. International Monetary Market. A division of the Chicago Mercantile Exchange.
Impossible trinity. An ideal currency would have exchange rate stability, full financial integration, and monetary independence.
In-house bank. An internal bank established within an MNE if its needs are either too large or too sophisti- cated for local banks. The in-house bank is not a sepa- rate corporation but performs a set of functions by the existing treasury department. Acting as an indepen- dent entity, the in-house bank transacts with various internal business units of the firm on an arm’s length basis.
Initial public offering (IPO). The first sale of shares of ownership to the public market of a private firm.
In-the-money (ITM). Circumstance in which an option is profitable, excluding the cost of the premium, if exercised immediately.
Indirect quote. The price of a unit of a home country’s currency expressed in terms of a foreign country’s currency.
Integrated foreign entity. An entity that operates as an extension of the parent company, with cash flows and
595Glossary
Location-specific advantage. Market imperfections or genuine comparative advantages that attract foreign direct investment to particular locations.
London Interbank Offered Rate (LIBOR). The deposit rate applicable to interbank loans in London. LIBOR is used as the reference rate for many international interest rate transactions.
Long position. A position in which foreign currency assets exceed foreign currency liabilities. The opposite of a long position is a short position.
Maastricht Treaty. A treaty among the 12 European Union countries that specified a plan and timetable for the introduction of a single European currency, to be called the euro.
Macro risk. See Country-specific risk. Macroeconomic uncertainty. Operating exposure’s sen-
sitivity to key macroeconomic variables, such as exchange rates, interest rates, and inflation rates.
Managed float. A country allows its currency to trade within a given band of exchange rates.
Margin. A deposit made as security for a financial transac- tion otherwise financed on credit.
Marked to market. The condition in which the value of a futures contract is assigned to market value daily, and all changes in value are paid in cash daily. The value of the contract is revalued using the closing price for the day. The amount to be paid is called the variation margin.
Market liquidity. 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.
Market segmentation. The divergence within a national market of required rates of return. If all capital markets are fully integrated, securities of comparable expected return and risk should have the same required rate of return in each national market after adjusting for foreign exchange risk and political risk.
Matching currency cash flows. The strategy of offsetting anticipated continuous long exposure to a particular cur- rency by acquiring debt denominated in that currency.
Merchant bank. A bank that specializes in helping corpo- rations and governments finance by any of a variety of market and/or traditional techniques. European mer- chant banks are sometimes differentiated from clearing banks, which tend to focus on bank deposits and clear- ing balances for the majority of the population.
Micro risk. See Firm-specific risk. Monetary assets or liabilities. Assets in the form of cash or
claims to cash (such as accounts receivable), or liabili- ties payable in cash. Monetary assets minus monetary liabilities are called net monetary assets.
Monetary/nonmonetary method. A method of translat- ing the financial statements of foreign subsidiaries into
International Monetary Fund (IMF). An international organization created in 1944 to promote exchange rate stability and provide temporary financing for countries experiencing balance of payments difficulties.
International Monetary Market (IMM). A branch of the Chicago Mercantile Exchange that specializes in trad- ing currency and financial futures contracts.
International monetary system. The structure within which foreign exchange rates are determined, interna- tional trade and capital flows are accommodated, and balance of payments adjustments made.
Intrinsic value. The financial gain if an option is exercised immediately.
Investment agreement. An agreement that spells out spe- cific rights and responsibilities of both the investing foreign firm and the host government.
Investment grade. A credit rating of BBB- or higher. J-curve affect. The adjustment path of a country’s trade
balance following a devaluation or significant deprecia- tion of the country’s currency. The path first worsens as a result of existing contracts before improving as a result of more competitive pricing conditions.
Joint venture (JV). A business venture that is owned by two or more entities, often from different countries.
Jumbo loans. Loans of $1 billion or more. Kangaroo bonds. Australian dollar-denominated bonds
issued within Australia by a foreign borrower. Lag. In the context of leads and lags, payment of a financial
obligation later than is expected or required. Lambda. A measure of the sensitivity of an option pre-
mium to a unit change in volatility. Last in, first out (LIFO). An inventory valuation approach
in which the cost of the latest inventory purchases is charged against current sales. The opposite is FIFO, or first in, first out.
Law of one price. The concept that if an identical prod- uct or service can be sold in two different markets, and no restrictions exist on the sale or transportation costs of moving the product between markets, the product’s price should be the same in both markets.
Lead. In the context of leads and lags, the payment of a financial obligation earlier than is expected or required.
Lender-of-last-resort. The body or institution within an economy which is ultimately capable of preserving the financial survival or viability of individual institutions. Typically the country’s central bank.
Letter of credit (L/C). An instrument issued by a bank, in which the bank promises to pay a beneficiary upon presentation of documents specified in the letter.
Link financing. See Back-to-back loan or Fronting loan. Liquid. The ability to exchange an asset for cash at or near
its fair market value.
596 Glossary
Nondeliverable forward (NDF). A forward or futures con- tract on currencies, settled on the basis of the differen- tial between the contracted forward rate and occurring spot rate, but settled in the currency of the traders. For example, a forward contract on the Chinese yuan that is settled in dollars, not yuan.
Nontariff barrier. Trade restrictive practices other than custom tariffs, such as import quotas, voluntary restric- tions, variable levies, and special health regulations.
North American Free Trade Agreement (NAFTA). A treaty allowing free trade and investment between Canada, the United States, and Mexico.
Note issuance facility (NIF). An agreement by which a syndicate of banks indicates a willingness to accept short-term notes from borrowers and resell those notes in the Eurocurrency markets. The discount rate is often tied to LIBOR.
Notional principal. The size of a derivative contract, in total currency value, as used in futures contracts, for- ward contracts, option contracts, or swap agreements.
NPV. See Net present value. NSF. Not-sufficient funds. Term used by a bank when a
draft or check is drawn on an account not having a suf- ficient credit balance.
O/A. Open account. Arrangement in which the importer (or other buyer) pays for the goods only after the goods are received and inspected. The importer is billed directly after shipment, and payment is not tied to any promissory notes or similar documents.
Offer. The price at which a trader is willing to sell foreign exchange, securities, or commodities. Also called ask.
Official reserves account. Total reserves held by official monetary authorities within the country, such as gold, SDRs, and major currencies.
Offshore finance subsidiary. A foreign financial subsidiary owned by a corporation in another country. Offshore finance subsidiaries are usually located in tax-free or low-tax jurisdictions to enable the parent multinational firm to finance international operations without being subject to home country taxes or regulations.
OLI paradigm. An attempt to create an overall framework to explain why MNEs choose foreign direct investment rather than serve foreign markets through alternative modes such as licensing, joint ventures, strategic alli- ances, management contracts, and exporting.
On the run. International banks of the highest credit quality that are willing to exchange obligations on a no-name basis.
Operating cash flows. The primary cash flows generated by a business from the conduct of trade, typically com- posed of earnings, depreciation and amortization, and changes in net working capital.
Operating exposure. The potential for a change in expected cash flows, and thus in value, of a foreign subsidiary as a
the parent’s reporting currency. All monetary accounts are translated at the current rate, and all nonmonetary accounts are translated at their historical rates. Some- times called temporal method in the United States.
Money market hedge. The use of foreign currency bor- rowing to reduce transaction or accounting foreign exchange exposure.
Money markets. The financial markets in various countries in which various types of short-term debt instruments, including bank loans, are purchased and sold.
Moral hazard. When an individual or organization takes on more risk than it would normally as a result of the existence or support of a secondary insuring or protect- ing authority or organization.
Mortgage Backed Security (MBS or MBO). A derivative security composed of residential or commercial real estate mortgages.
Most-favored-nation (MFN) treatment. The application by a country of import duties on the same, or most favored, basis to all countries accorded such treatment. Any tariff reduction granted in a bilateral negotiation will be extended to all other nations granted most- favored-nation status.
Multilateral netting. The process of netting intracompany payments in order to reduce the size and frequency of cash and currency exchanges.
Multinational enterprise (MNE). A firm that has oper- ating subsidiaries, branches, or affiliates located in foreign countries.
Natural hedge. The use or existence of an offsetting or matching cash flow from firm operating activities to hedge a currency exposure.
Negotiable instrument. A written draft or promissory note, signed by the maker or drawer, that contains an unconditional promise or order to pay a definite sum of money on demand or at a determinable future date, and is payable to order or to bearer. A holder of a negotiable instrument is entitled to payment despite any personal disagreements between the drawee and maker.
Nepotism. The practice of showing favor to relatives over other qualified persons in conferring such benefits as the awarding of contracts, granting of special prices, promotions to various ranks, etc.
Net present value. A capital budgeting approach in which the present value of expected future cash inflows is subtracted from the present value of outflows.
Net working capital (NWC). Accounts receivable plus inventories less accounts payable.
Netting. The mutual offsetting of sums due between two or more business entities.
Nominal exchange rate. The actual foreign exchange quotation, in contrast to real exchange rate, which is adjusted for changes in purchasing power.
597Glossary
each other’s currency for a specific period of time, and repay the other’s currency at an agreed maturity.
Parallel market. An unofficial foreign exchange market tolerated by a government but not officially sanctioned. The exact boundary between a parallel market and a black market is not very clear, but official tolerance of what would otherwise be a black market leads to use of the term parallel market.
Parity conditions. In the context of international finance, a set of basic economic relationships that provide for equilibrium between spot and forward foreign exchange rates, interest rates, and inflation rates.
Participating forward. A complex option position which combines a bought put and a sold call option at the same strike price to create a net zero position. Also called zero-cost option and forward participation agreement.
Pass-through. The time it takes for an exchange rate change to be reflected in market prices of products or services.
Phi. The expected change in an option premium caused by a small change in the foreign interest rate (interest rate for the foreign currency).
Plain vanilla swap. An interest rate swap agreement exchange fixed interest payments for floating interest payments, all in the same currency.
Points. The smallest units of price change quoted, given a conventional number of digits in which a quotation is stated.
Points quotation. A forward quotation expressed only as the number of decimal points (usually four decimal points) by which it differs from the spot quotation.
Political risk. The possibility that political events in a par- ticular country will influence the economic well-being of firms in that country. See also Sovereign risk.
Portfolio investment. Purchase of foreign stocks and bonds, in contrast to foreign direct investment.
Possessions corporation. A U.S. corporation, the sub- sidiary of another U.S. corporation located in a U.S. possession such as Puerto Rico, that for tax purposes is treated as if it were a foreign corporation.
Premium. In a foreign exchange market, the amount by which a currency is more expensive for future delivery than for spot (immediate) delivery. The opposite of premium is discount.
Prime mortgage. A mortgage categorized as conforming (also referred to as conventional loans), meaning it would meet the guarantee requirements for resale to Government-Sponsored Enterprises (GSEs) Fannie Mae and Freddie Mac.
Private equity. Assets that are composed of equity shares in companies that are not publicly traded.
Private placement. The sale of a security issue to a small set of qualified institutional buyers.
result of an unexpected change in exchange rates. Also called economic exposure.
Option. In foreign exchange, a contract giving the pur- chaser the right, but not the obligation, to buy or sell a given amount of foreign exchange at a fixed price per unit for a specified time period. Options to buy are calls and options to sell are puts.
Order bill of lading. A shipping document through which possession and title to the shipment reside with the owner of the bill.
Organization of Petroleum Exporting Countries (OPEC). An alliance of most major crude oil producing coun- tries, formed for the purpose of allocating and control- ling production quotas so as to influence the price of crude oil in world markets.
Originate-to-Distribute (OTD). A common practice in the U.S. real estate market during the 2001–2007 real estate boom in which a real estate lender, or originator, makes loans expressly for the purpose of immediate resale.
Out-of-the-money (OTM). An option that would not be profitable, excluding the cost of the premium, if exer- cised immediately.
Outright quotation. The full price, in one currency, of a unit of another currency. See Points quotation.
Outsourcing. See Supply chain management. Overseas Private Investment Corporation (OPIC). A U.S.
government-owned insurance company that insures U.S. corporations against various political risks.
Over-the-counter market. A market for share of stock, options (including foreign currency options), or other financial contracts conducted via electronic connec- tions between dealers. The over-the-counter market has no physical location or address, and is thus differ- entiated from organized exchanges that have a physical location where trading takes place.
Overvalued currency. A currency with a current for- eign exchange value (i.e., current price in the foreign exchange market) greater than the worth of that cur- rency. Because “worth” is a subjective concept, overval- uation is a matter of opinion. If the euro has a current market value of $1.20 (i.e., the current exchange rate is $1.20/€) at a time when its “true” value as derived from purchasing power parity or some other method is deemed to be $1.10, the euro is overvalued. The oppo- site of overvalued is undervalued.
Owner-specific advantage. A firm must have competitive advantages in its home market. These must be firm- specific, not easily copied, and in a form that allows them to be transferred to foreign subsidiaries.
Panda Bond. The issuance of a yuan-denominated bond in the Chinese market by a foreign borrower.
Parallel loan. Another name for a back-to-back loan, in which two companies in separate countries borrow
598 Glossary
Relative purchasing power parity. A theory that if the spot exchange rate between two countries starts in equilib- rium, 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.
Renminbi (RMB). The alternative official name (the yuan, CNY) of the currency of the People’s Republic of China.
Reporting currency. In the context of translating financial statements, the currency in which a parent firm pre- pares its own financial statements. Usually this is the parent’s home currency.
Repositioning of funds. The movement of funds from one currency or country to another. An MNE faces a vari- ety of political, tax, foreign exchange, and liquidity con- straints that limit its ability to move funds easily and without cost.
Representative office. A representative office established by a bank in a foreign country to help clients doing business in that country. It also functions as a geo- graphically convenient location from which to visit correspondent banks in its region rather than sending bankers from the parent bank at greater financial and physical cost.
Repricing risk. The risk of changes in interest rates charged or earned at the time a financial contract’s rate is reset.
Reserve currency. A currency used by a government or central banking authority as a resource asset or cur- rency to be used in market interventions to alter the market value of the domestic currency.
Restricted stock. Stock shares given to management that are not tradable or transferable before a speci- fied future date (when they vest) or other specified conditions.
Revaluation. A rise in the foreign exchange value of a cur- rency that is pegged to other currencies or to gold. Also called appreciation.
Rho. The expected change in an option premium caused by a small change in the domestic interest rate (interest rate for the home currency).
Risk. The likelihood that an actual outcome will differ from an expected outcome. The actual outcome could be better or worse than expected (two-sided risk), although in common practice risk is more often used only in the context of an adverse outcome (one-sided risk). Risk can exist for any number of uncertain future situations, including future spot rates or the results of political events.
Risk-sharing. A contractual arrangement in which the buyer and seller agree to share or split currency move- ment impacts on payments between them.
Rules of the Game. The basis of exchange rate determi- nation under the international gold standard during most of the 19th and early 20th centuries. All countries
Profit warning. The public announcement by a publicly traded company that current period earnings will fall significantly either from a previously reported period or investor expectations.
Project financing. Arrangement of financing for long-term capital projects, large in scale, long in life, and generally high in risk.
Protectionism. A political attitude or policy intended to inhibit or prohibit the import of foreign goods and services. The opposite of free trade policies.
Psychic distance. Firms tend to invest first in countries with a similar cultural, legal, and institutional environment.
Public debt. The debt obligation of a governmental body or sovereign authority.
Purchasing power parity (PPP). A theory that the price of internationally traded commodities should be the same in every country, and hence the exchange rate between the two currencies should be the ratio of prices in the two countries.
Put. An option to sell foreign exchange or financial con- tracts. See Option.
Qualified institutional buyer (QIB). An entity (except a bank or a savings and loan) that owns and invests on a discretionary basis a minimum of $100 million in secu- rities of non-affiliates.
Quota. A limit, mandatory or voluntary, set on the import of a product.
Quotation. In foreign exchange trading, the pair of prices (bid and ask) at which a dealer is willing to buy or sell foreign exchange.
Range forward. A complex option position that com- bines the purchase of a put option and the sale of a call option with strike prices equidistant from the for- ward rate. Also called flexible forward, cylinder option, option fence, mini-max, and zero-cost tunnel.
Real exchange rate. An index of foreign exchange adjusted for relative price-level changes from a base point in time, typically a month or a year. Sometimes referred to as real effective exchange rate, it is used to measure purchasing-power-adjusted changes in exchange rates.
Real option analysis. The application of option theory to capital budgeting decisions.
Reference rate. The rate of interest used in a standard- ized quotation, loan agreement, or financial derivative valuation.
Registered bond. Corporate or governmental debt in a bond form in which the owner’s name appears on the bond and in the issuer’s records, and interest payments are made to the owner.
Reinvoicing center. A central financial subsidiary used by a multinational firm to reduce transaction exposure by having all home country exports billed in the home cur- rency and then reinvoiced to each operating subsidiary in that subsidiary’s local currency.
599Glossary
agreed informally to follow the rule of buying and sell- ing their currency at a fixed and predetermined price against gold.
Samurai bonds. Yen-denominated bonds issued within Japan by a foreign borrower.
Sarbanes-Oxley Act. An act passed in 2002 to regulate corporate governance in the United States.
SEC Rule 144A. Permits qualified institutional buyers to trade privately placed securities without requiring SEC registration.
Section 482. The set of U.S. Treasury regulations governing transfer prices.
Securitization. The replacement of nonmarketable loans (such as direct bank loans) with negotiable securities (such as publicly traded marketable notes and bonds), so that the risk can be spread widely among many inves- tors, each of whom can add or subtract the amount of risk carried by buying or selling the marketable security.
Seignorage. The net revenues or proceeds garnered by a government from the printing of its money.
Self-sustaining foreign entity. One that operates in the local economic environment independent of the parent company.
Selling short (shorting). The sale of an asset which the seller does not (yet) own. The premise is that the seller believes he will be able to purchase the asset for con- tract fulfillment at a lower price before sale contract expiration.
Shared services. A charge to compensate the parent for costs incurred in the general management of interna- tional operations and for other corporate services pro- vided to foreign subsidiaries that must be recovered by the parent firm.
Shareholder wealth maximization (SWM). The corporate goal of maximizing the total value of the shareholders’ investment in the company.
Sharpe measure (SHP). Calculates the average return over and above the risk-free rate of return per unit of portfolio risk. It uses the standard deviation of a port- folio’s total return as the measure of risk.
Shogun bonds. Foreign currency-denominated bonds issued within Japan by Japanese corporations.
Short position. See Long position. SIBOR. Singapore interbank offered rate. Sight draft. A bill of exchange (B/E) that is due on
demand; i.e., when presented to the bank. See also Bill of exchange.
SIMEX. Singapore International Monetary Exchange. SIV. Structure Investment Vehicle. The SIV is an off-
balance-sheet entity first created by Citigroup in 1988. It was designed to allow a bank to create an invest- ment entity that would invest in long term and higher yielding assets such as speculative grade bonds, mort- gage-backed securities (MBSs) and collateralized debt
obligations (CDOs), while funding itself through com- mercial paper (CP) issuances.
Society for Worldwide Interbank Financial Telecommuni- cations (SWIFT). A dedicated computer network pro- viding funds transfer messages between member banks around the world.
Soft currency. A currency expected to drop in value rela- tive to other currencies. Free trading in a currency deemed soft is often restricted by the monetary author- ities of the issuing country.
Sovereign debt. The debt obligation or a sovereign or governmental authority or body.
Sovereign risk. The risk that a host government may unilaterally repudiate its foreign obligations or may prevent local firms from honoring their foreign obli- gations. Sovereign risk is often regarded as a subset of political risk.
Sovereign spread. The credit spread paid by a sovereign borrower on a major foreign currency denominated debt obligation. For example, the credit spread paid by the Venezuelan government to borrow U.S. dollars over and above a similar maturity issuance by the U.S. Treasury.
Special Drawing Right (SDR). An international reserve asset, defined by the International Monetary Fund as the value of a weighted basket of five currencies.
Special purpose vehicle (SPV) or special purpose entity (SPE). An off-balance sheet legal entity, typically a partnership, set up for a very special business purpose that will isolate or limit the partner’s financial risks associated with risks associated with the SPV’s activi- ties or assets. Similar in function to an SIV.
Speculation. An attempt to make a profit by trading on expectations about future prices.
Speculative grade. A credit quality that is below BBB, below investment grade. The designation implies a possibility of borrower default in the event of unfavo- rable economic or business conditions.
Spot rate. The price at which foreign exchange can be pur- chased (its bid) or sold (its ask) in a spot transaction. See Spot transaction.
Spot transaction. A foreign exchange transaction to be set- tled (paid for) on the second following business day.
Spread. The difference between the bid (buying) quote and the ask (selling) quote.
Stakeholder capitalism model (SCM). Another name for corporate wealth maximization.
State owned enterprise (SOE). Any organization or busi- ness which is owned (in-whole or in-part) and controlled by government, typically created to conduct commercial business activities.
Statutory tax rate. The legally imposed tax rate. Strategic alliance. A formal relationship, short of a merger
or acquisition, between two companies, formed for the
600 Glossary
diversification by not lending too much to a single borrower.
Synthetic forward. A complex option position which com- bines the purchase of a put option and the sale of a call option, or vice versa, both at the forward rate. Theo- retically, the combined position should have a net-zero premium.
Systematic risk. In portfolio theory, the risk of the market itself, i.e., risk that cannot be diversified away.
T/A. Trade acceptance. International trade term. Tariff. A duty or tax on imports that can be levied as a
percentage of cost or as a specific amount per unit of import.
Tax deferral. Foreign subsidiaries of MNEs pay host coun- try corporate income taxes, but many parent countries, including the United States, defer claiming additional taxes on that foreign source income until it is remitted to the parent firm.
Tax exposure. The potential for tax liability on a given income stream or on the value of an asset. Usually used in the context of a multinational firm being able to minimize its tax liabilities by locating some portion of operations in a country where the tax liability is minimized.
Tax haven. A country with either no or very low tax rates that uses its tax structure to attract foreign investment or international financial dealings.
Tax morality. The consideration of conduct by an MNE to decide whether to follow a practice of full disclosure to local tax authorities or adopt the philosophy, “When in Rome, do as the Romans do.”
Tax neutrality. In domestic tax, the requirement that the burden of taxation on earnings in home country opera- tions 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. Foreign tax neutrality requires that the tax burden on each foreign subsidiary of the firm be equal to the tax burden on its competi- tors in the same country.
Tax on undistributed profits. A different income tax applied to retained earnings from that applied to distributed earnings (dividends).
Tax treaties. A network of bilateral treaties that provide a means of reducing double taxation.
Technical analysis. The focus on price and volume data to determine past trends that are expected to continue into the future. Analysts believe that future exchange rates are based on the current exchange rate.
TED Spread. Treasury Eurodollar Spread. The differ- ence, in basis points, between the 3-month interest rate swap index or the 3-month LIBOR interest rate, and the 90-day U.S. Treasury bill rate. It is sometimes used as an indicator of credit crisis or fear over bank credit quality.
purpose of gaining synergies because in some aspect the two companies complement each other.
Strike price. The agreed upon rate of exchange within an option contract.
Stripped bonds. Bonds issued by investment bankers against coupons or the maturity (corpus) portion of original bearer bonds, where the original bonds are held in trust by the investment banker. Whereas the original bonds will have coupons promising interest at each interest date (say June and December for each of the next twenty years), a given stripped bond will rep- resent a claim against all interest payments from the entire original issue due on a particular interest date. A stripped bond is in effect a zero coupon bond manufac- tured by the investment banker.
Subpart F. A type of foreign income, as defined in the U.S. tax code, which under certain conditions is taxed imme- diately in the United States even though it has not been repatriated to the United States. It is income of a type that is otherwise easily shifted offshore to avoid current taxation.
Subprime (subprime mortgage). Subprime borrowers have a higher perceived risk of default, normally as a result of credit history elements which may include bankruptcy, loan delinquency, default, or simply a bor- rower with limited experience or history of debt. They are nearly exclusively floating-rate structures, and carry significantly higher interest rate spreads over the floating bases like LIBOR.
Subsidiary. A foreign operation incorporated in the host country and owned 50% or more by a parent corpora- tion. Foreign operations that are not incorporated are called branches.
Supply chain management. A strategy that focuses on cost reduction through imports from less costly foreign locations with lower wages.
Sushi bonds. Eurodollar or other non-yen-denominated bonds issued by a Japanese corporation for sale to Japanese investors.
Swap. This term is used in many contexts. In general it is the simultaneous purchase and sale of foreign exchange or securities, with the purchase executed at once and the sale back to the same party carried out at an agreed-upon price to be completed at a specified future date. Swaps include interest rate swaps, currency swaps, and credit swaps.
Swap rate. A forward foreign exchange quotation expressed in terms of the number of points by which the forward rate differs from the spot rate.
SWIFT. See Society for Worldwide Interbank Financial Telecommunications.
Syndicated loan. A large loan made by a group of banks to a large multinational firm or government. Syndi- cated loans allow the participating banks to maintain
601Glossary
Triangular arbitrage. An arbitrage activity of exchanging currency A for currency B for currency C back to cur- rency A to exploit slight disequilibrium in exchange rates.
Triffin Paradox (also Triffin Dilemma). The potential con- flict in objectives which may arise between domestic monetary policy and currency policy when a country’s currency is used as a reserve currency.
Trilemma of international finance. The difficult but required choice which a government must make between three conflicting international financial system goals: 1) a fixed exchange rate; 2) independent monetary policy; and 3) free mobility of capital.
Turnover tax. A tax based on turnover or sales, and is similar in structure to a VAT, in which taxes may be assessed on intermediate stages of a good’s production.
Unaffiliated. An independent third-party. Unbiased predictor. A theory that spot prices at some
future date will be equal to today’s forward rates. Unbundling. Dividing cash flows from a subsidiary to a
parent into their many separate components, such as royalties, lease payments, dividends, etc., so as to increase the likelihood that some fund flows will be allowed during economically difficult times.
Uncovered interest arbitrage (UIA). The process by which 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.
Undervalued currency. The status of currency with a cur- rent foreign exchange value (i.e., current price in the foreign exchange market) below the worth of that currency. Because “worth” is a subjective concept, undervaluation is a matter of opinion. If the euro has a current market value of $1.20 (i.e., the current exchange rate is $1.20/€) at a time when its “true” value as derived from purchasing power parity or some other method is deemed to be $1.30, the euro is under- valued. The opposite of undervalued is overvalued.
Unsystematic risk. In a portfolio, the amount of risk that can be eliminated by diversification.
Value-added tax. A type of national sales tax collected at each stage of production or sale of consumption goods, and levied in proportion to the value added during that stage.
Value date. The date when value is given (i.e., funds are deposited) for foreign exchange transactions between banks.
Value today. A spot foreign exchange transaction in which delivery and payment are made on the same day as the contract. Normal delivery is two business days after the contract.
Temporal method. In the United States, term for a codifi- cation of a translation method essentially similar to the monetary/nonmonetary method.
Tenor. The length of time of a contract or debt obligation; loan repayment period.
Tequila effect. Term used to describe how the Mexican peso crisis of December 1994 quickly spread to other Latin American currency and equity markets through the contagion effect.
Terms of trade. The weighted average exchange ratio between a nation’s export prices and its import prices, used to measure gains from trade. Gains from trade refers to increases in total consumption resulting from production specialization and international trade.
Territorial taxation (territorial approach). Taxation of income earned by firms within the legal jurisdiction of the host country, not on the country of the firm’s incorporation.
Theta. The expected change in an option premium caused by a small change in the time to expiration.
Time draft. A draft that allows a delay in payment. It is presented to the drawee, who accepts it by writing a notice of acceptance on its face. Once accepted, the time draft becomes a promise to pay by the accepting party. See also Banker’s acceptance.
Total Shareholder Return (TSR). A measure of corporate performance based on the sum of share price apprecia- tion and current dividends.
Tranche. An allocation of shares, typically to underwriters that are expected to sell to investors in their designated geographic markets.
Transaction exposure. The potential for a change in the value of outstanding financial obligations entered into prior to a change in exchange rates but not due to be settled until after the exchange rates change.
Transfer pricing. The setting of prices to be charged by one unit (such as a foreign subsidiary) of a multi-unit corpo- ration to another unit (such as the parent corporation) for goods or services sold between such related units.
Translation exposure. The potential for an accounting- derived change in owners’ equity resulting from exchange rate changes and the need to restate finan- cial statements of foreign subsidiaries in the single cur- rency of the parent corporation. See also Accounting exposure.
Transnational firm. A company owned by a coalition of investors located in different countries.
Transparency. The degree to which an investor can discern the true activities and value drivers of a company from the disclosures and financial results reported.
Treynor measure (TRN). A calculation of the average return over and above the risk-free rate of return per unit of portfolio risk. It uses the portfolio’s beta as the measure of risk.
602 Glossary
incorporated in a host country, regardless of where the income was earned.
Writer. Seller. Yankee bonds. Dollar-denominated bonds issued within
the United States by a foreign borrower. Yield to maturity. The rate of interest (discount) that
equates future cash flows of a bond, both interest and principal, with the present market price. Yield to matu- rity is thus the time-adjusted rate of return earned by a bond investor.
Yuan (CNY). The official currency of the People’s Repub- lic of China, also termed the renminbi.
Zero coupon bond. A bond that pays no periodic inter- est, but returns a given amount of principal at a stated maturity date. Zero coupon bonds are sold at a dis- count from the maturity amount to provide the holder a compound rate of return for the holding period.
Value tomorrow. A spot foreign exchange transaction in which delivery and payment are made on the next busi- ness day after the contract. Normal delivery is two busi- ness days after the contract.
Volatility. In connection with options, the standard devia- tion of daily spot price movement.
Weighted average cost of capital (WACC). The sum of the proportionally weighted costs of different sources of capital, used as the minimum acceptable target return on new investments.
Wire transfer. Electronic transfer of funds. Working capital management. The management of the net
working capital requirements (A/R plus inventories less A/P) of the firm.
World Bank. See International Bank for Reconstruction and Development.
Worldwide approach to taxes. The principle that taxes are levied on the income earned by firms that are
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626
Credits Cover photo: Marina, Dubai, United Arab Emirates, Middle East; © Robert Harding
World Imagery / Alamy.
Chapter 1 Page 2 Quote “I define globalization as producing...”: Narayana Murthy, President
and CEO, Infosys. 2 Excerpt “Back in the halcyon pre-crisis days...”: Gillian Tett, “Crisis Fears
Fuel Debate on Capital Controls,” Financial Times, December 15, 2011. 4 Global Finance in Practice 1.1: From Charles Rosburgh, Susan Lund, Charles
Arkins, Stanislas Belot, Wayne H. Hu and Moura S. Pierce, McKinsey & Company, “Global Capital Markets: Entering a New Era,” McKinsey Global Institute, September 2009.
6 Exhibit 1.2: All quotes are drawn from Financial Times, January 12, 2012. 12 Excerpt “Sustainable development is development...”: Brundtland Report
1987, p. 54. 16 Excerpt “Welcome to the future...”: Donald Lessard, in Global Risk, New
Perspectives and Opportunities, 2011, p. 33. 16 Exhibit 1.7: Constructed by authors based on Rene M. Stulz, “The Limits of
Financial Globalization,” Journal of Applied Corporate Finance, Volume 19, No. 1, Winter 2007, pp 8–15.
17 Excerpt “Rumors about this relatively secret company abound...”: G. Rodden, M. Rushton, F. Willis,“Five Companies to Watch” PPI January 2009, p. 21.
17 Excerpt “This time is really different...”: Cheung Yan, Chairwoman of Nine Dragons Paper, “Wastepaper Queen: Letter from China,” New Yorker, March 30, 2009, p. 8.
17 Mini-Case: Copyright 2011 © Thunderbird School of Global Management. This case was prepared by Professor Michael Moffett and Brenda Adelson, MBA ’08.
19 Exhibit 2: “Nine Dragons Paper” Morgan Stanley, January 29, 2009. 20 Excerpt “The market waits for no one...”: Cheung Yan, Chairwoman of
Nine Dragons Paper, “Wastepaper Queen: Letter from China,” New Yorker, March 30, 2009, p. 2.
20 Excerpt “Why are we in debt?...”: Cheung Yan, Chairwoman of Nine Drag- ons Paper, “Wastepaper Queen: Letter from China,” New Yorker, March 30, 2009, p. 2.
21 Excerpt “We understand that all NDPs banks have postponed...”: “Nine Dragons Paper” Morgan Stanley, January 29, 2009, p. 1.
22 Exhibit 5: Based on “Nine Dragons Paper,” Morgan Stanley, September 17, 2008, December 16, 2008, January 29, 2009, February 10, 2009, February 19, 2009, and March 18, 2009.
22 Excerpt “... we are concerned about the heavy reliance on bank borrow- ing...”: Morgan Stanley, March 18, 2009.
24 Excerpt “Nine Dragon’s earnings are very sensitive to prices...”: “Nine Drag- ons Paper” Morgan Stanley, January 29, 2009, p. 6.
24 Excerpt “Our future path of development may remain...”: “Chairlady’s State- ment,” 2008/09 Interim Report, Nine Dragons Paper (Holdings) Limited.
Chapter 2 27 Excerpt “Gerald L. Storch, CEO of Toys ‘R’ Us...”: “Public vs. Private,”
Forbes, September 1, 2006. 29 Global Finance in Practice 2.1: Le Figaro, June 2007. 30 Excerpt “What do investors want?...”: “The Brave New World of Corporate
Governance,” LatinFinance, May 2001. 33 Exhibit 2.2: Christian Caspar, Ana Karina Dias, and Heinz-Peter Elstrodt,
“The Five Attributes of Enduring Family Businesses,” McKinsey Quarterly, January 2010, p. 6.
34 Excerpt “One third of all companies in the S&P 500 index...”: Christian Cas- par, Ana Karina Dias, and Heinz-Peter Elstrodt, “The Five Attributes of Enduring Family Businesses,” McKinsey Quarterly, January 2010, p. 6.
35 Exhibit 2.3: Christian Caspar, Ana Karina Dias, and Heinz-Peter Elstrodt, “The Five Attributes of Enduring Family Businesses,” McKinsey Quarterly, January 2010 p. 7.
35 Excerpt “Today, the public company is in trouble…”: The Word in 2012, The Economist, December 2011, p. 31.
36 Exhibit 2.4: Derived by authors from statistics collected by the World Fed- eration of Exchanges (WFE).
40 Exhibit 2.6: Data from J. Tsui and T. Shieh, “Corporate Governance in Emerging Markets: An Asian Perspective,” International Finance and Accounting Handbook, Third Edition, Frederick D.S. Choi, editor, Wiley, 2004, pp. 24.4–24.6.
44 Exhibit 2.8: Data from irglobalrankings.com/figr2010. 49 Mini-Case: Copyright 2011 © Thunderbird School of Global Management.
All rights reserved. This case was prepared by Joe Kleinberg, MBA 2011 and Peter Macy, MBA 2011, under the direction of Professor Michael Moffett.
49 Quote “The basic rule is to be there at the right moment...”: Bernard Arnault, Chairman and CEO, LVMH.
50 Exhibit 1: LVMH Press Release, October 23, 2010.
50 Quote “Arnault is a shrewd man...”: Anonymous luxury brand CEO speak- ing on the LVMH announcement.
51 Exhibit 2: The Executive Management, Sunday October 24th, 2010. Reprinted by permission of Hermes International.
52 Quote “It’s clear his [Mr. Arnault] intention is to take over...”: Patrick Thomas, CEO Hermès, Le Figaro, October 27, 2010.
52 Quote “We would like to convince him...”: Mr. Puech, Executive Chairman of Emile Hermés SARL, Le Figaro, October 27, 2010.
52 Quote “I do not see how the head of a listed company...”: Bernard Arnault, CEO LVMH, Le Figaro, October 28, 2010.
53 Exhibit 3: From Hermes International Press Release, December 5, 2010. Reprinted by permission.
58 Mattel’s Global Sales: Mattel Annual Report, 2002, 2003, 2004.
Chapter 3 59 Quote “The price of everything rises and falls...”: Alfred Marshall. 63 Exhibit 3.2: International Monetary Fund, International Financial Statistics,
www.imfstatistics.org 2005=100. 65 Exhibit 3.3: Data from Karl Habermeier, Anamaria Kokenyne, Romain
Veyrune, and Harald Anderson, “Revised System for the Classification of Exchange Rate Arrangements,” IMF Working Paper WP/09/211, Interna- tional Monetary Fund, November 17, 2009.
69 Global Finance 3.2: “Swiss National Bank sets minimum exchange rate at CHF 1.20 per euro,” Communications Press Release, Swiss National Bank, September 6, 2011.
70 Exhibit 3.5: Data drawn from the International Monetary Fund’s Interna- tional Financial Statistics, imf.org, monthly average rate.
73 Exhibit 3.6: Pacific Currency Exchange, http://pacific.commerce.ubc.ca/xr © 2001 by Prof. Werner Antweiler, University of British Columbia.
75 Excerpt “One attraction of dollarization is that sound monetary...”: “The Dollar Club,” BusinessWeek, December 11, 2000.
77 Excerpt “Indeed, we believe that the choice of exchange rate regime...”: Guillermo A. Calvo and Frederic S. Mishkin, “The Mirage of Exchange Rate Regimes for Emerging Market Countries.”
79 Mini-Case: Copyright © 2012 Thunderbird School of Global Management. All rights reserved. This case was prepared by Professor Michael Moffett.
81 Quote “To understand the different challenges in these three stages...”: “Six Questions Regarding the Internationalisation of the Renminbi,” HKEx Chief Executive Charles Li, 21 Sept 2010.
82 Exhibit 3: Data from FX Pulse, Morgan Stanley, December 2, 2010, p. 14. 82 Excerpt from “Standard Chartered Launches RMB Corporate Bond in Hong
Kong for McDonald’s Corporation”: Press Release, Standard Chartered, August 19, 2010, Hong Kong.
84 Exhibit 4: From Samar Maziad, Pascal Farahmand, Shegzu Wang, Stephanie Segal, and Faisal Ahmed, “Internationalization of Emerging Market Curren- cies: A Balance Between Risks and Rewards,” IMF Staff Discussion Note SDN/11/17, October 19, 2011, p.14.
Chapter 4 87 Quote “The sort of dependence that results from exchange...”: Frederic Bastiat. 91 Exhibit 4.2: Derived from Balance of Payments Statistics Yearbook, Inter-
national Monetary Fund, December 2011, p. 1101. 93 Exhibit 4.3: Balance of Payments Statistics Yearbook, International Mon-
etary Fund, December 2011, p. 1101. 95 Exhibit 4.4: Derived from Balance of Payments Statistics Yearbook, Inter-
national Monetary Fund, December 2011, p. 1101. 96 Exhibit 4.5: Balance of Payments Statistics Yearbook, International Mon-
etary Fund, December 2011, p. 1101. 96 Exhibit 4.6: Balance of Payments Statistics Yearbook, International Mon-
etary Fund, December 2011, p. 1101. 97 Exhibit 4.7: Balance of Payments Statistics Yearbook, International Mon-
etary Fund, December 2011, p. 224. 98 Exhibit 4.8: Data drawn from State Administration of Foreign Exchange,
People’s Republic of China, as quoted by Chinability, http://www.chinability .com/Reserves.htm. 2011 is as end-of-month September.
99 Exhibit 4.9: Data drawn from “The World Factbook,” www.cia.gov, 2010. Data is for December 31, 2010.
108 Excerpt “Back in the halcyon pre-crisis days...”: Gillian Tett, “Crisis Fears Fuel Debate on Capital Controls,” Financial Times, December 15, 2011.
108 Exhibit 4.12: “An Introduction to Capital Controls,” Christopher J. Neely, Federal Reserve Bank of St. Louis Review, November/December 1999, p. 16, Table 1.
111 Excerpt “International flows of direct and portfolio investments...”: From Capi- tal Flight and Third World Debt, edited by Donald R. Lessard and John Wil- liamson, Institute for International Economics, Washington, D.C., 1987, p. 104.
111 Excerpt “Notwithstanding these benefits, many EMEs...”: Jonathan D. Ostry, Atish R. Ghosh, Karl Habermeier, Marcos Chamon, Mahvash S. Qureshi, and Dennis B.S. Reinhardt, “Capital Inflows: The Role of Con- trols,” IMF Staff Position Note, SPN/10/04, February 19, 2010, p. 4.
113 Mini-Case: Copyright © 2012 Michael H. Moffett.
627
113 Excerpt “Remittances are a vital source of financial support...”: “Remit- tances to Developing Countries Resilient in the Recent Crisis,” Press Release No. 2011/168DEC, The World Bank, November 8, 2010.
113 Exhibit 1: Data from the World Bank Development Prospects Group. 114 Exhibit 2: Data from The World Bank, 29. 114 Excerpt “Given the development impact of remittance flows...”: The G8 Final
Declaration on Responsible Leadership for a Sustainable Future, paragraph 134. 115 Exhibit 3: Data from PROFECO, the Federal Consumer Protection Commission
of Mexico. 116 Exhibit 4: Data from The World Bank
Chapter 5 122 Quote “Confidence in markets and institutions, it’s a lot like oxygen...”: War-
ren Buffett, October 1, 2008. 124 Exhibit 5.1: Flow of Funds Accounts of the United States, Annual Flows
and Outstandings, Board of Governors of the Federal Reserve System, FFA 1995–2004 and FFA 2005–2010, March 10, 2011, p. 2.
125 Exhibit 5.2: Data from Deutsche Bundesbank, UK Statistics Authority, U.S. Federal Reserve, The Economist.
126 Exhibit 5.3: Fannie Mae, Freddie Mac and the Federal Role in the Secondary Mortgage Market, Congressional Budget Office, December 2010, p. 11.
154 Exhibit 5.4: Data drawn from “Global Market Issuance Data,” Securities Industry and Financial Markets Association (SIFMA) sigma.org.
129 Excerpt “Despite its forbidding name, the CDS is a simple idea...”: “Deriva- tives: Giving Credit Where It Is Due,” The Economist, November 6, 2008.
129 Exhibit 5.5: Data drawn from Risk Category and Instrument, “Amounts Outstanding of Over-the-Counter-Derivatives,” BIS Quarterly Review, June 2009, bis.org.
130 Excerpt “The collapse of Lehman Brothers, an investment bank…”: Henry Tricks, “Dirty Words: Derivatives, Defaults, Disaster,” The Economist, November 19, 2008.
130 Global Finance in Practice 5.1: Warren Buffett on the Credit Crisis from Berkshire Hathaway Annual Report, 2008, Letter to Shareholders. Reprinted by permission.
131 Exhibit 5.6: British Bankers Association (BBA) Overnight lending rates. 133 Exhibit 5.7: Dick K. Nanto, “The U.S. Financial Crisis: The Global Dimen-
sion with Implications for U.S. Policy,” Congressional Research Service, January 29, 2009, p. 11.
134 Excerpt “Today’s failure of confidence...”: “The Credit Crunch: Saving the System,” The Economist, October 9, 2008 (29 words)
136 Exhibit 5.9: Data from British Bankers Association, Bloomberg. 138 Excerpt “The Eurozone is facing a serious sovereign debt crisis...”: Rebecca
M. Nelson, Paul Belkin, and Derek E. Mix, “Greece’s Debt Crisis: Overview, Policy Responses, and Implications.”
140 Exhibit 5.10: Debt-to-GDP ratios from “Sovereign Default in the Eurozone: Greece and Beyond,” UBS Research Focus, October 2011, p. 10.
140 Excerpt “‘Bringing owls to Athens’—in other words, doing something use- less...”: “Sovereign Default in the Eurozone: Greece and Beyond,” UBS Research Focus, 29 September 2011, p. 14.
141 Excerpt “The EFSFs mandate is to safeguard...”: European Financial Stabil- ity Facility, www.efsf.europa.eu.
143 Excerpt “Market contagion and rating downgrades...”: Robert M. Fishman, “Portugal’s Unnecessary Bailout,” The New York Times, April 12, 2011.
144 Exhibit 5.11: European Central Bank, www.ecb.int/stats/money/long. 145 Exhibit 5.12: Data from International Monetary Fund (IMF). 146 Exhibit 5.13: Author calculations based on “Global Economic Outlook and
Strategy” Citigroup Global Markets, November 28, 2011, p. 4. 147 Excerpt “There are a number of factors that affect the euro-dollar exchange
rate...”: Rebecca M. Nelson, Paul Belkin, and Derek E. Mix, “Greece’s Debt Crisis: Overview, Policy Responses, and Implications.”
148 Excerpt “We find that serial default is a nearly universal phenomenon...”: From Carmen M. Reinhart and Kenneth S. Rogoff “This Time Is Different: A Panoramic View of Eight Centuries of Financial Crises,” April 16, 2008.
148 Excerpt “Moreover, private-sector indebtedness across the euro area…”: “State of the Union—Can the eurozone survive its debt crisis?” The Econo- mist Intelligent Unit, March 2011.
151 Mini-Case: Letting Go of Lehman Brothers SOURCE: Copyright © 2009 Michael H. Moffett.
153 Excerpt “For the equilibrium of the world financial system...”: Joe Nocera and Edmund L. Andrews,”The Reckoning: Struggling to Keep Up as the Crisis Raced On,” The New York Times, October 22, 2008.
Chapter 6 158 Quote “The best way to destroy the capitalist system...”: John Maynard
Keynes. 159 Exhibit 6.1: Federal Reserve Bank of New York “The Foreign Exchange
Market in the United States,” 2001, www.frd.ny.org. 161 Global Finance in Practice 6.1: Foreign Exchange and Money Market
Transactions, UBS Investment Bank, undated, pp. 54–55. 162 Global Finance in Practice 6.2: Compiled from “Reminiscences of an anony-
mous intern.”
164 Exhibit 6.3: Foreign Exchange and Money Market Transactions, UBS Investment Bank, undated, p. 58.
166 Exhibit 6.4: Bank for International Settlements, “Triennial Central Bank Survey: Foreign Exchange and Derivatives Market Activity in April 2010: Preliminary Results,” September 2010.
167 Exhibit 6.5: Data from Bank for International Settlements, “Triennial Central Bank Survey: Foreign Exchange and Derivatives Market Activity in April 2010: Preliminary Results,” September 2010.
168 Exhibit 6.6: Data from Bank for International Settlements, “Triennial Central Bank Survey: Foreign Exchange and Derivatives Market Activity in April 2010: Preliminary Results” September 2010.
178 Mini-Case: Copyright © 2011 Thunderbird School of Global Management. 178 Excerpt “The Venezuelan bolivar dropped…”: Kejal Vyas, “Venezuela Boli-
var Falls in Parallel Market After Devaluation,” The Wall Street Journal, January 3, 2011.
178 Excerpt “Whoever, in one or multiple transactions...”: Tamara Pearson, “Venezuela Temporarily Closes Parallel Currency Market,” Venezuela- nalysis.com, May 18, 2010.
180 Excerpt “South America’s largest oil-producing nation will devalue its cur- rency...”: Charlie Devereux and Dominic Carey, “Venezuela to Devalue Bolivar for Second Time This Quarter,” Bloomberg, January 7, 2011.
Chapter 7 185 Excerpt “... if capital flowed freely towards those countries...”: David Ricardo,
On the Principles of Political Economy and Taxation, 1817, Chapter 7. 186 Exhibit 7.1: Data for “Big Mac Price in Local Currency” and “Actual Dol-
lar Exchange Rate on July 25th” drawn from “The Big Mac Index,” The Economist, July 28, 2011.
190 Exhibit 7.3: Data from International Financial Statistics, IMF, Annual, CPI- weighted real effective exchange rate, series RECZF.
191 Global Finance in Practice 7.2: Elroy Dimson, Paul Marsh, and Mike Staunton, Triumph of the Optimists, 101 Years of Global Investment Returns, Princeton University Press, 2002, pp. 97–98.
205 Excerpt “The weak economic for the euro zone...”: “Euro Becomes Increas- ingly Popular Choice to Fund Carry Trades,” The Wall Street Journal, December 21, 2010.
Chapter 8 216 Excerpt “Unless derivatives contracts are collateralized...”: From Warren
Buffett, Berkshire Hathaway Annual Report, 2002. Reprinted by permission. 230 Global Finance in Practice 8.2: Data from Table 13B, BIS Quarterly Review,
March 2009, p. 91.
Chapter 9 246 Quote “The herd instinct among forecasters makes sheep look like indepen-
dent thinkers”: Edgar R. Fiedler. 248 Excerpt “Under the skin of an international economist lies...”: Paul Krugman
1976. 248 Excerpt “There are basically three views of the exchange rate...”: Rudiger
Dornbusch, “Exchange Rate Economics: Where Do We Stand?,” Brookings Papers on Economic Activity 1, 1980, pp. 143–194.
250 Excerpt “... the case for macroeconomic determinants of exchange rates...”: Jeffrey A. Frankel and Andrew K. Rose, “A Survey of Empirical Research on Nominal Exchange Rates,” NBER Working Paper No. 4865, 1994.
251 Excerpt “Many economists reject the view that the short-term behavior of exchange rates...”: From Solnik, Bruno, McLeavey, Dennis, International Investments, 5th Ed., © 2004. Reprinted and Electronically reproduced by permission of Pearson Education, Inc., Upper Saddle River, NY 07458.
252 Excerpt “A fundamental problem with exchange rates...”: “Japan’s Currency Intervention: Policy Issues,” Dick K. Nanto, CRS Report to Congress, July 13, 2007, CRS-7.
258 Excerpt “For Thailand to blame Mr. Soros for its plight...”: The Economist, August 2, 1997, p. 57.
258 Excerpt “The financial crisis that originated in Thailand...”: George Soros, “The Crisis of Global Capitalism: Open Society Endangered,” PublicAffairs, 2000.
259 Excerpt “There will be no devaluation—that’s firm and definite...”: President Boris Yeltsin, speech at Novgorode.
260 Excerpt “Now, most Argentines are blaming corrupt politicians...”: Anthony Faiola,”Once-Haughty Nation’s Swagger Loses Its Currency,” The Washington Post, March 13, 2002.
262 Excerpt “In reality, the Argentines understood the risk...”: From Martin Feldstein, “Argentina’s Fall.” Reprinted by permission of FOREIGN AFFAIRS, March/April 2002. Copyright (c) 2002 by the Council on Foreign Relations, Inc., www.ForeignAffairs.com.
269 Mini-Case: Copyright © 2011 Thunderbird School of Global Management. 269 Quote “We will take decisive steps if necessary...”: Yoshihiko Noda, Finance
Minister of Japan, September 13, 2010. 270 Quote “There is no historical case in which [yen] selling...”: Tohru Sasaki,
Currency Strategist, JPMorgan. 273 Forecasting the Pan-Pacific Pyramid: Australia, Japan & the United States:
Data from The Economist, October 20, 2007.
628
Chapter 10 275 Excerpt “There are two times in a man’s life when he should not speculate...”:
“Following the Equator,” Pudd’nead Wilson’s New Calendar, Mark Twain. 291 Mini-Case: Copyright © 2010 Thunderbird, School of Global Management.
This case was prepared by Kyle Mineo, MBA ’10, Saurabh Goyal, MBA ’10, and Tim Erion, MBA ’10, under the direction of Professor Michael Moffett.
Chapter 11 309 Quote “The pen is mightier than the sword, but no match for the accoun-
tant”: Jonathan Glancey. 320 Mini-Case: Copyright ©2010 Thunderbird School of Global Management.
All rights reserved. This case was prepared by Professor Michael Moffett.
Chapter 12 326 Excerpt “The essence of risk management lies in...”: Peter Bernstein, Against
the Gods, Wiley, 1996. 330 Excerpt “These results support the hypothesis...”: Ila Patnaik and Ajay Shah,
“Does the currency regime shape unhedged currency exposure?,” Journal of International Money and Finance, 29, 2010, pp. 760–769.
Chapter 13 355 Exhibit 13.2: Data from from Rene Stulz, “The Cost of Capital in Interna-
tionally Integrated Markets: The Case of Nestlé,” European Financial Man- agement, Vol. 1, No. 1, March 1995, 11–22.
357 Exhibit 13.4: Equity risk premium quotes from “Stockmarket Valuations: Great Expectations,” The Economist, January 31, 2002.
362 Excerpt “Using a sample of firms with headquarters...”: Lars Oxelheim and Trond Randøy, “The impact of foreign board membership on firm value,” Journal of Banking and Finance, Vol. 27, No. 12, 2003, p. 2369.
367 Mini-Case: Based on Arthur Stonehill and Kåre B. Dullum, International- izing the Cost of Capital in Theory and Practice: The Novo Experience and National Policy Implications (Copenhagen: Nyt Nordisk Forlag Arnold Busck, 1982; and New York: Wiley, 1982).
Chapter 14 376 Excerpt “Do what you will, the capital is at hazard...”: Prudent Man Rule,
Justice Samuel Putnam, 1830. 377 Exhibit 14.1: Oxelheim, Stonehill, Randoy, Vikkula, Dullum and Moden,
Corporate Strategies in Internationalizing the Cost of Capital, Copenhagen Business School Press, 1998, p. 119.
387 Exhibit 14.6: Based on “Depositary Receipts Reference Guide,” JPMorgan, 2005, p. 33.
389 Exhibit 14.8: Data from “Depositary Receipts, Year in Review 2011,” JPMorgan, p. 9.
390 Excerpt “UBS is pioneering the Global Registered Share (GRS)...”: From UBS GRSs, Frequently Asked Questions, www.ubs.com/global/en/ about_ubs/investor_relations/faq.
401 Mini-Case: Copyright ©2012 Thunderbird School of Global Management. This case was prepared by Noah Emergy, Maria Iliopoulou, and Jones Dias under the direction of Professor Michael Moffett.
401 Excerpt “’Bringing owls to Athens’—in other words, doing something useless...”: From “Sovereign Default in the Eurozone: Greece and Beyond,” UBS Research Focus, 29 September 2011, p. 14. Copyright © UBS 2011. All rights reserved.
403 Exhibit 3: Data from Korres Natural Products and author calculations. 404 Exhibit 4: Data from Korres Natural Products and author calculations. 406 Excerpt “Some firms are finding ways round the stigma...”: “Greece and the
Euro: An Economy Crumbles,” The Economist, January 28, 2012, p. 70.
Chapter 15 415 Excerpt “Over and over again courts have said...”: Judge Learned Hand,
Commissioner v. Newman, 159 F.2d 848 (CA-2, 1947). 418 Exhibit 15.1: “Special Report: The Importance of Tax Deferral and a Lower
Corporate Tax Rate,” Tax Foundation, February 2010, No. 174, p. 4. 420 Exhibit 15.2: KPMG’s Corporate and Indirect Tax Rate Survey, 2011. 421 Exhibit 15.3: KPMG’s Corporate and Indirect Tax Rate Survey, 2011, p. 23 423 U.S. Dividend Repatriations, 1994–2010: Data from Bureau of Economic
Analysis, Joint Committee on Taxation, Congressional Research Service. 430 Mini-Case: Copyright © 2011 Michael H. Moffett. 430 Excerpt “So tonight, I’m asking Democrats and Republicans to simplify the sys-
tem...”: President Barack Obama, State of the Union Address, January 25, 2011. 431 Exhibit 1: Data from Center for Tax Policy and Administration, OECD.org. 432 Exhibit 2: Randy Myers, “Taxed to the Max,” CFO Magazine, March 1, 2009,
graph “Steady to a Fault.” 432 Excerpt “There are big companies that consider their tax departments to be
profit centers”: National Public Radio, January 29, 2011. 432 Excerpt “They make money by moving income overseas...”: Martin Sullivan, tax
expert, testimony before the House Ways and Means Committee, January 20, 2011. 432 Excerpt “I’m asking Congress to eliminate the billions in taxpayer dollars...”:
President Barack Obama, excerpts from the State of the Union Address, January 2011.
433 Exhibit 3: Martin Sullivan, tax expert, testimony before the House Ways and Means Committee, January 20, 2011.
433 Exhibit 4: Data from Peter Cohn and Mathrew Conniti, “The Multinational Tax Advantage,” BusinessWeek, January 20, 2011.
Chapter 16 440 Excerpt “It is not a case of choosing those which...”: John Maynard Keynes,
The General Theory of Employment, Interest, and Money, 1936. 449 Exhibit 16.7: Author estimates for the 1970–2010 period. 450 Exhibit 16.8: Data from Dimson, March, and Staunton, “Coefficients drawn
from Triumph of the Optimists,” 101 Years of Global Investment Returns, Princeton University Press, 2002, p. 15; Authors calculations using data extracted over multiple issues of Morgan Stanley Capital International.
454 Mini-Case: Based on Andrew Dales and Richard Meese, “Currency Man- agement: Strategies to Add Alpha and Reduce Risk,” Investment Insights, Barclays Global Investment, October 2003, Volume 6, Issue 7.
454 Excerpt “Put another way, investors...”: “Black Monday and Black Swans,” remarks by John C. Bogle, Founder and former Chief Executive, the Vanguard Group.
455 Excerpt “Any attempts to refine...”: Benoit Mandelbrot and Nassim Taleb, “A focus on the exceptions that prove the rule” Financial Times, March 23, 2006.
456 Excerpt “The statisticians subjected...”: Kenneth Arrow, “I Know a Hawk from a Handsaw” in Eminent Economists: Their Life Philosophies, edited by Michael Szenberg, Cambridge University Press, 1992, p. 47.
Chapter 17 460 Quote “People don’t want a quarter-inch drill...”: Theodore Levitt, Harvard
Business School. 462 Exhibit 17.1: Based on concepts described by Michael Porter in “The Com-
petitive Advantage of Nations” Harvard Business Review, March–April 1990.
464 Exhibit 17.2: Based on Finance-Specific Factors and the OLI Paradigm: Data from Lars Oxelheim, Arthur Stonehill and Trond Randøy, “On the Treat- ment of Finance Specific Factors Within the OLI Paradigm,” International Business Review, 10 (2001), pp. 381–398.
466 Exhibit 17.3: Adapted from Gunter Dufey and R. Mirus, “Foreign Direct Investment: Theory and Strategic Considerations,” unpublished, University of Michigan, 1985.
482 Hospira Statement Regarding Pentothal (TM) (Sodium Thiopental) Market Exit, Hospira press statement, January 21, 2011, Hospira.com. Reprinted by permission.
486 Excerpt “BCG argues that this is because they have managed...”: “Nipping at Their Heels: Firms from the Developing World Are Rapidly Catching Up with Their Old-World Competitors,” The Economist, January 22, 2011, p. 80.
487 Excerpt “All this is impressive...”: “Nipping at Their Heels: Firms from the Developing World Are Rapidly Catching Up with Their Old-World Com- petitors,” The Economist, January 22, 2011, p. 80.
Chapter 18 490 Quote “Whales only get harpooned when they come to the surface...”:
Charles A. Jaffe. 508 Exhibit 18.7: UNCTAD World Development Report 2000: Cross-border
Mergers and Acquisitions and Development, Figure V.1, p. 154. 512 Exhibit 18.9: Data from Eileen Liu and Michael J. Mariano, “Hedging Cur-
rency Risk in Cross-Border Acquisitions,” JPMorgan. 514 Mini-Case: Copyright © 2011 Thunderbird School of Global Management. 514 Excerpt “On 13 August 2009, the Felix Board announced...”: Felix Resources,
Scheme Booklet, 30 September 2009, p. 6. 514 Excerpt “While we continue to believe the emergence of a counter-bidder...”:
“Felix Resources: A New Year, A New Mine,” Macquarie Equities, 1 Sep- tember 2009, p. 1.
515 Exhibit 1: Data from International Monetary Fund. 516 Excerpt “Yanzhou is the latest in a long line of Chinese suitors...”: “Linc
Energy ends talks with Yanzhou over sale,” Financial Times, June 24, 2009. All rights reserved.
519 Exhibit 4: Bloomberg, DBS Vickers. Analysis revised by authors based on “Hong Kong/China Flash Notes: Yanzhou Coal,” DBS Group Research Equity, 14 August 2009 p. 2.
520 Exhibit 5: “Yanzhou Coal,” Flash Notes, DBS Group Research, 14 August 2009.
Chapter 19 528 Quote “Morality is all right...”: Kaiser Wilhelm II. 537 Exhibit 19.5: REL Cash Flow Delivered, The Hackett Group, CFO Maga-
zine, 2011.
Chapter 20 556 Quote “Financial statements are like fine perfume...”: Abraham Brilloff. 575 Mini-Case: Copyright ©1996, Thunderbird School of Global Management.
This case was prepared by Doug Mathieux and Geoff Mathieux under the direction of Professors Michael H. Moffett and James L. Mills.
2300 2200 2100 2000 1900 1800 1700 1600 1500 1400 1300 1200 1
–10 –09 –08 –07 –06 –05 –04 –03 –02 –01 –00
Greenwic
Hours diffe
The World of Foreign Exchange Dealing
San Francisco Chicago
New York
London
Frankfurt
San Francisco Chicago
New York London
Frankfurt
Foreign Exchange Dealing Times: GMT
00 1000 0900 0800 0600 04000700 0500 0300 0200 0100 2400
01 +02 +03 +04 +06 +08+05 +07 +09 +10 +11 +12
2300 h Mean Time
rent from GMT
Bahrain
Singapore
Hong Kong
Tokyo
Sydney
Singapore
Hong Kong
Bahrain Tokyo and Sydney
Country Currency ISO-4217
Code Symbol Afghanistan Afghan afghani AFN
Albania Albanian lek ALL
Algeria Algerian dinar DZD
American Samoa see United States
Andorra see Spain and France
Angola Angolan kwanza AOA
Anguilla East Caribbean dollar XCD EC$
Antigua and Barbuda East Caribbean dollar XCD EC$
Argentina Argentine peso ARS
Armenia Armenian dram AMD
Aruba Aruban florin AWG f
Australia Australian dollar AUD $
Austria European euro EUR €
Azerbaijan Azerbaijani manat AZN
Bahamas Bahamian dollar BSD B$
Bahrain Bahraini dinar BHD
Bangladesh Bangladeshi taka BDT
Barbados Barbadian dollar BBD Bds$
Belarus Belarusian ruble BYR Br
Belgium European euro EUR €
Belize Belize dollar BZD BZ$
Benin West African CFA franc XOF CFA
Bermuda Bermudian dollar BMD BD$
Bhutan Bhutanese ngultrum BTN Nu.
Bolivia Bolivian boliviano BOB Bs.
Bosnia-Herzegovina Bosnia and Herzegovina konvertibilna marka BAM KM
Botswana Botswana pula BWP P
Brazil Brazilian real BRL R$
British Indian Ocean Territory see United Kingdom
Brunei Brunei dollar BND B$
Bulgaria Bulgarian lev BGN
Burkina Faso West African CFA franc XOF CFA
Burma see Myanmar
Burundi Burundi franc BIF FBu
Cambodia Cambodian riel KHR
Cameroon Central African CFA franc XAF CFA
Canada Canadian dollar CAD $
Canton and Enderbury Islands see Kiribati
Cape Verde Cape Verdean escudo CVE Esc
Cayman Islands Cayman Islands dollar KYD KY$
Central African Republic Central African CFA franc XAF CFA
Chad Central African CFA franc XAF CFA
Chile Chilean peso CLP $
Currencies of the World
Country Currency ISO-4217
Code Symbol China Chinese renminbi CNY ¥
Christmas Island see Australia
Cocos (Keeling) Islands see Australia
Colombia Colombian peso COP Col$
Comoros Comorian franc KMF
Congo Central African CFA franc XAF CFA
Congo, Democratic Republic Congolese franc CDF F
Cook Islands see New Zealand
Costa Rica Costa Rican colon CRC C
Côte d’Ivoire West African CFA franc XOF CFA
Croatia Croatian kuna HRK kn
Cuba Cuban peso CUC $
Cyprus European euro EUR €
Czech Republic Czech koruna CZK Kč
Denmark Danish krone DKK Kr
Djibouti Djiboutian franc DJF Fdj
Dominica East Caribbean dollar XCD EC$
Dominican Republic Dominican peso DOP RD$
Dronning Maud Land see Norway
East Timor see Timor-Leste
Ecuador uses the U.S. Dollar
Egypt Egyptian pound EGP £
El Salvador uses the U.S. Dollar
Equatorial Guinea Central African CFA franc GQE CFA
Eritrea Eritrean nakfa ERN Nfa
Estonia Estonian kroon EEK KR
Ethiopia Ethiopian birr ETB Br
Faeroe Islands (Føroyar) see Denmark
Falkland Islands Falkland Islands pound FKP £
Fiji Fijian dollar FJD FJ$
Finland European euro EUR €
France European euro EUR €
French Guiana see France
French Polynesia CFP franc XPF F
Gabon Central African CFA franc XAF CFA
Gambia Gambian dalasi GMD D
Georgia Georgian lari GEL
Germany European euro EUR €
Ghana Ghanaian cedi GHS
Gibraltar Gibraltar pound GIP £
Great Britain see United Kingdom
Greece European euro EUR €
Greenland see Denmark
Country Currency ISO-4217
Code Symbol Grenada East Caribbean dollar XCD EC$
Guadeloupe see France
Guam see United States
Guatemala Guatemalan quetzal GTQ Q
Guernsey see United Kingdom
Guinea-Bissau West African CFA franc XOF CFA
Guinea Guinean franc GNF FG
Guyana Guyanese dollar GYD GY$
Haiti Haitian gourde HTG G
Heard and McDonald Islands see Australia
Honduras Honduran lempira HNL L
Hong Kong Hong Kong dollar HKD HK$
Hungary Hungarian forint HUF Ft
Iceland Icelandic króna ISK kr
India Indian rupee INR
Indonesia Indonesian rupiah IDR Rp
International Monetary Fund Special Drawing Rights XDR SDR
Iran Iranian rial IRR
Iraq Iraqi dinar IQD
Ireland European euro EUR €
Isle of Man see United Kingdom
Israel Israeli new sheqel ILS
Italy European euro EUR €
Ivory Coast see Côte d’Ivoire
Jamaica Jamaican dollar JMD J$
Japan Japanese yen JPY ¥
Jersey see United Kingdom
Johnston Island see United States
Jordan Jordanian dinar JOD
Kampuchea see Cambodia
Kazakhstan Kazakhstani tenge KZT T
Kenya Kenyan shilling KES KSh
Kiribati see Australia
Korea, North North Korean won KPW W
Korea, South South Korean won KRW W
Kuwait Kuwaiti dinar KWD
Kyrgyzstan Kyrgyzstani som KGS
Laos Lao kip LAK KN
Latvia Latvian lats LVL Ls
Lebanon Lebanese lira LBP
Lesotho Lesotho loti LSL M
Liberia Liberian dollar LRD L$
Libya Libyan dinar LYD LD
Currencies of the World (continued)
Country Currency ISO-4217
Code Symbol Liechtenstein uses the Swiss Franc
Lithuania Lithuanian litas LTL Lt
Luxembourg European euro EUR €
Macau Macanese pataca MOP P
Macedonia (Former Yug. Rep.) Macedonian denar MKD
Madagascar Malagasy ariary MGA FMG
Malawi Malawian kwacha MWK MK
Malaysia Malaysian ringgit MYR RM
Maldives Maldivian rufiyaa MVR Rf
Mali West African CFA franc XOF CFA
Malta European Euro EUR €
Martinique see France
Mauritania Mauritanian ouguiya MRO UM
Mauritius Mauritian rupee MUR Rs
Mayotte see France
Micronesia see United States
Midway Islands see United States
Mexico Mexican peso MXN $
Moldova Moldovan leu MDL
Monaco see France
Mongolia Mongolian tugrik MNT T
Montenegro see Italy
Montserrat East Caribbean dollar XCD EC$
Morocco Moroccan dirham MAD
Mozambique Mozambican metical MZM MTn
Myanmar Myanma kyat MMK K
Nauru see Australia
Namibia Namibian dollar NAD N$
Nepal Nepalese rupee NPR NRs
Netherlands Antilles Netherlands Antillean gulden ANG NAf
Netherlands European euro EUR €
New Caledonia CFP franc XPF F
New Zealand New Zealand dollar NZD NZ$
Nicaragua Nicaraguan córdoba NIO C$
Niger West African CFA franc XOF CFA
Nigeria Nigerian naira NGN N
Niue see New Zealand
Norfolk Island see Australia
Northern Mariana Islands see United States
Norway Norwegian krone NOK kr
Oman Omani rial OMR
Pakistan Pakistani rupee PKR Rs.
Palau see United States
Country Currency ISO-4217
Code Symbol Panama Panamanian balboa PAB B./
Panama Canal Zone see United States
Papua New Guinea Papua New Guinean kina PGK K
Paraguay Paraguayan guarani PYG
Peru Peruvian nuevo sol PEN S/.
Philippines Philippine peso PHP P
Pitcairn Island see New Zealand
Poland Polish zloty PLN
Portugal European euro EUR €
Puerto Rico see United States
Qatar Qatari riyal QAR QR
Reunion see France
Romania Romanian leu RON L
Russia Russian ruble RUB R
Rwanda Rwandan franc RWF RF
Samoa (Western) see Western Samoa
Samoa (America) see United States
San Marino see Italy
São Tomé and Príncipe São Tomé and Príncipe dobra STD Db
Saudi Arabia Saudi riyal SAR SR
Sénégal West African CFA franc XOF CFA
Serbia Serbian dinar RSD din.
Seychelles Seychellois rupee SCR SR
Sierra Leone Sierra Leonean leone SLL Le
Singapore Singapore dollar SGD S$
Slovakia European Euro EUR €
Slovenia European euro EUR €
Solomon Islands Solomon Islands dollar SBD SI$
Somalia Somali shilling SOS Sh.
South Africa South African rand ZAR R
Spain European euro EUR €
Sri Lanka Sri Lankan rupee LKR Rs
St. Helena Saint Helena pound SHP £
St. Kitts and Nevis East Caribbean dollar XCD EC$
St. Lucia East Caribbean dollar XCD EC$
St. Vincent and the Grenadines East Caribbean dollar XCD EC$
Sudan Sudanese pound SDG
Suriname Surinamese dollar SRD $
Svalbard and Jan Mayen Islands see Norway
© 2011 by Werner Antweiler, University of British Columbia. All rights reserved. The Pacific Exchange Rate Service is located in Vancouver, Canada. A continuously updated version of this table can be found on the Web at http://pacific.commerce.ubc.ca/xr/currency_table.html. This Web site was accessed in May 2011 to create the table shown here.
Currencies of the World (continued)
Country Currency ISO-4217
Code Symbol Swaziland Swazi lilangeni SZL E
Sweden Swedish krona SEK kr
Switzerland Swiss franc CHF Fr.
Syria Syrian pound SYP
Tahiti see French Polynesia
Taiwan New Taiwan dollar TWD NT$
Tajikistan Tajikistani somoni TJS
Tanzania Tanzanian shilling TZS
Thailand Thai baht THB B
Timor-Leste uses the U.S. dollar
Togo West African CFA franc XOF CFA
Trinidad and Tobago Trinidad and Tobago dollar TTD TT$
Tunisia Tunisian dinar TND DT
Turkey Turkish new lira TRY YTL
Turkmenistan Turkmen manat TMM m
Turks and Caicos Islands see United States
Tuvalu see Australia
Uganda Ugandan shilling UGX USh
Ukraine Ukrainian hryvnia UAH
United Arab Emirates UAE dirham AED
United Kingdom British pound GBP £
United States of America United States dollar USD US$
Upper Volta see Burkina Faso
Uruguay Uruguayan peso UYU $U
Uzbekistan Uzbekistani som UZS
Vanuatu Vanuatu vatu VUV VT
Vatican see Italy
Venezuela Venezuelan bolivar VEB Bs
Vietnam Vietnamese dong VND d
Virgin Islands see United States
Wake Island see United States
Wallis and Futuna Islands CFP franc XPF F
Western Sahara see Spain, Mauritania, and Morocco
Western Samoa Samoan tala WST WS$
Yemen Yemeni rial YER
Zaïre see Congo, Democratic Republic
Zambia Zambian kwacha ZMK ZK
Zimbabwe Zimbabwean dollar ZWD Z$
- Cover
- Title Page
- Copyright Page
- Contents
- Preface
- About the Authors
- PART I: Global Financial Environment
- Chapter 1 Current Multinational Challenges and the Global Economy
- Financial Globalization and Risk
- The Global Financial Marketplace
- The Theory of Comparative Advantage
- What Is Different About International Financial Management?
- Market Imperfections: A Rationale for the Existence of the Multinational Firm
- The Globalization Process
- Summary Points
- MINI-CASE: Nine Dragons Paper and the 2009 Credit Crisis
- Questions
- Problems
- Internet Exercises
- Chapter 2 Corporate Ownership, Goals, and Governance
- Who Owns the Business?
- The Goal of Management
- Summary Points
- MINI-CASE: Luxury Wars—LVMH vs. Hermès
- Questions
- Problems
- Internet Exercises
- Chapter 3 The International Monetary System
- History of the International Monetary System
- IMF Classification of Currency Regimes
- Fixed Versus Flexible Exchange Rates
- A Single Currency for Europe: The Euro
- Emerging Markets and Regime Choices
- Exchange Rate Regimes: What Lies Ahead?
- Summary Points
- MINI-CASE: The Yuan Goes Global
- Questions
- Problems
- Internet Exercises
- Chapter 4 The Balance of Payments
- Typical Balance of Payments Transactions
- Fundamentals of Balance of Payments Accounting
- The Accounts of the Balance of Payments
- The Capital and Financial Accounts
- Breaking the Rules: China’s Twin Surpluses
- The Balance of Payments in Total
- The Balance of Payments Interaction with Key Macroeconomic Variables
- Trade Balances and Exchange Rates
- Capital Mobility
- Summary Points
- MINI-CASE: Global Remittances
- Questions
- Problems
- Internet Exercises
- Chapter 5 The Continuing Global Financial Crisis
- The Credit Crisis of 2008–2009
- Global Contagion
- The European Debt Crisis of 2009–2012
- Summary Points
- MINI-CASE: Letting Go of Lehman Brothers
- Questions
- Problems
- Internet Exercises
- PART II: Foreign Exchange Theory and Markets
- Chapter 6 The Foreign Exchange Market
- Geographical Extent of the Foreign Exchange Market
- Functions of the Foreign Exchange Market
- Market Participants
- Transactions in the Foreign Exchange Market
- Size of the Foreign Exchange Market
- Foreign Exchange Rates and Quotations
- Summary Points
- MINI-CASE: The Saga of the Venezuelan Bolivar Fuerte
- Questions
- Problems
- Internet Exercises
- Chapter 7 International Parity Conditions
- Prices and Exchange Rates
- Exchange Rate Pass-Through
- The Forward Rate
- Prices, Interest Rates, and Exchange Rates in Equilibrium
- Summary Points
- MINI-CASE: Emerging Market Carry Trades
- Questions
- Problems
- Internet Exercises
- Appendix: An Algebraic Primer to International Parity Conditions
- Chapter 8 Foreign Currency Derivatives and Swaps
- Foreign Currency Futures
- Option Pricing and Valuation
- Interest Rate Derivatives
- Summary Points
- MINI-CASE: McDonald’s Corporation’s British Pound Exposure
- Questions
- Problems
- Internet Exercises
- PART III: Foreign Exchange Exposure
- Chapter 9 Foreign Exchange Rate Determination and Forecasting
- Exchange Rate Determination: The Theoretical Thread
- Currency Market Intervention
- Disequilibrium: Exchange Rates in Emerging Markets
- Forecasting in Practice
- Summary Points
- MINI-CASE: The Japanese Yen Intervention of 2010
- Questions
- Problems
- Internet Exercises
- Chapter 10 Transaction Exposure
- Types of Foreign Exchange Exposure
- Trident’s Transaction Exposure
- Summary Points
- MINI-CASE: Banbury Impex (India)
- Questions
- Problems
- Internet Exercises
- Appendix: Complex Option Hedges
- Chapter 11 Translation Exposure
- Overview of Translation
- Translation Methods
- U.S. Translation Procedures
- Trident Corporation’s Translation Exposure
- Trident Corporation’s Translation Exposure: Income
- Summary Points
- MINI-CASE: LaJolla Engineering Services
- Questions
- Problems
- Chapter 12 Operating Exposure
- Trident Corporation: A Multinational’s Operating Exposure
- Measuring Operating Exposure: Trident Germany
- Strategic Management of Operating Exposure
- Proactive Management of Operating Exposure
- Summary Points
- MINI-CASE: Toyota’s European Operating Exposure
- Questions
- Problems
- Internet Exercises
- PART IV: Financing the Global Firm
- Chapter 13 The Global Cost and Availability of Capital
- Financial Globalization and Strategy
- The Demand for Foreign Securities: The Role of International Portfolio Investors
- The Cost of Capital for MNEs Compared to Domestic Firms
- The Riddle: Is the Cost of Capital Higher for MNEs?
- Summary Points
- MINI-CASE: Novo Industri A/S (Novo)
- Questions
- Problems
- Internet Exercises
- Chapter 14 Raising Equity and Debt Globally
- Designing a Strategy to Source Capital Globally
- Optimal Financial Structure
- Raising Equity Globally
- Depositary Receipts
- Private Placement
- Foreign Equity Listing and Issuance
- Raising Debt Globally
- Summary Points
- MINI-CASE: Korres Natural Products and the Greek Crisis
- Questions
- Problems
- Internet Exercises
- Appendix: Financial Structure of Foreign Subsidiaries
- Chapter 15 Multinational Tax Management
- Tax Principles
- Summary Points
- MINI-CASE: The U.S. Corporate Income Tax Conundrum
- Questions
- Problems
- Internet Exercises
- PART V: Foreign Investment Decisions
- Chapter 16 International Portfolio Theory and Diversification
- International Diversification and Risk
- Internationalizing the Domestic Portfolio
- National Markets and Asset Performance
- Market Performance Adjusted for Risk: The Sharpe and Treynor Performance Measures
- Summary Points
- MINI-CASE: Portfolio Theory, Black Swans, and [Avoiding] Being the Turkey
- Questions
- Problems
- Internet Exercises
- Chapter 17 Foreign Direct Investment and Political Risk
- Sustaining and Transferring Competitive Advantage
- Deciding Where to Invest
- How to Invest Abroad: Modes of Foreign Involvement
- Political Risk
- Summary Points
- MINI-CASE: Corporate Competition from the Emerging Markets
- Questions
- Internet Exercises
- Chapter 18 Multinational Capital Budgeting and Cross-Border Acquisitions
- Complexities of Budgeting for a Foreign Project
- Project Versus Parent Valuation
- Illustrative Case: Cemex Enters Indonesia
- Project Financing
- Summary Points
- MINI-CASE: Yanzhou (China) Bids for Felix Resources (Australia)
- Questions
- Problems
- Internet Exercises
- PART VI: Managing Multinational Operations
- Chapter 19 Working Capital Management
- Trident Brazil’s Operating Cycle
- Trident’s Repositioning Decisions
- Constraints on Repositioning Funds
- Conduits for Moving Funds by Unbundling Them
- International Dividend Remittances
- Net Working Capital
- International Cash Management
- Financing Working Capital
- Summary Points
- MINI-CASE: Honeywell and Pakistan International Airways
- Questions
- Problems
- Internet Exercises
- Chapter 20 International Trade Finance
- The Trade Relationship
- The Trade Dilemma
- Benefits of the System
- Key Documents
- Example: Documentation in a Typical Trade Transaction
- Government Programs to Help Finance Exports
- Forfaiting: Medium- and Long-Term Financing
- Summary Points
- MINI-CASE: Crosswell International and Brazil
- Questions
- Problems
- Internet Exercises
- Answers to Selected End-of-Chapter Problems
- Glossary
- A
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- W
- Y
- Z
- Index
- A
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- D
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- F
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- M
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- W
- Y
- Credits