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International Financial Management ABRIDGED 10TH EDITION

J E F F M A D U R A Florida Atlantic University

Australia • Brazil • Japan • Korea • Mexico • Singapore • Spain • United Kingdom • United States

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International Financial Management, Abridged 10th Edition Jeff Madura

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Dedicated to Mary

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Brief Contents

PART 1: The International Financial Environment 1 1 Multinational Financial Management: An Overview 3 2 International Flow of Funds 27 3 International Financial Markets 55 4 Exchange Rate Determination 95 5 Currency Derivatives 117

PART 2: Exchange Rate Behavior 169 6 Government Influence on Exchange Rates 171 7 International Arbitrage and Interest Rate Parity 203 8 Relationships among Inflation, Interest Rates, and Exchange Rates 233

PART 3: Exchange Rate Risk Management 271 9 Forecasting Exchange Rates 273 10 Measuring Exposure to Exchange Rate Fluctuations 303 11 Managing Transaction Exposure 333 12 Managing Economic Exposure and Translation Exposure 373

PART 4: Long-Term Asset and Liability Management 395 13 Direct Foreign Investment 397 14 Multinational Capital Budgeting 415 15 International Corporate Governance and Control 451 16 Country Risk Analysis 477 17 Multinational Cost of Capital and Capital Structure

This chapter is made available to you at www.cengage.com/finance/madura.

18 Long-Term Financing This chapter is made available to you at www.cengage.com/finance/madura.

PART 5: Short-Term Asset and Liability Management 557 19 Financing International Trade

This chapter is made available to you at www.cengage.com/finance/madura.

20 Short-Term Financing This chapter is made available to you at www.cengage.com/finance/madura.

21 International Cash Management This chapter is made available to you at www.cengage.com/finance/madura.

Appendix A: Answers to Self-Test Questions, 635

Appendix B: Supplemental Cases Cases for web-only chapters are made available to you at www.cengage.com/finance/madura.

Appendix C: Using Excel to Conduct Analysis, 669

v

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Appendix D: International Investing Project, 677

Appendix E: Discussion in the Boardroom Exercises for web-only chapters are made available to you at www.cengage.com/finance/madura.

Glossary, 689

Direct Exchange Rates over Time, 699

Index, 703

International Credit Crisis Timeline, 710

vi Brief Contents

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Contents

From the Publisher, xxi Preface, xxiii About the Author, xxix

PART 1: The International Financial Environment 1

1: MULTINATIONAL FINANCIAL MANAGEMENT: AN OVERVIEW 3

Managing the MNC, 3 Facing Agency Problems, 4

Governance: How SOX Improved Corporate Governance of MNCs, 5 Management Structure of an MNC, 6

Why Firms Pursue International Business, 6 Theory of Comparative Advantage, 6 Imperfect Markets Theory, 8 Product Cycle Theory, 8

How Firms Engage in International Business, 8 International Trade, 9 Licensing, 10 Franchising, 10 Joint Ventures, 10 Acquisitions of Existing Operations, 10 Establishing New Foreign Subsidiaries, 11 Summary of Methods, 11

Valuation Model for an MNC, 13 Domestic Model, 13 Valuing International Cash Flows, 13 Uncertainty Surrounding an MNC’s Cash Flows, 15 Uncertainty of an MNC’s Cost of Capital, 17

Organization of the Text, 17 Summary, 18 Point Counter-Point: Should an MNC Reduce Its Ethical Standards to Compete

Internationally? 18 Self-Test, 19 Questions and Applications, 19

Advanced Questions, 20 Discussion in the Boardroom, 22 Running Your Own MNC, 22

Blades, Inc. Case: Decision to Expand Internationally, 23 Small Business Dilemma: Developing a Multinational Sporting

Goods Corporation, 24 Internet/Excel Exercises, 25 References, 25

Term Paper on the International Credit Crisis, 26

v i i

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2: INTERNATIONAL FLOW OF FUNDS 27 Balance of Payments, 27

Current Account, 27 Capital and Financial Accounts, 28

International Trade Flows, 30 Distribution of U.S. Exports and Imports, 30 U.S. Balance-of-Trade Trend, 32

International Trade Issues, 34 Events That Increased International Trade, 34 Trade Friction, 36

Governance: Managerial Decision about Outsourcing, 37 Factors Affecting International Trade Flows, 39

Impact of Inflation, 39 Impact of National Income, 39 Impact of Government Policies, 39 Impact of Exchange Rates, 40 Interaction of Factors, 41

Correcting a Balance-of-Trade Deficit, 41 Limitations of a Weak Home Currency Solution, 41

International Capital Flows, 43 Distribution of DFI by U.S. Firms, 44 Distribution of DFI in the United States, 44 Factors Affecting DFI, 44 Factors Affecting International Portfolio Investment, 45 Impact of International Capital Flows, 45

Agencies That Facilitate International Flows, 47 International Monetary Fund, 47 World Bank, 48 World Trade Organization, 48 International Financial Corporation, 48 International Development Association, 49 Bank for International Settlements, 49 OECD, 49 Regional Development Agencies, 49

How Trade Affects an MNC’s Value, 49 Summary, 50 Point Counter-Point: Should Trade Restrictions Be Used to Influence Human Rights Issues? 50 Self-Test, 50 Questions and Applications, 51

Advanced Questions, 51 Discussion in the Boardroom, 51 Running Your Own MNC, 51

Blades, Inc. Case: Exposure to International Flow of Funds, 52 Small Business Dilemma: Identifying Factors That Will Affect the Foreign Demand at the

Sports Exports Company, 52 Internet/Excel Exercises, 53 References, 53

3: INTERNATIONAL FINANCIAL MARKETS 55

Foreign Exchange Market, 55 History of Foreign Exchange, 55 Foreign Exchange Transactions, 56

viii Contents

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Foreign Exchange Quotations, 58 Interpreting Foreign Exchange Quotations, 61 Forward, Futures, and Options Markets, 64

International Money Market, 65 Origins and Development, 66 Money Market Interest Rates among Currencies, 67 Standardizing Global Bank Regulations, 68

International Credit Market, 69 Syndicated Loans, 69 Impact of the Credit Crisis on the Credit Market, 70

International Bond Market, 70 Eurobond Market, 70 Development of Other Bond Markets, 72

International Stock Markets, 72 Issuance of Stock in Foreign Markets, 72 Issuance of Foreign Stock in the United States, 73 Listing of Non-U.S. Firms on U.S. Stock Exchanges, 75

Governance: Effect of Sarbanes-Oxley Act on Foreign Stock Listings, 75 Investing in Foreign Stock Markets, 75

Governance: How Stock Market Characteristics Vary among Countries, 76 How Financial Markets Serve MNCs, 78 Summary, 79 Point Counter-Point: Should Firms That Go Public Engage in International Listings? 79 Self-Test, 80 Questions and Applications, 80

Advanced Questions, 81 Discussion in the Boardroom, 82 Running Your Own MNC, 82

Blades, Inc. Case: Decisions to Use International Financial Markets, 82 Small Business Dilemma: Use of the Foreign Exchange Markets by the Sports Exports

Company, 83 Internet/Excel Exercises, 83 References, 84

Appendix 3: Investing in International Financial Markets is made available to you at www. cengage.com/finance/madura.

4: EXCHANGE RATE DETERMINATION 95

Measuring Exchange Rate Movements, 95 Exchange Rate Equilibrium, 96

Demand for a Currency, 97 Supply of a Currency for Sale, 97 Equilibrium, 98

Factors That Influence Exchange Rates, 99 Relative Inflation Rates, 100 Relative Interest Rates, 101 Relative Income Levels, 102 Government Controls, 102 Expectations, 103 Interaction of Factors, 104 Influence of Factors across Multiple Currency Markets, 105

Contents ix

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Movements in Cross Exchange Rates, 106 Explaining Movements in Cross Exchange Rates, 107

Anticipation of Exchange Rate Movements, 107 Bank Speculation Based on Expected Appreciation, 107 Bank Speculation Based on Expected Depreciation, 108 Speculation by Individuals, 109

Summary, 110 Point Counter-Point: How Can Persistently Weak Currencies Be Stabilized? 110 Self-Test, 111 Questions and Applications, 111

Advanced Questions, 112 Discussion in the Boardroom, 114 Running Your Own MNC, 114

Blades, Inc. Case: Assessment of Future Exchange Rate Movements, 114 Small Business Dilemma: Assessment by the Sports Exports Company of Factors That Affect

the British Pound’s Value, 115 Internet/Excel Exercises, 116 References, 116

5: CURRENCY DERIVATIVES 117

Forward Market, 117 How MNCs Use Forward Contracts, 117 Non-Deliverable Forward Contracts, 120

Currency Futures Market, 121 Contract Specifications, 122 Trading Currency Futures, 123 Trading Platforms for Currency Futures, 123 Comparison to Forward Contracts, 123 Pricing Currency Futures, 124 Credit Risk of Currency Futures Contracts, 125 How Firms Use Currency Futures, 125 Closing Out a Futures Position, 125 Speculation with Currency Futures, 126

Currency Options Market, 127 Option Exchanges, 127 Over-the-Counter Market, 128

Currency Call Options, 128 Factors Affecting Currency Call Option Premiums, 129 How Firms Use Currency Call Options, 129 Speculating with Currency Call Options, 130

Currency Put Options, 133 Factors Affecting Currency Put Option Premiums, 133 Hedging with Currency Put Options, 134 Speculating with Currency Put Options, 134

Contingency Graphs for Currency Options, 136 Contingency Graph for a Purchaser of a Call Option, 136 Contingency Graph for a Seller of a Call Option, 136 Contingency Graph for a Purchaser of a Put Option, 136 Contingency Graph for a Seller of a Put Option, 137

Conditional Currency Options, 138 European Currency Options, 139

x Contents

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Summary, 140 Point Counter-Point: Should Speculators Use Currency Futures or Options? 140 Self-Test, 140 Questions and Applications, 141

Advanced Questions, 144 Discussion in the Boardroom, 147 Running Your Own MNC, 147

Blades, Inc. Case: Use of Currency Derivative Instruments, 147 Small Business Dilemma: Use of Currency Futures and Options by the Sports Exports

Company, 148 Internet/Excel Exercises, 149 References, 149

Appendix 5A: Currency Option Pricing is made available to you at www.cengage.com/ finance/madura.

Appendix 5B: Currency Option Combinations is made available to you at www.cengage. com/finance/madura.

Part 1 Integrative Problem: The International Financial Environment is made available to you at www.cengage.com/finance/madura.

PART 2: Exchange Rate Behavior 169

6: GOVERNMENT INFLUENCE ON EXCHANGE RATES 171

Exchange Rate Systems, 171 Fixed Exchange Rate System, 171 Freely Floating Exchange Rate System, 173 Managed Float Exchange Rate System, 174 Pegged Exchange Rate System, 175 Dollarization, 178 Classification of Exchange Rate Arrangements, 179

A Single European Currency, 180 Impact on European Monetary Policy, 180 Impact on the Valuation of Businesses in Europe, 180 Impact on Financial Flows, 181 Impact on Exchange Rate Risk, 181 Status Report on the Euro, 181

Government Intervention, 182 Reasons for Government Intervention, 182 Direct Intervention, 183 Indirect Intervention, 185

Intervention as a Policy Tool, 186 Influence of a Weak Home Currency, 186 Influence of a Strong Home Currency, 186

Summary, 188 Point Counter-Point: Should China Be Forced to Alter the Value of Its Currency? 188 Self-Test, 189 Questions and Applications, 189

Advanced Questions, 190 Discussion in the Boardroom, 191 Running Your Own MNC, 191

Contents xi

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Blades, Inc. Case: Assessment of Government Influence on Exchange Rates, 192 Small Business Dilemma: Assessment of Central Bank Intervention by the Sports Exports

Company, 193 Internet/Excel Exercises, 193 References, 193

Appendix 6: Government Intervention during the Asian Crisis is made available to you at www.cengage.com/finance/madura.

7: INTERNATIONAL ARBITRAGE AND INTEREST RATE PARITY 203

International Arbitrage, 203 Locational Arbitrage, 203 Triangular Arbitrage, 205 Covered Interest Arbitrage, 208 Comparison of Arbitrage Effects, 212

Interest Rate Parity (IRP), 213 Derivation of Interest Rate Parity, 214 Determining the Forward Premium, 215 Graphic Analysis of Interest Rate Parity, 216 How to Test Whether Interest Rate Parity Exists, 218 Interpretation of Interest Rate Parity, 219 Does Interest Rate Parity Hold? 219 Considerations When Assessing Interest Rate Parity, 219 Forward Premiums across Maturity Markets, 220 Changes in Forward Premiums, 221

Summary, 223 Point Counter-Point: Does Arbitrage Destabilize Foreign Exchange Markets? 224 Self-Test, 224 Questions and Applications, 225

Advanced Questions, 227 Discussion in the Boardroom, 230 Running Your Own MNC, 230

Blades, Inc. Case: Assessment of Potential Arbitrage Opportunities, 230 Small Business Dilemma: Assessment of Prevailing Spot and Forward Rates by the Sports

Exports Company, 231 Internet/Excel Exercise, 231 References, 232

8: RELATIONSHIPS AMONG INFLATION, INTEREST RATES,

AND EXCHANGE RATES 233

Purchasing Power Parity (PPP), 233 Interpretations of Purchasing Power Parity, 233 Rationale behind Relative PPP Theory, 234 Derivation of Purchasing Power Parity, 234 Using PPP to Estimate Exchange Rate Effects, 235 Graphic Analysis of Purchasing Power Parity, 236 Testing the Purchasing Power Parity Theory, 238 Why Purchasing Power Parity Does Not Occur, 241 Purchasing Power Parity in the Long Run, 242

International Fisher Effect (IFE), 243 Implications of the International Fisher Effect, 244 Implications of the IFE for Foreign Investors, 244

xii Contents

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Derivation of the International Fisher Effect, 246 Graphic Analysis of the International Fisher Effect, 248 Tests of the International Fisher Effect, 249 Does the International Fisher Effect Hold? 251

Comparison of the IRP, PPP, and IFE, 252 Summary, 253 Point Counter-Point: Does PPP Eliminate Concerns about Long-Term Exchange Rate Risk? 253 Self-Test, 254 Questions and Applications, 254

Advanced Questions, 256 Discussion in the Boardroom, 259 Running Your Own MNC, 259

Blades, Inc. Case: Assessment of Purchasing Power Parity, 259 Small Business Dilemma: Assessment of the IFE by the Sports Exports Company, 260 Internet/Excel Exercises, 260 References, 260

Part 2 Integrative Problem: Exchange Rate Behavior is made available to you at www. cengage.com/finance/madura.

Midterm Self-Exam, 263

PART 3: Exchange Rate Risk Management 271

9: FORECASTING EXCHANGE RATES 273

Why Firms Forecast Exchange Rates, 273 Forecasting Techniques, 274

Technical Forecasting, 274 Fundamental Forecasting, 276 Market-Based Forecasting, 280 Mixed Forecasting, 283 Reliance on Forecasting Services, 284 Governance of Forecasting Techniques Used, 284

Forecast Error, 284 Measurement of Forecast Error, 284 Forecast Errors among Time Horizons, 285 Forecast Errors over Time Periods, 285 Forecast Errors among Currencies, 286 Forecast Bias, 287 Graphic Evaluation of Forecast Performance, 288 Comparison of Forecasting Methods, 290 Forecasting under Market Efficiency, 291

Using Interval Forecasts, 292 Methods of Forecasting Exchange Rate Volatility, 293

Summary, 294 Point Counter-Point: Which Exchange Rate Forecast Technique Should MNCs Use? 294 Self-Test, 294 Questions and Applications, 295

Advanced Questions, 296 Discussion in the Boardroom, 299 Running Your Own MNC, 299

Contents xiii

Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

Blades, Inc. Case: Forecasting Exchange Rates, 299 Small Business Dilemma: Exchange Rate Forecasting by the Sports Exports

Company, 300 Internet/Excel Exercises, 301 References, 301

10: MEASURING EXPOSURE TO EXCHANGE RATE FLUCTUATIONS 303

Relevance of Exchange Rate Risk, 303 The Investor Hedge Argument, 303 Currency Diversification Argument, 304 Stakeholder Diversification Argument, 304 Response from MNCs, 304

Transaction Exposure, 305 Estimating “Net” Cash Flows in Each Currency, 305 Exposure of an MNC’s Portfolio, 307 Transaction Exposure Based on Value at Risk, 309

Economic Exposure, 313 Exposure to Local Currency Appreciation, 314 Exposure to Local Currency Depreciation, 315 Economic Exposure of Domestic Firms, 315 Measuring Economic Exposure, 316

Translation Exposure, 318 Does Translation Exposure Matter? 318 Determinants of Translation Exposure, 319 Examples of Translation Exposure, 320

Summary, 320 Point Counter-Point: Should Investors Care about an MNC’s Translation Exposure? 321 Self-Test, 321 Questions and Applications, 322

Advanced Questions, 323 Discussion in the Boardroom, 328 Running Your Own MNC, 328

Blades, Inc. Case: Assessment of Exchange Rate Exposure, 328 Small Business Dilemma: Assessment of Exchange Rate Exposure by the Sports Exports Company, 330 Internet/Excel Exercises, 330 References, 331

11: MANAGING TRANSACTION EXPOSURE 333

Hedging Exposure to Payables, 333 Forward or Futures Hedge on Payables, 333 Money Market Hedge on Payables, 334 Call Option Hedge on Payables, 335 Summary of Techniques to Hedge Payables, 337 Optimal Technique for Hedging Payables, 337 Optimal Hedge versus No Hedge on Payables, 338 Evaluating the Hedge Decision, 340

Hedging Exposure to Receivables, 340 Forward or Futures Hedge on Receivables, 341 Money Market Hedge on Receivables, 341 Put Option Hedge on Receivables, 341 Optimal Technique for Hedging Receivables, 344 Optimal Hedge versus No Hedge, 345

xiv Contents

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Evaluating the Hedge Decision, 347 Comparison of Hedging Techniques, 348 Hedging Policies of MNCs, 348 Selective Hedging, 348

Limitations of Hedging, 349 Limitation of Hedging an Uncertain Amount, 349 Limitation of Repeated Short-Term Hedging, 350

Hedging Long-Term Transaction Exposure, 352 Long-Term Forward Contract, 352 Parallel Loan, 352

Alternative Hedging Techniques, 352 Leading and Lagging, 353 Cross-Hedging, 353 Currency Diversification, 353

Summary, 354 Point Counter-Point: Should an MNC Risk Overhedging? 354 Self-Test, 355 Questions and Applications, 355

Advanced Questions, 358 Discussion in the Boardroom, 363 Running Your Own MNC, 363

Blades, Inc. Case: Management of Transaction Exposure, 363 Small Business Dilemma: Hedging Decisions by the Sports Exports Company, 365 Internet/Excel Exercises, 365 References, 366

Appendix 11: Nontraditional Hedging Techniques is made available to you at www.cengage. com/finance/madura.

12: MANAGING ECONOMIC EXPOSURE AND TRANSLATION

EXPOSURE 373

Managing Economic Exposure, 373 Assessing Economic Exposure, 374 Restructuring to Reduce Economic Exposure, 375 Issues Involved in the Restructuring Decision, 378

A Case Study on Hedging Economic Exposure, 379 Savor Co.’s Dilemma, 379 Assessment of Economic Exposure, 380 Assessment of Each Unit’s Exposure, 380 Identifying the Source of the Unit’s Exposure, 381 Possible Strategies to Hedge Economic Exposure, 381 Savor’s Hedging Solution, 383 Limitations of Savor’s Optimal Hedging Strategy, 383

Hedging Exposure to Fixed Assets, 383 Managing Translation Exposure, 384

Hedging with Forward Contracts, 385 Limitations of Hedging Translation Exposure, 385

Governance: Governing the Hedge of Translation Exposure, 386 Summary, 386 Point Counter-Point: Can an MNC Reduce the Impact of Translation

Exposure by Communicating? 387

Contents xv

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Self-Test, 387 Questions and Applications, 388

Advanced Questions, 388 Discussion in the …