Prof. Stew

Yr.

End

Yen

(¥/$)

Euro

($/€)

Pound

($/£)

Yuan

(CNY/$)

‘10 80.915 1.339 1.561 6.595

‘09 93.035 1.433 1.616 6.830

‘08 90.630 1.399 1.461

‘07 111.430 1.459 1.985

‘06 118.975 1.320 1.960

‘05 117.75 1.185 1.723

Holland Model

Classifying MNC's using Product, Factor, & Capital Market Variables

Firm Product Factor Foreign Debt Equity

Type Markets Markets Subsidiaries Capital Capital

D-I D D N D D

D-II I I N D D

MNC-I I I Y D D

MNC-II I I Y I D

MNC-III I I Y I I

D - domestic focus I - international focus

Classifying MNC's using Degree of Coordination

Three Dimensions:

1. Degree of integration of global operational decisions

2. Degree of integration of global financial decisions

3. Global flexibility of real & financial decisions

Classifications:

Domestic

No international considerations

Multi-Domestic

Each subsidiary operates independently

Collection of domestic's

Each subsidiary has superior knowledge of local market conditions

Objective - maximize subsidiary performance

Pure MNC

Total company, global perspective

Centralize certain decisions

Objective - maximize total firm performance, even if it reduces individual

subsidiary performance

Algebra of Currency Exchange

FX rates are frequently presented in a variety of differing formats. Using the FX rate

correctly requires different methods depending upon the reference format. A relatively

simple technique is available which eliminates confusion and the need to memorize

several rules.

For example, assume you have the following WSJ quotes:

$(a) per $(b)

Euro (€) 1.305 0.7663

(a) 1€ = $1.305 or 1.305$ or 1.305

$/€

1€

(b) $1 = 0.7663 € or 0.7663 € or 0.7663

€/$

$1

If you have $100 and want to buy E's, how many can you buy?

1. $100 x 0.7663 € = 76.63 € Right - receive €

$1

(Note from high school algebra: $ divide $, answer in €)

2. $100 x 1.305$ = 130.50$

2

Wrong - receive $

2

/€

1 € € Nonsense result

3. $100 / 10.7663 € = $100 x $1 = 130.50$

2

Wrong - receive $

2

/ €

$1 0.7663 € € Nonsense result

4. $100 / 01.305$ = $100 x 1€ = 76.63 € Right - receive €E

1€ 1.305$

The first step in any FX operatio n is to identify the rate characteristics (e.g.,

$/€

or

€/$

) and attach

this notation to the rate being examined. If this discipline is followed rigorously it is almost

impossible to make nonsense conversions. This displine becomes increasingly importa nt as the

complexities of FX translations increase (e.g., cross rate derivations, triangular arbitrage, parity

relationships).

Inflation

Differential

Income

Differential

Trade

Restrictions

Interest rate

differential

Capital Flow

Restrictions

US demand

for foreign

goods

Foreign

demand for

US goods

US demand

for the

foreign

currency

Supply of

the foreign

currency for

sale

US demand

for foreign

securities

Foreign

demand for

US

securities

US demand

for the

foreign

currency

Supply of

the foreign

currency for

sale

FX Rates

Comprehensive Hedging Example

Hero Books is a UK book publisher and has just made a big sale to Berlin Book Stores. It

expects to receive € 1 million in 90 days. How much is the sale worth to Hero?

Current financial market conditions are:

S = 1.20

€/£

90

F = 1.23

€/£

i

GR

= 0.054

i

UK

= 0.0811

=================================================================

Alternative #1 - Do Nothing

So = 1.20

€/£

A

S

90

= ??

90

F = 1.23

€/£

|------------------------------------- ---------------------------------------- |

d

1

d

90

1) Do nothing 1) Receive €1m from customer

2) Convert to £ @ current Spot (

A

S)

Actual value of the sale is unknown

A

S

90

L Received

1.23

€/£

€1,000,000 / 1.23

€/£

£813,008.13

1.25

€/£

€1,000,000 / 1.25

€/£

£800,000.00

1.26

€/£

€1,000,000 / 1.26

€/£

£793,650.79

Alternative #2 - Forward Hedge

So = 1.20

€/£

A

S

90

= ??

90

F =1.23

€/£

|------------------------------------------------------------------------- |

d

1

d

90

Sell € 1m Fwd @ 1.23

€/£

Receive € 1m from customer

Deliver € 1m on Fwd

Receive £813,008.13

(€1,000,000 / 1.23

€/£

)

Strategy locks in the actual receipt ( £813,008.13) on d

1

. There is no uncertainty about the actual

value of the sale (risk is zero). Any cha nge in market FX rates (up or down) does not affect

receipt.

Types of

FERM Exposure

Economic

-

Exposure of on

-

going cash flows and of the value of the firm.

Transactions

-

Exposure of open positions of known transactions.

Translations

-

Exposure of net accounting position

Time & Certainty Structure of Exposure

Time

Certainty

Exposure

On

-

going

Unknown or

Economic, Translations

& future

uncertain

Contingent

Lower degree of

Transactions

uncertainty

Short term

Known

Transactions

Note: Contingencies

-

these are potenti

al cash flows under negotiation. For example, Rolls

Royce makes a bid to supply jet engines to Boeing. The bid has to be placed in advance and

involves future deliveries over a 3 year period. The firm may, or may not, win the bid.

Responses to FERM Exposures

Real Responses

Principal responses to Economic exposure

Strategic

Organization of firm & subsidiaries

Operational

Operating methods

Financial Responses

Principal responses to Transactions exposure

Financial transactions & hedging

Strategic & Operational Responses to Economic Exposure

Objective: alter firm's exposure to known or anti cipated FX risks ...as part of strategy.

1. Locate production/sales in the same countries as major competitors.

Makes company subject to same risks as competitor...but not more risks

If major competitors in far east/Pac Rim...put production facility t here

2. Locate production & sales in many currency zones.

Diversifies real FX rate change exposure

3. Create flexible manufacturing systems

Provide ability to shift production between countries to take advantage of FX

opportunities.

Assume production plants in Korea & Thailand with: Korea principal producer for

Japan & Thailand principal producer for SE Asia & export. If FX problem with

Korea/Japan but not Thailand...shift Thailand production to Japan; shift Korean

production to SE Asia & export.

4. Differentiate Products

Reduced price sensitivity (elasticity); more resistent to substitutions; can increase prices

to compensate for FX shifts.

CASE #2 D-II Company - Exporter

The € has been steadily appreciating against the £... so the company begins exporting and

selling in Germany.

-------------------

| | exports

| UK |------------>Germany

| | (sales)

------------------

| |

| |

UK UK

(inputs) (sales)

The company has increased its FERM exposure by adding transactions risk in Germany.

However, at the present time the appreciating € increases UK profits. Marg ins are higher on

Germany sales (since more £L's are received for every € sale). The company now has an

important decision to make. They may choose among 2 major strategies:

1. Profitability maximization. The goal of this strategy is to obtain the maximum av ailable

profit from the appreciating €. They would keep prices steady with the German

competition, sustain current market share levels, and earn the increased margins. Note:

margins are superior to their German competitors since they receive more £'s per € sale

and their costs (in £'s) are cheaper than their German competitors.

2. Market Share maximization. The goal of this strategy is to rapidly grow market share. Its

accomplished by reducing prices in Germany while maintaining margins at the same

level as in the UK.

CASE #3 D-II Company - Importer/Exporter

In addition to the proceeding conditions, t he € has been steadily depreciating against the £... so

the company begins importing "inputs" from Japan.

-----------------

imports | | exports

Japan ----------------> | UK |------------>Germany

(inputs) | | (sales)

------------------

| |

| |

UK UK

(inputs) (sales)

The company has added to its FERM exposure by increasing its transactions risk to include

both € and ¥. However, under the present FX environment the compa ny is in a strong position.

Japanese inputs are cheaper than UK inputs (a £ buys more ¥); margins in the UK can

increase; margins in Germany can increase even more than in Case #2. This allows the

company to pursue even more aggressive price cutting/share b uilding strategies in both the UK

and Germany.

At this stage, 2 things could go wrong.

1. As the firm's German share strengthens, it can expect some sort of German government

response to protect the domestic industries. This could be in the form of t arriff's or

quota's. You'll recall very recent controversies between the US & Japan and between

the US & Mexico (tomatoes) about this exact issue. So its not an unusual response. This

government intervention would reduce the attractiveness of the German ma rket and

would arbitrarily increase prices without increasing margins (tarriff's go directly to the

government).

2. The current FX conditions could reverse. Any strengthening of the ¥ or weakening of the

€ could put the firm in a lower profitability position. At this point the company could

discontinue imports from Japan &/or exports to Germany. However, if the dependencies

on these activities has become large ("material" in the financial sense) , the company

would shrink. In fact if these depende ncies had become material, the company was

inadvertently picking up unrecognized economic exposure risk.

CASE #4 MNC-I Company - Direct Foreign Investment (DFI)

-----------------

imports | | exports

Japan ----------------> | UK |------------>Germany

(inputs) | | (sales)

(production) ------------------ (production)

(sales) | | (inputs)

| |

UK UK

(inputs) (sales)

Another alternative for the company is to put subsidiaries & production facilities (DFI) in both

Japan & Germany. This now recognizes the economic exposure created by the former material

activities. Under this structure:

1. The firm now opens the Japanese market to its products. Under a depreciating ¥, this

market was not possible since UK produced products would be more expensive than

Japanese products. It now uses Japanese inputs for the Japan subsidiary (selling at

domestic margins & prices) while continuing to export inputs to the UK.

2. In Germany the firm may continue to import products (& much cheaper Japanese inputs)

as well as purchase domestic inputs and domestic production. In the event of a German

government intervention, the firm may now just shift production to the German

subsidiary. While prices co uld be expected to rise to the domestic German level, market

share would be protected.

3. If the current FX advantages reverse, the firm would merely shift to German production

for the German market; UK production for the UK market; and Japanese production for

the Japan market. So market share in all markets would be protected.

4. Depending on the degree of reversal, the firm may also choose to import German inputs

into the UK market and export UK products into the Japanese market... completely

reversing the position in Case #3.

Case #4 demonstrates the value of an MNC oper ating with a "true MNC" vs a mul ti-domestic

strategy.

Assume Company

JPN UK GR

------------------ -------------------- --------------------

| | imports | | exports | |

| |------------> | Production |------------> | |

|___________ | |____________ | |_____________|

| |

| |

UK UK

inputs sales

Conditions/Outlook

Over next 1 -2 years, expect:

* € appreciates against £ (more €/£)

GR exports become more profitable

* £ appreciates against ¥ (more £/¥)

JPN imports become cheaper

Exposure Type

Transactions Exposure

Exposed to both € & ¥ (with no offset)

Economic Exposure

Long time frame

High degree of uncertainty

Decision alternatives

Alt #1 - Do nothing

* Leave export levels & prices the same (more £/€)

No competitive disadvantage to GR competitors

Increase UK profits

* Leave import levels the same

Increase UK profits

Alt #2 - Reduce € price (accept less proportion of £ increase); Increase ¥ imports (reduce UK

import dependancy)

* Increase production

* Increase share of GR market (GR firms at price disadvantage)

* Increase UK profits & GR share

NOTE: cannot sell in JPN (UK firms at price disadvantage)

JPN UK GR

------------------ -------------------- --------------------

| | imports | | exports | |

| |------------> | Production |------------> | |

|___________ | |____________ | |_____________|

| |

| |

UK UK

inputs sales

Conditions/Outlook

Over next 1 -2 years, expect:

* € depreciates against £ (more £/€)

GR exports become more expensive (UK price disadvantage)

* ¥ appreciates against £ (more ¥/£)

JPN imports become more expensive

Exposure Type

Transactions Exposure

Exposed to both € & ¥ (with no offset)

Economic Exposure

Long time frame

High degree of uncertainty

Decision alternatives

Alt #1 - Do nothing

* Lose share in GR

* Increased CGS from JPN imports

* UK profits decline

Alt #2

* Reduce exports to GR (lose share)

* Reduce imports from JPN (reduce CGS)

* Contract total Revenues

* Protect UK profit margins

NOTE: still cannot sell in JPN.

JPN UK GR

------------------ -------------------- --------------------

| | imports | | exports | |

| Production |------------> | Production |------------> | Production |

|___________ | |____________ | |_____________|

| | | | | |

| | | | | |

JPN JPN UK UK GR GR

inputs sales inputs sales inputs sales

Conditions/Outlook

Over next 1 -2 years, expect:

* € appreciates against £ (more €/£)

GR exports become more profitable

* £ appreciates against ¥ (more £/¥)

JPN imports become cheaper

Exposure Type

Transactions Exposure

€ flows at least partially offset (inflows & outflows)

¥ flows at least partially offset (inflows & outflows)

Economic Exposure - Reduced

Decisions

* GR: increase exports; reduce prices; increase share

begin manuf in GR

* JPN: increase imports; reduce CGS

manuf & sell in JPN; competitive with JPN firms; develop share

* UK: increase profit

Conditions/Outlook

Over next 1 -2 years, expect:

* £ appreciates against € (more £/€)

GR exports become more expensive

* ¥ appreciates against £ (more ¥/£)

JPN imports become more expensive

Decisions

* GR: increase manuf in GR; reduce exports

GR manuf products not at price disadvantage; hold share

export GR products to UK; price advantage over UK manuf

* JPN: reduce imports; export UK prod/inputs to JPN (price advantage)

increase JPN manuf; build JPN share

Evaluating the DFI

DFI

|

--------------------------------------------------------------------

| | |

Country Risk Business Risk Financial Risk

Political system Demand FX structure

Legal system Costs FX volatility,correlation

Trade policies Transportation Financial markets

Stability Inflation, interest rates

Capital flow policies Repatriation issues

Company E is a US MNC with subsidiaries in several countries. It has just obtained an exclusive

15 year contract with the government of Country I to develop, operate, an d manage that

country's Social Security system. Company E does not currently have any operations in Country

I.

The Contract

1. Company E is required to purchase and install computers and a nationwide data

communications network in Country I. The estimated cost is $150.0 million.

2. Company E is required to train the citizens of Country I to operate the computer systems

and network. Company E is also required to employ Country I citizens as business

managers. The estimated cost of the initial training is $10.0 million.

3. Company E is required to provide on -going technology & management training to

Country I citizens. The expected cost is $5.0 million per year for each year of the

contract.

4. Country I will pay Company E $30.0 million per year, in US $'s, through the life of the

contract.

Company E Background

1. Company E has significant & unique expertise an d experience in this area.

2. It is a world recognized provider of large scale computer based services and has

implemented this kind of service in other countries successfully.

3. This is the company's first dealings with Country I and it has no c urrent operations in that

country.

Country I Background

1. Country I has strong GDP growth and US levels of per capita income.

2. The country has a long history of strong & friendly ties with the US.

3. The country has adopted US culture and t here is a generally high standard of education

among its citizens.

4. The country's currency is pegged 1:1 to the US $.

5. It uses a US style legal system & has a US based commercial law

6. Inflation is consistent with the US rate and interest rates are slightly higher.

7. There is a developing financial market, but it is not as robust as the US

8. The government is stable and has been in place for more than 20 years.

Company E's evaluation

1. A discount rate slightly higher than th e firm's US domestic rate was used to evaluate the

contract. It yielded a positive NPV.

2. Because of the weaker financial markets and the slightly higher interest rate it was

decided to finance the investment in the US. Because all payments would be m ade in

US $'s, no economic exposure was anticipated.

Evaluating the Company E DFI

DFI

|

--------------------------------------------------------------------

| | |

Country Risk Business Risk Financial Risk

Political system Demand FX structure

stable & compatible guaranteed stable

Legal system Costs FX volatility,correlation

stable & compatible guaranteed pegged to $

Trade policies Transportation Financial markets

don't apply n/a thin, use US

Stability Inflation, interest rates

long term stability consistent with US

Capital flow policies Repatriation issues

no restrictions no restrictions

Overall Risk

low low low