International Financial Management

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Chapter 24

• International Financial Management

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After studying Chapter 24, you should be able to

• Explain why many firms invest in foreign
  operations.
• Explain why foreign investment is different from
  domestic investment.
• Describe how capital budgeting, in an
  international environment, is similar or
  dissimilar to that in a domestic environment.
• Understand the types of exchange-rate exposure
  and how to manage exchange-rate risk exposure.
• Compute domestic equivalents of foreign
  currencies given the spot or forward exchange
  rates.
• Understand and illustrate the purchasing-power
  parity (PPP) and interest rate parity.
• Describe the specific instruments and documents
  used in structuring international trade
  transactions.
• Distinguish among countertrade, export factoring,
  and forfaiting.

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International Financial Management

• Some Background
• Types of Exchange-Rate Risk Exposure
• Management of Exchange-Rate Risk Exposure
• Structuring International Trade Transactions

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Some Background
What is a companys motivation to invest capital
abroad?

• Fill product gaps in foreign markets where excess
  returns can be earned.
• To produce products in foreign markets more
  efficiently than domestically.
• To secure the necessary raw materials required
  for product production.

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International Capital Budgeting
How does a firm make an international capital
budgeting decision?

• 1. Estimate expected cash flows in the foreign
  currency.
• 2. Compute their U.S.-dollar equivalents at the
  expected exchange rate.
• 3. Determine the NPV of the project using the
  U.S. required rate of return, with the rate
  adjusted upward or downward for any risk premium
  effect associated with the foreign investment.

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International Capital Budgeting

• Only consider those cash flows that can be
  repatriated (returned) to the home-country
  parent.
• The exchange rate is the number of units of one
  currency that may be purchased with one unit of
  another currency.
• For example, the current exchange rate might be
  2.50 Freedonian marks per one U.S. dollar.

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International Capital Budgeting Example
International project details

• A firm is considering an investment in Freedonia,
  and the initial cash outlay is 1.5 million marks.
• The project has 4-year project life with cash
  flows given on the next slide.
• The appropriate required return for repatriated
  U.S. dollars is 18.
• The appropriate expected exchange rates are given
  on the next slide.

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International Capital Budgeting Example
End of Year
Expected Cash Flow (marks)
Expected Cash Flow (U.S. dollars)
Present Value of Cash Flows at 18
Exchange Rate (marks to U.S. dollar)

• 0 -1,500,000 2.50 -600,000
  -600,000
• 1 500,000 2.54
  196,850 166,822
• 2 800,000 2.59
  308,880 221,833
• 3 700,000 2.65
  264,151 160,770
• 4 600,000 2.72
  220,588 113,777
• Net Present Value 63,202

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International Capital Budgeting
Related issues of concern

• International diversification and risk reduction
• U.S. Government taxation
• Taxable income derived from non-domestic
  operations through a branch or division is taxed
  under U.S. code.
• Foreign subsidiaries are taxed under foreign tax
  codes until dividends are received by the U.S.
  parent from the foreign subsidiary.

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International Capital Budgeting

• Foreign Taxation

• Tax codes and policies differ from country to
  country, but all countries impose income taxes on
  foreign companies.
• The U.S. government provides a tax credit to
  companies to avoid the double taxation problem.
• A credit is provided up to the amount of the
  foreign tax, but not to exceed the same
  proportion of taxable earnings from the foreign
  country.
• Excess tax credits can be carried forward.

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International Capital Budgeting

• Political Risk

• Expropriation is the ultimate political risk.
• Developing countries may provide financial
  incentives to enhance foreign investment.
• Bottom line Forecasting political instability.
• Protect the firm by hiring local nationals,
  acting responsibly in the eyes of the host
  government, entering joint ventures, making the
  subsidiary reliant on the parent company, and/or
  purchasing political risk insurance.

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Important Exchange-Rate Terms
Spot Exchange Rate -- The rate today for
exchanging one currency for another for immediate
delivery.
Forward Exchange Rate -- The rate today for
exchanging one currency for another at a specific
future date.

• Currency risk can be thought of as the volatility
  of the exchange rate of one currency for another
  (say British pounds per U.S. dollar).

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Types of Exchange-Rate Risk Exposure

• Translation Exposure -- Relates to the change in
  accounting income and balance sheet statements
  caused by changes in exchange rates.
• Transactions Exposure -- Relates to settling a
  particular transaction at one exchange rate when
  the obligation was originally recorded at
  another.
• Economic Exposure -- Involves changes in expected
  future cash flows, and hence economic value,
  caused by a change in exchange rates.

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Management of Exchange-Rate Risk Exposure

• Natural hedges
• Cash management
• Adjusting of intracompany accounts
• International financing hedges
• Currency market hedges

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Natural Hedges
Globally Domestically
Determined Determined Scenario 1 Pricing
X Cost X Scenario 2 Pricing X Cost
X

• Both scenarios are natural hedges as any gain
  (loss) from exchange rate fluctuations in pricing
  is reduced by an offsetting loss (gain) in costs
  in similar global markets.

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Natural Hedges -- Not!
Globally Domestically
Determined Determined Scenario 3 Pricing
X Cost X Scenario 4 Pricing
X Cost X

• Both of these scenarios are not natural hedges
  and thus create a possible firm exposure to
  events that impact one market and not the other
  market.

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Cash Management
What should a firm do if it knew that a local
foreign currency was going to fall in value
(e.g., drop from .70 per peso to .60 per peso)?

• Exchange cash for real assets (inventories) whose
  value is in their use rather than tied to a
  currency.
• Reduce or avoid the amount of trade credit that
  will be extended as the dollar value that the
  firm will receive is reduced and reduce any cash
  that does arrive as quickly as possible.
• Obtain trade credit or borrow in the local
  currency so that the money is repaid with fewer
  dollars.

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Cash Management

• Generally, one cannot predict the future exchange
  rates, and the best policy would be to balance
  monetary assets against monetary liabilities to
  neutralize the effect of exchange-rate
  fluctuations.
• A reinvoicing center is a company-owned financial
  subsidiary that purchases exported goods from
  company affiliates and resells (reinvoices) them
  to other affiliates or independent customers.

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Cash Management
Netting -- A system in which cross-border
purchases among participating subsidiaries of the
same company are netted so that each participant
pays or receives only the net amount of its
intracompany purchases and sales.

• Generally, the reinvoicing center is billed in
  the selling units home currency and bills the
  purchasing unit in that units home currency.
• Allows better management of intracompany
  transactions.

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International Financing Hedges
1. Commercial Bank Loans and Trade Bills

• Foreign commercial banks perform essentially the
  same financing functions as domestic banks
  except
• They allow longer term loans.
• Loans are generally made on an overdraft basis.
• Nearly all major commercial cities have U.S. bank
  branches or offices available for customers.
• The use of discounting trade bills is widely
  utilized in Europe versus minimal usage in the
  United States.

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International Financing Hedges
2. Eurodollar Financing

• Eurodollars are bank deposits denominated in U.S.
  dollars but not subject to U.S. banking
  regulations.
• This market is unregulated. Therefore, the
  differential between the rate paid on deposits
  and that charged on loans varies according to the
  risk of the borrower and current supply and
  demand forces.
• Rates are typically quoted in terms of the LIBOR.
• It is a major source of short-term financing for
  the working capital requirements of the
  multinational company.

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International Financing Hedges
3. International Bond Financing

• A Eurobond is a bond issued internationally
  outside of the country in whose currency the bond
  is denominated.
• The Eurobond is issued in a single currency, but
  is placed in multiple countries.
• A foreign bond is issued by a foreign government
  or corporation in a local market. For example,
  Yankee bonds, and Samurai bonds.
• Many international debt issues are floating rate
  notes that carry a variable interest rate.

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International Financing Hedges
4. Currency-Option and Multiple-Currency bonds

• Currency-option bonds provide the holder with the
  option to choose the currency in which payment is
  received. For example, a bond might allow you to
  choose between yen and U.S. dollars.
• Currency cocktail bonds provide a degree of
  exchange-rate stability by having principal and
  interest payments being a weighted average of a
  basket of currencies.
• Dual-currency bonds have their purchase price and
  coupon payments denominated in one currency,
  while a different currency is used to make
  principal payments.

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Currencies and the Euro
Euro The name given to the single European
currency. Symbol is (much like the dollar, ).

• Each country has a representative currency like
  the (dollar) in the United States or the
  (pound) in Britain.
• On January 1, 1999, the euro started trading.
• The euro is the common currency of the European
  Monetary Union (EMU), which currently includes
  the following 12 European Union (EU) countries
• Austria, Belgium, Finland, France, Germany,
  Greece, Ireland, Italy, Luxembourg, the
  Netherlands, Portugal, and Spain.

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Currency Market Hedges
1. Forward Exchange Market

• A forward contract is a contract for the delivery
  of a commodity, foreign currency, or financial
  instrument at a price specified now, with
  delivery and settlement at a specified future
  date.
• Spot rate .168 per EFr
• 90-day forward rate .166 per EFr
• As shown, the Elbonian franc (EFr) is said to
  sell at a forward discount as the forward price
  is less than the spot rate.
• If the forward rate is .171, the EFr is said to
  sell at a forward premium.

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Currency Market Hedges
Fillups Electronics has just sold equipment worth
1 million Elbonian francs with credit terms of
net 90. How can the firm hedge the currency
risk?

• The firm has the option of selling 1 million
  Elbonian francs forward 90 days. The firm will
  receive 166,000 in 90 days (1 million Elbonian
  francs x .166).
• Therefore, if the actual spot price in 90 days is
  less than .166, the firm benefited from entering
  into this transaction.
• If the rate is greater than .166, the firm would
  have benefited from not entering into the
  transaction.

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Currency Market Hedges
How much does this insurance cost? Annualized
cost of protection ( .002 )/( .168 ) X ( 365
days / 90 days) .011905 X 4.0556 .0483 or
4.83

• Typical discount or premium ranges for stable
  currencies are from 0 to 8, but may be as high
  as 20 for unstable currencies.

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Currency Market Hedges
2. Currency Futures

• A futures contract is a contract for the delivery
  of a commodity, foreign currency, or financial
  instrument at a specified price on a stipulated
  future date.
• A currency futures market exists for the major
  currencies of the world.
• Futures contracts are traded on organized
  exchanges.
• The clearinghouse of the exchange interposes
  itself between the buyer and the seller.
  Therefore, transactions are not made directly
  between two parties.
• Very few contracts involve actual delivery at
  expiration.

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Currency Market Hedges
2. Currency Futures (continued)

• Sellers (buyers) cancel a contract by purchasing
  (selling) another contract. This is an
  offsetting position that closes out the original
  contract with the clearinghouse.
• Futures contracts are marked-to-market daily.
  This is different than forward contracts that are
  settled only at maturity.
• Contracts come in only standard-size contracts
  (e.g., 12.5 million yen per contract).

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Currency Market Hedges
3. Currency Options

• A currency option is a contract that gives the
  holder the right to buy (call) or sell (put) a
  specific amount of a foreign currency at some
  specified price until a certain (expiration)
  date.
• Currency options hedge only adverse currency
  movements (one-sided risk). For example, a put
  option can hedge only downside movements in the
  currency exchange rate.
• Options exist in both the spot and futures
  markets.
• The value depends on exchange rate volatility.

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Currency Market Hedges
4. Currency Swaps

• In a currency swap two parties exchange debt
  obligations denominated in different currencies.
  Each party agrees to pay the others interest
  obligation. At maturity, principal amounts are
  exchanged, usually at a rate of exchange agreed
  to in advance.
• The exchange is notional -- only the cash flow
  difference is paid.
• Swaps are typically arranged through a financial
  intermediary, such as a commercial bank.
• A variety of (complex) arrangements are available.

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Macro Factors Governing Exchange-Rate Behavior
Purchasing-Power Parity (PPP)

• The idea that a basket of goods should sell for
  the same price in two countries, after exchange
  rates are taken into account.
• For example, the price of wheat in Canadian and
  U.S. markets should trade at the same price
  (after adjusting for the exchange rate). If the
  price of wheat is lower in Canada, then
  purchasers will buy wheat in Canada as long as
  the price is cheaper (after accounting for
  transportation costs).

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Macro Factors Governing Exchange-Rate Behavior
Purchasing-Power Parity (PPP continued)

• Thus, demand will fall in the U.S. and increase
  in Canada to bring prices back into equilibrium.
• The price elasticity of exports and imports
  influences the relationship between a countrys
  exchange rate and its purchasing-power parity.
• Commodity items and products in mature industries
  are more likely to conform to PPP.
• Frictions such as government intervention and
  trade barriers cause PPP not to hold.

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Macro Factors Governing Exchange-Rate Behavior
Interest-Rate Parity

• It suggests that if interest rates are higher in
  one country than they are in another, the
  formers currency will sell at a discount in the
  forward market.
• Remember that the Fisher effect implies that the
  nominal rate of interest equals the real rate of
  interest plus the expected rate of inflation.
• The international Fisher effect suggests that
  differences in interest rates between two
  countries serve as a proxy for differences in
  expected inflation.

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Macro Factors Governing Exchange-Rate Behavior
Interest-Rate Parity (continued) The
international Fisher effect suggests
F S
1 rforeign 1 rdollar

• F current forward exchange-rate in foreign
  currency per dollar.
• S current spot exchange-rate in foreign
  currency per dollar.
• rforeign foreign interbank Euromarket interest
  rate
• rdollar U.S. interbank Euromarket interest
  rate

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Interest-Rate Parity Example

• The current German 90-day interest rate is 4.
• The current U.S. 90-day interest rate is 2.
• The current spot rate is .706 Freedonian marks
  per U.S. dollar (1.416 per mark).
• What is the implied 90-day forward rate?

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Interest-Rate Parity Example
The implied 90-day forward rate is
F .706
1 .04 1 .02

• F (1.04) x (.706) / (1.02)
• .720
• Thus, the implied 90-day forward rate is .720
  marks per dollar.

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Structuring International Trade Transactions

• In international trade, sellers often have
  difficulty obtaining thorough and accurate credit
  information on potential buyers.
• Channels for legal settlement in cases of default
  are more complicated and costly to pursue.
• Key documents are (1) an order to pay
  (international trade draft), (2) a bill of
  lading, and (3) a letter of credit.

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International Trade Draft

• The international trade draft (bill of exchange)
  is a written statement by the exporter ordering
  the importer to pay a specific amount of money at
  a specified time.
• Sight draft is payable on presentation to the
  party (drawee) to whom the draft is addressed.
• Time draft is payable at a specified future date
  after sight to the party (drawee) to whom the
  draft is addressed.

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Time Draft Features

• An unconditional order in writing signed by the
  drawer, the exporter.
• It specifies an exact amount of money that the
  drawee, the importer, must pay.
• It specifies the future date when this amount
  must be paid.
• Upon presentation to the drawee, it is accepted.

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Time Draft Features

• The acceptance can be by either the drawee or a
  bank.
• If the drawee accepts the draft, it is
  acknowledged in writing on the back of the draft
  the obligation to pay the amount so many
  specified days hence.
• It is then known as a trade draft (bankers
  acceptance if a bank accepts the draft).

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Bill of Lading
Bill of Lading -- A shipping document indicating
the details of the shipment and delivery of goods
and their ownership.

• It serves as a receipt from the transportation
  company to the exporter, showing that specified
  goods have been received.
• It serves as a contract between the
  transportation company and the exporter to ship
  goods and deliver them to a specific party at a
  specific destination.
• It serves as a document of title.

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Letter of Credit
Letter of Credit - A promise from a third party
(usually a bank) for payment in the event that
certain conditions are met. It is frequently
used to guarantee payment of an obligation.

• A letter of credit is issued by a bank on behalf
  of the importer.
• The bank agrees to honor a draft drawn on the
  importer, provided the bill of lading and other
  details are in order.
• The bank is essentially substituting its credit
  for that of the importer.

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Countertrade
Countertrade -- Generic term for barter and other
forms of trade that involve the international
sale of goods or services that are paid for -- in
whole or in part -- by the transfer of goods or
services from a foreign country.

• Used effectively when exchange restrictions exist
  or other difficulties prevent payment in hard
  currencies.
• Quality, standardization of goods, and resale of
  goods that are delivered are risks that arise
  with countertrade.

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Forfaiting
Forfaiting -- The selling without recourse of
medium- to long-term export receivables to a
financial institution, the forfaiter. A third
party, usually a bank or governmental unit,
guarantees the financing.

• The forfaiter assumes the credit risk and
  collects the amount owed from the importer.
• Most useful when the importer is in a
  less-developed country or in an Eastern European
  nation.