International Financial Management

1
Chapter 21

• International Financial Management

2
Introduction

• The world has become smaller due to
• Advances in communication transportation
• International flows of capital and technology
• Cooperation between different countries
• As a result, firms become MNCs

3
Todays agenda

• Multinational Corporation (MNC)
• Foreign Exchange Rates
• Managing Foreign Exchange Risk
• Financing International Business Operations

4
Multinational Corporations

• MNCs are firms doing business in more than one
  country (home country)
• 4 basic forms of MNCs
• Exporter
• Licensing or Franchising
• Joint Venture
• Foreign Subsidiary

5
Reasons for investment aboard

• Fear of import tariffs (e.g.Toyota)
• Lower production costs in foreign country
• Tax advantages
• Proximity to market
• International diversification (the overall risk
  of the MNC is reduced when foreign and domestic
  operations are not correlated)
• Following competitor

6
International vs Domestic Environment

• In addition to normal business risks, the MNC is
  faced with foreign exchange risk and political
  risk
• Higher risk, higher return. So MNC is more
  profitable

7
Intl vs Domestic Environment cont

• International environment is more complex
• Different from the domestic market in
• Inflation rates
• Tax rules
• Structure and operation of financial institution
• Financial policies and practices

8
Foreign Exchange Rates

• Exchange rate is the price of one currency in
  terms of another
• Rates are determined by the supply and demand for
  each currency
• Factors affecting exchange rates relative
  inflation/interest rates, balance of payments,
  government policies, confidence in future
  economic performance

9
Making money through the FX rates

• Assume todays exchange rate between USD/CAD is 1
  to 1.5 and the bank saving rates in the States
  and Canada are 3 and 4 respectively
• US investors are attracted to the high saving
  rate in Canada
• They convert USD1000 into CAD 1500 and save it in
  Canadian bank

10
Making money through the FX rates cont

• One year later, they get
• CAD 1500 (14) CAD 1560
• Assume the exchange rate by that time is 1 to
  1.48, the US investor will convert the CAD 1560
  back to USD (1560/1.48) i.e. USD 1054
• The rate of return is USD (1054-1000)/1000
  5.4 (compare with domestic return of 3)

11
Reminder

• The US investor is lucky and makes a gain in the
  saving rate as well as the foreign exchange rate
• However, the movement of large sums of money
  between borders would cause the exchange rates
  and available saving rates to adjust (e.g.
  Canadian bank may lower the saving rate due to
  large amount of deposits)

12
Foreign Exchange Rates cont

• Two types of exchange rates
• Spot rate exchange rate between currencies for
  immediate delivery
• Forward rate exchange rate that is established
  for future delivery
• Forward rate may be used to reduce the foreign
  exchange risk

13
Using forward rate to reduce FX risk

• Using the previous example, once the US investor
  has converted USD1000 into CAD1500 and deposits
  it in Canadian bank, he/she may afraid that CAD
  will depreciate after a year (i.e. exchange rate
  a year later may be 1USD/1.55CAD, then the return
  to US investor is (1560/1.55)-1000/1000
  0.65 much lower than the domestic return of 3)

14
Using forward rate to reduce FX risk cont

• To remove the FX risk, the US investor may lock
  in a one-year forward exchange rate of say
  1USD/1.51CAD (sell CAD in advance)
• By doing so, the investor is sure that the return
  will be (1560/1.51)-1000/1000 3.3 a bit
  higher than the domestic return
• Normally the forward exchange rate will move in a
  direction to prevent arbitrage (making profit
  without taking risk)

15
Who will buy at the forward rate?

• Example A US importer issue a purchase order to
  buy 1 M CAD raw material from a Canadian
  supplier. The goods will be shipped to US a year
  later. Once the goods are shipped, the US
  importer has to pay 1 M CAD to the Canadian
  supplier. The spot rate is 1 USD to 1.50 CAD. The
  one-year forward rate is 1 USD to 1.51 CAD.
• Fearing that the CAD may appreciate against USD
  on the shipment date, the firm decides to buy CAD
  at the forward rate now

16
Managing FX Risk

• Other than using forward exchange rate, US
  investor may reduce FX risk by
• Hedging in the currency futures market buying
  or selling standardize forward contract
• Hedging in the currency options market similar
  to currency futures but with an option not to
  exercise the future contract ( a premium is
  required in advance)

17
Financing International Business Operations

• Eurodollar loans major source of short-term
  loans for MNCs
• The borrowing costs are lower because
• Smaller overhead costs for lending banks given
  the huge size of transactions
• High credit of borrowers (MNCs)
• Absence of reserve or capital requirement by the
  local government

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Financing Intl Bus. Operations cont

• Eurobond market long-term bonds sold throughout
  the world but are denominated primarily in USD,
  DEM, SFC and YEN
• Advantages of Eurobonds
• Less stringent disclosure requirement
• Lower registration fees
• Some tax advantages exist

19
Summary

• The birth of MNCs - their risks and benefits
• Exchange rate spot and forward rates
• Managing FX risk through forward/future/option
  contracts
• Additional sources of finance for MNCs
  Eurodollar and Eurobond markets

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Summary of this course

• Through out this course, we have been learning
  how to raise capital for a company and how to
  invest the capital raised
• That is, make use of share/bond-holders money
  to create more value for the firm

21
Personal Application

• Start saving as early as possible
• Make use of others money to create more money
  for yourself (leverage)

22
Meaningful Life

• It is more important to share with people what we
  have for we are in the same boat

23
Life Journey
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Meaningful Life cont

• Unless life is lived for others, it is not
  worthwhile (Mother Theresa)
• We are borne not to fight against each other but
  to help each other (Johnny Tong)