Chapter 19 Multinational Financial ManagementExchange rates and trading in foreign exchange
International money and capital markets
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A corporation that operates in two or more countries.
Decision making within the corporation may be centralized in the home country, or may be decentralized across the countries the corporation does business in.
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To seek new markets.
To seek raw materials.
To seek new technology.
To seek production efficiency.
To diversify.
Different currency denominations.
Japanese yen 0.009
Australian dollar 0.650
Are these currency prices direct or indirect quotations?
Since they are prices of foreign currencies expressed in dollars, they are direct quotations.
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What is an indirect quotation?
The number of units of a foreign currency needed to purchase one U.S. dollar, or the reciprocal of a direct quotation.
Are you more likely to observe direct or indirect quotations?
Most exchange rates are stated in terms of an indirect quotation.
Except the British pound, which is usually in terms of a direct quotation.
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# of units of foreign
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What is a cross rate?
The exchange rate between any two currencies. Cross rates are actually calculated on the basis of various currencies relative to the U.S. dollar.
Cross rate between Australian dollar and the Japanese yen.
Cross rate = (Yen / US Dollar) x (US Dollar / A. Dollar)
= 111.11 x 0.650
0.0138 A. Dollars / Yen
Setting the appropriate price
A firm can produce a liter of orange juice and ship it to Japan for $1.75 per unit. If the firm wants a 50% markup on the project, what should the juice sell for in Japan?
Price = (1.75)(1.50)(111.11)
= 291.66 yen
Determining profitability
The product will cost 250 yen to produce and ship to Australia, where it can be sold for 6 Australian dollars. What is the U.S. dollar profit on the sale?
Cost in A. dollars = 250 yen (0.0138)
= 3.45 A. dollars
U.S. dollar profit = 2.55 / 1.5385 = $1.66
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What is exchange rate risk?
The risk that the value of a cash flow in one currency translated to another currency will decline due to a change in exchange rates.
For example, in the last slide, a weakening Australian dollar (strengthening dollar) would lower the dollar profit.
The current international monetary system is a floating rate system.
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European Monetary Union
In 2002, the full implementation of the “euro” was completed. The national currencies of the 12 participating countries were phased out in favor of the “euro.” The newly formed European Central Bank controls the monetary policy of the EMU.
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Austria
Belgium
Finland
France
Germany
Greece
Ireland
Italy
Luxembourg
Netherlands
Portugal
Spain
Britain, Sweden, and Denmark
What is a convertible currency?
A currency is convertible when the issuing country promises to redeem the currency at current market rates.
Convertible currencies are traded in world currency markets.
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What problems may arise when a firm operates in a country whose currency is not convertible?
It becomes very difficult for multi-national companies to conduct business because there is no easy way to take profits out of the country.
Often, firms will barter for goods to export to their home countries.
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What is difference between spot rates and forward rates?
Spot rates are the rates to buy currency for immediate delivery.
Forward rates are the rates to buy currency at some agreed-upon date in the future.
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When is the forward rate at a premium to the spot rate?
If the U.S. dollar buys fewer units of a foreign currency in the forward than in the spot market, the foreign currency is selling at a premium.
In the opposite situation, the foreign currency is selling at a discount.
The primary determinant of the spot/forward rate relationship is relative interest rates.
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What is interest rate parity?
Interest rate parity holds that investors should expect to earn the same return in all countries after adjusting for risk.
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Evaluating interest rate parity
Suppose one yen buys $0.0095 in the 30-day forward exchange market and kNOM for a 30-day risk-free security in Japan and in the U.S. is 4%.
ft = 0.0095
Does interest rate parity hold?
Therefore, for interest rate parity to hold, e0 must equal $0.0095, but we were given earlier that e0 = $0.0090.
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The Japanese security.
$1,000 x 111.111 = 111,111 yen.
Invest 111,111 yen in 30-day Japanese security. In 30 days receive 111,111 yen x 1.00333 = 111,481 yen.
Agree today to exchange 111,481 yen 30 days from now at forward rate, 111,481/105.2632 = $1,059.07.
30-day return = $59.07/$1,000 = 5.907%, nominal annual return = 12 x 5.907% = 70.88%.
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What is purchasing power parity (PPP)?
Purchasing power parity implies that the level of exchange rates adjusts so that identical goods cost the same amount in different countries.
Ph = Pf(e0)
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If grapefruit juice costs $2.00 per liter in the U.S. and PPP holds, what is the price of grapefruit juice in Australia?
e0 = Ph/Pf
$0.6500 = $2.00/Pf
Pf = $2.00/$0.6500
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What impact does relative inflation have on interest rates and exchange rates?
Lower inflation leads to lower interest rates, so borrowing in low-interest countries may appear attractive to multinational firms.
However, currencies in low-inflation countries tend to appreciate against those in high-inflation rate countries, so the effective interest cost increases over the life of the loan.
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Eurodollar markets
International bonds
Foreign bonds – sold by foreign borrower, but denominated in the currency of the country of issue.
Eurobonds – sold in country other than the one in whose currency the bonds are denominated.
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To what extent do average capital structures vary across different countries?
Previous studies suggested that average capital structures vary among the large industrial countries.
However, a recent study, which controlled for differences in accounting practices, suggests that capital structures are more similar across different countries than previously thought.
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Access to more markets for loans and for temporary investments.
Cash is often denominated in different currencies.
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Capital budgeting decisions
Foreign operations are taxed locally, and then funds repatriated may be subject to U.S. taxes.
Foreign projects are subject to political risk.
Funds repatriated must be converted to U.S. dollars, so exchange rate risk must be taken into account.
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Credit is more important, because commerce to lesser-developed countries often relies on credit.
Credit for future payment may be subject to exchange rate risk.
Inventory management
Inventory decisions can be more complex, especially when inventory can be stored in locations in different countries.
Some factors to consider are shipping times, carrying costs, taxes, import duties, and exchange rates.
1
e
0.0095
1.0033
1.0033
e
0.0095
0
0