Foundations of Multinational Financial Management, 6th Edition Solution Manual by Ace Test Banks

Foundations of Multinational Financial Management, 6th Edition

By Shapiro, Sarin

CHAPTER 1: INTRODUCTION

CHAPTER 1 INTRODUCTION Chapter 1 emphasizes the internationalization of business and economic activity that has occurred since the end of World War II. Although international business activities have existed for centuries, primarily in the form of exporting and importing, only in the postwar period have multinational firms become preeminent. The distinguishing characteristic of the MNC is its emphasis on global, rather than affiliate, performance. Specifically, MNCs ask, “Where in the world should we build our plants, sell our products, raise capital, and hire personnel?” Thus the true MNC is characterized more by attitude than the physical reality of an integrated, global system of marketing and production activities. It involves looking beyond the boundaries of the home country and treating the world as “our oyster.” After stimulating student interest with this vision of the MNC, I then introduce the financial decisions that MNCs must make. I begin by discussing the key concepts and lessons from domestic finance that apply directly to international corporate finance. The lessons include the emphasis on cash flow rather than accounting earnings, the time value of money, the importance of taxes, and the unwillingness of investors to reward companies for activities (like corporate diversification) that investors could replicate for themselves at no greater cost. The key concepts, which I point out will arise time and again in the course, are arbitrage, market efficiency, and the separation of risk into systematic risk, which must be rewarded, and unsystematic risk, which is not rewarded. The latter concept, of course, is the intuition underlying both the capital asset pricing model (CAPM) and the arbitrage pricing theory (APT). Although imperfect, the theoretical framework of domestic corporate finance provides a useful frame of reference, and understanding it is essential before proceeding with the more complex aspects of international financial management. I devote some time to explaining that total risk matters, even if the CAPM or APT holds. Otherwise, the astute student will see a conflict between the irrelevance of unsystematic risk and hedging activities. I then outline the key decision areas in international financial management: foreign exchange risk management, managing working capital and the internal financial system, financing foreign units, capital budgeting, and evaluation and control. I emphasize the additional parameters that MNC financial executives must cope with, including multiple currencies, rates of inflation, tax systems, and capital markets, as well as foreign exchange and political risks.

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SUGGESTED ANSWERS TO “THE DEBATE OVER OUTSOURCING” 1. What are the pros and cons of outsourcing? ANSWER. PROS: Outsourcing enables Americans to buy services less expensively abroad, increases U.S. productivity, and enables U.S. companies to cut their costs while improving quality, time to market, and capacity to innovate. It also allows the U.S. to use its comparative advantage in financial, managerial, and technical services by specializing in and exporting such services as higher-end computer programming, management consulting, engineering, banking, telecommunications, and legal work. CONS: As with any kind of trade, importing of services through outsourcing results in the loss of jobs for Americans previously employed in providing those services. Outsourcing may also cause U.S. companies that provide these services to go out of business. 2. How does outsourcing affect U.S. consumers? U.S. producers? ANSWER. As the answer to part a) points out, outsourcing allows companies to buy services less expensively abroad. Competitive pressures force companies to pass these savings along to consumers in the form of lower-priced goods and services. U.S. producers are able to boost productivity and cut costs while improving quality, time to market, and capacity to innovate. As such, American companies are better able to compete. This competition, however, forces companies to pass most of their savings from outsourcing through to their customers. 3. Longer term, what is the likely impact of outsourcing on American jobs? ANSWER. The longer-term effect of outsourcing on U.S. jobs should be insignificant. Trade has little, if anything, to do with the quantity of jobs in an economy but rather the nature and distribution of those jobs in various occupations. Outsourcing should lead to higher average productivity of those jobs that Americans work at and, hence, to higher wages and benefits. 4. Several states are contemplating legislation that would ban the outsourcing of government work to foreign firms. What would be the likely consequences of such legislation? ANSWER. Such legislation would result in less efficient and more expensive government. The end result would be higher taxes or, if taxpayers balk, fewer government services. SUGGESTED ANSWERS TO CHAPTER 1 QUESTIONS 1. Explain how globalization may affect even a small business in your local area. ANSWER. Globalization entails opening national borders to enable freer movement of goods and services. Due to the rapid decrease in communication and transportation costs over the last few decades, many firms find it cheaper to source products from foreign countries. Also, firms are now aware of international market opportunities and locate their plants and facilities abroad. As a result, the competition faced by any business is now more global rather than merely local. A small business in any local area now faces competition from both large MNCs and similarly situated businesses that take advantage of their international experience as well as internationally sourced products.

CHAPTER 1: INTRODUCTION

2. Opponents of globalization and outsourcing argue that locating manufacturing activities abroad causes a loss of U.S. jobs. However, total employment figures reveal that rather than resulting in a net loss of jobs, employment has actually increased. Also, the average wages of workers have increased. How would you account for this discrepancy between what the critics say and what statistics reveal? ANSWER. Globalization is a two-way street. While some U.S. firms locate their plants overseas, several foreign companies have also invested in the U.S. economy and located their plants here. For example, major foreign automobile manufacturers such as Toyota and BMW have set up manufacturing plants in the U.S. and created numerous U.S. jobs. Also, over the last 25 years, the U.S. economy has experienced unprecedented productivity growth due to the increase in trade from globalization. The net impact of this productivity growth as measured in output per hour has been such as to increase the inflation-adjusted worker compensation. Thus, while critics of globalization look at only one side of the picture and point to job losses due to outsourcing, they neglect to take into account the job creation due to foreign investment in the U.S. and the increase in trade due to globalization. Critics also ignore the fact the increased opportunities for trade due to globalization result in high-value-added services being performed in the U.S. and the increase in productivity of the U.S. worker. As a result, worker wages have also gone up. 3. Elaborate on the benefits of a proactive approach to globalization and global competition. ANSWER. Rather than react to globalization, firms benefit by facing globalization and global competition head on. Globalization and global competition unleash the forces of creative destruction, whereby new technologies and new methods of business force out poorly performing competitors. To take advantage of the full potential of globalization and to counter global competition, many firms adopt new technologies, improve production methods, explore new markets, and introduce new and better products. The results of such improvements are clear in terms of the lower prices and expanded choices for consumers. Thus, proactive firms stay ahead of their competition by taking advantage of the various benefits of globalization and the expanded trade opportunities. 4. What are the various reasons for the emergence of multinational firms? ANSWER. The primary reason for the emergence of MNCs is the international mobility of several factors of production. MNCs emerge to take advantage of globally available raw materials, markets, specialized skills, and knowledge. Also, firms may become multinational to keep domestic customers that have moved abroad or to exploit financial market imperfections. These are elaborated below. SEARCH FOR RAW MATERIALS.

Some firms become MNCs to exploit the raw materials that can be found overseas, such as oil, coal, minerals, and other natural resources.

MARKET SEEKING.

Some firms become MNCs to exploit foreign markets for their products. Since the same product may be demanded in different countries, MNCs not only take advantage of the marketing opportunities, but also gain from the economies of scale obtained by selling large volumes across different foreign markets.

COST MINIMIZATION.

Companies also become MNCs to seek out lower-production-cost sites. Specific skills needed for production may be available at lower costs in some countries, and MNCs may locate plants specializing in specific aspects of production, such as assembly or fabrication, in those countries.

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KNOWLEDGE SEEKING.

Some firms enter foreign markets to gain information and experience that are expected to prove useful elsewhere. Especially in industries characterized by rapid product innovation and technical breakthroughs, firms obtain technical product and process knowledge, which they leverage in other countries.

KEEPING DOMESTIC CUSTOMERS.

Suppliers of goods or services to MNCs often follow their customers abroad to guarantee them a continuing product flow. In the process, these firms also become MNCs.

EXPLOITING FINANCIAL MARKET IMPERFECTIONS. Companies may find it advantageous to reduce taxes and

circumvent currency controls when operating in multiple foreign markets. Doing so enables them to obtain greater project cash flows and lower costs of funds compared to a purely domestic firm. 5. Given the added political and economic risks that appear to exist overseas, are MNCs more or less risky than purely domestic firms in the same industry? Consider whether a firm that decides not to operate abroad is insulated from the effects of economic events that occur outside the home country. ANSWER. Individual foreign projects may face more political and economic risks than comparable domestic projects. Yet MNCs are likely to be less risky than purely domestic firms because much of the risk faced overseas is diversifiable. Moreover, by operating and producing overseas, the MNC has diversified its cost and revenue structure relative to what it would be if it were a purely domestic firm producing and selling in the home market. It is important to note that domestic firms are not insulated from economic changes abroad. For example, domestic firms face exchange risk because their competitive positions depend on the cost structures of both foreign and domestic competitors. Similarly, changes in the price of oil and other materials abroad immediately lead to changes in domestic prices. 6. How is the nature of IBM’s competitive advantages related to its becoming an MNC? ANSWER. IBM is selling more than black boxes; it is selling a stream of services associated with its computers. In effect, customers are buying the company. To provide customers with what they think they are buying, IBM must be there on the spot. This enables IBM to service customers’ machines as well as tailor software and systems to their specifications. 7. If capital markets were perfect, i.e., capital could move freely across national borders, would MNCs still exist? Why? Or, why not? ANSWER. Even if capital moved freely across national borders, MNCs would still exist, because MNCs bring a host of firm-specific knowledge and advantages along with capital to the countries in which they operate. Such advantages may include unique products, processes, technologies, patents, specific rights, or specific knowledge and skills. These advantages can be used profitably in foreign markets. Moreover, MNCs are better able to apply the knowledge and skills gained in their prior operations in other countries to each new country that they enter. Thus, from the point of view of a country attracting foreign capital, the capital that is brought in by an MNC brings with it firm-specific advantages that yield better returns than the capital that is simply borrowed from a foreign country.

CHAPTER 1: INTRODUCTION

8. What are the various ways in which domestic firms enter international markets? What are the benefits and risks of each strategy of foreign market entry? ANSWER. Three major ways in which domestic firms enter international markets are through exporting, licensing, and overseas production. When exporting, the domestic firm operates from its home country and merely sends its products overseas. In licensing, the domestic firm licenses its product, process, or technology to a foreign firm in return for royalties or other forms of payment. In overseas production, the domestic firm becomes an MNC by setting up a corporation overseas and engaging in manufacturing and/or marketing. The benefits and risks of each strategy are summarized below. Entry

Benefits

Risks

Exporting

• Minimal capital requirements and start-up costs

• Relatively low risk compared to other entry strategies

• Risk is low

• Full sales potential of the product is not realized

• Profits are immediate

Licensing

• Learn about present and future supply and demand, competition, distribution channels, payment conventions, financial institutions, and financial techniques in host country

• Foreign importer is in greater control of marketing, and thus the image, of the firm’s branded products in the foreign country

• Minimal investment requirements

• Cash flow is relatively low

• Faster market-entry time

• May be problems in maintaining product quality standards

• Fewer financial and legal risks

• Foreign licensee may engage in unauthorized exports of the firm’s products, resulting in loss of future revenues for the licensing firm • Foreign licensee may become a strong competitor when license agreement ends

Overseas Production

• The firm can more easily stay abreast of market developments, adapt its products and production schedules to changing local tastes and conditions, fill orders faster, and provide more comprehensive after-sales service • Firm can exploit local skills, including R&D • Signals a greater commitment to the local market, which in turn increases sales and assurance of supply stability

• Tremendous capital and top management commitment is required • Financial and operational risks are greater than those for other entry strategies • Companies face greater political risks, including the risk of expropriation of plants and facilities

9. Why do firms from each of the following categories become MNCs? Identify the competitive advantages that a firm in each category must have to be a successful MNC. a. Raw-materials seekers b. Market seekers c. Cost minimizers ANSWER. FDI is most likely to be economically viable where the possibility of opportunism on the part of unrelated parties or contractual difficulties make it especially costly to coordinate economic activities via arm’s length transactions in the marketplace. Firms go overseas to more fully utilize their skills and other tangible and intangible assets.

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RAW MATERIALS SEEKERS. The existence of low-cost raw materials overseas is not a sufficient condition for

firms to become MNCs; they could just import raw materials rather than set up operations abroad to extract them. Companies that become raw materials MNCs must a) Have intangible capabilities in the form of technical skills and face contractual difficulties in the form of an inability to price their know-how or to write, monitor, and enforce use restrictions governing technology transfer arrangements; and b) Face problems of opportunism that make it very expensive to enter into long-term purchase contracts to fully utilize their production or distribution capability. For example, an oil refining and distributing firm may find it too risky to invest in further refining capacity without controlling its own oil supply. An independent supplier may decide to break a contractual agreement and cut off the flow of oil to the refiner. MARKET SEEKERS. These firms usually have intangible capital in the form of organizational skills that are

inseparable from the firm itself. A basic skill involves knowledge about how best to service a market, including new product development and adaptation, quality control, advertising, distribution, and after-sales service. Since it would be difficult, if not impossible, to unbundle these services and sell them apart from the firm, this form of market imperfection often leads to corporate attempts to exert control directly via the establishment of foreign affiliates. COST MINIMIZERS. These firms seek to reduce their costs by producing overseas. Yet the existence of

lower-cost production sites overseas is not sufficient to justify FDI. Since local firms have an inherent cost advantage over foreign investors, MNCs can succeed abroad only if the production or marketing edge they possess cannot be purchased or duplicated by local competitors. The successful MNC in this category will possess specialized design or marketing skills, a good distribution system, or own a strong brand name. Excess profits are earned on these intangible assets, not on the low foreign labor or materials costs. Overseas production just enables them to be cost competitive; it doesn't give them an edge since any competitor can replicate its production location. 10. What factors help determine whether a firm will export its output, license foreign companies to manufacture its products, or set up its own production or service facilities abroad? Identify the competitive advantages that lead companies to prefer one mode of international expansion over another. ANSWER. Here are some factors involved in deciding how to enter a market: i)

PRODUCTION ECONOMIES OF SCALE. If these are important, then exporting might be appropriate.

ii) TRADE BARRIERS. Companies that might otherwise export to a market may be forced by regulations to produce abroad, either in a wholly owned operation, a joint venture, or through a licensing arrangement with a local manufacturer. iii) TRANSPORTATION COSTS. These have the same effect as trade barriers. The more expensive it is to ship a product to a market, the more likely it is that local production will take place. iv) SIZE OF THE FOREIGN MARKET. The larger the local market, the more likely local production will take place, particularly if significant production economies of scale exist. Conversely, with smaller markets, exporting is more likely to take place.

CHAPTER 1: INTRODUCTION

v) PRODUCTION COSTS. The real exchange rate, wage rates, and other cost factors will also play a part in determining whether exporting or local production takes place. vi) INTANGIBLE CAPITAL. If the MNC’s intangible capital is embodied in the form of products, exporting will generally be preferred. If intangible capital takes the form of specific product or process technologies that can be written down and transmitted objectively, foreign expansion will usually take the licensing route. If intangible capital takes the form of organizational skills that are inseparable from the firm itself, then the firm is likely to expand overseas via direct investment. vii) NECESSITY OF A FOREIGN MARKET PRESENCE. By investing in fixed assets abroad, companies can demonstrate to local customers their commitment to the market. This can enhance sales prospects. 11. Time Warner must decide whether to license foreign companies to produce its films and records or set up foreign sales affiliates to sell its products. What factors might determine whether it expands abroad via licensing or investing in its own sales force and distribution network? ANSWER. Some of the factors that Warner should consider in determining whether it expands abroad via licensing or by investing in its own sales force and distribution network are as follows: a) SALES VOLUME. It needs a certain minimum volume of business to justify its own sales force. b) POTENTIAL PROBLEMS OF OPPORTUNISM. How easy is it to monitor and control independent producers and sellers of its films and records? The easier it is to monitor and control them, the less value there is in having its own sales and distribution capability. c) CONFLICTS OF INTEREST. How motivated will independents be in pushing Time Warner’s products versus those of other companies? d) COLLATERAL BENEFITS TO WARNER. To the extent Time Warner gets other benefits from distributing its films (e.g., the sale of toys) that aren’t captured by independents, they will have less incentive to push Time Warner’s products than Time Warner will have. The more collateral benefits, the more important it is for Time Warner to control its own sales. e) THE IMPORTANCE OF MARKET INFORMATION. If products must be tailored to the foreign markets, Time Warner should probably develop its own sales force. Time Warner will find it difficult to gather the necessary market intelligence from independent distributors of its products. ADDITIONAL CHAPTER 1 QUESTIONS AND ANSWERS 1.a. What are the various categories of MNCs? ANSWER. Raw materials seekers, market seekers, and cost minimizers. 1.b. What is the motivation for international expansion of firms within each category? ANSWER. Raw materials seekers go abroad to exploit the raw materials that can be found there and can’t be found domestically. Market seekers go overseas to produce and sell in foreign markets. Cost minimizers invest in lower-cost production sites overseas to remain cost competitive both at home and abroad. In all cases, the firms involved recognize that the world is larger than the home country and provides opportunities to gain additional supplies, sell more products, or find lower-cost sources of production.

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2.a. How does foreign competition limit the prices domestic companies can charge and the wages and benefits workers can demand? ANSWER. As domestic producers raise their prices, customers begin substituting less-expensive goods and services supplied by foreign producers. The likelihood of losing sales limits the prices domestic firms can charge. Foreign competition also limits the wages and benefits workers can demand. If workers demand more money, firms have two choices: acquiesce to these demands or fight them. Absent foreign competition, the cost of acquiescence is relatively low, particularly if the industry is unionized. Since all firms will face the same higher costs, they can cover these higher costs by all simultaneously raising their prices without fear of being undercut or of being placed at a competitive disadvantage relative to their peers. Foreign competition changes the picture because foreign firms’ costs will be unaffected by higher domestic wages and benefits. If domestic firms give in on wages and benefits, foreign firms will underprice them in the market and take market share away. In this case, higher domestic costs will put domestic firms at a disadvantage vis-à-vis their foreign competitors. Recognizing this, domestic firms facing foreign competition are more likely to fight worker demands for higher wages and benefits. 2.b. What political solutions can help companies and unions avoid the limitations imposed by foreign competition? ANSWER. The classic political solution is protectionism. By limiting foreign competition either through tariffs or quotas, companies and workers limit the ability of foreign goods to restrain domestic price increases. The government can also subsidize domestic firms competing against foreign firms, allowing domestic firms and unions to perpetuate uneconomic work rules, wages, and productions processes. 2.c.

Who pays for these political solutions? Explain.

ANSWER. Consumers pay for protectionism in the form of higher prices for their goods and services, fewer choices, and lower quality. Taxpayers pay for subsidies in the form of higher taxes or fewer of the other services provided by government. 3.a. What factors appear to underlie the Asian currency crisis? ANSWER. Asian countries had run up huge debts, mostly in dollars, and were depending on the stability of their currencies to repay these loans. Worse, Asian banks, urged on by the often-corrupt political leadership, were making loans to money-losing ventures controlled by political cronies. The result was financially troubled economies that could not generate the income necessary to repay their dollar loans. 3.b. What lessons can we learn from the Asian currency crisis? ANSWER. Financial crises can be avoided or mitigated if financial markets are open and transparent, thereby leading to investment decisions based on sound economic principles rather than cronyism or political considerations. Countries can stimulate healthier economies by avoiding policies that suppress enterprise, reward cronies, and squander resources on economically dubious, grandiose projects. 4.a. What is an efficient market? ANSWER. An efficient market is one in which new information is readily incorporated in the prices of traded securities. In an efficient market, one cannot expect to prosper by finding overvalued or undervalued assets. In addition, all funds require the same risk-adjusted returns. Absent tax considerations or government intervention, therefore, market efficiency suggests that no financing bargains are available.

CHAPTER 1: INTRODUCTION

4.b. What is the role of a financial executive in an efficient market? ANSWER. In an efficient market, attempts to increase a firm’s value by purely financial measures or accounting manipulations are unlikely to succeed unless capital market imperfections or asymmetries in tax regulations exist. The net result has been to focus attention on those areas and circumstances in which financial decisions and financial managers can have a measurable impact. Key areas are capital budgeting, working capital management, and tax management. Circumstances to be aware of include capital market imperfections, caused primarily by government regulations, and asymmetries in the tax treatment of different types and sources of revenues and costs. As such, the role of the financial manager is to search for and take advantage of capital market imperfections and tax asymmetries to increase after-tax profits and lower the cost of capital. The value of good financial management is enhanced in the international arena because of the greater likelihood of market imperfections and multiple tax rates. In addition, the greater complexity of international operations is likely to increase the payoffs from a knowledgeable and sophisticated approach to internationalizing the traditional areas of financial management. 5.a. What is the capital asset pricing model? ANSWER. The CAPM quantifies the relevant risk of an investment and establishes the trade-off between risk and return; i.e., the price of risk. It posits a specific relationship between diversification, risk, and required asset returns. In effect, the CAPM says that the required return on an asset equals the risk-free return plus a risk premium based on the asset’s systematic or nondiversifiable risk. The latter is based on market-wide influences that affect all assets to some extent, such as unpredictable changes in the state of the economy or in some macroeconomic policy variable, such as the money supply or the government deficit. 5.b. What is the basic message of the CAPM? ANSWER. The CAPM’s basic message is that risk is priced in a portfolio context. From this it follows that only systematic risk is priced; unsystematic risk, which by definition can be diversified away, is not priced and hence doesn’t affect the required return on a project. 5.c.

How might an MNC use the CAPM?

ANSWER. The CAPM can be used to estimate the required return on foreign projects. It can also help a company raise the right questions about risk when considering the desirability of a foreign project, the most important being which elements of risk are diversifiable and which are not. 6.

Why might total risk be relevant for a multinational corporation?

ANSWER. Higher total risk is relevant for an MNC because it could have a negative impact on the firm’s expected cash flows The inverse relation between risk and expected cash flows arises because financial distress, which is more likely to occur for firms with high total risk, can impose costs on customers, suppliers, and employees, and thereby affect their willingness to commit themselves to relationships with the firm. In summary, total risk is likely to adversely affect a firm’s value by leading to lower sales and higher costs. Consequently, any action taken by a firm that decreases its total risk will improve its sales and cost outlooks, thereby increasing its expected cash flows.

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7. A memorandum by Labor Secretary Robert Reich to President Clinton suggests that the government penalize U.S. firms that invest overseas rather than at home. According to Reich, this kind of investment hurts exports and destroys well-paying jobs. Comment on this argument. ANSWER. The assumption underlying Secretary Reich’s memo is inconsistent with the empirical evidence. According to this evidence, U.S. firms that invest abroad tend to expand their exports. The jump in exports stems from the fact that by investing abroad, companies are able to expand their presence in foreign markets as well as protect foreign markets that would otherwise be lost to competitors. This enables them to sell more product, most of which is made in the U.S. In addition, the foreign plants tend to use components and capital equipment that are mostly made in and exported from U.S. plants. Penalizing U.S. companies that invest abroad would most likely lead to the loss of foreign markets as well as the additional exports that such markets generate. Such penalties would also reduce the efficiency of the world economy. After all, there is usually a sound economic reason for MNCs to invest abroad. 8.a. Are MNCs riskier than purely domestic firms? ANSWER. Although MNCs are confronted with many added risks when venturing overseas, they can also take advantage of international diversification to reduce their overall riskiness. We will also see in Chapter 16 that foreign operations enable MNCs to retaliate against foreign competitive intrusions in the domestic market and to more closely track their foreign competitors, reducing the risk of being blindsided by new developments overseas. 8.b. What data would you need to address this question? ANSWER. You would need to take relatively comparable firms in the same industry, but with different percentages of earnings from abroad, and compare the variability of their earnings. 9. Is there any reason to believe that MNCs may be less risky than purely domestic firms? Explain. ANSWER. Yes. International diversification may actually enable firms to reduce their total risk. Much of the general market risk facing a company is related to the cyclical nature of the domestic economy of the home country. Operating in a number of nations whose economic cycles are not perfectly in phase may, therefore, reduce the overall variability of the firm’s earnings. Thus, although the riskiness of operating in any one country may exceed the risk of operating in the U.S. (or other home country), much of that risk is eliminated through diversification. In fact, as shown in Chapter 15, the variability of earnings appears to decline as firms become more internationally oriented. 10.

In what ways do financial markets grade government economic policies?

ANSWER. Traders and their customers receive a continuing flow of news from around the world. The announcement of a new policy leads traders to buy or sell currency, stocks, or bonds based on their evaluation of the effect of that policy on the market. A desirable policy leads them to buy more of the assets favorably affected by the policy, while a policy that is judged to be harmful leads to sell orders of those assets that will be hurt by the policy. The result is a continuing global referendum on a nation’s economic policies, even before they are implemented.

CHAPTER 1: INTRODUCTION

Politicians who pursue economic policies they perceive to be beneficial to them (e.g., improving their re-election odds), even if these policies harm the national economy, usually don't appreciate the grades they receive. But the market is clear-eyed and hard-nosed and will respond negatively to unsound fiscal and monetary policies. Politicians will not admit that their own policies led to higher interest rates or lower currency values or stock prices; that would be political suicide. It is much easier to blame greedy speculators rather than their policies for the market’s response. 11.

In seeking to predict tomorrow’s exchange rate, are you better off knowing today’s exchange rate or the exchange rates for the past 100 days?

ANSWER. In an efficient market, which the foreign exchange market certainly appears to be, the current price of an asset such as a currency fully reflects all available information, including the complete price history. Thus, knowing today’s price is as informative from a forecasting standpoint as knowing all past prices. Past prices add nothing to the current price in terms of forecasting ability. 12.

Why might setting up production facilities abroad lead to expanded sales in the local market?

ANSWER. By producing abroad, a company can more easily keep abreast of market developments, adapting its products and production schedules to changing local tastes and conditions, while simultaneously providing more comprehensive after-sales service. Establishing local production facilities also demonstrates a greater commitment to the local market and an increased assurance of supply stability. This is particularly important for firms that produce intermediate goods for sale to other companies. 13a. How might total risk affect a firm’s production costs and its ability to sell? Give some examples of firms in financial distress that saw their sales drop. ANSWER. Higher total risk can lead to lower sales and higher production costs. The inverse relation between risk and expected cash flows arises because financial distress, which is more likely to occur for firms with high total risk, can impose costs on customers, suppliers, and employees and thereby affect their willingness to commit themselves to relationships with the firm. Examples include Chrysler and Texaco, which saw their sales fall and costs of doing business rise when they were in financial distress. 13.b. What is the relation between the effects of total risk on a firm's sales and costs and its desire to hedge foreign exchange risk? ANSWER. Since total risk is likely to adversely affect firm value, by lowering sales and raising costs, any action taken by a firm that decreases its total risk will improve its sales and cost outlook, thereby increasing its expected cash flows. These effects help justify the range of corporate hedging activities designed to reduce total risk that MNCs engage in.

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SUGGESTED ANSWERS TO APPENDIX 1A QUESTIONS 1. In a satirical petition on behalf of French candlemakers, French economist Frederic Bastiat called attention to cheap competition from afar: sunlight. A law requiring the shuttering of windows during the day, he suggested, would benefit not only candlemakers but “everything connected with lighting” and the country as a whole. He explained: “As long as you exclude, as you do, iron, corn, foreign fabrics, in proportion as their prices approximate to zero, what inconsistency it would be to admit the light of the sun, the price of which is already at zero during the entire day!” 1.a. Is there a logical flaw in Bastiat’s satirical argument? ANSWER. No. Bastiat is precisely right. The objective of trade is to gain access to goods and services at lower quality-adjusted prices. The ultimate consequence is to make more efficient use of the world’s resources and thereby increase worldwide production and consumption. Protectionism aims to prevent this end. If protectionism succeeds, world output and consumption are lower than they might otherwise be because resources are not being put to their highest-value use. In the example cited by Bastiat, protectionism will lead to a squandering of resources by replicating what the sun can do less expensively. 1.b. Do Japanese automakers prefer a tariff or a quota on their U.S. auto exports? Why? Is there likely to be consensus among the Japanese carmakers on this point? Might there be any Japanese automakers that are likely to prefer U.S. trade restrictions? Why? Who are they? ANSWER. It depends. Both tariffs and quotas will lead to higher prices to U.S. consumers of imported Japanese cars. With tariffs, however, most of this price increase will go to the U.S. government in the form of tariffs. Japanese companies (or their dealers), on the other hand, will collect most, if not all, of the higher prices associated with the scarcity of imported Japanese cars. Once the Japanese producers hit their quota limit, they have no incentive to compete with each other by cutting price because they cannot sell more cars than they already are. The net result is that the U.S. market will be extraordinarily profitable to Japanese automakers, which it was. Since quotas tend to be allocated based on current sales, automakers like Toyota and Nissan with large market shares would prefer quotas, whereas automakers like Honda and Mitsubishi with smaller market shares would prefer tariffs. The reason for the latter’s preference for tariffs is that efficient companies can eventually overcome the effects of tariffs by cutting costs and prices, whereas efficiency counts for nothing with quotas. Regardless of the type of trade barrier imposed, U.S. automakers will raise their prices in line with higher import prices. However, U.S. automakers are likely to prefer quotas because quotas enable them to disguise the reason for higher U.S. car prices. Consumers would be much quicker to figure out the cause-effect relationship between higher tariffs and higher prices on U.S. and Japanese cars. 1.c.

What characteristics of the U.S. auto industry have helped it gain protection? Why does protectionism persist despite the obvious gains to society from free trade?

ANSWER. The U.S. auto industry has received as much protection as it has for two key reasons. First, it is a large and powerful industry. Second, it is concentrated in several politically important states, such as Michigan and Illinois.

CHAPTER 1: INTRODUCTION

2. Review the arguments both pro and con on NAFTA. What is the empirical evidence so far? ANSWER. NAFTA has helped increase international trade between the U.S., Mexico, and Canada. The results thus far indicate that NAFTA has created some jobs in both countries and cost some jobs. Indeed, the purpose of free trade is not to create jobs but to increase the purchasing power and choice of consumers. With respect to jobs, the effect of free trade is to create higher-paying jobs that replace lowerpaying jobs. The number of jobs in an economy is independent of the presence or absence of trade. It has every thing to do with the incentives that people have to work, their productivity, and the costs to employers of hiring workers. What trade does is permit workers to hold jobs in those areas of the economy in which the nation has a comparative advantage. At the same time, trade destroys jobs in those goods and services in which the nation is at a comparative disadvantage. 3. Given the resources available to them, countries A and B can produce the following combinations of steel and corn. Country A

Country B

Steel (tons)

Corn (bushels)

Steel (tons)

Corn (bushels)

3.a. Do you expect trade to take place between countries A and B? Why? ANSWER. Yes. Given the data presented, if country A has 6 units of resources and it devotes X of these units to steel production, where X is an integer, it can produce a total of 6X tons of steel and 3(6 - X) bushels of corn Similarly, with 54 units of resources, country B of which it devotes Y units to steel production, it can produce Y tons of steel plus (54 - Y) bushels of corn. The net effect of these production functions is that one bushel of corn is worth 2 tons of steel in country A. In contrast, one bushel of corn is worth only one ton of steel in country B. These relative prices indicate that country A has a comparative advantage in the production of steel, whereas B has a comparative advantage in the production of corn. 3.b. Which country will export steel? Which will export corn? Explain. ANSWER. Given these comparative advantages, A will export steel and B will export corn. The price of corn will settle somewhere between one and two tons of steel. Suppose it settles at 1.5 tons of steel. Then, instead of producing, say, 30 tons of steel and 3 bushels of corn, it can devote an additional resource unit to the production of an additional 6 tons of steel. It can trade these 6 tons of steel with B for 6/1.5 = 4 bushels of corn, leaving it one bushel of corn better off. Similarly, B can now get 6 tons of steel for the 4 bushels of corn it trades to A instead of the 4 tons of steel it could produce on its own with the resources it took to produce the 4 bushels of corn.

CHAPTER 2: THE DETERMINATION OF EXCHANGE RATES

CHAPTER 2 THE DETERMINATION OF EXCHANGE RATES This chapter explains what an exchange rate is and how it is determined in a freely floating exchange rate regime, that is, in the absence of government intervention. This is done using a simple two-country model. Because of its pervasiveness, we also examine the different forms and consequences of central bank intervention in the foreign exchange markets. Since an exchange rate can be considered as the relative price of two financial assets, the chapter discusses the asset market model of currencies and the role of expectations in exchange rate determination. A separate section discusses the real changes in a nation’s economy that cause exchange rate changes. KEY POINTS 1. Absent government intervention, exchange rates respond to the forces of supply and demand, which in turn depend on relative inflation rates, interest rates, and GNP growth rates. 2. Monetary policy is crucial. If the central bank expands the money supply at a faster rate than money demand, the purchasing power of money declines both at home (from inflation) and abroad (from currency depreciation). 3. The healthier the economy is, the stronger the currency is likely to be. 4. Exchange rates are affected by expectations of future exchange rate changes, which depend on forecasts of future economic and political conditions. 5. To achieve certain economic or political objectives, governments often intervene in the currency markets to affect the exchange rate. Although the mechanics of such intervention vary, the general purpose of each variant is basically the same: to increase the market demand for one currency by increasing the market supply of another. Alternatively, the government can control the exchange rate directly by setting a price for its currency and then restricting access to the foreign exchange market. 6. A critical factor that helps explain the volatility of exchange rates is that, with fiat money, there is no anchor to a currency’s value, nothing around which beliefs can coalesce. Since people are unsure about what to expect, any new piece of information can dramatically alter their beliefs. Thus, if the underlying domestic economic policies are unstable, exchange rates will be volatile as traders react to new information.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

SUGGESTED ANSWERS TO “ASIAN CURRENCIES SINK IN 1997” 1. What were the origins of the Asian currency crisis? ANSWER. The case suggests several causes of the Asian currency crisis. First was the loss of export competitiveness. A number of Asian countries had tied their currencies to the dollar, so the dramatic appreciation of the dollar against the yen, Deutsche mark, and other currencies made their exports less price competitive. Their competitiveness problem was exacerbated by the fact that during this period, the Chinese yuan depreciated by about 25% against the dollar. A second contributing factor to Asia’s financial problems was moral hazard – the tendency to incur risks that one is protected against. Specifically, most Asian banks and finance companies operated with implicit or explicit government guarantees. When combined with poor regulation, these guarantees distorted investment decisions, encouraging financial institutions to fund risky projects in the expectation that the banks would enjoy any profits, while sticking the government with any losses. Without market discipline or risk-based bank lending, the result was overinvestment – financed by vast quantities of debt – and inflated prices of assets in short supply, such as land. The Asian financial crisis then was touched off when local investors began dumping their own currencies for dollars and foreign lenders refused to renew their loans to Asian companies and banks. 2. What role did expectations play in the Asian currency crisis? ANSWER. Expectations were critical in causing the financial bubble and then popping it. Specifically, the Asian financial bubble persisted as long as people believed the government could honor its implicit guarantee. However, this guarantee brought with it the seeds of its own demise as inevitable glut of real estate and excess production capacity lead to large amounts of nonperforming loans and widespread loan defaults. When reality struck and investors realized that the government didn’t have the resources to bail out everyone, asset values plummeted and the bubble burst. The decline in asset values triggered further loan defaults, causing a loss of the confidence on which economic activity depended. Investors also worried that the government would try to inflate its way out of its difficulty. The result was a selfreinforcing downward spiral and capital flight. As foreign investors refused to renew loans and begin to sell off shares of overvalued local companies, capital flight accelerated and the local currency fell, increasing the cost of servicing foreign debts. Local firms and banks scrambled to buy foreign exchange before the currency fell further, putting even more downward pressure on the exchange rate. This story explained why stock prices and currency values declined together and why Asian financial institutions were especially hard hit. Moreover, this process was likely to be contagious, as investors searched for other countries with similar characteristics. When such a country is found, everyone rushes for the exit simultaneously and another bubble is burst, another currency is sunk. In the case of the Asian currency crisis, investors also realized that their loss of export competitiveness gave the Asian central banks a mutual incentive to devalue their currencies to try to regain their export competitiveness. According to one theory, recognizing these altered incentives, speculators attacked the East Asian currencies almost simultaneously and forced a round of devaluations.

CHAPTER 2: THE DETERMINATION OF EXCHANGE RATES

3. How did the appreciation of the U.S. dollar and depreciation of the yuan affect the timing and magnitude of the Asian currency crisis? ANSWER. Sooner or later, the moral hazard associated with implicit government guarantees of reckless investments would result in a crisis. What dollar appreciation and yuan depreciation did was to speed up the crisis. Specifically, the loss of export competitiveness slowed down Asian growth and caused utilization rates – and profits – on huge investments in production capacity to plunge. It also gave the Asian central banks a mutual incentive to devalue their currencies to try to regain their export competitiveness. 4. What is moral hazard and how did it help cause the Asian currency crisis? ANSWER. As explained above, moral hazard is the tendency to incur risks that one is protected against. The origin of the moral hazard faced by Asian countries was the implicit or explicit government guarantees that most Asian banks and finance companies operated with. When combined with poor regulation, these guarantees distorted investment decisions, encouraging financial institutions to fund risky projects in the expectation that the banks would enjoy any profits, while sticking the government with any losses. Without market discipline or risk-based bank lending, the result was overinvestment – financed by vast quantities of debt – and inflated prices of assets in short supply, such as land. The Asian financial crisis then was touched off when local investors began dumping their own currencies for dollars and foreign lenders refused to renew their loans to Asian companies and banks. 5. Why did so many East Asian companies and banks borrow dollars, yen, and Deutsche marks instead of their local currencies to finance their operations? What risks were they exposing themselves to? ANSWER. East Asian banks and companies financed themselves with dollars, yen, and Deutsche marks – some $275 billion worth, much of it short term – because dollar and other foreign currency loans carried lower interest rates than did their domestic currencies. The risk they were exposing themselves – a risk that manifested itself – was that their local currencies would devalue against the borrowed foreign currencies, making these foreign currency loans more expensive to pay back in terms of their local currencies. This risk was also borne by the banks that made these foreign currency loans, since a company that goes bankrupt because it cannot repay its loans will eventually pass its loan losses onto its lenders. SUGGESTED ANSWERS TO “THE U.S. DOLLAR SELLS OFF” 1. How did China and Japan manage to weaken their currencies against the dollar? ANSWER. China and Japan intervened in the foreign exchange market to weaken their currencies against the dollar. Specifically, the Chinese and Japanese central banks issued additional yuan and yen, respectively, and used this money to buy an equivalent amount of dollars. By expanding the supply of yen and yuan and increasing the demand for dollars, both countries managed to hold down the value of their currencies against the dollar. China and Japan then used the dollars they acquired through their foreign exchange intervention to buy U.S. Treasury bonds.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

2. Why did the U.S. dollar and U.S. Treasury bonds fall in response to the G7 statement? ANSWER. The G7 endorsed “flexibility” in exchange rates, a codeword widely regarded as an encouragement for China and Japan to stop managing their currencies. If China and Japan accepted this advice, they would cease their purchases of dollars. Such an action would reduce the value of the dollar. At the same time, the reduced purchases of dollars would cause China and Japan to make fewer purchases of U.S. Treasury bonds, thereby reducing the demand for Treasury bonds. A reduced demand for U.S. Treasury bonds would lead to a drop in value. Both the dollar and U.S. Treasury bonds fell on the G7 announcement based on the expectation that China and Japan might accept the G7 advice. 3. What is the link between currency intervention and China and Japan buying U.S. Treasury bonds? ANSWER. As noted above, China and Japan acquired the dollars they used to buy U.S. Treasury bonds through their foreign exchange market intervention. The more these countries intervened in the foreign exchange market, the more dollars they would have to buy Treasury bonds. Conversely, ceasing such intervention would mean these countries would no longer have the dollars to buy Treasury bonds. 4. What risks do China and Japan face from their currency intervention? ANSWER. To intervene in the foreign exchange market, China and Japan have to expand their domestic money supplies. The danger is that the rising money supplies will cause inflation. Another risk is that other countries will engage in competitive devaluations to boost their export competitiveness vis-à-vis the Chinese and Japanese. Finally, China and Japan face the very real danger that their cheap currency policy will stir up protectionist measures in its trading partners. SUGGESTED ANSWERS TO “A YEN FOR YUAN” 1. Why is China trying to hold down the value of the yuan? What evidence suggests that China is indeed pursing a weak currently policy? ANSWER. China believes that it needs to export to keep people employed and provide jobs, as state enterprises become obsolete and close down. The government worries that a large body of unemployed people would lead to unrest. Evidence that a weak yuan policy is being pursued shows up in the peg to the dollar being maintained despite the weakening of the dollar. The existence of the peg is evident from the fixed exchange rate and the large quantity of dollars the government is buying up to support the dollar against the yuan (as seen in the jump in China’s foreign exchange reserves in recent years). 2. What benefits does China expect to realize from a weak currency policy? ANSWER. China hopes that flourishing export businesses will be able to absorb newly unemployed people from state enterprises that are being shut down. In addition, a perceived potential deflation can be averted by maintaining a weak yuan (which raises the price of foreign goods) and expanding the yuan money supply in pursuit of this policy.

CHAPTER 2: THE DETERMINATION OF EXCHANGE RATES

3. Other things being equal, what would a 27.5% tariff cost American consumers annually on $200 billion in imports from China? ANSWER. Other things being equal, American consumers would pay an additional $55 billion on such imports (0.275 * $200 billion). 4. Currently, imports from China account for about 10% of total U.S. imports. A 25% appreciation of the yuan would be the equivalent of what percent dollar depreciation? How significant would such a depreciation likely be in terms of stemming America’s appetite for foreign goods? ANSWER. All else being equal, if the yuan appreciates by 25%, the dollar cost of Chinese goods would rise by the same percent. With Chinese imports accounting for about 10% of total U.S. imports, a 25% yuan appreciation would increase the dollar cost of U.S. imports by about 2.5% overall. This figure represents an approximate 2.5% dollar depreciation. (1 - 1/1.025 = -2.439% to be exact). 5. What policy tool is China using to maintain the yuan at an artificially low level? Are there any potential problems with using this policy tool? What might China do to counter these problems? ANSWER. China is keeping the yuan pegged to the dollar by issuing more yuan to buy up dollars. The problem with maintaining the weak value is a rising money supply. A rapidly expanding money supply results in inflation. In China’s case, this inflationary pressure is most noticeable in asset prices. To cope with this problem, the Chinese government could sterilize its foreign exchange intervention, but that is likely to result in continuing pressure on the yuan to appreciate. Alternatively, as suggested in the answer to part 6, China could free its currency and allow capital outflows, which would absorb much of the pressure, to appreciate. 6. Does an undervalued yuan impose any cost on the Chinese economy? If so, what are they? ANSWER. An undervalued yuan raises the cost of foreign goods and services to Chinese consumers and companies, reducing their purchasing power overseas. Another potential cost of pursuing a cheap currency policy is the possibility of stirring up protectionist measures in its trading partners. 7. Suppose the Chinese government ceased its foreign exchange market intervention and the yuan climbed to five to the dollar. What would be the percentage gain to the dollar investor? ANSWER. In this scenario, the value of the yuan would rise from $0.1307 (1/7.65) to $0.20 (1/5). The resulting gain in dollar value is (0.20 – 0.1307)/0.1307 or 53%. 8. Currently the yuan is not a convertible currency, meaning Chinese individuals cannot exchange their yuan for dollars to invest abroad. Moreover, companies operating in China must convert all their foreign exchange earnings into yuan. What would happen to the pressure on the yuan to revalue if China relaxed these currency controls and restraints on capital outflows? ANSWER. Relaxing currency controls and constraints on capital outflows would result in increased capital outflows and an increase in the demand for foreign currency. Other things being equal, this increased demand for foreign exchange would reduce the pressure on the yuan to revalue and could even result in a depreciation of the yuan if the demand for foreign assets (for diversification and investment purpose, say) were sufficiently great.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

SUGGESTED ANSWERS TO CHAPTER 2 QUESTIONS 1. Describe how these three typical transactions should affect present and future exchange rates. 1.a. Seagram imports a year's supply of French champagne. Payment in euros is due immediately. ANSWER. The euro should appreciate relative to the dollar since demand for euros is rising. 1.b. MCI sells a new stock issue to Alcatel, the French telecommunications company. Payment in dollars is due immediately. ANSWER. The spot value of the dollar should increase as Alcatel demands dollars to pay for the new stock issue. The future value of the dollar should decline as dividend payments are sent to Alcatel and other Alcatel equipment and parts are imported. However, the value of the dollar in the future could increase if expanded MCI output substitutes for telecom imports. 1.c. Korean Airlines buys five Boeing 747s. As part of the deal, Boeing arranges a loan to KAL for the purchase amount from the U.S. Export-Import Bank. The loan is to be paid back over the next seven years with a two-year grace period. ANSWER. The spot price of the dollar should be unaffected. The future price of the dollar should increase as KAL repays the loan. 2. The maintenance of money's value is said to depend on the monetary authorities. What might the monetary authorities do to a currency that would cause its value to drop? ANSWER. The value of any good or asset is driven by its scarcity. The monetary authorities could make money less scarce by issuing more of it. This would lower its scarcity value. Even though its nominal value will always be the same, the added supply will reduce the purchasing power per unit of money. 3. For each of the following six scenarios, say whether the value of the dollar will appreciate, depreciate, or remain the same relative to the Japanese yen. Explain each answer. Assume that exchange rates are free to vary and that other factors are held constant. 3.a. The growth rate of national income is higher in the United States than in Japan. ANSWER. The value of the dollar should rise as more rapidly; rising GDP in the United States leads to a relative increase in demand for dollars. 3.b. Inflation is higher in the U.S. than in Japan. ANSWER. The value of the dollar should fall in line with purchasing power parity. 3.c.

Prices in Japan and the United States are rising at the same rate.

ANSWER. According to PPP, the exchange rate should remain the same. 3.d. Real interest rates are higher in the United States than in Japan. ANSWER. The value of the dollar should rise as the higher real rates attract capital from Japan that must first be converted into dollars.

CHAPTER 2: THE DETERMINATION OF EXCHANGE RATES

3.e.

The United States imposes new restrictions on the ability of foreigners to buy American companies and real estate.

ANSWER. The value of the dollar should fall as foreigners find it less attractive to own U.S. assets. 3.f.

U.S. wages rise relative to Japanese wages, and American productivity falls behind Japanese productivity.

ANSWER. Higher U.S. wages and declining relative productivity weaken the American economy and make it less attractive for investment purposes. Assuming that a weak economy leads to a weak currency, the dollar will fall. From a somewhat different perspective, when a nation’s productivity growth lags behind that of its major trading partners, the other country’s currency will depreciate. The lagging country regains its balance, but only by accepting a lower real price for its goods. In effect, the cheaper currency is the market’s way of cutting wages in the lagging country. 4. The Fed adopts an easier monetary policy. How is this likely to affect the value of the dollar and U.S. interest rates? ANSWER. If the Fed switches to an easier monetary policy, the value of the dollar will drop as fears of inflation rise. Short-term U.S. interest rates will initially fall but will then rise as investors seek to protect themselves from higher anticipated inflation. Long-term rates will probably rise immediately because of fears of future inflation. Over time, however, if the growth in the money supply stimulated the economy to grow more rapidly than it otherwise would, the value of the dollar could rise, and so could real interest rates. This is an unlikely scenario, however, as indicated by the experiences of Latin American nations. 5. Comment on the following news from the Wall Street Journal (April 3, 2007, p. C12): “The dollar was little changed against the euro and yen, but weakened versus the currencies of Australia and the United Kingdom as investors mulled possible further rate increases in those countries.” ANSWER. The increase in Australia and U.K. interest rates made assets in the two countries more attractive to investors. In the process of shifting funds from the U.S. to Australia and the U.K, investors sold dollars to buy the AUS$ and pounds they needed to invest in these assets. An alternative – and consistent – explanation is that the rise in interest rates reflected a tightening of monetary policies in Australia and U.K., leading investors to anticipate less inflation in the future for the two economies, which would increase their desire to hold AUS$ and pound and thereby boost its value. 6. On November 28, 1990, Federal Reserve Chairman Alan Greenspan told the House Banking Committee that despite possible benefits to the U.S. trade balance, “a weaker dollar also is a cause for concern.” This statement departed from what appeared to be an attitude of benign neglect by U.S. monetary officials toward the dollar’s depreciation. He also rejected the notion that the Fed should aggressively ease monetary policy, as some Treasury officials had been urging. At the same time, Mr. Greenspan didn’t mention foreign exchange market intervention to support the dollar’s value.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

6.a. What was the likely reaction of the foreign exchange market to Mr. Greenspan’s statements? Explain. ANSWER. The dollar rose when Chairman Greenspan indicated that he was concerned about the dollar's slide and would not aggressively ease monetary policy. Investors responded to his statement by lowering their expectations about future U.S. inflation, making dollars a more desirable asset. 6.b. Can Mr. Greenspan support the value of the U.S. dollar without intervening in the foreign exchange market? If so, how? ANSWER. Yes. By tightening U.S. monetary policy, he can lower investor expectations about future U.S. inflation and raise real U.S. interest rates (at least temporarily). Both these effects of tighter monetary policy will boost the dollar’ value. 7. Many Asian governments have attempted to promote their export competitiveness by holding down the values of their currencies through foreign exchange market intervention. 7.a. What is the likely impact of this policy on Asian foreign exchange reserves? On Asian inflation? On Asian export competitiveness? On Asian living standards? ANSWER. To hold down the value of their currencies, Asian central banks must buy up foreign exchange in the market. The result is increased foreign reserves and an expanded domestic money supply, which has the potential to increase inflation. At the same time, the lower exchange rates boost Asian export competitiveness, but at the expense of a lower living standards for their populations (who find foreign goods and services more expensive). 7.b. Some Asian countries have attempted to sterilize their foreign exchange market intervention by selling bonds. What are the likely consequences of sterilization on interest rates? On exchange rates in the longer term? On export competitiveness? ANSWER. To sterilize the expanded domestic money supply resulting from the purchase of foreign exchange, the Asian central bank must sell government securities to the market. These sales would drive down the price of government bonds and drive up domestic interest rates. Higher interest rates, in turn, would attract more foreign capital, which would boost the value of the domestic currency. Thus, in the long run, sterilized intervention will not affect exchange rates and export competitiveness. 8. Hong Kong has a currency board that fixes the exchange rate between the U.S. and HK dollars. 8.a. What is the likely consequence of a large capital inflow for the rate of inflation in Hong Kong? For the competitiveness of Hong Kong business? Explain. ANSWER. As capital flows in, the currency board must exchange the foreign currency for an equivalent amount of HK dollars. The rise in the supply of HK dollars will lead to a higher rate of inflation. Combined with the fixed exchange rate, the rise in the inflation rate will result in an increase in the real exchange rate, making Hong Kong business less competitive.

CHAPTER 2: THE DETERMINATION OF EXCHANGE RATES

8.b. Given a large capital inflow, what would happen to the value of the HK dollar if it were allowed to float freely? What would be the effect on the competitiveness of Hong Kong business? Explain. ANSWER. Given a freely floating HK dollar, all else being equal, a large capital inflow would cause the HK dollar to appreciate. As with a currency board, the resulting appreciation in the real value of the HK dollar would make Hong Kong business less competitive. 8.c.

Given a large capital inflow, will Hong Kong business be more or less competitive under a currency board or with a freely floating currency? Explain.

ANSWER. In both instances, the HK dollar will rise in real terms. However, the ways in which the real exchange rate change occurs will differ. With a currency board, the real exchange rate change will be brought about by the higher inflation that Hong Kong will experience, whereas with a free float it will be brought about by a rise in the nominal exchange rate. Indeed, the appreciation of a freely floating HK dollar will actually cause Hong Kong inflation to fall by reducing the cost of imports. The lower inflation rate will offset some of the loss of competitiveness brought about by the appreciating HK dollar. All else being equal, therefore, a large capital inflow would seem to harm Hong Kong business more under a currency board than with a freely floating currency. Because of this deflationary impact, however, the rise in the nominal exchange will likely be larger than it otherwise might be to balance the supply and demand for HK dollars. In general, the net effect is likely to be the same since it depends only on the demand for HK dollars, and the demand is not affected by the different ways in which that demand is satisfied. 9. In 1994, an influx of drug money to Colombia coincided with a sharp increase in its export earnings from coffee and oil. 9.a. What was the likely impact of these factors on the real value of the Colombian peso and the competitiveness of Colombia's legal exports? Explain. ANSWER. The sharp increase in earnings from drug dealing, coffee, and oil led – as expected – to an appreciation in the real value of the Columbian peso during 1994 (30% against the dollar) by boosting the demand for pesos in the foreign exchange market (as dollar earnings were converted into pesos). This real appreciation reduces the competitiveness of Columbia’s legal exports. 9.b. In 1996, Colombia’s president, facing charges of involvement in his country’s drug cartel, sought to boost his domestic popularity by pursing more expansionist monetary policies. Standing in the way was Colombia’s independent central bank – Banco de la Republica. In response, the president and his supporters discussed the possibility of returning central bank control to the executive branch. Describe the likely economic consequences of ending Banco de al Republica’s independence. ANSWER. A sharp and continuing increase in the money supply would lead to hyperinflation and lower popularity for the president.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

ADDITIONAL CHAPTER 2 QUESTIONS AND ANSWERS 1. Suppose prices start rising in the U.S. relative to prices in Japan. What would we expect to see happen to the dollar:yen exchange rate? Explain. ANSWER. As U.S. prices start rising relative to Japanese prices, both American and Japanese consumers will start substituting Japanese for U.S. goods, leading to increases in both the supply of U.S. dollars and the demand for Japanese yen. The result will be a depreciation of the dollar. 2. If a foreigner purchases a U.S. government security, what happens to the supply of and demand for dollars? ANSWER. In order to purchase a U.S. government security, the foreigner must first acquire dollars. This increases the demand for dollars, but has no affect on the supply of dollars. 3. In 1987, the British government cut taxes significantly, raising the after-tax return on investments in Great Britain. What would be the likely consequence of this tax cut on the equilibrium value of the British pound? ANSWER. The cut in British tax rates should raise after-tax returns, making investment in the U.K. more attractive to both British and foreign investors. In response, investors should demand more pounds to acquire the now-more-lucrative British assets, driving up the value of the pound. This is, in fact, what happened. 4. Some economists have argued that a lower government deficit could cause the dollar to drop by reducing high real interest rates in the U.S. What does the asset view of exchange rates predict will happen if the U.S. lowers its budget deficit? What is the evidence from countries such as Mexico and Brazil? ANSWER. The impact of a reduction in the budget deficit on the value of the dollar depends on how that deficit reduction is accomplished. The key according to the asset-market model is whether the mechanism used leads to a healthier or weaker economy. If the government reduces the deficit by raising taxes, economic incentives to work and invest will diminish, thereby hurting economic growth and the dollar. By contrast, deficit reduction brought about by a cut in government spending would signal a sensible economic policy and the dollar would rise. Another factor is also relevant. Lower deficits owing to a reduction in spending would convince foreigners that the chances for future inflation in the U.S. had decreased. This would make dollar investments look even better, further strengthening the dollar. As mentioned in the text, if high government deficits increased a currency’s value, Mexico and Brazil should have two of the strongest currencies in the world today. 5. What is there about fiat money that makes its exchange rate especially volatile? ANSWER. With fiat money, there is no anchor to a currency’s value, nothing around which beliefs can coalesce. In this situation, where people are unsure of what to expect, any new piece of information can dramatically alter their beliefs about currency values. As people change their views of what the future holds, they change the price at which they are willing to hold the existing stock of currency.

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6. Comment on the following headlines in The Wall Street Journal: 6.a. “Sterling Drops Sharply Despite Good Health of British Economy: Oil Price Slump Is Blamed” (January 17, 1985) ANSWER. The value of the pound is very sensitive to the price of oil because England has large North Sea oil reserves and is a major oil exporter. Hence, British wealth is positively related to the price of oil. Any event that reduces a nation’s wealth will also tend to drive down the value of its currency. The health of the British economy was already factored into the value of the pound. The new information about the price of oil drove down the pound’s value because it indicated that British wealth would be lower than was previously expected. 6.b. “Dollar Surges as Coup in Soviet Union Revives Unit’s Appeal as a Safe Haven” (August 20, 1991) ANSWER. With the reduction in world tension occasioned by the decline in Communism’s appeal in the Soviet Union, investors had less need for the U.S. dollar as a safe haven. The Soviet coup brought back the threat of Soviet militarism and led investors to desire once again to hold an increased share of their wealth in dollars. This increased demand for dollars led to the dollar’s surge in value. 6.c.

“Dollar Plummets on Soviet Coup Failure” (August 22, 1991)

ANSWER. As the threat of Soviet militarism once again faded with the failure of the Soviet coup, investors refused to continue paying the safe-haven premium they had previously been willing to pay. As investors shifted their demand from dollars to other currencies, the dollar reversed its previous run-up. 6.d. “Dollar Falls Across the Board as Fed Cuts Discount Rate to 6.5% From 7%” (December 19, 1990) ANSWER. There are two possible reasons for the fall in the dollar. One possibility is that the Fed’s cut in the discount rate reduced real interest rates in the U.S., reducing the attractiveness of dollar-denominated financial assets relative to assets denominated in foreign currencies. As investors shifted to non-U.S. assets, they had to first sell dollars, depressing the dollar’s value. The second possibility is that the Fed’s lowering of the discount rate was a harbinger of a looser U.S. monetary policy, fueling fears of higher inflation in the future. In response to higher expected U.S. inflation, the dollar fell immediately. 6.e.

“Canadian Dollar Likely to Fall Further On Recession and Constitutional Crisis” (September 28, 1992)

ANSWER. A Canadian recession combined with the perceived political risk associated with Canada’s constitutional crisis significantly reduces Canada’s appeal to investors, leading to expected capital outflows and a depressed Canadian dollar. However, to the extent that this bad news has already been factored into the Canadian dollar's value – and in an efficient market it should have been – the headline is wrong; the Canadian dollar should not fall further. Otherwise, speculators can earn risk-free profits by betting against the Canadian dollar.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

6.f.

“Dollar Soars on U.S. and Iraqi Tension, Hints of Possible Lower German Rates” (Dec. 12, 1992)

ANSWER. The combination of the desire to hold more dollars because of political fears brought about by new problems with Iraq and the reduced appeal of investing in Germany because of the possibility of lower interest rates there, led to a large increase in capital flows to the U.S. These capital inflows boosted the value of the dollar. 6.g. “Inflation, Slow Growth Seen Spurring Latin America to Devaluate Currencies” (January 22, 1990) ANSWER. The Latin American countries have been maintaining their currencies at an artificially high level. Inflation and slow growth increase the overvaluation of Latin American currencies, putting greater pressure on their governments to devalue their currencies. 7. Suppose a new Russian government makes threatening moves against Western Europe. How is this threat likely to affect the dollar's value? Why? ANSWER. As investors in Western Europe become more nervous about their prospects, they will try to shift out of Western European assets and into U.S. dollars and dollar-denominated assets. Since they can’t all sell off their Western European assets simultaneously, the result will be a drop in the real value of Western European currencies relative to the real value of the dollar. Once the dollar has risen sufficiently, investors will again be willing to hold the existing (now devalued) stock of Western European assets, including currencies. 8. On May 11, 1995, the House Budget Committee approved a plan to slash federal spending through 2002 and thereby end the persistent U.S. budget deficits. How do you think the dollar responded to this news? ANSWER. This news should be favorable for the dollar because it indicated that the U.S. was going to follow a sounder economy policy, which would lead to lower inflation and higher economic growth in the future. The improved economic climate would make the U.S. investment environment more desirable and lead to capital inflows, which would drive up the dollar. As predicted, the dollar rose on the news. 9. Comment on the following statement: “One of the puzzling aspects of central bank intervention is how those who manage our economic affairs think they know what is the ‘right’ price for a dollar in terms of francs, pounds, yen, or Deutsche marks. And if they do know, why do they keep changing their minds?” ANSWER. Here’s one possible answer. Once President Nixon decided to abandon the gold standard, the dollar became just a piece of paper backed by nothing more substantial than “the full faith and trust of the United States government.” Of course, we could again peg the dollar and other currencies to gold, which – as we will see in Chapter 3 – would make them relatively stable. Each country would then be forced to manage its economic affairs by the straitjacket imposed by a metal whose supply doesn’t vary much. Many people would view that situation as desirable, since they would then have a good idea today what the dollar would be worth tomorrow in world markets. But governments wouldn’t then be able to manipulate exchange rates or money supplies to achieve other objectives. So the odds are that the powers that be will keep tinkering with the dollar on the foreign exchange market while they search for the dollar’s “right” price. But that still leaves unresolved a key question: How will they know when they’ve found the “right” price for the dollar?

CHAPTER 2: THE DETERMINATION OF EXCHANGE RATES

10. In a widely anticipated move, on August 30, 1990, the Bank of Japan raised the discount rate (the rate it charges on loans to financial institutions) from 5.25% to 6% to reduce inflationary pressures in Japan. Many currency traders had expected the Japanese central bank to raise its rate by more than 0.75%. What was the likely consequence of this interest rate rise on the yen:dollar exchange rate? ANSWER. The key to this answer is to focus on the operative term “widely anticipated” and recognize that the foreign exchange market already factors any anticipated interest rate change into currency values. Thus, when the Bank of Japan hiked the interest rate by only 0.75%, the yen became a less desirable investment vehicle than it was before the announcement and investors sold off their yen assets. Consequently, the yen fell on August 30, 1990. In general, what moves markets is not what happens but what happens relative to what was expected to happen. 11. In the late 1980s, the Bank of Japan bought billions of dollars in the foreign exchange market to prop up the dollar’s value against the yen. What were the likely consequences of this foreign exchange market intervention for the Japanese economy? ANSWER. Without domestic sterilization, the increased purchase of dollars for yen led to a jump in the Japanese money supply. Initially, this increased supply of yen lowered Japanese interest rates and helped fuel what many observers have argued was a speculative rise in the Japanese stock and real estate markets. Over time, however, the higher money supply led to a rise in Japanese inflation. When the Bank of Japan responded in early 1990 to higher inflation by clamping down on the money supply, real Japanese interest rates rose and Japanese stock and real estate prices plunged. 12. Countries with high inflation need to keep devaluing their currencies to maintain competitiveness. But countries that try to maintain their competitiveness by devaluing their currencies only end up with even higher inflation. Discuss. ANSWER. Devaluation improves competitiveness to the extent that it does not cause higher inflation. If the devaluation causes domestic wages and prices to rise, any gain in competitiveness is immediately eroded. To address the competitive consequences of devaluation, therefore, two possible cases must be distinguished: Prior to devaluation, (a) the exchange rate is overvalued and (b) the exchange rate is in equilibrium. Consider, for example, a country with high inflation that tries to fix its nominal exchange rate. The currency will become overvalued and hurt local industry’s competitiveness. In this case, devaluation will reduce the currency overvaluation and improve competitiveness, even though prices will rise somewhat. That is, devaluation will reduce the local currency’s real exchange rate. But if the currency was in equilibrium to start with, then devaluation will occur only if monetary policy is eased. Easing will cause prices to rise (a) directly, by raising the price of imports and the goods that compete with them in the domestic market, and (b) indirectly, by forcing the central bank to expand the money supply to sustain the devaluation. Here, the real exchange rate stays the same and there is no improvement in competitiveness.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

13. The Russian government is trying to figure out how to stabilize the value of its currency. What advice would you offer to it? ANSWER. The value of the ruble depends on the available supply of rubles relative to the demand for rubles. To stabilize the ruble’s value, the Russian government must restore the public’s confidence that the ruble can be held and exchanged for something of value. That is, the Russian government must demonstrate its willingness to maintain the ruble’s value. Confidence in money can be won only by controlling its supply and convincing the public that a stable currency is the only goal of monetary policy. The West Germans achieved this feat in the postwar era by giving the Bundesbank a currencystabilization mandate and a high degree of political independence. Russia could do the same and go even one step further by creating a currency board, thereby fixing the value of the ruble to the dollar and not even establishing a central bank with discretionary money-creation authority. 14. “Unsterilized interventions are just open market operations conducted through the foreign exchange market rather than through the U.S. government securities market.” Comment on this statement. ANSWER. This statement accurately depicts the monetary consequences of unsterilized interventions. In ordinary open market operations, the central bank buys (sells) government bonds to expand (contract) the domestic money supply. Unsterilized interventions entail buying (selling) foreign exchange, which causes an increase (decrease) in the supply of domestic currency that is not offset by open market operations. 15. As 1992 began, the Russian government and the central bank tightened credit in an attempt to slow the growth in the supply of rubles. However, the moves weren’t popular with the country’s giant state-run industrial enterprises, which are still dependent on official subsidies and cheap credit. In July 1992, the Russian Parliament appointed Viktor Gerashchenko head of the central bank. One of his first acts was to say that he didn't think the time was right to make the ruble convertible. Then he said that he would continue to extend credits to bankrupt and inefficient state enterprises. 15.a. How independent is the Russian central bank likely to be? What political pressures is it facing? ANSWER. The Russian central bank is unlikely to be very independent since the Russian Parliament can fire its head at will. Mr. Gerashchenko will face pressure to keep funding the bankrupt state-run industrial enterprises with newly created money. If credit is cut off, these enterprises will go under. Their managers and workers will continue putting pressure on Parliament and the central bank to ensure their continued funding. 15.b. What is the likely effect of Mr. Gerashchenko's statements on inflationary expectations in Russia? ANSWER. In effect, Mr. Gerashchenko has abdicated his control over monetary policy. The amount of money to be created will depend on the losses of state enterprises, not the amount necessary for noninflationary growth. Rational individuals will, therefore, take his statement to imply higher inflation, possibly hyperinflation.

CHAPTER 2: THE DETERMINATION OF EXCHANGE RATES

15.c. How do you think the ruble:dollar exchange rate was affected by these statements? ANSWER. The expectation of higher future inflation, combined with the central bank’s unwillingness to permit ruble convertibility, should cause the ruble to fall in value, which it did. A stable, convertible currency is the cornerstone of maintaining a currency’s value and Mr. Gerashchenko’s statements indicated that this was not going to happen anytime soon. 15.d. In 1995, the Russian Central Bank signed an agreement with the International Monetary Fund not to issue cheap credits to state enterprises. How should the ruble react if the central bank sticks to its agreement with the IMF? ANSWER. This agreement is a positive development for the ruble because it implies that the Russian Central Bank will continue to expand the supply of rubles, which is the indirect consequence of subsidizing state enterprises through bank credits. A lower rate of growth in the ruble money supply means less Russian inflation and a stronger ruble. 16. In January 1991, President Mikhail Gorbachev banned all 50-ruble and 100-ruble bills, while permitting Soviet citizens to change only 1,000 rubles in these large bills into smaller denominations. In addition, savings-bank accounts were frozen for six months. The object of these measures was to strip the country's powerful black marketeers of their operating capital, driving as many as possible out of business, and to reduce inflation, which has been running at about 80% a year. The official Russian news agency Tass reported that the government had “clearly decided that the confiscation version of monetary reform was the most efficient and least expensive version at its disposal.” 16.a. Were these measures likely to achieve President Gorbachev's objectives? ANSWER. These measures might drive some black marketeers out of business, but they cannot reduce inflation. Although the confiscation of large bills and freezing savings accounts will reduce the money supply, the demonstrated willingness of the government to expropriate wealth held in the form of rubles will reduce the demand for money further. The result will be more inflation, not less. At the same time, these measures are likely to be much less effective at stripping black marketeers of their operating capital than Gorbachev thinks. Black marketeers are precisely the people who hold their wealth in gold, dollars, or other hard currencies. It is the ordinary citizens who will be (and were) most heavily penalized by Gorbachev’s policies. 16.b. How do you think the ruble’s exchange rate responded to President Gorbachev’s initiative? Explain. ANSWER. The ruble fell in value as people tried to convert their risky rubles into something, like dollars, more likely to hold its value.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

17. On October 29, 1995, the Mexican government announced a new economic plan that called for the government to boost the economy by cutting taxes and spending. The plan also included an agreement among business, labor, and government representatives to limit wage and price increases. How do you think the peso responded to this announcement? What about the Mexican stock market? Explain. ANSWER. This plan is positive news for the Mexican economy. If lived up to, the plan implies stronger economic growth and less inflation. Both of these factors should boost the Mexican stock market and the value of the peso, which happened. 18. Under the Convertibility Act, Argentina’s central bank is allowed to count dollar-denominated bonds issued by the Argentine government as part of its “foreign” reserve assets. What potential problem do you see with this rule? ANSWER. The central bank’s ability to count dollar-denominated bonds issued by the Argentine government as part of its “foreign” reserve assets is a loophole big enough to drive a truck through. Under Mr. Cavallo’s watchful eye, the central bank has not abused that loophole, with the so-called Bonex bonds varying between 3% and 9% of the monetary base cover. However, the central bank could alter its course overnight and expand the Bonex share of the reserves. In addition, although the Argentine government has always paid its Bonex obligations, it could refuse to honor Bonex obligations held by the central bank. 19. After the Mexican devaluation, investors questioning Argentina’s ability to maintain currency convertibility began pulling their money out of Argentina. In response, the Argentine government took extraordinary steps to maintain its exchange rate at $1 per peso. 19.a. What were the likely consequences of this capital flight for Argentina’s peso money supply? For Argentine peso interest rates? For economic growth? ANSWER. Since Argentina maintains a currency board, it cannot sterilize the effects of currency inflows or outflows. An outflow of capital, therefore, must lead to a decline in the quantity of pesos in circulation. The immediate impact was a jump in interest rates. In turn, high real rates led to a slowdown in economic growth. However, as investors became convinced that Argentina was not going to devalue the peso, the high real interest rates began attracting capital back into Argentina, lowering real interest rates back to where they had been before. This process of arbitrage is to be expected, as Argentina’s interest rates cannot diverge much from U.S. rates as long as the Argentine peso is perceived to be tied to the dollar. At the same time, the greater confidence in the value of the peso boosted business confidence and business began investing again in Argentina. The result was that economic growth picked up again after the initial fright and capital flight. 19.b. Why was the Argentine government so reluctant to devalue the peso? ANSWER. Argentina saw what happened in Mexico a month before, where peso devaluation led to higher inflation (because of the higher price of foreign goods and services), which led in turn to further devaluation and inflation. Interest rates jumped to account for the high inflation rate and loss of faith in the government’s ability to maintain the peso’s value. In other words, devaluation of the Mexican peso had not solved anything but rather had revived the specter of an ongoing inflation-devaluation cycle – a specter that most Mexicans hoped had disappeared during the 1980s.

CHAPTER 2: THE DETERMINATION OF EXCHANGE RATES

19.c

As U.S. interest rates rise, what is likely to happen to Argentine rates? Why?

ANSWER. Since the Argentine peso is tied to the U.S. dollar at a 1:1 rate, interest rates between the two countries cannot diverge by more than a small amount. Divergence in interest rates will come only if there is a fear of peso devaluation. Otherwise, the two currencies are virtually identical and so must bear virtually identical interest rates. 20. One recommended approach to strengthen the dollar against the yen is for the U.S. Treasury to issue about $70 billion a year (the Japanese share of the U.S. trade deficit) in yendenominated bonds. How might this move help the dollar? ANSWER. Such a move would strengthen the dollar by providing a highly visible signal that the U.S. government is interested in a strong dollar. A weakening dollar would increase the U.S. government’s cost of servicing its debt, thereby giving it a strong disincentive to talk down the dollar against the yen, which it has done on a fairly regular basis. 21. In 1993, President Carlos Salinas de Gortari proposed a bill that would formally grant the Bank of Mexico, Mexico’s central bank, autonomy vis-à-vis the central government. As an investor, how would you view such a proposal? What other changes might help to amplify the signals sent by this proposal? ANSWER. Investors, who value price stability, would view such a bill as strongly positive. Such a law would enable the Bank of Mexico to avoid financing government deficits by printing pesos and thereby improve financial discipline. The relentless printing of pesos is what has led to the ongoing inflationdevaluation cycle in Mexico. Investors would be even happier, however, if the Mexican government’s ability to run budget deficits were constrained, since these deficits are the driving force underlying the peso printing. Absent such constraints, investors would be concerned that future deficits could lead the government to renege on its commitment to central bank independence. Unfortunately, the Bank of Mexico badly damaged its credibility when, during 1994, it appeared to collaborate with an administration facing tough elections by pouring more pesos into the banking system. The monetary expansion kept interest rates low, which kept the economy growing but led to the traumatic devaluation of December 1994. 22. The People’s Bank of China, China's central bank, is run by bureaucrats whose prime objective seems to be funding loss-making state-owned firms. What is your prediction about the inflation outlook for China and the value of its currency, the yuan? Explain. ANSWER. Subsidizing money-losing state firms exacerbates the Chinese government’s budget deficit. These deficits, in turn, lead to inflation since they are being financed by printing additional yuan. The dilemma for Chinese policymakers is that tightening credit to the cash-starved state sector, while cooling inflation pressures, will also lead to a shutdown of many state firms and throw millions out of work, which could result in social chaos.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

23. In August 1994, Alan Blinder, recently appointed as vice chairman of the Federal Reserve Board, gave a talk in which he argued that the Fed should be willing to tolerate somewhat higher inflation to spur economic growth and job creation. The dollar fell almost immediately. Explain the link between Dr. Blinder's views and the value of the dollar. ANSWER. The view that the Fed should try to stimulate economic growth at the risk of somewhat more inflation is precisely the attitude that got the U.S. in so much trouble in the late 1960s and 1970s. By announcing that he was, in effect, “soft” on inflation, Dr. Blinder scared the financial markets because anyone who minimizes inflation’s dangers is likely to make inflationary mistakes. This is particularly true if the Fed must sometimes tolerate slow growth or a recession to reduce inflationary pressures. Fed directors will not dare to be unpopular by tightening the money supply, unless they truly believe (as Dr. Blinder seems not to) in inflation’s dangers. The upshot of Blinder’s comments is that they increased investors’ fears that inflation would be more likely in the future, especially given the likelihood that President Clinton would appoint additional inflation “doves” to the Fed, eventually giving them a majority (with Blinder, the current vice chairman, being the most likely future chairman of the Fed). Higher inflation would lead to a weaker dollar in the future. According to the expectations theory of exchange rate determination, investors will act immediately on these fears by dumping dollars, which they did, driving down the dollar now instead of later. 24. Describe the chief differences between a currency board and a central bank with a nominal exchange rate target. ANSWER. First, the central bank controls the money supply by setting the nominal exchange rate target and then adjusting the money supply to achieve that target. Under a currency board system, there is no central bank. The currency board passively responds to the demand for domestic money by buying or selling foreign exchange for domestic currency. Hence, unlike a central bank, the board has no discretionary monetary policy. Second, a central bank need not hold any foreign currency reserves (although it usually does), whereas a currency board holds foreign exchange reserves equal to 100%, or slightly more, of its notes and coins in circulation. Third, central banks can act as a lender of last resort to banks in trouble. In contrast, since monetary authorities are not permitted to print money without the hard currency to back it, the currency board can’t pump liquidity into troubled banks as most central banks would do. Most important, the central bank can change its exchange rate target and devalue its currency. The currency board cannot since the local currency’s foreign exchange rate is fixed and the currency board holds enough foreign exchange reserves to meet any speculative attack. As the currency board buys back local currency, interest rates rise and it becomes more expensive to mount a speculative attack. 25. In 1994, China sought to boost its foreign exchange reserves and stabilize the yuan (which was under pressure to appreciate) by mandating that Chinese enterprises sell all their foreign exchange to the country’s commercial banks. The People's Bank of China, in turn, was forced to buy surplus foreign exchange with yuan. 25.a. What are the likely consequences of this policy for China’s rate of inflation? Explain. ANSWER. As the People’s Bank of China buys up surplus foreign exchange, it is creating more yuan. The resulting increase in the yuan money supply, all else being equal, will increase China’s rate of inflation.

CHAPTER 2: THE DETERMINATION OF EXCHANGE RATES

25.b. What alternatives are open to China to achieve its attempt to simultaneously hold down the value of the yuan and curb inflation? ANSWER. In reality, there are no alternatives for China. After creating the additional yuan through the purchase of foreign exchange, China can attempt to sterilize this increase in the money supply by selling bonds. However, by taking yuan out of circulation through sterilization, the People’s Bank of China will be leaving the quantity of yuan and foreign exchange unaltered and maintain the yuan at an undervalued level (the question points out that the yuan is under pressure to appreciate, which it would do were it not for the Bank of China’s willingness to create more yuan). However, by then turning around and reducing the supply of yuan, the pressure on the yuan to appreciate will remain as before. Alternatively, if the People’s Bank chooses not to sterilize the increase in the yuan money supply, the result will be inflation. Thus, China cannot simultaneously maintain an undervalued currency and hold down inflation. 26. In the midst of the Asian financial crisis, Malaysia’s Prime Minister Mahathir Mohamad accused an international cabal of Jewish financiers of deliberately provoking the crisis to wreck Malaysia’s economy. “Jews are not happy to see Muslims prosper,” he said. Following his remarks, Malaysia’s financial markets and its currency, the ringgit, plunged to record lows. Explain. ANSWER. Financial markets are not the United Nations or the Third World organization of nonaligned nations. They don’t tell you that you have a point, or that they feel your pain, or that they understand your grievance because of your horrid colonial past. They listen to what you mean, not what you say, and what Dr. Mahathir’s words meant to them was that he was more interested in looking for scapegoats than at the real problems. So foreign banks and investors, already spooked by Asia’s currency crisis, lost even more confidence in Malaysia and began dumping the ringgit and its stocks. 27. In the 1995 election for the French presidency, the Socialist candidate, Lionel Jospin, vowed to halt all privatizations, raise taxes on business, spend heavily on job creation, and cut the work week without a matching pay cut. At the time Mr. Jospin made this vow, he was running neckand-neck with the conservative Prime Minister Jacques Chirac, who espoused free-market policies. In a surprise ending to the 1997 French parliamentary elections, the Socialist party won and Mr. Jospin became Prime Minister. Given that Mr. Jospin still espoused the same policies as before, what was the likely reaction of the French franc to his election? ANSWER. Negative, since implementation of these policies would lead to lower French growth and a weaker economy. With France being a less desirable place to invest in, one would expect capital flight and a lower franc, which occurred. SUGGESTED SOLUTIONS TO CHAPTER 2 PROBLEMS 1. On August 1, 2006, Zimbabwe changed the value of the Zim dollar from Z$101/U.S.$ to Z$250/U.S.$. 1.a. What was the original U.S. dollar value of the Zim dollar? What is the new U.S. dollar value of the Zim dollar? ANSWER. The U.S. dollar value of the Zim dollar prior to devaluation was $0.0099 (1/101). Subsequent to devaluation, the Zim dollar was worth $0.004 (1/250).

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

1.b. By what percent has the Zim dollar devalued (revalued) relative to the U.S. dollar? ANSWER. The U.S. dollar value of the Zim dollar has changed by (0.004 - 0.0099)/0.0099 = -59.6%. Thus, the Zim dollar has devalued by 24% against the U.S. dollar. 1.c. By what percent has the U.S. dollar appreciated (depreciated) relative to the Zim dollar? ANSWER. The U.S. dollar has appreciated against the Zim dollar by an amount equal to (250 - 101)/101 = 147.5%. 2. In 2002, one dollar bought ¥125. In 2006, it bought about ¥115. 2.a. What was the dollar value of the yen in 2005? What was the yen’s dollar value in 2006? ANSWER. The dollar value of the yen in 2002 was $0.008 (1/125). By 2006, the yen had risen to $0.0087. 2.b. By what percent has the yen risen in value between 2002 and 2006? ANSWER. Between 2002 and 2006, the yen rose by 8.8%, calculated as (0.0087 - 0.008)/0.008. 2.c.

By what percent has the dollar fallen in value between 2002 and 2006?

ANSWER. During this same period, the dollar depreciated by 8%, calculated as (115 - 125)/125. 3. On February 1, the euro is worth $1.2966. By May 1, it has moved to $1.3634. 3.a. By how much has the euro appreciated or depreciated against the dollar over this 3-month period? ANSWER. Since the euro is now worth more in dollar terms, it has appreciated against the dollar. The amount of euro appreciation is (1.3634 - 1.2966)/1.2966 = 5.15%. 3.b. By how much has the dollar appreciated or depreciated against the euro over this period? ANSWER. The flip side of euro appreciation is dollar depreciation. The dollar has depreciated by an amount equal to [(1/1.3634) – (1/1.2966)]/(1/1.2966) = -4.9% 4. In early August 2002 (the exact date is a state secret), North Korea reduced the official value of the won from $0.465 to $0.0067. The black market value of the won at the time was $0.005. 4.a. By what percent did the won devalue? ANSWER. Using Equation 2.1, the won devalued ($0.067-$0.465)/$0.465) = 98.56% 4.b. Following the initial devaluation what further percentage devaluation would be necessary for the won to equal its black market value? ANSWER. 25.4% 5. On March 29, 2007, the Indian rupee (Rs) was worth $0.023270. The next day, it was worth $0.022980.

CHAPTER 2: THE DETERMINATION OF EXCHANGE RATES

5.a. By how much has the rupee devalued against the dollar? ANSWER. Using Equation 2.1, the rupee devalued by (0.02298 - 0.02327)/0.02327, or -1.25%. 5.b. By how much has the dollar appreciated against the rupee? ANSWER. Using Equation 2.2, the dollar appreciated against the rupee by [(1/0.02298) - (1/0.02327)]/(1/0.02327), or 1.262%. 6. On June 14, 2001, Domingo Cavallo, Argentina’s treasury secretary announced a new exchange rate policy designed to stimulate Argentina’s slumping economy. Under the new policy, exporters and importers would be able to convert between dollars and pesos at an exchange rate that was an average of the dollar and the euro exchange rates, that is, P1 = $0.50 + €0.50. At that time, the euro was trading at $0.85. 6.a. How many pesos would an exporter receive for one dollar under the new system? ANSWER. Under the new system, P1 = $0.50 + €0.50 = $0.50 + $0.85/2 = $0.925. The peso value of a dollar is thus 1/0.925, or $1 = P1.081. This exchange rate is equivalent to dollar appreciation of 8.1% against the peso. 6.b. How many dollars would an importer receive for one peso under the new system? ANSWER. As shown in the answer to Part a, P1 = $0.925. This exchange rate is equivalent to peso devaluation against the dollar of 7.5%. ADDITIONAL CHAPTER 2 PROBLEMS AND SOLUTIONS 1. In the second half of 1997, the Indonesian rupiah devalued by 84% against the U.S. dollar. By how much has the dollar appreciated against the rupiah? ANSWER. If e0 is the initial dollar value of the rupiah and e1 is the post-devaluation exchange rate, then from Equation 2.1 (e1 - e0)/e0 = -84%. Solving for e1 in terms of e0 yields e1 = 0.16e0. From Equation 2.2, the dollar’s appreciation against the rupiah equals (e0 - e1)/e1, or (e0 - 0.16e0)/0.16e0 = 0.84/.16 = 525%. 2. During 1997, the U.S. dollar appreciated by 104% against the South Korean won. By how much did the won depreciate against the U.S. dollar during the year? ANSWER. If e0 is the initial dollar value of the South Korean won and e1 is the post-devaluation exchange rate, then from Equation 2.2 the dollar’s appreciation against the won equals (e0 - e1)/e1 = 104%. Solving for e1 in terms of e0 yields e1 = 0.49e0. From Equation 2.1, the won's depreciation against the dollar equals (e1 - e0)/e0, or (0.49e0 - e0)/e0 = -51%. In other words, the won has depreciated by 51% against the dollar.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

3. On January 1, 1975, the Mexican peso/U.S.$ exchange rate was Ps 12.5 = $1. By 1985, the exchange rate stood at Ps 208.9 = $1. 3.a. By how much has the Mexican peso appreciated or depreciated against the dollar over this 10-year period? ANSWER. Over this 10-year period, the peso’s dollar value has fallen from $0.08 (1/12.5) to $0.004787 (1/208.9). This change in dollar value is equivalent to a peso devaluation of 94.02% ((0.004787 0.08)/0.08). 3.b. By how much has the dollar appreciated or depreciated against the peso over this period? ANSWER. The U.S. dollar has risen from Ps 12.5 to Ps 208.9, which is equivalent to a dollar appreciation of 1,571% ((208.9 - 12.5)/12.5). 4. Suppose the Russian ruble devalues by 75% against the dollar. What is the percentage appreciation of the dollar against the ruble? ANSWER. The ruble is now worth 25% of its previous dollar value; that is, the dollar is now worth 4 times its previous ruble value. The ruble value of the dollar has, therefore, increased by 300% (the first 100% is its previous value). 5. Suppose the dollar appreciates by 500% against the Russian ruble. How much has the ruble devalued against the dollar? ANSWER. The dollar is now worth six times as many rubles as before (with a 0% appreciation, the dollar would be worth 1 times as many rubles as before). This means that the ruble's dollar value is one-sixth or 16.67% of its previous value. Thus, the ruble has devalued by 83.33%. 6. In 1993, the Brazilian cruzeiro lost 95% of its dollar value. What happened to the cruzeiro value of the dollar during 1993? ANSWER. A 95% devaluation in the dollar value of the cruzeiro is equivalent to a 1,900% rise in the dollar’s cruzeiro value. To see this, suppose that the exchange rate at the beginning of the year was Cr$1 = U.S.$1. A 95% devaluation of the cruzeiro is equivalent to an end-of-year exchange rate of Cr$1 = $0.05 or U.S.$1 = Cr$20. The dollar is now worth 20 times as many cruzeiros as at the start of the year, which is equivalent to a rise of 1900% in the dollar's cruzeiro value. 7. Between 1988 and 1991, the price of a room at the Milan Hilton rose from Lit 346,400 to Lit 475,000. Concurrently, the exchange rate went from Lit 1,302 = $1 in 1988 to Lit 1,075 = $1 in 1991. 7.a. By how much has the dollar cost of a room at the Milan Hilton changed over this three-year period? ANSWER. The dollar price of a room at the Milan Hilton in 1988 was 346,400/1,302 = $266. By 1991, that same room cost 475,000/1,075 = $442. Thus, the dollar price of a room rose during this three-year period by (442 - 266)/266 = 66.2%. This involved a combination of a 21.2% appreciation in the dollar value of the lira and a 37.1% increase in the lira price of a hotel room (1.211 * 1.371 = 1.661).

CHAPTER 2: THE DETERMINATION OF EXCHANGE RATES

7.b.

What has happened to the lira’s dollar value during this period?

ANSWER. According to Equation 2.1, the lira’s dollar value has appreciated by

(1/1075)− (1/1302) 1302 − 1075 = = 21.1% (1/1302) 1075 8. On the day that the Chancellor of the Exchequer announced independence for the Bank of England along with a boost in the base lending rate of one-quarter of a percentage point, the British stock market rose 1.4%, and British gilts rose about 2.1%. The pound rose to $1.6333 from $1.6223 and to DM2.8165 from DM2.8006. 8.a. Why did the British stock and bond markets jump on the news? ANSWER. The action underscored the newly elected Labour Party’s intent to keep inflation low and eased lingering concerns that Labour might not keep its promise to embrace a market economy and leave behind its socialist past. Low inflation is good for bond markets and the promise of stronger economic growth, which is what forswearing Labour’s socialist past foretold, is good for stock markets. 8.b. Why did the British pound appreciate on the news? ANSWER. Just as high inflation leads to currency depreciation, so low inflation strengthens a currency. Similarly, strong economic growth boosts a currency’s value as it makes for a more desirable investment location. The change in policy toward the Bank of England promised both low inflation and stronger economic growth, leading to a stronger pound. 8.c.

What was the pound’s percentage appreciation against the U.S. dollar?

ANSWER. The pound rose against the dollar by an amount equal to (1.6333 - 1.6223)/1.6223 = 0.678%. 8.d. What was the pound’s percentage appreciation against the DM? ANSWER. The pound rose against the DM by an amount equal to (2.8165 - 2.8006)/2.8006 = 0.568%.

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CHAPTER 3 THE INTERNATIONAL MONETARY SYSTEM This chapter helps students understand the international monetary system and how the choice of system affects currency values. It also provides a historical background of the international monetary system. This enables students to gain perspective when trying to interpret the likely consequences of new policies in the area of international finance. This chapter describes how exchange rates are determined under four different mechanisms – free float, managed float, fixed-rate system, and target-zone system. Under the latter three systems, governments intervene in the currency markets in one form or another to affect the exchange rate. KEY POINTS 1. Under the latter three systems, which involve varying degrees of central bank intervention, the real exchange rate is liable to change, with important implications for exchange risk management (discussed in Chapters 9 and 10). 2. Regardless of the form of intervention, neither fixed nor floating rates remain fixed for long, governments subordinate exchange rate considerations to domestic political considerations. 3. The gold standard is a specific type of fixed exchange rate system that required participating countries to maintain the value of their currencies in terms of gold. Calls for a new gold standard remind us of the fundamental lack of trust in fiat money due to the historical unwillingness of the monetary authorities to desist from tampering with the money supply. 4. Intervention to maintain a disequilibrium rate is usually either ineffective or injurious when pursued over lengthy periods. Seldom, if ever, have policymakers been able to outsmart for any extended period the collective judgment of buyers and sellers. The current volatile market environment, a consequence of unstable U.S. and world financial conditions, cannot for long be arbitrarily directed by government officials. 5. Examining U.S. experience since the abandonment of fixed rates, we find that free-market forces did indeed correctly reflect economic realities. The dollar’s value dropped sharply from 1973 to 1980 when the U.S. experienced high inflation and weakened economic conditions. It rose beginning in 1981 when American policies dramatically changed under the leadership of the Fed and a new president, and fell when foreign economies strengthened relative to the U.S. economy.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

SUGGESTED ANSWERS TO “THE EURO REACTS TO NEW INFORMATION” 1. Explain the differing initial and subsequent reactions of the euro to news about the European Central Bank’s monetary policy. ANSWER. The initial reaction is based on the expectation of no tightening in the money supply. The result will be higher inflation than previously expected and – according to purchasing power parity – a depreciating euro. The euro’s subsequent reaction was based on the view that monetary policy would in fact be tightened (that’s the objective of an interest rate increase) and inflation would be reduced. At the same time, a higher real interest rate would be expected to attract more capital and boost the euro’s value as well. 2. How does a strong pound reduce the threat of imported inflation and work against higher interest rates? ANSWER. A weak pound will bring higher prices of foreign goods and services, enabling domestic producers to raise their prices and leading to higher inflation. Conversely, a stronger pound will bring lower-priced foreign goods and services, putting downward pressure on domestic prices and reducing the threat of inflation. Lower inflation will lead – via the Fisher Effect – to lower interest rates. At the same time, the expectation of lower inflation means the Bank of England will be under less pressure to raise interest rates to fight nonexistent inflation. 3. Which U.K. manufacturers are likely to be pressured by a strong pound? ANSWER. Those British manufacturers that compete with imports or that export will be hurt by a stronger pound because foreign competitors will see their pound-equivalent prices fall. In addition, British manufacturers that use domestically sourced inputs in competition with those that use imported inputs will suffer. 4. Why might higher pound interest rates send sterling even higher? Give two possible reasons. ANSWER. Higher British interest rates occasioned by a tightening of monetary policy will lead to lower expected inflation. According to purchasing power parity, countries with lower rates of inflation will tend to see their currencies appreciate relative to those of countries with higher rates of inflation. At the same time, if the higher nominal interest rate is also a higher real interest rate, this will attract capital to the U.K. seeking to earn the higher real return. The greater demand for sterling for investment purposes will boost its value. 5. What tools are available to the European Central Bank and the Bank of England to manage their monetary policies? ANSWER. Both central banks can use open market operations – which involve buying and selling bonds denominated in their currencies to regulate the money supply. It may be more difficult for the ECB, however, as it doesn’t have Treasury bonds denominated in euros, but there will be other bonds issued in the euro that it can buy or sell. The central banks can also raise or lower the interest rate at which they lend money to banks and regulate the reserve requirements of banks. Another tool of monetary policy is foreign exchange market intervention, which involves buying or selling their currencies in the foreign exchange market.

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SUGGESTED ANSWERS TO “BRITAIN–IN OR OUT FOR THE EURO” 1. Discuss the pros and cons for Britain of joining EMU. ANSWER. By joining the EMU, Britain would lock itself into a new European monetary policy. Provided this monetary policy is dominated by Germany, it is likely to be a low-inflation policy. At the same time, the single-currency aspect of EMU will reduce currency risk and foreign exchange trading costs for British firms. These features are all pluses. However, Britain would also lose the ability to conduct an independent monetary policy. To the extent that economic shocks affect Britain differently than they affect EMU members, losing the flexibility to adjust monetary policy or its exchange rate to cope with these shocks could be costly in terms of lost economic output. In other words, Britain combined with continental Europe may not constitute an optimum currency area. The costs of fixing exchange rates were demonstrated when Britain and other European nations were forced to raise their interest rates to maintain their exchange rates fixed to the DM even as Germany was coping with the shock of reunification. 2. Commentators pointed to the fact that many people in Britain have variable rate mortgages as opposed to the fixed-rate mortgages more common in Europe. Britain also has the most flexible labor markets in Europe. How would these factors likely affect Britain’s economic costs and benefits of joining the euro? ANSWER. To the extent the EMU is viewed as a serious inflation fighter, Britain’s entry would be viewed as a plus by financial markets. The result would be lower interest rates in Britain, which would benefit British homeowners holding variable-rate mortgages. The biggest problem with joining a monetary union is the loss of exchange rate and monetary policy flexibility to absorb the effects of economic fluctuations. The most important substitute for monetary and exchange rate flexibility is labor market flexibility. The fact that Britain’s labor market is relatively flexible will lower the costs to Britain associated with joining EMU. 3. What types of British companies would most likely benefit from joining the EMU? ANSWER. Primary beneficiaries would be British companies that engage in extensive trade (both buying and selling) or other business with other EMU countries, as joining the EMU will reduce their currency risk and lower their foreign exchange transaction costs (the costs associated with converting between the pound and the euro). 4. Some large MNCs warned that they only chose to invest in Britain on the assumption it would ultimately adopt the euro. Why would MNCs be interested in Britain joining the euro? ANSWER. Many companies have used Britain as an export platform to other EU countries. If Britain joins EMU, that would reduce their currency risk and transaction costs. MNCs locating in Britain complain that they now must bear transaction costs and exchange rate uncertainty that they could avoid by basing themselves in EMU countries.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

SUGGESTED ANSWERS TO CHAPTER 3 QUESTIONS 1. a.

What are the five basic mechanisms for establishing exchange rates?

ANSWER. The five basic mechanisms for establishing exchange rates are free float, managed float, targetzone arrangement, fixed-rate system, and the current hybrid system. 1.b.

How does each work?

ANSWER. In a free float, exchange rates are determined by the interaction of currency supplies and demands. Under a system of managed floating, governments intervene actively in the foreign exchange market to smooth out exchange rate fluctuations to reduce the economic uncertainty associated with a free float. Under a target-zone arrangement, countries adjust their national economic policies to maintain their exchange rates within a specific margin around agreed-on fixed central exchange rates. Under a fixed-rate system, such as the Bretton Woods system, governments are committed to maintaining target exchange rates. Each central bank actively buys or sells its currency in the foreign exchange market whenever its exchange rate threatens to deviate from its stated par value by more than an agreed-on percentage. Currently, the international monetary system is a hybrid system, with major currencies floating on a managed basis, some currencies freely floating, and other currencies moving in and out of various types of pegged exchange rate relationships. 1.c.

What costs and benefits are associated with each mechanism?

ANSWER. Benefits of a Floating Rate System. When floating rates were adopted in 1973, proponents said the new system would reduce economic volatility and facilitate free trade. In particular, floating exchange rates would offset international differences in inflation rates so that trade, wages, employment, and output would not have to adjust. High-inflation countries would see their currencies depreciate, allowing their firms to stay competitive without having to cut wages or employment. At the same time, currency appreciation would not place firms in low-inflation countries at a competitive disadvantage. Real exchange rates would stabilize, even if permitted to float in principle, because the underlying conditions affecting trade and the relative productivity of capital would change only gradually; and if countries would coordinate their monetary policies to achieve a convergence of inflation rates, then nominal exchange rates would also stabilize. Another benefit is that – as Milton Friedman points out – with a floating exchange rate, there never has been a foreign exchange crisis. The reason is simple: The floating rate absorbs the pressures that would otherwise build up in countries that try to peg the exchange rate while simultaneously pursuing an independent monetary policy. For example, the Asian currency crisis did not spill over to Australia and New Zealand because the latter countries had floating exchange rates. A floating rate system can also act as a shock absorber to cushion real economic shocks that change the equilibrium exchange rate. Costs of a Floating Rate System. Many economists point to excessive volatility as a major cost of a floating-rate system. The experience to date is that the dollar’s fluctuations have had little to do with actual inflation and a lot to do with expectations of future government policies and economic conditions. Put another way, real exchange rate volatility has increased, not decreased, since floating began. This instability reflects in part nonmonetary (or real) shocks to the world economy, such as changing oil prices and shifting competitiveness among countries, but these real shocks were not obviously greater during the 1980s than in earlier periods. Instead, uncertainty over future government policies has increased.

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Benefits of a Managed Float. The potential benefit of a managed float is that governments can reduce the volatility associated with a freely floating exchange rate. Costs of a Managed Float. The costs of a managed float stem from the demonstrated inability of governments to recognize the difference between temporary and permanent exchange rate disequilibrium. By trying to manage exchange rates when a permanent shift in the equilibrium exchange rate has occurred, governments run the risk of creating an exchange rate crisis and wasting reserves. Benefits of a Target Zone Arrangement. The experience with the European Monetary System is that the target zone arrangement in effect forced convergence of monetary policy to that of the country – Germany – with the most disciplined anti-inflation policy and led to low inflation. Costs of a Target Zone Arrangement. Maintaining a genuinely stable target zone arrangement requires the political will to direct fiscal and monetary policies at that goal and not at purely national goals. This turns out to be difficult for countries to achieve. In the case of the European Monetary System, the result was periodic currency crises. Another cost of this system is that fundamental changes in the equilibrium exchange rate cannot get reflected in actual exchange rate changes without a currency crisis occurring. Benefits of a Fixed Rate System. A permanently fixed exchange rate system – such as that achieved by a currency board, dollarization, or monetary union – results in currency stability and the absence of currency crises. A system such as existed under Bretton Woods, whereby there is a commitment to a fixed exchange rate system but no mechanism to bind that commitment, will have more monetary discipline than in a freely floating system and hence lower inflation than might otherwise be the case. Costs of a Fixed Rate System. In a permanently fixed system, the exchange rate cannot cushion the effects of real economic shocks, such as devaluation of a major competitor’s currency. Instead, prices must adjust. Given the lack of flexibility of many prices – because of government regulations or union restrictions – the result of these economic shocks can be higher unemployment and less economic growth. In a system such as Bretton Woods, the result of changes in the equilibrium exchange rate will likely be currency crises and eventual devaluation or revaluation. Benefits of a Hybrid System. The current system gives countries the option to select the system that best meets their needs. However, all too often the decision is based on political rather than economic considerations. Costs of a Hybrid System. The cost of a hybrid system, such as the one currently in place, is that there is no constraint on the choices that governments can make. The resulting choices can be good or bad. 1.d. Have exchange rate movements under the current system of managed floating been excessive? Explain. ANSWER. Excessive movements would indicate that there are profits to be earned by betting against the market. In effect, if currency fluctuations are excessive they would exhibit the phenomenon of overshooting (i.e., currency rates would overreact to economic events and then return to equilibrium). There is no evidence that one could profit by betting that rate movements are excessive.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

2. Find a recent example of a nation’s foreign exchange market intervention and note what the government’s justification was. Does this justification make economic sense? ANSWER. Finding an example of foreign exchange market intervention by a government should be pretty easy to do. The trick will be to find a coherent statement of what the government’s justification was. Most of these justifications make little or no economic sense. 3. Gold has been called “the ultimate burglar alarm.” Explain what this expression means. ANSWER. Governments “burgle” holders of their currencies by printing more money and subjecting holders to an “inflation tax.” Since gold prices respond quickly to evidence of inflation, the expectation of an increase in inflation will cause a jump in gold prices. In this way, gold serves as a burglar alarm to warn that politicians are tampering with fiat money. 4. Suppose nations attempt to pursue independent monetary and fiscal policies. How will exchange rates behave? ANSWER. Independent monetary and fiscal policies will lead to volatile exchange rates as market participants receive and assess new information on these policies. 5. The experiences of fixed exchange-rate systems and target-zone arrangements have not been entirely satisfactory. 5.a. What lessons can economists draw from the breakdown of the Bretton Woods system? ANSWER. Adjusting monetary growth rates is the principal way to stabilize exchange rates. For example, raising the value of the dollar relative to the yen requires tightening U.S. monetary policy relative to Japanese monetary policy. The experience of Bretton Woods and similar experiments demonstrates that conscious and explicit coordination of monetary policies among sovereign authorities is difficult. The problem stems from the inability of sovereign authorities to coordinate their monetary growth rates. An agreement to stabilize the dollar at, say, 150 yen would be relatively easy if it did not entail interdependent monetary policies, robbing the Federal Reserve, or the Bank of Japan, or both, of important degrees of monetary freedom. Both Japan and the U.S. have their own targets for growth and inflation and their own independent assessment of the macroeconomic policies required to attain those targets. Except by coincidence, independent policies and preferences will not mesh at a stable exchange rate. Given clashing preferences, the only alternatives to the “chaos” of floating are: i) One side persuades the other to change its policies; ii) One side subordinates its policies to those of the other; or iii) Both sides subordinate their monetary policies to an external mechanism, such as a gold standard. Absent (iii), “international monetary reform” is the search for new ways to implement (i) or (ii), or some combination. Bretton Woods collapsed because the subordination it entailed was intolerable to the U.S. That is, the U.S. refused to follow economic policies that would maintain the value of gold at $35 an ounce. The basic lesson from Bretton Woods, therefore, is that stabilizing exchange rates requires dependence and subordination, not the freedom for everybody to do their own thing. But instead of changing policies to stay with the Bretton Woods system, the major countries simply dropped the system.

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5.b. What lessons can economists draw from the exchange rate experiences of the European Monetary System? ANSWER. Exchange rate stability requires that monetary policies be coordinated and geared toward maintaining exchange rate parities. The slow progress of the European community with respect to the EMS and policy coordination exemplifies the difficulties of achieving agreements on the many facets of economic policymaking. Implementing target zones on a wider scale would be all the more difficult. Differences in preferences, policy objectives, and economic structures account in part for these difficulties. More fundamentally, however, coordination of macroeconomic policies will not necessarily benefit all participant countries equally, and those that benefit the most may not be willing to compensate those that benefit least. In the EMS, Germany is less inflation-prone than the other members and is reluctant to cooperate at the risk of increasing its inflation rate. Another lesson is that in target-zone arrangements such as the EMS, a disproportionately large share of the adjustment burden will fall on the “weak” currency countries. Countries with appreciating currencies, trade surpluses, and increasing reserves are less prone to adjust than countries with depreciating currencies, trade deficits, or reserve losses. The convergence of inflation rates among the EMS countries supports this view. An equal sharing of the adjustment burden implies that inflation rates among member nations would converge to the average rate. Germany, however, has maintained a domestic monetary target of low or zero inflation and has often refused to alter domestic monetary policy because of exchange rate considerations. Because of Germany’s economic importance, the other member countries have had to adjust their domestic policies or their exchange rates to remain competitive in international markets. As a result, inflation rates have tended to converge toward Germany’s lower rate. 6. How did the European Monetary System limit the economic ability of each member nation to set its interest rate to be different from Germany’s? ANSWER. Each country within the European Monetary System had to fix its exchange rate relative to the DM. If a country’s exchange rate is expected to stay fixed relative to the DM, the interest rate associated with that country’s currency cannot diverge from Germany’s. Otherwise, it would present a virtually riskfree arbitrage opportunity: Borrow in the lower interest rate currency and lend the borrowed funds in the higher interest rate currency and earn the spread between the two rates. 7. Historically, Spain has had high inflation and has seen its peseta continuously depreciate. In 1989, though, Spain joined the EMS and pegged the peseta to the DM. According to a Spanish banker, EMS membership means that “the government has less capability to manage the currency but, on the other hand, the people are more trusting of the currency for that reason.” 7.a. What underlies the peseta's historical weakness? ANSWER. Spain has historically pursued an easy monetary policy with an associated high rate of inflation. High inflation, in turn, led to continual peseta devaluation.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

7.b. Comment on the banker’s statement. ANSWER. Countries that seek to participate in the EMS are effectively forced to pursue a monetary policy consistent with that of Germany, which eventually brings down their inflation rates. In effect, control of Spain’s monetary policy has been shifted from Spain’s central bank, which has a weak reputation for monetary discipline, to the much more reputable Bundesbank. Thus, Spaniards now are more trusting of their money. 7.c.

What are the likely consequences of EMS membership on the Spanish public’s willingness to save and invest?

ANSWER. By heightening the prospects for Spanish monetary stability, EMS membership has lowered the risks associated with holding financial assets in Spain. The result has been to make the Spanish public more willing to save and invest. 8. In discussing EMU, a recent government report stressed a need to make the central bank accountable to the “democratic process.” What are the likely consequences for price stability and exchange rate stability in the EMS if the “Eurofed” becomes accountable to the “democratic process?” ANSWER. The only good central bank is one that can say no to politicians. Unfortunately, the proposal makes it more difficult for the central bank to do so. Instead of assessing central bank performance in terms of an unambiguous, verifiable goal, such as price stability, thereby complementing central bank independence by giving it a single, long-term focus, the proposal’s definition of accountability will provide an avenue for political influence. The result will be higher inflation and more currency volatility. 9. In 1996, Chancellor Kenneth Clarke called for a national debate on whether Britain should join the EMU. Discuss the pros and cons for Britain of joining EMU. ANSWER. By joining the EMU, Britain would lock itself into a new European monetary policy. Provided this monetary policy is dominated by Germany, it is likely to be a low-inflation policy. At the same time, the single-currency aspect of the EMU will reduce currency risk and foreign exchange trading costs for British firms. These features are all pluses. However, Britain would also lose the ability to conduct an independent monetary policy. To the extent that economic shocks affect Britain differently than it affects other EMU members, losing the flexibility to adjust monetary policy or its exchange rate to cope with these shocks could be quite costly in terms of lost economic output. In other words, Britain combined with continental Europe may not constitute an optimum currency area. The costs of fixing exchange rates were demonstrated when Britain and other European nations were forced to raise their interest rates to maintain their exchange rates fixed to the DM even as Germany was coping with the shock of reunification.

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ADDITIONAL CHAPTER 3 QUESTIONS AND ANSWERS 1. Why has speculation failed to smooth exchange rate movements? ANSWER. Speculation can only be expected to smooth exchange rate movements if underlying economic processes are relatively stable. If there is a great deal of uncertainty over future government actions and their economic impact, expectations will not be strongly held. Thus, expectations can change dramatically from day to day, leading to rapidly fluctuating exchange rates. 2. Is a floating-rate system more inflationary than a fixed-rate system? Explain. ANSWER. To the extent that floating exchange rates allow monetary authorities to pursue more inflationary policies, then a floating-rate system can be more inflationary. However, this is an indirect effect, the direct cause of inflation being rapid money expansion. According to PPP, the direction of causation runs from price level changes to exchange rate changes, not vice versa. 3. Since 1979, the price of gold has fallen by more than 60%. What could explain such a steep price decline? Consider the roles of inflation and new financial instruments such as swaps and options that can provide lower-cost inflation hedges. ANSWER. Gold has traditionally provided a safe haven when economic and political conditions are uncertain and currencies are volatile because of the belief that it was a sounder store of value than paper money. However, gold’s value as an inflation hedge was diminished during the 1980s as inflation became a much less serious concern. At the same time, to the extent that modern financial instruments such as swaps and options now provide better, less costly shelters (especially since gold pays no interest, imposing a high opportunity cost on holders), these lower cost inflation-hedge substitutes would have the effect of reducing the demand for gold and hence its price relative to what it would be absent these lowercost inflation-hedge substitutes. The jump in the price of gold during 1993 may be due to the growing wealth of many Chinese and their attempt to avoid the high inflation stemming from the Bank of China’s expansionary monetary policy. Given their lack of access to more sophisticated hedging instruments, the Chinese may have found gold to be their best inflation hedge. Currency concerns also played a role in gold’s rally during 1993. Until recently, the Bundesbank has been the only reliable policeman putting the fight against inflation as its first priority. That certainty became questionable as the Bundesbank had to deal with the pressures brought on by the German recession to put economic expansion ahead of price stability as its priority. These concerns about the DM as a store of value were reflected in a fall in its exchange rate during much of the 1990s. 4. Comment on the following statement: “A system of floating exchange rate fails when governments ignore the verdict of the exchange markets on their policies and resort to direct controls over trade and capital flows.” ANSWER. In principle, floating offers a small degree of freedom from the subordination and coordination necessary to maintain stable exchange rates. But if governments abuse that degree of freedom and refuse to accept the exchange rate consequences (e.g., a drop in the exchange rate due to rapid expansion of the money supply), the system will fail. That is, if the governments involved wish to pursue independent policies while simultaneously stabilizing exchange rates, this can be accomplished only by imposing direct controls on trade and capital flows.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

5. Will coordination of economic policies make exchange rates more or less stable? Explain. ANSWER. Coordination of economic policies will make exchange rates more stable, since the relative attractiveness of the various currencies is less likely to change significantly. 6. Despite official parity between the DM and the Ostmark, the black market rate in early 1990 was about ten Ostmarks for one DM. What problems might setting the exchange rate at one Ostmark for each DM create for Germany? ANSWER. The basic problem is that, at a one-for-one exchange rate, the Ostmark will be overvalued relative to the DM. Unless East German wages fall, East German industry will find its cost of doing business rising without an offsetting gain in productivity. East German industry will become even less competitive than it already is, with massive unemployment resulting. At the same time, East Germans will rush to convert their Ostmarks to DMs. The resulting growth in the DM money supply will be inflationary unless the demand for DM grows in proportion to the supply. Clearly, the demand for DM will rise as it supplants the Ostmark as the official East German currency. Of course, the Bundesbank can always eliminate the threat of inflation by sterilizing the increase in DM through open market activities, that is, by issuing bonds to absorb the surplus DMs. Germany did set a one-for-one exchange rate, more than 30% of eastern Germans were unemployed by mid-1991 (this problem was compounded by the extremely generous German unemployment compensation system), inflation fears rose in Germany, and fewer than 10% of eastern German companies were solvent. 7. When Britain announced its entry into the exchange-rate mechanism of the EMS on October 5, 1990, the price of British gilts (long-term government bonds) soared and sterling rose in value. 7.a. What might account for these price jumps? ANSWER. By entering the exchange-rate mechanism, Britain has effectively foresworn devaluation of the pound against the DM. To maintain the pound’s value, Britain must follow a more disciplined and antiinflation monetary policy. Expectations of lower inflation and fewer currency swings in the future raised the demand for British assets, including pounds, thereby reducing interest rates (which are the inverse of the bond price) and raising the pound’s value. Put another way, expectations of lower inflation reduce interest rates (the Fisher Effect) and boost the value of a nation’s currency (purchasing power parity). 7.b. Sterling entered the ERM at a central rate against the DM of DM 2.95, and it is allowed to move within a band of +/- 6% of this rate. What are sterling’s upper and lower rates against the DM? ANSWER. Sterling’s lower limit against the DM is 0.94 * 2.95 = DM 2.77; its upper limit is 1.06 * 2.95 = DM 3.13. 8. What potential costs might be associated with the decision to widen the margins within which some currencies in the ERM can float? ANSWER. Widening the margins reduces the credibility of the system since such a system grants greater discretion to the monetary authorities. Currency holders don’t want the monetary authorities of suspect currency nations to have greater discretion. Indeed, the monetary authorities’ loss of discretion associated with the ERM is viewed by most as the ERM’s greatest value. For suspect currencies, the loss of credibility will likely lead to higher interest rates and more speculative attacks.

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9. Comment on the following headline in The Wall Street Journal (January 11, 1993): “Germany’s Rate Cut Takes Pressure Off French Franc, and the Rest of the EMS.” ANSWER. The origin of the September 1992 currency crisis was the Bundesbank’s decision to maintain high interest rates to restrain the inflationary effects of reunification. To maintain their currencies against the DM, the other members of the EMS were forced to push up their own interest rates, thereby stifling economic growth in their countries. Speculators bet that Britain, Spain, and some other countries would find that trade-off unpalatable and would devalue their currencies. As long as German rates remained high, this Hobson’s choice would continue to face other European governments and would maintain speculative pressure on their currencies. By cutting its discount rate, the Bundesbank allowed France and the other EMS members to cut their interest rates and stimulate their economies without devaluing their currencies. Therefore, by reducing the likelihood that they would devalue their currencies, this interest rate cut reduced speculative pressure. 10. The French franc was the main target of speculators during the August 1993 assault on the EMS despite the fact that France was running a 2% inflation rate while Germany had a 4.3% inflation rate. Why might this be? ANSWER. Two words explain this situation: credibility and expectations. Given the market’s trust in the Bundesbank, the high German inflation rate was viewed as an aberration that the Bundesbank would soon get under control. Conversely, currency traders were less certain of the Bank of France’s long-term commitment to low inflation, especially since the Bank of France has historically been subservient to the interests of the French government. More specifically, unlike the Bundesbank, the Bank of France did not have 35 years of independence behind it and could not count on the unwavering support of a citizenry that abhors inflation. Based on the high rate of unemployment and sluggish growth in France and the growing demands by the French public for easing up on monetary policy, it was rational to assign a high probability that the Bank of France would abandon its strong franc policy. The result would be higher French inflation in the future. Conversely, the history of the Bundesbank would suggest lower German inflation in the future. Given expectations of higher French inflation and lower German inflation in the future, the foreign exchange market rationally expected a weaker French franc. Acting immediately on such expectations, speculators sold francs and bought DM. 11. In early 1996, in response to growing doubts about the ability of EC nations to meet the Maestricht criteria and move toward monetary union by the 1999 deadline, yields on European bonds jumped. What is the likely link between the doubts on Maestricht and the EC bond yield increases? ANSWER. The expectation in the financial markets is that countries that meet the Maestricht criteria will be locked into a system that is essentially run on the same model as the Bundesbank, namely one that is committed to price stability as its one and only goal. In other words, the view is that Germany will run the EMU and the dominant characteristic of the single currency will be a low-inflation currency. To the extent the EMU is expected to materialize, therefore, interest rates on bonds denominated in different currencies will converge toward the rate on DM bonds, which is lower than that on other European currency bonds. Conversely, an expected movement away from monetary union lowers the probability that the other European countries will stick with the low-inflation German monetary policy. Anything that lowers the probability of EMU, therefore, lowers the odds that other currencies will follow a low-inflation monetary policy, leading to expectations of higher inflation and higher interest rates.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

12. “For a fixed exchange rate system to work, the government must be able to make tight budget and monetary policies stick from the outset.” Comment. ANSWER. A government that runs budget deficits and a lax monetary policy is unlikely to be able to maintain its commitment to a fixed exchange rate. Hence, one that starts out on the wrong foot will appear to observers to be willing to make exchange rate policy subservient to other national interests. Recognizing this apparent lack of government commitment to a fixed exchange rate, speculators are more likely to attack its currency, making its ability to maintain the fixed exchange rate even more doubtful. 13. On taking office in October 1993, the Bundesbank’s new president, Hans Tietmeyer, said, “Forced reductions in central bank interest rates which are contrary to stability policies can neither solve economic or structural problems. But they would undermine trust in currency values, drive long-term interest rates higher and delay necessary corrections in the real economy.” Explain the context in which Mr. Tietmeyer made these comments. Do you agree or disagree with his comments? Explain. ANSWER. Mr. Tietmeyer was responding to a chorus of complaints following the currency crisis of August 1993, which in turn led to the abandonment of the Exchange Rate Mechanism. The August crisis was triggered by the (correct) belief that the Bundesbank would not reduce its interest rates sufficiently to permit cuts in interest rates in other ERM countries such as France and Denmark where unemployment was high and inflation low. What Tietemayer said, in effect, was “Don't blame Germany for your high unemployment and slow growth. Monetary policy is not a good tool to use in stimulating an economy. You will just end up with high inflation and higher real interest rates. Rather, you should focus on correcting the structural problems that are driving your high unemployment rates, such as high taxes, a less productive workforce, a subservient central bank (leading to a risk premium), and expensive labor regulations.” 14. Comment on the following statement: “Wage flexibility is a substitute, albeit an imperfect one, for exchange rate flexibility.” ANSWER. If an economic shock leads to domestic imbalances between supply and demand, a change in the exchange rate can bring about the necessary changes in prices and wages to reestablish competitiveness. However, if the exchange rate is fixed, then wages and prices themselves must change to respond to domestic imbalances. Wage flexibility will go a long way to achieving this end, but it is imperfect since flexibility in the prices of goods and services is also an important element in adapting to changed economic circumstances.

CHAPTER 3: THE INTERNATIONAL MONETARY SYSTEM

SUGGESTED SOLUTIONS TO CHAPTER 3 PROBLEMS 1. During the currency crisis of September 1992, the Bank of England borrowed DM33 billion from the Bundesbank when a pound was worth DM2.78, or $1.912. It sold these DM in the foreign exchange market for pounds in a futile attempt to prevent a devaluation of the pound. It repaid these DM at the post-crisis rate of DM2.50:£1. By then, the dollar:pound exchange rate was $1.782:£1. 1.a. By what percentage had the pound sterling devalued in the interim against the DM? Against the dollar? ANSWER. During this period, the pound depreciated by 10.1% against the pound and by 6.8% against the dollar.

1.782 − 1.912 = - 6.8% 1.912 2.50 − 2.78 = - 10.1% 2.78 1.b. What was the cost of intervention to the Bank of England in pounds? In dollars? ANSWER. The Bank of England borrowed DM 33 billion and must repay DM33 billion. When it borrowed these DM, the DM was worth £0.3597, valuing the loan at £11.87 billion (DM33 billion * 0.3597). After devaluation, the DM was worth £0.4000. Hence, the Bank of England’s cost of repaying the DM loan was £13.20 billion (DM33 billion * 0.4), a rise of £1.33 billion. Thus, the cost to the Bank of England of this DM borrowing and intervention was £1.33 billion. In dollar terms, intervention cost the Bank of England $825 million. This estimate is based on the difference of $0.025 between the DM’s initial value of $0.6878 (1.912/2.78) and its ending value of $0.7128 (1/2.50) times the DM33 billion borrowed and spent defending the pound. Specifically, the cost calculation is $0.025 * 33,000,000,000 = $825 million. 2. Suppose the central rates within the ERM for the French franc and DM are FF 6.90403:ECU 1 and DM 2.05853:ECU 1, respectively. 2.a. What is the cross-exchange rate between the franc and the DM? ANSWER. Since things equal to the same thing are equal to each other, FF 6.90403 = DM2.05853. Hence, FF1 = DM2.05853/6.90403 = DM0.298164. Equivalently, DM 1 = FF6.90403/2.05853 = FF3.35386. 2.b. Under the original 2.25% margin on either side of the central rate, what were the approximate upper and lower intervention limits for France and Germany? ANSWER. Given the answer to part a, the French franc could rise to approximately DM0.298164 * 1.0225 = DM0.304872 or fall as far as DM0.298164 * 0.9775 = DM0.291455. Similarly, the upper limit for the DM is FF3.42933 and the lower limit is FF3.27840.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

2.c.

Under the revised 15% margin on either side of the central rate, what are the current approximate upper and lower intervention limits for France and Germany?

ANSWER. Given the answer to part a, the French franc could rise to approximately DM0.298164 * 1.15 = DM0.342888 or fall as far as DM2.98164 * 0.85 = DM 0.253439. Similarly, the upper limit for the DM is FF3.85694 and the lower limit is FF2.85078. 3. A Dutch company exporting to France has FF3 million due in 90 days. Suppose that the current exchange rate is FF1 = Dfl0.3291. 3.a. Under the exchange rate mechanism, and assuming central rates of FF6.45863/ECU and DFl2.16979/ECU, what is the central cross-exchange rate between the two currencies? ANSWER. Given central rates of DFl2.16979:ECU and FF6.45863:ECU for the Dutch guilder and French franc, respectively, the central cross rate between the two currencies is DFl1 = FF2.97662 (6.45863/2.16979). Equivalently, FF1 = DFl0.335952 (2.16979/6.45863). 3.b. Based on the answer to part a, what is the most the Dutch company could lose on its French franc receivable, assuming that France and the Netherlands stick to the ERM with a 15% band on either side of their central cross rate? ANSWER. At worst, the French franc can fall by 15% relative to its central guilder cross rate, to a crossexchange rate of FF1 = DFl0.285559 (0.335952 * 0.85). Since the current exchange rate is FF 1 = DFl 0.3291, the most the Dutch company can lose on its FF 3 million receivable is 3,000,000 * (0.3291 0.285559) = DFl130,622. 3.c.

Redo part b, assuming the band was narrowed to 2.25%.

ANSWER. If the band were narrowed to 2.25%, then the minimum value for the French franc would be DFl0.328393 and the maximum loss that the Dutch company could sustain would be 3,000,000 * (0.3291 - 0.328393) = DFl2,121. 3.d. Redo part b, assuming you know nothing about the current cross-exchange rate. ANSWER. Knowing nothing about the current cross-exchange rate, the worst that could happen is that the cross rate would be at its upper bound of DFl0.386345 (0.335952 * 1.15) and it falls to its lower bound of 0.285559 (established in the answer to part b). In this case, the maximum possible loss is 3,000,000 * (0.386345 - 0. 285559) = DFl302,357. 4. Panama adopted the U.S. dollar as its official paper money in 1904. Currently, about $400 million to $500 million in U.S. dollars is circulating in Panama. If interest rates on U.S. Treasury securities are 7%, what is the value of the seigniorage that Panama is forgoing by using the U.S. dollar instead of its own-issue money? ANSWER. Instead of using U.S. dollars as its currency in circulation, the Panamanian government could substitute its own currency and invest the $400 million to $500 million in U.S. Treasury securities. This policy would earn the Panamanian government $28 million to $35 million annually at the current 7% interest rate. Thus, the Panamanian government is foregoing seigniorage worth $28 million to $35 million annually. The present value of this seigniorage equals the amount of U.S. dollars in circulation, or $400 million ($28 million/.07) to $500 million ($35 million/.07).

CHAPTER 3: THE INTERNATIONAL MONETARY SYSTEM

5. By some estimates, $185 billion to $260 billion in currency is held outside the U.S. 5.a. What is the value to the U.S. of the seigniorage associated with these overseas dollars? Assume that dollar interest rates are about 6%. ANSWER. The annual value of seigniorage equals the foregone interest on the currency held outside the U.S. Based on the numbers presented in the question, this annual value varies between $11.1 billion (0.06 * $185 billion) and $15.6 billion (0.06 * $260 billion). If this money stays overseas permanently, then the value of seigniorage is just equal to the amount of dollars held outside the U.S., or $185 billion to $260 billion. In other words, the U.S. receives goods and services worth this amount of money from foreigners and paid for them with pieces of green paper that are never redeemed for U.S. goods and services. 5.b. Who in the United States realizes this seigniorage? ANSWER. The U.S. government realizes this seigniorage. Who in the U.S. benefits from this seigniorage is an issue in political economy and depends what the government does with the money: cuts taxes, spends it (which raises the further question of on whom), uses it to reduce the deficit, etc. ADDITIONAL CHAPTER 3 PROBLEM AND SOLUTION 1. The central rates for the Spanish and Belgian currencies on March 20, 1997, were Ptas 163.826/ECU and BF 39.7191/ECU. What central cross rate between these two currencies did these central rates imply? ANSWER. These rates imply a central cross rate between the two currencies of Ptas 4.1246/BF (163.826/39.7191), or equivalently, BF 0.242447/Ptas (39.7191/163.826).

CHAPTER 4: PARITY CONDITIONS IN INTERNATIONAL FINANCE/CURRENCY FORECASTING

CHAPTER 4 PARITY CONDITIONS IN INTERNATIONAL FINANCE AND CURRENCY FORECASTING This chapter emphasizes that currency prices are determined in the same way that other asset prices are, by the interaction of supply and demand curves. The key concept is the relationship between inflation and exchange rate changes – the internal devaluation of a currency (inflation) eventually leads to its external devaluation. KEY POINTS 1. Inflation is the logical outcome of an expansion of the money supply in excess of real output growth. As the supply of one commodity increases relative to supplies of all other commodities, the price of the first commodity must decline relative to the prices of other commodities. In other words, its value in exchange or exchange rate must decline. Similarly, as the supply of money increases relative to the supply of goods and services, the price of money in terms of goods and services must decline, i.e., the exchange rate between money and goods declines. 2. The international parallel to inflation is domestic currency depreciation relative to foreign currencies. To maintain the same exchange rate between money and goods both domestically and abroad, the exchange rate must decline by (approximately) the difference between the domestic and foreign rates of inflation. This is purchasing power parity, which is itself based on the law of one price. 3. Although the nominal or actual money exchange rate may fluctuate all over the place, we would normally expect the real, or inflation-adjusted exchange rate, to remain relatively constant over time. The same is true for nominal versus real rates of interest. However, although the prediction that real interest and exchange rates will remain constant over time is a reasonable one ex ante, ex post we find that these real rates wander all over the place. A changing real exchange rate is the most important source of exchange risk for companies. 4. Four additional equilibrium economic relationships tend to hold in international financial markets: Purchasing Power Parity (PPP), the Fisher Effect, International Fisher Effect (IFE), Interest Rate Parity (IRP), and the forward rate as an unbiased estimate of the future spot rate. 5. These equilibrium relationships are at the heart of a working knowledge of international financial management. I point out to the students that they will be seeing them in many different guises – from the analysis of a firm’s foreign exchange exposure to currency forecasting to the decision as to which currency to borrow or lend in.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

The final section makes six key points about exchange rate forecasting: 1. The foreign exchange market is no different from any other financial market in its susceptibility to being profitably predicted. 2. It is difficult to outperform the market’s own forecasts of future exchange rates as embedded in interest and forward differentials. However, while interest rates and forward rates provide unbiased forecasts of future exchange rates, these forecasts are highly inaccurate. 3. Those with inside information about events that will affect the value of a currency or of a security should benefit handsomely. 4. Those without such access will have to depend on luck or the existence of a market imperfection, such as government intervention, to earn above-average risk-adjusted profits. 5. Given the widespread availability of information and the many knowledgeable participants in the foreign exchange market, only the latter situation – government manipulation of exchange rates – holds the promise of superior returns from currency forecasting. This is because when, for political purposes, governments spend money to control exchange rates, money flows into the hands of those who bet against the government. The trick is to predict government actions. 6. The black-market rate is a good indicator of where the official rate is likely to go if the monetary authorities give in to market pressure. However, although the official rate can be expected to move toward the black-market rate, we should not expect to see it coincide with that rate because of the bias induced by government sanctions. The black-market rate seems to be most accurate in forecasting the official rate one month hence and is progressively less accurate as a forecaster of the future official rate for longer time periods. I usually bring in several currency column clippings from the Wall Street Journal to point out the effect of changing inflationary expectations or interest rates on foreign exchange rates. The case Oil Levies: The Economic Implications is a useful exercise that illustrates the difference between operating in a segmented national economy and operating in a world economy, while simultaneously demonstrating the implications of the law of one price. It can be found immediately following this chapter.

CHAPTER 4: PARITY CONDITIONS IN INTERNATIONAL FINANCE/CURRENCY FORECASTING

SUGGESTED ANSWERS TO CHAPTER 4 QUESTIONS 1.a. What is purchasing power parity (PPP)? ANSWER. In its absolute version, PPP states that price levels should be equal worldwide when expressed in a common currency. In other words, a unit of home currency (HC) should have the same purchasing power around the world. The relative version of PPP, which is used more commonly now, states that the exchange rate between the home currency and any foreign currency will adjust to reflect changes in the price levels of the two countries. For example, if inflation is 5% in the U.S. and 1% in Japan, the dollar value of the Japanese yen must rise by about 4% to equalize the dollar price of goods in the two countries. 1.b. What are some reasons for deviations from purchasing power parity? ANSWER. PPP might not hold because: • The price indices used to measure PPP may use different weights or different goods and services. • Arbitrage may be too costly because of tariffs and other trade barriers and high transportation costs, or too risky because prices could change during the time that an item is in transit between countries. • Since some goods and services used in the indices are not traded, there could be price discrepancies between countries. • Relative price changes could lead to exchange rate changes even in the absence of an inflation differential. • Government intervention could lead to a disequilibrium exchange rate. 1.c.

Under what circumstances can PPP be applied?

ANSWER. The relative version of PPP holds up best in two circumstances: (a) over long periods among countries with a moderate inflation differential since the general trend in the price level ratio will tend to dominate the effects of relative price changes, and (b) in the short run during periods of hyperinflation since with high inflation changes in the general level of prices quickly swamp the effects of relative price changes. 2. One proposal to stabilize the international monetary system involves setting exchange rates at their PPP rates. Once exchange rates are correctly aligned (according to PPP), each nation would adjust its monetary policy to maintain PPP. What problems might arise from using the PPP rate as a guide to the equilibrium exchange rate? ANSWER. The proposal to adjust monetary policy to maintain PPP assumes that the PPP rate is the equilibrium rate. This assumption ignores the many shortcomings of PPP as a theory of exchange rate determination. Deviations from PPP have prevailed throughout the history of floating rate regimes. Thus, there is good reason to believe that PPP provides a poor proxy for the equilibrium exchange rate at any point in time. If the PPP benchmark is used as a proxy for the equilibrium exchange rate when there are equilibrium departures from PPP, this guideline will interfere with long-run equilibration in the foreign exchange market. Here is the basic problem: Domestic and foreign goods are not perfect substitutes; hence, issues of spatial arbitrage and the law of one price are irrelevant. Imagine that at the PPP exchange

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

rate U.S. firms can’t find buyers for their goods, while Japanese firms work overtime to meet the demand for their goods. Something will have to give, probably the real exchange rate. When a country opens new markets, introduces new products, or experiences a favorable or unfavorable price shock for its traditional exports, the real exchange rate will change. Monetary policy that stabilizes a disequilibrium exchange rate is clearly inappropriate. 3. Suppose the dollar/rupiah rate is fixed but Indonesian prices are rising faster than U.S. prices. Is the Indonesian rupiah appreciating or depreciating in real terms? ANSWER. The rupiah’s real value is rising since it is not depreciating to compensate for higher Indonesian inflation. 4. Comment on the following statement: “It makes sense to borrow during times of high inflation because you can repay the loan in cheaper dollars.” ANSWER. According to the Fisher Effect, interest rates adjust to take into account the effects of inflation on the real cost of repaying a loan. Thus, borrowing during times of inflation is profitable only if inflation turns out to be higher than expected at the time the loan was made. By definition, however, it is impossible to expect to profit from the unexpected. Hence, this statement is inconsistent with elementary notions of market efficiency. 5. Which is likely to be higher, a 150% ruble return in Russia or a 15% dollar return in the U.S.? ANSWER. Since both are stated in nominal terms in different currencies, they cannot be compared directly. The ruple return must be adjusted for Russian inflation and the dollar return for U.S. inflation to get the real returns. Alternatively, the nominal Russian return should be converted into dollars to get the nominal dollar return in Russia. 6. The interest rate in England is 12%, while in Switzerland it is 5%. What are possible reasons for this interest rate differential? What is the most likely reason? ANSWER. Although there are several possible explanations for higher interest rates, the most likely explanation is that inflation is expected to be higher in England than in Switzerland. 7. Over the period 1982-1988, Peru and Chile stand out as countries whose interest rates are not consistent with their inflation experience. Specifically, Peru’s inflation and interest rates averaged about 125% and 8%, respectively, over this period, whereas Chile’s inflation and interest rates averaged about 22% and 38%, respectively. 7.a. How would you characterize the real interest rates of Peru and Chile (e.g., close to zero, highly positive, highly negative)? ANSWER. Highly negative for Peru and highly positive for Chile. 7.b. What might account for Peru's low interest rate relative to its high inflation rate? What are the likely consequences of this low interest rate? ANSWER. Peru’s nominal interest rate averaged around 8% during this period, even as its inflation rate approached 130% annually. This highly negative real interest rate was due to government controls on the interest rate that could be paid on savings. As a result, Peruvian savings plummeted, a black market for capital arose, and those Peruvians who could converted their money into dollars or other hard currencies likely to maintain their value.

CHAPTER 4: PARITY CONDITIONS IN INTERNATIONAL FINANCE/CURRENCY FORECASTING

7.c.

What might account for Chile’s high interest rate relative to its inflation rate? What are the likely consequences of this high interest rate?

ANSWER. Chile had undergone a period of rapid inflation prior to period shown in the exhibit. As a result, investors were projecting a high rate of future inflation and this was reflected in the interest rate (remember, the Fisher Effect says nominal rates are based on expected future inflation). In addition, investors probably added an inflation risk premium to the interest rate to compensate for inflation risk. 7.d. During the same period, Peru had a small interest differential and yet a large average exchange rate change. How would you reconcile this experience with the IFE and with your answer to part b? ANSWER. The narrow interest differential owes to the government interest rate controls mentioned in part b. The IFE refers to interest rates set in a free market. It says nothing about controlled interest rates. 8. Over the period 1982-1988 numerous countries (e.g., Pakistan, Hungary, Venezuela) had a small or negative interest rate differential and a large average annual depreciation against the dollar. How would you explain these data? Can you reconcile these data with the IFE? ANSWER. These countries have had fairly high inflation combined with controls that held their interest rates below those that would prevail in a free market. The large average annual depreciation can be explained by their rapid inflation, whereas the absence of the IFE is due to the interest rate controls. As noted in the answer to question 7.d, the IFE refers to interest rates set in a free market. It has nothing to say about controlled interest rates. 9. What factors might lead to persistent covered interest arbitrage opportunities among countries? ANSWER. The principal factor would be the existence of political risk, particularly the fear that at some point the government would impose exchange controls, not allowing capital to be removed. Another possible factor is differential tax laws which could lead to similar after-tax returns, even if before-tax returns differ. 10. In early 1989, Japanese interest rates were about 4 percentage points below U.S. rates. The wide difference between Japanese and U.S. interest rates prompted some U.S. real estate developers to borrow in yen to finance their projects. Comment on this strategy. ANSWER. The U.S. developers were gambling that the 400 basis point differential did not reflect market expectations of dollar depreciation, which is what the IFE would argue for. In other words, the developers were committing the economist’s unpardonable sin of comparing apples (dollar interest rates) with oranges (yen rates). This policy also makes no sense from a currency risk standpoint since the developers had dollar cash inflows (from the real estate rentals on their developments) and yen cash outflows on the mortgages, exposing them to considerable exchange risk. A rise in the value of the yen could conceivably cost them more than the savings on the lower yen interest rates. Moreover, this rise was quite likely since the IFE says that international differences in interest rates can be traced to expected changes in exchange rates, with low interest rate currencies expected to appreciate against high interest rate currencies. This is indeed what happened in the case of the yen.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

11. Recently, Japanese and German interest rates rose while U.S. rates fell. At the same time, the yen and DM fell against the U.S. dollar. What might explain the divergent trends in interest rates? ANSWER. According to the Fisher Effect, the most likely cause for the rise in German and Japanese interest rates was higher expected inflation in those countries. At the same time, the fall in U.S. interest rates could be attributable to a decline in expected U.S. inflation. If so, then PPP would predict that the future value of the dollar should rise relative to what was previously expected. Since these expectations would be immediately impounded in currency values, we would expect the dollar to rise relative to the yen and DM. This scenario is consistent with what actually happened. 12. In late December 1990, one-year German Treasury bills yielded 9.1%, whereas one-year U.S. Treasury bills yielded 6.9%. At the same time, the inflation rate during 1990 was 6.3% in the U.S., double the German rate of 3.1%. 12.a. Are these inflation and interest rates consistent with the Fisher Effect? ANSWER. Not if one assumes that future inflation will equal past inflation. In that case, the real interest rate in Germany will be approximately 6% (9.1% - 3.1%) and in the U.S. 0.6% (6.9% - 6.3%). More likely, the markets were anticipating a fall in U.S. inflation (because of tight money in the U.S. combined with the U.S. recession) and a rise in German inflation (given the costs of German unification). If so, then these rates are consistent with the Fisher Effect, which says that nominal interest rates are based on expected, not past inflation. 12.b. What might explain this difference in interest rates between the U.S. and Germany? ANSWER. One possible answer was suggested in 12.a, namely that 1990 inflation was not considered a reasonable predictor of 1991 inflation. An alternative answer is that real interest rates in Germany were rising to attract the added capital needed to finance the enormous investment in eastern Germany. 13. The spot rate on the euro is $0.91 and the 180-day forward rate is $0.93. What are possible reasons for the difference between the two rates? ANSWER. The relative values of the spot and forward rates suggest that the market believes the euro will appreciate against the dollar by about $0.02 over the next 180 days. The difference also indicates that the interest rate on dollars exceeds the interest rate on euros. These explanations are consistent with each other since a higher U.S. dollar interest rate indicates higher expected U.S. inflation and an expected depreciation of the dollar. 14. German government bonds, or Bunds, are currently paying higher interest rates than comparable U.S. Treasury bonds. Suppose the Bundesbank eases the money supply to drive down interest rates. How is an American investor in Bunds likely to fare? ANSWER. The answer is impossible to determine in advance. The fall in DM interest rates will increase the price of Bunds (bond prices move inversely with interest rates), giving U.S. investors a capital gain in DMs. Concurrently, however, the decline in DM interest rates and the easing of German monetary policy could lead to a weaker DM. The net effect on U.S. investors’ dollar returns of the higher DM price of Bunds and the lower dollar value of the DM depends on which of the two factors dominates.

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15. In 1993 and early 1994, Turkish banks borrowed abroad at relatively low interest rates to fund their lending at home. The banks earned high profits because rampant inflation in Turkey forced up domestic interest rates. At the same time, Turkey’s central bank was intervening in the foreign exchange market to maintain the value of the Turkish lira. Comment on the Turkish banks’ funding strategy. ANSWER. This strategy, while profitable in the short run, exposes the Turkish banks to significant and predictable exchange risk. It will work only so long as the Turkish central bank is able to maintain a fixed nominal exchange rate in the face of high domestic inflation. In the process of doing so, the Turkish lira’s real value will rise, putting pressure on exporters (who will see their goods priced out of world markets) and companies competing against imports. According to PPP, higher Turkish inflation will eventually lead to lira devaluation. If and when this happens, Turkish banks will find themselves facing a much higher lira cost of servicing their foreign debts. In fact, the Turkish lira did devalue by 28% (in April 1994), forcing a number of Turkish banks to the point of bankruptcy. The squeeze on Turkish banks was exacerbated when depositors, jittery over the banks’ problems, began to withdraw cash. The Turkish central bank was forced to step to help guarantee banks’ liquidity and calm depositors’ nerves. ADDITIONAL CHAPTER 4 QUESTIONS AND ANSWERS 1. If the dollar is appreciating against the Polish zloty in nominal terms but depreciating against the zloty in real terms, what do we know about Polish and U.S. inflation rates? ANSWER. The Polish inflation rate must be exceeding the U.S. inflation rate for the zloty to rise in real terms even as it is depreciating in nominal terms. This can be seen by studying Equation 8.6. 2. Suppose the nominal peso/dollar exchange rate is fixed. If the inflation rates in Mexico and the U.S. are constant (but not necessarily equal), will the real value of the peso/dollar exchange rate also be constant over time? ANSWER. No. For the real exchange rate to remain constant, price levels in both countries must remain constant. To see this, suppose that at time 0, the nominal and real exchange rates equal 1. If U.S. inflation is 2% and Mexican inflation is 15%, then according to Equation 8.6, the peso’s real exchange rate in one year will equal 1.13 (1 * 1.15/1.02). This figure represents a 13% rise in the real value of the peso. 3. If the average rate of inflation in the world rises from 5% to 7%, what will be the likely effect on the U.S. dollar’s forward premium or discount relative to foreign currencies? ANSWER. If inflation rises uniformly around the world, there will be no change in relative inflation rates. Hence, there should be no change in currency values and in the forward discount or premium on the dollar. 4. Comment on the following statement: “It makes sense to borrow during times of high inflation because you can repay the loan in cheaper dollars.” ANSWER. According to the Fisher Effect, interest rates adjust to take into account the effects of inflation on the real cost of repaying a loan. Thus, borrowing during times of inflation is profitable only if inflation turns out to be higher than expected at the time the loan is made. By definition, however, it is impossible to expect to profit from the unexpected. Hence, this statement is inconsistent with elementary notions of market efficiency.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

5. The empirical evidence shows that there is no consistent relationship between the spot exchange rate and the nominal interest rate differential. Why might this be? ANSWER. When the nominal interest rate differential rises (falls) because U.S. inflation is expected to increase (decrease), the value of the dollar can be expected to fall (rise). Alternatively, if the increase (decrease) in the nominal interest differential is due to a change in the real interest rate, the dollar can be expected to increase (decrease) in value. 6. During 1988, the U.S. prime rate (the rate of interest banks charge on loans to their best customers) stood at 9.5% while Japan’s prime rate was about 3.5%. Given that discrepancy, a number of commentators argued that the cost of capital must come down for U.S. business to remain competitive with Japanese companies. What additional information would you need to properly assess this claim? Why might interest rates be lower in Japan than in the U.S.? ANSWER. To begin, 3.5% in yen is not the same as 9.5% in dollars. Absent government controls or subsidized financing, the expected cost of the two loans should be about the same when measured in the same currency. This is the IFE. Further, the generalized version of the Fisher Effect says that the real cost of borrowing in different currencies should be about the same. The interest rates referred to in the question are nominal, not real. Absent government constraints on capital flows, nominal interest rates differ because lenders expect different rates of inflation measured in different currencies. Thus, to properly assess this claim, you would need to subtract expected inflation from the interest rates and compare real interest rates. Given U.S. inflation of about 5% in 1988 and Japanese inflation of about -1%, real interest rates were about the same in both countries. The bottom line is that these nominal rate differences don’t place U.S. companies at a competitive disadvantage. 7. In the late 1960s, Firestone Tire decided that Swiss francs at 2% were cheaper than U.S. dollars at 8% and borrowed about SFr 500 million. Comment on this choice. ANSWER. Firestone Tire was gambling that the 6% lower interest rate on the Swiss franc would not be offset by appreciation of the Swiss franc against the dollar. It lost its bet that the IFE would not hold. When it went to repay the loan several years later, the Swiss franc had more than doubled in value against the dollar. 8. Comment on the following quote from the Wall Street Journal (August 27, 1984, p. 6) that discusses the improving outlook for Britain's economy: “Recovery here will probably last longer than in the U.S. because there isn't a huge budget deficit to pressure interest rates higher.” ANSWER. In a world characterized by a relatively free flow of capital, a higher real return in the U.S. will attract capital from England, thereby driving up rates there as well. Thus, if real interest rates rise in the U.S., real rates in the U.K. will also rise. 9. Comment on the following headline that appeared in the Wall Street Journal (December 19, 1990, p. C10): “Dollar Falls Across the Board as Fed Cuts Discount Rate to 6.5% From 7%.” (The discount rate is the interest rate the Fed charges member banks for loans.) ANSWER. In cutting the discount rate, the Fed is easing monetary policy. This easing will likely bring with it higher future inflation which, via PPP, will cause future dollar depreciation. At the same time, the cut in the nominal U.S. interest rate was also a real cut (because expected future inflation is now higher). Both explanations predict that dollar investments will be less attractive. In response, traders and investors will dump dollars today, causing the dollar to fall immediately.

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10. In late 1990, the U.S. government announced that it might try to reduce the budget deficit by imposing a 0.5% transfer tax on all sales and purchases of securities in the U.S., with the exception of Treasury securities. It projected the tax would raise $10 billion in federal revenues – an amount derived by multiplying 0.5% by the value of the $2 trillion trading on the New York Stock Exchange each year. 10.a. What are the likely consequences of this tax? Consider its effects on trading volume in the U.S. and stock and bond prices. ANSWER. This classic example of static revenue analysis assumes that making trading in the U.S. more expensive and less profitable will not reduce the number of trades executed there. In fact, investors are likely to respond in one of two ways: (a) they will shift their trading activity overseas to avoid the transfer tax and/or (b) they will reduce the number of trades they make. It is easy for traders to shift their activities to any market via a phone line and a fax machine. So the U.S. government will collect less revenue, possibly far less, than it expected. Not surprisingly, the transfer tax has strong support from the British financial services sector, which anticipates a jump in trading activity for the City of London. In effect, a meaningful transfer tax will lead to the same type of regulatory arbitrage we have seen in other times and places. For example, the Kennedy Administration adopted the Interest Equalization Tax (IET), which taxed foreign borrowings in the U.S. to restrict capital outflows. The IET drove a wedge between the returns from lending dollars in the U.S. and the returns from lending dollars held on deposit in Europe (Eurodollars). The net result of the IET was to jump start the Eurodollar market, because lending Eurodollars did not incur the IET. Markets will also be more volatile since investors will not trade on information that would justify small increases or decreases in the prices of stocks. But as information continues to flow, a point will be reached where the benefits of doing the trade will exceed the cost of the tax. The tax, in other words, will cause stock prices to move in bigger jumps, both up and down, than they now do. The result: a less liquid and more volatile market. 10.b. Why does the U.S. government plan to exclude its securities from this tax? ANSWER. To the extent the transfer tax is effective, it will raise the cost of capital for American firms, since investors will demand to be compensated for the added costs of buying and selling securities. All investors care about is their net return after all taxes have been paid. Clearly, the government understands the harm its proposal can do since its proposal exempts federal debt from the tax. In effect, the proposal would raise capital costs for the private sector while subsidizing federal debt creation. 10.c. Critically assess the government’s estimates of the revenue it will raise from this tax. ANSWER. One of the axioms of tax economics is that you should try to tax behavior that won’t change much in response to the imposition of the tax. Here, the government is considering a tax on one of the world’s most quickly moving targets. Currently, 12% of all trading orders in New York are from foreign clients – but most of these orders could just as well be executed in London, Toronto, Tokyo, or Frankfurt. Moreover, U.S. institutions would surely shift some of their domestic business overseas to cut costs. As the case of the IET shows, when countries impose transaction fees, they lose business to competing markets. The Swedish transfer tax was recently abolished after resourceful Swedes successfully transferred much trading to London from Stockholm. And since Britain announced that it would abolish transfer taxes in 1991, both the Netherlands and Germany have decided to eliminate theirs too. Pressure is building on France and Switzerland to abolish their transfer taxes, while Japan and Italy are cutting transfer taxes as well. The net result is that the U.S. is unlikely to collect much revenue from the tax.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

11. It has been argued that the U.S. government’s economic policies, particularly as they affect the U.S. budget deficit, are severely constrained by the world’s financial markets. Do you agree or disagree? Discuss. ANSWER. Agree. To finance its huge budget deficits (which have recently turned into surpluses), the U.S. government has needed continual access to the world’s capital markets. Given deficits, if investors begin to believe that the U.S. would pursue economic policies that are inflationary, they would immediately change the terms on which they are prepared to lend the U.S. government money. Inflationary policies, therefore, would lead to higher interest rates, thereby worsening the budget deficit, hobbling economic growth, and even throwing the nation into a recession. At the same time, the value of the dollar would fall. The adverse political consequences of these two effects – higher interest rates and a falling dollar – actually constrained government policymakers to pursue economic policies that were regarded by the financial markets as being noninflationary. Of course, the U.S. government could always have promised to maintain the value of the dollar, but such a pledge would be far more credible if backed by serious deficit reduction, such as what happened. The actual deficit reduction is owed to rapid economic growth and the resulting jump in federal revenues. Rapid growth, in turn, has strengthened the U.S. dollar, as predicted. President Clinton got a taste of bond investors’ power in 1992 when, bondholders pushed up long-term interest rates by about 40 basis points in anticipation of his victory. Why? Because investors feared that he would honor his promise to reinvigorate the economy and put the unemployed back to work through traditional Democratic big government spending programs and regulations. Fearing that his policies and programs would accelerate inflation, investors sold bonds, causing bond prices to fall and interest rates to rise. It was the bond market’s way of warning Mr. Clinton that he would long be on probation, with his every move scrutinized by nervous investors. Conversely, bondholders tended to ignore the large budget deficits during the Reagan and Bush administrations because they felt secure with fiscally conservative Republicans in the White House. 12. In 1991, the U.S. government imposed a stiff import tariff on the active-matrix LCD screens that now appear in next-generation laptop computers. 12.a. Assess the likely consequences of the import duty for U.S. laptop computer manufacturers. ANSWER. U.S. laptop manufacturers will find their costs rising significantly, particularly since the activematrix LCD screen is already the most expensive component in a color laptop. Unfortunately, they will be unable to raise their prices by much since they are facing competition from foreign laptop manufacturers that pay no duty on assembled machines containing active-matrix screens. Moreover, U.S. companies don’t have the luxury of shifting to a U.S. active-matrix supplier since none exists. The result for U.S. manufacturers will be a steep decline in profits on laptops made in the U.S. 12.b. How are these manufacturers likely to react to this import duty? ANSWER. The key to answering this question is to recognize that the duty is imposed on the active-matrix screens, not on the computers. U.S. manufacturers will, and did, react by shifting manufacture of color laptops overseas and then exporting the assembled machines duty-free to the U.S. In June, 1993, the U.S. revoked its self-destructive LCD duties. Almost immediately, Apple Computer, Compaq, and Toshiba announced that they would shift laptop production back to the U.S.

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13. “High real interest rates can be a cause for celebration, not alarm.” Discuss. ANSWER. The most likely reason for a rise in real interest rates is a pickup in economic activity. Historically, an increase in real interest rates has usually signaled good economic times, while a real interest rate decrease has typically signaled economic decline. Specifically, real interest rates tend to be at their low point during a recession because of the low demand for capital. As the world economy comes out of recession, real rates typically rise. Hence, a high real interest rate likely signifies that economic growth is picking up. Of course, if real interest rates rise because the supply of capital is contracting, then high real rates would be a bad sign. But normally it is the demand for capital and not its supply that is the determining factor for real rates. 14. In an integrated world capital market, will higher interest rates in, say Japan, mean higher interest rates in, say, the U.S.? ANSWER. The answer depends critically on whether we are talking about real rates or nominal rates. If nominal interest rates rise in Japan because of higher expected Japanese inflation, this will have no effect on nominal U.S. rates unless the U.S. is following similar inflationary policies. However, a rise in real interest rates in Japan will tend to push up real rates in the U.S. through the process of international arbitrage, brought about by capital flows from the U.S. to Japan to take advantage of the higher real rates expected there. 15. In France in 1994, short-term interest rates and bond yields remained higher than in Germany, despite a better outlook for inflation in France. Does this situation indicate a violation of the Fisher Effect? Explain. ANSWER. No. The Fisher Effect is based on expected future inflation. Investors were saying that they believed Germany would likely have a lower rate of inflation in the future, despite its higher current rate of inflation. Hence, investors accorded lower interest rates to Germany than to France. Investors believed Germany would have a lower future rate of inflation than France because of the macroeconomic situation in these countries at the time. Both countries had high unemployment rates in 1994 and people were calling for the monetary authorities in the two countries to ease up on the money supply in order to boost economic growth, even if this led also led to higher inflation. Given France’s much shorter history of monetary rectitude than Germany’s and, hence, lesser degree of monetary credibility, investors were clearly saying that they believed French monetary authorities were less likely than the Bundesbank to resist the pressures to reflate. This expectation was based on the historical willingness of French authorities to tolerate higher inflation in order to stimulate economic growth. 16. On February 15, 1993, President Clinton previewed his State of the Union message to Congress in a toughly worded speech about how the growing federal budget deficit made tax increases necessary. Financial markets reacted by pushing bond prices up and pummeling stock prices. President Clinton said that the rise in Treasury bond prices was a “very positive” response to his televised speech the night before. How would you interpret the reaction of the financial markets to President Clinton's speech? ANSWER. News stories at the time reveal that the markets’ reaction was driven by investor expectations that a tax increase would reduce economic growth, thereby lowering both nominal and real interest rates. These stories are consistent with the differing reactions of the stock and bond markets. Lower interest rates will boost bond prices, but if those lower rates are driven by expectations of slower economic growth, then stock prices will fall (since expected future corporate earnings will be lower).

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

17. At the same time that it was talking down the dollar, the Clinton Administration was talking about the need for low interest rates to stimulate economic growth. Comment. ANSWER. These objectives were inconsistent with each other. If foreign investors expect the dollar to fall in the future, they will demand a higher U.S. interest rate to compensate themselves for their capital loss. Similarly, American investors will demand a higher dollar interest rate since their alternative is to invest in foreign bonds, which will provide them with a capital gain if and when the dollar falls. Moreover, dollar depreciation will also likely fuel inflation, which will push up interest rates. 18. One idea to curb potentially destabilizing international movements of capital has been devised by James Tobin, a Nobel Prize-winning economist. He proposes putting a small tax on foreign exchange transactions. He claims that his “Tobin tax” would make short-term speculation more costly while having little effect on long-term investment. 18.a. Why would the Tobin tax have a disproportionate impact on short-term investments? ANSWER. A given cost of buying and selling foreign exchange would be a larger percentage of annualized returns over a short period. For example, a cost of 0.1% would have an annualized cost of 5.2% over a one-week period (0.1% * 52) but only a 0.02% annualized cost over a five-year period (0.1%/5). The larger the annualized cost the greater the impact on a potential transaction. 18.b. Is the Tobin tax likely to accomplish its objective? Explain. ANSWER. No. A Tobin tax would be easy to avoid by moving currency trades to a country that does not tax them. It could also be avoided in other ways. For example, rather than trade DM for dollars, traders might agree to swap German bunds for U.S. Treasury bonds. It should also be noted that speculators who attack a currency expect returns far greater than the cost of a Tobin tax. Moreover, it would not necessarily solve problems such as those in East Asia, where the biggest sellers of local currency were not speculators but local firms trying desperately to hedge or repay debts denominated in dollars. SUGGESTED SOLUTIONS TO CHAPTER 4 PROBLEMS 1. From base price levels of 100 in 2000, Japanese and U.S. price levels in 2006 stood at 98 and 109, respectively. 1.a. If the 2000 $:¥ exchange rate was $0.00928, what should the exchange rate be in 2006? ANSWER. If e2006 is the dollar value of the yen in 2006, then according to PPP: e2003/0.00928 = 109/98, or e2006 = $0.0103. 1.b. In fact, the exchange rate in 2006 was ¥1 = $0.00860. What might account for the discrepancy? (Price levels were measured using the consumer price index.) ANSWER. The discrepancy between the predicted rate of $0.0103 and the actual rate of $0.0086 could be due to mismeasurement of the relevant price indices. Estimates based on narrower price indices reflecting only traded goods prices would probably be closer to the mark. Alternatively, it could be due to a switch in investors’ preferences from dollar to non-dollar assets.

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2. Two countries, the U.S. and England, produce only one good, wheat. Suppose the price of wheat is $3.25 in the U.S. and is £1.35 in England. 2.a. According to the law of one price, what should the $:£ spot exchange rate be? ANSWER. Since the price of wheat must be the same in both nations, the exchange rate, e, is 3.25/1.35 or e = $2.4074. 2.b. Suppose the price of wheat over the next year is expected to rise to $3.50 in the U.S and to £1.60 in England. What should the one-year $:£ forward rate be? ANSWER. In the absence of uncertainty, the forward rate, f, should be 3.50/1.60, or f = $2.1875. 2.c.

If the U.S. government imposes a tariff of $0.50 per bushel on wheat imported from England, what is the maximum possible change in the spot exchange rate that could occur?

ANSWER. If e is the exchange rate, then wheat selling in England at £1.35 will sell in the U.S. for 1.35e + 0.5, where 0.5 is the U.S. tariff on English wheat. To eliminate the possibility of arbitrage, 1.35e + 0.5 must be greater than or equal to $3.25, the price of wheat in the U.S. or e > $2.0370. Thus, the maximum exchange rate change that could occur is (2.4074 - 2.0370)/2.4074 = 15.38%. This solution assumes that the pound and dollar prices of wheat remain the same as before the tariff. 3. If expected inflation is 100% and the real required return is 5%, what will the nominal interest rate be according to the Fisher Effect? ANSWER. According to the Fisher Effect, the relationship between the nominal interest rate, r, the real interest rate a, and the expected inflation rate, i, is 1 + r = (1 + a)(1 + i). Substituting in the numbers in the problem yields 1 + r = 1.05 * 2 = 2.1, or r = 110%. 4. Suppose the short-term interest rate in France was 3.7%, and forecast French inflation was 1.8%. At the same time, the short-term German interest rate was 2.6% and forecast German inflation was 1.6%. 4.a. Based on these figures, what were the real interest rates in France and Germany? ANSWER. The French real interest rate was 1.037/1.018 - 1 = 1.87%. The corresponding real rate in Germany was 1.026/1.016 - 1 = 0.98%. 4.b. To what would you attribute any discrepancy in real rates between France and Germany? ANSWER. The most likely reason for the discrepancy is the inclusion of a higher inflation risk component in the French real interest rate than in the German real rate. Other possibilities are the effects of currency risk or transactions costs precluding this seeming arbitrage opportunity. 5. In July, the one-year interest rate is 12% on British pounds and 9% on U.S. dollars. 5.a. If the current exchange rate is $1.63:£1, what is the expected future exchange rate in one year? ANSWER. According to the IFE, the spot exchange rate expected in one year equals 1.63 * 1.09/1.12 = $1.5863.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

5.b. Suppose a change in expectations regarding future U.S. inflation causes the expected future spot rate to decline to $1.52:£1. What should happen to the U.S. interest rate? ANSWER. If rus is the unknown U.S. interest rate, and assuming that the British interest rate stayed at 12% (because there has been no change in expectations of British inflation), then according to the IFE, 1.52/1.63 = (1+rus)/1.12 or rus = 4.44%. 6. Suppose that in Japan the interest rate is 8% and inflation is expected to be 3%. Meanwhile, the expected inflation rate in France is 12%, and the English interest rate is 14%. To the nearest whole number, what is the best estimate of the one-year forward exchange premium (discount) at which the pound will be selling relative to the French franc? ANSWER. Japan’s real interest rate is about 5% (8% - 3%). From that, we can calculate France’s nominal interest rate as about 17% (12% + 5%), assuming that arbitrage will equate real interest rates across countries and currencies. Since England’s nominal interest rate is 14%, for IRP to hold, the pound should sell at around a 3% forward premium relative to the French franc. 7. An economic analysis firm has just published projected inflation rates for the U.S. and Germany for the next five years. U.S. inflation is expected to be 10% per year, and German inflation is expected to be 4% per year. 7.a. If the current exchange rate is $0.95/€, what should the exchange rates be for the next five years? ANSWER. According to PPP, the exchange rate for the euro at the end of year t should equal 0.95(1.10/1.04)t. Hence, projected exchange rates for the next five years are $1.0048, $1.0628, $1.1241, $1.1889, $1.2575. 7.b. Suppose that U.S. inflation over the next five years turns out to average 3.2%, German inflation averages 1.5%, and the exchange rate in five years is $0.99/€. What has happened to the real value of the euro over this five-year period? ANSWER. According to Equation 4.7, the real value of the euro at the end of five years is ’ t

e = et

(1 + i f )t 1.015 5 = 0.99 x ( ) = 0.9111 t 1.032 (1 + i h )

Hence, even though the euro has appreciated in nominal terms over this five-year period, it has fallen in real terms by 4.09% [(0.9111 - 0.95)/0.95]. 8. During 1995, the Mexican peso exchange rate rose from Mex$5.33/U.S.$ to Mex$7.64/U.S.$. At the same time, U.S. inflation was approximately 3% in contrast to Mexican inflation of about 48.7%. 8.a. By how much did the nominal value of the peso change during 1995? ANSWER. During 1995, the peso fell from $0.1876 (1/5.33) to $0.1309 (1/7.64), which is equivalent to a devaluation of 30.24% ((0.1309 - 0.1876)/0.1876)

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8.b. By how much did the real value of the peso change over this period? ANSWER. Using Equation 4.7, the real value of the peso by the end of 1995 was $0.1890: ’ t

e = et

(1 + i f )t 1.487 = 0.1309 x = 0.1890 t 1.03 (1 + i h )

Based on the real exchange rate, the peso has appreciated by 0.72% ((0.1890 - 0.1876)/0.1876). In other words, the real exchange rate stayed virtually constant, implying the PPP held during the year. 9. Suppose three-year deposit rates on Eurodollars and Eurofrancs (Swiss) are 12% and 7%, respectively. If the current spot rate for the Swiss franc is $0.3985, what is the spot rate implied by these interest rates for the franc three years from now? ANSWER. If rus and rsw are the associated Eurodollar and Eurofranc nominal interest rates, then the IFE says that et/e0 = (1 + rus)t/(1 + rsw)t where et is the period t expected spot rate and e0 is the current spot rate (SFr1 = $e). Substituting in the numbers given in the problem yields e3 = $0.3985 * (1.12/1.07)3 = $0.4570. 10. Assume the interest rate is 16% on pounds sterling and 7% on euros. At the same time, inflation is running at an annual rate of 3% in Germany and 9% in England. 10.a. If the euro is selling at a one-year forward premium of 10% against the pound, is there an arbitrage opportunity? Explain. ANSWER. According to IRP, with a euro rate of 7% and a 10% forward premium on the euro against the pound, the equilibrium pound interest rate should be 1.07 * 1.10 - 1 = 17.7% Since the pound interest rate is only 16%, there is an arbitrage opportunity. It involves borrowing pounds at 16%, converting them to euros, investing them at 7%, and then selling the proceeds forward, locking in a pound return of 17.7%. 10.b. What is the real interest rate in Germany? In England? ANSWER. The real interest rate in Germany is 1.07/1.03 -1 = 3.88%. The real interest rate in England is 1.16/1.09 -1 = 6.42%. 10.c. Suppose that during the year the exchange rate changes from €1.8/£1 to €1.77/£1. What are the real costs to a German company of borrowing pounds? Contrast this cost to its real cost of borrowing euros. ANSWER. At the end of one year, the German company must repay £1.16 for every pound borrowed. However, since the pound has devalued against the euro by 1.67% (1.77/1.80 - 1 = -1.67%), the effective cost in euros is 1.16 * (1 - 0.0167) - 1 = 14.07%. In real terms, given the 3% rate of German inflation, the cost of the pound loan is found as 1.1385/1.03 -1 = 10.74%.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

As shown above, the real cost of borrowing euros is 3.88%, which is significantly lower than the real cost of borrowing pounds. What happened is that the pound loan factored in an expected devaluation of about 9% (16% - 7%), whereas the pound only devalued by about 2%. The difference between the expected and actual pound devaluation accounts for the approximately 7% higher real cost of borrowing pounds. 10.d. What are the real costs to a British firm of borrowing euros? Contrast this cost to its real cost of borrowing pounds. ANSWER. During the year, the euro appreciated by 1.69% (1.80/1.77 - 1) against the pound. Hence, a euro loan at 7% will cost 8.81% in pounds (1.07 * 1.0169 - 1). In real pound terms, given a 9% rate of inflation in England, this loan will cost the British firm -0.2% (1.0881/1.09 - 1) or essentially zero. As shown above, the real interest on borrowing pounds is 6.42%. 11. Suppose the Eurosterling rate is 15%, and the Eurodollar rate is 11.5%. What is the forward premium on the dollar? Explain. ANSWER. According to IRP, if P is the forward premium on the dollar, then (1.115)(1 + P) = 1.15, or P = 3.14%. 12. Suppose the spot rates for the euro, pound sterling, and Swiss franc are $0.92, $1.13, and $0.38, respectively. The associated 90-day interest rates (annualized) are 8%, 16%, and 4%; the U.S. 90-day rate (annualized) is 12%. What is the 90-day forward rate on an ACU (ACU 1 = €1 + £1 + SFr 1) if interest parity holds? ANSWER. The key to working this problem is to recognize that the forward rate for a sum of currencies is just the sum of the forward rates for each individual currency. Also note that the forward rates are for 90 days. Hence, the interest rates must be divided by 4 to convert them into quarterly values. Assuming IRP, the forward rate for the pound is $1.13 * 1.03/1.04 = $1.1191, the forward rate for the euro is $0.92 * 1.03/1.02 = $0.9290, and the forward rate on the Swiss franc is $0.38 * 1.03/1.01 = $0.3875. If IRP holds, the 90-day forward rate on an ACU must, therefore, equal $1.1191 + $0.9290 + $0.3875 = $2.4356. 13. Suppose that three-month interest rates (annualized) in Japan and the U.S. are 7% and 9%, respectively. If the spot rate is ¥142:$1 and the 90-day forward rate is ¥139:$1: 13.a. Where would you invest? ANSWER. The dollar return from a three-month investment in Japan can be found by converting dollars to yen at the spot rate, investing the yen at 1.75% (7%/4), and then selling the proceeds forward for dollars. This yields a dollar return equal to 142 * 1.0175/139 = 1.0395 or 3.95%. This return significantly exceeds the 2.25% (9%/4) return available from investing in the U.S. 13.b. Where would you borrow? ANSWER. The flip side of a lower return in the U.S. is a lower borrowing cost. Borrow in the U.S. 13.c. What arbitrage opportunity do these figures present? ANSWER. Absent transaction costs that would wipe out the yield differential, it makes sense to borrow dollars in New York at 2.25% and invest them in Tokyo at 3.95%.

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13.d. Assuming no transaction costs, what would be your arbitrage profit per dollar or dollarequivalent borrowed? ANSWER. The profit would be a 1.7% (3.95% - 2.25%) return per dollar borrowed. 14. Here are some prices in the international money markets: Spot rate Forward rate (one year) Interest rate (€) Interest rate ($)

= $1.34/€ = $1.36/€ = 3.5% per year = 4.75% per year

14.a. Assuming no transaction costs or taxes exist, do covered arbitrage profits exist in the above situation? Describe the flows. ANSWER. The annual dollar return on dollars invested in Germany is (1.035 * 1.36)/1.34 - 1 = 5%. This return exceeds the 4.75% return on dollars invested in the U.S. by 0.25% per annum. Hence, arbitrage profits can be earned by borrowing dollars or selling dollar assets, buying euros in the spot market, investing the euros at 3.5%, and simultaneously selling the euro interest and principal forward for one year for dollars. 14.b. Suppose now that transaction costs in the foreign exchange market equal 0.25% per transaction. Do unexploited covered arbitrage profit opportunities still exist? ANSWER. In this case, the return on arbitraging dollars falls to 1.0.35 * 1.36/1.34 * 0.99752 - 1.0475 = -0.48% Thus, arbitraging from dollars to euros has now become unprofitable and no capital flows will occur. 14.c. Suppose no transaction costs exist. Let the capital gains tax on currency profits equal 25% and the ordinary income tax on interest income equal 50%. In this situation, do covered arbitrage profits exist? How large are they? Describe the transactions required to exploit these profits. ANSWER. In this case, the after-tax interest differential favors the U.S. is (0.0475 * 0.50 - 0.035 * 0.50)/ (1 + .0035 * 0.50) = (0.02375 - 0.0175)/1.0175 = 0.61%, while the after-tax forward premium on the euro is 0.75(1.36 - 1.34)/1.34 = 1.12%. Since the after-tax forward premium exceeds the after-tax interest differential, dollars will continue to flow to Germany as before. 15.

Suppose today’s exchange rate is $1.35/€. The six-month interest rates on dollars and euros are 6% and 3%, respectively. The six-month forward rate is $1.3672. A foreign exchange advisory service has predicted that the euro will appreciate to $1.375 within six months.

15.a. How would you use forward contracts to profit in the above situation? ANSWER. By buying euros forward for six months and selling them in the spot market, you can lock in an expected profit of $0.0078, (1.375 - 1.3672) per euro bought forward. This is a semiannual return of 0.57% (0.0078/1.03672). Whether this profit materializes depends on the accuracy of the forecast.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

15.b. How would you use money market instruments (borrowing and lending) to profit? ANSWER. By borrowing dollars at 6% (3% semiannually), converting them to euros in the spot market, investing the euros at 3% (1.5% semiannually), selling the euro proceeds at an expected price of $1.3750/ Є, and repaying the dollar loan, you will earn an expected semiannual return of 1.30%: Return per dollar borrowed = (1/1.35) * 1.015 * 1.3750 - 1.03 = 0.38% 15.c. Which alternatives (forward contracts or money market instruments) would you prefer? Why? ANSWER. The return per dollar in the forward market is substantially higher than the return using the money market speculation. Other things being equal, therefore, the forward market speculation would be preferred. ADDITIONAL CHAPTER 4 PROBLEMS AND SOLUTIONS 1. In February 1985, Bolivian inflation reached a monthly peak of 182%. What was the annualized rate of inflation in Bolivia for that month? ANSWER. The annualized rate of inflation is found as the solution to (1 + i) 12 - 1, where i is the monthly inflation rate. Hence, the annualized Bolivian inflation rate, in percentage terms, was (2.82) 12 -1 = 25,292,257%. 2. The inflation rate in Great Britain is expected to be 4% per year, and the inflation rate in France is expected to be 6% per year. If the current spot rate is £1 = FF 12.50, what is the expected spot rate in two years? ANSWER. Based on PPP, the expected value of the pound in two years is 12.5 * (1.06/1.04)2 = FF12.99. 3. If the $:¥ spot rate is $1 = ¥218 and interest rates in Tokyo and New York are 6% and 12%, respectively, what is the expected $:¥ exchange rate one year hence? ANSWER. According to the IFE, the dollar spot rate in one year should equal 218(1.06/1.12) = ¥206.32. 4. Suppose that on January 1, the cost of borrowing French francs for the year is 18%. During the year, U.S. inflation is 5% and French inflation is 9%. At the same time, the exchange rate changes from FF1 = $0.15 on January 1 to FF1 = $0.10 on December 31. What was the real U.S. dollar cost of borrowing francs for the year? ANSWER. During the year, the franc devalued by (.15 - .10)/.15 = 33.33%. The nominal dollar cost of borrowing French francs, therefore, was .18(1 - .3333) - .3333 = -21.33%. For each dollar’s worth of francs borrowed on January 1, it cost only $0.7867 to repay the principal plus interest. With U.S. inflation of 5% during the year, the real dollar cost of repaying the principal and interest is $0.7867/1.05 = $0.7492. Subtracting the original $1 borrowed, the real dollar cost of repaying the franc loan is -$0.2508 or a real dollar interest rate of -25.08%.

CHAPTER 4: PARITY CONDITIONS IN INTERNATIONAL FINANCE/CURRENCY FORECASTING

5. In late 1990, following Britain’s entry into the exchange-rate mechanism of the European Monetary System, 10-year British Treasury bonds yielded 11.5% and the German equivalent offered a yield of just 9%. Under terms of its entry, Britain established a central rate against the DM of DM 2.95 and pledged to maintain this rate within a band of +/- 6%. 5.a. By how much would sterling have to fall against the DM over a 10-year period for the German bond to offer a higher overall return than the British one? Assume the Treasuries are zero-coupon bonds with no interest paid until maturity. ANSWER. An investment of DM 1 in the zero-coupon British Treasury bond will return (1/e0)(1.115)10e10 DM in 10 years, where e0 is the current DM spot price of a pound and e10 is the spot rate in 10 years. To find the amount of sterling depreciation at which returns are equalized, we set this return equal to the DM return on investing in the German zero: (1/e0)(1.115)10e10 = 1.0910 Solving for the relation between the current and future spot values of sterling that will equalize the two returns, we get e10/e0 = 0.7971. In other words, the pound would have to depreciate by 20.29% over the next 10 years before the higher return on sterling would be offset by the exchange loss. 5.b. How does the exchange rate established in 5.a compare to the lower limit that the British government is pledged to maintain for sterling against the DM? ANSWER. The lower limit on sterling under the ERM is £1 = DM2.7730 (0.94 * 2.95). Given an initial rate of £1 = DM2.95, a 20.29% devaluation yields a rate of £1 = DM2.3514, far below the lower limit. 5.c.

What accounts for the difference between the two rates? Does this difference violate the IFE?

ANSWER. Clearly, the market is somewhat skeptical that Britain will uphold its end of the agreement. In other words, the market is betting that Britain will allow the pound to depreciate by more than 6% against the central rate. The difference in rates doesn’t violate the IFE, which deals with the market’s expectations, not with government promises that may not be fulfilled. 6. Assume the interest rate is 11% on pounds and 8% on euros. If the euro is selling at a one-year forward premium of 4% against the pound, is there an arbitrage opportunity? Explain. ANSWER. In order for there to be no arbitrage opportunity, the return on investing in sterling, 11%, must equal the sterling return on investing in euros, 0.08 + 0.04 + 0.08 * 0.04 = 12.32% (or 1.08 * 1.04 - 1). According to these numbers, there is an arbitrage incentive of 1.32% for investing in euros. 7. If the Swiss franc is $0.68 on the spot market and the 180-day forward rate is $0.70, what is the annualized interest rate in the U.S. over the next six months? The annualized interest rate in Switzerland is 2%. ANSWER. According to IRP, (1 + rus)/(1 + rsw) = f1/e0 where f1 and e0 are the SFr forward and spot rates. Substituting in the numbers and recalling that everything must be converted to a semi-annual basis, we have (1 + 0.5rus)/1.01 = 0.70/0.68, or 1 + 0.5rus = 1.0397. The solution is rus = 7.94%.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

8. The interest rate in the U.S. is 8%; in Japan the comparable rate is 2%. The spot rate for the yen is $0.007692. If IRP holds, what is the 90-day forward rate on the Japanese yen? ANSWER. According to the IRP, the 90-day forward rate on the yen should equal $0.007692[(1 + 0.08/4)/(1 + 0.02/4)] = $0.0078

CHAPTER 5: THE BOP AND INTERNATIONAL ECONOMIC LINKAGES

CHAPTER 5 THE BOP AND INTERNATIONAL ECONOMIC LINKAGES This chapter helps students understand the financial and real linkages between the domestic and world economies and how these linkages affect business viability. It identifies the basic forces underlying the flows of goods, services, and capital between countries and relates these flows to key political, economic, and cultural factors. These trade and capital flows are summarized in the BOP statistics. KEY POINTS 1. The balance of payments (BOP) is an accounting statement that shows the sum of economic transactions of individuals, businesses, and government agencies located in one nation with those located in the rest of the world during a specified period. Thus, the U.S. BOP for a given year is an accounting of all transactions between Americans and non-Americans during the year. 2. The balance-of-payments statement is based on double-entry bookkeeping; every transaction recorded as a credit requires an equal and offsetting debit entry, and vice versa. A debit entry shows a purchase of foreign goods, services, and assets or a decline in liabilities to foreigners. A credit entry shows a sale of domestic goods, services, and assets or an increase in liabilities to foreigners. 3. The BOP has several different components. Each shows a particular kind of transaction such as merchandise exports or foreign purchases of U.S. government securities. The most basic distinction among transactions in the BOP is between those that represent purchases and sales of goods and services in the current period, called the current account, and those that represent capital transactions, called the capital account. Changes in official reserves appear on the official reserves account. 4. Since double-entry bookkeeping ensures that debits equal credits, the sum of all transactions is zero. Absent official reserve transactions, a capital account surplus must just offset the current account deficit, and a capital account deficit must offset a current account surplus. 5. The total size of the current account deficit is a macroeconomic phenomenon; there is a basic accounting identity that a nation’s current account deficit reflects excess domestic spending. Equivalently, a current account deficit equals the excess of domestic investment over domestic savings. Taking government explicitly into account yields a new relation: The domestic spending balance equals the private savings-investment balance minus the government budget deficit.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

6. To reduce the current account deficit, domestic savings must rise, private investment must decline, or the government deficit must be reduced. Absent any of these changes, the current account deficit will not diminish, regardless of the trade barriers imposed or the amount of dollar depreciation. 7. The long-term consequences for a nation that runs a current account deficit depend on how the resulting capital inflow is used. If the capital account surplus finances productive investment, the nation is better off; the returns from these added investments will service the foreign debts and leave something extra. Conversely, a capital account surplus that finances consumption will increase the nation’s well-being today at the expense of its future well-being.

SUGGESTED ANSWERS “TO THE BANK OF KOREA REASSESSES ITS RESERVE POLICY” 1. What is the link between South Korea’s currency market interventions and its growing foreign exchange reserves? ANSWER. The Bank of Korea has been selling won and buying dollars and other foreign currencies in the foreign exchange market to hold down the value of the won. In the process, it has been accumulating dollars and other foreign currencies. 2. What is the annualized cost to the Bank of Korea of maintaining $205.5 billion in reserves? Assume that the government of Korea is issuing bonds that yield about 4% annually while buying dollar assets that yield about 3.25%. ANSWER. Assuming no change in currency values, the Bank of Korea has a negative arbitrage spread of 0.75%. This translates into an annual cost of $1.54 billion (0.0075 * $205.5 billion). 3. Suppose that during the year the won rose by 8% against the dollar and that the Bank of Korea kept 100% of its reserves in dollars. At a current exchange rate of W1,011/$, what would that do to the won cost of maintaining reserves of $205.5 billion? ANSWER. To maintain reserves of $205.5 billion while sterilizing its foreign exchange market intervention, South Korea has had to borrow the won equivalent of these reserves, or W207,760.5 billion (1,011 * 205.5 billion). At the end of the year, South Korea would owe lenders won principal plus interest at 4%, or W216,070.9 billion (1,011 * 205.5 billion * 1.04). By keeping these reserves in dollars invested at 3.25%, the Bank of Korea will have dollar reserves of $212.2 billion (1.0325 * $205.5 billion) by the end of the year. Translated into won, assuming won appreciation of 8%, yields a portfolio worth W198,622.9 billion (936.1 * 212.2 billion) by the end of the year. The value 936.1 is the year-end exchange rate assuming an 8% won appreciation (0.9259 * 1,011; note that if the dollar value of the won appreciates by 8%, then the won value of the dollar must depreciate by 1/1.08 - 1).

CHAPTER 5: THE BOP AND INTERNATIONAL ECONOMIC LINKAGES

4. What are some pros and cons of the Bank of Korea diversifying its investment holdings out of dollars and into other currencies, such as euros and yen? ANSWER. The most obvious pro is the reduction of currency risk through the portfolio effect; no longer will the value of its reserves be tied solely to movements in the dollar:won exchange rate. At the same time, the Bank of Korea may be able to increase its expected return by having a larger universe of assets to invest in. An obvious con to diversifying is that, to the extent the Bank of Korea desires liquidity, no other financial market has the breadth and depth, and hence liquidity, of the U.S. financial market. 5. How has the almost-universal central bank preference for investing reserve assets in U.S. Treasury bonds affected the cost of financing the U.S. budget deficit? ANSWER. The demand for U.S. Treasury bonds by foreign central banks has undoubtedly lowered the interest rate on these bonds, thereby lowering the cost of financing the U.S. budget deficit. This effect has been enhanced by the price inelastic nature of the foreign central bank demand for U.S. Treasury bonds. SUGGESTED ANSWERS TO “WARREN BUFFETT OFFERS A SOLUTION TO AMERICA’S TRADE DEFICITS” 1. In what way is Warren Buffett’s plan the equivalent of a tariff? What will be its likely impact on American consumers? ANSWER. A tariff is a tax on imports. Here the tax is the cost of the Import Certificates (ICs) that all importers will have the buy for the goods that they are importing. The result of Mr. Buffett’s plan, if implemented, would be to increase the cost of imports and hence their price. Some of the cost of the ICs would be absorbed by the importers and foreign exporters in the form of lower profit margins. Most of the cost increase, however, would be passed along to consumers in the form of higher prices. In addition, American consumers would find that prices of U.S. products competing with imports would go up as well, as U.S. producers faced with less price pressure from foreign imports raised their prices. 2. What will be the likely effect of Mr. Buffett’s plan on U.S. exports? ANSWER. Mr. Buffett’s plan should stimulate U.S. exports as U.S. producers are able to earn added revenues on their exports through the sale to U.S. importers of the ICs they will receive. Some of this IC revenue will be passed along to foreign customers, thereby lowering their cost of buying U.S. products and increasing their demand for these products. The rest of the IC revenues will go to increase profit margins on U.S. exports, thereby inducing U.S. companies to make greater efforts to export their products. 3. How would Mr. Buffett’s plan likely affect savings, investment, and interest rates in the U.S.? The value of the U.S. dollar? ANSWER. Given BOP accounting and the huge trade deficit the U.S. is currently experiencing, there is a large U.S. savings-investment gap. That is, U.S. savings are far less than investment in the U.S. economy. The difference is met by imports of foreign capital. Under Mr. Buffett’s plan, the trade deficit should be eliminated. The result would necessarily be a dramatic reduction in the current-account deficit (actually, given that the U.S. runs a surplus on the services account component of the current account, the U.S. current-account deficit would turn into a surplus). As such, the net inflow of capital to the U.S. would

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

cease. For U.S. savings and investment to balance, U.S. savings would have to rise and investment fall. The mechanism whereby these adjustments would occur is through an increase in real interest rates in the U.S. The effect of Mr. Buffett’s plan on the dollar is less obvious. To the extent the large trade deficit is depressing the dollar, this plan should result in a higher value of the dollar. At the same time, however, the plan would effectively eliminate the net inflow of foreign capital to the U.S., thereby reducing the demand for the dollar and depressing the dollar’s value. The net effect of these conflicting factors on the dollar depends on which holds greater sway. 4. How would the “bonus” ICs affect the U.S. trade deficit? ANSWER. Absent the bonus ICs, the U.S. trade deficit would be eliminated, given that under Mr. Buffett’s plan the supply of ICs would have to equal the demand for ICs. With the bonus ICs, the U.S. trade deficit would equal the supply of bonus ICs issued by the U.S. government. 5. Mr. Buffett’s plan focuses on the U.S. trade deficit. What would be its likely impact on the U.S. current-account deficit? ANSWER. As indicated in the answer to 5.b, the current account consists of both the trade account and the services account. Since the U.S. services account is currently in surplus, and under Mr. Buffett’s plan the trade deficit would go to zero, the result should be a current-account surplus. 6. What are some possible costs of Mr. Buffett’s plan? ANSWER. Mr. Buffett’s plan has several costs. First, consumers will pay higher prices for imports and for U.S. goods that compete with imports. Second, Americans will face higher interest rates associated with the closing of the savings-investment gap that is driving the current-account deficit. These higher interest rates will lead to lower investment in the American economy (while at the same time eliminating the returns that the U.S. would have to pay foreigners for their capital). The lower investment will lead to lower U.S. productivity and wages than would otherwise be the case. SUGGESTED ANSWERS TO CHAPTER 5 QUESTIONS 1. In a freely floating exchange rate system, if the current account is running a deficit, what are the consequences for the nation’s balance on capital account and its overall BOP? ANSWER. In a freely floating exchange rate system, the nation’s BOP must always be zero. Consequently, if the current account is running a deficit, the capital account must be running a surplus of the same size. Overall, international payments will still be in balance. 2.a. As the value of the U.S. dollar rises, what is likely to happen to the U.S. balance on current account? Explain. ANSWER. As the dollar rises in value, other things being equal, U.S. goods and services become relatively more expensive in foreign currency terms, while foreign goods and services become relatively less expensive in dollar terms. The result is a smaller surplus or larger deficit on the current account. Of course, this conclusion could be reversed if the reason for the rise in the real value of the dollar was a significant increase in U.S. productivity, which would facilitate exports. However, other things do not remain equal. In fact, exchange rates equate currency supplies and demands. They do not determine the

CHAPTER 5: THE BOP AND INTERNATIONAL ECONOMIC LINKAGES

distribution of these currency flows between trade flows (the current-account balance) and capital flows (the financial-account balance). This view of exchange rates predicts that there is no simple relation between the exchange rate and the current-account balance. Trade deficits do not cause currency depreciation, nor does currency depreciation by itself help reduce a trade deficit: Both exchange rate changes and trade balances are determined by more fundamental economic factors. These more fundamental factors are a nation’s savings and investment decisions. 2.b. What is likely to happen to the value of the dollar as the U.S. current-account deficit increases? Explain. ANSWER. It all depends on what is driving the increase in the U.S. current-account deficit. If the deficit increases because the U.S. economy is growing strongly, then the dollar is likely to rise in value as foreign capital comes in to take advantage of growth opportunities. On the other hand, if the currentaccount deficit rises because the government budget deficit is increasing, then the value of the dollar is likely to decline because of the adverse implications of a budget deficit for future economic growth. The current-account deficit could also be increasing because the exchange rate is set too high. If so, then the dollar’s future prospects would be dim as well. Similarly, if the U.S. current-account deficit is rising because foreign central banks are intervening to hold down the values of their currencies, then the U.S. dollar should fall sooner or later. 2.c.

A current-account surplus is not always a sign of health; a current-account deficit is not always a sign of weakness. Comment.

ANSWER. A current-account surplus represents an excess of domestic savings over domestic investment. This excess savings could reflect a lack of domestic investment opportunities. For example, Japan’s current-account surplus has grown since 1990, reflecting a prolonged economic slump and relatively poor domestic growth opportunities. Similarly, the Asian crisis that began in the summer of 1997 forced the various Asian nations to slow down their growth and led to outflows of capital. The flip side of a capital outflow, of course, is a current-account surplus. At the same time, countries growing rapidly are likely to face current-account deficits, as economic growth generates domestic investment opportunities that can't all be financed through domestic savings. In other words, the faster a nation grows relative to other nations, the more likely it is to have a current-account deficit; conversely, slow economic growth is more likely to lead to a current-account surplus. 3. Lufthansa buys $400 million worth of Boeing jets in 2008 and is financed by the U.S. Eximbank with a five-year loan that has no principal or interest payments due until 2009. What is the net impact of this sale on the U.S. current account, capital account, and overall BOP for 2008? ANSWER. In 2008, the sale of Boeing 747s is recorded on the U.S. BOP as a $400 million merchandise export matched by a capital outflow of $400 million to finance the planes. This appears as a $400 million plus on the U.S. current account, a $400 million minus on the U.S. capital account, and a zero impact on the overall BOP for 2009. As the loan is repaid, the interest payments will show up as inflows on the services account and principal repayments will appear as inflows on the capital account.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

4. What happens to Mexico’s ability to repay its foreign loans if the U.S. restricts imports of Mexican agricultural produce? ANSWER. A repayment of Mexico’s foreign loans is equivalent to an export of capital from Mexico. For Mexico to run a capital-account deficit, it must run a current-account surplus. Anything that reduces Mexico’s ability to export also reduces its ability to repay its debts. In effect, keeping out Mexican goods while demanding repayment is equivalent to firing a worker and then demanding that he repay all the money he has borrowed from the company. Without a job, he cannot repay the money. 5. Suppose Brazil starts welcoming foreign investment with open arms. How is this likely to affect the value of the Brazilian real? The Brazilian current-account balance? ANSWER. The increased demand for Brazilian assets resulting from the new Brazilian investment policy will cause the real to appreciate. This will reduce the Brazilian current-account balance. Another way to address this question is to recognize that the capital inflow must be matched by a reduced Brazilian current-account balance. 6. According to popular opinion, U.S. trade deficits indicate any or all of the following: a lack of U.S. competitiveness owing to low productivity or low-quality products and/or lower wages, superior technology, and unfair trade practices by foreign countries. Which of these factors is likely to underlie the persistent U.S. trade deficits. Explain. ANSWER. None of these factors underlie the persistent U.S. trade deficits. For example, Ireland is handicapped even more than the U.S. by these factors but nonetheless runs a trade surplus. Similarly, Latin American nations ran trade surpluses during the 1980s, when they were basket cases. The U.S. trade deficits reflect the U.S. savings deficit, period. 7. During the 1990s, Mexico and Argentina went from being economic pariahs with huge foreign debts to countries posting strong economic growth and welcoming foreign investment. What would you expect these changes to do to their current-account balances? ANSWER. One should expect their current-account balances to swing from surplus to deficit. During the 1980s, both Mexico and Argentina ran capital-account deficits, as capital fled from their dismal prospects. As their prospects changed for the better in the 1990s, capital flowed back in. The result was a capitalaccount surplus. Given that the current-account balance is the negative of the capital-account balance, we would expect an initial current-account deficit changing to a surplus. 8. Suppose that the trade imbalances of the 2000s largely disappear during the next decade. What is likely to happen to the huge global capital flows of the 2000s? What is the link between the trade imbalances and the global movement of capital? ANSWER. The flip side of a trade imbalance is an offsetting flow of capital. To the extent that trade imbalances are reduced, the international flows of capital will be reduced accordingly. Of course, even without trade imbalances there will still be international capital flows as investors seek to diversify their portfolios internationally and as companies try to take advantage of foreign investment opportunities. In fact, as the U.S. current-account deficit and Japanese current-account surplus have shrunk significantly, capital flows have declined sharply: Both Japanese capital exports and U.S. capital imports have declined.

CHAPTER 5: THE BOP AND INTERNATIONAL ECONOMIC LINKAGES

9. In the early 1990s, Japan underwent a recession that brought about a prolonged slump in consumer spending and capital investment (it was estimated that in 1994 only 65% of Japan’s manufacturing was being used). At the same time, the U.S. economy emerged from its recession and began expanding rapidly. Under these circumstances, what would you predict would happen to the U.S. trade deficit with Japan? ANSWER., The U.S. trade deficit with Japan should rise. First of all, a growing U.S. economy will import more goods and services at the same time that a weak Japanese economy will reduce its imports (since imports are positively related to GNP). Second, the slump in Japanese consumer spending is equivalent to a rise in savings. The combination of increased Japanese savings and falling Japanese investment will boost Japan’s current-account surplus (which equals Japanese savings - Japanese investment). 10. It has been argued that with freer markets, Third World nations are now able to attract capital and technology from the advanced nations. As a result, they can achieve productivity close to Western levels while paying low wages. Hence, the low-wage Third World nations will run huge trade surpluses, creating either large-scale unemployment or sharply falling wages in the advanced nations. Comment on this apocalyptic scenario. ANSWER. Despite the persuasiveness of this vision of the future, it makes no economic sense. The reason lies in the basic national income accounting identity presented by Equation 5.5 in the chapter: Savings - Investment = Exports - Imports The World Competitiveness Report says that capital will flow from Western nations to low-wage nations, enabling the latter nations to invest more than their domestic savings by relying on foreign capital to make up the difference. So for these economies, the left side of the equation is negative. At the same time, the report asserts that low-wage nations will export more than they import, making the right hand side of the equation positive. Obviously, both conditions cannot hold simultaneously and still satisfy Equation 5.5. According to Equation 5.5, if low-wage nations generate large trade surpluses it must be because they are exporting large quantities of capital to Western nations. This is an unlikely scenario. The obvious response to the concern over low-wage competition and trade deficits is that as capital and technology flow to Third World countries, their wage rates will rise along with their productivity. As their incomes rise with their productivity, local workers will buy more Western goods and services. At the same time, the low-wage nations must import capital and materials to apply the new technology they are acquiring. As a result, they will not run large trade surpluses; rather they will run trade deficits as the counterpart to their capital surpluses. Put another way, Equation 5.5 tells us that a nation that runs a capital account surplus must run a current account deficit. A good discussion of the economic illiteracy displayed by supposedly well-educated elites and policy intellectuals in the area of international trade and the BOP is provided by Paul Krugman, “The Illusion of Conflict in International Trade,” Peace Economics, Peace Science and Public Policy, Vol. 2, No. 2, 1995, pp. 9-18.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

ADDITIONAL CHAPTER 5 QUESTIONS AND ANSWERS 1. How does a trade deficit affect the current-account balance? ANSWER. There is no necessary relation between a trade account deficit and the balance on current account because the current account includes both the trade account and the service account. The current account could show a deficit, a surplus, or a zero balance, depending on what happens to the balance on the service account. 2. On which BOP account does tourism show up? ANSWER. The services account. 3. Suppose the U.S. expropriates all foreign holdings of American assets. What will happen to the U.S. current-account deficit? What will likely happen to U.S. savings and investment? Why? ANSWER. If all foreign holdings of American assets are expropriated, the inflow of foreign capital to the U.S. will cease and the U.S. capital account will be zero. This means that the U.S. current account must also be zero. In effect, foreigners will export to the U.S. an amount just equal in value to what they are willing to import. The microeconomic adjustment mechanism that will just balance exports and imports works as follows. The cessation of foreign capital inflows, by reducing the supply of available capital, will raise real domestic interest rates. Higher interest rates will stimulate more savings since the opportunity cost of consumption rises with the real interest rate, and cause domestic investment to fall since fewer projects will have positive NPVs. The outcome will be a balance between savings and investment and the elimination of the excess domestic spending that caused the current account deficit in the first place. 4. For Brazil to service its foreign debts without borrowing more money, what must be true of its trade balance? ANSWER. Brazil must run a trade surplus sufficient to service its debts. This means that the trade surplus must be large enough to pay back the principal of its debts plus interest. 5. Suppose the U.S. imposes import restrictions on Japanese steel. What is likely to happen to the U.S. current-account deficit? What else is likely to happen? ANSWER. Nothing will happen to the U.S. current account deficit, unless the import restrictions cause a change in savings or investment behavior. Absent these changes, which are unlikely, reduced U.S. imports of Japanese steel will lower the U.S. demand for yen, which will lead to a rise in the dollar’s value. The appreciating dollar will make U.S. exports less competitive and other foreign imports more attractive. The net result is that a reduction in U.S. imports of Japanese steel is balanced by reduced U.S. exports of goods and services and increased U.S. non-steel imports.

CHAPTER 5: THE BOP AND INTERNATIONAL ECONOMIC LINKAGES

6. Suppose that the trade imbalances of the 1990s largely disappear during the 2000s. What is likely to happen to the huge global capital flows of the 1980s? What is the link between the trade imbalances and the global movement of capital? ANSWER. The flip side of a trade imbalance is an offsetting flow of capital. To the extent that trade imbalances are reduced, the international flows of capital will be reduced accordingly. Of course, even without trade imbalances there will still be international capital flows as investors seek to diversify their portfolios internationally and as companies try to take advantage of foreign investment opportunities. In fact, as the U.S. current-account deficit and Japanese current-account surplus have shrunk significantly, capital flows have diminished very sharply: Both Japanese capital exports and U.S. capital imports have declined. 7. In 1965, about 34% of all adult workers were under the age of 34, compared with almost 47% by 1980. Meanwhile, the share of the workforce between 35 years and 59 years shrank from about 60% to 49%. What impact might this dramatic shift in the age distribution of the U.S. workforce have had on the U.S. current-account balance over this 15-year period? (Hint: Consider the difference in savings behavior between younger and older workers.) ANSWER. According to the life-cycle theory of consumer spending, consumption today is based not on current income but rather on an individual’s expected lifetime earnings. In the U.S., workers generally enter the labor market between the ages of 18 and 22 and retire from regular employment in their mid60s. Their average earnings vary dramatically over this time. Weekly earnings soar during the first 10 years of an individual’s work life, such that workers in their mid-30s earn roughly twice as much per week as those in their early 20s. Weekly earnings remain relatively constant until workers enter their 60s, at which time their earnings decline as they start retiring. Thus, a worker’s earnings potential depends crucially on age. Young workers have a large lifetime earnings potential relative to their current earnings because (a) they have a long expected worklife, and (b) they expect substantial wage increases as their experience in the workplace grows. However, spending patterns do not typically follow the earnings stream, as consumers attempt to maintain a more even standard of living relative to their income over time. They do this by borrowing against their expected future earnings (e.g., taking out a mortgage to buy a home). Thus, younger workers tend to have high levels of spending and debt relative to their current income, while middle-aged workers tend to spend less and save more for their retirement and to repay their previous indebtedness. An extreme shift in the composition of the work force toward young workers, as happened in the U.S. between 1965 and 1980, should lead to an increase in a nation’s desired consumption relative to its income, as the younger workers attempt to borrow and spend against their expected future earnings. The result will be a fall in the current-account balance, offset by an increase in the capital-account balance. As the American workforce ages, and its lifetime earnings potential falls relative to current income, the lifecycle theory predicts that the rate of personal savings will rise and foreign capital inflows will fall. Consistent with these predictions, the rate of personal savings has escalated recently and the trade deficit is falling.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

8. In 1990, Japan’s Ministry of International Trade and Investment (MITI) proposed that firms be given a tax credit equal to 5% of the value of its increased imports. The purpose of this tax subsidy is to encourage Japanese imports of foreign products and thereby reduce Japan’s persistent trade surplus. At the same time, the Japanese government announced that it will reduce its budget deficit during the coming year. 8.a. What are the likely consequences of the tax subsidy plan on Japan’s trade balance, the value of the yen, and the competitiveness of Japanese firms? ANSWER. The tax subsidy plan by itself should lead to an increase in imports and consumption since it subsidizes the purchase of foreign goods. (This plan would have the same effect even if it subsidized Japanese consumption of Japanese goods.) At the same time, by boosting the demand for foreign goods, it will reduce the value of the Japanese yen, thereby stimulating Japanese exports. The net effect of this plan will be to reduce the Japanese current-account surplus to the extent that it stimulates Japanese consumption and reduces Japanese saving. This is another illustration of the basic accounting identity that a nation’s current account surplus reflects a shortfall in domestic spending. 8.b. What are the likely consequences of a lower Japanese budget deficit on Japan’s trade balance? ANSWER. A lower Japanese budget deficit, by reducing Japanese dissaving and thereby boosting saving, should increase the Japanese current-account surplus. The net impact on the current-account balance of the two policies combined is uncertain, but they act in opposite directions. 9. Currently, social security is minimal in Japan. Suppose Japan institutes a comprehensive social security system. How is this policy switch likely to affect Japan's trade surplus? ANSWER. The existence of a comprehensive social security system will reduce the incentive for Japanese to save for their retirement. As the Japanese save less, Japan’s capital outflow will diminish. Since trade surplus is the mirror image of the capital account deficit, this policy switch will reduce Japan’s trade surplus. In effect, the Japanese will consume more foreign goods as well as some of the domestically produced goods that would otherwise be exported. 10. In 1992, Japan entered a recession. However, at the same time, its current-account surplus hit a record. Is there a contradiction between Japan’s large trade surplus and a weak national economy? Explain. ANSWER. A Japanese recession will reduce the attractiveness of investing in Japan. The basic accounting identity says that a nation’s current-account surplus equals the excess of domestic saving over domestic investment. Hence, any reduction in Japanese investment, relative to Japanese saving, will boost Japan’s current-account surplus. Thus, there is no contradiction between Japan’s large trade surplus and its weak national economy. 11. What will strong economic growth do for the U.S. current account balance? A U.S. recession? ANSWER. The answer is the flip side of the answer to the previous question. Strong U.S. economic growth will boost the attractiveness of investing in the U.S., raising investment relative to saving and increasing the current-account deficit. A U.S. recession should have a positive impact on the U.S. trade account. For example, during the 1980s, when investors stayed away from Latin America because of its poor economic prospects, Latin America ran persistent trade surpluses. When Latin American prospects picked up, because of fundamental changes in government policies, the flow of investment

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12. In the early 1990s, interest rates worldwide fell. As a net debtor nation, how should this affect the U.S. current-account balance? ANSWER. One component of the U.S. current-account balance is interest received from foreigners less interest paid to foreigners. To the extent that the U.S. pays out more in interest than it receives, a decline in interest rates will result in a smaller U.S. current-account deficit. 13. “The U.S. trade deficit is a consequence of the unwillingness of the current generation of American taxpayers to pay fully for the goods and services they want from government.” Comment. ANSWER. There is some truth to this statement. If people demand more from government than they are willing to pay in taxes, the net result will be a government budget deficit. This budget deficit, in turn, will absorb domestic savings that would otherwise be available to finance domestic investment. If the budget deficit is large enough, the result will be a net savings/investment deficit that causes a current-account deficit. However, the budget deficit is not the only factor driving the U.S. current-account deficit. Indeed, even as the federal budget deficit is shrinking, the U.S. current-account deficit is growing. The driver is strong U.S. growth that is generating both more tax revenue, which is shrinking the federal deficit, and more domestic investment opportunities, which are being partially financed with foreign capital. 14. The devastating earthquake that hit Kobe, Japan on January 17, 1995, was estimated to cause about $100 billion in damage to the Japanese economy. What is the likely effect of this earthquake on Japan’s 1995 current account? On its capital account? Explain. ANSWER. The Kobe quake caused an increase in Japanese investment to replace the assets destroyed in the quake. Other things being equal, increasing Japan’s domestic investment will reduce its currentaccount surplus (which equals Japanese savings - Japanese investment). The increase in Japanese investment will also redirect Japanese savings from foreign investment to domestic investment, thereby reducing its capital-account deficit (which is the converse of its current-account surplus). The net result, all else being equal, should be a reduction in Japan’s current-account surplus. 15. In 1990, Germany’s current-account surplus exceeded $50 billion. However, it is estimated that the reunification process will require that Germany invest several hundred billion dollars in its eastern states over the coming decade. 15.a. What implications does this huge investment have for Germany’s current-account balance in the future? Explain. ANSWER. Unless German savings rise in line with the increase in German domestic investment, balanceof-payment arithmetic tells us that Germany’s current-account surplus must fall. If domestic investment rises enough, Germany’s current-account surplus will become a deficit. As of early 1991, Germany’s current-account surplus had become a deficit for the first time since 1985. The current-account deficit is attributable to a jump in import demand, thanks to the brisk demand for Western products in eastern Germany, and the sizable growth in domestic demand that crowded out exports.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

15.b. How should the DM’s value change to facilitate the necessary shift in Germany’s economy? ANSWER. Other things being equal (e.g., Germany doesn’t ease monetary policy to help finance its growing budget deficit), the growth in domestic investment opportunities will boost the DM’s value. The rise in the value of the DM will help generate the additional capital needed to finance the rebuilding of eastern Germany by reducing German exports and increasing German imports. Again, as of early 1991, the DM had risen sharply against the dollar. 16. On June 23, 1997, Japanese Prime Minister Ryutaro Hashimoto spooked Wall Street. At a Columbia University luncheon, he appeared to warn that the Japanese might sell U.S. Treasury bills unless the U.S. helped stabilize exchange rates. The Dow Jones Industrial Average fell 192 points. 16.a. Why might the stock market have fallen on such a remark? Trace the causal links. ANSWER. The drop in demand for U.S. Treasurys, should it occur, will lead to higher real U.S. interest rates and a higher discount rate applied to the valuation of future corporate cash flows. The result will be a lower PV of future corporate cash flows and a lower value placed on securities that claim portions of those future cash flows, such as stocks. 16.b. How much substance is there to the possibility that the Japanese might sell off their U.S. investments? Explain. ANSWER. None. The Japanese threat to pull money out of the U.S. – a capital outflow – is equivalent to a threat that Japan will run a bilateral current-account deficit with the U.S. Although we can't directly assess the former threat, we can assess the latter one. It is inconceivable under current circumstances that Japan will either dramatically curb its exports to the U.S. or sharply boost its imports from the U.S. SUGGESTED SOLUTIONS TO CHAPTER 5 PROBLEMS 1. How would each of the following transactions show up on the U.S. BOP accounts? 1.a. Payment of $50 million in Social Security to U.S. citizens living in Costa Rica. ANSWER. This will show up as a net unilateral transfer abroad, which is a deficit on the services account. 1.b. Sale overseas of 125,000 Elvis Presley CDs. ANSWER. This will show up as a merchandise export. 1.c.

Tuition receipts of $3 billion received by American universities from foreign students.

ANSWER. This will show up as an export of U.S. services. 1.d. Payment of $1 million to U.S. consultants A.D. Little by a Mexican company. ANSWER. This will show up as an export of U.S. services. 1.e.

Sale of a $100 million Eurobond issue in London by IBM.

ANSWER. This will show up as an import of capital. If IBM uses to money to invest overseas, this import will be offset by an equal export of capital.

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1.f.

Investment of $25 million by Ford to build a parts plant in Argentina.

ANSWER. This will show up as an export of capital. 1.g. Payment of $45 million in dividends to U.S. citizens from foreign companies. ANSWER. This will show up as an export of services (for the use of capital), which is a surplus on the services account. 2. Set up the double-entry accounts showing the appropriate debits and credits associated with the following transactions: 2.a. ConAgra, a U.S. agribusiness, exports $80 million of soybeans to China and receives payment in the form of a check drawn on a U.S. bank. ANSWER. A credit is recorded for the increase in U.S. exports and a debit is recorded to reflect a decrease in liabilities to a foreigner associated with the check drawn on a U.S. bank, which is a private capital outflow: U.S. exports Private liabilities to foreigners

Credit $80,000,000

Debit $80,000,000

2.b. The U.S. government provides refugee assistance to Somalia in the form of corn valued at $1 million. ANSWER. This transaction appears as a credit to U.S. exports and a debit to the account called unilateral transfers: U.S. exports Unilateral transfer 2.c.

Credit $1,000,000

Debit $1,000,000

Dow Chemical invests $500 million in a chemical plant in Germany financed by issuing bonds in London.

ANSWER. A debit is recorded to reflect the increase in U.S. investment abroad (the acquisition of foreign assets) and a credit is recorded for the inflow of foreign capital used to finance that investment: Credit Private foreign assets Private liabilities to foreigners

Debit $500,000,000

$500,000,000

2.d. General Motors pays $5 million in dividends to foreign residents, who choose to hold the dividends in the form of bank deposits in New York. ANSWER. A debit is recorded for the importation of services (the use of foreign capital) and a credit is recorded to reflect the increase in liabilities (the bank deposit) to a foreigner, which is a source of funds: Credit U.S. imports (of services) Private liabilities to foreigners

$5,000,000

Debit $5,000,000

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

2.e.

The Bank of Japan buys up one billion dollars in the foreign exchange market to hold down the value of the yen and uses these dollars to buy U.S. Treasury bonds.

ANSWER. A debit is recorded to the U.S. private asset account to reflect the purchase of $1 billion worth of yen and a credit is recorded to the U.S. capital account to reflect the Bank of Japan's purchase of Treasury bonds. Credit Private foreign assets Foreign official assets 2.f.

Debit $1,000,000,000

$1,000,000,000

Cemex, a Mexican company, sells $2 million worth of cement to a Texas company and deposits the check in a bank in Dallas.

ANSWER. A debit is recorded for the import of cement and a credit is recorded for Cemex’s U.S. bank deposit, which represents an increase in liabilities to a foreigner. Credit U.S. imports Private liabilities to foreigners

Debit $2,000,000

$2,000,000

2.g. Colombian drug dealers receive $10 million in cash for the cocaine they ship to the U.S. market. The money is smuggled out of the U.S. and then invested in U.S. corporate bonds on behalf of a Cayman Islands bank. ANSWER. A debit is recorded to reflect the unfortunate U.S. importation of cocaine and a credit is recorded on the capital account to reflect the increased investment in U.S. Treasury bonds by foreigners. Credit U.S. imports Private foreign assets

Debit $10,000,000

$10,000,000

3. During the year, Japan had a current-account surplus of $98 billion and a financial-account deficit, aside from the change in its foreign-exchange reserves, of $67 billion. 3.a. Assuming the preceding data are measured with precision, what can you conclude about the change in Japan’s foreign exchange reserves during the year? ANSWER. The sum of the current-account and financial-account balances, aside from the change in official reserves, or $31 billion, must equal the official-reserves balance. Since this figure is positive, it indicates that Japanese official reserves increased by $31 billion, which is a deficit in the official reserves account. This analysis assumes the capital-account balance is zero. 3.b. What is the gap between Japan’s national expenditure and its national income? ANSWER. The current-account balance equals the difference between national income and national expenditure. In Japan's case, this identity means the income-expenditure gap is $98 billion; that is, Japan’s national income exceeds its spending by the equivalent of $98 billion.

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3.c.

What is the gap between Japan’s savings and its domestic investment?

ANSWER. Since national savings - domestic investment = national income - national expenditure, the answer is the same as the answer to 3.b. 3.d. What was Japan’s net foreign investment for the year? ANSWER. Japan’s net foreign investment = national savings minus domestic investment, or $98 billion. 3.e.

Suppose the Japanese government’s budget ran a $22 billion surplus during the year. What can you conclude about Japan’s private savings-investment balance for the year?

ANSWER. The sum of the private savings-investment balance and the public sector surplus or deficit must equal the national savings-investment balance. With a government surplus of $22 billion and an overall savings-investment balance of $98 billion, the private sector savings-investment balance must equal $76 billion. 4. The following transactions (expressed in U.S. $ billions) take place during a year. Calculate the U.S. merchandise-trade, current-account, capital-account, and financial-account balances. i)

The U.S. exports $300 of goods and receives payment in the form of foreign demand deposits abroad.

ii)

The U.S. imports $225 of goods and pays for them by drawing down its foreign demand deposits.

iii) The U.S. pays $15 to foreigners in dividends drawn on U.S. demand deposits here. iv) American tourists spend $30 overseas using traveler's checks drawn on U.S. banks here. v)

Americans buy foreign stocks with $60, using foreign demand deposits held abroad.

vi) The U.S. government sells $45 in gold for foreign demand deposits abroad. vii) In a currency support operation, the U.S. government uses its foreign demand deposits to purchase $8 from private foreigners in the United States. ANSWER. U.S. BOP accounts Exports

Imports

ii) $225 in goods iii) $15 payment of dividends iv) $30 in tourist services

merchandise: $300 in goods and services

Balance on current account: + $30

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

Capital Outflows i)

Capital Inflows

$300 increase in foreign deposits

ii) $225 decrease in foreign demand deposits

v) $60 increase in U.S. holdings of foreign stocks vii) $8 decrease in foreign-owned U.S. demand deposits vi) $45 in gold sales

iii) $15 increase in foreign-owned U.S. demand deposits iv) $30 increase in foreign-owned travelers checks drawn on U.S. banks v) $60 decrease in foreign demand deposits vi) $45 increase in foreign demand deposits vii) $8 decrease in foreign demand deposits

Balance on financial account: -$30 There are no capital-account transactions. 5. During the Reagan era, 1981-1988, the U.S. current account moved from a tiny surplus to a large deficit. The following table provides U.S. macroeconomic data for that period. Year Private savings Private investment Government budget deficit Current-account balance

1980 1981 1982 500 586 617 468 558 503 -35 -30 -109 2 5 -11

1983 1984 1985 1986 1987 1988 641 743 736 721 731 802 547 719 715 718 749 794 -140 -109 -125 -147 -112 -98 -45 -100 -125 -151 -167 -129

5.a. Based on these data, to what extent would you attribute the changes in the U.S. currentaccount balance to a decline in the U.S. private savings-investment balance? ANSWER. In 1980, U.S. private savings exceeded private investment by $32 billion. By 1988, this figure had fallen to $8 billion, a change of $24 billion. Over the same period, the U.S. current-account balance went from a surplus of $2 billion to a deficit of $129 billion, a change of $131 billion. Clearly, the change in the U.S. current-account balance is only minimally attributable to the change in the U.S. private savings-investment balance. 5.b. To what extent would you attribute the changes in the U.S. current-account balance to an increase in the U.S. government budget deficit? ANSWER. Over the period 1980-1988, the U.S. current-account balance tracked the U.S. government budget deficit much more closely than did the U.S. private savings-investment balance. This relationship can be seen in the following chart, which is based solely on the data presented in the previous table.

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-100

Based on these data, what was the excess of national spending over national income during this period? ANSWER. Using the identity national income - national expenditure = balance on current account, we can answer this question by summing the current-account balance over this nine-year period. The sum is -$721 billion, indicating that over this period, the U.S. spent $721 billion more than it earned. ADDITIONAL CHAPTER 5 PROBLEMS AND SOLUTIONS 1. Suppose Patagonia has a government surplus of $10 billion. At the same time, private investment in Patagonia exceeds private savings by $15 billion. What can you conclude about Patagonia's balance on current account? ANSWER. The current-account balance is the sum of net public sector savings (government revenues government spending) plus net private savings (private savings - private investment). In the case of Patagonia, the first component is +$10 billion and the second component is -$15 billion. The sum of these two savings figures is -$5 billion. Since this net figure is negative, Patagonia must have a current-account deficit of $5 billion. 2. In 1998, China’s current account had a surplus of $29.3 billion, its capital account had a zero balance, its financial account aside from official reserves had a deficit of $6.3 billion, and its official reserves increased by $6.2 billion. 2.a. What do these figures tell you about China’s errors and omissions? ANSWER. Absent errors and omissions, the sum of the current-account, capital-account, financial-account aside from official reserves, and its official-reserves balances should be zero. Given that an increase in a nation's official reserves shows up as a debit item (because the purchase of gold and other reserve assets is equivalent to importing these assets), the sum of these three accounts is $16.3 billion (29.3 -6.3 - 6.2). Errors and omissions, therefore, equal -$16.3 billion (the balancing item to a positive figure for the three balances is a negative figure).

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

2.b. What might account for these errors and omissions? ANSWER. This negative figure reflects a mysterious outflow of funds. Chinese nationals could be smuggling funds out of China to protect themselves against political risk or companies could be removing funds from China without informing the authorities. Chinese government restrictions on transferring funds overseas would account for the failure to inform the authorities. 3. Ruritania is calculating its BOP for the year. As usual, its data are perfectly accurate. All of the transactions for the year are listed below (in Rur$ millions). i)

Ruritania received weapons worth $200 from the United States under its military aid program; no payment is necessary.

ii) A Ruritanian firm exported $400 of cloth and received an IOU from the foreign importer. iii) A Ruritanian resident paid $10 in interest on a loan from a foreigner; the check was drawn on a domestic Ruritanian bank. iv) Foreign tourists visited Ruritania and spent $100 in traveler's checks drawn on foreign banks. v) The Ruritanian central bank sold $60 in gold to a foreign government and received U.S. Treasury bills in return. vi) A foreign central bank deposited $120 in a private domestic Ruritanian bank and paid with a check drawn on a private bank in the United States. Fill in the correct number for each balance-of-payments account for items a through j. Exports i) goods ii) services Imports iii) goods iv) services v) unilateral transfers Ruritanian assets abroad vi) privately owned vii) officially owned Foreign assets in Ruritania viii) privately owned ix) officially owned x) current account

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ANSWER. Ruritanian BOP accounts are as follows: Exports i) Goods: ii) Services: iii) Unilateral transfers:

$400 $100 (tourism) $200 (military aid)

Imports iv) Goods: v) Services:

$200 (military equipment) $10 (interest)

Ruritanian assets abroad vi) privately owned:

vii) officially owned:

Foreign assets in Ruritania viii) privately owned: ix) officially owned: x) current account:

$400 (IOU) $100 (travelers checks) $120 (U.S. demand deposit) $60 (U.S. Treasury bills) -$60 (gold sales)

$10 (check) $120 (foreign central bank) +$490

4. Select a country and undertake an analysis of that country’s BOP for 8 to 12 years, subject to availability of data. The analysis must include examinations (presentation of statistical data with discussion) of the trade balance, current-account balance, capital-account balance, basic balance, and overall balance. Your report should also address the following issues: 4.a. What accounts for swings in these various balances over time? 4.b. What is the relationship between shifts in the current-account balance and changes in savings and investment? Include an examination of government budget deficits and surpluses, explaining how they relate to the savings-investment and current-account balances. ANSWER. There is no set answer to this project. The key is to make sure the student knows what he or she is doing and understands what the different data mean. Professor Donald T. Buck, who suggested this project, reports that “Your encouraging instructors to require a comprehensive course paper on a selected country employing the material in Chapter 4, from my experience, would greatly assist students in developing their analytical skills.” 5. For the country selected in additional problem 4, analyze the exchange rate against the dollar during the same period. 5.a. Is there any observable relationship between the BOP accounts and the exchange rate? 5.b. Provide a possible explanation for your observations in (a) above. ANSWER. Again, there is no set answer to this project, but it should provide an indication of the student’s learning.

CHAPTER 6: THE FOREIGN EXCHANGE MARKET

CHAPTER 6 THE FOREIGN EXCHANGE MARKET Chapter 6 is basically institutional in nature, although it opens by discussing the rationale for a foreign exchange market, namely to facilitate the transfer of purchasing power denominated in one currency to purchasing power denominated in another currency. Like other financial markets, the foreign exchange market facilitates trading in financial assets by lowering transaction costs. The balance of the chapter provides the institutional framework of the foreign exchange market, both spot and forward transactions. It discusses pricing conventions, costs, size, and participants, and goes through some of the mechanics of foreign exchange trading. I always illustrate this subject matter with quotes found in The Wall Street Journal. Every issue of the Journal (Section C) contains a story on the foreign exchange market, providing spot quotations for the Canadian dollar, pound sterling, Swiss francs, euros, and Japanese yen. The financial section also carries a more extensive listing of spot and forward prices for about forty currencies. SUGGESTED ANSWERS TO “ARBITRAGING CURRENCY CROSS RATES” 1. Do any triangular arbitrage opportunities exist among these currencies? Assume that any deviations from the theoretical cross rates of 5 points or less are due to transaction costs. ANSWER. Unfortunately, there are no shortcuts here. It is necessary to try out each possibility. Here are the 4 arbitrage opportunities that I found. If anyone finds any additional ones, please contact me at my email address: ashapiro@marshall.usc.edu. 1) Convert dollars to SFr, SFr to DKr, and DKr back to dollars. The profit per dollar equals $1 * 1.2250 * 4.5570/5.5485 - $1 = $0.0061. 2) Convert dollars to DKr, DKr to pounds, and pounds back to dollars. The profit per dollar equals $1 * 5.5475 * 0.0910/.5012 - 1 = $0.0072. 3) Convert dollars to SFr, SFr to pounds, and pounds back to dollars. The profit per dollar equals $1 * 1.2250 * 0.4122/.5012 - 1 = $0.0055. 4) Convert dollars to yen, yen to pound, and pound back to dollars. The profit per dollar equals $1 * 121.33 * 0.0042/0.5012 - 1 = $0.0167. 2. Compute the profit from a $5 million transaction associated with each arbitrage opportunity. ANSWER. All answers are based on rounding the arbitrage profit per dollar to the fourth decimal place. 1) The profit for the $/SFr/DKr/$ arbitrage will be $5,000,000 * 0.0061 = $30,500. 2) The profit from the $/DKr/£/$ arbitrage will be $5,000,000 * 0.0072 = $36,000. 3) The profit from the $/£/DKr/$ arbitrage will be $5,000,000 * 0.0055 = $27,500. 4) The profit from the $/¥/DKr/$ arbitrage will be $5,000,000 * 0.0167 = $83,500.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

SUGGESTED ANSWERS TO CHAPTER 6 QUESTIONS 1. Answer the following questions based on data in Exhibit 6.5. 1.a. How many Swiss francs can you get for one dollar? ANSWER. The indirect quote is $1 = SFr 1.2297. 1.b. How many dollars can you get for one Swiss franc? ANSWER. The direct quote is SFr1 = $0.8132. 1.c.

What is the three-month forward rate for the Swiss franc?

ANSWER. The three-month forward rate is SFr1 = $0.8192. 1.d. Is the Swiss franc selling at a forward premium or discount? ANSWER. At a forward premium. 1.e.

What is the 90-day forward discount or premium on the Swiss franc?

ANSWER. The 90-day forward premium is 60 points (pips), which translates into an annualized forward premium of 2.95% (4 * (0.8192 – 0.8132)/0.8132). 2. What risks confront dealers in the foreign exchange market? How can they cope with these risks? ANSWER. Foreign exchange dealers must cope with exchange risk, because of the foreign currency positions they take. They also bear credit risk since the counterparties to the trades they enter into may not honor their obligations. They can cope with currency risk by using forward contracts and currency options, widening their bid-ask quotes, and limiting the position they are willing to take in any one currency. They can limit credit risk by restricting the position they are willing to take with any one customer and by setting margin requirements that vary with the riskiness of their customers (banks will generally not do this). 3. Suppose a currency increases in volatility. What is likely to happen to its bid-ask spread? Why? ANSWER. As a currency’s volatility increases, it becomes riskier for traders to take positions in that currency. To compensate for the added risks, traders quote wider bid-ask spreads. 4. Who are the principal users of the forward market? What are their motives? ANSWER. The principal users of the forward market are currency arbitrageurs, hedgers, importers and exporters, and speculators. Arbitrageurs wish to earn risk-free profits; hedgers, importers and exporters want to protect the home currency values of various foreign currency-denominated assets and liabilities; and speculators actively expose themselves to exchange risk to benefit from expected movements in exchange rates.

CHAPTER 6: THE FOREIGN EXCHANGE MARKET

5. How does a company pay for the foreign exchange services of a commercial bank? ANSWER. Companies compensate banks for foreign exchange services through the bid-ask spread. The bank will buy foreign exchange at the bid rate (low) and sell at the ask rate (high). SUGGESTED SOLUTIONS TO CHAPTER 6 PROBLEMS 1. The $: € exchange rate is €1 = $1.35, and the €/SFr exchange rate is SFr 1 = €0.61. What is the SFr/$ exchange rate? ANSWER. SFr1 = €0.61 * 1.35 = $0.8235. 2. Suppose the direct quote for sterling in New York is 1.9880-5. 2.a. How much would £500,000 cost in New York? ANSWER. To buy £500,000 would cost £500,000 * 1.9885 = $99,425. 2.b. What is the direct quote for dollars in London? ANSWER. The direct quote for the dollar in London is just the reciprocal of the direct quote for the pound in New York or 1/1.9880 - 1/1.9885 = 0.5029-0.5030. 3. Using the data in Exhibit 6.5, calculate the 30-day, 90-day, and 180-day forward discounts for the Canadian dollar. ANSWER. Here are the relevant rates for the Canadian dollar: Spot:

C$1 = $0.9207

30-day forward:

C$1 = $0.9216

90-day forward:

C$1 = $0.9231

180-day forward:

C$1 = $0.9250

The 30-day forward discount is:

[($0.9216 - $0.9207)/$0.9207] * 12 = 1.17%

The 90-day forward discount is:

[($0.9231 - $0.9207)/$0.9207] * 4 = 1.04%

The 180-day forward discount is:

[($0.9250 - $0.9207)/$0.9207] * 2 = 0.86%

In this case, the forward discounts at these maturities are relatively small, indicating that Canadian and U.S. interest rates are close to each other. 4. An investor wishes to buy euros spot (at $1.3480) and sell euros forward for 180 days (at $1.3526). 4.a. What is the swap rate on euros? ANSWER. A premium of 46 points. 4.b. What is the premium on 180-day euros? ANSWER. The 180-day premium is (1.3526 - 1.3480)/1.3480 * 2 = 0.68%.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

5. Suppose Credit Suisse quotes spot and 90-day forward rates of $0.7957-60 and 8-13, respectively. 5.a. What are the outright 90-day forward rates that Credit Suisse is quoting? ANSWER. The outright forwards are: bid rate = $0.7965 (0.7957 + 0.0008) and ask rate = $0.7973 (0.7960) 5.b. What is the forward discount or premium associated with buying 90-day Swiss francs? ANSWER. The annualized forward premium = [(0.7973 - 0.7960)/0.7960] * 4 = 0.65%. 5.c. Compute the percentage bid-ask spreads on spot and forward Swiss francs. ANSWER. The bid-ask spread is calculated as follows:

Percent spread =

Ask price - Bid price x 100 Ask price

Substituting in the numbers yields a spot bid-ask spread of (0.7960 - 0.7957)/0.7960 = 0.04%. The corresponding forward bid-ask spread is (0.7973 - 0.7965)/0.7973 = 0.10%. 6. Suppose Dow Chemical receives quotes of $0.008242-45 for the yen and $0.03023-27 for the Taiwan dollar (NT$). 6.a. How many U.S. dollars will Dow Chemical receive from the sale of ¥50 million? ANSWER. Dow must sell yen at the bid rate, meaning it will receive $412,100 (50,000,000 * 0.008242). 6.b. What is the U.S. dollar cost to Dow Chemical of buying ¥1 billion? ANSWER. Dow must buy at the ask rate, meaning it will cost Dow $8,245,000 (1,000,000,000 * 0.008245) to buy ¥1 billion. 6.c.

How many NT$ will Dow Chemical receive for U.S.$500,000?

ANSWER. Dow must sell at the bid rate for U.S. dollars (which is the reciprocal of the ask rate for NT$, or 1/0.03027), meaning it will receive from this sale of U.S. dollars NT$16,518,005 (500,000/0.03027). 6.d. How many yen will Dow Chemical receive for NT$200 million? ANSWER. To buy yen, Dow must first sell the NT$200 million for U.S. dollars at the bid rate and then use these dollars to buy yen at the ask rate. The net result from these transactions is ¥733,292,905 (200,000,000 * 0.03023/0.008245). 6.e.

What is the yen cost to Dow Chemical of buying NT$80 million?

ANSWER. Dow must sell the yen for dollars at the bid rate and then buy NT$ at the ask rate with the U.S. dollars. The net yen cost to Dow from carrying out these transactions is ¥293,812,182 (80,000,000 * 0.03027/0.008242)

CHAPTER 6: THE FOREIGN EXCHANGE MARKET

7. Suppose the euro is quoted at 0.6786-98 in London, and the pound sterling is quoted at 1.472470 in Frankfurt. 7.a. Is there a profitable arbitrage situation? Describe it. ANSWER. Buy euros for £0.6798/€ in London. Use the pounds to buy euros for €1.4770/£ in Frankfurt. This is equivalent to buying pounds for £0.6770. There is a net profit of £0.0028 per pound bought and sold – a percentage yield of 0.41% (0.0028/0.6798). 7.b. Compute the percentage bid-ask spreads on the pound and euro. ANSWER. The percentage bid-ask spreads on the pound and euro are calculated as follows: £ bid-ask spread = (1.4770 - 1.4724)/1.4770 = 0.31% € bid-ask spread = (0.6798 - 0.6786)/0.6798 = 0.18% 8. As a foreign exchange trader at Sumitomo Bank, one of your customers would like a yen quote on Australian dollars. Current market rates are: Spot

30-day

¥121.37-85/U.S.$1

15-13

A$1.1878-98/U.S.$1

20-26

8.a. What bid and ask yen cross rates would you quote on spot Australian dollars? ANSWER. By means of triangular arbitrage, we can calculate the market quotes for the Australian dollar in terms of yen as ¥102.00-58/A$1 These prices can be found as follows. For the yen bid price for the Australian dollar, we need to first sell Australian dollars for U.S. dollars and then sell the U.S. dollars for yen. It costs A$1.1898 to buy U.S.$1. With U.S.$1 we can buy ¥121.37. Hence, A$1.1898 = ¥121.37, or A$1 = ¥102.00. This is the yen bid price for the Australian dollar. The yen ask price for the Australian dollar can be found by first selling yen for U.S. dollars and then using the U.S. dollars to buy Australian dollars. Given the quotes above, it costs ¥121.85 to buy U.S.$1, which can be sold for A$1.1878. Hence, A$1.1878 = ¥121.85, or A$1 = ¥102.58. This is the yen ask price for the Australian dollar. 8.b. What outright yen cross rates would you quote on 30-day forward Australian dollars? ANSWER. Given the swap rates, we can compute the outright forward direct quotes for the yen and Australian dollar by adding or subtracting the forward points as follows Spot

30-day

30-day outright forward rates

¥121.37-85/U.S.$1

15-13

¥121.22-72/U.S.$1

A$1.1878-98/U.S.$1

20-26

A$1.1898-1.1924/U.S.$1

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

By means of triangular arbitrage, we can then calculate the market quotes for the 30-day forward Australian dollar in terms of yen as ¥101.66-102.30/A$1 These prices can be found as follows. For the yen bid price for the forward Australian dollar, we need to first sell Australian dollars forward for U.S. dollars and then sell the U.S. dollars forward for yen. It costs A$1.1924 to buy U.S.$1 forward. With U.S.$1 we can buy ¥121.22. Hence, A$1.1924 = ¥121.22, or A$1 = ¥100.82. This is the yen bid price for the forward Australian dollar. The yen ask price for the Australian dollar can be found by first selling yen forward for U.S. dollars and then using the U.S. dollars to buy forward Australian dollars. Given the quotes above, it costs ¥121.72 to buy U.S.$1, which can be sold for A$1.1898. Hence, A$1.1898 = ¥121.72, or A$1 = ¥102.30. This is the yen ask price for the forward Australian dollar. 8.c.

What is the forward premium or discount on buying 30-day Australian dollars against yen delivery?

ANSWER. As shown in 8.a and 8.b, the ask rate for 30-day forward Australian dollars is ¥102.30 and the spot ask rate is ¥102.58. Thus, the Australian dollar is selling at a forward discount to the yen. The annualized discount equals -0.27%, computed as follows: 9. Suppose Air France receives the following indirect quotes in New York: €0.92-3 and £0.63-4. Given these quotes, what range of £/€ bid and ask quotes in Paris will permit arbitrage? ANSWER. Triangular arbitrage can take place in either of two ways: (1) Convert from euros to dollars (at the ask rate), then from dollars to pounds (at the bid rate), or (2) convert from pounds to dollars (at the ask rate), then from dollars to euros (at the bid rate). The first quote will give us the bid price for the euro in terms of the pound and the second quote will yield the ask price. Using the given rates, Air France would end up with the following amounts: i) Euros to pounds

ii) Pounds to euros

€/$ (ask) *

$/£ (bid)

0.93

1/0.63

€ 1.4762/£ or £0.6774/ €

£/$ (ask) *

$/ € (bid)

0.64

1/0.92

£0.6957/€ or €1.4375/£

The significance of the figures in method (i) is that Air France can buy pounds in New York for €1.4762/£, which is the equivalent of selling euros at a rate of £0.6774/ €. So, if Air France can buy euros in Paris for less than £0.6774/€ (which is the equivalent of selling pounds for more than €0.6774/£), it can earn an arbitrage profit. Similarly, the figures in method (ii) tell us that Air France can buy euros in New York at a cost of £0.6957/€. Given this exchange rate, Air France can earn an arbitrage profit if it can sell these euros for more than £0.6957/FF in Paris. Thus, Air France can profitably arbitrage between New York and Paris if the bid rate for the euro in Paris is greater than £0.6957/€ or the ask rate is less than £0.6774/€.

CHAPTER 6: THE FOREIGN EXCHANGE MARKET

10. On checking the Telerate screen, you see the following exchange rate and interest rate quotes:

Currency

90-Day Interest Rates Annualized

Dollar

4.99% - 5.03%

Swiss franc

3.14% - 3.19%

Spot Rates

90-Day Forward Rates

$0.711-22

$0.726-32

10.a. Can you find an arbitrage opportunity? ANSWER. Yes. There are two possibilities: Borrow dollars and lend in Swiss francs or borrow Swiss francs and lend in dollars. The profitable arbitrage opportunity lies in the former: Lend Swiss francs financed by borrowing U.S. dollars. 10.b. What steps must you take to capitalize on it? ANSWER. Borrow dollars at 1.2575% for 90 days (5.03%/4), convert these dollars into francs at the ask rate of $0.722, lend the francs at 0.785% for 90 days (3.14%/4), and immediately sell the francs forward for dollars at the buy rate of $0.726. 10.c. What is the profit per $1,000,000 arbitraged? ANSWER. The profit is $1,000,000 * [(1.00785/0.722) * 0.726 - 1.012575] = $858.66. ADDITIONAL CHAPTER 6 PROBLEMS AND SOLUTIONS 1. Suppose the quote on pounds is $1.624-31. 1.a. If you converted $10,000 to pounds and then back to dollars, how many dollars would you end up with? ANSWER. For $10,000, you would buy pounds at the price of $1.631, giving you £6,131.21 ($10,000/1.631) and resell them at the bid price of $1.624. The latter transaction would yield $9,957.08, resulting in a round-trip cost of $42.92. 1.b. Suppose you could buy pounds at the bid rate and sell them at the ask rate. How many dollars would you have to transact in order to earn $1,000 on a round-trip transaction (buying pounds for dollars and then selling the pounds for dollars)? ANSWER. For every pound you could buy at the bid and sell at the ask, you would earn the spread of $0.007. To earn $1,000, you would have to transact £142,857.14 ($1,000/$0.0007). At the current bid rate of $1.624, this is equivalent to $232,000 (142,857.14 * $1.624).

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

2. Using the following data, calculate the 30-day, 90-day, and 180-day forward premiums for the British pound. Spot:

£1 = $1.4487

30-day forward:

£1 = $1.4498

90-day forward:

£1 = $1.4511

180-day forward:

£1 = $1.4529

ANSWER. Here are the relevant calculations for the pound: The 30-day forward premium is:

[($1.4498 - $1.4487)/$1.4487] * 12 = 0.91%

The 90-day forward premium is:

[($1.4511 - $1.4487)/$1.4487] * 4 = 0.66%

The 180-day forward premium is:

[($1.4529 - $1.4487)/$1.4487] * 2 = 0.58%

The small forward premiums at these maturities indicate that British and U.S. interest rates are very close. 3. The spot and 90-day forward rates for the pound are $1.1376 and $1.1350, respectively. What is the forward premium or discount on the pound? ANSWER. The forward premium (discount) on the British pound is [(f1 - e0)/e0] * (360/n) = [(1.1350 - 1.1376)/1.1376] * 4 = -0.91% which is a forward discount of 0.91%. 4. Suppose the spot quote on the euro is $0.9302-18, and the spot quote on the Swiss franc is $0.6180-90. 4.a. Compute the percentage bid-ask spreads on the euro and franc. ANSWER. The percentage bid-ask spreads on the euro and franc are calculated as follows: Euro bid-ask spread = (0.9318 - 0.9302)/0.9318 = 0.17% SFr bid-ask spread = (0.6190 - 0.6180)/0.6190 = 0.16% 4.b. What is the direct spot quote for the franc in Frankfurt? ANSWER. To sell one franc for euros, first sell the franc for $0.6180 and then convert $0.6180 into euros at the ask rate of $0.9318. Thus the bid rate for the franc is 0.6180/0.9318 = €0.6632. Similarly, to acquire one franc, sell euros for dollars and then sell dollars for francs. Specifically, it costs $0.6190 to buy €1. Because €1 can be converted into $0.9302, it takes €0.6190/0.9302 = €0.6654 to buy $0.6190. Thus the ask rate for francs is €0.6654. The bid-ask quote on the franc in Frankfurt is therefore €0.6632-54. 5. Suppose you observe the following direct spot quotations in New York and Toronto, respectively: 0.8000-50 and 1.2500-60. What are the arbitrage profits per $1 million? ANSWER. Converting the direct quotes in Toronto into indirect quotes yields bid-ask rates for the Canadian dollar in terms of the U.S. dollar of U.S.$.7962-.8000. Hence, there is no arbitrage opportunity.

CHAPTER 6: THE FOREIGN EXCHANGE MARKET

6. Assuming no transaction costs, suppose £1 = $2.4110 in New York, $1 = FF 3.997 in Paris, and FF 1 = £0.1088 in London. How could you take profitable advantage of these rates? ANSWER. Sell pounds in New York for $2.4110 apiece. Sell the dollars in Paris for FF 3.997, and sell the francs in London for £.1088. This sequence of transactions yields 2.4110 * 3.997 * 0.1088 pounds or £1.0485 per pound initially traded. 7. Suppose the euro is quoted at $0.8782-92, while the yen is quoted at $0.001760-69. 7.a. Given these quotes for the euro and yen, what is the maximum bid-ask spread in the ¥/DM rate for which there is no arbitrage? ANSWER. The ¥/€ bid rate based on triangular arbitrage is ¥496.44/€1 (0.8782/0.001769). Similarly, the ¥/€ ask rate based on triangular arbitrage is ¥499.55/€1 (0.8792/0.001760). Hence, the bid-ask spread based on triangular arbitrage is ¥499.55 - ¥496.44 = ¥3.11. This spread is the maximum one would expect. Beyond this spread, it would be profitable to engage in triangular arbitrage. 7.b. What is the maximum bid-ask spread in percentage terms? ANSWER. The maximum bid-ask spread in percentage terms equals the maximum spread divided by the bid price or 3.11/496.44 = 0.63%. Relative to the ask price, this percentage is 0.62% (/499.55). 8. Assume that back in 1995 the pound sterling is worth FF9.80 in Paris and SFr5.40 in Zurich. 8.a. Show how British arbitrageurs can make profits given that the Swiss franc is worth two French francs. What would be the profit per pound transacted? ANSWER. Sell pounds in Zurich for SFr5.40. Sell Swiss francs in Zurich for FF2. Then buy pounds in Paris for FF9.80. This yields (5.40 * 2)/9.8 = £1.102. 8.b. What would be the eventual outcome on exchange rates in Paris and Zurich given these arbitrage activities? ANSWER. The Swiss franc price of the pound would decline in Zurich. The Swiss franc would depreciate relative to the French franc. The pound would appreciate relative to the French franc in Paris. 8.c.

Rework 8.a, assuming that transaction costs amount to 0.6% of the amount transacted. What would be the profit per pound transacted?

ANSWER. Each transaction costs 0.6%. Thus, at each stage the arbitrageur receives 99.4% of what he previously received. Thus after the three transactions undertaken in part a, the arbitrageur receives 1.102 * (.994)3 = £1.0823 for a profit per pound sold equal to £0.0823. 8.d. Suppose the Swiss franc is quoted at FF2 in Zurich. Given a transaction cost of 0.6% of the amount transacted, what are the minimum/maximum French franc prices for the Swiss franc that you would expect to see quoted in Paris? ANSWER. With a transaction cost of 0.6%, an arbitrageur will receive 99.4% of what she would receive absent these costs. To find the maximum and minimum French franc prices for the Swiss franc that would be quoted in Paris, it is sufficient to invoke the following no-arbitrage conditions:

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

Converting FF1 into Swiss francs in Zurich and then converting the Swiss francs back into French francs in Paris should yield no more than one FF1.

ii) Converting SFr1 into French francs in Zurich and then converting the French francs back into Swiss francs in Paris should yield no more than SFr1. If e is the direct quote for the Swiss franc in Paris, the first no-arbitrage condition says that 0.5 * 0.994 * e * 0.994 < 1 or e < 2.0242 According to the second no-arbitrage condition, 2 * 0.994 * (1/e) * 0.994 < 1 or e > 1.9761 Combining these inequalities yields the minimum and maximum exchange rates or 1.9761 < e < 2.0242. 9. On checking the Reuters screen, you see the following exchange rate and interest rate quotes: 90-Day Interest Rates

Spot Rates

90-day Forward Rates

Pound

7 7/16 - 5/16%

¥159.9696-9912/£

¥145.5731-8692/£

Yen

2 3/8 - 1/4%

Currency

9.a. Can you find an arbitrage opportunity? ANSWER. There are two alternatives: (1) Borrow yen at 2 3/8%/4, convert the yen into pounds at the spot ask rate of ¥159.9912/£, invest the pounds at 7 5/16%/4, and sell the expected proceeds forward for yen at the forward bid rate of ¥145.5731/£; or (2) borrow pounds at 7 7/16%/4, convert the pounds into yen at the spot bid rate of ¥159.9696/£, invest the yen at 2 1/4%/4, and sell the proceeds forward for pounds at the forward ask rate of ¥145.8692/£. The first alternative will yield a loss of -¥7.94 per ¥100 borrowed, indicating that this is not a profitable arbitrage opportunity: (100/159.9912) * (1.0183) * 145.5731 - 100 * 1.0059 = -7.94 Switching to alternative 2, the return per £100 borrowed is £8.42, indicating that this is a very profitable arbitrage opportunity: 100 * 159.9696 * 1.0056/145.8692 - 100 * 1.0186 = 8.42 9.b. What steps must you take to capitalize on it? ANSWER. The steps to be taken have already been outlined in the answer to part a. 9.c.

What is the profit per £1,000,000 arbitraged?

ANSWER. Based on the answer to part a, the profit is £84,200 (8.42 * 10,000).

CHAPTER 6: THE FOREIGN EXCHANGE MARKET

NOTES ON FOREIGN EXCHANGE QUOTES 1. Spot rate - rate at which foreign exchange can be bought or sold for immediate delivery. €1 = $0.9107 SFr1 = $0.6340 1.a. Actual rates are given in pairs: a bid (buy) rate and ask (sell) rate €1 = $0.9107-10 SFr1 = $0.6340-42 1.b. Cross rates: €1 = SFr 1.4364 (0.9107/0.6340) €1 = SFr 1.4360-9 (0.9107/0.6342 - 0.9110/0.6340) 1.c.

Measuring currency changes ▪ Year 2: €1 = $0.9107 or $1 = €1.0981 ▪ Year 1: €1 = $0.8163 or $1 = €1.2250 ▪ The euro is said to have appreciated against the dollar by (0.9107 - 0.8163)/0.8163 = 11.56%. ▪ Alternatively, the dollar is said to have depreciated against the euro by (1.0981 - 1.2250)/1.2250 = - 10.37%. ▪ Thursday, January 9, 1986: Cr$1 = $0.00009615 or $1 = Cr$10400 ▪ Thursday, January 31, 1985: Cr$1 = $0.0002899 or $1 = Cr$3449.50 ▪ The Brazilian cruzeiro has depreciated against the dollar by (.00009615 - .0002899)/.0002899 = 66.83%. ▪ Alternatively, the dollar has appreciated against the cruzeiro by (10400-3449.5)/3449.5 = 201.49%. Note: The new Brazilian currency is now the real. This example dates back to a time when the Brazilian currency was running a very high rate of inflation and so was continually devaluing

2. Forward rate - rate at which foreign exchange can be bought or sold today for delivery at a fixed future date, typically in multiples of 30 days, e.g., 30, 60, 90, or 180 days. 2.a. Forward quotations 30 day forward rates €1 = $0.9120 SFr1 = $0.6338

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

2.b. Forward premium (+) or discount (-) (annualized) = [(forward rate - spot rate)/spot rate] * (360/n) where n is the number of days in the forward contract. Thus, the euro is selling at an annualized forward premium of 1.71% against the dollar: [(0.9120 - 0.9107)/0.9107] * 12 = 1.71%. The Swiss franc is selling at an annualized forward discount of 0.38% against the dollar: [(0.6338 - 0.6340)/0.1340] * 12 = - 0.38%. 2.c.

Swap rates Spot rates: €1 = $0.9107-10 SFr1 = $0.6340-42 30-day forward rates: €1 = $0.9120-25 SFr1 = $0.6338-41 Expressed as:

€1 = $0.9107-10 13-15 SFr1 = $0.6340-42 2-1

2.d. Cross rates on a 30-day forward contract: €1 = SFr1.4383-97 (0.9120/0.6341 - 0.9125/0.6338)

CHAPTER 7: CURRENCY FUTURES AND OPTIONS MARKETS

CHAPTER 7 CURRENCY FUTURES AND OPTIONS MARKETS This chapter describes foreign currency futures and options contracts and shows how they can be used to manage foreign exchange risk or take speculative positions on currency movements. It also shows how to read the prices of these contracts as they appear in the financial press. SUGGESTED ANSWERS TO CHAPTER 7 QUESTIONS 1. On April 1, the spot price of the British pound was $1.96 and the price of the June futures contract was $1.95. During April the pound appreciated so that by May 1 it was selling for $2.01. What do you think happened to the price of the June pound futures contract during April? Explain. ANSWER. The price of the June futures contract undoubtedly rose. Here’s why. The June futures price is based on the expectations of market participants as to what the spot value of the pound will be at the date of settlement in June. Since the spot value of the pound has risen in during April, the best prediction is that the future level of the pound will also be higher than it was on April 1. This expectation will undoubtedly be reflected in a June pound futures price that is higher on May 1 than it was on April 1. 2. What are the basic differences between forward and futures contracts? Between futures and options contracts? ANSWER. The basic differences between forward and futures contracts are described in Section 3.1. The most important difference between these two contracts and an options contract is that a buyer of a forward or futures contract must take delivery, while the buyer of an options contract has the right but not the obligation to complete the contract. 3. A forward market already existed, so why was it necessary to establish currency futures and currency options contracts? ANSWER. A currency futures market arose because private individuals were unable to avail themselves of the forward market. Currency options are partly a response to individuals and firms who would like to eliminate some currency risk while at the same time preserving the possibility of earning a windfall profit from favorable movements in the exchange rate. Options also enable firms bidding on foreign projects to lock in the home currency value of their bid without exposing themselves to currency risk if their bid is rejected. 4. Suppose that Texas Instruments must pay a French supplier €10 million in 90 days. 4.a. Explain how TI can use currency futures to hedge its exchange risk. How many futures contracts will TI need to fully protect itself? ANSWER. TI can hedge its exchange risk by buying euro futures contracts whose expiration date is the closest to the date on which it must pay its French supplier. Given a contract size of €125,000, TI must buy 10,000,000/125,000 = 80 futures contracts to hedge its euro payable.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

4.b. Explain how TI can use currency options to hedge its exchange risk. How many options contracts will TI need to fully protect itself? ANSWER. TI can hedge its exchange risk by buying euro call option contracts whose expiration date is the closest to the date on which it must pay its French supplier. Given a contract size of €62,500, TI must buy 10,000,000/62,500 = 160 options contracts to hedge its payable. 4.c.

Discuss the advantages and disadvantages of using currency futures versus currency options to hedge TI’s exchange risk.

ANSWER. A futures contract is most valuable when the quantity of foreign currency being hedged is known, as in the case here. An option contract is most valuable when the quantity of foreign currency is unknown. Other things being equal, therefore, TI should use futures contracts to hedge its currency risk. However, TI must honor its futures contracts even if the spot rate at settlement is less than the futures price. In contrast, TI can choose not to exercise currency call options if the call price exceeds the spot price. Although this feature is an advantage of currency options, it is fully priced out in the market via the call premium. Hence, options are not unambiguously better than futures. In this case, since the quantity of the future French franc outflow is known, TI should use currency futures to hedge its risk. 5. Suppose that Bechtel Group wants to hedge a bid on a Japanese construction project. Because the yen exposure is contingent on acceptance of its bid, Bechtel decides to buy a put option for the ¥15 billion bid amount rather than sell it forward. To reduce its hedging cost, however, Bechtel simultaneously sells a call option for ¥15 billion with the same strike price. Bechtel reasons that it wants to protect its downside risk on the contract and is willing to sacrifice the upside potential to collect the call premium. Comment on Bechtel’s hedging strategy. ANSWER. The combination of buying a put option and selling a call option at the same strike price is equivalent to selling ¥15 billion forward at a forward rate equal to the strike price on the put and call options. That is, Bechtel is no longer holding an option; it is now holding a forward contract. If the yen appreciates and Bechtel loses its bid, it will face an exchange loss equal to 15 billion * (actual spot rate exercise price). ADDITIONAL CHAPTER 7 QUESTIONS AND ANSWERS 1. What is the last day of trading and the settlement day for the IMM Australian dollar futures for September of the current year? ANSWER. The last day of trading for the IMM Australian dollar futures for September will be the third Wednesday of September. The specific date depends on the year. For 2001 it is September 19 and for 2002 it is September 18. Settlement takes place each day. 2. Which contract is likely to be more valuable, an American or a European call option? Explain. ANSWER. The American call option is likely to be more valuable since it can be exercised at any time prior to maturity, unlike the European option which can be exercised only at maturity. The option to exercise early is valuable when interest rates on the two currencies differ.

CHAPTER 7: CURRENCY FUTURES AND OPTIONS MARKETS

3. In Exhibit 7.9, the value of the call option is shown as approaching its intrinsic value as the option goes deeper and deeper in-the-money or further and further out-of-the-money. Explain why this is so. ANSWER. As the call option moves further out-of-the-money, the chances that it will expire unexercised and worthless increase, bringing it closer to its intrinsic value of 0. Alternatively, as the option goes deeper in-the-money, the chance that the exchange rate will fall below the exercise price declines, increasing the probability that the option will be exercised eventually at a profit equal to its intrinsic value. 4. During September 1992, options on ERM currencies with strike prices outside the ERM bands had positive values. At the same time, actual currency volatility was close to zero. 4.a. Is there a paradox here? Explain. ANSWER. There is no paradox. Although current volatility was almost zero, currency traders were betting that the ERM could not be maintained, which would lead to a jump in currency volatility. If the ERM broke up, there was a positive probability that ERM currency values would move outside the bands. Hence, it is not surprising that options on ERM currencies with strike prices outside the ERM bands had positive values. 4.b. Why might actual currency volatility have been close to zero? What does a zero volatility imply about the value of currency options? ANSWER. Actual currency volatility was close to zero because of government intervention to maintain currency values within the established bands. However, a zero current volatility implies nothing about the value of currency options. What matters in pricing an option is the underlying asset’s projected volatility over the life of the contract. If future volatility is expected to differ from current volatility, option prices will not reflect current volatility. 4.c.

What does the positive values of ERM options outside the bands tell you about the market’s perceptions of the possibility of currency devaluations or revaluations?

ANSWER. The market was clearly expecting currency movements beyond the established ERM bands. In other words, traders believed that currency devaluations or revaluations had a positive probability of occurring. Otherwise, the value of options with strike prices outside the ERM bands would have been insignificantly different from zero.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

SUGGESTED SOLUTIONS TO CHAPTER 7 PROBLEMS 1. On Monday morning, an investor takes a long position in a pound futures contract that matures on Wednesday afternoon. The agreed-on price is $1.95 for £62,500. At the close of trading on Monday, the futures price has risen to $1.96. At Tuesday close, the price rises further to $1.98. At Wednesday close, the price falls to $1.955, and the contract matures. The investor takes delivery of the pounds at the prevailing price of $1.955. Detail the daily settlement process (see Exhibit 7.3). What will be the investor's profit (loss)? ANSWER Time

Action

Cash Flow

Monday Open

Investor buys a pound futures contract that matures in two days

None. Price is $1.95

Monday Close

Futures price rises to $1.96. Contract is marked-to-market.

Investor receives 62,500 * (1.96 – 1.95) = $625

Tuesday Close

Futures price rises to $1.98. Contract is marked-to-market.

Investor receives 62,500 * (1.98 – 1.96) = $1,250

Wednesday Close

Future price falls to $1.955. 1) Contract is marked-to-market 2) Investor takes delivery of £62,500.

1) Investor pays 62,500 * (1.98 – 1.955) = $1,562.50 2) Investor pays 62,500 * 1.955 = $122,187.50

Net profit is $1,785 – $1,562.5 = $312.50. 2. Suppose that the forward ask price for March 20 on euros is $1.3327 at the same time the price of IMM euro futures for delivery on March 20 is $1.3345. How could an arbitrageur profit from this situation? What will be the arbitrageur’s profit per futures contract (size is €125,000)? ANSWER. Since the futures price exceeds the forward rate, the arbitrageur should sell futures contracts at $1.3345 and buy euro forward in the same amount at $1.3327. The arbitrageur will earn 125,000(1.3345 - 1.3327) = $225 per euro futures contract arbitraged. 3. Suppose DEC buys a Swiss franc futures contract (size is SFr 125,000) at a price of $0.83. If the spot rate for the Swiss franc at the date of settlement is SFr 1 = $0.8250, what is DEC’s gain or loss on this contract? ANSWER. DEC has bought Swiss francs worth $0.8250 at a price of $0.83. Thus, it has lost $0.005 per franc for a total loss of 125,000 * 0.005 = $625.

CHAPTER 7: CURRENCY FUTURES AND OPTIONS MARKETS

4. On January 10, Volkswagen agrees to import auto parts worth $7 million from the U.S. The parts will be delivered on March 4 and are payable immediately in dollars. VW decides to hedge its dollar position by entering into IMM futures contracts. The spot rate is $1.3447/€ and the March futures price is $1.3502. 4.a. Calculate the number of futures contracts that VW must buy to offset its dollar exchange risk on the parts contract. ANSWER. VW can lock in a euro price for its imported parts by buying dollars in the futures market at the current March futures price of €0.7406/$1 (1/1.3502). This is equivalent to selling euro futures contracts. At that futures price, VW will sell €5,184,200 for $7 million. At €125,000 per futures contract, this would entail selling 42 contracts (5,184,200/125,000 = 41.47) at a total cost of €5,250,000. 4.b. On March 4, the spot rate turns out to be $1.3452/€, while the March futures price is $1.3468/€. Calculate VW’s net euro gain or loss on its futures position. Compare this figure with VW’s gain or loss on its unhedged position. ANSWER. Under its futures contract, VW has agreed to sell €5,250,000 and receive $7,088,550 (5,250,000 * 1.3502). On March 4, VW can close out its futures position by buying back 42 March euro futures contracts (worth €5,250,000). At the current futures rate of $1.3468/€, VW must pay out $7,070,700 (5,250,000 * 1.3468). Hence, VW has a net gain of $17,850 ($7,088,550 - $7,070,700) on its futures contract. At the current spot rate of $1.3452/€, this translates into a gain of €13,269.40 (17,850/1.3452). On closing out the 42 futures contracts, VW will then buy $7 million in the spot market at a spot rate of $1.3452/€. Its net cost is €5,190,417.78 (7,000,000/1.3452 - 13,269.4). If VW had not hedged its import contract, it could have bought the $7 million on March 10 at a cost of €5,203,687.18 (7,000,000/1.3452). In contrast, the projected cost based on the spot rate on January 10 is €5,252,494.94 (7,000,000/1.3327). However, the latter “cost” is irrelevant since VW had no opportunity to buy March dollars at the January 10 spot rate of $1.3327/€. By not hedging, VW would have paid an extra €13,269.4 for the $7,000,000 to satisfy its dollar liability, the difference between the cost of $7 million with hedging (€5,190,471.78) and the cost without hedging (€5,203,687.18). 5. Citigroup sells a call option on euros (contract size is €500,000) at a premium of $0.04 per euro. If the exercise price is $1.34 and the spot price of the euro at expiration is $1.36, what is Citigroup’s profit (loss) on the call option? ANSWER. Since the spot price of $1.36 exceeds the exercise price of $1.34, Citigroup’s counterparty will exercise its call option, causing Citigroup to lose 2¢ per euro. Adding in the 4¢ call premium it received gives Citigroup a net profit of 2¢ per euro on the call option for a total gain of 0.02 * 500,000 = $10,000. 6. Suppose you buy three June PHLX call options with a 90 strike price at a price of 2.3 (¢/€). 6.a. What would be your total dollar cost for these calls, ignoring broker fees? ANSWER. With each call option being for €62,500, the three contracts combined are for €187,500. At a price of 2.3¢/€, the total cost is 187,500 * $0.023 = $4,312.50.

INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

6.b. After holding these calls for 60 days, you sell them for 3.8 (¢/€). What is your net profit on the contracts assuming that brokerage fees on both entry and exit were $5 per contract and that your opportunity cost was 8% per annum on the money tied up in the premium? ANSWER. The net profit would be 1.5¢/€ (3.8 - 2.3) for a total profit before expenses of $2,812.50 (0.015 * 187,500). Brokerage fees totaled $10 per contract or $30 overall. The opportunity cost would be $4,312.50 * 0.08 * 60/365 = $56.71. After deducting these expenses (which total $86.71), the net profit is $2,725.79. 7. A trader executes a “bear spread” on the Japanese yen consisting of a long PHLX 103 March put and a short PHLX 101 March put. 7.a. If the price of the 103 put is 2.81 (100ths of ¢/¥), while the price of the 101 put is 1.6 (100ths of ¢/¥), what is the net cost of the bear spread? ANSWER. Going long on the 103 March put costs 0.0281¢/¥ while going short on the 101 March put yields 0.016¢/¥. The net cost is therefore 0.0121¢/¥ (0.028 - 0.016). On a contract of ¥6,250,000, this is equivalent to $756.25. 7.b. What is the maximum amount the trader can make on the bear spread in the event the yen depreciates against the dollar? ANSWER. To begin, the 103 March put gives the trader the right but not the obligation to sell yen at a price of 1.03¢/¥. Similarly, the 101 March put gives the buyer the right but not the obligation to sell yen at a price of 1.01¢/¥. If the yen falls to 1.01¢/¥ or below, the trader will earn the maximum spread of 0.02¢/¥. After paying the cost of the bear spread, the trader will net 0.079¢/¥ (0.02¢ - 0.0121¢), or $493.75 on a ¥6,250,000 contract. 7.c.

Redo your answers to parts a and b assuming the trader executes a “bull spread” consisting of a long PHLX 97 March call priced at 0.0321¢/¥ and a short PHLX 103 March call priced at 0.0196¢/¥. What is the trader's maximum profit? Maximum loss?

ANSWER. In this case, the trader will pay 0.0321¢/¥ for the long 97 March call and receive 0.0196¢/¥ for the short 103 March call. The net cost to the trader, therefore, is 0.0125¢/¥, which is also the trader’s maximum potential loss. At any price of 1.03¢/¥ or greater, the trader will earn the maximum possible spread of 0.06¢/¥. After subtracting off the cost of the bull spread, the trader will net 0.0475¢/¥, or $2,968.75 per ¥6,250,000 contract.

CHAPTER 7: CURRENCY FUTURES AND OPTIONS MARKETS

8. Apex Corporation must pay its Japanese supplier ¥125 million in three months. It is thinking of buying 20 yen call options (contract size is ¥6.25 million) at a strike price of $0.00800 to protect against the risk of a rising yen. The premium is 0.015 cents per yen. Alternatively, Apex could buy 10 three-month yen futures contracts (contract size is ¥12.5 million) at a price of $0.007940 per yen. The current spot rate is ¥1 = $0.007823. Suppose Apex’s treasurer believes that the most likely value for the yen in 90 days is $0.007900, but the yen could go as high as $0.008400 or as low as $0.007500. 8.a. Diagram Apex’s gains and losses on the call option position and the futures position within its range of expected prices (see Exhibit 8.4). Ignore transaction costs and margins. ANSWER. In the following calculations, note that the current spot rate is irrelevant. When a spot rate is referred to, it is the spot rate in 90 days. If Apex buys the call options, it must pay a call premium of 0.00015 * 125,000,000 = $18,750. If the yen settles at its minimum value, Apex will not exercise the option and it loses the call premium. But if the yen settles at its maximum value of $0.008400, Apex will exercise at $0.008000 and earn $0.0004/¥1 for a total gain of 0.0004 * 125,000,000 = $50,000. Apex’s net gain will be $50,000 - $18,750 = $31,250. PROFIT (LOSS) ON APEX CORPORATION'S FUTURES AND OPTIONS POSITIONS

INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

Contract Option Inflow

Yen Price 75

79.4

81.5

---

$1,018,750

$1,050,000

Call Premium

-$18,750

-$1,000,000

Exercise Cost

---

-$1,000,000

-$18,750

$31,250

Inflow

$937,500

$992,500

$1,000,000

$1,050,000

Outflow

-$992,500

Profit

-$55,000

$7,500

$57,500

Outflow

Profit Futures

As the diagram and table show, Apex can use a futures contract to lock in a price of $0.007940/¥ at a total cost of 0.007940 * 125,000,000 = $992,500. If the yen settles at its minimum value, Apex will lose $0.007940 - $0.007500 = $0.000440/¥ (remember it is buying yen at 0.007940, when the spot price is only 0.007500), for a total loss on the futures contract of 0.00044 * 125,000,000 = $55,000. On the other hand, if the yen appreciates to $0.008400, Apex will earn $0.008400 - $0.007940 = $0.000460/¥ for a total gain on the futures contracts of 0.000460 * 125,000,000 = $57,500. 8.b. Calculate what Apex would gain or lose on the option and futures positions if the yen settled at its most likely value. ANSWER. If the yen settles at its most likely price of $0.007900, Apex will not exercise its call option and will lose the call premium of $18,750. If Apex hedges with futures, it will have to buy yen at a price of $0.007940 when the spot rate is $0.0079. This will cost Apex $0.000040/¥, for a total futures contract cost of 0.000040 * 125,000,000 = $5,000. 8.c.

What is Apex’s break-even future spot price on the option contract? On the futures contract?

ANSWER. On the option contract, the spot rate will have to rise to the exercise price plus the call premium for Apex to break even on the contract, or $0.008000 + $0.000150 = $0.008150. In the case of the futures contract, break-even occurs when the spot rate equals the futures rate, or $0.007940. 8.d. Calculate and diagram the corresponding profit-and-loss and break-even positions on the futures and options contracts for the sellers of these contracts. ANSWER. The sellers’ profit-and-loss and break-even positions on the futures and options contracts will be the mirror image of Apex’s position on these contracts. For example, the sellers of the futures contract will breakeven at a future spot price of ¥1 = $0.007940, while the options sellers will breakeven at a future spot rate of ¥1 = $0.008150. Similarly, if the yen settles at its minimum value, the options sellers will earn the call premium of $18,750 and the futures sellers will earn $55,000. But if the yen settles at its maximum value of $0.008400, the options sellers will lose $31,250 and the futures sellers will lose $57,500.

CHAPTER 7: CURRENCY FUTURES AND OPTIONS MARKETS

ADDITIONAL CHAPTER 7 PROBLEMS AND SOLUTIONS 1. On Monday morning, an investor takes a short position in a euro futures contract that matures on Wednesday afternoon. The agreed-on price is $0.9370 for €125,000. At the close of trading on Monday, the futures price has fallen to $0.9315. At Tuesday close, the price falls further to $0.9291. At Wednesday close, the price rises to $0.9420, and the contract matures. The investor delivers the euros at the prevailing price of $0.8420. Detail the daily settlement process (see Exhibit 8.2). What will be the investor's profit (loss)? ANSWER Time

Action

Cash Flow

Monday Open

Investor sells euro futures contract that matures in two days

None. Price is $0.9370

Monday Close

Futures price falls to $0.9315. Contract is marked-to-market.

Investor receives 125,000 * (0.9370 - 0.9315) = $687.50

Tuesday Close

Futures price falls to $0.9291. Contract is marked-to-market.

Investor receives 125,000 * (0.9315 - 0.9291) = $300

Wednesday Close

Future price rises to $0.9420. 1) Contract is marked-to-market 2) Investor takes delivery of €125,000.

1) Investor pays 125,000 * (0.9420 - 0.9291) = $1,612.50 2) Investor pays 125,000 * 0.9420 = $117,750

Net loss is -$1,612.50 + $987.50 = -$625. 2. On August 6, you go long one IMM yen futures contract at an opening price of $0.00812 with a performance bond of $4,590 and a maintenance performance bond of $3,400. The settlement prices for August 6, 7, and 8 are $0.00791, $0.00845, and $0.00894, respectively. On August 9, you close out the contract at a price of $0.00857. Your round-trip commission is $31.48. 2.a. Calculate the daily cash flows on your account. Be sure to take into account your required performance bond and any performance bond calls. ANSWER Time

Action

Cash Flow

August 6 Open

You sell one IMM yen futures contract

Performance bond of $4,590. Price is $0.00812.

August 6 Close

Futures price falls to $0.00791. Contract is marked-to-market.

You pay 12,500,000 * (0.00812 - 0.00791) = -$2,625

August 7 Close

Futures price rises to $0.00845. Contract is marked-to-market.

You receive 12,500,000 * (0.00845 - 0.00791) = $6,750

August 8 Close

Future price rises to $0.00894. Contract is marked-to-market.

You receive 12,500,000 * (0.00894 - 0.00845) = $6,125

August 9 Close

Futures price falls to $0.00857. 1) Contract is marked-to-market. 2) You close out the contract.

1) You pay 12,500,000 * (0.00894 - 0.00857) = -$4,625 2) None. You pay round-trip commission -$31.48

Net gain on the futures contract = -$2,625 + $6,750 + $6,150 - $4,625 - $31.48 = $5,593.52

INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

Your performance bond calls and cash balances as of the close of each day were as follows: August 6

With a loss of $2,625, your account balance falls to $1,965 ($4,590 -$2,625). You must add $2,625 ($4,590 - $2,625) to your account to restore it to the performance bond requirement of $4,590.

With subsequent gains on the futures contract, you have no further margin calls. 2.b. What is your cash balance with your broker on the morning of August 10? ANSWER. As shown in part a, your net profit was $5,593.52. Add to this the $4,590 performance bond and the further margin of $2,625 paid in on August 6 and the amount in your account on the morning of August 10 is $12,808.52 ($5,593.52 + $4,590 + $2,625). 3. Biogen expects to receive royalty payments totaling £1.25 million next month. It is interested in protecting these receipts against a drop in the value of the pound. It can sell 30-day pound futures at a price of $1.6513 per pound or it can buy pound put options with a strike price of $1.6612 at a premium of 2.0 cents per pound. The spot price of the pound is currently $1.6560, and the pound is expected to trade in the range of $1.6250 to $1.7010. Biogen’s treasurer believes that the most likely price of the pound in 30 days will be $1.6400. 3.a. How many futures contracts will Biogen need to protect its receipts? How many options contracts? ANSWER. With a futures contract size of £62,500, Biogen will need 20 futures contracts to protect its anticipated royalty receipts of £1.25 million. Since the option contract size is half that of the futures contract, or £31,250, Biogen will need 40 put options to hedge its receipts. 3.b. Diagram Biogen’s profit and loss associated with the put option position and the futures position within its range of expected exchange rates (see Exhibit 7.6). Ignore transaction costs and margins.

CHAPTER 7: CURRENCY FUTURES AND OPTIONS MARKETS

Contract

Pound Price

Option

1.6250

1.6400

1.6513

1.6612

1.7010

Inflow

$2,076,500

---

Put Premium

-$25,000

Exercise Cost

-$2,031,250

-$2,050,000

-$2,064,125

$20,250

$1,500

-$12,625

-$25,000

Inflow

$2,064,125

Outflow

-$2,031,250

-$2,050,000

-$2,064,125

-$2,056,625

-$2,126,250

$32,875

$14,125

-$7,500

-$62,125

Outflow

Profit Futures

Profit 3.c.

Calculate what Biogen would gain or lose on the option and futures positions within the range of expected future exchange rates and if the pound settled at its most likely value.

ANSWER. If Biogen buys the put options, it must pay a put premium of 0.02 * 1,250,000 = $25,000. If the pound settles at its maximum value, Biogen will not exercise and it loses the put premium. But if the pound settles at its minimum of $1.6250, Biogen will exercise at $1.6612 and earn $0.0362/£or a total of 0.0362 * 1,250,000 = $45,250. Biogen's net gain will be $45,250 - $25,000 = $20,250. With regard to the futures position, Biogen will lock in a price of $1.6513/£ for total revenue of $1.6513 * 1,250,000 = $2,064,125. If the pound settles at its minimum value, Biogen will have a gain per pound on the futures contracts of $1.6513 - $1.6250 = $0.0263/£ (remember it is selling pounds at a price of $1.6513 when the spot price is only $1.6250) for a total gain of 0.0263 * 1,250,000 = $32,875. On the other hand, if the pound appreciates to $1.70100, Biogen lose $1.7010 - $1.6513 = $0.0497/£ for a total loss on the futures contract of 0.0497 * 1,250,000 = $62,125. If the pound settles at its most likely price of $1.6400, Biogen will exercise its put option and earn $1.6612 - $1.6400 = $0.0212/£, or $26,500. Subtracting off the put premium of $25,000 yields a net gain of $1,500. If Biogen hedges with futures contracts, it will sell pounds at $1.6513 when the spot rate is $1.6400. This will yield Biogen a gain of $0.0113/£ for a total gain on the futures contract equal to 0.0113 * 1,250,000 = $14,125. 3.d. What is Biogen’s break-even future spot price on the option contract? On the futures contract? ANSWER. On the option contract, the spot rate will have to sink to the exercise price less the put premium for Biogen to break even on the contract, or $1.6612 - $0.02 = $1.6412. In the case of the futures contract, breakeven occurs when the spot rate equals the futures rate, or $1.6513.

INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

3.e.

Calculate and diagram the corresponding profit-and-loss and break-even positions on the futures and options contracts for those who took the other side of these contracts.

ANSWER. As in the case of Apex, the sellers’ profit-and-loss and break-even positions on the futures and options contracts will be the mirror image of Biogen’s position on these contracts. For example, the sellers of the futures and options contracts will break even at future spot prices of $1.6513/£ and $1.6412/£, respectively. Similarly, if the pound falls to its minimum value, the options sellers will lose $20,250 and the futures sellers will lose $32,875. But if the pound hits its maximum value of $1.7010, the options sellers will earn $25,000 and the futures sellers will earn $62,125.

CHAPTER 8: SWAPS AND INTEREST RATE DERIVATIVES

CHAPTER 8 SWAPS AND INTEREST RATE DERIVATIVES This chapter examines several special financing vehicles that MNCs can use to fund their foreign investments. These vehicles include interest rate and currency swaps, structured notes, interest rate forward and futures contracts, international leasing, and LDC debt-equity swaps. Each of these vehicles presents opportunities to the MNC to achieve one or more of the following goals: reduce the cost of funds, cut taxes, and reduce political and/or foreign exchange risk. These opportunities to create value arise from various market imperfections, which I discuss. Interest and currency swaps are financial transactions in which two counterparties agree to exchange streams of payments over time. In effect, a swap is a package of forward contracts. For swaps to provide a real economic benefit to both parties, a barrier generally must exist to prevent arbitrage from functioning fully. This impediment must take the form of legal restrictions on spot and forward foreign exchange transactions, different perceptions by investors of risk and creditworthiness of the two parties, appeal or acceptability of one borrower to a certain class of investor, tax differentials, and so forth. Structured notes are interest-bearing securities whose interest payments are determined by reference to a formula set in advance and adjusted on specified reset dates. The formula can be tied to a variety of different factors, such as LIBOR, exchange rates, or commodity prices. Sometimes the formula includes multiple factors, such as the difference between three-month dollar LIBOR and threemonth Swiss franc LIBOR. The common characteristic is one or more embedded derivative elements, such as swaps, forwards, or options. Structured notes can be used to reduce risk or bet on one’s forecast of future interest rates, exchange rates, and so on. In addition to swaps and structured notes, companies can use a variety of forward and futures contracts to manage their interest rate expense and risk. These contracts include forward forwards, forward rate agreements, and Eurodollar futures. These allow companies to lock in interest rates on future loans and deposits. A forward forward is a contract that fixes an interest rate today on a future loan or deposit. The contract specifies the interest rate, the principal amount of the future deposit or loan, and the start and ending dates of the future interest rate period. In recent years, forward forwards have been largely displaced by forward rate agreements (FRAs). An FRA is a cash-settled, over-the-counter forward contract that allows a company to fix an interest rate to be applied to a specified future interest period on a notional principal amount. It is analogous to a forward foreign currency contract but instead of exchanging currencies, the parties to an FRA agree to exchange interest payments.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTNATIONAL FINANCIAL MANAGEMENT, 6TH ED.

A Eurodollar future is a cash-settled futures contract on a three-month, $1,000,000 Eurodollar deposit that pays LIBOR. Eurodollar futures contracts are traded on various organized exchanges for March, June, September, and December delivery. Contracts are traded out to three years, with a high degree of liquidity out to two years. Eurodollar futures act like FRAs in that they help lock in a future interest rate and are settled in cash. But unlike FRAs, they are marked to market daily (as in currency futures, this means that gains and losses are settled in cash each day). Cross-border or international leasing can be used to both defer and avoid tax. It can also be used to safeguard the assets of an MNC’s foreign affiliates and avoid currency controls. Under a debt-equity program, a firm buys a country’s dollar debt on the secondary loan market at a discount and swaps it into local equity. Such swaps create the possibility of cheap financing for expanding plant and retiring local debt in hard-pressed LDCs. SUGGESTED ANSWERS TO CHAPTER 8 QUESTIONS 1. What is an interest rate swap? What is the difference between a basis swap and a coupon swap? ANSWER. An interest rate swap is an agreement between two parties to exchange interest payments in the same currency for a specific maturity on an agreed-on notional amount. Notional refers to the theoretical principal underlying the swap. In the coupon swap, one party pays a fixed rate calculated at the time of trade as a spread to a particular Treasury bond, while the other side pays a floating rate that resets periodically throughout the life of the deal against a designated index. In a basis swap, a floating-rate liability tied to one reference rate, say, LIBOR, is exchanged for a floating-rate liability with another reference rate, say, 90-day Treasury bills. Thus, coupon swaps convert fixed-rate debt into floating-rate debt (or vice versa), whereas the basis swap converts one type of floating-rate debt into another type of floating-rate debt. 2. What is a currency swap? ANSWER. A currency swap involves the exchange of principal plus interest payments in one currency for equivalent payments in another currency. 3. Comment on the following statement. “For one party to a swap to benefit, the other party must lose.” ANSWER. Given that both parties to the swap freely enter into the swap transaction, both must perceive benefits. The tax, financial market, and regulatory system arbitrage benefits associated with swaps are shared by both parties. 4. The Swiss Central Bank bans the use of Swiss francs for Eurobond issues. Explain how currency swaps can be used to enable foreign borrowers who want to raise Swiss francs through a bond issue outside of Switzerland to get around this ban. ANSWER. Foreign borrowers can issue Eurodollar bonds and then swap the proceeds for Swiss francs. In this way, they can raise Swiss francs without violating the ban on issuing Swiss franc Eurobonds.

CHAPTER 8: SWAPS AND INTEREST RATE DERIVATIVES

5. Explain how IBM can use a forward rate agreement to lock in the cost of a one-year, $25 million loan to be taken out in six months. Alternatively, explain how IBM can lock in the interest rate on this loan by using Eurodollar futures contracts. What is the major difference between using the FRA and the futures contract to hedge IBM’s interest rate risk? ANSWER. To lock in the rate on a one-year, $25 million loan to be taken out in six months, IBM could buy a “6 x 12” FRA on LIBOR for a notional principal of $25 million. That is, IBM enters into a sixmonth forward contract on 12-month LIBOR. Alternatively, IBM can lock in the interest rate on this loan by selling 25 $1 million 6-month futures contracts. However, this transaction will only protect IBM for the first three months of its loan. To hedge the remaining nine months of future loan, IBM would sell 25 $1 million 9-month, 12-month, and 15-month futures contracts. The most important difference between using the FRA and the futures contract is that the latter is marked to market daily. In addition, the FRA involves entering into just one contract for the 12-month loan, whereas using the futures contract to hedge IBM’s interest rate risk involves entering into four separate three-month futures contracts. ADDITIONAL CHAPTER 8 QUESTIONS AND ANSWERS 1. What factors underlie the economic benefits of swaps? ANSWER. To provide economic benefits, swaps must allow the transacting parties to engage in some form of tax, regulatory system, or financial market arbitrage. Thus, underlying the economic benefits of swaps are barriers that prevent other forms of arbitrage from functioning fully. This impediment must take the form of legal restrictions on spot and forward foreign exchange transactions, different perceptions by investors of risk and creditworthiness of the two parties, appeal or acceptability of one borrower to a certain class of investor, tax differentials, and so forth. If the world capital market were fully integrated, the incentive to swap would be reduced because fewer arbitrage opportunities would exist. 2. Comment on the following statement. “During the period 1987-1989, Japanese companies issued some $115 billion of bonds with warrants attached. Nearly all were issued in dollars. The dollar bonds usually carried coupons of 4% or less; by the time the Japanese companies swapped that exposure into yen (whose interest rate was as much as five percentage points lower than the dollar's), their cost of capital was zero or negative.” ANSWER. This statement assumes that the warrants on the Japanese bonds, which are long-dated call options, are costless for the Japanese firms to issue. They are not. During this period, Japanese stock prices rose dramatically. The net result was that Japanese firms did not issue cheap debt; instead, they issued expensive equity. That is, they issued equity at the exercise price on the warrants, which was typically far below the price at which they could have sold new stock in the marketplace. 3. Explain how Cisco Systems can use arbitrage to create a forward forward to fix the interest rate on a three-month $10 million loan to be taken out in nine months. The loan will be priced off LIBOR. ANSWER. Cisco can lock in a three-month rate on a $10 million loan to be taken out in nine months by buying a forward forward or by creating its own through arbitrage. Specifically, Cisco can derive a ninemonth forward rate on LIBOR3 by simultaneously lending the present value of $10 million for nine months and borrowing that same amount of money for 12 months.

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4. Why do governments provide subsidized financing for some investments? ANSWER. Governments use subsidized financing to encourage programs and activities that are deemed to be worthy. For example, governments provide subsidized trade financing to boost exports and low-cost financing to projects expected to create jobs in regions with high unemployment. Often, these subsidies offset regulatory and other costs that are imposed on companies by the same governments. SUGGESTED SOLUTIONS TO CHAPTER 8 PROBLEMS 1. Dell Inc. wants to borrow pounds, and Virgin Airlines wants to borrow dollars. Because Dell is better known in the U.S., it can borrow on its own dollars at 7% and pounds at 9%, whereas Virgin can borrow dollars at 8% and pounds at 8.5% 1.a. Suppose Dell wants to borrow £10 million for two years, Virgin wants to borrow $16 million for two years, and the current ($/£) exchange rate is $1.60. What swap transaction would accomplish this objective? Assume the counterparties would exchange principal and interest payments with no rate adjustments. ANSWER. Virgin would borrow £10 million for two years and Dell would borrow $16 million for two years. The two companies would then swap their proceeds and payment streams. 1.b. What savings are realized by Dell and Virgin? ANSWER. Assuming no interest rate adjustments, Dell would pay 8.5% on the £10 million and Virgin would pay 7% on its $16 million. Given that its alternative was to borrow pounds at 9%, Dell would save 0.5% on its borrowings, or an annual savings of £50,000. Similarly, Virgin winds up paying an interest rate of 7% instead of 8% on its dollar borrowings, saving it 1% or $160,000 annually. 1.c.

Suppose, in fact, that Dell can borrow dollars at 7% and pounds at 9% , whereas Virgin can borrow dollars at 8.75% and pounds at 9.5%. What range of interest rates would make this swap attractive to both parties?

ANSWER. Ignoring credit risk differences, Virgin would have to provide Dell with a pound rate of less than 9%. Given that Virgin has to borrow the pounds at 9.5%, it would have to save at least 0.5% on its dollar borrowing from Dell to make the swap worthwhile. If Dell borrows pounds from Virgin at 9% - x, Virgin would have to borrow dollars from Dell at 8.75% - (0.5% + x) to cover the (0.5% + x) difference between the interest rate at which it was borrowing pounds and the interest rate at which it was lending those pounds to Dell. 1.d. Based on the scenario in 1.c, suppose Dell borrows dollars at 7% and Virgin borrows pounds at 9.5%. If the parties swap their current proceeds, with Dell paying 8.75% to Virgin for pounds and Virgin paying 7.75% to Dell for dollars, what are the cost savings to each party? ANSWER. Under this scenario, Dell saves 0.25% on its pound borrowings and earns 0.75% on the dollars it swaps with Virgin, for a total benefit of 1% annually. Virgin loses 0.75% on the pounds it swaps with Dell and saves 1% on the dollars it receives from Dell, for a net savings of 0.25% annually.

CHAPTER 8: SWAPS AND INTEREST RATE DERIVATIVES

2. In May 1988, Walt Disney Productions sold to Japanese investors a 20-year stream of projected yen royalties from Tokyo Disneyland. The present value of that stream of royalties, discounted at 6% (the return required by the Japanese investors), was ¥93 billion. Disney took the yen proceeds, converted them to dollars, and invested the dollars in bonds yielding 10%. According to Disney’s CFO, “In effect, we got money at a 6% discount rate, reinvested it at 10%, and hedged our royalty stream against yen fluctuations – all in one transaction.” 2.a. At the time of the sale, the exchange rate was ¥124 = $1. What dollar amount did Disney realize from the sale of its yen proceeds? ANSWER. Disney realized 93,000,000,000/124 = $750,000,000 from the sale of its future yen proceeds. 2.b. Demonstrate the equivalence between Disney’s transaction and a currency swap. (Hint: a diagram would help) ANSWER. In a currency/interest rate swap, one party trades a stream of payments in one currency, at one interest rate, for a stream of payments in a second currency, at a second interest rate. Disney’s stream of yen royalties can be treated as a yen bond, which it traded for a dollar bond, with dollar payments. The only difference between the Disney swap and a traditional swap is that the latter usually involve cash outflows whereas the Disney swap involves cash inflows. 2.c.

Did Disney achieve the equivalent of a free lunch through its transaction?

ANSWER. The CFO is committing the economist’s unpardonable sin: He is comparing apples with oranges, in this case, a 6% yen interest rate with a 10% dollar interest rate. The IFE tells us that the most likely reason that the yen interest rate is 4 percentage points less than the equivalent dollar interest rate is because the market expects the dollar to depreciate by about 4% annually against the yen. 3. Suppose IBM would like to borrow fixed-rate yen, whereas Korea Development Bank (KDB) would like to borrow floating-rate dollars. IBM can borrow fixed-rate yen at 4.5% or floatingrate dollars at LIBOR + 0.25%. KDB can borrow fixed-rate yen at 4.9% or floating-rate dollars at LIBOR + 0.8%. 3.a. What is the range of possible cost savings that IBM can realize through an interest rate/currency swap with KDB? ANSWER. The cost to each party of accessing either the fixed-rate yen or the floating-rate dollar market for a new debt issue is as follows: Borrower Korea Development Bank IBM Difference

Fixed-Rate Yen Available

Floating-Rate Dollars Available

4.9% 4.5% 0.4%

LIBOR + 0.80% LIBOR + 0.25% 0.55%

Given the rate differences between the markets, the two parties can achieve a combined 15-basis-point savings through IBM borrowing floating-rate dollars at LIBOR + 0.25% and KDB borrowing fixed-rate yen at 4.9% and then swapping the proceeds. IBM would borrow fixed-rate yen at 4.35% if these savings were passed along in the swap. This could be achieved by IBM providing floating-rate dollars to KBD at LIBOR + 0.25%, saving KDB 0.55%, which then passed these savings along to IBM by swapping the fixed-rate yen at 4.9% - 0.55% = 4.35%. Thus, the potential savings to IBM range from 0% to 0.15%.

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3.b. Assuming a notional principal equivalent to $125 million and a current exchange rate of ¥105/$, what do these possible cost savings translate into in yen terms? ANSWER. At a current exchange rate of ¥105/$, IBM’s borrowing would equal ¥13,125,000,000 (125,000,000*105). A 0.15% savings on that amount would translate into ¥19,687,500 per annum (¥13,125,000,000*0.0015). 3.c.

Redo parts a and b assuming the parties use Bank of America, which charges 8 basis points to arrange the swap.

ANSWER. In this case, the potential savings from a swap net out to 7 basis points. If IBM realizes all these savings, its borrowing cost would be lowered to 4.43% (4.5% - 0.07%). The 7-basis-point saving would translate into an annual saving of ¥9,187,500 (¥13,125,000,000*0.0007). 4. At time t, 3M borrows ¥12.8 billion at an interest rate of 1.2%, paid semiannually, for a period of two years. It then enters into a two-year yen/dollar swap with Bankers Trust (BT) on a notional principal amount of $100 million (¥12.8 billion at the current spot rate). Every six months, 3M pays BT U.S. dollar LIBOR6, while BT makes payments to 3M of 1.3% annually in yen. At maturity, BT and 3M reverse the notional principals. 4.a. Assume that LIBOR6 (annualized) and the ¥/$ exchange rate evolve as follows. Calculate the net dollar amount that 3M pays to BT (-) or receives from BT (+) each six-month period. Time (months)

LIBOR6

¥/$ (spot)

t t+6 t + 12 t + 18 t + 24

5.7% 5.4% 5.3% 5.9% 5.8%

128 132 137 131 123

ANSWER. The semiannual receipts, payments, and net receipts (payments) are computed as follows: Time (months)

LIBOR6

¥/$ (spot)

Receipt

Payment

Net $ Receipt (+)/ Payment (-)

t t+6

5.7% 5.4%

128 132

$630,303

$2,700,000

$2,069,697

t + 12 t + 18

5.3% 5.9%

137 131

$607,299 $635,115

$2,650,000 $2,950,000

$2,042,701 $2,314,885

t + 24

5.8%

123

$676,423

$2,900,000

$2,223,577

There is no payment or receipt at time t. The semiannual payment is calculated as $100,000,000 * LIBOR6/2. The semiannual receipt is calculated as 12,800,000,000 * 0.013/2 * 1/S, where S is the current spot rate (¥/$).

CHAPTER 8: SWAPS AND INTEREST RATE DERIVATIVES

4.b. What is the all-in dollar cost of 3M’s loan? ANSWER. The net payments made semiannually by 3M are shown in the table below. The net payment is computed as the LIBOR6 payment made to BT less the dollar value of the 0.05% semiannual difference between the yen interest received and the yen interest paid (shown in the column labeled “Receipt.”) Time (months) t t+6 t + 12 t + 18 t + 24

4.c.

LIBOR6 5.7% 5.4% 5.3% 5.9% 5.8%

¥/$ (spot) 128 132 137 131 123 IRR IRR Annualized

Receipt

Payment

$48,485 $46,715 $48,855 $52,033

$2,700,000 $2,650,000 $2,950,000 $2,900,000

Net $ Payment -$100,000,000 $2,651,515 $2,603,285 $2,901,145 $102,847,967 2.75% 5.50%

Suppose 3M decides at t + 18 to use a six-month forward contract to hedge the t + 24 receipt of yen from BT. Six-month interest rates (annualized) at t + 18 are 5.9% in dollars and 2.1% in yen. With this hedge in place, what fixed dollar amount would 3M have paid (received) at time t + 24? How does this amount compare to the t + 24 net payment computed in part a?

ANSWER. Given the interest rates presented in the problem, we can use interest rate parity to compute the 6-month forward rate at time t + 18 as ¥128.58/$: 0.021 2 = ¥128.58 f 180 = 131x 0.059 1+ 2 1+

3M will pay out $2.9 million (0.059/2 * $100,000,000) and receive $647,056 (0.013/2 * 12,800,000 * 1/128.58). The latter figure is calculated by converting its yen receipt into dollars at the forward rate of ¥128.58/$. 3M’s net payment equals $2,252,944 ($2,900,000 - $647,056). This amount is $29,367 more than the net payment of $2,223,577 it would have made otherwise. 4.d. Does it make sense for 3M to hedge its receipt of yen from BT? Explain. ANSWER. No. As it now stands, 3M receives yen and pays out yen, resulting in a zero net exposure on the swap (aside from the net 0.05% semiannual yen receipt). Hedging would expose 3M to currency risk and negate the purpose of the cross-currency swap, which is to allow 3M to engage in arbitrage while being shielded from currency risk. 5. Suppose LIBOR3 is 7.93% and LIBOR6 is 8.11% . What is the forward forward rate for a LIBOR3 deposit to be placed in three months? ANSWER. Through arbitrage, the future value in six months of $1 invested today must be the same whether we invest at LIBOR3 today and enter into a forward forward for the following three months or invest at LIBOR6 today. That is,

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(1 + LIBOR3/4)(1 + r/4) = 1 + LIBOR6/2 where r equals the forward forward rate for a LIBOR3 deposit to be placed in three months. Substituting numbers from the problem, we have 1.0198(1 + r/4) = 1.04055. Solving this equation yields r = 8.13%. 6. Suppose that Skandinaviska Ensilden Banken (SEB), the Swedish bank, funds itself with three-month Eurodollar time deposits at LIBOR. Assume that Alfa Laval comes to SEB seeking a one-year, fixed-rate loan of $10 million, with interest to be paid quarterly. At the time of the loan disbursement, SEB raises three-month funds at 5.75%, but has to roll over this funding in three successive quarters. If it does not lock in a funding rate and interest rates rise, the loan could prove to be unprofitable. The three quarterly re-funding dates fall shortly before the next three Eurodollar futures contract expirations in March, June, and September. 6.a. At the time the loan is made, the price of each contract is 94.12, 93.95, and 93.80. Show how SEB can use Eurodollar futures contracts to lock in its cost of funds for the year. What is SEB’s hedged cost of funds for the year? ANSWER. The formula for the locked-in LIBOR, r, given a price P of a Eurodollar futures contract is r = 100 - P. Using this formula, the solution r for each of the contracts is 5.82%, 6.05%, and 6.2%. So SEB can lock in a cost for its $10 million loan equal to $10,000,000 * (1 + 0.0575/4)(1 + 0.0582/4)(1 + 0.0605)(1 + 0.062/4) = $10,608,927, which is equivalent to a one-year fixed interest rate of 6.09%. Effectively, this procedure rolls over the principal and cumulative interest payment each quarter until it is paid off in a lump sum at the end of the fourth quarter. 6.b. Suppose that the settlement prices of the March, June, and September contracts are, respectively, 92.98, 92.80, and 92.66. What would have been SEB’s unhedged cost of funding the loan to Alfa Laval? ANSWER. We can solve this problem by using the insight that at the time of settlement, arbitrage will ensure that the settlement price for a Eurodollar futures contract will be virtually identical to the actual LIBOR on that date. Given the stated prices at settlement, actual LIBOR on each rollover date was 7.02%, 7.2%, and 7.34%. Based on these figures, the unhedged cost of the loan is $10,000,000 * (1 + 0.0575/4)(1 + 0.0702/4)(1 + 0.072/4)(1 + 0.0734/4) = $10,700,379. This is equivalent to an annual rate of 7.00%, or 91 basis points more than the hedged cost of the loan. ADDITIONAL CHAPTER 8 PROBLEMS AND SOLUTIONS 1. Company A, a low-rated firm, desires a fixed-rate, long-term loan. Company A currently has access to floating-rate funds at a margin of 1.5% over LIBOR. Its direct borrowing cost is 13% in the fixed-rate bond market. In contrast, Company B, which prefers a floating-rate loan, has access to fixed-rate funds in the Eurodollar bond market at 11% and floating-rate funds at LIBOR + 0.50%. 6.a. How can A and B use a swap to advantage? ANSWER. Based on the numbers presented, there is an anomaly between the two markets: One judges that the difference in credit quality between the two firms is worth 200 basis points, whereas the other determines that this difference is worth only 100 basis points. The parties can share between themselves the difference of 100 basis points by engaging in a currency swap. This transaction would involve A borrowing floating-rate funds and B borrowing fixed-rate funds and then swapping the proceeds.

CHAPTER 8: SWAPS AND INTEREST RATE DERIVATIVES

6.b. Suppose they split the cost savings. How much would A pay for its fixed-rate funds? How much would B pay for its floating-rate funds? ANSWER. If they split the cost savings, the resulting costs to the two parties would be 12.5% for A and LIBOR for B, calculated as follows: Party

Normal Funding Cost

Cost After Swap

Difference

Counterparty A Counterparty B

13.00% LIBOR + 0.5%

12.50% LIBOR

0.50% 0.50% 1.00%

2. Square Corp. has not tapped the Swiss-franc public debt market because of concern about a likely appreciation of that currency and only wishes to be a floating-rate dollar borrower, which it can be at LIBOR + 3/8%. Circle Corp. has a strong preference for fixed-rate Swiss-franc debt, but it must pay 0.5% more than the 5 1/4% coupon that Square Corp.’s notes would carry. Circle Corp., however, can obtain Eurodollars at LIBOR flat (a zero margin). What is the range of possible cost savings to Square from engaging in a currency swap with Circle? ANSWER. Square Corp. can borrow fixed-rate Swiss francs at 5.25% and floating-rate dollars at LIBOR + 3/8%. Meanwhile Circle Corp. can borrow fixed-rate Swiss francs at 5.75% and floating-rate dollars at LIBOR flat. The logical set of transactions under these circumstances would be (1) Square borrows fixed-rate francs, (2) Circle borrows floating-rate dollars, and (3) the companies then swap the payment streams. The maximum benefit to Square arises when it provides fixed- rate francs to Circle at 5.75% (Circle is no worse off under this scenario) and receives floating-rate dollars at LIBOR, which is Circle's cost of funds (Circle is again no worse off under this scenario). This swap will cut Square’s cost of funds to LIBOR - 0.5%, which is a savings of 0.875%. At worst, Square will receive no benefit from the swap (otherwise it will not enter into it). Thus, the range of possible cost savings to Square from engaging in a currency swap with Circle is from 0% up to 0.875%. 3. Nestle rolls over a $25 million loan priced at LIBOR3 on a three-month basis. The company feels that interest rates are rising and that rates will be higher at the next roll-over date in three months. Suppose the current LIBOR3 is 5.4375%. 3.a. Explain how Nestle can use an FRA at 6% from Credit Suisse to reduce its interest rate risk on this loan. ANSWER. Nestle can use the FRA priced at 6% to lock in today LIBOR3 of 6% at its next rollover date three months from now. Whatever LIBOR3 is at the rollover date, Nestle will pay LIBOR3 of 6% in three months time.

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3.b. In three months, interest rates have risen to 6.25%. How much will Nestle receive/pay on its FRA? What will be Nestle's hedged interest expense for the upcoming three-month period? ANSWER. According to Equation 9.1 in the chapter, Nestle will receive an amount of interest (it will be a recipient because LIBOR3 on the rollover date exceeds the rate agreed to on its FRA) computed as:

(LIBOR - forward rate)( Interest payment = notional principalx 1 + LIBOR x(

days ) 360

Substituting in the figures from the problem yields an interest payment from Credit Suisse of $15,385:

90 ) 360 Interest payment = $25,000,000 x = $15,385 90 1 + 0.0625x( ) 360 (0.0625 - 0.06)(

3.c.

After three months, interest rates have fallen to 5.25%. How much will Nestle receive/pay on its FRA? What will be Nestle’s hedged interest expense for the next three-month period?

ANSWER. Under this interest rate scenario, Nestle must pay to Credit Suisse an amount equal to $46,268. 4. Ford has a $20 million Eurodollar deposit maturing in two months that it plans to roll over for a further six months. The company's treasurer feels that interest rates will be lower in two months time when rolling over the deposit. Suppose the current LIBOR6 is 7.875%. 4.a. Explain how Ford can use an FRA at 7.65% from Banque Paribas to lock in a guaranteed six-month deposit rate when it rolls over its deposit in two months. ANSWER. Ford today can enter into the FRA and guarantee itself a six-month deposit rate in two months of 7.65%. Specifically, Ford will sell a “2 x 6” FRA on LIBOR at 7.65% to Banque Paribas for a notional principal of $20 million. This means that Banque Paribas Trust has entered into a two-month forward contract on six-month LIBOR. Two months from now, if LIBOR6 is less than 7.65%, Banque Paribas will pay Ford the difference in interest expense. If LIBOR6 exceeds 7.65%, Ford will pay Banque Paribas the difference. 4.b. After two months, LIBOR6 has fallen to 7.5%. How much will Ford receive/pay on its FRA? What will be Ford's hedged deposit rate for the next six-month period? ANSWER. In this case, Ford will receive from Banque Paribas $20,000,000 * (0.0765 - 0.075)/2 = $15,000, giving it an annualized hedged deposit rate of 7.65% for the next six months. 4.c.

In two months, LIBOR6 has risen to 8%. How much will Ford receive/pay on its FRA? What will be Ford’s hedged deposit rate for the next six months?

ANSWER. In this case, Ford will pay Banque Paribas $20,000,000 *x (0.08 - 0.0765)/2 = $35,000, giving it – as before – an annualized hedged deposit rate of 7.65% for the next six months.

CHAPTER 9: MEASURING AND MANAGING ACCOUNTING EXPOSURE

CHAPTER 9 MEASURING AND MANAGING TRANSLATION AND TRANSACTION EXPOSURE This chapter introduces the concept of accounting exposure and describes the various alternatives available to measure accounting exposure and to manage it. A key point is the wide disparity in results possible for similarly situated firms when using different measures of translation exposure. Although the material is fairly mechanical, financial officers of MNCs should understand how companies measure exposure, at least for reporting purposes. When it comes to managing accounting exposure, companies have a number of different alternatives. Before deciding on which hedging alternatives to use, however, companies must first decide what they are trying to accomplish through their hedging programs. KEY POINTS ON MEASURING ACCOUNTING EXPOSURE 1. Accountants are concerned with the appropriate way to translate foreign-currency-denominated items on financial statements to their home currency values. If currency values change, translation gains or losses may result. 2. Four principal translation methods are available: the current/noncurrent method, the monetary/ nonmonetary method, the temporal method, and the current-rate method. 3. The past and present mandated translation methods are FASB-8 and FASB-52, respectively. 4. Regardless of the translation method selected, measuring accounting exposure is conceptually the same. It involves determining which foreign-currency-denominated assets and liabilities will be translated at the current (postchange) exchange rate and which will be translated at the historical (prechange) exchange rate. The former items are considered to be exposed, while the latter items are regarded as not exposed. Translation exposure is just the difference between exposed assets and exposed liabilities. 5. By far the most important feature of the accounting definition of exposure is the exclusive focus on the balance sheet effects of currency changes. This focus is misplaced since it has led firms to ignore the more important effect that these changes may have on future cash flows. KEY POINTS ON MANAGING ACCOUNTING EXPOSURE 1. Hedging cannot provide protection against expected exchange rate changes. Firms ordinarily cope with anticipated currency changes by engaging in forward contracts, borrowing locally, and adjusting their pricing and credit policies. However, there is reason to question the value of much of this activity.

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Several empirical studies indicate that forward rates provide an unbiased estimate of future spot rates. Furthermore, according to the IFE, interest differentials between currencies equal anticipated currency devaluations or revaluations. This proposition is also supported by empirical research. What this means is that gains or losses on contractual flows in hard currencies (those likely to revalue) will be offset by low interest rates and on soft currencies (those likely to be devalued) by higher interest rates. In fact, no other results would be consistent with the existence of a well-informed market with numerous participants as is represented by the international financial community. Persistent differences between forward and future spot rates, for instance, would provide profitable opportunities for speculators. However, the very act of buying or selling forward to take advantage of these differences would tend to bring about equality between hedging costs and expected currency changes. It is good business sense, of course, to factor expected exchange rate changes into pricing and credit decisions, since this is very relevant information and helps the company make better marketing and purchasing decisions. But because this is a zero-sum game, these trade-term adjustments can only be profitable at the expense of others. To consistently gain excess profits by making trade-term adjustments, one must consistently deal with less knowledgeable people. Certainly, though, a policy predicated on the continued existence of naive customers or suppliers is unlikely to be viable for very long in the highly competitive and well-informed world of international business. The real value to a firm of factoring currency change expectations into its pricing and credit decisions is to prevent others from profiting at its expense. The basic value of hedging, therefore, is to protect a company against unexpected exchange rate changes. But because such changes are unpredictable, they are impossible to profit from. Of course, to the extent that a government does not permit interest and/or forward rates to fully adjust to reflect market expectations, a firm with access to these financial instruments can expect, on average, to gain from currency changes. Nevertheless, the very nature of these imperfections severely limits a firm’s ability to engage in such profitable financial operations. 2. A policy of continual hedging will not reduce fluctuations in earnings caused by currency changes. It is true that a U.S. company selling to French customers, for example, can fix the dollar value of its franc revenues for the next three months or so, perhaps up to one year. For anything beyond that, however, the firm faces exchange risk, even if it plans on using the forward market consistently, since it must eventually roll these forward contracts over. Several studies have shown that the volatility of rates in the forward and spot markets, as measured by the standard deviation, is about the same. Furthermore, the foreign currency cash flows received by an MNC will themselves be affected by exchange rate changes. Specifically, currency changes will impact the competitive

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environment and cost structure faced by the firm, which in turn affects the firm’s foreign currency revenues and costs. The net result is that repeated forward hedging can do little to reduce the variability of future dollar cash flows caused by exchange rate changes. Although the occasional exporter can avoid unprofitable transactions by looking at the forward rate and selling in the home market if it is too low, the committed exporter or MNC has no such recourse. Instead, it must undertake the necessary restructuring of its marketing and production activities because its very existence depends on the continuation of these foreign sales. A policy of continued hedging transfers fluctuations in reported income due to translation gains or losses into earnings variations caused by changes in interest and forward rates. While this distinction may be important to a financial executive whose boss is concerned with exchange gains or losses, it is unlikely to be of consequence to the firm’s shareholders.

SUGGESTED ANSWERS TO “CHRYSLER SHARES ITS CURRENCY RISK WITH MITSUBISHI” MINI-CASE 1. Show how the dollar cost to Chrysler of an engine changed over the range ¥240/$ to ¥100/$. ANSWER. According to the case, from ¥240 to ¥220 to the dollar, Mitsubishi would absorb the entire cost of an exchange rate change. Within the range ¥220/$ to ¥190/$, Chrysler and Mitsubishi split the cost of exchange rate shifts evenly. In the range ¥190/$ to ¥130/$, Chrysler bore 75% of the costs of exchange rate shifts; below ¥130/$, Chrysler had to absorb the entire cost. These contractual terms translate into the following contractual exchange rates, where x is the contractual rate and e is the actual rate: e = ¥240 to ¥220: x = ¥240 e = ¥220 to ¥190: x = ¥240 – (¥220 – e)/2 or 240 < x < 225 e = ¥190 to ¥130: x = ¥240 – (¥220 – ¥190)/2 – 0.75 x (¥190 – e) or 225 < x < 180 e = ¥130 to ¥100: x = ¥240 – (¥220 – ¥190)/2 – 0.75 x (¥190 – ¥130) – (¥130 – e) or 190 < x < 150 Given that the price of a V6 engine was contractually set at ¥270,000, the price of an engine to Chrysler would be 270,000/x. This formula translates into the following engine prices, p, for Chrysler: e = ¥240 to ¥220: x = ¥240 and p = $1,125 e = ¥220 to ¥190: 240 < x < 225 and $1,125 < p < $1,200 e = ¥190 to ¥130: 225 < x < 180 and $1,200 < p < $1,500 e = ¥130 to ¥100: 190 < x < 150 and $1,500 < p < $1,800

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2. Show how Mitsubishi’s yen revenue per engine changed over the range ¥240/$ to ¥100/$. ANSWER. At any given exchange rate, Mitsubishi’s yen revenue equals Chrysler’s dollar price times the actual exchange rate; that is, it equals p * e (or pe). As such, Mitsubishi’s yen revenue varied as follows: e = ¥240 to ¥220: p = $1,125 and 247,500 < pe < 270,000 e = ¥220 to ¥190: $1,125 < p < $1,200 and 228,000 < pe < 247,500 e = ¥190 to ¥130: $1,200 < p < $1,500 and 195,000 < pe < 228,000 e = ¥130 to ¥100: $1,500 < p < $1,800 and 180,000 < pe > 195,000 3. Suppose at the time of a new engine shipment, the exchange rate was ¥150/$. What was the dollar cost to Chrysler per engine? What was Mitsubishi’s yen revenue per engine? ANSWER. Using the formulas above, the exchange rate would be set at ¥195 and Chrysler’s dollar cost per engine would be $1,384.62 (270,000/195). This dollar figure would translate into revenue to Mitsubishi of ¥207,692.31 (150 * 1,384.62). SUGGESTED ANSWERS TO DKNY MINI-CASE DKNY owes Mex$7 million in 30 days for a recent shipment from Mexico. It faces the following interest and exchange rates: Spot rate: Forward rate (30 days): 30-day put option on dollars at Mex$ 10.83/$: 30-day call option on dollars at Mex$ 11.03/$: U.S. dollar 30-day interest rate (annualized): Peso 30-day interest rate (annualized):

Mex$10.93/$ Mex$11.03/$ 1% premium 3% premium 7.5% 15%

1. What hedging options are available to DKNY? ANSWER. DKNY could use a forward market hedge, money market hedge, or call option on the Mexican peso (a put option would be worthless as DKNY needs to buy, not sell, pesos to make its peso payment). 2. What is the hedged cost of DKNY's payable using a forward market hedge? ANSWER. In other words, what dollar cost of the payable can DKNY lock in using the forward contract? By buying pesos forward, DKNY can lock in a dollar cost of $634,632.82 (7,000,000/11.03). 3. What is the hedged cost of DKNY's payable using a money market hedge? ANSWER. DKNY can hedge its payable by borrowing the dollar equivalent of the present value of the Mex$7 million payable, which equals Mex$6,913,580 (7,000,000/1.0125), converting the dollars to pesos at the current spot rate and investing the proceeds at the 1.25% monthly peso interest rate (15%/12). Mex$6,913,580 translates to $632,532.48 at the current spot rate of Mex$10.93/$ (Mex$6,913,580/10.93). This investment is financed by borrowing these dollars at the monthly rate of 0.625% (7.5%/12). At the end of 30 days, DKNY will pay off this dollar loan. The cost of doing so is $636,485.8 ($632,532.48 * 1.00625). The result from this money market hedge is the equivalent of buying forward the Mex$7 million at a forward rate of Mex$10.99 (7,000,000/636,485.8). From the standpoint of the treasurer, this is a worse rate than could be realized directly in the forward market.

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4. What is the hedged cost of DKNY’s payable using a put option? ANSWER. By buying a peso put option, DKNY can lock in a cost of $652,757 – the sum of the 1% put premium of $6,404.4 (0.01 * 7,000,000/10.93) plus the $646,352.7 (7,000,000/10.83) cost of buying pesos through the put option at a rate of Mex$10.83/$. (Notice that a put option on dollars with peso receipt is exactly the same as a call option on pesos. Hence, the terms can be used interchangeably as long as you bear in mind which currency is being bought and which is being sold.). Although it looks as if the put option costs $16,272 more than the forward contract, these costs are not strictly comparable, because the put option gives DKNY the option to buy pesos in the spot market in 30 days if the spot rate of the dollar at that time exceeds the exercise price of Mex$10.83/$. Hence, the $652.757 cost is the maximum cost of using a put option. Conversely, with a forward contract, DKNY must buy pesos at Mex$11.03/$ even if the spot rate at time of settlement is lower at, say, Mex$11.22/$. The value of this option accounts for the 1% premium that DKNY must pay to acquire the put option. 5. At what exchange rate is the cost of the put option just equal to the cost of the forward market hedge? to the cost of the money market hedge? ANSWER. The answer to this question depends on recognizing that at any exchange rate less than Mex$11.03/$, the forward contract will always be less expensive than the put option by the amount of the put premium, or $6,404, plus the additional cost of buying pesos at a rate of less than Mex$ 11.03/$. For a spot rate in 30 days, S30, greater than Mex$10.83/$, the put option will not be exercised and so DKNY’s cost of hedging its payable via the peso put option will be just the put premium plus the cost of buying pesos in the spot market, or $6404 + 7,000,000/S30. At the same time, since the forward contract must always be settled, the cost of hedging the payable with a forward contract will always be $634,632. To find the exchange rate at which the cost of using the put option just equals the cost of using the forward contract, we set these two figures equal: $6404 + 7,000,000/S30 = $634,632 or

S30 = 7,000,000/628,228 = Mex$11.143/$

6. How can DKNY construct a currency collar? What is the net premium paid for the currency collar? Using this currency collar, what is the net dollar cost of the payable if the spot rate in 30 days is Mex$10.75/$? Mex$11.03/$? Mex$11.25/$? ANSWER. DKNY can create a currency collar by simultaneously buying an out-of-the-money put option and selling an out-of-the-money call option of the same size. In effect, the purchase of the put option is financed by the sale of the call option. Specifically, DKNY can buy a put option on dollars at Mex$10.83/$ and sell a call option on dollars at Mex$11.03/$. The net premium paid is actually a receipt of funds in the amount of $12,987, the difference between the $6,404 (0.01 * 7,000,000/10.93) paid for the put option and the $19,391 (0.03 * 7,000,000/10.83) received from the sale of the call option. If the spot rate in 30 days is Mex$10.75/$, DKNY will exercise its put option and pay $646,353 to buy pesos at a rate of Mex$10.83. At the same time, the buyer of the call option will allow its option to sell Mex$7,000,000 to DKNY at a price of Mex$11.03 to expire unexercised. The net dollar cost of the payable, therefore, is $626,962, the difference between the $646,353 paid for the pesos and the $19,391 net option premium received.

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At a spot rate of Mex$11.03/$, DKNY will allow its option to buy pesos to expire unexercised as will the holder of the call option to buy Mex$7 million at a price of Mex$11.03. DKNY’s net dollar cost of hedging its payable, including receipt of the $10,769 net option premium, will be $615,241 ($634,632 $19,391). This figure also equals the net cost to DKNY of hedging its payable if the 30-day spot rate is Mex$11.25/$ because similar dynamics will hold – DKNY will not exercise its option but will end up buying pesos at a price of Mex$11.03/$ anyway because of the call option. That is, at a spot rate of Mex$11.25/$, DKNY will allow its option to buy pesos to expire unexercised but it will be forced by the holder of the call option to buy Mex$7 million at a price of Mex$11.03/$, or $634,632 (7,000,000/11.03). Hence, DKNY’s net dollar cost of hedging its payable, including receipt of the $19,391 net option premium, will be $615,241. 7. What is the preferred alternative? ANSWER. The preferred alternative would ordinarily be the forward contract because it precisely targets the risk and is less expensive than the money market hedge. However, we have seen from the answer to part e that the cost of the currency collar, even at its maximum, will be less expensive than the forward contract ($626,962 versus $634,632). 8. Suppose that DKNY expects the 30-day spot rate to be Mex$11.25/$. Should it hedge this payable? What other factors should go into DKNY’s hedging decision? ANSWER. The key question here is where DKNY’s comparative advantage lies. Does it lie in making and selling designer clothes or does it reside in trying to outguess apparently sophisticated financial markets? If the former, which I am sure most would agree with, DKNY should stick to its knitting (literally) and leave the speculation to financial institutions specifically organized for that purpose. Remember, to profit from speculative activity, your opinion not only has to differ from the market’s, it also has to be more correct. Hence, the related question is: What are the odds that DKNY knows something that the financial markets don’t and that DKNY is right? I would guess these to be long odds indeed. SUGGESTED ANSWERS TO CHAPTER 9 QUESTIONS 1. What is translation exposure? Transaction exposure? ANSWER. Translation exposure equals the difference between exposed assets and exposed liabilities. A foreign currency asset or liability is exposed if it must be translated at the current exchange rate. Transaction exposure equals the net amount of foreign-currency denominated transactions already entered into. On settlement, these transactions may give rise to currency gains or losses. 2. What are the basic translation methods? How do they differ? ANSWER. The basic translation methods are the current/noncurrent method, monetary/nonmonetary method, temporal method, and current-rate method. The current/noncurrent method treats only current assets and liabilities as being exposed. The monetary/nonmonetary method treats only monetary assets and liabilities as being exposed. The temporal method translates assets and liabilities valued at current cost as exposed and historical cost assets and liabilities as unexposed. The current rate method treats all assets and liabilities as exposed.

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3. What factors affect an MNC’s translation exposure? What can the company do to affect its degree of translation exposure? ANSWER. The factors affecting an MNC’s translation exposure under FASB 52 include the currency of the primary economic environment in which the company (or its affiliate) does business, the currency in which it invoices its sales, the currency in which it negotiates to buy, the currency denomination of its borrowings, the currency denomination of the securities in which it invests surplus cash, and the location of its customers. This list suggests the actions that a company can take to affect its degree of translation exposure: borrow, invest, and invoice both sales and purchases in the local currency. It also has some degree of control over which customers to serve – foreign or domestic – but this decision should be based on economic profitability rather than its impact on translation exposure. 4. What alternative hedging transactions are available to a company seeking to hedge the translation exposure of its German subsidiary? How would the appropriate hedge change if the German affiliate's functional currency is the U.S. dollar? ANSWER. As mentioned in the text, the parent has three available methods for managing its translation exposure: (1) adjusting fund flows, (2) entering into forward contracts, and (3) exposure netting. Direct funds-adjustment methods include pricing exports in hard currencies and imports in a soft currency, investing in hard-currency securities, and replacing hard-currency borrowings with local currency loans. The indirect methods include adjusting transfer prices on the sale of goods between affiliates; speeding up or slowing down the payment of dividends, fees, and royalties; and adjusting the leads and lags of intersubsidiary accounts. The standard techniques for responding to anticipated currency changes are summarized in Exhibit 9.1. The translation exposure would change if the functional currency were the U.S. dollar. For example, U.S. dollar transactions with the German sub would be considered exposed if the DM were the functional currency; by contrast, U.S. dollar transactions are exposed if the DM is the functional currency. 5. To eliminate all risk on its exports to Japan, an MNC decides to hedge both its actual and anticipated sales. What risk is the MNC exposing itself to? How could this risk be managed? ANSWER. The company faces uncertainty as to what its future yen sales revenue will be. This uncertainty stems from quantity risk, the risk that those future sales will not materialize, and price risk, the uncertainty as to the yen prices it can expect to realize in Japan. If it uses forward contracts to hedge its uncertain future yen sales revenue, it faces the risk that it will overhedge, winding up with yen liabilities not offset by yen assets. The company can protect itself by using forward contracts to hedge the certain component of its expected future yen sales then hedging the remainder of its projected sales revenue with currency options. 6. Instead of its previous policy of always hedging its foreign currency receivables, Sun Microsystems has decided to hedge only when it believes the dollar will strengthen. Otherwise, it will go uncovered. Comment on this new policy. ANSWER. Sun is engaging in selective hedging, which is really speculation. Sun faces the risk that it will be unhedged when foreign currencies weaken and be hedged when they strengthen. The purpose of hedging is to reduce risk, not to boost profits.

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7. Your bank is working with an American client that wishes to hedge its long exposure in the Malaysian ringgit. Suppose it is possible to invest in ringgit but not borrow in that currency. However, you can both borrow and lend in U.S. dollars. 7.a. Assuming there is no forward market in ringgit, can you create a homemade forward contract that would allow your client to hedge its ringgit exposure? ANSWER. To hedge its ringgit exposure, your bank’s American client should short the ringgit. This strategy would entail buying a forward contract from your bank. To create this forward contract, the bank needs to borrow ringgit, sell the proceeds spot for dollars, and invest the dollars. Unfortunately, since the bank can’t borrow ringgit, it cannot create the needed forward contract. 7.b. Several of your Malaysian clients are interested in selling their U.S. dollar export earnings forward for ringgit. Can you accommodate them by creating a forward contract? ANSWER. You can create the necessary forward contract by borrowing U.S. dollars, converting them to ringgit, and investing the ringgit until the forward contract you sell your Malaysian clients matures. 8. Eastman Kodak gives its traders bonuses if their selective hedging strategies are less expensive than the cost of hedging all transaction exposure. What are the problems with this bonus plan? ANSWER. The danger is that Kodak’s traders will take inappropriate risks to earn their bonuses. Specifically, they are being incented to engage in selective hedged, which runs the risk of leaving Kodak unhedged when the dollar is rising and being hedged when the dollar is falling. 9. Many managers prefer to use options to hedge their exposure because doing so allows them the possibility of capitalizing on favorable movements in the exchange rate. In contrast, a company using forward contracts avoids the downside but also loses the upside potential. Comment. ANSWER. Options are clearly more valuable than forward contracts for the reasons stated in the question. However, this does not mean that options are preferable to forward contracts. The reason has to do with cost. Options are more expensive than forward contracts at the same forward rate or exercise price. One must trade off the added benefits of options against their higher costs. To the extent that these derivative markets are efficient – and the evidence suggests they are – the expected net present value of entering into either of these contracts is zero. The appropriate use of these derivatives is to hedge foreign exchange risk, not to speculate on future exchange rate movements. As explained in the chapter, one should match the derivative against the type of risk being hedged: Known risks should be hedged with forward contracts and contingent risks with options.

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10. In January 1988, Arco bought a 24.3% stake in the British oil firm Britoil PLC. It intended to buy a further $1 billion worth of Britoil stock if Britoil was agreeable. However, Arco was uncertain whether Britoil, which had expressed a strong desire to remain independent, would accept its bid. To guard against a possible a pound appreciation in the interim, Arco decided to convert $1 billion into pounds and place them on deposit in London, pending the outcome of its discussions with Britoil’s management. What exchange risk did Arco face and did it choose the best way to protect itself from that risk? ANSWER. The exchange risk faced by Arco was that it had a contingent pound liability (the cost of its possible purchase of Britoil) offset by a fixed pound asset (the deposit). If the deal went through, Arco would know exactly how many dollars its bid will cost, namely, $1 billion. But if the deal fell apart (which it did), Arco would have a large bank account in London with an uncertain dollar value. Hedging that deposit would not eliminate exchange risk because if the deal went through Arco would not know at the time of its offer how many dollars it would take to buy $1 billion worth of shares at today’s exchange rate. (This analysis leaves aside the issue of fluctuations in the dollar price of Britoil shares.) Note that it doesn’t make sense to convert dollars into pounds and then hedge those pounds. Assuming IRP holds, Arco might as well have deposited dollars. The solution for Arco is to buy a call option on $1 billion worth of pounds at the current spot exchange rate. This limits Arco’s downside risk to the call premium, while enabling it to capitalize on an appreciation in the value of the pound. 11. Sumitomo Chemical has one week in which to negotiate a contract to supply products to a U.S. company at a dollar price fixed for one year. What advice would you give Sumitomo? ANSWER. This problem is identical to that faced by Weyerhaeuser in the text example. The general rule on credit sales overseas is to convert between the foreign currency price and the dollar price using the forward rate, not the spot rate. With a sequence of payments to be received at several points in time, the foreign currency price should be a weighted average of the forward rates for delivery on those dates. Here, Sumitomo should decide on the yen price that it would set and then convert that yen price into a dollar price using the forward rate or an average of forward rates, depending on whether it will be paid all at once or in installments. 12. U.S. Farm-Raised Fish Trading Co., a catfish concern in Jackson, Mississippi, tells its Japanese customers that it wants to be paid in dollars. According to its director of export marketing, this simple strategy eliminates all its currency risk. Is he right? Why? ANSWER. The marketing director for U.S. Farm-Raised Fish Trading Co. is confusing transaction exposure with economic exposure. By pricing in dollars, the company eliminates its transaction exposure. But it still has operating exposure. As the yen falls in value, if the firm maintains its dollar price, the yen price of its fish rises and Japanese customers will buy less fish. If the dollar price is reduced to maintain market share, the profit margin falls. Either way, dollar revenues and profits fall. Conversely, a falling dollar will boost the dollar profitability of selling to Japan.

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13. The Montreal Expos is a major-league baseball team located in Montreal, Canada. What currency risk is faced by the Expos, and how can this exchange risk be managed? ANSWER. Payroll costs account for the lion’s share of baseball costs. The team has currency risk since it pays its players in U.S. dollars while its principal source of income, from home game ticket sales, is in Canadian dollars. This currency mismatch means trouble when the U.S. dollar appreciates relative to the Canadian dollar. Most importantly, salaries for Expo ballplayers are based on the salaries these players would earn in the U.S.; they are not based on Canadian salaries. An extended discussion of the Toronto Blue Jays, another Canadian major league baseball team, appears in Section 9.4 and sheds further light on the currency risk faced by baseball teams. The Expos might protect themselves by doing what the Blue Jays do: Buy U.S. dollars forward. The larger the purchase, the greater the amount of protection. Typically, though, the Blue Jays buy enough U.S. dollars to cover their projected currency needs for the coming year. While this strategy protects them for next year, it doesn’t hedge their longer-term exposure. 14. General Electric recently had to put together a $50 million bid, denominated in Swiss francs, to upgrade a Swiss power plant. If it won, GE expected to pay subcontractors and suppliers in five currencies. The payment schedule for the contract stretched over a five-year period. 14.a. How should GE establish the Swiss franc price of its $50 million bid? ANSWER. GE should begin with the price it would set if the bid were in dollars, and then convert the expected cash inflows into Swiss francs at the forward rates prevailing for each of the dates on which it expects to receive a cash inflow. 14.b. What exposure does GE face on this bid? How can it hedge that exposure? ANSWER. To begin, GE is not certain of winning the bid. To hedge this quantity risk (it’s uncertain as to how many Swiss francs it will be receiving – either 0 or the amount of its bid), Westinghouse should buy a Swiss franc put option for the amount of its bid, less the amount of Swiss francs it expects to pay out. It should simultaneously buy call options in the amounts of the non-Swiss franc foreign currency cash payments it will be making if it wins the contract. If it wins the bid, GE should convert the SFr put option into a series of SFr forward sales, with the amounts and maturities of the forward contracts timed to coincide with the net Swiss franc inflows. At the same time, GE should convert the foreign currency call options into forward purchases of those foreign currencies, with the maturities and amounts of these contracts timed to coincide with the payments in those currencies. 15. Dell Inc. produces its machines in Asia with components largely imported from the U.S. and sells its products in various Asian nations in local currencies. 15.a. What is the likely impact on Dell’s Asian profits of a strengthened dollar? Explain. ANSWER. Dell’s dollar costs largely stay fixed whereas its dollar revenues will decline. Thus, a strengthened dollar reduced Dell’s dollar profits on its Asian sales.

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15.b. What hedging technique(s) can Dell employ to lock in a desired currency conversion rate for its Asian sales during the next year? ANSWER. Dell can use forward or futures contracts to sell the local currencies forward against the dollar in an amount equal to its projected annual local currency sales. It can also buy put options on the various Asian currencies that it can exercise in the event of dollar appreciation. 15.c. Suppose Dell wishes to lock in a specific conversion rate but does not want to foreclose the possibility of profiting from future currency moves. What hedging technique would be most likely to achieve this objective? ANSWER. Buying put options on the local currencies would allow Dell to offset its currency losses with gains on its put options if the local currencies depreciate against the dollar. If the local currencies remain stable or strengthen, Dell would just allow the options to expire unexercised and convert its local currency revenues at the higher spot rates. 15.d. What are the limits of Dell’s hedging approach? ANSWER. This approach will cover Dell for the first year. But if the dollar strengthens, when Dell goes to roll over its forwards or options to hedge the next year’s revenues, it will pay a price for these contracts that reflects the devalued exchange rates of the local Asian currencies. ADDITIONAL CHAPTER 9 QUESTIONS AND ANSWERS 1. Why was FASB-8 so widely criticized? How did the Financial Accounting Standards Board respond to this criticism? ANSWER. The major criticism of FASB 8 was that by disallowing all currency reserves, translation gains and losses flowed right through to the income statement, often leading to dramatic fluctuations in reported income. The corporate belief that this was a problem stemmed from the view that financial markets focus on earnings rather than cash flows. 2. A U.S. firm has fully hedged its sterling receivables and has bought credit insurance to cover the risk of default. Has this firm eliminated all risk on these receivables? Explain. ANSWER. No. The company has converted its sterling receivables into a fixed amount of dollars to be received in the future. But because this sum of money is set in nominal terms, the firm bears exchange risk. That is, it knows how many dollars it will receive in the future but it does not know what the purchasing power of those dollars will be. 3. What is the basic translation hedging strategy? How does it work? ANSWER. As discussed in the chapter, the basic translation hedging strategy involves increasing hard-currency assets and decreasing soft-currency assets, while simultaneously decreasing hard-currency liabilities and increasing soft-currency liabilities. The specific techniques used to hedge a particular translation exposure all involve establishing an offsetting currency position (e.g., by means of a forward contract) such that whatever is lost or gained on the original currency exposure is exactly offset by a corresponding foreign exchange gain or loss on the currency hedge.

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3. MNCs can always reduce the foreign exchange risk faced by their foreign affiliates by borrowing in the local currency. True or false? Why? ANSWER. False. Currency risk is reduced when swings in operating profits due to currency changes are offset, in whole or in part, by opposite movements in the cost of servicing its debts. In this way, currency changes have less effect on dollar cash flows. Consider an MNC with a foreign subsidiary that manufactures for export. The subsidiary’s dollar operating cash flows will rise with LC appreciation and fall with LC depreciation. If the subsidiary borrowed in the local currency, then the dollar cost of servicing its liabilities would also rise with LC appreciation and fall with LC depreciation. This would reinforce, not dampen, the swings in its operating profits caused by the currency changes. 4. Can hedging provide protection against expected exchange rate changes? Explain. ANSWER. No. The explanation is contained in fundamental point #1 on managing accounting exposure at the start of this chapter discussion. 5. What is the domestic counterpart to exchange risk? Explain. ANSWER. The domestic counterpart to exchange risk is inflation risk. Exchange risk involves uncertain changes in the exchange rate between domestic currency and foreign currency (and, ultimately, between domestic currency and foreign goods and services), while inflation risk involves uncertain changes in the exchange rate between domestic currency and domestic goods and services. 6. If a currency that a company is long in threatens to weaken, many companies will sell that currency forward. Comment on this policy. ANSWER. A reasonable working hypothesis is that financial markets are efficient. If so, the expected currency depreciation will already be reflected in the forward rate in the form of a forward discount which exactly offsets the expected loss-reducing benefits of hedging. Thus the company will benefit from hedging only to the extent that it can estimate the probability and timing of the depreciation more accurately than the general market can. Unless the company has some special information about the future spot rate that it has good reason to believe is not adequately reflected in the forward rate, it should accept the forward rate’s predictive validity as a working hypothesis and avoid speculative activities. 7. Studies have shown that in trade dealings between nations that have high and volatile inflation rates, most export prices are quoted in dollars. What might account for this finding? ANSWER. What matters to both importer and exporter is the real price of the goods traded, not its nominal price. However, with high and uncertain inflation, if the currency of either of the two nations is used, both exporter and importer will face uncertainty as to the real price of the goods being traded. The exporter faces the risk that inflation will be higher than expected, lowering its real revenue. Conversely, the importer faces the risk that inflation will be lower than expected, raising its real cost of goods. By pricing in dollars, which is more likely to maintain its real value than either of their home currencies, both parties can reduce their risk.

CHAPTER 9: MEASURING AND MANAGING ACCOUNTING EXPOSURE

8. Kemp & Beatley is a New York importer of table linens and accessories. It hedges all its import orders using forward contracts. Does Kemp & Beatley face any exchange risk? Explain. ANSWER. Yes. According to the Wall Street Journal (September 27, 1984, p.7), “Kemp & Beatley recently made a sizable purchase of Japanese placemats just before the dollar strengthened again. Competitors, as a result, will be able to buy the items for less and the profit margins of Kemp & Beatley will be squeezed, said Lee Greenbaum, president. ‘We had to eat’ the price difference, he said.” Thus, even though hedging enables the company to lock in a dollar price for its cost of goods, its revenue fluctuates in line with the exchange rate; that is, the price at which it can sell its products depends on the replacement cost of these items, which varies with the exchange rate. 9. Liz Claiborne contracts out much of its production to foreign manufacturers. As such, the company faces currency risk. 9.a. What currency risk does Liz Claiborne face? ANSWER. If foreign manufacturers bill in their local currencies, Liz Claiborne is uncertain as to what the dollar cost of its orders will be, both now and in the future. If Liz Claiborne insists on dollar invoicing, the dollar price will likely vary with the exchange rate. Hence, although Liz Claiborne can lock in the dollar price of its current orders, it has no idea what the dollar costs of its future orders will be. 9.b. How might Liz Claiborne go about hedging its currency risk? ANSWER. Liz Claiborne can hedge its transaction exposure (equal to the amount of current orders invoiced in foreign currencies) using forward market or money market hedges, depending on their relative costs. The company can hedge its future orders, whether denominated in foreign currencies or in dollars, by buying forward the anticipated amounts of its foreign currency requirements. Liz Claiborne could also use a money market hedge (which would involve the company borrowing dollars and then investing these dollars in foreign money market instruments to create a foreign currency asset to offset its foreign currency liabilities) to lock in the dollar cost of its anticipated future orders. This method would be less practical than the forward market hedge since it would involve Liz Claiborne holding a large portfolio of foreign securities. 9.c.

What danger does it face from locking in currency rates today?

ANSWER. This question is similar to that in Problem 17. The assumption in the hedging analysis so far is that the dollar prices Liz Claiborne can charge customers for its clothes are unrelated to its dollar costs. However, to the extent that its competitors also use foreign manufacturers, a rise in dollar costs of foreign orders will affect all companies in the market to a similar degree. Hence, the companies will likely raise their dollar prices if their dollar costs rise since they have similar cost structures. If Liz Claiborne has hedged its foreign costs, it will earn higher margins. Conversely, if the dollar appreciates, competitors will likely cut their prices to reflect the lower cost of replacing their goods sold. If Liz Claiborne has already locked in a higher dollar price for its orders and tries to recoup its higher costs by raising its prices, it will be placed at a competitive disadvantage and will lose market share. On the other hand, if Liz Claiborne reduces its dollar prices to maintain its competitive position in the market, its margins will shrink since its dollar costs have not fallen. To properly hedge its operating exposure, Liz Claiborne must estimate the responsiveness of price in the marketplace to changes in foreign exchange rates. The more responsive these prices are to changes in costs (and the quicker this response), the less operating exposure faced by Liz Claiborne and the less it needs to hedge.

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SUGGESTED SOLUTIONS TO CHAPTER 9 PROBLEMS 1. Suppose that at the start and end of the year, Bell U.K., the British subsidiary of Bell U.S., has current assets of £1 million, fixed assets of £2 million, and current liabilities of £1 million. Bell has no long-term liabilities. 1.a. What is Bell U.K.’s translation exposure under the current/noncurrent, monetary/ nonmonetary, temporal, and current rate methods? ANSWER. Under the current/noncurrent method, Bell U.K.’s translation exposure is £1 million - £1 million, or 0. We cannot determine Bell U.K.’s translation exposure under the monetary/nonmonetary method because we do not know the monetary/nonmonetary breakdown of its assets and liabilities. Similarly, we cannot determine Bell U.K.’s temporal exposure because we do not know the breakdown of its current assets between inventory and monetary assets. Under the current rate method, Bell U.K.’s exposure is £3 million - £1 million = £2 million. 1.b. Assuming the pound is the functional currency, if the pound depreciated during that year from $1.50 to $1.30, what is the FASB 52 translation gain (loss) to be included in the equity account of Bell's U.S. parent? ANSWER. Under FASB 52, Bell U.K. has net pound exposure equal to £3 million - £1 million = £2 million. At the original exchange rate of $1.50, the value of this net exposure is $3 million. By the end of the year, this net pound exposure is worth only 2 million * $1.30 = $2.6 million. The net result is a translation loss for Bell U.K.’s parent equal to the difference between the beginning and end-of-year values or $400,000. 1.c.

Redo part b assuming the dollar is the functional currency. Included in current assets is inventory of £0.5 million. The historical exchange rates for inventory and fixed assets are $1.45 and $1.65, respectively. If the dollar is the functional currency, where does Bell U.K.'s translation gain of loss show up on Bell U.S.'s financial statements?

ANSWER. If the dollar is the functional currency, then FASB-52 mandates the use of the temporal method for translation purposes. Under the temporal method, the value of fixed assets and inventory stays constant. The only change is to its monetary assets of £0.5 million and current liabilities of £1 million, for net exposure of -£0.5 million. With negative translation exposure, a depreciation in the value of the pound from $1.50 to $1.30 will result in a translation gain of $0.20 * 500,000, or $100,000. This translation gain must be included in Bell U.K.’s income statement. 2. Rolls-Royce, the British jet engine manufacturer, sells engines to U.S. airlines and buys parts from U.S. companies. Suppose it has accounts receivable of $1.5 billion and accounts payable of $740 million. It also borrowed $600 million. The current spot rate is $1.9528/£. 2.a. What is Rolls-Royce’s dollar transaction exposure in dollar terms? In pound terms? ANSWER. Rolls-Royce has $160 million in dollar transaction exposure ($1.5 billion - $740 million $600 million). In pound terms, its transaction exposure equals £81.93 million (160,000,000/1.9528).

CHAPTER 9: MEASURING AND MANAGING ACCOUNTING EXPOSURE

2.b. Suppose the pound appreciates to $2.064/£. What is Rolls-Royce’s gain or loss, in pound terms, on its dollar transaction exposure? ANSWER. Translated at the new exchange rate, the value of its transaction exposure is now £77.5 million. Compared to the former value of its transaction exposure, the result is a loss of £4.43 million (£77.5 million - £81.93 million). 3. Zapata Auto Parts, the Mexican affiliate of American Diversified, Inc., had the following balance sheet on January 1: Assets (Mex$ millions) Cash, marketable securities Accounts receivable Inventory Fixed assets

Liabilities (Mex$ millions) Mex$ 1,000 50,000 32,000 111,000 Mex$ 194,000

Current liabilities Long-term debt Equity

Mex$ 47,000 12,000 135,000 Mex$ 194,000

The exchange rate on January 1 was Mex$8,000 = $1. 3.a. What is Zapata’s FASB 52 peso translation exposure on January 1? ANSWER. Zapata’s translation exposure depends on the functional currency used. If, over the past three years, Mexico’s rate of inflation has exceeded 100%, Zapata must use the dollar as its functional currency. Thus, translation exposure is measured using the temporal method. In this case, Zapata’s FASB 52 translation exposure will be (in peso millions) Mex$83,000 - Mex$59,000 = Mex$24,000, or $3 million. This calculation treats cash, receivables, inventory, current liabilities, and long-term debt as exposed, and equity and net fixed assets as unexposed. It also assumes that all these assets and liabilities are in pesos. If inflation has cooled off and the peso is the functional currency, translation exposure equals Zapata’s net worth of Mex$135,000 (assuming as before that all assets and liabilities are denominated in pesos), or $16.875 million. The difference between the two translation exposure figures of Mex$111,000 = $13.875 million equals Zapata’s net fixed assets, which are exposed under the current rate method but not under the temporal method. 3.b. Suppose the exchange rate on December 31 is Mex$12,000. What will be Zapata’s translation loss for the year? ANSWER. The peso has lost one third of its dollar value during the year. Hence, Zapata’s translation loss equals one third its initial exposure. If the dollar is the functional currency, and assuming no change in assets and liabilities, Zapata’s translation loss for the year will be $3,000,000/3 = $1 million. Alternatively, if the peso is the functional currency, Zapata’s translation loss equals $16,875,000/3 = $5.625 million.

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3.c.

Zapata can borrow an additional Mex$15,000. How will this affect its translation exposure if it uses the funds to pay a dividend to its parent? If it uses the funds to increase its cash position?

ANSWER. If Zapata borrows an additional Mex$15,000 (in millions) and uses these funds to pay a dividend to its parent, its liabilities will rise by Mex$15,000 and its equity will fall by the same amount. With the added peso liabilities, its exposure will fall by Mex$15,000 or $1.875 million regardless of the functional currency. If the dollar is the functional currency, Zapata’s new translation exposure becomes $1.125 million; if the peso is the functional currency, the new translation exposure becomes $15 million. If Zapata uses the Mex$15,000 to increase its cash position, then its translation exposure stays the same; the added peso liabilities are exactly offset by the added peso assets. 4. Walt Disney expects to receive a Mex$16 million theatrical fee from Mexico in 90 days. The current spot rate is $0.0915/Mex$ and the 90-day forward rate is $0.0903/Mex$. 4.a. What is Disney’s peso transaction exposure associated with this fee? ANSWER. Disney’s peso transaction exposure on this fee equals Mex$16 million, or $1,464,000 (16,000,000 * 0.0915). 4.b. If the expected spot rate in 90 days is $0.0908, what is the expected U.S. dollar value of the fee? ANSWER. The expected value of this fee in 90 days is $1,452,800 (16,000,000 * 0.0908). 4.c.

What is the hedged dollar value of the fee?

ANSWER. The hedged value of this fee in 90 days is $1,444,800 (16,000,000 * 0.0903). 5. A foreign exchange trader assesses the euro exchange rate three months hence as follows: $1.31 with probability 0.25 $1.33 with probability 0.50 $1.35 with probability 0.25 The 90-day forward rate is $1.32. 5.a. Will the trader buy or sell euros forward against the dollar if she is concerned solely with expected values? In what volume? ANSWER. The expected future spot exchange rate is $1.33 ($1.31 * 0.25 + $1.33 * 0.50 + $1.35 * 0.25). Because this exceeds the forward rate of $1.32, the trader will buy euros forward against the dollar in an infinite amount. This absurd result is due to the assumption of a linear utility function. 5.b. In reality, what is likely to limit the trader's speculative activities? ANSWER. Regardless of her utility function, she will be restrained by bank policies designed to guard against excessive currency speculation.

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5.c.

Suppose the trader revises her probability assessment as follows: $1.29 with probability 0.33 $1.33 with probability 0.33 $1.37 with probability 0.33

Assuming the forward rate remains at $1.32, do you think this new assessment will affect the trader's decision? ANSWER. The expected future spot rate remains at $1.33. However, the variance of the expected spot rate is now greater than it was before. If the trader is concerned solely with expected values, this will not affect her speculative activities. But if she is concerned with risk in addition to expected return, the greater variance and consequent greater risk should lead her to reduce her speculative activities. 6. An investment manager hedges a portfolio of Bunds (German government bonds) with a 6month forward contract. The current spot rate is €0.75:$1 and the 180-day forward rate is €0.72:$1. At the end of the 6-month period, the Bunds have risen in value by 3.75 percent (in euro terms), and the spot rate is now €0.66:$1. 6.a. If the Bunds earn interest at the annual rate of 5 percent, paid semi-annually, what is the investment manager's total dollar return on the hedged Bunds? ANSWER. Ignoring hedging for the time being, for each $100 invested in Bunds at a spot rate of €0.75 per dollar, the investment manager would have at the end of six months an amount of euros equal to €79.69 as follows: 0.75 * 100 * (1 + 0.025 + 0.0375) = €79.69 This amount takes into account both the 3.75% capital gain on the Bunds and the 2.5% semiannual interest payment. Assuming that the investment manager did not anticipate the 3.75% capital gain and hedged only the expected amount of €76.88, he would now have $106.78 (76.88/0.72) from the original hedged principal and interest plus an additional $4.26 (0.75 * 100 * 0.0375/0.66) from the 3.75% capital gain on the Bund principal of €75 converted into dollars at the spot rate of €0.66:$1. The total dollar amount received in six months would, therefore, be $111.04 (106.78 + 4.26), which is an 11.04% return on the original $100 investment. 6.b. What would the return on the Bunds have been without hedging? ANSWER. As shown in the answer to part a, the euro value of the Bund’s principal plus interest at the end of six months would be 79.69. Converting this amount into dollars at the spot rate of 0.66:$1 yields an amount equal to $120.74 (79.69/0.66). This amount translates into a dollar return of 20.74%. 6.c.

What was the true cost of the forward contract?

ANSWER. As shown in the text (see the section titled “The True Cost of Hedging”), the forward contract reduces the return per dollar invested by an amount equal to the difference between the forward rate and the actual spot rate at the time of settlement.

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7. Magnetronics, Inc., a U.S. company, owes its Taiwanese supplier NT$205 million in three months. The company wishes to hedge its NT$ payable. The current spot rate is NT$1 = U.S.$0.03987, and the three-month forward rate is NT$1 = U.S.$0.04051. Magnetronics can also borrow/lend U.S. dollars at an annualized interest rate of 12% and Taiwanese dollars at an annualized interest rate of 8%. 7.a. What is the U.S. dollar accounting entry for this payable? ANSWER. Magnetronics will record a payable of U.S.$8,173,350, which is just NT$205 converted at the spot rate of U.S.$0.03987. 7.b. What is the minimum U.S. dollar cost that Magnetronics can lock in for this payable? Describe the procedure it would use to get this price. ANSWER. Magnetronics can use either a forward market hedge or a money market hedge. The forward market hedge will lock in a cost of U.S.$8,304,550 (205,000,000 * 0.04051). Or it can borrow U.S. dollars, convert them into NT$, invest the NT$ for three months, and use the proceeds to settle the NT$ payable. To estimate the cost of this money market hedge, we must work backwards to figure out how many NT$ are needed today. At a quarterly interest rate of 2%, Magnetronics must invest NT$200,980,392 (205,000,000/1.02) today to have NT$205 million in three months. At the current spot rate, this translates into U.S.$8,013,088 today. At a quarterly U.S. interest rate of 3%, this loan will cost U.S.$8,253,481 to repay in three months (8,013,088 * 1.03). Since this is $51,069 less than the cost of satisfying the payable using the forward market, use the money market hedge and lock in a cost of U.S.$8,253,481. 7.c.

At what forward rate would interest rate parity hold given the interest rates?

ANSWER. Interest rate parity will hold when the U.S. dollar return on U.S. dollars, 1.12, equals the hedged U.S. dollar return on NT$, or (1/0.03987) * 1.08 * f, where f is the equilibrium forward rate. The solution to this equation is f = .03987 * 1.12/1.08 = $0.04135. At this forward rate, interest rate parity will hold. 8. Cooper Inc., a U.S. firm, has just invested £500,000 in a note that will come due in 90 days and is yielding 9.5% annualized. The current spot value of the pound is $1.9612 and the 90-day forward rate is $1.9467. 8.a. What is the hedged dollar value of this note at maturity? ANSWER. At maturity, this note will pay off £511,875 (500,000 * 1 + 0.095/4) The hedged dollar value of this note at maturity is $996,467 (511,875 * 1.9467). 8.b. What is the annualized dollar yield on the hedged note? ANSWER. The dollar investment in the note today is $980,600 (500,000 * 1.9612). The 90-day return is 1.424% (996,467/980,600 - 1). Annualized, this dollar return is 6.47% (1.62% * 4). 8.c.

Cooper anticipates that the value of the pound in 90 days will be $1.9550. Should it hedge? Why or why not?

ANSWER. If Cooper does not hedge, it will expect to collect at maturity $1,000,715.6 (511,875 * 1.9550). This amount exceeds the hedged return. Whether it should hedge depends on how strongly it believes that its expectation of the 90-day spot rate is correct and the forward market is wrong, and on its risk preferences. It also depends on whether it has an offsetting exposure, as the question in part c indicates.

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8.d. Suppose that Cooper has a payable of £980,000 coming due in 180 days. Should this affect its decision of whether to hedge its sterling note? How and why? ANSWER. Yes. If Cooper hedges its investment, it will actually exacerbate its pound exposure. As it stands, the pound investment currently provides an offset of £511,875 to its negative exposure of £980,000, yielding a net exposure of -£468,125 (£511,875 - £980,000). If Cooper hedges the pound investment, its net exposure rises to -£980,000. 9. American Airlines is trying to decide how to go about hedging $70 million in ticket sales receivable in 180 days. Suppose it faces the following exchange and interest rates. Spot rate: Forward rate (180 days): DM 180-day interest rate (annualized): U.S. dollar 180-day interest rate (annualized):

$0.6433-42/SFr $0.6578-99/SFr 4.01%-3.97% 8.01%-7.98%

9.a. What is the hedged value of American’s ticket sales using a forward market hedge? ANSWER. By selling the ticket receipts forward, American Airlines can lock in a dollar value of 70,000,000 * 0.6578 = $46,046,000. 9.b. What is the hedged value of American’s ticket sales using a money market hedge? Assume the first interest rate is the rate at which money can be borrowed and the second one the rate at which it can be lent. ANSWER. American can also hedge it euro receivable by borrowing the present value of $70 million at a 180-day interest rate of 2.005% (4.01%/2), sell the proceeds in the spot market at a rate of $0.6433/SFr, and invest the dollar proceeds at a 180-day interest rate of 3.99% (7.98%/2). Using this money market hedge, American can lock in a value for its $70 million receivable of $45,907,296 (70,000,000/1.02005 * 0.6433 * 1.0399). 9.c.

Which hedge is less expensive?

ANSWER. The forward market hedge yields a higher dollar value for the ticket receivables so is preferable. 9.d. Is there an arbitrage opportunity here? ANSWER. Yes. By borrowing dollars at a semiannual rate of 4.005% (8.01%/2), converting them to euros at the ask rate of $0.6442, and simultaneously investing the euros at a semiannual rate of 1.985% (3.97%/2) and selling the loan proceeds forward at a bid rate of $0.6578, you can lock in an arbitrage spread of 0.133% semiannually. This can be seen as follows. Following the steps outlined above, the return on the borrowed dollars will be 4.138%.

1 x 1.01985 x 0.6578= 1.04138 0.6442 Subtracting off the 4.005% cost of borrowing the dollars yields a semiannual covered interest differential of 0.133% (4.138% - 4.005%).

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9.e.

Suppose the expected spot rate in 180 days is $0.67/SFr with a most likely range of $0.64$0.70/SFr. Should American hedge? What factors should enter into its decision?

ANSWER. Based on the expected 180-day spot rate and its expected range, it would appear that American would be better off waiting to convert its ticket sales at the future spot rate. However, American must ask itself where its comparative advantage lies? Does it lie in running an innovative airline or does it reside in trying to outguess apparently sophisticated financial markets? If the former, which most would agree with, American should stick to its knitting and leave the speculation to financial institutions specifically organized for that purpose. 10. Madison Inc. imports olive oil from Chilean firms and the invoices are always denominated in drachma (Dr). It currently has a payable in the amount of Dr 250 million that it would like to hedge. Unfortunately, there are no drachma futures contracts available and Madison is having difficulty arranging a Dr forward contract. Its treasurer, who recently received her MBA, suggests using Italian lira to cross-hedge the drachma exposure. She recently ran the following regression of the change in the exchange rate for the drachma against the change in the lira exchange rate: ΔDr/$ = 1.6(ΔLit/$) 10.a. There is an active market in forward lira. To cross-hedge Madison’s drachma exposure, should the treasurer buy or sell lira forward? ANSWER. Given that Madison is short Dr and there is a positive correlation between the lira and the Dr, Madison should create a long position in lira; that is, Madison should buy lira forward. 10.b. What is the risk-minimizing amount of lira that the treasurer would have to buy or sell forward to hedge Madison's Dr exposure? ANSWER. According to the regression, a 1¢ change in the value of the lira leads to a 1.6¢ change in the value of the Dr. To cross-hedge the forthcoming payment of Dr, Lit 1.6 must be bought forward for every unit of Dr owed. With a Dr exposure of Dr 250 million, the exporter must buy forward Lit in the amount of Lit 400 million (1.6 * 250,000,000). ADDITIONAL CHAPTER 9 PROBLEMS AND SOLUTIONS 1. Paragon U.S.’s Japanese subsidiary, Paragon Japan, has exposed assets of ¥8 billion and exposed liabilities of ¥6 billion. During the year, the yen appreciates from ¥125/$ to ¥95/$. 1.a. What is Paragon Japan’s net translation exposure at the beginning of the year in yen? In dollars? ANSWER. Paragon Japan has net translation exposure of ¥2 billion (¥8 billion - ¥6 billion). Converted into dollars, this figure yields translation exposure of $16 million (2 billion/125). 1.b. What is Paragon Japan’s translation gain or loss from the change in the yen's value? ANSWER. At the end-of-year exchange rate, Paragon Japan’s translation exposure equals $21,052,632 (2 billion/95). The net result is a translation gain for the year of $5,052,632 ($21,052,632 - $16,000,000).

CHAPTER 10: MEASURING AND MANAGING ACCOUNTING EXPOSURE 1.c.

At the start of the next year, Paragon Japan adds exposed assets of ¥1.5 billion and exposed liabilities of ¥2 billion. During the year, the yen depreciates from ¥95/$ to ¥130/$. What is Paragon Japan’s translation gain or loss for this year? What is its total translation gain or loss for the two years?

ANSWER. Paragon Japan’s new translation exposure at the start of the year is ¥1.5 billion (¥2 billion + ¥1.5 billion - ¥2 billion). Given this exposure and the exchange rate change during the year, its translation loss for the year equals $4,251,012 (1,500,000,000 * (1/95 - 1/130)). Over the two-year period, Paragon Japan has realized a translation gain of $801,620 ($5,052,632 - $4,251,012). 2. Suppose that on January 1, American Golf’s French subsidiary, Golf du France, had a balance sheet that showed current assets of FF1 million; current liabilities of FF300,000; total assets of FF2.5 million; and total liabilities of FF900,000. On December 31, Golf du France’s balance sheet in francs was unchanged from the figures given above, but the franc had declined in value from $0.1270 at the start of the year to $0.1180 at the end of the year. Under FASB 52, what is the translation amount to be shown on American Golf's equity account for the year if the franc is the functional currency? How would your answer change if the dollar were the functional currency? ANSWER. According to FASB 52, balance sheets must be translated using the current rate method; that is, all assets and all liabilities must be translated at the current rate. Golf du France’s net foreign currency translation exposure, therefore, is FF2,500,000 - FF900,000 or FF1,600,000. At the original rate of $0.1270, the value of the franc net exposure was FF1,600,000 * 0.1270 = $203,200. By the end of the year, this net exposure equals FF1,600,000 * $.1180 = $188,800. This involves a translation loss for American Golf of $14,400 ($203,200 - $188,800). If the current assets are all monetary or if inventory is carried at market value, Golf du France’s exposure if the dollar is the functional currency would be current assets minus current liabilities or FF1,000,000 FF900,000 = FF100,000. In this case, American Golf’s translation loss would equal 100,000 * (0.1270 0.1180) = $900. This loss must be included in the income statement. 3. Halon France, the French subsidiary of a U.S. company, Halon, Inc., has the following balance sheet: Assets (FF thousands) Cash, marketable securities Accounts receivable Inventory Net fixed assets

Liabilities (FF thousands) 7,000 18,000 31,000 63,000 FF119,000

Accounts payable Short-term debt Long-term debt Equity

14,000 8,000 45,000 52,000 FF119,000

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 5TH ED.

3.a. At the current spot rate of $0.21/FF, calculate Halon France’s accounting exposure under the current/noncurrent, monetary/nonmonetary, temporal, and current rate methods. ANSWER. Assuming all assets and liabilities are denominated in francs, under the current/noncurrent method, Halon France’s accounting exposure is FF34 million (7 + 18 + 31 - 14 - 8, in millions), or $7.14 million (0.21 * 34 million). Its monetary/nonmonetary method accounting exposure is -FF42 million (7 + 18 - 14 - 8 - 45, in millions), or -$8.82 million (0.21 * -42 million). Halon France’s temporal method exposure is the same as its current/noncurrent method exposure. Under the current rate method, Halon France’s exposure is its equity of FF52 million, or $10.92 million (0.21 * 52 million). 3.b. Suppose the French franc depreciates to $0.17. Produce balance sheets for Halon France at the new exchange rate under each of the four alternative translation methods. ANSWER. Current/noncurrent rate and temporal methods Assets ($ thousands) Cash, marketable securities* Accounts receivable* Inventory* Net fixed assets

Liabilities ($ thousands) 1,190 3,060 5,270 13,230 $22,750

Accounts payable* Short-term debt* Long-term debt Equity

2,380 1,360 9,450 9,560 $22,750

*Exposed Monetary/nonmonetary method Assets ($ thousands) Cash, marketable securities* Accounts receivable* Inventory Net fixed assets

Liabilities ($ thousands) 1,190 3,060 6,510 13,230 $23,990

Accounts payable* Short-term debt* Long-term debt* Equity

2,380 1,360 7,650 12,600 $23,990

*Exposed Current rate method Assets ($ thousands) Cash, marketable securities* Accounts receivable* Inventory* Net fixed assets*

*Exposed

Liabilities ($ thousands) 1,190 3,060 5,270 10,710 $20,230

Accounts payable* Short-term debt* Long-term debt* Equity

2,380 1,360 7,650 8,840 $20,230

CHAPTER 10: MEASURING AND MANAGING ACCOUNTING EXPOSURE 3.c.

Calculate the translation gains or losses associated with the FF depreciation for each of the four methods. Relate these gains and losses to the exposure calculations performed in part a combined with the exchange rate change. Where would these translation gains or losses show up in the balance sheets prepared for part b?

ANSWER. The translation gain (loss) equals the franc exposure multiplied by the -$0.04 change in the exchange rate. These translation gains (losses) are as follows: current/noncurrent/temporal methods – loss of $1.36 million (-0.04 * 34 million); monetary/nonmonetary method – gain of $1.68 million (-0.04 * -42 million); and current rate method – loss of $2.08 million (-0.04 * 52 million). These gains (losses) show up on the equity account and equal the difference in equity values calculated at the new exchange rate of $0.17/FF and the old exchange rate of $0.21/FF. 4. An importer has a payment of £8 million due in 90 days. 4.a. If the 90-day pound forward rate is $1.4201, what is the hedged cost of making that payment? ANSWER. The hedged cost of making the payment is $11,360,800 (8,000,000 * 1.4201). 4.b. If the spot rate expected in 90 days is $1.4050, what is the expected cost of payment? ANSWER. The expected cost of payment is $11,240,000 (8,000.000 * 1.4050)/ 4.c.

What factors will influence the hedging decision?

ANSWER. The importer must consider the basis for its expected future spot rate and why that value diverges from the forward rate, its willingness to bear risk, and whether it has any offsetting pound assets. 5. International Worldwide would like to execute a money market hedge to cover a ¥250,000,000 shipment from Japan of sound systems it will receive in six months. The current exchange rate is ¥124 = $1. 5.a. How would International structure the hedge? What would it do to hedge the Japanese yen it must pay in six months? The annual yen interest rate is 4%. ANSWER. International should invest the present value of ¥250,000,000, or ¥250,000,000/1.02 = ¥245,098,039 = $1,976,597 at today’s exchange rate of ¥124 = $1. In six months International can cash in its investment, which by then will have grown to ¥250,000,000, and use the proceeds to pay off its supplier. 5.b. The yen may rise to as much as ¥140 = $1 or fall to ¥115 = $1. What will the total dollar cash flow be in six months in either case? ANSWER. We can only value the future dollar cash flow in relation to the current spot rate of the yen. Converting the future value of ¥250,000,000 into dollars at today’s spot rate of ¥124, International Worldwide’s total dollar cost of paying for the sound system delivery, assuming it makes use of the money market hedge, will be $2,016,100, which is shown as follows:

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 5TH ED.

POSSIBLE OUTCOMES OF MONEY MARKET HEDGE IN 6 MONTHS Spot Exchange Rate in 6 Months

Value of Payable (1)

Loss/Gain on Money Market Hedge (2)

Total Cash Flow in 6 Months (1 + 2)

¥115 = $1

$2,173,900

($157,800)

$2,016,100

¥124 = $1

$2,016,100

¥140 = $1

$1,785,700

$230,400

$2,016,100

The money market hedge gain of $157,800 if the exchange rate moves to ¥115 = $1 arises because the investment proceeds of ¥250,000,000, valued at $2,016,100 at the exchange rate of ¥124 = $1, will be worth $2,173,900 at the new exchange rate. This gain is subtracted off the cost of the payable. 6. A French corporate treasurer expects to receive a DM11 million payment in 90 days from a German customer. The current spot rate is DM0.29870:FF1 and the 90-day forward rate is DM0.29631:FF1. In addition, the annualized three-month EuroDM and Eurofranc (French) rates are 9.8% and 12.3%, respectively. 6.a. What is the hedged value of the DM receivable using the forward contract? ANSWER. By selling the DM receivable forward, the French treasurer can lock in revenue of FF37,123,283 (11,000,000/0.29631). 6.b. Describe how the French treasurer could use a money market hedge to lock in the franc value of the DM receivable. What is the hedged value of the DM receivable? What is the effective forward rate that the treasurer can obtain using this money market hedge? ANSWER. The French treasurer can borrow the present value of the DM11 million receivable, which equals DM10,736,945 (11,000,000/1.0245) at the 2.45% quarterly interest rate (9.8%/4). Next, the treasurer converts these DM into French francs at the spot rate of DM0.29870:FF1 to get FF35,945,580. Finally, the treasurer will invest the francs at the quarterly rate of 3.075% (12.3%/4) and receive FF37,050,907 in 90 days. The result from this money market hedge is the equivalent of selling forward the DM11 million at a forward rate of 0.29689 (11,000,000/37,050,907). From the standpoint of the treasurer, this is a worse rate than could be realized directly in the forward market (as evidenced by the fact that the forward market hedge yields FF72,376 more than does the money market hedge). 6.c.

Given your answers in parts a and b, is there an arbitrage opportunity? How could the treasurer take advantage of it?

ANSWER. There is an arbitrage opportunity, assuming that transaction costs (such as the bid-ask spreads in both the foreign exchange and Euromarkets, which were ignored in this example) don’t offset the gains. The opportunity would involve borrowing francs, converting them into DM, investing the DM while simultaneously selling them forward for francs, and using the proceeds to repay the franc loan. However, since the difference between the actual and the constructed forward rates is only 0.2%, it is quite likely that transaction costs will preclude an arbitrage profit.

CHAPTER 10: MEASURING AND MANAGING ACCOUNTING EXPOSURE 6.d

At what 90-day forward rate would IRP hold?

ANSWER. IRP holds when the French franc return on francs equals the hedged franc return on DM. The former return is 1 + 0.123/4 = 1.03075. The latter return is 0.29870 * 1.0246/f90, where f90 is the 90-day forward rate. Setting these two terms equal and solving for f90 yields f90 = (1.0246/1.03075) * 0.29870 = DM0.29692. 7. Plantronics owes SKr50 million, due in one year, for some electrical equipment it recently bought from ABB Asea Brown Boveri. At the current spot rate of $0.1480/SKr, this payable is $7.4 million. It wishes to hedge this payable but is undecided how to do it. The one-year forward rate is currently $0.1436. Plantronics’ treasurer notes that the company has $10 million in a marketable U.S. dollar CD yielding 7% per annum. At the same time, SE Banken in Stockholm is offering a one-year time deposit rate of 10.5%. 7.a. What is the low-cost hedging alternative for Plantronics? What is the cost? ANSWER. Plantronics can use the forward market to lock in a cost for its payable of $7.18 million. Alternatively, Plantronics can use a money market hedge to lock in a lower dollar cost of $7,165,611 for its payable. Thus, the money market hedge is the low-cost hedge. To compute this cost, note that Plantronics must invest SKr45,248,869 today at 10.5% to have SKr 50 million in one year (45,248,869 * 0.105 = 50 million). This amount is equivalent to $6,696,833 at the current spot of SKr$0.1480/SKr. The opportunity cost to Plantronics of taking this amount from its CD today and converting it into SKr is $7,165,611, which is the future value of $6,696,833 invested at 7%. 7.b. Suppose interest rate parity held. What would the one-year forward rate be? ANSWER. Interest rate parity holds when the dollar return on investing dollars equals the dollar return on investing SKr, or 1.07 = (1/0.1480) * 1.105 * f1, where f1 is the equilibrium one-year forward rate. The solution to this equation is f1 = $0.1433/SKr. 8. Dow Chemical has sold SFr 25 million in chemicals to Ciba-Geigy. Payment is due in 180 days. Spot rate:

$0.7957/SFr

180-day forward rate:

$0.8095/SFr

180-day U.S. dollar interest rate (annualized):

5.25%

180-day Swiss franc interest rate (annualized): 1.90% 180-day call option at $0.80/SFr:

2% premium

180-day put option at $0.80/SFr:

1% premium

8.a. What is the hedged value of Dow’s receivable using the forward market hedge? The money market hedge? ANSWER. Dow Chemical can use a forward contract to lock in a value of $20,237,500 (25,000,000 * 0.8095) for its receivable. It can also use a money market hedge, which would proceed as follows. Dow would borrow the present value of the SFr 25 million receivable, which equals SFr24,764,735 (25,000,000/1.0095) at the 0.95% 180-day interest rate (1.9%/2). This franc amount translates into a dollar amount of $19,705,300 at the current spot rate of $0.7957/SFr. By investing these dollars at the semiannual rate of 2.625% (5.25%/2), Dow will have $20,222,564 at the end of 180 days (1.02625 * $19,705,300). It can then pay off the Swiss franc loan with the SFr25 million in collected receivables.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 5TH ED.

8.b. What alternatives are available to Dow to use currency options to hedge its receivable? Which option hedging strategy would you recommend? ANSWER. Dow can buy a put option giving it the right but not the obligation to sell SFr25 million in 180 days at a price of $0.80/SFr and a put premium of 1%. Dow can also use a currency collar, which would involve buying the put option and selling a call option in the amount of SFr25 million and receiving a 2% premium. With sale of the call option, if the Swiss franc appreciates beyond $0.80, the holder of the call option will call the francs away. Thus, Dow will cap its upside potential at $0.80 plus the 2% premium and be protected on the downside by the put option. By buying the put option and selling the call option at a strike price of $0.80/SFr and pocketing the 1% premium of $0.008 (0.01 * $0.7957), Dow would create the equivalent of a forward contract at $0.808. This is a poorer price than Dow would receive via the forward contract. 8.c.

Which hedging alternative analyzed in parts a and b would you recommend to Dow? Why?

ANSWER. The forward contract is the preferred alternative because its hedging characteristics are identical to those of the others but it has a higher payoff. Dow would be speculating on the future spot price of the Swiss franc if it bought the put option. Since Dow has no comparative advantage in pricing options, it should drop this alternative. 9.* Metalgesselschaft, a leading German metal processor, has scheduled a supply of 20,000 metric tons of copper for October 1. On April 1, copper is quoted on the London Metals Exchange at £562 per metric ton for immediate delivery and £605 per metric ton for delivery on October 1. Monthly storage costs are £10 for a metric ton in London and DM 30 in Hamburg, payable on the first day of storage. Exchange rate quotations are as follows: The pound is worth DM 3.61 on April 1 and is selling at a 6.3% annual discount. The opportunity cost of capital for Metalgesselschaft is estimated at 8% annually, and the pound sterling is expected to depreciate at a yearly rate of 6.3% over the next 12 months. Compute the DM cost for Metalgesselschaft on April 1 of the following options: 9.a. Buy 20,000 metric tons of copper on April 1 and store it in London until October 1. 9.b. Buy a forward contract of 20,000 metric tons on April 1, for delivery in six months. Cover sterling debt by purchasing forward pounds on April 1. 9.c.

Buy 20,000 metric tons of copper on October 1.

Identify other options available to Metalgesselschaft. Which one would you recommend? ANSWER. This problem illustrates some of the difficulties often encountered when trading in commodities, where the bulk of the contracting is generally done in pounds or U.S. dollars. In this case, Metalgesselschaft is confronted with two types of risk: (i) relative price risk stemming from fluctuations in the price of copper on the London Metals Exchange and (ii) currency risk resulting from fluctuations in the DM/pound exchange rate. Here are calculations for the present values of the alternatives. *

Problem contributed by Laurent Jacque.

CHAPTER 10: MEASURING AND MANAGING ACCOUNTING EXPOSURE

9.a. Buy the required 20,000 metric tons of copper and incur storage costs in London. Payment occurs on April 1, so the present value of the cost is the same as the actual cost. DM cost

Number of tons needed * [sterling price per ton for immediate delivery + pound storage cost in London per ton for a six-month period] * DM spot price of one pound on April 1

20,000 * (562 + 60) * 3.61

DM 44,908,400

9.b. Cover both commodity and currency risks through forward contracts of matching maturities in the respective markets. Payment doesn't take place until October 1. DM cost

9.c.

Number of tons needed x sterling price per ton of copper for delivery on October 1 * forward DM price per pound on April 1 for delivery on October 1/(1 + opportunity cost of funds)

20,000 * 605 * 3.61(1 - .063/2)/(1 + 0.08/2)

DM 40,677,931

Leave both commodity and currency positions uncovered. The DM cost of this option cannot be computed since no information is given as to the projected price of copper or the projected DM value of the pound six months hence. An additional option would consist of buying the copper on April 1 and storing it in Hamburg. This option is analogous to the first one, except for the geographical location of storage. This option is less expensive than the first one, however, because the cost of storage in Hamburg is only DM180, whereas it costs DM60 * 3.61 = DM216.6 to store copper in London. The total cost of this option is 20,000(562 * 3.61 + 180) = DM44,176,400. Of the options we can price, the second one, which involves hedging both commodity price risk and currency risk, is the least expensive. Whether Metalgesselschaft should, in fact, hedge depends on how its DM revenues vary with the spot cost of copper expressed in DM. If its DM revenues don’t vary with the current DM spot price of copper, the firm is probably better off hedging its copper purchases. On the other hand, if DM revenues vary directly with the spot price of copper, then hedging one end of the profit equation (costs) without hedging the other end (revenues) could subject Metalgesselschaft to more risk than if it didn’t hedge at all.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 5TH ED.

10. Cosmo, a Japanese exporter, wishes to hedge its $15 million in dollar receivables coming due in 60 days. To reduce its net cost of hedging to zero, however, Cosmo sells a 60-day dollar call option for $15 million with a strike price of ¥98/$ and uses the premium of $314,000 to buy a 60-day $15 million put option at a strike price of ¥90/$. 10.a. Graph the payoff on Cosmo’s hedged position over the range ¥80/$-¥110/$. What risk is Cosmo subjecting itself to with this option hedge? ANSWER. As can be seen from the payoff diagram on Cosmo’s currency collar, Cosmo is limiting the upside potential on its receivable with the call option but also limiting its downside risk. The put and call premiums of $314,000 cancel offset each other and so don’t affect the payoff on the currency collar. The diagram reflects the fact that Cosmo will not exercise its put option at an exchange rate above ¥90/$ and the buyer will not exercise its call option below ¥98/$. Neither option, therefore, will be exercised in the range of ¥90/$:¥98/$. PAYOFF ON COSMO'S CURRENCY COLLAR 1,700

1,600

Yen (millions)

1,500

1,400

1,300

Value of unhedged receivables Value of receivables hedged with a currency collar

1,200

1,100

1,000 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 100 101 102 103 104 105 106 107 108 109 110 Yen/dollar exchange rate

10.b. What is the net yen value of Cosmo’s option hedged position at the following future spot rates: ¥85/$, ¥95/$, and ¥105/$? ANSWER. Cosmo’s currency collar will return the following amounts of yen at the given exchange rates: ¥85/$, ¥1,350,000,000 (Cosmo will exercise its option to sell dollars at ¥90/$); ¥95/$, ¥1,425,000,000 (this exchange rate falls in the range where the put and call options won’t be exercised, so Cosmo will convert at the actual spot rate); ¥105/$, ¥1,470,000,000 (Cosmo’s dollars will be called away at the exercise price of ¥98/$).

CHAPTER 10: MEASURING AND MANAGING ACCOUNTING EXPOSURE

10.c. As an alternative to using options, Cosmo could have hedged with a 60-day forward contract at a price of ¥97/$. What would be the yen value of Cosmo’s hedged receivable if it had used a forward contract to hedge? ANSWER. Cosmo can lock in a value of ¥1,455,000,000 (¥97 * 15,000,000) with the forward contract. 10.d. At what exchange rate will the hedged value of Cosmo's dollar receivables be the same whether it used the option hedge or forward hedge? ANSWER. At an exchange rate of ¥97/$, the currency collar will return ¥1,455,000,000, since, at this rate, neither option will be exercised and Cosmo will convert at the spot rate.

CHAPTER 10: MEASURING AND MANAGING ECONOMIC EXPOSURE

CHAPTER 10 MEASURING AND MANAGING ECONOMIC EXPOSURE This chapter defines economic exposure as the extent to which a given currency change will change the value of a firm. Exchange risk is just the variability of a firm’s value that is due to uncertain currency changes. With regard to managing currency risk, the key issue is the proper role of corporate financial management. To the extent that the firm is operating in efficient financial markets, the primary exposure management objective of financial executives should be to arrange their firm’s finances in such a way as to minimize the real effects of exchange rate changes. The major burden of coping with exchange risk must be borne by the marketing and production people because they deal in imperfect product and factor markets where their specialized knowledge provides a real advantage. Their role is to design marketing and production strategies to deal with exchange risks. The appropriate marketing and production strategies are similar to those that would be suitable for any firm confronted with shifting relative output or input prices caused by any economic, political, or social factors. KEY POINTS ON MEASURING EXCHANGE RISK 1. Because the value of a firm is equal to the present value of future cash flows, accounting measures of exposure that are based on changes in the book values of foreign currency assets and liabilities need bear no relationship to reality. 2. Because currency changes are usually preceded by or accompanied by changes in relative price levels between two countries, it is impossible to determine exposure to a given currency change without considering simultaneously the offsetting effects of these price changes. This point is illustrated by the examples of Apex Spain, the Brazilian shoe manufacturer, and Chile. The latter two examples show what happens when the real exchange rate changes because inflation is not offset by exchange rate changes. Only foreign-currency-denominated contractual cash flows are affected by nominal currency changes. Noncontractual operating cash flows are affected only by real currency changes. The domestic analogue is that only nominal cash flows are affected by inflation. Noncontractual domestic operating cash flows are affected only by relative price changes (i.e., by changes in the prices of the firm’s inputs relative to its outputs). The impact of real exchange rate changes depends on the location of that firm’s markets, its sources of inputs, and its degree of flexibility in shifting its marketing and production efforts. These points are brought out in Section 10.3 on identifying economic exposure. The cases of Aspen Skiing Company, Pemex, and Toyota Motor emphasize the fact that exchange risk is ubiquitous and that a thorough exchange risk analysis requires them to identify whether a company is selling and buying in a world market or a domestic market. The Spectrum case lets students see how sensitive the projected effects of currency changes are to assumptions about the effects of exchange rate changes on output and input prices, the price elasticity of demand, and the ability to substitute between domestic and foreign inputs.

INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

Here are two myths concerning exchange risk. Myth 1: Exchange rate changes always increase the riskiness of multinational corporations. It is accepted almost as an article of faith that exchange rate changes are bad for MNCs. And yet, devaluations (revaluations) are usually preceded by higher (lower) rates of inflation. This is PPP, the notion that an internal appreciation or depreciation in a currency’s purchasing power will ultimately be reflected in a change in its external value. Hence, it is clearly inappropriate to evaluate only the devaluation phase of an inflation-devaluation cycle. In general, the effects of inflation on the dollar profits of a given firm or investment located in a foreign country are the reverse of a devaluation’s effects. For example, devaluation is probably the best corrective for an exporter or for a company selling locally that is facing stiff import competition. In either case, inflation will likely lead to an erosion of dollar profit margins which can only be reversed if a local currency devaluation occurs. Conversely, a firm selling locally without much import competition will usually benefit from inflation while being hurt by devaluation. Based on purchasing power parity, therefore, gains or losses from exchange rate changes should be offset over time by differences in relative rates of inflation. Therefore, for firms incurring costs and selling products in foreign countries, the net effect of currency movements may be less important in the long run. Thus, if nominal currency changes smooth out the profit peaks and valleys caused by differing rates of inflation, devaluations or revaluations should actually reduce earnings variability for MNCs. Only if currency changes involve real exchange rate changes does risk increase. Myth 2: MNCs are more subject to exchange risk than domestic companies. If exchange risk means the degree to which a firm’s value is affected by currency changes, this proposition is not self-evident. For example, domestic facilities that supply foreign markets normally entail much greater exchange risk than foreign facilities supplying local markets (because material and labor used in a domestic plant are paid for in the home currency while the products are sold in a foreign currency). Take, for instance, a Japanese company which builds a plant to produce cars for export, primarily to the U.S. That company will incur exchange risk from the point at which it invests in facilities to supply a foreign market (the U.S.) since its yen expenses will be matched with dollar, instead of yen, revenues. All too frequently, however, firms neglect these effects when analyzing proposed foreign investments. Furthermore, a purely domestic company selling locally but facing import competition may be seriously hurt (helped) by the devaluation (revaluation) of a competitor’s HC. Thus, contrary to conventional wisdom, the MNC may be subject to less exchange risk than an exporter, given the MNC’s greater ability to adjust its marketing and production operations on a global basis. For example, MNCs with worldwide production systems can allocate production among their plants in line with the changing dollar costs of production. Unlike the purely domestic firm, an MNC has the option of

CHAPTER 10: MEASURING AND MANAGING ECONOMIC EXPOSURE

increasing production in a nation whose currency has devalued and decreasing production in a country whose currency has revalued. The ability to shift production depends on many factors, including the power of the unions involved. However, the innovative nature of the typical MNC means a continued generation of new products. The sourcing of these new products among the firm’s various plants can be done based on the costs involved. KEY POINTS ON MANAGING EXCHANGE RISK 1. Since currency risk affects all facets of a firm’s operations, it should not be the concern of financial managers alone. Top executives should incorporate exchange rate expectations into nonfinancial decisions. 2. Operating managers should develop marketing and production initiatives that help to ensure profitability over the long run. They should also devise anticipatory or proactive, rather than reactive, strategic alternatives in order to gain competitive leverage internationally. 3. The key to effective exposure management is to integrate currency considerations into the general management process. 4. Managers trying to cope with actual or anticipated exchange rate changes must first determine whether the exchange rate change is real or nominal. Nominal changes can be ignored. Real changes must be responded to. 5. If real, the manager must first assess the permanence of the change. In general, real exchange rate movements that narrow the gap between the current rate and the equilibrium rate are likely to be longer lasting than are those that widen the gap. Neither, however, will be permanent. Rather, there will be a sequence of equilibrium rates, each of which has its own implications for the firm’s marketing and production strategies. 6. The role of the financial executive in an integrated exchange risk program is fourfold: to provide local operating management with forecasts of inflation and exchange rates; to identify and highlight the risks of competitive exposure; to structure evaluation criteria such that operating managers are not rewarded or penalized for the effects of unanticipated real currency changes; and to estimate and hedge whatever real operating exposure remains after the appropriate marketing and production strategies have been put in place.

INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

SUGGESTED ANSWERS TO “EURO APPRECIATION HURTS SOUTHERN EUROPEAN EXPORTS” 1. Why are southern European countries particularly vulnerable to a strong euro? ANSWER. Southern European countries are particularly vulnerable to a strong euro because they specialize in the export of low-tech, commodity-type products such as textiles, footwear, and toys. These products face competition from low-priced substitutes from China and other Asian countries. Thus, their price elasticity of demand is high. 2. How does the relatively high inflation rate in southern Europe add to the problems created by a strong euro? ANSWER. The high inflation rates in southern European countries mean the real value of the euro has appreciated even more than its nominal value, making their products even less cost-competitive with Asian imports. 3. In contrast to southern Europe, northern Europe, especially Germany, exports more complex and brand-name manufactured items, such as automobiles, machine tools, and specialty chemicals. Would you expect German exports to be more or less sensitive to pricing pressures from a strong euro than southern European exports? Explain. ANSWER. German exports should be less sensitive to pricing pressures from a strong euro because these products tend to be highly differentiated, reducing their price elasticity of demand. The price elasticity of demand is reduced further because Chinese and other Asian manufacturers do not manufacture many of these products, meaning Asian products are not close substitutes for most German products. In addition, much of the competition for German exports is other German exports (e.g.. BMW and Mercedes). With most competitors based in Germany, then all will face the same change in their cost structure from euro appreciation, and all can raise their foreign currency prices without putting any of them at a competitive disadvantage relative to their domestic competitors. 4. It turns out that Italian companies exporting food products such as Parma ham and Parmigiano cheese have not seen a drop in exports, nor have high-fashion exporters such as Armani and Valentino despite the strong euro. Explain ANSWER. The products pointed to in this question are branded, differentiated products, without close substitutes from Asian or other countries. As such, one would expect them to have a much lower price elasticity of demand than exists for undifferentiated products that face close substitutes from China and elsewhere.

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SUGGESTED ANSWERS TO “HOW RISING GOLD PRICES HURT HARMONY” 1. How much rand revenue per ounce was Harmony generating on September 11, 2001? Three years later? ANSWER. Harmony’s rand revenue per ounce on September 11, 2001, based on a price per ounce of $288 and an exchange rate of R8.62/$, stood at 288 * 8.62 = R2,482.56. Three years later, with a much higher gold price ($420/oz) and a higher exchange rate (R6.35/$), Harmony’s rand revenue per ounce was 420 * 6.35 = R2,667. 2. Compare Harmony’s earnings per ounce in rand terms during 2001:Q2 with the same figure in 2004:Q2. ANSWER. With a profit per ounce in 2001:Q2 of $20 and an average exchange rate during the quarter of R8.04/$ (see question 3), Harmony’s profit averaged R160.80 (20 * 8.04). In 2004:Q2, with an average exchange rate of R6.60/$ and a loss of $50 an ounce, Harmony’s rand loss averaged R330/oz (50 * 6.60). 3. The average exchange rate during 2001:Q2 was R8.04/$; in 2004:Q2, it was R6.60/$. By how much would Harmony have to reduce its rand costs per ounce in 2004:Q2 in order to make the same rand profit per ounce it was earning in 2001:Q2? ANSWER. To go from a loss of R330/oz to a profit of R160.80/oz, Harmony would have to cut its rand costs by the difference between these two figures, or R490.80 (given the reasonable assumption revenue per ounce stays the same). SUGGESTED ANSWERS TO “CHECK THE EURO AND SHIP THE BOXES!” 1. Why does a rise in the dollar hurt Markel? How does a falling dollar help Markel? ANSWER. With a 70% share of the world market for Teflon-coated cable-control liners, it is obvious that Markel exports a substantial amount of its output. With Markel’s export revenues denominated in foreign currency (and also determined in foreign currency, primarily euros it appears) and its costs set in dollars, a rise in the value of the dollar will either squeeze Markel’s margins (if it holds euro prices constant) or lower its sales volume (if it raises euro prices to compensate for a stronger dollar). A falling dollar has the opposite effect as specific euro prices translate into more dollars. Alternatively, Markel has the option of lowering its euro price, while still maintaining its dollar margins, in order to capture more market share. 2. What does Markel do to hedge its currency risk? Can Markel use hedging to completely eliminate its currency risk? ANSWER. As the mini-case points out, Markel uses forward contracts to lock in dollar revenues for the next several months and tries to improve efficiency to survive when the dollar appreciates (praying does not count in hedging). However, hedging cannot completely eliminate its currency risk through hedging as much of its risk involves operating exposure. That is, Markel’s competitive position is affected by changes in the value of the dollar and other currencies.

INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

3. Comment on Markel’s policy of selective hedging. Are there any speculative elements involved in such a policy? Would you recommend Markel continue to follow a policy of selective hedging? Why or why not? ANSWER. As discussed in Chapter 10, a selective hedging policy often leads to taking higher risks by hedging only when a currency change is expected and going unhedged otherwise. If financial markets are efficient, however, firms cannot hedge against expected exchange rate changes. Interest rates, forward rates, and sales-contract prices should already reflect currency changes that are anticipated, thereby offsetting the loss reducing benefits of hedging with higher costs. The unavoidable conclusion is that a firm can protect itself only against unexpected currency changes. Moreover, there is always the possibility of bad timing, as illustrated by Mr. Hoban’s forward sale of euros when he guessed wrongly that the euro would continue to fall. In effect, a policy of selective hedging involves betting that you are smarter than the foreign exchange market. This bet is one that many companies have learned to regret. Companies that really can beat the market should probably do this full time as they then would not have to deal with tough competitors, demanding customers, and difficult employees. 4. What are the basic elements of Markel’s pricing policy? Does this pricing policy reduce its currency risk? Explain. ANSWER. Markel’s basic pricing policy is to charge customers relatively stable prices in their own currencies to build overseas market share, while absorbing currency gains or losses. It also signs contracts in foreign currency based on its expectations of where exchange rates are headed. It sometimes guesses wrong on these contracts as well. 5. Does locking in Markel’s dollar costs of raw materials through multiyear dollar contracts automatically reduce the company’s currency exposure? ANSWER. No. Note that Markel is locking in its dollar costs at the same time it is locking in foreign currency revenues. For Markel, this means it will be feast or famine. If the dollar falls in value, it will earn windfall profits as its foreign currency revenues translate into more dollars. If the dollar rises, however, it will lose with the decline in the value of its foreign currency revenue. Allowing its dollar costs to move with its dollar revenues on overseas sales will provide some hedge against exchange rate fluctuations. SUGGESTED ANSWERS TO “PORSCHE REVS UP ITS RESULTS” 1. Why does Porsche face more operating exposure than Mercedes or BMW? ANSWER. Both Mercedes and BMW have U.S. plants, giving them a natural operating hedge against a rising euro. That is, the very same event (a strong euro) that lowers euro revenues per dollar of U.S. auto sales also lowers the euro cost of manufacturing for Mercedes and BMW. In contrast, Porsche makes its cars entirely in Europe but generates 40% to 45% of its sales revenue in the U.S. For Porsche, therefore, its dollar operating cash inflows are not offset by dollar operating cash outflows.

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2. Is Porsche really fully hedged through July 31, 2007? Suppose that gains on all its outstanding options were included in reported earnings for its fiscal year ended July 31, 2004. ANSWER. If Porsche reported the gains on all its outstanding options in earnings for the fiscal year ended July 31, 2004, then it will have no future currency gains to offset its ongoing uncompetitive cost structure associated with the problem of competing in the U.S. in dollars while manufacturing in Europe in euros. The only future gains it would realize on its options would stem from a further rise in the value of the euro, which would make Porsche even less competitive in the U.S. market. 3. Why would analysts be nervous if up to 75% of Porsche’s pretax profit for fiscal year 2004 came from gains on foreign currency options? ANSWER. Gains such as these are unpredictable because they stem from an unexpected rise in the value of the euro. As such, they cannot be counted on. Once these gains are stripped away, Porsche’s profit from operations is only 25% of its reported profit. Suppose, for example, that the euro stayed where it is. Then Porsche will have no more gains on its currency options but it will still be stuck with an uncompetitive cost structure and low operating profits. SUGGESTED ANSWERS TO “A STRONG REAL HURTS EMBRAER” 1. What factors affect Embraer’s operating exposure? Why did the real's appreciation reduce Embraer's operating profit? ANSWER. Most of its revenue comes from exports priced in dollars while most of its costs are denominated in reais. This currency mismatch between revenues and costs is the price source of its operating exposure. At the same time, it is competing against foreign companies that have a different cost structure than it does. 2. Did Embraer decrease or increase its currency risk by hedging its dollar liabilities? Explain. ANSWER. Embraer has significant dollar cash inflows while most of its cash outflows are in reais. The dollar liabilities actually establish a partial hedge of its dollar inflows. By hedging these liabilities, therefore, Embraer increased its currency risk. 3. How can Embraer use financial hedging to reduce its currency risk? ANSWER. It can better match its cash inflows and outflows by selling its contracted for dollar revenues forward. However, this strategy only goes so far. Most of the company’s value depends on its anticipated future sales, which will largely be in dollars. To hedge these revenues, Embraer should finance a substantial fraction of its assets with dollars (or swap its real loans for dollars).

INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

4. Suppose Embraer's $608 million in dollar receivables mentioned above were outstanding at the beginning of the second quarter and that payment for $397 million was not received until the end of the quarter. The remaining $211 million was still outstanding at the end of the quarter. With an 18% real appreciation during the quarter, how much of a dollar loss would Embraer take on these receivables? In performing the calculation, consider that Embraer must first translate its dollar receivables into reais and then convert any loss measured in reais back into dollars. ANSWER. If e0 is the dollar value of the real at the beginning of the second quarter, then Embraer’s total receivables in terms of reais were R608,000,000/e0. At the end of the quarter, with an 18% appreciation in the dollar value of the real, these receivables were worth R608,000,000/1.18e0., where 1.18e0. is the dollar value of the real at the end of the second quarter given the 18% real appreciation. Taking the difference between the beginning and ending real values of these dollar receivables translates into a loss in terms of the real equal to R92,745,762.71/e0. In dollar terms (converting the real loss into dollars using the end-ofsecond-quarter exchange rate), this loss equals 1.18e0 * 92,745,762.71/e0, or $109,440,000. SUGGESTED ANSWERS TO “LAKER AIRWAYS CRASHES AND BURNS” 1. What were the key components of Laker Airways’ operating exposure? ANSWER. Laker’s operating exposure stemmed from the imbalance in the currency denomination of cash flows (dollar-denominated cash outflows far exceeding dollar-denominated cash inflows). If sterling depreciated, its dollar costs converted into sterling would rise more rapidly than the sterling value of its dollar-denominated revenue. Moreover, not only were these revenues and costs denominated in dollars, they were also determined in dollars. Specifically, fuel and marketing expenses in the U.S. are set in dollar terms, as are fares for U.S. customers (who are comparing Laker’s fares to other dollar fares). Compounding Laker’s problem was the fact that it was targeting the most price-elastic segment of the market, meaning that it could not raise sterling-equivalent prices to cover its higher sterling costs because its customer would desert it. 2. What options did it have to hedge its operating exposure? ANSWER. Laker might have indexed its sterling fare to the day-to-day exchange rate. It might also have directed more of its marketing efforts toward American travelers, thereby giving it a more diversified demand structure. 3. Could Laker have hedged its "natural" dollar liability exposure? ANSWER. The first option of indexing the sale of sterling airfare to the day-to-day exchange rate was not a viable alternative. Advertisements, based on a set sterling fare, would have had to be revised almost daily and would have discouraged the company’s “price-elastic, budget-conscious” clientele. The option of Laker directing more of its marketing efforts toward American travelers is a more viable one. When the pound devalued against the dollar, fewer British tourists would vacation in the U.S., but more Americans would travel to Britain. Laker could also have financed the acquisition of DC-10 aircraft in sterling rather than in dollars, thereby more closely matching its pound outflows with its pound inflows. This example points out that the currency denomination of debt financing can ill afford to be determined apart from the currency risk faced by the firm’s total business portfolio.

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4. Should Laker have financed its purchase of DC-10 aircraft by borrowing sterling from a British bank rather than using the dollar-denominated financing supplied by McDonnell Douglas and the Eximbank? Consider the fact that Eximbank, a U.S. government agency, subsidized this financing in order to promote U.S. exports. ANSWER. Because of the interest subsidy provided by McDonnell Douglas and the Eximbank on the funds they supplied to Laker, the covered sterling cost of the dollar financing would have been less than the cost of borrowing sterling directly from a British bank at a market rate of interest. Thus it made sense for Laker to finance its purchase of DC-10 aircraft with dollar-denominated funds from McDonnell Douglas and the EximBank rather than by borrowing sterling from a British bank. However, Laker should have hedged this loan with forward contracts or by swapping the dollar loan for a pound loan, in effect converting the dollar loan into a pound liability. SUGGESTED ANSWERS TO CHAPTER 10 QUESTIONS 1. Please answer the following questions. 1.a. Define exposure, differentiating between accounting and economic exposure. What role does inflation play? ANSWER. Accounting exposure results when exchange rate changes alter the home currency value of foreign currency-denominated assets and liabilities. The big debate in the accounting profession centers on which foreign currency assets and liabilities should be translated at the current rate (these assets and liabilities are exposed because their HC values change in line with the exchange rate) and which assets and liabilities should be translated at the historical rate (the rate in effect at the time the asset was acquired or the liability incurred). These latter assets and liabilities are regarded as not being exposed because they maintain their home currency values regardless of what happens to the exchange rate. By contrast, economic exposure measures the extent to which a given currency change affects the value of the firm. Nominal exchange rate changes affect the home currency value of the transaction exposure component of economic exposure because these cash flows are fixed. But only real exchange rate changes – inflation-adjusted currency changes – affect the firm’s future sales revenues and costs, its operating cash flows. 1.b. Describe at least three circumstances under which economic exposure is likely to exist. ANSWER. Circumstances in which a firm faces economic exposure include when the firm: i)

Has entered into sales or purchase contracts denominated in a foreign currency;

ii) Is selling or buying abroad or it faces domestic competition from imports and the real exchange rate changes; and iii) Is operating in a foreign country whose government taxes nominal rather than real income.

1.c.

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Of what relevance are the IFE and PPP to your answers to parts a and b?

ANSWER. If PPP holds exactly, then the second situation involving exchange risk – a change in the real exchange rate – can never occur. Similarly, if the IFE holds continually, firms face no exposure on foreign currency-denominated transactions. In both cases, gains or losses on exchange rate changes are always offset, either by losses or gains due to offsetting changes in price levels or by price adjustments that reflect expected change rate changes. 1.d. What is exchange risk, as distinct from exposure? ANSWER. Exchange risk involves the extent to which uncertain exchange rate changes lead to uncertain fluctuations in the value of the firm. If the firm has no exposure, it has no exchange risk. 1.e.

Under what circumstances might MNCs be less subject to exchange risk than purely domestic firms in the same industry?

ANSWER. See the discussion of Myth 2 above. 2. The sharp decline of the U.S. dollar between 1985 and 1995 significantly improved the profitability of U.S. firms both at home and abroad. 2.a. In what sense is this profit improvement false prosperity? ANSWER. High profits are due to the state of the dollar, not to sustainable competitive advantage. A reversal of the dollar’s fortunes (as has recently occurred) will cause these profits to disappear. In the meantime, management may mistakenly believe it has performed well; this could lower incentives for efficient production and critical innovation of sustainable competitive advantages. 2.b. How would you incorporate the decline in the dollar in evaluating management performance? In making investment decisions? ANSWER. There are several ways to insulate the manager’s performance against currency shocks. First, one could tie compensation to comparable firms who will suffer the same relative currency shocks. Second, one could construct a hedge (real or synthetic) to determine the value added based on activity outside of exchange variations. In other words, try to determine what fraction of a firm’s profits are due to the value of the dollar, and what fraction can be attributed to controllable factors. In investment decisions, the manager should determine the market price of currency risk. Do otherwise equivalent firms that bear differing levels of currency risk earn different required rates of return? If so, then the market price of currency risk needs to be incorporated explicitly into the discount rate applied to capital projects. Also, an investment manager can develop future currency scenarios and assess profitability under these alternative scenarios. This exercise determines how robust profit projections are to changing international conditions.

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2.c.

Comment on the following statement: “The sharp appreciation of the U.S. dollar during the early 1980s might have been the best thing that ever happened to American industry.”

ANSWER. The resulting severe competitive pressure from foreign firms forced American industry to get lean and mean. This corporate restructuring raised productivity, made companies more responsive to the marketplace, led to improved product quality, shorter product cycles, and redirected capital to more productive uses. This doesn’t mean that American companies appreciated the tune-up; most people don’t like being put on a restrictive diet and being forced to exercise. 3. What marketing and production techniques can firms initiate to cope with exchange risk? ANSWER. Market selection and market segmentation provide the basic parameters within which a company may adjust its marketing mix over time. Short-term tactical responses include adjustments of pricing, promotional, and credit policies. Product sourcing and plant location are the principal variables companies manipulate to manage competitive risks that can’t be dealt with through marketing changes alone. This could include building plants overseas, buying more components overseas, allocating production among plants in line with their changing relative costs, and designing new facilities to provide added flexibility in making substitutions among various sources of goods so as to be better able to respond to relative price differences among domestic and imported inputs. 4. What is the role of finance in protecting against exchange risk? ANSWER. The role of financial management is to structure the firm’s liabilities such that when strategic operational adjustments are underway, the reduction in asset earnings is matched by a corresponding decrease in the cost of servicing these liabilities. For example, a firm that has developed a sizable export market should hold a portion of its liabilities in that country’s currency. In this way, any shortfall in operating cash flows due to an exchange rate change will be offset by a reduction in the debt service expenses. 5. E&J Gallo is the largest vintner in the U.S. It gets its grapes in California (some of which it grows itself) and sells its wines throughout the U.S. Does Gallo face currency risk? Why and how? ANSWER. E&J Gallo faces exchange risk because its wines are competing against foreign wines and changes in the value of the dollar affect its competitiveness. In the early 1980s, for example, the soaring dollar enabled vintners from countries such as France and Italy to cut their wine prices in the U.S. and still earn a good franc or lira profit. Gallo was forced to match these price cuts since the wine categories it sells in tend to be very price sensitive. Gallo’s loss of revenue was offset somewhat by the drop in wine grape prices. California wine grape prices fell since the demand for these grapes is derived from the demand for California wines. As the demand for California wines fell so did the demand for California wine grapes and their prices. 6. DaimlerChrysler’s Chrysler division exports vans to Europe in competition with the Japanese. Similarly, Compaq exports computers to Europe. However, its biggest competitors are all American companies – IBM, Hewlett-Packard, and Tandem. Assuming all else is equal, which of these companies--Chrysler or Digital – is likely to benefit more from a weak dollar? Explain. ANSWER. Chrysler is likely to be the bigger beneficiary of a weak dollar since its primary competitors are the Japanese. The falling dollar gives Chrysler an opportunity to gain market share in Europe from the Japanese by holding its dollar prices constant, thereby lowering its prices in terms of the various European currencies. The Japanese carmakers cannot respond effectively since their costs have not changed in European currency terms. Conversely, by holding its prices constant in European currency terms, Chrysler can fatten its profit margins.

INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

Compaq, on the other hand, will not gain a competitive advantage relative to its primary competitors from a falling dollar since all of them, being U.S. companies, share a common cost structure. Competition will likely force them to pass along lower costs (in European terms) in the form of lower European currency prices. This will probably expand the market overall, but no one company will gain a competitive advantage. By the same token, the existence of a common cost structure means that Compaq will be less affected than Chrysler by a rise in the dollar’s value. 7. In 1994, the Singapore dollar rose by 9% in real terms against the U.S. dollar. What was the likely impact of the strong Singapore dollar on U.S. electronics manufacturers using Singapore as an export platform? Consider the following facts. On average, materials and components – 85% of which are purchased abroad – account for about 60% of product costs. Labor accounts for an additional 15%; other operating costs account for the remaining 25%. ANSWER. The impact was less than might be expected. With 85% of materials and components coming from abroad, the net effect of the 9% rise in the real value of the Singapore dollar on this component of cost is likely to be only about 1.35% (0.15 * 0.09). Since these costs account for about 60% of product costs, the net effect on the overall cost of manufacturing will be only about 0.8%. Assuming that the other 40% of costs are fully exposed to the rise in the real value of the Singapore dollar, the impact of a 9% rise on overall manufacturing costs is 3.6% (0.4 * 0.09). The combination of these two cost elements is a rise in total costs of 4.4%, or just about half the 9% rise in the Singapore dollar. To the extent that some of the other elements of cost (especially energy and capital equipment) come from abroad or are price in U.S. dollar terms, this amount will overstate the overall impact of the rise in the real value of the Singapore dollar on U.S. costs of producing in Singapore. At the extreme, if only labor costs (which account for only 15% of total costs) are exposed, the net impact of the rise in the Singapore dollar is just 1.35% (0.15 * 0.09). 8. Di Giorgio International (DGI), a subsidiary of California-based Di Giorgio Corp., processes fruit juices and packages condiments in Turnhout, Belgium. It buys Brazilian orange concentrate in dollars, German apples in marks, Italian peaches in lire, and cartons in Dutch guilders. At the same time, its exports 85% of its production. Assess DGI’s currency risk and determine how it can structure its financing to reduce this risk. ANSWER. A key question is whether the supplies bought DGI and the products it sells are priced domestically or internationally. The odds are that both inputs and outputs are priced at least somewhat in domestic terms because of the costs and time lags involved in arbitraging among markets. Thus, while DGI is exposed to exchange risk on both its exports and its domestic (Belgian) sales, it has a natural hedge in the form of inputs purchased abroad and Belgian inputs. Since the countries in which it does business are all members of the EMS (except for Brazil), their currencies tend to move together. In the absence of better information, a best guess is that DGI is exposed to foreign exchange risk on its profit margin. One way to hedge this profit margin is to finance in ECUs a fraction of its assets equal to its return on investment. In this way, changes in the dollar value of operating profits will be offset by changes in the dollar cost of servicing its liabilities. Since the depreciation tax shield is also an important component of operating cash flow, and DGI’s depreciation is in Belgian francs, it should finance in Belgian francs a fraction of its assets equal to annual asset depreciation divided by total assets. In this way, if the Belgian franc devalues, DGI’s dollar cash flow from the depreciation tax shield will drop, but so will the cost of servicing its Belgian franc liabilities.

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9. A U.S. company needs to borrow $100 million for a period of seven years. It can issue dollar debt at 7% or yen debt at 3%. 9.a. Suppose the company is an MNC with sales in the U.S. and inputs purchased in Japan. How should this affect its financing choice? ANSWER. According to the IFE, the difference in interest rates reflects expected appreciation in the value of the yen. That is, yen are not automatically less expensive to borrow just because the interest rate on yen is lower than the rate on dollars. From a risk management standpoint, the key issue is the currency risk being borne by the MNC and the effect of its borrowing decision on that currency risk. From the facts given in the question, it appears that based on its sourcing of inputs in Japan, the company is short yen (regardless of whether the input prices are denominated in yen or dollars). Other things being equal, therefore, it appears that the MNC should borrow dollars; borrowing yen will just exacerbate its short position in yen. However, if the company is competing with Japanese firms, then it is more likely to be long yen, in the sense that if the yen appreciates, its competitive position improves and vice versa if the yen depreciates. If this is the case, then the firm’s yen exposure is the net of its short and long exposure, which we cannot ascertain from the facts presented in the question. 9.b. Suppose the company is a multinational firm with sales in Japan and inputs that are primarily determined in dollars. How should this affect its financing choice? ANSWER. In this case, the firm clearly has a long economic exposure to yen. By financing in yen, the MNC can offset its economic exposure. 10. Huaneng Power International is a large Chinese company that runs coal-fired power plants in five provinces and in Shanghai. It has close to $1.2 billion in U.S. dollar debt whose proceeds it has used to purchase equipment abroad. 10.a. What currency risks does Huaneng face? ANSWER. The biggest problem for HPI is that its debt is denominated in dollars whereas its revenues are both denominated and determined in yuan. If the yuan depreciates in real terms against the dollar, HPI will see its dollar-equivalent cash inflows fall while its dollar cash outflows will remain the same on its debt. Given this currency mismatch, HPI’s net yuan profit will rise when the yuan appreciates in real terms against the U.S. dollar and fall when the yuan depreciates in real terms. Another currency risk faced by HPI stems from the fact that coal is traded in a global market and tends to be priced in dollars. If the dollar appreciates in real terms against the yuan, the yuan cost of coal will rise. If HPI is unable to pass that higher cost along to its customers, then it will see its yuan margins shrink. 10.b. Do its lenders face any currency risks? Explain. ANSWER. Yes. If the U.S. dollar appreciates enough, HPI will have difficulty servicing its dollar debts. Thus, the lenders are exposed to risk on their loans stemming from currency fluctuations even though these loans are priced in dollars. In effect, currency risk will be turned into credit risk.

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ADDITIONAL CHAPTER 10 QUESTIONS AND ANSWERS 1. Suppliers of the equipment used to make semiconductors, such as Applied Materials and LAM Research, who produce in the U.S. but are heavily dependent on sales to Asia, saw their share prices plummet in the wake of the Asian financial crisis. Explain. ANSWER. These firms had their costs denominated in dollars and a large portion of their revenues originating in Asia, particularly in Japan and South Korea. The steep decline in the value of Asian currencies led to a dramatic rise in the local currency prices of their equipment. Asian demand fell due to the price increases and because Japanese equipment makers became more competitive. Lower dollar profits, in turn, lowered the present value of the future cash flows of these companies and led to a decline in their stock prices. 2. Malaysian palm oil producers export more than 90% of their product for sale in dollars. Virtually all their costs, however, are in Malaysian ringgit. 2.a. How would the 30% fall in the value of the ringgit during 1997 affect the ringgit profitability of these producers? Explain. ANSWER. Ringgit depreciation combined with a dollar price for palm oil translates into an increase in the ringgit revenue generated by exports of palm oil. At the same time, ringgit costs stay about the same. The result is an increase in the ringgit profit earned by Malaysia’s palm oil producers. 2.b. How would the ringgit's depreciation affect the dollar profits of these producers? Explain. ANSWER. With over 90% of their output exported, the dollar revenue earned by the producers will remain constant (even though domestic sales are priced in ringgit, the ringgit price will reflect the dollar price earned overseas). Their dollar costs, which are sourced in ringgit, will decline in line with the ringgit’s depreciation. Hence, Malaysian palm oil producers will see their dollar profits rise with the ringgit’s depreciation. 3. Many business people and the business press believe that a devalued dollar offers a significant advantage to foreign bidders for American companies and real estate. Comment on this position. ANSWER. It is true that the foreign currency (FC) cost of buying U.S. assets declines in line with depreciation of the U.S. dollar. However, the FC value of future dollar cash flows generated by these assets will simultaneously decline as well. The net result is that the foreign currency return on investment in U.S. assets will remain the same with dollar depreciation. 4. Saint-Gobain, a French firm, and Pilkington PLC, a British firm, are arch rivals in the European flat-glass business. After Britain's exit from the ERM in September 1992, the pound fell by 15% against the franc. 4.a. What was the likely impact on Saint-Gobain's profitability of the pound devaluation? ANSWER. Saint-Gobain will be placed at a competitive disadvantage vis-à-vis Pilkington since Pilkington can maintain its pound prices – thereby cutting its prices in French franc and other European currency terms – and gain market share. Were Saint-Gobain to respond by cutting its prices, its franc profits would fall. Of course, if Saint-Gobain has substantial production capacity in the U.K. it will be able to offset some of its problems by shifting more production to its U.K. operations. (It doesn’t, so it must bear the full brunt of the pound devaluation.)

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4.b. What was the likely impact on Pilkington’s profitability of the pound devaluation? ANSWER. Assuming that Pilkington is producing in England, its profitability should have gone up. Either it can fatten its margins by holding its European currency prices constant, or it can hold its pound prices constant and thereby gain market share from its European competitors. Of course, if Pilkington has other competitors who are producing in the U.K., then its competitive advantage will not be as great as it otherwise would be. 5. Bakrie, an Indonesian conglomerate, is assessing the likely consequences of the rupiah’s precipitous decline on its different businesses. These businesses include a telecommunications company that is building a network (using mostly imported equipment) throughout Jakarta to offer wireless service to its residents, a company that sells pipe to the Western firms exploiting Indonesia's oil and gas fields, and a big agricultural business (54% of its revenues are in dollars, compared with 40% of its costs) that owns rubber and palm plantations feeding a large refining and distribution operation. 5.a. Assess the likely impact of the rupiah’s depreciation on Bakrie's three different businesses. ANSWER. The telecommunications unit has its equipment costs in foreign currency whereas its revenues will be in devalued rupiah. Although its operating costs will be in rupiah as well, most expenses on a wireless network come from equipment costs. Hence, the net effect of rupiah devaluation on the telecommunications unit will be very negative. The pipe business will likely benefit from rupiah devaluation since it is paid in dollars, whereas its costs are largely in rupiah. Although the agricultural business’s dollar revenues and costs are more evenly balanced, it is a net recipient of dollars. Thus, it too should benefit from rupiah devaluation. 5.b. Which of Bakrie’s businesses will be most hurt by the rupiah’s fall? Will any of these businesses actually benefit from rupiah depreciation? ANSWER. The telecommunications business will be greatly hurt by rupiah devaluation. The other two businesses will benefit, although it is difficult to say which will benefit the most. 5.c.

Bakrie has about $1 billion in foreign debt. Will this debt increase or decrease its currency exposure? Explain.

ANSWER. As it turns out, the magnitude of Bakrie’s debt is so large that it completely offsets any benefits that rupiah devaluation might have on its agricultural and pipe businesses. The net effect of this transaction exposure is to swamp Bakrie and leave it greatly exposed to adverse effects from the rupiah’s devaluation. 6. Midwestern Bank has lent $10 million to finance an equipment sale to Thailand by Lasertech, a major exporter located in Michigan. Both the loan and the sale are priced in U.S. dollars. 6.a. Is Midwestern’s loan to Lasertech exposed to exchange risk? Explain. ANSWER. Yes. If the U.S. dollar appreciates against the Thai baht (which it has), the Thai importer’s cost of paying Lasertech will go up and Lasertech will likely have more difficulty collecting on its sale. If the importer defaults on the sale, Lasertech may have trouble repaying its debt. Thus, Midwestern is exposed to risk on its loan stemming from currency fluctuations even though the loan is priced in dollars.

INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

6.b. Suppose Midwestern has lent money to Lasertech secured by the general credit of the company. Are these loans exposed to exchange risk? Explain. ANSWER. Yes. If the dollar appreciates against other currencies, Lasertech will face more competition from foreign companies and will be under pressure from foreign customers to lower its dollar prices (who will see prices in their domestic currencies rise with dollar appreciation). By diminishing Lasertech’s profitability, a stronger dollar will also diminish the probability of timely repayment of Midwestern’s loans to Lasertech and, hence, Midwestern’s profitability. To the extent Midwestern’s loans are affected by the value of the dollar, those loans are subject to exchange risk. 7. Why should managers focus on marketing and production strategies to cope with foreign exchange risk? ANSWER. Unlike transaction exposure, which is amenable to financial hedging, competitive exposures – those arising from competition with firms based in other currencies – are longer-term, harder to quantify, and cannot be dealt with solely through financial hedging techniques. Rather, they require more strategic maneuvers involving changes in operating strategies. For this reason, the major burden of exchange risk management must fall on the shoulders of marketing and production executives. These executives deal in imperfect product and factor markets where their superior knowledge and specialized skills provide them with a comparative advantage in adjusting to the relative price changes caused by currency changes. 8. In what sense is the boost in profits of American companies due to a falling dollar artificial? ANSWER. The higher profits experienced by American companies due to a falling dollar are not the result of management excellence, product innovation, or a new low-cost production process. They are also not permanent since the real exchange rate follows a random walk. In this sense they are artificial. 9. How does a shorter product-cycle time help companies reduce the exchange risk they face? ANSWER. Success in an environment characterized by volatile exchange rates depends on a firm’s ability to react to change within a shorter time horizon than ever before. A key is shorter product cycle times – the time it takes to bring new and improved products to market. With shorter product cycles, the company can incorporate more up-to-date technology in its goods and respond faster to emerging market niches and changes in taste. The result is less price elasticity of demand and less exchange risk. Such speed and flexibility enable companies to change their strategies substantially before the impact of any currency change can make itself felt. In this way, the adjustment period following a large exchange rate change can be compressed dramatically, lessening exchange risk. 10. Why do exchange rate changes bring feast or famine for Volvo, but neither feast nor famine for Ford? Consider the distribution and concentration of their production facilities worldwide. ANSWER. Volvo has almost all its production facilities located in Sweden while it exports a large fraction of its output. The resulting imbalance in its revenue/cost structure means that for Volvo it has been feast or famine: When the krona appreciates, Volvo’s exports suffer from a lack of cost competitiveness, while a real krona depreciation brings high profits. By contrast, Ford, with worldwide manufacturing facilities, has substantial leeway in reallocating various stages of production among its several plants in line with relative production and shipping costs. For Ford, therefore, it is neither feast nor famine. It neither benefits as much from dollar depreciation nor loses as much from dollar appreciation.

CHAPTER 10: MEASURING AND MANAGING ECONOMIC EXPOSURE

11. To cut costs when the dollar was at its peak, Caterpillar shifted production of small construction equipment overseas. By contrast, Caterpillar's main competitors in that area, Deere & Co. and J.I. Case, make most of their small construction equipment in the U.S. What are the most likely competitive consequences of this restructuring? ANSWER. Caterpillar now has a diversified cost structure. Thus, it won’t be hurt as much when the dollar rises again, but it also will not benefit as much when the dollar falls. Its main competitors, Deere & Co. and J.I. Case, now have a competitive advantage vis-à-vis Caterpillar by producing most of their small construction equipment in the U.S. Caterpillar has responded to the weak dollar by shifting parts sourcing back to the U.S. It has also made an intense commitment to improving its U.S. manufacturing. To do this, it launched its so-called Plant With a Future program. The program involved overhauling virtually all the firm’s U.S. factories, installing fancy new robotics and streamlining assembly systems. It replaced obsolete assembly lines and their large parts inventories with highly automated clusters or cells that produce components for final assembly. 12. When the dollar was strong and it could not earn a reasonable profit on European sales, Osmose International gave up its government permits to sell its chemical wood preservatives in much of Europe. “Why pay for a permit when you can't sell anything there anyway?” said its president. 12.a. What response do you have for the president of Osmose? ANSWER. Maintaining its permits gives Osmose the option to return to the European market if and when the dollar weakened. This option is valuable in a world where exchange rates can fluctuate dramatically and stay at depressed levels for many years (as has subsequently proved to be the case). When the dollar fell in value, Osmose decided to reenter the European market, but it found that reapplying for permits takes years. At the same time, Osmose no longer has a service organization in Europe. 12.b. How might you go about assessing the trade-offs involved for Osmose? ANSWER. The more a currency fluctuates, the more valuable an option to move back into a market quickly becomes. Such an option also rises in value with the cost of reentry (in the form of having to recreate a sales organization) and with the time it takes to reapply for permits. The value of maintaining the option of reentering the market quickly must be traded off against the cost of maintaining the permits and the sales organization. All else being equal, the higher the cost of maintaining the permits and sales organization, the less valuable it is to preserve the market reentry option. 13. To avoid speculation, Honda hedges only the sales it has clinched, not the ones it expects. Comment on Honda's currency risk strategy. ANSWER. Honda is hedging its transaction exposure, but this leaves it with operating exposure, which is typically a much larger fraction of total economic exposure. In other words, while hedging some of its exposure reduces risk, the risk reduction is much less than it could be if Honda took its operating exposure into account when deciding on how much to hedge. The policy of only hedging actual sales also leaves Honda vulnerable if the dollar strengthens temporarily, as it did at the end of 1993. A bigger problem facing the Japanese companies in hedging their exposure is that they tend to hedge selectively; that is, they hedge only if they think the dollar will decline and go unhedged otherwise. However, their guesses are often wrong. For example, at the start of 1994, many Japanese firms thought the dollar would continue to strengthen and thus failed to roll over their forward contracts. They subsequently lost a great deal of money when the dollar plummeted in January following another trade fight between Japan and the U.S.

INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

SUGGESTED SOLUTIONS TO CHAPTER 11 PROBLEMS 1. Hilton International is considering investing in a new Swiss hotel. The required initial investment is $1.5 million (or SFr1.875 million at the current exchange rate of $0.8 = SFr1). Profits for the first ten years will be reinvested, at which time Hilton will sell out to its partner. Based on projected earnings, Hilton's share of this hotel will be worth SFr 3.88 million in ten years. 1.a. What factors are relevant in evaluating this investment? ANSWER. Hilton should focus on the real dollar value of future cash flows, or 3,880,000e10/[(1+k)(1+ius)]10 where e10 is the nominal dollar value of the Swiss franc in ten years, i us is the average annual rate of U.S. inflation over the next ten years, and k is Hilton’s real required return for this project. That is, the SFr3.88 million expected to be received in ten years should first be converted to nominal dollars, then into real dollars, and finally discounted at the real required return. This present value figure should then be compared to $1.5 million, the current cost of the investment (3,380,000 * 0.80). 1.b. How will fluctuations in the value of the Swiss franc affect this investment? ANSWER. Only fluctuations in the real value of the Swiss franc matter; fluctuations in the nominal value of the Swiss franc that are fully offset by higher U.S. inflation should not affect the investment. If the real value of the Swiss franc rises, the real dollar price of the hotel services being sold by Hilton will also rise. If demand for these services is elastic, which it seems to be given the Swiss hotel industry’s heavy dependence on tourists, real dollar revenues will decline. Inelastic demand will cause an increase in real dollar revenues. The hotel’s real dollar cost of Swiss labor and services will rise. Thus, if PPP holds, nominal currency changes shouldn’t affect Hilton’s Swiss investment; if PPP does not hold, an increase in the real exchange rate is likely to reduce the real value of Hilton’s investment. 1.c.

How would you forecast the $:SFr exchange rate ten years ahead?

ANSWER. There are several ways to forecast the nominal Swiss exchange rate ten years out: (1) Rely on the IFE, using nominal interest differentials between U.S. and Swiss bonds with maturities of ten years; (2) project relative price levels changes in Switzerland and the U.S. over the next ten years and then use PPP to forecast the rate change; and (3) use the forward rate if a ten-year swap can be found. But what really matters is what happens to the real exchange rate. The best forecast of the real rate ten years out is the current spot rate. Over the long run, PPP tends to hold, leading to a relatively constant real exchange rate.

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2. A proposed foreign investment involves a plant whose entire output of 1 million units per annum is to be exported. With a selling price of $10 per unit, the yearly revenue from this investment equals $10 million. At the present rate of exchange, dollar costs of local production equal $6 per unit. A 10% devaluation is expected to lower unit costs by $0.30, while a 15% devaluation will reduce these costs by an additional $0.15. Suppose a devaluation of either 10% or 15% is likely, with respective probabilities of 0.4 and 0.2 (the probability of no currency change is 0.4). Depreciation at the current exchange rate equals $1 million annually, while the local tax rate is 40%. 2.a. What will annual dollar cash flows be if no devaluation occurs? ANSWER. The cash flows associated with each exchange rate scenario are: Devaluation

10%

15%

Revenue

$10.00

Less Variable Cost

-6.00

-5.70

-5.55

Less Depreciation

-1.00

-0.90

-0.85

Taxable Income

3.00

3.40

3.60

Less Tax @ 40%

-1.20

-1.36

-1.44

After-Tax Income

1.80

2.04

2.16

Add Depreciation

1.00

0.90

0.85

Cash Flow

2.80

2.94

3.01

With no devaluation, the annual cash flow will equal $2.8 million. 2.b. Given the currency scenario described above, what is the expected value of annual after-tax dollar cash flows assuming no repatriation of profits to the U.S.? ANSWER. The expected dollar cash flow will equal the sum of the cash flows under each possible devaluation percentage multiplied by the probability of that devaluation occurring or 2.8(0.4) + 2.94(0.4) + 3.01(0.2) = $2.9 million. Thus expected dollar cash flows actually increase by $100,000. If the impact of the expected devaluation of 7% (0.1 * 0.4 + 0.15 * 0.2) were calculated by reducing expected cash flows by 7%, the expected (and incorrect) result would be a loss of $196,000 (2.8 * 0.07). 3. Mucho Macho is the leading beer in Patagonia, with a 65% share of the market. Because of trade barriers, it faces essentially no import competition. Exports account for less than 2% of sales. Although some of its raw material is bought overseas, the large majority of the value added is provided by locally supplied goods and services. Over the past five years, Patagonian prices have risen by 300%, and U.S. prices have risen by about 10%. During this time period, the value of the Patagonian peso has dropped from P 1 = $1.00 to P 1 = $0.50. 3.a. What has happened to the real value of the peso over the past five years? Has it gone up or down? A little or a lot? ANSWER. The real value of the Patagonian peso, relative to its value five years ago, is now $0.50 * 4/1.1 = $1.82. Thus, the real value of the peso has risen by 82%. As discussed in the chapter, an increase in the real value of the local currency should boost dollar profits for those firms selling locally and not subject to import competition.

INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

3.b. What has the high inflation over the past five years likely done to Mucho Macho’s peso profits? Has it moved profits up or down? A lot or a little? Explain. ANSWER. A reasonable assumption is that both Mucho Macho’s sales and costs have risen at least at the rate of Patagonian inflation. Thus, its peso profits, which equal the difference between the two, have risen at least 300% over the past five years. In fact, sales have probably risen by more than the rate of inflation, while costs have risen at less than the rate of inflation because some of the inputs are bought overseas. 3.c. Based on your answer to part a, what has been the likely effect of the change in the peso’s real value on Mucho Macho’s peso profits converted into dollars? Have dollar-equivalent profits gone up or down? A lot or a little? Explain. ANSWER. Given the answers to items a and b, each peso of profits five years ago should now have grown to at least four pesos. Converting these profits into dollars at the lower exchange rate ($0.50 vs. $1) yields at least two dollars of profit today for every dollar of profit five years ago. 3.d. Mucho Macho has applied for a dollar loan to finance its expansion. Were you to look solely at its past financial statements in judging its creditworthiness, what would be your likely response to Mucho Macho's dollar loan request? ANSWER. The real appreciation of the Patagonian peso should have boosted Mucho Macho’s dollar profits dramatically. Thus, any analysis of creditworthiness based solely on its financial statements would show a very profitable and successful company and one deserving of a loan. 3.e.

What foreign exchange risk would such a dollar loan face? Explain.

ANSWER. The profitability of Mucho Macho is an artifact of the real peso appreciation. Thus it is artificial and not sustainable. The odds are that the government will be unable to maintain such an overvalued exchange rate for long. Once the peso devalues, the dollar value of Mucho Macho’s peso cash flow will plummet and so will its ability to repay its dollar loan. This exercise points out that an analysis of credit risk based solely on financial statements is valid only if one assumes that the conditions that gave rise to the numbers reflected on these statements will persist into the future. Under a controlled exchange rate system in an inflationary environment, the real exchange rate is subject to dramatic changes. These changes in turn will give rise to dramatic changes in the business environment, making past financial statements irrelevant in forecasting future cash flows. Although the numbers have been changed, this problem is based on an actual situation. In the late 1970s, some major American banks lent a great deal of money to one of the largest Chilean brewers. This brewer faced essentially no competition and so was highly profitable in both peso and dollar terms prior to devaluation of the peso. Although its credit looked impeccable, the brewer’s loans are now in default. The bankers forgot to assess the conditions that led to the brewer’s high profits and the likelihood that these conditions would persist. When government intervention causes nominal exchange rate changes to lag inflation, the real value of the currency will rise. The more rapid the inflation and the greater the lag, the greater the real exchange rate change. The increasing real value of the local currency in turn will cause pressures to build up that must ultimately be released through an LC devaluation. Thus, in assessing credit risk for foreign borrowers operating in a controlled rate system, it is necessary to assess their creditworthiness both before and after the inevitable devaluation.

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4. In 1990, General Electric acquired Tungsram Ltd., a Hungarian light bulb manufacturer. Hungary’s inflation rate was 28% in 1990 and 35% in 1991, while the forint (Hungary’s currency) was devalued 5% and 15%, respectively, during those years. Corresponding inflation for the U.S. was 6.1% in 1990 and 3.1% in 1991. 4.a. What has happened to the competitiveness of GE’s Hungarian operations during 1990 and 1991? Explain. ANSWER. Since forint devaluations haven’t kept pace with Hungary’s roaring inflation, we know that the forint’s real exchange rate has risen. Specifically, if the nominal exchange rate (dollar value of the forint) at the start of 1990 was e0, the forint’s real value at the end of 1991 was: 0.95 * 0.85e0 * (1.28)(1.35)/[(1.061)(1.031)] = 1.276e0 This equation reflects the fact that if the nominal exchange rate (dollar value of the forint) at the start of 1990 was e0, then the 5% devaluation during 1990 left it at 0.95e0 by the end of 1990. A further 15% devaluation during 1991 would have left the nominal rate equal to 0.95 * 0.85e0 by the end of 1991. Based on this equation, we can see that the real exchange rate increased by 27.6% during this two-year period. The sharp appreciation in the real value of the forint reduced the cost competitiveness of GE’s Hungarian operations. 4.b. In early 1992, GE announced that it would cut back its capital investment in Tungsram. What might have been the purpose of GE’s publicly announced cutback? ANSWER. GE was trying to put pressure on the Hungarian government to devalue further the forint and thereby improve the cost competitiveness of its Tungsram manufacturing facilities. In effect, GE was telling the Hungarian government that it was in business to make a profit and that if it couldn’t make a profit in Hungary because of the high forint and the resulting sharp jump in its costs, it was not going to invest there in the future. 5. In 1985, Japan Airlines (JAL) bought $3 billion of foreign exchange contracts at ¥180/$1 over 11 years to hedge its purchases of U.S. aircraft. By 1994, with the yen at about ¥100/$1, JAL had incurred over $1 billion in cumulative foreign exchange losses on that deal. 5.a. What was the economic rationale behind JAL’s hedges? ANSWER. Most likely, JAL had signed contracts to take delivery of planes in the future and was using forward contracts to protect itself against a rise in the value of the dollar that would increase the yen cost of buying the planes. Alternatively, the forward contracts could have been used to hedge purchases of U.S. planes financed by borrowing dollars.

INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

5.b. Did JAL’s forward contracts constitute an economic hedge? That is, is it likely that JAL’s losses on its forward contracts were offset by currency gains on its operations? ANSWER. The answer to this question depends on whether JAL’s yen operating profits are negatively correlated with the yen’s value. If a stronger yen means lower yen operating profits, then these forward contracts would constitute an economic hedge. Some factors to consider in deciding whether this is likely to be the case are as follows. First, a good part of JAL’s costs are for Japanese flight crews, whose pay is denominated and determined in yen. To the extent that fares are determined in dollars (in part because JAL is competing with U.S. airlines, JAL’s yen profits will vary inversely with the yen’s value). At the same time, a stronger yen will induce more Japanese to travel to the U.S. but fewer Americans to visit Japan, increasing outbound volume but reducing inbound volume. Where the balance lies is an empirical question. It turns out that JAL has been hurt by yen appreciation and is now looking to cut costs, primarily by reducing its Japanese work force through job buyouts and hiring foreigners. It has also focused more on serving leisure travelers since the yen’s strength has led unprecedented numbers of Japanese tourists to travel abroad. 6. Nissan produces a car that sells in Japan for ¥1.8 million. On September 1, the beginning of the model year, the exchange rate is ¥150:$1. Consequently, Nissan sets the U.S. sticker price at $12,000. By October 1, the exchange rate has dropped to ¥125:$1. Nissan is upset because it now receives only $12,000 * 125 = ¥1.5 million per sale. 6.a. What scenarios are consistent with the U.S. dollar’s depreciation? ANSWER. Any model of exchange rate determination may be applied here. In a monetary model this would include a relative increase in the U.S. money supply (or velocity), a relative decrease in U.S. income, or the expectation of these events in future periods. In an open-economy Keynesian model, yen appreciation could arise from an increase in U.S. imports from Japan (due to an increase in U.S. income). If PPP holds, then relative prices levels should also have changed by 10%. Alternatively, the exchange rate change could be due to government intervention to push down the dollar’s value, or it could be due to the cessation of government intervention that was previously maintaining an overvalued dollar. 6.b. What alternatives are open to Nissan to improve its situation? ANSWER. The alternatives open to Nissan are: i)

Raise prices in the U.S. market.

ii) Do nothing for the short run. Incur some losses and hope that the exchange rate will return to ¥200. In addition, hold U.S. sales receipts in dollars and do not repatriate funds until the exchange rate is more favorable. The second part of this strategy is probably useless since it requires that any exchange rates changes not be offset by the differing interest rates between Japan and the U.S. iii) Invest in the U.S. and build the cars there. (In 1993, 45% of the cars Toyota sold in the U.S. were U.S. made.) iv) Try to reduce production costs in Japan, including buying more parts overseas. (How have production costs in Japan changed because of the exchange rate change? For example, consider the cost of domestic labor and the costs of imported iron ore and oil.) Many Japanese firms have also found that they could cut costs by simplifying their product line as well as by reducing the variety of

CHAPTER 10: MEASURING AND MANAGING ECONOMIC EXPOSURE

parts used in their products. For example, Nissan offers 437 different kinds of dashboard meters, 110 types of radiators, and over 300 varieties of ashtrays. In 1993, Nissan ordered its designers to slash the number of unique parts in its vehicles by 40%. Model variations, which had ballooned to more than 2,200, will be rolled back 35%. Another strategy being used by Japanese automakers is have designers work closely with suppliers, marketing, and manufacturing people--thus avoiding expensive mistakes later on and reducing product development times and costs. Japanese companies are also, for the first time, closing factories and cutting jobs. v) Recognize that your comparative advantage is permanently lost and exit the U.S. market. vi) Switch production to higher quality, less price-elastic and more income-elastic cars. 6.c.

How should Nissan respond in this situation?

ANSWER. The appropriate response by Nissan depends on its interpretation of the nature of the economic disturbance that caused the exchange rate change. If it believes that the shock is temporary, Nissan must calculate how long it will take for the exchange rate to return to its original level. If the shock is nominal (PPP holds), then the real terms of trade between Japan and the U.S. are unaffected. In this case, U.S. prices in general should have been rising and Nissan can pass along all of the exchange rate change to his U.S. customers. (This is an important point: Is PPP a “leading” or a “lagging” relationship? How quickly can exchange rate changes be incorporated into domestic prices?) In the present circumstance, it is virtually certain that the 10% drop in the value of the dollar is not just a manifestation of purchasing power parity; that is, the dollar depreciation is not due to a 10% jump in the U.S. price level relative to the Japanese price level in the space of one month (a 314% annual rate of U.S. inflation). If the exchange rate change is real, which it almost surely is, then the yen appreciation is not associated with offsetting changes in domestic prices. In this case, Nissan must make some real changes in response to stay competitive with U.S. automakers. These changes depend on whether the increase in the real exchange rate is expected to be temporary or permanent. If the increase is due to intervention by the U.S. or Japanese central banks, the change is likely to be temporary because it is a movement away from equilibrium. Alternatively, a real exchange rate change that is due to market forces or to the cessation of intervention by the Japanese or U.S. central banks can be assumed permanent. Permanent in this context means that the best predictor of tomorrow’s real exchange rate is today’s rate. It doesn’t mean that the real rate tomorrow will be the same as the real rate today; rather, the real rate follows a random walk. If the real exchange rate increase is expected to be temporary, it may not pay Nissan to raise dollar prices and lose market share in the U.S. The reason is that when the real exchange rate readjusts, enabling Nissan to be price competitive again, it will be expensive to buy back market share. But if the real exchange rate increase is expected to be permanent, then Nissan should consider raising its prices (the extent depends on the price elasticity of demand) and making more basic changes in production and marketing strategy. Most Japanese firms have followed a strategy of cutting costs at home and keeping dollar prices constant as long as possible so as to hang onto U.S. market share.

INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

6.d. Suppose that on November 1, the U.S. Federal Reserve intervenes to rescue the dollar, and the exchange rate adjusts to ¥220:$1 by the following July. What problems and/or opportunities does this situation present for Nissan and for General Motors? ANSWER. Here, the tables are reversed from part c. Nissan is “enjoying” an increase of 10% in its yen receipts from U.S. auto sales. Whether its "enjoyment" is real depends again on the nature of the economic disturbance associated with the exchange rate change. If Japanese production costs are rising because of inflation (associated with the yen devaluation) Nissan need not be better off in real terms. Its opportunities still depend on the “real/nominal” and “permanent/ temporary” nature of the shock. It is interesting to think about the possibilities here for domestic wage and price controls, foreign exchange controls, or foreign exchange market intervention that might be associated with these sharp exchange rate changes. Even if Nissan can determine an optimal response to the exchange rate change, its response may be foreclosed by government regulations. In this case, Nissan must consider second best strategies. 7. Chemex, a U.S. maker of specialty chemicals, exports 40% of its $600 million in annual sales: 5% goes to Canada and 7% each to Japan, Britain, Germany, France, and Italy. It incurs all its costs in U.S. dollars, while most of its export sales are priced in the local currency. 7.a. How is Chemex affected by exchange rate changes? ANSWER. As an exporter, Chemex is helped by dollar depreciation and hurt by dollar appreciation. If the dollar appreciates, the firm’s costs will appreciate in terms of the foreign currencies in which it sells. If it raises its foreign currency prices, it risks losing sales, and with them profits--and worse, permanent market standing. If it does not raise prices in the foreign currencies, its dollar profit margins shrink, and with them its profits. Yet, Chemex may not be affected as much by currency changes as a commodity chemical maker would be since its products are differentiated (it makes specialty chemicals). To the extent that its major competitors are other American companies, who share a common cost structure, its exchange risk will be lower still. 7.b. Distinguish between Chemex’s transaction exposure and its operating exposure. ANSWER. Chemex’s transaction exposure stems from the fact that most of its export sales are priced in the local currency of the countries to which it exports. Its operating exposure arises because the dollar-equivalent prices that it can charge in foreign markets and its foreign sales volume at a given dollar price are affected by currency changes. In other words, currency changes will affect the profits that Chemex can earn abroad. To the extent that Chemex faces competition in the U.S. from foreign firms, its domestic profits will also depend on exchange rates. 7.c.

How can Chemex protect itself against transaction exposure?

ANSWER. Chemex can hedge its transaction exposure by selling its foreign currency receipts forward for dollars.

CHAPTER 10: MEASURING AND MANAGING ECONOMIC EXPOSURE

7.d. What financial, marketing, and production techniques can Chemex use to protect itself against operating exposure? ANSWER. Chemex can finance its assets with foreign-currency-denominated debt in proportion to its sales in each country. This would involve raising 40% of its financing in foreign currencies as follows: 5% in Canadian dollars and 7% each in Japanese yen, British pounds, DM, French francs, and Italian lira. Although only a rough guide, this approach would help align its cost structure with its market structure. On the marketing side, Chemex’s position in the specialty chemical business already provides a hedge against currency risk since it reduces the price elasticity of demand. Chemex should continue to fund R&D to ensure a continuing stream of products with lower price elasticity of demand and work on bringing these new products to market quickly. In addition, Chemex should try to add more value to its products by providing more service to customers. This technique also lowers the price elasticity of demand, which is the basic marketing strategy for coping with currency risk. Chemex must also decide whether to price for market share or profit margin. This decision, which depends on both the price elasticity of demand and the marginal cost of production, will determine by how much it adjusts its dollar price when exchange rates change. On the production side, Chemex could globally source to shift suppliers in line with changing relative production costs in different countries. This strategy, however, is unlikely to pay big dividends because the raw materials that Chemex uses are commodity chemicals whose prices are similar worldwide. Chemex could also set production facilities in its major markets. But this strategy may not permit Chemex to take full advantage of production economies of scale. Chemex can also embark on a program of institutionalized cost cutting. The latter is just good business practice and will be beneficial regardless of currency movements. 7.e.

Can Chemex eliminate its operating exposure by hedging its position every time it makes a foreign sale or by pricing all foreign sales in dollars? Why or why not?

ANSWER. Either approach will allow Chemex to eliminate its transaction exposure. But neither will protect Chemex’s margins on future sales. This can only be done by hedging the present value of future sales, which is what financing assets with foreign currency debt in proportion to foreign sales effectively does. 8. During 1993, the Japanese yen appreciated by 11% against the dollar. In response to the lower cost of the main imported ingredients – beef, cheese, potatoes, and wheat for burger buns – McDonald’s Japanese affiliate reduced the price on certain set menus. For example, a cheeseburger, soda, and small order of french fries were marked down to ¥410 from ¥530. Suppose the higher yen lowered the cost of ingredients for this meal by ¥30. 8.a. How much of a volume increase is necessary to justify the price cut from ¥530 to ¥410? Assume the previous profit margin (contribution to overhead) for this meal was ¥220. What is the implied price elasticity of demand associated with this necessary rise in demand? ANSWER. The net effect of the price cut and the lower yen cost of ingredients is a decline in profit per meal of ¥90 (¥120 - ¥30). The new profit margin per meal will now fall to ¥130 (¥220 - ¥90). This is a decline of 41% (90/220). To maintain overall yen profitability, given unit profits only 59% of what they were previously, the volume of meals must rise by 69% (0.59 * 1.69 = 1). From a dollar standpoint, however, the new profit margin has fallen only 34%. This can be seen as follows. The new profit margin of ¥130 is worth 11% more in dollar terms. As a fraction of the previous margin, this is equivalent to a dollar margin that is 66% of the previous dollar margin (130 * 1.11/220). The difference of 34% represents the decline in the dollar margin. To maintain total dollar profits, therefore, McDonald’s volume must rise by 52% (0.66 * 1.52 = 1).

INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

8.b. Suppose sales volume of this meal rises by 60%. What will be the percentage change in McDonald’s dollar profit from this meal? ANSWER. Here, the new dollar profit relative to the previous one will be 0.66 * 1.60 = 1.06, or a 6% rise in dollar profit. 8.c.

What other reasons might McDonald’s have had for cutting price besides raising its profits?

ANSWER. McDonald’s may be trying to raise its market share in the expectation that this will enable it to later capitalize on this expansion and sell additional meals in the future. In addition, McDonald’s may be able to sell higher-priced meals to the additional people (family members and friends) that come along with the customers buying the discounted meals. In other words, the discounted meals may serve as loss leaders. 9. In 1990, a Japanese investor paid $100 million for an office building in downtown Los Angeles. At the time, the exchange rate was ¥145/$1. When the investor went to sell the building five years later, in early 1995, the exchange rate was ¥85/$1 and the building’s value had collapsed to $50 million. 9.a. What exchange risk did the Japanese investor face at the time of his purchase? ANSWER. The risk is that the value of the dollar would fall against the yen and that the dollar revenues would not keep up with the decline in the value of the dollar. 9.b. How could the investor have hedged his risk? ANSWER. The investor could have financed his purchase of the building by borrowing dollars, so that the very same event that led to a decline in the yen value of his asset – namely, a dollar decline – would simultaneously reduce the yen cost of the liability used to finance that asset. He could also have taken out a long-dated forward contract to hedge the yen value of his building. Nothing would have protected the investor from the decline in the building’s dollar price. 9.c.

Suppose the investor financed the building with a 10% downpayment in yen and a 90% dollar loan accumulating interest at the rate of 8% per annum. Since this is a zero-coupon loan, the interest on it (along with the principal) is not due and payable until the building is sold. How much has the investor lost in yen terms? In dollar terms?

ANSWER. Based on the 10% downpayment, the investor’s initial yen investment was ¥1.45 billion (0.10 * 100 million * 145). At an interest rate of 8%, the $90 million loan used to finance the balance of the building’s price will grow by the end of five years to $132,239,527 (1.085 * $90,000,000). On selling the building and paying off the loan, the investor will have a dollar loss of $82,239,527 ($132,239,527 $50,000,000). At the current spot rate of ¥85/$1, this dollar loss translates into a yen loss of ¥6.99 billion. Adding this loss to the investor’s initial downpayment of ¥1.45 billion yields a total yen loss for the investor of ¥8.44 billion.

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9.d. Suppose the investor financed the building with a 10% downpayment in yen and a 90% yen loan accumulating interest at the rate of 3% per annum. Since this is a zero-coupon loan, the interest on it (along with the principal) is not due and payable until the building is sold. How much has the investor lost in yen terms? In dollar terms? ANSWER. If the investor had financed the building with the 90% yen loan, the investor would have had to borrow 100,000,0000 * 0.90 * ¥145 = ¥13.05 billion. At an interest rate of 3%, the ¥13.05 billion loan will grow by the end of five years to ¥15.13 billion (1.035 * ¥13.05 billion). The $50 million sale price translates into ¥4.25 billion (50,000,000 * 85). After paying off the loan, the investor has a loss of ¥10.88 billion. Adding to this loss the initial downpayment of ¥1.45 billion produces a total loss for the investor of ¥12.33 billion. It can be seen from the answer to part c that the use of dollar financing reduced the investor’s loss. The investor, of course, lost anyway because the value of the building declined instead of rising by at least the rate of interest. 10. Over the past year, China has experienced an inflation rate of about 22%, in contrast to U.S. inflation of about 3%. At the same time, the exchange rate has gone from Y8.1/U.S.$1 to Y7.6/U.S.$1. 10.a. What has happened to the real value of the yuan over the past year? Has it gone up or down? A little or a lot? ANSWER. The real value of the yuan, relative to its value one year ago, has risen significantly. Specifically, in dollar terms, the nominal exchange rate has appreciated from $0.1235 (1/8.1) to $0.1316 (1/7.6), a 6.54% increase ([0.1316 - 0.1235]/0.1235). In real terms, the yuan has appreciated to $0.1316 * 1.22/1.03 = $0.1559. Thus, the real value of the yuan has risen by 21.1%: (0.1559 - 0.1235)/0.1235 = 26.2% If PPP held, the yuan should have devalued to a new exchange rate of e = 8.1 * 1.22/1.03= Y9.59/$ You can tell this is the PPP rate because at this exchange rate, the real rate remains at Y8.7/$: Real rate = 9.59 * 1.03/1.22 = Y8.1/$ 10.b. What are the likely effects of the change in the yuan’s real value on the dollar profits of a company like Procter & Gamble that sells almost exclusively in the local market? ANSWER. A reasonable assumption is that P&G’s sales, which are generated domestically, have risen at least at the rate of Chinese inflation. Meanwhile, costs are partially denominated in dollars (via imports of various inputs) and partially in yuan (via locally-sourced inputs, including labor). Hence, costs have risen by less than the rate of Chinese inflation (since the inflation-adjusted value of the dollar and, therefore, dollardenominated costs have fallen). This means that yuan profits, which equal the difference between revenues and costs, have risen at least 22% over the past year. In turn, given the 6.54% rise in the dollar value of the yuan, dollar profits for P&G should have risen by at least 30% (1.22 * 1.0654 - 1). These results just point to the more general truth that an increase in the real value of the local currency should boost dollar profits for those firms selling locally and not subject to import competition.

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10.c. What are the likely effects of the change in the yuan’s real value on the dollar profits of a textile manufacturer that exports most of its output to the U.S.? What can it do to manage these effects? ANSWER. The impact of the rise in the real value of the yuan on a textile manufacturer that exports most of its output to the U.S. will be the opposite of its impact on P&G. Specifically, the textile manufacturer will find that its costs in dollar terms have risen by about 30% (taking into account the combined effects of Chinese inflation and yuan appreciation) whereas its dollar revenues have risen by about the rate of U.S. inflation, or 3%. The combination of a 3% rise in revenues and a 30% rise in costs means shrinking margins in dollars. Since the dollar has fallen against the yuan, the result in an even bigger squeeze on the yuan profit margin. ADDITIONAL CHAPTER 11 PROBLEMS AND SOLUTIONS Problems 1 and 2 are based on the Spectrum Manufacturing AB case (scenarios 1, 2, and 3) presented in the chapter. Calculate Spectrum’s economic exposure under the following new scenarios: 1. Scenario 4: Sales and import prices rise; domestic materials substituted for imported materials; other variables remain the same. 1.a. Spectrum is able to raise the krona price of its sheet plastic to SEK 25 to exactly offset the effect of the devaluation. 1.b. Because of domestic materials substitutions, krona operating expenditures rise by only 4% relative to the base case. 1.c.

Physical sales volume stays at its predevaluation level.

SCENARIO 4 ANSWER: Under this scenario the post-devaluation operating cash flow will be $1,268,000 annually. The calculations are shown in Exhibit 1. Spectrum’s first year gain from operations is: First year cash flow (SEK 4 = $1) = $900,000 First year cash flow (SEK 5 = $1) = $1,268,000 Net gain from devaluation = $368,000 The present value of the economic gain associated with a krona devaluation in this case, based on a three-year adjustment period, is $939,212, as follows:

Year

PostDevaluation Cash Flow

PreDevaluation Cash Flow

Change in Cash Flow

15% Present Value Factor

Present Value

$1,268,000

$900,000

$368,000

0.870

$320,160

$1,268,000

$900,000

$368,000

0.756

$278,208

$1,418,000

$900,000

$518,000

0.658

$340,844

Net Gain

$939,212

CHAPTER 10: MEASURING AND MANAGING ECONOMIC EXPOSURE

Exhibit 1. Summary of Projected Operations for Spectrum Manufacturing AB: Scenario 4

Units (000)

Unit Price (SEK)

Total (SEK)

Domestic Sales

600

15,000,000

Export Sales

400

10,000,000

Financial Component

Total Revenue

25,000,000

Total Operating Expenses

11,232,000

Overhead Expenses

3,500,000

Interest on Krona Debt (10%)

300,000

Depreciation

900,000

Net Profit Before Tax

9,068,000

Income Tax @ 40%

3,627,000

Profit After Tax

5,441,000

Add Back Depreciation

900,000

Net Cash Flow in Krona

6,341,000

Net Cash Flow in Dollars (SEK 5 = $1)

$1,268,000

This gain occurs because the sales price increase keeps dollar revenues constant while dollar costs of production fall. If krona production costs rise, much, if not all, of this gain will be dissipated. The year 3 figure of $1,418,000 includes a $150,000 gain on repayment of the krona loan. 2. Scenario 5: Volume and import prices rise; other variables remain the same. 2.a. The krona sales price remains at SEK 20. 2.b. Unit sales volume rises by 50%, both domestically and abroad, owing to the lower dollar price. 2.c.

Because krona costs of local labor and materials stay the same, krona unit operating expenditures rise by only 5.6%.

2.d. The firm’s various overhead expenses do not change. SCENARIO 5 ANSWER: The net result of the assumptions in scenario 5 is a yearly post-devaluation operating cash flow of $1,163,000 – an increase of $263,000 over the pre-devaluation level of $900,000 (see Exhibit 2). Note that a 50% increase in sales volume leads to an 82% increase in profit after tax but to only a 62% increase in krona cash flow. The latter effect is due to the fixed depreciation charge which causes taxes to rise more rapidly than profits. This tax factor combined with the krona devaluation results in a rise in annual U.S. dollar operating cash flow of only 29%. The resulting post-devaluation cash flows for the following three years and consequent change in economic value are:

INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

Year

PostDevaluation Cash Flow

PreDevaluation Cash Flow

Change in Cash Flow

15% Present Value Factor

Present Value

$1,163,000

$900,000

$263,000

0.870

$228,810

$1,163,000

$900,000

$263,000

0.756

$198,828

$1,313,000*

$900,000

$413,000

0.658

$271,754

Net Gain

$669,392

* Includes a gain of $150,000 on repayment of the krona loan. Exhibit 2. Summary of Projected Operations for Spectrum Manufacturing AB: Scenario 5 Units (000)

Unit Price (SEK)

Total (SEK)

Domestic Sales

900

18,000,000

Export Sales

600

12,000,000

Financial Component

Total Revenue

30,000,000

Total Operating Expenses

17,017,000

Overhead Expenses

3,500,000

Interest on krona debt (10%)

300,000

Depreciation

900,000

Net Profit Before Tax

8,193,000

Income Tax @ 40%

3,277,000

Profit After Tax

4,916,000

Add Back Depreciation

900,000

Net Cash Flow in Kroner Net Cash Flow in Dollars (SEK 5 = $1)

5,816,000 $1,163,000

3. On January 1, the U.S. dollar:Japanese yen exchange rate is $1 = ¥250. During the year, U.S. inflation is 4% and Japanese inflation is 2%. On December 31, the exchange rate is $1 = ¥235. What are the likely competitive effects of this exchange rate change on Caterpillar Tractor, the American earth-moving manufacturer, whose toughest competitor is Japan’s Komatsu? ANSWER. The real value of the yen changed from $0.004000 (1/250) at the start of the year to $0.004339 (1/235 * 1.04/1.02) at the end of the year, an increase of 8.47%. Caterpillar Tractor should benefit from this increase in the real value of the yen since Komatsu does most of its manufacturing in Japan. The inflation-adjusted dollar cost of Japanese-supplied components and labor will rise in line with the increase in the real value of the yen. Komatsu’s raw materials and energy prices should not rise in dollar terms because these resources are imported.

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4. You are asked to lend money for a major commercial real estate development in Calexico, which is on the California side of the Mexican border. There is some talk about a further devaluation of the Mexican peso. What information do you need to assess the creditworthiness of this project? ANSWER. The economic viability of a shopping mall largely determined by the number of shoppers who frequent the development and the amount of money they spend there. In the case of a shopping center in Calexico, the odds are that many of the potential customers are Mexican. If the Mexican government has been artificially propping up the value of the peso, which it is has done consistently, then Mexicans will find that their pesos have more purchasing power in the U.S. The result will be more traffic for a shopping mall in a U.S. border town and higher profits. However, this situation is one of artificial prosperity that will not last long; when the peso is devalued, Mexican shoppers will stay home and profits will decline. This analysis is based on experience. Prior to 1982, the rising real value of the Mexican peso meant that border areas in Texas and California were popular markets for Mexican citizens and a large portion of the retail sales in these areas were to Mexican citizens. Laredo and other American border towns bustled with free-spending Mexican shoppers. U.S. goods were cheaper and easier to find than at home. But after Mexico’s two peso devaluations in 1982 quadrupled the price of dollar from 25 pesos to over 100, the lucrative traffic was washed out. Business activity was off by as much as 80% in some Texas border towns and nearly a third of the small businesses in the Rio Grande Valley were threatened with bankruptcy. Returning to the shopping center project, the more dependent it is on Mexican customers and the higher the real value of the peso is currently, the more exchange risk the project faces. 5. About two thirds of all California almonds are exported. The ups and downs of the U.S. dollar, therefore, cause headaches for almond growers. To avoid these problems, a grower decides to concentrate on domestic sales. Does that grower bear exchange risk? Why and how? ANSWER. A grower who sells only in the U.S. still bears exchange risk because the price at which he can sell his almonds varies with the exchange rate. For example, when the dollar appreciates, foreigners will demand fewer almonds at the current dollar price. This will cause the dollar price at which almonds are sold overseas to fall. Hence, almond growers who previously sold overseas will now find it more profitable to sell in the U.S. This will drive down the price of almonds in the U.S. until it just equals the price of almonds in Japan and other foreign markets minus transportation costs. If the dollar depreciates, the foreign demand for almonds at the current dollar price will increase, raising almond prices at home and abroad. This is just another illustration of the law of one price. It holds because growers will arbitrage between domestic and foreign markets in the search for higher profits. 6. Aldridge Washmon Co. is one of the largest distributors of heavy farming equipment in Brownsville, Texas, located on the border with Mexico. The time is late 1981. Sales have increased dramatically over the past two years, and Aldridge is requesting an expansion of its credit line. What information would you as a banker need before you accede to its request? ANSWER. The key to this question is to recognize that the real value of the Mexican peso rose dramatically over this time period. Thus, the rise in Aldridge Washmon’s sales was due almost exclusively to the rising real value of the Mexican peso, which made it less and less expensive for Mexican farmers to buy its farming equipment. By 1982, Mexican farmers accounted for 80% of its business. But the company experienced artificial prosperity. Once the peso devalued, as it had to, Aldridge’s sales plummeted because Mexican farmers could no longer afford its machines. According to an Aldridge manager, “Business just stopped flat, like running a car into a brick wall.”

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Aldridge plans to use the expanded line of credit to finance additional working capital, primarily accounts receivable on Mexican sales and additional inventory. When the peso devalues, Mexican buyers will have trouble repaying their dollar debts and Aldridge will have difficulty repossessing its tractors in Mexico. Thus, its receivables will be worth much less than 100 cents on the dollar. In addition, Aldridge will be stuck with a large inventory of tractors and other equipment. The value of this inventory will drop since the major market for farm equipment will have disappeared. Hence, even if the bank secures its loan with Aldridge’s inventory and receivables, the value of this collateral will drop following peso devaluation. One other consideration is worth mentioning. If peso devaluation makes Mexican agriculture more competitive in world markets, then Mexican farmers will gain from devaluation and will demand more farm equipment. This is a plausible scenario but is unlikely to hold here because we already know that the Mexican farmers benefited from a real appreciation of the peso; hence, a real peso devaluation should have the opposite effects. Evidently, Mexican farmers are selling in a protected domestic market. If they were exporting or competing against imports, they would have been hurt by the rising real value of the peso. As we saw in the chapter, companies selling in the local market and facing minimal import competition will gain from real LC appreciation and lose from LC devaluation. The opposite effects would be experienced by companies dealing in traded goods. This discussion implies the information that Aldridge’s bankers should gather: Who is it selling to? How will these customers be affected by peso depreciation? What has happened to the real value of the peso and what is likely to happen to its value in the future? What will happen to the value of collateral if the peso devalues? 7. Assess the likely consequences of a declining dollar on Fluor Corporation, the international construction-engineering contractor based in Irvine, California. Most of Fluor's value-added involves project design and management; most of its costs are for U.S. labor in design, engineering, and construction-management services. ANSWER. Fluor will benefit from a falling dollar since it will be more cost competitive vis-a-vis foreign contractors both at home and abroad. Its costs are primarily denominated and determined in dollars. Thus, when the dollar declines, these costs fall relative to those of its foreign competitors. Although many of the costs incurred on foreign projects are set in the local currency, these costs are the same for all potential competitors. Hence, in competing against foreign firms, Fluor will find that some of its costs are the same while other of its costs, particularly for the labor involved in design, engineering, and construction management services, are now lower. This is analogous to the situation confronting the U.S. chemical industry in problem #12. 8. The European chemical industry pays for an estimated 79% of its oil-based feedstock in dollars. Thus, its costs are declining sharply because of the drop in the price of oil combined with the sharp decline in the value of the dollar. What is the likely impact on the European chemical industry's profits of the dollar decline? Will it now be more competitive relative to the American chemical industry? ANSWER. The implication that lower dollar oil prices combined with the lower value of the dollar, by sharply cutting the costs of European chemical companies, will make them more competitive vis-à-vis American chemical companies is fallacious. Whether measured in dollars, DM, French francs, or British pounds, the price of oil is the same to all chemical companies worldwide. Thus, although a drop in the price of oil is likely to increase chemical industry profits, it will not disproportionately favor firms in one country

CHAPTER 10: MEASURING AND MANAGING ECONOMIC EXPOSURE

over those in another. But when it comes to labor and other goods and services sourced locally, U.S. chemical companies will now enjoy a competitive cost advantage. Whether measured in dollars, DM, or ECUs the price of labor and other non-oil inputs will now be lower for American firms than for European firms. The net result is that the decline in oil prices is neutral in terms of national competitiveness but the depreciation of the dollar will give U.S. chemical firms a competitive advantage. This prediction has been borne out: Companies like Du Pont, Dow Chemical, and Hercules have benefited greatly from dollar depreciation. By contrast, dollar depreciation has hurt European chemical companies. 9. Cooper Industries is a maker of compressors, pneumatic tools, and electrical equipment. It does not face much foreign competition in the U.S., and exports account for only 7% of its sales. Does it face exchange risk? ANSWER. As a supplier to industrial customers who compete against imports and that sell overseas, Cooper Industries benefits from a weaker dollar and is hurt by a stronger dollar. Customer sales rise with a weak dollar and fall with a strong dollar and these changes translate into more or less sales for Cooper. This is analogous to the case of Nippon Steel discussed in problem #16 below. 10. The Edmonton Oilers (Canada) of the National Hockey League are two-time defending Stanley Cup champions. (The Stanley Cup playoff is hockey’s equivalent of football’s Super Bowl or baseball’s World Series.) As is true of all NHL teams, most of the Oilers’ players are Canadian. How are the Oilers affected by changes in the Canadian dollar/U.S. dollar exchange rate? ANSWER. The fact that the Oilers are paid in Canadian dollars does not affect the answer to this question very much. While the C$ is the currency of denomination, the U.S.$ is the currency of determination. That is, the Canadian dollar salaries paid to the Oilers’ players are just equal to what the players’ salaries would be in U.S. dollars converted into Canadian dollars. Thus, the Edmonton Oilers are hurt by appreciation of the U.S.$ vis-a-vis the C$ and benefited by U.S. dollar depreciation. Consider what would happen, for example, if the U.S.$ appreciates against the C$. If the Oilers’ C$ salaries are not raised, they will find they are being paid less than players on U.S. hockey teams. The Oilers will be forced to raise the Canadian dollar equivalent of its players’ salaries to keep them on a par with their U.S. rivals. Otherwise, the Edmonton Oilers will either lose players to U.S. teams or have a hostile team. Player nationality is irrelevant. Canadian teams compete in a world market for talent and must pay the market price. 11. South Korean companies such as Goldstar, Samsung, and Daewoo have captured more than 10% of the U.S. color TV market with their small, low-priced TV sets. They are also becoming more significant exporters of videocassette recorders and small microwave ovens. What currency risk do these firms face? ANSWER. These firms have benefited greatly from the appreciation of the Japanese yen against the U.S. dollar because the won has not risen by nearly the same extent against the dollar. They have used their cost advantage vis-à-vis Japanese competitors to boost sales of low-end consumer electronics products by cutting prices below the level at which the Japanese could make money. Yen depreciation or won appreciation would reduce their cost advantage. Similarly, they face currency risk because competitors in other nations, such as Taiwan or Thailand, might devalue their currencies against the won.

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12. A common complaint leveled against the Japanese government is that it deliberately holds down the value of the yen to boost exports of Japanese products. American steelmakers have been particularly vocal in their complaints. As a remedy, steelmakers in 1985 asked President Reagan to curtail Japanese steel imports further and to impose a 25% tariff to offset what they describe as the "artificial" undervaluation of the yen. Does Nippon Steel profit from a weak yen? What are the likely consequences of the recent appreciation of the yen? Here are some facts. Imports of U.S. raw materials priced in dollars account for about one-third of costs, and exports to the U.S. generate about 4% to 5% of its revenues. Nippon Steel currently is exporting as much steel as it can to the U.S. under existing quota restrictions. What additional information do you need to fully assess the impact of currency changes on Nippon Steel? ANSWER. The initial response is that Nippon Steel gains more on the cost side than it loses on the revenue side from yen appreciation since it is not selling much overseas anyway. However, this analysis is misleading. Specifically, the demand for Japanese steel is driven largely by the demand for Japanese exports, such as cars and machine tools, that embody that steel. Other things being equal, as the yen appreciates, Japanese companies become less competitive abroad and they export less. This cuts their demand for Japanese steel. Meanwhile, other Japanese steel companies have access to the same lower-cost raw materials as does Nippon Steel. Competition among Japanese steel companies forces them to cut their yen prices in line with the decline in their yen costs. Thus, the benefit on the cost side is competed away and Nippon Steel is stuck with a loss of sales. The result: Nippon Steel is hurt by yen appreciation and is helped by yen depreciation. 13. Monsanto Co., the St. Louis chemical firm, is a major seller of herbicides. Its two brand-name herbicides, Roundup and Lasso, have a large share of the U.S. and foreign markets. It's major competitors are other U.S. chemical companies. How are sales and profits of these products, as well as Monsanto’s other chemicals, likely to be affected by changes in the value of the dollar? ANSWER. Monsanto will be hurt by dollar appreciation and helped by dollar depreciation. However, because it sells brand name products, the demand for its products is less price elastic than if it sold commodities. Thus, Monsanto will not be affected as much by currency changes as it would be if it were in a pure commodity business. The impact of currency changes will be greater on those of its product lines that are commodities. 14. Black & Decker Manufacturing Co. of Towson, Maryland, has roughly 45% of its assets and 40% of its sales overseas. How does a soaring dollar affect its profitability, both at home and abroad? ANSWER. Black & Decker has a rough balance between foreign sales and costs. Thus, as the dollar appreciates, both its sales revenue and its costs decline approximately in line with each other. This means that its profits will decline roughly in line with the rise of the dollar. (If both revenues and costs fall, say, 10%, then profit must also fall by 10%.) Dollar depreciation leads to corresponding increases in dollar revenues and costs. The bottom line is that B&D’s profits fall as the dollar rises and rise as the dollar falls. If B&D didn’t produce overseas, but instead exported from its U.S. plants, then currency changes would lead to much greater swings in its profits. Note that B&D’s domestic profitability is also affected by currency changes since it faces competition in the U.S. from foreign companies such as Japan’s Makita.

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15. The shipbuilding industry is facing a worldwide capacity surplus. Although Japan currently controls about 50% of the world market, it is facing severe competition from the South Koreans. Japanese shipyards are extraordinarily productive, but at current price levels were just about breaking even with an exchange rate of ¥240 = $1. What are the likely effects on Japanese shipbuilders of a yen appreciation to ¥180 = $1? The South Korean won has maintained its dollar value. ANSWER. The statement that “Japanese shipyards are extraordinarily productive” tells you that there is not much room for cost cutting by Japanese shipyards. Hence, Japanese shipyards will be devastated by a rise in the yen, as they were. As the yen appreciates against the won, South Korean shipyards gained a substantial cost advantage vis-a-via the Japanese. According to a story in the Wall Street Journal, “Japanese industry officials say ship buyers now automatically bypass Japanese makers, turning instead to Hyundai Corp. and other South Korean shipbuilders, which enjoy comparative reprieve on the currency front.” The only degree of freedom to adjust Japanese shipbuilder costs took place on the wage side. Japanese firms typically pay a substantial fraction of workers’ wages in the form of a semi-annual bonus that is tied to corporate profits. Thus, during hard times, labor costs fall automatically. However, this decrease in labor costs was not nearly enough and many Japanese shipyards went bankrupt. A spokesman for the Japan Ship Exporters Association said that they couldn’t lower prices further. “They’re already at the bottom. We can do nothing but watch competitors take away orders.” Japanese shipyards have responded by designing innovative ships for which demand is price inelastic. They are no longer competitive in the commodity ship business. 16. Nissho Iwai American Corporation is the American arm of a large Japanese trading company that deals in everything from steel to tuna fish. Assess the credit-risk implications for Nissho Iwai of a 30% rise in the dollar value of the yen. ANSWER. Yen appreciation makes Nissho Iwai’s products less competitive in the U.S. market. The greater the extent to which Nissho deals in commodity products (like steel and tuna fish), the more its sales and profits will be hurt by an appreciating yen. Conversely, if Nissho shifts its mix toward more technically sophisticated and more differentiated products, it will be less affected by the rising yen. The firm could in fact benefit from the strong yen by using its intelligence gathering system to find newly cost-competitive American products that it can now export to Japan. 17. Thomasville Plastics Corp. has contracted to buy $1.1 million worth of Japanese plastic-injection molding machines. The contract price is set in dollars. Does Thomasville bear any currency risk associated with this purchase? Explain. ANSWER. Thomasville bears exchange risk because a falling dollar might push up spare parts prices. This assumes that the parts are unique and cannot be gotten from domestic producers. It will also have to pay higher prices when it goes to replace machines that wear out, assuming that it doesn’t want to mix and match machines from different manufacturers.

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18. Middle American Corp. (MAC) produces a line of corn silk cosmetics. All of the inputs are purchased domestically and processed at the factory in Iowa. Sales are only in the U.S. 18.a. Is there any sense in which MAC is exposed to the risk of foreign exchange rate changes that effect large MNCs? If yes, how could MAC protect itself from these risks? ANSWER. MAC is exposed to the risk that the French franc/U.S. dollar exchange rate may change and alter the price of French cosmetics relative to U.S. cosmetics. The problem is analogous to problem 1. If the exchange rate change is real or if tastes change toward French cosmetics (another real disturbance), the market value of MAC shares should fall. The firm could protect itself by having net French franc liabilities. Some questions to ask are: How could MAC protect itself against the possible change in consumer tastes? What is the cost to MAC of establishing and maintaining the French franc liability position? What are the benefits? 18.b. If MAC opens a sales office in Paris, will its exposure to exchange rate risks increase? Explain. ANSWER. Your immediate reaction may be that the risks increase because MAC has more foreign currency operations on the books. However, exposure depends on the relative magnitudes of asset and liability positions in the foreign currencies. MAC may find ways to hedge the exchange risks associated with the French franc and incur no additional risks. In fact, we could look at the Paris venture as a way to diversify and therefore reduce several of the business risks faced by MAC. 19.

Gizmo, U.S.A. is investigating medium-term financing of $10 million in order to build an addition to its factory in Toledo, Ohio. Gizmo’s bank has suggested the following alternatives: Type of Loan

Rate

3-year U.S. dollar loan 3-year euro loan 3-year Swiss franc loan

14 8 4

19.a. What information does Gizmo require to decide among the three alternatives? ANSWER. It is useful to divide this problem into two issues: what is the expected cost and what is the risk of each alternative. Defining the terms “cost” and “risk” requires careful thought. If we assume that (1) the international money markets are efficient and (2) the IFE holds (these are separate issues) then the expected cost of each loan is the same. If the market is anticipating that for the next three years the euro and the Swiss franc will appreciate 6% and 10% annually, respectively, then the expected U.S. dollar cost of each loan is the same. If we are unwilling to make assumptions (1) and (2), then we need to use independent forecasts of the euro and Swiss franc exchange rates to calculate the loan whose expected U.S. dollar cost is the lowest. Even if the expected cost of each loan is the same, the risk associated with each loan may be different for Gizmo. This risk will depend on the currency denomination of assets that Gizmo holds as well as on the markets in which Gizmo buys its inputs and sells it outputs. For example, if Gizmo sells many products in Germany, then it probably has accounts receivable denominated in euros. It can use these receivables to pay off a euro-denominated loan and avoid the risks that are associated with an uncertain $/€ rate. If Gizmo desires a particular risk level, then it may rationally prefer a particular currency denomination for the loan. It may also be that forward markets are more developed in one currency or that unanticipated exchange rate changes are smaller in one currency, and therefore, the risks associated with that currency are smaller even if the expected costs are the same.

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19.b. Suppose the factory will be built in Geneva, Switzerland, rather than Toledo. How does this affect your answer in part a? ANSWER. If the factory in Geneva sells in Switzerland, then Gizmo has an asset which is essentially denominated in Swiss francs. This may establish a natural hedge against a Swiss franc loan and reduce the risk of this particular alternative. If the expected cost of each loan alternative if the same, and if the firm seeks to reduce total risk, then this information would suggest a Swiss franc loan. But if the Swiss factory is exporting to the U.S., or is selling in the Swiss market and facing import competition, then some dollar financing or financing in the currency of the country in which its main competitors are located might be appropriate. If the objective is to minimize currency risk, the relative amount of financing to do in each currency will also depend on the sources of Gizmo’s inputs, particularly the extent to which it uses Swiss labor. The more labor-intensive the production process, the less useful Swiss franc financing will be in reducing Gizmo’s exposure (since by using Swiss labor it already has Swiss franc outflows). 20.

In September 1992, Dow Chemical reacted to the currency chaos in Europe by switching to DM pricing for all its products in Europe. The purpose, said a Dow executive, was to shift currency risk from Dow to its European customers. Moreover, said the Dow executive, the policy was fairer: By setting the same DM price throughout Europe, Dow’s new policy would nullify any advantage that a Dow customer in one company might have over competitors in another country based on currency swings.

20.a. What is Dow really trying to accomplish with its new pricing policy? ANSWER. Dow was really trying to raise its prices in those European counties whose currencies devalued so as to preserve its dollar margins, which were eroding from the devaluations. 20.b. What is the likelihood that this new policy will reduce Dow’s currency risk? ANSWER. Not very likely. Unless all its leading competitors go along with DM pricing (its U.S. and foreign competitors said that they wouldn’t follow Dow but would continue doing business in local currencies), Dow will have to cut its DM price every time the DM appreciates or else lose market share. In other words, Dow can’t use DM pricing to avoid margin erosion when European currencies devalue against the dollar unless it is willing to sacrifice market share. 20.c. How are Dow’s customers likely to respond to this new policy? ANSWER. They will simply demand lower DM prices if their currencies devalue. If Dow doesn’t cut its DM prices, many of them will buy from those of Dow’s competitors who are willing to cut their dollar or DM prices.

21.

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Boeing Commercial Airplane Co. manufactures all its planes in the U.S. and prices them in dollars, even the 50% of its sales destined for overseas markets. Assess Boeing’s currency risk. How can it cope with this risk?

ANSWER. Boeing would have currency risk even in the absence of foreign competition since currency fluctuations will translate its dollar prices into varying amounts of foreign currency to its foreign customers. Given that foreign demand is somewhat responsive to price, and that Boeing prices in dollars, dollar appreciation will reduce foreign demand. Alternatively, to maintain sales volume, Boeing will be forced to cut its dollar price. Dollar depreciation benefits Boeing since it can either raise its dollar price, while keeping its foreign currency prices constant, or keep its dollar price constant and thereby cut its foreign currency prices and boost sales overseas. In reality, Boeing does face a major foreign competitor – Airbus Industries, a European consortium. The existence of Airbus increases Boeing’s price elasticity of demand and, hence, its exchange risk (i.e., Boeing is hurt more by dollar appreciation and helped more by dollar depreciation). Boeing can cope with this currency risk by sourcing some of its parts and components abroad, possibly from foreign firms with whom it forms strategic alliances. 22.

Fire King International, an Indiana manufacturer of fire-resistant filing cabinets and disk storage units, has sought to protect itself from currency risk by pricing its export sales in dollars and holding firm on price. What currency risk does Fire King face from a rising dollar? How can Fire King manage that risk?

ANSWER. This question is similar to the one involving U.S. Farm-Raised Fish Trading Co. (Chapter 9, #8). As before, the answer is no. What Fire King has done is to eliminate its transaction exposure, but it still faces operating exposure. The competitiveness of its products overseas is affected by the changing value of the dollar. The strong dollar caused export sales to plunge more than 60% in 1983. Unlike most small exporters, Fire King decided to do more than wait out the dollar. The company stopped promoting items that were available at a lower price from foreign competitors. Instead, Fire King began to promote quality, emphasizing such top-of-the-line items as a fancy wood-covered cabinet. It also shifted its emphasis away from such difficult markets as Europe to those where the strong dollar was having less of an impact, including the Far East, the Middle East, the Caribbean countries, and Canada. And within those markets, the company began selectively to target buyers, such as banks, that were favorably disposed to U.S. goods. At the same time, Fire King saw the strength of the dollar as an opportunity to boost its own imports. The company added a line of such complementary products as fire-resistant safes from Japan and data storage units from Sweden to sell in the U.S. Finally, officials from Fire King attended more trade shows and increased their contact with foreign distributors and customers.

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23.

Cost Plus Imports is a West Coast chain specializing in low-cost imported goods, principally from Japan. It has to put out its semiannual catalogue with prices that are good for six months. Advise Cost Plus Imports on how it can protect itself against currency risk.

ANSWER. A company such as Cost Plus will typically negotiate purchase contracts with the suppliers of its catalogue merchandise in advance. Cost Plus could hedge these purchases using forward contracts. A problem, though, is that if the foreign currencies devalue during the life of the catalogue, prices of substitute products for the items in the catalogue will likely come down somewhat. In this case, some customers who might have bought from Cost Plus will decide to buy the cheaper substitutes, costing Cost Plus sales. This is very likely here given the nature of Cost-Plus products: low-cost goods presumably bought by a price-sensitive clientele. The existence of quantity risk in addition to price risk suggests that Cost Plus should hedge less than 100% of its projected sales. As an alternative, Cost Plus could buy call options to cover its foreign purchases. If the foreign currencies drop below the call option price, the firm won’t exercise its options; if they rise above the call price, Cost Plus will exercise them. 24.

Matsushita exports about half of its TV set production to the U.S. under its Panasonic, Quasar, and Technics brand names. It prices its products in yen. Suppose the yen moves from ¥130 = $1 to ¥110 = $1. What currency risk is Matsushita facing? How can it cope with this currency risk?

ANSWER. As the yen rises against the dollar, Japanese producers such as Matsushita become less competitive in the U.S. We have good evidence on what Matsushita is doing to cope with the strong yen. Matsushita has raised prices in the U.S., although not to the extent of yen appreciation. Like other Japanese firms, Matsushita is willing to accept lower profits rather than give up market share that it has acquired. Typically, price increases are made in conjunction with the introduction of new models. Matsushita is also facing more competition from Korean exporters like Goldstar and Samsung. These firms are using the opportunity presented by the yen’s rise to sell more inexpensive televisions, microwave ovens, VCRs, and stereos. This means that Matsushita’s ability to raise price varies among products. It will have a difficult time getting price increases to stick on inexpensive products facing competition from Korean firms. By contrast, it will have an easier time raising price on the more expensive end of the consumer spectrum: the better stereos, cameras, TVS, and VCRs. The greater pricing latitude in this segment reflects that fact that most competitors in upmarket products are also Japanese firms with a similar cost structure. To bolster this strategy, Matsushita is investing more money in R&D to come up with higher quality, more technologically sophisticated products. Matsushita has also launched a crash effort to cut its costs through overhauls of products and factories in Japan as well as by shifting some production to lower-cost manufacturing facilities in countries like Taiwan or South Korea as well as the U.S. In many cases, parts produced abroad are shipped back to Japan to be incorporated in finished products. For example, Matsushita now produces car audio systems and VCRs in the U.S., printers, electronic typewriters and microwave ovens in the U.K., motors and copiers in Germany, and VCRs in France. It has also stepped up its purchases from foreign suppliers. The next stage has already begun: Matsushita is exporting finished products from offshore plants for sale to Japanese consumers. It is also trying to cut manufacturing costs at home by increased automation and better product design and material use.

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Another approach taken by Matsushita and other Japanese firms is to diversify out of consumer electronics and home appliances and into industrial markets, such as factory automation, where quality is more important and price less so. It hopes to sell fewer TVs and stereos and more robots, semiconductors, and office equipment. This involves hiring more technical people, more R&D spending, and retraining engineers as industrial salespeople. To be successful here, Matsushita must cut the time between laboratory development of new equipment and their commercial application. The chapter points out Matsushita and other Japanese companies are pruning their product lines after a decade of product proliferation. Perhaps 50% to 80% of the product lines of many Japanese companies account for no more than about 20% of sales, yet require major investments in design, capital equipment, and working capital. By eliminating low volume, low margin products, Matsushita and other Japanese companies can boost their profits. 25. Lyle Shipping, a British company, has chartered out ships at fixed-U.S.-dollar freight rates. How can Lyle use financing to hedge against its exposure? How will your recommendation affect Lyle’s translation exposure? Lyle uses the current rate method to translate foreign currency assets and liabilities. However, the charters are off-balance-sheet items. ANSWER. Since Lyle has chartered out its ships in dollars, it has fixed dollar revenues. By financing its ship purchases with dollars, Lyle can offset these contractual dollar inflows with contractual dollar outflows. Accountants will note that Lyle bears significant translation exposure. As the dollar rises against the pound, Lyle will show losses on its dollar debt and vice versa when the dollar falls. But gains or losses on the debts will be canceled out over time by changes in its operating cash flows. In 1984, when the dollar rose, its chairman pointed out that “Although foreign exchange losses have now been provided for in full on all loans and leases as if they had been repayable at 30 June 1984, it must be borne in mind that these are secured against ships chartered out at fixed freight rates, the U.S. dollar income from which will be sufficient to service both the interest and capital on the underlying loans. This future income will offset the exchange losses now provided for.” 26. Texas Instruments (TI) manufactures integrated circuits and memory chips that it sells around the world. It has major markets in Europe. TI’s primary competitors are Japanese companies. 26.a. What factors will influence TI’s exposure to movements in the dollar value of European currencies? ANSWER. Since TI’s main competitors worldwide are Japanese companies, one critical factor affecting its exposure is the $/¥ exchange rate. If the dollar appreciates relative to, say, the euro, but the $/¥ exchange rate remains constant, then TI should be able to raise its euro prices without suffering a loss of competitive advantage. However, changes in the dollar value of the euro that are not offset by changes in the dollar value of the yen, or changes in the $/¥ rate (even if the dollar value of the euro has not changed), expose TI to currency risk. Here we must ask how price-sensitive the European demand for TI chips is. The more price sensitive the demand, the more currency risk TI faces. Memory chips, being commodities, are likely to be more price-sensitive than microprocessors. TI’s currency risk also depends on the value-added work performed in Europe. The more value added done in Europe, or that can be done in Europe, the less currency risk TI faces since its local currency inflows will be offset by local currency outflows.

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26.b. Does TI’s European business have yen exposure? Explain. ANSWER. As mentioned in the answer to part a, TI has significant yen exposure. 26.c. How can TI use financing to reduce its yen exposure, to the extent this exposure exists? ANSWER. TI should finance itself to a significant extent with Japanese yen, so the same event (e.g., yen depreciation) that reduces TI’s dollar cash inflows will simultaneously reduce the dollar amount of its yen debt servicing costs. 27. South Korea’s Korean Air Lines (KAL) is the world’s 12th largest passenger airline and its second-largest cargo carrier. It has borrowed $5 billion (much of it denominated in dollars) to finance its fleet of planes. 27.a. In what ways is KAL affected by depreciation of the won against the dollar? ANSWER. The won’s depreciation against the dollar harms KAL in three ways. (1) Its dollar-denominated debt service payments rise in won terms because more won are needed to buy the dollars to pay interest and principal on its loans. (2) Its won cost of fuel rises since fuel prices are set in dollars. (3) Its won revenue growth slows down and may even fall as Asian fliers try to conserve their falling incomes. There are other considerations as well in assessing KAL’s currency risk. To the extent that KAL can replace Asian customers with U.S. and European customers attracted by the lower cost of visiting Asia, then KAL can boost its won operating income. However, KAL is unlikely to be able to fully recoup the lost income from its lost Asian customers. This prediction has been borne out by KAL’s actual experience following the won’s plunge in 1997. 27.b. How can KAL use financing to reduce its currency risk? ANSWER. KAL should finance its planes in won, so as to balance its revenues with its expenses. Such a policy is unlikely to eliminate KAL’s currency risk but at least it will not exacerbate it. Financing its fleet in dollars will add a transaction exposure to its operating exposure. 27.c. KAL argues that its jet fleet naturally hedges its currency exposure. Do you agree or disagree? Explain. ANSWER. There is some truth to KAL’s claim. The jet fleet is easy to sell and is likely to retain most of its dollar value. But this natural hedge only exists if KAL intends to sell off its fleet. To the extent that KAL continues to operate its fleet, then the fleet’s value is based on the cash flows generated by its operations. KAL’s won operating cash flow is unlikely to keep up with the won cost of servicing its dollar debts. 27.d. At the end of 1997, KAL decided to sell off its older planes, use the proceeds to pay down some of its debt, and replace the sold planes with aircraft it leases through a subsidiary in Ireland. Will this strategy lower KAL’s high debt ratio? ANSWER. All KAL is doing here is substituting lease payments for debt payments. The two are equivalent. KAL’s Irish subsidiary must borrow to finance the planes. On a consolidated basis, therefore, KAL is still responsible for these debts. To the extent that the Irish subsidiary borrows without recourse to its parent, then KAL must inject enough equity into the subsidiary to maintain its credit rating. At the same time, even though KAL can keep the subsidiary’s debts off its book through nonrecourse financing, it will also lose its assets (the planes, since they are leased and not owned). Hence, KAL does not lower its debt:equity ratio by leasing planes through an Irish subsidiary.

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28. Over the past year, Thailand has experienced an inflation rate of about 7%, in contrast to U.S. inflation of about 2.5%. At the same time, the exchange rate for the Thai baht (B) has gone from B26.1/$1 to B38.9/$1. 28.a. What has happened to the real value of the baht over the past year? Has it gone up or down? A little or a lot? How does this compare to the change in its nominal value? ANSWER. The real value of the baht, relative to its value one year ago, has fallen significantly. Specifically, in dollar terms, the nominal exchange rate has depreciated from $0.03831 (1/26.1) to $0.02571 (1/38.9), a 32.9% decrease ([0.02571 - 0.03831]/0.03831). In real terms, the baht has declined to $0.02571 * 1.07/1.025 = $0.02684. Thus, the real value of the baht has fallen by 30.0%: (0.02684 - 0.03831)/0.03831 = -30.0% If PPP held, the baht should have devalued to a new exchange rate of e = 26.1 * 1.07/1.025 = B27.25/$ You can tell this is the PPP rate because at this exchange rate, the real rate remains at B26/1/$: Real rate = 27.25 * 1.025/1.07 = B26.1/$ 28.b. What are the likely effects of the change in the baht’s real value on the dollar profits of the Thai subsidiary of a company like Coca-Cola that sells almost exclusively in the Thai market? ANSWER. A reasonable assumption is that Coca-Cola’s sales, which are generated domestically, have risen at about the rate of Thai inflation. Meanwhile, costs are partially denominated in dollars (via imports of various inputs) and partially in baht (via locally-sourced inputs, including labor). Hence, costs have risen by more than the rate of Thai inflation (since the inflation-adjusted value of the dollar and, therefore, dollardenominated costs have risen). How much more depends on the mix of domestic inputs and imported inputs. Since we don’t know the profit margin on Coke, and the mix of domestic and imported inputs, we can’t determine the actual consequences of the combined rise in baht revenues and rise in baht costs, although it is likely that baht profits have fallen given the large devaluation of the baht. However, even if baht profits have risen, they have done so by less than the 7% baht inflation rate. At best, therefore, dollar profits for Coca-Cola have fallen by at least 28.2%, the combined effect of a 7% increase in baht profits and a 32.9% decrease in the dollar value of the baht. This change in dollar profits can be computed by indexing old dollar profits at 1 and assuming that new baht profit rises by 7%: New dollar profit - old dollar profit = 1.07 * (1 - 0.329) -1 = -0.282 These results just point to the more general truth that an decrease in the real value of the local currency should reduce dollar profits for those firms selling locally and not subject to import competition (which would allow them to raise prices by the extent of the local currency devaluation).

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28.c. What are the likely effects of the change in the baht’s real value on the dollar profits of a textile manufacturer that exports most of its output to the U.S.? ANSWER. The impact of the fall in the real value of the baht on a textile manufacturer that exports most of its output to the U.S. will be the opposite of its impact on Coca-Cola. Specifically, the textile manufacturer will find that its costs in dollar terms have fallen by about 28.2% (taking into account the combined effects of Thai inflation and baht depreciation) whereas its dollar revenues have risen by about the rate of U.S. inflation, or 2.5%. The combination of a 2.5% rise in revenues and a 28.2% drop in costs means increasing margins in dollars. Since the dollar has risen against the baht, the result in an even bigger increase in the baht profit margin. 28.d. Suppose that Coca-Cola took out a B130 million loan at the beginning of the year. If the interest rate on the loan was 18%, what was Coca-Cola’s real (inflation-adjusted) baht cost of borrowing baht over the past year in percentage terms? ANSWER. According to the Fisher effect, the relationship between the nominal interest rate, r, the inflation rate, i, and the real interest rate, a, is as follows: 1 + r = (1 + a)(1 + i) Solving this equation for the real rate, a, we get a = (1 + r)/(1 + i) - 1 Substituting the values given above in this equation yields a real baht cost of Coca-Cola’s loan of 10.28%: a = 1.18/1.07 - 1 = 10.28% 28.e. Given the parameters in part d, what was Coca-Cola’s dollar cost of borrowing baht over the past year? ANSWER. At an exchange rate of B26.1/$, Coca-Cola’s loan of B130 million translated into a dollar figure of $4,980,843 (130,000,000/26.1). At the end of the year, Coca-Cola owes the bank principal plus interest of B130,000,000 * 1.18, or B153,400,000. At the end-of-year exchange rate of B38.9/$, this figure translates into a dollar figure of $3,943,445. Hence, Coca-Cola’s dollar cost of borrowing baht for the year is -$1,037,398 ($3,943,445 - $4,980,843), or -20.8% (-$1,037,398/$4,980,843) in percentage terms. In other words, the baht’s depreciation more than offset the interest owed, yielding a negative nominal dollar cost for the baht loan.

CHAPTER 11: COUNTRY RISK ANALYSIS

CHAPTER 11 COUNTRY RISK ANALYSIS I moved this chapter from the section on foreign investment analysis to this section because I have concluded that the international economic environment is heavily dependent on the policies individual countries pursue. Given the close linkage between a country’s economic policies and the degree of exchange risk, inflation risk, and interest rate risk that multinational companies and investors face, it is vital in studying and attempting to forecast those risks to understand their causes. Simply put, attempts to forecast exchange rates, inflation rates, or interest rates are helped immensely by a deeper understanding of how those economic parameters are affected by national policies. At the same time, no one can intelligently assess a country’s risk profile without comprehending its economic and political policies and how those policies are likely to affect the country’s prospects for economic growth. I spend some time discussing the nature of property rights and their implications for political risk and economic development. The chapter examines the experiences of Latin American countries and Eastern European countries and addresses the question of what it takes to promote economic growth. A good discussion of property rights and their effects on economic growth can be based on the end-of-chapter problems. This discussion serves to introduce the topic of country risk analysis – the assessment of the potential risks and rewards associated with making investments and doing business in a country. This is a vital task for multinational firms and international banks, who must constantly assess the business environments of the countries they are already operating in as well as the ones they are considering investing in. Similarly, private and public investors alike are interested in determining which countries offer the best prospects for sound investments. Ultimately, investors are interested in whether sensible economic policies are likely to be pursued because countries adopting such policies will generally have good business environments in which enterprise can flourish. However, because political considerations often lead countries to pursue economic policies that are detrimental to business and to their own economic health, the focus of a country risk analysis cannot be exclusively economic in nature. By necessity, it must also study the political factors that give rise to particular economic policies. This is the subject matter of political economy – the interaction of politics and economics. Such interactions occur on a continuous basis and affect not just monetary and fiscal (tax and spending) policies but also a host of other policies that impact the business environment, such as currency or trade controls, changes in labor laws, regulatory restrictions, and requirements for additional local production.

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SUGGESTED ANSWERS TO CHAPTER 11 QUESTIONS 1. What are some indicators of country risk? Of country health? ANSWER. The chapter points to the following indicators of country risk: -- A large government deficit relative to GNP -- A high rate of money expansion, especially when combined with a relatively fixed exchange rate -- Substantial government expenditures yielding low rates of return -- Price controls, interest rate ceilings, trade restrictions, and other barriers to the smooth adjustment of the economy to changing relative prices -- Vast state-owned firms run for the benefit of their managers and workers -- A citizenry that demands, and a political system that accepts, government responsibility for maintaining and expanding the nation’s standard of living through public sector spending and regulations Here are key indicators of a nation’s long-run economic health: -- A structure of incentives that rewards risk taking in productive ventures --A legal structure that stimulates the development of free markets -- Minimal regulations and economic distortions -- Clear incentives to save and invest -- An open economy 2. What can we learn about economic development and political risk from the contrasting experiences of East and West Germany, North and South Korea, and communist China and Taiwan, Hong Kong and Singapore? ANSWER. These countries provide us with as close to a controlled economic experiment as we are ever going to find in this world: same peoples, same language, same history, same culture, even members of the same families in many instances, divided by an accident of history. And what we see is that those societies that respect the rights of property and that subject their enterprises to the rigors of competition, particularly global competition, grow more rapidly, create far more wealth, are more innovative, more willing to take risk, and are far more productive than those nations with centrally planned economies. The lesson is as clear as possible: Incentives matter, and they matter greatly. 3. What role do property rights and the price system play in national development and economic efficiency? ANSWER. With property rights, people have a strong incentive to husband their assets and utilize them efficiently. They also have a strong incentive to practice thrift, bear risk, and work hard to accumulate more assets. Soviet communes founder on the question of “Who will stay up all night with the sick cow?” If the cow belongs to the commune, no one wants to stay up. In other words, everyone has an incentive to

CHAPTER 11: COUNTRY RISK ANALYSIS

be a free rider. But if it’s Ivan’s cow, Ivan stays up. The mere formality of “owning in common” has nothing like the practical bite of actually involving each participant in ownership. Property rights work in conjunction with the price system to ensure economic growth and wealth creation. By signaling members of society as to the relative scarcity of goods and resources, the price system ensures that society’s assets are employed in their highest valued use. Market prices, in conjunction with property rights, also motivate people to create more wealth by using appropriate combinations of capital, labor, and other resources. The market price of risk, as reflected in the cost of capital signals people as to which risks are worth taking and rewards them for taking those risks. 4. What indicators would you look for in assessing the political riskiness of an investment in Eastern Europe? ANSWER. Here are some key indicators to look for in assessing the political riskiness of investing in Eastern Europe: i)

Do they free prices quickly or continue the old system of administered prices that are based heavily on state subsidies? Although a free economy will need free prices, the public still expects the state to protect it against unexpected events. So the working public expects its wages to rise precisely in line with rising prices. If the governments give in on this point and index wages to inflation, they will institutionalize inflation.

ii) Do they dismantle and sell state-owned monopolies quickly? iii) Will Eastern Europeans be willing to see successful businessmen grow rich? Unfortunately, most of Eastern European society doesn’t understand business and the concept of making money. There are no role models or business traditions as there are in the West. Two generations in Eastern Europe have never experienced private contracts, free markets, or inventive enterprise. Instead, Communism mandated lethal doses of envy in everyone. They were taught to despise those who got ahead, and to pull them down. To avoid social self-destruction, Eastern Europeans need to learn to tame envy. They need to encourage one another to succeed, and to praise and honor those who do. Unfortunately, it might take a generation for negative attitudes concerning hard work and wealth to fade from the Eastern European psyche and be replaced with respect for honesty and enterprise. iv) Do they establish all the paraphernalia of capitalism--including capital markets, tax regimes, and contract law – to go along with their new-found enthusiasm for free markets? These are not mere details. Completing such tasks will embroil the region in all the wrangles about wealth distribution and the size and role of the state which Western countries have spent generations trying to resolve. Another key indicator of political risk would be seeing governments give in to the temptation to fine-tune their economies in order to reduce the costs of making the transition to a market economy. The constant changes of policy involved in fine-tuning will reduce government credibility--just when it is crucial--and increase the likelihood and costs of policy mistakes. The only hope for success is to devise a complete reform program and implement it as quickly as possible. Governments must convey that their commitment to the program is absolute. Some setbacks along the way are inevitable, but they must do the best they can. Milton Friedman has often said, “Don’t let the best be the enemy of the good.”

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Perhaps most important of all, the reform program should include a set of simple rules to govern how policy makers and the public are to operate. This will boost credibility, reduce investor uncertainty, and discourage any efforts by special interest groups, who will be hurt by some of the reforms, to forestall the reform program. ADDITIONAL CHAPTER 6 QUESTIONS AND ANSWERS 1. How might a government budget deficit lead to inflation? ANSWER. Instead of financing the deficit by raising taxes (unpopular) or issuing debt (expensive), the government could print money (a noninterest-bearing liability that need never be redeemed). The expansion in the supply of money without a corresponding increase in the demand for money will cause inflation. 2. What political realities underlie a government budget deficit? ANSWER. Generally speaking, government spending is popular and taxation is unpopular. So governments tend to be quick to spend money, but reluctant to tax their citizens to finance these expenditures. As government promises expand more rapidly than its ability to generate taxes through economic growth, the government faces a choice: Cut the growth in spending, raise taxes, or do neither. The Soviet Union is facing this choice now. And it is doing what governments often do: Take the easy way out and do neither. 3. What obstacles do Third World countries like Argentina, Brazil, and Ghana face in becoming developed nations with strong economies? ANSWER. These countries have not established and enforced the property rights that give their peoples the incentive to make the investments and take the risks that lead to economic growth. They have also not shed their statist dogma – economic nationalism, state ownership, protectionism, price controls, subsidies, and monopolies – in favor of market economics. At the same time, their cultures tend not to value those traits necessary for economic development--an emphasis on education, a willingness to break with tradition, and entrepreneurship. 4. What is the link between a controlled exchange rate system and political risk? ANSWER. A controlled exchange rate system, used to protect an overvalued currency, presents the risk of tighter currency controls, the likelihood of a large devaluation, and various economic distortions that lead to increasing government control of the rest of the economy. 5. Milton Friedman has suggested that public-sector firms in Latin American countries should simply be given away, possibly to their employees. How do you think workers would feel about being given (for free) ownership of the public sector firms that employ them? Why? ANSWER. Workers would most likely oppose such arrangements. Under state ownership, a firm’s survival depends on its access to the national treasury, not on its economic efficiency. Thus state-owned firms can, and often do, pay exorbitant wages and tolerate enormous overstaffing, with the excess costs covered by government subsidies. Private-sector companies cannot tolerate such labor practices. If a private-sector company’s costs exceed its revenues that company will die. Thus, workers who benefit from high pay and low effort at state-owned companies will, and do, oppose privatization.

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6. How did capital flight contribute to the international debt crisis? ANSWER. Capital flight – the flow of capital from debtor developing countries – occurs for several reasons, most of which have to do with inappropriate economic policies. These reasons include government regulations, controls, and taxes that lower the return on domestic investments. Perhaps the most powerful motive for capital flight is political risk. In unstable political regimes (and in some stable ones) wealth is not secure from government seizure, especially when changes in regime occur. It exacerbated the international debt crisis by reducing the foreign currency assets available to service developing country debts. SUGGESTED SOLUTIONS TO CHAPTER 11 PROBLEMS 1. Comment on the following statement discussing Mexico’s recent privatization. “Mexican state companies are owned in the name of the people, but are run and now privatized to benefit Mexico’s ruling class.” ANSWER. Historically, Mexican state companies have been run to benefit politicians as well as their bureaucrats and workers rather than consumers and taxpayers (who wound up subsidizing these firms). Whether privatization benefits Mexico’s ruling class depends on how prices are set and the terms of the sale. Even if privatization takes places at unrealistically low prices, it will benefit all Mexicans, provided that (a) no laws restrict the ability of domestic or foreign firms to compete with privatized firms and (b) the government ends its subsidies to them. Competition will force privatized firms to be more efficient and lower their prices to consumers, while cutting subsidies will end a major drain on the Mexican treasury. 2. Between 1981 and 1987, direct foreign investment in the Third World plunged by more than 50%. The World Bank is concerned about this decline and wants to correct it by improving the investment climate in Third World countries. Its solution: Create a Multilateral Investment Guarantee Agency (MIGA) that will guarantee foreign investments against expropriation at rates to be subsidized by Western governments. 2.a. Assess the likely consequences of MIGA on both the volume of Western capital flows to Third World nations and the efficiency of international capital allocation. ANSWER. By lowering the risk-adjusted return required by investors, MIGA will increase the flow of Western capital to Third World nations. At the same time, however, subsidizing investment insurance will tend to produce less efficient capital allocation; more money will be channeled to those countries that have the greatest risk of expropriation (since these are the countries that will receive the greater implicit subsidy from MIGA). Because respect for property rights is critical for economic growth, these are also the nations with the poorest economic prospects. Under MIGA, American taxpayers will wind up subsidizing the expropriation of American property. Thus, MIGA becomes another welfare scheme, not a business venture.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

2.b. How will MIGA affect the probability of expropriation and respect for property rights in Third World countries? Consider this question from an option pricing perspective. ANSWER. Governments always have the option of expropriating foreign property in their nations. The decision of whether to expropriate this property depends on the cost of exercising this option. By lowering the cost of expropriation, MIGA would make expropriation more advantageous for Third World governments and, hence, more likely. Instead of Third World governments compensating MIGA-insured investors, Western governments would provide this compensation. 2.c.

Is MIGA likely to improve the investment climate in Third World nations?

ANSWER. Quite the contrary. MIGA would counter the decline in private investment not by making foreign investment safer, but by having Western governments pay for the costs of Third World expropriations. If the World Bank really wants to improve the investment climate in the Third World, it could simply stop giving money to Third World governments that subvert their own development by expropriating foreign investors. 2.d. According to a senior World Bank official (Wall Street Journal, December 22, 1987, p. 20), “There is vastly more demand for political risk coverage than the sum total available.” Is this a valid economic argument for setting up MIGA? ANSWER. In general, a shortage of a good or service reflects underpricing. This situation is no exception. The problem is not that private insurance is not available – several private entities such as Lloyd’s of London offer insurance for foreign investments – but that its costs accurately reflect the true risk of placing one’s money in countries where property rights are routinely violated. In other words, the demand for low priced political risk insurance exceeds its supply. At the right price, enough insurance would be available to exactly satisfy the market’s demand. The purpose of MIGA is to boost FDI in Third World countries, most of which suffer from capital flight. The fact that the countries’ own citizens don’t trust the government is a clue that investment there is unsafe. 2.e.

Assess the following argument made on behalf of MIGA by a State Department memo: “We should avoid penalizing a good project [by not providing subsidized insurance] for bad government policies over which they have limited influence. … Restrictions on eligible countries [receiving insurance subsidies because of their doubtful investment policies] will decrease MIGA’s volume of business and spread of risk, making it harder to be self-sustaining.” (Quoted in the Wall Street Journal, December 22, 1987, p. 20.)

ANSWER. MIGA’s approach to foreign investments seems to be based more on a protection of greedy governments than on a respect for property rights. The World Bank seems to see expropriations as events that involve no human responsibility or blame. The World Bank refuses to loudly condemn Third World governments for seizing Western property. Countries throughout Africa that have nationalized foreign corporations have afterward received World Bank loans at subsidized rates to help run the new state-owned industries. A question that the MIGA official failed to ask is, “Why should taxpayers of developed countries subsidize the self-destructive behavior of Third World countries?” Some countries, like South Korea, Taiwan, and Hong Kong, have done very well at attracting foreign investment. MIGA would play down the differences in how governments treat investors, thus penalizing nations that honor property rights and rewarding nations that violate them. Given the crucial role that property rights play in economic development, this is a perverse set of incentives.

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3. In the early 1990s, China decided that by 2000 it would boost its electricity-generating capacity by more than half. To do that, it is planning on foreigners’ investing at least $20 billion of the roughly $100 billion tab. However, Beijing has informed investors that, contrary to their expectations, they will not be permitted to hold majority stakes in large power-plant or equipment-manufacturing ventures. In addition, Beijing has insisted on limiting the rate of return that foreign investors can earn on power projects. Moreover, this rate of return will be in local currency without official guarantees that the local currency can be converted into dollars and it will not be permitted to rise with the rate of inflation. Beijing says that if foreign investors fail to invest in these projects, it will raise the necessary capital by issuing bonds overseas. However, these bonds will not carry the “full faith and credit of the Chinese government.” 3.a. What problems do you foresee for foreign investors in China’s power industry? ANSWER. Since the return is set in nominal yuan terms, high inflation – a perennial Chinese problem – will reduce the real value of this return. This high inflation, in turn, will put pressure on the yuan to devalue, lowering the dollar value of the return. Finally, the local currency returns may be blocked. In other words, the dollar return is likely to be lower than the yuan return and the dollar return may never be realized because of inconvertibility. 3.b. What options do potential foreign investors have to cope with these problems? ANSWER. Don’t invest under these terms. If they do invest, they can buy political risk insurance against currency inconvertibility. They should also negotiate for higher yuan returns to compensate for the anticipated yuan devaluation and the cost of political risk insurance. 3.c.

How credible is the Chinese government’s fallback position of issuing bonds overseas to raise capital in lieu of foreign direct investment?

ANSWER. Not very credible. If the bonds don’t carry the “full faith and credit of the Chinese government,” then investors will either not buy them or, if they do, they will demand an interest rate that will compensate them for the political risks associated with the absence of the guarantee. The bonds will have to be dollar denominated and the interest rate will have to be as high as the dollar yield that investors would expect if they invested directly in the power plants themselves. In other words, the Chinese government will realize no benefit by financing the power projects through issuing bonds as opposed to enticing investors to provide equity financing for the projects.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

4. You have been asked to head up a special presidential commission on the Russian economy. Your first assignment is to assess the economic consequences of the following seven policies and suggest alternative policies that may have more favorable consequences. Note: Since this set of questions was first written, Russia has undergone massive changes. Yet many of the policies discussed here still persist and the consequences are as predicted. 4.a. Under the current Russian system, any profits realized by a state enterprise are turned over to the state to be used as the state sees fit. At the same time, shortfalls of money do not constrain enterprises from consuming resources. Instead, the state bank automatically advances needy enterprises credit, at a zero interest rate, to buy the inputs they need to fulfill the state plan and to make any necessary investments. ANSWER. The system as described completely destroys all incentive to be efficient and profitable. In effect, it penalizes success and rewards failure. At the same time, the ability to borrow unlimited amounts of money at a zero interest rate encourages firms to squander capital without penalty and reduces the incentive to cut costs. Moreover, the absence of any constraints on the ability of state banks to print money to cover shortfalls guarantees rapid expansion of the money supply and inflation. Short of an immediate and complete overhaul of the current system, the government should quit printing rubles and allocate the available supply of capital by auctioning it off to firms. To ensure that firms are realistic in the price they are willing to pay for capital, the state would have to allow enterprises that can’t service their debts to go bankrupt. Managers of profitable enterprises should be allowed to keep, say, 70% of their profits to reinvest or pay bonuses (equivalent to a 30% corporate tax rate). Enterprises that show losses should be forced to borrow at the auction-determined interest rate to cover their shortfalls or go out of business. At the same time, bankers should be similarly incentivized to make money, thereby forcing them to assess the creditworthiness of potential borrowers. 4.b. The Russian fiscal deficit had risen from 2.5% of GNP when Mikhail Gorbachev assumed power in 1985 to an estimated 13.1% of GNP in 1989. This deficit has been financed almost exclusively by printing rubles. Concurrently, prices are controlled for most goods and services. ANSWER. By printing money while controlling prices, the government guarantees that there will be massive shortages of goods and services throughout the Soviet Union. At the same time, black markets will arise in controlled products while prices of uncontrolled products will skyrocket. Shutting down the printing presses will end suppressed inflation. Decontrolling prices will end shortages. Gorbachev can eliminate the deficit by raising taxes or cutting spending. Alternatively, he can finance the deficit by borrowing from the public. This latter approach, however, will require the government to pay an interest rate that yields a positive real return to savers. 4.c.

Russian enterprises are allocated foreign exchange to buy goods and services necessary to accomplish the state plan. Any foreign exchange earned must be turned over to the state bank.

ANSWER. This system of foreign exchange allocation destroys any incentive to conserve on foreign exchange, and allows bureaucrats to decide what amount of foreign exchange is needed to accomplish the state plan. It also discourages Soviet exports since the government imposes what is, in effect, a 100% tax on foreign exchange earnings. A partial solution to this problem is to free up the market for foreign exchange. By allowing enterprises to buy or sell foreign exchange as they see fit, they will have a stronger incentive to earn foreign exchange and to conserve on its use.

CHAPTER 11: COUNTRY RISK ANALYSIS

4.d. In an effort to introduce a more market-oriented system, some Russian enterprises have been allowed to set their own prices on goods and services. However, other features of the system have not been changed: Each enterprise is still held accountable for meeting a certain profit target; only one state enterprise can produce each type of good or service; and individuals are not permitted to compete against state enterprises. ANSWER. The basic problem with this system is that without the possibility of competition, the state enterprises become unregulated monopolies. Since their goods are already underpriced, deregulated enterprises can reach their profit target by raising their prices rather than by cutting costs or producing higher quality goods. In fact, they appear to have not only raised prices but also cut production, thereby simplifying their lives. In other words, freeing prices for goods produced by monopoly factories just enables producers to reap monopoly profits. The answer here is to permit competition, from individuals, other state enterprises, and foreign companies. At the same time, producers must be able to keep most of their profits. Otherwise, they will have no incentive to produce more and better goods. 4.e.

Given the disastrous state of Russian agriculture, the Russian government has permitted some private plots on which anything grown can be sold at unregulated prices in open-air markets. Due to their success, the government has recently expanded this program, giving Russian farmers access to more acreage. At the same time, a number of Western nations are organizing massive food shipments to the Russia to cope with the current food shortages.

ANSWER. Although the Western nations are well-intentioned (we think; they may be using this as a means of dumping the agricultural surpluses they have accumulated by subsidizing their domestic farmers), the effect of food aid will be to drive down the price of food in the Russia, thereby reducing the incentive of Russian farmers to produce food. If Western nations wish to aid the Russia, they can provide it with advice and money tied to the implementation – not just the promise – of genuine economic and political reforms. After all, food shortages reflect a combination of price controls and lack of incentive faced by farmers; it is not an act of nature. 4.f.

The U.S. and other Western nations are considering instituting a Marshall Plan for Eastern Europe that would involve massive loans to Russia and other Eastern Bloc nations in order to prop up Gorbachev and the reform governments.

ANSWER. The key here is to recognize that we are dealing with a political problem, not an economic problem, and political problems cannot be solved with money alone. The basic problem with massive loans to these nations is that by alleviating their economic crisis, it would reduce the governments’ incentive to institute real economic and political reform. It also boosts the power of the bureaucrats at the expense of the private sector. Thus, any loans should be tied to the implementation of genuine reforms. Better still, money should be provided directly to private companies on close-to-market terms, thereby building up the private – not the public – sector. As Mr. Gorbachev has already proved to the world’s satisfaction, no matter how many Harvard economists he puts to work, he will not be able to restructure the Soviet economy and still preserve the power of the Communist Party. The two things are antithetical. You can’t have a free-market economy and an economy run by and for a Communist Party elite. The contradictions inherent in this attempt ultimately led to the downfall of communism in the Soviet Union, as it also will in China.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

5. The president of Mexico has asked you to advise him on the likely economic consequences of the following five policies designed to improve Mexico’s economic environment. Describe the consequences of each policy, and evaluate the extent to which these proposed policies will achieve their intended objective. 5.a. Expand the money supply to drive down interest rates and stimulate economic activity. ANSWER. Rapid expansion of the money supply will lead to higher inflation and higher nominal interest rates. It will also raise real interest rates to the extent that savers demand a bigger inflation risk premium for the higher inflation risk that they must now bear. Higher inflation will make it more difficult for business to plan and lead to a reduction in business investment. It will also reduce the reliability of price signals, thereby reducing the efficiency with which the Mexican economy operates. The net effect will be higher interest rates and slower economic growth, exactly the opposite of what is desired. 5.b. Increase the minimum wage to raise the incomes of poor workers. ANSWER. Workers covered by the higher minimum wage and who keep their jobs will see their incomes rise. However, many workers will lose their jobs since the new wages will exceed the value of their work (low wages typically signal low productivity and few salable worker skills, not exploitation). The most seriously affected companies will be those facing foreign competition, since they will be unable to raise their prices much. Such companies will attempt to lower their costs by substituting capital for labor, moving offshore, or just reducing their workforce. Moreover, those workers who are not covered will find more competition for their jobs, leading to a fall in wages in the uncovered sector of the economy. The net effect will be higher unemployment and a workforce that is worse off overall. To the extent that companies can offset their higher labor costs by raising prices, their customers will be worse off. 5.c.

Impose import restrictions on most products to preserve the domestic market for local manufacturers and, thereby, increase national income.

ANSWER. Import restrictions will lead to higher domestic prices for lower quality products. It will also stifle innovation and make domestic firms less competitive. The evidence is that countries that follow an export-oriented growth strategy grow much more rapidly than those that seek to grow through import substitution. Thus, this policy will reduce Mexico’s national income, not increase it. 5.d. Raise corporate and personal tax rates from 50% to 70% to boost tax revenues and reduce the Mexican government deficit. ANSWER. The odds are that the Mexican government will collect less tax revenue at a 70% tax rate than at a 50% rate. People will have greater incentive to cheat on their taxes and less incentive to work if 70% of what they earn goes to the government. Thus, both actual and reported income will probably be sufficiently lower at a 70% tax rate than at a 50% rate that the rise in the tax rate will be more than offset by the decline in taxable income. At the same time, economic growth will be reduced and there will be more demands on the government to “do something,” which usually means spending more money. The net result will be a higher deficit.

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5.e.

Fix the nominal exchange rate at its current level in order to hold down the cost to Mexican consumers of imported necessities (assume that inflation is currently 100% annually in Mexico).

ANSWER. Mexico and many other Latin American countries already tried this during the 1970s and early 1980s. To summarize the conclusions in the Mexican Peso case, the resulting jump in the real exchange rate boosted imports, cut exports, and led to capital flight and huge and unsustainable trade and government budget deficits. Sorting out the mess cost Latin America a decade of economic misery and lost economic growth. Fixing the exchange rate with inflation running at 100% annually, as proposed here, will double the real value of the peso in a year. This will bring on the troubles just described even faster than in the 1980s. ADDITIONAL CHAPTER 11 PROBLEMS AND SOLUTIONS 1. The president of Brazil has just appointed you to work with the country’s cabinet ministers to launch a radical restructuring of the Brazilian economy. Inflation is running at over 1,000% annually, and the federal government is running a deficit in excess of 10% of GNP (the U.S. deficit is about 3% of GNP). To finance the deficit, the government has incurred huge debts, both internally and externally. In your initial discussions with the cabinet ministers, you realize that there is considerable disagreement about a number of specific program proposals. Your job is to assess the issues and the relative merits of the proposed policies. 1.a. The Governor of the Banco do Brasil, Brazil’s central bank, wants to cease its purchases of government bonds issued by the Ministry of Finance to fund the ongoing federal budget deficit. The Banco do Brasil has acquired 50% to 60% of all government bonds issued in the past several years with money expressly created for that purpose. In other words, it has been monetizing the deficit. Other cabinet ministers are afraid that this policy will lead to higher interest rates and wonder how the deficit can be financed otherwise. ANSWER. Ending monetization of the deficit will reduce the growth in the money supply. This change in policy will actually lower nominal interest rates by reducing inflation, which is the primary cause of high rates. Ending the threat of inflation would lead to lower nominal rates and – as the inflation risk premium imbedded in nominal rates shrinks – to lower real rates as well. The government can reduce the deficit by cutting spending, leading to a healthier economy and stronger growth, or by increasing taxes, which will likely weaken the economy. Alternatively, the government can sell bonds to the market. This will probably boost real interest rates, but the nominal interest rate will still be lower than it was before. Borrowing from the private sector to finance large deficits, however, is not a sustainable policy. Sooner or later, the government will have to face the issue once again of whether to raise taxes, monetize the deficit, or cut spending. The latter can be done by selling off money-losing state enterprises. An alternative, and less traumatic way to reduce the deficit is to reduce the rate of increase in government spending and then allow the natural rise in tax revenues from a growing economy to eventually narrow the gap between tax revenues and spending.

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1.b. The Minister of Infrastructure has proposed that his ministry begin privatizing the hundreds of state-owned enterprises under his administration. These enterprises include virtually all of Brazil’s steel industry, mining industry, electric utilities, the telephone company, national oil company, chemical companies, and a wide range of manufacturers. Opponents claim that this move will lead to massive unemployment and the bankruptcy of vital national industries. ANSWER. Privatization is probably the single most valuable step that Brazil can take to deal with its economic crisis. Privatization will lead to efficiency gains for the whole economy by forcing the privatized companies to earn their keep in a competitive market. At the same time, the government will convert what has traditionally been a series of deficit-plagued companies into both a one-time source of revenue through the sell-off as well as an continuing stream of tax revenue from now-profitable companies. Consumers will likely receive higher-quality service at lower prices (assuming that the government permits competition in what have historically been run as government monopolies). The reason that state-owned enterprises are money losers is that most of them are way overmanned and very inefficient. Privatization will force them to cut their workforces. But to argue that this will result in massive unemployment ignores the fact that these enterprises are squandering vast resources that could be used more efficiently elsewhere in the economy and lead to higher economic growth. The laid-off workers will have to find jobs in the private sector of the economy. This leads to further gains in efficiency, as unproductive workers from the privatized firms become productive members of society. The surest guarantee of getting and keeping a job in the private sector is to be worth more than your compensation. The argument that giving people jobs, regardless of their productivity, helps the nation brings to mind the old solution to eliminate unemployment: Put half the population to work digging holes and let the other half fill them in. Everyone will be working, but to what end? Taxpayers and consumers subsidize the inefficiency of state-owned enterprises. If taxpayers and consumers decide they want to pay the redundant workers to do nothing, they should do so directly. Transparency is the key to allowing taxpayers and consumers to make informed decisions as to how they want to spend their money – on goods and services they value or on overpaid, underworked state employees. The bankruptcy argument ignores the fact that bankruptcy doesn’t destroy assets; it simply transfers them to those who are able to use them more efficiently. It also ends the possibility of cross-subsidization by the private sector through the tax collection mechanism. 1.c.

The Minister of Political Economy has proposed that Brazil enter into free trade agreements with its Latin American neighbors. This would involve eliminating all tariffs, duties, and fees on imports. A number of other government leaders oppose this move, because the Brazilian market is larger and generally more protected than those of its neighbors. They feel that opening the border would expose Brazil to rapid growth in imports that exceed any incremental export activity.

ANSWER. The more protected an economy is, the greater the disruption when it opens its borders, but also the greater the economic benefit that it reaps. Consumers will benefit because free trade will expand the quality and variety of goods and services available to them--and at better prices too. Opening the economy to imports will also force inefficient protected Brazilian firms to become more efficient to survive. Brazilian exporters will gain as well by being able to substitute higher-quality, lower-priced imports for domestic supplies. To the extent that the opening of free trade does lead to a net increase in Brazilian imports, that net increase will be financed by additional, voluntary inflows of foreign capital;

RESCUING THE INDONESIAN RUPIAH WITH A CURRENCY BOARD

that is, Brazil can run a deficit only if other nations are willing to finance it. Such a situation will not boost unemployment or slow down economic growth, the fear underlying resistance to free trade. If Brazilians demand more imports than foreigners demand Brazilian exports, the real’s value will fall until equilibrium is again established in trade. The net result from free trade, therefore, will be a more competitive Brazil and happier Brazilian consumers. 1.d. The Minister of Finance has proposed creating a new consumption tax and lowering income tax rates. His concern is that Brazil’s personal savings rate has been close to zero over the past several years. He believes increased savings will help to dampen inflation, lower interest rates on the federal debt, and promote exports. Critics of this proposal argue that the vast majority of Brazil’s population are living very near the poverty line and that a consumption tax would be highly regressive (hit the poor relatively harder than the rich). It also would tend to dampen domestic demand, the principal engine of economic growth in Brazil. ANSWER. The shift from an income tax to a consumption tax will increase the incentive to save while at the same time increasing the incentive to engage in productive activity (income, after all, is the return to productive activity), thereby stimulating economic activity. The problem facing Brazil is not a lack of consumption. Indeed Brazil is consuming too much relative to its income; otherwise, it could not have run such huge trade deficits. The main effect of higher savings will be to lower imports and free up resources to service the export market, thereby cutting the current-account deficit. It should also lead to lower interest rates and more investment. But increased savings will not lead to less inflation, unless the government uses those savings to substitute for newly printed money as a means of financing its deficit. Only from a static standpoint could one be concerned about the poor being hurt by the new tax system. From a dynamic standpoint, the increase in investment brought about by the additional savings will increase worker productivity and raise their wages. At the same time, the regressivity of the consumption tax can be reduced or eliminated by providing generous allowances to lower-income residents. Specifically, the consumption tax will tax workers on the difference between what they earn and what they save. By providing generous dependent deductions, the consumption tax can do away with taxes on the poor. Although a consumption tax will stifle consumption initially, by making Brazilians wealthier over time (by increasing their productivity), it will eventually lead to higher consumption and a higher standard of living. At the same time, even though consumption will fall at first, investment will rise since the increased saving will lower the cost of capital faced by companies, leading to more positive NPV projects. In other words, there is no necessary reason to expect that a nation with a high savings rate will have a low growth rate. Japan is a good example of a nation with a high savings rate and a (historically) high growth rate. Any excess domestic savings (that is, savings not invested domestically) are exported abroad as capital by running a current account surplus. 1.e.

The Minister of Labor has proposed raising the minimum wage to raise the income of poor workers and, thereby, offset the effects of restructuring on them. Other cabinet members are concerned about the effects this policy will have on employment and competitiveness.

ANSWER. Raising the minimum wage will boost incomes for those workers who retain their jobs. However, it will also cause higher unemployment among unskilled workers and make Brazilian industry less competitive. The most seriously affected Brazilian companies will be those facing foreign competition, since they will be unable to raise their prices much. Such companies will attempt to lower their costs by substituting capital for labor, moving offshore, or just reducing their workforce.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 5TH ED.

1.f.

The Central Bank has proposed that it replace the current fixed exchange rate system with a freely floating exchange rate system. Critics of this proposal argue that floating the real will devalue the currency and raise the cost of living (by boosting the price of imported necessities) for Brazilians.

ANSWER. The argument that floating the real will lead to currency devaluation implies that the real is currently overvalued. Although devaluation will raise the cost of imported goods, it will also end the subsidies used to maintain real overvaluation. These subsidies can be given directly to Brazilians instead of only to those who buy imported products. At the same time, devaluation will make Brazilian industry more competitive internationally and boost Brazil’s GNP, benefiting all. Finally, Brazil will be unable to maintain an overvalued currency forever. Hence, the only question is whether the real is devalued today or tomorrow. The longer Brazil waits, the more foreign exchange it will squander trying to preserve an overvalued currency. 1.g. To reduce the money supply and, thereby, suppress inflation, the Minister of Finance has proposed freezing all bank accounts. Depositors will be able to withdraw only the real equivalent of about $1,000. However, other cabinet ministers are concerned about possible adverse consequences of such a freeze. ANSWER. This policy smacks of lunacy. It destroys faith in the monetary system and discourages savings and the work that leads to those savings. Nonetheless, Brazil tried this in early 1990. The result, as predicted, was economic chaos. The message such an action sent is that work and saving aren’t the ways to get ahead. Citizens figured that such an action was likely to reoccur and responded with capital flight, increased consumption, and less investment.

CHAPTER 12: INTERNATIONAL FINANCING AND NATIONAL CAPITAL MARKETS

CHAPTER 12 INTERNATIONAL FINANCING AND NATIONAL CAPITAL MARKETS I begin this session by discussing the evolutionary process under way in world finance, which is characterized by three simultaneous developments. (1) Financial markets are becoming increasingly globalized. (2) Old kinds of debt are being made into new kinds of securities. (3) The distinction between commercial and investment banks is breaking down. Each of these developments will have a profound influence on everybody involved in the financing business. The process of globalization has been taking place for some time. U.S. banks developed worldwide branch networks in the 1960s and 1970s for loans, payments, clearings, and foreign exchange trading. U.S. securities firms also began to build up their operations abroad, starting in the 1970s at first in London with the Eurobond market, but then into other markets, including now Tokyo, Hong Kong, and Singapore. Foreign firms expanded into the U.S., first the commercial banks and later on the securities houses. Trading in individual markets has globalized. International finance is a Darwinian world – only the fittest will survive – and most financial firms have concluded that to survive as a force in any one of the world’s leading financial markets, a firm must have a significant presence in all of them. The second major development under way in world finance is the process of securitization. Twenty years ago, banks handled most of the short- and medium-term financing around the world. But corporate borrowers developed the means to obtain lower-cost funds directly from lenders, such as through commercial paper marketed by investment banks rather than by commercial banks. The third major development is the diminishing distinctions among different kinds of financial firms. Every financial firm wants to be in the most profitable product line and have the flexibility to shift to another, more promising, product line. In the U.S., the Glass-Steagall Act separates commercial banks from investment banks. Japan has a similar provision, Article 65 of the Securities and Exchange Act, separating the two kinds of banking activities. In recent years, commercial banking has not been as profitable as it was, while some kinds of investment banking have been extremely profitable. As a result, commercial banks in the U.S. and Japan have sought to break down the barriers established by Glass-Steagall and Article 65 to engage in investment banking activities. At the same time, investment banks have been encroaching into areas of activity that were traditionally the preserve of banks. One of the biggest moves was into money market mutual funds, which drew billions of dollars from banks in the late 1970s and early 1980s until banks were allowed to offer money market deposit accounts to their customers. I then discuss the differences in national financing patterns and relate these differences to some of the factors discussed in the chapter. Principal factors are differences in profitability and growth among national firms and differences in the role of banks and permissible banking activities. I note, however, that the evolutionary process discussed above is leading to a convergence of financing practices among countries. Finally, I discuss the role of international development banks in financing LDCs and private-sector alternatives.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

SUGGESTED ANSWERS TO “BEIJING TRIES TO OVERHAUL BANKS THROUGH IPOS” 1. Would you expect loans to SOEs to be safer or riskier than other Chinese bank loans? Explain. ANSWER. From a strict credit risk standpoint, loans to SOEs are much riskier. These companies are basically bankrupt, with few assets and lots of liabilities. Moreover, the loan proceeds go mostly to pay for current operating expenses rather than to purchase assets that will eventually generate cash to repay the loans. As such, these loans are unlikely to ever be paid off. On the other hand, one could argue that the government stands behind these loans since the borrowers are owned by the state. So far, the government has been bailing out the banks directly rather than the SOEs themselves by buying up the bad loans and injecting capital into the banks to compensate for their losses. 2. How can IPOs improve the sorry performance of Chinese banks? ANSWER. The problem with the banks is that they lack accountability and transparency and are subject to the whims of Communist Party officials in making lending decisions. By replacing party bosses with a board of directors accountable to shareholders, and by subjecting the banks to the scrutiny of international regulators that go along with a public listing, an IPO can improve the corporate governance of these banks and reduce the influence of Communist Party officials in lending decisions. 3. What difficulties will China face in preparing their state-owned banks for IPOs? ANSWER. There are several obvious difficulties. First, the state-owned banks have little experience or expertise in credit risk assessment and loan pricing. Second, the banks still have huge portfolios of nonperforming loans that have to be sorted out and resolved before they can function like normal banks. Third, Communist Party officials are unlikely to just walk away from the power they currently exercise and turn over the governance reins to outside investors. 4. What other steps can the Chinese government take to improve the performance of their banks? ANSWER. The biggest step would be for the government to reduce the role of the Communist Party in running the banks. One way to accomplish this is to have the banks report to independent boards rather than to Communist Party bosses. The government can also set financial goals for the banks that make them accountable for bank profit and reward or penalize bank executives based on achieving profit targets. 5. How would a more efficient banking system benefit China? ANSWER. A more efficient banking system leads to more effective capital allocation in the economy. This would lead to fewer credit losses and more capital accumulation. It would also result in better projects being selected, yielding higher Chinese growth at a lower cost in terms of foregone consumption. 6. What is the downside of introducing market forces into China’s banking system? ANSWER. The downside from the government’s standpoint is that market-oriented banks would quit making loans to SOEs, putting millions of people out of work and creating the possibility of riots and revolt by the unemployed. However, the government can mitigate this problem by making direct grants to the SOEs for a transitional period, giving the SOEs and their workers a grace period during which to restructure their businesses. In any event, the problem of bankrupt SOEs and their excess supply of workers is independent of whether the banks are state owned or privately owned.

CHAPTER 12: INTERNATIONAL FINANCING AND NATIONAL CAPITAL MARKETS

SUGGESTED ANSWERS TO “SIEMENS NEGOTIATES A EUROCURRENCY LOAN” 1. What are the net proceeds to Siemens from each of these syndicated loan proposals? ANSWER. With an up-front syndication fee of 1.125%, net proceeds to Siemens from the Bank of America loan proposal are: $500,000,000 - (0.01125 * 500,000,000) = $494.375 million. Similarly, after paying the 0.75% syndication fee with the Deutsche Bank proposal, Siemens would end up with $496.25 million. 2. Assuming that six-month LIBOR is currently at 4.35%, what is the effective annual interest cost to Siemens for the first six months of each loan? ANSWER. The interest rate on the Bank of America loan is set at LIBOR + 0.25%, with LIBOR reset every six months. Given an initial LIBOR6 rate of 4.35%, the first semiannual debt service payment is 0.5 * (0.0435 + 0.0025) x 500,000,000 = $11,500,000 Siemen’s effective annual interest rate for the first six months is thus 11,500,000/493,750,000 * 2 * 100 = 4.658% The interest rate on the Deutsche Bank loan is set at LIBOR + 0.375%, with LIBOR reset every six months. Given an initial LIBOR6 rate of 4.35%, the first semiannual debt service payment is 0.5 * (0.0435 + 0.00375) * 500,000,000 = $11,812,500 Siemen’s effective annual interest rate for the first six months is thus 11,812,500/496,250,000 * 2 * 100 = 4.761% The corresponding effective annual rate on the Deutsche Bank proposal is 4.725% (4.35% + 0.375%). 3. Which of these two loans would you select on the basis of cost, all else being equal? ANSWER. This is a capital budgeting problem. By going with the Bank of America loan proposal, Siemens would pay an additional syndication fee of $1,875,000 (0.01125 – 0.0075) * $500,000,000. In return, Siemens would save interest expense of $625,000 each year for five years. This annual interest savings is the difference between paying LIBOR6 + 0.25% vs. LIBOR6 + 0.375% (0.00375 – 0.0025) * $500,000,000. The cash flows associated with going with the Bank of America proposal instead of the Deutsche Bank loan are thus: 0 (1,875,000)

1 625,000

2 625,000

3 625,000

4 625,000

5 625,000

These cash flows yield an internal rate of return of 24.29%, significantly higher than any reasonable estimate of the appropriate cost of capital for Siemens. Hence, the Bank of America loan proposal has the lowest effective cost.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

4. What other factors might you consider in deciding between these two loan proposals? ANSWER. You might also want to consider how long it would take to put together the syndicates, the banking relationship you have with each of the banks, financial advice the banks might be able to provide, whether using the Bank of America syndicate would introduce Siemens to a new group of banks that it might be able to tap later on for more loans, the covenants associated with each loans, and the willingness of the banks to renegotiate these covenants at a later date. SUGGESTED ANSWERS TO CHAPTER 12 QUESTIONS 1. What are some basic differences between the financing patterns of U.S. and Japanese firms? What might account for some of these differences? ANSWER. The basic differences between the financing patterns of U.S. and Japanese firms are in the source of financing--internal versus external-- and the composition of external finance--bank borrowing versus debt securities. Historically, U.S. companies have received 60% to 70% of their funds from internal sources. By contrast, Japanese companies have relied heavily on external funds to finance their strategy of making huge industrial investments and pursuing market share at the expense of profit margins. Industry’s sources of external finance also differ widely between Japan and the U.S. Japanese firms rely heavily on bank borrowing, while U.S. firms raise much more money directly from financial markets by the sale of securities. 2. What is securitization? What forces underlie it and how has it affected MNC financing policies? ANSWER. Securitization is the process of matching up borrowers and savers by way of the financial markets. By contrast, financial intermediation involves the use of financial institutions such as banks and thrifts to bring together borrowers and savers. These institutions make a large number of loans and fund them by issuing liabilities (e.g., deposits) in their own name. Securitization largely reflects a reduction in the cost of using financial markets at the same time that the cost of bank borrowing has risen. Multinational companies and other large firms have participated in the securitization process. Instead of raising money in the form of nonmarketable loans provided by financial intermediaries, they are now issuing negotiable securities to the public capital markets. 3. Why is bank lending on the decline worldwide? How have banks responded to their loss of market share? ANSWER. Three economic forces underlie the decline of bank lending worldwide. (1) Upward pressure on the cost of bank intermediation, especially higher capital requirements not matched by a fall in the cost of capital at a time when transactions costs for both securities placement and risk management are falling. (2) An increase in financial risk, especially in interest rate volatility. Banks responded to higher interest rate volatility by sharply cutting back on loan commitments, thereby reducing the value of a banking relationship to corporate customers. (3) Increased competition to relationship lenders from banks and other financial institutions has reduced the perceived cost of severing a banking relationship. The perception that asset quality declined at many banks and that some might be vulnerable to liquidity problems in adverse market conditions also undermined bank credibility and the value of the banking relationship.

CHAPTER 12: INTERNATIONAL FINANCING AND NATIONAL CAPITAL MARKETS

Banks have responded to their loss of market share by eliminating the unprofitable aspect of the traditional lending relationship (retention of loans on the balance sheet) while reshaping their lending activity to retain the element crucial to the borrower (access to funds). Thus origination of loans for sale has emerged as a new business line. Banks have also expanded their nonlending services that produce fee income and are not (yet) covered by capital requirements. This includes engaging in investment banking activities such as underwriting commercial paper, foreign exchange trading, giving advice on mergers and acquisitions, and arranging swaps; providing credit commitments such as NIFs; and issuing standby letters of credit to guarantee the debt obligations of customers (called credit enhancement). 4.a. What is meant by the globalization of financial markets? ANSWER. The globalization of financial markets refers to the increasing integration of national financial markets. Markets for U.S. government securities and certain stocks, foreign exchange trading, interbank borrowing and lending--to cite a few examples--operate continuously around the clock and around the world and in enormous size. Foreign financial firms are increasing their participation in the world’s leading financial markets. Investors are scanning the globe to place their capital where it can realize the best risk-return combination, while companies are seeking to raise money wherever in the world they can receive the best terms and conditions. In effect, globalization reflects the process of breaking down the artificial barriers that separate domestic from foreign capital markets. True globalization will come when the price of risk and the time value of money are identical worldwide. 4.b. How has technology affected the process of globalization? Recent technological improvements in such areas as data manipulation and telecommunications have greatly reduced the costs of gathering, processing, and acting on information from anywhere in the world. This has facilitated the process of arbitrage across financial markets, which has brought prices of securities with similar risks and returns closer in line with each other and turned the world into a vast interconnected market. 4.c. How has globalization affected government regulation of national capital markets? ANSWER. Because the globalization of financial markets and institutions has been brought about by technology and innovation, it cannot be reversed in any material way by regulation or legislation. National systems of supervision and regulation that were created many years ago were not designed for a marketplace of worldwide dimensions in which firms with differing charters and national origins compete head-to-head with each other around the clock and around the world. Governments that try to restrict domestic financial institutions will find that foreign firms have a competitive advantage. Similarly, restrictions on domestic financial markets drives business overseas. The net result has been to increase pressure for loosening controls on domestic financial institutions and markets to enable them to be more competitive and to speed the process of financial deregulation. 5. Many financial commentators believe that bond owners and traders today have an enormous collective influence over a nation's economic policies. Explain why this might be correct. ANSWER. Bond owners and traders influence national access to capital markets. To the extent that a nation requires this access (and most do, at least at some point in time), this exerts a strong disciplinary effect on the types of economic policies a nation is likely to select. A policy perceived as being economically harmful will restrict the nation’s access to capital on favorable terms.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

6. Why are large MNCs located in small countries such as Sweden, Holland, and Switzerland interested in developing a global investor base? ANSWER. Large MNCs located in these small countries often need to raise substantial capital to continue growing. Quite often, the domestic market cannot provide this amount of capital on reasonable terms because local investors already have a large exposure to the local MNC. To add additional MNC paper will make their portfolios even less diversified, leading local investors to demand an added risk premium. By going overseas, MNCs from small countries such as Sweden and the Netherlands can find investors who view stocks and bonds from Dutch and Swedish MNCs as a source of diversification. In other words, although stocks of Dutch and Swedish MNCs comprise a large fraction of local portfolios, they comprise a small fraction of global wealth. The net result is a lower cost of capital for these MNCs from small countries (and hence a higher market value). In addition, developing a global investor base gives these MNCs access to capital in the event their local markets are subject to some event (most likely political) that restricts the ability of MNCs to raise capital there regardless of price. 7. Why are many U.S. MNCs seeking to improve their visibility with foreign investors, even going so far as to list their shares on foreign stock exchanges? ANSWER. There are several reasons for companies to list their shares on foreign stock exchanges: ▪

Diversification of equity funding risk: A pool of funds from a diversified shareholder base insulates a company from the vagaries of a single national market.

▪

Increase stock price: By selling stock overseas, a company can expand its investor base, thereby lowering its cost of equity capital and increasing its market value.

▪

Boost foreign sales: An international stock offering can spread the firm’s name in local markets and increase its sales overseas.

8. List some reasons a U.S.-based corporation might issue debt denominated in a foreign currency. ANSWER. A U.S. company might issue foreign currency debt because it ▪

Wants to hedge a foreign currency exposure; or

▪

Can borrow money at a lower effective interest rate. This is especially true for those bond issues that are combined with swaps.

9. In an attempt to regain business lost to foreign markets, Swiss authorities abolished stamp duties on transactions between foreigners as well on as new bond issues by foreign borrowers. However, transactions involving Swiss citizens will still attract a 0.15% tax, and bond issues by Swiss borrowers were also made more expensive. What are the likely consequences of these changes for Swiss financial markets? ANSWER. The reduced taxes on foreign investors and borrowers will slow down the loss of trading business to foreign markets, but it will not reverse it. Large Swiss companies that operate overseas (as most of them do) will try harder than ever to raise capital abroad and the big Swiss banks, wellestablished in London, have little reason to bring any of their Eurobond business back home. The trend for Swiss shares to increasingly trade abroad will not abate. Indeed, more Swiss companies are launching or are thinking of launching American Depository Receipts.

CHAPTER 12: INTERNATIONAL FINANCING AND NATIONAL CAPITAL MARKETS

10. What is the difference between a Eurocurrency loan and a Eurobond? ANSWER. The fundamental distinction between a Eurobond and a Eurocurrency loan stems from the financing mechanism. A Eurobond is issued by the final borrower directly, whereas a Eurocurrency loan is made by a bank. Thus, Eurobond investors hold a claim on the issuer directly, whereas Eurocurrency loans are funded by investors who hold short-term claims on banks that then act as intermediaries to transform these deposits into long-term claims on final borrowers. 11. What is the difference between a foreign bond and a Eurobond? ANSWER. A foreign bond is an issue sold in the domestic bond market by a foreign company or government. As such, foreign bonds are subject to local laws and must be denominated in the local currency. By contrast, a Eurobond is sold outside the country in whose currency it is denominated. Eurobonds are also almost entirely free of official regulation. 12. What is the basic reason for the existence of the Eurodollar market? What factors have accounted for its growth over time? ANSWER. The Eurodollar market, exists because it enables borrowers and lenders alike to avoid a variety of U.S. banking regulations and controls, and it gives them an opportunity to escape the payment of some taxes. Some of the factors that have affected the growth of the Eurodollar market include the interest equalization tax, U.S. withholding tax on interest received by foreign owners of domestic securities, Regulations M and Q, and regulations from the U.S. Office of Foreign Direct Investment (OFDI). 13. Why have Eurobonds traditionally yielded less than comparable domestic bonds? ANSWER. Eurobonds are issued in bearer form, meaning they are unregistered, with no record to identify the owners. This feature allows investors to collect interest in complete anonymity and, thereby, evade taxes. Although U.S. law discourages the sale of such bonds to U.S. citizens or residents, bonds issued in bearer form are common overseas. As expected, investors are willing to accept lower yields on bearer bonds than on nonbearer bonds of similar risk. ADDITIONAL CHAPTER 12 QUESTIONS AND ANSWERS 1. Suppose the Swiss government imposes an interest rate ceiling on Swiss bank deposits. What is the likely effect on Eurofranc interest rates of this regulation? ANSWER. If the Swiss government imposes an interest rate ceiling on Swiss bank deposits, holders of Swiss francs will shift some of their deposits into the Eurofranc market to earn a higher rate. As the supply of Eurofrancs rises relative to the demand for francs, the Eurofranc interest rate should decline. 2. What factors account for the rise and recent decline of the Eurobond market as a source of financing for American companies? ANSWER. The Eurobond market, like the Eurocurrency market, exists because it enables borrowers and lenders alike to avoid a variety of monetary authority regulations and controls, and it provides them with an opportunity to escape the payment of some taxes. As long as governments attempt to regulate domestic financial markets but allow a (relatively) free flow of capital among countries, the various external financial markets will survive. If tax and regulatory costs rise, these markets will grow in importance.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

The Eurobond market’s slump in recent years may be largely traced to a reversal of many of these tax and regulatory costs. The 1984 repeal of U.S. withholding tax on interest paid to foreign bondholders made domestic bonds, particularly U.S. Treasuries, more attractive to foreign investors. At the same time, the U.S. began permitting well-known companies--precisely the ones that would otherwise use the Eurobond market--to bypass complex securities laws when issuing new securities, by using the "shelf registration" procedure. By lowering the cost of issuing bonds in the U.S. and dramatically speeding up the issuing process, shelf registration improved the competitive position of the U.S. capital market relative to the Eurobond market. Other nations such as Japan, France, and England also embarked on a program of deregulating their financial markets. The dollar’s weakness has also played a role in the slump in Eurobond financing. Although more foreign investors are buying U.S. securities, most of them still turn first to the Euromarket for dollar-denominated bonds. Thus, if foreigners want to diversify out of dollar bonds, the Euromarket gets hit first. Another possible reason is the substitution of Euronotes for Eurobonds. 3. It had been said that if other European interest rates converged toward German rates, ECU bonds would soar in value. Explain why this would occur. ANSWER. ECU bonds are priced based on a weighted average of the interest rates of the currencies that comprise the ECU. Because of fears of higher inflation and hence currency devaluation in most European countries other than Germany, the weighted average interest rate on ECU bonds tends to exceed, often by a large margin, the German rate for a similar maturity DM issue. Hence, for other European interest rates to converge toward German rates, they would have to fall. Since bond prices move inversely to interest rates, a drop in ECU rates would boost ECU bond prices. SUGGESTED SOLUTIONS TO CHAPTER 12 PROBLEMS 1. A European company issues common shares that pay taxable dividends and bearer shares that pay an identical dividend but offer an opportunity to evade taxes: Bearer shares come with a large supply of coupons that can be redeemed anonymously at banks for the current value of the dividend. 1.a. Suppose taxable dividends are taxed at the rate of 10%. What is the ratio between market prices of taxable and bearer shares? If a new issue is planned, should taxable or bearer shares be sold? ANSWER. Under these conditions, the taxable proceeds are (1 - 0.10) = 90% of the bearer proceeds. Hence, the taxable shares will sell for 90% of the bearer shares. Bearer shares should be sold. 1.b. Suppose, in addition, that it costs 10% of proceeds to issue a taxable dividend, whereas it costs 20% of the proceeds to issue bearer stocks because of the expense of distribution and coupon printing. What type of share will the corporation prefer to issue? ANSWER. In this case, the taxable proceeds are (1 - .10)(1 - .10) = 81% of gross bearer proceeds, and net bearer proceeds are 1 - .20 = 80% of gross bearer proceeds. The firm will now prefer to issue taxable equity.

CHAPTER 12: INTERNATIONAL FINANCING AND NATIONAL CAPITAL MARKETS

1.c.

Suppose now that individuals pay 10% taxes on dividends, and corporations pay no taxes, but bear an administrative cost of 10% of the value of any bearer dividends. Can you determine the relative market prices for the two types of shares?

ANSWER. In this case, both issues yield 90% of gross bearer proceeds. Both types of shares will, therefore, sell for the same price and the firm will be indifferent between the two. 2. Suppose that the current 180-day interbank Eurodollar rate is 9% (all rates are stated on an annualized basis). If next period’s rate is 9.5%, what will a Eurocurrency loan priced at LIBOR plus 1% cost? ANSWER. Eurodollar loans are made on a floating rate basis, with the rate set at a fixed margin over LIBOR. Thus, if next period’s annualized LIBOR is 13%, then the Eurocurrency loan will be at 14% (13% + 1%) on an annualized basis. 3. Citibank offers to syndicate a Eurodollar credit for the government of Poland with the following terms: Principal Maturity Interest rate Syndication fee

US$1,000,000,000 7 years LIBOR + 1.5%, reset every six months 1.75%

3.a. What are the net proceeds to Poland from this syndicated loan? ANSWER. Poland will receive $982,500,000, which equals the $1 billion less the 1.75% syndication fee. 3.b. Assuming that six-month LIBOR is currently at 6.35%, what is the effective annual interest cost to Poland for the first six months of this loan? ANSWER. At LIBOR6 + 1.5%, Poland will pay interest at an annual rate of 7.85% (6.35% + 1.5%). 4. IBM needs to raise $1 billion and is trying to decide between a domestic dollar bond issue and a Eurobond issue. The U.S. bond can be issued at a coupon of 6.75%, paid semiannually, with underwriting and other expenses totaling 0.95% of the issue size. The Eurobond costs only 0.55% to issue but would bear an annual coupon of 6.88%. Both issues mature in 10 years. 4.a. Assuming all else is equal, which is the least expensive issue for IBM? ANSWER. The least expensive issue can be found by comparing the yield to maturity (YTM) for each bond, computed as the internal rate of return or IRR. For the domestic bond issue, the YTM is the solution r to the following equation:

20 $33,750,000 $1,000,000,000 $990,500,000 =  + (1 + r )t (1 + r )20 t=1 where the $990,500,000 in bond proceeds equals the billion dollar issue less 0.95% in issuance costs. The solution turns out to be r = 3.44%. Since this is a semiannual yield, we must convert it to annualized basis. The annualized YTM is found as (1.0344)2 - 1, or 7.00%.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

For the Eurobond issue, the YTM is the solution k to the following equation:

10 $68,800,000 $1,000,000,000 $994,500,000 =  + (1 + r )t (1 + r )10 t=1 The solution to this equation turns out to be k = 6.96%. Since this YTM is less than the annualized YTM for the U.S. bond, the Eurobond is the less expensive bond to issue. 4.b. What other factors might IBM want to consider before deciding which bond to issue? ANSWER. IBM might like to consider whether by issuing a Eurobond it can increase its investment presence among a different class of investor. It should also take into account the terms of the call and other provisions. Moreover, if it has any thoughts of revising the terms of the bond issue in the future, it should consider the greater difficulty it would have with the Eurobond issue (because buyers are largely anonymous). ADDITIONAL CHAPTER 12 PROBLEMS AND SOLUTIONS 1. Suppose that Zimbabwe has a choice of two possible $100 million, five-year Eurodollar loans. The first loan is offered at LIBOR + 1% with a 2.5% syndication fee, whereas the second loan is priced at LIBOR + 1.5% and a 0.75% syndication fee. Assuming that Zimbabwe has a 9% cost of capital, which loan is preferable? Hint: View this as a capital budgeting problem. ANSWER. The dollar cash flows associated with these two spread-syndicate fee combinations are as follows: Loan Option

Fee

Interest Spread (Years 1-5)

Loan 1 (2.5% fee, 1% spread)

$2,500,000

$1,000,000

Loan 2 (0.75% fee, 1.5% spread)

$750,000

$1,500,000

5 $1,000,000 $2,500,000+  = $6,389,651 (1.09 )t t=1

Using a 9% discount rate, we can compare the present values of these two combinations: Based on these comparisons, we can see that at a 9% discount rate, the first loan fee-spread combination is the least expensive one.

5 $1,500,000 $750,000+  = $6,584,477 (1.09 )t t=1

CHAPTER 12: INTERNATIONAL FINANCING AND NATIONAL CAPITAL MARKETS

2. Refer to the example of Exxon’s zero-coupon Eurobond issue in the section titled The Euromarkets. 2.a. How much would Exxon have earned if the yield on the stripped Treasurys had been 12.10%? 12.25%? ANSWER. As we saw in the chapter, Exxon realized proceeds of about $199 million from its $1.8 billion zero-coupon Eurobond issue. It would have cost Exxon about $183 million to purchase the $1.8 billion in stripped Treasury bonds at an interest rate of 12.10%: Bond value = $1,800,000,000/(1.1210)20 = $183,000,000 At this price, Exxon would have earned the difference of about $16 million. If the yield on stripped Treasuries had been 12.25%, Exxon could have purchased $1.8 billion in Treasuries for $178 million: Bond value = $1,800,000,000/(1.1225)20 = $178,000,000 At this price, Exxon would have earned the difference of about $21 million. 2.b. Suppose the Japanese government taxed the accretion in the value of zero-coupon bonds at a rate of 15%. Assuming the same 11.65% after-tax required yield, how would this tax have affected the price Japanese investors were willing to pay for Exxon’s Eurobond issue? What is pre-tax yield at this new price? Would any arbitrage incentive still exist for Exxon? ANSWER. At maturity, investors receive (1 -0.15)(1.8B - P), where P represents the amount paid for the bonds. Using the after-tax yield of 11.6% to set price, we get the following equation: Price = P = 0.85 * (1.8B - P)/1.116520 or P = $154 million. The yield can now be found by solving the following equation: 154,000,000 = 1,800,000,000/(1 + r)20, or r = 13.08% The pre-tax rate of 13.08% exceeds Exxon’s investment rate of 12.2%, so no arbitrage is possible. 2.c.

Suppose Exxon had sold its zero-coupon Eurobonds to yield 11.5% and bought stripped Treasury bonds yielding 12.30% to meet the required payment of $1.8 billion. How much would Exxon have earned through its arbitrage transaction?

ANSWER. At 11.5%, bond proceeds = 1.8B/1.115020 = $204 million. At 12.3%, bond cost = 1.8B/1.123020 = $177 million. Thus, profit = $204 million - $177 million = $27 million.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

3. British Telecom (BT) has issued $1 billion in Euro-CP maturing in 75 days and priced to yield 5.8% annually based on a 360-day year. 3.a. What are BT’s proceeds from the issue? ANSWER. According to Equation 13.7, the market price of a Euro-CP issue can be computed as follows:

Face value

Market price=

1 + ( Annual yield x

n ) 360

Substituting in the values for BT results in estimated proceeds of $988,060,930, computed as follows:

Market price=

$1,000,000,000 = $988,060,930 75 1 + ( 0.058x ) 360

3.b. What is the discount rate on BT’s issue? ANSWER. According to Equation 13.6, the relation between the annual yield and the discount rate can be expressed as follows:

Annual yield = Discount ratex

Face value Market price

By reversing Equation 13.6, we can solve for the discount rate as 5.73%:

Discount rate  Annual yield×

Market price Face value



5.80% ×

$988,060,930 $1,000,000,000



5.73%

CHAPTER 13: INTERNATIONAL PORTFOLIO INVESTMENT

CHAPTER 13 INTERNATIONAL PORTFOLIO INVESTMENT The basic message of this chapter is that international stock and bond diversification can provide substantially higher returns with less risk than investment in a single market. A major reason is that international investment offers a much broader range of opportunities than domestic investment alone, even in a market as large as the U.S. An investor restricted to the U.S. stock market, for example, is cut off, in effect, from about two-thirds of the available investment opportunities. International diversification pushes out the efficient frontier – the set of portfolios that has the smallest possible standard deviation for its level of expected return and has the maximum expected return for a given level of risk--allowing investors simultaneously to reduce their risk and increase their expected return. The chapter shows how to measure the total dollar return on foreign currency-denominated securities as well as how to estimate the risk-return trade-off associated with foreign portfolio investing. It does this by providing the formulas for the expected return and standard deviation for a portfolio consisting of a fraction a invested in U.S. stocks and the remaining fraction, 1 - a, invested in foreign stocks. The chapter details the several ways in which U.S. investors can diversify into foreign securities: buying stocks of firms that have listed their securities on the New York Stock Exchange or the American Stock Exchange; buying American Depository Receipts or American shares; and buying shares in the growing number of internationally diversified mutual funds. SUGGESTED ANSWERS TO “DEUTSCHE BANK LISTS AS A GLOBAL SHARE” 1. List the pros and cons of Deutsche Bank listing on the NYSE as a global share instead of an ADR. ANSWER. Pros include the savings to U.S. investors in trading Deutsche Bank global shares as opposed to ADRs, the fact that it can be traded in dollars, and the increased expected demand for Deutsche Bank’s global shares given this greater trading convenience and lower trading costs. These features should translate into a higher issue price for Deutsche Bank’s global shares. Negatives include the higher costs to Deutsche Bank associated with a global share issue along with the need to coordinate clearing and settlement systems and regulatory issues between the U.S. and German markets. 2. Are these pros and cons of a GSR issue likely to change over time? In which direction? ANSWER. Yes. As markets increasingly move toward 24-hour-a-day trading, the necessary coordination of clearing and settlement systems will naturally occur. The result will be to lower the costs of global shares relative to ADRs. 3. What changes would increase the desirability of issuing global shares? ANSWER. Greater coordination of clearing and settlement systems across countries would increase the desirability of issuing global shares. In addition, greater harmonization of regulatory systems and rules would lower the cost and increase the desirability of global shares.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

SUGGESTED ANSWERS TO CHAPTER 13 QUESTIONS 1. What characteristics of foreign securities lead to diversification benefits for American investors? ANSWER. The two basic characteristics are: i

Many foreign securities are issued by companies that produce goods and services not available from U.S. companies.

ii) All U.S. companies are more or less subject to the same cyclical economic fluctuations. Foreign securities by contrast involve claims on economies whose cycles are not perfectly in phase with the U.S. economic cycle. Thus, just as movements in different stocks partially offset one another in an all-U.S. portfolio, so also movements in U.S. and non-U.S. stocks cancel out each other somewhat. 2. Will increasing integration of national capital markets reduce the benefits of international diversifications? ANSWER. Despite increasing integration of national capital markets, they still don’t march in lock step. Some economies and, hence, their markets will do better than others at any given time, so having stakes in several countries still spreads risks. Nonetheless, increasing integration could lead to more co-movement in common risk factors (e.g., real interest rate changes). If so, this will increase the correlation of national markets and decrease the risk-reducing benefits of diversifying internationally. Ultimately, it’s an empirical issue, and one that should be addressed, as to whether the benefits of international investing are declining. My sense is that international investing can still reduce portfolio risk but the degree of risk reduction is less today than in the past. 3. Studies show that the correlations between domestic stocks are greater than the correlations between domestic and foreign stocks. Explain why this is likely to be the case. What implications does this fact have for international investing? ANSWER. Domestic stocks are more highly correlated because they are all subject in one way or another to the state of the domestic economy. The lower correlations between domestic and foreign stocks reflect the lower correlations between the domestic and foreign economies. These lower correlations also imply that international investing is likely to lead to greater diversification than just investing across industries within a country. As the text shows, these lower correlations appear to be persisting despite the greater integration of the global economy. 4. Who is likely to gain more from investing overseas, a resident of the U.S. or of Mexico? Explain. ANSWER. Mexican investors will gain much more from international investing. The size of the U.S. economy is such that the U.S. and world stock markets are highly correlated whereas the Mexican stock market, being much smaller, shows a much lower correlation with the world stock market. The result is greater diversification (and, hence, risk reduction) benefits for the Mexican investor than for the U.S. investor. In addition, the U.S. has a much greater range of industries than does Mexico, giving much more scope for industry diversification outside Mexico than would be true for a U.S. investor who has access to such a broad range of industries already.

CHAPTER 13: INTERNATIONAL PORTFOLIO INVESTMENT

5. Suppose Mexican bonds are yielding more than 100% annually. Does this high yield make them suitable for American investors looking to raise the return on their portfolios? Explain. ANSWER. These returns are denominated in nominal peso terms, subjecting them to currency risk. Nonetheless, holding a small percentage of your portfolio in Mexican bonds will reduce its risk, without sacrificing expected return. This is because arbitrage will equilibrate expected returns across countries at the same time that the actual returns from the Mexican peso bonds are relatively uncorrelated with returns on the U.S. stock market. Hence, the primary reason for holding Mexican bonds is to reduce risk, not raise expected return. 6. According to one investment advisor, “I feel more comfortable investing in Western Europe or Canada. I would not invest in South America or other regions with a record of debt defaults and restructuring. The underwriters of large new issues of ADRs of companies from these areas assure us that things are different now. Maybe, but who can say that a government that has defaulted on debt won't change the rules again?” Comment on this statement. ANSWER. True. A nation that has already defaulted on its debt is less trustworthy than one that never has. However, this possibility has already been factored into the prices of that nation’s bonds and stocks in the form of a large discount to what they would sell for absent that past experience. The important question is whether the discount is high enough to provide an expected return high enough to compensate for those risks. If so, Latin American stocks and bonds would be a reasonable investment since they would provide additional diversification benefits. 7. As noted in the chapter, from 1949 to 1990, the Japanese market rose 25,000%. 7.a. Given these returns, does it make sense for Japanese investors to diversify internationally? ANSWER. Note that the same argument could be made as to why non-Japanese investors should also invest all their money in Japan. Implicit in this argument is the expectation that historically high returns will persist into the future. Such an expectation is an unreasonable one in efficient markets. Thus, unless one unrealistically expects these superior returns to persist into the future, diversification would make sense for both Japanese and non-Japanese investors. The benefits of this diversification were pointed out in 1990, when the Tokyo Stock Exchange fell 35% in dollar terms (39% in yen), while the Morgan Stanley Capital International World Index fell by “just” 18.6% in dollar terms. 7.b. What arguments would you use to persuade a Japanese investor to invest overseas? ANSWER. Here are two arguments. First, you can’t expect stock markets to keep going up in a straight line. All markets entail risk, and one way to counter that risk is through diversification. This argument should by now be bolstered by the crash of the Japanese stock market in 1990. Second, to the extent that the Japanese investor consumes foreign goods and services, international investing can reduce the risk associated with the investor’s consumption stream by matching foreign currency inflows with foreign currency outflows. For example, if the yen depreciates, the higher yen cost of buying foreign goods and services will be offset by the higher yen value of foreign assets.

7.c.

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Why might Japanese (and other) investors still prefer to invest in domestic securities despite the potential gains from international diversification?

ANSWER. If investors buy mostly domestic goods and services (or at least goods and services priced in a domestic context), investing overseas will expose them to currency risk that is not offset by gains on the consumption side. For example, if the yen appreciates, the yen value of dollar assets will decline. If the Japanese investor is not consuming much in the way of U.S. goods and services, the reduction in consumption costs will not offset the investment losses. 8. Because ADRs are denominated in dollars and are traded in the U.S., they present less foreign exchange risk to U.S. investors than do the underlying foreign shares of stock. Comment. ANSWER. The answer to this question depends on the distinction between the currency of denomination and the currency of determination. Although the ADR currency of denomination is the dollar, the currency of determination is the local currency (or whatever currency determines the cash flows of the stock). More specifically, the price of an ADR is the price of the share of stock in its foreign currency multiplied by the spot dollar value of the foreign currency. As the spot exchange rate changes, the dollar price of the ADR will also change (unless the foreign currency value of the stock changes in inverse proportion to the change in the spot price, an unlikely scenario). Hence, ADRs are as subject to exchange risk as the underlying shares of foreign stock. ADDITIONAL CHAPTER 13 QUESTIONS AND ANSWERS 1. An alternative to investing in foreign stocks is to invest in the shares of domestic multinationals. Are MNCs likely to provide a reasonable substitute for international portfolio investment? ANSWER. No. The empirical evidence clearly shows that multinationals cannot provide a substitute for international portfolio investment. The economic rationale for this is simple. Multinationals already comprise part of the domestic stock index. A subset of an index cannot provide diversification benefits that the full index cannot. If domestic multinationals could provide a reasonable substitute for foreign stocks, then international investing should provide minimal incremental diversification benefits. In fact, the evidence is that international diversification provides substantial risk reduction benefits. 2. Why did Latin American stocks perform so well in recent years? Is this performance likely to continue? Explain. ANSWER. Until recently, Latin American countries followed statist economic policies that shackled their economies, discouraged private initiative, and imposed high risks on private enterprise. Local stock prices discounted these high risks and the lack of profitable private sector growth opportunities. In recent years, Latin American governments have begun to dismantle many of their statist policies. Investors have responded to the resulting more favorable investment opportunities by reducing the discounts they had imposed on local stocks. The result was a jump in stock prices across Latin America.

CHAPTER 13: INTERNATIONAL PORTFOLIO INVESTMENT

In an efficient market, stocks that are expected to earn excess returns in the future will see their prices jump immediately, thereby eliminating the expectation of future excess returns. The same holds true for stock markets. Current Latin American stock prices already reflect expectations of a more profitable future. Thus, in order for these stock prices to continue to grow as fast as they have in recent years, the future will have to turn out to be much more profitable than it is already expected to be. Since one cannot expect the future to be better than it is already expected to be, Latin American stocks can be expected to earn future returns that are just equal to their risk-adjusted cost of capital. Of course, if one believes that the Latin American future will turn out to be more bountiful than the expectations already embodied in Latin stock prices, then one can expect Latin American stocks to continue their superior performance. Then, however, the issue becomes whether one is privy to inside information or has better insight into economic trends than current investors do. 3. Would you expect emerging markets on average to outperform developed country markets in the future? Explain. ANSWER. As in the answer to question 7, in an efficient market, the performance of emerging markets should be about in line with expectations. This means that the expected risk-adjusted return on emerging markets should be just about equal to that on developed country markets. Emerging markets can be expected to outperform developed country markets only if investors perceive the former markets to be riskier and thereby demand a risk premium (relative to developed country markets) for investing in them. This situation may well be the case, leading to a higher expected return on emerging markets than on developed country markets. At the same time, the lower systematic risk of emerging markets may lead to a lower risk premium and lower future expected returns. 4. The Brazilian stock market rose by 165% during 1988. Are American investors likely to be pleased with that performance? Explain. ANSWER. These returns are stated in nominal cruzeiro terms. American investors are interested in dollar returns. Thus American pleasure with the Brazilian market’s performance depends on how much the cruzeiro devalued during the year. In fact, the cruzeiro (actually the cruzado then) devalued by about 90% during the year. Hence, the dollar return on the Brazilian market was approximately -74%. Not good enough to keep investors happy. 5. Persian Gulf countries receive virtually all their income from oil revenues denominated in dollars. At the same time, they buy substantial amounts of goods and services from Japan and Western Europe. Their investment portfolios are heavily weighted towards short-term U.S. Treasury bills and other dollar-denominated money market instruments. Comment on their asset allocation. ANSWER. Persian Gulf countries face exchange risk because of the currency mismatch between the dollar revenues they generate through oil sales and the nondollar costs they incur in buying goods and services from Japan and Western Europe. If the U.S. dollar devalues, for example, Persian Gulf oil revenues will buy fewer nonAmerican goods and services. One way to hedge this risk is to hold a substantial fraction of the investment portfolio in nondollar-denominated assets. In this way, the very same event that reduced the purchasing power of their revenues would increase the purchasing power of their investment returns. But this is not the strategy they have been following. One possible reason for the divergence is that these countries prefer highly liquid – meaning dollar – assets.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

6. In deciding where to invest your money, you read that Germany looks like it’s well-positioned to capitalize on the opening of Eastern Europe. But Britain is troubled by weak growth and high inflation and interest rates. Which of these countries would it make sense to invest in? Explain. ANSWER. As noted in the answer to the previous question, investors have already factored these expectations into the prices of assets in these countries. As events diverge from the expected, stock prices will adjust to reflect these new expectations so that at any point in time the expected risk-adjusted return from investing in different countries and assets will be the same. And the fact that the risks noted in the question are likely to be uncorrelated with each other should raise the diversification benefits from investing in both nations simultaneously. 7. Does the high volatility of emerging markets lead to high expected returns for investors? ANSWER. Not necessarily. To the extent emerging markets are open to foreign investors, investors are likely to be the marginal investors in these markets. In that case, what matters is the systematic component of that volatility (systematic in the context of the globally-diversified portfolios of the foreign investors). 8. As more U.S. investors shift funds into emerging markets, what will drive expected returns? ANSWER. Historically, most foreign investors have stayed out of emerging markets because of local government regulations, various restrictions on foreign investors’ ability to own local stocks, high transaction costs, and the significant political and economic risks associated with these markets. The net result is that these markets have been largely segmented and their expected returns driven by the specific risks of those markets (because the marginal investor has not been well diversified). As U.S. and other foreign investors become more important, the expected returns in emerging markets will be based more on the contribution of those markets to the systematic risk of a globally-diversified portfolio. The initial reaction of these markets will be a price jump as expected future cash flows get capitalized at a lower rate. In the future, however, this will mean lower expected returns from investing in emerging markets. 9. During 1995, the Morgan Stanley Capital International world index of developed country stock markets rose by 18.7% in dollar terms. In contrast, the IFC emerging markets index fell by just over 17% in dollar terms. Many investment advisors point to this sorry performance of emerging markets as an expensive lesson to investors not to venture too far from home. Do the diverging performances of mature and emerging markets argue against investing in emerging markets? ANSWER. The experience of 1995 illustrates the riskiness of emerging markets. Paradoxically, however, the poor performance of emerging markets in a year when practically all developed country stock markets jumped is reassuring. By providing more evidence that emerging and mature markets move independently of each other, the diverging performances of these markets in 1995 bolster the case for diversifying across these different sets of markets. Indeed, the fact that practically all mature markets moved together in 1995 argues against putting all of one’s money in these markets. It makes sense for investors to hedge against risk by putting some of their money in markets that tend to move independently of their main investment markets, thereby making their overall portfolio less risky than it were fully invested in highly correlated markets. One who had followed this advice would have benefited in 1993, when emerging markets significantly outperformed mature ones.

CHAPTER 13: INTERNATIONAL PORTFOLIO INVESTMENT

SUGGESTED SOLUTIONS TO CHAPTER 13 PROBLEMS 1. During the year the price of British gilts (government bonds) went from £102 to £106, while paying a coupon of £9. At the same time, the exchange rate went from £1:$1.76 to £1:$1.62. What was the total dollar return, in percent, on gilts for the year? ANSWER. Rewriting Equation 13.4, the one-period total dollar return on a foreign bond investment r$ can be calculated as follows:

Dollar Local currency Currency = x return return gain (loss)  B(1) B(0)+ C  1 + r $ = 1 +  (1 + g) B(0)   where B(t) = local currency bond price at time t C = local currency coupon income G = percent change in dollar value of LC With an initial bond price of £102, coupon income of £9, end-of-period bond price of £106, and pound depreciation of (1.62 - 1.76)/1.76 = -7.95%, the total dollar return is 3.79%: r$ = [1 + (106 - 102 + 9)/102](1 - .0795) - 1= (1.1275)(0.9205) - 1= 3.79% 2. Suppose during the first half of the year, government bonds yielded a local-currency return of -1.6%. However, the Swiss franc rose by 8% against the dollar over this six-month period. Corresponding figures for France were 1.8% and 2.6%. Which bond earned the higher U.S. dollar return? What was the return? ANSWER. The dollar return on Swiss bonds equaled (1 - .016)(1 + 0.08) - 1 = 6.27%. The return on French bonds was lower at (1.018)(1.026) - 1 = 4.45%. In this case, Swiss franc appreciation more than offset the lower local currency return on Swiss bonds.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

3. During the year Toyota Motor Company shares went from ¥9,000 to ¥11,200, while paying a dividend of ¥60. At the same time, the exchange rate went from $1 = ¥145 to $1 = ¥120. What was the total dollar return, in percent, on Toyota stock for the year? ANSWER. Rewriting Equation 15.5, the one-period total dollar return on a foreign stock investment R$ can

Dollar Local currency Currency = x return return gain(loss  P(1) P(0) + DIV  1 + R$ = 1 +  (1 + g) P(0)   be calculated as follows: where P(t) = local currency stock price at time t DIV = local currency dividend income Substituting in the numbers yields a total dollar return on Toyota stock for the year of 51.17%: R$ = [1 + (11,200 - 9,000 + 60)/9,000](1+.2083) - 1 = (1.2511)(1.2083) - 1 = 51.17% Note that yen appreciation during the year was (145 - 120)/120 = 20.83%. 4. During 1989, the Mexican stock market climbed 112%in peso terms while the peso depreciated by 28.6% against the U.S. dollar. What was the dollar return on the Mexican stock market during the year? ANSWER. According to these data, the dollar return on the Mexican stock market during 1989 was 51.37%: R$ = (1 + 1.12)(1 - 0.286) - 1 = 51.37% 5. Suppose that the dollar is now worth €0.7423. If one-year German bunds are yielding 9.8% and one-year U.S. Treasury bonds are yielding 6.5%, at what end-of-year exchange rate will the dollar returns on the two bonds be equal? What amount of euro appreciation or depreciation does this equilibrating exchange rate represent? ANSWER. To begin, given that German bunds are yielding more than U.S. Treasuries, it is clear that for dollar returns on these two securities to equilibrate, the euro must depreciate against the dollar by about the interest differential, which is 3.3%. Using Equation 13.4, the expected dollar return on investing $1 in a bund (after first converting it into €0.7423) for a year can be found as 0.7423(1.098)e1 = 0.8150e1 where e1 is the unknown end-of-year exchange rate ($/€). Note that ex ante, one cannot anticipate any capital gains or losses on investing. Setting this figure equal to the $1.065 expected dollar return from investing one dollar in a Treasury bond yields the solution e1 = $1.3067, which converts into a direct quote for the dollar of €0.7653. This exchange rate entails a euro depreciation of (0.7423 – 0.7653)/0.7653 = 3.01% against the dollar. Alternatively, the dollar has appreciated against the euro by (0.7653 – 0.7423)/0.7423= 3.10%.

CHAPTER 13: INTERNATIONAL PORTFOLIO INVESTMENT

6. In 1992, the Brazilian market rose by 1,117% in cruzeiro terms, while the cruzeiro fell by 91.4% in dollar terms. Meanwhile, the U.S. market rose by 8.5%. 6.a. Which market did better? ANSWER. The dollar return on the Brazilian market can be calculated using Equation 15.5: R$ = (1 + 11.17)(1 - 0.914) - 1 = 4.66% The numbers reflect the fact that a return of 1,127% is equivalent to receiving an additional Cr11.17 for each Cr1 invested. Based on these figures, the U.S. market return of 8.5% bested the dollar return on the Brazilian market by almost 4 percentage points. 6.b. In 1993, the Brazilian market rose by 4,190% in cruzeiro terms, while the cruzeiro fell by 95.9% in dollar terms. Did the Brazilian market do better in dollar terms in 1992 or in 1993? ANSWER. Redoing the numbers in the answer to part a, we see that the Brazilian market did far better in 1993 than in 1992: R$ = (1 + 41.90)(1 - 0.959) - 1 = 75.89% In this case, the very large local currency return more than offset the dramatic devaluation of the cruzeiro. 7. In 1990, Matsushita bought MCA Inc. for $6.1 billion. At the time of the purchase, the exchange rate was about ¥145/$. By the time that Matsushita sold an 80% stake in MCA to Seagram for $5.7 billion in 1995, the yen had appreciated to a rate of about ¥97/$. 7.a. Ignoring the time value of money, what was Matsushita’s dollar gain or loss on its investment in MCA? ANSWER. If an 80% stake in MCA was worth $5.7 billion, then the entire firm was worth $7.125 billion. Based on this valuation, Matsushita actually made $1.025 billion on its purchase of MCA. That is, by buying MCA at a price of $6.1 billion and selling it for a price that valued the business at $7.125 billion, Matsushita made $1.025 billion. 7.b. What was Matsushita’s yen gain or loss on the sale? ANSWER. Taking into account the differences in exchange rates, Matshushita paid ¥884,500,000,000 (6,100,000,000 * 145) for MCA in 1990 and sold MCA in 1995 for a price that valued it at ¥691,125,000,000 (7,125,000,000 * 97). The net result was a loss for Matsushita of ¥193,375,000,000 on its purchase of MCA. 7.c.

What did Matsushita's yen gain or loss translate into in terms of dollars? What accounts for the difference between this figure and your answer to part a?

ANSWER. Matsushita’s yen loss converts into a dollar loss of $1,993,556,701 (193,375,000,000/97). This figure differs from the answer in part a because it takes into account the change in exchange rates between 1990 and 1995. In effect, it asks what would have happened if Matsushita had held onto its yen instead of converting them into a dollar asset that didn’t appreciate in line with the yen’s appreciation. In other words, this computed dollar loss represents an opportunity cost.

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8. Suppose the standard deviations of the British and U.S. stock markets have risen to 38% and 22%, respectively, while the correlation between the U.S. and British markets has risen to 0.67. What is the new beta of the British market from a U.S. perspective?

Standard deviation Britishmarket Correlation with of Britishmarket = x beta U.S. market Standard deviationof U.S. market ANSWER. Using the following formula to calculate the beta of the British market, we can calculate the new British market beta from the perspective of a U.S. investor to be 0.67 * 38/22 = 1.16. 9. A portfolio manager is considering the benefits of increasing his diversification by investing overseas. He can purchase shares in individual country funds with the following characteristics: U.S. (%)

U.K. (%)

Spain (%)

15 10 1.0

12 9 0.33

5 4 0.06

Expected Return Standard Deviation Correlation with U.S.

9.a. What is the expected return and standard deviation of return of a portfolio with 25% invested in the United Kingdom and 75% in the U.S.? ANSWER. Use the formulas rp = w1r1 + w2r2 and σp2 = w12σ12 + w22σ22 + 2w1w2r12σ1σ2 to calculate the means and standard deviations of the portfolios.

% US

%UK

Expected Return

Standard Deviation

25 50 75

75 50 25

12.75 13.50 14.25

7.93 7.75 8.51

9.b. What is the expected return and standard deviation of return of a portfolio with 25% invested in Spain and 75% in the U.S.? ANSWER. Using the same formulas as in the answer to part a, we can calculate the means and standard deviations of the various portfolios as follows:

%US

%Spain

Expected Return

25 50 75

75 50 25

7.50 10.00 12.50

Standard Deviation 4.02 5.50 7.63

CHAPTER 13: INTERNATIONAL PORTFOLIO INVESTMENT

9.c.

Calculate the expected return and standard deviation of return of a portfolio with 50% invested in the U.S. and 50% in the United Kingdom. With 50% invested in the U.S. and 50% invested in Spain.

9.d. Calculate the expected return and standard deviation of return of a portfolio with 25% invested in the U.S. and 75% in the United Kingdom. With 25% invested in the U.S. and 75% invested in Spain. ANSWER. The answers to items a and b contain the answers to items c and d. 9.e.

Plot these two sets of risk-return combinations (a) through (d) as in Exhibit 15.5. Which leads to a better set of risk-return choices, Spain or the United Kingdom?

ANSWER. As the following diagram shows, Spain offers better diversification opportunities because its fund returns are less correlated with the U.S. market (correlation = 0.06) than U.K. funds (correlation = 0.33). However, it also obvious that investors are sacrificing a significant amount of expected return by choosing to add Spanish stocks to their portfolios.

Risk-Return Combinations for U.S., Spain, and the U.K. 15% 14% Portfolio Combinations of U.S. and Spanish Funds Portfolio Combinations of U.S. and U.K. Funds

Expected return

13% 12% 11% 10% 9% 8% 7% 6% 3%

Standard deviation

9.f.

How can you achieve an even better risk-return combination?

ANSWER. An investor can improve on the risk-return combination selected in the answer to part d by including the U.K. fund in the portfolio. You can never do worse by expanding the set of portfolio assets. The appropriate percent to invest in the U.K. fund depends on the correlation between the U.K. fund and the Spain fund, which we don’t know.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

10. Suppose that the standard deviation of the return on Nestlé, a Swiss firm, in terms of Swiss francs is 19% and the standard deviation of the rate of change in the dollar-franc exchange rate is 15%. In addition, the estimated correlation between the Swiss franc return on Nestlé and the rate of change in the exchange rate is 0.17. Given these figures, what is the standard deviation of the dollar rate of return on investing in Nestlé stock? ANSWER. According to Equation 15.8 in the text, we can write the standard deviation of the dollar return, σ$, as σ$ = [σf2 + σg2 + 2σfσgσf,g]½ where σf2 = the variance (the standard deviation squared) of the foreign currency return σg2 = the variance of the change in the exchange rate σf,g = the correlation between the foreign currency return and the exchange rate change Applying this equation, the standard deviation of the dollar rate of return on investing in Nestlé stock is 27.33%:

 $ (Nestle)= (0.192 + 0.152 + 2 x .19 x .15 x .17) = 0.2733 1/2

ADDITIONAL CHAPTER 13 PROBLEMS AND SOLUTIONS 1. On February 14, 1994, the dollar fell from ¥106.85 to ¥102.65. Meanwhile, the Tokyo stock market fell 1.63% as measured in yen. What was the one-day dollar return on the Tokyo stock market? ANSWER. On that day, the dollar value of the yen rose by (106..85 - 102.65)/102.65 = 4.09%. Using Equation 15.5 (see the answer to problem 3), the one-day return on the Tokyo Stock Exchange was R$ = (1 - 0.0163)(1.0409) - 1 = 2.39% 2. During 1997, the Korean Stock Exchange’s composite index fell by 42%, while the won lost half its value against the dollar. What was the combined effect of these two declines on the dollar return associated with Korean stocks during 1997? ANSWER. According to these data, the dollar return on the Korean Stock Exchange during 1997 was -71%: R$ = (1 - 0.42)(1 - 0.5) - 1 = -71%

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3. Here are data on stock market returns and exchange rate changes during 1988 for 12 stock markets.

Country Australia Belgium Canada France West Germany Holland Italy Japan Spain Sweden Switzerland United Kingdom

Return in Local Currency (%)

LC Units/Dollar 12/31/87

LC Units/Dollars 12/31/88

14.5 56.3 10.9 56.8 27.9 42.8 26.2 44.8 25.0 60.5 31.9 9.1

1.41 35.1 1.29 5.65 1.68 1.88 1230 129 114 6.03 1.37 0.56

1.17 38.8 1.20 6.31 1.85 2.09 1357 128 116 6.30 1.58 0.57

Determine the dollar return on each of these markets. ANSWER. Using Equation 15.5, here are the total dollar returns on these markets during 1988:

Australia Belgium Canada France West Germany Holland Italy Japan Spain Sweden Switzerland United Kingdom

Currency Gain (loss) (%)

Total Dollar Return (%)

20.5 -9.5 7.5 -10.5 -9.2 -10.1 -9.4 0.8 -1.7 -4.3 -13.3 -1.8

38.0 41.4 19.2 40.4 16.2 28.5 14.4 45.9 22.8 53.6 14.4 7.2

4. Suppose over a ten-year period the annualized peseta return of a Spanish bond has been 12.1%. If a comparable dollar bond has yielded an annualized return of 8.3%, what cumulative devaluation of the peseta over this period would be necessary for the return on the dollar bond to exceed the dollar return on the Spanish bond? ANSWER. The answer to this question can be found by solving the following equation: (1.121)10(1 - d) = (1.083)10 where d is the cumulative peseta devaluation over the ten-year period. That is,, the dollar return on investing in the Spanish bond just equals the dollar return on investing in the comparable dollar-denominated bond. The solution to this equation is d = 0.2917, or a cumulative peseta devaluation of 29.17%.

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5. The standard deviations of U.S. and Mexican returns over the period 1989-1993 were 12.7% and 29.7%, respectively. In addition, the correlation between the U.S. and Mexican markets over this period was 0.34. Assuming that these data reflect the future as well, what is the Mexican market beta relative to the U.S. market? ANSWER. Using the formula presented in the text, and substituting in the numbers in the problem, we have

Standard deviation Mexican market Correlation with of Mexican market 0.297 = x = 0.34 x = 0.80 beta U.S. market Standard deviationof U.S. market 0.127 In other words, despite the much greater riskiness of the Mexican market relative to the U.S. market, the low correlation between the two markets led to a Mexican market beta (0.80) which is lower than the U.S. market beta (1.00). 6. In an attempt to diversify your portfolio internationally, you must decide how to invest in Brazil. You can invest in an index fund that replicates the Brazilian stock market, or you can buy shares of the Brazil Fund traded on the New York Stock Exchange. The covariance of dollar returns on the index with the S&P 500 is 0.02; the covariance of dollar returns on the Brazil Fund with the S&P 500 is 0.03; the variance of the S&P 500 index is 0.035; and the beta of the Brazil Fund with respect to the Brazilian index is 0.90. In addition, the Brazil Fund and the Brazilian index are expected to yield annual dollar returns of 21% and 19%, respectively, in contrast to expected annual returns of 18% from investing in the S&P 500. 6.a. Ignoring other considerations, should you buy the Brazil Fund or the Brazilian index fund? ANSWER. To answer this question, we need to determine which investment provides a better risk-return trade-off in the context of the U.S. market, which is represented here by the S&P 500. This means that we must calculate the beta for the Brazilian index with respect to the S&P 500, ß Brazilian index, and the corresponding beta for the Brazil Fund, ßBrazil Fund (the Brazil Fund’s beta relative to the Brazilian index is irrelevant). By definition, ßBrazilian index = 0.02/0.035, or 0.57, and ßBrazil Fund = 0.03/0.035, or 0.86. Given these betas and the 5% Treasury bill rate mentioned in Part b, the CAPM predicts an expected return on the Brazilian index of 5% + 0.57(18% - 5%) = 12.43% and an expected return on the Brazil Fund of 5% + .86(18% - 5%) = 16.14%. Given their actual expected returns 19% and 21%, respectively, both investments appear to offer excess risk-adjusted returns, but the excess return for the Brazilian index of 6.57% (19% - 12.43%) exceeds the Brazil Fund’s excess return of 4.86% (21% - 16.14%). Hence, the Brazilian index fund appears to provide a better risk-return trade-off than the Brazil Fund. 6.b. Suppose the U.S. Treasury bill rate is 5%. Assuming the S&P 500 has a beta of 1, plot the capital market line and show the positions of the Brazil Fund and the Brazilian stock index relative to the capital market line. ANSWER. The following chart shows the position of the Treasury bill, S&P 500, Brazil Fund, and Brazilian index relative to the capital market line. Notice that both the Brazil Fund and Brazilian index are above the capital market line. In other words, for the same degree of systematic risk, their expected return exceeds the return expected in the U.S.

CHAPTER 13: INTERNATIONAL PORTFOLIO INVESTMENT

25%

Brazil Fund 20%

Expected Return

Brazilian index S&P 500 15%

10%

capital market line 5%

Treasury bill 0% 0

0.2

0.4

0.6

Beta

0.8

1.2

CHAPTER 14: CAPITAL BUDGETING FOR THE MULTINATIONAL CORPORATION

CHAPTER 14 CAPITAL BUDGETING FOR THE MULTINATIONAL CORPORATION This chapter focuses on three aspects of foreign investment analysis that are infrequently considered in evaluating domestic projects: the difference between project and parent cash flows; incorporating political risks such as expropriation and currency controls; and factoring in inflation and exchange rate changes in cash flow estimates. It also evaluates the various methods used to incorporate in the investment analysis the additional risks encountered overseas. These points are brought out in the process of working through the International Diesel Corporation Case. The ability to perform a capital budgeting analysis is one of the most valuable skills we can provide our students; this case is designed to make them aware of many of the intricacies involved in doing such an analysis. SUGGESTED ANSWERS TO CHAPTER 14 QUESTIONS 1. A foreign project that is profitable when valued on its own will always be profitable from the parent firm’s standpoint. True or false. Explain. ANSWER. There are many reasons why project cash flows can diverge from the incremental cash flows accruing to the parent. Therefore, the correct answer is false. 2. Early results on the Lexus, Toyota’s upscale car, showed it was taking the most business from customers changing from either BMW (15%), Mercedes (14%), Toyota (14%), General Motors’ Cadillac (12%), and Ford’s Lincoln (6%). With what in the auto business is considered a high percentage of sales coming from its own customers, how badly is Toyota hurting itself with the Lexus? ANSWER. Toyota appears to be hurting itself with Lexus. But, in fact, Lexus is doing exactly what Toyota intended: retaining customers, since Toyota determined that many of its customers who switched to Lexus were ready to “trade up” to a luxury car. Now Toyota’s customers are trading up to a Lexus instead of a BMW or Mercedes. The key point is that the cannibalization is more apparent than real: If Toyota had not built the Lexus, it would have lost these customers anyway, but to another company. 3. What factors should be considered in deciding whether the cost of capital for a foreign affiliate should be higher, lower, or the same as the cost of capital for a comparable domestic operation? ANSWER. Key factors include whether the cash flows of the affiliate are closely tied to the state of the local economy or to the world economy, the correlation between the local and domestic economies, and the volatility of the foreign affiliate’s cash flows relative to that of the domestic operation. The greater (lesser) each of these factors, the higher (lower) the foreign affiliate’s cost of capital relative to that of the domestic operation. In general, the closer these factors are to each other, the closer their costs of capital. 4.

According to an article in Forbes, “American companies can and are raising capital in Japan at relatively low rates of interest. Dow Chemical, for instance, has raised $500 million in yen. That cost the company over 50% less than it would have at home.” Comment on this statement.

INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

ANSWER. Forbes is comparing apples with oranges. Borrowing in yen is not the same as borrowing in dollars. When converting from yen into dollars Dow faces the possibility that the yen will appreciate, wiping out its apparent cost savings. In fact, in less than one year after the article appeared, the yen had appreciated by over 35% relative to the dollar, raising the dollar cost of repaying that $500 million yen borrowing to over $675 million. 5. Boeing Commercial Airplane Co. manufactures all its planes in the U.S. and prices them in dollars, even the 50% of its sales destined for overseas markets. What financing strategy would you recommend for Boeing? What data do you need? ANSWER. Boeing faces foreign exchange risk for two reasons: (1) It sells half its planes overseas and the demand for these planes depends on the foreign exchange value of the dollar, and (2) Boeing faces stiff competition from Airbus Industries, a European consortium of companies that builds the Airbus. As the dollar appreciates, Boeing is likely to lose both foreign and domestic sales to Airbus unless it cuts its dollar prices. One way to hedge this operating risk is for Boeing to finance a portion of its assets in foreign currencies in proportion to its sales in those countries. However, this tactic ignores the fact that Boeing is competing with Airbus. Absent a more detailed analysis, another suggestion is for Boeing to finance at least half of its assets with ECU bonds as a hedge against depreciation of the currencies of its European competitors. ECU bonds would also provide a hedge against appreciation of the dollar against the yen and other Asian currencies since European and Asian currencies tend to move up and down together against the dollar (albeit imperfectly). 6. United Airlines recently inaugurated service to Japan and now wants to finance the purchase of Boeing 747s to service that route. The CFO for United is attracted to yen financing because the interest rate on yen is 300 basis points lower than the dollar interest rate. Although he doesn’t expect this interest differential to be offset by yen appreciation over the ten-year life of the loan, he would like an independent opinion before issuing yen debt. 6.a. What are the key questions you would ask in responding to UAL’s CFO? ANSWER. What’s your business? Speculating on exchange rates or running an airline? Do you think you can profitably outguess the financial markets? How do your operating cash flows respond to changes in the dollar/yen exchange rate? 6.b. Can you think of any other reason for using yen debt? ANSWER. Another reason for preferring yen financing could be to use this financing to hedge operating cash flows on the Tokyo route against changes in the dollar/yen exchange rate. 6.c.

What would you advise him to do, given his likely responses to your questions and your answer to part b?

ANSWER. The professed reason for preferring yen financing runs afoul of the IFE. Yen interest rates are 300 basis points less than dollar interest rates because the market expects the dollar to depreciate by about 3% annually against the yen. This reason for borrowing yen is, therefore, a non-starter assuming that the CFO does not assert the ability to outguess financial markets.

CHAPTER 14: CAPITAL BUDGETING FOR THE MULTINATIONAL CORPORATION

If United’s dollar cash flow on its new route to Japan varies in line with the value of the dollar (that is, dollar cash flow drops when the dollar appreciates against the yen and vice versa when the dollar depreciates against the yen), then yen financing of its planes will reduce its exchange risk. Otherwise, dollar financing is the appropriate solution. It is difficult to say how United’s cash flow will be affected by the exchange rate. A rising dollar will reduce tourism from Japan to the U.S., but it might increase business travel involving purchases of less expensive Japanese products. Conversely, a falling dollar will stimulate Japanese tourist travel to the U.S., but could hurt business travel between the two countries. 7. Eastman Kodak’s CFO is thinking of borrowing Japanese yen because of the low interest rate, currently 4.5%. The interest rate on U.S. dollars is 9%. What is your advice to the CFO? ANSWER. My advice would be “don’t speculate.” The IFE says that the 450 basis point differential reflects a 4.5% expected annual appreciation of the yen against the dollar. Thus, the expected costs of dollar and yen financing should be the same. Unless Kodak needs yen financing to offset a yen transaction or operating exposure, it should stick to dollar financing. 8. Name some of the advantages and disadvantages of having highly leveraged foreign subsidiaries. ANSWER. A more highly leveraged subsidiary may also be a more efficient firm because management is unable to turn to the parent for help. The disadvantages of high leverage include the following: i)

Local suppliers and customers may shy away from doing business with a new subsidiary operating on a shoestring if that subsidiary is receiving minimal financial backing from its parent. Having a balance sheet with more equity demonstrates that the unit has greater staying power.

ii) The government might argue that the firm is overly leveraged and declare that certain debt payments are constructive dividends and impose taxes on those payments. 9. Compania Troquelados ARDA is a medium-sized Mexico City auto parts maker. It is trying to decide whether to borrow dollars at 9% or Mexican pesos at 75%. What advice would you give it? What information would you need before you gave the advice? ANSWER. To begin, it is necessary to recognize that 75% in pesos is not the same as 9% in dollars. In the absence of government controls or access to subsidized financing, the expected before-tax cost of the two loans should be about the same. If there is some tax asymmetry (e.g., foreign exchange losses are not tax deductible), then the expected after-tax costs of the two loans could diverge. Regardless of the expected costs of the two loans, the risks for the firm are quite different. The dollar loan entails foreign exchange risk, while the peso loan entails inflation risk. A key question, therefore, is how does the return on the firm’s assets respond to inflation and changes in the dollar/peso exchange rate. The answer depends on where the firm sells (domestic or abroad) and whether it faces import competition on domestic sales. If the firm is selling in the U.S., the dollar loan will probably lower its exchange risk. If it is selling in Mexico without much import competition (because of trade barriers), its nominal operating profits will likely increase in line with inflation, making the peso loan the low-risk loan. This assumes that the interest rate on the peso loan will adjust periodically. If the peso interest rate is fixed, then the peso loan is the low-risk funding technique only if the firm’s real operating profits move inversely with Mexican inflation. Otherwise, the dollar loan is probably a lower-risk bet.

INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

10.

What are the principal cash outflows associated with the IDC-U.K. project?

ANSWER. The principal cash outflows associated with the IDC-U.K. project are i)

The initial investment outlay, consisting of the plant purchase, equipment expenditures, and working capital requirements

ii) Operating expenses iii) Later additions to working capital as sales expand iv) Taxes paid on its net income. 11.

What are the principal cash inflows associated with the IDC-U.K. project?

ANSWER. The principal cash inflows associated with the IDC-U.K. project include i)

Cash inflows from sales in England and other EC countries

ii) The tax shield provided by depreciation and interest charges iii) Interest subsidies iv) The terminal value of its investment, net of any capital gains taxes owed upon liquidation. This figure includes recapture of working capital. 12.

In what ways do parent and project cash flows differ on the IDC- U.K. project? Why?

ANSWER. Parent and project cash flows differ on the IDC-U.K. project in several ways: i)

Funds remitted to IDC-U.S. may lead to additional taxes paid to England or the U.S. These are cash outflows from the view of IDC-U.S. but not IDC-U.K.

ii) IDC-U.S. owes tax to the U.S. Internal Revenue Service on gains associated with the sale for $5 million of equipment having a book value of zero. iii) IDC-U.S. receives licensing and overhead allocation fees each year, for which it incurs no additional expenses. These fees are costs to IDC-U.K. iv) IDC-U.S. also profits from exports to IDC-U.K. v) If sales of IDC-U.K. just substitute for exports from IDC-U.S., then IDC-U.K.’s profits are overstated by an amount equal to the incremental cash flow that IDC-U.S. would have earned on these lost exports. 13. Why are loan repayments by IDC-U.K. to Lloyds and NEB treated as a cash inflow to the parent company? ANSWER. Loan repayments by IDC-U.K. to Lloyds and NEB are treated as cash inflows to the parent because they reduce its outstanding consolidated debt burden and increase the value of its equity by an equivalent amount. Assuming that the parent would repay these loans regardless, then having IDC-U.K. borrow and repay funds is equivalent to IDC-U.S. borrowing the money, investing it in IDC- U.K., and then using IDC-U.K.’s higher cash flows (since it no longer has British loans to service) to repay IDC-U.S.’s debts.

CHAPTER 14: CAPITAL BUDGETING FOR THE MULTINATIONAL CORPORATION

14. How sensitive is the value of the project to the threat of currency controls and expropriation? How can the financing be structured to make the project less sensitive to these political risks? ANSWER. Figures in Exhibit 13.6 reveal that the value of IDC’s English project is quite sensitive to the potential political risks of currency controls and expropriation. The project NPV does not turn positive until well after its fifth year of operation (assuming there are no lost sales). Should expropriation occur or exchange controls be imposed at some point during the first five years, the project is unlikely to ever be economically viable. In the face of these risks, the project is viable only if compensation is sufficiently great in the event of expropriation, or if unremitted funds can earn a return reflecting their opportunity cost to IDC-U.S., with eventual repatriation, in the event of exchange controls. The project can be made less sensitive to political risks by using pound financing. Pound cash flows from the project can be used to service these debts. By borrowing from British banks, IDC will also have fewer assets at risk in the event of expropriation. In addition, the impact of potential currency controls can be minimized by setting high initial transfer prices on the sale of components to IDC-U.K. by other units, by setting fees and royalties at a high initial level, and, to the extent possible, by investing parent funds as debt rather than equity. 15. What options does investment in the new British diesel plant provide to IDC-U.S.? How can these options be accounted for in the traditional capital budgeting analysis? ANSWER. Here are some options IDC-U.S. will realize by investing in the British diesel plant: The plant’s output can be raised or lowered depending on current and expected future demand conditions, currency movements and other relative cost changes; the plant can be expanded or shut down, temporarily or permanently, again depending on future cost and market conditions (e.g., the success or failure of Europe 1992). Moreover, IDC has an enhanced market position in the EEC that can be used to expand its product offerings in the future, depending on demand conditions as well as the output of IDC’s R&D efforts. ADDITIONAL CHAPTER 14 QUESTIONS AND ANSWERS 1. Suppose the real value of the pound declines. How would this decline likely affect the economics of the IDC-U.K. project? ANSWER. If the real value of the pound declines, the dollar value of revenues on sales in England will undoubtedly decline. At the same time, however, dollar costs of production will also decline. The net effect on IDC-U.K. depends on what would have been done absent this project. If IDC-U.S. would have continued to service the U.K. market, then any reduction in revenues from the pound devaluation is irrelevant since it would not be incremental from the project’s standpoint. In this case, we are left with the cost reduction and the net impact of pound devaluation on the project is unambiguously positive. In contrast, if export sales would have ceased in the absence of the IDC-U.K. project, then the net impact of a pound devaluation must take into account both the revenue decline and the cost reduction. The net impact depends critically on the price elasticity of demand. The odds are that the impact will be negative but only slightly. The reason for the word "slightly" is that dollar costs of production decline on 100% of IDC-U.K.’s output but sales of only half the output are affected by pound devaluation (the other half is sold to other EEC nations).

INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

2. Describe the alternative ways to treat the interest subsidy provided by the British government. ANSWER. The interest subsidy provided by the British government can be incorporated in the investment analysis in one of two ways: i)

Employ a weighted cost of capital, where the interest rate used is the subsidized rate; or

ii) Explicitly include the subsidy (equal to the difference between the market interest rate and the subsidized rate multiplied by the subsidized principal amount) as one of the cash flows. 3. Under what circumstances should IDC-U.S. earnings on lost export sales to the United Kingdom and the rest of the Common Market countries be treated as a cost of the project? ANSWER. IDC-U.S. earnings on lost export sales to the U.K. and other EEC countries should be treated as a cost of the project if IDC-U.S. had sufficient excess capacity to have continued selling in the EEC in the absence of the IDC-U.K. project. 4. When should these lost export earnings be ignored when evaluating the project? ANSWER. The lost export earnings should be ignored when evaluating the project if the sales would have been lost anyway because (1) IDC- U.S. no longer had sufficient capacity to service both the U.S. market and the European market or (2) import restrictions would have kept out exports otherwise. 5. Should the cost of capital for the IDC-U.K. project be higher, lower, or the same as the cost of capital for a similar project to manufacture and sell diesel engines in the U.S.? Explain. ANSWER. There is no obviously correct answer. However, three points that are relevant here. First, one of the major messages of modern financial theory is that the required return on a project depends on the riskiness of the project itself. Thus, the required return on the project should equal the required return on a similar investment undertaken in the U.S. only if the risks are the same. Second, the relevant risk that is priced and enters the cost of capital is the systematic risk of the project, not the project’s total risk. Third, returns on the U.S. plant are strongly affected by variations in the U.S. economy – a major element of systematic risk. By contrast, returns on IDC-U.S.’s British venture are primarily affected by the state of the European economy, which is less related to factors that systematically affect returns on a welldiversified U.S. or world portfolio. The net result of these three points is that the cost of capital for IDCU.K. is most likely to be less than the cost of capital for a similar project in the U.S. 6. Some economists have stated that too many companies are not calculating the cost of not investing in new technology, world-class manufacturing facilities, or market position overseas. What are some of these costs? How do these costs relate to the notion of growth options discussed in the chapter? ANSWER. The company that gets to market first often goes on to dominate it. Those companies that don’t invest early may quickly be out of the business altogether. They may also lose out on other opportunities that were not foreseen at the time of the investment decision, but that developed later. For example, a company that forgoes investment in a novel technology passes up the chance to explore its technical possibilities, market opportunities, development costs, and competitors’ strategies. In other words, initial expenditures on product and process technologies and market position should be viewed as investments in information and in the creation of options to utilize that information in ways that may not have been envisioned originally. For example, Merck, the pharmaceutical firm, decided to invest in an automated

CHAPTER 14: CAPITAL BUDGETING FOR THE MULTINATIONAL CORPORATION

packaging and distribution plan, even though the labor savings didn’t justify the investment, in order to explore the potential benefits of plant automation. Results from the pilot project have clarified these benefits to the point that Merck is now expanding automation to its diverse manufacturing operations. Thus, firms that forgo investments in are passing up the chance to create and act on options. And the fact that a company passes up the chance to invest in options does not mean that its competitors will. For example, an auto maker may give up on ceramic engines, because technically they seem infeasible. But a rival who makes prosaic ceramic parts with the aim of one day using the knowledge to build a ceramic engine – as the Japanese are doing – can quickly change the competitive balance. Similarly, although liquid crystal displays (LCDs) are a U.S. invention (they were developed by RCA, which abandoned them as uneconomic), Japanese companies used them to make watches and small TVs; now they lead in LCD flat-panel computer screens. The ability to make these displays are a major reason Toshiba and other Japanese firms have won a large share of the laptop computer market. Moreover, the advanced display screens used in laptops not only are important as computer screens but also promise to open up huge markets in all types of display technology from cockpit, medical instrument, automotive, and home appliance displays to large flat-panel screens for HDTV. 7. Comment on the following statement that appeared in The Economist (August 20, 1988, p. 60): “Those oil producers that have snapped up overseas refineries – Kuwait, Venezuela, Libya, and, most recently, Saudi Arabia – can feed the flabbiest of them with dollar-a-barrel crude and make a profit. ... The majority of OPEC’s existing overseas refineries would be scrapped without its own cheap oil to feed them. Both Western European refineries fed by Libyan oil (in West Germany and Italy) and Kuwait’s two overseas refineries (in Holland and Denmark) would almost certainly be idle without it.” ANSWER. The statement is incorrect, assuming the author is referring to true economic profit. On an integrated basis, profits on the refinery are more than offset by losses on sales of the crude oil at subsidized prices. In fact, the oil producers are cross-subsidizing their refineries. They would be better off without the refineries and selling their oil on the open market. Investments should be evaluated taking into account the true opportunity costs of all the assets used. 8. In December 1989, General Electric spent $150 million to buy a controlling interest in Tungsram, the Hungarian state-owned light bulb maker. Even in its best year, Tungsram earned less than a 4% return on equity (based on the price GE paid). 8.a. What might account for GE’s decision to spend so much money to acquire such a dilapidated, inefficient manufacturer? ANSWER. Eastern Europe has the potential to be both a large market for Western goods and a low-cost manufacturing platform for export to Western Europe. But there are major uncertainties as to whether Eastern Europe will ever realize its market potential. As to manufacturing there, questions exist as to whether a workforce with 45 years experience in “they pretend to pay us and we pretend to work” can produce at the level and quality necessary to be competitive with their Western counterparts. By investing in Hungary, GE is buying an option to participate in the growth of the Eastern European market. It also is learning what it takes to install modern Western management methods in a former communist country and to use Hungary as a low-cost backdoor to Western Europe. The latter is especially critical to GE as part of its strategy to expand its weak global presence.

INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

GE’s presence is particularly dim in the European lighting market, where it is just sixth in sales, even though historically it has dominated the U.S. market. Then came a highly successful raid on GE’s U.S. fortress by Philips, which is the world’s largest light bulb producer. GE fought back by storming Philips’ European base but was unable to acquire a controlling interest in any Western European firm and building a new plant would have cost at least $300 million and several years. Buying Tungsram seemed a more promising alternative, since the Hungarian firm already exported 70% of its output to the West. Thus, it offered a tempting mix of Western European market share and low Eastern European wages. In effect, by investing in Tungsram, GE is buying options on: (a) the Western European market; (b) introducing new technologies and higher-priced products to Tungsram; and (c) a low-cost export platform. 8.b. A Hungarian light bulb worker earns about $170 a month in Hungary, compared with about $1,700 a month in the U.S. Do these figures indicate Tungsram will be a low-cost producer? ANSWER. No. You must also know how productive these workers are. What matters is what you are getting relative to what you are paying for. In fact, GE estimates that the productivity of Hungarian workers is one-seventh that of its workers in the U.S. Since GE is paying only one-tenth the wages but getting one-seventh the productivity, these figures taken together indicate that Tungsram should produce a light bulb 30% cheaper than GE’s U.S. plants (1/10:1/7 = .70). In response, Philips recently took over Poland’s leading lamp producer and another Western European competitor, Siemens’ Osram unit, has acquired an East German producer. SUGGESTED SOLUTIONS TO CHAPTER 14 PROBLEMS 1. Suppose a firm projects a $5 million perpetuity from a $20 million investment in Spain. If the required return on this investment is 20%, how large does the probability of expropriation in year 4 have to be before the investment has a negative NPV? Assume that all cash inflows occur at the end of each year and that the expropriation, if it occurs, will occur prior to the year-4 cash inflow or not at all. There is no compensation in the event of expropriation. ANSWER. This problem can be solved by breaking the cash flow stream into two components – one component if expropriation takes place and the other if no expropriation takes. The expected value of these streams is found by multiplying the first component by the probability that expropriation will take place and the other component by the probability that expropriation will not take place. Note that the cash flow streams are identical prior to year 4. All numbers are in millions of dollars. Year

Cash flow with expropriation

$20

Cash flow if no expropriation

If the probability of expropriation in year 4 is p, then the expected cash flows associated with this investment are:

CHAPTER 14: CAPITAL BUDGETING FOR THE MULTINATIONAL CORPORATION

Year 0

-$20

$5(1 - p)

The net present value of these cash flows, discounted at a 20% required return, is -20 + 5/1.2 + 5/(1.2)2 + 5/(1.2)3 + 5(1 - p)/(1.2)4 + ... + 5(1 - p)/(1.2)t + ... = -20 + 5/.2 - (5p/.2)/(1.2)3 = -20 + 25 - 14.68p Setting this quantity equal to 0 yields a solution of p = 34.1%. This means that the probability of expropriation has to be 34.1% before the investment no longer has a positive NPV. Note. The summation of the terms in the NPV equation uses the fact that the sum of an infinite annuity (a perpetuity) is a/r, where a is the annuity and r is the discount rate. Recognize also that the expected cash flow can be split into two annuities – one beginning in year 1 and equal to 5 per annum and the other beginning in year 4 and equal to -5p per annum. 2. Suppose a firm has just made an investment in France that will generate $2 million annually in depreciation, converted at today’s spot rate. Projected annual rates of inflation in France and in the U.S. are 7% and 4%, respectively. If the real exchange rate is expected to remain constant and the French tax rate is 50%, what is the expected real value (in terms of today’s dollars) of the depreciation charge in year 5, assuming that the tax write-off is taken at the end of the year? ANSWER. If the real exchange rate is expected to remain constant, then the real dollar value of the euro is expected to decline at the same rate as the real euro value, namely the 7% French inflation rate. Hence, the real dollar value of the depreciation tax write-off will decline at the rate of 7% per annum. If the French tax rate is 50%, then a depreciation charge of $2 million is worth $1 million in today’s dollars. If the real dollar value of this write- off is declining at the rate of 7% annually, then its real value in year 5, given that the write-off is taken at the end of the year, is $1,000,000/(1.07)5 = $712,986. 3. A firm with a corporate-wide debt/equity ratio of 1:2, an after-tax cost of debt of 7%, and a cost of equity capital of 15% is interested in pursuing a foreign project. The debt capacity of the project is the same as for the company as a whole, but its systematic risk is such that the required return on equity is estimated to be about 12%. The after-tax cost of debt is expected to remain at 7%. 3.a. What is the project’s weighted average cost of capital? How does it compare with the parent's WACC? ANSWER. The weighted average cost of capital for the project is kI = (1 - w) * ke’ + w * id(1 - t) where w is the ratio of debt to total assets, ke’ is the required risk-adjusted return on project equity, and id(1 - t) is the after-tax cost of debt for the project. Substituting in the numbers provided yields kI = 2/3 * 12% + 1/3 * 7% = 10.33%

INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

3.b. If the project’s equity beta is 1.21, what is its unlevered beta? ANSWER. The following approximation is usually used to unlever beta: Unlevered beta = levered beta/[1 + (1 - t)D/E] where t is the firm’s marginal tax rate and D/E is its debt/equity ratio. Without knowing the firm’s marginal tax rate, we cannot unlever beta. Assuming that the marginal tax rate is about 40%, the unlevered beta is Unlevered beta = 1.21/[1 + (1 - 0.4)0.25] = .93 4. Suppose that a foreign project has a beta of 0.85, the risk-free return is 12%, and the required return on the market is estimated at 19%. What is the cost of capital for the project? ANSWER. The cost of capital for the project is k* = Rf + β*[E(Rm) - Rf] where Rf is the risk-free required return, β* is the project beta, and E(Rm) is the expected return on the market. Substituting in the numbers provided in the problem yields k* = 012 + 0.85(0.19 - 0.12) = 17.95% 5. IBM is considering having its German affiliate issue a 10-year, $100 million bond denominated in euros and priced to yield 7.5%. Alternatively, IBM’s German unit can issue a dollardenominated bond of the same size and maturity and carrying an interest rate of 6.7%. 5.a. If the euro is forecast to depreciate by 1.7% annually, what is the expected dollar cost of the euro-denominated bond? How does this compare to the cost of the dollar bond? ANSWER. According to Chapter 14, the pre-tax dollar cost of borrowing in a foreign currency at an interest rate of rL, where the currency is expected to appreciate (depreciate) against the dollar at an annual rate of c, is rL(1 + c) + c. Substituting the numbers in the problem to this formula yields an expected dollar cost of borrowing euros of 5.67% [7.5% * (1 - 0.017) - 1.7%). This figure is substantially below the 6.7% cost of borrowing dollars. 5.b. At what rate of euro depreciation will the dollar cost of the euro-denominated bond equal the dollar cost of the dollar-denominated bond? ANSWER. The answer to this question is the solution to 7.5% * (1 + c) + c = 6.7%, or c = (6.7% 7.5%)/1.075 = -0.74%. 5.c.

Suppose IBM’s German unit faces a 35% corporate tax rate. What is the expected after-tax dollar cost of the euro-denominated bond?

ANSWER. According to Chapter 14, the effective after-tax dollar cost of borrowing a local currency at an interest rate of rL, annual currency appreciation (depreciation) of c, and a corporate tax rate of ta, is r = rL(1 + c)(1 - ta) + c. Substituting in the numbers from the question yields a solution of r = 7.5% * (1 0.017)(1 - 0.35) - 0.017 = 4.78%.

CHAPTER 14: CAPITAL BUDGETING FOR THE MULTINATIONAL CORPORATION

6. Suppose the cost of borrowing restricted euros is 7% annually, whereas the market rate for these funds is 12%. If a firm can borrow €10 million of restricted funds, how much will it save annually in before-tax franc interest expense? ANSWER. The annual interest savings on €10 million of restricted funds at 7% when the market rate is 12% equals €10,000,000(0.12 - 0.07) or €500,000. 7. Suppose one of the inducements provided by Taiwan to Xidex to set up a local production facility is a ten-year, $12.5 million loan at 8%. The principal is to be repaid at the end of the tenth year. The market interest rate on such a loan is about 15%. With a marginal tax rate of 40%, how much is this loan worth to Xidex? ANSWER. By borrowing at 8% when the market rate is 15%, Xebec saves 8% annually. This translates into annual before-tax savings of $12,500,000(0.15 - 0.08) = $875,000. With a marginal tax rate of 40%, this yields annual after-tax savings of $525,000. The value of this ten-year annuity, discounted at Xebec’s after-tax debt cost of 9% (15% * 0.6), is $525,000 * 6.4177 = $3,369,293. 8. Jim Toreson, CEO of Xebec Corp., a California, manufacturer of disk-drive controllers, must decide whether to switch to offshore production. Given Xebec’s well-developed engineering and marketing capabilities, Toreson could use offshore manufacturing to ramp up production, taking advantage of low-wage labor, tax holidays, low-interest loans, and other government largess. Most of his competitors seem to be doing it. The faster he follows suit, the better off Xebec would be according to the conventional discounted cash-flow analysis, which shows that switching production offshore is clearly a positive NPV investment. However, Toreson is concerned that such a move would entail the loss of certain intangible strategic benefits associated with domestic production. 8.a. What might be some strategic benefits of domestic manufacturing for Xebec? Consider the fact that its customers are all U.S. firms and that manufacturing technology – particularly automation skills – is key to survival in this business. ANSWER. Short-run benefits include better quality control and communication with customers and the ability to adapt quickly to changing markets. Longer term, a domestic manufacturing facility would give Xebec a laboratory to apply the latest thinking about automated production. By working with the production process on a daily basis, Xebec would have a better sense of the technology’s wider potential. For example, running a highly automated production operation next door to the engineering group would enable Xebec to provide production-related input in the early stages of product design – which offshore production managers can rarely do. With successfully automated production, Xebec’s new disk drives could be offered at a price and quality level to match those of potential competitors from Japan or anywhere else. By contrast, contracting to have its products built by a potential competitor in a country like Taiwan or Japan might cost Xebec both market share and its technological edge. The video recorder is an example of how production know-how can yield important technical advances. Sony, along with Matsushita Electric and its partner, Japan Victor Corp. (JVC), redesigned a professionaluse product from the U.S. costing $20,000 or more and turned it into a $1,500 home product with a relatively small market. Japanese designers then worked closely with Japanese factories to make every component smaller and less expensive. Cooperation between Matsushita’s design teams and employees on the shop floor eliminated more than three quarters of the product’s cost while dramatically improving its quality. In the process, the firm turned a niche product into the mass-market success story of the 1980s.

INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

8.b. What analytic framework can be used to factor these intangible strategic benefits of domestic manufacturing (which are intangible costs of offshore production) into the factory location decision? ANSWER. The intangible strategic benefits of domestic manufacturing can be factored into the factory location decision by using the option pricing framework. By investing in domestic manufacturing, Xebec creates for itself a series of opportunities to invest capital in the future so as to increase the profitability of its existing product lines and benefit from expanding into new products or markets or new process technologies. Whether Xebec will exercise these growth options depends on what happens in the future, which is unknowable today. The value of these growth options depends on several factors: i)

The length of time the project can be deferred. Factory automation allows Xebec to wait a longer time before responding to changes in the marketplace (since automation enables it to respond so quickly once it decides to). The investment in automation also provides Xebec with a set of long-lasting skills.

ii) The risk of the project. The riskier the investment the more valuable is an option on it. Thus, an investment in automation is likely to be especially valuable since it so risky. iii) The level of interest rates. The higher the interest rate the more valuable are projects that contain growth options. iv) The proprietary nature of the option. An exclusively owned option is clearly more valuable than one that is shared with others. Learning about the automation process is clearly a proprietary skill and so more valuable than investing in a new piece of equipment that everyone has access to. Valuing an investment in automation that embodies discretionary follow-up projects requires an expanded net present value rule that considers the attendant options. More specifically, the value of an option to undertake a follow-up project equals the expected NPV from investing in the project using the conventional discounted cash flow analysis plus the value of the discretion associated with undertaking the project. 8.c.

How would the possibility of radical shifts in manufacturing technology affect the production location decision?

ANSWER. The possibility of radical shifts in manufacturing technology would increase the benefits from investing in factory automation in the U.S. The phrase “radical shifts” implies that the project is high risk, which increases the option component of value. For example, companies that in the mid-1970s made the transition from electro-mechanical manually operated machine tools to automatic, electronically controlled ones, were subsequently able to exploit the revolution in capabilities – much higher performance at much lower cost – of the microprocessors and microcontrollers that became available in the early 1980s. For these companies, their operators, maintenance personnel, and process engineers were already familiar and comfortable with electronic technology so that it was a relatively simple task to retrofit powerful microelectronics when they became available. Companies that had deferred investment in the emerging electronic technology were not able to participate in the great technological advances in microelectronics; they had not acquired an option in this new process technology.

CHAPTER 14: CAPITAL BUDGETING FOR THE MULTINATIONAL CORPORATION

8.d. Xebec is considering producing more-sophisticated drives that require substantial customization. How does this possibility affect its production decision? ANSWER. The more customization is required, the more important it is to work closely with the customer. To meet the exacting needs of customers, there must be close personal contract between Xebec’s engineering and production staff and representatives of the purchasing company, something all but impossible to achieve over 10,000 miles and with severe language and cultural barriers. It is also difficult to coordinate the efforts of the marketing, engineering, design, and manufacturing people when they are spread around the globe. The need for coordination increases the value of domestic production facilities. 8.e.

Suppose the Taiwan government is willing to provide a loan of $10 million at 5% to Xebec to build a factory there. The loan would be paid off in equal annual installments over a five-year period. If the market interest rate for such an investment is 14%, what is the before-tax value of the interest subsidy?

ANSWER. Borrowing at 5% when the market rate of interest is 14% saves Xebec 9% annually on the principal balance. This leads to annual before-tax savings and their associated present values as follows:

Year

Principal

Interest Savings

PV Factor (@ 14%)

Present Value

1 2 3 4 5

$10,000,000 8,000,000 6,000,000 4,000,000 2,000,000

$900,000 720,000 540,000 360,000 180,000

.8772 .7695 .6750 .5921 .5194

$789,480 554,040 364,500 213,156 93,492

Total

$2,014,668

The value of this five-year stream of cash, discounted at 14%, is $2,014,668.

8.f.

INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

Projected before-tax income from the Taiwan plant is $1 million annually, beginning at the end of the first year. Taiwan’s corporate tax rate is 25%, and there is a 20% dividend withholding tax. However, Taiwan will exempt the plant’s income from corporate tax (but not withholding tax) for the first five years. If Xebec plans to remit all income as dividends back to the U.S., how much is the tax holiday worth?

ANSWER. Very little. Assuming that Xebec doesn’t have any excess foreign tax credits (FTCs), it will owe the difference between the 20% withholding tax on dividends and the 34% rate levied by the IRS on its Taiwanese income. Xebec’s after-tax income from Taiwan, with and without the tax holiday, will be:

Taiwan No Tax Holiday

Tax Holiday

PBT PAT (tax @ 25%) Dividend Withholding tax (@ 20%)

$1,000,000 750,000 750,000 150,000

PBT PAT (no tax) Dividend Withholding tax (@ 20%)

$1,000,000 1,000,000 1,000,000 200,000

Net Dividend to Xebec

$600,000

Net Dividend to Xebec

$800,000

United States U.S. tax owed (@ 34%) Direct FTC Indirect FTC

$340,000 150,000 250,000

U.S. tax owed (@ 34%) Direct FTC Indirect FTC

$340,000 200,000 0

Net U.S. tax owed PAT to Xebec

($60,000) $600,000

Net U.S. tax owed PAT to Xebec

$140,000 $660,000

Assuming that Xebec has no use for excess foreign tax credits, the calculations show that the value of the tax holiday to it is only about $60,000 annually. 8.g. An alternative sourcing option is to shut down all domestic production and contract to have Xebec’s products built for it by a foreign supplier in a country such as Japan. What are some of the potential advantages and disadvantages of foreign contracting vis-á-vis manufacturing in a wholly owned foreign subsidiary? ANSWER. See the answer to part a.

CHAPTER 15: FOREIGN TRADE AND SHORT-TERM FINANCING

CHAPTER 15 FOREIGN TRADE AND SHORT-TERM FINANCING This chapter is primarily factual, describing the various institutions and details involved in financing foreign trade. The most important documents encountered in bank-related financing are the draft, which is a written order to pay; the letter of credit, which is a bank guarantee of payment provided that certain stipulated conditions are met; and the bill of lading, the document covering title and actual shipment of the merchandise by a common carrier. Other documents of lesser importance include the commercial and consular invoices and insurance certificate. The section on short-term financing discusses the alternative financing options available to companies. It emphasizes how exchange rate changes affect the home currency costs of borrowing in different currencies. The domestic analogy is calculating real borrowing costs, factoring in inflation and nominal interest rates. In this edition, Key Points 1. The functions of these instruments, and hence the rationale for their existence, are: ▪

To reduce both buyer and seller risk.

▪

To pinpoint who bears those risks that remain.

▪

To facilitate the transfer of risk to a third party.

•

To facilitate financing.

2. Each instrument evolved over time as a rational response to the additional risks in international trade posed by greater distances, the lack of familiarity between exporters and importers, the possibility of government imposition of exchange controls, and greater costs involved in bringing suit against a party domiciled in another nation. 3. The existence of government programs that provide subsidized export financing, such as the U.S. Eximbank, creates a market imperfection that MNCs can exploit to lower their risk-adjusted cost of funds. 4. Countertrade has evolved in response to government efforts to control the allocation of foreign exchange. Although an inefficient means of conducting trade, it exists and should be understood. 5. In formulating a borrowing strategy, the key factors and objectives associated with that strategy must be consistent with our understanding of the way in which financial markets work. 6. If forward contracts exist, then the only valid objective of a borrowing strategy is to minimize covered after-tax interest costs.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

7. In the absence of forward contracts, firms can either attempt to minimize expected costs or establish some trade-off between reducing expected costs and reducing the degree of cash flow exposure. The latter goal involves offsetting operating cash inflows in a currency with financing cash outflows in that same currency. In general, the borrowing decision should be integrated with the hedging decision.

SUGGESTED ANSWERS TO CHAPTER 15 QUESTIONS 1. What are the basic problems arising in international trade financing and how do the main financing instruments help solve those problems? ANSWER. The main problems arising in international trade financing are the risks that both buyer and seller bear in cross border trade, how to allocate those risks in a way that ensures that those best able to bear them or are in the best position to mitigate them do so, to facilitate the transfer of remaining risks to a third party, and to attain financing at as low a cost as possible. The principal financing instruments and mechanisms examined here are the letter of credit, banker’s acceptance, factoring, forfaiting, and government export financing and credit guarantees. LETTER OF CREDIT. The L/C eliminates credit risk to the exporter if the bank that opens it is of undoubted

standing and it also reduces the danger that payment will be delayed or withheld owing to exchange controls or other political acts. Other risks that the L/C guards against are explained in the chapter. The L/C also facilitates financing because it ensures the exporter a ready buyer for its product. It also becomes especially easy to create a banker’s acceptance. From the importer’s standpoint, since payment is only in compliance with the L/C’s stipulated conditions, the importer is able to ascertain that the merchandise is actually shipped on, or before, a certain date by requiring an on-board bill of lading. BANKER’S ACCEPTANCE. With a banker’s acceptance, the bank effectively substitutes its own credit for that

of a borrower, and, in the process, it creates a negotiable instrument that may be freely traded. This feature lowers the cost of acceptance financing. A banker’s acceptance helps an importer who does not have a close relationship with and cannot obtain financing from the exporter it is dealing with. FACTORING. By factoring on a nonrecourse basis, exporters can shift to the factor all the credit and

political risks on their foreign sales except for those involving disputes between the transacting parties. Even if an exporter chooses not to discount its foreign receivables with a factor, it can still use the factor’s extensive credit information files to ascertain the creditworthiness of prospective customers. Despite its high costs, factoring can be quite worthwhile to many firms because the cost of bearing the credit risk associated with a given receivable can be substantially lower to a factor than to the selling firm. As the chapter notes, factoring is most useful for (1) the occasional exporter and (2) the exporter with a geographically diverse portfolio of accounts receivable. In both cases, it would be organizationally difficult and expensive to internalize the accounts receivable collection process. Such companies would generally be small or else would be involved on a limited scale in foreign markets. FORFAITING. This specialized factoring technique, which entails the discounting--at a fixed rate without

recourse--of medium-term export receivables denominated in fully convertible currencies (U.S. dollar, Swiss franc, Deutsche mark). is useful in the case of extreme credit risk.

CHAPTER 15: FOREIGN TRADE AND SHORT-TERM FINANCING

GOVERNMENT SOURCES OF EXPORT FINANCING AND CREDIT INSURANCE. Most governments of developed

countries provide their domestic exporters with low-cost export financing and concessionary rates on political and economic risk insurance. These credits and guarantees provide exporters with low-cost financing and shift risks to the government. Of course, there is a cost: Taxpayers get to bear these costs, although the risks may be lower since foreign governments may be more reluctant to interfere with payments to other governments than to private firms or banks. 2. The different forms of export financing distribute risks differently between the exporter and the importer. Analyze the distribution of risk in the following export financing instruments. 2.a. Confirmed, revocable letter of credit ANSWER. The revocable letter of credit can be revoked, without notice, at any time up to the time a draft is presented to the issuing bank. As such, it is favorable to the importer, but the exporter loses the guarantee that funds will be available if she meets the conditions specified on the L/C. 2.b. Confirmed, irrevocable letter of credit ANSWER. The confirmed, irrevocable L/C eliminates credit risk to the exporter if the banks that sign it are of undoubted standing. Other advantages of an irrevocable L/C are detailed in the chapter. 2.c. Open account credit ANSWER. Selling on open account is risky to the exporter because it has little evidence of the importer’s obligation to pay. The advantages come in the form of greater flexibility. But here the exporter bears virtually all the risk and the importer practically none. 2.d. Time draft, D/A ANSWER. A time draft D/A removes some of the risk faced by the exporter. Documents evidencing title to the merchandise are turned over to the importer only if the draft is accepted by the importer or his bank. The exporter still bears the risk of shipping goods that will be refused. In that case, the exporter must either sell the goods in the foreign market at a lower price or ship them home at added expense. 2.e.

Cash with order

ANSWER. Cash payment at the time of order provides the exporter with the greatest protection, because payment is received before he commits any of his funds. There is no risk of starting work on an order and then finding out that the order has been canceled. By contrast, the importer bears risk here because he has no guarantee that the exporter will perform the work as expected. 2.f.

Cash in advance

ANSWER. Cash in advance, prior to shipment or upon delivery of the goods, provides the exporter with a great deal of protection. The risk is that if cash is not received at the time the order is first processed, the exporter is out some of its cash if the order is canceled before payment is made. The importer bears risk because he has no guarantee that the goods requested will be delivered according to specifications.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

2.g. Consignment ANSWER. Sending goods on consignment provides some protection to the exporter because he retains title to the goods until they are paid for. But this is a very risky method since there is little evidence of obligation to pay and it may be difficult to collect if the importer’s government imposes currency controls. 2.h. Sight draft ANSWER. With a sight draft, the importer receives no credit. This lessens the credit risk to the exporter. With a time draft, by contrast, the exporter only knows at maturity whether the importer will honor it. As with a draft in general, credit risk is reduced because the shipper, acting on orders of the exporter, will not turn over the goods until payment is made. 3. Describe the different steps and documents involved in exporting motors from Kansas to Hong Kong using a confirmed letter of credit, with payment terms of 90 days sight. What alternatives are available to the exporter to finance this shipment? ANSWER. The exporter will receive a letter of credit addressed to itself, written and signed by a bank acting on behalf of the buyer. In the letter, the bank promises it will honor drafts drawn on itself if the seller conforms to the specific conditions set forth in the L/C. The exporter can use the L/C to finance its sale by sending a draft, signed by itself and addressed to the bank that confirmed the L/C, ordering the importer to pay in 90 days the amount specified on its face. When accepted by the confirming bank, this draft becomes a banker’s acceptance that the exporter can then sell for cash to finance its shipment. To be honored when presented for payment, the draft must be accompanied by a commercial invoice containing an authoritative description of the engines being shipped, a clean bill of lading certifying that the engines were received in apparently good condition, an insurance certificate, and possibly a consular invoice, which is presented to the local consul in exchange for a visa. Of course, the exporter must manufacture the engines or take them out of inventory, deliver them to the cargo ship, take out the necessary insurance, and fill out the B/L, commercial invoice, and consular invoice (if required). Instead of using the L/C to arrange financing (by creating a B/A), the exporter can also arrange bank financing or use general corporate funds to finance its export. If it does the latter, it will hold onto the acceptance and then present it in 90 days and receive payment at that time. 4. Explain the advantages and disadvantages of each of the following forms of export financing. 4.a. Banker’s acceptances ANSWER. The low-risk nature of banker’s acceptances mean that they trade at rates very close to those on CDS. That is, the exporter can sell a banker’s acceptance at a relatively small discount (the lower the interest rate, the lower the discount). On the other hand, there are additional costs attached to a banker’s acceptance. Specifically, the accepting bank levies a fee, or commission, for accepting the draft. The bank also receives a fee if a letter of credit is involved. 4.b. Discounting ANSWER. An advantage of discounting is that the discount rate for trade paper is often lower than interest rates on overdrafts, bank loans, and other forms of local funding. This lower rate is usually a result of export promotion policies that lead to direct or indirect subsidies of rates on export paper. A disadvantage is that there are often fees involved.

CHAPTER 15: FOREIGN TRADE AND SHORT-TERM FINANCING

4.c.

Factoring

ANSWER. Through factoring, firms can shift credit risks to the factor, who is often in a better position to assess and bear these risks, and also reduce their costs of the accounts receivable collection process. In addition, by using a factor, a firm can ensure that its terms are in accord with local practice and are competitive. However, factoring can be quite expensive once account is taken of the fees involved. 4.d. Forfaiting ANSWER. This specialized factoring technique helps shift extreme credit risk to the forfaiter, usually a multinational bank. Forfaiting also provides help with administrative and collection problems. As with factoring, these services can be expensive. 5. What are the potential advantages and disadvantages of countertrade for the parties involved? ANSWER. Countertrade is less efficient than using cash or credit because the products taken in trade are not liquid. Sellers factor these costs into the price they charge countertrading buyers. Both parties, therefore, bear costs. A principal problem for countertraders is that it causes them to lose sight of the market that they are in. By failing to deal directly with customers, the countertrader never learns what the market really wants or how it might improve its competitiveness. Countertrading also creates other problems. First, the goods that can be taken in countertrade are usually relatively undesirable. Those that can be readily converted into cash already have been. So although a firm shipping computers to Brazil might prefer to take coffee beans in return, the only goods available might be Brazilian shoes. Second, the details are difficult to work out (how many tons of naphtha is a pile of shoddy Polish goods worth?). The inevitable result is a high ratio of talk to action; only a small percentage of deals that are talked about getting done. Lost deals cost money. There are few advantages to countertrading as an economic means of transacting. About the best that can be said for the recipient is that it is preferable to having no sales in a given market. Countertrading may also permit countries to cheat on the cartels they belong to by effectively underpricing their products. Countertrade may also reduce the risk faced by a nation that contracts for a new manufacturing facility. If the contractor’s payment is taken in the form of goods supplied by the facility, he has a strong incentive to do quality work and to ensure that the technology and equipment are appropriate for the workforce’s skill level, available materials, and so on. 6. What are the three basic types of bank loans? Describe their differences. ANSWER. The major forms of bank financing include overdrafts, discounting, and term loans. Term loans are straight loans, often unsecured, that are made for a fixed period of time, usually 90 days. Rather than a one-time loan, like a term loan, an overdraft is a line of credit against which drafts (checks) can be drawn (written) up to a specified maximum amount. The discounting of trade bills is the preferred short-term financing technique in many European and Latin American countries. A manufacturer takes a trade bill – reflecting goods sold on credit to a retailer – to his or her bank, and the bank accepts it for a fee if the buyer’s bank has not already accepted it. The bill is then sold at a discount to the manufacturer’s bank or to a money market dealer.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

ADDITIONAL CHAPTER 15 QUESTIONS AND ANSWERS 1. To “meet the competition” from its counterparts overseas, Eximbank will mechanically match the terms of a loan provided by a rival export-financing agency – including the interest rate – when it finances U.S. exports. 1.a. What problems might arise from this rule of matching nominal interest rates? ANSWER. The effective subsidy associated with a particular interest rate equals the market interest rate minus the interest rate actually charged. Since nominal interest rates vary substantially from one country to another, this means that an 8% yen interest rate from Japan can imply a very different level of subsidy than an 8% interest rate on lira from Italy. For example, suppose that the market interest rates from Japan and Italy on a particular export credit are 9% and 15%, respectively. The implied Japanese subsidy will be 1% while the implied Italian subsidy will be 7%. If the intent is to match subsidies, therefore, matching nominal interest rates is a very inefficient way to achieve that objective. 1.b. As of January 15, 1988, the minimum interest rate on government-supplied export credits to rich countries was set at a flat rate of 10.4% for all nations providing such credits. What problems might arise with this rule? Comment on which governments would push for such a rule. Which would be against it? ANSWER. High-inflation countries tend to have high nominal interest rates while low-inflation countries tend to have low nominal interest rates. Thus, the real interest rate implied by a given nominal interest rate will be very high for countries with low inflation rates and very low for countries with high interest rates. Thus, at any given nominal interest rate, high-inflation countries are able to subsidize their exports more than low-interest-rate countries. To take a not-too-extreme case, suppose that due to low inflation, the nominal market interest rate in Germany is only 7%, while high French inflation results in a nominal interest rate of 12%. If the minimum interest rate on government-supplied export credits is 10.4%, the German government will be forced to charge an above-market rate, while the French government will be able to provide a 1.6% (12% - 10.4%) interest subsidy. High-inflation countries will push for setting maximum rates in nominal terms, while low-inflation countries will be against such a policy. 1.c.

How should minimum interest rates on export credits be set so as to ensure comparability across countries?

ANSWER. The best approach would be to tailor the minimum rate to each country according to its level of nominal interest rates. A simple implementation of this approach could involve setting the minimum rate equal to the risk-free rate in the country for a loan of that maturity plus or minus a constant S. For example, if S is set equal to -2%, then a country whose nominal risk-free rate is 10% would have to charge a minimum rate of 8%, and a country with a nominal risk- free rate of 6% would have to charge a minimum rate of 4%. 1.d. Suppose that instead of subsidizing interest rates, governments turn to export insurance subsidies. Is this move an improvement vis-á-vis export-credit subsidies? Explain. ANSWER. The most important aspect of providing export-credit insurance subsidies instead of subsidizing interest rates on export credits is that with the former the subsidy is limited to the difference between the market interest rate and the risk-free interest rate. In contrast, with interest rate subsidies, the interest rate on export credit can fall below the risk-free rate. In other words, the maximum possible subsidy with export-credit insurance is less than the maximum possible subsidy with interest rate subsidies.

CHAPTER 15: FOREIGN TRADE AND SHORT-TERM FINANCING

1.e.

Why has the U.S. government fought against export-credit subsidies?

ANSWER. They are expensive and lead to misallocation of resources: Unprofitable deals get done. Thus, a nation that subsidizes exports simply gives away part of its wealth. Moreover, it is doubtful that export subsidies really improve the trade balance. Any increase in exports achieved by a subsidy must necessarily increase the demand for dollars by foreign purchasers of U.S. goods. The increase in demand will boost the dollar’s value, encouraging imports and discouraging unsubsidized exports. If investment and savings are unaffected, the trade deficit will not respond to export subsidies. 2. One of the purposes of Eximbank is to absorb credit risks on export sales that the private sector will not accept. Comment on this purpose. ANSWER. The private sector is always willing to absorb credit risks, but not necessarily at a low price. By providing low-cost export credits, the government facilitates uneconomical deals. That is, the government is sending out the wrong signals about the profitability of doing certain deals. The exporter gets the benefits from any export sales while the taxpayer gets stuck with the cost of any credit that defaults. That is, poor foreign credit risks receive low-cost financing, and taxpayers subsidize these bad risks. 3. Comment on the following statement: “Eximbank does not compete with private financial institutions. It offers assistance only in cases in which the export-credit transaction would not take place without its help. Eximbank does not offer direct-loan assistance to foreign buyers when private institutions will provide comparable financing on reasonable terms.” ANSWER. The market always provides financing on “reasonable” terms. Competition among financial institutions ensures that. But reasonable does not necessarily mean low cost. If foreign customers are risky, then the interest rate charged by the market will be high. No private lender will supply funds at 8% if the market rate is 14%. Thus, the Eximbank will find that if it sets a below-market rate on its loans, no private institution will provide comparable financing on the same terms. Although the Eximbank might view this as a problem, most financial economists would not. 4. These questions relate to the Foreign Credit Insurance Association. 4.a. Describe the different risks covered by FCIA. Why does the FCIA require coinsurance? ANSWER. FCIA insurance offers protection from political and commercial risks to U.S. exporters: The private insurers cover commercial risks, and the Eximbank covers political risks. The exporter (or the financial institution providing the loan) must self-insure that portion not covered by the FCIA. Short-term insurance is available for export credits up to 180 days (360 days for bulk agricultural commodities and consumer durables) from the date of shipment. Coverage is of two types: comprehensive (90%-100% of political and 90%-95% of commercial risks) and political only (90%-100% coverage). Under the FCIA lease insurance program, lessors of U.S. equipment and related services can cover both the stream of lease payments and the fair market value of products leased outside the U.S. The FCIA charges a risk-based premium that is determined by country, lease term, and the type of lease. Coinsurance is required presumably because of the element of moral hazard: the possibility that exporters might take unreasonable risks knowing that they would still be paid in full.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

4.b. What factors affect the insurance premium charged by the FCIA? ANSWER. The greater the loss experience associated with the particular exporter and the countries and customers it deals with, the higher the insurance premium charged. The rates depend on the terms of sale, with longer-term sales bearing higher rates. 4.c.

Describe the basic features of a typical FCIA short-term policy.

ANSWER. Rather than sell insurance on a case-by-case basis, the FCIA approves discretionary limits within which each exporter can approve its own credits. Insurance rates are based on the terms of sale, type of buyer, and the country of destination and can vary from a low of 0.1% to a high of 2%. The FCIA also offers preshipment insurance up to 180 days from the time of sale. 4.d. Describe the basic features of a typical FCIA medium-term policy. ANSWER. Medium-term insurance is guaranteed by Eximbank and covers big-ticket items sold on credit usually from 181 days to five years. It is available on a case-by-case basis. As with short-term coverage, the exporter must reside in, and ship from, the U.S. However, the FCIA will provide medium-term coverage for that portion only of the value added that originated in the U.S. 5. Low-cost export financing is often a bad sign. Explain. ANSWER. A country that has a comparative advantage in the manufacture of certain products does not need to provide subsidies such as low-cost financing to stimulate exports of those products. Its cost advantage will suffice. Thus, the fact that a nation feels it must subsidize export sales to be competitive could indicate that it is a high cost producer. Of course, the possibility always remains that the country is cost competitive but uses subsidies to counter the subsidies that foreign competitors receive. 6. What is countertrade? Why is it termed a sophisticated form of barter? ANSWER. Countertrade involves purchasing local products to offset the exports of their own products to that market. Countertrade is a form of barter because both involve swapping goods for goods. Countertrade transactions are often very complex, involving two-way or three-way transactions, especially where a company is forced to accept unrelated goods for resale by outsiders. In this way, countertrade is a sophisticated form of barter; that is, it may involve more than two parties and a number of transactions. SUGGESTED SOLUTIONS TO CHAPTER 15 PROBLEMS 1. Texas Computers (TC) recently has begun selling overseas. It currently has 30 foreign orders outstanding, with the typical order averaging $2,500. TC is considering the following three alternatives to protect itself against credit risk on these foreign sales: ▪

Request a letter of credit from each customer. The cost to the customer would be $75 plus 0.25% of the invoice amount. To remain competitive, TC would have to absorb the cost of the letter of credit.

▪

Factor the receivables. The factor would charge a nonrecourse fee of 1.6%.

▪

Buy FCIA insurance. The FCIA would charge a 1% insurance premium.

CHAPTER 15: FOREIGN TRADE AND SHORT-TERM FINANCING

1.a. Which of these alternatives would you recommend to Texas Computers? Why? ANSWER. The L/C will cost TC an average of $81.25 ($75 + 0.0025*$2,500) per order, or a total of $2,437.50 (30 * $81.25). The factoring alternative will cost an average of $40 (0.016 * $2,500) per order, or $1,200 in all. The FCIA insurance will cost an average of $25 (0.01 * $2,500) per order, or $750 in all. Thus, the least expensive alternative is the FCIA insurance. 1.b. Suppose that TC’s average order size rose to $250,000. How would that affect your decision? ANSWER. If TC’s average order size rises to $250,000, then the L/C will cost an average of $700 per order ($75 + 0.0025 * $250,000), or $21,000 in total. The FCIA insurance will cost an average of $2,500 per order, or $75,000 in total. Thus, the L/C is now the least expensive alternative (factoring is dominated by the FCIA insurance). 2. L.A. Cellular has received an order for phone switches from Singapore. The switches will be exported under the terms of a letter of credit issued by Sumitomo Bank on behalf of Singapore Telecommunications. Under the terms of the L/C, the face value of the export order, $12 million, will be paid six months after Sumitomo accepts a draft drawn by L.A. Cellular. The current discount rate on 6-month acceptances is 8.5% per annum and the acceptance fee is 1.25% per annum. In addition, there is a flat commission, equal to 0.5% of the face amount of the accepted draft, that must be paid if it is sold. 2.a. How much cash will L.A. Cellular receive if it holds the acceptance until maturity? ANSWER. If L.A. Cellular chooses to hold the acceptance, then in six months it will receive the face amount of $12 million less the acceptance fee of 0.625% (1.25%/2): Face amount of acceptance Less: 1.25% per annum commission for six months Amount received by L.A. Cellular in six months

$12,000,000 -$75,000 $11,925,000

2.b. How much cash will it receive if it sells the acceptance at once? ANSWER. By selling the acceptance at once, paying the 0.5% selling commission, and taking the 4.25% discount (8.5%/2), L.A. Cellular will receive $11,355,000 immediately: Face amount of acceptance Less: 1.25% per annum commission for six months Less: 8.5% per annum discount for six months Less: 0.5% selling commission Amount received by L.A. Cellular immediately: $12,000,000 -$75,000 -$510,500 -$60,000 $11,355,000

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

2.c.

Suppose L.A. Cellular’s opportunity cost of funds is 8.75% per annum. If it wishes to maximize the present value of its acceptance, should it discount the acceptance?

ANSWER. Given that L.A. Cellular’s opportunity cost of money is 8.75%, then the present value of holding onto the acceptance is $11,925,000/(1 + (.0875/2)), or $11,425,150 (remember, it must pay the $75,000 commission in any case). Since this figure exceeds the amount of money it would receive from discounting the acceptance, L.A. Cellular should hold onto the acceptance. 3. Suppose Minnesota Machines (MM) is trying to price an export order from Russia. Payment is due nine months after shipping. Given the risks involved, MM would like to factor its receivable without recourse. The factor will charge a monthly discount of 2% plus a fee equal to 1.5% of the face value of the receivable for the nonrecourse financing. 3.a. If Minnesota Machines desires revenue of $2.5 million from the sale, after paying all factoring charges, what is the minimum acceptable price it should charge? ANSWER. At a monthly discount of 2%, and an extra 1.5% fee for nonrecourse financing, Minnesota Machines will pay a total fee equal to 19.5% (9 * 2% + 1.5%) of the face amount of its price for factoring its nine-month export receivable without recourse. In other words, after paying all factoring fees, MM will clear 80.5% of the price it sets. Thus, in order to net $2.5 million on its export sale, MM must set a price P such that 0.805P = $2,500,000. The solution to this equation is P = $3,105,590. This is the minimum acceptable price to MM. 3.b. Alternatively, CountyBank has offered to discount the receivable, but with recourse, at an annual rate of 14% plus a 1% fee. What price will net MM the $2.5 million it desires to clear from the sale? ANSWER. If MM decides to discount the receivable with CountyBank, it will pay a total fee equal to 11.5% (0.75 * 14% + 1%). Thus, in order to net $2.5 million on its export sale, MM must now set a price P* such that .885P* = $2,500,000, or P* = $2,824,859. 3.c.

Based on your answers to parts a and b, should Minnesota Machines discount or factor its Russian receivables? MM is competing against Nippon Machines for the order, so the higher MM’s price, the lower the probability that its bid will be accepted. What other considerations should influence MM’s decision?

ANSWER. Based purely on net revenue, MM should plan on discounting its receivable. However, this would expose it to credit risk. Credit risk reduces MM’s expected revenue from this sale (at the extreme it may receive nothing, if Russia defaults). This brings up two issues. First, is the price charged by the factor reasonably reflective of the risk of default or delay in receipt of payment? If so, then MM’s expected revenue from the sale at a given price will be the same from discounting or factoring even though the most likely revenue will differ. Second, how risk averse is MM? The more risk averse it is, the more reason for factoring its receivable. Most likely, the factor is charging a fair price for the risks involved. In that case, MM will be receiving the benefits of the factor's credit risk analysis and collection skills. In fact, as pointed out in the text, the cost of bearing the credit risk associated with MM’s Russian receivable may be substantially lower to the factor than to MM. If so, then MM will actually get a better deal with factoring then with discounting.

CHAPTER 15: FOREIGN TRADE AND SHORT-TERM FINANCING

A more important issue here is the price that MM should charge. Although MM desires revenue of $2.5 million from this sale, that may not be its minimum acceptable revenue. As a Japanese firm, Nippon is likely to focus on market share and so will probably compete very strongly on price. MM will therefore have to price its sale as low as possible. In setting a price, MM should consider the possibility of future sales stemming from this initial order. To the extent that there will be follow-up orders for additional units, parts, and service, MM might consider settling for a lower profit this time around in the expectation that it will make higher profits on future sales. 3.d. What other alternatives might be available to MM to finance its sale to Russia? ANSWER. MM may be able to take advantage of a government export financing agency to provide it with lower cost funds. Alternatively, MM may be able to receive low-cost government export insurance, thereby eliminating credit risk at a relatively low price. 4. Apex Supplies borrows FF 1 million at 12%, payable in one year. If Apex is required to maintain a compensating balance of 20%, what is the effective percentage cost of its loan (in FF)? ANSWER. The effective interest rate is defined as (annual interest paid)/(funds received). Since Apex Supplies receives only FF 800,000 net of the compensating balance requirement, this figure is FF 120,000/FF 800,000 = 15%. 5. The Olivera Corp., a manufacturer of olive oil products, needs to acquire Lit 100 million today to expand a pimento-stuffing facility. Banca di Roma has offered them a choice of an 11% loan payable at maturity or a 10% loan on a discount basis. Which loan should Olivera choose? ANSWER. The effective interest rate on the first loan just equals its stated rate of 11%. By contrast, the effective interest rate on the loan priced on a discount basis is Lit 10 million/Lit 90 million = 11.11%. Hence, the 11% loan is less expensive. 6. If Consolidated Corp. issues a Eurobond denominated in yen, the 7% interest rate on the $1 million, one-year borrowing will be 2% less than rates in the U.S. However, ConCorp would have to pay back the principal and interest in Japanese yen. Currently, the exchange rate is ¥183 = $1. By how much could the yen rise against the dollar before the Euroyen bond would lose its advantage to ConCorp? ANSWER. The breakeven exchange rate is found where the dollar cost of borrowing dollars just equals the dollar cost of borrowing yen. If ConCorp borrows dollars, it will owe 1.09 * $1,000,000 at the end of the year (the U.S. interest rate is 2% higher than the Japanese rate of 7%). The cost of borrowing yen equals 183 * 1,000,000 * 1.07/S, where S is the spot value of the dollar in one year. Setting these two figures equal and solving for S yields S = 183 * 1.07/1.09 = ¥179.64. Thus the yen must appreciate by (183 179.64)/179.64 = 1.87% before yen borrowing becomes more expensive than dollar borrowing.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

7. Ford can borrow dollars at 12% or pesos at 80% for one year. The peso:dollar exchange rate is expected to move from $1 = Ps 3300 currently to $1 = Ps 4500 by year end. 7.a. What is the expected after-tax dollar cost of borrowing dollars for one year if the Mexican corporate tax rate is 53%? ANSWER. According to Equation 19.4 in Section 19.4, the after-tax dollar cost of borrowing dollars overseas equals rus(1 - t) + ct, where rus is the dollar interest rate, t is the local tax rate and c is the change in the dollar value of the local currency (LC). Similarly, according to Equation 19.3, the after-tax dollar cost of borrowing LC is rL(1 + c)(1 - t) + c, where rL is the LC interest rate. In the situation facing Ford, the expected devaluation of the peso over the course of the year is (1/3300 - 1/4500)/(1/4500) = 22.67% The expected after-tax dollar cost of borrowing dollars for a year at 12% is 0.12(1 - 0.53) - 0.53 * 0.2667 = -8.50%. 7.b. What is Ford’s expected after-tax dollar cost of borrowing pesos for one year? ANSWER. The expected after-tax dollar cost of borrowing pesos at 80% for one year is .80(1 - 0.2667)(1 0.53) - 0.2667 = 0.90%. 7.c.

At what end-of-year exchange rate will the after-tax peso cost of borrowing dollars equal the after-tax peso cost of borrowing pesos?

ANSWER. The point at which the peso costs of borrowing dollars and pesos are identical is the same as the point at which their dollar costs are identical (one is just a linear multiple of the other). Using the formulas presented above, the breakeven amount of currency change d is found at the point at which rus(1 - t) + ct = rL(1 + c)(1 - t) or c = (rus - rL)/(1 + rL) Substituting in the numbers presented in the problem, c = (0.12 - 0.80)/1.80 = -37.78% The relationship between the beginning exchange rate, e0, and the end-of-period exchange rate, e1, is e1 = e0(1 + c). Here, e0 = 1/3300, so e1 = (1/3300) * (1 - 0.3778) = $0.00018855, or Ps 5300 = $1.

CHAPTER 16: MANAGING THE MULTINATIONAL FINANCIAL SYSTEM

CHAPTER 16 MANAGING THE MULTINATIONAL FINANCIAL SYSTEM Chapter 16 describes the nature of the multinational financial system and why the ability to shift profits and funds internally is potentially of far greater value to the MNC than to the purely domestic firm. It points out that the value of the multinational financial system arises out of the firm’s ability to use it to take advantage through arbitrage of market imperfections and tax differences. The three principal forms of arbitrage opportunities discussed include: 1. TAX ARBITRAGE. By shifting profits from units located in high-tax nations to those in lower-tax nations or from those in a taxpaying position to those with tax losses, MNCs can reduce their tax burden. 2. FINANCIAL MARKET ARBITRAge. By transferring funds among units, MNCs may be able to circumvent exchange controls, earn higher risk-adjusted yields on excess funds, reduce their risk-adjusted cost of borrowed funds, and tap previously unavailable capital sources. 3. REGULATORY SYSTEM ARBITRAGE. Where subsidiary profits are a function of government regulations (e.g., where a government agency sets allowable prices on the firm’s goods) or union pressure, rather than the marketplace, the ability to disguise true profitability by reallocating profits among units may provide the MNC with a negotiating advantage. The chapter then analyzes at length the most important conduits used by MNCs to transfer funds and profits internally: transfer pricing, fees and royalties, dividends, loans, leads and lags, and parent investment as debt or equity. It also illustrates the close relationship between a firm’s marketing, production, and logistics decisions (i.e., its real decisions) and its financial decisions. The greater the internal transfer of goods, technology, capital, and materials worldwide, the greater the scope for financial activities to enhance the value of the MNC globally. When teaching this material, I always emphasize the potential conflicts with home and host country governments inherent in taking advantage of the various arbitrage opportunities presented. An article that illustrates this point is M. Edgar Barrett, "Case of the Tangled Transfer Price," Harvard Business Review, May-June 1977, pp. 20-36.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

SUGGESTED ANSWERS TO CHAPTER 16 QUESTIONS 1.a. What is the internal financial transfer system of the multinational firm? ANSWER. The internal financial transfer system of the multinational firm is the collection of internal transfer mechanisms that enables the MNC to move money and profits among its various affiliates. These mechanisms for fund flows within the MNC stem from the internal transfer of goods, services, technology, and capital. 1.b. What are its distinguishing characteristics? ANSWER. Although the financial transfer mechanisms available to the MNC exist among independent firms, the MNC has greater control over the mode and timing of these financial transfers. The MNC has considerable freedom in selecting the financial channels through which funds and allocated profits are moved. In addition, most MNCs have some flexibility regarding the timing of fund flows. They can speed up or slow down dividend payments, loan repayments, and payments for fees, royalties, and interaffiliate sales of goods and services. 1.c.

What are the different modes of internal fund transfers available to the MNC?

ANSWER. The mechanisms for transferring funds internally include transfer prices on goods and services traded internally, intracorporate loans and equity investments, dividend payments, leading (speeding up) and lagging (slowing down) intercompany payments, and fee and royalty charges. 2. How does the internal financial transfer system add value to the multinational firm? ANSWER. The MNC’s ability to transfer funds and profits internally may enable it to reduce its tax payments globally, circumvent currency controls and other regulations, and tap previously inaccessible investment and financing opportunities. 3. California, like several other states, applies the unitary method of taxation to firms doing business within the state. Under the unitary method a state determines the tax on a company’s worldwide profit through a formula based on the share of the company’s sales, assets, and payroll falling within the state. In California’s case, the share of worldwide profit taxed is calculated as the average of these three factors. 3.a. What are the predictable corporate responses to the unitary tax? ANSWER. Aside from lobbying against such a tax, firms can be expected to modify their business activities in such a way as to reduce the incidence of the unitary tax. In California, for example, this would mean moving assets and employees out of the state and using transfer prices to lower the value of reported in-state sales. 3.b. What economic motives might help explain why Oregon, Florida, and several other states have eliminated their unitary tax schemes? ANSWER. These states were losing a lot of new investment, because any firm that increased its in-state assets was assessed a higher unitary tax. By eliminating unitary taxes, these states were able to better compete for new investments with states that do not impose a unitary tax.

CHAPTER 16: MANAGING THE MULTINATIONAL FINANCIAL SYSTEM

4. In comparisons of a multinational firm’s reported foreign profits with domestic profits, caution must be exercised. This same caution must also be applied when analyzing the reported profits of the firm’s various subsidiaries. Only coincidentally will these reported profits correspond to actual profits. 4.a. Describe five different means that MNCs use to manipulate reported profitability among their various units. ANSWER. MNCs can manipulate reported profit by adjusting transfer prices of goods, fees and royalties linked to patents, trademarks, and management assistance, allocated overhead, and interest rates on interaffiliate debt. The parent can also adjust the amount of equity it invests and, hence, the amount of debt and interest payments the unit must bear. 4.b. What adjustments to its reported figures would be required to compute the true profitability of a firm’s foreign operations so as to account for these distortions? ANSWER. “True profitability” is an amorphous concept, but basically it involves determining the marginal revenue and marginal costs associated with the unit. In effect, it is necessary to determine worldwide cash flows with the unit less worldwide cash flows without the unit. This involves adding back allocated corporate overhead in excess of the amount attributable to managing the unit, adjusting transfer prices to reflect marginal costs, and adding back fees and royalties on patents and trademarks that would otherwise go unused. 4.c.

Describe at least three reasons that might explain some of these manipulations.

ANSWER. Firms manipulate transfer prices on goods and services in order to reduce total tax and tariff payments, to get around currency controls, and to access lower cost sources of funds. 5. It has been found that U.S.-controlled companies, on the average, earned higher returns on their assets as compared to their foreign-controlled counterparts. A number of American politicians have used these figures to argue that there is widespread tax cheating by foreignowned multinationals. 5.a. What are some economically plausible reasons (other than tax evasion) that would explain the low rates of return earned by foreign-owned companies in the U.S.? Consider the consequences of the debt-financed U.S. investments made by foreign companies as well as the depreciation of the U.S. dollar. ANSWER. Buying binge in the U.S. meant big interest payments on acquisition debt and huge depreciation write-offs for newly acquired plant and equipment. Both depressed the bottom line, lowering tax liability. Many foreign companies have also spent millions building factories in the U.S., and that generates even more write-offs and lowers the reported return on assets. In addition, new investment usually involves high start-up costs, lowering initial returns as well. Moreover, historical-cost accounting means that the book value of older (mostly American) assets is often far below market value. So returns on these assets appear higher than those on newer, foreign investment. The devaluation of the dollar also raised the dollar cost of components imported into the U.S.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

5.b. Could the differences in returns be attributed to the risks faced by U.S.-controlled companies outside of the U.S. and the foreign-controlled companies operating in the U.S.? Explain. ANSWER. They can raise transfer prices on goods and services supplied to their U.S. affiliates and lower them on goods and services exported to their non-U.S. units. They can also force their U.S. affiliates to have more debt in their capital structures to gain the interest tax shield. 5.c.

A study reveals that a majority of foreign-controlled companies in the U.S. started their U.S. operations only during the late-1980s, while U.S.-controlled companies had been operating abroad for decades before that. Could the difference in returns be explained by experience? If not, why not? ADDITIONAL CHAPTER 16 QUESTIONS AND ANSWERS

1. In what aspect of an MNC’s multinational financial system does its value reside? ANSWER. The multinational financial system enables the MNC to engage in tax arbitrage, financial market arbitrage, and regulatory system arbitrage. 2. Under what circumstances is leading and lagging likely to be of most value? ANSWER. Leading and lagging has minimal impact on taxes and is of little value in currency risk management since companies can hedge their exchange risk in other ways. Expropriation risk can be managed, if need be, by shifting assets out of the country. The major value of leading and lagging is to enable firms to elude exchange and capital controls. 3. What are the principal advantages of investing in foreign affiliates in the form of debt instead of equity? ANSWER. By investing in the form of debt rather than equity, companies may be able to reduce their taxes (because principal repayments are treated as a return of capital and are not taxed) and to avoid currency controls (because governments are more reluctant to block loan repayments, even to a parent, than dividend payments). SUGGESTED SOLUTIONS TO CHAPTER 16 PROBLEMS 1. Suppose Navistar’s Canadian subsidiary sells 1,500 trucks monthly to the French affiliate at a transfer price of $27,000 per unit. The Canadian and French marginal tax rates on corporate income are assumed to equal 45% and 50%, respectively. 1.a. Suppose the transfer price can be set at any level between $25,000 and $30,000. At what transfer price will corporate taxes paid be minimized? Explain. ANSWER. Switching from a transfer price of $27,000 to a new transfer price P will lead to a monthly tax savings of 1,500(27,000 - P)(0.45 - 0.50). Tax savings are maximized when P is set equal to $30,000. In effect, the firm will be shifting profits from France, where they are taxed at 50%, to Canada, where they are taxed at 45%.

CHAPTER 16: MANAGING THE MULTINATIONAL FINANCIAL SYSTEM

1.b. Suppose the French government imposes an ad valorem tariff of 15% on imported tractors. How would this affect the optimal transfer pricing strategy? ANSWER. If the ad valorem tariff is paid by the French affiliate and is tax deductible, a change in the transfer price from $27,000 to P will lead to monthly tax savings of 1,500(27,000 - P)[.45 + .15 .50(1.15)] = 1,500(27,000 - P)(.025). In order to maximize the tax savings, P should now be set at its minimum level of $25,000. 1.c.

If the transfer price of $27,000 is set in euros and the euro revalues by 5%, what will happen to the firm’s overall tax bill? Consider the tax consequences both with and without the 15% tariff.

ANSWER. A 5% euro revaluation will increase the dollar value of the transfer price to $28,350. In the absence of a tariff, total taxes paid monthly will decline by 1,500(27,000 - 28,350)(0.45 - 0.50) = $101,250. With a 15% tariff, monthly taxes will increase by 1,500(28,350 - 27,000)[.45 + .15 - .50(1.15)] = $50,625. 1.d. Suppose the transfer price is increased from $27,000 to $30,000 and credit terms are extended from 90 days to 180 days. What are the fund-flow implications of these adjustments? ANSWER. Ignoring taxes, the month-by-month cash flows from the French affiliate to the Canadian affiliate before and after the changes in the transfer price and credit terms are: Cash Flow/Month ($ million)

New Original

0 40.5

40.5 40.5

45.0 40.5

Net change Cumulative change

-40.5 -40.5

-40.5 -81.0

-40.5 -121.5

0 -121.5

4.5 -117.0

These calculations assume that the new credit terms will be applied retroactively to previous credit sales. 2. Suppose a U.S. parent owes $5 million to its English affiliate. The timing of this payment can be changed by up to 90 days in either direction. Assume the following effective annualized after-tax dollar borrowing and lending rates in England and the U.S.

United States England

Lending (%)

Borrowing (%)

4.0 3.6

3.2 3.0

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

2.a. If the U.S. parent is borrowing funds while the English affiliate has excess funds, should the parent speed up or slow down its payment to England? ANSWER. Under the circumstances, the parent’s opportunity cost of funds is 3.2%, whereas the British unit’s opportunity cost of funds is 3.6%. Since the British unit has the higher opportunity cost of funds, the U.S. parent should speed up its $5 million payment by 90 days. 2.b. What is the net effect of the optimal payment activities in terms of changing the units’ borrowing costs and/or interest income? ANSWER. The U.S. parent will borrow an additional $5 million for 90 days, adding $5,000,000 * 0.032 * 0.25 = $40,000 to its interest expense. At the same time, the British unit will invest an additional $5 million for 90 days, raising its interest income by $5,000,000 * 0.036 * 0.25 = $45,000. The net effect is to raise consolidated income by $5,000. 3. Suppose that DMR SA, located in Switzerland, sells $1 million worth of goods monthly to its affiliate DMR Gmbh, located in Germany. These sales are based on a unit transfer price of $100. Suppose the transfer price is raised to $130 at the same time that credit terms are lengthened from the current 30 days to 60 days. 3.a. What is the net impact on cash flow for the first 90 days? Assume that the new credit terms apply only to new sales already booked but uncollected. ANSWER. This problem can best be worked by examining cash flows under the new setup and then subtracting cash flows under the old setup. Note that by changing credit terms to 60 days from 90 days, goods shipped in the first month are not paid for until the third month. The net effect during the first 90 days of simultaneously switching credit terms and changing the transfer price is to shift $700,000 from the Swiss affiliate to the German affiliate. This can be seen in the following exhibit, which traces out the cash flow effects of these changes. Cash Inflows for Swiss Unit and Cash Outflows for German Unit Month

New Terms Old Terms

$1,000,000 1,000,000

0 1,000,000

$1,300,000 1,000,000

Change Cumulative

0 0

-$1,000,000 -$1,000,000

+$300,000 -$700,000

3.b. Assume the tax rate is 25% in Switzerland and 50% in Germany and that revenues are taxed and costs deducted upon sale or purchase of goods, not upon collection. What is the impact on after-tax cash flows for the first 90 days? ANSWER. This problem is more complex because the tax effects occur prior to settling interaffiliate accounts with cash. The Swiss unit’s taxes are now $325,000/month (0.25 * $1,300,000) as compared with $250,000 previously, while the German unit’s monthly tax write-off has risen to $650,000 (0.5 * $1,300,000) as compared to $500,000 before.

CHAPTER 16: MANAGING THE MULTINATIONAL FINANCIAL SYSTEM

Cash Flows for Swiss Affiliate Month New Terms Collection of receivables Tax payments

1 $100,000 -325,000

2 0 -325,000

3 $1,300,000 -325,000

Net cash inflow

$675,000

-$325,000

$975,000

Old terms Collection of receivables Tax payments

1,000,000 -250,000

Net cash inflow

$750,000

Change in net cash inflow Cumulative change

-$75,000 -$75,000

-$1,075,000 -$1,150,000

$225,000 -$925,000

1 $1,000,000 -650,000

2 0 -650,000

3 $1,300,000 -650,000

$350,000

-$650,000

$650,000

$1,000,000 -500,000

Net cash outflow

$500,000

Change in net cash outflow Cumulative change

-$150,000 -$150,000

-$1,150,000 -$1,300,000

$150,000 -$1,150,000

Cash Flows for German Affiliate Month New Terms Payment of payables Value of tax write-offs Net cash outflow Old terms Payment of payables Value of tax write-offs

The net result of the simultaneous change in credit terms and transfer price is that for the first 90 days the Swiss unit’s after-tax cash inflow drops by $925,000 and the German unit’s after-tax cash outflow falls by $1,150,000. The $225,000 gain in net cash flow is attributable to the change in transfer price which leads to a shift of $300,000 in reported monthly income from Germany to Switzerland, or a shift of $900,000 over the first 90 days. Because income in Switzerland is taxed at a rate of 25%, while German income is taxed at 50%, the net effect of this income shift for the first three months is to save an amount of taxes equal to $900,000 * (0.50 - 0.25) = $225,000.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

4. Suppose a firm earns $1 million before tax in Spain. It pays Spanish tax of $0.52 million and remits the remaining $0.48 million as a dividend to its U.S. parent. Under current U.S. tax law, how much U.S. tax will the parent owe on this dividend? ANSWER. Under current U.S. tax law, the firm’s U.S. tax owed on the dividend is calculated as follows: Dividend Spanish tax paid Included in U.S. taxable income U.S. tax @ 35% Less: U.S. indirect tax credit Net U.S. tax owed

$480,000 520,000 $1,000,000 350,000 520,000 ($170,000)

As a result of paying Spanish tax at a rate that exceeds the U.S. tax rate of 35%, the company receives a $170,000 FTC that can be used to offset U.S. taxes owed on other foreign source income. 5. Suppose a French affiliate repatriates as dividends all the after-tax profits it earns. If the French income tax rate is 50% and the dividend withholding tax is 10%, what is the effective tax rate on the French affiliate’s before-tax profits, from the standpoint of its U.S. parent? ANSWER. Assume the French affiliate earns $1 million before tax. It then pays $500,000 in French income tax and remits the remaining $500,000 as a dividend to its U.S. parent. Only $450,000 gets through because of the 10% French dividend withholding tax. It appears as if the effective tax rate on this affiliate’s earnings from the parent’s standpoint is 55%. However, the parent will receive a foreign tax credit of $210,000, the difference between the $550,000 total tax payments to the French government and the $340,000 in U.S. tax owed on the $1 million in pre-tax earnings. If the full FTC can be used, then the parent’s effective tax rate declines to 34%. If the FTC is unusable, the parent’s effective tax rate on the affiliate’s earnings is 55%. If part, but not all, of the tax credit is usable, the parent’s effective tax rate on its French unit’s earnings will lie between 34% and 55%. The higher the fraction of the FTC that is usable, the lower the parent’s effective tax rate. ADDITIONAL CHAPTER 16 PROBLEMS AND SOLUTIONS 1. Suppose that covered after-tax lending and borrowing rates for three units of Eastman Kodak--located in the U.S., France, and Germany--are:

United States France Germany

Lending (%)

Borrowing (%)

3.1 3.0 3.2

3.9 4.2 4.4

Currently, the French and German units owe $2 million and $3 million, respectively, to their U.S. parent. The German unit also has $1 million in payables outstanding to its French affiliate. The timing of these payments can be changed by up to 90 days in either direction. Assume that Kodak U.S. is borrowing funds while both the French and German subsidiaries have excess cash available.

CHAPTER 16: MANAGING THE MULTINATIONAL FINANCIAL SYSTEM

1.a. What is Kodak’s optimal leading and lagging strategy? ANSWER. The following matrix of effective after-tax dollar interest rate differentials, which is based on the covered rates presented in the problem, can be used to determine the value of leading and lagging for Kodak. The countries on the top of the matrix are those which receive payment from the countries listed on the left. Each subsidiary column is subdivided into “L” and “B.”" The L column is applicable if the unit has excess funds which it can invest in the local money market. The B column is applicable if the subsidiary is currently borrowing on the local money market or would have to borrow in order to pay an intercompany account. Receiving Units U.S. Paying Units

France B

U.S.

L B

France

L B

0.1 -1.1

0.9 -0.3

Germany

L B

-0.1 -1.2

0.7 -0.5

Germany

-0.1 -0.9

1.1 0.3

0.1 -0.7

1.3 0.5

0.2 -1.0

1.4 0.2

-0.2 -1.4

1.0 -0.2

The entries refer to the dollar interest differentials that exist between each pair of affiliates given their current liquidity status. If this interest differential is positive, Kodak as a whole, by leading payments between the respective units, will either pay less on its borrowings or earn more interest on its investments. Lagging will be worthwhile if the interest differential is negative. According to the prevailing interest differentials, both subs should speed up their payments to the parent while the German unit should lag its payments to the French firm. 1.b. What is the net profit impact of these adjustments? ANSWER. The net effect of these adjustments is that Kodak U.S. reduces its borrowings by $5,000,000, the German unit has $2,000,000 less in cash, and the French affiliate winds up with a decrease in its cash balances of $3,000,000, all for 90 days. U.S. interest expense is pared by $48,750 ($5,000,000 * 0.039 * 90/360) while German and French interest income are reduced by $16,000 ($2,000,000 * 0.032 * 90/360) and $22,500 ($3,000,000 * 0.03 * 90/360), respectively, for a net savings of $10,250. This savings can be computed more directly by taking the interest differentials from the appropriate cells of the matrix. These differentials (in %) are: -0.9 (France “L” - U.S. “B”); -0.7 (Germany “L” - U.S. “B”); and -0.2 (Germany “L” - France “L”). Net interest saved equals 0.25[0.009($2,000,000) + 0.007($3,000,000) + 0.002($1,000,000)] = $10,250. Moreover, for each additional 90 days that this new payment schedule exists, net interest savings worldwide will be $10,250.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

1.c. How would Kodak’s optimal strategy and associated benefits change if the U.S. parent has excess cash available? ANSWER. If Kodak U.S. has excess cash, then the prevailing interest differentials indicate that the French affiliate should lag its payments to both the U.S. and French units. The higher interest earnings associated with this strategy can be calculated directly using the interest differentials taken from the matrix in part a). These differentials are: 0.1(U.S. L - France L); .1(Germany L - U.S. L); and 0.2(Germany L - France L). Net additional interest earnings then are 0.25[.001($2,000,000) + 0.001($3,000,000) + 0.002($1,000,000)] = $1,750. 2. Suppose that in the section titled Dividends, International Products has $500,000 in excess foreign tax credits available. How will this situation affect its dividend remittance decision? ANSWER. Even if IP has $500,000 in excess foreign tax credits available, the company should still pay dividends out of its German affiliate. Since the French tax rate exceeds 46%, IP does not pay U.S. tax on dividends from France. Hence, paying dividends out of France does not save any U.S. taxes. If the dividend is paid by the Irish affiliate, IP saves $460,000 in tax, cutting worldwide taxes to $2,020,000. But this still exceeds worldwide taxes of $1,910,000 if the dividend is paid by the German affiliate. 3. Suppose affiliate A sells 10,000 chips monthly to affiliate B at a unit price of $15. Affiliate A’s tax rate is 45%, and affiliate B’s tax rate is 55%. In addition, affiliate B must pay an ad valorem tariff of 12% on its imports. If the transfer price on chips can be set anywhere between $11 and $18, how much can the total monthly cash flow of A and B be increased by switching to the optimal transfer price? ANSWER. For each $1 increase in income shifted from B to A, A’s taxes rise by $0.45. At the same time, B owes an extra $0.12 in tariffs. The before-tax increase of $1.12 in B’s cost gives it a tax write-off worth $1.12 * 0.55 = $0.616. By shifting $1 in income from B to A, the effect is to lower B’s tax payments by $0.616 and raise its tariffs by $0.12, a net decrease in tax plus tariff payments of $0.496. The net effect of switching $1 in income from B to A is to lower tax plus tariff payments to the world by $0.496 - 0.45 = $0.046. Thus, the transfer price should be set as high as possible in order to shift as much income to A from B as possible. The new transfer price should, therefore, be set at $18, a $3 increase over the old transfer price. The resulting increase in monthly cash flow is $.046 * 3 * 10,000 = $1,380. 4. Suppose GM France sells goods worth $2 million monthly to GM Denmark on 60-day credit terms. A switch in credit terms to 90 days will involve a one-time shift of how much money between the two affiliates? ANSWER. Under the old 60-day terms, GM France is carrying two month’s worth of sales as receivables or $4 million. By switching credit terms to 90 days, GM France will now carry receivables equal to three month’s worth of sales or $6 million. The net result is a transfer of $2 million from GM France to GM Denmark.

CHAPTER 16: MANAGING THE MULTINATIONAL FINANCIAL SYSTEM

5. Merck Mexicana SA, the wholly owned affiliate of the U.S. pharmaceutical firm, is considering alternative financing packages for its increased working capital needs resulting from growing market penetration. Ps 250 million are needed over the next six months and can be financed as follows: ▪

From the Mexican banking system at the semiannual rate of 50%.

▪

From the U.S. parent company at the semiannual rate of 6%.

The parent company loan would be denominated in dollars and would have to be repaid through the floating-exchange-rate tier of the Mexican exchange market. The exchange loss would, thus, be fully incurred by the Mexican subsidiary. The exchange rate as of March 1, 1984, was Ps 250 = $1 and widely expected to depreciate further. 5.a. If interest payments can be made through the stabilized tier of the Mexican exchange market where the dollar is worth Ps 125, what is the break-even exchange rate on the floating tier that would make Merck Mexicana indifferent between dollar and peso financing? ANSWER. If it borrows pesos from the Mexican bank at a 180-day interest rate of 50%, Merck Mexicana will owe before-tax dollar principal plus interest payments in 180 days equal to 250,000,000(1 + 0.50) * e180 = 375,000,000e180 where e180 is the (unknown) spot rate in 180 days. Alternatively, if Merck Mexicana uses dollar financing, it would need to borrow $1 million (the dollar equivalent of Ps 250 million at the current exchange rate of Ps 250 = $1). At a semesterly rate of 6%, the total dollar interest plus principal payments owed in 180 days would be $1,000,000 + 125,000,000 * e180 = $1,000,000 + 7,500,000e180 The latter term reflects the fact that interest payments can be made at an exchange rate of Ps 125 to the dollar or a total of Ps 125,000,000 * 0.06 in peso interest payments on a loan of $1 million at 6% interest. The breakeven exchange rate – the rate at which the dollar cost of peso financing just equals the dollar cost of dollar financing – can be found by setting the two costs equal: 375,000,000e180 = 1,000,000 + 7,500,000e180 The solution is Ps 1 = $0.00272 or Ps 367.50 = $1.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

5.b. Merck Mexicana imports from its U.S. parent $500,000 worth of chemical compounds monthly, payable on a 90-day basis. Suppose that the parent adjusts its transfer prices so that Merck Mexicana must now pay $700,000 monthly for its chemical supplies. All payments for imports of chemicals involved in the manufacture of pharmaceuticals are transacted through the stabilized tier of the exchange market. At the current exchange rate of Ps 250 = $1, what is the net before-tax annual benefit to Merck of this transfer price increase? ANSWER. Because the importation of chemical compounds is carried out through the subsidized tier (i.e., at Ps 125 per dollar) Merck could lend in pesos rather than dollars but charge its subsidiary for the principal loss by setting a higher dollar transfer price. The parent would break even and the subsidiary would effectively pay for the principal loss through the subsidized exchange rate. In effect, Merck Mexicana would be paying back part of the principal at an exchange rate of Ps125 per dollar instead of the market rate, which will be at least Ps 250 = $1. If the dollar appreciates to Ps 300 = $1 from Ps 250 = $1, the dollar principal loss on a $1 million peso-denominated parent loan is $1,000,000 - 250,000,000/300 = $166,667 The term 250,000,000/300 is the peso equivalent of $1 million at an exchange rate of Ps 250 = $1 converted at an end-of-period exchange rate of Ps 300 = $1. To make up the loss on principal repayment, the subsidiary would have to pay $166,667 extra to the parent. At an exchange rate of Ps 125 = $1, this translates into added payments to the parent of Ps 20,833,334 through higher transfer prices. If the loss is to be made up over a period of six months, this means that transfer prices would have to be raised such that monthly imports go up by one-sixth of this amount or Ps 20,830,000/6 = Ps 3,472,223. With current monthly imports of Ps 100 million, this requires a transfer price increase of about 3.47%. 6. A well-known U.S. firm has a reinvoicing center (RC) located in Geneva. The reinvoicing center handles an annual sales volume of $1.2 billion – $700 million in interaffiliate sales and the rest in third-party sales. The RC buys goods manufactured by the parent company or other subsidiaries and reinvoices the product to other affiliates or third parties. Many of these trades are with “low-volume, highly complex countries.” When buying the goods, the RC takes title to them, but it does not take actual possession of the goods. The RC pays the selling company in its own currency and receives payment from the purchasing company in its own currency. What benefits can such a center provide? ANSWER. The reinvoicing center can provide several benefits to its parent company. It can: a) b) c) d) e) f) g) h) i)

Shift liquidity from surplus to deficit affiliates; Centralize management of transaction exposure; Reduce taxes by transfer price adjustments; Assure consistent pricing to customers placing orders with more than one unit; Net intercompany transfers; Take advantage of economies of scale in financing and investing; Concentrate trading expertise; Reduce FX trading costs by dealing in larger volumes; Centralize control over finance functions.

CHAPTER 16: MANAGING THE MULTINATIONAL FINANCIAL SYSTEM

NOTES ON INTERAFFILIATE TRANSACTIONS 1. Overview a) Mode of transfer b) Timing flexibility 2. Transfer pricing a) Tax effects A sells 100,000 circuit boards annually to B at a unit price of $10. Changing the transfer price to $10.50 will simultaneously increase A’s income by $50,000 and decrease B’s income by $50,000. If corporate tax rates for A and B are 35% and 50%, respectively, the net effect will be to increase A’s taxes by $17,500 and reduce B’s taxes by $50,000. Net tax savings are $7,500 annually. b) Section 482 i.

What it is

ii. Its consequences for setting transfer prices c) Shifting funds The above transfer price change will increase A’s after-tax cash flow by $32,500 and reduce B’s after-tax cash flow by $25,000. 3. Invoicing currency a) Importer’s currency i.

No exposure or tax effects for importer

ii. Exporter bears the currency exposure and tax effects b) Exporter’s currency i.

No exposure or tax effects for exporter

ii. Importer bears the currency exposure and tax effects 4. Leads and lags a) Shifting liquidity b) Costs and benefits i. Take advantage of interest differentials Borrowing Rate Lending Rate United States Germany

8.7% 8.1%

7.6% 7.2%

U.S. interest rate - German interest rate for surplus (+) and deficit (-) positions.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

Germany +

+ .4%

- .5%

1.5%

.6%

U.S.

ii. Avoid currency controls iii. Exposure management c) Information requirements i.

intercompany payables and receivables

ii. exchange control regulations iii. relevant tax laws iv. affiliate liquidity positions and fund requirements v. sources and availability of funds to each party vi. expected currency changes vii. forward exchange rates viii. currency exposures 5. Dividend planning a) Tax considerations b) Cash requirements c) Currency controls d) Corporate practice 6. Global tax planning a) U.S. taxation of foreign source income i.

Branches versus subsidiaries

ii. Foreign tax credits iii. Subpart F income iv. FSCs b) Information requirements i.

Tax rates by affiliate

ii. Cross-border tax rates iii. Liquidity by affiliate iv. Tax credits

CHAPTER 16: MANAGING THE MULTINATIONAL FINANCIAL SYSTEM

c) Information requirements i.

Intercompany payables and receivables

ii. Exchange control regulations iii. Relevant tax laws iv. Affiliate liquidity positions and fund requirements v. Sources and availability of funds to each party vi. Expected currency changes vii. Forward exchange rates viii. Currency exposures

Chapter 1

Introduction: Multinational Enterprise and Multinational Financial Management

Chapter 1 Outline A. Catalysts for Globalization B. Implications of Globalization for Businesses C. Consequences of Globalization D. Multinational Corporations

E. Rational for Multinational Corporations F. Process of Overseas Expansion by Multinationals G. Appendix

Chapter 1: Introduction: Multinational Enterprise and Multinational Financial Management

1.A Catalysts for Globalization ❑

Massive deregulation

❑

Collapse of Communism

❑

Worldwide sale of state-owned firms in privatizations

❑

Revolution in information technologies

❑

Rise in the market for corporate control

❑

Replacement of statist policies by free-market policies in many Third-World economies

Chapter 1: Introduction: Multinational Enterprise and Multinational Financial Management

1.B Implications of Globalization for Businesses ❑

Companies must be able to quickly adapt their policies to respond to new global market opportunities and challenges.

❑

The international mobility of capital has provided more financial options while simultaneously increasing complexity.

❑

Global managers need in-depth knowledge of their operations. – How their products are made

– Their supply chain, alternatives – Where the funds come from – How their changing relative values affect the bottom line. ❑

Global managers must understand the political and economic choices facing key nations and how those choices affect the outcomes of their decisions.

Chapter 1: Introduction: Multinational Enterprise and Multinational Financial Management

1.C Consequences of Globalization ❑

The global rationalization of production is driven by global competition.

❑

Free trade allocates resources to their highest valued use.

❑

Globalization fosters creative destruction – continuous change-out with the old, in with the new; i.e.: – Some industries advance, others recede; – Jobs are gained and lost; – Businesses boom and go bust; and – Some workers must change jobs and occupations.

❑

Consumers benefit from lower prices and expanded choices.

❑

Globalization enables nations to get richer together (i.e., expands the economic pie for all parties).

Chapter 1: Introduction: Multinational Enterprise and Multinational Financial Management

1.D Multinational Corporations ❑

Multinational corporations (MNCs) produce and sell goods or services in more than one country.

❑

MNCs emphasize group performance over performance of individual parts. MNC Home Country

Foreign Subsidiary 1

Foreign Subsidiary 2

Foreign Subsidiary 3

Foreign Subsidiary 4

Foreign Subsidiary 5

. . .

High degree of strategic interaction

❑

What differentiates MNCs from other firms engaged in international business is the globally coordinated allocation of resources by a single centralized management.

Chapter 1: Introduction: Multinational Enterprise and Multinational Financial Management

1.E Rationale for MNCs (1) ❑

The classical theory of international trade based on comparative advantage states that – Each nation should specialize in the production and export of those goods it can produce with the highest relative efficiency and import those goods that other nations can produce relatively more efficiently; and – Goods and services can move internationally but factors of production, i.e., land, labor, and capital, are relatively immobile.

❑

This theory is becoming increasingly irrelevant as differences among corporations are becoming more important than aggregate differences among countries and countries move their factors of production more rapidly in search of higher returns.

Chapter 1: Introduction: Multinational Enterprise and Multinational Financial Management

1.E Rationale for MNCs (2) ❑

The role of natural resources has diminished in national specialization as advanced, knowledge-based societies move rapidly toward artificial materials and genetic engineering.

❑

Capital moves instantaneously around the world.

❑

Labor skills are no longer fundamentally different – i.e., many foreign students attend American universities.

❑

Technology and know-how are rapidly becoming a global pool.

❑

The ability of MNCs to use these globally available factors of production fosters international competitiveness to a far greater degree than macroeconomic differences among countries.

Chapter 1: Introduction: Multinational Enterprise and Multinational Financial Management

1.E Rationale for MNCs (3) ❑

Search for raw materials – MNCs aim to exploit raw materials found in foreign countries.

❑

Market Seeking – MNCs’ firm-specific advantages can be profitably applied to foreign markets. • Products/processes • Technologies • Patents • Specific rights, knowledge, and skills – Exploitation of foreign markets may be possible at considerably lower costs. – Foreign markets provide opportunities for MNCs to achieve economies of scale and exploit premiums associated with strong brand names.

Chapter 1: Introduction: Multinational Enterprise and Multinational Financial Management

1.E Rationale for MNCs (4) ❑

Cost Minimization. Costs can be minimized by combining production shifts with rationalization and integration of the firm’s global manufacturing facilities; i.e., plants specialize in different stages of production.

❑

Knowledge Seeking. Some firms enter foreign markets to gain information and experience to use in other markets.

❑

Keeping Domestic Customers. MNC suppliers follow customers abroad to guarantee them a continuing product flow and reduce the risk that their customers will find an alternative local supplier.

❑

Exploiting Financial Market Imperfections. Operating in numerous countries with different economic cycles reduces systematic risk and risk relating to exchange rate fluctuations, currency controls, expropriation, and other foreign government interventions (“diversification effect”).

Chapter 1: Introduction: Multinational Enterprise and Multinational Financial Management

1.F Process of Overseas Expansion by MNCs (1) ❑

Firms become MNCs by degree – globalization does not initially occur through conscious design but is the inevitable outcome of the competitive pressures in oligopolistic industries.

❑

Typical sequence of transitioning from a domestic firm to an MNC 1. Exporting

2. Setting up a foreign sales subsidiary 3. Securing license agreements 4. Establishing foreign production ❑

Each sequence enables firms to move from a low-risk, low-return export strategy to a higher-risk, higher-return strategy emphasizing international production.

Chapter 1: Introduction: Multinational Enterprise and Multinational Financial Management

1.F Process of Overseas Expansion by MNCs (2) 1. Exporting – Advantages • Low capital requirements and start-up costs • Low risk • Immediate profits

• Firms learn about present and future market conditions, local competition, distribution channels, payment conventions, financial institutions, and financial techniques. – Disadvantages • Inability to realize full sales potential – As increased communication with customers reduces uncertainty, the firm might establish its own sales subsidiary.

Chapter 1: Introduction: Multinational Enterprise and Multinational Financial Management

1.F Process of Overseas Expansion by MNCs (3) 2. Overseas Production – Advantages • Keep abreast of market conditions and adapt products to changing local tastes and conditions • Faster order fulfillment • Ability to provide more comprehensive after-sales service • Conveys commitment to local market • Ensures certainty of supply – Key Decision – Create own affiliate or acquire going concern • Acquisition: Speedy transfer of parent skills, ready-made marketing network, and local market/technology knowledge; but may be more costly than creating affiliate. – Generally, the larger and more experienced the firm, the less it relies on acquisitions.

Chapter 1: Introduction: Multinational Enterprise and Multinational Financial Management

1.F Process of Overseas Expansion by MNCs (4) 3.

Licensing – alternative or precursor to overseas production – Advantages • Minimal investment • Faster market-entry time • Fewer financial and legal risks – Disadvantages • Cash flow relatively low • Risk of product quality problems

• Difficulty controlling exports by the licensee; licensee may become a competitor

Chapter 1: Introduction: Multinational Enterprise and Multinational Financial Management

1.F Process of Overseas Expansion by MNCs (5) ❑

General circumstances that drive selection of mode of overseas expansion – If MNC’s intangible capital • Can be incorporated into standardized products: Export • Is a product/process technology that can be codified: License • Is organizational capital that is not easily separable from the firm: Establish overseas production IF the benefits of circumventing market imperfections outweigh the costs of central control. – Types of overseas investment

• Vertical integration • Horizontal integration

Chapter 1: Introduction: Multinational Enterprise and Multinational Financial Management

1.G Appendix (1) ❑

Origins and consequences of international trade – Theory of absolute advantage •

Goods and services are commodities

•

Factors of production cannot move freely across borders

•

Ignores roles of uncertainty, economies of scale, and technology

•

Is static model

– Example using production schedule Commodity Produced (units of production required per ton) Country

Wheat

Coal

U.S.

2 units

1 unit

U.K.

3 units

4 units U.S. has an absolute advantage in producing both wheat and coal

Chapter 1: Introduction: Multinational Enterprise and Multinational Financial Management

1.G Appendix (2) ❑

Origins and consequences of international trade, continued – Theory of comparative advantage •

A country has a comparative advantage in producing the commodity that it has less of an absolute disadvantage in producing.

– Example using production schedule with inverted values reflecting output per unit of production Commodity Produced (tons produced per unit of production)

Country

Wheat

Coal

U.S.

2 units/ton = 0.5 tons/unit

1 unit/ton = 1 ton/unit

U.K.

3 units/ton = 0.33 tons/unit

4 units/ton = 0.25 tons/unit

U.K. has an absolute disadvantage in producing both wheat and coal but a comparative advantage in producing wheat

Chapter 1: Introduction: Multinational Enterprise and Multinational Financial Management

1.G Appendix (3) ❑

Gains from trade using comparative advantage – Profitability of producing each commodity is determined by determining exchange rate, or terms of trade, between wheat and coal in the U.S. and U.K. Commodity Produced (tons produced per unit of production) Country

Wheat

Coal

U.S.

0.5 tons/unit

1 ton/unit

U.K.

0.33 tons/unit

0.25 tons/unit

U.S.: 1 ton wheat = 1 / 0.5 = 2 tons coal

U.K.: 1 ton wheat = 0.25 / 0.33 = 0.75 tons coal

– The U.S. can produce coal more productively and trade with the U.K. for wheat. – The U.K can consume more coal than if it mined its own. Chapter 1: Introduction: Multinational Enterprise and Multinational Financial Management

1.G Appendix (4) ❑

Specialized factors of production – Assuming factors of production are specialized •

Prices of specialized factors used to produce exported goods will increase in home country as demand for exported goods increases.

•

Prices of specialized factors used to produce imported goods will decrease in home country as demand for imported goods increases.

– Computing gains to specialized factors •

Let terms of trade be 1 ton of wheat = 1.95 tons of coal

•

Gains for U.S. in producing coal and trading for wheat – The U.S. can consume 1 / 1.95 = 0.5128 tons of wheat per ton of coal

– The U.S. can produce 0.50 tons of wheat per ton of coal – Gain = (0.5128 / 0.50) - 1 = 2.5% more wheat than if it produced wheat itself

•

Gains for U.K. in producing wheat and trading for coal – The U.K. can consume 1.95 tons of coal per ton of wheat – The U.K. can produce 0.75 tons of coal per ton of wheat

– Gain = (1.95 / 0.75) - 1 = 160% more coal than if it produced coal itself Chapter 1: Introduction: Multinational Enterprise and Multinational Financial Management

1.G Appendix (5) ❑

Specialized factors of production, continued – The greater the gains from trade overall, the greater the cost of trade to those factors of production that specialize in producing the imported commodity. – Thus, losses for factors of production producing coal in the U.K. will be greater than losses for factors of production producing wheat in the U.S. – Computing losses to specialized factors, if countries continue to produce goods for which they have a comparative disadvantage •

Losses for U.S. in producing wheat: Using specialized factors of production to produce wheat will cause a 2.5% loss of income because the wheat produced buys 2.5% less coal ([1.95 tons / 2 tons] – 1).

•

Losses for U.K. in producing coal: Using specialized factors of production to produce coal will cause a 62% loss of income; wheat purchasing power was 1.33 (4 / 3) tons of coal and is now 0.5128 (1 / 1.95) tons of coal. Change in purchasing power is (0.5128 – 1.33) / 1.33 = -62%.

Chapter 1: Introduction: Multinational Enterprise and Multinational Financial Management

1.G Appendix (6) ❑

Monetary prices and exchange rates – Substituting unit prices for units of production in the preceding example and assuming each production unit costs $30 in the U.S. and £10 in the U.K.: Commodity Produced (price/ton) Country

Wheat

Coal

U.S.

2 units/ton * $30 = $60

1 unit/ton * $30 = $30

U.K.

3 units/ton * £10 = £30

4 units/ton * £10 = £40

– If the exchange rate is £1 = $3, then dollar-equivalent prices are: Commodity Produced (price/ton) Country

Wheat

Coal

U.S.

$60 * 1 = $60

$30 * 1 = $30

U.K.

$30 * 3 = $90

$40 * 3 = $120

Chapter 1: Introduction: Multinational Enterprise and Multinational Financial Management

1.G Appendix (7) ❑

Monetary prices and exchange rates, continued – At dollar-equivalent prices, U.K. will demand both wheat and coal, and the U.S. will demand no U.K. goods. – Result: trade deficit for U.K. and trade surplus for U.S. – Absent government intervention: •

U.K. demand for dollars increases value of dollar;

•

U.S. goods become more expensive to U.K.; U.K. goods become less expensive to U.S.;

•

Simultaneously, increased demand for U.S. factors raises factor prices and causes inflation;

•

Decreased demand for U.K. factors decreases factor prices and prices of wheat and coal; and

•

U.K. goods become more attractive to consumers.

– Process continues until terms of trade are equal.

Chapter 1: Introduction: Multinational Enterprise and Multinational Financial Management

1.G Appendix (8) ❑

Tariffs – Distort prices and reduce the quantity of goods traded. –

E.g., effects of a $0.15/pound tariff of Mexican tomatoes S1

S2 So

PTariff = $0.45 PFinal = $0.35 P0= $0.30

QTariff Q QFinal0

–

Mexican farmers must charge $0.45 to maintain their profit margin.

–

American consumers will demand fewer tomatoes at $0.45/pound.

–

Mexican suppliers will lower their prices (and their margins) to $0.35/pound to remain competitive.

–

Tariff harms Mexican farmers, U.S. consumers, and U.S. businesses that use Mexican tomatoes as a factor of production.

Chapter 1: Introduction: Multinational Enterprise and Multinational Financial Management

1.G Appendix (9) ❑ Effects of free trade

– Increased competition among businesses – Increased innovation – Higher productivity

– Lower prices and greater choice for consumers – Rising wages for workers – Higher living standards

Chapter 1: Introduction: Multinational Enterprise and Multinational Financial Management

Chapter 2

The Determination of Exchange Rates

Chapter 2 Outline A. Introduction to Exchange Rates B. Factors Affecting the Equilibrium Exchange Rate C. Calculating Exchange Rate Changes

D. Asset Market Model of Exchange Rates E. Central Banks and Currency Values F. Central Bank Intervention

Chapter 2: Determination of Exchange Rates

2.A Introduction to Exchange Rates (1) ❑

Exchange rate – the price of one nation’s currency in terms of another. – If $1 buys ¥100, the ¥/$ exchange rate, or yen value of the dollar, = ¥100/$1 – The inverse $/¥ exchange rate, or dollar value of the yen, = $1/ ¥100 and tells how many dollars one yen will buy = $0.01.

❑

Exchange rates are market-clearing prices that equilibrate supplies and demands in the foreign exchange market.

❑

Spot rate e0 – the price at which currencies are traded for immediate delivery.

❑

Forward rate f1 – the price at which currencies are quoted for delivery at a specified future date.

Chapter 2: Determination of Exchange Rates

2.A Introduction to Exchange Rates (2) ❑

Demand for a currency – Demand for a currency is a function of the demand for foreign goods denominated in that currency. E.g., U.S. demand for Euroland goods increases demand for euros to pay for those goods. – As demand for euros increases, the value of the dollar falls against the euro. – As the value of the dollar falls against the euro, Americans demand fewer Euroland goods, services, and assets.

❑

Supply of a currency – Supply of euros is a function of Euroland demand for U.S. goods. – Euroland consumers must buy dollars to buy U.S. goods. – As the value of the euro increases against the dollar, increased Euroland demand for U.S. goods increases demand for dollars, which increases the amount of euros supplied.

Chapter 2: Determination of Exchange Rates

2.A Introduction to Exchange Rates (3) ❑

Graphical representation of supply and demand for a currency

e S If supply of a currency exceeds demand, the value will fall relative to another currency until it reaches a new equilibrium.

Surplus

e0 Shortage

If demand for a currency exceeds supply, the value will increase relative to another currency until it reaches a new equilibrium.

D Q Q*

Chapter 2: Determination of Exchange Rates

2.B Factors Affecting the Equilibrium Exchange Rate (1) ❑

Factors that influence the supply and demand for one currency in terms of another affect the equilibrium exchange rate. – Inflation rates – Interest rates – Economic growth

– Political and economic risks

Chapter 2: Determination of Exchange Rates

2.B Factors Affecting the Equilibrium Exchange Rate (2) ❑

Inflation rates – e.g., U.S. inflation > Euroland inflation €/$

$ depreciates: fewer euros e0 required to buy $

S’

$/€ e1 e0

S’

€ appreciates over time in an amount such that Euroland and U.S. prices are again in equilibrium

S 6 4

D’

D €

$ Q*

1. U.S. imports become more expensive to Euroland consumers 2. Euroland consumers switch to domestic substitutes 3. Demand for $ decreases 4. Supply of euros decreases (fewer euros needed to buy dollars) 5. U.S. consumers substitute Euroland imports for domestic goods 6. Demand for euros increases 7. Supply of dollars increases Chapter 2: Determination of Exchange Rates

2.B Factors Affecting the Equilibrium Exchange Rate (3) ❑

Interest rates – e.g., U.S. interest rates > Euroland interest rates S’

€/$

$/€

S’

€ depreciates: fewer dollars e 0 required to buy €

$ appreciates over time in an amount such that U.S. and Euroland prices are again in equilibrium

D’

4 D’

D €

1. Capital shifts from Euroland to U.S. to exploit higher returns 2. Demand for dollars increases 3. Supply of euros increases to buy more dollars 4. Demand for euros decreases as demand to buy U.S. assets decreases 5. Supply of dollars decreases

Chapter 2: Determination of Exchange Rates

2.B Factors Affecting the Equilibrium Exchange Rate (4) ❑

Economic growth – e.g., U.S. GDP growth > Euroland GDP growth €/$

$/€

S’ S

e1 eo

D’ D

D €

$ Qo

1. As income increases, U.S. consumers spend more on Euroland imports 2. Demand for euros increases 3. Supply of dollars increases to buy more euros 4. Value of euro increases relative to the dollar

Chapter 2: Determination of Exchange Rates

2.B Factors Affecting the Equilibrium Exchange Rate (5) ❑

Political and economic risk – Investors prefer to hold fewer riskier assets. – Political and economically stable countries have lower-risk currencies. – Low-risk currencies are more highly valued and high-risk currencies.

Chapter 2: Determination of Exchange Rates

2.C Calculating Exchange Rate Changes (1) ❑

Using the $/€ as an example, euro appreciation/depreciation is computed as the fractional increase/decrease in the dollar value of the euro.

❑

General formula for computing currency appreciation/depreciation in dollar terms Currency appreciation/depreciation = (new dollar value of currency – old dollar value of currency) Old dollar value of currency

❑

E.g.: $/€ increases from $1.25/€1.00 to $1.35/€1.00 ($1.35 – $1.25) / $1.25 = 0.08, or 8%

❑

The euro has appreciated 8% against the dollar. That is, the amount of dollars required to buy one euro increased by 8%.

Chapter 2: Determination of Exchange Rates

2.C Calculating Exchange Rate Changes (2) ❑

General formula for computing dollar appreciation/depreciation in terms of another currency Dollar appreciation/depreciation = (old dollar value of currency - new dollar value of currency)

New dollar value of currency ❑

Using previous example: $/€ increases from $1.25/€1.00 to $1.35/€1.00 ($1.25 – $1.35) / $1.35 = -0.074, or -7.4%

❑

The dollar has depreciated 7.4% against the euro. That is, the amount of euros required to buy one dollar decreased by 7.4%.

Chapter 2: Determination of Exchange Rates

2.D Asset Market Model of Exchange Rate Determination ❑

The exchange rate between two currencies represents the price that just balances the relative supplies of and demand for assets denominated in those currencies.

❑

Shifts in preferences or expectations of future exchange rate movements affect the exchange rate of two currencies.

❑

The desire to hold currency today depends on expectations of the factors that affect the currency’s future value.

❑

Thus, currency values are forward-looking.

Chapter 2: Determination of Exchange Rates

2.E Central Banks and Currency Values (1) ❑

Central banks use monetary policy, including creating money, to achieve price stability, low interest rates, or a target currency value.

❑

Before 1971, currencies were linked to a commodity, usually gold.

❑

Fiat money – nonconvertible paper money – Is not linked to a commodity and thus has no “anchor.” – No standard of value for determining a currency’s future value. – Central bank determines a currency’s value through its control of the money supply. – Expectations of central bank behavior affect exchange rates.

Chapter 2: Determination of Exchange Rates

2.E Central Banks and Currency Values (2) ❑

A central bank’s reputation for maintaining currency stability is critical.

❑

Investors demand a risk premium to hold low-quality currencies.

❑

Central bank independence and focus is necessary to avoid political influence.

❑

The greater risk of political influence over central banks that do not have a clear mandate to pursue price stability will foster the perception of inflation risk.

❑

Central banks lacking independence must often monetize the deficit – that is, finance the deficit by creating money and buying government debt. – Releasing more money into an economy leads to inflation and currency devaluation.

Chapter 2: Determination of Exchange Rates

2.E Central Banks and Currency Values (3) ❑

Currency boards – Replace central banks – Issue notes and coins that are convertible on demand and at a fixed rate into a foreign reserve currency – Have no discretionary monetary policy – the market determines the money supply – Promote price stability

❑

Without a central bank to monetize a country’s deficit, a currency board compels a government to follow responsible fiscal policy.

❑

HOWEVER, a run on the currency causes a sharp contraction in the money supply and jump in interest rates, slowing economic activity.

Chapter 2: Determination of Exchange Rates

2.E Central Banks and Currency Values (4) ❑

Dollarization – A country replaces its currency with the U.S. dollar – Promotes price stability and thus low inflation – Eliminates local currency risk – Results in loss of seignorage, a central bank’s profit on the currency it prints.

Chapter 2: Determination of Exchange Rates

2.F Central Bank Intervention (1) ❑

How real exchange rates affect relative national competitiveness – Our previous diagram illustrates how the euro rises over time to fill the inflation differential created by rising U.S. inflation. E.g., if U.S. and Euroland inflation = 1% and U.S inflation increases to 3%, the value of the euro will appreciate by 2% to re-establish price parity. €/$

S’

$/€ e1

S S’

Euro appreciation reflects 2% rise in inflation

D’

e1 D’

D €

$ Q*

– Appreciation beyond 2% raises the relative price of Euroland goods, increasing U.S. consumption of domestic goods and stimulating domestic employment. Longer term, U.S. inflation will rise to re-establish price parity. Chapter 2: Determination of Exchange Rates

2.F Central Bank Intervention (2) ❑ Foreign exchange market intervention

– Whether governments prefer an overvalued, undervalued, or correctly valued domestic currency depends on their economic goals. – Governments may engage in unsterilized intervention, i.e., intervene in the foreign exchange market, to move e0 to a level consistent with their goals by buying or selling foreign currencies to influence the value of their own currencies. • To reduce the value of the dollar against the euro, the U.S. Central Bank (“the Fed”) will sell dollars and purchase an equivalent amount of euros, releasing dollars into the foreign market and reducing the supply of euros. • To increase the value of the dollar against the euro, the Fed will buy dollars with euros, releasing euros into the foreign market and reducing the supply of dollars. • Using unsterilized intervention, monetary authorities have not insulated their domestic money supplies from the foreign exchange transactions. • Unsterilized intervention leads to increases in inflation as exchange rates move out of equilibrium. Inflation will in turn affect interest rates. Chapter 2: Determination of Exchange Rates

2.F Central Bank Intervention (3) ❑

Foreign exchange market intervention, continued – In sterilized intervention, the Fed will intervene in the foreign exchange market AND simultaneously engage in open market operations, or the sale or purchase of domestic Treasury bills. – Example • To reduce the value of the dollar relative to the euro, the Fed sells dollars for euros in the foreign exchange market to flood the foreign market with dollars AND sells Treasury bills to reduce the number of dollars in the domestic market. • Net effect: The value of the dollar relative to the euro decreases without changing the domestic supply of dollars, thereby insulating the U.S. from inflation.

– The effects of sterilized intervention are temporary, because the Fed signals a change in monetary policy to the market, not a change in market fundamentals. – The effects of unsterilized intervention are permanent, because they create inflation in some countries and deflation in others. Chapter 2: Determination of Exchange Rates

Chapter 3

The International Monetary System

Chapter 3 Outline A. Exchange Rate Systems B. International Monetary System C. European Monetary System and Monetary Union

D. Emerging Market Currency Crises

Chapter 3: The International Monetary System

3.A Exchange Rate Systems (1) ❑

Free float

❑

Managed float

❑

Target-zone arrangement

❑

Fixed-rate system

❑

Hybrid system

Chapter 3: The International Monetary System

3.A Exchange Rate Systems (2) ❑

Free (“clean”) float – Exchange rates are determined by currency supply and demand with no government intervention. – As economic parameters change, market participants adjust their current and expected future currency needs. – Shifts in currency needs in turn shift currency supply and demand schedules, as seen in Chapter 2.

❑

Managed (“dirty”) float – Central banks intervene to reduce economic volatility. – Three categories of intervention 1. Smoothing out daily fluctuations – central bank buys or sells currency to smooth exchange rate adjustments. 2. Leaning against the wind – measures taken to moderate or prevent short- or medium-term exchange rate fluctuations caused by random events. 3. Unofficial pegging – a country pegs the value of its currency to a foreign currency to protect the value of its exports.

Chapter 3: The International Monetary System

3.A Exchange Rate Systems (3) ❑

❑

Target zone arrangement –

Countries agree to adopt economic policies that maintain their exchange rates within a specific range.

–

Designed to minimize exchange rate volatility and enhance economic stability in participating countries.

–

Requires coordination of economic policy objectives and practices.

Fixed-rate system –

Governments maintain target exchange rates.

–

Central banks buy/sell currency to increase (“revalue”)/decrease (“devalue”) exchange rates when exchange rates threaten to deviate from their stated par values by more than an agreed-on percentage.

–

Monetary policy becomes subordinate to exchange rate policy.

Hybrid system – current international system consisting of free-float, managed-float, and pegged currencies.

Chapter 3: The International Monetary System

3.B International Monetary System (1) ❑

Gold Standard – participating countries fixed the prices of their currencies in terms of a specified amount of gold.

❑

Because the value of gold is fairly stable over time, the gold standard ensured long-run price stability for both individual countries and groups of countries.

❑

Classical Gold Standard (1821-1914) –

Characterized by price-specie-flow mechanism •

Changes in the price level in one country were offset by an automatic balance of payments (“BOP”) adjustment. –

As U.S. exchange rate falls, exports rise, causing BOP surplus and inflow of foreign gold.

–

U.S. prices rise, foreign prices fall

–

U.S. exports fall, foreign exports rise

–

BOP equilibrium achieved

Chapter 3: The International Monetary System

3.B International Monetary System (2) ❑

Classical Gold Standard (1821-1914), continued –

1821 – England returns to gold standard

–

1821-1880 – other countries join the gold standard

–

1880-1914 •

Rapid expansion of virtually free international trade

•

Stable exchange rates and prices

•

Free flow of labor and capital

•

Rapid economic growth

•

World peace

•

However, some negative economic conditions –

Major depression in 1890s

–

Economic contraction in1907

–

Repeated recessions

Chapter 3: The International Monetary System

3.B International Monetary System (3) ❑

❑

Gold Exchange Standard (1925-1931) –

The U.S. and England could hold only gold reserves

–

Other nations could hold both gold and dollars/pounds as reserves.

–

In 1931, England departed from gold given massive gold and capital flows stemming from an unrealistic exchange rate, ending the Gold Exchange Standard.

1931-1944 –

Beggar thy neighbor devaluations – countries devalued their currencies to maintain trade competitiveness, leading to a trade war.

Chapter 3: The International Monetary System

3.B International Monetary System (4) ❑

Bretton Woods System (1946-1971) – Bretton Woods Conference, 1944 • New postwar monetary system –

Allied nations pledged to maintain a fixed (pegged) exchange rate in terms of the dollar or gold.

–

1 ounce of gold = $35

–

Exchange rates could fluctuate only within 1% of their stated par values.

–

Fixed rates were maintained by central bank intervention in foreign exchange markets.

Chapter 3: The International Monetary System

3.B International Monetary System (5) ❑

Bretton Woods System (1946-1971), continued –

Bretton Woods Conference, 1944, continued •

Two new institutions created –

International Monetary Fund (IMF) – created to promote monetary stability • Role has evolved over time • Oversees exchange rate policies in 182 member countries • Advises developing countries on economic policy • Lender of last resort • Moral hazard – expectation of IMF bailouts leads investors to underestimate risks of lending to governments that pursue irresponsible policies

–

International Bank for Reconstruction and Development (World Bank) – created to lend money to countries to rebuild their war-damaged infrastructures

Chapter 3: The International Monetary System

3.B International Monetary System (6) ❑

Bretton Woods System (1946-1971), continued – Fixed rate system in name only. • Of 21 major industrial countries: – Only the U.S. and Japan maintained their par values – 12 countries devalued their currencies >30% against the dollar – 4 countries revalued their currencies – 4 countries allowed their currencies to float

– Collapse of Bretton Woods system • Inflation in the U.S. stemming from the Johnson Administration printing money instead of raising taxes to finance Viet Nam conflict. • West Germany, Japan, and Switzerland would not accept the inflation that a fixed exchange rate with the dollar would have imposed on them.

Chapter 3: The International Monetary System

3.B International Monetary System (7) ❑

Post-Bretton Woods System (1971-Present) – Smithsonian Agreement • Dollar was devalued to 1/38 of an ounce of gold. • Other currencies revalued by agreed-on amounts in terms of the dollar.

– Attempts to set new fixed rates unsuccessful.

– International floating exchange rate system instituted in 1973. • System supposed to reduce economic volatility and facilitate free trade. – Floating rates would offset international differences in inflation. – Real exchange rates would stabilize given gradual changes in underlying conditions affecting trade and productivity of capital. – Nominal exchange rates would stabilize if countries coordinated their monetary policies to achieve inflation rate convergence. • However, currency volatility has increased due to non-monetary global economic shocks (e.g., changing oil prices).

Chapter 3: The International Monetary System

3.C European Monetary System (1) ❑

European Monetary System (EMS) –

Began operating in March 1979.

–

Purpose: Foster monetary stability in the European Community (EC)

–

Members established the European Currency Unit (ECU), a composite currency consisting of fixed amounts of the 12 EC member currencies.

–

The quantity of each currency reflected each country’s relative economic strength within the ECU.

–

In 1992, the EC became the European Union (EU).

–

The EU currently has 27 member states.

Chapter 3: The International Monetary System

3.C European Monetary System (2) ❑

Exchange rate mechanism (ERM) –

Target zone system

–

Allowed each EMS member to determine a mutually agreed-on currency exchange rate.

–

Each rate was denominated in central ECU currency units.

–

Central rates established a grid of bilateral cross-exchange rates between currencies.

–

Participating countries pledged to maintain their currencies within a +/-15% margin of cross-exchange rates.

–

By 1993, the ERM created a two-tiered system

–

•

One tier included currencies tightly anchored by the DM

•

One tier included weaker currencies

EMR abandoned in August 1993

Chapter 3: The International Monetary System

3.C European Monetary System (3) ❑

European Monetary Union (EMU, or EU) – Maastricht Treaty • Formalized the EC’s moved toward a monetary union • EC nations would establish the European Central Bank with sole power to issue a single currency (euro). – On January 1, 1999, the euro became a currency and conversion rates for the euro were locked in for member countries. – On January 1, 2002, member countries’ currencies were replaced by euro bills and coins.

– To join the EU, countries were subjected to the Maastricht criteria • Government debt ≤ 60% of GDP • Budget deficit ≤ 3% of GDP • Inflation ≤ 1.5 percentage points above the average rate of Europe’s three lowest-inflation countries • Long-term interest rates ≤ 2 percentage points above the average interest rate in the three lowest-inflation countries Chapter 3: The International Monetary System

3.C European Monetary System (4) ❑

European Monetary Union (EMU, or EU), continued –

Consequences of EU •

Lower cross-border currency conversion costs

•

Eliminated risk of currency fluctuations

•

Facilitated cross-border price comparisons

•

Encouraged flow of trade and investments among member countries

•

Greater integration of Europe’s capital, labor, and commodity markets

•

Increased Europe’s competitiveness

•

Greater coordination of monetary policy

Chapter 3: The International Monetary System

3.D Emerging Market Currency Crises (1) ❑

❑

Currency crises spread from one country to another by two means. –

Trade links – e.g., when Argentina is in crisis, it imports less from Brazil, causing Brazil’s economy to contract and its currency to weaken. Brazil’s contraction will in turn affect other trade partners.

–

The financial system – distress in one emerging market causes investors to exit other countries with similar risk profiles.

Common denominator in promoting currency crises: Countries issue too much short-term debt closely linked to the dollar. When the dollar depreciates, the cost of repaying dollar-linked bonds soars.

Chapter 3: The International Monetary System

3.D Emerging Market Currency Crises (2) ❑

Circumventing emerging market crises – Currency controls • Abandoning free capital movement to insulate a country’s currency from speculative attacks. • However: – Open capital markets channel savings to where they are most productive; – Developing nations need foreign capital and know-how; and – Currency controls have led to corruption.

– Freely floating currency – floating rates absorb the pressures created in emerging countries that simultaneously peg their exchange rates and pursue independent monetary policy. – Permanently fix the exchange rate – through dollarization, use of a currency board, or a monetary union, a country can permanently fix its exchange rate. Chapter 3: The International Monetary System

Chapter 4

Parity Conditions in International Finance and Currency Forecasting

Chapter 4 Outline A. Arbitrage and the Law of One Price B. Key Terms C. Theoretical Economic Relationships

D. Currency Forecasting

Chapter 4: Parity Conditions in International Finance and Currency Forecasting

4.A Arbitrage and the Law of One Price ❑

Arbitrage – the simultaneous purchase and sale of the same assets or commodities on different markets to profit from price discrepancies

❑

Law of One Price – in competitive markets, exchange-adjusted prices of identical tradable goods and financial assets must be within transaction costs of equality worldwide.

❑

Absent market imperfections, arbitrage ensures that exchangeadjusted prices of identical traded goods follow the Law of One Price.

Chapter 4: Parity Conditions in International Finance and Currency Forecasting

4.B Key Terms ❑

Spot rate e0 – current exchange rate of currency

❑

Forward rate f1 – exchange rate of currency on a specified future date

❑

Forward discount – the discount applied to a currency if the forward rate is below the spot rate

❑

Forward premium – the premium applied to a currency if the forward rate is above the spot rate

Forward premium/discount =

f1 – e0 e0

Chapter 4: Parity Conditions in International Finance and Currency Forecasting

360 Forward contract number of days

4.C Theoretical Economic Relationships (1) ❑

In the absence of market imperfections, risk-adjusted expected returns on financial assets in different markets should be equal.

❑

Five key theoretical economic relationships result from arbitrage. i.

Purchasing power parity (PPP) – for prices in two countries to be equal, the exchange rate between the two countries must change by the difference between the domestic and foreign rates of inflation.

ii.

Fisher effect (FE) – If expected real interest rates differ between the home and foreign countries, capital will flow to the country with the higher real rate until the real rates in both countries are equal and equilibrium is reached.

iii. International Fisher effect (IFE) – combines the conditions underlying PPP and FE; if real interest rates differ between the home and foreign countries, capital will flow to the country with the higher real rate until the exchange-adjusted returns are equal in both countries and equilibrium is reached. iv. Interest rate parity (IRP) – in an efficient market with no transaction costs, the interest rate differential between two countries should approximate the forward differential. v.

Forward rates as unbiased predictors of future spot rates (UFR) – Equilibrium is achieved when the forward differential equals the expected change in the spot rate.

Chapter 4: Parity Conditions in International Finance and Currency Forecasting

4.C Theoretical Economic Relationships (2) ❑

Note: The equations presented in the discussions of the theoretical economic relationships are “approximations” of formal equations. For example, in the discussion of purchasing power parity, we present the equilibrium state as achieved when e1 – e0 e0

= ih – if

This equation is a commonly used and accepted approximation of the following formal equation, which is presented and discussed in the textbook. et e0

(1 + if)t (1 + ih)t

The approximation equations are used to graphically illustrate each theoretical economic relationship. Chapter 4: Parity Conditions in International Finance and Currency Forecasting

4.C.i

Theoretical Economic Relationships: Purchasing Power Parity (PPP) (1)

❑

Price levels should be equal worldwide when expressed in a common currency.

❑

The exchange rate e0 will adjust to reflect changes in the price levels (inflation) of the two countries. – Purchasing power disparity occurs when inflation in one country changes, causing goods in that country to become more or less attractive to foreign consumers.

– e0 will change over time until inflation equalizes in the two countries and PPP is once again restored. – PPP is thus achieved when e1 – e0 e0

= ih – if

where et = home currency/ foreign currency

Chapter 4: Parity Conditions in International Finance and Currency Forecasting

4.C.i

Theoretical Economic Relationships: Purchasing Power Parity (PPP) (2)

❑ Graphical example e1 – e0 e0

Parity Line

1. At equilibrium E0, U.S. and Japan inflation both = 2% and change in e0 = 0

4 3

2. U.S. inflation increases to 5% (ih – if = 3%), causing disequilibrium, or purchasing power disparity, at (0,3).

2 1 -5

-4

-3

-2

E0 1

-1 -1 -2

-3

ih – if 2

3. $/¥ exchange rate will rise ~3% (e1–e0 / e0 ≈ 3%) to equalize the dollar price of goods in the two countries at a new equilibrium E1.

-4 -5

Chapter 4: Parity Conditions in International Finance and Currency Forecasting

4.C.i ❑

Theoretical Economic Relationships: Purchasing Power Parity (PPP) (3)

Nominal exchange rate versus real exchange rate – Nominal exchange rate = actual exchange rate et – Because changes in et offset changes in foreign and domestic price levels (i.e., inflation differentials), changes in et should not affect the relative competitive positions of domestic and foreign competitors. – et thus does not reveal the true effects of currency changes on a firm or country. – The real exchange rate indicates the real purchasing power of one currency relative to another. – Real exchange rate = et adjusted for changes in the relative purchasing power of each currency since a base year* = et’ e t ’ = et

(1 + if)t (1 + ih)t

*In base year, et = et’ Chapter 4: Parity Conditions in International Finance and Currency Forecasting

4.C.i ❑

Theoretical Economic Relationships: Purchasing Power Parity (PPP) (4)

Nominal exchange rate versus real exchange rate, continued –

If changes in et are offset by changes in inflation between two countries, et’ remains unchanged.

–

Thus, a change in et’ is equivalent to a deviation from PPP.

–

E.g., compute and compare changes in the real and nominal values of the yen relative to the dollar (i.e., et and et’ = $/¥) from 1982 to 2006 1. et in 1982 (e0 = base year) = $1/¥249.05, et in 2006 (e25) = $1/¥116.34 2. CPIJapan in 1982 = 80.75, CPIJapan in 2006 = 97.72; if = 21% 3. CPIUS in 1982 = 56.06, CPIUS in 2006 = 117.07; ih = 109% e25’ = $1/¥116.34

(1 + 21%)

(1 + 109%)

= $.004981

4. e0’ = $1/¥249.05 = $.004015.

5. Change in et’ = ($.004981 - $.004015) / $.004015 = 24%, meaning the yen appreciated 24% against the dollar in real terms – that is, the real dollar prices of Japanese exports rose by 24%. Chapter 4: Parity Conditions in International Finance and Currency Forecasting

4.C.i ❑

Theoretical Economic Relationships: Purchasing Power Parity (PPP) (5)

Nominal exchange rate versus real exchange rate, continued –

7. Difference between et and et’ = 114% - 24% = 90%. 8. Conclusion: Inflation differentials justify only a 90% rise in et . Thus, the increase in et’ causes a deviation from PPP by 24%.

Chapter 4: Parity Conditions in International Finance and Currency Forecasting

4.C.ii

Theoretical Economic Relationships: Fisher Effect (FE) (1)

❑

The nominal interest rate compensates lenders for the erosion of future purchasing power of dollars loaned.

❑

Because virtually all financial contracts are stated in nominal terms, the real interest rate a must be adjusted to reflect expected inflation.

❑

FE states that the nominal interest rate r = a required rate of return a and an inflation premium equal to expected inflation i: r = a + i + ai

❑

Real returns are equalized across countries through arbitrage; i.e., over time, ah = af.

❑

If expected ah ≠ af, capital would flow to the country with the higher real rate until ah = af and equilibrium is reached.

❑

In equilibrium with no government interference, rh - rf = ih - if

Chapter 4: Parity Conditions in International Finance and Currency Forecasting

4.C.ii

Theoretical Economic Relationships: Fisher Effect (FE) (2)

❑ Graphical example rh – rf Parity Line 5

2. Foreign interest rates increase by 2% (rh – rf = -2%), causing a 2% disequilibrium in real rates at (0,-2) (i.e., the differential in r and i).

4 3 2

E0 -5

-4

-3

-2

-1

ih – if 1

-1 -2

-3 -4

1. At equilibrium E0, rh = rf and i h = i f.

3. Funds will flow from the home country to the foreign country to equalize the real rates (if will increase by 2%) in the two countries at a new equilibrium E1.

-5

Chapter 4: Parity Conditions in International Finance and Currency Forecasting

4.C.ii ❑

Theoretical Economic Relationships: Fisher Effect (FE) (3)

Capital market segmentation – real interest rates are determined by local credit conditions. – Real interest rate in the U.S. aUS is based on the national supply and demand for credit. – Real interest rate in the rest of the world arw is based on the rest of the world’s supply and demand for credit.

❑

Capital market integration – real interest rates are determined by global supply and demand for funds. – If aUS > arw, when U.S. capital markets open up, aUS will fall and arw will rise to the new world rate aw , which is determined by world supply (SUS + Srw) and demand (DUS + Srw).

Chapter 4: Parity Conditions in International Finance and Currency Forecasting

4.C.iii Theoretical Economic Relationships: International Fisher Effect (IFE) (1) ❑

IFE combines the conditions underlying PPP and FE.

❑

Thus, in equilibrium, rh – rf =

ē1 – e0

❑

If rh ≠ rf, capital will flow from the country with the lower expected return to the country with the higher expected return, causing e0 to adjust by the interest rate differential such that rh = rf and a new equilibrium is established.

❑

Interest rate differentials are thus unbiased (while not necessarily accurate) predictors of ē1.

Chapter 4: Parity Conditions in International Finance and Currency Forecasting

4.C.iii

Theoretical Economic Relationships: International Fisher Effect (IFE) (2)

❑ Graphical example ē1 – e0 e0 Parity Line 5

2. ē1 increases by 4%, causing a 4% disequilibrium in exchange-adjusted interest rates at (4,0).

4 3 2 1

E0 -5

-4

-3

-2

-1

rh – rf 1

-1 -2

-3

1. At equilibrium E0, ih = if and change in e0 = 0.

3. Funds will flow from the home country to the foreign country to equalize the exchangeadjusted returns (rh increases by 4%) at a new equilibrium E1.

-4 -5

Chapter 4: Parity Conditions in International Finance and Currency Forecasting

4.C.iv Theoretical Economic Relationships: Interest Rate Parity (IRP) (1) ❑

The forward discount or premium is closely related to the interest differential between two currencies.

❑

IRP – in an efficient market with no transaction costs, the interest rate differential between two countries (rh – rf) should approximate the forward differential (f1 – e0)/e0.

❑

Thus, in equilibrium, rh – rf ≈

❑

f1 – e0 e0

IRP ensures that the return on a hedged, or covered, foreign investment will just equal the home interest rate on investments of identical risk.

Chapter 4: Parity Conditions in International Finance and Currency Forecasting

4.C.iv Theoretical Economic Relationships: Interest Rate Parity (IRP) (2) ❑

Covered interest arbitrage (CIA) – profiting from interest rate differentials in rh and rf (when IRP does not hold). E.g.: – rUK = 12%, rUS = 7% – e0 = $/£ = $1.95, f1 = $1.88 – rUK – rUS = 5%

– (f1 – e0)/e0 = ($1.88 - $1.95)/$1.95 = -3.6% = forward discount – rUK – rUS ≠ (f1 – e0)/e0 – Funds will flow from U.S. to U.K. to exploit profit opportunity (CIA) – As pounds are bought spot and sold forward, e0 will increase and f1 will decrease, increasing the forward discount – As funds flow from U.S. to U.K., rUS will increase and rUK will decrease. – CIA will continue until IRP is achieved.

Chapter 4: Parity Conditions in International Finance and Currency Forecasting

4.C.iv Theoretical Economic Relationships: Interest Rate Parity (IRP) (3) ❑ Graphical example In this example, let UK be home country

rh – rf CIA

Parity Line

Arbitrage inflow to UK

5 4

1. rh - rf = 5% and forward discount = -3.6%.

3 2 1

-5

-4

-3

-2

-1

-2 -3

– Increasing f1; and

f1 – e0 E 1

-1

2. Funds will flow from the U.S. to the U.K.:

Arbitrage outflow from UK*

– Increasing rUS and decreasing rUK until rh - rf = 0

3. CIA continues until IRP is achieved at E.

-4 -5

*Points below the parity line represent points at which the forward premium would negate the favorable UK interest rate differential

Chapter 4: Parity Conditions in International Finance and Currency Forecasting

4.C.iv Theoretical Economic Relationships: Interest Rate Parity (IRP) (4) ❑

Transaction costs cause effective rates to be lower than nominal rates, creating a band around the parity line. For CIA to occur, the covered differential must exceed transaction costs. rh – rf Parity Line

5 4 3 2 1 -5

-4

-3

-2

-1

f1 – e0 1

-1

-2 -3 -4 -5 Chapter 4: Parity Conditions in International Finance and Currency Forecasting

4.C.v

Theoretical Economic Relationships: Forward Rate and Future Spot Rate (1)

❑

Absent government intervention, e0 and f1 are heavily influenced by current expectations of future events.

❑

The two rates move in tandem, linked by interest differentials.

❑

E.g., the pound is expected to depreciate. – Holders of pounds sell pounds forward.

– Sterling-area dollar earners reduce sales of dollars in the forward market. – f1 will decrease. – Banks will sell e0 to offset f1 positions. – Earners of pounds will accelerate their collection and conversion of pounds. ❑

Thus, pressure from the forward market is transmitted to the spot market, and vice versa.

Chapter 4: Parity Conditions in International Finance and Currency Forecasting

4.C.v

Theoretical Economic Relationships: Forward Rate and Future Spot Rate (2)

❑

Equilibrium is achieved when the forward differential equals the expected change in e0 (ē1).

❑

Thus, in equilibrium, f1 – e0 e0

ē1 – e0 = e0

❑

In equilibrium, incentives to buy or sell currency forward do not exist.

❑

ft should reflect ēt on the date of settlement of the forward contract.

❑

Thus, the unbiased forward rate (UFR) condition is ft =

ēt

Chapter 4: Parity Conditions in International Finance and Currency Forecasting

4.C.v

Theoretical Economic Relationships: Forward Rate and Future Spot Rate (3)

❑ Graphical example ē1 – e 0 e0

Parity Line

5 4

2. The value of the pound is expected to depreciate by 4%.

3 2 1 -5

-4

-3

-2

-1 -2 -3

f1 – e0 E0 1

-1

1. At equilibrium E0, ē0 = f1 and there is no incentive to buy or sell currency forward.

3. Pound holders sell pounds forward, dollar holders delay converting dollars to pounds.

4. f1 decreases over time by 4% to establish a new equilibrium at E1.

-4 -5

Chapter 4: Parity Conditions in International Finance and Currency Forecasting

4.D Currency Forecasting (1) ❑

Requirements for successful currency forecasting – Exclusive use of a superior forecasting model – Consistent access to information – Exploiting small, temporary deviations from equilibrium – Predicting the nature of government intervention in the foreign exchange market

❑

Market-based forecasts can be obtained by extracting the predictions embodied in interest and forward rates. – f1 is an unbiased estimate of ē1 (forecasting usefulness limited to one year given the general absence of longer-term forward contracts) – Interest rate differentials can be used as predictors beyond one year.

Chapter 4: Parity Conditions in International Finance and Currency Forecasting

4.D Currency Forecasting (2) ❑

Model-based forecasts are based on technical and/or fundamental analysis – Fundamental analysis involves examining macroeconomic variables and policies likely to influence a currency’s prospects. – Technical analysis focuses exclusively on past price and volume movements to identify price patterns. – Model-based forecasts are inconsistent with the efficient market hypothesis – because markets are forward looking, exchange rates will fluctuate randomly as market participants assess and react to news.

❑

Exchange controls and restrictions on imports and capital flows often mask the true pressures on a currency to devalue.

Chapter 4: Parity Conditions in International Finance and Currency Forecasting

Chapter 5

The Balance of Payments and International Economic Linkages

Chapter 5 Outline A. Balance of Payments B. The International Flow of Goods, Services, and Capital C. Current Account Deficit

Chapter 5: The Balance of Payments and International Economic Linkages

5.A Balance of Payments (1) ❑

Balance of payments (“BOP”) – an accounting statement that summarizes all of the economic transactions between residents of the home country and residents of all other countries. – Current Account – reflects the net flow of • Goods and services (balance of trade); • Income (interest, dividends, and compensation); and • Unilateral transfers (pensions, remittances, and other transfers for which no services were rendered).

– Capital Account – reflects capital transfers that offset transactions undertaken without exchange in fixed assets or in their financing. – Financial Account – reflects net purchases of financial assets: • Portfolio investments – financial assets with maturity > one year • Direct investments – financial assets for which management control is exerted (at least 10% equity ownership) • Changes in reserve assets held by official monetary institutions

– Double-entry accounting ensures that the sum of all transactions is zero. – A “statistical discrepancy” line is included to offset non-zero balances. Chapter 5: The Balance of Payments and International Economic Linkages

5.A Balance of Payments (2) ❑

Basic BOP statement Category

Credit (+)

Debit (-)

Goods (export/import)

$xxx

-$xxx

Services (export/import)

$xxx

-$xxx

Income (receipts/payments)

$xxx

-$xxx

Current Account

Unilateral transfers

Balance of Trade

-$xxx

Capital Account Capital transfers

$xxx

-$xxx

Portfolio investment (in U.S./overseas)

$xxx

-$xxx

Direct investment (in U.S./overseas)

$xxx

-$xxx

Government investment (in U.S./overseas)

$xxx

-$xxx

Changes in reserve assets

$xxx

-$xxx

Financial Account

Surplus/Deficit

Statistical Discrepancy

Chapter 5: The Balance of Payments and International Economic Linkages

5.A Balance of Payments (3) ❑

BOP definitions – Basic balance – includes transactions that are fundamental to the economic health of a currency. – Net liquidity balance – measures change in private domestic borrowing or lending required to keep payments balanced without adjusting official reserves. – Official reserve transactions balance – measures the adjustment required in official reserves to achieve BOP equilibrium.

Chapter 5: The Balance of Payments and International Economic Linkages

5.B ❑

International Flow of Goods, Services, and Capital

Macroeconomic accounting identities –

Link domestic spending and production to savings, consumption, and investment behavior, and thus to Current Account and Financial Account balances.

–

Manipulating accounting identities reveals the nature of the links between U.S. and world economies.

Domestic savings and investment and the Financial Account

ii. Link between Current Account and Financial Account iii. Government budget deficits and the Current Account

Chapter 5: The Balance of Payments and International Economic Linkages

5.B.i International Flow of Goods, Services, and Capital: Savings and Investment and the Financial Account ❑

National income* is either spent or saved. Thus: Identity 5.1:

❑

National Income = Consumption + Savings

National expenditures consist of consumption and investment. Thus: Identity 5.2: National Expenditures = Consumption + Investment

❑

Thus: National Income – National Expenditures = Identity 5.3: (consumption + savings) – (consumption + investment) = Savings – Investment *same as national product

Chapter 5: The Balance of Payments and International Economic Linkages

5.B.i International Flow of Goods, Services, and Capital: Savings and Investment and the Financial Account ❑

If income > expenditures, then savings > investment, resulting in a capital surplus (excess savings).

❑

Surplus capital is invested overseas.

❑

Thus, surplus capital becomes net foreign investment.

❑

If positive, net foreign investment equals a Financial Account deficit. Financial Account

Credit (+)

Debit (-)

Portfolio investment (in U.S./overseas)

$xxx

-$xxx

Direct investment (in U.S./overseas)

$xxx

-$xxx

Government investment (in U.S./overseas)

$xxx

-$xxx

Changes in reserve assets

$xxx

-$xxx

Balance

Chapter 5: The Balance of Payments and International Economic Linkages

-$xxx

5.B.i International Flow of Goods, Services, and Capital: Savings and Investment and the Financial Account If a country’s… Production > Spending

Production < Spending

Domestic Savings > Domestic Investment

Domestic Savings < Domestic Investment

Capital Surplus

Capital Shortage

Net Capital Outflow

Net Capital Inflow

Financial Account Deficit

Financial Account Surplus

Chapter 5: The Balance of Payments and International Economic Linkages

5.B.ii International Flow of Goods, Services, and Capital: Link Between Current Account and Financial Account ❑

National income consists of domestic goods and services and exports.

❑

National expenditure consists of spending on domestic goods and services and imports.

❑

Thus: Identity 5.4:

National Income – National Expenditure = (dom. goods/services + exports) – (dom. goods/services + imports) = Exports – Imports ❑

If income > expenditures, then exports > imports, resulting in a Current Account surplus.

Chapter 5: The Balance of Payments and International Economic Linkages

5.B.ii International Flow of Goods, Services, and Capital: Link Between Current Account and Financial Account ❑

Combining Identity 5.3 and Identity 5.4: Identity 5.5:

– ❑

Savings – Investment = Exports – Imports

Thus, if savings > investment, net exports are positive and the Current Account will run a surplus.

Because net foreign investment = savings - investment: Identity 5.6:

Net Foreign Investment = Exports – Imports

–

Thus, the Current Account balance = net capital outflow.

–

If savings > investment, net foreign investment is positive and the Current Account will run a surplus.

Chapter 5: The Balance of Payments and International Economic Linkages

5.B.ii International Flow of Goods, Services, and Capital: Link Between Current Account and Financial Account ❑

By Identity 5.6, the excess of goods and services bought over goods and services produced domestically must be acquired through foreign trade and financed by an equal amount of borrowing from abroad.

❑

That is, if exports < imports, net foreign investment is negative.

❑

–

When exports < imports, the Current Account will run a deficit.

–

When net foreign investment is negative, the Financial Account will run a surplus.

Thus, the Current Account and Financial Account balances must exactly offset each other.

Chapter 5: The Balance of Payments and International Economic Linkages

5.B.ii International Flow of Goods, Services, and Capital: Link Between Current Account and Financial Account ❑

Using identities to assess the efficacy of solutions to improve the Current Account balance

❑

Two conditions must be satisfied to reduce/increase a Current Account deficit/surplus:

❑

–

By Identify 5.3, raise income relative to expenditures; and

–

Bv Identity 5.5, raise savings relative to investment.

However, a Current Account surplus is not necessarily a sign of economic health. –

Countries that provide good investment opportunities may run trade deficits (investment > savings).

–

Countries that grow rapidly import more goods and services and may thus run trade deficits.

–

Weak economies may reduce their imports, given a positive correlation of income with import consumption, and may thus run trade surpluses.

Chapter 5: The Balance of Payments and International Economic Linkages

5.B.iii International Flow of Goods, Services, and Capital: Govt. Budget Deficits and Current Account Deficits ❑

The previous identities include government spending and taxation in national income and expenditures.

❑

Differentiating government from household spending shows the effect of a government budget deficit on the Current Account. National Expenditures = Household Spending + Private Investment + Govt. Spending Identity 5.7: = (National Income – Private Savings – Taxes) + Private Investment + Govt. Spending

❑

By Identity 5.7, excess spending, or capital surplus is expressed as: Identity 5.8:

National Expenditures – National Income = Private Investment – Private Savings + Govt. Budget Deficit*

*Govt. budget deficit = taxes – govt. spending Chapter 5: The Balance of Payments and International Economic Linkages

5.B.iii International Flow of Goods, Services, and Capital: Govt. Budget Deficits and Current Account Deficits ❑

Rearranging and combining Identity 5.4 and Identity 5.8 shows the impact of the government budget deficit on the Current Account balance: Identity 5.9:

–

Current Account Balance = Private Savings Surplus – Govt. Budget Deficit

Thus, a country running a Current Account deficit is not saving enough to finance its private investment and government budget deficit, and a country running a Current Account surplus has excess savings after financing private investment and the government deficit.

Chapter 5: The Balance of Payments and International Economic Linkages

5.C. Current Account Deficit (1) ❑

Responses to a Current Account deficit include currency devaluation, protectionism, and increasing savings. –

Devaluation •

An overvalued currency acts as a tax on exports and a subsidy to imports.

•

Empirical review of currency devaluation and trade deficit – 1976-1980 – dollar depreciated as trade deficit first worsened and then improved. – 1980-1985 – dollar appreciated as trade deficit steadily worsened.

– 1985-1987 – Dollar began depreciating while trade deficit rose steadily. – 2002 – Dollar began depreciating as trade deficit reached record levels

Chapter 5: The Balance of Payments and International Economic Linkages

5.C. Current Account Deficit (2) ❑

Responses to a Current Account deficit include currency devaluation, protectionism, and increasing savings, continued –

Devaluation, continued •

Conventional explanations for disconnect between changes in currency value and changes in trade deficit –

Lagged effects – time is needed for an exchange rate change to affect trade. Empirical review indicates that changes in the dollar’s value explain less than 5% of the variation in the trade balance between 1970 and 2006.

–

J-Curve theory – as currency depreciates, the trade deficit initially worsens and then improves over time. Consistent with presence of lagged effects. Empirical review indicates that the trade deficit initially worsened in 1985 but did not reach its 1985 level until four years later. Subsequent Current Account improvements may have been due to budget deficit declines, rendering the J-curve theory inconclusive.

–

The attractive investment climate in the 1980s caused investors to expand holdings of U.S. assets, which bid up the value of the dollar such that Americans changed their assets for foreign goods and services, causing a Financial Account surplus and Current Account deficit.

Chapter 5: The Balance of Payments and International Economic Linkages

5.C. Current Account Deficit (3) ❑

Responses to a Current Account deficit include currency devaluation, protectionism, and increasing savings, continued –

Protectionism •

Tariffs increase the prices of imports, causing domestic consumers to opt for domestic substitutes.

•

Quotas restrict supply of imports, thereby raising prices and causing domestic consumers to opt for domestic substitutes.

•

Protectionism thus results in increased domestic prices, erosion in purchasing power, and a decline in living standards.

•

Protectionism does not affect the trade balance, as other imports rise or exports fall.

•

By Identity 5.5, as imports fall, exports will fall by an equal amount absent changes in saving or investment.

Chapter 5: The Balance of Payments and International Economic Linkages

5.C. Current Account Deficit (4) ❑

Responses to a Current Account deficit include currency devaluation, protectionism, and increasing savings, continued –

Increasing savings •

The prospect of receiving Social Security benefits may negatively affect American’s saving habits.

•

Increase tax-favored savings vehicles

•

Switch from income tax to consumption tax

•

Reduce the government budget deficit

Chapter 5: The Balance of Payments and International Economic Linkages

Chapter 6

The Foreign Exchange Market

Chapter 6 Outline A. Foreign Exchange Market B. Spot Market C. Forward Market

Chapter 6: The Foreign Exchange Market

6.A Foreign Exchange Market (1) ❑

Foreign exchange market permits transfers of purchasing power denominated in one currency to another.

❑

Interbank market – wholesale market in which major banks trade with one another. Accounts for ~95% of foreign exchange transactions. Spot market – where currencies are traded for immediate delivery Forward market – where contracts are made to buy or sell currencies for future delivery Swap transactions – involve a package of a spot and a forward contract

Chapter 6: The Foreign Exchange Market

35% 53% 12%

Spot Transactions Forward Transactions Swap Transactions

6.A Foreign Exchange Market (2) ❑

Methods of trading – Telephone – Telex – SWIFT (Society for Worldwide Interbank Financial Telecommunications) system

– Internet-based systems ❑

Market participants – Large commercial banks – Foreign exchange brokers in the interbank market

– Commercial customers (primarily MNCs) – Central banks ❑

The role of human brokers has declined as electronic brokers have significantly increased their share of the foreign exchange market.

Chapter 6: The Foreign Exchange Market

6.A Foreign Exchange Market (3) ❑

Quotations – Up to four different foreign exchange quotes are displayed in major newspapers. • Spot rate • Forward rates, including 30-, 90-, and 180-day forward

– Quotes are for dealers in the interbank market. – When interbank trades involve dollars, rates are expressed in American terms ($/foreign currency) or European terms (foreign currency/$).

Chapter 6: The Foreign Exchange Market

6.A Foreign Exchange Market (4) ❑

Forward market participants – Arbitrageurs – seek to earn risk-free profits by taking advantage of interest rates differentials among countries. Use forward contracts to eliminate the exchange rate risk involved in transferring their funds between countries. – Traders – use forward contracts to eliminate or cover the risk on export or import orders denominated in foreign currencies. – Hedgers – use forward contracts to protect the home currency value of various foreign currency-denominated assets and liabilities. – Speculators – actively expose themselves to exchange risk by buying or selling currencies forward to profit from exchange rate fluctuations. – Thus, arbitrageurs, traders, and hedgers seek to eliminate or minimize exchange risk while speculators expose themselves to risk through forward market transactions.

Chapter 6: The Foreign Exchange Market

6.A Foreign Exchange Market (5) ❑

Clearing System – In the U.S., where all foreign exchange transactions involving dollars are cleared, electronic funds transfers between banks are processed through the Clearing House Interbank Payments System (CHIPS). – Settlement payments are debited from and credited to a settlement account established by the New York Federal Reserve Bank for member banks. – Member banks with debit positions deposit funds into their settlement accounts through FedWire to cover their part of a transaction.

Chapter 6: The Foreign Exchange Market

6.A Foreign Exchange Market (6) ❑

Example of CHIPS process: Fuji Bank sells $15 million to Citibank for ¥1.5 billion.

Fuji Bank Enters transaction into CHIPS system Approves and releases transaction

Fuji Bank

CHIPS 1 2

+ Stores transaction

Makes appropriate debits and credits to Fuji and Citibank settlement accounts 5

¥1.5 bil. $15 mil. 4 Citibank + $15 mil. ¥1.5 bil.

Makes permanent record of transaction 6 Issues a settlement report to each member bank

Chapter 6: The Foreign Exchange Market

6.A Foreign Exchange Market (7) ❑

Electronic trading systems – First created in 1992 – Enable automatic matching and execution of foreign exchange transactions – Reduce cost of trading by eliminating brokers and reducing the number of transactions traders had to engage in to obtain market prices – Gather and publish information on prices and quantities of currencies as they are traded – FXall largest electronic trading system

Chapter 6: The Foreign Exchange Market

6.B Spot Market (1) ❑

Spot Quotations – Direct quote – gives the home currency price of a quantity of the foreign currency quoted. E.g., the price of the euro in Switzerland is SFr1.65, or the price of the franc in Germany is €0.61.

– Indirect quote – the home currency is quoted in terms of the foreign currency. E.g., the price of pounds in terms of dollars is quoted in Great Britain as $1.9721. – Quotes found in the financial press are for transactions in the interbank market exceeding $1,000,000.

– Quotes are provided in both American and European terms: American Terms

European Terms

• $/foreign currency

• Foreign currency/$

• Direct quote in U.S.

• Direct quote outside of U.S.

• Indirect quote outside of U.S.

• Indirect quote in U.S.

Chapter 6: The Foreign Exchange Market

6.B Spot Market (2) ❑

Spot Quotations, continued – Quotes are given in pairs that reflect the bid-ask price. • E.g., pound sterling is quoted at $1.9719-28. • $1.9719 is the (bid) rate at which banks will buy pounds

• $1.9728 is the (ask) rate at which banks will sell pounds • The spread equals the dealer’s profit • The bid-ask spread is often quoted by the last two numbers; e.g., 19-28.

– Bid-ask quote expressed in American and European terms and as direct and indirect quotes: American Terms Direct in U.S.

European Terms* Direct outside U.S.

$1.9719-28 Indirect outside U.S.

Indirect in U.S.

(1/$1.9728)-(1/$1.9719) =£0.5069-71

*Note that the bid and ask prices are reversed in quoting in European terms. Chapter 6: The Foreign Exchange Market

6.B Spot Market (3) ❑

Spot quotations, continued – Bid-ask spreads are expressed as a percentage cost of transacting in the foreign exchange market as follows:

Percent Spread =

❑

Ask price – Bid price x 100 Ask price

Cross rates – Most currencies are quoted against the dollar. – A cross rate is the exchange rate between two non-dollar currencies

Chapter 6: The Foreign Exchange Market

6.B Spot Market (4) ❑

Cross rates, continued – Example: Compute direct bid and ask cross rates for the pound in Zurich – Direct quote for pound sterling = $1.9719-36

– Direct quote for SFr = $0.8130-47

Bid cross rate =

Ask cross rate =

Bid rate for £ in $ Ask rate for SFr in $

Ask rate for £ in $ Bid rate for SFr in $

$1.9719 $0.8147

$1.9736 $0.8130

= SFr2.4204

= SFr2.4227

– Thus, the direct quote for the pound in Zurich is SFr2.4204-27.

Chapter 6: The Foreign Exchange Market

6.B Spot Market (5) ❑

Currency arbitrage – Triangular currency arbitrage – traders take advantage of exchange rate inconsistencies in different money markets by buying a currency in one market and simultaneously selling it in another.

– E.g., compute profit given the following exchange rates • $/£ = $1.9724 in New York • $/€ = $1.3450 in Frankfurt • €/£= €1.4655 in London New York

Sell pounds in New York for dollars: £507,332/(1/$1.9724) = $1,000,661

Sell $1,000,000 in Frankfurt for euros: $1,000,000/($1.3450) = €743,494

Profit = $661 London

Frankfurt Sell euros in London for pounds: €743,494/€1.4655 = £507,332

Chapter 6: The Foreign Exchange Market

6.B Spot Market (6) ❑

Currency arbitrage, continued – Results of triangular currency arbitrage

New York Selling pounds for dollars, the pound will depreciate against the dollar in New York

London

Selling dollars for euros, the euro will appreciate against the dollar in Frankfurt

Frankfurt Selling euros for pounds, the euro will depreciate against the pound in London

Chapter 6: The Foreign Exchange Market

6.B Spot Market (7) ❑

Exchange risk – Bank losses and gains from exchange rate transactions result from the immediate adjustment of quotes in response to new political and economic information affecting exchange rates.

– E.g., given a $/£ exchange rate of $1.9712, a bank buys $985,600 for £500,000 (£500,000/(1/$1.9712) = $985,600) in the foreign exchange market. – If no offsetting transaction to cover its position is made simultaneously, it is exposed to exchange rate risk.

– If the bank then decides to cover its position in the interbank market, increases or decreases in the exchange rate will affect its exchange loss/gain. • If the exchange rate increases to $1.9801 before the bank completes its transaction, the bank will pay $990,050 to buy £500,000, thus incurring a loss of $990,050 - $985,600 = $4,450. • If the exchange rate increases, the bank will realize an exchange gain. Chapter 6: The Foreign Exchange Market

6.C Forward Market (1) ❑

A forward contract between a bank and a customer calls for delivery on a fixed future date of a specified amount of one currency against dollar payment at a fixed exchange rate.

❑

Negotiating a forward contract for payment of a future liability eliminates exchange risk by locking in a known future exchange rate.

❑

E.g., a U.S. company buys textiles from England, with payment of £1 million due in 90 days. Day

e0 = $1.97

90 e90 > $1.98 Exchange risk: If e90 > f90, cost of payable will increase

❑

f90 = $1.98 No exchange risk: £1,000,000 = $1,980,000

Implicit gains/losses on forward positions are related to the difference between ft and et at the forward contract’s maturity.

Chapter 6: The Foreign Exchange Market

6.C Forward Market (2) ❑

Forward rate quotations – Actual price of f1 is the outright rate – Swap rate – quoted as the premium on or discount from eo, e.g.: •

eo for yen = $0.008225, f1 for yen = $0.008421

•

Swap rate is 0.008421-0.008225 = 196

– Determining whether swap rate is a premium or discount on f1 •

When forward bid < ask rate, f1 is at a premium.

•

When forward bid > ask rate, f1 is at a discount.

– Converting swap rate to outright rate – add the premium to or subtract the discount from eo

Chapter 6: The Foreign Exchange Market

6.C Forward Market (3) ❑

Forward cross rates – Computed in the same way as spot cross rates – Example: Compute the forward cross rates for yen in terms of euros* – f30 for €/$ = €0.81070 - €0.81243 – f30 for ¥/$ = ¥107.347 - ¥107.442

Bid cross rate =

Ask cross rate =

Ask rate for € Bid rate for ¥

Bid rate for €

Ask rate for ¥

€0.81243 ¥107.347

€0.81170 ¥107.442

= €0.0075683

= €0.0075548

– Forward cross rates for yen in terms of euros are €0.0075683 - €0.0075548. *Note that this example is in European terms, as opposed to previous example computing bid/ask cross rates for pounds in Zurich, which was in American terms. Thus, ask and bid rates are reversed in the cross rate formulas. Chapter 6: The Foreign Exchange Market

6.C Forward Market (4) ❑

Arbitraging between currencies and interest rates – Use arbitrage to take advantage of interest rate and spot/forward rate differentials. E.g., using the following table, compute profits from arbitrage. Currency

90-day interest rates

f90

7 7/16 – 5/16

¥240.9696 - 9912

¥224.5731 - 8692

2 3/8 – 1/4

1. Borrow £1,000,000 for 90 days (repayment = [1+ ((7 7/16)/4] = £1,018,594)

2. Buy £1,000,000 of yen ([£1,000,000 (¥240.9696)] = ¥240,969,600) 3. Invest yen for 90 days (proceeds = [¥240,969,600 (1 + ((2 3/8)/4)] = ¥242,325,054) 4. Sell proceeds forward for pounds (¥242,325,054/ ¥224.8692 = £1,077,627) Profit = £1,077,627 - £1,018,594 = £59,033 Chapter 6: The Foreign Exchange Market

Chapter 7

Currency Futures and Options Markets

Chapter 7 Outline A. Forward and Futures Contracts B. Currency Options C. Forward and Futures Contracts versus Currency Options

D. Futures Options E. Reading Currency Futures and Options Prices

Chapter 7: Currency Futures and Options Markets

7.A Futures and Forward Contracts (1) ❑

Futures contracts – Contracts to buy or sell standardized quantities of given currencies, with standardized delivery dates, trading on organized exchanges – Contracts are highly leveraged, meaning the contract value responds strongly to small changes in exchange rates. – Traders make money through commissions rather than from bid-ask spreads. – Low cost and high leverage attracts speculators. – Chicago Mercantile Exchange (CME) – the exchange on which most currency futures are traded

– Open interest – the number of contracts outstanding

Chapter 7: Currency Futures and Options Markets

7.A Futures and Forward Contracts (2) ❑

Futures contracts, continued – Margin requirements • Initial performance bond (formerly initial margin) – a minimum account balance required to enter into a contract • Maintenance performance bond (formerly maintenance margin) – the balance below which a performance bond call is triggered

• Performance bond call (formerly margin call) – a requirement to add funds when the account balance falls below the maintenance performance bond level to bring the balance in line with the initial performance bond level

– Daily settlement 1. Unrealized profits and losses on a contract resulting from price movements are marked to market (paid daily) 2. The existing contract reflecting the currency’s old price is canceled 3. A new contract reflecting the prevailing price is issued

Chapter 7: Currency Futures and Options Markets

7.A Futures and Forward Contracts (3) ❑

Futures contracts, continued – E.g.: Short one CME yen futures contract for ¥12.5 million with initial performance bond of $4,590 and maintenance performance bond of $3,400. Trading Day

Currency Price

1 (open)

$0.008233

1 (close)

$0.008342

Credit/Debit

Account Balance

Initial performance bond

$4,590.00

Daily loss marked to market

-$1,362.50

$3,227.50

Performance bond call deposit

$1,362.50

$4,590.00

Action

2 (close)

$0.008381

Daily loss marked to market

-$487.50

$4,102.50

3 (close)

$0.008175

Daily gain marked to market

$2,575.00

$6,677.50

4 (close)

$0.008169

Daily gain marked to market

$75.00

$6,752.50

5 (close)

$0.008194

Daily loss marked to market

-$312.50

$6,440.00

Round-trip commission to close account

-$27.00

$6,413.00

Chapter 7: Currency Futures and Options Markets

7.A Futures and Forward Contracts (4) ❑

Arbitrage using forward and futures contracts – Dealers seek to profit from differences in forward and futures bid prices for a currency. – E.g., Forward bid on £62,500 pounds sterling = $1.9727; futures price = $1.9715. • Buy futures contract for $123,218.75 (62,500 * $1.9715) • Simultaneously sell an equivalent amount of sterling forward (62,500 * $1.9727) for $123,293.75 • Profit = $75 – Arbitrage transactions will bid up the futures price and bid down the forward price until price equilibrium is restored.

Chapter 7: Currency Futures and Options Markets

7.B Currency Options (1) ❑

An option is a financial instrument that gives the holder the right but not the obligation to sell (put) or buy (call) another financial instrument at a set (strike or exercise) price and expiration date. – Options can be exercised or sold. • Exercising an option – The buyer of a call exercises an option to buy (take delivery of) the underlying currency at the strike price. – The buyer of a put exercises an option to sell (deliver) the underlying currency at the strike price. • Selling an option

– The buyer of a call or put sells an option to collect the difference between the initial option price and the price at the time of sale without taking delivery of/delivering the underlying currency.

Chapter 7: Currency Futures and Options Markets

7.B Currency Options (2) ❑

Options are in the money, at the money, or out of the money, depending on the strike price relative to the spot rate. – The purchaser of a call wants the spot rate to increase above the strike price in order to buy the underlying currency at a profit (to exercise) or see the value of the option increase (to sell). – The purchaser of a put wants the spot rate to decrease below the strike price in order to sell the underlying currency at a profit (to exercise) or see the value of the option increase (to sell). Option Description

Strike Price Relative to Spot Rate

Effect of Exercise

Call (buy) Option

Put (sell) Option

In the money

Strike < Spot

Strike > Spot

Profit

At the money

Strike = Spot

Indifference

Out of the money

Strike > Spot

Strike < Spot

Loss

Chapter 7: Currency Futures and Options Markets

7.B Currency Options (3) ❑

American-style option – can be exercised/sold any time up to expiration

❑

European-style option – can be exercised/sold only at maturity.

❑

Exchange-traded or listed options – standardized contracts with predetermined strike prices and expiration dates

❑

Market structure – Organized exchanges • In U.S.: United Currency Options Market (UCOM) of the Philadelphia Stock Exchange and Chicago Mercantile Exchange • Outside U.S.: European Options Exchange (Amsterdam, Montreal Stock Exchange

– Over-the-counter (OTC) market • Two segments – Retail market – nonbank customers purchase from banks – Wholesale market – composed of commercial banks, investment banks, and specialized trading firms. • OTC option specifications are generally negotiated in terms of amount, strike price and rights, underlying instrument, and expiration. Chapter 7: Currency Futures and Options Markets

7.B Currency Options (4) ❑

Using currency options – buying and exercising calls – Example: U.S. importer must make a €125,000 payment to a German exporter in 60 days. • To hedge against an exchange rate increase, buy a European-style call to have euros delivered at a strike price on the due date. • Strike = $1.34, premium = $0.02 • Option price = $0.02 * 125,000 = $2,500 • At the end of 60 days: – If value of euro has increased to $1.40, net profit = ($1.40 - $1.34) * 125,000 - $2,500 = $5,000. If strike equaled spot when the call was purchased, the implied cost of the importer’s payable increases by $7,500, whereas the actual increase is $2,500 (cost of the call). – If value of euro has decreased to $1.30, increase in cost of payable is limited to $2,500 because the option would not be exercised. Had the importer locked in a forward or futures rate of $1.34, the cost of the payable would have increased by $5,000.

Chapter 7: Currency Futures and Options Markets

7.B Currency Options (5) ❑

Using currency options – buying and exercising calls, continued – Break-even point – a call holder breaks even when Spot – Strike – Premium = Zero

– E.g., profit/loss/break-even for exercising previous call example Profit/ Loss $1.36 - $1.34 - $0.02 = $0

$5,000 $3,750 $2,500 $1,250 0 -$1,250

$1.30

$1.32

$1.34 $1.36 $1.38 Strike Break-even

$1.40

Spot at Expiration

-$2,500 -$3,750

Out of the money At the money

Chapter 7: Currency Futures and Options Markets

In the money

7.B Currency Options (6) ❑

Using currency options – buying and exercising puts – Example: German exporter has a €125,000 receivable due from a U.S. importer in 60 days. • To hedge against an exchange rate decrease, buy a European-style put to have euros delivered at a strike price on the due date • Strike = $1.34, premium = $0.02

• Option price = $0.02 * 125,000 = $2,500 • At the end of 60 days: – If value of euro has decreased to $1.28, net profit = ($1.34 - $1.28) * 125,000 - $2,500 = $5,000. If strike equaled spot when the put was purchased, the implied cost of the importer’s payable decreases by $7,500, whereas the actual decrease is $5,000. – If value of euro has increased to $1.40, the implied value of the receivable would decrease by $2,500 because the option would not be exercised, but the actual value would increase by $7,500 ($1.40 * 125,000 = $7,500). Thus, the net increase in value to the receivable is $5,000.

Chapter 7: Currency Futures and Options Markets

7.B Currency Options (7) ❑

Using currency options – buying and exercising puts, continued – Break-even point – a put holder breaks even when Strike – Spot – Premium = Zero

– E.g., profit/loss/break-even for exercising put example Profit/ Loss $5,000

$1.34 - $1.32 - $0.02 = $0

$3,750 $2,500 $1,250 0 -$1,250

$1.30

$1.32 $1.34 Break-even Strike

$1.36

$1.38

$1.40

Spot at Expiration

-$2,500 -$3,750

In the money

Out of the money At the money

Chapter 7: Currency Futures and Options Markets

7.B Currency Options (8) ❑

Using currency options – writing calls and puts – Call and put writers take on exchange risk transferred by call and put buyers. – Call and put writers keep the premium when options expire out of the money. – E.g., profit/loss/break-even for written call and put with same terms as previous examples Profit/ Loss $3,750 $2,500 $1,250 0 -$1,250

$1.30

-$2,500 -$3,750

$1.32 Put breakeven

$1.34 Strike

-$5,000 Profit/loss for put writer -$6,250 Chapter 7: Currency Futures and Options Markets

$1.36 Call breakeven

$1.38

$1.40

Spot at Expiration

Profit/loss for call writer 13

7.B Currency Options (9) ❑

Currency spreads – Combine calls or puts to lower the cost of speculating – Limit both downside and upside potential – Bull spread – speculating that the exchange rate will increase: buying a call at one strike price and writing a similar call at a different strike price – Bear spread – speculating that the exchange rate will decrease: buying a put at one strike price and writing a similar put at a different strike price

Profit/ Loss

Bull Spread

Bear Spread

Long call Bear spread Long put

Bull spread

Long call strike

Spot at Exp.

Short call strike Short call

Chapter 7: Currency Futures and Options Markets

Short put strike

Spot at Exp. Long put strike

Short put

7.B Currency Options (10) ❑

Knockout (“barrier”) options – Similar to a standard option except it is cancelled if the exchange rate crosses a predefined level (the outstrike) – Less expensive than standard options because of the risk of early cancellation – Types of knockout options • Down and out call – has a positive payoff to the option holder if the underlying currency increases • Down and out put – has a positive payoff to the option holder if the underlying currency decreases • Up and out options – cancelled if the underlying currency increases beyond the outstrike

Chapter 7: Currency Futures and Options Markets

7.B Currency Options (11) ❑

Option pricing – Option value Option Value = Intrinsic Value + Time Value where Intrinsic Value (call) = Spot S – Strike X

Intrinsic Value (put) = Strike X – Spot S and Time Value = Option Value – Intrinsic Value

Chapter 7: Currency Futures and Options Markets

7.B Currency Options (12) ❑

Option pricing – Time value reflects the probability that an option’s intrinsic value will increase before expiration, which decreases as expiration approaches. – A currency’s volatility increases the chances of very high or very low currency values at expiration. Thus, the higher the volatility of the underlying currency, the higher the option value. – The higher the option value, the higher the premium. – The value of an American option always exceeds its intrinsic value because time value is positive up to the expiration date. – An out-of-the-money option has only time value. – Because time value erodes as expiration approaches, an option with a longer expiration will have a higher price than an option with the same strike price but shorter expiration.

Chapter 7: Currency Futures and Options Markets

7.C ❑

Forward and Futures Contracts versus Options Contracts (1)

Compute benefits of hedging with futures and options assuming an American firm will collect a €125,000 receivable in 3 months – Spot rate = $1.3425; spot rate 3 months from now = $1.3125 – Futures rate = $1.3456; futures rate 3 months from now = $1.1350 – Put 1 premium = $0.0046; premium in 3 months = $0.0212 Put 2 premium = $0.0138; premium in 3 months = $0.0402

❑

Loss in value of the receivable in 3 months without hedge – ($1.3425 - $1.3125) * 125,000 = $3,750

❑

Hedging with options: Buy a put (to sell) – Profit on put 1 = ($0.0212 - $0.0046) * 125,000 = $2,075 – Profit on put 2 = ($0.0402- $0.0138) * 125,000 = $3,300

❑

Hedging with futures: Sell euros forward – Profit = ($1.3456 - $1.3150) * 125,000 = $3,825

❑

The futures hedge best offsets the loss in the receivable’s value.

Chapter 7: Currency Futures and Options Markets

7.C

Forward and Futures Contracts versus Options Contracts (2)

❑

HOWEVER, the currency could have appreciated in 3 months.

❑

Compute losses from hedging given the following assumptions: – Spot rate = $1.3425; spot rate 3 months from now = $1.3761 – Futures rate = $1.3456; futures rate 3 months from now = $1.3796 – Put 1 premium = $0.0046; premium in 3 months = $0.0001 Put 2 premium = $0.0138; premium in 3 months = $0.0001

❑

Gain in value of the receivable in 3 months without hedge – ($1.3761 - $1.3425) * 125,000 = $4,200

❑

Hedging with options: Buy a put (to sell) – Loss on put 1 = ($0.0001 - $0.0046) * 125,000 = -$562.5 – Loss on put 2 = ($0.0001- $0.0138) * 125,000 = -$1,712.5

❑

Hedging with futures: Sell euros forward – Loss = ($1.3456 - $1.3796) * 125,000 = -$4,250

❑

The options hedge minimizes hedging losses.

Chapter 7: Currency Futures and Options Markets

7.D Futures Options (1) ❑

Traders purchase and sell puts and calls on a contract calling for delivery of a standard CME currency futures contract, rather than the currency itself.

❑

When a contract is exercised, the holder receives a short or long position in the underlying currency futures contract that is marked to market. – On exercising a call futures option, the holder receives a long position in the underlying futures contract, plus an amount of cash equal to the current futures price less strike. – On exercising a put futures option, the holder receives a short position in the futures contract, plus an amount of cash equal to the strike price less the current futures price.

❑

Difference between a futures option contract and a futures contract – Futures contract: Holder must deliver one currency against the other or reverse the contract, regardless of whether doing so is profitable. – Futures option contract: Holder is protected against an adverse move in the exchange rate and may allow the option to expire unexercised.

Chapter 7: Currency Futures and Options Markets

7.D Futures Options (2) ❑

Example: Exercising a pound call futures option contract – An investor holds a June pound call futures option contract for £62,500 – Strike = $1.9565, spot = $1.9663 – At exercise, investor receives: • Long position in the futures contract at a price of $1.9565 • Cash payment of ($1.9663 - $1.9565) * 62,500 = $612.50.

– At exercise, option writer receives a short position in the same contract ❑

Example: Exercising a Swiss franc put futures option contract – An investor holds a June pound put futures option contract for SFr 125,000 – Strike = $0.8132, spot = $0.7950 – At exercise, investor receives: • Short position in the futures contract at a price of $1.9565 • Cash payment of ($0.8132 - $0.7950) * 125,000 = $2,275.

– At exercise, option writer receives a long position in the same contract Chapter 7: Currency Futures and Options Markets

7.E Reading Currency Futures and Options Prices

Strike = $1.3600

Cost per euro = $0.0109; 125,000 * $0.109 = $1,362.5 per contract

Chapter 7: Currency Futures and Options Markets

Chapter 8

Swaps and Interest Rate Derivatives

Chapter 8 Outline A. Interest Rate Swaps B. Currency Swaps C. Interest Rate/Currency Swaps

D. Interest Rate Forwards E. Interest Rate Futures

Chapter 8: Swaps and Interest Rate Derivatives

8.A Interest Rate Swaps (1) ❑

Interest rate swap – an agreement between two parties to exchange U.S. dollar interest payments for a specific maturity on an agreed-on notional, or theoretical, principal amount.

❑

No principal changes hands.

❑

Maturities range from less than one year to greater than 15 years.

❑

Enable a party to convert a floating rate to a fixed rate, and vice versa.

❑

Types of swaps – Coupon swap – one party pays a fixed rate computed at the time of trade as a spread to a particular Treasury bond, and one party pays a floating rate that resets periodically based on a designated index. – Basis swap – two parties exchange floating interest payments based on different reference rates.

Chapter 8: Swaps and Interest Rate Derivatives

8.A Interest Rate Swaps (2) ❑

Classical swap transaction – Counterparties A and B require $100 million for 5 years. – Based on their credit rating, Counterparties A (BBB rating) and B (AAA rating) have the following borrowing options. Counterparty

Fixed Rate

Floating Rate

8.5%

6-month LIBOR + 0.5%

7.0%

6-month LIBOR

– Counterparty A wants to borrow at a fixed rate lower than 8.5%.

– Counterparty B wants to borrow at a floating rate lower than LIBOR. – Counterparty A uses an interest rate swap to convert a floating rate to a more attractive fixed rate, and Counterparty B uses an interest rate swap to convert a fixed rate to a more attractive floating rate.

Chapter 8: Swaps and Interest Rate Derivatives

8.A Interest Rate Swaps (3) ❑

Classical swap transaction, continued Pays 7.35% Counterparty A

Receives 7.25% BigBank

Receives LIBOR Borrows $100m at (LIBOR + 0.5%) Floating Rate Lenders Net Cost = 7.35% + (LIBOR + 0.5%) – LIBOR = 7.85% Counterparty A • Pays BigBank 7.35% in return for LIBOR • Borrows $100 million at (LIBOR + 0.5%) • Trades floating rate for fixed rate and reduces 8.5% fixed rate to 7.85%, saving 0.65% Chapter 8: Swaps and Interest Rate Derivatives

Counterparty B Pays LIBOR

Net Gain = 7.35% – 7.25% + LIBOR – LIBOR = 0.10%

Issues $100m at 7.0% Eurobond Net Cost = LIBOR + 7.0% – 7.25% = LIBOR – 0.25%

Counterparty B • Pays BigBank LIBOR in return for 7.25% • Issues $100 million in Eurobonds at 7.0% • Trades fixed rate for floating rate and reduces LIBOR floating rate to (LIBOR – 0.25%), saving 0.25% 4

8.B Currency Swaps (1) ❑

Currency swap – an exchange of debt-service obligations denominated in one currency for the service on an agreed-on principal amount of debt denominated in another currency. – E.g., a U.S. firm borrows yen and engages in a swap with a company that borrows dollars with parallel interest and principal repayment schedules: Year 0 Principal payment in yen Principal payment in dollars

Company A

Years 1-10 Dollar interest payments

Company B

Yen interest payments Year 10 Principal payment in dollars Principal payment in yen

Chapter 8: Swaps and Interest Rate Derivatives

8.B Currency Swaps (2) ❑

Currency swap enables companies to effectively lower their costs of borrowing. – E.g., Dow Chemical wants to borrow $200 million in euros and Michelin wants to borrow $200 million, both at fixed rates. Borrowing options are: Better for Michelin

Counterparty

DollarDenominated Debt

EuroDenominated Debt

Dow Chemical

7.5%

8.25%

Michelin

7.7%

8.1%

Better for Dow Chemical

– Michelin’s euro-denominated rate is better for Dow Chemical, and Dow Chemical’s dollar-denominated rate is better for Michelin. – Given a current spot rate of €0.75/$, Michelin would borrow €150 million at 8.1% and Dow Chemical would borrow $200 million at 7.5%. – By engaging in a currency swap, each company benefits from the other’s borrowing terms (Dow Chemical effectively services €150 million at 8.1% and saves 15 basis points, and Michelin effectively services $200 million at 7.5% and saves 20 basis points). Chapter 8: Swaps and Interest Rate Derivatives

8.B Currency Swaps (3) ❑

Mechanics of Dow Chemical-Michelin currency swap* €150 million

$200 million Borrows at 7.5%

Borrows at 8.1% Year 0 $200 million principal €150 million principal

Dow Chemical

Years 1-10 €12.15 million interest

Michelin

$15 million interest Year 10 €150 million principal $200 million principal

*Actual swaps typically use intermediaries as illustrated in the classical swap transaction and are thus more complex. Chapter 8: Swaps and Interest Rate Derivatives

8.C Interest Rate/Currency Swaps (1) ❑

Interest rate/currency swap – combines the features of both a currency swap and interest rate swap.

❑

Designed to convert a liability in one currency with a stipulated type of interest payment into a liability denominated in another currency with a different type of interest payment.

❑

Types of interest rate/currency swap – Fixed-for-floating swap – most common type of interest rate/currency swap; converts a fixed-rate liability in one currency into a floating rate liability in another currency. – Dual currency bond swap – a company swaps the foreign-currencydenominated interest payments on its dual currency bond* for dollardenominated payments.

*A dual currency bond has the issue’s proceeds and interest payments stated in a foreign currency and the principal repayment in another currency. The swap effectively converts the dual currency bond to a single currency bond. Chapter 8: Swaps and Interest Rate Derivatives

8.C Interest Rate/Currency Swaps (2) ❑

Example: Fixed-for-floating swap – Dow Chemical wants to borrow floating-rate euros and Michelin wants to borrow fixed-rate dollars. Debt options are:

Better for Michelin

Counterparty

DollarDenominated Debt

EuroDenominated Debt

Dow Chemical

7.5%

LIBOR + 0.35%

Michelin

7.7%

LIBOR + 0.125%

Better for Dow Chemical

– Michelin’s euro-denominated floating rate is better for Dow Chemical, and Dow Chemical’s dollar-denominated fixed rate is better for Michelin. – Given a current spot rate of €0.75, Michelin would borrow €150 million at LIBOR + 0.125% and Dow Chemical would borrow $200 million at 7.5%. – By engaging in an interest rate/currency swap, each company benefits from the other’s borrowing terms (Dow Chemical effectively services €150 million at LIBOR + 0.125% and saves 22.5 basis points, and Michelin effectively services $200 million at 7.5% and saves 20 basis points). Chapter 8: Swaps and Interest Rate Derivatives

8.C Interest Rate/Currency Swaps (3) ❑

Mechanics of Dow Chemical-Michelin interest rate/currency swap* €150 million

$200 million

Borrows at LIBOR + 0.125%

Borrows at 7.5% Year 0 $200 million principal €150 million principal

Dow Chemical

Years 1-10 LIBOR + 0.125% interest

Michelin

$15 million interest Year 10 €150 million principal $200 million principal

*Actual swaps typically use intermediaries as illustrated in the classical swap transaction and are thus more complex. Chapter 8: Swaps and Interest Rate Derivatives

8.C Interest Rate/Currency Swaps (4) ❑

Example: Dual currency bond swap – On October 1, 1985, Fanny Mae issues 10-year, 8% dual currency bonds with ¥50 billion in proceeds, ¥4 billion interest payments, and $240,000 principal repayment. – Fanny Mae enters into a swap with Nomura, exchanging the ¥4 billion interest payments for a fixed schedule of dollar payments at implied exchange rates.* – The swap converts the dual currency bond into a single currency bond. – Scheduled payments lock in an internal rate of return on dollar payments of 10.67% and eliminate exchange risk associated with the yen over the period.

*The implied exchange rates are computed as ¥4 billion / scheduled dollar payment (see next slide). Chapter 8: Swaps and Interest Rate Derivatives

8.C Interest Rate/Currency Swaps (5) ❑

Dual currency bond swap: Fanny Mae-Nomura swap terms Payment Date (October 1)

Payment on Dual Currency Bond

Dollar Payment Under Swap

Implied Exchange Rate

1985

¥49,687,500,000

$209,468,314

¥237.378

1986

¥4,000,000,000

$18,811,800

¥212.633

1987

¥4,000,000,000

$19,124,381

¥209.157

1988

¥4,000,000,000

$19,464,370

¥205.504

1989

¥4,000,000,000

$19,854,506

¥201.466

1990

¥4,000,000,000

$20,304,259

¥197.003

1991

¥4,000,000,000

$20,942,375

¥191.000

1992

¥4,000,000,000

$21,499,712

¥186.049

1993

¥4,000,000,000

$22,116,872

¥180.857

1994

¥4,000,000,000

$22,718,882

¥176.065

1995

¥4,000,000,000

$23,665,096

¥169.025

1996

$240,400,000

¥207.987

Swap converts dual currency bond to single currency bond Chapter 8: Swaps and Interest Rate Derivatives

8.C Interest Rate/Currency Swaps (6) ❑

Mechanics of Fanny Mae-Nomura dual currency bond swap ¥50 billion in bonds Issues at 8.0% Year 0 ¥50 billion $209 million

Fanny Mae

Years 1-10 Scheduled dollar payments

Nomura

¥4 billion Year 10 $240.4 million $240.4 million

Chapter 8: Swaps and Interest Rate Derivatives

8.D Interest Rate Forwards (1) ❑

Forward forward – a contract that fixes an interest rate today on a future loan or deposit – E.g., if a company knows it will need to borrow money in 6 months for a 3-month period, it risks interest rate increases by waiting 3 months to borrow. – Buying a forward forward with a bank guarantees that 6 months from now, the bank will loan the company its funds at a known fixed rate (forward forward rate).

Chapter 8: Swaps and Interest Rate Derivatives

8.D Interest Rate Forwards (2) ❑

Forward forward, continued – Companies can create forward forwards and derive the forward forward rate through arbitrage. E.g.: • LIBOR3 = 6.7%, LIBOR9 = 6.95% • Borrow the present value of $1,000,000 for 3 months and loan the same amount for 9 months.

• Net effect: 6-month transaction to loan $1,000,000 3 months from now and receive $1,034,792 in 9 months. • Implied 6-month forward forward rate = interest of 3.479% over 6 months, or 6.958% per annum. t=0

3 months

Borrow $983,526

6.7%

Loan $983,526

6.95%

9 months

Repay $1,000,000 Collect $1,034,792 6-month forward forward

Chapter 8: Swaps and Interest Rate Derivatives

8.D Interest Rate Forwards (3) ❑

Forward rate agreement (FRA) – a cash-settled, OTC forward contract that allows a company to fix an interest rate to be applied to a specified future period on a notional principal amount. – Company and bank agree to exchange interest payments, such that, on a LIBOR-based FRA: • If fixed interest rate at time of contract (forward rate) < LIBORt in x months, bank pays company the interest payment differential • If forward rate > LIBORt in x months, company pays bank the interest payment differential

– Interest payment on a LIBOR-based FRA: (LIBOR – forward rate)(

days

)

360

Interest payment = notional principal * 1 + (LIBOR * (

days

))

360 where days = number of days in the future interest period Chapter 8: Swaps and Interest Rate Derivatives

8.D Interest Rate Forwards (4) ❑

Forward rate agreement (FRA), continued – E.g., Unilever needs to borrow $50 million for 6 months starting in 2 months – Unilever buys a “2 x 6” FRA on LIBOR at 6.5% from bank for notional principal of $50 million. – If in 2 months, LIBOR6 > 6.5%, bank pays Unilever the difference in interest expense, and if LIBOR6 < 6.5%, Unilever pays bank the difference. – In 2 months, LIBOR = 7.2% – Bank owes Unilever the difference in interest between 7.2% and 6.5%, computed as (0.072 – 0.065) (

Interest payment = $50,000,000 * 1 + (0.072 * (

182

)

360

182

= $170,730

))

360 Chapter 8: Swaps and Interest Rate Derivatives

8.E Interest Rate Futures (1) ❑

Eurodollar future – a cash-settled contract on a 3-month, $1,000,000 Eurodollar deposit that pays LIBOR. – Act like FRAs by helping to lock in a future interest rate and are settled in cash.

– Like other futures contracts, marked to market – Contract price quoted as an index number equal to (100 – annualized forward rate); e.g., if LIBOR3 = 8.32%, price = 100 – 8.23 = 91.68. – Initial value of contract Initial value of contract = $1,000,000 * (1 – LIBOR3 at inception) (

90 ) 360

– Settlement value of contract Settlement value of contract = $1,000,000 * (1 – LIBOR3 at settlement) (

Chapter 8: Swaps and Interest Rate Derivatives

90 ) 360

8.E Interest Rate Futures (2) ❑

Eurodollar future, continued – If LIBOR3 at settlement > LIBOR3 at inception, buyer will realize a gain. – Thus, • Borrowers looking to lock in a future cost of funds would sell futures contracts because increases in future interest rates would be offset by gains on the short position in the futures contracts; and • Investors seeking to lock in a forward interest rate would buy futures contracts because declines in future rates would be offset by gains on the long position in the futures contracts.

Chapter 8: Swaps and Interest Rate Derivatives

Chapter 9

Foreign Exchange Risk Management

Chapter 9 Outline A. Measures of Foreign Exchange Exposure B. Translation Exposure C. Transaction Exposure

D. Hedging E. Managing Translation Exposure F. Managing Transaction Exposure

Chapter 9: Foreign Exchange Risk Management

9.A Measures of Foreign Exchange Exposure (1) ❑

Foreign exchange exposure – the degree to which a company is affected by exchange rate changes

❑

Types of exposure – Translation (accounting) exposure – the extent to which currency fluctuations affect financial statement items denominated in foreign currency. • A company must convert the financial statements of its foreign operations from local currencies to the home currency. – Economic exposure – the extent to which the value of the firm, as measured by the present value of its expected cash flows, is affected by exchange rate fluctuations. Includes operating exposure and transaction exposure.

• Operating exposure – the extent to which currency fluctuations can alter a company’s future operating cash flows (revenues and costs) • Transaction exposure – the extent to which currency fluctuations affect contractually binding future foreign-currency-denominated cash inflows and outflows. Has aspects of both translation and operating exposure. Chapter 9: Foreign Exchange Risk Management

9.A Measures of Foreign Exchange Exposure (2) Foreign Exchange Exposure Economic Exposure = Operating Exposure + Transaction Exposure* Operating Exposure Aspects of both operating and transaction exposure

The extent to which revenues and costs are affected by currency fluctuations

Accounting Exposure Translation Exposure The extent to which assets, liabilities, revenues, expenses, gains, and losses denominated in foreign currencies result in foreign exchange gains and losses

Transaction Exposure E.g., contractual sales transactions affect revenues

The extent to which contractually binding transactions that have not been executed will be affected by currency fluctuations at settlement

Aspects of both translation and transaction exposure

E.g., A/R, debt

*Although transaction exposure is properly included as economic exposure, it is often included in accounting exposure because certain contractually binding transactions are included in a firm’s financial statements. Chapter 9: Foreign Exchange Risk Management

9.B Translation Exposure (1) ❑

The financial statements of foreign subsidiaries must be translated from local currency to home currency before consolidation with the parent’s financial statements.

❑

Assets and liabilities translated at the current (postchange) exchange rates are considered to be exposed.

❑

Assets and liabilities translated at historical (prechange) exchange rates maintain their historic home country values and are not exposed.

❑

Four principal methods are used to translate foreign subsidiary financial statements from local currency to home currency. 1. Current/noncurrent method 2. Monetary/nonmonetary method 3. Temporal method 4. Current rate method

Chapter 9: Foreign Exchange Risk Management

9.B Translation Exposure (2) 1. Current/noncurrent method – based on the maturity of the financial statement item – Balance sheet items • All of the foreign subsidiary’s current assets and liabilities are translated into home currency at the current exchange rate.

• All noncurrent assets and liabilities are translated at the historical exchange rate (the rate in effect at the time the asset was acquired or the liability was incurred). – Income statement items – are translated at the average exchange rate of the period, except for revenues and expenses associated with noncurrent assets (e.g., depreciation) or liabilities.

Chapter 9: Foreign Exchange Risk Management

9.B Translation Exposure (3) 2. Monetary/nonmonetary method – differentiates between monetary and nonmonetary (i.e., physical) assets and liabilities – Balance sheet items • All of the foreign subsidiary’s monetary assets and liabilities are translated into home currency at the current exchange rate.

• All nonmonetary assets and liabilities are translated at the historical exchange rate (the rate in effect at the time the asset was acquired or the liability was incurred). – Income statement items – are translated at the average exchange rate of the period, except for revenues and expenses associated with nonmonetary assets (e.g., depreciation, COGS) or liabilities.

Chapter 9: Foreign Exchange Risk Management

9.B Translation Exposure (4) 3. Temporal method – modified version of the monetary/nonmonetary method but based on the underlying approach to cost accounting (historical vs. market) rather than on the type of asset and liability. – Balance sheet items • All of the foreign subsidiary’s monetary assets and liabilities are translated into home currency at the current exchange rate. • All nonmonetary assets and liabilities are translated at the historical exchange rate (the rate in effect at the time the asset was acquired or the liability was incurred), except inventory, which can be translated at the current exchange rate if included on the balance sheet at market values.

– Income statement items – are translated at the average exchange rate of the period, except for depreciation, amortization, and COGS, which are translated at historical exchange rates.

4. Current rate method – all balance sheet and income statement items are translated at the current rate. Chapter 9: Foreign Exchange Risk Management

9.B Translation Exposure (5) Example: The effects of each translation method on balance sheet items Local Currency

Historical = LC4/$1

Current = LC5/$1

Monetary/ Nonmon.

Temporal

Current/ Noncurrent

Current Rate

Cash, marketable sec., A/R

2,600

650

520

Inventories (at market)

3,600

900

720

900

720

Prepaid Expenses

200

Total Current Assets

6,400

1,600

1,280

1,470

1,290

1,280

Fixed Assets less Acc. Dep.

3,600

900

720

900

720

Goodwill

1,000

250

200

250

200

Total Assets

11,000

2,750

2,200

2,620

2,440

2,430

2,200

Current Liabilities

3,400

850

680

Long-term Debt

3,000

750

600

750

600

500

125

100

125

100

6,900

1,725

1,380

1,555

1,380

Capital Stock

1,500

375

300

375

Retained Earnings

2,600

650

520

865

685

500

445

Total Equity

4,100

1,025

820

1,240

1,060

875

820

215

-150

-205

Balance Sheet Item

Current Assets

Deferred Income Taxes

Total Liabilities

Equity Gain/Loss

Chapter 9: Foreign Exchange Risk Management

9.C Transaction Exposure ❑ Transaction exposure stems from the possibility of incurring future exchange gains or losses on foreign-currency-denominated transactions already entered into but not settled. ❑ Transaction exposure is measured currency by currency and equals the difference between contractually fixed future cash inflows and outflows in each currency.

❑ Example: Boeing sells five 747s to Air India for Rs 50 billion and agrees to buy Indian parts worth Rs 22 billion.* –

Inflows = Rs 50 billion; outflows = Rs 22 billion

–

Net transaction exposure = inflows – outflows = Rs 28 billion.

–

If e0 = $0.0243, net transaction exposure in dollars = 28 billion * $0.0243 = $680.4 million.

–

If e0 decreases to $0.024255 at settlement, transaction loss = ($0.024255 $0.0243) * 22 billion = $1.4 million.

*This example also shows the effects of operating exposure (recall that transaction exposure overlaps with both operating and translation exposure), because the value of the contract, and thus the effect of currency fluctuations on the contract, directly affects revenues. Chapter 9: Foreign Exchange Risk Management

9.D Hedging (1) ❑ Before using hedging techniques, a firm must decide which exposures to manage and how to manage them. ❑ Clear, detailed objectives must be developed to eliminate the ambiguity inherent in broad or vague objectives (e.g., “eliminate all exposure). ❑ Elements of an exposure management strategy 1. Determine the types of exposure to be monitored. 2. Formulate corporate objectives and guidelines for conflicts of interest. 3. Ensure corporate objectives are consistent with maximizing shareholder value and can be implemented. 4. Clearly specify who is responsible for which exposures and detail the criteria by which each manager will be judged. 5. Make explicit any constraints on the use of exposure-management techniques. 6. Identify the channels by which exchange rate considerations are incorporated into operating decisions that will affect the firm’s exchange risk posture. 7. Develop a system to monitor and evaluate exchange risk management activities. Chapter 9: Foreign Exchange Risk Management

9.D Hedging (2) ❑ Strategy objectives 1. Minimize translation exposure – necessitates protecting foreigncurrency-denominated assets and liabilities from changes in value due to exchange rate fluctuations. 2. Minimize quarter-to-quarter (or year-to-year) earnings fluctuations related to currency fluctuations 3. Minimize transaction exposure 4. Minimize economic exposure 5. Minimize foreign exchange risk management costs

6. Avoid surprises

Chapter 9: Foreign Exchange Risk Management

9.D Hedging (3) ❑ Standard hedging techniques Anticipated Currency Change Depreciation

Appreciation

Sell local currency forward

Buy local currency forward

Buy a local currency put option

Buy a local currency call option

Reduce levels of local currency cash and marketable securities

Increase levels of local currency cash and marketable securities

Tighten local currency credit terms

Relax local currency credit terms

Delay collection of hard currency A/R

Accelerate collection of soft currency receivables

Accelerate dividend and fee remittance to parent and other subsidiaries

Delay dividend and fee remittance to parent and other subsidiaries

Accelerate payment of intersubsidiary A/P

Delay payment of intersubsidiary A/P

Delay collection of intersubsidiary A/R

Accelerate collection of intersubsidiary A/R

Invoice exports in foreign currency and imports in local currency

Invoice exports in local currency and imports in foreign currency

Chapter 9: Foreign Exchange Risk Management

9.D Hedging (4) ❑ Centralizing versus decentralizing hedging function – Arguments for centralization •

Local treasurers want to optimize their own financial and exposure positions, regardless of the overall corporate situation.

•

Through lack of knowledge or incentive, subsidiaries may engage in hedges that increase rather than decrease overall corporate exposure.

•

Reduces amount of hedging required and associated transaction costs.

•

Optimizes before-tax hedging cost variations that exist among subsidiaries because of market imperfections.

– Arguments for decentralization •

Local knowledge

•

Incentives for local managers to take advantage of situations that only they are familiar with.

Chapter 9: Foreign Exchange Risk Management

9.D Hedging (5) ❑ Costs of hedging – If devaluation is unlikely, hedging may be costly and inefficient. – If devaluation is likely, hedging costs rise to reflect the anticipated devaluation – Because one company’s payable is another company’s receivable, attempting to delay or accelerate payment given anticipated exchange rate changes will not produce a net gain. – Shifting funds from one country to another is not costless: Accelerating payables and delaying intercompany receivables forces a subsidiary in a devaluation-prone country to increase local currency borrowings at higher interest rates to finance additional working capital requirements. – Invoicing exports in the foreign currency and imports in the local currency may result in lost sales.

Chapter 9: Foreign Exchange Risk Management

9.D Hedging (6) ❑ Costs of hedging relating to currency depreciation Hedging Technique

Cost

Sell local currency forward

Transaction costs; difference between forward and future spot rates

Buy a local currency put option

Put option premium

Reduce levels of local currency cash and marketable securities

Operational problems; opportunity costs (loss of higher interest rates on local currency securities)

Tighten local currency credit terms

Lost sales and profits

Delay collection of hard currency A/R

Cost of financing additional receivables

Increase imports of hard currency goods

Financing and holding costs

Borrow locally

Higher interest rates

Delay payment of A/P

Negatively affect credit rating

Accelerate dividend and fee remittance to parent and other subsidiaries

Borrowing cost if funds not available or loss of higher interest rates if local currency securities are sold

Accelerate payment of intersubsidiary A/P

Opportunity cost of money

Delay collection of intersubsidiary A/R

Opportunity cost of money

Invoice exports in foreign currency and imports in local currency

Lost export sales or lower price; premium price for imports

Chapter 9: Foreign Exchange Risk Management

9.D Hedging (7) ❑ Benefits of hedging – A company can benefit from hedging only to the extent that it can forecast future exchange rates more accurately than the market. •

For a foreign cash inflow, hedge if f1 > ē0

•

For a foreign cash outflow, hedge if f1 < ē0

– The hedger (company) should assume that the market knows as much as it does. – Using market imperfections or tax asymmetries or both. E.g.: •

If a currency is overvalued and exchange controls are not imposed to prevent capital outflows, and if hard currency can be acquired at the official exchange rate, a subsidiary can accelerate intercompany accounts payable and remittances and make immediate purchases from other subsidiaries.

•

If forward contract losses are treated as a cost of doing business and gains are taxed at lower capital gains, a company can engage in tax arbitrage.

Chapter 9: Foreign Exchange Risk Management

9.D Hedging (8) ❑

Accounting for hedging and FASB 133 – FASB 133 establishes accounting and reporting standards for derivatives and hedging activities. •

A derivative that qualifies as a hedge gets special accounting treatment that matches gains/losses resulting from the changes in value of the derivatives with gains/losses in the value of the underlying transaction or asset, thus removing hedging gains/losses from current income.

•

A change in the value of the derivative not offset by a change in the value of the hedged item is recorded in current income.

– To qualify for hedge accounting, a company must demonstrate a hedging relationship to be highly effective (meaning a correlation ratio of 80% to 125%) in achieving offsetting changes in fair value or cash flows for the risk being hedged. – A foreign currency derivative that cannot be shown to be effective must be marked to market.

Chapter 9: Foreign Exchange Risk Management

9.E Managing Translation Exposure (1) ❑

Basic hedging strategy for translation exposure Currency

Anticipated Movement

Assets

Liabilities

Hard currencies

Appreciate

Increase

Decrease

Soft currencies

Depreciate

Decrease

Increase

Reduce cash

Soft Currency Devaluation

Tighten credit terms to decrease A/R

Increase cash

Increase local currency borrowing

Hard Currency Revaluation

Loosen credit terms to decrease A/R

Chapter 9: Foreign Exchange Risk Management

Decrease local currency borrowing

Sell weak currency forward Delay A/P

Buy weak currency forward Accelerate A/P

9.E Managing Translation Exposure (2) ❑

Only if a company’s anticipations differ from the market’s and are also superior to the market’s will hedging lead to reduced costs.

❑

Three methods for managing translation exposure – Adjusting flow funds – Entering into forward contracts – Exposure netting

Chapter 9: Foreign Exchange Risk Management

9.E Managing Translation Exposure (3) ❑

Funds adjustment – To reduce translation exposure in anticipation of a local currency devaluation, convert local currency cash into hard currency assets. – Funds adjustment alters the amounts or currencies or both of the planned cash flows of the parent or its subsidiaries to reduce the firm’s local currency accounting exposure. • Direct funds adjustment techniques (reverse for revaluation) – Price exports in hard currencies and imports in local currency – Invest in hard currency securities – Replace hard currency loans with local currency loans • Indirect funds adjustment techniques (reverse for revaluation) – Adjust transfer prices on the sale of goods between affiliates – Accelerate payment of dividends, fees, and royalties – Adjust the leads and lags of intersubsidiary A/P and A/R

Chapter 9: Foreign Exchange Risk Management

9.E Managing Translation Exposure (4) ❑

Evaluating alternative hedging mechanisms – two-stage process – Stage 1: Compute the profit associated with each funds adjustment technique on a covered after-tax basis. • Profitable transactions should be undertaken regardless of whether they increase or decrease the company’s translation exposure. These transactions involve the use of arbitrage and not hedging. – Stage 2: Any unwanted exposure resulting from stage 1 can be corrected in the forward market. • Where the forward market is nonexistent or limited, the company must determine both the appropriate techniques and their appropriate levels. • To determine the appropriate levels, comparing the net cost of a funds adjustment technique with the anticipated currency depreciation will indicate whether the hedging transaction is profitable on an expected-value basis.

Chapter 9: Foreign Exchange Risk Management

9.F Managing Transaction Exposure (1) ❑

Measures to protect against transaction exposure – Forward market hedge – Money-market hedge – Risk shifting – invoicing all transactions in dollars to avoid transaction exposure (still leaving the company open to operating exposure)

– Exposure netting – Price adjustment clauses (currency risk sharing) – Currency collars – Cross-hedging

– Currency options

Chapter 9: Foreign Exchange Risk Management

9.F Managing Transaction Exposure (2) ❑

Forward market hedge – a company fixes the dollar value of the future foreign currency cash flow by selling or buying currency forward. Currency Position

❑

Hedging Strategy

Protect Against

Long (receivable)

Sell forward

Currency depreciation

Short (payable)

Buy forward

Currency appreciation

Example –

GE has a €10 million receivable in one year.

–

If e0 = $1.3382 and f1 = $1.28, the market expects a euro devaluation. To protect against currency depreciation, GE sells forward €10 million for delivery in one year.

–

By selling forward, in one year, GE will receive a fixed amount of $12.8 million.

–

If e1 = $1.3382, receivable = $13.382 million and loss on hedge = -$582,000 = $1.28, receivable = $12.8 million and gain/loss on hedge = $0 = $1.25, receivable = $12.5 million and gain on hedge = $300,000

Chapter 9: Foreign Exchange Risk Management

9.F Managing Transaction Exposure (3) ❑

True cost of forward hedging – the cost of hedging can be computed only at settlement because it depends on the future spot rate e1.

❑

The traditional method for computing the cost of hedging is f1 – e0 e0

– This method computes only the forward discount or premium. ❑

The true cost of hedging is computed as f1 – e1 e0

– This method computes the opportunity cost of the hedge; that is, the difference between dollars per unit of foreign currency received with hedging (a function of f1) and without hedging (a function of e1). Chapter 9: Foreign Exchange Risk Management

9.F Managing Transaction Exposure (4) ❑

Money-market hedge – borrow and lend two currencies simultaneously to lock in the dollar value of a future foreign currency cash flow.

❑

Example –

GE has a €10 million receivable due in one year

–

rEur = 15%, rUS = 10%

–

If e0 = $1.3382 and f1 = $1.28, the market expects a euro devaluation.

–

To protect against currency depreciation: NOW • •

Borrow PV of €10 million = €(10 million/1.15) = €8.70 million for one year Convert €8.70 million to $11.64 million (€8.70 million * $1.3382)

•

Deposit $11.64 million for one year at 10%

IN ONE YEAR • •

–

Collect $11.64 million * 1.10 = $12.8 million Use proceeds from receivable to repay loan of €8.70 million * 1.15 = €10 million

If e1 = $1.3382, receivable = $13.382 million and loss on hedge = -$582,000 = $1.28, receivable = $12.8 million and gain/loss on hedge = $0

= $1.25, receivable = $12.5 million and gain on hedge = $300,000 Chapter 9: Foreign Exchange Risk Management

9.F Managing Transaction Exposure (5) ❑

Comparing forward and money-market hedges with transaction costs

❑

Example: Pepsi has a C$40 million payable due in 90 days – rCan = 4.71%-4.64%, rUS = 5.50%-5.35% – e0 = $0.9422-31, f1 = $0.9440-61, so the market expects a C$ appreciation

– Using money-market hedge to protect against currency appreciation NOW • Borrow [C$40 million/(1+4.64%/4)] * $0.9431 = $37,291,420 at 5.50%/4 = 1.375% • Convert $37,291,420 to C$39,541,321 ($37,291,420/$0.9431)

• Deposit C$39,541,321 for 90 days at 4.64%/4 = 1.16% IN 90 DAYS • Receive C$39,541,321 * 1.0116 = C$40 million • Use proceeds to pay payable • Repay loan of $37,291,420 * 1.01375 = $37,804,177 with cash Chapter 9: Foreign Exchange Risk Management

9.F Managing Transaction Exposure (6) ❑

Example, continued: Pepsi has a C$40 million payable due in 90 days – rCan = 4.71%-4.64%, rUS = 5.50%-5.35% – e0 = $0.9422-31, f1 = $0.9440-61, so the market expects a C$ appreciation

– Using forward hedge to protect against currency appreciation • Buy forward C$40 million at f1 = $0.9461 for delivery in 90 days • Pepsi locks in the cost of its payable at C$40 million * 0.9461 = $37,844,000

– In this case, using the money-market hedge instead of the forward hedge saves $37,844,000 - $37,804,177 = $39,823.

Chapter 9: Foreign Exchange Risk Management

9.F Managing Transaction Exposure (7) ❑

Risk shifting – Exporter invoices importer in exporter’s local currency, shifting the currency risk to the importer. – Exporter agrees to invoice importer in importer’s local currency, shifting the currency risk to itself. – Thus, risk shifting is a zero-sum game – An importer will take on exchange risk (be willing to pay the exporter in the exporter’s currency) only if it expects e1 to be no higher than f1.

Chapter 9: Foreign Exchange Risk Management

9.F Managing Transaction Exposure (8) ❑

Pricing decisions – When a company fails to account for anticipated exchange rate changes when making pricing decisions, it may incur losses at the time of the initial transaction unrelated to exchange risk. – E.g., GE sells turbine blades to Lufthansa •

GE prices blades at $13.382 million

•

Lufthansa demands a quote in euros

•

GE quotes blades at €10 million using e0 = $1.3382

•

The quote is only worth $12.8 million, GE’s risk-free price in using the forward market (f1 = $1.28)

•

Thus, the proper euro quote = €13.382 million/1.28 = €10.455 million.

•

GE loses $582,000 on the sale, not due to exchange risk

– General rule on credit sales overseas – convert between the foreign currency price and the dollar price using f1 and not e0. Chapter 9: Foreign Exchange Risk Management

9.F Managing Transaction Exposure (9) ❑ Exposure netting – Exposures in one currency are offset with exposures in the same or another currency – Only net exposures are hedged, saving on transaction costs – Basic example: Currency

Total Inflow

Total Outflow

Net Exposure

British pound

£15,000,000

£10,000,00

£5,000,000

Canadian dollar

C$8,000,000

C$4,000,000

Japanese yen

¥750,000,000

¥500,000,000

¥250,000,000

Mexican peso

MXP 120,000,000

MXP 40,000,000

MXP 80,000,000

Chapter 9: Foreign Exchange Risk Management

9.F Managing Transaction Exposure (10) ❑

Exposure netting, continued – Three ways to reduce transaction exposure through exposure netting: 1. Offset a long position in one currency with a short position in the same currency. 2. If the exchange rate movements of two currencies are positively correlated, offset a long position in one currency with a short position in another currency. 3. If the exchange rate movements of two currencies are negatively correlated, short or long positions in both currencies will offset each other.

– Correlation coefficients reflect the degree to which two currencies move in relation to each other and range from -1 to +1. •

Two currencies with a correlation coefficient of +1 are perfectly positively correlated; both currencies will move in perfect unison.

•

Two currencies with a correlation coefficient of -1 are perfectly negatively correlated; both currencies will move perfectly inversely.

– The stronger the correlations among currencies, the more effective exposure netting. Chapter 9: Foreign Exchange Risk Management

9.F Managing Transaction Exposure (11) ❑

Exposure netting, continued – How would you minimize currency exposure of the following positions? Currency Exposure (000) Historic positive correlation Historic negative correlation

Currency

Short

Swiss franc

-SFr 8,600

Chapter 9: Foreign Exchange Risk Management

-$6,880 €1,300

Euro Peso

Long

-MXP 15,400

Dollar Conversion (000)

$1,700 -$1,400

9.F Managing Transaction Exposure (12) ❑

Exposure netting, continued 1. Offset positively correlated currencies (offset long position with short position), leaving net short position of -$5,180 in SFr

Historic positive correlation

Currency

Dollar Conversion (000)

Offset (000)

Swiss franc

-$6,880

-$5,180

Euro

$1,700

$1,700 + -$6,880 = -$5,180

2. Offset negatively correlated currencies (offset short position with another short position), leaving net short position of -$3,780 in SFr

Historic negative correlation

Currency

Dollar Conversion (000)

Offset (000)

Swiss franc

-$5,180

-$3,780

Peso

-$1,400

-$5,180 – -$1,400 = -$3,780

3. Hedge only residual transaction exposure of -$3,780. Chapter 9: Foreign Exchange Risk Management

9.F Managing Transaction Exposure (13) ❑

Currency risk sharing – Two companies involved in a transaction can agree to share the currency risks associated with their transaction. – Companies develop a customized hedge contract embedded in the underlying trade transaction. – The hedge contains a price adjustment clause whereby a base price is adjusted to reflect certain exchange rate changes. – Within a neutral zone of exchange rates, the importer pays the dollar equivalent of the local currency payable using a base e1 to compute the value of the payable.

– Companies share currency risk beyond the neutral zone.

Chapter 9: Foreign Exchange Risk Management

9.F Managing Transaction Exposure (14) ❑

Currency risk sharing, continued –

Sharing currency risk when e1 moves outside of neutral zone •

If e1 < lower bound of neutral zone, the exchange rate used to compute the price at settlement is

Base rate -

Base rate – (lower bound of neutral zone – e1) 2

•

If e1 > upper bound of neutral zone, the exchange rate used to compute the price at settlement is

Base rate +

Base rate + (e1 – upper bound of neutral zone ) 2

Chapter 9: Foreign Exchange Risk Management

9.F Managing Transaction Exposure (15) ❑

Currency risk sharing, continued –

Example: currency risk sharing between GE and Lufthansa •

Lufthansa agrees to pay GE the dollar equivalent of €10 million in the neutral zone of $1.30 to $1.36, at a base rate of e1 = $1.33 Neutral Zone

$1.22

$1.30

$1.33

$1.36

$1.44

Base Rate e1 =

Payable =

e1 =

1.33 – (0.08/2) = $1.29

1.33 * €10 million

1.30 = dollar equivalent of €10.231 million = $13.3 million

= $13.3 million

1.36 = dollar equivalent of €9.779 million = $13.3 million

1.33 + (0.08/2) = $1.37

Payable =

1.29 * €10 million = $12.9 million Dollar equivalent of $12.9 million / 1.22 = €10.57 million

Dollar equivalent is set, but euro cost of payable changes

Chapter 9: Foreign Exchange Risk Management

Payable = 1.37 * €10 million = $13.7 million Dollar equivalent of $13.7 million / 1.44 = €9.51 million

9.F Managing Transaction Exposure (16) ❑

Currency collar (range forward) – a contract that provides protection against currency movements outside an agreed-on range – Example: GE is willing to accept variations in the value of its euro receivable resulting from fluctuations in e1 ranging from $1.28 to $1.38. – GE converts it receivable at the range forward rate RF, as follows: •

If e1 < $1.28, RF = $1.28

•

If $1.28 ≤ e1 ≤ $1.38, RF = e1

•

If e1 > $1.38, RF = $1.38 $1.28

$1.38

RF = $1.28

RF = e1

RF = $1.38

– When e1 > $1.38, GE converts euro proceeds at $1.38, and the bank profits on the RF. – When e1 < $1.38, GE converts euro proceeds at $1.28, and the bank suffers a loss on the RF. Chapter 9: Foreign Exchange Risk Management

9.F Managing Transaction Exposure (17) ❑

Cross-hedging – if a firm cannot find a futures/forward contract on the currency for which it has exposure, it will hedge its exposure using a futures/forward contract on a related currency. –

Use regression to estimate the relationship between the two related currencies.

–

The regression coefficient indicates the sign and approximate size of the futures/forward position to take in the related currency.

–

R2 measures the variation in the exposed currency that is explained by variation in the hedging currency; the greater R2, the better the cross-hedge.

–

Example • An exporter has a receivable due in Danish krone (DK), but there are no DK futures available. • The exporter can cross-hedge with euro futures. • Historical exchange rates suggest that every 1¢ change in the value of the euro leads to a 0.8¢ change in the value of the DK. • R2 = .91, indicating 91% of the variation in the DK is explained by variation in the euro; thus, the euro can be confidently used in a cross-hedge.

Chapter 9: Foreign Exchange Risk Management

9.F Managing Transaction Exposure (18) ❑

Foreign currency options – hedging mechanism used when future transaction exposure is uncertain. – Example: GE bids on contract on January 1 but will not know until April 1 if its bid is accepted, making a €10 million receivable on December 31 uncertain. Hedging with forward contracts increases risk: •

•

GE could wait until April 1 when it knows it has won the bid to sell €10 million forward for December delivery. –

Between January 1 and April 1, f1 for delivery in December may decrease, reducing the value of GE’s receivable should it win the bid.

–

E.g., f1 on January 1 = $1.28 and f1 on April 1 = $1.215. Waiting to sell forward on April 1 results in a loss of -$0.065 * 10,000,000 = -$650,000.

GE could sell €10 million forward in January for December delivery in anticipation of winning the contract. –

Should it lose the bid, GE must still sell the currency forward on December 31 but will have no receivable to sell. GE must buy currency on the open market to sell on December 31, possibly at a significant loss.

–

E.g., f1 on January 1 = $1.28 and e1 on December 31 = $1.356, GE buys at $1.356 and sells at $1.28, at a loss of -$.076 * 10,000,000 = -$760,000.

Chapter 9: Foreign Exchange Risk Management

9.F Managing Transaction Exposure (19) ❑

Foreign currency options, continued – Example: GE bids on contract on January 1 but will not know until April 1 if its bid is accepted, making a €10 million receivable on December 31 uncertain. Hedging with option contracts decreases risk: •

•

On January 1, GE purchases for $100,000 a currency option to sell €10 million on December 31 at strike = $1.28. –

Should GE lose the bid, its loss is limited to the $100,000 premium.

–

Should GE win the bid and e1 > $1.28 on December 31, GE lets the option expire and converts the €10 million receivable at e1, offsetting the loss of the premium.

On January 1, GE purchases a December currency futures put option expiring in April. –

If the put is out of the money on April 1, GE’s loss is limited to the premium.

–

If the put is in the money on April 1, GE exercises it and receives a short position in a euro futures contract, plus cash equal to strike minus December futures price as of April. •

Should GE lose the bid, it keeps the cash and closes its short position.

•

Should GE win the bid, it holds the contract until December 31.

Chapter 9: Foreign Exchange Risk Management

Chapter 10

Measuring and Managing Economic Exposure

Chapter 10 Outline A. Foreign Exchange Risk and Economic Exposure B. The Economic Consequences of Exchange Rate Changes C. Identifying Economic Exposure

D. Calculating Economic Exposure E. An Operational Measure of Exchange Risk F. Managing Operating Exposure G. Planning for Exchange Rate Changes H. Financial Management of Exchange Risk

Chapter 10: Measuring and Managing Economic Exposure

10.A Foreign Exchange Risk and Economic Exposure (1) ❑

Economic exposure – the degree to which the value of a firm, as measured by the present value of its expected future cash flows, will change when exchange rates change.

❑

Economic exposure comprises both transaction and operating exposure.

❑

Even if a firm prices all contracts in dollars or otherwise hedges its transaction exposure, the residual exposure – operating exposure – remains.

❑

Operating exposure is the degree to which currency fluctuations can alter a firm’s future revenues and costs, that is, its operating cash flows. Examples: – Euro decline against the dollar increases costs for European distributors of American films because the dollar cost of presale distribution rights has risen. – Euro increase against the dollar decreases revenues and profits for European manufacturers as dollar sales become less valuable when converted to Euros.

Chapter 10: Measuring and Managing Economic Exposure

10.A Foreign Exchange Risk and Economic Exposure (2) ❑

Real exchange rate = the nominal exchange rate adjusted for changes in the relative purchasing power of each currency since a base period. From Chapter 4 we computed the real exchange rate as et ’ = e t

(1 + if)t (1 + ih)t

– Example: The Danish krone has devalued by 5% this year. Danish and U.S. inflation rates were 3% and 2%, respectively. The real exchange rate is computed as

0.95e0

(1 + 0.03) (1 + 0.02)

= 0.96e0

– In this case, the real exchange rate et’ is 96% of the nominal exchange rate e0. *In base year, et = et’ Chapter 10: Measuring and Managing Economic Exposure

10.A Foreign Exchange Risk and Economic Exposure (3) ❑

The change in et’ is computed as Δet’ =

et ’ – e0

– Example: The change in the Dkr/$ et’ is computed as 0.96e0 – e0 e0 ❑

= -4%

The implications for exchange risk between et’ and et are vastly different. – A change in et accompanied by an equal change in prices should not affect the relative competitive positions of domestic and foreign competitors and will thus not alter real cash flows. – When et’ = et, relative prices are equal and no operating exchange risk exists. – A change in et’ affects relative price changes – a reduction in the purchasing power of one currency relative to another – which will alter real cash flows.

Chapter 10: Measuring and Managing Economic Exposure

10.A Foreign Exchange Risk and Economic Exposure (4) ❑

Effects of inflation on exchange risk – Without relative price changes, that is, with no change in et’, an MNC faces no real operating exchange risk. Recall example from Chapter 4: e1 – e0 e0

Parity Line

1. At equilibrium E0, U.S. and Japan inflation both = 2% and change in e0 = 0

4 3

2. U.S. inflation increases to 5% (ih – if = 3%), causing disequilibrium, or purchasing power disparity, at (0,3).

2 1 -5

-4

-3

-2

E0 1

-1

ih – if 2

-1 -2 -3

3. $/¥ exchange rate will rise ~3% (e1–e0 / e0 ≈ 3%) to equalize the dollar prices of goods in the two countries at a new equilibrium E1.

-4 -5 Chapter 10: Measuring and Managing Economic Exposure

10.A Foreign Exchange Risk and Economic Exposure (5) ❑

Also recall from Chapter 4: –

Compute and compare changes in the real and nominal values of the yen relative to the dollar (i.e., et and et’ = $/¥) from 1982 to 2006 1. et in 1982 (e0 = base year) = $1/¥249.05, et in 2006 (e25) = $1/¥116.34 2. CPIJapan in 1982 = 80.75, CPIJapan in 2006 = 97.72; if = 21% 3. CPIUS in 1982 = 56.06, CPIUS in 2006 = 117.07; ih = 109% e25’ = $1/¥116.34

(1 + 21%) (1 + 109%)

= $.004981

4. e0’ = $1/¥249.05 = $.004015. 5. Change in et’ = ($.004981 - $.004015) / $.004015 = 24%, meaning the yen appreciated 24% against the dollar in real terms – that is, the real dollar prices of Japanese exports rose by 24%. Chapter 10: Measuring and Managing Economic Exposure

10.A Foreign Exchange Risk and Economic Exposure (6) ❑

Example from Chapter 4, continued: –

E.g., compute and compare the changes in the real and nominal values of the yen relative to the dollar from 1982 to 2006, continued 6. Change in et = (($1/¥116.34) – ($1/¥249.05)) / ($1/¥249.05) = 114%, meaning the nominal dollar prices of Japanese exports rose by 114% over the period. 7. Difference between et and et’ = 114% - 24% = 90%. 8. Conclusion: Inflation differentials justify only a 90% rise in et . Thus, the increase in et’ causes a deviation from PPP by 24%.

Chapter 10: Measuring and Managing Economic Exposure

10.A Foreign Exchange Risk and Economic Exposure (7) ❑

With relative price changes, that is, a change in et’ (and a deviation from PPP) an MNC faces real operating exchange risk. Graphical depiction of example from Chapter 4: e25 – e0 e0

Inflation justifies only a 90% rise in e25

Parity Line

e25 114% e25’ 24% E0

ih – if 88%

Chapter 10: Measuring and Managing Economic Exposure

Japan’s relative prices have risen by 24% over the period, creating real operating exchange or inflation risk for companies selling yendenominated goods and services

10.A Foreign Exchange Risk and Economic Exposure (8) ❑

Example: An appreciation in the real value of the yen makes Japanese television exports less competitive by acting like a tax. – e0 = ¥240/$, e10 = ¥90/$; U.S. inflation not in line with yen appreciation; cost per television over period = ¥100,000. – Year 0: Break-even dollar price = $417 (¥100,000/¥240) – Year 10: Break-even dollar price = $1,111 (¥100,000/¥90)

– Dilemma: • Raising dollar prices results in lost sales because U.S. prices have not risen. • Maintaining dollar prices means cutting yen prices to ¥37,530 (417 * 90).

❑

Example: A depreciation in the real value of the peso makes Mexican exports more competitive by acting like a subsidy. – As the peso depreciates, the dollar value of Mexican exports increases, while peso-denominated costs stay constant, increasing revenues and profits.

❑

The economic impact of a currency change on a firm depends on whether the exchange rate change is fully offset by the inflation differential or whether et’, and thus relative prices, change.

Chapter 10: Measuring and Managing Economic Exposure

10.A Foreign Exchange Risk and Economic Exposure (9) ❑

Fixed exchange rates can create exchange risk.

❑

Example: Brazil’s nominal exchange rate is fixed – e0 and e0’ = $0.50 – Brazil’s inflation over year = 100% but nominal rate does not change – e1 = $0.50, e1’ = $1.00

– Impact on a Brazilian shoe manufacturer’s profits is as follows: Beginning of Year Profit Impact

End of Year

Reais*

Dollars

Reais

Dollars

Price

20.00

10.00

20.00

10.00

Cost of production

8.00

4.00

16.00

8.00

Profit

12.00

6.00

4.00

2.00

Costs double

Profits decrease by two thirds *Reais is plural for the Brazilian currency real Chapter 10: Measuring and Managing Economic Exposure

10.A Foreign Exchange Risk and Economic Exposure (10) ❑

Example, continued: Brazil’s nominal exchange rate is fixed – e0 and e0’ = $0.50 – Inflation over year = 100% – e1 = $0.50, e1’ = $1.00 – If shoe manufacturer raises prices to maintain profit margins, it loses competitiveness: Beginning of Year Profit Impact

End of Year

Reais*

Dollars

Reais

Dollars

Price

20.00

10.00

20.00

14.00

Cost of production

8.00

4.00

16.00

8.00

Profit

12.00

6.00

4.00

6.00

Dollar price increases

Profit margin preserved *Reais is plural for the Brazilian currency real Chapter 10: Measuring and Managing Economic Exposure

10.B Economic Consequences of Exchange Rate Changes (1) ❑

Transaction exposure –

Arises from various types of transactions that require settlement in a foreign currency.

–

Balance sheet items subject to transaction exposure •

–

Loans and receivables

Off-balance sheet items subject to transaction exposure •

Future sales and purchases

•

Lease payments

•

Forward contracts

•

Loan repayments

•

Other contractual or anticipated foreign currency receipts and disbursements

Chapter 10: Measuring and Managing Economic Exposure

10.B Economic Consequences of Exchange Rate Changes (2) ❑

Operating exposure –

Real exchange rates affect numerous aspects of a firm’s operations. • Pricing flexibility – in light of a dollar appreciation, can the firm maintain its dollar margins in its domestic (to compete against lower-cost imports) and foreign markets? • Pricing flexibility is a function of price elasticity of demand (i.e., increases/ decreases in demand given changes in price). – The more sensitive consumers are to price changes, the more elastic their demand will be. – The more differentiated a product, the less competition it faces, and the less elastic the demand will be. The more commoditized, the greater competition it faces, and the more elastic the demand will be.

Type of Good

Degree of Competition

Demand Elasticity

Pricing Flexibility

Exchange Risk

Differentiated

Lower

Higher

Lower

Commoditized

Higher

Lower

Higher

Chapter 10: Measuring and Managing Economic Exposure

10.B Economic Consequences of Exchange Rate Changes (3) ❑

Operating exposure, continued –

Real exchange rates affect numerous aspects of a firm’s operations, continued. • Ability to shift production and sourcing among countries – the greater a company’s flexibility to substitute between domestic and foreign inputs or production, the less exchange risk the company will face.

– All else equal, firms with global production and purchasing networks can manage currency changes by increasing production and purchasing in a country whose currency has been devalued in real terms and decreasing production and purchasing in a country whose currency has been revalued in real terms. – While prices in the local currency cannot be increased to the full extent of the local currency devaluation (to increase the exchange value), its lower prices will be more competitive, offsetting some revenue declines.

Chapter 10: Measuring and Managing Economic Exposure

10.B Economic Consequences of Exchange Rate Changes (4) ❑

Summary of economic effects of exchange rate changes

LC Cash Flow Category

Impact on Parent Company Cash Flows Relevant Economic Factors

LC Deval.

Reason

LC Reval.

Reason

Revenue Export Sales

Local Sales

Elastic demand

Increase (++)

Decrease (- -)

Increase (+)

Units demanded increases

Decrease (-)

Units demanded decreases

Inelastic demand Weak import competition

Decrease (- -)

Demand constant

Increase (++)

Demand constant

Strong import competition

Decrease (-)

Local consumers switch from highercost imports

Increase (+)

Price reductions preserve demand

Low import content

Decrease (- -)

High import content

Costs Local Inputs

Imported inputs

Increase (++)

Decrease (-)

Lowers dollar cost of production to decreasing degrees

Increase (+)

Raises dollar cost of production to decreasing degrees

Small local market

No change

Minimal impact

No change

Minimal impact

Large local market

Decrease (-)

Lowers dollar cost of production

Increase (+)

Raises dollar cost of production

Chapter 10: Measuring and Managing Economic Exposure

10.C Identifying Economic Exposure (1) ❑

Three examples illustrate a firm’s susceptibility to exchange risk 1. Aspen Skiing Company – consequences of a domestic company buying and selling only in dollars 2. Petroleos Mexicanos (Pemex) – consequences of a Mexican national company borrowing in dollars 3. Toyota Motor Company – consequences of having a mix of half foreign sales and half domestic sales

Chapter 10: Measuring and Managing Economic Exposure

10.C Identifying Economic Exposure (2) 1.

Aspen Skiing Company –

Because Aspen buys and sells only in dollars, no accounting exposure.

–

Economic exposure stems from how changes in the value of the dollar affect its competitive position and thus its future cash flows.

–

A dollar appreciation makes foreign ski alternatives attractive to both foreign and domestic customers, causing revenues to decrease and costs to remain constant.

–

A dollar depreciation makes Aspen more attractive to both domestic and foreign skiers, causing revenues to rise and cost to remain constant.

The competitive landscape makes demand for Aspen’s ski venue elastic – that is, consumers will switch to lower-cost alternatives.

Chapter 10: Measuring and Managing Economic Exposure

10.C Identifying Economic Exposure (3) 2.

Petroleos Mexicanos (Pemex) –

Pemex exports all its oil, priced in dollars.

–

Costs are denominated in both foreign currency and pesos –

Equipment and services related to oil exploration, drilling, and production denominated in foreign currency.

–

Labor, local supplies, services, and materials are denominated in pesos.

–

Pemex borrows in U.S. dollars

–

Given a peso devaluation: –

Dollar revenues remain unchanged.

–

Dollar costs of foreign currency inputs likely unchanged.

–

Dollar cost of peso-denominated inputs declines

–

Net effect: an increase in dollar cash flow and a decrease in credit risk from borrowing in pesos.

Chapter 10: Measuring and Managing Economic Exposure

10.C Identifying Economic Exposure (4) 3.

Toyota Motor Company –

Half of Toyota’s sales are in foreign markets, primarily in U.S.

–

Effect on a yen appreciation on revenues

–

•

Keeping yen price constant, dollar prices will rise but sales volume will drop; or

•

Keeping dollar price constant, U.S. market share is preserved but yen value of revenues will drop.

•

Either decision will cause a drop in revenues.

•

If Toyota decides to focus on the local market, it faces the flow-back effect stemming from other Japanese exporters refocus on the local market.

Effect on a yen appreciation on costs •

Most inputs are imported, so the yen cost of inputs will decline

•

Local inputs such as labor will likely remain constant.

•

Net effect: Overall reduction in yen costs

Overall effect of yen appreciation: Reduction in revenues exceeds the reduction in costs.

Chapter 10: Measuring and Managing Economic Exposure

10.D Calculating Economic Exposure (1) ❑

Quantitative determination of economic exposure using Spectrum Manufacturing AB, a wholly owned Swedish affiliate of a U.S. MNC. – Cash flow calculation using current exchange rate of SKr 4/$ Income Statement Item

Units

Unit Price (SKr)

Total

Domestic sales (60%)

600,000

12,000,000

Export sales (40%)

400,000

8,000,000

Total Revenue

20,000,000

Operating Expense

(10,800,000)

Overhead Expense

(3,500,000)

Interest on SKr debt @ 10%

(300,000)

Depreciation

(900,000)

EBT

4,500,000

Tax @ 40%

(1,800,000)

EAT

2,700,000

Add back depreciation

900,000

Net cash flow in SKr

3,600,000

Net cash flow in dollars

Chapter 10: Measuring and Managing Economic Exposure

900,000

10.D Calculating Economic Exposure (2) ❑

Given an exchange rate change to SKr 5/$, compute translation loss. Translation at SKr 5/$

SKr 4/$ Balance Sheet Item

SKr

Dollar

Current Rate

Monetary/ Nonmonetary

Assets

Cash

1,000,000

250,000

200,000

Accounts Rec.

5,000,000

1,250,000

1,000,000

Inventory

2,700,000

675,000

540,000

675,000

Net Fixed Assets

10,000,000

2,500,000

2,000,000

Total Assets

18,700,000

4,675,000

3,740,000

4,375,000

Accounts Payable

2,000,000

500,000

400,000

Long-Term Debt

3,000,000

750,000

600,000

Equity

13,700,000

3,425,000

2,640,000

3,375,000

Total Liabilities + Equity

18,700,000

4,675,000

3,740,000

4,375,000

(935,000)

(300,000)

Liabilities

Translation Loss

Chapter 10: Measuring and Managing Economic Exposure

10.D Calculating Economic Exposure (3) ❑

While accounting exposure is measured by balance sheet items (stock items), economic exposure is measured by income statement items (flow items)

❑

Compute and compare gain/loss from economic exposure to loss from accounting exposure

❑

Use 3 scenarios 1. All variables remain the same (inability to raise prices) 2. SKr sales prices and all costs rise; volume remains the same 3. Partial increases in prices, costs, and volume

Chapter 10: Measuring and Managing Economic Exposure

10.D Calculating Economic Exposure (4) ❑

Scenario 1: All variables remain the same – – – – –

First-year cash flow at SKr 4/$ = $900,000 First-year cash flow at SKr 5/$ = $720,000 Net loss from devaluation in first year = $180,000 Loss will continue until relative prices adjust Assuming a three-year adjustment period, gain in year 3 = $150,000 from loan repayment ($3,000,000/4 - $3,000,000/5 = $150,000)

–

Present value of loss/gain over the three-year adjustment period = economic loss/gain from SKr devaluation: t

Postdevaluation CF – Predevaluation CF = Change in CF * 15% discount factor = Present Value

$720,000 $900,000 -$180,000 1/1.15 -$156,600

$720,000 $900,000 -$180,000 1/1.152 -$136,080

3 $720,000 + $150,000 $900,000 -$30,000 1/1.153 -$19,740

Total economic gain/loss from devaluation = -$156,600 + -$136,080 + -$19,740 = -$312,420 Chapter 10: Measuring and Managing Economic Exposure

10.D Calculating Economic Exposure (5) ❑

Scenario 2: SKr sales prices and all costs rise; volume remains the same – Cash flows given SKr 5/$ change as follows: Income Statement Item

Units

Unit Price (SKr)

Total

Domestic sales (60%)

600,000

15,000,000

Export sales (40%)

400,000

10,000,000

Total Revenue

25,000,000

Operating Expense

(13,500,000)

Overhead Expense

(4,375,000)

Interest on SKr debt @ 10%

(300,000)

Depreciation

(900,000)

EBT

5,925,000

Tax @ 40%

(2,370,000)

EAT

3,555,000

Add back depreciation

900,000

Net cash flow in SKr

4,455,000

Net cash flow in dollars

Chapter 10: Measuring and Managing Economic Exposure

891,000

10.D Calculating Economic Exposure (6) ❑

Scenario 2: SKr sales prices and all costs rise; volume remains the same, continued – Computing the present value of cash flow loss/gain during the threeyear adjustment period, we derive the total economic loss/gain due to the SKr devaluation. t

Postdevaluation CF – Predevaluation CF = Change in CF * 15% discount factor = Present Value

$891,000 $900,000 -$9,000 1/1.15 -$7,830

$891,000 $900,000 -$9,000 1/1.152 -$6,800

3 $891,000 + $150,000 $900,000 $141,000 1/1.153 $92,780

Total economic gain/loss from devaluation = -$7,830 + -$6,800 + $92,780 = $78,150

– Net gain stems from gain on loan repayment.

Chapter 10: Measuring and Managing Economic Exposure

10.D Calculating Economic Exposure (7) ❑

Scenario 3: Partial increases in prices, costs, and volume – Cash flows given SKr 5/$ change as follows: Income Statement Item

Units

Unit Price (SKr)

Total

Domestic sales (60%)

720,000

15,840,000

Export sales (40%)

460,000

11,040,000

Total Revenue

26,906,000

Operating Expense

(14,906,000)

Overhead Expense

(3,850,000)

Interest on SKr debt @ 10%

(300,000)

Depreciation

(900,000)

EBT

6,924,000

Tax @ 40%

(2,769,000)

EAT

4,155,000

Add back depreciation

900,000

Net cash flow in SKr

5,055,000

Net cash flow in dollars

1,011,000

Chapter 10: Measuring and Managing Economic Exposure

10.D Calculating Economic Exposure (8) ❑

Scenario 3: Partial increases in prices, costs, and volume, continued – Computing the present value of cash flow loss/gain during the threeyear adjustment period, we derive the total economic loss/gain due to the SKr devaluation. t

Postdevaluation CF – Predevaluation CF = Change in CF * 15% discount factor = Present Value

1 $1,011,000 $900,000 $111,000 1/1.15 $96,570

2 $1,011,000 $900,000 $111,000 1/1.152 $83,920

3 $1,011,000 + $150,000 $900,000 $261,000 1/1.153 $171,740

Total economic gain/loss from devaluation = $96,570 + $83,920 + $171,740 = $352,230

– Net gain stems from increase in operating cash flows and gain on loan repayment. Chapter 10: Measuring and Managing Economic Exposure

10.E Operational Measure of Exchange Risk (1) ❑

Determining a firm’s true economic exposure and susceptibility to exchange risk using regression analysis

❑

Regression analysis – Establishes the correlation between the variations in the dollar value of the unit’s cash flows with variations in the nominal exchange rate. – Changes in dollar-value cash flows from past periods are regressed on changes in the average exchange rate during the corresponding period. – Regression formula ΔCFt = a + β(ΔEXCHt) + ut

Where ΔCFt = CFt – CFt-1, and CFt = dollar value of parent CF in period t ΔEXCHt = EXCHt – EXCHt-1, and EXCHt = average e0 in period t u = random error Chapter 10: Measuring and Managing Economic Exposure

10.E Operational Measure of Exchange Risk (2) ❑

Regression output –

Beta coefficient β measures the sensitivity of dollar cash flows to exchange rate changes. •

–

t-statistic measures the statistical significance of β. •

–

❑

The higher β, the greater the impact of a given exchange rate change on the dollar value of cash flows.

The larger the t-statistic, the higher the level of confidence in the value of β

R2 measures the fraction of cash flow variability explained by variation in the exchange rate. •

The most important parameter

•

Even if β is large and statistically significant as measured by t-statistic, if R2 is 0.01, indicating that only 1% is total cash flow variability is explained by exchange rate changes, the firm should not devote a high level of resources to managing exchange risk.

The validity of regression analysis depends on the sensitivity of future cash flows to exchange rates being similar to their historical sensitivity.

Chapter 10: Measuring and Managing Economic Exposure

10.F Managing Operating Exposure (1) ❑

Currency risk affects all areas of a firm’s operations

❑

Competitive exposures arise when competition with firms based in other currencies cannot be managed solely through financial hedging.

❑

Managing competitive exposures 1. Marketing management of exchange risk 2. Production management of exchange risk

Chapter 10: Measuring and Managing Economic Exposure

10.F Managing Operating Exposure (2) 1.

Marketing management of exchange risk – a firm’s marketing strategy can provide competitive leverage when the home currency fluctuates. – Market selection • A strong dollar places dollar-denominated firms at a competitive disadvantage in markets with weaker currencies, while making the U.S an attractive market for foreign companies seeking to gain market share from U.S. rivals. • A weak dollar makes foreign markets with stronger currencies attractive to U.S firms because of their pricing advantage.

Chapter 10: Measuring and Managing Economic Exposure

10.F Managing Operating Exposure (3) 1.

Marketing management of exchange risk, continued – Pricing strategy • Following dollar depreciation, MNCs have a competitive pricing advantage in foreign markets, and domestic firms facing strong import competition may

have a pricing advantage. – Both MNCs and domestic firms can keep dollar prices constant and expand market share or raise prices to increase profit margins, depending on whether •

Dollar depreciation is likely to persist;

•

The firm can achieve economies of scale;

•

The cost structure of expanding output is viable; and

•

Demand elasticity is conducive to increasing prices.

– Elastic demand and economies of scale favor keeping prices constant and expanding the market. – Inelastic demand and the absence of economies of scale favor increasing prices and profit margins. Chapter 10: Measuring and Managing Economic Exposure

10.F Managing Operating Exposure (4) 1.

Marketing management of exchange risk, continued – Pricing strategy, continued • Following dollar appreciation, foreign producers have a competitive pricing advantage in foreign and domestic markets. – At best, firms will be able to raise dollar prices only to the extent of the dollar appreciation. – At worst, firms will have to absorb a reduction in dollar revenues equal to the percentage decline in the value of the foreign currency.

– Product strategy – firms time new product introductions, product line extensions, and product innovation to optimize exchange rate changes. • A dollar depreciation creates opportunities for MNCs to develop brand franchises as well as expand their product lines in both the domestic and foreign markets. • A dollar appreciation enables firms to pursue product innovation through expanded R&D efforts, strengthening their product differentiation and thus making demand less elastic. Chapter 10: Measuring and Managing Economic Exposure

10.F Managing Operating Exposure (5) 2.

Production management of exchange risk – when pricing and other marketing strategies are not sufficient to preserve profit margins in the face of exchange rate fluctuations, firms can trim costs through production management. – Changing the input mix: Given a dollar appreciation, a firm shifts to foreign suppliers with costs least affected by exchange rate changes.

– Shifting production among plants • MNCs with a global production network can allocate production among their plants to align with changing dollar costs of production – increasing production in countries whose currencies have devalued and decreasing production in countries whose currencies have been revalued.

• Caveat – multiple plants can create manufacturing redundancies and reduce or eliminate economies of scale. • The value of a global manufacturing network increases with exchange rate volatility. Thus, despite higher unit costs associated with smaller plants and excess capacity, currency risk may justify the use of multiple production facilities. Chapter 10: Measuring and Managing Economic Exposure

10.F Managing Operating Exposure (6) 2.

Production management of exchange risk, continued – Plant location • A firm without foreign facilities may be forced to create new plants abroad if foreign sourcing is not sufficient to maintain unit profitability. • Caveat – while foreign manufacturing plants can create cost advantages in light of a home currency appreciation, these cost advantages erode in the face of a home currency depreciation.

– Raising productivity • Firms have sought to improve their cost structures by raising productivity. – Closing inefficient plants,

– Increasing automation, – Negotiating with unions, – Reducing product offerings to include those products that account for the bulk of sales and profits.

Chapter 10: Measuring and Managing Economic Exposure

10.G Planning for Exchange Rate Changes ❑

MNCs must plan for exchange rate changes with the understanding that equilibrium rates are constantly changing.

❑

The ability to respond to constantly changing equilibrium rates is critical to maintaining competitive viability.

❑

Competitive options include outsourcing, flexible manufacturing systems, a global network of production facilities, and shorter product cycles.

❑

Shorter product cycles provide the greatest competitive enhancement. – MNCs can charge a premium for being first to market, incorporate state-of-the-art technology, and respond faster to emerging market niches and changes in consumer tastes.

❑

Competitive options enable MNCs to change their strategies before the impact of a currency change is manifest.

Chapter 10: Measuring and Managing Economic Exposure

10.H Financial Management of Exchange Risk (1) ❑

Strategic marketing and production adjustments take time to implement.

❑

Financial management ensures that, while strategic adjustments are effected, any reduction in earnings on assets is matched by a corresponding decrease in the cost of servicing the liabilities that fund those assets. – A firm with a substantial export market should hold a portion of its liabilities in that country’s currency. – While an increase in the home currency may decrease revenues, it will also decrease payables.

Chapter 10: Measuring and Managing Economic Exposure

10.H Financial Management of Exchange Risk (2) ❑

Example: A devaluation results in increased local currency cash flows but still lower dollar cash flows. LC 1 - $0.25

LC 1 = $0.20

Cash Flow Component

Units (000)

Unit Price

Total (000)

Units (000)

Unit Price

Total (000)

Domestic Sales

400

8,000

300

7,000

Export Sales

400

8,000

500

12,000

Total Revenue

16,000

19,200

Local Labor (hours)

800

-8,000

800

-9,600

Local Material

800

-2,400

1,000

3.5

-3,500

Imported Material

600

-2,400

450

-2,250

Total Expenditures

-12,800

-15,350

Net Cash Flow from Operations (LC)

3,200

3,850

Net Cash Flow from Operations ($)

$800

$770

$30,000 exchange loss on operating cash flows Chapter 10: Measuring and Managing Economic Exposure

10.H Financial Management of Exchange Risk (3) ❑

Example, continued –

The subsidiary requires assets of LC 20 million, or $5 million (converted at LC 1 = $0.25). Assets can be financed with dollars at 8% and converting to local currency, or with local currency at 10%.

–

Structure financing to reduce the cost of servicing debt by $30,000. •

S = dollar outflow on local debt

•

0.2S = $30,000 (0.2 reflects the 20% devaluation)

•

S = $150,000, or LC 600, which reflects borrowing LC 6 million and the dollar equivalent of LC 14 million ($3.5 million; 8% of $3.5 million = $280,000) LC 1 = $0.25

LC 1 = $0.20

Cash Flow Component

Dollars

Net Cash Flow from Operations

3,200

800

3,850

770

Local Currency Debt

600

150

600

120

Dollar Debt

1,120

280

1,400

280

Total Debt Service Outflow

1,720

430

2,000

400

Net Cash Flow

1,480

370

1,850

370

Debt Service Requirements

Chapter 10: Measuring and Managing Economic Exposure

Translated postdevaluation net cash flow remains at predevaluation level 39

Chapter 11

Foreign Markets and Investments

Chapter 11 Outline A. Country Risk B. Measuring Political Risk C. Economic and Political Factors Underlying Country Risk

D. Country Risk Analysis in International Banking

E. Appendix: Managing Political Risk

Chapter 11: Foreign Markets and Investments

11.A Country Risk ❑

Country risk analysis – the assessment of the potential risks and rewards associated with making investments and doing business in a country. – Because economic policies are often a function of political considerations, country risk analysis focuses on both economic and political considerations.

❑

Nonbank MNCs analyze country risk to determine the investment climate in various countries.

❑

Banks analyze country risk to determine which countries to lend to, the currencies in which to denominate their loans, and the interest rates to demand on those loans.

Chapter 11: Foreign Markets and Investments

11.B Measuring Political Risk (1) ❑

Political economy – the interaction of politics and economics that creates risks relating to monetary and fiscal policy, currency or trade controls, changes in labor laws, regulatory restrictions, and requirements for additional local production.

❑

The degree of risk is a function of the nature of government intervention in a country.

❑

Two approaches to analyzing political risk – Country-specific perspective – Firm-specific perspective (see Chapter 14)

❑

Common political measures of political stability – Frequency of changes of government – Level of violence – Number of armed insurrections – Extent of conflicts with other states

Chapter 11: Foreign Markets and Investments

11.B Measuring Political Risk (2) ❑

MNCs use stability measures to determine how long the current regime will be in power and whether that regime will be willing and able to enforce its foreign investment guarantees.

❑

While many developing countries have the basic foundation of a nation-state (i.e., UN-endorsed borders, armies, foreign ministries, flags, currencies, national airlines), they lack social cohesion, political legitimacy, and the institutional infrastructure necessary for economic growth.

❑

Common economic measures of political stability – Inflation

– Balance of payments deficits/surpluses – Per-capita GDP growth ❑

In general, the better a country’s economic outlook, the less likely it is to face political and social instability that negatively impact MNCs.

Chapter 11: Foreign Markets and Investments

11.B Measuring Political Risk (3) ❑

Subjective measures of political stability are based on a general perception of the country’s attitude toward capitalism and MNCs. – Profit Opportunity Recommendation (POR) is an index that rates countries on an aggregation of subjective assessments of a panel of experts. – Property rights – from an economic standpoint, political risk refers to uncertainty over property rights. • Risk of expropriation – the degree to which a government can seize legal title to property or the stream of income generated by the property • Risk of constrained use of property

– Capital flight – the export of savings by a country’s citizens because of fears about the safety of their capital. • Capital flight is difficult to measure because it is not directly observed in most cases. • Capital flight can be inferred using balance of payments figures.

Chapter 11: Foreign Markets and Investments

11.B Measuring Political Risk (4) ❑

Subjective measures of political stability, continued – Capital flight, continued • Reasons for capital flight – Government regulations, controls, and taxes that lower the return on domestic investments – Increases in a country’s external debt that may precede a fiscal crisis – Political risk – in unstable political regimes, wealth is not secure from government seizure

Chapter 11: Foreign Markets and Investments

11.C Economic and Political Factors Underlying Country Risk (1) ❑

❑

Country risk is not confined to less developed countries (LDCs). –

Western European countries have problems with economic stagnation, overregulation, inflexible labor markets, and overly expansive and expensive welfare states.

–

The U.S. business environment is subject to arbitrary changes in employment and environmental laws, and the legal environment opens MNCs to litigation risk.

–

Japan’s highly regulated business system places a preponderance of power with the state, and its banking system has made approximately $1.23 trillion in bad loans.

Determinants of a country’s economic performance and degree of risk 1. 2. 3. 4. 5. 6.

Fiscal irresponsibility Monetary instability Controlled exchange rate system Wasteful government spending Resource base Adjustment to external shocks

Chapter 11: Foreign Markets and Investments

11.C Economic and Political Factors Underlying Country Risk (2) 1.

Fiscal irresponsibility – Indiscriminant government spending increases country risk. – The higher the government deficit as a percentage of GDP, the lower the probability a country can meet its obligations without resorting to expropriations of property, raising taxes, or printing money.

•

Expropriation causes capital flight and a shortage of new investment.

•

Raising taxes adversely affects incentives to work, save, and take risks.

•

Printing money to finance the government deficit (monetizing the deficit) results in monetary instability, high inflation, high interest rates, and currency depreciation.

Monetary instability – an expansion of the money supply in excess of real output growth results in inflation.

Chapter 11: Foreign Markets and Investments

11.C Economic and Political Factors Underlying Country Risk (3) 3.

Controlled exchange rate system –

Currency controls are used to fix the exchange rate and result in an overvalued local currency.

–

An overvalued currency effectively taxes exports and subsidizes imports.

–

The risk associated with currency controls encourages capital flight.

–

MNCs repatriate subsidiary profits rather than reinvest them.

–

A controlled exchange rate system exacerbates unfavorable trends in the country’s terms of trade (the exchange rate between exports and imports).

Wasteful government spending –

Unproductive spending results in a government having less money to repay its foreign debts.

–

Funds used to purchase foreign assets will not add to an economy’s dollargenerating capacity unless investors feel safe in repatriating their foreign earnings.

Chapter 11: Foreign Markets and Investments

11.C Economic and Political Factors Underlying Country Risk (4) 5.

Resource base – A country’s resources include natural, human, and financial resources. – All things equal, a country with substantial natural resources is a better economic risk than a country without natural resources. – However, the quality of human resources and the degree to which those resources are efficiently employed can offset disadvantages of having sparse natural resources. – Three factors are necessary to ensure the most efficient use of a country’s human resource base: •

A stable political system that encourages hard work and risk-taking by entrepreneurs;

•

A flexible labor market that permits workers to be allocated to those jobs in which they will be most productive; and

•

A free market system that ensures that prices people respond to correctly signal the relative desirability of engaging in different activities.

Chapter 11: Foreign Markets and Investments

11.C Economic and Political Factors Underlying Country Risk (5) 6.

Adjustment to external shocks – Domestic policies are critical in determining how effectively a country deals with external shocks. •

In response to falling commodity prices, rising interest rates, and rising exchange rates in the 1980s: – Asian countries’ policies, characterized by imitation and innovation in the international market, promoted timely internal and external adjustment. – Latin American countries, with extensive state ownership, controls, and policies to encourage import substitution, exploited their internal markets, fostering long-term inefficiency among Latin American manufacturers and worsening their international competitive positions.

Chapter 11: Foreign Markets and Investments

11.C Economic and Political Factors Underlying Country Risk (6) ❑

Market-oriented versus statist policies – Market (capitalist) economy •

Individual decisions makers make economic decisions based on prices of goods, services, capital, labor, land, and other resources.

•

Capitalism works because – Economic decisions are made by those who have the information necessary to determine the trade offs inherent in those decisions; and – People have the incentive to efficiently act on that information.

– Command (socialist) economy •

Top government decides what will be produced, how it is produced, and where it is produced, and commands others to follow the central plan.

•

Command economies don’t work because – All fragments of knowledge existing in different minds must be transferred to the central planner, which is impossible; and – Incentives that foster efficiency are lacking.

Chapter 11: Foreign Markets and Investments

11.C Economic and Political Factors Underlying Country Risk (7) ❑

Market-oriented versus statist policies, continued – Most modern economies are a mix of market and command economies. – Statist policies constrain growth through heavy government intervention, regulations, tax-and-spend policies, and state ownership or control of key industries. •

Special interest groups lobby for state benefits and oppose reforms to eliminate subsidies.

Chapter 11: Foreign Markets and Investments

11.C Economic and Political Factors Underlying Country Risk (8) ❑

Review of common characteristics of high country risk –

A large government deficit relative to GDP

–

High monetary expansion, especially if combined with a fixed exchange rate

–

High government spending yielding low rates of return

–

Price controls, interest rate ceilings, trade restrictions, rigid labor laws, and other barriers that impede a smooth adjustment to changing relative prices

–

High tax rates that destroy incentives to work, save, and invest

–

High level of state-owned firms

–

A citizenry that demands, and a political system that accepts, government responsibility for maintaining and expanding the nation’s standard of living through public-sector spending and regulations

–

Pervasive corruption that impedes development, discourages foreign investment, and breeds distrust of capitalism

–

The absence of basic institutions

Chapter 11: Foreign Markets and Investments

11.C Economic and Political Factors Underlying Country Risk (9) ❑

Review of common characteristics of low country risk –

A structure of incentives that rewards risk-taking in productive ventures

–

A legal structure that stimulates the development of free markets

–

Minimal regulations and economic distortions

–

Incentives to save and invest

–

An open economy

–

Stable macroeconomic policies

Chapter 11: Foreign Markets and Investments

11.D Country Risk Analysis in International Banking (1) ❑

Country risk from a bank’s perspective stems from the possibility that borrowers in a country will be unable to service their debts to foreign lenders in a timely manner.

❑

Underlying causes of default are internal and include –

Massive corruption;

–

Bureaucracy;

–

Government intervention;

–

Poor macroeconomic policies; and

–

Large budget deficits that have been monetized.

Chapter 11: Foreign Markets and Investments

11.D Country Risk Analysis in International Banking (2) ❑

Terms of trade –

When a country’s terms of trade improve, foreign goods become relatively less expensive, the country’s standard of living rises, and consumers and businesses become more dependent on imports.

–

When a country’s terms of trade decline, countries may fix the exchange rate at an artificially high level to maintain the standard of living.

–

Loans made when terms of trade were favorable are now doubly risky: Because the terms of trade have declined and because the government is maintaining an overvalued currency.

Chapter 11: Foreign Markets and Investments

11.E Appendix: Managing Political Risk (1) ❑

After analyzing a country’s political environment, assessing its implications for operations, and deciding to invest there, an MNC must determine how to structure its investment to minimize political risk.

❑

Preinvestment planning – four options to manage political risk –

Avoidance • An MNC may screen out investments in politically uncertain countries, but absolute avoidance is impossible because the home country also carries political risk. • However, avoiding investments with political risk ignores potentially high returns and the extent to which the firm can control the risks.

–

Insurance • Most developed countries sell political risk insurance covering foreign assets of domestic companies. • Problems with relying only on insurance – If an investment is unprofitable, it is unlikely to be expropriated. – If an investment is profitable and is expropriated, the firm is compensated only for the value of its assets rather than the economic value of the investment (i.e., present value of future cash flows).

Chapter 11: Foreign Markets and Investments

11.E Appendix: Managing Political Risk (2) ❑

Preinvestment planning, continued –

–

Negotiating the environment •

Concession agreements – MNCs negotiate with the host government to define rights and responsibilities of both parties before undertaking the investment.

•

Concession agreements may not be honored in many third-world countries.

Structuring the investment •

Minimize exposure to political risk by increasing the host government’s cost of nationalization (and ability to harm the MNC by seizing a single plant). –

Keep the subsidiary dependent on sister companies for markets and/or supplies.

–

Concentrate R&D facilities and proprietary technology in the home country.

–

Source production from multiple plants.

–

Raise capital from the host and other governments, international financial institutions, and customers instead of using funds supplied by the MNC.

–

Obtain unconditional host government guarantees for the amount of investment to give creditors legal leverage against transactions between the host country and third parties if a subsequent government repudiates the country’s obligations.

Chapter 11: Foreign Markets and Investments

11.E Appendix: Managing Political Risk (3) ❑

Operating policies – Change the benefit/cost ratio of expropriation – an MNC can raise the cost of expropriation by increasing the negative sanctions involved through •

Controlling export markets, transportation, technology, trademarks and brand names, and components manufactured in other countries.

•

When expropriation is inevitable, the MNC should prepare for negotiations to establish a future contract-based relationship.

– Develop local stakeholders – research indicates that having local private investors as partners seems to provide protection against expropriation. – Adaptation – MNCs pursue a policy of adapting to the inevitability of potential expropriation and try to earn profits on the firm’s resources through licensing and management agreements.

Chapter 11: Foreign Markets and Investments

Chapter 12

International Financing and National Capital Markets

Chapter 12 Outline A. Corporate Sources and Uses of Funds B. National Capital Markets as International Financial Centers C. Eurocurrency Market

D. Eurobonds E. Asiacurrency Market F. Project Finance

Chapter 12: International Financing and National Capital Markets

12.A Corporate Sources and Uses of Funds (1) ❑

Three general sources of corporate funds – Internally generated cash – Short-term external funds – Long-term external funds

❑

External finance comes from investors and/or lenders. – Negotiable securities are publicly issued debt or equity. – Debt accounts for vast majority of external funds.

❑

Investment banker – a financing specialist that designs and underwrites (markets) the securities – Investment bankers buy the securities and resell them to the public.

– Compensation is the spread between the purchase and selling prices. ❑

Financial intermediary – debt financing specialist that makes loans and issues its own securities or deposits in the market. – Commercial bank loans for short- and medium-term credit – Privately placed bonds for longer-term credit

Chapter 12: International Financing and National Capital Markets

12.A Corporate Sources and Uses of Funds (2) ❑

Privately placed bonds – Sold directly to a limited number of sophisticated investors – Generally nonnegotiable – Contain covenants (customized loan agreements) that are regularly renegotiated before maturity

❑

Financial markets vs. financial intermediaries – Globally, bank borrowing is declining. – Corporate borrowers are increasingly using securitization, i.e., issuing negotiable securities in public markets.

– Financial deregulation has reduced the cost of using financial markets while the cost of bank borrowing has risen.

Chapter 12: International Financing and National Capital Markets

12.A Corporate Sources and Uses of Funds (3) ❑

Difference between securitization and intermediation – a Belgian corporation seeks an investment, and a Japanese firm seeks funds

Belgian Corporation

Securitization Deposits funds

Belgian Bank

Redeposits funds

Issues and sells bonds

International Money Center Bank In London Lends funds

Intermediation

Chapter 12: International Financing and National Capital Markets

Japanese Bank Lends funds

Japanese Corporation

12.A Corporate Sources and Uses of Funds (4) ❑

Corporate governance – two general models – Anglo-Saxon (“AS” or market-oriented) model used in U.S. and U.K. • Institutional investors play a critical role and exert a high level of corporate control. • Equity finance is important. • Corporate objective: maximize shareholder value • High return on capital is stressed

– Continental European and Japanese (“CEJ”) model • Banks play a critical role. • Share ownership and control are concentrated in banks and other firms.

• Corporate decision-making is influenced heavily by close personal relationships between corporate leaders who sit on each other’s boards of directors. • Less focus on return on capital

Chapter 12: International Financing and National Capital Markets

12.A Corporate Sources and Uses of Funds (5) ❑

Corporate governance, continued – CEJ model, continued • The keiretsu (large industrial groupings often with a bank at the center) form the foundation of corporate Japan. – Provide financial banking, management advice, favorable contracts, and a safety net for members.

– The main bank has access to information about member companies and strong influence in their management. – Banks hold industrial shares and have sizable equity stakes in their borrowers. • Universal banking is practiced in Germany.

– German commercial banks perform investment banking and take major equity positions in companies. – “Cross-shareholdings” (i.e., banks are both debt and equity holders) has resulted in a loss of competitiveness. • Heavy reliance on bank debt has resulted in less freedom of action.

• Japanese and German companies are turning more to the AS model. Chapter 12: International Financing and National Capital Markets

12.A Corporate Sources and Uses of Funds (6) ❑

Globalization of financial markets – Advances in communications and technology combined with deregulation have reduced transaction costs and created a global financial market. – Competition among key financial centers and institutions has skyrocketed and further reduced the cost of issuing new securities. – Regulatory arbitrage draws users of capital markets to the financial centers with the lowest regulatory standards and thus the lowest costs.

❑

Financial innovation – Enables companies to tap previously inaccessible markets and permits investors and issuers to optimize tax loopholes. – To the extent that a firm can design a security that appeals to a capital market niche, it can attract funds at a lower cost than the market’s required return on securities of comparable risk.

Chapter 12: International Financing and National Capital Markets

12.B National Capital Markets as International Financial Centers (1) ❑

Well-functioning financial markets foster economic growth. Functions of a Well-Functioning Financial Market

Factors Promoting Well-Functioning Financial Markets • Secure property rights

• Mobilize savings

• Easily enforceable contracts

• Allocate resources based on expected risk-adjusted returns

• Meaningful accounting information • Accountability of borrowers and investors

• Borrowers and investors bear the consequences of their decisions

• Facilitate risk transfer and risk reduction through diversification • Monitor managers through informationgathering • Exert corporate control • Supply liquidity by enabling investors to sell their investments before maturity Consequences

Results • Stronger economic growth • Greater consumer satisfaction

• Greater capital accumulation • More and better projects get financed • More innovation • Managerial accountability • Preferred time pattern of consumption

Chapter 12: International Financing and National Capital Markets

12.B National Capital Markets as International Financial Centers (2) ❑

International financial markets – Political stability and minimal government intervention are necessary to become a major international financial center. – The most important global financial centers are in London, Tokyo, and New York. – The domestic markets in Switzerland, Luxembourg, Hong Kong, the Bahamas, and Bahrain serve as financial entrepôts (channels through which foreign funds pass).

❑

Foreign access to domestic markets – MNCs have greater latitude in accessing a variety of local money markets than domestic firms. – Money raised in local markets is often limited to local uses through exchange controls. – However, MNCs can transfer funds using a variety of financial channels.

Chapter 12: International Financing and National Capital Markets

12.B National Capital Markets as International Financial Centers (3) ❑

Foreign access to domestic markets, continued – Foreign bond market • The portion of the domestic bond market that represents issues floated by foreign companies or governments • Foreign bonds are subject to local laws and must be denominated in the local currency.

• Types of bonds – Fixed-rate issue – similar to domestic fixed-rate issues, with a fixed coupon, set maturity date, and full repayment of principal at maturity. – Floating-rate note (FRN) – variable coupon that is reset at fixed intervals at a margin above a mutually agreed-on reference rate such as the Treasury bill. – Equity-related issue – combines features of bonds and common stock • Convertible bonds – fixed rate bonds that are convertible into a given number of shares before maturity • Equity warrants – give the holder the right to buy a specified number of shares of common stock at a specified price during a designated period Chapter 12: International Financing and National Capital Markets

12.B National Capital Markets as International Financial Centers (4) ❑

Foreign access to domestic markets, continued – Foreign bank market • The portion of domestic bank loans supplied to foreigners for use abroad • Governments often restrict the amounts of bank funds allocated for foreign purposes.

– Foreign equity market • MNCs sell their stocks in foreign markets. • A pool of funds from a diversified shareholder base insulates a company from the uncertainties of a single national market. • Selling shares in foreign markets can increase the potential demand for, and thus the price of, the company’s shares. • Still, foreign listings by U.S. MNCs have trended downward since 2000. • Investors prefer to trade shares in the market in which they get the best price, which is typically the stock’s home market. • Companies pay annual fees to list on foreign exchanges and thus have an incentive to delist when trading is light in foreign markets. Chapter 12: International Financing and National Capital Markets

12.B National Capital Markets as International Financial Centers (5) ❑

Foreign access to domestic markets, continued – Foreign equity market, continued • Companies must meet often-stringent accounting and disclosure practices (such as in the U.S.) to be listed on a foreign exchange. • Rule 144A allows qualified institutional investors to trade in unregistered private placements (equity and debt), attracting foreign companies that would not enter the U.S. market given the reporting requirements.

– Global shares • Shares of a non-U.S. company listed and traded in the same form on any market in the world

• Tracked in a single global registry • Traded in the home currency of each market

Chapter 12: International Financing and National Capital Markets

12.C Eurocurrency Market (1) ❑

Eurocurrency – a dollar (Eurodollar) or other freely convertible currency deposited in a bank outside its country of origin. (The prefix euro is not related to the euro currency.)

❑

Eurobank – a foreign bank or foreign branch of a domestic U.S. bank that accepts deposits and makes loans in foreign countries.

❑

The Eurocurrency market enables investors to hold short-term claims on commercial banks, which then act as intermediaries to transform deposits into long-term claims on final borrowers.

❑

By operating in Eurocurrencies, banks and suppliers of funds avoid certain regulatory costs and restrictions, including – Reserve requirements that lower a bank’s earning asset base;

– Special charges and taxes on domestic banking transactions; e.g.,FDIC fees; – Requirements to lend money to certain borrowers at concessionary rates; – Interest rate ceilings on deposits or loans that inhibit competition for funds; – Rules or regulations that restrict competition among banks. Chapter 12: International Financing and National Capital Markets

12.C Eurocurrency Market (2) ❑

Eurodollar creation – Swedish firm Leksell AB receives a $1 million payable from a U.S. hospital 1. Deposits check

Leksell AB 2. Pays Leksell AB 3. To earn higher interest, Leksell deposits funds with Barclays Bank

Citibank New York

4. Loans funds to Ronninger SA

Barclays London

Owes Citibank New York +

Leksell AB +

$1 mil. Pays

$1 mil.

Owes

Barclays London

$1 mil.

+ $1 mil.

Deposits

$1 mil. + interest

Ronninger SA + $1 mil.

$1 mil. + interest

Loans

1 million Eurodollars created Chapter 12: International Financing and National Capital Markets

12.C Eurocurrency Market (3) ❑

Eurocurrency market versus domestic banking operations – The Eurocurrency market involves a chain of deposits and a chain of borrowers and lenders. • There is a chain of ownership between the original dollar depositor and the U.S. bank. • There is a changing control over the deposit and the use to which the funds are put.

– Domestic banking operations are typically characterized by an owner of dollars depositing the dollars in a bank, with the bank controlling the use of the funds until they are withdrawn. – The majority of Eurocurrency transactions involve transferring control of deposits from one Eurobank to another.

Chapter 12: International Financing and National Capital Markets

12.C Eurocurrency Market (4) ❑

Eurocurrency loans – Loans are made on a floating-rate basis, typically set at a fixed margin above LIBOR. – The bank’s spread is based on the borrower’s perceived riskiness and can range from 15 to 300 basis points. – Maturity ranges from 3 to 10 years. – If a loan is made by a syndicate of banks, a syndication fee of 0.25% to 2% of the loan value is charged. – The drawdown period and repayment period vary by the borrower’s needs. – Borrowers are mainly concerned about the effective interest rate (all-in cost) on their loans.

Chapter 12: International Financing and National Capital Markets

12.C Eurocurrency Market (5) ❑

Eurocurrency loans, continued – Example: compute the loan proceeds, first semiannual payment, and effective annual cost of a Eurocurrency loan • Loan = €250 million, five-year, euro-denominated Eurocurrency loan with a syndicate of banks and a syndication fee of 2.0% and interest rate of LIBOR6 (initially 5.5%) + 1.75%.

• Proceeds = €250 million – (€250 million * 0.02) = €245 million • First semiannual payment = [(0.055 + 0.0175) / 2] * €250 million = €9,062,500 • Effective annual interest rate for first six months = €9,062,500 / €245,000,000 * 2 * 100 = 7.4%

– Multicurrency clauses – the borrower has the right to switch from one currency to another on any rollover or reset date, enabling the borrower to match currencies on cash inflows and outflows based on expected exchange rate changes.

Chapter 12: International Financing and National Capital Markets

12.C Eurocurrency Market (6) ❑

Relationship between domestic and Eurocurrency money markets – The presence of arbitrage activities ensures a close relationship between interest rates in national and international (Eurocurrency) money markets. – Currency controls or risk explain any substantial differences between domestic and external interest rates. • If exchange controls are effective, the national money market can be isolated or segmented from its international counterpart. • If future exchange controls are expected, creating the possibility that the lender or borrower will not be able to transfer funds across a border, interest rate differentials may result.

Chapter 12: International Financing and National Capital Markets

12.C Eurocurrency Market (7) ❑

Relationship between domestic and Eurocurrency money markets – Eurocurrency spreads are generally narrower and lower than those in domestic money markets. • Lending rates can be lower because – Regulatory expenses that raise costs and lower returns on domestic transactions do not exist in the Eurocurrency market; – Most borrowers are well known, reducing the cost of information-gathering and credit analysis; – Eurocurrency lending is characterized by high volumes, resulting in lower margins and transaction costs; and – Eurocurrency lending often takes place out of tax-haven countries, providing higher after-tax returns.

• Deposit rates can be higher because – They must be to attract domestic deposits; – Eurobanks can afford to pay higher rates based on lower regulatory costs; – Eurobanks are not subject to the interest rate ceilings present in many countries; and

– A larger percentage of deposits can be loaned out. Chapter 12: International Financing and National Capital Markets

12.D Eurobonds (1) ❑

Eurobonds are similar to public debt sold in domestic markets. – Consist largely of fixed-rate, floating-rate, and equity-related debt. – Self-regulated by the Association of International Bond Dealers.

❑

70% of Eurobonds are swaps

❑

The growing presence of sophisticated investors willing to arbitrage between the domestic dollar and Eurodollar bond markets has eliminated most interest disparity that once existed between domestic bonds and Eurobonds.

❑

Issues are arranged through an underwriting group and often involve more than a hundred banks for an issue as small as $25 million.

❑

About 75% of Eurobonds are dollar denominated.

Chapter 12: International Financing and National Capital Markets

12.D Eurobonds (2) ❑

Fixed-rate Eurobonds – Coupons are typically paid annually. – The interest rate is the internal rate of return on the bond (the discount rate that equates the present value of future interest and principal payments to the net proceeds received). – Conversion of annual yield to semiannual yield Semiannual yield = (1 + annual yield)1/2 - 1

– Conversion of semiannual yield to annual yield Annual yield = (1 + semiannual yield)2 - 1

Chapter 12: International Financing and National Capital Markets

12.D Eurobonds (3) ❑

Floating-rate Eurobonds (FRNs) – The interest rate is a fixed amount above a floating reference rate, typically LIBOR (e.g., LIBOR3 + 0.5%), and is reset at regular intervals equaling the maturity of LIBOR used (e.g., if LIBOR3 is used, interest is reset every 3 months). – Inverse floaters – FRNs with coupons that move in the opposite direction of the reference rate (e.g., 12% - LIBOR3).

❑

Eurobond retirement – Sinking fund – requires the borrower to retire a fixed amount of bonds annually after a specified number of years. – Purchase fund – the bonds are retired only if the market price is below the issue price. – Call provisions give the borrower the option to retire the bonds before maturity if interest rates decline sufficiently. Eurobonds with call provisions typically require a call premium and higher interest rates.

Chapter 12: International Financing and National Capital Markets

12.D Eurobonds (4) ❑

Why the Eurobond market exists – The Eurobond market is largely unregulated and untaxed. • A relatively free flow of capital among countries attracts international investors. • MNCs can raise funds more quickly and flexibly than at home.

– Eurobonds are issued in bearer, or unregistered, form, meaning the bond owners are anonymous. ❑

The cost advantage of Eurobonds has eroded somewhat since regulatory relaxation in the U.S., Japan, and England. – In the U.S., the shelf registration procedure enables certain companies to bypass some complex securities laws when issuing new securities. – Rule 144A enables companies to issue bonds simultaneously in Europe and the U.S., blurring the distinction between the U.S. bond market and its Eurobond equivalent.

Chapter 12: International Financing and National Capital Markets

12.D Eurobonds (5) ❑

Eurobonds versus Eurocurrency loans – Cost of borrowing • Eurobonds are issued in both fixed- and floating-rate forms. Fixed-rate bonds are useful for exposure management because long-term currency inflows can be offset with known long-term outflows in the same currency. • Eurocurrency loan interest rates are variable. When rates decline, borrower costs decline; when rates increase, borrower costs increase.

– Maturity – Eurobonds have longer maturities. – Size of issue – the volume of Eurobond offerings exceeds that of global bank lending; sizes and prices of Eurobond financings are expanding.

Chapter 12: International Financing and National Capital Markets

12.D Eurobonds (6) ❑

Eurobonds versus Eurocurrency loans, continued

– Flexibility • Eurobonds – Funds are drawn down in one sum on a fixed date and repaid on a fixed schedule unless the borrower pays a prepayment penalty. – Switching the denomination involves a costly refunding and reissuing process. • Eurocurrency loan – The drawdown can be staggered to fit the borrower’s needs with a fee of about 0.5% per annum paid on the unused portion and can be prepaid without penalty. – A Eurocurrency loan with a multicurrency clause enables the borrower to switch currencies on any rollover date.

– Speed • Eurocurrency market – funds can be raised in as little as two to three weeks. • Eurobonds – financing takes more time, but the difference is becoming less significant. Chapter 12: International Financing and National Capital Markets

12.D Eurobonds (7) ❑

Euronotes – Note issuance facility (NIF) – a low-cost substitute for syndicated credits that allows borrowers to issue their own short-term Euronotes. – NIFs have features of both the U.S. commercial paper market and U.S. commercial lines of credit. • Like commercial paper, notes under NIFs are unsecured, short-term debt (also known as Euro-commercial paper or Euro-CP) generally issued by MNCs with excellent credit ratings. • Like lines of credit, NIFs generally include multiple pricing components for various contract features, including a market-based interest rate and participation, facility, and underwriting fees.

– Revolving underwriting facility (RUF) – a NIF that includes underwriting services and gives borrowers long-term continuous access to shortterm money underwritten by banks at a fixed rate.

Chapter 12: International Financing and National Capital Markets

12.D Eurobonds (8) ❑

Euronotes, continued – Euronote pricing • In lieu of a coupon rate, Euronotes are sold at a discount from face value. • The yield is usually quoted on a discount basis from its face value.

– Euro-medium term notes (Euro-MTNs) • Can be offered in small amounts; in different maturities, currencies, seniority, and security; and on a daily basis. • Issuers can thus take advantage of changes in the yield curve and of changing investor needs. • Maturities are typically from 5 to 30 years. However, increasing issues with maturities of less than one year are negatively impacting the Euro-CP market. • Euro-MTNs are typically underwritten in batches of more than $50 million.

Chapter 12: International Financing and National Capital Markets

12.E Asiacurrency (Asiadollar) Market ❑

Located in Singapore due to relaxed financial controls and taxes.

❑

Primary economic functions – Channel investment dollars to rapidly growing Southeast Asian countries – Provide deposit facilities for investors with excess funds

❑

Dragon bond – Asiabond counterpart to the Asiadollar market. – Denominated in a foreign currency, usually dollars, but launched, priced, and traded in Asia. – The market has slumped because Asian borrowers with good international credit ratings can raise funds with longer maturities and at lower cost in Europe or the U.S.

Chapter 12: International Financing and National Capital Markets

12.F Project Finance (1) ❑

Project finance – raising funds to finance an economically separable capital investment project in which the providers of the funds use the cash flow from the project to service their loans and provide the return of and a return on their equity investment in the project

❑

The ownership vehicle for a project is a single-purpose corporation that is legally independent of its sponsors.

❑

Key attributes of project finance – Focuses on the economically separable nature of investment projects suitable for project financing, such as power plants or pipelines. – Because projects are set up as legally independent entities, nonrecourse lenders have resort only to project assets and cash flows. – The underlying assets are large, illiquid industrial assets. – At the end of a project, all debt and equity investors are paid.

Chapter 12: International Financing and National Capital Markets

12.F Project Finance (2) ❑

Project finance shields the parent from financial obligations and risks associated with the project, and the project from problems the parent may have.

❑

Lenders factor in a greater degree of risk because the parent is not legally responsible for the project.

❑

Thus, the cost of project financing exceeds the parent’s cost of borrowing.

❑

The net benefit stems from the ability of project finance to resolve agency problems, reduce taxes and the costs of financial distress, and facilitate risk management. – Credit risk analysis is performed on the project only, and not on the parent. – The ability to exploit special tax holidays, tax rate reductions, and reduce royalty payments may result in reductions in corporate taxes. – The careful alignment of risks and returns with those best able to bear them improves incentives and increases the likelihood that the project will be operated with maximum efficiency.

Chapter 12: International Financing and National Capital Markets

Chapter 13

International Portfolio Investment

Chapter 13 Outline A. Risks and Benefits of International Equity Investing B. International Bond Investing C. Optimal International Asset Allocation

D. Measuring the Total Return from Foreign Portfolio Investing E. Measuring Exchange Risk on Foreign Securities

Chapter 13: International Portfolio Investment

13.A Risks and Benefits of International Equity Investing (1) ❑

Risks to international investing – Changes in currency exchange rate – dividends received on or proceeds from the sale of international investments may be reduced or increased when the dividends or proceeds are converted into dollars. – Currency controls may restrict or delay an investor’s ability to move currency out of a country. – Dramatic changes in foreign market value – Political, economic, and social events influence foreign markets. – Lack of liquidity – foreign markets may have lower trading volumes, fewer listed companies, abbreviated hours of operation, and restrictions on the amount and type of stocks investors may purchase. – Less information – Disclosure policies are often more lax in foreign countries than in the U.S.

Chapter 13: International Portfolio Investment

13.A Risks and Benefits of International Equity Investing (2) ❑

Risk to international investing, continued – Legal recourse – even if investors have legal recourse in the U.S., judgments may not be enforceable in foreign countries. Thus, investors may have to rely on the legal system of the foreign company’s home country. – Different market operations • Foreign markets may have different periods for clearance and settlement and may not report stock trades as quickly as U.S. markets. • Shares may not be protected if the custodian bank has credit problems.

❑

Benefit to international investing – International investments offer greater opportunities than domestic investments. • More than half the world’s market capitalization is in non-U.S. companies. • Most global manufacturers are overseas. • More than 80% of all cars, 85% of all stereos, and 99% of 35mm cameras are produced abroad.

Chapter 13: International Portfolio Investment

13.A Risks and Benefits of International Equity Investing (3) ❑

International diversification – Basic rule of portfolio diversification – the broader the diversification, the more stable the returns and the more diffuse the risks. – The expanded universe of international securities implies the possibility of achieving a better risk-return tradeoff than investing solely in U.S. securities. – While nearly 75% of investment risk can be eliminated in a fully diversified U.S. portfolio, all companies in a country are subject to the same cyclical economic fluctuations (systematic risk), which cannot be diversified out.

– By diversifying across countries whose economic cycles are not perfectly aligned (e.g., an oil price shock that hurts the U.S. economy helps oil-exporting countries), investors may further reduce risk by diversifying out some systematic risk.

Chapter 13: International Portfolio Investment

13.A Risks and Benefits of International Equity Investing (4) ❑

International diversification, continued – Annualized returns and standard deviations of returns for various developed and emerging stock markets from 1988 to 2006 indicate that emerging markets generally have higher risks and returns than developed markets. – The Morgan Stanley Capital International (MSCI) Europe, Australia, Far East (EAFE) Index (reflecting the 20 major stock markets outside the U.S.) has had lower risk than most of its individual country components. – The MSCI World Index (which combines EAFE countries with North America), has lower risk than any of its components except for the U.S.

Chapter 13: International Portfolio Investment

13.A Risks and Benefits of International Equity Investing (5) ❑

International diversification, continued – Domestic diversification reduces unsystematic risk, and international diversification reduces both unsystematic and systematic risk. Total Risk 100%

U.S. domestic portfolio ~10% difference in risk reduction

International portfolio Number of Stocks 50

Chapter 13: International Portfolio Investment

13.A Risks and Benefits of International Equity Investing (6) ❑

Correlations and gains from diversification – Foreign market betas measure market risk relative to the U.S. market (i.e., U.S. market beta = 1.00)

Foreign Market Beta =

Correlation with U.S. market *

Standard deviation of foreign market Standard deviation of U.S. market

– Market risk is also computed from a world perspective, whereby the correlations are computed relative to the world index. – High correlations (e.g., Canada-U.S. correlation of 0.72) indicate that the markets of the correlated countries move fairly synchronously.

– Low correlations (e.g., Austria-U.S. correlation of 0.19) indicate that markets of the correlated countries move largely independently of each other. Chapter 13: International Portfolio Investment

13.A Risks and Benefits of International Equity Investing (7) ❑

Correlations and gains from diversification, continued – Efficient frontier – the set of portfolios with the smallest possible standard deviations for their levels of expected returns and the maximum expected returns for a given level of risk. – International diversification pushes out (enhances) the efficient frontier. Expected Return • Portfolio B has the same expected return as Portfolio A but lower risk • Portfolio C has the same risk as Portfolio A but a higher expected return • Portfolio D has both a higher expected return and lower risk than Portfolio A

Chapter 13: International Portfolio Investment

Efficient frontier for U.S./foreign stock portfolios

C D

Efficient frontier for U.S. stock portfolios

B A

Standard Deviation 8

13.A Risks and Benefits of International Equity Investing (8) ❑

Correlations and gains from diversification, continued – Estimating the benefits of an international portfolio • Let  = fraction invested in U.S. stocks; 1 –  = fraction invested in foreign stocks • rus = expected return on U.S. stocks; rrw = expected return on international stocks • σus = standard deviation on U.S. stocks; σrw = standard deviation on international stocks • and us,rw = correlation between returns on the U.S. and international portfolios

– Return on an international portfolio rp = Rp = rus + (1 – )rrw – Risk on an international portfolio σp = 2

σp = [ σus + (1 – )2σrw + 2(1 – a)σusσrwus,rw]1/2 Chapter 13: International Portfolio Investment

13.A Risks and Benefits of International Equity Investing (9) ❑

Correlations and gains from diversification, continued – Example • Assume equal weights of U.S. and international stocks ( = 0.5) • Let EAFE Index represent foreign stock portfolio • σus = 15.16%; σrw = 16.43%; us,rw = 0.50

– Risk on an international portfolio σ p = σp = [0.52 (15.16)2 + (1 – 0.5)2 (16.43)2 + 2(0.5)(0.5) * 15.16 * 16.43 * 0.50]1/2

= [187.212]1/2 = 13.68% – Thus, diversifying internationally reduces risk by ~10% ((13.68 - 15.16)/15.16 = -9.8%).

Chapter 13: International Portfolio Investment

13.A Risks and Benefits of International Equity Investing (10) ❑

Correlations and gains from diversification, continued – Benefits of diversification depend on relatively low correlations among assets. • Experts assume that as their underlying economies become more closely integrated and cross-border financial flows accelerate, national capital markets will become more highly correlated, thus reducing the benefits (reductions in systematic risk) of international diversification. • Empirical evidence supports this assumption. – The correlations between the U.S. and non-U.S. stock markets are generally higher today than they were during the 1970s. – The correlation between the EAFE Index and the U.S. market increased from about 0.4 in the mid-1990s to about 0.84 in 2006. • As markets decline, correlations appear to increase as market volatility increases, reducing the benefits of international diversification. • Benefits still exist, particularly for long-term investors.

Chapter 13: International Portfolio Investment

13.A Risks and Benefits of International Equity Investing (11) ❑

Investing in emerging markets – Emerging markets with volatile economic and political prospects offer the greatest degree of diversification and highest expected returns. – High returns come with high risk. – Despite high risk, emerging markets reduce portfolio risk because of their low correlations with returns in developed markets (even though correlations are rising over time). • Shifting to a portfolio 100% invested in the MSCI World Index to one containing up to 10% invested in the IFC Emerging Markets Index reduces risk while simultaneously increasing expected return. • Beyond a 10% investment, risk increases.

• Thus, even if emerging markets are not expected to outperform developed country markets, risk reduction would dictate an investment of up to 10% in emerging markets.

– Caveat – the IFC database does not include emerging markets that fail to reach a certain threshold of capitalization. Thus, the IFC Index is biased against low-return markets. Chapter 13: International Portfolio Investment

13.A Risks and Benefits of International Equity Investing (12) ❑

Barriers to international diversification – Benefits of international diversification will be limited because of barriers to investing overseas. – Barriers include • Lack of liquidity • Currency controls • Tax regulations • Relatively less-developed capital markets abroad • Exchange risk • Lack of readily accessible and comparable information on foreign securities

• Home bias

– Home bias – the vast majority of U.S. investor portfolios consists of domestic stocks. The same bias applies to foreign investors.

Chapter 13: International Portfolio Investment

13.A Risks and Benefits of International Equity Investing (13) ❑

Barriers to international diversification, continued – How to diversify into foreign securities • Some foreign firms (< 100) are listed on the New York Stock Exchange or American Stock Exchange. • Buy U.S.-traded foreign stocks in the form of American depository receipts (ADRs) – Negotiable certificates issued by U.S. banks evidencing ownership of ADSs. – ADS – a dollar-denominated security representing foreign company shares held for the ADS owner by a custodian bank in the issuing company’s home country. Proof of ownership

Represents

ADR

ADS

Issued by U.S. bank

Held by custodian bank in issuing company’s home country

Shares of foreign stock

– ADR investors absorb handling costs through transfer and handling charges.

– ADRs eliminate custodian safekeeping charges in the issuer’s home country, reduce settlement delays, and facilitate prompt dividend payments. Chapter 13: International Portfolio Investment

13.A Risks and Benefits of International Equity Investing (14) ❑

Barriers to international diversification, continued – How to diversify into foreign securities, continued • Buy global depository receipts (GDRs) – Similar to ADRs but generally traded on two or more markets outside the foreign issuer’s home market. – Generally structured as a combination of a Rule 144A ADR (which trades in the U.S. private placement market and can be sold only to qualified institutional buyers) and a public offering outside the U.S. – Enable foreign companies to raise capital in two or more markets simultaneously and broaden their shareholder bases.

• Buy global depository shares (GDSs, or global shares) – Similar to an ordinary share but traded on any stock exchange in the world where it is registered and in the local currency. – Less expensive to trade than ADRs. – Currently only four global share issues – DaimlerChrysler, Celanese, UBS, and Deutsche Bank. Chapter 13: International Portfolio Investment

13.A Risks and Benefits of International Equity Investing (15) ❑

Barriers to international diversification, continued – How to diversify into foreign securities, continued • The easiest way to invest abroad is to buy shares in an internationally diversified mutual fund. Four basic categories: – Global funds – invest anywhere in the world, including the U.S. – International funds – invest only outside the U.S. – Regional funds – focus on specific geographical areas overseas, such as Asia or Europe. – Single-country funds – invest in individual countries, such as Germany or Taiwan.

• Greater diversification of the global and international funds reduces risk but also reduces the chance of high returns should a single country’s market increase substantially.

Chapter 13: International Portfolio Investment

13.B International Bond Investing (1) ❑

Research indicates that bond portfolios benefit from international diversification. – A portfolio fully invested in U.S. bonds is replaced in increments of 10% with a mixture of foreign bonds from 7 markets. – Ten portfolios were created over 1973-1983 and risk-returns computed.

– Conclusions • As the proportion of U.S. bonds fell, portfolio returns rose; foreign bonds outperformed U.S. bonds over the period. • As the proportion of U.S. bonds fell from 100% to 70%, volatility fell; correlation between U.S. and foreign bond returns was low over the period.

• By investing up to 60% in foreign bonds, U.S. investors could have raised their returns substantially while not increasing risk above the level associated with holding only U.S. bonds.

– Other studies have lead to similar findings.

Chapter 13: International Portfolio Investment

13.B International Bond Investing (2) ❑

Research indicates that bond portfolios benefit from international diversification, continued.

100% U.S. Bonds

Higher returns

U.S. + Foreign Bonds

100% U.S. Bonds

Lower volatility

70% U.S. Bonds

100% U.S. Bonds

Chapter 13: International Portfolio Investment

Substantially higher returns;

No increase in volatility

Up to 60% Foreign Bonds

13.C Optimal International Asset Allocation (1) ❑

Research indicates that expanding investments to include domestic and foreign stocks and bonds provides benefits. – Performances of various investment strategies were compared over the period 1970-1980. – Conclusions • International stock diversification yields a substantially better risk-return tradeoff than does holding only domestic stock. • International diversification combining stock and bond investments results in substantially less risk than international stock diversification alone. • A substantial improvement in the risk-return tradeoff can be realized by investing in internationally diversified stock and bond portfolios whose weights do not conform to relative market capitalizations (i.e., market indices used to measure world stock and bond portfolios do not lie on the efficient frontier).

Chapter 13: International Portfolio Investment

13.C Optimal International Asset Allocation (2) ❑

Research indicates that expanding investments to include domestic and foreign stocks and bonds provides benefits, continued.

100% U.S. Stocks

100% U.S. and Foreign Stocks

Weights conform to market indices that do not lie on the efficient frontier

Chapter 13: International Portfolio Investment

Higher riskreturn tradeoff

Lower volatility

Substantial risk-return improvement

U.S. + Foreign Stocks

U.S. and Foreign Stocks and Bonds

Weights do not conform to market indices that do not lie on the efficient frontier

13.D Measuring Total Return from Foreign Portfolio Investing (1) ❑

Total dollar return can be divided into 3 elements: – Dividend/interest income – Capital gains/losses – Currency gains/losses

❑

Bonds – One-period total dollar return R$ is computed as R$ = Foreign Currency Return * Currency Gain/Loss - 1

R$ = [1 +

B(1) – B(0) + C

] (1 + g) - 1

B(0)

– Where • B(t) = foreign currency (FC) bond price at time t • C = FC coupon income • g = percent change in dollar value of foreign currency Chapter 13: International Portfolio Investment

13.D Measuring Total Return from Foreign Portfolio Investing (2) ❑

Bonds, continued – Example: Compute R$ given the following: • B(0) = 95; C = 8; B(1) = 97 • Local currency appreciates by 3% against the dollar over period

R$ = [1 +

97 – 95 + 9

] (1 + 0.03) - 1

(1.105) * (1.03) – 1 = 13.8%

FC return Currency gain/loss

Chapter 13: International Portfolio Investment

13.D Measuring Total Return from Foreign Portfolio Investing (3) ❑

Stocks – One-period total dollar return R$ is computed as R$ = Foreign Currency Return * Currency Gain/Loss - 1

R$ = [1 +

P(1) – P(0) + DIV

] (1 + g) - 1

P(0)

– Where • P(t) = foreign currency (FC) stock price at time t • DIV = FC dividend income • g = percent change in dollar value of foreign currency

Chapter 13: International Portfolio Investment

13.D Measuring Total Return from Foreign Portfolio Investing (4) ❑

Stocks, continued – Example: Compute R$ given the following: • P(0) = 50; DIV = 1; P(1) = 48 • Local currency depreciates by 5% against the dollar over period

R$ = [1 +

48 – 50 + 1

] (1 + 0.05) - 1

(1.98) * (0.95) – 1 = -6.9%

Chapter 13: International Portfolio Investment

13.E Measuring Exchange Risk on Foreign Securities (1) ❑

R$ can be approximated as R$ ≈ Rf + g

❑

σ$, the standard deviation of R$, can be written as 2

σ$ = [σf + σg + 2σfσgf,g]1/2 – Where •

σf2 = variance of the FC return

• σg2 = variance of the change in the exchange rate

 f,g = correlation between FC return and exchange rate change ❑

Example: Compute σ$ given the following: – σf = 23%; σg = 17%; f,g= 0.31 σ$ = [232 + 172 + 2 * 23 * 17 * 0.31]1/2 = 32.56%

Chapter 13: International Portfolio Investment

13.E Measuring Exchange Risk on Foreign Securities (2) ❑

Hedging currency risk – Stock portfolios • During 1980-1985, the dollar was rising, and during 1986-1996, the dollar was generally falling. • Over the period 1980-1985, risk-adjusted returns on hedged stock portfolios exceeded those on unhedged portfolios.

• Over the period 1986-1996, this result reversed. • The reversal occurred because of changes over time in the standard deviations and correlation coefficients of national stock market returns expressed in dollars.

– Bond portfolios • The returns on hedged, internationally diversified bond portfolios exhibited lower volatility than the returns on unhedged bond portfolios over both above-discussed periods. • However, the lower standard deviation of hedged bond returns is generally matched by lower returns. Chapter 13: International Portfolio Investment

Chapter 14

Capital Budgeting for the Multinational Corporation

Chapter 14 Outline A. Capital Budgeting B. Discount Rates for Foreign Investments C. Issues in Foreign Investment Analysis

D. Establishing a Worldwide Capital Structure

Chapter 14: Capital Budgeting for the Multinational Corporation

14.A Capital Budgeting (1) ❑

Capital budgeting – the process of selecting the prospective capital investments that maximize an MNC’s shareholder value.

❑

A project’s net present value determines the project’s effect on shareholder value.

❑

Net present value (NPV) – the present value of future cash flows discounted at the project’s cost of capital less the initial investment. n

NPV = -I0 + 

– Where

t=1 (1 + k)t

• I0 = initial investment • Xt = net cash flow in period t • k = cost of capital (also known as weighted average cost of capital, or WACC) • n = investment horizon

– Only projects with positive NPV should be accepted. – If two projects are mutually exclusive, the project with the higher NPV should be accepted. Chapter 14: Capital Budgeting for the Multinational Corporation

14.A Capital Budgeting (2) ❑

❑

Example – compute NPV of a plant expansion project. Assume n = 3 and k = 10% t

-$4,000,000

$1,200,000

$2,700,000

1.00

1.10

(1.10)2

(1.10)3

Present Value

-$4,000,000

$1,091,000

$2,231,000

$2,029,000

Cumulative Present Value

-$4,000,000

-$2,909,000

-$678,000

$1,351,000 $1,351,000 NPV

The project has a positive NPV and is thus acceptable.

Chapter 14: Capital Budgeting for the Multinational Corporation

14.A Capital Budgeting (3) ❑

Incremental cash flows – incremental cash flows may differ from total cash flows for a number of reasons. 1. Cannibalization 2. Sales creation 3. Opportunity cost

4. Transfer pricing 5. Fees and royalties 6. Getting the base case right 7. Accounting for intangible benefits ❑

The impact of each of these factors on cash flows must be considered in determining the project’s viability.

Chapter 14: Capital Budgeting for the Multinational Corporation

14.A Capital Budgeting (4) 1.

Cannibalization –

A company’s new product steals sales from its earlier models.

–

A firm builds a plant overseas and substitutes foreign production for parent company exports.

–

To the extent that sales of a new product or plant replace existing corporate sales, the new project’s estimated profits must be reduced by the earnings on the lost sales.

–

The relevant measure of cannibalism for capital budgeting purposes is the lost profit on lost sales that would not otherwise have been lost had the new project not been undertaken.

Sales creation –

The opposite of cannibalization – a new project creates additional sales for existing products.

–

The new project’s estimated profits must be increased by the additional sales created by the project.

Chapter 14: Capital Budgeting for the Multinational Corporation

14.A Capital Budgeting (5) 3.

Opportunity cost –

Project costs must include the true economic cost of any resource required for the project, regardless of whether the firm already owns the resource or acquires it just for the project.

–

The opportunity cost – that is, the maximum amount of cash the asset could generate for the firm should it be sold or put to some other productive use – must be included in computing the value of undertaking the project.

Transfer pricing –

If an MNC’s new domestic plant will supply parts to its foreign subsidiary, it can increase the apparent profitability of the new plant by increasing the transfer price to the subsidiary, and vice versa.

–

Thus, the transfer prices at which goods and services are traded internally can significantly distort the profitability of a proposed investment.

–

Where possible, prices used to evaluate project inputs or outputs should reflect market prices.

Chapter 14: Capital Budgeting for the Multinational Corporation

14.A Capital Budgeting (6) 5.

Fees and royalties –

An MNC often charges fees and royalties to a project to cover various items such as legal counsel, power, lighting, heating, rent, R&D, headquarters staff, management costs, etc.

–

While fees and royalties are costs to the project, they are a benefit from the parent’s perspective.

–

The project should be charged only for additional expenses attributable to the project and not for overhead expenses unaffected by the project.

Getting the base case right –

Generally, a project’s incremental cash flows can be found only by subtracting worldwide corporate cash flows without the investment (the base case) from postinvestment corporate cash flows.

–

Getting the base case right requires correctly determining what will happen if the firm does not make the investment.

–

Toward this end, understanding the competitive landscape is critical. • E.g., a firm may forgo investing in a new product for fear of cannibalization, only to create a profitable niche for another company to exploit.

Chapter 14: Capital Budgeting for the Multinational Corporation

14.A Capital Budgeting (7) 7.

Accounting for intangible benefits –

Intangible assets include better quality, faster time to market, quicker and more efficient order processing, learning curve, knowledge, and higher customer satisfaction, among other things.

–

Intangible assets have a very tangible impact on cash flows.

–

Thus, while intangible benefits from a project cannot be measured precisely, they must be included in the capital-budgeting process.

Chapter 14: Capital Budgeting for the Multinational Corporation

14.B Discount Rates for Foreign Investments ❑

For capital budgeting purposes, the cost of capital k0 (also known as weighted average cost of capital, or WACC) is the required return for the project. k0 = (1 – L)ke + Lkd(1 – t)

– Where • L = parent’s debt ratio (debt to total assets) • ke= project’s cost of equity capital • kd = project’s cost of debt • t = tax rate

– A project’s estimated cash flows are discounted by k0 to determine its NPV. – Because a project’s risk may be different than the MNC’s risk, the project’s own cost of capital must be used to compute NPV.

Chapter 14: Capital Budgeting for the Multinational Corporation

14.B.i Discount Rates for Foreign Investments: Cost of Equity Capital (1) ❑

Cost of equity capital ke – The minimum rate of return necessary to induce investors to buy or hold the firm’s stock, consisting of a basic yield to cover time value and a risk premium to account for the specific risk of the project.

– The rate used to capitalize total corporate cash flows – the conceptually preferred definition, as ke is a function of the riskiness of the activities in which a firm is engaged, rather than of the riskiness of the firm itself. ❑

ke is defined as ri, the expected return on asset i, by the capital asset pricing model (CAPM): ri = rf + βi(rm – rf)

– Where • rf = rate of return on a risk-free asset (usually a U.S. Treasury bill or bond) • βi = the systematic or nondiversifiable risk of the asset • rm = expected return on the market portfolio consisting of all risky assets • rm – rf = the market risk premium (MRP) Chapter 14: Capital Budgeting for the Multinational Corporation

14.B.i Discount Rates for Foreign Investments: Cost of Equity Capital (2) ❑

The CAPM is based on the notion that intelligent, risk-averse shareholders will seek to diversify their risks; thus, the only risk that will be rewarded with a risk premium is systematic risk.

❑

A project’s systematic risk is measured by βi: βi =

i,mσi

σm

– Where •

i,m = correlation between returns on project i and the market portfolio

• σi = standard deviation of returns on project i • σm = standard deviation of returns on the market portfolio

Chapter 14: Capital Budgeting for the Multinational Corporation

14.B.i Discount Rates for Foreign Investments: Cost of Equity Capital (3) ❑

Much of the systematic risk affecting a company is related to the cyclical nature of the national economy in which the company is domiciled.

❑

The returns on a project located in a foreign country whose economy is not synchronous with the home country’s economy should be less correlated with domestic market returns than the returns on a comparable domestic project.

❑

In this case, a project’s systematic risk may be lower than that of a comparable domestic project.

❑

The project risk premium is represented by βi multiplied by the MRP. Risk premiumi = βi(rm – rf)

❑

When the returns and financial structure of a proposed investment are expected to be similar to those of a firm’s typical investment, the corporate ri may serve as a proxy for the project’s ri.

Chapter 14: Capital Budgeting for the Multinational Corporation

14.B.i Discount Rates for Foreign Investments: Cost of Equity Capital (4) ❑

Less developed countries (LDCs) may provide the largest diversification benefits (lower systematic risk) despite high political risk because their economies are less correlated with the U.S. or other Western economy.

❑

Conversely, diversification benefits from investing in developed countries diminish because of their high correlations. Investment in

Developed Country Investment in

Low correlation increases diversification benefits

LDC

High correlation decreases diversification benefits

Developed Country

Chapter 14: Capital Budgeting for the Multinational Corporation

14.B.i Discount Rates for Foreign Investments: Cost of Equity Capital (5) ❑

While the ratio of systematic risk to total risk in LDCs is generally very low, systematic risk in LDCs is probably not significantly lower than that in developed countries.

❑

Even given a low correlation to the world economy, systematic risk for a project located in an LDC could be large. – E.g., extraction (mining) projects rely on prices set in the world market. – Worldwide demand is systematically related to the state of the world economy.

❑

Conversely, a market-oriented project in an LDC, whose risk depends largely on the evolution of the local market, will likely have systematic risk that is small in both relative and absolute terms.

Chapter 14: Capital Budgeting for the Multinational Corporation

14.B.i Discount Rates for Foreign Investments: Cost of Equity Capital (6) ❑

To the extent an MNC can provide low-cost international diversification, investors may be willing to accept a lower rate of return on shares of MNCs than on shares of single-country firms – i.e., the required return on foreign projects may be less than the required return on comparable domestic projects.

❑

If individual investors can accomplish international portfolio diversification as easily and cheaply, the discount rate would not be reduced further to reflect investors’ willingness to pay a premium for the indirect diversification provided by an MNC’s shares. Single-Country Firm

Internationally Diversified MNC

Investment choice is singlecountry firm or MNC: Investors may accept a lower return on MNC shares Chapter 14: Capital Budgeting for the Multinational Corporation

Internationally Diversified Portfolio of Stocks

Investment choice is international portfolio or MNC: Investors may not accept a lower return on MNC shares 15

14.B.i Discount Rates for Foreign Investments: Cost of Equity Capital (7) ❑

Key issues in estimating ri – The information needed to estimate βi directly – i.e., a history of past subsidiary returns or future subsidiary returns relative to predicted market returns – does not exist.

– Thus, an MNC must find publicly traded firms that share similar risk characteristics and use the average beta for the portfolio of corporate surrogates to proxy for βi. – This process requires answering four key questions: 1. Should the proxies be U.S. or local? •

Local companies provide a better indication of risk but may not exist.

•

U.S. proxies and accessible information exist, but their betas may be very different than those of foreign subsidiaries.

Chapter 14: Capital Budgeting for the Multinational Corporation

14.B.i Discount Rates for Foreign Investments: Cost of Equity Capital (8) ❑

Key issues in estimating foreign project discount rates, continued – Four key questions, continued: 2. Is the relevant base portfolio against which the proxy betas are estimated the U.S. market portfolio, the local portfolio, or the world market portfolio? •

A risk that is systematic in the context of the local market may be diversifiable in the context of the U.S. or world portfolio.

•

In this case, using the local market portfolio will result in a higher required return.

3. Should the MRP be based on the U.S. market or the local market? •

The local MRP is the MRP demanded by investors on investments in that market.

•

Estimates of the local MRP may be subject to statistical error or irrelevant to the extent that an MNC’s investors are not the same as investors in the local market, and the two sets of investors measure risk differently.

Chapter 14: Capital Budgeting for the Multinational Corporation

14.B.i Discount Rates for Foreign Investments: Cost of Equity Capital (9) ❑

Key issues in estimating foreign project discount rates, continued – Four key questions, continued: 4. How, if at all, should country risk be incorporated into the cost of capital estimates?

•

A recently adopted approach is to add a country risk premium to the discount rate.

•

Adding a country risk premium may result in double counting risks.

– Estimating proxy betas – 3 alternatives in order of preference 1. Use local companies – Because the returns on an MNC’s local operations depend on the local economy, the degree of systematic risk for a foreign project may be lower than that of comparable U.S. companies. – Using U.S companies and their returns to proxy for the returns of a foreign project will likely lead to an upward-biased estimate of the MRP. Chapter 14: Capital Budgeting for the Multinational Corporation

14.B.i Discount Rates for Foreign Investments: Cost of Equity Capital (10) ❑

Key issues in estimating foreign project discount rates, continued – Estimating proxy betas – 3 alternatives in order of preference, continued 2. Use an industry in the local market whose U.S. industry beta is similar to that of the project’s U.S. industry beta.

3. Use an adjusted U.S. industry beta – compute the U.S. industry beta for the project and multiply it by the foreign market beta relative to the U.S. index.

– Relevant base portfolio • The relevant base portfolio against which to estimate proxy betas can be the home portfolio or the global market portfolio. • If capital markets are seen as globally integrated, use the global market portfolio. • CAPM becomes the global CAPM: ri = rf + βig(rg – rf) • Where – βig = project beta measured relative to the global market – rg = expected return on the global market Chapter 14: Capital Budgeting for the Multinational Corporation

14.B.i Discount Rates for Foreign Investments: Cost of Equity Capital (11) ❑

Key issues in estimating foreign project discount rates, continued – Relevant base portfolio, continued • Using the global CAPM, βig is computed as

βig =

i,gσif σg

• Where – i,g = correlation between returns on project i and the global portfolio – σf = standard deviation of returns on foreign project i – σg = standard deviation of returns on the global portfolio

Chapter 14: Capital Budgeting for the Multinational Corporation

14.B.i Discount Rates for Foreign Investments: Cost of Equity Capital (12) ❑

Key issues in estimating foreign project discount rates, continued – Relevant base portfolio, continued • If capital markets are not seen as globally integrated, use the home market portfolio.

• For a U.S. MNC, CAPM becomes ri = rf + βius(rus – rf) • Where – βius = project beta measured relative to the U.S. market – rus = expected return on the U.S. market portfolio • Capital markets are now integrated to a great extent and are expected to become more integrated over time. Government regulations and other market imperfections have been barriers to total global integration.

Chapter 14: Capital Budgeting for the Multinational Corporation

14.B.i Discount Rates for Foreign Investments: Cost of Equity Capital (13) ❑

Key issues in estimating foreign project discount rates, continued – Relevant base portfolio, continued •

Implications of global CAPM for MNCs – Other things equal, the use of a global CAPM means a lower cost of capital because the MRP will be lower. • As long as the domestic economy is less than perfectly correlated with the world economy, βig will be less when measured against the global portfolio than when measured against the domestic portfolio. • Risk that is systematic in the context of the U.S. economy may be unsystematic in the context of the global economy; thus, investors able to diversify internationally will demand a lower risk premium. • Reducing total risk can increase a firm’s cash flows – by operating in a number of countries, an MNC can trade off negative swings in some countries against positive swings in other countries.

Chapter 14: Capital Budgeting for the Multinational Corporation

14.B.i Discount Rates for Foreign Investments: Cost of Equity Capital (14) ❑

Relevant market risk premium –

The U.S. MRP is recommended because • The U.S. MRP is likely to be demanded by a U.S. MNC’s mostly American investors; • The betas for foreign subsidiaries are estimated relative to the U.S. market;

• The quality, quantity, and time span of U.S. capital market data are the best in the world and thus increase the statistical validity of the estimated MRP.

–

Even if the market price per unit of risk is uniform worldwide, the MRP may differ across countries because market risk itself differs across countries.

–

When computing foreign MRPs, adjust the U.S. MRP for differences in risk on a market-by-market basis, as follows: MRPf = MRPus

σf σus

• Where – MRPus = U.S. market risk premium – σf = standard deviation of returns on foreign market portfolio – σus = standard deviation of returns on the U.S. market portfolio Chapter 14: Capital Budgeting for the Multinational Corporation

14.B.ii Discount Rates for Foreign Investments: Cost of Debt ❑

Cost of debt kd – the dollar costs of foreign currency debt, which include the interest rate, currency gains/losses, and tax effects, computed as kd = rL(1 + c)(1 – ta) + c

– Where • rL= interest rate on foreign debt • c = exchange gain/loss, computed as (e1 – e0) / e0 • ta = project’s marginal tax rate

– Example: the French subsidiary of a U.S. MNC borrows €10 million for one year • rL = 7% • e0 = $1.34; e1 = $1.30; c = (1.30 – 1.34) / 1.34 = -2.99% • ta = 40% kd = 0.07(1 -0.0299)(1 – 0.40) – 0.0299 = 1.09%

Chapter 14: Capital Budgeting for the Multinational Corporation

14.B.iii Discount Rates for Foreign Investments: Weighted Average Cost of Capital (WACC) (1) ❑

Using ke and kd, we compute WACC k0 as k0 = (1 – L)ke + Lkd(1 – t) *

–

Where L = the parent’s debt ratio

❑

The debt ratio must be based on the proportion of the MNC’s capital structure accounted for by each source of capital using market – and not book – values.

❑

The debt ratio to be used must reflect the firm’s target capital structure, and not its historic capital structure.

❑

When project risk and capital structure differ from those of the parent, k0 = k0’. k0’ = (1 – L’)ke’ + Lkd’(1 – t)

*This equation assumes a pretax kd. If kd is computed after taxes, as in the previous slide, we omit (1-t): k0 = (1 – L)ke + Lkd Chapter 14: Capital Budgeting for the Multinational Corporation

14.B.iii Discount Rates for Foreign Investments: Weighted Average Cost of Capital (WACC) (2) ❑

Example: Compute and compare k0 and k0’ – An MNC planning for a foreign investment has a 40% debt ratio, ke of 14%, and after-tax kd of 6%. k0 = (1 – 0.40)0.14 + 0.40*0.06 = 10.8%

– The MNC’s foreign investment can support only a 30% debt ratio and, given the project’s high degree of risk, ke of 16% and after-tax kd of 6%. k0’ = (1 – 0.30)0.16 + 0.30*0.08 = 13.6%

Chapter 14: Capital Budgeting for the Multinational Corporation

14.C. Issues in Foreign Investment Analysis (1) ❑

Evaluating project cash flows – Tax regulations and exchange controls can create substantial differences in a project’s cash flow and the amount remitted to the parent.

– Project expenses such as management fees and royalties are returns to the parent. – Incremental revenue contributed to the parent can differ from total project revenue. ❑

Economic theory states that the value of a project is determined by the NPV of future cash flows to the investor.

❑

Thus, the parent should value only those cash flows repatriated net of transfer costs.

Chapter 14: Capital Budgeting for the Multinational Corporation

14.C. Issues in Foreign Investment Analysis (2) ❑

Evaluating project cash flows, continued – Three-step approach to project evaluation 1. Estimate project cash flows from the project’s standpoint. 2. Forecast the amounts, timing, and form of transfers, as well as taxes and other expenses incurred in the transfer process, to the parent. 3. Consider the indirect benefits and costs of the project.

– Estimating incremental project cash flows •

Subtract worldwide parent cash flows (without the investment) from postinvestment parent cash flows. – Adjust for transfer pricing and fees and royalties • Use market costs/prices for goods, services, and transfer prices. • Add back fees and royalties because they are benefits to the parent. • Remove the fixed portions of costs such as corporate overhead.

Chapter 14: Capital Budgeting for the Multinational Corporation

14.C. Issues in Foreign Investment Analysis (3) ❑

Evaluating project cash flows, continued – Estimating incremental project cash flows, continued •

Adjust for global costs/benefits not reflected in the project’s financial statements:

– Cannibalization – Sales creation – Additional taxes owed when repatriating profits – Foreign tax credits – Diversification of production facilities – Market diversification – Provision of a key link in a global service network – Intangible assets

Chapter 14: Capital Budgeting for the Multinational Corporation

14.C. Issues in Foreign Investment Analysis (4) ❑

Evaluating project cash flows, continued – Tax factors •

Only after-tax cash flows are relevant

•

Compute marginal tax rate on project profits

•

Example: A foreign subsidiary remits $150,000 in after-tax earnings to the parent through a dividend. – Dividend tax = 4% = $6,000 – Foreign tax credits = $50,000 + dividend tax = $56,000

– U.S. tax rate = 35% – Foreign tax rate = 25%. – Compute marginal tax rate: • Pretax income = $150,000 / 0.75 = $200,000 • U.S. tax owed = $200,000 * 0.35 = $70,000 • Taxes paid to IRS = $70,000 - $50,000 - $6,000 = $14,000 • Marginal tax rate = ($14,000 + $6,000) / $150,000 = 13.33% Chapter 14: Capital Budgeting for the Multinational Corporation

14.C. Issues in Foreign Investment Analysis (5) ❑

Political and economic risk analysis – Three primary methods to incorporate political and economic risk into foreign investment analysis •

Shorten the minimum payback period

•

Raise the cost of capital

•

Adjust cash flows to reflect the specific impact of a given risk

– Shortening the payback period and raising the cost of capital do not address the actual impact of a particular risk and may adulterate the analysis. •

E.g., if expropriation is likely in five years, increasing the cost of capital distorts the meaning of the present value of cash flows.

– Adjusting expected cash flows to reflect the specific impact of a given risk on a project’s cash flows is the recommended approach.

Chapter 14: Capital Budgeting for the Multinational Corporation

14.C. Issues in Foreign Investment Analysis (6) ❑

Exchange rate changes and inflation – Assessing the effect of exchange rate changes on expected cash flows from a foreign project involves removing the effect of offsetting inflation and exchange rate changes.

– Each effect should be analyzed separately. – First adjust cash flows for inflation and then convert the projected cash flows into dollars using the forecasted exchange rate. – Example: Compute the effects of inflation and currency depreciation on a new project in France. • Year 1 expected cash flow = €1,000,000, with 4% projected growth • Year 2 expected inflation = 6% • e0 = $1.34; Year 2 expected currency depreciation = 5%; e2 = 1.34 (1 – 0.05)2 = $1.209

• Year 2 forecasted cash flow = €1,000,000 (1.04)2 = €1,081,600 • Year 2 forecasted cash flow in dollars = €1,081,600 (1.209) = $1,307,654 Chapter 14: Capital Budgeting for the Multinational Corporation

14.C. Issues in Foreign Investment Analysis (7) ❑

Exchange rate changes and inflation, continued – Alternative approach • Discount the nominal foreign currency cash flows at the nominal foreign currency required rate of return.

• Convert the resulting foreign currency present value to the home currency using e0.

– Both approaches should yield the same results.

Chapter 14: Capital Budgeting for the Multinational Corporation

14.D. Establishing a Worldwide Capital Structure (1) ❑

Foreign subsidiary capital structure – MNCs must determine the mix of debt and equity for the parent and all consolidated and unconsolidated subsidiaries that maximizes shareholder wealth (i.e., a worldwide debt ratio).

– MNC options for financing affiliates • The parent raises funds in its own country and makes equity investments in the affiliates – debt ratio = 0% • The parent holds one dollar of share capital in each affiliate and requires all affiliates to borrow on their own – debt ratio ≈ 100% • The parent borrows and relends the funds as intracorporate advances – debt ratio ≈ 100%.

Chapter 14: Capital Budgeting for the Multinational Corporation

14.D. Establishing a Worldwide Capital Structure (2) ❑

Foreign subsidiary capital structure, continued – An MNC’s three primary options for financing affiliate operations Equity Investment

Dividend Payments

Subsidiary

Interest and Principal

Parent

Reloan

Loan

Interest and Principal

Loan

Bank

Chapter 14: Capital Budgeting for the Multinational Corporation

14.D. Establishing a Worldwide Capital Structure (3) ❑

Effect of foreign investment on debt ratios of affiliate and parent Parent Consolidated Debt Ratio Before Foreign Investment Total Investment = $1,000

D = $300 E = $700

D/E = 3:7

Affiliate Debt Ratio After $100 Investment 100% Parent Financed

100% Bank Financed

D = $0 E = $100

D = $50 E = $50

D = $100 E = $0

D/E = 0

D/E = 1:1

D/E = Infinity

Parent Consolidated Debt Ratio After Foreign Investment Total Investment = $1,100

D = $400 E = $700

Chapter 14: Capital Budgeting for the Multinational Corporation

D/E = 4:7

Whether parent or affiliate raises $100, affiliate’s debt ratio can vary from 0 to infinity

Whether parent or affiliate raises $100, parent’s debt ratio is 4:7 36

14.D. Establishing a Worldwide Capital Structure (4) ❑

Foreign subsidiary capital structure, continued – Political risk management • The use of financing to reduce political risks typically involves mechanisms to avoid or reduce the impact of certain risks, such as those related to exchange controls or expropriation. – By raising funds locally, if a subsidiary is expropriated, it would default on loans from local financial institutions. – Because local currency can be used to service local debt, borrowing locally decreases the MNC’s vulnerability to exchange controls. – Foreign investments may be funded through the host or other governments, international development agencies, overseas banks, and customers, with payment to be provided out of production. • Repayment is thus tied to the project’ success.

Chapter 14: Capital Budgeting for the Multinational Corporation

14.D. Establishing a Worldwide Capital Structure (5) ❑

Foreign subsidiary capital structure, continued – Currency risk management • Basic rule – finance assets that generate foreign currency cash flows with liabilities denominated in those same foreign currencies.

• For contractual cash flows, match net positive positions in each currency with liabilities of similar maturities in the same currency. • For noncontractual cash flows, match net positive positions in each currency with liabilities in the same currency.

– Leverage and foreign tax credits • Foreign tax credits (FTCs) are credits that home countries grant against domestic income tax for foreign income taxes already paid. – If the foreign tax on a dollar earned abroad and remitted to the U.S. is less than 35%, additional U.S. taxes will be owed to bring the total tax paid to $0.35. – If the foreign tax on a dollar earned abroad and remitted to the U.S. is greater than 35%, excess taxes paid will offset U.S. taxes owed. Chapter 14: Capital Budgeting for the Multinational Corporation

14.D. Establishing a Worldwide Capital Structure (6) ❑

Foreign subsidiary capital structure, continued – Leasing and taxes • Leasing an asset is economically equivalent to using borrowed funds to purchase the asset.

• However, tax consequences of leasing versus borrowing vary. – E.g., an MNC is considering buying or leasing a new asset for use in the U.S. • Under current U.S. tax law, deductible interest expense is a function of the preexisting proportion of assets used abroad versus domestically. E.g., if 50% of all assets are in the U.S., 50% of the interest expense on the new equipment is deductible. • Regardless of the location of existing assets, 100% of lease payments is deductible.

– Cost-minimizing approach to global capital structure • MNCs allow subsidiaries with access to low-cost capital markets to exceed the parent capitalization norm, while subsidiaries in higher-cost capital markets would have lower target debt ratios. Chapter 14: Capital Budgeting for the Multinational Corporation

14.D. Establishing a Worldwide Capital Structure (7) ❑

Joint ventures (JVs) – Debt raised by a joint venture may not be equivalent to parent-raised debt in terms of default risk. – Assessing the effects of leverage in a joint venture requires a qualitative analysis of the partner’s ties to the local financial community. – Conflicts may result if a JV is not isolated from a partner’s operations. • Each owner has an incentive to exploit the other through transfer pricing, royalty and licensing fees, and allocating production and markets among plants.

– Lack of complete control leads most MNCs to guarantee JV loans only in proportion to their share of ownership.

Chapter 14: Capital Budgeting for the Multinational Corporation

Chapter 15

Financing and Controlling Multinational Corporations

Chapter 15 Outline A. Payment Terms in International Trade B. Documents in International Trade C. Financing Techniques in International Trade

D. Government Sources of Export Financing and Credit Insurance E. Countertrade F. Short-Term Financing

Chapter 15: Financing and Controlling Multinational Corporations

15.A Payment Terms in International Trade (1) ❑

Five principal methods of payment in international trade (in order of increasing risk to the exporter) 1. Cash in advance 2. Letter of credit 3. Draft

4. Consignment 5. Open account ❑

Generally, the greater the protection afforded the exporter, the less convenient the terms are for the importer.

Chapter 15: Financing and Controlling Multinational Corporations

15.A Payment Terms in International Trade (2) ❑

Five principal means of payment in international trade, continued 1. Cash in advance – provides the exporter the greatest protection because – Payment is received either before shipment or on arrival of the goods; – Exporter’s funds are not tied up in receivables. Used if importer’s country is politically unstable or importer’s credit is poor.

2. Letter of credit (L/C) – a letter addressed to the seller, written and signed by a bank acting on behalf of the buyer. Satisfies both the exporter and importer because – The importer’s promise of payment is backed by a bank; – The importer may not want to pay for the goods until after receipt and inspection. The bank promises to honor drafts drawn on itself if the seller conforms to the conditions set forth in the L/C. Chapter 15: Financing and Controlling Multinational Corporations

15.A Payment Terms in International Trade (3) ❑

Five principal means of payment in international trade, continued 2. Letter of credit (L/C), continued – Advantages to the exporter – Eliminates credit risk if the issuing bank is of undoubted standing.

– Because countries generally permit local banks to honor L/Cs, reduces the danger of delayed or withheld payment due to exchange controls or other political acts. – Reduces uncertainty because all requirements are stipulated in the L/C.

– Guards against preshipment cancellations. – Facilitates financing by ensuring a ready buyer for the exporter’s product.

Chapter 15: Financing and Controlling Multinational Corporations

15.A Payment Terms in International Trade (4) ❑

Five principal means of payment in international trade, continued 2. Letter of credit (L/C), continued – Advantages to the importer – The importer can require an inspection certificate and ascertain that the merchandise is shipping on or before the stipulated date by requiring an on-board bill of lading. – Documents are carefully inspected by experienced clerks. – An L/C is as good as cash in advance, enabling the importer to secure more advantageous credit terms and/or prices.

– Some exporters will sell only on an L/C. – Because the L/C substitutes for cash in advance, cash is not tied up. – If prepayment is required, the importer is better off depositing its funds with the bank than with the exporter because funds are easier to recover if the exporter fails to ship the goods. Chapter 15: Financing and Controlling Multinational Corporations

15.A Payment Terms in International Trade (5) ❑

Five principal means of payment in international trade, continued 2. Letter of credit (L/C), continued – Mechanics of an L/C – example: USA importers purchases goods from Japan Exporters 1. Issue purchase order

USA Importers

2. Request L/C

10. Forward shipping docs

Japan Exporters

5. Ship goods

11. Pay L/C at maturity

4. Notify of L/C

6. Send draft and 9. Send shipping payment docs

3. Deliver L/C

Wells Fargo Bank

7. Send L/C, draft, shipping docs 8. Accept draft, remit funds

Chapter 15: Financing and Controlling Multinational Corporations

Bank of Tokyo

15.A Payment Terms in International Trade (6) ❑

Five principal means of payment in international trade, continued 2. Letter of credit (L/C), continued – Types of L/Cs – Documentary – the seller must submit necessary invoices and other documentation with the draft – Nondocumentary (“clean”) – L/C used for noncommercial transactions

– Revocable – L/C does not guarantee payment – Irrevocable – payment cannot be revoked without permission of all parties – Confirmed – issued by one bank and confirmed by another, obligating both banks to honor drafts drawn on the L/C. – Unconfirmed – the obligation of the issuing bank only – Transferable – the beneficiary has the right to instruct the paying bank to make the credit available to one or more secondary beneficiaries – Assignment – assigns part or all of the proceeds to another party but does not transfer the required documents to the party. Chapter 15: Financing and Controlling Multinational Corporations

15.A Payment Terms in International Trade (7) ❑

Five principal means of payment in international trade, continued 3. Draft (bill of exchange) – an unconditional order in writing signed by the exporter ordering the importer or importer’s agent to pay on demand or at a fixed or determinable future date the amount specified. – Key functions of a draft – Provides written evidence of a financial obligation

– Enables both parties to potentially reduce their costs of financing – Provides a negotiable and unconditional instrument – Enables an exporter to employ its bank as a collection agent (the bank forwards the draft to the importer, collects the funds, and remits the proceeds to the exporter)

– Key parties to a draft – Drawer – the party that signs and sends the draft to the second party – Drawee – the party to whom the draft is addressed – Payee – the party that receives the payment (often the same party as the drawer) Chapter 15: Financing and Controlling Multinational Corporations

15.A Payment Terms in International Trade (8) ❑

Five principal means of payment in international trade, continued 3. Draft, continued – Mechanics of a draft – example: USA importers purchases goods from Japan Exporters Japan Exporters Drawer

USA Importers

4. Pays at maturity

Wells Fargo Bank Drawee*

1. Signs and sends draft

2. Makes payment

3. Remits proceeds

Bank of Tokyo Payee

*In this example, in which an L/C is used, the drawee is the confirming bank. Chapter 15: Financing and Controlling Multinational Corporations

15.A Payment Terms in International Trade (9) ❑

Five principal means of payment in international trade, continued 3. Draft, continued – Types of drafts – Sight draft – must be paid on presentation or else dishonored – Time draft – payable at a specified future date

– Usance or tenor – the maturity of a time draft – A time draft becomes an banker’s acceptance after being accepted by the drawee. – Banker’s acceptance (B/A) – a draft accepted by a bank – Trade acceptance – a draft drawn on and accepted by a commercial enterprise – Clean draft – a draft unaccompanied by other papers, normally used for nontrade remittances – Documentary draft – a draft accompanied by other papers and can be either a sight or time draft Chapter 15: Financing and Controlling Multinational Corporations

15.A Payment Terms in International Trade (10) ❑

Five principal means of payment in international trade, continued 4. Consignment – Goods are shipped but not sold to the importer. – Exporter (consignor) retains title to the goods until the importer (consignee) sells them to a third party.

5. Open account – Goods are shipped and the importer is billed later. – No specific payment dates are set. – Fewer bank charges than with other methods of payment.

Chapter 15: Financing and Controlling Multinational Corporations

15.A Payment Terms in International Trade (11) ❑

Five principal means of payment in international trade, continued – Summary of payment methods

Payment Method

Risk

Chief Advantage to Exporter

Chief Disadvantage(s) to Exporter

Cash in advance

No credit extension required

Can limit sales potential

Sight draft

M/L

Retain control and title; payment before goods are delivered

Unaccepted goods remain at port of entry and no payment is due

Time draft

M/H

Lowers customer resistance by allowing extended payment

Same as sight draft, plus goods are delivered before payment is due

Irrevocable

Revocable

M/H

Banks accept responsibility to pay; payment on presentation of papers; costs go to buyer

If revocable, terms can change during contract work

Consignment

M/H

Facilitates delivery; lowers customer resistance

Capital tied up until sale; credit check on distributor; political risk insurance in some countries; increased risk from currency controls

Open account

Simplified procedure; no customer resistance

High risk; seller must finance production; increased risk from currency controls

Draft

Letter of credit

Chapter 15: Financing and Controlling Multinational Corporations

15.B Documents in International Trade (1) ❑

Bill of lading (B/L) – The most important shipping document – Three primary functions •

Contract between the carrier and shipper (exporter)

•

Shipper’s receipt for the goods

•

Establishes control over the goods

– Types of B/Ls •

Straight – goods are consigned to a specific party, usually the importer, and is not negotiable.

•

Order – goods are consigned to a specific party, usually the exporter.

•

On-board – certifies that the goods have been placed on board the vessel.

•

Received-for-shipment – acknowledges that the carrier has received the goods for shipment.

•

Clean – indicates that the goods were received in good condition.

•

Foul – a clean B/L becomes foul when shipment has been damaged.

Chapter 15: Financing and Controlling Multinational Corporations

15.B Documents in International Trade (2) ❑

Commercial invoice – Contains a detailed description of the goods shipped, names and addressees of exporter and importer, number of packages, distinguishing external marks, payment terms, other expenses, fees collectible from the importer, name of vessel, ports of departure and destination.

❑

Insurance certificate – All foreign shipments are insured. – An open (floating) policy covers all shipments made by the exporter. – Insurance certificate is evidence of insurance for a shipment under an open policy.

❑

Consular invoice – Presented to the local consul in exchange for a visa

Chapter 15: Financing and Controlling Multinational Corporations

15.C Financing Techniques in International Trade (1) ❑

Banker’s acceptance (B/A) – Time draft drawn on a bank – By accepting the draft, the bank makes an unconditional promise to pay the holder of the draft a stated amount on a specified day and creates a B/A. – The bank thus substitutes its own credit for that of the borrower. – A B/A is a negotiable instrument. – The accepting bank may either buy (discount) the B/A and hold it in its own portfolio or sell (rediscount) it in the money market.

Chapter 15: Financing and Controlling Multinational Corporations

15.C Financing Techniques in International Trade (2) ❑

Banker’s acceptance, continued 1. Issue purchase order

USA Importers

2. Request L/C

10. Forward shipping docs

Japan Exporters

5. Ship goods

13. Pay L/C at maturity

4. Notify of L/C

6. Send draft and shipping docs

9. Make payment

3. Deliver L/C

Wells Fargo Bank

7. Send L/C, draft, shipping docs 8. Accept draft (B/A created and discounted) and remit funds

Bank of Tokyo

11. Rediscount B/A 12. Remit payment for B/A 14. Present B/A at maturity 15. Send payment Chapter 15: Financing and Controlling Multinational Corporations

Money Market Investor

15.C Financing Techniques in International Trade (3) ❑

Banker’s acceptance, continued –

The accepting bank receives a commission for accepting the draft and an additional fee if an L/C is involved.

–

Evaluating costs of B/A financing – Example: assume a 90-day, $1,000,000 B/A with a 2% annual commission fee and 9.8% 90-day discount rate Option 1: Hold the B/A for 90 days Face amount of B/A = Less 2% commission = $1,000,000 * (.02/4) = Amount received in 90 days =

$1,000,000 -$5,000 $995,000

Option 2: Sell the B/A in the money market Face amount of B/A = Less 2% commission = $1,000,000 * (.02/4) = Less 9.8% annual discount = $1,000,000 * (0.98/4) = Amount received now =

–

$1,000,000 -$5,000 -$24,500 $970,500

To understand options, compute opportunity cost of holding B/A. Example: exporter’s opportunity cost of money is 10.2%: •

PV of holding B/A = $995,000 / [1 + (0.102/4) = $970,258

Chapter 15: Financing and Controlling Multinational Corporations

Proceeds from sale of B/A > PV of holding B/A 17

15.C Financing Techniques in International Trade (4) ❑

Discounting – Even if a draft is not accepted by a bank, the exporter can convert the draft into cash through discounting. – Exporter places draft with a bank and receives the face value of the draft less interest and commissions. – If draft is insured against political and commercial risks, the interest rate may be reduced. – The insurer pays covered losses to exporter or any institution to which the exporter transfers the draft. – Discounting with recourse – the bank can collect from the exporter if the importer fails to pay the bill when due. – Discounting without recourse – the bank bears the risk of collection. – Discounting is most useful for the occasional exporter and for the exporter with a geographically diverse portfolio of receivables.

Chapter 15: Financing and Controlling Multinational Corporations

15.C Financing Techniques in International Trade (5) ❑

Factoring – An exporter sells its accounts receivable to a factor at a discount plus fees for nonrecourse financing. – Because most factoring is nonrecourse (i.e., factor assumes all credit and political risks) factors may insist on purchasing all of an exporter’s receivables to avoid a selection bias (i.e., purchasing only receivables of risky customers). – Evaluating the cost of factoring – Example: A factor buys an exporter’s receivables at a 2.5% per month discount and 1.75% fee for nonrecourse financing. 1. Compute the amount received by an exporter for factoring $1 million in 90-day receivables without recourse. Face amount of receivable = $1,000,000 Less 1.75% nonrecourse fee = $1,000,000 * .0175 = -$17,500 Less 2.5% monthly discount = $1,000,000 * (0.025*3) = -$75,000 Amount received now = $907,500

Chapter 15: Financing and Controlling Multinational Corporations

15.C Financing Techniques in International Trade (6) ❑

Factoring, continued – Evaluating the cost of factoring – Example: A factor buys an exporter’s receivables at a 2.5% per month discount and 1.75% fee for nonrecourse financing, continued. 2. Compute annualized cost of factoring. $17,500 + $75,000 $1,000,000 - $17,500 - $75,000

•

365

= 41.34% 90

Despite the high costs, the cost of bearing credit risk associated with receivables can be substantially lower to a factor than to the exporter, because

– A factor’s greater credit information gives it more knowledge about the actual versus perceived risks involved and thus reduces its risk premium; and – By holding a well-diversified portfolio of receivables, the factor can eliminate some of the risks associated with individual receivables. Chapter 15: Financing and Controlling Multinational Corporations

15.C Financing Techniques in International Trade (7) ❑

Forfaiting – Discounting at a fixed rate without recourse of medium-term export receivables denominated in fully convertible currencies (U.S. dollar, Swiss franc, euro). – Generally used for capital-goods exports with a five-year maturity and repayment in semiannual installments. – Fixed-rate discount ≈ 1.25% above local cost of funds.

Chapter 15: Financing and Controlling Multinational Corporations

15.D Government Sources of Export Financing and Credit Insurance (1) ❑

Most governments of developed countries provide their domestic exporters with low-cost export financing and concessionary rates on political and economic risk insurance.

❑

Export financing – Programs extending supplier credits •

Supplier passes credit on to the importer.

•

Supplier bears the credit risk.

– Programs extending buyer credits •

Buyer uses credits to pay the supplier.

•

Buyer bears the credit risk.

– Export-Import Bank (Eximbank) •

U.S. government agency dedicated solely to financing and facilitating U.S. exports.

•

Provides competitive, fixed-rate financing for U.S. export sales facing foreign competition backed with subsidized official financing.

Chapter 15: Financing and Controlling Multinational Corporations

15.D Government Sources of Export Financing and Credit Insurance (2) ❑

Export financing, continued – Export-Import Bank (Eximbank), continued •

Eximbank operations – Eximbank covers up to 100% of the U.S. component content of exports, provided that the total amount financed does not exceed 85% of the total contract price of the item and the total U.S. content accounts for at least half of the contract price. – Eximbank provides financing only when private capital is unavailable. – Loans must have reasonable assurance of repayment and must be for projects that have a favorable impact on the country’s economic and social well being. – Fees and premiums for guarantees and insurance are based on the risks covered. – In authorizing loans, Eximbank takes into account any potential adverse effects on the U.S. economy or balance of payments.

Chapter 15: Financing and Controlling Multinational Corporations

15.D Government Sources of Export Financing and Credit Insurance (3) ❑

Export financing, continued – Private Export Funding Corporation (PEFCO) •

Purchases medium- to long-term debt obligations of importers of U.S. products at fixed rates.

•

Finances loans through the sale of its own securities.

•

Eximbank guarantees repayment of all PEFCO foreign obligations.

– Trends in public-source export financing •

Shift from supplier to buyer credits

•

Growing emphasis on acting as catalysts to attract private capital

•

Public agencies as a source of refinancing

•

Attempts to limit competition among agencies

Chapter 15: Financing and Controlling Multinational Corporations

15.D Government Sources of Export Financing and Credit Insurance (4) ❑

Export-credit insurance – Provides protection against losses from political and commercial risks. – Results in lowering the cost of borrowing from private institutions because the government agency is bearing those risks set forth in the insurance policy. – Foreign Credit Insurance Association (FCIA) •

Administers the U.S. export-credit program

•

Cooperative effort of Eximbank and a group of ~50 insurance companies.

•

Short-term insurance available for export credits up to 180 days – Comprehensive coverage covers 90% to 100% of political risks and 90% to 95% of commercial risks. – Political-only coverage covers 90% to100% of political risks.

•

Medium-term insurance covers big-ticket credits from 181 days to five years. – Coverage is only for that portion of the value added that originated in the U.S.

Chapter 15: Financing and Controlling Multinational Corporations

15.D Government Sources of Export Financing and Credit Insurance (5) ❑

Taking advantage of government-subsidized export financing – Export financing strategy • Foreign countries in which the MNC has plants are both markets AND potential sources of financing exports to Third-World countries. • E.g., Massey-Ferguson wants to sell 7,200 tractors to Turkey but is unwilling to assume risk of currency inconvertibility. Solution: –

Massey manufactured the tractors at its Brazilian subsidiary and sold them to Brazil’s Interbras.

–

Interbras paid Massey in cruzeiros and sold the tractors to Turkey.

–

Banco do Brazil underwrote all political, commercial, and exchange risks for Interbras’ cruzeiro financing.

– Import financing strategy • Many countries provide credit to foreign purchasers at below-market interest rates and long repayment periods. • Loans are typically tied to procurement in the agency’s country. • If an importer can source its needs from many countries, it will have leverage to extract more favorable financing terms from various export-credit agencies. Chapter 15: Financing and Controlling Multinational Corporations

15.E Countertrade ❑

Countertrade – a country requires exporters to purchase local products in order to sell their products in that market. – Countertrade results in an MNC acquiring goods that a country cannot or will not sell in international markets. – Goods may be unrelated to goods the MNC sells. – An MNC must usually sell the goods acquired in countertrade at a discount and thus may sell its exports to the country with which it engages in countertrade at a premium to offset price reductions. – Forms of countertrade • Barter – a direct exchange of goods between two parties without the use of money. E.g., oil for guns. • Counterpurchase (parallel barter) – the sale and purchase of goods that are unrelated to each other. E.g., soft drinks for vodka. • Buyback – repayment of the original purchase price through the sale of a related product. E.g., provide materials for the construction of a gas pipeline in exchange for purchasing a certain amount of gas each year.

Chapter 15: Financing and Controlling Multinational Corporations

15.F Short-Term Financing (1) ❑

Four aspects of developing a short-term foreign financing strategy 1. Identify key factors 2. Formulate and evaluate objectives 3. Describe available short-term borrowing options

4. Develop a methodology for calculating and comparing the effective dollar costs of options

Chapter 15: Financing and Controlling Multinational Corporations

15.F Short-Term Financing (2) 1.

Identify key factors – the basic determinants of any funding strategy are strongly influenced by six key factors. i.

If forward contracts are unavailable –

Determine whether differences in nominal interest rates among currencies are matched by anticipated exchange changes (i.e., whether IFE holds; see Chapter 4).

–

If there is a deviation in IFE, expected dollar borrowing costs will vary by currency, leading to tradeoffs between the expected borrowing costs and the exchange risks associated with each financing option.

ii. Exchange risk –

Borrowing locally can provide an offsetting liability if currency exposure exists.

–

Borrowing in a local currency in which an MNC has no exposure increases exchange risk.

Chapter 15: Financing and Controlling Multinational Corporations

15.F Short-Term Financing (3) 1.

Identify key factors, continued iii. MNC’s degree of risk aversion –

The more risk averse, the higher the price an MNC should be willing to pay to reduce its currency exposure.

iv. If forward contracts are available –

Currency risk should not be a factor in the MNC’s borrowing strategy.

–

Relative borrowing costs are the sole determinant of which currencies to borrow in.

–

Determine whether the nominal interest differential equals the forward differential (i.e., whether IRP holds; see Chapter 4).

–

If IRP holds, the currency denomination is irrelevant.

Given the existence or threat of government capital controls, the forward discount or premium may not offset the difference between the interest rate on the local currency loan versus the dollar loan (i.e., IRP will not hold).

Chapter 15: Financing and Controlling Multinational Corporations

15.F Short-Term Financing (4) 1.

Identify key factors, continued v. If IRP holds before taxes –

Currency denomination of MNC borrowings does matter when tax asymmetries exist.

–

Tax asymmetries are based on the differential treatment of foreign exchanges gains and losses on forward contracts and loan repayments.

–

Thus, MNCs must compute relative borrowing costs on an after-tax basis.

vi. Political risk –

Even if local financing is not the minimum cost option, MNCs should maximize local borrowings if they believe expropriation or exchange controls are serious possibilities.

Chapter 15: Financing and Controlling Multinational Corporations

15.F Short-Term Financing (5) 2.

Formulate and evaluate objectives – four possible objectives i.

Minimize expected cost and ignore risk – reduces information requirements, allows borrowing options to be evaluated without considering the correlation between loan cash flows and operating cash flows, and facilitates break-even analysis.

ii. Minimize risk without regard to cost – this objective is impractical and contrary to maximizing shareholder value. iii. Trade off expected cost and systematic risk – allows the MNC to evaluate loans without considering the relationship between loan cash flows and operating cash flows. Probably little difference between expected borrowing costs adjusted for systematic risk and unadjusted borrowing costs, because the correlation between currency fluctuations and a well-diversified portfolio is likely to be small. iv. Trade off expected cost and total risk – provides management with greater cash flow stability. Should be used only when forward contracts are unavailable. Chapter 15: Financing and Controlling Multinational Corporations

15.F Short-Term Financing (6) 3.

Describe available short-term borrowing options – three principal short-term financing options i. Intercompany loan – interest rate must fall within set limits. Relevant factors in establishing the interest rate include the lender’s opportunity cost of funds, tax rates and regulations, currency denomination of loan, and expected exchange movements over the term of the loan. ii. Local currency loan – MNCs prefer local currency financing for convenience and exposure management. – Bank financing – Term loans – straight loans, often unsecured, made for a fixed period – Line of credit (LOC) – an MNC draws down funds when required.

– Overdrafts – LOC against which drafts can be drawn. – Revolving credit agreement – similar to an LOC except the bank is legally committed to extend credit up to the stated maximum. The MNC pays interest on its outstanding balance, plus a fee on the unused portion of the credit line. – Discounting

– Nonbank financing – commercial paper and factoring Chapter 15: Financing and Controlling Multinational Corporations

15.F Short-Term Financing (7) 3.

Describe available short-term borrowing options, continued ii. Local currency loan, continued –

Determining interest rates

Annual interest paid Effective interest rate = –

Funds received

Example 1 – effective rate = stated rate: an MNC borrows $10,000 for one year at 11%, with interest paid at maturity. $1,100 Effective interest rate =

–

$10,000

= 11%

Example 2 – effective rate ≠ stated rate: an MNC borrows MXP10,000 for one year at 70%, with interest paid in advance. MXP7,000 Effective interest rate =

Chapter 15: Financing and Controlling Multinational Corporations

MXP3,000

= 233% 34

15.F Short-Term Financing (8) 3.

Describe available short-term borrowing options, continued ii. Local currency loan, continued –

Compensating balance requirement – banks require borrowers to hold 10% to 20% of outstanding loan balances in a non-interest-bearing account. Annual interest paid Effective interest rate =

–

Usable funds

Example 1 – an MNC borrows $10,000 for one year at 11%, with interest paid at maturity. Compensating balance requirement = 15%. $1,100 Effective interest rate =

–

$8,500

= 12.9%

Example 2 – an MNC borrows $10,000 for one year at 11%, with interest paid in advance. Compensating balance requirement = 15%. $1,100 Effective interest rate =

Chapter 15: Financing and Controlling Multinational Corporations

$7,400

= 14.9% 35

15.F Short-Term Financing (9) 3.

Describe available short-term borrowing options, continued iii. Commercial paper (CP) –

Short-term promissory note generally sold by large corporations on a discount basis to institutional investors and other corporations.

–

A favored alternative to bank borrowing.

–

Average maturities vary from 20 to 25 days.

–

By going directly to the market, MNCs can save as much as 1% in interest costs and avoid SEC registration requirements.

–

Three major non-interest costs –

Backup LOCs – because CP maturities are very short, the issuer may not be able to pay off or roll over maturing paper. Backup LOCs provide insurance against this occurrence.

–

Fees to banks – MNCs must pay fees to commercial and investment banks that act as issuing and paying agents.

–

Rating service fees – credit ratings are not legally required by any country but are often necessary for placing CPs.

Chapter 15: Financing and Controlling Multinational Corporations

15.F Short-Term Financing (10) 4.

Develop a methodology for calculating and comparing the effective dollar costs of options –

Break-even analysis determines the effective dollar costs of a local currency loan or dollar loan.

–

Example break-even analysis: an MNC can borrow pesos at 45% or dollars at 11%; peso expected to depreciate by 20% •

Analysis 1 – assume no taxes and forward contracts –

Cost of debt kd = kd = rL(1 + c) + c

1. Compute cost of local currency loan kd = 0.45(1 – 0.20) – 0.20 = 16% 2. Cost of dollar loan – the cost of a dollar loan to the affiliate is the interest rate on the dollar = 11%. Chapter 15: Financing and Controlling Multinational Corporations

15.F Short-Term Financing (11) 4.

Develop a methodology for calculating and comparing the effective dollar costs of options, continued –

Example break-even analysis: an MNC can borrow pesos at 45% or dollars at 11%; peso expected to depreciate by 20%, continued •

Analysis 1 – assume no taxes and forward contracts, continued 3. Set local currency and dollar interest rates equal to determine breakeven rate of currency depreciation (break-even c) at which the dollar cost of peso borrowing is equal to the cost of dollar financing. kd = 0.45(1 + c) + c = 11% •

c = -23.45%

•

Thus, the peso must devalue by 23.45% before it is less expensive to borrow pesos at 45% than dollars at 11%.

•

If c is expected to be -20%, borrow dollars.

Chapter 15: Financing and Controlling Multinational Corporations

15.F Short-Term Financing (12) 4.

Develop a methodology for calculating and comparing the effective dollar costs of options, continued –

Example break-even analysis : an MNC can borrow pesos at 45% or dollars at 11%; peso expected to depreciate by 20%, continued • Analysis 2 – assume taxes – Cost of debt kd = kd = 0.45(1 + c) + c = 11% 1. Compute cost of local currency loan given a 40% affiliate tax rate kd = 0.45(1 + c)(1 – 0.40) + c = 0.27 + 1.27c 2. Compute cost of dollar loan – when taxes are considered, the cost of a dollar loan to the affiliate is the after-tax interest less tax gain/loss cta. kd = 0.11(1 – 0.40) – (-0.4c) = 6.6% + 0.4c

Chapter 15: Financing and Controlling Multinational Corporations

15.F Short-Term Financing (13) 4.

Develop a methodology for calculating and comparing the effective dollar costs of options, continued –

Example analysis: an MNC can borrow pesos at 45% or dollars at 11%; peso expected to depreciate by 20%, continued •

Analysis 2 – assume taxes, continued 3. Set local currency and dollar interest rates equal to determine breakeven rate of currency depreciation at which the dollar cost of peso borrowing is equal to the cost of dollar financing. 0.066 + 0.4c = 0.27 + 1.27c •

c = -23.45%

•

The break-even exchange rate is the same as in Analysis 1.

•

Thus, although taxes affect the after-tax costs of the dollar and local currency loans, if one loan has a lower cost before tax, it will also be less costly on an after-tax basis.

Chapter 15: Financing and Controlling Multinational Corporations

15.F Short-Term Financing (14) 4.

Develop a methodology for calculating and comparing the effective dollar costs of options, continued –

Example analysis: an MNC can borrow pesos at 45% or dollars at 11%; peso expected to depreciate by 20%, continued •

Analysis 2 – assume taxes, continued •

Thus, in general, the break-even rate of currency appreciation or depreciation can be found by equating the dollar costs of local currency and dollar financing and solving for c: rH(1 – ta) + cta = rL(1 + c)(1 – ta) + c

Chapter 15: Financing and Controlling Multinational Corporations

Chapter 16

Managing the Multinational Financial System

Chapter 16 Outline A. Multinational Financial System B. Intercompany Fund-Flow Mechanisms: Costs and Benefits C. Designing a Global Remittance Policy

Chapter 16: Managing the Multinational Financial System

16.A Multinational Financial System (1) ❑

Financial transactions within the MNC result from the internal transfer of goods, services, technology, and capital.

❑

Mode of transfer – Intermediate to finished goods – transfer pricing facilitates movement of profits and cash from one unit to another. – Intangibles such as management skills, trademarks, and patents – transfer facilitated by selling outright to affiliate or through fees and royalties

❑

Timing flexibility – Leading and lagging – some internally generated financial claims require a fixed payment schedule while others can be accelerated or delayed. – Timing of fee and royalty payments can be modified when all parties are related. – Shipping schedules can be altered so one unit carries additional inventory for a sister affiliate.

Chapter 16: Managing the Multinational Financial System

16.A Multinational Financial System (2) ❑

The value of the MNC’s financial network stems from the wide variations in national tax systems and costs and barriers associated with internal financial transfers.

❑

The ability to transfer funds and reallocate profits internally creates arbitrage opportunities for MNCs. – Tax arbitrage – MNCs can reduce their global tax burden by shifting profits from units located in high-tax countries to those in lower-tax countries, or from units in a taxpaying position to those with tax losses. – Financial market arbitrage – internal funds transfers may enable MNCs to circumvent exchange controls, earn higher risk-adjusted yields on excess funds, reduce risk-adjusted cost of borrowed funds, and access previously unavailable capital sources. – Regulatory system arbitrage – when affiliate profits are a function of government regulations or union pressure, the ability to disguise profitability by reallocating profits among units may give MNCs a negotiating advantage.

Chapter 16: Managing the Multinational Financial System

16.B Intercompany Fund-Flow Mechanisms ❑

Tax factors –

Total tax payments on intercompany fund transfers depend on tax regulations in both the host and recipient countries.

–

Two types of taxes levied by the host country

– ❑

•

Corporate income taxes

•

Withholding taxes on dividend, interest, and fee remittances

Foreign tax credits (FTCs) – credits provided by the recipient country in consideration of foreign taxes paid on repatriated earnings.

Channels available to the MNC for moving money and profits internationally 1. Transfer pricing 2. Fee and royalty adjustments 3. Leading and lagging 4. Intercompany loans 5. Dividend adjustments

6. Investing in the form of debt versus equity Chapter 16: Managing the Multinational Financial System

16.B.1 Intercompany Fund-Flow Mechanisms: Transfer Pricing (1) ❑

Home and host governments have policing mechanisms to review the transfer pricing policies of MNCs.

❑

The most important uses of transfer pricing include –

–

Reducing taxes – general rule •

If tA > tB, set transfer prices as low as possible

•

If tA < tB, set transfer prices as high as possible

•

If price is too high, tax authorities in Affiliate B’s host country will see revenues forgone.

•

If price is too low, Affiliate A’s government may infer tax evasion through transfer pricing.

Reducing tariffs •

If Affiliate B is subject to ad valoerm tariffs (import duties set as a percentage of the value of the imported goods), increasing the transfer price will increase the duties Affiliate B must pay.

•

In general, the higher the ad valorem tariff relative to the income tax differential, the more likely a low transfer price is desirable.

Avoiding exchange controls

Chapter 16: Managing the Multinational Financial System

16.B.1 Intercompany Fund-Flow Mechanisms: Transfer Pricing (2) ❑

Tax effect of increasing transfer pricing Markup Policy

Affiliate A

Affiliate B

Affiliates A + B

Low-markup policy • Affiliate A produces 100 circuit boards at $10/unit

Low-Markup

Revenue

1,500

2,200

COGS

-1,000

-1,500

-1,000

Gross Profit

500

700

1,200

Other Expenses

-100

-200

EBT

400

600

1,000

Taxes (30% / 50%)

-120

-300

-420

Net Income

280

300

580

• Affiliate B sells circuit boards to customers for $22/unit High-markup policy

High-Markup Revenue

1,800

2,200

COGS

-1,000

-1,800

-1,000

800

400

1,200

Gross Profit

• Affiliate A sells circuit boards to Affiliate B for $15/unit

Other Expenses

-100

-200

EBT

700

300

1,000

Taxes (30% / 50%)

-210

-150

-360

Net Income

490

150

640

Same EBT Lower taxes Higher net income

• Affiliate A produces 100 circuit boards at $10/unit

• Affiliate A sells circuit boards to Affiliate B for $18/unit • Affiliate B sells circuit boards to customers for $22/unit

Higher transfer pricing shifts more income to lower-tax jurisdiction Chapter 16: Managing the Multinational Financial System

16.B.1 Intercompany Fund-Flow Mechanisms: Transfer Pricing (3) ❑

Tariff effect of increasing transfer pricing Markup Policy

Affiliate A

Affiliate B

Affiliates A + B

Revenue

1,500

2,200

COGS

-1,000

-1,500

-1,000

Tariff (10%)

-0

-150

Gross Profit

500

550

1,050

Other Expenses

-100

-200

EBT

400

450

850

Taxes (30% / 50%)

-120

-225

-345

Net Income

280

225

505

Revenue

1,800

2,200

COGS

-1,000

-1,800

-1,000

Tariff (10%)

-0

-180

Gross Profit

800

220

1,020

Other Expenses

-100

-200

EBT

700

120

820

Taxes (30% / 50%)

-210

-60

-270

Net Income

490

550

Low-Markup

High-Markup

Chapter 16: Managing the Multinational Financial System

Higher transfer pricing increases import duties and decreases EBT, but lower taxes still result in higher, although reduced, net income

Lower gross profit Lower EBT Higher net income

16.B.1 Intercompany Fund-Flow Mechanisms: Transfer Pricing (4) ❑

U.S. Revenue Code Section 482 provides for four alternative methods to establish intercompany arm’s length pricing. – Comparable uncontrolled price method – transfer prices are set by direct reference to market prices charged by the MNC or comparable companies to unrelated parties. – Resale price method – transfer prices are determined by reducing the price at which a good is resold to an independent purchaser by an appropriate markup. – Cost-plus method – adds an appropriate profit markup to the seller’s cost to determine arm’s length transfer prices.

– Another appropriate method – in some cases, the use of combinations of the above methods or other methods are appropriate. ❑

Advance pricing agreements – the MNC, IRS, and foreign tax authority agree in advance on a method to compute transfer prices.

Chapter 16: Managing the Multinational Financial System

16.B.1 Intercompany Fund-Flow Mechanisms: Transfer Pricing (5) ❑

Exchange controls – Given a U.S. corporate tax rate of 35%, in the absence of offsetting FTCs, a U.S. MNC will net after-tax earnings of $0.65Q0 for each dollar increase in the price at which it sells Q0 units to an affiliate with blocked funds. – A transfer price increase from P0 to P1 results in an increase of 0.65(P1–P0)Q0 dollars to the parent. – The affiliate will show a corresponding decrease in its cash balances and taxes due to higher COGS.

❑

Joint ventures – Conflicts over transfer pricing may result when an affiliate is owned jointly by one or more other partners. – Outside partners may be suspicious that transfer pricing is being used to shift shared profits from the joint venture to a wholly owned subsidiary.

Chapter 16: Managing the Multinational Financial System

16.B.1 Intercompany Fund-Flow Mechanisms: Transfer Pricing (6) ❑

Reinvoicing centers – MNCs may use reinvoicing in low-tax countries to disguise profitability. – The reinvoicing center takes title to all goods sold by one corporate unit to another, while the goods move directly from the factory or warehouse to the purchaser. – The center pays the seller and is in turn paid by the purchasing unit. Title to goods

Affiliate A

Pay for goods

Reinvoicing Center t = 10%

Sale/delivery of goods

Affiliate B t = 50%

Chapter 16: Managing the Multinational Financial System

Pay for goods

16.B.1 Intercompany Fund-Flow Mechanisms: Transfer Pricing (7) ❑

Reinvoicing centers, continued –

U.S. Revenue Act of 1962 – declared reinvoicing to be Subpart F income.

–

Subpart F income – a category of foreign-source income subject to U.S. taxation immediately, whether or not remitted to the U.S.

–

A 1977 IRS ruling allocated to an MNC’s foreign affiliates certain parent expenses that previously could be written off in the U.S.

–

Additional FTCs are generated that can be utilized only against U.S. taxes owed on foreign-sourced income.

–

Subpart F income generated by reinvoicing centers offsets excess FTCs. Title to goods

Affiliate A Sale/delivery of goods

Payment = $90

Reinvoicing Center t = 10%

Creates $25 tax payment for which FTCs can be used

Affiliate B t = 50% Chapter 16: Managing the Multinational Financial System

Payment = $100

16.B.2 Intercompany Fund-Flow Mechanisms: Fees and Royalties ❑

Management services such as headquarters advice, allocated overhead, patents, and trademarks are often unique and thus have no reference market price.

❑

By varying the fees and royalties charged for their use, intangible resources become additional routes for funneling remittances from foreign affiliates.

❑

By setting low transfer prices on intangibles to manufacturing affiliates in low-tax locations, MNCs can receive profits essentially tax free.

❑

To counter such an occurrence, Section 482 provides that the transfer price of an intangible asset must be “commensurate with the income” the intangible generates. –

A related-party transfer price for an intangible is not arm’s length unless it produces a split in profits between transferor and transferee that falls within the range of profits that unrelated parties realize on similar intangibles in similar circumstances.

Chapter 16: Managing the Multinational Financial System

16.B.3 Intercompany Fund-Flow Mechanisms: Leading and Lagging (1) ❑

MNCs shift liquidity among affiliates by accelerating (leading) or delaying (lagging) the payment of interaffiliate accounts. Example: Affiliate A bills Affiliate B $1,000,000 per month

Month

$1,000,000

$1,000,000 $1,000,000 1

$1,000,000 $1,000,000 2

$1,000,000 $1,000,00 3

$1,000,000 $1,000,000 4

$1,000,000 $1,000,000 1

$1,000,000 $1,000,000 2

$1,000,000 $1,000,000 3

$1,000,000 $1,000,000 4

$1,000,000 $1,000,000 5

$1,000,000 $1,000,000 6

$1,000,000

90-day (normal) Affiliate A A/R Affiliate B A/P A/P for month 30-day (leading) Affiliate A A/R Affiliate B A/P A/P for month

Creates $2,000,000 of cash flow for A 180-day (lagging)

Affiliate A A/R Affiliate B A/P A/P for month

$1,000,000

$1,000,000 $1,000,000 1 Provides $3,000,000 of working capital for B

Chapter 16: Managing the Multinational Financial System

16.B.3 Intercompany Fund-Flow Mechanisms: Leading and Lagging (2) ❑

The value of leading and lagging depends on the opportunity cost of funds to both the Affiliate A and Affiliate B. – When an affiliate in a surplus position receives payment, it can invest the additional funds at the prevailing local lending rate or use it to reduce its borrowings at the borrowing rate. – If the paying unit has excess funds, it loses cash it would have invested at the lending rate, and if in a deficit position, it has to borrow at the borrowing rate.

Chapter 16: Managing the Multinational Financial System

16.B.3 Intercompany Fund-Flow Mechanisms: Leading and Lagging (3) ❑

Example – The U.S. and German affiliates of a U.S. MNC face the following effective, after-tax dollar borrowing and lending rates. Affiliate

Borrowing Rate

Lending Rate

U.S.

3.8%

2.9%

Germany

3.6%

2.7%

– Both units can have either surplus or deficit of funds. – Four possibilities •

Both units have surplus funds.

•

Both units have a deficit of funds.

•

U.S. has a surplus while Germany has a deficit.

•

Germany has a surplus while U.S. has a deficit.

Chapter 16: Managing the Multinational Financial System

16.B.3 Intercompany Fund-Flow Mechanisms: Leading and Lagging (4) ❑

Example, continued –

If both units have excess funds, the opportunity costs of funds are the lending rates for both affiliates.

–

If U.S. requires funds while Germany has a surplus, the opportunity costs of funds are the borrowing rate for U.S. and the lending rate for Germany.

–

Etc. Germany

Affiliate/Cash Position

2.9% / 2.7% (0.2%)

2.9% / 3.6% (-0.7%)

3.8% / 2.7% (1.1%)

3.8% / 3.6% (0.2%)

U.S.

–

Based on the interest differentials, all borrowings should be done in Germany, and surplus funds should be invested in the U.S.

–

Only if the U.S. unit has excess cash and the German unit requires funds should money flow into Germany.

Chapter 16: Managing the Multinational Financial System

16.B.3 Intercompany Fund-Flow Mechanisms: Leading and Lagging (5) ❑

Example, continued Germany

Affiliate/Cash Position

2.9% / 2.7% (0.2%)

2.9% / 3.6% (-0.7%)

3.8% / 2.7% (1.1%)

3.8% / 3.6% (0.2%)

U.S.

–

Let Germany owe $2 million to U.S.

–

The timing of the payment can be changed by up to +/- 90 days.

–

Assume U.S. is borrowing funds and Germany has excess funds.

–

Given the interest differential of 1.1%, Germany should accelerate (lead) its payment to U.S.

–

Net effect: U.S. can reduce its borrowing by $2 million and Germany has $2 million less in cash for 90 days.

–

Net savings = $2,000,000 * 0.011 * 90/360 = $5,500.

Chapter 16: Managing the Multinational Financial System

16.B.3 Intercompany Fund-Flow Mechanisms: Leading and Lagging (6) ❑

Advantages of leading and lagging strategy – No formal note is required. – The amount of credit can be adjusted up or down by adjusting the terms on the accounts. – Governments are less likely to interfere with payments on intercompany accounts than on direct loans. – Section 482 allows intercompany accounts up to six months to be interest free while interest must be charged on intercompany loans.

Chapter 16: Managing the Multinational Financial System

16.B.4 Intercompany Fund-Flow Mechanisms: Intercompany Loans (1) ❑

Intercompany loans are more valuable than arm’s length transactions only if at least one of the following market distortions exists: – Credit rationing (due to a ceiling on local rates); – Currency controls; – Differential tax rates among countries.

❑

Most important types of intercompany loans 1. Direct loans 2. Back-to-back loans 3. Parallel loans

Chapter 16: Managing the Multinational Financial System

16.B.4 Intercompany Fund-Flow Mechanisms: Intercompany Loans (2) ❑

Most important types of intercompany loans, continued 1. Direct loans – straight extensions of credit from the parent to an affiliate or from one affiliate to another. 2. Back-to-back (also called fronting or link) loans – The parent deposits funds with a bank in country A that in turn lends the money to a subsidiary in country B. – Typically used to finance affiliates in countries with high interest rates or restricted capital markets. Parent in Country A

Intercompany loan

Affiliate in Country B

Deposit

Bank in Country A

Back-to-back loan

Chapter 16: Managing the Multinational Financial System

16.B.4 Intercompany Fund-Flow Mechanisms: Intercompany Loans (3) ❑

Most important types of intercompany loans, continued 2. Back-to-back loans, continued – Advantages of back-to-back loans over direct loans – Certain countries apply different withholding tax rates to interest paid to a foreign parent and interest paid to a financial institution. Thus, a back-to-back loan may offer cost savings through lower taxes.

– If currency controls are imposed, the government will typically permit the affiliate to honor bank loan payments while not necessarily authorizing repayment of an intercompany loan. – Costs are evaluated as follows. Cost =

Interest cost to parent

Interest income to parent

Interest cost to affiliate

Tax gain on exchange loss

– Example: parent’s opportunity cost of funds = 10%, parent and affiliate tax margins = 34% and 40% respectively, parent lending rate = 8%, affiliate borrowing rate = 9%. – Cost of loan = 0.10(0.66) - 0.08(0.66) + 0.09(0.6) – 0.40(0.11) = 2.32% Chapter 16: Managing the Multinational Financial System

16.B.4 Intercompany Fund-Flow Mechanisms: Intercompany Loans (4) ❑

Most important types of intercompany loans, continued 3. Parallel loan – Consists of two related but separate (i.e., parallel) borrowings and usually involves four parties in at least two countries. – Used to repatriate blocked funds, circumvent exchange control restrictions, avoid a premium exchange rate for investments abroad, finance foreign affiliates without incurring additional exchange risk, or obtain foreign currency financing at attractive rates. – Example: a U.S. MNC wishing to invest in Spain lends dollars to the U.S. affiliate of a Spanish MNC wishing to invest in the U.S., which lends euros to the U.S. firm’s Spanish affiliate. U.S. Parent Direct loan in dollars

Spanish Firm’s U.S. Affiliate

Spanish Parent Direct loan in euros

U.S. Firm’s Spanish Affiliate

Draw downs, interest payments, and principal repayments made simultaneously Chapter 16: Managing the Multinational Financial System

16.B.5 Intercompany Fund-Flow Mechanisms: Dividend Adjustments (1) ❑

Dividends are the most important means of transferring funds from foreign affiliates to the parent.

❑

Factors considered when deciding on dividend payments – Taxes – Financial statement effects – Exchange risk – – – –

Currency controls Financing requirements Availability and cost of funds The parent’s dividend payout ratio

Chapter 16: Managing the Multinational Financial System

16.B.5 Intercompany Fund-Flow Mechanisms: Dividend Adjustments (2) ❑

Tax effects – by increasing payout ratios for foreign affiliates with the lowest transfer costs, the MNC can reduce its total tax burden.

❑

Example: – U.S. MNC wants to withdraw $1 million from its affiliates through dividends.

– Three affiliates – Germany, Ireland, France –each earn $2 million before tax. – Germany subject to corporate tax rate of 50% on undistributed gross earnings, 36% on dividends, and10% dividend withholding tax – Ireland grants a 15-year tax holiday on all export profits, so no taxes – France subject to 45% corporate tax rate and 10% dividend withholding tax – U.S. MNC corporate tax rate is 35%; MNC has no excess FTCs (continued next slide) Chapter 16: Managing the Multinational Financial System

16.B.5 Intercompany Fund-Flow Mechanisms: Dividend Adjustments (3) ❑

Tax effects example, continued ($ 000) –

Germany: 50% corporate tax on undistributed gross earnings, 36% on dividends, and10% dividend withholding tax

–

Ireland: 15-year tax holiday on all export profits, so no taxes

–

France: 45% corporate tax rate and 10% dividend withholding tax

–

Earnings for each affiliate = $2 million Host Country Income Tax if Dividend Paid

Host Country Dividend Withholding Tax

U.S. Income Tax*

Total Taxes if Dividend Paid

Host Country Income Tax if No Dividend Paid

Worldwide Tax Liability if Dividend Paid

Affiliate

Dividend

Germany

$1,000

$360 $500 $860

$100

$960

$1,000

$1,860**

Ireland

$1,000

$350

$2,250

France

$1,000

$900

$100

$1,000

$900

$2,000

*FTCs applied to Germany and France **$960 + $0 + $900 = $1,860 Chapter 16: Managing the Multinational Financial System

Cheapest to remit dividends from Germany 25

16.B.5 Intercompany Fund-Flow Mechanisms: Dividend Adjustments (4) ❑

Dividend payments lead to liquidity shifts.

❑

The value of moving dividends depends on the different opportunity costs of money among the affiliates. – An affiliate that must borrow funds will usually have a higher opportunity cost than a unit with excess cash.

– Some subsidiaries will have access to low-cost financing sources, whereas others must borrow at a relatively high interest rate. ❑

All else equal, a parent can increase its value by exploiting yield differences among its affiliates (i.e., setting a high dividend payout rate for affiliates with relatively low opportunity costs of funds, and vice versa).

Chapter 16: Managing the Multinational Financial System

16.B.5 Intercompany Fund-Flow Mechanisms: Dividend Adjustments (5) ❑

Effect of exchange controls on dividend decisions – Countries with balance of payments problems may restrict dividend payments to foreign companies. – An MNC may try to reduce the chance of interference by maintaining a record of consistent dividend payments. •

Consistent payments imply the existence of an established program rather than an act of speculation against the host country’s currency.

•

Dividend payout ratios may be uniform throughout the MNC to show that all affiliates pay an equivalent percentage dividend.

Chapter 16: Managing the Multinational Financial System

16.B.6 Intercompany Fund-Flow Mechanisms: Equity versus Debt (1) ❑

MNCs generally prefer to invest through loans rather than equity. – An MNC typically has wider latitude to repatriate funds through interest and loan repayments than as dividends or reductions in equity. – Loans are more likely to create more favorable tax benefits •

Interest paid on a loan is typically tax deductible in the host country, whereas dividend payments are not.

•

Unlike dividends, principal repayments do not normally constitute taxable income to the parent.

– Example: Compare cash flows generated from parent’s $1,000,000 investment in affiliate made as debt and equity •

Additional after-tax sales generated from investment = $200,000 annually

•

10% withholding tax on dividend and interest payments

•

Interest rate on principal = 10%

•

Interest 50% tax deductible

•

Use 15% discounting factor to determine present value of cash flows to parent

(see next two slides) Chapter 16: Managing the Multinational Financial System

16.B.6 Intercompany Fund-Flow Mechanisms: Equity versus Debt (2) ❑

Example: Cash flows ($000) to parent over repayment period given $1,000,000 debt investment a

a–b=d

c+d=e

(b+e)(0.10) =f

a+b+e-f Cash Flow to Parent

b/2 = c

Funds Remaining

Dividend

Withholding Tax

Year

Principal

Interest

Interest Tax Savings

100

15.0

235.0

100

14.5

230.5

100

14.0

226.0

100

13.5

221.5

100

13.0

217.0

100

12.5

212.5

100

12.0

208.0

100

11.5

203.5

100

11.0

199.0

100

10.5

194.5

Present Value of Cash Flows to Parent Discounted at 15% Chapter 16: Managing the Multinational Financial System

$1,102.7 29

16.B.6 Intercompany Fund-Flow Mechanisms: Equity versus Debt (3) ❑

Example: Cash flows ($000) to parent given $1,000,000 equity investment; dividend = additional after-tax sales generated a

a-b

Year

Dividend

Withholding Tax

Cash Flow to Parent

200

180

200

180

200

180

200

180

200

180

200

180

200

180

200

180

200

180

200

180

Present Value of Cash Flows to Parent Discounted at 15%

Chapter 16: Managing the Multinational Financial System

903.42

16.C Designing a Global Remittance Policy (1) ❑

Coordinating the use of an MNC’s financial linkages in a manner consistent with value maximization requires four interrelated decisions. – How much money (if any) to remit – When to remit

– Where to transmit remittances – Which transfer method(s) to use

Chapter 16: Managing the Multinational Financial System

16.C Designing a Global Remittance Policy (2) ❑

Factors affecting the benefits of an internal financial transfer system – Number of financial linkages – the wider the range of choice, the greater a firm’s ability to achieve specific goals. – Volume of interaffiliate transactions – more affiliates specializing in different components and stages of production increase interaffiliate trade. – Foreign-affiliate ownership pattern – 100% ownership removes impediments to efficient worldwide funds allocation. – Degree of product and services standardization – the more standardization, the less latitude an MNC has to adjust transfer prices, fees, and royalties. – Government regulations – tax, credit allocation, and exchange control policies can provide incentives for or create impediments to international fund flows.

Chapter 16: Managing the Multinational Financial System