Chapter 19:

Summary
Chan, Lim, Muyrong, Shin, Tan

#1Multinational Corporation

An international firm registered in one home country

Centralized - managed from the home country
Decentralized - managed by different sector/regions headquarters
Why go Global
o seek raw materials
o New Technology
o Production efficiency
o Market expantion
o Retain customers
o Avoid political, trade & regulatory problems
o Protect process & Productis
o Diversification
o

Multinaional VS. Domestic Financial Management

Currency Denomination
Political Risk
Economic & Legal Systems
Role of Governments
Language & Culture Differences

#2 International Monetary System

Framework of exchange rate determination driven by each countrys

political and economic objectives.
Exchange Rate- price of one countrys currency in terms of another
countrys currency.
o Spot Exchange Rate - quoted price for a unit of foreign currency to
be delivered on the spot.
o Forward Exchange Rate - quoted price for a unit of foreign currency
to be delivered at the specified date in the future.
o Fixed Exchange Rate -set by government at a par value with minimal
fluctuation.
o Floatinge/Flexible Exchange Rate- determined by market supply
and demand

 Devaluation or Revaluation of a Currency - Decrease

or increase in the stated par value of a currency whose
value is fixed.
Depreciation or Appreciation of a Currency decrease or increase, respectively, in a foreign
exchange value of a floating currency.

Floating
o Free - Determined by the supply and demand for the currency
o Manged - With government intervention to manipulate the currencys
supply and demand.
Fixed Rate Regime
o No Local Currency - no currency of their own, or uses a currency
shared by a group of countries. ( EU)
o Currency Board Arrangement - Country has its own currency but
commits to exchange it for a fixed exchange rate of specified foreign
currency, unless it has the foreign currency reserves to cover
requested exchanges.
o Fixed-Peg Arrangement - country locks its currency to a specific
currecy at a fixedd exchange rate.

#3 Foreign Exchange Rate

Foreign Exchange Rates

Price of a nations currency in terms of another currency
Ex. US Dollars (USD) to Philippine Pese (PHP)

Cross Rate
Exchange rate between any two currencies.
Ex. US$ 1.00 = Php 44.50
You can buy US$1 for Php 44.50.
Php 4,450 / Php 44.50 = US$ 100.00
For Php 4,450, you can buy $100.00.

Interbank Foreign Currency

American Terms
o US$ 0.022 = Php 1.00
o US$ 1.12 = Eur 1.00
Direct Quotation
o US$ 0.022/Php 1.00
Indirect Quotation
o Php 44.50/US$ 1.00

Trading in Foreign Exchange

o Forex global decentralized market for the trading of currencies
o Currency Conversion

Spot Rates and Forward Rates

Spot Rates
Delivery rate of the currency no more than two days after trade
Forward Rates
Agreed upon price at which two currencies will be exchanged at some
future date.
o Discount
Spot rate < Forward Rate
o Premium
Spot Rate > Forward Rate

#4 Interest Rate Parity

Interest Rate Parity (IRP)
specifies that investors must expect to earn the same return on interest-bearing
investments in all countries after adjusting for risks
Interes Rate (dif. Bet. 2 countris) = Spot Exchange Rate Forward Exchange
Rate
F/S = (1+rh)/(1+rf)
If IRP holds, arbitrage is not possible
If IRP does not hold, arbitrage is possible
If Domestic Interest Rates (rh) < Foreign interest rates (if), invest in foreign
countries at higher interest rates
If Domestic

Example:
The nominal annual interest rate on 6-month U.S. Treasuries is 0.06% (semiannual is 0.03%). The spot rate of the British Pound is $1.6426 ( 0.6088 per
USD) and 6-month forward rate of the British Pound is $1.6396 ( 0.6099 per
USD). If IRP holds, what is the nominal annual interest rate on default-free 6month British bonds?

IRP = (Forward Exchange Rate/ Spot Exchange Rate) = (1+rh)/(1+rf)

= ($1.6396/$1.6426) = 1.0003/(1+rf)
= (0.99817)(0.99817rf) = 1.0003
rf = 0.00213
If IRP holds, 2 x 0.213% = 0.426%

#4 INTEREST RATE PARITY

Interest Rate Parity (IRP)
specifies that investors must expect to earn the
same return on interest-bearing investments in
all countries after adjusting for risks

Interes Rate (dif. Bet. 2 countris) = Spot Exchange Rate

Forward Exchange Rate
F/S = (1+rh)/(1+rf)
If IRP holds, arbitrage is not possible
If IRP does not hold, arbitrage is possible
If Domestic Interest Rates (rh) < Foreign interest rates
(if), invest in foreign countries at higher interest rates
If Domestic

Example:
The nominal annual interest rate on 6-month U.S.
Treasuries is 0.06% (semi-annual is 0.03%). The spot
rate of the British Pound is $1.6426 ( 0.6088 per USD)
and 6-month forward rate of the British Pound is $1.6396
( 0.6099 per USD). If IRP holds, what is the nominal
annual interest rate on default-free 6-month British
bonds?

IRP = (Forward Exchange Rate/ Spot Exchange Rate) =

(1+rh)/(1+rf)
= ($1.6396/$1.6426) = 1.0003/(1+rf)
= (0.99817)(0.99817rf) = 1.0003
rf = 0.00213
If IRP holds, 2 x 0.213% = 0.426%

#5Purchasing Power Parity

also known as the law of one price

implies that the level of exchange rates adjusts so as to cause identical goods to cost the
same in different countries.
PPP assumes that market forces will eliminate situations in which the same product sells at
a different price overseas.
PPP assumes there are no transportations costs or transaction costs (import restrictions)
PPP is important when anticipating future interest rate, inflation, and exchange rates
conditions.
PPP does not hold because of the overvalue or undervalue of labor and raw materials in
other countries compared to the US.

Equation:
Ph = (Pf)(Spot Rate)
or
Spot Rate = Ph/Pf

Example (page 659)

A US consumer observes that a golf club costs $200. Currently in the spot
market, 1 euro can be exchange for $1.4323. If PPP holds, how many euros
should you expect to pay the same golf club in Europe?
Solution:
Ph = (Pf)(Spot Rate)
$200 = Pf ($1.4323)
Pf = $200/$1.4323
Pf = 139.6356
If PPP follows, the price of the golf club in the European market should be
139.6356.

Inflation Rates

Inflation: a general increase in prices and fall in the purchasing value of

money.
Relative Inflation Rates:
Factors that influence multinational corporations financing decisions
and profitability of foreign investments:
Relative inflation rates influences future production costs
domestically and in foreign countries.
Inflation has an important effect on relative interest rates and
exchange rates.
Currencies of country with higher inflation than the US inflation rate would
depreciate over time against the dollar and vice versa.

Interest Rates

Relative Inflation also affects interest rates; countries who have high
inflation rates would have higher interest rates and vice versa.
Having low interest rates increases consumer spending, thus increases
economic growth.
Countries tend to borrow from countries with low interest rate to achieve
low interest expense.
Loaning from a country with low interest rate could also be
disadvantageous since this would appreciate the currency of the country
causing the principal amount and annual interest to rise over time.

Foreign Exchange Trading

used to describe trading in the foreign exchange market by investors and

speculators
where currencies are traded
Helps enable trade and transactions between countries.
allows investment opportunities for risk seeking investors who do not mind
engaging in speculations.
Its main purpose is to make profit, circulate money (increases money
supply), and conduct foreign trade and business.

#6 International Money
Eurocredits - Floating rate bank loans, available in most major trading
currencies that are tied to LIBOR.
Eurodollar- A U.S. dollar deposited in a bank outside the United States.
Eurobond - An international bond underwritten by an international syndicate of
banks and sold to investors in countries other than the one in whose money
unit the bond is denominated.
American Depository Receipts - Certificates representing ownership of foreign
stock held in trust.

International Capital Market

NYSE - New York Stock Exchange
PSE - Philippines Stock Exchange
KOSPI - Korea Composite Stock Price Index

Investing Overseas
Country Risk- The risk that arises from investing or doing
business in a particular country.
Exchange Rate Risk - The risk that exchange rate changes
will reduce the number of dollars provided by a given
amount of a foreign currency.

#7 International Capital Budgeting

-Multinational firms set up separate subsidiaries for each foreign country
-Relevant cash flows for the parent company are the dividends and royalties
-Cash flows converted into the parent companys currency (subject to exchange
rate risk)
-Restriction of the repatriation of earnings to the parent company
-Cost of capital may be different for a foreign project because foreign projects
may be more or less risky.
*Higher risk from: exchange rate risk, political risk
Lower risk from: benefits of international diversification

Sample Questions
1.
2.
3.
4.
5.

If the Euros depreciates against the dollar, can a dollar buy buy more or
fewer euros?
Should firms require higher rates of return on foreign projects than on
identical projects located at home? Explain.
Why does PPP sometimes fail to hold?
Does interest rate parity imply that interest rates are the same in all
countries?
What are the certificates representing ownership of foreign stock held in
trust?

Sample Problems (Easy)

1.
2.

3.
4.

If British Pounds sell for $1.64 per pound, what should dollars sell for in pounds
per dollar?
A currency trader observes that in the spot exchange market, 1 US dollar can be
exchanged for 3.50 Israeli Shekels or for 77.What is the cross exchange rate
between the yen and the shekel; that is, how many yen would you receive for
every shekel exchanged?
A tv costs $500 in the US. The same tv costs 312.5. If PPP holds, what is the
spot exchange rate between the euro and dollar?
6 months T-bills have a nominal rate of 4%, while default-free Japanese bonds
that matures in 6 months have a nominal rate of 2.5%. In the spot exchange
market, 1=$0.013. if IRP holds, what is the 6 month forward exchange rate?

Sample Problems (Medium)

1.

Suppose that 1 Danish krone could be purchased in the foreign exchange

market for $0.20. If the krone appreciated 10% tomorrow against the dollar,
how many krones would a dollar buy tomorrow?