Multinational Corporations (MNC)

International Financial Management

Finance 221
Summer 2006

Fixed versus Floating Exchange

Exchange Rates: Quotes
Rates
Wall Street Journal: Wednesday, April 21, 2004
• Currencies float freely in this system,
Floating and exchange rates (prices) are set
US $ Equivalent Currency Per US $
exchange rate by supply and demand.
system • $US, Japanese Yen, British Pound, Country Wed Tue Wed Tue
Swiss Franc float freely.
Argentina (peso) .3506 .3525 2.8523 2.8369
• Currency value is fixed (pegged) in
terms of another currency.
Fixed
• If demand for currency increases
exchange rate (decreases), government must sell U.K. (pound) 1.7733 1.7877 .5639 .5594
system (buy) currency to maintain fixed rate.
1-month forward 1.7686 1.7828 .5654 .5609
Managed • Currency is loosely pegged to other 3-months forward 1.7593 1.7735 .5684 .5639
floating rate currency, but value is mostly
system determined by supply/demand. 6-months forward 1.7453 1.7593 .5730 .5684
3 4

Exchange Rate Quotes Exchange Rates: Spot vs. Forward

• The dollar cost of one unit of foreign Wall Street Journal: Wednesday, April 21, 2004
currency
• One Argentine peso equals $0.3525 US $ Equivalent Currency Per US $
$US equivalent on April 20, 2004 and $0.3506 on Country Wed Tue Wed Tue
April 21, 2004.
• The peso thus depreciated against Argentina (peso) .3506 .3525 2.8523 2.8369
the dollar.
• The value of each currency relative
to one U.S. dollar. Reciprocal of US$
Currency per equivalent U.K. (pound) 1.7733 1.7877 .5639 .5594
$US • One dollar was worth 2.8369
Argentine pesos on April 20, 2004 1-month forward 1.7686 1.7828 .5654 .5609
and 2.8523 Argentine pesos on April
21, 2004. 3-months forward 1.7593 1.7735 .5684 .5639
• The dollar appreciated vs. the peso.
6-months forward 1.7453 1.7593 .5730 .5684
dollars 1 1
= $0.3506/Ps =
peso peso/dollar Ps 2.8523/$5 6

1
Spot and Forward Exchange
Triangular Arbitrage
Rates
• The ratio of the exchange rate of
• The exchange rate that applies to each currency, expressed in terms of
Spot exchange currency trades that occur a third currency.
rate immediately. Cross exchange • Divide the dollar exchange rate for
• On April 21, 2004, spot exchange rate one currency by the dollar exchange
rate for British pound: $1.7733/£. rate for another currency: 4/21/04:
• The fixed price that applies for $1.7733/£
contracts with delivery in the future. = C$ 2.4117/£
Forward $0.7353/C$
• On April 21, 2004, the agreement to
exchange rate trade dollars for pounds one month Assume you are
• C$2.5000/£
later was a specified forward price of quoted the following
exchange rate: • Arbitrage opportunity
$1.7686/£.
The pound trades at a forward discount relative to 1. Exchange $1,000,000 into £563,920 (at £0.5639/$).
the dollar. 2. Trade £ 563,920 for C$1,409,800 (at C$2.5000/ £).
F − S $1.7686/£ - $1.7733/£ 3. Convert C$1,409,800 into $1,036,626(at
Discount/Premium : = = −0.265% $0.7353/C$).
S $1.7733/£
Annualized ⇒
F - S 360
× = - 3.18% 7 Allows a riskless, instant profit of $36,626 8
S N

Winners and Losers from ER

Forward-Spot Parity
Changes
If a forward market exists, the forward rate should
Suppose the euro appreciates against the Canadian
be approximately equal to expected future spot rate.
Dollar.
• An example…
• Assume: Spot = $1.4/£ 1M forward = $1.50/£
This benefits European consumers or producers
buying Canadian goods. Risk-neutral U.K. firms who intend to buy U.S. dollars
in the future will either:

It hurts Canadian consumers or producers buying

1. Enter the forward contract today if E(S) < $1.50/£.
European goods.
2. Wait and buy dollars at spot rate if E(S) > $1.50/£.
Winners and losers reversed when a currency U.S. firms who will need to buy pounds in the future
depreciates. will do the opposite.
9 10

Forward-Spot Parity The Law of One Price

Equilibrium: the forecast of the spot price is equal to Identical goods trading in different markets should
the current forward rate (forward – spot parity). sell at the same price.

E(S) = F
• An example…
• Assume €/$ exchange rate currently €0.95/$, and a pair
U.S. and U.K. firms are indifferent in this case
of Maui Jim sunglasses is selling for €180 in Italy.
whether they transact in the spot or forward market.
What if a pair of the same sunglasses sells for $200
Forward-spot parity does not hold. Forward rate in the United States?
does not reliably predict the direction of the spot
• Sunglasses should sell for €180 ÷ €0.95/$ = $189.47 in
rate. U.S.
• Buy sunglasses in Italy for €180 and sell them for $200
• Studies of exchange rates find a great deal of in U.S.
randomness in spot rate movements. • Convert back to euros, receive €190 ($200 x €0.95/$)
11 12

2
Purchasing Power Parity (PPP) Interest Rate Parity (IRP)
Differences in expected inflation between two
countries are associated with expected changes in Interest rate parity says that the risk-free returns
currency values. around the world should be equal.
Key empirical predictions of PPP:
Low-inflation nations ⇒ appreciating An investor can either buy a domestic risk-free asset
E (S for / dom
) [1 + E (i for )] currency or a foreign risk-free asset using forward contracts
=
S for / dom [1 + E (idom )] High-inflation nations ⇒ depreciating to cover currency exposure.
currency
Law holds for tradable goods over time, but The currency of the country with lower risk-free rate
deviations occur in the short run. Reasons: should trade at a forward premium.

• The process of trading goods across countries cannot happen F for / dom (1 + R for )
=
S for / dom (1 + Rdom )
instantaneously. IRP:
• Legal restrictions or physical impediments apply to
transporting goods. 13 14

Covered Interest Arbitrage Covered Interest Arbitrage

• An example… Borrow $1,000,000 at 2% per year, convert to

• Current spot rate = C$ 1.5855/$
C$1,585,500
• 6-month forward rate = C$ 1.5937/$
• Annualized interest rate on a six-month Canadian This will grow to C$1,633,065 in six months, at
government bond is 6%.
which time you convert back at the forward rate to
• Rate on similar U.S. instrument is 2%.
$1,024,700.
⎛ 0.06 ⎞
⎜1 + ⎟
C$1.5937/$ ⎝ 2 ⎠
< Next, repay the U.S. loan, which takes C$1,010,000.
C$1.5855 / $ ⎛ 0.02 ⎞
⎜1 + ⎟
⎝ 2 ⎠
This means Canadian interest rate is “too high”/ U.S. Arbitrage profit is $14,700.
interest rate is “too low” . Arbitrage opportunity!
15 16

Real Interest Rate Parity: the Real Interest Rate Parity: The
Fisher Effect Fisher Effect
Fisher effect: the nominal interest rate R is made up • Assume that expected inflation in the United States equals
of two components: zero and expected inflation in Italy is 12%.
• One-year risk free rate in the U.S. is 3%.

• Real required return assumed to be same in both countries.

What should the one year interest rate be to
• Inflation premium equals the expected rate of inflation, I.
maintain real interest rate parity?

1 + R Italy (1 + 0.12)
If real required return is the same across countries, = R Italy = 15.36%
then the following equation is true: 1 + 0.03 (1 + 0.0)
Deviations from real interest rate parity occur because of
1 + R for [1 + E (i for )] limits to arbitrage
=
1 + Rdom [1 + E (idom )] • Scarcity of risk-free investments that offer fixed
17 real, rather than nominal, returns 18

3
Transaction Risk
Exchange rate risk arises when the value of a
company’s cash flows can be affected by a change in
exchange rates.
• An example…Assume Boeing Company sells an airplane to
a Japanese buyer:
1. Boeing must receive $1,000,000 to cover costs and profits.
2. Since payment usually in buyer’s currency, priced in Yen.
3. Current exchange rate is ¥100.00/$.
4. Price of airplane therefore ¥100,000,000.
• If delivery and payment occur immediately, there is no
foreign exchange risk: just exchange ¥100,000,000 for
$1,000,000 on spot market.
If price is set today, but delivery is in 6 months,
Boeing is exposed to significant foreign exchange risk
unless it hedges that risk. 19
Transaction Risk
If exchange rate in 6 months is ¥110.00/$:
• The dollar appreciates; yen depreciates.
• Boeing will still receive the same ¥100,000,000 but these will
only be worth $909,091.
1. Boeing will suffer an exchange rate loss of $90,909.
2. Japanese customer is unaffected, since yen price is fixed.
If exchange rate in 6 months is ¥90/$ instead:
• Boeing will receive $1,111,111 for its ¥100 million payment.
1. Boeing will enjoy an exchange rate gain of $111,111.
2. Japanese customer again unaffected.
Who would gain/lose if price were set in dollars? 20

Translation and Economic Risk Political Risk

Translation • Cost and revenue of the subsidiary
(accounting) (in foreign currency) are translated
in the domestic currency to be
exposure included in the financial statements
of the MNC.
• How does the foreign exchange rate
affect firm’s value?
• Exchange rate changes might
influence firm’s cash flows.
Economic • Rise in the value of the dollar vs. yen
makes Japanese cars less expensive
exposure to U.S. customers and U.S. cars more
expensive for Japanese customers.
• Hedge by using currency derivatives
and by matching costs and revenues
in a given currency. 21
Actions taken by a government which have an
impact on the value of foreign companies operating
in that country:
Tax increases or barriers to repatriation of profits
• Impacts all foreign firms in the
Macro political country
risk • Near collapse of Indonesia currency
in 1997-1998
• Government actions that affect only
a subset of companies operating in a
Micro political foreign country
risk • 1970s nationalization international
oil company assets by large number
of oil-exporting countries 22

EMU and the Rise of Regional

Capital Budgeting
Trading Blocks
MNCs have to answer the following questions in their
European Monetary Union established Euro as
capital budgeting process:
currency for twelve countries in Western Europe.

In 1991, Brazil, Argentina, Paraguay, and Uruguay • In what currency should the firm express a foreign project's cash
formed the Mercosur Group. flows?
• How is the cost of capital computed for MNCs?

• Removed tariffs, other barriers to intra-regional trade • An example…Assume U.S. firm performs analysis for
project with cash flows in euros:
• Common tariffs on external trade from 1994
Initial Cost Year 1 Year 2 Year 3
General Agreement on Tariffs and Trade (GATT): - €2,000,000 €900,000 €850,000 €800,000
international treaty that regulates trade
Two alternatives • Discount euro-denominated cash
flows using euro-based cost of
to compute
• In 1994, revised GATT established World Trade Organization capital,then convert back to dollars
project’s NPV:
(WTO).
23
• Calculate NPV in dollar terms 24

4
 First Approach to Compute NPV Second Approach to Compute NPV
Assume risk-free in Europe is 5% and the spot rate is $0.95/€ Calculate NPV in dollar terms; U.S. risk free rate is
3%
The company estimates that cost of capital for this
project is 10% (5% risk premium). • Assume that the firms will hedge the project's cash
flows using forward contracts.
• Using interest parity, can compute one, two, and three year
900,000 850,000 800,000
NPV = −2,000,000 + + + = 121,713 forward exchange rates:
1.10 1.10 2 1.103
F $ / euro (1 + RUS ) F1$− /year
euro
1.03
= = F1$− /year
euro
= $0.9319 / euro
Convert into dollar- S $ / euro (1 + Reuro ) 0.95 1.05
based NPV
NPV = $116,000
F $ / euro (1 + RUS ) F2$−/year
2 euro
1.032
= = F2$−/year
euro
= $0.9142/ euro
• The firm can hedge its currency exposure in the future S $ / euro (1 + Reuro )2 0.95 1.052
with forward contracts.
F $ / euro (1 + RUS ) F3$−/year
3 euro
• Accept or reject the project based on NPV of project; 1.033
= = F3$−/year
euro
= $0.8967/ euro
currency exposure should not affect the decision.
25 S $ / euro (1 + Reuro )3 0.95 1.053 26

Second Approach to Compute NPV Cost of Capital

• Compute beta of investment to assess risk and use CAPM to
Cash flow of the project converted in dollars: same compute discount rate for the project’s cash flows.
results as the first approach • A Japanese auto manufacturer that plans to build a
plant in U.S. computes two betas.
Currency Initial Investment Year 1 Year 2 Year 3
• If firm’s shareholders cannot diversify internationally:
€ -2,000,000 X .95 900,000 X .9319 8500,000 X .9142 800,000 X .8967
• Compute project’s beta by measuring the covariance of
$ -1,900,000 839,000 777,000 717,000
similar European investments with the U.S. market.
• Japanese firm computes beta of 1.1 for the project.
Need to discount the cash flow at risk-adjusted U.S. Risk-free interest rate is 2%; market risk premium on
interest rate: Nikkei is 8%.
• Rproject= 2%+1.1(8%)=10.8%
(1 + 0.03)
(1 + RUS ) = (1 + 0.10) RUS = 7.9% • If firm’s shareholders have portfolios internationally
(1 + 0.05) diversified:
• Compute project’s beta by computing covariance of
return of similar investments with returns on worldwide
839,000 777,000 717,000 stock index.
NPV = −1,900,000 + + + = $116,000
1.0791 1.0792 1.0793 • Project beta is computed 1.3. The world market risk
27
premium is 5%: Rproject=2%+1.3(5%)= 8.5%. 28

Multinational corporations dominate international

trade and investment today.
Companies trading in the international markets are
exposed to exchange rate risk.

Total volume of foreign direct investment surged

during the 1990s.
MNCs can use a variety of techniques to hedge or
even profit from exchange rate fluctuations.