INTERNATIONAL FINANCE (MULTINATIONAL FINANCE):Major Issues Faced by Multinationals

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Financial Management MGT201

Lesson 44

INTERNATIONAL FINANCE (MULTINATIONAL FINANCE)

Learning Objectives:

After going through this lecture, you would be able to have an understanding of the following

topics:

· International Finance (Multinational Finance)

In the lecture we shall cover three areas of International Finance:

· Multinational Finance

· Impact of Globalization and International Finance on different areas of financial management

like capital budgeting, capital structure and Capital asset pricing model

· Foreign Exchange (F/x)

First we discuss the first area of Multinational Finance.

Issues of International Finance:

· All Finance has become International

Financial Markets (Money and Capital Markets) of all countries are Linked by hi-speed

telecom satellite links, computer, and Internet

Butterfly Effect "When New York Stock Exchange Sneezes, the Tokyo Stock

Exchange catches a cold". It explains the impact of capital markets that are linked all

over the world. As all the financial markets over the world are linked due to

international flow of money and international trade and transactions. So any change in

one part of the world has its affects on the other part of the world.

· All Firms affected by International Factors

Even 100% Domestic Firm is affected by International Finance because it competes

with Importers and Foreign Franchises substitutes and competing products whose prices

change with Foreign Exchange Rate.

· 2 Fundamental Flows Determine a Country's Foreign Exchange Rate

International Flow or Trade of Real Physical Goods:

Trade Surplus / Deficit = Imports - Exports

International Flow of Capital or Money Balance of Payments (BOP)

= Current Account + Capital Account + Foreign Exchange Reserves. Current

Account includes Trade of Goods and Services.

Capital Account measures Capital coming in (FDI and Portfolio Investment) and

Going Out.

Domestic Macroeconomic Factors affecting Foreign Exchange:

1) Inflation

2) Fiscal Deficit (if government expenditures exceed their revenues through taxes etc.)

Why do Multinationals Do Business Internationally?

To Expand Market Share: USA and EU are about $ 10 Trillion Economies Each. And

each has about 300 million people.

Get Closer to End Users / Consumers i.e. Toyota of Japan in USA

Lower Production Costs, Shipping Costs, Raw Material Costs i.e. British BAT Tobacco

in NWFP, Union Texas in Badin

Bypass Trade Barriers and Import Tariffs i.e. Pakistanis set up textile units in Srilanka,

UAE and Mexico to legally bypass US Textile quota for exports from Pakistan.

Diversify and Reduce Sovereign (Country-Specific Political) Risk

· Portfolio of Subsidiary Companies, Divisions, Projects, Investments diversified

across different countries can reduce the Sovereign (or Country-Specific

Political) Risk

· Manage Foreign Exchange Rate Exposure. If your home currency is very weak

or Depreciating (because of Inflation, Deficits, Political Turmoil etc. ) then

invest abroad

· Take advantage of Lower Costs of Debt (interest rates) in foreign countries or

lower Taxes.

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Financial Management MGT201

Major Issues Faced by Multinationals:

Foreign Exchange Risk i.e. Turkish Lira, Russian Ruble. Caused by Unexpectedly high

Inflation, Deficits, and Political Turmoil etc.

Sovereign and Political Risk i.e. South Africa, Afghanistan, Rwanda - risk of War, Civil

Unrest

Different Laws Business Contract, Property, Companies, Capital Flow & Different Tax

Rates, Different Government Involvement, and Different Maturity of Financial Markets

· Saudi Arabia (Restricted property rights)

· USA (strict Monopoly laws) vs. Bahamas (Lenient Laws and Tax)

· Japan (MITI supports Japanese exporters abroad)

Different Cultures, Customer Awareness about their rights and Quality Standards,

Credit Cultures, and Business Practices and Ethics

· Japanese Kereitsu (Bank is Business Partner and Shareholder) so in Japan large

companies like Sony have large of debt in their capital.

· Korean Chaebols (Conglomerates with Monopoly power)

· German Consumer Standards

· Business Ethics i.e. Nigeria vs. Singapore

· Central Asia (Barter economy and Long Credit Cycle)

Now we move to the second area of today discussion:

International Financial Management:

· International Diversification

Bruno Solnik: These two persons analyzed INTERNATIONAL Portfolio of 20 Stocks

has HALF as much risk as same portfolio containing stocks of just 1 country.

· International CAPM Model for Integrated Global Market

r P = r RF + Beta (r W - r RF )

r W is the WORLD MARKET Required Rate of Return expected by all investors all

over the world

Assets are priced in LOCAL (or SEGMENTED) MARKETS so if an Investor can

diversify internationally, then he may attain RISK-RETURN above the Local Market

Capital Market Line.

Global Efficient Frontier (for Investment in World Markets) offers higher Risk-Return

combinations than Local Segmented Market Efficient Frontier.

Global Investing Makes the Efficient Frontier and the

CML (Capital Market Line) Rise Up

Higher Return for Same Level of Risk

Efficient Frontier (for

)

rP*

nts

Global Investments)

stm

ent

ves

(fo

ntr

le C

Efficient Frontier

Sin

(for Investment in

for

rRF

(

Single Country)

Risk

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Financial Management MGT201

International Corporate Financing

Raise capital in the country where you can get the best price and yield.

Euro equities Example ADR's (American Depository receipts): Non-US firms can be

listed and traded on the NASDAQ Stock Exchange in USA. So Pakistani firms can

raise equity capital in America. Foreign firms can also be listed on Luxembourg stock

exchange to raise Equity capital in Euro currency.

Eurobonds: Currency of bond issue is different from the country of issue. Example:

Pakistani company selling US$-denominated Bonds in Luxembourg can raise Debt

capital in Euro currency.

International Capital Budgeting

PV = CF 1 / (1+r) + CF 2 / (1+r) 2 + CF 3 / (1+r) 3 + ...

CF or Cash Flows in foreign countries need to be converted into the Home Currency of

the Investor (or country where Head Office is located).

· Transfer Pricing, Royalties, and Foreign Country's Inflation affect forecast of

cash flows

· Opportunity Cost of Foreign Funds Blocked because of Remittance Restriction

· Different taxes in different countries. Tax on Remitted Income.

Discount rate "r"

· Discount the foreign cash flows in the nominal foreign currency discount rate.

Then convert the PV in foreign currency to home currency.

· Use High Discount Rate if High Level of Country - specific Political or

Sovereign Risk

· Impact of Concessionary Financing can affect choice of "r"

International Accounting Standards

Profit & Loss Statement (or Income Statement) Convert foreign expenses and

revenues at the AVERAGE F/x Rate prevailing during the Accounting Period.

Balance Sheet Foreign FIXED (Non-Financial) Asset values converted at

HISTORICAL F/x Rate prevailing at the time of purchase. But, Foreign FINANCIAL

Assets converted at AVERAGE F/x Rate prevailing during the Accounting Period.

Foreign Exchange Rate:

· Currencies, like Goods, are bought and sold in markets. The price of a currency increases if the

financial, economic, and political health of that Country becomes stronger. Like price of cotton

from Pakistan which is different from China and Egypt and changes with quality and

Supply/Demand.

· Currencies or F/x are traded in International F/x Markets which is the largest Financial Market

of all with trading in Trillions of Dollars. Banks, Firms, and Individuals can trade in Virtual

Electronic F/x Markets from their computer 24-hours a day. F/x rates are changing every

second!

· The Demand / Supply of F/x affect the Value of the Currency.

· 3 F/x Markets:

F/x Spot Market : "Current" exchange rate for Delivery within 2 Days

F/x Forwards Market: Make contract today for Delivery in future. Forward Price

Determined by Interest Rate Yield Curve and Spot Rate. Contract size and delivery

date negotiated privately with banks.

F/x Futures Market: Derivative securities whose value is derived from Forward prices

and "Mark-to-market" risk premium for meeting minimum balance in Margin Account

for trading. Tradable in Exchanges because of Standardized contract size and fixed

future delivery dates.

F/x Options Market: Derivative securities. Spot Option values derived from Spot F/x

Rate. Future Option values derived from Futures F/x Rate. Options (unlike Forwards

and Futures) are not obligations. It is cheaper to buy an Option to buy a house than to

buy the house! Same for F/x. Also, you can decide not to buy and let the option expire.

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Financial Management MGT201

Call Option Right to Buy something at a fixed Strike Price for a limited time

in the future

Put Option Right to Sell something at a fixed Strike Price for a limited time in

the future

Valuation or Pricing of Options using famous BLACK & SCHOLES MODEL

or simpler Binomial Model

Relationship between Foreign Exchange Rate, Interest Rate & Inflation Rate:

· Spot F/x Rate of 2 Countries determined by Prices of Real Goods:

Relative Prices of Same Good Purchasing Power Parity Theorem (PPP)

· Spot price (Rs. / US$) = Price (Pak) / Price (USA)

· Example: Use Price of Levis Jeans made in Pakistan and USA to estimate the

theoretical Spot F/x Rate. Price of Levis 501 is US$50 in USA and Rs.3100 in

Pakistan so the Estimated Spot F/x Rate = S (Rs. / US$) = Rs.3100 / US$50 =

Rs.62 / US$1. This is close to the actual Spot F/x rate in range of Rs.50-60.

· Nominal Interest Rate determined by Expected Inflation.

Relative Expected Inflation Rates ( g ) Fischer Effect

· (1+ i Rs.) / (1+ i US$ ) = (1+ g Pak ) / (1+g USA )

· Forward F/x Rate determined by Interest Rate Yield Curve

Relative Interest Rates ( i ) - Interest Rate Parity Theorem (IRP)

· F (Rs. /US$) / S (Rs. /US$)

= (1+ i RS) / (1+ i US$)

· Example: Use 1 Year Estimate of Interest Rates in Pakistan and USA to

estimate the 1 Year Forward F/x Rate. Using Yield Curves, you know that the

interest on 1 Year Maturity in Pakistan is 10% and in USA 2%. You know that

the current (or Spot) Rate is Rs.60/US$1. So, the 1 Year Forward Rate

= F = S (Rs. /US$) (1+ i Rs.) / (1+ i US$)

= (60) (1+0.1) / (1+0.02)

= Rs.64.7 / US$1.

In other words, we have forecasted the F/x Rate after 1 Year.

· 2 Conventions for Quotation of F/x Rates used by Banks and F/x Dealers:

American: US$ / FCY i.e. US$0.9 / 1Euro (means "Bid US$ 0.9 / Ask 1 Euro")

European: FCY / US$ i.e. JY100 / US$1, Rs.60 / US$1.

Inverse Relationship: European = 1 / American. So, Japanese Yen (JY) under

American Convention = 1 / 100 = US$0.01 / 1JY. Commonly written as 1.000.

In Pakistan generally we follow European convention.

PAIR of Market Prices for Every Currency in the F/x Market

BID Rate = Buying Price for Currency. Example: Bid Rs.60 / US$1

Means Bank

or Money Changer will Buy (or Bid) one US$ from you for Rs.60. This also means that

you (the Customer) are Selling Dollar to the Bank. Bid Rs.60 / US$1 means Bid Rs60 /

Ask US$1

ASK Rate = Selling Price for Currency. Example Ask Rs.61 / US$1 Means Bank or

Money Changer will Sell (or Ask) one US$ to you for Rs.61. This also means that you

(the Customer) are Buying Dollar from the Bank. Ex. If you are going to travel abroad

to USA.

Fundamental Principle for F/x Traders and "Money Changers": Buy Low and Sell

High. So, ASK > BID Rate.

Standard Quotation Format: Bid Rate / Ask Rate.

· Ex 1. "US$ 60/61" means Money Changer will Buy 1 US$ from you (the

customer) for Rs.60 BUT they will Sell 1 US$ to you for Rs.61. Means a Profit

of Rs.1 for every US$ traded!

· Ex2. If you see only 1 Quote i.e. "US$ 60" then it generally refers to the Bid

Quote i.e. Bid Rs60 / US$1.

Cross Rates (Transitivity of F/x Rates)

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Financial Management MGT201

Example with Either Bid OR Ask Rates: Suppose you want to convert your Euros into

US Dollars in Pakistan and you need to estimate the E/US$ F/x rate. Money Changers

and Banks in Pakistan show Spot F/x Rates in Rupee-Terms: Rs.60 / 1US$ and Rs.55 /

1Euro. Then Spot US$ / Euro = ( US$ / Rs. ) x ( Rs. / Euro) = ( 1US$ / Rs. 60) x

( Rs55 / 1 Euro) = US$ 0.9167 / 1Euro

If you are given Both Bid and Ask Rates, then Estimate the Cross Rate RANGE.

· Bid Euro / Ask US$ < ( Bid Euro / Ask Rs. ) x ( Bid Rs. / Ask US$)

· Ask Euro / Bid US$ > (Ask Euro / Bid Rs.) x ( Ask Rs. / Bid US$)

Global Investments

Make SML (for Efficient Stocks) Rise Up

Higher Return for Same Level of Risk

Required

nt)

Return (r*)

tme

Inve

rW (Global

rA = rRF + (rW - rRF )

oba

L (G

Market)

ent)

estm

rRF (Global

y In

untr

Market)

rM (Single

Sing

rA = rRF + (rM - rRF )

Market)

rRF (Single

Market)

M =+ 1.0

Beta Risk (

)

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