26 - 1  Factors that make multinational financial management different  Exchange rates and trading  International monetary system  International financial markets  Specific features of multinational financial management CHAPTER 26 Multinational Financial Management 26 - 2 What is a multinational corporation?  A multinational corporation is one that operates in two or more countries.  At one time, most multinationals produced and sold in just a few countries.  Today, many multinationals have world-wide production and sales. 26 - 3 Why do firms expand into other countries?  To seek new markets.  To seek new supplies of raw materials.  To gain new technologies.  To gain production efficiencies.  To avoid political and regulatory obstacles.  To reduce risk by diversification. 26 - 4 What are the major factors that distinguish multinational from domestic financial management?  Currency differences  Economic and legal differences  Language differences  Cultural differences  Government roles  Political risk 26 - 5 Are these currency prices direct or indirect quotations? Since they are prices of foreign currencies expressed in U.S. dollars, they are direct quotations (dollars per currency). Consider the following exchange rates: U.S. $ to buy 1 Unit Euro 0.8000 Swedish krona 0.1000 26 - 6 What is an indirect quotation?  An indirect quotation gives the amount of a foreign currency required to buy one U.S. dollar (currency per dollar).  Note than an indirect quotation is the reciprocal of a direct quotation.  Euros and British pounds are normally quoted as direct quotations. All other currencies are quoted as indirect. 26 - 7 Calculate the indirect quotations for euros and kronas. # of Units of Foreign Currency per U.S. $ Euro 1.25 Swedish krona 10.00 Euro: 1 / 0.8000 = 1.25. Krona: 1 / 0.1000 = 10.00. 26 - 8 What is a cross rate?  A cross rate is the exchange rate between any two currencies not involving U.S. dollars.  In practice, cross rates are usually calculated from direct or indirect rates. That is, on the basis of U.S. dollar exchange rates. 26 - 9  Cross rate = x = 1.25 x 0.1000 = 0.125 euros/krona.  Cross rate = x = 10.00 x 0.8000 = 8.00 kronas/euro. Calculate the two cross rates between euros and kronas. Euros Dollars Dollar Krona Kronas Dollars Dollar Euros 26 - 10  The two cross rates are reciprocals of one another.  They can be calculated by dividing either the direct or indirect quotations. Note: [...]... kronas profit Dollar profit = 4.0 kronas(0.1000 dollars per krona) = $0.40 26 - 13 What is exchange rate risk? Exchange rate risk is the risk that the value of a cash flow in one currency translated from another currency will decline due to a change in exchange rates 26 - 14 Currency Appreciation and Depreciation  Suppose the exchange rate goes from 10 kronas per dollar to 15 kronas per dollar  A dollar... strengthening  The krona is depreciating, or weakening 26 - 15 Affect of Dollar Appreciation  Suppose the profit in kronas remains unchanged at 4.0 kronas, but the dollar appreciates, so the exchange rate is now 15 kronas/dollar  Dollar profit = 4.0 kronas / (15 kronas per dollar) = $0 .267  Strengthening dollar hurts profits from international sales 26 - 16 Describe the current and former international... risk and none of the traders own money invested 26 - 33 Impact of Arbitrage Activities  Traders would recognize the arbitrage opportunity and make huge investments  Their actions would tend to move interest rates, forward rates, and spot rates to parity 26 - 34 What is purchasing power parity? Purchasing power parity implies that the level of exchange rates adjusts so that identical goods cost... Pf(Spot rate), or Spot rate = Ph/Pf 26 - 35 If grapefruit juice costs $2.00/liter in the U.S and purchasing power parity holds, what is price in Spain? Spot rate = Ph/Pf $0.8000= $2.00/Pf Pf = $2.00/$0.8000 = 2.5 euros  Do interest rate and purchasing power parity hold exactly at any point in time? 26 - 36 What impact does relative inflation have on interest rates and exchange rates?  Lower inflation... 1971, a fixed exchange rate system was in effect The U.S dollar was tied to gold Other currencies were tied to the dollar 26 - 17 The European Monetary Union In 2002, the full implementation of the “euro” was completed (those still holding former currencies have 10 years to exchange them at a bank) The newly formed European Central Bank now controls the monetary policy of the EMU 26 - 18 The 12... rate parity hold? Spot rate = $0.8000 rh = 6%/2 = 3% rf = 4%/2 = 2% (More ) 26 - 27 Forward rate 1 + rh = Spot rate 1 + rf 1.03 Forward rate = 1.02 0.8000 Forward rate = 0.8078 If interest rate parity holds, the implied forward rate, 0.8078, would equal the observed forward rate, 0.8100; so parity doesn’t hold 26 - 28 Which 180-day security (U.S or Spanish) offers the higher return?  A U.S investor... strategy is higher than 6%, then the Spanish security has the higher rate 26 - 29 What is the return to a U.S investor in the Spanish security?  Buy $1,000 worth of euros in the spot market: $1,000(1.25 euros/$) = 1,250 euros  Spanish investment return (in euros): 1,250(1.02)= 1,275 euros (More ) 26 - 30  Buy contract today to exchange 1,275 euros in 180 days at forward rate of 0.8100 dollars/euro ... the rate of return: $32.75/$1,000 = 3.275% per 180 days = 6.55% per year (More ) 26 - 31 The Spanish security has the highest return, even though it has a lower interest rate  U.S rate is 6%, so Spanish securities at 6.55% offer a higher rate of return to U.S investors  But could such a situation exist for very long? 26 - 32 Arbitrage  Traders could borrow at the U.S rate, convert to pesetas at the... Spain France Luxembourg Greece 26 - 19 What is a convertible currency?  A currency is convertible when the issuing country promises to redeem the currency at current market rates  Convertible currencies are traded in world currency markets 26 - 20 What problems arise when a firm operates in a country whose currency is not convertible?  It becomes very difficult for multinational companies to conduct... foreign interest rates 26 - 25 What is interest rate parity? Interest rate parity implies that investors should expect to earn the same return on similar-risk securities in all countries: Forward rate = 1 + rh Spot rate 1 + rf Forward and spot rates are direct quotations rh = periodic interest rate in the home country rf = periodic interest rate in the foreign country 26 - 26 Assume 1 euro = $0.8100 . markets  Specific features of multinational financial management CHAPTER 26 Multinational Financial Management 26 - 2 What is a multinational corporation?  A multinational corporation is one. 26 - 1  Factors that make multinational financial management different  Exchange rates and trading  International monetary system  International financial markets  Specific. sale? 26 - 13 Exchange rate risk is the risk that the value of a cash flow in one currency translated from another currency will decline due to a change in exchange rates. What is exchange