Processes of going global Exporting Positives: low capital required, low risk, profits immediate, opportunity to learn Negatives: inability to realize full sales potential Licensing Positives: minimal investment, fast market entry, few financial and legal risks Negatives: lower cash flow, maintaining product quality, difficulty controlling exports by licensee, difficulty entering market when agreement expires Overseas production Positives: easier to keep abreast of market, adapt to changing local tastes, fill orders faster, service after sale, R&D local, shows greater commitment Negatives: cost and time before profitable Chapter 6 ? Country Risk Analysis Managing political risk Preinvestment Avoidance Insurance Adverse selection Adverse incentives Negotiating Concession agreement Structure the investment Chapter 2 ? Determination of Exchange Rates Equilibrium exchange rate occurs when the quantity supplied equals the quantity demanded of a foreign currency at a specific local price. Computing Percent Change in Value of a Currency SHAPE \* MERGEFORMAT SHAPE \* MERGEFORMAT = old currency value SHAPE \* MERGEFORMAT = new currency value Computing Percent Change from the perspective of the other currency SHAPE \* MERGEFORMAT SHAPE \* MERGEFORMAT In US $ = American terms How did the US $ perform versus Japanese Yen? SHAPE \* MERGEFORMAT How did the Japanese Yen perform versus the US $? SHAPE \* MERGEFORMAT Per US $ = European terms How did US $ perform versus the Japanese Yen? SHAPE \* MERGEFORMAT How did the Japanese Yen perform versus the US $? SHAPE \* MERGEFORMAT Cross Rates SHAPE \* MERGEFORMAT Therefore, 1 Yen = 0.009998 Franc SHAPE \* MERGEFORMAT Therefore 1 Franc = 100.02 Yen SHAPE \* MERGEFORMAT Some ?Rules of Thumb? ? Use cautiously Low risk currencies are more highly valued than high risk currencies More trustworthy currencies are more valuable and have lower interest rates A rise in the value of a currency results in cheaper foreign goods at home A rise in the value of a currency results in less price inflation pressure at home Lower relative inflation causes a nation?s currency to rise An increase in the level of interest rates will cause a nations currency to rise (short-term) A rise in the value of a currency hurts exports (balance of trade) Chapter 3 ? International Monetary System Five Major Market Mechanisms Freely Floating (Clean Float) Market forces of supply and demand determine rates Forces influenced by Price levels Interest rates Economic growth Rates fluctuate over time Managed float (dirty float) Market forces set rates unless excess volatility occurs Central bank intervenes to smooth the fluctuations of a free float Target-Zone Arrangement Rate determination Market forces constrained to upper and lower range of rates Members to the arrangement adjust their national economic policies to maintain target Fixed rate System Price-Specie-Flow mechanism Disturbances in the price level of one country automatically offset, at least in part, by a balance of payments adjustment EX: US productivity increases. Decreases prices of US exports. US runs balance of payments surplus. Difference made up by increased flow of gold to US. Increased gold flow into US increases US money supply and US prices. Non-US money supply decreases, decreasing non-US prices Bretton Woods Conference (NeW Hampshire) Implemented in 1946 Created IMF Promote cooperation among countries on international monetary issues Promote stability in exchange rates Provide temporary funds to member countries attempting to correct imbalances in international payments Promote free mobility of capital funds among countries Promote free trade Created World Bank Objective: to make loans to countries in order to enhance economic development Chapter 4 PPP Relative Version The exchange rate between a home currency and any foreign currency will adjust to reflect changes in the price level of the two countries SHAPE \* MERGEFORMAT That is, if inflation in the US is 4% annually and inflation in Japan is 1%, the dollar value of the yen must rise 3% to equalize the dollar price of goods in the two countries SHAPE \* MERGEFORMAT EX: US inflation rate = 5% Swiss inflation rate is 3% Spot rate is SFr 1 = #0.75 According to relative PPP, the rate for the Swiss franc in 3 years should be SHAPE \* MERGEFORMAT Better in long-run than short-run Real exchange rate is the nominal exchange rate adjusted for changes in the relative purchasing power of each currency since some base period. % over- or undervalued a currency is SHAPE \* MERGEFORMAT The Fisher Effect Currencies with high underlying rates of inflation should bear higher interest rates than currencies with low underlying rates of inflation. Real interest rates, not nominal interest rates, are what matter SHAPE \* MERGEFORMAT International Fisher Effect The spot exchange rate should change in an equal amount, but in an opposite direction to, the difference in interest rates between two countries Ex: In July, the one year interest rate is 4% on Swiss francs and 13% on US dollars If the current exchange rate is SFr 1 = $0.63, what is the expected future exchange rate in one year? According to the international Fisher effect, the spot exchange rate expected in one year equals 0.63 x 1.13/1.04 = $0.6845 If a change in the expectations regarding future US inflation causes the expected future spot rate to rise to $0.70, what should happen to the US interest rate? If SHAPE \* MERGEFORMAT is the unknown US interest rate, and the Swiss interest rate stayed at 4% (because there has been no change in expectations of Swiss inflation), then according to the international fisher effect, SHAPE \* MERGEFORMAT or SHAPE \* MERGEFORMAT = 15.56% Evidence: There is a clear tendency for currencies with high interest rates to depreciate and for currencies with low interest rates to appreciate. There are, however, considerable short-term deviations. Interest Rate Parity The currency of the country with a lower interest rate should be at a forward premium in terms of the currency of the country with a higher interest rate. A hedged (covered) foreign investment should have a return just equal to a domestic interest rate investment of similar risk. Covered interest differential ? the difference between the domestic interest rate and the hedged foreign rate. Should equal 0? otherwise there is covered interest arbitrage EX: the interest rate in the US is 10&; in Japan, the comparable rate is 7%. The spot rate for the yen is $0.003800. If interest rate parity holds, what is the 90-day forward rate? According to IRP, the 90day forward rate on the yen, SHAPE \* MERGEFORMAT , should be $0.003828; SHAPE \* MERGEFORMAT In other words, the 90 day forward Japanese yen should be selling at an annualized premium of about 2.95% [4 x (0.003828-0.003800)/0.0038] Chapter 15 ? International Portfolio Management Benefits of international equity investing There are more opportunities when you include foreign country investments versus a purely domestic portfolio There is a possible risk reduction benefit from the additional diversification that results from investing abroad Recent studies show: Cross-market correlations are generally higher today than in the 70s, a logical result of globalizations (emerging markets are the big exception) The markets seem to be most correlated when volatility is greatest Unique risks (Opportunities) Investing Abroad Political and regulatory risk Exchange rate risk SHAPE \* MERGEFORMAT Where: SHAPE \* MERGEFORMAT = return on the foreign investment in your home currency SHAPE \* MERGEFORMAT = return on the foreign investment in local currency SHAPE \* MERGEFORMAT = Return on the foreign exchange EX: 10% foreign market return with a 7.5% FX loss: (1.10)(.9250) = 1.0175-1 = 1.75% 5.0% FX gain (1.10)(1.05) = 1.156-1 = 15.5% NOTE: you CANNOT just add the returns together Easy access to foreign markets American Depository Receipts (ADRs) or foreign companies listed directly on the American exchanges Chapter 5-The Balance of Payments An accounting statement that measures all economic transactions between home and foreign countries Three major accounts Current Capital Official reserves Current Account Records net flow of goods (balance of trade) Trade deficit= ex< im Trade surplus= ex > im Capital Account Records public and private investment and lending Portfolio transactions ? financial assets > 1 year Short term- financial assets < 1 year Direct (FDI)- management control exerted (US defines at 10% equity Official Reserves account Measures changes in international reserves (gold/convertible securities) owned by central banks Reflects surplus/deficit of current/capital accounts Solutions for improving CA deficit Raise national income (output) relative to domestic investment Increase savings (S) relative to domestic investment Four basic policy solutions for current account deficit Currency depreciation Results in cheaper exports and more expensive imports Result: depreciation ineffective, it takes time to affect trade J-curve effect depreciation will initially worsen deficit before improving it Impose Trade Barriers Tariffs, quotas Result: most likely will reduce both exports and imports Restrict foreign ownership of domestic assets Would place limits on or eliminate foreign ownership that leads to capital inflows Result: works, but slower economic growth likely due to decreased availability of foreign capital Boosting the savings rate Change the tax regulations and rates Result: linkages unpredictable, possible unintended consequences Healthy economies tend to run account deficits Chapter 7 ? The Foreign Exchange Market The Spot Quotations Spot price Forward prices of 30-day, 90-day, 180-day Method of Quotation America Terms: U.S. dollar price per unit of foreign currency $/.79euros European Terms: Foreign currency units per dollar 1.49euros/$ For Nonbank Customers Method of Quotation Direct quote: Gives the home currency price, always in the numerator, of one unit of foreign currency. Example $1.81/1 pound. Since this is a direct quote, we know that in the U.S. that one pound equals $1.81 Transactions Costs Bid-Ask Spread: This is a fee charged by the bank. Bid = The price at which the bank is willing to buy the currency Ask = The price it will sell the currency Percent Spread Formula (PS) PS = (Ask ? Bid)/Ask x 100 For widely traded currencies, the spread may be around 0.02% Cross Rates The exchange rate between 2 non- US$ currencies - know how to calculate (obviously haha) Currency Arbitrage - As markets become more efficient and transparent, opportunities for arbitrage decline (Know how to calculate all three) 1. Locational Arbitrage 2. Triangular Arbitrage (Just know how to test for arbitrage 3. Covered Interest Arbitrage Forward Contract An agreement between a bank and a customer to deliver a specified amount of currency against another currency at a specified future date and at a fixed exchange rate. Forward Rate Quotations Outright Rate: quoted to commercial customers in the actual price Swap Rate: quoted in the Interbank market as a discount or premium Discount if forward is expressed in dollars below current spot rate Premium if the forward rate is above the spot rate Chapter 8 Part II ? Currency Options Expiration Dates of Currency Options American Style ? You may exercise any time up to the expiration date European Style ? You man exercise only on the expiration date and not before Premium The price of an option that the writer charges the buyer Exercise Price Sometimes called the ?strike price,? this is the exchange rate aw which the option holder can buy or sell the contracted (?underlying?) currency. Status of an Option In-the-money Call: Spot > Strike Put: Spot < Strike Out-of-the-money Call: Spot < Strike Put: Spot > Strike At-the-money Spot = the Strike The intrinsic value of the option is the amount by which the option is in-the-money. Types of Options Vanilla ?Exotic? options, by contract, trade over the counter, (sometimes referred to as OTC options) they offer greater flexibility. There is a very active OTC market for currency options. Chapter 9 ? Swaps and Interest Rate Derivatives Interest Rate Swaps Definition: An agreement between 2 parties to exchange US$ interest payments for a specific maturity on an agreed amount. LIBOR is the most important reference rate in swaps. Swap usage ? To reduce risk potential and borrowing costs Notional Principal Simply a reference amount used to calculate interest expense, but is never repaid. Maturity range can be between 1 to over 15 years. Types of Interest Rate Swaps Coupon Swap: Fixed for Floating ? One party pays a fixed rate calculated at the time of trade as a spread to a particular Treasury bond, and the other side pays a floating rate that resets periodically throughout the life of the deal against a designated index. Basis Swap: Floating for floating, but based on different reference rates. They may behavior differently to external forces. Currency Swaps ? Swap contracts across currencies. Definition: Two parties exchange foreign currency-denominated debt at periodic intervals. It?s purpose is to replace cash flows denominated in one currency with cash flows in a more desirable currency. The principal Classic Currency Swap example: A U.S. company wants to issue bonds denominated in Euros because it has Euro cash flow from an affiliate that it wants to make payments with. The same situation is occurring for a European company with a U.S. affiliate and Dollar cash flows. The solution is for each company to issues bonds in their home currency at a better rate than the foreign company. The U.S. company provides Euro payments to the European company in exchange for dollar payments. This allows both companies to make payments in the desired currency at lower cost. Interest Rate Forwards and Futures Three major types used to manage interest rate risk 1. Forward forwards 2. Forward rate agreements 3. Eurodollar futures Forward Forwards A contract that fixes an interest rate today on a future loan or deposit. The conditions include a specific interest rate, principal amount of future loan, and start and ending dates of future interest rate period. Example: A company needs to borrow $10m in six months, for a three month period. Instead of waiting for six months to see what interest rates may be, (fearing they will go up) they enter into a forward agreement with a bank, fixing the interest rate. Forward Rate Agreement (FRA?s) Cash-settled, over-the-counter forward contract. Company fixes an interest rate applied to a specified future interest period on notional amount. Example: A company needs to borrow $50m in two months for a six month period. To lock in the interest rate, the company buys a 2x6 FRA on LIBOR of 6.5%. If in two month the LIBOR exceeds 6.5%, the bank pays the company the difference in interest expense, vice-versa if it is less than 6.5% Eurodollar Futures Marked to market daily with March/June/September/December delivery Structured Notes Structured Notes: interest-bearing securities whose interest payments are determined by reference to a formula set in advance and adjusted on specific reset dates. Chapter 10 ? Measuring and Managing Translation and Transaction Exposure Current Rate Method: The balance sheet is at current rate. Accounting Standards NO. 52 mandates the use of the current rate method to translate foreign currency denominated assets and liabilities into dollars. Transaction gains or losses generally appear on the foreign unit income statement and recorded in a separate equity account on balance sheet known as cumulative translation adjustment account. International Accounting Standards Board (IASB) versus FASB Know what IASB does (write Int?l Acc St?) Designing a hedging strategy Hedging defined as simply establishing an offsetting currency position. Whatever is lost or gained by the original currency exposure is offset by the hedge. Another definition is to lock in the home currency value. It has a basic objective to reduce/eliminate volatility of earnings as a result of exchange rate changes. Hedging exchange rate risk always incurs a cost and should be evaluated as a purchase of insurance. Centralization is key to implementation. FASB 133 ? Must formally document each hedging transaction from the outset. Match gains or losses from the derivative with gains or losses from the underlying transaction or asset. Removes gains or losses from current income unless the change is not offset by a change in the underlying assets value Forward Market Hedge If long a foreign currency, sell the foreign currency forward. If short a foreign currency, buy the foreign currency forward. Risk Shifting Eliminates transaction risk by pricing contracts in home currency. Firms will invoice exports in strong currency, import in weak currency. The drawback is it is not possible with well informed customers or suppliers. They will realize your benefit and adjust pricing. Cross-hedging Often forward contracts not available in a certain currency so the solution is to engage in a forward contract in related currency. Correlation between the currencies is critical to success of this hedge. Basic Asset and Liability Strategy HARD CURRENCY (likely to appreciate): Increase hard currency assets and decrease hard currency liabilities. SOFT CURRENCY (Likely to depreciate): Decrease soft currency assets. Increase soft currency liabilities. Chapter 11 ? Measuring and Managing Economic Exposure Real Exchange Rates, which are nominal rate adjusted for price changes, are key. If nominal rates change with equal price change, no alteration to cash flows is needed. If real rates change, it causes relative price changes and changes in purchasing power. A decline in the real value of a home currency makes exports and import-competing goods more competitive. Appreciation in the real value of a home currency makes imports and export-competing goods more competitive. A dilemma for exporter is to raise foreign currency prices and lose market share or maintain prices and reduce profits. Pricing flexibility Price elasticity of demand. If the demand is inelastic, not sensitive to price, then demand wont be changed. Degree of product differentiation ? the more unique the product the better Marketing Management Pricing Strategy Exporter gains competitive advantage when home currency depreciates and vice versa. Elasticity of demand is key. If home currency is strong, you can?t market the product as a value product because it will be higher relative to foreign goods. A weak dollar opens up the opportunity to enter new markets. Chapter 12 ? International Financing and National Capital Markets Three major types of foreign bonds: 1. Fixed rate, 2. floating rate, 3. Equity related. The Foreign Equity Market ?Cross listing? internationally can diversify risk by insulating company from vagaries of a single national market, increase potential demand for company shares, and spread firm?s name in local market. Types of Development Banks World Bank Group includes International Bank for Reconstruction and Development. They get their money from governments, the United States provides the most money. International Development Association which was created in the 60?s due to critics saying other banks were to profit orientated. Chapter 13 ? The Euromarkets The Eurocurrency Market Composed of eurobanks who accept/maintain deposits of foreign currency. The dominant currency is the US $. A U.S. dollar on deposit outside the U.S. becomes a ?eurodollar,? the bank accepting the deposit is known as a eurobank A Eurocurrency is a dollar or other freely convertible currency deposited in a bank outside its country of origin. Growth of Eurodollar Market The Eurocurrency has thrived for one reason, government regulation. Post WWII and caused by restrictive US government policies like reserve requirements on deposits, charges and taxes, interest rate ceilings, rules which restrict bank competition. The United States didn?t want to deal with possible legal battles of foreign deposits as assets were being seized by collective governments. Eurobonds Definition of Eurobonds Bonds sold outside the country of currency denomination. US $ denominated bonds sold in Mexico or Europe. Recent substantial market growth: due to the use of swaps Links to Domestic Bond Markets: arbitrage has eliminated interest rate differential. Placement: underwritten by syndicates of banks Currency denomination: Most often in US$, cocktails allow for a basket of currencies. Eurobond Secondary Market: Results in rising investor demand. It was not robust at first, but is improving. Retirement: sinking fund usually, some carry call provisions. Ratings: According to relative risk, agencies include Moody?s, Standard and Poor?s. Due to known issues and investors, there was no ratings. SEC is no involved. Rationale for Market Existence: Eurobonds avoid government regulation, may fade as market deregulate. Americans must invest indirectly. Eurobond vs Eurocurrency loans Five differences Eurocurrency loans use variable rates, have shorter maturities, bonds have greater volume, loans have greater flexibility, loans obtained faster. Note Issuance Facilities Note Issuance Facility (NIF) offer low-cost substitute for loan, allow borrowers to issue own notes which are placed/distributed by banks NIFs vs. Eurobonds Notes draw down credit as needed, notes let owners determine timing, notes must be held to maturity. Euronotes and Euorcommecial Paper Euronotes are unsecured short-term debt securities denominated in US$ and issued by corporations and governments Euro-commercial paper (CP) are euronotes not bank underwritten. The difference between U.S. and Euro commercial paper is that the average maturity is longer for euro-CP?s and a secondary market for Euro which isn?t the case for U.S. US never has longer than 270 day maturity. AsiaCurrency Market aka Asiadolalr Market Smaller than Eurocurrency, but rapid growth. It is located in Singapore due to lack of restrictive financial controls and taxes. Channels investment dollars to rapidly growing SE Asia economies and provides deposit facilities. Dragon Bond is a debt denominated in a foreign currency, usually the US$, but is launched, priced, and traded in Asia. It has grown rapidly, but hasn?t seen maintained growth. Big borrowers can go almost anywhere. Chapter 20 ? Managing the Multinational Financial System Managing the Multinational Financial System The value of the multinational financial system rests in its ability to arbitrage in the following areas, tax systems, financial markets, regulatory systems. Intercompany Fund-flow mechanisms Methods used to move funds from one subsidiary to another. Commonly used methods include unbundling, transfer pricing, dividends (largest way to get profits home), fees and royalties. Transfer pricing ? pricing internally traded goods of the firm for the purpose of moving profits to a more tax-friendly nation. It reduces taxes paid, reduces ad valorem tariffs paid, avoids exchange controls. Tax agencies are aware of this internal pricing and have taken steps to combat it. Governments use comparable uncontrolled price method, resale price method, cost-plus method, etc to produce an ?arms-length price? for tax purposes. Dividend Mechanism is the most important method used by MNC?s to transfer funds to parent. Accounts for more than half of all remittances to U.S. firms. Also, focus on Chapters 16 ? cross-investment, overseas expansion (exporting, licensing, overseas production) Chapter 18 ? Payment terms (cash in advance, letter of credit, drafts, consignment, open account, what is most risky? Open account) Know about letters of credit (types, advantages, what exporter likes) Bankers acceptance vs trade acceptance What is consignment Know about bill of lading, commercial invoice and insurance Evaluating cost of acceptance financing Factoring ? and evaluating the cost of factoring According to art, is barter still used often? Chapter 19 Interaffiliate payments Calculating interest costs ? EIR ? sample problems 1 2 3 4 Commercial paper Article questions included: Most traded currency in world? According to IRS how are they short money (or something along those lines...) (tax havens, transfer pricing, etc) Islam is a religion that encompasses all aspects of life
Want to see the other 15 page(s) in 456 - Final Exam Notes.doc?JOIN TODAY FOR FREE!