International Financial Risk Management

1. International Financial Risk Management 14-15 January 2005 - I I. Ertürk

2. Exposure to International Risk International business usually increases an MNC’s exposure to: • exchange rate movements • Exchange rate fluctuations affect cash flows and foreign demand. • foreign economies • Economic conditions affect demand. • political risk • Political actions affect cash flows.

3. Managing for Value • Like domestic projects, foreign projects involve an investment decision and a financing decision. • When managers make multinational finance decisions that maximize the overall present value of future cash flows, they maximize the firm’s value, and hence shareholder wealth.

4. E (CF$,t ) = expected cash flows to be received at the end of period t n = the number of periods into the future in which cash flows are received k = the required rate of return by investors Valuation Model for an MNC • Domestic Model

5. E (CFj,t ) = expected cash flows denominated in currency j to be received by the parent at the end of period t E (ERj,t ) = expected exchange rate at which currency j can be converted to the parent’s currency at the end of period t k = the weighted average cost of capital of the parent company Valuation Model for an MNC • Valuing International Cash Flows

6. Valuation Model for an MNC • An MNC’s financial decisions include how much business to conduct in each country and how much financing to obtain in each currency. • Its financial decisions determine its exposure to the international environment.

7. Impact of New International Opportunities on an MNC’s Value Exposure to Foreign Economies Exchange Rate Risk Political Risk Valuation Model for an MNC

8. Foreign Exchange Transactions MNC Parent Export/Import Dividend Remittance & Financing Eurocurrency Market Eurocredit & Eurobond Markets Foreign Business Clients Medium- & Long-Term Financing Short-Term Investment & Financing Long-Term Financing Export/Import Foreign Exchange Markets International Stock Markets Short-Term Investment & Financing Foreign Subsidiaries Medium- & Long-Term Financing Long-Term Financing Foreign Cash Flow Chart of an MNC

9. Foreign ExchangeTransactions • There is no specific building or location where traders exchange currencies. Trading also occurs around the clock. • The market for immediate exchange is known as the spot market. • The forward market enables an MNC to lock in the exchange rate at which it will buy or sell a certain quantity of currency on a specified future date.

10. Foreign ExchangeTransactions • Hundreds of banks facilitate foreign exchange transactions, though the top 20 handle about 50% of the transactions. • At any point in time, arbitrage ensures that exchange rates are similar across banks. • Trading between banks occurs in the interbank market. Within this market, foreign exchange brokerage firms sometimes act as middlemen.

11. Interest Rate Parity (IRP) Forward Rate Discount or Premium Fisher Effect Inflation Rate Differential Interest Rate Differential Purchasing Power Parity (PPP) International Fisher Effect (IFE) Exchange Rate Expectations Comparison of IRP, PPP, and IFE Theories

12. Government Monetary and Fiscal Policies Relative Interest Rates Relative National Income Levels Relative Inflation Rates International Capital Flows International Trade Exchange Rates Government Purchases & Sales of Currencies Government Intervention in Foreign Exchange Market Quotas, Tariffs, etc. Tax Laws, etc. Impact of Government Actions on Exchange Rates

13. Exchange Rate Systems • Exchange rate systems can be classified according to the degree to which the rates are controlled by the government. • Exchange rate systems normally fall into one of the following categories: • fixed • freely floating • managed float • pegged

14. Currency Boards • A currency board is a system for maintaining the value of the local currency with respect to some other specified currency. • For example, Hong Kong has tied the value of the Hong Kong dollar to the U.S. dollar (HK$7.8 = $1) since 1983, while Argentina has tied the value of its peso to the U.S. dollar (1 peso = $1) since 1991.

15. Currency Boards • For a currency board to be successful, it must have credibility in its promise to maintain the exchange rate. • It has to intervene to defend its position against the pressures exerted by economic conditions, as well as by speculators who are betting that the board will not be able to support the specified exchange rate.

16. Exposure of a Pegged Currency to Interest Rate Movements • A country that uses a currency board does not have complete control over its local interest rates, as the rates must be aligned with the interest rates of the currency to which the local currency is tied. • Note that the two interest rates may not be exactly the same because of different risks.

17. Exposure of a Pegged Currency to Exchange Rate Movements • A currency that is pegged to another currency will have to move in tandem with that currency against all other currencies. • So, the value of a pegged currency does not necessarily reflect the demand and supply conditions in the foreign exchange market, and may result in uneven trade or capital flows.

18. Dollarization • Dollarization refers to the replacement of a local currency with U.S. dollars. • Dollarization goes beyond a currency board, as the country no longer has a local currency. • For example, Ecuador implemented dollarization in 2000.

19. A Single European Currency • In 1991, the Maastricht treaty called for a single European currency. On Jan 1, 1999, the euro was adopted by Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, Netherlands, Portugal, and Spain. Greece joined the system in 2001. • By 2002, the national currencies of the 12 participating countries were withdrawn and completely replaced with the euro.

20. A Single European Currency • Within the euro-zone, cross-border trade and capital flows occur without the need to convert to another currency. • European monetary policy is also consolidated because of the single money supply. The Frankfurt-based European Central Bank (ECB) is responsible for setting the common monetary policy.

21. A Single European Currency • The ECB aims to control inflation in the participating countries and to stabilize the euro within reasonable boundaries. • The common monetary policy may eventually lead to more political harmony. • Note that each participating country may have to rely on its own fiscal policy (tax and government expenditure decisions) to help solve local economic problems.

22. A Single European Currency • As currency movements among the European countries are eliminated, there should be an increase in all types of business arrangements, more comparable product pricing, and more trade flows. • It should also be easier to compare and conduct valuations of firms across the participating European countries.

23. A Single European Currency • Stock and bond prices should also be more comparable and there should be more cross-border investing. However, non-European investors may not achieve as much diversification as in the past. • Exchange rate risk and foreign exchange transaction costs within the euro-zone are eliminated, while interest rates are similar.

24. €/£ €/$  strengthens € weakens  €/100¥ €/SwF (Swiss Franc) A Single European Currency

25. Types of Exposure • Although exchange rates cannot be forecasted with perfect accuracy, firms can at least measure their exposure to exchange rate fluctuations. • Exposure to exchange rate fluctuations comes in three forms: • Transaction exposure • Economic exposure • Translation exposure

26. Is Exchange Rate Risk Relevant? Purchasing Power Parity Argument • Exchange rate movements will be matched by price movements. • PPP does not necessarily hold.

27. Is Exchange Rate Risk Relevant? The Investor Hedge Argument • MNC shareholders can hedge against exchange rate fluctuations on their own. • The investors may not have complete information on corporate exposure. They may not have the capabilities to correctly insulate their individual exposure too.

28. Is Exchange Rate Risk Relevant? Currency Diversification Argument • An MNC that is well diversified should not be affected by exchange rate movements because of offsetting effects. • This is a naive presumption.

29. Is Exchange Rate Risk Relevant? Stakeholder Diversification Argument • Well diversified stakeholders will be somewhat insulated against losses experienced by an MNC due to exchange rate risk. • MNCs may be affected in the same way because of exchange rate risk.

30. Is Exchange Rate Risk Relevant? Response from MNCs • Many MNCs have attempted to stabilize their earnings with hedging strategies, which confirms the view that exchange rate risk is relevant.