Chapter 18: Multinational Financial Management

PURCHASING POWER PARITY: In the spot market, 22.4 Mexican pesos can be exchanged for 1 U.S. dollar. A compact disc costs $15 in the United States. If purchasing power parity (PPP) holds, what should be the price of the same disc in Mexico?

$1 = 22.4 pesos or 22.4 peso/$ --direct quotation for Mexico and indirect for U.S. PPP = e0 =Ph/Pf 22.4 pesos/$ = Ph/$15 22.4 pesos/$ * $15 = 336 pesos = Ph

CROSS RATE: A currency trade observes that in the spot exchange market, 1 U.S. dollar can be exchanged for 3.4 Israeli shekels or for 106 Japanese yen. What is the cross-exchange rate between the yen and the shekel; that is, how many yen would you receive for every shekel exchanged?

- 1 / 3.40 dollars in a shekel - 106 yen in a dollar - 106 / 3.4 = 31.18 yen per shekel *on final use rate for $ to cross cancel

EXCHANGE RATE: If British pounds sell for $1.30 (U.S.) per pound, what should dollars sell for in pounds per dollar?

- 1 British Pound / $1.30 U.S. = $1 U.S. - 0.77 British Pounds = $1 U.S. *just take reciprocal

PURCHASING POWER PARITY: A television costs $750 in the United States. The same television costs 637.5 euros. If purchasing power parity holds, what is the spot exchange rate between the euro and the dollar?

- e0 = Ph/Pf - e0 = $750/ 637.5 euro = 1.18 $/euro

INTEREST RATE PARITY: Assume that interest rate parity holds. In the spot market 1 Japanese yen = $0.0094400, while in the 90-day forward market 1 Japanese yen = $0.0094426. In Japan, 90-day risk-free securities yield 2%. What is the yield on 90-day risk-free securities in the United States?

- f90 day/ e0 = 1+rh/1+rf - 0.0094426 $/yen / 0.00944 $/yen = 1 + rh/1+2%/4 - 1.000275 = 1+rh/1.005 = 1.000275 * 1.005 = 1.00528 = 1+rh =0.00528 = rh or 0.528% so Inom = 0.528% * 4 = 2.11%

CURRENCY APPRECIATION: Suppose that 1 Danish krone could be purchased in the foreign exchange market today for $0.16. If the krone appreciated 4% tomorrow against the dollar, how many drones would a dollar buy tomorrow?

-Today 1 krone = $0.16 -Tomorrow 1 krone = $0.16 * 1.04 = $0.1664 - 1/$0.1664 = 6.0096 krones - $1 would buy 6.0096 krones

What is a multinational corporation?

-a corporation that operates in two or more countries -decision making within the corporation may be centralized in the home country, or may be decentralized across the countries in which the corporation does business -deals in and with multiple currencies

Forward premium and discount: The current nominal interest rates in Japan and US are 8% and 12.5%, respectively. What is the implied forward premium or discount of the yen (over the current spot rate for a five-year forward contract $/yen)?

-based on IRP, the expected premium is: ft = e0 * (1+rh)^t/(1+rf)^t = e0 * (1.125)^5/(1.08)^5 = 1.2264e0 premium = 1.2264 - 1 = 0.2264 = 22.64% -adjust t for Ft to reflect if its greater than one year or less than one year by dividing percentage by unit or multiplying the exponent of the unit for more than one year -whichever is chosen for home rate; it doesn't matter which is home rate numerator or denominator

When is the forward rate at a premium to the spot rate?

-if the U.S.$ buys fewer units of a foreign currency in the forward than in the spot market (the U.S.$ depreciates while the foreign currency appreciates), the US$ is selling at a discount while the foreign currency is selling at a premium -in the opposite situation, the foreign currency is selling at a discount and the US$ is selling at a premium -the primary determinant of the spot/forward rate relationship is relative interest rates -investments change the exchange rate more than consumption because of interest rates -varying interest rates will flow between countries because of exchange rates--buying and selling between countries causes differing interest rates to create incentive for countries which changes exchange rates when countries don't buy domestically --main reason for exchange rates to change would be because interest rates differ between countries

What makes a currency price a direct quotation?

-if they are prices of foreign currencies expressed in dollars, they are direct quotations (dollars per foreign currency) H/F or home/foreign -ex: Japanese Yen: 0.009($/Yen) Australian $: 0.650($/A$) -how much 1 Yen or 1 $A is compared to U.S. dollars; so both the Yen and the A$ do not have as high of a value as U.S.$

What is the law of one price?

-in competitive markets, exchange-adjusted prices of identical traceable goods and financial assets must be within transaction costs of equality worldwide --absent market imperfections, arbitrage ensures that exchange-adjusted prices of identical traded goods follow the Law of One Price

How is interest rate parity calculated?

-interest rate parity holds that investors should expect to earn the same return in all countries after adjusting for risk ft/e0 = 1+rh/1+rf ft = t-period forward exchange rate e0 = today's spot exchange rate rh = periodic interest rate in home country rf = periodic interest rate in foreign country -ex: e0= 1$/pound; annual interest rate US = 5% and for UK = 5% F1 year/e0 = 1+ rUS/1+ rUK F1 year/$1/pound = 1+5%/1+5% = 1 = 1 year forward rate is equal to the spot rate of 1$/pound --so no trading at discount or premium because values for both exchange rates are to stay the same; $ is trading at par; pound is trading at par

What impact does relative inflation have on interest rates and exchange rates?

-lower inflation leads to lower interest rates, so borrowing in low-interest countries may appear attractive to multinational firms -however, currencies in low-inflation countries tend to appreciate (implication of IRP) against those in high-inflation rate countries, so the effective interest cost increases over the life of the loan

What is included in chapter 18?

-multinational vs. domestic financial management -exchange rates and trading in foreign exchange -international monetary system -interest rate parity -purchasing power parity -swap transactions and futures can be exchanged between individuals and countries -chapter is about globalization and enabling growth internationally -based on differences of interpretation of interest rates: if I believe rates are increasing then I will have fixed rate, decreasing then I will want floating rate on loans

How is purchasing power parity calculated?

-purchasing power parity implies that the level of exchange rates adjusts so that identical goods cost the same amount in different countries (Law of One Price) Ph = Pf(e0) OR e0 = Ph/Pf -identical traceable goods so law of one price should hold meaning that price is equal across countries but varies because of the currency worth --ex: (A) iPhone 13 = $1,000 (B) iPhone 13 = 10,000 yen (C) so A = B; A = C; then B = C so $1,000 = 10,000 yen; spot rate or e0 = 10,000 yen/$1,000 = 10 yen/$ or 0.1$/yen

What is the difference between spot rates and forward rates?

-spot rates are the rates to buy currency for immediate delivery -forward rates are the rates to buy currency at some agreed-upon date in the future

Which security offers the highest return?

-the Japanese security --convert $1,000 to yen in the spot market: $1000 * 111.11 = 111,111 yen ($ units cancel out) --F30day / e0 = 1+rh/1+rf = 0.0095$/yen /e0 = 1+0.33%/1+0.33% = 1 --invest 111,111 yen in 30-day Japanese security. In 30 days receive 111,111 yen * 1.00333 = 111,481 yen --agree today to exchange 111,481 yen 30 days from now at forward rate, 111,481 * 0.0095 = $1,059.07 aka old forward rate exchange --30-day return = $59.07/$1000 = 5.907%, nominal annual return = 12*5.907% = 70.88%

What is a cross rate?

-the exchange rate between any two currencies. Cross rates are actually calculated on the basis of various currencies relative to the U.S. dollar -cross rate between Australian dollar and the Japanese yen cross rate = (Yen/US$) * (US$/A$) =111.11 * 0.650 =72.22 Yen/A$ -the inverse of this cross rate yields 0.0138 A$/Yen --denominator is currency being expressed through numerator currency or 1 yen = 0.0138A$ for inverse rate -US$ > AUS$ > Yen in terms of value -ex: nominal interest rates or Inom = 12%; semi-annual rate = 12%/2=6%; mostly rate = 12%/12 = 1%

What is the international monetary system?

-the framework within which exchange rates are determined -exchange rate terminology: --spot vs. forward exchange rate --fixed vs. floating exchange rate --devaluation and revaluation --depreciation and appreciation -spot rate is the immediate exchange between two currencies -forward rate is the exchange rate the bank promise to give for future delivery -fixed rate is when you suspect currency will devalue so you ask for fixed rate to save yourself from losing money in an exchange; can be individual or country --most countries used floating rates hence why rates change all the time -if you are trading at a premium: your importers will be hurt but your exporters will be happy; weak U.S.$ -If you are trading at a discount: your exporters will be hurt but your importers will be happy; strong U.S.$ -depreciating - losing value; appreciating --gaining value: for floating rates -devaluation -- losing value; revaluation -- gaining value: for fixed rates

What makes a currency price an indirect quotation?

-the indirect quotation represents the number of units of a foreign currency needed to purchase one U.S. dollar. The indirect quotation is the reciprocal of the direct quotation. F/H or foreign/home -ex: Japanese Yen: 111.11 (Yen/$) Australian $: 1.5385 (A$/$) -how much $1 U.S. is worth in each currency

What is the exchange rate risk?

-the risk that the value of a cash flow in one currency translated to another currency will decline due to a change in exchange rates -ex: in determining profitability orange juice project slide, a weakening A$ (strengthening US$) would lower the U.S. dollar profit -when involved in international business you have risk because of the ever changing exchange risk; you run the risk of devaluing your profits through an exchange in a different country -profit = revenue - costs = $200,000 US - 80,000 euros; 2$/euro; $200,000 - (80,000 euros * 2$/euro) = $200,000 - $160,000 = $40,000 profit --6 months from now the exchange rate is now 2.5$/euro: $200,000 - (80,000 euros * $2.5/euro = $200,000 - $200,000 = $0 profit --the euro became more valuable hence the loss in profit --the euro is trading at a premium and the U.S.$ is trading at a discount

What is the difference between multinational financial management and domestic financial management?

1. different currency denominations- change with country's worth 2. political risk 3. language and cultural differences- can exist in the workplace because of varying backgrounds and offices in different countries could have very different cultures

Why do firms expand into other countries?

1. to seek production efficiency- lowest costs and highest revenues -profit = revenue - costs -lowest possible costs for highest production level 2. to avoid political and regulatory hurdles- illegal vs. legal products in different countries or in different states, for example: marijuana; better sold in different states or countries than NY because it's illegal recreationally here 3. to seek new markets- ex: smart phone available here but maybe not other places in the world then expand to those places if there is demand for those products 4. to seek raw materials and new technology- ex: if oil quota in US go to different country with no oil quota 5. to diversify- Ri = rRF + (rM-rRF0^Bi) - RM-rRF = MRP -all about risk: more countries, then the less they are impacted by the systematic risk of one country; the risk in one country through an international corporation is a non-systematic risk to consumers not in that country 6. to retain customers- either new or old by expanding to new areas closer to them or giving them products for cheap by finding lower costs in other countries

If the euro depreciates against the U.S. dollar, can a dollar buy more or fewer euros as a result? Explain.

A currency depreciates when its value is comparatively lower against another currency, meaning that more units of the currency would be needed to buy a unit of the other currency. If the euro depreciates and the U.S. dollar stays constant, then more euros will be needed to buy one U.S. dollar.

Orange Juice Project: Determining Profitability: The product will cost 250 yen to produce and ship to Australia, where it can be sold for 6A$. What is the U.S. dollar profit on the sale?

Cost in A$ = 250 Yen (0.0138) = 3.45 A$ A$ profit = 6 - 3.45 = 2.55A$ U.S.$ profit = 2.55/1.5385 = $1.66 US

What does freely floating mean?

Exchange rate determined by the market's supply and demand for the currency. Governments may occasionally intervene and buy or sell their currency to stabilize fluctuations. -simplified: no government intervention in exchange rate for their currency

INTEREST RATE PARITY: Six-month T-bills have a nominal rate of 2%, while default-free Japanese bonds that mature in 6 months have a nominal rate of 1.25%. In the spot exchange market, 1 yen equals $0.009. If interest rate parity holds, what is the 6-month forward exchange rate?

F 6-month / e0 = 1+rh / 1+rf F 6-month / 0.009 $/yen = (1 +0.02/2) / (1+0.0125/2) F 6-month = 1.0037 x 0.009 $/yen = 0.00903 $/yen *yen trading at premium*

Interest rate parity: US rate has changed to 2%, what is the forward rate?

F1 year/ 1$/pound = 1+2%/1+5% = 1.02/1.05 = 0.9714$/pound; 0.9714 $/pound is forward rate -pound is trading at a discount; pound is losing value or depreciating; $ is traded at premium -country that has a lower interest rate; their currency is going to appreciate --residents of country will want to invest in other country's currency and then trade their currency back which causes the lower interest rate -if UK is home country: F1 year/1 pound/$ = 1+5%/1+2% = 1.05/1.02 = 1.0294 pound/$ --dollar is appreciating or trading at a premium; pound is traded at a discount

Should firms require higher rates of return on foreign projects than on identical projects located at home? Explain.

Firms should require higher rates of return on foreign projects than on identical projects located at home because foreign projects have a higher risk. Projects with higher risk are usually associated with higher returns. This is turn, balances out the liability and the reward of the project. Oppositely, domestic projects have lower risk and therefore, lower returns because there does not have to be as much incentive offered to get a firm to participate in the project.

What are the fixed monetary agreements?

No local currency and currency board arrangement

What does managed floating mean?

Significant government intervention manages the exchange rate by manipulating the currency's supply and demand. The target exchange rates are kept secret to limit speculation. -government intervention at certain high and low extremes; want to keep rate in between certain bounds as to not hurt importers too much and not hurt exporters too much

What is a fixed peg arrangement?

The country "pegs" its currency to another (or a basket of currencies) at a fixed rate. Slight fluctuations are okay, but the rate must stay within a desired range. For example, the Chinese yuan is pegged to a basket of currencies.

What does currency board arrangement mean?

The country technically has its own currency but commits to exchange it for a specified foreign currency at a fixed exchanged rate (like Argentina before its January 2002 crisis).

What does no local currency mean?

The country uses either another country's currency as its legal tender (like the U.S.$ in Ecuador) or else belongs to a group of countries that share a currency (like the euro). -give up your monetary adjustment power; these countries have no monetary policy within their countries --countries then can only use fiscal policy; have model based by Keynes Y = C+I+G+(X-M) --EU was formed to compete with the US for senior reach power which is paying other countries in US$ because the US$ is worth the most and has the most power internationally ---Came together in size, population, international power to have currency be accepted as international currency

Why do U.S. corporations build manufacturing plants abroad when they can build them at home?

U.S. corporations build manufacturing plants abroad because they are trying to get production efficiency. They do this by moving production from higher cost countries to lower cost ones. They are searching for the lowest total per unit cost. They also build plants abroad to avoid political, trade, and regulatory barriers, to broaden markets, to find raw materials and new technology, to protect processes and products, to diversify, and to retain customers.

PPP: If grapefruit juice costs $2.00 per liter in the US and PPP holds, what is the price of grapefruit juice in Australia?

e0 = Ph/Pf 0.650 $/A$ = $2.00/Pf Pf = $2.00/0.650 $/A$ Pf = 3.0769 A$ -currency exchange: US$/AUS$ = 0.65

INTEREST RATE PARITY: Assume that interest rate parity holds and that 90-day risk-free securities yield a nominal annual rate of 3% in the United States and a nominal annual rate of 3.5% in the United Kingdom. In the spot market, 1 pound = $1.30. (a) What is the 90-day forward rate? (b) Is the 90-day forward rate trading at a premium or a discount relative to the spot rate?

f90 day/e0 = 1+rh/1+rf f90 day / 1.3$/pound = 1+ 3%/4 / 1+ 3.5%/4 f90 day/ 1.3$/pound = 1.0075/1.00875 f90 day = 1.3 $/pound * 0.99876 f90 day= 1.2984$/pound -90 days from today currency depreciates so pound is traded at discount and dollar is traded at premium because it appreciated

what is purchasing power parity (PPP)?

for prices in two countries to be equal, the exchange rate between the two countries must change by the difference between the domestic and foreign rates of inflation

What are the floating monetary agreements?

freely floating and managed floating

Evaluating interest rate parity: Suppose one yen buys $0.0095 in the 30-day forward exchange market and nominal interest rate (rNOM) in Japan and in the US is 4%.

ft = 0.0095 rh = 4%/12 = 0.333% rf = 4%/12 = 0.333% 0.0095/e0 = 1+0.333%/1+0.333% 0.0095/e0 = 1.333%/1.333% 0.0095/e0 = 1 e0 = 0.0095 -for interest rate parity to hold, e0 must equal $0.0095, but we were given earlier that e0=$0.0090, so interest rate parity does NOT hold (Japanese yen is undervalued) -buy undervalued assets and sell overvalued assets always so buy more yen and sell $

CROSS RATES: Suppose the exchange rate between the U.S. dollar and the Swedish krona was 8.8 krona = $1, and the exchange rate between the dollar and the British pound was 1 pound = $1.30. What would be the exchange rate between Swedish kronas and pounds?

given = 8.8 krona/$ given = 1.3$/pound - 8.8 krona/$ * 1.3$/pound = 11.44 krona/pound

what is interest rate parity (IRP)?

in an efficient market with no transaction costs, the interest rate differential between two countries should approximate the forward differential -Ft is forward exchange rate based on t which can be years--should be equal to spot rate in perfect world

What are the theoretical economic relationships that result from arbitrage?

interest rate parity (IRP) and purchasing power parity (PPP)

Orange Juice Project: Setting the Appropriate price: A firm can produce a liter of orange juice in the U.S. and ship it to Japan for $1.75. If the firm wants a 50% markup on the project, what should the juice sell for in Japan?

price in the U.S. = ($1.75)(1.50) = $2.625 price in Japan = ($2.625)(111.11 Yen/$) = 291.66 Yen

What is arbitrage?

the simultaneous purchase and sale of the same assets or commodities on different markets to profit from price discrepancies