Lecture Notes for International Finance (FIN 435)CH2. INTERNATIONAL MONETARY SYSTEM* FORECASTING EXCHANGE RATESCH 8, 9, 10, EXCAHGE RATE RISK EXPOSURES AND MANAGEMENTLecture Notes for International Finance (FIN 435)CH 1. GLOBALIZATION AND THE MULTINATIONAL FIRM* WHY BUSINESS?* WHAT NEEDED?* MAJOR FINANCIAL DECISIONS?* WHY INTERNATIONAL BUSINESS? – MORE OPPORTUNITIES: INCREASEDREVENUE AND/OR REDUCED COSTS => MULTI-NATIONAL CORPORATIONS(MNCs)* WHAT MAKES INTERNATIONAL BUSINESS UNIQUE? 1. EXPANDED OPPORTUNITY SET and COMPARATIVE ADVANTAGE (DavidRicardo) 2. ADDITIONAL RISKS2.1 EXCHANGE RISK: AN ELEMENT OF CASHFLOW VARIABILITY THAT ISDUE TO CURRENCY FLUCTUATIONS. $ VALUE OF FOREIGN CURRENCYDENOMINATED CASHFLOWS CHANGES. ASIDE: EXCH. RATE? : Relative value of two currencies Also note the difference between American terms and Europeanterms. Example: 800 won/$ IN NOVEMBER 1997 AND 1600 won/$ INDECEMBER 1997. IF A US FIRM MADE A $ 1M SALE (=800 MILLION won) INNOVEMBER, 1997 AND RECEIVED AN A/R DENOMINATED IN won THATMATURED IN DECEMBER 1997, THEN HOW MUCH DID THE COMPANY LOSE?2.2 POLITICAL RISK: ARISES SINCE A SOVERIGN COUNTRY CAN CHANGETHE “RULES OF THE GAME”3. MARKET IMPERFECTIONS: INTERNATIONAL MARKET IS NOT PERFECT INTHE SENSE THERE ARE MANY MARKET FLICTIONS SUCH AS TRANSACTIONSCOSTS (E.G., TRANSPORTATION COSTS), GOVERNMENT REGULATIONS,DIFFERENT TAXES, TARIFFS, AND RESTRICTIONS ON FOREIGN INVESTMENTS.Example: Nestlé HAS BEARER SHARES AND REGISTERED SHARES.* MNC GOAL: MAXIMIZING THE VALUE OF THE ENTIRE MNC!- AGENCY CONFLICTS p.81* WORLD ECONOMY: RECENT TRENDS - EMERGENCE OF GLOBALIZED MARKETS - LIBERALIZATION - ECONOMIC INTEGRATION - PRIVATIZATION - TECHNOLOGY (Internet)* MNC: A most advanced form of the multinational enterprise, incorporated inone country and doing business in several other countries via globalcoordination by a single centralized management. Examples: GE, FORD,ROYAL DUTCH/SHELL, - - - * MULTINATIONAL FINANCIAL MGT - FIRMS HAVE TO MAKE THE FOLLOWING DECISIONS: CAPITAL BUDGETING AND INVESTMENTS, CAPITAL STRUCTURE, WORKING CAPITAL MGT, DIVIDENDPOLICY AND REINVESTMENT. MNCs DO THE SAME, BUT ALL SUBJECT TO UNIQUE ASPECTS OF INTERNATIONAL BUSINESS:* MNC PATTERNS: 1. RAW-MATERIALS SEEKERS: 2. MARKET SEEKERS: OFTEN IN RESPONSE TO ANY RESTRICTIONS ON THEIREXPORTS TO THE MKT. 3.COST MINIMIZERS: PRODUCE GOODS IN LOWER-COST AREAS OVERSEAS INORDER TO BE COST-COMPETITIVE.* EVOLUTION: INTL TRADE (IMPORT/EXPORT) => SETTING UP A FOREIGN SALES SUBSIDIARYFOR DISTRIBUTION => SECURING LICENSING AGREEMENTS => FRANCHISING=> JOINT VENTURES => EVENTUALLY ESTABLISHING A FOREIGN SUBSIDIARYREF) MOVING TO NEXT STAGE => RISKIER, BUT MORE OPPORTUNITIES* IMPORTANT CONCEPTS OF FINANCIAL MGT (FIN331-333) 1. ARBITRAGE; ACTIONS TO MAKE PROFITS WITHOUT TAKING ADDITIONALRISK => IF THE MKT IS PERFECT, THERE IS NO ARBITRAGE IE, LAW OF ONEPRICE PREVAILS. 2. MKT EFFICIENCY: NEW INFO IS READILY INCORPORATED IN SECURITYPRICES. => NO ABNORMAL RETURNS 3. CAPITAL ASSET PRICING: SECURITIES ARE VALUED IN TERMS OF THEIREXPECTED RISKS AND RETURNS.* MULTINATIONAL FINANCIAL MGT 1. MECHANISM OF FINANCIAL TRANSACTIONS WITHIN THE MNC: IT CANEASILY MOVE GOODS, SERVICES, CAPITAL, AND PROFITS AMONG ITS VARIOUSAFFILIATES AND SUBSIDIARIES THROUGH THE INTERNAL INTERNATIONALTRANSFER MECHANISM TO MAXIMIZE THE GLOBAL VALUE OF THE FIRM.1) MODE OF TRANSFER: Freedom in the selection of financial channels.2) TIMING FLEXIBILITY: Payment schedule can be accelerated or delayed.3) REDUCTION OF GLOBAL TAX PAYMENTS: Shifting profits from high-taxto lower-tax nations to reduce its global tax payments. 2. FACTORS TO CONSIDER AS A CFO IN MNC – UNIQUE ASPECTS OF INTLBUSINESS* INTL OPPORTUNITIES AND EXPOSURE TO INTL RISKS* VALUATION MODEL FOR AN MNC USING THE QUOTATION TABLE (pacific.commerce.ubc.ca/xr/) 1. WHAT IS THE NATIONAL CURRENCY OF INDIA, JAPAN, RUSSIA, SOUTH KOREA,and SPAIN? 2. US $ EQUIV. (S) VS. FOREIGN (LOCAL) CURRENCY (FC) PER US $ (1/S)? EX1) WHAT IS THE yen/US $ RATE OF MAY 28, 2002?EX2) US $/euro ? NOTE: CURRENCIES WHICH HAVE “S” GREATER THAN 1? MEANING?3. APPRECIATION OF A FC (AGAINST US $): (S1-S0)/S0 (USE oanda.com, for % changes) EX) euro APPRECIATION (VIA-A-VIS US $) FROM 5/23 TO 5/28? <=> US $ APPRECIATION (VIS-A-VIS LC) = (1/S1 - 1/S0) / (1/S0) = (S0-S1)/S1 EX) US $ APPRECIATION AGAINST euro FROM 5/23 TO 5/28? NOTE: FC APPRECIATION RATE AND US $ APPRECIATION RATE AGAINST THE FC IS DIFFERENT. EX) $/TW FROM .4 TO .8?4. SDR: SPECIAL DRAWING RIGHTS (read the PACIFIC) euro: EU’s5. CURRENCY CROSS-RATES. FC1/FC2 = (FC1/$)*($/FC2) = (1/S1)*S2 EX) £/¥ AT THIS MOMENT (finance.yahoo.com)? of 5/27 (oanda.com)? EX) 6. FWD RATE (from PACIFIC to bmo.com/economic/regular/fxrates.html) - FWD CONTRACT: A COMMITMENT TODAY TO TRANSACT IN THE FUTURE ATTHE TODAY'S AGREED-UPON TERMS. MONEY DOES NOT CHANGE HANDSTODAY IE, NO INVESTMENTSCH2. INTERNATIONAL MONETARY SYSTEM* ALTERNATIVE EXCHANGE RATE SYSTEMS 1. FREE FLOAT: EXCH RATES ARE DETERMINED SOLELY BY THE INTERACTIONOF CURRENCY SUPPLY & DEMAND (OR MKT FUNDAMENTALS)-EXCHANGE RATE EQUILIBRIUM AND FREE FLOAT: EXCH RATES AREDETERMINED BY THE INTERACTION OF CURRENCY SUPPLY & DEMAND (OR MKTFUNDAMENTALS) => EXTERNAL SHOCKS: INFLATION RATES, INTEREST RATES, INCOMELEVLES, GOVERNMENT CONTROLS, EXPECTATIONS, ETC.*Difference between a shift in demand/supply separately in response to a non-price external shock and a move along the curve. - e.g., external shock (e.g., new discovery of nutritional facts about TWs) =>increased demand shift for TWs => increased price of TW and equilibriumquantity of TWs sold(bought) without a change in supply curve. A shift in ddcurve is not affecting the ss curve! An increase in the quantity sold (demandinduced increase in supply) is not due to a change (or shift) in the supplycurve!*INTERACTION OF FACTORS. *FOREIGN CURRECNY INDEX 2. MANAGED FLOAT: BASICALLY, A FLOATING SYSTEM. GOVERNMENTSINTERVENE IN THE FOREIGN EXCH MARKET TO SMOOTH OUT EXCH RATEFLUCTUATIONS. 3. TARGET-ZONE