INTERNATIONAL FINANCIAL

MANAGEMENT

Alan C. Shapiro
and
Peter Moles

WlLEY

CONTENTS

PREFACE
xvii
SELECTED CURRENCIES AND SYMBOLS
SYMBOLS AND ACRONYMS
xxi

xix

PART 1 THE GLOBAL FINANCLAL MANAGEMENT ENVIRONMENT

1

INTRODUCTION TO INTERNATIONAL FINANCIAL MANAGEMENT

1.1 The Rise ofthe International Company 5

Evolution ofthe Multinational Corporation 9
The Process of Overseas Expansion by Multinational 18
A Behavioral Definition ofthe Multinational Corporation 21
The Global Manager 24
1.2 The Internationalization of Business and Finance 24
Political and Labor Union Concerns about Global Competition 25
Consequences of Global Competition 32
1.3 International Financial Management: Theory and Practice 36
Criticisms ofthe International Corporation 37
Functions of Financial Management 37
Theme of This Text 38
Relationship to Domestic Financial Management 38
The Importance of Total Risk 40
The Global Financial Marketplace 41
The Role ofthe Financial Executive in an Efficient Market 41
1.4 Outline ofthe Text 42
The Global Financial Management Environment 42
Currency and Derivatives Markets 42
Managing Currency Risks 42
Financing International Operations 43
International Capital Budgeting 43
International Management of Working Capital 43
APPENDIX 1A The Origins and Consequences of International Trade 45
The Gains from Trade 46
Specialized Factors of Production 47
Monetary Prices and Exchange Rates 48
Tariffs 49

Bfli

I CONTENTS
2

EXCHANGE RATE DETERMINATION

51

2.1 Setting the Equilibrium Spot Exchange Rate 52

Demand for a Currency 52
Supply of a Currency 52
Factors that Affect the Equilibrium Exchange Rate 53
Calculating Exchange Rate Changes 54
2.2 Expectations and the Asset Market Model of Exchange Rates 58
The Nature of Money and Currency Values 61
Central Bank Reputations and Currency Values 63
2.3 The Fundamentals of Central Bank Intervention 73
How Real Exchange Rates Affect Relative Competitiveness 73
Foreign Exchange Market Intervention 74
The Effects of Foreign Exchange Market Intervention 78
2.4 The Equilibrium Approach to Exchange Rates 80
Disequilibrium Theory and Exchange Rate Overshooting 80
The Equilibrium Theory of Exchange Rates and Its Implications 82
2.5 Summary and Conclusions 83
3

THE INTERNATIONAL MONETARY SYSTEM

87

3.1 Alternative Exchange Rate Systems 88

The Trilemma and Exchange Rate Regime Choice 89
Free Float 91
Managed Float 93
Target-Zone Arrangement 94
Fixed-Rate System 94
3.2 A Brief History of the International Monetary System 97
The Classical Gold Standard 99
How the Classical Gold Standard Worked in Practice: 1821-1914 100
The Gold Exchange Standard and Its Aftermath: 1925-1944 100
The Bretten Woods System: 1946-1971 103
The Post-Bretton Woods System: 1971 to the Present 105
Assessment of the Floating-Rate System 108
3.3 The European Monetary System and Monetary Union 109
The Exchange-Rate Mechanism 109
Lessons from the European Monetary System 109
The Currency Crisis of September 1992 110
The Exchange Rate Mechanism is Abandoned in August 1993 111
European Monetary Union 112
Optimum Currency Area 118
Lessons from EMU and the Euro 128
Exchange Rate Regimes Today 129
3.4 Emerging Market Currency Crises 129
Transmission Mechanisms 129

CONTENTS
Origins of Emerging Market Crises 130
Policy Proposais for Dealing with Emerging Market Crises 131
3.5 Summary and Conclusions 132

CURRENCIES: EXPECTATIONS, PARITIES, AND FORECASTING

135

4.1 Arbitrage and the Law of One Price 135

4.2 Purchasing Power Parity 138
The Lesson of Purchasing Power Parity 142
Expected Inflation and Exchange Rate Changes 144
The Monetary Approach 145
Empirical Evidence 145
4.3 The Fisher Effect 147
Empirical Evidence 149
4.4 The International Fisher Effect 153
Empirical Evidence 155
4.5 Interest Rate Parity Theory 157
Empirical Evidence 161
4.6 The Relationship Between the Forward Rate and the Future Spot Rate 162
Empirical Evidence 164
4.7 Currency Forecasting 165
Requirements for Successful Currency Forecasting 166
Market-Based Forecasts 166
Model-Based Forecasts 168
Model Evaluation 169
Forecasting Controlled Exchange Rates 171
4.8 Summary and Conclusions 171

THE INTERNATIONAL MONETARY SYSTEM AND THE BALANCE OF PAYMENTS

5.1 Balance-of-Payments Categories 179
Current Account 181
Capital Account 182
Financial Account 182
Balance-of-Payments Measures 183
The Missing Numbers 184
5.2 The International Flow of Goods, Services, and Capital 184
Domestic Saving and Investment and the Financial Account 185
The Link between the Current and Financial Accounts 186
Government Budget Deficits and Current-Account Deficits 189
The Current Situation 190
5.3 Coping with the Current-Account Deficit 193
Currency Depreciation 193
Protection ism 198

178

CONTENTS
Ending Foreign Ownership of Domestic Assets 199
Boosting the Saving Rate 199
Adjusting Global Economic Policies 201
Current-Account Deficits and Unemployment 202
The Bottom Line on Current-Account Deficits and Surpluses 202
5.4 Summary and Conclusions 203
6

COUNTRYRISK

208

6.1 Measuring Political Risk 209

Political Stability 210
Economic Factors 210
Subjective Factors 210
6.2 Economic and Political Factors Underlying Country Risk 218
Fiscal Irresponsibility 219
Monetary Instability 222
Controlled Exchange Rate System 223
Wasteful Government Spending 223
Resource Base 223
Country Risk and Adjustment to External Shocks 224
Market-Oriented Versus Statist Policies 225
Key Indicators of Country Risk and Economic Health 229
6.3 Country Risk Analysis in International Lending 236
The Mathematics of Sovereign Debt Analysis 236
Country Risk and the Terms of Trade 238
The Government's Cost/Benefit Calculus 239
Lessons from the International Debt Crisis 242
6.4 Summary and Conclusions 243
PART 2 CURRENCY AND DERIVATIVES MARKETS
7

CURRENCY MARKETS

249

7.1 Organization ofthe Foreign Exchange Market 250

The Participants 251
Size 255
7.2 The Spot Market 257
Spot Quotations 257
The Mechanics of Spot Transactions 264
7.3 The Forward Market 265
Forward Quotations 266
Forward Contra et Maturities 269
7.4 Summary and Conclusions 269

^ONTENTS [
8

CURRENCY DERIVATIVES

272

8.1 Futures Contracts 272

Forward Contract versus Futures Contract 274
8.2 Currency Options 279
Market Structure 280
Using Currency Options 282
Option Pricing and Valuation 287
Using Forward or Futures Contracts Versus Options Contracts 288
Futures Options 294
8.3 Reading Currency Futures and Options Prices 295
8.4 Summary and Conclusions 297
APPENDIX 8A Option Pricing Using Black-Scholes 299
Implied Volatilities 301
Shortcomings of the Black-Scholes Option Pricing Model 302
APPENDIX 8B Put-Call Option Interest Rate Parity 302
9

INTEREST RATE DERIVATIVES

306

9.1 Interest Rate and Currency Swaps 306

Interest Rate Swaps 307
Currency Swaps 310
Economic Advantages of Swaps 318
9.2 Interest Rate Forwards and Futures 318
Forward Forwards 318
Forward Rate Agreement 319
Short-Term Interest Rate Futures 320
9.3 Structured Notes 322
Inverse Floaters 323
Callable Step-Up Note 324
Step-Down Coupon Note 324
9.4 Credit Default Swaps 324
9.5 Summary and Conclusions 326

PART 3 MANAGING CURRENCY RISKS

10

TRANSLATION AND TRANSACTION EXPOSURE

10.1

33I

Alternative Measures of Foreign Exchange Exposure 332

Translation Exposure 332
Transaction Exposure 332
Operating Exposure 333

13

CONTENTS

10.2

Alternative Currency Translation Methods 334

Current/Noncurrent Method 334
Monetary/Nonmonetary Method 334
Temporal Method 335
Current Rate Method 335
10.3 Transaction Exposure 335
10.4 Designing a Hedging Strategy 337
Objectives 338
Costs and Benefits of Standard Hedging Techniques 340
Centralization versus Decentralization 343
Managing Risk Management 344
Accounting for Hedging under IFRS 345
Empirical Evidence on Hedging 346
10.5 Managing Translation Exposure 347
Funds Adjustment 347
Evaluating Alternative Hedging Mechanisms 348
10.6 Managing Transaction Exposure 349
Forward Market Hedge 350
Money Market Hedge 351
Risk Shifting 354
Pricing Decisions 355
Exposure Wetting 355
Currency Risk Sharing 356
Currency Collars 358
Cross-Hedging 360
Foreign Currency Options 361
10.7 Summary and Conclusions 364
APPENDIX 10A Currency Translation in Practice 369

11

ECONOMIC EXPOSURE
11.1

373

Foreign Exchange Risk and Economic Exposure 374

Real Exchange Rate Changes and Exchange Risk 375
Importance ofthe Real Exchange Rate 376
Inflation and Exchange Risk 376
Competitive Effects of Real Exchange Rate Changes 377
11.2 The Economic Consequences of Exchange Rate Changes 379
Transaction Exposure 380
Operating Exposure 380
11.3 Identifying Economic Exposure 383
Pia Seau Beach Resort 383
Petrleos Mexicanos 385
Toyota Motor Company 385

CONTENTS
11.4

Calculating Economic Exposure 386

Spectrum's Accounting Exposure 387
Spectrum's Economic Exposure 387
11.5 An Operational Measure of Exchange Risk 391
Limitations 392
11.6 Managing Operating Exposure 393
Marketing Management of Exchange Risk 394
Production Management of Exchange Risk 396
Flanning for Exchange Rate Changes 398
Financial Management of Exchange Risk 400
11.7 Summary and Conclusions 404

PART 4
12

FINANCING INTERNATIONAL OPERATIONS

INTERNATIONAL AND DOMESTIC CAPITAL MARKETS

12.1

12.2

12.3

12.4
12.5
13

Corporate Sources and Uses of Funds 412

Financial Markets versus Financial Intermediaries 412
Financial Systems and Corporate Governance 413
Globalization of Financial Markets 416
Domestic Capital Markets as International Financial Centers 419
International Financial Markets 422
Foreign Access to Domestic Markets 423
Globalization of Financial Markets Has Its Downside 428
Development Banks 429
The World Bank Group 430
Regional and National Development Banks 431
Regional Development Banks 431
Private Sector Alternatives 432
Project Finance 433
Summary and Conclusions 435

INTERNATIONAL FINANCIAL MARKETS

13.1

13.2

411

438

The Eurocurrency Market 438

Modern Origins 439
Eurodollar Creation 439
Eurocurrency Loans 441
Relationship Between Domestic and Eurocurrency Money Markets 443
Euromarket Trends 444
Eurobonds 445
To be confirmed Swaps 445
Links Between the Domestic and Eurobond Markets 445

CONTENTS

13.3

13.4
13.5
13.6

14

Rationale for Existence of Eurobond Market 449

Eurobonds versus Eurocurrency Loans 450
Note Issuance Facilities and Euronotes 451
Note Issuance Facilities versus Eurobonds 453
Euro-Medium-Term Notes 453
Euro-Commercial Paper 455
The Asiacurrency Market 456
Summary and Conclusions 457

THE INTERNATIONAL COST OF CAPITAL

459

14.1 The Cost of Equity Capital 460

14.2 The Weighted Average Cost of Capital for Foreign Projects 461
14.3 Discount Rates for Foreign Investments 462
Evidence From the Stock Market 463
Key Issues in Estimating Foreign Project Discount Rates 464
Proxy Companies 465
The Relevant Base Portfolio 466
The Relevant Market Risk Premium 470
Recommendations 471
14.4 The Cost of Debt Capital 471
Annual Exchange Rate Change 472
Using Sovereign Risk Spreads 473
14.5 Establishing a Worldwide Capital Structure 473
Foreign Subsidiary Capital Structure 474
Joint Ventures 479
14.6 Valuing Low-Cost Financing Opportunities 479
Taxes 481
Government Credit and Capital Controls 482
Government Subsidies and Incentives 482
14.7 Summary and Conclusions 484

PART 5 INTERNATIONAL CAPITAL BUDGETING

15

INTERNATIONAL PORTFOLIO INVESTMENT

491

15.1 The Risks and Benefits of International Equity Investing 491

International Diversification 493
Investing in Emerging Markets 501
Barriers to International Diversification 506
15.2 International Bond Investing 509
15.3 Optimal International Asset Allocation 509

CONTENTS
15.4

Measuring the Total Return from Foreign Portfolio Investing 510

Bonds 511
Stocks 511
15.5 Measuring Exchange Risk on Foreign Securities 512
Hedging Currency Risk 512
15.6 Summary and Conclusions 513
16

STRATEGIES FOR FOREIGN DIRECT INVESTMENT

517

16.1

Theory of the Multinational Corporation 518

Product and Factor Market Imperfections 518
Financial Market Imperfections 519
16.2 The Strategy of Multinational Enterprise 520
Innovation-Based Multinationals 520
The Mature Multinationals 520
The Senescent Multinationals 523
Foreign Direct Investment and SurvivaI 523
16.3 Designing a Global Expansion Strategy 527
Awareness of Profitable Investments 528
Selecting a Mode of Entry 528
Auditing the Effectiveness of Entry Modes 529
Using Appropriate Evaluation Criteria 529
Estimating the Longevity of a Competitive Advantage 530
16.4 Summary and Conclusions 530
17

INTERNATIONAL CAPITAL BUDGETING

17.1

17.2

17.3

17.4

17.5
17.6

534

Basics of Capital Budgeting 535

Net Present Value 535
Incremental Cash Flows 536
Alternative Capital-Budgeting Frameworks 538
Issues in Foreign Investment Analysis 540
Parent versus Project Cash Flows 540
Political and Economic Risk Analysis 542
Exchange Rate Changes and Inflation 543
Foreign Project Appraisal: The Caseof International Machine Tools 544
Estimation of Project Cash Flows 544
Estinnation of Parent Cash Flows 549
Political Risk Analysis 552
Expropriation 552
Blocked Funds 553
Growth Options and Project Evaluation 554
Summary and Conclusions 556

CONTENTS

ESI

APPENDIX 17A Managing Political Risk 559

Pre-investment Flanning 559
Operating Policies 561
PART 6 INTERNATIONAL MANAGEMENT OF WORKING CAPITAL
18

INTERNATIONAL TRADE MANAGEMENT

18.1

18.2

18.3

18.4

18.5
18.6
19

Payment Terms in International Trade 568

Cash in Advance 568
Documentary Credit 568
Draft 573
Consignment 576
Open Account 576
Banks and Trade Financing 576
Collecting Overdue Accounts 577
Documents in International Trade 577
Bill of Lading 577
Commercial Invoice 578
Insurance Certificate 578
Consular Invoice 578
Financing Techniques in International Trade 579
Bankers' Acceptances 579
Discounting 581
Factoring 581
Forfaiting 582
Government Sources of Export Financing and Credit Insurance 582
Export Financing 583
Export-Credit Insurance 585
Taking Advantage of Government-Subsidized Export Financing 586
Countertrade 586
Summary and Conclusions 589

MANAGING WORKING CAPITAL

19.1

567

592

International Cash Management 593

Organization 593
Collection and Disbursement of Funds 594
Payments Wetting in International Cash Management 596
Management ofthe Short-Term Investment Portfolio 600
Optimal Worldwide Cash Levels 602
Cash Flanning and Budgeting 602
Bank Relations 605

CONTENTS ^
19.2

Accounts Receivable Management 606

Credit Extension 606
19.3 Inventory Management 607
Production Location and Inventory Control 607
Advance Inventory Purchases 608
Inventory Stockpiling 608
19.4 Short-Term Financing 608
Key Factors in Short-Term Financing Strategy 609
Short-Term Financing Objectives 610
Short-Term Financing Options 610
Calculating the Costs of Alternative Financing Options 614
19.5 Summary and Conclusions 616
20

FINANCIAL MANAGEMENT FOR THE GLOBAL ENTERPRISE

20.1

620

The Value of the Multinational Financial System 621

Mode of Transfer 621
Tinning Flexibility 621
Value 623
20.2 Intercompany Fund-Flow Mechanisms: Costs and Benefits 624
Tax Factors 624
Transfer Pricing 625
Reinvoicing Centers 628
Fees and Royalties 629
Leading and Lagging 630
Intercompany Loans 632
Dividends 634
Equity versus Debt 637
20.3 Designing a Global Remittance Policy 640
Prerequisites 641
Information Requirements 641
Behavioral Consequences 642
20.4 Summary and Conclusions 642
GLOSSARY
INDEX

645
679