Financial Management

(MBA 512)

Chapter 7 – International Finance

What are Multinational Corporations ?
• Multinational corporations (MNCs):
Businesses that operate in many countries
around the world.
• MNC is an entity that conducts business in
more than one jurisdiction;
• Financial managers of MNCs require an
understanding of the complexities of
international finance to make sound
financial and investment decisions.
 Goal of the MNC
• The commonly accepted goal of an MNC
is to maximize shareholder wealth.
 Conflicts Against the MNC Goal

• For corporations with shareholders who differ

from their managers, a conflict of goals can
exist - the agency problem.
• Agency costs are normally larger for MNCs
than for purely domestic firms.
– The sheer size of the MNC.
– The scattering of distant subsidiaries.
– The culture of foreign managers.
– Subsidiary value versus overall MNC value.
 Impact of Management Control
• The magnitude of agency costs can vary with the
management style of the MNC.
• A centralized management style reduces agency
costs.
• A centralized management style can reduce
agency costs because it allows managers of the
parent to control foreign subsidiaries and
therefore reduces the power of subsidiary
managers.
 Impact of Management Control
• Alternatively, a decentralized style gives more
control to those managers who are closer to
the subsidiary’s operations and environment.
• This style is more likely to result in higher
agency costs because subsidiary managers
may make decisions that do not focus on
maximizing the value of the entire MNC.
• Yet, this style gives more control to those
managers who are closer to the subsidiary’s
operations and environment.
 Centralized Multinational Financial Management
for an MNC with two subsidiaries, A and B

Cash Financial Cash

Management Managers Management
at A of Parent at B

Inventory and Inventory and

Accounts Accounts
Receivable Receivable
Management at A Management at B

Financing at A Financing at B

Capital Expenditures Capital Expenditures

at A at B
 Decentralized Multinational Financial Management
for an MNC with two subsidiaries, A and B

Cash Financial Financial Cash

Management Managers Managers Management
at A of A of B at B

Inventory and Inventory and

Accounts Accounts
Receivable Receivable
Management at A Management at B

Financing at A Financing at B

Capital Expenditures Capital Expenditures

at A at B
Theories of International Business

Why are firms motivated to expand

their business internationally?
Theory of Comparative Advantage
– Specialization by countries can increase
production efficiency.
Imperfect Markets Theory
– The markets for the various resources used in
production are “imperfect.”
Theories of International Business

Why are firms motivated to expand

their business internationally?

Product Cycle Theory

– As a firm matures, it may recognize additional
opportunities outside its home country.
 International
Business Methods
There are several methods by which firms
can conduct international business.
• International trade is a relatively
conservative approach involving exporting
and/or importing.
– The internet facilitates international trade by
enabling firms to advertise and manage orders
through their websites.
 International
Business Methods
• Licensing is an arrangement in which a company (licensor) sells the right
to use intellectual property, or produce a company’s product to the
licensee, for a negotiated fee i.e. royalty.

• Franchising is an arrangement in which the franchisor permits the

franchisee to use business model, brand name or process for a fee, to
conduct business, as an independent branch of the parent company
(franchisor).
 International
Business Methods
• Firms may also penetrate foreign markets by
engaging in a joint venture (joint ownership
and operation) with firms that reside in those
markets.
• Acquisitions of existing operations in foreign
countries allow firms to quickly gain control
over foreign operations as well as a share of
the foreign market.
 International
Business Methods
• Firms can also penetrate foreign markets by
establishing new foreign subsidiaries.
• In general, any method of conducting business
that requires a direct investment in foreign
operations is referred to as a Foreign Direct
Investment (FDI).
• The optimal international business method
may depend on the characteristics of the
MNC.
 Concept Questions
1. Why Firms Pursue International Business?

2. Why might agency costs be larger for an

MNC than for a purely domestic firm?
3. How Firms Engage in International Business?

4. Would the agency problem be more pronounced for

ABC Corp., which has its parent company make most
major decisions for its foreign subsidiaries, or XYZ
Corp., which uses a decentralized approach?
 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.
 International Financial Management
• Management-main objective is wealth maximization of
shareholders:

– Investment decision

– Financing decision

– Risk management decision

 Role of International Financial
institutions

• International Monetary Fund (IMF)

• The World Bank (IBRD)
• International Finance Corporation (IFC)
• Africa Development Bank (AfDB)
 International Monetary Fund
• Established in 1944 as an element of the Breton Woods
system
• 189 member countries;
• It has the following objectives:
– Promote cooperation among countries on international
monetary issues
– Promote stability of exchange rates
– Provide temporary funds to countries to correct international
payment imbalances
 International Monetary Fund
• Objectives:
– Provide free mobility of capital across countries
– Promote free trade
– During the Breton woods era IMF would maintain fixed
exchange rate system
– Post-Breton woods era, the fund engaged more on helping
nations correct payment balances
– It also extended loans to countries with difficulty in servicing
their financial obligations
 The World Bank
• Established to provide long-term loans to promote
economic growth and also encourage international
trade
• The main sources of funds are sales of debt and other
instrument to private investors and governments
• To become a member of the Bank, a country must first
join the (IMF).
• 189 member countries;
 International Finance Corporation

• Established in 1956 to promote private sector

development across the world
• Comprises countries as its members
• Provides loans to corporations and buys their
shares;
• 184 member countries;
 African Development Bank (AfDB)
• Established in 1964 in Khartoum
• Membership of the AfDB Group at the end of May 2015,
comprised 54 African countries and 26 non-African countries.
• Provides loans aimed at alleviating poverty and enhancing
economic growth
• Has ministers and high-level officials of economic and
financial institutions of member countries as board of
governors
 Exchange Rates
• An exchange rate is the relative price of two
currencies;
• Rather than write out the full name of these
currencies, contractual parties use abbreviations.
• In banking and commercial transactions, it is
important that all parties understand which
currencies are being used. Hence, there is a need
for standardization of the abbreviations.
• The International Organization for Standardization
(called ISO from the Greek word for equal) sets
these standards.
 Cont’d
• In most cases, the abbreviation is the ISO two-digit
country code plus a letter from the name of the currency.
Country Currency ISO Currency Code
Ethiopia Birr ETB
Egypt Pound EGP
European Union Euro (€) EUR
India Rupee INR
Japan Yen (¥) JPY
Saudi Arabia Riyal SAR
South Korea Won KRW
United Kingdom Pound (£) GBP
United States Dollar ($) USD
 Exchange Rate Systems
• Exchange rate: the price of one currency in
terms of another currency.
• Floating exchange rate: An exchange rate
system in which a currency’s value is allowed to
fluctuate in response to market forces.
• Fixed exchange rate: An exchange rate system in
which the price of one currency is fixed relative
to all other currencies by government
authorities.
• Managed floating rate system:- A hybrid currency
system in which a government loosely fixes the
value of the national currency.
• Currency board arrangement:- An exchange rate
system in which each unit of the domestic
currency is backed by a unit of some foreign
currency.
• In such an arrangement, the national currency
continues to circulate, but every unit of the
currency is fully backed by government holdings of
another currency— usually the U.S. dollar.
• The International Monetary Fund, in its April 2003 issue
of International Financial Statistics, detailed the
exchange rate systems in place for 186 countries.
• 41 countries had independently floating exchange rates,
40 had conventional fixed exchange rates, 33 had
managed floats, 39 used another currency as their
country’s legal tender (including the 12 Western
European countries using the euro), 8 maintained
currency boards, and 15 maintained some other type of
hybrid system.
• In terms of trading volume, the major currencies in
international finance today are (in no particular order)
the British pound sterling (£), the Swiss franc (SF), the
Japanese yen (¥), the Canadian dollar (C$), the U.S.
dollar (US$, or simply $), and the euro (€).
 How a currency is quoted?
• Direct quote: An exchange rate quoted in
terms of units of domestic currency per unit of
foreign currency.
USD/BIRR = 23.22
• Indirect quote: An exchange rate quoted in
terms of foreign currency per unit of domestic
currency.
BIRR/USD = 0.04
 Bid/Ask Price
• A currency exchange rate is typically given as a bid
price and an ask price.
• The Bid price is always lower than the ask price.
• The bid price represents what will be obtained in
the quote currency when selling one unit of the
base currency.
• The Ask Price represents what has to be paid in the
quote currency to obtain one unit of the base
currency.
• A Spread is the amount by which the ask price
exceeds the bid price for an asset in the market.
 Foreign Exchange Market

➢Spot transaction

➢Currency forward

➢Currency future

➢Currency options

➢Currency swaps
• Spot trade is an agreement to exchange currency
“on the spot,” which actually means that the
transaction will be completed or settled within
two business days.
• A forward trade is an agreement to exchange
currency at some time in the future.
• The exchange rate that will be used is agreed
upon today and is called the forward exchange
rate.
• A forward trade will normally be settled sometime
in the next 12 months.
• The spot rate is the exchange rate for immediate
delivery of currencies exchanged, while the forward
rate is the exchange rate for later delivery of
currencies exchanged. For example, there may be a
90-day exchange rate.
• The forward exchange rate of a currency will be slightly
different from the spot rate at the current date
because of future expectations and uncertainties.
• Forward rates may be greater than the current spot
rate (premium) or less than the current spot rate
(discount).
• For example, the spot exchange rate for the
Swiss franc is SF 1 $.7210. The 180-day (6-
month) forward exchange rate is SF 1 $.7342.

• This means that you can buy a Swiss franc

today for $.7210 or you can agree to take
delivery of a Swiss franc in 180 days and pay
$.7342 at that time.
• Notice that the Swiss franc is more expensive in
the forward market ($.7342 versus $.7210).
Because the Swiss franc is more expensive in the
future than it is today, it is said to be selling at a
premium relative to the dollar. For the same
reason, the dollar is said to be selling at a discount
relative to the Swiss franc.
• Why does the forward market exist?
• One answer is that it allows businesses and
individuals to lock in a future exchange rate today,
thereby eliminating any risk from unfavorable
shifts in the exchange rate.
 Futures
• A Future is a contract to buy or sell a standard quantity and quality
of an asset or security at a specified date and price.

• Futures are similar to Forward Contracts, but are standardized and

traded on an exchange, and are valued daily.

• Unlike Forward Contracts, the counterparty to the buyer or seller

in a Futures contract is the clearing corporation on the
appropriate exchange.

• Futures often are settled in cash or cash equivalents, rather than

requiring physical delivery of the underlying asset.
 Swaps
• A Swap is a simultaneous buying and selling of the same security
or obligation.

• Currency swaps - substitution of one debt denominated in one

currency by another denominated in a different currency.

• Financial institutions may act as a broker or a counterpart or an

intermediary.

• Swaps may involve cross-currency payments (U.S. Dollars vs.

Mexican Pesos) and cross-market payments, e.g., U.S. short-term
rates vs. U.K. short-term rates.
 Options
• The purchaser of an Option has rights (but not obligations) to buy
or sell the asset during a given time for a specified price (the
"Strike" price). An Option to buy is known as a "Call," and an
Option to sell is called a "Put. "

• The seller of a Call Option is obligated to sell the asset to the

party that purchased the Option. The seller of a Put Option is
obligated to buy the asset.

• In a “Covered” Option, the seller of the Option already owns the

asset. In a “Naked” Option, the seller does not own the asset

• Options are traded on organized exchanges and OTC.

 Parity conditions in international
finance and Currency Forecasting
• Factors affecting exchange rate
– Rate of inflation (PPP)

– Interest rate (IRP)

– Balance of payment

– Foreign exchange reserve

 Purchasing Power Parity (PPP)
• Purchasing power parity (PPP): The idea that the exchange rate
adjusts to keep purchasing power constant among currencies.

• Purchasing power of a currency is determined by the amount of

goods/services that can be purchased with one unit of currency.

• Levels of appreciations/depreciation

• Deviations from PPP

– Difference in the components of the index
– Trade barriers
– Disregard capital movement
– Government intervention on the exchange market
 Interest Rate Parity relationship
• John M. Keynes, in the 1920s

• Premium or discount of one currency against

another country reflects interest rate differential
between the two countries

• Reasons for deviation from IRP

– Capital control

– Transaction cost
 Exchange rate and BoP
• When a country is importing more than it exports, the
demand for foreign currency increases leading to
deprecation of local currency

• Conversely, when a country exports more than it imports,

the demand for foreign currency exceeds the supply
leading to appreciation of local currency

• In this process, apart from the trade flow, capital flow

plays a role.
 Exchange rate & foreign exchange
reserve
• Reserves are kept to meet obligations; namely debt service and
import payments

• The relationship can be explained by the “perception” of

economic agents

• Depletion of reserve below some level may be perceived as signs

of some sort of problem, subsequently leading to depreciation of
domestic currency

• Building up of reserve may lead to a positive perception and is

likely to harden the domestic currency
END