Fall 2010 Final Exam Notes

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International Finance Final Exam Notes (Chapter 9,10,13,14,17)

Contents

Chapter 9 pg 250

Hedging Decision - MNCs constantly face the decision of whether to hedge future payables and receivables in foreign currencies. Whether a firm hedges may be determined by its forecasts of foreign currency values.

Example: Laredo Co. based in the US, plans to pay for clothing imported from Mexico in 90 days. If the forecasted value of the peso in 90 days is sufficiently below the 90-day forward rate, the MNC may decide not to hedge. Forecasting may enable the firm to make a decision that will increase its cash flows.

Short-Term Financing Decision - when large corporations borrow they have access to several different currencies. The currency they borrow will ideally: exhibit a low interest rate and weaken in value over the financing period.

Example: Westbury Co considers borrowing Japanese yen to finance its US operations because the yen has a low interest rate. If the yen depreciates against the US dollar over the financing period, the firm can pay back the loan with fewer dollars (when converting those dollars in exchange for the amount owed in yen). The decision of whether to finance with yen or dollars is dependent on a forcaste of the future value of the yen.

Short-Term Investment Decision - corporations sometimes have a substantial amount of excess cash available for a short time period. Large deposits can be established in several currencies. The ideal currency for deposits will: exhibit high interest rate and strengthen in value over the investment period.

Example: Lafayette Co has excess cash and considers depositing the cas into a British bank account. If the British pound appreciates against the dollar by the end of the deposit period when pounds will be withdrawn and exchanged for US dollars, more dollars will be received. Thus, the firm can use forecasts of the pound's exchange rate when determining whether to invest the short-term cash in a British account or a US account.

Capital Budgeting Decision - when an MNC's parent assesses whether to invest funds in a foreign project, the firm takes into account that the project may periodically require the exchange of currencies. The capital budgeting analysis can be completed only when all estimated cash flows are measured in the parent's local currency.

Example: Evansville Co wants to determine whether to establish a subsidiary in Thailand. Forecasts of the future cash flows used in the capital budgeting process will be dependent on the future exchange rate of Thailand's currency against the dollar. This dependency can be to: future inflows denominated in baht that will require conversion to dollars and the influence of future exchange rates on demand for the subsidiary's products. Accurate forecasts of currency values will improve the estimates of the cash flows and therefore enhance the MNC's decision making.

Earnings Assessment - the parent's decision about whether a foreign subsidiary should reinvest earnings in a foreign country or remit earnings back to the parent may be influenced by exchange rate forecasts. If a strong foreign currency is expected to weaken substantially against the parent's currency, the parent may prefer to expedite the remittance of subsidiary earnings before the foreign the foreign currency weakens. Exchange rate forecasts are also useful for forecasting MNC's earnings. When earnings of an MNC are reported, subsidiary earnings are consolidated and translated into the currency representing the parent firm's home country.

Example: DuPont has a large amount of business in Europe. Its forecast of consolidated earnings requires a forecast of earnings generated by subsidiaries in each country along with a forecast of the exchange rate at which those earnings will be translated into dollars. Given the uncertainty of exchange rates and other factors that affect earnings, DuPont uses a range when forecasting its earnings. The low end allows for the possibility of a weak euro, while the high end allows for the possibility of a strong Euro.

Long-Term Financing Decision - corporations that issue bonds to secure long-term funds may consider denominating the bonds in foreign currencies. They prefer that the currency borrowed depreciate over time against the currency they are receiving from sales. To estimate the cost of issuing bonds denominated in a foreign currency, forecasts of exchange rates are required.

Example:Bryce Co needs long-term funds to support its US business. It can issue 10-year bonds denominated in Japanese yen at a 1 percent coupon rate, which is 5 percentage points less than the prevailing coupon rate on dollar-denominated bonds. However, Bryce will need to convert dollars to make the coupon or principal payments on the yen-denominated bond, so if the yen's value rises, the yen-denominated bond could be more costly to Bryce than the US bond. Bryce's decision to issue yen-denominated bonds versus dollar-denominated bonds will be dependent on its forecast of the yen's exchange rate over the 10-year period.

Forecasting Techniques:

Technical Forecasting - involves the use of historical exchange rate data to predict future values.
Technical Forecasting Limitations - focuses on the near future, rarely provides point estimates or range of possible future values, and a technical forecasting model that worked well in one period may not work well in another.
Example: Tomorrow Kansas Co has to pay 10 milling Mexican pesos for supplies that it recently received from Mexico. Today, the peso has appreciated by 3% against the dollar. Kansas Co could send the payment today so that it would avoid the effects of any additional appreciation tomorrow. Based on an analysis of historical time series, Kansas has determined that whenever the peso appreciates against the dollar by more than 1%, it experiences a reversal of about 60% of that change on the following day.
So E(t-1) = E(t)% x reversal% where E(t-1) is "Tomorrow's Exchange Rate", E(t) is the amount that it has appreciated today, and reversal% is how much it is expected to reverse. So in this example:
E(t-1) = 3% x -60% = -1.8%. -1.8% is how much the rate is expected to drop tomorrow so Kansas Co would be better off waiting until tomorrow.
Fundamental Forecasting - based on fundamental relationships between economic variables and exchange rates. Use of sensitivity analysis to account for uncertainty by considering more than one possible outcome. Use of PPP for fundamental analysis by forecasting inflation rate differentials.
Fundamental Forecasting Limitations - unknown timing of the impact of some factors, forecasts of some factors may be difficult to obtain, some factors are not easily quantified, and regression coefficients may not remain constant.
Example: To forecast the percentage change (rate of appreciation/depreciation) in the British pound with respect to the US dollar during the next quarter. The DV in this is the British pound on two factors: Inflation in the US relative to the inflation in the UK and Income Growth in the US relative to income growth in the UK (measured in the % change). First we use the regression equation:
BP1 = b0 + b1(INFt-1) + b2(INCt-1) + u1
BP1 = quarterly percentage change in the British pound.
b0 = a constant
b1 = measures the sensitivity of BP1 to changes in INFt-1
b2 = measure the sensitivity of BP1 to changes in INCt-1
u1 = represents an error term
INFt-1 = inflation differential
INCt-1 = income growth differential
Regression analysis is used to find these coefficients. The coefficient b1 will exhibit a positive sign if, when INFt-1 changes, BP1 changes in the same direction (other things equal). A negative sign indicates that BP1 and INFt-1 move in opposite directions.
Sensitivity Analysis - when a regression model is used for forecasting, and the values of the influential factors have a lagged impact on exchange rates, the actual value of those factors can be used as input for the forecast. Fore example if the inflation differential has a lagged impact on exchange rates, the inflation differential in the previous period may be used to forecast the percentage change in the exchange rate over the future period. Some factors, however, have an instantaneous influence on exchange rates. Since these factors obviously cannot be know, forecasts must be used. Firms recognize that poor forecasts of these factors can cause poor forecasts of the exchange rate movements, so they may attempt to account for the uncertainty by using sensitivity analysis, which considers more than one possible outcome for the factors exhibiting uncertainty.
Example: Phoenix Corp develops a regression model to forecast the percentage change in the Mexican peso's value. It believes that the real interest rate differential and the inflation differential are the only factors that affect exchange rate movements, as shown in this regression model:
et = a0 + a1(INTt) + a2(INFt-1) + u1
et = percentage change in the peso's exchange rate over period t
INTt = real interest rate differential over period t
INFt-1 = inflation differential in the previous period t
a0,a1,a2 = regression coefficients
u1 = error term
Use of PPP for Fundamental Analysis - purchasing power parity (PPP) specifies the fundamental relationship between the inflation differential and the exchange rate. In simple terms, the PPP states that the currency of the relatively inflated country will depreciate by an amount that reflects that country's inflation differential. It also states that the percentage change in the foreign currency's value (e) over a period should reflect the differential between the home inflation rate (Ih) and the foreign inflation rate (If) over that period. Which is written as: ef = [(1 + Ih)/(1+If)]-1 or
E(St+1) = St(1+ef) where St = existing spot rate, E(St+1) = expected spot rate, ef = percentage change in the foreign currency's value.
In reality, the inflationrates of two countries over an upcoming period are uncertain and therefore would have to be forecasted when using PPP to forecast the future exchange rate at the end of the period. This complicates the use of PPP to forecast future exchange rates. Even if the inflation rates in the upcoming period were known with certainty, PPP might not be able to forecast exchange rates accurately. Problems come from: the timing of the impact of inflation fluctuations on changing trade patterns is not known with certainty, data used to measure relative prices of two countries may be somewhat inaccurate, barriers to trade can disrupt the trade patterns that should emerge in accordance with PPP theory, and other factors such as the interest rate differential between countries. Due to this, the inflation differential by itself is not sufficient to accurately forecast exchange rate movements, but should be included in the fundamental forecasting model.
Market-Based Forecasting - use of the spot rate to forecast the future spot rate and use of the forward rate to forecast the future spot rate.
Spot Rate - today's spot rate may be used as a forecast of the spot rate that will exist on a future date. To see why the spot rate can be a useful market-based forecast, assume the British pound is expected to appreciate against the dollar in the very near future. This expectation will encourage speculators to buy the pound with US dollars today in anticipation of its appreciation, and these purchases can force the pound's value up immediately. Conversely, if the pound is expected to depreciate against the dollar, speculators will sell off pounds now, hoping to purchase them back at a lower price after they decline in value. Such actions can force the pound to depreciate immediately. Thus, the current value of the pound should reflect the expectation of the pound's value in the very near future. Corporations can use the spot rate to forecast since it represents the market's expectation of the spot rate in the near future.
Forward Rate - a forward rate quoted for a specific date in the future is commonly used as the forecasted spot rate on that future date. That is, a 30-day forward rate provides a forecast for the spot rate in 30 days.
Forward Rate is: F = S (1+p) where F = Forward Rate, S = Spot Rate, and p = forward premium.
E(e) = p = (F/S) -1 where E(e) = expected percentage change in the exchange rate
Long-term Forecasting with Forward Rates - you have to determine the compounded return by: (1_ interest rate)^# of years -1 = compounded interest rate. Then plug it in: p = [(1+compounded interest home)/(1+ compounded interest foreign)] - 1.
Mixed Forecasting - uses a combination of forecasting techniques. Mixed forecast is then a weighted average of the various forecasts developed.
Forecast Error - the potential forecast error is larger for currencies that are more volatile because the spot rates of these currencies could easily wander far from any forecasted value in the future. The potential forecast error also depends on the forecast horizon (the length of time you are trying to forecast).
Measurement of Forecast Error: Absolute Forecast Error as a Percentage of the Realized Value = |Forecasted Value - Realized Value|/Realized Value. "| |" means absolute value.
Forecast Accuracy Among Currencies - the ability to forecast currency values may vary with the currency of concern. A financial manager can feel more confident about the number of dollars to be received or needed on transactions with countries whose values are more stable over time. However, even the most steady are still subject to large forecast errors.
Forecast Accuracy Over Time - MNCs are likely to have more confidence in their measurement of the forecast error when they measure it over each of several periods. The absolute forecast error as a percentage of the realized value can be estimated for each period to derive the mean error over all of these periods. If an MNC is most interested in forecasting the value of a currency 90 from now, it will assess errors from the application of various forecast procedures over the the last several quarters.
Forecasting Under Market Efficiency - the efficiency of the foreign exchange market also has implications for forecasting. If the foreign exchange market is weak-form efficient, then historical and current exchange rate information is not useful for forecasting exchange rate movements because today's exchange rates reflect all of this information. That is, technical analysis would not be capable of improving forecasts. If the foreign exchange market is semistrong-form efficient, then all relevant public information is already reflected in today's exchange rates. If today's exchange rates fully reflect any historical trends in exchange rate movements, but not other public information on expected interest rate movements, the foreign exchange market is weak-form efficient but not semi-strong form efficient. If foreign exchange markets are strong-form efficient, then all relevant public and private information is already reflected in today's exchange rates. This for of efficiency cannot be tested because private information is not available.
Weak-Form Efficiency - historical and current exchange rate information is already reflected in today's exchange rate and is not useful for forecasting.
Semistrong-Form Efficiency - all relevant information is already reflected in today's exchange rate.
Strong-Form Efficiency - all relevant public and private information is already reflected in today's exchange rate.
Forecast Bias (see handout for graph) - the difference between the forecasted and realized exchange rates for a given point in time is a nominal forecast error. Negative errors over time indicate underestimating, while positive errors indicate overestimating. If the errors are consistently positive or negative over time, then a bias in the forecasting procedure does exist. It appears that a bias did exist in distinct periods. If the forward rate is a biased predictor of the future spot rate, this implies that there is a systematic forecast error, which could be corrected to improve forecast accuracy. If the forward rate is unbiased, it fully reflects all available information about the future spot rate.
Methods of Forecasting Exchange Rate Volatility - use of recent volatility level, use of historical pattern of volatilities, and implied standard deviation.
Use of the Recent Volatility Level - the volatility of historical exchange rate movements over a recent period can be used to forecast the future.
Use of a Historical Pattern of Volatilities - a series of time periods may be used to forecast volatility in the next period.
Implied Standard Deviation - derives the exchange rate's implied standard deviation from the currency option pricing model.
MNCs need exchange rate forecasts to make decisions on hedging payables and receivables, short-term financing and investment, capital budgeting, and long-term financing.

Chapter 10 - pg 280

PPP Argument - One argument for exchange rate irrelevance is that, according to PPP theory, exchange rate movements are just a response to differentials in price changes between countries. Therefore, the exchange rate effect is offset by the change in prices. PPP does not necessarily hold, however, so the exchange rate will not necessarily change in accordance with the inflation differential between two countries. Since a perfect offsetting effect is unlikely, the firm's competitive capabilities may indeed be influenced by exchange rate movements. Even if PPP did holdover a very long period of time, this would not comfort mangers of MNCs that are focusing on the next quarter or so.

Investor Hedge Argument - A second argument for exchange rate irrelevance is that investors in MNCs can hedge exchange rate risk on their own. The investor hedge argument assumes that investors have complete information on corporate exposure to exchange rate fluctuations as well as the capabilities to correctly insulate their individual exposure. To the extent that investors prefer that corporations perform the hedging for them, exchange rate exposure is relevant to corporations. An MNC may be able to hedge at a lower cost than individual investors. In addition, it has more information about its exposure and can more effectively hedge its exposure.

Currency Diversification Argument - Another argument is that if a US-based MNC is well diversified across numerous countries, its value will not be affected by exchange rate movements because of offsetting effects. It is naive, however, to presume that exchange rate effects will offset each other just because an MNC has transactions in many different countries.

Stakeholder Diversification Argument - some critics also argue that is stakeholders are well diversified, they will be somewhat insulated against losses experienced by an MNC due to exchange rate risk. Many MNCs are similarly affected by exchange rate movements, however, so it is difficult to compose a diversified portfolio of stocks that will be insulated from exchange rate movements.

Forms of Exchange Rate Exposure:

Transaction Exposure - sensitivity of the firm's contractual transactions in foreign currencies to exchange rate movements.
To assess transaction exposure, the MNC must: estimate net cash flows in each currency and measure potential impact of the currency exposure.
Exposure of an MNC's Portfolio is affected by: Measurement of Currency Variability, Currency Variability Over Time, Measurement of Currency Correlations, Applying Currency Correlations to Net Cash Flows, and Currency Correlations Over Time.
Transaction Exposure based on Value-at-Risk (VaR) - measures the potential maximum 1-day loss on the value of positions of an MNC that is exposed to exchange rate movements.
Factors that affect the maximum 1-day loss: expected percentage change in the currency rate for the next day, confidence level used, and standard deviation of the daily percentage changes in the currency.
Using VaR:
Applying VaR to longer time horizons - pg 288.
Applying VaR to transaction exposure of a portfolio - pg 288
Estimating VaR with an electronic spreadsheet
Limitations of VaR - pg 289
Economic Exposure - the sensitivity of the firm's cash flows to exchange rate movements, sometimes referred to as operating exposure. pg 289
Economic Exposure arises from: local currency appreciation and local currency depreciation. (pg 291)
Measuring Economic Exposure - use of sensitivity analysis and use of regression analysis. (pg 292)
Translation Exposure - the exposure of the MNC's consolidated financial statements to exchange rate fluctuations.
Does Translation Exposure matter?
Cash Flow Perspective - pg 295
Stock Price Perspective - pg 295
Determinants of translation exposure: the proportion of business conducted by foreign subsidiaries, the locations o foreign subsidiaries, and accounting methods used. (pg 296)

Chapter 13 pg 370

Pg 370-371:

Motives for Direct Foreign Investment
Revenue-Related Motives
Boost Revenues
Attract new sources of demand
Enter profitable markets
Exploit monopolistic advantages
React to trade restrictions
Diversify internationally
Cost-Related Motives

Pg 372-373

economies of scale
use of foreign factors of production
use of foreign raw materials
use foreign technology
react to exchange rate movements
Cost-Related Motives in the Expanded European Union
selfish managerial motives for DFI
comparing benefits of DFI among countries

pg 374-377

comparing benefits of DFI over time
table of motives
benefits of international diversification
diversification of international projects

pg 378-379

comparing portfolios along the frontier
Comparing frontiers among MNCs
Diversification among countries

pg 380-382

Decisions subsequent to DFI
Host government view of DFI
incentives to encourage DFI
Barriers to DFI
Protective Barriers
"Red Tap" Barriers
Industry Barriers
Environmental Barriers
Regulatory Barriers
Ethical Differences
Political Instability
Government Imposed Conditions to engage in DFI

Chapter 14 pg 387

pg 387-388

Subsidiary versus Parent Perspective
Tax Differentials
Restricted Remittances
Excessive Remittances
Exchange Rate Movements
Summary of Factors

pg 389-391

Input for MNC Budgeting
Initial Investment
Price and Consumer Demand
Costs
Tax Laws
Remitted Funds
Exchange Rates
Salvage (liquidation)Value
Required Rate of Return

pg 391-394

Multinational Capital Budgeting Example
Background
Initial Investment
Price and Demand
Costs
Depreciation
Taxes
Remitted Funds
Salvage Value
Exchange Rates
Required Rate of Return
Analysis
Calculation of Net Present Value (NPV)

pg 395-403

Factors to consider in Multinational Capital Budgeting
Exchange Rate Fluctuations
Inflation 396
Financing Arrangement 397
Subsidiary Financing397
Parent Financing 340
Comparison of Parent vs Subsidiary Financing 400
Financing with Other Subsidiaries' Retained Earnings 400
Blocked Funds 400
Uncertain Salvage Value 401
Impact of Project on Prevailing Cash Flows 402
Host Government Incentives 403
Real Options 403

pg 404-

Adjusting Project Assessment Risk
Risk-Adjusted Discount Rate 404
Sensitivity Analysis 404
Simulation 405

Chapter 17 pg 472

pg 472

Background on Cost of Capital
Comparing the Costs of Equity and Debt 472

pg 473 -476

Cost of Capital for MNCs
Size of firm 473
access to international capital markets 473
international diversification 474
exposure to exchange rate risk 474
exposure to country risk 474
Summary of factors that cause the Cost of Capital to differ from that of domestic firms 475
Cost-of-Equity Comparison Using the CAPM 475
Implications of the CAPM for an MNC's Risk 476

pg 477 - 480

Costs of Capital Across Countries
Country diffferences in the cost of debt 477
differences in the risk-free rate 477
differences in the risk premium 478
comparative costs of debt across countries 478
Country differences in the cost of equity 478
impact of the euro 479
Combining the costs of debt and equity 480
estimating the cost of debt and equity 480

pg 481 - 485

Using the Cost of Capital for Assessing Foreign Projects
Derive Net Present Values Based on the Weighted Average Cost of Capital 481
Adjust the weighted average cost of capital for the risk differential 482
Derive the NPV of the equity investment 482
Relationship between projects NPV and capital structure 483
Trade-off when financing in developing countries 483
Accounting for multiple periods 484
Comparing alternative date compositions 484
comparing alternative capital structures 485
assessing alternative exchange rate scenarios 485
considering foreign stock ownership 485

pg 486 - 488

The MNC's Capital Structure Decision
Influence of Corporate Characteristics 486
Stability of MNC's Cash Flows 486
MNC's Credit Risk 486
MNC's Access to Retained Earnings 486
MNC's Guarantees on Debt 487
MNC's Agency Problems 487
Influence of Country Characteristics 487
Stock Restrictions in Host Countries 487
Interest Rates in Host Countries 487
Strength of host country currencies 488
country risk in host countries 488
tax laws in host countries 488
Revising the Capital Structure in Changing Conditions 488

pg 489 - 491

Interaction between Subsidiary and Parent Financing Decision 489
Impact of increased debt financing by the subsidiary 490
impact of reduced debt financing by the subsidiary 491
summary of interaction between subsidiary and parent financing decision 491

pg 492

Local vs Global Target Capital Structure
Offsetting a subsidiary's high degree of financial leverage
Offsetting a subsidiary's low degree of financial leverage
Limitations in offsetting a subsidiary's abnormal degree of financial leverage.
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