Chapter  1  –  An  Introduction  to  Multinational  Finance    

• Goals  of  MNC  -­‐ Maximize  shareholder  wealth.  -­‐ Stakeholders:  VREVENUES  =  VEXPENSES  +  VGOVT  +  VOTHER  +  VDEBT  +  VEQUITY.  -­‐ Agency  Costs.  -­‐ Protection  of  stakeholders  (ie.  Tariffs,  Subsidies,  Price  Support  etc.)  ie.  Rice  industry  in  Japan.  

• Challenges  of  MNCs  -­‐ Cultural  Differences  (Language,  Customs,  Beliefs  etc.)  –  Affects  marketing  -­‐ Differences  in  systems  (Tax,  Accounting,  Legal,  Financial)  -­‐ Risks:  Country  Risk  (Risk  that  business  environment  in  host  country  will  change)  

→ Political  Risk:  Risk  that  political  events  will  change  business  environment.  → Financial  Risk:  Risk  that  financial/economic  environment  will  change.  

• Opportunities  of  MNCs  -­‐ Value  =  Σt  [E[CFt]  /  (1+it)t]  -­‐ MNC  has  more  investment  choices  and  more  financing  choices  than  a  domestic  company.  

• Investment  Opportunities  -­‐ Enhancing  Revenues:  Global  Branding,  Marketing  Flexibility,  Advantages  of  Scale  &  Scope.  -­‐ Reducing  Operating  Costs:  Low-­‐cost  materials/labour,  Flexibility  site  global  selection,  sourcing  

and  production,  Economies  of  scale/scope,  Vertical  integration.  • Perfect  Financial  Market  Assumptions  

-­‐ Frictionless  Markets  -­‐ Rational  Investors  -­‐ Equal  access  to  costless  information  -­‐ Equal  access  to  market  prices  

• Market  Efficiency  -­‐ Operational  Efficiency:  No  loss  of  funds  when  moved  around.  Frictionless  markets.  -­‐ Information  Efficiency:  Rational  investors  have  equal  access  to  markets.  Prices  reflect  info.  -­‐ Allocational  Efficiency:  Allocating  capital  to  its  most  productive  uses.  -­‐ Comparative   Advantage:   Linked   to   Allocational   Efficiency.   A   country   should   produce   and  

export  what  it  is  efficient  at  producing.  It  should  import  goods  from  nations  that  produce  things  more  efficiently.  

 Chapter  2  –  World  Trade  and  the  Monetary  System    

• Balance  of  Payments  -­‐ Shows  inflows  and  outflows  of  goods,  services  and  capital.  -­‐ Trade  Balance:  Shows  if  it  is  net  export  (surplus)  or  net  import  (deficit).  -­‐ Current  Account:  Shows  the  balance  of  import/export  activity.  -­‐ Financial  Account:  Shows  changes  in  financial  assets/liabilities.  

• Bretton  Woods  Agreement  -­‐ Created  World  Bank  and  IMF.  -­‐ Pegged  Gold  System.  Gold  is  worth  US$35/oz.  Other  currencies  pegged  to  it.  -­‐ Stopped  on  August  15,  1971  due  to  market  forces  pressuring  the  system.  

   

• Exchange  Rate  Systems  -­‐ Pegged/Fixed:  Governments  maintain  currency  values  at  a  set  exchange  rate.  Devaluations  and  

Revaluations.  -­‐ Floating:   Supply   and   Demand   (Market)   determines   value   of   currency.   Depreciation   and  

Appreciation.  • Currency  Crises  

-­‐ Common  Causes:  Fixed/Pegged  Rates,  Large  foreign  currency  debt,  Low  reserves.  • IMF  Lending  and  Moral  Hazard  

-­‐ Existence  of  a  contract  can  change  behaviours  of  parties  to  the  contract.  That  is,  the  existence  of  bailouts  change  behaviours  by  making  countries  more  risky,  knowing  that  they  will  be  saved  by  the  IMF.  

 Chapter  3:  Foreign  Exchange  and  Eurocurrency  Markets    

• Characteristics  -­‐ Liquidity:  Ease  of  conversion  to  cash.  -­‐ Efficiency:  Operational/Informational/Allocational.  

• Eurocurrencies  -­‐ Bank  deposits  and  loans  residing  outside  of  a  single  country.  -­‐ Floating   rate   price   (low   interest   rate   [LIBOR]/default   risk),   Short  maturities   (5   years   or   less),  

Few  regulations,  High  Liquidity,  Competitive  Pricing.  • Participants  

-­‐ Wholesale  Market:  Dealers,  Brokers  -­‐ Retail  Market:  Governments,  Corporations,  Financial  Institutions,  Individuals.  

• Rules  for  Multinational  Finance  -­‐ Rule  1:  Keep  track  of  currency  units.  -­‐ Rule   2:   Always   buy   or   sell   the   currency   in   the   denominator   of   the   foreign   exchange   quote.  

(Allows  buying  low  and  selling  high.)  -­‐ European  Quotes:  Dollar  in  the  denominator.  -­‐ American  Quotes:  Euro  in  the  denominator.  -­‐ Direct  Quotes:  Foreign  currency  in  denominator.  -­‐ Indirect  Quotes:  Foreign  currency  in  the  numerator.  

• Forward  Premiums/Discounts  -­‐ Premium:  Nominal  value  is  higher  than  the  spot  exchange  market.  -­‐ Discount:  Nominal  value  is  lower  than  the  spot  exchange  market.  -­‐ Formula:  (Forward  Rate  –  Spot  Rate)  /  Spot  Rate  

• Change  in  FX  Rate  -­‐ Formula:  (Spot  Rate1  –  Spot  Rate0)  /  Spot  Rate0    -­‐ Converting  to  the  other  currency:  (1  +  Spot  RateORIGINAL)  =  1  /  Spot  RateOTHER  

• GARCH  -­‐ Variance  depends  on  previous  variance.  Changes  are  approximately  normally  distributed.  -­‐ Formula:  σt

2  =  a0  +  a1  σt-­‐12  +  b1  st-­‐12  [GIVEN]  

• Value-­‐at-­‐Risk  (VaR)  -­‐ Estimates  potential  losses  with  a  certain  level  of  confidence  over  a  certain  time  period.  

   

Chapter  4:  International  Parity  Conditions    

• The  Law  of  One  Price  -­‐ Purchasing  Power  Parity  (PPP):  Equivalent  assets  sell  for  the  same  price.  -­‐ Rarely  holds  for  non-­‐traded  assets,  assets  with  variable  quality  and  market  frictions.  -­‐ Arbitrage  opportunity  if  Pt$  =  PtA$  St$/A$  does  not  hold.  

• Arbitrage  -­‐ Locational  Arbitrage:  Involving  two  or  more  locations.  

Sd/e  (X)  /  Sd/e  (Y)  =  1.  Locational  arbitrage  opportunity  if  this  is  not  true.  -­‐ Triangular  Arbitrage:  Involves  three  currencies.  

Sd/e  Se/f  Sf/d  <  1.  Buy  denominator  with  numerator.  Vice  versa  for  >  1.  -­‐ Covered  Interest  Arbitrage:  Takes  advantage  of  disequilibrium  in  interest  rate  parity.  

Ftd/f/S0d/f  >  [(1+id)/(1+if)]t  [GIVEN].  Borrow  id,  buy  S0d/f,  Invest  if,  Sell  Ftd/f.  Vice  versa  for  <.  -­‐ Might   not   undertake   arbitrage   because   of:   transaction   costs,   political   risks,   tax   differences,  

liquidity  preferences,  capital  controls  and  market  imperfections.  • Relative  Purchasing  Power  Parity  

-­‐ Formula:  E[Std/f]/S0d/f  =  (1+E[pd])t  /(1+  E[pf])t  [GIVEN]  -­‐ Only  holds  on  average  since  expected  inflation  and  expected  future  spot  rates  are  not  traded.  

• International  Fisher  Relation  -­‐ Formula:  (1+nominal  interest  rate)  =  (1+inflation  rate)(1+real  interest  rate)  -­‐ Takes  into  account  inflation.  

• Real  Exchange  Rate  -­‐ Adjusts  nominal  exchange  rate  for  differential  inflation.  -­‐  (1+xtd/f)  =  (Std/f/St-­‐1d/f  )[(1+pf)/(1+pd)]  [GIVEN]  

• Exchange  Rate  Forecasting  -­‐ Forecasting  can  be  done  based  on  parity  conditions,  since  these  must  always  hold  true.  -­‐ E[Std/f]/Ftd/f  -­‐ E[Std/f]  =  S0d/f  [(1+id)/(1+if)]t  [GIVEN]  -­‐ E[Std/f]  =  S0d/f  [(1+pd)/(1+pf)]t  -­‐ Technical  Analysis:  Using  past  exchange  rates  to  predict  future.  -­‐ Fundamental  Analysis:  Using  macroeconomic  data  to  predict  future.  

 Chapter  5:  Currency  Futures  and  Futures  Markets    

• Futures  Contracts  -­‐ Forwards  are  a  zero-­‐sum  game  so  one  party  always  has  incentive  to  default.  -­‐ Clearinghouse  takes  one  side  of  a  futures  contract  to  solve  this.  Margins  ensure  settlement.  -­‐ Marked-­‐to-­‐market  daily.  

• Differences  between  Forwards  and  Futures  -­‐ Forwards  are  highly  customisable.  Gains/Losses  realised  at  maturity.  Usually  settled  at  maturity.  -­‐ Futures  are  highly  standardised.  Gains/Losses  realised  daily.  Usually  settled  early.  -­‐ Futures  are  like  a  bundle  of  consecutive  one-­‐day  forward  contracts.  -­‐ Both  are  equal:  Futt,Td/f  =  Ft,Td/f  =  Std/f  [(1+id)/(1+if)]T-­‐t  [GIVEN]  

• Basis  Risk  -­‐ Risk  of  change  in  relation  between  futures  and  spot  prices.  -­‐ These  two  will  converge  at  expiry.  -­‐ Maturity  mismatches  mean  futures  may  not  provide  the  perfect  hedge  compared  to  forwards.  

• Futures  Hedges  -­‐ Perfect  Hedge  (No  Mismatch):  std/f    =  α  +  β  std/f    +  et  [GIVEN]  -­‐ Delta  Hedge  (Maturity  Mismatch):  std/f    =  α  +  β  futtd/f    +  et  [GIVEN]  -­‐ Cross  Hedge  (Currency  Mismatch):  std/f1    =  α  +  β  std/f2    +  et  [GIVEN]  -­‐ Delta-­‐Cross  Hedge  (Maturity  &  Currency  Mismatch):  std/f1    =  α  +  β  futtd/f2    +  et  [GIVEN]  -­‐ -­‐  β  =  (amount  in  futures)/(amount  exposed)  [GIVEN]  

 Chapter  6:  Currency  Options  and  Options  Markets    

• Options  -­‐ Call  Option:  Holder  has  right  to  buy.  -­‐ Put  Option:  Holder  has  the  right  to  sell.  -­‐ European:  Exercisable  only  on  expiration  date.  -­‐ American:  Exercisable  any  day  up  to  expiration  date.  -­‐ Other  things  equal,  this  means  American  options  are  worth  more.  -­‐ In-­‐the-­‐money  (Call  Option):  Exercise  price  is  less  than  spot  price.  -­‐ At-­‐the-­‐money  (Call  Option):  Exercise  price  is  the  same  as  spot  price.  -­‐ Out-­‐of-­‐the-­‐money  (Call  Option):  Exercise  price  is  higher  than  spot  price.  

• Payoffs  of  Currency  Options  -­‐ Call  Option:  CallTd/f  =  max[STd/f-­‐KTd/f  ,  0]  [GIVEN]  -­‐ Put  Option:  PutTd/f  =  max[KTd/f  -­‐  STd/f,  0]  [GIVEN]  -­‐ Where,  KTd/f  is  the  exercise  price  and  STd/f  is  the  spot  rate.  

• Payoff  Profiles                    

• Option  Value  -­‐ Option  Value  =  Intrinsic  Value  +  Time  Value  

Intrinsic  Value:  The  value  of  the  option  if  exercised  immediately.  Time  Value:  Market  Value  less  intrinsic  value.  (FX  rate,  Price,  Risk-­‐free  rate,  Volatility,  Time)  

• Time  and  Volatility  -­‐ Instantaneous  changes  are  a  random  walk.  -­‐ Equation:  σt

2  =  Tσ2  [GIVEN]  -­‐ In  words:  1-­‐period  variance  multiplied  by  T-­‐periods  is  T-­‐period  variance.  

 Chapter  7:  Currency  Swaps  and  Swaps  Markets    

• Parallel  Loans  -­‐ Borrow  in  local  currency,  then  swap  it  with  the  debt  of  a  foreign  counterparty.  -­‐ Benefits:   Allows   legal   circumvention   of   taxes,   possibly   at   lower   cost   of   capital   and   provides  

foreign  source.  Main  benefit  is  a  lower  interest  rate.  

-­‐ Problems:  Default  Risk,  Must  be  capitalized  on  balance  sheet,  search  costs  high.  • Swaps  

-­‐ Currency   Swaps:   Parallel   loan  packaged   into  a   single   contract.   Counters  problems   to  parallel  loans.  Interest  payments  usually  also  swapped.    

-­‐ Banks  gain  profit  from  bid/ask  spread  using  LIBOR.  They  sell  swap  contracts  and  match  them  to  others.  

-­‐ Interest  Rate  Swaps:  Same  as  currency  swap,  except  in  one  country.  Normally  used  to  change  fixed  to  floating  rate  or  vice  versa.  

-­‐ Commodity  Swaps:  Allows  the  fixing  of  commodity  prices.  Most  normally  are  fixed-­‐for-­‐floating  swaps  based  on  swap  prices.  

-­‐ Debt-­‐for-­‐Equity  Swaps:  Giving  the  equity  returns  to  a  swap  dealer  and  getting  a  fixed  rate  debt.  • Day  Count  Convention  

-­‐ Eurocurrency  rates  (such  as  LIBOR),  are  quoted  at  money  market  yield  (MMY)  [360  days].  -­‐ Normal  fixed  rate  instruments  are  quoted  using  bond  equivalent  yield  (BEY)  [365  days].  -­‐ Equation:  MMY  =  BEY  (360/365)  [GIVEN]  

 Chapter  8:  The  Rationale  for  Hedging  Currency  Risk    

• Perfect  Market  Assumptions  Revisited  -­‐ If  financial  markets  are  perfect,  then  hedging  is  irrelevant.  -­‐ Hedging  must  either  increase  expected  future  cash  flows  or  decrease  the  discount  rate.  

• Hedging  Matters  -­‐ Indirect  and  Direct  costs  of  financial  distress.  -­‐ Agency  costs  -­‐ Tax  schedule  convexity.  

• Calculating  Firm  Value  -­‐ Find  the  value  of  bonds  and  stock,  by  multiplying  the  possible  scenarios  by  the  expected  value  

in  that  scenario,  taking  into  account  any  costs.  -­‐ In   absence   of   financial   distress,   hedging   does   not   create   value   and   wealth   transfers   from  

shareholders   to   bondholders.   When   there   is   hedging,   shareholders   benefit   from   this   by  reducing  borrowing  costs.  

• Consequences  of  Hedging  -­‐ Shareholders  benefit  from  the  gain  in  hedging  compared  to  the  shift  in  wealth  to  debt  holders.  -­‐ Increase  cash  flow  by  reducing  costs  of  financial  distress.  -­‐ Reduces  debt’s  required  return  and  cost  of  capital.  

• Agency  Costs  -­‐ Managers  have  an  incentive  to  hedge  their  performance.  But  if  the  firm  is  already  hedged  itself,  

any  additional  hedging  by  individual  managers  will  be  a  waste  of  money.  • Progressive  Taxation  

-­‐ Calculated  expected  tax  in  same  way  as  calculating  firm  value.  -­‐ Expected  tax  savings  are  generally  small  

 Chapter  9:  Multinational  Treasury  Management    

• Setting  MNC  Goals  &  Strategies  -­‐ Identify  core  competencies  and  growth  opportunities  

-­‐ Evaluate  business  environment.  -­‐ Formulate  strategic  plan  for  sustainable  competitive  advantage.  -­‐ Develop  processes  to  implement  a  strategic  business  plan.  

• Problems  of  International  Trade  -­‐ Exporters  need  to  assure  timely  payment.  -­‐ Importers  need  to  ensure  timely  delivery.  -­‐ Geographic  and  cultural  discrepancies.  -­‐ Trade  disputes  can  be  difficult  to  settle.  

• International  Payment  Methods  -­‐ Cash  in  advance:  Payment  prior  to  shipment.  -­‐ Open  account:  Billed  under  agreed  terms  to  be  paid  within  an  agreed  time  period.  -­‐ Documentary  credits:  Letter  of  Credit.    Same  as  documentary  collections  but  with  2  banks.  -­‐ Documentary  collections:  Sight  drafts  (paid  on  demand)  and  Time  drafts  (paid  on  a  set  date)  -­‐ Countertrade:  Exchange  of  goods/services  (no  cash).  Can  be  counterpurchase  or  offset.  

• All-­‐in  cost  of  trade  finance  -­‐ (Foregone  cash  flow)  /  (Discounted  Value)  –  1  -­‐ The  internal  rate  of  return  associated  with  a  financing  alternative.  

• Hedging  with  Forward  Contracts  -­‐ Hedge  a  long  position  with  a  short  forward  contract  in  the  foreign  currency.  

• Types  of  Exposure  to  Currency  Risk  -­‐ Economic  Exposure  

Transaction  Exposure  (contractual  CF)  and  Operating  Exposure  (non-­‐contractual  CF)  -­‐ Translation  (Accounting)  Exposure  

Exposure  to  changes  in  financial  statements  from  changes  in  exchange  rates.  • 5-­‐step  Currency  Risk  Management  Program  

-­‐ Identify  exposures  to  future  exchange  rates.  -­‐ Estimate  the  sensitivity  of  revenues  and  expenses.  -­‐ Determine  if  hedging  is  desirable.  -­‐ Evaluate  alternatives.  -­‐ Monitor  the  hedged  position  and  re-­‐evaluate.  

 Chapter  10:  Managing  Transaction  Exposure  to  Currency  Risk    

• Multinational  Netting  -­‐ Offset  and  net  movements  after  a  period  of   time.   Saves   transaction   costs  by   limiting   to  only  

necessary  movements  in  funds  internally.  • Leading  and  Lagging  

-­‐ Leading  (Bringing  forward)  or  Lagging  (Pushing  back)  cash  flows  so  that  they  match.  -­‐ Charge  market  rates  of  interest  on  these  intra-­‐company  loans/deposits  

• Financial  Market  Hedges  Vehicle   Advantages   Disadvantages  Forwards   Perfect.  Low  spread.   Large  spread  on  thin  

currencies/long  deals.  Futures   Low  cost  for  small  deals.  Low  risk.   Only  few  currencies.  CF  mismatch  

possible  with  mark-­‐to-­‐market.  Options   Disaster  hedge  provides  insurance.   Premiums  can  be  expensive.  

Swaps   Quick  and  low  cost.   Innovative  swaps  costly.  Not  for  short-­‐term.  

Money  Market  Hedges   Synthetic  forward  positions   Expensive.  Not  always  possible.    

• Money  Market  Hedge  -­‐ Synthetic  forward  positions  where  no  futures  market  exists,  but  is  expensive.  -­‐ Borrow,  Convert  then  Invest.  

• Active  Treasuries  -­‐ Large  firms  with  centralised  risk  management.  -­‐ Use  sophisticated  valuation  methods.  -­‐ Derivatives  are  periodically  marked  to  market.  -­‐ Managers  closely  monitored.  -­‐ Compensation  aligns  managers  with  stakeholders  -­‐ Performance  benchmarks  to  manage  potential  abuse.