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CONTENTS

PREFACE m

PART I ENVIRONMENT OF INTERNATIONAL.FINANCIAL. MANAGEMENT

1 INTRODUCTION

Learning Objectives 2Key Terms 2

1.1 The Rise of the MultinationalCorporation 4

Evolution of the MultinationalCorporation 9Search for Row Haterías 10Market Seeking 11Cost Minimization 13Knowledge Seeking 17Keeping Domestic Customers 18Exploiting Financial Market

Imperfections 18

The Process of Overseas Expansionby Multinationals 19Exporting 20Overseas Production 20licensing 21Trade-offs Between Alternative Modes

of Overseas Expansion 21

A Behavioral Definition of theMultinational Corporation 22

The Global Manager 251.2 The Internationalization of Business

and Finance 26

Political and Labor Union ConcernsAbout Global Competition 27

Consequences of Global Competition 341.3 Multinational Financial Management: Theory

and Practice 42Criticisms of the Multinational

Corporation 43Functions of Financial Management 44Theme of This Book 44Relationship to Domestic Financial

Management 45Arbitrage 46Market Effidency 46

Capital Asset Príáng 47

The Importance of Total Risk 47The Global Financial Marketplace 48The Role of the Financial Executive in an

Efficient Market 481.4 Outline of the Book 49

Environment of International FinancialManagement 49

Foreign Exchange and Derivatives

Markets 49Foreign Exchange Risk Management 50Financing die Multinational

Corporation 50

CONTENTS XI

Foreign Investment Analysis 50Multinational Working Capital

Management 50Questions 51Web Resources 51Web Exercises 52Appendix 1A: The Origins andConsequences of International Trade 53

The Gains from Trade 53Specialized Factors of Production 54Monetary Prices and Exchange

Rates 55Tariffs 55

Questions 56

2 UNDERSTANDING EXCHANGERATES 5 7


2.1 Setting die Equilibrium SpotExchange Rate 58

Demand for a Currency 58Supply of a Currency 59Factors That Affect the Equilibrium

Exchange Rate 60Relative Inflation Rates 60Relative Interest Rates 61Relative Economic Growth Rates 61Political and Economic Risk 61

Calculating Exchange RateChanges 62

2.2 Expectations and the Asset Market Model ofExchange Rates 65

The Nature of Money and CurrencyValues 68

Central Bank Reputations and CurrencyValues 70Price Stability and Central Bank

Independence 71

Currency Boards 76Dollarization 79Expectations and Currency Values 79

2.3 The Fundamentals of Central BankIntervention 82

How Real Exchange Rates Affect RelativeCompetitiveness 82

Foreign Exchange Market Intervention 84Mechanics of Intervention 87

Sterilized versus Unsterilized Intervention 88

The Effects of Foreign Exchange MarketIntervention 89

2.4 The Equilibrium Approach to ExchangeRates 91

Disequilibrium Theory and Exchange RateOvershooting 92

The Equilibrium Theory of ExchangeRates and Its Implications 93

2.5 Summary and Conclusions 95Questions 95Problems 97Web Resources 97Web Exercises 98Bibliography 98

3 DEFINING AND ANALYZING THEINTERNATIONAL MONETARY SYSTEM 9 9


3.1 Alternative Exchange Rate Systems 100Free Float 101Managed Float 101Target-Zone Arrangement 103Fixed-Rate System 103The Current System of Exchange Rate

Determination 1053.2 A Brief History of the International Monetary

System 105The Classical Gold Standard 108

XII CONTENTS

How the Classical Gold Standard Workedin Practice: 1821-1914 110

The Gold Exchange Standard and ItsAftermadi: 1925-1944 111Competitive Devaluations 111Bretton Woods Conference and the Postwar

Monetary System 111Role of the IMF 111Role of the World Bank 112Role of the Bank for International

Settlements 112

The Bretton Woods System:1946-1971 113

The Post-Bretton Woods System:1971 to the Present 114

Assessment of the Floating-RateSystem 119Increasing Currency Volatility 120Requirements for Currency Stability 120

3.3 The European Monetary System andMonetary Union 121

The Exchange Rate Mechanism 121Lessons from the European Monetary

System 121The Currency Crisis of September

1992 122The Catalyst 122

The High Cost of Intervention 122

Abandonment of the Exchange RateMechanism in August 1993 122The Catalyst 123Governments Surrender to the Market 123

A Postmortem an the EMS 124

European Monetary Union 124Maastricht Convergence Criteria 125Launch of the Euro 125EMU and the European Welfare State 125Consequences of EMU 127

Performance of the Euro 129

Optimum Currency Area 1323;4 Emerging Market Currency Crises 135

Transmission Mechanisms 135Trade UiAs 135Financial System 135

Debt Policy 136

Origins of Emerging MarketCrises 136Moral Hazard 136

Fundamental Policy Conflict 136

Policy Proposals for Dealing withEmerging Market Crises 137Currency Controls 137Freely Floating Currency 137Permanently Fixed Exchange Rate 137

Better Information 138


4 INTERNATIONAL. FINANCE ANDCURRENCY: PARITY CONDITIONS 142


4.1 Arbitrage and the Law of One Price 1434.2 Purchasing Power Parity 147

The Lesson of Purchasing PowerParity 151

Expected Inflation and Exchange RateChanges 153

The Monetary Approach 153Empirical Evidence 154

4.3 The Fisher Effect 158Empirical Evidence 159

Adding Up Capital MarketsInternationally 165

4.4 The International Fisher Effect 166Empirical Evidence 168

4.5 Interest Rate Parity Theory 169Empirical Evidence 174

4.6 The Relationship Between the Forward Rateand the Future Spot Rate 175

CONTENTS XIII

Empirical Evidence 1774.7 Currency Forecasting 179

Requirements for Successful CurrencyForecasting 179

Market-Based Forecasts 181Forward Rates 181

Interest Rates 181

Model-Based Forecasts 181Fundamental Analysis 181

Technical Analysis 182

Model Evaluation 183Forecasting Controlled Exchange

Rates 1854.8 Summary and Conclusions 186

Questions 188Problems 189Web Resources 190Web Exercises 191Bibliography 191

5 INTERNATIONAL. ECONOMICLINKAGES AND BALANCE OFPAYMENTS 193


5.1 Balance-of-Payments Categories 194Current Account 196Capital Account 198Financial Account 198Balance-of-Payments Measures 199The Missing Numbers 200

5.2 The International Flow of Goods, Services,and Capital 200

Domestic Savings and Investment and theFinancial Account 201

The link Between the Current and

Financial Accounts 201Government Budget Deficits and

Current-Account Deficits 205The Current Situation 208

5.3 Coping With the Current-AccountDeficit 211

Currency Depreciation 211Lagged Ejects 212J-Curve Theory 212

Devaluation and Inflation 214U.S. Deficits and the Demand

for U.S. Assets 214

Protectionism 215Ending Foreign Ownership of Domestic

Assets 216

Boosting the Saving Rate 217External Policies 219Current-Account Deficits and

Unemployment 219The Bottom Line on Current-Account

Deficits and Surpluses 2215.4 Summary and Conclusions 222

Questions 223Problems 224Web Resources 225Web Exercises 225

6 ANALYZING COUNTRY RISK 2 2 6


6.1 Measuring Political Risk 227Political Stability 228Economic Factors 230Subjective Factors 230

Political Risk and UncertainProperty Rights 230

Capital Flight 236Culture 238

6.2 Economic and Political FactorsUnderlying Country Risk 239

Fiscal Irresponsibility 240Monetary Instability 242Controlled Exchange Rate System 243Wasteful Government Spending 244

X i V CONTENTS

Resource Base 244Country Risk and Adjustment to External

Shocks 244Market-Oriented versus Statist

Policies 245Why Capitalism Works 246Statist Policies Constrain Growth 246Why Statist Policies Persist 248

Key Indicators of Country Risk andEconomic Health 248Market-Oriented Policies Work 251Market-Onented Reform in latin

America 252Obstacles to Economic Reform 254

6.3 Country Risk Analysis in InternationalBanking 256

Country Risk and the Terms ofTrade 256

The Governments Cost/BenefitCalculus 257

Lessons from the International DebtCrisis 258Onset of the Crisis 258Reform Takes Hold 258Debt Relief 258The Crisis Ends 259Lessons from Successful Economic

Reform 259


PART II FOREIGN EXCHANGE AND DERIVATIVES

MARKETS 263

J<,-•;• F O R E I G N E X C H A N G E M A R K E T : gs

OPERATION AND MECHANICS 264

Learning Objectives 264Key Terms 264 ,

7.1 Organization of The Foreign ExchangeMarket 265

The Participants 266The Clearing System 269Electronic Trading 270

Size 2717.2 The Spot Market 273

Spot Quotations 273 ;..-,.Transaction Costs 276Cross Rates 277Currency Arbitrage 279Settlement Date 281Exchange Risk 282

The Mechanics of Spot Transactions 282

7.3 The Forward Market 283Forward Quotations 285

Exchange Risk 287

Cross Rates 287

Forward Contract Maturities 2887.4 Summary and Conclusions 289


8 OPTIONS CONTRACTS AND CURRENCY

FUTURES 292

Learning ObjectivesKey Terms 292

292

CONTENTS XV

8.1 Futures Contracts 293Forward Contract versus Futures

Contract 294Advantages and Disadvantages of Futures

Contracts 298Arbitrage Between the Futures and Forward

Markets 2998.2 Currency Options 299

Market Structure 300Using Currency Options 303

Currency Spread 307

Knockout Options 308

Option Pricing and Valuation 309Using Forward or Futures Contracts

versus Options Contracts 311Futures Options 316

8.3 Reading Currency Futures and OptionsPrices 317

8.4 Summary and Conclusions 320Questions 320Problems 320Web Resources 321Web Exercises 322Bibliography 322Appendix 8A: Option Pricing UsingBlack-Scholes 322

Implied Volatilities 323Shortcomings of die Black-Scholes

Option Pricing Model 324

Problems 325Appendix 8B: Put-Call Option InterestRate Parity 325Problems 327

9 INTEREST RATE DERIVATIVESAND SWAPS 3 2 8


9.1 Interest Rate and Currency Swaps 329Interest Rate Swaps 329

The Classic Swap Transaction 330Cost Savings Associated with Swaps 331

Currency Swaps 333Interest Rate/Currency Swaps 335Dual Currency Bond Swaps 340

Economic Advantages of Swaps 3419.2 Interest Rate Forwards and Futures 342

Forward Forwards 342Forward Rate Agreement 343Eurodollar Futures 344

9.3 Structured Notes 346Inverse Floaters 347Callable Step-Up Note 348Step-Down Coupon Note 349


PART H I FOREIGN EXCHANGE RISK MANAGEMENT 353

1O MEASURING AND MANAGINGACCOUNTING EXPOSURE


10.1 Alternative Measures of Foreign Exchange3 5 4 Exposure 355

Translation Exposure 355Transaction Exposure 356Operating Exposure 357

XVI CONTENTS

10.2 Alternative Currency Translation *'Methods 357

Current/Noncurrent Method 357Monetary/Nonmonetary Method 358Temporal Method 358Current Rate Method 358

10.3 Transaction Exposure 35910.4 Designing a Hedging Strategy 362

Objectives 363Costs and Benefits of Standard Hedging

Techniques 365Costs of Hedging 365Benefits of Hedging 366Exposure Netting 369

Centralization versus Decentralization 369Managing Risk Management 370Accounting for Hedging

and FASB 133 37110.5 Managing Translation Exposure 372

Funds Adjustment 372Evaluating Alternative Hedging

Mechanisms 373

10.6 Managing Transaction Exposure 374Forward Market Hedge 375

The True Cost of Hedging 376

Money Market Hedge 377

Risk Shifting 380Pricing Decisions 381Exposure Netting 382Currency Risk Sharing 383Currency Collars 385Cross-Hedging 388Foreign Currency Options 389

Using Options to Hedge Bids 389Using Options to Hedge Other Currency

Risks 390 . •-Options versus Forward Contracts 391

10.7 Summary and Conclusions 393Questions 394Problems 395Web Resources 397

Web Exercises 398Bibliography 398Appendix 10A: Statement of FinancialAccounting Standards No. 52 398Application of FASB No. 52 401

1 1 D E F I N I N G F O R E I G N E X C H A N G ER I S K 4O3

Learning Objectives 403

Key Terms 40311.1 Foreign Exchange Risk and Economic

Exposure 404Real Exchange Rate Changes

and Exchange Risk 406Importance of the Real Exchange

Rate 407Inflation and Exchange Risk 407Competitive Effects of Real Exchange

Rate Changes 40911.2 The Economic Consequences of Exchange

Rate Changes 412Transaction Exposure 412Operating Exposure 413

11.3 Identifying Economic Exposure 417Aspen Skiing Company 417Petróleos Mexicanos 418Toyota Motor Company 419

11.4 Calculating Economic Exposure 420

Spectrum's Accounting Exposure 421Spectrum's Economic Exposure 421

Case Analysis 42511.5 An Operational Measure of Exchange

Risk 425limitations ' 427 '

11.6 Managing Operating Exposure 427Marketing Management of Exchange

Risk 427Market Selection 427Pricing Strategy 428

CONTENTS XVII

Product Strategy 430

Production Management of ExchangeRisk 432Input Mix 432Shifting Production Among Plants 433Plant Location 434

Raising Productivity 434

Planning for Exchange RateChanges 435

Financial Management of Exchange

Risk 43711.7 Summary and Conclusions 444


PART IV FINANCING THE MULTINATIONAL.

CORPORATION 449

1 2 NATIONAL CAPITAL MARKETS AND

INTERNATIONAL FINANCING 45O

Learning Objectives 450

Key Terms 45012.1 Corporate Sources and Uses

of Funds 451

Financial Markets versus FinancialIntermediaries 452

Financial Systems and Corporate

Governance 452

Globalization of Financial Markets 45612.2 National Capital Markets as International

Financial Centers 459International Financial Markets 463

Foreign Access to DomesticMarkets 464The Foreign Bond Market 464The Foreign Bank Market 465The Foreign Equity Market 466

Globalization of Financial MarketsHas Its Downside 476

12.3 Development Banks 477

The World Bank Group 478IBRD 478IFC 478IDA 479

Regional and National DevelopmentBanks 479Regional Development Banks 479National Development Banks 480

Private Sector Alternatives 48012.4 Project Finance 48212.5 Summary and Conclusions 483

Questions 484

Problems 484Web Resources 484Web Exercises 485Bibliography 485

1 3 FUNCTIONS OF EUROMARKETS 486


13.1 The Eurocurrency Market 486Modern Origins 487Eurodollar Creation 488Eurocurrency Loans 490

Terms 490

Multicurrency Clauses 491

Relationship Between Domestic andEurocurrency Money Markets 492Interest Differentials 492

XVIII CONTENTS

Eurocurrency Spreads 492Euromarket Trends 493

13.2 Eurobonds 494 :-Swaps 494 ;links Between the Domestic and

Eurobond Markets 494Placement 495Currency Denomination 496Interest Rates on Fixed-Rate Eurobonds 496Interest Rates on Floating-Rate Eurobonds 497Eurobond Retirement 498Ratings 498

Rationale for Existence of EurobondMarket 498

Eurobonds versus EurocurrencyLoans 501

13.3 Note Issuance Facilities and Euronotes 502Note Issuance Facilities versus

Eurobonds 504

Euro-Medium-Term Notes 505Reasons for Success 505Costs of a Euro-MTN Program 505Characteristics 505Risks 506

13.4 Euro-Commercial Paper 50613.5 The Asiacurrency Market 50813.6 Summary and Conclusions 509

Questions 509Problems 509

> Web Resources 510Web Exercises 510Bibliography 510

1 4 FOREIGN INVESTMENTS:

THE COST OF CAPITAL 511


14.1 The Cost ôf Equity Capital 51214.2 The Weighted Average Cost of Capital

for Foreign Projects 513

14.3 Discount Rates for Foreign Investments 515Evidence from the Stock Market 516Key Issues in Estimating Foreign Project

Discount Rates 517Proxy Companies 518

Local Companies 518Proxy Industry 519Adjusted Ú.S. industry Beta 519

The Relevant Base Portfolio 520The Impact of Globalization on the Cost

of Capital 521• Empirica Evidence ' 523

A Recommendation. 524.

The Relevant Market Risk Premium 524Recommendations 525

14.4 The Cost of Debt Capital 526Annual Exchange Rate Change 527Using Sovereign Risk Spreads 528

14.5 Establishing a Worldwide CapitalStructure 528

Foreign Subsidiary Capital Structure 529Political Risk Management 532Currency Risk Management 532Leverage and Foreign Tax Credits 533Leasing and Taxes 533Cost-Minimizing Approach to Global Capital

Structure 534

Joint Ventures 53414.6 Valuing Low-Cost Financing

Opportunities 535Taxes 537

Zero-Coupon Bonds 537Debt versus Equity Financing 538

Government Credit and CapitalControls 538

Government Subsidies and Incentives 538

14.7 Summary and Conclusions 541Questions 542


CONTENTS

PART V FOREIGN INVESTMENT ANALYSIS

XIX

547

1 5 EXAMINING INTERNATIONALPORTFOLIO INVESTING


15.1 The Risks and Benefits of InternationalEquity Investing 549

International Diversification 550Correlations and the Gains from

Diversification 552Recent Correlations 557

Investing in Emerging Markets 559

Barriers to InternationalDiversification 565

15.2 International Bond Investing 56915.3 Optimal International Asset

Allocation 56915.4 Measuring the Total Return from Foreign

Portfolio Investing 570Bonds 571Stocks 571

15.5 Measuring Exchange Risk, on ForeignSecurities 572

Hedging Currency Risk 57315.6 Summary and Conclusions 574


Product and Factor MarketS48 Imperfections 579

Financial Market Imperfections 58016.2 The Strategy of Multinational

Enterprise 581Innovation-Based Multinationals 582The Mature Multinationals 582The Senescent Multinationals 585Foreign Direct Investment and

Survival 586Cost Reduction 586Economies of Scale 587Multiple Sourcing 588Knowledge Seeking 588Keeping Domestic Customers 590

16.3 Designing a Global Expansion Strategy 5911. Awareness of Profitable

Investments 5922. Selecting a Mode of Entry 5933. Auditing the Effectiveness of Entry

Modes 5934. Using Appropriate Evaluation

Criteria 5945. Estimating the Longevity of a

Competitive Advantage 59516.4 Summary and Conclusions 595


1 6 FOREIGN DIRECT INVESTMENTAND CORPORATE STRATEGY


16.1 Theory of the MultinationalCorporation 579

578 1 T MULTINATIONAL CORPORATIONS

AND CAPITAL BUDGETING 599


17.1 Basics of Capital Budgeting 600

X X CONTENTS

Net Present Value 600Incremental Cash Flows 601

Cannibahzation 601Saks Creation 602Opportunity Cost 602Transfer Pricing 602Fees and Royalties 603Getting the Base Case Right 603Accounting for Intangible Benefits 604

Alternative Capital-BudgetingFrameworks 605An Adjusted Present Value Approach 605

17.2 Issues in Foreign InvestmentAnalysis 607

Parent versus Project Cash Flows 607A Three-Stage Approach 607Estimating Incremental Project Cash

Flows 608Tax Factors 608

Political and Economic RiskAnalysis 609Adjusting the Discount Rate or Payback

Period 609Adjusting Expected Values 609

Exchange Rate Changesand Inflation 610

17.3 Foreign Project Appraisal: The Case ofInternational Diesel Corporation 611

Estimation of Project Cash Flows 612Initial Investment Outlay 6J2Financing ÏDC-U.K 612

interest Subsidies 613Sales and Revenue Forecasts 614Production Cost Estimates 614Projected Net Income 616Additions to Worhing Capital 616Terminal Value 616Estimated Project Present Value 617

Estimation of Parent Cash Flows 617Loan Payments 617Remittances to IDC-U.S. 618Earnings on Exports to 1DC-U.K. 618Estimated Present Value of Project

to ¡DC-U.S. 618Lost Sales 620

17 A Political Risk Analysis 621Expropriation 621Blocked Funds 622

17.5 Growth Options and ProjectEvaluation 623

17.6 Summary and Conclusions 627Questions 627Problems 628Web Resources 629Web Exercises 629Bibliography 629Appendix 17A: Managing PoliticalRisk 629

Preinvestment Planning 630Operating Policies 631

PART VI MULTINATIONAL WORKING

CAPITAL MANAGEMENT 635

1 8 INTERNATIONAL TRADE

FINANCING 036


18.1 Payment Terms in International Trade 637Cash in Advance 637

Letter of Credit 638Online Alternatives 642

Draft 643Consignment 645Open Account 646Banks and Trade Financing 647Collecting Overdue Accounts 647

CONTENTS XXI

18.2 Documents in International Trade 648Bill of Lading 648Commercial Invoice 649Insurance Certificate 649Consular Invoice 649

18.3 Financing Techniques in InternationalTrade 650

Bankers' Acceptances 650Creating an Acceptance 650Terms of Acceptance Financing 650Evaluating the Cost of Acceptance

Financing 652

Discounting 652Factoring 653

Evaluating the Cost of Factoring 653

Forfaiting 65418.4 Government Sources of Export Financing

and Credit Insurance 654Export Financing 654

Export-Import Bank 655Private Export Funding Corporation 657Trends 657

Export-Credit Insurance 657Foreign Credit Insurance Association 658

Taking Advantage of Government-Subsidized Export Financing 658Export Financing Strategy 659Import Financing Strategy 659

18.5 Countertrade 66018.6 Summary and Conclusions 663

Questions 664


1 9 SHORT-TERM FINANCING:

MANAGING CURRENT ASSETS 6 6 6

Learning Objectives

Key Terms 666

666

19.1 International Cash Management 667Organization 668Collection and Disbursement

of Funds 668

Payments Netting in International CashManagement 671Bilateral and Multilateral Netting 672In/ormation Requirements 673Foreign Exchange Controls 674Analysis 674

Management of the Short-TermInvestment Portfolio 675Portfolio Guidelines 676

Optimal Worldwide Cash Levels 678Evaluation and Control 678

Cash Planning and Budgeting 679Multinational Cash Mobilization 679

Bank Relations 68119.2 Accounts Receivable Management 683

Credit Extension 68319.3 Inventory Management 684

Production Location and InventoryControl 685

Advance Inventory Purchases 686Inventory Stockpiling 686

19.4 Short-Term Financing 686Key Factors in Short-Term Financing

Strategy 687

Short-Term Financing Objectives 688Short-Term Financing Options 689

Intercompany Financing 689Local Currency Financing 689Bank Loans 689

Commercial Paper 692Calculating the Dollar Costs of Alternative

Financing Options 693Case 1: No Taxes 694Case 2: Taxes 695

19.5 Summary and Conclusions 697Questions 698Problems 699Web Resources 700

XXII CONTENTS

Web Exercises, 700Bibliography 700

2 O ANALYZING MULTINATIONAL

FINANCIAL SYSTEMS

701

7 O 1

Learning ObjectivesKey Terms 701

20.1 The Value of the Multinational FinancialSystem 702

Mode of Transfer 703Timing Flexibility 704Value 704

20.2 Intercompany Fund-Flow Mechanisms:Costs and Benefits 706

Tax Factors 706Transfer Pricing 706

ToxEJfects 707Tariffs 708Exchange Controls 710Joint Ventures 711Disguising Profitability 711

Evaluation and Control 711

Reinvoicing Centers 711Fees and Royalties 712Leading and Lagging 714

Shi/ting Liquidity 714

Advantages 716

Government Restrictions 716

Intercompany Loans 716Back-lo-Back Loans 716

Parallel Loans 719

Dividends 720Tax Ejects 720Financing Requirements 721Exchange Controls 721

Joint Ventures 723

Equity versus Debt 72320.3 Designing a Global Remittance

Policy 726Prerequisites 727Information Requirements 728Behavioral Consequences 728


GLOSSARY 735

INDEX 751