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Introduction to Global Business
Chapter 14
Global Financial Management
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After studying this chapter, you should be able to:
1. Explain how foreign exchange risk affects firms and
investors.
2. Describe different ways to hedge exchange rate risk.
3. Discuss sources of funds to finance international trade
and investment.
4. Apply net present value analyses to the capital
budgeting decisions facing firms with international
operations.
5. Discuss how exchange rate risk affects firms’ cash flows
and its impact on stock returns.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Measuring Foreign Exchange Exposure
• Exchange rate risk
– The impact of random change in the value of one currency with
respect to other currencies
• Transactions risk
– How short-term changes in exchange rates can affect operating
costs and revenues of firms engaged in international business
activities
• Translation risk
– The short-term effects of currency movements on the consolidated
accounting statements of a firm
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Measuring Foreign Exchange Risk (continued)
• Consolidated accounting statements
– The income statements and balance sheets of multinational
corporations and of all subsidiaries abroad
• Economic risk
– The ways in which long-term exchange rate movements affect
firms
• Special drawing right (SDR)
– A basket of currencies consisting of dollars, euros, pounds, and
yen created by the International Monetary Fund (IMF)
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Hedging Foreign Exchange (Forex) Risk
with Derivatives
• Hedging
– Using currency derivatives to reduce potential transaction,
translation, and economic risks of currency movements that could
lead to losses for a firm or investor
• Speculators
– Trade in currencies and currency derivatives to earn profits and to
help to make currency prices efficient
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Futures Contracts
• Currency futures contracts
– Standardized agreements to buy or sell a specified amount of
currency at a date in the future at a predetermined price
• Long position
– Buying a currency contract and profiting on the increased value of
the underlying currency over time
• Short position
– Selling a currency contract and profiting on the decreased value of
the currency over time
• Organized exchanges
– Trade futures contracts in major currencies and offer price
transparency and efficiency in addition to eliminating counterparty
risk due to guaranteed payments on contacts
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Futures Contracts (continued)
• Common rules in trading currency futures contracts:
– Futures contracts are marked-to-market—gains (losses) are
earned (paid) in cash at the end of each trading day.
– Contracts can be purchased for a small commitment fee called the
margin.
– If losses occur causing a participant’s balance to fall below the
maintenance margin at the end of the trading day, a margin call
occurs that requires the customer to replenish the margin account.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Forward Contracts
• Currency forward contracts
– Futures contracts in the currencies of emerging-market countries
offered by large banks in the OTC market
– Less standardized than future contracts such that they can be
customized by the seller/counterparty to meet the hedging needs
of the buyer
– Are not marked-to-market daily
• Over-the-counter (OTC) market
– Derivatives market run by large banks
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Options Contracts
• Call option
– An investor’s right (but not obligation) to buy an asset (e.g., a
currency) at a predetermined (strike) price
• Put option
– An investor’s right (but not obligation) to sell an asset (e.g., a
currency) at a predetermined price
• Premium
– The price paid by the buyer to the seller for an option contract
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Swap Contracts
• Currency swaps
– Allow firms to exchange currencies at a previously agreed
exchange rate as a way to hedge exchange rate movements
• Plain vanilla currency swap
– An interest rate swap, often combined with a currency swap, if the
interest being swapped is in different currencies
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Financing International Trade
and Investment
• Firms finance international operations in a variety of
ways.
– Short-term financing of goods and services is handled by large
banks.
– Long-term financing of capital equipment, land, and buildings is
provided by international bond and stock markets.
– Government financing is also available to meet international trade
policy goals in a particular country.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
International Banking
• Money center banks
– Large global banks
• Clearing House Interbank Payments System (CHIPS)
– Provides large, wholesale dollar payments services for
businesses, banks, and governments
• Society of Worldwide Interbank Financial
Telecommunications (SWIFT)
– Provides secure communications for contracts, invoices, and other
trade documents that accompany cash payments
• Syndicate
– A group of banks that collectively make a loan to an international
firm
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
International Payment Methods
and Documentation
Payment in
Advance
• The safest
method for
exporters, but it
exposes
importers to risk
related to
delivery of
goods
Commercial
Letter of
Credit (LC)
• Provides
payment
protection to
both exporters
and importers,
as the importer’s
bank writes a
guarantee of
payment
Banker’s
Acceptance
Open
Account
• When a bank
sells a LC into
the financial
marketplace as
a money market
instrument
• A simple
agreement
wherein the
exporter sends
an invoice with
the goods and
the exporter
pays upon the
receipt
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
International Bond Markets
• Bond ratings
– Moody’s and Standard and Poor’s rating services that are
important in assuring foreign investors of the credit quality of bond
issues
• Domestic bonds
– Debt contracts sold by firms domiciled in a country in the home
currency
• Foreign bonds
– Bonds that are issued by foreign firms in another country in the
home currency of that country
• Eurobonds
– Bonds that are sold in any country outside the home country, but in
the home country’s currency
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
International Stock Markets
• Diversification
– Buying securities in a portfolio with price patterns over time that
are different from one another, which reduces the volatility of the
portfolio
• Home bias
– Investing most of retirement and other savings in one’s home
country, which reduces diversification
• Contagion
– When stock markets in many countries move down in concert with
one another and thereby reduce international diversification
benefits
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Government Financing
• International Monetary Fund (IMF)
– Provides “lender-of-last-resort” short-term loans to countries in
financial crisis
– Evaluates exchange rate policies
– Gives technical assistance to countries
• World Bank
– Provides long-term loans for economic reform and infrastructure
development in emerging and developing markets
• IMF and World Bank are major suppliers of emergency
and development assistance to poorer countries.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Government Financing (continued)
• Major government-supported international financing
institutions include:
– Export-Import (Ex-Im) Bank—a U.S. government export finance
agency that supports U.S. firms competing against governmentsupported exports of other countries
– Bank of International Cooperation (JBIC)—Japanese bank that
supports exporters around the world that have at least 30 percent
Japanese content
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Government Financing (continued)
• Trade finance
– Bank and government loans used by exporters to finance working
capital (i.e., labor, materials, inventory, and accounts receivables)
• Term financing
– Bank and government loans to importers to cover the cost of major
purchases
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Parent Firm Capital Budgeting (continued)
• Country risk
– The uncertainty in predicting how economic, political, inflation, and
tax risk factors will affect an investment in a country
• Sensitivity analysis
– An examination of optimistic, expected, and pessimistic scenarios
to give a more complete picture of the risks and returns of
investments abroad
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
The Cost of Capital: Domestic Versus Global
• Cost of capital
– The required rate of return demanded by stock and bond investors
– Used in net present value capital budgeting analyses as the
discount rate
• Weighted average cost of capital
– The sum of the costs of equity and debt weighted by the amount of
financing from these two capital sources
© 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
The Cost of Capital: Domestic Versus Global
(continued)
• The weighted average cost of capital for a firm is:
K = (Equity/Total Market Value) R + (Debt/Total Market Value) (1 – Tax Rate) I
where
Equity = market value of common and preferred stock
outstanding
Debt = market value of long-term debt outstanding
R = cost of equity or required rate of return of equity
holders
I = before-tax cost of debt or interest rate
Tax Rate = marginal tax rate of the firm
Total Market Value = Equity + Debt.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
The Cost of Capital: Domestic Versus Global
(continued)
• Cost of debt
– The weighted average of different interest rates paid on long-term
borrowings
• Cost of equity
– The rate of return on equity required by stockholders as estimated
by Capital Asset Pricing Model (CAPM)
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
The Cost of Capital: Domestic Versus Global
(continued)
• The CAPM is written as follows:
Rit = Rft + i(Rmt – Rft),
where
Rit = the one-month return on stock i in month t
Rmt = the one-month return on a domestic market index (e.g.,
the S&P 500 index of the 500 largest U.S. firms)
Rft = the one-month riskless rate of return (e.g., the U.S.
Treasury bill rate)
i = the domestic beta risk measure for the stock.
© 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
The Cost of Capital: Domestic Versus Global
(continued)
• International CAPM (ICAPM)
– An asset pricing model that includes both domestic and global
market factors to estimate the cost of equity or required rate of
return on stocks
– The estimated rate of return required by stockholders as estimated
by ICAPM) is:
𝑅𝑖𝑡 = 𝑅𝑓𝑡 + 𝛽𝑖 𝑅𝑚𝑡 − 𝑅𝑓𝑡 +
𝑔
𝛽𝑖 (𝑅𝑔𝑡
− 𝑅𝑓𝑡 )
where
Rgt = the one-month return on a global market index (e.g.,
the Dow Jones world index of stocks
𝑔
𝛽𝑖 = the global beta risk measure for the stock and other
terms as before.
© 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Currency Risk and Stock Valuation
• Cash flow sensitivity to exchange rate risk
– Firms can experience positive and negative fluctuations in cash
flows and profits due to currency movements that strengthen or
weaken the value of their products in overseas markets.
– One channel for currency movements to impact MNC cash flows is
export sales.
– Another channel for dollar movements to affect companies is
through oil imports, normally priced in dollars.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Stock Values and Foreign Exchange Movements
• Measurement of long-run exchange risk (Adler and
Dumas):
Rit = Rft + i(Rmt – Rft) + CRCt
where
RCt = the one-month return on local currency relative to a
basket of currencies in month t
C = the exchange rate risk measure for the stock and other
terms are the same as in the CAPM equation.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Stock Values and Foreign Exchange Movements
(continued)
• Market factors affecting equity valuations
– Exchange rate sensitivity—a stock value measured with the
coefficient obtained by regressing the stock’s return on a
currency’s return over time
– Exchange risk beta—the sensitivity of a stock to market risk
affected by currency movements
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Stock Values and Foreign Exchange Movements
(continued)
• Measurement of exchange risk (Armstrong, Knif, Kolari,
and Pynnönen):
Rit = Rft + b0(Rmt – Rft) + b1(Rmt – Rft) RCt
where
b0 = the market beta with no exchange risk
b1 = the market beta associated with exchange risk
© 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Key Terms
exchange rate risk
transactions risk
translation risk
consolidated accounting
statements
economic risk
Special Drawing Right (SDR)
hedging
speculators
currency futures contracts
long position
short position
organized exchanges
marked-to-market
margin
margin call
currency forward contracts
over-the-counter (OTC) market
call option
put option
premium
currency swaps
plain vanilla currency swap
money center banks
© 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Key Terms (continued)
CHIPS (Clearing House
Interbank Payments System)
SWIFT (Society of Worldwide
Interbank Financial
Telecommunications)
payment in advance
commercial letter of credit (LC)
banker’s acceptance
open account
syndicate
bond ratings
domestic bonds
foreign bonds
eurobonds
diversification
home bias
contagion
Export-Import (Ex-Im) Bank
trade finance
term financing
Bank of International
Cooperation (JBIC)
net present value
country risk
© 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Key Terms (continued)
sensitivity analysis
cost of capital
weighted average cost of
capital
cost of debt
cost of equity
beta risk
international CAPM (ICAPM)
size factor
value factor
exchange rate sensitivity
exchange risk beta
© 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.