International Finance Fundamentals: MNCs, FX Risk, and Global Operations

Chapter 21: International Financial Management Concepts

Key International Finance Terminology

• Know all terms and their definitions.

Multinational Corporations (MNCs)

What is a multinational corporation? MNCs engage in various forms of international business:

• Exporter
• Licensing Agreement
• Joint Venture
• Fully Owned Foreign Subsidiary

Foreign Exchange Rates and Influencing Factors

Understand foreign exchange rates and the factors that influence them:

• Purchasing Power Parity (PPP) and the Purchasing Power Parity Theory
  • Practice Problems 3, 4
• Inflation
• Interest Rates and the Interest Rate Parity Theory
• Balance of Payments (A trade surplus strengthens the currency; a trade deficit weakens it.)
• Government Policies (e.g., central bank’s actions)
• Other factors: stock market rallies, increased demand for primary exports, political instability, etc.

Spot Rates vs. Forward Rates

• Spot Rates: The exchange rate at the time of the exchange.
• Forward Rates: The exchange rate agreed upon for future delivery.
• Forward Premium (or Discount, if negative) Calculation:

  Forward Premium = [(Forward Rate - Spot Rate) / Spot Rate] * 12 / months length of forward contract

  • Example: Spot rate for Swiss Franc is $1.0281, and 90-day (3 months) forward rate is $1.0316.

    Forward Premium = [(1.0316 - 1.0281) / 1.0281] * 12 / 3 = 1.36%

  • Practice Problem 1

Calculating Cross Rates

Cross Rates are used to find the exchange rates of two other currencies using their exchange rates relative to the USD.

• For example: Swiss Franc (CHF) price was $1.0231; British Pound (GBP) price was $1.46596.

  The cross rate of Swiss Franc and British Pound is 1.43294 francs to buy 1 pound.

  • Calculation: ($1 / $1.0231 per CHF) * $1.46596 per GBP = 1.43294 CHF per 1 GBP
  • Practice Problem 2

Managing Foreign Exchange Risk

Understanding and mitigating risks associated with currency fluctuations.

Sources of Foreign Exchange Exposure:

• Accounting (Translating) Exposure
• Transaction Exposure (Practice Problems 5, 6)
  • Strategies to minimize transaction exposure:
    • Hedging in the Forward Exchange Market
    • Hedging in the Money Market
    • Hedging in the Currency Futures Market
    • Practice Problem 7

Foreign Investment Decisions and Political Risk

• Political Risk: Risks associated with government actions, such as Repatriation (restrictions on moving funds) and Expropriation (government seizure of assets).
• Strategies to minimize political risk:
  • Establish joint ventures with local entrepreneurs.
  • Establish joint ventures with partners from other countries.
  • Get insurance through OPIC (Overseas Private Investment Corporation), or other providers like Lloyd's of London, American International Group Inc. (AIG), CIGNA, etc.

Financing International Operations

• Letters of Credit
• Export Credit Insurance (FCIA - Foreign Credit Insurance Agency)
• Eximbank (Export-Import Bank of the United States)
• Borrowing from a parent company or a sister affiliate
• Eurodollar Loans (loans issued at LIBOR)
• Eurobonds
• International Equity Markets (use of ADRs - American Depository Receipts)
• International Finance Corporation (IFC)

The Dynamic Nature of International Finance

International financial management is an ever-changing process.