MNC Overview Exchange Rate Determination 𝑭𝒖𝒕𝒖𝒓𝒆 𝑺𝒑𝒐𝒕 𝑹𝒂𝒕𝒆

𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑬/𝑹 = −𝟏
Justification of overseas expansion Factors influencing the E/R; 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑺𝒑𝒐𝒕 𝑹𝒂𝒕𝒆
1) Theory of Comparative Advantage: each country specialise 1)∆in inflation differential of home & foreign 𝟏 + 𝑰𝒏𝒇𝒍𝒂𝒕𝒊𝒐𝒏𝑯𝒐𝒎𝒆
= −𝟏
to increase production efficiency and depend on others for other
2)∆in interest rate differential of home & foreign 𝟏 + 𝑰𝒏𝒇𝒍𝒂𝒕𝒊𝒐𝒏𝑭𝒐𝒓𝒆𝒊𝒈𝒏
needs. 3)∆in income level differential of home & foreign *Factors preventing PPP in SR is the transaction costs, interest
2) Imperfect Markets Theory: Immobile factors of production 4)∆in Government controls rates… since PPP only considers inflation
encourage countries to specialise. 5)∆in expectations of future exchange rate
3) Product Cycle Theory: Market saturated, need to expand -Speculations Limitations of PPP;
overseas to renew relevance Effects of inflation, I/R and income on E/R 1) Confounding effects; spot rate is affected by other factors such
as e=f(∆INT, ∆INF, ∆GC, ∆EXP, ∆INC). ∴ relationship not as
Expansion Choices ↑Inflation=↑Price of currency =↑Import+↓Export simple as ∆INF=∆E/R.
1) Int’l Trade 2) Licensing 3) Franchising =↑ Supply +↓Demand = ↓ E/R 2)No Substitute for traded goods; no alternative to buy from
4) Joint Ventures 5) Acquisition 6) Establish foreign subsidies↑Int. Rate=↑ Inflow +↓Outflow = ↓Supply+↑ Demand imports if domestically unavailable
1 has lowest risk, 6 is highest risk due to capital =↑ E/R (Ppl invest for attractive Int Rates) *𝟕. 𝟗𝟔 =
𝟏.𝟔
, 𝟖. 𝟎𝟓 =
𝟏.𝟔𝟏
Fisher Effect; Nominal interest rate contains expected inflation
Valuation Model For MNC ↑Income levels= ↑Imports = ↑Supply = ↓ E/R 𝟎.𝟐𝟎𝟏 𝟎.𝟐𝟎𝟎
rate and real interest rate; Suggests that differences in interest
𝑬[𝑪𝑭] Covered Interest Arbitrage (Takes Time)
𝑽=∑ *Changes in Income has no effect on Demand of E/R rate is due to differences in expected inflation rates.
(𝟏 + 𝒌)𝒕 Capitalise on interest rate differential between 2 countries while
Interest is derived from Bank Lending Rates covering Exchange rate risk with a forward contract
Uncertainties cause valuation to fall. Limitation of Fisher Effect: Difference between nominal Int rate
Currency Derivatives
1) Economic Exposure (Chapter 10) 𝑭𝒐𝒓𝒘𝒂𝒓𝒅 𝑹𝒂𝒕𝒆 𝟏 + 𝒊⁄𝒓𝒉 and Actual Inflation rate not consistent. ∴ there is a poor
𝑭𝒐𝒓𝒘𝒂𝒓𝒅 𝑹𝒂𝒕𝒆 𝑭𝒐𝒓𝒘𝒂𝒓𝒅 𝑷𝒓𝒆𝒎𝒊𝒖𝒎 = −𝟏= −𝟏 estimation of reality of market and estimated expected inflation.
2) Exposure to Political Risk (Tax & Barriers) 𝑭𝒐𝒓𝒘𝒂𝒓𝒅 𝑷𝒓𝒆𝒎𝒊𝒖𝒎 = −𝟏 𝑺𝒑𝒐𝒕 𝑹𝒂𝒕𝒆 𝟏 + 𝒊⁄𝒓𝒇
𝑺𝒑𝒐𝒕 𝑹𝒂𝒕𝒆
3) Translation & Transaction Exposure
Futures Speculation; If Currency expected to ↓, *If Forward Premium = interest rate differential, covered interest
∴ Higher Required return & ↓ 𝑉𝑎𝑙𝑢𝑎𝑡𝑖𝑜𝑛
1) Sell futures contract at $ 0.09 arbitrage is not possible
2)Buy at future spot rate at $0.08. International Fisher Effect; Suggests that currencies with high
Int’l Flow of Funds interest rates will have high expected inflation (Due to FE) &
3)Fulfil contract by selling at $0.09, earning $0.01
Current Account; Imports & Exports, Taxes, Investment Income, relatively high inflation causes the currencies to depreciate (due
Uses of Futures, Forwards & Options;
Factor Income Payment to PPP).
1) Sell to hedge receivables
Capital Accounts; Transactions in financial instrument for ppl
2) Buy to hedge payables *In the LR, returns of both foreign & domestic returns must be
who migrate overseas the same due to smart money flowing to achieve equilibrium
3) Speculate to earn money
Financial Accounts; DFI, Stock Investment, Errors & Omissions (investors will achieve same yield after adjusting for E/R
Factors Affecting Options Premiums; fluctuations)
& Reserves
Premium= f(Spot-Strike price, Time , variability ) 𝟏 + 𝒊⁄𝒓𝒉
Debit= Outflow, Credit = Inflow
*Paid Upfront 𝑰𝒏𝒕𝒆𝒓𝒏𝒂𝒕𝒊𝒐𝒏𝒂𝒍 𝑭𝒊𝒔𝒉𝒆𝒓 𝑬𝒇𝒇𝒆𝒄𝒕 = −𝟏
Factors affecting Int’l Trade Flow; 𝟏 + 𝒊⁄𝒓𝒇
Breakeven on options= Strike Price + Option Premium
1) Labour Cost 2) Inflation 3) National Income
Put Options Profit =Sell Price- Purchase price- Premium
4) Credit Conditions 5) E/R 6) Govt Policies Exposure to Exchange Rate Fluctuations
Factors Affecting Direct Foreign Investment; Definition; Dollar Value of MNC’s future cashflow in foreign
1) Changes in Govt Restriction (Barriers Removed) currency can change substantially due to E/R
2) Privatisation 3) Potential Economic Growth Interest Rate Parity; suggests that in equilibrium, forward rate
Arguments against Hedging;
4) Tax rates 5) Exchange Rate 6) Interest Rate differs from spot rate by a sufficient amount to offset interest rate
1)Investor Hedge Argument; can do it on their own due to better
differential. (Size of forward premium should equal interest rate
corporate knowledge
Int’l Financial Markets differential of the two countries of concern)
2)Currency Diversification; MNCs are well diversified across
Bid Ask Spread= (Ask-Bid)/Ask *If IRP holds, Covered Interest Arbitrage not possible
numerous currencies to offset the fluctuations in exchange rate
Factors affecting spread; *If Implied forward rate<Given forward rate; sell forward
3)Stakeholder diversification; if they are well diversified, they are
1) Order Costs 2) Inventory Cost contract
insulated against losses
3) Competition 4) Volume 5) Currency Risk Factors to consider when interpreting IRP;
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑃𝑒𝑠𝑜 𝑖𝑛 $ 𝑆0.07 1) Transaction costs
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑃𝑒𝑠𝑜 𝑖𝑛 𝐶$ = = = 𝐶$0.1 Transaction Exposure: Sensitivity of firm’s contractual
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐶$ 𝑖𝑛 $ $0.7 2) Political Risks (restrict exchange of currency)
transactions in foreign currency due to Exchange Rate
Forwards: OTC, Customised, if Forward>Spot, currency is 3) Differential Tax laws (After-tax returns of Covered interest
movements.
expected to appreciate Arbitrage may not be feasible)
Must assess overall transaction exposure via absolute dollar
Futures: Standardised and traded on exchange; used to hedge if *Arbitrage opportunities disappear due to;
future spot rate > futures rate, more liquid than forwards. value comparison
Int’l Arbitrage & Interest Rate Parity 1) Withdrawal of home currency causes ↑i/r
Options: Right to buy/sell at a specific price at specific time. Call 2) Influx of foreign currency causes ↓i/r 𝜎𝑝 = √𝑊𝜒2 𝜎𝜒2 + 𝑊𝛾2 𝜎𝛾2 + 2𝑊𝜒 𝑊𝛾 𝜎𝜒 𝜎𝛾 𝐶𝑂𝑅𝑅𝜒𝛾
Defined: Capitalising on a discrepancy in quoted prices by
Options; Hedge Payable & Put Options; Hedge Receivables.
making a riskless profit. *Generally, MNCs with less foreign costs than revenues will be
Money Mkt, Credit Mkt & Bond Mkt used by companies to gain
funds from short to longest term. Locational Arbitrage (Instantaneous) R/S btwn Inflatn, Interest & Exchange Rates favourably affected by a stronger foreign currency
Risk of Bonds: 1) Int Rate Risk 2) Liquidity Risk (Can’t sell off) 3) Process of buying currency at a cheaper rate & selling it at a
Credit Risk 4) Exchange Rate Risk higher rate in another location Purchasing Power Parity: Specifies a precise relationship
between the relative inflation rate of 2 countries & their
Factors Influencing the International Stock Mkt; Triangular Arbitrage (Instantaneous) exchange rates.
1) Rights 2) Legal Protection of Shareholders Currency transaction in spot market to capitalise pricing Equilibrium exchange rate will adjust by the same magnitude
3) Accounting Laws 4) Govt. Enforcement of Securities Law discrepancies in cross exchange rate in 2 countries as the difference between 2 countries’ exchange rate
Rate of Return=[(1+i/r)(1+ε)]-1, Suggests that consumers shift demand where price is cheaper
Where ε= appreciation/ depreciation of currency until equilibrium is formed & Purchasing Power is Equal.
Economic Exposure: Sensitivity of firm’s cashflow to exchange Involves adjusting timing of payment request or disbursement 3)Restriction on earning’s repatriation(Blocked Funds)
rate movements (E.g.: Due to ↑E/R, clients seek cheaper to reflect expectations of future currency movements. Lead; faster
alternatives from overseas competitors, causing overall fall in & vice versa Components of a forecasted budget;
sales) 2) Cross Hedging 1) Initial Investment
Due to lack of currency liquidity, use another currency with
2) Price & Consumer Demand
high correlation as proxy to hedge.
3) Fixed & Variable Costs
3) Currency Diversification
Diversify business interests among many countries 4) Tax Laws
Purchase Put Option ( Exercise = $0.72, premium=.02) 5) Remitted Funds
Managing Economic Exposure 6) Exchange Rate
Step1: Assess Economic exposure (Inflow Vs. Outflow) 7) Salvage Values
8) Required Rate of Return

Measuring Economic Exposure using regression analysis 𝐶𝐹 𝑆𝑉

𝑁𝑃𝑉 = −𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑂𝑢𝑡𝑙𝑎𝑦 + ∑ +
𝑃𝐶𝐹𝑡 = 𝛼0 + 𝛼1𝜀𝑡 + 𝜇𝑡 (1 + 𝑘)𝑡 (1 + 𝑘)𝑃𝑟𝑜𝑗𝑒𝑐𝑡 𝐿𝑖𝑓𝑒
Where, PCF= %∆inflation- adjusted CF in home currency
𝛼0 = 𝐼𝑛𝑡𝑒𝑟𝑐𝑒𝑝𝑡 , 𝜀𝑡 = %∆ in direct exchange rate, Money Market Hedge Breakeven Salvage Value
𝜇𝑡 = 𝑅𝑎𝑛𝑑𝑜𝑚 𝑒𝑟𝑟𝑜𝑟 𝑡𝑒𝑟𝑚, 𝛼1 = 𝑠𝑙𝑜𝑝𝑒 𝑐𝑜𝑒𝑓𝑓𝑖𝑐𝑖𝑒𝑛𝑡 𝐶𝐹
𝑆𝑉 = (−𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑂𝑢𝑡𝑙𝑎𝑦 + ∑ ) ∗ (1 + 𝑘)𝑃𝑟𝑜𝑗𝑒𝑐𝑡 𝐿𝑖𝑓𝑒
(1 + 𝑘)𝑡
Translation Exposure: Exposure of MNC’s consolidated
financial statements to E/R fluctuations when repatriating profits Sample Capital Budgeting Analysis
(Can only occur with presence of overseas subsidiary)
Step 2: Restructure to Increase sensitivity of revenue and
Factors affecting Translation Exposure: decrease sensitivity of expenses.
1) % of business conducted by foreign subsidiaries
2) Location of subsidiary & its corresponding currency
3) Accounting method it uses (Affect Valuation due to P/E
multiple)

Managing Transaction Exposure

Methods of Hedging:
1) Forwards/ Futures Hedge Difficulties in Implementation;
2) Call Options Hedge 1) Source of economic exposure is not obvious
Cost= Payable X (min (future spot rate, Strike price) + Call Premium) 2) Level of economic exposure is uncertain
3) Money Market Hedge Possible Strategies in hedging Economic Exposure
Borrow home currency & convert to foreign currency to earn 1)Pricing Policy (Discounts off its goods) Other Factors of Consideration that affects Budget
interest in foreign banks 2) Hedging with forward contracts 1) Exchange Rate Fluctuations
*If IRP holds, money market & forward hedge will yield same 3) Purchasing Foreign Supplies
returns as forward premiums on forward rates reflects the
interest rate differential Managing Translation Exposure
Real cost of hedging = Cost of hedging payable- Cost of not Manage by hedging with forward contracts;
hedging Gain= Quantum X (Forward Rate-Spot Rate)
Limitations;
Factors to picking Hedging Techniques; 1)Inaccurate Earnings Forecast
1) Preference for Forwards or Futures 2)Inadequate forward contracts for some currencies
2) Desirability of money market Vs Future/Forwards based on
3)Increased Transaction Exposure
cost
3) Feasibility of currency call option based on estimated cash 2) Inflation
flows Multinational Capital Budgeting 3) Financing Arrangements
MNCs determine whether an international project is feasible by If Parent’s finance big purchase, there is no need for interest/
comparing the present value of that project’s expected future principal repayment as compared to leasing
Forward Hedge cash flows to the initial investment that would be necessary for 4) Blocked Funds
Purchase Euros (€) one year forward that project.  Certain countries may impose a vesting period of at least 3
$ needed in 1 year= Payables in € X forward rate of € years which disallows immediate repatriation
=€100,000 X $1.2 Cost Benefit Analysis should be done from parent’s perspective 5) Uncertain Salvage Value
= $120,000 unless it is not wholly owned. 6) Host Government Incentives
Call Options
Cash flow differences may occur due to;
Purchase Call option (Exercise =$1.20, Premium=$0.03)
Limitations of Hedging 1)Tax on remitted funds (feasible from subsidiary perspective
1) Overhedging due to uncertainty in transaction quantum but not when remitted back to parents)
2) Fall in effectiveness of ST hedging (hedging effect is minimal as 2)Exchange Rate Movements
it is continuously revised upwards) May not be feasible to parent if subsidiary’s currency expected
Alternative Hedging Techniques to weaken over time
1)Leading & Lagging