Multinational Financial Management

List of Figures xix List of Tables xxiii Preface xxvii World Currencies and Symbols xxxi Acronyms and Symbols xxxv Part I The International Financial Management Environment 1 Introduction: Multinational Corporations and Financial Management 3 1.1 The Rise of the Multinational Corporation 4 1.1.1 Evolution of the Multinational Corporation 7 1.1.2 The Process of Overseas Expansion by Multinationals 14 1.1.3 A Behavioral Definition of the Multinational Corporation 17 1.1.4 The Global Manager 18 1.2 The Internationalization of Business and Finance 18 1.2.1 Political and Labor Union Concerns About Global Competition 19 1.2.2 Consequences of Global Competition 22 1.3 Multinational Financial Management: Theory and Practice 24 1.3.1 Functions of Financial Management 25 1.3.2 Theme of This Book 25 1.3.3 Relationship to Domestic Financial Management 26 1.3.4 The Global Financial Marketplace 28 1.3.5 The Role of the Financial Executive in an Efficient Market 28 1.4 Outline of the Book 29 1.4.1 The International Financial Management Environment 29 1.4.2 The Foreign Exchange and Derivatives Markets 29 1.4.3 Foreign Exchange Risk Management 29 1.4.4 The International Capital Markets and Portfolio Management 29 1.4.5 International Capital Budgeting 30 Questions 30 Appendix: The Origins and Consequences of International Trade 31 Questions 35 2 The Determination of Exchange Rates 37 2.1 Setting The Equilibrium Spot Exchange Rate 38 2.1.1 Factors That Affect the Equilibrium Exchange Rate 39 2.1.2 Calculating Exchange Rate Changes 41 2.2 Expectations and The Asset Market Model of Exchange Rates 43 2.2.1 The Nature of Money and Currency Values 44 2.2.2 Central Bank Reputations and Currency Values 44 2.3 The Fundamentals of Central Bank Intervention 49 2.3.1 How Real Exchange Rates Affect Relative Competitiveness 50 2.3.2 Foreign Exchange Market Intervention 50 2.3.3 The Effects of Foreign Exchange Market Intervention 53 2.4 The Equilibrium Approach To Exchange Rates 55 2.5 Disequilibrium Theory and Exchange Rate Overshooting 55 2.5.1 The Equilibrium Theory of Exchange Rates and Its Implications 56 2.6 Conclusions 58 Questions 60 Problems 61 References 62 3 The International Monetary System 63 3.1 Alternative Exchange Rate Systems 64 3.1.1 The Trilemma and Exchange Rate Regime Choice 64 3.1.2 Free Float 66 3.1.3 Managed Float 67 3.1.4 Target-Zone Arrangement 69 3.1.5 Fixed Rate System 69 3.2 A Brief History of the International Monetary System 70 3.2.1 The Classical Gold Standard 71 3.2.2 How the Classical Gold Standard Worked in Practice: 1821–1914 73 3.2.3 The Gold Exchange Standard and Its Aftermath: 1925–1944 73 3.2.4 The Bretton Woods System: 1946–1971 74 3.2.5 The Post-Bretton Woods System: 1971 to the Present 76 3.2.6 Assessment of the Floating Rate System 77 3.3 The European Monetary System and Monetary Union 78 3.3.1 The Exchange Rate Mechanism 79 3.3.2 Lessons from the European Monetary System 79 3.3.3 The Currency Crisis of September 1992 79 3.3.4 The Exchange Rate Mechanism Is Abandoned in August 1993 80 3.3.5 European Monetary Union 81 3.3.6 Optimum Currency Area 88 3.3.7 Exchange Rate Regimes Today 93 3.4 Emerging Market Currency Crises 96 3.4.1 Transmission Mechanisms 96 3.4.2 Origins of Emerging Market Crises 96 3.4.3 Policy Proposals for Dealing with Emerging Market Crises 97 3.5 Summary and Conclusions 98 Questions 99 Problems 100 References 100 4 Parity Conditions in International Finance and Currency Forecasting 101 4.1 Arbitrage and the Law of One Price 102 4.2 Purchasing Power Parity 104 4.2.1 The Lesson of Purchasing Power Parity 108 4.2.2 Expected Inflation and Exchange Rate Changes 109 4.2.3 The Monetary Approach 110 4.2.4 Empirical Evidence 110 4.3 The Fisher Effect 113 4.3.1 Empirical Evidence 114 4.4 The International Fisher Effect 118 4.4.1 Empirical Evidence 119 4.5 Interest Rate Parity Theory 120 4.5.1 Empirical Evidence 123 4.6 The Relationship Between The Forward Rate and The Future Spot Rate 123 4.6.1 Empirical Evidence 126 4.7 Currency Forecasting 126 4.7.1 Requirements for Successful Currency Forecasting 127 4.7.2 Market-Based Forecasts 127 4.7.3 Model-Based Forecasts 129 4.7.4 Model Evaluation 130 4.7.5 Forecasting Controlled Exchange Rates 132 4.8 Summary and Conclusions 132 Questions 133 Problems 135 References 137 5 The Balance of Payments and International Economic Linkages 139 5.1 Balance-Of-Payments Categories 140 5.1.1 Current Account 141 5.1.2 Capital Account 144 5.1.3 Financial Account 144 5.1.4 Balance-of-Payments Measures 145 5.1.5 The Missing Numbers 146 5.2 The International Flow of Goods, Services, and Capital 146 5.2.1 Domestic Saving and Investment and the Financial Account 146 5.2.2 The Link between the Current and Financial Accounts 147 5.2.3 Government Budget Deficits and Current-Account Deficits 149 5.2.4 The Current Situation 150 5.3 Coping with the Current-Account Deficit 153 5.3.1 Currency Depreciation 153 5.3.2 Protectionism 157 5.3.3 Ending Foreign Ownership of Domestic Assets 158 5.3.4 Boosting the Saving Rate 158 5.3.5 External Policies 159 5.3.6 Current-Account Deficits and Unemployment 160 5.3.7 The Bottom Line on Current-Account Deficits and Surpluses 161 5.4 Summary and Conclusions 161 Questions 162 Problems 163 References 164 Part II The Foreign Exchange and Derivative Markets 6 The Foreign Exchange Market 167 6.1 Organization of the Foreign Exchange Market 168 6.1.1 The Participants 169 6.1.2 Size 172 6.2 The Spot Market 174 6.2.1 Spot Quotations 174 6.2.2 The Mechanics of Spot Transactions 181 6.3 The Forward Market 181 6.3.1 Forward Quotations 183 6.3.2 Forward Contract Maturities 186 6.4 Summary and Conclusions 186 Questions 186 Problems 187 References 188 7 Currency Futures and Options Markets 189 7.1 Futures Contracts 190 7.1.1 Forward Contract versus Futures Contract 191 7.2 Currency Options 194 7.2.1 Market Structure 195 7.2.2 Using Currency Options 196 7.2.3 Option Pricing and Valuation 201 7.2.4 Using Forward or Futures Contracts versus Options Contracts 203 7.2.5 Futures Options 205 7.3 Reading Currency Futures and Options Prices 206 7.4 Summary and Conclusions 206 Questions 208 Problems 209 Appendix: Option Pricing Using Black-Scholes 210 A.1 The Black-Scholes Model 210 A.2 Implied Volatilities 212 A.3 Shortcomings of the Black-Scholes Option Pricing Model 212 Problems 213 Appendix: Put-Call Option Interest Rate Parity 213 Problems 215 References 215 8 Currency, Interest Rate, and Credit Derivatives and Swaps 217 8.1 Interest Rate and Currency Swaps 218 8.1.1 Interest Rate Swaps 218 8.1.2 Currency Swaps 221 8.1.3 Economic Advantages of Swaps 228 8.2 Interest Rate Forwards and Futures 229 8.2.1 Forward Forwards 229 8.2.2 Forward Rate Agreement 230 8.2.3 Eurodollar Futures 231 8.3 Structured Notes 233 8.3.1 Inverse Floaters 233 8.3.2 Callable Step-Up Note 234 8.3.3 Step-Down Coupon Note 234 8.4 Credit Default Swaps 235 8.4.1 Single-Name CDS 235 8.4.2 CDS Indexes 237 8.5 Summary and Conclusions 238 Questions 239 Problems 239 Reference 241 Part III Foreign Exchange Risk Management 9 Measuring and Managing Translation and Transaction Exposure 245 9.1 Alternative Measures of Foreign Exchange Exposure 246 9.1.1 Translation Exposure 246 9.1.2 Transaction Exposure 246 9.1.3 Operating Exposure 247 9.2 Alternative Currency Translation Methods 247 9.2.1 Current/Noncurrent Method 248 9.2.2 Monetary/Nonmonetary Method 248 9.2.3 Temporal Method 248 9.2.4 Current Rate Method 249 9.3 Transaction Exposure 251 9.4 Designing a Hedging Strategy 251 9.4.1 Objectives 252 9.4.2 Costs and Benefits of Standard Hedging Techniques 255 9.4.3 Centralization versus Decentralization 258 9.4.4 Managing Risk Management 259 9.4.5 Accounting for Hedging and FASB 133 260 9.4.6 Empirical Evidence on Hedging 260 9.5 Managing Translation Exposure 261 9.5.1 Funds Adjustment 261 9.5.2 Evaluating Alternative Hedging Mechanisms 262 9.6 Managing Transaction Exposure 263 9.6.1 Forward Market Hedge 263 9.6.2 Money Market Hedge 265 9.6.3 Risk Shifting 267 9.6.4 Pricing Decisions 268 9.6.5 Exposure Netting 269 9.6.6 Currency Risk Sharing 270 9.6.7 Currency Collars 270 9.6.8 Cross-Hedging 273 9.6.9 Foreign Currency Options 274 9.7 Summary and Conclusions 277 Questions 278 Problems 279 References 282 Appendix: Statement of Financial Accounting Standards No. 52 283 10 Measuring and Managing Economic Exposure 287 10.1 Foreign Exchange Risk and Economic Exposure 288 10.1.1 Real Exchange Rate Changes and Exchange Risk 289 10.1.2 Importance of the Real Exchange Rate 290 10.1.3 Inflation and Exchange Risk 291 10.1.4 Competitive Effects of Real Exchange Rate Changes 292 10.2 The Economic Consequences of Exchange Rate Changes 294 10.2.1 Transaction Exposure 294 10.2.2 Operating Exposure 295 10.3 Identifying Economic Exposure 298 10.3.1 Aspen Skiing Company 298 10.3.2 Petróleos Mexicanos 298 10.3.3 Toyota Motor Company 299 10.4 Calculating Economic Exposure 300 10.4.1 Spectrum’s Accounting Exposure 301 10.4.2 Spectrum’s Economic Exposure 301 10.5 An Operational Measure of Exchange Risk 305 10.5.1 Limitations 306 10.6 Managing Operating Exposure 307 10.6.1 Marketing Management of Exchange Risk 307 10.6.2 Production Management of Exchange Risk 310 10.6.3 Planning for Exchange Rate Changes 313 10.6.4 Financial Management of Exchange Risk 314 10.7 Summary and Conclusions 316 Questions 318 Problems 319 References 322 Part IV The International Capital Markets and Portfolio Management 11 International Financing and National Capital Markets 325 11.1 Corporate Sources and Uses of Funds 326 11.1.1 Financial Markets versus Financial Intermediaries 326 11.1.2 Financial Systems and Corporate Governance 327 11.1.3 Globalization of Financial Markets 330 11.2 National Capital Markets As International Financial Centers 332 11.2.1 International Financial Markets 334 11.2.2 Foreign Access to Domestic Markets 335 11.3 Development Banks 340 11.3.1 The World Bank Group 341 11.3.2 Regional and National Development Banks 342 11.3.3 Private Sector Alternatives 343 11.4 Project Finance 344 11.5 Summary and Conclusions 345 Questions 345 Problems 346 References 347 12 The Euromarkets 348 12.1 The Eurocurrency Market 348 12.1.1 Modern Origins 349 12.1.2 Eurodollar Creation 350 12.1.3 Eurocurrency Loans 351 12.1.4 Relationship between Domestic and Eurocurrency Money Markets 353 12.1.5 Euromarket Trends 354 12.2 Eurobonds 355 12.2.1 Swaps 355 12.2.2 Links between the Domestic and Eurobond Markets 355 12.2.3 Rationale for Existence of Eurobond Market 358 12.2.4 Eurobonds versus Eurocurrency Loans 360 12.3 Note Issuance Facilities and Euronotes 360 12.3.1 Note Issuance Facilities versus Eurobonds 362 12.3.2 Euro-Medium-Term Notes 363 12.4 Euro-Commercial Paper 364 12.5 The Asiacurrency Market 365 12.6 Summary and Conclusions 365 Questions 366 Problems 366 References 367 13 International Portfolio Management 368 13.1 The Risks and Benefits of International Equity Investing 369 13.1.1 International Diversification 370 13.1.2 Investing in Emerging Markets 376 13.1.3 Barriers to International Diversification 380 13.1.4 Ways to Invest Internationally 381 13.2 International Bond Investing 383 13.3 Optimal International Asset Allocation 383 13.4 Measuring the Total Return From Foreign Portfolio Investing 385 13.4.1 Bonds 385 13.4.2 Stocks 385 13.5 Measuring Exchange Risk on Foreign Securities 386 13.5.1 Hedging Currency Risk 386 13.6 Summary and Conclusions 387 Questions 387 Problems 388 References 390 Part V International Capital Budgeting 14 Country Risk Analysis 395 14.1 Learning Objectives 395 14.2 Measuring Political Risk 396 14.2.1 Political Stability 397 14.2.2 Economic Factors 399 14.2.3 Subjective Factors 400 14.3 Economic and Political Factors Underlying Country Risk 405 14.3.1 Fiscal Irresponsibility 406 14.3.2 Monetary Instability 406 14.3.3 Controlled Exchange Rate System 408 14.3.4 Wasteful Government Spending 408 14.3.5 Resource Base 408 14.3.6 Country Risk and Adjustment to External Shocks 409 14.3.7 Market-Oriented versus Statist Policies 410 14.3.8 Key Indicators of Country Risk and Economic Health 413 14.4 Country Risk Analysis in International Lending 418 14.4.1 The Mathematics of Sovereign Debt Analysis 418 14.4.2 Country Risk and the Terms of Trade 420 14.4.3 The Government’s Cost/Benefit Calculus 421 14.5 Summary and Conclusions 422 Questions 424 Problems 424 References 426 15 The Cost of Capital for Foreign Investments 427 15.1 The Cost of Equity Capital 428 15.2 The Weighted Average Cost of Capital For Foreign Projects 429 15.3 Discount Rates for Foreign Investments 430 15.3.1 Evidence from the Stock Market 431 15.3.2 Key Issues in Estimating Foreign Project Discount Rates 432 15.3.3 Proxy Companies 433 15.3.4 The Relevant Base Portfolio 434 15.3.5 The Relevant Market Risk Premium 438 15.3.6 Recommendations 439 15.4 The Cost of Debt Capital 439 15.4.1 Annual Exchange Rate Change 440 15.4.2 Using Sovereign Risk Spreads 441 15.5 Establishing a Worldwide Capital Structure 441 15.5.1 Foreign Subsidiary Capital Structure 442 15.5.2 Joint Ventures 446 15.6 Valuing Low-Cost Financing Opportunities 447 15.6.1 Taxes 448 15.6.2 Government Credit and Capital Controls 449 15.6.3 Government Subsidies and Incentives 450 15.7 Summary and Conclusions 452 Questions 453 Problems 454 References 455 16 Corporate Strategy and Foreign Direct Investment 457 16.1 Theory of the Multinational Corporation 458 16.1.1 Product and Factor Market Imperfections 458 16.1.2 Financial Market Imperfections 459 16.1.3 The Strategy of Multinational Enterprise 460 16.1.4 Innovation-Based Multinationals 460 16.1.5 The Mature Multinationals 460 16.1.6 The Senescent Multinationals 463 16.1.7 Foreign Direct Investment and Survival 464 16.2 Designing a Global Expansion Strategy 469 16.2.1 Awareness of Profitable Investments 469 16.2.2 Selecting a Mode of Entry 469 16.2.3 Auditing the Effectiveness of Entry Modes 470 16.2.4 Using Appropriate Evaluation Criteria 471 16.2.5 Estimating the Longevity of a Competitive Advantage 471 16.3 Summary and Conclusions 472 Questions 474 Problems 475 References 475 17 Capital Budgeting for the Multinational Corporation 477 17.1 Basics of Capital Budgeting 478 17.1.1 Net Present Value 478 17.1.2 Incremental Cash Flows 479 17.1.3 Alternative Capital-Budgeting Frameworks 482 17.2 Issues in Foreign Investment Analysis 483 17.2.1 Parent versus Project Cash Flows 484 17.2.2 Political and Economic Risk Analysis 485 17.2.3 Exchange Rate Changes and Inflation 486 17.3 Foreign Project Appraisal: The Case of International Diesel Corporation 487 17.3.1 Estimation of Project Cash Flows 487 17.3.2 Estimation of Parent Cash Flows 492 17.4 Political Risk Analysis 495 17.4.1 Expropriation 495 17.4.2 Blocked Funds 496 17.5 Growth Options and Project Evaluation 497 17.6 Summary and Conclusions 500 Questions 501 Problems 502 References 503 Appendix: Managing Political Risks 503 18 Managing the Internal Capital Markets of Multinational Corporations 509 18.1 The Value of The Multinational Financial System 510 18.1.1 Mode of Transfer 510 18.1.2 Timing Flexibility 511 18.1.3 Value 512 18.2 Intercompany Fund-Flow Mechanisms: Costs and Benefits 513 18.2.1 Tax Factors and the Tax Cuts and Jobs Act of 2017 513 18.2.2 Transfer Pricing 516 18.2.3 Offshore Centers 520 18.2.4 Fees and Royalties 521 18.2.5 Leading and Lagging 522 18.2.6 Intercompany Loans 524 18.2.7 Dividends 527 18.2.8 Equity versus Debt 529 18.3 Designing a Global Remittance Policy 530 18.3.1 Prerequisites 532 18.3.2 Information Requirements 532 18.3.3 Behavioral Consequences 532 18.4 Summary and Conclusions 534 Questions 534 Problems 535 References 536 Glossary G-1 Index I-1