International Finance: Revision Lecture Dr Michael Dowling

Disclaimers These revision notes don’t necessarily cover everything that will be on the exam Please don’t assume that essay and computation parts will be linked in exam questions

Exam Structure Total of 6 questions on exam Have two hours to answer 4 questions. Only first 4 questions marked. 1 single essay question, 1 five-part essay question, 4 mixture essay and computation questions

Part 1 1. Introduction to International Finance 2. Currencies 3. Financing Exchange Rates Foreign Exchange Market Financing of Operations International Cost of Capital

1. Introduction to International Finance Essay Question What are the main types of multinational enterprises? What are the particular international financial management needs of each type? [S] How does international financial management differ from purely domestic financial management? [S]

2. Currencies (1) Essay Questions Ricardo’s theory of comparative advantage illustrates some of the advantages of international trade. What are some of the practical difficulties with the model in a modern context? [S] A Gold Standard exchange rate system would offer stability that flexible exchange rates cannot. [S] Explain cross-hedging and discuss the factors determining its effectiveness. [S] The on-going Eurozone crisis could be said to illustrate some of the practical problems with currency monetary unions. Briefly discuss some of the problems with implementing effective currency monetary unions, using examples from the current Eurozone crisis. [S] [L]

2. Currencies (2) Calculation Question NO CALCULATION QUESTION

3. Financing (1) Essay Questions Discuss whether companies can lower their cost of capital and increase their access to finance by internationalising their approach to financing. [L] “A centralised cash depositary is necessary in a modern multinational.” Discuss this statement with reference to benefits and drawbacks of centralised cash depositaries and drawing on your wider reading on the topic. [L]

3. Financing (2) Calculation Questions Netting Calculating WACC

Netting… ReceiptsUSCanadaGermanyUK US Canada Germany UK No netting - Bilateral netting - Multilateral netting (assume 1% transaction cost) Precautionary cash with / without centralised cash <- revise this too!

Calculating WACC…  Risk-free rate: [5 year risk free country?]  Beta / market return: [broad market index]  Debt: [yield vs interest rate]  Tax rate: [headquarters]  Debt / equity value: [market rates]

Part 2 Risk management 4. Foreign exchange 5. Economic exposure 6. Country risk

4. Foreign Exchange Risk Management (1) Essay Questions Evaluate the benefits and drawbacks of using forwards and options to hedge foreign exchange exposure, including a discussion of whether firms should hedge such exposures. [L]

4. Foreign Exchange Risk Management (2) Calculation Questions The use of forwards, options and money market hedges in forex risk management

Hedging when we have to pay money in a foreign currency US-based Boeing agree to buy a Rolls Royce jet engine for £5 million payable in one year US interest rate6.00% per annum UK interest rate6.50% per annum Spot exchange rate$1.80/£ Forward exchange rate$1.75/£ (1 year maturity) To calculate: -Forward market hedge -Money market hedge -Option market hedge (assume $1.80/£ call options cost $0.018 per pound)

Forward Market Hedge  Boeing buys its foreign currency payables forward to eliminate its exchange risk exposure  Boeing buys forward its £5m payable in exchange for a given amount of dollars  On maturity date of contract, Boeing will pay the £5m due to BA for a cost of $8.75m ($1.75 x 5 million)  Forward ensures that a certain amount of dollars will have to be paid

Money Market Hedge  Hedging by lending and borrowing in the domestic and foreign money markets  Firm lends in foreign currency to hedge its foreign currency payables, thus matching its assets and liabilities in the same currency  If the implied interest rate in the forward contract is the same as the actual interest rates in the two countries, then there will be no difference in amount received under money market and forward hedging

Step-by-step money market hedging Step 1 Buy sterling now with US dollars to match the present value of foreign currency payable = £4,694,836 (£5,000,000/1.065)x($1.80/£) = $8,450,705 Step 2 Invest £4,694,836 at UK interest rate of 6.5%. Step 3 Pay £5m to Rolls Royce from the UK savings which is now worth £5m Cost Future value cost of hedge is US dollar amount x US interest rate i.e. $8,957,747 (= $8,450,705*1.06) Forward hedge preferred as cheaper

Options Market Hedge  Forward and money market hedges completely eliminate exchange exposure; however this then removes the opportunity to benefit from favourable exchange rate movements  It also commits us to the exchange, which might not always be appropriate  Options provide more flexibility in our hedging, as well as allowing us to benefit from favourable forex movements

Applying this to Boeing

Another example Princess Cruise Company (PCC) purchased a ship from Mitsubishi for 500 million yen payable in one year. The current spot rate is Y124/$ and the one-year forward rate is 110/$. The annual interest rate is 5 percent in Japan and 8 percent in the United States. PCC can also buy a one-year call option on yen at the strike price of $ per yen for a premium of cents per yen.

5. Economic Exposure Risk Management (1) Essay Questions Describe the differences between economic exposure and transaction exposure, and the different approaches necessary to manage both risks. [S] Discuss some possible approaches to managing operating risk in the multinational enterprise. Give examples to illustrate the analysis [L] What approaches can a firm adopt to optimally manage their economic exposure from international trade? Give examples and use wider readings to illustrate your analysis. [L]

5. Economic Exposure Risk Management (2) Calculation Questions Calculate operating exposure and how to minimise using forward hedging

A British venture capitalist… … holding a major stake in a social media start- up in Silicon Valley. As a British resident he is concerned with the pound value of the US equity investment. Assume that if US economy booms in the future the equity stake will be worth $1m and the exchange rate will be $1.40/£. If US experiences a recession the stake will be worth $0.5m and exchange rate will be $1.60/£. Probability of boom is 70 percent and recession is 0.30 percent

OutcomeProbabilityP*SSP 1 0.7$1,000,000$1.40£714, $500,000$1.60£312,500

Computation of beta SP = (0.7 x £714,286) + (0.3 x £312,500) = £593,750 S = (0.7 / 1.4) + (0.3 / 1.6) = £0.689/$ Var (S)= [0.7 x (0.714 – 0.688) 2 ]+ [0.3 x (0.625 – 0.688) 2 ]= Cov (SP) = [0.7 x ( )( )] +[0.3 x ( )( )] = 7509 β = 7509/ = $4,523,494

Hedging this exposure

6. Country Risk Management Essay Question What are the important factors to consider in evaluating the political risk associated with making a foreign direct investment in a foreign country? What operational and financial measures can a multinational corporation take to minimize the political risk associated with FDI? [L]