1. Introduction to Global Business Chapter 14 Global Financial Management © 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.

2. 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. © 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. After studying this chapter, you should be able to:

3. 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 © 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.

4. 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) © 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.

5. 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 © 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.

6. 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 © 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.

7. 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. © 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.

8. 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 © 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.

9. 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 © 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.

10. 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 © 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.

11. 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. © 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.

12. 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 © 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.

13. 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 When a bank sells a LC into the financial marketplace as a money market instrument Open Account A simple agreement wherein the exporter sends an invoice with the goods and the exporter pays upon the receipt © 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.

14. 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 © 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.

15. 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 © 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.

16. 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. © 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.

17. 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 government- supported 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 © 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.

18. 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 © 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.

19. 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 © 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.

20. 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.

21. 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. © 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.

22. 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) © 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.

23. The Cost of Capital: Domestic Versus Global (continued) © 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 CAPM is written as follows: R it = R ft +  i (R mt – R ft ), where R it =the one-month return on stock i in month t R mt =the one-month return on a domestic market index (e.g., the S&P 500 index of the 500 largest U.S. firms) R ft =the one-month riskless rate of return (e.g., the U.S. Treasury bill rate)  i =the domestic beta risk measure for the stock.

24. The Cost of Capital: Domestic Versus Global (continued) © 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.

25. 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. © 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.

26. Stock Values and Foreign Exchange Movements Measurement of long-run exchange risk (Adler and Dumas): R it = R ft +  i (R mt – R ft ) +  C R Ct where R Ct =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. © 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.

27. 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 © 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.

28. Stock Values and Foreign Exchange Movements (continued) Measurement of exchange risk (Armstrong, Knif, Kolari, and Pynnönen): R it = R ft + b 0 (R mt – R ft ) + b 1 (R mt – R ft ) R Ct where b 0 =the market beta with no exchange risk b 1 =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.

29. 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

30. 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)

31. 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. Key Terms (continued)