Chapter

1 An Introduction to Multinational Finance Goals of MNC - Maximize shareholder wealth. - Stakeholders: VREVENUES = VEXPENSES + VGOVT + VOTHER + VDEBT + VEQUITY. - Agency Costs. - Protection of stakeholders (ie. Tariffs, Subsidies, Price Support etc.) ie. Rice industry in Japan. Challenges of MNCs - Cultural Differences (Language, Customs, Beliefs etc.) Affects marketing - Differences in systems (Tax, Accounting, Legal, Financial) - Risks: Country Risk (Risk that business environment in host country will change) Political Risk: Risk that political events will change business environment. Financial Risk: Risk that financial/economic environment will change. Opportunities of MNCs - Value = t [E[CFt] / (1+it)t] - MNC has more investment choices and more financing choices than a domestic company. Investment Opportunities - Enhancing Revenues: Global Branding, Marketing Flexibility, Advantages of Scale & Scope. - Reducing Operating Costs: Low-cost materials/labour, Flexibility site global selection, sourcing and production, Economies of scale/scope, Vertical integration. Perfect Financial Market Assumptions - Frictionless Markets - Rational Investors - Equal access to costless information - Equal access to market prices Market Efficiency - Operational Efficiency: No loss of funds when moved around. Frictionless markets. - Information Efficiency: Rational investors have equal access to markets. Prices reflect info. - Allocational Efficiency: Allocating capital to its most productive uses. - Comparative Advantage: Linked to Allocational Efficiency. A country should produce and export what it is efficient at producing. It should import goods from nations that produce things more efficiently. Chapter 2 World Trade and the Monetary System Balance of Payments - Shows inflows and outflows of goods, services and capital. - Trade Balance: Shows if it is net export (surplus) or net import (deficit). - Current Account: Shows the balance of import/export activity. - Financial Account: Shows changes in financial assets/liabilities. Bretton Woods Agreement - Created World Bank and IMF. - Pegged Gold System. Gold is worth US$35/oz. Other currencies pegged to it. - Stopped on August 15, 1971 due to market forces pressuring the system.

Exchange Rate Systems - Pegged/Fixed: Governments maintain currency values at a set exchange rate. Devaluations and Revaluations. - Floating: Supply and Demand (Market) determines value of currency. Depreciation and Appreciation. Currency Crises - Common Causes: Fixed/Pegged Rates, Large foreign currency debt, Low reserves. IMF Lending and Moral Hazard - Existence of a contract can change behaviours of parties to the contract. That is, the existence of bailouts change behaviours by making countries more risky, knowing that they will be saved by the IMF.

Chapter 3: Foreign Exchange and Eurocurrency Markets Characteristics - Liquidity: Ease of conversion to cash. - Efficiency: Operational/Informational/Allocational. Eurocurrencies - Bank deposits and loans residing outside of a single country. - Floating rate price (low interest rate [LIBOR]/default risk), Short maturities (5 years or less), Few regulations, High Liquidity, Competitive Pricing. Participants - Wholesale Market: Dealers, Brokers - Retail Market: Governments, Corporations, Financial Institutions, Individuals. Rules for Multinational Finance - Rule 1: Keep track of currency units. - Rule 2: Always buy or sell the currency in the denominator of the foreign exchange quote. (Allows buying low and selling high.) - European Quotes: Dollar in the denominator. - American Quotes: Euro in the denominator. - Direct Quotes: Foreign currency in denominator. - Indirect Quotes: Foreign currency in the numerator. Forward Premiums/Discounts - Premium: Nominal value is higher than the spot exchange market. - Discount: Nominal value is lower than the spot exchange market. - Formula: (Forward Rate Spot Rate) / Spot Rate Change in FX Rate - Formula: (Spot Rate1 Spot Rate0) / Spot Rate0 - Converting to the other currency: (1 + Spot RateORIGINAL) = 1 / Spot RateOTHER GARCH - Variance depends on previous variance. Changes are approximately normally distributed. - Formula: t2 = a0 + a1 t-12 + b1 st-12 [GIVEN] Value-at-Risk (VaR) - Estimates potential losses with a certain level of confidence over a certain time period.

Chapter 4: International Parity Conditions The Law of One Price - Purchasing Power Parity (PPP): Equivalent assets sell for the same price. - Rarely holds for non-traded assets, assets with variable quality and market frictions. - Arbitrage opportunity if Pt$ = PtA$ St$/A$ does not hold. Arbitrage - Locational Arbitrage: Involving two or more locations. Sd/e (X) / Sd/e (Y) = 1. Locational arbitrage opportunity if this is not true. - Triangular Arbitrage: Involves three currencies. Sd/e Se/f Sf/d < 1. Buy denominator with numerator. Vice versa for > 1. - Covered Interest Arbitrage: Takes advantage of disequilibrium in interest rate parity. Ftd/f/S0d/f > [(1+id)/(1+if)]t [GIVEN]. Borrow id, buy S0d/f, Invest if, Sell Ftd/f. Vice versa for <. - Might not undertake arbitrage because of: transaction costs, political risks, tax differences, liquidity preferences, capital controls and market imperfections. Relative Purchasing Power Parity - Formula: E[Std/f]/S0d/f = (1+E[pd])t /(1+ E[pf])t [GIVEN] - Only holds on average since expected inflation and expected future spot rates are not traded. International Fisher Relation - Formula: (1+nominal interest rate) = (1+inflation rate)(1+real interest rate) - Takes into account inflation. Real Exchange Rate - Adjusts nominal exchange rate for differential inflation. - (1+xtd/f) = (Std/f/St-1d/f )[(1+pf)/(1+pd)] [GIVEN] Exchange Rate Forecasting - Forecasting can be done based on parity conditions, since these must always hold true. - E[Std/f]/Ftd/f - E[Std/f] = S0d/f [(1+id)/(1+if)]t [GIVEN] - E[Std/f] = S0d/f [(1+pd)/(1+pf)]t - Technical Analysis: Using past exchange rates to predict future. - Fundamental Analysis: Using macroeconomic data to predict future. Chapter 5: Currency Futures and Futures Markets Futures Contracts - Forwards are a zero-sum game so one party always has incentive to default. - Clearinghouse takes one side of a futures contract to solve this. Margins ensure settlement. - Marked-to-market daily. Differences between Forwards and Futures - Forwards are highly customisable. Gains/Losses realised at maturity. Usually settled at maturity. - Futures are highly standardised. Gains/Losses realised daily. Usually settled early. - Futures are like a bundle of consecutive one-day forward contracts. - Both are equal: Futt,Td/f = Ft,Td/f = Std/f [(1+id)/(1+if)]T-t [GIVEN] Basis Risk - Risk of change in relation between futures and spot prices. - These two will converge at expiry. - Maturity mismatches mean futures may not provide the perfect hedge compared to forwards.

Futures Hedges - Perfect Hedge (No Mismatch): std/f = + std/f + et [GIVEN] - Delta Hedge (Maturity Mismatch): std/f = + futtd/f + et [GIVEN] - Cross Hedge (Currency Mismatch): std/f1 = + std/f2 + et [GIVEN] - Delta-Cross Hedge (Maturity & Currency Mismatch): std/f1 = + futtd/f2 + et [GIVEN] - - = (amount in futures)/(amount exposed) [GIVEN]

Chapter 6: Currency Options and Options Markets Options - Call Option: Holder has right to buy. - Put Option: Holder has the right to sell. - European: Exercisable only on expiration date. - American: Exercisable any day up to expiration date. - Other things equal, this means American options are worth more. - In-the-money (Call Option): Exercise price is less than spot price. - At-the-money (Call Option): Exercise price is the same as spot price. - Out-of-the-money (Call Option): Exercise price is higher than spot price. Payoffs of Currency Options - Call Option: CallTd/f = max[STd/f-KTd/f , 0] [GIVEN] - Put Option: PutTd/f = max[KTd/f - STd/f, 0] [GIVEN] - Where, KTd/f is the exercise price and STd/f is the spot rate. Payoff Profiles Option Value - Option Value = Intrinsic Value + Time Value Intrinsic Value: The value of the option if exercised immediately. Time Value: Market Value less intrinsic value. (FX rate, Price, Risk-free rate, Volatility, Time) Time and Volatility - Instantaneous changes are a random walk. - Equation: t2 = T2 [GIVEN] - In words: 1-period variance multiplied by T-periods is T-period variance. Chapter 7: Currency Swaps and Swaps Markets Parallel Loans - Borrow in local currency, then swap it with the debt of a foreign counterparty. - Benefits: Allows legal circumvention of taxes, possibly at lower cost of capital and provides foreign source. Main benefit is a lower interest rate.

- Problems: Default Risk, Must be capitalized on balance sheet, search costs high. Swaps - Currency Swaps: Parallel loan packaged into a single contract. Counters problems to parallel loans. Interest payments usually also swapped. - Banks gain profit from bid/ask spread using LIBOR. They sell swap contracts and match them to others. - Interest Rate Swaps: Same as currency swap, except in one country. Normally used to change fixed to floating rate or vice versa. - Commodity Swaps: Allows the fixing of commodity prices. Most normally are fixed-for-floating swaps based on swap prices. - Debt-for-Equity Swaps: Giving the equity returns to a swap dealer and getting a fixed rate debt. Day Count Convention - Eurocurrency rates (such as LIBOR), are quoted at money market yield (MMY) [360 days]. - Normal fixed rate instruments are quoted using bond equivalent yield (BEY) [365 days]. - Equation: MMY = BEY (360/365) [GIVEN]

Chapter 8: The Rationale for Hedging Currency Risk Perfect Market Assumptions Revisited - If financial markets are perfect, then hedging is irrelevant. - Hedging must either increase expected future cash flows or decrease the discount rate. Hedging Matters - Indirect and Direct costs of financial distress. - Agency costs - Tax schedule convexity. Calculating Firm Value - Find the value of bonds and stock, by multiplying the possible scenarios by the expected value in that scenario, taking into account any costs. - In absence of financial distress, hedging does not create value and wealth transfers from shareholders to bondholders. When there is hedging, shareholders benefit from this by reducing borrowing costs. Consequences of Hedging - Shareholders benefit from the gain in hedging compared to the shift in wealth to debt holders. - Increase cash flow by reducing costs of financial distress. - Reduces debts required return and cost of capital. Agency Costs - Managers have an incentive to hedge their performance. But if the firm is already hedged itself, any additional hedging by individual managers will be a waste of money. Progressive Taxation - Calculated expected tax in same way as calculating firm value. - Expected tax savings are generally small Chapter 9: Multinational Treasury Management Setting MNC Goals & Strategies - Identify core competencies and growth opportunities

- Evaluate business environment. - Formulate strategic plan for sustainable competitive advantage. - Develop processes to implement a strategic business plan. Problems of International Trade - Exporters need to assure timely payment. - Importers need to ensure timely delivery. - Geographic and cultural discrepancies. - Trade disputes can be difficult to settle. International Payment Methods - Cash in advance: Payment prior to shipment. - Open account: Billed under agreed terms to be paid within an agreed time period. - Documentary credits: Letter of Credit. Same as documentary collections but with 2 banks. - Documentary collections: Sight drafts (paid on demand) and Time drafts (paid on a set date) - Countertrade: Exchange of goods/services (no cash). Can be counterpurchase or offset. All-in cost of trade finance - (Foregone cash flow) / (Discounted Value) 1 - The internal rate of return associated with a financing alternative. Hedging with Forward Contracts - Hedge a long position with a short forward contract in the foreign currency. Types of Exposure to Currency Risk - Economic Exposure Transaction Exposure (contractual CF) and Operating Exposure (non-contractual CF) - Translation (Accounting) Exposure Exposure to changes in financial statements from changes in exchange rates. 5-step Currency Risk Management Program - Identify exposures to future exchange rates. - Estimate the sensitivity of revenues and expenses. - Determine if hedging is desirable. - Evaluate alternatives. - Monitor the hedged position and re-evaluate.

Chapter 10: Managing Transaction Exposure to Currency Risk Multinational Netting - Offset and net movements after a period of time. Saves transaction costs by limiting to only necessary movements in funds internally. Leading and Lagging - Leading (Bringing forward) or Lagging (Pushing back) cash flows so that they match. - Charge market rates of interest on these intra-company loans/deposits Financial Market Hedges Vehicle Advantages Disadvantages Forwards Perfect. Low spread. Large spread on thin currencies/long deals. Futures Low cost for small deals. Low risk. Only few currencies. CF mismatch possible with mark-to-market. Options Disaster hedge provides insurance. Premiums can be expensive.

Swaps

Quick and low cost.

Money Market Hedges Synthetic forward positions Money Market Hedge - Synthetic forward positions where no futures market exists, but is expensive. - Borrow, Convert then Invest. Active Treasuries - Large firms with centralised risk management. - Use sophisticated valuation methods. - Derivatives are periodically marked to market. - Managers closely monitored. - Compensation aligns managers with stakeholders - Performance benchmarks to manage potential abuse.

Innovative swaps costly. Not for short-term. Expensive. Not always possible.