International Financial Management

21

Author's Overview
The instructor should stress the importance of international financial management (and
international trade) to the class. Data demonstrating Canadas exceptional openness to the forces
of trade should be emphasized. Factors leading to a more integrated world economy can be
mentioned. The students can easily appreciate the everyday events that bring the world closer
together.
The nature of the international firm can be described, along with the many forms entry into a
foreign country can take. The increased risks of foreign investment can be identified.
An important point is that international finance has the same elements as domestic financial
management only the issues tend to be more involved. The firm must not only make a profit on a
transaction, but consider currency fluctuations. Inflation, interest rates, balance of payments, and
government policies impact on foreign exchange rates. Spot and forward exchange rates can be
illustrated. The foreign exchange market hedge, the money market hedge, and the currency
futures market hedge are discussed as means to manage foreign exchange risk.
Increasingly students must understand how to conduct business across international borders.
Transferring funds internationally, the Euromarket, government institutions facilitating trade
financing, and international equity markets are all part of international trade.

Chapter Objectives
1.

Describe the purposes and nature of the multinational operations of the corporation.

2.

Discuss the effects of exchange rates on the firms profitability and cash flow.

3.

Outline the factors influencing exchange rates.

4.

Define spot and forward rates and compute forward premiums and discounts.

5.

Evaluate techniques to hedge or reduce foreign exchange risk.

6.

Discuss the impact of political risk on the foreign investment decision.

7.

Analyze a foreign investment decision.

8.

Outline potential ways to finance international operations.

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Annotated Outline and Strategy

I.

Introduction
A.

B.

Many factors have contributed to greater economic interaction among the world's
nations:
1.

Advances in communication and transportation

2.

Adaptation of political systems:

a.
Post World War II rebuilding programs
b.
European Common Market (ECM or EU)
c.
Political, social and economic changes in Russia

3.

International flows of capital and technology

4.

International currency: U.S. Dollar

5.

Interdependence for scarce resources

International business operations are complex, risky and require special

understanding. Canada and Canadian corporations are particularly dependent on
international trade as emphasized by Figures 21-1 and 21-2. Figure 21-3
demonstrates Canadas close trading relationship with the United States. Canadas
preponderance of merchandise trade is evidenced in Figure 21-4.

PPT 21-1

Worlds leading merchandise exporters, 1997 (Figure 21-1)

PPT 21-2
PPT 21-3

Worlds leading merchandise importers, 1997 (Figure 21-2)

Canadas 1998 merchandise exports and imports by region (Figure 21-3)

PPT 21-4

Canadas international balance of payments, current account, 1998

(Figure 21-4)

Finance in Action: The Birth of a New Currency The Euro!

In 1999 the Euro came into existence for electronic transactions. In 2002 paper and coin Euros
will be available.
II.

The Multinational Corporation (MNC)

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A.

Basic forms of MNC:

1.

Exporter: exportation to foreign markets of domestically produced

products
Licensing Agreement: the granting of a license to an independent local (in
the foreign country) firm to use the "exporting" firm's technology
Joint Venture: cooperative business operation with a firm (or firms) in the
foreign country
Fully Owned Foreign Subsidiary

2.
3.
4.
B.

International Environment versus Domestic Environment:

1.

More risky: in addition to normal business risks, the MNC is faced with
foreign exchange risk and political risk. The portfolio risk of the parent
company, however, may be reduced if foreign and domestic operations are
not correlated
Potentially more profitable
More complex: the laws, customs, and economic environment of the host
country may vary in many respects:
a.
Rates of inflation
b.
Tax rules
c.
Structure and operation of financial institutions
d.
Financial policies and practices
e.
Work habits and wages of laborers

2.
3.

III.

Foreign Exchange Rates

A.

To facilitate international trade, currencies must be exchanged. For example, and

exporter will usually desire payment in the currency of the home country. The
importer must swap the domestic currency for the currency desired by the exporter
in order to pay the bill.

Perspective 21-1: The instructor may wish to use Table 21-1 to illustrate foreign
exchange rates and how they change over time. He or she may wish to comment on
the declining value of the dollar and give an update on the current value of the dollar.

PPT 21-5

B.

Selected currencies and exchange rates (Table 21-1)

Factors affecting exchange rates:

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1.
2.
3.
4.

Supply of and demand for the currencies of the various countries

The degree of central bank intervention
Inflation rate differentials (Purchasing Power Parity Theory)
Interest rate differentials (Interest Rate Parity Theory).

Finance in Action: Interest Rate in Other Countries: Are They Any Better?
This example taken from the financial pages of a newspaper demonstrates a swap deposit,
interest parity theory, and the integration of world financial markets. Although interest rates
may look better in another country they turn out to be remarkably similar through the forward
covered rate (page 817).
5.
6.
7.

Balance of payments
Government policies
Other factors:
a.
Capital market movements
b.
Changes in supply of and demand for the products and services of
individual countries
c.
Labor disputes
d.
Political turmoil

C.

Many variables affect currency exchange rates. The importance of each variable or
set of variables will change as economics and political conditions change
throughout the world.

D.

Spot Rates, Forward Rates, and Cross Rates

Perspective 21-2: There are a number of easily understood examples in the text on
spot and forward rates, as well as cross rates. The instructor can use these with
students who have little or no international background.

Forward

premium
Forward rate - Spot rate
12
=
x
x 100 %
Length
of
forward
(discount)
Spot rate
contract (months)

1.
2.

Foundations of Fin. Mgt.

Spot rate: the exchange rate between currencies with immediate delivery.
Forward rate: the rate of exchange between currencies when delivery will
occur in the future.
(21-1; page 820)

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3.

IV.

Managing Foreign Exchange Risk

A.

V.

Cross rate: the exchange rate between currencies such as Danish Krone and
British Pounds based on their exchange rate with another currency such as
Canadian Dollars.

Foreign exchange risk is the possibility of experiencing a drop in revenue or an

increase in cost in an international transaction due to a change in foreign exchange
rates.
1.

Three types of foreign exchange risk exposure:

a.
Economic exposure identifies market value of net investment
subject to change in economic value due to currency fluctuation.
b.
Accounting or translation exposure: depends upon accounting rules
established by CICA accounting recommendations. This is often an
unrealized gain or loss.
b.
Transaction exposure: the foreign exchange gains and losses
resulting from international transactions, when foreign funds are
converted to Canadian dollars.

2.

There are four strategies used to minimize transaction exposure:

a.
Hedging in the forward exchange market: the recipient (seller) of
foreign currency in an international transaction sells a forward
contract to assure the amount that will be received in domestic
currency.
b.
Hedging in the money market: the recipient borrows foreign
currency in the amount to be received and then immediately
converts to domestic currency. When the receivable is collected,
the loan is paid off.
c.
Hedging in the currency futures market: futures contracts in foreign
currencies began trading in the International Monetary Market
(IMM) of the Chicago Mercantile Exchange (CME) on May 16,
1972.
d.
Hedging in the currency options market: options contracts on
foreign currencies are traded on the CME.

Foreign Investment Decisions

A.

Canada invests abroad.

1.

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Canada held $647 billion in assets abroad, primarily by way of direct

investment ($240 billion).

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2.

The primary locale of Canadian investment abroad is the United States,

followed by the U.K., and the EEC.

PPT 21-6

Canadas international investment position, 1998 (Figure 21-5)

PPT 21-7

Canadas investment abroad by region, 1998 (assets) (Figure 21-6)

B.

Reasons for Canadian firms to invest in foreign countries:

1.
Higher rates of return;
a. Resources readily available
b. Lower production costs particularly with regard to labor costs
c. Tax advantages
d.
Ease of entry because of advanced technology
2.
Strategic considerations:
a. Trade Blocs
b. Proximity to market
c.
Competition
3.
International diversification

PPT 21-8
C.

Risk reduction from international diversification (Figure 21-7)

Foreign firms are expanding their investment in Canada.

1.

Foreign investments in Canada reached $971 billion in 1998 with the

United States dominating followed by Britain and the EU. Bond holdings
were $410 billion and direct investment was $217 billion.
The great foreign control of Canadian assets and industry is a continuing
concern.

2.
PPT 21-9
D.

Foreign investment in Canada by region, 1998 (liabilities) (Figure 21-8)

Analysis of Political Risk

1.
The structure of the foreign government and/or those in control may
change many times during the lengthy period necessary to recover an
investment. "Unfriendly" changes may result in:
a.
Foreign exchange restriction
b.
Foreign ownership limitations
c.
Blockage of repatriation of earnings
d.
Expropriation of foreign subsidiary's assets
2.

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Safeguards against political risk.

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a.
b.
c.
d.

A thorough investigation of the country's political stability

Joint ventures with local (foreign) companies
Joint ventures with multiple companies representing multiple
countries
Insurance through the federal government agency, the Export
Development Corporation (EDC)

Finance in Action: Whiskey is Risky!

In the mid-1990s Seagram was allowed to enter the liquor business in India. It found the early
going tougher than it expected as several unique cultural, political, and technical risks were
encountered.
VI.

Financing International Business Operations

A.

Letters of credit: in order to reduce the risk of non-payment, an exporter may

require an importer to furnish a letter of credit. The letter of credit is normally
issued by the importer's bank and guarantees payment to the exporter upon
delivery of the merchandise if the specified conditions are met.

B.

Export credit insurance: the Export Development Corporation may provide

insurance against non-payment by foreign customers.

C.

Funding of transactions
1.
Export Development Corporation: facilitates the financing of Canadian
exports through several programs.
2.
Loans from the parent company or sister affiliate.
a.
Parallel loans: an arrangement where two parent firms in different
countries each make a loan to the affiliate of the other parent. The
procedure eliminates foreign exchange risk.
b.
Fronting loans: loans from a parent firm to a foreign subsidiary via
PPT 21-10
A parallel loan arrangement (Figure 21-9) and A fronting loan
arrangement (Figure 21-10)
a bank located in the foreign country.
3.

Foundations of Fin. Mgt.

Eurocurrency loans: loans from foreign banks that are denominated in

dollars.
a.
There are many participants in the Eurodollar market from
throughout the world particularly the U.S., Canada, Western
Europe and Japan.
b.
Lower borrowing costs and greater credit availability have enabled
these markets to become an important source of short-term
funding.

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c.
d.

The lending rate is based on the London Interbank Offered Rate

(LIBOR).
Lending in the Eurodollar market is almost exclusively done by
commercial banks. Large Euro-currency loans are frequently
syndicated and managed by a lead bank.

Finance in Action: Rating the Countries

Moodys Bond Rating Service rates the sovereign debt of countries. www.moodys.com

VII.

4.

Eurobond market: long-term funds may be secured by issuing Eurobonds.

These bonds are sold throughout the world but are denominated primarily
in U.S. dollars, Deutsche marks, Swiss francs and Japanese yen.
a.
Disclosure requirements are less stringent.
b.
Registration costs are lower.
c.
Some tax advantages exist.
d.
Caution must be exercised because of the exposure to foreign
exchange risk.

5.

International equity markets: selling common stock to residents of a foreign

country provides financing and also reduces political risk.
a.
Multinational firms list their shares on major stock exchanges
around the world.
b.
Marketing securities internationally requires firms to adjust their
procedures. For example, chartered banks have a dominant role in
the securities business throughout Europe.

6.

International Finance Corporation (IFC): the IFC was established in 1956

and is unit of the World Bank. Its objective is to promote economic
development to member countries of the World Bank.
a.
A multinational firm may be able to raise equity capital by selling
partial ownership to the IFC.
b.
The IFC decides to participate in the venture on the basis of
profitability and the potential benefit to the host country.
c.
Once the venture is well established, the IFC frees up its capital by
selling its ownership interest.

Global Cash Management

A.

Government restrictions, volatile interest rates, differing inflation rates,

technological constraints, and other variables increase the complexity of managing
cash globally.

VIII. Unsettled Issues in International Finance

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A.

B.
IX.

The complexity of the multinational business environment generates questions for

which there are no easy answers.
1.
Should a foreign affiliate design a capital structure similar to that of the
parent firm or one that fits the acceptable pattern of the host country?
2.
Who should determine the dividend policy of a foreign affiliate - the
affiliate management or the parent management?
Successful participation in the international business environment requires
cohesive, coordinated financial management.

Appendix 21A: Cash Flow Analysis and the Foreign Investment Decision
A.
B.
C.
D.
E.

Cash Flow Analysis

Tax Factors
Foreign Exchange Considerations
Present Value Analysis
The Risk Factor

Perspective 21-3: The appendix represents a reasonably complicated consideration of

a foreign investment decision by a corporation.

PPT 21-10

Cash flow analysis of a foreign investment (Table 21A-1)

Summary Listing of PowerPoint Slides

PPT 21-1
PPT 21-2
PPT 21-3
PPT 21-4
PPT 21-5
PPT 21-6
PPT 21-7
PPT 21-8
PPT 21-9
PPT 21-10
PPT 21-11
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Worlds leading merchandise exporters, 1997 (Figure 21-1)

Worlds leading merchandise importers, 1997 (Figure 21-2)
Canadas 1998 merchandise exports and imports by region (Figure 21-3)
Canadas international balance of payments, current account, 1998 (Figure
21-4)
Selected currencies and exchange rates (Table 21-1)
Canadas international investment position, 1998 (Figure 21-5)
Canadas investment abroad by region, 1998 (assets) (Figure 21-6)
Risk reduction from international diversification (Figure 21-7)
Foreign investment in Canada by region, 1998 (liabilities) (Figure 21-8)
A parallel loan arrangement (Figure 21-9) and A fronting loan arrangement
(Figure 21-10)
Cash Flow Analysis of a Foreign Investment (Table 21A-1)
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