Financial Management

Foreign Exchange Exposure and

Currency Hedging
 LEARNING OUTCOMES
At the end of the lesson students should be able
to:
 Explain the definition multinational corporation (MNC).
 Describe the factors which differentiate between the
financial management of MNC and domestic corporation.
 Differentiate between a direct and indirect quotations as
well as spot and forward rates.
 Compute a direct and indirect quotations as well as spot
and forward rates.
 Discuss the impact of relative inflation on interest rates
and exchange rates.
 Explain to what extent does average capital structures
vary across different countries.
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 Topic & Structure of the lesson

Foreign Exchange Exposure & Currency hedging:

Definition multinational corporation (MNC).
Differentiate between the financial management of
MNC and domestic corporation.
Direct and indirect quotations as well as spot and
forward rates.
Discussion on the impact of relative inflation on
interest rates and exchange rates.
Discussion on the extent average capital structures
vary across different countries.

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 Key Terms you must be able to use

 Foreign exchange rate.

 Multinational firm.
 Spot and forward rates.
 capital structure.
 Exchange rate risk.

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 Introduction

 Introduction to international financial

management.

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 What is a multinational corporation?

• A corporation that
operates in two or more
countries.
• Decision making within
the corporation may be
centralized in the home
country, or may be
decentralized across the
countries the corporation
does business in.
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 Why do firms expand into other
countries?
1. To seek new markets.
2. To seek raw materials.
3. To seek new technology.
4. To seek production efficiency.
5. To avoid political and regulatory hurdles.

6. To diversify.

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 What factors distinguish multinational financial
management from domestic financial
management?

1. Different currency denominations.

2. Economic and legal ramifications.
3. Language differences.
4. Cultural differences.
5. Role of governments.
6. Political risk.

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 Consider the following exchange rates

US $ to buy 1 unit
Japanese yen 0.009
Australian dollar0.650

• Are these currency prices direct or indirect

quotations?
– Since they are prices of foreign currencies
expressed in dollars, they are direct
quotations.

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 What is an indirect quotation?

• The number of units of a foreign

currency needed to purchase one U.S.
dollar, or the reciprocal of a direct
quotation.
• Are you more likely to observe direct or
indirect quotations?
– Most exchange rates are stated in terms of
an indirect quotation.
– Except the British pound, which is usually in
terms of a direct quotation.
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 Calculate the indirect
quotations for yen and
Australian dollar

# of units of foreign
currency per US $
Japanese yen 111.11
Australian dollar1.5385

• Simply find the inverse of the direct quotations.

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 What is a cross rate?

• The exchange rate between any two

currencies. Cross rates are actually calculated
on the basis of various currencies relative to the
U.S. dollar.
• Cross rate between Australian dollar and the
Japanese yen.
– Cross rate = (Yen / US Dollar) x (US Dollar / A. Dollar)
= 111.11 x 0.650
= 72.22 Yen / A. Dollar
– The inverse of this cross rate yields:
0.0138 A. Dollars / Yen
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 Orange juice project:
Setting the appropriate price
• A firm can produce a liter of orange juice
and ship it to Japan for $1.75 per unit. If
the firm wants a 50% markup on the
project, what should the juice sell for in
Japan?

Price = (1.75)(1.50)(111.11)
= 291.66 yen

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 Orange juice project:
Determining profitability
• The product will cost 250 yen to produce and
ship to Australia, where it can be sold for 6
Australian dollars. What is the U.S. dollar profit
on the sale?
– Cost in A. dollars = 250 yen (0.0138)
= 3.45 A. dollars
– A. dollar profit = 6 – 3.45 = 2.55 A. dollars
– U.S. dollar profit = 2.55 / 1.5385 = $1.66

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 What is exchange rate risk?

• The risk that the value of a cash flow in

one currency translated to another
currency will decline due to a change in
exchange rates.
• For example, in the last slide, a weakening
Australian dollar (strengthening dollar)
would lower the dollar profit.
• The current international monetary system
is a floating rate system.

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 European Monetary Union

• In 2002, the full implementation of

the “euro” was completed. The
national currencies of the 12
participating countries were phased
out in favor of the “euro.” The newly
formed European Central Bank
controls the monetary policy of the
EMU.

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 Member nations of the EMU

• Austria  Ireland
• Belgium  Italy
• Finland  Luxembourg
• France  Netherlands
• Germany  Portugal
• Greece  Spain
 Notable European Union
countries not in the EMU:
 Britain, Sweden, and
Denmark
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 What is a convertible
currency?

• A currency is convertible when the

issuing country promises to redeem
the currency at current market rates.
• Convertible currencies are traded in
world currency markets.

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 What problems may arise when a firm
operates in a country whose currency is
not convertible?
• It becomes very difficult for multi-
national companies to conduct
business because there is no easy
way to take profits out of the country.
• Often, firms will barter for goods to
export to their home countries.

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 What is difference between spot
rates and forward rates?

• Spot rates are the rates to buy

currency for immediate delivery.
• Forward rates are the rates to buy
currency at some agreed-upon date
in the future.

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 When is the forward rate at a
premium to the spot rate?

• If the U.S. dollar buys fewer units of a

foreign currency in the forward than in the
spot market, the foreign currency is selling
at a premium.
• In the opposite situation, the foreign
currency is selling at a discount.
• The primary determinant of the
spot/forward rate relationship is relative
interest rates.

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 What is interest rate parity?

• Interest rate parity holds that investors should

expect to earn the same return in all countries
after adjusting for risk.
ft 1  k h

e0 1  k f

ft  t - period forward exchange rate

e 0  today' s spot exchange rate
k h  periodic interest rate in home country
k f  periodic interest rate in foreign country
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 Evaluating interest rate parity

• Suppose one yen buys $0.0095 in the 30-

day forward exchange market and kNOM for
a 30-day risk-free security in Japan and in
the U.S. is 4%.
– ft = 0.0095
– kh = 4% / 12 = 0.333%
– kf = 4% / 12 = 0.333%

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 Does interest rate parity hold?

0.0095 1.0033

e0 1.0033

0.0095
1
e0

• Therefore, for interest rate parity to hold, e 0

must equal $0.0095, but we were given
earlier that e0 = $0.0090.

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 What impact does relative inflation
have on interest rates and exchange
rates?

• Lower inflation leads to lower interest rates,

so borrowing in low-interest countries may
appear attractive to multinational firms.
• However, currencies in low-inflation countries
tend to appreciate against those in high-
inflation rate countries, so the effective
interest cost increases over the life of the
loan.

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 International money and capital
markets
• Eurodollar markets
– a source of dollars outside the U.S.
• International bonds
– Foreign bonds – sold by foreign
borrower, but denominated in the
currency of the country of issue.
– Eurobonds – sold in country other than
the one in whose currency the bonds
are denominated.

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 To what extent do average capital
structures vary across different
countries?

• Previous studies suggested that

average capital structures vary among
the large industrial countries.
• However, a recent study, which
controlled for differences in accounting
practices, suggests that capital
structures are more similar across
different countries than previously
thought.

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 Impact of multinational operations

• Cash management
– Distances are greater.
– Access to more markets for loans and for
temporary investments.
– Cash is often denominated in different
currencies.

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 Impact of multinational operations

• Capital budgeting decisions

– Foreign operations are taxed locally,
and then funds repatriated may be
subject to U.S. taxes.
– Foreign projects are subject to political
risk.
– Funds repatriated must be converted to
U.S. dollars, so exchange rate risk must
be taken into account.

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 Impact of multinational operations

• Credit management
– Credit is more important, because commerce to
lesser-developed countries often relies on credit.
– Credit for future payment may be subject to exchange
rate risk.
• Inventory management
– Inventory decisions can be more complex, especially
when inventory can be stored in locations in different
countries.
– Some factors to consider are shipping times, carrying
costs, taxes, import duties, and exchange rates.

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 Question and Answer Session

Q&A

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 THANK YOU

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