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International Financial Management

Australia • Brazil • Mexico • Singapore • United Kingdom • United States

International Financial tnemeganaM

13th Edition

Jeff Madura Florida Atlantic University

International Financial Management, 13th Edition Jeff Madura

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Printed in Canada Print Number: 01 Print Year: 2016

Dedicated to my mother Irene

Brief Contents

PART 1: The International Financial Environment 1 1 Multinational Financial Management: An Overview 3 2 International Flow of Funds 33 3 International Financial Markets 63 4 Exchange Rate Determination 103 5 Currency Derivatives 131

PART 2: Exchange Rate Behavior 185 6 Government Influence on Exchange Rates 187 7 International Arbitrage and Interest Rate Parity 227 8 Relationships among Inflation, Interest Rates, and Exchange Rates 257

PART 3: Exchange Rate Risk Management 295 9 Forecasting Exchange Rates 297 10 Measuring Exposure to Exchange Rate Fluctuations 325 11 Managing Transaction Exposure 355 12 Managing Economic Exposure and Translation Exposure 393

PART 4: Long-Term Asset and Liability Management 415 13 Direct Foreign Investment 417 14 Multinational Capital Budgeting 437 15 International Corporate Governance and Control 477 16 Country Risk Analysis 503 17 Multinational Capital Structure and Cost of Capital 527 18 Long-Term Debt Financing 551

PART 5: Short-Term Asset and Liability Management 575 19 Financing International Trade 577 20 Short-Term Financing 595 21 International Cash Management 611

Appendix A: Answers to Self-Test Questions 643

Appendix B: Supplemental Cases 656

Appendix C: Using Excel to Conduct Analysis 676

Appendix D: International Investing Project 684

Appendix E: Discussion in the Boardroom 687

Appendix F: Use of Bitcoin to Conduct International Transactions 695

Glossary 697 Index 705

Contents

Preface, xix

About the Author, xxvi

PART 1: The International Financial Environment 1

1: MULTINATIONAL FINANCIAL MANAGEMENT: AN OVERVIEW 3 1-1 Managing the MNC, 4

1-1a How Business Disciplines Are Used to Manage the MNC, 4 1-1b Agency Problems, 4 1-1c Management Structure of an MNC, 6

1-2 Why MNCs Pursue International Business, 8 1-2a Theory of Comparative Advantage, 8 1-2b Imperfect Markets Theory, 8 1-2c Product Cycle Theory, 9

1-3 Methods to Conduct International Business, 10 1-3a International Trade, 10 1-3b Licensing, 10 1-3c Franchising, 11 1-3d Joint Ventures, 11 1-3e Acquisitions of Existing Operations, 11 1-3f Establishment of New Foreign Subsidiaries, 12 1-3g Summary of Methods, 12

1-4 Valuation Model for an MNC, 13 1-4a Domestic Model, 14 1-4b Multinational Model, 14 1-4c Uncertainty Surrounding an MNC’s Cash Flows, 17 1-4d Summary of International Effects, 20 1-4e How Uncertainty Affects the MNC’s Cost of Capital, 21

1-5 Organization of the Text, 21

2: INTERNATIONAL FLOW OF FUNDS 33 2-1 Balance of Payments, 33

2-1a Current Account, 33 2-1b Financial Account, 35 2-1c Capital Account, 36 2-1d Relationship between the Accounts, 37

2-2 Growth in International Trade, 37 2-2a Events That Increased Trade Volume, 37 2-2b Impact of Outsourcing on Trade, 39 2-2c Trade Volume among Countries, 40 2-2d Trend in U.S. Balance of Trade, 42

2-3 Factors Affecting International Trade Flows, 43 2-3a Cost of Labor, 43

2-3b Inflation, 44 2-3c National Income, 44 2-3d Credit Conditions, 44 2-3e Government Policies, 44 2-3f Exchange Rates, 48

2-4 International Capital Flows, 52 2-4a Factors Affecting Direct Foreign Investment, 52 2-4b Factors Affecting International Portfolio Investment, 53 2-4c Impact of International Capital Flows, 53

2-5 Agencies That Facilitate International Flows, 55 2-5a International Monetary Fund, 55 2-5b World Bank, 56 2-5c World Trade Organization, 57 2-5d International Finance Corporation, 57 2-5e International Development Association, 57 2-5f Bank for International Settlements, 57 2-5g OECD, 58 2-5h Regional Development Agencies, 58

3: INTERNATIONAL FINANCIAL MARKETS 63 3-1 Foreign Exchange Market, 63

3-1a History of Foreign Exchange, 63 3-1b Foreign Exchange Transactions, 64 3-1c Foreign Exchange Quotations, 70 3-1d Derivative Contracts in the Foreign Exchange Market, 74

3-2 International Money Market, 75 3-2a European and Asian Money Markets, 76 3-2b Money Market Interest Rates among Currencies, 76 3-2c Risk of International Money Market Securities, 77

3-3 International Credit Market, 78 3-3a Syndicated Loans in the Credit Market, 78 3-3b Bank Regulations in the Credit Market, 79 3-3c Impact of the Credit Crisis, 79

3-4 International Bond Market, 80 3-4a Eurobond Market, 80 3-4b Development of Other Bond Markets, 81 3-4c Risk of International Bonds, 81 3-4d Impact of the Greece Crisis, 82

3-5 International Stock Markets, 83 3-5a Issuance of Stock in Foreign Markets, 83 3-5b Issuance of Foreign Stock in the United States, 84 3-5c Comparing the Size among Stock Markets, 85 3-5d How Governance Varies among Stock Markets, 86 3-5e Integration of International Stock Markets and Credit Markets, 87

3-6 How Financial Markets Serve MNCs, 88

Appendix 3: Investing in International Financial Markets, 95

4: EXCHANGE RATE DETERMINATION 103 4-1 Measuring Exchange Rate Movements, 103 4-2 Exchange Rate Equilibrium, 104

4-2a Demand for a Currency, 105 4-2b Supply of a Currency for Sale, 106

x Contents

4-2c Equilibrium Exchange Rate, 106 4-2d Change in the Equilibrium Exchange Rate, 107

4-3 Factors That Influence Exchange Rates, 108 4-3a Relative Inflation Rates, 109 4-3b Relative Interest Rates, 110 4-3c Relative Income Levels, 111 4-3d Government Controls, 112 4-3e Expectations, 112 4-3f Interaction of Factors, 114 4-3g Influence of Factors across Multiple Currency Markets, 115 4-3h Impact of Liquidity on Exchange Rate Adjustments, 116

4-4 Movements in Cross Exchange Rates, 116 4-5 Capitalizing on Expected Exchange Rate Movements, 117

4-5a Institutional Speculation Based on Expected Appreciation, 118 4-5b Institutional Speculation Based on Expected Depreciation, 119 4-5c Speculation by Individuals, 120 4-5d The “Carry Trade”, 120

5: CURRENCY DERIVATIVES 131 5-1 Forward Market, 131

5-1a How MNCs Use Forward Contracts, 131 5-1b Bank Quotations on Forward Rates, 132 5-1c Premium or Discount on the Forward Rate, 133 5-1d Movements in the Forward Rate over Time, 134 5-1e Offsetting a Forward Contract, 134 5-1f Using Forward Contracts for Swap Transactions, 135 5-1g Non-Deliverable Forward Contracts, 135

5-2 Currency Futures Market, 136 5-2a Contract Specifications, 136 5-2b Trading Currency Futures, 137 5-2c Credit Risk of Currency Futures Contracts, 138 5-2d Comparing Currency Futures and Forward Contracts, 138 5-2e How MNCs Use Currency Futures, 139 5-2f Speculation with Currency Futures, 141

5-3 Currency Options Market, 142 5-3a Currency Options Exchanges, 142 5-3b Over-the-Counter Currency Options Market, 142

5-4 Currency Call Options, 142 5-4a Factors Affecting Currency Call Option Premiums, 143 5-4b How MNCs Use Currency Call Options, 144 5-4c Speculating with Currency Call Options, 145

5-5 Currency Put Options, 148 5-5a Factors Affecting Currency Put Option Premiums, 149 5-5b How MNCs Use Currency Put Options, 149 5-5c Speculating with Currency Put Options, 150

5-6 Other Forms of Currency Options, 152 5-6a Conditional Currency Options, 152 5-6b European Currency Options, 154

Appendix 5A: Currency Option Pricing, 165

Appendix 5B: Currency Option Combinations, 169

Part 1 Integrative Problem: The International Financial Environment, 183

Contents xi

PART 2: Exchange Rate Behavior 185

6: GOVERNMENT INFLUENCE ON EXCHANGE RATES 187 6-1 Exchange Rate Systems, 187

6-1a Fixed Exchange Rate System, 187 6-1b Freely Floating Exchange Rate System, 189 6-1c Managed Float Exchange Rate System, 190 6-1d Pegged Exchange Rate System, 191 6-1e Dollarization, 197 6-1f Black Markets for Currencies, 197

6-2 A Single European Currency, 198 6-2a Monetary Policy in the Eurozone, 198 6-2b Impact on Firms in the Eurozone, 199 6-2c Impact on Financial Flows in the Eurozone, 199 6-2d Impact of Eurozone Country Crisis on Other Eurozone Countries, 199 6-2e Impact of a Country Abandoning the Euro, 202

6-3 Direct Intervention, 203 6-3a Reasons for Direct Intervention, 203 6-3b The Direct Intervention Process, 204 6-3c Direct Intervention as a Policy Tool, 207 6-3d Speculating on Direct Intervention, 208

6-4 Indirect Intervention, 209 6-4a Government Control of Interest Rates, 209 6-4b Government Use of Foreign Exchange Controls, 210

Appendix 6: Government Intervention during the Asian Crisis, 218

7: INTERNATIONAL ARBITRAGE AND INTEREST RATE PARITY 227 7-1 Locational Arbitrage, 227

7-1a Gains from Locational Arbitrage, 228 7-1b Realignment due to Locational Arbitrage, 228

7-2 Triangular Arbitrage, 229 7-2a Gains from Triangular Arbitrage, 230 7-2b Realignment due to Triangular Arbitrage, 232

7-3 Covered Interest Arbitrage, 232 7-3a Covered Interest Arbitrage Process, 232 7-3b Realignment due to Covered Interest Arbitrage, 234 7-3c Arbitrage Example When Accounting for Spreads, 235 7-3d Covered Interest Arbitrage by Non-U.S. Investors, 236 7-3e Comparing Different Types of Arbitrage, 236

7-4 Interest Rate Parity (IRP), 236 7-4a Derivation of Interest Rate Parity, 237 7-4b Determining the Forward Premium, 238 7-4c Graphic Analysis of Interest Rate Parity, 240 7-4d How to Test Whether Interest Rate Parity Holds, 242 7-4e Does Interest Rate Parity Hold?, 242 7-4f Considerations When Assessing Interest Rate Parity, 243

7-5 Variation in Forward Premiums, 244 7-5a Forward Premiums across Maturities, 244 7-5b Changes in Forward Premiums over Time, 245

xi i Contents

8: RELATIONSHIPS AMONG INFLATION, INTEREST RATES, AND EXCHANGE RATES 257

8-1 Purchasing Power Parity (PPP), 257 8-1a Interpretations of Purchasing Power Parity, 257 8-1b Rationale behind Relative PPP Theory, 258 8-1c Derivation of Purchasing Power Parity, 258 8-1d Using PPP to Estimate Exchange Rate Effects, 259 8-1e Graphic Analysis of Purchasing Power Parity, 260 8-1f Testing the Purchasing Power Parity Theory, 263 8-1g Does Purchasing Power Parity Exist?, 265

8-2 International Fisher Effect (IFE), 266 8-2a Deriving a Country’s Expected Inflation Rate, 266 8-2b Estimating the Expected Exchange Rate Movement, 267 8-2c Implications of the International Fisher Effect, 267 8-2d Derivation of the International Fisher Effect, 270 8-2e Graphic Analysis of the International Fisher Effect, 272 8-2f Testing the International Fisher Effect, 273 8-2g Limitations of the IFE Theory, 274 8-2h IFE Theory versus Reality, 275 8-2i Comparison of IRP, PPP, and IFE Theories, 275

Part 2 Integrative Problem: Exchange Rate Behavior, 286 Midterm Self-Exam, 287

PART 3: Exchange Rate Risk Management 295

9: FORECASTING EXCHANGE RATES 297 9-1 Why Firms Forecast Exchange Rates, 297 9-2 Forecasting Techniques, 299

9-2a Technical Forecasting, 299 9-2b Fundamental Forecasting, 299 9-2c Market-Based Forecasting, 303 9-2d Mixed Forecasting, 306

9-3 Assessment of Forecast Performance, 307 9-3a Measurement of Forecast Error, 307 9-3b Forecast Errors among Time Horizons, 308 9-3c Forecast Errors over Time Periods, 308 9-3d Forecast Errors among Currencies, 308 9-3e Comparing Forecast Errors among Forecast Techniques, 309 9-3f Graphic Evaluation of Forecast Bias, 309 9-3g Statistical Test of Forecast Bias, 311 9-3h Shifts in Forecast Bias over Time, 312

9-4 Accounting for Uncertainty Surrounding Forecasts, 312 9-4a Sensitivity Analysis Applied to Fundamental Forecasting, 313 9-4b Interval Forecasts, 313

10: MEASURING EXPOSURE TO EXCHANGE RATE FLUCTUATIONS 325 10-1 Relevance of Exchange Rate Risk, 325 10-2 Transaction Exposure, 326

10-2a Estimating “Net” Cash Flows in Each Currency, 328 10-2b Transaction Exposure of an MNC’s Portfolio, 329

Contents xi i i

10-2c Transaction Exposure Based on Value at Risk, 332 10-3 Economic Exposure, 335

10-3a Exposure to Foreign Currency Depreciation, 336 10-3b Exposure to Foreign Currency Appreciation, 337 10-3c Measuring Economic Exposure, 337

10-4 Translation Exposure, 340 10-4a Determinants of Translation Exposure, 340 10-4b Exposure of an MNC’s Stock Price to Translation Effects, 342

11: MANAGING TRANSACTION EXPOSURE 355 11-1 Policies for Hedging Transaction Exposure, 355

11-1a Hedging Most of the Exposure, 355 11-1b Selective Hedging, 355

11-2 Hedging Exposure to Payables, 356 11-2a Forward or Futures Hedge on Payables, 356 11-2b Money Market Hedge on Payables, 357 11-2c Call Option Hedge on Payables, 357 11-2d Comparison of Techniques for Hedging Payables, 360 11-2e Evaluating Past Decisions on Hedging Payables, 363

11-3 Hedging Exposure to Receivables, 363 11-3a Forward or Futures Hedge on Receivables, 363 11-3b Money Market Hedge on Receivables, 364 11-3c Put Option Hedge on Receivables, 364 11-3d Comparison of Techniques for Hedging Receivables, 367 11-3e Evaluating Past Decisions on Hedging Receivables, 370 11-3f Summary of Hedging Techniques, 370

11-4 Limitations of Hedging, 371 11-4a Limitation of Hedging an Uncertain Payment, 371 11-4b Limitation of Repeated Short-Term Hedging, 371

11-5 Alternative Methods to Reduce Exchange Rate Risk, 373 11-5a Leading and Lagging, 374 11-5b Cross-Hedging, 374 11-5c Currency Diversification, 374

Appendix 11: Nontraditional Hedging Techniques, 388

12: MANAGING ECONOMIC EXPOSURE AND TRANSLATION EXPOSURE 393

12-1 Managing Economic Exposure, 393 12-1a Assessing Economic Exposure, 394 12-1b Restructuring to Reduce Economic Exposure, 395 12-1c Limitations of Restructuring Intended to Reduce Economic Exposure, 398

12-2 A Case Study on Hedging Economic Exposure, 398 12-2a Savor Co.’s Assessment of Economic Exposure, 398 12-2b Possible Strategies for Hedging Economic Exposure, 400

12-3 Managing Exposure to Fixed Assets, 401 12-4 Managing Translation Exposure, 402

12-4a Hedging Translation Exposure with Forward Contracts, 403 12-4b Limitations of Hedging Translation Exposure, 403

Part 3 Integrative Problem: Exchange Risk Management, 412

xiv Contents

PART 4: Long-Term Asset and Liability Management 415

13: DIRECT FOREIGN INVESTMENT 417 13-1 Motives for Direct Foreign Investment, 417

13-1a Revenue-Related Motives, 417 13-1b Cost-Related Motives, 418 13-1c Comparing Benefits of DFI among Countries, 420

13-2 Benefits of International Diversification, 421 13-2a Diversification Analysis of International Projects, 422 13-2b Diversification among Countries, 424

13-3 Host Government Impact on DFI, 424 13-3a Incentives to Encourage DFI, 425 13-3b Barriers to DFI, 425

13-4 Assessing Potential DFI, 427 13-4a A Case Study of Assessing Potential DFI, 427 13-4b Evaluating DFI Opportunities That Pass the First Screen, 429

14: MULTINATIONAL CAPITAL BUDGETING 437 14-1 Subsidiary versus Parent Perspective, 437

14-1a Tax Differentials, 437 14-1b Restrictions on Remitted Earnings, 438 14-1c Exchange Rate Movements, 438 14-1d Summary of Factors That Distinguish the Parent Perspective, 438

14-2 Input for Multinational Capital Budgeting, 439 14-3 Multinational Capital Budgeting Example, 441

14-3a Background, 441 14-3b Analysis, 442

14-4 Other Factors to Consider, 443 14-4a Exchange Rate Fluctuations, 444 14-4b Inflation, 447 14-4c Financing Arrangement, 447 14-4d Blocked Funds, 450 14-4e Uncertain Salvage Value, 451 14-4f Impact of Project on Prevailing Cash Flows, 452 14-4g Host Government Incentives, 453 14-4h Real Options, 453

14-5 Adjusting Project Assessment for Risk, 454 14-5a Risk-Adjusted Discount Rate, 454 14-5b Sensitivity Analysis, 454 14-5c Simulation, 457

Appendix 14: Incorporating International Tax Law in Multinational Capital Budgeting, 469

15: INTERNATIONAL CORPORATE GOVERNANCE AND CONTROL 477 15-1 International Corporate Governance, 477

15-1a Governance by Board Members, 477 15-1b Governance by Institutional Investors, 478 15-1c Governance by Shareholder Activists, 478

15-2 International Corporate Control, 479 15-2a Motives for International Acquisitions, 479 15-2b Trends in International Acquisitions, 479

Contents xv

15-2c Barriers to International Corporate Control, 480 15-2d Model for Valuing a Foreign Target, 481

15-3 Factors Affecting Target Valuation, 482 15-3a Target-Specific Factors, 482 15-3b Country-Specific Factors, 483

15-4 A Case Study of Valuing a Foreign Target, 484 15-4a International Screening Process, 484 15-4b Estimating the Target’s Value, 485 15-4c Uncertainty Surrounding the Target’s Valuation, 487 15-4d Changes in Market Valuation of Target over Time, 487

15-5 Disparity in Foreign Target Valuations, 488 15-5a Expected Cash Flows of the Foreign Target, 488 15-5b Exchange Rate Effects on Remitted Earnings, 489 15-5c Required Return of Acquirer, 489

15-6 Other Corporate Control Decisions, 490 15-6a International Partial Acquisitions, 490 15-6b International Acquisitions of Privatized Businesses, 490 15-6c International Divestitures, 491

15-7 Corporate Control Decisions as Real Options, 492 15-7a Call Option on Real Assets, 492 15-7b Put Option on Real Assets, 493

16: COUNTRY RISK ANALYSIS 503 16-1 Country Risk Characteristics, 503

16-1a Political Risk Characteristics, 503 16-1b Financial Risk Characteristics, 506

16-2 Measuring Country Risk, 507 16-2a Techniques for Assessing Country Risk, 508 16-2b Deriving a Country Risk Rating, 509 16-2c Comparing Risk Ratings among Countries, 511

16-3 Incorporating Risk in Capital Budgeting, 512 16-3a Adjustment of the Discount Rate, 512 16-3b Adjustment of the Estimated Cash Flows, 512 16-3c Analysis of Existing Projects, 515

16-4 Preventing Host Government Takeovers, 516 16-4a Use a Short-Term Horizon, 516 16-4b Rely on Unique Supplies or Technology, 516 16-4c Hire Local Labor, 516 16-4d Borrow Local Funds, 516 16-4e Purchase Insurance, 517 16-4f Use Project Finance, 517

17: MULTINATIONAL CAPITAL STRUCTURE AND COST OF CAPITAL 527 17-1 Components of Capital, 527

17-1a Retained Earnings, 527 17-1b Sources of Debt, 528 17-1c External Sources of Equity, 529

17-2 The MNC’s Capital Structure Decision, 530 17-2a Influence of Corporate Characteristics, 531 17-2b Influence of Host Country Characteristics, 531 17-2c Response to Changing Country Characteristics, 532

xvi Contents

17-3 Subsidiary versus Parent Capital Structure Decisions, 533 17-3a Impact of Increased Subsidiary Debt Financing, 533 17-3b Impact of Reduced Subsidiary Debt Financing, 533 17-3c Limitations in Offsetting a Subsidiary’s Leverage, 534

17-4 Multinational Cost of Capital, 534 17-4a MNC’s Cost of Debt, 534 17-4b MNC’s Cost of Equity, 534 17-4c Estimating an MNC’s Cost of Capital, 535 17-4d Comparing Costs of Debt and Equity, 535 17-4e Cost of Capital for MNCs versus Domestic Firms, 536 17-4f Cost-of-Equity Comparison Using the CAPM, 537

17-5 Cost of Capital across Countries, 539 17-5a Country Differences in the Cost of Debt, 540 17-5b Country Differences in the Cost of Equity, 541

18: LONG-TERM DEBT FINANCING 551 18-1 Debt Denomination Decision of Foreign Subsidiaries, 551

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