SEC B

B.6. INTERNATIONAL FINANCE

Multinational corporations (MNCs)

Multinational corporations (also called multinational entities, or MNEs) are large
companies that have operations in more than one country.

They tend to bring efficiencies of scale to large operations and a more efficient
distribution network.
As a result, more products are available around the world for a lower price.

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Impact of Multinationals on the Home Country:
Benefit from MNCs:

• Higher profits of the MNC, which leads to higher taxes collected in the home
country.
• An MNC may bring in positive balances of trade( export – import) through its
exports.
• An MNC may also bring other businesses into the country, as supporting
businesses to the MNC.
Limitations from MNCs:

• The MNC may find it cheaper to produce its products in other countries. This
will cause a loss of jobs and trade for the home country, as production
facilities relocate abroad.

Impact of Multinationals on the Host Country

Benefits of MNCs:

• Local jobs are created by the MNC,

• The investment of capital and technology by the MNC into the country,
• Possibly an improved balance of trade resulting from the exports of the MNC
• The presence of one MNC may cause other MNCs to come to the host
country as well.
Limitations of MNCs:

• Cash and profits generated in the host country being sent to the home
country.
• The presence of a dominating MNC may stifle and prevent smaller, local
companies from starting or developing.

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Foreign Direct Investment (FDI)
Foreign direct investment (FDI) is an investment in production or in a business
located in a country made by an individual or a company that is in another
country.

It represents capital movement from one country to another.

Foreign direct Investment includes joint ventures with foreign firms, the acquisition
of foreign firms, and establishing new foreign subsidiaries.
Foreign Direct Investment is an active investment.
The primary motivation for foreign direct investment should always be the
expectation of improved profitability and maximized shareholder returns
Most multinationals make foreign direct investments in order to increase demand
and revenue, reduce costs, or both
Foreign Portfolio Investment
Foreign portfolio investment is an investment in the securities (stocks or bonds) of
a company in a foreign country, and it is a passive investment.

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Benefits of Foreign Direct Investment

• New source of demand is created

• International diversification
• Economies of scale
• Availability of lower cost foreign raw materials and labour
• Availability of foreign technology
Risks of Foreign Direct Investment
Country risk: Country risk is the impact on a multinational firm’s cash flows caused
by the environments in the foreign countries in which the company operates.
Country risk factors include Political risk and financial risk.

• Political risk: Political risks include the risks of;

government expropriation(government seizure of private property), the
blockage of fund transfers or an inconvertible currency,
government bureaucracy, regulations, and taxes, corruption,
attitudes of the consumers ( to purchase local products), civil war.
• Financial risk: financial risk includes exchange rate fluctuations ,changes in
inflation rates etc.
NOTE:
International projects can actually reduce a company’s overall risk because of
the benefits derived from diversification.

FOREIGN CURRENCY EXCHANGE RATE:

The exchange rate between any two currencies is simply the number of units of
Currency B that are required to buy one unit of Currency A.

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The exchange rate of currency can be written in two way; Direct quote and Indirect
quote.
Direct quote:

“ 1 unit of foreign currency= X units of national currency”

For example,
€1 = $1.50
Here, To buy 1 unit of foreign currency (euro) the buyer need spend 1.50 national
currency (US dollar).
Indirect quote:

“1 unit of national currency= X unit of foreign currency”

For example,
$1= €0.667
Here, 1 unit of national currency ( US dollar) the buyer needs to spend 0.667 foreign
currency (euro).
Example: US$1.00 = 118.27 Japanese yen (an indirect quote to someone in the
U.S.). To convert to a direct quote: 1/118.27 = 0.008455.
1 Japanese yen = US$0.008455 (a direct quote to someone in the U.S.). To convert
to an indirect quote: 1 / 0.008455 = 118.27.

Example: Assume the exchange rates between the U.S. dollar and the following
two currencies are as below. The exchange rate in respect to one unit of the
foreign currency is written as follows. These are direct quotes to someone in the
U.S.
Europe €1.00 = US$0.90
Canada C$1.00 = US$0.73
Similarly, the exchange rate can be expressed in reference to US$1.00. These are
indirect quotes to someone in the U.S.
Europe US$ 1.00= €1.11(1/0.90)
Canada US$1.00=C$1.37(1/0.73)

Currency pairs:

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Currencies are traded in pairs.

Note:
To avoid getting confused, remember these four things about currency exchange
rates:
• In an exchange rate quote, the first currency listed is the base currency and
the second currency listed is the quote currency.
• The value of the base currency is always 1.
• When the value of the quote currency increases, the base currency has
appreciated and the quote currency has depreciated.
• When the value of the quote currency decreases, the base currency has
depreciated and the quote currency has appreciated.

Example:
If USD/CAD=1.12 that means, US$1.00=C$1.12
One month after, USD/CAD=1.16 That means U.S dollar appreciated and the
Canadian dollar depreciated.

The Exchange Rate Changes Over Time

The terms used to refer to these changes in exchange rates are appreciation and
depreciation. A currency appreciates or depreciates relative to another currency.

• Currency A appreciates (becomes more valuable) relative to Currency B when

it can purchase more units of Currency B than it previously purchased
or when fewer units of Currency A are required to purchase one unit of
Currency B than previously.

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 • Currency A depreciates (becomes less valuable) relative to Currency B when
it can purchase fewer units of Currency B than previously or when more units
of Currency A are required to purchase one unit of Currency B than
previously.

Measuring the Amount of Appreciation or Depreciation

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The Effect of Appreciation and Depreciation of a Currency
When a currency appreciates or depreciates in value, a number of results will
impact the economy of that country.
The main impact is the impact on international trade, or more specifically, the
amount of exports from and imports to the country.

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Balance of trade:

Appreciation

Depreciation

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How many Banks Make Money on Exchange Rates
Large commercial banks serve as intermediaries for the sale and purchase of
foreign currencies. The banks buy the currency at the bid price and resell it at the
ask price. The difference, or the bid-ask spread.

Determination of Exchange Rates

1. A floating exchange rate:

Exchange rates that are determined by supply and demand in the market
are called floating exchange rate.

Assume that the domestic currency is the U.S. dollar and all other currencies
are foreign currencies. If foreigners want to buy more goods and services
from the United States or make investments in the U.S., they must buy more
U.S. dollars in order to pay the U.S. suppliers for their purchases.
When the rest of the world’s demand for U.S. goods and services increases,
the demand for the U.S. dollar also increases. The increase in demand for the
dollar will cause the price of the dollar to increase on the foreign exchange
market. The value of U.S. dollars in terms of other currencies will go up, or
appreciate.

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 When U.S. demand for goods and services from other countries increases, or
when U.S. residents want to invest abroad, they must sell their U.S. dollars
in order to purchase the foreign currency necessary to pay the foreign
suppliers. As a result, the supply of U.S. dollars increases on the world’s
currency markets, and the price of the U.S. dollar falls. The value of the U.S.
dollar depreciates because of the increased supply.

Note:
The following items are the key points in understanding the floating rate system:
• When the U.S. dollar appreciates, the prices of imported goods fall in the
U.S. and the prices of U.S. exports to other nations rise.
• When the U.S. dollar depreciates, prices for imported goods rise in the U.S.
and prices of U.S. exports fall.
• The demand for the U.S. dollar by residents of other countries reflects their
demand for U.S. products and U.S. investments.
• The supply of U.S. dollars to residents of other countries by U.S. residents
reflects U.S. demand for imported goods and services and foreign
investments.

Factors That Influence Supply of and Demand for Currency and Influence
Exchange Rates
Since currency exchange rates are determined by the supply of and demand for
currencies, factors that influence the supply of and demand for currencies will also
affect exchange rates.
A. Relative inflation rates (the inflation rates for the two countries):

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 US Dollar in terms of British Pound
Inflation in Great Britain suddenly increases substantially while inflation in
the U.S. remains the same. The increase in British inflation causes an increase
in demand for U.S. goods from British residents, because U.S. goods cost less
due to the lower inflation rate in the U.S. Demand in Great Britain for U.S.
dollars to pay for the U.S. goods increases. As a result, the demand curve for
U.S. dollars shifts to the right (D2). Demand in the U.S. for British goods and
for British pounds to pay for the British goods decreases because prices of
goods from Great Britain are higher due to the inflation in Great Britain. As
a result, the supply of U.S. dollars on currency markets decreases since fewer
U.S. residents are using their dollars to buy British pounds. The supply curve
for U.S. Dollars shifts to the left (S2). The combination of greater demand
for U.S. dollars and a lower supply of U.S. dollars causes the equilibrium
exchange rate to increase from £0.60 per U.S. dollar to £0.62 per U.S. dollar.

B. Relative Interest Rates:

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Japanese Yen in terms of US Dollar
Interest rates in Japan increase while interest rates in the U.S. remain the
same. The increase in Japanese interest rates causes investors in the U.S. to
move investments to Japan. Investors in the U.S. sell their dollars to buy yen.
The demand for yen increases, causing the demand curve to shift to the
right (D2). Because the interest rates in Japan are higher than the interest
rates in the U.S., fewer people in Japan will want to sell their yen to buy U.S.
dollars, so the supply of yen on currency markets decreases. The supply
curve for yen shifts to the left (S2). The result is an increase in the
equilibrium exchange rate for the yen.

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C. Relative Income Levels

US Dollar against Foreign Currency

When the U.S. is experiencing a recession, more people will be unemployed,
so less will be spent on imports in the U.S. Lower spending on imports to the
U.S. leads to lowered demand for foreign currencies to pay for the imports.
The supply of U.S. dollars in the currency markets will decrease because
fewer people are using their U.S. dollars to purchase other currencies. The
supply curve for U.S. dollars will shift to the left (S2) while the demand for
U.S. dollars remains the same, causing the equilibrium exchange rate (price)
for the U.S. Dollar to rise.

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 In an expanding economy, the opposite of the above scenario will take place.
Because the U.S. economy is expanding and incomes in the U.S. are
increasing, U.S. residents will buy more imported goods. The supply of U.S.
dollars in the currency markets will increase because more U.S. residents
are using their dollars to buy other currencies so they can pay for imports.
The increased supply of U.S. dollars will shift the supply curve for U.S.
dollars to the right (S2), decreasing the price for the U.S. dollar.

D. Expectations of Future Exchange Rates

• The release of economic data for a country can affect currency
exchange rates for the country because the economic data reflects the
country’s economic health.
Positive expectations - demand↑ - traders retain currency
Negative expectations- demand↓ - traders sell off currency
• Political instability in a country can also cause the country’s currency
to become less attractive to currency traders, and demand for the
currency will fall, causing depreciation of the currency and vice versa.

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 E. Government controls
Governments of some countries can manipulate the equilibrium exchange
rate by means of their policies and actions in the currency markets. These
policies and actions include ;
• Foreign exchange barriers such as restricting the exchange of their
country’s currency for other currencies.
• Foreign trade barriers such as tariffs can limit the amount of imports
coming into a country.
• A country’s government can intervene in the market by buying and
selling its own currency in order to affect both the supply of and the
demand for its currency.
• A government can affect economic variables such as inflation, interest
rates and income levels that in turn affect its exchange rate

Note:
A freely-floating exchange rate system are those which are not controlled
by any government.
Other exchange rate systems that are controlled by governments are
classified as follows:
• Fixed exchange rate system
• Managed float
• Pegged

2. Fixed Exchange Rates

A fixed exchange rate in which the exchange rate is set by a government.
Fixed exchange rates are rates that are either held constant by the
government or allowed to fluctuate within a narrow range.

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 Note: The following items are the key points to the fixed exchange rate system:

• Under a fixed exchange rate, the government buys and sells its own currency
to control its supply and demand in order to maintain a fixed currency
exchange rate that it determines.
• An overvalued currency is one whose exchange rate is held above the free
market valuation.
• When a government overvalues its currency, it will have a balance-
ofpayments deficit. It will need to use its reserves of foreign currency to
purchase its own currency on the currency markets in order to maintain the
artificially high exchange rate. Eventually, its reserves will run out, forcing it
to allow the exchange rate to decrease, thus devaluing its currency.
• An undervalued currency is one whose fixed exchange rate is below its free
market value.
• When a government undervalues its currency, it will have a trade surplus
and an international transactions balance surplus, and it will accumulate
foreign currency reserves. To avoid accumulating too much, allow its
exchange rate to increase, thus revaluing its currency.

Note:
• A major reason for devaluation of a country’s currency is to improve its
international transactions balance.

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 • A common currency is the most fixed of exchange rates because there are
no exchange rates between the currencies of the countries that have
adopted the euro—1 euro will always equal 1 euro.

3. Managed Float Exchange Rates

A managed float system includes elements of both the floating and fixed
exchange rate models. The Managed float system is similar to the
freelyfloating rate system because exchange rates are allowed to fluctuate
in response to market forces and there are no officially fixed rates. It is
similar to the fixed rate system because the government sometimes does
intervene to prevent its currency exchange rate from moving too far in one
direction or the other.

4. Pegged Exchange Rate System

A pegged currency’s value is fixed in terms of the foreign currency
or currencies it is pegged to, and it moves with that currency
against other currencies. Pegged systems are generally used by
smaller countries.

Foreign Currency “Cross Rates”

The term “cross rate” refers to the practice of using a third currency to calculate
the exchange rate between two currencies that are not traded much for each
other.
E.g.,
1 USD = 1.7898 JPY 1
USD = 1.99 BZD
Calculate JPY / BZD?
Ans: 1.99 /1.7898= 1.1119

Q1) A currency exchange trader needed to calculate the exchange rate

between the Canadian dollar (CAD) and the Swiss Franc (CHF), however
this rate is not given on the currency exchanges. The trader had the

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exchange rates of the USD / CAD and the USD / CHF, so the trader was
able to Calculate the CAD/CHF cross rate. If the exchange rate of the
USD/CAD = 0.9250 and the exchange rate of the USD/CHF = 1.6250, what
would be the CAD/CHF cross rate?
Ans) 1.6250/0.9250 = 1.7567

The Purchasing Power Parity (PPP) Theorem

According to the purchasing power parity theorem, the relative price for
a particular good should be the same in any country.
As a simple example, if a coffee costs $1 in the U.S., someone should be
able to take $1 to India, change it into the Indian rupee ($1=INR 80) , and
buy a coffee from India for same INR 80.

The PPP states the exchange rate between two currencies is in

equilibrium when the domestic purchasing power of residence of both
countries is the same.

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E.g. : If a coffee costs $2 and the same coffee costs JPY180, then
according to the PPP, the exchange rate between U.S. and Japanese yen
should be approximately 90 yen for US$1 (180 ÷ 2). The PPP can thus be
calculated by the ratio of prices for the typical basket of goods in the two
countries.

Managing Exchange Rate Risk

Between the time an international transaction is contracted for and the
time the payment changes hands, the exchange rate could fluctuate
considerably. It is called Foreign Exchange Risk
Foreign exchange rate risk can be managed in several ways;
1. Natural Hedges
If a company, or the foreign subsidiary of a country, has its
expenses and revenues denominated in the same currency,
there will be little exchange rate risk, if any, for that company.
By keeping expenses and revenues denominated in the same
currency, a company can use a natural hedge to protect
themselves from changes in exchange rates.
2. Operational Hedges
The best operational hedge is to balance the monetary assets
denominated in a specific currency and the monetary
liabilities held in that currency.
E.g. :If its receivables and payables are in balance, gains in
Receivables will be offset by losses in payables and vice versa
when the exchange rate fluctuates.
Note:

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A firm may also attempt to manage its exchange rate risk through
diversification. Investing in different economies and currencies can
minimize the risk of exchange-rate losses because it is unlikely that all
of the currencies will experience exchange-rate losses at the same
time.
3. International Financing Hedges
A firm can borrow in a foreign currency to offset a net
receivables position in that currency. Or, a company with a
foreign subsidiary can borrow in the country where the
subsidiary is located in order to offset its exposure.
4. Currency Market Hedges Using Derivatives
Foreign exchange derivatives can be used to hedge
anticipated cash inflows and outflows in any specific foreign
currency.
A. Currency forward contract
A forward contract is executed between two parties, one
agreeing to buy and one agreeing to sell the currency at a
future date.
The contract specifies the amount of the particular
currency that will be purchased/sold at a specified future
date and at a specified exchange rate.
The forward rate is the rate used for forward contracts for
transactions that will be completed at a future date. The
spot rate is the current exchange rate that is used in
currency transactions that are completed at that point in
time.

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 Calculating the Percentage of a Forward Discount or
Premium

Example:
The spot exchange rate between the U.S. dollar (USD) and the Indian
rupee (INR) is USD/INR 60. (US$1 = ₹60) and the forward rate for 60
days is USD/INR 60.199 (US$1 = ₹60.199).
(60.199- 60)/60= 0.33%
The premium for 60 day period Is 0.33%
However, the 0.33% premium is for a period of only 2 months(60days).
To calculate Annualised premium,
[(60.199 – 60)/ 60] * 6 = 0.019 or 2%
B. Currency Futures
Currency futures contracts are similar to currency forward
contracts, except they are standardized and are traded on
organized exchanges, whereas forward contracts are
arranged between the two contracting parties and are not
traded on exchanges.
Standardized agreement specifies delivery of currency at a
specified future date and future date is limited to 3 rd
Wednesday of March, June, September and December. A
future contract can be closed out before its expiration date
by taking an offsetting position.

C. Currency Options
Currency options are used to hedge risk that currency will
move in an adverse direction only, in contrast to forward

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 contracts and futures contracts, which hedge movements
in either direction.
The buyer of the option has the right but not the obligation
to buy (sell) the currency any time before the expiration
date. In exchange for this “insurance,” the buyer pays a
premium.

Determining the Effective Interest Rate on a Foreign Currency Loan

The actual cost of a loan in a foreign currency will depend on two things:
1)The interest rate on the loan, and
2)The change in the borrowed currency’s value over the term of the loan
The effective interest rate can be calculated using the following
formula:

Where: Rf =The effective financing rate

If =The interest rate of the foreign currency loan

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 Ef =The percentage change in the foreign currency unit against
the U.S. dollar

The percentage change in the foreign currency against the U.S. dollar (Ef)
is calculated as follows:

Where:
St + 1 =The spot rate of the foreign currency in terms of U.S. dollars (a
direct quote, with the foreign currency as the base currency) at the end
of the financing period.
S =The spot rate of the foreign currency in terms of U.S. dollars (a direct
quote, with the foreign currency as the base currency) at the beginning
of the financing period.
Q)Last year, the treasurer of a multinational firm headquartered in the
U.S. obtained a loan from a bank in a foreign country denominated in
foreign currency units (FCUs) at an interest rate of 25%. The exchange
rate was $1 US = 5 FCU. The principal amount of the loan was 10 million
FCU. After twelve months, the treasurer has repaid the loan when the
exchange rate is $1 US = 5.7 FCU. Assuming that the interest is paid at
the end of the loan period, what is the effective interest rate, based on
U.S. dollars?
Ans:
St+1 = $1 US / 5.7 FCU = $0.175439
S = $1 US / 5 FCU = $0.20

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Ef = ($0.175439 − $0.20) / $0.20
Ef = (0.122805)
The effective interest rate is:
Rf = (1 + 0.25) × (1 + [0.122805]) – 1
Rf = (1.25 × 0.877195) – 1 Rf
= 0.09649, or 9.65%

International Payment and Financing

The more common methods of paying for international transactions and
financing international transactions include:
1. Prepayment
When prepayment is made for the goods, the risk to
the seller is eliminated and the buyer has the risk of
non-delivery by the seller.
Prepayment is usually used when a seller is working
with a new customer for the first time.
Payment is made using a wire transfer(bank to bank)
or can be made by cheque ( it carries more risk than
wire transfer).
2. Documentary collection and drafts:
It can be used only for ocean shipment. To use
documentary collections as to receive payment, the
seller sends a draft along with the bill of lading for
ocean freight, through international bank channels to
the buyer’s bank.
Bill of lading is a negotiable document and constitutes
title to the goods, and buyer can receive the shipment.

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 Draft is a written order by one party(seller) directing a
second party (buyer) to make payment to third
party(buyer’s bank)
The buyer makes payment to their bank and receive
bill of lading from their bank. Buyer’s bank then
transfers the funds paid by the buyer to the seller’s
bank and credits it to seller’s bank account. Using a
sight draft, the seller retains title to the goods (but not
possession) until the buyer has paid for the goods that
were shipped. The payment is to be made as soon as
the buyer sees the draft. The buyer’s bank does not
release the shipping document to the buyer until the
buyer has made the payment.
3. Open Account
A sale made on open account means that payment is
to be made on an agreed-upon future date. With an
open account arrangement, the seller bears the risk
that the buyer will not pay. Therefore, a seller would
not want to sell on open account unless he has had a
long and favourable relationship with the buyer or the
buyer has excellent credit.
4. Countertrade, or Barter
Countertrade, or barter, may be used if the buyer does
not have access to currency conversion, if exchange
rates are unfavourable, or if the two parties can
exchange goods or services on a mutually satisfactory
basis.
Countertrade means that the sale of goods to one
country is linked to the purchase or exchange of goods
from the same country. Barter is a specific type of

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 countertrade that involves the exchange of goods or
services between two parties without the use of any
currency as a medium of exchange

5. Commercial Letter of Credit

A commercial letter of credit is a guarantee by the
buyer’s bank that the bank will pay for the
merchandise, provided that the seller (exporter) can
provide the required documents in accordance with
the terms of the commercial letter of credit.
The required documents are generally bills of lading
and freight documents evidencing shipment of the
goods. A commercial letter of credit provides
reasonable assurances to both the buyer and the seller
that the goods will be delivered and payment made
because the seller is assured of payment when the
conditions of the letter of credit are met; and the
buyer is assured of receiving the goods ordered.
6. Cross-Border Factoring
An exporter might use cross-border factoring, which
involves selling the receivable for the sale to a third
party, or a factor. The exporter can eliminate the risk
of the receivable not being paid if it sells the receivable
without recourse.
7. Banker’s Acceptance
A banker’s acceptance is a time draft that has been
issued under a letter of credit and has been accepted
by the importer’s bank. When the buyer’s bank

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 accepts the time draft, a banker’s acceptance is
created.
The bank that has accepted the draft is obligated to
pay the amount of the draft to the holder of the draft
on the maturity date. Note that if the exporter does
not want to wait for payment, the exporter may sell
the banker’s acceptance at a discount in the money
market. The buyer of the banker’s acceptance will
receive the full payment from the bank on the
maturity date.

8. Forfaiting
Forfaiting is a form of factoring in that the forfeiter is
responsible for collecting the cash payment from the
importer/buyer. Forfaiting is used for large
transactions (larger than $500,000) that are medium
to long-term in length. The forfaiting bank must assess
the creditworthiness of the importer because it is in
effect extending to the importer a medium-term loan.
Forfeit transactions generally require a bank
guarantee or a letter of credit to be issued by the
importer’s bank for the term of the transaction to
serve as a secondary repayment source.

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