Type
Quiz
Book Title
Introduction to Global Business: Understanding the International Environment & Global Business Functions 2nd Edition
ISBN 13
978-1305501188

978-1305501188 Chapter 14

August 27, 2020
CHAPTER 14
Global Financial Management
Chapter Outline
Introduction
Measuring Foreign Exchange Exposure
Hedging Forex Risk with Derivatives
Futures Contracts
o Example of a Forex Futures Hedge
Forward Contracts
Options Contracts
Swap Contracts
Financing International Trade and Investment
International Banking
International Bond Markets
International Stock Markets
Government Financing
Multinational Capital Budgeting
Parent Firm Capital Budgeting
The Cost of Capital: Domestic Versus Global
Currency Risk and Stock Valuation
Cash Flow Sensitivity to Exchange Rate Risk
Stock Values and Foreign Exchange Movements
Teaching Objectives
After covering this chapter, the student should be able to:
Explain how foreign exchange risk affects firms and investors.
Describe different ways to hedge exchange rate risk.
Discuss sources of funds to finance international trade and investment.
Apply net present value analyses to the capital budgeting decisions facing firms with
international operations.
Discuss how exchange rate risk affects firms’ cash flows and its impact on stock returns.
COMPREHENSIVE LECTURE OUTLINE
I. Introduction. A currency changing in value relative to another currency is an exchange
rate risk. There are more than 150 currencies in circulation. The effects of exchange rate risk on
firms are complex. Floating exchange rates can randomly change over time as currencies are
traded in world currency markets. Some exchange rate risk can be hedged with derivative
instruments. Firms competing in the global economy need to acquire funds for their investment
projects from global financial markets. Firms incorporate the effects of exchange rate risk in
capital budgeting decisions that determine their future investments.
CLASS ACTIVITY: Use the Cultural Perspective case as an opportunity to allow students to
explore the impact of higher oil prices and their denomination in U.S. dollars on economies of
the U.S. and Europe. Exhibit 14.1 The Price in Dollars of One Barrel of Crude Oil.
II. Measuring Foreign Exchange Exposure. Two kinds of short-term effects of currency
movements are transactions risk and translation risk. The long-term effects of currency
movements are associated with economic risk.
Transactions risk arises from the import and export of goods and services. It
affects both exporters and importers. If the dollar decreased in value relative
to the euro, the U.S. exporter would gain profits, and the U.S. importer would
lose profits.
Translation risk is associated with the short-term effects of currency
movements on the consolidated accounting statements of a firm. Converting
the subsidiary’s financial statements from their operating currency to the
MNC’s home country reporting currency is necessary for reporting in
financial statements the financial performance of all subsidiaries abroad to the
home country tax authorities. Changes in currency values over time will affect
accounting values. The currency denomination of accounting statements can
affect their interpretation. Translation risk can affect firms reporting
accounting information with operations abroad.
Economic risk is associated with the ways in which long-term exchange rate
movements affect firms. Protracted swings in exchange rates over a period of
time can affect a firm’s long-run cash flows and thereby alter the firm’s value.
A convenient way to measure a currency’s value in world markets is to use a
basket of currencies.
DISCUSSION STARTER: REALITY CHECK 1.
Imagine buying a car to be built in Germany and then shipped to the United States. You pay
an initial small amount to sign the contract and proceed with the order. The contract shows
the balance due in dollars when you pick up the car from a local dealer in four months. Are
you exposed to exchange rate risk? What about the car manufacturer in Germany?
III. Hedging Forex Risk with Derivatives. Hedging intends to reduce potential transaction,
translation, and economic risks of currency movements that could lead to volatile cash flows and
losses. Speculation is the opposite of hedging. Speculators attempt to earn profits from trading in
currencies or currency derivatives.
Futures Contracts. Currency futures contracts are standardized agreements to
buy or sell a specified amount of currency on a particular date in the future at a
pre-determined price. Futures contracts are marked-to-market daily: gains and
losses in futures positions are reconciled at the close of trading each day by the
exchange organization. Buyers and sellers can close them at any time prior to the
delivery date. Contracts can be purchased for a small commitment fee known as a
margin. This low cost of futures contracts makes them very affordable to use as a
way to manage exchange rate and other market risks.
o Example of a Forex Futures Hedge. Exhibit 14.2 • Payoffs for Futures
Contracts.
Forward Contracts. Foreign currency contracts are one of the most popular
forward futures. However, they are available only for major currencies. Currency
forward contracts in other currencies can be arranged with large banks in the
over-the-counter market. Unlike futures contracts, forward contracts are less
standardized, can be customized to meet the hedging needs of the buyer, and are
not marked-to-market daily.
Options Contracts. Currency options contracts give an investor the right, but not
the obligation, to buy (call option) or sell (put option) a specified amount of
currency at a date in the future at a pre-determined price. Exhibit 14.3 • Payoffs
for Call and Put Options Contracts.
Swap Contracts. As another way to hedge exchange rate movements, firms can
agree to swap currencies in the future at a previously agreed exchange rate.
Currency swaps can be established over a period of up to ten years. Some
exchanges offer currency swaps, which lower counterparty risk due to guaranteed
performance by the exchange. Currency swaps are often combined with interest
rate swaps, which are commonly known as plain vanilla currency swaps. Exhibit
14.4 Vanilla Currency Swap. The firms seek loans from foreign banks because
they are able to secure credit with more favorable interest rates or other loan terms
from the foreign lender. Firms can use currency swaps to save on credit costs.
DISCUSSION STARTER: REALITY CHECK 2.
Assume that you are a manager for a U.S. company that is selling products to a Japanese
company that will pay you in yen. Do you have exchange rate risk? How could you hedge this
risk to protect your company?
IV. Financing International Trade and Investment. Firms finance their international
operations in a variety of ways.
International Banking. Large, money center banks in different countries dominate
international banking. Large, wholesale payments by businesses, banks, and governments
are made via CHIPS in New York City for dollar payments. SWIFT provides secure
communications for contracts, invoices, and other trade documents that accompany cash
payments. A number of payment methods exist that differ in terms of their risk.
o Payment in advance is the safest method.
o A commercial letter of credit offers payment protection to both parties.
o An open account is a simple agreement wherein the exporter sends an invoice
with the goods and the exporter pays upon their receipt.
International Bond Markets. For the most of the 20th century only large MNCs of
developed countries could issue long-term bonds in international markets. A number of
changes have occurred in the last 20 years that have expanded bond markets. Emerging
markets opened their financial markets to foreign investors, and Moody’s and S&P rating
services expanded their ratings to foreign bonds by opening offices outside the U.S. The
advent of the euro was another important event. The availability of bonds denominated in
the euro currency has increased the access of European companies to a larger pool of
investors. International bond markets have contributed to world economic growth by
increasing capital flows to larger firms requiring substantial capital. Bonds are
categorized in three ways:
o Domestic. Domestic bonds are debt contracts sold by firms domiciled in a
country in the home currency.
o Foreign. Foreign bonds are issued by foreign firm in another country in the home
currency of that country.
o Eurobond. Eurobonds are sold in any country outside the home country, but in
the home country’s currency. Exhibit 14.5 • International Bonds and Notes by
Currency and Issuer.
ECONOMIC PERSPECTIVES: How Securitization of Home Loans Triggered a Global
Financial Crisis. Use the Economic Perspectives case as an opportunity to discuss the impact of
securitization of home loans on individuals, banks, and governments.
Suggestion: You could ask students to do this case as individuals or in teams as a class activity.
Have the students read the case presented in the text and answer the questions at the end of the
case.
Questions:
1. Describe the securitization process for home loans. Is this financial innovation beneficial
to some participants in the financial system? Answer: Banks could make home loans and
2. What went wrong with securitization of home loans in the United States? Did government
also play a role in the situation? Answer: In the 1990s banks began repackaging
International Stock Markets. Stock markets enable firms to issue new equity and raise
long-term capital. They allow investors around the world to invest in firms on a global
basis. Stock investing is popular due to the fact that stocks have outpaced other types of
financial instruments in terms of returns. There is the possibility that stock prices can fall
dramatically. Diversifying stock investments in different sectors of the economy and
different countries can help manage this risk. Exhibit 14.6 • Diversification Can
Reduce Risk for Investors. H. Markowitz argued that investors need to buy securities
with price patterns that are different from one another over time. Yet, investors typically
invest most of their retirement and other savings in their home countries. Home bias
means that investors are not reducing their risk as much as possible. They may prefer
domestic companies due to the belief that they have a better understanding of their
products and services, or due to the desire to support businesses in their own countries.
Home bias likely increases investor risk. One problem of international investing is that
diversification may not work when bad news affects exchanges in different countries at
the same time. When stock markets in many countries move down in concert with one
another, international diversification benefits are reduced.
Government Financing. Government financing can play an important role in providing
interim credit to help firms in financial crisis. In 1944 the IMF and World Bank were
established as agencies of the United Nations. The IMF can serve as a “lender of last
resort” to reduce currency panics and assist troubled banks. The World Bank focuses on
long-term loans to developing countries seeking financing for economic reform purposes.
Government-supported international finance is provided in developed countries by
various agencies. Export-Import (EX-IM) Bank in the U.S. is a government export
finance agency. It supports U.S. firms competing against exports of other countries. The
U.S. Small Business Administration offers export financing support to smaller firms.
Bank and government loans can be used by exporters to finance working capital (trade
finance), and by importers to cover the cost of major purchases (term financing). Global
economic and financial crises since autumn 2008 have moved governments around the
world to implement financial assistance programs to offer government credit and
investment funds to banks.
ETHICAL PERSPECTIVES: Executive Compensation Rules in Financial Institutions. Use
the Ethical Perspectives case as an opportunity to discuss executive compensation in the finance
industry and the relationship between excessive executive pay and the performance of financial
executives in financial crisis.
Questions:
1. Are financial executive salaries and other compensation tied to performance? If not, give
some examples and comment on whether they are ethical. Answer: Financial executive
2. What is the U.S. government doing about ethical abuses by financial executives? Will
these changes help prevent future financial crises? Answer: According to issued
DISCUSSION STARTER: REALITY CHECK 3.
Using the Internet, navigate to the Yahoo! Finance page. Look up U.S. indices and print out a
chart of the past five years for the Dow Jones Composite Average. Then, look up World
Indices and find a stock market index in another country. Print out the foreign country’s
chart for the past five years. Comparing these two charts, are there periods of time in which
diversification would be obtained by investing in both stock market indices? Are there periods
of time in which there would not be much diversification?
V. Multinational Capital Budgeting. Multinational firms with operations in different
countries make profits over time in different currencies. Earnings on investment over time should
be converted to their present values. Earnings in different currencies need to be also converted to
the home currency in order to compute their present values. Fluctuations in currency values can
affect the profitability of foreign subsidiaries of MNCs.
Parent Firm Capital Budgeting. A holding company is a conglomerate firm that is
common in MNCs. When evaluating the profitability of capital investments in
subsidiaries, the parent firm needs to take the perspective of the consolidated holding
company, including both the parent firm and its subsidiary. The first step is to calculate
the net present value of capital investments in the foreign subsidiary. If NPV is positive,
the capital investment should be approved. Economic risk is associated with exchange
rate movements. Diversifying overseas operations in more than one foreign country with
different home currencies is one way for MNCs to address the impact of exchange rates
on NPVs of capital investment projects. Another approach is to hedge exchange rate
movements using derivative contracts. A variety of other risks may be involved in
multinational capital budgeting decisions. Sensitivity analysis is a good way to assess
risky investments abroad. Exhibit 14.7 Selecting Acceptable Capital Budgeting
Projects.
The Cost of Capital: Domestic Versus Global. The cost of capital is the required rate
of return demanded by stock and bond investors. The cost of debt is readily measured by
calculating a weighted average of different interest rates paid by the firm on sources of
long-term borrowings. The cost of equity is estimated using the Capital Asset Pricing
Model (CAPM). Internationally integrated equity markets require the use of the
International CAPM (ICAPM) to estimate the cost of equity. MNCs have an advantage
over domestic firms in their ability to tap global financial markets in search of the lowest
costs of equity and debt.
DISCUSSION STARTER: REALITY CHECK 4.
Refer again to the example in Exhibit 14.7 and re-compute the NPV in dollars for the U.S.
firm. Assume that the euro increases in value over time. Insert some hypothetical EUR-to-
USD exchange rates. How did the NPV in dollars change?
VI. Currency Risk and Stock Valuation. Foreign sales of firms will decline due to local
currency appreciation. Import costs can rise when local currency depreciates. Suppliers and
buyers that are affected by exchange rate risk can affect domestic firms with no export or import
business.
Cash Flow Sensitivity to Exchange Rate Risk. Firms can experience fluctuations in
cash flows due to currency movements. Exchange rate risk can dramatically affect the
cash flows of firms.
Stock Values and Foreign Exchange Movements. Stock returns are a convenient way
to measure long-run exchange rate risk for a firm. Exchange rate risk affects only about
1020% of stocks. Given that exchange rates are approximately ten times more volatile
than inflation, and that most stocks are affected by changes in the level of inflation, this
small percentage of stocks exposed to exchange rate risk is disappointing. Exchange risk
affects most U.S. firms by changing their market risk. Emerging-market countries have
country risk that may increase the costs of equity and debt. Particular countries may have
political risk due to government instability and opposition, economic risk, and other
issues. These risks require that an appropriate premium be added to the cost of capital
that would decrease the NPV of emerging-market projects under consideration.
DISCUSSION STARTER: REALITY CHECK 5.
Assume that you buy some shares of Nokia in the United States in dollars. Your friend in
France buys some Nokia shares in Europe in euros. Will your rate of return over the next year
be the same as your friend’s? Is your market beta risk different from your friend’s risk?
Assignments
End-of-Chapter Discussion Questions
1. What is the difference between foreign exchange risk arising from
translation, transactions, and economic risks? Answer: Transactions
2. What derivative securities can be used to hedge the effects of
fluctuations in currency values on the cash flows of firms and
3. Briefly describe the main sources of finance for international trade
and investment. Distinguish between short-term and long-term finance
Mini-Case Synopsis and Questions
With more than $2 trillion in total assets, Citigroup is one of the largest and most
global banks in the world. It has more than 200 million customers in more than 100
countries and offers a vast array of financial services. While Citigroup has been a
highly profitable and successful bank, in 2008 massive losses on securities related
to home loans and other asset-backed securities caused negative profits and
damage to its capital that threatened the bank’s solvency. The U.S. government
injected more than $40 billion of new capital in an effort to prevent the bank’s
failure. The government also provided guarantees on more than $300 billion of
risky loans made by Citicorp.
Questions:
1. What are some arguments in favor of continuing government support of
Citigroup? Discuss who would be hurt by the bank’s failure. Is the failure of
2. What are the counterarguments in favor of letting the bank fail? Discuss the
concepts of free markets and capitalism that create competition and allow
unsuccessful firms to fail. Does bailing out large banks cause them to take
Point/Counterpoint, Interpreting Global Business News, and Portfolio Projects
Students’ answers to these assignments will vary widely. Their writing should
reflect an understanding of the chapter’s basic concept, thorough research, and
logic and critical thinking skills.