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International Financial Management

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Copyright 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.

International Financial Management 12th Edition

Jeff Madura Florida Atlantic University

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Dedicated to my mother Irene

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Brief Contents

Preface, xx

About the Author, xxvi

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 107

5 Currency Derivatives 135

PART 2: Exchange Rate Behavior 187 6 Government Influence on Exchange Rates 189

7 International Arbitrage and Interest Rate Parity 225

8 Relationships among Inflation, Interest Rates, and Exchange Rates 255

PART 3: Exchange Rate Risk Management 293 9 Forecasting Exchange Rates 295

10 Measuring Exposure to Exchange Rate Fluctuations 323

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 435

15 International Corporate Governance and Control 471

16 Country Risk Analysis 497

17 Multinational Capital Structure and Cost of Capital 521

18 Long-Term Debt Financing 545

PART 5: Short-Term Asset and Liability Management 571 19 Financing International Trade 573

20 Short-Term Financing 593

21 International Cash Management 615

Appendix A: Answers to Self-Test Questions 650

Appendix B: Supplemental Cases 663

Appendix C: Using Excel to Conduct Analysis 684

Appendix D: International Investing Project 692

Appendix E: Discussion in the Boardroom 695

Glossary 702 Index 709

vii

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Contents

Preface, xx

About the Author, xxvi

PART 1: The International Financial Environment 1

1: MULTINATIONAL FINANCIAL MANAGEMENT: AN OVERVIEW 3

1-1 Managing the MNC, 3 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 Firms Pursue International Business, 8 1-2a Theory of Comparative Advantage, 8 1-2b Imperfect Markets Theory, 8 1-2c Product Cycle Theory, 8

1-3 How Firms Engage in International Business, 9 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, 11 1-3g Summary of Methods, 12

1-4 Valuation Model for an MNC, 13 1-4a Domestic Model, 13 1-4b Multinational Model, 14 1-4c Uncertainty Surrounding an MNC’s Cash Flows, 16 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

Term Paper on the International Credit Crisis, 31

2: INTERNATIONAL FLOW OF FUNDS 33

2-1 Balance of Payments, 33 2-1a Current Account, 33 2-1b Capital Account, 35 2-1c Financial Account, 36

2-2 Growth in International Trade, 36 2-2a Events That Increased Trade Volume, 37 2-2b Impact of Outsourcing on Trade, 38 2-2c Trade Volume among Countries, 39 2-2d Trend in U.S. Balance of Trade, 41

2-3 Factors Affecting International Trade Flows, 42 2-3a Cost of Labor, 42 2-3b Inflation, 42

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2-3c National Income, 43 2-3d Credit Conditions, 43 2-3e Government Policies, 43 2-3f Exchange Rates, 47

2-4 International Capital Flows, 51 2-4a Factors Affecting Direct Foreign Investment, 51 2-4b Factors Affecting International Portfolio Investment, 52 2-4c Impact of International Capital Flows, 52

2-5 Agencies That Facilitate International Flows, 54 2-5a International Monetary Fund, 54 2-5b World Bank, 55 2-5c World Trade Organization, 56 2-5d International Financial Corporation, 56 2-5e International Development Association, 56 2-5f Bank for International Settlements, 56 2-5g OECD, 57 2-5h Regional Development Agencies, 57

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, 67 3-1d Interpreting Foreign Exchange Quotations, 69

3-2 International Money Market, 74 3-2a Origins and Development, 75 3-2b Money Market Interest Rates among Currencies, 76

3-3 International Credit Market, 77 3-3a Syndicated Loans in the Credit Market, 78 3-3b Regulations in the Credit Market, 79 3-3c Impact of the Credit Crisis, 80

3-4 International Bond Market, 80 3-4a Eurobond Market, 81 3-4b Development of Other Bond Markets, 82 3-4c Risk of International Bonds, 83 3-4d Impact of the Greek Crisis, 84

3-5 International Stock Markets, 85 3-5a Issuance of Stock in Foreign Markets, 85 3-5b Issuance of Foreign Stock in the United States, 86 3-5c Non-U.S. Firms Listing on U.S. Exchanges, 87 3-5d Investing in Foreign Stock Markets, 88 3-5e How Market Characteristics Vary among Countries, 89 3-5f Integration of Stock Markets, 90 3-5g Integration of International Stock Markets and Credit Markets, 91

3-6 How Financial Markets Serve MNCs, 91

Appendix 3: Investing in International Financial Markets, 99

4: EXCHANGE RATE DETERMINATION 107

4-1 Measuring Exchange Rate Movements, 107 4-2 Exchange Rate Equilibrium, 108

4-2a Demand for a Currency, 109

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4-2b Supply of a Currency for Sale, 110 4-2c Equilibrium, 110 4-2d Change in the Equilibrium Exchange Rate, 111

4-3 Factors That Influence Exchange Rates, 112 4-3a Relative Inflation Rates, 113 4-3b Relative Interest Rates, 114 4-3c Relative Income Levels, 115 4-3d Government Controls, 116 4-3e Expectations, 116 4-3f Interaction of Factors, 117 4-3g Influence of Factors across Multiple Currency Markets, 119 4-3h Impact of Liquidity on Exchange Rate Adjustment, 120

4-4 Movements in Cross Exchange Rates, 120 4-4a Explaining Movements in Cross Exchange Rates, 122

4-5 Capitalizing on Expected Exchange Rate Movements, 122 4-5a Institutional Speculation Based on Expected Appreciation, 122 4-5b Institutional Speculation Based on Expected Depreciation, 123 4-5c Speculation by Individuals, 124 4-5d The “Carry Trade”, 124

5: CURRENCY DERIVATIVES 135

5-1 Forward Market, 135 5-1a How MNCs Use Forward Contracts, 135 5-1b Bank Quotations on Forward Rates, 136 5-1c Premium or Discount on the Forward Rate, 137 5-1d Movements in the Forward Rate over Time, 138 5-1e Offsetting a Forward Contract, 138 5-1f Using Forward Contracts for Swap Transactions, 139 5-1g Non-Deliverable Forward Contracts, 139

5-2 Currency Futures Market, 140 5-2a Contract Specifications, 140 5-2b Trading Currency Futures, 141 5-2c Comparing Futures to Forward Contracts, 142 5-2d Credit Risk of Currency Futures Contracts, 143 5-2e How Firms Use Currency Futures, 143 5-2f Speculation with Currency Futures, 145

5-3 Currency Options Market, 146 5-3a Option Exchanges, 146 5-3b Over-the-Counter Market, 146

5-4 Currency Call Options, 147 5-4a Factors Affecting Currency Call Option Premiums, 147 5-4b How Firms Use Currency Call Options, 148 5-4c Speculating with Currency Call Options, 149

5-5 Currency Put Options, 151 5-5a Factors Affecting Currency Put Option Premiums, 151 5-5b Hedging with Currency Put Options, 152 5-5c Speculating with Currency Put Options, 152 5-5d Contingency Graph for the Purchaser of a Call Option, 154 5-5e Contingency Graph for the Seller of a Call Option, 154 5-5f Contingency Graph for the Buyer of a Put Option, 154 5-5g Contingency Graph for the Seller of a Put Option, 155

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5-5h Conditional Currency Options, 156 5-5i European Currency Options, 157

Appendix 5A: Currency Option Pricing, 168

Appendix 5B: Currency Option Combinations, 172

Part 1 Integrative Problem: The International Financial Environment, 186

PART 2: Exchange Rate Behavior 187

6: GOVERNMENT INFLUENCE ON EXCHANGE RATES 189

6-1 Exchange Rate Systems, 189 6-1a Fixed Exchange Rate System, 189 6-1b Freely Floating Exchange Rate System, 191 6-1c Managed Float Exchange Rate System, 192 6-1d Pegged Exchange Rate System, 193 6-1e Dollarization, 198

6-2 A Single European Currency, 198 6-2a Monetary Policy in the Eurozone, 199 6-2b Impact on Firms in the Eurozone, 199 6-2c Impact on Financial Flows in the Eurozone, 199 6-2d Exposure of Countries within the Eurozone, 200 6-2e Impact of Crises within the Eurozone, 200 6-2f Impact on a Country That Abandons the Euro, 202 6-2g Impact of Abandoning the Euro on Eurozone Conditions, 202

6-3 Government Intervention, 203 6-3a Reasons for Government Intervention, 203 6-3b Direct Intervention, 204 6-3c Indirect Intervention, 207

6-4 Intervention as a Policy Tool, 208 6-4a Influence of a Weak Home Currency, 208 6-4b Influence of a Strong Home Currency, 208

Appendix 6: Government Intervention during the Asian Crisis, 217

7: INTERNATIONAL ARBITRAGE AND INTEREST RATE PARITY 225

7-1 International Arbitrage, 225 7-1a Locational Arbitrage, 225 7-1b Triangular Arbitrage, 227 7-1c Covered Interest Arbitrage, 230 7-1d Comparison of Arbitrage Effects, 234

7-2 Interest Rate Parity (IRP), 234 7-2a Derivation of Interest Rate Parity, 235 7-2b Determining the Forward Premium, 236 7-2c Graphic Analysis of Interest Rate Parity, 238 7-2d How to Test Whether Interest Rate Parity Holds, 240 7-2e Interpretation of Interest Rate Parity, 240 7-2f Does Interest Rate Parity Hold?, 240 7-2g Considerations When Assessing Interest Rate Parity, 241

7-3 Variation in Forward Premiums, 242 7-3a Forward Premiums across Maturities, 242 7-3b Changes in Forward Premiums over Time, 243

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8: RELATIONSHIPS AMONG INFLATION, INTEREST RATES,

AND EXCHANGE RATES 255

8-1 Purchasing Power Parity (PPP), 255 8-1a Interpretations of Purchasing Power Parity, 255 8-1b Rationale behind Relative PPP Theory, 256 8-1c Derivation of Purchasing Power Parity, 256 8-1d Using PPP to Estimate Exchange Rate Effects, 257 8-1e Graphic Analysis of Purchasing Power Parity, 258 8-1f Testing the Purchasing Power Parity Theory, 260 8-1g Why Purchasing Power Parity Does Not Hold, 263

8-2 International Fisher Effect (IFE), 264 8-2a Fisher Effect, 264 8-2b Using the IFE to Predict Exchange Rate Movements, 265 8-2c Implications of the International Fisher Effect, 266 8-2d Derivation of the International Fisher Effect, 267 8-2e Graphical Analysis of the International Fisher Effect, 269

8-3 Tests of the International Fisher Effect, 271 8-3a Limitations of the IFE, 272 8-3b IFE Theory versus Reality, 273

8-4 Comparison of the IRP, PPP, and IFE, 274

Part 2 Integrative Problem: Exchange Rate Behavior, 284

Midterm Self-Exam, 285

PART 3: Exchange Rate Risk Management 293

9: FORECASTING EXCHANGE RATES 295

9-1 Why Firms Forecast Exchange Rates, 295 9-2 Forecasting Techniques, 296

9-2a Technical Forecasting, 296 9-2b Fundamental Forecasting, 298 9-2c Market-Based Forecasting, 302 9-2d Mixed Forecasting, 304 9-2e Guidelines for Implementing a Forecast, 305

9-3 Forecast Error, 306 9-3a Measurement of Forecast Error, 306 9-3b Forecast Errors among Time Horizons, 307 9-3c Forecast Errors over Time Periods, 307 9-3d Forecast Errors among Currencies, 307 9-3e Forecast Bias, 307 9-3f Comparison of Forecasting Methods, 310 9-3g Forecasting under Market Efficiency, 311

9-4 Using Interval Forecasts, 312 9-4a Methods of Forecasting Exchange Rate Volatility, 312

10: MEASURING EXPOSURE TO EXCHANGE RATE FLUCTUATIONS 323

10-1 Relevance of Exchange Rate Risk, 323 10-1a The Investor Hedge Argument, 324 10-1b Currency Diversification Argument, 325 10-1c Stakeholder Diversification Argument, 325 10-1d Response from MNCs, 325

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10-2 Transaction Exposure, 326 10-2a Estimating “Net” Cash Flows in Each Currency, 326 10-2b Exposure of an MNC’s Portfolio, 327 10-2c Transaction Exposure Based on Value at Risk, 331

10-3 Economic Exposure, 335 10-3a Exposure to Local Currency Appreciation, 335 10-3b Exposure to Local Currency Depreciation, 336 10-3c Economic Exposure of Domestic Firms, 337 10-3d Measuring Economic Exposure, 337

10-4 Translation Exposure, 339 10-4a Determinants of Translation Exposure, 340 10-4b Exposure of an MNC’s Stock Price to Translation Effects, 341

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 to Hedge Payables, 360 11-2e Evaluating the Hedge Decision, 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 the Hedge Decision, 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 Hedging Techniques, 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, 395 12-1b Restructuring to Reduce Economic Exposure, 396 12-1c Issues Involved in the Restructuring Decision, 398

12-2 A Case of Hedging Economic Exposure, 399 12-2a Savor Co.’s Dilemma, 399 12-2b Possible Strategies for Hedging Economic Exposure, 401 12-2c Savor’s Hedging Strategy, 402 12-2d Limitations of Savor’s Hedging Strategy, 403

12-3 Hedging Exposure to Fixed Assets, 403

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12-4 Managing Translation Exposure, 404 12-4a Hedging with Forward Contracts, 404 12-4b Limitations of Hedging Translation Exposure, 405

Part 3 Integrative Problem: Exchange Risk Management, 413

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 13-1d Measuring an MNC’s Benefits of DFI, 421

13-2 Benefits of International Diversification, 421 13-2a Diversification Analysis of International Projects, 423 13-2b Diversification among Countries, 424

13-3 Host Government Views of DFI, 425 13-3a Incentives to Encourage DFI, 425 13-3b Barriers to DFI, 427 13-3c Government-Imposed Conditions on Engaging in DFI, 428

14: MULTINATIONAL CAPITAL BUDGETING 435

14-1 Subsidiary versus Parent Perspective, 435 14-1a Tax Differentials, 435 14-1b Restrictions on Remitted Earnings, 436 14-1c Exchange Rate Movements, 436 14-1d Summary of Factors, 436

14-2 Input for Multinational Capital Budgeting, 437 14-3 Multinational Capital Budgeting Example, 439

14-3a Background, 439 14-3b Analysis, 440

14-4 Other Factors to Consider, 441 14-4a Exchange Rate Fluctuations, 442 14-4b Inflation, 445 14-4c Financing Arrangement, 445 14-4d Blocked Funds, 448 14-4e Uncertain Salvage Value, 448 14-4f Impact of Project on Prevailing Cash Flows, 450 14-4g Host Government Incentives, 450 14-4h Real Options, 451

14-5 Adjusting Project Assessment for Risk, 451 14-5a Risk-Adjusted Discount Rate, 451 14-5b Sensitivity Analysis, 452 14-5c Simulation, 452

Appendix 14: Incorporating International Tax Law in Multinational Capital Budgeting, 464

15: INTERNATIONAL CORPORATE GOVERNANCE AND CONTROL 471

15-1 International Corporate Governance, 471 15-1a Governance by Board Members, 471 15-1b Governance by Institutional Investors, 472 15-1c Governance by Shareholder Activists, 472

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15-2 International Corporate Control, 473 15-2a Motives for International Acquisitions, 473 15-2b Trends in International Acquisitions, 474 15-2c Barriers to International Corporate Control, 474 15-2d Model for Valuing a Foreign Target, 475 15-2e Impact of the SOX Act on the Valuation of Targets, 476

15-3 Factors Affecting Target Valuation, 476 15-3a Target-Specific Factors, 477 15-3b Country-Specific Factors, 477

15-4 Example of the Valuation Process, 478 15-4a International Screening Process, 478 15-4b Estimating the Target’s Value, 479 15-4c Changes in Valuation over Time, 481

15-5 Disparity in Foreign Target Valuations, 482 15-5a Expected Cash Flows of the Foreign Target, 482 15-5b Exchange Rate Effects on Remitted Earnings, 483 15-5c Required Return of Acquirer, 483

15-6 Other Corporate Control Decisions, 483 15-6a International Partial Acquisitions, 483 15-6b International Acquisitions of Privatized Businesses, 484 15-6c International Divestitures, 484

15-7 Control Decisions as Real Options, 486 15-7a Call Option on Real Assets, 486 15-7b Put Option on Real Assets, 487

16: COUNTRY RISK ANALYSIS 497

16-1 Country Risk Characteristics, 497 16-1a Political Risk Characteristics, 497 16-1b Financial Risk Characteristics, 499

16-2 Measuring Country Risk, 501 16-2a Techniques for Assessing Country Risk, 501 16-2b Deriving a Country Risk Rating, 502 16-2c Comparing Risk Ratings among Countries, 505

16-3 Incorporating Risk in Capital Budgeting, 505 16-3a Adjustment of the Discount Rate, 505 16-3b Adjustment of the Estimated Cash Flows, 507 16-3c Analysis of Existing Projects, 510

16-4 Preventing Host Government Takeovers, 510 16-4a Use a Short-Term Horizon, 510 16-4b Rely on Unique Supplies or Technology, 511 16-4c Hire Local Labor, 511 16-4d Borrow Local Funds, 511 16-4e Purchase Insurance, 511 16-4f Use Project Finance, 511

17: MULTINATIONAL CAPITAL STRUCTURE AND COST OF CAPITAL 521

17-1 Components of Capital, 521 17-1a External Sources of Debt, 522 17-1b External Sources of Equity, 523

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17-2 The MNC’s Capital Structure Decision, 524 17-2a Influence of Corporate Characteristics, 524 17-2b Influence of Host Country Characteristics, 525 17-2c Response to Changing Country Characteristics, 526

17-3 Subsidiary versus Parent Capital Structure Decisions, 526 17-3a Impact of Increased Subsidiary Debt Financing, 527 17-3b Impact of Reduced Subsidiary Debt Financing, 527 17-3c Limitations in Offsetting a Subsidiary’s Leverage, 527

17-4 Multinational Cost of Capital, 527 17-4a MNC’s Cost of Debt, 527 17-4b MNC’s Cost of Equity, 528 17-4c Estimating an MNC’s Cost of Capital, 528 17-4d Comparing Costs of Debt and Equity, 528 17-4e Cost of Capital for MNCs versus Domestic Firms, 529 17-4f Cost-of-Equity Comparison Using the CAPM, 531

17-5 Cost of Capital across Countries, 533 17-5a Country Differences in the Cost of Debt, 533 17-5b Country Differences in the Cost of Equity, 535

18: LONG-TERM DEBT FINANCING 545

18-1 Financing to Match the Inflow Currency, 545 18-1a Using Currency Swaps to Execute the Matching Strategy, 546 18-1b Using Parallel Loans to Execute the Matching Strategy, 547

18-2 Debt Denomination Decision by Subsidiaries, 550 18-2a Debt Decision in Host Countries with High Interest Rates, 551 18-2b Debt Denomination to Finance a Project, 554

18-3 Debt Maturity Decision, 556 18-3a Assessment of the Yield Curve, 556 18-3b Financing Costs of Loans with Different Maturities, 556

18-4 Fixed versus Floating Rate Debt Decision, 557 18-4a Financing Costs of Fixed versus Floating Rate Loans, 558 18-4b Hedging Interest Payments with Interest Rate Swaps, 558

Part 4 Integrative Problem: Long-Term Asset and Liability Management, 569

PART 5: Short-Term Asset and Liability Management 571

19: FINANCING INTERNATIONAL TRADE 573

19-1 Payment Methods for International Trade, 573 19-1a Prepayment, 573 19-1b Letters of Credit, 574 19-1c Drafts, 574 19-1d Consignment, 575 19-1e Open Account, 575 19-1f Impact of the Credit Crisis on Payment Methods, 575

19-2 Trade Finance Methods, 576 19-2a Accounts Receivable Financing, 576 19-2b Factoring, 576 19-2c Letters of Credit (L/Cs), 577 19-2d Banker’s Acceptances, 581 19-2e Working Capital Financing, 583

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19-2f Medium-Term Capital Goods Financing (Forfaiting), 584 19-2g Countertrade, 584

19-3 Agencies That Facilitate International Trade, 585 19-3a Export-Import Bank of the United States, 585 19-3b Private Export Funding Corporation, 587 19-3c Overseas Private Investment Corporation, 587

20: SHORT-TERM FINANCING 593

20-1 Sources of Foreign Financing, 593 20-1a Internal Short-Term Financing, 593 20-1b External Short-Term Financing, 594 20-1c Access to Funding during the Credit Crisis, 594

20-2 Financing with a Foreign Currency, 594 20-2a Comparison of Interest Rates among Currencies, 595