List of Figures xix

List of Tables xxiii

Preface xxvii

World Currencies and Symbols xxxi

Acronyms and Symbols xxxv

Part I The International Financial Management Environment

1 Introduction: Multinational Corporations and Financial Management 3

1.1 The Rise of the Multinational Corporation 4

1.1.1 Evolution of the Multinational Corporation 7

1.1.2 The Process of Overseas Expansion by Multinationals 14

1.1.3 A Behavioral Definition of the Multinational Corporation 17

1.1.4 The Global Manager 18

1.2 The Internationalization of Business and Finance 18

1.2.1 Political and Labor Union Concerns About Global Competition 19

1.2.2 Consequences of Global Competition 22

1.3 Multinational Financial Management: Theory and Practice 24

1.3.1 Functions of Financial Management 25

1.3.2 Theme of This Book 25

1.3.3 Relationship to Domestic Financial Management 26

1.3.4 The Global Financial Marketplace 28

1.3.5 The Role of the Financial Executive in an Efficient Market 28

1.4 Outline of the Book 29

1.4.1 The International Financial Management Environment 29

1.4.2 The Foreign Exchange and Derivatives Markets 29

1.4.3 Foreign Exchange Risk Management 29

1.4.4 The International Capital Markets and Portfolio Management 29

1.4.5 International Capital Budgeting 30

Questions 30

Appendix: The Origins and Consequences of International Trade 31

Questions 35

2 The Determination of Exchange Rates 37

2.1 Setting The Equilibrium Spot Exchange Rate 38

2.1.1 Factors That Affect the Equilibrium Exchange Rate 39

2.1.2 Calculating Exchange Rate Changes 41

2.2 Expectations and The Asset Market Model of Exchange Rates 43

2.2.1 The Nature of Money and Currency Values 44

2.2.2 Central Bank Reputations and Currency Values 44

2.3 The Fundamentals of Central Bank Intervention 49

2.3.1 How Real Exchange Rates Affect Relative Competitiveness 50

2.3.2 Foreign Exchange Market Intervention 50

2.3.3 The Effects of Foreign Exchange Market Intervention 53

2.4 The Equilibrium Approach To Exchange Rates 55

2.5 Disequilibrium Theory and Exchange Rate Overshooting 55

2.5.1 The Equilibrium Theory of Exchange Rates and Its Implications 56

2.6 Conclusions 58

Questions 60

Problems 61

References 62

3 The International Monetary System 63

3.1 Alternative Exchange Rate Systems 64

3.1.1 The Trilemma and Exchange Rate Regime Choice 64

3.1.2 Free Float 66

3.1.3 Managed Float 67

3.1.4 Target-Zone Arrangement 69

3.1.5 Fixed Rate System 69

3.2 A Brief History of the International Monetary System 70

3.2.1 The Classical Gold Standard 71

3.2.2 How the Classical Gold Standard Worked in Practice: 1821–1914 73

3.2.3 The Gold Exchange Standard and Its Aftermath: 1925–1944 73

3.2.4 The Bretton Woods System: 1946–1971 74

3.2.5 The Post-Bretton Woods System: 1971 to the Present 76

3.2.6 Assessment of the Floating Rate System 77

3.3 The European Monetary System and Monetary Union 78

3.3.1 The Exchange Rate Mechanism 79

3.3.2 Lessons from the European Monetary System 79

3.3.3 The Currency Crisis of September 1992 79

3.3.4 The Exchange Rate Mechanism Is Abandoned in August 1993 80

3.3.5 European Monetary Union 81

3.3.6 Optimum Currency Area 88

3.3.7 Exchange Rate Regimes Today 93

3.4 Emerging Market Currency Crises 96

3.4.1 Transmission Mechanisms 96

3.4.2 Origins of Emerging Market Crises 96

3.4.3 Policy Proposals for Dealing with Emerging Market Crises 97

3.5 Summary and Conclusions 98

Questions 99

Problems 100

References 100

4 Parity Conditions in International Finance and Currency Forecasting 101

4.1 Arbitrage and the Law of One Price 102

4.2 Purchasing Power Parity 104

4.2.1 The Lesson of Purchasing Power Parity 108

4.2.2 Expected Inflation and Exchange Rate Changes 109

4.2.3 The Monetary Approach 110

4.2.4 Empirical Evidence 110

4.3 The Fisher Effect 113

4.3.1 Empirical Evidence 114

4.4 The International Fisher Effect 118

4.4.1 Empirical Evidence 119

4.5 Interest Rate Parity Theory 120

4.5.1 Empirical Evidence 123

4.6 The Relationship Between The Forward Rate and The Future Spot Rate 123

4.6.1 Empirical Evidence 126

4.7 Currency Forecasting 126

4.7.1 Requirements for Successful Currency Forecasting 127

4.7.2 Market-Based Forecasts 127

4.7.3 Model-Based Forecasts 129

4.7.4 Model Evaluation 130

4.7.5 Forecasting Controlled Exchange Rates 132

4.8 Summary and Conclusions 132

Questions 133

Problems 135

References 137

5 The Balance of Payments and International Economic Linkages 139

5.1 Balance-Of-Payments Categories 140

5.1.1 Current Account 141

5.1.2 Capital Account 144

5.1.3 Financial Account 144

5.1.4 Balance-of-Payments Measures 145

5.1.5 The Missing Numbers 146

5.2 The International Flow of Goods, Services, and Capital 146

5.2.1 Domestic Saving and Investment and the Financial Account 146

5.2.2 The Link between the Current and Financial Accounts 147

5.2.3 Government Budget Deficits and Current-Account Deficits 149

5.2.4 The Current Situation 150

5.3 Coping with the Current-Account Deficit 153

5.3.1 Currency Depreciation 153

5.3.2 Protectionism 157

5.3.3 Ending Foreign Ownership of Domestic Assets 158

5.3.4 Boosting the Saving Rate 158

5.3.5 External Policies 159

5.3.6 Current-Account Deficits and Unemployment 160

5.3.7 The Bottom Line on Current-Account Deficits and Surpluses 161

5.4 Summary and Conclusions 161

Questions 162

Problems 163

References 164

Part II The Foreign Exchange and Derivative Markets

6 The Foreign Exchange Market 167

6.1 Organization of the Foreign Exchange Market 168

6.1.1 The Participants 169

6.1.2 Size 172

6.2 The Spot Market 174

6.2.1 Spot Quotations 174

6.2.2 The Mechanics of Spot Transactions 181

6.3 The Forward Market 181

6.3.1 Forward Quotations 183

6.3.2 Forward Contract Maturities 186

6.4 Summary and Conclusions 186

Questions 186

Problems 187

References 188

7 Currency Futures and Options Markets 189

7.1 Futures Contracts 190

7.1.1 Forward Contract versus Futures Contract 191

7.2 Currency Options 194

7.2.1 Market Structure 195

7.2.2 Using Currency Options 196

7.2.3 Option Pricing and Valuation 201

7.2.4 Using Forward or Futures Contracts versus Options Contracts 203

7.2.5 Futures Options 205

7.3 Reading Currency Futures and Options Prices 206

7.4 Summary and Conclusions 206

Questions 208

Problems 209

Appendix: Option Pricing Using Black-Scholes 210

A.1 The Black-Scholes Model 210

A.2 Implied Volatilities 212

A.3 Shortcomings of the Black-Scholes Option Pricing Model 212

Problems 213

Appendix: Put-Call Option Interest Rate Parity 213

Problems 215

References 215

8 Currency, Interest Rate, and Credit Derivatives and Swaps 217

8.1 Interest Rate and Currency Swaps 218

8.1.1 Interest Rate Swaps 218

8.1.2 Currency Swaps 221

8.1.3 Economic Advantages of Swaps 228

8.2 Interest Rate Forwards and Futures 229

8.2.1 Forward Forwards 229

8.2.2 Forward Rate Agreement 230

8.2.3 Eurodollar Futures 231

8.3 Structured Notes 233

8.3.1 Inverse Floaters 233

8.3.2 Callable Step-Up Note 234

8.3.3 Step-Down Coupon Note 234

8.4 Credit Default Swaps 235

8.4.1 Single-Name CDS 235

8.4.2 CDS Indexes 237

8.5 Summary and Conclusions 238

Questions 239

Problems 239

Reference 241

Part III Foreign Exchange Risk Management

9 Measuring and Managing Translation and Transaction Exposure 245

9.1 Alternative Measures of Foreign Exchange Exposure 246

9.1.1 Translation Exposure 246

9.1.2 Transaction Exposure 246

9.1.3 Operating Exposure 247

9.2 Alternative Currency Translation Methods 247

9.2.1 Current/Noncurrent Method 248

9.2.2 Monetary/Nonmonetary Method 248

9.2.3 Temporal Method 248

9.2.4 Current Rate Method 249

9.3 Transaction Exposure 251

9.4 Designing a Hedging Strategy 251

9.4.1 Objectives 252

9.4.2 Costs and Benefits of Standard Hedging Techniques 255

9.4.3 Centralization versus Decentralization 258

9.4.4 Managing Risk Management 259

9.4.5 Accounting for Hedging and FASB 133 260

9.4.6 Empirical Evidence on Hedging 260

9.5 Managing Translation Exposure 261

9.5.1 Funds Adjustment 261

9.5.2 Evaluating Alternative Hedging Mechanisms 262

9.6 Managing Transaction Exposure 263

9.6.1 Forward Market Hedge 263

9.6.2 Money Market Hedge 265

9.6.3 Risk Shifting 267

9.6.4 Pricing Decisions 268

9.6.5 Exposure Netting 269

9.6.6 Currency Risk Sharing 270

9.6.7 Currency Collars 270

9.6.8 Cross-Hedging 273

9.6.9 Foreign Currency Options 274

9.7 Summary and Conclusions 277

Questions 278

Problems 279

References 282

Appendix: Statement of Financial Accounting Standards No. 52 283

10 Measuring and Managing Economic Exposure 287

10.1 Foreign Exchange Risk and Economic Exposure 288

10.1.1 Real Exchange Rate Changes and Exchange Risk 289

10.1.2 Importance of the Real Exchange Rate 290

10.1.3 Inflation and Exchange Risk 291

10.1.4 Competitive Effects of Real Exchange Rate Changes 292

10.2 The Economic Consequences of Exchange Rate Changes 294

10.2.1 Transaction Exposure 294

10.2.2 Operating Exposure 295

10.3 Identifying Economic Exposure 298

10.3.1 Aspen Skiing Company 298

10.3.2 Petróleos Mexicanos 298

10.3.3 Toyota Motor Company 299

10.4 Calculating Economic Exposure 300

10.4.1 Spectrum’s Accounting Exposure 301

10.4.2 Spectrum’s Economic Exposure 301

10.5 An Operational Measure of Exchange Risk 305

10.5.1 Limitations 306

10.6 Managing Operating Exposure 307

10.6.1 Marketing Management of Exchange Risk 307

10.6.2 Production Management of Exchange Risk 310

10.6.3 Planning for Exchange Rate Changes 313

10.6.4 Financial Management of Exchange Risk 314

10.7 Summary and Conclusions 316

Questions 318

Problems 319

References 322

Part IV The International Capital Markets and Portfolio Management

11 International Financing and National Capital Markets 325

11.1 Corporate Sources and Uses of Funds 326

11.1.1 Financial Markets versus Financial Intermediaries 326

11.1.2 Financial Systems and Corporate Governance 327

11.1.3 Globalization of Financial Markets 330

11.2 National Capital Markets As International Financial Centers 332

11.2.1 International Financial Markets 334

11.2.2 Foreign Access to Domestic Markets 335

11.3 Development Banks 340

11.3.1 The World Bank Group 341

11.3.2 Regional and National Development Banks 342

11.3.3 Private Sector Alternatives 343

11.4 Project Finance 344

11.5 Summary and Conclusions 345

Questions 345

Problems 346

References 347

12 The Euromarkets 348

12.1 The Eurocurrency Market 348

12.1.1 Modern Origins 349

12.1.2 Eurodollar Creation 350

12.1.3 Eurocurrency Loans 351

12.1.4 Relationship between Domestic and Eurocurrency Money Markets 353

12.1.5 Euromarket Trends 354

12.2 Eurobonds 355

12.2.1 Swaps 355

12.2.2 Links between the Domestic and Eurobond Markets 355

12.2.3 Rationale for Existence of Eurobond Market 358

12.2.4 Eurobonds versus Eurocurrency Loans 360

12.3 Note Issuance Facilities and Euronotes 360

12.3.1 Note Issuance Facilities versus Eurobonds 362

12.3.2 Euro-Medium-Term Notes 363

12.4 Euro-Commercial Paper 364

12.5 The Asiacurrency Market 365

12.6 Summary and Conclusions 365

Questions 366

Problems 366

References 367

13 International Portfolio Management 368

13.1 The Risks and Benefits of International Equity Investing 369

13.1.1 International Diversification 370

13.1.2 Investing in Emerging Markets 376

13.1.3 Barriers to International Diversification 380

13.1.4 Ways to Invest Internationally 381

13.2 International Bond Investing 383

13.3 Optimal International Asset Allocation 383

13.4 Measuring the Total Return From Foreign Portfolio Investing 385

13.4.1 Bonds 385

13.4.2 Stocks 385

13.5 Measuring Exchange Risk on Foreign Securities 386

13.5.1 Hedging Currency Risk 386

13.6 Summary and Conclusions 387

Questions 387

Problems 388

References 390

Part V International Capital Budgeting

14 Country Risk Analysis 395

14.1 Learning Objectives 395

14.2 Measuring Political Risk 396

14.2.1 Political Stability 397

14.2.2 Economic Factors 399

14.2.3 Subjective Factors 400

14.3 Economic and Political Factors Underlying Country Risk 405

14.3.1 Fiscal Irresponsibility 406

14.3.2 Monetary Instability 406

14.3.3 Controlled Exchange Rate System 408

14.3.4 Wasteful Government Spending 408

14.3.5 Resource Base 408

14.3.6 Country Risk and Adjustment to External Shocks 409

14.3.7 Market-Oriented versus Statist Policies 410

14.3.8 Key Indicators of Country Risk and Economic Health 413

14.4 Country Risk Analysis in International Lending 418

14.4.1 The Mathematics of Sovereign Debt Analysis 418

14.4.2 Country Risk and the Terms of Trade 420

14.4.3 The Government’s Cost/Benefit Calculus 421

14.5 Summary and Conclusions 422

Questions 424

Problems 424

References 426

15 The Cost of Capital for Foreign Investments 427

15.1 The Cost of Equity Capital 428

15.2 The Weighted Average Cost of Capital For Foreign Projects 429

15.3 Discount Rates for Foreign Investments 430

15.3.1 Evidence from the Stock Market 431

15.3.2 Key Issues in Estimating Foreign Project Discount Rates 432

15.3.3 Proxy Companies 433

15.3.4 The Relevant Base Portfolio 434

15.3.5 The Relevant Market Risk Premium 438

15.3.6 Recommendations 439

15.4 The Cost of Debt Capital 439

15.4.1 Annual Exchange Rate Change 440

15.4.2 Using Sovereign Risk Spreads 441

15.5 Establishing a Worldwide Capital Structure 441

15.5.1 Foreign Subsidiary Capital Structure 442

15.5.2 Joint Ventures 446

15.6 Valuing Low-Cost Financing Opportunities 447

15.6.1 Taxes 448

15.6.2 Government Credit and Capital Controls 449

15.6.3 Government Subsidies and Incentives 450

15.7 Summary and Conclusions 452

Questions 453

Problems 454

References 455

16 Corporate Strategy and Foreign Direct Investment 457

16.1 Theory of the Multinational Corporation 458

16.1.1 Product and Factor Market Imperfections 458

16.1.2 Financial Market Imperfections 459

16.1.3 The Strategy of Multinational Enterprise 460

16.1.4 Innovation-Based Multinationals 460

16.1.5 The Mature Multinationals 460

16.1.6 The Senescent Multinationals 463

16.1.7 Foreign Direct Investment and Survival 464

16.2 Designing a Global Expansion Strategy 469

16.2.1 Awareness of Profitable Investments 469

16.2.2 Selecting a Mode of Entry 469

16.2.3 Auditing the Effectiveness of Entry Modes 470

16.2.4 Using Appropriate Evaluation Criteria 471

16.2.5 Estimating the Longevity of a Competitive Advantage 471

16.3 Summary and Conclusions 472

Questions 474

Problems 475

References 475

17 Capital Budgeting for the Multinational Corporation 477

17.1 Basics of Capital Budgeting 478

17.1.1 Net Present Value 478

17.1.2 Incremental Cash Flows 479

17.1.3 Alternative Capital-Budgeting Frameworks 482

17.2 Issues in Foreign Investment Analysis 483

17.2.1 Parent versus Project Cash Flows 484

17.2.2 Political and Economic Risk Analysis 485

17.2.3 Exchange Rate Changes and Inflation 486

17.3 Foreign Project Appraisal: The Case of International Diesel Corporation 487

17.3.1 Estimation of Project Cash Flows 487

17.3.2 Estimation of Parent Cash Flows 492

17.4 Political Risk Analysis 495

17.4.1 Expropriation 495

17.4.2 Blocked Funds 496

17.5 Growth Options and Project Evaluation 497

17.6 Summary and Conclusions 500

Questions 501

Problems 502

References 503

Appendix: Managing Political Risks 503

18 Managing the Internal Capital Markets of Multinational Corporations 509

18.1 The Value of The Multinational Financial System 510

18.1.1 Mode of Transfer 510

18.1.2 Timing Flexibility 511

18.1.3 Value 512

18.2 Intercompany Fund-Flow Mechanisms: Costs and Benefits 513

18.2.1 Tax Factors and the Tax Cuts and Jobs Act of 2017 513

18.2.2 Transfer Pricing 516

18.2.3 Offshore Centers 520

18.2.4 Fees and Royalties 521

18.2.5 Leading and Lagging 522

18.2.6 Intercompany Loans 524

18.2.7 Dividends 527

18.2.8 Equity versus Debt 529

18.3 Designing a Global Remittance Policy 530

18.3.1 Prerequisites 532

18.3.2 Information Requirements 532

18.3.3 Behavioral Consequences 532

18.4 Summary and Conclusions 534

Questions 534

Problems 535

References 536

Glossary G-1

Index I-1

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