A+ Cheat Sheet IF (1) PDF

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SEM 1: Managing MNCs Agency Problem: Managers serve own interest, instead of maximising shareholder value Cost of Agency Problems High 1) Monitoring overseas managers difficult (Geographic) 2) Managers from foreign cultures seek different goals  tend to focus on Subsidiary Goals 3) Larger MNCs have larger number, and more significant problems How to Mitigate Agency Problems 1) Parent Control: Communicate goals clearly, Assign decision rights, Measure performance 2) Corporate control: Align goals across management (e.g. Offering stock options) Centralised Management– all report to Financial Manager of Parent - More inefficiency, Parent not informed of subsidiary’s conditions; Less agency risk Decentralised Management – all report to Financial Manager of Individual Companies - Higher risk of conflicting objectives; More control to subsidiary managers, better at adapting operations to various environments Sarbanes-Oxley Act -Transparent process for managers to report Productivity & Finances Why International Business 1) Theory of Competitive Advantage - Use CA to specialise in production; rely on others to meet other needs for a mutually beneficial outcome. Overall greater production efficiency. (assume: free will to trade) 2) Imperfect Markets Theory - Factors of production immobile (like coal mines); countries should specialise based on available resources  if you don’t produce for me, I won’t be able to enjoy it 3) Product Cycle Theory - Natural life-cycle of a product; Local firms will mature and expand into foreign countries Mode of International Business Entry International Trade - Export Products & Import Supplies Pros: Low cost of market entry; Low Political & Economic Risk Cons: Lower margins; Copycats in foreign market Licensing - Sale of tech/ copyright Pros: Expansion is fast; Low Political & Economic Risk Cons: Lack of control; Reputational risk; Loses Profit Making Apparatus Franchising – like licensing, but parent coy more involved to ensure quality Pros: Expansion is fast; Low Political & Economic Risk Cons: Lack of control; Reputational risk; Loses Profit Making Apparatus Joint Venture – jointly owned by 2 or more firms Pros: Gain local market knowledge and contacts; Share the risk Cons: High CAPEX; High Political & Economic Risk Acquisition of existing operations Pros: Gain local market knowledge and contacts; Company cultures may clash Cons: High CAPEX; High Political & Economic Risk Establishing new Foreign Subsidiary Pros: Full control for coordination from HQ Cons: High CAPEX; High Political & Economic Risk Domestic Model

MNC Valuation Model Multinational Model

- Higher required cost of capital leads to lower valuation

Uncertainty in foreign cash-flows due to political/economic conditions + Exchange Rate fluctuations  higher returns K demanded by investors--> lower Valuation SEM 2: INTL FLOW OF FUNDS (BOP) International Trade Volume Rising 1) Change in political mind-set (Removal of Berlin Wall) 2) Inception of Treaties which reduce tariffs (Single European Act of 1987, GATT) 3) Reducing FOREX risk (inception of Euro, involvement of more countries) 4) Acceptance towards outsourcing and Theory of CA (outsourcing creates domestic unemployment) Factors to Consider before Outsourcing: (1) Quality (2) Cost (3) Legal constraints Balance of Payments: Summary of country’s transactions with the rest of the world Having surplus means producing more than consuming (neutral outcome) Negative View: opportunity cost - could be buying more, dollar can be strengthened Positive View: save up for rainy day Current Account – flow of funds from purchase & sales of G&S and Income from Fin Assets (Exports – Imports) + factor income payments + Net transfers Balance of Trade interest/dividends remittance, grants, aid Capital Account - Flow of funds from purchase & sale of assets (1) Capital Account (Value of assets transferred, e.g. patents) (2) Financial Account – DFI, Portfolio investments and others (short term money market) (3) Error & Omission –fudge factor to create balance

To correct BOT Deficit, countries DEVALUE CURRENCY: [Why devaluing currency works]

 Value of currency drop, Foreign imports more expensive, purchase less foreign currency  Local exported goods seem cheaper to foreigners, export more. BOT Corrected. Why devaluing currency will backfire (1) Foreign debts become more expensive (2) Trigger other governments to devalue  everyone loses  Political disputes (3) Shake investor confidence Why devaluing currency is ineffective (4) Pre-arranged international trade transactions  time-lag for about 18 months (5) Must devalue against one country at a time, hard to solve all (6) Foreign firms can lower prices to stay competitive Other Protectionist Solutions: restrict import, subsidize export, offer tax relief, restrictions Factors which affect International Trade: 1) Inflation ↑ , Production cost ↑, Cost of local goods more ex, demand for foreign currency up  Consume more foreign goods  Worsen BOP 2) National income ↑, demand for Foreign Imports ↑ 3) Credit conditions (LOC) ↑, Export ↓ 4) Government policies (protectionism measures, tariffs etc) 5) FX rate appreciates  Export more expensive to foreigners, Imports cheaper Factors which affect DFI 1) Government Restrictions (Capital Controls) 2) Privatisation stimulates DFI, since members of privately-owned businesses are more motivated to ensure profitability 3) Potential for Economic Growth – countries like Myammar 4) Low tax rates for corporations  higher returns 5) Exchange rates – prefer currencies expected to appreciate against home currency Factors which affect Portfolio Investment (indirect investment) 1) High interest rates (money flows to countries with high IR in the short term, as long as currency not expected to weaken yet. IFE says it will weaken in LT) 2) Tax rate on interest/ dividends 3) Exchange rates – prefer currencies expected to appreciate against home currency *Markets with less trading speculation experience more volatility

(earnings fall, but debts also fall) SEM 4: INTL FINANCIAL MARKETS - Increased demand for currency, Dd shift right, Price of Currency ↑ - Decreased supply for currency, Ss shift left, Price of Currency ↑ Until it reaches an Equilibrium Exchange Rate E = f [ ∆INF, ∆INT, ∆INC, GC, ∆EXP ] Equilibrium is a function of inflation differential, interest differential, income level differential, presence of government controls and expectation of future rates

SEM 3: INTL FINANCIAL MARKETS Freedom for Countries to manage 1) Floating Rate: Mkt Driven – Central Bank might intervene occasionally [insulate against economic conditions] 2) Managed Float: CB intervenes regularly – keeps FX rate within an undisclosed band Pros: Stability & Predictability Good for LT investments 3) Pegged (fixed rate): Fixed ex∆ rate to foreign currency, some may allow some flexibility (e.g. crawling peg) 4) Common currency: Share a currency, countries do not have the ability to control the rate (give up monetary policy) 5) Dollarization: Use a major currency instead of your own Banks which provide Foreign Exchange differentiate through: 1) Competitiveness of quote 2) Special relationship with bank 3) Speed of execution 4) Advice about market conditions 5) Forecasting advice Direct Quotation (Foreign currency =1) – How many units of Home currency are needed to buy 1 unit of foreign currency? $0.042 SGD buys $1.00 THB BID price: Bank Buys – I sell ASK price: Bank Sells – I buy BID – ASK Spread = (Ask – Bid) / Ask

Expectations Theory – the forward rate is the expected future spot rate. Forward premium (Forward > Spot). = Foreign currency expected to appreciate

Indirect Quotation (Home currency =1) – How many units of Foreign currency can 1 unit of home currency buy? $1.00 SGD buys $23.65 THB Factors that affect Spread 1) Order costs, processing & transaction (+ve) 2) Inventory Costs (+ve) 3) Competition (smaller spread if intense competition in market) (-ve) 4) Volume (high volume of trade  more liquid  smaller spread) (-ve) 5) Currency Risk – Demand/ supply of current changes abruptly  larger risk/ spread (+ve)

Cross Rate =

Euro Euro USD X = SGD USD SGD

Foreign Exchange Market Forwards/ Futures/Options/ Money markets Companies borrow short-term funds in foreign currencies to: 1) Fulfil payables 2) Interest is lower 3) Expected to depreciate against home currency, making it easier to pay back If SGD = Home Currency Depreciates Consumers going overseas : convert to less foreign dollar, LOSE Producers: raw materials paid in foreign currency expensive, LOSE Exporters: Foreign consumers find the local exports/products cheaper, WIN Importers: Imports are more expensive, harder to sell, LOSE Investor investing abroad: After conversion, more SGD, WIN Foreign investors in SGP: After conversion to their home currency, even less, LOSE Risks of International Bonds 1) IR Risk (proportionate to bond length) 2) Exchange Rate Risk (since bond is in foreign $) 3) Liquidity Risk (hard to trade) 4) Credit Risk (country can default) To avoid FOREX risk: 1) Invoice in home currency 2) Hedge against FX risk with Forwards, Futures and Options 3) Have equal assets and liabilities in foreign countries to create a natural hedge

∆INF: Relative Inflation Rates ↑in US inflation  ↑Dd for Foreign Gds ↑ Dd for Foreign $  Foreign $ Appreciate ∆INT: Relative Interest Rates ↑in US IR  ↑Dd for US deposits ↑Dd for US $  Home $ Appreciates [Short Term] ∆INC: Relative Income Level ↑in US Income  ↑Dd for Foreign Gds  ↑ Dd for Foreign $  Foreign $ Appreciate Government Controls Foreign exchange barriers + capital controls  affect macro variables like ∆INF, ∆INT, ∆INC Expectations of the Future Signals on currency speculation  causing currencies to be temporarily over/undervalued *more liquid the currency, less sensitive to large changes, got buffer *currencies moving in same direction & magnitude show no change in cross-exchange rate 3 Theories for Exchange Rate Determination 1. Interest Rate Parity (based on IR differential) [Always use direct quotation] - In equilibrium, difference between interest rates of 2 currencies will be offset by the difference between spot rate and forward rate

Types of ARBITRAGE Locational Arbitrage: -buy at one bank sell at another where it is priced higher –exchange rate not set properly Bank X | Bid Price: 3.00 USD | Ask Price: 3.02 USD Bank Y | Bid Price: 2.98 USD | Ask Price: 2.99 USD - one of the ASK price must be LOWER than the other BID price Implications: Realignment of prices, Gains = amount of capital * size of discrepancy Triangular Arbitrage: - Cross-rate not set properly Example Value of CAD dollar in USD : $0.90 USD  Value of CAD in NZD: $3.00 NZD Value of NZD dollar in USD : $0.30 USD Value of CAD dollar in NZD : $3.02 NZD [Given Cross-rate priced too high] Step 1: Buy CAD, sell USD $100 USD * [1 CAD / 0.90 USD ] = $111.1 CAD Step 2: Buy NZD, sell CAD $111.1 CAD * [3.02 NZD / 1 CAD ] = $335.5 CAD Step 3 Buy USD, sell NZD $335.5 CAD * [0.3 USD / 1 CAD ] = $100.7 CAD Profit of $0.7 Implication: Subject to bid-ask spread, may eliminate/reduce gains Covered Interest Arbitrage: Capitalise on IR differential between currencies, while covering exchange rate risk with forward contract (assume IRP does not hold) - Forward rate not set properly

If IRH > IRF , p is +ve: forward rate is at premium; Foreign currency expected to appreciate If IRH < IRF , p is -ve: forward rate is at discount; Foreign currency expected to depreciate

*Market speculators engage in longing future and selling spot, placing upward pressure on futures and downward pressure on expected future spot. Process continues until futures rate is equal to the future spot rate. Implications: No Covered Interest arbitrage is possible –forward contract to eliminate FX risk will cost the gains from interest rate differential [forward rate shifts to offset] No carry trade is possible – borrow currency with lower IR to invest in another currency with higher IR 2. Purchasing Power Parity (PPP) (based on INF differential) - Law of One Price – same good should sell for same price anywhere in the world Absolute PPP: without intl barriers, consumers shift demand to wherever price is lower ∴ Price of goods should be equal anywhere in the world when measured in same currency Relative PPP: Rate of change in prices (inflation) should be similar - To make the price same for countries with diff levels of inflation, Exchange Rate will adjust to equalise the purchasing power for currency - Otherwise, consumers will buy from Cheaper Countries until Dd for currency inflates

Implications: Magnitude of Inflation differential reflects Exchange Rate appreciation/ depreciation - If INFH > INFF , ef is +ve, Foreign currency will appreciate - If INFH < INFF , ef is -ve, Foreign currency will depreciate PPP does not hold due to (1) Confounding Effects E = f [ ∆INF, ∆INT, ∆INC, GC, ∆EXP and (2) because there is no substitutes for some traded goods  Imperfect Markets Theory [factors of production are immobile] (3) historically false: high inflation in certain countries did not have high IR 3. International Fisher Effect (IFE) (based on both IR and INF differential) - Fisher effect suggests: Nominal IR = Expected INF rate + Real IR *Real IR is the same all over the world, just that INF fluctuates, so Nominal IR also varies - Currency with higher nominal IR --> high inflation coming, currency will depreciate (PPP)

Implications: (1) Beware of earnings from high inflation countries, depreciation may erode. (PPP) (2) No covered interest arbitrage  earnings wiped out by high inflation and depreciation Comparison of the 3 Theories IRP suggests that IR differential between 2 countries creates the difference in forward rate and spot rate (premium) -relates to a specific point in time (current forward vs current spot) Expectations Theory predicts that forward rate will be equal to spot rate in the future. PPP and IFE focus on how a currency’s spot rate will change over time - PPP suggest changes according to Inflation Differentials (relative PPP) - IFE suggest changes according to Nominal IR Differential (Inflation Differentials + Real IR) -Governments that raise IR to attract more investors deposit will only succeed in short run. --In the long run, IFE kicks in, currency depreciates & investors no long find it attractive to invest in the country

Home investor (Change to Foreign Currency, Put in Deposit) A: Gain Foreign Currency Appreciation 5%, Lose Higher Home IR 2% B: Gain Foreign Currency Appreciation 3%, Gain Higher Foreign IR 3% C: Lose Foreign Currency Depreciation 2%, Gain Higher Foreign IR 4% Foreign investor (Change to Home Currency, Put in Deposit) D: Lose Home Currency Depreciation 2%, Gain Higher Home IR 4% E: Gain Home Currency Appreciation 3%, Gain Higher Home IR 3% F: Gain Home Currency Appreciation 5%, Lose Lower Home IR 2% No Arbitrage Opportunity G: IRP holds true – Forward rate reflects IR differential Considerations before Arbitrage: Transaction Costs, Political Risks, Differential tax laws which will erode gains = IRP line thickens CURRENCY DERIVATIVES Currency Derivatives: contract of which price is derived from the value of an underlying currency (futures, forwards, options) Forwards: Agreement to exchange a specified amount of currency, on a specified date - customized to fit corporations’ need; Can be settled in net gain/loss (no real change) Total Cost of Transaction when hedged – Total Cost of Transaction when not hedged = Real Cost of Hedging (should be negative if it was the right decision) *cost and payable is different, payable is the premium paid Forward Rate quoted rate F=forward rate, s=spot rate, n= time period, p=premium when +, discount when –

( F−S S )

p=

X ( 360/ n )

**remember to annualize Futures: Like forwards, but is Standardized; Sold on markets  more liquidity Options [In the money, At the money, Out of the money] Premium on Call options: f[ S-X , T , σ ] - lock the price ceiling (spot price relative to strike price), (time to expiration), (potential variability of currency) Uses: 1) Hedge against uncertain payables/ expenses 2) Speculators who expect Foreign currency to appreciate [so they buy call first, when price appreciate, call option price goes up, they sell option away for profit] Premium on Put options: f[ -( S-X) , T , σ ] - lock the price floor -(spot price relative to strike price), (time to expiration), (potential variability of currency) Uses: 1) Hedge; 2) Speculators who expected currency to depreciate [so they buy put first, when price depreciate, put option price goes up, they sell option away for profit]

Structured Options B-can be structured with conditional premium - premium paid depends on actual movement in currency’s value Straddle Buy put & call at same Strike Price  expect volatility in Spot Rate, dunno ↑ or ↓ -When spot ≤ 1.70, Put premium = Free= $0.00

[Person buys put cause he scared Spot Rate drop, he want price floor. But if heng spot rate rise, he must now share his earnings by paying higher premium] Hedge Payables – Buy forward, Buy future, Buy call Hedge Receivables – Sell forward, Sell future, Buy put Speculate Foreign Currency to Appreciate: Buy future contract now – When currency appreciate, contract value will go up, sell the contract for cash Speculate Foreign Currency to Depreciate: Sell future contract now – When currency depreciate, buy back at low Spot rate to fulfil contract Options (Pros and Cons) Pros: flexible, can choose not to exercise, good if the receivable/payable is not confirmed Cons: premium paid may be high if currency fluctuates greatly, uncertainty on whether to exercise (need do due diligence, cannot calculate NPV), Sunk cost at the start Generally, MNCs prefer Forwards because it has less risk and uncertainty. 3 forms of FX Exposure 1) Transaction Exposure: sensitivity of contractual transactions in foreign currencies How to Measure Transaction Exposure? 1) Standard Deviation of Currency Volatility - estimate net cash flows in various currencies, find proportion W - measure potential impact of currency exposure with SD

w: weightage of each currency in portfolio σ: standard deviation of percentage change P: correlation co-efficient of both currencies = [Covariance / σ1 σ2] 2) Value at Risk Maximum 1-day loss = E (et) – (1.65 * σMXP) E (et) = Expected % change in currency for the next day 1.65 = Confidence level used : InvNorm (0.95) σMXP = Standard Deviation of the daily percentage changes in currency Limitation: distribution of exchange rate movements may not be normal, SD assumed to be stable across time Techniques to Manage Transaction Exposure 1) Use forwards, futures – lock in the spot rate today 2) Money Market hedges – convert to foreign currency today to limit exposure 3) Options – pay a premium to fix the highest/ lowest spot rate 4) Don’t hedge – believe the exchange rate will favour you - find the Effective Cost of each method, using the probability of the spot rate occuring Money Market Hedge – Example Receivables in Euro Payables in Euro 1) Borrow in Euro today 1) Convert USD to Euro today 2) Convert to USD and put in Bank 2) Put Euro in Bank 3) Use Receivables to pay off Euro (Loan 3) Use Euro (Deposit + interest) to fulfil + interest) Payables Limitations to Hedging 1) Uncertainty in Payments: could lead to over-hedging (additional costs) 2) Repeated short-term hedging (high hedging costs in LR and lose effectiveness) Alternative Hedging Techniques 1) Leading and Lagging – adjust timing of payables/ receivables to reflect expectations of currency movements 2) Cross-hedging - Hedge by using currency that serves as a proxy for another (identify correlation co-efficient between 2 currencies) – eg hedge SGD instead of Brunei $ 3) Currency Diversification – diversify business into numerous countries to receive different currencies 2) Economic Exposure: sensitivity of cash-flow to ER (includes Transactn Exposure) * Key point: even if you only sell domestically, still exposed to economic exposure. If foreign currency depreciates, your...