Multinational Financial Management
ANSWERS TO END-OF-CHAPTER QUESTIONS
26-1 a. A multinational corporation is one that operates in two or more countries.
b. The exchange rate specifies the number of units of a given currency that can be purchased for one unit of another currency. The fixed exchange rate system was in effect from the end of World War II until August 1971. Under the system, the U. S. dollar was linked to gold at the rate of $35 per ounce, and other currencies were then tied to the dollar. Under the floating exchange rate system, which is currently in effect, the forces of supply and demand are allowed to determine currency prices with little government intervention.
c. A country has a deficit trade balance when it imports more goods from abroad than it exports. Devaluation is the lowering, by governmental action, of the price of its currency relative to another currency. For example, in 1967 the British pound was devalued from $2.80 per pound to $2.50 per pound. Revaluation, the opposite of devaluation, occurs when the relative price of a currency is increased.
d. Exchange rate risk refers to the fluctuation in exchange rates between currencies over time. A convertible currency is one which can be traded in the currency markets and can be redeemed at current market rates. When an exchange rate is pegged, the rate is fixed against a major currency such as the U. S. dollar. Consequently, the values of the pegged currencies move together over time.
e. Interest rate parity holds that investors should expect to earn the same return in all countries after adjusting for risk. Purchasing power parity, sometimes referred to as the “law of one price,” implies that the level of exchange rates adjusts so that identical goods cost the same in different countries.
f. The spot rate is the exchange rate which applies to “on the spot” trades, or, more precisely, exchanges that occur two days following the day of trade. In other words, the spot rate is for current exchanges. The forward exchange rate is the prevailing exchange rate for exchange (delivery) at some agreed-upon future date, usually 30, 90, or 180 days from the day the transaction is negotiated. Forward exchange rates are analogous to future prices on commodity exchanges. Discounts (or premiums) on forward rates occur when the forward exchange rate differs from the spot rate. When the forward rate is below the spot rate, the forward rate is said to be at a discount. Conversely, when the forward rate is above the spot rate, it is said to be at a premium.
g. Repatriation of earnings is the cash flow, usually in the form of dividends or royalties, from the foreign branch or subsidiary to the parent company. These cash flows must be converted to the currency of the parent, and thus are subject to future exchange rate changes. A foreign government may restrict the amount of cash that may be repatriated. Political risk refers to the possibility of expropriation and to the unanticipated restriction of cash flows to the parent by a foreign government.
h. A Eurodollar is a U. S. dollar on deposit in a foreign bank, or a foreign branch of a U. S. bank. Eurodollars are used to conduct transactions throughout Europe and the rest of the world. An international bond is any bond sold outside of the country of the borrower. There are two types of international bonds: Eurobonds and foreign bonds. A Eurobond is any bond sold in some country other than the one in whose currency the bond is denominated. Thus, a U. S. firm selling dollar bonds in Switzerland is selling Eurobonds. A foreign bond is a bond sold by a foreign borrower but denominated in the currency of the country in which the issue is sold. Thus, a U. S. firm selling bonds denominated in Swiss francs in Switzerland is selling foreign bonds.
i. The Euro is a currency used by the nations in the European Monetary Union who signed the Treaty of Mastricht.
26-2 The U. S. dollar. The primary reason for using the dollar was that it provided a relatively stable benchmark, and it was accepted universally for transaction purposes.
26-3 Under the fixed exchange rate system, the fluctuations were limited to +1% and -1%. Under the floating exchange rate system, there are no agreed-upon limits.
26-4 A dollar will buy more Swiss francs.
26-5 There will be an excess supply of dollars in the foreign exchange markets, and thus, will tend to drive down the value of the dollar. Foreign investments in the United States will increase.
26-6 Taking into account differential labor costs abroad, transportation, tax advantages, and so forth, U. S. corporations can maximize long-run profits. There are also nonprofit behavioral and strategic considerations, such as maximizing market share and enhancing the prestige of corporate officers.
26-7 The foreign project’s cash flows have to be converted to U. S. dollars, since the shareholders of the U. S. corporation (assuming they are mainly U. S. residents) are interested in dollar returns. This subjects them to exchange rate risk, and therefore requires an additional risk premium. There is also a risk premium for political risk (mainly the risk of expropriation). However, foreign investments also help diversify cash flows, so the net effect on the required rate of return is ambiguous.
26-8 A Eurodollar is a dollar deposit in a foreign bank, normally a European bank. The foreign bank need not be owned by foreigners--it only has to be located in a foreign country. For example, a Citibank subsidiary in Paris accepts Eurodollar deposits. The Frenchman’s deposit at Chase Manhattan Bank in New York is not a Eurodollar deposit. However, if he transfers his deposit to a bank in London or Paris, it would be.
The existence of the Eurodollar market makes the Federal Reserve’s job of controlling U. S. interest rates more difficult. Eurodollars are outside the direct control of the U. S. monetary authorities. Because of this, interest rates in the U. S. cannot be insulated from those in other parts of the world. Thus, any domestic policies the Federal Reserve might take toward interest rates would be affected by the Eurodollar market.
26-9 No, interest rate parity implies that an investment in the U. S. with the same risk as a similar investment in a foreign country should have the same return. Interest rate parity is expressed as:
.
Interest rate parity shows why a particular currency might be at a forward premium or discount. A currency is at a forward premium whenever domestic interest rates are higher than foreign interest rates. Discounts prevail if domestic interest rates are lower than foreign interest rates. If these conditions do not hold, then arbitrage will soon force interest rates back to parity.
26-10 Purchasing power parity assumes there are neither transaction costs nor regulations which limit the ability to buy and sell goods across different countries. In many cases, these assumptions are incorrect, which explains why PPP is often violated. An additional complication, when empirically testing to see whether PPP holds, is that products in different countries are rarely identical. Frequently, there are real or perceived differences in quality, which can lead to price differences in different countries.
26-1 $1 = 9 Mexican pesos; $1 = 111.23 Japanese yen; Cross exchange rate, yen/peso = ?
Cross Rate: = .
Note that an indirect quotation is given for Mexican; however, the cross rate formula requires a direct quotation. The indirect quotation is the reciprocal of the direct quotation. Since $1 = 9 pesos, then 1 peso = $0.1111.
Yen/Peso = 0.1111 dollars per peso ´ 111.23 yen per dollar
= 12.358 yen per peso.
26-2 rNom, 6-month T-bills = 7%; rNom of similar default-free 6-month Japanese bonds = 5.5%; Spot exchange rate: 1 Yen = $0.009; 6-month forward exchange rate = ft = ?
rf = 5.5%/2 = 2.75%.
rh = 7%/2 = 3.5%.
e0 = $0.009.
=
1.0275 ft = $0.00932
ft = $0.00907.
The 6-month forward exchange rate is 1 yen = $0.00907.
26-3 U. S. T.V. = $500; French T.V. = 550 euros; Spot rate between euro and dollar = ?
Ph = Pf(e0)
$500 = 550 euros(e0)
500/550 = e0
$0.9091 = e0.
1 euro = $0.9091 or $1 = 1 / 0.9091 = 1.1000 euros.
26-4 Dollars should sell for 1/1.50, or 0.6667 pounds per dollar.
26-5 The price of francs is $0.60 today. A 10 percent appreciation will make it worth $0.66 tomorrow. A dollar will buy 1/0.66 = 1.5152 francs tomorrow.
26-6 Cross rate = francs/dollars ´ dollars/pounds = francs/pounds
= 1.6 ´ 1.5 = 14.16 francs per pound.
26-7 The U. S. dollar liability of the corporation falls from $0.75(5,000,000) = $3,750,000 to $0.70(5,000,000) = $3,500,000, corresponding to a gain of 250,000 U. S. dollars for the corporation. However, the real economic situation might be somewhat different. For example, the loan is presumably a long-term loan. The exchange rate will surely change again before the loan is paid. What really matters, in an economic sense, is the expected present value of future interest and principal payments denominated in U. S. dollars. There are also possible gains and losses on inventory and other assets of the firm. A discussion of these issues quickly takes us outside the scope of this textbook.
26-8 a. The automobile’s value has increased because the dollar has declined in value relative to the yen.
b. 245/108 = 2.2685, so $8,000 ´ 2.1491 = $18,148.00.
Note that this represents a 4.9% compound annual increase over 17 years.
26-9 a. SFr. 1,000,000 (1.6590 $/SFr.) = $1,659,000, or
SFr. 1,000,000 / $0.6028 = $1,658,925.
(Difference is due to rounding.)
b. SFr. 1,000,000/SFr. 0.6075 = $1,646,091, or
FF. 1,000,000 ´ $1.6460 = $1,646,000.
c. If the exchange rate is SFr. 0.500 to $1 when payment is due in 3 months, the SFr. 1,000,000 will cost:
SFr. 1,000,000/SFr. 0.500 = $2,000,000,
which is more than the spot price today and more than purchasing a forward contract for 90 days.
26-10 a. rNom of 90-day U. S. risk-free securities = 5%; of 90-day German risk-free securities = 5.3%; e0 = 1 euro = $0.80; ft selling at premium or discount = ?
rh = 5%/4 = 1.25%; rf = 5.3%/4 = 1.325%; e0 = $0.80.
= 0.9993.
ft = $0.7994.
The forward rate is selling at a discount, since a euro buys fewer dollars in the forward market than it does in the spot. In other words, in the spot market $1 would buy 1/0.80 = 1.25 euros, but at the forward rate $1 would buy 1/0.7994 = 1.2509 euros; therefore, the forward currency is said to be selling at a discount.
b. The 90-day forward rate is ft = $0.7994.
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