Understanding International Finance and Multinational
School
University of British Columbia**We aren't endorsed by this school
Course
COMM 298
Subject
Communications
Date
Dec 11, 2024
Pages
26
Uploaded by ChiefPowerWildcat30
Class 18: International FinanceCOMM 298 2024W1: Introduction to Finance Jose Pizarro
Objectives•Describe Multinational Corporations•Discuss what makes international finance special•Explain foreign exchange risk and the role of financial management in an international framework•Define an exchange rate•Examine how exchange rates are determined •Identify the factors that affect the equilibrium exchange rateCOMM 298 2024W1 Introduction to Finance | Jose Pizarro | Do not post without permission
Financial Management in an International Setting•We discussed the role of the CFO:•Optimally make corporate financial decisions•Investing, financing, risk management, etc.•But overall, their role is to maximize shareholder wealth•These objectives will not change when the CFO manages a multinational corporation (MNC)•MNC: Corporation engaged in producing and selling goods or services in more than one country•Most corporations in the market are MNCs•Roughly 40% of the S&P500 firms’ revenues in 2022 were generated in foreign marketsCOMM 298 2024W1 Introduction to Finance | Jose Pizarro | Do not post without permission
Financial Management of a Multinational Corporation•Most MNCs have centralized management•This ensures globally coordinated allocation of resources•Parent company located in the home country •Several foreign subsidiaries•Raise capital simultaneously in several major markets•Investment decisions and financial management are centralized•MNCs rely on the international mobility of factors of production•Differences in labor costs and unique national attributes or skills•Product development, design, production, assembly, or marketing•Natural resources or geography COMM 298 2024W1 Introduction to Finance | Jose Pizarro | Do not post without permission
The Rise of Multinational Corporations•Due to economic globalization, it is difficult to think of corporations that are not multinational•This was not always the case. What are the main factors that drove the rise of MNCs?•Search for Raw Materials•Oil and mining: the first to make foreign investments•Market Seeking•Go overseas to produce and sell in foreign markets. Essential for obtaining economies of scale•Cost Minimization•Invest in lower-cost production sites overseas. Offshoring of services.•Explore financial-market Imperfections•Tax reduction and capital control. Diversification from operating in countriesCOMM 298 2024W1 Introduction to Finance | Jose Pizarro | Do not post without permission
What Makes International Finance Special? •Exchange rate: The price of one nation’s currency in terms of another nation’s currency•The Canadian dollar (CAD)/US dollar (USD) exchange rate is the number of Canadian dollars that one US dollar will buy or, equivalently, the number of Canadian dollars needed to buy one US dollar•If 1 US dollar buys 1.39 Canadian dollars•Exchange rate: 1.39 CAD/USD•Canadian dollar (CAD) is the “reference currency”•US dollar (USD) is the “base currency”•Foreign exchange risk: Changes in exchange rates that directly affect the firm’s profitability and valueCOMM 298 2024W1 Introduction to Finance | Jose Pizarro | Do not post without permission
What Makes International Finance Special? COMM 298 2024W1 Introduction to Finance | Jose Pizarro | Do not post without permissionExchange Rates Change Significantly over Time!$0.80$0.90$1.00$1.10$1.20$1.30$1.40$1.50$1.60$1.70Jan-00Sep-00May-01Jan-02Sep-02May-03Jan-04Sep-04May-05Jan-06Sep-06May-07Jan-08Sep-08May-09Jan-10Sep-10May-11Jan-12Sep-12May-13Jan-14Sep-14May-15Jan-16Sep-16May-17Jan-18Sep-18May-19Jan-20Sep-20May-21Jan-22Sep-22May-23Jan-24Sep-24CAD/USD
Exchange Rates•Exchange rates can be for spot or forward delivery•Spot rate:•Price at which currencies are traded for immediate delivery•Actual delivery takes place two days later•Forward rate:•Price at which foreign exchange is quoted for delivery at a specified future date•An important tool to manage Foreign Exchange Risk•If I enter a forward contract, the rate at which I will exchange currency in the future is fixedCOMM 298 2024W1 Introduction to Finance | Jose Pizarro | Do not post without permission
Exchange Rates•Currency Appreciation•Increase in the value of the base currencywith respect to the reference currency•The USD (base) appreciates with respect to the CAD (reference)•More CAD to purchase 1 USD •CAD/USD exchange rate will increase•Currency Depreciation•Decrease in the value of the base currencywith respect to the reference•The USD (base) depreciates relative to the CAD (reference)•Less CAD to purchase 1 USD•CAD/USD exchange rate will decreaseCOMM 298 2024W1 Introduction to Finance | Jose Pizarro | Do not post without permission
Exchange Rates•Calculating Exchange Rate Changes•The magnitude of an appreciation or depreciation of the base currency is computed as the percent change in the exchange rate:Δ𝑆𝑆=𝑆𝑆1− 𝑆𝑆0𝑆𝑆0•𝑆𝑆1: New value of the exchange rate•𝑆𝑆0: Old value of the exchange rateCOMM 298 2024W1 Introduction to Finance | Jose Pizarro | Do not post without permission
US Dollar Depreciation against Japanese Yen•Calculate the US dollar (USD) depreciation against the Yen (JPY) during 2019•Jan-2023: 109.24 JPY/USD•Dec-2023: 108.60 JPY/USD•What is the magnitude of the depreciation of the USD against the JPY?•Solution:•The USD depreciated against the JPY by 0.586%COMM 298 2024W1 Introduction to Finance | Jose Pizarro | Do not post without permission
Exchange Rates•How exchange rates are set?•Market-clearing prices•Equate supply and demand in the foreign exchange market•Demand for a Base Currency in the Foreign Exchange Market: •Canadian investors would like to invest or consume in the US •For Canadians investing in the US, they must convert their CAD into US dollars (USD)•Canadian investors will demand USD in exchange for CAD•Supply of a Base Currency in the Foreign Exchange Market: •US investors would like to invest or consume in Canada•US investors need to convert their US dollars (USD) into CAD•US investors will supply USD in exchange for CADCOMM 298 2024W1 Introduction to Finance | Jose Pizarro | Do not post without permission
Exchange RatesCOMM 298 2024W1 Introduction to Finance | Jose Pizarro | Do not post without permissionCanadian dollar price of 1 US dollarCAD/USD𝑆𝑆0Quantity of USDSupply of USD•US consuming/investing in Canada Demand for USD•Canadians consuming/investing in the US 𝑄𝑄0Equilibrium Exchange Rate:CAD value of 1 USDQuantity of USD Traded in Equilibrium
Factors That Affect the Equilibrium Exchange Rate•To understand and manage foreign exchange risk, it is fundamental to understand what factors will affect the equilibrium exchange rate•These factors will influence the supply and demand of a currency, consequently influencing the equilibrium exchange rate •Factors that influence currency supply and demand are:1.Inflation rates2.Interest rates3.Economic growth4.Political and economic risks•Expectations about these factors also influence exchange ratesCOMM 298 2024W1 Introduction to Finance | Jose Pizarro | Do not post without permission
Factors That Affect the Equilibrium Exchange Rate1.Inflation rates•Canadian consumers would like to invest or consume in the US•What will happen to their demand for USD if prices in Canada rise (inflation)?•Canadian consumers will buy more goods in the US•More demand for USD in exchange for CAD•US consumers will buy less goods in Canada•Less supply of USD in exchange for CAD•Higher inflation in Canada relative to the US will lead to a gain of value of the USD relative to the CAD (appreciation of the USD)•The CAD/USD exchange rate will increase! More CAD to buy 1 USDCOMM 298 2024W1 Introduction to Finance | Jose Pizarro | Do not post without permission
Factors That Affect the Equilibrium Exchange RateCOMM 298 2024W1 Introduction to Finance | Jose Pizarro | Do not post without permissionCanadian dollar price of 1 US dollarCAD/USD𝑆𝑆0Quantity of USDSupply of USD•US consuming/investing in the Canada Demand for USD•Canadians consuming/investing in the US 𝑄𝑄0Quantity of USD Traded in Equilibrium𝑆𝑆1
Factors That Affect the Equilibrium Exchange Rate2.Relative interest rates•Higher real interest rates in the US relative to Canada•Where will investors in Canada want to deposit?•All else being equal, investors will seek higher rates•Canadians will demand more USD, Higher demand for USD in exchange for CAD•Americans will supply less USD. That is, a lower supply of USD in exchange for CAD•The USD will appreciate relative to the CAD•The CAD/USD exchange rate increasesCOMM 298 2024W1 Introduction to Finance | Jose Pizarro | Do not post without permission
Factors That Affect the Equilibrium Exchange Rate3.Relative economic growth•Growth in the Gross Domestic Product, the total market value of all final goods and services produced in an economy within one year•A nation with strong economic growth will attract investments:•The demand for domestic assets results in an increased demand for the domestic currency •If the Canadian GDP is expected to grow more than the US GDP, US investors will look to invest in Canada•They will need CAD to buy Canadian Assets•Higher Supply of USD in exchange for CAD•Less Demand for USD in exchange for CAD•The USD will depreciate with respect to the CAD•The CAD/USD exchange rate decreasesCOMM 298 2024W1 Introduction to Finance | Jose Pizarro | Do not post without permission
Factors That Affect the Equilibrium Exchange Rate4.Political and Economic Risk•Investors prefer to hold lesser amounts of riskier assets•Low-risk currencies are associated with more politically and economically stable nations•Due to future elections, Canadian investors consider that the US has higher political risk:•Less Demand for USD in exchange for CAD•Higher Supply of USD in exchange for CAD•The USD depreciates with respect to the CAD•The CAD/USD exchange rate decreasesCOMM 298 2024W1 Introduction to Finance | Jose Pizarro | Do not post without permission
Central Banks: A Key Player•As mentioned, economic growth, risk and interest rates are fundamental for understanding the equilibrium exchange rate•An important player in economic growth and stability is the Central Bank•Central Banksuse Monetary Policyto control economic growth and stability•Affecting the equilibrium exchange rates!•The flexible exchange rate•In extreme cases, like market breakdown, the Bank of Canada (Central Bank) will directly intervene in the currency market when the value of the CAD is too volatile or there is no market liquidity•Protect the value of the CADCOMM 298 2024W1 Introduction to Finance | Jose Pizarro | Do not post without permission
Pros and Cons of a Strong Currency•Positive effects of a strong CAD•CAD prices of imported goods, services, and raw materials are lower•Benefiting consumers•Cost to firms and individuals of foreign investment is lower•Negative effects of a strong CAD•Exports become less competitive in foreign markets•Firms face more competition domestically from lower-priced imports•Higher cost of operating in Canada reduces foreign direct investmentCOMM 298 2024W1 Introduction to Finance | Jose Pizarro | Do not post without permission
Pros and Cons of a Weak Currency•Positive effects of a weak CAD•Exports become more competitive in foreign markets•Firms are more competitive domestically against higher-priced imports•Lower cost of operating in Canada increases foreign direct investment•Negative effects of a weak CAD•Prices of imported goods, services, and raw materials are higher•Detrimental for consumersCOMM 298 2024W1 Introduction to Finance | Jose Pizarro | Do not post without permission
Summary•MNCs are a fundamental part of modern global business•A significant amount of revenues and assets are located in foreign markets•Drivers of an MNC•Search for raw materials, market seeking, cost minimization, knowledge seeking, keeping domestic customers and exploiting financial market imperfections•What makes international finance special? •Foreign exchange risk•The role of financial management•Capital budgeting, understanding the factors that affect currency values, managing the MNC’s foreign exchange risksCOMM 298 2024W1 Introduction to Finance | Jose Pizarro | Do not post without permission
Summary•Exchange rate•The price of one nation’s currency in terms of another currency•Spot rate •Price at which currencies are traded for immediate delivery•Actual delivery takes place two days later•Forward rate •Price at which foreign exchange is quoted for delivery at a specified future date•Appreciation•Increase in the value of the base currency with respect to the reference currency•Depreciation•Decrease in the value of the base currency with respect to the reference•How are exchange rates set?•Market-clearing prices that equate supply and demand in the foreign exchange marketCOMM 298 2024W1 Introduction to Finance | Jose Pizarro | Do not post without permission
Summary•The supply and demand for a currency change over time•The equilibrium exchange rate also changes•Factors that influence currency supply and demand are:1.Inflation rates2.Interest rates3.Economic growth4.Political and economic risks•Expectations about these factors also influence exchange ratesCOMM 298 2024W1 Introduction to Finance | Jose Pizarro | Do not post without permission
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