1、ECON 334: INTERNATIONAL BUSINESS AND FINANCE,Lecture 6: Financial risk and the multinational firm,INTERNATIONAL BUSINESS AND EXCHANGE RISK,RRs lectures have discussed the sources of MNE competitive advantage These real advantages suggest higher rates of return for MNEs over competitors But MNEs also
2、 face sources of financial risk and NSs sessions turn to this topic Concentration on forex risk, but also see how the risks of multinational operation may affect the MNEs cost of finance for undertaking real projects,FOREIGN EXCHANGE RISK,Three questions arise: What is foreign exchange risk? Should
3、the MNE be concerned about it? What can be done (if so)? Foreign exchange risk arises if the firm suffers losses from unexpected changes in exchange rates. What do we mean by unexpected?,(1) FOREX RISK AND PPP,Recall the law of one price from second year macro: P = eP* If all countries consume the s
4、ame basket this would imply absolute PPP. In % changes: e/e = P/P P*/P* This is relative PPP. If it always held, unexpected losses would not arise. The value of forex amounts would rise or fall reflecting relative inflation. But do we observe relative PPP? Look at the /$ rate since 1975:,Exchange ra
5、te quotes,Note that the exchange rate is /$ - A higher value means the $ is - appreciating (rising in value) This is a direct quote for the $ and is how most currencies are quoted against it but not the or (exceptions quoted $/, $/) But, how does the market rate relate to PPP? Recall the vertical li
6、ne at Sept. 1992,Choosing a PPP base,In terms of forex risk the nominal exchange rate does not help much the firm is worried about unexpected changes in the rate No problem if PPP is always true. The next graph assumes that the ERM crisis helped to establish the right exchange rate at the time (the
7、economy began to recover):,Nature of the risk,While the may have been a little undervalued immediately after the ERM crisis, the graph suggests that the strengthened in real terms from late 2002. British MNCs with $ revenues would have lower gains in terms eg. Ford sales of UK-sourced Jaguars in the
8、 USA The crisis at Airbus is linked to the weak $,(2) DOES FOREX RISK MATTER?,It has been argued that MNEs should be concerned only with maximising expected shareholder wealth Expected implies the mean (average) of a distribution of possible values The implication is that they should not be bothered
9、 by risk (standard deviation) of returns as such. Why? Think of a shareholder holding portfolio A,MEAN-VARIANCE PORTFOLIO,Expected return,Risk (standard deviation of return),A,B,Implications,For a European investor, A may be a European firm and B an American one. The US firm may be more profitable b
10、ut also more risky But it may do well when the $ is weak, while the Euro firm will do badly (negative covariance) Exchange risk might be diversified completely by holding both assets the shareholder is not concerned about idiosyncratic risk,A case for hedging?,Losses could cause financial distress c
11、ostly measures to avoid bankruptcy. More likely, the firm may need to borrow to cover its cash flow losses - expensive* Management may have more information on the actual risks so hedging could be better for shareholders How might forex risk be hedged? Start with a basic relationship:,(3) FORWARD EX
12、CHANGE HEDGE (UK perspective),TODAY,ONE YEAR LATER,Repay eS,Borrow eS/(1+rUK),Buy $ spot eS = $1 (eg eS = 0.5),$ value = $1/(1+rUK),Deposit 12 months in US bank,Yields $(1+r*US)/(1+rUK),Sell $ forward for eF per $1,So eF(1+r*US)/(1+rUK) = eS or eF = eS(1+rUK)/(1+r*US)?,Cash-and-carry arbitrage,YES W
13、hat if eF eS (1+rUK )/(1+r*US)? Borrow in US, lend in UK (to get the RHS in 12 months) and buy $ forward eF to clear debt (riskless arbitrage) This action will tend both to strengthen the $ forward (eF) and to strengthen the spot (eS) to produce the equality above,Quoting a forward rate,A bank can a
14、lways quote a rate eF If a customer wants to buy $ forward (with ) the bank can offset its exposure by borrowing in and depositing in $ This $ deposit will yield the $ the customer wants at year-end and the customers payment then will repay the banks loan This gives the eF quote and a firm can buy o
15、r sell forex forward to cover export-import payments,Covered interest parity,So, with direct quotes for the exchange rate and with r* the foreign interest rate the covered interest parity condition is:,The decision to buy (sell) a currency spot and sell (buy) a currency forward is sometimes referred
16、 to as a foreign exchange swap. These are very common transactions:,Forward transactions (April 07),UNCOVERED INTEREST PARITY?,CIP holds through arbitrage, but what if we thought that the foreign currency would be stronger than suggested by eF? We expect rate eeeF (Say, we think .55.5 per $) This im
17、plies (given CIP): ee(1+r*)es(1+r) What should we do if ee = .55 and eF=.5 -?,BACKING A HUNCH WITH ee(1+r*)es(1+r),Commit to make huge forward purchases of $ at the rate eF = .5 and hope that they will be worth ee= .55 (NB. No immediate outlay) We go long the $ (forex exposed) In both cases you tend
18、 to increase eF (driving the domestic currency to a forward discount) and towards your expected value ee,NO RISK PREMIUM?,If we are entirely risk-neutral or all foreign exchange risk can be diversified perfectly then this suggests that ef would = ee through such speculation In this case ee = es(1+r)
19、/(1+r*) = uncovered interest parity (UIP). In practice the foreign exchange risk premium is likely to leave ee ef What does this imply for an MNEs foreign exchange risk?,HEDGING RELEVANCE,If UIP held, the forward rate would be an unbiased predictor of the expected future spot rate Even if not, the MNE can use forward transactions to lock in the future exchange rate. This involves dealing costs, but small relative to the amounts involved,
