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FIN 645: International Financial Management Lecture 9-10 Selected Topics

FIN 645: International Financial Management Lecture 9-10 Selected Topics. How to Measure Economic Exposure. Economic exposure is the sensitivity of (1) the future home currency value of the firm’s assets and liabilities and

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FIN 645: International Financial Management Lecture 9-10 Selected Topics

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  1. FIN 645: International Financial Management Lecture 9-10 Selected Topics

  2. How to Measure Economic Exposure • Economic exposure is the sensitivity of • (1) the future home currency value of the firm’s assets and liabilities and • (2) the firm’s operating cash flow to random changes in exchange rates. • There exist statistical measurements of sensitivity.

  3. Channels of Economic Exposure Home currency value of assets and liabilities asset exposure Exchange rate fluctuations Firm value Operating exposure Future operating cash flows

  4. How to Measure Economic Exposure • If a U.S. MNC were to run a regression on the dollar value (P) of its British assets on the dollar pound exchange rate, S($/£), the regression would be of the form: Where a is the regression constant and e is the random error term with mean zero. The regression coefficient b measures the sensitivity of the dollar value of the assets (P) to the exchange rate, S.

  5. How to Measure Economic Exposure The exposure coefficient, b, is defined as follows: Where Cov(P,S) is the covariance between the dollar value of the asset and the exchange rate, and Var(S) is the variance of the exchange rate. The exposure coefficient shows that there are two sources of economic exposure: the variance of the exchange rate and the covariance between the dollar value of the asset and exchange rate.

  6. Measurement of Currency Exposure

  7. Class Exercise • Computation of the Exposure Coefficient b • Computation of Means • P = ΣqiPi • S = ΣqiSi • Computation of Variance and Covariance • Var (S) = Σqi(Si–S)² • Cov (PiS) = Σqi (Pi–P) (Si –S) • Computation of the Exposure Coefficient • b = Cov (P,S)/Var(S) • Note: qi denotes the probability for the ith state

  8. Computation of Means • P = ΣqiPi= 1/3 (1.372+1,500+1,712) = 1,528 • S = ΣqiSi = 1/3 (1.40+1.50+1.60) = 1.50 • Computation of Variance and Covariance • Var (S) = Σqi(Si–S)² • = 1/3[(1.40-1.50)² + (1.50-1.50) ² +(1.60-1.50) ²] = 0.02/3 • Cov (PiS) = Σqi (Pi –P) (Si –S) • = 1/3 [(1,372-1,528) (1.40-1.50) + (1,500-1,528) (1.50-1.50) • + (1,712-1,528) (1.60-1.50)] = 34/3 • Computation of the Exposure Coefficient • b = Cov (P,S)/Var(S) = (34/3) / (0.02/3) = 1,700 • Note: qi denotes the probability for the ith state i i i i Computation of Regression Parameters

  9. Interpretation of Results Case 1: Cov(P,S) = 34/3, Var(S) = .02/3, b = £ 1,700 The pound amount £ 1,700, represents the sensitivity of the future dollar value of the British asset to random changes in the exchange rate; US firms faces a substantial exposure to currency risk Case 2: Cov(P,S) = 0, Var(S) = .02/3, b = 0 The effect of the exchange rate changes is exactly offset by movements in the local currency price of assets, rendering dollar value of the British asset totally insensitive to exchange rate changes; Uncertain exchange rates or exchange rate risk does not necessarily constitute exchange exposure Case 3: Cov(P,S) = 20/3, Var(S) = .02/3, b = £ 1,000 Transaction exposure. The exposure coefficient, b, is the same as the magnitude of contractual cash flow fixed in terms of foreign exchange

  10. Consequences of Hedging Currency Exposure

  11. Operating Exposure: Definition • The effect of random changes in exchange rates on the firm’s competitive position, which is not readily measurable. • A good definition of operating exposure is the extent to which the firm’s operating cash flows are affected by the exchange rate.

  12. An Illustration of Operating Exposure • Recently, there was an enormous shortage in the shipping market from Asia, due to the Asian currency crisis. • This affected not only the shipping companies, which enjoyed “boom times”. • But also retailers, who experienced increased costs and delays.

  13. An Illustration of Operating Exposure • Note that the exposure for the retailers has two components: • The Competitive Effect • Difficulties and increased costs of shipping. • The Conversion Effect • Lower dollar prices of imports due to foreign currency exchange rate depreciation.

  14. Determinants of Operating Exposure • Recall that operating exposure cannot be readily determined from the firm’s accounting statements as can transaction exposure. • The firm’s operating exposure is determined by: • The firm’s ability to adjust its markets, product mix, and sourcing in response to exchange rate changes. • The market structure of inputs and products: how competitive or how monopolistic the markets facing the firm are.

  15. Managing Operating Exposure • Selecting Low Cost Production Sites • Flexible Input Sourcing Policy • Diversification of the Market • R&D and Product Differentiation • Financial Hedging

  16. Selecting Low Cost Production Sites • A firm may wish to diversify the location of their production sites to mitigate the effect of exchange rate movements. • e.g. Honda built North American factories in response to a strong yen, but later found itself importing more cars from Japan due to a weak yen.

  17. Flexible Sourcing Policy • Sourcing does not apply only to components, but also to “guest workers”. • e.g. Japan Air Lines hired foreign crews to remain competitive in international routes in the face of a strong yen, but later contemplated a reverse strategy in the face of a weak yen and rising domestic unemployment.

  18. Diversification of the Market • Selling in multiple markets to take advantage of economies of scale and diversification of exchange rate risk.

  19. R&D and Product Differentiation • Successful R&D that allows for • cost cutting • enhanced productivity • product differentiation. • Successful product differentiation gives the firm less elastic demand—which may translate into less exchange rate risk.

  20. Financial Hedging • The goal is to stabilize the firm’s cash flows in the near term. • Financial Hedging is distinct from operational hedging. • Financial Hedging involves use of derivative securities such as currency swaps, futures, forwards, currency options, among others.

  21. International Portfolio Investments • Surpassing the volume of FDI • (1) Why investors diversify their portfolio internationally, (2) How much investors can gain from international diversification, (3) the affects of fluctuating exchange rate on international portfolio investments, (4) benefits from investing in in international mutual funds, (5) the possible reasons for “home bias” in actual portfolio holdings.

  22. International Correlation Structure and Risk Diversification • Security returns are much less correlated across countries than within a country. • This is so because economic, political, institutional, and even psychological factors affecting security returns tend to vary across countries, resulting in low correlations among international securities. • Business cycles are often highly asynchronous across countries.

  23. Stock Market AU FR GM JP NL SW UK US Australia (AU) .586 France (FR) .286 .576 Germany (GM) .183 .312 .653 Japan (JP) .152 .238 .300 .416 Netherlands (NP) .241 .344 .509 .282 .624 Switzerland (SW) .358 .368 .475 .281 .517 .664 United Kingdom (UK) .315 .378 .299 .209 .393 .431 .698 United States (US) .304 .225 .170 .137 .271 .272 .279 .439 International Correlation Structure Relatively low international correlations imply that investors should be able to reduce portfolio risk more if they diversify internationally rather than domestically.

  24. Domestic vs. International Diversification When fully diversified, an international portfolio can be less than half as riskyas apurely U.S. portfolio. A fully diversified international portfolio is only 12 percent as risky as holding a single security. Portfolio Risk (%) Swiss stocks 0.44 U.S. stocks 0.27 0.12 International stocks 1 10 20 30 40 50 Number of Stocks

  25. Optimal International Portfolio Selection • The correlation of the U.S. stock market with the returns on the stock markets in other nations varies. • The correlation of the U.S. stock market with the Canadian stock market is 70%. • The correlation of the U.S. stock market with the Japanese stock market is 26%. • A U.S. investor would get more diversification from investments in Japan than Canada.

  26. Stock Market Correlation Coefficient Mean (%) SD (%)  CN FR GM JP UK Canada (CN) .79 5.83 0.90 France (FR) 0.38 1.42 7.01 1.02 Germany (GM) 0.33 0.66 1.23 6.74 0.87 Japan (JP) 0.26 0.42 0.36 1.47 7.31 1.22 United Kingdom 0.58 0.54 0.49 0.42 1.52 5.41 0.90 United States 0.70 0.45 0.37 0.24 0.57 1.33 4.56 0.80 Summary Statistics for Monthly Returns 1980-1992 ($U.S.) .79% monthly return = 9.48% per year

  27. Stock Market Correlation Coefficient Mean (%) SD (%)  CN FR GM JP UK Canada (CN) .79 5.83 0.90 France (FR) 0.38 1.42 7.01 1.02 Germany (GM) 0.33 0.66 1.23 6.74 0.87 Japan (JP) 0.26 0.42 0.36 1.47 7.31 1.22 United Kingdom 0.58 0.54 0.49 0.42 1.52 5.41 0.90 United States 0.70 0.45 0.37 0.24 0.57 1.33 4.56 0.80 Summary Statistics for Monthly Returns 1980-1992 ($U.S.) • measures the sensitivity of the market to the world market. Clearly the Japanese market is more sensitive to the world market than is the U.S.

  28. Sharp Performance Measure Sharp performance measure (SHP) represents the excess return (above and beyond risk free interest rate) per standard deviation risk SHP = (¯Ri-Rf)/σi The optimal international portfolio can be solved by maximizing the Sharp ratio of the excess portfolio return to the standard deviation risk. Max SHPp = [¯Rp-Rf]/ σp

  29. The Optimal International Portfolio OIP Efficient set 1.53 JP UK US FR GM Rf CN 4.2%

  30. Composition of the OIP for a U.S. Investor

  31. OIP ODP Mean Return 1.53% 1.33% Standard Deviation 4.27% 4.56% Gains from International Diversification • For a U.S. investor, the risk-return tradeoff for the optimal international portfolio and optimal domestic portfolio are shown below and at right. return OIP 1.53% 1.33% ODP 4.27% 4.56% risk

  32. Effects of Changes in the Exchange Rate • The realized dollar return for a U.S. resident investing in a foreign market will depend not only on the return in the foreign market but also on the change in the exchange rate between the U.S. dollar and the foreign currency.

  33. Effects of Changes in the Exchange Rate • The realized dollar return for a U.S. resident investing in a foreign market is given by Where Riis the local currency return in the ith market eiis the rate of change in the exchange rate between the local currency and the dollar

  34. Effects of Changes in the Exchange Rate • For example, if a U.S. resident just sold shares in a British firm that had a 15% return (in pounds) during a period when the pound depreciated 5%, his dollar return is 9.25%:

  35. Effects of Changes in the Exchange Rate • The risk for a U.S. resident investing in a foreign market will depend not only on the risk in the foreign market but also on the risk in the exchange rate between the U.S. dollar and the foreign currency. The Var term represents the contribution of the cross-product term, Riei, to the risk of foreign investment.

  36. Effects of Changes in the Exchange Rate This equation demonstrates that exchange rate fluctuations contribute to the risk of foreign investment through three channels: • Its own volatility, Var(ei). • Its covariance with the local market returns Cov(Ri,ei). • The contribution of the cross-product term, Var.

  37. Why Home Bias in Portfolio Holdings? • Home bias refers to the extent to which portfolio investments are concentrated in domestic equities.

  38. Country Share in World Market Value Proportion of Domestic Equities in Portfolio France 2.6% 64.4% Germany 3.2% 75.4% Italy 1.9% 91.0% Japan 43.7% 86.7% Spain 1.1% 94.2% Sweden 0.8% 100.0% United Kingdom 10.3% 78.5% United States 36.4% 98.0% Total 100.0% The Home Bias in Equity Portfolios

  39. Why Home Bias in Portfolio Holdings? • Three explanations come to mind: • Domestic equities may provide a superior inflation hedge. • Home bias may reflect institutional and legal restrictions on foreign investment. • Extra taxes and transactions/information costs for foreign securities may give rise to home bias.

  40. Foreign Direct Investment • Global Trends in FDI • Why Do Firms Invest Overseas? • Cross-Border Acquisitions • Political Risk and FDI

  41. Global Trends in FDI • Foreign Direct Investment often involves the establishment of production facilities abroad. • Greenfield Investment • Involves building new facilities from the ground up. • Cross-Border Acquisition • Involves the purchase of existing business.

  42. Global Trends in FDI • Several developed nations are the sources of FDI outflows. • About 90% of total world-wide FDI comes from the developed world. • Both developing and developed nations are the recipient of inflows of FDI.

  43. Average Annual FDI (in Billions)

  44. Why Do Firms Invest Overseas? • Trade Barriers • Labour Market Imperfections • Intangible Assets • Vertical Integration • Product Life Cycle • Shareholder Diversification

  45. Trade Barriers • Government action leads to market imperfections. • Tariffs, quotas, and other restrictions on the free flow of goods, services and people. • Trade Barriers can also arise naturally due to high transportation costs, particularly for low value-to-weight goods.

  46. Labour Market Imperfections • Among all factor markets, the labor market is the least perfect. • Recall that the factors of production are land, labor, capital, and entrepreneurial ability. • If there exist restrictions on the flow of workers across borders, then labor services can be underpriced relative to productivity. • The restrictions may be immigration barriers or simply social preferences.

  47. Labour Market Imperfections Persistent wage differentials across countries exist. This is one on the main reasons MNCs are making substantial FDIs in less developed nations.

  48. Intangible Assets • Coca-Cola has a very valuable asset in its closely guarded “secret formula”. • To protect that proprietary information, Coca-Cola has chosen FDI over licensing. • Since intangible assets are difficult to package and sell to foreigners, MNCs often enjoy a comparative advantage with FDI.

  49. Vertical Integration • MNCs may undertake FDI in countries where inputs are available in order to secure the supply of inputs at a stable accounting price. • Vertical integration may be backward or forward: • Backward: e.g. a furniture maker buying a logging company. • Forward: e.g. a U.S. auto maker buying a Japanese auto dealership.

  50. Product Life Cycle • U.S. firms develop new products in the developed world for the domestic market, and then markets expand overseas. • FDI takes place when product maturity hits and cost becomes an increasingly important consideration for the MNC.

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