Copyright 2022 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-300 INTERNATIONAL financial management Copyright 2022 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-300 Copyright 2022 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-300 Copyright 2022 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-300 International Financial Management © 2022 Cengage Learning Australia Pty Limited 2nd Edition Jeff Madura Copyright Notice Ariful Hoque This Work is copyright. No part of this Work may be reproduced, stored in a Chandrasekhar Krishnamurti retrieval system, or transmitted in any form or by any means without prior written permission of the Publisher. 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For permission to use material from this text or product, please email [email protected] Adapted from International Financial Management, 13th edition by Jeff Madura [9781337099738], published by Cengage © 2018 National Library of Australia Cataloguing-in-Publication Data ISBN: 9780170449014 This 2nd edition published in 2022 A catalogue record for this book is available from the National Library of Australia. Cengage Learning Australia Level 7, 80 Dorcas Street South Melbourne, Victoria Australia 3205 Cengage Learning New Zealand Unit 4B Rosedale Office Park 331 Rosedale Road, Albany, North Shore 0632, NZ For learning solutions, visit cengage.com.au Printed in Singapore by 1010 Printing International Limited. 1 2 3 4 5 6 7 26 25 24 23 22 Copyright 2022 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-300 BRIEF CONTENTS PART 1 THE INTERNATIONAL FINANCIAL ENVIRONMENT 1 1 Multinational financial management: An overview 2 2 International flow of funds 40 3 International financial markets 81 4 Exchange rate systems and central bank intervention 112 PART 2 EXCHANGE RATE BEHAVIOUR 158 5 Exchange rate determination 159 6 Relationships among inflation, interest rates and exchange rates 193 7 International arbitrage and interest rate parity 222 8 Forecasting exchange rates 260 MIDTERM SELF-EXAM 294 PART 3 EXCHANGE RATE RISK MANAGEMENT 302 9 Currency derivatives 303 10 Currency and interest rate swaps 358 11 Measuring exposure to exchange rate fluctuations 378 12 Managing transaction exposure 412 13 Managing economic exposure and translation exposure 456 PART 4 MANAGEMENT OF LONG-TERM INTERNATIONAL INVESTMENTS AND FINANCING 480 14 Foreign direct investment 481 15 Multinational capital budgeting 525 16 Country risk analysis and international corporate governance 568 17 International equity markets 606 18 International debt markets 637 PART 5 INTERNATIONAL BANKING AND TRADE FINANCING 662 19 International banking 663 20 Trade financing and facilitation 700 FINAL SELF-EXAM 726 v Copyright 2022 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-300 CONTENTS Guidetothetext xiv 1.4e HowuncertaintyaffectstheMNC’s Guidetotheonlineresources xvii costofcapital 22 Preface xviii LO1.5 Theglobalfinancialcrisis 23 Abouttheauthors xxi 1.5a FundamentalcauseoftheGFC 23 Acknowledgements xxii 1.5b Foreignexchangemarkets 24 1.5c MNCcurrencyriskmanagement 24 PART 1 LO1.6 TheimpactofCOVID-19onmultinational companies 25 THE INTERNATIONAL FINANCIAL ENVIRONMENT 1 LO1.7 Organisationofthetext 27 Termpaperontheinternationalcreditcrisis 39 1 MULTINATIONAL FINANCIAL 2 INTERNATIONAL FLOW OF FUNDS 40 MANAGEMENT: AN OVERVIEW 2 LO2.1 Balanceofpayments 41 LO1.1 ManagingtheMNC 3 2.1a Australia’sbalanceofpayments 41 1.1a Howbusinessdisciplinesareusedto 2.1b Currentaccount 43 managetheMNC 3 2.1c Capitalaccount 45 1.1b Agencyproblems 4 2.1d Financialaccount 46 1.1c ManagementstructureofanMNC 6 LO2.2 Growthininternationaltrade 47 LO1.2 Whycompaniespursueinternational 2.2a Eventsthatincreasedtradevolume 47 business 7 2.2b Impactofoutsourcingontrade 49 1.2a Theoryofcomparativeadvantage 7 2.2c Tradevolumeamongcountries 51 1.2b Imperfectmarketstheory 8 2.2d TrendinAustralianbalanceoftrade 52 1.2c Productcycletheory 8 LO2.3 Factorsaffectinginternational LO1.3 Howcompaniesengageininternational tradeflows 57 business 9 2.3a Costoflabour 58 1.3a Internationaltrade 9 2.3b Inflation 59 1.3b Licensing 10 2.3c Nationalincome 59 1.3c Franchising 10 2.3d Creditconditions 59 1.3d Jointventures 10 2.3e Governmentpolicies 60 1.3e Acquisitionsofexistingoperations 11 2.3f Exchangerates 66 1.3f Establishmentofnewforeignsubsidiaries 11 1.3g Summaryofmethods 11 LO2.4 Internationalcapitalflows 70 2.4a Factorsaffectingforeigndirectinvestment 71 LO1.4 ValuationmodelforanMNC 13 2.4b Factorsaffectinginternationalportfolio 1.4a Domesticmodel 13 investment 72 1.4b Multinationalmodel 14 1.4c UncertaintysurroundinganMNC’s LO2.5 Agenciesthatfacilitateinternationalflows 72 cashflows 17 2.5a InternationalMonetaryFund 73 1.4d Summaryofinternationaleffects 21 2.5b WorldBank 74 vi Copyright 2022 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-300 CONTENTS 2.5c WorldTradeOrganization 74 4.2f Impactonacountrythatabandons 2.5d InternationalFinancialCorporation 75 theeuro 131 2.5e InternationalDevelopmentAssociation 75 4.2g Impactofabandoningtheeuroon 2.5f BankforInternationalSettlements 75 eurozoneconditions 131 2.5g OECD 75 LO4.3 ReserveBankofAustraliaintervention 133 2.5h Regionaldevelopmentagencies 75 4.3a ReasonsforRBAintervention 133 4.3b Directintervention 135 3 INTERNATIONAL FINANCIAL 4.3c Indirectintervention 138 MARKETS 81 LO4.4 Interventionasapolicytool 140 LO3.1 Foreignexchangemarket 82 4.4a Influenceofaweakhomecurrency 140 3.1a Historyofforeignexchange 82 4.4b Influenceofastronghomecurrency 141 3.1b Foreignexchangetransactions 83 APPENDIX 4: GOVERNMENT 3.1c Foreignexchangequotations 86 INTERVENTION DURING THE 3.1d Interpretingforeignexchangequotations 89 ASIAN CRISIS 148 LO3.2 Forwardmarket 95 PART1INTEGRATIVEPROBLEM:THE 3.2a HowMNCsuseforwardcontracts 96 INTERNATIONALFINANCIALENVIRONMENT 157 3.2b Bankquotationsonforwardrates 97 3.2c Premiumordiscountontheforwardrate 97 PART 2 3.2d Movementsintheforwardrateovertime 99 3.2e Offsettingaforwardcontract 99 EXCHANGE RATE BEHAVIOUR 158 3.2f Usingforwardcontractsforswap transactions 100 5 EXCHANGE RATE DETERMINATION 159 3.2g Non-deliverableforwardcontracts 100 LO5.1 Measuringexchangeratemovements 160 LO3.3 Internationalmoneymarket 102 3.3a Originsanddevelopment 102 LO5.2 Exchangerateequilibrium 161 3.3b Moneymarketinterestratesamong 5.2a Demandforacurrency 162 currencies 104 5.2b Supplyofacurrencyforsale 163 5.2c Equilibrium 163 4 EXCHANGE RATE SYSTEMS AND 5.2d Changeintheequilibriumexchangerate 164 CENTRAL BANK INTERVENTION 112 LO5.3 Factorsthatinfluenceexchangerates 166 5.3a Relativeinflationrates 166 LO4.1 Exchangeratesystems 113 5.3b Relativeinterestrates 167 4.1a Fixedexchangeratesystem 113 5.3c Relativeincomelevels 169 4.1b Freelyfloatingexchangeratesystem 115 5.3d Governmentcontrols 170 4.1c Managedfloatexchangeratesystem 116 5.3e Expectations 170 4.1d Peggedexchangeratesystem 118 5.3f Interactionoffactors 172 4.1e Dollarisation 123 5.3g Influenceoffactorsacrossmultiple 4.1f Australia’sexchangeratesystem 124 currencymarkets 173 LO4.2 AsingleEuropeancurrency 127 5.3h Impactofliquidityonexchangerate 4.2a Monetarypolicyintheeurozone 127 adjustment 174 4.2b Impactoncompaniesintheeurozone 127 LO5.4 Movementsincrossexchangerates 175 4.2c Impactonfinancialflowsintheeurozone 128 5.4a Explainingmovementsincross 4.2d Exposureofcountrieswithintheeurozone 128 exchangerates 176 4.2e Impactofcriseswithintheeurozone 128 vii Copyright 2022 Cengage Learning. 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WCN 02-300 CONTENTS LO5.5 Capitalisingonexpectedexchangerate 7.1c ArbitragestrategyforfiveAsian movements 176 tiger-denominatedcurrencies 229 5.5a Institutionalspeculationbasedon 7.1d Coveredinterestarbitrage 230 expectedappreciation 176 7.1e Comparisonofarbitrageeffects 234 5.5b Institutionalspeculationbasedon LO7.2 Interestrateparity(IRP) 236 expecteddepreciation 178 7.2a Derivationofinterestrateparity 236 5.5c Speculationbyindividuals 179 7.2b Determiningtheforwardpremium 237 5.5d The‘carrytrade’ 180 7.2c Graphicanalysisofinterestrateparity 239 LO5.6 WhywastheAustraliandollarfloated? 183 7.2d Howtotestwhetherinterestrate parityholds 241 6 RELATIONSHIPS AMONG 7.2e Interpretationofinterestrateparity 241 INFLATION, INTEREST RATES 7.2f Doesinterestrateparityhold? 242 AND EXCHANGE RATES 193 7.2g Considerationswhenassessinginterest rateparity 242 LO6.1 Purchasingpowerparity(PPP) 194 LO7.3 Variationinforwardpremiums 243 6.1a Interpretationsofpurchasingpowerparity 194 7.3a Forwardpremiumsacrossmaturities 244 6.1b RationalebehindrelativePPPtheory 195 7.3b Changesinforwardpremiumsovertime 244 6.1c Derivationofpurchasingpowerparity 195 6.1d UsingPPPtoestimateexchangerate LO7.4 ComparisonoftheIRP,PPPandIFE 247 effects 196 8 FORECASTING EXCHANGE RATES 260 6.1e Graphicanalysisofpurchasingpower parity 198 LO8.1 Whycompaniesforecastexchangerates 261 6.1f Testingthepurchasingpowerparity theory 200 LO8.2 Forecastingtechniques 263 6.1g Whypurchasingpowerparitydoes 8.2a Technicalforecasting 263 nothold 202 8.2b Fundamentalforecasting 264 LO6.2 InternationalFishereffect(IFE) 204 8.2c Market-basedforecasting 269 8.2d Mixedforecasting 272 6.2a Fishereffect 204 6.2b UsingtheIFEtopredictexchangerate 8.2e Guidelinesforimplementingaforecast 273 movements 205 LO8.3 Forecasterror 274 6.2c ImplicationsoftheinternationalFisher 8.3a Measurementofforecasterror 274 effect 206 8.3b Forecasterrorsamongtimehorizons 275 6.2d DerivationoftheinternationalFisher 8.3c Forecasterrorsovertimeperiods 275 effect 208 8.3d Forecasterrorsamongcurrencies 275 6.2e Graphicalanalysisoftheinternational 8.3e Forecastbias 276 Fishereffect 210 8.3f Comparisonofforecastingmethods 279 LO6.3 TestsoftheinternationalFishereffect 212 8.3g Forecastingundermarketefficiency 280 6.3a LimitationsoftheIFE 213 LO8.4 Usingintervalforecasts 281 6.3b IFEtheoryversusreality 214 8.4a Methodsofforecastingexchangerate volatility 281 7 INTERNATIONAL ARBITRAGE AND PART2INTEGRATIVEPROBLEM:EXCHANGERATE INTEREST RATE PARITY 222 BEHAVIOUR 293 LO7.1 Internationalarbitrage 223 MIDTERM SELF-EXAM 294 7.1a Locationalarbitrage 223 7.1b Triangulararbitrage 226 viii Copyright 2022 Cengage Learning. 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WCN 02-300 CONTENTS PART 3 10 CURRENCY AND INTEREST EXCHANGE RATE RISK RATE SWAPS 358 MANAGEMENT 302 LO10.1 Currencyswaps 359 LO10.2 Financingtomatchtheinflowcurrency 359 9 CURRENCY DERIVATIVES 303 10.2a Usingcurrencyswapstoexecutethe LO9.1 Currencyfuturesmarket 304 matchingstrategy 361 9.1a Contractspecifications 304 10.2b Usingparallelloanstoexecutethe matchingstrategy 362 9.1b Tradingcurrencyfutures 305 9.1c Comparingfuturestoforwardcontracts 306 LO10.3 Interestrateswaps 365 9.1d Creditriskofcurrencyfuturescontracts 307 LO10.4 Fixed-versus-floating-ratedebt 9.1e Howcompaniesusecurrencyfutures 308 decision 366 9.1f Speculationwithcurrencyfutures 310 10.4a Financingcostsof LO9.2 Currencyoptionsmarket 311 fixed-versus-floating-rateloans 367 9.2a Optionexchanges 311 LO10.5 Hedginginterestpaymentswith 9.2b Over-the-countermarket 312 interestrateswaps 367 LO9.3 Currencycalloptions 312 10.5a Limitationsofinterestrateswaps 370 9.3a Factorsaffectingcurrencycalloption 10.5b Othertypesofinterestrateswaps 370 premiums 313 10.5c Standardisationoftheswapmarket 370 9.3b Howcompaniesusecurrencycall options 313 11 MEASURING EXPOSURE TO 9.3c Speculatingwithcurrencycalloptions 315 EXCHANGE RATE FLUCTUATIONS 378 LO9.4 Currencyputoptions 318 LO11.1 Relevanceofexchangeraterisk 379 9.4a Factorsaffectingcurrencyputoption 11.1a Theinvestorhedgeargument 379 premiums 318 11.1b Currencydiversificationargument 379 9.4b Hedgingwithcurrencyputoptions 318 11.1c Stakeholderdiversificationargument 379 9.4c Speculatingwithcurrencyputoptions 319 11.1d ResponsefromMNCs 380 9.4d Contingencygraphforthepurchaser ofacalloption 321 LO11.2 Transactionexposure 380 9.4e Contingencygraphforthesellerofacall 11.2a Estimating‘net’cashflowsineach option 322 currency 381 9.4f Contingencygraphforthebuyerofaput 11.2b ExposureofanMNC’sportfolio 382 option 323 11.2c Transactionexposurebasedon 9.4g Contingencygraphforthesellerofaput value-at-risk 386 option 323 LO11.3 Economicexposure 391 9.4h Conditionalcurrencyoptions 323 11.3a Exposuretolocalcurrencyappreciation 392 9.4i Asia-Pacificexample:Usingcurrency 11.3b Exposuretolocalcurrencydepreciation 393 optionstohedgeagainstcurrencyprice 11.3c Economicexposureofdomestic movements 325 companies 393 APPENDIX 9A: CURRENCY OPTION 11.3d Measuringeconomicexposure 394 PRICING 338 LO11.4 Translationexposure 397 APPENDIX 9B: CURRENCY OPTION 11.4a Determinantsoftranslationexposure 397 COMBINATIONS 342 11.4b ExposureofanMNC’sstockpriceto translationeffects 399 ix Copyright 2022 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-300