05 May Your textbook and the unit lesson discuss the two versions of purchasing power parity (PPP). They are absolute PPP and relative PPP. If a domestic government entity released e
Your textbook and the unit lesson discuss the two versions of purchasing power parity (PPP). They are absolute PPP and relative PPP. If a domestic government entity released economic information that suggested that the purchasing power of money in the future will be less than previously expected, what would happen to the current exchange rate today? Will both absolute PPP and relative PPP hold, or will only one of them hold? Support your answer, and analyze the responses of your peers.
FIN 6302, Advanced Financial Management 1
Course Learning Outcomes for Unit VI Upon completion of this unit, students should be able to:
5. Propose international and ethical considerations to financial decision-making. 5.1 Appraise the impact of global financing. 5.2 Analyze international macroeconomic variables on financial decisions. 5.3 Interpret currency fluctuations on firm activity.
Course/Unit Learning Outcomes
5.1 Unit Lesson Chapter 18 Unit VI Case Study
5.2 Unit Lesson Chapter 18 Unit VI Case Study
5.3 Unit Lesson Chapter 18 Unit VI Case Study
Required Unit Resources Chapter 18: International Aspects of Financial Management
Unit Lesson Introduction There are thousands of multinational corporations in the world today. They operate globally; participate across national borders; and deal with suppliers, competitors, and customers. For these firms to be successful, they must ensure that their international financial management utilizes optimal corporate financial decisions, including investments, financing, and working capital management. In addition, international financial management must align with overall organizational goals and objectives. It is important for you to be able to apply this material to companies with international operations and be able to determine the effects that various factors and situations have on multinational companies. International firms are constantly and consistently engaged in international business activities. Examples of such activities include exporting, importing, and direct foreign investment. These business activities involve international flow of funds and trade. Factors such as cost of labor, inflation, national income, government policies, and exchange rates impact international flow of funds and trade (Madura, 2012). A great deal of time is spent operating in the foreign exchange market. Foreign Exchange Market If the world used only one currency, we would not need a foreign exchange market. There is no physical place where exchange takes place, but it is a market that averages about $4 trillion dollars a day. That is about 53 times what is exchanged on the New York Stock Exchange (Pure FX, 2011). The foreign exchange market is essentially an over-the-counter market, in which one currency is traded for another currency.
UNIT VI STUDY GUIDE
International Considerations in Finance
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The foreign exchange market serves as an intermediary between the individuals and the multinational corporations that trade internationally. To know the equivalent of one currency’s purchasing power versus another currency’s purchasing power, there must be an exchange rate that specifies the values of each currency. The exchange rate is basically the amount of currency in units that is required to purchase a unit of another currency. For instance, the exchange rate of the Japanese yen will determine how many dollars an individual who wants to stay at a Japanese hotel will need or how many dollars a U.S.-based company would need to purchase 500,000 yen in supplies. Cash, check, and debit and credit cards are no longer the only mediums of currency. The concept of digital currency has been introduced to the economy. Digital currency, also known as cryptocurrency, is a medium of exchange that may be used in foreign exchange and financial transactions. Bitcoin is an example of the currency of today and another means to purchase/exchange goods and services. The Spot Market The spot market is the most common type of foreign exchange transaction. In the spot market, there is immediate or almost immediate exchange of currency. This market needs to be contrasted with the forward market. In the forward market, the exchange of currencies occurs at a future agreed-upon price or what is called a forward rate. The major participants in the spot market include commercial banks, brokers, and customers of commercial and central banks. Exchange Rates
Exchange rate quotations for major currencies are listed in the Wall Street Journal and on online business and financial sections. These quotations reflect the ask prices for currencies at one specific time during the day. These quotations are examples of spot rates. When the value increases, it is called appreciation; depreciation is when the value decreases. Alternative terms are revaluation for appreciation and devaluation for depreciation. Devaluation is calculated as shown below.
Devaluation = New Exchange Rate – Old Exchange Rate / Old Exchange Rate The spot rates quotation can be direct or indirect. If a quotation represents the value of a foreign currency in home currency, then it is a direct quotation. If, on the other hand, a quotation represents the value of home currency in terms of foreign currency, it is an indirect quotation.
Online software showing currencies and cross rates with red and green colors indicating trends in the market (Nicolino, n.d.)
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Another way to think about it is that the indirect quotation is the reciprocal of the direct quotation, which, in equation form, is below.
Indirect Quotation = 1 / Direct Quotation A bank’s (or any institution participating in the foreign exchange market) bid quote is the buy quote of a foreign currency, and an ask price is the sell quote. All things being equal, the bid quote is less than the ask quote. That numerical difference creates the profit margin for the dealers of the currency, whether it be physical or over-the-counter. From the perspective of a multinational firm that is based in the United States, there are some important facts to note about the ask and bid rates.
The firm sells foreign currency at the bid rate to obtain dollars.
The firm buys at the ask rate to obtain dollars.
The firm receives one foreign currency but wants another foreign currency. It must first sell the received foreign currency at the bid rate and use these dollars to buy the other foreign currency at the ask rate.
Managing Currency Risk Exposure Multinational companies that operate in countries with lower labor costs have better competitive advantage than those in countries with higher labor costs. This is especially true in agricultural and manufacturing industries, which are more labor intensive. All things being equal, an increase in inflation in one country relative to other countries with which the country trades creates a decrease in the country’s current account. When there is higher inflation, residents, citizens, and corporations of the country will import goods and services, and exports will decrease. Current account is the measure of a country’s international trade in goods and services or unilateral transactions such as provision of income on financial assets. Other things being equal, the current account decreases if a country’s national income increases by a higher percentage than other countries with which the country trades. This is because as income levels rise, consumption of goods and services typically rise. Government policies affect a country’s economic growth, income level, and unemployment level. These factors influence which firms get a higher market share. In international transactions, each country’s currency is valued relative to other currencies by using exchange rates. As explained earlier, the exchange rate is basically the comparative price of two currencies. The Japanese yen price of one U.S. dollar or the Mexican peso price of one euro are examples of exchange rates. As a country’s currency rises in value relative to the currencies of other countries with which it trades, the current account decreases, assuming other things remain equal. The reason is that the higher strength of the currency makes exports more expensive to the importing countries, thereby causing a lower demand for goods and services. The International Monetary System The international monetary system is a set of policies, institutions, practices, regulations, and mechanisms that determine exchange rates (Shapiro, 2014). There are five mechanisms for determining exchange rates. These are free float, managed float, target-zone arrangement, fixed-rate system, and hybrid system. In a free float exchange rate system, there is no government intervention or restriction. Instead, the relative market values of currencies are determined by market forces. A floating exchange rate can correct international trade imbalances if there is a deficit in a country’s balance of trade; therefore, a deficit indicates that the country spends more funds on imports than it receives on exports. As the country imports, it exchanges (supplies) its currency in greater volume than its currency demands since the currency may devalue. This may then attract more foreign demands for the home country’s goods and services as the home country’s currency declines in value. It is important to note that free float might not correct international trade imbalances if there are other forces affecting international trade at the time.
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A managed float (or dirty float) is an exchange rate system whereby a central bank intervenes to reduce currency fluctuations. In a clean float exchange rate system, there is no central bank intervention, and if it causes a sudden change in a country’s currency value, this may negatively impact the export industries (if currency appreciates) or increase the inflation rate (if currency depreciates). In this case, a central bank’s intervention can help smooth exchange rate fluctuations. Target-zone arrangement is a system under which countries pledge to maintain a specific agreed-upon margin or fixed central exchange rate (Nasdaq, n.d.). In other words, the exchange rates among the target- zone can only fluctuate within a fixed band of values. Major European countries had this kind of agreement for their currencies, which eventually led to the euro being the main currency in that region. Fixed-rate system indicates that the government sets exchange rates. In a fixed exchange system, governments are committed to maintaining target exchange rates. Hence, each country’s central bank frequently buys and sells its currency in the foreign exchange market whenever its currency exchange rate deviates from an agreed-upon percentage range. Today, the international monetary system operates on a hybrid system, where there is central bank activity but also where market forces are allowed to function. Various currencies use one form or another of the aforementioned systems. Multinational firm managers must understand the differences between the various exchange rate systems because each system affects currency risks. Managing Risk A multinational corporation forecasts exchange rates for hedging, short-term investment, capital budgeting, earnings assessment, long-term financing, and other purposes. Below are some ways that it manages risk.
A firm may decide to hedge future payables and receivables in foreign currencies based on the forecasts of foreign currency values.
A company with extra cash available short-term may divide the money and deposit in several currencies based on forecasts of the currencies. If the multinational corporation does this well, then the deposits will yield high interest rates and strengthened value over the investment period.
In making international capital budgeting decisions, a corporation may take into account the future exchange rates of the countries’ currencies before making a commitment.
Forecasts of exchange rates are useful in making decisions of whether a foreign subsidiary should reinvest earnings or remit them to the parent corporation. Additionally, since subsidiaries’ financial statements are consolidated and translated into the parents’ financial statements, forecasts of exchange rates can aid in forecasting earnings.
In international bond issuance used to finance long-term projects, it may opt to denominate the bonds in foreign currencies.
The three types of risk exposure are translation exposure, transaction exposure, and operating (economic) exposure. While some of the components of each exposure can be clear-cut, other components are not, and the exposures’ components often overlap to some extent. Translation exposure occurs when the normal market fluctuations in currency impact financial statements that have multiple nation exposure. Transaction exposure is encountered when these same fluctuations have an effect on either monies received or monies paid in a foreign denomination. Operating or economic exposure occurs when currency fluctuations impact either the market value of the firm, cash flows, or the computation of future cash flows. Of the three, economic is the most challenging to account for and prepare for as a company is obviously never certain of what exchange rate shifts there will be in the future. Translation and transaction exposures can be hedged, whereas that is not the case for operating. Hedging means that the company takes positions on both sides of the transaction so that when it loses on one side, it gains on the other.
References Madura, J. (2012). Financial markets and institutions (10th ed.). Mason, OH: South-Western.
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Nasdaq. (n.d.). Glossary of stock market terms: Target zone arrangement. Retrieved from https://www.nasdaq.com/investing/glossary/t/target-zone-arrangement
Nicolino, E. (n.d.). Data table with financial information about currencies trading market (ID 49968254)
[Photograph]. Retrieved from https://www.dreamstime.com/stock-photo-data-table-financial- information-currencies-trading-market-complex-providing-forex-identified-image49968254
Pure FX. (2011). 10 fun facts about foreign exchange. Retrieved from https://www.purefx.co.uk/2011/12/10-
fun-facts-about-foreign-exchange/ Shapiro, A. C. (2014). Multinational financial management (10th ed.). Hoboken, NJ: Wiley.
Learning Activities (Nongraded) Nongraded Learning Activities are provided to aid students in their course of study. You do not have to submit them. If you have questions, contact your instructor for further guidance and information. Review key concepts from this unit by answering the questions in the following activity: Unit VI Check for Understanding (PDF version of Unit VI Check for Understanding).
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