Pike Robert, Neal Bill. Corporate finance and investment: decisions and strategy

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Chapter 21 Managing currency risk 625

Further reading

Extensive treatments of foreign exchange exposure and ways of hedging risks can be found in a

variety of textbooks on international finance: for example, McRae (1996), Buckley (2004),

Shapiro (2002) and Eiteman et al. (2003). For detailed treatments of the mechanics of the var-

ious markets for hedging instruments, see Andersen (1987) and Price and Henderson (1988). For

the underlying economic theory of the operation of currency and other markets, see Prindl

(1978) and Kindleberger (1978).

Articles by Rodriguez (1981), Collier and Davies (1985) and Belk and Glaum (1990) report on the

currency management practices of US and UK multinational companies. Giddy (1994) contains

several excellent chapters on the use of derivatives in managing foreign exchange exposure.

Madura (2005) is highly readable on all these issues.

CFAI_C21.QXD 3/15/07 7:47 AM Page 625

Questions with

coloured numbers have solutions in Appendix B on page 718.

1 The Local Bank plc quotes the following rates for the euro versus sterling:

(a) How many euros would a firm receive when selling

(b) How much sterling would it receive when selling

2 On 30 November, a UK exporter sells goods worth to a French importer on three months’ credit.

The customer is billed in euros, for which the spot rate versus sterling is vs. The three-month forward

rate is per

(a) What is the amount invoiced?

(b) If the spot rate is vs. at the settlement date, what is the exporter’s gain or loss, assuming it does

not hedge?

(d) If the exporter takes forward cover, what is the cost of the hedge

(i) compared to the current spot rate?

(ii) compared to case (b)?

(iii) compared to case (c)?

3 Work out the forward outrights from the exchange rates versus sterling given in the table below.

Country/Currency Closing market rates One-month forward rates

Euro 1.0 to 4.0 dis

Japan 61.0 to 50.0 prem

USA 22.6 to 20.6 prem

Source: Guardian, 10 November 2001.

4 A selected bundle of goods costs in the UK, and a similar bundle costs 1200 krona (DKR) in Denmark.

People generally expect the rate of inflation to be 5 per cent in the UK and 3 per cent in Denmark.

(a) Assuming that PPP applies, what is the current exchange between GBP and DKR?

(b) Assuming that PPP will continue to hold, what spot exchange rate would you predict for twelve months

hence?

5 The respective interest rates in the USA and the UK are 9 per cent and 10 per cent respectively in annual terms.

If the spot exchange rate is US$1.6000 to what is the forward rate if IRP applies?

6 Assume you are the treasurer of a multinational company based in Switzerland. Your company trades exten-

sively with the USA. You have just received US$1 million from a customer in the USA. As the company has

no immediate need of capital you decide to invest the money in either US$ or Swiss Francs for 12 months. The

following information is relevant:

■ The spot rate of exchange is CHF1.3125 to US$1.

■ The 12-month forward rate is CHF1.275 to US$1.

■ The interest rate on a 1-year Swiss Franc bond is per cent.

■ The interest rate on a 1-year US$ bond is per cent.

Assume investment in either currency is risk-free and ignore transaction costs.



£1,

£100

1.4571  1.4576

175.16  175.28

1.6296  1.6320

£1;1.5

£1;1.7

£1.;1.62

£1.;1.6

£10 million

;12 million?

£10 million?

1.6296  1.6320

QUESTIONS

626 Part VI International finance

CFAI_C21.QXD 3/15/07 7:47 AM Page 626

Required

Calculate the returns under both options (investing in US$ or Swiss Francs) and explain why there is so little

difference between the two figures.

Your answer may be expressed either in $US or in Swiss Francs.

(CIMA May 1998)

7 The following situation is observed in the money markets.

Sterling: US dollar exchange rates:

Spot $1.6550–1.6600

Forward (1 Year) $1.6300–1.6450

Interest rates (fixed): New York

London

(a) Calculate both the interest and the exchange agios.

(b) Using the figures provided, investigate whether an arbitrageur operating in London could profit from

covered interest arbitrage.

Notes:

(a) Assume he borrows

(b) You may ignore commission and transaction costs other than the spreads.

8 Europa plc is a UK-based import–export company. It is now 15 May and the following transaction has been

agreed:

The sale of pine furniture worth $1,250,000 to the USA receivable on 15 August.

FX rates

Spot 1.6480–1.6490

2 months forward 0.88–0.76c premium

3 months forward 1.30–1.24c premium

Three-month money market interest rates

$8%–6%

Required

(a) Hedge Europa’s risk exposure on the forward market.

(b) Hedge Europa’s risk exposure on the money market.

9 Slade plc is a medium-sized UK company with export and import trade links with US companies. The

following transactions are due within the next six months. Transactions will be in the currency specified.

Purchase of components, cash payment due in 3 months:

Sale of finished goods, cash receipt due in 3 months: $197,000

Purchase of finished goods for resale,

cash payment due in 6 months: $447,000

Sale of finished goods, cash receipt due in 6 months: $154,000

Exchange rates quoted on London market

Spot 1.4106–1.4140

3 months forward 0.82–0.77

6 months forward 1.39–1.34

Interest rates (annual)

3 months or 6 months Borrowing Lending

Sterling 7.5% 4.5%

Dollars 6.0% 3.0%

Continued

$>£

£116,000

£10%–8%

$>£

£100,000.



%–5



%–5



Chapter 21 Managing currency risk 627

CFAI_C21.QXD 3/15/07 7:47 AM Page 627

Required

Calculate the net sterling receipts which Slade might expect for both its three and six month transactions if

it hedges foreign exchange risk on:

(a) the forward foreign exchange market;

(b) the money market.

10 Exchange-traded foreign currency option prices in Philadelphia for dollar/sterling contracts are shown

below:

Sterling contracts

Calls Puts

Exercise price ($) December September December September

1.90 5.55 7.95 0.42 1.95

1.95 2.75 3.85 4.15 3.80

2.00 0.25 1.00 9.40 –

2.05 – 0.20 – –

Option prices are in cents per The current spot exchange rate is

Required

Assume that you work for a US company that has exported goods to the United Kingdom and is due to

receive a payment of in three months’ time. It is now the end of June.

Calculate and explain whether your company should hedge its sterling exposure on the foreign currency

option market if the company’s treasurer believes the spot rate in three months’ time will be:

(a)

(b) (ACCA)

11 Hogan plc exports computer components valued at 28 million Australian dollars (AUD) to Dundee

Proprietary in Australia on three months credit. The current spot exchange rate is A$2.80 vs. Because of

recent volatility in the foreign exchange markets, Hogan’s directors are worried that a fall in the AUD could

wipe out their profits on the deal. Three alternative hedging strategies have been suggested:

(i) using a forward market hedge

(ii) using a money market hedge

(iii) using an option hedge.

Hogan’s treasurer discovers the following information:

■ The three-month forward rate is A$2.805 vs.

■ Hogan could borrow in AUD at 9 per cent interest (annual rate), and deposit in London at 7 per cent.

■ A three-month American put option to sell A$28 million at an exercise rate of A$2.81 vs. could be pur-

chased at a premium of on the London OTC option market.

Required

Show how each hedge would operate, assuming the following spot rates apply in three months’ time:

(a) A$2.78 vs.

(b) A$2.82 vs.

£1.

£1

£200,000

£1

£1.

$2.0240–2.0260>£

$1.8950–1.8970>£

£1,625,000

$1.9405–$1.9425>£.£.

1£12,5002

628 Part VI International finance

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Chapter 21 Managing currency risk 629

Many companies experience accounting problems in recording overseas transactions and in translating foreign

currency values into their accounts. Select a company involved in international trade. Examine its report and

accounts to determine its policy with regard to foreign exchange, and the extent of foreign currency losses or

gains for the year concerned. Do you think these were ‘real money’ losses or gains, or merely accounting entries?

Practical assignment

CFAI_C21.QXD 3/15/07 7:47 AM Page 629

Foreign investment decisions

Learning objectives

This chapter focuses on foreign investment decisions by multinational corporations (MNCs). It will:

■ study the advantages of MNCs.

■ discuss different ways of entering foreign markets.

■ consider the complexities of foreign direct investment (FDI).

■ analyse the appraisal of foreign FDI.

■ consider the impact of foreign exchange variations on foreign projects.

■ analyse ways of insulating projects against foreign exchange risk.

■ study political and country risk, and how to cope with it.

Cut or Shut

In early 2001, Japanese motor firm Nissan, 37 per

cent owned by its French strategic partner, Renault,

was mulling over whether to locate its new Micra

assembly plant in Sunderland, UK, or at Renault’s

Flins plant, near Paris. In the 1990s, Nissan had spent

several hundred million pounds building the

Sunderland site into a world-class manufacturing

plant, reputedly the most efficient in Europe. A

European base to get behind the EU’s tariff wall, the

flexible working attitudes, low labour costs and less

onerous social welfare overheads made the UK an

attractive location.

By 2001, things had changed. Despite

Sunderland’s productivity advantage, Flins had

become a serious contender for the new plant due

to the 27 per cent appreciation of sterling against

European currencies. A Nissan executive claimed: ‘A

currency movement of 20 per cent or more cancels

out all the gross margin on a B-class (small) car’.

The sterling appreciation had already put paid to car

assembly at Dagenham (Ford) and at Luton

(Vauxhall), as well as scuppering Siemens’ semi-

conductor plant near Sunderland.

In the event, Sunderland won the day, but only

after management pledged a 30 per cent cut in costs

over three years. Meanwhile Nissan announced that

it would henceforth increase its components sourcing

in euros from 25 per cent to 65 per cent.

Four years later, in February 2005, Nissan

announced that it would invest £200 million at

Sunderland to build its new four-wheel drive compact

crossover car that was designed and developed in the

UK. Currency fears appeared to have receded –

sterling had fallen 9 per cent against the euro over

this period. But apart from this, Sunderland produc-

tion had become ‘exchange rate neutral’. Nissan had

achieved a balance between costs and revenue that

neutralised the impact of changes in the sterling/euro

rate. In large measure, this was achieved by requiring

UK suppliers to invoice in euros, thus shouldering the

foreign exchange risk (actually to their advantage

over this period).

CFAI_C22.QXD 3/15/07 7:07 AM Page 630

Chapter 22 Foreign investment decisions 631

22.1 INTRODUCTION

portfolio investment

Investment in financial securi-

ties such as bonds and equi-

ties, with no stake in

management

Foreign investment may be divided into portfolio and direct investment. Portfolio

investment involves the purchase of shares or loan stock in an overseas organisation,

usually without control over the running of the business. Foreign direct investment

(FDI) is a lasting interest in an enterprise in another economy where the investor’s pur-

pose is to have an effective voice in the management of the enterprise. Such direct

investment may arise from the acquisition of a controlling interest in an overseas busi-

ness or from setting up an overseas branch or subsidiary. Firms such as Nissan that

invest in foreign countries are examples of multinational corporations (MNCs).

■ The multinational corporation

A working definition of a multinational corporation is: a firm that owns production,

sales and other revenue-generating assets in a number of countries (although a wider

definition would include firms that simply sell home-produced goods overseas).

Foreign direct investment by MNCs includes establishment and acquisition of overseas

raw material and component operations, production plants and sales subsidiaries. This

occurs because of potentially greater cost-effectiveness and profitability in sourcing

inputs and servicing markets through a direct presence in a number of locations, rather

than relying solely on a single ‘home’ base and on imports and exports to support oper-

ations. A global firm is one that trades and invests abroad.

It is tempting to think of MNCs as Western firms that invest in developing countries.

Not so: about 70% per cent of cross-border investment occurs between developed coun-

tries. In 2003, the United Nations Conference on Trade and Development (UNCTAD)

(UNCTAD, 2004) estimated that direct investment flows to developing countries

amounted to $172 billion out of a global total of $560 billion. Moreover, acquisitions of

firms in developed countries by those in developing countries are not unknown. The

acquisition of the UK’s Tetley tea operation by the Tata Corporation of India was a recent

example (2001). In 2003, UNCTAD reported that the top 15 Indian software and related

service companies had all invested abroad, almost entirely in developed countries.

direct investment

Investment in tangible and

intangible assets for business

operating purposes

22.2 ADVANTAGES OF MNCS OVER NATIONAL FIRMS

The MNC may be in a position to enhance its competitive position and profitability in

four main ways:

1 It can take advantage of differences in country-specific circumstances. In a world

where countries are at different stages of economic evolution (some industrially

advanced, others mainly primary producers), certain advantages in a country may

have knock-on effects that the MNC can exploit on a global basis. For example, the

MNC may locate its R&D establishments in a technologically advanced country in

order to draw on local scientific and technological infrastructure and skills.

Similarly, it may locate its production plants in a less developed country in order to

take advantage of lower input costs, especially cheap labour. Alternatively, it may

continue to produce its outputs in its ‘home’ country, but seek to remain competi-

tive by sourcing key components from subsidiary plants based abroad.

Self-assessment activity 22.1

What is meant by a multinational corporation?

(Answer in Appendix A at the back of the book)

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632 Part VI International finance

2 MNCs can choose the appropriate mode of serving a particular market. For example,

exporting may provide an entry route into a low-price, commodity-type market, with

the MNC taking advantage of marginal pricing and the absence of set-up costs; licens-

ing may be an appropriate mode if market size is limited or market niches are being

targeted; direct investment in production and sales subsidiaries may be a more effec-

tive way of capturing a large market share where proximity to customers is important,

or where market access via exporting is limited by tariffs. These various routes enable

an MNC to pursue a complex global market servicing strategy. For example, Ford

makes petrol engines in its plant at Bridgend, Wales, and manual gearboxes in its

German factories, which are shipped (along with other parts) to Valencia in Spain for

assembly into Ford Focus cars. These are then exported to other European markets.

3 ‘Internalisation’ of the MNC’s operations by foreign direct investment provides a

unique opportunity for the firm to maximise its global profits by using transfer pric-

ing policies. The transfer price is ‘the price at which one affiliate in a group of com-

panies sells goods and services to another affiliated unit’ (Buckley, 2004). While a

national, vertically integrated firm needs to establish transfer prices for components

and finished products that are transferred between component and assembly plants,

and between assembly plants and sales subsidiaries, the greater scale of cross-frontier

transactions by MNCs makes these transfer prices more significant because of the

impact on relative profitability and tax charges in different locations.

4 An international network of production plants and sales subsidiaries enables an

MNC to protect component supplies. The Swedish/Swiss engineering conglomerate

Asea Brown Boveri (ABB) has built up a network of component-manufacturing sub-

sidiaries in the Baltic region, including the former Soviet bloc, in order to diversify

sources of supply. Networks also help in the simultaneous introduction of new prod-

ucts in several markets. This is important (where products have a relatively short life

cycle and/or patent protection) in order to maximise sales potential. Equally impor-

tantly, it spreads the risk of consumer rejection across a diversified portfolio of over-

seas markets, so that failure in one market may be offset (or perhaps more than

compensated by) rapid acceptance in another. Additionally, it enables the MNC to

develop a ‘global brand’ identity (e.g. Coca-Cola, Levis and McDonald’s) or to ‘cus-

tomise’ a product more effectively to suit local demand preferences.

22.3 FOREIGN MARKET ENTRY STRATEGIES

Firms enter foreign markets in pursuit of incremental profits and cash flows by exploit-

ing advantages over local producers and other MNCs. The two basic vehicles for for-

eign market entry are, first, via transactions, and second, via Foreign Direct Investment

(FDI). Each mode can be pursued in a number of ways. Figure 22.1 shows the spectrum

of entry modes arranged by degree of commitment.

At one extreme, exporting (one-off or ‘spot’ transactions) involves least commit-

ment, as it is relatively inexpensive and withdrawal is easy. At the other extreme,

establishing a fully-owned foreign operating subsidiary involves managing a range of

complex functions including production, marketing and distribution. This is relatively

expensive and requires substantial long-term commitment.

Exporting includes both indirect export of products from the home country via

independent agents or distributors, and direct export of products through the firm’s

own export division to foreign markets. With exporting, most value-adding activity

takes place in the home country, while FDI transfers many of these activities to the for-

eign location. Both exporting and FDI involve internalisation, i.e. retaining value-

adding activities within the firm (although to different degrees).

Licensing is often a halfway house that results in externalising most of these activ-

ities. It involves transferring to a licensee the right to use corporate assets, such as a

exporting

Sale of goods and services to a

foreign customer

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Chapter 22 Foreign investment decisions 633

TRANSACTIONS

DIRECT INVESTMENT

Joint

venture

Wholly owned

subsidiary

Marketing and

distribution only

Marketing and

sales only

Fully

integrated

Fully

integrated

VERSUS

Exporting:

Spot

transactions

Exporting:

with foreign

distributor/agent

Licensing

technology and

trademarks

FranchisingExporting:

Long-term

contracts

Figure 22.1

Alternative modes of

market entry

brand name, and often the sale of intermediate goods for the licensee to use in pro-

duction. Licensing enables a firm to gain rapid overseas market penetration when it

lacks the resources to set up overseas operations.

■ Choosing between entry modes: the determinants

The choice of entry mode hinges on several factors:

1 Whether the firm’s source of competitive advantage is based on location-specific

factors, e.g. low labour costs. If so, the firm is more likely to export. If managerial

skills are transferable to other locations, FDI is more likely.

2 Whether the product is tradable, and whether barriers to trade exist. If import

restrictions such as tariff barriers and government-imposed regulations make trade

infeasible, licensing or FDI becomes more likely.

3 Whether the firm possesses the required skills and resources to build and exploit

competitive advantage abroad. Marketing and distribution capabilities are essen-

tial for foreign operation, which argues in favour of appointing a distributor or

agent when these skills are lacking. If a wider range of manufacturing and/or

marketing skills is needed, the firm may license its product and/or technology to

a local operator.

In marketing-intensive industries, MNCs may offer their brands to local firms

by trademark licensing. Licensing involves assigning production and selling

rights to producers located in foreign locations in return for royalty payments. If

tighter control over operations is required, a joint venture with a local firm may

be set up.

4 Whether the resources are ‘appropriable’ – can the technology be stolen? In some

industries, technology can be closely guarded via patents, but in more service-

oriented activities such as computer software, ownership rights are far more diffi-

cult to enforce. In the former case, FDI involves less risk, while in the latter case,

exporting may be preferred. When licensing a foreign partner, the firm must con-

sider any potential damage to the reputation of its brand resulting from poor qual-

ity or service provided by a local operator.

Where a firm wants to exert close control over the use of its trademarks, tech-

nologies or trade secrets, franchising may be chosen as a way of licensing a fully-

packaged business system, as in the international fast food business.

5 What transactions costs are involved? These are the costs of negotiating, monitor-

ing and enforcing the terms of such agreements as compared with internationalisa-

tion via a fully-owned subsidiary. With low or no transactions costs, exporting

would usually be preferred.

patents

A legal device giving the holder

the exclusive right to exploit

the technology described

therein

franchising

Licensing out of a fully-

packaged business system,

including technology and supply

of materials, to an entrepre-

neur operating a separate

legally-constituted business

Source: Grant (2004), p. 425.

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634 Part VI International finance

■ Factors favouring foreign direct investment (FDI)

International expansion through FDI is an alternative to growth focused on the firm’s

domestic market. A firm may choose to expand horizontally on a global basis by

replicating its existing business operations in a number of countries, or via interna-

tional vertical integration, backwards by establishing raw material/components

sources and forwards into final production and distribution. Firms may also choose

product diversification to develop their international business interests. Firms may

expand internationally by greenfield (new ‘start-up’) investments in component and

manufacturing plants, etc.; takeover of, and merger with, established suppliers; or

forming joint ventures with overseas partners. In the case of foreign market servicing,

the MNC may also choose to complement direct investment with some exporting and

licensing.

FDI also provides opportunities for exploiting competitive advantages over rival

suppliers. A firm may possess advantages in the form of patented process technology,

know-how and skills, or a unique branded product that it can better exploit and pro-

tect by establishing overseas production or sales subsidiaries. A production facility in

an overseas market may enable a firm to reduce its distribution costs and keep it in

closer touch with local market conditions – customer tastes, competitors’ actions, etc.

Moreover, direct investment enables a firm to avoid government restrictions on mar-

ket access, such as tariffs and quotas, and the problems of currency variation. For

example, the growth of protectionism by the European Union and the rising value of

the yen were important factors behind increased Japanese investment in the EU, espe-

cially in the UK motor and electronics sectors.

Firms may benefit from grants and other subsidies by ‘host’ governments to

encourage inward investment. Much Japanese investment (e.g. Nissan’s plant near

Sunderland) was attracted into the UK by regional selective assistance. In the case of

sourcing, direct investment allows the MNC to take advantage of some countries’

lower labour costs or provides them with access to superior technological know-how,

thereby enhancing their international competitiveness.

Moreover, direct investment, by internalising input sourcing and market servicing

within one organisation, enables the MNC to avoid various transaction costs: the costs

of finding suppliers and distributors and negotiating contracts with them; and the

costs associated with imperfect market situations, such as monopoly surcharges

imposed by input suppliers, unreliable sources of supply and restrictions on access to

distribution channels. It also allows the MNC to take advantage of the internal trans-

fer of resources at prices that enable it to minimise its tax bill (‘transfer pricing’) or

practise price discrimination between markets.

Finally, for some products (e.g. flat glass, metal cans, cement), decentralised local

production rather than exporting is the only viable way an MNC can supply an over-

seas market because of the prohibitive costs of transporting a bulky product or one

which, for competitive reasons, has to be marketed at a low price.

22.4 THE INCREMENTAL HYPOTHESIS

Johanson and Wiedersheim-Paul (1975) observed that firms tend to progress through

several stages of foreign market servicing, typically beginning with exporting to obtain

a ‘bridgehead’ and eventually graduating to FDI. A major factor in the progression is

the relative cost of each servicing mode, which is a function of market size, or volume

of sales.

This thesis can be illustrated with a simple break-even diagram, using Buckley and

Casson’s (1981) model. Two possible entry modes, exporting and FDI, are displayed in

Figure 22.2.

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