Multinational Corporations and International Finance

Posted on Sep 6, 2024 in Economy

Multinational Corporations (MNCs)

A Multinational Corporation (MNC) has facilities and other assets in at least one country other than its home country. Such companies have offices and/or factories in different countries and usually have a centralized head office where they coordinate global management.

Very large multinationals have budgets that exceed those of many small countries. The 100 largest international companies comprise over 6 million employees outside their country of origin and generate $2,100 billion of turnover.

Note: MNCs are not only large companies, but also small and medium-sized companies like:

Juice producers
Window-builders
Water filter producers
Scientific skull producers

Management’s Goal

The primary goal of management is to increase shareholder wealth. This can be achieved through:

Expanding into new international markets
Benefiting both small and large companies

However, there are hurdles to achieving this goal, such as the agency problem and constraints to business.

Agency Problem

Three reasons for the agency problem are:

Distance from the headquarter
Different cultures
Sheer size of the company

Other factors contributing to the agency problem include:

Different sizes of the subsidiaries
Long-term performance focus (non-US) vs. short-term performance focus (US)
Varying tax systems
Wealth of the subsidiary vs. wealth of the company in total (shareholder’s interest)
Profit Centre and wealth of the company in total
Centralized vs. decentralized financial management

Theories of International Business: Product Cycle

As a firm matures, it may recognize additional opportunities outside its home country. The product cycle typically follows these stages:

Domestic Production for local demand
Export for foreign demand
Foreign production for international demand
Foreign production for foreign demand

The Balance of Payments

The balance of payments is “a statistical statement that systematically summarizes, for a specific time period, the economic transactions of an economy with the rest of the world.” (IMF official definition)

It measures all transactions between domestic and foreign residents over a specific period of time. Each transaction is recorded by double-entry bookkeeping rule.

The transactions are presented in two main groups:

Current account: Summarizes the flow of funds between one specified country and all other countries due to purchases of goods, services, the provision of income on financial assets, and unilateral current transfers.
Capital account: Summarizes the flow of funds resulting from the sale of assets between one specified country and all other countries.

Current Account

Export of goods
Import of goods
Merchandise trade balance (1-2)
Export of services
Import of services
Net royalties
Net investment income
Invisible balance (4-5+6+7)
Balance of goods and services (3+8)
Net foreign worker’s remittances
Net international aid
Unilateral transfers (10+11)
Current account balance (CA) (3+8+12)

Capital Account

Gross inward direct investment
Gross outward direct investment
Gross inward portfolio investment
Gross outward portfolio investment
Long-term capital account balance (14-15+16-17)
Short-term inward capital flows
Short-term outward capital flows
Short-term capital account balance (19-20)
Capital account balance (KA) (18+21)

Factors Affecting Current Account

Impact of Inflation (ceteris paribus): A relative increase in a country’s inflation rate (to other countries) will decrease its current account, as imports increase and exports decrease.

Impact of National Income: An increase in a country’s income level will decrease its current account, as imports increase. Greater wealth implies greater need for foreign goods.

Impact of Government Restrictions: Tariffs (taxes on imported goods) can reduce a country’s imports.

Impact of Exchange Rates:

An increase in the exchange rate (appreciation) suggests a decrease in the current account.
Exported goods would cost more for foreigners, decreasing exports.
Imported goods would cost less, increasing imports.
Assumes price-elastic goods (sensitive to price changes).

Correcting the Balance of Trade Deficit

A floating exchange rate system may correct a trade imbalance automatically since the trade imbalance will affect the demand and supply of the currencies involved.

However: A weak home currency may not necessarily improve a trade deficit because:

Foreign companies may lower their prices to maintain their competitiveness.
Some other currencies may weaken too – currency pegs.
Many trade transactions are prearranged and cannot be adjusted immediately = J-curve effect.
The impact of exchange rate movements on intracompany trade is limited. Intracompany trade is resistant to currency fluctuations (50% of all international trade). Firms purchase products that are produced by their subsidiaries.
International competition of depreciation.

Factors Affecting Capital Account

Privatization: Direct foreign investment (DFI) is stimulated by selling state-owned enterprises. (Examples: Poland, Hungary, Czech Republic, etc.)

Changes in Restrictions: The removal of government barriers can encourage DFI.

Potential Economic Growth: Countries with higher potential for economic growth are more attractive to foreign investors.

Tax Rates: Countries that impose relatively low tax rates on corporate earnings are more likely to attract DFI. (Example: Estonia).

Exchange Rates: Foreign investors may be attracted if the local currency is expected to strengthen (double profit: Profit from investment + profit from appreciation of the foreign currency).

Interest Rates: Money tends to flow to countries with high interest rates.

Investing and Financing in Foreign Markets

Investing in foreign markets: Consider economic conditions, exchange rate expectations, and international diversification.

Providing credit in foreign markets: Consider high foreign interest rates, exchange rate expectations, and international diversification portfolio.

Borrowing in foreign markets: Consider low foreign interest rates and exchange rate expectations.

Foreign Exchange Market

The foreign exchange market allows currencies to be exchanged to facilitate international trade or financial transactions.

The system for exchanging foreign currencies has evolved from the gold standard, to agreements on fixed exchange rates, to a floating rate system.

Foreign Exchange Transactions

Spot rate: The market for immediate exchange is known as the spot market.

Volume of exchanges linked to international trade and finance.
Five currencies comprise 90% of US exchange volume – JPY, Euro, GBP, CAD, CHF.
US banks’ opening exchange rates are based on prevailing rates of London banks.

Banks provide foreign exchange services for a fee:

A bank’s bid (buy) quote for a foreign currency will be less than its ask (sell) quote.
Bid/ask spread = (ask rate – bid rate) / ASKRATE.
Banks buy low and sell high to profit from the difference.

Forward Contracts

The forward market involves contracting today for the future purchase or sale of foreign currency.

A forward contract is an agreement made today to buy or sell a specific amount of a specific currency at a specific exchange rate at a specific time in the future.

Banks act as intermediaries.

Eurocurrency Market

Composition of market: Eurobanks (several large European banks) accept deposits and give loans in various currencies.
Primarily work with US dollars (earlier named Eurodollar market, changed to Eurocurrency market).
Eurocurrency deposits are typically short-term deposits (<1 year).

History:

MNCs deposited US$ (known as Eurodollars) at European banks.
Outgrowth of international banking needs and circumvention of US banking regulations.
USA limits foreign lending by US banks.
USA sets ceilings for interest rates of $ deposits.
Greater efficiency of Eurobanks (lower operating costs, fewer regulations, lower spreads).
Capital is available more quickly, with fewer formalities and fewer conditions.
Oil price crisis (petrodollars = dollar deposits related to the sale/purchase of oil).

Measuring Exchange Rate Movements

An exchange rate measures the value of one currency in units of another currency.

Appreciation: A stronger currency; an increase in currency value relative to another.

Depreciation: A weaker currency; a decrease in currency value (i.e., purchasing power) relative to another.

Exchange Rate Equilibrium

An exchange rate represents the price of a currency, which is determined by the demand for that currency relative to the supply for that currency.

Spot exchange rate: The price of a currency at a specific time, set by supply and demand for the currency.

Factors Influencing Exchange Rates

Relative Inflation Rates: Affects supply and demand for currency and impacts international trade.

Relative Interest Rates: It is useful to consider the real interest rate, which adjusts the nominal interest rate for inflation. A relatively high interest rate may actually reflect expectations of relatively high inflation, which may discourage foreign investment. Real interest rate = Nominal interest rate – Inflation rate.

Relative Income Levels (ceteris paribus): E.g., if British income rises relative to US income, the demand schedule for GBP remains the same, but the supply of GBP for sale for $ should rise (British buy more US goods), leading to GBP devaluation against the $.

Government Controls: Governments may influence the equilibrium exchange rate by:

Imposing foreign exchange barriers
Imposing foreign trade barriers
Intervening in the foreign exchange market
Affecting macro variables such as inflation, interest rates, and income levels

Reasons for Government Intervention

Smooth exchange rate movements
Establish implicit exchange rate boundaries
React to temporary disturbances

Expectations

Foreign exchange markets react to any news that may have a future effect.
News of a potential surge in U.S. inflation may cause currency traders to sell dollars.
Many institutional investors take currency positions based on anticipated interest rate movements in various countries.

Forward vs. Future Contracts

Forward Contracts:

A stated amount of a currency to be exchanged on a specific day at a specific rate.
Individually tailored contracts.

Future Contracts:

A stated amount of a currency to be exchanged on a specific day at a specific rate.
Standardized contracts.

Closing out a futures position:

Buyers can sell an identical contract (same settlement date) to eliminate the need for an additional transaction. Additional costs may include changes in the value of the futures contract.
Sellers can buy an identical contract.
Most currency futures contracts are closed out before the settlement date.

Currency Options

A currency option is another type of contract that can be purchased or sold by speculators and firms.

The standard options that are traded on an exchange through brokers are guaranteed but require margin maintenance.
U.S. option exchanges (e.g., Chicago Board Options Exchange) are regulated by the Securities and Exchange Commission.

A currency call option grants the holder the right to buy a specific currency at a specific price (called the exercise or strike price) within a specific period of time (USA) / at the end of the period (Europe).

If the contract is implemented:

A call option is in the money if the exchange rate > strike price.
A call option is at the money if the exchange rate = strike price.
A call option is out of the money if the exchange rate < strike price.

Buy call option:

Zero-sum game; expect currency to appreciate.
Exercise option if the price increases beyond the strike price.
Buy (low) at the strike price and sell (high) at the spot rate.

Sell (write) call option:

Expect currency to decline in value.
Obligated to sell a currency at a specified price.
Make money if the option is not exercised (received premium).

A currency put option grants the holder the right to sell a specific currency at a specific price (the strike price) within a specific period of time (USA) / at the end of the period (Europe).

A put option is:

In the money if the exchange rate < strike price.
At the money if the exchange rate = strike price.
Out of the money if the exchange rate > strike price.

Factors Affecting Put Option Premiums

Level of existing spot price (vs. strike price): Option price increases as the spot price falls (improves chances of selling currency at a high price).
Length of time before expiration date: The longer the time, the higher the premium (improves chances that the spot price will fall below the strike price).
Volatility of currency price: The higher the volatility, the higher the premium (improves chances that the spot price will fall below the strike price).

Hedging reduces risk exposure in receivables.

International Arbitrage

International arbitrage exploits mispricing between locations.

Locational arbitrage is possible when a bank’s buying price (bid price) is higher than another bank’s selling price (ask price) for the same currency.

Triangular arbitrage is possible when a cross-exchange rate quote differs from the rate calculated from spot rates. When the exchange rates of the currencies are not in equilibrium, triangular arbitrage will force them back into equilibrium.

Covered interest arbitrage is the process of capitalizing on the interest rate differential between two countries while covering for exchange rate risk. It tends to force a relationship between forward rate premiums and interest rate differentials.

Variables to consider:

Spot rate of foreign currency
Home interest rate
Foreign interest rate
Forward rate of foreign currency

Effects of Arbitrage:

Locational arbitrage ensures that quoted exchange rates are similar across banks in different locations.
Triangular arbitrage ensures that cross-exchange rates are set properly.
Covered interest arbitrage ensures that forward exchange rates are set properly.