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INTERNATIONAL FINANCIAL MANAGEMENT

Thus far we have talked principally about doing business at home. But many companies have substantial overseas interests. Of course the objectives of international financial management are still the same. You want to buy assets that are worth more than they cost, and you want to pay for them by issuing liabilities that are worth less than the money raised. But when you try to apply these criteria to an international business, you come up against some new wrinkles.

You must, for example, know how to deal with more than one currency. Therefore we open this material with a look at foreign exchange markets.

The financial manager must also remember that interest rates differ from country to country. For example, in late 1999 the short-term rate of interest was about .1 percent in Japan, 6 percent in the United States, and 3 percent in the euro countries. We will discuss the reasons for these differences in interest rates, along with some of the implications for financing overseas operations.

Exchange rate fluctuations can knock companies off course and transform black ink into red. We will therefore discuss how firms can protect themselves against exchange risks.

We will also discuss how international companies decide on capital investments. How do they choose the discount rate? You`ll find that the basic principles of capital budgeting are the same as for domestic projects, but there are a few pitfalls to watch for. After studying this material you should be able to

_ Understand the difference between spot and forward exchange rates.

_ Understand the basic relationships between spot exchange rates, forward exchange rates, interest rates, and inflation rates.

_ Formulate simple strategies to protect the firm against exchange rate risk.

_ Perform an NPV analysis for projects with cash flows in foreign currencies.

Foreign Exchange Markets

An American company that imports goods from Switzerland may need to exchange its dollars for Swiss francs in order to pay for its purchases. An American company exporting to Switzerland may receive Swiss francs, which it sells in exchange for dollars. Both firms must make use of the foreign exchange market, where currencies are traded.

The foreign exchange market has no central marketplace. All business is conducted by computer and telephone. The principal dealers are the large commercial banks, and any corporation that wants to buy or sell currency usually does so through a commercial bank.

Turnover in the foreign exchange markets is huge. In London alone about $640 billion of currency changes hands each day. That is equivalent to an annual turnover of $159 trillion ($159,000,000,000,000). New York and Tokyo together account for a further $500 billion of turnover per day. Compare this to trading volume of the New York Stock Exchange, where no more than $30 billion of stock might change hands on a typical day.

Suppose you ask someone the price of bread. He may tell you that you can buy two loaves for a dollar, or he may say that one loaf costs 50 cents. Similarly, if you ask a foreign exchange dealer to quote you a price for Ruritanian francs, she may tell you that you can buy two francs for a dollar or that one franc costs $.50. The first quote (the number of francs that you can buy for a dollar) is known as an indirect quote of the exchange rate. The second quote (the number of dollars that it costs to buy one franc) is known as a direct quote. Of course, both quotes provide the same information. If you can buy two francs for a dollar, then you can easily calculate that the cost of one franc is 1/2.0 = $.50.

Now look at Table 6.5, which has been adapted from the daily table of exchange rates in the London Financial Times. The first column of figures in the table shows the exchange rate for a number of countries on October 6, 1999. By custom, the prices of most currencies are expressed as indirect quotes. Thus you can see that you could buy 9.438 Mexican pesos for one dollar. However, to make things confusing, the price of the euro and the British pound are generally expressed as direct quotes. So Table 6.5 shows that it cost $1.0707 to buy one euro ( 1).

EXCHANGE RATE Amount of one currency needed to purchase one unit of another.