Multinational Financial Management

Multinational Financial Management
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Course Introduction
The world has become more integrated with increased international trade between and among countries influencing consumption, production as well as investment patterns. However, nations are still sovereign, and there are unique circumstances that affect international finance. For instance market imperfections, political risks, the foreign exchange risk and opportunities the global economy. Globalization has also been characterized with increased privatization of previous sate run corporations in many countries. In any case, the 2008/ 2009 financial crisis highlighted the links among the world financial systems. Besides international trade the multinational corporations also contribute towards foreign direct investments, they improve productivity while also encouraging competition on a global scale.
Foreign Exchange Market
The foreign exchange market provides a platform for the exchange of one currency for another since currencies are convertible (Madura, 2012). The interbank market is the wholesale while the client market consists of the retailers. Non bank dealers, foreign exchange brokers’ international banks, central banks and customers of the international banks are the main participants in the foreign exchange market. The foreign exchange market mostly focuses on the spot rate quotation and the forward rate quotation. Another financial instrument in the FX market is the swap which allows parties to exchange cash flows/ securities based on cash or interest rates, and they facilitate interbank FX trading.
In order to facilitate the functioning of the FX market, commercial banks demand deposit accounts through correspondent banking relationships. It is through communication that the international commercial banks enhance FX transactions offering a platform as clearing houses. The bid-ask spread then influences the spot FX market, with the increase in foreign exchange rate volatility as well dealer competition have a direct impact on the exchange rate (Levi, 2009). At the same time, the extent to which people have access to information also influences the spot exchange rates.
Nonetheless, the spot market is dependent on the spot rate quotations, the spread, spot FX trading as well as the cross rates the spot quotations may take the form of direct quotation or the indirect quotation depending on the expression of a currency either as the U.S. dollar equivalent or the U.S. dollar in another currency. The spread is dependent on the ask price that a buyer is willing to pay, with the ask price that the dealer desires to sell (Eiteman, Stonehill, & Moffett, 2007). The spread then facilitates currency conversion with the speculator looking at the spread to make arbitrage profit. Overall, the cross bid-ask spread as well as triangular arbitrage in turn influence the spot exchange.
The important elements of the forward market include the forward rate quotations, the forward positions, cross exchange rates, swap transactions and forward premium. The forward contract gives a one the right to buy or sell an asset in the future at agreed prices, but there is no obligation. The aspect of differences in the interest rate is reflected in the forward premium/ discount. The long forward position is based on agreeing to buy the FX forward, while agreeing to sell the FX forward constitutes the short forward position. Like the spot rates, triangular arbitrage is useful to calculate the cross rates.
International Parity Conditions & Exchange Rate Determination
The main International Parity Conditions are the interest rate parity (IRP), purchasing power parity, and the international Fischer effect. The international parity conditions links exchange rates with the price levels and interest rates (Levi, 2009). The interest rate parity assumes that the arbitrage condition holds. If this assumption did not hold, then it would be possible for dealers and traders to make extra ordinary returns from the arbitrage opportunity. In reality the arbitrage conditions are not always present meaning that the interest rate parity holds true.
The forward premium represented as the interest rate differential then affects the interest rate parity. Interest rate parity exists when there is no arbitrage, and since the IRP assumes that there is a 360-day forward rate, this then is utilized in the exchange rate determination. The hedging currency risk shows the use of the forward market hedge in the international market. This depends on borrowing in one currency translating and then later on investing to reduce the risk of currency and transition risk exposure
Nonetheless, the transaction costs and the capital controls increase deviations from the IRP. The transaction costs exist when the interest rate for which an arbitrageur borrows is higher than what he is willing to lend, meaning there is a need to overcome the bid-ask spreads (Eun & Resnick, 2010). On the other hand, capital controls exists because of government restrictions imposed on the import or export of money.
The purchasing power parity (PPP), assumes that the exchange rate of currencies is equated to the ratio price levels in the two countries (Madura, 2012). However, since inflation rates differ, and the relative PPP shows that changes in the exchange rate is equivalent to the differences in inflation rates. The increase in the inflation rate is associated with a proportionate increase in the interest rate and vice versa. In reality tariffs, import taxes and a country’s GDP influence purchasing power, but the PPP still an important benchmark of the exchange rate.
The demand and supply of a currency as well as the action of exporters, importers, speculators and foreign investors influence the exchange rate. At times, governments can intervene to influence the exchange rate, while exchange arte agreements are typically flexible based on market forces. The exchange rate systems can be fixed and pegged on other currencies. The demand of a currency cause appreciation making imports cheaper, but exports expensive and vice versa.
Foreign Currency Derivatives
Foreign currency derivatives include options, currency futures and forwards. The foreign currency derivatives are similar to other derivatives instruments. For instance, the futures contact is similar to the forward contract, where a currency is exchanged for another in future at a specified date and price. However, futures are standardized contacts that are resettled on a daily basis through a clearing house, and this depends on the contract size, delivery month and daily resettlement. In the US the main currency futures market is the Chicago Mercantile Exchange (CME), while the open interest represents the contracts outstanding in a month, and this helps to determine the demand for contracts (Eun & Resnick, 2010). The options give the right to buy or sell without imposing an obligation on the parties. The American option gives one the right to exercise during the option’s life unlike the European option that may allow one to exercise on the expiration date. The American option has more worth since it allows parties to exercise early unlike the European options.
Management of Transaction Exposure
Transaction exposure results from contractual cash flows denominated in a foreign currency, meaning that unexpected changes in the exchange rate result to the exposure. However, the transaction exposure is typically short-term compared to economic exposure. It is advisable for firms to hedge because of market imperfections, whereby default costs may occur, if there is information asymmetry and differential transaction costs. Taxes can also cause market imperfection, highlighting the benefit of hedging a corporation’s tax obligations when the effect on transitions has a more profound effect on earnings. The forward, options and swaps are the most used hedging techniques by US corporations, and firms with bigger international oper...