Management of International Business Finance - Essay Example

Management of International Business Finance Question 1) Explain with an example what is meant by the Purchasing Power Parity In the article about Purchasing Power Parity from “Encyclopedia of World Trade Since 1450” (J. Peter Neary, 2004) we are given the following details regarding PPP: the concept of Purchasing Power Parity – or PPP – defines the idea that with the same amount of a unit of purchasing (one dollar or one euro), it should be possible to pay for a same quantity of goods or for the same service all around the world. PPP is an important notion in international economics for 3 major reasons. Thanks to PPP we can have a particularly simple theory of exchange rate determinations i.e. we can conclude that as long as the relative price of two currencies is flexible, it will then adjust to equal the ratio of their price level. Even if this type of adjustment does not take place, the ratio of price levels can give us a reference point from which we can assess if a current exchange rate is under or over evaluated in relation to its PPP level. Even though PPP does not occur in practice, it is very useful as some derivations of it can give us strong grounds for comparing real income internationally or interregionaly . The OECD gives us a simple example to understand how the PPP is calculated and how these results can be used. (OECD, Purchasing Power Parities (PPP), 2006) For the OECD the simplest way to calculate PPP is to take into consideration a same product within two countries. It uses a liter of Coca-Cola to illustrate the example. In France, one liter is worth 2.3 euros where in the United States the same liter costs 2 dollars. Therefore the PPP (calculated as a ratio) is 2.3/2 which equals 1.15. The result can be interpreted as follows: for every dollar which is spent in the United States to purchase a liter of Coca-Cola, in France, it is necessary to spend 1.15 euros to receive the same quantity and quality of Coca-Cola. As the OECD points out, the PPPs are not only calculated for individual products but also for group of products. One of the most famous PPP index is the Big Mac PPP. Used as a vulgarization for a greater part of the population to understand the issues regarding PPP, it represents the exchange rate that would leave a burger in any country costing the same in America. (See Appendix 1) (The Economist “Food for Thought” May 27th, 2004.) 2) Discuss the validity of PPP in the long run Many economists have tried to tackle the issue of PPP in the long run. Unfortunately the findings of many of them lead to the conclusion that the PPP should not hold in a long term period. The most important and certainly the best known research made on the failure of PPP in the long run is the “Balassa-Samuelson” effect, work of Balassa (1964) and Samuelson (1964) The effect states that if high-income countries hold a more important relative productivity advantage in the production of traded goods, they will consequently produce these goods more cheaply. Starting from the hypothesis that the law of one price – abstracting from complicating factors such as transportation costs, taxes, and tariffs, the law of one price states that the price of any particular good that is traded on world markets will be the same price in every country engaged in trade, once all the currencies have been expressed through a unique currency after application of the exchange rates –can be applied to traded goods, it would result in the equalization of the nominal prices internationally. This would mean that the relative price of non-traded goods would be lower in low-income countries which would result in a systematic deviation from the PPP in the long run. As we stated earlier, the “Balassa-Samuelson effect” is one explanation of long term deviations of the PPP among many. The “Dutch disease” for example, puts forward the situation where an unpredicted increase in productivity in an export sector – which can be explained by a rapid development of natural resources – would cause a real exchange rate appreciation and as a consequence, would create a loss of competitiveness for the non-booming sectors. (Neary, 2004) These theories regarding the deviation of the PPP in the long run were not really a revolution in the idea that the PPP would not hold in the long run. Gustav Cassel in 1918 (“Abnormal derivations in International exchanges”) studied the derivations of the PPP, but the main difference in his findings was that the deviation would be minor (Papell & Prodan, “Long Run Purchasing Parity: Cassel or Balassa-Samuelson?” 2003.) Cassel identifies three different groups of disturbances: actual and expected inflation or deflation, new hindrances to trade and shifts in international movements of capital. However, to Cassel’s opinion and economic judgment, even if the disturbances are recognized, their quantitative effect on deviations from PPP is seen as confined within rather narrow limits. When trying to tackle the issue of the validity of PPP in the long run, these two ways of approaching the issue are often confronted in order to find an adequate justification. What should be noted, even though Cassel’s theory does not stand when faced against empirical studies, the “Balassa- Samuelson effect” have found many opponent through the years and many studies have shown the limitations of the theory such as that deviations of the PPP do not reflect differences in the relative prices of non-tradables. If we continue with the example of the Big Mac Index, the date proves that there is a deviation in the long run of the relative PPP – the relative PPP states that changes in price levels will be related to changes in exchange rates. “[…] relative PPP held for the Hungarian forint and Irish punt relative to the dollar. For all other currencies, even over a longer period, relative PPP fails to hold. Furthermore, for many countries, contrary to what theory predicts, the exchange rate changes and the inflation differentials moved in opposite directions.” (Michael R. Pakko and Patricia S. Pollard “For Here or to Go? Purchasing Power Parity and the Big Mac” Federal Bank of Saint Louis. Review. 1996) Question 2 a) Examine the nature of your company’s foreign exchange and discuss the differences between this type of risk and other types of foreign exchange risk. The main issue for Zack Plc in this very transaction is the risk to lose some profit due to the exchange rate volatility and therefore the consequence could be that the deal would result as unprofitable. This is a typical case of exchange rate risk. Our following assessment will introduce some solutions on how to manage this risk in order to ensure the profitability of the deal. There are different types of exchange rate risk which can be defined in relation to 1) Economic Exposure, 2) Transaction Exposure, 3) Operating Exposure and 4) Translation Exposure. In the case of Zack Plc, we are confronted with Transaction Exposure as it could affect the cash flows of a transaction which has already started because of a possible fluctuation of the exchange rates. Economic Exposure relates to the effect of exchange rates on a firm’s value. Operating Exposure refers to the possible changes in the measurement of the firm’s value which would result from the variation of future cash flows of a firm due to the volatility of exchange rates. Finally, Translation Exposure defines the possible variation of value of the consolidated financial statements because of the translation of income and balance sheets from foreign currencies. In the case of Transaction Exposure, exchange rates, interest rates and inflation rates can affect the outcome of the transaction. These three factors are linked one to another through three different kinds of relationships: a) the Purchasing Power Parity which defines the connection between relative inflation rates and exchange rates; b) the International Fisher Effect which describes that the interest rate differential would only occur if the exchange rate changes in a particular way that the advantage of the higher interest rate is offset by the loss on the foreign exchange transactions; c) the Unbiased Forward Rate Theory which presents the forward exchange rate as the best and unbiased estimate of the expect future spot exchange rate and therefore the best option for the firm to face foreign exchange risk. (Giddy and Dufey, “The Management of Foreign Exchange Risk” 1992) b) Assessment 1. Forward Hedge In this first option, if Zack Plc chooses a 90 days forward contract to avoid foreign exchange rate, he will receive the following amount of GB Pounds in 90 days GB Pounds received in 90 days = amount to be received in $ / 90 days forward rate = $10 m / (spot rate - 90 days forward discount) = $10 m / (1.50 - 0.02) = $10m / 1.48 =£ 6.757m 2. Money Market Hedge If Zack Plc decides to go with the option of Money Market Hedge i.e. eliminating currency risk by locking in the value of a foreign currency transaction in his own countrys currency, the outcome of the process would be as follows: Amount to be borrowed from U.S. market = $ 10 m /1+9.0% = $ 10 m / 1.09 = $ 9.174 m OR = £ 6.116 m ($9.174/1.5) Investment in U.K. at 9.5% will give = £ 6.116 x (1+9.5%) = £ 6.697 m 3. Call Option If Zack Plc goes for call option then it will only be favourable if the exchange rate at that particular time is $1.45 = £ 1 because this option is giving the maximum return. Pounds received after 90 days if the exchange rate is (1) $10m / ($1.45+0.025) = £6.780m (2) $10m / ($1.47+0.025) = £6.689m (3) $10m / $1.485 = £6.734m (4) $10m / ($1.51 +0.025) = £6.515m Where 0.025 is the fix cost or price to exercise call option. 4. No hedging position If Zack Plc decides for no hedging then the position of amount in GB Pounds to be received will be as follows: Forecasted future spot rate in 90 days Probability GB Pounds to be received in 90 days $1.45 = £ 1 20% £ 6.897 m $1.47 = £ 1 70% £ 6.803 m $1.51 = £ 1 10% £ 6.623 m In regards of the different options available to Zack Plc, it seems that the No Hedging Position would be the most profitable as there is a 70% probability that the exchange rate will be $1.47 = £ 1 and that therefore, Zack Plc receives £ 6.8083 m ( in comparison of £ 6.757m with Forward Hedge, £ 6.697 m with Money Market Hedge and £6.515m with Call Option) c) Discuss why hedging using currency futures is not likely to be 100% efficient There may be several arguments against the efficiency of hedging. First of all, Hedging using currency futures is not free. A certain cost is associated to the hedging operation and in some cases this cost can be superior to the actual risk connected to the exchange rate that the company is trying to manage. One of the other arguments against hedging is the lack of visibility regarding the forecast of future exchange rates. Or even sometimes, the errors that the managers may commit regarding these forecasts. Hedging can be a powerful and successful tool, however one who chooses to use that tool shall have the necessary information about the possible fluctuations of the exchange rates otherwise hedging may prove useless and even costly. One of the examples of mismanagement due to hedging is the case of Rolls Royce. The efficiency of hedging relies on the simple fact that it is made to reduce the risk linked to foreign exchange rates. Nevertheless, using hedging is not a way to increase the cash flows of a company. Therefore, in many cases hedging is not efficient as it is not properly used as many managers may believe it can improve the outcome of the deal. The gain or loss that can come from an hedging position can be represented by the following equation: Gain(Loss)= X[(St+n- bSt) - (Zt+n,T-Zt,T)] Where: X is the amount of exposure b= [1+it,t+n]1/a^/ [1+ i*t,t+n]1/a^ (The interest rate ratio) a^= annualized factor for the interval from t to t+n (S t+n - bSt) = is the deviation of the future spot exchange rate (or forward rate) at inception of the position (Z t+n,T-Z t,T) = is the change the price of a futures contract maturing time T, over the time period from ,t inception of the position, to t+n, liquidation of the position (Jeffrey Miracle. “Hedging with Foreign Currency Futures and Swaps”2003) Therefore, the lack of efficiency of hedging using currency futures may come from the fact that the deviation of the future spot exchange may be lower than the change of price of the futures contract over the entire period of the contract. The efficiency is directly linked to the fluctuations of these two variables. d) Identify and explain two modes of foreign market entry suitable for Zack Plc Zack Plc can enter the Chinese market by two different ways: an acquisition or a Greenfield investment. In the case of an acquisition, Zack Plc will buy an existing Chinese firm which creates the same type of product. However, the limitation in this case is that – as the firm already exists in China – Zack Plc will face the same problems linked to the Chinese Market, such as this very firm did. On the other hand, when talking about a Greenfield investment could allow Zack Plc to place itself in the Chinese Market as a monopole because it will create a new operation and the methods of production and the products can create a competitive advantage necessary to this monopole. However, when dealing with such two typed of foreign entry, there must be a clear evaluation of the costs of each operation compared with the possible outcomes of these two different kind of foreign direct investment. As far as the investment cost is concerned, if it is considered to be very important the acquisition will be preferred as the company may consider the fact of buying an existing firm less risky than establishing a new firm which has not any power on the market. e) Suggest alternative financing sources that Zack Plc might consider for financing this production facility and give reasons for your choice One of the solution that Zack Plc may have is to start a joint venture with a Chinese Partner. The Advantages of such a partnership can make the access to the new market easier, allow the risk to be shared between the two actors of the joint venture and can provide an access to specialized staff and technology on the Chinese market to Zack Plc. Otherwise, another possibility for Zack Plc is to use debt instruments. The advantages of debt instruments are retaining equity, fixed interest payments and flexible payment or payback terms. One of the instruments available is convertible debt and it can be very profitable to Zack Plc as it will not have to give away an important amount of equity. Furthermore, a study by Yasheng Huang (“Why is there so much demand for foreign equity capital in China? An institutional and policy perspective.” Harvard Business School. 1999.) shows that the Chinese financial market is very fund of foreign equity capital. Then, the real question will be to choose between issuing bonds or stocks. Work Cited Page Neary, J. P. “Encyclopedia of World Trade Since 1450” Article “Purchasing Power Parity” ed. J.J. McCusker et al., New York: Macmillan Reference (2004). OECD “Purchasing Power Parities” (2006) Available at: http://www.oecd.org/faq/0,2583,en_2649_34357_1799281_1_1_1_1,00.html#1799075 The Economist. “Food for Thought” The Big Mac Index. May 27th, 2004. Available at: http://www.economist.com/markets/bigmac/displayStory.cfm?story_id=2708584 Giddy I.H. and Dufey G. “The Handbook of International Accounting”. The Management of Foreign Exchange Risk, John Wiley & Sons. 1992. Miracle, J. “Hedging with Foreign Currency Futures and Swaps”2003 Available at: http://www.willamette.edu/~fthompso/IFM/19.JM.ppt Huang, Y. “Why is there so much demand for foreign equity capital in China? An institutional and policy perspective.” Harvard Business School. 1999. Available at: www.hbs.edu/research/facpubs/workingpapers/papers2/9899/99-055.pdf Pakko M.R. and Pollard P.S.“For Here or to Go? Purchasing Power Parity and the Big Mac” Federal Bank of Saint Louis. Review. January/February 1996. Available at: http://research.stlouisfed.org/publications/review/96/01/9601mp.pdf Cassel, Gustav “Abnormal derivations in International exchanges”. The Economic Journal, 28, 413-415. 1918. Papell D.H. & Prodan R, “Long Run Purchasing Parity: Cassel or Balassa-Samuelson?” University of Houston, 2003. Appendix 1 Read More