C H A P T E R 2 0

Chapter 20

International business finance

Learning objectives

This chapter focuses on extending financial decision-making horizons to an international context. In particular it examines how the globalisation of business requires financial managers to consider additional factors in making financial decisions.

When you have completed this chapter you will:

·  understand the impact of the globalisation of product and financial markets on the Australian economy;

·  be able to read and understand how exchange rates are quoted;

·  appreciate the role of interest-rate parity and purchasing-power parity in explaining exchange-rate determination;

·  be able to identify the impact of exchange-rate risk on the operations of organisations;

·  appreciate the factors influencing multinational working-capital management and international financing and capital-structure decisions; and

·  understand the mechanics of exchange-rate risk management.

Introduction

As more and more firms conduct business activities in more than one country, financial managers need to consider additional factors in managing their foreign operations. Moreover, because of the increasing international integration of product and financial markets, most firms are subject to and are influenced by international events and global economic forces. An understanding of issues arising in doing business in an international context is therefore essential for financial managers.

Firms can operate internationally in various ways. In the simplest instance, a firm exports to (or imports from) a single foreign country. Other firms operate in many countries simultaneously. For example, a number of the national banks conduct business in many countries, resulting in them lending in some currencies and borrowing in others. Many manufacturing companies set up production facilities in foreign countries, selling the output back in the home country, or selling it abroad.

Some companies have more elaborate international operations. For example, a Japanese automobile company may have a plant in Australia for manufacturing engines, another plant in Japan for automatic transmissions, a third in Belgium for other components, and an assembly plant in Italy. The final product, the automobile, may be destined for all markets in Europe and Africa. This is an example of a multinational corporation (MNC). The basic problems facing international companies differ from those facing domestic companies. Examples of additional complexities of conducting international business include the following:

1.  Multiple currencies Revenues may be denominated in one currency, costs in another, assets in a third, liabilities in a fourth, and share price in a fifth. Thus, the goal of maximisation of the wealth of the owners must consider changing currency values. In other words, fluctuations in exchange rates may give rise to a monetary loss, also known as exchange-rate risks.

2.  Differing legal and political environments International variations exist in tax laws, depreciation allowances and other accounting practices, as well as in government regulation and control of business activity. Repatriation of profits may be a problem in certain countries.[i]

3.  Differing economic and capital markets The extent of government regulation and control of the economy and capital markets may differ greatly across nations. For example, the ability of a company to raise different types and amounts of capital in its home financial market may be restricted.

4.  Internal management and central control It may be difficult to organise, evaluate and control different divisions of a company when they are separated geographically and when they operate in different environments.

Globalisation

Globalisation refers to the economic interrelationship of national economies and their firms.

An illustration of globalisation is given by the growth in world trade as a percentage of world aggregate output (global gross national product or GNP). In the early 1960s global exports and imports were about one-fifth of global aggregate output, whereas today they are more than one-third and are likely to grow even further.

In addition to the significant increase in world trade in recent years, there has also been a rise in the global level of international direct and portfolio investment. Direct investment refers to investment by a company in an overseas business over which it has control, such as when it builds an offshore manufacturing facility or purchases the majority of the shares in an overseas company. Portfolio investment involves investment overseas in financial assets with maturities greater than one year, such as foreign shares and bonds, where the investor does not have control over the management of the investments. The motivation for portfolio investment is twofold: to obtain returns higher than those obtainable in the domestic capital markets and to reduce portfolio risk through international diversification.

The increase in world trade and investment activity is also reflected in the globalisation of financial markets. For example, the globally integrated foreign exchange markets have grown rapidly in the last 20 years measured by the increased daily dollar volume of foreign currency transactions. An important point for financial management is that even a purely domestic firm that buys all its inputs and sells all its output in its home country is not immune to globalisation, nor can it totally ignore the workings of the international financial markets. The globalisation of the purely domestic firm’s competitors will affect its competitiveness in the market.

The foreign exchange market

The foreign exchange market facilitates the exchange of currencies of different countries. However, not only do currencies change hands in the foreign exchange market but also short-term financial assets, such as bank deposits, are exchanged. The exchange rate between two currencies that is quoted on the foreign exchange market provides a mechanism for the transfer of purchasing power from one currency to the other. An interesting feature of the foreign-exchange market is that it is not located in one physical place but comprises an international network of electronic connections (telephone, fax, telex, computer, Reuters and Telerate data display screens) between foreign exchange dealers, brokers and customers. In Australia foreign-exchange dealers comprising banks and other finance organisations are licensed to buy and sell foreign currencies. The Reserve Bank of Australia was traditionally the licensing authority until March 2002 when the role was transferred to the Australian Securities & Investments Commission (ASIC). Foreign-exchange brokers are other organisations that act as intermediaries between the other market participants.

The foreign exchange market is the largest market on earth as measured by the daily dollar volume of transactions. According to a survey conducted by the Bank for International Settlements in April 2004, the daily turnover in the foreign exchange market rose to USD1.9 trillion, representing an increase of 57% from 2001 based on current exchange rates. The foreign exchange market is also said to be the most perfect market of all. It is characterised by a large number of buyers and sellers, a relatively free flow of information and homogenous product. Product homogeneity means that no matter where you buy currency, it is very likely that the notes or coins that you get would be identical. The foreign exchange market is a 24-hour market. At any point in time, there are foreign exchange transactions taking place in some regions of the globe.

The foreign-exchange market operates simultaneously at two levels. At the first level, customers buy and sell small amounts of foreign exchange through banks or dealers. This is called the retail segment of the foreign-exchange market. At the second level, dealers buy and sell foreign exchange from other dealers in the same country, from dealers in foreign-exchange markets located in other countries or from their large corporate clients. This is called the interbank or wholesale segment of the foreign-exchange market. Interbank transactions account for a vast majority of all foreign exchange transactions.

Because currency markets provide transactions in a continuous manner for a very large volume of sales and purchases, the markets are efficient in the sense that it is difficult to make a profit by shopping around from one dealer to another. Minute differences in the exchange-rate quotes from different dealers are quickly eliminated by a mechanism known as arbitrage, which will be discussed later. Thus, simultaneous quotes by different dealers in Sydney, Singapore and London are likely to be the same.

Exchange rate quotation

Unlike other markets where money is being exchanged for a different commodity, in the foreign exchange market money is being exchanged for money and this is the major source of confusion for students of international finance. Remember that the exchange rate is the price of one currency in terms of another, but which one is which?

Direct exchange rate quotation

A direct exchange rate quotes the price of one unit of foreign currency in terms of the home currency. Most countries follow a direct quotation system against the US dollar (USD) so the exchange rate is represented as the amount of the home currency required to buy 1USD. For example, an exchange rate quote of 1.63 between the USD and Singapore dollar (SGD) would be interpreted as 1USD is worth 1.63 SGD. In practice, the currency in the unit of 1 is displayed first. For example, in this case the USD is in the unit of 1 so the quotation would be USD/SGD 1.63. In many textbooks, however, the convention is to display the currency in the unit of 1 second so the exchange rate between the USD and the SGD is likely to be displayed as SGD/USD which means 1 USD is worth 1.63 SGD. We will follow this convention in this chapter.

Indirect exchange rate quotation

In contrast to the direct quote, an indirect exchange rate quotation states the price of one unit of home currency in terms of the foreign currency. Many countries belonging to the Commonwealth (for example, England, Australia, New Zealand) tend to adopt an indirect quotation system. This is a tradition dating back to before England adopted the decimal currency system. Understandably, the old English currency system which was not divisible by 10 made it difficult for calculations to be done in pounds. From 1971, the pound’s coinage system was changed to the decimal system but the tradition of quoting in one unit of the home currency (which in the case of England is the pound) continues on. In the case of Australia, the exchange rate is quoted as AUD/USD 0.75 which is read as 1 AUD is worth 0.75 USD.

There are two major types of exchange rate quote: spot exchange rate which is applicable to spot transactions and forward rate which is applicable to forward exchange contracts.

Spot transactions

Spot transactions are those taking place at the effective spot exchange rates. By definition, spot transactions encompass both those that result in immediate exchange of currency and interbank transactions that result in settlement two business days later.

Spot exchange rates are quoted by foreign-exchange dealers to apply to spot transactions with their customers and comprise two figures. The first is the rate at which the dealer is prepared to buy one currency in exchange for another and the second is the rate at which the dealer is prepared to sell one currency in exchange for another. The price at which the dealer is willing to buy foreign currency is the bid price and the price at which they are willing to sell is the ask price. As the dealer aims to make a profit on a round transaction to compensate themselves for the risk inherent in the business the ask price is always greater than the bid price. The difference between these two rates is known as the spread. The spread exists as a margin to compensate the dealers for holding the risky foreign currency and for providing the service of exchanging currencies.

When there is a large volume of transactions exchanging two currencies and the trading is continuous, the bid-ask spread is small and can be less than 0.5% of the spot rate for the major currencies. The spread is much higher for infrequently traded currencies. For example, looking at the rates quoted in Table 20.1, we can see that for the 1 AUD/USD rate the spread is equal to 0.7582 – 0.7574 = 0.0008, which is approximately 1% of the spot rate, whereas for the Indian rupee the spread is 33.0329 – 32.0121 = 1.02 which is approximately 3% of the spot rate.

Because every foreign-exchange transaction will involve two currencies, we need to know which currency is being bought and sold and for how much of the other currency. Generally, the bid and ask exchange rate applies to the foreign currency. For example, the bid (ask) exchange rate is the exchange rate that dealers are willing to buy (sell) one unit of foreign currency. However, due to the indirect quotation system, on the foreign-exchange market in Australia, the exchange rate involving the Australian dollar which is quoted to retail customers indicates the number of units of the foreign currency the dealer is prepared to buy and sell in exchange for one unit of the AUD.

Looking at the retail market exchange rates in Table 20.1 we can see that the bank is prepared to buy USD0.7582 from a customer in exchange for AUD1 and is prepared to sell USD0.7574 to a customer is exchange for AUD1. Similarly, the exchange rate quoted between the British Pound, GBP, and the AUD is the rate at which the bank is prepared to buy GBP0.4058 from a customer in exchange for AUD1 and is prepared to sell GBP0.4040 to a customer in exchange for AUD1. Note that because Australia follows an indirect quotation system, the ‘buy’ quote is greater than the ‘sell’ quote as ‘buy’ and ‘sell’ refer to buy and sell foreign currencies.