70-398 INTERNATIONAL FINANCE

SPRING 2023

Ch.1 & 2 Foreign Exchange Markets and Risks: MNCs

Prof. Serkan Akguc

Introduction

• Globalization – increasing connectivity and integration of countries

and corporations and the people within them in terms of their
economic, political, and social activities

• Multinational corporation – produces and sells goods or services in

more than one nation
– BRIC countries (Brazil, Russia, India and China) offer a lot of
opportunities for expansion

• International scope creates opportunities but also challenges

– Recent crisis (started in the U.S. and spread to Europe)
– Countries are moving in the direction of protection domestic industries
Successful Risk Management

DON’T WORRY, IT
MAY MELT BEFORE
WE GET THERE!
Successful Risk Management

WE CAN DECIDE
WHAT TO DO, IF AND
WHEN WE HIT IT!
Successful Risk Management

WE NEVER NEEDED
TO USE LIFE BOATS
BEFORE!!
Globalization and the Growth of International
Trade and Capital Flows

The growth of international trade

• Trade liberalization→ countries can specialize at production of goods for
which they have a comparative advantage
– 1960s only 20% of countries were open
– By 2000, over 70% of countries were open
– Free Trade agreements
• GATT (1947) - The General Agreement on Tariffs and Trade
• WTO (1986)
– The WTO replaced GATT as an international organization, but the General
Agreement still exists as the WTO's umbrella treaty for trade in goods, updated
as a result of the Uruguay Round negotiations (1986-1993).
• Regional Trade agreements
– European Union
– NAFTA
– ASEAN
– Outsourcing – shifting of non-strategic functions to specialist firms
 Globalization and the Growth of International
Trade and Capital Flows

The growth in trade (next slide)

– Germany/Qatar are most open, Japan is among least

– China’s trade jumped due to trade reforms
– Countries that border oceans tend to trade more

Composition of GDPs
https://www.cia.gov/library/publications/the-world-factbook/geos/ja.html
https://www.cia.gov/library/publications/the-world-factbook/geos/gm.html
 International Trade as a Percentage of GDP

https://data.worldbank.org/indicator/NE.TRD.GNFS.ZS?contextual=default&end=2017&locations=DE-JP-CN-GB-US&start=1960&view=chart
Globalization and the Growth of
International Trade and Capital Flows

• Incredible growth in the number of MNCs after WWII

– 37,000 MNCs in 1990
– 82,053 in 2010
– ~ 100,000 most recently

• Globalization of financial markets

– Trends in financial openness
• 1980s: countries began to allow foreigners to invest in their markets
 Multinational Corporations

• A parent company in the firm’s originating country and operating subsidiaries,

branches and affiliates abroad
o UN calls these “transnational corporations”

• How they enter foreign markets

o Exporting/Importing
o Licensing – gives local firms right to manufacture their products in
exchange for a fee
o Franchising – the firm provides sales or service strategies in exchange for
fees
o Joint venture – two or more firms form a new legal entity, jointly owned
by all of the firms
o Greenfield – starting company from scratch
Multinational Corporations

Some Key Reasons for Being a Multinational Corporation

1. Access to lower production costs

2. Proximity to target international markets

3. Avoidance of tariffs
The world's top 100 non-financial MNEs, ranked by foreign
assets, 2021 (latest)

See full list at the following link TNI, the Transnationality Index, is calculated
https://unctad.org/topic/investment/world-investment-report as the average of the following three ratios:
foreign assets to total assets, foreign sales
For TNI calculation: to total sales and foreign employment to
https://unctad.org/press-material/foreign-activities-largest-tncs-developing-economies-have-grown- total employment.
noticeably
World Investment Report 2022
https://unctad.org/webflyer/world-investment-report-2022
See World Investment Report 2022 for very interesting facts about how
Covid-19 and Ukraine War affected businesses worldwide.
What’s the main goal of any corporation? MNCs?
What’s an Agency Problem? Any Different in MNCs?
What’s the main goal of any corporation? MNCs?
What’s an Agency Problem? Any Different in MNCs?

Methods of Overcoming Agency Problems Due to the Separation of

Ownership and Control
Foreign Direct Investment (DFI)

• FDI – when a company from one country buys at least 10% of a

company in another country
– Has grown 30-fold since 1980 to $18 trillion
– M&A play a huge role in this trend

FDI and M&A Statistics at

https://unctad.org/en/Pages/DIAE/World%20Investment%20Report/Annex-Tables.aspx
 Foreign Direct Investment, Net Inflows (% of GDP)

https://data.worldbank.org/indicator/BX.KLT.DINV.WD.GD.ZS?locations=US-XC
 Foreign Direct Investment, Net Inflows (% of GDP)

https://data.worldbank.org/indicator/BX.KLT.DINV.WD.GD.ZS?locations=CN-JP
 Foreign Direct Investment, Net Inflows (% of GDP)

https://data.worldbank.org/indicator/BX.KLT.DINV.WD.GD.ZS?locations=QA
Cross-Border Mergers and Acquisitions
As companies seek increased competitiveness and growth in new geographies, cross-border Mergers
and Acquisitions (M&A) has emerged as one way to quickly gain new market and customer access.

Percentage of Cross-Border M&A to Total Announced Worldwide M&A

Year Worldwide M&A Deals Cross-Border M&A % Cross-Border Deals

2000 16,346 4,003 24.49%

2001 18,464 4,637 25.11%
2002 15,460 3,593 23.24%
2003 16,855 3,800 22.54%
2004 20,293 4,841 23.86%
2005 30,706 7,740 25.21%
2006 41,080 10,327 25.14%
2007 46,691 12,012 25.73%
2008 41,419 13,620 24.20%
2009 35,640 7,080 19.87%
2010 46,436 9,300 20.03%
2011 51,419 10,224 19.88%
2012 52,632 9,967 19.03%
2013 51,701 9,549 18.47%
2014 56,202 10,738 19.11%
2015 59,264 11,435 19.30%
2016 58,643 11,864 20.23%
Source: https://www.spglobal.com/en/research-insights/articles/Cross-Border-MA-Activity-on-the-Upswing
See detailed list and breakdown for the latest year: https://unctad.org/system/files/official-document/wir2022_en.pdf
Globalization and the MNC: Benefactor or Menace?
• Global crisis leading to protectionism (recent U.S. Policy)
– Increasing tariffs and trade litigation/technical barriers
• Slowing trade liberalization
• Countries who had opened their markets to foreigners subsequently fell into
crisis
• Benefits of openness
– Channels savings to most productive uses
– Sharing of risk beyond what is possible domestically
– Domestic recessions can be buffered through borrowing
– Cost of capital decreases
• Costs of openness
– Sometimes capital is not used wisely
– Foreign capital can leave quickly causing financial volatility
– Difficulty in taxing profits – MNCs shift to avoid
– Capital control effectiveness decreases
Globalization and the MNC: Benefactor or Menace?

• Anti-globalist movement and MNCs

– Movement opposing globalization

– Identifies MNCs as “villains” of globalization
• https://www.businessinsider.com/americans-paint-china-globalization-villain-2018-8

– Criticize global financial institutions such as the World Bank, IMF and WTO

– They fear that MNC activities will harm the environment

– They argue that globalization is seen as a threat to employment in their

own country
Globalization and the MNC: Benefactor or Menace?

• Final thoughts on globalization

– Can be valuable

– Some evidence that workers in developed countries have not benefited

• Globalization destroys some jobs and creates others

– Some believe that government must intervene to better spread the newly
created wealth by helping those that have been displaced by
globalization
• Retraining
The Foreign Exchange
Market
Functions of the Foreign Exchange Market

• The Foreign Exchange Market is the mechanism by which

participants

– Transfer purchasing power between countries

– Obtain/provide credit for international trade transactions

– Minimize exposure to the risks of exchange rate changes

Structure of the Foreign Exchange
Market

• Geographically, the foreign exchange market spans the globe with prices
moving and currencies trading every hour of every business day

• Major world trading starts each morning in Sydney and Tokyo

• Then moves west to Hong Kong and Singapore

• Continuing to Europe and finishing on the West Coast of the U.S.

Global Currency Trading: The Trading Day
 The Structure of the Foreign Exchange Market

Most important cities:

London
New York
Tokyo

ForEx (or FX)

operates 24 hrs/day

Most trades are $1M

or more!

One unique aspect of this international

market is that there is no central
marketplace for foreign exchange ➔
electronic over-the-counter (OTC)
 Bank and Nonbank Dealers

• They profit from buying foreign exchange at a “bid” price and reselling it at a
slightly higher “offer” or “ask” price

• Large international banks often function as “market makers”

• These dealers stand willing at all times to buy and sell those currencies in
which they specialize and thus maintain an “inventory” position in those
currencies
 Individuals and Firms

• Individuals (such as tourists) and firms (such as importers, exporters and

MNEs) conduct commercial and investment transactions in the foreign
exchange market.

• Their use of the foreign exchange market is necessary but nevertheless

incidental to their underlying commercial or investment purpose.

• Some of the participants use the market to “hedge” foreign exchange risk.
 Speculators and Arbitragers

• Speculators and arbitragers operate for their own interest

• Speculators seek all their profit from exchange rate changes

• Arbitragers try to profit from simultaneous differences in exchange rates in

different markets

• A large proportion of speculation and arbitrage is conducted by major banks

 Central Banks and Treasuries

• Use the market to acquire or spend their country’s currency reserves as well
as to influence the price at which their own currency trades

• Support the value of their currency because of their government’s policies

or obligations

• Their motive is not to profit but rather influence the foreign exchange value
The Organization of the Foreign Exchange Market

• Size of the FX market, the largest financial market in the world

• $7.5 trillion a day in 2022 (Spot and Derivative Transactions)!
• $2.1 trillion (Spot)
• $3.8 trillion (foreign exchange swaps)
– https://stats.bis.org/statx/toc/DER.html
– https://stats.bis.org/statx/srs/table/d11.1

• Compare the size to daily volumes on

• NYSE : $102.6 billion / day
• Nasdaq : $97.4 billion / day
– Source: https://www.cboe.com/us/equities/market_share/
The Organization of the Foreign Exchange Market

• Types of contracts traded

– Spot
– Future transactions: swaps, forward contracts (Ch. 3)
– Derivatives: futures and options (Ch. 20)
 Foreign Currency Quotations

1
= 𝑈𝑆𝐷 1.2174/𝐸𝑈𝑅
𝐸𝑈𝑅 0.8214/𝑈𝑆𝐷

https://www.bloomberg.com/quote/USDQAR:CUR
 Foreign Exchange Rates & Quotations

• A direct quote - home currency price of a unit of a foreign

currency
– QAR3.65/$ direct quote in Qatar (and indirect quote in the US)

• An indirect quote - foreign currency price in a unit of the home

currency
– $0.274/QAR indirect quote in Qatar (and direct quote in the US)
Currencies and Currency Symbols

Quotes
https://www.wsj.com/market-data/currencies

For full list see attached Excel File ➔ https://www.six-group.com/en/products-services/financial-information/data-standards.html

Currency Quotes and Prices

• Triangular arbitrage
• An arbitrage process involving three currencies
• Keeps cross-rates in line with exchange rates quoted relative to the U.S.
dollar
• Occurs when one can trade three currencies and make a profit (versus
two)
€/£ < €/$ * $/£
For example, a trader might start with euros, buy pounds with the euros, then
simultaneously sell those pounds for dollars and sell those dollars for euros. In other
words, instead of exchanging just two currencies, the trader exchanges three (hence the
term “triangular” arbitrage).
➔ If the number of euros the trader has at the end of these three transactions is greater
than the number of euros at the beginning, there is a profit.
 Triangular Arbitrage Diagram

Insert Exh. 2.7 here

See the Example on in-class handout

 Triangular Arbitrage Diagram

Insert Exh. 2.7 here

Empirical Evidence? → see academic paper!

 The Reciprocal Nature of Bid and Ask
Exchange Rates
See numerical example in the next slide

Bid – rate at which banks will buy

the base currency
Ask – rate at which banks will sell
base currency
Yen–Dollar and Dollar–Yen Bid and Ask Rates
A yen–dollar bank trader quotes the following
• bid price of yen per dollar at which she is willing to buy dollars in exchange for yen of, say,
¥110.25/$.
• ask price of yen per dollar (also called the offer price) at which she is willing to sell dollars for
yen, say, at an exchange rate of ¥110.30/$.

What are the dollar per yen bid and ask rates?
• The bid rate is the dollar price of yen at which the bank trader is willing to buy yen with
dollars from the market, and the ask rate is the dollar price at which the bank trader is willing
to sell yen for dollars to the market.
• Since buying yen from the market is equivalent to selling dollars to the market, the dollar per
yen bid rate must be the reciprocal of the yen per dollar ask rate,

• [1/¥110.30/$]ask = ($0.009066/¥)bid.

• Similarly, selling yen to the market is the equivalent of buying dollars from the market, thus

• [1/(¥110.25/$)bid] = ($0.009070/¥)ask
Inside the Interbank Market: Bid-Ask
Spreads and Bank Profits

• Magnitude of bid-ask spreads

– Interbank market
• Within 5 pips (fourth decimal point in a currency quote)
• 0.05% - 0.07% for major currencies
• Lower for extremely liquid currencies like U.S. dollar (i.e., 0.03% for $/€
exchange rate quote)
• Higher for less liquid currencies
• For currencies not trading around a value of 1, the convention is different.
For example, Yen 110.25/Dollar, a pip represents 0.01.

– Use credit cards to exchange when in another country – this is

the best possible rate for you!

– Differs across the day

Inside the Interbank Market : Bid-Ask
Spreads and Bank Profits
Treasurer of a U.S. company purchases pounds with dollars to hedge a British
goods purchase. Directly after, he is told that they no longer need to purchase
the goods. He then sells the pounds back for dollars. Assume that the % bid-ask
spread is 4 pips. If the ask rate is $1.50/£, the bid rate is $1.4996/£ and the
percentage spread is:
𝐴𝑠𝑘𝑡 − 𝐵𝑖𝑑𝑡
% 𝑠𝑝𝑟𝑒𝑎𝑑 =
[($1.50/£) – ($1.4996/£)]/($1.4998/£) = 0.0267% 𝑀𝑖𝑑𝑝𝑜𝑖𝑛𝑡

If the treasurer bought £1M at $1.50/£, the cost would have been: £1M *
($1.50/£) = $1.5M

Selling back: £1M * ($1.4996/£) = $1,499,600, or a loss of $400 on the two

transactions – 0.0267% of $1.5M → approximately
 Inside the Interbank Market:
Communications and Fund Transfers

Communication systems

• Society of Worldwide Interbank Financial Telecommunications (SWIFT) –

links more than 7500 banks in 200 countries
• Clearing House Interbank Payments System (CHIPS) – clearing house in U.S.
for dollars
• Fedwire – links computers of more than 7500 institutions that have
deposits with the U.S. Federal Reserve
• Trans-European Automated Real-time Gross Settlement Express Transfer
(TARGET) – Euro counterpart to Fedwire
Describing Changes in Exchange Rates

• Appreciate/depreciate – the value of a currency increases/decreases

in terms of another

• Devalue/Revalue – the value of a currency is changed by the domestic

government

• Rate: (new – old)/old

– Refers to the currency in the denominator of the exchange rate
(for $/£ - we’re talking about £)

– Rate will not necessarily be the same if you calculate the rate for
the £ and the rate for the $ due to perspective (i.e., the
denominators are different)
Describing Changes in Exchange Rates

• An appreciation or a depreciation refers to the currency that is in the

denominator of the exchange rate.
• For example, for dollar–pound exchange rates, the percentage change
in the exchange rate describes an appreciation or a depreciation of the
pound

(𝑛𝑒𝑤 $/£) − (old $/£)

𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑎𝑝𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑜𝑟 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑜𝑢𝑛𝑑 =
(old $/£)

For example, if the exchange rate changes from $2.00/£ to $2.50/£, the pound
is said to have appreciated relative to the dollar by 25%

($2.50/£) − ($2.00/£)
25% =
($2.00/£)
 Describing Changes in Exchange Rates

Now, let’s examine the rate of depreciation of the dollar relative to the pound
in the same situation. Unfortunately, it will turn out to be a slightly different
percentage change. Because the old exchange rate of pounds per dollar is
£1/$2.00 = £0.50/$, and the new exchange rate is £1/$2.50 = £0.40/$, the
dollar is said to have depreciated relative to the pound by 20%, because

(£0.40/$) −(£0.50/$)
= −20%
(£0.50/$)

Greece before Euro – quotation changes based on political motivation

Suppose the Greek drachma value of the dollar rose from GRD200/$ to
GRD220/$. Newspapers that wanted to heighten concern about the event would
report “Dollar Strengthens Relative to Drachma by 10%,” while newspapers that
wanted to reduce concern would announce “Drachma Weakens Relative to Dollar
by 9%.”

You should be able to explain why these statements actually describe the same event.
Describing Changes in Exchange Rates

Now let’s go back to the previous example where the exchange rate changes from
$2.00/£ to $2.50/£.

What if portfolio decisions are made monthly and we express the percentage
change with monthly compounding. Can you calculate annualized compound
monthly rate of appreciation of the pound?

How about continuous compounding?