FIN 6302, Advanced Financial Management 1
Course Learning Outcomes for Unit VI
Upon completion of this unit, students should be able to:
5. Propose international and ethical considerations to financial decision-making.
5.1 Appraise the impact of global financing.
5.2 Analyze international macroeconomic variables on financial decisions.
5.3 Interpret currency fluctuations on firm activity.
Course/Unit
Learning Outcomes
Learning Activity
5.1
Unit Lesson
Chapter 18
Unit VI Case Study
5.2
Unit Lesson
Chapter 18
Unit VI Case Study
5.3
Unit Lesson
Chapter 18
Unit VI Case Study
Required Unit Resources
Chapter 18: International Aspects of Financial Management
Unit Lesson
Introduction
There are thousands of multinational corporations in the world today. They operate globally; participate
across national borders; and deal with suppliers, competitors, and customers. For these firms to be
successful, they must ensure that their international financial management utilizes optimal corporate financial
decisions, including investments, financing, and working capital management. In addition, international
financial management must align with overall organizational goals and objectives. It is important for you to be
able to apply this material to companies with international operations and be able to determine the effects that
various factors and situations have on multinational companies.
International firms are constantly and consistently engaged in international business activities. Examples of
such activities include exporting, importing, and direct foreign investment. These business activities involve
international flow of funds and trade. Factors such as cost of labor, inflation, national income, government
policies, and exchange rates impact international flow of funds and trade (Madura, 2012). A great deal of time
is spent operating in the foreign exchange market.
Foreign Exchange Market
If the world used only one currency, we would not need a foreign exchange market. There is no physical
place where exchange takes place, but it is a market that averages about $4 trillion dollars a day. That is
about 53 times what is exchanged on the New York Stock Exchange (Pure FX, 2011). The foreign exchange
market is essentially an over-the-counter market, in which one currency is traded for another currency.
UNIT VI STUDY GUIDE
International Considerations in Finance
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The foreign exchange market serves as an intermediary between the individuals and the multinational
corporations that trade internationally. To know the equivalent of one currency’s purchasing power versus
another currency’s purchasing power, there must be an exchange rate that specifies the values of each
currency. The exchange rate is basically the amount of currency in units that is required to purchase a unit of
another currency. For instance, the exchange rate of the Japanese yen will determine how many dollars an
individual who wants to stay at a Japanese hotel will need or how many dollars a U.S.-based company would
need to purchase 500,000 yen in supplies.
Cash, check, and debit and credit cards are no longer the only mediums of currency. The concept of digital
currency has been introduced to the economy. Digital currency, also known as cryptocurrency, is a medium of
exchange that may be used in foreign exchange and financial transactions. Bitcoin is an example of the
currency of today and another means to purchase/exchange goods and services.
The Spot Market
The spot market is the most common type of foreign exchange transaction. In the spot market, there is
immediate or almost immediate exchange of currency. This market needs to be contrasted with the forward
market. In the forward market, the exchange of currencies occurs at a future agreed-upon price or what is
called a forward rate. The major participants in the spot market include commercial banks, brokers, and
customers of commercial and central banks.
Exchange Rates
Exchange rate quotations for major currencies are listed in the Wall Street Journal and on online business
and financial sections. These quotations reflect the ask prices for currencies at one specific time during the
day. These quotations are examples of spot rates.
When the value increases, it is called appreciation; depreciation is when the value decreases. Alternative
terms are revaluation for appreciation and devaluation for depreciation. Devaluation is calculated as
shown below.
Devaluation = New Exchange Rate – Old Exchange Rate / Old Exchange Rate
The spot rates quotation can be direct or indirect. If a quotation represents the value of a foreign currency in
home currency, then it is a direct quotation. If, on the other hand, a quotation represents the value of home
currency in terms of foreign currency, it is an indirect quotation.
Online software showing currencies and cross rates with red
and green colors indicating trends in the market
(Nicolino, n.d.)
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Another way to think about it is that the indirect quotation is the reciprocal of the direct quotation, which, in
equation form, is below.
Indirect Quotation = 1 / Direct Quotation
A bank’s (or any institution participating in the foreign exchange market) bid quote is the buy quote of a
foreign currency, and an ask price is the sell quote. All things being equal, the bid quote is less than the ask
quote. That numerical difference creates the profit margin for the dealers of the currency, whether it be
physical or over-the-counter.
From the perspective of a multinational firm that is based in the United States, there are some important facts
to note about the ask and bid rates.
The firm sells foreign currency at the bid rate to obtain dollars.
The firm buys at the ask rate to obtain dollars.
The firm receives one foreign currency but wants another foreign currency. It must first sell the
received foreign currency at the bid rate and use these dollars to buy the other foreign currency at the
ask rate.
Managing Currency Risk Exposure
Multinational companies that operate in countries with lower labor costs have better competitive advantage
than those in countries with higher labor costs. This is especially true in agricultural and manufacturing
industries, which are more labor intensive. All things being equal, an increase in inflation in one country
relative to other countries with which the country trades creates a decrease in the country’s current account.
When there is higher inflation, residents, citizens, and corporations of the country will import goods and
services, and exports will decrease. Current account is the measure of a country’s international trade in goods
and services or unilateral transactions such as provision of income on financial assets.
Other things being equal, the current account decreases if a country’s national income increases by a
higher percentage than other countries with which the country trades. This is because as income levels
rise, consumption of goods and services typically rise. Government policies affect a country’s economic
growth, income level, and unemployment level. These factors influence which firms get a higher market
share. In international transactions, each country’s currency is valued relative to other currencies by using
exchange rates.
As explained earlier, the exchange rate is basically the comparative price of two currencies. The Japanese
yen price of one U.S. dollar or the Mexican peso price of one euro are examples of exchange rates. As a
country’s currency rises in value relative to the currencies of other countries with which it trades, the current
account decreases, assuming other things remain equal. The reason is that the higher strength of the
currency makes exports more expensive to the importing countries, thereby causing a lower demand for
goods and services.
The International Monetary System
The international monetary system is a set of policies, institutions, practices, regulations, and mechanisms
that determine exchange rates (Shapiro, 2014). There are five mechanisms for determining exchange rates.
These are free float, managed float, target-zone arrangement, fixed-rate system, and hybrid system.
In a free float exchange rate system, there is no government intervention or restriction. Instead, the relative
market values of currencies are determined by market forces. A floating exchange rate can correct
international trade imbalances if there is a deficit in a country’s balance of trade; therefore, a deficit indicates
that the country spends more funds on imports than it receives on exports. As the country imports, it
exchanges (supplies) its currency in greater volume than its currency demands since the currency may
devalue. This may then attract more foreign demands for the home country’s goods and services as the home
country’s currency declines in value. It is important to note that free float might not correct international trade
imbalances if there are other forces affecting international trade at the time.
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A managed float (or dirty float) is an exchange rate system whereby a central bank intervenes to reduce
currency fluctuations. In a clean float exchange rate system, there is no central bank intervention, and if it
causes a sudden change in a country’s currency value, this may negatively impact the export industries (if
currency appreciates) or increase the inflation rate (if currency depreciates). In this case, a central bank’s
intervention can help smooth exchange rate fluctuations.
Target-zone arrangement is a system under which countries pledge to maintain a specific agreed-upon
margin or fixed central exchange rate (Nasdaq, n.d.). In other words, the exchange rates among the targetzone can only fluctuate within a fixed band of values. Major European countries had this kind of agreement for
their currencies, which eventually led to the euro being the main currency in that region.
Fixed-rate system indicates that the government sets exchange rates. In a fixed exchange system,
governments are committed to maintaining target exchange rates. Hence, each country’s central bank
frequently buys and sells its currency in the foreign exchange market whenever its currency exchange rate
deviates from an agreed-upon percentage range. Today, the international monetary system operates on a
hybrid system, where there is central bank activity but also where market forces are allowed to function.
Various currencies use one form or another of the aforementioned systems.
Multinational firm managers must understand the differences between the various exchange rate systems
because each system affects currency risks.
Managing Risk
A multinational corporation forecasts exchange rates for hedging, short-term investment, capital budgeting,
earnings assessment, long-term financing, and other purposes. Below are some ways that it manages risk.
A firm may decide to hedge future payables and receivables in foreign currencies based on the
forecasts of foreign currency values.
A company with extra cash available short-term may divide the money and deposit in several
currencies based on forecasts of the currencies. If the multinational corporation does this well, then
the deposits will yield high interest rates and strengthened value over the investment period.
In making international capital budgeting decisions, a corporation may take into account the future
exchange rates of the countries’ currencies before making a commitment.
Forecasts of exchange rates are useful in making decisions of whether a foreign subsidiary should
reinvest earnings or remit them to the parent corporation. Additionally, since subsidiaries’ financial
statements are consolidated and translated into the parents’ financial statements, forecasts of
exchange rates can aid in forecasting earnings.
In international bond issuance used to finance long-term projects, it may opt to denominate the bonds
in foreign currencies.
The three types of risk exposure are translation exposure, transaction exposure, and operating (economic)
exposure. While some of the components of each exposure can be clear-cut, other components are not, and
the exposures’ components often overlap to some extent. Translation exposure occurs when the normal
market fluctuations in currency impact financial statements that have multiple nation exposure. Transaction
exposure is encountered when these same fluctuations have an effect on either monies received or monies
paid in a foreign denomination. Operating or economic exposure occurs when currency fluctuations impact
either the market value of the firm, cash flows, or the computation of future cash flows. Of the three, economic
is the most challenging to account for and prepare for as a company is obviously never certain of what
exchange rate shifts there will be in the future. Translation and transaction exposures can be hedged,
whereas that is not the case for operating. Hedging means that the company takes positions on both sides of
the transaction so that when it loses on one side, it gains on the other.
References
Madura, J. (2012). Financial markets and institutions (10th ed.). Mason, OH: South-Western.
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Nasdaq. (n.d.). Glossary of stock market terms: Target zone arrangement. Retrieved from
https://www.nasdaq.com/investing/glossary/t/target-zone-arrangement
Nicolino, E. (n.d.). Data table with financial information about currencies trading market (ID 49968254)
[Photograph]. Retrieved from https://www.dreamstime.com/stock-photo-data-table-financialinformation-currencies-trading-market-complex-providing-forex-identified-image49968254
Pure FX. (2011). 10 fun facts about foreign exchange. Retrieved from https://www.purefx.co.uk/2011/12/10-
fun-facts-about-foreign-exchange/
Shapiro, A. C. (2014). Multinational financial management (10th ed.). Hoboken, NJ: Wiley.
Learning Activities (Nongraded)
Nongraded Learning Activities are provided to aid students in their course of study. You do not have to submit
them. If you have questions, contact your instructor for further guidance and information.
Review key concepts from this unit by answering the questions in the following activity: Unit VI Check for
Understanding (PDF version of Unit VI Check for Understanding).
