‫المملكة العربية السعودية‬ ‫وزارة التعليم‬ ‫الجامعة السعودية اإللكترونية‬ Kingdom of Saudi Arabia Ministry of Education Saudi Electronic University College of Administrative and Financial Sciences Assignment 3 FIN 406 (2nd Term 2021-2022) Deadline: 22/05/2022 @ 23:59 Course Name: International Finance Student’s Name: Course Code: FIN 406 Student’s ID Number: Semester: II CRN: Academic Year: 1442/1443 H, 2nd Term For Instructor’s Use only Instructor’s Name: Sulaiman Aldhawyan Students’ Grade: / 10 Level of Marks: High/Middle/Low Instructions – PLEASE READ THEM CAREFULLY • • This assignment is an individual assignment. The Assignment must be submitted only in WORD format via allocated folder. • Assignments submitted through email will not be accepted. • Students are advised to make their work clear and well presented, marks may be reduced for poor presentation. This includes filling your information on the cover page. • Students must mention question number clearly in their answer. • Late submission will NOT be accepted. • Avoid plagiarism, the work should be in your own words, copying from students or other resources without proper referencing will result in ZERO marks. No exceptions. • All answered must be typed using Times New Roman (size 12, double-spaced) font. No pictures containing text will be accepted and will be considered plagiarism). Submissions without this cover page will NOT be accepted. Kingdom of Saudi Arabia Ministry of Education Saudi Electronic University ‫المملكة العربية السعودية‬ ‫وزارة التعليم‬ ‫الجامعة السعودية اإللكترونية‬ College of Administrative and Financial Sciences You are required to provide a critical analysis of the following question in 1000 words. Use evidence and recent research results to support your answer. You should refer to the wider literature and real-life examples. Should companies hedge their exposures to foreign exchange risk? Discuss both views critically and state your recommendation. Use relevant research results to support your answer. In this assessment, the following learning outcomes will be covered: LO 1. Demonstrate comprehensive knowledge of exchange rate systems and the interaction between exchange rates, interest rates and inflation LO 2. Appreciate the types of risks faced by investors and multinational companies LO 3. Apply and critically evaluate alternative techniques for managing foreign exchange risks Answer: Fundamentals of MULTINATIONAL FINANCE Fifth Edition The Pearson Series in Finance Berk/DeMarzo Corporate Finance* Corporate Finance: The Core* Berk/DeMarzo/Harford Fundamentals of Corporate Finance* Brooks Financial Management: Core Concepts* Copeland/Weston/Shastri Financial Theory and Corporate Policy Dorfman/Cather Introduction to Risk Management and Insurance Eakins/McNally Corporate Finance Online* Eiteman/Stonehill/Moffett Multinational Business Finance Fabozzi Bond Markets: Analysis and Strategies Fabozzi/Modigliani/Jones Foundations of Financial Markets and Institutions Finkler Financial Management for Public, Health, and Not-for-Profit Organizations Foerster Financial Management: Concepts and Applications* Frasca Personal Finance Gitman/Zutter Principles of Managerial Finance* Principles of Managerial Finance—Brief Edition* Haugen The Inefficient Stock Market: What Pays Off and Why Modern Investment Theory Holden Excel Modeling in Corporate Finance Excel Modeling in Investments Hughes/MacDonald International Banking: Text and Cases Hull Fundamentals of Futures and Options Markets Options, Futures, and Other Derivatives Keown Personal Finance: Turning Money into Wealth* Keown/Martin/Petty Foundations of Finance: The Logic and Practice of Financial Management* Kim/Nofsinger Corporate Governance Madura Personal Finance* *denotes Marthinsen Risk Takers: Uses and Abuses of Financial Derivatives McDonald Derivatives Markets Fundamentals of Derivatives Markets Mishkin/Eakins Financial Markets and Institutions Moffett/Stonehill/Eiteman Fundamentals of Multinational Finance Nofsinger Psychology of Investing Pennacchi Theory of Asset Pricing Rejda/McNamara Principles of Risk Management and Insurance Smart/Gitman/Joehnk Fundamentals of Investing* Solnik/McLeavey Global Investments Titman/Keown/Martin Financial Management: Principles and Applications* Titman/Martin Valuation: The Art and ­Science of Corporate Investment ­Decisions Weston/Mitchell/Mulherin Takeovers, Restructuring, and Corporate Governance titles   Visit www.myfinancelab.com to learn more. Fundamentals of Multinational Finance Fifth Edition Michael H. Moffett Thunderbird School of Global Management Arthur I. Stonehill Oregon State University and University of Hawaii at Manoa David K. Eiteman University of California, Los Angeles Boston Columbus Indianapolis New York San Francisco Hoboken Amsterdam Cape Town Dubai London Madrid Milan Munich Paris Montreal Toronto Delhi Mexico City Sao Paulo Sydney Hong Kong Seoul Singapore Taipei Tokyo Vice President, Product Management: Donna Battista Director of Editorial Services: Ashley Santora Acquisitions Editor, Finance: Kate Fernandes Editorial Project Manager: Erin McDonagh Editorial Assistant: Elissa Senra-Sargent Vice President, Marketing: Maggie Moylan Director, Strategy and Marketing: Scott Dustan Manager, Field Marketing: Leigh Ann Sims Product Marketing Manager: Alison Haskins Executive Field Marketing Manager: Lori DeShazo Senior Strategic Marketing Manager: Erin Gardner Team Lead, Project Management: Jeff Holcomb Senior Project Manager: Meredith Gertz Senior Manufacturing Buyer: Carol Melville Art Director/Cover Designer: Jonathan Boylan Executive Media Producer: Melissa Honig Rights and Permissions Project Manager: Jenell Forschler Cover Image: dell/Fotolia Full-Service Project Management, Composition, and Text Illustrations: Laserwords, Inc. Text Design and Copyediting: Gillian Hall, The Aardvark Group Proofreader: Holly McLean-Aldis Indexer: Jack Lewis Printer/Binder: RR Donnelley Willard Cover Printer: Phoenix Color Typeface: 10/12 Times Ten Credits and acknowledgments borrowed from other sources and reproduced, with permission, in this textbook appear on the appropriate page within text and as follows: Photo on part and chapter opening pages by dell/Fotolia. Copyright © 2015, 2012, 2009 by Pearson Education, Inc., All rights reserved. Manufactured in the United States of America. This publication is protected by Copyright, and permission should be obtained from the publisher prior to any prohibited reproduction, storage in a retrieval system, or transmission in any form or by any means, electronic, mechanical, photocopying, recording, or likewise. To obtain permission(s) to use material from this work, please submit a written request to Pearson Education, Inc., Permissions Department, 221 River Street, Hoboken, New Jersey 07030. Many of the designations by manufacturers and sellers to distinguish their products are claimed as trademarks. Where those designations appear in this book, and the publisher was aware of a trademark claim, the designations have been printed in initial caps or all caps. Library of Congress Cataloging-in-Publication Data Moffett, Michael H. Fundamentals of multinational finance / Michael Moffett, Arthur Stonehill, David Eiteman.—5th edition.    pages cm Includes bibliographical references and index. ISBN 978-0-205-98975-1 (alk. paper) 1. International business enterprises—Finance. 2. International finance. 3. Foreign exchange. I. Stonehill, Arthur I. II. Eiteman, David K. III. Title. HG4027.5.M64 2015 332:042—dc23 2014012796 10 9 8 7 6 5 4 3 2 1 www.pearsonhighered.com ISBN-10: 0-205-98975-6 ISBN-13: 978-0-205-98975-1 v Preface Fundamentals of Multinational Finance, Fifth Edition, reflects the multitude of changes sweeping over global business today. This edition has been revised to reflect a global marketplace that has moved five years beyond global financial crisis and into an era in which new country markets and players like that of China, India, and Turkey are altering the global financial landscape. The book has been focused on the challenges faced by the business leaders of tomorrow in multinational business—with three points of emphasis. ■ ■ ■ Organizations. The term multinational enterprise (MNE) applies to organizations of all kinds—the publicly traded, the privately held, the state-run, the state-owned organizations— all forms that permeate global business today. Who owns and operates the organization alters its goals and therefore its management. Markets. Country markets like that of China and India are no longer the sources of lowcost labor for global manufacturers. They are increasingly the focus for sales and growth of all firms, manufacturing and services, for earnings and growth. Although they may still be categorized as “emerging,” they are the economic drivers and primary challenges for global finance and global financial management. Leadership. Individuals in positions of leadership within these organizations and markets are faced with a changing global landscape in which emerging market finance is no longer on the outer edge of financial management, but moving to its core. These leaders of MNEs face numerous foreign exchange and political risks, which are actually more volatile, with global capital moving in and out of countries at an ever-increasing rate. These risks can be daunting but they also present opportunities for creating value if properly understood. In the end, the primary question is whether business leaders are able to navigate the strategic and financial challenges that business faces. New in the Fifth Edition The theme for this Fifth Edition could be described as the maturation of the emerging ­markets. The cast of characters dominating global finance is changing, with economies and currencies from Russia, China, India, Brazil, Turkey, to name a few, moving to the forefront of global business. All companies, from start-ups in Mumbai to mature multinationals in Montreux, are facing similar currency risks and cross-border business risks as more of global commerce has moved to a digital interface across a much greater number of countries. The MNEs in this new world arise from all countries, industrialized and emerging alike, and are all in search of ever-cheaper labor, raw materials, and outsourced manufacturing, while all are competing for the same customers across all markets for sales, profits, and cash flow. These markets—whether they be labeled as BRICs (Brazil, Russia, India, China) or some other popular label—represent the majority of the earth’s population and therefore its consumers. We have pursued this theme throughout the book. v vi Preface The following is a short overview of the features in the Fifth Edition. ■ ■ ■ ■ ■ ■ We have increased the detail on changing currency regimes, theory, and practice, as emerging market currencies become ever-greater contributors to global cash flow. We have introduced the challenges faced by governments and central banks as cryptocurrencies like Bitcoin have shaken the very foundations of traditional definitions of “currency.” We have added new content throughout the book on the growing complexity of major emerging markets which are more open to capital movements, but also subject to sudden government or central bank intervention in pursuit of sovereign goals and objectives. We increased our coverage of the multitude of different currency regimes and devices used by sovereigns over their currencies and markets, currencies like the Chinese yuan, the Russian ruble, the Indian rupee, the Turkish lira, and the South African rand. We have introduced a number of new Mini-Cases with these currency complexity themes, while retaining a number of the most popular cases from previous editions. We have supplemented each chapter with a number of insights into the subtle nuances of the conduct of financial management with new Global Finance in Practice boxes. Fundamentals, Fifth Edition, has been restructured to be much shorter and tighter. The creation of a more intense exploration of global finance without sacrificing depth or detail was achieved through the integration of a number of concepts and topics. ■ ■ ■ ■ Chapters on the international monetary system cover both the fundamental principles of defining a currency with the complexities of macroeconomic policy and digital exchange. Chapters covering the creation and use of currency and interest rate derivatives for hedging and speculation have been selectively reorganized. Chapters on raising equity capital and international portfolio theory have been integrated into one unified exploration of the global cost and availability of capital. Chapters on the sources of capital and changing financial structures utilized by multinational firms have been reorganized for a more integrated presentation, combining theory and current practice. International finance is a subject of sophistication, constant change, yet rich in history. We have tried to bridge the traditional business practices with digital practices with a mix of currency notations and symbols throughout the book, using both the common three-letter currency codes—USD, CNY, EUR—with the traditional currency symbols—$, ¥, £, €—which are seeing a resurgence as countries like Russia and Turkey have introduced new “currency identities” of their own. Audience Fundamentals of Multinational Finance, Fifth Edition, is aimed at university-level courses in international financial management, international business finance, international finance, and similar titles. It can be used at either the undergraduate or graduate level as well as in executive education and corporate learning courses. A prerequisite course or experience in corporate finance or financial management would be ideal. However, we review the basic finance concepts before we extend them to the multinational case. We also review the basic concepts of international economics and international business. Preface vii We recognize the fact that a large number of our potential adopters live outside of the United States and Canada. Therefore, we use a significant number of non-U.S. examples, Mini-Cases, and Global Finance in Practice examples seen in the business and news press (anecdotes and illustrations). Organization Fundamentals of Multinational Finance, Fifth Edition, has been redesigned and restructured for tightness—critical elements of the field but in a much shorter delivery framework. This has been accomplished by integrating a number of previous topics along financial management threads. The book is in five parts unified by the common thread of the globalization process by which a firm moves from a domestic to a multinational business orientation. ■ ■ ■ ■ ■ Part 1 introduces the global financial environment Part 2 explains foreign exchange theory and markets Part 3 explores foreign exchange rate exposure Part 4 details the financing of the global firm Part 5 analyzes international investment decisions Pedagogical Tools To make Fundamentals of Multinational Finance, Fifth Edition, as comprehensible as possible, we use a large number of proven pedagogical tools. Again, our efforts have been informed by the detailed reviews and suggestions of a panel of professors who are recognized individually for excellence in the field of international finance, particularly at the undergraduate level. Among these pedagogical tools are the following: ■ ■ ■ ■ ■ ■ A student-friendly writing style combined with a structured presentation of material, beginning with learning objectives for each chapter, and ending with a summary of how those learning objectives were realized. A wealth of illustrations and exhibits to provide a visual parallel to the concepts and content presented. The entire book uses a multicolor presentation, which we believe provides a visual attractiveness that contributes significantly to reader attention and retention. A running case on a hypothetical U.S.-based firm, Trident Corporation, provides a cohesive framework for the multifaceted globalization process, and is reinforced in several end-ofchapter problems. A Mini-Case at the end of each chapter illustrates the chapter content and extends it to the multinational finance business environment. And, as noted, six of the 17 are new to the Fifth Edition. Global Finance in Practice boxes in every chapter illuminate the theory with accounts of actual business practices. These applications extend the concepts without adding to the length of the text itself. Every chapter has a number of end-of-chapter Exercises requiring the use of the Internet, while a variety of Internet references are dispersed throughout the chapters in text and exhibits. viii Preface ■ A multitude of end-of-chapter Questions and Problems assess the students’ understanding of the course material. All end-of-chapter Problems are solved using spreadsheet solutions. Selected end-of-chapter Problem answers, indicated by an asterisk (*), are now included at the back of the book. A Rich Array of Support Materials A robust package of materials for both instructor and student accompanies the text to facilitate learning and to support teaching and testing. ■ ■ ■ ■ ■ ■ Online Instructor’s Manual. The Online Instructor’s Manual, prepared by William ­Chittenden of Texas State University, contains complete answers to all end-of-chapter Questions, Problems, and chapter Mini-Cases. All quantitative end-of-chapter Problems are solved using spreadsheets prepared by the authors, which are also available online. Online Test Item File. The Online Test Item File, prepared by Borijan Borozanov of the Thunderbird School of Global Management, contains over 1,200 multiple-choice and short essay questions. The multiple-choice questions are labeled by topic and by category: recognition, conceptual, and analytical types. Computerized Test Bank. The Test Item File is also available in Pearson Education’s TestGen Software. Fully networkable, it is available for Windows and Macintosh. TestGen’s graphical interface enables instructors to view, edit, and add questions; transfer questions to tests; and print different forms of tests. Search-and-sort features enable the instructor to locate questions quickly and arrange them in a preferred order. The TestGen plug-in automatically grades the exams and allows the instructor to view and print a variety of reports. Online Mini-Case PowerPoint® Presentations. Each of the 17 Mini-Cases has a standalone PowerPoint presentation available online. Online PowerPoint Presentation Slides. The extensive set of PowerPoint slides provides lecture outlines and selected graphics from the text for each chapter. Web Site. A dedicated Web site at www.pearsonhighered.com/moffett contains the Web exercises from the book with wired links, electronic flash cards of glossary terms, and selected solutions and spreadsheets for end-of-chapter problems. All of the teaching resources are available online for download at the Instructor Resource Center at www.pearsonhighered.com/irc. International Editions Fundamentals of Multinational Finance and Multinational Business Finance have been used throughout the world to teach students of international finance. Our books are published in a number of foreign languages including Chinese, French, Spanish, Indonesian, Portuguese, and Ukrainian. Preface ix Acknowledgments We are very thankful for the many detailed reviews of previous editions and suggestions from a number of colleagues. The final version of Fundamentals, Fifth Edition, reflects most of the suggestions provided by these reviewers. The survey reviewers were anonymous, but the detailed reviewers were: Dev Prasad, University of Massachusetts Lowell Anand M. Vijh, University of Iowa, Tippie College of Business Yoon S. Shin, Loyola University Maryland Raymond M. Johnson, Auburn University Montgomery Cheryl Riffe, Columbus State Community College Additionally, we would like to thank Rodrigo Hernandez of Radford University who meticulously reviewed the Fifth Edition for accuracy. We would also like to thank all those with Pearson Education who have worked so diligently on this edition: Katie Rowland, Kate Fernandes, Erin McDonagh, and Meredith Gertz. In addition, Gillian Hall, our outstanding project manager, deserves much gratitude. Finally, we would like to dedicate this book to our parents, Bennie Ruth and the late Hoy Moffett, the late Harold and Norma Stonehill, and the late Wilford and Sylvia Eiteman, who gave us the motivation to become academics and authors. We thank our wives, Megan, Kari, and Keng-Fong, for their patience while we were preparing Fundamentals of Multinational Finance. Glendale, Arizona Honolulu, Hawaii Pacific Palisades, California M.H.M. A.I.S. D.K.E. About the Authors Michael H. Moffett Michael H. Moffett is Continental Grain Professor in Finance at the Thunderbird School of Global Management, where he has been since 1994. He has also held teaching or research appointments at Oregon State University (1985–1993); the University of Michigan, Ann Arbor (1991–1993); the Brookings Institution, Washington, D.C.; the University of Hawaii at Manoa; the Aarhus School of Business (Denmark); the Helsinki School of Economics and Business Administration (Finland); the International Centre for Public Enterprises (Yugoslavia); and the University of Colorado, Boulder. Professor Moffett received a B.A. (Economics) from the University of Texas at Austin (1977); an M.S. (Resource Economics) from Colorado State University (1979); an M.A. (Economics) from the University of Colorado, Boulder (1983); and Ph.D. (Economics) from the University of Colorado, Boulder (1985). He has authored, co-authored, or contributed to a number of books, articles, and other publications. He has co-authored two books with Art Stonehill and David Eiteman, Multinational Business Finance, and this book, Fundamentals of Multinational Finance. His articles have appeared in the Journal of Financial and Quantitative Analysis, Journal of Applied Corporate Finance, Journal of International Money and Finance, Journal of International Financial Management and Accounting, Contemporary Policy Issues, Brookings Discussion Papers x Preface in International Economics, and others. He has contributed to a number of collected works including the Handbook of Modern Finance, the International Accounting and Finance Handbook, and the Encyclopedia of International Business. He is also co-author of a number of books in multinational business with Michael Czinkota and Ilkka Ronkainen, International Business (Seventh Edition) and Global Business (Fourth Edition), and The Global Oil and Gas Industry: Strategy, Finance, and Management, with Andrew Inkpen. Arthur I. Stonehill Arthur I. Stonehill is a Professor of Finance and International Business, Emeritus, at Oregon State University, where he taught for 24 years (1966–1990). During 1991–1997 he held a split appointment at the University of Hawaii at Manoa and Copenhagen Business School. From 1997 to 2001 he continued as a Visiting Professor at the University of Hawaii at Manoa. He has also held teaching or research appointments at the University of California, Berkeley; Cranfield School of Management (U.K.); and the North European Management Institute (Norway). He was a former president of the Academy of International Business, and was a western director of the Financial Management Association. Professor Stonehill received a B.A. (History) from Yale University (1953); an M.B.A. from Harvard Business School (1957); and a Ph.D. in Business Administration from the University of California, Berkeley (1965). He was awarded honorary doctorates from the Aarhus School of Business (Denmark, 1989), the Copenhagen Business School (Denmark, 1992), and Lund University (Sweden, 1998). He has authored or co-authored nine books and 25 other publications. His articles have appeared in Financial Management, Journal of International Business Studies, California Management Review, Journal of Financial and Quantitative Analysis, Journal of International Financial Management and Accounting, International Business Review, European Management Journal, The Investment Analyst (U.K.), Nationaløkonomisk Tidskrift (Denmark), Sosialøkonomen (Norway), Journal of Financial Education, and others. David K. Eiteman David K. Eiteman is Professor Emeritus of Finance at the John E. Anderson Graduate School of Management at UCLA. He has also held teaching or research appointments at the Hong Kong University of Science and Technology, Showa Academy of Music (Japan), the National University of Singapore, Dalian University (China), the Helsinki School of Economics and Business Administration (Finland), University of Hawaii at Manoa, University of Bradford (U.K.), Cranfield School of Management (U.K.), and IDEA (Argentina). He is a former president of the International Trade and Finance Association, Society for Economics and Management in China, and Western Finance Association. Professor Eiteman received a B.B.A. (Business Administration) from the University of Michigan, Ann Arbor (1952); M.A. (Economics) from the University of California, Berkeley (1956); and a Ph.D. (Finance) from Northwestern University (1959). He has authored or co-authored four books and 29 other publications. His articles have appeared in The Journal of Finance, The International Trade Journal, Financial Analysts Journal, Journal of World Business, Management International, Business Horizons, MSU Business Topics, Public Utilities Fortnightly, and others. xi Brief Contents Part 1 Part 2 Part 3 Part 4 Part 5 Global Financial Environment 1 Chapter 1 Multinational Financial Management: Opportunities and Challenges 2 Chapter 2 The International Monetary System 23 Chapter 3 The Balance of Payments 51 Chapter 4 Financial Goals and Corporate Governance 79 Foreign Exchange Theory and Markets 107 Chapter 5 The Foreign Exchange Market Chapter 6 International Parity Conditions 137 Chapter 7 Foreign Currency Derivatives and Swaps 168 Chapter 8 Foreign Exchange Rate Determination 195 Foreign Exchange Exposure 223 Chapter 9 Transaction Exposure 224 Chapter 10 Translation Exposure 250 Chapter 11 Operating Exposure 267 Financing the Global Firm 108 291 Chapter 12 The Global Cost and Availability of Capital 292 Chapter 13 Raising Equity and Debt Globally 318 Chapter 14 Multinational Tax Management 353 Chapter 15 International Trade Finance 373 Foreign Investment Decisions 399 Chapter 16 Foreign Direct Investment and Political Risk 400 Chapter 17 Multinational Capital Budgeting and Cross-Border Acquisitions 430 Answers A-1 Glossary G-1 Index I-1 xi This page intentionally left blank xiii Contents Part 1 Global Financial Environment 1 Chapter 1 Multinational Financial Management: Opportunities and Challenges 2 Financial Globalization and Risk 3 The Global Financial Marketplace 4 Global Finance In Practice The Trouble with Libor 5 The Theory of Comparative Advantage 9 What Is Different about International Financial Management? 11 Global Finance In Practice Corporate Responsibility and Corporate Sustainability 12 Market Imperfections: A Rationale for the Existence of the Multinational Firm 12 The Globalization Process 13 Summary Points 17 Mini-Case Bitcoin—Cryptocurrency or Commodity? 17 Questions 20 Problems 20 Internet Exercises 21 Chapter 2 The International Monetary System 23 History of the International Monetary System 23 Global Finance In Practice Hammering Out an Agreement at Bretton Woods 26 IMF Classification of Currency Regimes 28 Global Finance In Practice Swiss National Bank Sets Minimum Exchange Rate for the Franc 33 Fixed versus Flexible Exchange Rates 34 Global Finance In Practice Who Is Choosing What in the Trinity/Trilemma? 35 A Single Currency for Europe: The Euro 36 Global Finance In Practice The Euro and the Greek/EU Debt Crisis 37 Emerging Markets and Regime Choices 38 Globalizing the Chinese Renminbi 42 Exchange Rate Regimes: What Lies Ahead? 45 Summary Points 46 Mini-Case Russian Ruble Roulette 46 Questions 48 Problems 49 Internet Exercises 50 Chapter 3 The Balance of Payments 51 Typical Balance of Payments Transactions 52 Fundamentals of BOP Accounting 52 The Accounts of the Balance of Payments 54 Global Finance In Practice The Global Current Account Surplus 56 Global Finance In Practice A Country’s Net International Investment Position (NIIP) BOP Impacts on Key Macroeconomic Rates 62 Trade Balances and Exchange Rates 64 Capital Mobility 67 58 xiii xiv Contents Summary Points 72 Mini-Case Global Remittances Questions 74 Problems 75 Internet Exercises 78 72 Chapter 4 Financial Goals and Corporate Governance 79 Who Owns the Business? 80 The Goal of Management 83 Publicly Traded versus Privately Held: The Global Shift 88 Corporate Governance 90 Global Finance In Practice Italian Cross-Shareholding and the End of the Salatto Buono Global Finance In Practice Is Good Governance Good Business Globally? 97 Summary Points 98 Mini-Case Luxury Wars—LVMH vs. Hermès 98 Questions 103 Problems 103 Internet Exercises 106 Part 2 Foreign Exchange Theory and Markets Chapter 5 The Foreign Exchange Market 107 108 Functions of the Foreign Exchange Market 109 Structure of the Foreign Exchange Market 109 Global Finance In Practice FX Market Manipulation: Fixing the Fix 112 Global Finance In Practice My First Day of Foreign Exchange Trading 113 Transactions in the Foreign Exchange Market 114 Size of the Foreign Exchange Market 116 Foreign Exchange Rates and Quotations 119 Global Finance In Practice Russian Symbolism 120 Summary Points 129 Mini-Case The Venezuelan Bolivar Black Market 129 Questions 133 Problems 133 Internet Exercises 136 Chapter 6 International Parity Conditions Prices and Exchange Rates 137 138 Global Finance In Practice The Immiseration of the North Korean People—The “Revaluation” of the North Korean Won 140 Interest Rates and Exchange Rates 145 Global Finance In Practice Hungarian Mortgages 152 Forward Rate as an Unbiased Predictor of the Future Spot Rate 153 Prices, Interest Rates, and Exchange Rates in Equilibrium 155 Summary Points 156 Mini-Case Mrs. Watanabe and the Japanese Yen Carry Trade 157 Questions 159 Problems 159 Internet Exercises 163 94 Contents Appendix: An Algebraic Primer to International Parity Conditions 164 The Law of One Price 164 Purchasing Power Parity 164 Forward Rates 165 Covered Interest Arbitrage (CIA) and Interest Rate Parity (IRP) 165 Fisher Effect 166 International Fisher Effect 166 Chapter 7 Foreign Currency Derivatives and Swaps Foreign Currency Futures Currency Options 171 168 169 Global Finance In Practice The New Zealand Kiwi, Key, and Krieger Option Pricing and Valuation 179 Interest Rate Risk 181 Global Finance In Practice A Fixed-Rate or Floating-Rate World? Interest Rate Derivatives 183 Summary Points 187 Mini-Case McDonald’s Corporation’s British Pound Exposure 188 Questions 189 Problems 190 Internet Exercises 194 Chapter 8 Foreign Exchange Rate Determination 179 182 195 Exchange Rate Determination: The Theoretical Thread 196 Currency Market Intervention 200 Global Finance In Practice Rules of Thumb for Effective Intervention 204 Disequilibrium: Exchange Rates in Emerging Markets 205 Global Finance In Practice Was George Soros to Blame for the Asian Crisis? 207 Forecasting in Practice 212 Global Finance In Practice JPMorgan Chase Forecast of the Dollar/Euro 214 Summary Points 216 Mini-Case The Japanese Yen Intervention of 2010 217 Questions 219 Problems 219 Internet Exercises 222 Part 3 Foreign Exchange Exposure 223 Chapter 9 Transaction Exposure 224 Types of Foreign Exchange Exposure 224 Why Hedge? 225 Transaction Exposure Management: The Case of Trident 230 Risk Management in Practice 238 Global Finance In Practice Hedging and the German Automobile Industry 238 Global Finance In Practice The Credit Crisis and Option Volatilities in 2009 239 Summary Points 239 Mini-Case Banbury Impex (India) 240 Questions 244 Problems 244 Internet Exercises 249 xv xvi Contents Chapter 10 Translation Exposure 250 Overview of Translation 250 Translation Methods 252 Trident Corporation’s Translation Exposure 254 Global Finance In Practice Foreign Subsidiary Valuation 258 Managing Translation Exposure 259 Global Finance In Practice When Business Dictates Hedging Results 260 Summary Points 261 Mini-Case LaJolla Engineering Services 261 Questions 264 Problems 265 Internet Exercises 266 Chapter 11 Operating Exposure 267 A Multinational’s Operating Exposure 267 Global Finance In Practice Expecting the Devaluation—Ford and Venezuela 271 Measuring Operating Exposure: Trident Germany 272 Strategic Management of Operating Exposure 277 Global Finance In Practice Do Fixed Exchange Rates Increase Corporate Currency Risk in Emerging Markets? 278 Proactive Management of Operating Exposure 279 Summary Points 284 Mini-Case Toyota’s European Operating Exposure 285 Questions 287 Problems 288 Internet Exercises 290 Part 4 Financing the Global Firm 291 Chapter 12 The Global Cost and Availability of Capital 292 Financial Globalization and Strategy 292 International Portfolio Theory and Diversification 295 The Demand for Foreign Securities: The Role of International Portfolio Investors 301 The Cost of Capital for MNEs Compared to Domestic Firms 306 The Riddle: Is the Cost of Capital Higher for MNEs? 307 Summary Points 309 Mini-Case Novo Industri A/S (Novo) 310 Questions 313 Problems 314 Internet Exercises 316 Chapter 13 Raising Equity and Debt Globally 318 Designing a Strategy to Source Capital Globally 319 Optimal Financial Structure 320 Optimal Financial Structure and the MNE 321 Raising Equity Globally 323 Global Finance In Practice The Planned Directed Equity Issue of PA Resources of Sweden Depositary Receipts 327 Private Placement 333 Foreign Equity Listing and Issuance 334 Raising Debt Globally 337 Global Finance In Practice Islamic Finance 341 Summary Points 342 327 Contents Mini-Case Petrobrás of Brazil and the Cost of Capital 343 Questions 346 Problems 347 Internet Exercises 349 Appendix: Financial Structure of Foreign Subsidiaries 350 Local Norms 350 Financing the Foreign Subsidiary 351 Chapter 14 Multinational Tax Management 353 Tax Principles 354 Transfer Pricing 361 Global Finance In Practice Offshore Profits and Dividend Repatriation 361 Tax Management at Trident 364 Tax-Haven Subsidiaries and International Offshore Financial Centers 365 Summary Points 367 Mini-Case Google, Taxes, and “Do No Evil” 368 Questions 370 Problems 370 Internet Exercises 372 Chapter 15 International Trade Finance 373 The Trade Relationship 373 Benefits of the System 376 Key Documents 378 Global Finance In Practice Florence—The Birthplace of Trade Financing Documentation in a Typical Trade Transaction 383 Government Programs to Help Finance Exports 385 Trade Financing Alternatives 386 Global Finance In Practice Factoring in Practice 388 Forfaiting: Medium- and Long-Term Financing 389 Summary Points 391 Mini-Case Crosswell International and Brazil 392 Questions 395 Problems 395 Internet Exercises 398 Part 5 381 Foreign Investment Decisions 399 Chapter 16 Foreign Direct Investment and Political Risk 400 Sustaining and Transferring Competitive Advantage 400 The OLI Paradigm and Internationalization 403 Deciding Where to Invest 404 Modes of Foreign Investment 406 Predicting Political Risk 410 Global Finance In Practice Apache Takes a Hit from Egyptian Protests 412 Firm-Specific Political Risk: Governance Risk 412 Country-Specific Risk: Transfer Risk 416 Country-Specific Risk: Cultural and Institutional Risk 419 Global-Specific Risk 421 Global Finance In Practice Drugs, Public Policy, and the Death Penalty in 2011 Summary Points 425 Mini-Case Corporate Competition from the Emerging Markets 426 Questions 428 Internet Exercises 429 422 xvii xviii Contents Chapter 17 Multinational Capital Budgeting and Cross-Border Acquisitions Complexities of Budgeting for a Foreign Project 431 Project versus Parent Valuation 432 Illustrative Case: Cemex Enters Indonesia 433 Project Financing 446 Cross-Border Mergers and Acquisitions 448 Global Finance In Practice Statoil of Norway’s Acquisition of Esso of Sweden Summary Points 453 Mini-Case Elan and Royalty Pharma 454 Questions 458 Problems 459 Internet Exercises 462 Answers A-1 Glossary G-1 Index I-1 453 430 PART 1 Global Financial Environment Chapter 1 Multinational Financial Management: Opportunities and Challenges Chapter 2 The International Monetary System Chapter 3 The Balance of Payments Chapter 4 Financial Goals and Corporate Governance CHAPTER 1 Multinational Financial Management: Opportunities and Challenges I define globalization as producing where it is most costeffective, selling where it is most profitable, and sourcing capital where it is cheapest, without worrying about national boundaries. —Narayana Murthy, Founder and Executive Chairman of the Board, Infosys. Learning Objectives ■ Examine the requirements for the creation of value ■ Consider the basic theory, comparative advantage, and its requirements for the explanation and justification for international trade and commerce ■ Discover what is different about international financial management ■ Detail which market imperfections give rise to the multinational enterprise ■ Consider how the globalization process moves a business from a purely domestic focus in its financial relationships and composition to one truly global in scope ■ Examine possible causes of the limitations to globalization in finance The subject of this book is the financial management of multinational enterprises (MNEs)— multinational financial management. MNEs are firms—both for-profit companies and notfor-profit organizations—that have operations in more than one country, and conduct their business through branches, foreign subsidiaries, or joint ventures with host country firms. New MNEs are appearing all over the world today, while many of the older and established ones are struggling to survive. Businesses of all kinds are seeing a very different world than in the past. Today’s MNEs depend not only on the emerging markets for cheaper labor, raw materials, and outsourced manufacturing, but also increasingly on those same emerging markets for sales and profits. These markets—whether they are emerging, less developed, or developing, or are BRIC (Brazil, Russia, India, and China), BIITS (Brazil, India, Indonesia, Turkey, South Africa, which are also termed the Fragile Five), or MINTs (Mexico, Indonesia, Nigeria, Turkey)—represent the majority of the earth’s population and, therefore, potential 2 Chapter 1   Multinational Financial Management: Opportunities and Challenges 3 customers. And adding market complexity to this changing global landscape is the risky andchallenging international macroeconomic environment, both from a long-term and short-term perspective. The global financial crisis of 2008–2009 is already well into the business past, and capital is flowing again—although in and out of economies—at an ever-increasing pace. How to identify and navigate these risks is the focus of this book. These risks may all occur on the playing field of the global financial marketplace, but they are still a question of management—of navigating that complexity in pursuit of the goals of the firm. Financial Globalization and Risk Back in the halcyon pre-crisis days of the late 20th and early 21st centuries, it was taken as self evident that financial globalisation was a good thing. But the subprime crisis and eurozone dramas are shaking that belief. . . . what is the bigger risk now—particularly in the eurozone—is that financial globalisation has created a system that is interconnected in some dangerous ways. —“Crisis Fears Fuel Debate on Capital Controls,” Gillian Tett, Financial Times, December 15, 2011. The theme dominating global financial markets today is the complexity of risks associated with financial globalization—far beyond whether it is simply good or bad, but how to lead and manage multinational firms in the rapidly moving marketplace. ■ The international monetary system, an eclectic mix of floating and managed fixed exchange rates, is under constant scrutiny. The rise of the Chinese renminbi is changing much of the world’s outlook on currency exchange, reserve currencies, and the roles of the dollar and the euro (see Chapter 2). ■ Large fiscal deficits, including the current eurozone crisis, plague most of the major trading countries of the world, complicating fiscal and monetary policies, and ultimately, interest rates and exchange rates (see Chapter 3). ■ Many countries experience continuing balance of payments imbalances, and in some cases, dangerously large deficits and surpluses—whether it be the twin surpluses enjoyed by China, the current account surplus of Germany amidst a sea of eurozone deficits, or the continuing current account deficit of the United States, all will inevitably move exchange rates (see Chapter 3). ■ Ownership, control, and governance vary radically across the world. The publicly traded company is not the dominant global business organization—the privately held or familyowned business is the prevalent structure—and their goals and measures of performance vary dramatically (see Chapter 4). ■ Global capital markets that normally provide the means to lower a firm’s cost of capital, and even more critically, increase the availability of capital, have in many ways shrunk in size and have become less open and accessible to many of the world’s organizations (see Chapter 1). ■ Today’s emerging markets are confronted with a new dilemma: the problem of first being the recipients of capital inflows, and then of experiencing rapid and massive capital outflows. Financial globalization has resulted in the ebb and flow of capital in and out of both industrial and emerging markets, greatly complicating financial management (Chapter 5 and 8). 4 PART 1  Global Financial Environment These are but a sampling of the complexity of risks. This first chapter is meant only as an introduction and a taste. The Mini-Case at the end of this first chapter, Bitcoin—­ Cryptocurrency or Commodity?, is intended to push you in your thinking about how and why money moves across the globe today. The Global Financial Marketplace Business—domestic, international, global—involves the interaction of individuals and individual organizations for the exchange of products, services, and capital through markets. The global capital markets are critical for the conduct of this exchange. The global financial crisis of 2008–2009 served as an illustration and a warning of how tightly integrated and fragile this marketplace can be. Assets, Institutions, and Linkages Exhibit 1.1 provides a map of the global capital markets. One way to characterize the global financial marketplace is through its assets, institutions, and linkages. Assets. The assets—financial assets—at the heart of the global capital markets are the debt securities issued by governments (e.g., U.S. Treasury Bonds). These low-risk or risk-free assets form the foundation for the creation, trading, and pricing of other financial assets like bank loans, corporate bonds, and equities (stock). In recent years, a number of additional securities have been created from existing securities—derivatives, whose value is based on market value changes of the underlying securities. The health and security of the global financial system relies on the quality of these assets. Exhibit 1.1 Global Capital Markets The global capital market is a collection of institutions (central banks, commercial banks, investment banks, not-forprofit financial institutions like the IMF and World Bank) and securities (bonds, mortgages, derivatives, loans, etc.), which are all linked via a global network—the Interbank Market. This interbank market, in which securities of all kinds are traded, is the critical pipeline system for the movement of capital. Public Debt Mortgage Loan Corporate Loan Corporate Bond Bank Interbank Market (LIBOR ) Bank Currency Currency Currency Private Debt Private Equity Bank Central Banks Institutions The exchange of securities—the movement of capital in the global financial system—must all take place through a vehicle—currency. The exchange of currencies is itself the largest of the financial markets. The interbank market, which must pass-through and exchange securities using currencies, bases all of its pricing through the single most widely quoted interest rate in the world—LIBOR (the London Interbank Offered Rate). Chapter 1   Multinational Financial Management: Opportunities and Challenges 5 Institutions. The institutions of global finance are the central banks, which create and control each country’s money supply; the commercial banks, which take deposits and extend loans to businesses, both local and global; and the multitude of other financial institutions created to trade securities and derivatives. These institutions take many shapes and are subject to many different regulatory frameworks. The health and security of the global financial system relies on the stability of these financial institutions. Linkages. The links between the financial institutions, the actual fluid or medium for exchange, are the interbank networks using currency. The ready exchange of currencies in the global marketplace is the first and foremost necessary element for the conduct of financial trading, and the global currency markets are the largest markets in the world. The exchange of currencies, and the subsequent exchange of all other securities globally via currency, is the international interbank network. This network, whose primary price is the London Interbank Offered Rate (LIBOR), is the core component of the global financial system. The movement of capital across currencies and continents for the conduct of business has existed in many different forms for thousands of years. Yet, it is only within the past 50 years that these capital movements have started to move at the pace of an electron in the digital marketplace. And it is only within the past 20 years that this market has been able to reach the most distant corners of the earth at any moment of the day. The result has been an explosion of innovative products and services—some for better, some for worse, and as described in Global Finance in Practice 1.1, not always without challenges. Global Finance in Practice 1.1 The Trouble with LIBOR “The idea that my word is my Libor is dead.” — Mervyn King, Bank of England Governor. No single interest rate is more fundamental to the operation of the global financial markets than the London Interbank Offered Rate (LIBOR). LIBOR is used in loan agreements, financial derivatives, swap agreements, in different maturities and different currencies, every day—globally. But beginning as early as 2007, a number of participants in the interbank market on both sides of the Atlantic suspected that there was trouble with LIBOR. LIBOR is published under the auspices of the British Bankers Association (BBA). Each day, a panel of 16 major multinational banks are requested to submit their estimated borrowing rates in the unsecured interbank market which are then collected, massaged, and published in three steps. Step 1. The banks on the LIBOR panels must submit their estimated borrowing rates by 11:10 a.m. London time. The submissions are directly to Thomson Reuters, which executes the process on behalf of the BBA. Step 2. Thomson Reuters discards the lowest 25% and highest 25% of interest rates submitted. It then calculates an average rate by maturity and currency using the remaining 50% of borrowing rate quotes. Step 3. The BBA publishes the day’s LIBOR rates 20 minutes later, by 11:30 a.m. London time. This process is used to publish LIBOR for 10 different currencies across 15 different maturities. The three-month and six-month maturities are the most significant maturities due to their widespread use in various loan and derivative agreements, with the dollar and the euro being the most widely used currencies. The Trouble One problem with LIBOR is the origin of the rates submitted by banks. First, rates are not limited to those at which actual borrowing occurred, meaning they are not market transaction rates. The logic behind including “estimated borrowing rates” was to avoid reporting only actual transactions, as many banks may not conduct actual transactions in all maturities and currencies each day. As a result, the origin of the rate submitted by each bank becomes, to some degree, discretionary. Secondly, banks—specifically money-market and derivative traders within the banks—have a number of interests that may be impacted by borrowing costs reported by the bank that day. One such example can be found in the concerns of banks in the interbank market in September 2008, when the credit crisis was in full-bloom. A bank reporting that other banks were demanding it pay a higher rate that day would, in effect, be self-reporting the market’s 6 PART 1  Global Financial Environment assessment that it was increasingly risky. In the words of one analyst, akin “to hanging a sign around one’s neck that I am carrying a contagious disease.” Market analysts are now estimating that many of the banks in the LIBOR panel were reporting borrowing rates which were anywhere from 30 to 40 basis points lower than actual rates throughout the financial crisis. As one financial reform advocate so sharply stated it, “the issue is Lie More, not Libor.” Court documents continue to shed light on the depth of the market’s manipulation, although it is not really known to what degree attempts at manipulation have been successful. Hi Guys, We got a big position in 3m libor for the next 3 days. Can we please keep the libor fixing at 5.39 for the next few days. It would really help. —Barclays New York trader email, September 13, 2006, as reported in Barclays PLC, Barclays Bank PLC, and Barclays Capital Inc., CFTC Docket No. 12-25, CFTC, p.10. In December 2013, a collection of banks in London and New York agreed to pay $2.3 billion in fines to the European Commission for LIBOR manipulation. And more lawsuits, accusations, and regulations are sure to come. The Market for Currencies The price of any one country’s currency in terms of another country’s currency is called a foreign currency exchange rate. For example, the exchange rate between the U.S. dollar ($ or USD) and the European euro (€ or EUR) may be stated as “1.3654 dollar per euro” or simply abbreviated as $1.3654/€. This is the same exchange rate as when stated “EUR1.00 = USD1.3654.” Since most international business activities require at least one of the two parties in a business transaction to either pay or receive payment in a currency that is different from their own, an understanding of exchange rates is critical to the conduct of global business. Currency Symbols. As noted, USD and EUR are often used as the symbols for the U.S. dollar and the European Union’s euro. These are the computer symbols (ISO-4217 codes) used today on the world’s digital networks. The field of international finance, however, has a rich history of using a variety of different symbols in the financial press, and a variety of different abbreviations are commonly used. For example, the British pound sterling may be £ (the pound symbol), GBP (Great Britain pound), STG (British pound sterling), ST£ (pound sterling), or UKL (United Kingdom pound). This book uses the simpler common symbols—the $ (dollar), the € (euro), the ¥ (yen), the £ (pound)—but be warned and watchful when reading the business press! Exchange Rate Quotations and Terminology. Exhibit 1.2 lists currency exchange rates for January 13, 2014, as would be quoted in New York or London. The exchange rate listed is for a specific country’s currency—for example, the Argentina peso against the U.S. dollar is Peso 6.6580/$, against the European euro is Peso 9.0905/€, and against the British pound is Peso 10.9078/£. The rate listed is termed a “mid-rate” because it is the middle or average of the rates at which currency traders buy currency (bid rate) and sell currency (offer rate). The U.S. dollar has been the focal point of most currency trading since the 1940s. As a result, most of the world’s currencies have been quoted against the dollar—Mexican pesos per dollar, Brazilian real per dollar, Hong Kong dollars per dollar, etc. This quotation convention is also followed against the world’s major currencies, as listed in Exhibit 1.2. For example, the Japanese yen is commonly quoted as ¥103.365/$, ¥141.129/€, and 169.343/£. Quotation Conventions. Several of the world’s major currency exchange rates, however, follow a specific quotation convention that is the result of tradition and history. The exchange rate between the U.S. dollar and the euro is always quoted as “dollars per euro” or $/€. For example, $1.3654 listed in Exhibit 1.2 under “United States.” Similarly, the exchange rate between the U.S. dollar and the British pound is always quoted as “dollars per pound” or $/£. For example, $1.6383 listed under “United States” in Exhibit 1.2. In addition, countries that were formerly members of the British Commonwealth will often be quoted against the U.S. dollar, as in U.S. dollars per Australian dollar or U.S. dollars per Canadian dollar. Exhibit 1.2 January 13, 2014 Country Selected Global Currency Exchange Rates Currency Symbol Code Currency to Equal 1 U.S. Dollar Currency to Equal 1 Euro Currency to Equal 1 Pound 10.9078 Argentina peso Ps ARS 6.6580 9.0905 Australia dollar A$ AUD 1.1043 1.5078 1.8092 Bahrain dinar — BHD 0.3770 0.5148 0.6177 Bolivia boliviano Bs BOB 6.9100 9.4346 11.3207 Brazil real R$ BRL 2.3446 3.2012 3.8411 Canada dollar C$ CAD 1.0866 1.4836 1.7801 863.351 Chile peso $ CLP 526.980 719.512 China yuan ¥ CNY 6.0434 8.2514 9.9009 Colombia peso Col$ COP 1,924.70 2,627.89 3,153.24 colon 499.475 681.959 818.291 koruna // C Kc CRC Czech Republic Costa Rica CZK 20.0425 27.3650 32.8356 Denmark krone Dkr DKK 5.4656 7.4624 8.9542 Egypt pound £ EGP 6.9562 9.4977 11.3964 12.7045 Hong Kong dollar HK$ HKD 7.7547 10.5878 Hungary forint Ft HUF 218.680 298.575 358.264 India rupee INR 61.5750 84.0715 100.8780 Indonesia rupiah Rp IDR 12,050.0 16,452.5 19,741.5 rial — IRR 12,395.5 16,924.2 20,307.5 Israel shekel Shk ILS 3.4882 4.7627 5.7148 Japan yen ¥ JPY 103.365 141.129 169.343 141.303 Iran Kenya shilling KSh KES 86.250 117.761 Kuwait dinar — KWD 0.2824 0.3856 0.4627 Malaysia ringgit RM MYR 3.2635 4.4559 5.3466 21.2561 Mexico new peso $ MXN 12.9745 17.7148 New Zealand dollar NZD 1.1957 1.6326 1.9590 Nigeria naira NZ$ = N NGN 159.750 218.115 261.718 Norway krone NKr NOK 6.1216 8.3581 10.0290 Pakistan rupee Rs. PKR 105.535 144.092 172.898 new sol S/. = P PEN 2.7965 3.8182 4.5816 peso PHP 44.5950 60.8878 73.0600 zloty — PLN 3.0421 4.1535 4.9839 new leu L RON 3.3133 4.5238 5.4281 54.4997 Peru Phillippines Poland Romania Russia ruble RUB 33.2660 45.4198 Saudi Arabia riyal SR SAR 3.7505 5.1207 6.1444 Singapore dollar S$ SGD 1.2650 1.7272 2.0725 South Africa rand R ZAR 10.7750 14.7117 17.6527 South Korea won W KRW 1,056.65 1,442.70 1,731.11 Sweden krona SKr SEK 6.4986 8.8728 10.6466 Switzerland franc Fr. CHF 0.9026 1.2324 1.4788 Taiwan dollar T$ TWD 30.0060 40.9687 49.1588 Thailand baht B THB 32.9750 45.0224 54.0230 Tunisia dinar DT TND 1.6548 2.2593 2.7110 Turkey lira TRY 2.1773 2.9728 3.5671 Ukraine hrywnja — UAH 8.3125 11.3495 13.6184 United Arab Emirates dirham — AED 3.6730 5.0149 6.0175 United Kingdom pound £ GBP 0.6104 0.8334 — United States dollar $ USD — 1.3654 1.6383 peso $U UYU 21.6050 29.4984 35.3955 bolivar fuerte Bs d – € VEB 6.2921 8.5910 10.3084 VND 21,090.0 28,795.2 34,551.8 EUR 0.7324 — 1.1999 — SDR 0.6509 0.8887 1.0663 Uruguay Venezuela Vietnam dong Euro euro Special Drawing Right — Notes: A number of different currencies use the same symbol (for example both China and Japan have traditionally used the ¥ symbol, yen or yuan, meaning round or circle). That is one of the reasons why most of the world’s currency markets today use the three-digit currency code for clarity of quotation. All quotes are mid-rates, and are drawn from the Financial Times, January 14, 2014. The British pound and euro are quoted here in the identical terms — per dollar, per euro, per pound — as are all other country currencies. However, the Financial Times, which is the original source for these currency quotations, will quote the pound and euro in the reciprocal form as is industry practice for these currencies. 7 8 PART 1  Global Financial Environment Eurocurrencies and LIBOR One of the major linkages of global money and capital markets is the eurocurrency market and its interest rate, which is LIBOR. Eurocurrencies are domestic currencies of one country on deposit in a second country for a period ranging from overnight to more than a year or longer. Certificates of deposit are usually for three months or more and in million-dollar increments. A eurodollar deposit is not a demand deposit—it is not created on the bank’s books by writing loans against required fractional reserves, and it cannot be transferred by a check drawn on the bank having the deposit. Eurodollar deposits are transferred by wire or cable transfer of an underlying balance held in a correspondent bank located within the United States. In most countries, a domestic analogy would be the transfer of deposits held in nonbank savings associations. These are transferred when the association writes its own check on a commercial bank. Any convertible currency can exist in “euro-” form. Note that this use of “euro-” should not be confused with the new common European currency called the euro. The eurocurrency market includes eurosterling (British pounds deposited outside the United Kingdom); euroeuros (euros on deposit outside the eurozone); euroyen (Japanese yen deposited outside Japan) and eurodollars (U.S. dollars deposited outside the U.S.). Eurocurrency markets serve two valuable purposes: 1) eurocurrency deposits are an efficient and convenient money market device for holding excess corporate liquidity; and 2) the eurocurrency market is a major source of short-term bank loans to finance corporate working capital needs, including the financing of imports and exports. Banks in which eurocurrencies are deposited are called eurobanks. A eurobank is a financial intermediary that simultaneously bids for time deposits and makes loans in a currency other than that of its home currency. Eurobanks are major world banks that conduct a eurocurrency business in addition to all other banking functions. Thus, the eurocurrency operation that qualifies a bank for the name eurobank is, in fact, a department of a large commercial bank, and the name springs from the performance of this function. The modern eurocurrency market was born shortly after World War II. Eastern European holders of dollars, including the various state trading banks of the Soviet Union, were afraid to deposit their dollar holdings in the United States because those deposits might be attached by U.S. residents with claims against communist governments. Therefore, Eastern European holders deposited their dollars in Western Europe, particularly with two Soviet banks: the Moscow Narodny Bank in London, and the Banque Commerciale pour l’Europe du Nord in Paris. These banks redeposited the funds in other Western banks, especially in London. Additional dollar deposits were received from various central banks in Western Europe, which elected to hold part of their dollar reserves in this form to obtain a higher yield. Commercial banks also placed their dollar balances in the market because specific maturities could be negotiated in the eurodollar market. Such companies found it financially advantageous to keep their dollar reserves in the higher-yielding eurodollar market. Various holders of international refugee funds also supplied funds. Although the basic causes of the growth of the eurocurrency market are economic efficiencies, many unique institutional events during the 1950s and 1960s contributed to its growth. ■ ■ In 1957, British monetary authorities responded to a weakening of the pound by imposing tight controls on U.K. bank lending in sterling to nonresidents of the United Kingdom. Encouraged by the Bank of England, U.K. banks turned to dollar lending as the only alternative that would allow them to maintain their leading position in world finance. For this they needed dollar deposits. Although New York was “home base” for the dollar and had a large domestic money and capital market, international trading in the dollar centered in London because of that city’s Chapter 1   Multinational Financial Management: Opportunities and Challenges ■ 9 expertise in international monetary matters and its proximity in time and distance to major customers. Additional support for a European-based dollar market came from the balance of payments difficulties of the U.S. during the 1960s, which temporarily segmented the U.S. domestic capital market. Ultimately, however, the eurocurrency market continues to thrive because it is a large international money market relatively free from governmental regulation and interference. Eurocurrency Interest Rates. The reference rate of interest in the eurocurrency market is the London Interbank Offered Rate, or LIBOR. LIBOR is the most widely accepted rate of interest used in standardized quotations, loan agreements or financial derivatives valuations. The use of interbank offered rates, however, is not confined to London. Most major domestic financial centers construct their own interbank offered rates for local loan agreements. Examples of such rates include PIBOR (Paris Interbank Offered Rate), MIBOR (Madrid Interbank Offered Rate), SIBOR (Singapore Interbank Offered Rate), and FIBOR (Frankfurt Interbank Offered Rate), to name but a few. The key factor attracting both depositors and borrowers to the eurocurrency loan market is the narrow interest rate spread within that market. The difference between deposit and loan rates is often less than 1%. Interest spreads in the eurocurrency market are small for many reasons. Low lending rates exist because the eurocurrency market is a wholesale market, where deposits and loans are made in amounts of $500,000 or more on an unsecured basis. Borrowers are usually large corporations or government entities that qualify for low rates because of their credit standing and because the transaction size is large. In addition, overhead assigned to the eurocurrency operation by participating banks is small. Deposit rates are higher in the eurocurrency markets than in most domestic currency markets because the financial institutions offering eurocurrency activities are not subject to many of the regulations and reserve requirements imposed on traditional domestic banks and banking activities. With these costs removed, rates are subject to more competitive pressures, deposit rates are higher, and loan rates are lower. A second major area of cost avoided in the eurocurrency markets is the payment of deposit insurance fees (such as the Federal Deposit Insurance Corporation, FDIC) and assessments paid on deposits in the United States. The Theory of Comparative Advantage The theory of comparative advantage provides a basis for explaining and justifying international trade in a model world assumed to enjoy free trade, perfect competition, no uncertainty, costless information, and no government interference. The theory’s origins lie in the work of Adam Smith, and particularly with his seminal book, The Wealth of Nations, published in 1776. Smith sought to explain why the division of labor in productive activities, and subsequently international trade of those goods, increased the quality of life for all citizens. Smith based his work on the concept of absolute advantage, with every country specializing in the production of those goods for which it was uniquely suited. More would be produced for less. Thus, with each country specializing in products for which it possessed absolute advantage, countries could produce more in total and trade for goods that were cheaper in price than those produced at home. In his work, On the Principles of Political Economy and Taxation, published in 1817, David Ricardo sought to take the basic ideas set down by Adam Smith a few logical steps further. Ricardo noted that even if a country possessed absolute advantage in the production of two goods, it might still be relatively more efficient than the other country in one good’s 10 PART 1  Global Financial Environment production than the production of the other good. Ricardo termed this comparative advantage. Each country would then possess comparative advantage in the production of one of the two products, and both countries would then benefit by specializing completely in one product and trading for the other. Although international trade might have approached the comparative advantage model during the nineteenth century, it certainly does not today, for a variety of reasons. Countries do not appear to specialize only in those products that could be most efficiently produced by that country’s particular factors of production. Instead, governments interfere with comparative advantage for a variety of economic and political reasons, such as to achieve full employment, economic development, national self-sufficiency in defense-related industries, and protection of an agricultural sector’s way of life. Government interference takes the form of tariffs, quotas, and other non-tariff restrictions. At least two of the factors of production—capital and technology—now flow directly and easily between countries, rather than only indirectly through traded goods and services. This direct flow occurs between related subsidiaries and affiliates of multinational firms, as well as between unrelated firms via loans and license and management contracts. Even labor flows between countries, such as immigrants into the United States (legal and illegal), immigrants within the European Union, and other unions. Modern factors of production are more numerous than in this simple model. Factors considered in the location of production facilities worldwide include local and managerial skills, a dependable legal structure for settling contract disputes, research and development competence, educational levels of available workers, energy resources, consumer demand for brand name goods, mineral and raw material availability, access to capital, tax differentials, supporting infrastructure (roads, ports, and communication facilities), and possibly others. Although the terms of trade are ultimately determined by supply and demand, the process by which the terms are set is different from that visualized in traditional trade theory. They are determined partly by administered pricing in oligopolistic markets. Comparative advantage shifts over time as less-developed countries become more developed and realize their latent opportunities. For example, over the past 150 years comparative advantage in producing cotton textiles has shifted from the United Kingdom to the United States, to Japan, to Hong Kong, to Taiwan, and to China. The classical model of comparative advantage also did not really address certain other issues such as the effect of uncertainty and information costs, the role of differentiated products in imperfectly competitive markets, and economies of scale. Nevertheless, although the world is a long way from the classical trade model, the general principle of comparative advantage is still valid. The closer the world gets to true international specialization, the more world production and consumption can be increased, provided that the problem of equitable distribution of the benefits can be solved to the satisfaction of consumers, producers, and political leaders. Complete specialization, however, remains an unrealistic limiting case, just as perfect competition is a limiting case in microeconomic theory. Global Outsourcing of Comparative Advantage Comparative advantage is still a relevant theory to explain why particular countries are most suitable for exports of goods and services that support the global supply chain of both MNEs and domestic firms. The comparative advantage of the twenty-first century, however, is one that is based more on services, and their cross-border facilitation by telecommunications and the Internet. The source of a nation’s comparative advantage, however, still is created from the mixture of its own labor skills, access to capital, and technology. Chapter 1   Multinational Financial Management: Opportunities and Challenges 11 For example, India has developed a highly efficient and low-cost software industry. This industry supplies not only the creation of custom software, but also call centers for customer support, and other information technology services. The Indian software industry is composed of subsidiaries of MNEs and independent companies. If you own a Hewlett-Packard computer and call the customer support center number for help, you are likely to reach a call center in India. Answering your call will be a knowledgeable Indian software engineer or programmer who will “walk you through” your problem. India has a large number of well-educated, English-speaking technical experts who are paid only a fraction of the salary and overhead earned by their U.S. counterparts. The overcapacity and low cost of international telecommunication networks today further enhances the comparative advantage of an Indian location. The extent of global outsourcing is already reaching out to every corner of the globe. From financial back-offices in Manila, to information technology engineers in Hungary, modern telecommunications now take business activities to labor rather than moving labor to the places of business. What Is Different about International Financial Management? Exhibit 1.3 details some of the main differences between international and domestic financial management. These component differences include institutions, foreign exchange and political risks, and the modifications required of financial theory and financial instruments. Multinational financial management requires an understanding of cultural, historical, and institutional differences such as those affecting corporate governance. Although both domestic firms and MNEs are exposed to foreign exchange risks, MNEs alone face certain unique risks, such as political risks, that are not normally a threat to domestic operations. MNEs also face other risks that can be classified as extensions of domestic finance theory. For example, the normal domestic approach to the cost of capital, sourcing debt and equity, Exhibit 1.3 What Is Different about International Financial Management? Concept International Domestic Culture, history, and institutions Each foreign country is unique and not always understood by MNE management Each country has a known base case Corporate governance Foreign countries’ regulations and institutional practices are all uniquely different Regulations and institutions are well known Foreign exchange risk MNEs face foreign exchange risks due to their subsidiaries, as well as import/ export and foreign competitors Foreign exchange risks from import/ export and foreign competition (no subsidiaries) Political risk MNEs face political risk because of their foreign subsidiaries and high profile Negligible political risks Modification of domestic finance theories MNEs must modify finance theories like capital budgeting and the cost of capital because of foreign complexities Traditional financial theory applies Modification of domestic financial instruments MNEs utilize modified financial instruments such as options, forwards, swaps, and letters of credit Limited use of financial instruments and derivatives because of few foreign exchange and political risks 12 PART 1  Global Financial Environment Global Finance in Practice 1.2 Corporate Responsibility and Corporate Sustainability Sustainable development is development that meets the needs of the present without compromising the ability of future generations to meet their own needs. —Brundtland Report, 1987, p. 54. What is the purpose of the corporation? It is accepted that the purpose of the corporation is to certainly create profits and value for its stakeholders, but the responsibility of the corporation is to do so in a way that inflicts no costs on society, including the environment. As a result of globalization, this growing responsibility and role of the corporation in society has added a level of complexity to the leadership challenges faced by the multinational firm. This developing controversy has been somewhat hampered to date by conflicting terms and labels—corporate goodness, corporate responsibility, corporate social responsibility (CSR), corporate philanthropy, and corporate sustainability, to list but a few. Confusion can be reduced by using a guiding principle—that sustainability is a goal, while responsibility is an obligation. It follows that the obligation of leadership in the modern multinational is to pursue profit, social development, and the environment, all along sustainable principles. The term sustainability has evolved greatly within the context of global business in the past decade. A traditional primary objective of the family-owned business has been the “sustainability of the organization”—the long-term ability of the company to remain commercially viable and provide security and income for future generations. Although narrower in scope, the concept of environmental sustainability shares a common core thread—the ability of a company, a culture, or even the earth, to survive and renew over time. capital budgeting, working capital management, taxation, and credit analysis needs to be modified to accommodate foreign complexities. Moreover, a number of financial instruments that are used in domestic financial management have been modified for use in international financial management. Examples are foreign currency options and futures, interest rate and currency swaps, and letters of credit. The main theme of this book is to analyze how an MNE’s financial management evolves as it pursues global strategic opportunities and new constraints emerge. In this chapter, we will take a brief look at the challenges and risks associated with Trident Corporation (Trident), a company evolving from domestic in scope to becoming truly multinational. The discussion will include constraints that a company will face in terms of managerial goals and governance as it becomes increasingly involved in multinational operations. But first we need to clarify the unique value proposition and advantages that the MNE was created to exploit. And as noted by Global Finance in Practice 1.2, the objectives and responsibilities of the modern multinational have grown significantly more complex in the twenty-first century. Market Imperfections: A Rationale for the Existence of the Multinational Firm MNEs strive to take advantage of imperfections in national markets for products, factors of production, and financial assets. Imperfections in the market for products translate into market opportunities for MNEs. Large international firms are better able to exploit such competitive factors as economies of scale, managerial and technological expertise, product differentiation, and financial strength than are their local competitors. In fact, MNEs thrive best in markets characterized by international oligopolistic competition, where these factors are particularly critical. In addition, once MNEs have established a physical presence abroad, they are in a better position than purely domestic firms to identify and implement market opportunities through their own internal information network. Chapter 1   Multinational Financial Management: Opportunities and Challenges 13 Why Do Firms Become Multinational? Strategic motives drive the decision to invest abroad and become an MNE. These motives can be summarized under the following categories: 1. Market seekers produce in foreign markets either to satisfy local demand or to export to markets other than their home market. U.S. automobile firms manufacturing in Europe for local consumption are an example of market-seeking motivation. 2. Raw material seekers extract raw materials wherever they can be found, either for export or for further processing and sale in the country in which they are found—the host country. Firms in the oil, mining, plantation, and forest industries fall into this category. 3. Production efficiency seekers produce in countries where one or more of the factors of production are underpriced relative to their productivity. Labor-intensive production of electronic components in Taiwan, Malaysia, and Mexico is an example of this motivation. 4. Knowledge seekers operate in foreign countries to gain access to technology or managerial expertise. For example, German, Dutch, and Japanese firms have purchased U.S.-located electronics firms for their technology. 5. Political safety seekers acquire or establish new operations in countries that are considered unlikely to expropriate or interfere with private enterprise. For example, Hong Kong firms invested heavily in the United States, United Kingdom, Canada, and Australia in anticipation of the consequences of China’s 1997 takeover of the British colony. These five types of strategic considerations are not mutually exclusive. Forest products firms seeking wood fiber in Brazil, for example, may also find a large Brazilian market for a portion of their output. In industries characterized by worldwide oligopolistic competition, each of the above strategic motives should be subdivided into proactive and defensive investments. Proactive investments are designed to enhance the growth and profitability of the firm itself. Defensive investments are designed to deny growth and profitability to the firm’s competitors. Examples of the latter are investments that try to preempt a market before competitors can get established in it, or capture raw material sources and deny them to competitors. The Globalization Process Trident is a hypothetical U.S.-based firm that will be used as an illustrative example throughout the book to demonstrate the globalization process—the structural and managerial changes and challenges experienced by a firm as it moves its operations from domestic to global. Global Transition I: Trident Moves from the Domestic Phase to the International Trade Phase Trident is a young firm that manufactures and distributes an array of telecommunication devices. Its initial strategy is to develop a sustainable competitive advantage in the U.S. market. Like many other young firms, it is constrained by its small size, competitors, and lack of access to cheap and plentiful sources of capital. The top half of Exhibit 1.4 shows Trident in its early domestic phase. Trident sells its products in U.S. dollars to U.S. customers and buys its manufacturing and service inputs from U.S. suppliers, paying U.S. dollars. The creditworth of all suppliers and buyers is established under domestic U.S. practices and procedures. A potential 14 PART 1  Global Financial Environment Exhibit 1.4 Trident Corp: Initiation of the Globalization Process Phase One: Domestic Operations U.S. Suppliers (domestic) U.S. Buyers (domestic) All payments in U.S. dollars. All credit risk under U.S. law. Trident Corporation (Los Angeles, USA) Mexican Suppliers Canadian Buyers Are Mexican suppliers dependable? Will Trident pay US$ or Mexican pesos? Are Canadian buyers creditworthy? Will payment be made in US$ or C$? Phase Two: Expansion into International Trade issue for Trident at this time is that although Trident is not international or global in its operations, some of its competitors, suppliers, or buyers may be. This is often the impetus to push a firm like Trident into the first phase of the globalization process—into international trade. Trident was founded by James Winston in Los Angeles in 1948 to make telecommunications equipment. The family-owned business expanded slowly but steadily over the following 40 years. The demands of continual technological investment in the 1980s, however, required that the firm raise additional equity capital in order to compete. This need led to its initial public offering (IPO) in 1988. As a U.S.-based publicly traded company on the New York Stock Exchange, Trident’s management sought to create value for its shareholders. As Trident became a visible and viable competitor in the U.S. market, strategic opportunities arose to expand the firm’s market reach by exporting product and services to one or more foreign markets. The North American Free Trade Area (NAFTA) made trade with Mexico and Canada attractive. This second phase of the globalization process is shown in the lower half of Exhibit 1.4. Trident responded to these globalization forces by importing inputs from Mexican suppliers and making export sales to Canadian buyers. We define this phase of the globalization process as the International Trade Phase. Exporting and importing products and services increases the demands of financial management over and above the traditional requirements of the domestic-only business in two ways. First, direct foreign exchange risks are now borne by the firm. Trident may now need to quote prices in foreign currencies, accept payment in foreign currencies, or pay suppliers in foreign currencies. As the values of currencies change from minute to minute in the global marketplace, Trident will increasingly experience significant risks from the changing values associated with these foreign currency payments and receipts. Second, the evaluation of the credit quality of foreign buyers and sellers is now more important than ever. Reducing the possibility of non-payment for exports and non-delivery of imports becomes a key financial management task during the international trade phase. This credit risk management task is much more difficult in international business, as buyers and suppliers are new, subject to differing business practices and legal systems, and generally more challenging to assess. Chapter 1   Multinational Financial Management: Opportunities and Challenges 15 Global Transition II: The International Trade Phase to the Multinational Phase If Trident is successful in its international trade activities, the time will come when the globalization process will progress to the next phase. Trident will soon need to establish foreign sales and service affiliates. This step is often followed by establishing manufacturing operations abroad or by licensing foreign firms to produce and service Trident’s products. The multitude of issues and activities associated with this second larger global transition is the real focus of this book. Trident’s continued globalization will require it to identify the sources of its competitive advantage, and with that knowledge, expand its intellectual capital and physical presence globally. A variety of strategic alternatives are available to Trident—the foreign direct investment sequence—as shown in Exhibit 1.5. These alternatives include the creation of foreign sales offices, the licensing of the company name and everything associated with it, and the manufacturing and distribution of its products to other firms in foreign markets. As Trident moves farther down and to the right in Exhibit 1.5, the degree of its physical presence in foreign markets increases. It may now own its own distribution and production facilities, and ultimately, may want to acquire other companies. Once Trident owns assets and enterprises in foreign countries it has entered the multinational phase of its globalization. The Limits to Financial Globalization The theories of international business and international finance introduced in this chapter have long argued that with an increasingly open and transparent global marketplace in which capital may flow freely, capital will increasingly flow and support countries and companies Exhibit 1.5 Trident’s Foreign Direct Investment Sequence Trident and Its Competitive Advantage Change Competitive Advantage Greater Foreign Presence Exploit Existing Competitive Advantage Abroad Production at Home: Exporting Production Abroad Licensing Management Contract Control Assets Abroad Wholly Owned Subsidiary Joint Venture Greater Foreign Investment Greenfield Investment Acquisition of of aa Acquisition Foreign Enterprise Enterprise Foreign 16 PART 1  Global Financial Environment based on the theory of comparative advantage. Since the mid-twentieth century, this has indeed been the case as more and more countries have pursued more open and competitive markets. But the past decade has seen the growth of a new kind of limit or impediment to financial globalization: the growth in the influence and self-enrichment of organizational insiders. One possible representation of this process can be seen in Exhibit 1.6. If influential insiders in corporations and sovereign states continue to pursue the increase in firm value, there will be a definite and continuing growth in financial globalization. But, if these same influential insiders pursue their own personal agendas, which may increase their personal power and influence or personal wealth, or both, then capital will not flow into these sovereign states and corporations. The result is the growth of financial inefficiency and the segmentation of globalization outcomes—creating winners and losers. As we will see throughout this book, this barrier to international finance may indeed be increasingly troublesome. This growing dilemma is also something of a composite of what this book is about. The three fundamental elements—financial theory, global business, and management beliefs and actions—combine to present either the problem or the solution to the growing debate over the benefits of globalization to countries and cultures worldwide. The Mini-Case sets the stage for our debate and discussion. Are the controlling family members of this company creating value for themselves or for their shareholders? We close this chapter—and open this book—with the simple words of one of our colleagues in a recent conference on the outlook for global finance and global financial management. Welcome to the future. This will be a constant struggle. We need leadership, citizenship, and dialogue. —Donald Lessard, in Global Risk, New Perspectives and Opportunities, 2011, p. 33. Exhibit 1.6 The Limits of Financial Globalization There is a growing debate over whether many of the insiders and rulers of organizations with enterprises globally are taking actions consistent with creating firm value or consistent with increasing their own personal stakes and power. Actions of Rulers of Sovereign States Higher Firm Value (possibly lower insider value) The Twin Agency Problems Limiting Financial Globalization Lower Firm Value (possibly higher insider value) Actions of Corporate Insiders If these influential insiders are building personal wealth over that of the firm, it will indeed result in preventing the flow of capital across borders, currencies, and institutions to create a more open and integrated global financial community. Source: Constructed by authors based on “The Limits of Financial Globalization,” Rene M. Stulz, Journal of Applied Corporate Finance, Vol. 19, No. 1, Winter 2007, pp. 8–15. Chapter 1   Multinational Financial Management: Opportunities and Challenges 17 Summary Points ■ The creation of value requires combining three critical elements: 1) an open marketplace; 2) high-quality strategic management; and 3) access to capital. ■ The theory of comparative advantage provides a basis for explaining and justifying international trade in a model world assumed to enjoy free trade, perfect competition, no uncertainty, costless information, and no government interference. ■ ■ ■ International financial management requires an understanding of cultural, historical, and institutional differences, such as those affecting corporate governance. Although both domestic firms and MNEs are exposed to foreign exchange risks, MNEs alone face certain unique risks, such as political risks, that are not normally a threat to domestic operations. MNEs strive to take advantage of imperfections in national markets for products, factors of production, and financial assets. Mini-Case Bitcoin—Cryptocurrency or Commodity?1 The difference is that established fiat currencies—ones where the bills and coins, or their digital versions, get their value by dint of regulation or law—are underwritten by the state which is, in principle at least, answerable to its citizens. Bitcoin, on the other hand, is a community currency. It requires self-policing on the part of its users. To some, this is a feature, not a bug. But, in the grand scheme of things, the necessary open-source engagement remains a niche pursuit. Most people would rather devolve this sort of responsibility to the authorities. Until this mindset changes, Bitcoin will be no rival to real-world dosh. —“Bits and bob,” The Economist, June 13, 2011. Bitcoin is an open-source, peer-to-peer, digital currency. It is a cryptocurrency, a digital currency that is created and managed using advanced encryption techniques known as cryptography. And it may be the world’s first completely decentralized digital-payments system. The unofficial three letter currency code for Bitcoin is BTC, and its singular currency symbol is shown above. ■ Large international firms are better able to exploit such competitive factors as economies of scale, managerial and technological expertise, product differentiation, and financial strength than are their local competitors. ■ A firm may first enter into international trade transactions, then international contractual arrangements, such as sales offices and franchising, and ultimately the acquisition of foreign subsidiaries. At this final stage it truly becomes a multinational enterprise (MNE). ■ The decision whether or not to invest abroad is driven by strategic motives and may require the MNE to enter into global licensing agreements, joint ventures, crossborder acquisitions, or greenfield investments. ■ If influential insiders in corporations and sovereign states pursue their own personal agendas, which may increase their personal power, influence, or wealth, then capital will not flow into these sovereign states and corporations. This will, in turn, create limitations to globalization in finance. But is Bitcoin a true currency? Is it, or can it become, money? In January 2014 a number of major regulatory bodies across the world—the U.S. Federal Reserve, the European Central Bank, the People’s Bank of China—were all trying to decide whether Bitcoin was something to be prohibited, regulated, or simply left alone. Perspectives on Bitcoin use varied dramatically, and in many cases, unexpectedly so. But the regulators were only one stakeholder interest; users and producers had their own perspectives on the potential of Bitcoin. Producing and Using Bitcoins Bitcoin was invented in 2009 by a man claiming to be Satoshi Nakamoto. Nakamoto published, via the Internet, a nine-page paper outlining how the Bitcoin system would work. He also provided the open-source code needed to both produce the digital coins (mine in Bitcoin terminology) and trade Bitcoins digitally as money. (Nakamoto is not thought to be a real person, likely being a nome de plume for some relatively small working group. Nakamoto disappeared from the Internet in 2012.) Mining. The actual mining of Bitcoins is a mathematical process. The miner must find a sequence of data (called a block) that produces a particular pattern when the Bitcoin Copyright © 2014 Thunderbird School of Global Management. All rights reserved. This case was prepared by Professor Michael H. Moffett for the purpose of classroom discussion only and not to indicate either effective or ineffective management. 1 18 PART 1  Global Financial Environment hash algorithm is applied to it. When a match is found, the miner obtains a bounty—an allocation—of Bitcoins. This repetitive guessing, conducted by increasingly complex computers, is called hashing. The motivation for mining is clear: to make and earn money. The Bitcoin software system is designed to release a 25-coin reward to the miner in the worldwide network (anyone, anywhere, can theoretically be a part of the network) who succeeds in solving the mathematical problem. Once solved, the solution is broadcast network-wide, and competition for the next 25-coin reward begins. The system’s protocol is designed to release a new block of Bitcoins every 10 minutes until all 21 million are released, with the blocks getting smaller as time goes on. If the miners in the network take more than 10 minutes to find the correct code, the Bitcoin program adapts to make the mathematics easier. If the miners solve the problems in less than 10 minutes, the mathematical code becomes harder. The difficulty of the search continually increases over time with mining. This creates an ever-increasing scarcity over time, similar to what many believe about gold when gold was the basis of currency values. But ultimately the Bitcoin system is limited in both time (every 10 minutes) and total issuance (21 million). Theoretically the last of the 21 million Bitcoins would be mined in 2140. Within a few short years Bitcoin mining has become a big business of its own. Whereas in the early stages an individual could have theoretically mined Bitcoins on a laptop, or theoretically without a computer at all, that is no longer the case. By 2014, Bitcoin mining had become the object of multimillion dollar investments in computer systems by business startups from Iceland to Austin in what one journalist described as a “computational arms race.” Eleven ­million of the total potential 21 million coins had been mined. Users. Once mined, Bitcoins are considered a pseudonymous—nearly anonymous—cryptocurrency.2 Bitcoins are initially issued to the successful miners, who are then able to buy things with them or sell them to non-miners who wish to use digital currency for purchases or speculate on its future value. Ownership of each and every coin is verified and registered through a digital chain timestamp across the thousands of network nodes. Like cash, this prevents double spending, since every Bitcoin exchange is authenticated across the decentralized Bitcoin network (currently estimated at 20,000 nodes). Unlike cash, every transaction that has ever occurred in the Bitcoin system is recorded in terms of the two public keys (the transactors, the Bitcoin addresses) in the system. This record, called the block chain, includes the time, amount, and the two near-anonymous IP addresses (public keys are not tied to any person’s identity). And unlike credit cards or PayPal, there is no third-party facilitator. It is true peer-to-peer. The Bitcoin Foundation, a nonprofit organization, runs the global system. The current Bitcoin Foundation chief scientist is Gavin Andresen, who is paid a salary. The Foundation is funded mainly through grants made by for-profit companies (like the Linux Foundation) who either mine or use the Bitcoin system. Value Drivers and Concerns Traditional currencies are issued by governments through central banks. They regulate the growth of the currency, its supply, and they also implicitly guarantee its value in some way. Bitcoin has no such guarantor, no insurer, no lenderof-last-resort. If a Bitcoin user were to lose or erase their records of ownership, there would be no support or insurer—no one to sue, no institution to apply to for recourse.3 The value of a Bitcoin is completely dependent on what users and investors are willing to pay for it at any point in time. This makes it similar in nature to both a currency and a commodity. Bitcoin is a rather complex composite of currency systems. A gold standard like that used in the first part of the twentieth century, is a system based on specie; it has some fixed link to a scarce metal of some intrinsic value. Bitcoin does have digital scarcity, and ultimately a fixed limit on its availability. But Bitcoins have no intrinsic value; they are not composed of a precious metal; they are nothing more than digital code. Their value reflects the supply and demand by those in the marketplace who believe in its value—a fiat currency—similar to the world’s major currencies today. As illustrated in Exhibit A, that value has been very volatile. After spending several years trading at less than $10 per Bitcoin (using U.S. dollar values, like an exchange rate), its price skyrocketed to $1238 per coin in December 2013—and then plummeted. The reasons behind Bitcoin’s price volatility in 2013 provide some insight into its potential uses. A bank crisis in November 2013 in Cyprus resulted in many Cypriot citizens putting their money into Bitcoins (bidding the price up) in an effort to keep their money out of the hands of government. Similarly, in late 2013 Bitcoins surged in interest and use in China. Chinese residents, in search of a way to invest their money outside of China despite Chinese capital controls (restrictions on taking money out of the country), purchased Bitcoins through a number of different Bitcoin exchanges in China, using Chinese renminbi, and then used the Bitcoins to invest abroad. Chinese authorities moved Bitcoin is not the only cryptocurrency or altcoin. Competitors include Litecoin, Ripple, MintChip, Anoncoin, Peercoin, and Zerocoin. Physical bitcoins, called Casascius coins, can be purchased from casascius.com. These coins contain a private key on a card embedded in the coin and sealed with a tamper-evident hologram. 2 3 19 Chapter 1   Multinational Financial Management: Opportunities and Challenges Exhibit A Bitcoin Price in U.S. Dollars Daily close: January 1, 2013 – January 19, 2014 $1,4...
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