Book summary “International financial management”: summary

Introduction

You operate in a world where borders no longer define business limits. Sovereign currencies, distinct tax regimes, and varying regulatory frameworks create complex operational risks that domestic finance principles alone cannot solve.

International financial management requires mastering foreign exchange risks, market imperfections, and global capital allocation to maximize shareholder wealth. Cheol S. Eun provides a comprehensive framework to navigate these multinational financial challenges and global capital markets.

The book structures these solutions across four core areas. You will explore the foundational differences of international finance, foreign exchange markets, exposure management, and global financial policies.

Consider how you will answer these critical questions:

• How do you measure and hedge foreign exchange exposure?
• Where should you raise capital to minimize your cost of capital?
• How do you evaluate foreign direct investments under political risk?

1. Foundations of International Financial Management

International finance differs from domestic finance because sovereign nations issue separate currencies, set independent economic policies, levy taxes, and regulate cross-border movements.

International finance differs from domestic finance due to foreign exchange and political risks, market imperfections, and an expanded opportunity set.

When the Mexican peso depreciated drastically in December 1994, American exports were priced out of the Mexican market.

What is Special about International Finance

Political risk involves unexpected changes in rules or expropriation of assets by sovereign governments where affected parties lack effective legal recourse. Sovereign nations possess the power to alter the rules of the game, which can wipe out shareholder and investor property rights in countries lacking the rule of law.

In 1995, nationalist politicians in Maharashtra, India, canceled Enron Development Corporation's power plant project after Enron spent nearly $300 million. Similarly, Argentina nationalized YPF from Repsol in 2012, and Russian authorities forced Yukos into bankruptcy.

Market imperfections such as legal restrictions, transaction costs, and tax barriers prevent free movement of resources and create unique international pricing anomalies. Barriers across national boundaries restrict optimal portfolio diversification and cause price disparities between shares reserved for domestic residents versus foreign investors.

Nestle Corporation formerly issued bearer shares and registered shares where foreigners could only hold bearer shares, causing bearer shares to trade at roughly twice the price of registered shares until restrictions were lifted.

Evolution of the International Monetary System

The classical gold standard automatically regulated exchange rates and international trade imbalances via cross-border gold flows. Under the classical gold standard, currencies were pegged to fixed amounts of gold, and international payment imbalances were self-correcting through David Hume's price-specie-flow mechanism, where gold flows adjusted domestic price levels.

The dollar-sterling exchange rate remained within a narrow range of $4.84 and $4.90 per pound during the entire period of the classical gold standard.

The Triffin paradox explains that a reserve-currency country must run continuous balance of payments deficits to supply reserves, which ultimately undermines confidence in the reserve currency. Under a dollar-based gold-exchange standard, the world needs a steady supply of dollars for reserves, requiring perennial U.S. deficits, but these growing deficits eventually exceed the U.S. gold stock, causing a crisis of confidence.

By the early 1960s, the total value of the U.S. gold stock at thirty-five dollars per ounce fell short of foreign dollar holdings, prompting President Charles de Gaulle to have the Bank of France buy gold from the U.S. Treasury.

The incompatible trinity dictates that a country can simultaneously choose only two of three conditions: a fixed exchange rate, free international capital flows, and an independent monetary policy. To maintain a fixed exchange rate alongside monetary policy independence, a country must implement capital controls, while full financial market integration forces policymakers to sacrifice either exchange rate stability or monetary autonomy.

China and India avoided the worst of the Asian currency crisis because they maintained capital controls, whereas Hong Kong pegged its currency to the U.S. dollar via a currency board while allowing free capital flows, thereby surrendering monetary independence.

Balance of Payments Accounting

The balance of payments is a statistical record of all economic transactions between a country's residents and the rest of the world over a specific period, utilizing a double-entry bookkeeping system. Every international transaction generates a matching credit and debit entry. Transactions resulting in receipts from foreigners are recorded as credits with a positive sign, while transactions resulting in payments to foreigners are recorded as debits with a negative sign.

Boeing Corporation exported an aircraft to Japan Airlines for $50 million paid from a New York bank account, recorded as a $50 million credit for the export and a matching $50 million debit for the reduction of the U.S. bank liabilities.

A country's international transactions are grouped into four main accounts: the current account, the capital account, the financial account, and the official reserve account. The current account tracks goods, services, primary income, and secondary income. The capital account records capital transfers and nonproduced, nonfinancial assets. The financial account covers direct investment, portfolio investment, and other investments. The official reserve account handles international reserve assets.

The financial account measures the net difference between a country's sales and purchases of financial assets and is divided into direct investment, portfolio investment, and other investment. Foreign direct investment involves acquiring a controlling interest, defined as 10 percent or more of voting shares. Portfolio investment covers stock and bond transactions without control transfer. Other investment includes bank deposits, currency, and trade credits.

Abu Dhabi Investment Authority invested $7.5 billion in Citigroup and Temasek Holdings injected $5.0 billion into Merrill Lynch to replenish capital bases following subprime mortgage losses.

A country's current account balance is intimately connected to national income accounting through domestic savings, private investment, and government budget deficits. When domestic savings are insufficient to finance domestic investment, or when tax revenues fall short of government spending, you must rely on foreign-controlled capital and run a current account deficit.

To evaluate these macroeconomic relationships, you can apply several specific adjustments:

• Reduce the government budget deficit for a given level of savings and investment.
• Increase savings for a given level of investment and government budget deficit.
• Reduce investment for a given level of savings and government budget deficit.

2. Foreign Exchange Markets and Derivatives

The decentralized foreign exchange market operates continuously across global trading centers, supported by spot, forward, futures, and options contracts.

Function and Structure of the FX Market

The foreign exchange market is the largest financial market globally, operating continuously with massive daily turnover. Worldwide daily trading reached trillions in 2019, driven heavily by swap transactions. You participate through an over-the-counter network of banks, nonbank dealers, and brokers.

• London remains the world's largest foreign exchange trading center.
• New York represents the primary U.S. hub.

In 2019, worldwide daily trading of spot and forward foreign exchange hit $6.19 trillion. The U.K. recorded $3.33 trillion in daily trading volume, while U.S. daily turnover reached $1.30 trillion. Spot foreign exchange trading accounted for 32 percent of FX trades. Interbank forward swap transactions made up 50 percent of trading, and outright forward trades accounted for 15 percent.

Spot exchange rates involve immediate currency exchanges, and are expressed through direct or indirect quotations depending on your perspective. Standard spot settlement between the U.S. dollar and non-North American currencies takes two business days. Settlement between the U.S. dollar and the Canadian dollar or Mexican peso takes one business day.

Quotations are categorized as American terms, which state the price of foreign currency in domestic currency, or European terms, which state the price of domestic currency in foreign currency. The spot quote for one British pound was 1.3158 in American terms and 0.7600 in European terms.

Cross-exchange rates between non-dollar currencies must align with implied rates to prevent risk-free triangular arbitrage. You can calculate cross-rates using dollar exchange rates. If direct cross-rates quoted by market makers diverge from implied rates, you can execute a sequence of three currency trades to lock in a zero-risk profit.

A trader starts with $1,000,000, converts dollars to Swiss francs, sells those francs for Japanese yen at a mispriced rate at Mizuho Bank, and converts the yen back to dollars for a profit of $4,560.07.

To capture this mispricing, you follow these steps:

• Sell dollars and buy the first currency from a bank quoting a specific ask or bid rate.
• Sell the first currency and buy a third currency from the mispriced direct cross-rate market maker.
• Sell the third currency back to dollars via the corresponding interbank market quote to realize a risk-free dollar profit.

Bank dealers frequently use forward swap transactions and forward points to quote rates and neutralize currency exposures. A forward swap involves the simultaneous spot and forward purchase or sale of currencies. When spot SFr/$ bid-ask is 0.9982-0.9985 and one-month forward points are 29-27, you subtract the points to yield outright forward bid-ask quotes of 0.9953-0.9958.

Interest Rate Parity

Interest rate parity is an arbitrage condition that links interest rates between two countries through spot and forward exchange rates.

When international financial markets are in equilibrium, investing domestically must yield the exact same future dollar return as investing in a foreign country and hedging the exchange risk with a forward contract. If this equality is violated, covered interest arbitrage opportunities arise. The theory rests on the law of one price and assumes capital moves freely across borders.

Purchasing power parity states that the exchange rate between two currencies should equal the ratio of their price levels, reflecting the law of one price applied to standard consumption baskets. The absolute version of PPP equates exchange rates directly to price level ratios. The relative version equates the rate of change in the exchange rate to the inflation rate differential between countries.

Empirical tests show that short-run deviations are substantial and convergence is slow. The Economist utilizes the Big Mac index to compare local burger prices converted at actual exchange rates against the United States price to evaluate whether currencies are overvalued or undervalued. As of January 2019, an American Big Mac cost $5.58, while a Chinese Big Mac cost 20.9 yuan. Historical studies estimate that PPP deviations have a half-life of 3 to 5 years.

You can project exchange rates using the fundamental approach, which uses formal macroeconomic models based on variables like relative money supplies, velocities, and national outputs. Generating forecasts requires specific operational steps:

• Estimation of the structural model using historical data to determine numerical parameter values.
• Estimation of future values of the independent variables.
• Substituting the estimated values of independent variables into the estimated structural model to generate exchange rate forecasts.

Derivatives and Risk Management

Forward contracts allow participants to lock in exchange rates for future delivery dates, quoting prices at a premium or discount. Forward agreements involve no immediate cash exchange, and maturities typically range from one to twelve months. Forward premiums or discounts reflect annualized percentage deviations from spot rates.

A trader taking a short position on a three-month Swiss franc forward contract at 1.0104 profits when the spot rate drops to 1.0000 on the maturity date. When calculating forward maturities, you use a 360-day banker's year. For instance, the Japanese yen exhibited a 2.65 percent three-month forward premium versus the U.S. dollar in illustrative market quotes. Non-Deliverable Forward Contracts serve markets where physical currency delivery is restricted.

Futures contracts differ significantly from forward contracts because they are standardized, exchange-traded, and settled daily via marking-to-market. While forward contracts are tailor-made over-the-counter agreements where delivery is common, futures contracts have standardized sizes and maturities, are traded on organized exchanges, and use a clearinghouse as a third party.

Futures positions are marked-to-market daily through a performance bond account, meaning profits and losses are realized daily rather than at maturity. Ninety percent of all forward contracts result in short making delivery, whereas only one percent of currency futures contracts result in delivery. You maintain an initial performance bond equal to roughly 2 percent of contract value, and a maintenance performance bond level equal to roughly 90 percent of the initial bond.

Currency options provide the right, but not the obligation, to buy or sell an asset at a specified price, existing in both American and European styles. An option buyer pays a premium to acquire a call option to buy or a put option to sell. European options can only be exercised at expiration, whereas American options allow early exercise at any time during the contract life. In 2019, average daily OTC options trading volume reached $294 billion, with $1,000,000 serving as the typical minimum size for over-the-counter options.

3. Foreign Exchange Exposure and Management

Multinational corporations must measure and manage transaction, economic, and translation exposures using financial and operational hedging techniques.

Three Types of Exposure

Foreign currency exposures are classified into three types: transaction exposure, economic exposure, and translation exposure. Transaction exposure is the sensitivity of realized domestic currency values of contractual cash flows denominated in foreign currencies to unexpected exchange rate changes. Economic exposure measures the extent to the total firm value affected by unanticipated exchange rate changes. Translation exposure refers to the potential impact of exchange rate changes on consolidated financial statements when translating local currency subsidiary accounts into the home currency.

A U.S. multinational firm with subsidiaries in the United Kingdom and Japan must translate local currency financial statements into U.S. dollars for global consolidation.

While corporate hedging might be redundant in a perfect capital market, market imperfections such as taxes and default costs make it value-enhancing. Market imperfections that justify corporate hedging include information asymmetry between management and stockholders, differential transaction costs where firms acquire lower-cost hedges, default costs whose reduction improves credit ratings and lowers financing costs, and progressive corporate taxes where stable earnings lead to lower tax burdens compared to volatile earnings.

Exporting firm A expects $15 million or $5 million with equal chances under progressive taxes, resulting in a $2.5 million expected tax, whereas hedged firm B earns a certain $10 million and pays a $2 million tax, saving $500,000.

Managing Transaction and Economic Exposure

Firms can eliminate transaction exposure on foreign receivables using forward contracts, money market instruments, or options contracts. A forward market hedge locks in a guaranteed future exchange rate with no upfront cost, eliminating exchange rate uncertainty. A money market hedge replicates this by borrowing in the foreign currency, converting spot, and investing domestically. An options hedge provides a minimum receipt floor while preserving upside potential by paying an upfront premium.

Boeing billing British Airways £10 million in one year with a U.S. interest rate of 6.10 percent, U.K. interest rate of 9.00 percent, spot rate of $1.50/£, and forward rate of $1.46/£.

• Step 1: Borrow £9,174,312.
• Step 2: Convert £9,174,312 into $13,761,468 at the current spot exchange rate of $1.50/£.
• Step 3: Invest $13,761,468 in the United States.
• Step 4: After one year, collect £10 million from British Airways and use it to repay the pound loan.
• Step 5: Receive the maturity value of the dollar investment, that is, $14,600,918 = ($13,761,468)(1.061), which is the guaranteed dollar proceeds from the British sale.

Transaction exposure on foreign payables can be managed to minimize the future domestic currency cost using forward contracts, money market hedges, or options. For payables, a forward contract fixes the purchase cost of the foreign currency. A money market hedge requires borrowing domestic currency, buying foreign currency spot, and investing it at the foreign interest rate. A call option sets a ceiling cost for acquiring the foreign currency while allowing the firm to benefit if the foreign currency weakens.

Boeing importing a Rolls-Royce jet engine for £5 million payable in one year with a U.S. interest rate of 6.00 percent, U.K. interest rate of 6.50 percent, spot rate of $1.80/£, and forward rate of $1.75/£.

Firms can manage transaction exposure using operational techniques such as choice of invoice currency, lead and lag strategies, and exposure netting. Firms can shift, share, or diversify exposure by invoicing in home currency, splitting invoice currencies, or using currency baskets like the SDR. Leading and lagging help avoid losses on soft currencies and capture gains on hard currencies. Exposure netting involves hedging only residual portfolio exposure rather than individual currency positions separately.

Lufthansa signing a contract to buy $3 billion of aircraft from Boeing while having significant dollar-denominated cash flows, creating a natural hedge that rendered an unhedged forward contract a source of loss when the dollar depreciated.

Economic exposure measures what is truly at risk from random exchange rate changes, unlike currency risk or uncertainty which simply denotes random fluctuations. Under certain conditions, assets or cash flows can possess an embedded hedge against exchange risk, making them entirely insensitive to exchange rate movements. Exposure is properly defined as the sensitivity of future home currency values of assets, liabilities, and operating cash flows to random exchange rate changes.

A company maintaining a staff vacation home in the British countryside where local prices move inversely and proportionally with pound-dollar rates faces zero exposure because of an embedded hedge.

To manage operating exposure, firms must implement long-term strategic plans that stabilize cash flows through operational adjustments rather than short-term tactical fixes. Managing operating exposure requires integrating currency considerations into strategic planning regarding facility locations, sourcing channels, and market diversification. These operational hedges protect against both price and quantity risks.

Japanese automakers like Nissan and Toyota shifted production to U.S. and Mexican facilities and maintained multiple manufacturing sites worldwide to mitigate the strong yen.

• Selecting low-cost production sites
• Flexible sourcing policy
• Diversification of the market
• Product differentiation and R&D efforts
• Financial hedging

When operational hedging is impractical or cost-ineffective, firms can establish a structured financial hedging program using derivative instruments to protect strategic R&D investments. Merck & Co. evaluated resource redeployment to shift costs but found it impractical, choosing instead a rigorous five-step financial hedging procedure focused on long-term cash flow maximization and currency options.

Merck controlled a 4.7 percent global market share with $6.6 billion in worldwide sales in 1989, relying on overseas assets for 40 percent of its total and 50 percent of its sales.

• Exchange forecasting
• Assessing strategic plan impact
• Hedging rationale
• Financial instruments
• Hedging program

Managing Translation Exposure

Translation exposure refers to how unanticipated exchange rate changes affect a multinational corporation's consolidated financial reports. Also known as accounting exposure, it occurs when a foreign subsidiary's assets and liabilities denominated in foreign currency are viewed from the parent firm's perspective, requiring a mechanical consolidation process.

Four primary methods have been used in recent history for foreign currency translation: current/noncurrent, monetary/nonmonetary, temporal, and current rate. The current/noncurrent method translates based on maturity. The monetary/nonmonetary method groups accounts by attribute similarity. The temporal method translates monetary accounts at current rates and historical-cost accounts at historical rates. The current rate method translates almost all balance sheet accounts at the current exchange rate, using a cumulative translation adjustment account.

FASB 8 required recognizing translation gains or losses through the income statement, while FASB 52 introduced the functional currency concept and routed translation adjustments to equity. FASB 8 caused excessive year-to-year earnings fluctuations because it was essentially the temporal method. FASB 52 replaced it in December 1981, requiring a two-stage translation process depending on the foreign entity's functional currency.

Transaction exposure involves real cash flows and is considered far more important to manage than translation exposure, which involves paper adjustments. Eliminating translation and transaction exposure simultaneously is often impossible, and eliminating one can create the other. Because translation exposure has no direct effect on reporting currency cash flows, firms place significantly more emphasis on transaction exposure.

A survey of multinational firms found that 83 percent placed significant or most emphasis on transaction exposure, compared to only 37 percent for translation exposure.

4. Global Financial Markets and Corporate Policy

Firms access international debt and equity markets, utilize interest rate and currency swaps, and execute foreign direct investment to optimize their cost of capital.

International Banking and Bond Markets

The Eurocurrency market is an external banking system running parallel to domestic markets where time deposits are held in banks located outside the country of the issuing currency, using benchmarks like LIBOR for pricing. Eurocurrency deposits are free from domestic reserve requirements and deposit insurance premiums, giving them a cost advantage. At year-end 2018, total international bank external liabilities reached $22,969 billion.

The Eurocurrency market originated in the 1950s and 1960s when Soviet-bloc countries deposited U.S. dollars in a French bank named EURO-BANK to avoid the risk of having their funds frozen in U.S. banks.

International bonds are divided into foreign bonds issued in a national market using that nation's currency, and Eurobonds sold outside the country of the denominating currency. Eurobonds constitute about eighty percent of new international bonds annually and are typically issued as bearer bonds, providing anonymity and lower yields. Examples of foreign bonds include Yankee bonds in the U.S., Samurai bonds in Japan, and Bulldogs in the U.K.

Swaps and Cost of Capital

Swaps are contractual agreements between counterparties to exchange cash flows at periodic intervals to hedge long-term risks or achieve cost savings. A single-currency interest rate swap involves exchanging floating-rate interest payments for fixed-rate interest payments in the same currency. A currency swap involves exchanging debt service obligations denominated in different currencies.

A fixed-for-floating interest rate swap is feasible when a positive quality spread differential exists between the default-risk premium differentials of fixed-rate and floating-rate debt. To evaluate swap opportunities, you follow specific analytical steps:

• Calculate the fixed-rate borrowing cost differential between the two counterparties.
• Calculate the floating-rate borrowing cost differential between the two counterparties.
• Subtract the floating-rate differential from the fixed-rate differential to find the quality spread differential.

Bank A and Company B utilize a swap bank quoting 10.375–10.50 percent against LIBOR flat to generate a 0.75 percent quality spread differential, allowing Bank A to save 0.375 percent and Company B to save 0.25 percent.

Foreign Direct Investment and International Capital Budgeting

Firms invest overseas through foreign direct investment to circumvent trade barriers and avoid the high transportation costs of exporting bulky goods. Governments regulate trade using tariffs and quotas to protect domestic industries. When faced with these restrictions or high transit costs relative to economic value, firms establish foreign production facilities to maintain market access.

Honda built an assembly plant in Marysville, Ohio, in the early 1980s to bypass the Voluntary Restraint Agreement that limited automobile exports from Japan to the United States.

Firms with valuable intangible assets undertake direct foreign investment to use those assets on a large scale while preventing misappropriation. Intangible assets like technological, managerial, and marketing know-how possess public good properties and are difficult to protect through market mechanisms or licensing agreements due to potential leakage. Coca-Cola invested globally in bottling plants rather than licensing local firms, choosing to withdraw from India in the 1960s rather than comply with demands to reveal its secret soft drink formula.

Multinational corporations can manage political risk through conservative capital budgeting, operational structuring, and specialized insurance policies. When safeguarding foreign ventures, you rely on concrete protective actions:

• Explicitly incorporate political risk into the capital budgeting process by reducing expected cash flows or increasing the cost of capital.
• Form a joint venture with a local company to make expropriation costly to the host government.
• Create a consortium of international companies to undertake the foreign project.
• Use local debt to finance the foreign project so the debt can be repudiated if host government actions harm interests.
• Purchase insurance against the hazard of political risk from specialized providers.

10 Key Ideas

1. International finance requires mastering foreign exchange risks, market imperfections, and global capital allocation to maximize shareholder wealth across sovereign nations.
2. The incompatible trinity dictates that a country can simultaneously choose only two of three conditions: a fixed exchange rate, free international capital flows, and an independent monetary policy.
3. The balance of payments uses a double-entry bookkeeping system to record all economic transactions between a country's residents and the rest of the world across current, capital, financial, and official reserve accounts.
4. Cross-exchange rates between non-dollar currencies must align with implied rates to prevent risk-free triangular arbitrage.
5. Interest rate parity is an arbitrage condition that links interest rates between two countries through spot and forward exchange rates.
6. Currency options provide the right, but not the obligation, to buy or sell an asset at a specified price, existing in both American and European styles.
7. Multinational corporations must measure and manage transaction, economic, and translation exposures using financial and operational hedging techniques.
8. FASB 52 introduced the functional currency concept and routed translation adjustments to equity rather than the income statement.
9. A single-currency interest rate swap involves exchanging floating-rate interest payments for fixed-rate interest payments in the same currency when a positive quality spread differential exists.
10. Firms invest overseas through foreign direct investment to circumvent trade barriers, avoid high transportation costs, and exploit valuable intangible assets on a large scale.