574 CHAPTER 15 Multinational Financial Management
Exchange rate fluctuationsmake it difficult to estimate the dollars that overseas
operations will produce.
Prior to August 1971, the world was on a fixed exchange rate systemwhereby
the U.S. dollar was linked to gold, and other currencies were then tied to the dol-
lar. After August 1971, the world monetary system changed to a floating system
under which major world currency rates float with market forces, largely unre-
stricted by governmental intervention. The central bank of each country does
operate in the foreign exchange market, buying and selling currencies to smooth
out exchange rate fluctuations, but only to a limited extent.
The consolidation of the European market has had a profound impact on Euro-
pean exchange rates. The exchange rates for the currencies of each of the partici-
pating countries are now fixed relative to the euro.Consequently, the cross rates
between the various participating currencies are also fixed. However, the value of
the euro continues to fluctuate.
Pegged exchange ratesoccur when a country establishes a fixed exchange rate
with a major currency. Consequently, the values of pegged currencies move to-
gether over time.
A convertible currencyis one that may be readily exchanged for other currencies.
Spot ratesare the rates paid for delivery of currency “on the spot,” while the for-
ward exchange rateis the rate paid for delivery at some agreed-upon future date,
usually 30, 90, or 180 days from the day the transaction is negotiated. The forward
rate can be at either a premiumor a discountto the spot rate.
Interest rate parityholds that investors should expect to earn the same return in
all countries after adjusting for risk.
Purchasing power parity,sometimes referred to as the law of one price,implies
that the level of exchange rates adjusts so that identical goods cost the same in dif-
ferent countries.
Granting credit is more risky in an international context because, in addition to the
normal risks of default, the multinational firm must worry about exchange rate
changesbetween the time a sale is made and the time a receivable is collected.
Credit policy is important for a multinational firm for two reasons: (1) Much trade
is with less-developed nations, and in such situations granting credit is a necessary
condition for doing business. (2) The governments of nations such as Japan whose
economic health depends upon exports often help their firms compete by granting
credit to foreign customers.
Foreign investments are similar to domestic investments, but political risk and ex-
change rate risk must be considered. Political riskis the risk that the foreign gov-
ernment will take some action that will decrease the value of the investment, while
exchange rate riskis the risk of losses due to fluctuations in the value of the dol-
lar relative to the values of foreign currencies.
Investments in international capital projectsexpose firms to exchange rate risk
and political risk. The relevant cash flows in international capital budgeting are the
dollars that can be repatriatedto the parent company.
Eurodollarsare U.S. dollars deposited in banks outside the United States. Inter-
est rates on Eurodollars are tied to LIBOR,the London Interbank Offer Rate.
U.S. firms often find that they can raise long-term capital at a lower cost outside
the United States by selling bonds in the international capital markets.Interna-
tional bonds may be either foreign bonds,which are exactly like regular domestic
bonds except that the issuer is a foreign company, or Eurobonds,which are bonds
sold in a foreign country but denominated in the currency of the issuing company’s
home country.
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