CME Australian Dollar
C. Three-Month Treasury Bills
The Treasury bill rate is a widely watched rate for secure cash investments. In turbulent times the rate can be volatile and can be viewed as a signal of the economy’s health. T-bills, both three- month and six-month issues, are auctioned every Monday by the U.S. Treasury through the Federal Reserve. The T-bill rate shows what can be expected to be earned on no-risk investments.
Historically, T-bills have returned little more than the inflation rate. Many conservative investors buy T-bills directly from the government. T-bill rates approximate rates on money-market mutual funds or statement savings accounts, also popular savings tools for the small investor.
INTERNAL FINANCIAL TRANSFER SYSTEM
The internal financial transfer system of the MNC covers various mechanisms for transferring funds internally. It includes transfer prices on goods and services traded internally, dividend payments, leading and lagging intercompany payments, payments for fees and royalty charges, intercompany loans, and equity investments.
INTERNAL RATE OF RETURN
Internal rate of return (IRR) is defined as the rate of interest that equates initial capital outlay (I) with the present value (PV) of future cash inflows. Or at IRR, I = PV.
Decision rule: Accept the project if the IRR exceeds the cost of capital. Otherwise, reject it.
INTERNAL RATE OF RETURN
158
EXAMPLE 70
Consider the following foreign investment project:
We set the following equality (I = PV):
$12,950,000 = $3,000,000 × T4(k, 10 years) where T4 is a present value of an annuity factor.
which stands somewhere between 18% and 20% in the 10-year line of Exhibit 4 in the Appendix.
The interpolation follows:
Therefore,
Since the IRR of the investment is greater than the cost of capital (12%), accept the project. The advantage of using the IRR method is that it considers the time value of money. The shortcomings of this method are that (1) it fails to recognize the varying sizes of investment in competing project, and (2) it is time-consuming to compute, especially when the cash inflows are not even.
However, spreadsheet software and financial calculators can be used in making IRR calculations.
For example, MSExcel has a function IRR(values, guess). Excel considers negative numbers such as the initial investment as cash outflows and positive numbers as cash inflows. Many financial calculators have similar features. As in the example, suppose you want to calculate the IRR of a $12,950,000 investment (the value −12950000 entered in year 0 that is followed by 10 year cash inflows of $3,000,000. Using a guess of 12% (0.12), which is in effect the cost of capital, your formula would be @IRR(values, 0.12) and Excel would return 19.15%, as shown below.
Initial investment (I) $12,950,000
Estimated life 10 years
Annual cash inflows (CF) $3,000,000
Cost of capital 12%
PV of an Annuity of $1 Factor T4(k,10 years)
18% 4.494 4.494
IRR 4.317
20% 4.192
Difference 0.177 0.302
Year 0 1 2 3 4 5 6 7 8 9 10
−12,950,000 3,000,000 3,000,000 3,000,000 3,000,000 3,000,000 3,000,000 3,000,000 3,000,000 3,000,000 3,000,000 IRR = 19.15%
T4(k, 10 years) $12,950,000
$3,000,000
--- 4.317
= =
IRR 18% 0.177 0.302
--- 20%( –18%)
+ 18%
= = +0.586 2%( ) = 18%+1.17% = 19.17%
INTERNAL RATE OF RETURN
159
INTERNATIONAL ACCOUNTING STANDARDS COMMITTEE
The International Accounting Standards Committee (IASC), founded in 1973, aims at the development of international accounting standards. It also works toward the improvement and harmonization of accounting standards and procedures relating to the presentation and comparability of financial statements (or at least through enhanced disclosure, if differences are present). To date, it has developed a conceptual framework and issued a total of 32 International Accounting Standards (IAS) covering a wide range of accounting issues. It is currently working on a project concerned with the core standards in consultation with other international groups, especially the International Organization of Securities Commissions (IOSCO), to develop worldwide standards for all corporations to facilitate multilisting of foreign corporations on various stock exchanges. At the inception, its members consisted of the accountancy bodies of Australia, Canada, France, Japan, Mexico, the Netherlands, the United Kingdom, Ireland, the United States, and Germany. Since its founding, membership has grown to around 116 accountancy bodies from approximately 85 countries.
INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT (IBRD) The International Bank for Reconstruction and Development, also called the World Bank (http://www.worldbank.org), was established in December 1945 to help countries recon- struct their economies after World War II. IBRD assists developing member countries by lending to government agencies and by guaranteeing private loans for such projects as agricultural modernization or infrastructural development. It attempts to promote economic and social progress through the creation of modern economic and social infrastructures. It makes loans to countries or firms for such purposes as roads, irrigation projects, and electric generating plants. Bank headquarters are in Washington, D.C.
See also WORLD BANK.
INTERNATIONAL BANKING FACILITY (IBF)
An international Banking Facility (IBF), authorized in December 1981, is a separate banking operation within a domestic U.S. bank, created to allow that bank to accept Eurocurrency deposits from foreign residents without the need for domestic reserve requirements, interest rate regulations, or deposit insurance premiums applicable to normal U.S. banking. IBFs simply require a different set of books to receive deposit from, and make loans to, nonresidents of the U.S. or other IBFs. IBFs are not institutions in the organizational sense, but accounting entities that represent a separate set of asset and liability accounts of their establishing offices.
They are actually a set of asset and liability accounts segregated on the books of the establishing institutions. IBFs are allowed to conduct international banking operations that, for the most part, are exempt from U.S. regulation. Deposits, which can be accepted only from non-U.S. residents or other IBFs and must be at least $100,000, are exempt from reserve requirements and interest rate ceilings. The deposits obtained cannot be used domestically;
they must be used for making foreign loans. In fact, to ensure that U.S.-based firms and individuals comply with this requirement, borrowers must sign a statement agreeing to this stipulation, when taking out the loan.
INTERNATIONAL CAPITAL ASSET PRICING MODEL
The international capital asset pricing model (ICAPM) is an international version of the Capital Asset Pricing Model (CAPM). It differs from a domestic CAPM in two respects.
First, the relevant market risk is world market risk, not domestic market risk. Second, additional risk premium is linked to an asset’s sensitivity to currency movements. The ICAPM
INTERNATIONAL CAPITAL ASSET PRICING MODEL
160
can be used to estimate the required return on foreign projects, taking into account the world market risk.
INTERNATIONAL CAPITAL BUDGETING See ANALYSIS OF FOREIGN INVESTMENTS.
INTERNATIONAL CASH MANAGEMENT See INTERNATIONAL MONEY MANAGEMENT.
INTERNATIONAL DEVELOPMENT ASSOCIATION
The International Development Association (IDA), a part of the World Bank Group, was created in 1959 (and began operations in November 1990) to lend money to developing countries at no interest and for a long repayment period. IDA provides development assistance through soft loans to meet the needs of many developing countries that cannot afford devel- opment loans at ordinary rates of interest and in the time span of conventional loans. The Association’s headquarters are in Washington, D.C.
See also WORLD BANK.
INTERNATIONAL DIVERSIFICATION
International diversification is an attempt to reduce the multinational company’s risk by operating facilities in more than one country, thus lowering the country risk. It is also an effort to reduce risk by investing in more than one nation. By diversifying across nations whose business cycles do not move in tandem, investors can typically reduce the variability of their returns. Adding international investments to a portfolio of U.S. securities diversifies and reduces your risk. This reduction of risk will be enhanced because international invest- ments are much less influenced by the U.S. economy, and the correlation to U.S. investments is much less. Foreign markets sometimes follow different cycles from the U.S. market and from each other. Although foreign stocks can be riskier than domestic issues, supplementing a domestic portfolio with a foreign component can actually reduce your portfolio’s overall volatility. The reason is that by being diversified across many different economies which are at different points in the economic cycle, downturns in some markets may be offset by superior performance in others.
There is considerable evidence that global diversification reduces systematic risk (beta) because of the relatively low correlation between returns on U.S. and foreign securities.
Exhibit 69 illustrates this, comparing the risk reduction through diversification within the United States to that obtainable through global diversification. A fully diversified U.S.
portfolio is only 27% as risky as a typical individual stock, while a globally diversified portfolio appears to be about 12% as risky as a typical individual stock. This represents about 44% less than the U.S. figure.
Exhibit 70 demonstrates the effect over the past ten years. Notice how adding a small percentage of foreign stocks to a domestic portfolio actually decreased its overall risk while increasing the overall return. The lowest level of volatility came from a portfolio with about 30% foreign stocks and 70% U.S. stocks. And, in fact, a portfolio with 60% foreign holdings and only 40% U.S. holdings actually approximated the risk of a 100% domestic portfolio, yet the average annual return was over two percentage points greater.
The benefits of international diversification can be estimated by considering the portfolio risk and portfolio return in which a fraction, w, is invested in domestic assets (such as stocks, bonds, investment projects) and the remaining fraction, 1 − w, is invested in foreign assets:
INTERNATIONAL CAPITAL BUDGETING
161
EXHIBIT 69
Risk Reduction from International Diversification
EXHIBIT 70
How Foreign Stocks Have Benefitted a Domestic Portfolio
80 100
60
40
20
10 20 30 40 50
U.S. stocks International stocks
18
17
16
15
Average Annual Returns (6/29/84—6/30/94)
Low Overall Portfolio Volatility High 100% U.S.
20% Foreign/80% U.S.
60% Foreign/40% U.S.
80% Foreign/20% U.S.
100% Foreign
40% Foreign/60% U.S.
INTERNATIONAL DIVERSIFICATION
162
The expected portfolio return is calculated as follows:
rp= wrd + (1 − w)rf
where rd = return on domestic assets and rf = return on foreign assets.
The expected portfolio standard deviation is calculated as follows:
where σd and σf= standard deviation on domestic and foreign assets, respectively, and ρdf= correlation coefficient between domestic and foreign assets.
The risk of an internationally diversified portfolio is less than the risk of a fully diversified domestic portfolio.
EXAMPLE 71
Suppose that three projects are being considered by U.S. Minerals Corporation: Nickel projects in Australia and South Africa and a zinc mine project in Brazil. The firm wishes to invest in two plants, but it is unsure of which two are preferred. The relevant data are given below.
Possible portfolios and their portfolio returns and risks are the following:
Component Projects
Nickel Projects Zinc Mine Australia South Africa Brazil
Mean return 0.20 0.25 0.20
Standard deviation 0.10 0.25 0.12
Correlation coefficient 0.8
0.2 0.2
A. Australian and South African Nickel Operations:
Mean return = 0.5(0.20) + 0.5(0.25) = 0.225 = 22.5%
Standard deviation
B. Australian Nickel Operation and Brazil Zinc Mine:
Mean return = 0.5(0.20) + 0.5(0.20) = 0.20 = 20%
Standard deviation
C. South African Nickel Operation and Brazil Zinc Mine:
Mean return = 0.5(0.25) + 0.5(0.20) = 0.225 = 22.5%
Standard deviation
σp w2σd
2 (1–w)2σf 2 2ρd.f
2 w(1–w)σdσf
+ +
=
(0.5)2(0.10)2+(0.5)2(0.25)2+2 0.8( )(0.5)(0.5)(0.10)(0.25)
=
0.028125
= = 0.168 = 16.8%
(0.5)2(0.10)2+(0.5)2(0.25)2+2 0.2( )(0.5)(0.5)(0.10)(0.12)
= 0.0073
= = 0.085 = 8.5%
(0.5)2(0.10)2+(0.5)2(0.25)2+2 0.2( )(0.5)(0.5)(0.25)(0.12)
=
0.02223
= = 0.149 = 14.9%
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163
To summarize:
The efficient portfolios, in increasing order of returns, are portfolios B, C , and A. Portfolio A can be eliminated as being inferior to portfolio C—both portfolios yield a mean return of 22.5%, but portfolio A has a higher risk than portfolio C. Management has to select between portfolios B and C, based on their risk–return trade-off.
See also PORTFOLIO THEORY.
INTERNATIONAL EXCHANGE RATE PARITY CONDITIONS See PARITY CONDITIONS.
INTERNATIONAL FINANCIAL CENTERS
International banking is heavily concentrated on cities in which international money center banks are located, such as New York, London, and Tokyo. Four major types of financial transactions transpire in an international financial center that is in effect an important domestic financial center. Exhibit 71 displays major transactions that occur in this arena.
INTERNATIONAL FINANCING
1. Also called foreign financing, overseas financing, or offshore financing, raising capital in the Eurocurrency or Eurobond markets.
2. A strategy used by MNCs for financing foreign direct investment, international banking activities, and foreign business operations.
Portfolio Mean Return Standard Deviation B. Australian Nickel Operation and Brazil Zinc Mine 20.0% 8.5%
C. South African Nickel Operation and Brazil Zinc Mine 22.5% 14.9%
A. Australian and South African Nickel Operations 22.5% 16.8%
EXHIBIT 71
Major Types of Financial Transactions in an International Financial Market Arena
International Market International Market
Domestic Investor/
Depositor
Foreign Investor/
Depositor Domestic
Borrower
Foreign Borrower
Domestic Market
Offshore (Foreign or Overseas) Market INTERNATIONAL FINANCING
164
INTERNATIONAL FISHER EFFECT
Often, called Fisher-open, the theory states that the spot exchange rate should change by the same amount as the interest differential between two countries. The International Fisher effect is derived by combining the purchasing power parity (PPP) and the Fisher effect.
(Equation 1) where rh and rf= the respective national interest rates and S = the spot exchange rate (using direct quotes) at the beginning of the period (S1) and the end of the period (S2).
According to Equation 1, the expected return from investing at home, (1 + r), should equal the expected home currency (HC) return form investing abroad, (1 + rf) S2/S1. EXAMPLE 72
In March, the one-year interest rate is 4% on Swiss francs and 13% on U.S. dollars.
(a) If the current exchange rate is SFr 1 = $0.63, the expected future exchange rate in one year would be $0.6845:
S2= S1 (1 + rh)/(1 + rf) = 0.613 × 1.13/1.04 = $0.6845
(b) Assume that the Swiss interest rate stays at 4% (because there has been no change in expectations of Swiss inflation). If a change in expectations regarding future U.S. inflation causes the expected future spot rate to rise to $0.70, according to the international Fisher effect, the U.S. interest rate would rise to 15.56%:
S2/S1= (1 +rh)/(1 + rf) 0.70/0.63 = (1 + rh)/1.04
rh= 15.56%
A simplified version states that, for any two countries, the spot exchange rate should change in an equal amount but in the opposite direction to the difference in the nominal interest rates between the two countries. It can be stated more formally:
(Equation 2) Subtracting 1 from both sides of Equation 1 yields:
Equation 2 follows if rf is relatively small.
S2 S1
--- (1+rh) 1+rf
( )
---
=
S2–S1 S1
--- = rh–rf
S2–S1 S1
--- (rh–rf) 1+rf
( )
---
=
Difference in interest rates rh–rf
( )
(1+rf)
--- equals
Expected change in spot rate S2–S1
S1 ---
INTERNATIONAL FISHER EFFECT
165
The rationale behind this theory is that investors must be rewarded or penalized to offset the change in exchange rates. Thus, the currency with the lower interest rate is expected to appreciate relative to the currency with the higher interest rate.
EXAMPLE 73
If a U.S. dollar-based investor buys a one-year yen deposit earning 4% interest, compared with 10% interest in dollars, the investor must be expecting the yen to appreciate vis-à- vis the dollar by about 6% (10% − 4% = 6%) during the year. Otherwise, the dollar-based investor would be better off staying in dollars.
A graph of Equation 2 in Example 72 is presented in Exhibit 72. The vertical axis shows the expected change in the home currency value of the foreign currency, and the horizontal axis shows the interest differential between the two countries for the same time period.
The parity line shows all points for which rh− rf = (S2− S1)/S1. Point A is a position of equilibrium because it lies on the parity line, with the 4% interest differential in favor of the home country just offset by the anticipated 4% appreciation in the home currency value of the foreign currency. Point B, however, illustrates a case of disequilibrium. If the foreign currency is expected to appreciate by 3% in terms of the home currency but the interest differential in favor of the foreign country is only 2%, then funds flow from the home to the foreign country to take advantage of the higher exchange-adjusted returns there. This capital flow will continue until exchange-adjusted returns are equal in the two nations.
INTERNATIONAL FUND
Also called a foreign fund, an international fund is a mutual fund that invests only in foreign stocks. Because these funds focus only on foreign markets, they allow investors to control
EXHIBIT 72
International Fisher Effect
5 4 3 2 1
1 2 3 4 5
-1 -1 -2 -3 -4 -5
-2 -3 -4 -5 Expected change in home currency value of foreign currency (%)
Inflation differential in favor of home country (%)
Parity line
A B
INTERNATIONAL FUND
166
what portion of their personal portfolio they want to allocate to non-U.S. stocks. There exists currency risk associated with international fund investing. Note: General Electric Financial Network (www.gefn.com), for example, has a tool “How do exchange rates affect my foreign fund?” (www.calcbuilder.com/cgi-bin/calcs/MUT12.cgi/gefa).
INTERNATIONAL LENDING
International lending involves some risks: (1) Commercial risk (business risk) as in domestic lending, and (2) the added risk comes from cultural differences and lack of information (espe- cially due to differing accounting standards and disclosure practices)—Country risk including political risk and currency risk. Further, the central role played by the enforcement problem and the absence of collateral make international lending fundamentally different from domes- tic lending.
See also COMMERCIAL RISK; CURRENCY RISK; POLITICAL RISK.
INTERNATIONAL MONETARY FUND (IMF)
International Monetary Fund (IMF) (www.imf.org) is an international financial institution that was created in 1946 after the 1944 Bretton Woods Conference. It aims at promoting international monetary harmony, monitoring the exchange rate and monetary policies of member nations, and providing credit for member countries which experience temporary balance of payments deficits. Each member has a quota, expressed in Special Drawing Rights, which reflects both the relative size of the member’s economy and that member’s voting power in the Fund. Quotas also determine members’ access to the financial resources of, and their shares in the allocation of Special Drawing Rights by, the Fund. The IMF, funded through members’ quotas, may supplement resources through borrowing.
INTERNATIONAL MONETARY MARKET
International Monetary Market (IMM) is a division of the Chicago Mercantile Exchange where currency futures contracts, patterned after grain and commodity contracts, are traded.
Futures contracts are currently traded in the British pound, Canadian dollar, German mark, Swiss franc, French franc, Japanese yen, Australian dollar, and U.S. dollar. Most recently, the IMM has introduced a cross-current futures contract (e.g., DM/¥).
INTERNATIONAL MONETARY SYSTEM
1. The financial market for transactions between countries that belong to the International Monetary Fund (IMF), or between one of these countries and the IMF itself. A market among the central banks of these countries, functioning as a kind of central banking system for the national governments of its 137 members. Each member country deposits funds at the IMF, and in return each may borrow funds in the currency of any other member nation. This system is not open to private sector participants, so it is not directly useful to company managers. However, agreements made between member countries and the IMF often lead to major changes in government policies toward companies and banks (such as exchange rate changes and controls and trade controls), so an understand- ing of the international monetary system may be quite important to managers. Regulation in this system comes through rules passed by the IMF’s members. The major financial instruments used in the international monetary system are national currencies, gold, and a currency issued by the IMF itself, called the SDR (special drawing right).
2. The sum of all of the devices by which nations organize their international economic relations.
INTERNATIONAL LENDING
167
3. The set of policies, arrangements, mechanisms, legal aspects, customs, and institutions dealing with money (investments, obligations, and payments) that determine the rate at which one currency is exchanged for another.
INTERNATIONAL MONEY MANAGEMENT
Also called international working capital management or narrowly international cash man- agement, international money management (IMM) is concerned with financial policies used by MNCs aiming at optimizing profitability from currency and interest rate fluctuation while controlling risk exposure. It can be considered as comprising a series of interrelated sub- systems that perform the following functions: (1) positing of funds—choice of location and currency of denomination for all liquid funds, (2) pooling funds internationally, (3) keeping costs of intercompany funds transferred at a minimum, (4) increasing the speed with which funds are transferred internationally between corporate units, and (5) improving returns on liquid funds.
INTERNATIONAL MONEY MARKET
The international money market is the Eurocurrency market and its linkages with other segments of national markets for credit. One unique feature of the international money market is the diversity of its participants, the wide range of borrowers and lenders that compete with one another on the same basis. It is simultaneously an interbank market, a market where governments raise funds, and a lending and deposit market for corporations. The market is extremely homogeneous in its treatment of borrowers and lenders. While in national markets there is invariably credit rationing during periods of tight credit, often mandated by govern- ment, in the Euromarkets the funds are always available for those willing and able to pay the price. Equally important, the market’s size assures that the marginal cost of funds is less.
Another advantage to borrowers is that funds raised in the international money market have no restrictions attached as where they can be deployed. And also, the Euromarkets provide corporate borrowers with flexibility as to terms, conditions, covenants, and even currencies.
The international money market parallels the foreign exchange market. It is located in the same centers as its foreign exchange counterparts. The market operates only in those curren- cies for which forward exchange market exists and that are easily convertible and available in sufficient quantity.
INTERNATIONAL RETURNS
When investors buy and sell assets in other countries, they must consider exchange rate risk.
This risk can convert a gain from an investment into a loss or a loss from an investment into a gain. An investment denominated in an appreciating currency relative to the investor’s domestic currency will experience a gain from the currency movement, while an investment denominated in a depreciating currency relative to the investor’s domestic currency will experience a decrease in the return because of the currency movement. To calculate the return from an investment in a foreign country, we use the following formula:
The foreign currency is stated direct terms; that is, the amount of domestic currency necessary to purchase one unit of the foreign currency.
Total return (TR) in domestic terms = Return relative (RR)
Ending value of foreign currency Beginning value of foreign currency ---–1.0
×
INTERNATIONAL RETURNS