One of the most challenging areas of a multinational firm's business is setting target pricing and revenue for foreign markets, given the complications arising from currency denominations and exchange rates.
That is because exchange rates demonstrate the linkage between one nation and its partners in the global marketplace. They affect the relative price of goods being traded (exports and imports), the valuation of assets, and of course the final economic yield on those very assets.
In the period of fixed or constant exchange rates these prices, values, and yields were predictable over time. However, since 1973 we have been living in a world of flexible rates where foreign exchange markets determine these rates based on trade flows, interest rate differentials, differing rates of inflation, and speculation about future events.
Exchange rates can be expressed as the foreign price of a domestic currency (i.e., the Euro price of a U.S. dollar) or its reciprocal -- the domestic price of foreign currency. We will express these values using the following notation:
the Euro price of a Dollar: €P/$
or the Dollar price of a Euro: $P/€
Multinational companies compete with an array of external factors, internal considerations, and other forces and magnitudes that shift budget policies, composition, and control. Budgeting in a global business environment demands an enhanced level of coordination and communication because of the plethora of important components that influence organization performance.
Foreign currency exchange rates, interest rates, and inflation are the three critical external factors that impact multinationals and their markets. Although these factors are interrelated -- for example, higher inflation in a specific country tends to drive the value of its currency down, which impacts the exchange rate -- changes in currency exchange rates have the most effect on the budgeting process.
For a striking example, in June 2001, the value of the U.S. dollar was at a 15-year high when compared to the British pound and other currencies of the major U.S. trading partners. This caused John T. Dillon, CEO of International Paper and head of the Business Roundtable, to complain to U.S. Treasury Secretary Paul O'Neill that the dollar's strength made it difficult for U.S. companies to compete with imports and penetrate foreign markets.
According to Milani's recent research, "Changes in these three external factors stem from several sources, including economic conditions, government policies, monetary systems, and political risks. Each factor is a significant external variable affecting areas such as policy decisions, strategic planning, profit planning, and budget control. To minimize the possible negative impact of these factors, multinational corporate management must establish and implement policies and practices that recognize and respond to them. Other external forces such as political turmoil, competition, labor quality, and cultural or religious orientation of the local populace exist, but they tend to be related specifically to one country or particular region of the world." (Milani, 2004)
An excellent example is that of General Motors. General Motors' sales have been dropping precipitously in the United States, prompting Toyota and other market-share-appreciating foreign manufacturers of automobiles to consider temporary price increases to help rescue General Motors.
However, General Motors' sales have been very strong overseas, especially with its European Opel brand. But, how does General Motors price its cars geared at foreign markets? Generally, in order to gain market share in foreign countries, a manufacturer will 'dump' its products, relative to currency exchange rate, but in General Motors' case, it cannot afford to do that since its profitability stems from its foreign sales, not from its core United States sales.
As a result, it must maintain pricing pursuant to currency rates of exchange. If the dollar is overvalued, however, General Motors suffers as it must correspondingly increase the prices of its cars abroad -- and this will cut into profitability.
So that is why, for instance, International Paper fought the dollar's value. Fortunately for General Motors and its colleagues, the dollar has been consistently devalued since the terrorist attacks of September 11, 2001.
Milani, Ken. 2004. The rigorous business of budgeting for international operations: managing global risk is at the center of budgeting for overseas subsidiaries. But transfer pricing and inventory policy also weigh heavily on international budgeting. Management Accounting Quarterly.
Daniels, Lily. 2004. Exchange rates changing overseas COLA. All Hands.
Applegate, Craig. 2003. Capital controls as a means of minimising speculative bubbles in real exchange rates: key features of the literature and its application to China and India. Economic Papers, Australia.
Dolbeck, Andrew. 2005. U.S. Vs. The Euro. Weekly Corporate Growth Report.
Irish Lottery Questions
1) E. 1,000,000 / 1.25 = $800,000
2) E. 1,000,000 x 1.05 = E 1,050,000
3) $800,000 x 1.02 = $816,000
4) E. 1,050,000 / 1.30 = $807,692.31
5) You should have brought them back to the U.S. because the currency fluctuated and you lost $816,000 - $807,692.31 = $8,307.69
Covered interest arbitrage takes place when a fund manager invests a particular currency, for instance U.S. dollars, into an instrument denominated in another currency (a stock, bond, or any financial mechanism). The fund manager then hedges the foreign exchange risk, associated with that instrument, by selling off the proceeds of the investment forward: selling futures of that currency in exchange for the original currency (U.S. dollars).
The purpose of international financial markets is to facilitate the balancing process by providing financing to prevent the loss of reserves by debtor nations. Their value is in the marginal contribution they make to moving capital around the world. Most of this capital, and the corresponding money flows, take place via covered interest arbitrage transactions.
Interest arbitrage in general represents the transfer of liquid funds from one monetary center (and currency) to another to take advantage of higher rates of return or interest.
In order to make the foreign investment, the national currency must be converted into the foreign currency. Then, when the investment matures or is liquidated, the foreign currency must be reconverted into the national currency.
A foreign exchange risk manifests itself because during the period of the investment, the (spot) exchange rate of the foreign currency may fall (so that the fund manager retrieves fewer national currency units than he originally paid). This occurrence may wipe out most or all of the extra interest earned on the foreign over the domestic investment and may even lead to an actual loss. Foreign exchange risk, however, may be covered, if at the same time the investor exchanges the national for the foreign currency to make the foreign investment, he also engages in a forward sale of an equal amount of the foreign currency to coincide with the maturity of the original investment -- this is the trick behind the tactic, and of course, it requires much working capital.
Covered interest arbitrage represents the transfer of liquid funds from one monetary center (and currency) to another to take advantage of higher rates of return or interest, while covering the transaction with a forward currency hedge. Since the foreign currency is likely to be at a forward discount, the investor loses on the foreign transfers currency transaction per se. But if the positive interest differential in favor of the foreign money center exceeds the forward discount on the foreign currency (when both are expressed in percentage per year), it pays to make the foreign investment.
An Example of Covered Interest Arbitrage when U.S. Interest Rates are Higher than Foreign Interest Rates: When interest rates in the United States are greater than in Germany (or elsewhere), a German investor can exchange dms for dollars today and use these dollars to buy a 3-month T-bill in New York at 12%. He earns 4% more per year (or 1% more per 3 months) than if he had used his dms to buy a 3-month T-bill in Frankfurt at 8%.…