Why Do Firms Establish International Operations?

• To open up new markets
• To seek raw materials
• To lower production costs
• To diversify their exposure to their home country's economy.

1. To seek new markets
While the US is one of the biggest consumer markets in the world, it still represents only a fraction of the total consumer market worldwide. Remember from Chapter One that we estimated that approximately 95% of the population and 70% of the economic activity is based outside the US. If firms operate solely in the US, they are giving up a large amount of potential sales. Expanding to new markets worldwide is especially important for firms that have saturated the US markets (Coca-Cola, Pepsi, Wal-Mart, etc.) or firms that see a decline in their US market (tobacco firms).

2. To seek raw materials
Raw materials necessary to produce many products are found throughout the world. We can think of many different materials (oil, coffee, cocoa, diamonds, etc.) that are primarily found outside the US. For firms that use a significant amount of non-US-based resources, it makes sense to open production facilities in countries where these resources are more prominent.

3. To lower production costs
Production costs in the US are relatively high. With the costs of health care, other benefits, and wages; labor costs are very high in the US compared to some developing economies. There are also legal and regulatory costs that may be higher in the US. Alternatively, there are also markets where labor costs are higher than the US. This is one of the most controversial aspects of international operations. Are firms taking necessary steps to stay competitive (and creating economic growth in areas that need it), or are they exploiting foreign laborers and at the same time depriving the US labor force of jobs in exchange for higher profits for shareholders and upper level management? There are legitimate arguments on both sides and I do not plan to solve the debate here. However, let me say that I believe it depends a lot on the approach that a firm takes. It is possible to use international production in a method that improves efficiency (increases shareholder wealth) and provides net social benefits. It is also possible to use international production in an exploitive method. However, as mentioned in Chapter One, I firmly believe that, in the long-run, firms that try to achieve value maximization within a framework of ethics and social responsibility will be more successful than those that try to achieve value maximization without considering social responsibility and ethics.

4. To diversify
Given that national economies tend to move in different business cycles, firms can diversify some of their business risk by operating internationally. Interest rates, inflation, and recessions occur at different times in different countries. By having operations across the globe, firms can offset down years in one country with strong years in markets in other countries. While there is significant "world economy" impacts that can not be diversified away, there are still significant benefits in diversifying country-specific risk.

Difficulties in International Operations

• Different currency denominations
• Regulatory and legal ramifications
• Language differences
• Cultural differences
• Political Risk

1. Different currency denominations
Today's multinational corporation handles transactions in pesos, euros, yen, and many other currencies (including many "dollars" that are NOT equivalent to US dollars). However, many shareholders are concerned with their return in US dollars. Therefore, the exchange rate between these other currencies and the US Dollar will influence the revenues (a weaker dollar means your foreign currency sales will be worth more in dollars and vice-versa), expenses (if you have expenses outside the US, a weaker US dollar will mean those expenses effectively cost more), and competition/suppliers (a weaker US dollar means international firms will likely have to charge more in US dollars) for a US-based firm. The changing value of a currency may improve the value of some firms while lowering the value of others (depending on each firm's particular exposure). Thus, we can think of exchange rates as another important risk element that firms must manage.

2. Regulatory and legal ramifications
If a firm has operations in many different countries, than it also has numerous tax and other legal regulations that must be addressed. Tax codes, import/export regulations, and other costs of doing international business are an important element that firms must address. Legal business practices in one country may be illegal in another. Managing these legal factors can generate additional costs and exposes the firm to greater risk.

3. Language differences
To operate internationally, we must be able to communicate internationally. Multilingual employees are considered a valuable resource by firms that are doing business in many different countries.

4. Cultural differences
Language is only one of the many cultural differences that firms undertake when operating internationally. Many other cultural differences develop that can drastically affect the effectiveness of our human resources, marketing, and general management strategies. What works in the US may not work in Mexico or Germany. We must respect the cultures of our customers and employees in order to be successful. Ignoring these cultural differences can result in lower efficiency within the firm and offending potential customers.

5. Political Risk
Political instability can make it very difficult to do business in a given country. This can range from the extreme case involving expropriation or our plant and equipment (a situation where the government claims the firm's assets as their own) to subtle changes in the political climate that cause movements towards a more pro-business or anti-business regulatory environment.

Currency Issues

The current currency environment can best be described as a managed floating system. Following the collapse (in 1972) of the Bretton Woods System in which countries strived to maintain fixed exchange rates, the international community has allowed currency rates to be established primarily by market forces. Supply and Demand conditions operate on a daily basis to influence the level of exchange rates. Exchange rates fluctuate on a daily basis. However, government central banks operate in the market in attempts to influence the movement in currency markets. This intervention is why it is referred to as a managed floating system as opposed to a pure floating system. One important implication of a managed floating system is that by allowing exchange rates to fluctuate on a daily basis, currency risk becomes an important element that firms must address.

Factors Influencing Exchange Rates
In the above paragraph, I mentioned that supply and demand conditions are the primary factor setting exchange rates and leading to the changing values of currencies. What factors influence supply and demand and what impact do they have on exchange rates? There are too many forces that impact supply and demand to make an inclusive list, but here are a few examples.

• Trade balances -- When foreign firms and consumers purchase US goods and services, there is demand for US dollars (either because the US firms demand dollars or because they convert the foreign currency to dollars after the transaction). When US firms and consumers purchase foreign goods, there is demand for foreign currencies. Thus, when the US trade balance gets worse, we should expect less demand for US dollars relative to foreign currencies and a weaker US dollar (and vice-versa).
• Investment -- When foreign firms and individuals invest in the US (purchasing stocks/bonds, real estate, bonds, etc.), they need US dollars (creating demand for dollars). This is referred to as capital account activity. When US firms and individuals invest outside the US, the opposite situation develops (creating demand for foreign currencies). Thus, as investment flows into the US increase, the US dollar should get stronger (and vice-versa). As US interest rates and investment prospects increase, we would expect more net investment inflows into the US (and a stronger US dollar). As US interest rates and investment prospects decrease, we would expect more net outflows (and a weaker US dollar).
• Speculation -- Sometimes supply and demand are driven by real economic forces (as in the two situations above) and sometimes by investor (currency speculator) psychology and expectations. For instance, if currency speculators anticipate that the US dollar is going to decline due to reduced demand or increased supply, then they will likely sell US dollars. This selling will result in increased supply and cause the value of the dollar to decline (assuming all other forces are held constant). Note that this looks like an easy way to make money. All I have to do is start buying US dollars and then the price will increase due to the increased demand I created. However, several things make this much more difficult. First, I am one of many investors in the currency market and it is very unlikely I can buy/sell enough to move prices. Second, all the other factors impacting supply and demand are likely to dominate any influence my actions create. Third, even if I can raise the value of the US dollar by buying enough dollars, in order for me to profit I will need to sell them. If I made the price go up by buying, I will make the price go down by selling and offset my influence. Thus, any one speculator is not likely to influence prices, however as a group they will be one of the factors driving supply/demand.
• Governments/Central Banks -- The US Government (through the Treasury and Federal Reserve system) determine the monetary supply. Thus, they influence the amount of US dollars available in the markets (supply) and impact the value of the US dollar. Also, many foreign governments hold US dollars (as well as their own currencies) and can buy/sell these dollars (or change the supply of their currencies) to influence the market prices of exchange rates. Sometimes these actions are done to influence exchange rates (the managed portion of the managed floating system) and sometimes they are done for other purposes (such as using monetary supply to influence inflation and economic activity).

A direct quotation is an exchange rate stated to tell us how many dollars are required to purchase one unit of a foreign currency. For example, if we say that the exchange rate is .00934 $/yen, we know that it will cost $0.00934 to buy 1 yen. Alternatively, we could state the exchange rate as 107.066 yen/$. This is an indirect quotation and tells us how many foreign currency units we can buy with one dollar. In this case, we can buy 107.066 yen with $1. We can move from direct to indirect quotations by inversion. One divided by the direct quotation gives us the indirect quotation and one divided by the indirect quotation gives us the direct quotation.

Currency Conversion
The process of converting from one currency to the next is relatively simple, but can also be confusing. Because currencies quotations can be presented in two ways (direct vs indirect quotes) it is not always easy to remember if you should multiply by the exchange rate or divide by the exchange rate. The way that I recommend keeping this straight is through labels. For instance, lets say we need to convert $400 US into British Pounds. I know the exchange rate is 0.4997 pounds/dollar (an indirect quote). Since I want to know the value in pounds, I set this up as follows:
($400)*(0.4997 pounds/$1) = 199.88 pounds
Note that the "$" labels cancelled out with one in the numerator and one in the denominator, leaving me with pounds. What if I would have divided instead of multiplied?
($400)*($1/0.4997 pounds) = 800 dollars squared/pound
Now, the dollars won't cancel out and I'm left with "dollars squared/pound" which makes no sense. By leaving the labels in unless they cancel out, I can tell if I did my conversion correctly. This system will work for any currency conversion regardless of which direction I am converting (from foreign currency to US dollars or US dollars to foreign currency) and which quote format (direct or indirect) I am given.

Strengthening vs Weakening Currencies
We often hear on the news about the US dollar strengthening or weakening and I have mentioned it a few times above. However, what does it mean, what are the implications, and how do I know if the dollar is getting stronger or weaker? First, let's look at what we mean by strengthening and weakening. We can think of exchange rates as prices -- the price of one currency relative to another. If the US dollar is getting stronger relative to another currency, that means that it costs more of the foreign currency to purchase one dollar (or one dollar can buy more of the other currency than it could previously). In other words, the price of the dollar has gone up. If the dollar is weakening, then the price of the dollar has gone done and it takes more dollars to purchase a specific amount of foreign currency. One thing to keep in mind here is that currencies are a relative price. The price of the US dollar in yen (the yen/dollar exchange rate) is different than the price of the US dollar in euros (the euro/dollar exchange rate. Therefore, it is important when we talk about the US dollar getting stronger or weaker to be precise and say what currency it is stronger or weaker relative to. The US dollar may strengthen relative to the yen while weakening relative to the euro.

Second, we need to look at the implications. Who benefits from a stronger US dollar? Who benefits from a weaker US dollar? Let me start with a disclaimer. The effects of changing exchange rates are often complex and impact a variety of economic factors (some of which feed back to the exchange rate itself). Therefore, think of these as the primary (or first-level) impacts.

• US-based consumers will typically benefit from a stronger US dollar. The stronger dollar means that it is now cheaper to buy imported goods. This may also cause US firms to lower prices to stay competitive. A weaker US dollar will typically increase the costs of goods and services for US-based consumers.
• US-based firms will typically benefit from a weaker US dollar. A weaker dollar means that foreign firms will become less competitive. Also, exports will be cheaper to foreign customers (as each unit of foreign revenue buys more US dollars). A stronger US dollar will typically have a negative impact.
• Foreign-based firms will typically benefit from a stronger US dollar. The stronger dollar means that each dollar in revenues they receive in US markets translates into more revenues in their home currency.
• US-based investors in international markets will typically benefit from a weaker US dollar. Their investment returns in these foreign markets will need to be converted back into dollars. A weaker US dollar means each unit of foreign currency earned as investment income will buy more US dollars, increasing their return in US dollars.
• Foreign-based investors in US markets will typically benefit from a stronger US dollar. As the dollar strengthens, each dollar received in investment income will buy more of their home currency which increases their rate of return in their home currency.

Finally, we need to look at identifying if a currency has strengthened or weakened relative to another currency. In doing so, one must be careful not to focus solely on the number in the exchange rate, but on the purchasing power of the currency. For instance, consider the following two situations.
Situation 1 ==> Last year the exchange rate was 0.953 euros/$ and today it is 0.753 euros/$.
Situation 2 ==> Last year the exchange rate was $2.40/pound and today it is $2.00/pound.
It is tempting to look at the numbers and say that in both cases the number decreased so the currency weakened. However, instead we must look at the situation (and whether the quote was a direct or indirect quote). In the first situation, each dollar buys fewer euros today than it did last year. This tells us that the US dollar has weakened relative to the euro. On the other hand, each pound buys fewer dollars today than it did last year. This tells us that the US dollar has strengthened relative to the pound. By focusing on the change in purchasing power of the currency instead of the raw number, you will better be able to identify if a currency is getting stronger or weaker.

Cross Currency Exchange Rates
If we know the exchange rate between currency one and the dollar and we know the exchange rate between currency two and the dollar, we can get the exchange rate between currency one and two. For example, lets assume that we know the following two exchange rates: 7.443 pesos/$ and 0.890 euros/$. What is the euro/peso exchange rate?
(0.890 euros/$)/(7.443 pesos/$) = 0.1196 euros/peso
Note: One key to converting currencies is to make sure the units in your final answer make sense. If the dollar in the numerator cancels out the dollar in the denominator, we know we are doing it right.

Spot vs Forward Rates
The Spot Rate refers to the exchange rate for a transaction to take place today. Alternatively, the Forward Rate refers to an exchange rate that is set today, but the transaction does not take place until a later date. The spot and forward rates will rarely be equal and the difference is typically based on interest rate differentials between the two countries. Forward rates (and associated forward contracts) provide a way for firms to reduce (hedge) their exchange rate risk by locking in an exchange rate. Consider a US firm that agrees to sell 10,000 widgets to a German firm for 125,000 euros on credit with the payment being due in 2 months. The US firm is now subject to exchange rate risk (if the dollar strengthens, the euros will be worth less at the time they are received). By entering into a forward contract that allows them to exchange euros for dollars at the agreed forward rate, they no longer have this exchange rate risk as they now know exactly how much the 125,000 in euros will be worth when payment is received in 2 months.

Hedging vs Speculating

Hedging is the process of entering into a forward, future, option, or swap contract to offset a natural risk position. The object is not to make a profit, but to eliminate risk. One example would be a US company that knows it will need to make a payment of 2,000,000 yen 6 months from now purchasing a forward contract to exchange dollars for yen in 6 months at forward rate set today. Entering this contract allows the company to eliminate the natural risk arising from their currency situation.

Speculation is the process of entering into a forward, future, option, or swap contract in an attempt to generate a profit. This type of transaction creates risk where none previously existed. For instance, if I thought that the US dollar was going to get weaker in the near future relative to the euro (the euro price in dollars would increase), I might enter into a futures contract which allows me to buy euros at a price set today. If I was right and the dollar did indeed get weaker relative to the euro, my futures contract would increase in price and I would make a profit. If I was wrong and the dollar got stronger relative to the euro, my futures contract would decrease in price and I would lose money. Therefore, I have created a situation where I will make or lose money based on the dollar/euro exchange rate -- creating a risk position in an attempt to make a profit.

The primary contracts for hedging and speculating in currencies are forward, future, swap, and option contracts. The characteristics of each are quite different. Some (futures and options) are tools for both individual investors and institutions while others (forwards and swaps) are institutional contracts. Also, the risk, complexity, and costs can vary across the contracts. For this class, you will not need to know the differences across these instruments. The following information describing the basics of each contract is presented for those that are curious, but will not be part of quiz/exam material.

Forward Contracts are negotiated instruments (size, pricing and expiration date are determined between the parties involved in the contract). They are a legal agreement in that we are bound to carry out our contract regardless of whether it is profitable for us. There are no money flows taking place in forward contracts until the expiration. Also, forward contracts tend to be used primarily by large creditworthy corporations. Individuals do not use forward contracts.

Futures contracts are standardized instruments. They have a set expiration date and contract size. Prices are determined in financial markets. They are also a legal agreement that we are bound to carry out (or settle) regardless of whether it is profitable for us. Money flows take place throughout the contract period as gains/losses are settled on a daily basis (referred to as "marked-to-market". Futures contracts can be used both by corporations and individuals and typically involve significant leverage.

Swap contracts are negotiated instruments between the parties involved in the contract. In a swap, parties agree to exchange cash flows associated with specific assets. For example, company A in Japan may issue a bond in its home market in yen. Company B in the US may issue a bond in its home market in dollars. Then, they agree to swap the interest payments so that the US firms interest expense is in yen while the Japanese firm's interest expense is in dollars. This is attractive if the Japanese firm has some revenues in dollars and the US firm has some revenues in yen. By matching their revenues and expenses in the same currency, they reduce their overall currency risk.

International Investing

While the majority of people invest in stocks and bonds from their home country, there are reasons to consider investing at least a portion of one's assets with an international perspective. International investing may be beneficial due to increased diversification benefits and more opportunities. Complications with international investing can include currency issues, tax complications, information, and potentially greater risk. However, there are also ways to invest internationally while reducing the complications.

There has been ample evidence to document that international stock and bond markets do not always move in the same direction. Therefore, the correlations across the various national markets are less than one. If you remember from Chapter Seven, we can reduce the risk of our portfolio by investing in countries that have low correlations with our home markets. While these risk reductions are real, there is also evidence to suggest that the correlations are highest at the times when markets are crashing. This means that the diversification benefits are smallest when they are needed most.

Another reason to invest internationally is the increased opportunities. There are many great companies that exist outside the US. By expanding our horizons to include these companies, we can develop stronger portfolios. Also, some developing and emerging markets might offer the opportunity for higher returns (although likely with more risk) that might appeal to many investors.

While there are advantages to investing internationally, it can also lead to many complications. Countries outside the US don't follow the same Generally Accepted Accounting Principles and thus financial statement analysis can be misleading. Also, tax complications can occur when profits are made in other countries. Additionally, we have currency issues to worry about as investing in different countries means investing with different currencies and introducing exchange rate risk. Finally, getting information and trading while the markets are open can sometimes be a challenge.

If we do decide to invest internationally, there are a few different ways to accomplish this.

• International Mutual Funds
• Direct International Purchases
• US Listed (ADR's) International Stocks
• Multinational Firms based in the US

International mutual funds allow us the advantages of international investing while letting a professional manage the currency, tax, and information issues. In addition to traditional mutual funds, there are Exchange Traded Funds that allow us to purchase a basket of stocks from a specific country that represent an index of that countries stocks. Note that while mutual funds eliminate the hassle of currency conversion, they are still affected by currency fluctuations.

Most large brokerage firms allow their customers to make purchases of stocks outside the US. However, these purchases need to be made in a foreign currency which entails an additional transaction. In addition, investors may face additional tax issues. Finally, due to time differences, many foreign exchanges are open during inconvenient hours for trading. These complications make direct international purchases the most difficult method of international investing.

Many international companies are listed on the US exchange. Many of these are structured as American Depository Receipts (ADR's). These allow us to buy stock in many foreign firms (Nokia and Sony for instance) in the US markets. This eliminates many of the extra hassles. Specifically, our purchases are in dollars and trading takes place during normal US hours. As with the International Mutual Funds, the currency risk is not eliminated, merely the need for trading in different currencies.

Finally, we might be able to get some of the same benefits by investing in countries with substantial international activities. For instance, Coca-Cola gets a substantial amount of its revenues and profits from outside the US and thus might provide us with some international diversification. Unfortunately, it appears that the benefits from investing in Multinationals are not as good (from a diversification standpoint at least) as other strategies for investing internationally.