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International Financial Management

Seventh Edition

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ii

The McGraw-Hill/Irwin Series in Finance, Insurance, and Real Estate Stephen A. Ross Franco Modigliani Professor of Finance and Economics Sloan School of Management Massachusetts Institute of Technology Consulting Editor

FINANCIAL MANAGEMENT

Adair Excel Applications for Corporate Finance First Edition

Block, Hirt, and Danielsen Foundations of Financial Management Fifteenth Edition

Brealey, Myers, and Allen Principles of Corporate Finance Eleventh Edition

Brealey, Myers, and Allen Principles of Corporate Finance, Concise Second Edition

Brealey, Myers, and Marcus Fundamentals of Corporate Finance Seventh Edition

Brooks FinGame Online 5.0

Bruner Case Studies in Finance: Managing for Corporate Value Creation Seventh Edition

Cornett, Adair, and Nofsinger Finance: Applications and Theory Third Edition

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Higgins Analysis for Financial Management Tenth Edition

Kellison Theory of Interest Third Edition

Ross, Westerfield, and Jaffe Corporate Finance Tenth Edition

Ross, Westerfield, Jaffe, and Jordan Corporate Finance: Core Principles and Applications Fourth Edition

Ross, Westerfield, and Jordan Essentials of Corporate Finance Eighth Edition

Ross, Westerfield, and Jordan Fundamentals of Corporate Finance Tenth Edition

Shefrin Behavioral Corporate Finance: Decisions that Create Value First Edition

White Financial Analysis with an Electronic Calculator Sixth Edition

INVESTMENTS

Bodie, Kane, and Marcus Essentials of Investments Ninth Edition

Bodie, Kane, and Marcus Investments Tenth Edition

Hirt and Block Fundamentals of Investment Management Tenth Edition

Hirschey and Nofsinger Investments: Analysis and Behavior Second Edition

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FINANCIAL INSTITUTIONS AND MARKETS

Rose and Hudgins Bank Management and Financial Services Ninth Edition

Rose and Marquis Financial Institutions and Markets Eleventh Edition

Saunders and Cornett Financial Institutions Management: A Risk Management Approach Eighth Edition

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INTERNATIONAL FINANCE

Eun and Resnick International Financial Management Seventh Edition

REAL ESTATE

Brueggeman and Fisher Real Estate Finance and Investments Fourteenth Edition

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FINANCIAL PLANNING AND INSURANCE

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International Financial Management

Seventh Edition

Cheol S. Eun Georgia Institute of Technology

Bruce G. Resnick Wake Forest University

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INTERNATIONAL FINANCIAL MANAGEMENT, SEVENTH EDITION

Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright © 2015 by McGraw-Hill Education. All rights reserved. Printed in the United States of America. Previous editions © 2012, 2009, and 2007. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of McGraw-Hill Education, including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning.

Some ancillaries, including electronic and print components, may not be available to customers outside the United States.

This book is printed on acid-free paper.

1 2 3 4 5 6 7 8 9 0 DOW/DOW 1 0 9 8 7 6 5 4

ISBN 978-0-07-786160-5 MHID 0-07-786160-4

Senior Vice President, Products & Markets: Kurt L. Strand Vice President, Content Production & Technology Services: Kimberly Meriwether-David Managing Director: Douglas Reiner Brand Manager: Chuck Synovec Development Editors: Noelle Bathurst and Sarah Otterness Director of Development: Ann Torbert Marketing Manager: Melissa Caughlin Director, Content Production: Terri Schiesl Content Production Manager: Faye Schilling Content Project Manager: Judi David Buyer: Nichole Birkenholz Media Project Manager: Siva Kamar Compositor: Cenveo® Publisher Services Typeface: 10/12.5 Times LT Std Printer: R. R. Donnelley

All credits appearing on page or at the end of the book are considered to be an extension of the copyright page.

Library of Congress Cataloging-in-Publication Data

Eun, Cheol S. International financial management / Cheol S. Eun, Georgia Institute of Technology, Bruce G. Resnick, Wake Forest University.—Seventh Edition. pages cm Includes index. ISBN 978-0-07-786160-5 (alk. paper) 1. International finance. 2. International business enterprises—Finance. 3. Foreign exchange. 4. Financial institutions, International. I. Title. HG3881.E655 2014 658.15’99—dc23 2013041099

The Internet addresses listed in the text were accurate at the time of publication. The inclusion of a website does not indicate an endorsement by the authors or McGraw-Hill Education, and McGraw-Hill Education does not guarantee the accuracy of the information presented at these sites.

www.mhhe.com

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To Elizabeth C.S.E.

To Donna B.G.R.

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vi

Cheol S. Eun, Georgia Institute of Technology

Cheol S. Eun (Ph.D., NYU, 1981) is the Thomas R. Williams Chair and Professor of Finance at the Scheller College of Business, the College of Management, Georgia Institute of Technology. Before joining Georgia Tech, he taught at the University of Minnesota and the University of Maryland. He also taught at the Wharton School of the University of Pennsylvania, Korea Advanced Institute of Science and Technology (KAIST), Singapore Management University, and the Esslingen University of Technology (Germany) as a visiting pro- fessor. He has published extensively on international finance issues in such major journals as the Journal of Finance, JFQA, Journal of Banking and Finance, Jour- nal of International Money and Finance, Management Science, and Oxford Economic Papers . Also, he has served on the editorial boards of the Journal of Banking and Finance, Journal of Financial Research, Journal of International Business Studies, and European Financial Management . His research is widely quoted and refer- enced in various scholarly articles and textbooks in the United States as well as abroad.

Dr. Eun is the founding chair of the Fortis/Georgia Tech Conference on International Finance. The key objectives of the conference are to promote research on international finance and provide a forum for interactions among academics, practitioners, and regulators who are interested in vital current issues of international finance.

Dr. Eun has taught a variety of courses at the under- graduate, graduate, and executive levels, and was the winner of the Krowe Teaching Excellence Award at the University of Maryland. He also has served as a con- sultant to many national and international organizations, including the World Bank, Apex Capital, and the Korean Development Institute, advising on issues relating to capital market liberalization, global capital raising, inter- national investment, and exchange risk management. In addition, he has been a frequent speaker at academic and professional meetings held throughout the world.

Bruce G. Resnick, Wake Forest University

Bruce G. Resnick is the Joseph M. Bryan Jr. Professor of Banking and Finance at the Wake Forest University School of Business in Winston-Salem, North Carolina. He has a D.B.A. (1979) in finance from Indiana Uni- versity. Additionally, he has an M.B.A. from the Uni- versity of Colorado and a B.B.A. from the University of Wisconsin at Oshkosh. Prior to coming to Wake For- est, he taught at Indiana University for ten years, the University of Minnesota for five years, and California State University for two years. He has also taught as a visiting professor at Bond University, Gold Coast, Queensland, Australia, and at the Helsinki School of Economics and Business Administration in Finland. Additionally, he served as the Indiana University resi- dent director at the Center for European Studies at the Maastricht University, the Netherlands. He also served as an external examiner to the Business Administration Department of Singapore Polytechnic and as the faculty advisor on Wake Forest University study trips to Japan, China, and Hong Kong.

Dr. Resnick teaches M.B.A. courses at Wake Forest University. He specializes in the areas of investments, portfolio management, and international financial man- agement. Dr. Resnick’s research interests include mar- ket efficiency studies of options and financial futures markets and empirical tests of asset pricing models. A major interest has been the optimal design of interna- tionally diversified portfolios constructed to control for parameter uncertainty and exchange rate risk. In recent years, he has focused on information transmission in the world money markets and yield spread comparisons of domestic and international bonds. His research articles have been published in most of the major academic journals in finance. His research is widely referenced by other researchers and textbook authors. He is an associ- ate editor for the Emerging Markets Review, Journal of Economics and Business, and the Journal of Multina- tional Financial Management .

About the Authors

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vii

Preface

Our Reason for Writing this Textbook Both of us have been teaching international financial management to undergraduates and M.B.A. students at Georgia Institute of Technology, Wake Forest University, and at other universities we have visited for three decades. During this time period, we conducted many research studies, published in major finance and statistics journals, concerning the operation of international financial markets. As one might imagine, in doing this we put together an extensive set of teaching materials that we used success- fully in the classroom. As the years went by, we individually relied more on our own teaching materials and notes and less on any one of the major existing textbooks in international finance (most of which we tried at some point).

As you may be aware, the scope and content of international finance have been fast evolv- ing due to deregulation of financial markets, product innovations, and technological advance- ments. As capital markets of the world are becoming more integrated, a solid understanding of international finance has become essential for astute corporate decision making. Reflecting the growing importance of international finance as a discipline, we have seen a sharp increase in the demand for experts in the area in both the corporate and academic worlds.

In writing International Financial Management, Seventh Edition, our goal was to provide well-organized, comprehensive, and up-to-date coverage of the topics that take advantage of our many years of teaching and research in this area. We hope the text is challenging to students. This does not mean that it lacks readability. The text discussion is written so that a self-contained treatment of each subject is presented in a user-friendly fashion. The text is intended for use at both the advanced undergraduate and M.B.A. levels.

The Underlying Philosophy International Financial Management, Seventh Edition, like the first six editions, is written based on two tenets: emphasis on the basics and emphasis on a managerial perspective.

We believe that any subject is better learned if one first is well grounded in the basics. Consequently, we initially devote several chapters to the fundamental concepts of international finance. After these are learned, the remaining material flows easily from them. We always bring the reader back, as the more advanced topics are developed, to their relationship to the fundamentals. By doing this, we believe students will be left with a framework for analysis that will serve them well when they need to apply this material in their careers in the years ahead.

We believe this approach has produced a successfuI textbook: International Finan- cial Management is used in many of the best business schools in the world. Various editions of the text have been translated into Spanish and two dialects of Chinese. There is a global edition. In addition, local co-authors have assisted in preparing a Canadian, Malaysian, and Indian adaptations.

Emphasis on the Basics

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viii P R E F A C E

Seventh Edition Organization International Financial Management, Seventh Edition, has been completely updated. All data tables and statistics are the most current available when the text went to press. Additionally, the chapters incorporate several new International Finance in Practice boxes that contain real-world illustrations of chapter topics and concepts. In the mar- gins below, we highlight specific changes in the Seventh edition.

Part ONE Foundations of International Financial Management 2

Part THREE Foreign Exchange Exposure and Management 196

Part TWO The Foreign Exchange Market, Exchange Rate Determination, and Currency Derivatives 110

Globalization and the Multinational Firm 4

International Monetary System 29

Balance of Payments 64

Corporate Governance around the World 83

1

2

3

4

The Market for Foreign Exchange 112

International Parity Relationships and Forecasting Foreign Exchange Rates 139

Futures and Options on Foreign Exchange 172

Management of Transaction Exposure 198

Management of Economic Exposure 231

Management of Translation Exposure 252

5

6

7

8

9

10

Conceptual and managerial analysis of economic exposure to currency risk.

Systematic coverage of foreign currency transaction exposure management and a new case application.

This part describes the various types of foreign exchange risk and discusses methods available for risk management.

This part lays the macroeconomic foundation for all the topics to follow.

Updated coverage of monetary developments, including the euro zone crisis.

Updated balance-of-payments statistics.

Review of corporate governance systems in different countries, the Dodd-Frank Act, and managerial implications.

This part describes the market for foreign exchange and introduces currency derivatives that can be used to manage foreign exchange exposure.

Integrated coverage of key parity conditions and currency carry trade.

Recent economic developments such as the global financial crisis and sovereign debt crisis of Europe.

Fully updated market data and examples. New section on non-deliverable forward contracts.

Fully updated market data and examples.

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P R E F A C E ix

A Managerial Perspective The text presentation never loses sight of the fact that it is teaching students how to make managerial decisions. International Financial Management, Seventh Edition, is founded in the belief that the fundamental job of the financial manager is to maximize shareholder wealth. This belief permeates the decision-making process we present from cover to cover. To reinforce the managerial perspective, we provide numerous “real-world” stories whenever appropriate.

Part FOUR World Financial Markets and Institutions 270

Part FIVE Financial Management of the Multinational Firm 410

International Banking and Money Market 272

International Bond Market 310

International Equity Markets 330

Interest Rate and Currency Swaps 354

International Portfolio Investment 372

11

12

13

14

15

Foreign Direct Investment and Cross-Border Acquisitions 412

International Capital Structure and the Cost of Capital 439

International Capital Budgeting 465

Multinational Cash Management 484

International Trade Finance 495

International Tax Environment and Transfer Pricing 506

16

17

18

19

20

21

This part provides a thorough discussion of international financial institutions, assets, and marketplaces.

This part covers topics on financial management practices for the multinational firm.

Updated trends in cross-border investment and M&A deals. Updated political risk scores for countries.

New analysis of home bias and the cost of capital around the world.

Updated discussion of multilateral netting systems available for commercial use.

Fully updated market data and statistics. Updated discussion on Basel 2.5 and III capital adequacy standards. Updated discussion on the causes and consequences of the global financial crisis. New Finance in Practice box on the Libor scandal. New section on BBA Libor.

Fully updated market data and examples. Updated empirical coverage of the features, characteristics, and regulations governing dollar denominated foreign bonds, Eurobonds, and global bonds.

Fully updated market data and statistics. Updated discussion of market consolidations and mergers.

Fully updated market data and statistics.

Updated statistical analysis of international markets and diversification with small-cap stocks.

Fully updated comparative national income tax rate table with updated examples. New Finance in Practice box reading on transfer pricing.

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Pedagogical Features Chapter Outline—At the beginning of each chapter, a chapter outline is presented to provide a roadmap of concepts to be learned in that chapter.

Exhibits—Within each chapter, extensive use is made of graphs and tables to illustrate important concepts.

Examples—These are integrated throughout the text, providing students with immediate application of the text concepts.

The Value of the U.S. Dollar since 1960 a EXHIBIT 2.3

a The value of the U.S. dollar represents the nominal exchange rate index (2005 5 100) with weights derived from trade among 21 industrialized countries.

Source: International Financial Statistics.

180

160 Collapse of

Bretton Woods

Jamaica Agreement

Reagan Era

Louvre Accord

Plaza Agreement

Technology Boom

Global Financial Crisis

140

120

100

N om

in al

E ff

ec tiv

e E

xc ha

ng e

R at

e

80

60 60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12

EXAMPLE 11.1: Rollover Pricing of a Eurocredit Teltrex International can borrow $3,000,000 at LIBOR plus a lending margin of .75 percent per annum on a three-month rollover basis from Barclays in London. Suppose that three-month LIBOR is currently 517⁄32 percent. Further suppose that over the second three-month interval LIBOR falls to 51⁄8 percent. How much will Teltrex pay in interest to Barclays over the six-month period for the Eurodollar loan?

Solution: $3,000,000 3 (.0553125 1 .0075)/4 1 $3,000,000 3 (.05125 1 .0075)/4 5 $47,109.38 1 $44,062.50

5 $91,171.88

x

C H

A P

T E

R O

U T

L IN

E

Balance-of-Payments Accounting Balance-of-Payments Accounts

The Current Account The Capital Account Statistical Discrepancy Official Reserve Account

The Balance-of-Payments Identity Balance-of-Payments Trends in Major Countries Summary Key Words Questions Problems Internet Exercises MINI CASE: Mexico’s Balance-of-Payments

Problem References and Suggested Readings APPENDIX 3A: The Relationship Between

Balance of Payments and National Income Accounting

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International Finance in Practice Boxes —Selected chapters contain International Finance in Practice boxes. These real-world illustrations offer students a practical look at the major concepts presented in the chapter.

Annotated Web Resources —Web links located in the margins within each chapter serve as a quick reference of pertinent chapter-related websites. Each URL listed also includes a short statement on what can be found at that site.

In More Depth —Some topics are by nature more complex than others. The chapter sections that contain such material are indicated by the section heading “In More Depth”’ and are in blue type. These sections may be skipped without loss of continuity, enabling the instructor to easily tailor the reading assignments to the students. End-of-chapter Questions and Problems relating to the In More Depth sections of the text are also indicated by blue type.

The FX market is growing at record levels, according to figures released by the CME Group, the largest regulated foreign exchange market in the world.

Last month the CME Group reported average daily notional volume at a record level of $121 billion, up 82 percent compared to a year earlier.

With a number of indicators at play, like the news of Greece's credit concerns and the continued appetite for high-yielding currencies like the Australian dollar and the Canadian dollar, the CME saw record volumes and notional values in the euro and Australian and Canadian dollars. Euro FX futures and options saw total average daily volume of 362,000 contracts with total notional ADV of slightly over $62 billion.

Australian dollar futures and options climbed to nearly 119,000 contracts in average daily volume with almost $11 billion in total notional ADV, and Canadian

dollar futures and options surpassed 88,000 contracts in ADV and $8 billion in total notional ADV.

With foreign currency futures going from strength to strength, the CME Group recently published a white paper outlining the benefits of FX futures.

“These contracts provide an ideal tool to manage currency or FX risks in an uncertain world,” it said. “Product innovation, liquidity, and financial surety are the three pillars upon which the CME Group has built its world-class derivatives market. The CME Group provides products based on a wide range of frequently transacted currencies, liquidity offered on the state-of-the-art CME Globex electronic trading platform, and financial sureties afforded by its centralized clearing system.”

Source: Global Investor, March 2010.

FX Market Volumes Surge INTERNATIONAL FINANCE IN PRACTICE

www.theice.com

This is the website of the Intercontinental Exchange (ICE). Several FX futures contracts are traded on their electronic trading platform.

www.numa.com/ref/ exchange.htm

This is the website of The Numa Directory. It provides the website address of most of the stock and derivative exchanges in the world.

In More Depth

European Option-Pricing Formula In the last section, we examined a simple one-step version of binomial option-pricing model. Instead, we could have assumed the stock price followed a multiplicative binomial process by subdividing the option period into many subperiods. In this case, S T and C T could be many different values. When the number of subperiods into which the option period is subdivided goes to infinity, the European call and put pricing formulas presented in this section are obtained. Exact European call and put pricing formulas are: 5

Ce 5 Ste 2riTN(d1) 2 Ee2r$TN(d2) (7.12)

and

Pe 5 Ee2r$TN(2d2) 2 Ste 2riTN(2d1) (7.13)

The interest rates r i and r $ are assumed to be annualized and constant over the term-to- maturity T of the option contract, which is expressed as a fraction of a year.

Invoking IRP, where with continuous compounding F T 5 S t e (r $ – r i )T , C e and P e in Equations 7.12 and 7.13 can be, respectively, restated as:

Ce 5 [FT N(d1) 2 EN(d2)]e 2r$T (7.14)

and

Pe 5 [EN(2d2) 2 FT N(2d1)]e 2r$T (7.15)

where

d1 5 ln (FT /E) 1 .5s2T ________________ s √

__ T

and

d2 5 d1 2 s √ __

T

N ( d ) denotes the cumulative area under the standard normal density function from 2` to d 1 (or d 2 ). The variable s is the annualized volatility of the change in exchange rate ln ( S t11 / S t ). Equations 7.14 and 7.15 indicate that C e and P e are functions of only five variables: F T , E, r $, T , and s. It can be shown that both C e and P e increase when s becomes larger.

xi

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Summary —A short summary concludes each chapter, providing students with a handy overview of key concepts. The main points of the chapter are summarized and numbered for easy r