Management of risk arising from exchange rate movements is one of the most important tasks for multinationals managers. This task includes forecasting exchange rate movements, which is a challenging task. Unfortunately, however, we are often forced to forecast it. The best model for the forecasting has yet to be found although many theories including the Dornbush’s overshooting model, other monetary approach models, the balance of payment theory, and the portfolio balance theory have been proposed.
As such, we have to rely on a couple of businessmen’s forecasting methods: (1) forecasting based on recent trend (technical method); (2) focus on economic growth, interests, inflations (fundamental method); and (3) rely on market spot and forward rate (market-based method).
Assume that you are CEO of the Yangkee Multinational Fund Management Company located in Washington, America and considering portfolio investment on shares listed on the Australian Stock Exchange for a year from 1 June 2014. You are planning to repatriate all the investments (e.g. principal+dividend payment) and expected capital gains to the U.S. at one-time in a year. Understanding your thoughts, board of directors of your company requested a formal report of the plan by on-line submission. Next board meeting will be on Friday, 3 October in 2014. Chair of the board, Clinton- Obama, is one of alumni from your University and advised you that many board members are not familiar with international financial management so that the report should include at least:
Predict what is expected (spot) exchange rate between US$ and A$ in 1 June 2015? Justify your answer.
Baseline readings: Lecture W2 + Ch.9 (Text book)
- What are the advantages and disadvantages of investing in Australia compared to investing in China?
- What are the advantages and disadvantages of portfolio investment compared to purchasing an existing company (e.g. mergers and acquisition)?
An analysis of an international portfolio investment for board of directors
International investment involves the flow of monetary capital or industrial capital as a profit-seeking economic behavior, and it is gradually ubiquitous in globalized modern life (Dunning, 1998). Since investing is actually targeting the profit in the future, international investment requires market research and local adjustment. Multinational corporations (MNCs) sprung up like mushrooms and connected the firms from all over the world, and the business connection led to closer understanding in every aspect. As stated in Obstfeld, Rogoff and Wren-lewis (1996), the most important influential factor in international investment would be the exchange rate, because it directly changes the balance of international payment or even alters the direction of capital flow. For example, one country has the comparative advantage in producing a certain product for a lower price, but such comparative advantage would disappear if their currency is appreciated considerably. More specifically, the uncertainty of the exchange rate would affect the MNCs for hedging decisions, capital budgeting decisions, earning assessment, short-term or long-term investment decisions. Therefore the analysis of an international investment should firstly start with the prediction of exchange rate using technological analysis, fundamental analysis or market-based method, and then evaluate the related risk. The next step would be the macroeconomic analysis of the investing environment. The Yangkee Multinational Fund Management Company is located in Washington, while their short-term investing target is Australia and a secondary alternative China. This report would also provide thoroughly comparison regarding the resources, geographical advantage, transportation costs, energy, communication costs, tariff and other regulatory policies. The last question needs to be answered is the choice of Greenfield investment or merger and acquisition, and a comparative analysis would be provided for the board of directors.
Prediction of exchange rate
The fundamental principle of prediction on exchange rate is the law of one price, which was proposed by the monetary economist Friedman (1953). The law of one price could be simply stated as that the commodities should be sold at the same value, assuming there are no transaction costs and trading barriers. It reveals the underlying connection between the price of domestic goods and exchange rate. The law of one price also relies on the dynamics of international arbitrage, since the commodities could be sold freely all over the world without frictions. Though imperfections exist in real world, the law of one price is regarded as the ideally efficient economy and could be used to predict the asset price. For specific prediction methods for exchange rate, they generally fall into three categories, namely the technological analysis, fundamental analysis and market-based method. The technological analysis is the forecasting based on recent trend, relying on the assumption that history would repeat itself with certain pattern. However, such method could not be used herein for the prediction of exchange rate in the next year, because the time horizon is certainly long and the yearly historical pattern is actually in different political or economic regime. What is more, the technological analysis is sometimes arbitrary and subjective. As for the fundamental analysis, it focuses on the interaction between and exchange rate and other economic factors such as interest rate or inflation rate. Two common theories for practical prediction of exchange rate is the purchase power parity and international Fisher effect, and the prediction of this report is based on the fundamental analysis, since it produces more reliable prediction with exact numerical results. Putting the prediction issue in another perspective, it could be also performed by using market-based method like the market spot and forward rate. As noted in Hodrick (2014) the prediction of exchange rate based on forward rate often has the so-called forward discount bias as the risk premium, therefore it is not used for prediction since it also only affect the current market evaluation and varies considerably in short term.
Theory of Purchase Power Parity (PPP) states the long-term co-integration relationship among currencies among different countries, based on the assumptions like equilibrium of international trade and law of one price. According to the deduction of Fisher and Park (1991), there are three models to test the PPP:
Comparison of investing environment in Australia and China
As an MNC located in the United States, Australia and China would be two reasonable options for international investing. Australia has great deal advantages over natural resources, geographic location, lower energy cost, modern communication technology, and preferential policy to attract international investment. First of all, Australia has profound quantity of natural resources, including iron ore, coal and bauxite, and it is also the ninth largest country of energy production. Australia features a giant in agricultural industry with cultivated area of 40.8 billion acres, making up to 63% of the national territorial area. What is more, almost 90% of the cultivated area is nature pasture and making it as the largest exporter for wool and beef in the world. Australia is located in the middle of South Pacific Ocean and Indian Ocean, making it the crucial connection between Asia and the western world. Australia has an intense transportation network in the east coast, where gather most of the population and economy. The electricity in Australia is also abundant due to the richly endowed nature resources. The most important factor for Australia to attract international investors is the huge demand in domestic market. According to the annual report of the Australian Bureau of Statistics, the private consumption and government purchase made up the proportion of 55.7% and 18.2% to the overall GDP over 2011-2012. To sum up, Australia has a huge market and also countless nature resources with cheap price. However, Australia started to impose Mineral Resource Rent Tax from 1st July 2013, targeting on the companies in coal and iron ore industries. If their annual profit exceeds A$75 million and the government would impose this tax at the rate of 30%. If the company wishes to invest in the energy or mineral industry, the strict environmental regulations in Australia should be well informed. As stated above, Australia has the reputation of huge consumption but it also brings them with large financial deficit. The national financial deficit in 2012 reached $5.23 billion. According to the report of United Nations Conference on Trade and Development, the population of Australia is 22.9 million at a low growth rate with the risk of turning into an aging population. Therefore Australia has the potential of huge consumption market but also the hanging credit risk and the investment plan should avoid the industries relying on exports and should manage the legal risk on environment protection.
Since China joined the WTO, the investing situation is getting increasingly better. The main advantages of investing in China are the huge domestic market, the stable politic environment and the favorable economy circumstance. As we all known that China is the biggest country of population, there are over 1.3 billion people live in China, which indicate the domestic market of China has huge potential. And the GDP in 2012 exceeded Japan and took the second place of the largest economy in the world. After the policy of Reform and Opening-up has been implemented; the politic environment is relatively steady, which is also an advantage for investment. But disadvantages of Chinese market in recent years are also very important to note. China attracted great amounts of foreign direct investment in last decades due to its cheap price on labor and resources, but now the price rose considerably and more and more MNCs started to quit the Chinese market. This could be ascribed to the economic stimulus policy undertaken by the government to overcome the financial crisis since 2007, and it is actually a typical phenomenon for a developing country. What is more, the term of guanxi has been widely accepted by the MNCs in China due to severe corruption in bureaucracy, thus there is undeniable legal risk conducting commercial bribe. Therefore the cultural difference could become an obstacle for MNCs to become successful in China. It is also worthy to mention that Google quitted the Chinese market in recent years due to the disappointment on internet sanctions and unreliable legal system.
Portfolio investment or purchasing an existing company
The company faces the choice between direct portfolio investment and purchasing an existing company, like merger and acquisition. Direct portfolio investing is also called Greenfield investment, and it is often compared with merger and acquisition (for theoretical arguments, see as in the seminal work of Hennart and Park 1993). Greenfield investment has the advantage of autonomy, which means the MNCs would have the freedom to choose the specific industry and manage the company in their own way. What is more, the Greenfield investment would maintain the advantages in technology and management for the MNCs, and help them to be competitive enough in local market. However, the Greenfield investment needs quite a lot of time for preparation and also needs to start the business from empty. Furthermore, MNCs could have difficulties in getting used to the local culture and face greater uncertainty since they need to take the risk alone. If the culture difference leads to conflictions in managing local staffs or their marketing strategy does not fit the local fashion, they would result in painful loss. However, international merger and acquisition is very flexible and could usually combine the strengths of the local company and MNCs. MNCs usually have solid funding resources and they could seek the most competitive partners in market who are starving for funds. But there is considerable risk of asymmetric information due to difference in international accounting standards, or evaluation of other assets. The MNCs also need to face the local protectionism either from the government or citizens. At last, the MNCs may face difficulty to change the local companies into the track of more efficient and modernized model.