Question

Questions: Critique and comment on how Purchasing Power Parity Theory and Efficient Market Hypothesis may enable a MNC to undertake the foreign market transactions. (10marks)

Answer 1

I. Forecasting Needs of the MNC

A. MNCs have a variety of foreign-currency denominated payables, receivables, credit purchases, credit sales, and uncovered forward contracts. All of these expose MNCs to exchange rate risks and prod MNCs to hedge against these potential losses which can be achieved only through purchasing power parity

B. Working capital management consists of short-term financing and short-term investment decisions.

i. The value of the currency borrowed or invested will change with respect to the borrower’s or the investor’s local currency over time due to efficient market hypothesis

ii. When MNCs borrow, they have access to a variety of sources in a variety of currencies. They should choose the one with a low interest rate and whose currency will depreciate over the life of the loan through looking at purchasing power parity and efficient market hypothesis

1. Additionally, large short-term loans should be spread across a number of different currencies.

C. Long-term Investment Analysis and Financing Decisions

i. An important feature of long-term investment analysis is that the projected cash flows depend partially on future exchange rates.

ii. More accurate predictions of exchange rate movements will result in more accurate cash flow predictions and better company decision-making.

1. Investors should invest in a currency that will have a high rate of return and appreciate over the investment period.

iii. When MNCs issue bonds to obtain long-term funds, they should denominate the bonds in a currency that will depreciate in value over the life of the bond.

D. Other MNC situations requiring exchange rate forecasts:

i. To assess foreign subsidiary earnings.

ii. To buy or sell a product in a foreign currency.

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