Interview with Prof. Robert Hodrick on International financial management(2)

2007-09-05 13:28:34 [ Big Normal Small ]    　Comment

Xing Zong: Market imperfection is a term used to describe the market circumstances. In your opinion, what are some market imperfections that Chinese companies might encounter?

Hodrick: One of the biggest market imperfections is the assessment of credit risk. Local bankers typically know a lot more about the company than overseas analysts. That is why it is typically cheaper to borrow in the domestic economy, from local banks, than to borrow overseas. The only way to overcome this disadvantage is to provide information that is consistent with foreign accounting standards. The movement to common international accounting standards is helping eliminate this imperfection, but locals will always have an information advantage.

Xing Zong: A few internal financial techniques are employed by company finance staff for currency risk management. Such as netting and matching. Could you please introduce these two to our readers in layman’s terms?

Hodrick: Well, netting is the process of making sure that you aren’t doing common offsetting transactions within the same firm. Suppose the company has subsidiaries in Malaysia and Thailand. The Malaysian sub may need dollars to purchase some imports from the U.S. and the Thai sub may extra dollars from just having exported to the U.S. It is cheaper for the firm if the dollars get transferred from the Thai sub to the Malaysian sub than if each goes to the marketplace. International banks have a lot of experience in helping companies establish such netting programs. Matching refers to the process of avoiding exchange rate losses by matching assets denominated in a currency with liabilities denominated in that currency. If the exchange rate changes, the loss in value on the asset is offset by the gain in value on the liability.

Xing Zong: The use of external risk management instruments is also quite common. Forward exchange contracts, currency futures, options, swaps, etc. What should Chinese firms do to take advantage of these financial innovations?

Hodrick: As I mentioned above, smart companies use these financial innovations to manage and hedge their cash flows. A hedge works like this. Suppose you are selling to the U.S. and generating dollars in 90 days. If you choose not to hedge, you will sell your dollars for yuan in the future spot market and take a loss if the yuan strengthens relative to the dollar. If you hedge, you can contract to sell these dollars in the future for yuan, but at an exchange rate (the forward rate) that is set today. Any strengthening of the yuan versus the dollar in the spot market would not lower the amount of yuan generated by the transaction.

Xing Zong: Corporate foreign investment decisions are complicated. A lot of complex issues such as risk of political interference, control of repatriation of overseas income often play a hand. My question is, how to distinguish the different forms of overseas expansions? i.e. DFI, licensing and exporting (contractual resources transfer)?

Hodrick: Well, this is a pretty complicated issue. Let’s just start with DFI, which is direct foreign investment. The key here is that you retain control of the overseas operations. You would certainly want to do this if you have some proprietary technology. Licensing allows someone else to produce your products and market them overseas.

Xing Zong: This question is concerned about the overseas capital budgeting decision. How can Chinese firms assess the opportunity cost of the capital for the project cash flows? How do they measure the dependency between investment decisions and financing decisions?

Hodrick: The key to understanding the cost of capital is to ask who are the owners of the firm, and what kind of portfolio are they holding, because the opportunity cost of doing the investment is returning the capital to the owners of the firm and letting them invest. If the owners of the firm are internationally diversified, then the cost of capital is set by how the equity cash flows from the project covary with the return on an internationally diversified portfolio.

Xing Zong: Before we end our discussions, I would like to know your impression of China.

Hodrick: I’ve never been to China, but I would certainly like to go. I have had many Chinese graduate students over the 31 years that I have been teaching, especially the last 10 years or so. They tell me how much the country is changing. It is certainly an exciting time, and I hope that I have contributed to a better understanding of international finance for your audience. It was great chatting with you.

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