Chapter 17: International Finance Copyright © 1999 Addison Wesley Longman 1 Part IV Bringing It All Together Copyright © 1999 Addison Wesley Longman

International Finance 17 CHAPTER Basics of Exchange Rates Role of Exchange Rates Reading Exchange Rate Quotes Foreign Exchange Markets Explaining the Level of Exchange Rates (cont.) Copyright © 1999 Addison Wesley Longman

Chapter 17: International Finance Copyright © 1999 Addison Wesley Longman 3 International Finance Risk Political Risk Foreign Investments Evaluating Foreign Investments How Foreign Investments Are Financed International Trade Agreements

Chapter 17: International Finance Copyright © 1999 Addison Wesley Longman 4 Objectives  Understand supply and demand for currency  Understand purchasing power parity  Explain why exchange rates adjust  Understand interest rate parity  Review other risks to international finance

Chapter 17: International Finance Copyright © 1999 Addison Wesley Longman 5 A Major Issue in International Finance Is the Exchange Rate  The level of exchange rates affect the demand for goods and the amount of imports and exports

Chapter 17: International Finance Copyright © 1999 Addison Wesley Longman 6  International firms face the risk that exchange rate movements will cause losses

Chapter 17: International Finance Copyright © 1999 Addison Wesley Longman 7 Table 17.1Using the Currency Trading Column to Convert Currency To convert U.S. dollarsMultiply by “Currency into a foreign currencyper U.S. $” column To convert a foreign Multiply by “U.S. $ currency into U.S. dollars Equivalent” column

Chapter 17: International Finance Copyright © 1999 Addison Wesley Longman 8 Figure 17.1 Wall Street Journal Currency Trading Column

Chapter 17: International Finance Copyright © 1999 Addison Wesley Longman 9 Spot Exchange Rate  The rate of exchange available at the present time

Chapter 17: International Finance Copyright © 1999 Addison Wesley Longman 10 Forward Exchange Rate  The rate of exchange available for currency exchanges that will occur at some point in the future—for example, in 30, 90, or 180 days

Chapter 17: International Finance Copyright © 1999 Addison Wesley Longman 11 Exchange Rates Move Over Time  If $1 will buy more foreign currency the dollar has strengthened or appreciated  If $1 will buy less foreign currency the dollar has weakened or depreciated

Chapter 17: International Finance Copyright © 1999 Addison Wesley Longman 12 The Level of Exchange Rates  The supply and demand for a currency affect exchange rates – For example: if a Japanese firm exports goods and receives dollars it must convert them to yen. Selling dollars would lower or depreciate the dollar.

Chapter 17: International Finance Copyright © 1999 Addison Wesley Longman 13  Purchasing power parity – Goods in foreign countries must have the same price after adjusting for exchange rates – If they did not speculators would buy the good where it is cheap and sell it where it would be more expensive

Chapter 17: International Finance Copyright © 1999 Addison Wesley Longman 14  The purchasing power parity says that exchange rates will adjust to ensure that the price of goods is the same in two countries after adjustment using the exchange rate

Chapter 17: International Finance Copyright © 1999 Addison Wesley Longman 15 PPP in Equation Form P $ = S 0  P f P $ = price in dollars P f = price in a foreign currency S 0 = spot exchange rate

Chapter 17: International Finance Copyright © 1999 Addison Wesley Longman 16 PPP Will Not Hold  For goods that are not transportable or identical  If there are tariffs, taxes, or political barriers to trade

Chapter 17: International Finance Copyright © 1999 Addison Wesley Longman 17 If inflation in one country is greater than in another, then the exchange rate must adjust over time to maintain PPP

Chapter 17: International Finance Copyright © 1999 Addison Wesley Longman 18 Interest Rate Parity  At any point in time similar risk securities in different countries will have different interest rates

Chapter 17: International Finance Copyright © 1999 Addison Wesley Longman 19 Table 17.2 Interest Rates, 1992 Percent per Year Eurodollars 3.70% United Kingdom 9.56 Canada 6.76 Germany 9.42 Switzerland 7.67 Netherlands 9.25 France Italy Belgium 9.31 Japan 4.39  In which country would you prefer to invest?

Chapter 17: International Finance Copyright © 1999 Addison Wesley Longman 20  Interest rate parity says that your return from every country would be the same  To invest in a foreign security you must – Convert dollars to the foreign currency – Buy the foreign security – Convert foreign currency back to dollars

Chapter 17: International Finance Copyright © 1999 Addison Wesley Longman 21  The term on the left is the income from a $1 domestic investment  The term on the right is the income from a foreign investment after converting to the foreign currency at the spot rate S 0 and back to dollars at the forward exchange rate F 1

Chapter 17: International Finance Copyright © 1999 Addison Wesley Longman 22 Does Interest Rate Parity Actually Hold?  Yes, because – Money is very easy to move if a profit opportunity surfaces – Many speculators are constantly looking for opportunities for arbitrage.

Chapter 17: International Finance Copyright © 1999 Addison Wesley Longman 23 How Can You Control Exchange Rate Risk?  A hedge controls for losses

Chapter 17: International Finance Copyright © 1999 Addison Wesley Longman 24 – For example: If a drop in the exchange rate will cost a firm money, a futures contract is sold so that the same drop will cause the value of the hedge to increase by exactly the amount of the loss

Chapter 17: International Finance Copyright © 1999 Addison Wesley Longman 25 Table 17.3Interest Rate Hedge Land Land cost in pesosInitial exchange rate$ Cost of land 8,000,000 pesos $1 to 8 pesos$1,000,000 New exchange rate 8,000,000 pesos $1 to 7 pesos$1,142,857 Loss due to exchange $ 142,857 rate

Chapter 17: International Finance Copyright © 1999 Addison Wesley Longman 26 Forward Contract Amount of forwardContract exchange rate$ Value of contract contract 8,000,000 pesos $1 to 7.95 pesos$1,006,289 New exchange rate $1 to 7 pesos$1,142,857 Gains from sale of contract$ 136,568 Net gain (loss) due to($ 6,289) exchange rate change

Chapter 17: International Finance Copyright © 1999 Addison Wesley Longman 27 Political Risk  Foreign investments can be nationalized or expropriated  Unexpected import or export duties may be imposed  Taxes, labor laws, and restrictions on moving profits out of the foreign country may occur

Chapter 17: International Finance Copyright © 1999 Addison Wesley Longman 28 Financing Foreign Investments  Eurodollars  LIBOR – London Interbank Office Rate  Eurobonds

Chapter 17: International Finance Copyright © 1999 Addison Wesley Longman 29 International Trade Agreements  NAFTA 1994 – North American Free Trade Agreement  European Union (EU) 1993