Ian Giddy

INTERNATIONAL FINANCIAL MANAGEMENT

www.stern.nyu.edu

www.stern.nyu.edu/~igiddy/ifmx.htm

www.giddy.org

International Financial Management Prof. Ian Giddy Stern School of Business, New York University

International Financial Management Management of international assets Management of international liabilities Management of cross-border financial risks Cross-border funds transfers These depend on the environmental features of international finance--notably, the global financial markets

Corporate Finance CORPORATE FINANCE DECISONS INVESTMENT FINANCING RISK MGT PORTFOLIO MEASUREMENT CAPITAL DEBT EQUITY M&A TOOLS

What is Special about Corporate Finance in the International Environment? Financial markets are partially linked, partially separated by national jurisdications Exchange rate fluctuations affect revenues, costs and valuation of firms The competitive international financial markets offer special tools, opportunities and risks

What are the Global Financial Markets? The Foreign Exchange Market The Derivatives Domestic and International Money Markets Domestic and International Capital Markets Beyond the Money and Bond Markets: International Equity and Commodity Markets Using the Global Capital Markets: Investors’ and Issuers’ Perspectives

Global Financial Markets: A Framework Jurisdiction 1. Domestic 2. Foreign 3. External Claims 1. Direct 2. Intermediated 3. Enhanced

Policies and Exchange Rate Regimes Exchange rate systems--fixed vs floating Managed floating EMS-type currency blocs De facto blocs--the dollar

The Eurocurrency Market “A Eurodollar is a dollar deposited in a bank within a jurisdication outside the United States” Separation of currency, institution and jurisdiction Why do people want Eurocurrency deposits and loans? Why is LIBOR the world’s key benchmark rate?

The Eurocurrency Market “A Eurodollar is a dollar deposited in a bank within a jurisdication outside the United States” Separation of currency, institution and jurisdiction Why do people want Eurocurrency deposits and loans? Why is LIBOR the world’s key benchmark rate?

Where the Eurocurrency Market Fits In US Domestic German Market EUR0CURRENCY MARKET Domestic Market Euro-Deutsche Mark Eurodollar Market Market Japanese Euro-Yen Domestic Market Market

Where the Eurocurrency Market Fits In US Domestic German Market EUR0CURRENCY MARKET Domestic Market Euro-Deutsche Mark Eurodollar Market Market Foreign Exchange Market Japanese Euro-Yen Domestic Market Market Euro-Commercial Euro-Floating Rate Straight Paper Market Note Market Eurobond Market

Interest Rate Linkages in the International Money Market Two stories to tell: Domestic vs. Euro Eurocurrency A vs. Eurocurrency B Domestic Market A The Euromarkets Domestic Market B Trea- Bank Euro Euro Bank Trea- sury Deposit Deposit Deposit Deposit sury Bill Market Market Bill Trea- Corp- Euro Euro Corp- Trea- sury orate Bond Bond orate sury Bond Bond Market Market Bond Bond

Domestic versus Euro The Eurodollar Premium Market price of risk versus Cost of regulation Eurodollar vs. U.S. Interest Rate Effective cost of domestic deposit = (interest rate + FDIC fees) (1 - reserve requirement) Capital controls and divided credit markets

Mechanics and calculations How banks make money How banks hedge Foreign Exchange Mechanics and calculations How banks make money How banks hedge Tasks of the corporate FX manager

Foreign Exchange Mechanics and Calculations “Money never leaves homes” Funds transfer, chips, and timing Relative interest rates 1. Forward premium or discount 2. Points 3. Spot and forward Spot and forward 1. Points 2. Forward premium or discount 3. Relative interest rates

Foreign Exchange Quotations Bid Offer Spot Forward points Rule: add if bid<offer, subtract if bid>offer Outright forward

How Banks Make Money Speculative positioning in the interbank market Arbitrage 1. Triangular 2. CIA Bid-offer spread “Customer trading”

Triangular Arbitrage US dollars Dutch Australian guilders dollars

Covered Interest Arbitrage

The Dealing Room Diagram of a Dealing Room Foreign exchange and Eurocurrency dealing are interrelated activities and so are done on the same trading floor. The Dealing Room CUS- FOR- Foreign TOMER SPOT WARD Exchange Dealing Money FUNDING EUROCURRENCY Market Dealing The Dealing Room

Diagram of a Dealing Room Foreign exchange and Eurocurrency dealing are interrelated activities and so are done on the same trading floor. The Dealing Room CUS- FOR- Foreign TOMER SPOT WARD Exchange Dealing Money FUNDING EUROCURRENCY Market Dealing

How Banks Hedge SHORT LONG Today T+2 T+90 Methods: - Spot + swap - Spot + rollover swap - Money market - Outright forward

Linkages Between Eurocurrency Rates Interest rate differential Forward premium Expected % change in exchange rate

Linkages Between Eurocurrency Rates Interest rate differential Covered interest rate parity Forward premium Expected % change in exchange rate

Linkages Between Eurocurrency Rates Interest rate differential Covered interest rate parity Uncovered interest rate parity Forward premium Expected % change in exchange rate

Linkages Between Eurocurrency Rates Interest rate differential Covered interest rate parity Uncovered interest rate parity Forward premium Expected % change in exchange rate Unbiased forward rate

Interest-Rate Parity $1 (1 + / E$) = ($1/ S t )(1 + /EBP) Fnt where St is the spot exchange rate (dollars per British Pound) and Fnt is the forward rate. to a close approximation, (/E$ - /EBP) = [(Ft n - St)/St] (365/n) 100 Interest-rate differential = forward premium or discount

Example: Anglo’s Funding Anglo-American, the natural resources conglomerate, is seeking 3-month US$ funding. Anglo can fund in the US CP market at 5.5% Or in the Eurosterling market at 6.7% The BP is: spot $1.5484, 3-mo forward $1.5454 Which is cheaper?

It’s cheaper for Anglo-American to borrow in the US CP market. Reason: Anglo’s Answer It’s cheaper for Anglo-American to borrow in the US CP market. Reason: US: simply borrow for 3 months Cost: $1(1+5.5%/4) = 1.01375 UK: borrow British pounds, change into dollars at spot rate, cover by buying sterling at 3-mo forward rate to repay the pounds Cost: ($1/1.5484)(1+6.7%/4)1.5454 = 1.01478

Unbiased Forward Rate Theory EXCHANGE RATE Spot Forward Actual Today TIME In three months

Unbiased Forward Rate Theory Probability EXCHANGE RATE distribution of actual Spot exchange rate Forward Actual Today TIME In three months

Forward premium or discount = Expected annual rate of change Unbiased Forward Rate Forward premium or discount = Expected annual rate of change of the exchange rate That is, P$/DM = E(R$/DM )

International Fisher Effect INTEREST RATE DIFFERENTIAL

International Fisher Effect /E$ = /EDM + E(R$/DM ) That is, Interest-rate differential equals Expected annual rate of change of exchange rate

Cost of Hedging

Corporate Hedging Decisions: Frutas Amazonas Exporting bananas to Spain, get paid in Spanish pesetas. Funding is in U.S. dollars.

Corporate Hedging Decisions: Frutas Amazonas Continue funding in U.S. dollars. The peseta might get stronger in the next three months, from $1=128 pesetas to $1=126 pesetas. This could be the cheapest Switch funding to pesetas, despite the slightly higher cost Borrow in dollars, but hedge the exchange risk in the forward market.

Frutas Amazonas

Frutas Amazonas

Law of One Price p=Sp* The Price of Tin In New York On the Kuala On the Lumpur London Metal Market Metal Exchange 273c per lb. 15.37 ringgit US$5830 per = US$6.02 per kilogram tonne per kilograma =US5.70 = US5.83 per kilogramb per kilogramc a1 avoirdupois pound = 0.45359 kilograms bUS$1 = 2.6965 Malaysian ringgit on the date of calculation c 1 tonne = 1000 kilogram. All data taken from the Commodities section of the London Financial Times.

Purchasing Power Parity: Theory and Evidence S t=1-St = I-I* St 1+I* EXCHANGE-RATE CHANGE MEXICO 1994 RELATIVE INFLATION JAPAN 1995

Deviations from Purchasing Power Parity Source: JP Morgan. Index of real effective exchange rate versus 18 industrial country currencies, adjusted for change in relative wholesale price of domestic manufactures. A fall in the index indicates improved international competitiveness.

Deviations from Purchasing Power Parity Source: JP Morgan. Index of real effective exchange rate versus 18 industrial country currencies, adjusted for change in relative wholesale price of domestic manufactures. A fall in the index indicates improved international competitiveness.

Inflation & Interest Rates US Expected Inflation Rate 2% Canadian Expected Inflation Rate 7% US Interest Rate 5% Canadian Interest Rate 10%

Inflation & Interest Rates US Expected Inflation Rate 2% Canadian Expected Inflation Rate 7% US Interest Rate 5% Canadian Interest Rate 10% Expected Rate of Change of the Exchange Rate

Borrow at US Interest Rate 5% Invest at Canadian Interest Rate 10% Inflation & Interest Rates Borrow at US Interest Rate 5% Invest at Canadian Interest Rate 10%

Inflation & Interest Rates Borrow at US Interest Rate 5% Invest at Canadian Interest Rate 10% Buy Canadian Dollars Forward (at discount of 5%)

Inflation & Interest Rates Borrow at US Interest Rate 5% Invest at Canadian Interest Rate 10% Buy Canadian Dollars Forward (at discount of 5%) Buy Canadian Dollar Futures (at discount of 5%)

The Linkages Again 1 2 3 4 5 6 Relative excess money supply Relative inflation rates 2 3 4 Relative interest rates Exchange rate change Forward exchange premium or discount 5 6

A Framework Country A Country B DOMESTIC DOMESTIC ECONOMIC ECONOMIC POLICIES POLICIES INFLATION INFLATION RATE RATE EXCHANGE RATE INTEREST INTEREST FORWARD

Conclusion: Corporate Exchange Rate Risk Exchange Rate Risk is the risk arising from fluctuating exchange rates between two currencies

Conclusion: Corporate Exchange Rate Risk Exchange Rate Risk is the risk arising from fluctuating exchange rates between two currencies; but it’s tied to prices and to business risk. Relative monetary and fiscal policies Relative inflation Exchange rate change

Turkey, 1995 Turkish Lira: Down 33.5%

Turkey, 1995 Turkish prices: up 83.8%! Turkish Lira: Down 33.5%

Waiting for Godot: Choices for Waterford Foods “Clearly it’s of great importance to us to determine whether or not the punt will devalue within the next three months. “We should systematically assemble the evidence and views on spot and forward exchange rates, on interest rates, inflation and other economic variables and decide what will happen. “In particular, what’s the probability of a devaluation in the next three months, and how much? “Then we must decide whether it’s worth covering our DM exposure, given the forward premium and relative interest rates.”

www.giddy.org

www.giddy.org Ian Giddy NYU Stern School of Business Tel 212-998-0332; Fax 212-995-4233 ian.giddy@nyu.edu http://www.giddy.org