Corporate Financial Theory Lecture 12

International Finance Today Capital Budgeting (international style) Financing (international style) Topics Exchange rates Currency risk Managing Currency Risk Capital Budgeting w/ currency risk Financing w/currency risk

Foreign Exchange Markets Exchange Rate - Amount of one currency needed to purchase one unit of another. Spot Rate The price of a currency for immediate delivery (i.e. today’s exchange rate) Forward Rate The price of a currency on a specified future date (i.e. a forward contract in which the exercise price is the exchange rate) Futures - Same as forward (w/secondary markets) Options - on exchange rates & Future Ks 3

Exchange Rates December 2017

Foreign Exchange Markets Forward Premiums and Forward Discounts Example - The Peso spot price is 10.9892 peso per dollar and the 3 month forward rate is 11.0408 Peso per dollar, what is the premium and discount relationship? 5

Foreign Exchange Markets Forward Premiums and Forward Discounts Example - The Peso spot price is 10.9892 peso per dollar and the 3 month forward rate is 11.0408 Peso per dollar, what is the premium and discount relationship? Answer - The dollar is selling at a 1.90% premium, relative to the peso. The peso is selling at a 1.90% discount, relative to the dollar. 6

Exchange Rates Example Swiss franc spot price is SF 1.4457 per $1 Swiss franc 6 mt forward price is SF1.4282 per $1 The franc is selling at a Forward Premium The Dollar is selling at a Forward Discount This means that the market expects the dollar to get weaker, relative to the franc Example (premium? discount?) The Japanese Yen spot price is 101.18 per $1 The Japanese 6mt fwd price is 103.52 per $1

Exchange Rates Example What is the franc premium (annualized)? What is the Yen discount (annualized)?

Exchange Rate Relationships Basic Relationships equals equals equals equals 7

Exchange Rate Relationships 1) Interest Rate Parity Theory The ratio between the risk free interest rates in two different countries is equal to the ratio between the forward and spot exchange rates. 8

Exchange Rate Relationships Example - You have the opportunity to invest $1,000,000 for one year. All other things being equal, you have the opportunity to obtain a 1 year Mexican bond (in peso) @ 7.35 % or a 1 year US bond (in dollars) @ 5.05%. The spot rate is 10.9892 peso:$1 The 1 year forward rate is 11.2274 peso:$1 Which bond will you prefer and why? Ignore transaction costs 9

Exchange Rate Relationships Example - You have the opportunity to invest $1,000,000 for one year. All other things being equal, you have the opportunity to obtain a 1 year Mexican bond (in peso) @ 7.35 % or a 1 year US bond (in dollars) @ 5.05%. The spot rate is 10.9892 peso:$1 The 1 year forward rate is 11.2274 peso:$1 Which bond will you prefer and why? Ignore transaction costs Value of US bond = $1,000,000 x 1.0505 = $1,050,500 Value of Mexican bond = $1,000,000 x 10.9892 = 10,989,200 peso exchange 10,989,200 peso x 1.0735 = 11,796,906 peso bond pmt 11,796,906 peso / 11.2274= $1,050,725 exchange 14

Exchange Rate Relationships 2) Expectations Theory of Exchange Rates Theory that the expected spot exchange rate equals the forward rate. 15

Exchange Rate Relationships 3) Purchasing Power Parity The expected change in the spot rate equals the expected difference in inflation between the two countries. 16

Exchange Rate Relationships Example - If inflation in the US is forecasted at 2.5% this year and Mexico is forecasted at 4.7%, what do we know about the expected spot rate? Given a spot rate of 10.9892 peso:$1 solve for Es Es = 11.2251 20

Exchange Rate Relationships 4) International Fisher effect The expected difference in inflation rates equals the difference in current interest rates. Also called common real interest rates 21

Exchange Rate Relationships Example - The real interest rate in each country is about the same 23

Exchange Rates Another Example You are doing a project in Switzerland which has an initial cost of $100,000. All other things being equal, you have the opportunity to obtain a 1 year Swiss loan (in francs) @ 8.0% or a 1 year US loan (in dollars) @ 10%. The spot rate is 1.4457sf:$1 The 1 year forward rate is 1.4194sf:$1 Which loan will you prefer and why? Ignore transaction costs Cost of US loan = $100,000 x 1.10 = $110,000 Cost of Swiss Loan = $100,000 x 1.4457 = 144,570 sf exchange 144,570 sf x 1.08 = 156,135 sf loan pmt 156,135 sf / 1.4194 = $110,000 exchange If the two loans created a different result, arbitrage exists!

Exchange Rates Swiss Example Given a spot rate of sf:$ 1.4457:$1 Given a 1yr fwd rate of 1.4194:$1 If inflation in the US is forecasted at 4.5% this year, what do we know about the forecasted inflation rate in Switzerland? 𝐸 𝑆 𝑓 $ 𝑆 𝑓 $ = 𝐸(1+ 𝑖 𝑓 ) 𝐸(1+ 𝑖 $ ) Solve for 𝑖 𝑓 𝑖 𝑓 =.026 or 2.6% 1.4194 1.4457 = (1+ 𝑖 𝑓 ) 1+.045

Exchange Rates Swiss Example In the previous examples, show the equilibrium of interest rates and inflation rates 1+ 𝑟 𝑓 1+ 𝑟 $ = 1.08 1.10 =.9818 𝐸(1+ 𝑖 𝑓 ) 𝐸(1+ 𝑖 $ ) = 1.026 1.045 =.9818

Currency Risk Example Your US company is building a plant in Switzerland. Your cost will be 2,000,000 sf, with full payment due in 6 months. You are concerned about currency risk. The spot rate is 1.4397sf:$1 and the 6 mt forward rate is 1.4350sf:$1. How can you eliminate the currency risk? How does this help in evaluating the project?

Currency Risk Example Your US company is building a plant in Switzerland. Your cost will be 2,000,000 sf, with full payment due in 6 months. You are concerned about currency risk. The spot rate is 1.4397sf:$1 and the 6 mt forward rate is 1.4350sf:$1. How can you eliminate the currency risk? How does this help in evaluating the project? Since you are short in Swiss Francs, you should long sf contracts 2,000,000sf / 1.4350 = $1,393,728 worth of 6mt sf Ks. This will lock in your Co cash flow at $1,393,728 The forward premium paid is 0.33% (using capital market equilibrium, this premium probably equals the inflation rate.

Exchange Rates Applications Q: What does it mean to a business if the dollar is trading at a forward premium? A: Stronger purchasing power

Exchange Rate Risk Currency Risk can be reduced by using various financial instruments Currency forward contracts, futures contracts, and even options on these contracts are available to control the risk 29

Capital Budgeting Techniques 1) Exchange to $ and analyze 2) Discount using foreign cash flows and interest rates, then exchange to $. Option 1 preferred because discount rates in US are more reliable. 30

Example Q: What are the 1, 2, 3, 4, 5 year forward rates? A: Outland Corporation is building a plant in Holland to produce reindeer repellant to sell in that country. The plant is expected to produce a cash flow (in guilders ,000s) as follows. The US risk free rate is 8%, the Dutch rate is 9%. US inflation is forecasted at 5% per year and the current spot rate is 2.0g:$1. year 1 2 3 4 5 400 450 510 575 650 Q: What are the 1, 2, 3, 4, 5 year forward rates? A: 𝐸 𝑆 𝑓 $ 2.02 2.04 2.06 2.08 2.10 𝐸 𝑆 𝑓 $ 𝑆 𝑓 $ = 𝐸(1+ 𝑟 𝑓 ) 𝑡 𝐸(1+ 𝑟 $ ) 𝑡 𝐸 𝑆 𝑓 $ 2.0 = (1+.09) 𝑡 (1+.08) 𝑡

Example Q: Convert the CF to $ using the forward rates. 1 2 3 4 5 Outland Corporation is building a plant in Holland to produce reindeer repellant to sell in that country. The plant is expected to produce a cash flow (in guilders ,000s) as follows. The US risk free rate is 8%, the Dutch rate is 9%. US inflation is forecasted at 5% per year and the current spot rate is 2.0g:$1. year 1 2 3 4 5 400 450 510 575 650 Q: Convert the CF to $ using the forward rates. 1 2 3 4 5 CFg 400 450 510 575 650 E(S) 2.02 2.04 2.06 2.08 2.10 CF$ 198 221 248 276 310

Political Risk

Political Risk

Trade Policy

Exchange Rate Risk Example - Honda builds a new car in Japan for a cost + profit of 1,715,000 yen. At an exchange rate of 120.700Y:$1 the car sells for $14,209 in Indianapolis. If the dollar rises in value, against the yen, to an exchange rate of 134Y:$1, what will be the price of the car? 1,715,000 = $12,799 134 Conversely, if the yen is trading at a forward discount, Japan will experience a decrease in purchasing power. 26

Exchange Rate Risk Example - Harley Davidson builds a motorcycle for a cost plus profit of $12,000. At an exchange rate of 120.700Y:$1, the motorcycle sells for 1,448,400 yen in Japan. If the dollar rises in value and the exchange rate is 134Y:$1, what will the motorcycle cost in Japan? $12,000 x 134 = 1,608,000 yen 27

Trade Policy

Employment Conventional wisdom We are losing all of our jobs to Mexico, China, and India? FALSE

Employment Trend Population 2007 = 301 mil 1970 = 203 mil Source: Bureau of Labor Statistics

Employment & Foreign Trade Population Employed 2007 = 301 mil 1970 = 203 mil 2007 = 146.0 mil 1970 = 78.6 mil 86 % Source: Bureau of Labor Statistics

UIndy Nightly News News Alert on the unemployment report released today by the Department of Labor.

PR - News Releases “Last month the unemployment rate in the United States increased slightly from 4.6% to 4.7%. White House officials were quick to point out that at the same time the U.S. economy added 141,000 new jobs.” “Last month 322,000 manufacturing jobs were lost. Union leaders site cheap overseas labor costs as the culprit, saying that good jobs are leaving the US and the economy will suffer.”

Behind The Numbers September 2007 Unemployment = 4.7% Jobs added 463,000 Jobs lost 322,000 Net change +141,000 Source: Bureau of Labor Statistics

Behind The Numbers Totals for 2006 Unemployment = 4.6% Jobs added 2,697,000 Jobs lost 625,000 Net change +2,072,000 Source: Bureau of Labor Statistics

Comparative Advantage Human Nature 101 Wants Needs

Comparative Advantage Human Nature 101 Wants Needs

Comparative Advantage Human Nature 101 Wants Needs

Employment But are they better paying jobs? Source: Bureau of Labor Statistics

Employment Source: Bureau of Labor Statistics

Foreign Trade Conventional wisdom We have huge trade deficits with other countries. These large trade deficits are destroying our economy. FALSE

Foreign Trade Source: US Census Bureau

Trade Deficit and Economic Strength Source: S&P & Nikkei

Foreign Trade Why does this work? KEY Strong Dollar Stuff USA China Cash Dollars Wall Street & (Indiana) KEY Strong Dollar Wall Street invests this money, which… creates more jobs, which… grows the economy, which… strengthens the dollars, which… starts the cycle again

What We Know Net Present Value Capital Asset Pricing Model (CAPM) Efficient Capital markets Value Additivity & Conservation Option Theory Agency Theory

What We Do Not Know How major decisions are made What determines the risk & PV ? CAPM shortfalls Why are some markets inefficient? Is management a liability?

What We Do Not Know Why do IPOs succeed & new markets emerge? Why is capital structure not optimized? Dividend policy - Answer? Liquidity value? Why do mergers come in waves?

Review for Final In normal class room Topics Format Difficulty Bonus Points