Chapter 15 International Business Finance Key sections –Factors affecting exchange rates –Nature of exchange risk and types –How control exchange risk?

Introduction Globalization –to make something worldwide in scope/application –In finance, integration of countries’ financial and product markets –Increases availability of funds and liquidity –Made possible by computer and communications technologies

Multinational Corporations Multinational corporations or MNC’s –Have operations in more than one country –Problems: different languages, currencies financial markets, taxes, cultures, etc.

World Trade Trade growing rapidly, capital flows even faster –US imports/exports – 20% of GDP; Higher in other countries; US has high deficit in balance of trade (imports greater than exports) –Overseas investment achieves diversification and increases returns Companies operating in one country not immune to international factors

Exchange Rates (X-rates) Price of a foreign currency in terms of the domestic currency Exchange risk – future rates may be different Exchange markets –method of transferring purchasing power –Extremely active market -trades $110 billion/day

Market Evolution – exchange rates fixed (more or less) Since 1973 – floating rates Determined by supply/demand; change minute by minute Most exchange controls eliminated

The Euro 1999 – 11 European countries adopted common currency, the Euro (€) No more DM, FF, Lira Easier to travel and trade goods and services Eliminates price differences Broadens/deepens capital markets

8 Exchange Rates

Exchange Terminology Devaluation – currency made cheaper –Revaluation – becomes more expensive Direct quote = number of units of home currency to buy one unit of foreign currency –50 US cents to buy one Australian dollar Indirect – foreign units per home unit Two Aussies for each US$1.

More Terminology Spot rate – rate agreed today for exchange in two days Forward rate – rate agreed today for future exchange Cross rates – two foreign currencies for each other How many yen per British pound?

Terminology Concluded Bid-asked spread Bid price- what dealer will pay for unit of currency, say $ / £ Asked rate – dealer’s selling price, say $1.5320/£

What Determines X- Rates? Market conditions (supply/demand) Economic situation – growth or no-growth BoP – surplus or deficit? Relative interest rates – high rates attract capital flows Say’s Law of One Price – purchasing power parity All based on “perceived value”

Forward Contracts Forward contract requires delivery at a fixed date of fixed amounts of two currencies –This locks in the exchange rate –Very little evidence that forwards accurately predict future spot rates

British Pound Forwards Direct ($/£)Indirect (£/$) Spot$1.5315£ month months months

How Do We Use Forwards? Can buy £ forward today and will know the precise amount due. Locks in exchange rates. Protects against future fluctuations

£ Forward Contract Example Spot rate (delivery in two days) = $ Six month forward= $ I owe £1,000,000 in six months Buy forward, locks in $1,514,900 –What if spot is $1.60 in six months without forward? Cost is $1,600,000 or $85,100 more

Arbitrage Buying and selling an asset simultaneously at different prices, usually in different markets. When sale price is higher, provides riskless profit Process continues until differential no longer exists Arbitrage maintains narrow price range between markets

Arbitrage Example Gold in New York - $200/oz;London - £90 Exchange rate is $2.00 per £1.00. What Would You Do?. Convert $180 to £90. Buy gold in London for £90. Sell in New York for $200.Make $20.

Risk and Its Control Owe UK supplier £1 million in six months. Risk comes from writing contract in foreign currency. One of us is going to have to take risk

Hedging Risk Hedge – take action to offset risk Prepay? Gives up interest. Buy £ denominated asset (bank account)?Probably OK. Buy forward? Very flexible – customized Use futures or options? Another possibility

Other Sources of Risk Foreign currency receivables Foreign currency securities in a portfolio Foreign subsidiaries have foreign currency revenue/expenses and asset/liabilities

Measuring Exposure to Risk Assets in foreign currency depreciate if currency devalues Liabilities also decline What is the net exposed position? Translation exposure – translating accounting statements into dollars Transactions exposure – when receipts or payments are in foreign currency

Economic Exposure Overall impact on value of the firm or its competitive position What happens to GM if yen depreciates? Affected by market structure and price elasticity

Portfolio Investment Purchase of foreign security – Portfolio Return unknown – risky –In local currency return might be –2% to +8% –Exchange rate could change from –4% to +6% –For US investor return could range between –6% and +14% Exchange rates introduce greater variability

Direct Investment Purchase of a company or factory Assets (balance sheet) and income statement in local currency Profits returned in dollars –Risk applies to dollar value of assets and the home currency profit stream. –Additional risks – business, financial and political

Political Risk Expropriation Inconvertibility Changes in taxes Government controls such as required local equity participation May be possible to hedge with insurance, government or private