Chapter 17

International Business Finance

Chapter Objectives Internationalization of business Why foreign exchange rates in two different countries must be in line with each other Interest rate parity Purchasing-power parity and the law of one price Exchange rate risk Working-capital management Financing sources available to multinational corporations Direct foreign investment

Globalization of Products and Financial Markets Direct Investment When the multinational corporation (MNC) has control over the investment such as building an offshore manufacturing facility Portfolio investment Financial assets with maturities greater than 1 year such as purchase of foreign stock and bonds Total foreign investment in the U.S. now exceeds such U.S. investment overseas

International Financial Investment Earn higher returns than those obtainable in the domestic capital markets Reduce portfolio risk through international diversification

Exchange Rates Floating-rate international currency system – A system in which exchange rates between different national currencies are allowed to fluctuate with supply and demand conditions. Short-term day to day fluctuations in exchange rates are caused by changing supply and demand conditions in the foreign exchange market

Euroland and the Eurodollar Jan 2002, 11 countries in the European Union began circulating a new single currency, the Euro. These countries are often referred to as “Euroland” Include:Germany, France, Italy, Spain, Portugal, Belgium, Netherlands, Luxembourg, Ireland, Finland and Austria Germany and France account for over 50 percent of Euroland’s output

Rationale for Eurodollar Ease in travel across national borders Eliminates exchange costs Eliminates the uncertainty associated with exchange rate fluctuations Cost differences for goods in different countries Easier to compare prices and reduce the discrepancies

Foreign Exchange Market Operates at three levels: – Customers buy and sell foreign exchange through their banks – Banks buy and sell foreign exchange from other banks in the same commercial center – Banks buy and sell foreign exchange from banks in commercial centers i.e. New York, London, Zurich, Frankfurt, Hong Kong, Singapore, Tokyo

Spot Exchange Rates Exchange rate – The price of foreign currency in terms of the domestic currency Spot Transactions – When one currency is traded for another currency, today – Rates are typically “Direct Quotes” Direct Quotes – indicates the number of units of the home currency required to buy one unit of the foreign currency Dollar/foreign currency rate ($/FC)

Exchange Rates If an American company must pay DM 2,000 to a German firm, how many dollars will be required? $.449 = DM 1 Need DM 2, X 2,000 = $898

Indirect Quote Indicates the number of units of a foreign currency that can be bought for one unit of the home currency General method used in the over-the- counter market Foreign currency/dollar (FC/$) Reciprocal of a direct quote

Direct and Indirect Exchange Rates Example: Calculate the indirect quote from the direct quote of spot rate German Mark /direct quote = indirect quote 1/.4490 = 2.227

Exchange Rates If an American company must pay $2,000 to a German Firm, how many marks will the German Company receive? Indirect rate = X $2,000 = DM 4,454

Exchange Rates and Arbitrage Foreign exchange quotes in two different countries must be in line with each other If the exchange rates are out of line, a trader could make a profit by buying in the market where the currency was cheaper and selling it in the other ArbitrageThe process of buying and selling in more than one market to make a riskless profit Types of Arbitrage: Simple, Triangular, Covered- interest

Arbitrage Simple – Eliminates exchange rate differentials across the markets for a single currency Triangular – Eliminates exchange rate differentials across the markets for all currencies Covered-interest – Eliminates differentials across currency and interest rate markets

Asked and Bid Rates Asked rate – Rate the bank of the foreign exchange trader asks the customer to pay in home currency for foreign currency when the bank is selling and the customer is buying. – Also know as selling rate or offer rate Bid Rate – The rate at which the bank buys the foreign currency from the customer by paying in home currency – Also know as buying rate Bid-Asked Spread – The difference between the asked quote and the bid quote

Exchange Rate Terms Cross rates – The computation of an exchange rate for a currency from the exchange rates of two other currencies Forward Exchange contract – Requires delivery at a specified future date of one currency for a specified amount of another currency – The exchange rate for the forward transaction is agreed up today; the actual payment of one currency and receipt of another currency take place at the future date – The forward rate is often quoted at a premium or a discount from the existing spot rate – The premium or discount is also call the forward-spot differential

Exchange Rate Risk The risk that tomorrow’s exchange rate will differ from today’s rate Examples: – Exchange rate risk in international trade contracts – Exchange rate risk in foreign portfolio investments – Exchange rate risk in direct foreign investment

Exchange Rate Risk in Foreign Portfolio Investments The return is unknown—the security is a risky investment The exchange rate fluctuation may increase the riskiness of the investment

Exchange Rate Risk in Direct Foreign Investment Fluctuations in the dollar value of the assets located abroad as well as the fluctuations in the home currency-denominated profit stream.

Exchange Rate Risk in International Trade Contracts Can occur when a contract is written in the foreign currency, the exact dollar amount of the contract is not known The variability of the exchange rate induces variability in the future cash flow

Interest-Rate Parity Theory The forward premium or discount (except for the effects of small transaction costs) should be equal and opposite in size to the difference in the national interest rates for securities of the same maturity The interest differential between two countries must be equal to the difference between the forward and spot exchange rates

Purchasing-Power Parity Theory (PPP) In the long run, exchange rates adjust so that the purchasing power of each currency tends to be the same. The exchange rate changes tend to reflect international differences in inflation rates Countries with high rates of inflation tend to experience declines in the value of their currency Expected spot rate = Current spot rate X expected difference in inflation rate

PPP Expected spotCurrent Spot Rate (1 – expected domestic Rate (domestic = (domestic currency Xinflation rate) currency per unitper unit of foreign (1 – expected foreign of foreign currency)currency) inflation rate) Law of one Price – In competitive markets in which there are no transportation costs or barriers to trade, the same goods sold in different countries sell for the same price if all the different prices are expressed in terms of the same currency International Fisher Effect – Nominal interest rates reflect the expected inflation rate and a real rate of return Nominal interest rate = expected inflation rate + real rate of interest

Exposure to Exchange Rate Risk Translation Exposure Transaction Exposure Money-Market Hedge The Forward-Market Hedge Currency-Futures Contracts and Options Economic Exposure

Direct Foreign Investment Business Risk Financial Risk Political Risk Exchange Rate Risk