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 Balance of Trade Deficit – $600 billion, up from less than $500 billion in We are a deficit nation and have to borrow from other countries – Japan and China - Will they continue to lend? Pressure on the dollar?

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 $1.9 trillion/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

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?

10 Exchange Rates

What Determines X- Rates? Market conditions (supply/demand) Economic situation – growth or no-growth Balance of Payments – surplus or deficit? Relative interest rates – high rates attract capital flows Relative inflation rates All based on “perceived value”

Forward Contracts Forward contract requires delivery at a fixed date of fixed amounts of two currencies at a fixed exchange rate –This locks in the exchange rate (cost) Most active markets – 30, 60, 90 day periods but up to ten years

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

15 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

£ Forward Contract Example Spot rate (two day delivery) = $ Six month forward= $ 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 –But what if spot is $1.50? Could have saved $14,900 (if willing to speculate)

Hedging Risk Hedge – take action to offset risk Prepay? Gives up interest. Buy foreign currency 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 appreciates? –Raise prices without losing sales? - Affected by product, 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 Worldwide foreign direct investment was $1.4 trillion in 2000 Assets (balance sheet) and income statement kept 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