Welcome to class of International Finance/Forces by Dr. Satyendra Singh University of Winnipeg Canada

Outline Purchasing Power Parity Factors affecting Foreign currency Fisher’s Effect Arbitrage Hedge (Forward, Currency option, Money Market) Transfer Pricing Swap (Parallel loan, Bank, Currency) Debt vs. Equity Impact of Culture on Accounting Accounting Standards

Purchasing Power Parity (PPP)… –The number of units of a currency required to buy the same amount of goods and services in a domestic market that $1.00 would buy in the U.S. –Helps to make comparisons possible across economies CIA Fact Book

Purchasing Power Parity (PPP) If, 1 Lt. MilkUS$ Lt. MilkIndiaRs Then, PPP: US $1 = Rs. 20 Reality: US $1 = Rs. 40 ie Rs. Is 50% undervalued –artificially?!

Factors affecting Foreign Currency Three factors: –Inflation –Interest rate –Speculation Fisher’s Effect –Diff. in interest rate may determine strength of FOREX € 1= $1.5, Interest rate: € (3%) and $(5%) Speculation: Which currency becomes weaker/stronger?

Atlas Conversion Factor It is used for speculation Average of FOREX for the last 2 years adjusted by the ratio of domestic inflation and combined inflation of US, UK, EU and Japan

Weak Foreign Currency…

Weak Foreign Currency

Arbitrage: The process of buying and selling instantaneously to make profit at no risk Algeria Dinar Brazil Riel Chile Peso 1:2 1:3 1:5 5 dinar

Transaction Exposure: Hedging  Hedging  process to reduce or eliminate financial risk  Forward market hedge  Foreign currency contract sold or bought forward in order to protect against foreign currency movement  Currency option hedge  Option to buy or sell specific amount of foreign currency at specific time to protect against foreign currency risk  Money market hedge  Method to hedge foreign currency exposure by borrowing and lending in domestic and foreign money markets

Forward Hedge Hedge is a process to reduce risk € 1= $1.5 (now/spot) $ is expected to be weak € 1= $1.6 (speculate/forward) Interest rate: € (3%) and $(5%) Suppose you have accounts receivables for €20,000 If quoted in €, supplier may not have problem (i.e. Risk prone) But strong currency is desirable by both seller and buyer If you quoted in € (ie € 20,000 x 1.5 = $30,000), You now get $ (ie € 20,000 x 1.6 = $32,000) You gained: $2000, because $ became weak You lose, if $ became stronger (say 1.4) = $2,000

Currency Option Hedge So you have accounts receivables in a currency that works best for your company Firms may have bank accounts in multiple currencies such as Dollar, Euro, Yen… to avoid conversion charges.

Money Market Hedge Counter balancing the risk by borrowing the same amount for FOREX (A/R) in domestic market and investing it until accounts receivables are received Suppose the AR is €20,000 (in 90 days) € 1= $1.4 (expected) $ is expected to be strong! € 1= $1.5 (now) Interest rate: € (5%) and $(3%) Borrow €20,000  convert in $ (€ 20,000 x 1.5 = $30,000)  Invest  Income (but pay interest) After 90 days, pay €20,000 to local bank, so no debt So, Investment + income - interest ≥ €20,000

Source: Wall Street Journal, Exchange rate June 19, 2006 Fri: June 16 (SPOT) Mon: June 19 (FORWARD) Last Friday

Movement of $, Transfer Pricing Supplier Local business Customer Profit $1 $10 $9 Say, 30% tax $6.30 Net profit $2.70 tax

Movement of $, Transfer Pricing Supplier Local business Customer Foreign $1 $10 $8 Now profit $1 Say, 30% tax 33 Cents tax! $9

Movement of $, Transfer Pricing – 3 countries UKOFC: JamaicaUSA $100 to produce Sells at $110 Sells at $210 Sells at $220 Profit $10 Profit $100 Profit $10 Tax 50% Tax 5% Tax 30% Tax paid $5 Tax paid $5 Tax paid $3.33

OFC: Offshore Ffinancial Centres  Offshore financial center specializes in financing nonresidents, low taxes and few banking regulations  Too small to exist on its own  Boosts economy  Employment  Switzerland  Cayman Island  Hong Kong  Bahamas  Bermuda  Gibraltar  Luxemburg  …

Swaps  Parallel Loans  Matched loans across currencies made to cover risk  Bank Swap  Swap made between banks to acquire temporary foreign currencies  Currency Swap  Exchange of debt service of loan or bond in one currency for debt service of loan or bond in another currency

Parallel Loan Swap CANADA:Canada (parent)India (child) INDIA:Canada (child)India (parent) $1m Rs. 40m $1 = Rs. 40

Bank Swap Canadian Bank in Canada Indian Bank in IndiaCanadian child in India Canadian parent in Canada $1m Rs. 40m Canadian Parent deposits $1m to the credit of the Indian Bank  The Correspondent Indian Bank lends Rs. 40m (spot rate) to the Child  At a later agreed date, the Child returns Rs. 40m to Indian Bank  Indian Bank instructs the Canadian Bank to pay $1m to the Parent So, no conversion of $1 to Rs. Useful if you want hard currency only

Currency Swap CANADA CYPRUS I am Known hereSame is true for So the interest rate is low for methe Cypriot person in Cyprus So, I take the loan for the Cypriot guyPerson does the In Canada at low interest ratesame for me in $1.5mCyprus (€ 1m) Then, we swap currency, i.e., I service the loan in € for the Cypriot guy in CYPRUS And the Cypriot guy services my loan in $ in Canada € 1 = $1.5

Capital Structure of a Firm  Debt  Borrow from Bank  Conservative, report less, ↓ tax exposure, ↑ dividend pay outs  save $ to service debt  France, Germany, Japan, some Emerging Markets  Debt financing is less expensive than equity financing, because interest paid on debt is tax deductable, but dividends paid out to shareholders are not.  Equity  Shares, Bonds  Impressive (Inflated report) to attract investors  Value of Bond ↓, if interest rate ↑

How do Bonds perform? Suppose, now you have bonds worth for a year So expect $500 at the end of the year Now, interest rate changed to 6% Value of your bond now is: $x x.06 = $500 ie x = $8334 Drop in value = 17%!

Cultural Differences in Measurement and Disclosure for Accounting Systems

Annual Reports  Depends  Calculation of Inventory  Depreciation  Income only when contract is complete  Valuation of assets  Goodwill  …  So we need uniform accounting system

International Accounting Standards Triple Bottom Line Standard (3BL) –Environmental, social, and financial impacts of the business International Accounting Standards Board (IASB) International Financial Reporting Standards (IFRS) Sarbans-Oxley Act (2002, US) –Public Company Accounting Reform and Investor Protection Act (in the Senate) –Corporate and Auditing Accountability and Responsibility Act (in the House) –Heavy penalty for corporate finance fraud

Use of International Financial Reporting Standards (IFRS)

Tax System Direct Tax –Income Tax –VAT – Value Added Tax Indirect Tax (Withholding Tax) –Dividend –Interest –Royalty