© 2007 Thomson South-Western Chapter 20 International Financial Management Professor XXXXX Course Name / Number

2 2 Exchange Rate Fundamentals  Why do international financial markets exist?  Fundamentally, to facilitate international trade & investment  Why do nations trade?  Different countries produce what they are relatively best at, and trade to acquire other goods & services.  Nations should specialize in their comparative advantage

3 3 The Growth of World Trade  Barriers to trade remain:  Geographic--distance alone increases trading costs  Protectionism--governments impose tariffs, quotas  Political/legal risks of transacting in different countries

4 4 Fixed Versus Floating Exchange Rates  Most important trade barrier: countries use some 200 different national currencies  Imposes transactions costs and exchange rate risk on traders  But over half of world trade denominated in $US  Three basic types of exchange rate systems:  Fixed exchange rate  Floating exchange rate  Managed floating rate

5 5 Fixed Versus Floating Exchange Rates Floating exchange rate system Currencies float freely in this system, and exchange rates (prices) are set by supply and demand. $US, Japanese Yen, British Pound, Swiss Franc float freely. Fixed exchange rate system Currency value is fixed (pegged) in terms of another currency. If demand for currency increases (decreases), Government must sell (buy) currency to maintain fixed rate. Managed floating rate system Currency is loosely pegged to other currency.

6 6 Exchange Rate Quotes $US equivalent The dollar cost of one unit of foreign currency One Argentine peso equals $ on August 15, 2003 and $ on August 14, The peso thus depreciated against the dollar. Currency per $US The value of each currency relative to one U.S. dollar. Reciprocal of US$ Equivalent. One dollar was worth Argentine pesos on April 3, 2002 and Argentine pesos on April 4, The dollar appreciated against the peso.

7 7 Exchange Rate Quotes  Direct quotation: a quote that gives the home currency price of a unit of foreign currency  Indirect quotation: gives the foreign currency price of one unit of the home currency

8 8 Spot and Forward Exchange Rates Spot exchange rate The exchange rate that applies to currency trades that occur immediately On November 15, 2005, spot exchange rate for British pound was $1.5587/£. Forward exchange rate The fixed price that applies for contracts with delivery in the future On November 15, 2005, the agreement to trade dollars for pounds one month later was a specified forward price of $1.5558/£. The pound trades at a forward discount relative to the dollar.

9 9 Triangular Arbitrage Cross exchange rate The exchange rate between two currencies other than $US Divide the dollar exchange rate for one currency by the dollar exchange rate for another currency: on November 15, 2005 SF1.50/$; €1.00/$; SF1.25/€ Arbitrage opportunity Assume you are quoted the following exchange rates 1. Exchange $1,000,000 into SF1,500,000 (at SF1.50/$). 2. Trade SF1,500,000 for €1,200,000 (at €0.80/SF). 3. Convert €1,200,000 into $1,200,000 (at $1.0000/€). Could make a riskless, instant profit of $200,000.

10 Winners and Losers From ER Changes Suppose the euro appreciates against the Canadian Dollar. This benefits European consumers or producers buying Canadian goods. It hurts Canadian consumers or producers buying European goods. Winners and losers reversed when a currency depreciates.

11 The Foreign Exchange Market  forex: a global telecommunications market  Players:  Importers/exporters  Investors  Hedgers  Dealers  Governments

12 Forward-Spot Parity If a forward market exists, the forward rate should be approximately equal to expected future spot rate. An example… Assume: Spot = $1.5/£ 1M forward = $1.55/£ Assumption of risk neutrality for all firms U.S. firms who will need to pay in pounds in the future will do the opposite. All U.K. (risk neutral) firms who intend to buy U.S. dollars in the future will either: 1. Enter the forward contract today if E(S) < $1.55/£. 2. Wait and buy dollars at the spot rate if E(S) > $1.55/£.

13 Forward-Spot Parity Equilibrium: the forecast of the spot price is equal to the current forward rate (forward – spot parity). E(S) = F U.S. and U.K. firms are indifferent in this case whether they transact in the spot or forward market. Forward-spot parity does not hold. Forward rate is not a reliable predictor of the direction of the spot rate. –Many studies show that on average the spot rate moves in opposite direction than that predicted by the forward rate. –All studies of exchange rates find a great deal of randomness in spot rate movements.

14 The Law of One Price Identical goods trading in different markets should sell at the same price. An example… Assume $/£ exchange rate currently $2.00/£, and gold is selling for $400.00/oz in New York City. What is the most and least that gold can sell for in London (in £) without offering arbitrage opportunity?  Gold should sell for $ ÷ $2.00/£ = £ in London. If gold costs more than £200.00; buy in NYC, sell in London. If gold costs less than £200.00; buy in London, sell in NYC.

15 Purchasing Power Parity (PPP) Key empirical predictions of PPP: Low-inflation nations  appreciating currency High-inflation nations  depreciating currency Differences in expected inflation between two countries are associated with expected changes in currency values. Law holds for tradable goods over time, but deviations occur in the short run. Reasons: –The process of trading goods across countries cannot happen instantaneously. –Legal restrictions or physical impediments apply to transporting goods.

16 Interest Rate Parity (IRP) IRP: Interest rate parity says that the risk-free returns around the world should be equal. An investor can either buy a domestic risk-free asset or a foreign risk-free asset using forward contract to cover currency exposure. The currency of the country with lower risk-free rate should trade at a forward premium.

17 Covered Interest Arbitrage  An example… Current spot rate = C$ 2.00/£ Forward rate = C$ 2.05/ £ Annualized interest rate on a six-month Canadian government bond is 6%. Rate on similar UK instrument is 2%. This means Canadian interest rate is “too low” or UK interest rate is “too high.” Arbitrage opportunity!

18 Covered Interest Arbitrage Borrow C$1,000,000 at 6% per year, convert to 500,000 pounds. This will grow to 505,000 pounds in six months, at which time you convert back at the forward rate to C$1,035,250. Next, repay the Canadian loan which takes C$1,030,000. Arbitrage profit is C$5,250.

19 Real Interest Rate Parity: The Fisher Effect Fisher effect: the nominal interest rate R is made up of two components:  Real required return, assumed to be same in both countries.  Inflation premium equals the expected rate of inflation, i. If real required return is the same across countries, then the following equation is true.

20 Real Interest Rate Parity: The Fisher Effect  Assume that expected inflation in the United States equals 3% and expected inflation in Italy is 8%. One-year risk free rate in the U.S is 3.2%. What should the one year interest rate be to maintain real interest rate parity? Deviations from real interest rate parity occur because of limits to arbitrage. –Scarcity of risk-free investments that offer fixed real, rather than nominal, returns

21 Asset Market Model of Exchange Rates  Asset market model of exchange rates makes a distinction between the demand for a currency as a means of payment (transactions demand) and the demand for currency as a financial asset (as a store of value).  Predicts that currency values will be set by investors rather than by traders

22 Financial, Economic, and Political Risks  Transactions exposure cannot be eliminated, but can be hedged (transferred to a third party) by using financial contracts.  Some hedging options include:  In the forward or futures market  In the currency options market  Via swaps  Via money market instruments.

23 Transaction Risk Exchange rate risk arises when the value of a company’s cash flows can be affected by a change in exchange rates.  An example…  Assume Boeing Company has sold an airplane to a Japanese buyer: 1. Boeing must receive $1,200,000 to cover costs and profits. 2. Since payment usually in buyer’s currency, priced in Yen. 3. Current exchange rate is ¥105.00/$. 4. Price of airplane therefore ¥126,000,000.  If delivery and payment occur immediately, there is no foreign exchange risk: Just exchange ¥126,000,000 for $1,200,000 on spot market. If price is set today, but delivery is in 6 months, Boeing is exposed to significant foreign exchange risk unless it hedges that risk.

24 Transaction Risk If exchange rate in 6 months is ¥110.00/$:  The dollar appreciates; yen depreciates.  Boeing will still receive the same ¥126,000,000 but these will only be worth $1,145, Boeing will suffer an exchange rate loss of $54, Japanese customer is unaffected, since yen price is fixed. If exchange rate in 6 months is ¥100/$ instead:  Boeing will receive $1,260,000 for its ¥126 million payment. 1. Boeing will enjoy an exchange rate gain of $60, Japanese customer again unaffected. Question: who would gain/lose if price set in dollars?

25 Translation and Economic Risk Translation (accounting) exposure Cost and revenue of the subsidiary (in foreign currency) are translated in the domestic currency to be included in the financial statements of the MNC. Economic exposure How does the foreign exchange rate affect firm’s value? Exchange rate changes might influence firm’s cash flows. Rise in the value of the dollar against the yen makes Japanese cars less expensive to U.S. customers and U.S. cars more expensive for Japanese customers. Hedge by using currency derivatives and by matching costs and revenues in a given currency.

26 Political Risk Actions taken by a government which have an impact on the value of foreign companies operating in that country: Macro political risk Impacts all foreign firms in the country Near collapse of Indonesia currency in Micro political risk Government actions that affect only a subset of companies operating in a foreign country 1970s nationalization of the assets of international oil companies by a large number of oil-exporting countries Tax increases or barriers to repatriation of profits

27 EMU and the Rise of Regional Trading Blocks European Monetary Union established Euro as currency for twelve countries in Western Europe. In 1991, Brazil, Argentina, Paraguay, and Uruguay formed the Mercosur Group. – Removed tariffs and other barriers to intraregional trade – Common tariffs on external trade from 1994 General Agreement on Tariffs and Trade (GATT): international treaty that regulates trade – In 1994 revised GATT established the World Trade Organization (WTO).

28 The Growth of World Trade World trade increased at a compound interest rate of around 8% from Merchandise trade has tripled since 1986 to $6.5 trillion; services add another $2-3 trillion. Foreign Direct Investment (FDI) The transfer by a multinational firm of financial, managerial, and technical assets from home country to a host country FDI inflows grew from $180 billion in 1991 to $1.2 trillion in U.S. attracts over 20% of total FDI inflows. Developing country exports account for almost 40% of the world’s total.

29 Worldwide Merchandise and Service Exports, US$ Billions, 1994–2004

30 Merchandise Exports for Leading Exporting Countries, US$ Billions, 1994–2004

31 Foreign Direct Investment Inflows, US$ Billions, 1990–2004

32 Long-Term Investment Decisions: Capital Budgeting Initial CostYear 1Year 2Year 3 - €2,000,000€900,000€850,000€800,000 MNCs have to answer the following questions in their capital budgeting process. In what currency should the firm express a foreign project's cash flows? How is the cost of capital computed for MNCs? An example… Assume U.S. firm performs analysis for project with cash flows in euros: Two alternatives to compute project’s NPV Discount euro-denominated cash flows using euro-based cost of capital and then convert back to dollars. Calculate NPV in dollar terms.

33 First Approach to Compute NPV Assume risk-free in Europe is 5% and the spot rate is $1.15/€. The company estimates that cost of capital for this project is 10% (5% risk premium). Convert into dollar-based NPV The firm can hedge its currency exposure in the future with forward contracts. –Accept or reject the project based on NPV of project; currency exposure should not affect the decision.

34 Second Approach to Compute NPV Calculate NPV in dollar terms; risk free rate in U.S. is 4%.  Assume that the firms will hedge the project's cash flows using forward contracts. Using interest parity, can compute one, two, and three year forward exchange rates:

35 Second Approach to Compute NPV Cash flow of the project converted in dollars: same results as the first approach Need to discount the cash flow at risk-adjusted U.S. interest rate:

36 Cost of Capital  Compute beta of the investment to assess the risk and use CAPM to compute discount rate for the project’s cash flows.  A Japanese auto manufacturer that plans to build a plant in U.S. computes two betas.  If firm’s shareholders cannot diversify internationally:  Compute project’s beta by measuring the covariance of similar European investments with the U.S. market.  Japanese firm computes beta of 1.2 for the project. Risk-free interest rate is 0.8%; market risk premium on Nikkei is 8%.  R project =0.8%+1.2(8%)=10.4%.

37 Cost of Capital  If firm’s shareholders have portfolios internationally diversified:  Compute project’s beta by computing the covariance of return of similar investments with returns on a worldwide stock index.  Project beta is computed 1.4. The world market risk premium is 5%: R project =0.8%+1.4(5%)=7.8%.

38 Short-Term Financial Decisions  Cash management  Hedging strategies – used to offset/protect against risk, usually in transactions exposure  Adjustments to operations  adjustments in assets and liabilities  leading/lagging  Credit and inventory management  Credit terms  Inventory levels