Class 11 Applications: International Finance and Real Options

Offshore Borrowing n Suppose you are an Australian wheat farmer and you want to borrow to expand your operations. n You face a rate of 12% in Australian Dollar- denominated loans. n A Swiss bank, however, will lend at 9% by way of Swiss Franc-denominated loans. n What should you do?

Offshore Borrowing n Suppose you intend to borrow 10 million AUD for 5 years. The spot rate is 0.8 AUD/CHF. n AUD loan: n CHF loan: m AUD10(1.12) 5 m AUD m CHF12.5(1.09) 5 m CHF

Offshore Borrowing n The question is whether 10(1.12) 5 m AUD will be more than 12.5(1.09) 5 m CHF. n This depends on the spot rate 5 years from now, which is uncertain. n Since most wheat farmers are better at growing wheat than forecasting foreign exchange rate movements, you decide to hedge this risk using the forward market.

Offshore Borrowing n Suppose the 5-year forward rate is AUD/CHF. n Paying back the 12.5(1.09) 5 m CHF will require 12.5(1.09) 5 ( ) m AUD = m AUD n But this is exactly what would have to be repaid under the AUD loan since 10(1.12) 5 m AUD = m AUD. n Hence nothing has been gained by borrowing offshore.

Covered Interest Rate Parity n This equivalence always holds and is known as covered interest rate parity:

Proof By Arbitrage n Suppose the forward rate is 0.80 AUD/CHF:  Borrow 1.25 CHF and convert to 1.00 AUD.  Invest for 5 years at 12% yielding 1.00(1.12) 5 =1.76 AUD in 5 years.  Convert to 1.76/0.8=2.20 CHF.  Repay CHF loan with 1.25(1.09) 5 =1.92 CHF.  The remaining =0.28 is an arbitrage profit.

Proof By Arbitrage n Suppose the forward rate is 1.00 AUD/CHF:  Borrow 1.00 AUD and convert to 1.25 CHF.  Invest for 5 years at 9% yielding 1.25(1.09) 5 =1.92 CHF in 5 years.  Convert to 1.92(1.00)=1.92 AUD.  Repay AUD loan with 1.00(1.12) 5 =1.76 AUD.  The remaining =0.16 is an arbitrage profit.

Real Options n Standard discounted cash flow or net present value analysis ignores real or strategic options available to the firm. n Discounting the expected cash flow ignores the flexibility that management may have to abandon the project if the cash flows appear likely to be negative. n The most common real option is the option to abandon the project as uncertainty is revealed.

The Abandonment Option -50 Good Bad Cash Flows

The Abandonment Option n Expected NPV:

The Abandonment Option n Abandonment Option:

Types of Real Options n Input Mix/Process Flexibility n Output Mix/Product Flexibility n Abandonment/Termination n Temporary Stop/Shutdown n Intensity/Operating Scale n Initiation/Deferment n Sequencing

Natural Resource Investments n Your company has a two year lease to extract copper from a deposit. The deposit contains 8 million pounds of copper. A 1-year development phase costs $1.25 immediately. Extraction costs of 85 cents per pound would be paid to a contractor in advance. The rights to the copper would be sold at the spot price of copper one year from now. Percentage price changes for copper are N(0.07, 0.20). The current spot price is 95 cents. The discount rate for this kind of project (from the CAPM) is 10% and the riskless rate is 5%.

Standard Expected NPV Analysis

Option Analysis Max[S ,0] 0.85S1S1 Payoff

Option Analysis

Terminal Distribution Distribution of Copper Price at Time Copper Price Probability Density

Shutdown and Restart Options { } C O Gold Price P 2 P 1 Present Value of Open Mine Present Value of Closed Mine Present Value