Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Foreign Exchange Markets Exchange Rate - Amount of one currency needed to purchase one unit of another. Direct Quote - Cost in $ of 1 unit of currency Indirect Quote - Units of currency = $1 Spot Rate of Exchange - Exchange rate for an immediate transaction. Forward Exchange Rate - Exchange rate for a transaction that will occur at a future date.

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Exchange Rate Risk Example - Honda builds a new car in Japan for a cost + profit of 1,715,000 yen. At an exchange rate of :$1 the car sells for $16,950 in Indianapolis. If the dollar rises in value, against the yen, to an exchange rate of 105:$1, what will be the price of the car? 1,715,000 = $16, Which currency gets stronger here? As $1 buys more Yen, the Dollar gets stronger compared to the Yen. The effect is that Japanese cars become cheaper in the U.S. due to the increased purchasing power of the Dollar.

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Exchange Rate Risk Example - Harley Davidson builds a motorcycle for a cost plus profit of $12,000. At an exchange rate of :$1, the motorcycle sells for 1,214,160 yen in Japan. If the dollar rises in value and the exchange rate is 105:$1, what will the motorcycle cost in Japan? $12,000 x 105 = 1,260,000 yen (3.78% rise) If the $ gets stronger, the prices of U.S. goods in Yen go up as Japan experiences a decrease in purchasing power for U.S. goods.

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Exchange Rate Risk  Currency Risk can be reduced by using various financial instruments  Currency forward contracts, futures contracts, and even options on these contracts are available to control the risk

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Holding Period Returns & Exchange Rate Risk The Holding Period Return on an international investment has two components: - Return on the investment in the asset (r A ) - Return on the investment in the exchange rate (r fx ) HPR = [(1+r A ) x (1+r fx )] - 1

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Example – HPR and Exchange Rates Example – A Japanese investor buys $10,000 in Harley Davidson stock in the U.S. when the exchange rate is 105:$1. She sells the stock one year later when the stock value is $11,000, $100 in dividends were received and the exchange rate is 90:$1. What is the Japanese investors return when the money is brought back to Japan? Solution Method 1: use HPR = (P 1 – P 0 + Div)/P 0 Solution Method 2: use HPR = [(1+r A ) x (1+r fx )] - 1

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Example (Solution Method 1) P 0 = initial cost in Yen = $10,000 x 105 = 1,050,000¥ Div = 100 x 90 = 9,000 ¥ P 1 = sale price in Yen = $11,000 x 105 = 990,000¥ HPR = (990,000 – 1,050, ) / 1,050,000 = = or 4.86%

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Example (Solution Method 2) HPR = [(1+r A ) x (1+r fx )] – 1 r A = return on the asset (without considering FX) r A = (11,000 – 10, )/ 10,000 =.11 or 11% r fx = return on investment in foreign currency [Note: assume Japanese investor bought as manydollars as possible with one Yen] r fx = (90 – 105) / 105 = or % HPR = [(1 +.11) x ( )] – 1 = or – 4.86%

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Capital Budgeting Techniques 1) Exchange to $ and analyze 2) Discount using foreign cash flows and interest rates, then exchange to $. 3) Choose a currency standard ($) and hedge all non dollar CF.

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Capital Budgeting KW Corporation manufactures flat-packed kit wardrobes. It is considering building a manufacturing facility in Narnia. The company is expected to cost/produce Narnian cash flows as shown below. The current spot rate is 2.0Leos:$1 and KW expects a 15% return on its investment. What is the NPV of the project? Cash Flow Forecasts (in millions of Leos) year

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Capital Budgeting Method 1: Work in Leos and convert at the end Method 2: Convert everything to Dollars and do a traditional NPV analysis Method 3: Combination of 1 and 2. Method 1: NPV = / / / / / NPV = 1,992,000 Leos = $995,900 (at the spot rate) Method 2: NPV = $ $1/ $1.25/ $1.50/ $1.75/ $2/ NPV = $995,900

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Exchange Rate Relationships  Basic Relationships equals