1. Corporate Financial Theory
Lecture 12

2. International Finance
Today
Capital Budgeting (international style)
Financing (international style)
Topics
Exchange rates
Currency risk
Managing Currency Risk
Capital Budgeting w/ currency risk
Financing w/currency risk

3. Foreign Exchange Markets
Exchange Rate - Amount of one currency needed to purchase one unit of another. Spot Rate The price of a currency for immediate delivery (i.e. today’s exchange rate) Forward Rate The price of a currency on a specified future date (i.e. a forward contract in which the exercise price is the exchange rate) Futures - Same as forward (w/secondary markets) Options - on exchange rates & Future Ks 3

4. Exchange Rates
December 2017

5. Foreign Exchange Markets
Forward Premiums and Forward Discounts
Example - The Peso spot price is peso per dollar and the 3 month forward rate is Peso per dollar, what is the premium and discount relationship? 5

6. Foreign Exchange Markets
Forward Premiums and Forward Discounts
Example - The Peso spot price is peso per dollar and the 3 month forward rate is Peso per dollar, what is the premium and discount relationship?
Answer - The dollar is selling at a 1.90% premium, relative to the peso. The peso is selling at a 1.90% discount, relative to the dollar. 6

7. Exchange Rates Example Swiss franc spot price is SF 1.4457 per $1
Swiss franc 6 mt forward price is SF per $1
The franc is selling at a Forward Premium
The Dollar is selling at a Forward Discount
This means that the market expects the dollar to get weaker, relative to the franc
Example (premium? discount?)
The Japanese Yen spot price is per $1
The Japanese 6mt fwd price is per $1

8. Exchange Rates
Example What is the franc premium (annualized)? What is the Yen discount (annualized)?

9. Exchange Rate Relationships
Basic Relationships
equals
equals
equals
equals 7

10. Exchange Rate Relationships
1) Interest Rate Parity Theory
The ratio between the risk free interest rates in two different countries is equal to the ratio between the forward and spot exchange rates. 8

11. Exchange Rate Relationships
Example - You have the opportunity to invest $1,000,000 for one year. All other things being equal, you have the opportunity to obtain a 1 year Mexican bond (in 7.35 % or a 1 year US bond (in 5.05%. The spot rate is peso:$1 The 1 year forward rate is peso:$1
Which bond will you prefer and why?
Ignore transaction costs 9

12. Exchange Rate Relationships
Example - You have the opportunity to invest $1,000,000 for one year. All other things being equal, you have the opportunity to obtain a 1 year Mexican bond (in 7.35 % or a 1 year US bond (in 5.05%. The spot rate is peso:$1 The 1 year forward rate is peso:$1
Which bond will you prefer and why? Ignore transaction costs
Value of US bond = $1,000,000 x = $1,050,500
Value of Mexican bond = $1,000,000 x = 10,989,200 peso exchange
10,989,200 peso x = 11,796,906 peso bond pmt
11,796,906 peso / = $1,050, exchange 14

13. Exchange Rate Relationships
2) Expectations Theory of Exchange Rates
Theory that the expected spot exchange rate equals the forward rate. 15

14. Exchange Rate Relationships
3) Purchasing Power Parity
The expected change in the spot rate equals the expected difference in inflation between the two countries. 16

15. Exchange Rate Relationships
Example - If inflation in the US is forecasted at 2.5% this year and Mexico is forecasted at 4.7%, what do we know about the expected spot rate?
Given a spot rate of peso:$1
solve for Es
Es = 20

16. Exchange Rate Relationships
4) International Fisher effect
The expected difference in inflation rates equals the difference in current interest rates.
Also called common real interest rates 21

17. Exchange Rate Relationships
Example - The real interest rate in each country is about the same 23

18. Exchange Rates Another Example
You are doing a project in Switzerland which has an initial cost of $100,000. All other things being equal, you have the opportunity to obtain a 1 year Swiss loan (in 8.0% or a 1 year US loan (in 10%. The spot rate is sf:$1 The 1 year forward rate is sf:$1
Which loan will you prefer and why? Ignore transaction costs
Cost of US loan = $100,000 x = $110,000
Cost of Swiss Loan = $100,000 x = 144,570 sf exchange
144,570 sf x 1.08 = 156,135 sf loan pmt
156,135 sf / = $110,000 exchange
If the two loans created a different result, arbitrage exists!

19. Exchange Rates
Swiss Example Given a spot rate of sf:$ :$1 Given a 1yr fwd rate of :$1 If inflation in the US is forecasted at 4.5% this year, what do we know about the forecasted inflation rate in Switzerland?
𝐸 𝑆 𝑓 $ 𝑆 𝑓 $ = 𝐸(1+ 𝑖 𝑓 ) 𝐸(1+ 𝑖 $ )
Solve for 𝑖 𝑓
𝑖 𝑓 =.026 or 2.6%
= (1+ 𝑖 𝑓 )

20. Exchange Rates Swiss Example
In the previous examples, show the equilibrium of interest rates and inflation rates
1+ 𝑟 𝑓 1+ 𝑟 $ = =.9818
𝐸(1+ 𝑖 𝑓 ) 𝐸(1+ 𝑖 $ ) = =.9818

21. Currency Risk
Example
Your US company is building a plant in Switzerland. Your cost will be 2,000,000 sf, with full payment due in 6 months. You are concerned about currency risk. The spot rate is sf:$1 and the 6 mt forward rate is sf:$1. How can you eliminate the currency risk? How does this help in evaluating the project?

22. Currency Risk
Example
Your US company is building a plant in Switzerland. Your cost will be 2,000,000 sf, with full payment due in 6 months. You are concerned about currency risk. The spot rate is sf:$1 and the 6 mt forward rate is sf:$1. How can you eliminate the currency risk? How does this help in evaluating the project?
Since you are short in Swiss Francs, you should long sf contracts
2,000,000sf / = $1,393,728 worth of 6mt sf Ks.
This will lock in your Co cash flow at $1,393,728
The forward premium paid is 0.33% (using capital market equilibrium, this premium probably equals the inflation rate.

23. Exchange Rates Applications
Q: What does it mean to a business if the dollar is trading at a forward premium?
A: Stronger purchasing power

24. 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 29

25. Capital Budgeting Techniques 1) Exchange to $ and analyze
2) Discount using foreign cash flows and interest rates, then exchange to $.
Option 1 preferred because discount rates in US are more reliable. 30

26. Example Q: What are the 1, 2, 3, 4, 5 year forward rates? A:
Outland Corporation is building a plant in Holland to produce reindeer repellant to sell in that country. The plant is expected to produce a cash flow (in guilders ,000s) as follows. The US risk free rate is 8%, the Dutch rate is 9%. US inflation is forecasted at 5% per year and the current spot rate is 2.0g:$1.
year
Q: What are the 1, 2, 3, 4, 5 year forward rates? A:
𝐸 𝑆 𝑓 $
𝐸 𝑆 𝑓 $ 𝑆 𝑓 $ = 𝐸(1+ 𝑟 𝑓 ) 𝑡 𝐸(1+ 𝑟 $ ) 𝑡
𝐸 𝑆 𝑓 $ = (1+.09) 𝑡 (1+.08) 𝑡

27. Example Q: Convert the CF to $ using the forward rates. 1 2 3 4 5
Outland Corporation is building a plant in Holland to produce reindeer repellant to sell in that country. The plant is expected to produce a cash flow (in guilders ,000s) as follows. The US risk free rate is 8%, the Dutch rate is 9%. US inflation is forecasted at 5% per year and the current spot rate is 2.0g:$1.
year
Q: Convert the CF to $ using the forward rates.
CFg
E(S)
CF$

28. Political Risk

29. Political Risk

30. Trade Policy

31. 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 Y:$1 the car sells for $14,209 in Indianapolis. If the dollar rises in value, against the yen, to an exchange rate of 134Y:$1, what will be the price of the car?
1,715,000 = $12,799
134
Conversely, if the yen is trading at a forward discount, Japan will experience a decrease in purchasing power. 26

32. Exchange Rate Risk
Example - Harley Davidson builds a motorcycle for a cost plus profit of $12,000. At an exchange rate of Y:$1, the motorcycle sells for 1,448,400 yen in Japan. If the dollar rises in value and the exchange rate is 134Y:$1, what will the motorcycle cost in Japan?
$12,000 x = 1,608,000 yen 27

33. Trade Policy

34. Employment Conventional wisdom
We are losing all of our jobs to Mexico, China, and India?
FALSE

35. Employment Trend Population 2007 = 301 mil 1970 = 203 mil
Source: Bureau of Labor Statistics

36. Employment & Foreign Trade
Population
Employed
2007 = 301 mil
1970 = 203 mil
2007 = mil
1970 = 78.6 mil
86 %
Source: Bureau of Labor Statistics

37. UIndy Nightly News
News Alert on the unemployment report released today by the Department of Labor.

38. PR - News Releases
“Last month the unemployment rate in the United States increased slightly from 4.6% to 4.7%. White House officials were quick to point out that at the same time the U.S. economy added 141,000 new jobs.”
“Last month 322,000 manufacturing jobs were lost. Union leaders site cheap overseas labor costs as the culprit, saying that good jobs are leaving the US and the economy will suffer.”

39. Behind The Numbers September 2007 Unemployment = 4.7%
Jobs added 463,000
Jobs lost 322,000
Net change ,000
Source: Bureau of Labor Statistics

40. Behind The Numbers Totals for 2006 Unemployment = 4.6%
Jobs added 2,697,000
Jobs lost ,000
Net change ,072,000
Source: Bureau of Labor Statistics

41. Comparative Advantage
Human Nature 101
Wants
Needs

42. Comparative Advantage
Human Nature 101
Wants
Needs

43. Comparative Advantage
Human Nature 101
Wants
Needs

44. Employment But are they better paying jobs?
Source: Bureau of Labor Statistics

45. Employment
Source: Bureau of Labor Statistics

46. Foreign Trade Conventional wisdom
We have huge trade deficits with other countries. These large trade deficits are destroying our economy.
FALSE

47. Foreign Trade
Source: US Census Bureau

48. Trade Deficit and Economic Strength
Source: S&P & Nikkei

49. Foreign Trade Why does this work? KEY Strong Dollar
Stuff
USA
China
Cash
Dollars
Wall Street &
(Indiana)
KEY
Strong Dollar
Wall Street invests this money, which…
creates more jobs, which…
grows the economy, which…
strengthens the dollars, which…
starts the cycle again

50. What We Know Net Present Value Capital Asset Pricing Model (CAPM)
Efficient Capital markets
Value Additivity & Conservation
Option Theory
Agency Theory

51. What We Do Not Know How major decisions are made
What determines the risk & PV ?
CAPM shortfalls
Why are some markets inefficient?
Is management a liability?

52. What We Do Not Know Why do IPOs succeed & new markets emerge?
Why is capital structure not optimized?
Dividend policy - Answer?
Liquidity value?
Why do mergers come in waves?

53. Review for Final
In normal class room Topics Format Difficulty Bonus Points