1. Copyright ©2000 Ian H. Giddy International Financial Management 1

2. Copyright ©2000 Ian H. Giddy International Financial Management 2 Ian Giddy

3. INTERNATIONAL FINANCIAL MANAGEMENT

4. n www.stern.nyu.edu

5. n www.stern.nyu.edu/~igiddy/ifmx.htm

6. www.giddy.org

7. International Financial Management Prof. Ian Giddy Stern School of Business, New York University

8. Copyright ©2000 Ian H. Giddy International Financial Management 8 International Financial Management l Management of international assets l Management of international liabilities l Management of cross-border financial risks l Cross-border funds transfers These depend on the environmental features of international finance-- notably, the global financial markets

9. Copyright ©2000 Ian H. Giddy International Financial Management 9 Corporate Finance CORPORATE FINANCE DECISONS CORPORATE FINANCE DECISONS INVESTMENT RISK MGT FINANCING CAPITAL PORTFOLIO M&A DEBTEQUITY TOOLS MEASUREMENT

10. Copyright ©2000 Ian H. Giddy International Financial Management 10 What is Special about Corporate Finance in the International Environment? l Financial markets are partially linked, partially separated by national jurisdications l Exchange rate fluctuations affect revenues, costs and valuation of firms l The competitive international financial markets offer special tools, opportunities and risks

11. Copyright ©2000 Ian H. Giddy International Financial Management 11 What are the Global Financial Markets? l The Foreign Exchange Market l The Derivatives l Domestic and International Money Markets l Domestic and International Capital Markets l Beyond the Money and Bond Markets: International Equity and Commodity Markets l Using the Global Capital Markets: Investors’ and Issuers’ Perspectives

12. Copyright ©2000 Ian H. Giddy International Financial Management 12 Global Financial Markets: A Framework l Jurisdiction 1. Domestic 2. Foreign 3. External l Claims 1. Direct 2. Intermediated 3. Enhanced

13. Copyright ©2000 Ian H. Giddy International Financial Management 13 Policies and Exchange Rate Regimes l Exchange rate systems--fixed vs floating l Managed floating l EMS-type currency blocs l De facto blocs--the dollar

14. Copyright ©2000 Ian H. Giddy International Financial Management 14 The Eurocurrency Market “A Eurodollar is a dollar deposited in a bank within a jurisdication outside the United States” l Separation of currency, institution and jurisdiction l Why do people want Eurocurrency deposits and loans? l Why is LIBOR the world’s key benchmark rate?

15. Copyright ©2000 Ian H. Giddy International Financial Management 15 The Eurocurrency Market “A Eurodollar is a dollar deposited in a bank within a jurisdication outside the United States” l Separation of currency, institution and jurisdiction l Why do people want Eurocurrency deposits and loans? l Why is LIBOR the world’s key benchmark rate?

16. Copyright ©2000 Ian H. Giddy International Financial Management 16 US Domestic German Market EUR0CURRENCY MARKET Domestic Market Euro-Deutsche Mark Eurodollar Market Market Japanese Euro-Yen Domestic Market Market Where the Eurocurrency Market Fits In

17. Copyright ©2000 Ian H. Giddy International Financial Management 17 Where the Eurocurrency Market Fits In US Domestic German Market EUR0CURRENCY MARKET Domestic Market Euro-Deutsche Mark Eurodollar Market Market Foreign Exchange Market Japanese Euro-Yen Domestic Market Market Euro-CommercialEuro-Floating Rate Straight Paper Market Note Market Eurobond Market

18. Copyright ©2000 Ian H. Giddy International Financial Management 18 Interest Rate Linkages in the International Money Market Two stories to tell: l Domestic vs. Euro l Eurocurrency A vs. Eurocurrency B Domestic Market A The Euromarkets Domestic Market B Trea- Bank Euro Euro Bank Trea- sury Deposit Deposit Deposit Deposit sury Bill Market Market Bill Trea- Corp- Euro Euro Corp- Trea- sury orate Bond Bond orate sury Bond Bond Market Market Bond Bond

19. Copyright ©2000 Ian H. Giddy International Financial Management 19 Domestic versus Euro The Eurodollar Premium Market price of risk versus Cost of regulation l Eurodollar vs. U.S. Interest Rate Effective cost of domestic deposit = (interest rate + FDIC fees) (1 - reserve requirement) l Capital controls and divided credit markets

20. Copyright ©2000 Ian H. Giddy International Financial Management 20 Foreign Exchange l Mechanics and calculations l How banks make money l How banks hedge l Tasks of the corporate FX manager

21. Copyright ©2000 Ian H. Giddy International Financial Management 21 Foreign Exchange Mechanics and Calculations l “Money never leaves homes” l Funds transfer, chips, and timing l Relative interest rates 1. Forward premium or discount 2. Points 3. Spot and forward l Spot and forward 1. Points 2. Forward premium or discount 3. Relative interest rates

22. Copyright ©2000 Ian H. Giddy International Financial Management 22 Foreign Exchange Quotations Bid Offer Spot Forward points Rule: add if bid<offer, subtract if bid>offer Outright forward

23. Copyright ©2000 Ian H. Giddy International Financial Management 23 How Banks Make Money l Speculative positioning in the interbank market l Arbitrage 1. Triangular 2. CIA l Bid-offer spread l “Customer trading ”

24. Copyright ©2000 Ian H. Giddy International Financial Management 24 Triangular Arbitrage US dollars Dutch Australian guilders dollars

25. Copyright ©2000 Ian H. Giddy International Financial Management 25 Covered Interest Arbitrage

26. Copyright ©2000 Ian H. Giddy International Financial Management 26 Foreign exchange and Eurocurrency dealing are interrelated activities and so are done on the same trading floor. The Dealing Room CUS- FOR- Foreign TOMER SPOT WARD Exchange Dealing Money FUNDING EUROCURRENCY Market Dealing Diagram of a Dealing Room The Dealing Room

27. Copyright ©2000 Ian H. Giddy International Financial Management 27 Foreign exchange and Eurocurrency dealing are interrelated activities and so are done on the same trading floor. The Dealing Room CUS- FOR- Foreign TOMER SPOT WARD Exchange Dealing Money FUNDING EUROCURRENCY Market Dealing Diagram of a Dealing Room

28. Copyright ©2000 Ian H. Giddy International Financial Management 28 How Banks Hedge SHORT LONG Today T+2 T+90 Methods: - Spot + swap - Spot + rollover swap - Money market - Outright forward

29. Copyright ©2000 Ian H. Giddy International Financial Management 29 Linkages Between Eurocurrency Rates Interest rate differential Interest rate differential Forward premium Forward premium Expected % change in exchange rate Expected % change in exchange rate

30. Copyright ©2000 Ian H. Giddy International Financial Management 30 Linkages Between Eurocurrency Rates Interest rate differential Interest rate differential Forward premium Forward premium Expected % change in exchange rate Expected % change in exchange rate Covered interest rate parity

31. Copyright ©2000 Ian H. Giddy International Financial Management 31 Linkages Between Eurocurrency Rates Interest rate differential Interest rate differential Forward premium Forward premium Expected % change in exchange rate Expected % change in exchange rate Covered interest rate parity Uncovered interest rate parity

32. Copyright ©2000 Ian H. Giddy International Financial Management 32 Linkages Between Eurocurrency Rates Interest rate differential Interest rate differential Forward premium Forward premium Expected % change in exchange rate Expected % change in exchange rate Covered interest rate parity Unbiased forward rate Uncovered interest rate parity

33. Copyright ©2000 Ian H. Giddy International Financial Management 33 Interest-Rate Parity $1 (1 + / E$ ) = ($1/ S t )(1 + / EBP ) F n t where S t is the spot exchange rate (dollars per British Pound) and F n t is the forward rate. to a close approximation, (/ E$ - / EBP ) = [(Ft n - S t )/S t ] (365/n) 100 Interest-rate differential = forward premium or discount

34. Copyright ©2000 Ian H. Giddy International Financial Management 34 Example: Anglo’s Funding l Anglo-American, the natural resources conglomerate, is seeking 3-month US$ funding.  Anglo can fund in the US CP market at 5.5%  Or in the Eurosterling market at 6.7%  The BP is: spot $1.5484, 3-mo forward $1.5454  Which is cheaper?

35. Copyright ©2000 Ian H. Giddy International Financial Management 35 Anglo’s Answer It’s cheaper for Anglo-American to borrow in the US CP market. Reason:  US: simply borrow for 3 months q Cost: $1(1+5.5%/4) = 1.01375  UK: borrow British pounds, change into dollars at spot rate, cover by buying sterling at 3-mo forward rate to repay the pounds q Cost: ($1/1.5484)(1+6.7%/4)1.5454 = 1.01478

36. Copyright ©2000 Ian H. Giddy International Financial Management 36 TIME EXCHANGE RATE Spot Forward Actual Today In three months Unbiased Forward Rate Theory

37. Copyright ©2000 Ian H. Giddy International Financial Management 37 TIME EXCHANGE RATE Spot Forward Actual Probability distribution of actual exchange rate Today In three months Unbiased Forward Rate Theory

38. Copyright ©2000 Ian H. Giddy International Financial Management 38 Unbiased Forward Rate Forward premium or discount = Expected annual rate of change of the exchange rate That is, P $/DM =E(R $/DM )

39. Copyright ©2000 Ian H. Giddy International Financial Management 39 International Fisher Effect INTEREST RATE DIFFERENTIAL

40. Copyright ©2000 Ian H. Giddy International Financial Management 40 International Fisher Effect / E$ = / EDM + E(R $/DM ) That is, Interest-rate differential equals Expected annual rate of change of exchange rate

41. Copyright ©2000 Ian H. Giddy International Financial Management 41 Cost of Hedging

42. Copyright ©2000 Ian H. Giddy International Financial Management 42 Corporate Hedging Decisions: Frutas Amazonas Exporting bananas to Spain, get paid in Spanish pesetas. Funding is in U.S. dollars.

43. Copyright ©2000 Ian H. Giddy International Financial Management 43 Corporate Hedging Decisions: Frutas Amazonas l Continue funding in U.S. dollars. The peseta might get stronger in the next three months, from $1=128 pesetas to $1=126 pesetas. This could be the cheapest l Switch funding to pesetas, despite the slightly higher cost l Borrow in dollars, but hedge the exchange risk in the forward market.

44. Copyright ©2000 Ian H. Giddy International Financial Management 44 Frutas Amazonas

45. Copyright ©2000 Ian H. Giddy International Financial Management 45 Frutas Amazonas

46. Copyright ©2000 Ian H. Giddy International Financial Management 46 Law of One Price p=Sp* The Price of Tin In New YorkOn the KualaOn the Lumpur London Metal MarketMetal Exchange 273c per lb.15.37 ringgitUS$5830 per = US$6.02per kilogramtonne per kilogram a =US5.70= US5.83 per kilogram b per kilogram c a 1 avoirdupois pound = 0.45359 kilograms b US$1 = 2.6965 Malaysian ringgit on the date of calculation c 1 tonne = 1000 kilogram. All data taken from the Commodities section of the London Financial Times.

47. Copyright ©2000 Ian H. Giddy International Financial Management 47 S t=1 -S t = I - I * S t 1+ I * n JAPAN 1995 n MEXICO 1994 EXCHANGE- RATE CHANGE RELATIVE INFLATION Purchasing Power Parity: Theory and Evidence

48. Copyright ©2000 Ian H. Giddy International Financial Management 48 Deviations from Purchasing Power Parity Source: JP Morgan. Index of real effective exchange rate versus 18 industrial country currencies, adjusted for change in relative wholesale price of domestic manufactures. A fall in the index indicates improved international competitiveness.

49. Copyright ©2000 Ian H. Giddy International Financial Management 49 Deviations from Purchasing Power Parity Source: JP Morgan. Index of real effective exchange rate versus 18 industrial country currencies, adjusted for change in relative wholesale price of domestic manufactures. A fall in the index indicates improved international competitiveness.

50. Copyright ©2000 Ian H. Giddy International Financial Management 50 US Expected Inflation Rate 2% Inflation & Interest Rates Canadian Expected Inflation Rate 7% US Interest Rate 5% Canadian Interest Rate 10%

51. Copyright ©2000 Ian H. Giddy International Financial Management 51 US Expected Inflation Rate 2% Inflation & Interest Rates Canadian Expected Inflation Rate 7% US Interest Rate 5% Canadian Interest Rate 10% Expected Rate of Change of the Exchange Rate Expected Rate of Change of the Exchange Rate

52. Copyright ©2000 Ian H. Giddy International Financial Management 52 Inflation & Interest Rates Borrow at US Interest Rate 5% Invest at Canadian Interest Rate 10%

53. Copyright ©2000 Ian H. Giddy International Financial Management 53 Inflation & Interest Rates Borrow at US Interest Rate 5% Invest at Canadian Interest Rate 10% Buy Canadian Dollars Forward (at discount of 5%) Buy Canadian Dollars Forward (at discount of 5%)

54. Copyright ©2000 Ian H. Giddy International Financial Management 54 Inflation & Interest Rates Borrow at US Interest Rate 5% Invest at Canadian Interest Rate 10% Buy Canadian Dollars Forward (at discount of 5%) Buy Canadian Dollars Forward (at discount of 5%) Buy Canadian Dollar Futures (at discount of 5%) Buy Canadian Dollar Futures (at discount of 5%)

55. Copyright ©2000 Ian H. Giddy International Financial Management 55 The Linkages Again Relative excess money supply Relative inflation rates Forward exchange premium or discount Exchange rate change Relative interest rates 6 5 4 1 3 2

56. Copyright ©2000 Ian H. Giddy International Financial Management 56 A Framework Country ACountry BDOMESTICECONOMICPOLICIESINFLATION RATE RATE EXCHANGE RATEINTEREST RATE RATE FORWARD RATE

57. Copyright ©2000 Ian H. Giddy International Financial Management 57 Conclusion: Corporate Exchange Rate Risk l Exchange Rate Risk is the risk arising from fluctuating exchange rates between two currencies

58. Copyright ©2000 Ian H. Giddy International Financial Management 58 Conclusion: Corporate Exchange Rate Risk l Exchange Rate Risk is the risk arising from fluctuating exchange rates between two currencies; but it’s tied to prices and to business risk. Relative monetary and fiscal policies Relative monetary and fiscal policies Relative inflation Relative inflation Exchange rate change Exchange rate change

59. Copyright ©2000 Ian H. Giddy International Financial Management 59 Turkey, 1995 Turkish Lira: Down 33.5%

60. Copyright ©2000 Ian H. Giddy International Financial Management 60 Turkey, 1995 Turkish Lira: Down 33.5% Turkish prices: up 83.8%!

61. Copyright ©2000 Ian H. Giddy International Financial Management 61 Waiting for Godot: Choices for Waterford Foods “Clearly it’s of great importance to us to determine whether or not the punt will devalue within the next three months. “We should systematically assemble the evidence and views on spot and forward exchange rates, on interest rates, inflation and other economic variables and decide what will happen. “In particular, what’s the probability of a devaluation in the next three months, and how much? “Then we must decide whether it’s worth covering our DM exposure, given the forward premium and relative interest rates.”

62. Copyright ©2000 Ian H. Giddy International Financial Management 62

63. Copyright ©2000 Ian H. Giddy International Financial Management 63 www.giddy.org

64. Copyright ©2000 Ian H. Giddy International Financial Management 64

65. Copyright ©2000 Ian H. Giddy International Financial Management 65 www.giddy.org Ian Giddy NYU Stern School of Business Tel 212-998-0332; Fax 212-995-4233 ian.giddy@nyu.edu http://www.giddy.org