1. Chapter 28 Principles PrinciplesofCorporateFinance Ninth Edition Managing International Risks Slides by Matthew Will Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin

2. 28- 2 Topics Covered  Foreign Exchange Markets  Some Basic Relationships  Hedging Currency Risk  Exchange Risk and International Investment Decisions  Political Risk

3. 28- 3 Exchange Rates April 16, 2007

4. 28- 4 Foreign Exchange Markets Exchange Rate - Amount of one currency needed to purchase one unit of another. Spot Rate of Exchange - Exchange rate for an immediate transaction. Forward Exchange Rate - Exchange rate for a forward transaction.

5. 28- 5 Foreign Exchange Markets Forward Premiums and Forward Discounts Example - The Peso spot price is 10.9892 peso per dollar and the 3 month forward rate is 11.0408 Peso per dollar, what is the premium and discount relationship?

6. 28- 6 Foreign Exchange Markets Forward Premiums and Forward Discounts Example - The Peso spot price is 10.9892 peso per dollar and the 3 month forward rate is 11.0408 Peso per dollar, what is the premium and discount relationship?

7. 28- 7 Foreign Exchange Markets Forward Premiums and Forward Discounts Example - The Peso spot price is 10.9892 peso per dollar and the 3 month forward rate is 11.0408 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.

8. 28- 8 Exchange Rates Example SF Swiss franc spot price is SF 1.4457 per $1 SF Swiss franc 6 mt forward price is SF 1.4282 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 101.18 per $1 The Japanese 6mt fwd price is 103.52 per $1

9. 28- 9 Exchange Rates Example What is the franc premium (annualized)? franc Premium = 2 x ( 1.4457 - 1.4282) = 2.45% 1.4282 Dollar Discount = 2.45% Example What is the Yen discount (annualized)? Yen Discount = 2 x ( 103.52 - 101.18) = 4.26% 103.52 Dollar Premium = 4.26%

10. 28- 10 Exchange Rate Relationships  Basic Relationships equals

11. 28- 11 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.

12. 28- 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 peso) @ 7.35 % or a 1 year US bond (in dollars) @ 5.05%. The spot rate is 10.9892 peso:$1 The 1 year forward rate is 11.2274 peso:$1 Which bond will you prefer and why? Ignore transaction costs

13. 28- 13 Value of US bond = $1,000,000 x 1.0122 = $1,050,500 Value of Mexican bond = $1,000,000 x 10.9892 = 10,989,200 peso exchange 10,989,200 peso x 1.0735 = 11,796,906 peso bond pmt 11,796,906 peso / 11.2274= $1,050,725 exchange 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 peso) @ 7.35 % or a 1 year US bond (in dollars) @ 5.05%. The spot rate is 10.9892 peso:$1 The 1 year forward rate is 11.2274 peso:$1 Which bond will you prefer and why? Ignore transaction costs

14. 28- 14 Exchange Rate Relationships 2) Expectations Theory of Exchange Rates Theory that the expected spot exchange rate equals the forward rate.

15. 28- 15 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. 28- 16 Exchange Rate Relationships Example - If inflation in the US is forecasted at 2.5% this year and Mexico is forecasted at 4.5%, what do we know about the expected spot rate? Given a spot rate of 10.9892 peso:$1 solve for Es Es = 11.204

17. 28- 17 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

18. 28- 18 Exchange Rate Relationships Example - The real interest rate in each country is about the same

19. 28- 19 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 francs) @ 8.0% or a 1 year US loan (in dollars) @ 10%. The spot rate is 1.4457sf:$1 The 1 year forward rate is 1.4194sf:$1 Which loan will you prefer and why? Ignore transaction costs Cost of US loan = $100,000 x 1.10 = $110,000 Cost of Swiss Loan = $100,000 x 1.4457 = 144,570 sf exchange 144,570 sf x 1.08 = 156,135 sf loan pmt 156,135 sf / 1.4194 = $110,000exchange If the two loans created a different result, arbitrage exists!

20. 28- 20 Exchange Rates Swiss Example Given a spot rate of sf:$ 1.4457:$1 Given a 1yr fwd rate of 1.4194:$1  If inflation in the US is forecasted at 4.5% this year, what do we know about the forecasted inflation rate in Switzerland? E (S f/$ ) = E ( 1 + i f ) S f/$ E ( 1 + i $ ) solve for i 1.4194 = E( 1 + i) i =.026 or 2.6% 1.4457 1 +.045

21. 28- 21 Exchange Rates Swiss Example  In the previous examples, show the equilibrium of interest rates and inflation rates 1 + r f = 1.08 =.9818 1 + r $ 1.10 E ( 1 + i f ) = 1.026 =.9818 E ( 1 + i $ ) 1.045

22. 28- 22 Forward Rate vs. Actual Spot Rate Percent error in the one month forward rate for Swiss Franc per US $ compared to actual spot rate

23. 28- 23 International Prices The Big Mac Index – The price of a Big Mac in different countries (Feb 1, 2007)

24. 28- 24 Purchasing Power & Exchange Rates

25. 28- 25 Exchange Rates Nominal versus Real Exchange Rates U.S. Dollar / UK (in log scale)

26. 28- 26 Exchange Rates Nominal versus Real Exchange Rates U.S. Dollar / France (in log scale)

27. 28- 27 Exchange Rates Nominal versus Real Exchange Rates U.S. Dollar / Italy (in log scale)

28. 28- 28 Interest Rates and Inflation Countries with the highest interest rates generally have the highest inflation rates. In this diagram each of the 55 points represents a different country.

29. 28- 29 Auto Industry Data 2003

30. 28- 30 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 120.700Y:$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.

31. 28- 31 Exchange Rate Risk Example - Harley Davidson builds a motorcycle for a cost plus profit of $12,000. At an exchange rate of 120.700Y:$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 134 = 1,608,000 yen

32. 28- 32 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

33. 28- 33 Capital Budgeting 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. Techniques

34. 28- 34 Example 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:$1. year 12345 400450510575650 Q: What are the 1, 2, 3, 4, 5 year forward rates? A: E (S f/$ ) = E ( 1 + i f ) t solve for E(S) S f/$ E ( 1 + i $ ) t E(S) 2.022.042.062.082.10

35. 28- 35 Example 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 12345 400450510575650 Q: Convert the CF to $ using the forward rates. 12345 CFg 400450510575650 E(S)2.022.042.062.082.10 CF$198221248276310

36. 28- 36 Example 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 12345 400450510575650 What is the PV of the project in dollars at a risk premium of 7.4%? $ discount rate = 1.08 x 1.074 = 1.16 PV = $794,000

37. 28- 37 Example 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 12345 400450510575650 What is the PV of the project in guilders at a risk premium of 7.4%? Convert to dollars. $ discount rate = 1.09 x 1.074 = 1.171 PV = 1,588,000 guilders exchanged at 2.0:$1 = $794,000

38. 28- 38 Political Risk

39. 28- 39 Web Resources www.oecd.org www.bankofengland.co.uk www.ecb.int www.oanda.com www.x-rates.com www.emgmkts.com www.securities.com www.prsgroup.com Click to access web sites Internet connection required