1. 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

2. Exchange Rates 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. Exchange Rates Example SF Swiss franc spot price is SF 1.4457 per $1 SF Swiss franc 6 mt forward price is SF1.4282 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

4. Exchange Rates Example What is the franc premium (annualized)?

5. 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%

6. 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)?

7. 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%

8. Exchange Rates 1) Interest Rate Parity Theory 1 + r f = F f/$ 1 + r $ S f/$ The difference between the risk free interest rates in two different countries is equal to the difference between the forward and spot rates

9. Exchange Rates 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

10. Exchange Rates 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

11. Exchange Rates 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 German 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

12. Exchange Rates 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 German 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

13. Exchange Rates 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 German 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!

14. Exchange Rates 2) Expectations Theory of Forward Rates F f/$ = E (S f/$ ) S f/$ S f/$ The difference between the forward & spot rates equals the expected change in the spot rate.

15. Exchange Rates 3) Law of One Price (Purchasing Power Parity) E (S f/$ ) = E ( 1 + i f ) S f/$ E ( 1 + i $ ) The expected change in the spot rate equals the expected difference in inflation between the two countries.

16. Exchange Rates 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?

17. Exchange Rates 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 $ )

18. Exchange Rates 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 $ ) 1.4194 = E( 1 + i) 1.4457 1 +.045

19. Exchange Rates 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

20. Exchange Rates 4) Capital market Equilibrium E ( 1 + i f ) = 1 + r f E ( 1 + i $ ) 1 + r $ The expected difference in inflation rates equals the difference in current interest rates. Also called common real interest rates

21. Exchange Rates Example In the previous examples, show the equilibrium of interest rates and inflation rates 1 + r f = 1.08 =.9818 1 + r $ 1.10

22. Exchange Rates 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

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

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

25. Exchange Rates Example Honda builds a new car in Japan for a cost + profit of 1,715,000 yen. At an exchange rate of 101.18:$1 the car sells for $16,950 in Baltimore. If the dollar rises in value, against the yen, to an exchange rate of 105:$1, what will be the price of the car?

26. Exchange Rates Example Honda builds a new car in Japan for a cost + profit of 1,715,000 yen. At an exchange rate of 101.18:$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 = $16,333 105

27. Exchange Rates Example Honda builds a new car in Japan for a cost + profit of 1,715,000 yen. At an exchange rate of 101.18:$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 = $16,333 105 Conversely, if the yen is trading at a forward discount, Japan will experience a decrease in purchasing power.

28. Exchange Rates Example Harley Davidson builds a motorcycle for a cost plus profit for $12,000. At an exchange rate of 101.18:$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?

29. Exchange Rates Example Harley Davidson builds a motorcycle for a cost plus profit for $12,000. At an exchange rate of 101.18:$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)

30. Currency 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

31. 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 1.4397sf:$1 and the 6 mt forward rate is 1.4350sf:$1. How can you eliminate the currency risk? How does this help in evaluating the project?

32. 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 1.4397sf:$1 and the 6 mt forward rate is 1.4350sf:$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 / 1.4350 = $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.

33. Capital Budgeting Techniques 1) Exchange to $ and analyze 2) Discount and then exchange 3) Choose a currency standard ($) and hedge all non dollar CF

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

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: What are the 1, 2, 3, 4, 5 year forward rates?

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

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

38. 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

39. 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

40. 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

41. 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%?

42. 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

43. 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.

44. 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

45. Misc Items Tax Comparisons between countries Political Risk

46. Misc Items Tax Comparisons between countries Political Risk

47. Corporate Financial Theory - Go over Final - Answer questions for final - in normal class room

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

49. 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?

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

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