Transcript Financial Management

Chapter
22
International
Business
Finance
 2005, Pearson Prentice Hall
International Business Finance
 Exchange Rate: the price of one
currency in terms of another.
Exchange Rates
Exchange rates affect our economy and
each of us because:
1) When the dollar appreciates (strong
dollar), the dollar becomes more
valuable relative to other currencies.
Exchange Rates
Exchange rates affect our economy and
each of us because:
1) When the dollar appreciates (strong
dollar), the dollar becomes more
valuable relative to other currencies.
 Foreign products become cheaper to us.
Exchange Rates
Exchange rates affect our economy and
each of us because:
1) When the dollar appreciates (strong
dollar), the dollar becomes more
valuable relative to other currencies.
 Foreign products become cheaper to us.
 U.S. products become more expensive
overseas.
Exchange Rates
Exchange rates affect our economy
and each of us because:
Exchange Rates
Exchange rates affect our economy
and each of us because:
2) When the dollar depreciates
(weak dollar), the dollar falls in
value relative to other currencies.
Exchange Rates
Exchange rates affect our economy
and each of us because:
2) When the dollar depreciates
(weak dollar), the dollar falls in
value relative to other currencies.
 Foreign products become more
expensive for us.
Exchange Rates
Exchange rates affect our economy
and each of us because:
2) When the dollar depreciates
(weak dollar), the dollar falls in
value relative to other currencies.
 Foreign products become more
expensive for us.
 U.S. products become cheaper
overseas.
Spot Exchange Rates
£ / $ = .6162 (it takes .6162 pounds to = $1)
$ / £ = 1.6229 (it takes $1.6229 to = 1 pound)
¥ / $ = 115.97 (it takes 115.97 yen to = $1)
$ / ¥ = .00862 ( it takes $.00862 to = 1 yen)
(note: direct and indirect quotes are reciprocals)
What Determines Exchange Rates?
Floating Rate Currency System: Since
1973, the world has allowed exchange
rates to change daily in response to
market forces.
Exchange rates are affected by:
 foreign investors
 speculators
 political conditions here and overseas
 inflation
 trade policies (tariffs and quotas) and…
What Determines Exchange Rates?
Supply and Demand for currencies!
Let’s consider the £ / $ market.
What Determines Exchange Rates?
Supply and Demand for currencies!
Let’s consider the £ / $ market.
What Determines Exchange Rates?
Supply and Demand for currencies!
Let’s consider the £ / $ market.
What Determines Exchange Rates?
Suppose the British increase demand for
U.S. products.
British importers buy the U.S. products to
sell in England. They buy dollars with
pounds, so they can pay U.S. firms in
dollars.
The demand for dollars increases and forces
up the £ / $ exchange rate, which makes
U.S. products more expensive in England.
What Determines Exchange Rates?
£/$
(price of
dollars)
Supply of
Dollars
Demand for Dollars
Quantity of dollars
What Determines Exchange Rates?
£/$
(price of
dollars)
Supply of
Dollars
Demand for Dollars
Quantity of dollars
What Determines Exchange Rates?
Another example:
Let’s consider the ¥ / $ market.
What Determines Exchange Rates?
Another example:
Let’s consider the ¥ / $ market.
What Determines Exchange Rates?
Another example:
Let’s consider the ¥ / $ market.
What Determines Exchange Rates?
Suppose American demand for Japanese
cars and stereos increases rapidly.
American importers buy the Japanese
products to sell in the U.S. They buy yen
with dollars, so they can pay Japanese
firms in yen.
The supply of dollars increases, and forces
down the ¥ / $ exchange rate, which
makes Japanese products more expensive
in the U.S.
What Determines Exchange Rates?
¥/$
Supply of
Dollars
(price of
dollars)
Demand for Dollars
Quantity of dollars
What Determines Exchange Rates?
¥/$
Supply of
Dollars
(price of
dollars)
Demand for Dollars
Quantity of dollars
Foreign Exchange Markets
Different exchange rates are used for different
types of transactions:
1) Spot Exchange Market: deals with
currency for immediate delivery.
 The exchange rate used in spot transactions
is called the spot exchange rate.
 If you need 500,000 francs to buy imports,
and the spot exchange rate is .1457, you
would pay your bank $72,850.
Foreign Exchange Markets
2) Forward Exchange Market: deals with the
future delivery of foreign currency.
 You can buy or sell currency for future
delivery, usually in one, three, or six
months.
 The exchange rate for forward transactions
is called the forward exchange rate.
 Forward exchange contracts allow you to
hedge foreign exchange risk!
Forward Market Hedge
Example: You will import wine from France,
to be delivered and paid for in six months.
 You have agreed to a price of 500,000
francs. With the spot exchange rate of
.1457, this comes to $72,850.
 Suppose the dollar weakens over the next six
months, and the $/F exchange rate rises to .20.
 The wine would cost you $100,000. This is
an example of foreign exchange risk!
Forward Market Hedge
You decide to hedge your risk with a
forward exchange contract!
 The six-months $/F forward exchange
rate is .1476. By agreeing to this forward
rate with your bank, you lock in a price of
$73,800 for 500,000 francs, six months
from now.
 Now it doesn’t matter what happens to
the $/F exchange rate over the next six
months.
Money Market Hedge
For the previous problem, another potential
solution is the money market hedge.
1) Borrow $72,850 from your bank.
2) Buy the 500,000 francs now (at the current
spot exchange rate of .1457) for $72,850.
3) Invest the 500,000 francs in interest-bearing
French securities.
4)Complete your transaction after six months.
[Borrowing and investment rates determine the cost of the
hedge.]
Forward-Spot Differential
If the forward rate > the spot rate, the
forward is trading at a premium.
If the forward rate < the spot rate, the
forward is trading at a discount.
Forward-Spot Differential
If the forward rate > the spot rate, the
forward is trading at a premium.
If the forward rate < the spot rate, the
forward is trading at a discount.
premium
or discount
=[
forward - spot
spot
] [ ] x 100
12
n
Forward-Spot Differential
For our example,
Forward-Spot Differential
For our example,
premium
or discount
=[
forward - spot
spot
12
n
] [ ] x 100
Forward-Spot Differential
For our example,
premium
or discount
=[
forward - spot
spot
12
n
] [ ] x 100
=[
.1476 - .1457
.1457
] [ ] x 100
12
6
Forward-Spot Differential
For our example,
premium
or discount
=[
forward - spot
spot
12
n
] [ ] x 100
=[
.1476 - .1457
.1457
] [ ] x 100
12
6
= 2.6. The forward is trading at a 2.6%
premium.
Interest Rate Parity
Links the forward exchange market with
the spot exchange market. The idea:
The annual percentage difference between
the forward rate and the spot rate
(forward premium or discount) is
approximately equal to the difference in
interest rates between the two countries.
Arbitrage in the forward and spot markets
helps to hold this relationship in place.
Purchasing Power Parity
Links changes in exchange rates with
differences in inflation rates and the
purchasing power of each nation’s currency.
 In the long run, exchange rates adjust so that
the purchasing power of each currency tends
to be the same.
 Exchange rate changes tend to reflect
international differences in inflation rates.
 Countries with high inflation tend to
experience currency devaluation.
The Law of One Price
In competitive markets where there are no
transportation costs or barriers to trade, the
same goods sold in different countries sell for
the same price if all the different prices are
expressed in terms of the same currency.
 This proposition underlies the PPP
relationship.
 Arbitrage allows the law of one price to hold
for commodities that can be shipped to other
countries and resold.
Exchange Rate Risk
 Translation exposure - foreign currency
assets and liabilities that, for accounting
purposes, are translated into domestic
currency using the exchange rate, are
exposed to exchange rate risk.
 However, if markets are efficient, investors
know that any translation losses are
“paper” losses and are unrealized.
Exchange Rate Risk
 Transaction exposure - refers to
transactions in which the monetary
value is fixed before the transaction
actually takes place.
 Example: your firm buys foreign goods
to be received and paid for at a later
date. The exchange rate can change,
which can affect the price actually paid.
Multinational Working-Capital
Management
Leading and Lagging
 Lead: dispose of a net asset position in a
weak currency.
Pay a net liability position in a weak
currency.
 Lag: Delay collection of a net asset position
in a strong currency.
Delay payment of a net liability position in
a weak currency.
Direct Foreign Investment
Risks
 Business Risk - firms must be aware
of the business climate in both the
U.S. and the foreign country.
 Financial Risk - not much difference
between financial risks of foreign
operations and those of domestic
operations.
Direct Foreign Investment
Risks
 Political Risk - firms must be aware
that many foreign governments are
not as stable as the U.S.
 Exchange Rate Risk - exchange rate
changes can affect sales, costs of
goods sold, etc. as well as the firm’s
profit in dollars.