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Chapter 16 - International Financial Management

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Chapter 16 learning goals

What are exchange rates and what factors affect exchange rates.Using exchange rates.What is exchange rate risk?Managing exchange rate risk.International Capital Budgeting

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International Business FinanceSpot Exchange Rate: today’s price of one currency in terms of another.

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Exchange RatesExchange 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.

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Exchange RatesExchange 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, andU.S. products become cheaper overseas.

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Got to get some beer!Moe opens a new bar in Springfield called Moe’s International Drinking Emporium and needs to convert dollars into other currencies buy some imported brews.He is considering buying 500 cases of CuatroEquis beer from Mexico for 30,000 pesos and 500 cases of King Homer’s Mead from England for 3,000 pounds.How many dollars would Moe need to convert to complete each of these transactions?

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Exchange RatesDirect Quote: number of units of domestic (home) currency needed to acquire a unit of a foreign currency.Indirect Quote: number of units of a foreign currency needed to acquire a unit of the domestic (home) currency.Direct and Indirect quotes are reciprocals of each other.$/peso rate = 0.09048; peso/$ rate = 11.0520$/pound rate = 1.7822; pound/$ rate = 0.5611

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Back to MoeXXXX Beer: 30,000 pesos

King Homer’s Mead: 3,000 pounds

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More MoeQuestion: How many pesos would it take to buy King Homer’s Mead?

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Peso to Pound Exchange (Cross) Rate

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Transaction RiskExchange rate risk arises when the value of a company’s cash

flows can be affected by a change in exchange rates.

• An example…Assume Boeing Company sells an airplane to a Japanese buyer:

1. Boeing must receive $1,000,000 to cover costs and profits.2. Since payment usually in buyer’s currency, priced in Yen.3. Current exchange rate is ¥100.00/$.4. Price of airplane therefore ¥100,000,000.• If delivery and payment occur immediately, there is no

foreign exchange risk: just exchange ¥100,000,000 for $1,000,000 on spot market.

If price is set today, but delivery is in 6 months, Boeing is exposed to significant foreign exchange risk

unless it hedges that risk. 12

Transaction RiskImagine Moe is considering entering into a contract to purchase 1,000 cases of Maple Leaf Beer in 6 months for 20,000 Canadian Dollars (cd)What will be Moe’s dollar cost?Don’t know for sure. This is an example of transaction risk.Let’s investigate.

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Moe’s exchange rate riskCurrently $0.8813/cd (known as spot price), which makes today’s cost $0.8819/cd x 20,000 cd= $17,638.However, in 6 months the exchange rate could be higher or lower making Moe’s cost uncertain.If Moe wants to know his future $ cost with certainty, how could he hedge this risk?Solution: a 6-month forward contract with Bank of Springfield.

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Moe’s Forward HedgeWith this forward contract, the bank agrees to sell Moe Canadian Dollars in 6 months at an exchange rate agreed to today.Today’s 6-month forward rate is $0.88675/cd.Moe’s Forward Hedge Cost = CD20,000 x forward rate = CD20,000($0.88675/CD) = $17,735 guaranteed

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Forward to spot premiumAnnualized Premium(Discount) relative to US$ = (F – S)/S x 360/n x 100%

Where F = forward rate (direct quote: dom/for)S = spot rate (today’s exchange rate: direct quote)n = # of days

From our 6-month forward example:(.88675 - .8819)/.8819 x 360/180 x 100% = 1.1% Canadian Dollar forward premium.

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Exchange Rate Parity and Interest Rate Relationships

We will look at each individual relationship, but all the relationships are equal to one another.

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Exchange Rate RelationshipsBasic Relationships

dom

foreign

R+1R+1

)E(i+1)E(i+1

dom

foreign

for/dom

for/dom

SF

for/dom

domfor

SSE( )/

equals

equals

equals equals

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Forward-Spot Parity

• An example…• Assume: Spot = $1.7822/£ 1M forward = $1.7828/£

U.S. firms who will need to buy pounds in the future will do the opposite.

Risk-neutral U.K. firms who intend to buy U.S. dollars in the future will either:

1. Enter the forward contract today if E(S) < $1.7828/£.2. Wait and buy dollars at spot rate if E(S) > $1.7828/£.

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Forward-Spot Parity

U.S. and U.K. firms are indifferent in this case whether they transact in the spot or forward market.

Forward-spot parity does not hold. Forward rate does not reliably predict the direction of the spot

rate.

• Studies of exchange rates find a great deal of randomness in spot rate movements.

Equilibrium: the forecast of the spot price is equal to the current forward rate (forward – spot parity).

E(S) = F

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Interest Rate ParityLinks 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 risk-free interest rates between the two countries.Arbitrage in the forward and spot markets helps to hold this relationship in place.

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Interest Rate Parity (IRP)

( )( )dom

fordomfor

domfor

RR

SF

+

+=

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/

/

IRP:

An investor can either buy a domestic risk-free asset or a foreign risk-free asset using forward contracts

to cover currency exposure.

The currency of the country with lower risk-free rate should trade at a forward premium.

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Interest Rate Parity ExampleToday’s spot exchange rate is 0.5611GBP/$. The 12-month forward rate is 0.5577GBP/$. Today’s 1-year US T-bond rate is 4.9%. What should be today’s one-year risk-free rate in Great Britain?

RGB=1.049(0.5577/0.5611)-1 = 0.043 =4.3%4.4% was the 1-yr GB T-bill rate at the end of last week.

( )( ) 049.1

15611.0

05577:11

/

/GB

dom

fordomfor

domfor RRR

SF +

=+

+=

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The Law of One PriceIn 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.

Arbitrage allows the law of one price to hold for commodities that can be shipped to other countries and resold.

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Purchasing Power ParityLinks 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.

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Purchasing Power Parity (PPP)

)](1[)](1[)(

/

/

dom

fordomfor

domfor

iEiE

SSE

+

+=

Key empirical predictions of PPP:

Low-inflation nations ⇒ appreciating currency

High-inflation nations ⇒ depreciating currency

Law holds for tradable goods over time, but deviations occur in the short run. Reasons:

• The process of trading goods across countries cannot happen instantaneously.

• Legal restrictions or physical impediments apply to transportinggoods. 26

Real Interest Rate Parity: the Fisher Effect

)](1[)](1[

1R1 for

dom

for

dom iEiE

R +

+=

++

Fisher effect: the nominal interest rate R is made up of two components:

Real required return assumed to be same in both countries.Inflation premium equals the expected rate of inflation, I.

If real required return is the same across countries, then the following equation is true:

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International Capital BudgetingTechniques for a U.S. firm

Given a dollar denominated cost of capital, exchange expected foreign currency cash flows to $ using interest rate parity theory and find NPV.

or

Given foreign currency denominated cost of capital, discount using foreign cash flows and interest rates, then exchange to $.

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International Capital Budgeting ExampleHomer & Son manufactures grease gougers. It is considering building a manufacturing facility in Australia. The company is expected to produce Australian cash flows as follows. The 1-yr US risk free rate is 4.9% and the Australian rate is 5.65%. The current spot rate is 1.3436 Aus$:$1US and Homer & Son expects a 13% return in US$ on its investment. What is the US$ NPV of the project?

Cash Flow Forecasts (in thousands of Aus$)

year 0 1 2 3

-400 200 210 222

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International Capital Budgeting Example ( 2nd approach)

Convert US required return (k) to Australian required return using a version of real interest rate parity(1+kAus)/(1+kUS) = (1+RAus)/(1+RUS)RAus = 5.65%, RUS = 4.9%, kUS = 13%kAus =(1.13)x[(1.0565)/(1.049)]-1 = 13.8%NPV of Aus$ at 13.8% = A$88,539Convert A$NPV to $NPV at spot rate = A$85,294/(A$1.3436/$) = $65,897

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Homer & Son Example (1st

Approach)What are the 1, 2, and 3 year forward rates?

(fAus$/$)t = Spot Aus$/$ x (1.0565/1.049)t

(fAus$/$)t = 1.3436 x (1.0565/1.049)t

( )( )dom

fordomfor

domfor

RR

SF

+

+=

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/

/

IRP:

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Homer & Son Example (cont.)

Find NPV by discounting US$ cash flows at Homer’s 13% US$ denominated cost of capitalNPV = $65.8 or $65,848

161.7154.1147.8-297.7US $ CF1.37261.36291.35321.3436F(Aus/$)222210200-400Aus$ CF3210Year

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TOP10

LIST

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Top 10 questions we will answer in Finance 221 this semester.

10. What is the goal of the firm?9. Why there is no such thing as a free lunch?8. How do you figure out loan payments?7. Why do bond and stock prices tend to fall

when inflation or interest rates go up?6. Why Microsoft deserves its legal troubles.

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Top 10 questions we will answer in Finance 221 this semester.

5. Why is Homer Simpson so dumb?4. How do you calculate a P/E ratio? (Anna

Kournikova: guest lecturer)3. Why do they call bond interest payments

coupon payments?2. Where in the world can you find the

cheapest Big Mac?1. How to make a million dollars and not pay

taxes.

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3 Key Things to RememberGoal of the Firm is to maximize stockholder wealth (stock price).Asset prices and interest rates have an inverse relationship.To enhance wealth select positive NPV investments.