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INTERN TION L FIN NCI L

M N GEMENTCHAPTER 34

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LEARNING OBJECTIVES

Understand how the foreign exchange market operates

Explain the relationship between interest rates,inflation rates and exchange rates

Focus on the techniques that can be used to hedge theforeign exchange risk

Illustrate how the international capital budgetingdecisions are made

Highlight the methods of financing internationaloperations

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THE FOREIGN EXCHANGE MARKET

Theforeign exchange marketis the market where thecurrency of one country is exchanged for the currencyof another country. Most currency transactions arechannelled through the world-wide interbank market.

Interbank marketis the wholesale market in whichmajor banks trade with each other.

Participants

SpeculatorsArbitrageurs

Traders

Hedgers

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Foreign Exchange Rates

Aforeign exchange rateis the price of one currency quoted in terms ofanother currency.

When the rate is quoted per unit of the domestic currency, it is referredto as direct quote. Thus, the US$ and INR exchange rate would bewritten as US$ 0.02538/INR.

When the rate is quoted as units of domestic currency per unit of theforeign currency, it is referred to asindirect quote.

A cross rateis an exchange rate between the currencies of two countriesthat are not quoted against each other, but are quoted against onecommon currency.

Suppose that German DM is selling for $ 0.62 and the buying rate forthe French franc (FF) is $ 0.17, what is the DM/FF cross-rate? It is:

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$ 0.62 3.65

$ 0.17

US FF FF

DM US DM

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Foreign Exchange Rates

Thespot exchange rateis the rate at which a currency can be boughtor sold for immediate delivery which is within two business days afterthe day of the trade.

Bid-ask spreadis the difference between the bid and ask rates of acurrency.

Theforward exchange rateis the rate that is currently paid for thedelivery of a currency at some future date.

The forward rate may be at a premium or at a discount.

For adirect quote,the annualised forward discount or premium can becalculated as follows:

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Spot rate Forward rate 360Forward premium (discount)Spot rate Days

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INTERNATIONAL PARITY RELATIONSHIPS

There are the following four international parity

relationships:

1. Interest rate parity (IRP)

2. Purchasing power parity (PPP)

3. Forward rates and future spot rates parity

4. International Fisher effect (IFE)

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Interest Rate Parity

It states that the exchange rate of two countries will be affectedby their interest rate differential. In other words, the currencyof a high-interest-rate-country will be at a forward discountrelative to the currency of a low-interest-rate-country, and viceversa. This implies that the exchange rate (forward and spot)differential will be equal to the interest rate differential

between the two countries. That is:

Interest differential = Exchange rate (forward and spot)differential

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/

/

(1 )

(1 )

F F D

D F D

r f

r s

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Purchasing Power Parity

In absolute terms, purchasing power parity states that the exchange ratebetween the currencies of two countries equals the ratio between theprices of goods in these countries. Further, the exchange rate mustchange to adjust to the change in the prices of goods in the twocountries. In relative terms, purchasing power states that the exchange

rate between the currencies of the two countries will adjust to reflectchanges in the inflation rates of the two countries. In formal terms, itimplies that the expected inflation differential equals to the current spotrate and the expected spot rate differential. Thus:

Inflation rate differential = Current spot rate and expected spot ratedifferential

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/

/

(1 ) ( )

(1 )

F F D

D F D

i E s

i s

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Expectation Theory of Forward Rates

The expectation theory of forward exchange rates states

that the forward rate provides the best and unbiased

forecast of the expected future spot rate. In formal terms,

it means that the forward rate and the current rate

differential must be equal to the expected spot rate and

the current spot rate differential. Thus:

Forward and current spot rate differential = Expected and

current spot rate differential

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/ /

/ /

( )F D F D

F D F D

f E s

s s

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International Fisher Effect

In formal terms, theinternational Fisher effect

states that the nominal interest rate differential

must equal to the expected inflation rate

differential in two countries. Thus:Nominal interest rate differential = Expected

inflation rate differential

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(1 ) (1 )

(1 ) (1 )

F F

D D

r E i

r E i

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Foreign Exchange Risk

Foreign exchange risk is the risk that the domesticcurrency value of cash flows, denominated in foreigncurrency, may change because of the variation in theforeign exchange rate. There would not be any foreignexchange risk if the exchange rates were fixed.

We can distinguish between three types of foreignexchange exposure:

1. Transaction exposure

2. Economic exposure3. Translation exposure

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Foreign Exchange Risk

Transaction exposureinvolves the possible exchange loss orgain on existing foreign currency-denominated transactions.

Economic exposurerefers to the change in the value of the

firm caused by the unexpected changes in the exchange rate.It is also referred to asoperating exposureor the long-termcash flow exposure.

A firm is exposed to translation loss if it uses current

exchange rate to translate its assets and liabilities. There arefour methods in use in translating assets and liabilities:1. Cur r ent/non-cur r ent method

2. M onetary/non-monetar y method

3. Temporal method

4. Curr ent r ate method

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Hedging Foreign Exchange Risk

Forward contract

Foreign currency option

Money market operations

The hedging techniques of foreign currency option andmoney operations may not be available to companies inmany countries, particularly developing countries.

However, a large majority of companies can cover theirforeign exchange exposure through forward contracts.

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Cost of forward contractis the difference between theforward rate and the expected spot rate (notthe currentspot rate) at the time cash flows are paid or received.

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Foreign Currency Option

The foreign currency option is the right (not an

obligation) to buy or sell a currency at an agreed

exchange rate (exercise price) on or before an

agreed maturity period.The right to buy is called acall optionand right to

sell aput option.

A foreign currency option holder will exercise hisright only if it is advantageous to do so.

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Cost of put option16

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Another hedging technique is the money marketoperations. Suppose, Air India can borrow FF 1,000million now, convert them into rupees at the currentexchange rate and invest in the money market in India for

six months. If interest rate parity holds, the difference inthe forward rate and the spot rate is the reflection of thedifferences in the interest rates in two countries. Thus, AirIndia will be able to hedge against the change in theexchange rate.

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INTERNATIONAL CAPITAL INVESTMENT

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ANALYSIS

The basic principles applicable to an internationalinvestment decision are similar to a domestic investmentdecision.

The incremental cash flow of the investment should bediscounted at an opportunity cost of capital appropriate to

the risk of the investment. The investment should beaccepted if the net present value is positive.

One factor that distinguishes the international investmentdecisions from the domestic investment decisions is thatcash flows are earned in foreign currency. This fact should

be considered while estimating the incremental cash flows.

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Beta of a foreign investment can be calculated byregressing the projects return to a benchmarkmarket index.

In fully integrated international financial

markets, both the firms and the individualinvestors are free to invest anywhere in the world.In this case, the projectscost of capital does notdepend on any country. Investors could diversifyinternationally and obtain the internationaldiversification benefits themselves. In this case,

beta is calculated relative the world marketindex.

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ANALYSIS

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Cont

Taiwanese Dollar Cost of Capital

Formula for converting the Taiwanese dollar

cost of capital to the Thai baht cost of capital:

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Investment Evaluation: Parent vs. Project

Restrictions on Remittances

Differences in Taxes

Cash Flows to Parent

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POLITICAL RISK OF FOREIGN INVESTMENTS

There are two ways in which a firm can handle thepolitical risks in the investment evaluation.

The firm may increase the cost of capital (discount rate) toallow for the political risks

or

Adjust the investmentscash flows to account for politicalrisk.

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FINANCING INTERNATIONAL OPERATIONS

Eurocurrency Loans

Eurobonds and Foreign Bonds

Depository Receipts

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Cost and Risk of International Financing

A firm may be capable of raising funds below

market rate due to government subsidies, tax

asymmetries government regulations.

Borrowing in local currency to finance a foreign

investment can expose a company to foreign

exchange risks.

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