Welcome to class of

International Finance/Forces

byDr. Satyendra Singh

University of WinnipegCanada

Outline• Purchasing Power Parity• Factors affecting Foreign currency• Fisher’s Effect• Arbitrage• Hedge (Forward, Currency option, Money Market)• Transfer Pricing• Swap (Parallel loan, Bank, Currency)• Debt vs. Equity• Impact of Culture on Accounting• Accounting Standards

Purchasing Power Parity (PPP)…

– The number of units of a currency required to buy the same amount of goods and services in a domestic market that $1.00 would buy in the U.S.

– Helps to make comparisons possible across economies

CIA Fact Book

Purchasing Power Parity (PPP)If,1 Lt. Milk US $1.001 Lt. Milk India Rs. 20.00

Then, PPP: US $1 = Rs. 20

Reality: US $1 = Rs. 40

ie Rs. Is 50% undervalued –artificially?!

Factors affecting Foreign Currency• Three factors:

– Inflation– Interest rate– Speculation

• Fisher’s Effect– Diff. in interest rate may determine strength of FOREX

€ 1 = $1.5,Interest rate: € (3%) and $(5%)

Speculation: Which currency becomes weaker/stronger?

Atlas Conversion Factor

• It is used for speculation

Average of FOREX for the last 2 years adjusted by the ratio of domestic inflation and combined inflation of US, UK, EU and Japan

Weak Foreign Currency…

Weak Foreign Currency…

Weak Foreign Currency…

Weak Foreign Currency…

Weak Foreign Currency

Arbitrage: The process of buying and selling instantaneously to make profit at no risk

AlgeriaDinar

BrazilRiel

ChilePeso

1:21:3

1:5

5 dinar

Transaction Exposure: Hedging Hedging process to reduce or eliminate financial risk

Forward market hedge Foreign currency contract sold or bought forward in order to protect against foreign currency

movement Currency option hedge Option to buy or sell specific amount of foreign currency at specific time to protect against

foreign currency risk Money market hedge Method to hedge foreign currency exposure by borrowing and lending in domestic and foreign

money markets

Forward Hedge• Hedge is a process to reduce risk

€ 1 = $1.5 (now/spot) $ is expected to be weak € 1 = $1.6 (speculate/forward)Interest rate: € (3%) and $(5%)

Suppose you have accounts receivables for €20,000If quoted in €, supplier may not have problem (i.e. Risk prone)But strong currency is desirable by both seller and buyerIf you quoted in € (ie € 20,000 x 1.5 = $30,000),You now get $ (ie € 20,000 x 1.6 = $32,000)You gained: $2000, because $ became weakYou lose, if $ became stronger (say 1.4) = $2,000

Currency Option Hedge

• So you have accounts receivables in a currency that works best for your company

• Firms may have bank accounts in multiple currencies such as Dollar, Euro, Yen… to avoid conversion charges.

Money Market Hedge

• Counter balancing the risk by borrowing the same amount for FOREX (A/R) in domestic market and investing it until accounts receivables are received

Suppose the AR is €20,000 (in 90 days)€ 1 = $1.4 (expected) $ is expected to be strong! € 1 = $1.5 (now)Interest rate: € (5%) and $(3%)

Borrow €20,000 convert in $ (€ 20,000 x 1.5 = $30,000) Invest Income (but pay interest)

After 90 days, pay €20,000 to local bank, so no debtSo, Investment + income - interest ≥ €20,000

Source: Wall Street Journal, Exchange rate June 19, 2006

Fri: June 16 (SPOT)Mon: June 19 (FORWARD)Last Friday

Movement of $, Transfer Pricing

Supplier

Local business

Customer

Profit

$1

$10

$9

Say, 30% tax$6.30 Net profit$2.70 tax

Movement of $, Transfer Pricing

Supplier

Local business

Customer

Foreign

$1

$10

$8

Now profit $1Say, 30% tax33 Cents tax!

$9

Movement of $, Transfer Pricing – 3 countries

UK OFC: Jamaica USA

$100 to produceSells at $110 Sells at $210 Sells at $220Profit $10 Profit $100 Profit $10Tax 50% Tax 5% Tax 30%Tax paid $5 Tax paid $5 Tax paid $3.33

OFC: Offshore Ffinancial Centres

Offshore financial center specializes in financing nonresidents, low taxes and few banking regulations Too small to exist on its own Boosts economy Employment

Switzerland Cayman Island Hong Kong Bahamas Bermuda Gibraltar Luxemburg …

Swaps

Parallel Loans Matched loans across currencies made to cover

risk Bank Swap

Swap made between banks to acquire temporary foreign currencies

Currency Swap Exchange of debt service of loan or bond in one

currency for debt service of loan or bond in another currency

Parallel Loan Swap

CANADA: Canada (parent) India (child)

INDIA: Canada (child) India (parent)

$1m

Rs. 40m

$1 = Rs. 40

Bank Swap

Canadian Bank in Canada

Indian Bank in India Canadian child in India

Canadian parent in Canada$1m

Rs. 40m

Canadian Parent deposits $1m to the credit of the Indian BankThe Correspondent Indian Bank lends Rs. 40m (spot rate) to the ChildAt a later agreed date, the Child returns Rs. 40m to Indian BankIndian Bank instructs the Canadian Bank to pay $1m to the Parent

So, no conversion of $1 to Rs. Useful if you want hard currency only

Currency SwapCANADA CYPRUSI am Known here Same is true for So the interest rate is low for me the Cypriot

person in Cyprus

So, I take the loan for the Cypriot guy Person does the In Canada at low interest rate same for me in $1.5m Cyprus (€ 1m)

Then, we swap currency,i.e., I service the loan in € for the Cypriot guy in CYPRUSAnd the Cypriot guy services my loan in $ in Canada

€ 1 = $1.5

Capital Structure of a Firm

Debt Borrow from Bank Conservative, report less, ↓ tax exposure, ↑ dividend

pay outs save $ to service debt France, Germany, Japan, some Emerging Markets

Debt financing is less expensive than equity financing, because interest paid on debt is tax deductable, but dividends paid out to shareholders are not.

Equity Shares, Bonds Impressive (Inflated report) to attract investors Value of Bond ↓, if interest rate ↑

How do Bonds perform?

Suppose, now you have bonds worth$10,000 @5% for a year

So expect $500 at the end of the year

Now, interest rate changed to 6%

Value of your bond now is: $x x.06 = $500ie x = $8334

Drop in value = 17%!

Cultural Differences in Measurement and Disclosure for Accounting Systems

Annual Reports

Depends Calculation of Inventory Depreciation Income only when contract is complete Valuation of assets Goodwill …

So we need uniform accounting system

International Accounting Standards

• Triple Bottom Line Standard (3BL)– Environmental, social, and financial impacts of the business

• International Accounting Standards Board (IASB)• International Financial Reporting Standards (IFRS)• Sarbans-Oxley Act (2002, US)

– Public Company Accounting Reform and Investor Protection Act (in the Senate)

– Corporate and Auditing Accountability and Responsibility Act (in the House)

– Heavy penalty for corporate finance fraud

Use of International Financial Reporting Standards (IFRS)

Tax System

• Direct Tax– Income Tax– VAT – Value Added Tax

• Indirect Tax (Withholding Tax)– Dividend– Interest– Royalty