Chapter 16 - International Financial Management

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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 Finance

• Spot Exchange Rate todays price of one
  currency in terms of another.

Euro
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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.

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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,
  and
• U.S. products become cheaper overseas.

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Got to get some beer!

• Moe opens a new bar in Springfield called Moes
  International Drinking Emporium and needs to
  convert dollars into other currencies buy some
  imported brews.
• He is considering buying 500 cases of Cuatro
  Equis beer from Mexico for 30,000 pesos and 500
  cases of King Homers 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 Rates

• Direct 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 Moe

• XXXX Beer 30,000 pesos
• King Homers Mead 3,000 pounds

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More Moe

• Question How many pesos would it take to buy
  King Homers Mead?

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Peso to Pound Exchange (Cross) Rate
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Transaction Risk
Exchange rate risk arises when the value of a
companys cash flows can be affected by a change
in exchange rates.
If price is set today, but delivery is in 6
months, Boeing is exposed to significant foreign
exchange risk unless it hedges that risk.
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Transaction Risk

• Imagine 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 Moes dollar cost?
• Dont know for sure. This is an example of
  transaction risk.
• Lets investigate.

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Moes exchange rate risk

• Currently 0.8819/cd (known as spot price), which
  makes todays cost 0.8819/cd x 20,000 cd
  17,638.
• However, in 6 months the exchange rate could be
  higher or lower making Moes 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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Moes Forward Hedge

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

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Forward to spot premium

• Annualized Premium(Discount) relative to US
  (F S)/S x 360/n x 100
• Where F forward rate (direct quote dom/for)
• S spot rate (todays 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 Relationships

• Basic Relationships

equals
equals
equals
equals
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Forward-Spot Parity
U.S. firms who will need to buy pounds in the
future will do the opposite.
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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.

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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 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)
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 Example

• Todays spot exchange rate is 0.5611GBP/. The
  12-month forward rate is 0.5577GBP/. Todays
  1-year US T-bond rate is 4.9. What should be
  todays one-year risk-free rate in Great Britain?
• RGB1.049(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.

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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.
• 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 Parity

• Links changes in exchange rates with differences
  in inflation rates and the purchasing power of
  each nations 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)
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 transporting goods.

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Real Interest Rate Parity the Fisher Effect
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 Budgeting
Techniques 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 Example
Homer 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 Aus1US
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
• (1kAus)/(1kUS) (1RAus)/(1RUS)
• 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 A88,539
• Convert ANPV to NPV at spot rate
  A85,294/(A1.3436/) 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

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Homer Son Example (cont.)

• Find NPV by discounting US cash flows at Homers
  13 US denominated cost of capital
• NPV 65.8 or 65,848

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• TOP
• 10
• 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?
• 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 Remember

• Goal 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.