Chapter 21 International Financial Management

1
Chapter 21International Financial Management
2
Factors Affecting Exchange Rates

• Supply and Demand
• Foreign buyers
• Investors
• Speculators
• Economic Conditions
• Inflation
• Interest rates
• Government Trade Policies
• Political stability
• Sovereignty Risk

3
Why Do Exchange Rates Fluctuate Over Time ?
IRP
Absolute
Theories of currency fluctuation
PPP
Relative
ET
IFE
4
IRP
Interest Rate Parity
The annual percentage forward premium for a
currency is equal to the approximate difference
in interest rates prevailing between two
countries.
5
Interest Rate Parity
F 1 i h S 0 1 i f

6
Covered Interest Rate Parity

• Covered interest rate parity conditions imply
  that interest earnings in every major country
  will tend to be equal after adjusting for
  exchange rate gains or losses necessary to ensure
  that unexpected foreign currency transaction
  losses will not occur.

7
Relative
PPP
Absolute
Absolute Purchasing Power Parity
Relative Purchasing Power Parity
Law of One Price -- Prices should be the same
across countries
8
RPPP
Relative Purchasing Power Parity
Works!
9
According to Relative Purchasing Power Parity
Differential rates of inflation between two
countries will be offset by equal, but opposite,
changes in expected future spot exchange rate.
10
Relative Purchasing Power Parity (RPPP)
?
S 1 1 h S 0 1 f

?
11
The forward rate should be an unbiased estimate
of expected future spot rates.

12
Expectations Theory of Forward Exchange Rates
F S 1
13
IFE International Fisher Effect
Differences in interest rates between two
countries should be offset by equal but opposite
changes in the future spot exchange rate.
14
IFE
nominal interest rates are based on
real interest rate effect of expected inflation
Equation for domestic Fisher Effect
(1 nominal rate of interest) (1 real
rate of return ) x ( 1 expected inflation rate )

15
International Fisher Effect
Differences in interest rates between two
countries should be offset by equal but opposite
changes in the future spot exchange rate.
S 1 1 i h S 0 1 i f

Use the IFE relationship when making longer term
exchange forecasts.
16
IF US rate 6 Japan rate 1/2
Time horizon 1 year
Difference 5 1/2
IFE says the inflation rates differ by 5 1/2
the one - year future spot rate - 5 1/2
the weakens to a strengthened yen
IRP says the dollar will sell at a 5 1/2
discount RPPP says US higher inflation rates will
cause a lower US dollar
17
Exchange rates fluctuate over time in response to
changing supply and demand.
18
Foreign Exchange Risk
Foreign exchange risk occurs whenever a portion
of the cash flows expected to be received by a
firm are denominated in foreign currencies.
Transaction
Kinds of Foreign Exchange Risk
Economic
Accounting
(Translation)
19
Hedging to Reduce Transaction Exposure

• Forward Market Hedge
• Execute a forward contract in the forward
  exchange market
• Execute a futures contract on the futures
  exchange
• Differences between contracts
• Futures are traded on organized exchanges
• Futures are standardized contracts
• Futures are not typically delivered
• Futures are marked to market daily

More
20

• Money Market Hedge to Reduce Transaction Exposure
• The U.S. firm could borrow funds from its bank,
  exchange them for the foreign currency (or
  perhaps EUROs) on the spot market, and invest the
  foreign currency in interest bearing securities
  denominated in that foreign currency.
• At maturity, the U.S. firm pays off the U.S. bank
  loan in dollars and the invested securities
  mature overseas providing the needed foreign
  currency.
• Foreign Currency Options
• Options give the buyer the right to buy or sell a
  futures contract at a point in time.

21
Economic or Operating Risk Exposure

• Economic Risk refers to changes in a firms
  operating cash flows that happen because of real
  rather than nominal changes in exchange rates.

22
Economic Risk
1. Shift production 2. Increase
productivity 3. Outsource 4. Reduce price
sensitivity - Increase product differentiation 5.
Change to markets with strong currencies
5 ways to manage the Economic impact
23
Accounting For Risk (Translation Exposure)
FASB - Financial Accounting Standards Board 52
Assets Liabilities
converted to exchange rate at date of balance
sheet
Income Statement
converted on date of transaction or a
weighted average of exchange rates
- Equity Accounts converted at historical rates
- Gains and losses are not recognized on the
income statement till subsidiary is sold or
liquidated

24
Ethical Issues

• Foreign Corrupt Practices Act of 1988
• Payments in the form of phony discounts, fake
  invoices and inflated expense accounts are
  illegal.
• Bribes are illegal

25
International Financial Management

• Interest Rate Parity
• Relative Purchasing Power Parity
• Expectations Theory
• International Fisher Effect
• Foreign Exchange Risks
• Transaction Risk - Hedging
• Forward Hedge
• Money Market Hedge
• Translation Exposure