Ch' 17: International Business Finance

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Ch. 17International Business Finance
? 2000, Prentice Hall, Inc.
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International Business Finance

• Exchange Rate the price of one currency in
  terms of another.

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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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Spot Exchange Rates

• / .6284 (it takes .6284 pounds to 1)
• / 1.5913 (it takes 1.5913 to 1 pound)
• / 102.98 (it takes 102.98 yen to 1)
• / .009711 ( it takes .009711 to 1 yen)
• (note direct and indirect quotes are
  reciprocals)

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What Determines Exchange Rates?

• Floating Rate Currency System Since 1973, the
  world has allowed exchange rates to change daily
  in response to market forces.
• Exchange rates are affected by
• foreign investors,
• speculators,
• political conditions here and overseas,
• inflation,
• trade policies (tariffs and quotas), and

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What Determines Exchange Rates?

• Supply and Demand for currencies!
• Lets consider the / market.

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What Determines Exchange Rates?

• Suppose the British increase demand for U.S.
  products.
• British importers buy the U.S. products to sell
  in England. They buy dollars with pounds, so
  they can pay U.S. firms in dollars.
• The demand for dollars increases, and forces up
  the / exchange rate, which makes U.S.
  products more expensive in England.

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What Determines Exchange Rates?
/ (price of dollars)
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What Determines Exchange Rates?

• Another example
• Lets consider the / market.

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What Determines Exchange Rates?

• Suppose American demand for Japanese cars and
  stereos increases rapidly.
• American importers buy the Japanese products to
  sell in the U.S. They buy yen with dollars, so
  they can pay Japanese firms in yen.
• The supply of dollars increases, and forces down
  the / exchange rate, which makes Japanese
  products more expensive in the U.S.

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What Determines Exchange Rates?
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Foreign Exchange Markets

• Different exchange rates are used for different
  types of transactions
• 1) Spot Exchange Market deals with currency
  for immediate delivery.
• The exchange rate used in spot transactions is
  called the spot exchange rate.
• If you need 500,000 francs to buy imports, and
  the spot exchange rate is .1457, you would pay
  your bank 72,850.

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Foreign Exchange Markets

• 2) Forward Exchange Market deals with the
  future delivery of foreign currency.
• You can buy or sell currency for future delivery,
  usually in 1, 3, or 6 months.
• The exchange rate for forward transactions is
  called the forward exchange rate.
• Forward exchange contracts allow you to hedge
  foreign exchange risk!

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Forward Market Hedge

• Example You will import wine from France, to be
  delivered and paid in 6 months.
• You have agreed to a price of 500,000 francs.
  With the spot exchange rate of .1457, this comes
  to 72,850.
• Suppose the dollar weakens over the next 6
  months, and the /F exchange rate rises to .20.
• The wine would cost you 100,000. This is an
  example of foreign exchange risk!

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Forward Market Hedge

• You decide to hedge your risk with a forward
  exchange contract!
• The 6-months /F forward exchange rate is .1476.
  By agreeing to this forward rate with your bank,
  you lock in a price of 73,800 for 500,000
  francs, 6 months from now.
• Now it doesnt matter what happens to the /F
  exchange rate over the next 6 months.

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Money Market Hedge

• For the previous problem, another potential
  solution is the money market hedge.
• 1) Borrow 72,850 from your bank.
• 2) Buy the 500,000 francs now (at the current
  spot exchange rate of .1457) for 72,850.
• 3) Invest the 500,000 francs in interest-bearing
  French securities.
• 4)Complete your transaction after 6 months.
• Borrowing and investment rates determine cost of
  hedge

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Forward-Spot Differential

• If the forward rate gt the spot rate, the
  forward is trading at a premium.
• If the forward rate lt the spot rate, the
  forward is trading at a discount.

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Forward-Spot Differential

• If the forward rate gt the spot rate, the
  forward is trading at a premium.
• If the forward rate lt the spot rate, the
  forward is trading at a discount.
• premium forward - spot 12
  
• or discount spot
  n

x 100
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Forward-Spot Differential

• For our example,

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Forward-Spot Differential

• For our example,
• premium forward - spot 12
  
• or discount spot
  n
• .1476 - .1457
  12
• .1457
  6
• 2.6. The forward is trading
  at a 2.6
• premium.

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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 interest rates between the two
  countries.
• Arbitrage in the forward and spot markets helps
  to hold this relationship in place.

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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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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.
• This proposition underlies the PPP relationship.
• Arbitrage allows the law of one price to hold for
  commodities that can be shipped to other
  countries and resold.

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Exchange Rate Risk

• Translation exposure - foreign currency assets
  and liabilities that, for accounting purposes,
  are translated into domestic currency using the
  exchange rate, are exposed to exchange rate risk.
• However, if markets are efficient, investors know
  that any translation losses are paper losses
  and are unrealized.

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Exchange Rate Risk

• Transaction exposure - refers to transactions in
  which the monetary value is fixed before the
  transaction actually takes place.
• Ex your firm buys foreign goods to be received
  and paid for at a later date. The exchange rate
  can change, which can affect the price actually
  paid.

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Multinational Working-Capital Management

• Leading and Lagging
• Lead dispose of a net asset position in a weak
  currency.
• Pay a net liability position in a weak currency.
• Lag Delay collection of a net asset position in
  a strong currency.
• Delay payment of a net liability position in a
  weak currency.

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Direct Foreign Investment

• Risks
• Business Risk - firms must be aware of the
  business climate in both the US and the foreign
  country.
• Financial Risk - not much difference between
  financial risks of foreign operations and those
  of domestic operations.

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Direct Foreign Investment

• Risks
• Political Risk - firms must be aware that many
  foreign governments are not as stable as the U.S.
• Exchange Rate Risk - exchange rate changes can
  affect sales, costs of goods sold, etc. as well
  as the firms profit in dollars.