Lecture Essentials of corporate finance (2/e) – Chap 18: International aspects of financial management

Chapter 18 decribes international aspects of financial management. In this chapter you will understand how exchange rates are quoted and what they mean, know the difference between spot and forward rates, understand purchasing power parity and interest rate parity and the implications for changes in exchange rates, understand the types of exchange rate risk and how they can be managed, understand the impact of political risk on international business investing.

International aspects of financial management

Chapter 18

Key concepts and skills

• Understand how exchange rates are

quoted and what they mean

• Know the difference between spot and

forward rates

• Understand purchasing power parity and interest rate parity and the implications for changes in exchange rates

• Understand the types of exchange rate

risk and how they can be managed

• Understand the impact of political risk on international business investing

Chapter outline

• Terminology

• Foreign exchange markets and

exchange rates

• Purchasing power parity

• Exchange rates and interest rates

• Exchange rate risk

• Political risk

Domestic financial management

and international financial

management

• Considerations in international financial management

– Have to consider the effect of exchange

rates when operating in more than one

currency

– Have to consider the political risk

associated with actions of foreign

governments

– More financing opportunities when you

– Money deposited in a financial centre outside the

country of the currency involved

– Eurodollars are US dollars deposited in a foreign bank

• Foreign bonds

– Sold by foreign borrower

– Denominated in currency of the country of issue

International finance terminology (cont.)

• Gilts

– British and Irish government securities

• London Interbank Offer Rate (LIBOR)

– Rate international banks charge each other for

loans of Eurodollars overnight in the London

market

– Frequently used as a benchmark rate for money market instruments

• Swaps

– Interest rate swap = two parties exchange a

floating-rate payment for a fixed-rate payment

Global capital markets

• Foreign exchange market

– The market in which one country's currency is bought or

sold for another country's currency

• The number of exchanges in foreign countries continues

to increase, as does the liquidity on those exchanges.

• International foreign markets are becoming more

competitive and are often willing to try more innovative

ways of doing business.

– The second number, 89.19, is how many

Japanese Yen it takes to buy $1AUD

– The two numbers are reciprocals of each other

(1/89.19= 0.0112)

Direct and indirect exchange

rate quotations

• Direct quotation

– One US dollar = ‘x’ of the local currency

• Indirect quotation

– One unit local currency = ‘x’ US dollars

• Australia and New Zealand follow

indirect quote

Exchange rates—Example

• Suppose you have $10 000 Given the rates below, how many

US dollars can you buy?

– Exchange rate = 0.8213 US dollar per Australian dollar

– Buy 10 000(0.8213) = $8213 US dollars

• Suppose you are visiting London and you want to buy a

souvenir that costs 1000 British pounds How much does it cost

if the exchange rate is AUD/GBP 0.4945?

– Exchange rate = 0.4945 pounds per dollar

– Cost = 1000 / 0.4945 = $2022.24

Example: Work the Web

• You just returned from Japan and had

left over 10000 yen.

– How much will you have in Australian

Triangle arbitrage—Example

18.2

• We observe the following quotes:

– Pounds per AUD $1 = 0.60

– Swiss francs (SF) per AUD $1 = 2.00

– Swiss francs (SF) per pound = 3

• What is the cross rate?

– SF 2.00/£ 0.60 = SF 3.33 per £

• We have AUD $100 to invest; buy low, sell high

– 1 Exchange dollars for francs: AUD $100 x 2 = SF

200

– 2 Exchange francs for pounds: SF 200/3 = £66.67.

– 3 Exchange pounds for dollars: £66.67/0.60 = AUD

$111.12.

• This would result in an AUD $11.12 round-trip

Transaction terminology

• Spot trade—exchange currency immediately

– Spot rate—the exchange rate for an immediate

trade

• Forward trade—agree today to exchange

currency at some future date and some

specified price (also called a forward contract).

– Forward rate—the exchange rate specified in the forward contract.

– If the forward rate is higher than the spot rate, the foreign currency is selling at a premium (when

quoted as $ equivalents).

– No barriers to trade (no taxes, tariffs, etc.)

– No difference in the commodity between locations

• Absolute PPP rarely holds in practice

– Usually only for uniform, traded goods

Relative purchasing-power

parity

• Provides information about what causes

changes in exchange rates

• The basic result is that exchange rates

depend on relative inflation between

countries

• E(S t ) = S 0 [1 + (h FC – h AUD )] t

– Where:

•S0 = current (time 0) spot exchange rate (foreign

currency per dollar)

PPP—Example

• Suppose the Singapore spot exchange

rate is 1.4680 Singapore dollars per

Australian dollar Australian inflation is

expected to be 3% per year and

Singapore inflation is expected to be 2%.

– Do you expect the Australian dollar to

appreciate or depreciate relative to the

Singapore dollar?

• Since inflation is higher in Australia, we would expect the AUD to depreciate relative to the Singapore dollar.

Covered interest arbitrage

• Examine the relationship between spot rates,

forward rates and nominal rates between

countries.

• Again, the formulas will assume that the exchange rates are quoted in terms of foreign currency per

Australian dollars (AUD).

• The Australian risk-free rate is assumed to be the short-dated government bond rate.

• Covered interest arbitrage

– ‘C overed’ refers to the fact that we are covered

in the event of a change in the exchange rate

since we lock in the forward exchange rate

Covered interest arbitrage—

– 210 SGD/(1.8 SGD/$) = $116.67 and repay loan

– Profit = 116.67 – 100(1.1) = $6.67 risk free

Interest rate parity

• The condition of the interest rate

differential between two countries being equal to the percentage difference

between the forward exchange rate

and the spot exchange rate.

• With reference to the example on the

previous slide, there must be a forward rate that would prevent the arbitrage

opportunity.

Interest rate parity (cont.)

• Interest rate parity defines what that

forward rate should be

Forward and spot rates are direct quotations.

R AU = periodic interest rate in the home country

(Australia)

) (

1   

: Approx

) 1

(

) 1

(   

: Exact

0 1 0 1

AU FC

AU FC

R

R S

F

R

R S

F

Exchange rate risk

• The risk that the value of a cash flow in one currency translated from another

currency will decline owing to a change

Short-run exposure

• Risk from day-to-day fluctuations in

exchange rates and the fact that

companies have contracts to buy and

sell goods in the short run at fixed

prices.

• Managing risk

– Enter into a forward agreement to

guarantee the exchange rate.

– Use foreign currency options to lock in

exchange rates if they move against you

but benefit from rates if they move in your

Long-run exposure

• Long-run fluctuations come from

unanticipated changes in relative

economic conditions.

• Could be due to changes in labour

markets or governments.

• Managing risk

– More difficult to hedge

– Try to match long-run inflows and outflows in the same currency

– Borrowing in the foreign country may mitigate

Translation exposure

• Income from foreign operations has to be

translated back to dollars for accounting

purposes, even if foreign currency is not

actually converted back to dollars.

• If gains and losses from this translation flowed through directly to the income statement, there would be significant volatility in EPS.

• Current accounting regulations require that all cash flows be converted at the prevailing

exchange rates with currency gains and losses accumulated in a special account within

Managing exchange rate

risk

• Large multinational firms may need to

manage the exchange rate risk

associated with several different

currencies.

• The firm needs to consider its net

exposure to currency risk instead of

just looking at each currency

separately.

Political risk

• Risk of changes in value owing to political actions

in the foreign country.

• Investment in countries that have unstable

governments should require higher returns.

• The extent of political risk depends on the nature

of the business.

– The more dependent the business is on other

operations within the firm, the less valuable it is to

others.

– Natural resource development can be very valuable to others, especially if much of the groundwork in

developing the resource has already been done.

• Local financing can often reduce political risk.

Quick quiz

• What does an exchange rate tell us?

• What is triangle arbitrage?

• What are absolute purchasing-power

parity and relative purchasing-power

parity?

• What are covered interest arbitrage and

interest rate parity?

• What is the difference between short-run

interest rate exposure and long-run

interest rate exposure? How can you

hedge each type?

Chapter 18

END