Lecture Essentials of corporate finance - Chapter 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

• Foreign Exchange Markets and Exchange Rates

• Purchasing Power Parity

• Exchange Rates and Interest Rates

• Exchange Rate Risk

• Political Risk

– 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 consider the

international capital markets and this may reduce the

firm’s cost of capital

Global Capital Markets

• The number of exchanges in foreign countries continues to increase, as does the liquidity on those exchanges

• Exchanges that allow for the flow of capital are extremely

important to developing countries

• Australia and New Zealand have well developed capital

markets in world terms

• International foreign markets are becoming more competitive and are often willing to try more innovative ways to do

business

• The price of one country’s currency in terms of another

• All currencies are in some way quoted to U.S dollars

– Most countries are in terms of U.S dollars except for countries like Australia and New Zealand

• Consider the following quote:

Example: Exchange Rates

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

many U.S Dollars can you buy?

– Exchange rate = 0.8213 U.S dollar per Australian dollar

– Buy 10,000(0.8213) = $8,213 U.S 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 = $2,022.24

Example: Triangle Arbitrage

• We observe the following quotes:

– 29.10 Thai Baht (THB) per $1AUD

– 2.882 Singapore $ (SGD) per $1AUD

– 9.50 Thai Baht per $1SGD

• What is the cross rate?

– (29.10 THB/$1) / (2.882 SGD/$1) = 10.10 THB per SGD

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

– Buy $100(29.10THB/$1) =2910THB, use THB to buy SGD

– Buy 2910THB /(9.5THB/SGD) = 306.32SGD, use SGD to buy AUD dollars

– Buy 306.32SGD / (2.882SGD/$1) = $106.29

– Make $6.29 risk-free

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)

– If the forward rate is lower than the spot rate, the foreign currency is selling at a discount

Absolute Purchasing Power Parity

• Price of an item is the same regardless of the

currency used to purchase it

• Requirements for absolute PPP to hold

– Transaction costs are zero

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

– No difference in the commodity between locations

• Absolute PPP rarely holds in practice for many 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(St ) = S0[1 + (hFC – hAUD)]t

• Because absolute PPP doesn’t hold for many

goods, we will focus on relative PPP from here on

Example: PPP

• 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.

– What is the expected exchange in one year?

• E(S1) = 1.4680[1 + (.02 - 03)] 1 = 1.4533

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

Example: Covered Interest Arbitrage

• Consider the following information:

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

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

Interest Rate Parity

• Based on the previous example, there must be a forward rate that would prevent the arbitrage

opportunity

• Interest rate parity defines what that forward rate should be

)(

1  

:Approx

)1

(

)1

(  

:Exact

0 1 0 1

AUD FC

AUD FC

R

R S

F

R

R S

F

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

Long-Run Exposure

• Long-run fluctuations come from unanticipated

changes in relative economic conditions

• Could be due to changes in labour markets or

governments

• More difficult to hedge

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

• Borrowing in the foreign country may mitigate

some of the problems

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 shareholders equity

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

• Hedging individual currencies could be expensive and may actually increase exposure

Political Risk

• Changes in value due 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 ground work 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 are uncovered interest parity and the International Fisher