International aspects of financial management

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 interes

International Aspects of Financial Management

International Aspects of Financial Management

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 it 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

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 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 facilitate the flow of capital are

extremely important to developing countries

• The United States has one of the most

developed capital markets in the world, but

foreign markets are becoming more

competitive, and they are often willing to try

more innovative ways to do business

Example: Work the Web

• Thinking about going to Mexico for spring

break or Japan for your summer vacation?

• How many pesos or yen can you get in

exchange for $1,000?

• Click on the Web surfer to find out

Exchange Rates

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

another

• Most currency is quoted in terms of dollars

• Consider the following quote:

– Euro 1.34922 74117

– The first number (1.34922) is how many U.S

dollars it takes to buy 1 euro

– The second number ( 74117) is how many

euros it takes to buy U.S.$1

– The two numbers are reciprocals of each other

(1/ 74117 = 1.34922)

Example: Exchange Rates

• Suppose you have $10,000 Based on the

rates in Figure 18.1, how many Norwegian

Krone can you buy?

– Exchange rate = 6.2461 Krone per U.S dollar

– Buy 10,000(6.2461) = 62,461 Krone

• Suppose you are visiting London and you

want to buy a souvenir that costs 1,000 British

pounds How much does it cost in U.S

dollars?

– Exchange rate = $1.9669 dollars per pound

– Cost = 1,000 X 1.9669 = $1,966.90

• We observe the following fictitious quotes:

– 1 Euro per $1

– 2 Swiss Franc per $1

– 4 Euro per 1 Swiss Franc

• What is the cross rate?

– (1 Euro / $1) / (2 SF / $1) = 5 Euro / SF

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

– Buy $100(1 Euro/$1) = 100 Euro, use Euro to buy

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,

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 – hUS)]t

• Because absolute PPP doesn’t hold for

many goods, we will focus on relative

PPP from here on

• Suppose the Canadian spot exchange rate is

1.18 Canadian dollars per U.S dollar U.S

inflation is expected to be 3% per year and

Canadian inflation is expected to be 2%

– Do you expect the U.S dollar to appreciate or

depreciate relative to the Canadian dollar?

• Since expected inflation is higher in the U.S., we would expect the U.S dollar to depreciate relative to the

Canadian dollar.

– What is the expected exch rate in one year?

• E(S 1 ) = 1.18[1 + (.02 - 03)] 1 = 1.1682

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 U.S dollar

• The U.S risk-free rate is assumed to be

the T-bill rate

• Consider the following information

– In 1 year, receive 80(1.02) = 81.6 Euro and

convert back to dollars

– 81.6 Euro / (.7 Euro / $) = $116.57 and repay

loan

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

US FC

US FC

R

R S

F

R

R S

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

favor

Long-Run Exposure

• Long-run fluctuations come from

unanticipated changes in relative

economic conditions

• Could be due to changes in labor

markets or governments

• More difficult to hedge

• Try to match long-run inflows and

outflows in the currency

• Borrowing in the foreign country may

mitigate some of the problems

• Income from foreign operations has to be

translated back to U.S 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

• 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 is the difference between short-run

interest rate exposure and long-run interest

rate exposure? How can you hedge each

type?

• What is political risk and what types of

Comprehensive Problem

• Assume that one U.S dollar buys 115

Japanese Yen, and one U.S dollar buys

54 Pound Sterling.

• What must the dollar – pound exchange

rate be in order to prevent triangular

arbitrage (ignore transaction costs)?