International finance 5

Purchasing Power Parity PPP…– The number of units of a currency required to buy the same amount of goods and services in a domestic market that $1.00 would buy in the U.S.. Factors affec

Welcome to class of

International Finance/Forces

by

Dr Satyendra Singh University of Winnipeg

Canada

• Purchasing Power Parity

• Factors affecting Foreign currency

Purchasing Power Parity (PPP)…

– The number of units of a currency required to buy the same amount of goods and services in a domestic market that $1.00 would buy in the U.S.

– Helps to make comparisons possible across economies

CIA Fact Book

Purchasing Power Parity (PPP)If,

Factors affecting Foreign Currency

Interest rate: € (3%) and $(5%)

Speculation: Which currency becomes weaker/stronger?

Atlas Conversion Factor

• It is used for speculation

Average of FOREX for the last 2 years adjusted by the

ratio of domestic inflation and combined inflation of US,

UK, EU and Japan

Arbitrage: The process of buying and selling

instantaneously to make profit at no risk

AlgeriaDinar

BrazilRiel

ChilePeso

1:5

5 dinar

Transaction Exposure: Hedging

 Hedging

 process to reduce or eliminate financial risk

 Forward market hedge

 Foreign currency contract sold or bought forward in order to protect against foreign currency movement

 Currency option hedge

 Option to buy or sell specific amount of foreign currency at specific time to protect against foreign currency risk

 Money market hedge

 Method to hedge foreign currency exposure by borrowing and lending in domestic and foreign money markets

Forward Hedge

• Hedge is a process to reduce risk

€ 1 = $1.5 (now/spot) $ is expected to be weak

€ 1 = $1.6 (speculate/forward)

Interest rate: € (3%) and $(5%)

Suppose you have accounts receivables for €20,000

If quoted in €, supplier has no problem (ie Risk prone)

If quoted in $ (ie € 20,000 x 1.5 = $30,000),

You now get $ (ie € 20,000 x 1.6 = $32,000)

You gain: $2000, because $ became weak

You lose, if $ became stronger (say 1.4) = $2,000

Currency Option Hedge

• So you have accounts receivables in a currency that works best for your company

Money Market Hedge

• Counter balancing the risk by borrowing the same amount for FOREX (A/R) in domestic market and investing it until accounts receivables are received

Suppose the AR is €20,000 (in 90 days)

€ 1 = $1.4 (expected) $ is expected to be strong!

€ 1 = $1.5 (now)

Interest rate: € (5%) and $(3%)

Borrow €20,000  convert in $ (€ 20,000 x 1.5 = $30,000) 

Invest  Income (but pay interest)

After 90 days, pay €20,000 to local bank, so no debt

So, Investment + income - interest ≥ €20,000

Source: Wall Street Journal, Exchange rate

June 19, 2006

Fri: June 16 (SPOT)

Mon: June 19 (FORWARD)

Movement of $, Transfer Pricing

Supplier Local business

Movement of $, Transfer Pricing

Supplier Local business

30 Cents tax!

$9

Movement of $, Transfer Pricing

– 3 countries

$100 to produce $200 Sells at $200

$100 sold Profit $100

Tax paid $0 Tax paid $5 Tax paid $0

OFC: Offshore Ffinancial Centres

 Offshore financial center specializes in financing nonresidents, low taxes and few banking regulations

 Too small to exist on its own

Parallel Loan Swap

$1m

Rs 40m

$1 = Rs 40

Bank Swap

Canadian Bank in Canada

Indian Bank in India Canadian child in India

Canadian parent in Canada $1m

Rs 40m

Canadian Parent deposits $1m to the credit of the Indian Bank

The Correspondent Indian Bank lends Rs 40m (spot rate) to the Child

At a later agreed date, the Child returns Rs 40m to Indian Bank

Indian Bank instructs the Canadian Bank to pay $1m to the Parent

So, no conversion of $1 to Rs Useful if you want hard currency only

Currency Swap

So the interest rate is low for me the Cypriot

person in Cyprus

So, I take the loan for the Cypriot guy Person does the

In Canada at low interest rate same for me in

Then, we swap currency,

i.e., I service the loan in € for the Cypriot guy in CYPRUSAnd the Cypriot guy services my loan in $ in Canada

€ 1 = $1.5

Capital Structure of a Firm

 Debt  Borrow from Bank

 Conservative, report less, ↓ tax exposure, ↑ dividend pay outs  save $ to service debt  France, Germany, Japan, some Emerging Markets

 Debt financing is less expensive than equity financing, because interest paid on debt is tax deductable, but dividends paid out to shareholders are not

 Equity  Shares, Bonds

 Impressive (Inflated report) to attract investors

 Value of Bond ↓, if interest rate ↑

How do Bonds perform?

Suppose, now you have bonds worth

$10,000 @5% for a year

So expect $500 at the end of the year

Now, interest rate changed to 6%

Value of your bond now is: $x x.06 = $500

ie x = $8334

Drop in value = 17%!

Cultural Differences in Measurement and

Disclosure for Accounting Systems

International Accounting Standards

• Triple Bottom Line Standard (3BL)

– Environmental, social, and financial impacts of the business

• International Accounting Standards Board (IASB)

• International Financial Reporting Standards (IFRS)

• Sarbans-Oxley Act (2002, US)

– Public Company Accounting Reform and Investor Protection Act (in the Senate)

– Corporate and Auditing Accountability and Responsibility Act (in the House)

– Heavy penalty for corporate finance fraud

Use of International Financial Reporting Standards (IFRS)

Tax System

• Direct Tax

– Income Tax

– VAT – Value Added Tax

• Indirect Tax (Withholding Tax)

– Dividend

– Interest

– Royalty