International Business Finance

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International Business Finance

• Chapter 15

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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 in the U.S.
• 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 in the
  U.S. and
• U.S. products become cheaper overseas.

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Spot Exchange Rates

• What is a spot exchange rate?
• The price of one unit of foreign currency in
  terms of the domestic currency traded today
• for example 1.50/
• The direct spot exchange rate quote
• The price of one unit of foreign currency stated
  in local currency terms
• In the U.S. 1.50/ is the direct quote

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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 the major currency 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)

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What Determines Exchange Rates?

• Supply and Demand for currencies!
• Lets consider the London market for U.S. dollars
  ( / ) 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 go to London to 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)
..80/U.S.
.667/U.S.
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What Determines Exchange Rates?

• Another example
• Lets consider the Japanese market for U.S.
  dollars in Tokyo ( / ).

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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. Assume they buy yen with
  dollars in Tokyo, so they can pay Japanese firms
  in yen.
• The supply of U.S. floods the market and forces
  down the / exchange rate, which makes
  Japanese products more expensive in the U.S.
  because the dollar has depreciated.

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What Determines Exchange Rates?
120/
100/
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Exchange Rates and Arbitrage

• Foreign exchange quotes in two different
  countries must be in line with each other.
• If the exchange rates are out of line, then a
  trader could make a profit by buying in the
  market where the currency was cheaper and selling
  it in the other.
• The process of buying and selling in more than
  one market to make a riskless profit is called
  arbitrage. Such opportunities do not exist for a
  long time due to arbitrage process.

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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 Norwegian Krone 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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• What is currency hedging?
• The process of mitigating or reducing exchange
  rate risk.

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Forward Market Hedge

• Example You will import fish from Norway, to be
  delivered and paid in 6 months.
• You have agreed to a price of 500,000 krone.
  With the spot exchange rate of .1457, this comes
  to 72,850.
• Suppose the dollar weakens over the next 6
  months, and the /NOK exchange rate rises to .20.
• The fish 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 /NOK 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 krone, 6 months from now.
• Now it doesnt matter what happens to the /NOK
  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 krone now (at the current spot
  exchange rate of .1457) for 72,850.
• 3) Invest the 500,000 krone in interest-bearing
  Norwegian 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 the spot rate, the
  forward is trading at a premium.
• If the forward rate forward is trading at a discount.

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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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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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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.

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Globalization of Products and Financial Markets

• Direct Foreign Investment
• Occurs when the multinational corporation (MNC)
  has control over the investment, such as when it
  builds an offshore manufacturing facility.
• Portfolio Investment
• Financial assets with maturities greater than one
  year such as purchase of foreign stock and bonds.
• Total foreign investment in the U.S. now exceeds
  such U.S. investment overseas.

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International Financial Investment

• Major reasons for long-run overseas investments
• Earn higher returns than those obtainable in the
  domestic capital markets.
• Reduce portfolio risk through international
  diversification.

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Exchange Rates
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Exchange Rates

• Floating-rate international currency system is a
  system in which exchange rates between different
  national currencies are allowed to fluctuate with
  supply and demand conditions.

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Exchange Rates

• A countrys relative economic strengths, trade
  balance, level of monetary activity, and BOP are
  important determinants of exchange rates.
• Short-term day to day fluctuations in exchange
  rates are caused by changing supply and demand
  conditions in the foreign exchange market.

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Euroland and the Eurodollar

• Since Jan 2002, 11 countries in the European
  Union began circulating a new single currency,
  the Euro.
• These countries, which are often referred to as
  Euroland, include Germany, France, Italy,
  Spain, Portugal, Belgium, Netherlands,
  Luxembourg, Ireland, Finland and Austria
• Germany and France account for over 50 percent of
  Eurolands output.

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Rationale for Euro

• Easier for goods, people and services traveling
  across national borders
• Eliminates exchange costs when trading between
  countries
• Eliminates the uncertainty associated with
  exchange rate fluctuations
• Eliminates cost differences for goods in
  different countries
• Easier to compare prices and reduce the
  discrepancies

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Implications of Euro for USA

• Competition from Eurozone will be stronger in the
  future.
• Euro will be an important currency.
• If Euro is strong, it will boost US exports.
• If Euro is weak, US exports will suffer.

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The Foreign Exchange Market

• The Foreign Exchange Market is organized as an
  over-the-counter market i.e. a network of
  telephone and computer connections among banks,
  foreign exchange dealers, and brokers.

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• The FE market operates at three levels
• Level 1 Customers buy and sell foreign exchange
  through their banks.
• Level 2 Banks buy and sell foreign exchange from
  other banks in the same commercial center.
• Level 3 Banks buy and sell foreign exchange from
  banks in commercial centers in other countries
  (i.e. New York, London, Zurich, Frankfurt, Hong
  Kong, Singapore, Tokyo).

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Exchange Rates and Quotes

• Exchange rate
• The price of foreign currency in terms of the
  domestic currency
• Spot Transactions at spot rate
• In a spot transaction, one currency is traded for
  another currency today
• Rates are typically Direct Quotes

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Direct and Indirect Quote

• Direct Quote
• Indicates the number of units of the home
  currency required to buy one unit of the foreign
  currency
• Example 1.8720 dollars per British pound
• Indirect Quote
• Indicates the number of units of a foreign
  currency that can be bought for one unit of the
  home currency. It is the reciprocal of direct
  quote.
• Example .5342 pounds per dollar

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Bid and Ask rates

• Bid Rate at which bank buys foreign currency
  from a customer
• Ask Rate at which bank sells foreign currency to
  a customer
• The difference between the asked quote and the
  bid quote is known as bid-asked spread.

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Forward rate

• A forward exchange contract requires delivery, at
  a specified future date, of one currency for a
  specified amount of another currency.
• The exchange rate for the future is agreed today
  and is known as the forward rate. The actual
  payment of one currency and receipt of another
  currency take place at the future date

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Forward contract example

• Forward contracts are usually quoted for periods
  of 30, 90, and 180 days.
• If the 30-day forward quote for Euros is 1.30,
  it means that the bank is contractually bound to
  deliver Euro at 1.30 and the customer is bound
  to buy Euro at 1.30, regardless of the actual
  spot rate.

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Exchange Rate Risk

• The risk that tomorrows exchange rate will
  differ from todays rate.
• Exchange rate risk affects
• International trade contracts
• Foreign portfolio investments
• Direct foreign investment

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Exchange Rate Risk in International Trade
Contracts

• Example You are expecting to receive 1m Euros
  next year from exports.
• The future value of Euros in dollars is uncertain
  and depends on future exchange rate.
• If Euro 1.25, you will receive 1.25m but if
  the Euro depreciates to .90, your contract is
  worth only .90m

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Exchange Rate Risk in Foreign Portfolio
Investments

• The future return on a portfolio is unknown as
  investments in securities is a risky investment.
  Thus investing in Euro market could yield -5 or
  10. In addition, the investor is exposed to US
  /Euro exchange rate fluctuation.
• Thus if the Euro investment yields 10 but the
  Euro depreciates during the period, the net
  return will be less than 10 depending on the
  extent of Euro depreciation.

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Exchange Rate Risk in Direct Foreign Investment

• In a DFI, a parent company invests in assets
  denominated in foreign currency. The US based
  parent company receives the repatriated profit
  stream from the subsidiary in dollars.
• Thus exchange rate risk arises due to
• Fluctuations in the dollar value of the assets
  located abroad.
• Fluctuations in the home currency-denominated
  profit stream.

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Interest-Rate Parity Theory

• Interest Rate Parity Theory states that the
  forward premium or discount (except for the
  effects of small transaction costs) should be
  equal and opposite in size to the difference in
  the national interest rates for securities of the
  same maturity.
• In other words, because of arbitrage, the
  interest rate differential between two countries
  must be equal to the difference between the
  forward and spot exchange rates.

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Exposure to Exchange Rate Risk

• Three Measures of foreign exchange exposure
• Transaction Exposure
• Translation Exposure
• Economic Exposure

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Transaction Exposure

• Transaction exposure refers to the net contracted
  foreign currency transactions (such as
  receivables, payables, fixed price sales or
  purchase contract) for which the settlement
  amounts are subject to changing exchange rates.
• Transaction exposure can be hedged by using money
  market hedge, or forward contracts or futures
  contracts or options.

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Translation Exposure

• Translation exposure risk arises because the
  foreign operations of MNCs have financial
  statements denominated in the local currencies of
  the countries in which the operations are
  located. These denominations must be translated
  into the MNCs home currency at the prevailing
  exchange rate.
• Exchange rate gains or losses due to translation
  exposure are not realized, and have little or no
  impact on taxable income.

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Economic Exposure

• Economic exposure refers to the overall impact of
  exchange rate changes on the value of the firm.
  This change in value may be caused by a rate
  change-induced decline in the level of expected
  cash flows and/or by an increase in the riskiness
  of these cash flows.

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Direct Foreign Investment
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Direct Foreign Investment

• The decision process for DFI is similar to
  capital budgeting decisions in the domestic
  context.
• Risks in domestic capital budgeting arise from
  two sources business risk and financial risk.
• In international capital budgeting problems, we
  also have to incorporate political risk and
  exchange risk.

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Political Risk

• Political risk arises because the foreign
  subsidiary conducts business in a political
  system different from that of the home country.
• Some examples of such risk include
• Expropriation of assets without compensation
• Nonconvertibility of the subsidiarys foreign
  earnings into the parents currency
• Changes in the laws governing taxation
• Restrictions on sale price, wage rates, local
  borrowing, extent of local ownership, hiring of
  personnel, transfer payments made to the parent.

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Exchange Rate Risk

• As observed before, exchange rate risks can have
  significant effect on cash flows and earnings.