Chapter Outline

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Chapter Outline

• 32.1 Terminology
• 32.2 Foreign Exchange Markets and Exchange Rates
• 32.3 The Law of One Price and Purchasing Power
  Parity
• 32.4 Interest Rates and Exchange Rates Interest
  Rate Parity
• 32.5 International Capital Budgeting
• 32.6 International Financial Decisions
• 32.7 Reporting Foreign Operations
• 32.8 Summary and Conclusions

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32.1 Terminology

• Cross rate the exchange rate between two foreign
  currencies, e.g., the exchange rate between and
  .
• Euro is a basket of 10 European currencies and
  serves as the monetary unit for the European
  Monetary System. Effective January 2002, the euro
  replaced the 10 currencies.
• Eurobonds bonds denominated in a particular
  currency and issued simultaneously in the bond
  markets of several countries.

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32.1 Terminology

• Eurocurrency money deposited in a financial
  centre outside the home country. Eurodollars are
  dollar deposits held outside the U.S. Euroyen
  are yen denominated deposits held outside Japan.
• Foreign bonds bonds issued in another nations
  capital market by a foreign borrower.
• Gilts British and Irish government securities.
• LIBOR the London Interbank Offer Rate is the
  rate most international banks charge on another
  for loans of Eurodollars overnight in the London
  market.

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32.1 Terminology

• SWAPs
• Interest rate swaps when two parties exchange
  debt with a floating-rate payment for debt with a
  fixed-rate payment.
• Currency swaps agreements to deliver one
  currency against another currency.
• Export Development Corporation (EDC) a federal
  Crown corporation with a mandate to promote
  Canadian exports.

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32.2 Foreign Exchange Markets and Exchange Rates

• Without a doubt the foreign exchange market is
  the worlds largest financial market.
• In this market one countrys currency is traded
  for anothers.
• Most of the trading takes place in a few
  currencies
• The U.S. dollar
• The euro
• The British pound sterling
• The Japanese Yen
• The Swiss franc

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FOREX Market Participants

• The FOREX market is a two-tiered market
• Interbank Market (Wholesale)
• About 700 banks worldwide stand ready to make a
  market in Foreign exchange.
• Nonbank dealers account for about 20 of the
  market.
• There are FX brokers who match buy and sell
  orders but do not carry inventory and FX
  specialists.
• Client Market (Retail)
• Market participants include international banks,
  their customers, nonbank dealers, FOREX brokers,
  and central banks.

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Correspondent Banking Relationships

• Large commercial banks maintain demand deposit
  accounts with one another that facilitates the
  efficient functioning of the forex market.
• International commercial banks communicate with
  one another with
• SWIFT The Society for Worldwide Interbank
  Financial Telecommunications.
• CHIPS Clearing House Interbank Payments System
• ECHO Exchange Clearing House Limited, the first
  global clearinghouse for settling interbank FOREX
  transactions.

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Spot Rate Quotations

• The spot market is the market for immediate
  delivery. (Settlement is due within two days.)
• Direct quotation
• the U.S. dollar equivalent
• e.g., a Japanese Yen is worth about a penny
• Indirect Quotation
• the price of a U.S. dollar in the foreign
  currency
• e.g., you get 100 yen to the dollar

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Spot FX trading

• In the interbank market, the standard size trade
  is about U.S. 10 million.
• A bank trading room is a noisy, active place.
• The stakes are high.
• The long term is about 10 minutes.

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Cross Rates

• Suppose that SDM(0) .50
• i.e. 1 2 DM in the spot market
• and that S(0) 100
• i.e. 1 100
• What must the DM/ cross rate be?

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Triangular Arbitrage
Suppose we observe these banks posting these
exchange rates.


First calculate the implied cross rates to see if
an arbitrage exists.
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Triangular Arbitrage
The implied S(/) cross rate is S(/) 80

Credit Agricole has posted a quote of S(/)85
so there is an arbitrage opportunity.

So, how can we make money?
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Triangular Arbitrage
As easy as 1 2 3


1. Sell our for , 2. Sell our for , 3.
Sell those for .
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Triangular Arbitrage
Sell 100,000 for at S(0) 1.50 receive
150,000
Sell our 150,000 for at S/(0) 85 receive
12,750,000
Sell 12,750,000 for at S(0) 120
receive 106,250
profit per round trip 106,250- 100,000
6,250
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The Forward Market

• A forward contract is an agreement to buy or sell
  an asset in the future at prices agreed upon
  today.
• If you have ever had to order an out-of-stock
  textbook, then you have entered into a forward
  contract.

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Forward Rate Quotations

• The forward market for FOREX involves agreements
  to buy and sell foreign currencies in the future
  at prices agreed upon today.
• Bank quotes for 1, 3, 6, 9, and 12 month
  maturities are readily available for forward
  contracts.
• Longer-term swaps are available.

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Forward Rate Quotations

• Suppose you observe that for Japanese yen, the
  spot rate is
• 115.75 1.00
• While the 180-day forward rate is
• 112.80 1.00
• Whats up with that?
• The FOREX market clearly thinks that the yen is
  going to be worth more in six months (the yen is
  expected to appreciate) because one dollar will
  buy fewer yen.

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Long and Short Forward Positions

• If you have agreed to sell anything (spot or
  forward), you are short.
• If you have agreed to buy anything (forward or
  spot), you are long.
• If you have agreed to sell FOREX forward, you are
  short.
• If you have agreed to buy FOREX forward, you are
  long.

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32.3 The Law of One Price and Purchasing Power
Parity

• The exchange rate between two currencies should
  equal the ratio of the countries price levels.
• S(0) P ?P
• Relative PPP states that the rate of change in an
  exchange rate is equal to the differences in the
  rates of inflation.
• e ? - ?
• If Canadian inflation is 5 and U.K. inflation is
  8, the pound should depreciate by 3.

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Evidence on PPP

• PPP probably doesnt hold precisely in the real
  world for a variety of reasons.
• Haircuts cost 10 times as much in the developed
  world as in the developing world.
• Film, on the other hand, is a highly standardized
  commodity that is actively traded across borders.
• Shipping costs, as well as tariffs and quotas,
  can lead to deviations from PPP.
• PPP-determined exchange rates still provide a
  valuable benchmark.

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32.4 Interest Rates and Exchange Rates Interest
Rate Parity

• IRP is an arbitrage condition.
• If IRP did not hold, then it would be possible
  for an astute trader to make unlimited amounts of
  money exploiting the arbitrage opportunity.
• Since we dont typically observe persistent
  arbitrage conditions, we can safely assume that
  IRP holds.

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Interest Rate Parity Defined

• Suppose you have 100,000 to invest for one year.
• You can either
• Invest in Canada at i.
• Future value 100,000(1 iCan)
• Trade your dollars for yen at the spot rate,
  invest in Japan at i and hedge your exchange
  rate risk by selling the future value of the
  Japanese investment forward.
• Future value 100,000(F/S)(1 i)
• Since both of these investments have the same
  risk, they must have the same future
  valueotherwise an arbitrage would exist.
• (F/S)(1 i) (1 iCan)

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Interest Rate Parity Defined

• Formally,
• (F/S)(1 i) (1 iCan)
• or if you prefer,

IRP is sometimes approximated as
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IRP and Covered Interest Arbitrage

• If IRP failed to hold, an arbitrage would exist.
  Its easiest to see this in the form of an
  example.
• Consider the following set of foreign and
  domestic interest rates and spot and forward
  exchange rates.

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IRP and Covered Interest Arbitrage

• A trader with 1,000 to invest could invest in
  Canada, in one year his investment will be worth
  1,071 1,000?(1 i) 1,000?(1.071)
• Alternatively, this trader could exchange 1,000
  for 800 at the prevailing spot rate, (note that
  800 1,0001.25/) invest 800 at i
  11.56 for one year to achieve 892.48. Translate
  892.48 back into dollars at F(360) 1.20/,
  the 892.48 will be exactly 1,071.

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IRP Exchange Rate Determination

• According to IRP only one 360-day forward rate,
• F(360), can exist. It must be the case that
• F(360) 1.20/
• Why?
• If F(360) ? 1.20/, an astute trader could make
  money with one of the following strategies

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Arbitrage Strategy I

• If F(360) 1.20/
• i. Borrow 1,000 at t 0 at i 7.1.
• ii. Exchange 1,000 for 800 at the prevailing
  spot rate, (note that 800 1,0001.25/)
  invest 800 at 11.56 (i) for one year to
  achieve 892.48
• iii. Translate 892.48 back into dollars, if
• F(360) 1.20/ , 892.48 will be more than
  enough to repay your dollar obligation of 1,071.

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Arbitrage Strategy II

• If F(360)
• i. Borrow 800 at t 0 at i 11.56 .
• ii. Exchange 800 for 1,000 at the prevailing
  spot rate, invest 1,000 at 7.1 for one year to
  achieve 1,071.
• iii. Translate 1,071 back into pounds, if
• F(360) enough to repay your obligation of 892.48.

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IRP and Hedging Currency Risk

• You are a Canadian importer of British woolens
  and have just ordered next years inventory.
  Payment of 100M is due in one year.

IRP implies that there are two ways that you fix
the cash outflow a) Put yourself in a position
that delivers 100M in one yeara long forward
contract on the pound. You will pay
(100M)(1.2/) 120M b) Form a forward market
hedge as shown below.
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IRP and a Forward Market Hedge
To form a forward market hedge Borrow 112.05
million in Canada (in one year you will owe 120
million). Translate 112.05 million into pounds
at the spot rate S(0) 1.25/ to receive
89.64 million. Invest 89.64 million in the UK
at i 11.56 for one year. In one year your
investment will have grown to 100
millionexactly enough to pay your supplier.
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Forward Market Hedge
Where do the numbers come from? We owe our
supplier 100 million in one yearso we know that
we need to have an investment with a future value
of 100 million. Since i 11.56 we need to
invest 89.64 million at the start of the year.
How many dollars will it take to acquire 89.64
million at the start of the year if S(0)
1.25/?
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Reasons for Deviations from IRP

• Transactions Costs
• The interest rate available to an arbitrageur for
  borrowing, ib,may exceed the rate he can lend at,
  il.
• There may be bid-ask spreads to overcome, Fb/Sa F/S
• Thus
• (Fb/Sa)(1 il) ? (1 i b) ? 0
• Capital Controls
• Governments sometimes restrict import and export
  of money through taxes or outright bans.

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More Advanced Short-Term Hedges

• Currency swaps,currency options, and other
  financially engineered products are taking
  considerable business away from the forward
  exchange market.
• In 1986, the federal government of Canada made an
  80 billion-yen bond issue and swapped part of it
  into U.S. dollars.The interest rate was six-month
  LIBOR and the ending liability was in U.S.
  dollars.

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Equilibrium Exchange Rate Relationships
IFE
FP
PPP
IRP
FE
FRPPP
? - ?
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32.5 International Capital Budgeting

• A recipe for international decision-makers
• 1. Estimate future cash flows in foreign
  currency.
• 2. Convert to Canadian dollars at the predicted
  exchange rate.
• 3. Calculate NPV using the Canadian cost of
  capital.

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International Capital Budgeting Example

• Consider this European investment opportunity

Is this a good investment from the perspective of
the Canadian shareholders?
P 3 P 6 S(0) .55265
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International Capital Budgeting Example
331.6
CF0 (600) S(0) (600)(.5526/) 331.6
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International Capital Budgeting Example
331.6
113.70
CF1 (200)ES(1) ES(1) can be found by
appealing to the interest rate differential
ES(1) (1.06/1.03)? S(0)
(1.06/1.03)?(.5526/) .5687/ so CF1
(200)(.5687/) 113.7
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International Capital Budgeting Example
331.6
113.70
292.60
180.70
Similarly, CF2 (1.06)2/(1.03)2 S(0)
?(500) 292.6 CF3 (1.06)3/(1.03)3 S(0)
?(300) 180.7
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Risk Adjustment in the Capital Budgeting Process

• Clearly risk and return are correlated.
• Political risk may exist alongside of business
  risk, necessitating an adjustment in the discount
  rate.
• Firms may determine that international
  investments inherently involve more political
  risk than domestic investments.
• This extra risk may offset the gains from
  international diversification.
• Firms may increase the discount rate to allow for
  the risk of expropriation and F/X remittance
  controls.

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32.6 International Financial Decisions

• An international firm can finance foreign
  projects in three basic ways
• It can raise cash in the home country and export
  it to finance the foreign project.
• It can raise cash by borrowing in the foreign
  country where the project is located.
• It can borrow in a third country where the cost
  of debt is lowest.

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32.6 International Financial Decisions

• If a Canadian firm raises cash for its foreign
  projects by borrowing in Canada, it faces F/X
  risk.
• If the foreign currency depreciates, the Canadian
  parent firm will experience an exchange rate loss
  when the foreign cash flow is remitted to Canada.
• The Canadian firm may sell foreign exchange
  forward to hedge this risk.
• However, for many currencies, it is difficult to
  sell forward contracts beyond one year.

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Short-Term and Medium-Term Financing

• Canadian international firms have a choice
  between borrowing from a chartered bank at the
  Canadian rate or borrowing Euro-Canadian from a
  bank outside Canada through the Eurocurrency
  market.
• In the Eurocurrency market, loans are made on a
  floating-rate basis.
• Interest rates are set at a fixed margin above
  the LIBOR for the given period and currency
  involved.

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32.7 Reporting Foreign Operations

• When a Canadian multinational experiences
  favourable exchange rate movements, should this
  be reflected in the measurement of income?
• This is a controversial area. Two issues seem to
  arise
• What is the appropriate exchange rate to use for
  translating each balance-sheet account?
• How should the unrealized accounting gains and
  losses from foreign-currency translation be
  handled?
• Currency is currently translated under
  complicated rules set out by the Canadian
  Institute of Chartered Accountants (CICA) 1650.

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CICA 1650

• The rules divide a firms foreign subsidiaries
  into two categories
• Integrated
• Self-sustaining
• The rules require that all assets and liabilities
  be translated from the subsidiarys currency into
  the parents currency using the exchange rate
  that currently prevails.
• Since Canadian accountants consolidate the
  financial statements of subsidiaries owned over
  50 by the parent firm, translation gains and
  losses are reflected on the income statement of
  the parent company.

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CICA 1650

• For a self-sustaining subsidiary, any translation
  gains and losses that occur are accumulated in a
  special account within the shareholders equity
  section of the parent companys balance sheet.
• This account might be labelled something like
  unrealized foreign exchange gains (losses).
• These gains/losses are not reported on the income
  statement.
• The impact of translation gains/losses will not
  be recognized explicitly in net income until the
  underlying assets and liabilities are sold or
  otherwise liquidated.

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32.8 Summary and Conclusions

• This chapter describes some fundamental theories
  of international finance
• Purchasing Power Parity
• Expectations theory of exchange rates
• The interest-rate parity theorem
• This chapter also describes some of the problems
  of international capital budgeting.
• We briefly describe international financial
  markets.