Chapter 15 International Business Finance

1
Chapter 15International Business Finance

• Key sections
• Factors affecting exchange rates
• Nature of exchange risk and types
• How control exchange risk?

2
Introduction

• Globalization to make something worldwide in
  scope/application
• In finance, integration of countries financial
  and product markets
• Increases availability of funds and liquidity
• Made possible by computer and communications
  technologies

3
Multinational Corporations

• Multinational corporations or MNCs
• Have operations in more than one country
• Problems different languages, currencies
• financial markets, taxes, cultures, etc.

4
World Trade

• Trade growing rapidly, capital flows even faster
• US imports/exports 20 of GDP Higher in
  other countries US has high deficit in balance
  of trade (imports greater than exports)
• Overseas investment achieves diversification and
  increases returns
• Companies operating in one country not immune to
  international factors

5
Exchange Rates (X-rates)

• Price of a foreign currency in terms of the
  domestic currency
• Exchange risk future rates may be different
• Exchange markets method of transferring
  purchasing power
• Extremely active market -trades 110 billion/day

6
Market Evolution

• 1949-1970 exchange rates fixed (more or less)
• Since 1973 floating rates
• Determined by supply/demand change minute by
  minute
• Most exchange controls eliminated

7
The Euro

• 1999 11 European countries adopted common
  currency, the Euro ()
• No more DM, FF, Lira
• Easier to travel and trade goods and services
• Eliminates price differences
• Broadens/deepens capital markets

8
Exchange Rates
9
Exchange Terminology

• Devaluation currency made cheaper
• Revaluation becomes more expensive
• Direct quote number of units of home currency
  to buy one unit of foreign currency
• 50 US cents to buy one Australian dollar
• Indirect foreign units per home unit
• Two Aussies for each US1.

10
More Terminology

• Spot rate rate agreed today for exchange in two
  days
• Forward rate rate agreed today for future
  exchange
• Cross rates two foreign currencies for each
  other
• How many yen per British pound?

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Terminology Concluded

• Bid-asked spread
• Bid price- what dealer will pay for unit of
  currency, say 1.5310 /
• Asked rate dealers selling price, say
  1.5320/

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What Determines X- Rates?

• Market conditions (supply/demand)
• Economic situation growth or no-growth
• BoP surplus or deficit?
• Relative interest rates high rates attract
  capital flows
• Says Law of One Price purchasing power parity
• All based on perceived value

13
Forward Contracts

• Forward contract requires delivery at a fixed
  date of fixed amounts of two currencies
• This locks in the exchange rate
• Very little evidence that forwards accurately
  predict future spot rates

14
British Pound Forwards

• Direct (/) Indirect (/)
• Spot 1.5315 .6530
• 1 month 1.5285 .6542
• 3 months 1.5231 .6566
• 6 months 1.5149 .6601

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How Do We Use Forwards?

• Can buy forward today and will know the precise
  amount due
• . Locks in exchange rates
• . Protects against future fluctuations

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Forward Contract Example

• Spot rate (delivery in two days) 1.5315
• Six month forward 1.5149
• I owe 1,000,000 in six months
• Buy forward, locks in 1,514,900
• What if spot is 1.60 in six months without
  forward?
• Cost is 1,600,000 or 85,100 more

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Arbitrage

• Buying and selling an asset simultaneously at
  different prices, usually in different markets.
• When sale price is higher, provides riskless
  profit
• Process continues until differential no longer
  exists
• Arbitrage maintains narrow price range between
  markets

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Arbitrage Example

• Gold in New York - 200/oz London - 90
• Exchange rate is 2.00 per 1.00.
• What Would You Do?
• . Convert 180 to 90
• . Buy gold in London for 90
• . Sell in New York for 200
• .Make 20.

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Risk and Its Control

• Owe UK supplier 1 million in six months
• . Risk comes from writing contract in foreign
  currency
• . One of us is going to have to take risk

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Hedging Risk

• Hedge take action to offset risk
• Prepay? Gives up interest.
• Buy denominated asset (bank account)?Probably
  OK.
• Buy forward? Very flexible customized
• Use futures or options? Another possibility

21
Other Sources of Risk

• Foreign currency receivables
• Foreign currency securities in a portfolio
• Foreign subsidiaries have foreign currency
  revenue/expenses and asset/liabilities

22
Measuring Exposure to Risk

• Assets in foreign currency depreciate if currency
  devalues
• Liabilities also decline
• What is the net exposed position?
• Translation exposure translating accounting
  statements into dollars
• Transactions exposure when receipts or payments
  are in foreign currency

23
Economic Exposure

• Overall impact on value of the firm or its
  competitive position
• What happens to GM if yen depreciates?
• Affected by market structure and price elasticity

24
Portfolio Investment

• Purchase of foreign security Portfolio
• Return unknown risky
• In local currency return might be 2 to 8
• Exchange rate could change from 4 to 6
• For US investor return could range between 6
  and 14
• Exchange rates introduce greater variability

25
Direct Investment

• Purchase of a company or factory
• Assets (balance sheet) and income statement in
  local currency
• Profits returned in dollars
• Risk applies to dollar value of assets and the
  home currency profit stream.
• Additional risks business, financial and
  political

26
Political Risk

• Expropriation
• Inconvertibility
• Changes in taxes
• Government controls such as required local equity
  participation
• May be possible to hedge with insurance,
  government or private