Post on 20-Dec-2015
Chapter 15International Business
FinanceKey sections
– Factors affecting exchange rates
– Nature of exchange risk and types
– How control exchange risk?
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
Multinational Corporations
Multinational corporations or MNC’s
– Have operations in more than one country
– Problems: different languages, currencies
financial markets, taxes, cultures, etc.
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
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
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
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
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 US$1.
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?
Terminology Concluded
Bid-asked spread
Bid price- what dealer will pay for unit of currency, say $1.5310 / £
Asked rate – dealer’s selling price, say $1.5320/£
What Determines X- Rates?
Market conditions (supply/demand)Economic situation – growth or no-growth
BoP – surplus or deficit?Relative interest rates – high rates attract
capital flows
Say’s Law of One Price – purchasing power parity
All based on “perceived value”
Forward Contracts
Forward contract requires delivery at a fixed date of fixed amounts of two currencies
– This locks in the exchange rate
– Very little evidence that forwards accurately predict future spot rates
British Pound Forwards
Direct ($/£) Indirect (£/$)
Spot $1.5315 £ .6530
1 month 1.5285 .6542
3 months 1.5231 .6566
6 months 1.5149 .6601
How Do We Use Forwards?
Can buy £ forward today and will know the precise amount due
. Locks in exchange rates
. Protects against future fluctuations
£ Forward Contract Example
Spot rate (delivery in two days) = $1.5315Six 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
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 existsArbitrage maintains narrow price range between markets
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.
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
Hedging Risk
Hedge – take action to offset risk
Prepay? Gives up interest.Buy £ denominated asset (bank account)?Probably OK.Buy forward? Very flexible – customizedUse futures or options? Another possibility
Other Sources of Risk
Foreign currency receivables
Foreign currency securities in a portfolio
Foreign subsidiaries have foreign currency revenue/expenses and asset/liabilities
Measuring Exposure to Risk
Assets in foreign currency depreciate if currency devalues
Liabilities also declineWhat is the net exposed position?
Translation exposure – translating accounting statements into dollars
Transactions exposure – when receipts or payments are in foreign currency
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
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
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
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