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