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CORPORATE FINANCIAL THEORY Lecture 12. International Finance Today Capital Budgeting (international style) Financing (international style) Topics Exchange.

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Presentation on theme: "CORPORATE FINANCIAL THEORY Lecture 12. International Finance Today Capital Budgeting (international style) Financing (international style) Topics Exchange."— Presentation transcript:

1 CORPORATE FINANCIAL THEORY Lecture 12

2 International Finance Today Capital Budgeting (international style) Financing (international style) Topics Exchange rates Currency risk Managing Currency Risk Capital Budgeting w/ currency risk Financing w/currency risk

3 Foreign Exchange Markets Exchange Rate - Amount of one currency needed to purchase one unit of another. Spot Rate The price of a currency for immediate delivery (i.e. today’s exchange rate) Forward Rate The price of a currency on a specified future date (i.e. a forward contract in which the exercise price is the exchange rate) Futures - Same as forward (w/secondary markets) Options - on exchange rates & Future Ks

4 Exchange Rates

5 Foreign Exchange Markets Forward Premiums and Forward Discounts Example - The Peso spot price is peso per dollar and the 3 month forward rate is Peso per dollar, what is the premium and discount relationship?

6 Foreign Exchange Markets Forward Premiums and Forward Discounts Example - The Peso spot price is peso per dollar and the 3 month forward rate is Peso per dollar, what is the premium and discount relationship? Answer - The dollar is selling at a 1.90% premium, relative to the peso. The peso is selling at a 1.90% discount, relative to the dollar.

7 Exchange Rates Example SF Swiss franc spot price is SF per $1 SF Swiss franc 6 mt forward price is SF per $1 The franc is selling at a Forward Premium The Dollar is selling at a Forward Discount  This means that the market expects the dollar to get weaker, relative to the franc Example (premium? discount?) The Japanese Yen spot price is per $1 The Japanese 6mt fwd price is per $1

8 Exchange Rates Example What is the franc premium (annualized)? Example What is the Yen discount (annualized)?

9 Exchange Rate Relationships Basic Relationships equals

10 Exchange Rate Relationships 1) Interest Rate Parity Theory  The ratio between the risk free interest rates in two different countries is equal to the ratio between the forward and spot exchange rates.

11 Exchange Rate Relationships Example - You have the opportunity to invest $1,000,000 for one year. All other things being equal, you have the opportunity to obtain a 1 year Mexican bond (in 7.35 % or a 1 year US bond (in 5.05%. The spot rate is peso:$1 The 1 year forward rate is peso:$1 Which bond will you prefer and why? Ignore transaction costs

12 Value of US bond = $1,000,000 x = $1,050,500 Value of Mexican bond = $1,000,000 x = 10,989,200 peso exchange 10,989,200 peso x = 11,796,906 peso bond pmt 11,796,906 peso / = $1,050,725 exchange Exchange Rate Relationships Example - You have the opportunity to invest $1,000,000 for one year. All other things being equal, you have the opportunity to obtain a 1 year Mexican bond (in 7.35 % or a 1 year US bond (in 5.05%. The spot rate is peso:$1 The 1 year forward rate is peso:$1 Which bond will you prefer and why? Ignore transaction costs

13 Exchange Rate Relationships 2) Expectations Theory of Exchange Rates Theory that the expected spot exchange rate equals the forward rate.

14 Exchange Rate Relationships 3) Purchasing Power Parity The expected change in the spot rate equals the expected difference in inflation between the two countries.

15 Exchange Rate Relationships Example - If inflation in the US is forecasted at 2.5% this year and Mexico is forecasted at 4.7%, what do we know about the expected spot rate? Given a spot rate of peso:$1 solve for Es Es =

16 Exchange Rate Relationships 4) International Fisher effect The expected difference in inflation rates equals the difference in current interest rates. Also called common real interest rates

17 Exchange Rate Relationships Example - The real interest rate in each country is about the same

18 Exchange Rates Another Example You are doing a project in Switzerland which has an initial cost of $100,000. All other things being equal, you have the opportunity to obtain a 1 year Swiss loan (in 8.0% or a 1 year US loan (in 10%. The spot rate is sf:$1 The 1 year forward rate is sf:$1 Which loan will you prefer and why? Ignore transaction costs Cost of US loan = $100,000 x 1.10 = $110,000 Cost of Swiss Loan = $100,000 x = 144,570 sf exchange 144,570 sf x 1.08 = 156,135 sf loan pmt 156,135 sf / = $110,000exchange If the two loans created a different result, arbitrage exists!

19 Exchange Rates Swiss Example Given a spot rate of sf:$ :$1 Given a 1yr fwd rate of :$1 If inflation in the US is forecasted at 4.5% this year, what do we know about the forecasted inflation rate in Switzerland?

20 Exchange Rates Swiss Example  In the previous examples, show the equilibrium of interest rates and inflation rates

21 Currency Risk Example Your US company is building a plant in Switzerland. Your cost will be 2,000,000 sf, with full payment due in 6 months. You are concerned about currency risk. The spot rate is sf:$1 and the 6 mt forward rate is sf:$1. How can you eliminate the currency risk? How does this help in evaluating the project?

22 Currency Risk Example Your US company is building a plant in Switzerland. Your cost will be 2,000,000 sf, with full payment due in 6 months. You are concerned about currency risk. The spot rate is sf:$1 and the 6 mt forward rate is sf:$1. How can you eliminate the currency risk? How does this help in evaluating the project? Since you are short in Swiss Francs, you should long sf contracts 2,000,000sf / = $1,393,728 worth of 6mt sf Ks. This will lock in your Co cash flow at $1,393,728 The forward premium paid is 0.33% (using capital market equilibrium, this premium probably equals the inflation rate.

23 Exchange Rates Applications Q: What does it mean to a business if the dollar is trading at a forward premium? A: Stronger purchasing power

24 Exchange Rate Risk  Currency Risk can be reduced by using various financial instruments  Currency forward contracts, futures contracts, and even options on these contracts are available to control the risk

25 Capital Budgeting 1) Exchange to $ and analyze 2) Discount using foreign cash flows and interest rates, then exchange to $.  Option 1 preferred because discount rates in US are more reliable. Techniques

26 Example Outland Corporation is building a plant in Holland to produce reindeer repellant to sell in that country. The plant is expected to produce a cash flow (in guilders,000s) as follows. The US risk free rate is 8%, the Dutch rate is 9%. US inflation is forecasted at 5% per year and the current spot rate is 2.0g:$1. year Q: What are the 1, 2, 3, 4, 5 year forward rates? A:

27 Example Outland Corporation is building a plant in Holland to produce reindeer repellant to sell in that country. The plant is expected to produce a cash flow (in guilders,000s) as follows. The US risk free rate is 8%, the Dutch rate is 9%. US inflation is forecasted at 5% per year and the current spot rate is 2.0g:$1. year

28 Example Outland Corporation is building a plant in Holland to produce reindeer repellant to sell in that country. The plant is expected to produce a cash flow (in guilders,000s) as follows. The US risk free rate is 8%, the Dutch rate is 9%. US inflation is forecasted at 5% per year and the current spot rate is 2.0g:$1. year Q: Convert the CF to $ using the forward rates CFg E(S) CF$

29 Political Risk

30

31 Trade Policy

32 Exchange Rate Risk Example - Honda builds a new car in Japan for a cost + profit of 1,715,000 yen. At an exchange rate of Y:$1 the car sells for $14,209 in Indianapolis. If the dollar rises in value, against the yen, to an exchange rate of 134Y:$1, what will be the price of the car? 1,715,000 = $12, Conversely, if the yen is trading at a forward discount, Japan will experience a decrease in purchasing power.

33 Exchange Rate Risk Example - Harley Davidson builds a motorcycle for a cost plus profit of $12,000. At an exchange rate of Y:$1, the motorcycle sells for 1,448,400 yen in Japan. If the dollar rises in value and the exchange rate is 134Y:$1, what will the motorcycle cost in Japan? $12,000 x 134 = 1,608,000 yen

34 Trade Policy

35 Employment Conventional wisdom We are losing all of our jobs to Mexico, China, and India?FALSE

36 Employment Trend Source: Bureau of Labor Statistics Population 2007 = 301 mil 1970 = 203 mil 2007 = 301 mil 1970 = 203 mil

37 Employment & Foreign Trade Source: Bureau of Labor Statistics Population 2007 = 301 mil 1970 = 203 mil 2007 = 301 mil 1970 = 203 mil Employed

38 UIndy Nightly News  News Alert on the unemployment report released today by the Department of Labor.

39 PR - News Releases  “Last month the unemployment rate in the United States increased slightly from 4.6% to 4.7%. White House officials were quick to point out that at the same time the U.S. economy added 141,000 new jobs.”  “Last month 322,000 manufacturing jobs were lost. Union leaders site cheap overseas labor costs as the culprit, saying that good jobs are leaving the US and the economy will suffer.”

40 Behind The Numbers September 2007  Unemployment = 4.7% Jobs added 463,000 Jobs lost322,000 Net change +141,000 Source: Bureau of Labor Statistics

41 Behind The Numbers Totals for 2006  Unemployment = 4.6% Jobs added 2,697,000 Jobs lost 625,000 Net change +2,072,000 Source: Bureau of Labor Statistics

42 Employment  But are they better paying jobs? Source: Bureau of Labor Statistics

43 Employment Source: Bureau of Labor Statistics

44 Foreign Trade Conventional wisdom We have huge trade deficits with other countries. These large trade deficits are destroying our economy.FALSE

45 Foreign Trade Source: US Census Bureau

46 Trade Deficit and Economic Strength Source: S&P & Nikkei

47 Comparative Advantage Wants Needs

48 Comparative Advantage Wants Needs

49 Comparative Advantage Wants Needs

50 Foreign Trade Why does this work? China Stuff Cash Dollars Wall Street & (Indiana) Wall Street & (Indiana) Wall Street invests this money, which… 1.creates more jobs, which… 2.grows the economy, which… 3.strengthens the dollars, which… 4.starts the cycle again KEY Strong Dollar

51 What We Know  Net Present Value  Capital Asset Pricing Model (CAPM)  Efficient Capital markets  Value Additivity & Conservation  Option Theory  Agency Theory

52 What We Do Not Know  How major decisions are made  What determines the risk & PV ?  CAPM shortfalls  Why are some markets inefficient?  Is management a liability?

53 What We Do Not Know  Why do IPOs succeed & new markets emerge?  Why is capital structure not optimized?  Dividend policy - Answer?  Liquidity value?  Why do mergers come in waves?

54 Review for Final In normal class room Topics Format Difficulty Bonus Points


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