1. Managing International Risks
Principles of
Corporate Finance
Tenth Edition
Chapter 27
Managing International Risks
Slides by
Matthew Will
McGraw-Hill/Irwin
Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved. 1 1 1 1 1 2

2. Topics Covered The Foreign Exchange Market Some Basic Relationships
Hedging Currency Risk
Exchange Risk and International Investment Decisions
Political Risk 2 2 2 2 3 2

3. Exchange Rates
July 24, 2009

4. Foreign Exchange Markets
Exchange Rate - Amount of one currency needed to purchase one unit of another. Spot Rate of Exchange - Exchange rate for an immediate transaction. Forward Exchange Rate - Exchange rate for a forward transaction. 3

5. 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. 8

6. 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 6.67 % or a 1 year US bond (in 1.505%. The spot rate is peso:$1 The 1 year forward rate is peso:$1
Which bond will you prefer and why?
Ignore transaction costs 9

7. 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 6.67 % or a 1 year US bond (in 1.505%. The spot rate is peso:$1 The 1 year forward rate is peso:$1.
Which bond will you prefer and why? Ignore transaction costs
Value of US bond = $1,000,000 x = $1,015,000
Value of Mexican bond = $1,000,000 x = 13,215,500 peso exchange
13,215,500 peso x = 14,096,974 peso bond pmt
14,096,974 peso / = $1,014, exchange 14

8. Exchange Rate Relationships
3) Purchasing Power Parity
The expected change in the spot rate equals the expected difference in inflation between the two countries. 16

9. Exchange Rate Relationships
Example - If inflation in the US is forecasted at 1.0% this year and Mexico is forecasted at 6.0%, what do we know about the expected spot rate? Given a spot rate of peso:$1
solve for Es
Es = 20

10. 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 21

11. Exchange Rate Relationships
Example - The real interest rate in each country is about the same 23

12. 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 6.0% or a 1 year US loan (in 6.8%. 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 = $106,800
Cost of Swiss Loan = $100,000 x = 107,230 sf exchange
107,230 sf x 1.06 = 113,664 sf loan pmt
113,664 sf / = $106,797 exchange
If the two loans created a different result, arbitrage exists!

13. Exchange Rates
% Forecast Error in Forward Rate for Swiss Francs

14. International Prices
The Big Mac Index – The price of a Big Mac in different countries (July 16, 2009)

15. Exchange Rates Nominal versus Real Exchange Rates
U.S. Dollar / UK (in log scale)

16. Exchange Rates Nominal versus Real Exchange Rates
U.S. Dollar / France (in log scale)

17. Exchange Rates Nominal versus Real Exchange Rates
U.S. Dollar / Italy (in log scale)

18. Interest Rates and Inflation
Countries with the highest interest rates generally have the highest inflation rates. In this diagram each of the 55 points represents a different country.
Turkey
Japan

19. 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 1,136,460 yen in Japan. If the dollar rises in value and the exchange rate is 103Y:$1, what will the motorcycle cost in Japan?
$12,000 x = 1,236,000 yen 27

20. 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 29

21. Capital Budgeting Techniques
1) Exchange to $ and analyze 2) Discount using foreign cash flows and interest rates, then exchange to $. 3) Choose a currency standard ($) and hedge all non dollar CF. 30

22. Example
Suppose that the Swiss pharmaceutical company, Roche, is evaluating a proposal to build a new plant in the United States. To calculate the project’s net present value, Roche forecasts the following dollar cash flows from the project. The US cost of capital is 12% and the spot exchange rate is 1.2sf / 1 $ . What is the project value in US dollars and Swiss francs?
year
NPV ($) = $ 513 million
NPV (sf) = $513 x 1.2 (sf/$) = 616 sf million

23. Example
Suppose that the Swiss pharmaceutical company, Roche, is evaluating a proposal to build a new plant in the United States. To calculate the project’s net present value, Roche forecasts the following dollar cash flows from the project. The US cost of capital is 12% and the spot exchange rate is 1.2sf / 1 $ . What are the forward rates in each year, if risk free rates are US = 6% and Swiss = 4%?
year
A: (Ff/$) = ( 1 + rf )t solve for Ff/$
Sf/$ ( 1 + r$ )t
year
Ff/$

24. Example
Suppose that the Swiss pharmaceutical company, Roche, is evaluating a proposal to build a new plant in the United States. To calculate the project’s net present value, Roche forecasts the following dollar cash flows from the project. The US cost of capital is 12% and the spot exchange rate is 1.2sf / 1 $ . What are the cash flows in each year, given the forward rates?
year
A: CFf = (Ff/$) x CF$
year
CF$
Ff/$
CFf

25. Example
Suppose that the Swiss pharmaceutical company, Roche, is evaluating a proposal to build a new plant in the United States. To calculate the project’s net present value, Roche forecasts the following dollar cash flows from the project. The US cost of capital is 12% and the spot exchange rate is 1.2sf / 1 $ . What is the NPV of the project in Swiss francs?
A: franc return = ( 1 + rf ) solve for Franc return dollar return ( 1 + r$ )
Franc return = 9.9%
NPV (sf) = 616 sf

26. Political Risk

27. Web Resources Click to access web sites Internet connection required