International Financial Management 21 International Financial Management

Introduction This chapter explores the factors that determine exchange rates, the ways to forecast future exchange rates, the aspects of foreign exchange risk, and the ways of managing that risk. It looks at the determinants of foreign currency exchange rates and considers options open to multinational firms who must compete globally in a currency marketplace characterized by rapid change in relative values.

Factors Affecting Exchange Rates Supply and Demand Economic Conditions Inflation Interest rates Government trade policies Political stability Expropriation

Why Do Exchange Rates Fluctuate Over Time ? Theories of currency fluctuation IRP PPP ET IFE Absolute Relative

Foreign Exchange Terminology Check out the Global Forex Web site for foreign exchange terminology: http://www.globalforex.com/terminology.htm

Interest Rate Parity Forward rate will differ from spot rate to offset interest rate differences. If not covered, interest arbitrage will move rates back to parity.

Purchasing Power Parity PPP Relative Absolute Absolute Purchasing Power Parity Relative Purchasing Power Parity

Absolute PPP: The Law of One Price Prices for a good will be the same after currency conversion. It holds loosely for commodities. Trade restrictions and taxes keep prices different between countries. Consider the “Big Mac” index.

Relative Purchasing Power Parity Different rates of inflation will be offset by equal but opposite changes in expected future spot exchange rates. Less restrictive than absolute PPP If inflation is higher in Germany than in the United States, then the DM weakens relative to the U.S. dollar.

PPP Analysis Check out the PPP analysis of living standards in developing countries on this Web site: www1.oecd.org/std/ppp1.pdf

Expectations Theory The forward rate reflects the market expectation of the future spot rate. Provides an unbiased estimate of the future spot rate Implication for managers Exchange rate forecasts are provided free from the marketplace. Hedging is cost effective.

International Fisher Effect Nominal (quoted) interest rates consist of a real interest rate plus the expected inflation rate. IFF holds that in equilibrium real interest rates will be equal in different countries. If not, then capital will flow to the currency with the higher real interest rate until it reaches equilibrium.

Example If: U.S. rate = 6% Japan rate = ½% Time horizon = 1 year Difference = 5½% IFE says the inflation rates differ by 5½%. The one-year future spot rate is 5½% —the dollar weakens to a strengthen yen. IRP says the dollar will sell at a 5½% discount. RPPP says U.S. higher inflation rates will cause a lower U.S. dollar.

Exchange Rates Exchange rates fluctuate over time in response to changing supply and demand. In the case of the Peso Demand for Pesos decreased Supply of Pesos increased Value of Pesos decreased in relation to other currencies Exchange rate conversion tool: http://www.xe.com/ucc

Foreign Exchange Risk Transaction Economic Translation The potential for a change in value of a foreign-currency denominated transaction due to foreign exchange risk Economic Changes to a firm’s cash flow due to changes in real exchange rates Translation Changes in the value of assets and liabilities due to foreign exchange changes

Managing Transaction Exposure Do nothing Works for multinationals with many different FX exposures Invoice in U.S. dollars Shift the risk to other party Hedge Forward Money market

Managing Economic Exposure Shift production Increase productivity Outsource Reduce price sensitivity Change to markets with strong currencies

Translation Risk FASB - Financial Accounting Standards Board Assets & Liabilities converted to exchange rate at date of balance sheet converted on date of transaction or a weighted average of exchange rates Income Statement Equity Accounts converted at historical rates. Gains and losses are not recognized on the income statement until a subsidiary is sold or liquidated.