Chapter 19 International Business Finance

Slide Contents Learning Objectives Principles Applied in This Chapter Foreign Exchange Markets and Currency Exchange Rates Interest Rate and Purchasing-Power Parity Capital Budgeting for Direct Foreign Investment Principles Applied in This Chapter Key Terms

Learning Objectives Understand the nature and importance of the foreign exchange market and learn to read currency exchange rate quotes. Describe interest rate and the purchasing-power parity. Discuss the risks that are unique to the capital budgeting analysis of direct foreign investments.

Principles Applied in This Chapter Principle 2: There is a Risk-Return Tradeoff. Principle 3: Cash Flows Are the Source of Value.

19.1 Foreign Exchange Markets and the Currency Exchange Rates

Foreign Exchange Markets and the Currency Exchange Rates The foreign exchange (FX) market: Largest financial market with daily trading volumes of more than $4 trillion. Organized as over-the-counter market Trading dominated by few currencies including U.S. dollar, the Japanese Yen, and the Euro. Major participants include importers/exporters, currency traders, and investors/portfolio managers.

Figure 19.1 The Market for Foreign Exchange

Foreign Exchange Rates An exchange rate is simply the price of one currency stated in terms of another. For example, if the exchange rate of U.S. dollar for Euro was $1.35 to 1, it means that it would take $1.35 to purchase one Euro.

Table 19.1 Foreign Exchange Rates (December 26, 2012)

Table 19.1 Foreign Exchange Rates (December 26, 2012) (cont.)

Foreign Exchange Rates (cont.) Direct quote - indicates the number of units of U.S. dollar to buy 1 foreign currency unit. You will need $0.99 to buy 1 Canadian dollar (see table 19.1). Indirect Quote – indicates the number of foreign currency units to buy one American dollar. You will need C$1.0074 to buy 1 U.S. dollar (see table 19.1).

Foreign Exchange Rates (cont.) The direct quote for Chilean Peso is 479.35. The related indirect quote will be: Indirect quote = 1÷ 479.35 =0.0021

CHECKPOINT 19.1: CHECK YOURSELF Exchanging Currencies

Problem Suppose an American business had to pay $2,000 to a British resident on December 26, 2012. How many pounds did the British resident receive?

Step 1: Picture the Problem The key determinant of the number of British pounds received by the British resident is the exchange rate between dollars and pounds. The chart (next slide) shows that the amount received in Pounds varies depending on the exchange rate. Thus if the exchange rate is 1$=£.8, the British resident will receive only£1,600.

Step 1: Picture the Problem (cont.)

Step 2: Decide on a Solution Strategy To determine the number of British pounds that will be received by the British resident for $2,000 we need to know the number of pounds it takes to buy one dollar i.e. indirect exchange rate quote.

Step 3: Solve Number of British Pounds received = (£/$ × $) × $2,000 = Indirect quote × $2,000 = £ 0.6198/$ × $2,000 = £1,239.60

Step 4: Analyze The British resident will receive £ 1,239.60 using the indirect quote. Had we used the direct quote, we would have arrived at the wrong answer of £3,226.60 (2000 × 1.6133).

Exchange Rates and Arbitrage Arbitrage is the process of buying and selling in more than one market to make a riskless profit. Simple arbitrage eliminates exchange rate differentials across the markets for a single currency.

Asked and Bid Rates The asked rate (selling rate) - the rate at which the bank sells the foreign currency. The bid rate (buying rate) – the rate at which the bank buys the foreign currency. The difference between the asked quote and the bid quote is known as the bid-asked spread.

Cross Rates A cross rate is the computation of an exchange rate for a currency from the exchanges rates of two other currencies.

Table 19.2 Key Currency Cross Rates (December 26, 2012)

Types of Foreign Exchange Transactions Spot exchange rate is the rate for immediate delivery. Forward exchange rate is an rate agreed upon today but which calls for delivery or payment at a future date. Spot and forward rate quotes are given in Table 19-1.

Types of Foreign Exchange Transactions (cont.) The forward rate is often quoted at a premium to or a discount from the existing spot rate. For example, the 30-day Switzerland franc will be quoted as 0.0001 premium(0.9773-0.9772). This premium or discount is known as the forward-spot differential.

Types of Foreign Exchange Transactions (cont.) The forward-spot differential can be expressed as: Where F= the forward rate, direct quote S = the spot rate, direct quote

Types of Foreign Exchange Transactions (cont.) The premium or discount can also be expressed as an annual percentage rate, computed as follows:

CHECKPOINT 19.2: CHECK YOURSELF Determining the Percent-per-annum Premium or discount

The Problem Given the information provided, what is the premium or discount on from the existing spot rate on the one-month yen?

Step 1: Picture the Problem

Step 2: Decide on a Solution Strategy We can determine the size of the premium or discount using the following equation and then annualize it.

Step 3: Solve = (0.01180 - .01179)/.01179 × (12/1) × 100 = 1.018%

Step 4: Analyze We obtained a premium of 1.018% as the forward rate is greater than the spot rate. The degree of premium or discount is determined by market forces.

19.2 Interest Rate and Purchasing Power Parity

Interest Rate Parity Interest rate parity is a theory that can be used to relate differences in the interest rates in two countries to the ratios of spot and forward exchange rates of the two countries’ currencies. Specifically, Differences in interest rates = Ratio of the forward and spot rates

Interest Rate Parity (cont.)

Interest Rate Parity (cont.) Interest rate parity means that you get the same total return for the following two options: Invest dollars in the US risk-free rate; or Convert dollars to Japanese Yens and invest in the risk-free rate in Japan and then convert them back to dollars.

Interest Rate Parity (cont.) Example You have $1,000,000 to invest and you observe the following quotes in the market: 1$ = ¥ 106 180-day forward rate = 103.50 U.S. 180-day risk-free interest rate = 4.4% Japan 180-day risk-free interest rate = 2% Determine whether interest rate parity holds.

Interest Rate Parity (cont.) Option I: Invest directly in USA and earn 4.4% 1,000,000 * 1.044 = $1,044,000 Option II: (a) Convert to Yen at spot rate = ¥ 106,000,000 (b) Invest at 2% = ¥106,000(1.02) = ¥ 108,120,000 (c) Convert to $ at the forward rate = 108,120,000 ÷103.5 = $1,044,638 ==> Difference of $638 ==> Interest Rate Parity does not hold

Purchasing Power Parity and the Law of One Price According to the theory of purchasing power parity (PPP), exchange rates adjust so that identical goods cost the same amount regardless of where in the world they are purchased. Underlying PPP is the law of one price.

Purchasing Power Parity and the Law of One Price (cont.)

Table 19.2 Key Currency Cross Rates (December 26, 2012)

Purchasing Power Parity and the Law of One Price (cont.) The differences in Big Mac prices could be explained by differences in taxes, labor costs, raw material costs, and rental costs among countries. In general, we expect PPP to hold for goods that can be cheaply shipped between countries. PPP does not seem to hold for non-traded goods like restaurant meals and haircuts.

The International Fisher Effect The International Fisher Effect (IFE) assumes that real rates of return are the same across the world, so that the differences in nominal returns around the world arise because of differences in inflation rates.

The International Fisher Effect (cont.) Example What will be the nominal interest rate in UK and USA, if UK is expecting an inflation rate of 6% and USA is expecting an inflation rate of 3%. Assume real rate of interest is equal to 2% in both countries. USA) = .03 + .02 + [.03×.02] = 5.06% UK = .06 + .02 + [.06×.02] = 8.12%

The International Fisher Effect (cont.) IFE cautions us that we should not invest in a country just because it offers the highest interest rates. Such high interest rate is an indication of high inflation. Accordingly, any gain in interest rates will be offset by losses due to foreign currency depreciation.

19.3 Capital Budgeting for Direct Foreign Investment

Capital Budgeting for Direct Foreign Investment Direct foreign investment occurs when a company from one country makes a physical investment into building a factory in another country. A multinational corporation (MNC) is one that has control over this investment.

Capital Budgeting for Direct Foreign Investment (cont.) A major reason for direct foreign investment by U.S. companies is the prospect of higher rates of return from these investments. The method used to evaluate foreign investments is very similar to the method used to evaluate capital budgeting decisions in a domestic context.

CHECKPOINT 19.3: CHECK YOURSELF International Capital Budgeting

The Problem An American firm is looking for a new project that will produce the following cash flows which are expected to be repatriated to the parent company and are measured in South African Rand (SAR). Year Cash flow (in millions of SAR) 0 -20 1 10 2 10 3 6 4 6

The Problem (cont.) In addition, the risk-free rate in the United States is 4 percent, and this project is riskier than most, and as such, the firm has determined that it should require a 10 percent premium over the risk-free rate. Thus, the appropriate discount rate for this project is 14 percent. In addition, the current spot exchange rate is .11 SAR/$, and the 1-year forward exchange rate is .107SAR/$. What is the project’s NPV?

Step 1: Picture the Problem Time Cash flow -20 10 10 6 6 (millions, SAR) The timeline illustrates the following: The discount rate is 14%. A cash outflow of -20 million SAR occurs at the beginning of the first year (at time 0), followed by positive cash inflows during the next four years. 1 2 3 4

Step 2: Decide on a Solution Strategy To calculate the project’s NPV, we need to convert South African Rand into U.S. dollars. However, we only have 1-year forward rates. We can use equation 19-5 and the given forward rate and spot rate to determine the interest rate differential in the two countries.

Step 2: Decide on a Solution Strategy (cont.) 1 year forward rate = (interest rate differential) × (spot exchange rate) We can then use the forward rate to convert the cash flows measured in SARs into U.S. dollars. Once we have the cash flows, we can compute the NPV using a 14% discount rate.

Step 3: Solve Interest rate differential = Forward rate/spot rate = .107/.1= 0.9727 We can use the interest rate differential to calculate the forward exchange rate and then convert the SAR denominated cash flows into U.S. dollars.

Step 3: Solve (cont.)

Step 3: Solve (cont.) Solve using an Excel Spreadsheet NPV = -181.81 + npv (0.14;93.458, 96.061,59.288, 60.91) = $50.16 million Year Cash flow (in millions of SAR) Implied Forward Rate/SAR Cash flow (in millions of $) -20 $9.0909 -$181.81 1 10 $9.3458 93.458 2 $9.6061 96.061 3 6 $9.8814 59.288 4 $10.1523 60.91 NPV $50.16 Input in Excel

Step 4: Analyze Note, the only relevant cash flows are those that are expected to be repatriated back to the home country and the initial cash outflow. Also, discount rate should be in the same currency that the cash flows are measured in. Here discount rate was in U.S. dollars, so we converted the SAR cash flows into U.S. dollars.

Foreign Investment Risks Risks in domestic capital budgeting arises from two sources: Business risk related to the specific product or service and the uncertainty associated with that market. Financial risk is the risk imposed on the investment as a result of how the project is financed.

Foreign Investment Risks (cont.) Foreign direct investment will also include: Political risk - political instability leading to changes in policies such as: Expropriation of plants and equipment Non-convertibility of the subsidiary’s foreign earnings Substantial changes in tax rates. Requirements regarding the local ownership of business.

Foreign Investment Risks (cont.) Exchange rate risk - risk that the value of the firm’s operations and investments will be adversely affected by changes in exchange rates. For example, if the Japanese Yen depreciates, it will translate to fewer dollars when it is sent back to the U.S.

Key Terms Arbitrage Asked rate Bid rate Bid-asked spread Buying rate Cross rate Delivery rate

Key Terms (cont.) Direct foreign investment Direct quote Exchange rate Exchange rate risk Foreign exchange (FX) market Forward exchange contract Forward exchange rate

Key Terms (cont.) Forward-spot differential Indirect quote Interest-rate parity (IRP) International fisher effect (IFE) Law of one price Multinational corporation Political risk

Key Terms (cont.) Purchasing-power parity (PPP) Selling rate Simple arbitrage Spot exchange rate