17-1 Chapter 17 Exchange Rates & International Investment

17-2 International Investment  Advantage  Increased portfolio diversification  Disadvantages  Returns affected by exchange rates  Foreign information is harder to obtain  Financial disclosure may differ

17-3  Disadvantages continued  Accounting definitions may vary  Political risks  Risk of exchange controls  Higher transactions costs

17-4 Two Ways of Stating Exchange Rates 1.# units of domestic per unit of foreign $1.50 = 1 £ (pound). 2.# units of foreign per domestic unit of currency = £ = $1.00.

17-5 Changing Exchange Rates Time 0: 125 ¥ (yen) = $1.00. Time 1: 100 ¥ = $1.00. Dollar depreciations (i.e., one dollar buys fewer yen). Yen appreciations (i.e., fewer yen are required to buy one dollar).

17-6 Exports and Imports Dollar Depreciates Exports from US to Japan Imports from Japan to US Time ¥ = $1 $1 = 1 cigar 125 ¥ = 1 cigar 1 radio = 12,500 ¥ 1 radio = $100 Time ¥ = $1 1 cigar = 100 ¥1 radio = $125 (12,500/100) US exports cheaper in yen Imports into US more expensive in dollars

17-7 Exchange Rates and International Investment R 0, US = 1-period spot interest rate in US R 0, J = 1-period spot interest rate in Japan X 0, S = Spot exchange rate at time 0 ($1 = 125 ¥) X 1, S = Spot exchange rate at time 1 ($1 = 100 ¥) X 0,S 01 X 1,S

R 0, US $ Invest in US Exchange & invest in Japan Exchange back for dollars X 0, S 125 ¥ X 0, S [1 + R 0, J ] [125 ¥][1 + R 0, J ] X 0,S [1 + R 0J ] X 1, S [125 ¥][1 + R 0, J ] 100 ¥

17-9 Compare 1 + ROR US 1 + Rate of return in US 1 + ROR US 1 + R 0, US 1 + ROR J 1 + Rate of return in Japan in dollars 1 + ROR J versus X 0, S [1 + R 0, J ] X 1, S ≥<≥< ≥<≥<

17-10 If R 0, US =R 0, J 1 + ROR US 1 + ROR J as X 1, S X 0, S X 1,S > X 0, S,Dollar appreciates US investment is better X 1,S = X 0,S,Constant exchange rate US = Japanese X 1,S < X 0, S,Dollar depreciates US investment is inferior ≥<≥< ≥<≥<

17-11 General Case Dollar depreciates: X 0,S /X 1,S > 1 Example:X 0, S = 125 ¥, X 1, S = 100 ¥ R 0, US = R 0, J = 8%. Dollar depreciation results in return of 35% vs 8%.

17-12 Example of Dollar Appreciating Time 0:X 0, S = 100 ¥; $1 = 100 ¥ Time 1:X 1, S = 125 ¥; $1 = 125 ¥

17-13 Dollar depreciates: Dollar appreciates:

17-14

17-15 Assume spot interest rates in the U.S. (R 0,US ) and in Japan (R 0,J ) and spot (X 0,S ) and forward exchange rates (X 0,f ). Table Covered Interest Arbitrage Time 0Time 1 Invest in U.S. bonds $1$1 + R 0,US At time 0, exchange for yen and invest in Japanese bonds. At time 1, exchange yen for dollars. X 0,s yen(X 0,s )(1 + R 0,J )/X 0,f

17-16 Since both strategies start with the same amount and there is no risk in either strategy, the values at time 1 must be equal.

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