Chapter 13 Fundamentals of Corporate Finance International Financial Management Slides by Matthew Will McGraw Hill/Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved

23- 2 McGraw Hill/Irwin Topics Covered  Foreign Exchange Markets  Some Basic Relationships  Hedging Exchange Rate Risk  International Capital Budgeting

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin 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.

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin Foreign Exchange Markets Forward Premiums and Forward Discounts Example - The yen spot price is yen per dollar and the 1 year forward rate is yen per dollar, what is the premium and discount relationship?

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin Foreign Exchange Markets Forward Premiums and Forward Discounts Example - The yen spot price is yen per dollar and the 1 year forward rate is yen per dollar, what is the premium and discount relationship?

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin Foreign Exchange Markets Forward Premiums and Forward Discounts Example - The yen spot price is yen per dollar and the 1 year forward rate is yen per dollar, what is the premium and discount relationship? Answer - The dollar is selling at a 2.28% premium, relative to the yen. The yen is selling at a 2.28% discount, relative to the dollar.

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin Exchange Rate Relationships  Basic Relationships equals

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin 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.

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin Exchange Rate Relationships Example - You are doing a project in Australia which has an initial cost of $100,000. All other things being equal, you have the opportunity to obtain a 1 year Australian dollar 6.0% or a 1 year US dollar 2.8%. The spot rate of exchange is Aus$: $1 U.S. The 1 year forward rate is Aus$:$1 U.S. Which loan will you prefer and why? Ignore transaction costs

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin Exchange Rate Relationships Cost of US loan = $100,000 x = $102,800 Example - You are doing a project in Australia which has an initial cost of $100,000. All other things being equal, you have the opportunity to obtain a 1 year Australian dollar 6.0% or a 1 year US dollar 2.8%. The spot rate of exchange is Aus$: $1 U.S. The 1 year forward rate is Aus$:$1 U.S. Which loan will you prefer and why? Ignore transaction costs Cost of Australian Loan = $100,000 x = 175,180 Aus$ exchange 175,180 Aus$ x 1.06 = 185,690 Aus$ loan pmt 185,690 Aus$ / = $102,800 exchange If the two loans created a different result, arbitrage exists (purchase of one security and simultaneous sale of another to give a risk free profit)!

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin Exchange Rate Relationships 2) Expectations Theory of Exchange Rates Theory that the expected spot exchange rate equals the forward rate.

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin Exchange Rate Relationships 3) Purchasing Power Parity The expected change in the spot rate equals the expected difference in inflation between the two countries.

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin Exchange Rate Relationships Example If inflation in the US is forecasted at 0.8% this year, what do we know about the forecasted inflation rate in Australia? Given a spot rate of Aus$: $1 U.S. Given a 1yr fwd rate of Aus$: $1 U.S.

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin Exchange Rate Relationships Example - If inflation in the US is forecasted at 0.8% this year, what do we know about the forecasted inflation rate in Australia? Given a spot rate of Aus$: $1 U.S. Given a 1yr fwd rate of Aus$: $1 U.S. solve for i i =.0395 or 3.95%

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin Solution

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin 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

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin Exchange Rate Relationships Example - In the previous examples, show the equilibrium of interest rates and inflation rates

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin 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 :$1 the car sells for $16,950 in Indianapolis. If the dollar rises in value, against the yen, to an exchange rate of 105:$1, what will be the price of the car? Conversely, if the yen is trading at a forward discount, Japan will experience a decrease in purchasing power. 1,715,000 = $16,

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin Exchange Rate Risk Example - Harley Davidson builds a motorcycle for a cost plus profit of $12,000. At an exchange rate of :$1, the motorcycle sells for 1,214,106 yen in Japan. If the dollar rises in value and the exchange rate is 105:$1, what will the motorcycle cost in Japan? $12,000 x 105 = 1,260,000 yen (3.78% rise)

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin 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

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin 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 (buy one security and sell another in order to reduce risk ) all non dollar Cash Flow.

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin Capital Budgeting KW Corporation manufactures flat-packed kit wardrobes. It is considering building a manufacturing facility in Narnia. The company is expected to produce Narnian cash flows as follows. The US risk free rate is 5% and the Narnian rate is 10%. The current spot rate is 2.0Leos:$1 and KW expects a 15% return on its investment. What is the NPV of the project? Cash Flow Forecasts (in millions of Leos) year

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin Capital Budgeting KW Corporation manufactures flat-packed kit wardrobes. It is considering building a manufacturing facility in Narnia. The company is expected to produce Narnian cash flows as follows. The US risk free rate is 5% and the Narnian rate is 10%. The current spot rate is 2.0Leos:$1 and KW expects a 15% return on its investment. What is the NPV of the project? Cash Flow Forecasts (in millions of Leos) year Q: What are the 1, 2, 3, 4, 5 year forward rates? Forward rates =

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin Solution  Year 1  1+r foreign = r foreign /$ 1 + r $ s foreign /$ 1.1/1.05 = rforeign/$/2 Forward rate =2(1.1)/(1.05)=2.095 Year 2  1+r foreign = r foreign /$ 1 + r $ s foreign /$ (1.1) 2 /(1.05) 2 = rforeign/$/2 Forward rate =2(1.1) 2 /(1.05) 2 =2.195 Year 3  1+r foreign = r foreign /$ 1 + r $ s foreign /$ (1.1) 3 /(1.05) 3 = rforeign/$/2 Forward rate =2(1.1) 3 /(1.05) 3 =2.299 or 2.3

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin Solution Year 4  1+r foreign = r foreign /$ 1 + r $ s foreign /$ (1.1) 4 /(1.05) 4 = rforeign/$/2 Forward rate =2(1.1) 4 /(1.05) 4 =2.409 Year 5 1+rforeign = rforeign/$ 1 + r$ sforeign/$ (1.1) 5 /(1.05) 5 = rforeign/$/2 Forward rate =2(1.1) 5 /(1.05) 5 =2.524

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin Capital Budgeting Q: Convert the CF to $ using the forward rates CF L F(r) CF$ (-7.6/2) ( 2/2.095) (2.5/2.195) (3/2.3) (3.5/2.409) (4/2.524) KW Corporation manufactures flat-packed kit wardrobes. It is considering building a manufacturing facility in Narnia. The company is expected to produce Narnian cash flows as follows. The US risk free rate is 5% and the Narnian rate is 10%. The current spot rate is 2.0Leos:$1 and KW expects a 15% return on its investment. What is the NPV of the project? Cash Flow Forecasts (in millions of Leos) year

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin KW Corporation manufactures flat-packed kit wardrobes. It is considering building a manufacturing facility in Narnia. The company is expected to produce Narnian cash flows as follows. The US risk free rate is 5% and the Narnian rate is 10%. The current spot rate is 2.0Leos:$1 and KW expects a 15% return on its investment. What is the NPV of the project? Cash Flow Forecasts (in millions of Leos) year Capital Budgeting What is the PV of the project in dollars at a risk premium of 10.0%? $ discount rate = 5% + 10% = 15% NPV = $360,000

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin Solution  Year 1 =.95/15=  Year 2 =1.14/(1.15) 2 =  Year 3 =1.30/(1.15)3 =  Year 4 =1.45/(1.15)4 =  Year 5 =1.58/(1.15)5 =  Total PV =4.16 million  Less: Cash Outflow = 3.8 million  NPV =.36 million

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin Summary  The International financial manager has to cope with different currencies, interest rates and inflation rates. To produce order, the manager needs some model of how they are related. There are 4 very simple but useful theories.  1. Interest rate parity theory states that the interest differential between two countries must be equal to the difference between the forward and spot exchange rates. There are 2 ways to hedge against risk. One is to take out forward cover; the other is to borrow or lend abroad. Interest rate parity tells us that the cost of two methods should be the same.

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin Summary  2.The expectation theory of exchange rates tells us that the forward rate equals the expected spot rate. If you believe the expectation theory, you will generally insure against exchange risks  3.The purchasing power parity states that $1 must have the same purchasing power in every country. That does not square well with the facts, for differences in inflation rates are not perfectly related to changes in exchange rates. This means that there may be some genuine exchange risks in doing business overseas. On the other hand, the difference in inflation rates is just as likely to be above as below the change in the exchange rate.

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin Summary  4. Integrated world capital market theory states that real rates of interest would have to be the same. In practice, government regulation and taxes can cause difference in real interest rates. But do not simply borrow where interest rates are lowest. Those countries are also likely to have the lowest inflation rates and the strongest currencies.

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin Summary  With these perceptions, we showed how you can use forward markets or the loan markets to hedge transactions exposure, which arises from delays in foreign currency payment and receipts but the company’s financing choices also need to reflect the impact of a change in the exchange rate on the value of the entire business. This is known as ECONOMIC EXPOSURE.

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin Summary  Two ways for a company to calculate the NPV of an overseas project.  A) First is to forecast the foreign currency cash flows and to discount them at the foreign currency cost of capital  B) Second is to translate the foreign currency cash flows into domestic currency assuming that they are hedged against exchange rate risk. These domestic currency flows can then be discounted at the domestic cost of capital. The answers should be identical.  In addition to currency risk, overseas operation may be exposed to extra political risk. However, firms may be able to structure the financing to reduce the chances that government will change the rules of the game..

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