Chapter 22 International Business Finance International Business Finance  2005, Pearson Prentice Hall

International Business Finance  Exchange Rate: the price of one currency in terms of another.

Exchange Rates Exchange rates affect our economy and each of us because: 1) When the dollar appreciates (strong dollar), the dollar becomes more valuable relative to other currencies.

Exchange Rates Exchange rates affect our economy and each of us because: 1) When the dollar appreciates (strong dollar), the dollar becomes more valuable relative to other currencies.  Foreign products become cheaper to us.

Exchange Rates Exchange rates affect our economy and each of us because: 1) When the dollar appreciates (strong dollar), the dollar becomes more valuable relative to other currencies.  Foreign products become cheaper to us.  U.S. products become more expensive overseas.

Exchange Rates Exchange rates affect our economy and each of us because:

Exchange Rates Exchange rates affect our economy and each of us because: 2) When the dollar depreciates (weak dollar), the dollar falls in value relative to other currencies.

Exchange Rates Exchange rates affect our economy and each of us because: 2) When the dollar depreciates (weak dollar), the dollar falls in value relative to other currencies.  Foreign products become more expensive for us.

Exchange Rates Exchange rates affect our economy and each of us because: 2) When the dollar depreciates (weak dollar), the dollar falls in value relative to other currencies.  Foreign products become more expensive for us.  U.S. products become cheaper overseas.

Spot Exchange Rates £ / $ =.6162 (it takes.6162 pounds to = $1) £ / $ =.6162 (it takes.6162 pounds to = $1) $ / £ = (it takes $ to = 1 pound) $ / £ = (it takes $ to = 1 pound) ¥ / $ = (it takes yen to = $1) ¥ / $ = (it takes yen to = $1) $ / ¥ = ( it takes $ to = 1 yen) $ / ¥ = ( it takes $ to = 1 yen) (note: direct and indirect quotes are reciprocals) (note: direct and indirect quotes are reciprocals)

What Determines Exchange Rates? Floating Rate Currency System: Since 1973, the world has allowed exchange rates to change daily in response to market forces. Exchange rates are affected by:  foreign investors  speculators  political conditions here and overseas  inflation  trade policies (tariffs and quotas) and…

What Determines Exchange Rates? Supply and Demand for currencies! Let’s consider the £ / $ market.

What Determines Exchange Rates? Supply and Demand for currencies! Supply and Demand for currencies! Let’s consider the £ / $ market.

What Determines Exchange Rates? Supply and Demand for currencies! Supply and Demand for currencies! Let’s consider the £ / $ market.

What Determines Exchange Rates? Suppose the British increase demand for U.S. products. Suppose the British increase demand for U.S. products. British importers buy the U.S. products to sell in England. They buy dollars with pounds, so they can pay U.S. firms in dollars. The demand for dollars increases and forces up the £ / $ exchange rate, which makes U.S. products more expensive in England.

What Determines Exchange Rates? £ / $ (price of dollars) Supply of Dollars Demand for Dollars Quantity of dollars

What Determines Exchange Rates? £ / $ (price of dollars) Supply of Dollars Demand for Dollars Quantity of dollars

What Determines Exchange Rates? Another example: Let’s consider the ¥ / $ market.

What Determines Exchange Rates? Another example: Let’s consider the ¥ / $ market.

What Determines Exchange Rates? Another example: Let’s consider the ¥ / $ market.

What Determines Exchange Rates? Suppose American demand for Japanese cars and stereos increases rapidly. Suppose American demand for Japanese cars and stereos increases rapidly. American importers buy the Japanese products to sell in the U.S. They buy yen with dollars, so they can pay Japanese firms in yen. The supply of dollars increases, and forces down the ¥ / $ exchange rate, which makes Japanese products more expensive in the U.S.

What Determines Exchange Rates? ¥ / $ (price of dollars) Supply of Dollars Demand for Dollars Quantity of dollars

What Determines Exchange Rates? ¥ / $ (price of dollars) Supply of Dollars Demand for Dollars Quantity of dollars

Foreign Exchange Markets Different exchange rates are used for different types of transactions: 1) Spot Exchange Market: deals with currency for immediate delivery.  The exchange rate used in spot transactions is called the spot exchange rate.  If you need 500,000 francs to buy imports, and the spot exchange rate is.1457, you would pay your bank $72,850.

Foreign Exchange Markets 2) Forward Exchange Market: deals with the future delivery of foreign currency.  You can buy or sell currency for future delivery, usually in one, three, or six months.  The exchange rate for forward transactions is called the forward exchange rate.  Forward exchange contracts allow you to hedge foreign exchange risk!

Forward Market Hedge Example: You will import wine from France, to be delivered and paid for in six months.  You have agreed to a price of 500,000 francs. With the spot exchange rate of.1457, this comes to $72,850.  Suppose the dollar weakens over the next six months, and the $/F exchange rate rises to.20.  The wine would cost you $100,000. This is an example of foreign exchange risk!

Forward Market Hedge You decide to hedge your risk with a forward exchange contract!  The six-months $/F forward exchange rate is By agreeing to this forward rate with your bank, you lock in a price of $73,800 for 500,000 francs, six months from now.  Now it doesn’t matter what happens to the $/F exchange rate over the next six months.

Money Market Hedge For the previous problem, another potential solution is the money market hedge. 1) Borrow $72,850 from your bank. 2) Buy the 500,000 francs now (at the current spot exchange rate of.1457) for $72,850. 3) Invest the 500,000 francs in interest-bearing French securities. 4)Complete your transaction after six months. [Borrowing and investment rates determine the cost of the hedge.]

Forward-Spot Differential If the forward rate > the spot rate, the forward is trading at a premium. If the forward rate > the spot rate, the forward is trading at a premium. If the forward rate < the spot rate, the forward is trading at a discount. If the forward rate < the spot rate, the forward is trading at a discount.

Forward-Spot Differential If the forward rate > the spot rate, the forward is trading at a premium. If the forward rate > the spot rate, the forward is trading at a premium. If the forward rate < the spot rate, the forward is trading at a discount. If the forward rate < the spot rate, the forward is trading at a discount. premium forward - spot 12 or discount spot n = [ ] [ ] x 100

Forward-Spot Differential For our example,

Forward-Spot Differential = [ ] [ ] x 100 For our example, premium forward - spot 12 or discount spot n

Forward-Spot Differential = [ ] [ ] x 100 For our example, premium forward - spot 12 or discount spot n

Forward-Spot Differential = [ ] [ ] x 100 For our example, premium forward - spot 12 or discount spot n = 2.6. The forward is trading at a 2.6% = 2.6. The forward is trading at a 2.6%premium.

Interest Rate Parity Links the forward exchange market with the spot exchange market. The idea: The annual percentage difference between the forward rate and the spot rate (forward premium or discount) is approximately equal to the difference in interest rates between the two countries. Arbitrage in the forward and spot markets helps to hold this relationship in place.

Purchasing Power Parity Links changes in exchange rates with differences in inflation rates and the purchasing power of each nation’s currency.  In the long run, exchange rates adjust so that the purchasing power of each currency tends to be the same.  Exchange rate changes tend to reflect international differences in inflation rates.  Countries with high inflation tend to experience currency devaluation.

The Law of One Price In competitive markets where there are no transportation costs or barriers to trade, the same goods sold in different countries sell for the same price if all the different prices are expressed in terms of the same currency.  This proposition underlies the PPP relationship.  Arbitrage allows the law of one price to hold for commodities that can be shipped to other countries and resold.

Exchange Rate Risk  Translation exposure - foreign currency assets and liabilities that, for accounting purposes, are translated into domestic currency using the exchange rate, are exposed to exchange rate risk.  However, if markets are efficient, investors know that any translation losses are “paper” losses and are unrealized.

Exchange Rate Risk  Transaction exposure - refers to transactions in which the monetary value is fixed before the transaction actually takes place.  Example: your firm buys foreign goods to be received and paid for at a later date. The exchange rate can change, which can affect the price actually paid.

Multinational Working-Capital Management Leading and Lagging  Lead: dispose of a net asset position in a weak currency. Pay a net liability position in a weak currency. Pay a net liability position in a weak currency.  Lag: Delay collection of a net asset position in a strong currency. Delay payment of a net liability position in a weak currency.

Direct Foreign Investment Risks  Business Risk - firms must be aware of the business climate in both the U.S. and the foreign country.  Financial Risk - not much difference between financial risks of foreign operations and those of domestic operations.

Direct Foreign Investment Risks  Political Risk - firms must be aware that many foreign governments are not as stable as the U.S.  Exchange Rate Risk - exchange rate changes can affect sales, costs of goods sold, etc. as well as the firm’s profit in dollars.