International Finance Chapter 18 © 2003 South-Western/Thomson Learning

2 Globalization of Business Imports and exports have increased substantially since the 1960s Many U.S. companies are now multi-national companies Own facilities and equipment and produce goods in another country Virtually all large companies have some international dealings Many investors now view having investments in foreign stocks as part of a ‘normal’ portfolio Foreigners currently invest more in the US than we invest abroad

3 Currency Exchange When paying a bill (such as an invoice for goods purchased in a foreign country) the payee expects to be paid in the currency of his country So, payer has to obtain foreign currency U.S. manufacturer would have to exchange U.S. dollars for foreign currency (say, Japanese Yen)

4 The Foreign Exchange Market U.S. company would purchase Yen in the foreign exchange market Basically a network of brokers/banks based in financial centers around the world Most commercial banks can access the foreign exchange market and purchase/sell currency for their customers

5 Exchange Rates An exchange rate states the price of one currency in terms of another A table of exchange rates shows two reciprocal rates for each currency

6 Exchange Rates Cross Rates It is possible to develop an exchange rate between any two currencies without going through U.S. dollars How many Canadian Dollars (CAD) will 1 Yen buy? $1US = Yen (or $XUS = 1 Yen) $1US = CAD (or $XUS = 1 CAD) Yen = CAD 1 Yen = CAD (or 1CAD will buy Yen) Dollars per Yen  Dollars per CAD =  = CAD per Yen

7 Changing Exchange Rates and Exchange Rate Risk Exchange rates are constantly changing Sometimes rapidly and significantly Fluctuating exchange rates give rise to exchange rate risk Exchange rate risk is the chance of gain or loss from exchange rate movements that occur during a transaction

8 Changing Exchange Rates and Exchange Rate Risk The change in exchange rates affects the profitability of the firm If the rate goes against the firm (the foreign currency strengthens—$1 U.S. will buy fewer foreign currency or 1 unit of foreign currency will buy more U.S.dollars) the profitability will decrease and vice versa

9 Spot and Forward Rates The spot rate is the exchange rate for the immediate (on-the-spot) delivery of a currency The forward market is the price for currencies to be delivered in the future Major currencies have well-developed forward markets (1, 3 and 6 months forward)

10 Spot and Forward Rates The spot rates are a bit different from the forward rates This difference reflects the movement that the foreign exchange brokers expect in the future relationship of the currencies When a foreign currency is expected to become less (more) valuable in the future, the forward currency is said to be selling at a discount (premium) Terminology of Exchange Rate Movements When a currency becomes more (less) valuable in terms of dollars, it is becoming stronger (weaker), or rising (falling) against the dollar

11 Hedging with Forward Exchange Rates Exchange rate risk can be eliminated by hedging with a forward contract If a company knows it will need a foreign currency in the future it can lock in an exchange rate Eliminates the uncertainty as to the price that will be paid for the currency Can be done by buying the currency at the forward rate

12 Supply and Demand—The Source of Exchange Rate Movement An exchange rate is just the price of a particular currency The price of that currency will fluctuate with supply & demand, like any other commodity What determines the supply and demand for exchange rates? Primarily stems from trade and the flow of investment capital between nations For example, a strong Yen means the demand for US goods in Japan will rise (because US goods will become cheaper in Japanese Yen) As US goods become cheaper in Japan, demand for U.S. goods will increase (exports from US to Japan will rise)

13 Why the Exchange Rate Moves What factors have an influence on the demand for a country’s products and investments? Preferences in consumption In the 1980s U.S. consumers perceived Japanese cars as more reliable and durable Japanese electronics were once perceived as inferior, but no longer Government policy Impose quotas, tariffs

14 Why the Exchange Rate Moves Economic conditions Expansion vs recession Level of interest rates Countries with high interest rates attract more investors which increases the demand for that country’s currency Inflation High levels of inflation can cause a country’s currency to lose value quickly Speculation (trading in a currency just for the sake of profit—not because you need the currency to pay bills) Direct Government Intervention Government purposefully tries to keep currency trading in a certain range

15 Governments and the International Monetary System When a currency strengthens relative to another two things happen The prices of the foreign good become cheaper Demand for foreign products increases Domestic products become more expensive in foreign countries Demand for domestic products declines

16 Governments and the International Monetary System Government Influence on Exchange Rates Governments occasionally intervene to keep rates within reasonable limits Government buys/sells their own currency in foreign exchange market to either increase/decrease demand to affect exchange rate Ability to support a weakening currency is limited because government has to pay for purchases of its own money with gold or foreign exchange These sources are limited

17 International Monetary System A floating exchange rate system exists today Exchange rates are allowed to fluctuate based on demand/supply in the free market Prior to 1970s world had a fixed exchange rate system Rates were fixed by international treaty and each country was required to hold the exchange rate nearly constant (relative to USD) Countries bought/sold their currency to maintain exchange rate After World War II it became impossible to maintain certain exchange rates A country may experience a revaluation or devaluation to keep its exchange rate constant

18 Convertibility Not all currencies are convertible to other currencies using processes discussed in this chapter For these processes to work a nation has to agree to allow the currency to be traded in the foreign currency markets Russia and China have not traditionally had convertible currencies For example, some currencies you can exchange at the official exchange rate but on the street no one is willing to use that rate Inconvertibility is an impediment to international trade

19 The Balance of Trade The net flow between two countries from trade is known as the balance of trade If we import (export) more from a country than we export (import) a trade deficit (trade surplus) exists Our currency accumulates in that country The available pool of the deficit country’s currency tends to weaken the value of its currency Should make the deficit nation’s exports cheaper in the surplus nation, bringing trade back in balance

20 International Capital Markets Many individuals and businesses invest in countries other than their own U.S. dollar is the world’s leading currency Serves as “international money” People have more confidence in its continuing value than any other currency Many international contracts are denominated in U.S. dollars even though none of the parties of the contract are American

21 The Eurodollar Market Eurodollars are American dollar deposits in foreign banks Loaned to international businesses in the eurodollar market Borrowers use Eurodollars to Pay for U.S. exports Invest in American stocks and bonds Medium of exchange between parties that don’t want to deal in their own currencies Don’t have to be in European banks—can be anywhere in the world Practice started in Europe—hence the name

22 The International Bond Market Companies can borrow internationally by selling bonds outside their own country Called international bonds Bond can be denominated in The currency of the issuing company’s home country (Euro bond) The currency of the country in which it is sold (foreign bond) A third currency

23 The International Bond Market Most Eurobonds are denominated in American dollars Securities regulations require lower levels of disclosure—lowers issuing costs Eurobonds are issued in bearer form— owner is not identified Most governments don’t withhold income taxes on Eurobonds

24 Political Risk Political risk is the chance that a foreign government will expropriate property or that terrorists will destroy it Other examples of value-reducing foreign risk exposure include Raising taxes Limiting the amount of profit that can be withdrawn from the country Requiring key inputs be purchased from local suppliers at arbitrary prices Limit the prices charged for the product sold within the country Require part ownership by citizens of the host country Terrorist activities, including kidnapping key executives

25 Transaction and Translation Risks Translation gains/losses arise when assets and liabilities held in a foreign country are translated into dollars Translating the financial statements of a foreign subsidiary into the local currency of the parent company Especially troublesome for the balance sheet The Relevance of Translation Gains and Losses Translation gains/losses are only paper gains/losses—they are not realized Shown cumulatively in an account that adds or subtracts to stockholders’ equity Not taxable since they are not realized