ABR class ppt-10-International Finance-RWJ-Chap31-2016-17.pptx

International Finance
Strategic Financial Management
PT MBA III
Dr. A. B. Rastogi
NMIMS

ABR class ppt-10-International Finance-RWJ-Chap31-2016-17
Key Concepts
• Terminology
• Foreign Exchange Markets and Exchange
Rates
• Purchasing Power Parity
• Interest Rate Parity, Unbiased Forward
Rates, and the International Fisher Effect
• International Capital Budgeting
• Exchange Rate Risk
• Political Risk

Terminology
• Cross-rates
• Eurobonds
• Eurocurrency
• Foreign bonds
• Gilts
• LIBOR
• SWAPS

Foreign Exchange Markets and
Exchange Rates
• Exchange rate
• Exchange rate quotations

Purchasing Power Parity
(Absolute )
• Price of an item is the same regardless of
the currency used to purchase it.
• Requirements for absolute PPP to hold:
– Transaction costs are zero
– No barriers to trade (no taxes, tariffs, etc.)
– No difference in the commodity between
locations
• For most goods, Absolute PPP rarely holds
in practice.

Purchasing Power Parity
(Relative)
• Provides information about what causes
changes in exchange rates.
• The basic result is that exchange rates
depend on relative inflation between
countries:
 E(St ) = S0[1 + (hFC – hUS)]t
• Because absolute PPP does not hold for
many goods, we will focus on relative PPP
from here on.

Example
• Suppose the Canadian spot exchange rate
is 1.18 Canadian dollars per U.S. dollar.
U.S. inflation is expected to be 3% per
year, and Canadian inflation is expected to
be 2%.
– Do you expect the U.S. dollar to appreciate or
depreciate relative to the Canadian dollar?
• Since inflation is higher in the U.S., we would
expect the U.S. dollar to depreciate relative to the
Canadian dollar.
– What is the expected exchange rate in one
year?
• E(S1) = 1.18[1 + (.02 - .03)]1 = 1.1682

Interest Rate Parity
• IRP is an arbitrage condition.
• If IRP did not hold, then it would be possible
for an astute trader to make unlimited
amounts of money exploiting the arbitrage
opportunity.
• Since we do not typically observe persistent
arbitrage conditions, we can safely assume
that IRP holds.

Suppose you have $100,000 to invest for one year.
You can either
1. Invest in the U.S. at i$.
Future value = $100,000×(1 + i$)
2. Trade your dollars for yen at the spot rate, invest in
Japan at i¥ and hedge your exchange rate risk by
selling the future value of the Japanese investment
forward.
F
S
× (1 + i¥) = (1 + i$)
F
S
× (1 + i¥)
Future value = $100,000 ×
Since both of these investments have the same risk,
they must have the same future value:

Formally,
IRP is sometimes approximated as
F
S
× (1 + i¥) = (1 + i$)
F
S
=
(1 + i$)
(1 + i¥)
or if you prefer,
i$ – i¥ = F – S
S

IRP and Covered Interest Arbitrage
If IRP failed to hold, an arbitrage opportunity would exist. It
is easiest to see this in the form of an example.
Consider the following set of foreign and domestic interest
rates and spot and forward exchange rates.
Spot exchange rate S£(0) = $1.25/£
360-day forward rate F£(360) = $1.20/£
U.S. discount rate i$ = 7.10%
British discount rate i£ = 11.56%

IRP and Covered Interest
Arbitrage
A trader with $1,000 to invest could invest in the
U.S., in one year his investment will be worth
$1,071 = $1,000(1+ i$) = $1,000(1.071)
Alternatively, this trader could:
1.exchange $1,000 for £800 at the prevailing spot
rate, (note that £800 = $1,000÷$1.25/£)
2.invest £800 at i£ = 11.56% for one year to achieve
£892.48.
3.Translate £892.48 back into dollars at F£(360) =
$1.20/£, the £892.48 will be exactly $1,071.

IRP and Covered Interest
Arbitrage
Can invest in the U.S.
In one year his investment
will be worth
$1,071 = $1,000(1.071)
= $1,000(1+ i$)
A trader with $1,000 to invest:

$1,000
£800
£800= $1,000×
£1
$1.25
IRP and Covered Interest Arbitrage
Invest £800
at i£ =
11.56%
In one year £800
will be worth
£892.48 =
$1,000(1+ i£)
$1,071 = £892.48 ×
£1
$1.20
Bring it on back
to the U.S.A.
Domestic FV =
$1,071 and
British FV =
$1,071

Reasons for Deviations from
IRP
• Transactions Costs
– The interest rate available to an arbitrageur for
borrowing, ib,may exceed the rate he can lend at, il.
– There may be bid-ask spreads to overcome, Fb/Sa <
F/S
– Thus
(Fb/Sa)(1 + i¥
l)  (1 + i¥
b)  0
• Capital Controls
– Governments sometimes restrict import and export of
money through taxes or outright bans.

International Fisher Effect
• Combining PPP and UIP we can get the
International Fisher Effect:
RUS – inflUS = RFC – inflFC
• The International Fisher Effect tells us that
the real rate of return must be constant
across countries.
• If it is not, investors will move their money
to the country with the higher real rate of
return.

Equilibrium Exchange Rate
Relationships
infl$ – infl£
IRP
PPP
FE FRPPP
IFE FP
i$ – i¥
F – S
S
E(e)

International Capital Budgeting
• Home Currency Approach
– Estimate cash flows in foreign currency
– Estimate future exchange rates using UIP
– Convert future cash flows to dollars
– Discount using domestic required return
• Foreign Currency Approach
– Estimate cash flows in foreign currency
– Use the IFE to convert domestic required return to
foreign required return
– Discount using foreign required return
– Convert NPV to dollars using current spot rate

Home Currency Approach
• Your company is looking at a new project
in Mexico. The project will cost 9 million
pesos. The cash flows are expected to be
2.25 million pesos per year for 5 years.
The current spot exchange rate is 9.08
pesos per dollar. The risk-free rate in the
US is 4%, and the risk-free rate in Mexico
8%. The dollar required return is 15%.
– Should the company make the investment?

Foreign Currency Approach
• Use the same information as the previous
example to estimate the NPV using the
Foreign Currency Approach
– Mexican inflation rate from the International
Fisher Effect is 8% - 4% = 4%
– Required Return = 15% + 4% = 19%
– PV of future cash flows = 6,879,679
– NPV = 6,879,679 – 9,000,000 = -2,120,321
pesos
– NPV = -2,120,321 / 9.08 = -233,516

Exchange Rate Risk
• Short-Term Exposure
• Long-Term Exposure
• Translation Exposure

Short-Term Exposure
• Risk from day-to-day fluctuations in
exchange rates and the fact that companies
have contracts to buy and sell goods in the
short run at fixed prices
• Managing risk
– Enter into a forward agreement to guarantee the
exchange rate.
– Use foreign currency options to lock in
exchange rates if they move against you, but
benefit from rates if they move in your favor.

Long-Term Exposure
• Long-run fluctuations come from
unanticipated changes in relative
economic conditions
• Could be due to changes in labor markets
or governments
• More difficult to hedge
• Try to match long-run inflows and outflows
in the currency
• Borrowing in the foreign country may
mitigate some of the problems

Translation Exposure
• Income from foreign operations must be
translated back to U.S. dollars for accounting
purposes, even if foreign currency is not actually
converted back to dollars.
• If gains and losses from this translation flowed
through directly to the income statement, there
would be significant volatility in EPS.
• Current accounting regulations require that all
cash flows be converted at the prevailing
exchange rates, with currency gains and losses
accumulated in a special account within
shareholders equity.

Managing Exchange Rate Risk
• Large multinational firms may need to
manage the exchange rate risk associated
with several different currencies.
• The firm needs to consider its net exposure
to currency risk instead of just looking at
each currency separately.
• Hedging individual currencies could be
expensive and may actually increase
exposure.

Political Risk
• Changes in value due to political actions in the
foreign country
• Investment in countries that have unstable
governments should require higher returns.
• The extent of political risk depends on the nature
of the business:
– The more dependent the business is on other
operations within the firm, the less valuable it is to
others.
– Natural resource development can be very valuable
to others, especially if much of the ground work in
developing the resource has already been done.
• Local financing can often reduce political risk.

Thank you

ABR class ppt-10-International Finance-RWJ-Chap31-2016-17.pptx

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