Fin M14 International Business Finance and Derivatives

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Chapter 16

International Business Finance

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Learning Objectives

Discuss the internationalization of business.

Explain how to read foreign exchange rate quotes and why they matter.

Discuss the concept of interest rate parity.

Explain the purchasing-power parity theory and the law of one price.

Discuss the risk that are unique to the capital-budgeting analysis of direct foreign investment.

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THE GLOBALIZATION OF PRODUCT AND FINANCIAL MARKETS

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The Globalization of Product and Financial Markets

Direct Foreign Investment (DFI) occurs when a company from one country makes a physical investment, such building a manufacturing facility, in another country. A major reason for increase in DFI by U.S. companies is the high rate of return available in other countries.

Capital flows (Portfolio Investment) between countries has also been increasing and is motivated by the possibility of obtaining higher returns and/or reducing portfolio risk through international diversification.

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FOREIGN EXCHANGE MARKETS AND CURRENCY EXCHANGE RATES

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The Foreign Exchange Market

The foreign exchange (FX) market is by far the world’s largest financial market, with daily trading volumes of more than $4 trillion.

Trading in this market is dominated by few key currencies including the U.S. dollar, the British pound sterling, the Japanese yen, and the euro.

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The Foreign Exchange Market

The foreign exchange market is an over-the-counter market with participants (buyers and sellers) located in major commercial and investment banks around the world.

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Foreign Exchange Market

Some of the major participants in foreign exchange trading include:

Importers and exporters of goods and services

Investors and portfolio managers who purchase foreign stocks and bonds

Currency traders who make a market in one or more foreign currencies

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Business Implications

Exchange rates changed dramatically in 2014 and 2015. Possible reasons include:

Relative strengthening of U.S. economy

Expectations of interest rate changes in Europe

Uncertainty surrounding a possible Greek default

Plummet of oil prices and sanctions during the Ukrainian crisis

Stronger dollar means U.S. goods become more expensive for foreigners

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Reading Exchange Rate Quotes

Exchange rate

The price of one currency stated in terms of another.

For example, if the exchange rate of U.S. dollars for euro is 1.37 to 1, this means that it would take $1.37 to purchase one euro.

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Reading Exchange Rate Quotes

A country’s relative economic strengths, trade balance, level of monetary activity, and balance of payments (BOP) are important determinants of exchange rates.

Short-term day-to-day fluctuations in exchange rates are caused by changing supply and demand conditions in the foreign exchange market.

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Direct and Indirect Quote

Direct Quote

Indicates the number of units of the home currency required to buy one unit of the foreign currency

Example: 1.6288 dollars per British pound

Indirect Quote

Indicates the number of units of a foreign currency that can be bought for one unit of the home currency. It is the reciprocal of direct quote.

Example: 1/1.6288 = 0.6139 pounds per dollar

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Exchange Rates and Arbitrage

Foreign exchange quotes in two different countries must be in line with each other.

If the exchange rates are out of line, then a trader could make a profit by buying in the market where the currency was cheaper and selling it in the other.

The process of buying and selling in more than one market to make a riskless profit is called arbitrage. Such opportunities do not exist for a long time due to arbitrage process.

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Asked and Bid Rates

Bid: Rate at which bank buys foreign currency from a customer

Ask: Rate at which bank sells foreign currency to a customer

The difference between the asked quote and the bid quote is known as bid-asked spread.

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Cross Rates

A cross rate is the exchange rate between two foreign currencies, neither of which is the currency of the domestic country.

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Spot Exchange Rate

Exchange rates and transactions meant for immediate delivery are called spot exchange rates.

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Forward Rate

A forward exchange contract requires delivery, at a specified future date, of one currency for a specified amount of another currency.

The exchange rate for the future is agreed today and is known as the forward rate. The actual payment of one currency and receipt of another currency take place on a future date called the delivery date.

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Forward Contract Example

Forward contracts are usually quoted for periods of 30, 90, and 180 days.

If the 30-day forward quote for euros is $1.30, it means that the bank is contractually bound to deliver a euro at $1.30 and the customer is bound to buy a euro at $1.30, regardless of the actual spot rate.

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Exchange Rate Risk

The risk that tomorrow’s exchange rate will differ from today’s rate.

Exchange rate risk affects:

international trade contracts

foreign portfolio investments

direct foreign investment

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Exchange Rate Risk in International Trade Contracts

Example: You are expecting to receive €1m next year from exports.

The future value of euros in dollars is uncertain and depends on future exchange rate.

If € = $1.25, you will receive $1.25m, but if the euro depreciates to $0.90, your contract is worth only $0.9m.

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Exchange Rate Risk in Foreign Portfolio Investments

The future return on portfolio is unknown as investments in securities is a risky investment. Thus, investing in euro market securities could yield –5% or +10%. In addition, investor is exposed to U.S. $/euro exchange rate fluctuation.

Thus, if the euro investment yields 10% but the euro depreciates during the period, the net return will be less than 10%, depending on the extent of euro depreciation.

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Exchange Rate Risk in Direct Foreign Investment

In a DFI, parent company invests in assets denominated in foreign currency. The U.S.-based parent company receives the repatriated (or converted) profit stream from the subsidiary in dollars.

Thus, exchange rate risk arises due to:

Fluctuations in the dollar value of the assets located abroad

Fluctuations in the home currency-denominated profit stream

Possible effect on future profit stream

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INTEREST RATE PARITY

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Interest Rate Parity

IRP theory can be used to relate differences in the interest rates in two countries to the ratio of spot and forward exchange rates of the two countries’ currencies. The IRP condition can be stated as follows:

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PURCHASING-POWER PARITY AND THE LAW OF ONE PRICE

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Purchasing-Power Parity Theory (PPP)

According to PPP, exchange rates adjust so that identical goods cost the same amount regardless of where in the world they were purchased.

For example, if an Apple iPad costs $399 in the U.S. and €353.10 in France, according to PPP, the spot exchange rate should be $1.13 per euro ($399/€353.10). Thus, an iPad will cost the same whether it is bought in the U.S. or France.

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Law of One Price

The law one price implies that the same goods should sell for the same price in different countries after making adjustment for the exchange rate between the two currencies.

Thus, if a Big Mac costs $2 in U.S. dollars and the exchange rate with the British pound is £1 = $2, a Big Mac should cost £1 in the UK.

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The International Fisher Effect

International Fisher Effect states that the real interest rate should be the same all over the world, with the differences in nominal rate resulting from differences in expected inflation rates.

Thus, investing in a foreign bank with the highest interest rate may simply mean investing in a country with the highest rate of inflation.

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CAPITAL BUDGETING FOR DIRECT FOREIGN INVESTMENT

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Capital Budgeting for DFI

The method used by multinational corporations to evaluate foreign investments is very similar to the method used to evaluate domestic investments.

Since there might be repatriation restrictions, evaluations of these investments must focus on after-tax cash flows that can be repatriated. Firms may be subject to taxes in both the home country and foreign country.

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Foreign Investment Risks

The decision process for DFI is similar to capital budgeting decisions in the domestic context.

Risks in domestic capital budgeting arises from two sources:

business risk

financial risk

In international capital budgeting problem, we also have to incorporate political risk and exchange rate risk.

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Political Risk

Political risk arises because the foreign subsidiary conducts business in a political system different from that of the home country.

Some examples of such risk include:

Expropriation of assets without compensation

Nonconvertibility of the subsidiary’s foreign earnings into the parent’s currency

Changes in the laws governing taxation

Restrictions on sale price, wage rates, local borrowing, extent of local ownership, hiring of personnel, transfer payments made to the parent

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Exchange Rate Risk

As observed before, exchange rate risks can have significant effect on cash flows and earnings.

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Key Terms

Arbitrageur

Asked rate

Bid-asked spread

Bid rate

Cross rate

Delivery date

Direct foreign investment (DFI)

Direct quote

Eurodollars

Exchange rate

Exchange rate risk

Foreign exchange (FX) market

Forward exchange contract

Forward exchange rate

Forward-spot differential

Indirect quote

Interest rate parity (IRP) theory

Law of one price

Multinational corporation (MNC)

Purchasing-power parity (PPP) theory

Spot exchange rate

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