political and business risks
rude-1
chap018_8e.ppt18-*
Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin
18-*
Key Concepts and Skills
Understand
- How exchange rates are quoted and what they mean
- The difference between spot and forward rates
- Purchasing power parity and interest rate parity and the implications for changes in exchange rates
- The types of exchange rate risk and how it can be managed
- The impact of political risk on international business investing
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Chapter Outline
18.1 Terminology
18.2 Foreign Exchange Markets and Exchange Rates
18.3 Purchasing Power Parity
18.4 Exchange Rates and Interest Rates
18.5 Exchange Rate Risk
18.6 Political Risk
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International Finance Terminology
- American Depositary Receipt (ADR)
- Security issued in the U.S. representing shares of a foreign stock
- Can be traded in the U.S.
- Cross-rate
- Implicit exchange rate between two currencies when both are quoted in a third (usually dollars) currency.
- Eurobond
- Bond issued in multiple countries but denominated in the issuer’s home currency
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International Finance Terminology
- Eurocurrency (Eurodollars)
- Money deposited in a financial center outside the country of the currency involved
- “Eurodollars” = dollar-denominated deposits in banks outside the U.S. banking system
- Foreign bonds
- Sold by foreign borrower
- Denominated in currency of the country of issue
- Gilts
- British and Irish government securities
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International Finance Terminology
- London Interbank Offer Rate (LIBOR)
- Rate international banks charge each other for loans of Eurodollars overnight in the London market
- Frequently used as a benchmark rate for money market instruments
- Swaps
- Interest rate swap = two parties exchange a floating-rate payment for a fixed-rate payment
- Currency swap = agreement to deliver one currency in exchange for another
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Global Capital Markets
- Number of exchanges in foreign countries continues to increase, as does the liquidity on those exchanges
- Exchanges facilitate the flow of capital
- Extremely important to developing countries
- Differences:
- Market Structure
- Regulation
- Trading rules
- United States = most developed capital markets in the world, but:
- Foreign markets becoming more competitive
- Often more willing to innovate
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Example: Work the Web
- Thinking about going to Mexico for spring break or Japan for your summer vacation?
- How many pesos or yen can you get in exchange for $1,000?
- Click on the Web surfer to find out
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FOREX Trading
- Foreign Exchange
- Largest financial market in the world
- Trading = 24/7 over-the-counter
- Most trading in USD, £, ¥, and €
- FOREX quotations:
- Direct = USD per foreign currency
- Indirect = Units of foreign currency per USD
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Foreign Exchange Quotes
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Exchange Rates
- The price of one country’s currency in terms of another
- Most currency quoted in terms of dollars
- Direct Quotation = price of foreign currency expressed in U.S. dollars. (dollars per currency); Figure 18.1 “in US$”
- Indirect quotation = the amount of a foreign currency required to buy one U.S. dollar (currency per dollar); Figure 18.1 “per US$”
Return to Quick Quiz
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Direct Exchange Rate Quotations
- Direct Quotation = price of FC in USD
$1.3187 to buy 1 Euro:
“Euro selling at $1.3187”
$0.1482 to buy 1 Krona:
“Krona selling at $.1482”
| U.S. $ to buy 1 Unit | |
| Euro | 1.3187 |
| Swedish krona | 0.1482 |
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Indirect Exchange Rate Quotations
- Indirect quotation = FC per USD
0.7583 Euros to buy 1 USD
“USD at 0.7583 Euros”
6.7465 Kronas to buy 1 USD
“USD at 6.7465 Kronas”
| Units of FC to buy 1 USD | |
| Euro | 0.7583 |
| Swedish krona | 6.7465 |
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Direct & Indirect Exchange Rate Quotations
- An indirect quotation is the reciprocal of a direct quotation
- Direct Quotation = 1/Indirect Quotation
- Euros and British pounds normally quoted as direct quotations
- “The pound is selling at 1.5961 USD”
- All other currencies quoted as indirect
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Example: Exchange Rates
- Suppose you have $10,000. Based on the rates in Figure 18.1, how many Norwegian krone can you buy?
- Exchange rate = 5.7664 krone per U.S. dollar
- Buy 10,000(5.7664) = 57,664 krone
- Suppose you are visiting London and you want to buy a souvenir that costs 1,000 British pounds. How much does it cost in U.S. dollars?
- Exchange rate = $1.5961 dollars per pound
- Cost = 1,000 X 1.5961 = $1,596.10
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Cross Rates
- The exchange rate between any two currencies not involving U.S. dollars
- Usually calculated from direct or indirect rates
- Based on U.S. dollar exchange rates
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Cross Rates: Euros and Swedish Kronas
Euros Dollars
Dollar Krona
Kronas Dollars
Dollar Euros
×
×
= 0.7583 x 0.1482
= 0.1124 Euros/Krona
Cross Rate =
Cross Rate =
= 6.7465 x 1.3187
= 8.8966 Kronas/Euro
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Arbitrage
- A violation of the “Law of One Price”
- Arbitrage:
- A positive cash flow
- No risk
- Triangle Arbitrage
- Moves through 3 exchange rates
Return to Quick Quiz
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Example: Triangle Arbitrage
- Quoted Rates:
10.00 Mexican Pesos (Ps) per $1
2.00 Swiss Francs (SF) per $1
4.00 Ps per SF
- Implied Cross-Rate
(10.00 Ps/$1) / (2.00 SF/$1) =
5.00 Ps per SF
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Example: Triangle Arbitrage
- Use $100 to buy Pesos
100*(10 Ps/$1) = 1000 Ps
- Use 1000 Pesos to buy SF
1000 Ps / (4 Ps/SF) = 250 SF
- Use 250 SF to buy USD
250 SF / (2 SF/$1) = $125
- $25 risk-free profit
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Triangle Arbitrage
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TRIANG
| Triangle Arbitrage | |||||
| Quote | |||||
| Mexican Pesos /USD | 10.00 | ||||
| Swiss Francs/USD | 2.00 | ||||
| Pesos/SF - Quoted | 4.00 | ||||
| Pesos/SF - Implied | 5.00 | ||||
| USD | Pesos | SF | |||
| Use $100 to buy Mexican Pesos | ($100.00) | 1,000.00 | |||
| Use 1,000 Pesos to buy SF | (1,000.00) | 250.00 | |||
| Use 250 SF to buy USD | $125.00 | (250.00) | |||
| Profit/Loss | $25.00 |
CIA-1
| Covered Interest Arbitrage | ||||||||||||||
| t=0 | t=1 | Interest Rates | ||||||||||||
| SPOT | FWD | Home | Foreign | LHS | RHS | Choose | ||||||||
| $ 1.60 | $ 1.60 | 0.02 | 0.04 | 1.000 | 0.981 | Foreign | ||||||||
| Scenario 1: - Foreign Rate Better | (Spot=FWD; Interest Rate Differential) | |||||||||||||
| Begin holding USD | ||||||||||||||
| No borrowed funds | ||||||||||||||
| At time t=0: | USD | FC | At time t=1: | USD | FC | |||||||||
| SPOT | 1. Convert $800,000 to foreign currency | |||||||||||||
| at the SPOT rate of $1.60 for 1 unit of FC | ||||||||||||||
| Receive 500,000 FC units | ($800,000) | 500,000 | ||||||||||||
| FOREX | 2. Invest 500,000 FC units at the foreign | -500,000 | 1. Receive 520,000 units of | 520,000 | ||||||||||
| rate of 4% for 90 days. | foreign currency. | |||||||||||||
| FWD | 3. Contract to convert $800,000 *(1.04) | - | 2. Convert 520,000 FC to USD | $832,000 | -520,000 | |||||||||
| = $832,000 to USD at time t=1 at FWD | ||||||||||||||
| rate of $1.60 per 1 unit of FC | Receive $832,000 | |||||||||||||
| ($800,000) | $0 | $832,000 | $0 | |||||||||||
| 90-day return | 4.00% | |||||||||||||
| Scenario 2: - Foreign Rate Better | (Spot=FWD; Interest Rate Differential) | |||||||||||||
| Begin holding USD | ||||||||||||||
| Initial investment borrowed | ||||||||||||||
| At time t=0: | USD | FC | At time t=1: | USD | FC | |||||||||
| 1. Borrow $800,000 at the local rate of | $ 800,000 | |||||||||||||
| 2% per year | ||||||||||||||
| SPOT | 2. Convert $800,000 to foreign currency | |||||||||||||
| at the SPOT rate of $1.60 for 1 unit of FC | ||||||||||||||
| Receive 500,000 FC units | ($800,000) | -500,000 | ||||||||||||
| FOREX | 3. Invest 500,000 FC units at the foreign | 500,000 | 1. Receive 520,000 units of | 520,000 | ||||||||||
| rate of 4% for 90 days. | foreign currency. | |||||||||||||
| FWD | 4. Contract to convert $800,000 *(1.04) | 0 | 2. Convert 520,000 FC to USD | $832,000 | -520,000 | |||||||||
| = $832,000 to USD at time t=1 at FWD | ||||||||||||||
| rate of $1.60 per 1 unit of FC | Receive $832,000 | |||||||||||||
| 3. Repay loan of $800,000 for | ||||||||||||||
| 90 days at 2% per year | $ (4,000) | |||||||||||||
| ($800,000) | $0 | $828,000 | $0 | |||||||||||
| 90-day return | 3.50% |
CIA-2
| Covered Interest Arbitrage | Page 196 | ||||||||||||
| t=0 | t=1 | Interest Rates | |||||||||||
| SPOT | FWD | Home | Foreign | ||||||||||
| Bid | Ask | Bid | Ask | Deposit | Borrow | Deposit | Borrow | ||||||
| $ 1.12 | $ 1.13 | $ 1.12 | $ 1.13 | 6.0% | 9.0% | 6.5% | 9.5% | ||||||
| Begin holding USD | |||||||||||||
| No borrowed funds | |||||||||||||
| At time t=0: | USD | FC | At time t=1: | USD | FC | ||||||||
| SPOT | 1. Convert $100,000 to Euros | ||||||||||||
| at the SPOT ASK rate of $1.13 for 1 Euro | |||||||||||||
| Receive 500,000 Euros | ($100,000) | 88,496 | |||||||||||
| FOREX | 2. Invest 88,496 Euros at the foreign | -88,496 | 1. Receive 94,248 units of | 94,248 | |||||||||
| rate of 6.5% for 1 year. | foreign currency. | ||||||||||||
| FWD | 3. Contract to convert 88,496 *(1.065) | - | 2. Convert 94,248 FC to USD | $105,558 | -94,248 | ||||||||
| = 94,248 Euros to USD at time t=1 at FWD | at a BID rate of $1.12 | ||||||||||||
| BID rate of $1.12 per 1 unit of FC | 0 | 0 | Receive $105,558 | ||||||||||
| ($100,000) | $0 | $105,558 | $0 | ||||||||||
| Annual Return | 5.558% | ||||||||||||
| Begin holding USD | |||||||||||||
| Initial investment borrowed | |||||||||||||
| At time t=0: | USD | FC | At time t=1: | USD | FC | ||||||||
| 1. Borrow $100,000 at the local rate of | $ 100,000 | ||||||||||||
| 9% per year | |||||||||||||
| SPOT | 1. Convert $100,000 to Euros | ||||||||||||
| at the SPOT ASK rate of $1.13 for 1 Euro | |||||||||||||
| Receive 500,000 Euros | ($100,000) | 88,496 | |||||||||||
| FOREX | 2. Invest 88,496 Euros at the foreign | -88,496 | 1. Receive 94,248 units of | 94,248 | |||||||||
| rate of 6.5% for 1 year. | foreign currency. | ||||||||||||
| FWD | 3. Contract to convert 88,496 *(1.065) | - | 2. Convert 94,248 FC to USD | $105,558 | -94,248 | ||||||||
| = 94,248 Euros to USD at time t=1 at FWD | at a BID rate of $1.12 | ||||||||||||
| BID rate of $1.12 per 1 unit of FC | $0 | $0 | Receive $105,558 | ||||||||||
| 3. Repay loan of $100,000 for | |||||||||||||
| 1 year at 9% per year. | $ (9,000) | ||||||||||||
| $0 | $0 | $96,558 | $0 | ||||||||||
| Annual Return | -3.442% |
IRP
| Interest Rate Parity | LHS > RHS => Foreign | ||||||||||||
| RHS > LHS => Home | |||||||||||||
| t=0 | t=1 | Interest Rates | |||||||||||
| SPOT | FWD | Home | Foreign | LHS | RHS | Choose | Interest | FOREX | Total | ||||
| 1 | 50 | 50 | 5% | 10% | 1.000 | 0.955 | Foreign | 10% | 0 | 10% | |||
| 2 | 50 | 50 | 10% | 5% | 1.000 | 1.048 | Home | 10% | 0 | 10% | |||
| 3 | 50 | 60 | 5% | 5% | 0.833 | 1.000 | Home | 5% | 20% | 26% | |||
| 4 | 60 | 50 | 5% | 5% | 1.200 | 1.000 | Foreign | 5% | 20% | 26% | |||
| 5 | 60 | 50 | 10% | 5% | 1.200 | 1.048 | Foreign | 5% | 20% | 26% | |||
| 6 | 50 | 60 | 5% | 10% | 0.833 | 0.955 | Home | 5% | 20% | 26% | |||
| Scenario 1: - Foreign Rate Better | (Spot=FWD; Interest Rate Differential) | ||||||||||||
| Begin holding USD | |||||||||||||
| At time t=0: | USD | FC | At time t=1: | USD | FC | ||||||||
| SPOT | 1. Convert $1,000 to foreign currency | ||||||||||||
| at the SPOT rate of 50 units of FC to | |||||||||||||
| 1 USD. | |||||||||||||
| Receive 50,000 FC units | $ (1,000) | 50,000 | |||||||||||
| For | 2. Invest 50,000 FC units at the foreign | (50,000) | 1. Receive 55,000 units of | 55,000 | |||||||||
| rate of 10% for 1 time period. | foreign currency. | ||||||||||||
| FWD | 3. Contract to convert $1,000 *(1.10) | - 0 | 2. Convert 55,000 FC to USD | $ 1,100 | (55,000) | ||||||||
| to FC at time t=1 at FWD rate of | at a rate of 50 FC/1 USD. | ||||||||||||
| 50 units of FC to 1 USD. | Receive $1,100. | ||||||||||||
| $ (1,000) | - 0 | $ 1,100 | - 0 | ||||||||||
| E(R) = | 10% | ||||||||||||
| Scenario 2: - Home Rate Better | (Spot=FWD; Interest Rate Differential) | ||||||||||||
| Begin holding foreign currency | |||||||||||||
| At time t=0: | USD | FC | At time t=1: | USD | FC | ||||||||
| SPOT | 1. Convert 50,000 units of foreign | ||||||||||||
| currency to USD at the SPOT rate of | |||||||||||||
| 50 units of FC to 1 USD. | |||||||||||||
| Receive $1,000. | 1,000 | (50,000) | |||||||||||
| For | 2. Invest $1,000 at home rate | (1,000) | 1. Receive $1,100 | $ 1,100 | |||||||||
| of 10% for 1 time period. | |||||||||||||
| FWD | 3. Contract to convert 1,000 *(1.10) | - 0 | 2. Convert $1,100 to FC at | $ (1,100) | 55,000 | ||||||||
| to FC at time t=1 at FWD rate of | rate of 50 FC/1 USD. | ||||||||||||
| 50 units of FC to 1 USD. | Receive 55,000 units of FC. | ||||||||||||
| $ - 0 | (50,000) | $ - 0 | 55,000 | ||||||||||
| E(R) = | 10% | ||||||||||||
| Scenario 3: - Home Rate Better | (Interest rates =; Exchange Rate Differential) | ||||||||||||
| Begin holding foreign currency | |||||||||||||
| At time t=0: | USD | FC | At time t=1: | USD | FC | ||||||||
| SPOT | 1. Convert 50,000 units of foreign | ||||||||||||
| currency to USD at the SPOT rate of | |||||||||||||
| 50 units of FC to 1 USD. | |||||||||||||
| Receive $1,000. | 1,000 | (50,000) | |||||||||||
| For | 2. Invest $1,000 at home rate | (1,000) | 1. Receive $1,050 | $ 1,050 | |||||||||
| of 5% for 1 time period. | |||||||||||||
| FWD | 3. Contract to convert 1,000 *(1.05) | - 0 | 2. Convert $1,050 to FC at | $ (1,050) | 63,000 | ||||||||
| to FC at time t=1 at FWD rate of | rate of 60 FC/1 USD. | ||||||||||||
| 60 units of FC to 1 USD. | Receive 63,000 units of FC. | ||||||||||||
| $ - 0 | (50,000) | $ - 0 | 63,000 | ||||||||||
| E(R) = | 26% | ||||||||||||
| Scenario 4: - Foreign Rate Better | (Interest rates =; Exchange Rate Differential) | ||||||||||||
| Begin holding USD | |||||||||||||
| At time t=0: | USD | FC | At time t=1: | USD | FC | ||||||||
| SPOT | 1. Convert $1,000 to foreign currency | ||||||||||||
| at the SPOT rate of 60 units of FC to | |||||||||||||
| 1 USD. | |||||||||||||
| Receive 60,000 FC units | $ (1,000) | 60,000 | |||||||||||
| For | 2. Invest 60,000 FC units at the foreign | (60,000) | 1. Receive 63,000 units of | 63,000 | |||||||||
| rate of 5% for 1 time period. | foreign currency. | ||||||||||||
| FWD | 3. Contract to convert $1,000 *(1.05) | - 0 | 2. Convert 63,000 FC to USD | $ 1,260 | (63,000) | ||||||||
| to FC at time t=1 at FWD rate of | at a rate of 50 FC/1 USD. | ||||||||||||
| 50 units of FC to 1 USD. | Receive $1,260. | ||||||||||||
| $ (1,000) | - 0 | $ 1,260 | - 0 | ||||||||||
| E(R) = | 26% | ||||||||||||
| Scenario 5: - Foreign Rate Better | (Interest Rate Differential; Exchange Rate Differential) | ||||||||||||
| Begin holding USD | |||||||||||||
| At time t=0: | USD | FC | At time t=1: | USD | FC | ||||||||
| SPOT | 1. Convert $1,000 to foreign currency | ||||||||||||
| at the SPOT rate of 60 units of FC to | |||||||||||||
| 1 USD. | |||||||||||||
| Receive 60,000 FC units | $ (1,000) | 60,000 | |||||||||||
| For | 2. Invest 60,000 FC units at the foreign | (60,000) | 1. Receive 63,000 units of | 63,000 | |||||||||
| rate of 5% for 1 time period. | foreign currency. | ||||||||||||
| FWD | 3. Contract to convert 60,000 *(1.05) | - 0 | 2. Convert 63,000 FC to USD | $ 1,260 | (63,000) | ||||||||
| to USD at time t=1 at FWD rate of | at a rate of 50 FC/1 USD. | ||||||||||||
| 50 units of FC to 1 USD. | Receive $1,260 | ||||||||||||
| $ (1,000) | - 0 | $ 1,260 | - 0 | ||||||||||
| E(R) = | 26% | ||||||||||||
| Scenario 6: - Home Rate Better | (Interest Rate Differential; Exchange Rate Differential) | ||||||||||||
| Begin holding foreign currency | |||||||||||||
| At time t=0: | USD | FC | At time t=1: | USD | FC | ||||||||
| SPOT | 1. Convert 50,000 units of foreign | ||||||||||||
| currency to USD at the SPOT rate of | |||||||||||||
| 50 units of FC to 1 USD. | |||||||||||||
| Receive $1,000. | 1,000 | (50,000) | |||||||||||
| For | 2. Invest $1,000 at home rate | (1,000) | 1. Receive $1,050 | $ 1,050 | |||||||||
| of 5% for 1 time period. | |||||||||||||
| FWD | 3. Contract to convert 1,000 *(1.05) | - 0 | 2. Convert $1,050 to FC at | $ (1,050) | 63,000 | ||||||||
| to FC at time t=1 at FWD rate of | rate of 60 fc/1 USD. | ||||||||||||
| 60 units of FC to 1 USD. | Receive 63,000 units of FC. | ||||||||||||
| $ - 0 | (50,000) | $ - 0 | 63,000 | ||||||||||
| E(R) = | 26% |
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18-*
Currency Appreciation and Depreciation
- Suppose the exchange rate goes from 8.19 Kronas per USD to 12 Kronas per USD.
- A USD now buys more Kronas, so:
- The USD is appreciating (strengthening)
- The Krona is depreciating (weakening)
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Transaction Terminology
- Spot rate (S)
- The exchange rate for an immediate trade
- Forward rate (F)
- The exchange rate specified today in a forward contract to exchange currency at some future date
- Normally reported as indirect quotations
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The Forward Rate at a Premium to the Spot Rate
- F > S Foreign currency selling at a premium
- Example: Spot rate = 0.7 £/$
Forward rate = 0.6 £/$ - The pound is expected to appreciate
- £ will buy more dollars in the future
Forward rate for the pound is at a premium
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The Forward Rate at a Discount to the Spot Rate
- F < S Foreign currency selling at a discount
- Example: Spot rate = 0.7 £/$
Forward rate = 0.8 £/$ - The pound is expected to depreciate
- £ will buy fewer dollars in the future
Forward rate for the pound is at a discount
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Spot/Forward Relationship
- Primary determinant of the spot/forward rate relationship = relationship between domestic and foreign interest rates.
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Absolute Purchasing Power Parity
- Price of an item is the same regardless of the currency used to purchase it or where it is selling:
- Requirements for Absolute PPP to hold
- No transaction costs
- No barriers to trade (no taxes, tariffs, etc.)
- No difference in the commodity between locations
- Absolute PPP rarely holds in practice
- Usually only for uniform, traded goods
P = Price of goods
S0 = Spot rate
Return to Quick Quiz
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Relative Purchasing Power Parity
- Quantifies inflation-exchange rate relationship
- Provides information about what causes changes in exchange rates
Exchange rates depend on relative inflation between countries
E(St ) = S0[1 + (hFC – hUS)]t
S0 = Current spot exchange rate
E(ST) = Expected exchange rate at time t
hUS = Inflation rate in the U.S.
hFC = Inflation rate in foreign country
(18.3)
Return to Quick Quiz
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PPP Example
- Given:
- Canadian$ spot rate (S0) = 1.2488 C$/USD
- Expected U.S. inflation (hUS) = 3% per year
- Expected Canadian inflation (hFC) = 2%
- Will the USD appreciate or depreciate relative to the Canadian dollar?
- What is the expected exchange rate in one year?
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PPP Example
- Will the USD appreciate or depreciate relative to the Canadian dollar?
- Since inflation is higher in the US, we would expect the US dollar to depreciate relative to the Canadian dollar
- What is the expected exchange rate in one year?
E(St ) = S0[1 + (hFC – hUS)]t
E(S1) = 1.2488[1 + (.02 - .03)]1 = 1.2363
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Covered Interest Arbitrage
Capitalizing on the interest rate
differential between two countries
while covering exchange rate risk with
a forward contract
Return to Quick Quiz
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18-*
Example: Covered Interest Arbitrage
- Consider the following information
- S0 = 2 SF / $ RUS = 10%
- F1 = 1.9 SF / $ RS = 5%
- What is the arbitrage opportunity?
Profit = 110.53 – 100(1.1) = $.53 risk free
In 1 year:
- Receive 200(1.05) = 210 SF
- Convert 210 SF back to dollars
- 210 SF / (1.9 SF / $) = $110.53
- Repay loan = 100(1.10) = $110
Now:
- Borrow $100 at 10%
- Buy $100(2 SF/$) = 200 SF
- Invest 200 SF at 5% for 1 year
- Contract to exchange SF in 1 year at 1.90 SF/US$
*
18-*
Covered Interest Arbitrage
*
TRIANG
| Triangle Arbitrage | |||||
| Quote | |||||
| Mexican Pesos /USD | 10.00 | ||||
| Swiss Francs/USD | 2.00 | ||||
| Pesos/SF - Quoted | 4.00 | ||||
| Pesos/SF - Implied | 5.00 | ||||
| USD | Pesos | SF | |||
| Use $100 to buy Mexican Pesos | ($100.00) | 1,000.00 | |||
| Use 1,000 Pesos to buy SF | (1,000.00) | 250.00 | |||
| Use 250 SF to buy USD | $125.00 | (250.00) | |||
| Profit/Loss | $25.00 |
CIA
| Covered Interest Arbitrage | ||||||||||||
| t=0 | t=1 | Interest Rates | ||||||||||
| SPOT | FWD | Home | Foreign | |||||||||
| 2.00 | 1.90 | 10% | 5% | |||||||||
| At time t=0: | USD | FC | At time t=1: | USD | FC | |||||||
| 1. Borrow $100 at 10% | $ 100.00 | |||||||||||
| SPOT | 2. Convert $100 to foreign currency | |||||||||||
| at the SPOT rate of 2 SF/USD | ||||||||||||
| Receive 200 FC units | $ (100.00) | 200.00 | ||||||||||
| FOREX | 3. Invest 200 FC units at the foreign | -200.00 | 1. Receive 200*(1.05) units of | 210.00 | ||||||||
| rate of 5% | foreign currency. | |||||||||||
| FWD | 4. Contract to convert 200 *(1.05) | - | 2. Convert 210 FC to USD | $110.53 | -210.00 | |||||||
| = $210 to USD at time t=1 at FWD | ||||||||||||
| rate of 1.90 units FC per 1 USD | Receive $110.53 | |||||||||||
| 3. Repay loan of $100 *(1.10) | $ (110.00) | |||||||||||
| $0.00 | $0.00 | $0.53 | 0.00 |
18-*
Interest Rate Parity
Interest rate parity investors should expect to earn the same return on similar-risk securities in all countries:
Forward and spot rates are direct quotations.
RUS = periodic interest rate in the home country (US)
RFC = periodic interest rate in the foreign country
(18.4)
(18.5)
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Exchange Rate Risk
- The risk that the value of a cash flow in one currency translated from another currency will decline due to a change in exchange rates.
- A natural consequence of international operations in a world where relative currency values move up and down.
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Short-Run 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
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Long-Run Exposure
- Long-run fluctuations from unanticipated changes in relative economic conditions
- Managing risk
- 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
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Translation Exposure
- Income from foreign operations translated back to U.S. dollars for accounting, even if foreign currency not actually converted:
- If gains/losses flowed through directly to the income statement significant EPS volatility
- Accounting regulations require:
- All cash flows be converted at the prevailing exchange rates
- Currency gains and losses accumulated in a special account within shareholders’ equity
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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
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Political Risk
- Changes in value due to political actions in the foreign country
- Investment in countries that have unstable governments should require higher returns
- 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 has already been done
- Local financing can often reduce political risk
Return to Quick Quiz
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18-*
Quick Quiz
- What does an exchange rate tell us? (Slide 18.11)
- What is triangle arbitrage? (Slide 18.18)
- What is absolute purchasing power parity? (Slide 18.27)
- What is relative purchasing power parity? (Slide 18.28)
- What is covered interest arbitrage? (Slide 18.31)
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Quick Quiz
- What is interest rate parity? (Slide 18.34)
- What is the difference between short-run interest rate exposure and long-run interest rate exposure and how can you hedge each type? (Slide 18.36) (Slide 18.37)
- What is political risk and what types of business face the greatest risk? (Slide 18.40)
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Chapter 18
END
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Quote
Mexican Pesos /USD 10.00
Swiss Francs/USD 2.00
Pesos/SF - Quoted 4.00
5.00
USD Pesos SF
($100.00) 1,000.00
(1,000.00) 250.00
$125.00 (250.00)
Profit/Loss $25.00
Pesos/SF - Implied
Triangle Arbitrage
Use $100 to buy Mexican Pesos
Use 250 SF to buy USD
Use 1,000 Pesos to buy SF
US
0
UK
P
S
P
´
=
Covered Interest Arbitrage
t=0t=1
SPOTFWDHomeForeign
2.001.9010% 5%
At time t=0: USD FC At time t=1: USD FC
1. Borrow $100 at 10% 100.00$
SPOT2. Convert $100 to foreign currency
at the SPOT rate of 2 SF/USD
Receive 200 FC units (100.00)$ 200.00
FOREX3. Invest 200 FC units at the foreign -200.00 1. Receive 200*(1.05) units of 210.00
rate of 5% foreign currency.
FWD4. Contract to convert 200 *(1.05) - 2. Convert 210 FC to USD $110.53 -210.00
= $210 to USD at time t=1 at FWD
at a rate of 1.90 SF/USD
rate of 1.90 units FC per 1 USD Receive $110.53
3. Repay loan of $100 *(1.10) (110.00)$
$0.00 $0.00 $0.53 0.00
Interest Rates
)
R
R
(
S
)
S
F
(
)
R
1
(
)
R
1
(
S
F
US
FC
0
0
1
US
FC
0
1
-
=
-
+
+
=
:
Approx.
:
Exact
