political and business risks

Chapter 18 – International Aspects of Financial Management

Chapter 18 – International Aspects of Financial Management

Chapter 18 – International Aspects of Financial Management

ANNOTATED CHAPTER OUTLINE

Slide 18.2 Key Concepts and Skills

Slide 18.3 Chapter Outline

Slide 18.4 International Finance Terminology

ADR—security issued in the U.S. that represents shares in a foreign company’s stock

Cross-rate—implied exchange rate between two currencies, when both currencies are quoted in terms of a third one

Eurobond—bond sold in more than one country, but denominated in one currency (usually the issuer’s domestic currency)

Slide 18.5 International Finance Terminology

Eurocurrency—money deposited in a bank in a country with a different currency; Eurodollars are U.S. dollars deposited in a foreign bank.

Foreign bonds—bonds issued in a single foreign country in that country’s currency

Gilts—British and Irish government issues

Slide 18.6 International Finance Terminology

LIBOR—loan rate on Eurodollars; commonly used as an index for floating rate securities

Swaps

• Interest rate swap—agreement between two parties to pay interest to one another on some notional amount; one party pays a fixed rate, and the other pays a floating rate

• Currency swap—agreement to periodically swap currencies, with exchange rate based on some pre-specified rate

Lecture Tip: Although the definition of Eurodollars is “deposits of U.S. dollars in banks located outside the United States,” you should emphasize that Eurodollars are not actual U.S. currencies deposited in a bank but are bookkeeping entries on a bank’s ledger. These deposits are loaned to the Euro bank’s U.S. affiliate to meet liquidity needs, or the funds might be loaned to a corporation abroad that needs the loan denominated in U.S. dollars. Money does not normally leave the country of its origination; merely the ownership is transferred to another country.

You might add that a dollar-denominated Eurobond is free of exchange rate risk for a U.S. investor, regardless of where it is issued. A foreign bond would be subject to this risk if it was not issued in the U.S. The reason is that the Eurobond pays interest in U.S. dollars, but the foreign bond pays interest in the currency of the country in which it was issued.

Slide 18.7 Global Capital Markets (Web link)

www: Click on the Web Surfer icon to go to a site that provides a wealth of information on international business (www.internationalist.com/business).

Video Note : “International Finance” takes a look at McDonald’s expansion into India.

Slide 18.8 Example: Work the Web (Web link)

Finding spot exchange rates on the web.

Slide 18.9 FOREX Trading

Foreign exchange market—market for buying and selling currencies. It is the largest market in $ value in the world.

Trades 24 hours a day/7 days a week.

Most currency trading is done with currencies being quoted in U.S. dollars.

Quotes are direct or indirect.

Slide 18.10 Foreign Exchange Quotes: Figure 18.1

Slide 18.11 Exchange Rates

Direct quotes = price of FC in USD

Indirect = #FC to 1 USD

Slide 18.12 Direct Exchange Rate Quotations

Example using Euros and Krona.

Direct quotes are stated as “the Euro is selling at nnn USD.”

Slide 18.13 Indirect Exchange Rate Quotations

Example using Euros and Krona.

Indirect quotes are states as “the USD is at nn FC.”

Slide 18.14 Direct and Indirect Exchange Rate Quotations

Direct and indirect quotes are reciprocals of each other.

Slide 18.15 Example: Exchange Rates

Two examples

Slide 18.16 Cross Rates

Implicit in exchange rate quotations is an exchange rate between non-U.S. currencies. The exchange rate between two non-U.S. currencies must equal the cross rate to prevent arbitrage.

Slide 18.17 Cross Rates: Euros and Kronas

Example of calculating cross rates using Euros, Krona, and the USD.

Slide 18.18 Arbitrage

Risk-free arbitrage requires:

• A zero investment

• No risk

• A positive cash flow

Slide 18.19 Example: Triangle Arbitrage

The only cross-rate that will prevent triangle arbitrage is 4 Ps/SF.

Students often have difficulty with figuring out when they need to multiply or divide. It may help to show them that the currencies need to “cancel”.

Lecture Tip: The opportunity to exploit a triangle arbitrage may appear to be an easy opportunity to make a quick profit. Point out that arbitrage opportunities are rare and that the transaction costs for small investors would outweigh any profit opportunity available. However, traders that have cheaper access to the currency market may be able to take advantage of opportunities that would not be available to the “normal” investor— like us.

Slide 18.20 Example: Triangle Arbitrage

Outlines the steps in the Triangle arbitrage using the Swiss Franc, the Mexican Peso, and the USD.

Slide 18.21 Triangle Arbitrage

Triangle arbitrage shown in an Excel worksheet.

Slide 18.22 Currency Appreciation and Depreciation

Currency appreciation and depreciation—appreciation of one currency relative to another means that it takes more of the second currency to buy the first. For example, if the dollar appreciates relative to the yen, it means it will take more yen to buy $1. Depreciation is just the opposite.

Lecture Tip: When asked, “Which is better—a stronger dollar or a weaker dollar?” most students answer a stronger one. While this makes imports relatively cheaper, it makes U.S. exports relatively more expensive. In general, consumers like a stronger dollar, and producers (especially exporters) prefer a weaker one. At times, the government has spent considerable resources on making the dollar cheaper against the yen in an effort to reduce our trade deficit with Japan.

The effects of a falling dollar were exemplified in 1995 when the dollar fell to record lows against the yen. By mid-summer, the deficit with Japan had narrowed significantly. On the other hand, the dollar had risen sharply against the Mexican peso, and the U.S. trade deficit with Mexico skyrocketed over the same period.

Slide 18.23 Transaction Terminology

Spot trade—exchange of currencies at immediate prices (spot rate)

Forward trade—contract for the exchange of currencies at a future date at a price specified today (forward rate)

Slide 18.24 The Forward Rate at a Premium to the Spot Rate

If the forward rate > spot rate (based on $ equivalent or “direct” quotes), then the foreign currency is expected to appreciate and is selling at a premium; its dollar price is expected to rise.

Slide 18.25 The Forward Rate at a Discount to the Spot Rate

If the forward rate < spot rate (based on $ equivalent or “direct” quotes), then the foreign currency is expected to depreciate and is selling at a discount; its dollar price is expected to fall.

Slide 18.26 Spot/Forward Relationship

Primary determinant—relationship between domestic and foreign interest rates.

Slide 18.27 Absolute Purchasing Power Parity

Absolute PPP indicates that a commodity should sell for the same real price regardless of currency used.

Absolute PPP can be violated due to transaction costs, barriers to trade, and differences in the product.

Slide 18.28 Relative Purchasing Power Parity

The change in the exchange rate depends on the difference in inflation rates between countries.

Relative PPP says that:

E(St ) = S0[1 + (hF – hUS)]t (18.3)

The exchange rate must be quoted as foreign currency per dollar for this form of the equation to hold.

Lecture Tip: The concept of relative PPP can be reinforced by considering an identical product that sells in both England and the U.S. at identical relative prices. If the inflation rate is 4% per year in the U.S., then the price for the product would increase by 4% over the year. However, if the inflation rate in England is 10%, the product price would increase by 10% in England over the year.

Suppose the original price is $1 in the U.S. and the exchange rate is .5 pound per dollar, so the product would cost .5 pound in England. At the end of the year, the price in the U.S. would be 1(1.04) = $1.04 and the price in England would be .5(1.1) = .55 pound. To prevent arbitrage, the exchange rate must change so that $1.04 is now equivalent to .55 pound. Thus, the new exchange rate must be .55 pound /$1.04 = .5288 pound per dollar.

The dollar has appreciated relative to the pound (it takes more pounds to buy $1) because of the lower inflation rate in the U.S.

Slide 18.29 PPP Example

Slide 18.30 PPP Example

Slide 29 lays out the example data and questions.

Slide 30 contains the solutions.

Slide 18.31 Covered Interest Arbitrage

A covered interest arbitrage exists when a riskless profit can be made by buying low and selling high. The opportunity exists due to interest rate differentials between two countries’ exchange rates.

Slide 18.32 Example: Covered Interest Arbitrage

In this example, we borrow in the U.S. at the U.S. risk-free rate, convert the borrowed dollars into Swiss Francs, invest at that country’s rate of interest, enter into a forward contract to convert the francs back into U.S. dollars, and then repay the loan.

Example:

S0 = 2 SF/$ RUS = 10%

F1 = 1.9 DM/$ RS = 5%

1. Borrow $100 at 10%.

2. Buy $100(2 SF/$) = 200 SF and invest at 5% (RS).

3. At the same time, enter into a forward contract.

4. In 1 year, receive 200(1.05) = 210 SF.

5. Convert to $ using forward contract; 210 SF/(1.9 SF/$) = $110.53.

6. Repay loan and pocket profit: 110.53 – 100(1.1) = $.53.

Slide 18.33 Covered Interest Arbitrage

Demonstrates the steps in covered interest arbitrage

Slide 18.34 Interest Rate Parity

Interest rate parity says the investors should expect to earn the same return on similar risk securities in all countries.

To prevent covered arbitrage: