fm10e ch22

Chapter Chapter 2222

InternationalInternationalBusiness Business FinanceFinance

InternationalInternationalBusiness Business FinanceFinance

2005, Pearson Prentice Hall

International Business FinanceInternational Business Finance

Exchange Rate:Exchange Rate: the price of one the price of one currency in terms of another.currency in terms of another.

Exchange RatesExchange Rates

Exchange rates affect our economy and Exchange rates affect our economy and each of us because:each of us because:

1) When the 1) When the dollar appreciatesdollar appreciates (strong (strong dollar), the dollar becomes more dollar), the dollar becomes more valuable relative to other currencies.valuable relative to other currencies.



1) When the 1) When the dollar appreciatesdollar appreciates (strong (strong dollar), the dollar becomes more dollar), the dollar becomes more valuable relative to other currencies.valuable relative to other currencies. Foreign products become cheaper to us. Foreign products become cheaper to us.



1) When the 1) When the dollar appreciatesdollar appreciates (strong (strong dollar), the dollar becomes more dollar), the dollar becomes more valuable relative to other currencies.valuable relative to other currencies. Foreign products become cheaper to us. Foreign products become cheaper to us. U.S. products become more expensive U.S. products become more expensive

overseas.overseas.


Exchange rates affect our economy Exchange rates affect our economy and each of us because:and each of us because:



2) When the 2) When the dollar depreciatesdollar depreciates (weak dollar), the dollar falls in (weak dollar), the dollar falls in value relative to other currencies.value relative to other currencies.



2) When the 2) When the dollar depreciatesdollar depreciates (weak dollar), the dollar falls in (weak dollar), the dollar falls in value relative to other currencies.value relative to other currencies. Foreign products become more Foreign products become more

expensive for us.expensive for us.



2) When the 2) When the dollar depreciatesdollar depreciates (weak dollar), the dollar falls in (weak dollar), the dollar falls in value relative to other currencies.value relative to other currencies. Foreign products become more Foreign products become more

expensive for us.expensive for us. U.S. products become cheaper U.S. products become cheaper

overseas.overseas.

Spot Exchange RatesSpot Exchange Rates

£ / $ = £ / $ = .6162.6162 (it takes .6162 pounds to = $1) (it takes .6162 pounds to = $1)

$ / £ = $ / £ = 1.62291.6229 (it takes $1.6229 to = 1 (it takes $1.6229 to = 1

pound)pound)

¥ / $ = ¥ / $ = 115.97115.97 (it takes 115.97 yen to = $1) (it takes 115.97 yen to = $1)

$ / ¥ = $ / ¥ = .00862.00862 ( it takes $.00862 to = 1 ( it takes $.00862 to = 1 yen)yen)

(note: direct and indirect quotes are reciprocals)(note: direct and indirect quotes are reciprocals)

What Determines Exchange Rates?What Determines Exchange Rates?

Floating Rate Currency System:Floating Rate Currency System: Since Since 1973, the world has allowed exchange 1973, the world has allowed exchange rates to change daily in response to rates to change daily in response to market forces.market forces.

Exchange rates are affected by:Exchange rates are affected by: foreign investorsforeign investors speculatorsspeculators political conditions here and overseaspolitical conditions here and overseas inflationinflation trade policies (tariffs and quotas) and…trade policies (tariffs and quotas) and…


Supply and Demand for currencies!Supply and Demand for currencies!

Let’s consider the Let’s consider the £ / $£ / $ market. market.


Suppose the British increase demand for Suppose the British increase demand for U.S. products.U.S. products.

British importers buy the U.S. products to British importers buy the U.S. products to sell in England. They sell in England. They buy dollars with buy dollars with poundspounds, so they can pay U.S. firms in , so they can pay U.S. firms in dollars.dollars.

The The demand for dollars increasesdemand for dollars increases and and forces forces up the £ / $ exchange rateup the £ / $ exchange rate, which makes , which makes U.S. products more expensive in England.U.S. products more expensive in England.


£ / $(price ofdollars)

Supply ofDollars

Demand for Dollars

Quantity of dollars


Another example:Another example:

Let’s consider the Let’s consider the ¥ / $¥ / $ market. market.


Suppose American demand for Japanese Suppose American demand for Japanese cars and stereos increases rapidly.cars and stereos increases rapidly.

American importers buy the Japanese American importers buy the Japanese products to sell in the U.S. They products to sell in the U.S. They buy yen buy yen with dollarswith dollars, so they can pay Japanese , so they can pay Japanese firms in yen.firms in yen.

The The supply of dollars increasessupply of dollars increases, and , and forces forces down the ¥ / $ exchange ratedown the ¥ / $ exchange rate, which , which makes Japanese products more expensive makes Japanese products more expensive in the U.S.in the U.S.


¥ / $(price ofdollars)

Supply ofDollars

Demand for Dollars

Quantity of dollars

Foreign Exchange MarketsForeign Exchange Markets

Different exchange rates are used for Different exchange rates are used for different types of transactions:different types of transactions:

1) 1) Spot Exchange MarketSpot Exchange Market:: deals with deals with currency for immediate delivery. currency for immediate delivery.

The exchange rate used in spot transactions The exchange rate used in spot transactions is called the is called the spot exchange rate.spot exchange rate.

If you need If you need 500,000 francs500,000 francs to buy imports, to buy imports, and the spot exchange rate is and the spot exchange rate is .1457.1457, you , you would pay your bank would pay your bank $72,850$72,850..

Foreign Exchange MarketsForeign Exchange Markets

2) 2) Forward Exchange MarketForward Exchange Market:: deals with the deals with the future delivery of foreign currency. future delivery of foreign currency.

You can buy or sell currency for future You can buy or sell currency for future delivery, usually in one, three, or six delivery, usually in one, three, or six months.months.

The exchange rate for forward transactions The exchange rate for forward transactions is called the is called the forward exchange rate.forward exchange rate.

Forward exchange contracts allow you to Forward exchange contracts allow you to hedge foreign exchange risk!hedge foreign exchange risk!

Forward Market HedgeForward Market Hedge

Example: You will import wine from France, Example: You will import wine from France, to be delivered and paid for in six months.to be delivered and paid for in six months.

You have agreed to a price of You have agreed to a price of 500,000500,000 francsfrancs. With the spot exchange rate . With the spot exchange rate of of .1457.1457, this comes to , this comes to $72,850$72,850..

Suppose the dollar weakens over the next six Suppose the dollar weakens over the next six months, and the months, and the $/F exchange rate rises to .20.$/F exchange rate rises to .20.

The wine would cost you The wine would cost you $100,000$100,000. This is . This is an example of an example of foreign exchange riskforeign exchange risk!!

Forward Market HedgeForward Market Hedge

You decide to hedge your risk with a You decide to hedge your risk with a forward exchange contract! forward exchange contract!

The The six-months $/F forward exchange six-months $/F forward exchange raterate is is .1476.1476. By agreeing to this forward . By agreeing to this forward rate with your bank, you lock in a price of rate with your bank, you lock in a price of $73,800$73,800 for 500,000 francs, six months for 500,000 francs, six months from now.from now.

Now it doesn’t matter what happens to Now it doesn’t matter what happens to the $/F exchange rate over the next six the $/F exchange rate over the next six months.months.

Money Market HedgeMoney Market Hedge

For the previous problem, another potential For the previous problem, another potential solution is the money market hedge.solution is the money market hedge.

1) Borrow 1) Borrow $72,850$72,850 from your bank. from your bank.

2) Buy the 2) Buy the 500,000 francs500,000 francs now (at the current now (at the current spot exchange rate of spot exchange rate of .1457.1457) for ) for $72,850$72,850..

3) Invest the 3) Invest the 500,000 francs500,000 francs in interest-bearing in interest-bearing French securities.French securities.

4)Complete your transaction after six months.4)Complete your transaction after six months.[Borrowing and investment rates determine the cost of the [Borrowing and investment rates determine the cost of the

hedge.]hedge.]

Forward-Spot DifferentialForward-Spot Differential

If the If the forward rate > the spot rateforward rate > the spot rate, the , the forward is trading at a forward is trading at a premiumpremium..

If the If the forward rate < the spot rateforward rate < the spot rate, the , the forward is trading at a forward is trading at a discountdiscount. .


If the If the forward rate > the spot rateforward rate > the spot rate, the , the forward is trading at a forward is trading at a premiumpremium..

If the If the forward rate < the spot rateforward rate < the spot rate, the , the forward is trading at a forward is trading at a discountdiscount. .

premium premium forward - spot 12 forward - spot 12

or discountor discount spot n spot n = [ ] [ ] x 100


For our example, For our example,


= [ ] [ ] x 100



or discountor discount spot n spot n


= [ ] [ ] x 100

= [ ] [ ] x 100




.1476 - .1457 12.1476 - .1457 12

.1457 6.1457 6


= [ ] [ ] x 100

= [ ] [ ] x 100




.1476 - .1457 12.1476 - .1457 12

.1457 6.1457 6

= 2.6. = 2.6. The forward is trading at a 2.6% The forward is trading at a 2.6% premium.premium.

Interest Rate ParityInterest Rate Parity

Links the forward exchange market with Links the forward exchange market with the spot exchange market. The idea:the spot exchange market. The idea:

The annual percentage difference between The annual percentage difference between the forward rate and the spot rate the forward rate and the spot rate (forward premium or discount) is (forward premium or discount) is approximately equal to the difference in approximately equal to the difference in interest rates between the two countries.interest rates between the two countries.

Arbitrage in the forward and spot markets Arbitrage in the forward and spot markets helps to hold this relationship in place.helps to hold this relationship in place.

Purchasing Power ParityPurchasing Power Parity

Links changes in exchange rates with Links changes in exchange rates with differences in inflation rates and the differences in inflation rates and the purchasing power of each nation’s currency.purchasing power of each nation’s currency.

In the long run, exchange rates adjust so that In the long run, exchange rates adjust so that the purchasing power of each currency tends the purchasing power of each currency tends to be the same.to be the same.

Exchange rate changes tend to reflect Exchange rate changes tend to reflect international differences in inflation rates.international differences in inflation rates.

Countries with high inflation tend to Countries with high inflation tend to experience currency devaluation.experience currency devaluation.

The Law of One PriceThe Law of One Price

In competitive markets where there are no In competitive markets where there are no transportation costs or barriers to trade, the transportation costs or barriers to trade, the same goods sold in different countries sell for same goods sold in different countries sell for the same price if all the different prices are the same price if all the different prices are expressed in terms of the same currency.expressed in terms of the same currency.

This proposition underlies the PPP This proposition underlies the PPP relationship.relationship.

Arbitrage allows the law of one price to hold Arbitrage allows the law of one price to hold for commodities that can be shipped to other for commodities that can be shipped to other countries and resold.countries and resold.

Exchange Rate RiskExchange Rate Risk

Translation exposureTranslation exposure - - foreign currency foreign currency assets and liabilities that, for accounting assets and liabilities that, for accounting purposes, are translated into domestic purposes, are translated into domestic currency using the exchange rate, are currency using the exchange rate, are exposed to exchange rate risk.exposed to exchange rate risk.

However, if markets are efficient, However, if markets are efficient, investors know that any translation losses investors know that any translation losses are “paper” losses and are unrealized.are “paper” losses and are unrealized.

Exchange Rate RiskExchange Rate Risk

Transaction exposureTransaction exposure - - refers to refers to transactions in which the monetary transactions in which the monetary value is fixed before the transaction value is fixed before the transaction actually takes place. actually takes place.

ExampleExample: your firm buys foreign goods : your firm buys foreign goods to be received and paid for at a later to be received and paid for at a later date. The exchange rate can change, date. The exchange rate can change, which can affect the price actually paid.which can affect the price actually paid.

Multinational Working-Capital Multinational Working-Capital ManagementManagement

Leading and LaggingLeading and Lagging Lead:Lead: dispose of a net asset position in a dispose of a net asset position in a

weak currency.weak currency.

Pay a net liability position in a weak Pay a net liability position in a weak currency.currency.

Lag:Lag: Delay collection of a net asset position Delay collection of a net asset position in a strong currency. in a strong currency.

Delay payment of a net liability position in Delay payment of a net liability position in a weak currency.a weak currency.

Direct Foreign InvestmentDirect Foreign Investment

RisksRisks Business Risk - Business Risk - firms must be aware firms must be aware

of the business climate in both the of the business climate in both the U.S. and the foreign country.U.S. and the foreign country.

Financial Risk - Financial Risk - not much difference not much difference between financial risks of foreign between financial risks of foreign operations and those of domestic operations and those of domestic operations.operations.

Direct Foreign InvestmentDirect Foreign Investment

RisksRisks Political Risk - Political Risk - firms must be aware firms must be aware

that many foreign governments are that many foreign governments are not as stable as the U.S.not as stable as the U.S.

Exchange Rate Risk - Exchange Rate Risk - exchange rate exchange rate changes can affect sales, costs of changes can affect sales, costs of goods sold, etc. as well as the firm’s goods sold, etc. as well as the firm’s profit in dollars.profit in dollars.

fm10e ch22

Business

exchange rates exchange

spot exchange rates

forward exchange market

spot exchange market

f exchange rate

theforward exchange

thespot exchange rate

forward exchange contracts