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Copyright © 2011 Pearson Prentice Hall. All rights reserved.

International Business Finance

Chapter 19

Copyright © 2011 Pearson Prentice Hall. All rights reserved.19-2

Slide Contents

• Learning Objectives• Principles Used in This Chapter

1. Foreign Exchange Markets and Currency Exchange Rates

2. Interest Rate and Purchasing-Power Parity3. Capital Budgeting for Direct Foreign

Investment

• Key Terms


Learning Objectives

1. Understand the nature and importance of the foreign exchange market and learn to read currency exchange rate quotes.

2. Describe interest rate and the purchasing power parity.

3. Discuss the risks that are unique to the capital budgeting analysis of direct foreign investments.


Principles Used in This Chapter

• Principle 2:– There is a Risk-Return Tradeoff.

• Principle 3:– Cash Flows Are the Source of Value.


19.1 Foreign Exchange Markets and the Currency Exchange Rates


Foreign Exchange Markets and the Currency Exchange Rates

• The foreign exchange (FX) market:– Largest financial market with daily trading

volumes of more than $4 trillion.– Organized as over-the-counter market with

participants located in major commercial and investment banks around the world.

– Trading dominated by few currencies including U.S. dollar, the British pound sterling, the Japanese Yen, and the Euro.


Foreign Exchange Markets and the Currency Exchange Rates (cont.)

• Major participants in foreign exchange trading include the following:– Importers and exporters of goods and services,– Investors and portfolio managers who

purchase foreign stocks and bonds, and– Currency traders who make a market in one or

more foreign currencies.


Foreign Exchange Rates

• An exchange rate is simply the price of one currency stated in terms of another.

• For example, if the exchange rate of U.S. dollar for Euro was $1.35 to 1, it means that it would take $1.35 to purchase one Euro.


Foreign Exchange Rates (cont.)

• Direct quote

– It indicates the number of units of U.S. dollar to buy 1 foreign currency unit.

– In the table we see that it took $0.97 to buy 1 Canadian dollar.



• Indirect Quote

– It indicates the number of foreign currency units to buy one American dollar.

– For example, in the table it shows that it will take 6.8276 Chinese yuan to buy 1 U.S. dollar



• We can compute the direct quote from the indirect quote.



• The direct quote for Canadian dollars is $0.97. The related indirect quote will be:

• Indirect quote = 1÷ $0.97 = $1.03


Checkpoint 19.1

Exchanging Currencies

U.S. firm Claremont Steel ordered parts for a generator that were made by a German firm. Claremont was required to pay 1,000 euros to the German firm on January 8, 2010. How many dollars were required for this transaction?


Checkpoint 19.1


Checkpoint 19.1: Check Yourself

Suppose an American firm had to pay $2,000 to a British resident on January 8, 2010. How many pounds did the British resident receive?


Step 1: Picture the Problem

• The key determinant of the number of British pounds received by the British resident is the exchange rate between dollars and pounds.

• The chart (next slide) shows that the amount received in Pounds varies depending on the exchange rate. Thus if the exchange rate is 1$=£.8, the British resident will receive only£1,600.


Step 1: Picture the Problem (cont.)


Step 2: Decide on a Solution Strategy

• To determine the number of British pounds that will be received by the British resident for $2,000 we need to know the number of pounds it takes to buy one dollar i.e. indirect exchange rate quote.


Step 3: Solve

• Number of British Pounds received= (£/$ × $) × $2,000= Indirect quote × $2,000= £ 0.6239/$ × $2,000

= £1,247.80


Step 4: Analyze

• The British resident will receive £ 1,247.80 using the indirect quote.

• Had we used the direct quote, we would have arrived at the wrong answer of £3,205.60 (2000 × 1.6028).


Exchange Rates and Arbitrage

• Arbitrage is the process of buying and selling in more than one market to make a riskless profit.

• Simple arbitrage eliminates exchange rate differentials across the markets for a single currency.


Exchange Rates and Arbitrage (cont.)

• The asked rate (also known as the selling rate or the offer rate) is the rate the bank or the foreign exchange trader “asks” the customer to pay in home currency for foreign currency when the bank is selling and the customer is buying.

• Table 19-1 contains the asked rate quotes.



• The bid rate (also known as the buying rate) is the rate at which the bank buys the foreign currency from the customer by paying in home currency.



• The bank sells a unit of foreign currency for more than it pays for it. The difference between the asked quote and the bid quote is known as the bid-asked spread.

– The spread will be relatively lower for popular currencies that are frequently traded.


Cross Rates

• A cross rate is the computation of an exchange rate for a currency from the exchanges rates of two other currencies.


Types of Foreign Exchange Transactions

• Spot exchange rate is the rate for immediate delivery.

• Forward exchange rate is an exchange rate agreed upon today but which calls for delivery or payment at a future date.

• Spot and forward rate quotes are given in Table 19-1.


Types of Foreign Exchange Transactions (cont.)

• The forward rate is often quoted at a premium to or a discount from the existing spot rate. For example, the 30-day Switzerland franc will be quoted as 0.0001 premium(0.9773-0.9772).

• This premium or discount is known as the forward-spot differential.



• The forward-spot differential can be expressed as:

• Where F= the forward rate, direct quoteS = the spot rate, direct quote



• The premium or discount can also be expressed as an annual percentage rate, computed as follows:


Checkpoint 19.2

Determining the Percent-per-Annum Premium or DiscountYou are in need of yen in six months, but before entering a forward contract to buy them, you would like to know their premium or discount from the existing spot rate. Calculate the premium or discount from the existing spot rate for the 6-month yen as of January 8, 2010 using the data given in Table 19.1.


Checkpoint 19.2



Given the information provided above, what is the premium or discount on from the existing spot rate on the one-month yen?



• To determine the premium or discount from the existing spot rate, we need to know the prices.


Step 1: Picture the Problem (cont.)

• Given spot and forward rates



• We can determine the size of the premium or discount using the following equation and then annualize it.


Step 3: Solve

• = (0.010798 - .010798)/.010798 × (12/1) × 100

• = 0%


Step 4: Analyze

• Since the spot rate and 1-month forward rate are equal, the premium or discount percent is equal to zero.

• The degree of premium or discount is determined by market forces. Generally, the premium or discount is not equal to zero.


19.2 Interest Rate and Purchasing Power Parity


Interest Rate Parity

• Interest rate parity is a theory that can be used to relate differences in the interest rates in two countries to the ratios of spot and forward exchange rates of the two countries’ currencies.

• Specifically,Differences in interest rates = Ratio of the

forward and spot rates


Interest Rate Parity (cont.)



• Interest rate parity means that you get the same total return for the following two options:

– Invest directly in the US; or

– Convert dollars to Japanese Yens,– Invest Yens in the risk-free rate in Japan, and– Convert Yens back to U.S. dollars.



• Example 19.1 You have $1,000,000 to invest and you observe the following quotes in the market:1$ = ¥ 106 180-day forward rate = 103.50U.S. 180-day risk-free interest rate = 4.4%Japan 180-day risk-free interest rate = 2%

• Determine whether interest rate parity holds.



Option I: Invest directly in USA and earn 4.4%1,000,000 * 1.044 = $1,044,000

Option II:(a) Convert to Yen at spot rate = ¥ 106,000,000(b) Invest at 2% = ¥106,000(1.02) = ¥ 108,120,000

(c) Convert to $ at the forward rate = 108,120,000 ÷103.5 = $1,044,638

==> Difference of $638 ==> Interest Rate Parity does not hold


Purchasing Power Parity and the Law of One Price

• According to the theory of purchasing power parity (PPP), exchange rates adjust so that identical goods cost the same amount regardless of where in the world they are purchased.


Purchasing Power Parity and the Law of One Price (cont.)

• Underling PPP theory is the law of one price, which states that the same good should sell for the same price in different countries after making adjustments for the exchange rate between the two currencies.

• Figure 19-2 illustrates one example of exception to the PPP theory.



• The differences in prices around the world could be explained by:– Tax differences among countries– Differences in labor costs– Differences in raw material costs– Differences in rental costs



• In general, we expect PPP to hold for goods that can be cheaply shipped between countries (for example, expensive gold jewelry).

• PPP does not seem to hold for non-traded goods like restaurant meals and haircuts.


The International Fisher Effect

• The International Fisher Effect (IFE) assumes that real rates of return are the same across the world, so that the differences in nominal returns around the world arise because of differences in inflation rates.

• Like purchasing power parity, IFE is just an approximation that may not hold exactly.


The International Fisher Effect (cont.)

• Example 19.2 Assume that the real rate of interest is equal to 2% in all countries. What will be the nominal interest rate in UK and USA, if UK is expecting an inflation rate of 6% and USA is expecting an inflation rate of 3%.



• Interest rate (USA) = .03 + .02 + [.03×.02]

= .0506 or 5.06%

• Interest rate (UK) = .06 + .02 + [.06×.02]= .0812 or 8.12%



• IFE cautions us that we should not invest in a country just because it offers the highest interest rates.

• IFE notes that such high interest rate is an indication of high inflation. Accordingly, any gain in interest rates will be offset by losses due to foreign currency depreciation.


19.3 Capital Budgeting for Direct Foreign Investment


Capital Budgeting for Direct Foreign Investment

• Direct foreign investment occurs when a company from one country makes a physical investment into building a factory in another country. A multinational corporation (MNC) is one that has control over this investment.


Capital Budgeting for Direct Foreign Investment (cont.)

• A major reason for direct foreign investment by U.S. companies is the prospect of higher rates of return from these investments.

• The method used to evaluate foreign investments is very similar to the method used to evaluate capital budgeting decisions in a domestic context.


Checkpoint 19.3

International Capital BudgetingYou are working for an American firm that is looking at a new project that will produce the following cash flows, which are expected to be repatriated to the parent company and are measured in South African Rand (SAR),

In addition, the risk-free rate in the United States is 4 percent and this project is riskier than most; as such, the firm has determined that it should require a 9 percent premium over the risk-free rate. Thus, the appropriate discount rate for this project is 13 percent. In addition, let’s assume the current spot exchange rate is .11SAR/$, and the 1-year forward exchange rate is .107SAR/$. Calculate the expected cash flows for this project in U.S. dollars, and then use these cash flows to calculate the project’s NPV.


Checkpoint 19.3



The ProblemAn American firm is looking for a new project that will produce the following cash flows which are expected to be repatriated to the parent company and are measured in South African Rand (SAR).

Year Cash flow (in millions of SAR)0 -201 102 103 64 6


The Problem (cont.)

• In addition, the risk-free rate in the United States is 4 percent, and this project is riskier than most, and as such, the firm has determined that it should require a 10 percent premium over the risk-free rate. Thus, the appropriate discount rate for this project is 14 percent. In addition, the current spot exchange rate is .11 SAR/$, and the 1-year forward exchange rate is .107SAR/$. What is the project’s NPV?



i=14%

Time

Cash flow -20 10 10 6 6(millions, SAR)

• The timeline illustrates the following:– The discount rate is 14%.– A cash outflow of -20 million SAR occurs at the beginning of

the first year (at time 0), followed by positive cash inflows during the next four years.

0 1 2 3 4



• To calculate the project’s NPV, we need to convert South African Rand into U.S. dollars. However, we only have 1-year forward rates.

• We can use equation 19-5 and the given forward rate and spot rate to determine the interest rate differential in the two countries.


Step 2: Decide on a Solution Strategy (cont.)

• 1 year forward rate = (interest rate differential)1 × (spot exchange

rate)

• We can then use the forward rate to convert the cash flows measured in SARs into U.S. dollars. Once we have the cash flows, we can compute the NPV using a 14% discount rate.


Step 3: Solve

• Interest rate differential = Forward rate/spot rate= .107/.11= 0.9727

• We can use the interest rate differential to calculate the forward exchange rate and then convert the SAR denominated cash flows into U.S. dollars.


Step 3: Solve (cont.)

Year Spot Rate × (Interest Rate Differential) n

Forward rate for year n

0 0.111 0.11 SAR/$ x 0.9727 0.107 SAR/$2 0.11 SAR/$ x (0.9727) 2 0.10415 SAR/$3 0.11 SAR/$ x (0.9727) 3 0.1012 SAR/$4 0.11 SAR/$ x (0.9727) 4 0.0985 SAR/$



• Solve using an Excel Spreadsheet

• NPV = -2.2 + npv (0.14; 1.07,1.041,0.6072,0.591)

= $0.299 million or $299,000

Input in Excel

Year

Cash flow (in millions

of SAR)

Implied Forward

Rate

Cash flow (in millions

of $)

0 -20 0.11 -2.2

1 10 0.107 1.07

2 10 0.1041 1.041

3 6 0.1012 0.6072

4 6 0.0985 0.591

NVP $0.299



• Computing NPV using equation

• NPV = -$2.2m + $1.07m/(1.14) + $1.041m/(1.14)2 + $0.6072m/(1.14)3 + $0.591m/(1.14)4

= $0.299 million or $299,000


Step 4: Analyze

• Note, the only relevant cash flows are those that are expected to be repatriated back to the home country and the initial cash outflow.

• Also, discount rate should be in the same currency that the cash flows are measured in. Here discount rate was in U.S. dollars, so we converted the SAR cash flows into U.S. dollars.


Foreign Investment Risks

• Risks in domestic capital budgeting arises from two sources:

– Business risk related to the specific product or service and the uncertainty associated with that market.

– Financial risk is the risk imposed on the investment as a result of how the project is financed.


Foreign Investment Risks (cont.)

• Foreign direct investment includes both business and financial risk, plus political risk and exchange rate risk.



• Political risk can arise if the business is conducted in a country that is not politically stable leading to changes in policies with respect to businesses.



• Some examples of political risk are as follows:– Expropriation of plants and equipment without

compensation.– Non-convertibility of the subsidiary’s foreign

earnings into the parent’s currency.– Substantial changes in tax rates.– Requirements regarding the local ownership of

business.



• Exchange rate risk is the risk that the value of the firm’s operations and investments will be adversely affected by changes in exchange rates.

• For example, if the Japanese Yen depreciates, it will translate to fewer dollars when it is sent back to the U.S.


Key Terms

• Arbitrage• Asked rate• Bid rate• Bid-asked spread• Buying rate• Cross rate• Delivery rate


Key Terms (cont.)

• Direct foreign investment• Direct quote• Exchange rate• Exchange rate risk• Foreign exchange (FX) market• Forward exchange contract• Forward exchange rate


Key Terms (cont.)

• Forward-spot differential• Indirect quote• Interest-rate parity (IRP)• International fisher effect (IFE)• Law of one price• Multinational corporation• Political risk


Key Terms (cont.)

• Purchasing-power parity (PPP)• Selling rate• Simple arbitrage• Spot exchange rate