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International Financial Management Professor Thomson Fin 3013 International Financial Management Professor Thomson Fin 3013

International Finance • Broadens the application of finance • If you have excess cash International Finance • Broadens the application of finance • If you have excess cash available, you could look at all of the US banks to make your deposit and choose the highest rate • A broader perspective would be to look at banks around the world • Similarly, you would like to sell your product into the market that will pay the most, or you may wish to expand sales by selling in more places 2

International Finance What are the risks from transacting on a global scale? – One International Finance What are the risks from transacting on a global scale? – One risk is that the transactions will not be made in $US so if currencies fluctuate you have added a degree of risk 3

Fixed versus Floating Exchange Rates Floating exchange rate system Fixed exchange rate system Managed Fixed versus Floating Exchange Rates Floating exchange rate system Fixed exchange rate system Managed floating rate system 4 • Currencies float freely in this system, and exchange rates (prices) are set by supply and demand. • $US, Japanese Yen, British Pound, Swiss Franc float freely. • Currency value is fixed (pegged) in terms of another currency. • If demand for currency increases (decreases), government must sell (buy) currency to maintain fixed rate. • Currency is loosely pegged to other currency, but value is mostly determined by supply/demand.

Exchange Rate Quotes $US equivalent Currency per $US 5 • The dollar cost of Exchange Rate Quotes $US equivalent Currency per $US 5 • The dollar cost of one unit of foreign currency • One Argentine peso equals $0. 3525 on April 20, 2004 and $0. 3506 on April 21, 2004. • The peso thus depreciated against the dollar. • The value of each currency relative to one U. S. dollar. Reciprocal of US$ equivalent • One dollar was worth 2. 8369 Argentine pesos on April 20, 2004 and 2. 8523 Argentine pesos on April 21, 2004. • The dollar appreciated vs. the peso.

See www. xe. com for current 6 See www. xe. com for current 6

Winners and Losers from Exchange Rate Changes Suppose the euro appreciates against the Canadian Winners and Losers from Exchange Rate Changes Suppose the euro appreciates against the Canadian Dollar. This benefits European consumers or producers buying Canadian goods. It hurts Canadian consumers or producers buying European goods. 7 Winners and losers reversed when a currency depreciates.

Law of one price • States that the same good must have the same Law of one price • States that the same good must have the same price in all markets, or else there will be an arbitrage opportunity. • If that new plasma TV costs less at Best Buy than Circuit City everyone will buy at Best Buy, so Circuit City will have to match the price • The limits to arbitrage are the transaction costs of implementing the required trades 8

Where to buy those sunglasses 9 • XE. com displays the following exchange rate Where to buy those sunglasses 9 • XE. com displays the following exchange rate for $1 US. • 0. 7844 Euros 0. 5443 British Pounds • Julbo Colorados can be purchase for 44 Euros or 35 Pounds. Which country has the best deal? • Euro deal is 1/. 7844 * 44= $56. 09 • British deal is 1/. 5443 * 30 = $55. 12 • Buy those shades in Britian

Definition: Arbitrage • The purchase of securities on one market for immediate resale on Definition: Arbitrage • The purchase of securities on one market for immediate resale on another market in order to profit from a price discrepancy. • [Middle English, arbitration, from Old French, from arbitrer, to judge, from Latin arbitr r , to give judgment. See arbitrate. ] 10

Arbitrage Opportunity • You could buy Julbo’s in Britain, and sell them in Europe Arbitrage Opportunity • You could buy Julbo’s in Britain, and sell them in Europe and make $. 97. You sell them for $56. 09 (Euro selling price converted in dollars) after buying them for $55. 12 (British pound selling price converted into dollars) • The transactions cost of doing so, however, may limit your profit opportunity 11

Absence of Arbitrage 12 • Because Arbitrage is easy to do, financial markets rely Absence of Arbitrage 12 • Because Arbitrage is easy to do, financial markets rely on the concept of “Absence of Arbitrage” • In other words, any arbitrage opportunity will disappear quickly as someone will see it and take advantage of it • Computers monitor markets around the world for arbitrage opportunities and make trades to take advantage of them. • Apparent arbitrage opportunities are limited due to transactions costs

Purchasing Power Parity • If everything is cheaper in one country than others, everyone Purchasing Power Parity • If everything is cheaper in one country than others, everyone will try to buy from the cheap country and sell to the expensive countries. This will create a high demand for the currency people need to purchase (to buy the goods), which will push up the exchange rate, and thus remove the arbitrage opportunity 13

Purchasing Power Parity 14 • The Economist's Big Mac index is based on theory Purchasing Power Parity 14 • The Economist's Big Mac index is based on theory of purchasing-power parity, under which exchange rates should adjust to equalise the cost of a basket of goods and services, wherever it is bought around the world. Our basket is the Big Mac. The cheapest burger in our chart is in China, where it costs $1. 30, compared with an average American price of $3. 15. This implies that the yuan is 59% undervalued.

The Big Mac Index (example of purchasing power parity) 15 The Big Mac Index (example of purchasing power parity) 15

Currency Equilibrium Given our previously quoted exchange rates, to exclude arbitrage, what must the Currency Equilibrium Given our previously quoted exchange rates, to exclude arbitrage, what must the Pounds to Euro exchange rate? ($1=0. 5443 Pounds) ($1=0. 7844 Euro so, 1 Euro =1/0. 7844 = 1. 2749$ By dimensional analysis we see: • Applying to our data 16

Triangular Currency Arbitrage Cross exchange rate • The ratio of the exchange rate of Triangular Currency Arbitrage Cross exchange rate • The ratio of the exchange rate of each currency, expressed in terms of a third currency. • Divide the dollar exchange rate for one currency by the dollar exchange rate for another currency: 4/21/04: Assume you are • C$2. 5000/£ quoted the following • Arbitrage opportunity exchange rate: 1. Exchange $1, 000 into £ 563, 920 (at £ 0. 5639/$). 2. Trade £ 563, 920 for C$1, 409, 800 (at C$2. 5000/ £). 3. Convert C$1, 409, 800 into $1, 036, 626(at $0. 7353/C$). 17 Allows a riskless, instant profit of $36, 626

Spot and Forward Markets • Spot market – the market for the immediate exchange Spot and Forward Markets • Spot market – the market for the immediate exchange of goods • Forward market – the market to exchange in the future, at a price set today • Futures market – the standardization of forward market contracts 18

Spot and Forward Exchange Rates Spot exchange rate Forward exchange rate • The exchange Spot and Forward Exchange Rates Spot exchange rate Forward exchange rate • The exchange rate that applies to currency trades that occur immediately. • On April 21, 2004, spot exchange rate for British pound: $1. 7733/£. • The fixed price that applies for contracts with delivery in the future. • On April 21, 2004, the agreement to trade dollars for pounds one month later was a specified forward price of $1. 7686/£. The pound trades at a forward discount relative to the dollar. 19

Why are forward rates important? • If Dell has a contract to sell computers Why are forward rates important? • If Dell has a contract to sell computers in England in 3 months, but has to buy the parts today to fulfill the contract, it can protect its profits by transacting in the currency futures market and thus remove the risk of the exchange rate changing. • This is a risk reducing action which is referred to as “hedging” its currency risk • If you believe you can predict the direction of exchange rate movements, you could “speculate” by trading in futures markets 20

Transaction Risk Exchange rate risk arises when the value of a company’s cash flows Transaction Risk Exchange rate risk arises when the value of a company’s cash flows can be affected by a change in exchange rates. • An example…Assume Boeing Company sells an airplane to a Japanese buyer: 1. Boeing must receive $1, 000 to cover costs and profits. 2. Since payment usually in buyer’s currency, priced in Yen. 3. Current exchange rate is ¥ 100. 00/$. 4. Price of airplane therefore ¥ 100, 000. • If delivery and payment occur immediately, there is no foreign exchange risk: just exchange ¥ 100, 000 for $1, 000 on spot market. 21 If price is set today, but delivery is in 6 months, Boeing is exposed to significant foreign exchange risk unless it hedges that risk.

Transaction Risk If exchange rate in 6 months is ¥ 110. 00/$: • The Transaction Risk If exchange rate in 6 months is ¥ 110. 00/$: • The dollar appreciates; yen depreciates. • Boeing will still receive the same ¥ 100, 000 but these will only be worth $909, 091. 1. Boeing will suffer an exchange rate loss of $90, 909. 2. Japanese customer is unaffected, since yen price is fixed. If exchange rate in 6 months is ¥ 90/$ instead: • Boeing will receive $1, 111 for its ¥ 100 million payment. 1. Boeing will enjoy an exchange rate gain of $111, 111. 2. Japanese customer again unaffected. 22 Who would gain/lose if price were set in dollars?

Interest Rate Parity • Just as prices of goods across the world will tend Interest Rate Parity • Just as prices of goods across the world will tend to equilibrate, so will financial instruments • Investors will choose countries with the highest rates, subject to the effect of changing currency values • If inflation is high in one country compared to another, purchasing power parity will force the exchange rates to change to enforce the law of one price • The combination of inflation rate and exchange rate will allow investors to estimate the real rate it can earn in any country. 23

Translation and Economic Risk Translation (accounting) exposure Economic exposure 24 • Cost and revenue Translation and Economic Risk Translation (accounting) exposure Economic exposure 24 • Cost and revenue of the subsidiary (in foreign currency) are translated in the domestic currency to be included in the financial statements of the MNC. • How does the foreign exchange rate affect firm’s value? • Exchange rate changes might influence firm’s cash flows. • Rise in the value of the dollar vs. yen makes Japanese cars less expensive to U. S. customers and U. S. cars more expensive for Japanese customers. • Hedge by using currency derivatives and by matching costs and revenues in a given currency.

EMU and the Rise of Regional Trading Blocks European Monetary Union established Euro as EMU and the Rise of Regional Trading Blocks European Monetary Union established Euro as currency for twelve countries in Western Europe. In 1991, Brazil, Argentina, Paraguay, and Uruguay formed the Mercosur Group. • Removed tariffs, other barriers to intra-regional trade • Common tariffs on external trade from 1994 General Agreement on Tariffs and Trade (GATT): international treaty that regulates trade • In 1994, revised GATT established World Trade Organization (WTO) 25

Political Risk • A further risk of international investments is that of political risk Political Risk • A further risk of international investments is that of political risk • Current examples are the freezing of oil assets in some countries as the government takes over the assets • WSJ earlier this semester reported that the Government of Sudan is not honoring its oil contracts with British Petroleum 26

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Purchasing Power Parity (PPP) Differences in expected inflation between two countries are associated with Purchasing Power Parity (PPP) Differences in expected inflation between two countries are associated with expected changes in currency values. Key empirical predictions of PPP: Low-inflation nations appreciating currency High-inflation nations depreciating currency Law holds for tradable goods over time, but deviations occur in the short run. Reasons: 28 • The process of trading goods across countries cannot happen instantaneously. • Legal restrictions or physical impediments apply to transporting goods.

Interest Rate Parity (IRP) Interest rate parity says that the risk-free returns around the Interest Rate Parity (IRP) Interest rate parity says that the risk-free returns around the world should be equal. An investor can either buy a domestic risk-free asset or a foreign risk-free asset using forward contracts to cover currency exposure. The currency of the country with lower risk-free rate should trade at a forward premium. IRP: 29

Covered Interest Arbitrage • An example… • Current spot rate = C$ 1. 5855/$ Covered Interest Arbitrage • An example… • Current spot rate = C$ 1. 5855/$ • 6 -month forward rate = C$ 1. 5937/$ • Annualized interest rate on a six-month Canadian government bond is 6%. • Rate on similar U. S. instrument is 2%. 30 This means Canadian interest rate is “too high”/ U. S. interest rate is “too low”. Arbitrage opportunity!

Covered Interest Arbitrage Borrow $1, 000 at 2% per year, convert to C$1, 585, Covered Interest Arbitrage Borrow $1, 000 at 2% per year, convert to C$1, 585, 500 This will grow to C$1, 633, 065 in six months, at which time you convert back at the forward rate to $1, 024, 700. Next, repay the U. S. loan, which takes C$1, 010, 000. Arbitrage profit is $14, 700. 31

Real Interest Rate Parity: the Fisher Effect Fisher effect: the nominal interest rate R Real Interest Rate Parity: the Fisher Effect Fisher effect: the nominal interest rate R is made up of two components: • Real required return assumed to be same in both countries. • Inflation premium equals the expected rate of inflation, I. If real required return is the same across countries, then the following equation is true: 32

Real Interest Rate Parity: The Fisher Effect • Assume that expected inflation in the Real Interest Rate Parity: The Fisher Effect • Assume that expected inflation in the United States equals zero and expected inflation in Italy is 12%. • One-year risk free rate in the U. S. is 3%. What should the one year interest rate be to maintain real interest rate parity? Deviations from real interest rate parity occur because of limits to arbitrage 33 • Scarcity of risk-free investments that offer fixed real, rather than nominal, returns

Capital Budgeting MNCs have to answer the following questions in their capital budgeting process: Capital Budgeting MNCs have to answer the following questions in their capital budgeting process: • In what currency should the firm express a foreign project's cash flows? • How is the cost of capital computed for MNCs? • An example…Assume U. S. firm performs analysis for project with cash flows in euros: Initial Cost Year 2 Year 3 - € 2, 000 34 Year 1 € 900, 000 € 850, 000 € 800, 000 Two alternatives to compute project’s NPV: • Discount euro-denominated cash flows using euro-based cost of capital, then convert back to dollars • Calculate NPV in dollar terms

First Approach to Compute NPV Assume risk-free in Europe is 5% and the spot First Approach to Compute NPV Assume risk-free in Europe is 5% and the spot rate is $0. 95/€ The company estimates that cost of capital for this project is 10% (5% risk premium). Convert into dollarbased NPV 35 • The firm can hedge its currency exposure in the future with forward contracts. • Accept or reject the project based on NPV of project; currency exposure should not affect the decision.

Second Approach to Compute NPV Calculate NPV in dollar terms; U. S. risk free Second Approach to Compute NPV Calculate NPV in dollar terms; U. S. risk free rate is 3% • Assume that the firms will hedge the project's cash flows using forward contracts. • Using interest parity, can compute one, two, and three year forward exchange rates: 36

Second Approach to Compute NPV Cash flow of the project converted in dollars: same Second Approach to Compute NPV Cash flow of the project converted in dollars: same results as the first approach Currency Initial Investment Year 1 Year 2 Year 3 € -2, 000 X. 95 900, 000 X. 9319 8500, 000 X. 9142 800, 000 X. 8967 $ -1, 900, 000 839, 000 777, 000 717, 000 Need to discount the cash flow at risk-adjusted U. S. interest rate: 37

Cost of Capital 38 • Compute beta of investment to assess risk and use Cost of Capital 38 • Compute beta of investment to assess risk and use CAPM to compute discount rate for the project’s cash flows. • A Japanese auto manufacturer that plans to build a plant in U. S. computes two betas. • If firm’s shareholders cannot diversify internationally: • Compute project’s beta by measuring the covariance of similar European investments with the U. S. market. • Japanese firm computes beta of 1. 1 for the project. Risk -free interest rate is 2%; market risk premium on Nikkei is 8%. • Rproject= 2%+1. 1(8%)=10. 8% • If firm’s shareholders have portfolios internationally diversified: • Compute project’s beta by computing covariance of return of similar investments with returns on worldwide stock index. • Project beta is computed 1. 3. The world market risk premium is 5%: Rproject=2%+1. 3(5%)= 8. 5%.

Forward-Spot Parity If a forward market exists, the forward rate should be approximately equal Forward-Spot Parity If a forward market exists, the forward rate should be approximately equal to expected future spot rate. • An example… • Assume: Spot = $1. 4/£ 1 M forward = $1. 50/£ Risk-neutral U. K. firms who intend to buy U. S. dollars in the future will either: 1. Enter the forward contract today if E(S) < $1. 50/£. 2. Wait and buy dollars at spot rate if E(S) > $1. 50/£. 39 U. S. firms who will need to buy pounds in the future will do the opposite.

Forward-Spot Parity Equilibrium: the forecast of the spot price is equal to the current Forward-Spot Parity Equilibrium: the forecast of the spot price is equal to the current forward rate (forward – spot parity). E(S) = F U. S. and U. K. firms are indifferent in this case whether they transact in the spot or forward market. Forward-spot parity does not hold. Forward rate does not reliably predict the direction of the spot rate. • Studies of exchange rates find a great deal of randomness in spot rate movements. 40

International Financial Management Multinational corporations dominate international trade and investment today. Companies trading in International Financial Management Multinational corporations dominate international trade and investment today. Companies trading in the international markets are exposed to exchange rate risk. Total volume of foreign direct investment surged during the 1990 s. MNCs can use a variety of techniques to hedge or even profit from exchange rate fluctuations.

Political Risk Actions taken by a government which have an impact on the value Political Risk Actions taken by a government which have an impact on the value of foreign companies operating in that country: Tax increases or barriers to repatriation of profits Macro political risk Micro political risk 42 • Impacts all foreign firms in the country • Near collapse of Indonesia currency in 1997 -1998 • Government actions that affect only a subset of companies operating in a foreign country • 1970 s nationalization international oil company assets by large number of oil-exporting countries

The Law of One Price Identical goods trading in different markets should sell at The Law of One Price Identical goods trading in different markets should sell at the same price. • An example… • Assume €/$ exchange rate currently € 0. 95/$, and a pair of Maui Jim sunglasses is selling for € 180 in Italy. What if a pair of the same sunglasses sells for $200 in the United States? • Sunglasses should sell for € 180 ÷ € 0. 95/$ = $189. 47 in U. S. • Buy sunglasses in Italy for € 180 and sell them for $200 in U. S. • Convert back to euros, receive € 190 ($200 x € 0. 95/$) 43