1. Explain how foreign exchange risk affects firms
and investors.
2. Describe different ways to hedge exchange rate
risk.
3. Discuss sources of funds to finance international
trade and investment.
4. Apply net present value analyses to the capital
budgeting decisions facing firms with
international operations.
5. Discuss how exchange rate risk affects firms’
cash flows and its impact on stock returns.
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14–2
EXHIBIT 14.1 THE PRICE IN DOLLARS OF ONE BARREL OF CRUDE OIL,
MARCH 2007 TO MARCH 2009
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
14–3
Measuring Foreign Exchange Exposure
• Exchange Rate Risk
– The impact of random change in the value of
one currency with respect to other currencies
• Transactions Risk
– How short-term changes in exchange rates can
affect operating costs and revenues of firms
engaged in international business activities
• Translation Risk
– The short-term effects of currency movements on
the consolidated accounting statements of a firm
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
14–4
Interpreting Financial Performance
• Consolidated Accounting Statements
– Are the income statements and balance sheets of a
multinational corporation and of its all subsidiaries
abroad
– Are required reporting to home country tax
authorities
– Are affected by currency translation risks
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
14–5
World Currency Markets
• Special Drawing Right (SDR)
– A basket of currencies consisting of dollars,
euros, pounds, and yen created by the
International Monetary Fund (IMF)
• Economic Risk
– The ways in which long-term exchange
rate movements affect firms
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
14–6
Hedging Foreign Exchange (Forex) Risk
with Derivatives
• Hedging
– Is the use of currency derivatives to reduce
potential transaction, translation, and economic
risks of currency movements that could lead to
losses for a firm or investor
• Speculators
– Trade in currencies and currency derivatives to
earn profits and to help to make currency prices
efficient
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
14–7
Derivatives: Futures Contracts
• Currency Futures Contracts
– Standardized agreements to buy or sell a specified
amount of currency at a date in the future at a predetermined price
• Long Position
– Buying a currency contract and profiting on the
increased value of the underlying currency over time
• Short Position
– Selling a currency contract and profiting on the
decreased value of the currency over time
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
14–8
EXHIBIT 14.2 PAYOFFS FOR FUTURES CONTRACTS
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
14–9
Trading Markets
• Organized Exchanges
– Trade futures contracts in major currencies and offer
price transparency and efficiency
– Eliminate counterparty risk due to guaranteed
payments on contacts
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
14–10
Trading Market Terms
• Marked-to-Market
– Futures contracts in which gains (losses) are earned
(paid) in cash at the end of each trading day
• Margin
– The small commitment fee needed to purchase a
futures contract
• Margin Call
– Losses that cause the contract holder’s balance to fall
below the maintenance margin at the end of the
trading day thus requiring additional investment in the
contract to continue holding the contract
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
14–11
Forward Contracts
• Currency Forward Contracts
– Are contracts in the currencies of emerging-market
countries offered by large banks in the OTC market
– Are less standardized than future contracts such that
they can be customized by the seller/counterparty to
meet the hedging needs of the buyer
– Are not marked-to-market daily
• Over-the-Counter (OTC) Market
– The derivatives market run by large banks
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14–12
Options Contracts
• Call Option
– An investor’s right (but not obligation) to buy an asset
(e.g., a currency) at a pre-determined (strike) price
• Put Option
– An investor’s right (but not obligation) to sell an asset
(e.g., a currency) at a pre-determined price
• Premium
– The price paid by the buyer to the seller for an option
contract
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
14–13
EXHIBIT 14.3
PAYOFFS FOR CALL
AND PUT OPTIONS
CONTRACTS
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14–14
Swap Contracts
• Currency Swaps
– Allow firms to exchange currencies at a previously
agreed exchange rate as a way to hedge exchange
rate movements
• Plain Vanilla Currency Swap
– An interest rate swap, often combined with a currency
swap, if the interest being swapped is in different
currencies
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
14–15
EXHIBIT 14.4 VANILLA CURRENCY SWAP
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14–16
Financing International Trade
and Investment
• Money Center Banks
– Large global banks
• Clearing House Interbank Payments System (CHIPS)
– Provides large, wholesale dollar payments services
for businesses, banks, and governments
• Society of Worldwide Interbank Financial
Telecommunications (SWIFT)
– Provides secure communications for contracts, invoices, and
other trade documents that accompany cash payments
• Syndicate
– A group of banks that collectively make a participation loan to
a large international firm
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
14–17
International Payment Methods
and Documentation
Payment In
Advance
The safest method
for exporters, but it
exposes importers
to risk related to
delivery of goods
Commercial
Letter Of Credit
(LC)
Provides payment
protection to both
exporters and
importers, as the
importer’s bank
writes a guarantee
of payment
Banker’s
Acceptance
Open
Account
When a bank sells a
LC into the financial
marketplace as a
money market
instrument
A simple
agreement wherein
the exporter sends
an invoice with the
goods and the
exporter pays upon
the receipt
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
14–18
International Bond Markets
• Bond Ratings
– Moody’s and Standard and Poor’s rating services which are
important in assuring foreign investors of the credit quality of
bond issues
• Domestic Bonds
– Debt contracts sold by firms domiciled in a country in the home
currency
• Foreign Bonds
– Bonds that are issued by foreign firms in another country in the
home currency of that country
• Eurobonds
– Bonds that are sold in any country outside the home country, but
in the home country’s currency
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14–19
EXHIBIT 14.5a INTERNATIONAL BONDS AND NOTES BY CURRENCY AND ISSUER
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
14–20
EXHIBIT 14.5b INTERNATIONAL BONDS AND NOTES BY CURRENCY AND ISSUER
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
14–21
International Stock Markets
• Diversification
– Buying securities in a portfolio with price patterns
over time that are different from one another,
which reduces the volatility of the portfolio
• Home Bias
– Investing most of retirement and other savings in
one’s home country, which reduces diversification
• Contagion
– When stock markets in many countries move down
in concert with one another and thereby reduce
international diversification benefits
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
14–22
EXHIBIT 14.6 DIVERSIFICATION CAN REDUCE RISK FOR INVESTORS
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
14–23
Consolidation Among
International Exchange Markets
• New York Stock Exchange (NYSE) and Euronext, which
comprises a group of European countries’ exchanges
• NASDAQ (National Association of Securities Dealers
Automated Quotation system) and American Stock
Exchange (AMEX)
• London Stock Exchange and Italy’s Borsa Italiana
• Chicago Mercantile Exchange (SME) and Chicago Board
of Trade
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
14–24
Government-Supported
International Financing
• International Monetary Fund (IMF)
– Provides “lender-of-last-resort” short-term loans
to countries in financial crisis
– Evaluates exchange rate policies
– Gives technical assistance to countries
• World Bank
– Provides long-term loans for economic reform and
infrastructure development in emerging and
developing markets
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
14–25
Government-Supported
International Financing Terms
• Trade Finance
– Bank and government loans used by exporters to
finance working capital (i.e., labor, materials,
inventory, and accounts receivables)
• Term Financing
– Bank and government loans to importers to cover the
cost of major purchases
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
14–26
Major Government-Supported
International Financing Institutions
• Export-Import (Ex-Im) Bank
– A U.S. government export finance agency that
supports U.S. firms competing against governmentsupported exports of other countries
• Bank of International Cooperation (JBIC)
– Japanese bank that supports exporters around the
world that have at least thirty percent Japanese
content
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
14–27
Parent Firm Capital Budgeting
• Net Present Value (NPV)
– The difference between present value of future profits on an
investment project minus the initial investment cost
• To calculate the NPV of capital investments in a foreign
subsidiary:
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14–28
Assessing Country Risk in Multinational
Capital Budgeting Decisions
• Country Risk
– The uncertainty in predicting how economic, political,
inflation, and tax risk factors will affect an
investment in a country
• Sensitivity Analysis
– An examination of optimistic, expected, and
pessimistic scenarios to give a more complete picture
of the risks and returns of investments abroad
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14–29
EXHIBIT 14.7 SELECTING ACCEPTABLE CAPITAL BUDGETING PROJECTS
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14–30
The Cost of Capital: Domestic Versus Global
• Cost Of Capital
– Is the required rate of return demanded
by stock and bond investors
– Is used in net present value capital
budgeting analyses as the discount rate
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14–31
The Cost of Capital: Domestic Versus Global
• Weighted Average Cost Of Capital
– The sum of the costs of equity and debt weighted by
the amount of financing from these two capital
sources
– The weighted average cost of capital for a firm is:
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
14–32
The Cost of Capital: Domestic Versus Global
• Cost Of Debt
– The weighted average of different interest rates paid
on long-term borrowings
• Cost Of Equity
– The rate of return on equity required by stockholders
as estimated by Capital Asset Pricing Model (CAPM):
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
14–33
Estimating the Cost of Equity
• International CAPM (ICAPM)
– An asset pricing model that includes both domestic
and global market factors to estimate the cost of
equity or required rate of return on stocks
– The estimated rate of return required by stockholders
as estimated by ICAPM) is:
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
14–34
Currency Risk and Stock Valuation
• Cash Flow Sensitivity to Exchange Rate Risk
– Firms can experience positive and negative
fluctuations in cash flows and profits due to currency
movements that strengthen or weaken the value of
their products in overseas markets
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
14–35
Measuring Stock Values and
Foreign Exchange Movements
• Measurement of Long-Run Exchange Risk
(Adler and Dumas):
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
14–36
Market Factors Affecting Equity Valuations
• Exchange Rate Sensitivity
– A stock value measured with the coefficient obtained
by regressing the stock’s return on a currency’s return
over time
• Exchange Risk Beta
– The sensitivity of a stock to market risk affected by
currency movements
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
14–37
Measuring Stock Values and
Foreign Exchange Movements (cont’d)
• Measurement of Exchange Risk (Armstrong, Knif,
Kolari, and Pynnönen):
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
14–38
KEY TERMS
exchange rate risk
transactions risk
translation risk
consolidated accounting statements
economic risk
Special Drawing Right (SDR)
hedging
speculators
currency futures contracts
long position
short position
organized exchanges
marked-to-market
margin
margin call
currency forward contracts
over-the-counter (OTC) market
call option
put option
premium
currency swaps
plain vanilla currency swap
money center banks
CHIPS (Clearing House Interbank
Payments System)
SWIFT (Society of Worldwide
Interbank Financial
Telecommunications)
payment in advance
commercial letter of credit (LC)
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
14–39
KEY TERMS
banker’s acceptance
open account
syndicate
bond ratings
domestic bonds
foreign bonds
eurobonds
diversification
home bias
contagion
Export-Import (Ex-Im) Bank
trade finance
term financing
Bank of International Cooperation (JBIC)
net present value
country risk
sensitivity analysis
cost of capital
weighted average cost of capital
cost of debt
cost of equity
beta risk
international CAPM (ICAPM)
size factor
value factor
exchange rate sensitivity
exchange risk beta
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
14–40