Chapter 16 learning goals
What are exchange rates and what
factors affect exchange rates.
Using exchange rates.
What is exchange rate risk?
Managing exchange rate risk.
International Capital Budgeting
Chapter 16 - International
Financial Management
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International Business Finance
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Exchange Rates
Spot Exchange Rate: today’s price of
one currency in terms of another.
Exchange rates affect our economy
and each of us because:
1) When the dollar appreciates (strong
dollar), the dollar becomes more
valuable relative to other currencies.
Foreign products become cheaper to us.
U.S. products become more expensive
overseas.
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Exchange Rates
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Got to get some beer!
Moe opens a new bar in Springfield called
Moe’s International Drinking Emporium and
needs to convert dollars into other currencies
buy some imported brews.
He is considering buying 500 cases of Cuatro
Equis beer from Mexico for 30,000 pesos and
500 cases of King Homer’s Mead from
England for 3,000 pounds.
How many dollars would Moe need to convert
to complete each of these transactions?
Exchange rates affect our economy
and each of us because:
2) When the dollar depreciates (weak
dollar), the dollar falls in value relative
to other currencies.
Foreign products become more expensive
for us, and
U.S. products become cheaper overseas.
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Exchange Rates
Back to Moe
Direct Quote: number of units of domestic
(home) currency needed to acquire a unit of a
foreign currency.
Indirect Quote: number of units of a foreign
currency needed to acquire a unit of the
domestic (home) currency.
Direct and Indirect quotes are reciprocals of
each other.
$/peso rate = 0.09048; peso/$ rate = 11.0520
$/pound rate = 1.7822; pound/$ rate = 0.5611
XXXX Beer: 30,000 pesos
King Homer’s Mead: 3,000 pounds
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Peso to Pound Exchange (Cross)
Rate
More Moe
Question: How many pesos would it
take to buy King Homer’s Mead?
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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 $1,000,000 to cover costs and profits.
2. Since payment usually in buyer’s currency, priced in Yen.
3. Current exchange rate is ¥100.00/$.
4. Price of airplane therefore ¥100,000,000.
• If delivery and payment occur immediately, there is no
foreign exchange risk: just exchange ¥100,000,000 for
$1,000,000 on spot market.
If price is set today, but delivery is in 6 months,
Boeing is exposed to significant foreign exchange risk
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unless it hedges that risk.
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Transaction Risk
Imagine Moe is considering entering into a
contract to purchase 1,000 cases of Maple
Leaf Beer in 6 months for 20,000 Canadian
Dollars (cd)
What will be Moe’s dollar cost?
Don’t know for sure. This is an example of
transaction risk.
Let’s investigate.
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2
Moe’s exchange rate risk
Moe’s Forward Hedge
Currently $0.8813/cd (known as spot price),
which makes today’s cost $0.8819/cd x 20,000 cd
= $17,638.
However, in 6 months the exchange rate could be
higher or lower making Moe’s cost uncertain.
If Moe wants to know his future $ cost with
certainty, how could he hedge this risk?
Solution: a 6-month forward contract with Bank of
Springfield.
With this forward contract, the bank agrees to sell
Moe Canadian Dollars in 6 months at an exchange
rate agreed to today.
Today’s 6-month forward rate is $0.88675/cd.
Moe’s Forward Hedge Cost = CD20,000 x forward
rate = CD20,000($0.88675/CD) = $17,735
guaranteed
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Exchange Rate Parity and Interest
Rate Relationships
Forward to spot premium
Annualized Premium(Discount) relative to
US$ = (F – S)/S x 360/n x 100%
We will look at each individual
relationship, but all the relationships are
equal to one another.
Where F = forward rate (direct quote: dom/for)
S = spot rate (today’s exchange rate: direct
quote)
n = # of days
From our 6-month forward example:
(.88675 - .8819)/.8819 x 360/180 x 100% =
1.1% Canadian Dollar forward premium.
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Forward-Spot Parity
Exchange Rate Relationships
Basic Relationships
1 + R foreign
1 + R dom
equals
equals
F
S
1+ E(idom)
equals
1M forward = $1.7828/£
Risk-neutral U.K. firms who intend to buy U.S. dollars
in the future will either:
equals
for/dom
for/dom
• An example…
• Assume: Spot = $1.7822/£
1+ E(iforeign)
E( S for/ dom)
S for/dom
1. Enter the forward contract today if E(S) < $1.7828/£.
2. Wait and buy dollars at spot rate if E(S) > $1.7828/£.
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U.S. firms who will need to buy pounds in the future
will do the opposite.
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3
Forward-Spot Parity
Interest Rate Parity
Equilibrium: the forecast of the spot price is equal to
the current forward rate (forward – spot parity).
E(S) = F
U.S. and U.K. firms are indifferent in this case
whether they transact in the spot or forward market.
Forward-spot parity does not hold. Forward rate
does not reliably predict the direction of the spot
rate.
• Studies of exchange rates find a great deal of
randomness in spot rate movements.
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Interest Rate Parity Example
Interest Rate Parity (IRP)
An investor can either buy a domestic risk-free asset
or a foreign risk-free asset using forward contracts
to cover currency exposure.
The currency of the country with lower risk-free rate
should trade at a forward premium.
IRP:
Links the forward exchange market with the
spot exchange market. The idea:
The annual percentage difference between
the forward rate and the spot rate (forward
premium or discount) is approximately equal
to the difference in risk-free interest rates
between the two countries.
Arbitrage in the forward and spot markets
helps to hold this relationship in place.
F for / dom (1 + R for )
=
S for / dom (1 + Rdom )
Today’s spot exchange rate is 0.5611GBP/$. The 12-month
forward rate is 0.5577GBP/$. Today’s 1-year US T-bond rate is
4.9%. What should be today’s one-year risk-free rate in Great
Britain?
F for / dom (1 + R for ) 05577 1 + RGB
=
:
=
S for / dom (1 + Rdom ) 0.5611 1.049
RGB=1.049(0.5577/0.5611)-1 = 0.043 =4.3%
4.4% was the 1-yr GB T-bill rate at the end of last
week.
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The Law of One Price
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Purchasing Power Parity
In competitive markets where there are no
transportation costs or barriers to trade, the
same goods sold in different countries sell for
the same price if all the different prices are
expressed in terms of the same currency.
Arbitrage allows the law of one price to hold
for commodities that can be shipped to other
countries and resold.
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Links changes in exchange rates with
differences in inflation rates and the
purchasing power of each nation’s currency.
In the long run, exchange rates adjust so that
the purchasing power of each currency tends
to be the same.
Exchange rate changes tend to reflect
international differences in inflation rates.
Countries with high inflation tend to
experience currency devaluation.
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4
Real Interest Rate Parity: the
Fisher Effect
Purchasing Power Parity (PPP)
Key empirical predictions of PPP:
E ( S for / dom ) [1 + E (i for )]
=
[1 + E (idom )]
S for / dom
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:
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:
1 + R for [1 + E (i for )]
=
1 + Rdom [1 + E (idom )]
• The process of trading goods across countries cannot happen
instantaneously.
• Legal restrictions or physical impediments apply to transporting
goods.
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International Capital Budgeting Example
International Capital Budgeting
Homer & Son manufactures grease gougers. It is considering
building a manufacturing facility in Australia. The company is
expected to produce Australian cash flows as follows. The 1yr US risk free rate is 4.9% and the Australian rate is 5.65%.
The current spot rate is 1.3436 Aus$:$1US and Homer & Son
expects a 13% return in US$ on its investment. What is the
US$ NPV of the project?
Techniques for a U.S. firm
Given a dollar denominated cost of capital,
exchange expected foreign currency cash
flows to $ using interest rate parity theory
and find NPV.
or
Given foreign currency denominated cost
of capital, discount using foreign cash
flows and interest rates, then exchange to
$.
Cash Flow Forecasts (in thousands of Aus$)
year
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0
1
2
3
-400
200
210
222
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Homer & Son Example (1st
Approach)
International Capital Budgeting
Example ( 2nd approach)
Convert US required return (k) to Australian
required return using a version of real interest
rate parity
(1+kAus)/(1+kUS) = (1+RAus)/(1+RUS)
RAus = 5.65%, RUS = 4.9%, kUS = 13%
kAus =(1.13)x[(1.0565)/(1.049)]-1 = 13.8%
NPV of Aus$ at 13.8% = A$88,539
Convert A$NPV to $NPV at spot rate =
A$85,294/(A$1.3436/$) = $65,897
What are the 1, 2, and 3 year forward
rates?
IRP:
F for / dom (1 + R for )
=
S for / dom (1 + Rdom )
(fAus$/$)t = Spot Aus$/$ x (1.0565/1.049)t
(fAus$/$)t = 1.3436 x (1.0565/1.049)t
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Homer & Son Example (cont.)
Year
Aus$ CF
F(Aus/$)
US $ CF
0
-400
1.3436
-297.7
1
200
1.3532
147.8
2
210
1.3629
154.1
3
222
1.3726
161.7
TOP
10
LIST
Find NPV by discounting US$ cash flows at
Homer’s 13% US$ denominated cost of
capital
NPV = $65.8 or $65,848
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Top 10 questions we will answer in
Finance 221 this semester.
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Top 10 questions we will answer in
Finance 221 this semester.
10. What is the goal of the firm?
9. Why there is no such thing as a free lunch?
8. How do you figure out loan payments?
7. Why do bond and stock prices tend to fall
when inflation or interest rates go up?
6. Why Microsoft deserves its legal troubles.
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5. Why is Homer Simpson so dumb?
4. How do you calculate a P/E ratio? (Anna
Kournikova: guest lecturer)
3. Why do they call bond interest payments
coupon payments?
2. Where in the world can you find the
cheapest Big Mac?
1. How to make a million dollars and not pay
taxes.
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3 Key Things to Remember
Goal of the Firm is to maximize
stockholder wealth (stock price).
Asset prices and interest rates have an
inverse relationship.
To enhance wealth select positive NPV
investments.
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