THE BALANCE OF
PAYMENTS
Definition
Balance of payments(BOP)
refers to a record of the value of
all transactions of a country with
the rest of the world over a period
of time.
Role of BOP
• It shows all payments received from
transactions with other countries, called
CREDIT
• It shows all payments made from
transactions to other countries, called
DEBIT
Distinguish between credit and
debit items in a BOP
CREDIT
DEBIT
• Any transactions that
lead to money entering
the country from abroad
e.g. export goods such
as cash crops, food
crops, manufactured
goods, etc
• exportation of services
such as tourism, skills,
etc
• It gives a positive value
• Any transactions that lead
to money leaving the
country to go abroad e.g.
import goods such as food
items, manufactured
goods, machinery, etc
• Importation of services
such as tourism,
expertise, insurance, etc
• It gives a negative value
COMPONENTS OF BOP
1. CURRENT ACCOUNT
It is a measure of the flow of funds from trade in goods and
services, plus other income flows
It is divided into FOUR components:
• Balance of trade in goods/ Visible trade
balance/Merchandise account/Balance of trade
• Balance of trade in services/ Invisible trade balance/Net
services
• Income/Net investment income
• Current transfers
Balance of trade in goods/ Visible trade
balance/Merchandise account/Balance of trade
• It measures the revenue received from the export of
tangible goods minus the expenditure on the imports of
tangible goods over a given time period
• NOTE:
• Exports lead to inflow of money while imports lead to an out
flow of money
• There is a surplus when X>M
• There is a deficit when M>X
Balance of trade in service/ Invisible trade
balance/Service balance/Net services
• It measures the revenue received from the export of
services minus the expenditure on the imports of services
over a given time period
Examples of these services include:
• Banking
• Insurance
• Tourism
• Transport
• Postal and courier services
• Communication services
• Financial services
Income/Net investment income
• It is a measure of the net monetary movement of profit,
interest, and dividends moving into and out of the country
over a given period of time, as a result of financial
investment abroad.
• Examples:
• Profits, Interests and Dividends from portfolio
• Direct investments
• Compensation of employees (wages and salaries)
• Returns from rental resources e.g. granting fishing, grazing
mining, and forestry rights.
Current transfers
• It is a measurement of the net transfers of money, often
known as net unilateral transfers from abroad.
• It refers to transfers with nothing received in return
•
•
•
•
•
•
Examples:
Worker’s remittances
Donations
Grants
Foreign aid
Food aid and emergency aid after natural disasters.
The sum of net export of goods and
services, net income and net current
transfers over a period of time is defined
as current account balance.
It is referred to as a current account
surplus if it is positive while a current
account deficit if it is negative.
NOTE:
• The current account of the balance of
payments of a country is composed of the sum
of the balance of trade (recording exports
minus imports of goods) plus the balance on
service, or invisible balance (recording exports
of service minus imports of services), plus net
income plus net transfers.
• The most important part of the current account
in most countries is the balance of trade.
CAPITAL ACCOUNT
This section of the BOP includes the following:
1. Capital transfers receivable and payable i.e. the net
monetary movements gained or lost through actions such
as the transfer of goods and financial assets by migrants
entering or leaving the country.
Note: These items of value that have not been produced e.g.
land or natural resources.
Other examples include:
• Gift taxes
• Inheritance taxes
• Death duties
• Debt forgiveness
2. Transaction in non – produced, non- financial assets
This consists of the net international sales and purchases of
non – produced assets such as land and the rights to natural
resources, and the net international sales and purchases if
intangible assets such as patents, copyrights, brand names or
franchises.
NOTE: THE CAPITAL ACCOUNT IS SMALL AND OF MINOR
IMPORTANCE
FINANCIAL ACCOUNT
• This account includes investments and assets.
• It measures the net change in foreign ownership of
domestic financial assets.
• If foreign ownership of domestic financial assets >
domestic ownership of foreign financial assets, then
there is more money coming into the country than
going out and so there is a financial account surplus.
• The vice versa leads to a financial account deficit.
COMPONENTS OF THE FINANCIAL
ACCOUNT
1. Direct investment: this is also referred to as Foreign Direct
Investment (FDI) when a resident in one country acquires
control or a significant degree of influence on the
management of a firm in another economy (normally more
than 10%)
• It is a measure of the purchase of long – term assets.
• It includes things such as:
Buying of property
Outright purchasing of a business
Purchasing of stocks or shares in a business.
2. PORTFOLIO INVESTMENT
It refers to a measure of stock and bond purchases – these
do not lead to a lasting interest in a company.
It includes:
• Treasury bills
• Government bonds
• Saving account deposits
NOTE: THESE ASSETS ARE SIMPLY BORROWING AND
LENDING ON THE INTERNATIONAL MARKET.
3. RESERVE ASSETS/ OFFICIAL RESERVES
This includes the assets that the Central Bank
holds to finance balance of payments needs and
to intervene in the foreign exchange market
• It includes the reserves of gold and foreign
currencies which all countries hold.
• It is movements into and out of this account
that ensures that the BOPs will always balance
to zero.
CURRENT ACCOUNT =
CAPITAL ACCOUNT +
FINANCIAL ACCOUNT+
NET ERRORS AND
OMISSIONS
RELATIONSHIP BETWEEN CURRENT
ACCOUNT AND THE EXCHANGE RATES
• A deficit in the current account of the
BOP results in a downward pressure on
the exchange rate of a currency.
• This mostly affects the fixed exchange
rate more than the floating exchange
rate.
• A surplus in the current account of the
BOP may result in an upward pressure on
the exchange rate of the currency.
HL: CONSEQUENCES OF CURRENT
ACCOUNT AND CAPITAL IMBALANCES
CONSEQUENCES OF A CURRENT ACCOUNT
DEFICIT
• If the current account is in deficit, the capital
account will have to be in surplus in order
balance the current account benefit.
• It means the economy is not earning enough
FOREX from its imports and income earnings
from abroad to finance its imports.
SOLUTION
1. Running down FOREX reserves – this can only be down for
a short period of time because these reserves are limited.
2. Surplus from the combined Capital and Finance Accounts:
• This can only be done it two ways:
a) Sale of domestic assets (businesses, stock or property) to
foreigners – they might want at low prices. This may lead
to loss of economic sovereignty.
b) Borrowing from abroad – this involves future repayment
either in the short or long run – opportunity cost will be
diversion in the future of national income; since
repayment is in FOREX and this implies diversion away
from purchase of import consumer or capital goods
METHODS OF CORRECTING A PERSISTENT
CURRENT ACCOUNT DEFICIT
1. Expenditure reducing strategies – this
includes policies that decrease AD ( decrease
spending on imports), for example
contractionary fiscal and monetary policies.
Decrease in AD will lead to decrease in inflation,
exports may benefit from increased
competitiveness.
• Shrinking imports and increasing exports will
help narrow the current account deficit.
2. Expenditure switching policies - this
includes devaluation, as well as increased
trade protection that renders imports
more expensive.
• NOTE – devaluation increases exports
but may leads to inflation.
• Trade protection restricts imports but
may lead to trade friction.
3. Supply – side policies – these are more
of a long run nature and they include
decreasing domestic monopoly power,
increasing labor market flexibility and
improving incentives.
• They increase the competitiveness of the
economy and especially of the export
sector.
QUESTION?
IS A CURRENT
ACCOUNT SURPLUS
A PROBLEM?
DISCUSS!
THE MARSHALL-LERNER
CONDITION
DEVALUATION (SHARP
DEPRECIATION) WILL
IMPROVE A TRADE DEFICIT
IF:
PED (X) + PED (M) > 1
• http://www.youtube.com/watch?v=VgCFN9M2aFE ( The
Marshall Lerner
• condition)
THE J – CURVE EFFECT
• http://www.youtube.com/watch?v=HSd7ybLJUuw (J –
curve)
REFERENCES
• Blink and Dorton, (2012), Economics: Course Companion,
Oxford University Press, New York
• Ziogas, C., (2012), IB study guide, Oxford university Press,
New York.
• Welker’s Wikinomics videos lectures.
Capital Asset Pricing Model
(CAPM)
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INTRODUCTION
A widely-used valuation model, known as the
Capital Asset Pricing Model, seeks to value
financial assets by linking an asset's return and
its risk. Prepared with two inputs
-- The market's overall expected return and an
asset's risk compared to the overall market
-- The CAPM predicts the asset's expected return
and thus a discount rate to determine price.
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Capital Asset Pricing Model
 CAPM is an framework for determining the
equilibrium expected return for risky assets.
 Relationship between expected return and systematic
risk of individual assets or securities or portfolios.
 The general idea behind CAPM is that investors need to
be compensated in two ways: time value of money and
risk
 William F Sharpe developed the CAPM. He
emphasized that risk factor in portfolio theory is a
combination of two risk , systematic and unsystematic
risk.
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ASSUMPTIONS
 Can lend and borrow unlimited amounts under the risk free
rate of interest
 Individuals seek to maximize the expected utility of their
portfolios over a single period planning horizon.
 Assume all information is available at the same time to all
investors
 The market is perfect: there are no taxes; there are no
transaction costs; securities are completely divisible; the
market is competitive.
 The quantity of risky securities in the market is given.
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The CAPM, despite its theoretical elegance,
makes some heady assumptions. It assumes
prices of financial assets (the model's measure
of returns) are set in informationally-efficient
markets. It relies on historical returns and
historical variability, which might not be a
good predictor of the future.
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CHARACTERISTICS - CAPM
To work with the CAPM have to understand
three things.
(1) The kinds of risk implicit in a financial asset
(namely diversifiable and non-diversifiable
risk)
(2) An asset's risk compared to the overall market
risk -- its so-called beta coefficient (β)
(3) The linear formula (or security market line)
that relates return and β.
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How is the CAPM derived?
The CAPM begins with the insight that
financial assets contain two kinds of risk.
There is risk that is diversifiable - it can
be eliminated by combining the asset with
other assets in a diversified portfolio. And
there is non diversifiable risk - risk that reflects
the future is unknowable and cannot be
eliminated by diversification.
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Implications and Relevance of CAPM
 Investors will always combine a risk free asset with a market
portfolio of risky assets. Investors will invest in risky assets
in proportion to their market value..
 Investors can expect returns from their investment according
to the risk. This implies a liner relationship between the
asset’s expected return and its beta.
 Investors will be compensated only for that risk which they
cannot diversify. This is the market related (systematic) risk
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BETA (β)
 A measure of the volatility, or systematic risk, of a security or
a portfolio in comparison to the market as a whole.
 Beta is used in the capital asset pricing model (CAPM), a
model that calculates the expected return of an asset based on
its beta and expected market returns.
 Also known as "beta coefficient.“
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CAPM Formula
CAPM - Rs
= Rf + β (Rm – Rf)
Rs = Expected Return/ Return required on the investment
Rf = Risk-Free Return/ Return that can be earned on a
risk-free investment
Rm = Average return on all securities
β = The securities beta (systematic) risk factor.
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DIVERSIFIABLE RISK
Diversifiable
risk
sometimes
called
unsystematic risk. That part of an asset's risk
arising from random causes that can be
eliminated through diversification.
For example, the risk of a company losing a
key account can be diversified away by
investing in the competitor that look the
account.
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NON-DIVERSIFIABLE RISK
Non-diversifiable risk sometimes called
systematic risk. The risk attributable to market
factors that affect all firms and that cannot be
eliminated through diversification.
For example, if there is inflation, all
companies experience an increase in prices of
inputs, and generally their profitability will
suffer if they cannot fully pass the price
increase on to their customers.
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ADVANTAGES - CAPM
There are numerous advantages to the application
of CAPM,
Ease-of-use: CAPM is a simplistic calculation that
can be easily tested to derive a range of possible
outcomes to provide confidence around the required
rates of return.
Diversified Portfolio: The assumption that investors
hold a diversified portfolio, similar to the market
portfolio, eliminates the unsystematic risk.
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Systematic risk (ß): CAPM takes into account
systematic risk, which is left out of other
return models.
Business and Financial Risk Variability:
When businesses investigate opportunities, if
the business mix and financing differ from the
current business, then other required return
calculations.
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Drawbacks - CAPM
Risk-free Rate (Rf): The commonly accepted rate
used as the Rf is the yield on short-term government
securities.
Return on the Market (Rm): The return on the
market can be described as the sum of the capital
gains and dividends for the market. A problem arises
when at any given time, the market return can be
negative. As a result, a long-term market return is
utilized to smooth the return.
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Ability to Borrow at a Risk-free Rate: The minimum
required return line might actually be less steep
(provide a lower return) than the model calculates.
Determination of Project Proxy Beta: Businesses that
use CAPM to assess an investment need to find a beta
reflective to the project or investment. Often a proxy
beta is necessary. However, accurately determining one
to properly assess the project is difficult and can affect
the reliability of the outcome.
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Limitations of CAPM
CAPM has the following limitations:
It is based on unrealistic assumptions.
It is difficult to test the strength of CAPM.
Betas do not remain stable over time.
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Exercise
The AT&T has an expected ß = .92, and
Microsoft has a ß = 1.23 (both based on past
stock price volatility). Further, assume that
analysts are predicting the S&P 500 will go up
14.7% over the next year, and currently the
return on a one-year Treasury bill is 5.2% both
(AT&T and Microsoft. What return should
investor expect for AT&T and Microsoft?
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International
Financial Management
7th Edition
by
Jeff Madura
Florida Atlantic University
PowerPoint® Presentation
by
Yee-Tien Fu
National Cheng-Chi University
Taipei, Taiwan
South-Western/Thomson Learning © 2003
Part I
The International Financial Environment
Multinational Corporation (MNC)
Foreign Exchange Markets
Exporting
& Importing
Product Markets
Dividend
Remittance
& Financing
Subsidiaries
Investing
& Financing
International
Financial
Markets
Chapter
1
Multinational Financial Management:
An Overview
South-Western/Thomson Learning © 2003
Chapter Objectives
• To identify the main goal of the
multinational corporation (MNC) and
conflicts with that goal;
• To describe the key theories that justify
international business; and
• To explain the common methods used to
conduct international business.
A1 - 4
Goal of the MNC
• The commonly accepted goal of an MNC is
to maximize shareholder wealth.
• We will focus on MNCs that are based in
the United States and that wholly own
their foreign subsidiaries.
A1 - 5
Conflicts Against the MNC Goal
• For corporations with shareholders who
differ from their managers, a conflict of
goals can exist - the agency problem.
• Agency costs are normally larger for MNCs
than for purely domestic firms.
¤ The sheer size of the MNC.
¤ The scattering of distant subsidiaries.
¤ The culture of foreign managers.
¤ Subsidiary value versus overall MNC value.
A1 - 6
Impact of Management Control
• The magnitude of agency costs can vary
with the management style of the MNC.
• A centralized management style reduces
agency costs. However, a decentralized
style gives more control to those
managers who are closer to the
subsidiary’s operations and environment.
A1 - 7
Impact of Management Control
• Some MNCs attempt to strike a balance they allow subsidiary managers to make
the key decisions for their respective
operations, but the decisions are
monitored by the parent’s management.
A1 - 8
Impact of Management Control
• Electronic networks make it easier for the
parent to monitor the actions and
performance of foreign subsidiaries.
• For example, corporate intranet or internet
email facilitates communication. Financial
reports and other documents can be sent
electronically too.
A1 - 9
Impact of Corporate Control
• Various forms of corporate control can
reduce agency costs.
¤ Stock compensation for board members
and executives.
¤ The threat of a hostile takeover.
¤ Monitoring and intervention by large
shareholders.
A1 - 10
Constraints
Interfering with the MNC’s Goal
• As MNC managers attempt to maximize
their firm’s value, they may be confronted
with various constraints.
¤
Environmental constraints.
¤
Regulatory constraints.
¤
Ethical constraints.
A1 - 11
Theories of International Business
Why are firms motivated to expand
their business internationally?
 Theory of Comparative Advantage
¤ Specialization by countries can increase
production efficiency.
 Imperfect Markets Theory
¤ The markets for the various resources
used in production are “imperfect.”
A1 - 12
Theories of International Business
Why are firms motivated to expand
their business internationally?
 Product Cycle Theory
¤ As a firm matures, it may recognize
additional opportunities outside its home
country.
A1 - 13
International
Business Methods
There are several methods by which firms
can conduct international business.
• International trade is a relatively
conservative approach involving
exporting and/or importing.
¤ The internet facilitates international trade
by enabling firms to advertise and manage
orders through their websites.
A1 - 14
International
Business Methods
• Licensing allows a firm to provide its
technology in exchange for fees or some
other benefits.
• Franchising obligates a firm to provide a
specialized sales or service strategy,
support assistance, and possibly an initial
investment in the franchise in exchange
for periodic fees.
A1 - 15
International
Business Methods
• Firms may also penetrate foreign markets
by engaging in a joint venture (joint
ownership and operation) with firms that
reside in those markets.
• Acquisitions of existing operations in
foreign countries allow firms to quickly
gain control over foreign operations as
well as a share of the foreign market.
A1 - 16
International
Business Methods
• Firms can also penetrate foreign markets
by establishing new foreign subsidiaries.
• In general, any method of conducting
business that requires a direct investment
in foreign operations is referred to as a
direct foreign investment (DFI).
• The optimal international business
method may depend on the characteristics
of the MNC.
A1 - 17
International Opportunities
• Investment opportunities - The marginal
return on projects for an MNC is above
that of a purely domestic firm because of
the expanded opportunity set of possible
projects from which to select.
• Financing opportunities - An MNC is also
able to obtain capital funding at a lower
cost due to its larger opportunity set of
funding sources around the world.
A1 - 18
International Opportunities
• Opportunities in Europe
¤
¤
¤
The Single European Act of 1987.
The removal of the Berlin Wall in 1989.
The inception of the euro in 1999.
• Opportunities in Latin America
¤
¤
The North American Free Trade Agreement
(NAFTA) of 1993.
The General Agreement on Tariffs and
Trade (GATT) accord.
A1 - 19
International Opportunities
• Opportunities in Asia
¤
¤
¤
The reduction of investment restrictions by
many Asian countries during the 1990s.
China’s potential for growth.
The Asian economic crisis in 1997-1998.
A1 - 20
Exposure to International Risk
International business usually increases an
MNC’s exposure to:
 exchange rate movements
¤ Exchange rate fluctuations affect cash
flows and foreign demand.
 foreign economies
¤ Economic conditions affect demand.
 political risk
¤ Political actions affect cash flows.
A1 - 21
Managing for Value
• Like domestic projects, foreign projects
involve an investment decision and a
financing decision.
• When managers make multinational
finance decisions that maximize the
overall present value of future cash flows,
they maximize the firm’s value, and hence
shareholder wealth.
A1 - 22
Valuation Model for an MNC
• Domestic Model
n
Value = ∑
t =1
E (CF$, t )
(1 + k )
t
E (CF$,t ) = expected cash flows to be received at
the end of period t
n
= the number of periods into the future
in which cash flows are received
k
= the required rate of return by
investors
A1 - 23
Valuation Model for an MNC
• Valuing International Cash Flows
m

[E (CFj , t )× E (ER j , t )]
n ∑
 j =1

Value = ∑ 

t
(1 + k )
t =1 



E (CFj,t ) = expected cash flows denominated in currency j
to be received by the U.S. parent at the end of
period t
E (ERj,t ) = expected exchange rate at which currency j can
be converted to dollars at the end of period t
k
= the weighted average cost of capital of the U.S.
parent company
A1 - 24
Valuation Model for an MNC
• An MNC’s financial decisions include how
much business to conduct in each country
and how much financing to obtain in each
currency.
• Its financial decisions determine its
exposure to the international environment.
A1 - 25
Valuation Model for an MNC
Impact of New International Opportunities
on an MNC’s Value
Exposure to
Foreign Economies
Exchange Rate Risk
m

[E (CFj , t )× E (ER j , t )]
n ∑
 j =1

Value = ∑ 

t
(1 + k )
t =1 



Political Risk
A1 - 26
Chapter Review
• Goal of the MNC
¤
¤
¤
¤
Conflicts Against the MNC Goal
Impact of Management Control
Impact of Corporate Control
Constraints Interfering with the MNC’s Goal
• Theories of International Business
¤
¤
¤
Theory of Comparative Advantage
Imperfect Markets Theory
Product Cycle Theory
A1 - 27
Chapter Review
• International Business Methods
¤
¤
¤
¤
¤
¤
International Trade
Licensing
Franchising
Joint Ventures
Acquisitions of Existing Operations
Establishing New Foreign Subsidiaries
A1 - 28
Chapter Review
• International Opportunities
¤
¤
¤
¤
¤
Investment Opportunities
Financing Opportunities
Opportunities in Europe
Opportunities in Latin America
Opportunities in Asia
A1 - 29
Chapter Review
• Exposure to International Risk
¤
¤
¤
Exposure to Exchange Rate Movements
Exposure to Foreign Economies
Exposure to Political Risk
• Managing for Value
A1 - 30
Chapter Review
• Valuation Model for an MNC
¤
¤
¤
Domestic Model
Valuing International Cash Flows
Impact of Financial Management and
International Conditions on Value
A1 - 31
Chapter
11
Managing Transaction, Economic and
Translation Exposure
South-Western/Thomson Learning © 2003
Transaction Exposure
• Transaction exposure exists when the
future cash transactions of a firm are
affected by exchange rate fluctuations.
• When transaction exposure exists, the
firm faces three major tasks:
 Identify its degree of transaction exposure,
 Decide whether to hedge its exposure, and
 Choose among the available hedging
techniques if it decides on hedging.
A11 - 2
Identifying Net Transaction Exposure
• Centralized Approach - A centralized
group consolidates subsidiary reports to
identify, for the MNC as a whole, the
expected net positions in each foreign
currency for the upcoming period(s).
• Note that sometimes, a firm may be able to
reduce its transaction exposure by pricing
some of its exports in the same currency
as that needed to pay for its imports.
A11 - 3
Techniques to Eliminate
Transaction Exposure
• Hedging techniques include:
¤
¤
¤
¤
Futures hedge,
Forward hedge,
Money market hedge, and
Currency option hedge.
• MNCs will normally compare the cash
flows that could be expected from each
hedging technique before determining
which technique to apply.
A11 - 4
Techniques to Eliminate
Transaction Exposure
• A futures hedge involves the use of
currency futures.
• To hedge future payables, the firm may
purchase a currency futures contract for
the currency that it will be needing.
• To hedge future receivables, the firm may
sell a currency futures contract for the
currency that it will be receiving.
A11 - 5
Techniques to Eliminate
Transaction Exposure
• A forward hedge differs from a futures
hedge in that forward contracts are used
instead of futures contract to lock in the
future exchange rate at which the firm will
buy or sell a currency.
• Recall that forward contracts are common
for large transactions, while the
standardized futures contracts involve
smaller amounts.
A11 - 6
Techniques to Eliminate
Transaction Exposure
• An exposure to exchange rate movements
need not necessarily be hedged, despite
the ease of futures and forward hedging.
• Based on the firm’s degree of risk
aversion, the hedge-versus-no-hedge
decision can be made by comparing the
known result of hedging to the possible
results of remaining unhedged.
A11 - 7
Techniques to Eliminate
Transaction Exposure
Real cost of hedging payables (RCHp) =
+ nominal cost of payables with hedging
– nominal cost of payables without
hedging
Real cost of hedging receivables (RCHr) =
+ nominal home currency revenues
received without hedging
– nominal home currency revenues
received with hedging
A11 - 8
Techniques to Eliminate
Transaction Exposure
• If the real cost of hedging is negative, then
hedging is more favorable than not
hedging.
• To compute the expected value of the real
cost of hedging, first develop a probability
distribution for the future spot rate, and
then use it to develop a probability
distribution for the real cost of hedging.
A11 - 9
Techniques to Eliminate
Transaction Exposure
• If the forward rate is an accurate predictor
of the future spot rate, the real cost of
hedging will be zero.
• If the forward rate is an unbiased predictor
of the future spot rate, the real cost of
hedging will be zero on average.
A11 - 10
Techniques to Eliminate
Transaction Exposure
• A money market hedge involves taking
one or more money market position to
cover a transaction exposure.
• Often, two positions are required.
¤
¤
Payables: Borrow in the home currency,
and invest in the foreign currency.
Receivables: borrow in the foreign
currency, and invest in the home
currency.
A11 - 11
Techniques to Eliminate
Transaction Exposure
• Note that taking just one money market
position may be sufficient.
¤ A firm that has excess cash need not
borrow in the home currency when hedging
payables.
¤ Similarly, a firm that is in need of cash
need not invest in the home currency
money market when hedging receivables.
A11 - 12
Techniques to Eliminate
Transaction Exposure
• The known results of money market
hedging can be compared with the known
results of forward or futures hedging to
determine which the type of hedging that
is preferable.
A11 - 13
Techniques to Eliminate
Transaction Exposure
• If interest rate parity (IRP) holds, and
transaction costs do not exist, a money
market hedge will yield the same result as
a forward hedge.
• This is so because the forward premium
on a forward rate reflects the interest rate
differential between the two currencies.
A11 - 14
Techniques to Eliminate
Transaction Exposure
• A currency option hedge involves the use
of currency call or put options to hedge
transaction exposure.
• Since options need not be exercised, firms
will be insulated from adverse exchange
rate movements, and may still benefit from
favorable movements.
• However, the firm must assess whether
the premium paid is worthwhile.
A11 - 15
Techniques to Eliminate
Transaction Exposure
Hedging Payables Hedging Receivables
Purchase currency
futures contract(s).
Negotiate forward
contract to buy
foreign currency.
Money
Borrow local
market
currency. Convert
hedge
to and then invest
in foreign currency.
Currency Purchase currency
option
call option(s).
Futures
hedge
Forward
hedge
Sell currency
futures contract(s).
Negotiate forward
contract to sell
foreign currency.
Borrow foreign
currency. Convert
to and then invest
in local currency.
Purchase currency
put option(s).
A11 - 16
Techniques to Eliminate
Transaction Exposure
• A comparison of hedging techniques
should focus on minimizing payables, or
maximizing receivables.
• Note that the cash flows associated with
currency option hedging and remaining
unhedged cannot be determined with
certainty.
A11 - 17
Techniques to Eliminate
Transaction Exposure
• In general, hedging policies vary with the
MNC management’s degree of risk
aversion and exchange rate forecasts.
• The hedging policy of an MNC may be to
hedge most of its exposure, none of its
exposure, or to selectively hedge its
exposure.
A11 - 18
Limitations of Hedging
• Some international transactions involve
an uncertain amount of foreign currency,
such that overhedging may result.
• One way of avoiding overhedging is to
hedge only the minimum known amount in
the future transaction(s).
A11 - 19
Limitations of Hedging
• In the long run, the continual hedging of
repeated transactions may have limited
effectiveness.
• For example, the forward rate often moves
in tandem with the spot rate. Thus, an
importer who uses one-period forward
contracts continually will have to pay
increasingly higher prices during a strongforeign-currency cycle.
A11 - 20
Hedging Long-Term
Transaction Exposure
• MNCs that are certain of having cash
flows denominated in foreign currencies
for several years may attempt to use longterm hedging.
• Three commonly used techniques for
long-term hedging are:
¤ long-term forward contracts,
¤ currency swaps, and
¤ parallel loans.
A11 - 21
Hedging Long-Term
Transaction Exposure
• Long-term forward contracts, or long
forwards, with maturities of ten years or
more, can be set up for very creditworthy
customers.
• Currency swaps can take many forms. In
one form, two parties, with the aid of
brokers, agree to exchange specified
amounts of currencies on specified dates
in the future.
A11 - 22
Hedging Long-Term
Transaction Exposure
• A parallel loan, or back-to-back loan,
involves an exchange of currencies
between two parties, with a promise to reexchange the currencies at a specified
exchange rate and future date.
A11 - 23
Alternative Hedging Techniques
• Sometimes, a perfect hedge is not
available (or is too expensive) to eliminate
transaction exposure.
• To reduce exposure under such a
condition, the firm can consider:
¤ leading and lagging,
¤ cross-hedging, or
¤ currency diversification.
A11 - 24
Alternative Hedging Techniques
• The act of leading and lagging refers to an
adjustment in the timing of payment
request or disbursement to reflect
expectations about future currency
movements.
• Expediting a payment is referred to as
leading, while deferring a payment is
termed lagging.
A11 - 25
Alternative Hedging Techniques
• When a currency cannot be hedged, a
currency that is highly correlated with the
currency of concern may be hedged
instead.
• The stronger the positive correlation
between the two currencies, the more
effective this cross-hedging strategy will
be.
A11 - 26
Alternative Hedging Techniques
• With currency diversification, the firm
diversifies its business among numerous
countries whose currencies are not highly
positively correlated.
A11 - 27
Economic Exposure
• Economic exposure refers to the impact
exchange rate fluctuations can have on a
firm’s future cash flows.
• Recall that corporate cash flows can be
affected by exchange rate movements in
ways not directly associated with foreign
transactions.
A11 - 28
Economic Exposure
• Exchange rate changes are often linked to
variability in real growth, inflation, interest
rates, governmental actions,… If material,
the changes may cause firms to adjust
their financing and operating strategies.
• The importance of managing economic
exposure can be seen from the case of the
bankruptcy of Laker Airways, and from the
the 1997-98 Asian crisis.
A11 - 29
Economic Exposure
• A firm can assess its economic exposure
by determining the sensitivity of its
expenses and revenues to various
possible exchange rate scenarios.
• The firm can then reduce its exposure by
restructuring its operations to balance its
exchange-rate-sensitive cash flows.
• Note that computer spreadsheets are
often used to expedite the analysis.
A11 - 30
Economic Exposure
• Restructuring may involve:
 increasing/reducing sales in new or
existing foreign markets,
 increasing/reducing dependency on
foreign suppliers,
 establishing or eliminating production
facilities in foreign markets, and/or
 increasing or reducing the level of debt
denominated in foreign currencies.
A11 - 31
Economic Exposure
• MNCs must be very confident about the
long-term potential benefits before they
proceed to restructure their operations,
because of the high costs of reversal.
A11 - 32
Translation Exposure
• Translation exposure results when an
MNC translates each subsidiary’s financial
data to its home currency for consolidated
financial reporting.
• Translation exposure does not directly
affect cash flows, but some firms are
concerned about it because of its potential
impact on reported consolidated earnings.
A11 - 33
Translation Exposure
• An MNC may attempt to avoid translation
exposure by matching its foreign liabilities
with its foreign assets.
• To hedge translation exposure, forward or
futures contracts can be used.
Specifically, an MNC may sell the currency
that its foreign subsidiary receive as
earnings forward, thus creating an
offsetting cash outflow in that currency.
A11 - 34
Translation Exposure
• For example, a U.S.-based MNC that is
concerned about the translated value of
its British earnings may enter a one-year
forward contract to sell pounds.
• If the pound depreciates during the fiscal
year, the gain generated from the forward
contract position will help to offset the
translation loss.
A11 - 35
Translation Exposure
• Hedging translation exposure is limited
by:
¤ inaccurate earnings forecasts,
¤ inadequate forward contracts for some
currencies,
¤ accounting distortions (the choice of the
translation exchange rate, taxes, etc.), and
¤ increased transaction exposure (due to
hedging activities).
A11 - 36
Translation Exposure
• In particular, if the foreign currency
depreciates during the fiscal year, the
transaction loss generated by a forward
contract position will somewhat offset the
translation gain.
• Note that the translation gain is simply a
paper gain, while the loss resulting from
the hedge is a real loss.
A11 - 37
Translation Exposure
• Perhaps, the best way for MNCs to deal
with translation exposure is to clarify how
their consolidated earnings have been
affected by exchange rate movements.
A11 - 38
Impact of Hedging Economic Exposure
on an MNC’s Value
Hedging Decisions on
Economic Exposure
m

[E (CFj , t )× E (ER j , t )]
n ∑
 j =1

Value = ∑ 

t
(1 + k )
t =1 



E (CFj,t ) = expected cash flows in currency j to be received
by the U.S. parent at the end of period t
E (ERj,t ) = expected exchange rate at which currency j can
be converted to dollars at the end of period t
k
= weighted average cost of capital of the parent
A11 - 39
12
Chapter
Managing Economic Exposure
And Translation Exposure
South-Western/Thomson Learning © 2003
Chapter Objectives
• To explain how an MNC’s economic
exposure can be hedged; and
• To explain how an MNC’s translation
exposure can be hedged.
A12 - 2
Economic Exposure
• Economic exposure refers to the impact
exchange rate fluctuations can have on a
firm’s future cash flows.
• Recall that corporate cash flows can be
affected by exchange rate movements in
ways not directly associated with foreign
transactions.
A12 - 3
Economic Exposure
• Exchange rate changes are often linked to
variability in real growth, inflation, interest
rates, governmental actions,… If material,
the changes may cause firms to adjust
their financing and operating strategies.
• The importance of managing economic
exposure can be seen from the case of the
bankruptcy of Laker Airways, and from the
the 1997-98 Asian crisis.
A12 - 4
Economic Exposure
• A firm can assess its economic exposure
by determining the sensitivity of its
expenses and revenues to various
possible exchange rate scenarios.
• The firm can then reduce its exposure by
restructuring its operations to balance its
exchange-rate-sensitive cash flows.
• Note that computer spreadsheets are
often used to expedite the analysis.
A12 - 5
Economic Exposure
• Restructuring may involve:
 increasing/reducing sales in new or
existing foreign markets,
 increasing/reducing dependency on
foreign suppliers,
 establishing or eliminating production
facilities in foreign markets, and/or
 increasing or reducing the level of debt
denominated in foreign currencies.
A12 - 6
Economic Exposure
• MNCs must be very confident about the
long-term potential benefits before they
proceed to restructure their operations,
because of the high costs of reversal.
A12 - 7
Translation Exposure
• Translation exposure results when an
MNC translates each subsidiary’s financial
data to its home currency for consolidated
financial reporting.
• Translation exposure does not directly
affect cash flows, but some firms are
concerned about it because of its potential
impact on reported consolidated earnings.
A12 - 8
Translation Exposure
• An MNC may attempt to avoid translation
exposure by matching its foreign liabilities
with its foreign assets.
• To hedge translation exposure, forward or
futures contracts can be used.
Specifically, an MNC may sell the currency
that its foreign subsidiary receive as
earnings forward, thus creating an
offsetting cash outflow in that currency.
A12 - 9
Translation Exposure
• For example, a U.S.-based MNC that is
concerned about the translated value of
its British earnings may enter a one-year
forward contract to sell pounds.
• If the pound depreciates during the fiscal
year, the gain generated from the forward
contract position will help to offset the
translation loss.
A12 - 10
Translation Exposure
• Hedging translation exposure is limited
by:
¤ inaccurate earnings forecasts,
¤ inadequate forward contracts for some
currencies,
¤ accounting distortions (the choice of the
translation exchange rate, taxes, etc.), and
¤ increased transaction exposure (due to
hedging activities).
A12 - 11
Translation Exposure
• In particular, if the foreign currency
depreciates during the fiscal year, the
transaction loss generated by a forward
contract position will somewhat offset the
translation gain.
• Note that the translation gain is simply a
paper gain, while the loss resulting from
the hedge is a real loss.
A12 - 12
Translation Exposure
• Perhaps, the best way for MNCs to deal
with translation exposure is to clarify how
their consolidated earnings have been
affected by exchange rate movements.
A12 - 13
Impact of Hedging Economic Exposure
on an MNC’s Value
Hedging Decisions on
Economic Exposure
m

[E (CFj , t )× E (ER j , t )]
n ∑
 j =1

Value = ∑ 

t
(1 + k )
t =1 



E (CFj,t ) = expected cash flows in currency j to be received
by the U.S. parent at the end of period t
E (ERj,t ) = expected exchange rate at which currency j can
be converted to dollars at the end of period t
k
= weighted average cost of capital of the parent
A12 - 14
Chapter Review
• Managing Economic Exposure
¤
¤
¤
Assessing Economic Exposure
Reducing Economic Exposure through
Restructuring
Issues Involved in the Restructuring
Decision
A12 - 15
Chapter Review
• Managing Translation Exposure
¤
¤
¤
Use of Forward Contracts to Hedge
Translation Exposure
Limitations of Hedging Translation
Exposure
Alternative Solution to Hedging Translation
Exposure
• How Economic Exposure Management
Affects an MNC’s Value
A12 - 16
Chapter 14:
Role of Exchange Rates in
International Trade and how
Exchange Rates are determined
Exchange Rate:
Definition: The price of one
currency in terms of another
• E.g.
E¥/$=104
1 $ buys 104 ¥.
You need 104 ¥ to buy 1 $.
Price of 1$ in terms of ¥ is 104.
E¥/$ is called “dollar-yen.”
• E.g.
E$/€=1.30
1 € buys 1.30 $.
You need 1.30 $ to buy 1 €.
Price of 1 € in terms of $ is 1.30
E$/€ is called “euro-dollar.”
E¥/$
You need E¥/$ units of the
numerator currency (¥) to
buy
1
unit
of
the
denominator currency ($).
• Note: In Europe the opposite
convention is used.
If E$/€=1.30
(i.e., you need 1.30 $ to buy 1 €.)
then:
you need
E €/$=
1
E$/€
1
€ to buy 1 $.
1.30
=
1
=0.77
1.30
Domestic and Foreign Prices
If we know the exchange rate
between two countries’ currencies,
we can compute the price of one
country ’ s exports in terms of the
other country’s money.
Example: The dollar price of a £50
sweater with a dollar exchange rate
of $1.50 per pound is (1.50 $/£) x
(£50) = $75.
Exchange rate appreciation and
depreciation
Today: E$/€=1.5
Last year: E$/€ =1
$ depreciated against the €
€ appreciated against the $
When E$/€ goes up, the currency in
numerator depreciates and the
currency in the denominator
appreciates
Exchange rate and relative price of
goods
• US is exporting T-shirts to France
and importing wine.
The initial exchange rate E$/€ =1. Price of wine is €15
and the price of T-shirt is $30
• Calculating relative price (price of
one good in terms of another
good).
• a) express the price of wine in
terms of dollars (or any common
currency). €15* E$/€ = $15
• b) $30/$15 = 2 ( you receive 2
bottles of wine per 1 T-shirt).
• 2 is the relative price of T- shirts in
terms of wine
Exchange rate and relative price of
goods (cont.)
• Suppose dollar depreciates and
now E$/€ =1.5
• What happens to the relative price of US
exports, the T-shirts?
A bottle of wine is now 15*1.5=$22.5
And relative price of T-shirts in terms of
wine = $30/$22.5 = 1.33
Since 2<1.33, we can see that relative price
of country’s exports goes down as the
currency depreciates. Conversely, the
relative price of foreign imports (wine)
increases.
If dollar appreciates vis-a-vis euro, you can
check that relative price of US exports wil
increase, and the relative price of imports
into US from France will decrease.
Rate of appreciation/depreciation
%Change in the exchange rate
Today: E$/€=1.3
Last year: E$/€ =1
%Δ E$/€=
1.3 -1
=0.3
1
In general:
%Δ E$/€ =
=(Final E$/€ - Initial E$/€)/Initial E$/€
The Foreign Exchange
Market
• Exchange rates are determined in
the foreign exchange market.
– The market in which international
currency trades take place
• The Actors
– The major participants in the foreign
exchange market are:
•
•
•
•
Commercial banks
International corporations
Nonbank financial institutions
Central banks
• Interbank trading
• Foreign currency trading among banks
• It accounts for most of the activity in the
foreign exchange market.
Characteristics of the FX
Market
– Over the counter.
– High volume of transactions (‘89
average daily trading=$600bn; ’01 it
was $1.2trn ’04 daily trading was
$1.9trn, 2010 $ 4trn).
– Major foreign exchange trading
centers: London, New York, Frankfurt,
Singapore, Tokyo.
– No significant arbitrage.
– $ is the vehicle currency: in 2001,
around 90% of transactions between
banks involved exchanges of foreign
currencies for U.S. dollars (only 38%
of transactions involved the Euro).
– Trading mainly happens through an
exchange of bank deposits.
1989 Foreign exchange market
London
31%
Other
31%
United States
19%
Tokyo
19%
2004 Foreign Exchange Market
Other
26%
Tokyo
10%
London
40%
United States
24%
Exchange Rates Transactions
–Spot transaction
Price: spot exchange rate
–Forward transactions
Exchange of currencies on some
future date at a prenegotiated
exchange rate.
Price: forward exchange rate.
E.g., you agree to exchange dollar for
euros in 3 months at the exch. rate F$/€=1.3
In three month you are obliged to
enter into the transaction whatever the
current exchange rate is (e.g., even if it is
not convenient for you).
Forward contracts. Why Do Forwards
Exist?
•International trade example:
•A US retailer must pay a German
supplier.
•It sells radios for $100 and must
pay the supplier €90 per radio.
•The current euro-dollar spot
exchange rate is 1. Therefore, the
US retailer would pay $90 per radio
and make $10 profits per radio.
•However, the retailer does not have
the funds to pay for the radios until it
sells them, e.g., 30 days. What if the
exchange rate moves?
• If dollar depreciates to the eurodollar = 1.3 dollars per euro, the
retailer would pay the equivalent of
117 dollars per radio (90*1.3), thus
making a loss.
•The retailer can go to a bank and
buy euro forward. Let’s say that the
forward rate is 1. The supplier
makes a $10 profit for sure.
Forwards
•With a forward contract, the retailer
insures himself against a possible
dollar depreciation.
•If the dollar appreciates, however,
the retailer would make less money
than it would have been otherwise.
Forward Premium and
Discount
If FD/F> ED/F⇒ F trades at forward
premium; D trades at forward
discount.
If FD/F< ED/F⇒ F trades at forward
discount; D trades at forward
premium.
Return of a Foreign
Currency Investment
Market participants need two pieces of
information in order to compare returns on
different investments:
• How the interest rate will change.
• How the exchange rate will change.
In our examples:
-two countries:
Domestic with currency D
Foreign with currency F
- we assume that investors invest their
money in bank deposits (foreign and
domestic).
Example
Start: ED/F=1
End: ED/F = 1.2
RF = 0.05
Starting wealth: D100
Change into F⇒ F100
After 1 year ⇒F105
Change into D ⇒D126
Final wealth: D126
RoR = 26%
A Simple Rule
The rate of return on a foreign
currency deposit is (approximately)
the foreign interest rate plus the rate
of appreciation of the foreign
currency with respect to the
domestic one.
RF +
(ED/FEnd - ED/FStart )
ED/F Start
•E.g. (D=$, F=€)
At the beginning of 2005 you invest
$100 in euros. The euro-dollar
exchange rate is E$/€=1.
The 1-year interest rate paid on euro
deposits is 5%.
At the end of the year, you close your
investment. The euro-dollar exchange
rate is 1.20.
The rate of return is (approximately):
0.05+(1.2-1)/1=0.05+0.2=0.25≅0.26
Caveat
In order to apply the rule the
exchange rate needs to be quoted
as number of domestic currency that
one unit of the foreign currency buys
(ED/F).
If the exchange rate is not quoted in
this way, it needs to be transformed.
•E.g.
At the beginning of 2005 you invest $100 in
yen. The dollar-yen exchange rate is
E¥/$=100.
The 1-year interest rate paid on yen
deposits is 5%.
At the end of the year, you close your
investment. The dollar-yen exchange rate is
90.
In order to compute the rate of return you
need to transform dollar-yen into yen-dollar
(the number of dollars that one yen buys).
Initially, yen-dollar is (1/100)=0.01, at the
end of the investment period it is
(1/90)=0.011.
The rate of return is (approximately):
0.05+(0.011-0.01)/0.01=0.05+0.1=0.15
Investing at home or abroad?
Example:
Let’s consider an investor based in
country D who, at the end of the year,
expects the exchange rate to
reach ÊeD/F :
Return of investing at home:
RD
Return on investing abroad:
[RF + (ÊeD/F - ED/F )/ED/F ]
If RD < [RF + (ÊeD/F - ED/F )/ED/F ]
Our investor will invest abroad.
If RD > [RF + (ÊeD/F - ED/F )/ED/F ]
Invest at home.
Note: our investor need not be based
in country D (i.e., he need not have
wealth denominated in currency D)
If RD > [RF + (ÊeD/F - ED/F )/ED/F ]
Then our investor can borrow
currency F and invest in D (go short
on F and long on D).
If RD < [RF + (ÊeD/F - ED/F )/ED/F ]
Our investor can borrow currency D
and invest in F (go short D and long
on F).
• Suppose D is expected to
appreciate. The investor is
based in country D and has
wealth in D.
• How can the investor make
money?
– borrow F, exchange
immediately for D. Deposit D in
the bank
– At the end of the year exchange
D back into F.
– Give back the original loan in F.
The remainder is your profit.
Taking a short position
(borrowing) on the currency that
is expected to lose value.
• Starting capital $100; E$/€ =1 and Êe $/€ =
0.8
• R1year,$ = 0%, R1uear €= 0%
• A) How can you make money on the
expected euro depreciation?
– Borrow euros – suppose you borrow €1000
– Exchange immediately euros into dollars at
the current exchange rate of 1 – you receive
$1000
– Wait for the end of the year
– Exchange dollars back into Euros at the
current exchange rate of 0.8 – you get €1,250
– Give back your original loan.
– €250 is your profit.
Let’s define EeD/F as the average
expectation on the future value of the
exchange rate by all market
participants.
If RD> [RF + (EeD/F - ED/F )/ED/F ]
More traders will want to invest in D
than in F.
If RD< [RF + (EeD/F - ED/F )/ED/F ]
More traders will want to invest in F
than in D.
(Uncovered)
Interest Parity Condition
The foreign exchange market is in
equilibrium when deposits of all
currencies offer the same expected
rate of return.
RD = [RF + (EeD/F - ED/F )/ED/F ]
UIRP is the fundamental equation in
exchange rate determination theory.
If UIRP holds does it
mean that there is no
trade?
No
Some traders: ÊeD/F> EeD/F
Some traders: ÊeD/F<EeD/F
Traders in the first group will buy
currency F (in exchange for
currency D) from traders in the
second group.
Using UIRP to compute market’s expectations…
Start: ED/F=1
RD = 0.1
RF = 0.05
RD = [RF + (EeD/F - ED/F )/ED/F ]
EeD/F = (RD –RF)ED/F + ED/F
EeD/F =(0.1-0.05)*1+1=1.05
The market expects currency F to appreciate vis a vis
currency D.
Note: When foreign exchange markets are in
equilibrium (UIRP holds), the market expects
the currency with lower interest rate to
appreciate in the future vis a vis the currency
with higher interest rate.
Example: Developing countries with higher
inflation rates usually offer higher returns on
their currency deposits than US. Why?
Higher inflation usually means cheaper
currency in the future
From UIRP
RD - RF = (EeD/F - ED/F )/ED/F
Therefore:
If RD>RF⇒
D is expected to depreciate vis a vis
F
If RD<RF⇒
D is expected to appreciate vis a vis
F
•E.g.
RF = 0.05
RD = 0.10
RD-RF = (EeD/F - ED/F )/ED/F=0.05
D is expected to depreciate by
5% vis a vis F.
Does UIRP hold in
practice?
The evidence is mixed. UIRP
seems to hold better for pairs of
major currencies, and better in
the long run. There are
significant short and medium run
deviations from UIRP
How do we test for UIRP?
Why do we observe deviations
from the UIRP?
Covered Interest rate
parity
• RD = RF + (FD/F - ED/F )/ED/F
• Where FD/F is the exchange
rate on a forward contract
Therefore,
FD/F = (RD –RF ) ED/F + ED/F
• Empirically, there is strong support for
CIRP (there are no significant arbitrage
opportunities in transactions with forward
contracts).
Forward Rate and Market
Expectations
RD = [RF + (FD/F - ED/F )/ED/F ]
RD = [RF + (EeD/F - ED/F )/ED/F ]
EeD/F= FD/F
If we assume that expectations are rational, and
both CIRP and UIRP hold, then forward rate should
be an unbiased predictor of the future spot
exchange rate. Given that there is strong empirical
evidence for CIRP, testing the “unbiasedness
hypothesis” would be a test for UIRP.
If UIRP does not hold, then it is possible that a
currency carries “risk premium”, associated with
the exchange rate risk.
Assumptions about risk
• When discussing returns on domestic
and foreign assets we often abstract from
risk (assume there is no risk premium
associated with holding a certain
currency).
• What this implies: either the two
currencies are subject to the same risk
factors, or investors do not care about
risk when evaluating the returns on the
two currencies (e.g. speculators)
• Risk will come into picture a little later on,
when we discuss fixed exchange rate
regimes and interventions of the foreign
exchange market.
Current Exchange Rate
and Expected Returns
– For given interest rates and
expectations of the future exchange
rate, the Depreciation of a country’s
currency today lowers the expected
domestic currency return on foreign
currency deposits.
– For given interest rates and
expectations of the future exchange
rate, the Appreciation of the domestic
currency today raises the expected
domestic currency return of foreign
currency deposits.
•E.g.
Start: ED/F=1
End: ED/F = 1.2
RF = 0.05
RoR = 0.05+(1.2-1)/1=25%
If the starting value of the
exchange rate moves to 1.1
Then:
RoR=0.05+(1.2-1.1)/1.1=14%
Equilibrium
Determination of the Equilibrium D/F Exchange Rate
Exchange
rate, ED/F
E2D/F
E1
Return on
Domestic deposits
2
1
D/F
3
E3D/F
Expected return
on Foreign deposits
RD
Rates of return
(in D terms)
Interest Rates and
Equilibrium
Effect of a Rise in the Domestic Interest Rate
Exchange
rate, ED/F
Return on Domestic
deposits
1
E1D/F
1'
2
E2D/F
Expected return on
Foreign deposits
R1D
R2D
Rates of return
(in D terms)
Interest Rates and
Equilibrium
Effect of a Rise in the Foreign Interest Rate
Exchange
rate, ED/F
Return on Domestic
deposits
Rise in the Foreign
interest rate
E2D/F
E1D/F
2
1
Expected return
on Foreign deposits
RD
Rates of return
(in D terms)
Expectations and
Equilibrium
Effect of a Rise in EeD/F
Exchange
rate, ED/F
Return on Domestic
deposits
Rise in Ee
E2D/F
E1D/F
2
1
Expected return
on Foreign deposits
RD
Rates of return
(in D terms)
Financial derivatives.
Some examples
• Derivative: a security whose
payoff depends on the price
of underlying assets (e.g.
future spot price of a
currency, prices of bonds,
stocks, commodities, etc.)
• Examples of derivates:
forward contracts, futures
contracts, currency options,
currency swaps.
Forwards and Futures
Futures are tradable forward
contracts.
»They are traded in exchanges.
»The exchange specifies the size
of the contract, its maturity, etc…
»They are standardized contracts.
»As a result, they are more liquid
(easy to sell).
»There is no physical delivery.
Currency Options
• The owner of an option has the
right (but not the obligation) to
exchange currencies in the future.
•Calls are the right to buy.
•Puts are the right to sell.
•Amount, price and maturity are
specified in the option contract.
• The price at which the option
can be exercised is called the
strike price.
•The maturity date specified in
the option is called the
expiration date.
•The price paid for the option
is called the option premium.
Payoff for the Buyer of Call
Option on €
Profit
Strike Price
E$/€
Break-even point
Payoff for the Buyer of Put
Option on €
Profit
Strike Price
E$/€
Break-even point
•The break-even point for a put
option is strike-premium.
The graph shows the payoff of a
euro call option at maturity.
•The difference between the x-axes
and the horizontal part of the payoff
is the premium.
•At the strike the payoff start sloping
upward (as the buyer finds it
convenient to exercise the option
whenever the spot at maturity is
above the strike).
•The option breaks even if the spot
reaches strike+premium.
Options
•In the previous example, by buying
an option, the retailer guarantees
himself the option to buy euro at a
given price (the strike price), e.g., 1.
•If the dollar appreciates beyond the
strike price, the retailer will simply
not exercise the option.
•An option is similar to an insurance
contract. In order to buy it, you have
to pay a premium (the option price).
Straddle
Profit
E$/€
Payoff of a straddle
•Straddles
volatility.
are
used
to
trade
•They consist of the simultaneous
buying of a call and a put with the
same strike.
•The buyer of a straddle “ buys
volatility”, i.e., he thinks that the
market will be more volatile than
currently implied.
•If his judgment is correct the
buyer will make a profit. If it is not,
he will suffer a loss.
Profit
Implied Volatility
E$/€
This it the market’s expectation on future
volatility.
It is determined by the options’ premium
For this reason is called implied volatility.
Profit
E$/€
If most traders in the market expected a
level of volatility higher than that implied
by the straddle, they would buy put and
call options.
The options prices would go up.
Implied volatility would rise to reflect
traders’ expectation.
Currency Swaps
• 2 firms A and B
•2 markets, US and Japan
US
A
B
10
15
Japan 5
7
• A can borrow at better terms than
B
• A has a comparative advantage
in US
• A needs to have funds in Japan,
B needs to have funds in the US.
•Assume dollar-yen equals 100.
•A borrows $100,000.
•B borrows ¥10,000,000.
•They exchange the funds and
promise to exchange them back
after a year.
•A pays 6% interest to B.
•B pays a 12% interest to A.
• To borrow in Japan, A would
normally have to pay 5%.
• With the currency swap, it pays
10-12+6=4%.
• To borrow in the US, B would
normally have to pay 14%.
• With the currency swap, it pays
7-6+12=13%.
Part V
Short-Term Asset and Liability Management
Subsidiaries
of MNC with
Excess Funds
Deposits
Provision
of Loans
Eurobanks in
Eurocurrency
Market
Deposits
Borrow
Funds
Borrow
Funds
Borrow Funds
Purchase
Securities
Provision
of Loans
Purchase
Securities
MNC
Parent
Borrow
Funds
International
Commercial
Paper Market
Borrow
Funds
Subsidiaries
of MNC with
Deficient Funds
Borrow Funds
19
Chapter
Financing International Trade
South-Western/Thomson Learning © 2003
Chapter Objectives
• To describe the methods of
payment for international trade;
• To explain common trade finance
methods; and
• To describe the major agencies that
facilitate international trade with export
insurance and/or loan programs.
A19 - 3
Payment Methods
for International Trade
• In any international trade transaction,
credit is provided by either
¤ the supplier (exporter),
¤ the buyer (importer),
¤ one or more financial institutions, or
¤ any combination of the above.
• The form of credit whereby the supplier
funds the entire trade cycle is known as
supplier credit.
A19 - 4
Payment Methods
for International Trade
https://statrys.com/blog/int-trade-payment-methods#1
A19 - 5
Payment Methods
for International Trade
Method  : Prepayments
• The cash in advance method is the safest for exporters
because they are securely paid before goods are shipped
and ownership is transferred.
• Typically payments are made by wire transfers or credit
cards.
• This is the least desirable method for importers because
they have the risk of goods not being shipped, and it is also
not favorable for business cash flow.
• Cash in advance is usually only used for small purchases.
No exporter who requires only this method of payment can
be competitive.
A19 - 6
Payment Methods
for International Trade
Method  : Prepayments
• The goods will not be shipped until the buyer
has paid the seller.
• Time of payment : Before shipment
• Goods available to buyers : After payment
• Risk to exporter : None
• Risk to importer : Relies completely on
exporter to ship goods as ordered
A19 - 7
Payment Methods
for International Trade
Method  : Letters of credit (L/C)
A documentary credit, or letter of credit, is basically a promise by a bank to pay an
exporter if all terms of the contract are executed properly. This is one of the most secure
methods of payment.
It is used if the importer has not established credit with the exporter, but the exporter is
comfortable with the importer’s bank.
Here are the general steps in a documentary credit transaction:
• The contract is negotiated and confirmed.
• The importer applies for the documentary credit with their bank.
• The documentary credit is set up by the issuing bank and the exporter and the
exporter’s bank (the collecting bank) are notified by the importer’s bank.
• The goods are shipped.
• Documents verifying the shipment and all terms of the sale are provided by the
exporter to the exporter’s bank and the exporter’s bank sends the documents to the
importer’s issuing bank.
• The issuing bank verifies the documents and issues payment to the exporter’s bank.
• The importer collects the goods
A19 - 8
Payment Methods
for International Trade
Method  : Letters of credit (L/C)
• These are issued by a bank on behalf of the
importer promising to pay the exporter upon
presentation of the shipping documents.
• Time of payment : When shipment is made
• Goods available to buyers : After payment
• Risk to exporter : Very little or none
• Risk to importer : Relies on exporter to ship
goods as described in documents
A19 - 9
Payment Methods
for International Trade
Method  : Drafts (Bills of Exchange)
• A documentary collection is when the exporter instructs
their bank to forward documents related to the sale to the
importer’s bank with a request to present the documents
to the buyer as a request for payment, indicating when
and on what conditions these documents can be released
to the buyer.
• The importer may obtain possession of goods if the
importer has the shipping documents.
• The documents are only released to the buyer after
payment has been made.
• This can be done in two ways.
A19 - 10
Documents Against Payment
The exporter gives the ownership documents of an asset to their bank, which then
presents them to the importer after payment is received.
The importer can then use the documents to take possession of the merchandise.
The risk for the exporter is that the importer will refuse to pay, and even though the
importer won’t be able to collect the goods, the exporter has very little recourse to collect.
Here's how Documents Against Payment works:
• The contract is negotiated and confirmed.
• The exporter ships the goods. The exporter gives his bank all documents confirming
the transaction.
• The exporter’s bank forwards the documents to the importer’s bank.
• The importer’s bank requests payment from the importer by presenting the
documents.
• The importer pays his bank.
• The importer’s bank sends payment to the exporter’s bank.
• The exporter’s bank pays the exporter.
A19 - 11
Documents Against Acceptance
The exporter’s bank on behalf of the exporter instructs the importer’s bank
to release the transaction documents to the importer.
Here's how Documents Against Acceptance works:
• The contract is negotiated and confirmed.
• The exporter ships the goods.
• The exporter presents the transaction documents to their bank.
• The exporter’s bank forwards the documents to the importer’s bank.
• The importer’s bank requests payment from the importer by presenting
the documents.
• The importer makes payment and receives the documents and collects
the goods.
• The importer’s bank pays the exporter’s bank and the exporter’s bank
pays the exporter.
A19 - 12
Payment Methods
for International Trade
Method  : Drafts (Bills of Exchange)
• These are unconditional promises drawn by
the exporter instructing the buyer to pay the
face amount of the drafts.
• Banks on both ends usually act as
intermediaries in the processing of shipping
documents and the collection of payment. In
banking terminology, the transactions are
known as documentary collections.
A19 - 13
Payment Methods
for International Trade
Method  : Drafts (Bills of Exchange)
• Sight drafts (documents against payment) :
When the shipment has been made, the draft
is presented to the buyer for payment.
• Time of payment : On presentation of draft
• Goods available to buyers : After payment
• Risk to exporter : Disposal of unpaid goods
• Risk to importer : Relies on exporter to ship
goods as described in documents
A19 - 14
Payment Methods
for International Trade
Method  : Drafts (Bills of Exchange)
• Time drafts (documents against acceptance) :
When the shipment has been made, the
buyer accepts (signs) the presented draft.
• Time of payment : On maturity of draft
• Goods available to buyers : Before payment
• Risk to exporter : Relies on buyer to pay
• Risk to importer : Relies on exporter to ship
goods as described in documents
A19 - 15
Payment Methods
for International Trade
Method  : Open Accounts
• An open account is a sale in which the goods are
shipped and delivered before payment is due usually
in 30, 60, or 90 days.
• This is one of the most advantageous options to the
importer, but it is a higher-risk option for an exporter.
• Foreign buyers often want exporters to offer open
accounts because it is much more common in other
countries, and the payment-after-receipt structure is
better for the bottom line.
A19 - 16
Payment Methods
for International Trade
Method  : Open Accounts
• The exporter ships the merchandise and
expects the buyer to remit payment according
to the agreed-upon terms.
• Time of payment : As agreed upon
• Goods available to buyers : Before payment
• Risk to exporter : Relies completely on buyer
to pay account as agreed upon
• Risk to importer : None
A19 - 17
Payment Methods
for International Trade
Method  : Consignments
• Consignment is similar to an open account in some ways, but
•
•
•
•
payment is sent to the exporter only after the goods have
been sold by the importer and distributor to the end
customer.
The exporter retains ownership of the goods until they are
sold.
Exporting on consignment is very risky since the exporter is
not guaranteed any payment.
Consignment, however, helps exporters become more
competitive because the goods are available for sale faster.
Selling on consignment reduces the exporter’s costs of
storing inventory.
A19 - 18
Payment Methods
for International Trade
Method  : Consignments
• The exporter retains actual title to the goods
that are shipped to the importer.
• Time of payment : At time of sale to third
party
• Goods available to buyers : Before payment
• Risk to exporter : Allows importer to sell
inventory before paying exporter
• Risk to importer : None
A19 - 19
Trade Finance Methods
 Accounts Receivable Financing
¤
An exporter that needs funds immediately
may obtain a bank loan that is secured by
an assignment of the account receivable.
 Factoring (Cross-Border Factoring)
¤
The accounts receivable are sold to a third
party (the factor), that then assumes all the
responsibilities and exposure associated
with collecting from the buyer.
A19 - 20
Trade Finance Methods
 Letters of Credit (L/C)
¤
¤
¤
These are issued by a bank on behalf of
the importer promising to pay the exporter
upon presentation of the shipping
documents.
The importer pays the issuing bank the
amount of the L/C plus associated fees.
Commercial or import/export L/Cs are
usually irrevocable.
A19 - 21
Trade Finance Methods
 Letters of Credit (L/C)
¤
¤
The required documents typically include a
draft (sight or time), a commercial invoice,
and a bill of lading (receipt for shipment).
Sometimes, the exporter may request that
a local bank confirm (guarantee) the L/C.
A19 - 22
Trade Finance Methods
 Letters of Credit (L/C)
¤
Variations include
- standby L/Cs : funded only if the buyer
does not pay the seller as agreed upon
- transferable L/Cs : the first beneficiary
can transfer all or part of the original L/C
to a third party
- assignments of proceeds under an L/C :
the original beneficiary assigns the
proceeds to the end supplier
A19 - 23
Trade Finance Methods
 Banker’s Acceptance (BA)
¤
¤
This is a time draft that is drawn on and
accepted by a bank (the importer’s bank).
The accepting bank is obliged to pay the
holder of the draft at maturity.
If the exporter does not want to wait for
payment, it can request that the BA be sold
in the money market. Trade financing is
provided by the holder of the BA.
A19 - 24
Trade Finance Methods
 Banker’s Acceptance (BA)
¤
¤
The bank accepting the drafts charges an
all-in-rate (interest rate) that consists of the
discount rate plus the acceptance
commission.
In general, all-in-rates are lower than bank
loan rates. They usually fall between the
rates of short-term Treasury bills and
commercial papers.
A19 - 25
Trade Finance Methods
 Working Capital Financing
¤
Banks may provide short-term loans that
finance the working capital cycle, from the
purchase of inventory until the eventual
conversion to cash.
A19 - 26
Trade Finance Methods
 Medium-Term Capital Goods Financing
(Forfaiting)
¤ The importer issues a promissory note to
the exporter to pay for its imported capital
goods over a period that generally ranges
from three to seven years.
¤ The exporter then sells the note, without
recourse, to a bank (the forfaiting bank).
A19 - 27
Trade Finance Methods
 Countertrade
¤
¤
¤
These are foreign trade transactions in
which the sale of goods to one country is
linked to the purchase or exchange of
goods from that same country.
Common countertrade types include barter,
compensation (product buy-back), and
counterpurchase.
The primary participants are governments
and multinationals.
A19 - 28
Agencies that Motivate
International Trade
• Due to the inherent risks of international
trade, government institutions and the
private sector offer various forms of
export credit, export finance, and
guarantee programs to reduce risk and
stimulate foreign trade.
A19 - 29
Agencies that Motivate
International Trade
Export-Import Bank of the U.S. (Ex-Imbank)
• This U.S. government agency aims to
create jobs by financing and facilitating
the export of U.S. goods and services and
maintaining the competitiveness of U.S.
companies in overseas markets.
• It offers guarantees of commercial loans,
direct loans, and export credit insurance.
A19 - 30
Agencies that Motivate
International Trade
Private Export Funding Corporation (PEFCO)
• PEFCO is a private corporation that is
owned by a consortium of commercial
banks and industrial companies.
• In cooperation with Ex-Imbank, PEFCO
provides medium- and long-term fixed-rate
financing for foreign buyers through the
issuance of long-term bonds.
A19 - 31
Agencies that Motivate
International Trade
Overseas Private Investment Corporation
(OPIC)
• OPIC is a U.S. government agency that
assists U.S. investors by insuring their
overseas investments against a broad
range of political risks.
• It also provides financing for overseas
businesses through loans and loan
guaranties.
A19 - 32
Agencies that Motivate
International Trade
• Beyond insurance and financing, the U.S.
has tax provisions that encourage
international trade.
• The FSC Repeal and Extraterritorial
Income Exclusion Act of 2000, which
replaced the 1984 Foreign Sales
Corporation provisions in response to
WTO concerns, excludes certain
extraterritorial income from the definition
of gross income for U.S. tax purposes.
A19 - 33
Impact of International Trade Financing
Decisions on an MNC’s Value
Trade Financing Decisions
m

[E (CFj , t )× E (ER j , t )]
n ∑
 j =1

Value = ∑ 

t
(1 + k )
t =1 



E (CFj,t ) = expected cash flows in currency j to be received
by the U.S. parent at the end of period t
E (ERj,t ) = expected exchange rate at which currency j can
be converted to dollars at the end of period t
k
= weighted average cost of capital of the parent
A19 - 34
Chapter Review
• Payment Methods for International Trade
¤
¤
¤
¤
¤
Prepayments
Letters of Credit
Sight Drafts and Time Drafts
Consignments
Open Accounts
A19 - 35
Chapter Review
• Trade Finance Methods
¤
¤
¤
¤
¤
¤
¤
Accounts Receivable Financing
Factoring
Letters of Credit
Banker’s Acceptances
Working Capital Financing
Medium-Term Capital Goods Financing
(Forfaiting)
Countertrade
A19 - 36
Chapter Review
• Agencies that Motivate International Trade
¤
¤
¤
¤
Export-Import Bank of the U.S.
Private Export Funding Corporation
Overseas Private Investment Corporation
Other Considerations
• Impact of International Trade Financing on
an MNC’s Value
A19 - 37
Money Market,
Interest rates and
Exchange rates
Equilibrium in the Money
Market
The condition for equilibrium in
the money market is:
Ms = Md
The money market equilibrium
condition can be expressed in
terms of aggregate real money
demand as:
Ms/P = L(R,Y)
Determination of the
Equilibrium Interest Rate
Interest
rate, R
Aggregate real
money demand,
L(R,Y)
R*
Ms*/P
M/P
Effect of an Increase in the
Money Supply on the
Equilibrium Interest Rate
Interest
rate, R
Real money
supply
Real money
supply increase
R1
R2
L(R,Y1)
M1
P
M2
P
M/P
Effect of a Rise in Real
Income on the Equilibrium
Interest Rate
Interest
rate, R
Real money supply
Increase in
real income
2
R2
1
R1
1'
L(R,Y2)
L(R,Y1)
MS
P
M/P
Money-Market/Exchange Rate
Linkages
United States
Federal Reserve System
MSUS
Europe
European System
of Central Banks
(United States
money supply)
United States
money market
MS E
(European
money
supply)
European
money market
Foreign
R$
(Dollar interest exchange
market
rate)
R€
(Euro interest
rate)
E€/ $
(Dollar-Euro
exchange rate)
Simultaneous Equilibrium in the
Domestic Money Market and the
Foreign-Exchange Market
ED/F
Return on
D deposits
Expected
return on
F deposits
ED/F
(increasing)
0
(increasing)
MS
D/PD
MD/PD
RD
L(RD, YD)
D real
money
supply
Rates
of
return
(in D
terms)
Effect of an Increase in the D
Money Supply on the D/F
Exchange Rate and on the D
Interest Rate
ED/F
Return on
D deposits
2'
E2D/F
E1
1'
D/F
0
R2
R1
D
M1D/PD
M 2D/PD
MD/PD
1
2
Expected
return on
F deposits
D
Rates of
return
L(RD, YUS)
(in D
terms)
Increase in D
real money supply
Effect of an Increase in the F Money
Supply on the D/F Exchange Rate
ED/F
D return
1'
E1D/F
2'
E2D/F
Increase in F
money supply
Expected
F return
0
R1D
L(RD, YD)
MSD/ PD
MD/PD
1
D real
money
supply
Rates of
return
(in D
terms)
Effect on the D/F Exchange Rate
and the D Interest Rate of an
Increase in D Income
ED/F
Return on
D deposits
1'
E1D/F
E2D/F
0
2'
R2D
R1D
Expected
return on
F deposits
L(RD, Y1D)
L(RD, Y2D)
MUS/PUS
MD/PD
1
2
Rates of
return
(in D
terms)
What happens in the Long Run
if the Money supply is increased
permanently?
• In the Long Run Y and R will not change
• Price level P will become permanently
higher
• What will happen to ED/F ? Price of
Foreign currency will behave like all
other prices – increase. (ED/F )
• So, if the Money Supply increases
permanently, we should expect a
permanent depreciation of D with
respect to F.
Exchange Rate Overshooting
Return on
D deposits
ED/F
3
E3D/F
2'
E2
D/F
E1
D/F
0
2'
1
R2D
R1D
M1D/PD
M 2D/PD
MD/PD
1
2
Expected
return on
F deposits
L(RD, YUS)
Increase/Decrease in D
real money supply
FIGURE 19-1
(1 of 2)
Introduction
Exchange Rates Regimes of the World, 1870–2007 The shaded regions show the
fraction of countries on each type of regime by year, and they add up to 100%.
From 1870 to 1913, the gold standard became the dominant regime.
During World War I (1914–1918), most countries suspended the gold standard,
and resumptions in the late 1920s were brief.
FIGURE 19-1
(2 of 2)
Introduction
Exchange Rates Regimes of the World, 1870–2007 (continued)
After further suspensions in World War II (1939–1945), most countries were fixed
against the U.S. dollar (the pound, franc, and mark blocs were indirectly pegged
to the dollar). Starting in the 1970s, more countries opted to float. In 1999 the
euro replaced the franc and the mark as the base currency for many pegs.
Three principles: the impossible trinity
•
-
Impossible trinity principle: only two of the three
following features are compatible with each other:
full capital mobility;
fixed exchange rates;
autonomous monetary policy.
1 Exchange Rate
Regime Choice: Key
Issues
Key Factors in Exchange Rate Regime Choice:
Integration and Similarity
• The fundamental source of this divergence between
what Britain wanted and what Germany wanted was
that each country faced different shocks.
• The fiscal shock that Germany experienced after
reunification was not felt in Britain or any other ERM
country.
• The issues that are at the heart of this decision are:
economic integration as measured by trade and other
transactions, and economic similarity, as measured by
the similarity of shocks.
1 Exchange Rate
Regime Choice: Key
Issues
Economic Integration and the Gains in Efficiency
• The term “economic integration” refers to the growth of
market linkages in goods, capital, and labor markets
among regions and countries.
• We have argued that by lowering transaction costs, a
fixed exchange rate might promote integration and
hence increase economic efficiency. Why?
■ The lesson: the greater the degree of economic
integration between markets in the home country
and the base country, the greater will be the volume
of transactions between the two, and the greater will
be the benefits the home country gains from fixing its
exchange rate with the base country. As integration
rises, the efficiency benefits of a common currency
increase.
1 Exchange Rate
Regime Choice: Key
Issues
Economic Similarity and the Costs of
Asymmetric Shocks
• A fixed exchange rate can lead to costs when a
country-specific shock or asymmetric shock is not
shared by the other country: the shocks were dissimilar.
• In our example, German policy makers wanted to
tighten monetary policy to offset a boom, while British
policy makers did not want to implement the same
policy because they had not experienced the same
shock.
• The simple, general lesson we can draw is that for a
home country that unilaterally pegs to a foreign country,
asymmetric shocks impose costs in terms of lost output.
1 Exchange Rate
Regime Choice: Key
Issues
Economic Similarity and the Costs of
Asymmetric Shocks
■ The lesson: if there is a greater degree of
economic similarity between the home
country and the base country, meaning that
the countries face more symmetric shocks
and fewer asymmetric shocks, then the
economic stabilization costs to home of
fixing its exchange rate to the base become
smaller. As economic similarity rises, the
stability costs of common currency
decrease.
1 Exchange Rate
Regime Choice: Key
Issues
Simple Criteria for a Fixed Exchange Rate
• Our discussions about integration and similarity yields
the following:
■ As integration rises, the efficiency benefits of a
common currency increase.
■ As symmetry rises, the stability costs of a common
currency decrease.
• The key prediction of our theory is this: pairs of
countries above the FIX line (more integrated, more
similar shocks) will gain economically from adopting a
fixed exchange rate. Those below the FIX line (less
integrated, less similar shocks) will not.
1 Exchange Rate
Regime Choice: Key
Issues
FIGURE 19-4
(1 of 2)
Building Block: Price Levels and Exchange Rates in the Long Run According to
the PPP Theory Points 1 to 6 in the figure represent a pair of locations. Suppose
one location is considering pegging its exchange rate to its partner.
If their markets become more integrated (a move to the right along the horizontal
axis) or if the economic shocks they experience become more symmetric (a
move up on the vertical axis), the net economic benefits of fixing increase.
1 Exchange Rate
Regime Choice: Key
Issues
FIGURE 19-4
(2 of 2)
Building Block: Price Levels and Exchange Rates in the Long Run According to
the PPP Theory (continued)
If the pair moves far enough up or to the right, then the benefits of fixing exceed
costs (net benefits are positive), and the pair will cross the fixing threshold
shown by the FIX line.
Below the line, it is optimal for the region to float.
Above the line, it is optimal for the region to fix.
2 Other Benefits of
Fixing
Fiscal Discipline, Seigniorage, and Inflation
• One common argument in favor of fixed exchange rate
regimes in developing countries is that an exchange
rate peg prevents the government from printing money
to finance government expenditure.
• Under such a financing scheme, the central bank is
called upon to monetize the government’s deficit (i.e.,
give money to the government in exchange for debt).
This process increases the money supply and leads to
high inflation.
• The source of the government’s revenue is, in effect, an
inflation tax (called seigniorage) levied on the members
of the public who hold money.
2 Other Benefits of
Fixing
Fiscal Discipline, Seigniorage, and Inflation
• If a country’s currency floats, its central bank can print a
lot or a little money, with very different inflation
outcomes. If a country’s currency is pegged, the central
bank might run the peg well, with fairly stable prices, or
run the peg so badly that a crisis occurs, the exchange
rate ends up in free fall, and inflation erupts.
• Nominal anchors—whether money targets, exchange
rate targets, or inflation targets—imply a “promise” by
the government to ensure certain monetary policy
outcomes in the long run.
• However, these promises do not guarantee that the
country will achieve these outcomes.
2 Other Benefits of
Fixing
Liability Dollarization, National Wealth, and
Contractionary Depreciations
• The Home country’s total external wealth is the sum total
of assets minus liabilities expressed in local currency:
W = ( AH + EAF ) − ( LH + ELF )
 
Assets
Liabilities
• A small change ΔE in the exchange rate, all else equal.
affects the values of EAF and ELF expressed in local
currency. We can express the resulting change in
national wealth as
∆W =
∆
E

Change in
exchange rate
×
[AF 
− LF ]


Net international credit(+) or debit (-)
position in dollar assets
(19-1)
2 Other Benefits of
Fixing
Destabilizing Wealth Shocks:
• If foreign currency external assets do not equal foreign
currency external liabilities, the country is said to have a
currency mismatch on its external balance sheet, and
exchange rate changes will affect national wealth.
• If foreign currency assets exceed foreign currency
liabilities, then the country experiences an increase in
wealth when the exchange rate depreciates.
• If foreign currency liabilities exceed foreign currency
assets, then the country experiences a decrease in
wealth when the exchange rate depreciates.
• In principle, if the valuation effects are large enough, the
overall effect of a depreciation can be contractionary!
3 Fixed Exchange Rate
Systems
• Fixed exchange rate systems involve multiple
countries.
• Examples include the global Bretton Woods system in
the 1950s and 1960s and the European Exchange Rate
Mechanism (ERM) through which all potential euro
members must pass.
• These systems were based on a reserve currency
system in which there are N countries (1, 2, . . . , N)
participating.
• One of the countries, the center country (the Nth
country), provides the reserve currency, which is the
base or center currency to which all the other countries
peg.
3 Fixed Exchange Rate
Systems
• When the center country has monetary policy autonomy
it can set its own interest rate i * as it pleases. The
other noncenter country, which is pegging, then has to
adjust its own interest rate so that i equals i * in order to
maintain the peg.
• The noncenter country loses its ability to conduct
stabilization policy, but the center country keeps that
power.
• The asymmetry can be a recipe for political conflict and
is known as the Nth currency problem.
• Cooperative arrangements can be worked out to try to
avoid this problem.
3 Fixed Exchange Rate
Systems
Cooperative and Noncooperative Adjustments to
Exchange Rates
Caveats
• We can now see that adjusting the peg is a policy that
may be cooperative or noncooperative in nature. If
noncooperative, it is usually referred to as a beggar-thyneighbor policy: Home can improve its position at the
expense of Foreign and without Foreign’s agreement.
• If Home engages in such a policy, it is possible for Foreign
to respond with a devaluation of its own in a tit-for-tat way.
• Cooperation may be most needed to sustain a fixed
exchange rate system with adjustable pegs, so as to
restrain beggar-thy-neighbor devaluations.
Currency Crises and Speculative
Attack
• Generation I
• Generation II
• Generation III
Breaching the central bank’s defenses.
API-120 - Prof.J.Frankel
Speculative
Attacks
Traditional pattern:
Reserves gradually run down to zero,
at which point CB is forced to devalue.
Breaching the central bank’s defenses.
API-120 - Prof.J.Frankel
In 1990s episodes, reserves seem to fall off a cliff.
See graph for Mexico, 1994….
An “irrational” stampede?
Not necessarily. Rational expectations theory
says S can’t jump unless there is news;
this turns out to imply that Res must jump instead.
API-120 - Prof.J.Frankel
Mexico’s Reserves in the Peso Crisis of 1994
Reserves fell abruptly in December 1994
API-120 - Prof.J.Frankel
Azerbaijan: Foreign exchange reserves
(measure: billion U.S. Dollar, source: Central Bank of the Republic of Azerbaijan)
API-120 - Prof.J.Frankel
Models of Speculative Attacks
First Generation
Episodes that
inspired model
Bretton Woods
crises 1969-73;
1980s debt crisis
"Whose fault
is it?"
and why
Seminal authors
Macro policies: Krugman (1979);
excessive credit Flood & Garber (1984)
expansion
API-120 - Prof.J.Frankel
Models of Speculative Attacks, continued
Second Generation
Episode
inspiring
model
ERM crises
1992-93:
Sweden,
France
"Whose
fault
is it?"
International
financial
markets:
multiple
equilibria
Seminal authors
1. Speculators’ game
Obstfeld (1994);
2. Endogenous monetary policy
Obstfeld (1996), Jeanne (1997)
3. Bank runs
Diamond-Dybvyg (1983),
Chang-Velasco (2000)
4. With uncertainty
Morris & Shin (1998)
API-120 - Prof.J.Frankel
Models of Speculative Attacks, concluded
Third Generation
Episode
inspiring
model
"Whose fault
is it?"
Structural
Emerging fundamentals:
market crises moral hazard
of 1997-2001 (“crony
capitalism”)
Seminal authors
Dooley (2000) insurance model;
Diaz-Alejandro (1985);
McKinnon & Pill (1996); Krugman (1998);
Corsetti, Pesenti & Roubini (1999);
Burnside, Eichenbaum & Rebelo (2001)
API-120 - Prof.J.Frankel
Currency Crises
First-Generation Model of Currency Crises
API-120 - Prof.J.Frankel
Currency Crises
First-Generation Model of Currency Crises
API-120 - Prof.J.Frankel
Currency Crises
First-Generation Model of Currency Crises
API-120 - Prof.J.Frankel
Currency Crises
First-Generation Model of Currency Crises
API-120 - Prof.J.Frankel
Currency Crises
First-Generation Model of Currency Crises
First Generation Currency Crises in Former Soviet Union
• Collapse of the Soviet ruble (1989–1993) -
(i) declining oil prices
(which led to deteriorating balance of payments and declines in budget revenues), (ii)
the anti-alcohol campaign (which caused further damage to budget revenue) and (iii)
the gradual loss of control of the Soviet Union’s authorities over state-owned
enterprises and over the Soviet republics.
• Monetary instability in the FSU (1992–1995) – (i) FSU countries had
liberalized, fully or partly, consumer and producer prices, (ii) the situation worsened
because of weak monetary and fiscal policies underpinned by macroeconomic and
social populism, the continued existence of the Soviet ruble , (iii) violent conflict and
political instability
• Russian and CIS financial crisis of 1998–1999 –
(i) domestic
financial markets remained shallow and foreign purchasers required high risk premia;
(ii) the slow pace of fiscal adjustment and structural reforms, and continued output
decline undermined the sustainability of such financing; (iii) the contagion effect from
the Asian crises of 1997–1998, (iv) a strengthening USD and (v) the collapse of oil
prices added to the market pressures.
API-120 - Prof.J.Frankel
Currency Crises
First-Generation Model of Currency Crises
To summarize, first-generation models made a number of important contributions to the
development of theories about currency crises. These include:
•
currency crises are predictable,
•
macroeconomic indicators and other fundamental factors behave in a typical way
before crises; these
•
factors are mainly pertinent to exchange rate and balance of payments models and are
amazing
•
indicators from the crisis prediction standpoint,
•
crisis may occur at a time when international reserves are not yet fully exhausted,
•
central banks may adopt a fixed exchange rate regime provided they have sufficient
foreign exchange reserves,
•
central bank reserves need to be able to cover its entire liabilities, especially in
economies with a higher dollarization rate,
•
with concern over monetary stability under high mobility of capital flows, the central
bank’s sterilization policy steered to foreign exchange rate stability is ultimately
doomed to failure and the currency crisis is inevitable, if speculative traders predict the
authorities’ intentions (in fact, these structural models touch the phenomenon of the
„impossible trinity“).
API-120 - Prof.J.Frankel
Currency Crises
Second-Generation Model of Currency Crises
•
Following the collapse of the ERM in the early 1990s, which was characterized by the tradeoff
between the declining activity level and abandoning the exchange rate management system, the socalled first-generation model of currency attacks did not seem suitable any more to explain the
ongoing crisis phenomena.
•
This led to the development of the so-called ‘second generation model of currency attacks,’
pioneered by Obstfeld (1994, 1996).
•
A basic idea here is that the government’s policy is not just on ‘automatic pilot’ like in Krugman
(1979) above, but rather that the government is setting the policy endogenously, trying to maximize
a well-specified objective function, without being able to fully commit to a given policy.
•
In this group of models, there are usually self-fulfilling multiple equilibria, where the expectation
of a collapse of the fixed exchange rate regime leads the government to abandon the regime.
•
This is related to the Diamond and Dybvig (1983) model of bank runs, creating a link between
these two strands of the literature.
API-120 - Prof.J.Frankel
2nd-generation
model of
speculative attack:
Obstfeld version of
multiple equilibria
(a) Strong fundamentals
(b) Weak fundamentals
(c) Intermediate
fundamentals
API-120 - Prof.J.Frankel
Currency Crises
Second-Generation Model of Currency Crises
• As argued by Paul De Grauwe (2011), the problem can become more
severe for countries that participate in a currency union since their
governments do not have the independent monetary tools to reduce the
cost of the debt.
• Morris and Shin (1998) applied global games methods to tackle the
problem of multiplicity of equilibrium in the second-generation
models of speculative attacks.
Currency Crises
Second-Generation Model of Currency Crises
• The second generation models mostly withdraw from crisis explanation
approaches based on fundamentals and stress the role of expectations at the core
of the crises.
• In the face of immeasurability of the coordination of expectations and the loss
of confidence, it is impossible to develop crisis forecasting models based on
fundamentals.
• The best way to combat crises not justified by macroeconomic indicators is to
increase credibility of central banks, because, if there is a belief that after the
crisis the central bank will implement a policy which implies an exchange rate
appreciation, it will eliminate the motivation of the agents to achieve a selffulfilling crisis and own benefits as a result of speculative attacks.
API-120 - Prof.J.Frankel
Currency Crises
Third-Generation Model of Currency Crises
• Distinguishing the authors of the models of this generation is rather
difficult but basically they are Chang and Velasco (1998), Kaminsky and
Reinhart (1999), and Gerlach and Smets (1994).
• TGMs are divided into three major groups that address, accordingly, three
different causes of crises:
1. The first group of theories emphasize on the weaknesses in the
banking system (enormous foreign debt, troubles with balance sheet
positions, moral hazard provoked by bogus government guarantees,
weak supervision, etc.) that lead to banking and currency crises.
2. The second group of this generation models considers the herd effect
of banking and financial system agents as the main cause for currency
crises. When faced with certain problems, these agents, massively
following each other, seek safe haven in foreign currency assets.
3. The third group of models refers to perhaps the most important
contribution of this generation theories, i.e. the effect of contagion.
API-120 - Prof.J.Frankel
Currency Crises
Third-Generation Model of Currency Crises
First Generation Currency Crises in Former Soviet Union
• Fallout from the global financial crisis (2008–2009)
• Regional Currency Crisis of 2014–2016
• COVID-19 Pandemic and Global Economic Crisis
API-120 - Prof.J.Frankel
Chapter
6
McGraw-Hill/Irwin
Common Stock
Valuation
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
Learning Objectives
Separate yourself from the commoners by having a good
Understanding of these security valuation methods:
1. The basic dividend discount model.
2. The two-stage dividend growth model.
3. The residual income model.
4. Price ratio analysis.
6-2
Common Stock Valuation
• Our goal in this chapter is to examine the methods
commonly used by financial analysts to assess the
economic value of common stocks.
• These methods are grouped into three categories:
– Dividend discount models
– Residual Income models
– Price ratio models
6-3
Security Analysis: Be Careful Out There
• Fundamental analysis is a term for studying a
company’s accounting statements and other financial and
economic information to estimate the economic value of
a company’s stock.
• The basic idea is to identify “undervalued” stocks to buy
and “overvalued” stocks to sell.
• In practice however, such stocks may in fact be correctly
priced for reasons not immediately apparent to the
analyst.
6-4
The Dividend Discount Model
• The Dividend Discount Model (DDM) is a method to estimate the
value of a share of stock by discounting all expected future dividend
payments. The basic DDM equation is:
D3
D1
D2
DT
+
+
+
P0 =
2
3
(1 + k ) (1 + k ) (1 + k )
(1 + k )T
• In the DDM equation:
– P0 = the present value of all future dividends
– Dt = the dividend to be paid t years from now
– k = the appropriate risk-adjusted discount rate
6-5
Example: The Dividend Discount Model
• Suppose that a stock will pay three annual dividends of
$200 per year, and the appropriate risk-adjusted discount
rate, k, is 8%.
• In this case, what is the value of the stock today?
P0 =
D3
D1
D2
+
+
(1 + k ) (1 + k )2 (1 + k )3
P0 =
$200
$200
$200
+
+
= $515.42
2
3
(1 + 0.08 ) (1 + 0.08 ) (1 + 0.08 )
6-6
The Dividend Discount Model:
the Constant Growth Rate Model
• Assume that the dividends will grow at a constant growth rate g. The
dividend next period (t + 1) is:
D t +1 = D t × (1 + g)
So, D 2 = D1 × (1 + g) = D 0 × (1 + g) × (1 + g)
• For constant dividend growth for “T” years, the DDM formula
becomes:
T
D1 (1 + g)   1 + g  
P0 =
 
1 − 
k − g   1 + k  
if k ≠ g
P0 = T × D 0
if k = g
6-7
Example: The Constant Growth Rate Model
• Suppose the current dividend is $10, the dividend growth rate is
10%, there will be 20 yearly dividends, and the appropriate discount
rate is 8%.
• What is the value of the stock, based on the constant growth rate
model?
T
D 0 (1 + g)   1 + g  
P0 =
 
1 − 
k − g   1 + k  
20
$10 × (1.10 )   1.10  
P0 =
  = $243.86
1 − 
.08 − .10   1.08  
6-8
The Dividend Discount Model:
the Constant Perpetual Growth Model.
• Assuming that the dividends will grow forever at a
constant growth rate g.
• For constant perpetual dividend growth, the DDM formula
becomes:
P0 =
D 0 × (1 + g)
D
= 1
k−g
k−g
(Important : g < k)
6-9
Example: Constant Perpetual Growth Model
• Think about the electric utility industry.
• In 2007, the dividend paid by the utility company, DTE Energy Co.
(DTE), was $2.12.
• Using D0 =$2.12, k = 6.7%, and g = 2%, calculate an estimated value
for DTE.
P0 =
$2.12 × (1.02 )
= $46.01
.067 − .02
Note: the actual mid-2007 stock price of DTE was $47.81.
What are the possible explanations for the difference?
6-10
The Dividend Discount Model:
Estimating the Growth Rate
• The growth rate in dividends (g) can be estimated in a
number of ways:
– Using the company’s historical average growth rate.
– Using an industry median or average growth rate.
– Using the sustainable growth rate.
6-11
The Historical Average Growth Rate
•
Suppose the Broadway Joe Company paid the following dividends:
– 2002: $1.50
– 2003: $1.70
– 2004: $1.75
•
2005: $1.80
2006: $2.00
2007: $2.20
The spreadsheet below shows how to estimate historical average
growth rates, using arithmetic and geometric averages.
Year:
2007
2006
2005
2004
2003
2002
Dividend:
$2.20
$2.00
$1.80
$1.75
$1.70
$1.50
Pct. Chg:
10.00%
11.11%
2.86%
2.94%
13.33%
Arithmetic Average:
8.05%
Geometric Average:
7.96%
Year:
2002
2003
2004
2005
2006
2007
Grown at
7.96%:
$1.50
$1.62
$1.75
$1.89
$2.04
$2.20
6-12
The Sustainable Growth Rate
Sustainable Growth Rate = ROE × Retention Ratio
= ROE × (1 - Payout Ratio)
• Return on Equity (ROE) = Net Income / Equity
• Payout Ratio = Proportion of earnings paid out as dividends
• Retention Ratio = Proportion of earnings retained for investment
6-13
Example: Calculating and Using the
Sustainable Growth Rate
• In 2007, American Electric Power (AEP) had an ROE of 10.17%,
projected earnings per share of $2.25, and a per-share dividend of
$1.56. What was AEP’s:
– Retention rate?
– Sustainable growth rate?
• Payout ratio = $1.56 / $2.25 = .693
• So, retention ratio = 1 – .693 = .307 or 30.7%
• Therefore, AEP’s sustainable growth rate = .1017 × .307 = .03122, or
3.122%
6-14
Example: Calculating and Using the
Sustainable Growth Rate, Cont.
• What is the value of AEP stock, using the perpetual growth model,
and a discount rate of 6.7%?
P0 =
$1.56 × (1.03122 )
= $44.96
.067 − .03122
• The actual mid-2007 stock price of AEP was $45.41.
• In this case, using the sustainable growth rate to value the stock
gives a reasonably accurate estimate.
• What can we say about g and k in this example?
6-15
The Two-Stage Dividend Growth Model
• The two-stage dividend growth model assumes that a
firm will initially grow at a rate g1 for T years, and
thereafter grow at a rate g2 < k during a perpetual second
stage of growth.
• The Two-Stage Dividend Growth Model formula is:
T
T
D 0 (1 + g1 )   1 + g1    1 + g1  D 0 (1 + g 2 )
P0 =

 +
1 − 
k − g1   1 + k    1 + k 
k − g2
6-16
Using the Two-Stage
Dividend Growth Model, I.
• Although the formula looks complicated, think of it as two
parts:
– Part 1 is the present value of the first T dividends (it is the same
formula we used for the constant growth model).
– Part 2 is the present value of all subsequent dividends.
• So, suppose MissMolly.com has a current dividend of
D0 = $5, which is expected to shrink at the rate, g1 = 10%
for 5 years, but grow at the rate, g2 = 4% forever.
• With a discount rate of k = 10%, what is the present value
of the stock?
6-17
Using the Two-Stage
Dividend Growth Model, II.
T
T
D 0 (1 + g1 )   1 + g1    1 + g1  D 0 (1 + g 2 )
P0 =

 +
1 − 
k − g1   1 + k    1 + k 
k − g2
5
5
$5.00(0.90 )   0.90    0.90  $5.00(1 + 0.04)
P0 =

 +
1 − 
0.10 − ( −0.10)   1 + 0.10    1 + 0.10 
0.10 − 0.04
= $14.25 + $31.78
= $46.03.
• The total value of $46.03 is the sum of a $14.25 present value of the
first five dividends, plus a $31.78 present value of all subsequent
dividends.
6-18
Example: Using the DDM to Value a Firm
Experiencing “Supernormal” Growth, I.
• Chain Reaction, Inc., has been growing at a phenomenal rate of 30%
per year.
• You believe that this rate will last for only three more years.
• Then, you think the rate will drop to 10% per year.
• Total dividends just paid were $5 million.
• The required rate of return is 20%.
• What is the total value of Chain Reaction, Inc.?
6-19
Example: Using the DDM to Value a Firm
Experiencing “Supernormal” Growth, II.
• First, calculate the total dividends over the “supernormal” growth
period:
Year
Total Dividend: (in $millions)
1
$5.00 x 1.30 = $6.50
2
$6.50 x 1.30 = $8.45
3
$8.45 x 1.30 = $10.985
• Using the long run growth rate, g, the value of all the shares at Time
3 can be calculated as:
P3 = [D3 x (1 + g)] / (k – g)
P3 = [$10.985 x 1.10] / (0.20 – 0.10) = $120.835
6-20
Example: Using the DDM to Value a Firm
Experiencing “Supernormal” Growth, III.
• Therefore, to determine the present value of the firm today, we need
the present value of $120.835 and the present value of the dividends
paid in the first 3 years:
P0 =
D3
P3
D1
D2
+
+
+
(1 + k ) (1 + k )2 (1 + k )3 (1 + k )3
$6.50
$8.45
$10.985
$120.835
P0 =
+
+
+
(1 + 0.20 ) (1 + 0.20 )2 (1 + 0.20 )3 (1 + 0.20 )3
= $5.42 + $5.87 + $6.36 + $69.93
= $87.58 million.
6-21
Discount Rates for
Dividend Discount Models
• The discount rate for a stock can be estimated using the capital
asset pricing model (CAPM ).
• We will discuss the CAPM in a later chapter.
• However, we can estimate the discount rate for a stock using this
formula:
Discount rate = time value of money + risk premium
= U.S. T-bill Rate + (Stock Beta x Stock Market Risk Premium)
T-bill Rate: return on 90-day U.S. T-bills
Stock Beta: risk relative to an average stock
Stock Market Risk Premium: risk premium for an average stock
6-22
Observations on Dividend
Discount Models, I.
Constant Perpetual Growth Model:
•
•
•
•
•
•
Simple to compute
Not usable for firms that do not pay dividends
Not usable when g > k
Is sensitive to the choice of g and k
k and g may be difficult to estimate accurately.
Constant perpetual growth is often an unrealistic assumption.
6-23
Observations on Dividend
Discount Models, II.
Two-Stage Dividend Growth Model:
•
•
•
•
•
More realistic in that it accounts for two stages of growth
Usable when g > k in the first stage
Not usable for firms that do not pay dividends
Is sensitive to the choice of g and k
k and g may be difficult to estimate accurately.
6-24
Residual Income Model (RIM), I.
• We have valued only companies that pay dividends.
– But, there are many companies that do not pay dividends.
– What about them?
– It turns out that there is an elegant way to value these
companies, too.
• The model is called the Residual Income Model (RIM).
• Major Assumption (known as the Clean Surplus Relationship, or
CSR): The change in book value per share is equal to earnings per
share minus dividends.
6-25
Residual Income Model (RIM), II.
• Inputs needed:
–
–
–
–
Earnings per share at time 0, EPS0
Book value per share at time 0, B0
Earnings growth rate, g
Discount rate, k
• There are two equivalent formulas for the Residual Income Model:
P0 = B 0 +
EPS 0 (1 + g) − B 0 × k
k−g
or
P0 =
BTW, it turns out that the
RIM is mathematically the
same as the constant
perpetual growth model.
EPS 1 − B 0 × g
k−g
6-26
Using the Residual Income Model.
• Superior Offshore International, Inc. (DEEP)
• It is July 1, 2007—shares are selling in the market for $10.94.
• Using the RIM:
–
–
–
–
–
EPS0 = $1.20
DIV = 0
B0 = $5.886
g = 0.09
k = .13
• What can we say
about the market
price of DEEP?
P0 = B 0 +
EPS 0 × (1 + g) − B 0 × k
k−g
P0 = $5.886 +
$1.20 × (1 + .09) − $5.886 × .13
.13 − .09
P0 = $5.886 +
$1.308 − $.7652
= $19.46.
.04
6-27
DEEP Growth
• Using the information from the previous slide, what growth rate
results in a DEEP price of $10.94?
P0 = B 0 +
EPS 0 × (1 + g) − B 0 × k
k−g
$10.94 = $5.886 +
$1.20 × (1 + g) − $5.886 × .13
.13 − g
$5.054 × (.13 − g) = 1.20 + 1.20g − .7652
$.6570 − 5.054g = 1.20g + .4348
.2222 = 6.254g
g = .0355 or 3.55%.
6-28
Price Ratio Analysis, I.
• Price-earnings ratio (P/E ratio)
– Current stock price divided by annual earnings per share (EPS)
• Earnings yield
– Inverse of the P/E ratio: earnings divided by price (E/P)
• High-P/E stocks are often referred to as growth stocks,
while low-P/E stocks are often referred to as value
stocks.
6-29
Price Ratio Analysis, II.
• Price-cash flow ratio (P/CF ratio)
– Current stock price divided by current cash flow per share
– In this context, cash flow is usually taken to be net income plus
depreciation.
• Most analysts agree that in examining a company’s
financial performance, cash flow can be more informative
than net income.
• Earnings and cash flows that are far from each other may
be a signal of poor quality earnings.
6-30
Price Ratio Analysis, III.
• Price-sales ratio (P/S ratio)
– Current stock price divided by annual sales per share
– A high P/S ratio suggests high sales growth, while a low P/S ratio
suggests sluggish sales growth.
• Price-book ratio (P/B ratio)
– Market value of a company’s common stock divided by its book
(accounting) value of equity
– A ratio bigger than 1.0 indicates that the firm is creating value for
its stockholders.
6-31
Price/Earnings Analysis, Intel Corp.
Intel Corp (INTC) - Earnings (P/E) Analysis
5-year average P/E ratio
Current EPS
EPS growth rate
27.30
$.86
8.5%
Expected stock price = historical P/E ratio × projected EPS
$25.47 = 27.30 × ($.86 × 1.085)
Mid-2007 stock price = $24.27
6-32
Price/Cash Flow Analysis, Intel Corp.
Intel Corp (INTC) - Cash Flow (P/CF) Analysis
5-year average P/CF ratio
Current CFPS
CFPS growth rate
14.04
$1.68
7.5%
Expected stock price = historical P/CF ratio × projected CFPS
$25.36 = 14.04 × ($1.68 × 1.075)
Mid-2007 stock price = $24.27
6-33
Price/Sales Analysis, Intel Corp.
Intel Corp (INTC) - Sales (P/S) Analysis
5-year average P/S ratio
Current SPS
SPS growth rate
4.51
$6.14
7%
Expected stock price = historical P/S ratio × projected SPS
$29.63 = 4.51 × ($6.14 × 1.07)
Mid-2007 stock price = $24.27
6-34
An Analysis of the
McGraw-Hill Company
The next few slides contain a financial
analysis of the McGraw-Hill Company, using
data from the Value Line Investment Survey.
6-35
The McGraw-Hill Company Analysis, I.
6-36
The McGraw-Hill Company Analysis, II.
6-37
The McGraw-Hill Company Analysis, III.
• Based on the CAPM, k = 3.1% + (.80 × 9%) = 10.3%
• Retention ratio = 1 – $.66/$2.65 = .751
• Sustainable g = .751 × 23% = 17.27%
• Because g > k, the constant growth rate model cannot be
used. (We would get a value of -$11.10 per share)
6-38
The McGraw-Hill Company Analysis
(Using the Residual Income Model, I)
•
Let’s assume that “today” is January 1, 2008, g = 7.5%, and k = 12.6%.
•
Using the Value Line Investment Survey (VL), we can fill in column two
(VL) of the table below.
•
We use column one and our growth assumption for column three (CSR) of
the table below.
End of 2007
2008 (VL)
NA
$6.50
$6.50
EPS
$3.05
$3.45
$3.2788
DIV
$.82
$.82
$2.7913
Ending BV per share
$6.50
$9.25
$6.9875
Beginning BV per share
2008 (CSR)
3.05 × 1.075 6.50 × 1.075
" Plug" = 3.2788 - (6.9875 - 6.50)
6-39
The McGraw-Hill Company Analysis
(Using the Residual Income Model, II)
•
Using the CSR assumption:
P0 = B 0 +
EPS 0 × (1 + g) − B 0 × k
k−g
P0 = $6.50 +
Stock price at the time = $57.27.
What can we say?
•
Using Value Line numbers for
EPS1=$3.45, B1=$9.25
B0=$6.50; and using the actual
change in book value instead of an
estimate of the new book value,
(i.e., B1-B0 is = B0 x k)
$3.05 × (1 + .075) − $6.50 × .126
.126 − .075
P0 = $54.73.
P0 = B 0 +
EPS 0 × (1 + g) − B 0 × k
k−g
P0 = $6.50 +
$3.45 − ($9.25 - 6.50)
.126 − .075
P0 = $20.23
6-40
The McGraw-Hill Company Analysis, IV.
6-41
Useful Internet Sites
•
•
•
•
•
www.nyssa.org (the New York Society of Security Analysts)
www.aaii.com (the American Association of Individual
Investors)
www.eva.com (Economic Value Added)
www.valueline.com (the home of the Value Line Investment
Survey)
Websites for some companies analyzed in this chapter:
• www.aep.com
• www.americanexpress.com
• www.pepsico.com
• www.intel.com
• www.corporate.disney.go.com
• www.mcgraw-hill.com
6-42
Chapter Review, I.
• Security Analysis: Be Careful Out There
• The Dividend Discount Model
–
–
–
–
Constant Dividend Growth Rate Model
Constant Perpetual Growth
Applications of the Constant Perpetual Growth Model
The Sustainable Growth Rate
6-43
Chapter Review, II.
• The Two-Stage Dividend Growth Model
– Discount Rates for Dividend Discount Models
– Observations on Dividend Discount Models
• Residual Income Model (RIM)
• Price Ratio Analysis
–
–
–
–
–
Price-Earnings Ratios
Price-Cash Flow Ratios
Price-Sales Ratios
Price-Book Ratios
Applications of Price Ratio Analysis
• An Analysis of the McGraw-Hill Company
6-44
BOP
BOP
Copyright © 2003 Pearson Education, Inc.
Slide 13-2
Chapter 13
Exchange Rates and the Foreign Exchange Market:
An Asset Approach
Prepared by Iordanis Petsas
To Accompany
International Economics: Theory and Policy, Sixth Edition
by Paul R. Krugman and Maurice Obstfeld
Chapter Organization
 Introduction
 Exchange Rates and International Transactions
 The Foreign Exchange Market
 The Demand for Foreign Currency Assets
 Equilibrium in the Foreign Exchange Market
 Interest Rates, Expectations, and Equilibrium
 Summary
Copyright © 2003 Pearson Education, Inc.
Slide 13-4
Introduction
 Exchange rates are important because they enable us


to translate different counties’ prices into comparable
terms.
Exchange rates are determined in the same way as
other asset prices.
The general goal of this chapter is to show:
• How exchange rates are determined
• The role of exchange rates in international trade
Copyright © 2003 Pearson Education, Inc.
Slide 13-5
Exchange Rates and
International Transactions
 An exchange rate can be quoted in two ways:
• Direct
– The price of the foreign currency in terms of dollars
• Indirect
– The price of dollars in terms of the foreign currency
Copyright © 2003 Pearson Education, Inc.
Slide 13-6
Exchange Rates and
International Transactions
Table 13-1: Exchange Rate Quotations
Copyright © 2003 Pearson Education, Inc.
Slide 13-7
Exchange Rates and
International Transactions
 Domestic and Foreign Prices
• If we know the exchange rate between two countries’
currencies, we can compute the price of one country’s
exports in terms of the other country’s money.
– Example: The dollar price of a £50 sweater with a dollar
exchange rate of $1.50 per pound is (1.50 $/£) x (£50) =
$75.
Copyright © 2003 Pearson Education, Inc.
Slide 13-8
Exchange Rates and
International Transactions
• Two types of changes in exchange rates:
– Depreciation of home country’s currency
– A rise in the home currency prices of a foreign currency
– It makes home goods cheaper for foreigners and foreign goods
more expensive for domestic residents.
– Appreciation of home country’s currency
– A fall in the home price of a foreign currency
– It makes home goods more expensive for foreigners and
foreign goods cheaper for domestic residents.
Copyright © 2003 Pearson Education, Inc.
Slide 13-9
Exchange Rates and
International Transactions
 Exchange Rates and Relative Prices
• Import and export demands are influenced by relative
prices.
• Appreciation of a country’s currency:
– Raises the relative price of its exports
– Lowers the relative price of its imports
• Depreciation of a country’s currency:
– Lowers the relative price of its exports
– Raises the relative price of its imports
Copyright © 2003 Pearson Education, Inc.
Slide 13-10
Exchange Rates and
International Transactions
Table 13-2: $/£ Exchange Rates and the Relative Price of American
Designer Jeans and British Sweaters
Copyright © 2003 Pearson Education, Inc.
Slide 13-11
The Foreign Exchange Market
 Exchange rates are determined in the foreign
exchange market.
• The market in which international currency trades take
place
 The Actors
• The major participants in the foreign exchange market
are:
– Commercial banks
– International corporations
– Nonbank financial institutions
– Central banks
Copyright © 2003 Pearson Education, Inc.
Slide 13-12
Exchange Rates and
International Transactions
• Interbank trading
– Foreign currency trading among banks
– It accounts for most of the activity in the foreign
exchange market.
Copyright © 2003 Pearson Education, Inc.
Slide 13-13
Exchange Rates and
International Transactions
 Characteristics of the Market
• The worldwide volume of foreign exchange trading is
enormous, and it has ballooned in recent years.
• New technologies, such as Internet links, are used
among the major foreign exchange trading centers
(London, New York, Tokyo, Frankfurt, and
Singapore).
• The integration of financial centers implies that there
can be no significant arbitrage.
– The process of buying a currency cheap and selling it
dear.
Copyright © 2003 Pearson Education, Inc.
Slide 13-14
Exchange Rates and
International Transactions
• Vehicle currency
– A currency that is widely used to denominate
international contracts made by parties who do not
reside in the country that issues the vehicle currency.
– Example: In 2001, around 90% of transactions between banks
involved exchanges of foreign currencies for U.S. dollars.
Copyright © 2003 Pearson Education, Inc.
Slide 13-15
Exchange Rates and
International Transactions
 Spot Rates and Forward Rates
• Spot exchange rates
– Apply to exchange currencies “on the spot”
• Forward exchange rates
– Apply to exchange currencies on some future date at a
prenegotiated exchange rate
• Forward and spot exchange rates, while not necessarily
equal, do move closely together.
Copyright © 2003 Pearson Education, Inc.
Slide 13-16
Forward Exchange Rates
 A forward premium is a situation when the forward
exchange rate is higher than the spot exchange rate.
Conversely, a forward discount is when the forward
exchange rate is lower than the spot exchange rate.
Copyright © 2003 Pearson Education, Inc.
Slide 13-17
Forward Exchange Rates
Copyright © 2003 Pearson Education, Inc.
Slide 13-18
Copyright © 2003 Pearson Education, Inc.
Slide 13-19
Exchange Rates and
International Transactions
Figure 13-1: Dollar/Pound Spot and Forward Exchange Rates,
1981-2001
Copyright © 2003 Pearson Education, Inc.
Slide 13-20
Exchange Rates and
International Transactions
 Foreign Exchange Swaps
• Spot sales of a currency combined with a forward
repurchase of the currency.
• They make up a significant proportion of all foreign
exchange trading.
Copyright © 2003 Pearson Education, Inc.
Slide 13-21
Copyright © 2003 Pearson Education, Inc.
Slide 13-22
Interest Rate SWAP
Copyright © 2003 Pearson Education, Inc.
Slide 13-23
Exchange Rates and
International Transactions
 Futures and Options
• Futures contract
– The buyer buys a promise that a specified amount of
foreign currency will be delivered on a specified date in
the future.
• Foreign exchange option
– The owner has the right to buy or sell a specified
amount of foreign currency at a specified price at any
time up to a specified expiration date.
Copyright © 2003 Pearson Education, Inc.
Slide 13-24
Futures Contract
Copyright © 2003 Pearson Education, Inc.
Slide 13-25
Options
Copyright © 2003 Pearson Education, Inc.
Slide 13-26
Copyright © 2003 Pearson Education, Inc.
Slide 13-27
The Demand for
Foreign Currency Assets
 The demand for a foreign currency bank deposit is

influenced by the same considerations that influence
the demand for any other asset.
Assets and Asset Returns
• Defining Asset Returns
– The percentage increase in value an asset offers over
some time period.
• The Real Rate of Return
– The rate of return computed by measuring asset values
in terms of some broad representative basket of products
that savers regularly purchase.
Copyright © 2003 Pearson Education, Inc.
Slide 13-28
The Demand for
Foreign Currency Assets
 Risk and Liquidity
• Savers care about two main characteristics of an asset
other than its return:
– Risk
– The variability it contributes to savers’ wealth
– Liquidity
– The ease with which it can be sold or exchanged for goods
Copyright © 2003 Pearson Education, Inc.
Slide 13-29
The Demand for
Foreign Currency Assets
 Interest Rates
• Market participants need two pieces of information in
order to compare returns on different deposits:
– How the money values of the deposits will change
– How exchange rates will change
• A currency’s interest rate is the amount of that
currency an individual can earn by lending a unit of
the currency for a year.
– Example: At a dollar interest rate of 10% per year, the
lender of $1 receives $1.10 at the end of the year.
Copyright © 2003 Pearson Education, Inc.
Slide 13-30
The Demand for
Foreign Currency Assets
Figure 13-2: Interest Rates on Dollar and Deutschemark Deposits,
1975-1998
Copyright © 2003 Pearson Education, Inc.
Slide 13-31
The Demand for
Foreign Currency Assets
 Exchange Rates and Asset Returns
• The returns on deposits traded in the foreign exchange
market depend on interest rates and expected exchange
rate changes.
• In order to decide whether to buy a euro or a dollar
deposit, one must calculate the dollar return on a euro
deposit.
Copyright © 2003 Pearson Education, Inc.
Slide 13-32
The Demand for
Foreign Currency Assets
 A Simple Rule
• The dollar rate of return on euro deposits is
approximately the euro interest rate plus the rate of
depreciation of the dollar against the euro.
– The rate of depreciation of the dollar against the euro is
the percentage increase in the dollar/euro exchange rate
over a year.
Copyright © 2003 Pearson Education, Inc.
Slide 13-33
The Demand for
Foreign Currency Assets
• The expected rate of return difference between dollar
and euro deposits is:
R$ - [R€ + (Ee$/ € - E$/€ )/E$/€ ]= R$ - R€ - (Ee$/€ -E$/€ )/E$/€ (13-1)
where:
R$ = interest rate on one-year dollar deposits
R€ = today’s interest rate on one-year euro deposits
E$/€ = today’s dollar/euro exchange rate (number of
dollars per euro)
Ee$/€ = dollar/euro exchange rate (number of dollars per
euro) expected to prevail a year from today
Copyright © 2003 Pearson Education, Inc.
Slide 13-34
The Demand for
Foreign Currency Assets
• When the difference in Equation (13-1) is positive,
dollar deposits yield the higher expected rate of return.
When it is negative, euro deposits yield the higher
expected rate of return.
Copyright © 2003 Pearson Education, Inc.
Slide 13-35
The Demand for
Foreign Currency Assets
Table 13-3: Comparing Dollar Rates of Return on Dollar and
Euro Deposits
Copyright © 2003 Pearson Education, Inc.
Slide 13-36
The Demand for
Foreign Currency Assets
 Return, Risk, and Liquidity in the Foreign Exchange
Market
• The demand for foreign currency assets depends not
only on returns but on risk and liquidity.
– There is no consensus among economists about the
importance of risk in the foreign exchange market.
– Most of the market participants that are influenced by
liquidity factors are involved in international trade.
– Payments connected with international trade make up a very
small fraction of total foreign exchange transactions.
• Therefore, we ignore the risk and liquidity motives for
holding foreign currencies.
Copyright © 2003 Pearson Education, Inc.
Slide 13-37
Equilibrium in the
Foreign Exchange Market
 Interest Parity: The Basic Equilibrium Condition
• The foreign exchange market is in equilibrium when
deposits of all currencies offer the same expected rate
of return.
• Interest parity condition
– The expected returns on deposits of any two currencies
are equal when measured in the same currency.
– It implies that potential holders of foreign currency
deposits view them all as equally desirable assets.
– The expected rates of return are equal when:
R$ = R€ + (Ee$/€ - E$/€)/E$/€
Copyright © 2003 Pearson Education, Inc.
(13-2)
Slide 13-38
Equilibrium in the
Foreign Exchange Market
 How Changes in the Current Exchange Rate Affect
Expected Returns
• Depreciation of a country’s currency today lowers the
expected domestic currency return on foreign currency
deposits.
• Appreciation of the domestic currency today raises the
domestic currency return expected of foreign currency
deposits.
Copyright © 2003 Pearson Education, Inc.
Slide 13-39
Equilibrium in the
Foreign Exchange Market
Table 13-4: Today’s Dollar/Euro Exchange Rate and the Expected Dollar
Return on Euro Deposits When Ee$/€ = $1.05 per Euro
Copyright © 2003 Pearson Education, Inc.
Slide 13-40
Equilibrium in the
Foreign Exchange Market
Figure 13-3: The Relation Between the Current Dollar/Euro Exchange Rate
and the Expected Dollar Return on Euro Deposits
Today’s dollar/euro
exchange rate, E$/€
1.07
1.05
1.03
1.02
1.00
0.031
Copyright © 2003 Pearson Education, Inc.
0.050 0.069 0.079 0.100
Expected dollar return on
euro deposits, R€ + (Ee$/€ E$/€)/(E$/€)
Slide 13-41
Equilibrium in the
Foreign Exchange Market
 The Equilibrium Exchange Rate
• Exchange rates always adjust to maintain interest
parity.
• Assume that the dollar interest rate R$, the euro interest
rate R€, and the expected future dollar/euro exchange
rate Ee$/€, are all given.
Copyright © 2003 Pearson Education, Inc.
Slide 13-42
Equilibrium in the
Foreign Exchange Market
Figure 13-4: Determination of the Equilibrium Dollar/Euro Exchange Rate
Exchange rate, E$/€
E2$/€
E1$/€
E3
Return on
dollar deposits
2
1
3
$/€
Expected return
on euro deposits
R$
Copyright © 2003 Pearson Education, Inc.
Rates of return
(in dollar terms)
Slide 13-43
Interest Rates, Expectations,
and Equilibrium
 The Effect of Changing Interest Rates on the Current
Exchange Rate
• An increase in the interest rate paid on deposits of a
currency causes that currency to appreciate against
foreign currencies.
– A rise in dollar interest rates causes the dollar to
appreciate against the euro.
– A rise in euro interest rates causes the dollar to
depreciate against the euro.
Copyright © 2003 Pearson Education, Inc.
Slide 13-44
Interest Rates, Expectations,
and Equilibrium
Figure 13-5: Effect of a Rise in the Dollar Interest Rate
Exchange rate, E$/€
E1$/€
Dollar return
1
E2$/€
1'
2
Expected
euro return
R1$
Copyright © 2003 Pearson Education, Inc.
R2$
Rates of return
(in dollar terms)
Slide 13-45
Interest Rates, Expectations,
and Equilibrium
Figure 13-6: Effect of a Rise in the Euro Interest Rate
Exchange rate, E$/€
Dollar return
Rise in euro
interest rate
E2$/€
2
E1$/€
1
Expected
euro return
R$
Copyright © 2003 Pearson Education, Inc.
Rates of return
(in dollar terms)
Slide 13-46
Interest Rates, Expectations,
and Equilibrium
 The Effect of Changing Expectations on the Current
Exchange Rate
• A rise in the expected future exchange rate causes a
rise in the current exchange rate.
• A fall in the expected future exchange rate causes a fall
in the current exchange rate.
Copyright © 2003 Pearson Education, Inc.
Slide 13-47
Summary
 Exchange rates play a role in spending decisions


because they enable us to translate different countries’
prices into comparable terms.
A depreciation (appreciation) of a country’s currency
against foreign currencies makes its exports cheaper
(more expensive) and its imports more expensive
(cheaper).
Exchange rates are determined in the foreign
exchange market.
Copyright © 2003 Pearson Education, Inc.
Slide 13-48
Summary
 An important category of foreign exchange trading is


forward trading.
The exchange rate is most appropriately thought of as
being an asset price itself.
The returns on deposits traded in the foreign
exchange market depend on interest rates and
expected exchange rate changes.
Copyright © 2003 Pearson Education, Inc.
Slide 13-49
Summary
 Equilibrium in the foreign exchange market requires
interest parity.
• For given interest rates and a given expectation of the
future exchange rate, the interest parity condition tells
us the current equilibrium exchange rate.
 A rise in dollar (euro) interest rates causes the dollar

to appreciate (depreciate) against the euro.
Today’s exchange rate is altered by changes in its
expected future level.
Copyright © 2003 Pearson Education, Inc.
Slide 13-50