Chapter 21
International Financial
Management
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21–1
Learning Objectives
•
Understand the importance of international
transactions for the Australian economy.
•
Read, interpret and use foreign exchange rates.
•
Understand the roles of interest rates and inflation
rates in exchange-rate determination.
•
Understand the empirical evidence on the behaviour
of exchange rates.
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21–2
Learning Objectives (cont.)
•
Understand the techniques that can be used to
manage exchange risk.
•
Explain the advantages of international
diversification of investments.
•
Identify the characteristics and uses of currency
swaps.
•
Identify the main sources of foreign currency
borrowing used by Australian companies.
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Background Statistics
• International trade now represents about 20% of
Australia’s gross domestic product:
EXPORTS
IMPORTS
YEAR
$Ab
%
$Am
%
1988/89
55.4
15.8
62.3
17.7
1992/93
76.9
18
79.1
18.5
1996/97
105.2
19.7
103.6
19.4
1997/98
113.7
20.1
118.5
21
1998/99
111.9
18.8
126.5
21.2
1999/2000
125.9
19.9
140.3
22.2
2000/2001
153.9
22.9
153.2
22.8
2001/2002
153.3
21.5
154.6
21.6
2002/2003
148.5
19.7
167.2
22.2
Table 21.1, Source: Reserve Bank of Australia, Bulletin.
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Background Statistics (cont.)
• Historically, Australia has been a net importer of
capital.
– Levels of foreign investment in $A billion: non-official
sector:
DATE
PORTFOLIO TOTAL
DIRECT
AND
NONINVESTMENT OTHER
OFFICAL
30 June 1989
30 June 1992
30 June 1996
30 June 2000
30 June 2001
30 June 2002
30 June 2003
91.2
109.8
147.7
216.9
222.7
234.7
254.8
143.3
201.3
272.0
472.1
578.9
585
606.1
PORTFOLIO TOTAL
DIRECT
AND
NONINVESTMENT OTHER
OFFICAL
234.5
311.1
419.4
689.0
801.6
819.7
860.9
44.3
51.2
81.6
190.5
204.7
177.7
178.6
35.0
52.2
80.9
150.3
209.6
225.6
221.5
79.3
103.4
162.5
340.8
414.3
403.3
400
Table 21.2, Source: Reserve Bank of Australia
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Background Statistics (cont.)
• The extent of Australia’s external indebtedness is
shown below:
Australia's gross and net external debt in $A million
DATE
30 June 1981
30 June 1986
30 June 1991
30 June 1996
30 June 2001
30 June 2002
30 June 2003
GROSS $Ab
NET $Ab
18.8
101.9
196.8
275.5
493.9
524.4
570.9
9.4
78.4
142.1
193.9
306
329.1
358.2
Table 21.3, Source: Reserve Bank of Australia
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Foreign Exchange Market
•
No actual market, instead a communications
network linking banks and other dealers in foreign
exchange.
•
This market determines the prices of foreign
currencies.
•
These prices are called ‘exchange rates’.
•
‘Exchange rate’ — the price at which one country’s
currency can be exchanged for another country’s
currency in the foreign exchange market.
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The Spot Exchange Rate
•
‘Spot rate’: rate for transactions for immediate
delivery. In the case of foreign exchange, the spot
rate is for settlement in 2 days.
•
Examples of spot rates for one Australian dollar, as
at 30 June 2004, are shown in Table 21.4.
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The Spot Exchange Rate (cont.)
for $A1 as at 30/6/2004
CURRENCY
US dollars (USD)
UK pounds (GBP)
Japan yen (JPY)
Europe euro (EUR)
Singapore dollar (SGD)
Malta pound (MTP)
W. Samoa tala (WST)
(1)
CUSTOMER SELLS
FOREIGN CURRENCY
AND BUYS $A1
0.6936
0.3862
75.67
0.5795
1.2029
0.2493
1.9975
(2)
CUSTOMER SELLS
$A1 AND BUYS
(3)
FOREIGN CURRENCY RATIO OF (2)/(1)%
0.6849
0.3767
73.65
0.5621
1.1596
0.2353
1.8250
98.75
97.54
97.33
97.00
96.40
94.38
91.36
Table 21.4, Source: Australian Financial Review
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The Spot Exchange Rate (cont.)
•
In Table 21.4:
–
–
–
–
–
Column (1) provides the exchange rate applicable where
a customer has foreign currency and wishes to obtain
Australian dollars.
Column (2) provides the exchange rate applicable where
a customer has Australian dollars and wishes to obtain
foreign currency.
The difference (spread) between the rates is one source
of the foreign exchange dealer’s profit.
Column (3) shows how the spread varies from currency
to currency.
Essentially, those currencies that are traded most
frequently (from an Australian viewpoint) are the
currencies with the smallest spreads.
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Foreign Exchange Trading in Australia
Market Share by Currency Pair, April 1998, 2001 and 2004
Market Share
Currency Pair
April 1998
April 2001
April 2004
Aust. dollar–US dollar
48.2
49.4
44.7
Euro–US dollar
N/A
11.4
17.0
US dollar–D’mark
3.5
N/A
N/A
US dollar–Yen
16.0
14.0
12.7
UK pound–US dollar
5.4
6.4
6.2
NZ dollar–US dollar
6.7
9.0
6.0
Other currencies
10.2
9.8
13.4
Total
100.0
100.0
100.0
Table 21.5, Source: BIS survey reported by RBA
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The Forward Exchange Rate
•
‘Forward rate’: exchange rate that is established
now, but with payment and delivery to occur at a
specified future date.
–
Commonly for time periods of 1, 3 or 6 months.
–
Forward contracts for periods exceeding 1 year are
unusual, only about 3% of all contracts.
–
Forward exchange rates are usually quoted in terms of
the difference between the spot rate and the forward rate.
Referred to as the ‘forward margin’.
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The Forward Exchange Rate (cont.)
•
Suppose that for US dollars (per one AUD) you
are told that the spot rate is 0.5460/70 and the
3 months’ forward margin is –16/–16.
US$ AND BUYS $A1
US$ AND SELLS $A1
Spot rate
0.5470
0.5460
less Forward margin
0.0016
0.0016
0.5454
0.5444
Forward rate
Table 21.6
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The Forward Exchange Rate (cont.)
•
In this case, the spread between the buying and
selling rates for the forward contract is:
0.5454 – 0.5444 = 0.0010.
•
•
•
We can see that the spread for the spot contract
in this case is also only 0.0010.
The spread for a forward contract is always
greater than or equal to the spread for the
matching spot contract.
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Calculations Using Foreign Exchange
Rates
• There are only four types of calculation.
• The UK pound exchange rates are used as an
example. Assume the following exchange rates:
Customer sells
£ and buys $A1
UK pounds (GBP)
Customer buys
£ and sells $A1
0.3862
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0.3767
21–15
Calculations Using Foreign Exchange
Rates (cont.)
• Type 1: to obtain a given sum in $A using £:
–
A UK resident may wish to obtain $A10 000.
–
How many pounds are needed?
–
As £0.3862 is needed for every $A1 required,
the answer is:
£(10 000 × 0.3862) = £3862
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Calculations Using Foreign Exchange
Rates (cont.)
•
Type 2: to convert a given sum of £ to $A:
– An Australian company has been paid £10 000
and wishes to exchange this for Australian dollars.
– How many Australian dollars will this buy?
–
As each $A will cost £0.3862 to buy, the
answer is:
$A (10 000 / 0.3862) = $A25 893.32
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Calculations Using Foreign Exchange
Rates (cont.)
•
Type 3: to obtain a given sum in £ using $A:
– An Australian company may wish to obtain
£10 000.
–
How many Australian dollars are needed?
–
As $A1 will obtain £0.3767, the answer is:
$A(10 000 / 0.3767) = $A26 546.32
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Calculations Using Foreign Exchange
Rates (cont.)
•
Type 4: to convert a given sum of $A to £:
– A UK resident has been paid $A10 000 and
wishes to exchange this for pounds.
–
How many pounds will this buy?
–
As each Australian dollar will buy £0.3767, the
answer is:
£(10 000 × 0.3767) = £3767
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Triangular Arbitrage and Cross Rates
•
‘Cross rates’: exchange rates between two currencies
derived from the exchange rates between the currencies and
a third currency.
•
Suppose that the following spot rates are observed
simultaneously:
–
•
$A1 = US$0.6000 and US$1 = £0.7000
Using only these two spot rates, the spot rate linking AUD
and GBP must be:
–
$A1 = £(0.6000 × 0.7000) = £0.4200
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Triangular Arbitrage and Cross Rates
(cont.)
•
If this were not the case, a riskless profit could be made.
•
For example, if the spot rate was $A1 = £0.4180 instead,
then a foreign exchange dealer could profit from undertaking
the following three transactions simultaneously:
•
–
Sell $A1 for US$0.6000
–
Sell US$0.6000 for £(0.6000 × 0.7000) = £0.4200
–
Sell £0.4200 for $A(0.4200 / 0.4180) = $A1.0048
A risk-free profit of $A0.0048 for every AUD transacted in
the first step.
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Size of Foreign Exchange Market in
Australia
•
The Australian dollar is one of the more actively
traded currencies in the world.
•
Average daily turnover in the Australian Foreign
Exchange Market in 2003 is nearly $A126b, with
$A61b against Australian dollars.
–
•
Australian exports plus imports for the entire year 2003
amounted to only $A306b!
Approximately two-thirds of the trading volume is
between foreign exchange dealers and banks
overseas.
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Interest Rates, Inflation Rates, Spot
and Forward Exchange Rates
•
Assumptions
–
Market participants are risk-neutral.
–
There are no barriers or frictions in any market.
–
Analysis applies to any two currencies; Australian dollars
and UK pounds are used for illustration.
–
Analysis could be applicable to any time period; we
assume that the period is 1 year for illustration.
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Interest Rates, Inflation Rates, Spot
and Forward Exchange Rates (cont.)
•
Notation
i  interest rate (nominal, per annum)
p  inflation rate (per annum)
s  spot exchange rate (expressed as pounds per dollar)
f  forward exchange rate for 1 year
(expressed as pounds per dollar)
£  subscript used to indicate that a
variable refers to pounds
$  subscript used to indicate that a
variable refers to Australian dollars
E  the expectatio n operator for 1 year
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Interest Rate Parity
• Interest rate parity maintains that:
1  i£
f

1  i$ s
• Interest rate parity states that relative interest rates
determine the relativity between the forward
exchange rate and the spot exchange rate.
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Interest Rate Parity (cont.)
•
If interest rate parity does not hold, then arbitrage
would be possible.
–
‘Covered interest arbitrage’: movement of funds between
two currencies to profit from interest rate differences,
while using forward contracts to eliminate exchange risk.
–
Because of interest rate parity, a foreign investment with
forward cover is equivalent to a domestic investment.
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Interest Rate Parity (cont.)
•
Example 21.1
–
An investor has $A1m to invest for 1 year in
government securities.
–
The interest rate on Australian dollars is 6.2%
and the interest rate on UK pounds is 4.1%.
–
The spot exchange rate is $A1 = £0.5265
and the forward exchange rate for 1 year is
$A1 = £0.5161.
–
Calculate the return on an Australian investment,
and the return (in Australian dollars) on an equivalent
UK investment.
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Interest Rate Parity (cont.)
Example 21.1 (cont.)
• Invest $A1 million in Australian securities for 1 year:
Cash inflow after 1 year = $A1 000 000 × 1.062
= $A1 062 000
•
Invest $A1 million in UK securities for 1 year:
Spot conversion of $A1 million to pounds:
$A1 000 000 = £(1 000 000 × 0.5265) = £526 500
Cash inflow (in pounds) after 1 year investment:
= £526 500 × 1.041 = £548 086.50
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Interest Rate Parity (cont.)
Example 21.1 (cont.)
• Reconversion to Australian dollars at the forward
rate:
£548 086.50 = $A(548 086.50 / 0.5161)
= $A1 061 977.33
•
The difference between these two investments is
trivial, about $A22.67 on an investment of $A1m.
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Interest Rate Parity (cont.)
•
•
The following example shows how a set of
exchange rates and interest rates can be examined
to determine whether covered interest arbitrage
is feasible.
Example 21.2
–
–
–
–
–
Spot rate:
$A1 = US$0.7525
Forward rate (1 month):
$A1 = US$0.7474
$A interest rate (1 month):
1.25% per month
US$ interest rate (1 month):
0.65% per month
Assumption that the spread is zero and there are no
transaction costs.
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Interest Rate Parity (cont.)
•
Example 21.2 (cont.)
1  iUS 1.0065

 0.994 074
1  iA 1.0125
However:
f 0.7474

 0.993 223
s 0.7525
The forward rate indicated by interest rate parity is
(0.994 074) (0.7525) = 0.7480, compared with the
actual forward rate of 0.7474, implying there is an
arbitrage opportunity.
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Interest Rate Parity (cont.)
•
Example 21.3
–
Illustrate covered interest arbitrage by assuming that
an arbitrager simultaneously undertakes the following
four transactions:
–
Borrows $A5 million for 1 month at 1.25% p.m.
–
Converts the sum of $A5 million to US dollars, thereby
obtaining US$(5 000 000 × 0.7525) = US$3 762 500
–
Lends US$3 762 500 for 1 month at an interest rate of
0.65% p.m., producing a future cash repayment to the
arbitrager of
US$3 762 500 × 1.0065 = US$3 786 956.25
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Interest Rate Parity (cont.)
•
Example 21.3 (cont.)
–
Sells forward (1 month) the sum of US$3 786 956.25, thereby
ensuring an AUD inflow in 1 month’s time of:
$A(3 786 956.25/ 0.7474) = $A5 066 840.05
–
The loan requires a repayment of
$A5 000 000 × 1.0125 = $A5 062 500
–
After 1 month, the inflow of $A5 066 840.05 can be used to
make the repayment of $A5 062 500, thereby giving the
arbitrager a profit of $A4340.05 for a net investment of zero.
–
Since the arbitrager made no net outlay, and all transactions
were undertaken simultaneously, there was no exposure to risk.
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Unbiased Forward Rates
•
Unbiased forward rates imply:
f E s 

s
s
•
If market participants are risk-neutral and there are
no transaction costs, the market will set the forward
rate, f, equal to the spot rate that is expected to
be observed at the date on which the forward
contract matures.
• If this result did not hold, then risk-neutral
speculators would trade in foreign currency until the
forward rate was equal to the expected spot rate.
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Purchasing Power Parity
•
Purchasing Power Parity (PPP) maintains that:
E s  1  E  p £ 

s
1  E  p$ 
•
PPP holds that the expected change in the exchange
rate is due to differences in expected inflation rates in
the respective countries.
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Purchasing Power Parity (cont.)
•
The simplest derivation of PPP assumes that the
law of one price is valid. This states that the dollar
price of any given commodity should be the same
everywhere in the world.
•
If all markets were free and frictionless, and all
goods were traded internationally, then the law of
one price would hold because, otherwise, an
arbitrage could be undertaken.
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Purchasing Power Parity (cont.)
•
However, for many commodities, the law of one
price clearly does not hold.
•
Fortunately, PPP may also be proved by making
the weaker assumption that the ratio of dollar
prices for the same commodity in two countries will
stay constant as time passes.
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Purchasing Power Parity (cont.)
•
Example 21.4
–
–
Suppose the spot rate is $A1 = £0.3325.
If the expected inflation rates are 9% in Australia and 4%
in the UK, what is next year’s spot rate expected to be?
1.04 
0.3325   0.3172
E s   

1.09 
–
By year’s end $A1 = £0.3172, a depreciation of 4.6% in
the value of the $A in terms of UK pounds.
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Message of Purchasing Power Parity
•
A country with a high inflation rate can expect
to have a depreciating exchange rate (a
‘weak’ currency).
•
Whereas a country with a low inflation rate can
be expected to have an appreciating exchange
rate (a ‘strong’ currency).
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Uncovered Interest Parity or the
International Fisher Effect
•
If interest rate parity and unbiased forward rates hold
simultaneously, then:
E s  1  i£

s
1  i$
•
This implies that the spot exchange rate will tend to adjust in
the direction indicated by interest rates in the two currencies.
•
In particular, a country’s currency will tend to appreciate
(depreciate) relative to another currency if its interest rate is
lower (higher) than the interest rate on the other currency.
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Empirical Evidence on the Behaviour
of Exchange Rates
•
Interest rate parity: evidence
–
Where the interest rate data are collected from
unregulated markets (Eurodollar market), the overseas
evidence nearly always supports interest rate parity.
–
An early study by Bird, Dyer and Tippett (1987) found that
after the floating of the AUD in 1983, there were few
opportunities for covered interest arbitrage if interest rates
were measured by rates on government securities and
transaction costs were included.
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Empirical Evidence on the Behaviour
of Exchange Rates (cont.)
•
Unbiased forward rates: evidence
–
Most tests of unbiased forward rates relationships have
found that the forward rate is not an unbiased estimate of
the future spot rate.
–
Sources of this bias are not obvious — one possibility is
risk aversion among foreign exchange participants,
requiring a risk premium for holding currency.
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Empirical Evidence on the Behaviour
of Exchange Rates (cont.)
•
Purchasing power parity: evidence
–
In practice, the law of one price does not hold for a great
many commodities.
–
Where a commodity is readily defined, cheaply
transportable and frequently traded in organised markets,
it is likely that the law of one price will provide an accurate
description of reality.
–
Baldwin and Yan (2004) find some parity between US and
Canada for highly standardised products but Canadians
pay up to 4% premiums for some products and up to 8%
less for some services.
Copyright  2006 McGraw-Hill Australia Pty Ltd
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Prepared by Dr Buly Cardak
21–43
Empirical Evidence on the Behaviour
of Exchange Rates (cont.)
•
Purchasing power parity: evidence (cont.)
–
Generally, PPP is found to give a poor description of
exchange rate behaviour, unless a long time period is
used for testing.
–
This makes international comparisons using current
exchange rates misleading.
–
For example, OECD data shows per capita GDP in
Australia in 2002 to be US$20 700 using current
exchange rates, but US$28 100 using PPP-adjusted
figures.
Copyright  2006 McGraw-Hill Australia Pty Ltd
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Prepared by Dr Buly Cardak
21–44
Empirical Evidence on the Behaviour
of Exchange Rates (cont.)
•
Uncovered interest parity: evidence
–
The interest rate difference between currencies is
typically found to give a biased forecast of the future spot
rate, and often does not even predict the direction of
movement correctly.
Copyright  2006 McGraw-Hill Australia Pty Ltd
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Prepared by Dr Buly Cardak
21–45
Empirical Evidence on the Behaviour
of Exchange Rates (cont.)
•
Forecasting exchange rates
–
Little evidence in Australia that market participants can
forecast successfully the AUD–USD exchange rate.
–
Hunt (1987) studied short-term forecasts by 16 foreign
exchange dealers.
–
Found no evidence that dealers could forecast the spot
rate — random walk performed better.
–
Easton and Lalor (1995) found no evidence that longerterm exchange rate forecasts are accurate.
Copyright  2006 McGraw-Hill Australia Pty Ltd
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Prepared by Dr Buly Cardak
21–46
Management of Exchange Risk
•
What is an exchange risk?
–
The variability of an entity’s value that is due to changes
in exchange rates.
–
The exchange risk arising from trade-related contracts is
often termed ‘transaction risk’.
–
The exchange risk arising from capital-related contracts is
often termed ‘translation risk’.
Copyright  2006 McGraw-Hill Australia Pty Ltd
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Prepared by Dr Buly Cardak
21–47
Management of Exchange Risk (cont.)
•
Who faces exchange risk?
–
Exchange risk arises whenever a company needs to deal,
now or in the future, in a currency other than the currency
that shareholders use to finance their consumption.
–
However, an electronics retailer may never transact in
the foreign currency market, yet it will face exchange
risk because it may obtain CD players from Australian
wholesalers who, in turn, import CD players
from overseas.
–
Some entities exposed to exchange risk include tourism
operators and universities — both provide services in
Australia to foreign customers whose demand is sensitive
to exchange movements.
Copyright  2006 McGraw-Hill Australia Pty Ltd
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Prepared by Dr Buly Cardak
21–48
Management of Exchange Risk (cont.)
•
The ‘hedging principle’
–
A financial strategy that will ensure that the Australian
dollar value of a commitment to pay or receive a sum of
foreign currency in the future is not affected by changes
in the exchange rate.
–
The basic principle of hedging is to undertake another,
offsetting, commitment in the same foreign currency.

For example, an Australian importer who is committed to
making a cash payment in UK pounds can hedge by
entering into a commitment to receive UK pounds for the
same amount and on the same date.
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Prepared by Dr Buly Cardak
21–49
Management of Exchange Risk (cont.)
•
Forward rate hedge
–
For example, suppose that an Australian importer is
committed to paying a future sum in UK pounds. In
effect, this is a contract to buy UK pounds in the future.
–
By entering into a forward contract to buy UK pounds,
the value of the commitment can be fixed in Australian
dollar terms.
–
The future outflow of UK pounds required by the import
contract is matched by an inflow of UK pounds required
by the forward contract.
Copyright  2006 McGraw-Hill Australia Pty Ltd
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Prepared by Dr Buly Cardak
21–50
Management of Exchange Risk (cont.)
•
Hedging by borrowing or lending
–
A hedging technique consisting of establishing an
offsetting cash flow by borrowing or lending the
foreign currency.
Copyright  2006 McGraw-Hill Australia Pty Ltd
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21–51
Management of Exchange Risk (cont.)
•
Who should hedge exchange risk?
–
It is useful to distinguish between three broad categories
of companies:

Category 1: the domestic company that unexpectedly faces
a significant foreign exchange involvement.

Category 2: the repeat exporter (or importer), regularly
involved in foreign currency transactions.

Category 3: the multinational company producing and
selling in two or more countries.
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21–52
Management of Exchange Risk (cont.)
•
Category 1 (the one-off transaction)
–
The incentive to hedge is obvious.
–
The company has little or no international experience
and an unfavourable result from a single large
transaction could place a significant strain on the
company’s finances.
–
A forward contract is likely to be the most suitable
means of hedging.
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Prepared by Dr Buly Cardak
21–53
Management of Exchange Risk (cont.)
•
Category 2 (the repeat exporter/importer)
–
A sequence of foreign exchange transactions should not
necessarily be treated as merely the equivalent of a oneoff transaction repeated many times.
–
The ‘true’ cost of a transaction at the forward rate is its
opportunity cost. In this case, the forgone alternative is to
transact at the spot rate that occurs at the expiration of
the forward contract.
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Prepared by Dr Buly Cardak
21–54
Management of Exchange Risk (cont.)
•
Category 2 (the repeat exporter/importer)
–
If the repeat importer does not hedge but simply pays for
the imported goods by transacting at the spot rate, has
the importer’s exchange risk increased?
–
Exchange risk is really the risk of suffering a greater
variability in cash flows, and there is no reason to believe
that future forward rates will be less variable than future
spot rates.
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Prepared by Dr Buly Cardak
21–55
Management of Exchange Risk (cont.)
•
Category 3 (the multinational company)
–
A multinational company is likely to receive net cash
flows in a number of currencies on a continuing basis,
with no fixed terminal date in contemplation.
–
Long-term debt denominated in the same currencies will
commit such a company to foreign currency payments
and therefore act as a ‘natural’ hedge.
–
While it is inevitable that some exchange rate changes
will cause losses, others will produce gains. There is,
therefore, a kind of portfolio effect.
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Prepared by Dr Buly Cardak
21–56
Management of Exchange Risk (cont.)
•
Contingent hedging
–
A contingent exchange risk may exist where a company
tenders for an overseas contract. The company’s
exposure to exchange risk is, therefore, contingent upon
winning the tender.
–
In effect, the company has granted (i.e. sold at a price of
zero) an option.
–
Therefore, the most suitable way to hedge such a
contingency is by purchasing a matching option.
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Prepared by Dr Buly Cardak
21–57
Management of Exchange Risk (cont.)
•
There are four possible outcomes from a
contingent sale of an asset in US dollars:
–
$A appreciates against US$ and the sale occurs;
–
$A appreciates against US$ and the sale does not occur;
–
$A depreciates against US$ and the sale occurs; or
–
$A depreciates against US$ and the sales does not
occur.
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Prepared by Dr Buly Cardak
21–58
Management of Exchange Risk (cont.)
If $A appreciates
If $A depreciates
Sale Occurs
Sale Doesn’t
Occur
Sale Occurs
Sale Doesn’t
Occur
US$ Bought
Forward
Nil
Loss
Nil
Gain
US$ Not
Bought
Forward
Gain
Nil
Loss
Nil
Table 21.8
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Prepared by Dr Buly Cardak
21–59
International Diversification of
Investments
• Once 30 or 40 domestic shares have been selected,
the benefit of further diversification is rather slight, as
most of the characteristics of the Australian market are
already represented.
• A further source of diversification is to invest in shares
listed on foreign stock exchanges.
• When an asset’s returns are measured in a foreign
currency, without a hedge, the overall return is the joint
result of the asset return and the return on the
exchange rate.
Copyright  2006 McGraw-Hill Australia Pty Ltd
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Prepared by Dr Buly Cardak
21–60
International Diversification of
Investments (cont.)
•
Benefits will be received so long as the correlation
between the returns of the foreign shares and the
domestic shares is less than 1.
•
The correlations between the share markets of
different countries are positive, but less than 1
(typically ranging from 0.3 to 0.6).
•
This suggests that substantial benefits can be
gained from international diversification.
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Prepared by Dr Buly Cardak
21–61
International Diversification of
Investments (cont.)
•
Potential disadvantages of international
diversification:
–
Possible adverse tax implications.
–
Increased transaction costs.
–
Difficulties in obtaining reliable information on foreign
securities.
–
Political risks (limitations on the withdrawal of capital or
expropriation).
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Prepared by Dr Buly Cardak
21–62
Currency Swaps
•
Swaps are one of the most significant new financial
instruments of the past 25 years.
•
Two counterparties agree to exchange a series
of cash flows as a consequence of a swap of
loan obligations.
•
Two main forms of swap contacts are the interest
rate swap and the currency swap.
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Prepared by Dr Buly Cardak
21–63
Currency Swaps (cont.)
•
Interest rate swaps
–
Agreement between two parties to exchange interest
payments for a specific period, related to an agreed
principal amount.
–
The most common type of interest rate swap involves
an exchange of fixed interest payments for floating
interest payments.
–
Interest rate swaps do not necessarily have any
international features, that is, a fixed-for-floating rate
swap between two domestic borrowers.
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21–64
Currency Swaps (cont.)
•
Currency swaps
–
A simultaneous borrowing and lending operation in which
two parties initially exchange specific amounts of two
currencies at the spot rate.
–
Interest payments in the two currencies are also
exchanged and the parties agree to reverse the initial
exchange after a fixed term at a fixed exchange rate.
–
Simplest currency swap is of fixed rate commitments in
different currencies.

This comprises the exchange of principal at the outset.
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21–65
Currency Swaps (cont.)
•
Currency swaps
–
Simplest currency swap (cont.)

Followed by exchanges of interest flows on interest
payment dates.

Completed with a re-exchange of principal’s at maturity
date of loans.
–
While forward contracts of more than 1 year are
uncommon, a currency swap effectively offers longer-term
forward contracts.
–
Credit risk is an important issue with currency swaps
(compared to interest rate swaps) as counterparties not
only swap interest commitments but also principal.
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21–66
Currency Swaps (cont.)
•
Example 21.9
• Yanko wants to borrow £100m for 3 years and
Britco wants to borrow US$200m for 3 years.
•
Current spot exchange rate is US$1 = £0.5000.
•
They plan to follow a bond structure of repayment,
coupon (interest) payments for 3 years with
principal at maturity.
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Prepared by Dr Buly Cardak
21–67
Currency Swaps (cont.)
•
Example 21.9
• The interest rates available to the two borrowers is
given in Table 21.10 below:
•
.
•
The key point here is that yanko has a 2% borrowing
cost advantage in $US dollars.
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21–68
Currency Swaps (cont.)
•
Example 21.9 (cont.)
• Yanko borrows US$200m, which it pays to Britco, and
Britco borrows £100m, which it pays to Yanko.
• The originally agreed and post swap cashflows are
shown in Table 21.11.
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Prepared by Dr Buly Cardak
21–69
Currency Swaps (cont.)
•
Example 21.9 (cont.)
• Note that an intermediary has entered the
agreement, brokering the swap.
•
After the swap, Britco is paying 11.8% for US$,
which is 0.2% better than it could do on its own.
•
Similarly, Yanko is paying 13.3% for UK £ after the
swap; this is 0.2% better than it could do on its own.
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Prepared by Dr Buly Cardak
21–70
Currency Swaps (cont.)
•
Example 21.9 (cont.)
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21–71
Currency Swaps (cont.)
•
Example 21.9 (cont.)
• The exchange risk falls on the intermediary with a
US$3.6m inflow and a £1.2m outflow.
•
The intermediary is likely to hedge this exposure
away with forward contracts or through the natural
hedge created by brokering a portfolio of swaps.
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21–72
Foreign Currency Borrowing by
Australian Companies
•
Risk of foreign currency borrowing
– Domestic borrowers may be induced to borrow overseas
because of lower interest rates on offer.
–
As seen earlier, interest rate differentials should be
interpreted to imply exchange rate movements —
interest rate parity.
–
A foreign currency loan left unhedged is exposed to
depreciation of the Australian dollar, making repayment of
the loan more costly.
–
A hedge, if available, may wipe out the cost savings (this
is expected in an efficient market), though a swap may
offer risk-management opportunities.
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21–73
Reasons for Borrowing Overseas
•
Foreign currency debt can provide a useful hedge
for a foreign-currency asset holding.
•
Alternatively, a currency swap can be used to
hedge the currency risk.
•
Offshore borrowing offers the Australian corporation
a broader range of lenders that can handle
extremely large loans which might be a strain on
the domestic capital market.
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21–74
Reasons for Borrowing Overseas
(cont.)
•
Hedging efficiency — foreign lenders may not want Australian
currency exposure, even though they are willing to lend to
Australian firms.
•
Thus, to access these lenders, Australian firms must borrow in
foreign currency and hedge the risk themselves — the cost is
likely to be shared between the lender and borrower (it would
be factored into the borrowing rate).
•
Diversification — lenders prefer not to be the sole creditor of a
large firm and in such cases may require risk premium, the
firm may look overseas for cheaper funds, spreading the risk
across several institutions (local and overseas).
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21–75
Borrowing Overseas: Market Structure
•
•
Overseas borrowing, first choice
–
Borrow from an overseas bank or financial institution.
–
Or, the borrower may issue, in a foreign country,
marketable securities.
Overseas borrowing, second choice
–
Should the funds be raised in a foreign market or in
a ‘Euro’ market.
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Borrowing Overseas: Market Structure
(cont.)
•
Foreign transaction — carried out in foreign country
in currency of that country.
–
•
Foreign bond — Australian company issuing US$ bonds in
US capital markets.
Eurocurrency transaction — carried out in the
currency other than currency of country where
transaction occurs.
–
Eurocurrency loan — London banks lend Swedish
government US$500m.
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Borrowing Overseas: Market
Structure (cont.)
•
‘Bearer security’: a security whose ownership is not
registered by the issuer; possession of the physical
document is primary evidence of ownership.
•
Eurocurrency markets are dominated by US$ but
Euro is of increasing importance.
•
Since 1985, Australian dollar securities have
been included in Euromarkets and traded by
participants, providing another source of funds for
Australian firms.
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21–78
Foreign and Eurocurrency Loans
•
Similar to loans from domestic banks, but they are
arranged overseas and are normally denominated
in a foreign currency.
•
Short-term Eurocurrency bank loans
–
Typically involve a principal of at least US$5m.
–
Interest rate is set at a margin (0.5 to 3.0%) above an
agreed reference rate (usually LIBOR).
–
Different LIBOR rates for different currencies and terms to
maturity.
–
Often provided under a revolving credit facility.
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Foreign and Eurocurrency Loans
(cont.)
•
Eurocurrency standby facilities
–
A bank is committed to providing short-term loan funds
should the borrower require them.
–
Normally arranged for periods up to 2 years and intended
to be used only in times of difficulty or tight liquidity.
–
Bank charges a commitment fee as well as interest.
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21–80
Foreign and Eurocurrency Loans
(cont.)
•
Eurocurrency term loans
–
Typically for a principal of at least US$5m, to be repaid
over 5 to 10 years.
–
Interest charged on a floating-rate basis, set at a margin
above LIBOR.
–
The time pattern for the repayment of principal is
negotiable between parties.
–
Loans of more than US$50 to US$100m will usually
require a syndicate of banks to provide the funds.
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21–81
Foreign and Eurocurrency Securities
•
There has been a trend towards borrowers
obtaining funds from lenders by selling them
marketable securities, such as bonds and notes,
rather than by borrowing from a bank.
•
One reason for this trend may be due to the
possibility of the borrower qualifying for an
exemption from the interest withholding tax.
•
‘Foreign securities’ — securities sold in a country by
a foreign issuer (in the local currency).
–
‘Kangaroo bonds’, foreign companies issuing $A
denominated bonds in the Australian capital market.
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21–82
Foreign and Eurocurrency Securities
(cont.)
•
Euronote issuance facilities
–
Facilities under which one or more institutions agrees to
underwrite a borrower’s short-term securities (Euronotes).
–
Euronotes are issued for short terms (up to 6 months) but
the facility is generally arranged for a much longer period
(up to 7 years).
–
These notes are essentially bearer promissory notes
drawn by the borrower, with face values of US$100 000
and US$500 000.
–
These facilities involve a range of fees: establishment,
commitment and take-up fees.
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21–83
Foreign and Eurocurrency Securities
(cont.)
•
Commercial paper and certificates of deposit
–
‘Commercial paper’: unsecured short-term promissory
notes.
–
‘Certificates of deposit’: a marketable fixed-rate debt
instrument issued by a bank in exchange for a deposit
of funds.
–
‘Commercial paper facility’: similar to a note issuance
facility, but not underwritten.
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21–84
Foreign and Eurocurrency Securities
(cont.)
•
Transferable loan certificates
–
Euromarket borrowers can obtain a bank term loan
with provision for the lender to convert the loan into
a transferable loan certificate.
–
Similar to a syndicated loan from the viewpoint of
the borrower.
–
Interest rate set at a margin above LIBOR.
–
Ownership is registered (not bearer instruments).
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21–85
Foreign and Eurocurrency Securities
(cont.)
•
Medium-term notes
–
Unsecured, bearer, coupon securities with terms to
maturity ranging from 1 to 30 years.
–
Coupon rate can be fixed or floating.
–
The size of each facility is typically between US$50m
and US$500m.
–
Offer flexibility: notes issued within a given facility can
have a range of maturities, currencies and fixed and
floating coupon rates.
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21–86
Foreign and Eurocurrency Securities
(cont.)
•
Eurobonds
–
Medium- to long-term international bearer securities sold
in countries other than the country of the currency in
which the bond is denominated.
–
Many different types:

Fixed rate bonds
 Floating rate notes
 Equity-related bonds
–
A Eurobond issue is usually for a minimum of
US$50m.
–
Maturities are usually between 3 and 12 years.
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21–87
Foreign and Eurocurrency Securities
(cont.)
•
Eurobonds
–
In 2003, financial institutions issue the bulk of international bonds
(72%), followed by corporations (13%) and governments and state
agencies (10%).
–
Australian issues account for 0.8% of all issues, though they rank
6th currency, with 60% of all issues being straight fixed rate bonds
in US$ or Euro.
–
Australian and NZ Eurobond issues dominated by banks and
financial institutions, property developers and property trusts.
–
Uridashi Market — A$ bonds placed in Japanese retail
bond market.
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21–88
Summary
•
Australia has always been a relatively open
economy, international globalisation — thus
international financial management is important
in Australia.
•
Exchange rates
–
–
Spot rate — price of currency for immediate delivery.
Forward rate — price of currency for delivery on a
specified later date.
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Summary (cont.)
•
International finance relationships
–
Interest rate parity — empirical support strong.
–
Unbiased forward rates — empirical support weak.
–
PPP – high inflation = depreciation.
–
International Fisher effect — interest rates and exchange
rate expectations.
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21–90
Summary (cont.)
•
Competitive market for currencies means it is
impossible to consistently forecast exchange
rates successfully.
•
Exchange risk — loss due to unanticipated
exchange rate changes.
–
Manage exchange risk by hedging — appropriate for
one-off transactions.
–
Hedging is not helpful in long-term situations, such as
committed repeat exporter.
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21–91
Summary (cont.)
•
Return on foreign assets depends on exchange
rates as well as investment return.
•
Foreign investment popular because it offers
increased diversification.
•
Currency swaps — changes the currency in which
a loan must be repaid, i.e. converts a foreign
currency loan into a domestic currency loan.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
21–92
Summary (cont.)
•
Australian companies increasingly borrow
overseas.
•
Two main mechanisms include Eurocurrency loans
and debt security issues.
•
These foreign borrowings are often complemented
with a swap as a hedging mechanism, either
currency or interest rate.
•
Australian-based foreign bonds — kangaroo
bonds.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
21–93