Brealey−Meyers: Principles of Corporate Finance, 7th Edition - Chapter 28 ppsx

Brealey−Meyers: Principles of Corporate Finance, Seventh Edition VIII. Risk Management 28. Managing International Risks © The McGraw−Hill Companies, 2003 CHAPTER TWENTY-EIGHT 786 MANAGING INTERNATIONAL RI SK S Brealey−Meyers: Principles of Corporate Finance, Seventh Edition VIII. Risk Management 28. Managing International Risks © The McGraw−Hill Companies, 2003 IN THE LAST chapter we considered the risks that flow from changes in interest rates and commodity prices. But companies with substantial overseas interests encounter a variety of other hazards, including political risks and currency fluctuations. Political risk means the possibility that a hostile foreign government will expropriate your business without compensation or not allow profits to be taken out of the country. To understand currency risk, you first need to understand how the foreign exchange market works and how prices for foreign currency are determined. We therefore start this chapter with some basic institutional detail about the foreign exchange market and we will look at some simple theories that link exchange rates, interest rates, and inflation. We will use these theories to show how firms assess and hedge their foreign currency exposure. When we discussed investment decisions in Chapter 6, we showed that financial managers do not need to forecast exchange rates in order to evaluate overseas investment proposals. They can simply forecast the foreign currency cash flows and discount these flows at the foreign currency cost of capital. In this chapter we will explain why this rule makes sense. It turns out that it is the ability to hedge foreign exchange risk that allows companies to ignore future exchange rates when making investment decisions. We conclude the chapter with a discussion of political risk. We show that, while companies cannot restrain a determined foreign government, they can structure their operations to reduce the risk of hostile actions. 787 28.1 THE FOREIGN EXCHANGE MARKET An American company that imports goods from France may need to buy euros to pay for the purchase. An American company exporting to France may receive euros, which it sells in exchange for dollars. Both firms make use of the foreign exchange market. The foreign exchange market has no central marketplace. Business is conducted electronically. The principal dealers are the larger commercial banks and invest- ment banks. A corporation that wants to buy or sell currency usually does so through a commercial bank. Turnover in the foreign exchange market is huge. In London in April 2001 $504 billion of currency changed hands each day. That is equivalent to an annual turnover of $126 trillion ($126,000,000,000,000). New York and Tokyo together accounted for a further $400 billion of turnover per day. 1 Table 28.1 is adapted from the table of exchange rates in the Financial Times. Ex- change rates are generally expressed in terms of the number of units of the foreign currency needed to buy one U.S. dollar. This is termed an indirect quote. In the first column of Table 28.1, the indirect quote for the yen shows that you can buy 120.700 yen for $1. This is often written as . A direct exchange rate quote states how many dollars you can buy for one unit of foreign currency. The euro and the British pound sterling are usually shown as direct quotes. 2 For example, Table 28.1 shows that is equivalent to $1.4483 or, more concisely, . If buys $1.4483, then $1 must buy . Thus the indirect quote for the pound is . 3 £.6905/$ 1/1.4483 ϭ £.6905£1$ˇ 1.4483/£ £1 ¥120.700/$ 1 The results of the triennial survey of foreign exchange business are published on www.bis.org/publ. 2 The euro is the common currency of the European Monetary Union. The 12 members of the Union are Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portu- gal, and Spain. 3 Foreign exchange dealers usually refer to the exchange rate between pounds and dollars as cable. In Table 28.1 cable is 1.4483. Brealey−Meyers: Principles of Corporate Finance, Seventh Edition VIII. Risk Management 28. Managing International Risks © The McGraw−Hill Companies, 2003 The exchange rates in the first column of Table 28.1 are the prices of currency for immediate delivery. These are known as spot rates of exchange. The spot rate for the yen is , and the spot rate for the pound is . In addition to the spot exchange market, there is a forward market. In the forward market you buy and sell currency for future delivery. If you know that you are going to pay out or receive foreign currency at some future date, you can insure yourself against loss by buying or selling forward. Thus, if you need one million yen in three months, you can enter into a three-month forward contract. The forward rate on this contract is the price you agree to pay in three months when the one million yen are delivered. If you look again at Table 28.1, you will see that the three-month forward rate for the yen is quoted at . If you buy yen for three months’ delivery, you get fewer yen for your dollar than if you buy them spot. In this case the yen is said to trade at a forward premium relative to the dollar, because forward yen are more ex- pensive than spot ones. Expressed as an annual rate, the forward premium is 4 You could also say that the dollar was selling at a forward discount. A forward purchase or sale is a made-to-measure transaction between you and the bank. It can be for any currency, any amount, and any delivery day. You could buy, say, 99,999 Vietnamese dong or Haitian gourdes for a year and a day forward as long as you can find a bank ready to deal. Most forward transactions are for six months or less, but banks are prepared to buy and sell the major currencies for several years forward. 5 4 ϫ a 120.700 119.66 Ϫ 1 bϭ .035, or 3.5% ¥ ˇ119.66/$ $ˇ 1.4483/£¥ˇ120.700/$ 788 PART VIII Risk Management Forward Rate* Spot Rate* 1 Month 3 Months 1 Year Europe: EMU (euro) .9094 .9088 .9076 .9057 Norway (krone) 8.8756 8.9006 8.9594 9.1889 Sweden (krona) 10.3159 10.3221 10.3389 10.4034 Switzerland (franc) 1.6680 1.6677 1.6667 1.6563 United Kingdom (pound) 1.4483 1.4468 1.4432 1.4289 Americas: Canada (dollar) 1.5397 1.5403 1.5415 1.545 Mexico (peso) 9.1390 9.1865 9.307 9.924 Pacific/Africa: Hong Kong (dollar) 7.7999 7.7987 7.7962 7.7954 Japan (yen) 120.700 120.36 119.66 116.535 Singapore (dollar) 1.7542 1.7525 1.7491 1.7322 South Africa (rand) 8.3693 8.4102 8.4963 8.8278 Thailand (baht) 44.3450 44.39 44.555 45.295 TABLE 28.1 Spot and forward exchange rates, August 28, 2001. *Rates show the number of units of foreign currency per U.S. dollar, except for the euro and the UK pound, which show the number of U.S. dollars per unit of foreign currency. Source: Financial Times, August 29, 2001. 4 Here is an occasional point of confusion. Since the quote for the yen is indirect, we calculate the pre- mium by taking the ratio of the spot rate to the forward rate. If we use direct quotes, then we need to calculate the ratio of the forward rate to the spot rate. In the case of the yen, the forward premium with direct quotes is , or 3.5 percent. 5 Forward and spot trades are often undertaken together. For example, a company might need the use of Japanese yen for one month. In this case it would buy the yen spot and simultaneously sell them for- ward. This is known as a swap trade, but do not confuse it with the longer-term interest rate and cur- rency swaps described in Chapter 27. 4 ϫ 311/119.662/11/120.72Ϫ 14ϭ .035 Brealey−Meyers: Principles of Corporate Finance, Seventh Edition VIII. Risk Management 28. Managing International Risks © The McGraw−Hill Companies, 2003 There is also an organized market for currency for future delivery known as the currency futures market. Futures contracts are highly standardized; they exist only for the main currencies, and they are for specified amounts and for a limited choice of delivery dates. 6 When you buy a forward or futures contract, you are committed to taking de- livery of the currency. As an alternative, you can take out an option to buy or sell currency in the future at a price that is fixed today. Made-to-measure currency op- tions can be bought from the major banks, and standardized options are traded on the options exchanges. CHAPTER 28 Managing International Risks 789 6 See Chapter 27 for a further discussion of the difference between forward and futures contracts. 28.2 SOME BASIC RELATIONSHIPS You can’t develop a consistent international financial policy until you understand the reasons for the differences in exchange rates and interest rates. We will consider the following four problems: • Problem 1. Why is the dollar rate of interest different from, say, the yen rate ? • Problem 2. Why is the forward rate of exchange different from the spot rate ? • Problem 3. What determines next year’s expected spot rate of exchange between dollars and yen ? • Problem 4. What is the relationship between the inflation rate in the United States and the inflation rate in Japan ? Suppose that individuals were not worried about risk and that there were no bar- riers or costs to international trade. In that case the spot exchange rates, forward exchange rates, interest rates, and inflation rates would stand in the following sim- ple relationship to one another: 1i ¥ 21i $ 2 3E1r ¥/$ 24 1s ¥/$ 2 1f ¥ ˇˇˇ/$ 2 1r ¥ 21r $ 2 Difference in interest rates 1 + r Y 1 + r $ equals = Expected difference in inflation rates E (1 + i Y ) E (1 + i $ ) = Difference between forward and spot rates f Y/$ s Y/$ equals equals equals = = Expected change in spot rate E ( s Y/$ ) s Y/$ = = Why should this be so? Brealey−Meyers: Principles of Corporate Finance, Seventh Edition VIII. Risk Management 28. Managing International Risks © The McGraw−Hill Companies, 2003 Interest Rates and Exchange Rates It is August 2001 and you have $1 million to invest for one year. U.S. dollar deposits are offering an interest rate of about 3.65 percent; Japanese yen deposits are offer- ing a meager .06 percent. Where should you put your money? Does the answer sound obvious? Let’s check: • Dollar loan. The rate of interest on one-year dollar deposits is 3.65 percent. Therefore at the end of the year you get . • Yen loan. The current exchange rate is . For $1 million, you can buy . The rate of interest on a one-year yen deposit is .06 percent. Therefore at the end of the year you get . Of course, you don’t know what the exchange rate is going to be in one year’s time. But that doesn’t matter. You can fix today the price at which you sell your yen. The one-year forward rate is . Therefore, by selling forward, you can make sure that you will receive at the end of the year. Thus, the two investments offer almost exactly the same rate of return. 7 They have to—they are both risk-free. If the domestic interest rate were different from the cov- ered foreign rate, you would have a money machine. When you make the yen loan, you receive a lower interest rate. But you get an offsetting gain because you sell yen forward at a higher price than you pay for them today. The interest rate differential is And the differential between the forward and spot exchange rates is Interest rate parity theory says that the difference in interest rates must equal the dif- ference between the forward and spot exchange rates: f ¥/$ s ¥/$ 1 ϩ r ¥ 1 ϩ r $ 120,772,420/116.535 ϭ $ˇ 1,036,400 ¥ ˇ116.535/$ 120,700,000 ϫ 1.0006 ϭ ¥120,772,420 1,000,000 ϫ 120.700 ϭ ¥ ˇ120,700,000 ¥ˇ120.700/$ 1,000,000 ϫ 1.0365 ϭ $ ˇ 1,036,500 790 PART VIII Risk Management 7 The minor difference in our calculated end-of-year payoffs was mostly due to rounding in the in- terest rates. Difference in interest rates 1 + r Y 1 + r $ equals = Difference between forward and spot rates f Y/$ s Y/$ = = In our example, The Forward Premium and Changes in Spot Rates Now let’s consider how the forward premium is related to changes in spot rates of exchange. If people didn’t care about risk, the forward rate of exchange would de- pend solely on what people expected the spot rate to be. For example, if the one- 1.0006 1.0365 ϭ 116.535 120.700 Brealey−Meyers: Principles of Corporate Finance, Seventh Edition VIII. Risk Management 28. Managing International Risks © The McGraw−Hill Companies, 2003 year forward rate on yen is , that could only be because traders expect the spot rate in one year’s time to be . If they expected it to be, say, , nobody would be willing to buy yen forward. They could get more yen for their dollar by waiting and buying spot. Therefore the expectations theory of exchange rates tells us that the percentage difference between the forward rate and today’s spot rate is equal to the expected change in the spot rate: ¥ ˇ125/$ ¥116.535/$ ¥116.535/$ CHAPTER 28 Managing International Risks 791 Difference between forward and spot rates f Y/$ s Y/$ equals = = Expected change in spot rate E( s Y/$ ) s Y/$ = = Of course, this assumes that traders don’t care about risk. If they do care, the for- ward rate can be either higher or lower than the expected spot rate. For example, suppose that you have contracted to receive one million yen in three months, You can wait until you receive the money before you change it into dollars, but this leaves you open to the risk that the price of yen may fall over the next three months. Your alternative is to sell yen forward. In this case, you are fixing today the price at which you will sell your yen. Since you avoid risk by selling forward, you may be willing to do so even if the forward price of yen is a little lower than the expected spot price. Other companies may be in the opposite position. They may have contracted to pay out yen in three months. They can wait until the end of the three months and then buy yen, but this leaves them open to the risk that the price of yen may rise. It is safer for these companies to fix the price today by buying yen forward. These companies may, therefore, be willing to buy forward even if the forward price of yen is a little higher than the expected spot price. Thus some companies find it safer to sell yen forward, while others find it safer to buy yen forward. When the first group predominates, the forward price of yen is likely to be less than the expected spot price. When the second group predomi- nates, the forward price is likely to be greater than the expected spot price. On av- erage you would expect the forward price to underestimate the expected spot price just about as often as it overestimates it. Changes in the Exchange Rate and Inflation Rates Now we come to the third side of our quadrilateral—the relationship between changes in the spot exchange rate and inflation rates. Suppose that you notice that silver can be bought in the United States for $4.00 a troy ounce and sold in Japan for . You think you may be onto a good thing. You decide to buy silver for $4.00 and put it on the first plane to Tokyo, where you sell it for . Then you exchange your for . You have made a gross profit of $1.59 an ounce. Of course, you have to pay transportation and insurance costs out of this, but there should still be something left over for you. Money machines don’t exist—not for long, anyway. As others notice the dis- parity between the price of silver in Japan and the price in the United States, the price will be forced down in Japan and up in the United States until the profit op- portunity disappears. Arbitrage ensures that the dollar price of silver is about the 675/120.700 ϭ $ ˇ 5.59¥ˇ675 ¥ˇ675 ¥ˇ675 Brealey−Meyers: Principles of Corporate Finance, Seventh Edition VIII. Risk Management 28. Managing International Risks © The McGraw−Hill Companies, 2003 same in the two countries. Of course, silver is a standard and easily transportable commodity, but the same forces should act to equalize the domestic and foreign prices of other goods. Those goods that can be bought more cheaply abroad will be imported, and that will force down the price of domestic products. Similarly, those goods that can be bought more cheaply in the United States will be exported, and that will force down the price of the foreign products. This is often called purchasing power parity. 8 Just as the price of goods in Safeway must be roughly the same as the price of goods in A&P, so the price of goods in Japan when converted into dollars must be roughly the same as the price in the United States: Purchasing power parity implies that any differences in the rates of inflation will be offset by a change in the exchange rate. For example, if prices are rising by 2.6 per- cent in the United States while they are declining by percent in Japan, the num- ber of yen that you can buy for $1 must fall by , or about 3.5 percent. Therefore purchasing power parity says that to estimate changes in the spot rate of exchange, you need to estimate differences in inflation rates: 9 .99/1.026 Ϫ 1 Ϫ1.0 Dollar price of goods in the USA ϭ yen price of goods in Japan number of yen per dollar 792 PART VIII Risk Management 8 Economists use the term purchasing power parity to refer to the notion that the level of prices of goods in general must be the same in the two countries. They tend to use the phrase law of one price when they are talking about the price of a single good. 9 In other words, the expected difference in inflation rates equals the expected change in the exchange rate. Strictly interpreted, purchasing power parity also implies that the actual difference in the inflation rates always equals the actual change in the exchange rate. 10 In Section 24.1 we discussed Irving Fisher’s theory that over time money interest rates change to re- flect changes in anticipated inflation. Here we argue that international differences in money interest rates also reflect differences in anticipated inflation. This theory is sometimes known as the international Fisher effect. Expected difference in inflation rates E (1 + i Y ) E (1 + i $ ) = equals Expected change in spot rate E ( s Y/$ ) s Y/$ = = In our example, Current spot rate ϫ expected difference in inflation rates ϭ expected spot rate 120.700 ϫ .99/1.026 ϭ 116.5 Interest Rates and Inflation Rates Now for the fourth leg! Just as water always flows downhill, so capital tends to flow where returns are greatest. But investors are not interested in nominal returns; they care about what their money will buy. So, if investors notice that real interest rates are higher in Japan than in the United States, they will shift their savings into Japan until the expected real returns are the same in the two countries. If the ex- pected real interest rates are equal, then the difference in money rates must be equal to the difference in the expected inflation rates: 10 Brealey−Meyers: Principles of Corporate Finance, Seventh Edition VIII. Risk Management 28. Managing International Risks © The McGraw−Hill Companies, 2003 In Japan the real one-year interest rate is just over 1 percent: Ditto for the United States: Is Life Really That Simple? We have described above four theories that link interest rates, forward rates, spot exchange rates, and inflation rates. Of course, such simple economic theories are not going to provide an exact description of reality. We need to know how well they predict actual behavior. Let’s check. 1. Interest Rate Parity Theory Interest rate parity theory says that the yen rate of interest covered for exchange risk should be the same as the dollar rate. In the ex- ample that we gave you earlier we used the rates of interest on dollar and yen de- posits in London. Since money can be moved easily between these deposits, inter- est rate parity almost always holds. In fact, dealers set the forward price of yen by looking at the difference between the interest rates on deposits of dollars and yen. 11 The relationship does not hold so exactly for deposits made in different domes- tic money markets. In these cases taxes and government regulations sometimes prevent the citizens of one country from switching out of one country’s bank de- posits and covering their exchange risk in the forward market. 2. The Expectations Theory of Forward Rates How well does the expectations theory explain the level of forward rates? Scholars who have studied exchange rates have found that forward rates typically exaggerate the likely change in the spot rate. When the forward rate appears to predict a sharp rise in the spot rate (a forward premium), the forward rate tends to overestimate the rise in the spot rate. Conversely, when the forward rate appears to predict a fall in the currency (a for- ward discount), it tends to overestimate this fall. 12 This finding is not consistent with the expectations theory. Instead it looks as if sometimes companies are prepared to give up return to buy forward currency and other times they are prepared to give up return to sell forward currency. In r $ 1real2ϭ 1 ϩ r $ E11 ϩ i $ 2 Ϫ 1 ϭ 1.0365 1.026 Ϫ 1 ϭ .0102 r ¥ 1real2ϭ 1 ϩ r ¥ E11 ϩ i ¥ 2 Ϫ 1 ϭ 1.0006 .99 Ϫ 1 ϭ .0107 CHAPTER 28 Managing International Risks 793 Difference in interest rates 1 + r Y 1 + r $ equals = Expected difference in inflation rates E (1 + i Y ) E (1 + i $ ) = 11 The forward exchange rates shown in the Financial Times and reproduced in Table 28.1 are simply cal- culated from the differences in interest rates. 12 Many researchers have even found that, when the forward rate predicts a rise, the spot rate is more likely to fall, and vice versa. For a readable discussion of this puzzling finding, see K. A. Froot and R. H. Thaler, “Anomalies: Foreign Exchange,” Journal of Political Economy 4 (1990), pp. 179–192. Brealey−Meyers: Principles of Corporate Finance, Seventh Edition VIII. Risk Management 28. Managing International Risks © The McGraw−Hill Companies, 2003 other words, forward rates seem to contain a risk premium, but the sign of this premium swings backward and forward. 13 You can see this from Figure 28.1. Al- most half the time the forward rate for the Swiss franc overstates the likely future spot rate and half the time it understates the likely spot rate. On average the for- ward rate and future spot rate are almost identical. This is important news for the financial manager; it means that a company which always uses the forward mar- ket to protect against exchange rate movements does not pay any extra for this insurance. 3. Purchasing Power Parity Theory What about the third side of our quadrilat- eral—purchasing power parity theory? No one who has compared prices in for- eign stores with prices at home really believes that prices are the same throughout the world. Look, for example, at Table 28.2, which shows the price of a Big Mac in different countries. Notice that at current rates of exchange a Big Mac costs $3.65 in Switzerland but only $2.54 in the United States. To equalize prices in Switzerland and the United States, the number of Swiss francs that you could buy for your dol- lar would need to increase by , or 44 percent. This suggests a possible way to make a quick buck. Why don’t you buy a hamburger-to-go in (say) the Philippines for the equivalent of $1.17 and take it for resale in Switzerland, where the price in dollars is $3.65? The answer, of course, is that the gain would not cover the costs. The same good can be sold for 3.65/2.54 Ϫ 1 ϭ .44 794 PART VIII Risk Management 13 For evidence that forward exchange rates contain risk premia that are sometimes positive and some- times negative, see, for example, E. F. Fama, “Forward and Spot Exchange Rates,” Journal of Monetary Economics 14 (1984), pp. 319–338. Nov. 83 Nov. 84 Nov. 85 Nov. 86 Nov. 87 Nov. 88 Nov. 89 Nov. 90 Nov. 91 Nov. 92 Nov. 93 Nov. 94 Nov. 95 Nov. 96 Nov. 97 Nov. 98 Nov. 99 Nov. 00 -10 -8 -6 -4 -2 0 Percent error 2 4 6 8 10 FIGURE 28.1 Percentage error from using the one-month forward rate for Swiss francs to forecast next month’s spot rate. Note that the forward rate overestimates and underestimates the spot rate with about equal frequency. Brealey−Meyers: Principles of Corporate Finance, Seventh Edition VIII. Risk Management 28. Managing International Risks © The McGraw−Hill Companies, 2003 different prices in different countries because transportation is costly and in- convenient. 14 On the other hand, there is clearly some relationship between inflation and changes in exchange rates. For example, between 1994 and 1999 prices in Turkey rose about 20 times. Or, to put it another way, you could say that the purchasing power of money in Turkey declined by about 95 percent. If exchange rates had not adjusted, Turkish exporters would have found it impossible to sell their goods. But, of course, exchange rates did adjust. In fact, the value of the Turkish currency de- clined by 92 percent relative to the U.S. dollar. Turkey is an extreme case, but in Figure 28.2 we have plotted the relative change in purchasing power for a sample of countries against the change in the exchange rate. Turkey is tucked in the bottom left-hand corner; the United States is closer to the top right. You can see that although the relationship is far from exact, large differences in inflation rates are generally accompanied by an offsetting change in the exchange rate. Strictly speaking, purchasing power parity theory implies that the differential inflation rate is always identical to the change in the spot rate. But we don’t need to go as far as that. We should be content if the expected difference in the inflation rates equals the expected change in the spot rate. That’s all we wrote on the third side of our quadrilateral. Look, for example, at Figure 28.3. The solid line shows that in 2000 sterling bought almost 70 percent fewer dollars than it did at the be- ginning of the century. But this decline in the price of sterling was largely matched by the higher inflation rate in the United Kingdom. The thin line shows that the inflation-adjusted, or real, exchange rate ended the century at roughly the same level as it began. 15 Of course, the real exchange rate does change, sometimes dra- matically. For example, the real value of sterling almost halved between 1980 and 1985 before recovering in the next five years. However, if you were a financial man- ager called on to make a long-term forecast of the exchange rate, you could not £1 CHAPTER 28 Managing International Risks 795 Local Price Local Price Converted to Converted to Country U.S. Dollars Country U.S. Dollars Australia 1.52 Japan 2.38 Brazil 1.64 Mexico 2.36 Canada 2.14 Philippines 1.17 China 1.20 Russia 1.21 Denmark 2.93 Sweden 2.33 Germany 2.30 Switzerland 3.65 Hong Kong 1.37 United Kingdom 2.85 Hungary 1.32 United States 2.54 TABLE 28.2 Price of Big Mac hamburgers in different countries. Source: “Big Mac Currencies,” The Economist, April 21, 2001, p. 74. 14 Of course, even within a currency area there may be considerable price variations. The price of a Big Mac, for example, differs substantially from one part of the United States to another. And even after the introduction of the euro, the price of Big Macs varied between $1.96 in Italy and $2.49 in France. 15 The real exchange rate is equal to the nominal exchange rate multiplied by the inflation differential. For example, suppose that the value of sterling falls from to at the same time that the price of goods rises 10 percent faster in the United Kingdom than in the United States. The inflation- adjusted, or real, exchange rate is unchanged at Initial exchange rate ϫ 11 ϩ i £ 2/11 ϩ i $ 2ϭ 1.40 ϫ 1.1 ϭ $ˇ 1.54/£ $ˇ 1.40 ϭ £1$ˇ 1.54 ϭ £1 [...]... Brealey−Meyers: Principles of Corporate Finance, Seventh Edition Brealey−Meyers: Principles of Corporate Finance, Seventh Edition PART EIGHT RELATED WEBSITES VIII Risk Management © The McGraw−Hill Companies, 2003 28 Managing International Risks The major futures exchanges have useful sites that provide data and explain how futures markets work: www.erivativesreview.com www.cbot.com (Chicago Board of. .. and Costs through Financial Innovation, Business International Corporation, New York, 1987 Visit us at www.mhhe.com/bm7e Brealey−Meyers: Principles of Corporate Finance, Seventh Edition Brealey−Meyers: Principles of Corporate Finance, Seventh Edition 812 PART VIII VIII Risk Management 28 Managing International Risks © The McGraw−Hill Companies, 2003 Risk Management The spot exchange rate for euros is... Risk, Financial Risk, and Economic Risk,” Financial Analysts Journal 52 (1996), pp 28 46 Campbell Harvey’s web page (www.duke.edu/~charvey) is also a useful source of information on political risk Brealey−Meyers: Principles of Corporate Finance, Seventh Edition VIII Risk Management 28 Managing International Risks CHAPTER 28 © The McGraw−Hill Companies, 2003 Managing International Risks improve your bargaining... the Firm, South-Western College Publishing, Cincinnati, OH, 1995 Brealey−Meyers: Principles of Corporate Finance, Seventh Edition VIII Risk Management 28 Managing International Risks © The McGraw−Hill Companies, 2003 CHAPTER 28 Managing International Risks 807 A C Shapiro: Multinational Financial Management, 6th ed., John Wiley & Sons, New York, 1999 Here are some general discussions of international... 1940 1950 1960 1970 1980 1990 2000 Brealey−Meyers: Principles of Corporate Finance, Seventh Edition VIII Risk Management © The McGraw−Hill Companies, 2003 28 Managing International Risks CHAPTER 28 Managing International Risks Average money market rate, percent, 1995–1999 80 70 60 50 40 30 20 10 0 0 20 40 60 80 100 Average inflation rate, percent, 1995–1999 FIGURE 28. 4 Countries with the highest interest... selling spot Fourth, the cost of for17 It also relieves shareholders of worrying about the foreign exchange exposure they may have acquired by purchase of the firm’s shares 18 Sometimes governments also attempt to prevent currency speculation by limiting the amount that companies can sell forward Brealey−Meyers: Principles of Corporate Finance, Seventh Edition VIII Risk Management 28 Managing International... but the cost of servicing dollar loans would also have fallen However, while borrowing dollars would have reduced the risk for German car producers, it should not have affected their decisions about where to produce and sell cars Brealey−Meyers: Principles of Corporate Finance, Seventh Edition VIII Risk Management © The McGraw−Hill Companies, 2003 28 Managing International Risks CHAPTER 28 Managing... example, if a copper mine looks profitable only because you are unusually optimistic about the price of copper, then maybe you would do better to buy copper futures or the shares of other copper producers rather than opening a copper mine 801 Brealey−Meyers: Principles of Corporate Finance, Seventh Edition 802 VIII Risk Management © The McGraw−Hill Companies, 2003 28 Managing International Risks PART... for such goods 27 The early history of the San Tomé mine is described in Joseph Conrad’s Nostromo In Section 25.7 we described how the World Bank provided the Hubco power project with a guarantee against political risk 28 805 Brealey−Meyers: Principles of Corporate Finance, Seventh Edition Visit us at www.mhhe.com/bm7e SUMMARY FURTHER READING VIII Risk Management 28 Managing International Risks © The.. .Brealey−Meyers: Principles of Corporate Finance, Seventh Edition 796 PART VIII VIII Risk Management © The McGraw−Hill Companies, 2003 28 Managing International Risks Risk Management FIGURE 28. 2 100 80 Relative change in exchange rate, percent A decline in the exchange rate and a decline in a currency’s purchasing power usually go hand in hand In this diagram, each of the 138 points . Brealey−Meyers: Principles of Corporate Finance, Seventh Edition VIII. Risk Management 28. Managing International Risks © The McGraw−Hill Companies, 2003 CHAPTER TWENTY-EIGHT 786 MANAGING INTERNATIONAL RI. with the longer-term interest rate and cur- rency swaps described in Chapter 27. 4 ϫ 311/119.662/11/120.72Ϫ 14ϭ .035 Brealey−Meyers: Principles of Corporate Finance, Seventh Edition VIII. Risk. TWENTY-EIGHT 786 MANAGING INTERNATIONAL RI SK S Brealey−Meyers: Principles of Corporate Finance, Seventh Edition VIII. Risk Management 28. Managing International Risks © The McGraw−Hill Companies, 2003 IN THE LAST chapter we