Chapter 18 decribes international aspects of financial management. In this chapter you will understand how exchange rates are quoted and what they mean, know the difference between spot and forward rates, understand purchasing power parity and interest rate parity and the implications for changes in exchange rates, understand the types of exchange rate risk and how they can be managed, understand the impact of political risk on international business investing.
International aspects of financial management Chapter 18 Key concepts and skills • Understand how exchange rates are quoted and what they mean • Know the difference between spot and forward rates • Understand purchasing power parity and interest rate parity and the implications for changes in exchange rates • Understand the types of exchange rate risk and how they can be managed • Understand the impact of political risk on international business investing Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 18-2 Chapter outline • Terminology • Foreign exchange markets and exchange rates • Purchasing power parity • Exchange rates and interest rates • Exchange rate risk • Political risk Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 18-3 Domestic financial management and international financial management • Considerations in international financial management – Have to consider the effect of exchange rates when operating in more than one currency – Have to consider the political risk associated with actions of foreign governments – More financing opportunities when you consider theAustralia international capital markets Copyright © 2011 McGraw-Hill Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al 18-4 and this may reduce the firm’s cost of Slides prepared by David E Allen and Abhay K Singh International finance terminology • Cross-rate – Implicit exchange rate between two currencies when both are quoted in a third (usually dollars) currency • Eurobond – Bond issued in multiple countries but denominated in the issuer’s home currency • Eurocurrency (Eurodollars) – Money deposited in a financial centre outside the country of the currency involved – Eurodollars are US dollars deposited in a foreign bank • Foreign bonds – Sold by foreign borrower – Denominated in currency of the country of issue Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 18-5 International finance terminology (cont.) • Gilts – British and Irish government securities • London Interbank Offer Rate (LIBOR) – Rate international banks charge each other for loans of Eurodollars overnight in the London market – Frequently used as a benchmark rate for money market instruments • Swaps – Interest rate swap = two parties exchange a floating-rate payment for a fixed-rate payment – Currency swap = agreement to deliver one currency in exchange for another Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 18-6 Global capital markets • Foreign exchange market – The market in which one country's currency is bought or sold for another country's currency – Over-the-counter market – Communications done using electronic telecommunication devices • Society for Worldwide Interbank Financial Telecommunications (SWIFT) • The number of exchanges in foreign countries continues to increase, as does the liquidity on those exchanges • International foreign markets are becoming more competitive and are often willing to try more innovative ways of doing business Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 18-7 International currency symbols and codes Table 18.1 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 18-8 Exchange rates • The price of one country’s currency in terms of another • All currencies are in some way quoted to US dollars – Most countries are in terms of US dollars, except for countries like Australia and New Zealand • Consider the following quote: – Japan (Yen) 0.0112 89.19 – The first number, 0.0112, is how many Australian dollars it takes to buy Yen – The second number, 89.19, is how many Japanese Yen it takes to buy $1AUD – The two numbers are reciprocals of each other (1/89.19= 0.0112) Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 18-9 Direct and indirect exchange rate quotations • Direct quotation – One US dollar = ‘x’ of the local currency • Indirect quotation – One unit local currency = ‘x’ US dollars • Australia and New Zealand follow indirect quote Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 18-10 Absolute purchasing-power parity • Price of an item is the same regardless of the currency used to purchase it or where it is selling: P = Price of goods PUK S0 PAU S0 = Spot rate • Requirements for absolute PPP to hold: – No transaction costs – No barriers to trade (no taxes, tariffs, etc.) – No difference in the commodity between locations • Absolute PPP rarely holds in practice – Usually only for uniform, traded goods Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 18-15 Relative purchasing-power parity • Provides information about what causes changes in exchange rates • The basic result is that exchange rates depend on relative inflation between countries • E(St ) = S0[1 + (hFC – hAUD)]t – Where: •S0 = current (time 0) spot exchange rate (foreign currency per dollar) •E(St) = expected exchange rate in t periods hAU = inflation rate in Australia Copyright â 2011 McGraw-Hill rate Australia Pty Ltd foreign country h = inflation in the • FC PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 18-16 PPP—Example • Suppose the Singapore spot exchange rate is 1.4680 Singapore dollars per Australian dollar Australian inflation is expected to be 3% per year and Singapore inflation is expected to be 2% – Do you expect the Australian dollar to appreciate or depreciate relative to the Singapore dollar? • Since inflation is higher in Australia, we would expect the AUD to depreciate relative to the Singapore dollar – What is the expected exchange in one year? Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al David E Allen and Abhay K Singh Slides prepared by • E(S ) = 1.4680[1 + (.02 - 03)]1 = 1.4533 18-17 Covered interest arbitrage • Examine the relationship between spot rates, forward rates and nominal rates between countries • Again, the formulas will assume that the exchange rates are quoted in terms of foreign currency per Australian dollars (AUD) • The Australian risk-free rate is assumed to be the short-dated government bond rate • Covered interest arbitrage – ‘Covered’ refers to the fact that we are covered in the event of a change in the exchange rate since we lock in the forward exchange rate today Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 18-18 Covered interest arbitrage— Example • Consider the following information: – S0 = SGD/$ RAUD = 10% – • F1 = 1.8 SGD/$ RSGD = 5% What is the arbitrage opportunity? – Borrow $100 at 10% – Buy $100(2 SGD/$) = 200 SGD and invest at 5% for year – In year, receive 200(1.05) = 210 SGD and convert back to dollars – 210 SGD/(1.8 SGD/$) = $116.67 and repay loan – Profit = 116.67 – 100(1.1) = $6.67 risk free Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 18-19 Interest rate parity • The condition of the interest rate differential between two countries being equal to the percentage difference between the forward exchange rate and the spot exchange rate • With reference to the example on the previous slide, there must be a forward rate that would prevent the arbitrage opportunity Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 18-20 Interest rate parity (cont.) • Interest rate parity defines what that forward rate should be F1 Exact : S0 F1 Approx : S0 (1 (1 RFC ) R AU ) ( RFC RAU ) Forward and spot rates are direct quotations RAU = periodic interest rate in the home country (Australia) RFCCopyright = periodic interest rate in the foreign country © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 18-21 Exchange rate risk • The risk that the value of a cash flow in one currency translated from another currency will decline owing to a change in exchange rates • A natural consequence of international operations in a world where relative currency values move up and down Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 18-22 Short-run exposure • Risk from day-to-day fluctuations in exchange rates and the fact that companies have contracts to buy and sell goods in the short run at fixed prices • Managing risk – Enter into a forward agreement to guarantee the exchange rate – Use foreign currency options to lock in exchange rates if they move against you but benefit from rates if they move in your favour Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 18-23 Long-run exposure • Long-run fluctuations come from unanticipated changes in relative economic conditions • Could be due to changes in labour markets or governments • Managing risk – More difficult to hedge – Try to match long-run inflows and outflows in the same currency – Borrowing in the foreign country may mitigate some of the problems Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 18-24 Translation exposure • Income from foreign operations has to be translated back to dollars for accounting purposes, even if foreign currency is not actually converted back to dollars • If gains and losses from this translation flowed through directly to the income statement, there would be significant volatility in EPS • Current accounting regulations require that all cash flows be converted at the prevailing exchange rates with currency gains and losses accumulated in a special account within shareholders’ equity Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 18-25 Managing exchange rate risk • Large multinational firms may need to manage the exchange rate risk associated with several different currencies • The firm needs to consider its net exposure to currency risk instead of just looking at each currency separately • Hedging individual currencies could be expensive and may actually increase 18-26 exposure Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh Political risk • Risk of changes in value owing to political actions in the foreign country • Investment in countries that have unstable governments should require higher returns • The extent of political risk depends on the nature of the business – The more dependent the business is on other operations within the firm, the less valuable it is to others – Natural resource development can be very valuable to others, especially if much of the groundwork in developing the resource has already been done • Local financing can often reduce political risk Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 18-27 Quick quiz • What does an exchange rate tell us? • What is triangle arbitrage? • What are absolute purchasing-power parity and relative purchasing-power parity? • What are covered interest arbitrage and interest rate parity? • What is the difference between short-run interest rate exposure and long-run interest rate exposure? How can you hedge each type? • What is political risk and what types of businesses face the greatest risk? Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 18-28 Chapter 18 END 18-29 ... Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 18-3 Domestic financial management and international financial management • Considerations... dollars – 210 SGD/(1.8 SGD/$) = $116.67 and repay loan – Profit = 116.67 – 100(1.1) = $6.67 risk free Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e... Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 18-5 International finance terminology (cont.) • Gilts – British and Irish