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Chapter 15. International Business Finance. International Business Finance. Exchange Rate: the price of one currency in terms of another. Exchange Rates. Exchange rates affect our economy and each of us because:

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International Business Finance

  • Exchange Rate: the price of one currency in terms of another.


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Exchange Rates

Exchange rates affect our economy and each of us because:

  • 1) When the dollar appreciates (strong dollar), the dollar becomes more valuable relative to other currencies.


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Exchange Rates

Exchange rates affect our economy and each of us because:

  • 1) When the dollar appreciates (strong dollar), the dollar becomes more valuable relative to other currencies.

    • Foreign products become cheaper to us.


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Exchange Rates

Exchange rates affect our economy and each of us because:

  • 1) When the dollar appreciates (strong dollar), the dollar becomes more valuable relative to other currencies.

    • Foreign products become cheaper to us.

    • U.S. products become more expensive overseas.


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Exchange Rates

Exchange rates affect our economy and each of us because:


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Exchange Rates

Exchange rates affect our economy and each of us because:

  • 2) When the dollar depreciates (weak dollar), the dollar falls in value relative to other currencies.


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Exchange Rates

Exchange rates affect our economy and each of us because:

  • 2) When the dollar depreciates (weak dollar), the dollar falls in value relative to other currencies.

    • Foreign products become more expensive for us, and


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Exchange Rates

Exchange rates affect our economy and each of us because:

  • 2) When the dollar depreciates (weak dollar), the dollar falls in value relative to other currencies.

    • Foreign products become more expensive for us, and

    • U.S. products become cheaper overseas.


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Spot Exchange Rates

£ / $ = .6284 (it takes .6284 pounds to = $1)

$ / £ = 1.5913 (it takes $1.5913 to = 1 pound)

¥ / $ = 102.98 (it takes 102.98 yen to = $1)

$ / ¥ = .009711 ( it takes $.009711 to = 1yen)

Real Time Exchange Rates

(note: direct and indirect quotes are reciprocals)


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What Determines Exchange Rates?

Floating Rate Currency System: Since 1973, the world has allowed exchange rates to change daily in response to market forces.

Exchange rates are affected by:

  • foreign investors,

  • speculators,

  • political conditions here and overseas,

  • inflation,

  • trade policies (tariffs and quotas), and


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What Determines Exchange Rates?

Supply and Demand for currencies!

Let’s consider the £ / $ market.


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What Determines Exchange Rates?

Supply and Demand for currencies!

Let’s consider the £ / $ market.


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What Determines Exchange Rates?

Supply and Demand for currencies!

Let’s consider the £ / $ market.


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What Determines Exchange Rates?

Suppose the British increase demand for U.S. products.

British importers buy the U.S. products to sell in England. They buy dollars with pounds, so they can pay U.S. firms in dollars.

The demand for dollars increases, and forces up the £ / $ exchange rate, which makes U.S. products more expensive in England.


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Supply of

Dollars

Demand for Dollars

Quantity of dollars

What Determines Exchange Rates?

£ / $

(price of

dollars)


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Supply of

Dollars

Demand for Dollars

Quantity of dollars

What Determines Exchange Rates?

£ / $

(price of

dollars)


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What Determines Exchange Rates?

Another example:

Let’s consider the ¥ / $ market.


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What Determines Exchange Rates?

Another example:

Let’s consider the ¥ / $ market.


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What Determines Exchange Rates?

Another example:

Let’s consider the ¥ / $ market.


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What Determines Exchange Rates?

Suppose American demand for Japanese cars and stereos increases rapidly.

American importers buy the Japanese products to sell in the U.S. They buy yen with dollars, so they can pay Japanese firms in yen.

The supply of dollars increases, and forces down the ¥ / $ exchange rate, which makes Japanese products more expensive in the U.S.


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Supply of

Dollars

¥ / $

(price of

dollars)

Demand for Dollars

Quantity of dollars

What Determines Exchange Rates?


What determines exchange rates24 l.jpg

Supply of

Dollars

¥ / $

(price of

dollars)

Demand for Dollars

Quantity of dollars

What Determines Exchange Rates?


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Foreign Exchange Markets

Different exchange rates are used for different types of transactions:

  • 1) Spot Exchange Market: deals with currency for immediate delivery.

  • The exchange rate used in spot transactions is called the spot exchange rate.

  • If you need 500,000 Norwegian Krones to buy imports, and the spot exchange rate is .1457, you would pay your bank $72,850.


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Foreign Exchange Markets

2) Forward Exchange Market: deals with the future delivery of foreign currency.

  • You can buy or sell currency for future delivery, usually in 1, 3, or 6 months.

  • The exchange rate for forward transactions is called the forward exchange rate.

  • Forward exchange contracts allow you to hedge foreign exchange risk!


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Forward Market Hedge

Example: You will import fish from Norway, to be delivered and paid in 6 months.

  • You have agreed to a price of 500,000 krones. With the spot exchange rate of .1457, this comes to $72,850.

  • Suppose the dollar weakens over the next 6 months, and the $/NOK exchange rate rises to .20.

  • The fish would cost you $100,000. This is an example of foreign exchange risk!


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Forward Market Hedge

You decide to hedge your risk with a forward exchange contract!

  • The 6-months $/NOK forward exchange rate is .1476. By agreeing to this forward rate with your bank, you lock in a price of $73,800 for 500,000 krones, 6 months from now.

  • Now it doesn’t matter what happens to the $/NOK exchange rate over the next 6 months.


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Money Market Hedge

For the previous problem, another potential solution is the money market hedge.

1) Borrow $72,850 from your bank.

2) Buy the 500,000 kroners now (at the current spot exchange rate of .1457) for $72,850.

3) Invest the 500,000 kroners in interest-bearing Norwegian securities.

4)Complete your transaction after 6 months.

[Borrowing and investment rates determine cost of hedge]


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Forward-Spot Differential

If the forward rate > the spot rate, the forward is trading at a premium.

If the forward rate < the spot rate, the forward is trading at a discount.


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Forward-Spot Differential

If the forward rate > the spot rate, the forward is trading at a premium.

If the forward rate < the spot rate, the forward is trading at a discount.

premium forward - spot 12

or discount spot n

= [ ] [ ]x 100


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Forward-Spot Differential

For our example,


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= [ ] [ ]x 100

Forward-Spot Differential

For our example,

premium forward - spot 12

or discount spot n


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= [ ] [ ]x 100

= [ ] [ ]x 100

Forward-Spot Differential

For our example,

premium forward - spot 12

or discount spot n

.1476 - .1457 12

.1457 6


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= [ ] [ ]x 100

= [ ] [ ]x 100

Forward-Spot Differential

For our example,

premium forward - spot 12

or discount spot n

.1476 - .1457 12

.1457 6

= 2.6. The forward is trading at a 2.6%

premium.


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Exchange Rate Risk

  • Translation exposure - foreign currency assets and liabilities that, for accounting purposes, are translated into domestic currency using the exchange rate, are exposed to exchange rate risk.

  • However, if markets are efficient, investors know that any translation losses are “paper” losses and are unrealized.


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Exchange Rate Risk

  • Transaction exposure - refers to transactions in which the monetary value is fixed before the transaction actually takes place.

  • Ex: your firm buys foreign goods to be received and paid for at a later date. The exchange rate can change, which can affect the price actually paid.


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Direct Foreign Investment

Risks

  • Business Risk - firms must be aware of the business climate in both the US and the foreign country.

  • Financial Risk - not much difference between financial risks of foreign operations and those of domestic operations.


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Direct Foreign Investment

Risks

  • Political Risk - firms must be aware that many foreign governments are not as stable as the U.S.

  • Exchange Rate Risk - exchange rate changes can affect sales, costs of goods sold, etc. as well as the firm’s profit in dollars.


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