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International Finance. Chapter 18. © 2003 South-Western/Thomson Learning. Globalization of Business. Imports and exports have increased substantially since the 1960s Many U.S. companies are now multi-national companies Own facilities and equipment and produce goods in another country

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International Finance

Chapter 18

© 2003 South-Western/Thomson Learning

Globalization of Business

  • Imports and exports have increased substantially since the 1960s

  • Many U.S. companies are now multi-national companies

    • Own facilities and equipment and produce goods in another country

    • Virtually all large companies have some international dealings

  • Many investors now view having investments in foreign stocks as part of a ‘normal’ portfolio

  • Foreigners currently invest more in the US than we invest abroad

Currency Exchange

  • When paying a bill (such as an invoice for goods purchased in a foreign country) the payee expects to be paid in the currency of his country

  • So, payer has to obtain foreign currency

    • U.S. manufacturer would have to exchange U.S. dollars for foreign currency (say, Japanese Yen)

The Foreign Exchange Market

  • U.S. company would purchase Yen in the foreign exchange market

    • Basically a network of brokers/banks based in financial centers around the world

  • Most commercial banks can access the foreign exchange market and purchase/sell currency for their customers

Exchange Rates

  • An exchange rate states the price of one currency in terms of another

  • A table of exchange rates shows two reciprocal rates for each currency

Exchange Rates

  • If a U.S. company owed 75,000 German marks, how much would this cost in U.S. dollars?

    • 75,000 German marks  0.4581 = $34,357.5

Represents an indirect quote—the inverse of a direct quote—how many units $1 U.S. will buy.

Represents a direct quote—how many U.S. dollars are required to buy one unit of foreign currency.

Exchange Rates

  • Cross Rates

    • It is possible to develop an exchange rate between any two currencies without going through U.S. dollars

    • How many Canadian Dollars (CAD) will 1 Yen buy?

      • $1US = 121.19 Yen (or $XUS = 1 Yen)

      • $1US = 1.5921 CAD (or $XUS = 1 CAD)

      • 121.19 Yen = 1.5921 CAD

      • 1 Yen = 0.013137 CAD (or 1CAD will buy 76.12 Yen)

        • Dollars per Yen  Dollars per CAD =

        • .00825151 0.62810 = 0.013137 CAD per Yen

Changing Exchange Rates and Exchange Rate Risk

  • Exchange rates are constantly changing

    • Sometimes rapidly and significantly

  • Fluctuating exchange rates give rise to exchange rate risk

  • Exchange rate risk is the chance of gain or loss from exchange rate movements that occur during a transaction

Q: An American company orders 500 sweaters on 9/07/01 from a German company at a cost of 55,000 marks with terms of n/60. The exchange rate at that time was $0.4579 U.S. per mark. Calculate the gain or loss on the transaction if the bill was not paid until 11/7/01, when the exchange rate was $0.4581 U.S. per mark.

A:If the bill had been paid on 9/07/01 at the then current exchange rate, the cost would have been $25,184.5, or 55,000 marks  0.4579. However, if the bill was not paid until 11/7/01 at the then current exchange rate, the price would have been $25,195.5, or 55,000 marks  0.4579. Thus, an $11 loss would have resulted due to the slight shift in exchange rates over the two months.


Changing Exchange Rates and Exchange Rate Risk—Example

Changing Exchange Rates and Exchange Rate Risk

  • The change in exchange rates affects the profitability of the firm

    • If the rate goes against the firm (the foreign currency strengthens—$1 U.S. will buy fewer foreign currency or 1 unit of foreign currency will buy more U.S.dollars) the profitability will decrease and vice versa

Spot and Forward Rates

  • The spot rate is the exchange rate for the immediate (on-the-spot) delivery of a currency

  • The forward market is the price for currencies to be delivered in the future

    • Major currencies have well-developed forward markets (1, 3 and 6 months forward)

Spot and Forward Rates

  • The spot rates are a bit different from the forward rates

    • This difference reflects the movement that the foreign exchange brokers expect in the future relationship of the currencies

  • When a foreign currency is expected to become less (more) valuable in the future, the forward currency is said to be selling at a discount (premium)

  • Terminology of Exchange Rate Movements

    • When a currency becomes more (less) valuable in terms of dollars, it is becoming stronger (weaker), or rising (falling) against the dollar

Hedging with Forward Exchange Rates

  • Exchange rate risk can be eliminated by hedging with a forward contract

  • If a company knows it will need a foreign currency in the future it can lock in an exchange rate

    • Eliminates the uncertainty as to the price that will be paid for the currency

  • Can be done by buying the currency at the forward rate

Supply and Demand—The Source of Exchange Rate Movement

  • An exchange rate is just the price of a particular currency

  • The price of that currency will fluctuate with supply & demand, like any other commodity

  • What determines the supply and demand for exchange rates?

    • Primarily stems from trade and the flow of investment capital between nations

      • For example, a strong Yen means the demand for US goods in Japan will rise (because US goods will become cheaper in Japanese Yen)

        • As US goods become cheaper in Japan, demand for U.S. goods will increase (exports from US to Japan will rise)

Why the Exchange Rate Moves

  • What factors have an influence on the demand for a country’s products and investments?

    • Preferences in consumption

      • In the 1980s U.S. consumers perceived Japanese cars as more reliable and durable

      • Japanese electronics were once perceived as inferior, but no longer

    • Government policy

      • Impose quotas, tariffs

Why the Exchange Rate Moves

  • Economic conditions

    • Expansion vs recession

    • Level of interest rates

      • Countries with high interest rates attract more investors which increases the demand for that country’s currency

    • Inflation

      • High levels of inflation can cause a country’s currency to lose value quickly

  • Speculation (trading in a currency just for the sake of profit—not because you need the currency to pay bills)

  • Direct Government Intervention

    • Government purposefully tries to keep currency trading in a certain range

Governments and the International Monetary System

  • When a currency strengthens relative to another two things happen

    • The prices of the foreign good become cheaper

      • Demand for foreign products increases

    • Domestic products become more expensive in foreign countries

      • Demand for domestic products declines

Governments and the International Monetary System

  • Government Influence on Exchange Rates

    • Governments occasionally intervene to keep rates within reasonable limits

      • Government buys/sells their own currency in foreign exchange market to either increase/decrease demand to affect exchange rate

      • Ability to support a weakening currency is limited because government has to pay for purchases of its own money with gold or foreign exchange

        • These sources are limited

International Monetary System

  • A floating exchange rate system exists today

    • Exchange rates are allowed to fluctuate based on demand/supply in the free market

  • Prior to 1970s world had a fixed exchange rate system

    • Rates were fixed by international treaty and each country was required to hold the exchange rate nearly constant (relative to USD)

      • Countries bought/sold their currency to maintain exchange rate

    • After World War II it became impossible to maintain certain exchange rates

    • A country may experience a revaluation or devaluation to keep its exchange rate constant


  • Not all currencies are convertible to other currencies using processes discussed in this chapter

    • For these processes to work a nation has to agree to allow the currency to be traded in the foreign currency markets

      • Russia and China have not traditionally had convertible currencies

  • For example, some currencies you can exchange at the official exchange rate but on the street no one is willing to use that rate

  • Inconvertibility is an impediment to international trade

The Balance of Trade

  • The net flow between two countries from trade is known as the balance of trade

  • If we import (export) more from a country than we export (import) a trade deficit (trade surplus) exists

    • Our currency accumulates in that country

      • The available pool of the deficit country’s currency tends to weaken the value of its currency

        • Should make the deficit nation’s exports cheaper in the surplus nation, bringing trade back in balance

International Capital Markets

  • Many individuals and businesses invest in countries other than their own

  • U.S. dollar is the world’s leading currency

    • Serves as “international money”

    • People have more confidence in its continuing value than any other currency

  • Many international contracts are denominated in U.S. dollars even though none of the parties of the contract are American

The Eurodollar Market

  • Eurodollars are American dollar deposits in foreign banks

    • Loaned to international businesses in the eurodollar market

      • Borrowers use Eurodollars to

        • Pay for U.S. exports

        • Invest in American stocks and bonds

        • Medium of exchange between parties that don’t want to deal in their own currencies

  • Don’t have to be in European banks—can be anywhere in the world

    • Practice started in Europe—hence the name

The International Bond Market

  • Companies can borrow internationally by selling bonds outside their own country

    • Called international bonds

  • Bond can be denominated in

    • The currency of the issuing company’s home country (Euro bond)

    • The currency of the country in which it is sold (foreign bond)

    • A third currency

The International Bond Market

  • Most Eurobonds are denominated in American dollars

  • Securities regulations require lower levels of disclosure—lowers issuing costs

  • Eurobonds are issued in bearer form—owner is not identified

  • Most governments don’t withhold income taxes on Eurobonds

Political Risk

  • Political risk is the chance that a foreign government will expropriate property or that terrorists will destroy it

  • Other examples of value-reducing foreign risk exposure include

    • Raising taxes

    • Limiting the amount of profit that can be withdrawn from the country

    • Requiring key inputs be purchased from local suppliers at arbitrary prices

    • Limit the prices charged for the product sold within the country

    • Require part ownership by citizens of the host country

    • Terrorist activities, including kidnapping key executives

Transaction and Translation Risks

  • Translation gains/losses arise when assets and liabilities held in a foreign country are translated into dollars

    • Translating the financial statements of a foreign subsidiary into the local currency of the parent company

      • Especially troublesome for the balance sheet

  • The Relevance of Translation Gains and Losses

    • Translation gains/losses are only paper gains/losses—they are not realized

    • Shown cumulatively in an account that adds or subtracts to stockholders’ equity

    • Not taxable since they are not realized

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