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Ch. 22. International Business Finance.  2002, Prentice Hall, Inc. International Business Finance. Exchange Rate: the price of one currency in terms of another. International Business Finance. Exchange Rate: the price of one currency in terms of another.

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ch 22
Ch. 22

InternationalBusiness Finance

 2002, Prentice Hall, Inc.

international business finance
International Business Finance
  • Exchange Rate: the price of one currency in terms of another.
international business finance3
International Business Finance
  • Exchange Rate: the price of one currency in terms of another.
international business finance4
International Business Finance
  • Exchange Rate: the price of one currency in terms of another.
international business finance5
International Business Finance
  • Exchange Rate: the price of one currency in terms of another.
international business finance6
International Business Finance
  • Exchange Rate: the price of one currency in terms of another.
international business finance7
International Business Finance
  • Exchange Rate: the price of one currency in terms of another.
exchange rates
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.
exchange rates9
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.
exchange rates10
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.
exchange rates11
Exchange Rates

Exchange rates affect our economy and each of us because:

exchange rates12
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.
exchange rates13
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
exchange rates14
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.
spot exchange rates
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)

(note: direct and indirect quotes are reciprocals)

what determines exchange rates
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
what determines exchange rates17
What Determines Exchange Rates?

Supply and Demand for currencies!

Let’s consider the £ / $ market.

what determines exchange rates18
What Determines Exchange Rates?

Supply and Demand for currencies!

Let’s consider the £ / $ market.

what determines exchange rates19
What Determines Exchange Rates?

Supply and Demand for currencies!

Let’s consider the £ / $ market.

what determines exchange rates20
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.

what determines exchange rates21

Supply of

Dollars

Demand for Dollars

Quantity of dollars

What Determines Exchange Rates?

£ / $

(price of

dollars)

what determines exchange rates22

Supply of

Dollars

Demand for Dollars

Quantity of dollars

What Determines Exchange Rates?

£ / $

(price of

dollars)

what determines exchange rates23
What Determines Exchange Rates?

Another example:

Let’s consider the ¥ / $ market.

what determines exchange rates24
What Determines Exchange Rates?

Another example:

Let’s consider the ¥ / $ market.

what determines exchange rates25
What Determines Exchange Rates?

Another example:

Let’s consider the ¥ / $ market.

what determines exchange rates26
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.

what determines exchange rates27

Supply of

Dollars

¥ / $

(price of

dollars)

Demand for Dollars

Quantity of dollars

What Determines Exchange Rates?
what determines exchange rates28

Supply of

Dollars

¥ / $

(price of

dollars)

Demand for Dollars

Quantity of dollars

What Determines Exchange Rates?
foreign exchange markets
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 francs to buy imports, and the spot exchange rate is .1457, you would pay your bank $72,850.
foreign exchange markets30
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!
forward market hedge
Forward Market Hedge

Example: You will import wine from France, to be delivered and paid for in 6 months.

  • You have agreed to a price of 500,000francs. With the spot exchange rate of .1457, this comes to $72,850.
  • Suppose the dollar weakens over the next 6 months, and the $/F exchange rate rises to .20.
  • The wine would cost you $100,000. This is an example of foreign exchange risk!
forward market hedge32
Forward Market Hedge

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

  • The 6-months $/F 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 francs, 6 months from now.
  • Now it doesn’t matter what happens to the $/F exchange rate over the next 6 months.
money market hedge
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 francs now (at the current spot exchange rate of .1457) for $72,850.

3) Invest the 500,000 francs in interest-bearing French securities.

4)Complete your transaction after 6 months.

[Borrowing and investment rates determine cost of hedge]

forward spot differential
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.

forward spot differential35
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

forward spot differential36
Forward-Spot Differential

For our example,

forward spot differential37

= [ ] [ ]x 100

Forward-Spot Differential

For our example,

premium forward - spot 12

or discount spot n

forward spot differential38

= [ ] [ ]x 100

= [ ] [ ]x 100

Forward-Spot Differential

For our example,

premium forward - spot 12

or discount spot n

.1476 - .1457 12

.1457 6

forward spot differential39

= [ ] [ ]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.

interest rate parity
Interest Rate Parity

Links the forward exchange market with the spot exchange market. The idea:

The annual percentage difference between the forward rate and the spot rate (forward premium or discount) is approximately equal to the difference in interest rates between the two countries.

Arbitrage in the forward and spot markets helps to hold this relationship in place.

purchasing power parity
Purchasing Power Parity

Links changes in exchange rates with differences in inflation rates and the purchasing power of each nation’s currency.

  • In the long run, exchange rates adjust so that the purchasing power of each currency tends to be the same.
  • Exchange rate changes tend to reflect international differences in inflation rates.
  • Countries with high inflation tend to experience currency devaluation.
the law of one price
The Law of One Price

In competitive markets where there are no transportation costs or barriers to trade, the same goods sold in different countries sell for the same price if all the different prices are expressed in terms of the same currency.

  • This proposition underlies the PPP relationship.
  • Arbitrage allows the law of one price to hold for commodities that can be shipped to other countries and resold.
exchange rate risk
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.
exchange rate risk44
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.
multinational working capital management
Multinational Working-Capital Management

Leading and Lagging

  • Lead: dispose of a net asset position in a weak currency.
  • Pay a net liability position in a weak currency.
  • Lag: Delay collection of a net asset position in a strong currency.

Delay payment of a net liability position in a weak currency.

direct foreign investment
Direct Foreign Investment

Risks

  • Business Risk - firms must be aware of the business climate in both the U.S. and the foreign country.
  • Financial Risk - not much difference between financial risks of foreign operations and those of domestic operations.
direct foreign investment47
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.