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Chapter 15 International Business Finance. Key sections Factors affecting exchange rates Nature of exchange risk and types How control exchange risk?. Introduction. Globalization –to make something worldwide in scope/application

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chapter 15 international business finance
Chapter 15International Business Finance

Key sections

  • Factors affecting exchange rates
  • Nature of exchange risk and types
  • How control exchange risk?
introduction
Introduction

Globalization –to make something worldwide in scope/application

  • In finance, integration of countries’ financial and product markets
  • Increases availability of funds and liquidity
  • Made possible by computer and communications technologies
multinational corporations
Multinational Corporations

Multinational corporations or MNC’s

  • Have operations in more than one country
  • Problems: different languages, currencies

financial markets, taxes, cultures, etc.

world trade
World Trade

Trade growing rapidly, capital flows even faster

US Balance of Trade Deficit – 2004- $600 billion, up from less than $500 billion in 2003.

-We are a deficit nation and have to borrow from other countries – Japan and China

- Will they continue to lend? Pressure on the dollar?

exchange rates x rates
Exchange Rates (X-rates)

Price of a foreign currency in terms of the domestic currency

Exchange risk – future rates may be different

Exchange markets –method of transferring purchasing power

  • Extremely active market -trades $1.9 trillion/day
market evolution
Market Evolution

1949-1970 – exchange rates fixed (more or less)

Since 1973 – floating rates

Determined by supply/demand; change minute by minute

Most exchange controls eliminated

the euro
The Euro

1999 – 11 European countries adopted common currency, the Euro (€)

No more DM, FF, Lira

Easier to travel and trade goods and services

Eliminates price differences

Broadens/deepens capital markets

exchange terminology
Exchange Terminology

Devaluation – currency made cheaper

  • Revaluation – becomes more expensive

Direct quote = number of units of home currency to buy one unit of foreign currency

  • 50 US cents to buy one Australian dollar

Indirect – foreign units per home unit

    • Two Aussies for each US$1.
more terminology
More Terminology

Spot rate – rate agreed today for exchange in two days

Forward rate – rate agreed today for future exchange

Cross rates – two foreign currencies for each other

How many yen per British pound?

what determines x rates
What Determines X- Rates?

Market conditions (supply/demand)

Economic situation – growth or no-growth

Balance of Payments – surplus or deficit?

Relative interest rates – high rates attract capital flows

Relative inflation rates

All based on “perceived value”

forward contracts
Forward Contracts

Forward contract requires delivery at a fixed date of fixed amounts of two currencies at a fixed exchange rate

  • This locks in the exchange rate (cost)

Most active markets – 30, 60, 90 day periods but up to ten years

british pound forwards
British Pound Forwards

Direct ($/£)Indirect (£/$)

Spot $1.5315 £ .6530

1 month 1.5285 .6542

3 months 1.5231 .6566

6 months 1.5149 .6601

how do we use forwards
How Do We Use Forwards?

Can buy £ forward today and will know the precise amount due

. Locks in exchange rates

. Protects against future fluctuations

risk and its control
Risk and Its Control

Owe UK supplier £1 million in six months

. Risk comes from writing contract in foreign currency

. One of us is going to have to take risk

forward contract example
£ Forward Contract Example

Spot rate (two day delivery) = $1.5315

Six month forward = $1.5149

Owe £1,000,000 in six months

Buy forward, locks in $1,514,900

  • What if spot is $1.60 in six months without forward?

Cost is $1,600,000 or $85,100 more

  • But what if spot is $1.50? Could have saved $14,900 (if willing to speculate)
hedging risk
Hedging Risk

Hedge – take action to offset risk

Prepay? Gives up interest.

Buy foreign currency denominated asset (bank account)? Probably OK.

Buy forward? Very flexible – customized

Use futures or options? Another possibility

other sources of risk
Other Sources of Risk

Foreign currency receivables

Foreign currency securities in a portfolio

Foreign subsidiaries have foreign currency revenue/expenses and asset/liabilities

measuring exposure to risk
Measuring Exposure to Risk

Assets in foreign currency depreciate if currency devalues

Liabilities also decline

What is the net exposed position?

Translation exposure – translating accounting statements into dollars

Transactions exposure – when receipts or payments are in foreign currency

economic exposure
Economic Exposure

Overall impact on value of the firm or its competitive position

What happens to GM if yen appreciates?

  • Raise prices without losing sales?

- Affected by product, market structure and price elasticity

portfolio investment
Portfolio Investment

Purchase of foreign security – Portfolio

Return unknown – risky

  • In local currency return might be –2% to +8%
  • Exchange rate could change from –4% to +6%
  • For US investor return could range between –6% and +14%

Exchange rates introduce greater variability

direct investment
Direct Investment

Purchase of a company or factory

Worldwide foreign direct investment was $1.4 trillion in 2000

Assets (balance sheet) and income statement kept in local currency

Profits returned in dollars

  • Risk applies to dollar value of assets and the home currency profit stream.
  • Additional risks – business, financial and political
political risk
Political Risk

Expropriation

Inconvertibility

Changes in taxes

Government controls such as required local equity participation

May be possible to hedge with insurance, government or private