Chapter 15International 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 • 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 or MNC’s • Have operations in more than one country • Problems: different languages, currencies financial markets, taxes, cultures, etc.
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) 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 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 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 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$1.
More Terminology Spot rate – rate agreed today for exchange in two days Forward rate – rate agreed today for future exchange Cross rates – two foreign currencies for each other How many yen per British pound?
What Determines X- Rates? Market conditions (supply/demand) Economic situation – growth or no-growth Balance of Payments – surplus or deficit? Relative interest rates – high rates attract capital flows Relative inflation rates All based on “perceived value”
Forward Contracts Forward contract requires delivery at a fixed date of fixed amounts of two currencies at a fixed exchange rate • This locks in the exchange rate (cost) Most active markets – 30, 60, 90 day periods but up to ten years
British Pound Forwards Direct ($/£)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? Can buy £ forward today and will know the precise amount due . Locks in exchange rates . Protects against future fluctuations
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 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 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 Foreign currency receivables Foreign currency securities in a portfolio Foreign subsidiaries have foreign currency revenue/expenses and asset/liabilities
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 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 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 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 Expropriation Inconvertibility Changes in taxes Government controls such as required local equity participation May be possible to hedge with insurance, government or private