Welcome to class of International Finance/Forces by Dr. Satyendra Singh University of Winnipeg Canada

1. Welcome to class ofInternational Finance/ForcesbyDr. Satyendra SinghUniversity of WinnipegCanada

2. Outline • Purchasing Power Parity • Factors affecting Foreign currency • Fisher’s Effect • Arbitrage • Hedge (Forward, Currency option, Money Market) • Transfer Pricing • Swap (Parallel loan, Bank, Currency) • Debt vs. Equity • Impact of Culture on Accounting • Accounting Standards

3. Purchasing Power Parity (PPP)… • The number of units of a currency required to buy the same amount of goods and services in a domestic market that $1.00 would buy in the U.S. • Helps to make comparisons possible across economies CIA Fact Book

4. Purchasing Power Parity (PPP) If, 1 Lt. Milk US $1.00 1 Lt. Milk India Rs. 20.00 Then, PPP: US $1 = Rs. 20 Reality: US $1 = Rs. 40 ie Rs. Is 50% undervalued –artificially?!

5. Factors affecting Foreign Currency • Three factors: • Inflation • Interest rate • Speculation • Fisher’s Effect • Diff. in interest rate may determine strength of FOREX € 1 = $1.5, Interest rate: € (3%) and $(5%) Speculation: Which currency becomes weaker/stronger?

6. Atlas Conversion Factor • It is used for speculation Average of FOREX for the last 2 years adjusted by the ratio of domestic inflation and combined inflation of US, UK, EU and Japan

7. Arbitrage: The process of buying and selling instantaneously to make profit at no risk Brazil Riel 1:3 1:2 5 dinar Chile Peso Algeria Dinar 1:5

8. Transaction Exposure: Hedging • Hedging • process to reduce or eliminate financial risk • Forward market hedge • Foreign currency contract sold or bought forward in order to protect against foreign currency movement • Currency option hedge • Option to buy or sell specific amount of foreign currency at specific time to protect against foreign currency risk • Money market hedge • Method to hedge foreign currency exposure by borrowing and lending in domestic and foreign money markets

9. Forward Hedge • Hedge is a process to reduce risk € 1 = $1.5 (now/spot) $ is expected to be weak € 1 = $1.6 (speculate/forward) Interest rate: € (3%) and $(5%) Suppose you have accounts receivables for €20,000 If quoted in €, supplier has no problem (ie. Risk prone) If quoted in $ (ie € 20,000 x 1.5 = $30,000), You now get $ (ie € 20,000 x 1.6 = $32,000) You gain: $2000, because $ became weak You lose, if $ became stronger (say 1.4) = $2,000

10. Currency Option Hedge • So you have accounts receivables in a currency that works best for your company

11. Money Market Hedge • Counter balancing the risk by borrowing the same amount for FOREX (A/R) in domestic market and investing it until accounts receivables are received Suppose the AR is €20,000 (in 90 days) € 1 = $1.4 (expected) $ is expected to be strong! € 1 = $1.5 (now) Interest rate: € (5%) and $(3%) Borrow €20,000  convert in $ (€ 20,000 x 1.5 = $30,000)  Invest  Income (but pay interest) After 90 days, pay €20,000 to local bank, so no debt So, Investment + income - interest ≥ €20,000

12. Source: Wall Street Journal, Exchange rate June 19, 2006 Fri: June 16 (SPOT) Mon: June 19 (FORWARD)

13. Movement of $, Transfer Pricing Customer $10 Profit $9 Local business Say, 30% tax $6.30 Net profit $2.70 tax $1 Supplier

14. Movement of $, Transfer Pricing Customer $10 $9 $8 Local business Foreign $1 Now profit $1 Say, 30% tax 30 Cents tax! Supplier

15. Movement of $, Transfer Pricing – 3 countries UK OFC: Jamaica USA $100 to produce $200 Sells at $200 $100 sold Profit $100 Tax 50% Tax 5% Tax 30% Tax paid $0 Tax paid $5 Tax paid $0

16. OFC: Offshore Ffinancial Centres • Offshore financial center specializes in financing nonresidents, low taxes and few banking regulations • Too small to exist on its own • Boosts economy • Employment • Switzerland • Cayman Island • Hong Kong • Bahamas • Bermuda • Gibraltar • Luxemburg • …

17. Swaps • Parallel Loans • Matched loans across currencies made to cover risk • Bank Swap • Swap made between banks to acquire temporary foreign currencies • Currency Swap • Exchange of debt service of loan or bond in one currency for debt service of loan or bond in another currency

18. Parallel Loan Swap $1m CANADA: Canada (parent) India (child) INDIA: Canada (child) India (parent) Rs. 40m $1 = Rs. 40

19. Bank Swap $1m Canadian parent in Canada Canadian Bank in Canada Rs. 40m Indian Bank in India Canadian child in India • Canadian Parent deposits $1m to the credit of the Indian Bank • The Correspondent Indian Bank lends Rs. 40m (spot rate) to the Child • At a later agreed date, the Child returns Rs. 40m to Indian Bank • Indian Bank instructs the Canadian Bank to pay $1m to the Parent So, no conversion of $1 to Rs. Useful if you want hard currency only

20. Currency Swap CANADA CYPRUS I am Known here Same is true for So the interest rate is low for me the Cypriot person in Cyprus So, I take the loan for the Cypriot guy Person does the In Canada at low interest rate same for me in $1.5m Cyprus (€ 1m) Then, we swap currency, i.e., I service the loan in € for the Cypriot guy in CYPRUS And the Cypriot guy services my loan in $ in Canada € 1 = $1.5

21. Capital Structure of a Firm • Debt  Borrow from Bank • Conservative, report less, ↓ tax exposure, ↑ dividend pay outs  save $ to service debt  France, Germany, Japan, some Emerging Markets • Debt financing is less expensive than equity financing, because interest paid on debt is tax deductable, but dividends paid out to shareholders are not. • Equity  Shares, Bonds • Impressive (Inflated report) to attract investors • Value of Bond ↓, if interest rate ↑

22. How do Bonds perform? Suppose, now you have bonds worth $10,000 @5% for a year So expect $500 at the end of the year Now, interest rate changed to 6% Value of your bond now is: $x x.06 = $500 ie x = $8334 Drop in value = 17%!

23. Cultural Differences in Measurement and Disclosure for Accounting Systems

24. Annual Reports • Depends • Calculation of Inventory • Depreciation • Income only when contract is complete • Valuation of assets • Goodwill • … • So we need uniform accounting system

25. International Accounting Standards • Triple Bottom Line Standard (3BL) • Environmental, social, and financial impacts of the business • International Accounting Standards Board (IASB) • International Financial Reporting Standards (IFRS) • Sarbans-Oxley Act (2002, US) • Public Company Accounting Reform and Investor Protection Act (in the Senate) • Corporate and Auditing Accountability and Responsibility Act (in the House) • Heavy penalty for corporate finance fraud

26. Use of International Financial Reporting Standards (IFRS)

27. Tax System • Direct Tax • Income Tax • VAT – Value Added Tax • Indirect Tax (Withholding Tax) • Dividend • Interest • Royalty