Chapter 28 PrinciplesPrinciples

ofof

CorporateCorporate

FinanceFinance

Ninth Edition

Managing International Risks

Slides by

Matthew Will

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved

McGraw Hill/Irwin

28- 2

Topics Covered

Foreign Exchange MarketsSome Basic RelationshipsHedging Currency RiskExchange Risk and International

Investment DecisionsPolitical Risk

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Exchange Rates

Spot Rate * 1 Month 3 Months 1 Year

EuropeEMU (euro) 1.3549 1.3565 1.3595 1.3689Norway (krone) 5.9566 5.9514 5.9436 5.9377Sweden (krona) 6.8028 6.7915 6.7705 6.7041Switzerland (franc) 1.213 1.2099 1.2038 1.1812United Kingdom (pound) 1.9901 1.99 1.9892 1.9811Americas:Canada (dollar) 1.1309 1.1298 1.1278 1.1208Mexico (peso) 10.9892 11.0055 11.0408 11.2274Pacific/ Africa:Hong Kong (dollar) 7.8129 7.8071 7.7916 7.7429Japan (yen) 1119.795 119.33 118.397 114.571South Africa (rand) 7.0942 7.116 7.162 7.3807South Korea (won) 903.55 929.85 928.45 923.65

Forward Rate *

April 16, 2007

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Foreign Exchange Markets

Exchange Rate - Amount of one currency needed to purchase one unit of another.

Spot Rate of Exchange - Exchange rate for an immediate transaction.

Forward Exchange Rate - Exchange rate for a forward transaction.

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Foreign Exchange Markets

Forward Premiums and Forward DiscountsExample - The Peso spot price is 10.9892 peso per

dollar and the 3 month forward rate is 11.0408 Peso per dollar, what is the premium and discount relationship?

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Foreign Exchange Markets

Forward Premiums and Forward DiscountsExample - The Peso spot price is 10.9892 peso per

dollar and the 3 month forward rate is 11.0408 Peso per dollar, what is the premium and discount relationship?

-1.90%=1-11.0408

10.98924

)(-Discountor Premium=1-Price Forward

PriceSpot

T

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Foreign Exchange Markets

Forward Premiums and Forward DiscountsExample - The Peso spot price is 10.9892 peso per dollar and the 3 month

forward rate is 11.0408 Peso per dollar, what is the premium and discount relationship?

Answer - The dollar is selling at a 1.90% premium, relative to the peso. The peso is selling at a 1.90% discount, relative to the dollar.

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Exchange RatesExample

Swiss franc spot price is SF SF 1.4457 per $1

Swiss franc 6 mt forward price is SFSF1.4282 per $1

The franc is selling at a Forward Premium

The Dollar is selling at a Forward Discount

This means that the market expects the dollar to get weaker, relative to the franc

Example (premium? discount?)

The Japanese Yen spot price is 101.18 per $1

The Japanese 6mt fwd price is 103.52 per $1

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Exchange Rates

Example

What is the franc premium (annualized)?franc Premium = 2 x ( 1.4457 - 1.4282) = 2.45%

1.4282

Dollar Discount = 2.45%

Example

What is the Yen discount (annualized)?

Yen Discount = 2 x ( 103.52 - 101.18) = 4.26%

103.52

Dollar Premium = 4.26%

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Exchange Rate Relationships

Basic Relationships

1 + r

1 + rforeign

$

1 + i

1 + iforeign

$

f

Sforeign / $

foreign / $

E(s

Sforeign / $

foreign / $

)

equals

equals

equals equals

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Exchange Rate Relationships

1) Interest Rate Parity Theory

The ratio between the risk free interest rates in two different countries is equal to the ratio between the forward and spot exchange rates.

1 + r

1 + r=

foreign

$

f

Sforeign / $

foreign / $

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Exchange Rate Relationships

Example - You have the opportunity to invest $1,000,000 for one year. All other things being equal, you have the opportunity to obtain a 1 year Mexican bond (in peso) @ 7.35 % or a 1 year US bond (in dollars) @ 5.05%. The spot rate is 10.9892 peso:$1 The 1 year forward rate is 11.2274 peso:$1

Which bond will you prefer and why?

Ignore transaction costs

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Value of US bond = $1,000,000 x 1.0122 = $1,050,500

Value of Mexican bond = $1,000,000 x 10.9892 = 10,989,200 peso exchange

10,989,200 peso x 1.0735 = 11,796,906 peso bond pmt

11,796,906 peso / 11.2274= $1,050,725 exchange

Exchange Rate Relationships

Example - You have the opportunity to invest $1,000,000 for one year. All other things being equal, you have the opportunity to obtain a 1 year Mexican bond (in peso) @ 7.35 % or a 1 year US bond (in dollars) @ 5.05%. The spot rate is 10.9892 peso:$1 The 1 year forward rate is 11.2274 peso:$1

Which bond will you prefer and why? Ignore transaction costs

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Exchange Rate Relationships

2) Expectations Theory of Exchange Rates

Theory that the expected spot exchange rate equals the forward rate.

f

Sforeign / $

foreign / $

=E(s

Sforeign / $

foreign / $

)

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Exchange Rate Relationships

3) Purchasing Power Parity

The expected change in the spot rate equals the expected difference in inflation between the two countries.

1 + i

1 + i=

foreign

$

E(s

Sforeign / $

foreign / $

)

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Exchange Rate Relationships

Example - If inflation in the US is forecasted at 2.5% this year and Mexico is forecasted at 4.5%, what do we know about the expected spot rate?

Given a spot rate of 10.9892 peso:$1

solve for Es

Es = 11.204

foreign/$

foreign/$

$

foreign )=

i+1

i+1

S

E(s

10.9892

E(s )=

.025+1

.0451 foreign/$

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Exchange Rate Relationships

4) International Fisher effect

The expected difference in inflation rates equals the difference in current interest rates.

Also called common real interest rates

1 + r

1 + r=

foreign

$

1 + i

1 + iforeign

$

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Exchange Rate Relationships

Example - The real interest rate in each country is about the same

.027 =1-1.045

1.0735=

i+1

r+1)(

foreign

foreignrealr

.025=1-1.025

1.0505=

i+1

r+1)(

$

$realr

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Exchange RatesAnother Example

You are doing a project in Switzerland which has an initial cost of $100,000. All other things being equal, you have the opportunity to obtain a 1 year Swiss loan (in francs) @ 8.0% or a 1 year US loan (in dollars) @ 10%. The spot rate is 1.4457sf:$1 The 1 year forward rate is 1.4194sf:$1

Which loan will you prefer and why? Ignore transaction costs

Cost of US loan = $100,000 x 1.10 = $110,000

Cost of Swiss Loan = $100,000 x 1.4457 = 144,570 sf exchange

144,570 sf x 1.08 = 156,135 sf loan pmt

156,135 sf / 1.4194 = $110,000 exchange

If the two loans created a different result, arbitrage exists!

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Exchange Rates

Swiss Example

Given a spot rate of sf:$ 1.4457:$1

Given a 1yr fwd rate of 1.4194:$1

If inflation in the US is forecasted at 4.5% this year, what do we know about the forecasted inflation rate in Switzerland?

E (Sf/$) = E ( 1 + if )

Sf/$ E ( 1 + i$ )

solve for i

1.4194 = E( 1 + i) i = .026 or 2.6%1.4457 1 + .045

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Exchange Rates

Swiss Example In the previous examples, show the equilibrium of

interest rates and inflation rates

1 + rf = 1.08 = .9818

1 + r$ 1.10

E ( 1 + if ) = 1.026 = .9818

E ( 1 + i$ ) 1.045

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Forward Rate vs. Actual Spot Rate

Percent error in the one month forward rate for Swiss Franc per US $ compared to actual spot rate

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International Prices

CountryLocal Price Converted

to U.S. Dollars CountryLocal Price Converted

to U.S. Dollars

Canada 3.08 Philippines 1.74China 1.41 Russia 1.85Denmark 4.84 South Africa 2.14Euro area 3.82 Switzerland 5.05Japan 2.31 United Kingdom 3.9Mexico 2.66 United States 3.22

CountryLocal Price Converted

to U.S. Dollars CountryLocal Price Converted

to U.S. Dollars

Canada 3.08 Philippines 1.74China 1.41 Russia 1.85Denmark 4.84 South Africa 2.14Euro area 3.82 Switzerland 5.05Japan 2.31 United Kingdom 3.9Mexico 2.66 United States 3.22

The Big Mac Index – The price of a Big Mac in different countries (Feb 1, 2007)

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Purchasing Power & Exchange Rates

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Exchange Rates

Nominal versus Real Exchange Rates

U.S. Dollar / UK (in log

scale)

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Exchange Rates

Nominal versus Real Exchange Rates

U.S. Dollar / France (in log scale)

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Exchange Rates

Nominal versus Real Exchange Rates

U.S. Dollar / Italy (in log

scale)

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Interest Rates and Inflation

Countries with the highest interest rates generally have the highest inflation rates. In this diagram each of the 55 points

represents a different country.

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Auto Industry Data 2003

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Exchange Rate Risk

Example - Honda builds a new car in Japan for a cost + profit of 1,715,000 yen. At an exchange rate of 120.700Y:$1 the car sells for $14,209 in Indianapolis. If the dollar rises in value, against the yen, to an exchange rate of 134Y:$1, what will be the price of the car?

1,715,000 = $12,799

134Conversely, if the yen is trading at a forward discount, Japan will experience a decrease in purchasing power.

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Exchange Rate Risk

Example - Harley Davidson builds a motorcycle for a cost plus profit of $12,000. At an exchange rate of 120.700Y:$1, the motorcycle sells for 1,448,400 yen in Japan. If the dollar rises in value and the exchange rate is 134Y:$1, what will the motorcycle cost in Japan?

$12,000 x 134 = 1,608,000 yen

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Exchange Rate Risk

Currency Risk can be reduced by using various financial instruments

Currency forward contracts, futures contracts, and even options on these contracts are available to control the risk

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Capital Budgeting

1) Exchange to $ and analyze

2) Discount using foreign cash flows and interest rates, then exchange to $.

3) Choose a currency standard ($) and hedge all non dollar CF.

Techniques

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ExampleOutland Corporation is building a plant in Holland to produce reindeer repellant to sell in that country. The plant is expected to produce a cash flow (in guilders ,000s) as follows. The US risk free rate is 8%, the Dutch rate is 9%. US inflation is forecasted at 5% per year and the current spot rate is 2.0g:$1.

year 1 2 3 4 5

400 450 510 575 650

Q: What are the 1, 2, 3, 4, 5 year forward rates?

A: E (Sf/$) = E ( 1 + if )t solve for E(S)

Sf/$ E ( 1 + i$ )t

E(S) 2.02 2.04 2.06 2.08 2.10

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ExampleOutland Corporation is building a plant in Holland to produce reindeer repellant to sell in that country. The plant is expected to produce a cash flow (in guilders ,000s) as follows. The US risk free rate is 8%, the Dutch rate is 9%. US inflation is forecasted at 5% per year and the current spot rate is 2.0g:$1.

year 1 2 3 4 5

400 450 510 575 650

Q: Convert the CF to $ using the forward rates.

1 2 3 4 5

CFg 400 450 510 575 650

E(S) 2.02 2.04 2.06 2.08 2.10

CF$ 198 221 248 276 310

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ExampleOutland Corporation is building a plant in Holland to produce reindeer repellant to sell in that country. The plant is expected to produce a cash flow (in guilders ,000s) as follows. The US risk free rate is 8%, the Dutch rate is 9%. US inflation is forecasted at 5% per year and the current spot rate is 2.0g:$1.

year 1 2 3 4 5

400 450 510 575 650

What is the PV of the project in dollars at a risk premium of 7.4%?

$ discount rate = 1.08 x 1.074 = 1.16

PV = $794,000

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ExampleOutland Corporation is building a plant in Holland to produce reindeer repellant to sell in that country. The plant is expected to produce a cash flow (in guilders ,000s) as follows. The US risk free rate is 8%, the Dutch rate is 9%. US inflation is forecasted at 5% per year and the current spot rate is 2.0g:$1.

year 1 2 3 4 5

400 450 510 575 650

What is the PV of the project in guilders at a risk premium of 7.4%? Convert to dollars.

$ discount rate = 1.09 x 1.074 = 1.171

PV = 1,588,000 guilders

exchanged at 2.0:$1 = $794,000

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Political RiskPolitical Risk Scores

A B C D E F G H I J K L TotalMaximum Score 12 12 12 12 12 6 6 6 6 6 6 4 100

Luxembourg 11 11 12 12 12 5 6 6 6 5 5 4 95Netherlands 9 11 12 11 12 5 6 6 6 5 6 4 91Singapore 11 9 12 11 12 5 6 5 5 6 2 4 87UK 9 10 12 10 9 5 6 6 6 4 6 4 86Japan 11 8 12 12 10 4 6 5 5 6 5 4 86Germany 9 8 12 11 10 5 6 5 5 4 5 4 83United States 11 8 12 11 8 4 5 5 5 5 6 4 81Italy 9 9 12 11 11 3 4 3 3 5 4 3 78China 11 7 8 12 11 2 5 5 5 5 1 2 71Brazil 9 6 8 11 11 4 6 2 2 3 5 2 69Russia 12 7 9 9 10 2 6 4 4 2 4 1 68India 9 4 9 8 9 2 1 4 4 2 6 3 59Indonesia 9 4 6 8 11 1 1 2 2 2 4 2 52Somalia 5 1 3 5 4 1 3 2 2 2 1 0 27

A = Govt stability G = Military in politicsB = Socioeonmic conditions H = Religious tensionsC = Investment profile I = Law and orderD = Internal conflict J = Ethnic tensionsE = External conflict K = Democratic accountabilityF = Corruption L = Bureaucracy quality

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Web Resources

www.oecd.org

www.bankofengland.co.uk

www.ecb.int

www.oanda.com

www.x-rates.com

www.emgmkts.com

www.securities.com

www.prsgroup.com

Click to access web sitesClick to access web sites

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