International Finance Today Capital Budgeting (international style) Financing (international style)...

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International Finance

Capital Budgeting (international style)

Financing (international style)

Topics

Exchange rates

Currency risk

Managing Currency Risk

Capital Budgeting w/ currency risk

Financing w/currency risk

Exchange Rates

Spot Rate

The price of a currency for immediate delivery (i.e. today’s exchange rate)

Forward Rate

The price of a currency on a specified future date (i.e. a forward contract in which the exercise price is the exchange rate)

Futures - Same as forward (w/secondary markets)

Options - on exchange rates & Future Ks

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

Exchange Rates

Example

What is the franc premium (annualized)?

Exchange Rates

Example

franc Premium = 2 x ( 1.4457 - 1.4282) = 2.45%

1.4282

Dollar Discount = 2.45%

Exchange Rates

Example

franc Premium = 2 x ( 1.4457 - 1.4282) = 2.45%

1.4282

Example

What is the Yen discount (annualized)?

Exchange Rates

Example

franc Premium = 2 x ( 1.4457 - 1.4282) = 2.45%

1.4282

Example

What is the Yen discount (annualized)?

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

103.52

Dollar Premium = 4.26%

Exchange Rates

1) Interest Rate Parity Theory

1 + rf = Ff/$

1 + r$ Sf/$

• The difference between the risk free interest rates in two different countries is equal to the difference between the forward and spot rates

Exchange Rates

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

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

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 German 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

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

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

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

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

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

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!

Exchange Rates

2) Expectations Theory of Forward Rates

Ff/$ = E (Sf/$)

Sf/$ Sf/$

The difference between the forward & spot rates equals the expected change in the spot rate.

Exchange Rates

3) Law of One Price (Purchasing Power Parity)

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

Sf/$ E ( 1 + i$ )

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

Exchange Rates

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?

Exchange Rates

Example

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

Sf/$ E ( 1 + i$ )

Exchange Rates

Example

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

Sf/$ E ( 1 + i$ )

1.4194 = E( 1 + i) 1.4457 1 + .045

Exchange Rates

Example

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

Exchange Rates

4) Capital market Equilibrium

E ( 1 + if ) = 1 + rf

E ( 1 + i$ ) 1 + r$

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

Also called common real interest rates

Exchange Rates

Example

• In the previous examples, show the equilibrium of interest rates and inflation rates

1 + rf = 1.08 = .9818

1 + r$ 1.10

Exchange Rates

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

Exchange Rates

Applications

Q: What does it mean to a business if the dollar is trading at a forward premium?

Exchange Rates

Applications

Q: What does it mean to a business if the dollar is trading at a forward premium?

A: Stronger purchasing power

Honda builds a new car in Japan for a cost + profit of 1,715,000 yen. At an exchange rate of 101.18:$1 the car sells for $16,950 in Baltimore. If the dollar rises in value, against the yen, to an exchange rate of 105:$1, what will be the price of the car?

Honda builds a new car in Japan for a cost + profit of 1,715,000 yen. At an exchange rate of 101.18:$1 the car sells for $16,950 in Indianapolis. If the dollar rises in value, against the yen, to an exchange rate of 105:$1, what will be the price of the car?

1,715,000 = $16,333

Honda builds a new car in Japan for a cost + profit of 1,715,000 yen. At an exchange rate of 101.18:$1 the car sells for $16,950 in Indianapolis. If the dollar rises in value, against the yen, to an exchange rate of 105:$1, what will be the price of the car?

1,715,000 = $16,333

105Conversely, if the yen is trading at a forward discount, Japan will experience a decrease in purchasing power.

Exchange Rates

Example

Harley Davidson builds a motorcycle for a cost plus profit for $12,000. At an exchange rate of 101.18:$1, the motorcycle sells for 1,214,160 yen in Japan. If the dollar rises in value and the exchange rate is 105:$1, what will the motorcycle cost in Japan?

Exchange Rates

Example

Harley Davidson builds a motorcycle for a cost plus profit for $12,000. At an exchange rate of 101.18:$1, the motorcycle sells for 1,214,160 yen in Japan. If the dollar rises in value and the exchange rate is 105:$1, what will the motorcycle cost in Japan?

$12,000 x 105 = 1,260,000 yen (3.78% rise)

Currency 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

Currency Risk

Example

Your US company is building a plant in Switzerland. Your cost will be 2,000,000 sf, with full payment due in 6 months. You are concerned about currency risk. The spot rate is 1.4397sf:$1 and the 6 mt forward rate is 1.4350sf:$1. How can you eliminate the currency risk? How does this help in evaluating the project?

Currency RiskExample

Your US company is building a plant in Switzerland. Your cost will be 2,000,000 sf, with full payment due in 6 months. You are concerned about currency risk. The spot rate is 1.4397sf:$1 and the 6 mt forward rate is 1.4350sf:$1. How can you eliminate the currency risk? How does this help in evaluating the project?

•Since you are short in Swiss Francs, you should long sf contracts

•2,000,000sf / 1.4350 = $1,393,728 worth of 6mt sf Ks.

•This will lock in your Co cash flow at $1,393,728

•The forward premium paid is 0.33% (using capital market equilibrium, this premium probably equals the inflation rate.

Capital Budgeting

Techniques

1) Exchange to $ and analyze

2) Discount and then exchange

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

Example

Outland 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

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?

year 1 2 3 4 5

400 450 510 575 650

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

Sf/$ E ( 1 + i$ )t

year 1 2 3 4 5

400 450 510 575 650

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

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

year 1 2 3 4 5

400 450 510 575 650

1 2 3 4 5

CFg 400 450 510 575 650

E(S) 2.02 2.04 2.06 2.08 2.10

year 1 2 3 4 5

400 450 510 575 650

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

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%?

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

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.

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

Misc Items

• Tax Comparisons between countries

• Political Risk

Misc Items

• Tax Comparisons between countries

• Political Risk

Corporate Financial Theory

- Go over Final

- Answer questions for final - in normal class room

What We Know

• Net Present Value

• Capital Asset Pricing Model (CAPM)

• Efficient Capital markets

• Value Additivity & Conservation

• Option Theory

• Agency Theory

What We Do Not Know

• How major decisions are made

• What determines the risk & PV ?

• CAPM shortfalls

• Why are some markets inefficient?

• Is management a liability?

• Why do IPOs succeed & new markets emerge?

• Why is capital structure not optimized?

• Dividend policy - Answer?

• Liquidity value?

• Why do mergers come in waves?

What We Do Not Know

Review for Final

In normal class room

Topics

Format

Difficulty

Bonus Points

International Finance Today Capital Budgeting (international style) Financing (international style)...

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