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Chapter 28Principlesof
CorporateFinance
Ninth Edition
Managing
International Risks
Slides by
Matthew Will
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reservedMcGraw Hill/Irwin
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Topics Covered
Foreign Exchange MarketsSome Basic Relationships
Hedging Currency Risk
Exchange Risk and International InvestmentDecisions
Political Risk
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Exchange Rates
Spot Rate * 1 Month 3 Months 1 Year
Europe
EMU (euro) 1.3549 1.3565 1.3595 1.3689
Norway (krone) 5.9566 5.9514 5.9436 5.9377
Sweden (krona) 6.8028 6.7915 6.7705 6.7041
Switzerland (franc) 1.213 1.2099 1.2038 1.1812
United Kingdom (pound) 1.9901 1.99 1.9892 1.9811
Americas:
Canada (dollar) 1.1309 1.1298 1.1278 1.1208
Mexico (peso) 10.9892 11.0055 11.0408 11.2274Pacific/ Africa:
Hong Kong (dollar) 7.8129 7.8071 7.7916 7.7429
Japan (yen) 1119.795 119.33 118.397 114.571
South Africa (rand) 7.0942 7.116 7.162 7.3807
South 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
)(-DiscountorPremium=1-PriceForward
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 Rates
Example
Swiss franc spot price is SF1.4457 per $1
Swiss franc 6 mt forward price is SF1.4282 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 + r
foreign
$
1 + i
1 + i
foreign
$
f
S
foreign / $
foreign / $
E(s
S
foreign / $
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
S
foreign / $
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 USbond (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. Allother 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 rateequals the forward rate.
f
S
foreign / $
foreign / $
=
E(s
S
foreign / $
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
S
foreign / $
foreign / $
)
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Exchange Rate Relationships
Example - If inflation in the US is forecasted at2.5% 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:$1
solve forEs
Es = 11.204
foreign/$
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 + i
foreign
$
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Exchange Rate Relationships
Example - The real interest rate in each country isabout the same
.027=1-1.0451.0735=
i+1r+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. Allother 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:$1
If inflation in the US is forecasted at 4.5% this year, whatdo we know about the forecasted inflation rate in
Switzerland?
E (Sf/$) = 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 = .98181 + r$ 1.10
E ( 1 + if ) = 1.026 = .9818E ( 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
-20.0
-15.0
-10.0
-5.0
0.0
5.0
10.0
15.0
20.0
25.0
1/30/1970
1/30/1972
1/30/1974
1/30/1976
1/30/1978
1/30/1980
1/30/1982
1/30/1984
1/30/1986
1/30/1988
1/30/1990
1/30/1992
1/30/1994
1/30/1996
1/30/1998
1/30/2000
1/30/2002
1/30/2004
1/30/2006
Percent
error
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International Prices
CountryLocal Price Converted
to U.S. Dollars CountryLocal Price Converted
to U.S. Dollars
Canada 3.08 Philippines 1.74
China 1.41 Russia 1.85
Denmark 4.84 South Africa 2.14
Euro area 3.82 Switzerland 5.05
Japan 2.31 United Kingdom 3.9
Mexico 2.66 United States 3.22
The Big Mac Index
The price of a Big Mac indifferent 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 adifferent 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 aforward discount, Japan willexperience a decrease inpurchasing 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 usingvarious financial instruments
Currency forward contracts, futurescontracts, 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 reindeerrepellant 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%, theDutch rate is 9%. US inflation is forecasted at 5% per year and thecurrent 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 reindeerrepellant 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%, theDutch rate is 9%. US inflation is forecasted at 5% per year and thecurrent 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 reindeerrepellant 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%, theDutch rate is 9%. US inflation is forecasted at 5% per year and thecurrent 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 riskpremium 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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