Chapter 28

Managing International Risk

Principles of Corporate Finance

Seventh Edition

Richard A. Brealey

Stewart C. Myers

Slides by

Matthew Will

Chapter 28

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved

28- 2


Topics Covered

Foreign Exchange Markets Some Basic Relationships Hedging Currency Risk Exchange Risk and International Investment

Decisions Political Risk

28- 3


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.

28- 4



Forward Premiums and Forward DiscountsExample - The yen spot price is 120.700 yen per

dollar and the 3 month forward rate is 119.660 yen per dollar, what is the premium and discount relationship?

28- 5



Forward Premiums and Forward DiscountsExample - The yen spot price is 120.700 yen per dollar and the

3 month forward rate is 119.660 yen per dollar, what is the premium and discount relationship?

3.5%=1-119.66120.7004

)(-Discountor Premium=1-Price Forward

PriceSpot

T

28- 6



Forward Premiums and Forward DiscountsExample - The yen spot price is 120.700 yen per dollar and the

3 month forward rate is 119.660 yen per dollar, what is the premium and discount relationship?

Answer - The dollar is selling at a 3.5% discount, relative to the yen. The yen is selling at a 3.5% premium, relative to the dollar.

28- 7


Exchange Rate Relationships

Basic Relationships

1 + r1 + r

foreign

$

1 + i1 + i

foreign

$

fS

foreign / $

foreign / $

E(sS

foreign / $

foreign / $

)

equals

equals

equals equals

28- 8



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 + r1 + r

=foreign

$

fS

foreign / $

foreign / $

28- 9



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 Japanese bond (in yen) @ 0.06 % or a 1 year US bond (in dollars) @ 3.65%. The spot rate is 120.700 yen:$1 The 1 year forward rate is 116.535 yen:$1

Which bond will you prefer and why? Ignore transaction costs

28- 10


Value of US bond = $1,000,000 x 1.0365 = $1,036,500

Value of Japan bond = $1,000,000 x 120.700 = 120,700,000 yen exchange

120,700,000 yen x 1.0006 = 120,772,420 yen bond pmt

120,772,420 yen / 116.535 = $1,036,400 exchange

Exchange Rate RelationshipsExample - 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 Japanese bond (in yen) @ 0.06 % or a 1 year US bond (in dollars) @ 3.65%. The spot rate is 120.700 yen:$1 The 1 year forward rate is 116.535 yen:$1

Which bond will you prefer and why? Ignore transaction costs

28- 11



2) Expectations Theory of Exchange Rates

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

fS

foreign / $

foreign / $

= E(sS

foreign / $

foreign / $

)

28- 12



3) Purchasing Power Parity

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

1 + i1 + i

=foreign

$

E(sS

foreign / $

foreign / $

)

28- 13



Example If inflation in the US is forecasted at 2.0% this year and Japan is forecasted to fall 1.5%, what do we know about the expected spot rate?

Given a spot rate of 120.700 yen:$1

28- 14



foreign/$

foreign/$

$

foreign )=

i+1i+1

SE(s

Example - If inflation in the US is forecasted at 2.0% this year and Japan is forecasted to fall 1.5%, what do we know about the expected spot rate?


28- 15



foreign/$

foreign/$

$

foreign )=

i+1i+1

SE(s



120.700E(s )

=.02+1

.015-1 foreign/$

28- 16



solve for Es

Es = 116.558

foreign/$

foreign/$

$

foreign )=

i+1i+1

SE(s



120.700E(s )

=.02+1

.015-1 foreign/$

28- 17



4) International Fisher effect

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

Also called common real interest rates

1 + r1 + r

=foreign

$

1 + i1 + i

foreign

$

28- 18



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

1.016 =.985

1.0006=i+1r+1

)(foreign

foreignrealr

1.016 =1.02

1.0365=i+1r+1

)($

$realr

28- 19


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.

28- 20


Exchange Rate RiskExample - 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

28- 21


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

28- 22


Capital Budgeting

Techniques

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.

28- 23


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

Netherlands 9 10 10 12 12 6 6 6 6 6 6 4 93USA 11 10 11 11 8 4 6 6 6 5 6 4 88Germany 10 8 9 12 11 5 6 6 6 5 5 4 87UK 11 10 11 9 9 5 6 6 6 4 6 4 87France 10 7 9 10 11 3 5 6 5 5 5 4 80Japan 10 6 6 12 10 2 6 5 6 6 5 4 78Brazil 9 4 5 9 11 3 4 6 2 4 4 2 63China 11 4 6 10 9 2 2 5 5 4 1 2 61India 5 5 5 8 5 3 5 2 4 2 5 3 52Russia 7 2 3 8 10 1 4 5 3 3 2 1 49Indonesia 10 3 5 4 9 1 1 2 2 2 2 3 44Iraq 8 3 4 3 4 1 0 5 2 2 0 0 32

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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