Dr. David P. EchevarriaAll Rights Reserved1 International Financial Management Chapter 17 Exchange...

Dr. David P. Echevarria All Rights Reserved 1

International Financial ManagementChapter 17

Exchange Rates

Forfaiting

Rationales for Going Global


INTERNATIONAL FINANCE TERMINOLOGY

A. American Depositary Receipt (ADR)

B. Currency Cross-rate table

C. Eurobond

D. Eurocurrency (Eurodollars)

E. London Interbank Offer Rate (LIBOR)

F. Swaps1. Interest rate (fixed for variable)

2. Currency (dollars for yen)


EXCHANGE RATES

A. The price of one country’s currency in terms of another1. Direct quotes: how much to buy a foreign currency?2. Indirect quotes: how much of our currency will a unit of foreign

currency buy?

B. Many currencies quoted in terms of dollars (direct quotes)C. Consider the following quote:

1. Euro 1.3397 .74652. The first number (1.3397) is how many U.S. dollars it takes to buy 1

euro (direct quote)3. The second number (. 7465) is how many Euros it takes to buy U.S.

$1 (indirect quote)4. The two numbers are reciprocals of each other (1/. 7465 = 1.3397)


EXCHANGE RATES

D. Example 1: Exchange Rates1. Suppose you have $10,000 . How many Norwegian

Krone can you buy? (4/26/2011 rates)2. Exchange rate = 5.3478 Krone per U.S. dollar3. Buy 10,000(5.3478) = 53,478 Krone

E. Example 2: Exchange rates1. Suppose you are visiting London and you want to buy a

souvenir that costs 1,000 British pounds. How much does it cost in U.S. dollars? (4/26/2011 rates)

2. Exchange rate = $1.6478 dollars per pound3. Cost = 1,000 x 1.6478 = $1,647.80


EXCHANGE RATES

F. Example 3: Triangle Arbitrage1. We observe the following fictitious quotes:

1. 1 Euro per $1a. 2 Swiss Franc per $1b. .4 Euro per 1 Swiss Franc

2. What should the Euro/SF cross rate be? a. (1 Euro / $1) / (2 SF / $1) = .5 Euro / SF (a mispricing)

3. How can we profit from the mispricing? We have $1000 to invest (buy the low, exchange to the high)

a. Exchange $1000 for Euros (@ $1 = E1) = 1000 Eurob. Exchange 1000 Euro (@ .4 Euro = 1 SF) = 2500 SFc. Exchange 2500 SF for $/ (@ 2 SF = $1) = $1250d. You used a mispricing in the markets to make $250 risk-free


TRANSACTION TERMINOLOGY

A. Spot trade – exchange currency immediately1. Spot rate – the exchange rate for an immediate trade

B. Forward trade – agree today to exchange currency at some future date and some specified price (also called a forward contract)

1. Forward rate – the exchange rate specified in the forward contract

C. If the forward rate is higher than the spot rate, the foreign currency is selling at a premium (when quoted as $ equivalents)

D. If the forward rate is lower than the spot rate, the foreign currency is selling at a discount


TRANSLATION EXPOSURE

Income from foreign operations must be translated back to U.S. dollars for accounting purposes, even if foreign currency is not actually converted back to dollars

A. Managing Exchange Rate Risk1. Large multinational firms may need to manage the

exchange rate risk associated with several different currencies

2. The firm needs to consider its net exposure to currency risk instead of just looking at each currency separately

3. Hedging individual currencies could be expensive and may actually increase exposure


TRANSLATION EXPOSURE

B. Political Risk1. Changes in value due to political actions in the foreign

country2. Investment in countries that have unstable governments

should require higher returns3. The extent of political risk depends on the nature of the

business4. The more dependent the business is on other operations

within the firm, the less valuable it is to others5. Natural resource development can be very valuable to

others, especially if much of the ground work in developing the resource has already been done

6. Local financing can often reduce political risk


FORFAITING (Medium-Term Capital Goods Financing)

A. Forfaiting means selling a bill of exchange, at a discount, to a third party, the forfaiter.

B. The forfaiter collects the payment from an overseas customer, through a collateral bank(s)

C. The forfaiter assumes the underlying responsibility of exporters and simultaneously providing trade finance for importers by converting a short-term loan to a medium term one.

D. Forfaiting is the discounting of international trade receivables on a without recourse basis.



E. Characteristics:1. The exporter extends credit for period ranging

between 180 days to 7 years.2. Minimum bill size should be US$ 250,000 (US$

500,000/- is preferred)3. The payment should be receivable in any major

convertible currency.4. A Letter of Credit, or a guarantee by a bank,

usually in importer's country.5. The contract can be for either goods or services.



F. Documentation:

At its simplest, the receivables must be backed by any of the following debt instruments:

1. Promissory Note (~ a note payable)

2. Bills of Exchange

3. Deferred payment letter of credit

4. A [bank] letter of guarantee



G. Pricing1. Discount Rate: LIBOR plus margin2. Days of Grace: cover b-days until settlement3. Commitment Fee: ~ to cover exposure days

H. Benefits:1. Eliminates risks like political, transfer and commercial

risks2. Enhances competitive advantage.

a. Ability to provide vendor financing making products more attractive

b. Enables the exporter to do business in risky countries.3. Increases cash flow. Forfaiting converts a credit-based

transaction in to a cash transaction.


ABSOLUTE PURCHASING POWER PARITY

A. Price of an item is the same regardless of the currency used to purchase it

B. Requirements for absolute PPP to hold1. Transaction costs are zero2. No barriers to trade (no taxes, tariffs, etc.)3. No difference in the commodity between

locations4. Absolute PPP rarely holds in practice for many

goods


RELATIVE PURCHASING POWER PARITY

Provides information about what causes changes in exchange rates

A. The basic result is that exchange rates depend on relative inflation between countries

B. E (St) = S0 [1 + (hFC – hUS)]t

C. Because absolute PPP doesn’t hold for many goods, we will focus on relative PPP from here on


RELATIVE PURCHASING POWER PARITY

D. Example: PPP1. Suppose the Canadian spot exchange rate is 1.18

Canadian dollars per U.S. dollar. U.S. inflation is expected to be 3% per year and Canadian inflation is expected to be 2%.

2. Do you expect the U.S. dollar to appreciate or depreciate relative to the Canadian dollar?

3. Since expected inflation is higher in the U.S., we would expect the U.S. dollar to depreciate relative to the Canadian dollar.

4. What is the expected exch. rate in one year?

5. E(S1) = 1.18[1 + (.02 - .03)]1 = 1.1682


QUESTIONS YOU SHOULD BE ABLE TO ANSWER

A. What does an exchange rate tell us?

B. What is triangle arbitrage?

C. Comprehensive Problem1. Assume that one U.S. dollar buys 81.748 Japanese Yen,

and one U.S. dollar buys .60687 Pound Sterling.

2. What must the Yen – pound exchange rate be in order to prevent triangular arbitrage (ignoring transaction costs)?

D. What is forfaiting and how is it used?


HOMEWORK CHAPTER 17

A. Self-Test: ST-1, d, e, h, j, k, m, p

B. Questions: 17-1, 17-2, 17-4, 17-5

C. Problems: 17-1, 17-2, 17-3, 17-7


COVERED INTEREST ARBITRAGE

A. How can we take advantage of differences in interest rates to earn risk free returns?

B. Examine the relationship between spot rates, forward rates, and nominal rates between 2 countries

1. Again, the formulas will assume that the exchange rates are quoted in terms of foreign currency per U.S. dollar

2. The U.S. risk-free rate is assumed to be the T-bill rate



C. Example: Covered Interest Arbitrage1. Consider the following information

a. S0 = .8 Euro / $ RUS = 4%

b. F1 = .7 Euro / $ RE = 2%

2. What is the arbitrage opportunity?a. Borrow $100 at 4%b. Buy $100(.8 Euro/$) = 80 Euro and invest at 2% for 1 yearc. Open [“Buy”] a Euro forward contract (.7 Euro = $1)d. In 1 year, receive 80 * (1.02) = 81.6 Euro and convert back to

dollars (exercise the forward contract)e. 81.6 Euro / (.7 Euro / $) = $116.57 and repay loanf. Profit = 116.57 – 100 * (1.04) = $12.57 risk free



D. Interest Rate Parity1. Based on the previous example, there must be a forward rate that

would prevent the arbitrage opportunity.2. Interest rate parity defines what that forward rate should be

E. Short-Run Exposure1. Risk from day-to-day fluctuations in exchange rates and the fact that

companies have contracts to buy and sell goods in the short-run at fixed prices

2. Managing riska. Enter into a forward agreement to guarantee the exchange rateb. Use foreign currency options to lock in exchange rates if they move

against you, but benefit from rates if they move in your favor



E. Long-Run Exposure1. Long-run fluctuations come from unanticipated

changes in relative economic conditions2. Could be due to changes in labor markets or

governments3. More difficult to hedge4. Try to match long-run inflows and outflows in

the currency5. Borrowing in the foreign country may mitigate

some of the problems

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