Chapter 27Principles of

Corporate FinanceTenth Edition

Managing International Risks

Slides by

Matthew Will

McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

27-2

Topics Covered

The Foreign Exchange MarketSome 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) 1.4201 1.4201 1.42 1.4207Norway (krone) 6.2452 6.2502 6.2603 6.3007Sweden (krona) 7.4533 7.4523 7.4502 7.4313Switzerland (franc) 1.0723 1.0719 1.0711 1.0643United Kingdom (pound) 1.6414 1.6413 1.6411 1.6396Americas:Canada (dollar) 1.0808 1.0807 1.0804 1.0801Mexico (peso) 13.2155 13.2705 13.3805 13.8891Pacific/ Africa:Hong Kong (dollar) 7.7501 7.748 7.7437 7.7311Japan (yen) 94.705 94.678 94.6161 94.087South Africa (rand) 7.784 7.833 7.9263 8.3283South Korea (won) 1249.55 1249.1 1247.65 1241.05

Forward Rate *

July 24, 2009

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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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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) @ 6.67 % or a 1 year US bond (in dollars) @ 1.505%. The spot rate is 13.2155 peso:$1 The 1 year forward rate is 13.8891 peso:$1

Which bond will you prefer and why?

Ignore transaction costs

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Value of US bond = $1,000,000 x 1.0150 = $1,015,000

Value of Mexican bond = $1,000,000 x 13.2155 = 13,215,500 peso exchange

13,215,500 peso x 1.0667 = 14,096,974 peso bond pmt

14,096,974 peso / 13.8891= $1,014,967 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) @ 6.67 % or a 1 year US bond (in dollars) @ 1.505%. The spot rate is 13.2155 peso:$1 The 1 year forward rate is 13.8891 peso:$1.

Which bond will you prefer and why? Ignore transaction costs

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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 1.0% this year and Mexico is forecasted at 6.0%, what do we know about the expected spot rate?

Given a spot rate of 13.2155 peso:$1

solve for Es

Es = 13.87

foreign/$

foreign/$

$

foreign )=

i+1

i+1

S

E(s

13.2155

E(s )=

.010+1

.0601 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

.006 =1-1.060

1.0667=

i+1

r+1)(

foreign

foreignrealr

.005=1-1.010

1.015=

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) @ 6.0% or a 1 year US loan (in dollars) @ 6.8%. The spot rate is 1.0723 sf:$1 The 1 year forward rate is 1.0643 sf:$1

Which loan will you prefer and why? Ignore transaction costs

Cost of US loan = $100,000 x 1.068 = $106,800

Cost of Swiss Loan = $100,000 x 1.0723 = 107,230 sf exchange

107,230 sf x 1.06 = 113,664 sf loan pmt

113,664 sf / 1.0643 = $106,797 exchange

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

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Exchange Rates

% Forecast Error in Forward Rate for Swiss Francs

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International Prices

CountryLocal Price Converted

to U.S. Dollars CountryLocal Price Converted

to U.S. Dollars

Canada 3.35 Philippines 2.05China 1.83 Russia 2.04Denmark 5.53 South Africa 2.17Euro area 4.62 Switzerland 5.98Japan 3.46 United Kingdom 3.69Mexico 2.39 United States 3.57

CountryLocal Price Converted

to U.S. Dollars CountryLocal Price Converted

to U.S. Dollars

Canada 3.35 Philippines 2.05China 1.83 Russia 2.04Denmark 5.53 South Africa 2.17Euro area 4.62 Switzerland 5.98Japan 3.46 United Kingdom 3.69Mexico 2.39 United States 3.57

The Big Mac Index – The price of a Big Mac in different countries (July 16, 2009)

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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.

Japan

Turkey

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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 94.705Y:$1, the motorcycle sells for 1,136,460 yen in Japan. If the dollar rises in value and the exchange rate is 103Y:$1, what will the motorcycle cost in Japan?

$12,000 x 103 = 1,236,000 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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ExampleSuppose that the Swiss pharmaceutical company, Roche, is evaluating a proposal to build a new plant in the United States. To calculate the project’s net present value, Roche forecasts the following dollar cash flows from the project. The US cost of capital is 12% and the spot exchange rate is 1.2sf / 1 $ . What is the project value in US dollars and Swiss francs?

year 0 1 2 3 4 5

-1300 400 450 510 575 650

NPV ($) = $ 513 million

NPV (sf) = $513 x 1.2 (sf/$) = 616 sf million

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Example

A: (Ff/$) = ( 1 + rf )t solve for Ff/$

Sf/$ ( 1 + r$ )t

year 0 1 2 3 4 5

Ff/$ 1.2 1.177 1.155 1.133 1.112 1.091

Suppose that the Swiss pharmaceutical company, Roche, is evaluating a proposal to build a new plant in the United States. To calculate the project’s net present value, Roche forecasts the following dollar cash flows from the project. The US cost of capital is 12% and the spot exchange rate is 1.2sf / 1 $ . What are the forward rates in each year, if risk free rates are US = 6% and Swiss = 4%?

year 0 1 2 3 4 5

-1300 400 450 510 575 650

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Example

A: CFf = (Ff/$) x CF$

year 0 1 2 3 4 5

CF$ -1300 400 450 510 575 650

Ff/$ 1.2 1.177 1.155 1.133 1.112 1.091

CFf -1560 471 520 578 639 709

Suppose that the Swiss pharmaceutical company, Roche, is evaluating a proposal to build a new plant in the United States. To calculate the project’s net present value, Roche forecasts the following dollar cash flows from the project. The US cost of capital is 12% and the spot exchange rate is 1.2sf / 1 $ . What are the cash flows in each year, given the forward rates?

year 0 1 2 3 4 5

-1300 400 450 510 575 650

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ExampleSuppose that the Swiss pharmaceutical company, Roche, is evaluating a proposal to build a new plant in the United States. To calculate the project’s net present value, Roche forecasts the following dollar cash flows from the project. The US cost of capital is 12% and the spot exchange rate is 1.2sf / 1 $ . What is the NPV of the project in Swiss francs?

A: 1+ franc return = ( 1 + rf ) solve for Franc return 1+dollar return ( 1 + r$ )

Franc return = 9.9%

NPV (sf) = 616 sf

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Political Risk

A B C D E F G H I J K L Total

Maximium 12 12 12 12 12 6 6 6 6 6 6 4 100Finland 9.5 9.5 12.0 11.0 11.5 6.0 6.0 6.0 6.0 6.0 6.0 4.0 93.5Sweden 7.5 9.0 12.0 11.5 11.0 5.0 5.5 6.0 6.0 5.0 6.0 4.0 88.5Switzerland 9.0 10.5 12.0 12.0 11.0 4.5 6.0 4.5 5.0 4.0 6.0 4.0 88.5Australia 10.0 10.5 12.0 10.0 9.5 4.5 6.0 6.0 5.5 4.0 6.0 4.0 88.0Germany 10.0 8.0 12.0 11.0 10.5 5.0 6.0 5.0 5.0 4.0 6.0 4.0 86.5Singapore 11.0 9.5 12.0 10.5 10.5 4.5 5.0 4.5 5.0 6.0 2.0 4.0 84.5United Kingdom 8.0 9.5 12.0 9.5 7.0 4.0 6.0 6.0 5.5 4.0 6.0 4.0 81.5France 9.5 8.0 12.0 10.0 10.0 5.0 5.5 4.0 5.0 2.5 6.0 3.0 80.5Japan 6.5 8.0 11.5 10.5 9.5 3.0 5.0 5.5 5.0 5.5 5.0 4.0 79.0United States 6.0 8.0 12.0 10.0 7.0 4.0 4.0 5.5 5.0 5.0 6.0 4.0 76.5China, Peoples' Rep.11.0 9.0 7.0 10.0 10.0 2.5 3.0 5.0 4.5 4.5 1.5 2.0 70.0Russian Federation.11.5 7.0 9.5 8.0 8.5 2.0 4.5 5.5 4.0 3.0 2.5 1.0 67.0Brazil 8.5 6.0 7.5 10.0 10.5 2.0 4.0 6.0 2.0 3.0 5.0 2.0 66.5Turkey 9.0 6.5 8.0 8.0 7.5 2.5 2.0 4.5 4.5 2.5 5.0 2.0 62.0India 6.0 5.5 8.5 6.5 10.0 2.5 4.0 2.5 4.0 2.5 6.0 3.0 61.0Pakistan 4.0 5.0 7.5 5.5 8.5 2.0 1.0 1.0 3.0 1.0 1.0 2.0 41.5Somalia 5.5 0.0 2.0 4.0 4.0 1.0 1.0 3.0 0.5 2.0 1.0 0.0 24.0

A = Govt stability G = Military in politicsB = Socioeonmic conditions H = Religious tensionsC = Investment profile I = Law and order as of January 2008D = Internal conflict J = Ethnic tensionsE = External conflict K = Democratic accountabilityF = Corruption L = Bureaucracy quality

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Web Resources

Click to access web sitesClick to access web sites

Internet connection requiredInternet connection required

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