Copyright ©2000 Ian H. Giddy International Financial Management 1

Copyright ©2000 Ian H. Giddy International Financial Management 1


Ian Giddy

INTERNATIONAL

FINANCIAL

MANAGEMENT

www.stern.nyu.edu

www.stern.nyu.edu/~igiddy/ifmx.htm

www.giddy.org

InternationalFinancial Management

Prof. Ian GiddyStern School of Business,

New York University


International Financial Management

Management of international assets Management of international liabilities Management of cross-border financial

risks Cross-border funds transfers

These depend on the environmental features of international finance--notably, the global financial markets


Corporate Finance

CORPORATE FINANCE

DECISONS

CORPORATE FINANCE

DECISONS

INVESTMENTINVESTMENT RISK MGTRISK MGTFINANCINGFINANCING

CAPITAL

PORTFOLIO

M&ADEBT EQUITY

TOOLS

MEASUREMENT


What is Special about Corporate Finance in the International Environment?

Financial markets are partially linked, partially separated by national jurisdications

Exchange rate fluctuations affect revenues, costs and valuation of firms

The competitive international financial markets offer special tools, opportunities and risks


What are the Global Financial Markets?

The Foreign Exchange Market The Derivatives Domestic and International Money Markets Domestic and International Capital Markets Beyond the Money and Bond Markets:

International Equity and Commodity Markets Using the Global Capital Markets: Investors’

and Issuers’ Perspectives


The Eurocurrency Market

“A Eurodollar is a dollar deposited in a bank within a jurisdication outside the United States”

Separation of currency, institution and jurisdiction

Why do people want Eurocurrency deposits and loans?

Why is LIBOR the world’s key benchmark rate?


The Eurocurrency Market

“A Eurodollar is a dollar deposited in a bank within a jurisdication outside the United States”

Separation of currency, institution and jurisdiction

Why do people want Eurocurrency deposits and loans?

Why is LIBOR the world’s key benchmark rate?


US Domestic German

Market EUR0CURRENCY MARKET Domestic Market

Euro-Deutsche Mark

Eurodollar Market

Market

Japanese

Euro-Yen Domestic

Market Market

Where the Eurocurrency Market Fits In


Where the Eurocurrency Market Fits In

US Domestic German

Market EUR0CURRENCY MARKET Domestic Market

Euro-Deutsche Mark

Eurodollar Market

Market Foreign

Exchange

Market Japanese

Euro-Yen Domestic

Market Market

Euro-Commercial Euro-Floating Rate Straight

Paper Market Note Market Eurobond Market


Interest Rate Linkages in the International Money Market

Two stories to tell: Domestic vs. Euro Eurocurrency A vs. Eurocurrency B

Domestic Market A The Euromarkets Domestic Market B

Trea- Bank Euro Euro Bank Trea-

sury Deposit Deposit Deposit Deposit sury

Bill Market Market Bill

Trea- Corp- Euro Euro Corp- Trea-

sury orate Bond Bond orate sury

Bond Bond Market Market Bond Bond


Domestic versus Euro

The Eurodollar Premium

Market price of risk

versus

Cost of regulation

Eurodollar vs. U.S. Interest Rate

Effective cost of domestic deposit

= (interest rate + FDIC fees)

(1 - reserve requirement)

Capital controls and divided credit markets


Covered Interest Arbitrage

Moneymarket 1

Moneymarket 2

Spot Forward


Foreign exchange and Eurocurrency dealing are interrelated activities and so are done on the same trading floor.

The Dealing RoomCUS- FOR- Foreign TOMER SPOT WARD Exchange Dealing

Money

FUNDING EUROCURRENCY Market

Dealing

Diagram of a Dealing Room

The Dealing Room


Foreign exchange and Eurocurrency dealing are interrelated activities and so are done on the same trading floor.

The Dealing RoomCUS- FOR- Foreign TOMER SPOT WARD Exchange Dealing

Money

FUNDING EUROCURRENCY Market

Dealing

Diagram of a Dealing Room


Linkages Between Eurocurrency Rates

Interest rate

differential

Interest rate

differential

Forward

premium

Forward

premium

Expected

% change in

exchange rate

Expected

% change in

exchange rate



Interest rate

differential

Interest rate

differential

Forward

premium

Forward

premium

Expected

% change in

exchange rate

Expected

% change in

exchange rate

Covered interest

rate parity



Interest rate

differential

Interest rate

differential

Forward

premium

Forward

premium

Expected

% change in

exchange rate

Expected

% change in

exchange rate

Covered interest

rate parity

Uncovered interest

rate parity



Interest rate

differential

Interest rate

differential

Forward

premium

Forward

premium

Expected

% change in

exchange rate

Expected

% change in

exchange rate

Covered interest

rate parity

Unbiased

forward rate

Uncovered interest

rate parity


Interest-Rate Parity

$1 (1 + / E$) = ($1/ S t )(1 + /EBP) Fnt

where St is the spot exchange rate (dollars per British

Pound) and Fnt is the forward rate.

to a close approximation,

(/E$ - /EBP) = [(Ft n - St)/St] (365/n) 100

Interest-rate differential = forward

premium or

discount


Example: Anglo’s Funding

Anglo-American, the natural resources conglomerate, is seeking 3-month US$ funding.Anglo can fund in the US CP market at

5.5%Or in the Eurosterling market at 6.7%The BP is:

spot $1.5484, 3-mo forward $1.5454 Which is cheaper?


Anglo’s Answer

It’s cheaper for Anglo-American to borrow in the US CP market. Reason:US: simply borrow for 3 months

Cost: $1(1+5.5%/4) = 1.01375

UK: borrow British pounds, change into dollars at spot rate, cover by buying sterling at 3-mo forward rate to repay the pounds

Cost: ($1/1.5484)(1+6.7%/4)1.5454 = 1.01478


TIME

EXCHANGE RATE Spot

Forward

Actual

Today In three

months

Unbiased Forward Rate Theory


TIME

EXCHANGE RATE Spot

Forward

Actual

Probabilitydistributionof actualexchange rate

Today In three

months

Unbiased Forward Rate Theory


Unbiased Forward Rate

Forward premium or discount

= Expected annual rate of change

of the exchange rate

That is,

P$/DM = E(R$/DM )


TIME

EXCHANGE RATE

Spot

Forward

Actual

Probabilitydistributionof actualexchange rate

Today In threemonths

International Fisher Effect

INTEREST

RATE

DIFFERENTIAL


International Fisher Effect

/E$ = /EDM + E(R$/DM )

That is,

Interest-rate differential

equals

Expected annual rate of change of

exchange rate


Cost of Hedging

Type of Hedge Cost of HedgingForward Forward premium

Money Market Hedge(Borrow to matchassets)

Interest ratedifferential

Do nothing Expected rate ofchange ofexchange rate


Corporate Hedging Decisions:Frutas Amazonas

Exporting bananas to Spain, get paid in Spanish pesetas. Funding is in U.S. dollars.


Corporate Hedging Decisions:Frutas Amazonas

Continue funding in U.S. dollars. The peseta might get stronger in the next three months, from $1=128 pesetas to $1=126 pesetas. This could be the cheapest

Switch funding to pesetas, despite the slightly higher cost

Borrow in dollars, but hedge the exchange risk in the forward market.


Frutas Amazonas

Eurodollar 3-monthloan rate

5 9/16%

Europeseta 3-month loan rate

7 15/16%

Spot exchangerate today

Pta128.210 perUSD

Forward exchangerate today

Pta129.005 perUSD

Forward discount,% per annum

-2.5


Frutas Amazonas

Type of Hedge Cost of HedgingForward 2.5%

Money Market Hedge(Borrow to matchassets)

2.375%

Do nothing 2/128 x 4= 6.25% gain(or 2.5% loss?)


Law of One Price

p=Sp*The Price of Tin

In New York On the Kuala On the

Lumpur London Metal

Market Metal

Exchange

273c per lb. 15.37 ringgit US$5830 per

= US$6.02 per kilogram tonne

per kilograma =US5.70 = US5.83

per kilogramb per kilogramc

a1 avoirdupois pound = 0.45359 kilogramsbUS$1 = 2.6965 Malaysian ringgit on the date of calculationc 1 tonne = 1000 kilogram.

All data taken from the Commodities section

of the London Financial Times.


S t=1-St = I-I*

St 1+I*

JAPAN 1995

MEXICO 1994

EXCHANGE-RATE

CHANGE

RELATIVE

INFLATION

Purchasing Power Parity:Theory and Evidence


Deviations fromPurchasing Power Parity

60

70

80

90

100

110

120

130

140

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

Q1

RE

AL

EX

CH

AN

GE

RA

TE

UNITED STATES

JAPAN

Source: JP Morgan. Index of real effective exchange rate versus 18 industrial country currencies, adjusted for change in relative wholesale price of domestic manufactures. A fall in the index indicates improved international competitiveness.


Deviations fromPurchasing Power Parity

Source: JP Morgan. Index of real effective exchange rate versus 18 industrial country currencies, adjusted for change in relative wholesale price of domestic manufactures. A fall in the index indicates improved international competitiveness.

60

70

80

90

100

110

120

130

140

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

Q1

RE

AL

EX

CH

AN

GE

RA

TE

UNITED STATES

JAPANGERMANY

FRANCE ITALY

UK


US Expected Inflation Rate 2%US Expected Inflation Rate 2%

Inflation & Interest Rates

Canadian Expected Inflation Rate 7%Canadian Expected Inflation Rate 7%

US Interest Rate 5%US Interest Rate 5%

Canadian Interest Rate 10%Canadian Interest Rate 10%


US Expected Inflation Rate 2%US Expected Inflation Rate 2%


Canadian Expected Inflation Rate 7%Canadian Expected Inflation Rate 7%

US Interest Rate 5%US Interest Rate 5%

Canadian Interest Rate 10%Canadian Interest Rate 10%

Expected Rate of Changeof the Exchange Rate

Expected Rate of Changeof the Exchange Rate



Borrow at US Interest Rate 5%Borrow at US Interest Rate 5%

Invest at Canadian Interest Rate 10%Invest at Canadian Interest Rate 10%





Buy Canadian Dollars Forward(at discount of 5%)








Buy Canadian Dollar Futures(at discount of 5%)

Buy Canadian Dollar Futures(at discount of 5%)


The Linkages Again

Relativeexcessmoneysupply

Relativeinflation

rates

Forwardexchangepremium

or discount

Exchangerate

change

Relativeinterestrates

65

4

1

32


A Framework

Country A Country B

DOMESTIC DOMESTIC

ECONOMIC ECONOMIC

POLICIES POLICIES

INFLATION INFLATION

RATE RATE

EXCHANGE

RATE

INTEREST INTEREST

RATE RATE

FORWARD

RATE


Conclusion: Corporate Exchange Rate Risk

Exchange Rate Risk is the risk arising from fluctuating exchange rates between two currencies


Conclusion:Corporate Exchange Rate Risk

Exchange Rate Risk is the risk arising from fluctuating exchange rates between two currencies; but it’s tied to prices and to business risk.

Relativemonetaryand fiscalpolicies

Relativemonetaryand fiscalpolicies

Relativeinflation

Relativeinflation

Exchangerate

change

Exchangerate

change


Turkey, 1995

Turkish Lira:Down 33.5%


Turkey, 1995

Turkish Lira:Down 33.5%

Turkish prices:up 83.8%!



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Copyright ©2000 Ian H. Giddy International Financial Management 1