International Finance
Today
Capital Budgeting (international style)
Financing (international style)
Topics
Exchange rates
Currency risk
Managing Currency Risk
Capital Budgeting w/ currency risk
Financing w/currency risk
Exchange Rates
Spot Rate
The price of a currency for immediate delivery (i.e. today’s exchange rate)
Forward Rate
The price of a currency on a specified future date (i.e. a forward contract in which the exercise price is the exchange rate)
Futures - Same as forward (w/secondary markets)
Options - on exchange rates & Future Ks
Exchange RatesExample
Swiss franc spot price is SF SF 1.4457 per $1
Swiss franc 6 mt forward price is SFSF1.4282 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 $1
Exchange Rates
Example
What is the franc premium (annualized)?
Exchange Rates
Example
What is the franc premium (annualized)?
franc Premium = 2 x ( 1.4457 - 1.4282) = 2.45%
1.4282
Dollar Discount = 2.45%
Exchange Rates
Example
What is the franc premium (annualized)?
franc Premium = 2 x ( 1.4457 - 1.4282) = 2.45%
1.4282
Dollar Discount = 2.45%
Example
What is the Yen discount (annualized)?
Exchange Rates
Example
What is the franc premium (annualized)?
franc Premium = 2 x ( 1.4457 - 1.4282) = 2.45%
1.4282
Dollar Discount = 2.45%
Example
What is the Yen discount (annualized)?
Yen Discount = 2 x ( 103.52 - 101.18) = 4.26%
103.52
Dollar Premium = 4.26%
Exchange Rates
1) Interest Rate Parity Theory
1 + rf = Ff/$
1 + r$ Sf/$
• The difference between the risk free interest rates in two different countries is equal to the difference between the forward and spot rates
Exchange Rates
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) @ 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
Exchange RatesExample
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) @ 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
Exchange RatesExample
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 German 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
Exchange RatesExample
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 German 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
Exchange RatesExample
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 German 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 = $110,000 exchange
If the two loans created a different result, arbitrage exists!
Exchange Rates
2) Expectations Theory of Forward Rates
Ff/$ = E (Sf/$)
Sf/$ Sf/$
The difference between the forward & spot rates equals the expected change in the spot rate.
Exchange Rates
3) Law of One Price (Purchasing Power Parity)
E (Sf/$) = E ( 1 + if )
Sf/$ E ( 1 + i$ )
The expected change in the spot rate equals the expected difference in inflation between the two countries.
Exchange Rates
Example
Given a spot rate of sf:$ 1.4457:$1
Given a 1yr fwd rate of 1.4194:$1
• If inflation in the US is forecasted at 4.5% this year, what do we know about the forecasted inflation rate in Switzerland?
Exchange Rates
Example
Given a spot rate of sf:$ 1.4457:$1
Given a 1yr fwd rate of 1.4194:$1
• If inflation in the US is forecasted at 4.5% this year, what do we know about the forecasted inflation rate in Switzerland?
E (Sf/$) = E ( 1 + if )
Sf/$ E ( 1 + i$ )
Exchange Rates
Example
Given a spot rate of sf:$ 1.4457:$1
Given a 1yr fwd rate of 1.4194:$1
• If inflation in the US is forecasted at 4.5% this year, what do we know about the forecasted inflation rate in Switzerland?
E (Sf/$) = E ( 1 + if )
Sf/$ E ( 1 + i$ )
1.4194 = E( 1 + i) 1.4457 1 + .045
Exchange Rates
Example
Given a spot rate of sf:$ 1.4457:$1
Given a 1yr fwd rate of 1.4194:$1
• If inflation in the US is forecasted at 4.5% this year, what do we know about the forecasted inflation rate in Switzerland?
E (Sf/$) = E ( 1 + if )
Sf/$ E ( 1 + i$ )
solve for i
1.4194 = E( 1 + i) i = .026 or 2.6%1.4457 1 + .045
Exchange Rates
4) Capital market Equilibrium
E ( 1 + if ) = 1 + rf
E ( 1 + i$ ) 1 + r$
The expected difference in inflation rates equals the difference in current interest rates.
Also called common real interest rates
Exchange Rates
Example
• In the previous examples, show the equilibrium of interest rates and inflation rates
1 + rf = 1.08 = .9818
1 + r$ 1.10
Exchange Rates
Example
• In the previous examples, show the equilibrium of interest rates and inflation rates
1 + rf = 1.08 = .9818
1 + r$ 1.10
E ( 1 + if ) = 1.026 = .9818
E ( 1 + i$ ) 1.045
Exchange Rates
Applications
Q: What does it mean to a business if the dollar is trading at a forward premium?
Exchange Rates
Applications
Q: What does it mean to a business if the dollar is trading at a forward premium?
A: Stronger purchasing power
Exchange RatesExample
Honda builds a new car in Japan for a cost + profit of 1,715,000 yen. At an exchange rate of 101.18:$1 the car sells for $16,950 in Baltimore. If the dollar rises in value, against the yen, to an exchange rate of 105:$1, what will be the price of the car?
Exchange RatesExample
Honda builds a new car in Japan for a cost + profit of 1,715,000 yen. At an exchange rate of 101.18:$1 the car sells for $16,950 in Indianapolis. If the dollar rises in value, against the yen, to an exchange rate of 105:$1, what will be the price of the car?
1,715,000 = $16,333
105
Exchange RatesExample
Honda builds a new car in Japan for a cost + profit of 1,715,000 yen. At an exchange rate of 101.18:$1 the car sells for $16,950 in Indianapolis. If the dollar rises in value, against the yen, to an exchange rate of 105:$1, what will be the price of the car?
1,715,000 = $16,333
105Conversely, if the yen is trading at a forward discount, Japan will experience a decrease in purchasing power.
Exchange Rates
Example
Harley Davidson builds a motorcycle for a cost plus profit for $12,000. At an exchange rate of 101.18:$1, the motorcycle sells for 1,214,160 yen in Japan. If the dollar rises in value and the exchange rate is 105:$1, what will the motorcycle cost in Japan?
Exchange Rates
Example
Harley Davidson builds a motorcycle for a cost plus profit for $12,000. At an exchange rate of 101.18:$1, the motorcycle sells for 1,214,160 yen in Japan. If the dollar rises in value and the exchange rate is 105:$1, what will the motorcycle cost in Japan?
$12,000 x 105 = 1,260,000 yen (3.78% rise)
Currency 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
Currency Risk
Example
Your US company is building a plant in Switzerland. Your cost will be 2,000,000 sf, with full payment due in 6 months. You are concerned about currency risk. The spot rate is 1.4397sf:$1 and the 6 mt forward rate is 1.4350sf:$1. How can you eliminate the currency risk? How does this help in evaluating the project?
Currency RiskExample
Your US company is building a plant in Switzerland. Your cost will be 2,000,000 sf, with full payment due in 6 months. You are concerned about currency risk. The spot rate is 1.4397sf:$1 and the 6 mt forward rate is 1.4350sf:$1. How can you eliminate the currency risk? How does this help in evaluating the project?
•Since you are short in Swiss Francs, you should long sf contracts
•2,000,000sf / 1.4350 = $1,393,728 worth of 6mt sf Ks.
•This will lock in your Co cash flow at $1,393,728
•The forward premium paid is 0.33% (using capital market equilibrium, this premium probably equals the inflation rate.
Capital Budgeting
Techniques
1) Exchange to $ and analyze
2) Discount and then exchange
3) Choose a currency standard ($) and hedge all non dollar CF
Example
Outland Corporation is building a plant in Holland to produce reindeer repellant 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%, the Dutch rate is 9%. US inflation is forecasted at 5% per year and the current spot rate is 2.0g:$1.
year 1 2 3 4 5
400 450 510 575 650
ExampleOutland Corporation is building a plant in Holland to produce reindeer repellant 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%, the Dutch rate is 9%. US inflation is forecasted at 5% per year and the current 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?
ExampleOutland Corporation is building a plant in Holland to produce reindeer repellant 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%, the Dutch rate is 9%. US inflation is forecasted at 5% per year and the current 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
ExampleOutland Corporation is building a plant in Holland to produce reindeer repellant 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%, the Dutch rate is 9%. US inflation is forecasted at 5% per year and the current 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
ExampleOutland Corporation is building a plant in Holland to produce reindeer repellant 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%, the Dutch rate is 9%. US inflation is forecasted at 5% per year and the current spot rate is 2.0g:$1.
year 1 2 3 4 5
400 450 510 575 650
Q: Convert the CF to $ using the forward rates.
1 2 3 4 5
CFg 400 450 510 575 650
ExampleOutland Corporation is building a plant in Holland to produce reindeer repellant 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%, the Dutch rate is 9%. US inflation is forecasted at 5% per year and the current spot rate is 2.0g:$1.
year 1 2 3 4 5
400 450 510 575 650
Q: Convert the CF to $ using the forward rates.
1 2 3 4 5
CFg 400 450 510 575 650
E(S) 2.02 2.04 2.06 2.08 2.10
ExampleOutland Corporation is building a plant in Holland to produce reindeer repellant 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%, the Dutch rate is 9%. US inflation is forecasted at 5% per year and the current spot rate is 2.0g:$1.
year 1 2 3 4 5
400 450 510 575 650
Q: Convert the CF to $ using the forward rates.
1 2 3 4 5
CFg 400 450 510 575 650
E(S) 2.02 2.04 2.06 2.08 2.10
CF$ 198 221 248 276 310
ExampleOutland Corporation is building a plant in Holland to produce reindeer repellant 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%, the Dutch rate is 9%. US inflation is forecasted at 5% per year and the current 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%?
ExampleOutland Corporation is building a plant in Holland to produce reindeer repellant 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%, the Dutch rate is 9%. US inflation is forecasted at 5% per year and the current 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
ExampleOutland Corporation is building a plant in Holland to produce reindeer repellant 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%, the Dutch rate is 9%. US inflation is forecasted at 5% per year and the current 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 risk premium of 7.4%? Convert to dollars.
ExampleOutland Corporation is building a plant in Holland to produce reindeer repellant 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%, the Dutch rate is 9%. US inflation is forecasted at 5% per year and the current 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 risk premium 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
Misc Items
• Tax Comparisons between countries
• Political Risk
Misc Items
• Tax Comparisons between countries
• Political Risk
Corporate Financial Theory
- Go over Final
- Answer questions for final - in normal class room
What We Know
• Net Present Value
• Capital Asset Pricing Model (CAPM)
• Efficient Capital markets
• Value Additivity & Conservation
• Option Theory
• Agency Theory
What We Do Not Know
• How major decisions are made
• What determines the risk & PV ?
• CAPM shortfalls
• Why are some markets inefficient?
• Is management a liability?
• Why do IPOs succeed & new markets emerge?
• Why is capital structure not optimized?
• Dividend policy - Answer?
• Liquidity value?
• Why do mergers come in waves?
What We Do Not Know
Review for Final
In normal class room
Topics
Format
Difficulty
Bonus Points