Ch19-International-Business-Finance.ppt

Copyright © 2011 Pearson Prentice Hall. All rights reserved.
International
Business Finance
Chapter 19

19-2
Slide Contents
• Learning Objectives
• Principles Used in This Chapter
1. Foreign Exchange Markets and Currency
Exchange Rates
2. Interest Rate and Purchasing-Power Parity
3. Capital Budgeting for Direct Foreign
Investment
• Key Terms

19-3
Learning Objectives
1. Understand the nature and importance of
the foreign exchange market and learn to
read currency exchange rate quotes.
2. Describe interest rate and the purchasing
power parity.
3. Discuss the risks that are unique to the
capital budgeting analysis of direct
foreign investments.

19-4
Principles Used in This Chapter
• Principle 2:
– There is a Risk-Return Tradeoff.
• Principle 3:
– Cash Flows Are the Source of Value.

19.1 Foreign
Exchange Markets
and the Currency
Exchange Rates

19-6
Foreign Exchange Markets and the
Currency Exchange Rates
• The foreign exchange (FX) market:
– Largest financial market with daily trading
volumes of more than $4 trillion.
– Organized as over-the-counter market with
participants located in major commercial and
investment banks around the world.
– Trading dominated by few currencies including
U.S. dollar, the British pound sterling, the
Japanese Yen, and the Euro.

19-7
Foreign Exchange Markets and the
Currency Exchange Rates (cont.)
• Major participants in foreign exchange
trading include the following:
– Importers and exporters of goods and services,
– Investors and portfolio managers who
purchase foreign stocks and bonds, and
– Currency traders who make a market in one or
more foreign currencies.

19-8

19-9

19-10
Foreign Exchange Rates
• An exchange rate is simply the price of
one currency stated in terms of another.
• For example, if the exchange rate of U.S.
dollar for Euro was $1.35 to 1, it means
that it would take $1.35 to purchase one
Euro.

19-11

19-12
Foreign Exchange Rates (cont.)
• Direct quote
– It indicates the number of units of U.S. dollar
to buy 1 foreign currency unit.
– In the table we see that it took $0.97 to buy 1
Canadian dollar.

19-13
• Indirect Quote
– It indicates the number of foreign currency
units to buy one American dollar.
– For example, in the table it shows that it will
take 6.8276 Chinese yuan to buy 1 U.S. dollar

19-14
• We can compute the direct quote from the
indirect quote.

19-15
• The direct quote for Canadian dollars is
$0.97. The related indirect quote will be:
• Indirect quote = 1÷ $0.97 = $1.03

19-16
Checkpoint 19.1
Exchanging Currencies
U.S. firm Claremont Steel ordered parts for a generator that
were made by a German firm. Claremont was required to pay
1,000 euros to the German firm on January 8, 2010. How
many dollars were required for this transaction?

19-17
Checkpoint 19.1

19-18
Checkpoint 19.1

19-19
Checkpoint 19.1: Check Yourself
Suppose an American firm had to pay $2,000 to a
British resident on January 8, 2010. How many
pounds did the British resident receive?

19-20
Step 1: Picture the Problem
• The key determinant of the number of
British pounds received by the British
resident is the exchange rate between
dollars and pounds.
• The chart (next slide) shows that the amount
received in Pounds varies depending on the
exchange rate. Thus if the exchange rate is
1$=£.8, the British resident will receive
only£1,600.

19-21
Step 1: Picture the Problem (cont.)
0
500
1000
1500
2000
2500
0 0.2 0.4 0.6 0.8 1 1.2
Pounds
Pounds per Dollar
Exchange Rate Impact on
Pounds Received

19-22
Step 2: Decide on a Solution
Strategy
• To determine the number of British pounds
that will be received by the British resident
for $2,000 we need to know the number of
pounds it takes to buy one dollar i.e.
indirect exchange rate quote.

19-23
Step 3: Solve
• Number of British Pounds received
= (£/$ × $) × $2,000
= Indirect quote × $2,000
= £ 0.6239/$ × $2,000
= £1,247.80

19-24
Step 4: Analyze
• The British resident will receive £ 1,247.80
using the indirect quote.
• Had we used the direct quote, we would
have arrived at the wrong answer of
£3,205.60 (2000 × 1.6028).

19-25
Exchange Rates and Arbitrage
• Arbitrage is the process of buying and
selling in more than one market to make a
riskless profit.
• Simple arbitrage eliminates exchange
rate differentials across the markets for a
single currency.

19-26
(cont.)
• The asked rate (also known as the selling
rate or the offer rate) is the rate the bank
or the foreign exchange trader “asks” the
customer to pay in home currency for
foreign currency when the bank is selling
and the customer is buying.
• Table 19-1 contains the asked rate quotes.

19-27
(cont.)
• The bid rate (also known as the buying
rate) is the rate at which the bank buys
the foreign currency from the customer by
paying in home currency.

19-28
(cont.)
• The bank sells a unit of foreign currency
for more than it pays for it. The difference
between the asked quote and the bid
quote is known as the bid-asked spread.
– The spread will be relatively lower for popular
currencies that are frequently traded.

19-29
Cross Rates
• A cross rate is the computation of an
exchange rate for a currency from the
exchanges rates of two other currencies.

19-30

19-31
Types of Foreign Exchange
Transactions
• Spot exchange rate is the rate for
immediate delivery.
• Forward exchange rate is an exchange
rate agreed upon today but which calls for
delivery or payment at a future date.
• Spot and forward rate quotes are given in
Table 19-1.

19-32
Transactions (cont.)
• The forward rate is often quoted at a
premium to or a discount from the existing
spot rate. For example, the 30-day
Switzerland franc will be quoted as 0.0001
premium(0.9773-0.9772).
• This premium or discount is known as the
forward-spot differential.

19-33
• The forward-spot differential can be
expressed as:
• Where F= the forward rate, direct quote
S = the spot rate, direct quote

19-34
• The premium or discount can also be
expressed as an annual percentage rate,
computed as follows:

19-35
Checkpoint 19.2
Determining the Percent-per-Annum Premium or
Discount
You are in need of yen in six months, but before entering a forward
contract to buy them, you would like to know their premium or discount
from the existing spot rate. Calculate the premium or discount from the
existing spot rate for the 6-month yen as of January 8, 2010 using the
data given in Table 19.1.

19-36
Checkpoint 19.2

19-37
Checkpoint 19.2

19-38
Given the information provided above, what is the
premium or discount on from the existing spot rate
on the one-month yen?

19-39
• To determine the premium or discount
from the existing spot rate, we need to
know the prices.

19-40
Step 1: Picture the Problem (cont.)
• Given spot and forward rates
0.010798 0.010798
0.0108
0.010803
0.010795
0.010796
0.010797
0.010798
0.010799
0.0108
0.010801
0.010802
0.010803
0.010804
Spot rate 1-mos forward 3-mos forward 6-mos forward
Exchange
Rate
($
to
yen)
Contract Months Forward

19-41
Strategy
• We can determine the size of the premium
or discount using the following equation
and then annualize it.

19-42
Step 3: Solve
• = (0.010798 - .010798)/.010798 × (12/1)
× 100
• = 0%

19-43
Step 4: Analyze
• Since the spot rate and 1-month forward
rate are equal, the premium or discount
percent is equal to zero.
• The degree of premium or discount is
determined by market forces. Generally,
the premium or discount is not equal to
zero.

19.2 Interest Rate
and Purchasing
Power Parity

19-45
Interest Rate Parity
• Interest rate parity is a theory that can be
used to relate differences in the interest
rates in two countries to the ratios of spot
and forward exchange rates of the two
countries’ currencies.
• Specifically,
Differences in interest rates = Ratio of the
forward and spot rates

19-46
Interest Rate Parity (cont.)

19-47
• Interest rate parity means that you get the
same total return for the following two
options:
– Invest directly in the US; or
– Convert dollars to Japanese Yens,
– Invest Yens in the risk-free rate in Japan, and
– Convert Yens back to U.S. dollars.

19-48
• Example 19.1 You have $1,000,000
to invest and you observe the following
quotes in the market:
1$ = ¥ 106
180-day forward rate = 103.50
U.S. 180-day risk-free interest rate = 4.4%
Japan 180-day risk-free interest rate = 2%
• Determine whether interest rate
parity holds.

19-49
Option I: Invest directly in USA and earn 4.4%
1,000,000 * 1.044 = $1,044,000
Option II:
(a) Convert to Yen at spot rate = ¥ 106,000,000
(b) Invest at 2% = ¥106,000(1.02) = ¥ 108,120,000
(c) Convert to $ at the forward rate = 108,120,000 ÷103.5 =
$1,044,638
==> Difference of $638 ==> Interest Rate Parity does not hold

19-50
Purchasing Power Parity and the
Law of One Price
• According to the theory of purchasing
power parity (PPP), exchange rates
adjust so that identical goods cost the
same amount regardless of where in the
world they are purchased.

19-51
Law of One Price (cont.)
• Underling PPP theory is the law of one
price, which states that the same good
should sell for the same price in different
countries after making adjustments for the
exchange rate between the two currencies.
• Figure 19-2 illustrates one example of
exception to the PPP theory.

19-52

19-53
• The differences in prices around the world
could be explained by:
– Tax differences among countries
– Differences in labor costs
– Differences in raw material costs
– Differences in rental costs

19-54
• In general, we expect PPP to hold for goods that
can be cheaply shipped between countries (for
example, expensive gold jewelry).
• PPP does not seem to hold for non-traded goods
like restaurant meals and haircuts.

19-55
The International Fisher Effect
• The International Fisher Effect (IFE) assumes
that real rates of return are the same across the
world, so that the differences in nominal returns
around the world arise because of differences in
inflation rates.
• Like purchasing power parity, IFE is just an
approximation that may not hold exactly.

19-56
(cont.)
• Example 19.2 Assume that the real rate of
interest is equal to 2% in all countries.
What will be the nominal interest rate in
UK and USA, if UK is expecting an inflation
rate of 6% and USA is expecting an
inflation rate of 3%.

19-57
(cont.)
• Interest rate (USA) = .03 + .02 +
[.03×.02]
= .0506 or 5.06%
• Interest rate (UK) = .06 + .02 + [.06×.02]
= .0812 or 8.12%

19-58
(cont.)
• IFE cautions us that we should not invest
in a country just because it offers the
highest interest rates.
• IFE notes that such high interest rate is an
indication of high inflation. Accordingly,
any gain in interest rates will be offset by
losses due to foreign currency
depreciation.

19-59

19-60

19-61

19.3 Capital
Budgeting for
Direct Foreign
Investment

19-63
Capital Budgeting for Direct Foreign
Investment
• Direct foreign investment occurs when
a company from one country makes a
physical investment into building a factory
in another country. A multinational
corporation (MNC) is one that has
control over this investment.

19-64
Capital Budgeting for Direct Foreign
Investment (cont.)
• A major reason for direct foreign
investment by U.S. companies is the
prospect of higher rates of return from
these investments.
• The method used to evaluate foreign
investments is very similar to the method
used to evaluate capital budgeting
decisions in a domestic context.

19-65
Checkpoint 19.3
International Capital Budgeting
You are working for an American firm that is looking at a new project that will
produce the following cash flows, which are expected to be repatriated to the
parent company and are measured in South African Rand (SAR),
In addition, the risk-free rate in the United States is 4 percent and this project is
riskier than most; as such, the firm has determined that it should require a 9
percent premium over the risk-free rate. Thus, the appropriate discount rate for
this project is 13 percent. In addition, let’s assume the current spot exchange rate
is .11SAR/$, and the 1-year forward exchange rate is .107SAR/$. Calculate the
expected cash flows for this project in U.S. dollars, and then use these cash flows
to calculate the project’s NPV.

19-66
Checkpoint 19.3

19-67
Checkpoint 19.3

19-68
Checkpoint 19.3

19-69
Checkpoint 19.3

19-70
The Problem
An American firm is looking for a new project that
will produce the following cash flows which are
expected to be repatriated to the parent company
and are measured in South African Rand (SAR).
Year Cash flow (in millions of SAR)
0 -20
1 10
2 10
3 6
4 6

19-71
The Problem (cont.)
• In addition, the risk-free rate in the United
States is 4 percent, and this project is
riskier than most, and as such, the firm has
determined that it should require a 10
percent premium over the risk-free rate.
Thus, the appropriate discount rate for this
project is 14 percent. In addition, the
current spot exchange rate is .11 SAR/$,
and the 1-year forward exchange rate is
.107SAR/$. What is the project’s NPV?

19-72
i=14%
Time
Cash flow -20 10 10 6 6
(millions, SAR)
• The timeline illustrates the following:
– The discount rate is 14%.
– A cash outflow of -20 million SAR occurs at the beginning of
the first year (at time 0), followed by positive cash inflows
during the next four years.
0 1 2 3 4

19-73
Strategy
• To calculate the project’s NPV, we need to
convert South African Rand into U.S.
dollars. However, we only have 1-year
forward rates.
• We can use equation 19-5 and the given
forward rate and spot rate to determine
the interest rate differential in the two
countries.

19-74
Strategy (cont.)
• 1 year forward rate
= (interest rate differential)1 × (spot exchange
rate)
• We can then use the forward rate to
convert the cash flows measured in SARs
into U.S. dollars. Once we have the cash
flows, we can compute the NPV using a
14% discount rate.

19-75
Step 3: Solve
• Interest rate differential
= Forward rate/spot rate
= .107/.11
= 0.9727
• We can use the interest rate differential to
calculate the forward exchange rate and
then convert the SAR denominated cash
flows into U.S. dollars.

19-76
Step 3: Solve (cont.)
Year Spot Rate × (Interest Rate
Differential)n
Forward rate for
year n
0 0.11
1 0.11 SAR/$ x 0.9727 0.107 SAR/$
2 0.11 SAR/$ x (0.9727)2 0.10415 SAR/$
3 0.11 SAR/$ x (0.9727)3 0.1012 SAR/$
4 0.11 SAR/$ x (0.9727) 4 0.0985 SAR/$

19-77
• Solve using an Excel Spreadsheet
• NPV = -2.2 + npv (0.14;
1.07,1.041,0.6072,0.591)
= $0.299 million or $299,000
Input in Excel
Year
Cash flow
(in millions
of SAR)
Implied
Forward
Rate
Cash flow
(in millions
of $)
0 -20 0.11 -2.2
1 10 0.107 1.07
2 10 0.1041 1.041
3 6 0.1012 0.6072
4 6 0.0985 0.591
NVP $0.299

19-78
• Computing NPV using equation
• NPV = -$2.2m + $1.07m/(1.14) +
$1.041m/(1.14)2 + $0.6072m/(1.14)3 +
$0.591m/(1.14)4
= $0.299 million or $299,000

19-79
Step 4: Analyze
• Note, the only relevant cash flows are
those that are expected to be repatriated
back to the home country and the initial
cash outflow.
• Also, discount rate should be in the same
currency that the cash flows are measured
in. Here discount rate was in U.S. dollars,
so we converted the SAR cash flows into
U.S. dollars.

19-80
Foreign Investment Risks
• Risks in domestic capital budgeting arises
from two sources:
– Business risk related to the specific product or
service and the uncertainty associated with
that market.
– Financial risk is the risk imposed on the
investment as a result of how the project is
financed.

19-81
Foreign Investment Risks (cont.)
• Foreign direct investment includes both
business and financial risk, plus political
risk and exchange rate risk.

19-82
• Political risk can arise if the business is
conducted in a country that is not
politically stable leading to changes in
policies with respect to businesses.

19-83
• Some examples of political risk are as
follows:
– Expropriation of plants and equipment without
compensation.
– Non-convertibility of the subsidiary’s foreign
earnings into the parent’s currency.
– Substantial changes in tax rates.
– Requirements regarding the local ownership of
business.

19-84
• Exchange rate risk is the risk that the
value of the firm’s operations and
investments will be adversely affected by
changes in exchange rates.
• For example, if the Japanese Yen
depreciates, it will translate to fewer
dollars when it is sent back to the U.S.

19-85
Key Terms
• Arbitrage
• Asked rate
• Bid rate
• Bid-asked spread
• Buying rate
• Cross rate
• Delivery rate

19-86
Key Terms (cont.)
• Direct foreign investment
• Direct quote
• Exchange rate
• Exchange rate risk
• Foreign exchange (FX) market
• Forward exchange contract
• Forward exchange rate

19-87
Key Terms (cont.)
• Forward-spot differential
• Indirect quote
• Interest-rate parity (IRP)
• International fisher effect (IFE)
• Law of one price
• Multinational corporation
• Political risk

19-88
Key Terms (cont.)
• Purchasing-power parity (PPP)
• Selling rate
• Simple arbitrage
• Spot exchange rate

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