Chap 018
Chap 018
Chap 018
International
Aspects of
Financial
Management
1
McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
1-218-2
2
1-318-3
Chapter Outline
• Terminology
• Foreign Exchange Markets and Exchange
Rates
• Purchasing Power Parity
• Exchange Rates and Interest Rates
• Exchange Rate Risk
• Political Risk
3
1-418-4
4
1-518-5
International Finance
Terminology
• American Depositary Receipt (ADR)
• Cross-rate
• Eurobond
• Eurocurrency (Eurodollars)
• Foreign bonds
• Gilts
• London Interbank Offer Rate (LIBOR)
• Swaps
5
1-618-6
6
1-718-7
7
1-818-8
Exchange Rates
• The price of one country’s currency in terms
of another
• Most currency is quoted in terms of dollars
• Consider the following quote:
– Euro 1.34922 .74117
– The first number (1.34922) is how many U.S.
dollars it takes to buy 1 euro
– The second number (. 74117) is how many
euros it takes to buy U.S.$1
– The two numbers are reciprocals of each other
(1/. 74117 = 1.34922)
8
1-918-9
9
1-10
18-10
Transaction Terminology
• Spot trade – exchange currency immediately
– Spot rate – the exchange rate for an
immediate trade
• Forward trade – agree today to exchange
currency at some future date and some
specified price (also called a forward
contract)
– Forward rate – the exchange rate specified in
the forward contract
– If the forward rate is higher than the spot rate,
the foreign currency is selling at a premium
(when quoted as $ equivalents)
– If the forward rate is lower than the spot rate,
the foreign currency is selling at a discount
11
1-12
18-12
12
1-13
18-13
14
1-15
18-15
17
1-18
18-18
Short-Run Exposure
• 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
• Managing risk
– Enter into a forward agreement to
guarantee the exchange rate
– Use foreign currency options to lock in
exchange rates if they move against you,
but benefit from rates if they move in your
favor
18
1-19
18-19
Long-Run Exposure
• Long-run fluctuations come from
unanticipated changes in relative
economic conditions
• Could be due to changes in labor
markets or governments
• More difficult to hedge
• Try to match long-run inflows and
outflows in the currency
• Borrowing in the foreign country may
mitigate some of the problems
19
1-20
18-20
Translation Exposure
• Income from foreign operations has to be
translated back to U.S. dollars for accounting
purposes, even if foreign currency is not
actually converted back to dollars
• If gains and losses from this translation flowed
through directly to the income statement,
there would be significant volatility in EPS
• Current accounting regulations require that all
cash flows be converted at the prevailing
exchange rates with currency gains and
losses accumulated in a special account
within shareholders’ equity
20
1-21
18-21
•
Political Risk
Changes in value due to political actions in the
foreign country
• Investment in countries that have unstable
governments should require higher returns
• The extent of political risk depends on the
nature of the business
– The more dependent the business is on other
operations within the firm, the less valuable it is to
others
– Natural resource development can be very
valuable to others, especially if much of the
ground work in developing the resource has
already been done
• Local financing can often reduce political risk
22
1-23
18-23
Quick Quiz
• What does an exchange rate tell us?
• What is triangle arbitrage?
• What are absolute purchasing power parity
and relative purchasing power parity?
• What are covered interest arbitrage and
interest rate parity?
• What is the difference between short-run
interest rate exposure and long-run interest
rate exposure? How can you hedge each
type?
• What is political risk and what types of
business face the greatest risk?
23
1-24
18-24
Comprehensive Problem
• Assume that one U.S. dollar buys 115
Japanese Yen, and one U.S. dollar
buys .54 Pound Sterling.
• What must the dollar – pound exchange
rate be in order to prevent triangular
arbitrage (ignore transaction costs)?
24