Lecture Essentials of corporate finance (2/e) – Chap 18: International aspects of financial management

International aspects of
financial management
Chapter 18


Key concepts and skills
• Understand how exchange rates are
quoted and what they mean
• Know the difference between spot and
forward rates
• Understand purchasing power parity and
interest rate parity and the implications for
changes in exchange rates
• Understand the types of exchange rate
risk and how they can be managed
• Understand the impact of political risk on
international business investing
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PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

18-2


Chapter outline
• Terminology
• Foreign exchange markets and
exchange rates
• Purchasing power parity
• Exchange rates and interest rates
• Exchange rate risk

• Political risk
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PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

18-3


Domestic financial management
and international financial
management

• Considerations in international financial
management
– Have to consider the effect of exchange
rates when operating in more than one
currency
– Have to consider the political risk
associated with actions of foreign
governments
– More financing opportunities when you
consider
theAustralia
international
capital markets
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and
this
may
reduce
the firm’s cost of
Slides
prepared
by David
E. Allen and
Abhay K. Singh


International finance
terminology
• Cross-rate
– Implicit exchange rate between two currencies when
both are quoted in a third (usually dollars) currency

• Eurobond
– Bond issued in multiple countries but denominated in
the issuer’s home currency

• Eurocurrency (Eurodollars)
– Money deposited in a financial centre outside the
country of the currency involved
– Eurodollars are US dollars deposited in a foreign bank

• Foreign bonds
– Sold by foreign borrower
– Denominated in currency of the country of issue

Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

18-5


International finance
terminology (cont.)
• Gilts
– British and Irish government securities

• London Interbank Offer Rate (LIBOR)
– Rate international banks charge each other for
loans of Eurodollars overnight in the London
market
– Frequently used as a benchmark rate for money
market instruments

• Swaps
– Interest rate swap = two parties exchange a
floating-rate payment for a fixed-rate payment
– Currency swap = agreement to deliver one
currency in exchange for another
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

18-6

Global capital markets
• Foreign exchange market
– The market in which one country's currency is bought or
sold for another country's currency
– Over-the-counter market
– Communications done using electronic telecommunication
devices
• Society for Worldwide Interbank Financial Telecommunications
(SWIFT)

• The number of exchanges in foreign countries continues
to increase, as does the liquidity on those exchanges.
• International foreign markets are becoming more
competitive and are often willing to try more innovative
ways of doing business.
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PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

18-7


International
currency
symbols and
codes
Table 18.1

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PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
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18-8


Exchange rates
• The price of one country’s currency in terms of
another
• All currencies are in some way quoted to US
dollars
– Most countries are in terms of US dollars, except
for countries like Australia and New Zealand

• Consider the following quote:

– Japan (Yen)
0.0112
89.19
– The first number, 0.0112, is how many Australian
dollars it takes to buy 1 Yen
– The second number, 89.19, is how many
Japanese Yen it takes to buy $1AUD
– The two numbers are reciprocals of each other
(1/89.19= 0.0112)

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PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
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18-9


Direct and indirect exchange
rate quotations
• Direct quotation
– One US dollar = ‘x’ of the local currency

• Indirect quotation
– One unit local currency = ‘x’ US dollars

• Australia and New Zealand follow
indirect quote

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PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
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18-10


Exchange rates—Example
•

•

Suppose you have $10 000. Given the rates below, how many
US dollars can you buy?
– Exchange rate = 0.8213 US dollar per Australian dollar
– Buy 10 000(0.8213) = $8213 US dollars

Suppose you are visiting London and you want to buy a
souvenir that costs 1000 British pounds. How much does it cost
if the exchange rate is AUD/GBP 0.4945?
– Exchange rate = 0.4945 pounds per dollar
– Cost = 1000 / 0.4945 = $2022.24

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PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
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18-11


Example: Work the Web
• You just returned from Japan and had
left over 10000 yen.
– How much will you have in Australian
dollars ?

• Click on the information icon to go to <
/>> and use the currency converter to
find out.
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PPTs t/a Essentials of Corporate Finance 2e by Ross et al
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18-12


Triangle arbitrage—Example

18.2
• We observe the following quotes:
– Pounds per AUD $1 = 0.60
– Swiss francs (SF) per AUD $1 = 2.00
– Swiss francs (SF) per pound = 3

• What is the cross rate?
– SF 2.00/£ 0.60 = SF 3.33 per £

• We have AUD $100 to invest; buy low, sell high
– 1. Exchange dollars for francs: AUD $100 x 2 = SF
200
– 2. Exchange francs for pounds: SF 200/3 = £66.67.
– 3. Exchange pounds for dollars: £66.67/0.60 = AUD
$111.12.

• This would result in an AUD $11.12 round-trip
profit.
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PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

18-13


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.
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
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18-14


Absolute purchasing-power
parity
• Price of an item is the same regardless of the
currency used to purchase it or where it is
selling:
P = Price of goods

PUK

S0 PAU

S0 = Spot rate

• Requirements for absolute PPP to hold:
– No transaction costs
– No barriers to trade (no taxes, tariffs, etc.)
– No difference in the commodity between locations

• Absolute PPP rarely holds in practice
– Usually only for uniform, traded goods
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PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
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18-15


Relative purchasing-power
parity
• Provides information about what causes
changes in exchange rates
• The basic result is that exchange rates
depend on relative inflation between
countries
• E(St ) = S0[1 + (hFC – hAUD)]t
– Where:

•S0 = current (time 0) spot exchange rate (foreign
currency per dollar)
•E(St) = expected exchange rate in t periods
•hAU = inflation rate in Australia
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Australia
Pty
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h
=
inflation
in
the
•
FC
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
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18-16


PPP—Example
• Suppose the Singapore spot exchange
rate is 1.4680 Singapore dollars per
Australian dollar. Australian inflation is
expected to be 3% per year and
Singapore inflation is expected to be 2%.
– Do you expect the Australian dollar to
appreciate or depreciate relative to the
Singapore dollar?
• Since inflation is higher in Australia, we would
expect the AUD to depreciate relative to the
Singapore dollar.

– What is the expected exchange in one year?

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PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
1 David E. Allen and Abhay K. Singh
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• E(S ) = 1.4680[1 + (.02 - .03)]1 = 1.4533

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Covered interest arbitrage
• Examine the relationship between spot rates,
forward rates and nominal rates between
countries.
• Again, the formulas will assume that the exchange
rates are quoted in terms of foreign currency per
Australian dollars (AUD).
• The Australian risk-free rate is assumed to be the
short-dated government bond rate.
• Covered interest arbitrage
– ‘Covered’ refers to the fact that we are covered
in the event of a change in the exchange rate
since we lock in the forward exchange rate
today.
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PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

18-18


Covered interest arbitrage—
Example
•

Consider the following information:
– S0 = 2 SGD/$
RAUD = 10%
–

•

F1 = 1.8 SGD/$

RSGD = 5%

What is the arbitrage opportunity?
– Borrow $100 at 10%
– Buy $100(2 SGD/$) = 200 SGD and invest at 5% for 1 year
– In 1 year, receive 200(1.05) = 210 SGD and convert back to
dollars
– 210 SGD/(1.8 SGD/$) = $116.67 and repay loan
– Profit = 116.67 – 100(1.1) = $6.67 risk free

Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

18-19


Interest rate parity
• The condition of the interest rate
differential between two countries being
equal to the percentage difference
between the forward exchange rate
and the spot exchange rate.
• With reference to the example on the
previous slide, there must be a forward
rate that would prevent the arbitrage
opportunity.
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PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

18-20


Interest rate parity (cont.)
• Interest rate parity defines what that
forward rate should be
F1
Exact :  
S0
F1
Approx :  
S0

(1
(1
1

RFC )
R AU )
( RFC

RAU )

Forward and spot rates are direct quotations.
RAU = periodic interest rate in the home country
(Australia)
RFCCopyright
= periodic
interest rate in the foreign country
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PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
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18-21


Exchange rate risk
• The risk that the value of a cash flow in
one currency translated from another
currency will decline owing to a change
in exchange rates.
• A natural consequence of international
operations in a world where relative

currency values move up and down.
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PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
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18-22


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
favour.
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PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

18-23


Long-run exposure

• Long-run fluctuations come from
unanticipated changes in relative
economic conditions.
• Could be due to changes in labour
markets or governments.
• Managing risk
– More difficult to hedge
– Try to match long-run inflows and outflows in
the same currency
– Borrowing in the foreign country may mitigate
some of the problems
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PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
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18-24


Translation exposure
• Income from foreign operations has to be
translated back to 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.
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PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
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18-25