Lecture Essentials of corporate finance - Chapter 18: International aspects of financial management

International Aspects of Financial
Management
Chapter 18


Key Concepts and Skills
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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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Chapter Outline
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Terminology
Foreign Exchange Markets and Exchange Rates
Purchasing Power Parity
Exchange Rates and Interest Rates
Exchange Rate Risk
Political Risk

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Domestic Financial Management and
International Financial Management
• Considerations in International Financial

Management
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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 the

international capital markets and this may reduce the
firm’s cost of capital

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International Finance Terminology
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Cross-rate
Eurobond
Eurocurrency (Eurodollars)
Foreign bonds
Gilts
London Interbank Offer Rate (LIBOR)
Swaps

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Global Capital Markets
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The number of exchanges in foreign countries continues to
increase, as does the liquidity on those exchanges
Exchanges that allow for the flow of capital are extremely
important to developing countries
Australia and New Zealand have well developed capital
markets in world terms
International foreign markets are becoming more competitive
and are often willing to try more innovative ways to do
business

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Exchange Rates
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The price of one country’s currency in terms of another
All currencies are in some way quoted to U.S. dollars
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Most countries are in terms of U.S. 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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Example: Exchange Rates
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Suppose you have $10,000. Given the rates below, how
many U.S. Dollars can you buy?
– Exchange rate = 0.8213 U.S. dollar per Australian dollar
– Buy 10,000(0.8213) = $8,213 U.S. 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 = $2,022.24

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Example: Triangle Arbitrage
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We observe the following quotes:
29.10 Thai Baht (THB) per $1AUD
– 2.882 Singapore $ (SGD) per $1AUD
– 9.50 Thai Baht per $1SGD
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What is the cross rate?
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(29.10 THB/$1) / (2.882 SGD/$1) = 10.10 THB per SGD

We have $100 to invest; buy low, sell high
Buy $100(29.10THB/$1) =2910THB, use THB to buy SGD

– Buy 2910THB /(9.5THB/SGD) = 306.32SGD, use SGD to buy
AUD dollars
– Buy 306.32SGD / (2.882SGD/$1) = $106.29
– Make $6.29 risk-free
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Transaction Terminology
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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

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Absolute Purchasing Power Parity
• Price of an item is the same regardless of the

currency used to purchase it
• Requirements for absolute PPP to hold
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Transaction costs are zero
No barriers to trade (no taxes, tariffs, etc)
No difference in the commodity between locations

• Absolute PPP rarely holds in practice for many

goods

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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
• Because absolute PPP doesn’t hold for many

goods, we will focus on relative PPP from here on

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Example: PPP
• 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%.
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Do you expect the Australian dollar to appreciate or
depreciate relative to the Singapore dollar?
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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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E(S1) = 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

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Example: Covered Interest Arbitrage
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Consider the following information:
– S0 = 2 SGD/$
RAUD = 10%
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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

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Interest Rate Parity
• Based on the previous example, there must be a

forward rate that would prevent the arbitrage
opportunity
• Interest rate parity defines what that forward rate
should be

F1
Exact :  
S0
F1
Approx :  
S0

(1 RFC )
(1 R AUD )
1

( RFC

RAUD )

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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
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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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Long-Run Exposure
• Long-run fluctuations come from unanticipated
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changes in relative economic conditions
Could be due to changes in labour markets or
governments
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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Translation Exposure
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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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Managing Exchange Rate Risk
• Large multinational firms may need to manage the

exchange rate risk associated with several different
currencies
• The firm needs to consider its net exposure to
currency risk instead of just looking at each
currency separately
• Hedging individual currencies could be expensive
and may actually increase exposure

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Political Risk
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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

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Quick Quiz
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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 are uncovered interest parity and the International Fisher

Effect?
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?

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