Copyright © 2003 McGraw Hill Ryerson Limited 24-1 prepared by: Carol Edwards BA, MBA, CFA...

copyright © 2003 McGraw Hill Ryerson Limited

24-124-1

prepared by:Carol EdwardsBA, MBA, CFA

Instructor, FinanceBritish Columbia Institute of Technology

Fundamentals

of Corporate

Finance

Second Canadian Edition


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Chapter 24International Financial Management

Chapter Outline Foreign Exchange Markets Some Basic Relationships Hedging Exchange Rate Risk International Capital Budgeting


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Foreign Exchange Markets• Introduction

The objectives of international financial management do not change for a firm: It still wishes to acquire assets that are worth

more than they cost.Projects must still have a positive NPV to be

acceptable. However, going international creates new

problems for the financial managers:How do you deal with more than one currency?How do you deal with different interest rates?


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Foreign Exchange Markets•Currency Markets

The foreign exchange market is where you can acquire, or sell, other currencies.

The exchange rate is the amount of one currency needed to purchase one unit of another.For example, if you look at Table 24.1 on

page 713 of your text, you will see that you need $1.5703 Canadian to purchase one US dollar in the spot market.


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Foreign Exchange Markets• Currency Markets

The spot rate of exchange is the exchange rate for an immediate transaction.

Exchange rates fluctuate from minute to minute. When you need less of a foreign currency to

acquire one Canadian dollar, that currency has appreciated.

When you need more of a foreign currency to acquire one Canadian dollar, that currency has depreciated.


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These fluctuations in exchange rate can get companies into trouble:

For example, you agree to purchase a shipment of Japanese VCR’s, to be delivered in 3 months, for 100 m yen.

If the spot rate is $0.013550/yen, then if you were to pay now, the transaction would cost you:

100 m yen x $0.013550/yen = $1.355 m


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Assuming you can resell the VCR’s for $1.5 m, your profit is $145,000.

Suppose, instead, you paid for the VCR’s in 3 months when they are delivered.

If the spot rate at that time is $0.014220/yen, then the transaction will cost you:

100 m yen x $0.014320/yen = $1.432 m Now your profit is $68,000 – less than half of

what it was before!


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Firms must be very careful when dealing with foreign currency.Small fluctuations in the value of the foreign

exchange can rapidly turn a profitable transaction into an unprofitable one.

You could avoid the exchange rate risk and fix the dollar cost of the VCR’s by “buying the yen forward”.Buying forward a currency means arranging to

buy it now for future delivery at a pre-specified price.


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The forward exchange rate is the price of a currency for delivery at some time in the future.

If you look again at Table 24.1 on page 713, you will see that it would cost you:$0.013550 to buy 1 yen in the spot market.$0.013591 to buy 1 yen 1 month forward.$0.013662 to buy 1 yen 3 months forward.$0.013754 to buy 1 yen 6 months forward.$0.013963 to buy 1 yen 12 months forward.


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Did you notice that it takes you more Canadian dollars to purchase yen in the future?This means the Canadian dollar is

expected to depreciate (or that the yen is expected to appreciate) in value.

The yen is said to trade at a premium to the dollar.


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Expressed as a percentage, the 12 month forward premium is:

Forward Rate – Spot Rate

Premium (or –Discount) =

Spot RateX 100

0.013963 – 0.013550

0.013550X 100 = 3.04%=


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If the yen is selling at a 3.04% forward premium to the dollar, then the dollar must be selling at a 3.04% forward discount to the yen.

A forward market is a “made-to-order” market, where you negotiate the terms of the forward contract, usually with a bank.

There is also an organized futures market, where you can can purchase standardized forward contracts on several major currencies.


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Some Basic Relationships• Exchange Rate Relationships

The financial manager must be aware that there are:Spot rates and forward rates.That interest rates vary by country.That inflation rates also vary by country.

However, there is a series of relationships between these variables, which may be used to understand financial conditions in other countries.


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Some Basic Relationships

1 + rforeign

1 + r$

equals

equals

equalsequals

1 + iforeign

1 + i$

E(Sforeign/$)

Sforeign/$

fforeign/$

Sforeign/$

Difference in Interest Rates

Expected Difference in Inflation Rates

Expected Change inSpot Exchange Rates

Difference between Forward and Spot Exchange Rates


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Some Basic Relationships• Exchange Rates and Inflation

equals1 + iforeign

1 + i$

E(Sforeign/$)

Sforeign/$



These equations demonstrate a relationship known as Purchasing Power Parity (PPP).PPP states that the expected change in the

spot rate equals the difference in inflation between the two countries.


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For example, from 1993 to 2001, Russia experienced inflation of about 35% per year, causing the purchasing power of the ruble to drop. As prices in Russia increased, Russian exporters

would have found it impossible to sell their goods if the exchange rate had not also adjusted. Each year, the ruble cost about 33% less foreign

currency than the year before. Thus, a 35% annual price increase for Russian

goods was offset by a 33% decline in the value of the ruble.


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Some Basic Relationships•Exchange Rates and Inflation

Example:The spot exchange rate between the US

dollar and the peso is US$0.1055/peso, or pesos 9.479 pesos/US$.

If inflation is 2% in the US and 6% in Mexico, what is the expected spot rate of the peso at the end of the year?Looking at the inflation numbers, do you

think the peso will appreciate or depreciate?


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equals1 + 0.06

1 + 0.02

E(Sforeign/$)

9.479



Solving for E(Sforeign/$), we find that the expected spot rate for the peso at the end of the year will be 9.851 pesos/US$.

That is, the peso will depreciate.


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Some Basic Relationships• International Fisher Effect

1 + rforeign

1 + r$

equals1 + iforeign

1 + i$



These equations demonstrate a relationship known as the International Fisher Effect.It states that the expected difference in

inflation rates equals the difference in current interest rates.


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Interest rates in Russia were about 25% in 2001.So, could you have made a fortune by putting

funds in a Russian bank in early 2001? NO!

You must distinguish between nominal and real rates. That is, if you have 25% more rubles at the end of

the year, it doesn’t mean you are 25% better off – i.e., that you can buy 25% more goods.

Inflation in Russia consumed a good part of that gain.


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Example:The inflation rate in Mexico is 6%.If interest rates in Mexico are 9% and they

are 4.88% in the US, what is the US inflation rate?


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1 + 0.09

1 + 0.0488equals

1 + 0.06

1 + i$



Solving for i$, we find that the inflation rate in the US should be 2% per year.

We saw the US inflation rate was 2% in the previous example.


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Some Basic Relationships• Interest Rate Parity

1 + rforeign

1 + r$

equalsfforeign/$

Sforeign/$



These equations demonstrate a relationship known as Interest Rate Parity.It states that the ratio between the risk free

interest rates in two countries is equal to the ratio between the forward and spot rates.


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Some Basic Relationships• Interest Rate Parity.

Interest rates were 25% in Russia in 2001, way above Canadian rates. If you had $1 million Canadian, would it have

made sense to convert your dollars to rubles and lend your money for a year to a Russian investor?

No, because at the end of the year you would have to convert rubles back to Canadian dollars. Remember, the ruble bought about 33% less

foreign currency at the end of 2001. Thus, what you made on the ruble loan, you

would lose when you converted back to dollars!


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Some Basic Relationships• Interest Rate Parity.

Example:The spot exchange rate between the peso

and the US dollar is 9.479 pesos/US$.If interest rates in Mexico are 9% and they

are 4.88% in the US, what is the forward rate between the peso and US dollar?


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Some Basic Relationships• Interest Rate Parity

1 + 0.09

1 + 0.0488equals

fforeign/$

9.479



Solving for fforeign/$, we find that forward rate between the peso and US dollar should be 9.851 pesos/US $.


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Some Basic Relationships• Expectations Theory of Exchange Rates

These equations demonstrate a relationship known as the Expectations Theory of Exchange Rates.It states that the expected spot exchange rate

equals the forward rate.

equalsE(Sforeign/$)

Sforeign/$

fforeign/$

Sforeign/$




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Example:The spot exchange rate between the peso

and the US dollar is 9.479 pesos/US$.If the forward rate is 9.851 pesos/US

dollar, what is the expected spot rate between pesos and the US dollar?


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Solving for E(Sforeign/$), we find that the expected spot rate between the peso and US dollar should be 9.851 pesos/US $.

equalsE(Sforeign/$)

9.479

9.8519.479




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The Expectations Theory does not imply that markets are perfect at forecasting the actual spot rate.

Sometimes the actual spot rate will turn out to be above the previous forward rate, and sometimes it will be below.

But, if the theory is correct, we should find that on average the forward rate is equal to the future spot rate.


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Some Basic Relationships• Some Implications

The four simple relationships we have developed ignore many of the complexities of the market.

However, they capture some very important fundamental concepts:Capital and currency markets tend to function

well.These markets offer no free lunches.

For managers who forget this, it can be costly.


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In the late 1980’s several Australian banks noted that interest rates in Switzerland were 8% below the Australian rates.

They advised their clients to borrow Swiss francs at the cheaper rates and convert them to Australian dollars.

Then, at maturity, convert back to Swiss francs to repay the loan.

Given what you now know,what do you think of this advice?


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The International Fisher Effect tells you that a lower Swiss interest rate indicated a lower inflation rate in Switzerland than in Australia.

This meant you could expect the Swiss franc to appreciate relative to the Australian dollar.

Thus, the advantage of low Swiss interest rates would be offset by the fact that it would cost the Australian borrowers more Australian dollars to pay off their loans.

The Swiss franc did indeed appreciate – quite rapidly – and the Australian banks had to compensate their clients for large losses.


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Hedging Exchange Rate Risk•Reducing Currency Risks

The four simple relationships we have built also tell us something very important about avoiding exchange rate risk:That a company which covers its foreign

commitments by buying or selling currency forward can do so without paying a premium.

On average, the forward rate at which it agrees to exchange currency will equal the eventual spot exchange rate, no better but no worse.


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Hedging Exchange Rate Risk•Reducing Currency Risks

We have seen that fluctuations in exchange rates can significantly alter the profitability of international transactions.Thus, most companies try to limit their exposure

to currency fluctuations. There are a number of ways, by using financial

instruments, a company can reduce it currency risk. To take actions to avoid, or reduce, risk is

known as hedging.


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International Capital Budgeting• Net Present Value Analysis

KW Corporation (KWC) of Canada is considering establishing manufacturing operations in Narnia (currency: the leo).

It has forecasted the following cash flows from the project:

Year 0 1 2 3 4 5

Cash Flow* -7.6 2.0 2.5 3.0 3.5 4.0

* Millions of leos

Should KWC undertake this project?


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You need a discount rate to value these cash flows to see if they have a positive NPV.

The risk free rate in Canada is 5% and you estimate that the firm would need an additional 10% to compensate for risk. So the discount rate is 15% for this project.

However, 15% is the discount rate for Canadian dollar projects!The discount rate for a project in Narnia could

be higher or lower, depending on the risks associated with that country and its currency.


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You cannot compare a project’s return measured in one currency with the return you require from investing in another currency. If the opportunity cost of capital is measured in

dollar-denominated return, consistency demands that the forecast cash flow should also be stated in dollars.

Thus, you must convert the cash flows of the project to Canadian dollars before you discount them at the 15% opportunity cost of capital.


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International Capital Budgeting•Net Present Value Analysis

To translate the leo cash flows into dollars, you need a forecast of the leo/dollar exchange rate for the next 5 years.Where does that come from?

You could use the parity relationships we have developed to forecast the value of the leo.

Suppose that:The spot exchange rate is 2 leos to $1 CDN. Interest rates are 5% in Canada and 10% in

Narnia.


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You should see that the leo is expected to depreciate by 5% per year against the Canadian dollar.

You also know that:

1 + rforeign

1 + r$

equals


E(Sforeign/$)

Sforeign/$



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Substituting in the information you have and solving for the expected spot rate tells you that 1 year from today it will be 2.095 leos / $1 CDN:

1 + 10%

1 + 5%equals


E(Sforeign/$)

2.0



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The forecast exchange rate for each year of the project are calculated in a similar way as follows:Year Forecast Exchange Rate

0 Spot Exchange Rate = 2.000 leos/$1 2.0 x (1.10 / 1.05) = 2.095 leos/$2 2.0 x (1.10 / 1.05)2 = 2.195 leos/$3 2.0 x (1.10 / 1.05)3 = 2.300 leos/$4 2.0 x (1.10 / 1.05)4 = 2.409 leos/$5 2.0 x (1.10 / 1.05)5 = 2.524 leos/$


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Now convert the leo cash flows to dollars :

Year 0 1 2 3 4 5

Cash Flow -7.6 2.0 2.5 3.0 3.5 4.02.000 2.095 2.195 2.300 2.409 2.524

Cdn $ = -3.8 0.95 1.14 1.30 1.45 1.58

Discounting these dollar cash flows at the Canadian opportunity cost of 15%, the NPV of the project is $360,000 and it should be accepted.


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Summary of Chapter 24 The exchange rate is the amount of currency

needed to purchase one unit of another currency.

The spot exchange rate is the exchange rate for immediate transactions.

The forward rate is the exchange rate for a transaction on a specified future date.

There is a simple series of relationships between exchange rates, interest rates and inflation rates.


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Summary of Chapter 24 Purchasing Power Parity states that $1 has the

same purchasing power in every country. Thus, the expected change in the spot rate will

equal the expected difference in inflation between two countries.

The International Fisher Effect suggests that a firm should not simply borrow where interest rates are lowest. Countries with low inflation rates generally have appreciating currencies.

The Interest Parity Theory says that the differential between the interest rates in two countries is equal to the ratio between the forward and spot exchange rates.


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Summary of Chapter 24 The Expectations Theory of Exchange Rates

tells us that the future spot rate should equal the forward rate.

It is possible to hedge a firm’s international operations against currency risk.

When doing a NPV analysis, you must convert to Canadian dollars if you wish to discount the foreign cash flows using a Canadian opportunity cost of capital.

To do this requires a forecast of foreign exchange rates.

This forecast can be done using the simple parity relationships developed in this chapter.

Copyright © 2003 McGraw Hill Ryerson Limited 24-1 prepared by: Carol Edwards BA, MBA, CFA...

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Transcript of Copyright © 2003 McGraw Hill Ryerson Limited 24-1 prepared by: Carol Edwards BA, MBA, CFA...