Chapter 17. International Business Finance Chapter Objectives Internationalization of business Why...
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Transcript of Chapter 17. International Business Finance Chapter Objectives Internationalization of business Why...
Chapter 17Chapter 17
International Business International Business FinanceFinance
Chapter ObjectivesChapter Objectives
Internationalization of business Why foreign exchange rates in two different countries
must be in line with each other Interest rate parity Purchasing-power parity and the law of one price Exchange rate risk Working-capital management Financing sources available to multinational
corporations Direct foreign investment
Globalization of Products and Globalization of Products and Financial MarketsFinancial Markets
Direct Investment When the multinational corporation (MNC) has
control over the investment such as building an offshore manufacturing facility
Portfolio investment Financial assets with maturities greater than 1 year
such as purchase of foreign stock and bonds Total foreign investment in the U.S. now exceeds
such U.S. investment overseas
International Financial International Financial InvestmentInvestment
Earn higher returns than those obtainable in the domestic capital markets
Reduce portfolio risk through international diversification
Exchange RatesExchange Rates
Floating-rate international currency system– A system in which exchange rates between
different national currencies are allowed to fluctuate with supply and demand conditions.
Short-term day to day fluctuations in exchange rates are caused by changing supply and demand conditions in the foreign exchange market
Euroland and the EurodollarEuroland and the Eurodollar
Jan 2002, 11 countries in the European Union began circulating a new single currency, the Euro.
These countries are often referred to as “Euroland”
Include: Germany, France, Italy, Spain, Portugal, Belgium, Netherlands, Luxembourg, Ireland, Finland and Austria
Germany and France account for over 50 percent of Euroland’s output
Rationale for EurodollarRationale for Eurodollar
Ease in travel across national bordersEliminates exchange costsEliminates the uncertainty associated with
exchange rate fluctuationsCost differences for goods in different
countriesEasier to compare prices and reduce the
discrepancies
Foreign Exchange MarketForeign Exchange Market
Operates at three levels:– Customers buy and sell foreign exchange
through their banks– Banks buy and sell foreign exchange from other
banks in the same commercial center– Banks buy and sell foreign exchange from
banks in commercial centers i.e. New York, London, Zurich, Frankfurt, Hong Kong, Singapore, Tokyo
Spot Exchange RatesSpot Exchange Rates
Exchange rate– The price of foreign currency in terms of the domestic
currency Spot Transactions
– When one currency is traded for another currency, today– Rates are typically “Direct Quotes”
Direct Quotes– indicates the number of units of the home currency
required to buy one unit of the foreign currency Dollar/foreign currency rate ($/FC)
Exchange RatesExchange Rates
If an American company must pay DM 2,000 to a German firm, how many dollars will be required?
$.449 = DM 1Need DM 2,000.449 X 2,000 = $898
Indirect QuoteIndirect Quote
Indicates the number of units of a foreign currency that can be bought for one unit of the home currency
General method used in the over-the-counter market
Foreign currency/dollar (FC/$)Reciprocal of a direct quote
Direct and Indirect Exchange Direct and Indirect Exchange RatesRates
Example:Calculate the indirect quote from the direct
quote of spot rateGerman Mark .44901/direct quote = indirect quote1/.4490 = 2.227
Exchange RatesExchange Rates
If an American company must pay $2,000 to a German Firm, how many marks will the German Company receive?
Indirect rate = 2.2272.227 X $2,000 = DM 4,454
Exchange Rates and Exchange Rates and ArbitrageArbitrage
Foreign exchange quotes in two different countries must be in line with each other
If the exchange rates are out of line, a trader could make a profit by buying in the market where the currency was cheaper and selling it in the other
Arbitrage The process of buying and selling in more than one market to make a riskless profit
Types of Arbitrage: Simple, Triangular, Covered-interest
ArbitrageArbitrage
Simple– Eliminates exchange rate differentials across the
markets for a single currency
Triangular – Eliminates exchange rate differentials across the
markets for all currencies
Covered-interest– Eliminates differentials across currency and interest
rate markets
Asked and Bid RatesAsked and Bid Rates
Asked rate– Rate the bank of 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.
– Also know as selling rate or offer rate Bid Rate
– The rate at which the bank buys the foreign currency from the customer by paying in home currency
– Also know as buying rate Bid-Asked Spread
– The difference between the asked quote and the bid quote
Exchange Rate TermsExchange Rate Terms Cross rates
– The computation of an exchange rate for a currency from the exchange rates of two other currencies
Forward Exchange contract– Requires delivery at a specified future date of one currency for a
specified amount of another currency – The exchange rate for the forward transaction is agreed up today;
the actual payment of one currency and receipt of another currency take place at the future date
– The forward rate is often quoted at a premium or a discount from the existing spot rate
– The premium or discount is also call the forward-spot differential
Exchange Rate RiskExchange Rate Risk
The risk that tomorrow’s exchange rate will differ from today’s rate
Examples:– Exchange rate risk in international trade
contracts– Exchange rate risk in foreign portfolio
investments– Exchange rate risk in direct foreign investment
Exchange Rate Risk in Exchange Rate Risk in Foreign Portfolio InvestmentsForeign Portfolio Investments
The return is unknown—the security is a risky investment
The exchange rate fluctuation may increase the riskiness of the investment
Exchange Rate Risk in Direct Exchange Rate Risk in Direct Foreign InvestmentForeign Investment
Fluctuations in the dollar value of the assets located abroad as well as the fluctuations in the home currency-denominated profit stream.
Exchange Rate Risk in Exchange Rate Risk in International Trade ContractsInternational Trade Contracts
Can occur when a contract is written in the foreign currency, the exact dollar amount of the contract is not known
The variability of the exchange rate induces variability in the future cash flow
Interest-Rate Parity TheoryInterest-Rate Parity Theory
The forward premium or discount (except for the effects of small transaction costs) should be equal and opposite in size to the difference in the national interest rates for securities of the same maturity
The interest differential between two countries must be equal to the difference between the forward and spot exchange rates
Purchasing-Power Parity Purchasing-Power Parity Theory (PPP)Theory (PPP)
In the long run, exchange rates adjust so that the purchasing power of each currency tends to be the same.
The exchange rate changes tend to reflect international differences in inflation rates
Countries with high rates of inflation tend to experience declines in the value of their currency
Expected spot rate = Current spot rate X expected difference in inflation rate
PPPPPP
Expected spot Current Spot Rate (1 – expected domesticRate (domestic = (domestic currency X inflation rate)currency per unit per unit of foreign (1 – expected foreign of foreign currency) currency) inflation rate)
Law of one Price– In competitive markets in which there are no transportation costs or
barriers to trade, the same goods sold in different countries sell for the same price if all the different prices are expressed in terms of the same currency
International Fisher Effect– Nominal interest rates reflect the expected inflation rate and a real
rate of return Nominal interest rate = expected inflation rate + real rate of
interest
Exposure to Exchange Rate Exposure to Exchange Rate RiskRisk
Translation ExposureTransaction ExposureMoney-Market HedgeThe Forward-Market HedgeCurrency-Futures Contracts and OptionsEconomic Exposure
Direct Foreign InvestmentDirect Foreign Investment
Business RiskFinancial RiskPolitical RiskExchange Rate Risk