Welcome to class of International Finance/Forces by Dr. Satyendra Singh University of Winnipeg...
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Welcome to class of
International Financial Forces &Finance Management
Dr. Satyendra SinghProfessor, Marketing and International Business
University of WinnipegCanada
[email protected] http://abem.uwinnipeg.ca
www.abem.ca/conference
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Outline• Purchasing Power Parity• Factors affecting Foreign currency• Fisher’s Effect• Arbitrage• Hedge (Forward, Currency option, Money Market)• Transfer Pricing• Swap (Parallel loan, Bank, Currency)• Debt vs. Equity• Impact of Culture on Accounting• Accounting Standards
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Purchasing Power Parity (PPP)…
– The number of units of a currency required to buy the same amount of goods and services in a domestic market that $1.00 would buy in the U.S.
– Helps to make comparisons possible across economies
CIA Fact Book
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Purchasing Power Parity (PPP)If,1 Lt. Milk US $1.001 Lt. Milk India Rs. 20.00
Then, PPP: US $1 = Rs. 20
Reality: US $1 = Rs. 40
ie Rs. Is 50% undervalued –artificially?!
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Factors affecting Foreign Currency• Three factors:
– Inflation– Interest rate– Speculation
• Fisher’s Effect– Diff. in interest rate may determine strength of FOREX
€ 1 = $1.5,Interest rate: € (3%) and $(5%)
Speculation: Which currency becomes weaker/stronger?
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Inflation and the International Company.. High inflation rates Make capital expenditure planning more difficult Cause the cost of goods and services to rise Tend to cause BOP deficits Could lead to more restrictive fiscal or monetary policies, currency controls, export
incentives, and import obstacles Encourage borrowing because the loan will be repaid with cheaper money Bring high interest rates Discourage lending Make capital expenditure planning more difficult
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Atlas Conversion Factor
• It is used for speculation
Average of FOREX for the last 2 years adjusted by the ratio of domestic inflation and combined inflation of US, UK, EU and Japan
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Weak Foreign Currency…
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Weak Foreign Currency…
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Weak Foreign Currency… (thousand)
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Weak Foreign Currency… (million)
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Weak Foreign Currency (billion)
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Weak Foreign Currency (trillion)
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No Foreign Currency
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Border: Rwanda and Burundi
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Foreign Exchange Office in Africa
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Arbitrage: The process of buying and selling instantaneously to make profit at no risk
AlgeriaDinar
BrazilRiel
ChilePeso
1:21:3
1:5
5 dinar
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Movement of $, Transfer Pricing
Supplier
Local business
Customer
Profit
$1
$10
$9
Say, 30% tax$6.30 Net profit$2.70 tax
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Movement of $, Transfer Pricing
Supplier
Local business
Customer
Foreign
$1
$10
$8
Now profit $1Say, 30% tax33 Cents tax!
$9
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Movement of $, Transfer Pricing – 3 countries
UK OFC: Jamaica USA
$100 to produceSells at $110 Sells at $210 Sells at $220Profit $10 Profit $100 Profit $10Tax 50% Tax 5% Tax 30%Tax paid $5 Tax paid $5 Tax paid $3.33
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OFC: Offshore Ffinancial Centres
Offshore financial center specializes in financing nonresidents, low taxes and few banking regulations Too small to exist on its own Boosts economy Employment
Switzerland Cayman Island Hong Kong Bahamas Bermuda Gibraltar Luxemburg …
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Transaction Exposure: Hedging Hedging process to reduce or eliminate financial risk
Forward market hedge Foreign currency contract sold or bought forward in order to protect against foreign currency
movement Currency option hedge Option to buy or sell specific amount of foreign currency at specific time to protect against foreign
currency risk Money market hedge Method to hedge foreign currency exposure by borrowing and lending in domestic and foreign
money markets
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Forward Hedge• Hedge is a process to reduce risk
€ 1 = $1.5 (now/spot) $ is expected to be weak € 1 = $1.6 (speculate/forward)Interest rate: € (3%) and $(5%)
Suppose you have accounts receivables for €20,000If quoted in €, supplier may not have problemBut strong currency is desirable by both seller and buyerIf you quoted in € (ie € 20,000 x 1.5 = $30,000),You now get $ (ie € 20,000 x 1.6 = $32,000)You gained: $2000, because $ became weakYou lose, if $ became stronger (say 1.4) = $2,000
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Currency Option Hedge
• So you have accounts receivables in a currency that works best for your company
• Firms may have bank accounts in multiple currencies such as Dollar, Euro, Yen… to avoid conversion charges.
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Money Market Hedge• Counter balancing the risk by borrowing the same amount
for FOREX (A/R) in domestic market and investing it until accounts receivables are received
Suppose the AR is €20,000 (in 90 days)€ 1 = $1.4 (expected) $ is expected to be strong! € 1 = $1.5 (now)Interest rate: € (5%) and $(3%)
Borrow €20,000 convert in $ (€ 20,000 x 1.5 = $30,000) Invest Income (but pay interest)
After 90 days, pay €20,000 to local bank, so no debtSo, Investment + income - interest ≥ €20,000
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Source: Wall Street Journal, Exchange rate June 19, 2006
Fri: June 16 (LAST)Mon: June 19 (SPOT)Last Friday
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Swaps
Parallel Loans Matched loans across currencies made to cover
risk Bank Swap
Swap made between banks to acquire temporary foreign currencies
Currency Swap Exchange of debt service of loan or bond in one
currency for debt service of loan or bond in another currency
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Parallel Loan Swap
CANADA: Canada (parent) India (child)
INDIA: Canada (child) India (parent)
$1m
Rs. 40m
$1 = Rs. 40
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Bank Swap
Canadian Bank in Canada
Indian Bank in India Canadian child in India
Canadian parent in Canada$1m
Rs. 40m
Canadian Parent deposits $1m to the credit of the Indian BankThe Correspondent Indian Bank lends Rs. 40m (spot rate) to the ChildAt a later agreed date, the Child returns Rs. 40m to Indian BankIndian Bank instructs the Canadian Bank to pay $1m to the Parent
So, no conversion of $1 to Rs. Useful if you want hard currency only
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Correspondent Bank
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Currency SwapCANADA CYPRUSI am Known here Same is true for So the interest rate is low for me the Cypriot
person in Cyprus
So, I take the loan for the Cypriot guy Person does the In Canada at low interest rate same for me in $1.5m Cyprus (€ 1m)
Then, we swap currency,i.e., I service the loan in € for the Cypriot guy in CYPRUSAnd the Cypriot guy services my loan in $ in Canada
€ 1 = $1.5
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Capital Structure of a Firm
Debt Borrow from Bank Conservative, report less, ↓ tax exposure, ↑ dividend
pay out save $ to service debt France, Germany, Japan, some Emerging Markets
Debt financing is less expensive than equity financing, because interest paid on debt is tax deductible, but dividends paid out to shareholders are not.
Equity Shares, Bonds Impressive (Inflated report) to attract investors Value of Bond ↓, if interest rate ↑
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How do Bonds perform?
Suppose, now you have bonds worth$10,000 @5% for a year
So expect $500 at the end of the year
Now, interest rate changed to 6%
Value of your bond now is: $x x.06 = $500ie x = $8334
Drop in value = 17%!
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Cultural Differences in Measurement and Disclosure for Accounting Systems
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Annual Reports
Depends Calculation of Inventory Depreciation Income only when contract is complete Valuation of assets Goodwill …
So we need uniform accounting system
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International Accounting Standards
• Triple Bottom Line Standard (3BL)– Environmental, social, and financial impacts of the business
• International Accounting Standards Board (IASB)• International Financial Reporting Standards (IFRS)• Sarbans-Oxley Act (2002, US)
– Public Company Accounting Reform and Investor Protection Act (in the Senate)
– Corporate and Auditing Accountability and Responsibility Act (in the House)
– Heavy penalty for corporate finance fraud
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Use of International Financial Reporting Standards (IFRS)
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Tax System
• Direct Tax– Income Tax– VAT – Value Added Tax
• Indirect Tax (Withholding Tax)– Dividend– Interest– Royalty
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Corporate Tax Rates