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