Chapter 21 International Financial Management

Copyright 2006 McGraw-Hill Australia Pty LtdPPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and PinderPrepared by Dr Buly Cardak

21–1

Chapter 21

International Financial Management


21–2

Learning Objectives

• Understand the importance of international transactions for the Australian economy.

• Read, interpret and use foreign exchange rates.

• Understand the roles of interest rates and inflation rates in exchange-rate determination.

• Understand the empirical evidence on the behaviour of exchange rates.


21–3

Learning Objectives (cont.)

• Understand the techniques that can be used to manage exchange risk.

• Explain the advantages of international diversification of investments.

• Identify the characteristics and uses of currency swaps.

• Identify the main sources of foreign currency borrowing used by Australian companies.


21–4

Background Statistics• International trade now represents about 20% of

Australia’s gross domestic product:

Table 21.1, Source: Reserve Bank of Australia, Bulletin.

EXPORTS IMPORTS

YEAR $Ab % $Am %

1988/89 55.4 15.8 62.3 17.7

1992/93 76.9 18 79.1 18.5

1996/97 105.2 19.7 103.6 19.4

1997/98 113.7 20.1 118.5 21

1998/99 111.9 18.8 126.5 21.2

1999/2000 125.9 19.9 140.3 22.2

2000/2001 153.9 22.9 153.2 22.8

2001/2002 153.3 21.5 154.6 21.6

2002/2003 148.5 19.7 167.2 22.2


21–5

Background Statistics (cont.)

• Historically, Australia has been a net importer of capital.– Levels of foreign investment in $A billion: non-official sector:

PORTFOLIO TOTAL PORTFOLIO TOTAL DIRECT AND NON- DIRECT AND NON-

DATE INVESTMENT OTHER OFFICAL INVESTMENT OTHER OFFICAL

30 June 1989 91.2 143.3 234.5 44.3 35.0 79.330 June 1992 109.8 201.3 311.1 51.2 52.2 103.430 June 1996 147.7 272.0 419.4 81.6 80.9 162.530 June 2000 216.9 472.1 689.0 190.5 150.3 340.830 June 2001 222.7 578.9 801.6 204.7 209.6 414.330 June 2002 234.7 585 819.7 177.7 225.6 403.330 June 2003 254.8 606.1 860.9 178.6 221.5 400

Table 21.2, Source: Reserve Bank of Australia


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Background Statistics (cont.)

• The extent of Australia’s external indebtedness is shown below:

Table 21.3, Source: Reserve Bank of Australia

Australia's gross and net external debt in $A million

DATE GROSS $Ab NET $Ab

30 June 1981 18.8 9.430 June 1986 101.9 78.430 June 1991 196.8 142.130 June 1996 275.5 193.930 June 1997 302.8 208.630 June 2001 493.9 30630 June 2002 524.4 329.130 June 2003 570.9 358.2


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Foreign Exchange Market• No actual market, instead a communications

network linking banks and other dealers in foreign exchange.

• This market determines the prices of foreign currencies.

• These prices are called ‘exchange rates’.

• ‘Exchange rate’ — the price at which one country’s currency can be exchanged for another country’s currency in the foreign exchange market.


21–8

The Spot Exchange Rate

• ‘Spot rate’: rate for transactions for immediate delivery. In the case of foreign exchange, the spot rate is for settlement in 2 days.

• Examples of spot rates for one Australian dollar, as at 30 June 2004, are shown in Table 21.4.


21–9

The Spot Exchange Rate (cont.)for $A1 as at 30/6/2004

Table 21.4, Source: Australian Financial Review

(1) (2)CUSTOMER SELLS CUSTOMER SELLS

FOREIGN CURRENCY $A1 AND BUYS (3)CURRENCY AND BUYS $A1 FOREIGN CURRENCY RATIO OF (2)/(1)%

US dollars (USD) 0.6936 0.6849 98.75UK pounds (GBP) 0.3862 0.3767 97.54Japan yen (JPY) 75.67 73.65 97.33Europe euro (EUR) 0.5795 0.5621 97.00Singapore dollar (SGD) 1.2029 1.1596 96.40Malta pound (MTP) 0.2493 0.2353 94.38W. Samoa tala (WST) 1.9975 1.8250 91.36


21–10

The Spot Exchange Rate (cont.)

• In Table 21.4:– Column (1) provides the exchange rate applicable where

a customer has foreign currency and wishes to obtain Australian dollars.

– Column (2) provides the exchange rate applicable where a customer has Australian dollars and wishes to obtain foreign currency.

– The difference (spread) between the rates is one source of the foreign exchange dealer’s profit.

– Column (3) shows how the spread varies from currency to currency.

– Essentially, those currencies that are traded most frequently (from an Australian viewpoint) are the currencies with the smallest spreads.


21–11

Foreign Exchange Trading in Australia

Table 21.5, Source: BIS survey reported by RBA

Market Share by Currency Pair, April 1998, 2001 and 2004

Market Share

Currency Pair April 1998 April 2001 April 2004

Aust. dollar–US dollar 48.2 49.4 44.7

Euro–US dollar N/A 11.4 17.0

US dollar–D’mark 3.5 N/A N/A

US dollar–Yen 16.0 14.0 12.7

UK pound–US dollar 5.4 6.4 6.2

NZ dollar–US dollar 6.7 9.0 6.0

Other currencies 10.2 9.8 13.4

Total 100.0 100.0 100.0


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The Forward Exchange Rate

• ‘Forward rate’: exchange rate that is established now, but with payment and delivery to occur at a specified future date.– Commonly for time periods of 1, 3 or 6 months.

– Forward contracts for periods exceeding 1 year are unusual, only about 3% of all contracts.

– Forward exchange rates are usually quoted in terms of the difference between the spot rate and the forward rate. Referred to as the ‘forward margin’.


21–13

The Forward Exchange Rate (cont.)

• Suppose that for US dollars (per one AUD) you are told that the spot rate is 0.5460/70 and the 3 months’ forward margin is –16/–16.

Table 21.6

US$ AND BUYS $A1 US$ AND SELLS $A1

Spot rate 0.5470 0.5460

less Forward margin 0.0016 0.0016

Forward rate 0.5454 0.5444


21–14

The Forward Exchange Rate (cont.)

• In this case, the spread between the buying and selling rates for the forward contract is:

0.5454 – 0.5444 = 0.0010.

• We can see that the spread for the spot contract • in this case is also only 0.0010.

• The spread for a forward contract is always greater than or equal to the spread for the matching spot contract.


21–15

Calculations Using Foreign Exchange Rates

• There are only four types of calculation.

• The UK pound exchange rates are used as an example. Assume the following exchange rates:

Customer sells Customer buys

£ and buys $A1 £ and sells $A1

UK pounds (GBP) 0.3862 0.3767


21–16

Calculations Using Foreign Exchange Rates (cont.)

• Type 1: to obtain a given sum in $A using £:– A UK resident may wish to obtain $A10 000.

– How many pounds are needed?

– As £0.3862 is needed for every $A1 required, the answer is:

£(10 000 × 0.3862) = £3862


21–17


• Type 2: to convert a given sum of £ to $A:– An Australian company has been paid £10 000

and wishes to exchange this for Australian dollars.– How many Australian dollars will this buy?

– As each $A will cost £0.3862 to buy, the answer is:

$A (10 000 / 0.3862) = $A25 893.32


21–18


• Type 3: to obtain a given sum in £ using $A:– An Australian company may wish to obtain

£10 000.

– How many Australian dollars are needed?

– As $A1 will obtain £0.3767, the answer is:

$A(10 000 / 0.3767) = $A26 546.32


21–19

Calculations Using Foreign Exchange Rates (cont.)• Type 4: to convert a given sum of $A to £:

– A UK resident has been paid $A10 000 and wishes to exchange this for pounds.

– How many pounds will this buy?

– As each Australian dollar will buy £0.3767, the answer is:

£(10 000 × 0.3767) = £3767


21–20

Triangular Arbitrage and Cross Rates

• ‘Cross rates’: exchange rates between two currencies derived from the exchange rates between the currencies and a third currency.

• Suppose that the following spot rates are observed simultaneously:

– $A1 = US$0.6000 and US$1 = £0.7000

• Using only these two spot rates, the spot rate linking AUD and GBP must be:

– $A1 = £(0.6000 × 0.7000) = £0.4200


21–21

Triangular Arbitrage and Cross Rates (cont.)

• If this were not the case, a riskless profit could be made.

• For example, if the spot rate was $A1 = £0.4180 instead, then a foreign exchange dealer could profit from undertaking the following three transactions simultaneously:

– Sell $A1 for US$0.6000

– Sell US$0.6000 for £(0.6000 × 0.7000) = £0.4200

– Sell £0.4200 for $A(0.4200 / 0.4180) = $A1.0048

• A risk-free profit of $A0.0048 for every AUD transacted in the first step.


21–22

Size of Foreign Exchange Market in Australia• The Australian dollar is one of the more actively

traded currencies in the world.

• Average daily turnover in the Australian Foreign Exchange Market in 2003 is nearly $A126b, with $A61b against Australian dollars.– Australian exports plus imports for the entire year 2003

amounted to only $A306b!

• Approximately two-thirds of the trading volume is between foreign exchange dealers and banks overseas.


21–23

Interest Rates, Inflation Rates, Spot and Forward Exchange Rates

• Assumptions– Market participants are risk-neutral.

– There are no barriers or frictions in any market.

– Analysis applies to any two currencies; Australian dollars and UK pounds are used for illustration.

– Analysis could be applicable to any time period; we assume that the period is 1 year for illustration.


21–24

• Notation

year 1for operator n expectatio the

dollars Australian torefers ariable v

a that indicate tousedsubscript $

pounds torefers ariable v

a that indicate tousedsubscript £

dollar)per pounds as (expressed

year 1for rate exchange forward

dollar)per pounds as (expressed rate exchangespot

annum)(per rateinflation

annum)per (nominal, rateinterest

E

f

s

p

i

Interest Rates, Inflation Rates, Spot and Forward Exchange Rates (cont.)


21–25

Interest Rate Parity

• Interest rate parity maintains that:

• Interest rate parity states that relative interest rates determine the relativity between the forward exchange rate and the spot exchange rate.

s

f

i

i

$

£

1

1


21–26

Interest Rate Parity (cont.)

• If interest rate parity does not hold, then arbitrage would be possible.

– ‘Covered interest arbitrage’: movement of funds between two currencies to profit from interest rate differences, while using forward contracts to eliminate exchange risk.

– Because of interest rate parity, a foreign investment with forward cover is equivalent to a domestic investment.


21–27

Interest Rate Parity (cont.)• Example 21.1

– An investor has $A1m to invest for 1 year in government securities.

– The interest rate on Australian dollars is 6.2% and the interest rate on UK pounds is 4.1%.

– The spot exchange rate is $A1 = £0.5265 and the forward exchange rate for 1 year is $A1 = £0.5161.

– Calculate the return on an Australian investment, and the return (in Australian dollars) on an equivalent UK investment.


21–28


Example 21.1 (cont.)• Invest $A1 million in Australian securities for 1 year:

Cash inflow after 1 year = $A1 000 000 × 1.062 = $A1 062 000

• Invest $A1 million in UK securities for 1 year:

Spot conversion of $A1 million to pounds:$A1 000 000 = £(1 000 000 × 0.5265) = £526 500

Cash inflow (in pounds) after 1 year investment: = £526 500 × 1.041 = £548 086.50


21–29


Example 21.1 (cont.)• Reconversion to Australian dollars at the forward

rate:

£548 086.50 = $A(548 086.50 / 0.5161)

= $A1 061 977.33

• The difference between these two investments is trivial, about $A22.67 on an investment of $A1m.


21–30


• The following example shows how a set of exchange rates and interest rates can be examined to determine whether covered interest arbitrage is feasible.

• Example 21.2– Spot rate: $A1 = US$0.7525– Forward rate (1 month): $A1 = US$0.7474– $A interest rate (1 month): 1.25% per month– US$ interest rate (1 month): 0.65% per month– Assumption that the spread is zero and there are no

transaction costs.


21–31


• Example 21.2 (cont.)

However:

The forward rate indicated by interest rate parity is (0.994 074) (0.7525) = 0.7480, compared with the actual forward rate of 0.7474, implying there is an arbitrage opportunity.

074 994.00125.1

0065.1

1

1

A

US

i

i

223 993.07525.0

7474.0

s

f


21–32


• Example 21.3– Illustrate covered interest arbitrage by assuming that

an arbitrager simultaneously undertakes the following four transactions:

– Borrows $A5 million for 1 month at 1.25% p.m.

– Converts the sum of $A5 million to US dollars, thereby obtaining US$(5 000 000 × 0.7525) = US$3 762 500

– Lends US$3 762 500 for 1 month at an interest rate of 0.65% p.m., producing a future cash repayment to the arbitrager of

US$3 762 500 × 1.0065 = US$3 786 956.25


21–33

Interest Rate Parity (cont.)• Example 21.3 (cont.)

– Sells forward (1 month) the sum of US$3 786 956.25, thereby ensuring an AUD inflow in 1 month’s time of:

$A(3 786 956.25/ 0.7474) = $A5 066 840.05

– The loan requires a repayment of

$A5 000 000 × 1.0125 = $A5 062 500

– After 1 month, the inflow of $A5 066 840.05 can be used to make the repayment of $A5 062 500, thereby giving the arbitrager a profit of $A4340.05 for a net investment of zero.

– Since the arbitrager made no net outlay, and all transactions were undertaken simultaneously, there was no exposure to risk.


21–34

Unbiased Forward Rates• Unbiased forward rates imply:

• If market participants are risk-neutral and there are no transaction costs, the market will set the forward rate, f, equal to the spot rate that is expected tobe observed at the date on which the forward contract matures.

• If this result did not hold, then risk-neutral speculators would trade in foreign currency until the forward rate was equal to the expected spot rate.

s

sE

s

f


21–35

Purchasing Power Parity

• Purchasing Power Parity (PPP) maintains that:

• PPP holds that the expected change in the exchange rate is due to differences in expected inflation rates in the respective countries.

$

£

1

1

pE

pE

s

sE


21–36

Purchasing Power Parity (cont.)

• The simplest derivation of PPP assumes that the law of one price is valid. This states that the dollar price of any given commodity should be the same everywhere in the world.

• If all markets were free and frictionless, and all goods were traded internationally, then the law of one price would hold because, otherwise, an arbitrage could be undertaken.


21–37


• However, for many commodities, the law of one price clearly does not hold.

• Fortunately, PPP may also be proved by making the weaker assumption that the ratio of dollar prices for the same commodity in two countries will stay constant as time passes.


21–38


• Example 21.4– Suppose the spot rate is $A1 = £0.3325. – If the expected inflation rates are 9% in Australia and 4%

in the UK, what is next year’s spot rate expected to be?

– By year’s end $A1 = £0.3172, a depreciation of 4.6% in the value of the $A in terms of UK pounds.

3172.0 3325.009.1

04.1

sE


21–39

Message of Purchasing Power Parity

• A country with a high inflation rate can expect to have a depreciating exchange rate (a ‘weak’ currency).

• Whereas a country with a low inflation rate can be expected to have an appreciating exchange rate (a ‘strong’ currency).


21–40

Uncovered Interest Parity or the International Fisher Effect

• If interest rate parity and unbiased forward rates hold simultaneously, then:

• This implies that the spot exchange rate will tend to adjust in the direction indicated by interest rates in the two currencies.

• In particular, a country’s currency will tend to appreciate (depreciate) relative to another currency if its interest rate is lower (higher) than the interest rate on the other currency.

$

£

1

1

i

i

s

sE


21–41

Empirical Evidence on the Behaviour of Exchange Rates

• Interest rate parity: evidence– Where the interest rate data are collected from

unregulated markets (Eurodollar market), the overseas evidence nearly always supports interest rate parity.

– An early study by Bird, Dyer and Tippett (1987) found that after the floating of the AUD in 1983, there were few opportunities for covered interest arbitrage if interest rates were measured by rates on government securities and transaction costs were included.


21–42

Empirical Evidence on the Behaviour of Exchange Rates (cont.)

• Unbiased forward rates: evidence– Most tests of unbiased forward rates relationships have

found that the forward rate is not an unbiased estimate of the future spot rate.

– Sources of this bias are not obvious — one possibility is risk aversion among foreign exchange participants, requiring a risk premium for holding currency.


21–43


• Purchasing power parity: evidence– In practice, the law of one price does not hold for a great

many commodities.

– Where a commodity is readily defined, cheaply transportable and frequently traded in organised markets, it is likely that the law of one price will provide an accurate description of reality.

– Baldwin and Yan (2004) find some parity between US and Canada for highly standardised products but Canadians pay up to 4% premiums for some products and up to 8% less for some services.


21–44


• Purchasing power parity: evidence (cont.)– Generally, PPP is found to give a poor description of

exchange rate behaviour, unless a long time period is used for testing.

– This makes international comparisons using current exchange rates misleading.

– For example, OECD data shows per capita GDP in Australia in 2002 to be US$20 700 using current exchange rates, but US$28 100 using PPP-adjusted figures.


21–45


• Uncovered interest parity: evidence– The interest rate difference between currencies is

typically found to give a biased forecast of the future spot rate, and often does not even predict the direction of movement correctly.


21–46


• Forecasting exchange rates– Little evidence in Australia that market participants can

forecast successfully the AUD–USD exchange rate.

– Hunt (1987) studied short-term forecasts by 16 foreign exchange dealers.

– Found no evidence that dealers could forecast the spot rate — random walk performed better.

– Easton and Lalor (1995) found no evidence that longer-term exchange rate forecasts are accurate.


21–47

Management of Exchange Risk

• What is an exchange risk?– The variability of an entity’s value that is due to changes

in exchange rates.

– The exchange risk arising from trade-related contracts is often termed ‘transaction risk’.

– The exchange risk arising from capital-related contracts is often termed ‘translation risk’.


21–48

Management of Exchange Risk (cont.)

• Who faces exchange risk?– Exchange risk arises whenever a company needs to

deal, now or in the future, in a currency other than the currency that shareholders use to finance their consumption.

– However, an electronics retailer may never transact in the foreign currency market, yet it will face exchange risk because it may obtain CD players from Australian wholesalers who, in turn, import CD players from overseas.

– Some entities exposed to exchange risk include tourism operators and universities — both provide services in Australia to foreign customers whose demand is sensitive to exchange movements.


21–49

• The ‘hedging principle’– A financial strategy that will ensure that the Australian

dollar value of a commitment to pay or receive a sum of foreign currency in the future is not affected by changes in the exchange rate.

– The basic principle of hedging is to undertake another, offsetting, commitment in the same foreign currency.

For example, an Australian importer who is committed to making a cash payment in UK pounds can hedge by entering into a commitment to receive UK pounds for the same amount and on the same date.



21–50

• Forward rate hedge– For example, suppose that an Australian importer is

committed to paying a future sum in UK pounds. In effect, this is a contract to buy UK pounds in the future.

– By entering into a forward contract to buy UK pounds, the value of the commitment can be fixed in Australian dollar terms.

– The future outflow of UK pounds required by the import contract is matched by an inflow of UK pounds required by the forward contract.



21–51

• Hedging by borrowing or lending– A hedging technique consisting of establishing an

offsetting cash flow by borrowing or lending the foreign currency.



21–52

• Who should hedge exchange risk?– It is useful to distinguish between three broad categories

of companies:

Category 1: the domestic company that unexpectedly faces a significant foreign exchange involvement.

Category 2: the repeat exporter (or importer), regularly involved in foreign currency transactions.

Category 3: the multinational company producing and selling in two or more countries.



21–53

• Category 1 (the one-off transaction)– The incentive to hedge is obvious.

– The company has little or no international experience and an unfavourable result from a single large transaction could place a significant strain on the company’s finances.

– A forward contract is likely to be the most suitable means of hedging.



21–54

• Category 2 (the repeat exporter/importer)– A sequence of foreign exchange transactions should not

necessarily be treated as merely the equivalent of a one-off transaction repeated many times.

– The ‘true’ cost of a transaction at the forward rate is its opportunity cost. In this case, the forgone alternative is to transact at the spot rate that occurs at the expiration of the forward contract.



21–55

• Category 2 (the repeat exporter/importer)– If the repeat importer does not hedge but simply pays for

the imported goods by transacting at the spot rate, has the importer’s exchange risk increased?

– Exchange risk is really the risk of suffering a greater variability in cash flows, and there is no reason to believe that future forward rates will be less variable than future spot rates.



21–56

• Category 3 (the multinational company)– A multinational company is likely to receive net cash

flows in a number of currencies on a continuing basis, with no fixed terminal date in contemplation.

– Long-term debt denominated in the same currencies will commit such a company to foreign currency payments and therefore act as a ‘natural’ hedge.

– While it is inevitable that some exchange rate changes will cause losses, others will produce gains. There is, therefore, a kind of portfolio effect.



21–57

• Contingent hedging– A contingent exchange risk may exist where a company

tenders for an overseas contract. The company’s exposure to exchange risk is, therefore, contingent upon winning the tender.

– In effect, the company has granted (i.e. sold at a price of zero) an option.

– Therefore, the most suitable way to hedge such a contingency is by purchasing a matching option.



21–58

• There are four possible outcomes from a contingent sale of an asset in US dollars:

– $A appreciates against US$ and the sale occurs;

– $A appreciates against US$ and the sale does not occur;

– $A depreciates against US$ and the sale occurs; or

– $A depreciates against US$ and the sales does not occur.



21–59


If $A appreciates If $A depreciates

Sale Occurs Sale Doesn’t Occur

Sale Occurs Sale Doesn’t Occur

US$ Bought Forward

Nil Loss Nil Gain

US$ Not Bought Forward

Gain Nil Loss Nil

Table 21.8


21–60

International Diversification of Investments

• Once 30 or 40 domestic shares have been selected, the benefit of further diversification is rather slight, as most of the characteristics of the Australian market are already represented.

• A further source of diversification is to invest in shares listed on foreign stock exchanges.

• When an asset’s returns are measured in a foreign currency, without a hedge, the overall return is the joint result of the asset return and the return on the exchange rate.


21–61

International Diversification of Investments (cont.)• Benefits will be received so long as the correlation

between the returns of the foreign shares and the domestic shares is less than 1.

• The correlations between the share markets of different countries are positive, but less than 1 (typically ranging from 0.3 to 0.6).

• This suggests that substantial benefits can be gained from international diversification.


21–62

International Diversification of Investments (cont.)• Potential disadvantages of international

diversification:– Possible adverse tax implications.

– Increased transaction costs.

– Difficulties in obtaining reliable information on foreign securities.

– Political risks (limitations on the withdrawal of capital or expropriation).


21–63

Currency Swaps

• Swaps are one of the most significant new financial instruments of the past 25 years.

• Two counterparties agree to exchange a series of cash flows as a consequence of a swap of loan obligations.

• Two main forms of swap contacts are the interest rate swap and the currency swap.


21–64

Currency Swaps (cont.)

• Interest rate swaps– Agreement between two parties to exchange interest

payments for a specific period, related to an agreed principal amount.

– The most common type of interest rate swap involves an exchange of fixed interest payments for floating interest payments.

– Interest rate swaps do not necessarily have any international features, that is, a fixed-for-floating rate swap between two domestic borrowers.


21–65


• Currency swaps– A simultaneous borrowing and lending operation in which

two parties initially exchange specific amounts of two currencies at the spot rate.

– Interest payments in the two currencies are also exchanged and the parties agree to reverse the initial exchange after a fixed term at a fixed exchange rate.

– Simplest currency swap is of fixed rate commitments in different currencies.

This comprises the exchange of principal at the outset.


21–66


• Currency swaps– Simplest currency swap (cont.)

Followed by exchanges of interest flows on interest payment dates.

Completed with a re-exchange of principal’s at maturity date of loans.

– While forward contracts of more than 1 year are uncommon, a currency swap effectively offers longer-term forward contracts.

– Credit risk is an important issue with currency swaps (compared to interest rate swaps) as counterparties not only swap interest commitments but also principal.


21–67


• Example 21.9• Yanko wants to borrow £100m for 3 years and

Britco wants to borrow US$200m for 3 years.

• Current spot exchange rate is US$1 = £0.5000.

• They plan to follow a bond structure of repayment, coupon (interest) payments for 3 years with principal at maturity.


21–68


• Example 21.9• The interest rates available to the two borrowers is

given in Table 21.10 below:

• .

• The key point here is that yanko has a 2% borrowing cost advantage in $US dollars.


21–69


• Example 21.9 (cont.)• Yanko borrows US$200m, which it pays to Britco, and

Britco borrows £100m, which it pays to Yanko.• The originally agreed and post swap cashflows are

shown in Table 21.11.


21–70


• Example 21.9 (cont.)• Note that an intermediary has entered the

agreement, brokering the swap.

• After the swap, Britco is paying 11.8% for US$, which is 0.2% better than it could do on its own.

• Similarly, Yanko is paying 13.3% for UK £ after the swap; this is 0.2% better than it could do on its own.


21–71


• Example 21.9 (cont.)


21–72


• Example 21.9 (cont.)• The exchange risk falls on the intermediary with a

US$3.6m inflow and a £1.2m outflow.

• The intermediary is likely to hedge this exposure away with forward contracts or through the natural hedge created by brokering a portfolio of swaps.


21–73

Foreign Currency Borrowing by Australian Companies• Risk of foreign currency borrowing

– Domestic borrowers may be induced to borrow overseas because of lower interest rates on offer.

– As seen earlier, interest rate differentials should be interpreted to imply exchange rate movements — interest rate parity.

– A foreign currency loan left unhedged is exposed to depreciation of the Australian dollar, making repayment of the loan more costly.

– A hedge, if available, may wipe out the cost savings (this is expected in an efficient market), though a swap may offer risk-management opportunities.


21–74

Reasons for Borrowing Overseas

• Foreign currency debt can provide a useful hedge for a foreign-currency asset holding.

• Alternatively, a currency swap can be used to hedge the currency risk.

• Offshore borrowing offers the Australian corporation a broader range of lenders that can handle extremely large loans which might be a strain on the domestic capital market.


21–75

Reasons for Borrowing Overseas (cont.)• Hedging efficiency — foreign lenders may not want Australian

currency exposure, even though they are willing to lend to Australian firms.

• Thus, to access these lenders, Australian firms must borrow in foreign currency and hedge the risk themselves — the cost is likely to be shared between the lender and borrower (it would be factored into the borrowing rate).

• Diversification — lenders prefer not to be the sole creditor of a large firm and in such cases may require risk premium, the firm may look overseas for cheaper funds, spreading the risk across several institutions (local and overseas).


21–76

Borrowing Overseas: Market Structure

• Overseas borrowing, first choice– Borrow from an overseas bank or financial institution.

– Or, the borrower may issue, in a foreign country, marketable securities.

• Overseas borrowing, second choice– Should the funds be raised in a foreign market or in

a ‘Euro’ market.


21–77

Borrowing Overseas: Market Structure (cont.)• Foreign transaction — carried out in foreign country

in currency of that country.

– Foreign bond — Australian company issuing US$ bonds in US capital markets.

• Eurocurrency transaction — carried out in the currency other than currency of country where transaction occurs.

– Eurocurrency loan — London banks lend Swedish government US$500m.


21–78

Borrowing Overseas: Market Structure (cont.)• ‘Bearer security’: a security whose ownership is not

registered by the issuer; possession of the physical document is primary evidence of ownership.

• Eurocurrency markets are dominated by US$ but Euro is of increasing importance.

• Since 1985, Australian dollar securities have been included in Euromarkets and traded by participants, providing another source of funds for Australian firms.


21–79

Foreign and Eurocurrency Loans

• Similar to loans from domestic banks, but they are arranged overseas and are normally denominated in a foreign currency.

• Short-term Eurocurrency bank loans– Typically involve a principal of at least US$5m.

– Interest rate is set at a margin (0.5 to 3.0%) above an agreed reference rate (usually LIBOR).

– Different LIBOR rates for different currencies and terms to maturity.

– Often provided under a revolving credit facility.


21–80

Foreign and Eurocurrency Loans (cont.)

• Eurocurrency standby facilities– A bank is committed to providing short-term loan funds

should the borrower require them.

– Normally arranged for periods up to 2 years and intended to be used only in times of difficulty or tight liquidity.

– Bank charges a commitment fee as well as interest.


21–81

• Eurocurrency term loans– Typically for a principal of at least US$5m, to be repaid

over 5 to 10 years.

– Interest charged on a floating-rate basis, set at a margin above LIBOR.

– The time pattern for the repayment of principal is negotiable between parties.

– Loans of more than US$50 to US$100m will usually require a syndicate of banks to provide the funds.

Foreign and Eurocurrency Loans (cont.)


21–82

Foreign and Eurocurrency Securities• There has been a trend towards borrowers

obtaining funds from lenders by selling them marketable securities, such as bonds and notes, rather than by borrowing from a bank.

• One reason for this trend may be due to the possibility of the borrower qualifying for an exemption from the interest withholding tax.

• ‘Foreign securities’ — securities sold in a country by a foreign issuer (in the local currency).

– ‘Kangaroo bonds’, foreign companies issuing $A denominated bonds in the Australian capital market.


21–83

Foreign and Eurocurrency Securities (cont.)• Euronote issuance facilities

– Facilities under which one or more institutions agrees to underwrite a borrower’s short-term securities (Euronotes).

– Euronotes are issued for short terms (up to 6 months) but the facility is generally arranged for a much longer period (up to 7 years).

– These notes are essentially bearer promissory notes drawn by the borrower, with face values of US$100 000 and US$500 000.

– These facilities involve a range of fees: establishment, commitment and take-up fees.


21–84

• Commercial paper and certificates of deposit

– ‘Commercial paper’: unsecured short-term promissory notes.

– ‘Certificates of deposit’: a marketable fixed-rate debt instrument issued by a bank in exchange for a deposit of funds.

– ‘Commercial paper facility’: similar to a note issuance facility, but not underwritten.

Foreign and Eurocurrency Securities (cont.)


21–85

• Transferable loan certificates

– Euromarket borrowers can obtain a bank term loan with provision for the lender to convert the loan into a transferable loan certificate.

– Similar to a syndicated loan from the viewpoint of the borrower.

– Interest rate set at a margin above LIBOR.

– Ownership is registered (not bearer instruments).



21–86

• Medium-term notes– Unsecured, bearer, coupon securities with terms to

maturity ranging from 1 to 30 years.

– Coupon rate can be fixed or floating.

– The size of each facility is typically between US$50m and US$500m.

– Offer flexibility: notes issued within a given facility can have a range of maturities, currencies and fixed and floating coupon rates.



21–87

• Eurobonds– Medium- to long-term international bearer securities sold

in countries other than the country of the currency in which the bond is denominated.

– Many different types: Fixed rate bonds Floating rate notes Equity-related bonds

– A Eurobond issue is usually for a minimum of US$50m.

– Maturities are usually between 3 and 12 years.



21–88

• Eurobonds– In 2003, financial institutions issue the bulk of international bonds

(72%), followed by corporations (13%) and governments and state agencies (10%).

– Australian issues account for 0.8% of all issues, though they rank 6th currency, with 60% of all issues being straight fixed rate bonds in US$ or Euro.

– Australian and NZ Eurobond issues dominated by banks and financial institutions, property developers and property trusts.

– Uridashi Market — A$ bonds placed in Japanese retail bond market.



21–89

Summary

• Australia has always been a relatively open economy, international globalisation — thus international financial management is important in Australia.

• Exchange rates– Spot rate — price of currency for immediate delivery. – Forward rate — price of currency for delivery on a

specified later date.


21–90

Summary (cont.)

• International finance relationships

– Interest rate parity — empirical support strong.

– Unbiased forward rates — empirical support weak.

– PPP – high inflation = depreciation.

– International Fisher effect — interest rates and exchange rate expectations.


21–91

Summary (cont.)

• Competitive market for currencies means it is impossible to consistently forecast exchange rates successfully.

• Exchange risk — loss due to unanticipated exchange rate changes.

– Manage exchange risk by hedging — appropriate for one-off transactions.

– Hedging is not helpful in long-term situations, such as committed repeat exporter.


21–92

Summary (cont.)

• Return on foreign assets depends on exchange rates as well as investment return.

• Foreign investment popular because it offers increased diversification.

• Currency swaps — changes the currency in which a loan must be repaid, i.e. converts a foreign currency loan into a domestic currency loan.


21–93

Summary (cont.)

• Australian companies increasingly borrow overseas.

• Two main mechanisms include Eurocurrency loans and debt security issues.

• These foreign borrowings are often complemented with a swap as a hedging mechanism, either currency or interest rate.

• Australian-based foreign bonds — kangaroo bonds.

Documents

Chapter 21 International Financial Management