Chapter 27 Principles of Corporate Finance Tenth Edition

Chapter 27 Principles of Corporate Finance Tenth Edition Managing International Risks Slides by Matthew Will Mc. Graw-Hill/Irwin Copyright © 2011 by the Mc. Graw-Hill Companies, Inc. All rights reserved.

Topics Covered Ø The Foreign Exchange Market Ø Some Basic Relationships Ø Hedging Currency Risk Ø Exchange Risk and International Investment Decisions Ø Political Risk 27 -2

Exchange Rates July 24, 2009 27 -3

Foreign Exchange Markets Exchange Rate - Amount of one currency needed to purchase one unit of another. Spot Rate of Exchange - Exchange rate for an immediate transaction. Forward Exchange Rate - Exchange rate for a forward transaction. 27 -4

Foreign Exchange Markets Forward Premiums and Forward Discounts Example - The Peso spot price is 13. 2155 peso per dollar and the 3 month forward rate is 13. 3805 Peso per dollar, what is the premium and discount relationship? 27 -5

Foreign Exchange Markets Forward Premiums and Forward Discounts Example - The Peso spot price is 13. 2155 peso per dollar and the 3 month forward rate is 13. 3805 Peso per dollar, what is the premium and discount relationship? 27 -6

Foreign Exchange Markets Forward Premiums and Forward Discounts Example - The Peso spot price is 13. 2155 peso per dollar and the 3 month forward rate is 13. 3805 Peso per dollar, what is the premium and discount relationship? Answer - The dollar is selling at a 1. 20% premium, relative to the peso. The peso is selling at a 1. 20% discount, relative to the dollar. 27 -7

Exchange Rates Example Swiss franc spot price is SF 1. 0723 per $1 Swiss franc 1 yr forward price is SF 1. 0643 per $1 The franc is selling at a Forward Premium The Dollar is selling at a Forward Discount Ø This means that the market expects the dollar to get weaker, relative to the franc Example (premium? discount? ) The Japanese Yen spot price is 94. 705 per $1 The Japanese 1 yr fwd price is 94. 087 per $1 27 -8

Exchange Rates Example What is the franc premium (annualized)? Example What is the Yen discount (annualized)? 27 -9

Exchange Rate Relationships Ø Basic Relationships equals 27 -10

Exchange Rate Relationships 1) Interest Rate Parity Theory Ø The ratio between the risk free interest rates in two different countries is equal to the ratio between the forward and spot exchange rates. 27 -11

Exchange Rate Relationships Example - You have the opportunity to invest $1, 000 for one year. All other things being equal, you have the opportunity to obtain a 1 year Mexican bond (in peso) @ 6. 67 % or a 1 year US bond (in dollars) @ 1. 505%. The spot rate is 13. 2155 peso: $1 The 1 year forward rate is 13. 8891 peso: $1 Which bond will you prefer and why? Ignore transaction costs 27 -12

Exchange Rate Relationships 27 -13 Example - You have the opportunity to invest $1, 000 for one year. All other things being equal, you have the opportunity to obtain a 1 year Mexican bond (in peso) @ 6. 67 % or a 1 year US bond (in dollars) @ 1. 505%. The spot rate is 13. 2155 peso: $1 The 1 year forward rate is 13. 8891 peso: $1. Which bond will you prefer and why? Ignore transaction costs Value of US bond = $1, 000 x 1. 0150 = $1, 015, 000 Value of Mexican bond = $1, 000 x 13. 2155 = 13, 215, 500 peso exchange 13, 215, 500 peso x 1. 0667 = 14, 096, 974 peso bond pmt 14, 096, 974 peso / 13. 8891= $1, 014, 967 exchange

Exchange Rate Relationships 2) Expectations Theory of Exchange Rates Theory that the expected spot exchange rate equals the forward rate. 27 -14

Exchange Rate Relationships 3) Purchasing Power Parity The expected change in the spot rate equals the expected difference in inflation between the two countries. 27 -15

Exchange Rate Relationships Example - If inflation in the US is forecasted at 1. 0% this year and Mexico is forecasted at 6. 0%, what do we know about the expected spot rate? Given a spot rate of 13. 2155 peso: $1 solve for Es Es = 13. 87 27 -16

Exchange Rate Relationships 4) International Fisher effect The expected difference in inflation rates equals the difference in current interest rates. Also called common real interest rates 27 -17

Exchange Rate Relationships Example - The real interest rate in each country is about the same 27 -18

Exchange Rates Another Example You are doing a project in Switzerland which has an initial cost of $100, 000. All other things being equal, you have the opportunity to obtain a 1 year Swiss loan (in francs) @ 6. 0% or a 1 year US loan (in dollars) @ 6. 8%. The spot rate is 1. 0723 sf: $1 The 1 year forward rate is 1. 0643 sf: $1 Which loan will you prefer and why? Ignore transaction costs Cost of US loan = $100, 000 x 1. 068 = $106, 800 Cost of Swiss Loan = $100, 000 x 1. 0723 = 107, 230 sf exchange 107, 230 sf x 1. 06 = 113, 664 sf loan pmt 113, 664 sf / 1. 0643 = $106, 797 If the two loans created a different result, arbitrage exists! exchange 27 -19

Exchange Rates % Forecast Error in Forward Rate for Swiss Francs 27 -20

International Prices The Big Mac Index – The price of a Big Mac in different countries (July 16, 2009) 27 -21

Purchasing Power & Exchange Rates 27 -22

Exchange Rates Nominal versus Real Exchange Rates U. S. Dollar / UK (in log scale) 27 -23

Exchange Rates Nominal versus Real Exchange Rates U. S. Dollar / France (in log scale) 27 -24

Exchange Rates Nominal versus Real Exchange Rates U. S. Dollar / Italy (in log scale) 27 -25

27 -26 Interest Rates and Inflation Countries with the highest interest rates generally have the highest inflation rates. In this diagram each of the 55 points represents a different country. Average money market rate, %, 2000 -08 40 35 30 Turkey 25 20 15 10 5 0 -10 Japan -5 -10 0 10 20 Average inflation rate, %, 2000 -08 30

Auto Industry Data 2003 27 -27

Exchange Rate Risk Example - Honda builds a new car in Japan for a cost + profit of 1, 715, 000 yen. At an exchange rate of 94. 705 Y: $1 the car sells for $14, 209 in Indianapolis. If the dollar rises in value, against the yen, to an exchange rate of 134 Y: $1, what will be the price of the car? 1, 715, 000 = $18, 109 94. 705 Conversely, if the yen is trading at a forward discount, Japan will experience a decrease in purchasing power. 27 -28

Exchange Rate Risk Example - Harley Davidson builds a motorcycle for a cost plus profit of $12, 000. At an exchange rate of 94. 705 Y: $1, the motorcycle sells for 1, 136, 460 yen in Japan. If the dollar rises in value and the exchange rate is 103 Y: $1, what will the motorcycle cost in Japan? $12, 000 x 103 = 1, 236, 000 yen 27 -29

Exchange Rate Risk Ø Currency Risk can be reduced by using various financial instruments Ø Currency forward contracts, futures contracts, and even options on these contracts are available to control the risk 27 -30

Capital Budgeting Techniques 1) Exchange to $ and analyze 2) Discount using foreign cash flows and interest rates, then exchange to $. 3) Choose a currency standard ($) and hedge all non dollar CF. 27 -31

27 -32 Example Suppose that the Swiss pharmaceutical company, Roche, is evaluating a proposal to build a new plant in the United States. To calculate the project’s net present value, Roche forecasts the following dollar cash flows from the project. The US cost of capital is 12% and the spot exchange rate is 1. 2 sf / 1 $. What is the project value in US dollars and Swiss francs? year 0 1 2 3 4 5 -1300 450 510 575 650 NPV ($) = $ 513 million NPV (sf) = $513 x 1. 2 (sf/$) = 616 sf million

27 -33 Example Suppose that the Swiss pharmaceutical company, Roche, is evaluating a proposal to build a new plant in the United States. To calculate the project’s net present value, Roche forecasts the following dollar cash flows from the project. The US cost of capital is 12% and the spot exchange rate is 1. 2 sf / 1 $. What are the forward rates in each year, if risk free rates are US = 6% and Swiss = 4%? year A: 0 1 2 3 4 5 -1300 450 510 575 650 (Ff/$) = ( 1 + rf )t solve for Ff/$ Sf/$ year Ff/$ ( 1 + r $ )t 0 1. 2 1 2 3 4 5 1. 177 1. 155 1. 133 1. 112 1. 091

27 -34 Example Suppose that the Swiss pharmaceutical company, Roche, is evaluating a proposal to build a new plant in the United States. To calculate the project’s net present value, Roche forecasts the following dollar cash flows from the project. The US cost of capital is 12% and the spot exchange rate is 1. 2 sf / 1 $. What are the cash flows in each year, given the forward rates? year 0 1 2 3 4 5 -1300 450 510 575 650 1 2 3 4 5 A: CFf = (Ff/$) x CF$ year 0 CF$ -1300 450 510 575 650 Ff/$ 1. 2 1. 177 1. 155 1. 133 1. 112 1. 091 CFf -1560 471 520 578 639 709

Example Suppose that the Swiss pharmaceutical company, Roche, is evaluating a proposal to build a new plant in the United States. To calculate the project’s net present value, Roche forecasts the following dollar cash flows from the project. The US cost of capital is 12% and the spot exchange rate is 1. 2 sf / 1 $. What is the NPV of the project in Swiss francs? A: 1+ franc return = ( 1 + rf ) solve for Franc return 1+dollar return Franc return = 9. 9% NPV (sf) = 616 sf ( 1 + r$ ) 27 -35

Political Risk 27 -36

Web Resources Click to access web sites Internet connection required www. oecd. org www. bankofengland. co. uk www. ecb. int www. oanda. com www. x-rates. com www. emgmkts. com www. securities. com www. prsgroup. com 27 -37