International Financial Management Chapter 17 Exchange Rates Forfaiting

International Financial Management Chapter 17 Exchange Rates Forfaiting Rationales for Going Global Dr. David P. Echevarria All Rights Reserved 1

INTERNATIONAL FINANCE TERMINOLOGY A. B. C. D. E. F. American Depositary Receipt (ADR) Currency Cross-rate table Eurobond Eurocurrency (Eurodollars) London Interbank Offer Rate (LIBOR) Swaps 1. Interest rate (fixed for variable) 2. Currency (dollars for yen) Dr. David P. Echevarria All Rights Reserved 2

EXCHANGE RATES A. The price of one country’s currency in terms of another 1. 2. B. C. Direct quotes: how much to buy a foreign currency? Indirect quotes: how much of our currency will a unit of foreign currency buy? Many currencies quoted in terms of dollars (direct quotes) Consider the following quote: 1. 2. 3. 4. Euro 1. 3397. 7465 The first number (1. 3397) is how many U. S. dollars it takes to buy 1 euro (direct quote) The second number (. 7465) is how many Euros it takes to buy U. S. $1 (indirect quote) The two numbers are reciprocals of each other (1/. 7465 = 1. 3397) Dr. David P. Echevarria All Rights Reserved 3

EXCHANGE RATES D. Example 1: Exchange Rates 1. Suppose you have $10, 000. How many Norwegian Krone can you buy? (4/26/2011 rates) 2. Exchange rate = 5. 3478 Krone per U. S. dollar 3. Buy 10, 000(5. 3478) = 53, 478 Krone E. Example 2: Exchange rates 1. Suppose you are visiting London and you want to buy a souvenir that costs 1, 000 British pounds. How much does it cost in U. S. dollars? (4/26/2011 rates) 2. Exchange rate = $1. 6478 dollars per pound 3. Cost = 1, 000 x 1. 6478 = $1, 647. 80 Dr. David P. Echevarria All Rights Reserved 4

EXCHANGE RATES F. Example 3: Triangle Arbitrage 1. We observe the following fictitious quotes: 1. a. b. 1 Euro per $1 2 Swiss Franc per $1. 4 Euro per 1 Swiss Franc 2. What should the Euro/SF cross rate be? a. (1 Euro / $1) / (2 SF / $1) =. 5 Euro / SF (a mispricing) 3. How can we profit from the mispricing? We have $1000 to invest (buy the low, exchange to the high) a. b. c. d. Exchange $1000 for Euros (@ $1 = E 1) = 1000 Euro Exchange 1000 Euro (@. 4 Euro = 1 SF) = 2500 SF Exchange 2500 SF for $/ (@ 2 SF = $1) = $1250 You used a mispricing in the markets to make $250 risk-free Dr. David P. Echevarria All Rights Reserved 5

TRANSACTION TERMINOLOGY A. Spot trade – exchange currency immediately 1. Spot rate – the exchange rate for an immediate trade B. Forward trade – agree today to exchange currency at some future date and some specified price (also called a forward contract) 1. Forward rate – the exchange rate specified in the forward contract C. If the forward rate is higher than the spot rate, the foreign currency is selling at a premium (when quoted as $ equivalents) D. If the forward rate is lower than the spot rate, the foreign currency is selling at a discount Dr. David P. Echevarria All Rights Reserved 6

TRANSLATION EXPOSURE Income from foreign operations must be translated back to U. S. dollars for accounting purposes, even if foreign currency is not actually converted back to dollars A. Managing Exchange Rate Risk 1. Large multinational firms may need to manage the exchange rate risk associated with several different currencies 2. The firm needs to consider its net exposure to currency risk instead of just looking at each currency separately 3. Hedging individual currencies could be expensive and may actually increase exposure Dr. David P. Echevarria All Rights Reserved 7

TRANSLATION EXPOSURE B. Political Risk 1. Changes in value due to political actions in the foreign country 2. Investment in countries that have unstable governments should require higher returns 3. The extent of political risk depends on the nature of the business 4. The more dependent the business is on other operations within the firm, the less valuable it is to others 5. Natural resource development can be very valuable to others, especially if much of the ground work in developing the resource has already been done 6. Local financing can often reduce political risk Dr. David P. Echevarria All Rights Reserved 8

FORFAITING (Medium-Term Capital Goods Financing) A. Forfaiting means selling a bill of exchange, at a discount, to a third party, the forfaiter. B. The forfaiter collects the payment from an overseas customer, through a collateral bank(s) C. The forfaiter assumes the underlying responsibility of exporters and simultaneously providing trade finance for importers by converting a short-term loan to a medium term one. D. Forfaiting is the discounting of international trade receivables on a without recourse basis. Dr. David P. Echevarria All Rights Reserved 9

FORFAITING (Medium-Term Capital Goods Financing) E. Characteristics: 1. The exporter extends credit for period ranging between 180 days to 7 years. 2. Minimum bill size should be US$ 250, 000 (US$ 500, 000/- is preferred) 3. The payment should be receivable in any major convertible currency. 4. A Letter of Credit, or a guarantee by a bank, usually in importer's country. 5. The contract can be for either goods or services. Dr. David P. Echevarria All Rights Reserved 10

FORFAITING (Medium-Term Capital Goods Financing) F. Documentation: At its simplest, the receivables must be backed by any of the following debt instruments: 1. 2. 3. 4. Promissory Note (~ a note payable) Bills of Exchange Deferred payment letter of credit A [bank] letter of guarantee Dr. David P. Echevarria All Rights Reserved 11

FORFAITING (Medium-Term Capital Goods Financing) G. Pricing 1. Discount Rate: LIBOR plus margin 2. Days of Grace: cover b-days until settlement 3. Commitment Fee: ~ to cover exposure days H. Benefits: 1. Eliminates risks like political, transfer and commercial risks 2. Enhances competitive advantage. a. b. Ability to provide vendor financing making products more attractive Enables the exporter to do business in risky countries. 3. Increases cash flow. Forfaiting converts a credit-based transaction in to a cash transaction. Dr. David P. Echevarria All Rights Reserved 12

ABSOLUTE PURCHASING POWER PARITY A. Price of an item is the same regardless of the currency used to purchase it B. Requirements for absolute PPP to hold 1. Transaction costs are zero 2. No barriers to trade (no taxes, tariffs, etc. ) 3. No difference in the commodity between locations 4. Absolute PPP rarely holds in practice for many goods Dr. David P. Echevarria All Rights Reserved 13

RELATIVE PURCHASING POWER PARITY Provides information about what causes changes in exchange rates A. The basic result is that exchange rates depend on relative inflation between countries B. E (St) = S 0 [1 + (h. FC – h. US)]t C. Because absolute PPP doesn’t hold for many goods, we will focus on relative PPP from here on Dr. David P. Echevarria All Rights Reserved 14

RELATIVE PURCHASING POWER PARITY D. Example: PPP 1. Suppose the Canadian spot exchange rate is 1. 18 Canadian dollars per U. S. dollar. U. S. inflation is expected to be 3% per year and Canadian inflation is expected to be 2%. 2. Do you expect the U. S. dollar to appreciate or depreciate relative to the Canadian dollar? 3. Since expected inflation is higher in the U. S. , we would expect the U. S. dollar to depreciate relative to the Canadian dollar. 4. What is the expected exch. rate in one year? 5. E(S 1) = 1. 18[1 + (. 02 -. 03)]1 = 1. 1682 Dr. David P. Echevarria All Rights Reserved 15

QUESTIONS YOU SHOULD BE ABLE TO ANSWER A. What does an exchange rate tell us? B. What is triangle arbitrage? C. Comprehensive Problem 1. Assume that one U. S. dollar buys 81. 748 Japanese Yen, and one U. S. dollar buys. 60687 Pound Sterling. 2. What must the Yen – pound exchange rate be in order to prevent triangular arbitrage (ignoring transaction costs)? D. What is forfaiting and how is it used? Dr. David P. Echevarria All Rights Reserved 16

HOMEWORK CHAPTER 17 A. Self-Test: ST-1, d, e, h, j, k, m, p B. Questions: 17 -1, 17 -2, 17 -4, 17 -5 C. Problems: 17 -1, 17 -2, 17 -3, 17 -7 Dr. David P. Echevarria All Rights Reserved 17

COVERED INTEREST ARBITRAGE A. How can we take advantage of differences in interest rates to earn risk free returns? B. Examine the relationship between spot rates, forward rates, and nominal rates between 2 countries 1. Again, the formulas will assume that the exchange rates are quoted in terms of foreign currency per U. S. dollar 2. The U. S. risk-free rate is assumed to be the T-bill rate Dr. David P. Echevarria All Rights Reserved 18

COVERED INTEREST ARBITRAGE C. Example: Covered Interest Arbitrage 1. Consider the following information a. b. S 0 =. 8 Euro / $ F 1 =. 7 Euro / $ RUS = 4% RE = 2% 2. What is the arbitrage opportunity? a. b. c. d. e. f. Borrow $100 at 4% Buy $100(. 8 Euro/$) = 80 Euro and invest at 2% for 1 year Open [“Buy”] a Euro forward contract (. 7 Euro = $1) In 1 year, receive 80 * (1. 02) = 81. 6 Euro and convert back to dollars (exercise the forward contract) 81. 6 Euro / (. 7 Euro / $) = $116. 57 and repay loan Profit = 116. 57 – 100 * (1. 04) = $12. 57 risk free Dr. David P. Echevarria All Rights Reserved 19

COVERED INTEREST ARBITRAGE D. Interest Rate Parity 1. 2. E. Based on the previous example, there must be a forward rate that would prevent the arbitrage opportunity. Interest rate parity defines what that forward rate should be Short-Run Exposure 1. 2. Risk from day-to-day fluctuations in exchange rates and the fact that companies have contracts to buy and sell goods in the short-run at fixed prices Managing risk a. b. Enter into a forward agreement to guarantee the exchange rate Use foreign currency options to lock in exchange rates if they move against you, but benefit from rates if they move in your favor Dr. David P. Echevarria All Rights Reserved 20

COVERED INTEREST ARBITRAGE E. Long-Run Exposure 1. Long-run fluctuations come from unanticipated changes in relative economic conditions 2. Could be due to changes in labor markets or governments 3. More difficult to hedge 4. Try to match long-run inflows and outflows in the currency 5. Borrowing in the foreign country may mitigate some of the problems Dr. David P. Echevarria All Rights Reserved 21