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Topics Covered
Foreign Exchange Markets Some Basic Exchange Rate Relationships Hedging Currency Risk Purchasing Power and Exchange Rates Exchange Rate Risk and International Investment Decisions Political Risk-Definition, Characteristics, Assessment Techniques, incorporation and ways to mitigate

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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.

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Foreign Exchange Markets


Forward Premiums and Forward Discounts
Example - The Peso spot price is 10.9892 peso per dollar and the 3 month forward rate is 11.0408 Peso per dollar, what is the premium and discount relationship?
Spot Price T - 1 = Premium or (-Discount ) ForwardPrice 10.9892 4 - 1 = -1.90% 11.0408

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Foreign Exchange Markets


Forward Premiums and Forward Discounts
Example - The Peso spot price is 10.9892 peso per dollar and the 3 month forward rate is 11.0408 Peso per dollar, what is the premium and discount relationship? Answer - The dollar is selling at a 1.90% premium, relative to the peso. The peso is selling at a 1.90% discount, relative to the dollar.

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Exchange Rates
Example Swiss franc spot price is SF 1.4457 per $1 Swiss franc 6 mth forward price is SF1.4282 per $1 The franc is selling at a Forward Premium The Dollar is selling at a Forward Discount

This means that the market expects the dollar to get weaker, relative to the franc
Example (premium? discount?) The Japanese Yen spot price is 101.18 per $1 The Japanese 6mt fwd price is 103.52 per $1

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Exchange Rates
Example What is the franc premium (annualized)?
franc Premium = 2 x ( 1.4457 - 1.4282) = 2.45% 1.4282 Dollar Discount = 2.45%

Example What is the Yen discount (annualized)? Yen Discount = 2 x ( 103.52 - 101.18) = 4.26% 103.52 Dollar Premium = 4.26%

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Exchange Rate Relationships


Basic Relationships

1 + rforeign 1 + r$
equals equals

1 + i foreign 1 + i$
equals

f foreign / $ S foreign / $
equals

E(sforeign / $) S foreign / $

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Exchange Rate Relationships


1) Interest Rate Parity Theory

1 + rforeign 1 + r$

f foreign / $ S foreign / $

The ratio between the risk free interest rates in two different countries is equal to the ratio between the forward and spot exchange rates.

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Exchange Rate Relationships


Example - You have the opportunity to invest $1,000,000 for one year. All other things being equal, you have the opportunity to obtain a 1 year Mexican bond (in peso) @ 7.35 % or a 1 year US bond (in dollars) @ 5.05%. The spot rate is 10.9892 peso:$1 The 1 year forward rate is 11.2274 peso:$1 Which bond will you prefer and why? Ignore transaction costs

Value of US bond = $1,000,000 x 1.0122 = $1,050,500

Value of Mexican bond = $1,000,000 x 10.9892 = 10,989,200 peso exchange 10,989,200 peso x 1.0735 = 11,796,906 peso 11,796,906 peso / 11.2274= $1,050,725 bond pmt exchange

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Exchange Rate Relationships


2) Expectations Theory of Exchange Rates

f foreign / $ S foreign / $

E(sforeign / $) S foreign / $

Theory that the expected spot exchange rate equals the forward rate.

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Exchange Rate Relationships


3) Purchasing Power Parity

1 + i foreign 1 + i$

E(sforeign / $) S foreign / $

The expected change in the spot rate equals the expected difference in inflation between the two countries.

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Exchange Rate Relationships


Example - If inflation in the US is forecasted at 2.5% this year and Mexico is forecasted at 4.5%, what do we know about the expected spot rate? Given a spot rate of 10.9892 peso:$1

1 + i foreign 1 + i$

E(sforeign/$) Sforeign/$

1 .045 E(sforeign/$) = 1 + .025 10.9892

solve for Es Es = 11.204

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Exchange Rate Relationships


4) International Fisher effect

1 + rforeign 1 + r$

1 + i foreign 1 + i$

The expected difference in inflation rates equals the difference in current interest rates.

Also called common real interest rates

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Exchange Rate Relationships


Example - The real interest rate in each country is about the same

r (real )

1 + rforeign 1 + i foreign

1.0735 = - 1 = .027 1.045

1 + r$ 1.0505 r (real ) = - 1 = .025 1 + i $ 1.025

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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) @ 8.0% or a 1 year US loan (in dollars) @ 10%. The spot rate is 1.4457sf:$1 The 1 year forward rate is 1.4194sf:$1 Which loan will you prefer and why? Ignore transaction costs

Cost of US loan = $100,000 x 1.10 = $110,000

Cost of Swiss Loan = $100,000 x 1.4457 = 144,570 sf

exchange

144,570 sf x 1.08 = 156,135 sf


156,135 sf / 1.4194 = $110,000

loan pmt
exchange

If the two loans created a different result, arbitrage exists!

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Exchange Rates
Swiss Example Given a spot rate of sf:$ Given a 1yr fwd rate of 1.4457:$1 1.4194:$1

If inflation in the US is forecasted at 4.5% this year, what do we know about the forecasted inflation rate in Switzerland?
E (Sf/$) = E ( 1 + if ) Sf/$ E ( 1 + i$ )

1.4194 = E( 1 + i) 1.4457 1 + .045

solve for i i = .026 or 2.6%

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Exchange Rates
Swiss Example In the previous examples, show the equilibrium of interest rates and inflation rates 1 + rf = 1.08 = .9818 1 + r$ 1.10 E ( 1 + if ) = 1.026 = .9818 E ( 1 + i$ ) 1.045

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International Prices
The Big Mac Index The price of a Big Mac in different countries (Feb 1, 2007)

Country Canada China Denmark Euro area Japan Mexico

Local Price Converted to U.S. Dollars 3.08 1.41 4.84 3.82 2.31 2.66

Country Philippines Russia South Africa Switzerland United Kingdom United States

Local Price Converted to U.S. Dollars 1.74 1.85 2.14 5.05 3.9 3.22

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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 120.700Y:$1 the car sells for $14,209 in Indianapolis. If the dollar rises in value, against the yen, to an exchange rate of 134Y:$1, what will be the price of the car?

1,715,000 = $12,799 134


Conversely, if the yen is trading at a forward discount, Japan will experience a decrease in purchasing power.

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Exchange Rate Risk


Example - Harley Davidson builds a motorcycle for a cost plus profit of $12,000. At an exchange rate of 120.700Y:$1, the motorcycle sells for 1,448,400 yen in Japan. If the dollar rises in value and the exchange rate is 134Y:$1, what will the motorcycle cost in Japan?

$12,000 x 134 = 1,608,000 yen

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Exchange Rate Risk


Currency Risk can be reduced by using various financial instruments Currency forward contracts, futures contracts, and even options on these contracts are available to control the risk How to use these instruments?

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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.

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Example
Outland Corporation is building a plant in Holland to produce reindeer repellant to sell in that country. The plant is expected to produce a cash flow (in guilders ,000s) as follows. The US risk free rate is 8%, the Dutch rate is 9%. US inflation is forecasted at 5% per year and the current spot rate is 2.0g:$1. year 1 400 2 450 3 510 4 575 5 650

Q: What are the 1, 2, 3, 4, 5 year forward rates? A: E (Sf/$) = E ( 1 + if )t solve for E(S)

Sf/$
E(S) 2.02

E ( 1 + i$ )t
2.04 2.06 2.08 2.10

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Example
Outland Corporation is building a plant in Holland to produce reindeer repellant to sell in that country. The plant is expected to produce a cash flow (in guilders ,000s) as follows. The US risk free rate is 8%, the Dutch rate is 9%. US inflation is forecasted at 5% per year and the current spot rate is 2.0g:$1. year 1 400 2 450 3 510 4 575 5 650

Q: Convert the CF to $ using the forward rates. 1 2 3 4 5

CFg

400

450
2.04 221

510
2.06 248

575
2.08 276

650
2.10 310

E(S) 2.02 CF$ 198

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Example
Outland Corporation is building a plant in Holland to produce reindeer repellant to sell in that country. The plant is expected to produce a cash flow (in guilders ,000s) as follows. The US risk free rate is 8%, the Dutch rate is 9%. US inflation is forecasted at 5% per year and the current spot rate is 2.0g:$1. year 1 400 2 450 3 510 4 575 5 650

What is the PV of the project in dollars at a risk premium of 7.4%?

$ discount rate = 1.08 x 1.074 = 1.16


PV = $794,000

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Example
Outland Corporation is building a plant in Holland to produce reindeer repellant to sell in that country. The plant is expected to produce a cash flow (in guilders ,000s) as follows. The US risk free rate is 8%, the Dutch rate is 9%. US inflation is forecasted at 5% per year and the current spot rate is 2.0g:$1. year 1 400 2 450 3 510 4 575 5 650

What is the PV of the project in guilders at a risk premium of 7.4%? Convert to dollars. $ discount rate = 1.09 x 1.074 = 1.171 PV = 1,588,000 guilders exchanged at 2.0:$1 = $794,000

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Exchange Rate Issues


Does change in exchange rates (up or down) have any advantages and disadvantages? How to manage Exchange Rate Risk? What determines Exchange Rates? Why is US$ the world currency despite the odds faced by US in terms of slowing economy, large amount of debts, trade deficits.? Can the Chinese currency replace the US$? As the world-currency?

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Political Risks
Political Risk Characteristics Attitude of consumers in the host country - a tendency of residents to purchase only locally produced goods. Actions of the host government - A host government might impose pollution control standards and additional corporate taxes, as well as withholding taxes and fund transfer restrictions. Blockage of fund transfers - A host government may block fund transfers, which could force subsidiaries to undertake projects that are not optimal (just to make use of the funds). Currency inconvertibility - Some governments do not allow the home currency to be exchanged into other currencies

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Political Risks
War Conflicts with neighboring countries or internal turmoil can affect the safety of employees hired by an MNCs subsidiary or by salespeople who attempt to establish export markets for the MNC Inefficient bureaucracy - Bureaucracy can delay an MNCs efforts to establish a new subsidiary or expand business in a country. Corruption Corruption can occur at the firm level or with firmgovernment interactions. Transparency International has derived a corruption index for most countries (see www.transparency.org).

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Political Risks
Macro-assessment of country risk represents an overall risk assessment of a country and considers all variables that affect country risk except those that are firm-specific. Micro-assessment of country risk involves assessment of a country as it relates to the MNCs type of business.

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Techniques to Assess Political Risk


Checklist approach: ratings assigned to various factors Delphi technique: collection of independent opinions without group discussion Quantitative analysis: use of models such as regression analysis Inspection visits: Meetings with government officials, business executives, and consumers to clarify risk. Combination of techniques: many MNCs have no formal method but use a combination of methods.

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Political Risk
Political Risk Scores Maximum Score Luxembourg Netherlands Singapore UK Japan Germany United States Italy China Brazil Russia India Indonesia Somalia A 12 11 9 11 9 11 9 11 9 11 9 12 9 9 5 B 12 11 11 9 10 8 8 8 9 7 6 7 4 4 1 C 12 12 12 12 12 12 12 12 12 8 8 9 9 6 3 D 12 12 11 11 10 12 11 11 11 12 11 9 8 8 5 E 12 12 12 12 9 10 10 8 11 11 11 10 9 11 4 F 6 5 5 5 5 4 5 4 3 2 4 2 2 1 1 G 6 6 6 6 6 6 6 5 4 5 6 6 1 1 3 H 6 6 6 5 6 5 5 5 3 5 2 4 4 2 2 I 6 6 6 5 6 5 5 5 3 5 2 4 4 2 2 J 6 5 5 6 4 6 4 5 5 5 3 2 2 2 2 K 6 5 6 2 6 5 5 6 4 1 5 4 6 4 1 L 4 4 4 4 4 4 4 4 3 2 2 1 3 2 0 Total 100 95 91 87 86 86 83 81 78 71 69 68 59 52 27

A = Govt stability B = Socioeonmic conditions C = Investment profile D = Internal conflict E = External conflict F = Corruption

G = Military in politics H = Religious tensions I = Law and order J = Ethnic tensions K = Democratic accountability L = Bureaucracy quality

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Incorporating Political risks in Project Evaluation Adjustment of the discount rate: lower risk rating implies higher risk and higher discount rate. Adjustment of the estimated cash flows: adjust estimates for the probability that cash flows may not be realized. Assessing Risk of Existing Projects: review country risk periodically after project has been implemented.

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Ways to mitigate political risks


Strategies to reduce exposure to a host government takeover include: Use a short-term horizon Rely on unique supplies or technology Hire local labor Borrow local funds Purchase insurance Use project finance

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Case & Readings


Case:
Carrefour S.A. (Refer to pages 537 5 44 of the Book, Case Studies in Finance: Managing for Corporate Value Creation, by Robert F. Bruner, Kenneth M. Eades and Michael J. Schill, 6th Edition, McGraw-Hill International Edition, 2010). Articles: M.D. Levi and P. Sercu, Erroneous and Valid Reasons for Hedging Foreign Exchange Exposure, Journal of Multinational Financial Management 1 (1991), pp: 25-37. A.M. Taylor and M.P. Taylor, The Purchasing Power Parity Debate, Journal of Economic Perspectives 18 (Autumn 2004), pp: 135-158.