Multnatonal Corporatons (MNC Internatonal nancal Management nance ummer 006 xed versus loatng Exchange Rates loatng xed Managed floatng rate Currences float freely n ths, and s (prces are set by supply and demand. $U, Japanese Yen, Brtsh Pound, wss ranc float freely. Currency value s fxed (pegged n terms of another. If demand ncreases (decreases, government must sell (buy to mantan fxed rate. Currency s loosely pegged to other, but value s mostly determned by supply/demand. Exchange Rates: Quotes Wall treet Journal: Wednesday, Aprl, 004 U $ Equvalent Currency Per U $ Country Wed Tue Wed Tue Argentna (peso.506.55.85.869 U.K. (pound.77.7877.569.5594 -month ward.7686.788.5654.5609 -months ward.759.775.5684.569 6-months ward.745.759.570.5684 4 Exchange Rate Quotes $U equvalent Currency per $U dollars peso peso/dollar The dollar cost of one unt of egn One Argentne peso equals $0.55 on Aprl 0, 004 and $0.506 on Aprl, 004. The peso thus deprecated aganst the dollar. The value of each relatve to one U.. dollar. Recprocal of U$ equvalent One dollar was worth.869 Argentne pesos on Aprl 0, 004 and.85 Argentne pesos on Aprl, 004. The dollar apprecated vs. the peso. $0.506/Ps 5 Ps.85/$ Exchange Rates: pot vs. orward Wall treet Journal: Wednesday, Aprl, 004 U $ Equvalent Currency Per U $ Country Wed Tue Wed Tue Argentna (peso.506.55.85.869 U.K. (pound.77.7877.569.5594 -month ward.7686.788.5654.5609 -months ward.759.775.5684.569 6-months ward.745.759.570.5684 6
pot and orward Exchange Rates pot exchange rate orward The that apples to trades that occur mmedately. On Aprl, 004, spot exchange rate Brtsh pound: $.77/. The fxed prce that apples contracts wth delvery n the future. On Aprl, 004, the agreement to trade dollars pounds one month later was a specfed ward prce of $.7686/. The pound trades at a ward dscount relatve to the dollar. $.7686/ -$.77/ Dscount/Premum : 0.65% $.77/ - 60 Annualzed -.8% N 7 Trangular Arbtrage Cross exchange rate Assume you are quoted the followng : The rato of the of each, expressed n terms of a thrd. Dvde the dollar one by the dollar exchange rate another : 4//04: $.77/ C$.47/ $0.75/C$ C$.5000/ Arbtrage opportunty. Exchange $,000,000 nto 56,90 (at 0.569/$.. Trade 56,90 C$,409,800 (at C$.5000/.. Convert C$,409,800 nto $,06,66(at $0.75/C$. Allows a rskless, nstant proft of $6,66 8 Wnners and Losers from ER Changes uppose the apprecates aganst the Canadan Dollar. Ths benefts European consumers or producers buyng Canadan goods. orward-pot Party If a ward market exsts, the ward rate should be approxmately equal to expected future spot rate. Assume: pot $.4/ M ward $.50/ Rsk-neutral U.K. frms who ntend to buy U.. dollars n the future wll ether: It hurts Canadan consumers or producers buyng European goods. Wnners and losers reversed when a deprecates. 9. Enter the ward contract today f E( < $.50/.. Wat and buy dollars at spot rate f E( > $.50/. U.. frms who wll need to buy pounds n the future wll do the opposte. 0 orward-pot Party The Law of One Prce Equlbrum: the ecast of the spot prce s equal to the current ward rate (ward spot party. E( U.. and U.K. frms are ndfferent n ths case whether they transact n the spot or ward market. orward-spot party does not hold. orward rate does not relably predct the drecton of the spot rate. tudes of s fnd a great deal of randomness n spot rate movements. Identcal goods tradng n dfferent markets should sell at the same prce. Assume /$ currently 0.95/$, and a par of Mau Jm sunglasses s sellng 80 n Italy. What f a par of the same sunglasses sells $00 n the Unted tates? unglasses should sell 80 0.95/$ $89.47 n U.. Buy sunglasses n Italy 80 and sell them $00 n U.. Convert back to s, receve 90 ($00 x 0.95/$
Purchasng Power Party (PPP Interest Rate Party (IRP Dfferences n expected nflaton between two countres are assocated wth expected changes n values. Key emprcal predctons of PPP: Low-nflaton natons apprecatng E( [ + E( ] [ + E( dom ] Hgh-nflaton natons deprecatng Law holds tradable goods over tme, but devatons occur n the short run. Reasons: Interest rate party says that the rsk-free returns around the world should be equal. An nvestor can ether buy a domestc rsk-free asset or a egn rsk-free asset usng ward contracts to cover exposure. The of the country wth lower rsk-free rate should trade at a ward premum. ( R The process of tradng goods across countres cannot happen nstantaneously. IRP: Legal restrctons or physcal mpedments apply to ( + Rdom transportng goods. 4 + Covered Interest Arbtrage Covered Interest Arbtrage Current spot rate C$.5855/$ 6-month ward rate C$.597/$ Annualzed nterest rate on a sx-month Canadan government bond s 6%. Rate on smlar U.. nstrument s %. 0.06 + C$.597/$ < C$.5855/ $ 0.0 + Ths means Canadan nterest rate s too hgh / U.. nterest rate s too low. Arbtrage opportunty! 5 Borrow $,000,000 at % per year, convert to C$,585,500 Ths wll grow to C$,6,065 n sx months, at whch tme you convert back at the ward rate to $,04,700. Next, repay the U.. loan, whch takes C$,00,000. Arbtrage proft s $4,700. 6 Real Interest Rate Party: the sher Effect sher effect: the nomnal nterest rate R s made up of two components: Real requred return assumed to be same n both countres. Inflaton premum equals the expected rate of nflaton, I. If real requred return s the same across countres, then the followng equaton s true: + R [ + E( + R [ + E( dom dom ] ] 7 Real Interest Rate Party: The sher Effect Assume that expected nflaton n the Unted tates equals zero and expected nflaton n Italy s %. One-year rsk free rate n the U.. s %. What should the one year nterest rate be to mantan real nterest rate party? + R Italy + 0.0 0. 0.0 R Italy 5.6% Devatons from real nterest rate party occur because of lmts to arbtrage carcty of rsk-free nvestments that offer fxed real, rather than nomnal, returns 8
Transacton Rsk Transacton Rsk Exchange rate rsk arses when the value of a company s cash flows can be affected by a change n s. Assume Boeng Company sells an arplane to a Japanese buyer:. Boeng must receve $,000,000 to cover costs and profts.. nce payment usually n buyer s, prced n Yen.. Current s 00.00/$. 4. Prce of arplane theree 00,000,000. If delvery and payment occur mmedately, there s no egn exchange rsk: just exchange 00,000,000 $,000,000 on spot market. If prce s set today, but delvery s n 6 months, Boeng s exposed to sgnfcant egn exchange rsk If n 6 months s 0.00/$: The dollar apprecates; yen deprecates. Boeng wll stll receve the same 00,000,000 but these wll only be worth $909,09.. Boeng wll suffer an loss of $90,909.. Japanese customer s unaffected, snce yen prce s fxed. If n 6 months s 90/$ nstead: Boeng wll receve $,, ts 00 mllon payment.. Boeng wll enjoy an gan of $,.. Japanese customer agan unaffected. Who would gan/lose f prce were set n dollars? unless t hedges that rsk. 9 0 Translaton and Economc Rsk Poltcal Rsk Translaton (accountng exposure Economc exposure Actons taken by a government whch have an mpact on the value of egn companes operatng n that country: Cost and revenue of the subsdary (n egn are translated n the domestc to be ncluded n the fnancal statements Tax ncreases or barrers to repatraton of profts of the MNC. How does the egn affect frm s value? Impacts all egn frms n the Exchange rate changes mght Macro poltcal country nfluence frm s cash flows. rsk Near collapse of Indonesa Rse n the value of the dollar vs. yen n 997-998 makes Japanese cars less expensve Government actons that affect only to U.. customers and U.. cars more a subset of companes operatng n a expensve Japanese customers. Mcro poltcal egn country Hedge by usng dervatves rsk 970s natonalzaton nternatonal and by matchng costs and revenues ol company assets by large number n a gven. of ol-exportng countres EMU and the Rse of Regonal Tradng Blocks European Monetary Unon establshed Euro as twelve countres n Western Europe. In 99, Brazl, Argentna, Paraguay, and Uruguay med the Mercosur Group. Removed tarffs, other barrers to ntra-regonal trade Common tarffs on external trade from 994 General Agreement on Tarffs and Trade (GATT: nternatonal treaty that regulates trade In 994, revsed GATT establshed World Trade Organzaton (WTO. Captal Budgetng MNCs have to answer the followng questons n ther captal budgetng process: In what should the frm express a egn project's cash flows? How s the cost of captal computed MNCs? Assume U.. frm perms analyss project wth cash flows n s: Intal Cost -,000,000 Two alternatves to compute project s NPV: Year 900,000 Year 850,000 Year 800,000 Dscount -denomnated cash flows usng -based cost of captal,then convert back to dollars 4 Calculate NPV n dollar terms 4
rst Approach to Compute NPV Assume rsk-free n Europe s 5% and the spot rate s $0.95/ The company estmates that cost of captal ths project s 0% (5% rsk premum. 900,000 850,000 800,000 NPV,000,000 + + +.0.0.0 Convert nto dollarbased NPV,7 NPV $6,000 The frm can hedge ts exposure n the future wth ward contracts. Accept or reject the project based on NPV of project; exposure should not affect the decson. 5 econd Approach to Compute NPV Usng nterest party, can compute one, two, and three year ward s: Calculate NPV n dollar terms; U.. rsk free rate s % Assume that the frms wll hedge the project's cash flows usng ward contracts. ( + RU R year.0 year 0.95.05 ( + RU R year.0 0.95.05 ( + RU R $/ year.0 0.95.05 year year $0.99/ $0.94/ $0.8967/ 6 econd Approach to Compute NPV Cash flow of the project converted n dollars: same results as the frst approach Currency Intal Investment Year Year -,000,000 X.95 900,000 X.99 8500,000 X.94 $ -,900,000 89,000 777,000 ( + 0.0 R U ( + 0.0 RU 7.9% ( + 0.05 89,000 777,000 77,000 NPV,900,000 + + +.079.079.079 Year 800,000 X.8967 77,000 Need to dscount the cash flow at rsk-adjusted U.. nterest rate: $6,000 7 Cost of Captal Compute beta of nvestment to assess rsk and use CAPM to compute dscount rate the project s cash flows. A Japanese auto manufacturer that plans to buld a plant n U.. computes two betas. If frm s shareholders cannot dversfy nternatonally: Compute project s beta by measurng the covarance of smlar European nvestments wth the U.. market. Japanese frm computes beta of. the project. Rsk-free nterest rate s %; market rsk premum on Nkke s 8%. R project %+.(8%0.8% If frm s shareholders have portfolos nternatonally dversfed: Compute project s beta by computng covarance of return of smlar nvestments wth returns on worldwde stock ndex. Project beta s computed.. The world market rsk premum s 5%: R project %+.(5% 8.5%. 8 Multnatonal corporatons domnate nternatonal trade and nvestment today. Companes tradng n the nternatonal markets are exposed to rsk. Total volume of egn drect nvestment surged durng the 990s. MNCs can use a varety of technques to hedge or even proft from fluctuatons. 5