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Unformatted text preview: Indirect quote: Buy FC with 1 unit of HC (1 dollar→ ? FC) Seminar 1: Introduction to International Finance Cross rate = exchange rate of currency A and B, with respect to a 3rd currency. Main goal of MNC: maximize shareholders wealth (stock px) Spot (immediate trans.) and forward rate(certain) vs. Future spot rate Agency problem: conflict of goals between shareholders and managers (uncertain) MNCs have higher agency costs:  International Moey Market (ST funds < 1yr) Low default, high FX risk § More difficult to monitor managers in foreign subsidiaries § Govt & MNCs borrow funds:1) pay for imports denominated in FC, 2) § Different culture; make decisions that serve subsidiary instead of MNC borrow in low i/r currency or 3) depreciating FC (against their HC) MNCs can reduce agency problems by:  Inter. Credit Market (Medium term funds: 1-‐5yrs) § Proper incentives (eg. Issue company shares to employees) § Banks, MNCs, Govt issue treasury notes. Use floating rate loans tied to LIBOR § Parent should communicate goals of each subsidiary and oversee to avoid i/r risk. Basel Accord I, II, III: to ensure banks have enough periodically collateral (↓ possibility of default risk) Eg. Sarbanes-‐Oxley Act (SOX): corporate control by having more transparent  Inter. Bond Market (LT fund > 5yrs) reporting (centralized database to report productivity and financial status) § MNCs issue corporate bonds with annual coupon paym; callable/convertible Management Structure of MNC: Centralized VS Decentralized. § I/r risk (value of LT bonds↓ due to ↑i/r), FX risk, liquidity risk, default risk Factors promoting growth in international trade:  removal of cross-‐
 Inter. Stock Market (equity fund: perpetuity) border restrictions (trade agreements)  outsourcing  technological Eg. Yankee stock offerings (non-‐US co. issue stocks in US) advancement  rise in income, change in consumer taste Why firms pursue international business: Seminar 4: Exchange Rate Determination  Theory of Comparative Advantage (CA) – country should use its CA to Measurement of exchange rate movements specialize in production and trade with other countries for other g/s. = Specialization increases product efficiency.  Imperfect market theory: Factors of production (eg. Labour, RM) are ! − !!!
%∆ = immobile→ specialize on existing resources they have. Provide incentive for !!!
MNC to seek out foreign opportunities. Eg. Nike outsourcing their production. Positive = Appreciation, increase in foreign currency value. Negative =  Product cycle theory: MNCs expand their product specialization in Depreciation, decrease in foreign currency value. foreign countries to retain adv. in foreign market (↓ transport costs), after Determination of equilibrium exchange rate being established in home market and exporting g/s. Exchange rate is determined by Demand and Supply. Equilibrium is the  Search for input to lower costs – internal (set up subsidiary) and balance point where !! = !! . external (outsourcing/offshoring) HOW? International trade (X), licensing Factors that determine the equilibrium exchange rate (do not require FDI); Franchising, JV, acquisitions of existing operations, e = f (ΔINF,ΔINT,ΔINC,ΔGC,ΔEXP) establish foreign subsidiary (highest upfront capital and parent control) where e = percentage change in spot rate Valuation of a MNC = PV of Fut. CFs discounted at required rate of return Δ = change in differential (relative) WACC (k): Weighted Average Cost of Capital based of all firm’s projects Relative Inflation Rates: Increase in U.S. inflation leads to increase in U.S. Different discount rate (k): MNC (↑uncertainty in CF, ↑WACC) vs Domestic demand for foreign goods, an increase in U.S. demand for foreign currency, Uncertainty of CFs: due to international economic conditions, international and an increase in the exchange rate for the foreign currency. political risk and exchange rate risk. Relative Interest Rates: Increase in U.S. rates leads to increase in demand for Seminar 2: International Flow of Funds U.S. deposits and a decrease in demand for foreign deposits, leading to a Events increased trade vol: Removal of Berlin Wall, Single European Act, increase in demand for dollars and an increased exchange rate for the dollar. expansion of EU, trade treaties (NAFTA, GATT) Relative Income Levels: Increase in U.S. income leads to increase in U.S. BOP = Current a/c surplus + Capital a/c surplus = 0 demand for foreign goods and increased demand for foreign currency relative to the dollar and an increase in the exchange rate for the foreign currency. Current a/c surplus >Capital a/c deficit (CF out to invest) → national reserve ↑ Government Controls can affect x/r via: § Imposing foreign exchange Balance of Payment: country’s economic transactions with rest of the world, barriers § Imposing foreign trade barriers § Intervening in foreign exchange Balanced BOP: current a/c surplus (deficit) = capital a/c deficit markets § Affecting macro variables such as inflation, interest rates, and (surplus). income levels. Eg, when a country imposes barriers on imports from a foreign country, it reduces the demand for foreign currency relative to the home Current A/C = (X-‐M) + investment income + net transfer currency, resulting in a decrease in the x/r for the foreign currency Balance of trade = (X-‐M) of g/s. Foreign invt income: interest and div. Net Change in Expectations of future x/r: § Impact of favorable expectations: If transfers = international aid, employees’ remittance. investors expect interest rates in one country to rise, they may invest in that Factors that affect International Trade (X-‐M): Cost of labour (px country leading to a rise in the demand for foreign currency à appreciate. competitiveness of X), high inflation (↑M, ↓X), GDP, credit condition, ex∆ rate § Impact of unfavorable expectations: Speculators can place downward Depreciation: ↓value of HC, cheaper to buy domestic gds, more ex to buy pressure on a currency when they expect it to depreciate. § Impact of signals imports. Improve BOT (X-‐M↑) L Trigger retaliation, J-‐curve effect (18mth lag) on currency speculation. Speculators may overreact to signals causing Government policies: subsidies on exports, tariffs, tax relief, corruption currency to be temporarily overvalued or undervalued. CAPITAL A/C = capital sub a/c + financial a/c + errors & omissions. Capital sub a/c = capital transfer + international transactions on non-‐
financial asset. Financial a/c = FDI, portfolio (LT) and other ST investments + reserve assets. Purchase (sale) of foreign assets reduces (increases) the capital a/c. Factors affecting FDI: govt policies, potential econ. growth, privitazation, ex∆ rate (appreciating) portfolio: High i/r, low tax rates on div & int, ex∆ rate International financial agencies: IMF, World Bank, WTO, IFC, BIS(central bank), OECD Seminar 3: International Financial Markets  Foreign Exchange Market Gold/sterling standards (fixed at 1£ = 113.0015 grains, 1USD = 23.22 grains) Interaction of Factors: some factors place upward pressure while other factors Each currency is convertible back to gold at a specific fixed rate. place downward pressure. Bretton Woods system (1944) (1oz. gold = 35 USD, other currencies pegged Influence of Factors across Multiple Currency Markets: common for European against USD) Govt intervened to ensure ex∆ rate within ±1% band; adjustable currencies to move in the same direction against the dollar. peg. Influence of Liquidity on X/R adjustment: If a currency’s spot market is liquid Floating rate: Currencies allowed to fluctuate acc. to market forces (dd/ss) then its x/r will not be highly sensitive to a single large purchase or sale. Others: managed float, pegged rate, common currency, dollarization\ Bank dealer’s perspective: BID (buy: $ Dealer pays), ASK (sell: $ Dealer Financial institutions capitalize on anticipated x/r movements: receives) Invest where appreciates, borrow where depreciates. Dealer’s profits: Bid/ask % spread = (ask rate – bid rate)/ask rate International Arbitrage: Determinants of spread: ↑Order costs(processing), inventory lvl of currencies, Arbitrage means to capitalize on a discrepancy in quoted prices to make a competition w banks (↓spread), liquidity of FC, currency risk (↑spread) riskless profit. Arbitrage will cause prices to realign. Direct quote: Buy 1 unit of Foreign currency (1 FC→? dollars) Locational Arbitrage Buy a currency at the location where it is priced cheap and immediately selling it at another location where it is priced higher. ! > ! (Buy at Ask, Sell at Bid) Realignment due to locational arbitrage readjusts prices in different locations to eliminate discrepancies. Triangular Arbitrage Capitalise on discrepancies in the cross x/r between two currencies. Transaction costs (Bid/Ask spread) can reduce or even eliminate the gains Covered Interest Arbitrage Capitalise on the interest rate differential between two countries while covering your exchange rate risk with a forward contract. 2 Parts: § 1) Interest arbitrage: capitalise on the i/r differentials between two countries. § 2) Covered: hedging the position against x/r risk. § Realignment is focused on the forward rate adjustments § Investor must account for the effects of the spread between the bid and ask quotes and of the spread between deposit and loan rates. Seminar 5: IRP, PPP, IFE Interest Rate Parity: At equilibrium: difference in interest rate between 2 currencies = difference between forward rate and spot rate. 1 + !
= 1 + ! *FORWARD PREMIUM/DISCOUNT IS ANNUALISED! Implications: If the forward premium is equal to the interest rate differential and IRP holds, covered interest arbitrage will not be feasible. Considerations when assessing IRP: § 1) Transaction costs: The actual point reflecting the interest rate differential and forward rate premium must be further from the IRP line to make covered interest arbitrage worthwhile. § 2) Political risk: A crisis in the foreign country could cause its government to restrict any exchange of the local currency for other currencies. § 3) Differential tax laws: Covered interest arbitrage might be feasible when considering before-‐tax returns but not necessarily when considering after-‐tax returns. Variations in Forward Premiums: Forward Premiums across Maturities: § The annualized interest rate differential between two countries can vary among debt maturities, and so will the annualized forward premiums. Changes in Forward Premiums Over Time: If IRP holds, the forward premium must adjust to existing interest rate conditions. § The forward rate is indirectly affected by all the factors that can affect the spot rate (S) over time, including inflation differentials, interest rate differentials, etc. Change in the forward rate can also be due to a change in the premium. Purchasing Power Parity: Interpretations of Purchasing Power Parity § Absolute Form of PPP: without international barriers, consumers shift their demand to wherever prices are lower. Prices of the same basket of products in two different countries should be equal when measured in common currency. § Relative Form of PPP: Due to market imperfections, prices of same basket of products in diff countries will not necessarily be the same, but the rate of change in prices should be similar when measured in common currency. Rational Behind Relative PPP Theory § Exchange rate adjustment is necessary to keep relative purchasing power the same whether buying products locally or from another country. § If the purchasing power is not equal, consumers will shift purchases to wherever products are cheaper until the purchasing power is equal. Implication: The degree a currency will depreciate based on inflation differential. X/R adjust to inflation rate in order for same relative purchasing power across countries (with extensive international trade) 1 + !
− 1 1 + !
Why Purchasing Power Parity Does Not Hold § Confounding effects: A change in a country’s x/r is driven by more than the inflation differential between two countries: e = f (ΔINF,ΔINT,ΔINC,ΔGC,ΔEXP) § No Substitutes for Traded Goods: If substitute goods are not available domestically, consumers may not stop buying imported goods. International Fisher Effect Suggests that the nominal interest rate contain two components: § Expected inflation rate § Real interest rate = + § The real rate of interest represents the return on the investment to savers after accounting for expected inflation. Using the IFE to Predict Exchange Rate Movements: 1) Apply the Fisher Effect to derive Expected Inflation per Country § The Fisher effect suggests that nominal interest rates of two countries differ because of the difference in expected inflation between the two countries. 2) Rely on PPP to Estimate the Exchange Rate Movement § Apply PPP to determine how x/r would change in response to those expected inflation rates of the two countries. Implications of the International Fisher Effect: § IFE suggests that currencies with high interest rates will have high expected inflation (due to the Fisher effect) and the relatively high inflation will cause the currencies to depreciate (due to the PPP effect). § Foreign investors will be adversely affected by the effects of a relatively high U.S. inflation rate if they try to capitalize on the high U.S. interest rates. Limitations of the IFE: The IFE theory relies on the Fisher effect and PPP § Limitation of the Fisher Effect: The difference between the nominal interest rate and actual inflation rate is not consistent. Thus, while the Fisher effect can effectively use nominal interest rates to estimate the market’s expected inflation over a particular period, the market may be wrong. § Limitation of PPP: Other country characteristics besides inflation (income levels, government controls) can affect exchange rate movements. Even if the expected inflation derived from the Fisher effect properly reflects the actual inflation rate over the period, relying solely on inflation to forecast the future exchange rate is subject to error. IFE Theory versus Reality § The IFE theory contradicts how a country with a high i/r can attract more capital flows and therefore cause the local currency’s value to strengthen. § IFE theory also contradicts how central banks may purposely try to raise i/r in order to attract funds and strengthen the value of their local currencies. All 3 theories have different implications: § IRP focuses on why the forward rate differs from the spot rate and on the degree of difference that should exist. It relates to a specific point in time. § PPP and IFE focus on how a currency’s spot rate will change over time. § Whereas PPP suggests that the spot rate will change in accordance with inflation differentials, IFE suggests that it will change in accordance with interest rate differentials. § PPP is related to IFE because expected inflation differentials influence the nominal interest rate differentials between two countries. IRP Key Variables of Theory Summary Forward rate Interest The forward rate of currency w ill contain a premium or rate premium/discount that is determined by the differential discount differential in i/r. Covered interest arbitrage w ill provide a return = domestic return. PPP %Δ in spot x/r Inflation The spot rate of currency w ill change in reaction to the rate differential in inflation rates. Purchasing power for differential consumers w hen purchasing goods in their own country will be the same as importing from foreign country. IFE %Δ in spot x/r Interest The spot rate of currency w ill change in accordance to rate i/r differential. Return on uncovered foreign m oney differential market securities = return on domestic m oney m arket securities for the investors of home country. Seminar 6: Currency Derivatives Contract with px partially derived from underlying currency. Used by MNCs to  Speculate on future x/r movements  Hedge exposure to x/r risks. Forward contract § Dealer and M NC § Customized (OTC) Future contract § Sold over exchange § Standard vol. Call/ Put options § Right to buy/sell at strike px  Forward contract: MNCs hedge their imports by locking in at fixed forward rate. Less liquid→more sensitive to ddΔ ; higher bid-‐ask spread. IRP: Forward premium (rate) Δ acc. to i/r differential over time. *annualized value (forward prem.): 90days forward contract = 360days/90days Real cost= Cost of transaction(hedged) – Cost (when NOT hedged)  Future contract: standardized no. of units per contract. May leave some units of FC unhedgedL. Greater liquidity than forward→more buyers/sellers. Speculators:  FC expected to appreciate: Buy future contracts and sell FC FC expected to depreciate: Short-‐sell futures, buy back FC at lower px. MNCs Hedge:Purchase future to hedge payables (future spot rate: appreciate)  Sell Futures to hedge receivables (future spot rate: depreciate)  Currency Call/Put Option: Right (not obligation) to buy/sell currency at specified strike/exercise px within specific period of time (expiration) Buy LOW, Sell HIGH. In the money: exercise option J (Call: spot > X) American option: up to expiration. European: on expiration date (lower premium.) Factors affecting ↑Call premium:  Spot px relative to strike px (S-‐X)  Length of expiration T  Potential variability of currency σ § Speculators: FC expected to appreciate: Buy call options, sell at spot rate. Net profits= Selling px of FC (S) – Purchase px (X) – option premium § Hedge payables: Call exercise px= ceiling price (max. price). If S < X, let option expire and buy at spot (lower). § Gain on forward contract = Amt received from forward sale – Amt paid to fulfil contract. Limitations: ↓translation exposure; ↑ transaction exposure (Real G/L L) Inaccurate earnings forecast→overhedging. Seminar 9: International Capital Budgeting § If foreign subsidiary wholly owned by parent, to enhance shareholders’(parent) wealth Based on parent’s perspective: Remittable CFs to parent, net of ALL taxes. Difference in Subsidiary and parents perspective: 1) Tax differential 2) Restriction on Remitted earnings (by host govt) 3) X/r movement § If other owners involved: eg. Local partners’ perspective: NPV of proj. in local currency Project/asset with economic life >1 year. Feasible if NPV>0. Seminar 10: Long-‐Term Debt Financing What affects Cost of debt: 1) Currency denomination. 2) Maturity. 3) Fixed or floating rate. à Affects required rate of return (hurdle rate) Debt Denomination Decision to Minimise Exposure to X/R Risk Subsidiaries finance their operations with the host currency used to invoice Call option
Put their products à Reduces exposure to x/r by using portion of cash inflow to option. finance interest and debt (in foreign currency). Best if host i/r are low. § Speculators: FC expected to depreciate: Sell put options, buy at spot rate 1) Use Currency Swaps: Specifies the exchange of currencies at periodic Net profits= Selling px of FC (X) – Purchase px (S) – option intervals and may allow the MNC to have cash outflow in the same currency it premium issued the bond/borrowed money in. 2) Use Parallel Loans: Two parent companies provide simultaneous loans to the other parent’s subsidiary, with same agreement to repay at specified time, Seminar 7 & 8: Exposure Management in same currency. Transaction exposure – sensitivity of the firm’s contractual transactions Potential benefits from financing with a low interest rate currency that invoiced in foreign currencies to exchange rate movements (how Δ in FX rates differs from its cash inflow currency: affect the value of CF (in HC) generated by foreign transaction→export 1. Subsidiary financing with Host currency (Matching) denominated in FC Repay loan with inflow à then Remit. Method: 1) S.D of Volatility σP = √(!! !! + !! !! + 2! ! ! ! !" ) [+] Low exposure to exchange rate...
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- Fall '13
- International Finance