Unformatted text preview: FIN2101
BUSINESS FINANCE II Module 11
Management Student Activities
Reading Text, Chapter 20
Text Study Guide, Chapter 20
Study Book, Module 11 Tutorial Work Tutorial Workbook, Self Assessment Activity 11.1
Text Study Guide, Chapter 20, All Lecture Overview
Foreign exchange (FOREX) market Transactions in FOREX market FOREX rates and quotes Exchange rate risk Political risk International investment and financing decisions Relevance of International
Finance Firms are part of and operate in a highly globalised and integrated world economy.
Australiandollar denominated financial instruments are traded among a wider clientele of international investors and borrowers.
The profitability of Australian importers and exporters is affected by exchange rate fluctuations. FOREX Market
FOREX Where FOREX (different currencies) is (are) traded.
As a result of these transactions, FOREX rates between different currencies are determined, for example, 1 AUD / 0.5185 USD.
FOREX management is implemented.
FOREX activities are based on supply and demand. Market Characteristics
Largest financial market in the world – 1.2 trillion USD traded daily in 2001. Highly integrated. Operates 24 hours a day. London, New York and Tokyo dominate the market activity (75% of turnover). FOREX Market Structure
Interbank market wholesale, large transactions Retail market small scale transactions Where Is The Market?
Where An overthecounter (OTC) market.
There is no one market place.
Transactions occur in trading rooms by telephone, telex, computer, automated dealing systems.
Trades must be conducted by authorised dealers (8090), licensed by the RBA. Market Participants
Bank and nonbank dealers Individuals and firms exporters/importers Tourists Speculators/arbitragers Central banks FOREX brokers Transactions in FOREX
Market Spot transaction Forward transaction Swap transaction Spot Transaction
Spot A FOREX term indicating settlement will occur in two business days time. Forward Transaction
Delivery at a future date of the specified amount of one currency for a specified amount of another currency. Exchange rate is established at the time of contract but payment and delivery not required until maturity, eg 1, 2, 3, 6, 12 months time. Swap Transaction
Swap Simultaneous sale (or purchase) of spot foreign exchange against a forward purchase (or sale) of approximately an equal amount of the foreign currency.
Swaps account for about 56% of interbank FOREX trading. FOREX Rates and Quotes
FOREX The vehicle currency (or unit currency) is the currency being traded.
1 AUD/0.5185 USD, the AUD is being traded and is the unit currency.
1 USD/1.9286 AUD, the USD is the unit currency. FOREX Rates and Quotes
• home currency is the vehicle or unit currency (the currency being traded) Direct
• foreign currency is the vehicle or unit currency Conversion of Quotes
1 AUD / 0.5185 USD
1 USD / (1/0.5185) AUD
1 USD / 1.9286 AUD Currency Appreciation
Currency Currency strengthens relative to other currencies.
If AUD appreciates relative to USD, it takes more USD to buy AUD.
The same as USD depreciating relative to the AUD.
Example: 1 AUD / 0.5185 USD to 1 AUD / 0.5205 USD Currency Depreciation
Currency A currency weakens relative to other currencies.
If AUD depreciates relative to the USD, it takes fewer USD to buy AUD.
The same as the USD appreciating relative to the AUD.
Example: 1 AUD / 0.5185 USD to 1 AUD / 0.5125 USD Bid/Offer Rates (Retail Market)
Bid/Offer When conducting a FOREX transaction, you will generally be presented with two rates, the BID (buy) rate and the OFFER (sell) rate.
In the RETAIL market, the quotes are from your point of view. Bid/Offer Rates (Retail Market)
1 AUD / 0.5215 - 0.5185 USD
In the RETAIL market you can buy 1 AUD
for 0.5215 USD, or sell 1 AUD for 0.5185 USD. Dealer will BUY LOW, SELL HIGH. Bid/Offer Rates (Interbank
1 AUD / 0.5185 - 0.5215 USD The dealer will buy AUD off you @ 0.5185,
and sell AUD to you @ 0.5215. Example 1
Retail market quote:
• 1 AUD / 0.5215 0.5185 USD. You are an exporter who has just received 1 million USD. How much AUD will you receive? Example 1 Solution
Example You will be selling your USD to the dealer and buying AUD.
Therefore use the bid rate of 0.5215.
To convert USD to AUD, 1 000 000 USD / 0.5215 = 1 917 546 AUD. Example 2
Retail market quote:
• 1 AUD / 0.5215 0.5185 USD. You are an importer who has to pay 1 million USD. How many AUD will you need? Example 2 Solution
Example You will be buying USD, by selling AUD to the dealer.
Therefore use the OFFER rate of 0.5185.
To convert AUD to USD, 1 000 000 USD / 0.5185 = 1 928 640 AUD.
If you had 1 928 640 AUD and needed to convert to USD, sell AUD using offer rate 0.5185 = 1 928 640 AUD x 0.5185 = 1m USD. Forward Exchange Rates
Quoted 3 different ways:
Outright Points basis Percentage premium or discount per annum (not concerned with) Outright Forward Rates
Outright Full bid and offer rates to all decimal points (same as spot rate).
For example, a 3 month forward rate:
1 AUD / 0.5185 0.5245 USD Can be > or < spot rates. Outright Forward Rates
When one unit of unit currency is worth more forward than it is spot.
When one unit of unit currency is worth less forward than it is spot. Example
Spot 1 AUD / 0.5185 - 0.5215 USD 3 mth Forward 1 AUD / 0.5205 - 0.5295 USD The AUD is at a premium in the forward
market. (The USD is at a discount in the
forward market). Forward Points
Forward Forward rates can be quoted as points, showing the difference between the forward and spot rates. A point is 0.0001. 100 points equals 1 cent. Example
Spot 1 AUD / 0.5185 - 0.5215 USD 3 mth Forward 0.0035 - 0.0045 3 mth Outright Fwd:
1 AUD / 0.5220 - 0.5260 USD Forward Points
If points are ascending, ADD to spot rate.
If points are descending, DEDUCT from
the spot rate. Exchange Rate Risk
Exchange Exchange rate risk exists when there is the potential for unanticipated changes in an exchange rate to affect the value of the company.
Any firm that is involved in exporting or importing will be exposed to exchange rate risk.
A depreciation of the AUD will increase the price (in AUD terms) of imports if the price is fixed in say USD.
An appreciation of the AUD will reduce an exporter’s profits in AUD terms if the invoice price is fixed say in USD. Causes of Exchange Rate
Fluctuations Inflation rates • Exchange rates will move so that currencies will have the same purchasing power – purchasing power parity (PPP). Interest rates • The expected movement in an exchange rate should equalise the effective interest rates between the two countries (IRP). Causes of Exchange Rate
Fluctuations Terms of trade • An improvement in a country’s ratio of export prices to its import prices will tend to increase its net export income and strengthen the value of its currency. Current account balance • Countries with an accumulated current account deficit have ‘weak’ exchange rates. Central bank trading • Central banks intervene when they are concerned about the market for the currency and when they believe that the exchange rate is impacting adversely on monetary policy. Effects of Exchange Rate Risk
Effects Economic exposure • The impact on the value of the firm of exchange rate variations. Accounting (translation) exposure • The impact of exchange rate changes on financial statement items denominated in foreign currencies.
• AASB 1012: Foreign Currency Translation. Risk Management
Risk Hedging is a strategy that will ensure that the Australian dollar value of a commitment to pay or receive a sum of foreign currency in the future is not affected by changes in the exchange rate.
Hedging involves taking another, offsetting, commitment in the same foreign currency. Forward Hedge
Forward An Australian importer is committed to paying a future sum in UK pounds. This is effectively a commitment to buy UK pounds in the future.
By entering into a forward contract today to buy UK pounds in the future, the value of the commitment can be fixed in Australian dollar terms.
In this case, the future outflow of UK pounds required by the import contract is matched by the future inflow of UK pounds required by the forward contract. Money Market Hedge
Money Involves borrowing in one currency and exchanging the proceeds for another currency.
If the transaction to be hedged is a foreign currency receipt, borrow in the foreign currency.
If the transaction is a foreign currency payment, borrow in the home currency.
Example 11.6 in the Study Book. Political Risk
Political Multinationals are exposed to political risk which refers to “the implementation by a host government of specific rules and regulations that can result in the discontinuity or seizure of the operations of a foreign company in that country” (Gitman, p. 743).
Macro vs micro political risk.
Text, pp. 7434. International Investment
Decisions Generally use the same approach as that used to evaluate domestic investment proposals (Study Book, pp. 11.1411.17).
Identify the relevant cash flows and discount them at the firm’s WACC or the project’s required rate of return to determine the NPV. International Investment
Decisions Either estimate cash flows in the foreign currency and discount at the appropriate (foreign) discount rate.
Or translate foreign cash flows to domestic currency cash flows and discount at the domestic required rate of return. Modes of Foreign Investment
Modes Joint venture with local partner(s).
100% owned greenfield (newly established) foreign subsidiary.
Merger with, or acquisition of, an existing local firm.
Strategic alliance with one or more partners.
Study Book, pp. 11.1611.17. International Financing
Decisions Raise the funds in the home country.
Borrow funds in the foreign country.
Borrow in a third country.
Raise equity funds in offshore market.
Study Book, pp. 11.1811.19. Exam Format
Section A 30 multiple choice questions (theory & practical). 30 marks/30%.
Section B 6 questions (1 @ 5, 1 @ 6, 1 @ 7, 1 @ 9, 1 @ 11, 1 @ 12). Some questions have a shortanswer part. 50 marks/50%. ...
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