Lecture Series II (2007 - IsM)

International Business Finance

Financial Management Issues

COW ECONOMY

• TRADITIONAL CORPORATION

You have two cows.

You sell one and buy a bull. Your herd multiplies, and the economy grows. You sell them and retire on the income.

AMERICAN CORPORATION

You have two cows.

You sell three of them to your publicly listed company, using letters of credit opened by your brother-in-law at the band, then execute a debt/equity swap with an

associated general offer so that you get all four cows back, with a tax exemption for five cows. The milk rights of the six cows are transferred via an intermediary to a

Cayman Island company secretly owned by the majority shareholder who sells the rights to all seven cows back to your listed company. The annual report says the

company owns eight cows, with an option on one more. Sell one cow to buy a new president of the United States, leaving you with nine cows. No balance sheet

provided with the release. The public buys your bull.

COW ECONOMY (Cont.)

• AN AUSTRALIAN CORPORATION

You have two cows.

You sell one, and force the other to produce the milk of four cows. You are surprised when the cow drops dead.

• FRENCH CORPORATION

You have two cows.

You go on strike because you want three cows.

• JAPANESE CORPORATION

You have two cows.

You redesign them so they are one-tenth the size of an ordinary cow and produce twenty time the milk. You then create clever cow cartoon images called Cowikimon

and market them worldwide.

COW ECONOMY (Cont.)

• A GERMAN CORPORATION

You have two cows.

You reengineer them so they live for 100 years, eat once a month, and milk themselves.

COW ECONOMY (Cont.)

A SWISS CORPORATION You have 5000 cows, none of which belong to you. You charge others for

storing them.

CHINESE CORPORATION

• You have two cows.

You have 300 people milking them. You claim full employment, high bovine productivity, and arrest the

newsman who reported the numbers.

COW ECONOMY (Cont.)A RUSSIAN CORPORATION

You have two cows.

You count them and learn you have five cows. You count them again and learn you have 42 cows. You count them again and learn you have 12 cows.

You stop counting cows and open another bottle of vodka.

A BRITISH CORPORATION

You have two cows... both are mad.

AN INDIAN CORPORATION

You have two cows, but you don't know where they are... You break for lunch.

Management Joke• A man in a hot air balloon realized he was lost. He reduced altitude and

spotted a woman below. He descended a bit more and shouted, "Excuse me, can you help me? I promised a friend I would meet him an hour ago, but I don't know where I am."

• The woman below replied, "You are in a hot air balloon hovering approximately 30 feet above the ground. You are between 40 and 41 degrees north latitude and between 59 and 60 degrees west longitude."

• "You must be an engineer," said the balloonist.• "I am," replied the woman. "How did you know?"• "Well," answered the balloonist, "everything you told me is technically

correct, but I have no idea what to make of your information, and the fact is I am still lost. Frankly, you've not been much help so far."

• The woman below responded, "You must be in management."• "I am," replied the balloonist, "but how did you know?"• "Well," said the woman, "you don't know where you are or where you are

going. You have risen to where you are, due to a large quantity of hot air. You made a promise which you have no idea how to keep, and you expect people beneath you to solve your problems. The fact is you are in exactly the same position you were in before we met, but now, somehow, it's my fault."

Global Finance & Financial Management Issues

• Generally Speaking, an organization goes through five stages of evolution viz.: (1) domestic, (2) international, (3) multinational, (4) global and (5) meta national.

• Firms go abroad for organizational (internal) and / or environmental reasons.

• Internal reasons might range from wanting to exploit worldwide market imperfections to opportunities that arise in different stages of the lifecycle of a firm’s product or life cycle.

• Environmental reasons are external to the organization include exploitation of competitive advantages of a nation such as declining costs of transportation and communication, globalization of capital markets, etc.

Organizational Characteristics

• Multinational – Key assets, responsibilities and decisions are highly decentralized i.e. overseas subsidiary is responsible for identifying and exploiting opportunities in local markets, knowledge is developed and retained by the subsidiaries. Example Unilever.

• International - some assets, resources and responsibilities are decentralized with occasional control from HQ – some degree of centralization. Overseas sub. Leverage parent’s capabilities and adapt to suit local markets. Knowledge developed at the HQ is passed on to subsidiaries.Example – Kellog, IBM, P&G

Organizational Characteristics

• Global – Strategic assets, resources, responsibilities and decisions are highly centralized. Subsidiaries simply implement parent company’s strategic and market standardized products. Knowledge is developed and retained by parent company. Texas Instrument, Motorola Matsushita are some of the examples.

Corporate India

• There are various ( six or so) ways to enter a foreign markets Viz.: exporting, turnkey projects, licensing, franchising, setting up of joint venture with host country firm, setting up a wholly owned subsidiary in the host country.

Corporate India

• In 2003 India loosened controls on overseas investment by Indian companies.

• The volume of overseas acquisitions by Indian companies has grown from around $2 billion in 2004 to $4.5 billion in 2005 and may reach over $10 billion in 2006. Videocon, Bharat Forge, Ranbaxy and other pharma companies, the IT majors and, of course, ONGC are some of the others who have been active.

• In 2006 Tata bids to acquire Anglo - Dutch Steel group Corus for 4.15 pence/share or $7.6 billion. Deal is still pending and a bidding war has ensued.

Corporate India

• The recent bid to acquire Corus by Tata has signaled that some of the Indian Corporations are looking beyond the national market and seeing their future as multi-nationals, competing for space in the global economy with the present Occupants.

Go global!

• Why do companies choose to go global?

Why global?

• Ambition (most important perhaps!)

• Special value management can provide (The Tata-Corus deal - The Tatas have operated a steel plant under difficult conditions, coped with competition and developed plant management, supply management, maintenance and marketing skills, which constitute a viable business-model for developed country commodity producers teetering on the edge of commercial decline). In some ways Mittal's empire rests on the same strength as he has brought in management talent from India even though he himself is based in Europe.

Why Global?

• To reach new markets and get the technical and marketing muscle required for this. Acquisition provides access to new markets and acts as beach head.Example: Bharat Forge & Phermacutical Companies.

• Organic growth of a company, by setting up sales and service facilities, manufacturing plants, and R&D centers abroad. This becomes necessary at a certain scale because of the long supply chains, particularly from Asia to Europe and the US. Example IT majors.

• Efforts at securing supply source. Example: ONGC

Global Survival

• In the long run, survival in a global market depends on building a strong brand presence or a cost or technical advantage that allows a company to capture, say, 25 per cent or more of a global market.

• Overseas expansion necessarily involves some financial packaging. Most of these financial services are today provided by investment bankers abroad.

International Capital /Financial Flows

• International Business activity involves trade and financial (capital) flow through the transfer of goods and services across international borders. Corporations with significant foreign operation are often engaged in producing and selling goods or services in more than one country.

• International Business need to consider many financial factors that do not directly affect purely domestic firms.

• These include foreign exchange rates, differing interest and inflation rates from country to country, currency control, differences in foreign tax rates, multiple money markets, complex accounting methods for foreign operations, and foreign government intervention such as sudden or creeping expropriation and politically motivated actions.

Finance JargonsInternational finance like many other specialty area is full of jargons.Therefore, the first step in learning about international finance is to learn thenew vocabulary or jargons.

SOME INTERNATIONAL FINANCE TERMINOLOGY

• ADR: American Depository Receipts – A security issued in the U.S. that represents shares of foreign stock, allowing that stock to be traded in the U.S

• Arbitrage: Traditionally defined as the purchase of commodity, security or currency in one market for immediate resale on another market in order to profit from a price discrepancy

• Cross-rate: The implicit exchange rate between two countries (usually non US) when both are quoted in some third currency, usually the U.S. dollar

• Eurobond: A bond issued in multiple countries, but denominated in a single currency, usually the issuer’s home country

International Finance Terminology

• Eurocurrency: Money deposited in a financial center outside of the country whose currency is involved

• Eurodollar: US dollars deposited in banks outside the U.S. banking system• Exchange rate: The price of one country’s currency expressed in terms of

another country’s currency• LIBOR: London Inter Bank Offer Rate is the interest rate that most international

banks charge one another for loans of Eurodollars overnight in the London market• Market efficiency: An efficient market is one in which the price of traded

securities readily incorporate new information. Most large and developed capital markets are efficient, that is, trading rules based on past prices or publicly available information can not consistently lead to profits after adjusting for transaction cost in excess of those due solely to risk taking

• Swaps:Agreements to exchange two securities or currencies. There are two basic types of swaps viz. Interest rate and currency. Interest rate swap occurs when two parties exchange a floating-rate payment for a fixed-rate payment or vice versa. Currency swaps are agreements to deliver one currency in exchange for another.

International Currencies• International Currencies and their Symbols• Country Currency Symbol• Australia Dollar A$• Austria Schilling Sch• Belgium Franc BF• Canada Dollar Can$• Denmark Krone DKr• EMU Euro e• Finland Markka FM• France Franc FF• Germany Deutsch Mark DM• Greece Markka FM• India Rupee Rs• Iran Rial Rl• Italy Lira Lit• Japan Yen Y• Kuwait Diner KD• Mexico Peso Ps• Netherlands Guilder FL• Norway Krone NKr• Saudi Arabia Riyal SR• Singapore Dollar S$• South Africa Rand R• Spain Peseta Pta• Sweden Krone SKr• Switzerland Franc SF• United Kingdom Pound L• United States Dollar $

Currency Exchange Market• The market where one country’s currency is for another’s is called foreign

exchange market.

• Foreign exchange market is the world’s largest financial market.

• Foreign exchange markets are over the counter markets as opposed to exchanges, that is, there is no single physical location for traders to get together. Instead, market participants are located in the major commercial and investment banks around the world. They communicate using computer terminals, telephones and other telecommunications devices. Society for Word-wide Inter-bank Financial Telecommunication (SWIFT), a not-for-profit co-operative, maintains communication network for foreign transaction. Using data transmission line, a bank in New York can send messages to a bank in London via SWIFT regional processing center.

Currency Exchange Terminology

• Eurocurrency: Money deposited in a financial center outside of the country whose currency is involved

• Eurodollar: US dollars deposited in banks outside the U.S. banking system• Exchange rate: The price of one country’s currency expressed in terms of

another country’s currency• LIBOR: London Inter Bank Offer Rate is the interest rate that most international

banks charge one another for loans of Eurodollars overnight in the London market• Market efficiency: An efficient market is one in which the price of traded

securities readily incorporate new information. Most large and developed capital markets are efficient, that is, trading rules based on past prices or publicly available information can not consistently lead to profits after adjusting for transaction cost in excess of those due solely to risk taking

• Swaps: Agreements to exchange two securities or currencies. There are two basic types of swaps viz. Interest rate and currency. Interest rate swap occurs when two parties exchange a floating-rate payment for a fixed-rate payment or vice versa. Currency swaps are agreements to deliver one currency in exchange for another.

Foreign exchange - the most important issue

• overview of international finance jargons

• International finance like many other specialty area is full of jargons. Therefore, the first step in learning about international finance is to learn the new vocabulary or jargons.

SOME INTERNATIONAL FINANCE TERMINOLOGY ADR: American Depository Receipts – A security issued in the U.S. that represents shares of foreign stock, allowing that stock to be traded in the U.S

• Arbitrage: Traditionally defined as the purchase of commodity, security or currency in one market for immediate resale on another market in order to profit from a price discrepancy

• Cross-rate: The implicit exchange rate between two countries (usually non US) when both are quoted in some third currency, usually the U.S. dollar

• Eurobond: A bond issued in multiple countries, but denominated in a single currency, usually the issuer’s home country

commonly used currencies • Some of the more commonly used currencies and their symbols are listed bellow: • International Currencies and their Symbols• Country Currency Symbol• Australia Dollar A$• Austria Schilling Sch• Belgium Franc BF• Canada Dollar Can$• Denmark Krone DKr• EMU Euro e• Finland Markka FM• France Franc FF• Germany Deutsch Mark DM• Greece Markka FM• India Rupee Rs• Iran Rial Rl• Italy Lira Lit• Japan Yen Y• Kuwait Diner KD• Mexico Peso Ps• Netherlands Guilder FL• Norway Krone NKr• Saudi Arabia Riyal SR• Singapore Dollar S$• South Africa Rand R• Spain Peseta Pta• Sweden Krone SKr• Switzerland Franc SF• United Kingdom Pound L• United States Dollar $

Currency exchange Market:• The market where one country’s currency is for another’s is called foreign

exchange market.

• Foreign exchange market is the world’s largest financial market.

• Foreign exchange markets are over the counter markets as opposed to exchanges, that is, there is no single physical location for traders to get together. Instead, market participants are located in the major commercial and investment banks around the world. They communicate using computer terminals, telephones and other telecommunications devices. Society for Word-wide Inter-bank Financial Telecommunication (SWIFT), a not-for-profit co-operative, maintains communication network for foreign transaction. Using data transmission line, a bank in New York can

send messages to a bank in London via SWIFT regional processing center.

Currency exchange market

• Most of the currency trading (Over 60%) takes place in a few currencies viz.: the U.S. dollar; the deutsche mark; the British pound; the Swiss franc; the Japanese yen and the French franc.

• Exchange Rate: It is the price of one country’s currency expressed in terms of another country’s currency. In practice almost all currency trading takes place in terms of U.S. Dollar. For example, both the French franc and German mark are traded with their prices quoted in U.S. Dollar.

Exchange Rate Quotations

• Foreign exchange rates are quoted either as: • American OR Direct – it gives number of domestic currency (dollars) it

takes to buy one unit of foreign currency. For example, when Indian Rupee is quoted at 0.0229 in NY, it means that one can buy 1 Indian Rupee for US. $ 0.0229 (2.29 Cents).

• European OR Indirect – it gives the amount of the foreign currency that will be needed to buy 1 unit of domestic currency (even though the currency may not be European). For example, when U.S. $ is quoted in NY at 43.7, it means that one can buy 1 U.S. dollar for Rs.43.7.

Example of foreign exchange quotation

• The Statesman provided the following foreign exchange quotation on January 29, 2005: • Currency Rs.• UK Pound 82.56522• Yen 0.42413659• HK $ 5.605613• Sw Fr 36.972516• Saudi Riyal 11.657734• Euro 57.0400• US $ 43.7200

• Are these direct or indirect quotes?

• Suppose you have 100,000 Yen. Based on the above rates how many Rupees can you get?

• Suppose a new Apartment / Flat costs Rs. 8,500,000. How many US dollars would I need to buy this flat?

Foreign Exchange

• Direct

• 100,000 Y x 0.42413659 Rs./ Y = Rs. 42413.659

• Rs. 85,00,000/43.72 (Rs./$) = US $ 194,419

CROSS-RATES AND TRIANGULAR

ARBITRAGE • Cross-rate is the exchange rate for a non-U.S. currency expressed in terms of

another non U.S. currency.

• Often, most currencies are quoted against the dollar. Therefore, it becomes necessary to work out cross-rates for currencies other than the dollar.

• EXAMPLE:Suppose we are given the following exchange rates:

Currency• Currency U.S. $ per U.S. $• U.K. Pound 1.6570 0.6035• German marks .5907 1.6929• French Franc .15 6.6667• Japanese Yen .008776 113.95• Swiss Franc .7210 1.3870• Euro 1.1553 .8656

Cross-Rate Example

• Previous slide indicate that Deutsch mark is selling for $0.5907 and the buying rate for the French franc is $0.15.

• What is the FF / DM exchange rate or in other words what is the cross-rate?

• What is the Yen – DM cross-rate?

• What is the SFr –DM cross-rate?

Cross – rate Example

• 0.5907($/DM) / 0.15 ($/FF) = 3.938 FF/ DM

• Y/DM = .5907/.008776 =67.3086,

• SFr/DM= .5907/.721 = 0.8193, etc.

Triangular Arbitrage

• Suppose:• U.S banks are bidding $1.9809 for Pound starling.

German banks in Frankfurt are bidding $0.6251 for DM

At the same time, London banks are offering pound starling at DM 3.1650

• You are an astute currency trader with $ 1,000,000.00.

• What would you do?

Triangular Arbitrage Example

• You would sell dollars for DM in Frankfurt and get 1,599,744 DM ($1,000,000/0.6251 $/DM)

• Sell these DM in London for L 505,448.35 (1599744/3.165)

• Re-sell the Pound starlings in NY for $1,001,242 (505,448.35 x 1.9809) an instant gain/profit of $1,242.64

• Say you did this in one hour (max). You gained 0.124% in one hour. This is about 3%/ day. Which will calculate to over 40000%/year. I suppose you will not be happy with this kind of return and will want to do something else. If you can perform like this as an employee, then what kind of bonus would you expect from your employer?

• This particular activity is called “Triangular Arbitrage”

US Dollar Quote

• Until recently, the widely used practice among bank dealers was to quote all currencies against the U.S. dollar when trading among them.

• WHY?

Uniform Exchange Rates

• Traders are alert to “triangular arbitrage” possibility due to inconsistencies in different money centers and this arbitrage helps to keep exchange rates uniform in various markets.

• The opportunities for such arbitrage have been greatly reduced in recent years, due to the extensive network of people who are continually collecting, comparing and acting on currency quotes in all financial markets – aided by high-speed computers, computerized information system.

• Because, in case of the example discussed, a large number of these transactions would tend to cause DM to appreciate in Frankfurt and to depreciate against the pound in London. At the same time pound will tend to fall in NY.

U.S. Dollar as common denominator

• Using U.S. Dollar as the common denominator in quoting exchange rates has some advantages.

• This greatly reduces the number of possible cross-currency rate quotes. For example, with five major currencies, there could potentially be 10 exchange rates instead of 4.

• Also, the fact that the dollar is used throughout cuts down on inconsistencies in the exchange rate quotes i.e. rates for a specific currency tend to be the same everywhere, with only minimal deviation due to transactional cost.

• However, now, about 40% of all currency trades do not involve the dollar.

• Therefore, Swiss banks may quote the Deutsche mark against Swiss franc.

Transactional Cost

• The bid-asked spread is the transaction cost. Banks do not normally charge a commission on their currency transactions. However, they do make profit through bid-asked spread. Bid is the price at which they will buy the currency. The price at which they will sell is asked or offer rate. Quotes are always given in pairs. The first rate is the bid or buy rate, the second is the sell or asked rate.

• Suppose you see the pound sterling quote as $1.7019 -36. What does this mean?

Bid – Asked Spread

• It means that the bank is willing to buy pound sterling at $1.7019 and willing to sell them at $1.7036. In practice, dealers do not quote the full rate to each other; instead, they quote only the last two digits of the decimal.

• The bid-asked spread depends on the breadth and depth of the market for that currency as well as the volatility. The spread is generally stated as a percentage cost of transacting in the foreign exchange market.

• % spread = 100 x (asked –bid)/asked

• For widely traded currencies, the spread might be on the order of 0.1 - 0.5 % and is higher for less heavily traded currencies.

Bid – Asked Spread

• NOTE:

The quotes found in financial press are not those that individuals or firms would get at the local bank. These quotes are for inter-bank markets exceeding $1 million.

The market for traveler’s check and smaller currency exchanges, such as made by travelers going abroad, the spread is much wider.

Types of Transactions• There are two basic types of trades in the foreign exchange market viz.: Spot trade

and Forward trade.

• Spot Trade: Agreement to exchange currency “on the spot”. Spot trade is a misnomer. Spot tread actually is settled/completed in two business days. The exchange rate on the spot trade is called as spot exchange rate.

• Forward trade: Agreement to exchange currency at some time in the future. The exchange rate that will be used is agreed upon today and is called the forward exchange rate or in other words the agreed upon exchange rate to be used in the future for a forward trade.

The 180-day Swiss franc forward exchange rate quote SF 1= U.S. $0.7342, means that one can agree to take delivery of a Swiss franc in 180 days and pay $0.7342 at that time.

Forward Market• Forward market allows businesses and individuals to lock in future exchange rate

today and eliminate any risk from unfavorable shifts in the exchange rate.

• Forward Market Participants:• Arbitrageurs seeks risk free profit by taking advantage of difference interest rates

among countries• Hedgers (mostly MNC) use this market to protect home currency value of various

foreign currency dominated assets and liabilities on their B/S that are not realizable over the life of the contract

• Traders use forward contract to protect the value of a specific payment or receipt expected at a specified point in time,

• Speculators buy or sale in the forward market on the basis of future exchange rates speculation.

• To avoid confusion, we will always assume that the exchange rates are quoted in foreign currency per U.S. $, unless otherwise stated.

Pure Purchasing Power Parity (PPP)

• The concept of purchasing power parity helps us at least partially understand, what determines the level of spot exchange rates and the rate of change in exchange rates. It is relatively simple concept.

• It says, exchange rates adjust to keep purchasing power constant among currencies i.e. a commodity costs the same regardless of the currency used to purchase it or where it is selling.

• For example:

If a 12 OZ. can of Coca-Cola costs $1.00 in NY and the exchange rate is 43/ $, then, the cost of the same Coca-cola in Dhanbad is Rs.43.

Pure Purchasing Power Parity

• OR, it says $1 will buy you the same number of Samosas of same size and taste anywhere in the world.

• PI / PUSA = So ; where PI and PUSA are current India and U.S.A prices respectively and So is the exchange rate of Indian currency per dollar on a particular commodity

• Similarly, we can say, British price for something is equal to the U.S. price for the same something multiplied by the exchange rate (pound/dollar).

• This is called pure purchasing power parity (PPP). The rationale behind

PPP is similar to that behind triangular arbitrage.

PPP and arbitrage

• Example:• Apples are selling for $4 per bushel in NY and in London for L 2.4. The

exchange rate is L 0.5 per $ (Instead of L 0.6 = 2.4/4).

• What will happen?Traders will buy bushel of Apple in NY for $4.00 and move it to London and

sell it for L 2.4.

• Convert L 2.4 to US $ at prevailing exchange rate and get $4.80 (2.4/.5) - a round trip gain of 80 cents.

PPP and arbitrage

• This will cause Apples to move from NY to London causing prices in NY to go up and increased supply in London will tend to reduce price of Apple in London.

• In addition, the traders will convert pounds to dollar to buy more Apples. This will increase the supply of pound and increase the demand for $. Therefore, we would expect the value of pound to fall and dollar to be more valuable. That means it would take more pounds to buy one dollar. Therefore, we would expect exchange rate to rise from L 0.5.

Purchasing Power Parity (PPP)• Pure purchasing power parity assumes that:

The transaction cost is “zero”

No barriers to trading, no tariffs, no taxes, or other political barriers

An Apple in NY is identical to an Apple in London. It wont do any good if Londoners eat Golden Apples and in NY Apples are only red

In reality, transaction costs are not zero and most other assumptions regarding PPP often do not apply. It is only applicable to very uniform traded goods like Gold. We do not see significant violation of PPP for Gold.

On the other hand, PPP does not imply Mercedes costs the same as Maruti and This brings us to relative purchasing power parity

Relative Purchasing Power Parity

• Relative PPP tells us what determines the change in the exchange rate over time.

• It states that the change in the exchange rate is determined by the difference in the inflation rates of the two countries.

• Relative PPP concept can be explained with the following example:

• Example:• Suppose, British pound – U.S. dollar exchange rate is currently So = 0.5 L• British inflation rate is expected to be 10%/year over the coming years• U.S inflation rate in the U.S. is expected to be zero (Assume for now) during the

same period. What will be the exchange rate in a year?

Relative PPP (Cont.)• With 10% inflation, one would expect prices in Britain to go up by 10% in one year. Price in

the U.S. will not change.

• Current price of U.S $ is L 0.5. The price of dollar in terms of pound would also increase by 10% to (.5 x 1.1) L 0.55, in other words exchange rate should rise to L 0.55.

• If the expected U.S inflation rate is say 4%, then relative to price in the U.S, the prices in Britain is increasing by 6% per year. So, one would expect the price of dollar to rise by 6% and the predicted exchange rate would be 0.5 x 1.06 = L 0.53

• Or• E(St) = So x [1 + ( hfc – hus)]t

• Where:• E(St) = Expected exchange rate in “t” periods• So = Current (Time zero) spot exchange rate (foreign currency per dollar)• hus = Inflation rate in the U.S, hfc = Inflation rate in foreign country

Relative PPP (cont.)Example:

• Japanese exchange rate is currently 105 Yen to U.S. $

• Inflation rate in Japan over the next three years is expected to run at 2% per year

• The U.S. inflation rate is expected to run at 6% per year during this period

Based on Relative Purchasing Power Parity, what will be the exchange rate in three years?

Relative PPP (Cont.)• The U.S. inflation rate being higher, one would expect that the dollar will become

less valuable.

• So = 105

• t = 3

• hfc = 2%

• hus = 6%

• E(St) = S0 x [1 + ( hfc – hus)]t

= 105 x [1+ (0.02 -0.06)]3

=105 x (0.96)3 = 92.897

Covered Interest Arbitrage

• Suppose we observe the following information about U.S. and German currencies in the market:

• Spot exchange rate, S0 = DM 2.00; One year forward rate, F1 = 1.90

• Risk free U.S. interest rate, RUS = 10%;

• Risk free German interest rate, RG = 5%

Suppose you have $ 1.00 to invest, and you want a risk free investment. How would you invest?

Covered Interest Arbitrage

• OPTION ONE:

• Invest $1.00 in a risk free U.S. investment such as a 360 – day T-bill. If you take this path, then, in one period your $1 will be worth:

[$1 x (1+RUS)] = $1 x (1+0.1) = $1.1

Covered Interest Arbitrage

• OPTION TWO:• Invest in risk free German investment

Convert US $1 to ( 2 x 1) = 2 DM

• Invest 2DM at RG = 5% and simultaneously execute a forward trade to convert marks to dollars in one year. = (2 DM x (1+0.05))/1.9 = 2.10 DM/1.9 = $1.1053

• This can be written as:• $ Value in 1 year = $1 x S0 x (1+ RG )/ F1 • Return on this investment is 10.53%, which is higher than 10%, which we

would have gotten by investing in the U.S. and since both investments are risk free, there was an arbitrage opportunity.

Covered interest rate parity

• Offshore Borrowing Example: The relative costs of domestic Vs. offshore borrowing.

• Suppose a US firm faced with the following situation:

It needs to borrow $1 million (U.S) for one year.

(a) It can Borrow from a US bank at 12% p.a. OR

(b) It can borrow from a German bank at 8% p.a.

General reaction would be to borrow from German bank at lower interest rate.

Current $/DM rate exchange rate (Spot) is 0.625

Covered interest rate parity

• Also, suppose that in one year $/DM spot rate would be 0.66

• If the firm decides to borrow from its US bank, it receives $1 million today and repays $1.12 million one year from now.

• If the firm borrows DM 1.6 million today, and converts to (DM 1.6 times 0.625) $1 million dollar, one year from now, the German bank would require a payment of DM 1.6 times 1.08 = 1.728 million DM.

• One year from now the firm would need 0.66 times 1.728 = 1.1405 million dollars to meet its repayment obligation to the German bank.

• Note: This exceeds the $1.12 million required under the domestic alternative.

Covered interest rate parity (Cont.)

• Conversely, if the exchange rate one year from now is unchanged at 0.625, the firm requires 0.625 times 1.728 = 1.08 million dollars to meet its repayment to the German bank and the offshore borrowing appears to have paid off.

• The resulting effect of offshore borrowing is that it has introduced foreign exchange rate risk. If the funds are borrowed from the US bank, the amount to be repaid is certain: $1.12 million. If the funds are borrowed offshore, the amount to be repaid is random, depending on the exchange rate in effect one year from now.

Covered interest rate parity

• This risk could be eliminated by buying Deutschemarks forward. That is, if an arrangement can be made with a bank to exchange a fixed amount of Dollars (agreed upon now) for 1.728 DM one year from now. The amount of dollars will be determined according to the forward rate.

• Suppose a bank agrees or accepts today to pay $1.12 million for 1.728 million DM one year from now i.e. agrees to a one year forward exchange rate of 0.6481 DM to a dollar.

Covered Interest rate Parity

• In this case, the firm is indifferent between borrowing domestically or offshore, since it has to repay $1.12 million under either alternative or there is parity at the forward exchange rate of 0.6481.

• It is called covered interest rate parity (Covered IRP). The term covered refers to the fact that the firm is covered in the event of change in the exchange rate, the firm has locked in the exchange rate.

• Clearly, if the forward rate was less than 0.6481, offshore borrowing would be preferred, and if it was greater, domestic borrowing would be preferred. Parity (indifference) in the interest rate is achieved at an exchange rate of 0.6481.

• The concept of covered interest rate parity, however, guarantees that the forward rate in this example will always be very close to 0.6481.

Interest Rate Parity

• Interest rate parity arbitrage example showed that there is a relationship between spot exchange rates, forward exchange rates, and interest rates.

• This example shows that:

Investment in risk free U.S. yields (1+RUS) for each dollar invested.

Investment in risk free German yields S0 x (1+ RG )/ F1 for every dollar invested

• To prevent arbitrage opportunity, yield from both investments have to be the same i.e.

(1+RUS) = S0 x (1+ RG)/ F1

Interest Rate Parity

• Or,

• F1/ S0 = (1+ RG)/ (1+RUS), This is the Interest Rate Parity condition

• This can be approximated as: (F1 - S0 ) / S0 = RG - RUS

• Or, F1 = S0 x [1+ (RG - RUS)] ; • In general, if we have “t” periods instead of just one, the IRP

approximation is written as: Ft = S0 x [1+ (RFC - RUS)]t

Interest rate parity (Cont.)

• Interest rate differential in the offshore borrowing example is 4%. The percentage difference between the forward and the spot exchange rate is (0.648148-0.625)/0.625 = 0.0369.

• If we define percentage forward premium or discount as (Forward rate – Spot Rate)/ Spot rate,

• Then Interest Rate Parity (IRP) says that this percentage premium or discount is approximately equal to the difference in interest rates.

IRP Example

• Example:

Exchange rate for Japanese yen is currently Y 120 = $ 1.00 U.S

Interest rate in the United States is 10% and the interest rate in Japan is 5%

• What must the forward rate be to prevent covered interest arbitrage?

IRP Example

• Answer:

• (1+RUS) = S0 x (1+ RFC)/ F1

• F1 = S0 x (1+ RFC) / (1+RUS)

= 120 x (1 + .05) / (1 + 0.1)

= 114.55

Forward Rates and Future Spot rates

• Unbiased Forward Rate (UFR) concept explains the relationship between the forward rate and expected future spot rate.

• Suppose the forward rate for Japanese Yen is consistently lower than future spot

rate, by, say 10 yen. • This means that any one who wanted to convert dollars to yen in the future would

consistently get more Yen by not agreeing to forward exchange.

• Therefore, the forward rate would have to rise to get anyone interested in forward exchange.

• For this reason, the forward and actual future spot rate should be equal to each other. This is known as Unbiased Forward Rate (UFR). UFR says that the current forward rate is an unbiased predictor of the future spot exchange rate (UFR)

Forward Rates and Future Spot rates

• F1 = E(S1); Where: E(S1) = Expected one year future spot rate and F1 is one year forward rate.

• With “t” periods, UFR would be written as: Ft = E(St) • Of course, what the future spot rate will actually be is uncertain. Therefore, traders

may be willing to pay a premium to avoid the uncertainty.

• If the condition does hold, then the 180 - day forward rate that we see today should be an unbiased predictor of what the exchange rate will actually be in 180 days.

Uncovered Interest rate Parity• WE have three relationships viz.:• PPP: E(S1) = S0 x [1+(hFC – hUS )]• IRP: F1 = S0 x [1+ (RFC - RUS)]• UFR: F1 = E(S1)

• These provide us with the relationships between interest rates, exchange rates and inflation rates. Combine these relationship, we get uncovered interest rate parity (UIP) as: E(S1) = F1 = S0 x [1+ (RFC - RUS)] Or, (E(S1)- S0)/ S0 = (RFC - RUS)

• This says that the expected percentage change in the exchange rate is equal to the difference in interest rates

• Also with “t” periods, this relationship is:

E(St) = Ft = S0 x [1+ (RFC - RUS)]t

The International Fisher Effect• Now let us compare PPP and IRP.

S0 x [1+(hFC – hUS )] = S0 x [1+ (RFC - RUS)]

OR

(hFC – hUS ) = (RFC - RUS)

• This says that, the difference in returns between the U.S.A and a foreign country is just equal to the difference in inflation rates. This implies that real rates are equal across countries.

• If real returns were higher in, say, France than in the U.S, money would flow out of the U.S. financial markets and into French markets, Asset prices in France would rise and their returns would fall. This process acts to equalize real returns.

Exchange Rate Risk

• However, in all our discussions we have not explicitly considered risk. All of our conclusion could change once we consider risk and especially if people in different countries have different attitude and test towards risk.

• Also, we have not considered barriers to movement of money or capital around the world. In reality there are many such barriers.

Risks & Barriers

• However, in all our discussions we have not explicitly considered risk. All of our conclusion could change once we consider risk and especially if people in different countries have different attitude and taste for risk.

• Also, we have not considered barriers to movement of money or capital around the world. In reality there are many such barriers.

EXCHANGE RATE RISKS

• Exchange Rate Risk stems from the possibility of incurring future exchange gains or losses on transactions already entered into and dominated in foreign currency.

• Managing Exchange rate risk is an important part of international finance.

• Relative currency values move up and down. Therefore for international operation exchange rate risk is a natural consequence. Exposure refers to the degree to which a firm is affected by exchange rate change.

• There are basically three types of exchange risk exposures viz. (1) Short-term (2) Long-term and (3) Translation. Sometimes these are also referred to as accounting exposures.

Short-term Exposure • The day-to-day fluctuations create short-term risk for international firms.

• Most international firms have contractual agreements to buy and sell goods in the near future at set prices. Different currencies involved in such transaction create an extra element of risk.

• Imagine you are importing pasta from Italy and reselling it in India under the brand name IPASTA.

• Your largest customer has ordered 10,000 cases of IPASTA. You place the order with your supplier today, but you will not pay until the goods arrive in 60 days. Your selling price is Rs. 270 per case. Your cost is 8,400 Italian Lira per case. Current exchange rate is 33.333 Lira to Rupee.

• At the current exchange rate, your cost of filling the order is Rs. 252 (8,400/33.333) per case. Your Pre-tax profit = 10,000.00 x ((270-252) = Rupees 180,000

Short-term Exposure

• However, the exchange rate in 60 days probably will be different, so your profit will depend upon what the future exchange rate turns out to be.

• If the rate goes to 35, your cost will be Rs. 240 per case and your profit will go up to Rs. 300,000

• If the exchange rate goes to 31.111, the profit vanishes to zero and so on.

• Therefore, your short term exposure fluctuates with the exchange rate.

Long-term Exposure

• Value of a foreign operation can fluctuate because of unanticipated changes in relative economic conditions in a more permanent way.

• Suppose a firm owns a labor-intensive operation in another country to take advantage of lower wages. Through time, unexpected changes in economic conditions can raise foreign wage levels to the point where cost advantage is eliminated or even becomes negative.

Translation Exposure • This exposure arises from the need, for the purpose of reporting and consolidation of

financial results. This involves converting financial statements of foreign operations from the local currencies involved to the home currency.

• When a U.S. company (say) calculates its accounting net income or EPS for some period, it must “translate” everything in dollars.

• If exchange rate has changed since the previous period, then the translation, or restatement of accounts (Assets, liabilities, revenues, expenses, net income, etc.) that are dominated in foreign currencies will result in foreign exchange gain or loss.

• The translation process can create some problem for the accountants because of the following issues:

• What is the appropriate exchange rate for translating each balance sheet item?

• How should accounting gains and losses from foreign currency translation be handled?

Managing Exchange Rate Risks

• How do you eliminate or Hedge this exchange rate uncertainty?

• Hedging:

Reducing a firm’s exposure to price or rate fluctuation is called hedging or immunization.

• It involves entering into a transaction that offsets the original transaction such that whatever is lost or gained in one transaction is exactly offset by the corresponding gain or loss of the other transaction, regardless of what happens to the future exchange rate or interest rate or inflation rate. This protects the firm from unforeseen movement of currency, interest rate or inflation as the case may be.

• Financial Risk Management is a complex subject and requires consideration of many aspects of the business - which exposure to manage? How should it manage the position? How much of the position should it hedge? Which exposure-reducing technique should it use? Etc.

• However, we will limit our discussion only to the available techniques.

Hedging for risk management

• Hedging Techniques:When we speak of hedging, we are in general referring to uncertainty related to a firm’s cash flow. A verity of hedging techniques may be available to a firm.

• Hedging with Forward Contracts:• A forward contract is a legally binding arrangement between

two parties calling for the sale of an asset or product in the future at a price agreed upon today. The terms of the contract call for one party to deliver the goods to the other on a certain date in the future, called the settlement date. The other party pays the previously agree-upon forward price and takes the goods.

Forward contracts as a hedging tool

• Forward contracts can be bought and sold. The buyer of the forward contract is obligated to take the delivery of the goods and pay for the goods. The seller has the obligation to make delivery and accept payment.

• The buyer of the forward contract benefits if prices increase because the buyer will have locked in a lower price.

• The seller wins if the price falls. Forward contract is a zero sum game.

EXAMPLE: Forward Market Hedge

• By selling forward the proceeds from its sale of Turbine blades to a German firm for DM 25 million GE can effectively transform the currency denomination of its DM 25 million receivable from DM to $, thereby eliminating all the currency risk on the sale.

Hedging with Futures Contracts

• A futures contract is exactly the same as a forward contract with one exception.

With forward contract buyer, the buyer and the seller realize gains or losses only on the settlement date.

With futures contract gains and losses are realized on a daily basis. If we buy futures contract on oil, then, if oil prices rise today, we have a profit and the seller of the contract has a loss. The seller pays up, and we start again tomorrow with neither party owing the other. It is called “marking to market”

Hedging with Swap Contracts

• A swap contract is an agreement by two parties to exchange, or swap, specified cash flows at specified intervals.

• A swap contract is really a portfolio, or series, of forward contracts. In principal, a swap contract can be tailored to exchange just about anything. However, in practice, most swap contracts fall into one of the three basic categories: Currency, interest rate and commodity.

Currency Swaps

• The Structure of currency swaps differs from interest rate swap in a variety of way. The major difference is that with a currency swap, there is always an exchange of principal amounts at maturity at a predetermined exchange rate. Thus, the swap contract behaves like a long dated forward FX contract, where the forward rate is the current spot rate.

Interest Rate Swaps • Suppose, a firm that wishes to obtain a fixed-rate loan, but can only get a good deal

on floating rate loan, that is, a loan for which payments are adjusted periodically to reflect changes in interest rates.

• Another firm can obtain a fixed rate loan, but wishes to obtain the lowest possible interest rate and therefore willing to take a floating rate loan.

• Both firms could accomplish their objectives by agreeing to exchange loan payments, that is, the two firms would make each others loan payments.

Interest rate swap Example

• Suppose, Company A can borrow at a floating rate equal to prime plus 1% or at a fixed rate of 10%.

• Company B can borrow at a floating rate of prime plus 2% or at a fixed rate of 9.5%.

• Company A desires a fixed rate loan, where as company B desires a floating rate loan.

• Company A contacts a swap dealer and a deal is struck.

Interest rate swap (Cont.)

9.75% Fixed 9.5% Fixed

Prime +1% Prime+1.5% Floating FLOATING

?

Company A

Swap Dealer Company B

Debt Market Debt Market

Interest Rate Swap (Cont.)

• Company A - borrows the money at a rate of prime plus 1 percent. The swap dealer agrees to cover the loan payments, and, in exchange, the company agrees to make fixed rate payment to the swap dealers at the rate of 9.75%. Swap dealer is receiving fixed and making floating rate payments. The company is making fixed rate payment, so it has swapped a floating payment for fixed one.

• Company B – also contacts a swap dealer. The deal here calls for Company B to borrow the money at a fixed rate of 9.5%. The swap dealer agrees to cover the fixed loan payments, and the company agrees to make floating rate payment to the swap dealer at a rate of prime plus 1.5%. In this second arrangement the swap dealer is making fixed rate payment and receiving floating rate payments.

Interest rate swap (cont)• Net Effect: Company A gets a fixed rate loan at 9.75%, which is cheaper than 10%

which it can get on its own.

• Company B gets a floating rate loan at prime plus 1% instead of prime plus 2%.

• The dealer also wins. Swap dealers book is perfectly balanced in terms of risk and does not have any exposure to interest rate fluctuations.

Currency Swaps • With currency swap, two entities agree to exchange a specific amount of one

currency for a specific amount of another currency at a specific date in the future.

• Example: Suppose a U.S. firm has a German subsidiary and wishes to obtain debt financing for an expansion of the subsidiary’s operations. Because most of the sub’s cash flows are in DM, the company would like the sub to borrow and make payments in DM and thereby hedging against changes in the DM - $ exchange rate.

• Unfortunately, the company has good access to US debt markets, but not to German debt markets.

• At the same time, a German firm would like to obtain US financing. It can borrow cheaply in DM, but not in $.

• Both firms can borrow at favorable rates but not in desired currency.

• Therefore, currency swap is one of the solutions.

Currency Swaps• A swap contract across currencies i.e. an American (U.S) company for

example that has borrowed Yen at fixed interest rate can “Swap way” the exchange rate risk by setting up a contract whereby it receives yen at a fixed rate in return for dollars at either a fixed- or a floating- interest rate. Such contracts are called currency swaps and can help manage both interest rate and exchange rate risk.

• Since currency swap is not a loan it does not often appear as liability on the parties’ balance sheet.

• Right to “off set” i.e. the right to offset any nonpayment of principal or interest with a comparable non-payment is more firmly established

Currency Hedging - Example• Your largest customer has ordered 10,000 cases of IPASTA. You place the order

with your supplier today, but you will not pay until the goods arrive in 60 days. Your selling price is Rs. 270 per case. Your cost is 8,400 Italian Lira per case. Current exchange rate is 33.333 Lira to Rupee.

• At the current exchange rate, your cost of filling the order is Rs. 252 (8,400/33.333) per case. Your Pre-tax profit = 10,000.00 x ((270-252) = Rupees 180,000

• However, the exchange rate in 60 days probably will be different, so your profit will depend upon what the future exchange rate turns out to be.

• If the rate goes to 35, your cost will be Rs. 240 per case and your profit will go up to Rs. 300,000

• If the exchange rate goes to 31.111, the profit vanishes to zero and so on. • Therefore, your short term exposure fluctuates with the exchange rate.• This exposure can be eliminated or reduced in several ways.

Hedging - Example• The most obvious is by entering into a forward exchange agreement to lock in an

exchange rate. Suppose, the 60 days forward rate is Rs. 32.916

• What will be your profit if you hedge?• What profit would you expect if do not hedge?

• If you hedge, you lock in an exchange rate 32.916. Your cost in Rupees will be 255.20 (8400/32.916) per case and your profit Rs.148,000.00.

• If you do not hedge, then, assuming that the forward rate is an unbiased predictor, you should expect that the exchange rate will actually be Lira 32.916 and you should expect to make 148,000 Rupees in profit.

Hedging - Example

• Alternatively, if the strategy is not feasible, you could simply borrow the rupees today, convert them into lira, invest the lira for 60 days, earn some interest.

• Based on IRP, this amounts to entering into a forward contract

Political Risk • Political risk refers to changes in value that arises as a consequence of political

actions or government intervention into the workings of the economy that affects the value of the firm.

• Political risk exists nationally and internationally. It includes such risks as Tax law change, currency controls, requirements for additional local production, expropriation are some of the areas of concern.

• Given the recognition of political risk, an International firm has at least four separate, though not necessarily mutually exclusive policies that it can follow;

• Avoidance• Insurance• Negotiating the environment• Structuring the investment

Political Risk (Cont.)

• Avoidance: The easiest way to manage political risk is to avoid it. Many companies do that by screening out investments in politically uncertain countries

• Insurance: An alternative to risk avoidance is insurance. By insuring assets in politically risky areas, the firms can concentrate on managing their business. Most developed countries sell political risk insurance to cover the foreign assets of domestic companies. (Overseas private Investment Corporation OPIC in the U.S)

• Negotiating the environment: Some firms try to reach an understanding with the host government before undertaking the investment, defining rights and responsibilities of both parties. Such understanding specifies precisely the rules under which the firm can operate locally.

Political risks (Cont.)• Structuring the investment: Once the firm has decided to invest in the country, it

can then try to minimize it exposure to political risk by increasing the host government’s cost of interfering with company operation. The actions involve the operating policies (production, logistics, technology transfer, etc.) and the financial policies.

• One such strategy involve keeping the local affiliates dependent on sister companies for markets and/or supplies.

Political Risk Analysis

• Consequences of Expropriation

• Example: UFC is informed that its banana plantation in Honduras will be expropriated during the next 12 months. The Honduran government has promised, however, that compensation of $100 million will be paid at the year’s end if the plantation is expropriated. UFC believes that this promise will be kept.If expropriation does not occur this year, it will not occur anytime in the foreseeable future. The plantation is expected to be worth $300 million at the end of the year.A wealth Honduran has just offered UFC $128 million for the plantation. UFC’S risk adjusted discount rate is 22%.

At what probability of expropriation UFC is just indifferent between selling now or holding onto its plantation?

Political Risk analysis

• Consequences of Expropriation• Expropriation No Expropriation Expected PV

• Sell out now 128 128 128

• Wait 100 300 [100p+300(1-p)]/1.22

• 128 = (300 – 200p)/1.22 or, p = 72%

Banking Joke

• Question: Why doesn’t money grow on trees?

Banking Jokes

• Because the banks control all of the branchaes.

Stupidity• An old Indian chief sat in his hut on the reservation, smoking a

ceremonial pipe and eyeing two US government officials sent to interview him. "Chief Two Eagles," asked one official, "You have observed the white man for 90 years. You've seen his wars and his material wealth. You've seen his progress, and the damage he's done."

• The chief nodded in agreement. The official continued, "Considering all these events, in your opinion, where did the white man go wrong?"

• The chief stared at the government officials for over a minute and then calmly replied, "When white man found the land, Indians were running it. No taxes, no debt, plenty buffalo, plenty beaver, women did all the work, medicine man free, Indian man spent all day hunting and fishing, all night sleeping."

• Then the chief leaned back and smiled, "Only white man dumb enough to think he could improve system like that.