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B40.2302 Class #9. BM6 chapters 25.2-25.6, 26, 27 25: Leasing 26: Risk management 27: International risk management Based on slides created by Matthew Will Modified 11/07/2001 by Jeffrey Wurgler. Principles of Corporate Finance Brealey and Myers Sixth Edition. Leasing. Slides by - PowerPoint PPT Presentation
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©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
14- 1
B40.2302 Class #9
BM6 chapters 25.2-25.6, 26, 27 25: Leasing 26: Risk management 27: International risk management
Based on slides created by Matthew Will Modified 11/07/2001 by Jeffrey Wurgler
Leasing
Principles of Corporate FinanceBrealey and Myers Sixth Edition
Slides by
Matthew Will, Jeffrey Wurgler
Chapter 25.2-25.6
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
14- 3
Topics Covered
Why Lease? Operating (Short-term) Leases Financial (Long-term) Leases
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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Why Lease?
Sensible (Non-tax) Reasons for Leasing
Short-term leases are convenient
Cancellation options are valuable
Maintenance may be provided
Standardization leads to low transaction costs• (Relative to bond or stock issue)
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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Why Lease?
Sensible (Tax) Reasons for Leasing
Tax shields can be used• Lessor owns asset, and so deducts its depreciation
• If lessor can make better use of tax shield than lessee, then lessor should own equipment and pass on some tax benefits to lessee (in form of lower lease payments)
• So direct tax gain to lessor, indirect gain to lessee
Reduces the alternative minimum tax (AMT)• Corporate tax = max{regular tax, AMT}
• Leasing (as opposed to buying) reduces lessee’s AMT
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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Why Lease?
Dubious Reasons for Leasing
Leasing avoids internal capital expenditure controls
Leasing preserves capital
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Why Lease?
Dubious Reasons for Leasing (contd.)
Leases may be off-balance-sheet financing• In Germany, all leases are off balance sheet• In US, only operating leases are off balance sheet
Leasing affects book income• Leasing reduces book income bec. lease payments are
expensed• Buy-and-borrow alternative reduces book income
through both interest and depreciation
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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Operating Leases
Review: Suppose you decide to lease a machine for one year
Q: What is the rental payment in a competitive leasing industry?
A: The lessor’s equivalent annual cost (EAC)
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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Operating LeasesExample: Calculate a competitive lease payment / EAC
Acme Limo has a client who will sign a lease for 7 years, with lease payments due at the start of each year. The following table shows the NPV of the limo if Acme purchases the new limo for $75,000 and leases it out for 7 years.
(amounts in 000s) Year0 1 2 3 4 5 6
Initial cost -75Maintenance, insurance, selling, -12 -12 -12 -12 -12 -12 -12
and administrative costsTax shield on costs 4.2 4.2 4.2 4.2 4.2 4.2 4.2Depreciation tax shield 0 5.25 8.4 5.04 3.02 3.02 1.51Total -82.8 -2.55 0.6 -2.76 -4.78 -4.78 -6.29
PV @ 7% = - $98.15
Break even rent(level) 26.18 26.18 26.18 26.18 26.18 26.18 26.18Tax -9.16 -9.16 -9.16 -9.16 -9.16 -9.16 -9.16Break even rent after-tax 17.02 17.02 17.02 17.02 17.02 17.02 17.02
PV @ 7% = $98.15
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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Operating Leases
Bottom line for lessee: Operating lease or buy?
Buy if the lessee’s equivalent annual cost of ownership and operation is less than the best available operating lease rate
Otherwise lease
Complication: If operating lease includes option to cancel/abandon, need to factor that in
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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Financial LeasesExample - cont
Greymare Bus Lines is considering a lease. Your operating manager wants to buy a new bus for $100,000. The bus has an 8 year life. An alternative is to lease the bus for 8 years at $16,900 per year, but Greymare still assumes all operating and maintenance costs.
Should Greymare buy or lease the bus?
Cash flow consequences of the financial lease contract:
•Greymare saves the $100,000 cost of the bus.
•Loss of depreciation benefit of owning the bus.
•$16,900 lease payment is due at the start of each year.
•Lease payments are tax deductible.
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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Financial Leases
(amounts in 000s) Year0 1 2 3 4 5 6 7
Cost of new bus 100.00 Lost Depr tax shield (7.00) (11.20) (6.72) (4.03) (4.03) (2.02) - Lease payment (16.90) (16.90) (16.90) (16.90) (16.90) (16.90) (16.90) (16.90) Tax shield of lease pmt. 5.92 5.92 5.92 5.92 5.92 5.92 5.92 5.92 Net cash flow of lease 89.02 (17.98) (22.18) (17.70) (15.01) (15.01) (13.00) (10.98)
Cash flow consequences of the financial lease contract
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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Financial Leases
How to discount CFs?
Since lessor is essentially lending money to lessee, appropriate rate is the equivalent lending/borrowing rate• Lender pays tax on interest it receives: net return is after-tax interest rate• Borrower deducts interest from taxable income: net cost is after-tax interest rate• Thus, after-tax interest rate is effective rate at which company can transfer debt-equivalent cash flows across time• Suppose Greymare can borrow at 10%. Then the lease payments should be discounted at (1-.35)*.10 =.065.
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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Financial LeasesExample – contd.
Greymare Bus Lines can borrow at 10%, thus the value of the lease should be discounted at 6.5% or .10 x (1-.35). The result will tell us if Greymare should lease or buy the bus.
Buy, don’t lease
$700-or 70.
1.065
10.98-
1.065
13.00-
1.065
15.02-
1.065
15.02-
1.065
17.71-
1.065
22.19-
1.065
17.99-89.02lease NPV
765
432
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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Financial LeasesExample – Equivalent loan cash flows
Another way to think about where the lease value comes from (or goes) is to imagine a loan that generates exactly the same year 1 - 7 cash outflows as the lease.
This costs same, but brings in 89.72 in year 0 (vs. 89.02 in the lease).
Thus, borrowing-and-buying is 89.72-89.02=0.70=$700 better than lease.
(amounts in 000s) Year0 1 2 3 4 5 6 7
Amount borrowed at year end 89.72 77.56 60.42 46.64 34.66 21.89 10.31 0.00Interest paid @ 10% -8.97 -7.76 -6.04 -4.66 -3.47 -2.19 -1.03Tax shield @ 35% 3.14 2.71 2.11 1.63 1.21 0.77 0.36Interest paid after tax -5.83 -5.04 -3.93 -3.03 -2.25 -1.42 -0.67Principal repaid -12.15 -17.14 -13.78 -11.99 -12.76 -11.58 -10.31Net cash flow of equivalent loan 89.72 -17.99 -22.19 -17.71 -15.02 -15.02 -13.00 -10.98
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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Financial Leases
Bottom line for lessee: Financial lease or buy-and-borrow?
Buy-and-borrow if can devise a borrowing plan that gives same cash flow as lease in every future period, but higher immediate cash flow (equivalently, buy-and-borrow if incremental lease cash flows are NPV<0)
Otherwise lease
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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Leases in APV framework
lease of NPV project of NPVAPV
• Can think of leases as financing that may have side effects.
• Thus, the APV of a project financed by a lease:
• This is consistent with all the previous examples.
Managing Risk
Principles of Corporate FinanceBrealey and Myers Sixth Edition
Slides by
Matthew Will, Jeffrey Wurgler
Chapter 26
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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Topics Covered
Insurance Futures contracts Forward contracts Swaps How to set up a hedge
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Insurance
Most businesses insure against fire, theft, environmental liability, vehicle accidents, etc.
Insurance transfers risk from company to insurer
Insurers pool risks The claims on any individual policy are very risky… … but the claims on a large portfolio of policies may be
quite predictable This gives insurers a risk-bearing advantage Of course, insurers cannot diversify away macro risks
• In same way that investors can’t diversify away systematic risk
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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Insurance
ExampleAn offshore oil platform is valued at $1 billion. Expert
meteorologist reports indicate that a 1 in 10,000 chance exists that the platform may be destroyed by a storm over the course of the next year. What is the “fair price” of insurance?
Answer:There is no systematic risk; it’s all due to the weatherTherefore no systematic risk premium required
The expected loss per year is = (1/10,000)*$1 billion = $100,000 = “fair price”
But for several reasons we’d expect a higher price …
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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Insurance
Why would an insurance company probably not offer a policy on this oil platform for $100,000/yr?
Administrative costs Adverse selection Moral hazard
If these costs are large, there may be cheaper ways to protect against risk
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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Insurance: British Petroleum
During the 1980s BP paid out $115m/year in insurance, recovered $25m/year in claims
BP has decided to cut down insurance BP felt it was better-placed to assess risk And insurance was not competitively priced
So now BP assumes more risk than when it insured BP guesses a big loss of $500m happens every 30 years Even so, this is <1% of BP market equity ! BP can afford not to insure against these risks
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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Hedging
Hedging Taking on one risk to offset another
Some basic tools for hedging Futures Forwards Swaps
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Futures
Futures contract - A contract between two parties for the delivery of an asset, at a negotiated price, on a set future date
Example: Wheat farmer expects to have 100,000 bushels of wheat next Sept. He’s worried that price may decline in the meantime To hedge this risk, he can sell 100,000 bushels of Sept. wheat futures
at a price that is set today Bottom line -- perfect hedge
• If price rises, value of his wheat goes up but futures contract value falls
• If price falls, value of his wheat falls but futures contract value rises
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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Futures
Futures are standardized contracts,
traded on organized futures exchanges
Commodity Futures
-Sugar -Corn -OJ -Lumber
-Wheat -Soybeans -Pork bellies
-Oil -Copper -Silver -...
Financial Futures
-Tbills -Japanese govt. bonds
-S&P 500 -DJIA index -...
SUGAR
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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Futures
When you buy a financial future, you end up with the same security that you would have if you bought in the “spot market” (i.e. on-the-spot today)
Except: You don’t pay up front, so you earn interest on purchase price You miss out on any dividend or interest in interim
Therefore for a financial future:
Futures price/(1+rf)t
= Spot price – PV(foregone interest or dividends)
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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FuturesFutures price/(1+rf)t
= Spot price – PV(foregone interest or dividends)
Example: Stock index futures
Q: Suppose 6-month stock index futures trade at 1,235 when index is at 1,212. 6-month interest rate is 5% and average dividend yield of stocks in index is 1.2%/year. Are these #s consistent?
A: Yes:
Futures price/(1+rf)t = 1,235/(1.05)1/2 = 1,205
Spot price – PV(foregone interest or dividends)
= 1,212 – 1,212*(1/2)*(.012)/(1.05)1/2 = 1,205
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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Futures When you buy a commodities future, you end up with the same
commodity that you would have if you bought in the “spot market”
Except: You don’t pay up front, so you earn interest on purchase price You don’t have to store the commodity in the interim; saves on storage
costs You don’t get a “convenience yield” – the value of having the real thing
So for a commodities future:
Futures price/(1+rf)t
= Spot price + PV(storage costs) – PV(convenience yield)
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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Forwards
Futures contracts are standardized, exchange traded
Forward contracts are tailor-made futures contracts, not exchange traded
Main forward market is in foreign currency Also forward interest-rate contracts
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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ForwardsExample: Lock in a rate today on a loan tomorrow (“a homemade forward loan”)
Suppose you borrow $90.91 for one year at 10%, and you lend $90.91 for two years at 12%
These are interest rates today, i.e. spot interest rates
Net cash flow Year 0: 90.91 – 90.91 = 0 Year 1: -90.91*1.10 = -100 Year 2: 90.91*1.12*1.12 = 114.04
So paid out 100 at year 1, take in 114.04 at year 2, essentially you made a “forward loan” at locked-in interest rate of
Fwd. rate = (1+r2)2/(1+ r1) – 1 = (1.12)2/(1.1) – 1 = .1404
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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Swaps
Swap contract - An agreement between two parties (“counterparties”) lend to each other on different terms, e.g. in different currencies, or one at fixed rate and the other at a floating rate
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Swaps
Example: Currency swap
USA Inc. wants to borrow euros to finance European operations, but it gets better rates in US
So it issues US debt (say $10M of 8%, 5-year notes) And contracts with a bank to swap its future dollar
liability for euros Combined effect: convert an 8% dollar loan into a 5.9%
euro loan (see next page)
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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Swaps
Year 0 Years 1-4 Year 5
Dollars Euros Dollars Euros Dollars Euros
Dollar loan +10 -.8 -10.8
Swap dollars for euros
-10 +8.5 +.8 -.5 +10.8 -9.0
Net cash flow 0 +8.5 0 -.5 0 -9.0
Net cash flow to USA Inc. after the currency swap
Bottom line: currency swap turned dollar debt into euro debt
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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Swaps
Example: Fixed-to-floating interest rate swap
Bancorp has made a 5-year, $50m loan at a fixed rate of 8%; annual interest payments are $4m
Bank wants to swap the $4m, 5-year annuity (the fixed interest payments) into a floating rate annuity
Bank has ability to borrow at 6% for 5 years. So $4m interest annuity could support a fixed-rate loan of 4/.06 = $66.67m.
Bank can construct “homemade swap” by borrowing $66.67m at 6% for 5 years, then simultaneously lend this amount at LIBOR (a floating rate)
Bottom line: bank’s fixed rate interest stream has been converted into a floating-rate stream
(Easier way to do all this: Bank could just call a swap dealer)
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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Setting up a hedge
In our futures examples, firm has hedged by buying one asset and selling an equal amount of another
In practice, the appropriate “hedge ratio” may not be 1.0 The asset to be hedged may not move 1-to-1 with the available hedge
contract
Suppose you own A and you want to hedge by making an offsetting sale of B. If percentage changes in value of A and B are related as follows:
Expected change in A = a + *(change in B)
Then delta is the hedge ratio – the # of units of B that should be sold to hedge each unit of A
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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Setting up a hedge
You can calculate deltas by brute force, or you can use finance theory to set up a hedge
Example: Suppose a leasing company has a lease contract to receive a fixed $1m for 5 years.
If interest rates go up (down), the value of the lease payments go down (up)
The company can hedge this interest rate risk by financing the leased asset with a package of debt that has exactly the same duration as the lease payments
So if interest rates change, the lease payments’ value changes, but the debt obligations change by an equal amount
We say the company is immunized against interest rate risk
Managing International Risk
Principles of Corporate FinanceBrealey and Myers Sixth Edition
Slides by
Matthew Will, Jeffrey Wurgler
Chapter 27
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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Topics Covered
Foreign Exchange Markets Some Basic Relationships Hedging Currency Risk International Capital Budgeting
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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Foreign Exchange Markets
Exchange Rate - Amount of one currency needed to purchase one unit of another.
Spot Exchange Rate – Price of currency for immediate delivery.
Forward Exchange Rate – Price for future delivery.
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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Foreign Exchange Markets
Example - The yen spot price is 112.645 yen per dollar and the 3 month forward rate is 111.300 yen per dollar. What is the forward premium, expressed as an annual rate?
So yen trades at a “4.8% forward premium relative to dollar”
(could also say dollar sells at a 4.8% forward discount)
4.8%=100x 111.300
111.300-112.6454
)(-Discountor Premium= PriceForward
PriceForward-Spot Price
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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Exchange Rate Relationships How are these various quantities related?
(i = inflation, f=forward rate, s=spot rate, r=interest rate)
$
foreign
r+1
r+1
)i+E(1
)i+E(1
$
foreign
foreign/$
foreign/$
s
f
foreign/$
foreign/$)E
s
(s
?
?
? ?
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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Exchange Rate Relationships In simplest world (people are risk-neutral and face no
transaction costs for international trade), they are all equal (!)
$
foreign
r+1
r+1
)i+E(1
)i+E(1
$
foreign
foreign/$
foreign/$
s
f
foreign/$
foreign/$)E
s
(s
=
=
= =
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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Exchange Rate Relationships
Leg #1) “Interest Rate Parity Theory” links interest rates and exchange rates
It says that the ratio between the interest rates in two different countries is equal to the ratio of the forward and spot exchange rates.
1 + r
1 + r=
foreign
$ foreign/$
foreign/$
s
f
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Exchange Rate Relationships
Interest Rate Parity Example - You have $1,000,000 to invest for one year. You can buy a 1- year Japanese bond (in yen) @ 0.25 % or a 1-year US bond (in dollars) @ 5%.
The spot exchange rate is 112.645 yen:$1.
The 1-year forward exchange rate is 107.495 yen:$1
Which bond will you prefer?
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Next year’s payoff to dollar bond = $1,000,000 x 1.05 = $1,050,000
Next year’s payoff to Yen bond = $1,000,000 x 112.645 x 1.0025
= 112,927,000 yen
= 112,927,000/107.495 = $1,050,000
In other words, you are indifferent only if the interest rate differential (1.0025)/(1.05) equals the difference between the forward and spot exchange rates (107.495/112.645), as it does here. (If this “interest rate parity” doesn’t hold, you’d have an arbitrage opportunity. Hence, it must hold.)
Exchange Rate Relationships
Interest Rate Parity Example - You have $1,000,000 to invest for one year. You can buy a 1- year Japanese bond (in yen) @ 0.25 % or a 1-year US bond (in dollars) @ 5%. The spot exchange rate is 112.645 yen:$1. The 1-year forward exchange rate is 107.495 yen:$1. Which bond to prefer?
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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Exchange Rate Relationships
Leg #2) “Expectations Theory of Forward Rates” links forward rates to expected spot rates
It says that in risk-neutral world, the expected future spot exchange rate equals the forward rate
foreign/$
foreign/$
s
f
foreign/$
foreign/$)E
s
(s
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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Exchange Rate Relationships
Expectations theory logic
Suppose one-year forward rate on yen is 107.495
But that traders expect the future spot rate to be 120.
Then no trader would be willing to buy yen forward, since would get more yen by waiting and buying spot.
Thus the forward rate will have to rise until the two rates are equal
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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Exchange Rate Relationships
Leg #3) “Purchasing Power Parity (PPP)” implies that
And so the expected difference in inflation rates equals the expected change in spot rates
foreign/$
foreign/$)E
s
(s
)i+E(1
)i+E(1
$
foreign
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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Exchange Rate Relationships
PPP intuitionIf $1 buys a McDonald’s hamburger in the USA, it also buys (after currency conversion) a hamburger in Japan
So spot exchange rates should be set such that $1 has the same “purchasing power” around the world – else, there would be import/export arbitrage – buy goods where $1 buys a lot, sell them where $1 doesn’t buy much.
And if this relationship is to hold tomorrow as well, then the expected change in the spot rate must reflect relative inflation.
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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Exchange Rate Relationships
Leg #4) “International Fisher Effect” relates relative interest rates to inflation
rates
Says that expected inflation accounts for differences in current interest rates, i.e. real interest rates are the same across countries
1 + r
1 + r=
foreign
$ )i+E(1
)i+E(1
$
foreign
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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Exchange Rate Relationships
Example: International Fisher effect Claims that the real interest rate in each country is about equal. Suppose Japan
and US, interest rates as before, expected deflation in Japan is 2.5%, inflation in US is 2%. Then real interest rates are about equal, Intl. Fisher effect holds.
.028 =.975
1.0025=
)i+E(1
r+1)(
foreign
foreignforeign realr
.029 =1.02
1.05=
)i+E(1
r+1)(
$
$$ realr
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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Hedging Currency Risk
Outland Steel: Current situation
Has profitable export business
Contracts involve substantial payment delays
Company invoices in $, so it is naturally protected against exchange rates
But wonders if it’s losing sales to firms that are willing to accept foreign currencies…
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Hedging Currency Risk
Outland Steel: Proposal #1
Accept foreign currency payments…• But if value of that currency declines before payment is made,
company may suffer a big loss in dollar terms
… and hedge by selling the currency forward• If contract is to receive X yen next year, then sell X yen forward
today. Lock in dollar rate today.
Cost of this “insurance” is the difference between the forward rate and the expected spot rate next year
• Cost =0 if these are equal, as in expectations theory (“leg #2”)
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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Hedging Currency Risk
Outland Steel: Proposal #2
Accept foreign currency payments…
… and hedge by borrowing foreign currency against foreign receivables, sell the currency spot, invest dollar proceeds in the US
• Interest rate parity theory (“leg #1”) says that the difference between selling forward and selling spot equals the difference between foreign interest that you pay, and dollar interest you receive
This should be equally effective as proposal #1
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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International Capital Budgeting
Equivalent Intl. Capital Budgeting Techniques
1) (Easy) Discount foreign CFs at foreign cost of capital. (Can then convert this present value to $ using spot exchange rate.)
2) (Hard) Convert to $ assuming all currency risk was hedged (use forward exchange rates), and then discount with $ cost of capital.
These techniques are equivalent (verify BM6 p. 806-807)
Thus, hedging allows you to separate the investment decision from decision to take on currency risk