Chapter 15. International Business Finance n Exchange Rate: the price of one currency in terms of another

Chapter 15

International Business Finance

International Business FinanceInternational Business Finance

Exchange Rate:Exchange Rate: the price of one the price of one currency in terms of another.currency in terms of another.

Exchange RatesExchange Rates

Exchange rates affect our economy and Exchange rates affect our economy and each of us because:each of us because:

1) When the 1) When the dollar appreciatesdollar appreciates (strong dollar), the dollar becomes (strong dollar), the dollar becomes more valuable relative to other more valuable relative to other currencies.currencies.



1) When the 1) When the dollar appreciatesdollar appreciates (strong dollar), the dollar becomes (strong dollar), the dollar becomes more valuable relative to other more valuable relative to other currencies.currencies. Foreign products become cheaper to us. Foreign products become cheaper to us.



1) When the 1) When the dollar appreciatesdollar appreciates (strong (strong dollar), the dollar becomes more valuable dollar), the dollar becomes more valuable relative to other currencies.relative to other currencies. Foreign products become cheaper to us. Foreign products become cheaper to us. U.S. products become more expensive U.S. products become more expensive

overseas.overseas.


Exchange rates affect our economy Exchange rates affect our economy and each of us because:and each of us because:



2) When the 2) When the dollar depreciatesdollar depreciates (weak dollar), the dollar falls in (weak dollar), the dollar falls in value relative to other currencies.value relative to other currencies.



2) When the 2) When the dollar depreciatesdollar depreciates (weak dollar), the dollar falls in (weak dollar), the dollar falls in value relative to other currencies.value relative to other currencies. Foreign products become more Foreign products become more

expensive for us, andexpensive for us, and



2) When the 2) When the dollar depreciatesdollar depreciates (weak (weak dollar), the dollar falls in value relative dollar), the dollar falls in value relative to other currencies.to other currencies. Foreign products become more expensive Foreign products become more expensive

for us, andfor us, and U.S. products become cheaper overseas.U.S. products become cheaper overseas.

Spot Exchange RatesSpot Exchange Rates

£ / $ = £ / $ = .6284.6284 (it takes .6284 pounds to = $1) (it takes .6284 pounds to = $1)

$ / £ = $ / £ = 1.59131.5913 (it takes $1.5913 to = 1 (it takes $1.5913 to = 1

pound)pound)

¥ / $ = ¥ / $ = 102.98102.98 (it takes 102.98 yen to = $1) (it takes 102.98 yen to = $1)

$ / ¥ = $ / ¥ = .009711.009711 ( it takes $.009711 to = 1 ( it takes $.009711 to = 1 yen)yen)

Real Time Exchange RatesReal Time Exchange Rates(note: direct and indirect quotes are reciprocals)(note: direct and indirect quotes are reciprocals)

What Determines Exchange Rates?What Determines Exchange Rates?

Floating Rate Currency System:Floating Rate Currency System: Since Since 1973, the world has allowed exchange 1973, the world has allowed exchange rates to change daily in response to rates to change daily in response to market forces.market forces.

Exchange rates are affected by:Exchange rates are affected by: foreign investors,foreign investors, speculators,speculators, political conditions here and overseas,political conditions here and overseas, inflation,inflation, trade policies (tariffs and quotas), andtrade policies (tariffs and quotas), and


Supply and Demand for currencies!Supply and Demand for currencies!

Let’s consider the Let’s consider the £ / $£ / $ market. market.








Suppose the British increase demand for Suppose the British increase demand for U.S. products.U.S. products.

British importers buy the U.S. products to British importers buy the U.S. products to sell in England. They sell in England. They buy dollars with buy dollars with poundspounds, so they can pay U.S. firms in , so they can pay U.S. firms in dollars.dollars.

The The demand for dollars increasesdemand for dollars increases, and , and forces forces up the £ / $ exchange rateup the £ / $ exchange rate, which makes , which makes U.S. products more expensive in England.U.S. products more expensive in England.


£ / $£ / $(price of(price ofdollars)dollars)

Supply ofSupply ofDollarsDollars

Demand for DollarsDemand for Dollars

Quantity of dollarsQuantity of dollars


£ / $£ / $(price of(price ofdollars)dollars)





Another example:Another example:

Let’s consider the Let’s consider the ¥ / $¥ / $ market. market.








Suppose American demand for Japanese Suppose American demand for Japanese cars and stereos increases rapidly.cars and stereos increases rapidly.

American importers buy the Japanese American importers buy the Japanese products to sell in the U.S. They products to sell in the U.S. They buy yen buy yen with dollarswith dollars, so they can pay Japanese , so they can pay Japanese firms in yen.firms in yen.

The The supply of dollars increasessupply of dollars increases, and , and forces forces down the ¥ / $ exchange ratedown the ¥ / $ exchange rate, which makes , which makes Japanese products more expensive in the Japanese products more expensive in the U.S.U.S.

What Determines Exchange Rates?

¥ / $¥ / $(price of(price ofdollars)dollars)




What Determines Exchange Rates?

¥ / $¥ / $(price of(price ofdollars)dollars)




Foreign Exchange MarketsForeign Exchange Markets

Different exchange rates are used for Different exchange rates are used for different types of transactions:different types of transactions:

1) 1) Spot Exchange MarketSpot Exchange Market:: deals with deals with currency for immediate delivery. currency for immediate delivery.

The exchange rate used in spot The exchange rate used in spot transactions is called the transactions is called the spot exchange spot exchange rate.rate.

If you need If you need 500,000 Norwegian Krones500,000 Norwegian Krones to to buy imports, and the spot exchange rate buy imports, and the spot exchange rate is is .1457.1457, you would pay your bank , you would pay your bank $72,850$72,850..

Foreign Exchange MarketsForeign Exchange Markets

2) 2) Forward Exchange MarketForward Exchange Market:: deals with deals with the future delivery of foreign currency. the future delivery of foreign currency.

You can buy or sell currency for future You can buy or sell currency for future delivery, usually in 1, 3, or 6 months.delivery, usually in 1, 3, or 6 months.

The exchange rate for forward The exchange rate for forward transactions is called the transactions is called the forward forward exchange rate.exchange rate.

Forward exchange contracts allow you to Forward exchange contracts allow you to hedge foreign exchange risk!hedge foreign exchange risk!

Forward Market HedgeForward Market Hedge

Example: You will import fish from Example: You will import fish from Norway, to be delivered and paid in 6 Norway, to be delivered and paid in 6 months.months.

You have agreed to a price of You have agreed to a price of 500,000500,000 krones. With the spot exchange rate krones. With the spot exchange rate of of .1457.1457, this comes to , this comes to $72,850$72,850..

Suppose the dollar weakens over the next 6 Suppose the dollar weakens over the next 6 months, and the months, and the $/NOK exchange rate rises $/NOK exchange rate rises to .20.to .20.

The fish would cost you The fish would cost you $100,000$100,000. This is . This is an example of an example of foreign exchange riskforeign exchange risk!!

Forward Market HedgeForward Market Hedge

You decide to hedge your risk with a You decide to hedge your risk with a forward exchange contract! forward exchange contract!

The The 6-months $/NOK forward exchange 6-months $/NOK forward exchange raterate is is .1476.1476. By agreeing to this forward . By agreeing to this forward rate with your bank, you lock in a price of rate with your bank, you lock in a price of $73,800$73,800 for 500,000 krones, 6 months for 500,000 krones, 6 months from now.from now.

Now it doesn’t matter what happens to Now it doesn’t matter what happens to the $/NOK exchange rate over the next 6 the $/NOK exchange rate over the next 6 months.months.

Money Market HedgeMoney Market Hedge

For the previous problem, another potential For the previous problem, another potential solution is the money market hedge.solution is the money market hedge.

1) Borrow 1) Borrow $72,850$72,850 from your bank. from your bank.

2) Buy the 2) Buy the 500,000 kroners500,000 kroners now (at the now (at the current spot exchange rate of current spot exchange rate of .1457.1457) for ) for $72,850$72,850..

3) Invest the 3) Invest the 500,000 kroners500,000 kroners in interest- in interest-bearing Norwegian securities.bearing Norwegian securities.

4)Complete your transaction after 6 months.4)Complete your transaction after 6 months.[Borrowing and investment rates determine cost of hedge][Borrowing and investment rates determine cost of hedge]

Forward-Spot DifferentialForward-Spot Differential

If the If the forward rate > the spot rateforward rate > the spot rate, the , the forward is trading at a forward is trading at a premiumpremium..

If the If the forward rate < the spot rateforward rate < the spot rate, the , the forward is trading at a forward is trading at a discountdiscount. .


If the If the forward rate > the spot rateforward rate > the spot rate, the , the forward is trading at a forward is trading at a premiumpremium..

If the If the forward rate < the spot rateforward rate < the spot rate, the , the forward is trading at a forward is trading at a discountdiscount. .

premium premium forward - spot 12 forward - spot 12

or discountor discount spot n spot n = [ ] [ ] x 100


For our example, For our example,


= [ ] [ ] x 100



or discountor discount spot n spot n


= [ ] [ ] x 100

= [ ] [ ] x 100




.1476 - .1457 12.1476 - .1457 12

.1457 6.1457 6


= [ ] [ ] x 100

= [ ] [ ] x 100




.1476 - .1457 12.1476 - .1457 12

.1457 6.1457 6

= 2.6. = 2.6. The forward is trading at a 2.6% The forward is trading at a 2.6% premium.premium.

Exchange Rate RiskExchange Rate Risk

Translation exposureTranslation exposure - - foreign currency foreign currency assets and liabilities that, for accounting assets and liabilities that, for accounting purposes, are translated into domestic purposes, are translated into domestic currency using the exchange rate, are currency using the exchange rate, are exposed to exchange rate risk.exposed to exchange rate risk.

However, if markets are efficient, However, if markets are efficient, investors know that any translation losses investors know that any translation losses are “paper” losses and are unrealized.are “paper” losses and are unrealized.

Exchange Rate RiskExchange Rate Risk

Transaction exposureTransaction exposure - - refers to refers to transactions in which the monetary transactions in which the monetary value is fixed before the transaction value is fixed before the transaction actually takes place. actually takes place.

Ex: your firm buys foreign goods to be Ex: your firm buys foreign goods to be received and paid for at a later date. received and paid for at a later date. The exchange rate can change, which The exchange rate can change, which can affect the price actually paid.can affect the price actually paid.

Direct Foreign InvestmentDirect Foreign Investment

RisksRisks Business Risk - Business Risk - firms must be firms must be

aware of the business climate in aware of the business climate in both the US and the foreign both the US and the foreign country.country.

Financial Risk - Financial Risk - not much not much difference between financial risks difference between financial risks of foreign operations and those of of foreign operations and those of domestic operations.domestic operations.

Direct Foreign InvestmentDirect Foreign Investment

RisksRisks Political Risk - Political Risk - firms must be aware firms must be aware

that many foreign governments are that many foreign governments are not as stable as the U.S.not as stable as the U.S.

Exchange Rate Risk - Exchange Rate Risk - exchange rate exchange rate changes can affect sales, costs of changes can affect sales, costs of goods sold, etc. as well as the firm’s goods sold, etc. as well as the firm’s profit in dollars.profit in dollars.

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Chapter 15. International Business Finance n Exchange Rate: the price of one currency in terms of another