Chapter 22 - International Business Finance

Today’s agenda and learning goals

Using exchange rates.What is exchange rate risk?Managing exchange rate risk?Jerry Springer Minutes: What have we learned?

Top 10 List revisited3 key course things to remember.

Got to get some beer!Moe opens a new bar in Springfield called Moe’s International Drinking Emporium and needs to convert dollars into other currencies buy some imported brews.He is considering buying 500 cases of Cuatro Equis beer from Mexico for 300,000 pesos and 500 cases of King Homer’s Mead from England for 3,000 pounds.How many dollars would Moe need to convert to complete each of these transactions?

Exchange RatesDirect Quote: number of units of home currency needed to acquire a unit of a foreign currency.Indirect Quote: number of units of a foreign currency needed to acquire a unit of the home currency.Direct and Indirect quotes are reciprocals of each other.$/peso rate = 0.1080; peso/$ rate = 9.259S/pound rate = 1.4506; pound/$ rate = 0.689

Back to MoeCost of Cuatro Equis = $0.108/peso x 30,000 pesos = $3,240Cost of King Homer’s Mead = $1.4506/pound x 3,000 pounds = $4,351.80Question: How many pesos would it take to buy King Homer’s Mead?$4,351.80 x 9.259 pesos/$ = 40,293 pesosThe peso/pound exchange rate is 40,293pesos/3,000pounds or $1.4506/pound x 9.259 pesos/$ = 13.4311 – This is called a cross rate.

Exchange Rate Risk

Imagine Moe is considering entering into a contract to purchase 1,000 cases of Alp Yodel Ale in 3 months for 40,000 Swiss Francs.What will be Moe’s dollar cost?Don’t know for sure. This is an example of transaction risk.Let’s investigate.

Moe’s exchange rate riskCurrently $0.607/franc (known as spot price), which makes today’s cost $0.607/franc x 40,000 francs = $24,280.However, in 3 months the exchange rate could be $0.65/franc, making Moe’s cost $26,000. Ouch!If Moe wants to know his future $ cost with certainty, how could he hedge this risk?Franc futures, options? Too small of an amount here.Solution: a 3-month forward contract with Bank of Springfield.

Moe’s Forward HedgeWith this forward contract, the bank agrees to sell Moe Swiss Francs in 3 months at an exchange rate agreed to today.Today’s 3-month forward rate is $0.6075/franc.This makes Moe’s cost of Alp Yodel Ale = $0.6075/franc x 40,000 francs = $24,300.Thanks to the forward contract Moe’s future cost is fixed (locked in).

Forward to spot premium

Annualized Premium(Discount) = (F – S)/S x 12/n x 100%

Where F = forward rateS = spot rate (today’s exchange rate)n = # of months

From our 3-month forward example:(.6075 - .0607)/.0607 x 12/3 x 100% = 0.33% Swiss Franc forward premium.

TOP10

LIST(revisited)

Top 10 questions we will answer in Finance 254 this semester.

10. What is the goal of the firm?9. Why there is no such thing as a free

lunch?8. How do you figure out loan payments?7. Why do bond and stock prices tend to

fall when inflation or interest rates go up?

6. Why Microsoft deserves its legal troubles.

Top 10 questions we will answer in Finance 254 this semester.

5. Why is Homer Simpson so dumb?4. How do you calculate a P/E ratio? (Anna

Kournikova: guest lecturer)3. Why do they call them coupon payments?2. How does a rookie futures trader turn a

$1000 into $100,000 by playing the cattle futures market? (Guest lecturer: Hillary Clinton)

1. How to make a million dollars and not pay taxes.

The 3 key things to remember from Fin 254!

The goal of the firm is to maximize the owners’ (shareholders) wealth.Asset prices and interest rates move in opposite directions.Choose investments that have positive NPV!