Documenti di Didattica
Documenti di Professioni
Documenti di Cultura
Topics Covered
Foreign Exchange Markets Some Basic Exchange Rate Relationships Hedging Currency Risk Purchasing Power and Exchange Rates Exchange Rate Risk and International Investment Decisions Political Risk-Definition, Characteristics, Assessment Techniques, incorporation and ways to mitigate
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Exchange Rates
Example Swiss franc spot price is SF 1.4457 per $1 Swiss franc 6 mth forward price is SF1.4282 per $1 The franc is selling at a Forward Premium The Dollar is selling at a Forward Discount
This means that the market expects the dollar to get weaker, relative to the franc
Example (premium? discount?) The Japanese Yen spot price is 101.18 per $1 The Japanese 6mt fwd price is 103.52 per $1
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Exchange Rates
Example What is the franc premium (annualized)?
franc Premium = 2 x ( 1.4457 - 1.4282) = 2.45% 1.4282 Dollar Discount = 2.45%
Example What is the Yen discount (annualized)? Yen Discount = 2 x ( 103.52 - 101.18) = 4.26% 103.52 Dollar Premium = 4.26%
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1 + rforeign 1 + r$
equals equals
1 + i foreign 1 + i$
equals
f foreign / $ S foreign / $
equals
E(sforeign / $) S foreign / $
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1 + rforeign 1 + r$
f foreign / $ S foreign / $
The ratio between the risk free interest rates in two different countries is equal to the ratio between the forward and spot exchange rates.
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Value of Mexican bond = $1,000,000 x 10.9892 = 10,989,200 peso exchange 10,989,200 peso x 1.0735 = 11,796,906 peso 11,796,906 peso / 11.2274= $1,050,725 bond pmt exchange
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f foreign / $ S foreign / $
E(sforeign / $) S foreign / $
Theory that the expected spot exchange rate equals the forward rate.
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1 + i foreign 1 + i$
E(sforeign / $) S foreign / $
The expected change in the spot rate equals the expected difference in inflation between the two countries.
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1 + i foreign 1 + i$
E(sforeign/$) Sforeign/$
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1 + rforeign 1 + r$
1 + i foreign 1 + i$
The expected difference in inflation rates equals the difference in current interest rates.
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r (real )
1 + rforeign 1 + i foreign
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Exchange Rates
Another Example You are doing a project in Switzerland which has an initial cost of $100,000. All other things being equal, you have the opportunity to obtain a 1 year Swiss loan (in francs) @ 8.0% or a 1 year US loan (in dollars) @ 10%. The spot rate is 1.4457sf:$1 The 1 year forward rate is 1.4194sf:$1 Which loan will you prefer and why? Ignore transaction costs
exchange
loan pmt
exchange
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Exchange Rates
Swiss Example Given a spot rate of sf:$ Given a 1yr fwd rate of 1.4457:$1 1.4194:$1
If inflation in the US is forecasted at 4.5% this year, what do we know about the forecasted inflation rate in Switzerland?
E (Sf/$) = E ( 1 + if ) Sf/$ E ( 1 + i$ )
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Exchange Rates
Swiss Example In the previous examples, show the equilibrium of interest rates and inflation rates 1 + rf = 1.08 = .9818 1 + r$ 1.10 E ( 1 + if ) = 1.026 = .9818 E ( 1 + i$ ) 1.045
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International Prices
The Big Mac Index The price of a Big Mac in different countries (Feb 1, 2007)
Local Price Converted to U.S. Dollars 3.08 1.41 4.84 3.82 2.31 2.66
Country Philippines Russia South Africa Switzerland United Kingdom United States
Local Price Converted to U.S. Dollars 1.74 1.85 2.14 5.05 3.9 3.22
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Capital Budgeting
Techniques 1) Exchange to $ and analyze 2) Discount using foreign cash flows and interest rates, then exchange to $. 3) Choose a currency standard ($) and hedge all non dollar CF.
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Example
Outland Corporation is building a plant in Holland to produce reindeer repellant to sell in that country. The plant is expected to produce a cash flow (in guilders ,000s) as follows. The US risk free rate is 8%, the Dutch rate is 9%. US inflation is forecasted at 5% per year and the current spot rate is 2.0g:$1. year 1 400 2 450 3 510 4 575 5 650
Q: What are the 1, 2, 3, 4, 5 year forward rates? A: E (Sf/$) = E ( 1 + if )t solve for E(S)
Sf/$
E(S) 2.02
E ( 1 + i$ )t
2.04 2.06 2.08 2.10
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Example
Outland Corporation is building a plant in Holland to produce reindeer repellant to sell in that country. The plant is expected to produce a cash flow (in guilders ,000s) as follows. The US risk free rate is 8%, the Dutch rate is 9%. US inflation is forecasted at 5% per year and the current spot rate is 2.0g:$1. year 1 400 2 450 3 510 4 575 5 650
CFg
400
450
2.04 221
510
2.06 248
575
2.08 276
650
2.10 310
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Example
Outland Corporation is building a plant in Holland to produce reindeer repellant to sell in that country. The plant is expected to produce a cash flow (in guilders ,000s) as follows. The US risk free rate is 8%, the Dutch rate is 9%. US inflation is forecasted at 5% per year and the current spot rate is 2.0g:$1. year 1 400 2 450 3 510 4 575 5 650
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Example
Outland Corporation is building a plant in Holland to produce reindeer repellant to sell in that country. The plant is expected to produce a cash flow (in guilders ,000s) as follows. The US risk free rate is 8%, the Dutch rate is 9%. US inflation is forecasted at 5% per year and the current spot rate is 2.0g:$1. year 1 400 2 450 3 510 4 575 5 650
What is the PV of the project in guilders at a risk premium of 7.4%? Convert to dollars. $ discount rate = 1.09 x 1.074 = 1.171 PV = 1,588,000 guilders exchanged at 2.0:$1 = $794,000
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Political Risks
Political Risk Characteristics Attitude of consumers in the host country - a tendency of residents to purchase only locally produced goods. Actions of the host government - A host government might impose pollution control standards and additional corporate taxes, as well as withholding taxes and fund transfer restrictions. Blockage of fund transfers - A host government may block fund transfers, which could force subsidiaries to undertake projects that are not optimal (just to make use of the funds). Currency inconvertibility - Some governments do not allow the home currency to be exchanged into other currencies
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Political Risks
War Conflicts with neighboring countries or internal turmoil can affect the safety of employees hired by an MNCs subsidiary or by salespeople who attempt to establish export markets for the MNC Inefficient bureaucracy - Bureaucracy can delay an MNCs efforts to establish a new subsidiary or expand business in a country. Corruption Corruption can occur at the firm level or with firmgovernment interactions. Transparency International has derived a corruption index for most countries (see www.transparency.org).
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Political Risks
Macro-assessment of country risk represents an overall risk assessment of a country and considers all variables that affect country risk except those that are firm-specific. Micro-assessment of country risk involves assessment of a country as it relates to the MNCs type of business.
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Political Risk
Political Risk Scores Maximum Score Luxembourg Netherlands Singapore UK Japan Germany United States Italy China Brazil Russia India Indonesia Somalia A 12 11 9 11 9 11 9 11 9 11 9 12 9 9 5 B 12 11 11 9 10 8 8 8 9 7 6 7 4 4 1 C 12 12 12 12 12 12 12 12 12 8 8 9 9 6 3 D 12 12 11 11 10 12 11 11 11 12 11 9 8 8 5 E 12 12 12 12 9 10 10 8 11 11 11 10 9 11 4 F 6 5 5 5 5 4 5 4 3 2 4 2 2 1 1 G 6 6 6 6 6 6 6 5 4 5 6 6 1 1 3 H 6 6 6 5 6 5 5 5 3 5 2 4 4 2 2 I 6 6 6 5 6 5 5 5 3 5 2 4 4 2 2 J 6 5 5 6 4 6 4 5 5 5 3 2 2 2 2 K 6 5 6 2 6 5 5 6 4 1 5 4 6 4 1 L 4 4 4 4 4 4 4 4 3 2 2 1 3 2 0 Total 100 95 91 87 86 86 83 81 78 71 69 68 59 52 27
A = Govt stability B = Socioeonmic conditions C = Investment profile D = Internal conflict E = External conflict F = Corruption
G = Military in politics H = Religious tensions I = Law and order J = Ethnic tensions K = Democratic accountability L = Bureaucracy quality
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Incorporating Political risks in Project Evaluation Adjustment of the discount rate: lower risk rating implies higher risk and higher discount rate. Adjustment of the estimated cash flows: adjust estimates for the probability that cash flows may not be realized. Assessing Risk of Existing Projects: review country risk periodically after project has been implemented.
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