2-6-2014

1
INTERNATIONAL FINANCE
Lecture 10 BAB 24 (2013)
Introduction
The goal of this lecture is to introduce some of the key models of
international finance which include:
urchasing !ower !arity"
Interest rate !arity"
International Fischer effect#
$e will end the class with a %rief discussion a%out the e&am#
2
2-6-2014
2
art '
urchasing !ower !arity:
rices and E&change rates
3
urchasing !ower !arity ()
In " e&change rates are linked to !rices of goods and ser*ices in
*arious countries#
There are two *ersions of " each discussed in more detail in the ne&t
few slides:
A%solute +
Relati*e #
4
2-6-2014
3
A%solute
If the ,Law of one !rice- were true for all goods and ser*ices" the
!urchasing !ower !arity () e&change rate could %e found from any
indi*idual set of !rices#
.ence" %y com!aring the !rices of identical !roducts denominated in
different currencies" we could determine the ,real- or im!lied
e&change rate that should e&ist if markets were efficient#
E&am!le of the Law of One rice:
Imagine there are no transaction costs (incl# trans!ortation and
ta&es) when %uying or selling gold %etween countries#
In addition" we ha*e: current s!ot e&change rate is /'#0123#
The !rice !er ounce of gold is: /455 in N6 and 3788 in aris#
$hat should you do9
5
A%solute
At :;< '#0123" the !rice for gold in New 6ork in Euros is 3785
(=/4552(/'#0123))# Thus" %uying gold in N6 is chea!er than the sales
!rice of 3 788 in aris#
>uying gold in N6 and selling in aris yields you a riskless !rofit of 38#
6ou %uy one ounce of gold in N6 at /455" shi! it to aris" sell it for
3788# Con*ert this into /451 (=3788?(/'#0123))#" which yields you a
net !rofit of /1 (or 38)#
If sufficient traders !artici!ate in this strategy" then the international
gold !rices automatically ad@ust (!rice increases in N6+ !rice decreases
in aris)#
6
2-6-2014
4
A%solute
T.E ECONOAI;T-s >ig Aac inde& is %ased on the theory of !urchasing
!ower !arity: in the long run" e&change rates should ad@ust to eBual
the !rice of a %asket of goods and ser*ices in different countries#
This !articular %asket holds a Ac<onald-s >ig Aac" whose !rice around
the world we com!ared with its American a*erage of /8#05#
7
A%solute
8
2-6-2014
5
A%solute
9
In the e&am!le" the >ig Aac costs :;<8#CD in the :;# In Argentina" it
costs 'E#55 !esos#
Assuming the ham%urger has a uniform !rice (=a%solute )" then the
im!lied e&change rate (FX

)%ased on the >ig Aac inde& is:

FX

=
Big Nac piice in countiy i
Big Nac piice in 0. S. A
In this case" FX

ARS,USA
=
19.0
4.37
= 4.S478261#
The true e&change rate was FX = ARS4.980SB.
.ence" the Argentine !eso was o*er*alued (or under*alued %y):
(FX

-FX)
FX
=
4.SS -4.98
4.98
= -12.6%.
A%solute
10
The currencies of many
countries are either
o*er*alued or under*alued
relati*e to the :; <ollar#
i#e#" the actual e&change
rate is not eBual to that
im!lied %y the a%solute
#
2-6-2014
6
Relati*e
11
If the assum!tions of the a%solute *ersion of the theory are
rela&ed a %it more" we o%ser*e what is termed relati*e !urchasing
!ower !arity (R)#
R holds that is not !articularly hel!ful in determining what the
s!ot rate is today" %ut that the relati*e change in !rices %etween two
countries o*er a !eriod of time determines the change in the e&change
rate o*er that !eriod#
Aore s!ecifically" with regard to R:
If the s!ot e&change rate %etween two countries starts in eBuili%rium"
any change in the differential rate of inflation %etween them tends to
%e offset o*er the long run %y an eBual %ut o!!osite change in the
s!ot e&change rate#
Relati*e
12
6ou can inter!ret this R
gra!h as follows:
In !oint the 8F inflation
differential (home higher
inflation than foreign) is @ust
offset %y the 8F
a!!reciation of the foreign
currency relati*e to the
home currency#
.ence" in general terms
under R" higher inflation
in one country is fully offset
%y a de!reciation of that
country-s currency#
2-6-2014
7
Relati*e
13
Aore formally" the R does not tell us what determines the a%solute
le*el of the e&change rate# Instead" it tells us what determines the change
in the e&change rate o*er time#
If S
0
is the current s!ot e&change rate (i#e#" foreign currency !er home
currency)" E S
t
is the e&!ected e&change rate in t !eriods" E
HC
is the
inflation rate in the home country and E
PC
is the inflation rate in the
foreign country" then:
E S
t
= S
0
- 1 + B
FC
-B
HC
t
6ou are assuming that the antici!ated
inflation rate in the foreign 2 home country
is a constant#
Relati*e
14
As an e&am!le" consider a !roduct that sells for 385 in the Euro Gone and
/15 in the :;# The e&change rate %etween the :;< and the Euro is
/'#0123#
Assume that the e&!ected inflation in the EuroHGone is 1F o*er the ne&t
year while that in the :; is CF#
Further" assume that the e&change rate %etween the :;< and the Euro
remains unchanged at /'#0123#
The !rice of the !roduct in the Euro Gone one year from now:
t4u - 1.uS = t42.
The !rice of the !roduct in the :; one year from now:
$Su - 1.uS = $S1.Su.
It would %e chea!er to %uy the !roduct in the :; and shi! it to Euro!e
(assume shi!ment costs are negligi%le) as it would effecti*ely cost:
$51.50
$1.25t
= t41.2u.
2-6-2014
8
Relati*e
15
eo!le in the Euro Gone would con*ert Euros into :;< so as to %uy the
!roduct in the :;" dri*ing u! the demand for :;< and hence it !rice#
:ntil what !oint will the :;< rise in relati*e to the Euro#
If the :;< a!!reciates to /'#00123" then the !rice of the !roduct will %e
the same in the two regions# If one were to %uy the !roduct in the :; it
would cost:
$S1.Su
$1.22St
= t42.u4, which is the same as the !rice of the
!roduct in the Euro Gone#
E S
1
= $1.2St - 1 + u.uS -u.uS = $1.22St
Relati*e
16
Em!irical testing of and the law of one !rice has %een done" %ut
has not !ro*ed to %e accurate in !redicting future e&change rates#
Two general conclusions can %e made from these tests:
holds u! well o*er the *ery long run %ut !oorly for shorter time
!eriods+ and"
The theory holds %etter for countries with relati*ely high rates of
inflation and underde*elo!ed ca!ital markets#
2-6-2014
9
art 0
17
Interest rate !arity I
Co*ered interest ar%itrage
Interest rate !arity
18
Esta%lishes the relation %etween s!ot e&change rates" forward
e&change rates and relati*e interest rates#
The interest rate !arity im!lies that" in eBuili%rium" the return on
currencies will %e the same# That is:
F
1
S
0
=
1 +R
FC
1 +R
HC
where"
F
1
is the oneHyear forward rate of foreign currency (!er unit home
currency)"
S
0
is the s!ot e&change rate of foreign currency (!er unit home
currency)"
R
PC
and R
HC
are the annual nominal riskHfree interest rate in the
foreign and home region res!ecti*ely#
2-6-2014
10
Interest rate !arity
19
;u!!ose" you ha*e 3' (home currency)#
If you con*ert it into :;< (foreign currency)" you would recei*e /S
0
(=
3'?/S
0
23)#
If you in*est /S
0
in the :; for one year" then %y the end of the year" you
would ha*e /S
0
?(1 +R
FC
)#
If the e&change rate %etween the :;< and the Euro one year from now is
$F
1
t " then you would effecti*ely ha*e
S
0
1+R
FC
F
1

Euros (home currency)#
The IR says that this amount should e&actly %e the same as in*esting 3' in
and earning an return of R
HC
on it: t1 - (1 +R
HC
)#
1 +R
HC
=
S
0
1 +R
FC
F
1
Rearranging"
F
1
S
0
=
1+R
FC
1+R
HC
`
Interest rate !arity
20
The interest rate !arity can %e a!!ro&imated as %elow:
F
1
- S
0
S
0
Forward
prcmIum
= (R
FC
-R
HC
)
The a%o*e a!!ro&imation im!lies that the forward !remium (or discount) is
a!!ro&imately eBual to the difference in interest rates#
ReHwriting the a%o*e eBuation further:
F
1
= S
0
|1 + R
FC
-R
HC
]
In geneial, if we have t peiious:
F
t
= S
0
1 + R
FC
-R
HC
t

The e&act eBuation is: F
t
= S
0
1+R
FC
1+R
HC
t
The IR thus im!lies that
any difference in interest
rate %etween two
countries for some !eriod
is @ust offset %y the change
in the relati*e *alue of the
two currencies#
2-6-2014
11
Interest rate !arity
21
If the a%o*e interest rate !arity eBuality holds" then ar%itraging is
ruled out# That is" soHcalled ,sho!!ingHaround com!utations-" or
,roundtri!s- are a waste of time#
Consider the following e&am!le:
Current s!ot rate: S
0
= $1.S28t#
'Hyear forward rate: F
1
= $1.S26t#
The annual riskHfree rate in the EuroHGone is '#0F and that in the :;
is 5#71F#
Is the IR satisfied9
Are there any ar%itrage !rofits to %e made9 .ow would you
im!lement an ar%itrage strategy9 Assume that you startHoff %y
%orrowing /'"555#
Interest rate !arity
22
Is the IR satisfied9
;ince we are talking of :;<2Euro" the Euro is the home currency#
If the IR holds" then:
F
1
S
0
=
1 +R
FC
1 +R
HC
F
1
= S
0
-
1+R
FC
1+R
HC
= $1.S28 pei t -
1.0065
1.012
F
1
= $1.S21 pei t
If the forward rate is /'#C07 !er t then the IR is *iolated#
2-6-2014
12
Interest rate !arity
23
Are there any ar%itrage !rofits to %e made9 .ow would you
im!lement an ar%itrage strategy9 Assume that you startHoff %y
%orrowing /'"555#
;et u! the following ar%itrage strategy: >orrow /'"555 at 5#71F
interest rate#
;ell a forward that would allow you to e&change Euros for :;< at the
rate of /'#C0723#
Con*ert /'"555 to Euros at the s!ot rate of /'#C0423# 6ou will
recei*e:
G,"""
G.$Ig XYT h\TS
= E(4'.F,.
In*est E(4'.F, in the EuroHGone and earn an annual interest rate of
'#'0F# In one year you would ha*e: E(4'.F, ? ,.F,* = E(+*.F4.
Con*ert E(+*.F4 into :;< at the forward rate of /'#C0723# 6ou
would recei*e: E(+*.F4 ? G,.'*+ per E = G,,F,F.&).
ay %ack your /'"555 loan with 5#71F interest# 6ou would thus earn
an ar%itrage !rofit: G,,F,F.&) 3G,,FFF ? ,.FF+4 = G'.0).
Interest rate !arity
24
The ar%itrage strategy illustrated in the !re*ious slide is called
JCo*ered interest ar%itrageK#
;ince traders ,lock in- the forward e&change rate" the strategy
%ecomes riskless#
Thus" if you could earn a !ositi*e return %y means of a roundtri! using
co*ered interest rate !arity (so you lock in the forward rate) then this
would %e !ure ar%itraging#
The alternati*e would %e to ,take a gam%le- on the forward rate" and
rely on the e&!ected future s!ot rate as we do in the ,:nco*ered
interest rate !arity- (:I):
= S

= S
"
?
, @/
BC
, @/
DC
In this case" in*estors %orrow in countries and currencies e&hi%iting
relati*ely low interest rates and con*ert the !roceed into currencies
that offer much higher interest rates#
2-6-2014
13
Interest rate !arity
25
The transaction is ,unco*ered- %ecause the in*estor does no sell the
higher yielding currency !roceeds forward" choosing to remain
unco*ered and acce!t the currency risk of e&changing the higher yield
currency into the lower yielding currency at the end of the !eriod#
Any !rofitHseeking strategies are thus risky" and can at %est %e called
,riskHar%itraging-#
art C
26
:n%iased forward rates I
the international Fischer effect
2-6-2014
14
:n%iased forward rate
27
The un%iased forward rates (:FR) lays out the relation %etween the
forward rate and the e&!ected future s!ot rate#
F

= = S

The :FR condition says that on a*erage" the forward rate J

" is eBual
to the e&!ected future s!ot rate" 7 6

.
For e&am!le" if the forward rate of :;<2Euro (say /'#C523) is
consistently lower than the future s!ot e&change rate %etween the
:;< and Euro (say /'#C023)" then anyone who wants to con*ert Euros
into :;< will not agree to a forward trade#
For in*estors to agree to a forward trade" on a*erage" the forward
rate should %e eBual to the future s!ot rate#
The international Fischer effect
28
Let us !ut together" what we already know:
R: = S

= S
"
? ], @ b
BC
3b
DC
^
IR: F

= S
"
? ], @ /
BC
3 /
DC
^
:FR: F

= = S

Com%ining" :FR and IR:

= S

= S
"
? ], @ /
BC
3/
DC
^
Com!aring the R with the a%o*e eBuation:
S
"
? , @ b
BC
3b
DC
= S
"
? , @ /
BC
3/
DC
b
BC
3b
DC
= /
BC
3/
DC
The International Fischer effect (IFR): the
difference in returns %etween the home country
and foreign country is eBual the difference in
their inflation rates#
2-6-2014
15
The international Fischer effect
29
b
BC
3b
DC
= /
BC
3/
DC
Further reHarranging the a%o*e eBuation:
/
DC
3b
DC
YVi [j>YTYk> TV>Y
[j >lY lSZY mS\j>Tn
= /
BC
3b
BC
YVi [j>YTYk> TV>Y
[j >lY oSTY[pj mS\j>Tn
If real interest rates are different from one country to another" then
ca!ital must flow from the countries with the lowest interest rates to
those with the highest interest rates until all rates are eBualiGed#
The International Fischer effect (IFR) im!lies
that the real interest rates across countries
should %e eBual#
International financial management
30
Any firm with foreign o!erations is e&!osed to either (') e&change
rate risk" or (0) country risk" or (C) a com%o of the !re*ious two#
$hen e&change rates fluctuate" a firm faces two ty!es of risk:
'# Accounting (or ,translation-) e&!osure: The effect of changes in
e&change rate on the firm-s %alance sheet and income statement#
0# Economic e&!osure: Effect of e&change rate fluctuations on the
firm-s cash flows#
:sing financial risk management" firms can use deri*ati*es (forwards"
futures" swa!s" o!tions) to reduce a firm-s economic e&!osure to
currency risk#
2-6-2014
16
International financial management
31
;ome suggested reading to learn more a%out international financial
management:
;ercu" iet (055E) International Finance: utting Theory Into
ractice" rinceton :ni*ersity ress#
>ekaert" Leert" and Ro%ert M# .odrik (05'') International
Financial Aanagement" 0nd Ed#" rentice .all#
art 8
32
On the e&am
2-6-2014
17
On the e&am
33
E&am materials:
;tudy cha!ters '0" '8" '1" '7" 'D" '4" 'E" 05" 00" 0C" 08" 01" 0E
and C5 (see Course Aanual)#
From cha!ters such as '8" 'E" 08 and 0E that are not discussed in
class" there will %e no numerical Buestions# There will howe*er %e
theory 2 conce!tual Buestions#
<o the suggested e&ercises:
;ee Course Aanual for the full list of e&ercises#
Recommended: $ork through the sam!le e&am !osted on >lack>oard#
$hat will %e tested
34
E&am format (roughly):
Numerical Buestions: 75F (01 Buestions):
Numerical e&ercises" all ins!ired %y: The suggested endHofH
cha!ter e&ercises from cha!ters that were discussed in class#
The e&am!les gi*en during the lectures or $e%casts#
Conce!t 2 theory Buestions: 85F ('1 Buestions):
Conce!t Buestions (theory or intuition) on all of the
aforementioned cha!ters#
In case I ask a numerical e&ercise on a to!ic not e&!licitly dealt with in
the endHofHcha!ter e&ercises or in class" do not !anic# 6ou should %e
a%le to sol*e these e&ercises %y means of your general insights" and
your e&!erience in sol*ing the other numerical e&ercises#
2-6-2014
18
At the e&am
35
>ring a normal (nonH!rogramma%le) scientific calculator" which has the
%asic functions necessary to calculate CAAHrelated !ro%lems" and
real o!tion !ro%lems# (e#g#" N+ H + &" 2" e&!+ ln)and a sim!le memory
function to store intermediate results#)
6ou will %e gi*en some ta%les and a formula sheet (see !re*ious e&ams
for an im!ression)" %ut should %e a%le to re!roduce all eBuations
yourself (with which I reser*e the right to change the formula sheet" or
use different sym%ols)#
6ou may use the ta%les 2 formula sheet in the sam!le e&am as a
re!resentati*e e&am!le of what you can e&!ect to see at the e&am#
At the e&am
36
;!read your time e*enly o*er the Buestions#
6ou get 85 AC Buestions" determining '55F of your ma&imum
grade#
I highly recommend that you s!end no more than D minus on any
numerical Buestion#
If you ha*e scored a ,'- in 7 out of the ten %onus tests" then you ha*e
the right to answer the two %onus Buestions (Buestion num%er 8' and
80) on the e&am#
As stated in the course manual" your !ossi%le score for the %onus
Buestions at this e&am will only %e added to your final grade in the
Mune e&am if you ha*e o%tained at least a 8#1 for this e&am (minimum
grade reBuirement)#
6our final grade is ca!!ed at a '5#5#
2-6-2014
19
art 1
37
Oaluation in !ractice
Oaluation in !ractice
38
In essence" cor!orate finance is a%out:
Oaluation#
Ca!ital structure#
The CAA in case cash flows were certain" and risk arises from the
assets or the ca!ital structure#
Real o!tions in case e*en cash flows are uncertain#
2-6-2014
20
Oaluation in !ractice
39
Last %ut not the least
40
I en@oyed the last '5 weeks *ery much# .o!e you did as well#
lease remem%er P learning is a !rocess and it takes each of
different le*els of effort and time to truly gras! 2 understand a to!ic#
;o kee! chi!!ing away at it H one to!ic at a time# I guarantee you
that the feeling of Jfinally getting itK will %e truly worth all the effort#
Lood %ye I Lood luckQ