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Ninth Edition
Chapter 28
Managing International Risks
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Topics Covered
Foreign Exchange Markets Some Basic Relationships Hedging Currency Risk Exchange Risk and International Investment Decisions Political Risk
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Exchange Rates
April 16, 2007
Forward Rate * Spot Rate * 1 Month 3 Months 1 Year Europe EMU (euro) Norway (krone) Sweden (krona) Switzerland (franc) United Kingdom (pound) Americas: Canada (dollar) Mexico (peso) Pacific/ Africa: Hong Kong (dollar) Japan (yen) South Africa (rand) South Korea (won) 1.3549 5.9566 6.8028 1.213 1.9901 1.1309 10.9892 7.8129 1119.795 7.0942 903.55 1.3565 5.9514 6.7915 1.2099 1.99 1.1298 11.0055 7.8071 119.33 7.116 929.85 1.3595 5.9436 6.7705 1.2038 1.9892 1.1278 11.0408 7.7916 118.397 7.162 928.45 1.3689 5.9377 6.7041 1.1812 1.9811 1.1208 11.2274 7.7429 114.571 7.3807 923.65
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Exchange Rates
Example Swiss franc spot price is SF 1.4457 per $1 Swiss franc 6 mt 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 / $
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E(sforeign / $)
equals
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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1/30/1974
1/30/1970
1/30/1972
1/30/1976
1/30/1978
1/30/1980
1/30/1982
1/30/1984
1/30/1986
1/30/1988
1/30/1990
1/30/1992
1/30/1994
1/30/1996
1/30/1998
1/30/2000
1/30/2002
1/30/2004
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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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Exchange Rates
Nominal versus Real Exchange Rates
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Exchange Rates
Nominal versus Real Exchange Rates
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Exchange Rates
Nominal versus Real Exchange Rates
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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
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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 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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Web Resources
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