1、McGraw-Hill/IrwinCopyright?2002 by The McGraw-Hill Companies,Inc.All rights reserved.32-0Chapter Outline32.1 Terminology32.2 Foreign Exchange Markets and Exchange Rates32.3 The Law of One Price and Purchasing PowerParity32.4 Interest Rates and Exchange Rates:Interest RateParity32.5 International Cap
2、ital Budgeting32.6 International Financial Decisions32.7 Reporting Foreign Operations32.8 Summary and ConclusionsMcGraw-Hill/IrwinCopyright?2002 by The McGraw-Hill Companies,Inc.All rights reserved.32-132.1 Terminology?American Depository Receipt(ADR):a security issued in the U.S.to represent shares
3、 of a foreign stock.?Cross rate:the exchange rate between two foreign currencies,e.g.the exchange rate between and￥.?Euro():the single currency of the European Monetary Union which was adopted by 11 Member States on 1 January 1999.These member states are:Belgium,Germany,Spain,France,Ireland,Italy,Lu
4、xemburg,Finland,Austria,Portugal and the Netherlands.?Eurobonds:bonds denominated in a particular currency and issued simultaneously in the bond markets of several countries.McGraw-Hill/IrwinCopyright?2002 by The McGraw-Hill Companies,Inc.All rights reserved.32-232.1 Terminology?Eurocurrency:money d
5、eposited in a financial center outside the home country.Eurodollars are dollar deposits held outside the U.S.;Euroyen are yen denominated deposits held outside Japan.?Foreign bonds:bonds issued in another nations capital market by a foreign borrower.?Gilts:British and Irish government securities.?LI
6、BOR:the London Interbank Offer Rate is the rate most international banks charge on another for loans of Eurodollars overnight in the London market.McGraw-Hill/IrwinCopyright?2002 by The McGraw-Hill Companies,Inc.All rights reserved.32-332.2 Foreign Exchange Markets and Exchange Rates?Without a doubt
7、 the foreign exchange market is the worlds largest financial market.?In this market one countrys currency is traded for anothers.?Most of the trading takes place in a few currencies.McGraw-Hill/IrwinCopyright?2002 by The McGraw-Hill Companies,Inc.All rights reserved.32-4FOREX Market Participants?The
8、 FOREX market is a two-tiered market:Interbank Market(Wholesale)?About 700 banks worldwide stand ready to make a market in Foreign exchange.?Nonbank dealers account for about 20%of the market.?There are FX brokers who match buy and sell orders but do not carry inventory and FX specialists.Client Mar
9、ket(Retail)?Market participants include international banks,their customers,nonbank dealers,FOREX brokers,and central banks.McGraw-Hill/IrwinCopyright?2002 by The McGraw-Hill Companies,Inc.All rights reserved.32-5Correspondent Banking Relationships?Large commercial banks maintain demand deposit acco
10、unts with one another which facilitates the efficient functioning of the forex market.?International commercial banks communicate with one another with:SWIFT:The Society for Worldwide Interbank Financial Telecommunications.CHIPS:Clearing House Interbank Payments System ECHO Exchange Clearing House L
11、imited,the first global clearinghouse for settling interbank FOREX transactions.McGraw-Hill/IrwinCopyright?2002 by The McGraw-Hill Companies,Inc.All rights reserved.32-6Spot Rate Quotations?The spot market is the market for immediate delivery.(Settlement is due within two days.)?Direct quotation the
12、 U.S.dollar equivalent e.g.“a Japanese Yen is worth about a penny”?Indirect Quotation the price of a U.S.dollar in the foreign currency e.g.“you get 100 yen to the dollar”McGraw-Hill/IrwinCopyright?2002 by The McGraw-Hill Companies,Inc.All rights reserved.32-7Spot FX trading?In the interbank market,
13、the standard size trade is about U.S.$10 million.?A bank trading room is a noisy,active place.?The stakes are high.?The“long term”is about 10 minutes.McGraw-Hill/IrwinCopyright?2002 by The McGraw-Hill Companies,Inc.All rights reserved.32-8Cross Rates?Suppose that SDM(0)=.50 i.e.$1=2 DM in the spot m
14、arket?and that S￥(0)=100 i.e.$1=￥100?What must the DM/￥cross rate be?0 DM1or .02 )0(?011$2?001$￥,$￥$￥since￥/?DMSDMDMDMDMDMMcGraw-Hill/IrwinCopyright?2002 by The McGraw-Hill Companies,Inc.All rights reserved.32-9Triangular Arbitrage$￥Credit LyonnaisS(0)=1.50Credit AgricoleS￥/(0)=85BarclaysS￥(0)=120Su
15、ppose we observe these banks posting these exchange rates.First calculate the implied cross rates to see if an arbitrage exists.McGraw-Hill/IrwinCopyright?2002 by The McGraw-Hill Companies,Inc.All rights reserved.32-10Triangular Arbitrage$￥Credit LyonnaisS(0)=1.50Credit AgricoleS￥/(0)=85BarclaysS￥(0
16、)=120The implied S(￥/)cross rate is S(￥/)=80Credit Agricole has posted a quote of S(￥/)=85 so there is an arbitrage opportunity.80￥1120￥1$1$50.1?So,how can we make money?McGraw-Hill/IrwinCopyright?2002 by The McGraw-Hill Companies,Inc.All rights reserved.32-11Triangular Arbitrage$￥Credit LyonnaisS(0
17、)=1.50Credit AgricoleS￥/(0)=85BarclaysS￥(0)=120As easy as 1 2 3:1.Sell our$for,2.Sell our for￥,3.Sell those￥for$.McGraw-Hill/IrwinCopyright?2002 by The McGraw-Hill Companies,Inc.All rights reserved.32-12Triangular ArbitrageSell$100,000 for at S(0)=1.50receive 150,000 Sell our 150,000 for￥at S￥/(0)=8
18、5 receive￥12,750,000Sell￥12,750,000 for$at S￥(0)=120receive$106,250profit per round trip=$106,250-$100,000=$6,250McGraw-Hill/IrwinCopyright?2002 by The McGraw-Hill Companies,Inc.All rights reserved.32-13The Forward Market?A forward contract is an agreement to buy or sell an asset in the future at pr
19、ices agreed upon today.?If you have ever had to order an out-of-stock textbook,then you have entered into a forward contract.McGraw-Hill/IrwinCopyright?2002 by The McGraw-Hill Companies,Inc.All rights reserved.32-14Forward Rate Quotations?The forward market for FOREX involves agreements to buy and s
20、ell foreign currencies in the future at prices agreed upon today.?Bank quotes for 1,3,6,9,and 12 month maturities are readily available for forward contracts.?Longer-term swaps are available.McGraw-Hill/IrwinCopyright?2002 by The McGraw-Hill Companies,Inc.All rights reserved.32-15Forward Rate Quotat
21、ions?Suppose you observe that for Japanese yen,the spot rate is￥115.75=$1.00While the 180-day forward rate is￥112.80=$1.00?Whats up with that?The forex market clearly thinks that the yen is going to be worth more in six months(the yen is expected to appreciate)because one dollar will buy fewer yen.M
22、cGraw-Hill/IrwinCopyright?2002 by The McGraw-Hill Companies,Inc.All rights reserved.32-16Long and Short Forward Positions?If you have agreed to sell anything(spot or forward),you are“short”.?If you have agreed to buy anything(forward or spot),you are“long”.?If you have agreed to sell forex forward,y
23、ou are short.?If you have agreed to buy forex forward,you are long.McGraw-Hill/IrwinCopyright?2002 by The McGraw-Hill Companies,Inc.All rights reserved.32-1732.3 The Law of One Price and Purchasing Power Parity?The exchange rate between two currencies should equal the ratio of the countries price le
24、vels.S(0)=P$?P?Relative PPP states that the rate of change in an exchange rate is equal to the differences in the rates of inflation.e=?$-?If U.S.inflation is 5%and U.K.inflation is 8%,the pound should depreciate by 3%.McGraw-Hill/IrwinCopyright?2002 by The McGraw-Hill Companies,Inc.All rights reser
25、ved.32-18Evidence on PPP?PPP probably doesnt hold precisely in the real world for a variety of reasons.Haircuts cost 10 times as much in the developed world as in the developing world.Film,on the other hand,is a highly standardized commodity that is actively traded across borders.Shipping costs,as w
26、ell as tariffs and quotas can lead to deviations from PPP.?PPP-determined exchange rates still provide a valuable benchmark.McGraw-Hill/IrwinCopyright?2002 by The McGraw-Hill Companies,Inc.All rights reserved.32-1932.4 Interest Rates and Exchange Rates:Interest Rate Parity?IRP is an arbitrage condit
27、ion.?If IRP did not hold,then it would be possible for an astute trader to make unlimited amounts of money exploiting the arbitrage opportunity.?Since we dont typically observe persistent arbitrage conditions,we can safely assume that IRP holds.McGraw-Hill/IrwinCopyright?2002 by The McGraw-Hill Comp
28、anies,Inc.All rights reserved.32-20Interest Rate Parity DefinedSuppose you have$100,000 to invest for one year.You can either 1.Invest in the U.S.at i$.Future value=$100,000(1+ius)2.Trade your dollars for yen at the spot rate,invest in Japan at i￥and hedge your exchange rate risk by selling the futu
29、re value of the Japanese investment forward.Future value=$100,000(F/S)(1+i￥)Since both of these investments have the same risk,they must have the same future value otherwise an arbitrage would exist.(F/S)(1+i￥)=(1+ius)McGraw-Hill/IrwinCopyright?2002 by The McGraw-Hill Companies,Inc.All rights reserv
30、ed.32-21Interest Rate Parity DefinedFormally,(F/S)(1+i￥)=(1+ius)or if you prefer,SFii?￥$11IRP is sometimes approximatedas S(F-S)-i(i￥?$McGraw-Hill/IrwinCopyright?2002 by The McGraw-Hill Companies,Inc.All rights reserved.32-22IRP and Covered Interest ArbitrageIf IRP failed to hold,an arbitrage would
31、exist.Its easiest to see this in the form of an example.Consider the following set of foreign and domestic interest rates and spot and forward exchange rates.Spot exchange rateS(0)=$1.25/360-day forward rateF(360)=$1.20/U.S.discount ratei$=7.10%British discount ratei=11.56%McGraw-Hill/IrwinCopyright
32、?2002 by The McGraw-Hill Companies,Inc.All rights reserved.32-23IRP and Covered Interest ArbitrageA trader with$1,000 to invest could invest in the U.S.,in one year his investment will be worth$1,071=$1,000?(1+i$)=$1,000?(1.071)Alternatively,this trader could exchange$1,000 for 800 at the prevailing
33、 spot rate,(note that 800=$1,000$1.25/)invest 800 at i=11.56%for one year to achieve 892.48.Translate 892.48 back into dollars at F(360)=$1.20/,the 892.48 will be exactly$1,071.McGraw-Hill/IrwinCopyright?2002 by The McGraw-Hill Companies,Inc.All rights reserved.32-24According to IRP only one 360-day
34、 forward rate,F(360),can exist.It must be the case thatF(360)=$1.20/Why?If F(360)?$1.20/,an astute trader could make money with one of the following strategies:IRP&Exchange Rate DeterminationMcGraw-Hill/IrwinCopyright?2002 by The McGraw-Hill Companies,Inc.All rights reserved.32-25Arbitrage Strategy
35、IIf F(360)$1.20/i.Borrow$1,000 at t=0 at i$=7.1%.ii.Exchange$1,000 for 800 at the prevailing spot rate,(note that 800=$1,000$1.25/)invest 800 at 11.56%(i)for one year to achieve 892.48iii.Translate 892.48 back into dollars,if F(360)$1.20/,892.48 will be more than enough to repay your dollar obligati
36、on of$1,071.McGraw-Hill/IrwinCopyright?2002 by The McGraw-Hill Companies,Inc.All rights reserved.32-26Arbitrage Strategy IIIf F(360)$1.20/i.Borrow 800 at t=0 at i=11.56%.ii.Exchange 800 for$1,000 at the prevailing spot rate,invest$1,000 at 7.1%for one year to achieve$1,071.iii.Translate$1,071 back i
37、nto pounds,ifF(360)$1.20/,$1,071 will be more than enough to repay your obligation of 892.48.McGraw-Hill/IrwinCopyright?2002 by The McGraw-Hill Companies,Inc.All rights reserved.32-27You are a U.S.importer of British woolens and havejust ordered next yearsinventory.Payment of 100M is due in one year
38、.IRP and Hedging Currency RiskIRP implies that there are two ways that you fix the cash outflowa)Put yourself in a position that delivers 100M in one yeara long forward contract on the pound.You will pay(100M)(1.2/)=$120Mb)Form a forward market hedge as shown below.Spot exchange rateS(0)=$1.25/360-d
39、ay forward rateF(360)=$1.20/U.S.discount ratei$=7.10%British discount ratei=11.56%McGraw-Hill/IrwinCopyright?2002 by The McGraw-Hill Companies,Inc.All rights reserved.32-28IRP and a Forward Market Hedge To form a forward market hedge:Borrow$112.05 million in the U.S.(in one year you will owe$120 mil
40、lion).Translate$112.05 million into pounds at the spot rate S(0)=$1.25/to receive 89.64 million.Invest 89.64 million in the UK at i=11.56%for one year.In one year your investment will have grown to 100 millionexactly enough to pay your supplier.McGraw-Hill/IrwinCopyright?2002 by The McGraw-Hill Comp
41、anies,Inc.All rights reserved.32-29Forward Market Hedge Where do the numbers come from?We owe our supplier 100 million in one year so we know that we need to have an investment with a future value of 100 million.Since i=11.56%we need to invest 89.64 million at the start of the year.How many dollars
42、will it take to acquire 89.64 million at the start of the year if S(0)=$1.25/?1.1156?00?9.64?.25$1.00?9.64$112.05?McGraw-Hill/IrwinCopyright?2002 by The McGraw-Hill Companies,Inc.All rights reserved.32-30Reasons for Deviations from IRP?Transactions Costs The interest rate available to an arbitrageur
43、 for borrowing,ib,may exceed the rate he can lend at,il.There may be bid-ask spreads to overcome,Fb/Sa F/S Thus(Fb/Sa)(1+i￥l)?(1+i￥b)?0?Capital Controls Governments sometimes restrict import and export of money through taxes or outright bans.McGraw-Hill/IrwinCopyright?2002 by The McGraw-Hill Compani
44、es,Inc.All rights reserved.32-31Equilibrium Exchange Rate RelationshipsS(F-S)E(e)-i(i￥$?$-?IRPPPPFEFRPPPIFEFPMcGraw-Hill/IrwinCopyright?2002 by The McGraw-Hill Companies,Inc.All rights reserved.32-32A recipe for international decision makers:1.Estimate future cash flows in foreign currency.2.Convert
45、 to U.S.dollars at the predicted exchange rate.3.Calculate APVusing the U.S.cost of capital.32.5 International Capital BudgetingMcGraw-Hill/IrwinCopyright?2002 by The McGraw-Hill Companies,Inc.All rights reserved.32-33Consider this European investment opportunity:International Capital Budgeting:Exam
46、ple%15$?iIs this a good investment from the perspective of the U.S.shareholders?P=3%P$=6%S(0)=$.55265 600200500 30001 year2 years3 yearsMcGraw-Hill/IrwinCopyright?2002 by The McGraw-Hill Companies,Inc.All rights reserved.32-34International Capital Budgeting:Example 600200500 30001 year2 years3 years
47、CF0=(600)S(0)=(600)($.5526/)=$331.6$331.6McGraw-Hill/IrwinCopyright?2002 by The McGraw-Hill Companies,Inc.All rights reserved.32-35International Capital Budgeting:Example 600200500 30001 year2 years3 yearsCF1=(200)ES(1)ES(1)can be found by appealing to the interest rate differential:ES(1)=(1.06/1.03
48、)?S(0)=(1.06/1.03)?($.5526/)=$.5687/so CF1=(200)($.5687/)=$113.7$331.6$113.70McGraw-Hill/IrwinCopyright?2002 by The McGraw-Hill Companies,Inc.All rights reserved.32-36International Capital Budgeting:Example 600200500 30001 year2 years3 yearsSimilarly,CF2=(1.06)2/(1.03)2 S(0)?(500)=$292.6CF3=(1.06)3/
49、(1.03)3 S(0)?(300)=$180.7$331.6$113.70$292.60$180.7030.107$)15.1(70.180$)15.1(60.292$)15.1(70.113$60.336$32?APVMcGraw-Hill/IrwinCopyright?2002 by The McGraw-Hill Companies,Inc.All rights reserved.32-37Risk Adjustment in the Capital Budgeting Process?Clearly risk and return are correlated.?Political
50、risk may exist along side of business risk,necessitating an adjustment in the discount rate.McGraw-Hill/IrwinCopyright?2002 by The McGraw-Hill Companies,Inc.All rights reserved.32-3832.6 International Financial Decisions?An international firm can finance foreign projects in three basic ways:1.It can
