chapter 19 international business financeoktato.econ.unideb.hu/domician/downloads/ppt/_c19.pdf ·...

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

International Business Finance

Chapter 19

Copyright © 2011 Pearson Prentice Hall. All rights reserved.19-2

Slide Contents

• Learning Objectives

• Principles Used in This Chapter

1. Foreign Exchange Markets and Currency Exchange Rates

2. Interest Rate and Purchasing-Power Parity

3. Capital Budgeting for Direct Foreign Investment

• Key Terms


Learning Objectives

1. Understand the nature and importance of the foreign exchange market and learn to read currency exchange rate quotes.

2. Describe interest rate and the purchasing power parity.

3. Discuss the risks that are unique to the capital budgeting analysis of direct foreign investments.


Principles Used in This Chapter

• Principle 2:

– There is a Risk-Return Tradeoff.

• Principle 3:

– Cash Flows Are the Source of Value.


19.1 Foreign Exchange Markets and the Currency Exchange Rates


Foreign Exchange Markets and the Currency Exchange Rates

• The foreign exchange (FX) market:

– Largest financial market with daily trading volumes of more than $4 trillion.

– Organized as over-the-counter market with participants located in major commercial and investment banks around the world.

– Trading dominated by few currencies including U.S. dollar, the British pound sterling, the Japanese Yen, and the Euro.


Foreign Exchange Markets and the Currency Exchange Rates (cont.)

• Major participants in foreign exchange trading include the following:

– Importers and exporters of goods and services,

– Investors and portfolio managers who purchase foreign stocks and bonds, and

– Currency traders who make a market in one or more foreign currencies.


Foreign Exchange Rates

• An exchange rate is simply the price of one currency stated in terms of another.

• For example, if the exchange rate of U.S. dollar for Euro was $1.35 to 1, it means that it would take $1.35 to purchase one Euro.


Foreign Exchange Rates (cont.)

• Direct quote

– It indicates the number of units of U.S. dollar to buy 1 foreign currency unit.

– In the table we see that it took $0.97 to buy 1 Canadian dollar.



• Indirect Quote

– It indicates the number of foreign currency units to buy one American dollar.

– For example, in the table it shows that it will take 6.8276 Chinese yuan to buy 1 U.S. dollar



• We can compute the direct quote from the indirect quote.



• The direct quote for Canadian dollars is $0.97. The related indirect quote will be:

• Indirect quote = 1÷ $0.97 = $1.03


Exchange Rates and Arbitrage

• Arbitrage is the process of buying and selling in more than one market to make a riskless profit.

• Simple arbitrage eliminates exchange rate differentials across the markets for a single currency.


Exchange Rates and Arbitrage (cont.)

• The asked rate (also known as the selling rate or the offer rate) is the rate the bank or the foreign exchange trader “asks” the customer to pay in home currency for foreign currency when the bank is selling and the customer is buying.



• The bid rate (also known as the buying rate) is the rate at which the bank buys the foreign currency from the customer by paying in home currency.



• The bank sells a unit of foreign currency for more than it pays for it. The difference between the asked quote and the bid quote is known as the bid-asked spread.

– The spread will be relatively lower for popular currencies that are frequently traded.


Cross Rates

• A cross rate is the computation of an exchange rate for a currency from the exchanges rates of two other currencies.


Types of Foreign Exchange Transactions

• Spot exchange rate is the rate for immediate delivery.

• Forward exchange rate is an exchange rate agreed upon today but which calls for delivery or payment at a future date.


Types of Foreign Exchange Transactions (cont.)

• The forward rate is often quoted at a premium to or a discount from the existing spot rate. For example, the 30-day Switzerland franc will be quoted as 0.0001 premium(0.9773-0.9772).

• This premium or discount is known as the forward-spot differential.


19.2 Interest Rate and Purchasing Power Parity


Interest Rate Parity

• Interest rate parity is a theory that can be used to relate differences in the interest rates in two countries to the ratios of spot and forward exchange rates of the two countries’ currencies.

• Specifically,

Differences in interest rates = Ratio of the forward and spot rates


Interest Rate Parity (cont.)



• Interest rate parity means that you get the same total return for the following two options:

– Invest directly in the US; or

– Convert dollars to Japanese Yens,

– Invest Yens in the risk-free rate in Japan, and

– Convert Yens back to U.S. dollars.



• Example 19.1 You have $1,000,000 to invest and you observe the following quotes in the market:1$ = ¥ 106

180-day forward rate = 103.50

U.S. 180-day risk-free interest rate = 4.4%

Japan 180-day risk-free interest rate = 2%

• Determine whether interest rate parity holds.



Option I: Invest directly in USA and earn 4.4%

1,000,000 * 1.044 = $1,044,000

Option II:

(a) Convert to Yen at spot rate = ¥ 106,000,000

(b) Invest at 2% = ¥106,000(1.02) = ¥ 108,120,000

(c) Convert to $ at the forward rate = 108,120,000 ÷103.5 = $1,044,638

==> Difference of $638 ==> Interest Rate Parity does not hold


Purchasing Power Parity and the Law of One Price

• According to the theory of purchasing power parity (PPP), exchange rates adjust so that identical goods cost the same amount regardless of where in the world they are purchased.


Purchasing Power Parity and the Law of One Price (cont.)

• Underling PPP theory is the law of one price, which states that the same good should sell for the same price in different countries after making adjustments for the exchange rate between the two currencies.

• Figure 19-2 illustrates one example of exception to the PPP theory.



• The differences in prices around the world could be explained by:

– Tax differences among countries

– Differences in labor costs

– Differences in raw material costs

– Differences in rental costs



• In general, we expect PPP to hold for goods that can be cheaply shipped between countries (for example, expensive gold jewelry).

• PPP does not seem to hold for non-traded goods like restaurant meals and haircuts.

chapter 19 international business financeoktato.econ.unideb.hu/domician/downloads/ppt/_c19.pdf ·...

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