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Ch. 17:
International
Business
Finance
 2000, Prentice Hall, Inc.
International Business Finance
 Exchange
Rate: the price of one
currency in terms of another.
International Business Finance
 Exchange
Rate: the price of one
currency in terms of another.
International Business Finance
 Exchange
Rate: the price of one
currency in terms of another.
International Business Finance
 Exchange
Rate: the price of one
currency in terms of another.
International Business Finance
 Exchange
Rate: the price of one
currency in terms of another.
International Business Finance
 Exchange
Rate: the price of one
currency in terms of another.
Exchange Rates
Exchange rates affect our economy and
each of us because:
 1) When the dollar appreciates
(strong dollar), the dollar becomes
more valuable relative to other
currencies.
Exchange Rates
Exchange rates affect our economy and
each of us because:
 1) When the dollar appreciates
(strong dollar), the dollar becomes
more valuable relative to other
currencies.
Foreign
products become cheaper to us.
Exchange Rates
Exchange rates affect our economy and
each of us because:
 1) When the dollar appreciates
(strong dollar), the dollar becomes
more valuable relative to other
currencies.
Foreign
products become cheaper to us.
U.S. products become more expensive
overseas.
Exchange Rates
Exchange rates affect our economy
and each of us because:
Exchange Rates
Exchange rates affect our economy
and each of us because:
 2) When the dollar depreciates
(weak dollar), the dollar falls in
value relative to other currencies.
Exchange Rates
Exchange rates affect our economy
and each of us because:
 2) When the dollar depreciates
(weak dollar), the dollar falls in
value relative to other currencies.
Foreign
products become more
expensive for us, and
Exchange Rates
Exchange rates affect our economy
and each of us because:
 2) When the dollar depreciates
(weak dollar), the dollar falls in
value relative to other currencies.
Foreign
products become more
expensive for us, and
U.S. products become cheaper
overseas.
Spot Exchange Rates
£ / $ = .6284 (it takes .6284 pounds to = $1)
$ / £ = 1.5913 (it takes $1.5913 to = 1 pound)
¥ / $ = 102.98 (it takes 102.98 yen to = $1)
$ / ¥ = .009711 ( it takes $.009711 to = 1 yen)
(note: direct and indirect quotes are reciprocals)
What Determines Exchange Rates?
Floating Rate Currency System: Since
1973, the world has allowed exchange
rates to change daily in response to
market forces.
Exchange rates are affected by:





foreign investors,
speculators,
political conditions here and overseas,
inflation,
trade policies (tariffs and quotas), and
What Determines Exchange Rates?
Supply and Demand for currencies!
Let’s consider the £ / $ market.
What Determines Exchange Rates?
Supply and Demand for currencies!
Let’s consider the £ / $ market.
What Determines Exchange Rates?
Supply and Demand for currencies!
Let’s consider the £ / $ market.
What Determines Exchange Rates?
Suppose the British increase demand for
U.S. products.
British importers buy the U.S. products to
sell in England. They buy dollars with
pounds, so they can pay U.S. firms in
dollars.
The demand for dollars increases, and forces
up the £ / $ exchange rate, which makes
U.S. products more expensive in England.
What Determines Exchange Rates?
£/$
(price of
dollars)
Supply of
Dollars
Demand for Dollars
Quantity of dollars
What Determines Exchange Rates?
£/$
(price of
dollars)
Supply of
Dollars
Demand for Dollars
Quantity of dollars
What Determines Exchange Rates?
Another example:
Let’s consider the ¥ / $ market.
What Determines Exchange Rates?
Another example:
Let’s consider the ¥ / $ market.
What Determines Exchange Rates?
Another example:
Let’s consider the ¥ / $ market.
What Determines Exchange Rates?
Suppose American demand for Japanese
cars and stereos increases rapidly.
American importers buy the Japanese
products to sell in the U.S. They buy yen
with dollars, so they can pay Japanese
firms in yen.
The supply of dollars increases, and forces
down the ¥ / $ exchange rate, which
makes Japanese products more expensive
in the U.S.
What Determines Exchange Rates?
¥/$
Supply of
Dollars
(price of
dollars)
Demand for Dollars
Quantity of dollars
What Determines Exchange Rates?
¥/$
Supply of
Dollars
(price of
dollars)
Demand for Dollars
Quantity of dollars
Foreign Exchange Markets
Different exchange rates are used for
different types of transactions:
1) Spot Exchange Market: deals with
currency for immediate delivery.
 The exchange rate used in spot
transactions is called the spot exchange
rate.
 If you need 500,000 francs to buy imports,
and the spot exchange rate is .1457, you
would pay your bank $72,850.

Foreign Exchange Markets
2) Forward Exchange Market: deals with
the future delivery of foreign currency.
 You can buy or sell currency for future
delivery, usually in 1, 3, or 6 months.
 The exchange rate for forward
transactions is called the forward
exchange rate.
 Forward exchange contracts allow you to
hedge foreign exchange risk!
Forward Market Hedge
Example: You will import wine from
France, to be delivered and paid in 6
months.
 You have agreed to a price of 500,000
francs. With the spot exchange rate of
.1457, this comes to $72,850.

Suppose the dollar weakens over the next 6
months, and the $/F exchange rate rises to .20.

The wine would cost you $100,000. This
is an example of foreign exchange risk!
Forward Market Hedge
You decide to hedge your risk with a
forward exchange contract!
 The 6-months $/F forward exchange rate
is .1476. By agreeing to this forward rate
with your bank, you lock in a price of
$73,800 for 500,000 francs, 6 months from
now.
 Now it doesn’t matter what happens to
the $/F exchange rate over the next 6
months.
Money Market Hedge
For the previous problem, another potential
solution is the money market hedge.
1) Borrow $72,850 from your bank.
2) Buy the 500,000 francs now (at the current
spot exchange rate of .1457) for $72,850.
3) Invest the 500,000 francs in interestbearing French securities.
4)Complete your transaction after 6 months.
[Borrowing and investment rates determine cost of hedge]
Forward-Spot Differential
If the forward rate > the spot rate, the
forward is trading at a premium.
If the forward rate < the spot rate, the
forward is trading at a discount.
Forward-Spot Differential
If the forward rate > the spot rate, the
forward is trading at a premium.
If the forward rate < the spot rate, the
forward is trading at a discount.
premium
or discount
=[
forward - spot
spot
] [ ] x 100
12
n
Forward-Spot Differential
For our example,
Forward-Spot Differential
For our example,
premium
or discount
=[
forward - spot
spot
12
n
] [ ] x 100
Forward-Spot Differential
For our example,
premium
or discount
=[
forward - spot
spot
12
n
] [ ] x 100
=[
.1476 - .1457
.1457
] [ ] x 100
12
6
Forward-Spot Differential
For our example,
premium
or discount
=[
forward - spot
spot
12
n
] [ ] x 100
=[
.1476 - .1457
.1457
] [ ] x 100
12
6
= 2.6. The forward is trading at a 2.6%
premium.
Interest Rate Parity
Links the forward exchange market with
the spot exchange market. The idea:
The annual percentage difference between
the forward rate and the spot rate
(forward premium or discount) is
approximately equal to the difference in
interest rates between the two countries.
Arbitrage in the forward and spot markets
helps to hold this relationship in place.
Purchasing Power Parity
Links changes in exchange rates with
differences in inflation rates and the
purchasing power of each nation’s currency.
 In the long run, exchange rates adjust so that
the purchasing power of each currency tends
to be the same.
 Exchange rate changes tend to reflect
international differences in inflation rates.
 Countries with high inflation tend to
experience currency devaluation.
The Law of One Price
In competitive markets where there are no
transportation costs or barriers to trade, the
same goods sold in different countries sell for
the same price if all the different prices are
expressed in terms of the same currency.
 This proposition underlies the PPP
relationship.
 Arbitrage allows the law of one price to hold
for commodities that can be shipped to other
countries and resold.
Exchange Rate Risk
Translation exposure - foreign currency
assets and liabilities that, for accounting
purposes, are translated into domestic
currency using the exchange rate, are
exposed to exchange rate risk.
 However, if markets are efficient, investors
know that any translation losses are
“paper” losses and are unrealized.

Exchange Rate Risk
 Transaction
exposure - refers to
transactions in which the monetary
value is fixed before the transaction
actually takes place.
 Ex: your firm buys foreign goods to be
received and paid for at a later date.
The exchange rate can change, which
can affect the price actually paid.
Multinational Working-Capital
Management
Leading and Lagging
 Lead: dispose of a net asset position in a
weak currency.
 Pay a net liability position in a weak
currency.
 Lag: Delay collection of a net asset
position in a strong currency.
Delay payment of a net liability position in
a weak currency.
Direct Foreign Investment
Risks
 Business Risk - firms must be
aware of the business climate in
both the US and the foreign
country.
 Financial Risk - not much
difference between financial risks
of foreign operations and those of
domestic operations.
Direct Foreign Investment
Risks
 Political Risk - firms must be aware
that many foreign governments are
not as stable as the U.S.
 Exchange Rate Risk - exchange rate
changes can affect sales, costs of
goods sold, etc. as well as the firm’s
profit in dollars.