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hus far we have talked principally about doing business at home. But

T many companies have substantial overseas interests. Of course the ob-
jectives of international financial management are still the same. You
want to buy assets that are worth more than they cost, and you want to pay for
them by issuing liabilities that are worth less than the money raised. But when you
try to apply these criteria to an international business, you come up against some new
You must, for example, know how to deal with more than one currency. Therefore
we open this material with a look at foreign exchange markets.
The financial manager must also remember that interest rates differ from country to
country. For example, in late 1999 the short-term rate of interest was about .1 percent
in Japan, 6 percent in the United States, and 3 percent in the euro countries. We will dis-
cuss the reasons for these differences in interest rates, along with some of the implica-
tions for financing overseas operations.
Exchange rate fluctuations can knock companies off course and transform black ink
into red. We will therefore discuss how firms can protect themselves against exchange
We will also discuss how international companies decide on capital investments.
How do they choose the discount rate? You™ll find that the basic principles of capital
budgeting are the same as for domestic projects, but there are a few pitfalls to watch for.
After studying this material you should be able to
Understand the difference between spot and forward exchange rates.
Understand the basic relationships between spot exchange rates, forward exchange
rates, interest rates, and inflation rates.
Formulate simple strategies to protect the firm against exchange rate risk.
Perform an NPV analysis for projects with cash flows in foreign currencies.

Foreign Exchange Markets
An American company that imports goods from Switzerland may need to exchange
its dollars for Swiss francs in order to pay for its purchases. An American company
exporting to Switzerland may receive Swiss francs, which it sells in exchange for
dollars. Both firms must make use of the foreign exchange market, where currencies
are traded.
The foreign exchange market has no central marketplace. All business is conducted
by computer and telephone. The principal dealers are the large commercial banks, and

International Financial Management 599

any corporation that wants to buy or sell currency usually does so through a commer-
cial bank.
Turnover in the foreign exchange markets is huge. In London alone about $640 bil-
lion of currency changes hands each day. That is equivalent to an annual turnover of
$159 trillion ($159,000,000,000,000). New York and Tokyo together account for a fur-
ther $500 billion of turnover per day. Compare this to trading volume of the New York
Stock Exchange, where no more than $30 billion of stock might change hands on a typ-
ical day.
Suppose you ask someone the price of bread. He may tell you that you can buy two
loaves for a dollar, or he may say that one loaf costs 50 cents. Similarly, if you ask a for-
eign exchange dealer to quote you a price for Ruritanian francs, she may tell you that
you can buy two francs for a dollar or that one franc costs $.50. The first quote (the
number of francs that you can buy for a dollar) is known as an indirect quote of the ex-
change rate. The second quote (the number of dollars that it costs to buy one franc) is
Amount of one currency
known as a direct quote. Of course, both quotes provide the same information. If you
needed to purchase one unit
can buy two francs for a dollar, then you can easily calculate that the cost of one franc
of another.
is 1/2.0 = $.50.
Now look at Table 6.5, which has been adapted from the daily table of exchange rates
in the London Financial Times. The first column of figures in the table shows the ex-
change rate for a number of countries on October 6, 1999. By custom, the prices of
most currencies are expressed as indirect quotes. Thus you can see that you could buy
9.438 Mexican pesos for one dollar. However, to make things confusing, the price of the
euro and the British pound are generally expressed as direct quotes. So Table 6.5 shows
that it cost $1.0707 to buy one euro ( 1).

Forward Rate
Currency exchange rates on
October 6, 1999 Spot Rate 3 Months 1 Year
EMU (euro) 1.0707 1.0785 1.0979
Greece (drachma) 306.675 307.75 314.125
Sweden (krona) 8.1400 8.0875 7.988
Switzerland (franc) 1.4865 1.471 1.4331
U.K. (pound) 1.6566 1.6573 1.6535
Canada 1.4703 1.4662 1.4594
Mexico 9.4380 9.853 11.153
Australia (dollar) 1.5148 1.5139 1.5133
Hong Kong (dollar) 7.7681 7.7687 7.896
Indonesia (rupiah) 7800.00 7952.5 8487.5
Japan (yen) 107.520 105.865 101.3
Singapore (dollar) 1.6790 1.665 1.6358

Note: Rates show the number of units of foreign currency per dollar (indirect quotes), except for the euro
and the U.K. pound, which show the number of dollars per unit of foreign currency (direct quotes).
Source: From Financial Times, October 7, 1999. Used by permission of Financial Times.

A Yen for Trade
How many yen will it cost a Japanese importer to purchase $1,000 worth of oranges
from a California farmer? How many dollars will it take for that farmer to buy a Japa-
nese VCR priced in Japan at 30,000 yen (¥)?
The exchange rate is ¥107.52 per dollar. The $1,000 of oranges will require the
Japanese importer to come up with 1,000 — 107.52 = ¥107,520. The VCR will require
the American importer to come up with 30,000/107.52 = $279.

Use the exchange rates in Table 6.5. How many euros can you buy for one dollar (an in-
Self-Test 1
direct quote)? How many dollars can you buy for one yen (a direct quote)?

The exchange rates in the first column of figures in Table 6.5 are the prices of cur-
rency for immediate delivery. These are known as spot rates of exchange. For exam-
ple, the spot rate of exchange for Mexican pesos is pesos9.4380/$. In other words, it
cost 9.438 Mexican pesos to buy one dollar.
rate for an immediate
Many countries allow their currencies to float, so that the exchange rate fluctuates
from day to day, and from minute to minute. When the currency increases in value,
meaning that you need less of the foreign currency to buy one dollar, the currency is
said to appreciate. When you need more of the currency to buy one dollar, the currency
is said to depreciate.

Table 6.5 shows the exchange rate for the Swiss franc on October 6, 1999. The next day
Self-Test 2
the spot rate of exchange for the Swiss franc was SFr1.4852/$. Thus you could buy
fewer Swiss francs for your dollar than one day earlier. Had the Swiss franc appreciated
or depreciated?

Some countries try to avoid fluctuations in the value of their currency and seek in-
stead to maintain a fixed exchange rate. But fixed rates seldom last forever. If every-
body tries to sell the currency, eventually the country will be forced to allow the cur-
rency to depreciate. When this happens, exchange rates can change dramatically. For
example, when Indonesia gave up trying to fix its exchange rate in fall 1997, the value
of the Indonesian rupiah fell by 80 percent in a few months.
These fluctuations in exchange rates can get companies into hot water. For example,
suppose you have agreed to buy a shipment of Japanese VCRs for ¥100 million and to
make the payment when you take delivery of the VCRs at the end of 12 months. You
could wait until the 12 months have passed and then buy 100 million yen at the spot ex-
change rate. If the spot rate is unchanged at ¥107.52/$, then the VCRs will cost you 100
million/107.52 = $930,060. But you are taking a risk by waiting, for the yen may be-
come more expensive. For example, if the yen appreciates to ¥100/$, then you will have
to pay out 100 million/100 = $1 million.
You can avoid exchange rate risk and fix the dollar cost of VCRs by “buying the yen
forward,” that is, by arranging now to buy yen in the future. A foreign exchange forward
contract is an agreement to exchange at a future date a given amount of currency at an
International Financial Management 601

FORWARD EXCHANGE exchange rate agreed to today. The forward exchange rate is the price of currency for
RATE Exchange rate for a delivery at some time in the future. The second and third columns in Table 6.5 show 3-
forward transaction. month and 1-year forward exchange rates. For example, the 1-year forward rate for the
yen is quoted at 101.3 yen per dollar. If you buy 100 million yen forward, you don™t pay
anything today; you simply fix today the price which you will pay for your yen in the
future. At the end of the year you receive your 100 million yen and hand over 100 mil-
lion/101.3 = $987,167 in payment.
Notice that if you buy Japanese yen forward, you get fewer yen for your dollar than
if you buy spot. In this case, the yen is said to trade at a forward premium relative to the
dollar. Expressed as a percentage, the 1-year forward premium is
107.52 “ 101.3
— 100 = 6.14%
You could also say that the dollar was selling at a forward discount of about 6.14 per-
A forward purchase or sale is a made-to-order transaction between you and the bank.
It can be for any currency, any amount, and any delivery day. You could buy, say, 99,999
Vietnamese dong or Haitian gourdes for a year and a day forward as long as you can
find a bank ready to deal. Most forward transactions are for 6 months or less, but banks
are prepared to buy or sell the major currencies for up to 10 years forward.
There is also an organized market for currency for future delivery known as the cur-
rency futures market. Futures contracts are highly standardized versions of forward con-
tracts”they exist only for the main currencies, they are for specified amounts, and
choice of delivery dates is limited. The advantage of this standardization is that there is
a very low-cost market in currency futures. Huge numbers of contracts are bought and
sold daily on the futures exchanges.

A skiing vacation in Switzerland costs SFr1,500.
Self-Test 3
a. How many dollars does that represent? Use the exchange rates in Table 6.5.
b. Suppose that the dollar depreciates by 10 percent relative to the Swiss franc, so that
each dollar buys 10 percent fewer Swiss francs than before. What will be the new
value of the indirect exchange rate?
c. If the Swiss vacation continues to cost the same number of Swiss francs, what will
happen to the cost in dollars?
d. If the tour company that is offering the vacation keeps the price fixed in dollars, what
will happen to the number of Swiss francs that it will receive?

1 Hereis a minor point that sometimes causes confusion. To calculate the forward premium, we divide by the
forward rate as long as the exchange quotes are indirect. If you use direct quotes, the correct formula is
forward rate “ spot rate
Forward premium =
spot rate

In our example, the corresponding direct quote for spot yen is 1/107.52 = .009301, while the direct forward
quote is 1/101.3 = .009872. Substituting these rates in our revised formula gives
.009872 “ .009301 = .0614, or 6.14%
Forward premium =

The two methods give the same answer.

Some Basic Relationships
The financial manager of an international business must cope with fluctuations in ex-
change rates and must be aware of the distinction between spot and forward exchange
rates. She must also recognize that two countries may have different interest rates. To
develop a consistent international financial policy, the financial manager needs to un-
derstand how exchange rates are determined and why one country may have a lower in-
terest rate than another. These are complex issues, but as a first cut we suggest that you
think of spot and forward exchange rates, interest rates, and inflation rates as being
linked as shown in Figure 6.1. Let™s explain.

Consider first the relationship between changes in the exchange rate and inflation
rates (the two boxes on the right of Figure 6.1). The idea here is simple: if country X
suffers a higher rate of inflation than country Y, then the value of X™s currency will de-
cline relative to Y™s. The decline in value shows up in the spot exchange rate for X™s cur-
But let™s slow down and consider why changes in inflation and spot interest rates are
linked. Think first about the prices of the same good or service in two different coun-
tries and currencies.
Suppose you notice that gold can be bought in New York for $300 an ounce and sold
in Mexico City for 4,000 pesos an ounce. If there are no restrictions on the import of
gold, you could be onto a good thing. You buy gold for $300 and put it on the first plane
to Mexico City, where you sell it for 4,000 pesos. Then (using the exchange rates from
Table 6.5) you can exchange your 4,000 pesos for 4,000/9.438 = $424. You have made
a gross profit of $124 an ounce. Of course, you have to pay transportation and insur-
ance costs out of this, but there should still be something left over for you.
You returned from your trip with a sure-fire profit. But sure-fire profits don™t exist”
not for long. As others notice the disparity between the price of gold in Mexico and the

Some simple theories linking
spot and forward exchange Difference in Expected difference
rates, interest rates, and interest rates in inflation rates
inflation rates. 1 rpeso 1 ipeso
1 r$ 1 i$

equals equals

Difference between forward Expected change in
and spot exchange rates spot exchange rates
fpeso/$ E(speso/$)
speso/$ speso/$


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