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there is a 20 percent chance that KW™s cash flow may be expropriated without com-
pensation. The expected cash flow is not L2.5 million but .8 — 2.5 million = L2.0 mil-
The end result may be the same if you pretend that the expected cash flow is L2.5
million but add a fudge factor to the discount rate. Nevertheless, adjusting cash flows
brings management™s assumptions about “political risks” out in the open for scrutiny
and sensitivity analysis.

What is the difference between spot and forward exchange rates?
The exchange rate is the amount of one currency needed to purchase one unit of another
currency. The spot rate of exchange is the exchange rate for an immediate transaction. The
forward rate is the exchange rate for a forward transaction, that is, a transaction at a
specified future date.

What are the basic relationships between spot exchange rates, forward exchange
rates, interest rates, and inflation rates?
To produce order out of chaos, the international financial manager needs some model of the
relationships between exchange rates, interest rates, and inflation rates. Four very simple
theories prove useful:

• In its strict form, purchasing power parity states that $1 must have the same purchasing
power in every country. You only need to take a vacation abroad to know that this doesn™t
square well with the facts. Nevertheless, on average, changes in exchange rates match
differences in inflation rates and, if you need a long-term forecast of the exchange rate, it
is difficult to do much better than to assume that the exchange rate will offset the effect
of any differences in the inflation rates.
• In an open world capital market real rates of interest would have to be the same. Thus
differences in nominal interest rates result from differences in expected inflation rates.
This international Fisher effect suggests that firms should not simply borrow where
interest rates are lowest. Those countries are also likely to have the lowest inflation rates
and the strongest currencies.
• Interest rate parity theory states that the interest differential between two countries
must be equal to the difference between the forward and spot exchange rates. In the
international markets, arbitrage ensures that parity almost always holds.
• The expectations theory of exchange rates tells us that the forward rate equals the
expected spot rate (though it is very far from being a perfect forecaster of the spot rate).

What are some simple strategies to protect the firm against exchange rate risk?
Our simple theories about forward rates have two practical implications for the problem of
hedging overseas operations. First, the expectations theory suggests that hedging exchange
risk is on average costless. Second, there are two ways to hedge against exchange risk”one
is to buy or sell currency forward, the other is to lend or borrow abroad. Interest rate parity
tells us that the cost of the two methods should be the same.

How do we perform an NPV analysis for projects with cash flows in foreign cur-

Overseas investment decisions are no different in principle from domestic decisions. You
need to forecast the project™s cash flows and then discount them at the opportunity cost of
capital. But it is important to remember that if the opportunity cost of capital is stated in
dollars, the cash flows must also be converted to dollars. This requires a forecast of foreign
exchange rates. We suggest that you rely on the simple parity relationships and use the
interest rate differential to produce these forecasts. In international capital budgeting the
return that shareholders require from foreign investments must be estimated. Adding a
premium for the “extra risks” of overseas investment is not a good solution.

www.cme.com/eurofx/ The Chicago Mercantile Exchange™s information center on managing Eu-
Related Web ropean foreign exchange risk with Euro contracts
Links www.bloomberg.com/markets Data on current exchange rates as well as securities
www.ms.com/msci.html Information for global investing from Morgan Stanley Capital Interna-
www.global-investor.com Global Investor Directory with information about major international
www.emgmkts.com/index.htm Analysis of economic, political, and financial events in emerg-
ing markets
www.jpmorgan.com/research Information about emerging markets
www.florin.com/v4/valore4.html Issues in currency risk management

exchange rate law of one price international Fisher effect
Key Terms
spot rate of exchange purchasing power parity interest rate parity
forward exchange rate (PPP) expectations theory of exchange rates

1. Exchange Rates. Use Table 6.5 to answer these questions:
a. How many euros can you buy for $100? How many dollars can you buy for 100 euros?
b. How many Swiss francs can you buy for $100? How many dollars can you buy for 100
Swiss francs?
c. If the euro depreciates with respect to the dollar, will the direct exchange rate quoted in
Table 6.5 increase or decrease? What about the indirect exchange rate?
d. Is a United States or an Australian dollar worth more?

2. Exchange Rate Relationships. Look at Table 6.5.

a. How many Japanese yen do you get for your dollar?
b. What is the 1-year forward rate for the yen?
c. Is the yen at a forward discount or premium on the dollar?
d. Calculate the annual percentage discount or premium on the yen.
e. If the interest rate on dollars is 6.5 percent, what do you think is the interest rate on yen?
f. According to the expectations theory, what is the expected spot rate for the yen in 1 year™s
g. According to purchasing power parity, what is the expected difference in the rate of price
inflation in the United States and Japan?

3. Exchange Rate Relationships. Define each of the following theories in a sentence or sim-
ple equation:
International Financial Management 619

a. Interest rate parity theory.
b. Expectations theory of forward rates.
c. Law of one price.
d. International Fisher effect (relationship between interest rates in different countries).

4. International Capital Budgeting. Which of the following items do you need if you do all
your capital budgeting calculations in your own currency?

Forecasts of future exchange rates
Forecasts of the foreign inflation rate
Forecasts of the domestic inflation rate
Foreign interest rates
Domestic interest rates
5. Foreign Currency Management. Ms. Rosetta Stone, the treasurer of International Reprints,
Inc., has noticed that the interest rate in Switzerland is below the rates in most other coun-
tries. She is therefore suggesting that the company should make an issue of Swiss franc
bonds. What considerations ought she first take into account?
6. Hedging Exchange Rate Risk. An importer in the United States is due to take delivery of
silk scarves from Europe in 6 months. The price is fixed in euros. Which of the following
transactions could eliminate the importer™s exchange risk?

a. Buy euros forward.
b. Sell euros forward.
c. Borrow euros, buy dollars at the spot exchange rate.
d. Sell euros at the spot exchange rate, lend dollars.

7. Currency Risk. Sanyo produces audio and video consumer goods and exports a large frac-
Practice tion of its output to the United States under its own name and the Fisher brand name. It
Problems prices its products in yen, meaning that it seeks to maintain a fixed price in terms of yen.
Suppose the yen moves from ¥108.02/$ to ¥100/$. What currency risk does Sanyo face?
How can it reduce its exposure?
8. Managing Exchange Rate Risk. A firm in the United States is due to receive payment of
1 million Australian dollars in 8 years™ time. It would like to protect itself against a decline
in the value of the Australian dollar but finds it difficult to arrange a forward sale for such
a long period. Is there any other way that it can protect itself?
9. Interest Rate Parity. The following table shows interest rates and exchange rates for the
U.S. dollar and Mexican peso. The spot exchange rate is 9.5 pesos per dollar. Complete the
missing entries:

1 Month 1 Year
Dollar interest rate (annually compounded) 5.5 7.0
Peso interest rate (annually compounded) 20% ___
Forward pesos per dollar ____ 11.2

Hint: When calculating the 1-month forward rate, remember to translate the annual interest
rate into a monthly interest rate.
10. Exchange Rate Risk. An American investor buys 100 shares of London Enterprises at a
price of £50 when the exchange rate is $1.60/£. A year later the shares are selling at £52. No
dividends have been paid.

a. What is the rate of return to an American investor if the exchange rate is still $1.60/£?
b. What if the exchange rate is $1.70/£?
c. What if the exchange rate is $1.50/£?

11. Interest Rate Parity. Look at Table 6.5. If the 3-month interest rate on dollars is 6.0 percent
(annualized), what do you think is the 3-month sterling (U.K.) interest rate? Explain what
would happen if the rate were substantially above your figure. Hint: In your calculations re-
member to convert the annually compounded interest rate into a rate for 3 months.
12. Expectations Theory. Table 6.5 shows the 1-year forward rate on the Canadian dollar.

a. Is the Canadian dollar at a forward discount or a premium on the U.S. dollar?
b. What is the annualized percentage discount or premium?
c. If you have no other information about the two currencies, what is your best guess about
the spot rate in 1 year?
d. Suppose that you expect to receive 100,000 Canadian dollars in 1 year. How many U.S.
dollars is this likely to be worth?

13. Interest Rate Parity. Suppose the interest rate on 1-year loans in the United States is 5 per-
cent while in the United Kingdom the interest rate is 6 percent. The spot exchange rate is
$1.55/£ and the forward rate is $1.54/£. In what country would you choose to borrow? To
lend? Can you profit from this situation?
14. Purchasing Power Parity. Suppose that the inflation rate in the United States is 4 percent
and in Canada it is 5 percent. What would you expect is happening to the exchange rate be-
tween the United States and Canadian dollars?
15. Cross Rates. Look at Table 6.5. How many Swiss francs can you buy for $1? How many yen
can you buy? What rate do you think a Japanese bank would quote for buying or selling
Swiss francs? Explain what would happen if it quoted a rate that was substantially less than
your figure.
16. International Capital Budgeting. Suppose that you do use your own views about exchange
rates when valuing an overseas investment proposal. Specifically, suppose that you believe
that the leo will depreciate by 2 percent per year. Recalculate the NPV of KW™s project.
17. Currency Risk. You have bid for a possible export order that would provide a cash inflow
of ∼1 million in 6 months. The spot exchange rate is ∼1.06/$ and the 1-year forward rate is
∼1.07/$. There are two sources of uncertainty: (1) the euro could appreciate or depreciate,
and (2) you may or may not receive the export order. Illustrate in each case the profits or
losses that you would make if you sell ∼1 million forward by filling in the following table.
Assume that the exchange rate in 1 year will be either ∼1.02/$ or ∼1.12/$.

Spot Rate Receive Order Lose Order
∼1.12/$ __________ __________
∼1.02/$ __________ __________

18. Managing Currency Risk. General Gadget Corp. (GGC) is a United States“based multi-
national firm that makes electrical coconut scrapers. These gadgets are made only in the
United States using local inputs. The scrapers are sold mainly to Asian and West Indian
countries where coconuts are grown.

a. If GGC sells scrapers in Trinidad, what is the currency risk faced by the firm?
b. In what currency should GGC borrow funds to pay for its investment in order to mitigate
its foreign exchange exposure?
International Financial Management 621

c. Suppose that GGC begins manufacturing its products in Trinidad using local (Trini-
dadian) inputs and labor. How does this affect its exchange rate risk?

19. Currency Risk. If investors recognize the impacts of inflation and exchange rate changes
on a firm™s cash flows, changes in exchange rates should be reflected in stock prices. How
would the stock price of each of the following Swiss companies be affected by an unantici-
pated appreciation in the Swiss franc of 10 percent, only 2 percent of which could be justi-
fied by comparing Swiss inflation to that in the rest of the world?

a. Swiss Air: More than two-thirds of its employees are Swiss. Most revenues come from in-
ternational fares set in U.S. dollars.
b. Nestl©: Fewer than 5 percent of its employees are Swiss. Most revenues are derived from
sales of consumer goods in a wide range of countries with competition from local pro-
c. Union Bank of Switzerland: Most employees are Swiss. All non“Swiss franc monetary
positions are fully hedged.

20. International Capital Budgeting. An American firm is evaluating an investment in In-
Challenge donesia. The project costs 500 billion Indonesian rupiah and it is expected to produce an in-
Problem come of 250 billion Indonesian rupiah a year in real terms for each of the next 3 years. The
expected inflation rate in Indonesia is 12 percent a year and the firm estimates that an ap-
propriate discount rate for the project would be about 8 percent above the risk-free rate of
interest. Calculate the net present value of the project in U.S. dollars. Exchange rates are
given in Table 6.5. The interest rate is about 15.3 percent in Indonesia and 6 percent in the
United States.

1 Direct quote: $1.0707/
Solutions to Indirect quote: 1/1.0707 = .934/$.
Self-Test Indirect quote: ¥107.520/$
Direct quote: $.0093/¥
Questions 2 The dollar buys fewer Swiss francs, so the franc has appreciated with respect to the dollar.
3 a. 1,500/1.4865 = $1,009
Indirect exchange rate: $1 = .9 — 1.4865 = 1.3379 francs.
c. 1,500/1.3379 = $1,121. The dollar price increases.
1,009 — 1.3379 = 1,350 francs.

4 a. £220 = $330. Therefore £1 = 330/220 = $1.50.
b. In the United States, price = $330 — 1.02 = $336.60. In Great Britain, price = £220 — 1.05
= £231. The new exchange rate = $336.60/£231 = $1.457/£.
c. Initially $1 buys 1/1.50 = £.667. At the end of the year, $1 buys 1/1.457 = £.686, which
is about 3 percent higher than the original value of £.667.
5 The real interest rate in the United States is 1.06/1.02 “ 1 = .039, or 3.9%. If the real rate


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