Chapter 17International Business FinanceChapter ObjectivesGlobalization of Products and Financial MarketsInternational Financial InvestmentExchange RatesEuroland and the EurodollarRationale for EurodollarForeign Exchange MarketSpot Exchange RatesSlide 11Indirect QuoteDirect and Indirect Exchange RatesSlide 14Exchange Rates and ArbitrageArbitrageAsked and Bid RatesExchange Rate TermsExchange Rate RiskExchange Rate Risk in Foreign Portfolio InvestmentsExchange Rate Risk in Direct Foreign InvestmentExchange Rate Risk in International Trade ContractsInterest-Rate Parity TheoryPurchasing-Power Parity Theory (PPP)PPPExposure to Exchange Rate RiskDirect Foreign InvestmentChapter 17Chapter 17International Business International Business FinanceFinanceChapter ObjectivesChapter ObjectivesInternationalization of businessWhy foreign exchange rates in two different countries must be in line with each otherInterest rate parityPurchasing-power parity and the law of one priceExchange rate risk Working-capital managementFinancing sources available to multinational corporationsDirect foreign investmentGlobalization of Products and Globalization of Products and Financial MarketsFinancial MarketsDirect InvestmentWhen the multinational corporation (MNC) has control over the investment such as building an offshore manufacturing facilityPortfolio investmentFinancial assets with maturities greater than 1 year such as purchase of foreign stock and bondsTotal foreign investment in the U.S. now exceeds such U.S. investment overseasInternational Financial International Financial InvestmentInvestmentEarn higher returns than those obtainable in the domestic capital marketsReduce portfolio risk through international diversificationExchange RatesExchange RatesFloating-rate international currency system–A system in which exchange rates between different national currencies are allowed to fluctuate with supply and demand conditions.Short-term day to day fluctuations in exchange rates are caused by changing supply and demand conditions in the foreign exchange marketEuroland and the EurodollarEuroland and the EurodollarJan 2002, 11 countries in the European Union began circulating a new single currency, the Euro.These countries are often referred to as “Euroland”Include: Germany, France, Italy, Spain, Portugal, Belgium, Netherlands, Luxembourg, Ireland, Finland and AustriaGermany and France account for over 50 percent of Euroland’s outputRationale for EurodollarRationale for EurodollarEase in travel across national bordersEliminates exchange costsEliminates the uncertainty associated with exchange rate fluctuationsCost differences for goods in different countriesEasier to compare prices and reduce the discrepanciesForeign Exchange MarketForeign Exchange MarketOperates at three levels:–Customers buy and sell foreign exchange through their banks–Banks buy and sell foreign exchange from other banks in the same commercial center–Banks buy and sell foreign exchange from banks in commercial centers i.e. New York, London, Zurich, Frankfurt, Hong Kong, Singapore, TokyoSpot Exchange RatesSpot Exchange RatesExchange rate–The price of foreign currency in terms of the domestic currencySpot Transactions–When one currency is traded for another currency, today–Rates are typically “Direct Quotes”Direct Quotes–indicates the number of units of the home currency required to buy one unit of the foreign currencyDollar/foreign currency rate ($/FC)Exchange RatesExchange RatesIf an American company must pay DM 2,000 to a German firm, how many dollars will be required?$.449 = DM 1Need DM 2,000.449 X 2,000 = $898Indirect QuoteIndirect QuoteIndicates the number of units of a foreign currency that can be bought for one unit of the home currencyGeneral method used in the over-the-counter marketForeign currency/dollar (FC/$)Reciprocal of a direct quoteDirect and Indirect Exchange Direct and Indirect Exchange RatesRatesExample:Calculate the indirect quote from the direct quote of spot rateGerman Mark .44901/direct quote = indirect quote1/.4490 = 2.227Exchange RatesExchange RatesIf an American company must pay $2,000 to a German Firm, how many marks will the German Company receive?Indirect rate = 2.2272.227 X $2,000 = DM 4,454Exchange Rates and ArbitrageExchange Rates and ArbitrageForeign exchange quotes in two different countries must be in line with each other If the exchange rates are out of line, a trader could make a profit by buying in the market where the currency was cheaper and selling it in the otherArbitrage The process of buying and selling in more than one market to make a riskless profitTypes of Arbitrage: Simple, Triangular, Covered-interestArbitrageArbitrageSimple–Eliminates exchange rate differentials across the markets for a single currencyTriangular –Eliminates exchange rate differentials across the markets for all currenciesCovered-interest–Eliminates differentials across currency and interest rate marketsAsked and Bid RatesAsked and Bid RatesAsked rate–Rate the bank of 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.–Also know as selling rate or offer rateBid Rate–The rate at which the bank buys the foreign currency from the customer by paying in home currency–Also know as buying rateBid-Asked Spread–The difference between the asked quote and the bid quoteExchange Rate TermsExchange Rate TermsCross rates–The computation of an exchange rate for a currency from the exchange rates of two other currenciesForward Exchange contract–Requires delivery at a specified future date of one currency for a specified amount of another currency –The exchange rate for the forward transaction is agreed up today; the actual payment of one currency and receipt of another currency take place at the future date–The forward rate is often quoted at a premium or a discount from the existing spot rate–The premium or discount is also call the forward-spot differentialExchange Rate RiskExchange Rate RiskThe risk that tomorrow’s exchange rate will differ from today’s rateExamples:–Exchange rate risk in international trade contracts–Exchange rate risk in foreign portfolio investments–Exchange rate risk in direct