FIN2101
BUSINESS FINANCE II
Module 11
International Financial
Management
Student Activities
Reading
Text,Chapter 20
Text Study Guide,Chapter 20
Study Book,Module 11
Tutorial Work
Tutorial Workbook,Self Assessment
Activity 11.1
Text Study Guide,Chapter 20,All
Lecture Overview
Foreign exchange (FOREX)
market
Transactions in FOREX market
FOREX rates and quotes
Exchange rate risk
Political risk
International investment and
financing decisions
Relevance of International
Finance
Firms are part of and operate in a
highly globalised and integrated
world economy.
Australian-dollar denominated
financial instruments are traded
among a wider clientele of
international investors and borrowers.
The profitability of Australian
importers and exporters is affected
by exchange rate fluctuations.
FOREX Market
Where FOREX (different currencies)
is (are) traded.
As a result of these transactions,
FOREX rates between different
currencies are determined,for
example,1 AUD / 0.5185 USD.
FOREX management is implemented.
FOREX activities are based on supply
and demand.
Market Characteristics
Largest financial market in the
world – 1.2 trillion USD traded
daily in 2001.
Highly integrated.
Operates 24 hours a day.
London,New York and Tokyo
dominate the market activity
(75% of turnover).
FOREX Market Structure
Two tiers:
Interbank market - wholesale,
large transactions
Retail market - small scale
transactions
Where Is The Market?
An over-the-counter (OTC) market.
There is no one market place.
Transactions occur in trading rooms
by telephone,telex,computer,
automated dealing systems.
Trades must be conducted by
authorised dealers (80-90),licensed
by the RBA.
Market Participants
Bank and non-bank dealers
Individuals and firms -
exporters/importers
Tourists
Speculators/arbitragers
Central banks
FOREX brokers
Transactions in FOREX
Market
Spot transaction
Forward transaction
Swap transaction
Spot Transaction
A FOREX term indicating
settlement will occur in two
business days time.
Forward Transaction
Delivery at a future date of the
specified amount of one currency
for a specified amount of another
currency.
Exchange rate is established at
the time of contract but payment
and delivery not required until
maturity,eg 1,2,3,6,12
months time.
Swap Transaction
Simultaneous sale (or purchase)
of spot foreign exchange against
a forward purchase (or sale) of
approximately an equal amount
of the foreign currency.
Swaps account for about 56% of
interbank FOREX trading.
FOREX Rates and Quotes
The vehicle currency (or unit
currency) is the currency being
traded.
1 AUD/0.5185 USD,the AUD is being
traded and is the unit currency.
1 USD/1.9286 AUD,the USD is the
unit currency.
FOREX Rates and Quotes
Indirect
home currency is the vehicle or
unit currency (the currency
being traded)
Direct
foreign currency is the vehicle
or unit currency
Conversion of Quotes
1 AUD / 0.5185 USD
1 USD / (1/0.5185) AUD
1 USD / 1.9286 AUD
Currency Appreciation
Currency strengthens relative to
other currencies.
If AUD appreciates relative to USD,it
takes more USD to buy AUD.
The same as USD depreciating
relative to the AUD.
Example,1 AUD / 0.5185 USD to 1
AUD / 0.5205 USD
Currency Depreciation
A currency weakens relative to other
currencies.
If AUD depreciates relative to the
USD,it takes fewer USD to buy AUD.
The same as the USD appreciating
relative to the AUD.
Example,1 AUD / 0.5185 USD to 1
AUD / 0.5125 USD
Bid/Offer Rates (Retail Market)
When conducting a FOREX
transaction,you will generally be
presented with two rates,the BID
(buy) rate and the OFFER (sell) rate.
In the RETAIL market,the quotes
are from your point of view.
Bid/Offer Rates (Retail Market)
Bid Offer
1 AUD / 0.5215 - 0.5185 USD
In the RETAIL market you can buy 1 AUD
for 0.5215 USD,or sell 1 AUD for 0.5185 USD.
Dealer will BUY LOW,SELL HIGH.
Bid/Offer Rates (Interbank
Market)
1 AUD / 0.5185 - 0.5215 USD
The dealer will buy AUD off you @ 0.5185,
and sell AUD to you @ 0.5215.
Example 1
Retail market quote:
1 AUD / 0.5215 - 0.5185 USD.
You are an exporter who has just
received 1 million USD.
How much AUD will you receive?
Example 1 Solution
You will be selling your USD to the
dealer and buying AUD.
Therefore use the bid rate of 0.5215.
To convert USD to AUD,1 000 000
USD / 0.5215 = 1 917 546 AUD.
Example 2
Retail market quote:
1 AUD / 0.5215 - 0.5185 USD.
You are an importer who has to
pay 1 million USD.
How many AUD will you need?
Example 2 Solution
You will be buying USD,by selling
AUD to the dealer.
Therefore use the OFFER rate of
0.5185.
To convert AUD to USD,1 000 000
USD / 0.5185 = 1 928 640 AUD.
If you had 1 928 640 AUD and
needed to convert to USD,sell AUD
using offer rate 0.5185 = 1 928 640
AUD x 0.5185 = 1m USD.
Forward Exchange Rates
Quoted 3 different ways:
Outright
Points basis
Percentage premium or discount
per annum (not concerned with)
Outright Forward Rates
Full bid and offer rates to all decimal
points (same as spot rate).
For example,a 3 month forward rate:
1 AUD / 0.5185 - 0.5245 USD
Can be > or < spot rates.
Outright Forward Rates
Forward Premium
When one unit of unit currency is
worth more forward than it is
spot.
Forward Discount
When one unit of unit currency is
worth less forward than it is spot.
Example
Spot 1 AUD / 0.5185 - 0.5215 USD
3 mth Forward 1 AUD / 0.5205 - 0.5295 USD
The AUD is at a premium in the forward
market,(The USD is at a discount in the
forward market).
Forward Points
Forward rates can be quoted as
points,showing the difference
between the forward and spot rates.
A point is 0.0001.
100 points equals 1 cent.
Example
Spot 1 AUD / 0.5185 - 0.5215 USD
3 mth Forward 0.0035 - 0.0045
3 mth Outright Fwd:
1 AUD / 0.5220 - 0.5260 USD
Forward Points
RULE
If points are ascending,ADD to spot rate.
If points are descending,DEDUCT from
the spot rate.
Exchange Rate Risk
Exchange rate risk exists when there is
the potential for unanticipated changes in
an exchange rate to affect the value of the
company.
Any firm that is involved in exporting or
importing will be exposed to exchange
rate risk.
A depreciation of the AUD will increase the
price (in AUD terms) of imports if the price
is fixed in say USD.
An appreciation of the AUD will reduce an
exporter?s profits in AUD terms if the
invoice price is fixed say in USD.
Causes of Exchange Rate
Fluctuations
Inflation rates
Exchange rates will move so that
currencies will have the same
purchasing power – purchasing power
parity (PPP).
Interest rates
The expected movement in an exchange
rate should equalise the effective
interest rates between the two countries
(IRP).
Causes of Exchange Rate
Fluctuations
Terms of trade
An improvement in a country?s ratio of export
prices to its import prices will tend to increase
its net export income and strengthen the value
of its currency.
Current account balance
Countries with an accumulated current account
deficit have?weak? exchange rates.
Central bank trading
Central banks intervene when they are
concerned about the market for the currency
and when they believe that the exchange rate
is impacting adversely on monetary policy.
Effects of Exchange Rate Risk
Economic exposure
The impact on the value of the firm of
exchange rate variations.
Accounting (translation)
exposure
The impact of exchange rate changes on
financial statement items denominated
in foreign currencies.
AASB 1012,Foreign Currency
Translation.
Risk Management
Hedging is a strategy that will
ensure that the Australian dollar
value of a commitment to pay or
receive a sum of foreign currency in
the future is not affected by changes
in the exchange rate.
Hedging involves taking another,
offsetting,commitment in the same
foreign currency.
Forward Hedge
An Australian importer is committed to
paying a future sum in UK pounds,This is
effectively a commitment to buy UK
pounds in the future.
By entering into a forward contract today
to buy UK pounds in the future,the value
of the commitment can be fixed in
Australian dollar terms.
In this case,the future outflow of UK
pounds required by the import contract is
matched by the future inflow of UK
pounds required by the forward contract.
Money Market Hedge
Involves borrowing in one currency
and exchanging the proceeds for
another currency.
If the transaction to be hedged is a
foreign currency receipt,borrow in
the foreign currency.
If the transaction is a foreign
currency payment,borrow in the
home currency.
Example 11.6 in the Study Book.
Political Risk
Multinationals are exposed to
political risk which refers to,the
implementation by a host
government of specific rules and
regulations that can result in the
discontinuity or seizure of the
operations of a foreign company in
that country” (Gitman,p,743).
Macro vs micro political risk.
Text,pp,743-4.
International Investment
Decisions
Generally use the same approach as
that used to evaluate domestic
investment proposals (Study Book,
pp,11.14-11.17).
Identify the relevant cash flows and
discount them at the firm?s WACC or
the project?s required rate of return
to determine the NPV.
International Investment
Decisions
Either estimate cash flows in the
foreign currency and discount at the
appropriate (foreign) discount rate.
Or translate foreign cash flows to
domestic currency cash flows and
discount at the domestic required
rate of return.
Modes of Foreign Investment
Joint venture with local partner(s).
100% owned greenfield (newly
established) foreign subsidiary.
Merger with,or acquisition of,an
existing local firm.
Strategic alliance with one or more
partners.
Study Book,pp,11.16-11.17.
International Financing
Decisions
Raise the funds in the home country.
Borrow funds in the foreign country.
Borrow in a third country.
Raise equity funds in offshore market.
Study Book,pp,11.18-11.19.
Exam Format
Section A
30 multiple choice questions (theory &
practical).
30 marks/30%.
Section B
6 questions (1 @ 5,1 @ 6,1 @ 7,1 @ 9,
1 @ 11,1 @ 12).
Some questions have a short-answer part.
50 marks/50%.