Finance 476

Instructor:

Greg MacKinnon

Introduction

Introduction

• “International Finance” versus “Domestic Finance”

- main difference is exchange rates

1) How do exchange rates affect firms and investors?

2) What factors cause exchange rates to change?

3) How can firms/investors insulate themselves from changes in exchange rates?

4) What opportunities do the international financial markets present?

What is an exchange rate?• Exchange rate is a price

• price of a foreign currency

Example:Canada-US exchange rate = 1.3713 $Can/$US (Sept. 8, 2003)

“Price” of a $US is $1.3713 Can.

Can$/US$7292.03713.1

1 = “price” of a $Can (in $US)

QuestionQuestion: Is a higher Canadian dollar good or bad for Canada?

Effect of Currency Fluctuations on Investors: Example

Since beginning of 2003, through September 8:TSX Composite (Canada) return = 15.1%S&P 500 return (US) return = 16.1%

As of January 2, 20031.5787 $Can/$US

As of September 8, 20031.3713 $Can/$US

Canadian invested $1000 Can in the US markets at beginning of the year.

Example (cont.)Amount invested in US markets:

Has now grown to:

US41.735$161.1US43.633$

US43.633$Can$

US$

5787.1

1Can1000$

In Canadian dollars, this is worth:

.Can47.1008$US$

Can$3713.1US41.735$

Investors return in Canadian dollar terms:

%85.01000

100047.1008

Example (cont.)

Currency changes almost wiped out investor’s return.

Foreign investment is always investment in two things:- the asset being invested in- the currency of the foreign country

Another way to see same effect in the example:

Percentage change in $US since start of year=

%14.135787.1

5787.13713.1

Example (cont.)

Return in $Can terms = (1.161)(1-0.1314)-1= 0.85% (slightly different due to rounding)

What if opposite example? US investor puts money into Canadian stocks at start of year. How have they done?

Percentage change in $Can (versus $US):

%12.15

5787.1

15787.1

1

3713.1

1

Example (cont.)

13.14% depreciation in $US is equivalent to 15.12% appreciation in $Can.

- Strange but true.

Return on TSX Composite in $US terms = (1.151)(1.1512) –1 = 32.5%

ConclusionConclusion:: Currency swings can have huge effect on outcomes when investing internationally.

Example: Canadian firm selling in Europe, annual sales of 10,000,000 euros

January 2003:Sales convert to

$16.5 million

September 2003:Sales convert to

$15.1 million

• $1.4 million decline in revenue, when unit sales have not changed!

Canadian retailer: buys $25,000 US in goods each month

June 2003:costs

$33,250 Can.

September 2003:costs

$34,500 Can.

• costs have increased $1250 Can. per month

Exchange Rate Risk

• Volatility of currencies creates risk.

• Could be good / could be bad• uncertainty in the outcome = risk

Primary Cause of Exposure to Exchange Rates:

Mismatch of Revenues and Costs• MacKay Bridge

• financed with German Marks• Mark appreciates

• refinance with Swiss Francs• Franc appreciates

• when finally refinanced with dollars (1991), owed more than had initially borrowed

“Natural Hedge”• structure company to reduce currency risk

• try to match currencies of revenues and costs

• Example:

• Canadian firm starting business in Japan:

• finance new business in yen• revenues and costs (interest payments) are both in yen• reduces (but does not eliminate) exposure

• overseas employees?• Pay them in the local currency?

• Example: Japanese expansion

• send employees to Japan• pay in yen

• BUT...shifts risk to the employees!

• Risks faced by employees is commonly overlooked.

Simplified Numerical Example

• Canadian firm starting operations in Japan

• borrows $1,000,000 @ 10% to finance• interest of $100,000 (only cost)• revenue of ¥9,000,000

• exchange rate = 77.68543 ¥ per $Can.

• convert revenue to $Can. = $115, 852• profit = $15,852 per year

• BUT…what of ¥ depreciates to 85 ¥ per $Can?

• Revenue now only convertible into $105, 852• profit = $5882

• major fall in profit because the value (in $Can) of revenue fell while costs (interest) stayed the same

• When financing operations initially, what if had financed in ¥?• Borrow ¥77,685,430 @ 10% (same interest rate?)

•revenue: ¥9,000,000 •costs: ¥7,768,543• profit: ¥1,231,457

• only have to worry about converting the net amount

• if at 77.68543 ¥ per $, profit = $15,852• if at 85 ¥ per $, profit = $14,487

• Profits are much more stable and predictable.

Considerations in Financing in Foreign Currencies:

• can help reduce “income statement risk”• BUT…may create “balance sheet risk”

• firm has access to foreign currency loans?• “currency swaps” may help (talk about later in course)

Pricing strategy and Natural Hedge

• selling to foreign buyers

• can you price in Canadian dollars?•depends on industry

• Dow Chemical (1992)• prices all European goods in Marks• shifts risk to customers• marketing problems!

A “Typical” International Transaction

• How exactly is an international transaction (import or export)conducted?

• most transactions share some common elements• a standard manner to effect payment for goods shipped across borders

• a system of international payments has developed to protect both importers and exporters

A “Typical” International Transaction

• look at the mechanics of a “typical” transaction

• most important thing is the documents used

• there are many, many variations on this process

• every transaction is different

First Step - Sales Agreement

• importer in one country and exporter in another agree to sale of goods

Second Step- Letter of Credit

• Importer applies to its bank (call it Bank of Importer) for aletter of credit

• letter of credit = document that states the Bank of Importer promises to pay exporter a certain amount upon presentation of certain documents

• the documents that are required to get payment areones which show the goods have been shipped and meet the terms of the agreement

Second Step- Letter of Credit (cont.)

• importer will have to pay a fee to get letter of credit

• Note: importer applies to its bank for a letter of credit, but once it is drawn up it is really a contract betweenBank of Importer and the exporter

• as part of the letter of credit agreement, importer must sign promissory note payable to Bank of Importer upon payment by bank on the letter of credit

Second Step- Letter of Credit (cont.)

• letter of credit essential link in international trade

• creditworthiness of importer no longer a concern • Bank of Importer guarantees payment• protects exporter

• Bank of Importer only makes payment when documents show correct goods have been shipped

• protects importer

Third Step- Bill of Lading

• after letter of credit is issued, the Bank of Importer will sendit to the Bank of Exporter

• Bank of Exporter will notify exporter that a letter of credit isin place and that the exporter can now ship the goods

•Bill of Lading issued by shipping company, given to exporter• describes what the goods are and shows that they have been delivered to shipping company

Possible Problem

•the letter of credit will require presentation of the Bill of Lading (and possibly other documents) in order to receive payment

• letter of credit must be prepared carefully

• payment on it depends entirely on documents presented

• if documents do not meet requirements of letter of credit, bank will not pay

Fourth Step- Time Draft

• exporter gives Bill of Lading (and any other required documents) and a time draft to Bank of Exporter, who forwards them to Bank of Importer

• time draft = document which officially demands payment on the letter of credit • demands payment after certain period of time (usually 30, 60 or 90 days)

Fifth Step- Acceptance

• Bank of Importer examines Bill of Lading (and any other required documents) and makes sure it matches requirementsof Letter of Credit

• if everything in order, Bank of Importer accepts the time draft

• means that the Bank of Importer now unconditionally guarantees that it will pay the time draft on maturity

• Bank of Importer will charge a fee for accepting a draft (charged to exporter, although may be passed on to Importer through higher price)

Fifth Step- Acceptance (cont.)

Example:

• a time draft is for $100,000 • the bank charges a 1% acceptance fee• after 60 days the bank will pay the exporter

$100,000 - 0.01($100,000) = $99,000

Banker’s Acceptances (BA’s)

• once a time draft is accepted by the bank, it becomes a Banker’s Acceptance

• Bank will pay holder the value (less fee) on maturity

• just like very short term discount bond• exporter can sell it at a discount to an investor in order to get cash now

• BA’s are one of the largest and most active parts of the money market