Week 5: International Financial Management (Learn how companies decide if… Coggle
Week 5: International Financial Management (Learn how companies decide if…
Learn how companies decide if they should invest overseas, and how they manage international risks. Currency values change and many countries are unstable. Is the potential profit from international investing worth the risk?
Explain how exchange rates work.
Discuss Interest Rate Parity (IRP) and Purchasing Power Parity (PPP)
Analyze international risks.
The current floating exchange rate system came into use after the breakdown of the Bretton Woods Agreement in the early 1970s.
Under the Bretton Woods agreement, the U.S. dollar had been pegged to gold at $35/ounce and all of the world’s major currencies had been pegged to the U.S. dollar.
The Federal Reserve printed more dollars than it had gold to back to finance expenses such as the Vietnam War and Lyndon Johnson’s Great Society Program.
Richard Nixon announced the United States’ default on the international gold standard in 1971.
Spot Currency Exchange Examples
Consider two different stable currencies such as the euro and the U.S. dollar and investments in short-term risk-free government debt in Europe and the United States.
FV($) = PV($) (1 + R$ rf) = PV($) S(euro/$) * (1 + Reurorf)/F(euro/$)
PV($) is the initial investment in dollars
FV($) is the future value in dollars
R$ rf is the risk free rate in dollars
R euro rf is the risk free rate in euros
S(euro/$) is the spot exchange rate between Euros and dollars
F(euro/$) is the future exchange rate between Euros and dollars
IRP Equation:
used to hedge overseas investments and try to predict future exchange rate movements.
F(euro/$) = S(euro/$) (1 + Reurorf)/ (1 + R$rf)
If one invests PV($) in risk-free treasury bills, the future dollar amount FV($) is risk-free.
Similarly, if one converts PV($) to euros at the spot exchange rate S(euro/$), invests in risk-free euro debt, and signs a futures contract to convert the euros back to dollars at a future exchange rate of F(euro/$, the investment is also basically risk-free.
This is because the major exchanges such as the Chicago Board of Trade (CBOT) have never defaulted on a futures contract.
Over time, costs in high cost countries tend to drop and costs in low cost countries tend to increase as individuals and companies figure out ways of getting around legal restrictions.
Examples include moving factories outside the United States, traveling outside the U.S. for health care, and Mexican labor sneaking over the U.S. border.
A common mechanism to attempt to compare violations of PPP worldwide is the Big Mac Index that shows the price of a Big Mac in many countries.
The price will be influenced by both the cost of food and the cost of labor.
Six most expensive countries according to the Big Mac Index
Big Mac Index Least Expensive
Pdollar = S(dollar/euro) * Peuro
Pdollar = Price item of US Dollar
Peuro = Price item of Euro
S(dollar/euro) = Spot exchange rate between US Dollar & Euro
The Idea of Purchasing Power Parity (PPP) is that products should cost the same all over the world.
In a free market, if this were not true, arbitrage would take place (i.e. goods and services would be purchased in one location and moved to another location for a profit).
Adam Smith discussed this in his book, Wealth of Nations, in 1776. If gold was more expensive in one country than another, it would be purchased in the cheap location and shipped to the more expensive location.
Hence the price of a product in dollars should equal the price of the same product in euros times the exchange rate.
General Untrue
Because currencies can generally move freely from one country to another, but people and products cannot.
Pharmaceuticals and physician’s services are much cheaper overseas than in the United States, but it is illegal to buy drugs overseas and sell them in the United States. Clothing and electronics are commonly much cheaper in the United States than in Africa or the Middle East, but there are many restrictions on buying these products in the U.S. and selling them in those locations. There are also restrictions on cheap labor moving from India or Mexico to the United States.
Index of Economic Feedom
When Investing in different countries businesses must consider the cost of taxation and the risks of not getting their investments back. A common starting point when examining these risks are the various Indexes of Economic Freedom which examine issues such as a company’s:
On average, the more economic freedom a country possess, the easier it is to start and operate a business in that country.