LECTURE 9 Flashcards
(19 cards)
importer-exporter dilemma
US importer: weaker $ = more expensive to import
Foreign exporter to US: get less money when convert $ back to €
3 ways to reduce ER risk
- Hedge with forwards contracts
- Cash and carry strategy
- Hedge with currency options
Currency forward =
An agreement between 2 parties to trade currency on some future date at an ER that is locked in now.
Futures vs forwards
Forwards = name of contract, OTC, cannot tarde Futures = on exchange, anonymous, can trade
3 steps to cash and carry
- Borrow FC today using 1-year loan at foreign IR
- Convert immediately to DC at spot ER
- Invest DC at domestic IR and carry until next period
cash and carry are profitable for…
Banks as can borrow easily at low transaction costs
2 ways to value foreign projects
- Discount foreign cash flows by foreign cost of K then convert to $ at spot ER
- Convert foreign future cash flows to domestic at forward ER then discount using domestic cost of K
What does CIRP imply?
No arbitrage opportunity - cannot profit from moving capital from low to high IR country as spot and froward ER change to offset
CIRP vs UIRP
Covered = forward rate Uncovered = no forward contract, use expected future spot rate
3 assumptions behind IR parity
- Internationally integrated K markets
- Free K mobility
- perfect sub domestic and foreign assets
Define Internationally integrated K markets
an investor can exchange currencies in any amount at the spot or forward rates & it is free to purchase or sell any security in any amount in any country at its current market price. Value of investment doesn’t depend on currency used.
What is the WACC method of valuing foreign projects?
Convert foreign future cash flows to domestic at forward ER then discount using domestic rWACC
What 3 things do we need to find foreign rWACC i.e. foreign denominated cost of K?
- Domestic rWACC
- Domestic rF
- Foreign rF
Foreign rWACC formula + simplification
(1 + rWACCf) = (1 + rff/1+rfd)* (1+rWACCd)
foreign rWACC = foreign rF + [domestic rWACC - domestic rF]
When to exercise currency call option?
When spot ER > K so that would have to give up more $ to get €1 at market than under strike rate.
2 reasons to use options over forwards
- Can still benefit if market moves favourably
2. The transaction they’re hedging might not end up taking place
3 reasons for internationally segmented K markets
- K controls
- forex controls
- political, social, cultural reasons across countries that may require country risk premium.
Differential access to K markets are the best reason for the existence of what?
currency swaps = a contract in which parties agree to exchange coupon payments and final face value that are in different currencies
What does segmented K markets mean for CIRP?
IT may NOT hold - firms may be able to benefit from higher ROR in another country, even after both in same currency.
