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The Saudi Vision 2030  is a plan to diversify the economy and develop sectors such as  education, infrastructure, and tourism. The government desires the  encouragement of private investment in a number of sectors of the Saudi  economy and emphasizes economic and investment activities and increasing  non-oil industry trade between countries.

What role do you consider foreign investors play in  achieving this vision this and how should they deal with the exchange  rate risks associated with investing in the Saudi economy?

Chapter 16
International
Business Finance
Learning Objectives
• Discuss the internationalization of business.
• Explain how to read foreign exchange rate
quotes and why they matter.
• Discuss the concept of interest rate parity.
• Explain the purchasing-power parity theory
and the law of one price.
• Discuss the risk that are unique to the
capital-budgeting analysis of direct foreign
investment.
16-2
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THE GLOBALIZATION OF
PRODUCT AND
FINANCIAL MARKETS
16-3
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The Globalization of Product and
Financial Markets
• Direct Foreign Investment (DFI) occurs when a
company from one country makes a physical
investment, such building a manufacturing facility,
in another country. A major reason for increase in
DFI by U.S. companies is the high rate of return
available in other countries.
• Capital flows (Portfolio Investment) between
countries has also been increasing and is motivated
by the possibility of obtaining higher returns and/or
reducing portfolio risk through international
diversification.
16-4
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FOREIGN EXCHANGE
MARKETS AND CURRENCY
EXCHANGE RATES
16-5
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The Foreign Exchange Market
• The foreign exchange (FX) market is by far
the world’s largest financial market, with
daily trading volumes of more than $4
trillion.
• Trading in this market is dominated by few
key currencies including the U.S. dollar, the
British pound sterling, the Japanese yen,
and the euro.
16-6
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The Foreign Exchange Market
• The foreign exchange market is an overthe-counter market with participants
(buyers and sellers) located in major
commercial and investment banks around
the world.
16-7
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16-8
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Foreign Exchange Market
• Some of the major participants in foreign
exchange trading include:
– Importers and exporters of goods and services
– Investors and portfolio managers who purchase
foreign stocks and bonds
– Currency traders who make a market in one or
more foreign currencies
16-9
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Business Implications
• Exchange rates changed dramatically in
2014 and 2015. Possible reasons include:
–
–
–
–
Relative strengthening of U.S. economy
Expectations of interest rate changes in Europe
Uncertainty surrounding a possible Greek default
Plummet of oil prices and sanctions during the
Ukrainian crisis
• Stronger dollar means U.S. goods become
more expensive for foreigners
16-10
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Reading Exchange Rate Quotes
• Exchange rate
– The price of one currency stated in terms of
another.
– For example, if the exchange rate of U.S. dollars
for euro is 1.37 to 1, this means that it would
take $1.37 to purchase one euro.
16-11
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16-12
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Reading Exchange Rate Quotes
• A country’s relative economic strengths,
trade balance, level of monetary activity,
and balance of payments (BOP) are
important determinants of exchange rates.
• Short-term day-to-day fluctuations in
exchange rates are caused by changing
supply and demand conditions in the foreign
exchange market.
16-13
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Direct and Indirect Quote
• Direct Quote
– Indicates the number of units of the home
currency required to buy one unit of the foreign
currency
– Example: 1.6288 dollars per British pound
• Indirect Quote
– Indicates the number of units of a foreign
currency that can be bought for one unit of the
home currency. It is the reciprocal of direct
quote.
– Example: 1/1.6288 = 0.6139 pounds per dollar
16-14
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Exchange 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, then a
trader could make a profit by buying in the
market where the currency was cheaper and
selling it in the other.
• The process of buying and selling in more
than one market to make a riskless profit is
called arbitrage. Such opportunities do not
exist for a long time due to arbitrage
process.
16-15
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Asked and Bid Rates
• Bid: Rate at which bank buys foreign
currency from a customer
• Ask: Rate at which bank sells foreign
currency to a customer
• The difference between the asked quote and
the bid quote is known as bid-asked
spread.
16-16
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Cross Rates
• A cross rate is the exchange rate between
two foreign currencies, neither of which is
the currency of the domestic country.
16-17
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16-18
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Spot Exchange Rate
• Exchange rates and transactions meant for
immediate delivery are called spot
exchange rates.
16-19
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Forward Rate
• A 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 future is agreed
today and is known as the forward rate.
The actual payment of one currency and
receipt of another currency take place on a
future date called the delivery date.
16-20
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Forward Contract Example
• Forward contracts are usually quoted for
periods of 30, 90, and 180 days.
• If the 30-day forward quote for euros
is $1.30, it means that the bank is
contractually bound to deliver a euro at
$1.30 and the customer is bound to buy a
euro at $1.30, regardless of the actual spot
rate.
16-21
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16-22
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Exchange Rate Risk
• The risk that tomorrow’s exchange rate will
differ from today’s rate.
• Exchange rate risk affects:
– international trade contracts
– foreign portfolio investments
– direct foreign investment
16-23
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Exchange Rate Risk in
International Trade Contracts
• Example: You are expecting to receive €1m
next year from exports.
• The future value of euros in dollars is
uncertain and depends on future exchange
rate.
• If € = $1.25, you will receive $1.25m, but if
the euro depreciates to $0.90, your contract
is worth only $0.9m.
16-24
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Exchange Rate Risk in Foreign
Portfolio Investments
• The future return on portfolio is unknown as
investments in securities is a risky
investment. Thus, investing in euro market
securities could yield –5% or +10%. In
addition, investor is exposed to U.S. $/euro
exchange rate fluctuation.
• Thus, if the euro investment yields 10% but
the euro depreciates during the period, the
net return will be less than 10%, depending
on the extent of euro depreciation.
16-25
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Exchange Rate Risk in
Direct Foreign Investment
• In a DFI, parent company invests in assets
denominated in foreign currency. The U.S.-based
parent company receives the repatriated (or
converted) profit stream from the subsidiary in
dollars.
• Thus, exchange rate risk arises due to:
– Fluctuations in the dollar value of the assets
located abroad
– Fluctuations in the home currency-denominated
profit stream
– Possible effect on future profit stream
16-26
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INTEREST RATE PARITY
16-27
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Interest Rate Parity
• IRP theory can be used to relate differences
in the interest rates in two countries to the
ratio of spot and forward exchange rates of
the two countries’ currencies. The IRP
condition can be stated as follows:
16-28
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PURCHASING-POWER
PARITY AND THE LAW OF
ONE PRICE
16-29
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Purchasing-Power Parity Theory
(PPP)
• According to PPP, exchange rates adjust so
that identical goods cost the same amount
regardless of where in the world they were
purchased.
• For example, if an Apple iPad costs $399 in
the U.S. and €353.10 in France, according
to PPP, the spot exchange rate should be
$1.13 per euro ($399/€353.10). Thus, an
iPad will cost the same whether it is bought
in the U.S. or France.
16-30
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Law of One Price
• The law one price implies that the same
goods should sell for the same price in
different countries after making adjustment
for the exchange rate between the two
currencies.
• Thus, if a Big Mac costs $2 in U.S. dollars
and the exchange rate with the British
pound is £1 = $2, a Big Mac should cost £1
in the UK.
16-31
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The International
Fisher Effect
• International Fisher Effect states that the
real interest rate should be the same all
over the world, with the differences in
nominal rate resulting from differences in
expected inflation rates.
• Thus, investing in a foreign bank with the
highest interest rate may simply mean
investing in a country with the highest rate
of inflation.
16-32
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CAPITAL BUDGETING FOR
DIRECT FOREIGN
INVESTMENT
16-33
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Capital Budgeting for DFI
• The method used by multinational
corporations to evaluate foreign investments
is very similar to the method used to
evaluate domestic investments.
• Since there might be repatriation
restrictions, evaluations of these
investments must focus on after-tax cash
flows that can be repatriated. Firms may be
subject to taxes in both the home country
and foreign country.
16-34
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Foreign Investment Risks
• The decision process for DFI is similar to
capital budgeting decisions in the domestic
context.
• Risks in domestic capital budgeting arises
from two sources:
– business risk
– financial risk
• In international capital budgeting problem,
we also have to incorporate political risk and
exchange rate risk.
16-35
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Political Risk
• Political risk arises because the foreign subsidiary
conducts business in a political system different
from that of the home country.
• Some examples of such risk include:
– Expropriation of assets without compensation
– Nonconvertibility of the subsidiary’s foreign earnings into
the parent’s currency
– Changes in the laws governing taxation
– Restrictions on sale price, wage rates, local borrowing,
extent of local ownership, hiring of personnel, transfer
payments made to the parent
16-36
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Exchange Rate Risk
• As observed before, exchange rate risks can
have significant effect on cash flows and
earnings.
16-37
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Key Terms
•
•
•
•
•
•
•
•
•
•
•
16-38
Arbitrageur
Asked rate
Bid-asked spread
Bid rate
Cross rate
Delivery date
Direct foreign investment
(DFI)
Direct quote
Eurodollars
Exchange rate
Exchange rate risk
© 2017 Pearson Education, Inc. All rights reserved.
• Foreign exchange (FX)
market
• Forward exchange contract
• Forward exchange rate
• Forward-spot differential
• Indirect quote
• Interest rate parity (IRP)
theory
• Law of one price
• Multinational corporation
(MNC)
• Purchasing-power parity
(PPP) theory
• Spot exchange rate

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