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Finance (Subject) / International Finance (Lesson)
- Is there exchange rate risk? Most likely, but not necessarily Typical std. for stock returns about 0.2 Typical std. for foreign currencies about 0.1 (it could be a risk) Why it might not matter: Purchasing Power Parity (PPP). If it holds, then If the Exchange rates moves to 1.1 at the same time, the CAD price of an iphone drops Then buying the iPhone in the Us or Canada still costs the same in USD. In practice: Many frictions that prevent the PPP to hold true Sometimes commodity arbitrage, you would expect prices to adjust, but not always in reality Sometimes with commodities traded globally, PPP over countries holds true Salaries i.e. adjust very slow Locally produced things are not affected Prices usually adjust very slowly and the changes persits for years Why it might matter? The Real Exchange Rate! e = s*P*/P Should be equal to 1 If the real exchange rate moves --> exchange rate risk
- Hedging foreign currency Cashflows FC INFLOWS at a future date can be hedged by SELLING FC forward FC OUTFLOWS at a future date can be hedged by BUYING FC forward Hedging allows us to translate a future outflow of FC, whose HC value would depend on the future random spot price S∼T into an outflow of HC, whose value is equalt to F which is known today
- Covered Interest Rate Parity In frictionless markets we have F = S * (1+r) / (1+r*) no-arbitrage relationship There is an arbitrage whenever there is a profit without investment or risk (money maching) free lunch cannot prevail in a financial market equilibrium. If it existed, market participants would want to exploit this arbitrage opportunity, and prices would adjust until there is no more gain from an arbitrage. - with forward contract, the exchange rate risk is said to be covered. - Forward Rate > Spot Rate if Home interest is higher than Foreign interest
- Financial market integration Definition no restrictions on cross-border portfolio investments between the 2 countries investors effectively hold many foreing assets if Financial markets are integrated, then the 3 models are equivalent to discount 1 FC (1) First discount, then convert 1/(1+r*) x St (2) First convert, then discount (all in HC) F x 1/(1+r) if they are not integrated (segmented), we only can do this: (3) First convert, then discount: 1 x E(S∼) x 1/(1 + E(r∼) In absence of free capital flows, no mechanism that equates home value and translated forein value Restricted access to forward markets -> unsatisfies demand for forward sales or purchases Forward hedge has non-zero market value Adding hedge will change market value Hence, in segmented markets we need to make explicite exchange rate forecasts and discount them at a rate that reflects corresponding risk.
- International CAPM CAPM model is used to incorporate foreign exchange risks when dealing with several currencies. Depends on: Product Market Integration: Increasing Real Exchange Rates Exchange rate risk -> additional risk premium per unit of exchange rate covariance risk Financial Market Integration: Relevant market PF E(r) = r + Beta (Rm-RF) + Υ x E(s + r* - r) s = change in the spot rate, r*-r = excess return of Spot Rate Y = covariance of Spot Rates, like Beta I country is financially integrated: Market should be the world market PF If home country is financially segmented: Market should be the home country market
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