FIN 40500: International Finance

1. FIN 40500: International Finance Assessing Foreign Exchange Risk

2. The Truth is Out There...

3. There is a “true” probability distribution that governs the outcome of a coin toss The Truth Suppose that we were to flip a coin over and over again and after each flip, we calculate the percentage of heads & tails (Sample Statistic) (True Probability) That is, if we collect “enough” data, we can eventually learn the truth!

4. Continuous distributions Probability distributions identify the chance of each possible event occurring Probability Event -3 SD -2 SD -1 SD Mean 1 SD 2 SD 3 SD 65% 95% 99%

5. Sampling Suppose that you wanted to learn about the temperature in South Bend The Truth Temperature~ We could find this distribution by collecting temperature data for south bend Sample Mean (Average) Sample Variance

6. Conditional Distributions Obviously, the temperature in South Bend is different in the winter and the summer. That is, temperature has a conditional distribution Temp (Summer)~ The Truth Temp (Winter)~ Regression is based on the estimation of conditional distributions

7. Some useful properties of probability distributions Probability distributions are scaleable = 3 X Mean = 1 Variance = 4 Std. Dev. = 2 Mean = 3 Variance = 36 (3*3*4) Std. Dev. = 6

8. Probability distributions are additive = + Mean = 1 Variance = 1 Std. Dev. = 1 Mean = 2 Variance = 9 Std. Dev. = 3 Mean = 3 Variance = 14 (1 + 9 + 2*2) Std. Dev. = 3.7 COV = 2

9. Suppose we know that your salary is based on your shoe size: The Truth Salary = $20,000 +$2,000 (Shoe Size) Salary Shoe Size Mean = 6 Variance = 4 Std. Dev. = 2 Mean = $ 32,000 Variance = 16,000,000 Std. Dev. = $ 4,000

10. We could also use this to forecast: The Truth Salary = $20,000 +$2,000 (Shoe Size) If Bigfoot had a job…how much would he make? Salary = $20,000 +$2,000 (50) = $120,000 Size 50!!!

11. Searching for the truth…. You believe that there is a relationship between shoe size and salary, but you don’t know what it is…. • Collect data on salaries and shoe sizes • Estimate the relationship between them Note that while the true distribution of shoe size is N(6,2), our collected sample will not be N(6,2). This sampling error will create errors in our estimates!!

12. Slope = b a Salary = a +b * (Shoe Size) + error We want to choose ‘a’ and ‘b’ to minimize the error!

13. We have our estimate of “the truth” T-Stats bigger than 2 are considered statistically significant! Salary = $45,415 + $1,014 * (Shoe Size) + error Intercept (a) Mean = $45,415 Std. Dev. = $1,650 Shoe (b) Mean = $1,014 Std. Dev. = $257

14. Percentage of income variance explained by shoe size Error Term Mean = 0 Std, Dev = $11,673

15. Using regressions to forecast (Remember, Bigfoot wears a size 50)…. 50 Salary = $45,415 + $1,014 * (Shoe Size) + error Mean = $45,415 Std. Dev. = $1,650 Mean = $1,014 Std. Dev. = $ 257 Mean = $0 Std. Dev. = $11,673 Salary Forecast Mean = $96,115 Std. Dev. = $17,438 Given his shoe size, you are 95% sure Bigfoot will earn between $61,239 and $130,991

16. We’ve looked at several currency pricing models that have potential for being “the truth” Trade Balance Approach Price Level Approach Interest Rate Approach Monetary Approach Technical Approach Any combination of these could be “the truth”!!

17. PPP and the Swiss Franc Note: PPP implies that a = 0 and b = 1

18. For every 1% increase in US inflation over Swiss inflation, the dollar depreciates by 1.40%

19. Obviously, we have not explained very much of the volatility in the CHF/USD exchange rate

20. UIP and the Swiss Franc Note: UIP implies that a = 0 and b = 1

21. For every 1% increase in US interest rates over Swiss interest rates, the dollar appreciates by 2.87%

22. We still have not explained very much of the volatility in the CHF/USD exchange rate

23. Using regressions to forecast…. (3 – 1.5) = 1.5 Mean = .55 Std. Dev. = .31 Mean = -2.87 Std. Dev. = 1.53 Mean = 0 Std. Dev. = 2.69 Salary Forecast Mean = -3.755% Std. Dev. = 3.58% Given current interest rates, you are 95% sure that the % change in the exchange rate will be between -10.91% and 3.40%!!

24. Technical Analysis Uses prior movements in the exchange rate to predict the future

25. A 1% depreciation of the dollar is typically followed by a .29% depreciation

26. BLADES Board & Skate arrived on the action / extreme scene in 1990, and quickly became a trusted source of equipment and service to in-line skaters, skateboarders, and snowboarders. BLADES got its start in New York and currently operates 15 retail stores in New York, New Jersey, Massachusetts and Pennsylvania.

27. Blades could cut costs by importing lower cost components from Thailand Increasing competition and rising costs have lowered Blades’ profit margins

28. Suppose that Blades makes an agreement to buy plastic components sufficient to produce 72,000 pairs of rollerblades from Thai manufacturers at a price of THB2,870 per pair. ($1 = THB 38.87). Payment is due in one month (72,000*2,870 = THB 206.64 M) Trend

29. Should Blades import components from Thailand? THB 2,870 per pair (THB 1 = $ .0257) $75 Per Pair OR At the current exchange rate, Blades could cut their costs by 1.6% by importing from Thailand THB 2,870 (.0257) = $73.75 $75 - $73.75 100 = 1.6% $75

30. However, importing Thai components creates a transaction exposure for Blades THB 2,870 per pair (THB 1 = $ .0257) Costs ($) = e ($/THB) * 72,000* Costs (THB) Constant Random Variable We need to estimate this!!

31. Every 1% difference between US inflation and Thai inflation depreciates the dollar by .8%

32. US inflation is currently 1% (per month) while inflation in Thailand is 2.25% (per month) (1 – 2.25) = -1.25 Mean = . 80 Std. Dev. = .02 Mean = .80 Std. Dev. = . 35 Mean = 0 Std. Dev. = 2.20 Your 95% confidence interval for the (monthly) percentage change in the exchange rate is [-4.7% , 4.3% ] Forecast Mean = -.2% Std. Dev. = 2.25%

33. Assessing transaction exposure THB 2,870 per pair (THB 1 = $ .0257) Costs ($) = e ($/THB) * 72,000*2,870 THB Forecast (% Change) Mean = -.2% Std. Dev. = 2.25% Costs Mean = 72,000*2,870*.0257(1-.002) = $5,300,026 Std. Dev. = .0225*72000*2870*.0256 = $119,250

34. Assessing transaction exposure THB 2,870 per pair (THB 1 = $ .0257) Costs ($) = e ($/THB) * 72,000*2,870 THB You are 95% sure your costs will be between: $5,300,026 + 2*$119,250 = $5,538,526 and $5,300,026 - 2*$119,250 = $5,061,526 Mean = $5,300,026 Std. Dev. = $119,250

35. Should Blades import components from Thailand? THB 2,870 per pair (THB 1 = $ .0257) $75 Per Pair OR Mean = $5,400,000 Std. Dev. = $0 Mean = $5,300,026 Std. Dev. = $119,250 What do you do?

36. Blades is also thinking about exporting rollerblades to Thailand

37. Suppose that Blades makes an agreement to sell 30,000 pairs of roller blades to a Thai sporting goods store for THB 4,500 apiece. Trend

38. Assessing transaction exposure Net Cash Flows($) = e ($/THB) * ( 72,000*2,870 - 30,000*4,500) = e ($/THB) * ( 71,640,000THB) Forecast (% Change) Mean = -.2% Std. Dev. = 2.25% Net Cash Flows($) Mean = 71,640,000*.0257(1-.002) = $1,837,465 Std. Dev. = .0225*71,640,000*.0257 = $41,342

39. Blades could also import Japanese components. Japanese components are slightly more expensive (Y 8,000 per pair = $74.77) $1 = Y 107

40. Suppose that Blades splits its purchases of components between Thailand and Japan (Exports to Thailand = 0) THB 2,870 per pair (THB 1 = $ .0257) JPY 8,000 per pair (JPY 1 = $ .0093) THB 2,870*.0257*36,000 = $2,655,324 JPY 8,000*.0093*36,000 = $2,678,400 $5,333,724

41. Forecast (% Change) Mean = 0% Std. Dev. = 2.25% Forecast (% Change) Mean = 0% Std. Dev. = 3.50% CORR = -.65 $2,655,324 $2,678,400 = .49 = .51 $5,333,724 $5,333,724 Net Cash Flows

42. Importing from both Japan and Thailand can diversify currency exposure!!

43. Suppose that Blades is planning to expand sales into England. Should they try and invoice in dollars or Pounds? Current GBP 1 = $1.80 Forecast (% Change) Mean = 0 SD = 2.0% Contracting sales in GBP creates transaction exposure. However, contracting sales in USD creates economic exposure

44. Suppose that Blades agrees to sell roller blades to England for $125 apiece. (GBP 70) Forecast (% Change) Mean = 0 SD = 2.0% Current GBP 1 = $1.80 Demand in England is as follows: P = Local price of Roller blades Q = 400 - 3P At a local price of GBP 70, demand equal 500 - 3(70) = 190

45. Q = 400 – 3P P 1% 70 1.1% # Roller Blades 190 Elasticity of Demand refers to the responsiveness of demand to price changes

46. Suppose that Blades agrees to sell roller blades to England for $125 apiece. (GBP 70) Forecast (% Change) Mean = 0 SD = 2.0% Current GBP 1 = $1.80 Revenues = Price ($) * Quantity Forecast (% Change) Mean = 0 SD = 2.0%(Elasticity) = 2.2% Constant

47. GBP Pricing (Transaction Exposure) Revenues = e ($/L)* Price (L) * Quantity Forecast (% Change) Mean = 0 SD = 2.0 Constant USD Pricing (Economic Exposure) Revenues = Price ($) * Quantity Forecast (% Change) Mean = 0 SD = 2.0%(Elasticity) = 2.2% Constant

48. Changes in currency prices can have all kinds of economic impacts. A more general way to estimate economic exposure would be as follows: Percentage change in the exchange rate ($/F) Percentage change in cash flows (measured in home currency)

49. Every 1% depreciation in the dollar relative to the British pound lowers cash flows from England by 3.35%

50. Suppose that Blades sets up a Thai subsidiary. The Thai plant uses locally produced components to produce roller blades that will be sold to local (Thai) customers. Is Blades still exposed to currency risk?