FIN00126 International Finance For Annual Inflation Rates

1) You believe that IRP presently exists. The nominal annual interest rate in Peru is 5 percent and in Canada is 3 percent. You expect that annual inflation will be about 3 percent in Peru and 2 percent in Canada. The spot rate of the Peruvian Sol PEN/CAD 0.4.Put options on Soles are available with a one year expiration date, an exercise price of PEN/CAD 0.45, and a premium of CAD 0.07 per unit.

You will receive 1 million Peruvian Soles in one year. Use four (4) digits for your PEN/CAD exchange rate calculations.

a) Determine the expected amount of Canadian Dollars that you will receive if you use a forward contract hedge. 

b) Determine the expected amount of Canadian Dollars you will receive if you do not hedge and believe in purchasing power parity.

c) Determine the amount of Canadian dollars that you will expect to receive if you use a currency put option hedge. Account for the premium you would pay on the put option. 

2) Explain and provide examples of how multinational corporations (MNC) reduce their transaction and economic exposures. Factual (and referenced) examples will attract higher marks. 

3) Explain the differences (at least 4) between foreign direct investment (FDI) and portfolio investment (PI).Collect the required the data from the Australian Bureau of Statistics (ABS) website (you may also need to explore other government sources such as the Reserve Bank of Australia, Austrade, Treasury, Department of Foreign Affairs and Trade, etc.) and answer the following questions:

4) List the 8 largest countries by value of Foreign Direct Investment in Australian in the years 2004 and 2014. You need to provide the list of countries as well as the amount of FDI invested in AUD. 

5) What factors do you think account for these countries investing large amounts of FDI in Australia? Discussion should be based on unit’s content and other reliable sources of reference.

6) Have the list of investing countries changed over the concerned period? What might account for these changes? Consider global economic issues/trends and industries.

7) Do you expect a change to the 2014 list over the next 5 years? Explanation should be based on the unit’s material (i.e. application of the theories learned). 

Answers: 

• Domestic Country is Peru (PEN)
• Foreign Country is Canada(CAD)
• Spot Price = 0.40 PEN/CAD
• Put options on sole has 1year expiration period
• Exercise Price = 0.45 PEN/CAD
• Premium = CAD 0.07 per unit
• 1million Peruvian Soles
• Annual Interest Rates:
• Peru = 5%
• Canada = 3%
• Annual Inflation Rates:
• Peru = 3%
• Canada = 2%

Forward Contract Hedge:

In forward Contract, an exchange rate is quoted today for settlement at a future date (Clements and Lan, 2004)[1].

E (S₁) = Exercise Price * No. of units

Taken information from above figures, expected amount of CAD received after one year using forward contract hedge = 10,00,000 * 0.45 = CAD 4,50,000

Purchasing Power Parity (PPP):

Purchasing power parity focuses on ‘inflation-exchange rate’ relationship.

E (S₁) = Current Spot rate * expected difference in inflation rates 

E (S₁) = S_o *(1 + I_d)

 (1 + I_f)

Where

E (S₁) = Expected Spot Rate at end of expiration period i.e. 1year

S_o = Current Spot Rate i.e. 0.40 PEN/CAD

I_d = Inflation rate in domestic currency i.e. 3%

I_f = Inflation rate in foreign currency i.e. 2%

Thus, expected amount of CAD received after one year using PPP:

E (S₁) = 0.40 * (1 + 3%)     = 0.4039 PEN/CAD

(1 + 2%)

E (S₁) = 0.4039 * 10, 00,000 = CAD 4, 03,900.

Put option Hedge:

In put option, gives buyer the right, but not the obligation, to sell a specified no. of units of commodity or currency to seller of option at a fixed price on or up to a specified date.

Premium is also paid by the buyer at the inception of the contract (James, Marsh and Sarno, 2012)[2].

Therefore, Premium Amount received = CAD 0.07 per sole * 10, 00,000 soles = CAD   7, 00, 00.

If Expected spot price is greater than exercise price, then buyer do not exercise put option but where Expected spot price is less than exercise price, then buyer exercise put option. In both cases, Buyer has to pay premium amount.

Transaction exposure is also called as Transaction risk.

Example: Suppose that a company based in US signs a contract with a company based in Belgium to purchase a product. The contract states that payment should be made on supplier’s country currency i.e. Payment should be made in Euros (€). US Co. agrees to pay to Belgium co. $1.5/€ for every product purchased. After the completion of agreement, sale might not take place immediately then there is a possibility of change in ratios of dollars to Euros (which could be favorable change or adverse change or no change) before the final sale is happened. Thus, this risk of change is the transaction exposure.

In other words, greater the time between agreement and settlement of contract, greater is the risk of Transaction Exposure (Madura and Fox, 2011)[4]. 

Measures to reduce Transaction Exposure in MNC: Multi-national Corporation should enter a contract in forward exchange rate, which lowers the risk of transaction exposure.

Economic Exposure is also called as Operating Exposure.

Example: Suppose a small European Company only sell the products in their local market and do not export their exports, then also company would be adversely affected because of high value of Euros it make imports from other countries cheaper which increases competition in European markets.

In other words, Economic exposure deals with unanticipated fluctuations in foreign exchange rates which can have a significant impact on company’s market value (Eun and Resnick, 2015)[6].

Measures to reduce Economic Exposure in MNC: Economic exposure can be reduced either through operational strategies such as diversification of finance sources, product markets, production facilities etc or through currency risk strategies such as currency swaps etc.

(Source: Ahmad, Cova and Harrison, 2004)[7].

2004

(Source: Australian Bureau of Statistics, Catalogue 5352.0)[8].

(Source: Australian Bureau of Statistics, Catalogue 5352.0)[9].  

Australia is the rich resource country having a high skilled workforce (ranked 6^th in the world, Source: ABS). Australia also promotes competition and it is known for the innovation by bringing new technologies and services to the Australian Market (Source: DFAT)[10].

Factors:

• Australia has experienced consistent economic growth since 1990-1991.
• Australia has 6^th highest highly qualified and diverse workforce and friendly environment at the business place.
• Australia has strong geographic, trade and cultural links with fast growing Asia-Pacific-Region.
• Australia has well planned rail and road transports networks.
• As per World Bank development indicators, Australia stands 4^th on no. of new businesses.
• Australian Governance is also best in the world.
• It regulates liquidity market of bonds and stocks.

Therefore, on the basis of above factors, it is suggesting that foreign investment remains a steadily influence on the Australian economy which is important for the benefits of the economy and hence, above countries invests large amount of FDI in Australia.

• As per ABS Data, US remain the largest source of FDI into Australia followed by UK from 2004 to 2014.
• Belgium investment in FDI in Australia is rapidly growing from rank 8^th to rank 3^rd from 2004 to 2014.
• Netherland, New Zealand and Switzerland have decreased their FDI investment from 2004 to 2014.
• Singapore moved to the index of top 8 countries of FDI investment in Australia in 2014.
• Japan remains in top 8 investing countries from 2004 to 2014.

Reasons are as follows:

Positive Reasons:

FDI proved to be flexible during financial crisis, FDI opens up export opportunities thereby increasing export performance also encourages macroeconomic environment and digital innovation.

Negative Reasons:

In FDI, investing countries cannot easily have entered as well as exist from FDI and also do not sell their FDI investment easily. FDI’s share is higher in countries with weaker credit ratings.

Hence, from both positive and negative reasons, it is evidenced that FDI has appraised a beneficial impact on economy of the world.

Most investments cover 5 sectors these are: Software and IT services, business services, financial services, chemical sector, manufacturing sector etc. In future forecast, it is seen that majority of foreign investment approvals are for New Dwellings.

Thus, future expectations of 5 years over 2014 are that US, UK, Singapore and Japan will remain in the largest source of FDI in Australia. Other major investing countries include Hong Kong and China. India is also entered the top 10 list of FDI index. This survey indicates Asian Region is most interested in investing Australian FDI (Swieringa and Wokker, 2016)[12].

Thus, Australian FDI is projected to around 46727.90 AUD million in 202 (Source: Trading Economics)[13].

Hence, foreign investment has contributed to Australia’s sustained economic growth, innovation and ongoing prosperity.

References  

Ahmad, Y, S., Cova, P. and Harrison, R., Foreign Direct Investment versus Portfolio Investment: A global games approach, Whitewater working paper, University of Wisconsin, 2004. 

Australian Bureau of Statistics, 5352.0 – International Investment Position, Australia: Supplementary Country Statistics, [Website], 2004, https://www.abs.gov.au/AUSSTATS/[email protected]/allprimarymainfeatures/568F68EE36081C32CA2571C4007CCDE6?opendocument, (accessed 24 March 2017). 

Australian Bureau of Statistics, 5352.0 – International Investment Position, Australia: Supplementary Country Statistics, [Website], 2014, https://www.abs.gov.au/AUSSTATS/[email protected]/allprimarymainfeatures/011CD15D6E630B76CA257FAF001A4235?opendocument, (accessed 24 March 2017). 

Australian Trade and Investment commission, Guide to investing, [Website], 2017, https://www.austrade.gov.au/International/Invest/Investor-Guide, (accessed 24 March2017). 

Clements, K, W. and Lan, Y., A new approach to Forecasting exchange rates, Australia, The University of Western Australia, 2004. 

Department of Foreign Affairs and Trade, Australia and foreign investment, [Website], 2017, https://dfat.gov.au/trade/topics/investment/Pages/australia-and-foreign-investment.aspx, (accessed 24 March 2017). 

Eun, C,S. and Resnick, B,G. (7^th ed.),  International Financial Management., New York, The McGraw Hill Companies Inc, 2015. 

James, J., Marsh, I, W. and Sarno, L, Handbook of exchange rates, New Jersey, Wiley, 2012. 

Kearney, A, T., The 2016 Foreign Direct Investment (FDI) Confidence Index, [Website], 2016, https://www.austrade.gov.au/news/economic-analysis/the-2016-foreign-direct-investment-fdi-confidence-index,  (accessed 24 March 2017). 

Madura, J. and Fox, R. (3^rd ed.),  International Financial Management, Hampshire, South-Western Cengage Learning, 2011. 

Shapiro, A, C. (10^th ed.), Multinational Financial Management, University of Southern California, Hoffman, G, 2010. 

Swieringa, J. and Wokker, C, Foreign Investment and Residential Property Price Growth, Australia, the Australian Treasury, 2016. 

Trading Economics, Foreign Direct Investment/Forecast/2016-2020, [Website], 2017, https://www.tradingeconomics.com/forecast/foreign-direct-investment, (accessed 24 March2017).