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FIN 40500:
International Finance
{ ¦ { ¦ 5 . Pr Pr · · Tails Heads
There is a “true” probability distribution
that governs the outcome of a coin toss
Suppose that we were to flip a coin over and over again
and after each flip, we calculate the percentage of heads
& tails
Flips Total
Heads of
#
5 .
That is, if we collect “enough” data, we can eventually learn the
truth!
(Sample Statistic) (True Probability)
P
r
o
b
a
b
i
l
i
t
y
Event
Mean
Probability distributions
identify the chance of
each possible event
occurring
1
SD
2
SD
3
SD
1
SD
2
SD
3
SD
65%
95%
99%
Continuous distributions
( )
2
,σ µ N
Sampling
Suppose that you wanted to learn about the temperature in South Bend
Temperature ~
( )
2
,σ µ N
We could find this distribution by collecting temperature data for south bend
µ →
,
`
.

·
∑
·
N
i
i
x
N
x
1
1
( )
2
1
2
2
1
σ → −
,
`
.

·
∑
·
N
i
i
x x
N
s
Sample Mean
(Average)
Sample
Variance
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) ~
( )
2
,
s s
N σ µ
Temp (Winter) ~
( )
2
,
W W
N σ µ
Regression is based on the estimation of conditional distributions
Mean = 1
Variance = 4
Std. Dev. = 2
Probability distributions
are scaleable
( )
( )
2 2
2
σ ,k k N y
kx y
μ,σ N x
µ ∝
·
∝
3 X
=
Mean = 3
Variance = 36 (3*3*4)
Std. Dev. = 6
Some useful properties of probability distributions
Mean = 1
Variance = 1
Std. Dev. = 1
Probability distributions
are additive
( )
( )
( )
xy y x y x
y y
x x
σ ,σ N y x
,σ N y
,σ μ N x
cov 2
2 2
2
2
+ + + · +
∝
∝
µ µ
µ
+
Mean = 2
Variance = 9
Std. Dev. = 3
COV = 2
=
Mean = 3
Variance = 14 (1 + 9 + 2*2)
Std. Dev. = 3.7
Mean = 6
Variance = 4
Std. Dev. = 2
Mean = $ 32,000
Variance = 16,000,000
Std. Dev. = $ 4,000
Suppose we know that your salary is based on your shoe size:
Salary = $20,000 +$2,000 (Shoe Size)
Shoe Size
Salary
We could also use this to forecast:
Salary = $20,000 +$2,000 (Shoe Size)
If Bigfoot had a job…
how much would he
make?
Size 50!!!
Salary = $20,000 +$2,000 (50) = $120,000
Searching for the truth….
You believe that there is a relationship between shoe size and
salary, but you don’t know what it is….
1. Collect data on salaries and shoe
sizes
2. 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!!
0
10000
20000
30000
40000
50000
60000
70000
0 2 4 6 8 10 12 14
Shoe Size
S
a
l
a
r
y
Salary = a +b * (Shoe Size) + error
a
( )
2
0,σ N error ∝
Slope = b
We want to choose ‘a’ and ‘b’ to minimize the error!
Regression Results
Variable Coefficients Standard Error t Stat
Intercept 45415.65 1650.76 27.51
Shoe 1014.75 257.21 3.94
Salary = $45,415 + $1,014 * (Shoe Size) + error
We have our estimate of “the truth”
Intercept (a)
Mean = $45,415
Std. Dev. = $1,650
Shoe (b)
Mean = $1,014
Std. Dev. = $257
TStats bigger
than 2 are
considered
statistically
significant!
Regression Statistics
Multiple R 0.17
Standard Error 11673.01
Error Term
Mean = 0
Std, Dev = $11,673
Percentage of income
variance explained by
shoe size
Using regressions to forecast (Remember,
Bigfoot wears a size 50)….
Salary = $45,415 + $1,014 * (Shoe Size) + error
50
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
438 , 17 $ ) 673 , 11 ( ) 257 ( ) 50 ( ) 650 , 1 (
2 2 2 2
· + + · StdDev
Given his shoe size, you are
95% sure Bigfoot will earn
between $61,239 and $130,991
We’ve looked at several currency pricing models that have
potential for being “the truth”
Any combination of these could be “the truth”!!
t t
NX e β α + · ∆ %
( )
*
%
t t t
e π π β α − + · ∆
( )
*
% i i e
t
− + · ∆ β α
]
]
]
∆ · ∆
∑
∞
·
+
1
% %
i
i t t
f E e
Trade Balance Approach
Monetary Approach
Interest Rate Approach
Price Level Approach
]
]
]
∆ · ∆
∑
∞
·
−
1
% %
i
i t t
e E e Technical Approach
10
8
6
4
2
0
2
4
6
8
10
10.0 5.0 0.0 5.0 10.0 15.0
Inflation Differential
%
C
h
a
n
g
e
i
n
E
x
c
h
a
n
g
e
R
a
t
e
( )
t t t t
b a e ε π π + − + · ∆
*
%
Note: PPP implies that
a = 0 and b = 1
PPP and the Swiss Franc
Regression Results
Variable Coefficients Standard Error t Stat
Intercept .027 .231 .12
Inflation 1.40 .742 1.89
Regression Results
Variable Pvalue Lower 95% Upper 95%
Intercept .910 .49 .43
Inflation .06 .065 2.86
Regression Statistics
R Squared .02
Standard Error 2.69
Observations 155
For every 1% increase in
US inflation over Swiss
inflation, the dollar
depreciates by 1.40%
10
8
6
4
2
0
2
4
6
8
10
1 6 11 16 21 26 31 36 41 46 51 56 61 66 71 76 81 86 91 96 101 106 111 116 121 126 131 136 141 146 151
Predicted Actual
Obviously, we have not explained very much of the volatility
in the CHF/USD exchange rate
( )
t t t t
i i b a e ε + − + · ∆
*
%
Note: UIP implies that
a = 0 and b = 1
UIP and the Swiss Franc
10
8
6
4
2
0
2
4
6
8
10
0.4 0.3 0.2 0.1 0 0.1 0.2 0.3 0.4 0.5
Interest Differential
%
C
h
a
n
g
e
i
n
e
Regression Results
Variable Coefficients Standard Error t Stat
Intercept .55 .31 1.77
Interest Rate 2.87 1.53 1.87
Regression Results
Variable Pvalue Lower 95% Upper 95%
Intercept .07 .06 1.18
Interest Rate .06 5.89 .15
Regression Statistics
R Squared .02
Standard Error 2.69
Observations 155
For every 1% increase in US
interest rates over Swiss interest
rates, the dollar appreciates by
2.87%
We still have not explained very much of the volatility in the
CHF/USD exchange rate
10
8
6
4
2
0
2
4
6
8
10
1 7 13 19 25 31 37 43 49 55 61 67 73 79 85 91 97 103 109 115 121 127 133 139 145 151
Exchange Rate Predicted Exchange Rate
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%
% 58 . 3 ) 69 . 2 ( ) 53 . 1 ( ) 5 . 1 ( ) 31 (.
2 2 2 2
· + + · StdDev
Given current interest rates, you
are 95% sure that the % change in
the exchange rate will be between
10.91% and 3.40%!!
( )
t t t t
i i e ε + − − · ∆
*
87 . 2 55 . %
Technical Analysis Uses prior movements in the exchange rate
to predict the future
10
8
6
4
2
0
2
4
6
8
10
10 8 6 4 2 0 2 4 6 8 10
%Change (t1)
%
C
h
a
n
g
e
(
t
)
( )
t t t
e b a e ε + ∆ + · ∆
−1
% %
Regression Results
Variable Coefficients Standard Error t Stat
Intercept .12 .21 .57
Prior Change .29 .07 3.86
Regression Results
Variable Pvalue Lower 95% Upper 95%
Intercept .56 .29 .53
Prior Change .0001 .14 .45
Regression Statistics
R Squared .09
Standard Error 2.59
Observations 154
A 1% depreciation of the
dollar is typically followed by
a .29% depreciation
BLADES Board & Skate arrived on the action /
extreme scene in 1990, and quickly became a
trusted source of equipment and service to inline
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.
Increasing
competition and
rising costs have
lowered Blades’
profit margins
Blades could cut
costs by importing
lower cost
components from
Thailand
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 THB
2,870 per pair. ($1 = THB 38.87). Payment is due in one
month (72,000*2,870 = THB 206.64 M)
Trend
THB 2,870 per pair
(THB 1
= $ .0257)
Should Blades import components from
Thailand?
$75 Per Pair
THB 2,870 (.0257) = $73.75
$75  $73.75
$75
100 = 1.6%
At the current
exchange rate,
Blades could cut
their costs by 1.6%
by importing from
Thailand
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!!
Regression Results
Variable Coefficients Standard Error t Stat
Intercept . 80 .02 40
Inflation .80 .35 2.28
Regression Statistics
R Squared .43
Standard Error 2.20
Observations 240
( ) ε π π + − + · ∆ * % b a e
Every 1% difference between US inflation and Thai inflation
depreciates the dollar by .8%
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
Forecast
Mean = .2%
Std. Dev. = 2.25%
% 25 . 2 ) 20 . 2 ( ) 25 . 1 ( ) 35 (. ) 02 (.
2 2 2 2
· + + · StdDev
Your 95% confidence interval for
the (monthly) percentage change
in the exchange rate is
[4.7% , 4.3% ]
( ) ε π π + − + · ∆ * % b a e
Forecast (% Change)
Mean = .2%
Std. Dev. = 2.25%
Assessing transaction exposure
Costs ($) = e ($/THB) * 72,000*2,870 THB
THB 2,870 per pair
(THB 1
= $ .0257)
Costs
Mean = 72,000*2,870*.0257(1.002)
= $5,300,026
Std. Dev. = .0225*72000*2870*.0256
= $119,250
Assessing transaction exposure
Costs ($) = 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
THB 2,870 per pair
(THB 1
= $ .0257)
Mean = $5,300,026
Std. Dev. = $119,250
THB 2,870 per pair
(THB 1
= $ .0257)
Should Blades import components from
Thailand?
$75 Per Pair
Mean = $5,300,026
Std. Dev. = $119,250
Mean = $5,400,000
Std. Dev. = $0
What do you do?
Blades is also thinking
about exporting rollerblades
to Thailand
Suppose that Blades makes an agreement to sell 30,000
pairs of roller blades to a Thai sporting goods store for
THB 4,500 apiece.
Trend
Forecast (% Change)
Mean = .2%
Std. Dev. = 2.25%
Assessing transaction exposure
Net Cash Flows($) = e ($/THB) * ( 72,000*2,870  30,000*4,500)
Net Cash Flows($)
Mean = 71,640,000*.0257(1.002)
= $1,837,465
Std. Dev. = .0225*71,640,000*.0257
= $41,342
= e ($/THB) * ( 71,640,000THB)
Blades could also import
Japanese components.
Japanese components are
slightly more expensive
(Y 8,000 per pair = $74.77)
$1 = Y 107
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
$2,678,400
$5,333,724
Forecast (% Change)
Mean = 0%
Std. Dev. = 2.25%
Forecast (% Change)
Mean = 0%
Std. Dev. = 3.50%
$2,655,324
$5,333,724
= .49 = .51
CORR = .65
Net Cash Flows
( ) ( ) % 4 . 1 014 . ) 65 . )( 035 )(. 0225 )(. 51 )(. 49 (. 2 ) 035 (. ) 51 (. 0225 . 49 .
724 , 333 , 5 $
2 2
2 2
· · − + + ·
·
SD
Mean
Cash flow Situation… And the Currencies
are…
Currency
exposure
Equal Inflows/Outflows of Two
Currencies
Positively Correlated High
Equal Inflows/Outflows of Two
Currencies
Uncorrelated Moderate
Equal Inflows/Outflows of Two
Currencies
Negatively Correlated Low
Inflow in one currency/outflow in
another
Positively Correlated Low
Inflow in one currency/outflow in
another
Uncorrelated Moderate
Inflow in one currency/outflow in
another
Negatively Correlated High
Importing from both Japan and Thailand can diversify currency
exposure!!
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
Suppose that Blades agrees to sell roller
blades to England for $125 apiece. (GBP 70)
Current
GBP 1 = $1.80
Forecast (% Change)
Mean = 0
SD = 2.0%
Demand in England is as follows:
Q = 400  3P
P = Local price of
Roller blades
At a local price of GBP 70, demand equal 500  3(70) = 190
11 . 1
190
70
3 ·
,
`
.

·
∆
∆
·
d
d
d
Q
P
P
Q
ε
Elasticity of Demand refers to
the responsiveness of demand
to price changes
Q = 400 – 3P
# Roller Blades
P
190
70
d
d d
d
d
d
Q
P
P
Q
P
P
Q
Q
P
Q
∆
∆
·
∆
∆
·
∆
∆
·
%
%
ε
1%
1.1%
Suppose that Blades agrees to sell roller blades to
England for $125 apiece. (GBP 70)
Current
GBP 1 = $1.80
Forecast (% Change)
Mean = 0
SD = 2.0%
Revenues = Price ($) * Quantity
Constant
Forecast (% Change)
Mean = 0
SD = 2.0%(Elasticity) = 2.2%
Revenues = Price ($) * Quantity
Constant
Forecast (% Change)
Mean = 0
SD = 2.0%(Elasticity) = 2.2%
Revenues = e ($/L)* Price (L) * Quantity
Constant
Forecast (% Change)
Mean = 0
SD = 2.0
GBP Pricing (Transaction Exposure)
USD Pricing (Economic Exposure)
Changes in currency prices can have all kinds of economic
impacts. A more general way to estimate economic exposure
would be as follows:
t t t
be a PCF ε + + ·
Percentage change in the
exchange rate ($/F)
Percentage change in cash
flows (measured in home
currency)
Regression Results
Variable Coefficients Standard Error t Stat
Intercept .05 1.5 .03
% Change in
Exchange Rate
3.35 .97 3.45
Regression Statistics
R Squared .63
Standard Error 1.20
Observations 1,000
ε + + ·
t t
be a PCF
Every 1% depreciation in the dollar relative to the British
pound lowers cash flows from England by 3.35%
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?
Blades will need to produce consolidated cash flow and income statements
as well as a consolidated balance sheet. Translation exposure refers to the
impact of exchange rate changes on these financial statements.
FASB Rule #52 (for US Based MNCs)
The functional currency of an entity is the currency of the economic
environment in which the entity operates
The current exchange rate as of the reporting date is used to translate
assets/liabilities from the functional currency to the reporting currency
The weighted average exchange rate over the relevant reporting period
is used to translate revenues, expenses, gains, and losses
Translated Gains/Losses are not recognized as current net income, but
are reported as a second component of stockholders’ equity
Should we be worried about this type of
exposure??
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