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Chapter 17

Chapter 17. Exchange Rates & International Investment. International Investment. Advantage Increased portfolio diversification Disadvantages Returns affected by exchange rates Foreign information is harder to obtain Financial disclosure may differ. Disadvantages continued

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Chapter 17

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  1. Chapter 17 Exchange Rates & International Investment

  2. International Investment • Advantage • Increased portfolio diversification • Disadvantages • Returns affected by exchange rates • Foreign information is harder to obtain • Financial disclosure may differ

  3. Disadvantages continued • Accounting definitions may vary • Political risks • Risk of exchange controls • Higher transactions costs

  4. Two Ways of Stating Exchange Rates • # units of domestic per unit of foreign $1.50 = 1 £ (pound). • # units of foreign per domestic unit of currency = 0.6667 £ = $1.00.

  5. Changing Exchange Rates Time 0: 125 ¥ (yen) = $1.00. Time 1: 100 ¥ = $1.00. Dollar depreciations (i.e., one dollar buys fewer yen). Yen appreciations (i.e., fewer yen are required to buy one dollar).

  6. Exports and Imports

  7. 0 1 X0,S X1,S Exchange Rates and International Investment R0, US = 1-period spot interest rate in US R0, J = 1-period spot interest rate in Japan X0, S = Spot exchange rate at time 0 ($1 = 125 ¥) X1, S = Spot exchange rate at time 1 ($1 = 100 ¥)

  8. 0 1 1 1 + R0, US $1.10 [125 ¥][1 + R0, J] 100 ¥ Invest in US Exchange & invest in Japan X0, S 125 ¥ X0, S [1 + R0, J] [125 ¥][1 + R0, J] Exchange back for dollars X0,S [1 + R0J] X1, S

  9. Compare 1 + RORUS 1 + Rate of return in US 1 + RORUS 1 + R0, US versus 1 + RORJ 1 + Rate ofreturn in Japanin dollars 1 + RORJ ≥< X0, S[1 + R0, J] X1, S ≥<

  10. If R0, US = R0, J 1 + RORUS 1 + RORJ as X1, S X0, S X1,S > X0, S, Dollar appreciates US investment is better X1,S = X0,S, Constant exchange rate US = Japanese X1,S < X0, S, Dollar depreciates US investment is inferior ≥< ≥<

  11. General Case Dollar depreciates: X0,S/X1,S > 1 Example: X0, S = 125 ¥, X1, S = 100 ¥ R0, US = R0, J = 8%. Dollar depreciation results in return of 35% vs 8%.

  12. Example of Dollar Appreciating Time 0: X0, S = 100 ¥; $1 = 100 ¥ Time 1: X1, S = 125 ¥; $1 = 125 ¥

  13. Dollardepreciates: Dollarappreciates:

  14. Assume spot interest rates in the U.S. (R0,US) and in Japan (R0,J) and spot (X0,S) and forward exchange rates (X0,f). Table 17.4. Covered Interest Arbitrage

  15. Since both strategies start with the same amount and there is no risk in either strategy, the values at time 1 must be equal.

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