Common Stock and its Features: Announce Effect
Announcement of a positive news would cause the stock price to increase because its required ror is likely to decrease and the growth rate in future dividends to increase
Features of Common Stock
Claim on residual income
Preemptive rights
Limited liability.
Claim on Income
-Common shareholders have the right to residual income after bondholders and preferred stockholders have been paid.
-The residual or claim can be in the form of dividends or retained earnings.
Claim on Assets
-Common stock has a residual claim on assets after claims of debt holders and preferred stockholders are satisfied.
-If bankruptcy occurs, claims of the common shareholders generally go unsatisfied.
Preemptive Rights
entitles the existing common shareholders to maintain a proportionate share of ownership in the firm.
Rights
certificates issued to the existing shareholders giving them an option to purchase a stated number of new shares of stock at a specified price during a two- to ten-week period.
Limited Liability
Liability of the shareholder is limited to the amount of their investment.
-Limited liability feature aids the firm in raising funds.
Valuing Common Stock
The value of a common stock is the present value of future or expected dividends and the growth rate.
Valuing Common Stock: 3 Different Kinds of Stock
a) No growth, b) constant growth, and c) differential growth stock (in this class we would not be working on differential growth stock).
Growth
g = ROE x RE
G= ROE x RE
Where g = the growth rate of future earnings and the growth in the common stockholder's investment in the firm, ROE = the return on equity (net income/common book value) and RE = the company's percentage of profits retained - --profit retention rate or re
Valuing Common Stock
Common stock holders receive two types of income: dividends and capital gains/loss (appreciation/depreciation in price),
Dividend Valuation Method
Common stock value = expected dividend in year 1 / (required rate of return - growth rate)
Vcs= D1 / (kcs - g)
Expected dividend for next year: D1 = D0 (1+g)
*D0 is the current or past dividend
-Vcs= D1 / (kcs - g) reduces to Vcs= D0 / kcs as g=0
Valuation Model
assumes that the required ror must be larger than the growth rate, g; otherwise the value of common stock would turn out to be negative and that is not possible.
RROR
The reqd. rate of return, kcs on common stock is also called the cost of raising funds through common stock
Fundamental Principle of Finance
In general, the higher the risk, higher the required rate of return, ceteris paribus
What would be the market value of a stock that paid $2 dividend last year and the dividend growth is expected to be 10% and the investors' ror is 15%?
The dividend last year was $2. Compute the new expected dividend by:
Expected dividend for next year: D1 = D0(1+g) = $2(1+.10)=$2.20
Vcs= D1/ (kcs - g) = $2.20/(.15-.10) = $44
If the future earnings and future cash flows are expected to be positive,
then the value of stock would be positive regardless of the past losses for several years, the value of common stock depends mainly upon the future expected dividends and cash flows.
In calculating the value of common stock,
it is the expected dividend that counts and not the current dividend or past dividend and the value of any asset including common stock is the expected present value of the future cash flows or dividends,
Relationship between past and expected:
Expected dividend = present or past dividend(1+ growth rate) or D1 = D0(1+g),
1. Suppose IBM stock, expected dividend = $3, Mkt. price, P0 = $60, growth rate, g = 8%, what would be the rate of return?
1. Suppose IBM stock, expected dividend = $3, Mkt. price, P0 = $60, growth rate, g = 8%, what would be the rate of return?
IBM Stock, current dividend is $2.50, Mkt. price, P0 = $60, growth rate, g = 8%, what would be the rate of return?
What is the diffe
Expected Rate of Return
The expected rate of return on a security is the required rate of return of investors who are willing to pay the market price for the security. The expected ror differs from investor to investor.
Preferred Stock Expected Return
Annual dividend/market price
Common Stock Expected Return
(Dividend in year 1 / market price) + dividend growth rate
ROR= (D1/P0) + g
If a company is expected to generate profits and revenues for the next several years,
as a result the stock price is likely to increase because the required ror is likely to decrease and growth in future dividends is likely to increase,
Common stock dividends
are not fixed, whereas the dividends on preferred are fixed. These dividends are not tax deductible to individual investors and the issuing firms, but are 70% tax exempt to the holding corporations.
Growth Factor
The growth of a firm depends upon two factors: return on equity and profit retention rate or RE
In other words: g = ROE x Retained earnings ratio
ROE
Net income/book value of common equity
RE ratio
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Suppose, the net income is 4mm, common stock or common equity is 16mm and the dividend payout ratio is 40% then what is the growth rate?
ROE = net income/common equity = 4mm/16 = 25%, retention rate of earnings = 1-dividend payout = 1- .40 =60%
Growth rate, g = 25% x 60% = 15%
Cost of Capital
Hurdle rate for new investment, weighted average cost of capital (WACC), Discount rate, Opportunity cost of funds, Required rate of return that must be earned on additional investment if firm value to remain unchanged.
Investor's Required Rate of Return
the minimum rate of return necessary to attract an investor to purchase or hold a security. Differs from the company's cost of capital for two reasons: taxes and transaction or floatation cost,
Cost of Capital and Investor's Required Rate of Return :
A corporation's cost of capital is different than the investor's ror for two reasons: corporate taxes and floatation cost of new financing
-Corporate Taxes: the tax rate may be different
Floatation Costs
any transaction costs incurred when a firm raises funds by issuing a particular type of security
Flotation Costs
In trading the investment banker/broker charges the trader a transaction cost, also called trading cost, floatation cost or brokerage fee; that could be in
A) percent of the price like 4% of the Face value
B) Flat fee
Net proceeds from bonds, preferred or common stock
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Cost of Capital: We would notice that the cost of debt is the lowest and the cost of new common stock is the highest; rank the following from lowest to highest:
-Retained earnings
-Preferred stock
-New common stock
-Cost of debt
The Cost of Debt
is also called yield to maturity and is tax deductible,
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IBM bond paying 6%, maturing in 10 years and trading for $900. Calculate YTM (yield to maturity) or the cost of bond.
For yield to maturity (YTM) , use the calc as follows: annual coupon payment =$60
YTM: 60 PMT, 10 N, -900 PV, 1000 FV; CPT I/Y = 7.453%
Calculate the after tax cost of debt, given corporate tax rate = 34%
After tax cost of debt = YTM (1-Tc) , here Tc is the marginal corporate tax rate'
After tax cost = 7.453(1-0.34) = 4.92%
Notice, while computing the cost of old or new debt risk free rate is not used, we use only the maturity or principal value or future
Cost of new and old debt
8% YLM bond maturing in 20 years selling for $908.32 with a floatation cost of $58.32 per bond, calculate the YTM and given the tax rate of 34% calculate the after tax cost of new debt.
**Remember, the cost of debt is called the YTM.
-Net price of the bon
What if there were no floatation cost, YTM?
20N 80 PMT -908.32 PV 1000 FV, CPT I/Y = 9.005%
After tax cost of debt without the floatation cost = 9.005(1-0.34) = 5.94%
With a floatation cost, the YTM is always > than without the Floatation cost.
Cost of new preferred stock
is the dividend divided by the net trading or selling price of the preferred.
= Dividend/ (market price -floatation cost)
Market price - floatation cost is also called net selling price
is also called net selling price
Net trading price
is equal to market price minus the floatation cost.
Annual dividend $1.25 on preferred stock, market price of the preferred stock is $18.50 and flotation costs of $1.375 per share, calculate the cost of new preferred stock.
Cost = $1.25/(18.50 -1.375) = .073, or
the Cost of new preferred stock = 7.30%
Net selling price = market price - floatation cost
What if there were no floatation cost, cost of preferred ?
1.25/18.50= 6.76%
cost of new preferred stock features
The cost of preferred stock with floatation cost would always be larger than the cost of preferred stock without floatation cost.
Cost of new or old preferred stock is not tax deductible for the issuing firm, dividend on preferred is also not tax deductib
Common Equity
Sources:
Retained earnings, also called internal equity: No flotation costs on retained earnings
Sales of new common stock shares: involves floatation cost
No tax adjustment is made on these costs as these costs are not tax deductible to the issuing firm
Cost of Common Equity
More difficult to estimate than cost of debt or cost of preferred stock because common stockholder's rate of return is not observable.
Two methods for estimating the cost of common stock:
Dividend Growth Model:
CAPM
A company expects to pay dividends this year to be $2.20, based upon the fact that $2 were paid last year. The firm expects dividends to grow 10% next year and into the foreseeable future. Stock is trading at $50 a share. The floatation cost of new common
Cost of retained earnings: Kcs = (D1/Pcs )+ g
2.20/50 + .10 = .144 or 14.4%
Cost of new common stock: Kncs = ( D1/NPcs)+ g
2.20/(50-7.50) + .10 = .1518 or 15.18%
New common equity or stock (NPcs ), net price
trading price - floatation cost
Notice, the cost of external or new common equity or stock (NPcs) is greater than the cost of RE for one reason:
floatation cost.
Cost of Common Stock: Without Flotation cost
F, the cost to the firm and the ror to the investor is the same
Cost of Common Stock: With Flotation Cost
the cost to the firm would be larger than the ror for the investors
For example, the common stock is selling for $20 and the investors require ror =16%, the floatation cost is 2.00 per share; calculate the cost to the company.
Without F, the cost to the company = 16%
With F, the cost to the company is = 16/(20-2) x 20 = 17.8%
Effect of Beta on the cost of capital
From the CAPM, the cost or required rate return of common stock is influenced by two major factors: Risk free rate and beta
Larger the beta....
larger would be the cost of common stock whether it is a new common stock or old common stock,
Old common stock is
also called retained earnings,
common stock is
also called common equity or simply equity
Pecking Order Hypothesis
Out of convenience and to minimize asymmetric information, the firm uses the RE first followed by debt, preferred stock and new issues of common stock,
In terms of cost:
from lowest cost to the highest cost : debt, preferred stock, RE, and new common stock,
The cost of new common stock has the
highest cost to the firm followed by cost of retained earnings, cost of preferred stock and cost of debt;
So in terms of cost,
the firm finances the projects using outside financing by using debt, preferred stock, and lastly the new common stock issues.
A conflict of Pecking Order of Financing and Cost of Financing:
convenience vs. cost
Firm's cost of capital is influenced by
a) risk free rate
b) business risk
c) financial risk
WACC
is also called cost of capital
differs from the investor's required ror on the company's common stock because of the incurrence of floatation costs when new securities are issued
Capital Structure Mix
proportions of each source of financing used by the firm
Weighted Average Cost of Capital
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A firm borrows money at 6% after taxes and pays 10% for equity. The company raises capital in equal proportions - 50/50
WACC = (.06 X .5) + (.10 X .5) = .08 or 8%
Average WACC 1
Using the WACC as the required ror for every project will maximize the value of the company or shareholders wealth--Goal
Average WACC 2
The Wall mart Stores have the lowest WACC of 5.8% and the Intel Corporation has the highest WACC of 13.2% in 2005,
Average WACC 3
The average WACC has declined from 10.5% in 1993 to 8.7% in 2005,
Average WACC 4
This decline in average WACC is because the average yield on AAA corporate bonds has declined from7% in 1993 to 4.8% in 2005.
Economic Profits
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Total cost is
the sum of both direct (accounting cost) and indirect (opportunity cost of invested capital)
What is the difference between Economic and Accounting profits?
A firm's economic profits is the net operating after-tax profits minus the product of invested capital (indirect or opportunity cost) and the cost of capital (direct cost or accounting cost or dollar cost)
To increase economic profits,
the firm can a) operate machinery and equipment more efficiently
b) growing the firm's investment in projects that earn returns in excess of the firm's cost of capital, WACC
c) identify and improve economic efficiencies
d) increased sales
e) disposing of
By increasing the firm's cost of capital by restructuring the firm's financing resources,
the firm is likely to reduce economic profits and hence not a wise move.
Marginal cost of capital (MCC)
- is defined as the average cost associated with each additional dollar of financing investment projects.
-It is not the incremental return or the risk free rate and not the component cost of
-is always rising.
Capital Budgeting
-Long term Investments in assets, mostly long term fixed assets
-Evaluating the profitability of projects
-Often choosing between one or more projects
-Typically, a firm has a research & development (R & D) department that searches for ways of improving e
Capital Budgeting Criteria
-Payback Period
-Net Present Value
-Profitability Index
-Internal Rate of Return
Calculating Payback Period
-Number of years needed to recover the initial cash outlay of a capital budgeting project
-A Project with an initial cash outlay of $10,000 with following free cash flows for 5 years. Calculate the payback period. 3.5 years
Drawbacks of Payback period
-Drawbacks or disadvantages:
-Ignores the time value of money.
-It is not sensitive to interest rates
-Ignores cash flows after the cut off period
-The cut off period is arbitrary
Advantages of Payback Period
-Emphasizes liquidity
-Tends to reduce firm's risk because it favors projects that generate early and less uncertain returns
-Easier to compute and explain
-Does not increase firm's risk
Net present value
-First of all we calculate the present value of ALL the free cash flows
-Subtract the total of the present value of all of the free cash flows from the initial investment
-This is called the net present value or NPV
-If the NPV is positive the project is
Net present Valye
1 N, 15000 FV, 10 I/Y; CPT PV
If NPV >= 0, accept
If NPV <= 0, reject
1/(1+i)n
is called the present value of a dollar at 10% for n number of years
NPV for Even cash flow
A firm with a 10% required rate of return is considering investing in a new machine with an expected life of six years. The initial cash outlay is $30,000 with the following free cash flows. Calculate NPV given ror =10%,
-Initial investment or outlay = 30
Net Present Value (NPV)
-NPV is consistent with maximizing share holders' wealth
-Accounts for the time value of money
-Uses all the project's cash flows
-Superior to the payback method for the above reasons
-Criticism: However, the NPV method is criticized because it requires a
Profitability Index
PI = PV of cash flows/ Initial outlay
PI > 1 = accept PI < 1 = reject
NPV AND PI
When the present value of a project's cash flows are greater than the initial cash outlay, the project NPV will be positive, > 0
-PI will also be greater than 1.
-NPV and PI will always yield the same decision
-For project to be acceptable, the NPV>0 and
Internal Rate of Return
IRR involves calculating the ror such that the present value of cash flows is equal to the investment or outlay.
-Investment or cost or initial outlay = $45,555, Cash flow: $15000/ year for four years, Calculate IRR.
Soln.: 15000 PMT, 4N, -45,555 PV, CPT
IRR
-Discount rate or ror that equates the present value of a project's future net cash flows with the project's initial cash outlay or outflows
-If IRR > Required rate of return, accept
-IF IRR < Required rate of return, reject
IRR and NPV
-If NPV is positive, IRR will be greater than the required rate of return
-If NPV is negative, IRR will be less than required rate of return
-If NPV = 0, IRR is equal to the required rate of return.
-NPV, PI, and IRR are criticized because all of them req
Advantages of IRR
-Considers all the cash flows
-Fully considers the time value of money
Disadvantages of IRR
-IRR implicitly assumes that the cash flows are reinvested at the ror equal to the IRR; it is an unrealistic reinvestment assumption
-For mutually exclusive projects it gives conflicting answers
-It can result in multiple rates of return in some cases
Acceptability of a project
-NPV of an independent project is >0
-The NPV of a mutually exclusive project is positive and exceeds that of all other projects
-The Profitability index of an independent project >1
-The IRR of a mutually exclusive project exceeding the required ror is n
Mutually Exclusive Projects
-You take only one project and preclude all other projects, a set of proposals or projects performing essentially the same task, for example; two laptops, you need only one
-For mutually exclusive investment project, out of all the capital budgeting metho
Independent projects
you can take as many projects as you desire so long as the NPV>0
Capital Rationing
-Limit on the dollar size of the capital budget
-The company would not impose capital rationing if the company's stock price is historically high
-NPV always provides the correct decision provided capital rationing is not imposed
-If capital rationing is
Capital rationing is imposed
1) if the capital market conditions are poor
2) management has a fear of financing through debt
3) stockholders control the issuance of new additional stock
4) the shortage of qualified human capital.
Business Risk
Relative dispersion (variability) in the firm's expected earnings before interest and taxes (EBIT)
Operating Risk
operating risk varies as the firm's investment in long term assets (fixed cost) varies, we use break-even analysis to evaluate operating risk.
Financial Risk
also called Interest Rate Risk:
-a direct result of the firm's financing decision.
the additional variability in earnings available to the firm's common shareholders
-the additional chance of insolvency borne by the common shareholder caused by the use of
Risk
larger the risk, larger the expected ror, in general.
the business risk affects the volatility of the firm's revenues; EBIT and in turn affects the EPS; following are the basic determinants of Business risk:
-The stability of the domestic economy: developed nations have more stable economy, subject to fewer business cycles than a developing economy like China and India
-The exposure to international markets: think of China and India and other mainly dependent
Break-even Analysis
-The break-even analysis is used to assess the operating risk of investment in fixed assets
-Break-even may be calculated in units or sales dollars
-Use of break-even model enables the financial officer to determine the quantity of output that must be sol
Break Even point
EBIT = (Sales price per unit)* (units sold)
- [(variable cost per unit) *(units sold) + (total fixed cost)]
Net Income or profits =EBIT = P x Q - (VC x Q + FC),
or Net Income or profits = Q(P-VC) - FC
At the break even point the profits =0, therefore solv
Example:
Selling price per unit is $10, Variable cost per unit is $6, and Fixed costs are $100,000, What is the breakeven quantity?
Break-even quantity in units = $100,000/ ($10-$6) = 25,000 units
Break even in sales= 25,000 x 10 = $250,000
EBIT = $6000, variable
Variable Costs
includes the cost of goods sold or cost of prod'n, administrative and selling cost, commissions etc.
Break-even in sales
-Sales =20mm, EBIT = 10mm, Fixed expenses=2mm, Variable cost 40% of sales, calculate the BE in sales
-Total VC = TVC = 0.40 x 20mm = 8mm
-BE in sales or revenue = FC/(1-(TVC/Sales)) =2mm/(1- (8mm/20mm)) =$3,333,333
Fixed Costs
Indirect Cost or Fixed Costs
-Do not vary in total amount as sales volume or the quantity of output changes over some relevant range of output.
-As production volume increases, fixed costs per unit of product falls, as fixed costs are spread over a larger
Examples of Fixed Costs
Administrative salaries
Depreciation
Insurance
Lump sums spent on intermittent advertising programs
Property taxes
Rent or lease payments
Variable Costs
Direct or Variable Costs
Total variable costs are computed by taking the variable cost per unit (VC) and multiplying it by the quantity (Q) or output produced and sold,
TVC = VC x Q
Examples of Variable Costs
Direct labor
Direct materials
Energy costs (fuel, electricity, natural gas) associated with the production area
Freight costs
Packaging
Sales commissions
Shut down conditions: Short Run
-If the price of the product is < the variable cost, the plant would shut down
-The plant may operate so long as the selling price is larger or at least equal to the total and not just some of the variable cost even under depressed sales or recession
Shut down conditions: Long Run
The plant would operate if and only if the selling price covers all the costs- both the variable and fixed costs
Operating Leverage
Incurrence of fixed operating costs in the firm's income stream.
Financial Leverage
Financing a portion of the firm's assets with securities bearing a fixed (limited) rate of return in hopes of increasing the ultimate return to the common stockholders. It is the amount of debt in the capital structure.
Combined Leverage
combination of operating and financial leverage
If a firm has no leverage
either operating or financial leverage, then any increase in sales, say 15% would increase EPS exactly by 15%.
Operating Leverage (DOL)
The effect of fixed operating cost, i.e. Fixed costs (FC) on the firm's income stream is called Operating leverage
DOL = (Sales - Total Variable costs )/ (Sales - Total Variable costs - Total Fixed costs), or
DOL = [Q(P-VC)]/[(Q(P-VC) - FC)]
DOL = (Sales
Change in EBIT = change in Q * DOL
Larger the FC, larger the DOL; larger the DOL, larger the fluctuations in EBIT
Smaller the FC, smaller the DOL; smaller the DOL, smaller the fluctuations in EBIT
Operating leverage is the response of Firm's EBIT to the fluctuation in sales.
Let's calculate the DOL for the two firms: AMC and YLM; given Q = 70,000 units, P = $5.0, VC = $3.0, FC(AMC) = $40,000, FC(YLM) =$60,000; calculate the DOL for each firm.
DOL (AMC) =70K(5-3)/(70K(5-3)-40K) =1.40
DOL(YLM) = 70K(5-3)/(70K(5-3)-60K) =1.75
Notice, at a given level of output, Q, the DOL is larger for a larger FC firm
Financial Leverage (DFL)
-Financing a portion of the firm's assets with debt in the hopes of increasing return or EPS to stockholders
-DFL Measured by Percentage change in EPS / Percentage change in EBIT
-Larger the amount of debt, larger the DFL; larger the DFL, larger the fluct
DFL = EBIT/(EBIT - I), where I is the annual interest on debt
Lower the amount of debt, lower the DFL; lower the DFL, lower the fluctuations in EPS with changes in sales
-In other words, the amount of debt and its interest expense affect the fluctuations in EPS
-Financial leverage is the responsiveness of the firm's
Financial Leverage more defined
-Financial leverage implies the use of debt
-A firm is likely to use less debt in its capital structure if
-Desires to maintain financial flexibility
-To maintain high credit rating
-An increase in the marginal tax rate would increase the use of debt in i
Calculating DFL
-EBIT for both A and B are $50,000, Debt at 10% = $100,000 for A and $60,000 for B. Calculate DFL for A and B.
-DFL = EBIT/(EBIT - INT.)
DFL for A = 50,000/(50,000 - 10,000) = 1.25
-DFL for B = 50,000/(50,000 -6,000) = 1.14
-Make sure it is the annual Int
DOL, DFL and Combining Leverage
-Changes in sales revenues cause greater changes in EBIT; changes in EBIT create larger variations in both EPS and total earnings available to common shareholders, if the firm chooses to use financial leverage.
-Combining operating and financial leverage
Degree of Combined Leverage (DCL)
-DOL x DFL = DCL
-DCL= [Q (P-V)] / [Q(P-V) - FC - I]
-DCL = (Sales -Total VC)/ (Sales - Total VC - FC - I)
Note: Sales = Price per unit x Q; Total VC = VC per unit x Q
Net Income
-To see the effect on EBIT, use DOL
-To see the effect on net earnings or NI use DCL
-Change in net income = change in Q x DCL
-Change in EBIT = change in Q * DOL
Optimal Capital Structure
-Optimal capital structure consist of debt, preferred stock, RE and common stock; minimizes the firm's composite cost of capital, The composite cost is also called WACC, weighted average cost of capital.
-Hence the firm's capital structure occurs where WA
Practical Guide to Financial Management
Financial Flexibility
Credit Rating
Insufficient RE
Market Interest Rates and Tax deductibility
Floatation Cost
Probability of Bankruptcy
Comparable Industry Ratios about Debt
To see the effect on EBIT, use DOL
To see the effect on net earnings or NI use
The Multi-national Firm
Business risk is multidimensional and international, and is affected by:
-The sensitivity of the firm's product demand to general economic conditions
-The degree of competition to which the firm is exposed
-Product diversification
-Growth prospects
-Globa
Direct foreign Investment
When the multinational corporation (MNC), a corporation with holdings and/or operations in more than one country, has control over the investment, such as when it builds an offshore manufacturing facility.
Portfolio Investment
-Financial assets with maturities greater than one year such as purchase of foreign stock and bonds
-Total foreign investment in the U.S. now exceeds such U.S. investment overseas.
International Financial Investment
-Major reasons for long-run overseas investments:
-Earn higher returns with a lower risk than those obtainable in the domestic capital markets
-Reduce portfolio risk through international diversification
Exchange Rates
Floating or flexible Exchange rate international currency system
-A system in which exchange rates between different national currencies are allowed to fluctuate with supply and demand conditions.
Short-term day to day fluctuations in exchange rates
are caused by changing supply and demand conditions in the foreign exchange market.
Fact
Whereas the U.S. is on a floating/flexible exchange rate system, China is on a fixed exchange rate system.
A spot or current transaction
occurs when one currency is immediately�on the spot is exchanged to another currency at the current price.
A forward rate
is the actual spot or current rate that will prevail in the future and is not known today
Direct Quote
-Indicates the number of units of the home currency required to buy one unit of the foreign currency
-Direct Quote is the dollar/foreign currency rate ($/FC), e.g. one dollar = 5 francs
Indirect Quotes
-Indicates the number of units of a foreign currency that can be bought for one unit of the home currency
-Foreign currency/dollar (FC/$), e.g. one franc =$1/5=20c.
-Reciprocal of a direct quote
Spot Exchange Rate
implies current exchange rate
Forward or Future exchange rate
implies next period's exchange rate; sometimes a month or three months later.
If an American company must pay 1,000 euros to a German firm for a motor cycle . How many dollars will be required for this transaction, given one euro buys 1.2164 dollars?
1 euro = 1.2164 dollars
Therefore, 1, 000 euros = 1.2164 * 1,000 = $1,216.40
Asked rate
-Rate the bank of the foreign exchange trader "asks" the customer to pay in home currency for foreign currency when the bank is selling to the customer.
-Also known as selling rate or offer rate
Bid Rate
-The rate at which the bank buys the foreign currency from the customer by paying in home currency
-Also know as buying rate
Bid-Asked Spread (also called service charge or commission or transaction cost)
-The difference between the asked quote and the bid quote
-Wider the bid/ask spread, more inefficient market
-Larger the volume transaction, lower the bid/ask spread
-The presence of arbitrageurs would lower the bid/ask spread
-Frequent trading of currenc
Cross Rates
The computation of an exchange rate for a currency from the exchange rates of two other currencies
Cross Rates Example
For example; one dollar = 5 Francs, and one Franc = 22 yens, how many yens can you buy for a dollar?
$1 = 5 * 22 = 110 yens.
Purchasing power parity
The price of a good, assuming no market imperfections such as quotas, tariffs, transaction costs, would be equal in all countries in the long run after we adjust for the rate of inflation and the exchange rate
This theory states that in the long run the e
Interest Rate Parity
-Interest rates across the nations tend to be equal after adjusting for the rate of inflation and exchange rate, assuming no market imperfections
-This theory states that the forward premium or discount should be equal but opposite in size to the national
International Fisher Effect
-Any interest rate differential across the nations is mainly because of inflation differentials
-This Fisher effect assumes no market imperfections like quotas, embargo, tariffs and no transaction costs
-Empirically, this theory is proven to be correct
Factors Affecting Value of Currency in the Exchange Market
-A large Govt. spending decreases the value of currency in the exchange market
-Stock market rally: (rally means increase in the Down Jones's average ) increases the value of currency
-Increase in Money Supply increase the rate of inflation and decreases
Factors Affecting Value of Currency in the Exchange Market
-Net exports (export - imports ) if positive, increases the value of currency
-Real Interest rates: higher real interest rates increase the value of the currency in which the real interest rates are higher
-Exports increase the value of currency, while im
Exchange Rate Risk
-Exchange rate risk arises from the fact that the spot/current exchange rate on a future date is a random variable or it is unknown.
Examples:
-Exchange rate risk in international trade contracts
-Exchange rate risk in foreign portfolio investments
-Excha
Multinational Working-Capital Management
-Basic principles of working-capital (CA-CL) management for a multinational corporation are similar to those of a domestic firm.
-Tax rates and exchange rates are additional considerations
-Funds may be transferred from a subsidiary of the multinational c
Foreign Exchange market
-The foreign exchange market is a network of telephone and computer connections across the world
-It is not meant to provide mechanism for transfer of equity ownership from one party to the other
-It is a large in number and size of purchase
-There is no
Domestic Risk and International Risk
-Business Risk: fluctuations in cash flows; applicable to both domestic and MNC's
-Financial Risk: also called Interest Rate Risk: Refinancing and interest rate risk; applicable to both domestic and MNC's
International Risk
-Exchange Rate Risk: risk of fluctuating exchange rates as discussed above.
-Political Risk:
International Diversification
The whole idea of international investment is diversification of your portfolio in order to reduce portfolio risk.
Political Risk
--Expropriation or/and blockage of profits,
--Blocked funds
--Local equity participation requirements
-Exchange or local currency restrictions
Require certain amount of local owernship
Balance of Payments Accounting
Balance of Payments includes the net balance of three accounts:
-Current Account
-Capital Account
-Official Account
*The sum of the (net) balance of these 3 accounts should be equal to zero (more on this later); just like in an Accounting Balance Sheet: A
BOPA
Current Account (largest items): Exports - Imports
Capital Account (largest items): Foreign Direct Investment + Portfolio Investment
--Foreign Direct Investment (FDI)
-Transactions involving purchases and sales of Real Estate, factories and other real ass
Balance of Payments Accounting : portfolio Investment
Transactions involving purchases and sales of financial assets like, Treasury bills/bonds and stocks from and to other countries
Example:
China boosted its holdings of US Treasury securities by $1.5 billion in July to a total of $1.277 trillion
Balance of Payments Accounting: Official Settlement Account
transactions of international reserve assets (like, gold and foreign currency) between central banks.