BUSF_A01.qxd

Summary

This, from an internationally diversified shareholders’ perspective, means that busi-

nesses should leave international specific risks uncovered and not waste money on

managing them.

International investment and agency cost

The vast amount of trading in the international currency futures and options markets

clearly implies that businesses do not follow the message of modern portfolio theory

as applied to internationalised businesses. The reasons for this are not known with

certainty. It may be that managements are not clear on the theory and evidence of

risk reduction by portfolio diversification. Another possibility is that managers do not

always act in the best interests of the shareholder, but have some regard to their own

welfare. At the end of Chapter 7 we discussed the point that managers cannot norm-

ally diversify their employments. If their business suffers a major loss, perhaps as a result

of being exposed to a significant exchange rate risk, and is forced out of business, the

managers will lose their only employment. The well-diversified shareholder can be

more relaxed about the situation, since this loss is likely to be matched by a larger than

expected gain elsewhere. As we shall see in Chapter 16, this point may not be so relevant

for smaller businesses, where diversification at the portfolio level may be impractical.

Irrespective of the theory, it seems that many businesses internationalise at least

partly for risk diversification purposes. The, perhaps unnecessary, costs of managing

exchange rate risks could provide another example of an agency cost.

Business internationalisation

lMany, if not most, businesses are international to some extent.

lExpanded investment opportunities and financing options can generate value.

Foreign exchange (forex)

lA market exists where prices are determined by supply and demand.

lBecause of predictable central bank actions, the market is not necessarily price

efficient.

lCurrencies can be traded (exchanged) for immediate settlement (spot rate) or

for settlement at a point in the future (for example, after a month or a year) at

a different rate (forward rate).

lCurrency dealers will quote two spot rates (for example, US$ per £1) – the first

(lower figure) at which they will sell the foreign currency; the second (higher)

at which they will buy.

Theoretical explanations of relative exchange rates

lLaw of one price =a good or service will have the same price in all countries

and foreign exchange rates will adjust to make this true.

lPurchasing power parity =different inflation rates in different countries will

cause foreign exchange rates to alter so that the law of one price holds.

lFisher effect =real interest rates are equal in different countries, so different

inflation rates across countries should affect nominal (money) interest rates to

make this true.

Summary

‘