Welcome to Week 12

• Week 11 Content Quiz (Cash & Liquidity)

• Going Forward: #13 Course Review

(longer review quiz will be provided), #14
Final Examination (On-Line at 5:30pm)

• This evening's lecture: International

Aspects of Financial Management

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 Key Concepts and Skills
• Know the different terminologies used in international
finance
• Understand how exchange rates are quoted, what they
mean, and the difference between spot and forward rates
• Understand purchasing power parity, interest rate parity,
unbiased forward rates, uncovered interest rate parity, and
the generalized Fisher effect and their implications for
exchange rate changes
• Be able to estimate NPV using both the home and foreign
currency approach
• Know the different types of exchange rate risk and ways
firms manage this risk
• Understand the impact of political risk on international
business investing
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 Chapter Outline
• Terminology
• Foreign Exchange Markets and Exchange Rates
• Purchasing Power Parity
• Interest Rate Parity, Unbiased Forward Rates,
and the Generalized Fisher Effect
• International Capital Budgeting
• Financing International Projects
• Exchange Rate Risk
• Political and Governance Risks
• Summary and Conclusions

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 Domestic Financial Management and
International Financial Management
• Considerations in International Financial
Management
• Have to consider the effect of exchange rates
when operating in more than one currency
• Have to consider the political risk associated
with actions of foreign governments
• More financing opportunities when you consider
the international capital markets and this may
reduce the firm’s cost of capital

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 International Finance Terminology
• Cross-rate
• Eurobond
• Eurocurrency (Eurodollars)
• Export Development Canada (EDC)
• Foreign bonds
• Gilts
• London Interbank Offer Rate (LIBOR)
• Swaps – Interest rate and currency

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 Global Capital Markets
• The number of exchanges in foreign
countries continues to increase, as does
the liquidity on those exchanges
• Exchanges that allow for the flow of capital
are extremely important to developing
countries
• Canada has a very developed capital
market, but foreign markets are becoming
more competitive and are often willing to
try more innovative ways to do business
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 Exchange Rates
• The price of one country’s currency in
terms of another
• Most currency is quoted in terms of US
dollars
• Some currencies are quoted the other way
around
• Make sure that you know what the quote
means!

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Figure 21.1 – Spot Rate Quotations

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Figure 21.1 – Forward Exchange
Rate Quotations

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Figure 21.1 – Cross Rate Quotations

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 Interpreting Exchange Rate Quotes
• Consider the following quote from Figure 21.1:
• Canadian Dollar (Canada $) 1.2760
• The first number (1.2760) is how many Canadian
dollars it takes to buy U$1
• You can calculate a second number (0.7837),
which is how many U.S. dollars it takes to buy C$1
• Notice that the two numbers are reciprocals of
each other (1/ 1.2760 = 0.7837)

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 Example: Exchange Rates
• Suppose you have U$10,000 . Based on the
rates in Figure 21.1, how many Swiss francs can
you buy?
• Exchange rate = 0.9493 francs per U.S. dollar
• Buy 10,000(0.9493) = 9,493 francs
• Suppose you are visiting New Delhi and you
want to buy a souvenir that costs 1,000 Indian
Rupees. How much does it cost in U.S. dollars?
• Exchange rate = 63.4344 rupees per dollar
• Cost = 1000 / 63.4344 = U$15.76
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 Example: Cross Rates
• Assume that we observe the following quotes:
• 1.15 CAD per U$1
• 115 Yen per U$1
• 105 Yen per C$1

• What is the cross rate?

• (Y115 / U$1) / (C$1.15 / U$1) = Y100 per C$1

• Since the implied cross rate is Y100 per C$1, and the
observed cross rate is Y105 per C$1, there is an
arbitrage opportunity
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 Example continued: Triangle Arbitrage
• We have C$100 to invest; buy low, sell high
• Buy C$100(Y105/C$1) = Y10,500, use Y to
buy USD
• Buy Y10,500 / (Y115/U$1) = U$91.3043, use
USD to buy Canadian dollars
• Buy U$91.3043 (C$1.15/U$1) = C$105
• Make C$5 risk-free

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 Types of Transactions
• Spot trade – exchange currency
immediately
• Spot rate – the exchange rate for an
immediate trade
• Forward trade – agree today to exchange
currency at some future date and some
specified price (also called a forward
contract)
• Forward rate – the exchange rate
specified in the forward contract
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 Forward Premium
• If the forward rate is higher than the spot
rate, the foreign currency is selling at a
premium (when quoted as $ equivalents
i.e. U$/C$)
• From Figure 21.1, the Canadian dollar is
trading at 0.7837 spot against the U.S.
dollar and 0.7841 six-months forward
• Since C$1 will buy more U.S. dollars in the
future, the Canadian dollar is trading at a
forward premium
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 Forward Discount
• If the forward rate is lower than the spot
rate, the foreign currency is selling at a
discount
• From Figure 21.1, the U.S. dollar is trading
at 1.2760 spot against the Canadian dollar
and 1.2753 6-months forward
• Since U$1 will buy less Canadian dollars in
the future, the U.S. dollar is trading at a
forward discount
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 Absolute Purchasing Power Parity
• Price of an item is the same regardless of
the currency used to purchase it
• Requirements for absolute PPP to hold
• Transaction costs are zero
• No barriers to trade (no taxes, tariffs, etc.)
• No difference in the commodity between
locations
• Absolute PPP rarely holds in practice for
many goods
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 Relative Purchasing Power Parity
• Provides information about what causes
changes in exchange rates
• The basic result is that exchange rates
depend on relative inflation between
countries
• E(St ) = S0[1 + (hFC – hCDN)]t
• Because absolute PPP doesn’t hold for
many goods, we will focus on relative PPP
from here on out
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 Example: PPP
• Suppose the Japanese spot exchange rate
is 130 yen per Canadian dollar. Japanese
inflation over the next three years is
expected to be 2% per year and Canadian
inflation is expected to be 6%.
• Do you expect the Canadian dollar to appreciate
or depreciate relative to the yen?
• Since inflation is higher in Canada, we would expect
the dollar to depreciate relative to the yen.
• What is the expected exchange in three years?
• E(S3) = 130[1 + (.02 - .06)]3 = 115.02

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 Covered Interest Arbitrage
• Examine the relationship between spot
rates, forward rates and nominal rates
between countries
• The Canadian risk-free rate is assumed to
be the T-bill rate

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 Example: Covered Interest
Arbitrage
• Consider the following information
• S0 = 2 GBP / C$ RCAD = 10%
• F1 = 1.8 GBP / C$ RB = 5%
• What is the arbitrage opportunity?
• Borrow C$100 at 10%
• Buy C$100(2 GBP/$) = 200 GBP and invest at 5% for 1
year. Enter into a forward agreement to lock-in your
future exchange rate.
• In 1 year, receive 200(1.05) = 210 GBP and convert
back to Canadian dollars via the forward agreement
• 210 GBP / (1.8 GBP / $) = C$116.67 and repay loan
• Profit = C$116.67 – C$100(1.1) = C$6.67 risk free

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 Interest Rate Parity
• Based on the previous example, there
must be a forward rate that would prevent
the arbitrage opportunity.
• Interest rate parity defines what that
forward rate should be
F1 (1  RFC )
Exact : 
S0 (1  RCAD )
Approx. : F1  S 0  1  ( RFC  RCAD ) 

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 Unbiased Forward Rates
• The current forward rate is an unbiased
estimate of the future spot exchange
rate
• This means that on average the forward
rate will equal the future spot rate

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Unbiased Forward Rates Continued
• If the forward rate is consistently too high
• Those who want to exchange yen for dollars would
only be willing to transact in the future spot market
• The forward price would have to come down for trades
to occur
• If the forward rate is consistently too low
• Those who want to exchange dollars for yen would
only be willing to transact in the future spot market
• The forward price would have to come up for trades to
occur

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 Uncovered Interest Parity (UIP)
• What we know so far
• PPP: E(S1) = S0[1 + (hFC – hCAD)]
• IRP: F1 = S0[1 + (RFC – RCAD)]
• UFR: F1 = E(S1)
• Combining the formulas we get
uncovered interest parity (UIP):
• E(S1) = S0[1 + (RFC – RCAD)] for one period
• E(St) = S0[1 + (RFC – RCAD)]t for t periods

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 Generalized Fisher Effect
• Combining PPP and UIP we can get the
Generalized Fisher Effect
• RCAD – hCAD = RFC – hFC
• The Generalized Fisher Effect tells us that
the real rate of return must be constant
across countries
• If it is not, investors will move their money to
the country with the higher real rate of return

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 International Capital Budgeting
• Section 5

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Overseas Production: Alternative Approaches

• There are two approaches for evaluating

international capital budgeting projects:

1. Home Currency Approach

2. Foreign Currency Approach

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 Home Currency Approach
1. Estimate cash flows in foreign currency
2. Estimate future exchange rates using UIP
3. Convert future cash flows to dollars
4. Discount using domestic required return

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 Example: Home Currency Approach
• Your company is looking at a new project in
Mexico.
• The project will cost 9 million pesos. The cash
flows are expected to be 2.25 million pesos per
year for 5 years. The current spot exchange
rate is 9.08 pesos per Canadian dollar. The
risk-free rate in the Canada is 4% and the risk-
free rate in Mexico 8%. The dollar required 
return is 15%.
• Should the company make the investment?
• Spreadsheet: 
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 Foreign Currency Approach
1. Estimate cash flows in foreign currency
2. Use the IFE to convert domestic required return
to foreign required return
3. Discount using foreign required return
4. Convert NPV to dollars using current spot rate

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 Example: Foreign Currency Approach
• Use the same information as the previous
example to estimate the NPV using the Foreign
Currency Approach
• Mexican inflation rate premium from the
International Fisher Effect is 8% - 4% = 4%
• Required Return = 15% + 4% = 19%
• PV of future cash flows = 6,879,679
• NPV = 6,879,679 – 9,000,000 = -2,120,321
pesos
• NPV = -2,120,321 / 9.08 = -233,516
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 Repatriated Cash Flows
• Often some of the cash generated from a
foreign project must remain in the foreign
country due to restrictions on repatriation
• Repatriation can occur in several ways
• Dividends to parent company
• Management fees for central services
• Royalties on the use of trade names and patents

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 Financing International Projects
• Section 6

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Required Return for International
Projects
• Should the required return on an
international project be different from a
similar domestic project?
• Depends on:
• Segmentation of the international financial
market
• Risk of expropriation
• FX controls
• Taxes

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 Efficient Investment in
International Markets
• An Index Participation allows investors to
place funds in international markets
through financial engineering. 
• The most commonly quoted is the S&P 500
Index for equities. 

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 Sources of Financing
• In raising short-term and medium-term
cash, Canadian international firms can:
• Borrow from a Canadian bank at Canadian
rates
• Borrow from a Eurobank outside Canada
through the Eurocurrency market, often at a
floating interest rate (LIBOR + a margin)
• Issue short-term notes through a Note Issuance
Facility (NIF)

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 Exchange Rate Risk
• Section 7

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 Transaction Exposure
• Risk from day-to-day fluctuations in exchange
rates and the fact that companies have contracts
to buy and sell goods in the short-run at fixed
prices
• Managing risk
1. Enter into a forward agreement to guarantee
the exchange rate
2. Use foreign currency options to lock in
exchange rates if they move against you but
benefit from rates if they move in your favour
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 Economic Exposure
• Long-run fluctuations come from
unanticipated changes in relative economic
conditions
• Could be due to changes in labour markets
or governments
• More difficult to hedge
• Try to match long-run inflows and outflows
in the currency
• Borrowing in the foreign country may
mitigate some of the problems
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 Translation Exposure
• Income from foreign operations has to be translated
back to dollars for accounting purposes, even if
foreign currency is not actually converted back to
dollars
• If gains and losses from this translation flowed
through directly to the statement of comprehensive
income, there would be significant volatility in EPS
• Current accounting regulations require that all cash
flows be converted at the prevailing exchange
rates with currency gains and losses
accumulated in a special account within
shareholders equity

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 Managing Exchange Rate Risk
• Large multinational firms may need to
manage the exchange rate risk associated
with several different currencies
• The firm needs to consider its net exposure
to currency risk instead of just looking at
each currency separately
• Hedging individual currencies could be
expensive and cost may not match
potential benefit
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 Political and Governance Risk
• Section 8

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 Political & Governance Risks
• Political Risk – changes in value due
to political actions in the foreign country
such as confiscation, or interruption due
to war or civil unrest
• Governance Risk – loss due to lack of
transparency of foreign operations
• Investment in countries that have
unstable governments should require
higher returns
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 Political & Governance Risk -
continued
• The extent of political risk depends on the nature
of the business
• The more dependent the business is on other
operations within the firm, the less valuable it is
to others
• Natural resource development can be very
valuable to others, especially if much of the
ground work in developing the resource has
already been done
• Local financing can often reduce political
risk
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 Quick Quiz
• What does an exchange rate tell us?
• What is triangle arbitrage?
• What are absolute purchasing power parity and relative
purchasing power parity?
• What are covered interest arbitrage and interest rate parity?
• What are uncovered interest parity and the Generalized Fisher
Effect?
• What are the two methods for international capital budgeting?
• What is the difference between short-run interest rate exposure
and long-run interest rate exposure? How can you hedge each
type?
• What is political risk and what types of business face the
greatest risk?

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 Summary
• You should know:
• Basic terms such as LIBOR, Eurocurrency and cross-
rate.
• The basic mechanics of exchange rate quotations
• Fundamental relationships between international
financial variables such as purchasing power parity,
uncovered interest rate parity and the international
Fisher effect
• How to manage exchange rate risk
• How to evaluate international capital budgeting projects

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 End of Week 12
• Be sure to submit any outstanding
assignment. 
• Prepare for the final examination by
reviewing chapters 16, 17, 18, 19, 21.
• Focus on the basic questions from the
textbook, and review any lecture slides. 
• Next week is review, and I will distribute a
longer quiz for next class, which covers Ch.
21, and previous chapters. 
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