Chapter 20

International Corporate Finance

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 Key Concepts and Skills
 Understand how exchange rates are quoted and what
they mean
 Know the difference between spot and forward rates
 Understand purchasing power parity and interest rate
parity and the implications for changes in exchange
rates
 Understand the basics of international capital
budgeting
 Understand the impact of political risk on
international business investing
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 Chapter Outline
20.1 Terminology
20.2 Foreign Exchange Markets and Exchange Rates
20.3 Purchasing Power Parity
20.4 Interest Rate Parity, Unbiased Forward Rates, and
the International Fisher Effect
20.5 International Capital Budgeting
20.6 Exchange Rate Risk
20.7 Political Risk

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 20.1 Terminology
 American Depository Receipt (ADR): a security issued in the
U.S. to represent shares of a foreign stock
 Cross rate: the exchange rate between two foreign currencies,
e.g., the exchange rate between £ and ¥
 Euro (€): the single currency of the European Monetary
Union which was adopted by 11 Member States on 1 January
1999. These member states were: Belgium, Germany, Spain,
France, Ireland, Italy, Luxemburg, Finland, Austria, Portugal
and the Netherlands
 Eurobonds: bonds denominated in a particular currency and
issued simultaneously in the bond markets of several
countries
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 Terminology
 Eurocurrency: money deposited in a financial center
outside the home country. Eurodollars are dollar
deposits held outside the U.S.; Euroyen are yen
denominated deposits held outside Japan.
 Foreign bonds: bonds issued in another nation’s
capital market by a foreign borrower
 Gilts: British and Irish government securities
 LIBOR: the London Interbank Offer Rate is the rate
most international banks charge one another for
loans of Eurodollars overnight in the London market
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 20.2 Foreign Exchange Markets and
Exchange Rates
 Without a doubt, the foreign exchange market is the
world’s largest financial market.
 In this market, one country’s currency is traded for
another’s.
 Most of the trading takes place in a few currencies:
 U.S. dollar ($)
 British pound sterling (£)
 Japanese yen (¥)
 Euro (€)

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 FOREX Market Participants
 The FOREX market is a two-tiered market:
 Interbank Market (Wholesale)
 About 700 banks worldwide stand ready to make a
market in Foreign exchange.
 Nonbank dealers account for about 20% of the market.

 There are FX brokers who match buy and sell orders but

do not carry inventory and FX specialists.

 Client Market (Retail)
 Market participants include international banks,
their customers, nonbank dealers, FOREX
brokers, and central banks.
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 Exchange Rates
 The price of one country’s currency in terms of
another.
 Most currency is quoted in terms of dollars.
 Consider the following quote:
 Euro 1.3170 .7593
 The first number (1.3170) is how many U.S. dollars it
takes to buy 1 Euro
 The second number (.7593) is how many Euros it
takes to buy $1
 The two numbers are reciprocals of each other
(1/1.3170 = .7593)
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 Example
 Suppose you have $10,000. Based on the rates in
Figure 20.1, how many Swiss Francs can you buy?
 Exchange rate = 1.2146 Francs per dollar
 Buy 10,000(1.2146) = 12,146 Francs
 Suppose you are visiting Bombay and you want to
buy a souvenir that costs 1,000 Indian Rupees. How
much does it cost in U.S. dollars?
 Exchange rate = 43.384 rupees per dollar
 Cost = 1,000 / 43.384 = $23.05

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 Cross Rates
 Suppose that SDM(0) = .50
 i.e., $1 = 2 DM in the spot market
 and that S¥(0) = 100
 i.e., $1 = ¥100
 What must the DM/¥ cross rate be?
DM $ DM
since   ,
¥ ¥ $
DM $1 DM 2 DM 1
   
¥ ¥100 $1 ¥50
 S DM / ¥ (0)  .02 or DM1  ¥50
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 Triangular Arbitrage
Suppose we
observe these $
Barclays Credit
banks posting Lyonnais
these exchange S¥(0) = 120
S£(0) = 1.50
rates.

First calculate the ¥ £

implied cross Credit Agricole
rates to see if an S¥/£(0) = 85
arbitrage exists.
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 Triangular Arbitrage
The implied S(¥/£) cross rate is S(¥/£) = 80
$
Barclays Credit
£1.50 $1 £1 Lyonnais
× =
$1 ¥120 ¥80 S¥(0) = 120
S£(0) = 1.50
Credit Agricole has
posted a quote of ¥
S(¥/£)=85, so there £
is an arbitrage Credit Agricole
opportunity. S¥/£(0) = 85

So, how can we make money?

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 Triangular Arbitrage
As easy as 1 – 2 – 3:
$
Barclays Credit
Lyonnais
S¥(0) =120
S£(0) = 1.50

¥ £
1. Sell our $ for £, Credit Agricole
2. Sell our £ for ¥, S¥/£(0) = 85
3. Sell those ¥ for $.
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 Triangular Arbitrage
Sell $100,000 for £ at S£(0) = 1.50
receive £150,000
Sell our £ 150,000 for ¥ at S¥/£(0) = 85
receive ¥12,750,000
Sell ¥ 12,750,000 for $ at S¥(0) = 120
receive $106,250

profit per round trip = $ 106,250 – $100,000 = $6,250

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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
 If the forward rate is higher than the spot rate, the
foreign currency is selling at a premium (when quoted
as $ equivalents).
 If the forward rate is lower than the spot rate, the
foreign currency is selling at a discount.
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 20.3 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

 For most goods, Absolute PPP rarely holds in

practice.

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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 – hUS)]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
 Suppose the Canadian spot exchange rate is
1.18 Canadian dollars per U.S. dollar. U.S.
inflation is expected to be 3% per year, and
Canadian inflation is expected to be 2%.
 Do you expect the U.S. dollar to appreciate or
depreciate relative to the Canadian dollar?
 Since inflation is higher in the U.S., we would expect
the U.S. dollar to depreciate relative to the Canadian
dollar.
 What is the expected exchange rate in one year?
 E(S ) = 1.18[1 + (.02 - .03)] 1
= 1.1682
1
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 20.4 Interest Rate Parity
 IRP is an arbitrage condition.
 If IRP did not hold, then it would be possible
for an astute trader to make unlimited
amounts of money exploiting the arbitrage
opportunity.
 Since we don’t typically observe persistent
arbitrage conditions, we can safely assume
that IRP holds.

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 Interest Rate Parity
Suppose you have $100,000 to invest for one year.
You can either
1. Invest in the U.S. at i$.
Future value = $100,000×(1 + i$)
2. Trade your dollars for yen at the spot rate, invest in
Japan at i¥ and hedge your exchange rate risk by selling
the future value of the Japanese investment forward.
F
Future value = $100,000 × × (1 + i¥)
S
Since both of these investments have the same risk, they must
have the same future value:
F
× (1 + i¥) = (1 + i$)
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 Interest Rate Parity
F
Formally, × (1 + i¥) = (1 + i$)
S

F
or if you prefer, = (1 + i $ )
S (1 + i¥)

IRP is sometimes approximated as

i$ – i¥ = F–S
S
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 IRP and Covered Interest Arbitrage
If IRP failed to hold, an arbitrage opportunity would exist. It’s
easiest to see this in the form of an example.
Consider the following set of foreign and domestic interest rates
and spot and forward exchange rates.
Spot exchange rate S£(0) = $1.25/£
360-day forward F£(360) = $1.20/£
rate
U.S. discount rate i$ = 7.10%
British discount i£ = 11.56%
rate
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 IRP and Covered Interest Arbitrage
A trader with $1,000 to invest could invest in the U.S.,
in one year his investment will be worth $1,071 =
$1,000(1+ i$) = $1,000(1.071)
Alternatively, this trader could:
1. exchange $1,000 for £800 at the prevailing spot rate,
(note that £800 = $1,000÷$1.25/£)
2. invest £800 at i£ = 11.56% for one year to achieve
£892.48.
3. Translate £892.48 back into dollars at F£(360) =
$1.20/£, the £892.48 will be exactly $1,071.
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 IRP and Covered Interest Arbitrage
A trader with $1,000 to invest:

Can invest in the U.S.

In one year his investment
will be worth
$1,071 = $1,000(1.071)
= $1,000(1+ i$)
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 IRP and Covered Interest Arbitrage
£800
$1.25 Invest £800
£800= $1,000×
£1 at i£ =
11.56%
$1,000
In one year £800
will be worth
£892.48 =
$1,000(1+ i£)

Domestic FV = Bring it on back

$1,071 and to the U.S.A. $1.20
British FV = $1,071 = £892.48 ×
£1
$1,071
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 Reasons for Deviations from IRP
 Transactions Costs
 The interest rate available to an arbitrageur for
borrowing, ib,may exceed the rate he can lend at, il.
 There may be bid-ask spreads to overcome, Fb/Sa < F/S
 Thus
(Fb/Sa)(1 + i¥l)  (1 + i¥ b)  0
 Capital Controls
 Governments sometimes restrict import and export of
money through taxes or outright bans.

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 International Fisher Effect
 Combining PPP and UIP we can get the
International Fisher Effect:
 RUS – hUS = RFC – hFC
 The International 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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 Equilibrium Exchange Rate Relationships

E(e)
IFE FP
PPP
i$ – i¥ IRP
F–S
S
FE FRPPP
h$ – h£
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 20.5 International Capital Budgeting
 Home Currency Approach
 Estimate cash flows in foreign currency
 Estimate future exchange rates using UIP
 Convert future cash flows to dollars
 Discount using domestic required return
 Foreign Currency Approach
 Estimate cash flows in foreign currency
 Use the IFE to convert domestic required return to foreign
required return
 Discount using foreign required return
 Convert NPV to dollars using current spot rate
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 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 dollar. The
risk-free rate in the US is 4%, and the risk-free
rate in Mexico 8%. The dollar required return
is 15%.
 Should the company make the investment?
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 Foreign Currency Approach
 Use the same information as the previous
example to estimate the NPV using the
Foreign Currency Approach
 Mexican inflation rate 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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 20.6 Exchange Rate Risk
 Short-Run Exposure
 Long-Run Exposure
 Translation Exposure

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 Short-Run 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
 Enter into a forward agreement to guarantee the
exchange rate.
 Use foreign currency options to lock in exchange
rates if they move against you, but benefit from
rates if they move in your favor.
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 Long-Run Exposure
 Long-run fluctuations come from
unanticipated changes in relative economic
conditions
 Could be due to changes in labor 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 must be translated
back to U.S. 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 income statement, 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 may actually increase exposure.

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 20.7 Political Risk
 Changes in value due to political actions in the foreign
country
 Investment in countries that have unstable governments
should require higher returns.
 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 International 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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