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International Corporate Finance

International Corporate Finance. Multinational companies (MNC). Engages significantly in foreign production through its affiliates located in several countries, Exercises direct control over the policies of its affiliates,

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International Corporate Finance

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  1. International Corporate Finance

  2. Multinational companies (MNC) • Engages significantly in foreign production through its affiliates located in several countries, • Exercises direct control over the policies of its affiliates, • Implements business strategies in production, marketing, finance and staffing that transcend national boundaries. In other words, MNCs exhibit no loyalty to the country in which they are incorporated. A MNC is a company that generates at least 25% of its total sales from foreign countries. For example, Shell and Unilever, controlled by British and Dutch interests, are good examples.

  3. International Corporations • Basic Principles still apply: • Create more value for shareholders than they cost and to arrange financing that raises cash at lowest possible cash. Some important point need to be considered in MNC i.e. • Foreign Exchange Rate • Differing Interest Rates from Country to Country • Complex accounting methods • Foreign tax rates • Foreign government intervention

  4. Terminology • American Depositary Receipt • A security issued in the United States representing shares of the foreign stock and allowing that stock to be traded in the US. • Cross Rate • The implicit exchange rate b/w two currencies (usually non US) quoted in some third currency (usually the USD) • Eurobonds • International bonds issued in multiple countries but denominated in a single currency (usually the issuer’s currency) • Euro currency • Money deposited in a financial center outside of the country whose currency is involved.

  5. Foreign Bonds • International bonds issued in a single country, usually denominated in that country’s currency. • Gilts • British and Irish government securities. • London Interbank Offer Rate(LIBOR) • The rate most international banks charge on one another for overnight Eurodollars loans. • Swaps • Agreement to exchange two securities or currencies.

  6. Foreign Exchange Markets & Exchange Rates • Worlds largest financial market. • One country’s currency is traded for another’s. • FEM is an OTC markets. • Participants in FEM include the following • Importers/Exporters • Portfolio manager: buy & sell foreign stock and bonds. • FE Brokers: match buy & sell orders. • Traders: make a market in foreign currency. • Speculators: make profit from changes in exchange rates.

  7. Common Currencies

  8. Exchange Rates Price of one country’s currency expressed in terms of another country’s currency. Examples: 1- Australian dollar is quoted at .7620 which means you can buy one Australian dollar with USD .7620. 2- Suppose you have USD 1,000/-. If Japanese yen per USD is 115.78/-. How many yen can you get. 3- If Porsche costs Euro 100,000/-, how many dollars will you need to buy it?(Euro per USD is 0.7877).

  9. Triangle Arbitrage

  10. Currency Cross Rates Example Euro per $ 1 = 1.00 SF per $ 1 = 2.00 Suppose Cross rate is quoted as Euro per SF=0.4 Then Cross will be inconsistent $100 * SF 2 per $ 1 = SF 200 Converting SF to Euro SF 200 * Euro .4 per SF= € 80

  11. How To Make Money Buy € 100 for $ 100. Use € 100 to buy SF at the cross rate i.e. € per SF = 0.40. you will receive SF 250. Use SF200 to buy dollars. Because the exchange rate is SF 2 per $, you’ll receive $ 125 for a round trip profit of $ 25. This activity is called triangle arbitrage. Cross rate must € 1 per 2 SF otherwise there will be TA.

  12. Example Suppose the exchange rates for the GBP and SF are ; pounds per 1 $= .60 SF per $ 1= 2.00 The cross rate is three francs per pound. Is this consistent ? Explain how to make some money?

  13. Types Of Transactions • Spot Trade • An agreement to trade currencies based on the exchange rate today for settlement within two business days. • Spot Exchange Rate • The exchange rate on the spot trade. • Forward Trade • An agreement to exchange currency at some time in the future. • Forward Exchange Rate • The agreed upon exchange rate to be used in forward trade

  14. Looking Forward Selling at premium Selling at relative discount Example: Expecting to receive a million GBP in six month and you agree to forward rate. Is the pound selling at premium relative to dollar if So=$1.8576=1GBP & F (180 days)=$1.8646=1GBP.

  15. Purchasing Power Parity Purchasing power parity (PPP) is a theory, which states that exchange rates between currencies are in equilibrium when their purchasing power is the same in each of the two countries. This means that the exchange rate between two countries should equal the ratio of the two countries' price level of a fixed basket of goods and services. When a country's domestic price level is increasing (i.e., a country experiences inflation), that country's exchange rate must depreciated in order to return to PPP. The basis for PPP is the "law of one price". In the absence of transportation and other transaction costs, competitive markets will equalize the price of an identical good in two countries when the prices are expressed in the same currency.

  16. Absolute Purchasing Power Parity For example, a particular TV set that sells for 750 Canadian Dollars [CAD] in Vancouver should cost 500 US Dollars [USD] in Seattle when the exchange rate between Canada and the US is 1.50 CAD/USD. If the price of the TV in Vancouver was only 700 CAD, consumers in Seattle would prefer buying the TV set in Vancouver. If this process (called "arbitrage") is carried out at a large scale, the US consumers buying Canadian goods will bid up the value of the Canadian Dollar, thus making Canadian goods more costly to them. This process continues until the goods have again the same price. For absolute PPP to hold , several things must be true; Transaction cost of trading must be zero i.e. shipping, insurance etc. There must be no barriers to trading apples i.e. no tariff, taxes & other barriers. Merchandise should be identical.

  17. Absolute PPP Puk= So * Pus GBP 2.4=So* $ 4 So=GBP .60 & if So=GBP .50 Then round trip gain will be 80 cents.

  18. Relative PPP Its tells what determines the change in the exchange rate over time. And this change ER is determined be difference in the exchange rates of two countries . [E(S1)-So]/So= hfc – hus Or E(St)= So * [1 + (hfc – hus)] e.g. GBP exchange rate is currently So=GBP.50 and inflation rate is UK is predicted to be 10% over coming years and inflation rate in US lets suppose to be predicted at zero. Then we expect the price of dollar will go up by 10 and exchange rate should rise to 0.55 GBP.

  19. Example Suppose the Japanese exchange rate is currently 105 yen per dollar. The inflation rate in japan over the next three years will run, say, 2 % per year, where as the US inflation rate will be 6%. Based on relative PPP, what will the exchange rate be in three years?

  20. Currency Appreciation/Depreciation Strengthening/weakening of Dollar Fluctuation in exchange rate. Inflation rate impact

  21. Covered Interest Arbitrage The term covered refers to the fact that we are covered in the event of change in exchange rate because we lock in the forward exchange rate today. Example: So= SF 2 F1= SF1.90 Rus= 10% Rs= 5 % where Rs is nominal RF Rate in Switzerland. Now check Arbitrage Opportunity $ value in 1 period = $ 1 *(1+Rus)= $ 1.10

  22. If invested in SF. To do this, it need to convert your $ 1 to SF and simultaneously execute a forward trade to convert Francs back to dollars in one year. The steps would be; • Convert you $ 1 to SF $1*So=SF 2 • At the same time enter into forward agreement to convert SF back to dollars in one year. • Invest your SF 2 in Switzerland at Rs. In one year, you will have SF value in 1 year= SF 2 *(1+RS)=2*1.05=SF 2.10 • Convert you SF 2.10 back to dollars at the agreed upon rate of SF 1.90 = $ 1. you end up with a $ value in 1 year=SF 2.10/1.90 =$ 1.1053 The return on investment is apparently 10.53%

  23. Interest Rate Parity The condition stating that the interest rate differential b/w two countries is equal to the percentage difference b/w the forward exchange rate & spot exchange rate. 1+Rus = So * (1 + Rfc)/F1 rearranging this will give us IRP F1/So=(1+Rfc)/(1+Rus) Or (F1-So)/So=Rfc-Rus & F1= S0[1+(Rfc-Rus)]

  24. Example Suppose the exchange rate for the Japanese yen is currently Yen 120= $ 1. if the interest rate in the united states is Rus=10% and the interest rate in japan is Rj=5% then what must the forward rate be to prevent covered interest arbitrage?

  25. Unbiased Forward Rate The condition stating that the current forward rate is an unbiased predictor of the future spot exchange rate. Ft=E(St)

  26. Uncovered Interest Parity The condition stating that the expected percentage change in exchange rate is equal to the difference in interest rate. PPP: E(St)= So * [1 + (hfc – hus)] IRP: F1= S0[1+(Rfc-Rus)] UFR: Ft=E(St) UIP: E(St)= F1= S0[1+(Rfc-Rus)]

  27. International Fisher Effect The theory that real interest rates are equal across countries. S0*[1+(Rfc-Rus)]= So * [1 + (hfc – hus)] IFE: Rus-hus=Rfc-hfc It cause flow of funds to country where real interest rates are high.

  28. International Capital Budgeting • Home Currency Approach • Convert all the euro cash flow into dollars , and then discount at 10% to find NPV in dollars. In this approach, we have to come up with future exchange rates to convert the future projected euro cash flows. • The Foreign Currency Approach • Determine the required return on euro investments and then discount euro cash flow to find NPV in euro. Then convert this NPV to dollar NPV. This approach requires to convert the 10 % dollar return to the equivalent Euro return.

  29. Home Currency Approach Project Cost 2 million euro and expected cash flow will be 0.9 million euro for next three year. If risk free interest rate in Euro land is 7% and in dollar Land its 5%. And required return on this dollar investment is 10% then; exchange rate for the euro is Euro 0.5 E(St)=So * [1+(Re-Rus)]^t E(St)= .5 *[1 +.02]^t Year Expected Exchange rate .5* 1.02=euro 0.5100 .5* 1.02^2= euro 0.5202 .5* 1.02^3= euro 0.5306

  30. Foreign Currency Method hfc-hus=Rfc-Rus NPV= euro.16 million NPV in dollars= $.3 million

  31. Exchange Rate Risk Short Run Exposure Long Run Exposure Translation Exposure

  32. Political Risk

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