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Chapter 21 International Corporate Finance

Chapter 21 International Corporate Finance. 21.1 Terminology 21.2 Foreign Exchange Markets and Exchange Rates 21.3 Purchasing Power Parity 21.4 Interest Rate Parity, Unbiased Forward Rates, and the International Fisher Effect 21.5 International Capital Budgeting 21.6 Exchange Rate Risk

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Chapter 21 International Corporate Finance

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  1. Chapter 21International Corporate Finance • 21.1 Terminology • 21.2 Foreign Exchange Markets and Exchange Rates • 21.3 Purchasing Power Parity • 21.4 Interest Rate Parity, Unbiased Forward Rates, and the International Fisher Effect • 21.5 International Capital Budgeting • 21.6 Exchange Rate Risk • 21.7 Political Risk • 21.8 Summary and Conclusions Vigdis Boasson Mgf301 School of Management, SUNY at Buffalo

  2. 21.2 Domestic Financial Management and International Financial Management • Domestic financial management and international financial management differ in several important ways: • Whenever transactions involve more than one currency, one must be concerned with the levels of, and possible changes in, exchange rates. • Another risk that must be considered is the risk of loss associated with actions taken by foreign governments. This political risk can be difficult to assess, and difficult to hedge against; • Financing opportunities encompass international capital markets and instruments, which can reduce the firm’s cost of capital.

  3. 21.3 International Finance Terminology • American Depository Receipt (ADR) • Security issued in the US representing shares of a foreign stock and allowing that stock to be traded in the US. • Cross-Rate • Implicit exchange rate between two currencies quoted in a third currency. • European Currency Unit (ECU) • Index of 10 European currencies; served as a monetary unit for European Monetary System. • Eurobond • bonds issued in many countries but denominated in a single currency.

  4. 21.3 International Finance Terminology-continued • Eurocurrency • money deposited outside the country whose currency is involved. • Foreign Bonds • bonds issued in a single country, denominated in that country’s currency, but not issued by a domestic firm. • Gilts • British and Irish government securities. • LIBOR - London Interbank Offer Rate • the rate most international banks charge each one another for overnight Eurodollar loans. • Swaps • agreements to exchange securities, currencies, or even commodities.

  5. 21.4 Global Capital Markets - Representative Listing Americas New York Stock ExchangeAmerican Stock ExchangeBoston Stock ExchangeCincinnati Stock ExchangeChicago Stock ExchangePacific Stock ExchangePhiladelphia Stock ExchangeChicago Board of TradeKansas City Board of Trade Toronto Stock Exchange Asia/Pacific Region Australian Stock ExchangeSydney Futures ExchangeNew Zealand Stock Exchange Hong Kong Stock ExchangeHong Kong Futures Exchange Shanghai Securities ExchangeShenzen Stock Exchange Osaka Stock ExchangeTokyo Stock ExchangeTokyo Int’l Financial Futures Exchange Singapore Stock Exchange Kuala Lumpur Stock Exchange Europe and the U.K. Frankfurt Stock Exchange London Stock Exchange Paris Bourse Swiss Stock Exchange

  6. 21.5 Triangle Arbitrage • Suppose we observe the following exchange rates for French francs, German marks, and U.S. dollars. Does an arbitrage opportunity exist? FF per $1 = 10.00 DM per $ = 2.00 FF per DM = 4.00 Step 1. Buy 1,000 francs for 100 U.S. dollars Step 3.Step 2.Exchange DM 250 for $125 U.S. Buy DM 250 for 1,000 francs You’ve just made $25! The no-arbitrage cross rate is: FF per DM = 10/2 = 5.00

  7. 21.6 Triangle Arbitrage-continued In general: • If the exchange rate (C1 per C2) is less than the implied cross-rate (C1 indirect quote)/(C2 indirect quote), then buy C1 with dollars, trade C1 for C2, trade C2 for dollars. • If the exchange rate (C1 per C2) above the implied cross-rate (C1 indirect quote)/(C2 indirect quote), then buy C2 with dollars, trade C2for C1, trade C1 for dollars.

  8. 21.7 Exchange rate Triangle arbitrage: • If the exchange rate (C1 per C2) is less than the implied cross-rate (C1 indirect quote)/(C2 indirect quote), then buy C1 with dollars, trade C1 for C2, trade C2 for dollars. • If the exchange rate (C1 per C2) above the implied cross-rate (C1 indirect quote)/(C2 indirect quote), then buy C2 with dollars, trade C2for C1, trade C1 for dollars. Types of transactions: • Spot rate-exchange of currencies based on current quotes. • Forward rate -agreement for an exchange in the future at the forward exchange rate. If the direct quote forward exchange rate is higher than the spot rate, the currency is selling at a premium; if lower, at a discount.

  9. 21.8 Purchasing Power Parity Purchasing Power Parity (PPP) • Absolute PPP states that a commodity should sell for the same real price regardless of the currency used to purchase it. • Let S0 be the spot exchange rate (indirect quote) between a currency and the U.S. dollar at time 0. Let PF be the foreign price of a commodity, and PUS be the U.S. price. Absolute PPP states: • PF = S0 x PUS • Because of product differences, barriers to trade, tariffs, and transportation costs, absolute PPP tends to hold only for traded commodities with low transfer costs.

  10. 21.9 Purchasing Power Parity Example: Gold • Gold is a commodity that is easily traded by receipt. If gold is selling for £195 in London, and the spot rate between pounds and dollars is .5940, what price is gold likely to sell for in New York? • Rearranging:PF = S0xPUS • gives: PUS = (PF/S0) = (£195/.5940) = $328.28. • B. Relative Purchasing Power Parity • The change in the exchange rate is determined by the difference in the inflation rates between two countries. • In general, relative PPP states the expected exchange rate t periods hence is about: • E[St] = S0 x[1 + (hFC - hUS)]t

  11. 21.10 Interest Rate Parity • Covered Interest Arbitrage A covered interest arbitrage exists when an arbitrage profit can be made by: • Step1. converting dollars into a foreign currency, • Step 2. investing at that country's interest rate, • Step 3. taking a forward contract to convert the foreign currency back into U.S. dollars for more than could earned than by directly investing at the U.S. rate. • The foreign investment yields a total of: S0 x (1+RFC)/F1 per dollar. • If this is greater than the U.S. yield of (1 + RUS) per dollar, an arbitrage opportunity exists.

  12. 21.11 Interest Rate Parity • Interest Rate Parity (IRP) • To prevent covered interest arbitrage, S0 x (1 + RFC)/F1 = (1 + RUS) must hold. • Rearranging terms gives the interest rate parity (IRP) condition: F1/S0 = (1 + RFC)/(1 + RUS) Useful approximations: (F1 - S0)/S0 = RFC - RUS Ft = S0 x[1 + (RFC - RUS)]t • Loosely, IRP says the difference in interest rates between two countries is just offset by the change in the relative value of the currencies.

  13. 21.12 Interest Rate Parity Example: • Suppose the French Franc spot rate (indirect quote) is 6.3800. • If RF = 6% and RUS= 8%, what F1 will prevent covered interest rate arbitrage? Ft = S0 x[1 + (RFC - RUS)]t Ft = 6.3800 x [1 + (.06 - .08)] = FF 6.2524

  14. 21.13 IRP, UFR, International Fisher Effect Forward Rates and Future Spot Rates • Unbiased forward rates (UFR) states the forward rate, Ft, is equal to the expected future spot rate, E[St]. That is, on average, forward rates neither consistently understate nor overstate the future spot rate. • That is: Ft = E[St] Putting It All Together PPP: E[S1] =S0 x [1 + (hFC- hUS)] IRP: F1 = S0x [1 + (RFC-RUS)] UFR: Ft = E[St]

  15. 21.14 IRP, UFR, International Fisher Effect • Uncovered interest parity (UIP) combining UFR and IRP gives: • E[S1] = S0 x[1 + (RFC - RUS)] • E[St] = S0 x[1 + (RFC - RUS)]t • The International Fisher Effect combining PPP and UIP gives: • S0 x [1 + (hFC - hUS)] = S0 x [1 + (RFC - RUS)] so that: hFC- hUS = RFC- RUS And RUS - hUS = RFC - hFC • The IFE says that real rates must be equal across countries.

  16. 21.15 International capital budgeting Alternative Approaches to Overseas Production • Implementing production overseas can occur several ways. Firms wishing to do so must weigh such factors as the amount of capital they wish to supply, the nature and length of the commitment they are willing to make, and the amount of control they wish to retain in the operation. • Alternative approaches include: • Subcontracting/Licensing agreements • Joint venture • Acquisition of existing facility or firm • Construction of new facility

  17. 21.16 Example: International Capital Budgeting • A company is considering opening a store in Mexico. The store would cost $500,000 or, at 6.000 pesos per dollar, 3,000,000 pesos to open. They hope to operate the store for 2 years and then sell it to a local franchisee. • Assume that the expected cash flows are 250,000 pesos the first year and 5 million pesos the second year, including the selling price of the store and fixtures. The U.S. risk-free rate is 7%, and the Mexican risk-free rate is 10%. The required return is 12% (U.S.) (Ignore taxes in your computations.)

  18. 21.17 Example: International Capital Budgeting (continued) • 1. The home currency approach Using the uncovered interest parity relation: E[St] = S0 x[1 + (RFC - RUS)]t The projected exchange rates for the store are: E[S1] = 6 x[1 + (.10-.07)]1 = 6.1800 E[S2] = 6 x[1 + (.10-.07)]2 = 6.3654 Cash flow Expected Cash flow Year (pesos) exchange rate (dollars) 0 -3,000,000 6.0000 - 500,000 1 250,000 6.1800 40,453 2 5,000,000 6.3654 785,497 NPV = -$500,000 + 40,453/1.12 + 785,497/1.122 = $162,312

  19. 21.18 Example: International Capital Budgeting (concluded) • 2. The foreign currency approach Using a 3% inflation premium, (1.12 x 1.03) - 1 = 15.36% NPV (pesos) = - 3,000,000 + 250,000/1.1536 + 5,000,000/1.15362 = 973,871 pesos NPV (dollars) = 973,871/6.0000 = $162,312 The two approaches produce the same answer.

  20. 21.19 Types of Risk • Exchange rate risk • Short-run exposure • Long-run exposure • Translation exposure • Political risk Risk Nature of Loss Currency devaluation Loss in value of cash flows in terms of home currency. Increased taxation Reduction in total cash flows repatriated. Funds blockage Reduction or elimination of cash flows repatriated. Expropriation of assets Loss of firm property and future cash flows. Terrorism/sabotage Danger to employees and/or loss of future cash flows.

  21. 21.20 Solution to Problem 21.7 • The treasurer of a major U.S. firm has $20 million to invest for three months. The annual interest rate in the United States is 0.50 percent per month. The interest rate in Great Britain is .75 percent per month. The spot exchange rate is £0.59, and the three-month forward rate is £0.61. Ignoring transactions costs, in which country would the treasurer want to invest the company’s funds? Why? • If invested in the U.S., the $20 million will grow to: $20M(1.0050)3=$20,301,503 If invested in Great Britain, the $20 million will grow to: [($20M)(£0.59)(1.0075)3]/(£0.61) = $19,782,781 Thus, the treasurer will be $518,722 = ($20,301,503 - $19,782,781) ahead if the funds are invested in the U.S.

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