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CHAPTER. 31. International Corporate Finance. 31.1 Terminology 31.2 Foreign Exchange Markets and Exchange Rates 31.3 The Law of One Price and Purchasing Power Parity 31.4 Interest Rates and Exchange Rates: Interest Rate Parity 31.5 International Capital Budgeting

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  1. CHAPTER 31 InternationalCorporate Finance

  2. 31.1 Terminology 31.2 Foreign Exchange Markets and Exchange Rates 31.3 The Law of One Price and Purchasing Power Parity 31.4 Interest Rates and Exchange Rates: Interest Rate Parity 31.5 International Capital Budgeting 31.6 International Financial Decisions 31.7 Reporting Foreign Operations 31.8 Summary and Conclusions Chapter Outline

  3. 31.1 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 are: 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.

  4. 31.1 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 on another for loans of Eurodollars overnight in the London market.

  5. 31.2 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 (€) • German deutschemark (DM) • French franc (FF)

  6. 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.

  7. Correspondent Banking Relationships • Large commercial banks maintain demand deposit accounts with one another which facilitates the efficient functioning of the forex market. • International commercial banks communicate with one another with: • SWIFT: The Society for Worldwide Interbank Financial Telecommunications. • CHIPS: Clearing House Interbank Payments System • ECHO Exchange Clearing House Limited, the first global clearinghouse for settling interbank FOREX transactions.

  8. Spot Rate Quotations • The spot market is the market for immediate delivery. (Settlement is due within two days.) • Direct quotation • the U.S. dollar equivalent • e.g. “a Japanese Yen is worth about a penny” • Indirect Quotation • the price of a U.S. dollar in the foreign currency • e.g. “you get 100 yen to the dollar”

  9. Spot FX trading • In the interbank market, the standard size trade is about U.S. $10 million. • A bank trading room is a noisy, active place. • The stakes are high. • The “long term” is about 10 minutes.

  10. DM $ DM = ´ since , ¥ ¥ $ DM $ 1 DM 2 DM 1 = ´ = = ¥ ¥100 $ 1 ¥50 Þ = = S ( 0 ) .02 or DM1 ¥50 / ¥ DM 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?

  11. Credit Lyonnais S£(0) = 1.50 Barclays S¥(0) = 120 ¥ Credit Agricole S¥/£(0) = 85 Triangular Arbitrage Suppose we observe these banks posting these exchange rates. $ £ First calculate the implied cross rates to see if an arbitrage exists.

  12. £1.50 $1 × $1 ¥120 Credit Lyonnais S£(0) = 1.50 £1 Barclays S¥(0) = 120 = ¥80 ¥ Credit Agricole S¥/£(0) = 85 Triangular Arbitrage The implied S(¥/£) cross rate is S(¥/£) = 80 $ Credit Agricole has posted a quote of S(¥/£)=85 so there is an arbitrage opportunity. £ So, how can we make money?

  13. Credit Lyonnais S£(0) = 1.50 Barclays S¥(0) =120 ¥ Credit Agricole S¥/£(0) = 85 Triangular Arbitrage As easy as 1 – 2 – 3: $ £ 1. Sell our $ for £, 2. Sell our £ for ¥, 3. Sell those ¥ for $.

  14. 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

  15. The Forward Market • A forward contract is an agreement to buy or sell an asset in the future at prices agreed upon today. • If you have ever had to order an out-of-stock textbook, then you have entered into a forward contract.

  16. Forward Rate Quotations • The forward market for FOREX involves agreements to buy and sell foreign currencies in the future at prices agreed upon today. • Bank quotes for 1, 3, 6, 9, and 12 month maturities are readily available for forward contracts. • Longer-term swaps are available.

  17. Forward Rate Quotations • Suppose you observe that for Japanese yen, the spot rate is ¥115.75 = $1.00 While the 180-day forward rate is ¥ 112.80 = $1.00 • What’s up with that? The forex market clearly thinks that the yen is going to be worth more in six months (the yen is expected to appreciate) because one dollar will buy fewer yen.

  18. Long and Short Forward Positions • If you have agreed to sell anything (spot or forward), you are “short”. • If you have agreed to buy anything (forward or spot), you are “long”. • If you have agreed to sell forex forward, you are short. • If you have agreed to buy forex forward, you are long.

  19. 31.3 The Law of One Price and Purchasing Power Parity • The exchange rate between two currencies should equal the ratio of the countries’ price levels. S£(0) = P$ P£ • Relative PPP states that the rate of change in an exchange rate is equal to the differences in the rates of inflation. e = $- £ • If U.S. inflation is 5% and U.K. inflation is 8%, the pound should depreciate by 3%.

  20. Evidence on PPP • PPP probably doesn’t hold precisely in the real world for a variety of reasons. • Haircuts cost 10 times as much in the developed world as in the developing world. • Film, on the other hand, is a highly standardized commodity that is actively traded across borders. • Shipping costs, as well as tariffs and quotas can lead to deviations from PPP. • PPP-determined exchange rates still provide a valuable benchmark.

  21. 31.4 Interest Rates and Exchange Rates: 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.

  22. F Future value = $100,000 × × (1 + i¥) S F × (1 + i¥) = (1 + i$) S Interest Rate Parity Defined Suppose you have $100,000 to invest for one year. You can either • Invest in the U.S. at i$. Future value = $100,000×(1 + i$) • 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. Since both of these investments have the same risk, they must have the same future value:

  23. (1 + i$) F or if you prefer, = (1 + i¥) S F – S i$–i¥ = F S × (1 + i¥) = (1 + i$) S Interest Rate Parity Defined Formally, IRP is sometimes approximated as

  24. IRP and Covered Interest Arbitrage If IRP failed to hold, an arbitrage 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.

  25. 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: • exchange $1,000 for £800 at the prevailing spot rate, (note that £800 = $1,000÷$1.25/£) • invest £800 at i£ = 11.56% for one year to achieve £892.48. • Translate £892.48 back into dollars at F£(360) = $1.20/£, the £892.48 will be exactly $1,071.

  26. Can invest in the U.S. In one year his investment will be worth $1,071 = $1,000(1.071) = $1,000(1+ i$) IRP and Covered Interest Arbitrage A trader with $1,000 to invest

  27. £800 $1.25 £800 = $1,000× £1 In one year £800 will be worth £892.48 = $1,000 $1,000(1+ i£) Bring it on back to the U.S.A. $1.20 $1,071 = £892.48 × £1 IRP and Covered Interest Arbitrage Invest £800ati£ = 11.56% Domestic FV = $1,071 and British FV = $1,071

  28. IRP & Exchange Rate Determination According to IRP only one 360-day forward rate, F£(360), can exist. It must be the case that F£(360) = $1.20/£ Why? If F£(360)  $1.20/£, an astute trader could make money with one of the following strategies:

  29. Arbitrage Strategy I If F£(360) > $1.20/£ i. Borrow $1,000 at t = 0 at i$ = 7.1%. ii. Exchange $1,000 for £800 at the prevailing spot rate, (note that £800 = $1,000÷$1.25/£) invest £800 at 11.56% (i£) for one year to achieve £892.48 iii. Translate £892.48 back into dollars, if F£(360) > $1.20/£ , £892.48 will be more than enough to repay your dollar obligation of $1,071.

  30. £800 £1 £800= $1,000× $1.25 $1,000 F£(360) $1,071 < £892.48 × £1 Step 2: buy pounds Arbitrage I Step 3: Invest £800 at i£ = 11.56% In one year £800 will be worth £892.48 = £892.48 £800 (1+ i£) Step 4: repatriate to the U.S.A. Step 1: borrow $1,000 More than $1,071 Step 5: Repay your dollar loan with $1,071. If F£(360) > $1.20/£ , £892.48 will be more than enough to repay your dollar obligation of $1,071 the excess is your profit.

  31. Arbitrage Strategy II If F£(360) < $1.20/£ i. Borrow £800 at t = 0 at i£= 11.56% . ii. Exchange £800 for $1,000 at the prevailing spot rate, invest $1,000 at 7.1% for one year to achieve $1,071. iii. Translate $1,071 back into pounds, if F£(360) < $1.20/£ , $1,071 will be more than enough to repay your £ obligation of £892.48.

  32. Step 2: buy dollars $1.25 $1,000 = £800× £1 Step 3: Invest $1,000 at i$ Step 4: repatriate to the U.K. F£(360) $1,071 > £892.48 × £1 Arbitrage II £800 Step 1: borrow £800 $1,000 Step 5: Repay your pound loan with £892.48 . More than £892.48 In one year $1,000 will be worth $1,071 If F£(360) < $1.20/£ , $1,071 will be more than enough to repay your dollar obligation of £892.48. Keep the rest as profit.

  33. IRP and Hedging Currency Risk You are a U.S. importer of British woolens and have just ordered next year’s inventory. Payment of £100,000,000 is due in one year. IRP implies that there are two ways that you fix the cash outflow a) Put yourself in a position that delivers £100M in one year—a long forward contract on the pound. You will pay (£100,000,000)×($1.2/£) = $120,000,000 b) Form a forward market hedge as shown below.

  34. IRP and a Forward Market Hedge To form a forward market hedge: Borrow $112.05 million in the U.S. (in one year you will owe $120 million). Translate $112.05 million into pounds at the spot rate S£(0) = $1.25/£ to receive £89.64 million. Invest £89.64 million in the UK at i£ = 11.56% for one year. In one year your investment will have grown to £100 million—exactly enough to pay your supplier.

  35. £100 £89.64 = 1.1156 $100 $112.05 = £89.64 × £1.25 Forward Market Hedge Where do the numbers come from? We owe our supplier £100 million in one year—so we know that we need to have an investment with a future value of £100 million. Since i£ = 11.56% we need to invest £89.64 million at the start of the year. How many dollars will it take to acquire £89.64 million at the start of the year if S£(0) = $1.25/£?

  36. 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.

  37. E(e) IFE FP PPP F – S i$–i¥ IRP S FE FRPPP $–£ Equilibrium Exchange Rate Relationships

  38. 31.5 International Capital Budgeting A recipe for international decision makers: 1. Estimate future cash flows in foreign currency. 2. Convert to U.S. dollars at the predicted exchange rate. 3. Calculate APV using the U.S. cost of capital.

  39. – 600€ 200€ 500€ 300€ 0 1 year 2 years 3 years International Capital Budgeting: Example Consider this European investment opportunity: i$= 15% P€ = 3% P$ = 6% S€(0)= $.55265 Is this a good investment from the perspective of the U.S. shareholders?

  40. – 600€ 200€ 500€ 300€ 0 1 year 2 years 3 years International Capital Budgeting: Example $331.56 CF0 = (€600)× S€(0)=(€600)×($.5526/€) = $331.56

  41. – 600€ 200€ 500€ 300€ 0 1 year 2 years 3 years International Capital Budgeting: Example $331.56 $113.70 CF1 = (€200)×E[S€(1)] E[S€(1)]can be found by appealing to the interest rate differential: E[S€(1)]= [(1.06/1.03) S€(0)] = [(1.06/1.03)($.5526/€) ] = $.5687/€ so CF1 = (€200)×($.5687/€) = $113.7

  42. – 600€ 200€ 500€ 300€ 0 1 year 2 years 3 years $113.70 $292.60 $180.70 APV = –$331.56 + + + = $107.30 (1.15) (1.15)2 (1.15)3 International Capital Budgeting: Example $331.56 $113.70 $292.60 $180.70 Similarly, CF2 = [(1.06)2/(1.03)2 ]×S€(0)(€500) = $292.6 CF3 = [(1.06)3/(1.03)3 ]× S€(0)(€300) = $180.7

  43. Risk Adjustment in the Capital Budgeting Process • Clearly risk and return are correlated. • Political risk may exist along side of business risk, necessitating an adjustment in the discount rate.

  44. 31.6 International Financial Decisions • An international firm can finance foreign projects in three basic ways: • It can raise cash in the home country and export it to finance the foreign project. • It can raise cash by borrowing in the foreign country where the project is located. • It can borrow in a third country where the cost of debt is lowest.

  45. 31.7 Reporting Foreign Operations • When a U.S. multinational experiences favorable exchange rate movements, should this be reflected in the measurement of income? • This is a controversial area. Two issues seem to arise: • What is the appropriate exchange rate to use for translating each balance-sheet account? • How should the unrealized accounting gains and losses from foreign-currency translation be handled? • Currency is currently translated under complicated rules set out in FASB 52.

  46. The Mechanics of FASB Statement 52 • Functional Currency • The currency that the business is conducted in. • Reporting Currency • The currency in which the MNC prepares its consolidated financial statements.

  47. The Mechanics of FASB Statement 52 • Two-Stage Process • First, determine in which currency the foreign entity keeps its books. • If the local currency in which the foreign entity keeps its books is not the functional currency, remeasurement into the functional currency is required. • Second, when the foreign entity’s functional currency is not the same as the parent’s currency, the foreign entity’s books are translated using the current rate method.

  48. Current Rate Method • All balance sheet items (except for stockholder’s equity) are translated at the current exchange rate. • A “plug” equity account named cumulative translation adjustment (CTA) is used to make the balance sheet balance

  49. Parent’s Currency The Mechanics of FASB Statement 52 Parent’s currency Foreign entity’s books kept in? Nonparent Currency Third currency Functional Currency? Temporal Remeasurement Local currency Current Rate Translation Parent’s Currency

  50. 31.8 Summary and Conclusions • This chapter describes some fundamental theories of international finance: • Purchasing Power Parity • Expectations theory of exchange rates • The interest-rate parity theorem • This chapter also describes some of the problems of international capital budgeting. • We briefly describe international financial markets.

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