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I nternational C orporate F inance Chapter 21

I nternational C orporate F inance Chapter 21. Issue 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

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I nternational C orporate F inance Chapter 21

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  1. International Corporate FinanceChapter 21 Issue in International Financial Management • Have to consider the effect of exchange rateswhen operating in more than one currency • Have to consider the political riskassociated with actions of foreign governments • More financing opportunitieswhen you consider the international capital markets, which may reduce the firm’s cost of capital

  2. International Finance Terminology Cross-rates (see: http://fx.sauder.ubc.ca/ ) • Cross-rate – implied exchange rate between two currencies, when both currencies are quoted in terms of a third one • Eurobond – bond sold in more than one country, but denominated in one currency, usually the issuer’s domestic currency • Eurocurrency – money deposited in a bank in a country with a different currency; Eurodollars are US dollars deposited in a foreign bank • Foreign bonds – bonds issued in a single foreign country in that country’s currency • Gilts– British and Irish government issues • LIBOR – loan rate on Eurodollars – commonly used as an index for floating rate securities • Swaps – interest rate (agreement between two parties to pay interest to one another on some notional amount, one party pays a fixed rate, the other pays a floating rate) and currency (agreement to periodically swap currencies, with exchange rate based on some pre-specified rate)

  3. 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 • The United States has one of the most developed capital markets in the world, but foreign markets are becoming more competitive and are often willing to try more innovative ways to do business • Can buy and sell foreign stocks in dollars in the US with American Depository Receipts(ADRs)

  4. 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: Euro1.1237 .8899 • The first number (1.1237) is how many U.S. dollars it takes to buy 1 Euro, that is about $1.12. • The second number (.8899) is how many Euros it takes to buy $1, that is about € .89 • The two numbers are reciprocals of each other ( 1/ 1.1237 = .8899)

  5. April 19, 2019 • Grey column is the Direct Quote • if you live in the US, as in $ /€ Source: http://www.marketwatch.com/investing/currencies/tools

  6. Exchange Rates • Suppose you have $10,000. Based on the rates Yen = 108, how many Japanese Yen can you buy? • Exchange rate = 112 Yen per dollar • Buy 10,000(112) = 1,120,000 Yen • Suppose you are visiting Mumbai, India and you want to buy a souvenir that costs 1,000 Indian Rupees. How much does it cost in U.S. dollars? • Exchange rate = 69.4 rupees per dollar • Cost = 1,000 / 69.4 = $14.41

  7. Triangle Arbitrage • Suppose we observe the following quotes • 1 Euro per $1 • 2 Swiss Franc per $1 • .4 Euro per 1 Swiss Franc • What is the cross rate? • (1 Euro / $1) / (2 SF / $1) = .5 Euro / SF • We have $100 to invest; buy low, sell high • Buy $100(1 Euro/$1) = 100 Euro, use Euro to buy SF • Buy 100 Euro / (.4 Euro / 1 SF) = 250 SF, use SF to buy dollars • Buy 250 SF / (2 SF/$1) = $125 • Make $25 risk-free Free Money, Cool

  8. 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

  9. AbsolutePurchasing Power Parity • Price of an item is the same regardless of the currency used to purchase it • Obeys the law of one price • 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

  10. Relative Purchasing Power Parity • Provides information about what causes changes in exchange rates • The basic result is that exchange rates depend on relative inflation rates (shown as h’s) 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

  11. PPP • Suppose the Canadian spot exchange rate is C$ 1.27 per U.S. dollar (or $.79/1C$). • U.S. inflation is expected to be 2% per year and Canadian inflation is expected to be 3%. • Do you expect the U.S. dollar to appreciate or depreciate relative to the Canadian dollar? • Since expected inflation is higher in Canada, we would expect the U.S. dollar to appreciate relative to the Canadian dollar. • What is the expected exch. rate in one year E(S1) = 1.27 [1 + (.03 - .02)]1 = 1.2827 E(St ) = S0[1 + (hFC – hUS)]t

  12. Covered Interest Arbitrage • Examines the relationship between spot rates, forward rates, and nominal rates between countries • Again, the formulas will assume that the exchange rates are quoted in terms of foreign currency per U.S. dollar Indirect quotes, as in €.81 • The U.S. risk-free rate is assumed to be the T-bill rate

  13. Covered Interest Arbitrage • Consider the following information • S0 = .8 Euro / $ RUS = 4% • F1 = .7 Euro / $ RE = 2% • What is the arbitrage opportunity? • Borrow $100 at 4% • Buy $100(.8 Euro/$) = 80 Euro and invest at 2% for 1 year • In 1 year, receive 80(1.02) = 81.6 Euro and convert back to dollars • 81.6 Euro / (.7 Euro / $) = $116.57 and repay loan • Profit = 116.57 – 100(1.04) = $12.57 risk free • The Carry Trade • e.g., Japanese investors buying $’s, investing in US T-Bills to get higher US interest rates • Some is covered, much is not covered

  14. 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

  15. 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 • So if 1-year forward rate for the Canadian Dollar was C$1.28 /$, the forecast for spot rate in 1 year for the Canadian dollar is C$1.28 /$.

  16. Uncovered Interest Parity • What we know so far • PPP: E(S1) = S0[1 + (hFC – hUS)] • IRP: F1 = S0[1 + (RFC – RUS)] • UFR: F1 = E(S1) • Combining the formulas we get • E(S1) = S0[1 + (RFC – RUS)] for one period UIP: E(St) = S0[1 + (RFC – RUS)]t

  17. Diagram of Parity Conditions Exchange Rate Forecasts Unbiased Forward Rate Purchasing Power Parity Forward Rate Premium or Discount Uncovered Interest Rate Parity Differences in Inflation Rates International Fisher Effect Interest Rate Parity Differences in Interest Rates

  18. 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

  19. Overseas Production: Alternative Approaches • 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

  20. 1. 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 18.8 pesos per dollar. The risk-free rate in the US is 2% and the risk-free rate in Mexico 4%. The dollar required return is 15%. • Should the company make the investment? • Today’s FX rate is really 18.8 Ps per $.

  21.  UncoveredInterest Parity The future expected exchange rates estimated using the uncovered interest parity condition at a required return of 15% NPV = -$96,478.69 1. Using the Home Currency Approach:

  22. 2. 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 4% - 4% = 2% • Required Return = 15% + 2% = 17% • PV annuity: N = 5; PMT = 2,250,000; I/Y = 17; CPT PV = -7,198,529 • PV of future cash flows = 7,198,528 • NPV = 7,198,528 – 9,000,000 = -1,801,472 pesos • NPV = -1,801,472 / 18.80 = -95,822.98 • Both approaches say don’t do it.

  23. Problem • Assume that one U.S. dollar buys 115 Japanese Yen, and one U.S. dollar buys .54 Pound Sterling. • What must the dollar – pound exchange rate be in order to prevent triangular arbitrage (ignore transaction costs)? • $1U.S. = 115 yen • $1U.S. = .54 pounds • So, 115 yen = .54 pounds, so 1 yen = .54 / 115 = .004696 pounds, or 1 pound = 212.96 yen • Hence, $100 buys 11,500 yen, which buys (11,500/212.96) 54 pounds, which is worth $100. No riskless arbitrage is received.

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