Corporate Chapter31
International Finance
McGraw-Hill/Irwin
Copyright 2010 by the McGraw-Hill Companies, Inc. All rights reserved.
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
31-2
Chapter Outline
31.1 Terminology
31.2 Foreign Exchange Markets and Exchange Rates
31.3 Purchasing Power Parity
31.4 Interest Rate Parity, Unbiased Forward Rates, and
the International Fisher Effect
31.5 International Capital Budgeting
31.6 Exchange Rate Risk
31.7 Political Risk
31-3
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 were: Belgium, Germany, Spain,
France, Ireland, Italy, Luxemburg, Finland, Austria, Portugal
and the Netherlands
31-4
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.
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
31-5
31.2 Foreign Exchange Markets and
Exchange Rates
Without a doubt, the foreign exchange market is the
worlds largest financial market.
In this market, one countrys currency is traded for
anothers.
Most of the trading takes place in a few currencies:
U.S. dollar ($)
British pound sterling ()
Japanese yen ()
Euro ()
31-6
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.
31-7
Exchange Rates
The price of one countrys 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)
31-8
Example
Suppose you have $10,000. Based on the rates in
Figure 31.1, how many Swiss Francs can you buy?
Exchange rate = 1.0884 Francs per dollar
Buy 10,000(1.0884) = 10,884 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 = 46.490 rupees per dollar
Cost = 1,000 / 46.490 = $21.51
31-9
Cross Rates
Suppose that SDM(0) = .50
and that S(0) = 100
i.e., $1 = 2 DM in the spot market
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
31-10
Triangular Arbitrage
Suppose we
observe these
banks posting
these exchange
rates.
First calculate the
implied cross
rates to see if an
arbitrage exists.
$
Barclays
S(0) = 120
Credit
Lyonnais
S(0) = 1.50
Credit Agricole
S/(0) = 85
31-11
Triangular Arbitrage
The implied S(/) cross rate is S(/) = 80
$
1.50
$1
1
=
$1
120 80
Credit Agricole has
posted a quote of
S(/)=85, so there
is an arbitrage
opportunity.
Barclays
S(0) = 120
Credit
Lyonnais
S(0) = 1.50
Credit Agricole
S/(0) = 85
So, how can we make money?
31-12
Triangular Arbitrage
As easy as 1 2 3:
$
Barclays
S(0) =120
Credit
Lyonnais
S(0) = 1.50
1. Sell our $ for ,
Credit Agricole
2. Sell our for ,
S/(0) = 85
3. Sell those for $.
31-13
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
31-14
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.
31-15
Absolute Purchasing Power Parity
Price of an item is the same regardless of the
currency used to purchase it (i.e., 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.
31-16
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 does not hold for many
goods, we will focus on relative PPP from here
on out.
31-17
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
) = 1.18[1 + (.02 - .03)]1 = 1.1682
31-18
31.4 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 do not typically observe persistent
arbitrage conditions, we can safely assume
that IRP holds.
31-19
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 (1 + i )
Future value = $100,000
S
Since both of these investments have the same risk, they must
have the same future value:
F (1 + i ) = (1 + i )
$
S
31-20
Interest Rate Parity
Formally,
F (1 + i ) = (1 + i )
$
S
F = (1 + i$)
or if you prefer,
(1 + i)
S
IRP is sometimes approximated as
i$ i =
FS
S
31-21
IRP and Covered Interest Arbitrage
If IRP failed to hold, an arbitrage opportunity would exist. It is
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
360-day forward
rate
S(0) = $1.25/
F(360) = $1.20/
U.S. discount rate
i$ = 7.10%
British discount
rate
i = 11.56%
31-22
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.
31-23
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)
= $1,000 (1+ i$)
31-24
IRP and Covered Interest Arbitrage
800= $1,000
$1,000
Domestic FV =
$1,071 and
British FV =
$1,071
$1.25
1
800
Invest 800
at i =
11.56%
In one year 800
will be worth
892.48 =
$1,000 (1+ i)
Bring it on back
to the U.S.A.
$1.20
$1,071 = 892.48
1
31-25
Reasons for Deviations from IRP
Transactions Costs
The interest rate available to an arbitrageur for
borrowing, ib,may exceed the rate he can lend at, il.
There may be bid-ask spreads to overcome, Fb/Sa < F/S
Thus
(Fb/Sa)(1 + il) (1 + i b) 0
Capital Controls
Governments sometimes restrict import and export of
money through taxes or outright bans.
31-26
International Fisher Effect
Combining PPP and UIP we can get the
International Fisher Effect:
RUS hUS = RFC hFC
The International Fisher Effect tells us that the
real rate of return must be constant across
countries.
If it is not, investors will move their money to
the country with the higher real rate of return.
31-27
Equilibrium Exchange Rate Relationships
E (e )
IFE
i$ i
FP
PPP
FS
S
IRP
FE
FRPPP
h$ h
31-28
31.5 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
31-29
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?
31-30
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
31-31
31.6 Exchange Rate Risk
Short-Term Exposure
Long-Term Exposure
Translation Exposure
31-32
Short-Term 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.
31-33
Long-Term 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
31-34
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.
31-35
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.
31-36
31.7 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.
31-37
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-term interest rate exposure and
long-term interest rate exposure? How can you hedge each type?
What is political risk and what types of businesses face the greatest
risk?
31-38