Chapter 21 – International Corporate Finance
Chapter 21
INTERNATIONAL CORPORATE FINANCE
CHAPTER WEB SITES
Section Web Address
21.1 www.adr.com
www.bloomberg.com
21.2 www.swift.com
www.xe.com
www.exchangerate.com
www.ft.com
21.4 www.travlang.com/money
www.marketwatch.com
21.7 https://www.cia.gov/library/publications/the-
world-factbook/index.html
CHAPTER ORGANIZATION
21.1 Terminology
21.2 Foreign Exchange Markets and Exchange Rates
Exchange Rates
21.3 Purchasing Power Parity
Absolute Purchasing Power Parity
Relative Purchasing Power Parity
21.4 Interest Rate Parity, Unbiased Forward Rates, and the International Fisher Effect
Covered Interest Arbitrage
Interest Rate Parity
Forward Rates and Future Spot Rates
Putting It All Together
21.5 International Capital Budgeting
Method 1: The Home Currency Approach
Method 2: The Foreign Currency Approach
Unremitted Cash Flows
21.6 Exchange Rate Risk
Short-Run Exposure
Long-Run Exposure
Translation Exposure
Managing Exchange Rate Risk
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21.7 Political Risk
21.8 Summary and Conclusions
ANNOTATED CHAPTER OUTLINE
1. Terminology
American Depository Receipt (ADR) – security issued in the U.S. that
represents shares in a foreign company
Cross-rate – exchange rate between two currencies implied by the exchange
rates of each currency with a third
Eurobond – bonds issued in many countries but denominated in a single
currency
Eurocurrency – money deposited in the bank of a foreign country (dollars
deposited in a French bank are called Eurodollars)
Lecture Tip: Eurodollars are “deposits of U.S. dollars in banks located
outside the United States.” However, you should emphasize that Eurodollars
are not actual U.S. currencies deposited in a bank, but are bookkeeping
entries on a bank’s ledger. These deposits are loaned to the Euro bank’s U.S.
affiliate to meet liquidity needs, or the funds might be loaned to a corporation
abroad that needs the loan denominated in U.S. dollars. Money does not
normally leave the country of its origination; merely the ownership is
transferred to another country.
You might add that a dollar-denominated Eurobond is free of exchange rate
risk for a U.S. investor, regardless of where it is issued. A foreign bond would
be subject to this risk if it is not issued in the U.S. The reason is that the
Eurobond pays interest in U.S. dollars, but the foreign bond pays interest in
the currency of the country in which it was issued.
Foreign bonds – bonds issued by a foreign company in a single country and in
that country’s currency
Gilts – British and Irish government securities
London Interbank Offer Rate (LIBOR) – rate banks charge each other for
overnight Eurodollar loans; often used as an index in floating rate securities
Interest rate swap – agreement between two parties to periodically swap
interest payments on a notional amount; normally one party pays a fixed rate
and the other pays a floating rate
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Currency swap – agreement between two parties to periodically swap
currencies based on some notional amount
2. Foreign Exchange Markets and Exchange Rates
Foreign exchange market – market for buying and selling currencies
Foreign exchange market participants:
-Importers and exporters
-International portfolio managers
-Foreign exchange brokers
-Foreign exchange market markers
-Speculators
Video Note: “Foreign Exchange Market” looks at how Honda protects itself against
changing exchange rates.
A. Exchange Rates
Most currency trading is done with currencies being quoted in U.S.
dollars.
Cross rates and triangle arbitrage – implicit in exchange rate
quotations is an exchange rate between non-U.S. currencies. The
exchange rate between two non-U.S. currencies must equal the
cross rate to prevent arbitrage.
Example of Triangle Arbitrage:
Suppose the Japanese Yen is quoted at 133.9 Yen per dollar and the
South Korean Won is quoted at 666.0 Won per dollar. The
exchange rate between Yen and Won is .1750 Yen per Won.
The cross rate is (133.9 Yen/$) / (666.0 Won/$) = .201 Yen/Won
Buy low, sell high:
1) Have $1,000 to invest – buy yen = $1,000(133.9 Yen/$) =
133,900 Yen
2) Buy Won with Yen = 133,900 Yen / (.1750 Yen/Won) =
765,142.86 Won
3) Buy dollars with Won = 765,142.86 Won / (666 Won/$) =
$1,148.86
4) Risk-free profit of $148.86
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Lecture Tip: The opportunity to exploit a triangle arbitrage may
appear to be an easy opportunity to make a quick profit. Point out
that arbitrage opportunities are rare and that the transaction costs
for small investors would outweigh any profit opportunity
available.
Types of Transactions
Spot trade – exchange of currencies at immediate prices (spot rate)
Forward trade – contract for the exchange of currencies at a future
date at a price specified today (forward rate)
Premium – if the forward rate > spot rate (based on $ equivalent or
direct quotes), then the foreign currency is expected to appreciate
and is selling at a premium
Discount – if the forward rate < spot rate (based on $ equivalent or
direct quotes), then the foreign currency is expected to depreciate
and is selling at a discount
Lecture Tip: The late economist Milton Friedman provided a
primer on exchange rates in the November 2, 1998 issue of Forbes
magazine. He described three types of exchange rate regimes.
Fixed rate or unified currency: “The clearest example is a
common currency: the dollar in the U.S.; the euro that will shortly
reign in the common market … the key feature of the currency
board is that there is only one central bank with the power to
create money.”
Pegged exchange rate: “This prevailed in the East Asian countries
other than Japan. All had national central banks with the power to
create money and committed themselves to maintain the price of
their domestic currency in terms of the U.S. dollar at a fixed level,
or within narrow bounds – a policy they had been encouraged to
adopt by the IMF … In a world of free capital flows, such a regime
is a ticking time bomb. It is never easy to know whether a [current
account] deficit is transitory and will soon be reversed or is the
precursor to further deficits.”
Floating rates: “The third type of exchange rate regime is one
under which rates of exchange are determined in the market on the
basis of predominantly private transactions. In pure form, clean
floating, the central bank does not intervene in the market to affect
the exchange rate though it or the government may engage in
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exchange transactions in the course of its other activities. In
practice, dirty floating is more common: The central bank
intervenes from time to time to affect the exchange rate but does
not announce in advance any specific value it will seek to
maintain. That is the regime currently followed by the U.S.,
Britain, Japan and many other countries.
3. Purchasing Power Parity
A. Absolute Purchasing Power Parity
Absolute PPP indicates that a commodity should sell for the same
real price regardless of the currency used
Absolute PPP can be violated due to transaction costs, barriers to
trade, and differences in the product
B. Relative Purchasing Power Parity
The change in the exchange rate depends on the difference in
inflation rates between countries.
Relative PPP says that:
E(St ) = S0[1 + (hF – hUS)]t
assuming that rates are quoted as foreign currency per dollar.
Currency appreciation and depreciation – Appreciation of one
currency relative to another means that it takes more of the second
currency to buy the first. For example, if the dollar appreciates
relative to the yen, it means it will take more yen to buy $1.
Depreciation is just the opposite.
Lecture Tip: When asked, “Which is better – a stronger dollar or
a weaker dollar?” most students answer a stronger one. While this
makes imports relatively cheaper, it makes U.S. exports relatively
more expensive. In general, consumers like a stronger dollar and
producers, especially exporters, prefer a weaker one. At times, the
government has spent considerable resources on making the dollar
cheaper against the yen in an effort to reduce our trade deficit with
Japan.
Lecture Tip: The concept of relative PPP can be reinforced by
considering an identical product that sells in both England and the
U.S. at identical relative prices. If the inflation rate is 4% per year
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in the U.S., then the price for the product would increase by 4%
over the year. However, if the inflation rate in England is 10%, the
product price would increase by 10% in England over the year.
Suppose the original price is $1 in the U.S. and the exchange rate
is .5 pounds per dollar, so the product would cost .5 pounds in
England. At the end of the year, the price in the U.S. would be
1(1.04) = $1.04 and the price in England would be .5(1.1) = .55
pounds. To prevent arbitrage, the exchange rate must change so
that $1.04 is now equivalent to .55 pounds. In other words, the new
exchange rate must be .55 pounds / $1.04 = .5288 pounds per
dollar. The dollar has appreciated relative to the pound (it takes
more pounds to buy $1) because of the lower inflation rate.
4. Interest Rate Parity, Unbiased Forward Rates, and the International Fisher
Effect
A. Covered Interest Arbitrage
A covered interest arbitrage exists when a riskless profit can be
made by borrowing in the U.S. at the risk-free rate, converting the
borrowed dollars into a foreign currency, investing at that country’s
rate of interest, taking a forward contract to convert the currency
back into U.S. dollars and repaying the loan.
Example:
S0 = 2 Euro/$ RUS = 10%
F1 = 1.8 Euro/$ RE = 5%
1) Borrow $100 at 10%
2) Buy $100(2 Euro/$) = 200 Euro and invest at 5% (RE)
3) At the same time, enter into a forward contract
4) In 1 year, receive 200(1.05) = 210 Euro
5) Convert to $ using forward contract; 210 Euro / (1.8 Euro/
$) = $116.67
6) Repay loan and pocket profit: 116.67 – 100(1.1) = $6.67
B. Interest Rate Parity
To prevent covered arbitrage:
F1
S0
=1+RFC
1+RUS
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Approximation: Ft = S0[1 + (RFC – RUS)]t
Example:
Suppose the Euro spot rate is 1.3 Euro / $. If the risk-free rate in
France is 6% and the risk-free rate in the U.S. is 8%, what should
the forward rate be to prevent arbitrage?
Exact: F =1.3(1.06)/(1.08) = 1.28 Euro / $
Approximation: F = 1.3[1 + (.06 – .08)] = 1.274 Euro / $
C. Forward Rates and Future Spot Rates
Unbiased forward rates (UFR) –the forward rate, Ft, is equal to the
expected future spot rate, E[St]. That is, on average, the forward
rate neither consistently underestimates nor overestimates the
future spot rate. That is, Ft = E[St]
D. Putting It All Together
PPP: E[S1] = S0[1 + (hFC – hUS)]
IRP: F1 = S0[1 + (RFC – RUS)]
UFR: F1 = E[S1]
Uncovered interest parity (UIP) – combining UFR and IRP gives:
E[S1] = S0[1 + (RFC – RUS)]
E[St] = S0[1 + (RFC – RUS)]t
The International Fisher Effect – combining PPP and UIP gives:
S0[1 + (hFC – hUS)] = S0[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.
5. International Capital Budgeting
A. Method 1: The Home Currency Approach
This involves converting foreign cash flows into the domestic
currency and finding the NPV.
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B. Method 2: The Foreign Currency Approach
In this approach, we determine the comparable foreign discount
rate, find the NPV of foreign cash flows, and convert the NPV to
dollars.
Example: Pizza Shack is considering opening a store in Mexico
City, Mexico. The store would cost $1.5 million or 16,361,250
pesos to open. Pizza Shack hopes to operate the store for two years
and then sell it at the end of the second year to a local franchisee.
Cash flows are expected to be 1,000,000 pesos in the first year and
25,000,000 pesos the second year. The spot exchange rate for
Mexican pesos is 10.9075. The U.S. risk-free rate is 4%, and the
Mexican risk-free rate is 7%. The required return (U.S.) is 12%.
1. The home currency approach
Using UIP:
E[S1] = 10.9075[1 + (.07 – .04)] = 11.2347
E[S2] = 10.9075[1 + (.07 – .04)]2 = 11.5718
Year Cash Flow (pesos) E[St] Cash Flow ($)
0 -16,361,250 10.9075 -1,500,000.00
1 1,000,000 11.2347 89,009.94
2 25,000,000 11.5718 2,160,424.48
NPV at 12% = 301,750.33*
2. The foreign currency approach
Using the IFE to get the inflation premium (7 – 4) = hFC – hUS =
3%. Factor this into the US discount rate to get the Mexican
discount rate: (1.12*1.03 – 1) = 15.36%.
NPV of peso cash flows at 15.36% = 3,291,393.79 pesos
NPV in dollars = 3,291,393.79 / 10.9075 = 301,755.10*
*Note that the two approaches will produce exactly the same
answers if the exact formulas are used for each of the parity
equations instead of the approximations.
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C. Unremitted Cash Flows
Not all cash flows from foreign operations can be remitted to the
parent company.
Ways foreign subsidiaries remit funds to the parent:
1. dividends
2. management fees for central services
3. royalties on trade names and patents
Blocked funds – funds that cannot currently be remitted to the
parent
Ethics Note: The following case may be used as a class example to
expose the class to the ethical problems involving shell
corporations that attempt to conduct business on the fringe of
violating international law.
In February 1989, the West German Chemical Industry
Association suspended the membership of Imhausen Chemie, a
major West German chemical manufacturer in response to the
charge that Imhausen supplied Libya with the plant and
technology to produce chemical weapons. In June 1990, the
former Managing Director of Imhausen was convicted of tax
evasion and violating West Germany’s export control laws.
In November 1984, a shell corporation had been established in
Hong Kong to conceal actual ownership of the chemical
operations. In April 1987, a subsidiary of the shell corporation
was established in Hamburg, West Germany for the purpose of
acquiring materials from Imhausen, thus circumventing German
export laws. A shipping network was established to fake end-use
destinations and sell to Libya.
Reports later surfaced that Libya had constructed a chemical
weapons factory. Imhausen did not deny the plant’s existence but
Imhausen, as well as the government of Libya, claimed that the
plant was being used for the manufacturer of medicinal drugs.
International treaties forbade the use of chemical and biological
weapons but did not restrict chemical weapons facility
construction. The international community faced a further
dilemma, as aerial observation could not distinguish between a
weapons plant and a pharmaceutical plant. Additionally, such
plants could easily be switched to legitimate use in a few days.
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While construction of the plant did not violate German or
international law, the ease of conversion from legitimate use to
weapons production raised questions regarding the technical
knowledge transferred by Imhausen. You might question the class
as to Imhausen’s responsibility in the ultimate use of the plant,
despite the fact that the development of the shell corporation was a
positive NPV investment.
6. Exchange Rate Risk
A. Short-Run Exposure
Exchange rate risk – the risk of loss arising from fluctuations in
exchange rates
A great deal of international business is conducted on terms that fix
costs or prices while at the same time calling for payment or
receipt of funds in the future. One way to offset the risk from
changing exchange rates and fixed terms is to hedge with a
forward exchange agreement. Another hedging tool is to use
foreign exchange options. An option will allow the firm to protect
itself against adverse exchange rate movements and still benefit
from favorable exchange rate movements; however, this has an
added premium cost.
Lecture Tip: There were several earnings warnings for the third
quarter of 2000 by multinational firms. One of the biggest reasons
cited was the weak Euro relative to the dollar. A strong dollar
makes our products more expensive in Europe and reduces the
sales level by limiting the number of people that can afford to buy
the products. The exact opposite situation occurred in 2008, as the
weak dollar helped US multinationals.
B. Long-Run Exposure
Long-run changes in exchange rates can be partially offset by
matching foreign assets and liabilities, inflows and outflows.
C. Translation Exposure
U.S. based firms must translate foreign operations into dollars
when calculating net income and EPS.
Problems:
1. What is the appropriate exchange rate to use for translating
balance sheet accounts?
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2. How should balance sheet accounting gains and losses from
foreign currency translation be handled?
FASB 52 requires that assets and liabilities be translated at the
prevailing exchange rates. Translation gains and losses are
accumulated in a special equity account and are not recognized in
earnings until the underlying assets or liabilities are sold or
liquidated.
D. Managing Exchange Rate Risk
For large multinational firms, the net effect of fluctuating exchange
rates depends on the firm’s net exposure. This is probably best
handled on a centralized basis to avoid duplication and conflicting
actions.
7. Political Risk
Blocking funds and expropriation of property by foreign
governments are among routine political risks faced by
multinationals. Terrorism is also a concern.
Financing the subsidiary’s operations in the foreign country can
reduce some risk. Another option is to make the subsidiary
dependent on the parent company for supplies; this makes the
company less valuable to someone else.
8. Summary and Conclusions
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