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Chapter 31
INTERNATIONAL CORPORATE FINANCE
SLIDES
CHAPTER WEB SITES
Section Web Address
31.1 www.adr.com
31.1 Key Concepts and Skills
31.2 Chapter Outline
31.3 Terminology
31.4 Terminology
31.5 Foreign Exchange Markets and Exchange Rates
31.6 FOREX Market Participants
31.7 Exchange Rates
31.8 Example
31.9 Cross Rates
31.10 Triangle Arbitrage
31.11 Triangle Arbitrage
31.12 Triangle Arbitrage
31.13 Triangle Arbitrage
31.14 Types of Transactions
31.15 Absolute Purchasing Power Parity
31.16 Relative Purchasing Power Parity
31.17 Example
31.18 Interest Rate Parity
31.19 Interest Rate Parity
31.20 Interest Rate Parity
31.21 IRP and Covered Interest Arbitrage
31.22 IRP and Covered Interest Arbitrage
31.23 IRP and Covered Interest Arbitrage
31.24 IRP and Covered Interest Arbitrage
31.25 Reasons for Deviations from IRP
31.26 International Fisher Effect
31.27 Equilibrium Exchange Rate Relationships
31.28 International Capital Budgeting
31.29 Home Currency Approach
31.30 Foreign Currency Approach
31.31 Exchange Rate Risk
31.32 Short-Term Exposure
31.33 Long-Term Exposure
31.34 Translation Exposure
31.35 Managing Exchange Rate Risk
31.36 Political Risk
31.37 Quick Quiz
www.bloomberg.com
31.2 www.swift.com
www.xe.com
www.exchangerate.com
CHAPTER ORGANIZATION
31.1 Terminology
31.2 Foreign Exchange Markets and Exchange Rates
Exchange Rates
31.3 Purchasing Power Parity
Absolute Purchasing Power Parity
Relative Purchasing Power Parity
31.4 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
31.5 International Capital Budgeting
Method 1: The Home Currency Approach
Method 2: The Foreign Currency Approach
Unremitted Cash Flows
The Cost of Capital for International Firms
31.6 Exchange Rate Risk
Short-Term Exposure
Long-Term Exposure
Translation Exposure
Managing Exchange Rate Risk
31.7 Political Risk
ANNOTATED CHAPTER OUTLINE
Slide 31.0 Chapter 31 Title Slide
Slide 31.1 Key Concepts and Skills
Slide 31.2 Chapter Outline
1. Terminology
Slide 31.3 –
Slide 31.4 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
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 (defined in an
earlier chapter as: bonds issued in many countries but denominated in a
single currency) 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.
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
Currency swap – agreement between two parties to periodically swap
currencies based on some notional amount
2. Foreign Exchange Markets and Exchange Rates
Slide 31.5 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
Slide 31.6 FOREX Market Participants
A. Exchange Rates
Most currency trading is done with currencies being quoted in U.S.
dollars.
Slide 31.7 Exchange Rates
Slide 31.8 Example
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.
Slide 31.9 Cross Rates
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
Slide 31.10 –
Slide 31.13 Triangular Arbitrage
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 likely 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
Slide 31.14 Types of Transactions
Lecture Tip: Well-known economist Milton Friedman provides a primer
on exchange rates in the November 2, 1998, issue of Forbes magazine. He
describes 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 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. This is often referred to as the “law
of one price.”
Absolute PPP can be violated due to transaction costs, barriers to trade and
differences in the product.
Slide 31.15 Absolute Purchasing Power Parity
Lecture Tip: A common example used by The Economist magazine to
illustrate purchasing parity is the Big Mac Index, which looks at the
currency adjusted prices of Big Macs in various countries.
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. (Note, this is
actually an approximation, with the theoretically correct approach given in
footnote 2.)
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.
Slide 31.16 Relative Purchasing Power Parity
Slide 31.17 Example
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.
The effects of a falling dollar were exemplified in 1995 when the dollar
fell to record lows against the yen. By mid-summer, the deficit with Japan
had narrowed significantly. On the other hand, the dollar had risen
sharply against the Mexican peso, and the U.S. trade deficit with Mexico
skyrocketed over the same period.
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 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
