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Slide 31.18 –
Slide 31.20 Interest Rate Parity
.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:
US
FC
R
R
S
F
1
1
0
1
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 / $
Slide 31.21 –
Slide 31.24 IRP and Covered Interest Arbitrage
Slide 31.25 Reasons for Deviations from IRP
.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 (again, this
is an approximation):
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.
Slide 31.26 International Fisher Effect
Slide 31.27 Equilibrium Exchange Rate Relationship
31.2. International Capital Budgeting
Slide 31.28 International Capital Budgeting
.A Method 1: The Home Currency Approach
This involves converting foreign cash flows into the domestic currency and
finding the NPV.
Slide 31.29 Home Currency Approach
.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.
Slide 31.30 Foreign Currency Approach
Example: Pizza Shack is considering opening a store in Mexico City, Mexico.
The store would cost $1.5 million or 3,646,500,000 pesos to open.
Pizza Shack hopes to operate the store for two years and then sell it
at the end of the second year to a local franchisee. Cash flows are
expected to be 250,000,000 pesos in the first year, and
5,000,000,000 pesos the second year. The spot exchange rate for
Mexican pesos is 2,431. The U.S. risk-free rate is 7% and the
Mexican risk-free rate is 10%. The required return (U.S.) is 12%.
1. The home currency approach
Using the UIP:
E[S1] = 2,431[1 + (.1 - .07)] = 2,503.93
E[S2] = 2,431[1 + (.1 - .07)]2 = 2,579.05
Year Cash Flow (pesos) E[St] Cash Flow ($)
0 -3,646,500,000 2,431.00 -1,500,000.00
1 250,000,000 2,503.93 99,843.05
2 5,000,000,000 2,579.05 1,938,698.36
NPV at 12% = 134,664.04
2. The foreign currency approach
Using the IFE to get the inflation premium (10 – 7) = 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% = 327,371,337.6 pesos
NPV in dollars = 327,371,337.6 / 2,431 = $134,665.30
Note that the two approaches will produce exactly the same answers (net
rounding differences) if the exact formulas are used for each of the
parity equations instead of the approximations.
.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
Lecture Tip: While not an official blockage, the US tax code is
effectively causing firms to leave funds outside the US since they
would incur high taxes when the funds enter the US. This has been
a topic of recent political debates.
Lecture Tip: 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.
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.
.D The Cost of Capital for International Firms
If US investors face cross-border investing constraints, while US
companies do not, then the case can be made that diversification is
actually beneficial and would lead to the lowering of the risk
premium on international projects.
In general, if the costs of investing abroad are lower for the firm
than for its shareholders, there is an advantage to international
diversification by firms, and this advantage will be reflected in a
lower risk-adjusted discount rate.
31.3. Exchange Rate Risk
Slide 31.31 Exchange Rate Risk
.A Short-Term 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.
Slide 31.32 Short-Term Exposure
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.
.B Long-Term Exposure
Long-run changes in exchange rates can be partially offset by matching
foreign assets and liabilities, inflows and outflows.
Slide 31.33 Long-Term Exposure
.C Translation Exposure
Slide 31.34 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?
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.
Slide 31.35 Managing Exchange Rate Risk
31.4. Political Risk
Blocking funds and expropriation of property by foreign governments are
among the 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.
Slide 31.36 Political Risk
Slide 31.37 Quick Quiz
