CHAPTER 21
INTERNATIONAL CORPORATE FINANCE
Learning Objectives
LO1 The different terminologies used in international finance.
LO2 How exchange rates are quoted, what they mean, and the difference between spot and forward
exchange rates.
LO3 Purchasing power parity, interest rate parity, unbiased forward rates, uncovered interest rate parity, and
the generalized Fisher effect and their implications for exchange rate changes.
LO4 How to estimate NPV using home and foreign currency approach.
LO5 The different types of exchange rate risk and ways firms manage exchange rate risk.
LO6 The impact of political risk on international business investing.
Answers to Concepts Review and Critical Thinking Questions
1.
(LO2)
a. The dollar is selling at a premium because it is more expensive in the forward market than in the
spot market (SFr 1.53 versus SFr 1.50).
b.
The franc is expected to depreciate relative to the dollar because it will take more francs to buy
one dollar in the future than it does today.
c.
Inflation in Switzerland is higher than in the Canada, as are interest rates.
2.
(LO3) The exchange rate will increase, as it will take progressively more euros to purchase a dollar.
This is the relative PPP relationship.
3.
(LO2, 3)
a.
The Australian dollar is expected to weaken relative to the dollar, because it will take more A$ in
the future to buy one dollar than it does today.
b.
The inflation rate in Australia is higher.
c.
Nominal interest rates in Australia are higher; relative real rates in the two countries are the same.
4.
(LO1) A Yankee bond is most accurately described by d.
5.
(LO2) No. For example, if a country’s currency strengthens, imports become cheaper (good), but its
exports become more expensive for others to buy (bad). The reverse is true for currency depreciation.
6.
(LO5, 6) Additional advantages include being closer to the final consumer and, thereby, saving on
transportation, significantly lower wages, and less exposure to exchange rate risk. Disadvantages
include political risk and costs of supervising distant operations.
7.
(LO3) One key thing to remember is that dividend payments are made in the home currency. More
generally, it may be that the owners of the multinational are primarily domestic and are ultimately
concerned about their wealth denominated in their home currency because, unlike a multinational, they
are not internationally diversified.
8.
(LO3)
a.
False. If prices are rising faster in Great Britain, it will take more pounds to buy the same amount
of goods that one dollar can buy; the pound will depreciate relative to the dollar.
b.
False. The forward market would already reflect the projected deterioration of the euro relative to
the dollar. Only if you feel that there might be additional, unanticipated weakening of the euro
that isn’t reflected in forward rates today will the forward hedge protect you against additional
declines.
c.
True. The market would only be correct on average, while you would be correct all the time.
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9.
(LO5)
a.
Canadian exporters: their situation in general improves because a sale of the exported goods for a
fixed number of DMs will be worth more dollars.
Canadian importers: their situation in general worsens because the purchase of the imported goods
for a fixed number of DMs will cost more in dollars.
b.
Canadian exporters: they would generally be better off if the British government’s intentions
result in a strengthened pound.
Canadian importers: they would generally be worse off if the pound strengthens.
c.
Canadian exporters: would generally be much worse off, because a reduction in the value of the
peso will make Canadian more expensive to consumers in Argentina.
Canadian importers: would generally be much better off. In dollar terms, goods from Argentina
will become much cheaper to buy.
d.
Canadian exporters: would generally be much worse off, because an extreme case of fiscal
expansion like this one will make Canadian goods prohibitively expensive to buy, or else
Brazilian sales, if fixed in cruzeiros, would become worth an unacceptably low number of dollars.
Canadian importers: would generally be much better off, because Brazilian goods will become
much cheaper to purchase in dollars.
10. (LO3) IRP is the most likely to hold because it presents the easiest and least costly means to exploit any
arbitrage opportunities. Relative PPP is least likely to hold since it depends on the absence of market
imperfections and frictions in order to hold strictly.
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Solutions to Questions and Problems
Basic
For the 1st printing of the textbook, please note the following amendments to the question printed in the
textbook:
1 d.
1 e.
1 f.
1.
‘New Zealand dollar’ should read ‘Australian dollar’.
‘Chilean peso’ should read ‘Russian rouble’.
‘Mexican pesos’ should read ‘Swiss francs’.
(LO2) Using the quotes from the table, we get:
a.
$100(1/($1.6725 /€1.00)) = €59.79
b.
$1.6725 CDN
c.
€5M($1.6725/€) = $8,362,500
d.
Australian dollar
e.
Mexican peso
f.
SFr 0.9340/€
This is a cross rate.
g.
2.
Most valuable: UK pound = $1.7908
Least valuable: Japanese yen = $0.0126
(LO2)
a.
You would prefer £100, since:
(£100)($1.7908/£1) = $179.08 Canadian
b.
You would still prefer £100:
(€100)($1.6725/€) = $167.25 Canadian
c.
3.
4.
Swiss Francs per British pounds = SFr 1.6305/£1; British pounds per Swiss Franc = £0.6133/SFr1
(LO2)
a.
F6 = ¥79.00 (per $). The yen is selling at a premium because it is more expensive in the forward
market than in the spot market ($0.012658/¥ versus $0.012639/¥).
b.
F3 = $0.8133US/$1.00Can. The US dollar is selling at a premium because it is more expensive in
the forward market than in the spot market ($0.8133US/$Can versus $0.8120/$).
c.
The value of the dollar will fall relative to the yen, since it takes more dollars to buy one yen in
the future than it does today. The value of the dollar will fall relative to the US dollar, because it
takes more Canadian dollars to buy one US dollar in the future than it does today.
(LO2)
a.
The U.S. dollar, since one Canadian dollar will buy:
(Can$1)/(Can$1.06/$1US) = $0.9434 US
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b.
The cost in U.S. dollars is:
(Can$2.50)/(Can$1.06/$1US) = $2.36 US
c.
5.
Among the reasons that absolute PPP doesn’t hold are tariffs and other barriers to trade,
transactions costs, taxes, and different tastes.
The U.S. dollar is selling at a discount in the table, because it is less expensive in the 3 month
forward market than in the spot market (Can$1.2296 versus Can$1.2315).
d.
The Canadian dollar is expected to appreciate in value relative to the dollar, because it takes less
Canadian dollars to buy one U.S. dollar in the future than it does today.
e.
Interest rates in the United States are probably lower than they are in Canada. This fuels
additional investment in the Canada relative to the US and a strengthening Canadian dollar.
(LO2)
a.
The cross rate in ¥/£ terms is:
(¥112/$1)($1.93/£1) = ¥216.16/£1
b.
The yen is quoted too low relative to the pound. Take out a loan for $1 and buy ¥112. Use the
¥112 to purchase pounds at the cross-rate, which will give you:
¥112(£1/¥209) = £0.53589
Use the pounds to buy back dollars and repay the loan. The cost to repay the loan will be:
£0.53589($1.93/£1) = $1.0343
You arbitrage profit is $0.0343 per dollar used.
For the 1st printing of the textbook, please note the following amendment to the question printed in the
textbook:
6.
6.
‘In Switzerland?’ should read ‘In the European Union?’.
(LO3) We can rearrange the interest rate parity condition to answer this question. The equation we will
use is:
Ft/S0 = (1 + RFC) / (1 + RCDN)
[(Ft/S0) / (1 + RCDN)] - 1 = RFC
Using this relationship with t = 6 months, we find:
Great Britain:
RFC = (£0.5599 / £0.5584) / (1 + .022) – 1 = -.0188 or -1.88%
Japan:
RFC = (¥79.00 / ¥79.12) / (1 + .022) – 1 = -.0230 or -2.30%
European Union: RFC = (€0.5993 / €0.5979) / (1 + .022) – 1 = -.0192 or -1.92%
The interest rate parity condition suggests that the risk free interest rates in Great Britain, Japan, and the
European Union are negative. Such a condition could occur if nominal interest rates were below the
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inflation rates in those countries, which might happen if the central banks of those countries were using
very low interest rates to stimulate the economy.
7.
(LO3) If we invest in Canada for the next three months, we will have:
$30,000,000(1.0037)3 = $30,334,233.62
If we invest in Great Britain, we must exchange the dollars today for pounds, and exchange the pounds
for dollars in three months. After making these transactions, the dollar amount we would have in three
months would be:
($30,000,000)(£0.55/$1)(1.0051) 3/(£0.56/$1) = $29,917,392.29
8.
The company should invest in Canada.
(LO3) Using the relative purchasing power parity equation:
Ft = S0 × [1 + (hFC – hUS)]t
We find:
Z2.26 = Z2.17[1 + (hFC – hUS)]3
hFC – hUS = (Z2.26/Z2.17)1/3 – 1
hFC – hUS = .0136 or 1.36%
Inflation in Poland is expected to exceed that in Canada by 1.36% over this period.
9.
(LO5) The profit will be the quantity sold, times the sales price minus the cost of production. The
production cost is in Singapore dollars, so we must convert this to Canadian dollars. Doing so, we find
that if the exchange rates stay the same, the profit or loss will be:
Profit = 30,000[$150 – {(S$204.70)/(S$1.2248/$1)}]
Profit = –$513,879.81 = Loss
So this deal is not profitable at the current exchange rate. If the exchange rate rises, we must adjust the
cost by the increased exchange rate, so:
Profit = 30,000[$150 – {(S$204.70)/(1.1(S$1.2248/$1))}]
Profit = –$58,072.56 = Loss
If the exchange rate falls, we must adjust the cost by the decreased exchange rate, so:
Profit = 30,000[$150 – {(S$204.70)/(0.9(S$1.2248/$1))}]
Profit = –$1,070,977.57 = Loss
To calculate the breakeven change in the exchange rate, we need to find the exchange rate that make the
cost in Singapore dollars equal to the selling price in Canadian dollars, so:
$150 = S$204.70/ST
ST = S$1.3647/$1
∆ST = 1.3647 – 1.2248 = 0.1399 or 13.99% increase
10. (LO3)
a.
If IRP holds, then:
F180 = (Kr 5.15)[1 + (.057 – .038)]1/2
F180 = Kr 5.1987
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Since given F180 is Kr5.22, an arbitrage opportunity exists; the forward premium is too high.
Borrow Kr1 today at 5.7% interest. Agree to a 180-day forward contract at Kr 5.22. Convert the
loan proceeds into dollars:
Kr 1 ($1/Kr 5.15) = $0.19417
Invest these dollars at 3.8%, ending up with $0.19778. Convert the dollars back into krone as
$0.19778(Kr 5.22/$1) = Kr 1.03241
Repay the Kr 1 loan, ending with a profit of:
Kr1.03241 – Kr1.02771 = Kr 0.0469
b.
To find the forward rate that eliminates arbitrage, we use the interest rate parity condition, so:
F180 = (Kr 5.15)[1 + (.057 – .038)]1/2
F180 = Kr 5.1987
11. (LO3) The international Fisher effect states that the real interest rate across countries is equal. We can
rearrange the international Fisher effect as follows to answer this question:
RUS – hUS = RFC – hFC
hFC = RFC + hUS – RUS
a.
hAUS = .04 + .039 – .058
hAUS = .021 or 2.1%
b.
hCAN = .07 + .039 – .058
hCAN = .051 or 5.1%
c.
hTAI = .09 + .039 – .058
hTAI = .071 or 7.1%
12. (LO2)
a.
The yen is expected to get weaker, since it will take more yen to buy one dollar in the future than
it does today.
b.
hUS – hJAP  (¥116.03 – ¥114.32)/¥114.32
hUS – hJAP = 0.0150 or 1.50%
(1 + .0150)4 – 1 = 0.0612 or 6.12%
The approximate inflation differential between Canada and Japan is 6.12% annually.
13. (LO2) We need to find the change in the exchange rate over time so we need to use the interest rate
parity relationship:
Ft = S0 × [1 + (RFC – RUS)]t
Using this relationship, we find the exchange rate in one year should be:
F1 = 152.93[1 + (.086 – .049)]1
F1 = HUF 158.59
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The exchange rate in two years should be:
F2 = 152.93[1 + (.086 – .049)]2
F2 = HUF 164.46
And the exchange rate in five years should be:
F5 = 152.93[1 + (.086 – .049)]5
F5 = HUF 183.39
Intermediate
14. (LO4) First, we need to forecast the future spot rate for each of the next three years. From interest rate
and purchasing power parity, the expected exchange rate is:
E(ST) = [(1 + RUS) / (1 + RFC)]T S0
So:
E(S1) = (1.0480 / 1.0410)1 $1.28/€ = $1.2886/€
E(S2) = (1.0480 / 1.0410)2 $1.28/€ = $1.2973/€
E(S3) = (1.0480 / 1.0410)3 $1.28/€ = $1.3060/€
Now we can use these future spot rates to find the dollar cash flows. The dollar cash flow each year will
be:
Year 0 cash flow = –€$14,000,000($1.28/€)
Year 1 cash flow = €$2,100,000($1.2886/€)
Year 2 cash flow = €$3,400,000($1.2973/€)
Year 3 cash flow = (€4,300,000 + 9,600,000)($1.3060/€)
= –$17,920,000.00
=
$2,706,074.93
=
$4,410,725.12
= $18,153,335.30
And the NPV of the project will be:
NPV = –$17,920,000 + $2,706,074.93/1.13 + $4,410,725.12/1.13 2 + $18,153,335.30/1.133
NPV = $510,173.30
15. (LO4)
a.
Implicitly, it is assumed that interest rates won’t change over the life of the project, but the
exchange rate is projected to decline because the Euroswiss rate is lower than the Eurodollar rate.
b.
We can use relative purchasing power parity to calculate the dollar cash flows at each time. The
equation is:
E[St] = (SFr 1.09)[1 + (.07 – .08)]t
E[St] = 1.09(.99)t
So, the cash flows each year in Eurodollar (U.S. dollar) terms will be:
t
0
1
2
3
4
5
SFr
–24.0M
+6.6M
+6.6M
+6.6M
+6.6M
+6.6M
E[St]
1.0900
1.0791
1.0683
1.0576
1.0470
1.0366
US$
–$22,018,348.63
$6,116,207.95
$6,177,987.83
$6,240,391.75
$6,303,426.01
$6,367,096.98
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And the NPV is:
NPV = –$22,018,348.62 + $6,116,207.95/1.12 + $6,177,987.83/1.12 2 + $6,240,391.75 /1.123 +
$6,303,426.01/1.124 + $6,367,096.98/1.125
NPV = $428,195.99
c.
Rearranging the relative purchasing power parity equation to find the required return in Swiss
francs, we get:
RSFr = 1.12[1 + (.07 – .08)] – 1
RSFr = 10.88%
So the NPV in Swiss francs is:
NPV = –SFr 24.0M + SFr 6.6M(PVIFA10.88%,5)
NPV = SFr 466,733.63
Converting the NPV to dollars at the spot rate, we get the NPV in U.S. dollars as:
NPV = (SFr 466,733.63)($1/SFr 1.09)
NPV = $428,195.99
16. (LO5)
a.
To construct the balance sheet in dollars, we need to convert the account balances to dollars. At
the current exchange rate, we get:
Assets = solaris 23,000 / ($ / solaris 1.20) = $19,166.67
Debt = solaris 9,000 / ($ / solaris 1.20) = $7,500.00
Equity = solaris 14,000 / ($ / solaris 1.20) = $11,666.67
b.
In one year, if the exchange rate is solaris 1.40/$, the accounts will be:
Assets = solaris 23,000 / ($ / solaris 1.40) = $16,428.57
Debt = solaris 9,000 / ($ / solaris 1.40) = $6,428.57
Equity = solaris 14,000 / ($ / solaris 1.40) = $10,000.00
b.
If the exchange rate is solaris 1.12/$, the accounts will be:
Assets = solaris 23,000 / ($ / solaris 1.12) = $20,535.71
Debt = solaris 9,000 / ($ / solaris 1.12) = $8,035.71
Equity = solaris 14,000 / ($ / solaris 1.12) = $12,500.00
Challenge
17. (LO5) First, we need to construct the end of year balance sheet in solaris. Since the company has
retained earnings, the equity account will increase, which necessarily implies the assets will also
increase by the same amount. So, the balance sheet at the end of the year in solaris will be:
Balance Sheet (solaris)
Assets
$24,250.00
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Liabilities
$9,000.00
Equity
15,250.00
Total liabilities & equity
$24,250.00
Now we need to convert the balance sheet accounts to dollars, which gives us:
Assets = solaris 24,250 / ($ / solaris 1.24) = $19,556.45
Debt = solaris 9,000 / ($ / solaris 1.24) = $7,258.06
Equity = solaris 15,250 / ($ / solaris 1.24) = $12,298.39
18. (LO3, 4)
a.
The domestic Fisher effect is:
1 + RUS = (1 + rUS)(1 + hUS)
1 + rUS = (1 + RUS)/(1 + hUS)
This relationship must hold for any country, that is:
1 + rFC = (1 + RFC)/(1 + hFC)
The international Fisher effect states that real rates are equal across countries, so:
1 + rUS = (1 + RUS)/(1 + hUS) = (1 + RFC)/(1 + hFC) = 1 + rFC
b.
The exact form of unbiased interest rate parity is:
E[St] = Ft = S0 [(1 + RFC)/(1 + RUS)]t
c.
The exact form for relative PPP is:
E[St] = S0 [(1 + hFC)/(1 + hUS)]t
d.
For the home currency approach, we calculate the expected currency spot rate at time t as:
E[St] = (€0.65)[1.07/1.05]t = (€0.65)(1.019)t
We then convert the euro cash flows using this equation at every time, and find the present value.
Doing so, we find:
NPV = – [€2.5M/(€0.65)] + {€1.1M/[1.019(€0.65)]}/1.1 + {€1.1M/[1.019 2(€0.65)]}/1.12 +
{€1.1M/[1.0193(€0.65/$1)]}/1.13
NPV = –$3,846,153.85 + $1,509,705.25 + $1,346,805.87 +$1,201,483.57
NPV = $211,840.845
For the foreign currency approach we first find the return in the euros as:
RFC = 1.10(1.07/1.05) – 1 = 0.121
Next, we find the NPV in euros as:
NPV = – €2.5M + (€1.1M)/1.121 + (€1.1M)/1.121 2 + (€1.1M)/1.1213 = €137,696.55
And finally, we convert the euros to dollars at the current exchange rate, which is:
NPV ($) = €137,696.55 /(€0.65/$1) = $211,840.85
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