CHAPTER 21
INTERNATIONAL CORPORATE FINANCE
SLIDES
S21.1: Key Concepts and Skills
S21.2: Chapter Outline
S21.3: Domestic Financial Management and International Financial Management
S21.4: International Finance Terminology
S21.5: Global Capital Markets - Representative Listing
S21.6: Work the Web Example
S21.7: Exchange Rates and Example (2 pages)
S21.9: Example: Triangle Arbitrage
S21.10: Types of Transactions
S21.11: Absolute Purchasing Power Parity
S21.12: Relative Purchasing Power Parity and Example (2 pages)
S21.14: Covered Interest Arbitrage and Example (2 pages)
S21.16: Interest Rate Parity
S21.17: Unbiased Forward Rates
S21.18: Uncovered Interest Parity
S21.19: International Fisher Effect
S21.20: Overseas Production: Alternative Approaches (4 pages)
S21.24: Types of Exposure (3 pages)
S21.27: Managing Exchange Rate Risk
S21.28: Political Risk
S21.29: Quick Quiz
S21.30: Summary
CHAPTER ORGANIZATION
S21.1: Key Concepts and Skills
S21.2: Chapter Outline
21.1 TERMINOLOGY
21.2 FOREIGN EXCHANGE MARKETS AND EXCHANGE RATES
Exchange Rates
Types of Transactions
21.3 PURCHASING POWER PARITY
Absolute Purchasing Power Parity
Relative Purchasing Power Parity
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21.4 INTEREST RATE PARITY, UNBIASED FORWARD RATES, AND THE
INTERNATIONAL FISHER EFFECT
Covered Interest Arbitrage
Interest Rate Parity (IRP)
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 FINANCING INTERNATIONAL PROJECTS
The Cost of Capital for International Firms
International Diversification and Investors
Sources of Short- and Intermediate-Term Financing
21.7 EXCHANGE RATE RISK
Short-Run Exposure
Long-Run Exposure
Translation Exposure
Managing Exchange Rate Risk
21.8 POLITICAL RISK
21.9 SUMMARY AND CONCLUSIONS
ANNOTATED CHAPTER OUTLINE
S21.3: Domestic Financial Management and International Financial Management
21.1 TERMINOLOGY
S21.4: International Finance Terminology
Peter Drucker, the well-known management philosopher, made some interesting comments in his keynote address to the Chief Financial Officers' Conference in New
York some years ago. Professor Drucker suggested that:
-to be successful, multinational corporations must work to exploit global markets;
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-exchange rates are inevitably unstable, and attempting to predict them is foolish;
-not hedging against exchange rate fluctuations is equivalent to speculating; and,
-corporate losses can't be blamed on market volatility.
Readers may or may not completely agree with all of Professor Drucker's contentions, but each deserves serious consideration by the practicing financial decision-maker. And, not surprisingly, these points are useful for generating class discussion of the additional complications inherent in the financial management of a multinational corporation.
Terminology
American Depository Receipt (ADR) —security issued in the U.S. representing shares of a foreign stock and allowing that stock to be traded in the U.S.
Cross-rate —implicit exchange rate between two currencies quoted in a third currency
(usually the U.S. dollar).
European Currency Unit (ECU) —index of 10 European currencies intended to serve as a monetary unit for the European Monetary System.
Eurobonds —bonds issued in many countries but denominated in a single currency.
Eurocurrency —money deposited outside the country whose currency is involved.
Eurodollars
—U.S. dollars deposited in banks outside the U.S. banking system.
Foreign bonds
—bonds issued in a single country, denominated in that country's currency, but not issued by a domestic firm. Nearly half are issued in Switzerland.
Gilts —British and Irish government securities.
LIBOR (London Interbank Offer Rate)
—rate most international banks charge one another for overnight Eurodollar loans.
Swaps —agreements to exchange securities, currencies, or even commodities.
21.2 FOREIGN EXCHANGE MARKETS AND EXCHANGE RATES
Foreign exchange market —market for exchanging different country's currencies.
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A. Exchange Rates
S21.5:
S21.6:
Global Capital Markets – Representative Listing
Work the Web Example
S21.7:
In practice, almost all trading of currencies is with prices quoted in U.S. dollars. The
Financial Post and the Globe and Mail also show currencies with prices quoted in
Canadian dollars.
Exchange Rates and Example (2 pages)
Direct or American quote
—number of dollars to buy one unit of foreign currency.
Indirect or European exchange rate —amount of foreign currency per Canadian dollar.
Cross-Rates and Triangle Arbitrage Implicit in exchange rate quotes is an exchange rate between non-Canadian currencies. For there to be no arbitrage opportunities, the exchange rate between two non-Canadian currencies must equal the cross-rate. That is,
(Currency 1 indirect quote)/(Currency 2 indirect quote) equals Currency 1 per unit
Currency 2.
S21.9: Example : Triangle Arbitrage
Example: Triangle Arbitrage
Suppose the indirect quote on the Japanese Yen (Currency 1) is 133.90 and the indirect quote on the South Korean Won (Currency 2) is 666.00. If the exchange rate is
.1750 Yen per Won, does an arbitrage opportunity exist?
Yes. The no-arbitrage cross-rate is (133.90/666) = .20105 Yen per Won. The Won is cheaper in Yen than in dollars. To make an arbitrage profit, first buy Yen with dollars, say ¥133900 for $1,000. Next, trade the Yen for 765,142.86 Won. Finally, trade the Won for $1,148.86 for a quick $148.86 profit.
In general:
If the exchange rate (Currency 1 per Currency 2) is less than the implied cross-rate
(Currency 1 indirect quote)/(Currency 2 indirect quote), then buy Currency 1 with dollars, trade Currency 1 for Currency 2, trade Currency 2 for dollars.
If the exchange rate (Currency 1 per Currency 2) is above the implied cross-rate
(Currency 1 indirect quote)/(Currency 2 indirect quote), then buy Currency 2 with dollars, trade Currency 2 for Currency 1, trade Currency 1 for dollars.
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The opportunity to exploit a triangle arbitrage situation may appear to students an easy opportunity to make quick, riskless profits. Point out, however, that the foreign exchange markets are populated by smart, well-financed, professional traders, all of whom are looking to exploit the slightest discrepancies in rates. As a result, exchange rates between the commonest currencies are quickly driven to equilibrium - in other words, the foreign exchange market is generally informationally efficient. For small investors, therefore, it is unlikely that or riskless profits are possible.
B. Types of Transactions
Spot trade
—exchange of currencies based on current quotes ( spot exchange rate).
Forward trade —agreement for an exchange in the future at the forward exchange rate . If the direct quote forward exchange rate is higher than the spot rate, the currency is selling at a premium ; if lower, at a discount .
S21.10: Types of Transactions
21.3 PURCHASING POWER PARITY
S21.11: Absolute Purchasing Power Parity
A. Absolute Purchasing Power Parity (PPP)
Absolute PPP states that a commodity should sell for the same real price regardless of the currency used to purchase it.
Let S
0
be the spot exchange rate (indirect quote) between a currency and the Canadian dollar at time 0. Let P
F
be the foreign price of a commodity, and P
CAN
be the Canadian price. Absolute PPP states:
P
F
= S
0
× P
CAN
Because of product differences, barriers to trade, tariffs, and transportation costs, absolute PPP tends to hold only for traded commodities with low transfer costs.
Example: Gold
Gold is a commodity that is easily traded by receipt. If gold is selling for £195 in
London, and the spot rate between pounds and dollars is .5940, what price is gold likely to sell for in Toronto? Rearranging P
F
= S
0
× P
CAN
gives P
CAN
= ( P
F
/ S
0
) = (£195/.5940) =
$328.28.
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B. Relative Purchasing Power Parity
The change in the exchange rate is determined by the difference in the inflation rates between two countries.
S21.12: Relative Purchasing Power Parity (2 pages)
S
0
= Current indirect quote spot exchange rate
E [ S t
] = Expected exchange rate in t periods
H
CAN
= Inflation rate (expected) in the U.S. h
FC
= Foreign country inflation rate (expected)
In general, relative PPP states the expected exchange rate t periods hence is about:
E [ S t
] = S
0
× [1 + ( h
FC
– h
CAN
)] t
Currency Appreciation and Depreciation—Statements such as "the dollar was stronger today" are made from the perspective of an indirect quote exchange rate. That is, a stronger dollar means more of a foreign currency is needed to buy one Canadian dollar and vice-versa for a "weaker" dollar.
When asked "Which is better: a stronger dollar or a weaker dollar?," most students opt for the former. While this makes imports relatively cheaper, it makes Canadian exports relatively more expensive. In general, consumers like a stronger dollar and producers (especially exporters) a weaker one.
The concept of relative PPP may be reinforced by having the students consider a product that sells in both the United Kingdom and the Canada at identical relative prices; i.e., with a 2-to-1 relationship between the dollar and the pound, the product would sell for $1 in the Canada and .5 pounds in the UK. If the inflation rate is 4 percent per year in Canada, the product would cost $1.04 in one year.
However, if, in the UK inflation is expected to average 10 percent per year, the product would cost .55 pounds in one year. The student should recognize that, if they received $1.04 aftertax from an investment, they would be able to purchase the product in the Canada but, if the currency rate remained at $1 to .5 pounds, they would not be able to purchase the product in the UK one year later since converting $1.04 to pounds would yield .52 pounds, leaving the Canadian. purchaser .03 pounds short of the required price of the product in the UK.
Thus, to maintain parity, the dollar should rise in value (purchase more than .5 pounds in the future) to maintain relative PPP. The instructor may wish to use this simplified example to introduce the International Fisher Effect.
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21.4 INTEREST RATE PARITY, UNBIASED FORWARD RATES, AND THE INTERNATIONAL
FISHER EFFECT
S21.14: Covered Interest Arbitrage and Example (2 pages)
F t
= Forward exchange rate for settlement at time t
R
CAN
= Canadian nominal risk-free interest rate
R
FC
= Foreign country nominal risk-free interest rate
A. Covered Interest Arbitrage
A covered interest arbitrage exists when an arbitrage profit can be made by converting dollars into a foreign currency, investing at that country's interest rate, taking a forward contract to convert the foreign currency back into Canadian dollars for more than could earned than by directly investing at the Canadian rate. The foreign investment yields a total of S
0
× (1+ R
FC
)/ F
1
per dollar. If this is greater than the Canadian yield of (1 + R
CAN
) per dollar, an arbitrage opportunity exists.
B. Interest Rate Parity (IRP)
To prevent covered interest arbitrage, S
0
× (1 + R
FC
)/ F
1
= (1 + R
CAN
) must hold.
Rearranging terms gives the interest rate parity (IRP) condition:
F
1
/ S
0
= (1 + R
FC
)/(1 + R
CAN
).
Useful approximations:
( F
1
– S
0
)/ S
0
= R
FC
– R
CAN and
F t
= S
0
× [1 + ( R
FC
– R
CAN
)] t .
Loosely, IRP says the difference in interest rates between two countries is just offset by the change in the relative value of the currencies.
Example:
Suppose the French Franc spot rate (indirect quote) is 6.3800. If R
F
= 6% and R
CAN
=
8%, what F
1
will prevent covered interest rate arbitrage?
6.3800 × [1 + (.06 – .08)] = FF 6.2524
S21.16: Interest Rate Parity
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C. Forward Rates and Future Spot Rates
Unbiased forward rates (UFR)
—states the forward rate,
F t
, is equal to the expected future spot rate, E [ S t
]. That is, on average, forward rates neither consistently understate nor overstate the future spot rate. That is, F t
= E [ S t
].
S21.17: Unbiased Forward Rates
D. Putting It All Together
PPP:
IRP:
UFR:
E [ S
1
] = S
0
× [1 + ( h
FC
– h
US
)]
F
1
= S
0
× [1 + ( R
FC
– R
US
)]
F
1
= E [ S
1
]
Uncovered interest parity (UIP)—combining UFR and IRP gives:
E [ S
1
] = S
0
× [1 + ( R
FC
– R
CAN
)] and E [ S t
] = S
0
× [1 + ( R
FC
– R
CAN
)] t
The International Fisher Effect
—combining PPP and UIP gives:
S
0
× [1 + ( h
FC
– h
CAN
)] = S
0
× [1 + ( R
FC
– R
CAN
)] so that: h
FC
– h
CAN
= R
FC
– R
CAN
And
R
US
– h
CAN
= R
FC
– h
FC
.
The IFE says that real rates must be equal across countries.
S21.18: Uncovered Interest Parity
S21.19: International Fisher Effect
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21.5 INTERNATIONAL CAPITAL BUDGETING
S21.20: Overseas Production: Alternative Approaches (4 pages)
A. Method 1: The Home Currency Approach
This involves converting foreign cash flows into dollars and finding the NPV.
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 this NPV to dollars.
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. Shack hopes to operate the store for 2 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 billion pesos the second year.
The current spot exchange rate for Mexican pesos is 2,431.00. The Canadian risk-free rate is 7% and the Mexican risk-free rate is 10%. The required return (CAN) is 12%.
1. The home currency approach.
Using the uncovered interest parity relation E [ S t
] = S
0
× [1 + ( R
F
– R
CAN
)] t , the projected exchange rates for the store are:
E [ S
1
] = 2,431 × [1 + (.10 – .07)] 1 = 2,503.93
E [ S
2
] = 2,431 × [1 + (.10 – .07)] 2 = 2,579.05
Year
0
1
2
Cash Flow
(pesos)
–3,646,500,000
250,000,000
5,000,000,000
Expected exchange rate
2,431.00
2,503.93
2,579.05
Cash Flow
(dollars)
–$1,500,000
99,843.05
1,938,698.36
NPV = –1,500,000 + 99,843.05/1.12 + 1,938,698.36/1.12
2 = $134,664.04
2. The foreign currency approach.
Using the IFE, the difference in nominal rates, R
FC
– R
CAN
, equals the difference in inflation rates, h
FC
– h
CAN.
So a 3% inflation premium needs to be factored into the required Canadian return, giving [(1.12 × 1.03) – 1] = 15.36% considering inflation.
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NPV
FC
= –3,646,500,000 + 250,000,000/1.1536 + 5 billion/1.1536
NPV
$
= 327,371,337.6 pesos
= 327,371,337.6/2,431 = $134,665.30
2
Note that the two approaches will produce exactly the same answers if the exact forms of the various parity equations are used.
C. Unremitted Cash Flows
Not all cash flows from foreign operations can be remitted to the parent.
Ways foreign subsidiaries remit funds to a parent:
1. Dividends
2. Management fees for central services
3. Royalties on trade names and patents
Blocked funds— funds that cannot be currently remitted.
21.6
FINANCING INTERNATIONAL PROJECTS
A.
The Cost of Capital for International Firms
An important question for firms is whether the required rate of return on international projects should be different from the required rate on domestic projects. Earlier, it was discussed that the required rate of return should be risk-based, therefore, the answer depends on;
1.
Segmentation of the international financial market
2.
Foreign political risk of expropriation, foreign exchange risk, and taxes
B.
International Diversification and Investors
Holding foreign securities may subject investors to increased tax, trading, and information costs. As a result, as investors diversify globally, the cost of capital advantage to firms is likely to decline.
Index Participationis a current example of a financially engineered vehicle for international diversification. IPs are highly liquid, thus reducing trading costs. Note: The IP is an index of 500 US stocks.
Emerging Market Funda mutual fund investing in Latin America, Southeast Asia, China, and other emerging markets. In late 1997 and through 1998 emerging market funds proved highly volatile after the Asian Flu.
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C.
Sources of Short- and Intermediate-Term Financing
Eurocurrency markets are Eurobanks that make loans and accept deposits in foreign currencies.
21.7 EXCHANGE RATE RISK
Risk arising from fluctuations in exchange rates.
S21.24: Types of Exposure (3 pages)
A. Short-Run Exposure
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.
Perspectives:
To stimulate interest in this area, ask the students why Canadian auto producers would make a statement that the dollar is "too strong" and hurting their operations. Use the example of 1985, when the dollar traded at approximately three German marks. If a
Canadian-produced car costs $8,000 to produce and German competition dictated a selling price of $9,000, the Canadian auto producer would sell the car for 27,000 marks and make a profit of $1,000 (3,000 marks). This, of course, ignores excise taxes, transportation costs, etc. for simplicity.
If the dollar fell to two marks (which it soon did after the 1985 meeting of international finance ministers), the 27,000 mark selling price would generate $13,500, resulting in a profit of $5,500. The student should recognize that a weak dollar generally benefits companies that conduct operations abroad and a volatile dollar can result in a great deal of exchange rate risk. However, the instructor should also mention that a weak dollar results in higher cost products (inflation) in Canada since we now receive less foreign currency per dollar to purchase a foreign product. The foreign producer would eventually have to raise its price to compensate for the lower amount of its own currency it would receive per $1 of sales. The German producer would receive only two marks per $1 sales instead of three marks. If the product costs 2.5 marks to produce, the
German producer could not sell the product at $1 in the Canada and remain profitable.
B. Long-Run Exposure
Long-run changes in exchange rates can be partially offset by matching foreign assets and liabilities, and inflows and outflows.
C. Translation Exposure
Canadian based firms must translate foreign operations into dollars when calculating net income and EPS.
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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?
D. Managing Exchange Rate Risk
For the large MNC, 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.
S21.27: Managing Exchange Rate Risk
21.8 POLITICAL RISK
Blocking funds and expropriation of property by foreign governments are among the routine political risks faced by MNCs. Worse, in many places acts of terrorism are of concern. Blocking and expropriation can be hedged by making the operation dependent upon the parent firm, for example, for certain critical components or technical expertise.
S21.28: Political Risk
21.9
SUMMARY AND CONCLUSIONS
S21.29: Quick Quiz
S21.30: Summary
224