Chapter 22
INTERNATIONAL CORPORATE FINANCE
SLIDES
22.1
22.2
22.3
22.4
22.5
22.6
22.7
22.8
22.9
22.10
22.11
22.12
22.13
22.14
22.15
22.16
22.17
22.18
22.19
22.20
22.21
22.22
22.23
22.24
22.25
22.26
22.27
22.28
22.29
Key Concepts and Skills
Chapter Outline
Domestic Financial Management and International Financial Management
International Finance Terminology
Global Capital Markets
Work the Web Example
Exchange Rates
Example: Exchange Rates
Example: Triangle Arbitrage
Types of Transactions
Absolute Purchasing Power Parity
Relative Purchasing Power Parity
Example: PPP
Covered Interest Arbitrage
Example: Covered Interest Arbitrage
Interest Rate Parity
Unbiased Forward Rates
Uncovered Interest Parity
International Fisher Effect
Overseas Production: Alternative Approaches
Home Currency Approach
Foreign Currency Approach
Repatriated Cash Flows
Short-Run Exposure
Long-Run Exposure
Translation Exposure
Managing Exchange Rate Risk
Political Risk
Quick Quiz
CASE
The following case in Cases in Finance by DeMello can help illustrate the concepts in
this chapter:
International Capital Budgeting
CHAPTER 22 A-301
CHAPTER WEB SITES
Section
Introduction
22.1
22.2
22.4
End-of-chapter material
Web Address
www.adr.com
www.hsh.com
www.swift.com
www.chicagofed.org/consumerinformation
www.xe.com
www.exchangerate.com
www.chicagofed.org
www.ft.com
www.travlong.com/money
cbs.marketwatch.com
www.economist.com
www.marketvector.com
CHAPTER ORGANIZATION
22.1
Terminology
22.2
Foreign Exchange Markets and Exchange Rates
Exchange Rates
Types of Transactions
22.3
Purchasing Power Parity
Absolute Purchasing Power Parity
Relative Purchasing Power Parity
22.4
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
22.5
International Capital Budgeting
Method 1: The Home Currency Approach
Method 2: The Foreign Currency Approach
Unremitted Cash Flows
22.6
Exchange Rate Risk
Short-Run Exposure
Long-Run Exposure
Translation Exposure
Managing Exchange Rate Risk
A-302 CHAPTER 22
22.7
Political Risk
22.8
Summary and Conclusions
ANNOTATED CHAPTER OUTLINE
Slide 22.1 Key Concepts and Skills
Slide 22.2 Chapter Outline
Slide 22.3 Domestic Financial Management and International Financial
Management
Lecture Tip, page 749: 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;
-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.
Even if you don’t agree with everything Professor Drucker said, each
comment deserves consideration by the practicing financial manager. These
points are also useful for generating classroom discussion of the additional
complications involved with international financial management.
22.1.
Terminology
Slide 22.4
International Finance 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)
CHAPTER 22 A-303
Lecture Tip, page 750: You might emphasize that 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; 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
22.2.
Foreign Exchange Markets and Exchange Rates
Slide 22.5 Global Capital Markets Click on the web surfer icon to go to a
web site that provides a wealth of information on international business
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: “International Finance” takes a look at McDonald’s expansion into India.
Slide 22.6
Work the Web Example
A-304 CHAPTER 22
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.
Slide 22.7 Exchange Rates Click on the web surfer icon to go to the
Chicago Fed to see current and historical exchange rates.
Slide 22.8 Example: Exchange Rates
Slide 22.9 Example: Triangle 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
Lecture Tip, page 755: 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.
B.
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)
CHAPTER 22 A-305
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 22.10 Types of Transactions
Lecture Tip, page 756: 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.
22.3.
Purchasing Power Parity
A.
Absolute Purchasing Power Parity
Absolute PPP indicates that a commodity should sell for the same
real price regardless of currency used
A-306 CHAPTER 22
Absolute PPP can be violated due to transaction costs, barriers to
trade and differences in the product
Slide 22.11 Absolute Purchasing Power Parity
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.
Slide 22.12 Relative Purchasing Power Parity
Slide 22.13 Example: PPP
Lecture Tip, page 759: 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 to make
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, page 759: 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.
CHAPTER 22 A-307
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, 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 $1) because of the lower inflation rate.
22.4.
Interest Rate Parity, Unbiased Forward Rates, and the International Fisher
Effect
A.
Covered Interest Arbitrage
Slide 22.14 Covered Interest Arbitrage
Slide 22.15 Example: Covered Interest Arbitrage
A covered interest arbitrage exists when a riskless profit can be
made by borrowing in the U.S. at the risk-free rate, converting the
borrowed dollars into a foreign currency, investing at that
country’s rate of interest, taking a forward contract to convert the
currency back into U.S. dollars and repaying the loan.
Example:
S0 = 2 DM/$
F1 = 1.8 DM/$
1)
2)
3)
4)
5)
6)
B.
RUS = 10%
RG = 5%
Borrow $100 at 10%
Buy $100(2 DM/$) = 200 DM and invest at 5% (RG)
At the same time, enter into a forward contract
In 1 year, receive 200(1.05) = 210 DM
Convert to $ using forward contract; 210 DM / (1.8 DM/$)
= $116.67
Repay loan and pocket profit: 116.67 – 100(1.1) = $6.67
Interest Rate Parity
To prevent covered arbitrage:
F1 1  RFC

S 0 1  RUS
A-308 CHAPTER 22
Approximation: Ft = S0[1 + (RFC – RUS)]t
Example:
Suppose the French Franc spot rate is 6.38 FF / $. 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 = 6.38(1.06)/(1.08) = 6.2619 FF / $
Approximation: F = 6.38[1 + (.06 - .08)] = 6.2524 FF/$
Slide 22.16 Interest Rate Parity
C.
Forward Rates and Future Spot Rates
Unbiased forward rates (UFR) – states that the forward rate, Ft, is
equal to the expected future spot rate, E[St]. That is, on average,
the forward rates neither consistently underestimate nor
overestimate the future spot rate. That is, Ft = E[St]
Slide 22.17 Unbiased Forward Rates
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
Slide 22.18 Uncovered Interest Parity
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 22.19 International Fisher Effect
CHAPTER 22 A-309
22.5.
International Capital Budgeting
Slide 22.20 Overseas Production: Alternative Approaches
A.
Method 1: The Home Currency Approach
This involves converting foreign cash flows into the domestic
currency and finding the NPV.
Slide 22.21 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 22.22 Foreign Currency Approach
Example: Pizza Shack is considering opening a store in Mexico
City, Mexico. The store would cost $1.5 million or 3,646,500,000
pesos to open. Pizza Shack hopes to operate the store for two years
and then sell it at the end of the second year to a local franchisee.
Cash flows are expected to be 250,000,000 pesos in the first year,
and 5,000,000,000 pesos the second year. The spot exchange rate
for Mexican pesos is 2,431. The U.S. risk-free rate is 7% and the
Mexican risk-free rate is 10%. The required return (U.S.) is 12%.
1. The home currency approach
Using the UIP:
E[S1] = 2,431[1 + (.1 - .07)] = 2,503.93
E[S2] = 2,431[1 + (.1 - .07)]2 = 2,579.05
Year
0
1
2
Cash Flow (pesos)
-3,646,500,000
250,000,000
5,000,000,000
NPV at 12% = 134,664.04
E[St]
2431.00
2503.93
2579.05
Cash Flow ($)
-1,500,000.00
99,843.05
1,938,698.36
A-310 CHAPTER 22
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 / 2431 = 134,665.30
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.
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, page 766: 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.
CHAPTER 22 A-311
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 bud 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.
Slide 22.23 Repatriated Cash Flows
22.6.
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.
Lecture Tip, page 766: According to The Wall Street Journal in
1993 (Currency Waves: Global Money Trends Rattle Shop
Windows in Heartland America,” November 26, 1993), a set of
cultured pearls that cost $899 a few years ago now costs $3,000 at
a jewelry store in Troy, OH. The average Japanese car costs
approximately $2000 more than its American counterpart. A local
soybean farmer uses his satellite dish to keep track of commodity
prices and currency rates. These are all examples of how foreign
exchange rates affect the “average American.” The impact is even
more pronounced now than in 1993. Students often feel that world
A-312 CHAPTER 22
affairs are not relevant to our daily lives. This example servers as
an illustration that we are all impacted by what happens around
the world.
Slide 22.24 Short-Run Exposure
Lecture Tip, page 767: 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-Run Exposure
Long-run changes in exchange rates can be partially offset by
matching foreign assets and liabilities, inflows and outflows.
Slide 22.25 Long-Run Exposure
C.
Translation Exposure
Slide 22.26 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
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.
CHAPTER 22 A-313
Slide 22.27 Managing Exchange Rate Risk
22.7.
Political Risk
Blocking funds and expropriation of property by foreign
governments are among routine political risks faced by
multinationals. In some places, political terrorism is also a concern.
Financing the subsidiaries 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 22.28 Political Risk
22.8.
Summary and Conclusions
Slide 22.29 Quick Quiz