CORPORATE
FINANCIAL
THEORY
Lecture 12
International Finance
Today
Capital Budgeting (international style)
Financing (international style)
Topics
Exchange rates
Currency risk
Managing Currency Risk
Capital Budgeting w/ currency risk
Financing w/currency risk
Foreign Exchange Markets
Exchange Rate - Amount of one currency needed to purchase one unit of another.
Spot Rate
The price of a currency for immediate delivery (i.e. today’s exchange rate)
Forward Rate
The price of a currency on a specified future date (i.e. a forward contract in which
the exercise price is the exchange rate)
Futures - Same as forward (w/secondary markets)
Options - on exchange rates & Future Ks
Exchange Rates
Forward Rate *
Spot Rate * 1 Month 3 Months 1 Year
Europe
EMU (euro)
Norway (krone)
Sweden (krona)
Switzerland (franc)
United Kingdom (pound)
Americas:
Canada (dollar)
Mexico (peso)
Pacific/ Africa:
Hong Kong (dollar)
Japan (yen)
South Africa (rand)
South Korea (won)
1.3549
5.9566
6.8028
1.213
1.9901
1.3565
5.9514
6.7915
1.2099
1.99
1.3595
5.9436
6.7705
1.2038
1.9892
1.3689
5.9377
6.7041
1.1812
1.9811
1.1309
10.9892
1.1298
11.0055
1.1278
11.0408
1.1208
11.2274
7.8129
1119.795
7.0942
903.55
7.8071
119.33
7.116
929.85
7.7916
118.397
7.162
928.45
7.7429
114.571
7.3807
923.65
Foreign Exchange Markets
Forward Premiums and Forward Discounts
Example - The Peso spot price is 10.9892 peso per dollar and the
3 month forward rate is 11.0408 Peso per dollar, what is the
premium and discount relationship?
 Spot Price

T 
- 1 = Premium or (-Discount )
 Forward Price 
 10.9892 
4
- 1 = -1.90%
 11.0408 
Foreign Exchange Markets
Forward Premiums and Forward Discounts
Example - The Peso spot price is 10.9892 peso per dollar and the
3 month forward rate is 11.0408 Peso per dollar, what is the
premium and discount relationship?
Answer - The dollar is selling at a 1.90% premium, relative to the peso. The
peso is selling at a 1.90% discount, relative to the dollar.
Exchange Rates
Example
Swiss franc spot price is SF 1.4457 per $1
Swiss franc 6 mt forward price is SF1.4282 per $1
The franc is selling at a Forward Premium
The Dollar is selling at a Forward Discount

This means that the market expects the dollar to get weaker, relative to
the franc
Example (premium? discount?)
The Japanese Yen spot price is 101.18 per $1
The Japanese 6mt fwd price is 103.52 per $1
Exchange Rates
Example
What is the franc premium (annualized)?
Example
What is the Yen discount (annualized)?
Exchange Rate Relationships
Basic Relationships
1 + rforeign
1 + r$
1 + i foreign
equals
equals
equals
E(sforeign / $)
f foreign / $
S foreign / $
1 + i$
equals
S foreign / $
Exchange Rate Relationships
1) Interest Rate Parity Theory
1 + rforeign
1 + r$

=
f foreign / $
S foreign / $
The ratio between the risk free interest rates in two
different countries is equal to the ratio between the
forward and spot exchange rates.
Exchange Rate Relationships
Example - You have the opportunity to invest
$1,000,000 for one year. All other things being
equal, you have the opportunity to obtain a 1 year
Mexican bond (in peso) @ 7.35 % or a 1 year US
bond (in dollars) @ 5.05%. The spot rate is
10.9892 peso:$1 The 1 year forward rate is 11.2274
peso:$1
Which bond will you prefer and why?
Ignore transaction costs
Exchange Rate Relationships
Example - You have the opportunity to invest $1,000,000 for one year. All
other things being equal, you have the opportunity to obtain a 1 year Mexican
bond (in peso) @ 7.35 % or a 1 year US bond (in dollars) @ 5.05%. The
spot rate is 10.9892 peso:$1 The 1 year forward rate is 11.2274 peso:$1
Which bond will you prefer and why? Ignore transaction costs
Value of US bond = $1,000,000 x 1.0505 = $1,050,500
Value of Mexican bond = $1,000,000 x 10.9892 = 10,989,200 peso exchange
10,989,200 peso x 1.0735 = 11,796,906 peso
bond pmt
11,796,906 peso / 11.2274= $1,050,725
exchange
Exchange Rate Relationships
2) Expectations Theory of Exchange Rates
f foreign / $
S foreign / $
=
E(sforeign / $)
S foreign / $
Theory that the expected spot exchange rate equals
the forward rate.
Exchange Rate Relationships
3) Purchasing Power Parity
1 + i foreign
1 + i$
=
E(sforeign / $)
S foreign / $
The expected change in the spot rate equals the
expected difference in inflation between the two
countries.
Exchange Rate Relationships
Example - If inflation in the US is forecasted at 2.5% this
year and Mexico is forecasted at 4.7%, what do we
know about the expected spot rate?
Given a spot rate of 10.9892 peso:$1
1 + i foreign
1 + i$
=
E(sforeign/$)
S foreign/$
1  .047 E(sforeign/$ )
=
1 + .025
10.9892
solve for Es
Es = 11.2251
Exchange Rate Relationships
4) International Fisher effect
1 + rforeign
1 + r$
=
1 + i foreign
1 + i$
The expected difference in inflation rates equals the
difference in current interest rates.
Also called common real interest rates
Exchange Rate Relationships
Example - The real interest rate in each country is about the same
r (real ) 
1 + rforeign
1 + i foreign
1.0735
=
- 1 = .025
1.047
1 + r$ 1.0505
r (real ) 
=
- 1 = .025
1 + i $ 1.025
Exchange Rates
Another Example
You are doing a project in Switzerland which has an initial cost of $100,000. All other things
being equal, you have the opportunity to obtain a 1 year Swiss loan (in francs) @ 8.0% or a 1
year US loan (in dollars) @ 10%. The spot rate is 1.4457sf:$1 The 1 year forward rate is
1.4194sf:$1
Which loan will you prefer and why? Ignore transaction costs
Cost of US loan = $100,000 x 1.10 = $110,000
Cost of Swiss Loan =
$100,000 x 1.4457 = 144,570 sf
144,570 sf x 1.08 = 156,135 sf
156,135 sf / 1.4194 = $110,000
If the two loans created a different result, arbitrage exists!
exchange
loan pmt
exchange
Exchange Rates
Swiss Example
Given a spot rate of sf:$
1.4457:$1
Given a 1yr fwd rate of
1.4194:$1
If inflation in the US is forecasted at 4.5% this year, what do we know about the
forecasted inflation rate in Switzerland?
𝐸 𝑆𝑓 $
𝐸(1 + 𝑖𝑓 )
=
𝑆𝑓 $
𝐸(1 + 𝑖$ )
(1 + 𝑖𝑓 )
1.4194
=
1.4457 1 + .045
Solve for 𝑖𝑓
𝑖𝑓 =.026 or 2.6%
Exchange Rates
Swiss Example
 In the previous examples, show the equilibrium of interest rates
and inflation rates
1 + 𝑟𝑓 1.08
=
= .9818
1 + 𝑟$ 1.10
𝐸(1 + 𝑖𝑓 ) 1.026
=
= .9818
𝐸(1 + 𝑖$ ) 1.045
Currency Risk
Example
Your US company is building a plant in Switzerland. Your
cost will be 2,000,000 sf, with full payment due in 6 months.
You are concerned about currency risk. The spot rate is
1.4397sf:$1 and the 6 mt forward rate is 1.4350sf:$1.
How can you eliminate the currency risk? How does this
help in evaluating the project?
Currency Risk
Example
Your US company is building a plant in Switzerland. Your cost will be
2,000,000 sf, with full payment due in 6 months. You are concerned about
currency risk. The spot rate is 1.4397sf:$1 and the 6 mt forward rate is
1.4350sf:$1. How can you eliminate the currency risk? How does this help in
evaluating the project?
•Since you are short in Swiss Francs, you should long sf contracts
•2,000,000sf / 1.4350 = $1,393,728 worth of 6mt sf Ks.
•This will lock in your Co cash flow at $1,393,728
•The forward premium paid is 0.33% (using capital market equilibrium, this premium
probably equals the inflation rate.
Exchange Rates
Applications
Q: What does it mean to a business if the dollar is trading at
a forward premium?
A: Stronger purchasing power
Exchange Rate Risk


Currency Risk can be reduced by using various
financial instruments
Currency forward contracts, futures contracts, and
even options on these contracts are available to
control the risk
Capital Budgeting
Techniques
1) Exchange to $ and analyze
2) Discount using foreign cash flows and interest
rates, then exchange to $.

Option 1 preferred because discount rates in US are
more reliable.
Example
Outland Corporation is building a plant in Holland to produce reindeer
repellant to sell in that country. The plant is expected to produce a cash flow (in
guilders ,000s) as follows. The US risk free rate is 8%, the Dutch rate is 9%. US
inflation is forecasted at 5% per year and the current spot rate is 2.0g:$1.
year
1
2
3
4
5
400
450
510
575
650
Q: What are the 1, 2, 3, 4, 5 year forward rates?
A:
𝐸 𝑆𝑓
𝐸 𝑆𝑓 $
𝐸(1 + 𝑟𝑓 )𝑡
=
𝑆𝑓 $
𝐸(1 + 𝑟$ )𝑡
$
2.02 2.04 2.06
𝐸 𝑆𝑓 $
(1 + .09)𝑡
=
2.0
(1 + .08)𝑡
2.08
2.10
Example
Outland Corporation is building a plant in Holland to produce reindeer
repellant to sell in that country. The plant is expected to produce a cash flow (in
guilders ,000s) as follows. The US risk free rate is 8%, the Dutch rate is 9%. US
inflation is forecasted at 5% per year and the current spot rate is 2.0g:$1.
year
1
2
3
4
5
400
450
510
575
650
Q: Convert the CF to $ using the forward rates.
1
2
3
4
5
CFg
400
450
510
575
650
E(S)
2.02
2.04
2.06
2.08
2.10
CF$
198
221
248
276
310
Political Risk
Political Risk
Trade Policy
Exchange Rate Risk
Example - Honda builds a new car in Japan for a cost +
profit of 1,715,000 yen. At an exchange rate of 120.700Y:$1
the car sells for $14,209 in Indianapolis. If the dollar rises
in value, against the yen, to an exchange rate of 134Y:$1,
what will be the price of the car?
1,715,000 = $12,799
134
Conversely, if the yen is trading at a
forward discount, Japan will
experience a decrease in purchasing
power.
Exchange Rate Risk
Example - Harley Davidson builds a motorcycle for a
cost plus profit of $12,000. At an exchange rate of
120.700Y:$1, the motorcycle sells for 1,448,400 yen in
Japan. If the dollar rises in value and the exchange rate is
134Y:$1, what will the motorcycle cost in Japan?
$12,000 x 134 = 1,608,000 yen
Trade Policy
Employment
Conventional wisdom
 We are losing all of our jobs to Mexico, China,
and India?
FALSE
Employment Trend
Unemployment Rate
Population
% of Work Force
12
10
8
2007 = 301 mil
6
1970 = 203 mil
4
2
Source: Bureau of Labor Statistics
2006
2004
2002
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
1980
1978
1976
1974
1972
1970
0
Employment & Foreign Trade
Population
2007 = 301 mil
1970 = 203 mil
Source: Bureau of Labor Statistics
Employed
UIndy Nightly News

News Alert on the
unemployment report
released today by the
Department of Labor.
PR - News Releases


“Last month the unemployment rate in the United
States increased slightly from 4.6% to 4.7%. White
House officials were quick to point out that at the
same time the U.S. economy added 141,000 new
jobs.”
“Last month 322,000 manufacturing jobs were lost.
Union leaders site cheap overseas labor costs as the
culprit, saying that good jobs are leaving the US
and the economy will suffer.”
Behind The Numbers
September 2007
 Unemployment = 4.7%
Jobs added
Jobs lost
Net change
Source: Bureau of Labor Statistics
463,000
322,000
+141,000
Behind The Numbers
Totals for 2006
 Unemployment = 4.6%
Jobs added
Jobs lost
Net change
Source: Bureau of Labor Statistics
2,697,000
625,000
+2,072,000
Comparative Advantage
Wants
Needs
Comparative Advantage
Wants
Needs
Comparative Advantage
Wants
Needs
Employment

But are they better paying jobs?
Wages & Inflation
% Change (year over year)
8
Actual Wage
Increase
7
Inflation Rate
6
5
4
3
2
1
Source: Bureau of Labor Statistics
Sep-07
Aug-07
Jul-07
Jun-07
May-07
Apr-07
Mar-07
Feb-07
Jan-07
Dec-06
Nov-06
Oct-06
Sep-06
0
Employment
$20.00
$18.00
$16.00
$14.00
$12.00
$10.00
$8.00
$6.00
$4.00
$2.00
$0.00
1964
1966
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
Average Hourly Earnings
Source: Bureau of Labor Statistics
Foreign Trade
Conventional wisdom
 We have huge trade deficits with other countries.
These large trade deficits are destroying our
economy.
FALSE
Foreign Trade
US vs. Japan Trade Deficit
Cumulative Deficit $bil
(1985 base)
1,600
1,400
1,200
1,000
800
600
400
Source: US Census Bureau
2007
2005
2003
2001
1999
1997
1995
1993
1991
1989
1987
-
1985
200
Trade Deficit and Economic Strength
Stock Market Values
U.S. Stock Index
Source: S&P & Nikkei
Jan-07
Jan-05
Jan-03
Jan-01
Jan-99
Jan-97
Jan-95
Jan-93
Jan-91
Jan-89
Jan-87
Jan-85
Value (base 100)
Japan Stock Index
Foreign Trade
Why does this work?
Stuff
China
Cash
Wall Street &
(Indiana)
Wall Street invests this money, which…
1. creates more jobs, which…
2. grows the economy, which…
3. strengthens the dollars, which…
4. starts the cycle again
KEY
Strong Dollar
What We Know






Net Present Value
Capital Asset Pricing Model (CAPM)
Efficient Capital markets
Value Additivity & Conservation
Option Theory
Agency Theory
What We Do Not Know





How major decisions are made
What determines the risk & PV ?
CAPM shortfalls
Why are some markets inefficient?
Is management a liability?
What We Do Not Know





Why do IPOs succeed & new markets emerge?
Why is capital structure not optimized?
Dividend policy - Answer?
Liquidity value?
Why do mergers come in waves?
Review for Final
In normal class room
Topics
Format
Difficulty
Bonus Points