INTERNATIONAL CORPORATE FINANCE CHAPTER 21 INTERNATIONAL CORPORATE FINANCE Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved.

Key Concepts and Skills Understand how exchange rates are quoted and what they mean Know the difference between spot and forward rates Understand purchasing power parity and interest rate parity and the implications for changes in exchange rates Understand the basics of international capital budgeting Understand the impact of political risk on international business investing Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 21-2

Chapter Outline Terminology Foreign Exchange Markets and Exchange Rates Purchasing Power Parity Interest Rate Parity, Unbiased Forward Rates, and the International Fisher Effect International Capital Budgeting Exchange Rate Risk Political Risk Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 21-3

Domestic vs. International Financial Management Considerations in International Financial Management Need to consider the effect of exchange rates when operating in more than one currency Must consider the political risk associated with actions of foreign governments More financing opportunities when you consider the international capital markets, which may reduce the firm’s cost of capital Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 21-4

International Finance Terminology American Depositary Receipt (ADR) Cross-rate Eurobond Eurocurrency (Eurodollars) Foreign bonds Gilts London Interbank Offered Rate (LIBOR) Swaps ADR – security issued in the US that represents shares in a foreign company’s stock Cross-rate – implied exchange rate between two currencies, when both currencies are quoted in terms of a third currency Eurobond – bond sold in more than one country, but denominated in one currency, usually the issuer’s domestic currency Eurocurrency – money deposited in a bank in a country with a different currency; Eurodollars are US dollars deposited in a foreign bank Foreign bonds – bonds issued in a single foreign country in that country’s currency Gilts – British and Irish government issues LIBOR – loan rate on Eurodollars – commonly used as an index for floating rate securities Swaps – interest rate (agreement between two parties to pay interest to one another on some notional amount, one party pays a fixed rate, the other pays a floating rate) and currency (agreement to periodically swap currencies, with exchange rate based on some prespecified rate) Lecture Tip: 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. Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 21-5

Global Capital Markets The number of exchanges in foreign countries continues to increase, as does the liquidity on those exchanges Exchanges that allow for the flow of capital are extremely important to developing countries The United States has one of the most developed capital markets in the world, but foreign markets are becoming more competitive and are often willing to try more innovative ways to do business www: Click on the web surfer icon to go to a site that provides a wealth of information on international business (www.internationalist.com/business) Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 21-6

Exchange Rates The price of one country’s currency in terms of another country’s currency Most currency is quoted in terms of dollars Consider the following quote: Euro 1.3869 0.7210 The first number (1.3869) is how many U.S. dollars it takes to buy 1 Euro The second number (0.7210) is how many Euros it takes to buy $1 The two numbers are reciprocals of each other (1 / 1.3869 = 0.7210) www: Click on the web surfer icon to go to the PACIFIC Exchange Rate Service at http://fx.sauder.ubc.ca/ Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 21-7

Example: Exchange Rates Suppose you have $10,000. Based on the rates in Figure 21.1, how many Japanese Yen can you buy? Exchange rate = 102.32 Yen per dollar Buy $10,000(102.32) = 1,023,200 Yen Suppose you are visiting Mumbai and you want to buy a souvenir that costs 1,000 Indian Rupees. How much does it cost in U.S. dollars? Exchange rate = 60.150 rupees per dollar Cost = 1,000 / 60.150 = $16.63 Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 21-8

Work the Web Example Thinking about going to Mexico for spring break or Japan for your summer vacation? How many pesos or yen can you get in exchange for $1,000? Click on the web surfer to find out Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 21-9

Example: Triangle Arbitrage We observe the following quotes: 1 Euro per $1 2 Swiss Franc per $1 0.4 Euro per 1 Swiss Franc What is the cross rate for Euros per Swiss Franc? (1 Euro / $1) / (2 SF / $1) = 0.5 Euro / SF This is not the same as the quote above: (0.4 Euro per Swiss Franc) Triangle Arbitrage is the act of exchanging through three currencies to exploit a mispriced trio of currency quotes This slide uses the same information as the example in the book. The only cross-rate that will prevent triangle arbitrage is 0.5 Euro / SF Students often have difficulty with figuring out when they need to multiply or divide. It may help to show them that the currencies need to “cancel.” For example, in the first leg of the triangle arbitrage we multiply $100 by 1 Euro/$1. The $ units cancel out and we are left with Euro on top. Lecture Tip: 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. Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 21-10

Example: Triangle Arbitrage To execute triangle arbitrage in this example: buy low (0.4 Euro / SF), and sell high (0.5 Euro / SF) For example, with $100 to start: Buy $100 (1 Euro / $1) = 100 Euro; use Euro to buy SF Buy 100 Euro / (0.4 Euro / 1 SF) = 250 SF; use SF to buy dollars Buy 250 SF / (2 SF/$1) = $125 You now have $25 more than you started, and this was a risk-free transaction! This slide uses the same information as the example in the book. The only cross-rate that will prevent triangle arbitrage is 0.5 Euro / SF Students often have difficulty with figuring out when they need to multiply or divide. It may help to show them that the currencies need to “cancel.” For example, in the first leg of the triangle arbitrage we multiply $100 by 1 Euro/$1. The $ units cancel out and we are left with Euro on top. Lecture Tip: 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. Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 21-11

Types of Transactions Spot trade – exchange currency immediately Spot rate – the exchange rate for an immediate trade Forward trade – agree today to exchange currency at some future date and some specified price (also called a forward contract) Forward rate – the exchange rate specified in the forward contract If the forward rate is higher than the spot rate, the foreign currency is selling at a premium (when quoted as $ equivalents) If the forward rate is lower than the spot rate, the foreign currency is selling at a discount Futures contracts are examples of forward contracts. The major difference between futures and over-the-counter forward contracts are that futures must trade on an organized exchange, have standardized denominations and require margin deposits. These factors reduce the default risk and increase the liquidity of futures as compared to over-the-counter forwards. Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 21-12

Absolute Purchasing Power Parity Price of an item should be the same in real terms, regardless of the currency used to purchase it Requirements for absolute PPP to hold Transaction costs are zero No barriers to trade (no taxes, tariffs, etc.) No difference in the commodity between locations For most goods, absolute PPP rarely holds in practice Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 21-13

Relative Purchasing Power Parity Provides information about what causes changes in exchange rates The basic result is that exchange rates depend on relative inflation between countries E(St ) = S0[1 + (hFC – hUS)]t S0 is the current (Time 0) spot exchange rate (foreign currency per dollar) E(St ) is the expected exchange rate in t periods hUS is the inflation rate in the United States hFC is the foreign country inflation rate Because absolute PPP doesn’t hold for many goods, we will focus on relative PPP from here on out The exchange rate must be quoted as foreign currency per dollar for this form of the equation to hold. Lecture Tip: 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 on making the dollar cheaper against the yen in an effort to reduce our trade deficit with Japan. Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 21-14

Example: Relative PPP Suppose the Canadian spot exchange rate is 1.18 Canadian dollars per U.S. dollar. U.S. inflation is expected to be 3% per year, and Canadian inflation is expected to be 2%. Do you expect the U.S. dollar to appreciate or depreciate relative to the Canadian dollar? Since expected inflation is higher in the U.S., we would expect the U.S. dollar to depreciate relative to the Canadian dollar. What is the expected exchange rate in one year? E(S1) = 1.18[1 + (.02 - .03)]1 = 1.1682 Lecture Tip: 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. 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, the 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. Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 21-15

Covered Interest Arbitrage Examines the relationship between spot rates, forward rates, and nominal rates between countries Again, the formulas will assume that the exchange rates are quoted in terms of foreign currency per U.S. dollar The U.S. risk-free rate is assumed to be the T-bill rate Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 21-16

Example: Covered Interest Arbitrage Consider the following information S0 = 0.8 Euro / $ RUS = 4% F1 = 0.7 Euro / $ RE = 2% What is the arbitrage opportunity? Borrow $100 at 4% Buy $100(0.8 Euro/$) = 80 Euro and invest at 2% for 1 year In 1 year, receive 80(1.02) = 81.6 Euro and convert back to dollars 81.6 Euro / (0.7 Euro / $) = $116.57 and repay loan Loan payoff = $100(1.04) = $104 Profit = $116.57 – $104 = $12.57, risk free Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 21-17

Interest Rate Parity Based on the previous example, there must be a forward rate that would prevent the arbitrage opportunity. Interest rate parity defines what that forward rate should be: Note that equations 21.6 and 21.7 are approximations. Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 21-18

Unbiased Forward Rates The current forward rate is an unbiased estimate of the future spot exchange rate This means that, on average, the forward rate will equal the future spot rate If the forward rate is consistently too high Those who want to exchange yen for dollars would only be willing to transact in the future spot market The forward price would have to come down for trades to occur If the forward rate is consistently too low Those who want to exchange dollars for yen would only be willing to transact in the future spot market The forward price would have to come up for trades to occur Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 21-19

Uncovered Interest Parity What we know so far: PPP: E(S1) = S0[1 + (hFC – hUS)] IRP: F1 = S0[1 + (RFC – RUS)] UFR: F1 = E(S1) Combining the formulas we get: E(S1) = S0[1 + (RFC – RUS)], for one period E(St) = S0[1 + (RFC – RUS)]t Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 21-20

Multi-period Equation Summary Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved.

International Fisher Effect Combining PPP and UIP we can get the International Fisher Effect Real rate ≈ RUS – hUS = RFC – hFC The International Fisher Effect tells us that the real rate of return must be constant across countries If it is not, investors will move their money to the country with the higher real rate of return Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 21-22

Overseas Production: Alternative Approaches Home Currency Approach Estimate cash flows in foreign currency Estimate future exchange rates using UIP or Relative PPP Convert future cash flows to dollars Discount using domestic required return Foreign Currency Approach Use the IFE to convert domestic required return to foreign required return Discount using foreign required return Convert NPV to dollars using current spot rate Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 21-23

Home Currency Approach Your company is looking at a new project in Mexico. The project will cost 9 million pesos. The cash flows are expected to be 2.25 million pesos per year for 5 years. The current spot exchange rate is 10.91 pesos per dollar. The risk-free rate in the US is 4%, and the risk-free rate in Mexico 8%. The dollar required return is 15%. Should the company make the investment? Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 21-24

Foreign Currency Approach Use the same information as the previous example to estimate the NPV using the Foreign Currency Approach Relative inflation difference from the International Fisher Effect is Rfc – Rdc = 8% – 4% = 4% Required Return in foreign market = RRfc = (1 + RRdc) * (1 + Rfc – Rdc) – 1 RRfc = (1.15 * 1.04 – 1) = 19.6% PV of future cash flows = 6,788,537 pesos NPV = 6,788,537 – 9,000,000 = -2,211,463 pesos NPV = -2,211,463 / 10.91 = -202,701 PV annuity: N = 5; PMT = 2,250,000; I/Y = 19.6; CPT PV = 6,788,537 Note that both approaches return the same NPV. Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 21-25

Repatriated Cash Flows Often, some of the cash generated from a foreign project must remain in the foreign country due to restrictions on repatriation Repatriation can occur in several ways Dividends to parent company Management fees for central services Royalties on the use of trade names and patents Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 21-26

Short-Run Exposure Risk from day-to-day fluctuations in exchange rates and the fact that companies have contracts to buy and sell goods in the short-run at fixed prices Managing risk Enter into a forward agreement to guarantee the exchange rate Use foreign currency options to lock in exchange rates if they move against you, but benefit from rates if they move in your favor Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 21-27

Long-Run Exposure Long-run fluctuations come from unanticipated changes in relative economic conditions Could be due to changes in labor markets or governments More difficult to hedge Try to match long-run inflows and outflows in the currency Borrowing in the foreign country may mitigate some of the problems The last approach is often referred to as a “natural hedge.” Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 21-28

Translation Exposure Income from foreign operations must be translated back to U.S. dollars for accounting purposes, even if foreign currency is not actually converted back to dollars If gains and losses from this translation flowed through directly to the income statement, there would be significant volatility in EPS Existing accounting regulations require that all cash flows be converted at the prevailing exchange rates with currency gains and losses accumulated in a special account within shareholders equity Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 21-29

Managing Exchange Rate Risk Large multinational firms may need to manage the exchange rate risk associated with several different currencies The firm needs to consider its net exposure to currency risk instead of just looking at each currency separately Hedging individual currencies could be expensive and may actually increase exposure Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 21-30

Political Risk Changes in value due to political actions in the foreign country Investment in countries that have unstable governments should require higher returns The extent of political risk depends on the nature of the business The more dependent the business is on other operations within the firm, the less valuable it is to others Natural resource development can be very valuable to others, especially if much of the ground work in developing the resource has already been done Local financing can often reduce political risk Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 21-31

Quick Quiz What does an exchange rate tell us? What is triangle arbitrage? What are absolute purchasing power parity and relative purchasing power parity? What are covered interest arbitrage and interest rate parity? What are uncovered interest parity and the International Fisher Effect? What are the two methods for international capital budgeting? What is the difference between short-run interest rate exposure and long-run interest rate exposure? How can you hedge each type? What is political risk, and what types of businesses face the greatest risk? Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 21-32

Ethics Issues You are “stuck” in a customs line entering into a foreign country. A $20 “expediting fee” could be paid to forgo the line and enter immediately. What do you do? Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 21-33

Comprehensive Problem Assume that one U.S. dollar buys 115 Japanese Yen, and one U.S. dollar buys 0.54 Pound Sterling. What must the dollar – pound exchange rate be in order to prevent triangular arbitrage (ignore transaction costs)? $1U.S. = 115 yen $1U.S. = .54 pounds 115 yen = .54 pounds, so 1 yen = .54 / 115 = .004696 pounds, or 1 pound = 212.96 yen Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 21-34

Chapter 21 End of Chapter Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 21-35