Chapter Twenty-two International Corporate Finance Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Chapter Organisation 22.1 Terminology 22.2 Foreign Exchange Markets and Exchange Rates 22.3 Purchasing Power Parity 22.4 Interest Rate Parity, Unbiased Forward Rates and the International Fisher Effect 22.5 International Capital Budgeting 22.6 Exchange Rate Risk 22.7 Political Risk Summary and Conclusions Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Chapter Objectives Be familiar with international finance terminology. Apply exchange rates and cross rates. Understand triangle arbitrage and covered interest arbitrage. Distinguish between purchasing power parity, interest rate parity, unbiased forward rates, uncovered interest parity and the international Fisher effect. Calculate the NPV of a foreign operation in home currency terms. Explain exchange rate risk and political risk. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Domestic versus International Financial Management Whenever transactions involve more than one currency, the levels of, and possible changes in, exchange rates need to be considered. The risk of loss associated with actions taken by foreign governments also needs to be considered. This political risk can be difficult to assess and difficult to hedge against. Financing opportunities encompass international capital markets and instruments, which can reduce the firm’s cost of capital. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

International Finance Terminology Cross rate The implicit exchange rate between two currencies quoted in some third currency. Euro The monetary unit for the European Monetary System (EMS). Eurobonds International bonds issued in multiple countries but denominated in the issuer’s currency. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

International Finance Terminology Eurocurrency Money deposited in a financial centre outside the country whose currency is involved. Foreign bonds International bonds issued in a single country usually denominated in that country’s currency. Foreign exchange market The market in which one country’s currency is traded for another. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

International Finance Terminology Gilts British and Irish government securities. London Interbank Offer Rate (LIBOR) The rate most international banks charge one another for overnight Eurodollar loans. Swaps Agreements to exchange two securities or currencies. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Foreign Exchange Market The world’s largest financial market. Most trading takes place in a few currencies: US dollar ($), euro (€), British pound sterling (£), Japanese yen (¥) and Swiss franc (SF). Participants in the market include: Importers Exporters Portfolio managers Foreign exchange brokers Traders Speculators. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Exchange Rates Q: If you wish to exchange $100 for British pounds at an exchange rate of $A1/£0.337, how many pounds will you receive? A: $A100 × (0.337) = £33.7 Q: You paid 20 French francs for a croissant in France. If the exchange rate is $A1/FF4.1184, how much did it cost in dollars? A: FF20  4.1184 = $A4.8563 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Exchange Rate Quotations $US 0.8215 – 0.8190 Rate at which dealer BUYS $US or SELLS $A Rate at which dealer SELLS $US or BUYS $A Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Example—Exchange Rates If you wish to convert $A1 000 to $US at the above exchange rates: you SELL $A; therefore, the dealer BUYS $A $A1 000 × 0.8190 = $US819. If you now convert $US819 back to $A: you BUY $A; therefore, the dealer SELLS $A $US819  0.8215 = $A996.96. The difference is the dealer fee ($A1 000  996.96 = $A3.04). Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Triangle Arbitrage You have observed the following exchange rates: $A1/FF10 $A1/DM2.00 DM/FF4.00 Step 1 Buy 1000 francs for $100 Step 3 Exchange DM250 for $A125 Step 2 Buy DM250 for FF1000 You have just made $A25! Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Cross Rates To prevent triangle arbitrage: Cross rate must be: the $A can be exchanged for FF10 or DM2.00 Cross rate must be: Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Example—Cross Rates The exchange rates for the British pound and the Japanese yen are: $A1 = £0.3538 $A1 = ¥63.74 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Types of Transactions Spot deal  an agreement to trade currencies based on the exchange rate today for settlement within two business days. Spot exchange rate  the exchange rate on a spot deal. Forward deal  an agreement to exchange currency at some time in the future. Forward exchange rate  the agreed-upon exchange rate to be used in a forward deal. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Purchasing Power Parity The idea that the exchange rate adjusts to keep purchasing power constant among currencies. Absolute purchasing power parity (PPP)—a commodity costs the same regardless of what currency is used to purchase it or where it is selling. For absolute PPP to hold: transaction costs must be zero there must be no barriers to trade the items purchased must be identical in all locations. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Relative Purchasing Power Parity The idea that the change in the exchange rate between two currencies is determined by the difference in inflation rates between the two countries. Relative PPP, therefore, explains the changes in exchange rates over time rather than the absolute levels of exchange rates. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Relative PPP Equation Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Example—Relative PPP The German exchange rate is currently 1.3 DM per dollar. The inflation rate in Germany over the next five years is estimated to be 5 per cent per year, while the Australian inflation rate is estimated to be 3 per cent per year. What will be the estimated exchange rate in five years? Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Solution—Relative PPP The DM will become less valuable; $A will become more valuable. The exchange rate change will be 5% – 3% = 2% per year. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Example—Covered Interest Arbitrage (CIA) Assume: S0 = $A1/¥66.42 F1 = $A1/¥64.80 RA = 7% RJ = 5% $A1 000 000 @ 7% $A1 070 000 $A1 076 250 Profit @ ¥66.42 1 year @ ¥64.80 ¥66 420 000 @ 5% ¥69 741 000 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Interest Rate Parity (IRP) The interest rate differential between two countries is equal to the percentage difference between the forward exchange rate and the spot exchange rate. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Unbiased Forward Rates (UFR) The current forward rate is an unbiased predictor of the future spot exchange rate. On average, the forward exchange rate is equal to the future spot exchange rate. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Uncovered Interest Parity (UIP) The expected percentage change in the exchange rate is equal to the difference in interest rates. Combines IRP and UFR. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

International Fisher Effect (IFE) Real interest rates are equal across countries. Combines PPP and UFR. Ignores risk and barriers to capital movements. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Example—International Capital Budgeting Pizza Shack is considering opening a store in Mexico. The store would cost $A500 000 or 3 million pesos (at an exchange rate of $A1/6.000 pesos). They hope to operate the store for two years and then sell it to a local franchisee. Assume that the expected cash flows are 250 000 pesos in the first year and 5 million pesos in year 2 (including the selling price of the store and fixtures). The Australian risk-free rate is 7 per cent and the Mexican risk-free rate is 10 per cent. The required return in Australia is 12 per cent. Ignore taxes. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Example—Method 1: Home Currency Approach Using the interest rate parity relationship: Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Example—Method 2: Foreign Currency Approach Using a 3 per cent inflation premium: (1.12 × 1.03) – 1 = 15.36% Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Unremitted Cash Flows A foreign subsidiary can remit (or pay out) funds to a parent in many ways, including: dividends management fees for central services royalties on the use of trade name and patents. Earlier example assumed all after-tax cash flows from the foreign investment could be remitted or ‘repatriated’ to the parent firm. Not always the case. Some governments limit the ability of international firms to remit cash flows. Funds that cannot currently be remitted are sometimes said to be blocked. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Exchange Rate Risk The risk related to having international operations in a world where currency values vary. Short-run exposure—uncertainty arising from day-to-day fluctuations in exchange rates. Long-run exposure—potential losses due to long-run, unanticipated changes in the relative economic conditions in two or more countries. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Translation Exposure Uncertainty arising from the need to translate the results from foreign operations (in foreign currency) to home currency for accounting purposes. What is the appropriate exchange rate to use for transferring each balance sheet account? How should balance sheet accounting gains and losses from foreign currency translation be handled? Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

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  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Types of Political Risk Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Summary and Conclusions The international firm has a more complicated life than the purely domestic firm. Management must understand the connection between interest rates, foreign currency exchange rates, inflation, financial market regulations, and tax systems. The fundamental relationships between international variables are: Absolute and relative purchasing power parity (PPP) Interest rate parity (IRP) Unbiased forward rates (UFR). Foreign exchange relationships imply two conditions: Uncovered interest parity International fisher effect. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan