1. 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

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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  = $A4.8563
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

10. Exchange Rate Quotations
$US –
Rate at which dealer BUYS $US or SELLS $A
Rate at which dealer SELLS $US or BUYS $A
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11. 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 × = $US819.
If you now convert $US819 back to $A:
you BUY $A; therefore, the dealer SELLS $A
$US819  = $A
The difference is the dealer fee ($A1 000  = $A3.04).
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

12. 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

13. Cross Rates To prevent triangle arbitrage: Cross rate must be:
the $A can be exchanged for FF10 or DM2.00
Cross rate must be:
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14. Example—Cross Rates
The exchange rates for the British pound and the Japanese yen
are:
$A1 = £0.3538
$A1 = ¥63.74
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15. 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.
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16. 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.
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17. 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.
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18. Relative PPP Equation
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19. 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?
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20. 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.
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21. Example—Covered Interest Arbitrage (CIA)
Assume: S0 = $A1/¥66.42 F1 = $A1/¥64.80
RA = 7% RJ = 5%
$A @ 7% $A $A
Profit
@ ¥ year @ ¥64.80
¥ @ 5% ¥
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

22. 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.
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23. 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.
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24. Uncovered Interest Parity (UIP)
The expected percentage change in the exchange rate is equal to the difference in interest rates.
Combines IRP and UFR.
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25. International Fisher Effect (IFE)
Real interest rates are equal across countries.
Combines PPP and UFR.
Ignores risk and barriers to capital movements.
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26. Example—International Capital Budgeting
Pizza Shack is considering opening a store in Mexico. The store would cost $A 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 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.
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27. Example—Method 1: Home Currency Approach
Using the interest rate parity relationship:
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28. Example—Method 2: Foreign Currency Approach
Using a 3 per cent inflation premium: (1.12 × 1.03) – 1 = 15.36%
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29. 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.
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30. 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.
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31. 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?
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32. 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.
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33. Types of Political Risk
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34. 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