1. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 23-1 Chapter Twenty-three International Corporate Finance

2. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 23-2 23.1Terminology 23.2Foreign Exchange Markets and Exchange Rates 23.3Purchasing Power Parity 23.4Interest Rate Parity, Unbiased Forward Rates and the International Fisher Effect 23.5International Capital Budgeting 23.6Exchange Rate Risk 23.7Political Risk 23.8Summary and Conclusions Chapter Organisation

3. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 23-3 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.

4. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 23-4 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.

5. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 23-5 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.

6. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 23-6 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.

7. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 23-7 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.

8. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 23-8 Global Capital Markets Asia/Pacific Region Australian Stock Exchange Sydney Futures Exchange New Zealand Stock Exchange Hong Kong Stock Exchange Hong Kong Futures Exchange Shanghai Securities Exchange Shenzen Stock Exchange Osaka Stock Exchange Tokyo Stock Exchange Tokyo Int’l Financial Futures Exchange Singapore Stock Exchange Kuala Lumpur Stock Exchange Americas New York Stock Exchange American Stock Exchange Boston Stock Exchange Cincinnati Stock Exchange Chicago Stock Exchange Pacific Stock Exchange Philadelphia Stock Exchange Chicago Board of Trade Kansas City Board of Trade Toronto Stock Exchange Europe and the UK Frankfurt Stock Exchange London Stock Exchange Paris Bourse Swiss Stock Exchange Nasdaq

9. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 23-9 Participants in Foreign Exchange Market Importers Exporters Portfolio managers Foreign exchange brokers Traders Speculators

10. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 23-10 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

11. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 23-11 Exchange Rate Quotations $US 0.5215 – 0.5190 Rate at which dealer BUYS $US or SELLS $A Rate at which dealer SELLS $US or BUYS $A

12. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 23-12 Example—Exchange Rates If you wish to convert $A1000 to $US at the above exchange rates: – you SELL $A; therefore, the dealer BUYS $A – $A1000 × 0.5190 = $US519 If you now convert $US519 back to $A: – you BUY $A; therefore, the dealer SELLS $A – $US519  0.5215 = $A995.21 The difference is the dealer fee ($A1000  995.21 = $A4.79).

13. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 23-13 Triangle Arbitrage You have observed the following exchange rates: $A1/FF10$A1/DM2.00DM/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!

14. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 23-14 Cross Rates To prevent triangle arbitrage: – the $A can be exchanged for FF10 or DM2.00 Cross rate must be:

15. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 23-15 Example—Cross Rates The exchange rates for the British pound and the Japanese yen are: $A1 = £0.3538 $A1 = ¥63.74

16. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 23-16 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.

17. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 23-17 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.

18. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 23-18 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.

19. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 23-19 Relative PPP Equation

20. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 23-20 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?

21. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 23-21 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.

22. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 23-22 Example—Covered Interest Arbitrage (CIA) Assume:S 0 = $A1/¥66.42F 1 = $A1/¥64.80 R A = 7%R J = 5% $A1 000 000@ 7%$A1 070 000 $A1 076 250 @ ¥66.421 year@ ¥64.80 ¥66 420 000@ 5%¥69 741 000 Profit

23. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 23-23 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.

24. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 23-24 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.

25. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 23-25 Uncovered Interest Parity (UIP) The expected percentage change in the exchange rate is equal to the difference in interest rates. Combines IRP and UFR.

26. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 23-26 International Fisher Effect (IFE) Real interest rates are equal across countries. Combines PPP and UFR. Ignores risk and barriers to capital movements.

27. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 23-27 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.

28. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 23-28 Example—Method 1: Home Currency Approach Using the interest rate parity relationship:

29. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 23-29 Example—Method 2: Foreign Currency Approach Using a 3 per cent inflation premium: (1.12 × 1.03) – 1 = 15.36%

30. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 23-30 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.

31. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 23-31 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?

32. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 23-32 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.

33. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 23-33 Types of Political Risk