## Ch. 21: International Corporate Finance

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

Exchange Rates

• The price of one country’s currency in terms of another
• Most currency is quoted in terms of dollars
• Cross-rate: implied exchange rate between two currencies, when both currencies are quoted in terms of a third currency
• Example: Triangle Arbitrage
• We observe the following quotes:
• 1 Euro per $\$$1 • 2 Swiss Franc per \$$1 • 0.4 Euro per Swiss Franc • The cross rate is 0.5 Euro per Swiss Franc. • How can we make money? • Buy low, sell high. • Convert$100 to Euros to Francs. Then, convert back to dollars.

Types of Transactions

• Spot trades at spot rate
• Forward trade (contract) at forward rate
• agree today to exchange currency at some future date at specified price
• if forward rate (in $\$$equivalents) exceeds the spot rate, then currency is selling at a premium Purchasing Power Parity (PPP) • Absolute • the price of an item should be the same in real terms, regardless of the currency • requires: • no transaction costs • no barriers to trade (taxes/tariffs) • no difference in good (commodity) • Relative • exchange rates depend on relative inflation between countries • E(S_t) = S_0[1 + h_F - h_H]^t • Example • 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? Covered Interest Rate Parity • Arbitrage example • Consider the following information: S_0 = .8 Euro/\$$,$F_1$= .7 Euro/$\$$, R_{US} = 4%, R_E = 2%. • What is the arbitrage opportunity? • Borrow \$$100 at 4%.
• Earn \$\$$12.57 risk free. • What forward rate prevents this arbitrage opportunity? • Exact: \frac{F_1}{S_0} = \frac{1+R_F}{1+R_H} • Approximate: \frac{F_1}{S_0} = 1+R_F-R_H Unbiased Forward Rates • Forward rates are unbiased estimates of the future spot rate. • Combining PPP, IRP, and URF yields the International Fisher Effect • R_H-h_H = R_F - h_F • 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 International Capital Budgeting • Home Currency Approach • Estimate cash flows in foreign currency • Estimate future exchange rates using UIP • Convert future cash flows to dollars • Discount using domestic required return • Example • 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%. • NPV = -\$$202,701
• Foreign Currency Approach
• Estimate cash flows in foreign currency
• 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
• Example yields the same NPV

Managing Exchange Rate Exposure

• Short-run
• 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
• Long-run Exposure
• Try to match long-run inflows and outflows in the currency
• Borrow in the foreign country to create a natural hedge