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