2. McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. International Corporate Finance Chapter 31

3. 31-1 Key Concepts and Skills  Understand how exchange rates are quoted and what they mean  Know the difference between spot and forward rates  Understand purchasing power parity and interest rate parity and the implications for changes in exchange rates  Understand the basics of international capital budgeting  Understand the impact of political risk on international business investing

4. 31-2 Chapter Outline 31.1 Terminology 31.2 Foreign Exchange Markets and Exchange Rates 31.3 Purchasing Power Parity 31.4 Interest Rate Parity, Unbiased Forward Rates, and the International Fisher Effect 31.5 International Capital Budgeting 31.6 Exchange Rate Risk 31.7 Political Risk

5. 31-3 31.1 Terminology  American Depository Receipt (ADR): a security issued in the U.S. to represent shares of a foreign stock  Cross rate: the exchange rate between two foreign currencies, e.g., the exchange rate between £ and ¥  Euro (€): the single currency of the European Monetary Union which was adopted by 11 Member States on 1 January 1999. These member states were: Belgium, Germany, Spain, France, Ireland, Italy, Luxemburg, Finland, Austria, Portugal and the Netherlands.

6. 31-4 Terminology  Eurocurrency: money deposited in a financial center outside the home country. Eurodollars are dollar deposits held outside the U.S.; Euroyen are yen denominated deposits held outside Japan.  Gilts: British and Irish government securities  LIBOR: the London Interbank Offer Rate is the rate most international banks charge one another for loans of Eurodollars overnight in the London market

7. 31-5 31.2 Foreign Exchange Markets and Exchange Rates  Without a doubt, the foreign exchange market is the world’s largest financial market.  In this market, one country’s currency is traded for another’s.  Most of the trading takes place in a few currencies: U.S. dollar ($) British pound sterling (£) Japanese yen (¥) Euro (€)

8. 31-6 FOREX Market Participants  The FOREX market is a two-tiered market: Interbank Market (Wholesale)  About 700 banks worldwide stand ready to make a market in Foreign exchange.  Nonbank dealers account for about 20% of the market.  There are FX brokers who match buy and sell orders but do not carry inventory and FX specialists. Client Market (Retail)  Market participants include international banks, their customers, nonbank dealers, FOREX brokers, and central banks.

9. 31-7 Exchange Rates  The price of one country’s currency in terms of another.  Most currency is quoted in terms of dollars.  Consider the following quote: Euro1.3679.7310 The first number (1.3679) is how many U.S. dollars it takes to buy 1 Euro The second number (.7310) is how many Euros it takes to buy $1 The two numbers are reciprocals of each other (1/1.3679 =.7310)

10. 31-8 Example  Suppose you have $10,000. Based on the rates in Figure 31.1, how many Swiss Francs can you buy? Exchange rate = 0.8799 Francs per dollar Buy 10,000(0.8799) = 8,799 Francs  Suppose you are visiting Bombay and you want to buy a souvenir that costs 1,000 Indian Rupees. How much does it cost in U.S. dollars? Exchange rate = 46.650 rupees per dollar Cost = 1,000 / 46.650 = $21.44

11. 31-9 Cross Rates  Suppose that S DM (0) =.50 i.e., $1 = 2 DM in the spot market  and that S ¥ (0) = 100 i.e., $1 = ¥100  What must the DM/¥ cross rate be?

12. 31-10 Triangular Arbitrage $ £ ¥ Credit Lyonnais S £ (0) = 1.50 Credit Agricole S ¥/£ (0) = 85 Barclays S ¥ (0) = 120 Suppose we observe these banks posting these exchange rates. First calculate the implied cross rates to see if an arbitrage exists.

13. 31-11 Triangular Arbitrage $ £ ¥ Credit Lyonnais S £ (0) = 1.50 Credit Agricole S ¥/£ (0) = 85 Barclays S ¥ (0) = 120 The implied S(¥/£) cross rate is S(¥/£) = 80 Credit Agricole has posted a quote of S(¥/£)=85, so there is an arbitrage opportunity. So, how can we make money? £1.50 $1 × ¥120 = £1 ¥80

14. 31-12 Triangular Arbitrage $ £ ¥ Credit Lyonnais S £ (0) = 1.50 Credit Agricole S ¥/£ (0) = 85 Barclays S ¥ (0) =120 As easy as 1 – 2 – 3: 1. Sell our $ for £, 2. Sell our £ for ¥, 3. Sell those ¥ for $.

15. 31-13 Triangular Arbitrage Sell $100,000 for £ at S £ (0) = 1.50 receive £150,000 Sell our £ 150,000 for ¥ at S ¥/£ (0) = 85 receive ¥12,750,000 Sell ¥ 12,750,000 for $ at S ¥ (0) = 120 receive $106,250 profit per round trip = $ 106,250 – $100,000 = $6,250

16. 31-14 Types of Transactions  Spot trade – exchange currency immediately Spot rate – the exchange rate for an immediate trade  Forward trade – agree today to exchange currency at some future date and some specified price (also called a forward contract) Forward rate – the exchange rate specified in the forward contract If the forward rate is higher than the spot rate, the foreign currency is selling at a premium (when quoted as $ equivalents). If the forward rate is lower than the spot rate, the foreign currency is selling at a discount.

17. 31-15 Absolute Purchasing Power Parity  Price of an item is the same regardless of the currency used to purchase it (i.e., “law of one price).  Requirements for absolute PPP to hold: Transaction costs are zero No barriers to trade (no taxes, tariffs, etc.) No difference in the commodity between locations  For most goods, Absolute PPP rarely holds in practice.

18. 31-16 Relative Purchasing Power Parity  Provides information about what causes changes in exchange rates.  The basic result is that exchange rates depend on relative inflation between countries: E(S t ) = S 0 [1 + (h FC – h US )] t  Because absolute PPP does not hold for many goods, we will focus on relative PPP from here on out.

19. 31-17 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 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?  E(S 1 ) = 1.18[1 + (.02 -.03)] 1 = 1.1682

20. 31-18 31.4 Interest Rate Parity  IRP is an arbitrage condition.  If IRP did not hold, then it would be possible for an astute trader to make unlimited amounts of money exploiting the arbitrage opportunity.  Since we do not typically observe persistent arbitrage conditions, we can safely assume that IRP holds.

21. 31-19 Interest Rate Parity Suppose you have $100,000 to invest for one year. You can either 1. Invest in the U.S. at i $. Future value = $100,000×(1 + i $ ) 2. Trade your dollars for yen at the spot rate, invest in Japan at i ¥ and hedge your exchange rate risk by selling the future value of the Japanese investment forward. F S × (1 + i ¥ ) = (1 + i $ ) F S × (1 + i ¥ ) Future value = $100,000 × Since both of these investments have the same risk, they must have the same future value:

22. 31-20 Interest Rate Parity Formally, IRP is sometimes approximated as F S × (1 + i ¥ ) = (1 + i $ ) F S = (1 + i $ ) (1 + i ¥ ) or if you prefer, i $ – i ¥ = F – S S

23. 31-21 IRP and Covered Interest Arbitrage If IRP failed to hold, an arbitrage opportunity would exist. It is easiest to see this in the form of an example. Consider the following set of foreign and domestic interest rates and spot and forward exchange rates. Spot exchange rateS £ (0)=$1.25/£ 360-day forward rate F £ (360)=$1.20/£ U.S. discount ratei$i$ =7.10% British discount rate i £ =11.56%

24. 31-22 IRP and Covered Interest Arbitrage A trader with $1,000 to invest could invest in the U.S., in one year his investment will be worth $1,071 = $1,000  (1+ i $ ) = $1,000  (1.071) Alternatively, this trader could: 1. exchange $1,000 for £800 at the prevailing spot rate, (note that £800 = $1,000÷$1.25/£) 2. invest £800 at i £ = 11.56% for one year to achieve £892.48. 3. Translate £892.48 back into dollars at F £ (360) = $1.20/£, the £892.48 will be exactly $1,071.

25. 31-23 IRP and Covered Interest Arbitrage Can invest in the U.S. In one year his investment will be worth $1,071 = $1,000  (1.071) = $1,000  (1+ i $ ) A trader with $1,000 to invest:

26. 31-24 $1,000 £800 £800= $1,000× £1 $1.25 IRP and Covered Interest Arbitrage Invest £800 at i £ = 11.56% In one year £800 will be worth £892.48 = $1,000  (1+ i £ ) $1,071 =£892.48 × £1 $1.20 Bring it on back to the U.S.A. Domestic FV = $1,071 and British FV = $1,071

27. 31-25 Reasons for Deviations from IRP  Transactions Costs The interest rate available to an arbitrageur for borrowing, i b,may exceed the rate he can lend at, i l. There may be bid-ask spreads to overcome, F b /S a < F/S Thus (F b /S a )(1 + i ¥ l )  (1 + i ¥ b )  0  Capital Controls Governments sometimes restrict import and export of money through taxes or outright bans.

28. 31-26 International Fisher Effect  Combining PPP and UIP we can get the International Fisher Effect: R US – h US = R FC – h FC  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.

29. 31-27 Equilibrium Exchange Rate Relationships h$ – h£h$ – h£ IRP PPP FEFRPPP IFEFP i $ – i ¥ F – S S E(e)E(e)

30. 31-28 31.5 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  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

31. 31-29 Home Currency Approach  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 9.08 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%. Should the company make the investment?

32. 31-30 Foreign Currency Approach  Use the same information as the previous example to estimate the NPV using the Foreign Currency Approach Mexican inflation rate from the International Fisher Effect is 8% - 4% = 4% Required Return = 15% + 4% = 19% PV of future cash flows = 6,879,679 NPV = 6,879,679 – 9,000,000 = -2,120,321 pesos NPV = -2,120,321 / 9.08 = -233,516

33. 31-31 31.6 Exchange Rate Risk  Short-Term Exposure  Long-Term Exposure  Translation Exposure

34. 31-32 Short-Term Exposure  Risk from day-to-day fluctuations in exchange rates and the fact that companies have contracts to buy and sell goods in the short run at fixed prices  Managing risk 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.

35. 31-33 Long-Term Exposure  Long-run fluctuations come from unanticipated changes in relative economic conditions  Could be due to changes in labor markets or governments  More difficult to hedge  Try to match long-run inflows and outflows in the currency  Borrowing in the foreign country may mitigate some of the problems

36. 31-34 Translation Exposure  Income from foreign operations must be translated back to U.S. dollars for accounting purposes, even if foreign currency is not actually converted back to dollars.  If gains and losses from this translation flowed through directly to the income statement, there would be significant volatility in EPS.  Current accounting regulations require that all cash flows be converted at the prevailing exchange rates, with currency gains and losses accumulated in a special account within shareholders equity.

37. 31-35 Managing Exchange Rate Risk  Large multinational firms may need to manage the exchange rate risk associated with several different currencies.  The firm needs to consider its net exposure to currency risk instead of just looking at each currency separately.  Hedging individual currencies could be expensive and may actually increase exposure.

38. 31-36 31.7 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.

39. 31-37 Quick Quiz  What does an exchange rate tell us?  What is triangle arbitrage?  What are absolute purchasing power parity and relative purchasing power parity?  What are covered interest arbitrage and interest rate parity?  What are uncovered interest parity and the International Fisher Effect?  What are the two methods for international capital budgeting?  What is the difference between short-term interest rate exposure and long-term interest rate exposure? How can you hedge each type?  What is political risk and what types of businesses face the greatest risk?