Chapter 21 International Corporate Finance McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved. 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 21-2 Chapter Outline • Terminology • Foreign Exchange Markets and Exchange Rates • Purchasing Power Parity • Interest Rate Parity, Unbiased Forward Rates, and the International Fisher Effect • International Capital Budgeting • Exchange Rate Risk • Political Risk 21-3 Domestic Financial Management and International Financial Management • 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 21-4 International Finance Terminology • American Depositary Receipt (ADR) • Cross-rate • Eurobond • Eurocurrency (Eurodollars) • Foreign bonds • Gilts • London Interbank Offer Rate (LIBOR) • Swaps 21-5 Global Capital Markets • The number of exchanges in foreign countries continues to increase, as does the liquidity on those exchanges • Exchanges that allow for the flow of capital are extremely important to developing countries • The United States has one of the most developed capital markets in the world, but foreign markets are becoming more competitive and are often willing to try more innovative ways to do business 21-6 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: – Euro 1.2695 .7877 – The first number (1.2695) is how many U.S. dollars it takes to buy 1 Euro – The second number (.7877) is how many Euros it takes to buy $1 – The two numbers are reciprocals of each other (1/ 1.2695 = . 7877) 21-7 Example: Exchange Rates • Suppose you have $10,000. Based on the rates in Figure 21.1, how many Japanese Yen can you buy? – Exchange rate = 108.21 Yen per dollar – Buy 10,000(108.21) = 1,082,100 Yen • Suppose you are visiting Mumbai and you want to buy a souvenir that costs 1,000 Indian Rupees. How much does it cost in U.S. dollars? – Exchange rate = 42.882 rupees per dollar – Cost = 1,000 / 42.882 = $23.32 21-8 Work the Web Example • Thinking about going to Mexico for spring break or Japan for your summer vacation? • How many pesos or yen can you get in exchange for $1,000? • Click on the web surfer to find out 21-9 Example: Triangle Arbitrage • We observe the following quotes – 1 Euro per $1 – 2 Swiss Franc per $1 – .4 Euro per 1 Swiss Franc • What is the cross rate? – (1 Euro / $1) / (2 SF / $1) = .5 Euro / SF • We have $100 to invest: buy low, sell high – Buy $100(1 Euro/$1) = 100 Euro; use Euro to buy SF – Buy 100 Euro / (.4 Euro / 1 SF) = 250 SF; use SF to buy dollars – Buy 250 SF / (2 SF/$1) = $125 – Make $25 risk-free 21-10 [...]... trades to occur 21- 18 Uncovered Interest Parity • What we know so far: – PPP: E(S1) = S0[1 + (hFC – hUS)] – IRP: F1 = S0[1 + (RFC – RUS)] – UFR: F1 = E(S1) • Combining the formulas we get: – E(S1) = S0[1 + (RFC – RUS)] for one period – E(St) = S0[1 + (RFC – RUS)]t 21- 19 International Fisher Effect • Combining PPP and UIP we can get the International Fisher Effect • RUS – hUS = RFC – hFC • The International. .. estimate the NPV using the Foreign Currency Approach – Relative inflation difference from the International Fisher Effect is 8% - 4% = 4% – Required Return = (1.15*1.04 – 1) = 19.6% – PV of future cash flows = 6,788,537 pesos – NPV = 6,788,537 – 9,000,000 = -2 ,211 ,463 pesos – NPV = -2 ,211 ,463 / 10.91 = -202,701 21- 23 Repatriated Cash Flows • Often, some of the cash generated from a foreign project must... rate 21- 21 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 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% – Should the company make the investment? 21- 22... can often reduce political risk 21- 29 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?... U.S dollar buys 115 Japanese Yen, and one U.S dollar buys 54 Pound Sterling – What must the dollar – pound exchange rate be in order to prevent triangular arbitrage (ignore transaction costs)? 21- 32 End of Chapter 21- 33 ... $116.57 and repay loan – Profit = 116.57 – 100(1.04) = $12.57 risk free 21- 16 Interest Rate Parity • Based on the previous example, there must be a forward rate that would prevent the arbitrage opportunity • Interest rate parity defines what that forward rate should be F1 (1 + RFC ) Exact : = S0 (1 + RUS ) F1 Approx : = 1 + ( RFC − RUS ) S0 21- 17 Unbiased Forward Rates • The current forward rate is an unbiased... patents 21- 24 Short-Run 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 21- 25... within shareholders equity 21- 27 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 21- 28 Political Risk • Changes... selling at a discount 21- 11 Absolute Purchasing Power Parity • Price of an item should be the same in real terms, regardless of the currency used to purchase it • 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 21- 12 Relative Purchasing... exposure? How can you hedge each type? What is political risk, and what types of businesses face the greatest risk? 21- 30 Ethics Issues • You are “stuck” in a customs line entering into a foreign country A $20 “expediting fee” could be paid to forgo the line and enter immediately What do you do? 21- 31 Comprehensive Problem • Assume that one U.S dollar buys 115 Japanese Yen, and one U.S dollar buys 54 Pound . Chapter 21 International Corporate Finance McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc exchange rates • Understand the basics of international capital budgeting • Understand the impact of political risk on international business investing 21- 2 Chapter Outline • Terminology • Foreign. Forward Rates, and the International Fisher Effect • International Capital Budgeting • Exchange Rate Risk • Political Risk 21- 3 Domestic Financial Management and International Financial Management • Considerations