fundamentals of corporate finance/3e,ch23

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright

23-1

Chapter Twenty-three

International Corporate Finance


23-2

23.1 Terminology

23.2 Foreign Exchange Markets and Exchange Rates

23.3 Purchasing Power Parity

23.4 Interest Rate Parity, Unbiased Forward Rates and the International Fisher Effect

23.5 International Capital Budgeting

23.6 Exchange Rate Risk

23.7 Political Risk

23.8 Summary and Conclusions

Chapter Organisation


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.


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.


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.


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.


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.


23-8

Global Capital Markets

Asia/Pacific Region

Australian Stock ExchangeSydney Futures ExchangeNew Zealand Stock Exchange

Hong Kong Stock ExchangeHong Kong Futures Exchange

Shanghai Securities ExchangeShenzen Stock Exchange

Osaka Stock ExchangeTokyo Stock ExchangeTokyo Int’l Financial Futures Exchange

Singapore Stock Exchange

Kuala Lumpur Stock Exchange

Americas

New York Stock ExchangeAmerican Stock ExchangeBoston Stock ExchangeCincinnati Stock ExchangeChicago Stock ExchangePacific Stock ExchangePhiladelphia Stock ExchangeChicago Board of TradeKansas City Board of TradeToronto Stock Exchange

Europe and the UK

Frankfurt Stock ExchangeLondon Stock ExchangeParis BourseSwiss Stock ExchangeNasdaq


23-9

Participants in Foreign Exchange Market

• Importers• Exporters• Portfolio managers• Foreign exchange brokers• Traders• Speculators


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


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


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).


23-13

Triangle Arbitrage

You have observed the following exchange rates:

$A1/FF10 $A1/DM2.00 DM/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!


23-14

Cross Rates

• To prevent triangle arbitrage:– the $A can be exchanged for FF10 or DM2.00

• Cross rate must be:

FF5/DM1 DM2.00

FF10


23-15

Example—Cross Rates

The exchange rates for the British pound and the Japanese yen are:

$A1 = £0.3538

$A1 = ¥63.74

¥180.16/£ £0.3538

¥63.74 or

£0.0056/¥ ¥63.74

£0.3538 rate Cross


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.


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.


23-18

Relative Purchasing PowerParity

• 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.


23-19

Relative PPP Equation

h

h

S

t SE

h h S SE

FC

A

t

tAFCt

rateinflation country foreign

Australiain rateinflation

rate exchangespot 0) (timecurrent

at time rate exchange expected

where

1

0

0


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?


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.

43531

020131 55

.

. . SE


23-22

Example—Covered Interest Arbitrage (CIA)

Assume: S0 = $A1/¥66.42 F1 = $A1/¥64.80

RA = 7% RJ = 5%

$A1 000 000 @ 7% $A1 070 000

$A1 076 250

@ ¥66.42 1 year @ ¥64.80

¥66 420 000 @ 5% ¥69 741 000

Profit


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.

Australiain rate free-risk nominal

countryforeign in rate free-risk nominal

rate exchangespot current

at time settlementfor rate exchange forward

where

1

0

0

R

R

S

t F

R R S F

A

FC

t

tAFCt


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.

tt SE F


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.

tAFCt R R S SE 10


23-26

International Fisher Effect (IFE)

• Real interest rates are equal across countries.

• Combines PPP and UFR.

• Ignores risk and barriers to capital movements.

FCFCAA h R h R


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.


23-28

Example—Method 1: Home Currency Approach

Using the interest rate parity relationship:

312 $162

1.12

497 785

1.12

453 40 000 500 NPV

2


23-29

Example—Method 2: Foreign Currency Approach

Using a 3 per cent inflation premium: (1.12 × 1.03) – 1 = 15.36%

312 $162 6.0000

871 973 NPV

pesos 871 973

1.1536

000 000 5

1.1536

000 250 000 000 3 - NPV

Dollars

2Pesos


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.


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?


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.


23-33

Types of Political Risk

Risk Nature of Loss

Currency devaluation Loss in value of cash flows interms of home currency

Increased taxation Reduction in total cash flowsrepatriated

Funds blockage Reduction or elimination ofcash flows repatriated

Expropriation of assets Loss of firm property and futurecash flows

Terrorism/sabotage Danger to employees and/orloss of future cash flows

fundamentals of corporate finance/3e,ch23

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