FINANCIAL MANAGEMENT 3B

BSR3B01/FNM03B3

Unit 7: International Corporate Finance

Chapter 18: International Corporate Finance

Fundamentals of Corporate Finance
 Unit 7:
International Corporate Finance

Chapter 21:

International Corporate Finance

 Chapter 18
International Corporate
Finance

Copyright © 2017 McGraw-Hill Education. All rights reserved.

Chapter Overview

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

Islamic Corporate Finance- Self Study

Terminology
 Terminology

American
Depositary Cross-Rate Eurobond
Receipt (ADR)

Eurocurrency Foreign Bonds Gilts

London Interbank
Offered Rate
(LIBOR)
 International Finance Terminology
• ADR – security issued in the US that represents shares in a
foreign company
• Cross-rate – implied exchange rate between two currencies,
when both currencies are quoted in terms of a third one
• Eurobond – bond sold in more than one country, but
denominated in one currency, usually the issuer’s domestic
currency
• Eurocurrency – money deposited in a bank in a country with
a different currency; Eurodollars are US dollars deposited in
a foreign bank
• Foreign bonds – bonds issued in a single foreign country in
that country’s currency

20-7
 International Finance Terminology
• Gilts – British and Irish government securities
• LIBOR – loan rate on Eurodollars – commonly used as an
index for floating rate securities
• Swaps – interest rate (agreement between two parties to
pay interest to one another on some notional amount, one
party pays a fixed rate, the other pays a floating rate) and
currency (agreement to periodically swap currencies, with
exchange rate based on some prespecified rate)

20-8
Foreign Exchange Markets
and Exchange Rates
Foreign Exchange Markets and Exchange Rates

Exchange Rate
An exchange rate is simply
the price of one country’s
currency expressed in
terms of another
country’s currency.
 TWO TYPES OF QUOTATIONS

• Direct Quotation
• Indirect Quotation

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 DIRECT QUOTATION

• Direct quotation expresses 1 unit of foreign currency that

will buy X amount of local currency.

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 DIRECT QUOTATION EXAMPLE

• One US dollar will buy R14.30 in South African Rand

The direct R/$ exchange rate is expressed as:

• $1 = R14.30

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 INDIRECT QUOTATION

• An indirect quotation is the reciprocal of

a direct quotation
• It expresses the amount of the foreign
currency per R1 of local currency

Financial Management 3B 14
 INDIRECT QUOTATION EXAMPLE

• The indirect R/$ exchange rate is expressed as:

• R1 = $ 0.0699(1 / 14.30)

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15
 Triangular Arbitrage and Cross Rates

Cross-rate – implied exchange rate between two

currencies, when both currencies are quoted in
terms of a third one.

Triangular Arbitrage-Inconsistencies in exchange

rate quotations when applying cross rates.

When cross rates are inconsistent with exchange

rates, an arbitrage opportunity exists.
 Example: Triangle Arbitrage

We observe the following quotes

• 1 Euro per $1
• 2 Swiss Franc per $1
• 0,4 Euro per 1 Swiss Franc
What is the cross rate?
• (1 Euro / $1) / (2 SF / $1) = 0,5 Euro / SF
• It is cheaper to buy Swiss Franc using Euros
We have $100 to invest; buy low, sell high
• Buy $100(1 Euro/$1) = 100 Euro, use Euro to buy SF
• Buy 100 Euro / (0,4 Euro / 1 SF) = 250 SF, use SF to
buy dollars
• Buy 250 SF / (2 SF/$1) = $125
• Make $25 risk-free
 Example: Triangle Arbitrage

The only exchange rate that will prevent triangle

arbitrage is 0,5 Euro / SF
Foreign Exchange Markets and Exchange Rates

Spot Exchange
Spot Trade
Rate
Types of Transaction
Forward
Forward Rate
Transaction
 Example: Triangle Arbitrage

• 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
If the forward rate is lower than the spot rate, the foreign
currency is selling at a discount
Purchasing Power Parity
 Purchasing Power Parity

Purchasing power parity-The idea that

the exchange rate adjusts to keep
purchasing power constant among
currencies.
 Purchasing Power Parity

Absolute Relative
Purchasing Purchasing
Power Parity Power Parity
 Absolute Purchasing Power Parity
• Price of an item is the same 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
• Absolute PPP rarely holds in practice for many
goods
 Absolute Purchasing Power Parity
• Let S0 be the spot exchange rate between the euro
and the dollar today (time 0), and we are quoting
exchange rates as the amount of foreign currency
per euro.
• Let PUS and PEuro be the current U.S. and Euro
prices, respectively, on a particular commodity, say,
apples.
• Absolute PPP simply says that:

PUS = S0 x PEuro
Absolute Purchasing Power Parity

Conditions for
The transaction
Absolute
costs of trading
Purchasing Parity must be zero.
to Hold

The asset in one

There must be no location must be
barriers to trading. identical to the asset
in another location.
Relative Purchasing Power Parity

Relative purchasing power

parity does not tell us what
determines the absolute level
of the exchange rate.
Instead, it tells us what
determines the change in the
exchange rate over time.
 Relative Purchasing Power Parity

S0 = Current (Time 0) spot exchange rate (foreign

currency per home currency).
E(St) = Expected exchange rate in t periods./Spot rate in
the future
hHC = Inflation rate in the home currency.
hFC = Foreign country inflation rate.
Relative PPP says that the expected percentage change
in the exchange rate over the next year, [E(S1) - S0]/S0,
is: [E(S1) - S0]/S0 = hFC - hHC
E(S1) = S0 x [1 + (hFC - hHC)]
 Relative Purchasing Power Parity
The idea that the change in the exchange rate between two countries
is determined by the difference in the inflation rates of the two
countries.
Relative PPP, therefore, explains the changes in exchange rates over
time, rather than the absolute levels of exchange rates.
E[St] = S0 x [1 + (hSA - hFC)]t
where:
E(St ) = the expected exchange rate at some time in the future
S0 = current spot exchange rate (foreign currency per rand)
hSA = inflation rate in South Africa
hFC = foreign country inflation rate
Relative PPP tells us that the value of the rand will fall against South
Africa’s trading partners if our inflation rate is higher than theirs.
 Example: PPP
Suppose the RSA spot exchange rate is 14,10 rands per U.S. dollar.
U.S. inflation is expected to be 2% per year and RSA inflation is
expected to be 6%.
Do you expect the U.S. dollar to appreciate or depreciate relative to
the Rand?
Since inflation is higher in RSA, we would expect the US dollar to
appreciate relative to the US dollar.
What is the expected exchange in one year?
E(S1) = 14,10[1 + (0,06 – 0,02)] 1 = 14.664

R14.664 rands for every dollar

.
Interest Rate Parity,
Unbiased Forward Rates
and the International
Fisher Effect
 Interest Rate Parity, Unbiased Forward Rates
and the International Fisher Effect
Examine the relationship between spot
rates, forward rates and nominal rates
between countries
 Interest Rate Parity, Unbiased Forward Rates
and the International Fisher Effect
Need some additional notation:
• Ft = Forward exchange rate for settlement at time t.
• RHC = Home currency nominal risk-free interest rate.
• RFC = Foreign country nominal risk-free interest rate.

As before, we will use S0 to stand for the spot exchange

rate. You can take the home currency nominal risk-free
rate, RHC, to be the home country T-bill rate.
 Interest Rate Parity, Unbiased Forward Rates
and the International Fisher Effect
We observe the following information about the Australian
dollar and the US dollar:
S0 = 2 AUD / USD
F1=1,8 AUD / USD
RHC /(R US) = 10%
RFC /(R AUS )= 5%

where RFC is the nominal risk-free rate in the United States.

The period is one year, so F1 is the 360-day forward rate.
Do you see an arbitrage opportunity here?
 Interest Rate Parity, Unbiased Forward Rates
and the International Fisher Effect
• Borrow USD100 at 10%
• Buy USD100(2 AUD/USD) = 200 AUD and invest at
5% for 1 year
• In 1 year, receive 200(1,05) = 210 AUD and convert
back to US dollars
• 210 AUD / (1,8 AUD / USD) = USD116,67 and repay
loan
• Profit = 116,67 – 100(1,1) = USD6,67 risk free
Covered Interest arbitrage exists
 Interest Rate Parity, Unbiased Forward Rates
and the International Fisher Effect
Investing in a riskless home currency investment gives us
1 + RHC for every unit of home currency we invest.
Investing in a foreign risk-free investment, gives us S0 x (1
+ RFC)/F1 for every unit of home currency we invest.
Because these have to be equal to prevent arbitrage
(Seen in the previous slide), it must be the case that:
1 + RHC = S0 x (1 + RFC)/F1
F1/S0 = (1 + RFC)/(1 + RHC)
(F1 - S0)/S0 = RFC - RHC
F1 = S0 x [1 + (RFC - RHC)]
 Interest Rate Parity, Unbiased Forward Rates
and the International Fisher Effect

• In general, if we have t periods instead of just one,

the IRP approximation is written like this:

Ft = S0 x [1 + (RFC - RHC)]t
 Interest Rate Parity, Unbiased Forward Rates
and the International Fisher Effect

• Suppose the exchange rate for South African rand

is currently R13.0745=1USD. If the interest rate in
USA is 2.12% and Interest rate in South Africa is
10.95%, Then what must the 1 year forward rate
be to prevent the covered interest arbitrage?
 Interest Rate Parity, Unbiased Forward Rates
and the International Fisher Effect

Ft = S0 x [1 + (RHC - RFC)]t
S0 = 13.0745
RHC = 10.95%
RFC = 2.12%
t=1
Ft = 14.229
Forward should be R14.229 for every USD
 Interest Rate Parity, Unbiased Forward Rates
and the International Fisher Effect
• The unbiased forward rates (UFR) condition says
that the forward rate, F1, is equal to the expected
future spot rate, E(S1):
F1 = E(S1)
• With t periods, UFR would be written as:
Ft = E(St)
• Loosely, the UFR condition says that, on average,
the forward exchange rate is equal to the future
spot exchange rate.
 Interest Rate Parity, Unbiased Forward Rates
and the International Fisher Effect
Putting it All Together:
PPP E(S1) = S0 x [1 + (hFC - hHC)]
IRP F1 = S0 x [1 + (RFC - RHC)]
UFR F1 = E(S1)

UIP E(S1) = S0 x[1 + (RFC - RHC)]

This important relationship is called Uncovered
Interest Parity (UIP). With t periods, UIP becomes:
E(St) = S0 x [1 + (RFC - RHC)]t
 Interest Rate Parity, Unbiased Forward Rates
and the International Fisher Effect
International Fisher Effect
• Combining PPP and UIP we can get the
International Fisher Effect
• RUS – hUS = RFC – hFC
• 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
International Capital Budgeting

Two Approaches
Home Foreign
Currency Currency
Approach Approach
 International Capital Budgeting
• Home Currency Approach
– Estimate cash flows in foreign currency
– Estimate future exchange rates using UIP
– Convert future cash flows to rand
– 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 rand using current spot rate
 International Capital Budgeting
Home Currency Approach
A US 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?
 International Capital Budgeting
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
 Unremitted Cash flow
• Often some of the cash generated from a foreign project
must remain in the foreign country due to restrictions on
repatriation
• Repatriation can occur in several ways
– Dividends to parent company
– Management fees for central services
– Royalties on the use of trade names and patents
Exchange Rate Risk
 Exchange Rate Risk

Three Types

Short-Run Long-Run Translation

Exposure Exposure Exposure
 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 favour
 Long-Run Exposure
• Long-run fluctuations come from un-anticipated
changes in relative economic conditions
• Could be due to changes in labour 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
 Translation Exposure
• Income from foreign operations has to be translated back
to rand for accounting purposes, even if foreign currency
is not actually converted back to rand
• 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
Political Risk
Political Risk

Political Risk
Changes in value that
arise as a consequence
of political actions.
Concept Quiz
Do you understand the concepts?
 Concept Quiz
How much do you understand?
What is the difference between a Eurobond
Quiz and a Foreign Bond?

What does absolute PPP say? Why might it not

hold for many types of goods? According to
relative PPP, what determines the change in
exchange rates?

What are the different types of exchange rate

risk?