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McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

Corporate Finance Ross Westerfield Jaffe Sixth Edition

32Chapter Thirty Two

International Corporate Finance

Prepared by

Gady JacobyUniversity of Manitoba

and

Sebouh AintablianAmerican University of Beirut

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Chapter Outline

32.1 Terminology

32.2 Foreign Exchange Markets and Exchange Rates

32.3 The Law of One Price and Purchasing Power Parity

32.4 Interest Rates and Exchange Rates: Interest Rate Parity

32.5 International Capital Budgeting

32.6 International Financial Decisions

32.7 Reporting Foreign Operations

32.8 Summary and Conclusions

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32.1 Terminology

• Cross rate: the exchange rate between two foreign currencies, e.g., the exchange rate between £ and ¥.

• Euro: is a basket of 10 European currencies and serves as the monetary unit for the European Monetary System. Effective January 2002, the euro replaced the 10 currencies.

• Eurobonds: bonds denominated in a particular currency and issued simultaneously in the bond markets of several countries.

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32.1 Terminology

• Eurocurrency: money deposited in a financial centre outside the home country. Eurodollars are dollar deposits held outside the U.S.; Euroyen are yen denominated deposits held outside Japan.

• Foreign bonds: bonds issued in another nation’s capital market by a foreign borrower.

• Gilts: British and Irish government securities.• LIBOR: the London Interbank Offer Rate is the rate

most international banks charge on another for loans of Eurodollars overnight in the London market.

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32.1 Terminology

• SWAPs:– Interest rate swaps: when two parties exchange

debt with a floating-rate payment for debt with a fixed-rate payment.

– Currency swaps: agreements to deliver one currency against another currency.

• Export Development Corporation (EDC): a federal Crown corporation with a mandate to promote Canadian exports.

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32.2 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:

– The U.S. dollar

– The euro

– The British pound sterling

– The Japanese Yen

– The Swiss franc

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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.

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Correspondent Banking Relationships

• Large commercial banks maintain demand deposit accounts with one another that facilitates the efficient functioning of the forex market.

• International commercial banks communicate with one another with:– SWIFT: The Society for Worldwide Interbank Financial

Telecommunications.

– CHIPS: Clearing House Interbank Payments System

– ECHO Exchange Clearing House Limited, the first global clearinghouse for settling interbank FOREX transactions.

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Spot Rate Quotations

• The spot market is the market for immediate delivery. (Settlement is due within two days.)

• Direct quotation– the U.S. dollar equivalent

– e.g., “a Japanese Yen is worth about a penny”

• Indirect Quotation– the price of a U.S. dollar in the foreign currency

– e.g., “you get 100 yen to the dollar”

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Spot FX trading

• In the interbank market, the standard size trade is about U.S. $10 million.

• A bank trading room is a noisy, active place.• The stakes are high.• The “long term” is about 10 minutes.

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Cross Rates

• Suppose that SDM(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?

¥50 DM1or .02 )0(¥50

1

1$

2

¥100

1$

¥

,$¥

$

¥ since

¥/

DMS

DMDMDM

DMDM

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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.

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$

£¥

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.

80¥

1£

120¥

1$

1$

50.1£

So, how can we make money?

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$

£¥

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 $.

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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) = 120receive $106,250

profit per round trip = $ 106,250- $100,000 = $6,250

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The Forward Market

• A forward contract is an agreement to buy or sell an asset in the future at prices agreed upon today.

• If you have ever had to order an out-of-stock textbook, then you have entered into a forward contract.

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Forward Rate Quotations

• The forward market for FOREX involves agreements to buy and sell foreign currencies in the future at prices agreed upon today.

• Bank quotes for 1, 3, 6, 9, and 12 month maturities are readily available for forward contracts.

• Longer-term swaps are available.

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Forward Rate Quotations

• Suppose you observe that for Japanese yen, the spot rate is

¥115.75 = $1.00

While the 180-day forward rate is

¥ 112.80 = $1.00• What’s up with that?

The FOREX market clearly thinks that the yen is going to be worth more in six months (the yen is expected to appreciate) because one dollar will buy fewer yen.

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Long and Short Forward Positions

• If you have agreed to sell anything (spot or forward), you are “short”.

• If you have agreed to buy anything (forward or spot), you are “long”.

• If you have agreed to sell FOREX forward, you are short.

• If you have agreed to buy FOREX forward, you are long.

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32.3 The Law of One Price and Purchasing Power Parity• The exchange rate between two currencies should

equal the ratio of the countries’ price levels.

S£(0) = P$ P£

• Relative PPP states that the rate of change in an exchange rate is equal to the differences in the rates of inflation.

e = $ - £

• If Canadian inflation is 5% and U.K. inflation is 8%, the pound should depreciate by 3%.

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Evidence on PPP

• PPP probably doesn’t hold precisely in the real world for a variety of reasons.– Haircuts cost 10 times as much in the developed world as

in the developing world.

– Film, on the other hand, is a highly standardized commodity that is actively traded across borders.

– Shipping costs, as well as tariffs and quotas, can lead to deviations from PPP.

• PPP-determined exchange rates still provide a valuable benchmark.

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32.4 Interest Rates and Exchange Rates: 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 don’t typically observe persistent arbitrage conditions, we can safely assume that IRP holds.

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Interest Rate Parity Defined

Suppose you have $100,000 to invest for one year.You can either

1. Invest in Canada at i$.

Future value = $100,000(1 + iCan)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.

Future value = $100,000(F/S)(1 + i¥)

Since both of these investments have the same risk, they must have the same future value—otherwise an arbitrage would exist.

(F/S)(1 + i¥) = (1 + iCan)

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Interest Rate Parity Defined

Formally,

(F/S)(1 + i¥) = (1 + iCan)

or if you prefer,

S

F

i

i

¥

$

1

1

IRP is sometimes approximated as

S

(F- S) ) -i(i ¥ $

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IRP and Covered Interest Arbitrage

If IRP failed to hold, an arbitrage would exist. It’s 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 rate S£(0) = $1.25/£

360-day forward rate F£(360) = $1.20/£

Canadian discount rate

i$ = 7.10%

British discount rate i£ = 11.56%

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IRP and Covered Interest Arbitrage

A trader with $1,000 to invest could invest in Canada, in one year his investment will be worth $1,071 = $1,000(1+ i$) = $1,000(1.071)

Alternatively, this trader could exchange $1,000 for £800 at the prevailing spot rate, (note that £800 = $1,000÷$1.25/£) invest £800 at i£ = 11.56% for one year to achieve £892.48. Translate £892.48 back into dollars at F£(360) = $1.20/£, the £892.48 will be exactly $1,071.

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According to IRP only one 360-day forward rate, F£(360), can exist. It must be the case that

F£(360) = $1.20/£

Why?

If F£(360) $1.20/£, an astute trader could make money with one of the following strategies:

IRP & Exchange Rate Determination

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Arbitrage Strategy I

If F£(360) > $1.20/£

i. Borrow $1,000 at t = 0 at i$ = 7.1%.

ii. Exchange $1,000 for £800 at the prevailing spot rate, (note that £800 = $1,000÷$1.25/£) invest £800 at 11.56% (i£) for one year to achieve £892.48

iii. Translate £892.48 back into dollars, if F£(360) > $1.20/£ , £892.48 will be more than enough to repay your dollar obligation of $1,071.

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Arbitrage Strategy II

If F£(360) < $1.20/£

i. Borrow £800 at t = 0 at i£= 11.56% .

ii. Exchange £800 for $1,000 at the prevailing spot rate, invest $1,000 at 7.1% for one year to achieve $1,071.

iii. Translate $1,071 back into pounds, if F£(360) < $1.20/£ , $1,071 will be more than enough to repay your £ obligation of £892.48.

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You are a Canadian importer of British woolens and have just ordered next year’s inventory. Payment of £100M is due in one year.

IRP and Hedging Currency Risk

IRP implies that there are two ways that you fix the cash outflowa) Put yourself in a position that delivers £100M in one year—a

long forward contract on the pound. You will pay (£100M)(1.2/£) = $120M

b) Form a forward market hedge as shown below.

Spot exchange rate S£(0) = $1.25/£

360-day forward rate F£(360) = $1.20/£

Canadian discount rate

i$ = 7.10%

British discount rate i£ = 11.56%

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IRP and a Forward Market Hedge

To form a forward market hedge:Borrow $112.05 million in Canada (in one year you

will owe $120 million).Translate $112.05 million into pounds at the spot rate

S£(0) = $1.25/£ to receive £89.64 million.Invest £89.64 million in the UK at i£ = 11.56% for one

year.In one year your investment will have grown to £100

million—exactly enough to pay your supplier.

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Forward Market Hedge Where do the numbers come from? We owe our

supplier £100 million in one year—so we know that we need to have an investment with a future value of £100 million. Since i£ = 11.56% we need to invest £89.64 million at the start of the year.

How many dollars will it take to acquire £89.64 million at the start of the year if S£(0) = $1.25/£?

1.1156

£100 £89.64

£1.25

$1.00£89.64$112.05

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Reasons for Deviations from IRP

• Transactions Costs– The interest rate available to an arbitrageur for borrowing,

ib,may exceed the rate he can lend at, il.

– There may be bid-ask spreads to overcome, Fb/Sa < F/S

– Thus

(Fb/Sa)(1 + i¥l) (1 + i¥

b) 0

• Capital Controls– Governments sometimes restrict import and export of

money through taxes or outright bans.

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More Advanced Short-Term Hedges

• Currency swaps,currency options, and other financially engineered products are taking considerable business away from the forward exchange market.

• In 1986, the federal government of Canada made an 80 billion-yen bond issue and swapped part of it into U.S. dollars.The interest rate was six-month LIBOR and the ending liability was in U.S. dollars.

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Equilibrium Exchange Rate Relationships

S

(F - S)

E(e)

)-i(i ¥$

$ - £

IRPPPP

FE FRPPP

IFE FP

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A recipe for international decision-makers:

1. Estimate future cash flows in foreign currency.

2. Convert to Canadian dollars at the predicted exchange rate.

3. Calculate NPV using the Canadian cost of capital.

32.5 International Capital Budgeting

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Consider this European investment opportunity:

International Capital Budgeting: Example

%15$ i Is this a good investment from the perspective of the Canadian shareholders?

£ = 3%

$ = 6%

S£(0) = $.55265

– 600£ 200£ 500£ 300£

0 1 year 2 years 3 years

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– 600£ 200£ 500£ 300£


CF0 = (£600)× S£(0) =(£600)×($.5526/£) = $331.6

$331.6

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– 600£ 200£ 500£ 300£


CF1 = (£200)×E[S£(1)]

E[S£(1)] can be found by appealing to the interest rate differential:

E[S£(1)] = [(1.06/1.03) S£(0)] = [(1.06/1.03)($.5526/£) ] = $.5687/£

so CF1 = (£200)×($.5687/£) = $113.7

$331.6 $113.70

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– 600£ 200£ 500£ 300£


Similarly,

CF2 = [(1.06)2/(1.03)2 ]× S£(0) (£500) = $292.6

CF3 = [(1.06)3/(1.03)3 ]× S£(0) (£300) = $180.7

$331.6 $113.70 $292.60 $180.70

30.107$)15.1(

70.180$

)15.1(

60.292$

)15.1(

70.113$60.336$

32APV

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Risk Adjustment in the Capital Budgeting Process• Clearly risk and return are correlated.• Political risk may exist alongside of business risk,

necessitating an adjustment in the discount rate.• Firms may determine that international investments

inherently involve more political risk than domestic investments.

• This extra risk may offset the gains from international diversification.

• Firms may increase the discount rate to allow for the risk of expropriation and F/X remittance controls.

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• An international firm can finance foreign projects in three basic ways:

1. It can raise cash in the home country and export it to finance the foreign project.

2. It can raise cash by borrowing in the foreign country where the project is located.

3. It can borrow in a third country where the cost of debt is lowest.

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• If a Canadian firm raises cash for its foreign projects by borrowing in Canada, it faces F/X risk.

• If the foreign currency depreciates, the Canadian parent firm will experience an exchange rate loss when the foreign cash flow is remitted to Canada.

• The Canadian firm may sell foreign exchange forward to hedge this risk.

• However, for many currencies, it is difficult to sell forward contracts beyond one year.

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Short-Term and Medium-Term Financing

• Canadian international firms have a choice between borrowing from a chartered bank at the Canadian rate or borrowing Euro-Canadian from a bank outside Canada through the Eurocurrency market.

• In the Eurocurrency market, loans are made on a floating-rate basis.

• Interest rates are set at a fixed margin above the LIBOR for the given period and currency involved.

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32.7 Reporting Foreign Operations

• When a Canadian multinational experiences favourable exchange rate movements, should this be reflected in the measurement of income?

• This is a controversial area. Two issues seem to arise:

1. What is the appropriate exchange rate to use for translating each balance-sheet account?

2. How should the unrealized accounting gains and losses from foreign-currency translation be handled?

• Currency is currently translated under complicated rules set out by the Canadian Institute of Chartered Accountants (CICA) 1650.

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CICA 1650

• The rules divide a firm’s foreign subsidiaries into two categories:

– Integrated

– Self-sustaining

• The rules require that all assets and liabilities be translated from the subsidiary’s currency into the parent’s currency using the exchange rate that currently prevails.

• Since Canadian accountants consolidate the financial statements of subsidiaries owned over 50% by the parent firm, translation gains and losses are reflected on the income statement of the parent company.

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CICA 1650

• For a self-sustaining subsidiary, any translation gains and losses that occur are accumulated in a special account within the shareholders’ equity section of the parent company’s balance sheet.

• This account might be labelled something like “unrealized foreign exchange gains” (losses).

• These gains/losses are not reported on the income statement.

• The impact of translation gains/losses will not be recognized explicitly in net income until the underlying assets and liabilities are sold or otherwise liquidated.

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32.8 Summary and Conclusions

• This chapter describes some fundamental theories of international finance:

– Purchasing Power Parity

– Expectations theory of exchange rates

– The interest-rate parity theorem

• This chapter also describes some of the problems of international capital budgeting.

• We briefly describe international financial markets.

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