Fundamentals of corproate finance 3e chapter 23

Chapter Twenty-three
International Corporate Finance

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23-1


Chapter Organisation
23.1
23.2
23.3
23.4
23.5
23.6
23.7
23.8

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
Summary and Conclusions

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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.
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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.

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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.

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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.

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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.

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Global Capital Markets
Asia/Pacific Region

Americas

Australian Stock Exchange
Sydney Futures Exchange
New Zealand Stock Exchange

New York Stock Exchange
American Stock Exchange
Boston Stock Exchange
Cincinnati Stock Exchange
Chicago Stock Exchange
Pacific Stock Exchange
Philadelphia Stock Exchange
Chicago Board of Trade
Kansas City Board of Trade
Toronto Stock Exchange

Hong Kong Stock Exchange
Hong Kong Futures Exchange
Shanghai Securities Exchange
Shenzen Stock Exchange
Osaka Stock Exchange
Tokyo Stock Exchange
Tokyo Int’l Financial Futures Exchange
Singapore Stock Exchange
Kuala Lumpur Stock Exchange

Europe and the UK
Frankfurt Stock Exchange
London Stock Exchange
Paris Bourse
Swiss Stock Exchange
Nasdaq

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Participants in Foreign Exchange
Market
• Importers
• Exporters
• Portfolio managers
• Foreign exchange brokers
• Traders
• Speculators

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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

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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

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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).
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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

Step 2

Exchange DM250 for $A125

Buy DM250 for FF1000

You have just made $A25!

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Cross Rates
• To prevent triangle arbitrage:
–

the $A can be exchanged for FF10 or DM2.00

• Cross rate must be:

FF10

= FF5/DM1
DM2.00

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Example—Cross Rates
The exchange rates for the British pound and the Japanese
yen are:
$A1 = £0.3538
$A1 = ¥63.74

£0.3538
Cross rate =
= £0.0056/¥
¥63.74
¥63.74
or =
= ¥180.16/£
£0.3538
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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.
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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.

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Relative Purchasing Power
Parity
• 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.

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Relative PPP Equation
E ( St ) = S 0 × [1 + ( hFC − hA ) ]

t

where
E ( St ) = expected exchange rate at time t
S 0 = current (time 0) spot exchange rate
hA = inflation rate in Australia
hFC = foreign country inflation rate
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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?

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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.

E ( S5 ) = 1.3 × [1 + ( 0.02 ) ]

5

= 1.4353

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Example—Covered Interest Arbitrage
(CIA)
Assume:

$A1 000 000

S0 = $A1/¥66.42

F1 = $A1/¥64.80

RA = 7%

RJ = 5%

@ 7%

$A1 070 000

Profit

$A1 076 250
@ ¥66.42

¥66 420 000

1 year

@ 5%

@ ¥64.80

¥69 741 000

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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.
t

Ft = S 0 × [1 + ( RFC − RA ) ]

where
Ft = forward exchange rate for settlement at time t
S 0 = current spot exchange rate
RFC = nominal risk - free rate in foreign country
RA = nominal risk - free rate in Australia
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Unbiased Forward Rates (UFR)
• The current forward rate is an unbiased predictor of

the future spot exchange rate.

Ft = E [ St ]
• On average, the forward exchange rate is equal to

the future spot exchange rate.

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Uncovered Interest Parity (UIP)

• The expected percentage change in the exchange

rate is equal to the difference in interest rates.

E [ St ] = S 0 × [1 + ( RFC − RA ) ]

t

• Combines IRP and UFR.

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