International Corporate Finance

32-0
McGraw-Hill Ryerson
2003 McGrawHill Ryerson Limited
Corporate Finance
Ross - Westerfield - Jaffe
Sixth Edition
32
Chapter Thirty Two
International Corporate
Finance
Prepared by

Gady Jacoby
University of Manitoba

and

Sebouh Aintablian
American University of
Beirut
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McGraw-Hill Ryerson
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 nations
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
worlds largest financial market.
In this market one countrys currency is traded for
anothers.
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 S
DM
(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 DM1 or .02 ) 0 (
50
1
1 $
2
100
1 $
,
$
$
since
/
= =
= = =
=
DM
S
DM DM DM
DM DM
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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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McGraw-Hill Ryerson
$

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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McGraw-Hill Ryerson
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) = 120
receive $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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McGraw-Hill Ryerson
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
Whats 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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McGraw-Hill Ryerson
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 = t
$
- t

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 doesnt 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 dont 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 + i
Can
)
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 valueotherwise
an arbitrage would exist.
(F/S)(1 + i
) = (1 + i
Can
)
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Interest Rate Parity Defined
Formally,
(F/S)(1 + i
) = (1 + i
Can
)
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. Its
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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McGraw-Hill Ryerson
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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McGraw-Hill Ryerson
You are a Canadian importer of British woolens and have just
ordered next years 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 outflow
a) Put yourself in a position that delivers 100M in one yeara
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
millionexactly 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 yearso 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,
i
b
,may exceed the rate he can lend at, i
l
.
There may be bid-ask spreads to overcome, F
b
/S
a
< F/S
Thus
(F
b
/S
a
)(1 + i
l
) (1 + i

b
) s 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
$
t
$
- t

IRP
PPP
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?
H
= 3%
H
$
= 6%
S
(0) = $.55265

600 200 500 300

0 1 year 2 years 3 years
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McGraw-Hill Ryerson

600 200 500 300

CF
0
= (600) S
(0) =(600)($.5526/) = $331.6

$331.6
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600 200 500 300

CF
1
= (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/) ] = $.5687/
so CF
1
= (200)($.5687/) = $113.7
$331.6 $113.70
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600 200 500 300

Similarly,
CF
2
= [(1.06)
2
/(1.03)
2
] S
(0) (500) = $292.6

CF
3
= [(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 $
3 2
= + + + = APV
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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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McGraw-Hill Ryerson
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 firms foreign subsidiaries into two
categories:
Integrated
Self-sustaining
The rules require that all assets and liabilities be translated
from the subsidiarys currency into the parents 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 companys 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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McGraw-Hill Ryerson
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.

International Corporate Finance

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32-0

= 11.56% for one

(360) = $1.20/, the 892.48 will

(360), can exist. It must be the case that

(360) = $1.20/, an astute trader could make

(360) > $1.20/

) for one year to achieve 892.48

(360) > $1.20/ , 892.48 will be more than

(360) < $1.20/

(360) < $1.20/ , $1,071 will be more than

(0) = $1.25/ to receive 89.64 million.

= 11.56% for one

(0) =(600)($.5526/) = $331.6

(1)] can be found by appealing to the interest rate differential:

(0) (500) = $292.6

(0) (300) = $180.7

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