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CHAPTER 21 INTERNATIONAL CORPORATE FINANCE

Learning Objectives LO1 The different terminologies used in international finance. LO2 How exchange rates are quoted, what they mean, and the difference between spot and forward exchange rates. LO3 Purchasing power parity, interest rate parity, unbiased forward rates, uncovered interest rate parity, and the generalized Fisher effect and their implications for exchange rate changes. LO4 How to estimate P! using home and foreign currency approach. LO5 The different types of exchange rate ris" and ways firms manage exchange rate ris". LO6 The impact of political ris" on international business investing. Answers t C nce!ts Review an" Critica# T$in%ing &'esti ns 1( )LO2* a. The dollar is selling at a premium because it is more expensive in the forward mar"et than in the spot mar"et #$Fr %.&' versus $Fr %.&(). b. The franc is expected to depreciate relative to the dollar because it will ta"e more francs to buy one dollar in the future than it does today. c. *nflation in $witzerland is higher than in the +anada, as are interest rates. )LO3* The exchange rate will increase, as it will ta"e progressively more euros to purchase a dollar. This is the relative PPP relationship. )LO2+ 3* a. The ,ustralian dollar is expected to wea"en relative to the dollar, because it will ta"e more ,- in the future to buy one dollar than it does today. b. The inflation rate in ,ustralia is higher. c. ominal interest rates in ,ustralia are higher. relative real rates in the two countries are the same. )LO1* , /an"ee bond is most accurately described by d. )LO2* o. For example, if a country0s currency strengthens, imports become cheaper #good), but its exports become more expensive for others to buy #bad). The reverse is true for currency depreciation. )LO5+ 6* ,dditional advantages include being closer to the final consumer and, thereby, saving on transportation, significantly lower wages, and less exposure to exchange rate ris". 1isadvantages include political ris" and costs of supervising distant operations. )LO3* 2ne "ey thing to remember is that dividend payments are made in the home currency. 3ore generally, it may be that the owners of the multinational are primarily domestic and are ultimately concerned about their wealth denominated in their home currency because, unli"e a multinational, they are not internationally diversified. )LO3* a. False. *f prices are rising faster in 4reat 5ritain, it will ta"e more pounds to buy the same amount of goods that one dollar can buy. the pound will depreciate relative to the dollar. b. False. The forward mar"et would already reflect the pro6ected deterioration of the euro relative to the dollar. 2nly if you feel that there might be additional, unanticipated wea"ening of the euro

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that isn0t reflected in forward rates today will the forward hedge protect you against additional declines. True. The mar"et would only be correct on average, while you would be correct all the time.

)LO5* a. +anadian exporters9 their situation in general improves because a sale of the exported goods for a fixed number of 13s will be worth more dollars. +anadian importers9 their situation in general worsens because the purchase of the imported goods for a fixed number of 13s will cost more in dollars. b. +anadian exporters9 they would generally be better off if the 5ritish government0s intentions result in a strengthened pound. +anadian importers9 they would generally be worse off if the pound strengthens. c. +anadian exporters9 would generally be much worse off, because a reduction in the value of the peso will ma"e +anadian more expensive to consumers in ,rgentina. +anadian importers9 would generally be much better off. *n dollar terms, goods from ,rgentina will become much cheaper to buy. d. +anadian exporters9 would generally be much worse off, because an extreme case of fiscal expansion li"e this one will ma"e +anadian goods prohibitively expensive to buy, or else 5razilian sales, if fixed in cruzeiros, would become worth an unacceptably low number of dollars. +anadian importers9 would generally be much better off, because 5razilian goods will become much cheaper to purchase in dollars.

1/( )LO3* *:P is the most li"ely to hold because it presents the easiest and least costly means to exploit any arbitrage opportunities. :elative PPP is least li"ely to hold since it depends on the absence of mar"et imperfections and frictions in order to hold strictly.

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0 #'ti ns t &'esti ns an" Pr b#e1s Basic 1( )LO2* ;sing the quotes from the table, we get9 a. b. c. d. e. f. g. 2( -%((#%<#=(.>>? <-%.(()) @ =>>.? -%.7A7+1 =&3#-%.7A7A+1 ) @ -B,?B?,&(( ,ustralian dollar +hinese :enminbi -%.7A7 is the cross rate 3ost valuable9 ;C pound @ -%.&A7% Deast valuable9 Eapanese yen @ -(.(%'

)LO2* a. /ou would prefer F%((, since9 #F%(()#-%.&A7%<F%) @ -%&A.7% +anadian b. /ou would still prefer F%((9 #$Fr.%(()#-%.(>B><$Fr.%) @ -%(>.B>+, c. $wiss Francs per 5ritish pounds @ $Fr %.?>GB<F%. 5ritish pounds per $wiss Franc @ F(.B>B7<$Fr%

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)LO2* a. FB @ H>B.&> #per -). The yen is selling at a premium because it is more expensive in the forward mar"et than in the spot mar"et #-(.(%'(&AA?&<H versus -(.(%7A>A&G&<H). b. c. F' @ -(.A>%%;$<-%.((+an. The ;$ dollar is selling at a premium because it is more expensive in the forward mar"et than in the spot mar"et #-(.A>%%;$<-+1 versus -(.A>7A<-+1 ). The value of the +anadian dollar will fall relative to the yen, since it ta"es more dollars to buy one yen in the future than it does today. The value of the +anadian dollar will fall relative to the ;$ dollar, because it ta"es more +anadian dollars to buy one ;$ dollar in the future than it does today.

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)LO2* a. The ;.$. dollar, since one +anadian dollar will buy9 #+an-%)<#+an-%.(&<-%;$) @ -(.A&7? ;$ b. The cost in ;.$. dollars is9 #+an-7.&()<#+an-%.(&<-%;$) @ -7.'G ;$ ,mong the reasons that absolute PPP doesn0t hold are tariffs and other barriers to trade, transactions costs, taxes, and different tastes.

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c. d. e. 5(

The ;.$. dollar is selling at a premium in the table, because it is more expensive in the ' month forward mar"et than in the spot mar"et #+an-%.(7G& versus +an-%.(7>A). The +anadian dollar is expected to depreciate in value relative to the dollar, because it ta"es more +anadian dollars to buy one ;.$. dollar in the future than it does today. *nterest rates in the ;nited $tates are probably IJPI+TI1 to be higher than they are in +anada. This fuels additional investment in the ;$ relative to +anada and a strengthening ;$ dollar.

)LO2* a. The cross rate in H<F terms is9 #HG(<-%)#-%.&G<F%) @ H%7B.?(<F% b. The F is quoted too low relative to the H. Ta"e out a loan for -% +1 and buy (.B'7A%%'A7F. ;se the (.B'7(%%'A7F to purchase /ens at the cross8rate, which will give you9 (.B'7A%%'A7#%7AF<H%) @ HG%.B?&&BAB> ;se the /I to buy bac" dollars and repay the loan. The cost to repay the loan will be9 G%.B?&&BA&>#%KHG() @ -%.(7(&BAB7 /ou arbitrage profit is -(.(7(&BAB7 per dollar used. .

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)LO3* Le can rearrange the interest rate parity condition to answer this question. The equation we will use is9 Ft<$( @ #% M :F+) < #% M :+1 ) N#Ft<$() x #% M :+1 )O 8 % @ :F+ ;sing this relationship with t @ B months, we find9 4reat 5ritain9 Eapan9 :F+ @ #F(.B7B? < F(.B7G%) x #% M .(%>) P % @ .(%?7?> or %.?'Q :F+ @ #H>B.&> < H>>.(&) x #% M .(%>) P % @ .(%(BB? or %.(BBQQ

Iuropean ;nion9 :F+ @ #=(.>BA> < =(.>>?) x #% M .(%>) P % @ .(%%'& or %.%'&Q The interest rate parity condition suggests that the ris" free interest rates in 4reat 5ritain, Eapan, and the Iuropean ;nion are positive. $uch a condition could occur if nominal interest rates were above the inflation rates in those countries, which might happen if the central ban"s of those countries were using very high interest rates to stimulate the economy. ,( )LO3* *f we invest in +anada for the next three months, we will have9 -'(,(((,(((#%.((7?)' @ -'(,7%B,&%G.G% *f we invest in 4reat 5ritain, we must exchange the dollars today for pounds, and exchange the pounds for dollars in three months. ,fter ma"ing these transactions, the dollar amount we would have in three months would be9

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#-'(,(((,((()#F(.B'%<-%)#%.((7A)'<#F(.B''<-%) @ -'(,%BB,%?'.GB The company should invest in +anada. -( )LO3* ;sing the relative purchasing power parity equation9 Ft @ $( R N% M #hF+ P hcdn)Ot Le find9 S7.A? @ S7.GBN% M #hF+ P h;$)O' hF+ P h+1 @ #S7.A?<S7.GB)%<' P % hF+ P h+1 @ .((A7'G'AG or (.A7'G'AGQ *nflation in Poland is expected to exceed that in +anada by (.A7'G'AGQ over this period. .( )LO5* The profit will be the quantity sold, times the sales price minus the cost of production. The production cost is in $ingapore dollars, so we must convert this to +anadian dollars. 1oing so, we find that if the exchange rates stay the same, the profit or loss will be9 Profit @ '(,(((N-%A& P T#$-7''.&()<#$-%.7'AA<-%)UO Profit @ 7((,'&(.G' $o this deal is profitable at the current exchange rate. *f the exchange rate rises, we must ad6ust the cost by the increased exchange rate, so9 Profit @ '(,(((N-%A& P T#$-7''.&()<#%.%#$-%.7'AA<-%))UO Profit @ >%',A&&.'( *f the exchange rate falls, we must ad6ust the cost by the decreased exchange rate, so9 Profit @ '(,(((N-%A& P T#$-7''.&()<#(.A#$-%.7'AA<-%))UO Doss @ 8?7>,'G>.AB To calculate the brea"even change in the exchange rate, we need to find the exchange rate that ma"e the cost in $ingapore dollars equal to the selling price in +anadian dollars, so9 -%A& @ $-7''.&(<$T $T @ $-%.%A>?<-% $T @ #%.%A>? P %.7'AA) < %.7'AA @ 8 (.('?7 or '.?7Q decrease 1/( )LO3* a. *f *:P holds, then9 F%G( @ #Cr &.>G)N% M #.(&> P .('G)O%<7 F%G( @ Cr &.G'?B&%B7B $ince given F%G( is Cr&.GB, an arbitrage opportunity exists. the forward premium is too high. 5orrow Cr% today at &.>Q interest. ,gree to a %G(8day forward contract at Cr &.GB. +onvert the loan proceeds into dollars9 Cr % #-%<Cr &.>G) @ -(.%>'(%('G *nvest these dollars at '.GQ, ending up with -(.%>B7A>&>G. +onvert the dollars bac" into "rone as

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-(.%>B7A>&>G #Cr &.GB<-%) @ Cr %.(''%('G% :epay the Cr % loan, ending with a profit of9 Cr%.(''%('G% P Cr%.(7G& @ Cr (.(?B('G% b. To find the forward rate that eliminates arbitrage, we use the interest rate parity condition, so9 F%G( @ #Cr &.>G)N% M #.(&> P .('G)O%<7 F%G( @ Cr &.G'?B&%B7B 11( )LO3* The international Fisher effect states that the real interest rate across countries is equal. Le can rearrange the international Fisher effect as follows to answer this question9 :+1 P h+1 @ :F+ P hF+ hF+ @ :F+ M h+1 P :+1 a. b. c. h,;$ @ .(? M .(7B P .('? h,;$ @ .('7 or '.7Q h;$ @ .(> M .(7B P .('? h;$ @ .(B7 or B.7Q hT,* @ .(A M .(7B P .('? hT,* @ .(G7Q or G.7Q

12( )LO2* a. The yen is expected to get stronger, since it will ta"e less yen to buy one dollar in the future than it does today. b. h+1 P hE,P #H>G.B? P H>A.%7)<H>A.%7 h+1 P hE,P @ 8 (.((B(BB>'? or 8(.B(BB>'?Q #% 8 .((B(BB>'?)? P % @ (.(7? or 87.?Q The approximate inflation differential between +anada and Eapan is 87.?Q annually. 13( )LO2* Le need to find the change in the exchange rate over time so we need to use the interest rate parity relationship9 Ft @ $( R N% M #:F+ P :+1 )Ot ;sing this relationship, we find the exchange rate in one year should be9 F% @ 7(?.'7'N% M #.(?& P .(%A)O% F% @ H;F 7(A.B' The exchange rate in two years should be9 F7 @ 7(?.B7N% M #.(?& P .(%A)O7 F7 @ H;F 7%&.(G ,nd the exchange rate in five years should be9 F& @ 7(?.'7N% M #.(?& P .(%A)O& F& @ H;F 7'7.'(

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Intermediate 14( )LO4* First, we need to forecast the future spot rate for each of the next three years. From interest rate and purchasing power parity, the expected exchange rate is9 I#$T) @ N#% M :+1 ) < #% M :F+)OT $( $o9 I#$%) @ #%.(7'( < %.(%G()% -%.'B<= @ -%.'BB><= I#$7) @ #%.(7'( < %.(%G()7 -%.'B<= @ -%.'>'?<= I#$') @ #%.(7'( < %.(%G()' -%.'B<= @ -%.'G(%<= ow we can use these future spot rates to find the dollar cash flows. The dollar cash flow each year will be9 /ear ( cash flow @ P=%7,(((,(((#-%.'B<=) /ear % cash flow @ =%,G((,(((#-%.'BB><=) /ear 7 cash flow @ =7,B((,(((#-%.'>'?V=) /ear ' cash flow @ #=',&((,((( M G,A((,((()#-%.'G(%<=) ,nd the P! of the pro6ect will be9 P! @ P-%B,'7(,(((.((M -7,?B(,(7'.&G<%.%' M -',&>(,G7(.(G<%.%'7 M -%>,%%',>(A.>(<%.%'' P! @ -&%?,%?>.%A 15( )LO4* a. *mplicitly, it is assumed that interest rates won0t change over the life of the pro6ect, but the exchange rate is pro6ected to decline because the Iuroswiss rate is lower than the Iurodollar rate. b. Le can use relative purchasing power parity to calculate the dollar cash flows at each time. The equation is9 IN$tO @ #$Fr %.(A)N% M #.(? P .(&)Ot IN$tO @ %.(A#.AA)t $o, the cash flows each year in Iurodollar #+anadian dollar) terms will be9 t ( % 7 ' ? & $Fr P7%.(3 M&.A3 M&.A3 M&.A3 M&.A3 M&.A3 IN$tO %.(A(( %.(>A% %.(BG'(A %.(&>B7&A% %.(?>(?AB&% %.('B&>A%&? +1 P-%A,7BB,(&&.(& -&,?B>,&%A.7' -&,&77,>?B.>( -&,&>G,&'7.(% -&,B'?,GG(.G7 -&,BA%,>AG.G% @ P-%B,'7(,(((.(( @ -7,?B(,(7'.&G @ -',&>(,G7(.(G @ -%>,%%',>(A.>(

,nd the P! is9 P! @ P-19,266,055.05 M -5,467,519.23<%.%7 M -5,522,746.70<%.%77 M -5,578,532.01<%.%7' M -5,634,880.82<%.%7? M -5,691,798.81<%.%7& P! @ ->AA,>A&.?? c. :earranging the relative purchasing power parity equation to find the required return in $wiss francs, we get9

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:$Fr @ %.%7N% M #.(? P .(&)O P % :$Fr @ %(.GGQ $o the P! in $wiss francs is9 P! @ P$Fr 7%.(3 M $Fr &.A3#P!*F,%(.GGQ,&) P! @ $Fr G>%,>>>.(' +onverting the P! to dollars at the spot rate, we get the P! in +1 dollars as9 P! @ #$Fr G>%,>>>.(')#-%<$Fr %.(A) P! @ ->AA,>A&.?? 16( )LO5* a. To construct the balance sheet in dollars, we need to convert the account balances to dollars. ,t the current exchange rate, we get9 ,ssets @ solaris 7>,((( < #- < solaris %.&() @ -%G,((( 1ebt @ solaris %%,((( < #- < solaris %.&() @ ->,'''.'' Iquity @ solaris %B,((( < #- < solaris %.&() @ -%(,BBB.B> b. *n one year, if the exchange rate is solaris %.B(<-, the accounts will be9 ,ssets @ solaris 7>,((( < #- < solaris %.B() @ -%B,G>& 1ebt @ solaris %%,((( < #- < solaris %.B() @ -B,G>& Iquity @ solaris %B,((( < #- < solaris %.B() @ -%(,(((.(( c. *f the exchange rate is solaris %.?%<-, the accounts will be9 ,ssets @ solaris 7>,((( < #- < solaris %.?%) @ -%A,%?G.A? 1ebt @ solaris %%,((( < #- < solaris %.?%) @ ->,G(%.?7 Iquity @ solaris %B,((( < #- < solaris %.?%) @ -%%,'?>.&7 Challenge 1,( )LO5* First, we need to construct the end of year balance sheet in solaris. $ince the company has retained earnings, the equity account will increase, which necessarily implies the assets will also increase by the same amount. $o, the balance sheet at the end of the year in solaris will be9 5alance $heet #solaris) Diabilities Iquity ,ssets 7G,7&(.(( Total liabilities W equity

%%,(((.(( %>,7&(.(( 7G,7&(.((

ow we need to convert the balance sheet accounts to dollars, which gives us9 ,ssets @ solaris 7G,7&( < #- < solaris %.&?) @ -%G,'??.%B 1ebt @ solaris %%,((( < #- < solaris %.&?) @ ->,%?7.GB Iquity @ solaris %>,7&( < #- < solaris %.&?) @ -%%,7(%.'( 1-( )LO3+ 4* a. The domestic Fisher effect is9

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% M RCDN @ #% M rCDN)#% M hCDN) % M r+ 1 @ #% M RCDN)<#% M hCDN) This relationship must hold for any country, that is9 % M rFC @ #% M RFC)<#% M hFC) The international Fisher effect states that real rates are equal across countries, so9 % M rCDN @ #% M RCDN)<#% M hCDN) @ #% M RFC)<#% M hFC) @ % M rFC b. The exact form of unbiased interest rate parity is9 INStO @ Ft @ $( N#% M RFC)<#% M RCDN)Ot c. The exact form for relative PPP is9 INStO @ S( N#% M hFC)<#% M hCDN)Ot d. For the home currency approach, we calculate the expected currency spot rate at time t as9 INStO @ #=(.B&)N%.(><%.(&Ot @ #=(.B&)#%.(%A)t Le then convert the euro cash flows using this equation at every time, and find the present value. 1oing so, we find9 P! @ P N=7.&3<#=(.B&)O M T=%.%3<N%.(%A#=(.B&)OU<%.% M T=%.%3<N%.(%A7#=(.B&)OU<%.%7 M T=%.%3<N%.(%A'#=(.B&<-%)OU<%.%' P! @ P-',G?B,%&'.G& M -%,&(A,>(&.7& M -%,'?B,G(&.G> M-%,7(%,?G'.&> P! @ -7%%,G?(.G?& For the foreign currency approach we first find the return in the euros as9 RFC @ %.%(#%.(><%.(&) P % @ (.%7(A& ext, we find the P! in euros as9 P!= @ P =7.&3 M #=%.%3)<%.%7% M #=%.%3)<%.%7%7 M #=%.%3)<%.%7%' @ =%'>,BAB.&& ,nd finally, we convert the euros to dollars at the current exchange rate, which is9 P! #-) @ =%'>,BAB.&& <#=(.B&<-%) @ -7%%,G?(.G&

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