Fundamentals of corproate finance 3e chapter 23

Chapter Twenty-three International Corporate Finance Copyright  2004 McGraw-Hill Australia Pty Ltd 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 Copyright  2004 McGraw-Hill Australia Pty Ltd 23-2 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 Copyright  2004 McGraw-Hill Australia Pty Ltd 23-3 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 Copyright  2004 McGraw-Hill Australia Pty Ltd 23-4 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 Copyright  2004 McGraw-Hill Australia Pty Ltd 23-5 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 Copyright  2004 McGraw-Hill Australia Pty Ltd 23-6 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 Copyright  2004 McGraw-Hill Australia Pty Ltd 23-7 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 Copyright  2004 McGraw-Hill Australia Pty Ltd 23-8 Participants in Foreign Exchange Market • Importers • Exporters • Portfolio managers • Foreign exchange brokers • Traders • Speculators Copyright  2004 McGraw-Hill Australia Pty Ltd 23-9 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 Copyright  2004 McGraw-Hill Australia Pty Ltd 2310 Relative PPP Equation E ( St ) = S × [1 + ( hFC − hA ) ] t where E ( St ) = expected exchange rate at time t S = current (time 0) spot exchange rate hA = inflation rate in Australia hFC = foreign country inflation rate Copyright  2004 McGraw-Hill Australia Pty Ltd 2319 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 per cent per year, while the Australian inflation rate is estimated to be per cent per year What will be the estimated exchange rate in five years? Copyright  2004 McGraw-Hill Australia Pty Ltd 2320 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 ) ] = 1.4353 Copyright  2004 McGraw-Hill Australia Pty Ltd 2321 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 year @ 5% @ ¥64.80 ¥69 741 000 Copyright  2004 McGraw-Hill Australia Pty Ltd 2322 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 × [1 + ( RFC − RA ) ] where Ft = forward exchange rate for settlement at time t S = current spot exchange rate RFC = nominal risk - free rate in foreign country RA = nominal risk - free rate in Australia Copyright  2004 McGraw-Hill Australia Pty Ltd 2323 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 Copyright  2004 McGraw-Hill Australia Pty Ltd 2324 Uncovered Interest Parity (UIP) • The expected percentage change in the exchange rate is equal to the difference in interest rates E [ St ] = S × [1 + ( RFC − RA ) ] t • Combines IRP and UFR Copyright  2004 McGraw-Hill Australia Pty Ltd 2325 International Fisher Effect (IFE) • Real interest rates are equal across countries RA − hA = RFC − hFC • Combines PPP and UFR • Ignores risk and barriers to capital movements Copyright  2004 McGraw-Hill Australia Pty Ltd 2326 Example—International Capital Budgeting Pizza Shack is considering opening a store in Mexico The store would cost $A500 000 or million pesos (at an exchange rate of $A1/6.000 pesos) They hope to operate the store for two years and then sell it to a local franchisee Assume that the expected cash flows are 250 000 pesos in the first year and million pesos in year (including the selling price of the store and fixtures) The Australian risk-free rate is per cent and the Mexican risk-free rate is 10 per cent The required return in Australia is 12 per cent Ignore taxes Copyright  2004 McGraw-Hill Australia Pty Ltd 2327 Example—Method 1: Home Currency Approach Using the interest rate parity relationship: 40 453 785 497 NPV = − 500 000 + + 1.12 (1.12) = $162 312 Copyright  2004 McGraw-Hill Australia Pty Ltd 2328 Example—Method 2: Foreign Currency Approach Using a per cent inflation premium: (1.12 × 1.03) – = 15.36% NPVPesos = - 000 000 + 250 000 000 000 + 1.1536 (1.1536 ) = 973 871 pesos 973 871 6.0000 = $162 312 NPVDollars = Copyright  2004 McGraw-Hill Australia Pty Ltd 2329 Exchange Rate Risk • The risk related to having international operations in a world where currency values vary • Short-run exposure—uncertainty arising from day- to-day fluctuations in exchange rates • Long-run exposure—potential losses due to long- run, unanticipated changes in the relative economic conditions in two or more countries Copyright  2004 McGraw-Hill Australia Pty Ltd 2330 Translation Exposure • Uncertainty arising from the need to translate the results from foreign operations (in foreign currency) to home currency for accounting purposes • What is the appropriate exchange rate to use for transferring each balance sheet account? • How should balance sheet accounting gains and losses from handled? foreign currency Copyright  2004 McGraw-Hill Australia Pty Ltd translation be 2331 Political Risk • Changes in value due to political actions in the foreign country • Investment in countries that have unstable governments should require higher returns • The extent of political risk depends on the nature of the business: – – The more dependent the business is on other operations within the firm, the less valuable it is to others Natural resource development can be very valuable to others, especially if much of the ground work in developing the resource has already been done • Local financing can often reduce political risk Copyright  2004 McGraw-Hill Australia Pty Ltd 2332 Types of Political Risk Risk Nature of Loss Currency devaluation Loss in value of cash flows in terms of home currency Increased taxation Reduction in total cash flows repatriated Funds blockage Reduction or elimination of cash flows repatriated Expropriation of assets Loss of firm property and future cash flows Terrorism/sabotage Danger to employees and/or loss of future cash flows Copyright  2004 McGraw-Hill Australia Pty Ltd 2333 .. .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... Summary and Conclusions Copyright  2004 McGraw-Hill Australia Pty Ltd 23- 2 Chapter Objectives • Be familiar with international finance terminology • Apply exchange rates and cross rates • Understand... markets and instruments, which can reduce the firm’s cost of capital Copyright  2004 McGraw-Hill Australia Pty Ltd 23- 4 International Finance Terminology • Cross rate – The implicit exchange