International International Corporate Corporate FinanceFinance

Multinational companies Multinational companies (MNC)(MNC)

Engages significantly in foreign production through its Engages significantly in foreign production through its affiliates located in several countries,affiliates located in several countries,

Exercises direct control over the policies of its affiliates,Exercises direct control over the policies of its affiliates, Implements business strategies in production, Implements business strategies in production,

marketing, finance and staffing that transcend national marketing, finance and staffing that transcend national boundaries.boundaries.

In other words, MNCs exhibit no loyalty to the country In other words, MNCs exhibit no loyalty to the country in which they are incorporated. A MNC is a company in which they are incorporated. A MNC is a company that generates at least 25% of its total sales from foreign that generates at least 25% of its total sales from foreign countries. For example, Shell and Unilever, controlled countries. For example, Shell and Unilever, controlled by British and Dutch interests, are good examples.by British and Dutch interests, are good examples.

International International CorporationsCorporations

Basic Principles still apply: Basic Principles still apply: Create more value for shareholders than Create more value for shareholders than

they cost and to arrange financing that they cost and to arrange financing that raises cash at lowest possible cash. raises cash at lowest possible cash.

Some important point need to be considered in Some important point need to be considered in MNC i.e. MNC i.e.

Foreign Exchange RateForeign Exchange Rate Differing Interest Rates from Country to CountryDiffering Interest Rates from Country to Country Complex accounting methodsComplex accounting methods Foreign tax ratesForeign tax rates Foreign government interventionForeign government intervention

TerminologyTerminology American Depositary ReceiptAmerican Depositary Receipt

A security issued in the United States representing shares of A security issued in the United States representing shares of the foreign stock and allowing that stock to be traded in the US.the foreign stock and allowing that stock to be traded in the US.

Cross RateCross Rate The implicit exchange rate b/w two currencies (usually non US) The implicit exchange rate b/w two currencies (usually non US)

quoted in some third currency (usually the USD)quoted in some third currency (usually the USD) EurobondsEurobonds

International bonds issued in multiple countries but International bonds issued in multiple countries but denominated in a single currency (usually the issuer’s currency)denominated in a single currency (usually the issuer’s currency)

Euro currencyEuro currency Money deposited in a financial center outside of the country Money deposited in a financial center outside of the country

whose currency is involved. whose currency is involved.

Foreign BondsForeign Bonds International bonds issued in a single country, International bonds issued in a single country,

usually denominated in that country’s currency.usually denominated in that country’s currency. GiltsGilts

British and Irish government securities.British and Irish government securities. London Interbank Offer Rate(LIBOR)London Interbank Offer Rate(LIBOR)

The rate most international banks charge on one The rate most international banks charge on one another for overnight Eurodollars loans.another for overnight Eurodollars loans.

SwapsSwaps Agreement to exchange two securities or Agreement to exchange two securities or

currencies.currencies.

Foreign Exchange Foreign Exchange Markets & Markets &

Exchange Rates Exchange Rates Worlds largest financial market.Worlds largest financial market. One country’s currency is traded for One country’s currency is traded for

another’s.another’s. FEM is an OTC markets.FEM is an OTC markets. Participants in FEM include the followingParticipants in FEM include the following

Importers/Exporters Importers/Exporters Portfolio manager:Portfolio manager: buy & sell foreign stock and bonds. buy & sell foreign stock and bonds. FE Brokers:FE Brokers: match buy & sell orders. match buy & sell orders.

Traders: Traders: make a market in foreign currency.make a market in foreign currency.

Speculators: Speculators: make profit from changes in exchange rates.make profit from changes in exchange rates.

Common CurrenciesCommon CurrenciesCountry Currency Symbol

Australia Dollar A$

Canada Dollar Can$

Pakistan Rupee Rs

Japan Yen ¥

EU Euro €

Saudia Arabia Riyal SR

South Africa Rand R

US Dollar $

Switzerland Franc SF

UK Pound £

Norway Krone NKr

Exchange RatesExchange Rates

Price of one country’s currency Price of one country’s currency expressed in terms of another country’s expressed in terms of another country’s currency.currency.

Examples:Examples:1- Australian dollar is quoted at .7620 which means you can buy one 1- Australian dollar is quoted at .7620 which means you can buy one

Australian dollar with USD .7620.Australian dollar with USD .7620.

2- Suppose you have USD 1,000/-. If Japanese yen per USD is 2- Suppose you have USD 1,000/-. If Japanese yen per USD is 115.78/-. How many yen can you get.115.78/-. How many yen can you get.

3- If Porsche costs Euro 100,000/-, how many dollars will you need to 3- If Porsche costs Euro 100,000/-, how many dollars will you need to buy it?(Euro per USD is 0.7877).buy it?(Euro per USD is 0.7877).

Triangle ArbitrageTriangle Arbitrage

Currency Cross RatesCurrency Cross Rates

ExampleExample

Euro per $ 1 = 1.00Euro per $ 1 = 1.00

SF per $ 1 = 2.00SF per $ 1 = 2.00

Suppose Cross rate is quoted as Euro per Suppose Cross rate is quoted as Euro per SF=0.4SF=0.4

Then Cross will be inconsistentThen Cross will be inconsistent

$100 * SF 2 per $ 1 = SF 200$100 * SF 2 per $ 1 = SF 200

Converting SF to EuroConverting SF to Euro

SF 200 * Euro .4 per SF= € 80SF 200 * Euro .4 per SF= € 80

How To Make MoneyHow To Make Money

Buy € 100 for $ 100.Buy € 100 for $ 100. Use € 100 to buy SF at the cross rate i.e. Use € 100 to buy SF at the cross rate i.e.

€ per SF = 0.40. you will receive SF 250.€ per SF = 0.40. you will receive SF 250. Use SF200 to buy dollars. Because the Use SF200 to buy dollars. Because the

exchange rate is SF 2 per $, you’ll receive exchange rate is SF 2 per $, you’ll receive $ 125 for a round trip profit of $ 25.$ 125 for a round trip profit of $ 25.

This activity is called triangle arbitrage.This activity is called triangle arbitrage. Cross rate must € 1 per 2 SF otherwise Cross rate must € 1 per 2 SF otherwise

there will be TA. there will be TA.

ExampleExample

Suppose the exchange rates for the Suppose the exchange rates for the GBP and SF are ;GBP and SF are ;

pounds per 1 $= .60pounds per 1 $= .60

SF per $ 1= 2.00SF per $ 1= 2.00

The cross rate is three francs per The cross rate is three francs per pound. Is this consistent ? Explain pound. Is this consistent ? Explain how to make some money?how to make some money?

Types Of TransactionsTypes Of Transactions Spot TradeSpot Trade

An agreement to trade currencies based on the An agreement to trade currencies based on the exchange rate today for settlement within two exchange rate today for settlement within two business days.business days.

Spot Exchange RateSpot Exchange Rate The exchange rate on the spot trade.The exchange rate on the spot trade.

Forward TradeForward Trade An agreement to exchange currency at some time An agreement to exchange currency at some time

in the future.in the future. Forward Exchange RateForward Exchange Rate

The agreed upon exchange rate to be used in The agreed upon exchange rate to be used in forward tradeforward trade

Looking ForwardLooking Forward

Selling at premiumSelling at premium Selling at relative discountSelling at relative discount

Example: Example:

Expecting to receive a million GBP in Expecting to receive a million GBP in six month and you agree to forward six month and you agree to forward rate. Is the pound selling at premium rate. Is the pound selling at premium relative to dollar if relative to dollar if So=$1.8576=1GBP & So=$1.8576=1GBP &

F (180 days)=$1.8646=1GBP.F (180 days)=$1.8646=1GBP.

Purchasing Power ParityPurchasing Power Parity Purchasing power parity (PPP) is a theory, which states Purchasing power parity (PPP) is a theory, which states

that exchange rates between currencies are in equilibrium that exchange rates between currencies are in equilibrium when their purchasing power is the same in each of the when their purchasing power is the same in each of the two countries. This means that the exchange rate between two countries. This means that the exchange rate between two countries should equal the ratio of the two countries' two countries should equal the ratio of the two countries' price level of a fixed basket of goods and services. When a price level of a fixed basket of goods and services. When a country's domestic price level is increasing (i.e., a country country's domestic price level is increasing (i.e., a country experiences inflation), that country's exchange rate must experiences inflation), that country's exchange rate must depreciated in order to return to PPP.depreciated in order to return to PPP.

The basis for PPP is the "law of one price". In the absence The basis for PPP is the "law of one price". In the absence of transportation and other transaction costs, competitive of transportation and other transaction costs, competitive markets will equalize the price of an identical good in two markets will equalize the price of an identical good in two countries when the prices are expressed in the same countries when the prices are expressed in the same currency.currency.

For example, a particular TV set that sells for 750 Canadian For example, a particular TV set that sells for 750 Canadian Dollars [CAD] in Vancouver should cost 500 US Dollars [USD] in Dollars [CAD] in Vancouver should cost 500 US Dollars [USD] in Seattle when the exchange rate between Canada and the US is Seattle when the exchange rate between Canada and the US is 1.50 CAD/USD. If the price of the TV in Vancouver was only 700 1.50 CAD/USD. If the price of the TV in Vancouver was only 700 CAD, consumers in Seattle would prefer buying the TV set in CAD, consumers in Seattle would prefer buying the TV set in Vancouver. If this process (called "arbitrage") is carried out at a Vancouver. If this process (called "arbitrage") is carried out at a large scale, the US consumers buying Canadian goods will bid up large scale, the US consumers buying Canadian goods will bid up the value of the Canadian Dollar, thus making Canadian goods the value of the Canadian Dollar, thus making Canadian goods more costly to them. This process continues until the goods have more costly to them. This process continues until the goods have again the same price. again the same price.

For absolute PPP to hold , several things must be true; For absolute PPP to hold , several things must be true;

(1)(1) Transaction cost of trading must be zero i.e. shipping, insurance Transaction cost of trading must be zero i.e. shipping, insurance etc.etc.

(2)(2) There must be no barriers to trading apples i.e. no tariff, taxes & There must be no barriers to trading apples i.e. no tariff, taxes & other barriers. other barriers.

(3)(3) Merchandise should be identical.Merchandise should be identical.

Absolute Purchasing Absolute Purchasing Power ParityPower Parity

Absolute PPPAbsolute PPP

Puk= So * PusPuk= So * Pus

GBP 2.4=So* $ 4GBP 2.4=So* $ 4

So=GBP .60So=GBP .60

& if& if

So=GBP .50So=GBP .50

Then round trip gain will be 80 cents.Then round trip gain will be 80 cents.

Relative PPPRelative PPP

Its tells what determines the change in the Its tells what determines the change in the exchange rate over time. And this change exchange rate over time. And this change ER is determined be difference in the ER is determined be difference in the exchange rates of two countries .exchange rates of two countries .

[E(S1)-So]/So= hfc – hus[E(S1)-So]/So= hfc – hus

OrOr

E(St)= So * [1 + (hfc – hus)]E(St)= So * [1 + (hfc – hus)]e.g. GBP exchange rate is currently So=GBP.50 and inflation rate is UK is predicted to be e.g. GBP exchange rate is currently So=GBP.50 and inflation rate is UK is predicted to be

10% over coming years and inflation rate in US lets suppose to be predicted at zero. 10% over coming years and inflation rate in US lets suppose to be predicted at zero. Then we expect the price of dollar will go up by 10 and exchange rate should rise to Then we expect the price of dollar will go up by 10 and exchange rate should rise to 0.55 GBP.0.55 GBP.

ExampleExample

Suppose the Japanese exchange rate Suppose the Japanese exchange rate is currently 105 yen per dollar. The is currently 105 yen per dollar. The inflation rate in japan over the next inflation rate in japan over the next three years will run, say, 2 % per three years will run, say, 2 % per year, where as the US inflation rate year, where as the US inflation rate will be 6%. Based on relative PPP, will be 6%. Based on relative PPP, what will the exchange rate be in what will the exchange rate be in three years?three years?

Currency Currency Appreciation/DepreciatioAppreciation/Depreciatio

nn Strengthening/weakening of DollarStrengthening/weakening of Dollar Fluctuation in exchange rate.Fluctuation in exchange rate. Inflation rate impactInflation rate impact

Covered Interest Covered Interest ArbitrageArbitrage

The term covered refers to the fact that we are The term covered refers to the fact that we are covered in the event of change in exchange rate covered in the event of change in exchange rate because we lock in the forward exchange rate because we lock in the forward exchange rate today.today.

Example:Example:

So= SF 2So= SF 2

F1= SF1.90F1= SF1.90

Rus= Rus= 10%10%

Rs= Rs= 5 % where Rs is nominal RF Rate in Switzerland.5 % where Rs is nominal RF Rate in Switzerland.

Now check Arbitrage OpportunityNow check Arbitrage Opportunity

$ value in 1 period = $ 1 *(1+$ value in 1 period = $ 1 *(1+RusRus)= $ 1.10 )= $ 1.10

If invested in SF. To do this, it need to convert your $ If invested in SF. To do this, it need to convert your $ 1 to SF and simultaneously execute a forward trade to 1 to SF and simultaneously execute a forward trade to convert Francs back to dollars in one year. The steps convert Francs back to dollars in one year. The steps would be;would be; Convert you $ 1 to SF $1*So=SF 2Convert you $ 1 to SF $1*So=SF 2 At the same time enter into forward agreement to convert SF At the same time enter into forward agreement to convert SF

back to dollars in one year.back to dollars in one year. Invest your SF 2 in Switzerland at Rs. In one year, you will Invest your SF 2 in Switzerland at Rs. In one year, you will

havehaveSF value in 1 year= SF 2 *(1+RS)=2*1.05=SF 2.10SF value in 1 year= SF 2 *(1+RS)=2*1.05=SF 2.10

Convert you SF 2.10 back to dollars at the agreed upon rate Convert you SF 2.10 back to dollars at the agreed upon rate of SF 1.90 = $ 1. you end up withof SF 1.90 = $ 1. you end up with

aa $ value in 1 year=SF 2.10/1.90$ value in 1 year=SF 2.10/1.90

=$ 1.1053=$ 1.1053

The return on investment is apparently 10.53%The return on investment is apparently 10.53%

Interest Rate ParityInterest Rate Parity

The condition stating that the interest rate The condition stating that the interest rate differential b/w two countries is equal to the differential b/w two countries is equal to the percentage difference b/w the forward percentage difference b/w the forward exchange rate & spot exchange rate.exchange rate & spot exchange rate.

1+Rus = So * (1 + Rfc)/F11+Rus = So * (1 + Rfc)/F1

rearranging this will give us IRPrearranging this will give us IRPF1/So=(1+Rfc)/(1+Rus)F1/So=(1+Rfc)/(1+Rus)

Or Or

(F1-So)/So=Rfc-Rus(F1-So)/So=Rfc-Rus

& &

F1= S0[1+(Rfc-Rus)]F1= S0[1+(Rfc-Rus)]

ExampleExample

Suppose the exchange rate for the Suppose the exchange rate for the Japanese yen is currently Yen 120= Japanese yen is currently Yen 120= $ 1. if the interest rate in the united $ 1. if the interest rate in the united states is Rus=10% and the interest states is Rus=10% and the interest rate in japan is Rj=5% then what rate in japan is Rj=5% then what must the forward rate be to prevent must the forward rate be to prevent covered interest arbitrage?covered interest arbitrage?

Unbiased Forward RateUnbiased Forward Rate

The condition stating that the The condition stating that the current forward rate is an unbiased current forward rate is an unbiased predictor of the future spot predictor of the future spot exchange rate.exchange rate.

Ft=E(St)Ft=E(St)

Uncovered Interest Uncovered Interest ParityParity

The condition stating that the The condition stating that the expected percentage change in expected percentage change in exchange rate is equal to the exchange rate is equal to the difference in interest rate.difference in interest rate.

PPP:PPP: E(St)= So * [1 + (hfc – hus)]E(St)= So * [1 + (hfc – hus)] IRP:IRP:F1= S0[1+(Rfc-Rus)]F1= S0[1+(Rfc-Rus)] UFR:UFR: Ft=E(St)Ft=E(St) UIP:UIP: E(St)= E(St)= F1= S0[1+(Rfc-F1= S0[1+(Rfc-

Rus)]Rus)]

International Fisher International Fisher EffectEffect

The theory that real interest rates The theory that real interest rates are equal across countries.are equal across countries.

S0*[1+(Rfc-Rus)]= So * [1 + (hfc – S0*[1+(Rfc-Rus)]= So * [1 + (hfc – hus)]hus)]

IFE:IFE: Rus-hus=Rfc-hfc Rus-hus=Rfc-hfc

It cause flow of funds to country It cause flow of funds to country where real interest rates are high.where real interest rates are high.

International Capital International Capital BudgetingBudgeting

Home Currency ApproachHome Currency Approach Convert all the euro cash flow into dollars , and Convert all the euro cash flow into dollars , and

then discount at 10% to find NPV in dollars. In this then discount at 10% to find NPV in dollars. In this approach, we have to come up with future approach, we have to come up with future exchange rates to convert the future projected exchange rates to convert the future projected euro cash flows.euro cash flows.

The Foreign Currency ApproachThe Foreign Currency Approach Determine the required return on euro investments Determine the required return on euro investments

and then discount euro cash flow to find NPV in and then discount euro cash flow to find NPV in euro. Then convert this NPV to dollar NPV. This euro. Then convert this NPV to dollar NPV. This approach requires to convert the 10 % dollar approach requires to convert the 10 % dollar return to the equivalent Euro return.return to the equivalent Euro return.

Home Currency Home Currency ApproachApproach

Project Cost 2 million euro and expected cash flow Project Cost 2 million euro and expected cash flow will be 0.9 million euro for next three year. If risk will be 0.9 million euro for next three year. If risk free interest rate in Euro land is 7% and in dollar free interest rate in Euro land is 7% and in dollar Land its 5%. And required return on this dollar Land its 5%. And required return on this dollar investment is 10% then; exchange rate for the investment is 10% then; exchange rate for the euro is Euro 0.5euro is Euro 0.5

E(St)=So * [1+(Re-Rus)]^tE(St)=So * [1+(Re-Rus)]^t

E(St)= .5 *[1 +.02]^tE(St)= .5 *[1 +.02]^tYearYear Expected Exchange rate Expected Exchange rate

11 .5* 1.02=euro 0.5100.5* 1.02=euro 0.5100

22 .5* 1.02^2= euro 0.5202.5* 1.02^2= euro 0.5202

33 .5* 1.02^3= euro 0.5306.5* 1.02^3= euro 0.5306

Year Cash flow in euro million

Expected exchange

rate

Cash flow in million

dollars

0 -2 .5 -4

1 .9 .51 1.76

2 .9 .5202 1.73

3 .9 .5306 1.70

Foreign Currency Foreign Currency MethodMethod

hfc-hus=Rfc-Rushfc-hus=Rfc-Rus NPV= euro.16 millionNPV= euro.16 million NPV in dollars= $.3 millionNPV in dollars= $.3 million

Exchange Rate RiskExchange Rate Risk

Short Run ExposureShort Run Exposure

Long Run ExposureLong Run Exposure

Translation ExposureTranslation Exposure

Political RiskPolitical Risk