Concept

 A common definition of exchange rate risk relates to the

effect of unexpected exchange rate changes on the value of
the firm (Madura, 1989). In particular, it is defined as the
possible direct loss (as a result of an unhedged exposure) or
indirect loss in the firm’s cash flows, assets and liabilities,
net profit and, in turn, its stock market value from an
exchange rate move.
 To manage the exchange rate risk inherent in multinational
firms’ operations, a firm needs to determine the specific
type of current risk exposure, the hedging strategy and the
available instruments to deal with these currency risks.
 Multinational firms are participants in currency
markets by virtue of their international operations. To
measure the impact of exchange rate movements on a
firm that is engaged in foreign-currency denominated
transactions, i.e., the implied value-at-risk (VaR) from
exchange rate moves, we need to identify the type of
risks that the firm is exposed to and the amount of risk
encountered (Hakala and Wystup, 2002).
 The three main types of exchange rate risk that we
consider are as follows
 International Cost of Capital
 International cost of capital is a financial term that is loosely
defined and arrived at, but basically represents what the
minimum expected rate of return can be for an investment in a
foreign market that is sufficient to draw funds into that market.
This is seen as an opportunity cost because it means that, when
investors take risks in a particular foreign market, they are
forgoing the opportunity of investing their capital assets
elsewhere.
 Normally, the higher the risk, the higher the international cost of
capital. This leads to the basic premise that emerging markets
and developing nations have a higher international cost of
capital both because they are more unstable markets and
because the data available to analyze appropriate levels of risk for
the investor is usually more unreliable or scarce than in first-
world economies.
II. THE WEIGHTED AVERAGE COST OF CAPITAL FOR
FOREIGN PROJECTS
II. THE WEIGHTED AVERAGE COST OF CAPITAL
FOR FOREIGN PROJECTS
A. Weighted Average Cost of Capital
(WACC = k0)
k0 = (1-L) ke + L id (1 - t)
where L = the parent’s debt ratio
id (1 - t) = the after-tax debt cost
ke = the equity cost of capital
THE WEIGHTED AVERAGE COST OF CAPITAL
FOR FOREIGN PROJECTS
k0 is used as the discount rate in the
calculation of Net Present Value.
2. Two Caveats
a. Weights must be a proportion using
market, not book value.
b. Calculating WACC, weights must be
marginal reflecting future debt
structure.
 THE WEIGHTED AVERAGE COST OF
CAPITAL FOR FOREIGN PROJECTS
B. Costing Various Sources of Funds
1. Components of a New Investment (I)
I = P + Ef + Df
where I = require subsidiary
financing
P = dollars by parent
E f = subsidiary’s retained
earnings
D f = dollars from debt
THE WEIGHTED AVERAGE COST OF
CAPITAL FOR FOREIGN PROJECTS
2. First compute each component
a. Parent’s company funds (k0)
required rate equal to the marginal
cost of capital
b. Retained Earnings (ks)
a function of dividends,
withholding taxes, tax deferral,
and transfer costs.
ks = ke (1-T)
THE WEIGHTED AVERAGE COST OF
CAPITAL FOR FOREIGN PROJECTS
c. Local Currency Debt (rf )
after-tax dollar cost of borrowing
locally
 THE WEIGHTED AVERAGE COST OF
CAPITAL FOR FOREIGN PROJECTS
C. Computing WACC(k1)

k1 = k0 - a(ke - ks) - b[ id(1-t) - if ]

III. THE ALL-EQUITY COST OF
CAPITAL FOR FOREIGN PROJECTS
III. THE ALL-EQUITY COST OF
CAPITAL FOR FOREIGN PROJECTS
A. WACC sometimes awkward
1. To go from the parent to the project
2. Solution: Use all equity discount
rate
3. To calculate:

k* = rf + *( rm - rf )
THE ALL-EQUITY COST OF CAPITAL
FOR FOREIGN PROJECTS
4. * is the all-equity beta associated with
the unleveraged cash flows.
 THE ALL-EQUITY COST OF
CAPITAL FOR FOREIGN PROJECTS
5. Unlevering beta obtained by
e
 *

1  (1  t ) D / E
where B* = the firm’s stock price beta
D/E = the debt to equity ratio
t = the firm’s marginal tax
 IV. DISCOUNT RATES FOR FOREIGN
PROJECTS
IV. DISCOUNT RATES FOR FOREIGN
PROJECTS
A. Systematic Risk
1. Not diversifiable
2. Foreign projects in non-
synchronous economies should be
less correlated with domestic
markets.
 DISCOUNT RATES FOR FOREIGN
PROJECTS
3. Paradox: LDCs have greater political
risk but offer higher probability of
diversification benefits.
DISCOUNT RATES FOR FOREIGN PROJECTS
B. Key Issues in Estimating Foreign
Project Betas
-find firms publicly traded that share
similar risk characteristics
-use the average beta as a proxy
DISCOUNT RATES FOR FOREIGN PROJECTS
1. Three Issues:
a. Should proxies be U.S. or local
companies?
b. Which is the relevant base
portfolio to use?
c. Should the market risk premium be
based on U.S. or local market?
DISCOUNT RATES FOR FOREIGN PROJECTS
2. Proxy Companies
a. Most desirable to use local
firms
b. Alternative:
find a proxy industry in the
local market
DISCOUNT RATES FOR FOREIGN
PROJECTS
3. Relevant Base (Market) Portfolio
a. If capital markets are globally
integrated, choose world mkt.
b. If not, domestic portfolio is best
 DISCOUNT RATES FOR FOREIGN
PROJECTS
4. Relevant Market Risk Premium
a. Use the U.S. portfolio
b. Foreign project: should have
no higher than domestic risk
and cost of capital.
.
.

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