Chapter 17

International
Business Finance

Slide Contents
Learning Objectives
Principles Used in This Chapter
1. Foreign Exchange Markets and
Currency Exchange Rates
2. Interest Rate and Purchasing-Power
Parity
3. Capital Budgeting for Direct Foreign
Investment

Key Terms

172

Learning Objectives

173

1. Understand the nature and importance of

the foreign exchange market and learn
to read currency exchange rate quotes.
2. Describe interest rate and the purchasing
power parity.
3. Discuss the risks that are unique to the
capital budgeting analysis of direct
foreign investments.

Principles Used in
This Chapter
Principle 2:
There is a Risk-Return Tradeoff.

Principle 3:
Cash Flows Are the Source of Value.

174

17.1 Foreign Exchange

Markets and the
Currency Exchange
Rates

Foreign Exchange Markets and

the Currency Exchange Rates

176

The foreign exchange (FX) market:

Largest financial market with daily trading
volumes of more than $4 trillion.
Organized as over-the-counter market with
participants located in major commercial and
investment banks around the world.
Trading dominated by few currencies
including
U.S. dollar, the British pound sterling, the
Japanese Yen, and the Euro.

Foreign Exchange Markets and

the Currency Exchange Rates
(cont.)
Major participants in foreign exchange
trading include the following:

Importers and exporters of goods and

services,
Investors and portfolio managers
who purchase foreign stocks and
bonds, and
Currency traders who make a market in
one or
more foreign currencies.

177

Foreign Exchange Rates

178

An exchange rate is simply the price of

one currency stated in terms of
another.
For example, if the exchange rate of U.S.
dollar for Euro was $1.35 to 1, it means
that it would take $1.35 to purchase one
Euro.

Foreign Exchange Rates

(cont.)
Direct quote

179

It indicates the number of units of U.S. dollar

to buy 1 foreign currency unit.
In the table we see that it took $0.762660 to
buy 1 Canadian dollar.

17-10

Foreign Exchange Rates

(cont.)
Indirect Quote

1711

It indicates the number of foreign currency

units to buy one American dollar.
For example, in the table it shows that it will
take 6.52388 Chinese yuan to buy 1 U.S.
dollar

1712

Foreign Exchange Rates

(cont.)
We can compute the direct quote from the
indirect quote.

Foreign Exchange Rates (cont.)

The direct quote for Canadian dollars is
$0.762660. The related indirect quote
will be:
Indirect quote = 1 $0.762660 =
$1.3112

1713

Exchange Rates and Arbitrage

1714

Arbitrage is the process of buying and

selling in more than one market to make a
riskless profit.
Simple arbitrage eliminates exchange
rate differentials across the markets for a
single currency.

Exchange Rates and Arbitrage (cont.)

1715

The asked rate (also known as the selling

rate or the offer rate) is the rate the bank
or the foreign exchange trader asks the
customer to pay in home currency for
foreign currency when the bank is selling
and the customer is buying.

Exchange Rates and Arbitrage (cont.)

1716

The bid rate (also known as the buying

rate) is the rate at which the bank buys
the foreign currency from the customer by
paying in home currency.

Exchange Rates and Arbitrage

(cont.)

1717

The bank sells a unit of foreign currency

for more than it pays for it. The difference
between the asked quote and the bid
quote is known as the bid-asked spread.
The spread will be relatively lower for popular
currencies that are frequently traded.

Cross Rates

1718

A cross rate is the computation of an

exchange rate for a currency from the
exchanges rates of two other currencies.

Types of Foreign
Exchange Transactions

17-19

Spot exchange rate is the rate for

immediate delivery.
Forward exchange rate is an exchange
rate agreed upon today but which calls for
delivery or payment at a future date.

Types of Foreign
Exchange Transactions
The forward rate is often quoted at a
(cont.)
premium to or a discount from the existing
17-20

spot rate. For example, the 30-day

Switzerland franc will be quoted as 0.0001
premium(0.9773-0.9772).

This premium or discount is known as the

forward-spot differential.

Types of Foreign
Exchange Transactions
(cont.)

The forward-spot differential can be expressed

as:

Where F= the forward rate, direct quote

S = the spot rate, direct quote

17-21

Types of Foreign
Exchange Transactions
(cont.)

The premium or discount can also be expressed

as an annual percentage rate, computed as
follows:

17-22

19.2 Interest Rate and Purchasing

Power Parity

Interest Rate Parity

1724

Interest rate parity is a theory that can be

used to relate differences in the interest
rates in two countries to the ratios of spot
and forward exchange rates of the two
countries currencies.
Specifically,
Differences in interest rates = Ratio of the
forward and spot
rates

Interest Rate Parity

(cont.)

1725

1726

Interest Rate Parity

(cont.)
Interest rate parity means that you get the
same total return for the following two
options:
Invest directly in the US; or
Convert dollars to Japanese Yens,
Invest Yens in the risk-free rate in Japan, and
Convert Yens back to U.S. dollars.

Interest Rate Parity

(cont.)
Example: You have $1,000,000

1727

to invest and you observe the following

quotes in the market:
1$ = 106
180-day forward rate = 103.50
U.S. 180-day risk-free interest rate = 4.4%
Japan 180-day risk-free interest rate = 2%

Determine whether interest rate

parity holds.

Interest Rate Parity

(cont.)
Option I: Invest directly in USA

and earn 4.4% 1,000,000 * 1.044

= $1,044,000

Option

II:
(a) Convert to Yen at spot rate =
106,000,000
(b) Invest at 2% =
106,000(1.02) = 108,120,000
(c) Convert to $ at the forward
rate = 108,120,000 103.5 =
$1,044,638

1728

Purchasing Power Parity

and the Law of One Price

1729

According to the theory of purchasing

power parity (PPP), exchange rates
adjust so that identical goods cost the
same amount regardless of where in the
world they are purchased.

Purchasing Power Parity and the

Law of One Price (cont.)

17-30

Underling PPP theory is the law of one

price, which states that the same good
should sell for the same price in different
countries after making adjustments for the
exchange rate between the two
currencies.

Purchasing Power Parity and

the Law of One Price (cont.)

1731

The differences in prices around the world

could be explained by:

Tax differences among countries

Differences in labor costs
Differences in raw material costs
Differences in rental costs

Purchasing Power Parity and

the Law of One Price (cont.)

1732

In general, we expect PPP to hold for

goods that can be cheaply shipped
between countries (for example, expensive
gold jewelry).
PPP does not seem to hold for non-traded
goods like restaurant meals and haircuts.

Capital Budgeting for

Direct Foreign
Investment
Direct foreign investment occurs when a

company from one country makes a physical

investment into building a factory in another
country. A multinational corporation (MNC)
is one that has control over this investment.

17-33

Capital Budgeting for

Direct Foreign
Investment (cont.)

A major reason for direct foreign investment by

U.S. companies is the prospect of higher rates
of return from these investments.

The method used to evaluate foreign

investments is very similar to the method used
to evaluate capital budgeting decisions in a
domestic context.

17-34

17-35

Risks in Direct Foreign Investments

BUSINESS RISK

FINANCIAL RISK

POLITICAL RISK

EXCHANGE RISK

 Business Risk

17-36

International business risk is due to the response of a

business to economic conditions in the foreign country.

Financial Risk

Financial risk refers to the risks introduced in the profit

stream by the firm's financial structure.

 Political Risk

Political risk arises because the foreign

subsidiary conducts its business in a political
system different from that of the home country.
Examples of political risk are:
1.

Expropriation of assets

2.

Changes in taxes

3.

Government controls such as required local

equity participation.

17-37

 Exchange Rate Risk

The risk that changes in relative value of certain

currencies will reduce the value of investment
denominated in a foreign currency.
For example, if the Japanese Yen depreciates, it
will translate to fewer dollars when it is sent
back to the U.S.

17-38