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					Chapter 20
 20.1    Key Concepts and Skills
 20.2    Chapter Outline
 20.3    Terminology
 20.4    Terminology
 20.5    Foreign Exchange Markets and Exchange Rates
 20.6    FOREX Market Participants
 20.7    Exchange Rates
 20.8    Example
 20.9    Cross Rates
 20.10   Triangle Arbitrage
 20.11   Triangle Arbitrage
 20.12   Triangle Arbitrage
 20.13   Triangle Arbitrage
 20.14   Types of Transactions
 20.15   Absolute Purchasing Power Parity
 20.16   Relative Purchasing Power Parity
 20.17   Example
 20.18   Interest Rate Parity
 20.19   Interest Rate Parity
 20.20   Interest Rate Parity
 20.21   IRP and Covered Interest Arbitrage
 20.22   IRP and Covered Interest Arbitrage
 20.23   IRP and Covered Interest Arbitrage
 20.24   IRP and Covered Interest Arbitrage
 20.25   Reasons for Deviations from IRP
 20.26   International Fisher Effect
 20.27   Equilibrium Exchange Rate Relationships
 20.28   International Capital Budgeting
 20.29   Home Currency Approach
 20.30   Foreign Currency Approach
 20.31   Exchange Rate Risk
 20.32   Short-Run Exposure
 20.33   Long-Run Exposure
 20.34   Translation Exposure
 20.35   Managing Exchange Rate Risk
 20.36   Political Risk
 20.37   Quick Quiz
                                                                    CHAPTER 20 A-269


                 Section                                     Web Address
         End-of-chapter material   


20.1   Terminology

20.2   Foreign Exchange Markets and Exchange Rates
                 Exchange Rates

20.3   Purchasing Power Parity
                 Absolute Purchasing Power Parity
                 Relative Purchasing Power Parity

20.4   Interest Rate Parity, Unbiased Forward Rates, and the International Fisher Effect
                   Covered Interest Arbitrage
                   Interest Rate Parity
                   Forward Rates and Future Spot Rates
                   Putting It All Together

20.5   International Capital Budgeting
                  Method 1: The Home Currency Approach
                  Method 2: The Foreign Currency Approach
                  Unremitted Cash Flows

20.6   Exchange Rate Risk
                Short-Run Exposure
                Long-Run Exposure
                Translation Exposure
                Managing Exchange Rate Risk
A-270 CHAPTER 20

20.7   Political Risk


Slide 20.0    Chapter 20 Title Slide
Slide 20.1    Key Concepts and Skills
Slide 20.2    Chapter Outline
   20.1.   Terminology

Slide 20.3 –
Slide 20.4 Terminology

                        American Depository Receipt (ADR) – security issued in the U.S.
                        that represents shares in a foreign company

                        Cross-rate – exchange rate between two currencies implied by the
                        exchange rates of each currency with a third

                        Eurobond – bonds issued in many countries but denominated in a
                        single currency

                        Eurocurrency – money deposited in the bank of a foreign country
                        (dollars deposited in a French bank are called Eurodollars)

                        Lecture Tip: Eurodollars are “deposits of U.S. dollars in banks
                        located outside the United States.” However, you should
                        emphasize that Eurodollars are not actual U.S. currencies
                        deposited in a bank, but are bookkeeping entries on a bank’s
                        ledger. These deposits are loaned to the Euro bank’s U.S. affiliate
                        to meet liquidity needs, or the funds might be loaned to a
                        corporation abroad that needs the loan denominated in U.S.
                        dollars. Money does not normally leave the country of its
                        origination; merely, the ownership is transferred to another
                           You might add that a dollar-denominated Eurobond is free of
                        exchange rate risk for a U.S. investor, regardless of where it is
                        issued. A foreign bond would be subject to this risk if it is not
                        issued in the U.S. The reason is that the Eurobond pays interest in
                        U.S. dollars, but the foreign bond pays interest in the currency of
                        the country in which it was issued.

                        Foreign bonds – bonds issued by a foreign company in a single
                        country and in that country’s currency
                                                                   CHAPTER 20 A-271

                     Gilts – British and Irish government securities

                     London Interbank Offer Rate (LIBOR) – rate banks charge each
                     other for overnight Eurodollar loans; often used as an index in
                     floating rate securities

                     Interest rate swap – agreement between two parties to periodically
                     swap interest payments on a notional amount; normally one party
                     pays a fixed rate and the other pays a floating rate

                     Currency swap – agreement between two parties to periodically
                     swap currencies based on some notional amount

   20.2.   Foreign Exchange Markets and Exchange Rates

Slide 20.5    Foreign Exchange Markets and Exchange Rates
           Foreign exchange market – market for buying and selling currencies.

           Foreign exchange market participants:
           -Importers and exporters
           -International portfolio managers
           -Foreign exchange brokers
           -Foreign exchange market markers

Slide 20.6    FOREX Market Participants
Video Note: “Foreign Exchange Market”

              A.     Exchange Rates

                     Most currency trading is done with currencies being quoted in U.S.

Slide 20.7    Exchange Rates
Slide 20.8    Example
                     Cross rates and triangle arbitrage – implicit in exchange rate
                     quotations is an exchange rate between non-U.S. currencies. The
                     exchange rate between two non-U.S. currencies must equal the
                     cross rate to prevent arbitrage.

Slide 20.9    Cross Rates
A-272 CHAPTER 20

                   Example of Triangle Arbitrage:

                   Suppose the Japanese Yen is quoted at 133.9 Yen per dollar and
                   the South Korean Won is quoted at 666.0 Won per dollar. The
                   exchange rate between Yen and Won is .1750 Yen per Won.

                   The cross rate is (133.9 Yen/$) / (666.0 Won/$) = .201 Yen/Won

                   Buy low, sell high:

                   1) Have $1,000 to invest: buy yen = $1,000(133.9 Yen/$) =
                       133,900 Yen
                   2) Buy Won with Yen = 133,900 Yen / (.1750 Yen/Won) =
                       765,142.86 Won
                   3) Buy dollars with Won = 765,142.86 Won / (666 Won/$) =
                   4) Risk-free profit of $148.86

Slide 20.10 –
Slide 20.13 Triangular Arbitrage
                   Lecture Tip: The opportunity to exploit a triangle arbitrage may
                   appear to be an easy opportunity to make a quick profit. Point out
                   that arbitrage opportunities are rare and that the transaction costs
                   for small investors would generally outweigh any profit
                   opportunity available.

                   Types of Transactions

                   Spot trade – exchange of currencies at immediate prices (spot rate)
                   Forward trade – contract for the exchange of currencies at a future
                   date at a price specified today (forward rate)

                   Premium – if the forward rate > spot rate (based on $ equivalent or
                   direct quotes), then the foreign currency is expected to appreciate
                   and is selling at a premium
                   Discount – if the forward rate < spot rate (based on $ equivalent or
                   direct quotes), then the foreign currency is expected to depreciate
                   and is selling at a discount

Slide 20.14 Types of Transactions
                   Lecture Tip: Well-known economist Milton Friedman provides a
                   primer on exchange rates in the November 2, 1998 issue of Forbes
                   magazine. He describes three types of exchange rate regimes.
                                                                   CHAPTER 20 A-273

                        Fixed rate or unified currency: “The clearest example is a
                    common currency: the dollar in the U.S.; the euro that will shortly
                    reign in the common market … the key feature of the currency
                    board is that there is only one central bank with the power to
                    create money.”
                        Pegged exchange rate: “This prevailed in the East Asian
                    countries other than Japan. All had national central banks with the
                    power to create money and committed themselves to maintain the
                    price of their domestic currency in terms of the U.S. dollar at a
                    fixed level, or within narrow bounds – a policy they had been
                    encouraged to adopt by the IMF … In a world of free capital flows,
                    such a regime is a ticking time bomb. It is never easy to know
                    whether a [current account] deficit is transitory and will soon be
                    reversed or is the precursor to further deficits.”
                        Floating rates: “The third type of exchange rate regime is one
                    under which rates of exchange are determined in the market on the
                    basis of predominantly private transactions. In pure form, clean
                    floating, the central bank does not intervene in the market to affect
                    the exchange rate though it or the government may engage in
                    exchange transactions in the course of its other activities. In
                    practice, dirty floating is more common: The central bank
                    intervenes from time to time to affect the exchange rate but does
                    not announce in advance any specific value it will seek to
                    maintain. That is the regime currently followed by the U.S.,
                    Britain, Japan and many other countries.

  20.3.   Purchasing Power Parity

             A.     Absolute Purchasing Power Parity

                    Absolute PPP indicates that a commodity should sell for the same
                    real price regardless of the currency used. Absolute PPP can be
                    violated due to transaction costs, barriers to trade and differences
                    in the product.

Slide 20.15 Absolute Purchasing Power Parity
             B.     Relative Purchasing Power Parity

                    The change in the exchange rate depends on the difference in
                    inflation rates between countries.

                    Relative PPP says that:
                           E(St ) = S0[1 + (hFC – hUS)]t
                    assuming that rates are quoted as foreign currency per dollar.
A-274 CHAPTER 20

                      Currency appreciation and depreciation:
                      Appreciation of one currency relative to another means that it takes
                      more of the second currency to buy the first. For example, if the
                      dollar appreciates relative to the yen, it means it will take more yen
                      to buy $1. Depreciation is just the opposite.

Slide 20.16 Relative Purchasing Power Parity
Slide 20.17 Example
                      Lecture Tip: When asked, “Which is better – a stronger dollar or
                      a weaker dollar?” most students answer a stronger one. While this
                      makes imports relatively cheaper, it makes U.S. exports relatively
                      more expensive. In general, consumers like a stronger dollar and
                      producers, especially exporters, prefer a weaker one.

                      Lecture Tip: The concept of relative PPP can be reinforced by
                      considering an identical product that sells in both England and the
                      U.S. at identical relative prices. If the inflation rate is 4% per year
                      in the U.S., then the price for the product would increase by 4%
                      over the year. However, if the inflation rate in England is 10%, the
                      product price would increase by 10% in England over the year.
                          Suppose the original price is $1 in the U.S. and the exchange
                      rate is .5 pounds per dollar, so the product would cost .5 pounds in
                      England. At the end of the year, the price in the U.S. would be
                      1(1.04) = $1.04 and the price in England would be .5(1.1) = .55
                      pounds. To prevent arbitrage, the exchange rate must change so
                      that $1.04 is now equivalent to .55 pounds. In other words, the new
                      exchange rate must be .55 pounds / $1.04 = .5288 pounds per
                          The dollar has appreciated relative to the pound (it takes more
                      pounds to buy $1) because of the lower inflation rate.

   20.4.   Interest Rate Parity, Unbiased Forward Rates, and the International Fisher

Slide 20.18 –
Slide 20.20 Interest Rate Parity
              A.      Covered Interest Arbitrage

                      A covered interest arbitrage exists when a riskless profit can be
                      made by borrowing in the U.S. at the risk-free rate, converting the
                      borrowed dollars into a foreign currency, investing at that
                      country’s rate of interest, taking a forward contract to convert the
                      currency back into U.S. dollars and repaying the loan.
                                                                CHAPTER 20 A-275


                 S0 = 2 Euro/$          RUS = 10%
                 F1 = 1.8 Euro/$        RE = 5%

                 1)     Borrow $100 at 10%
                 2)     Buy $100(2 Euro/$) = 200 Euro and invest at 5% (RE)
                 3)     At the same time, enter into a forward contract
                 4)     In 1 year, receive 200(1.05) = 210 Euro
                 5)     Convert to $ using forward contract; 210 Euro / (1.8
                        Euro/$) = $116.67
                 6)     Repay loan and pocket profit: 116.67 – 100(1.1) = $6.67

           B.    Interest Rate Parity

                 To prevent covered arbitrage:

                  F1 1  RFC
                  S 0 1  RUS

                 Approximation: Ft = S0[1 + (RFC – RUS)]T

                 Suppose the Euro spot rate is 1.3 Euro / $. If the risk-free rate in
                 France is 6% and the risk-free rate in the U.S. is 8%, what should
                 the forward rate be to prevent arbitrage?

                 Exact: F =1.3(1.06)/(1.08) = 1.28 Euro / $
                 Approximation: F = 1.3[1 + (.06 - .08)] = 1.274 Euro / $

Slide 20.21 –
Slide 20.24 IRP and Covered Interest Arbitrage

Slide 20.25 Reasons for Deviations from IRP
           C.    Forward Rates and Future Spot Rates

                 Unbiased forward rates (UFR) –the forward rate, Ft, is equal to the
                 expected future spot rate, E[St]. That is, on average, the forward
                 rate neither consistently underestimates nor overestimates the
                 future spot rate. That is, Ft = E[St]
A-276 CHAPTER 20

              D.      Putting It All Together

                      PPP:   E[S1] = S0[1 + (hFC – hUS)]

                      IRP:   F1 = S0[1 + (RFC – RUS)]

                      UFR: F1 = E[S1]

                      Uncovered interest parity (UIP) – combining UFR and IRP gives:

                      E[S1] = S0[1 + (RFC – RUS)]
                      E[St] = S0[1 + (RFC – RUS)]T

                      The International Fisher Effect – combining PPP and UIP gives:

                      S0[1 + (hFC – hUS)] = S0[1 + (RFC – RUS)]
                      so that hFC – hUS = RFC - RUS
                      and RUS – hUS = RFC – hFC

                      The IFE says that real rates must be equal across countries.

Slide 20.26 International Fisher Effect

Slide 20.27 Equilibrium Exchange Rate Relationship
   20.5.   International Capital Budgeting

Slide 20.28 International Capital Budgeting

              A.      Method 1: The Home Currency Approach

                      This involves converting foreign cash flows into the domestic
                      currency and finding the NPV.

Slide 20.29 Home Currency Approach

              B.      Method 2: The Foreign Currency Approach

                      In this approach, we determine the comparable foreign discount
                      rate, find the NPV of foreign cash flows, and convert the NPV to

Slide 20.30 Foreign Currency Approach
                                                    CHAPTER 20 A-277

     Example: Pizza Shack is considering opening a store in Mexico
     City, Mexico. The store would cost $1.5 million or 3,646,500,000
     pesos to open. Pizza Shack hopes to operate the store for two years
     and then sell it at the end of the second year to a local franchisee.
     Cash flows are expected to be 250,000,000 pesos in the first year,
     and 5,000,000,000 pesos the second year. The spot exchange rate
     for Mexican pesos is 2,431. The U.S. risk-free rate is 7% and the
     Mexican risk-free rate is 10%. The required return (U.S.) is 12%.

     1. The home currency approach

     Using the UIP:

     E[S1] = 2,431[1 + (.1 - .07)] = 2,503.93
     E[S2] = 2,431[1 + (.1 - .07)]2 = 2,579.05

     Year             Cash Flow (pesos)    E[St]           Cash Flow ($)
      0               -3,646,500,000       2,431.00        -1,500,000.00
      1                  250,000,000       2,503.93            99,843.05
      2                5,000,000,000       2,579.05         1,938,698.36

     NPV at 12% = 134,664.04

     2. The foreign currency approach

     Using the IFE to get the inflation premium (10 – 7) = hFC – hUS =
     3%. Factor this into the US discount rate to get the Mexican
     discount rate: (1.12*1.03 – 1) = 15.36%.

     NPV of peso cash flows at 15.36% = 327,371,337.6 pesos

     NPV in dollars = 327,371,337.6 / 2,431 = $134,665.30

     Note that the two approaches will produce exactly the same
     answers if the exact formulas are used for each of the parity
     equations instead of the approximations.

C.   Unremitted Cash Flows

     Not all cash flows from foreign operations can be remitted to the
     parent company. Ways foreign subsidiaries remit funds to the
     1.      dividends
     2.      management fees for central services
     3.      royalties on trade names and patents
A-278 CHAPTER 20

                    Blocked funds – funds that cannot currently be remitted to the

                    Ethics Note: The following case may be used as a class example to
                    expose the class to the ethical problems involving shell
                    corporations that attempt to conduct business on the fringe of
                    violating international law.
                       In February 1989, the West German Chemical Industry
                    Association suspended the membership of Imhausen Chemie, a
                    major West German chemical manufacturer in response to the
                    charge that Imhausen supplied Libya with the plant and
                    technology to produce chemical weapons. In June 1990, the former
                    Managing Director of Imhausen was convicted of tax evasion and
                    violating West Germany’s export control laws.
                       In November 1984, a shell corporation had been established in
                    Hong Kong to conceal actual ownership of the chemical
                    operations. In April 1987, a subsidiary of the shell corporation
                    was established in Hamburg, West Germany for the purpose of
                    acquiring materials from Imhausen, thus circumventing German
                    export laws. A shipping network was established to fake end-use
                    destinations and sell to Libya.
                       Reports later surfaced that Libya had constructed a chemical
                    weapons factory. Imhausen did not deny the plant’s existence, but
                    Imhausen, as well as the government of Libya, claimed that the
                    plant was being used for the manufacturer of medicinal drugs.
                    International treaties forbade the use of chemical and biological
                    weapons but did not restrict chemical weapons facility
                    construction. The international community faced a further
                    dilemma, as aerial observation could not distinguish between a
                    weapons plant and a pharmaceutical plant. Additionally, such
                    plants could easily be switched to legitimate use in a few days.
                       While construction of the plant did not violate German or
                    international law, the ease of conversion from legitimate use to
                    weapons production raised questions regarding the technical
                    knowledge transferred by Imhausen. You might question the class
                    as to Imhausen’s responsibility in the ultimate use of the plant,
                    despite the fact that the development of the shell corporation was a
                    positive NPV investment.

  20.6.   Exchange Rate Risk

Slide 20.31 Exchange Rate Risk
             A.     Short-Run Exposure
                                                                CHAPTER 20 A-279

                 Exchange rate risk – the risk of loss arising from fluctuations in
                 exchange rates

                 A great deal of international business is conducted on terms that
                 fix costs or prices, while at the same time calling for payment or
                 receipt of funds in the future. One way to offset the risk from
                 changing exchange rates and fixed terms is to hedge with a
                 forward exchange agreement. Another hedging tool is to use
                 foreign exchange options. An option will allow the firm to protect
                 itself against adverse exchange rate movements and still benefit
                 from favorable exchange rate movements.

                 Lecture Tip: According to The Wall Street Journal in 1993
                 (Currency Waves: Global Money Trends Rattle Shop Windows in
                 Heartland America,” November 26, 1993), a set of cultured pearls
                 that cost $899 a few years ago now costs $3,000 at a jewelry store
                 in Troy, OH. The average Japanese car costs approximately $2000
                 more than its American counterpart. A local soybean farmer uses
                 his satellite dish to keep track of commodity prices and currency
                 rates. These are all examples of how foreign exchange rates affect
                 the “average American.” The impact is even more pronounced
                 now than in 1993. Students often feel that world affairs are not
                 relevant to our daily lives. This example serves as an illustration
                 that we are all impacted by what happens around the world.

Slide 20.32 Short-Run Exposure
                 Lecture Tip: There were several earnings warnings for the third
                 quarter of 2000 by multinational firms. One of the biggest reasons
                 cited was the weak Euro relative to the dollar. A strong dollar
                 makes our products more expensive in Europe and reduces the
                 sales level by limiting the number of people that can afford to buy
                 the products. In contrast, the exact opposite occurred in late 2007
                 and early 2008.

           B.    Long-Run Exposure

                 Long-run changes in exchange rates can be partially offset by
                 matching foreign assets and liabilities, inflows and outflows.

Slide 20.33 Long-Run Exposure
           C.    Translation Exposure

Slide 20.34 Translation Exposure
A-280 CHAPTER 20

                      U.S. based firms must translate foreign operations into dollars
                      when calculating net income and EPS.

                      1. What is the appropriate exchange rate to use for translating
                      balance sheet accounts?
                      2. How should balance sheet accounting gains and losses from
                      foreign currency translation be handled?

                      FASB 52 requires that assets and liabilities be translated at the
                      prevailing exchange rates. Translation gains and losses are
                      accumulated in a special equity account and are not recognized in
                      earnings until the underlying assets or liabilities are sold or

              D.      Managing Exchange Rate Risk

                      For large multinational firms, the net effect of fluctuating exchange
                      rates depends on the firm’s net exposure. This is probably best
                      handled on a centralized basis to avoid duplication and conflicting

Slide 20.35 Managing Exchange Rate Risk
   20.7.   Political Risk

                      Blocking funds and expropriation of property by foreign
                      governments are among routine political risks faced by
                      multinationals. Terrorism is also a concern.

                      Financing the subsidiary’s operations in the foreign country can
                      reduce some risk. Another option is to make the subsidiary
                      dependent on the parent company for supplies; this makes the
                      company less valuable to someone else.

Slide 20.36 Political Risk

Slide 20.37 Quick Quiz

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