Foundations of Finance

Tenth Edition

Chapter 16
International Business Finance

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Learning Objectives
16.1 Discuss the internationalization of business.
16.2 Explain how to read foreign exchange rate quotes and
why they matter.
16.3 Discuss the concept of interest rate parity.
16.4 Explain the purchasing-power parity theory and the law
of one price.
16.5 Discuss the risks that are unique to the capital-
budgeting analysis of direct foreign investment.

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The Globalization of Product and
Financial Markets

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Product and Financial Market
Globalization
• Direct foreign investment (DFI) occurs when a company
from one country makes a physical investment, such
building a manufacturing facility, in another country. A
major reason for increase in DFI by U.S. companies is the
high rate of return available in other countries.
• Capital flows (portfolio investment) between countries
has also been increasing and is motivated by the
possibility of obtaining higher returns and/or reducing
portfolio risk through international diversification.

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Foreign Exchange Markets and
Currency Exchange Rates

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The Foreign Exchange Market (1 of 2)
• The foreign exchange (FX) market is by far the world’s
largest financial market, with daily trading volumes of more
than $5 trillion.
• Trading in this market is dominated by few key currencies
including the U.S. dollar, the British pound sterling, the
Japanese yen, and the euro.

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The Foreign Exchange Market (2 of 2)
• The foreign exchange market is an over-the-counter
market with participants (buyers and sellers) located in
major commercial and investment banks around the world.

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Table 16.1 The Market for Foreign
Exchange: Most Traded Currencies

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Foreign Exchange Market
• Some of the 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
– Currency traders who make a market in one or more
foreign currencies

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Business Implications
• Exchange rates changed dramatically in 2014 and 2015
for several possible reasons:
– Relative strengthening of U.S. economy
– Expectations of interest rate changes in Europe
– Uncertainty surrounding a possible Greek default
– Plummet of oil prices and sanctions during the
Ukrainian crisis
• Stronger dollar means U.S. goods become more
expensive for foreigners.

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Reading Exchange Rate Quotes
(1 of 2)

• Exchange rate
– The price of one currency stated in terms of another.
– For example, if the exchange rate of U.S. dollars for
euro is 1.19 to 1, this means that it would take $1.19 to
purchase one euro.

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Table 16.2 Foreign Exchange Rates
(May 8, 2018)

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Reading Exchange Rate Quotes
(2 of 2)

• A country’s relative economic strengths, trade balance,

level of monetary activity, and balance of payments (BOP)
are important determinants of exchange rates.
• Short-term day-to-day fluctuations in exchange rates are
caused by changing supply and demand conditions in the
foreign exchange market.

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Direct and Indirect Quote
• Direct Quote
– Indicates the number of units of the home currency
required to buy one unit of the foreign currency
– Example: 1.3646 dollars per British pound
• Indirect Quote
– Indicates the number of units of a foreign currency that
can be bought for one unit of the home currency. It is
the reciprocal of direct quote.
– Example:

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Exchange Rates and Arbitrage
• Foreign exchange quotes in two different countries must
be in line with each other.
• If the exchange rates are out of line, then a trader could
make a profit by buying in the market where the currency
was cheaper and selling it in the other.
• The process of buying and selling in more than one
market to make a riskless profit is called arbitrage. Such
opportunities do not exist for a long time due to arbitrage
process.

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Asked and Bid Rates
• Bid: Rate at which bank buys foreign currency from a
customer
• Ask: Rate at which bank sells foreign currency to a
customer
• The difference between the asked quote and the bid quote
is known as the bid-asked spread.

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Cross Rates
• A cross rate is the exchange rate between two foreign
currencies, neither of which is the currency of the
domestic country.

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Table 16.3 Key Currency Cross
Rates, Thursday, May 8, 2018

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Spot Exchange Rate
• Exchange rates and transactions meant for immediate
delivery are called spot exchange rates.

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Forward Exchange Contract
• A forward exchange contract requires delivery, at a
specified future date, of one currency for a specified
amount of another currency.
• The exchange rate for the future is agreed today and is
known as the forward rate. The actual payment of one
currency and receipt of another currency take place on a
future date called the delivery date.

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Forward Exchange Contract Example
• Forward contracts are usually quoted for periods of 30, 90,
and 180 days.
• If the 30-day forward quote for euros is $1.30, it means
that the bank is contractually bound to deliver a euro at
$1.30 and the customer is bound to buy a euro at $1.30,
regardless of the actual spot rate.

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Table 16.4 U.S.-Dollar Forward
Exchange Rates

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Exchange Rate Risk (1 of 2)
• The risk that tomorrow’s exchange rate will differ from
today’s rate
• Exchange rate risk affects
– International trade contracts
– Foreign portfolio investments
– Direct foreign investment

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Exchange Rate Risk in International
Trade Contracts (1 of 3)
• Example: You are expecting to receive €1m next year
from exports.
• The future value of euros in dollars is uncertain and
depends on future exchange rate.
• If € = $1.25, you will receive $1.25m, but if the euro
depreciates to $0.90, your contract is worth only $0.9m.

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Exchange Rate Risk in International
Trade Contracts (2 of 3)
• The future return on portfolio is unknown as investments in
securities is a risky investment. Thus, investing in euro
market securities could yield −5 percent or +10 percent. In
addition, the investor is exposed to U.S. $/euro exchange
rate fluctuation.
• Thus, if the euro investment yields 10 percent, but the
euro depreciates during the period, the net return will be
less than 10 percent, depending on the extent of euro
depreciation.

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Exchange Rate Risk in International
Trade Contracts (3 of 3)
• In a DFI, parent company invests in assets denominated
in foreign currency. The U.S.-based parent company
receives the repatriated (or converted) profit stream from
the subsidiary in dollars.
• Thus, exchange rate risk arises due to several reasons:
– Fluctuations in the dollar value of the assets located
abroad
– Fluctuations in the home currency-denominated profit
stream
– Possible effect on future profit stream

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Interest Rate Parity

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Interest Rate Parity Theory
• IRP theory can be used to relate differences in the interest rates
in two countries to the ratio of spot and forward exchange rates
of the two countries’ currencies. The I RP condition can be
stated as follows:

This equation can be rearranged as follows:

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Purchasing-Power Parity and the
Law of One Price

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Purchasing-Power Parity Theory
(PPP)
• According to PPP, exchange rates adjust so that
identical goods cost the same amount regardless of
where in the world they were purchased.

• For example, if an Apple iPad costs $399 in the United

States and €353.10 in France, according to PPP, the
spot exchange rate should be $1.13 per euro
Thus, an iPad will cost the same whether it is bought
in the United States or France.

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Law of One Price
• The law of one price implies that the same goods should
sell for the same price in different countries after making
adjustment for the exchange rate between the two
currencies.
• Thus, if a Big Mac costs $2 in U.S. dollars and the
exchange rate with the British pound is £1 = $2, a Big Mac
should cost £1 in Britain.

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The International Fisher Effect
• International Fisher Effect states that the real interest rate
should be the same all over the world, with the differences
in nominal rate resulting from differences in expected
inflation rates.

• Thus, investing in a foreign bank with the highest interest

rate may simply mean investing in a country with the
highest rate of inflation.

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Capital Budgeting for Direct
Foreign Investment

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Capital Budgeting for DFI
• The method used by multinational corporations to evaluate
foreign investments is very similar to the method used to
evaluate domestic investments.
• Because there might be repatriation restrictions,
evaluations of these investments must focus on after-tax
cash flows that can be repatriated. Firms may be subject
to taxes in both the home country and foreign country.

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Foreign Investment Risks
• The decision process for DFI is similar to capital budgeting
decisions in the domestic context.
• Risks in domestic capital budgeting arise from two
sources:
– Business risk
– Financial risk
• In international capital budgeting problem, we also have to
incorporate political risk and exchange rate risk.

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Political Risk
• Political risk arises because the foreign subsidiary
conducts business in a political system different from that
of the home country.
• Some examples of such risk include the following:
– Expropriation of assets without compensation
– Nonconvertibility of the subsidiary’s foreign earnings
into the parent’s currency
– Changes in the laws governing taxation
– Restrictions on sale price, wage rates, local borrowing,
extent of local ownership, hiring of personnel, transfer
payments made to the parent

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Exchange Rate Risk (2 of 2)
• As observed before, exchange rate risks can have
significant effect on cash flows and earnings.

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Key Terms (1 of 3)
• Arbitrage
• Arbitrageur
• Asked rate
• Bid-asked spread
• Bid rate
• Cross rate
• Delivery date
• Direct foreign investment (DFI)

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Key Terms (2 of 3)
• Direct quote
• Eurodollars
• Exchange rate
• Foreign exchange (FX) market
• Forward exchange contract
• Forward exchange rate
• Forward-spot differential
• Indirect quote

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Key Terms (3 of 3)
• Interest rate parity (IRP) theory
• Law of one price
• Multinational corporation (MNC)
• Purchasing-power parity (PPP) theory
• Repatriation of profits
• Spot exchange rate

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