international corporate finance

1. International Corporate Finance
❖ Foreign Exchange Markets and Exchange Rates.
❖ Purchasing Power Parity.
❖ Interest Rate Parity, Unbiased Forward Rates, and the International Fisher Effect.
❖ International Capital Budgeting.
❖ Exchange Rate Risk.
❖ Political Risk.

2. Define how exchange rates are quoted, what they mean, and the difference between
spot and forward exchange rates.
Explain purchasing power parity, interest rate parity, unbiased forward rates,
uncovered interest rate parity, and the international Fisher effect and their implications
for exchange rate changes.
Illustrate the different types of exchange rate risk and ways firms manage exchange
rate risk.
Show the impact of political risk on international business investing.
2

3. Corporations with significant foreign operations are often called
international corporations or multinationals.
• Must consider many financial factors that do not directly affect
purely domestic firms.
Basic principles of corporate finance still apply to international
corporations.
• Net present value principle holds for both foreign and domestic
operations, although it is usually more complicated to apply the
NPV rule to foreign investments.
One of the most significant complications of international finance
is foreign exchange.
3

4. Foreign exchange market (that is forex or FX market) is the market in
which one country’s currency is traded for another country’s currency.
• OTC market, so market participants are located in the major commercial and
investment banks around the world.
Participants in the foreign exchange market include the following:
1. Importers who pay for goods using foreign currencies.
2. Exporters who receive foreign currency and may want to convert to the
domestic currency.
3. Portfolio managers who buy or sell foreign stocks and bonds.
4. Foreign exchange brokers who match buy and sell orders.
5. Traders who “make a market” in foreign currencies.
6. Speculators who try to profit from changes in exchange rates.
4

5. Exchange rate is the price of one
country’s currency expressed in
terms of another country’s currency.
Figure 1
• Second column gives number of
dollars it takes to buy one unit of
foreign currency (that is direct or
American quote).
• Third column shows indirect, or
European, exchange rate, which is the
amount of foreign currency per U.S.
dollar.
5
Country/Currency In US$ Per US$
Americas
Argentina peso .0167 60.0116
Brazil real .2391 4.1816
Canada dollar .7608 1.3145
Chile peso .001287 777.3
Colombia peso .000297 3365.07
Ecuador US dollor 1 1
Mexico peso .0532 18.7872
Uruguay peso .02678 37.34

6. Two basic types of trades in the foreign exchange market:
1. Spot trade is an agreement to trade currencies
based on the exchange rate today for settlement
within two business days.
• Exchange rate on a spot trade is called the spot
exchange rate.
2. Forward trade is an agreement to exchange currency
at some time in the future (normally within the next
12 months).
• Exchange rate that will be used is agreed upon
today and is called the forward exchange rate.
In Figure 2, spot exchange rate for the Swiss franc is SF 1 =
$1.0297 and 180-day forward exchange rate is SF 1 =
$1.0418.
• You can buy a Swiss franc today for $1.0297 or agree
to take delivery of a Swiss franc in 180 days (and pay
$1.0418 at that time.
Swiss franc is more expensive in the forward market
($1.0418 versus $1.0297), so it sells at a premium relative
to the dollar, while the dollar sells at a discount relative to
the Swiss franc.
6
Country/Curren
cy
In US$
Per
US$
Europe
Bulgaria lev .56382 1.774
Croatia kuna .1481 6.75
Czech Rep.
koruna
.04381 22.827
Denmark krone .1475 6.778
Euro area euro 1.1026 .9070
Hungary forint
.003279
12
304.96
Iceland krona .008025 124.61
Norway krone .1105 9.0484
Poland zloty .2590 3.8614
Romania leu .2306 4.336
Russia ruble .01611 62.073
Sweden krona .1045 9.5669
Switzerland
franc
1.0297 .9712
1 month 1.0317 .9693
3 month 1.0358 .9654
6 month 1.0418 .9599
Turkey lira .1684 5.9391
Ukraine
hryvnia
.0407 24.5652
UK pound 1.3074 .7649
1 month 1.3062 .7656
3 month 1.3069 .7663
6 month 1.3038 .7670

7. Suppose we observe the following for the euro (€) and the Swiss franc (SF):
 € per $1 = 1.00.
 SF per $1 = 2.00.
Suppose the cross-rate is quoted as:
 € per SF = .40.
This cross-rate is inconsistent with the exchange rates. Suppose you have $100. If you convert this to Swiss
francs, you will receive:
 $100 × SF 2 per $1 = SF 200.
If you convert this to euros at the cross-rate, you will have:
 SF 200 × €.4 per SF 1 = €80.
However, if you convert your dollars to euros without going through Swiss francs, you will have:
 $100 × €1 per $1 = €100.
7

8. What we see is that the euro has two prices, €1 per $1 and €.80 per $1, with the
price we pay depending on how we get the euros.
To make money, you need to buy low and sell high. Note that euros are cheaper if
you buy them with dollars because you get 1 euro instead of just .8. You should
proceed with triangle arbitrage:
1. Buy 100 euros for $100.
2. Use the 100 euros to buy Swiss francs at the cross-rate. Because it takes .4 euros to
buy a Swiss franc, you will receive €100/.4 = SF 250.
3. Use the SF 250 to buy dollars. Because the exchange rate is SF 2 per dollar, you receive
SF 250/2 = $125, for a round-trip profit of $25.
4. Repeat Steps 1 through 3.
8

9. Suppose the exchange rates for the British pound and Swiss franc are: Pounds per
$1 = .60
SF per $1 = 2.00
The cross-rate is three francs per pound. Is this consistent? Explain how to make
some money.
The cross-rate should be SF 2.00/£.60 = SF 3.33 per pound. You can buy a pound
for SF 3 in one market, and you can sell a pound for SF 3.33 in another. So, we
want to first get some francs, then use the francs to buy some pounds, and then
sell the pounds. Assuming you have $100, you could:
1. Exchange dollars for francs: $100 × 2 = SF 200.
2. Exchange francs for pounds: SF 200/3 = £66.67.
3. Exchange pounds for dollars: £66.67/.60 = $111.11.
This would result in an $11.11 round-trip profit.
9

10. Exchange Rate Determination
❖Explain how exchange rate movements are measured.
❖Explain how the equilibrium exchange rate is
determined.
❖Examine factors that determine the equilibrium
exchange rate.
❖Explain the movement in cross exchange rates.
❖Explain how financial institutions attempt to capitalize
on anticipated exchange rate movements.

11. 11
The two most commonly used methods for forecasting exchange rates are:
▪ Fundamental Approach: This is a forecasting technique that utilizes elementary
data related to a country, such as GDP, inflation rates, productivity, balance of
trade, and unemployment rate. The principle is that the ‘true worth’ of a
currency will eventually be realized at some point of time. This approach is
suitable for long-term investments.
▪ Technical Approach: In this approach, the investor sentiment determines the
changes in the exchange rate. It makes predictions by making a chart of the
patterns. In addition, positioning surveys, moving-average trend-seeking trade
rules, and Forex dealers’ customer-flow data are used in this approach.

12. 12
➢ Purchasing Power Parity theory is based on the premise that the same product cannot have different
prices in two different markets at any given point of time.
➢ This theory assumes restriction free movements of goods and absence of incidental costs such as
transportation. According to this theory, if a product costs Rs 150 in India and $ 2.5 in USA, then one
US dollar has to be equal to Rs 60. That is, a sum of Rs 60 has the same purchasing power as the sum
of $ 2.5.
➢ Depending on the principle, the PPP approach predicts that the exchange rate will adjust by offsetting
the price changes occurring due to inflation.
➢ For example, say the prices in India are predicted to go up by 4% over the next year and the prices in
USA are going to rise by only 2%. Then, the inflation differential between America and India is: 4% –
2% = 2%
➢ According to this assumption, the prices in India will rise faster in relation to prices in USA. Therefore,
the PPP approach would predict that the INR will depreciate by about 2% to balance the prices in
these two countries. So, in case the exchange rate was 60 INR per USD, the PPP would forecast an
exchange rate of:
(1+0.02) (60 INR per USD) = 61.2 INR per USD
So, it would now take 61.2 INR to buy one USD.
1

13. 13
Purchasing power parity (PPP) is the idea that the exchange rate adjusts to
keep purchasing power constant among currencies.
Basic idea behind absolute purchasing power parity is that a commodity
costs the same regardless of what currency is used to purchase it or where it
is selling.
Let S0 be the spot exchange rate between the British pound and the U.S.
dollar today (Time 0), and remember that we are quoting exchange rates as
the amount of foreign currency per dollar.
• Let PUS and PUK be the current U.S. and British prices, respectively, on a particular
commodity like apples.
• Absolute PPP says that the British price for something is equal to the U.S. price
for that same thing multiplied by the exchange rate:
PUK = S0 × PUS

14. 14
Suppose apples are selling in New York for $4 per bushel, whereas in London the price is
£2.40 per bushel.
Absolute PPP implies that:
PUK = S0 × PUS
£2.40 = S0 × $4.
Implied spot exchange rate is £.60 per dollar, so a pound is worth $1/£.60 = $1.67.
If actual exchange rate were less than £.60, a profit potential would exist, setting in motion
forces to change the exchange rate and/or the price of apples.
For absolute PPP to hold absolutely, several things must be true:
• Transactions costs of trading must be zero.
• No barriers to trading (for example tariffs, taxes, or other political barriers).
• Item being traded must be identical between the two countries.
0 0
S = /$4 = .6
£2 £
.40

15. 15
Relative purchasing power parity does not tell us what determines the absolute level of the
exchange rate, but rather what determines the change in the exchange rate over time.
Suppose the British pound–U.S. dollar exchange rate is currently S0 = £.50. Further suppose
that the inflation rate in Britain is predicted to be 10% over the coming year, and the inflation
rate in the U.S. is predicted to be zero. What do you think the exchange rate will be in a year?
• Price of a dollar will go up by 10%, and exchange rate should rise to.
If the inflation rate in the United States is not zero, then we need to worry about the relative
inflation rates in the two countries.
• Suppose the U.S. inflation rate is predicted to be 4%. Relative to prices in the U.S., prices in Britain are
rising at a rate of 10% − 4% = 6% per year. So, we expect the price of the dollar to rise by 6%, and.
the predicted exchange rate is.
5
.50 1. 5
1 .
 = £
£
.50 1.06 .
.53
 = £
£

16. 16
Relative PPP says the change in the exchange rate is determined by the difference in the
inflation rates of the two countries.
We will use the following notation:
• S0 = Current (Time 0) spot exchange rate (foreign currency per dollar).
• E(St) = Expected exchange rate in t periods.
• hUS = Inflation rate in the United States.
• hFC = Foreign country inflation rate.
Relative PPP says that the expected percentage change in the exchange rate over the next
year is
Essentially, relative PPP implies the expected percentage change in the exchange rate equals
the difference in inflation rates.
If we rearrange this slightly, we get:
1 0 0
E( )- / = ×
FC US
S S S h h
 
1 0
E( ) = × 1+ ( - )
FC US
S S h h

17. 17
Exchange rate will rise by hFC − hUS = 10% − 4% = 6% per year.
Assuming the difference in inflation rates doesn’t change, the expected exchange
rate in two years, E(S2), will be:
Notice that we could have written this as:
( ) ( ) ( )
2 1 1 .06
E S E S
=  +
.53 1.06
= 
.562
=
( )
2 .53 1.06
E S = 
( )
.50 1.06 1.06
=  
2
.50 1.06
= 
In general, relative PPP says the expected exchange rate at some
time in the future, E(St), is:
  .
0
E( ) = × 1+ ( - )
t
t FC US
S S h h

18. 18
Though this theory is conceptually sound, there are a number of factors which prevent it from predicting
exchange rate in practice. Some of the major factors in this regard are:
❖ Trade restrictions,
❖ Government restrictions on exchange rates,
❖ Continuation of long-term flows despite the disequilibrium between PPP and exchange rates,
❖ lack of definition of the relevant rate of inflation and price levels.
For example, it is important to establish whether price indices should be based on only those
commodities that are traded internationally or on all commodities.
The PPP takes into account only the movement of goods and not that of capital. In operational terms,
it is concerned only with the current account segment of BoP and not the total BoP. If a currency is an
instrument of payment for other countries, as is the case with the US dollar, then exchange rate may
evolve in a manner independent of price level of the country concerned, i.e. USA.
1

19. 19
▪ The relative economic strength model determines the direction of exchange rates by taking into
consideration the strength of economic growth in different countries. The idea behind this approach
is that a strong economic growth will attract more investments from foreign investors. To purchase
these investments in a particular country, the investor will buy the country's currency – increasing
the demand and price (appreciation) of the currency of that particular country.
▪ Another factor bringing investors to a country is its interest rates. High interest rates will attract more
investors, and the demand for that currency will increase, which would let the currency to
appreciate.
▪ Conversely, low interest rates will do the opposite and investors will shy away from investment in a
particular country. The investors may even borrow that country's low-priced currency to fund other
investments. This was the case when the Japanese yen interest rates were extremely low. This is
commonly called carry-trade strategy.
▪ If a country can achieve a successful balance of increased interest rates without an accompanying
increase in inflation, its currency's value and exchange rate is more likely to rise.
▪ The relative economic strength approach does not exactly forecast the future exchange rate like the
PPP approach. It just tells whether a currency is going to appreciate or depreciate.
2

20. 20
❖ The basic premise of this theory is that in an open economic system, the real future worth of a
monetary asset should be the same irrespective of the currency in which it is invested. As per Fisher,
the nominal rate of interest is related to real rate of interest and inflation by the equation:
(1 + n) = (1 + r) (1 + I) ; Where
n = nominal rate of interest
r = real rate of interest
I = rate of inflation
❖ Interest Rate Parity (IRP) is a theory in which the differential between the interest rates of two
countries remains equal to the differential calculated by using the forward exchange rate and the
spot exchange rate techniques. Interest rate parity connects interest, spot exchange, and foreign
exchange rates. It plays a crucial role in Forex markets.
❖ IRP theory comes handy in analyzing the relationship between the spot rate and a relevant forward
(future) rate of currencies. According to this theory, there will be no arbitrage in interest rate
differentials between two different currencies and the differential will be reflected in the discount or
premium for the forward exchange rate on the foreign exchange.
❖ The theory also stresses on the fact that the size of the forward premium or discount on a foreign
currency is equal to the difference between the spot and forward interest rates of the countries in
comparison.
2

21. 21
Interest rate parity (IRP) is the condition stating the interest rate differential
between two countries is equal to the percentage difference between the forward
exchange rate and the spot exchange rate, where the IRP condition is:
If we define the percentage forward premium or discount as (F1 − S0)/S0, then IRP
says that this percentage premium or discount is approximately equal to the
difference in interest rates:
Very loosely, IRP says any difference in interest rates between two countries for
some period is just offset by the change in relative value of the currencies, thereby
eliminating arbitrage possibilities.
In general, if we have t periods, the IRP approximation is written as:
2
1 0
/ (1 ) / (1 )
FC US
F S R R
= + +
1 0 0
( ) / FC US
F S S R R
− = −
 
0 1 ( ) .
t
t FC US
F S R R
=  + −

22. 22
Let us consider investing € 1000 for 1 year. As shown in the figure below, we'll have two options as
investment cases:
 Case I: Home Investment
In the US, let the spot exchange rate be $1.2245 / €1. So, practically, we get an exchange for our
€1000 @ $1.2245 = $1224.50.
We can invest this money $1224.50 at the rate of 3% for 1 year which yields $1261.79 at the end of
the year.
 Case II: International Investment
We can also invest €1000 in an international market, where the rate of interest is 5.0% for 1 year.
So, €1000 @ of 5% for 1 year = €1051.27
Let the forward exchange rate be $1.20025 / €1.
So, we buy forward 1 year in the future exchange rate at $1.20025/€1 since we need to convert our
€1000 back to the domestic currency, i.e., the U.S. Dollar.
Then, we can convert € 1051.27 @ $1.20025 = $1261.79
Thus, when there is no arbitrage, the Return on Investment (ROI) is equal in both cases, regardless
the choice of investment method.
Arbitrage is the activity of purchasing shares or currency in one financial market and selling it at a
premium (profit) in another.
2

23. 23
2

24. 24
2
According to Covered Interest Rate theory, the exchange rate forward premiums (discounts) nullify
the interest rate differentials between two sovereigns. In other words, covered interest rate theory
says that the difference between interest rates in two countries is nullified by the spot/forward
currency premiums so that the investors could not earn an arbitrage profit.
Example
Assume Yahoo Inc., the U.S. based multinational, has to pay the European employees in Euro
in a month's time. Yahoo Inc. can do this in many ways, one of which is given below:
❖Yahoo can buy Euro forward a month (30 days) to lock in the exchange rate. Then it can
invest this money in dollars for 30 days after which it must convert the dollars to Euro. This is
known as covering, as now Yahoo Inc. will have no exchange rate fluctuation risk.
❖Yahoo can also convert the dollars to Euro now at the spot exchange rate. Then it can invest
the Euro money it has obtained in a European bond (in Euro) for 1 month (which will have an
equivalently loan of Euro for 30 days). Then Yahoo can pay the obligation in Euro after one
month.
Under this model, if Yahoo Inc. is sure that it will earn an interest, it may convert fewer dollars
to Euro today. The reason for this being the Euro’s growth via interest earned. It is also known
as covering because by converting the dollars to Euro at the spot rate, Yahoo is eliminating
the risk of exchange rate fluctuation.

25. 25
2
If IRP theory holds, then it can negate the possibility of arbitrage. It means that even if investors
invest in domestic or foreign currency, the ROI will be the same as if the investor had originally
invested in the domestic currency.
❑ When domestic interest rate is below foreign interest rates, the foreign currency must trade at a
forward discount. This is applicable for prevention of foreign currency arbitrage.
❑ If a foreign currency does not have a forward discount or when the forward discount is not large
enough to offset the interest rate advantage, arbitrage opportunity is available for the domestic
investors. So, domestic investors can sometimes benefit from foreign investment.
❑ When domestic rates exceed foreign interest rates, the foreign currency must trade at a forward
premium. This is again to offset prevention of domestic country arbitrage.
❑ When the foreign currency does not have a forward premium or when the forward premium is not
large enough to nullify the domestic country advantage, an arbitrage opportunity will be available for
the foreign investors. So, the foreign investors can gain profit by investing in the domestic market.

26. 26
2
What is the connection between the forward rate and the expected future spot
rate?
Unbiased forward rates (UFR) is the condition stating that the current forward rate
is an unbiased predictor of the future spot exchange rate [that is the forward rate,
F1, is equal to the expected future spot rate, E(S1)]:
F1 = E(S1)
With t periods, UFR would be written as:
Ft = E(St)
UFR condition says that, on average, forward exchange rate equals future spot
exchange rate.
• If we ignore risk, the UFR condition should hold.
• UFR condition may not hold if traders are willing to pay a premium to avoid the
uncertainty of what the future spot rate will be.

27. 27
Recall the following market relationships:
Because we know F1 = E(S1) from the UFR condition, we can substitute E(S1)
for F1 in IRP.
• Result is the uncovered interest parity (UIP), the condition stating the expected
percentage change in the exchange rate is equal to the difference in interest
rates:
With t periods, UIP becomes:
 
1 0
: ( ) 1 ( )
FC US
PPP E S S h h
=  + −
 
1 0
: 1 ( )
FC US
IRP F S R R
=  + −
1 1
: ( )
UFR F E S
=
 
1 0
: ( ) 1 ( )
FC US
UIP E S S R R
=  + −
 
0
( ) 1 ( )
t
t FC US
E S S h h
=  + −

28. 28
International Fisher effect (IFE) is the theory that real interest rates are
equal across countries:
Note the following:
1. We haven’t explicitly dealt with risk in our discussion.
2. Many barriers exist to the movement of money and capital around the world.
• Real returns might be different in two different countries for long periods of time if
money can’t move freely between them.
US US FC FC
R H R H
− = −

29. 29
Kihlstrom Equipment, a U.S.-based international company, is evaluating an overseas
investment. Kihlstrom’s exports of drill bits have increased to such a degree that it is
considering building a distribution center in France. The project will cost €2 million
to launch. The cash flows are expected to be €.9 million per year for the next three
years.
The current spot exchange rate for euros is €.5. Recall that this is euros per dollar, so
a euro is worth $1/€.5 = $2. The risk-free rate in the United States is 5%, and the
risk-free rate in “Euroland” is 7%. Note that the exchange rate and the two interest
rates are observed in financial markets, not estimated. Kihlstrom’s required return
on dollar investments of this sort is 10%.
Should Kihlstrom take this investment?
• Answer depends on the NPV.

30. 30
Two basic methods to calculate NPV of this project in U.S. dollars:
1. Home currency approach: Convert all the euro cash flows into dollars, and then
discount at 10% to find the NPV in dollars.
• Notice this approach requires us to come up with future exchange rates to convert the
future projected euro cash flows into dollars.
2. Foreign currency approach: Determine the required return on euro investments,
and discount the euro cash flows to find the NPV in euros. Then convert this
euro NPV to a dollar NPV.
• This approach requires us to somehow convert the 10% dollar required return
to the equivalent euro required return.
Difference between these two approaches is primarily a matter of when we
convert from euros to dollars.
• In the first case, we convert before estimating the NPV, whereas, in the second
case, we convert after estimating NPV.

31. 31
Substantial differences can exist between the cash flows generated by a
foreign project and the amount that can actually be remitted, or
“repatriated,” to the parent firm.
Foreign subsidiary can remit funds to a parent in many forms, including the
following:
1. Dividends.
2. Management fees for central services.
3. Royalties on the use of trade names and patents.
May be current and future controls on remittances.
• Many governments are sensitive to being exploited by foreign national firms, and
in those cases, governments are tempted to limit the ability of international firms
to remit cash flows.
• Funds that cannot currently be remitted are said to be blocked.

32. 32
EXCHANGE RATE RISK: SHORT-RUN
EXPOSURE
Exchange rate risk is the risk related to having international operations in a
world where relative currency values vary.
Short-run exposure is characterized by day-to-day fluctuations in exchange
rates creating short-run risks for international firms.
Imagine you are importing imitation pasta from Italy and reselling it in the
U.S. under the Impasta brand name. Your largest customer has ordered
10,000 cases of Impasta. You place the order with your supplier today, but
you won’t pay until the goods arrive in 60 days. Your selling price is $6 per
case. Your cost is 8.4 euros per case, and the exchange rate is currently
€1.50; so it takes 1.50 euros to buy $1.
• At current exchange rate, your cost in dollars of filling the order is €8.4/1.5 =
$5.60 per case, so your pretax profit is 10,000 × ($6 − 5.60) = $4,000.
• Exchange rate in 60 days may be different, so your actual profit will depend on
what the future exchange rate turns out to be.

33. 33
EXCHANGE RATE RISK: SHORT-RUN
EXPOSURE
If the rate goes to €1.6, your cost is €8.4/1.6 = $5.25 per case,
and your profit goes to $7,500.
If the exchange rate goes to €1.4, then your cost is €8.4/1.4 =
$6, and your profit is zero.
Short-run exposure can be reduced or eliminated in several
ways:
• Entering into a forward exchange agreement to lock in an exchange
rate.
• Borrowing the dollars today, converting them into euros, and
investing the euros for 60 days to earn some interest.

34. 34
EXCHANGE RATE RISK: LONG-RUN
EXPOSURE
Long-run exposure is characterized by fluctuations in the value of a
foreign operation because of unanticipated changes in relative
economic conditions.
Hedging long-run exposure is more difficult than hedging short-term
risks.
• Organized forward markets don’t exist for such long-term needs.
Primary option firms have to reduce long-run exchange risk is to try to
match up foreign currency inflows and outflows.
• Example: Transplant auto manufacturers (for example BMW, Honda,
Mercedes, and Toyota) build a substantial portion of the cars they sell in
the U.S., thereby obtaining some degree of immunization against
exchange rate movements.
Firms can also reduce long-run exchange rate risk by borrowing in the
foreign country.

35. 35
EXCHANGE RATE RISK: TRANSLATION
EXPOSURE
When a U.S. company calculates its accounting net income and EPS for some
period, it must “translate” everything into dollars.
This creates problems for the accountants when there are significant foreign
operations due to the following two issues:
1. What is the appropriate exchange rate to use for translating each balance sheet
account?
2. How should balance sheet accounting gains and losses from foreign currency
translation be handled?
• Current approach to handling translation gains and losses is based on rules set
out in the Financial Accounting Standards Board (FASB) Statement of Financial
Accounting Standards No. 52 (FASB 52), issued in December 1981.
• FASB 52 generally requires that all assets and liabilities be translated from the
subsidiary’s currency into the parent’s currency using the exchange rate that
currently prevails.

36. 36
MANAGING EXCHANGE RATE RISK
For a large multinational firm, management of exchange rate risk is
complicated because there may be many different currencies involved in
many different subsidiaries.
Suppose a firm has two divisions:
• Division A buys goods in the U.S. for dollars and sells them in Britain for pounds,
while Division B buys goods in Britain for pounds and sells them in the U.S. for
dollars.
• Firm’s net position in pounds (that is amount coming in less amount going out) is
small, so exchange rate risk is small.
• If one division, acting on its own, started hedging its exchange rate risk, the
overall firm’s exchange rate risk would go up.
Multinational firms must be conscious of their overall positions in a
foreign currency; as such, management of exchange rate risk is probably
best handled on a centralized basis.

37. 37
POLITICAL RISK
Political risk is the risk related to changes in value that arise because of political
actions (for example “Brexit”).
• Tax laws are a form of political risk faced by multinational firms.
Before the signing of the Tax Cuts and Jobs Act of 2017, U.S. had corporate tax rates
among the highest in the developed world.
• U.S. was unique in that it taxed corporate profits only after they were brought back, or
“repatriated,” to the U.S., resulting in a strong incentive for U.S. companies not to repatriate
profits.
Tax Cuts and Jobs Act of 2017 changed things in several ways:
• New flat 21% tax rate (down from maximum of 35%) reduced incentive to leave cash
overseas.
• Law imposed a one-time tax of 15.5% on cash, securities, and receivables, and a one-time
tax of 8% on other, less liquid assets purchased with untaxed overseas dollars.
• Broadly speaking, new repatriated earnings are no longer subject to additional U.S. taxes,
thereby eliminating the repatriation issue.

38. 38
MANAGING POLITICAL RISK
Some countries have more political risk than others.
• Extra political risk may lead firms to require higher returns on overseas
investments to compensate for possibility that funds may be blocked, critical
operations interrupted, and contracts abrogated.
• Possibility of outright confiscation may be a concern in countries with relatively
unstable political environments.
Political risk also depends on the nature of the business.
Political risk can be hedged in several ways, particularly when confiscation or
nationalization is a concern.
1. Use of local financing reduces possible loss because company can refuse to pay
debt in the event of unfavorable political activities.
2. Structuring the operation in such a way that it requires significant parent
company involvement to function.

39. 39
Change in the Equilibrium Exchange Rate
▪ Increase in demand schedule: Banks will increase the
exchange to the level at which the amount demanded is equal
to the amount supplied in the foreign exchange market.
▪ Decrease in demand schedule: Banks will reduce the
exchange to the level at which the amount demanded is equal
to the amount supplied in the foreign exchange market.
▪ Increase in supply schedule: Banks will reduce the exchange
to the level at which the amount demanded is equal to the
amount supplied in the foreign exchange market.
▪ Decrease in supply schedule: Banks will increase the exchange
to the level at which the amount demanded is equal to the
amount supplied in the foreign exchange market.

40. 40

41. 41
rates
exchange
future
of
ns
expectatio
in
change
controls
government
in
change
level
income
s
country'
foreign
the
and
level
income
U.S.
e
between th
al
differenti
in the
change
rate
interest
s
country'
foreign
the
and
rate
interest
U.S.
e
between th
al
differenti
in the
change
inflation
s
country'
foreign
the
and
inflation
S.
between U.
al
differenti
in the
change
rate
spot
in the
change
percentage
where
)
,
,
,
,
(
=

=

=
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=

=
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=
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



=
EXP
GC
INC
INT
INF
e
EXP
GC
INC
INT
INF
f
e
The equilibrium exchange rate will change over time as
supply and demand schedules change.

42. 42
SELECTED CONCEPT QUESTIONS
• What are the differences between a Eurobond and a foreign bond?
• What do we mean by the 90-day forward exchange rate?
• What does absolute PPP say? Why might it not hold for many types of
goods?
• What is the international Fisher effect?
• What financial complications arise in international capital budgeting?
Describe two procedures for estimating NPV in the case of an
international project.
• How can a firm hedge short-run exchange rate risk? Long-run exchange
rate risk?
• What is political risk?