Chapter
Exchange Rate Determination and Forecasting
QUESTIONS
1. What is the difference between the ex ante and the ex post real interest rate?

10

Answer: The ex post interest rate corrects the nominal interest rate with the realized or ex post rate of inflation; whereas the ex-ante (or expected) real interest rate corrects the nominal interest rate for expected inflation. As a lender, you care about the real return on your investment, which is the return that measures your increase in purchasing power between two periods of time. If you invest $1, you sacrifice

$1 1+i real goods now, where P(t) is the price level. In 1 year, you get back , where i is the P(t) P(t+1) nominal rate of interest. We calculate the real return by dividing the real amount you get back by the real amount that you invest. Thus, if rep is the ex post real rate of return and ex post real interest rate, we have

1 + r ep

⎛ 1+i ⎞ ⎜ P(t+1) ⎟ ⎠ = (1 + i ) = ⎝ ⎛ 1 ⎞ ⎛ P(t+1) ⎞ ⎜ P(t) ⎟ ⎜ P(t) ⎟ ⎝ ⎠ ⎝ ⎠

Notice that the real rate of interest depends on the realization of the rate of inflation because P(t + 1)/P(t) = 1 + π(t + 1), where π(t + 1) is the rate of inflation between time t and t + 1. For simplicity, we drop the time notation and simply write

1 + r ep =
If we subtract 1 from each side, we have

(1 + i) (1 + π)

r ep = which is often approximated as

(1 + i) (1 + π) i-π = (1 + π) (1 + π) (1 + π)

rep = i – π The approximation involves ignoring the term (1 + π) in the denominator, which is close to 1 if inflation is not too high. Thus, the ex post real interest rate equals the nominal interest rate minus the actual rate of inflation. Because the inflation rate is uncertain at the time an investment is made, the lender cannot know with certainty the real rate of return on the loan. By taking the expected value of both sides of the equation, conditional on the information set at the time of the loan, we derive the lender’s expected real rate of return, which is also called the expected real interest rate, or the ex ante real interest rate, which we denote re:

r e = E t [r ep ] = i(t) - E t [π(t+1)]

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2. Suppose that the international parity conditions all hold and a country has a higher nominal interest rate than the United States. Characterize the country’s inflation rate compared to the United States, the country’s expected exchange rate change versus the dollar, the country’s currency forward premium (or discount) versus the dollar, and the country’s real interest rate compared to the U.S. real interest rate. Answer: When all the parity conditions hold, real interest rates are equalized across countries, so the country’s real interest rate should equal that of the United States. The country’s higher nominal interest rate therefore must reflect a higher expected rate of inflation relative to the United States. Since the parity conditions hold, a higher expected rate of inflation implies that country’s currency should be expected to depreciate relative to the dollar, and the currency will trade at a forward discount relative to the dollar.

3. How do fundamental analysis and technical analysis differ? Answer: Fundamental analysis typically uses formal economic models of exchange rate determination and macroeconomic fundamental data such as money supplies, inflation rates, productivity growth rates, and the current account to predict exchange rates. Technical analysis uses only past exchange rate data, and perhaps some other financial data, such as the volume of currency trade, to predict future exchange rates.

4. Would technical analysis be useful if the international parity conditions held? Why or why not? Answer: If the parity conditions held, technical analysis would not be useful in the sense of providing profitable trading information or information about expected exchange rates that could not be obtained elsewhere. If the parity conditions held, the best predictor of the future exchange rate would be the forward rate, and exchange rate forecasts based on other indicators would not lead to systematic profits on currency speculation.

5. Describe three statistics you should obtain from a currency-forecasting service in order to judge the quality of its currency forecasts. Answer: Three important statistics are the Root Mean Squared Error (RMSE) or Mean Absolute Deviation of its forecasting record, which would provide information on accuracy; the percentage of times they were on the correct side of the forward rate, which would provide useful information on the profitability, and a risk–return statistic (such as the Sharpe ratio), which would provide a characterization of the profitability of using their forecasts in a real time trading strategy. 6. Does a large increase in the domestic money supply always lead to a depreciation of the currency? Answer: Most theories of the determination of exchange rates would predict that a large increase in the money supply would imply a depreciation of the currency, definitely in the long run, and especially as economists say when “everything else is equal.” However, it is possible that the change in the money supply is accompanied by an increase in real income that increases the demand for money and thus offsets the money supply’s effect on the exchange rate.

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7. Is a current account deficit always associated with a strong real exchange rate (that is, one that is overvalued compared to the PPP prediction)? Answer: Not necessarily. It is best to view the current account and the real exchange rate as being determined in an equilibrium that depends on many forces, such as movements in net foreign assets, government spending, productivity growth, and the expectations and risk tolerances of domestic and foreign investors.

8. Describe how three macroeconomic fundamentals affect exchange rates. Answer: According to the monetary exchange rate model, the domestic currency weakens (strengthens) if the domestic (foreign) money supply increases today or if news arrives that leads people to believe that the future domestic (foreign) money supply will increase. The domestic currency also weakens if domestic real income falls, if foreign real income rises, or if news arrives that causes people to expect lower domestic real growth or faster foreign real growth. Finally, according to the equilibrium theory regarding the real exchange rate and the current account, an increase in government spending or a decrease in taxes that causes a budget deficit should increase the real exchange rate (and hence likely also the nominal exchange rate). This is because an increase in government spending increases aggregate demand in the economy, which causes the real interest rate to rise. The rise in the interest rate reduces investment and encourages private saving 9. Which simple statistical model yields some of the best exchange rate predictions available? What does this imply for the value of models of exchange rate determination to multinational businesses? Answer: It is surprisingly difficult to beat the forecasts of the random walk model. This model uses the current exchange rate as the predictor of the future exchange rate. If this model provided the best forecast, the unbiasedness hypothesis (which says the forward rate is the best predictor) would be violated. If there were a forward premium on the foreign currency, the forward rate would be above the expected future spot rate, and you would want to sell the foreign currency in the forward market.

10. What is chartism? Answer: Chartists graphically record the actual trading history of an exchange rate and then try to infer possible future trends based on that information alone.

11. What is an x% filter rule? Answer: An x% rule states that you should go long in the foreign currency (buy) after the foreign currency has appreciated relative to the domestic currency by x% above its most recent trough (or support level) and that you should go short in the foreign currency (sell) whenever the currency falls x% below its most recent peak (or resistance level). Common x% filter rules are 1% or 2%.

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12. What is a moving-average crossover rule? Answer: Moving-average crossover rules use moving averages of the exchange rate to indicate trade directions. An n-day moving average is just the sample average of the last n trading days, including the current rate. A (y, z) moving-average crossover rule uses averages over a short period (y days) and over a long period (z days). The strategy states that you should go long (short) in the foreign currency when the short-term moving average crosses the long-term moving average from below (above). Common rules use 1 and 5 days (1, 5), 1 and 20 days (1, 20), and 5 and 20 days (5, 20).

13. Have forecasting services been successful in forecasting exchange rates? Answer: The direct evidence on the forecasting prowess of forecasting services is rather dated by now (see, for example, a 1987 study by Robert Cumby and David Modest), but the results of these studies suggested that most forecasting services were more often wrong than correct, but that most did make profits. Academic studies have suggested that it has become more difficult to forecast currency movements based on technical signals more recently relative to the 1980s; but it is possible that other models may do better.

14. Are devaluations of pegged exchange rates totally unexpected? Answer: While there is a debate about their predictability, some theories suggest that devaluations may be partially predictable. These models argue that growing budget deficits, fast money growth, and rising wages and prices usually precede devaluations. Increases in nominal interest rates typically reflect a combination of the probability and magnitude of a possible devaluation.

15. Construct a list of a country’s economic statistics you would assemble to help determine the probability of a devaluation of its currency within the coming year. Answer: Based on theoretical and empirical work, the following economic variables should prove useful predictors: PPP-based measures of currency overvaluation, current account balances and monetary growth rates. In addition, if liquid financial markets exist, information about forward rates or interest rates, currency option prices, and so on may prove useful in terms of forecasting devaluations.

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PROBLEMS
1. Suppose the 1-year nominal interest rate in Zooropa is 9%, and Zooropa’s expected inflation rate is 4%. What is the real interest rate in Zooropa? Answer: The expected real interest rate is approximately 9% - 4% = 5%. The correct computation is: (1 + 0.09) / (1 + 0.04) – 1 = 0.0481 or 4.81%.

2. You were recently hired by the Doolittle Corporation corporate treasury to help oversee its expansion into Europe. Blake Francis, the CFO, wants to hire a foreign exchange forecasting company. Blake has asked you to evaluate three different companies, and he has obtained information on their past performances. Out of a total of 50 forecasts for the $/€ rate, the companies reported the number of times they correctly forecast appreciations and depreciations: Correct Down Forecasts 20 20 12 Correct Up Forecasts 5 4 12

Morrissey Forex Advisors Pixie Exchange Land FOREX Cures

There are a total of 35 dollar appreciations (down periods) and 15 dollar depreciations (up periods) in the sample. Blake wants to know two things: a. Can anything be said about the companies’ forecasting ability with the available data? Answer: Yes, one can compute the number of correct “directional” forecasts. Morrissey has the highest correct proportion with 25 out of 50 correct, whereas the other firms have less than 50% correct. However, note that the dollar over this period was relatively strong and appreciations (down forecasts for the $/€ rate) dominate. Hence, forecasts in the down period may be more useful (see footnote 3 in the chapter). If we look at correct conditional forecasts, we see that Morrissey is correct 20/35 or 57.14% of the time when the dollar appreciates, but only 5/15 or 33.33% of the time when the dollar depreciates. According to the Henriksson–Merton test, the sum of these two proportions should be over 1 for a firm to have market timing ability. However, the sum in this case is only 90.47%. While Morrissey obviously dominates Pixie Land Exchange, it is not clear that it is better than FOREX Cures. The proportions of correct conditional forecasts of FOREX Cures are 12/35 (34.29%) and 12/15 (80%) for a sum of 114.29%. Consequently, only FOREX Cures shows directional forecasting ability. b. What additional information should Blake try to obtain in order to form a better judgment? Answer: Directional forecasting ability in the foreign exchange market is not particularly useful if the forecasts are to be used in speculative strategies. To this end, it would have been more useful to know whether the forecasting firms were on the correct side of the forward rate. Ideally, a full record of forecasts would be obtained. Then, accuracy statistics (like the RMSE) and profitability statistics (like the Sharpe ratio) could be computed.

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3. Mini-Case: Currency Turmoil in Zooropa Fad Gadget has never worked so hard in his entire life. It is near midnight, and he is still poring over statistics and tables. Fad recently joined Smashing Pumpkins, a relatively young but fast-growing British firm. Smashing Pumpkins produces and distributes an intricate device that turns fresh pumpkins into pumpkin pie in about 30 minutes. Recently, the firm has started exporting to Zooropa. Some of the largest and tastiest pumpkins are grown in Zooropa, and Zooropa’s population boasts the highest per capita pumpkin consumption in the world. A recent analysis of the pumpkin market in Zooropa has left the company’s senior managers very impressed with the profit potential. Although Zooropa consists of 10 politically independent countries, their currencies are linked through a system called the Currency Rate Linkage System (CRLS) that works exactly like the former Exchange Rate Mechanism (ERM) of the EMS worked before the currency turmoil started in September 1992. The anchor currency is the banshee of Enigma, the leading country in Zooropa. Initial contacts with importers in Zooropean countries indicated that they typically insist on payment in their own local currency. About a week ago, Cab Voltaire, the CEO of Smashing Pumpkins, expressed concerns about this development and asked Fad to lead a research team to further examine the present state of the currency system of Zooropa. Cab viewed the outlook for the banshee relative to the pound quite favorably and did not predict any substantial depreciation of the banshee against any other major currency. However, the precarious economic situation of some of the countries in Zooropa and the growing importance of speculative pressures in Zooropa’s currency markets last week suddenly made him suspicious about the possibility of realignments within the system. He even doubted the longterm viability of the system. Cab instructed Fad to examine the following issues: Which currencies in the system exhibit the highest realignment risk? If a currency realigns and gets devalued, what are the effects on our sales and profit margins in this particular country? Can we take the realignment possibility into account in our pricing? Suppose a currency is forced to leave the CRLS. What are the effects on exchange rates, interest rates, and the outlook for sales in that country? What is the likelihood of this occurring for the different countries? Fad Gadget felt nervous. A meeting was scheduled with Cab the day after tomorrow. He wanted to write a thorough and insightful report. At the last management meeting, he had the uneasy feeling that some senior managers doubted his abilities. Some managers were naturally suspicious of a young Australian newcomer with his MBA. His earring and punk hairdo did not exactly help either. His team of analysts had already assembled a table with relevant macroeconomic and financial data (see Exhibit 10.11). “If only I could use this to rank the different countries according to realignment risk,” he thought. a) Realignment rankings The data provided are a scrambled version of an Exhibit that appeared in the Economist of September 19, 1992, when a currency crisis in Europe had just erupted. The Exhibit presented macroeconomic statistics for all the countries participating in the European system. To prevent students guessing where the data are from, we scrambled the country names two ways. First, we gave each European country another name that did provide a vague hint on the actual European country of origin. However, we then randomly assigned the actual data to the fictitious countries. Here is the “key:”

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Zooropa Country Sinead Carmen Marquee Fries Ney HelpIsink Benfica Che Ora Vachement Enigma

Reference to European Country Ireland (Irish singer) Carmen (Spanish opera) UK (club in London) Belgium (French fries are Belgian!) Denmark (No in Danish) the Netherlands (below sea level) Portugal (soccer team) Italy (only Italian Geert knows) France (French stop word) Germany (pop band)

Data from European country Ireland France Spain Portugal Denmark Belgium the Netherlands UK Italy Germany

We now reproduce the original Economist table from the article “A Ghastly Game of Dominoes.” Who’s Next? Legend for Chart: A - Currency's ERM position Sept 15th (*) B - Currency's over/under valuation, % (A) C - Reserves, import cover (**) D - Budget deficit as % of GDP, 1992 (B) E - Inflation rate %, latest F - GDP growth, %, 1992 (B) G - Devaluation risk (AA) A 27 -90 16 -3 -22 31 30 -36 -6 36 B 2 3 11 11 -2 -18 -16 -12 -10 -C 0.5 2.6 8.2 11.7 2.5 1.3 1.5 3.1 2.9 1.7 D -11.3 -4.6 -4.9 -5.4 -2.1 -5.5 -3.4 -2.3 -1.9 -3.4 E 5.2 3.6 5.7 9.5 2.2 2.1 3.5 2.7 3.6 3.5 F 1.3 -0.8 2.0 2.8 2.1 1.6 1.6 2.0 2.4 1.3 G 1 2 3 4 5= 5= 5= 8 9 --

Italy Britain Spail Portugal Denmark Belgium Holland France Ireland Germany

Sources: OECD; IMF; government statistics; NatWest; The Economist poll of forecasters (*) % of permitted divergence from central rate (A) Central rate against DM relative to PPP (**) Foreignexchange (mid September estimates), number of months' imports (B) Forecast (AA) 1=greatest risk, 9=least risk Based on this article, we can actually use the data given to come up with a realignment ranking. For example, the position in the CRLS system (the divergence indicator in the EMS, a summary measure of the currency’s position in its bands relative to all other currencies), and the reserves import cover are direct indicators of devaluation pressure. An overvalued currency, a large budget deficit, high inflation,

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and low GDP growth are “bad” economic fundamentals that may contribute to speculative pressure on the currency. The Economist did a very simple exercise. It ranked all the countries on these criteria from “worst” (most speculative pressure) to “best” (least speculative pressure). It then added up the ranks and came up with an overall devaluation risk ranking. Using the information provided on fundamentals leads to a surprisingly accurate realignment risk ranking. These ranks are reproduced in the last column of the Economist table. Italy and Britain were actually forced out of the EMS during the September currency crisis. Spain was forced to devalue and Portugal later followed suit. The other countries with better fundamentals duly survived. Whether the currency crisis in 1992 was actually predictable is still a topic of academic debate. Some important scholars in the area have argued that the crisis was almost completely unpredictable. Our case seems to indicate otherwise, although more formal analysis is necessary (and is still being conducted by many scholars). Finally, while some countries, such as France, still looked relatively “safe,” another currency crisis erupted in July August 1993, which led to rather drastic changes in the operation of the EMS, including a widening of the bands to 15%. b) Effects of Realignments/Exits for the Firm Since the British firm agrees to local currency pricing, the risk is that the Zooropa currencies get devalued. Two cases must be considered: (1) The price remains fixed. In this case, the revenue per unit sold in pounds decreases and the profit margin is squeezed because the firm's costs are local (in pounds). Except for "dynamic effects" (see below), there need not be any effect on the number of units sold. Sales may remain unchanged in local currency, but sales go down in pounds. (2) The firm tries to "pass through" the exchange rate change and raises the price of the pumpkin device as in Chapter 9. The optimal response will be to raise the domestic price because the firm does not want to sell as much quantity in that market. The amount of the price increase depends on the elasticity of the demand curve. The price will rise less, the more elastic is the demand – that is, the larger the percentage change in quantity with a given percentage change in price. These are the immediate effects. The realignment restores the general competitiveness of the Zooropean country. If the devaluation is successful, it accomplishes a decrease in real wages locally and shifts resources to the export sector. It should also make potential local competitors to Smashing Pumpkins more competitive. However, the case seems to indicate that these are non-existent. Initially, this may lower the demand for all imports (the whole idea of the devaluation in the first place). If the economy was not producing at full capacity, the increased competitiveness may spur considerable additional economic growth. This, in fact, happened in Britain and Sweden after the 1992 devaluations. Higher growth may then lead to higher imports and increase the demand for the pumpkin device. These are potential dynamic effects. Eventually, this may cause inflationary pressures to creep back into the economy. Unsuccessful devaluations will let higher import prices (if there is some pass through or most import products are priced in foreign currency) affect wages and the general price level. In this case, there may be only small effects for the British firm. Hence, the dynamic effects depend on the success of the devaluation. All of this analysis goes through for exits from the target zone. In fact, the effects for realignments are probably considerably smaller, since an exit may lead to much lower exchange rates and in some cases to lower interest rates, which further help the Zooropa economy become more competitive. It has to be said that these are all "elaborate guesses," since in reality new shocks to the economy may cause completely different outcomes.

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c) Incorporating Realignment Risk into Pricing/Hedging The market will anticipate the realignment. In fact, if UIRP holds, the interest differential with Britain and the forward rate relative to the pound will reflect the expected currency depreciation (the probability of a devaluation multiplied by the magnitude of the devaluation). Hence, hedging the risk will automatically lead to lower pound revenue in the future. Ideally, one establishes a pricing scheme that takes potential realignments into account, for example using forward rates. Your personal view on realignment risk may differ from the forward rates though. Alternatively, a dynamic real exchange rate risk sharing formula as in the SAFE AIR case could be proposed. d) Effects of devaluation/exits on exchange and interest rates Exchange rates fall, by definition. The effect on the interest rate however may be different in both cases. With devaluation it is very likely that the interest rate will drop. That is because the interest rate was most probably very high during the speculative attack preceding the realignment and it now drops back to normal levels, which are still likely to be above the interest rate of the anchor currency. With an exit, the pressure of a speculative attack gets relieved as well, and now the interest rate need not exceed the rate on the anchor currency. However, the exiting currency loses its "inflation credibility mechanism" by leaving the target zone, and hence, interest rates may go up reflecting higher expected inflation in the future. When Britain exited the ERM, its interest rates dropped substantially at the short end, but they remained quite high at the long end. In Mexico, after the December 1994 crisis, peso interest rates rose reflecting fears of future depreciation and inflation. Both market responses seem justified both by the data at the time of the event and the subsequent experiences of the economies.

Chapter
International Debt Financing
QUESTIONS
1. What are the three main sources of financing for any firm?

11

Answer: Corporations rely on three primary types of financing for their capital expenditures: internally generated funds, debt financing, and equity financing.

2. What is the difference between a centralized and decentralized debt denomination for an MNC? Answer: Under a decentralized debt-denomination model, MNCs issue debt in different currencies to hedge the cash flows they earn in these currencies from their foreign subsidiaries. Under a centralized model, debt is issued in the currency of the country in which the MNC has its headquarters.

3. Will an MNC issuing debt in low–interest rate currencies necessarily lower its cost of funds? Why? Answer: No. The ultimate cost of the debt will also depend on currency movements. If uncovered interest rate parity holds, the cost of the low interest rate debt, expressed in the home currency, is expected to be identical to the cost of high interest rate debt. After the fact, the debt will be either less expensive than corresponding debt denominated in the domestic currency, if the foreign currency appreciates less than predicted by UIRP; or it will be more expensive if the foreign currency appreciates more than predicted by UIRP.

4. Should an MNC borrow primarily short term when short-term interest rates are lower than long-term interest rates? Or should it keep the maturity the same but use a floating-rate loan rather than a fixed-rate loan? Explain. Answer: First, if short-term interest rates are lower than long-term interest rates, this may be an indication of impending increases in interest rates. In fact, if the expectations hypothesis of the term structure of interest rates holds, the long rate is simply an appropriately weighted average of short term rates. This implies that “timing” the loan by having a floating interest rate that allows for low interest payments when short rates are low and high interest payments when short rates are high does not add value. Second, the difference between simply borrowing short-term and using a floating rate note is that the latter approach also locks in the MNC’s credit spread. If the firm thinks its credit rating will improve over time, it may not want to issue a floating rate note, preferring instead to borrow short-term and borrow again at a better credit spread after the information is incorporated by the market.

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5. What is financial disintermediation? Answer: This concept refers to the phenomenon in which firms issue securities directly to investors in the capital markets, rather than borrowing from financial institutions that in turn raise funds from the capital markets.

6. What are the two main segments of the international bond market, and what types of regulations apply to them? Answer: One segment of the international bond market is the foreign bond market, where a foreign issuer issues bonds in a particular domestic bond market, subject to local regulations. The other segment is the Eurobond market, where bonds are issued simultaneously in various markets, outside the specific jurisdiction of any country. Hence, these bonds are not subject to the regulations of any particular country.

7. What is the difference between a foreign bond and a Eurobond? Answer: See the answer to Question 6.

8. Why might U.S. investors continue to purchase Eurobonds, despite the fact that the U.S. corporate bond market is well developed? Answer: The Eurobond market gives them access to bonds of firms that are not available in the US market thereby providing valuable diversification of default risk. Recall that the Eurobond market is a highly liquid, unregulated, convenient market to issue bonds, which has lead to a wide array of available bonds from which investors can choose. Also, Eurobonds are not registered (ownership is anonymous), and it may therefore allow certain tax avoidance benefits to non-scrupulous investors.

9. What is a global bond, and what role does the global bond market play in the blurring of the distinctions in the international bond market? Answer: Global bonds are issued simultaneously in a domestic market and in the Eurobond market, and they therefore straddle the two segments of the international bond market, making distinctions between them more difficult to draw.

10. What are the differences between a straight bond, a floating-rate note, and a convertible bond? Answer: A straight bond has no special features. It has a fixed coupon payment and a final principal payment at maturity. A floating-rate note carries a floating interest rate that typically varies with short-term LIBOR. Convertible bonds allow the holder to convert the bonds into a certain amount of stock and therefore have an option feature. 11. What is a dual-currency bond?

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Answer: Dual-currency bonds are issued in one currency and pay interest in that currency, but the final principal payment is denominated in another currency.

12. What kind of activities do international banks engage in? Answer: International banks typically develop a complete line of financial services to facilitate the overseas trade of their customers. In addition to commercial credit, these ancillary financial services include market making and trading in spot and forward currencies, international trade financing, and risk management services. Unlike domestic banks, international banks participate in the Eurocurrency market and are frequently members of international loan syndicates, lending out large sums of money to MNCs or governments. An international bank might also engage in the underwriting of Eurobonds and foreign bonds, which are investment-banking activities.

13. Why is there a need for international banking regulation? Answer: First, central banks are concerned that without an international regulatory framework to ensure that an adequate level of capital is maintained in the international banking system, bank failures could lead to a global financial crisis or at least domestic crises could spill over into other countries. Second, the variety of different national regulations potentially gives an unfair advantage to banks from countries with laxer regulatory standards, and this could decrease the soundness and safety of the international banking system overall. International regulations can create a more level playing field that avoids potential under-regulation if individual regulators compete to see who can be the least strict.

14. What are the differences between credit risk, market risk, and operational risk? Answer: Credit risk is the risk that a company or government will default on its promised payments on a loan or a bond. Market risk is the risk of losses in trading positions when prices move adversely. Operational risk is the risk of direct or indirect loss resulting from inadequate or failed internal processes, people, and systems or from external events, such as computer failure, poor documentation, or fraud.

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15. Which activity would require the largest capital charge under the 1988 Basel Accord: a loan to another bank or a loan to a large MNC? Would this necessarily be true under the Basel II? Answer: Under Basel I, claims on other banks receive only a 20% weighting, meaning that only 20% of the claim is counted against the 8% capital requirement. Some claims receive a 50% weighting, but virtually all claims on the non-bank private sector receive a 100% weight and hence the full capital charge. Hence, the charge for the loan to the MNC would be larger. Under Basel II, other risks are taken into account (market risk and operational risk), and credit risk is measured differently, primarily to better reflect the true creditworthiness of the borrower. Consequently, it is conceivable that the capital charge for the bank loan is larger than for the MNC under Basel II.

16. What is VaR? Answer: VaR stands for Value at Risk and measures the dollar loss that a given portfolio position can experience with 5% probability over a given length of time.

17. What is the difference between a foreign branch and a subsidiary bank? Answer: A foreign branch of a bank is legally a part of the parent bank, but it operates like a local bank. Foreign branch banks are subject to both the banking regulations of their home countries and the countries in which they operate. However, foreign branches of U.S. banks are not subject to U.S. reserve requirements and are not required to have federal deposit insurance. A subsidiary bank is also wholly or partly owned by a parent bank, but it is incorporated in the foreign country in which it is located. Subsidiary banks are therefore subject to the banking laws of the countries in which they are incorporated.

18. What is an offshore center? Answer: Offshore banking centers conduct international banking activities in a “lightly” regulated setting. Most of the transactions involve nonresidents as counterparties; the transactions are typically initiated outside the financial center, and the majority of the financial institutions involved are controlled by nonresidents who do business primarily with nonresidents. Offshore banking centers can be found in places such as Aruba, the Cayman Islands, and parts of the West Indies.

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19. What is the difference between an Edge Act bank and an international banking facility? Answer: Edge Act banks are federally chartered subsidiaries of U.S. banks that are physically located in the United States but are allowed to engage in a full range of international banking activities. Such activities include accepting deposits from foreign customers, trade financing, and transferring international funds. Edge Act banks are not prohibited from owning equity in U.S. corporations, as are domestic commercial banks. Consequently, U.S. parent banks own foreign subsidiaries and affiliate banks through an Edge Act setup. An international banking facility (IBF) is a separate set of asset and liability accounts that is segregated on the parent bank’s books, so it is not a unique physical or legal entity. Any U.S.-chartered depositary institution (including a U.S. branch, a subsidiary of a foreign bank, or a U.S. office of an Edge Act bank) can operate an IBF. An IBF operates as a foreign bank in the United States and is consequently not subject to domestic reserve requirements or FDIC insurance regulation. However, IBFs may only accept deposits from non-U.S. citizens and make loans to foreigners. The bulk of an IBF’s activities relate to interbank business.

20. What is the difference between a Eurocredit, a Euronote, and a Euro-medium-term note? Answer: Eurocredits are typically very large international loans extended by a consortium or syndicate of banks that share the risk of the loan. Eurocredits are typically issued at floating interest rates. Euronotes are short-term, negotiable promissory notes, established by a Euronote facility. Typically, in such a facility, a syndicate of banks commits to distribute for a specified period, typically 5 to 7 years, the borrower’s notes (the “Euronotes”), with maturities ranging between 1 month, 3 months, 6 months, and 12 months. In case the notes cannot be placed in the market, the syndicate banks in many Euronote facilities stand ready to buy them at previously guaranteed rates. Euro-Medium-Term Notes (Euro-MTN) are securities issued directly to the market and bridge the maturity gap between Euronotes and the longer-term international bond, with maturities as short as 9 months to as long as 10 years. Like Euronotes, the Euro-MTN is a facility with notes offered continuously or periodically rather than all at once, like a bond issue. Unlike conventional underwritten debt securities, medium-term notes can be issued in relatively small denominations and issuing costs are low, but they are not underwritten.

21. Why are Eurocredits not extended by one bank but by a large syndicate of banks? Answer: Eurocredits are typically very large so that banks appreciate the opportunity to share the risk of default on the loan with other banks.

22. What is the all-in cost of a 5-year loan? What are its main components? Answer: The all-in cost (AIC) has three components: The “default free” interest rate, the credit spread, and transaction costs. The default free interest rate is the rate available on risk-free government securities of the same maturity. The credit spread is the difference between the borrowing cost of the company and the borrowing cost of the government and reflects the market’s assessment of the ability of the company to repay its debt. Finally,

Chapter 10: Exchange Rate Determination and Forecasting 71

transaction costs reflect the fees that a company pays to arrange the bond, which also effectively raise the interest rate payable on the loan.

23. What is a credit rating? What is a credit spread? Answer: For credit spread, see the answer to Question 23. The credit spread a company faces in the market place is typically closely related to its credit rating. Companies that supply credit ratings, such as Moody’s Investors Service and Standard & Poor’s (S&P), provide information on the credit worthiness of companies across the world by producing a “rating” for the securities they issue. They classify bond issues into categories based on the creditworthiness of the borrower. The ratings are based on an analysis of current information regarding the likelihood of default and the specifics of the debt obligation. The ability of a firm to service its debt depends on the firm’s financial structure, its profitability, the stability of its cash flows, and its long-term growth prospects.

24. Should corporations issue bonds in countries where they face the lowest credit spreads? Be very specific about the concept of credit spread you use. Answer: The answer here is potentially yes. When expressed in a multiplicative sense (by dividing one plus the interest rate the company faces by one plus the rate on a comparable government bond), lower credit spreads do indeed translate into lower borrowing costs, provided the company can cheaply hedge the cash flows involved into its desired borrowing currency .

72 Chapter 10: Exchange Rate Determination and Forecasting

PROBLEMS
1. In 1985, R.J. Reynolds (RJR for short) acquired Nabisco Brands and financed the deal with a variety of financial instruments, including three dual-currency Eurobonds. The first dual-currency bond, lead-managed by Nikko, raised JPY25 billion (which was equivalent to USD105.5 million at the time of issue). Coupons were paid in yen, but the required final principal payment was not JPY25 billion but USD115.956 million. The coupon was 7.75%, even though a comparable fixed-rate Euroyen bond at that time carried only a 6.375% coupon. The actual 5-year forward rate at the time was around JPY200/USD. a. Given the “fat” coupon, is this bond necessarily a great deal for the investors? Answer: No, it isn’t a particularly great deal for the investor because the payment at the end is worth substantially less than the face amount of the bond. To see this, note that the yen value of final payment can be found by multiplying the USD115.956 million by the forward rate: USD115.956 million × JPY200/USD = JPY23.191 billion which is less than JPY25 billion, the original principal. Of course, the coupon is higher than the coupon on a straight Euroyen bond, so we shouldn’t expect the final principal payment to be JPY25 billion otherwise the rate of return on the bond would be 7.75%. If we hedge the dual currency bond and find the internal rate of return on the yen cash flows, we find the value, y, which sets the discounted yen payoffs equal to the cost of the bonds:

¥25 billion =

∑ i=1 5

0.0775 × ¥25billion

(1 + y )

i

+

(¥200/$) × $0.115956 billion

(1 + y )

5

Using Excel’s IRR command, we find that the internal rate of return on the bond is 6.48%, which is greater than the rate of return offered by the straight Euroyen bond. Thus, the bond is a good deal for investors if they can hedge at the forward rate of ¥200/$. b. At maturity, in August 1990, the exchange rate was actually JPY144/USD. Was the bond a good deal for investors? Answer: We need to calculate the return to investors if the investors were unhedged. Investors received USD115.956 million × JPY144/USD = JPY16.698 billion which is almost ¥7 billion less than if they had sold the face amount forward at the forward rate prevailing in August 1985. This loss happened because the yen appreciated by much more than was predicted by the forward rate. It is therefore also unlikely that the “fat coupon” would have made up for this huge capital loss. In fact, it is straightforward to compute the actual internal rate of return investors made on an unhedged investment in this bond. It is the rate that solves:

¥25 billion =

∑ i=1 5

0.0775 × ¥25billion

(1 + y )

i

+

¥16.698 billion

(1 + y )

5

We find y = 1.28%. This is a much lower return than the yield offered in 1985 by a regular Euroyen bond! This is not so hard to understand considering that the payment at the end represents a capital loss of approximately 30%!

Chapter 10: Exchange Rate Determination and Forecasting 73

2. GBA Company wishes to raise $5,000,000 with debt financing. The funds will be repaid with interest in 1 year. The treasurer of GBA Company is considering three sources: i. Borrow USD from Citibank at 1.50% ii. Borrow EUR from Deutsche Bank at 3.00% iii. Borrow GBP from Barclays at 4.00% If the company borrows in euros or British pounds, it will not cover the foreign exchange risk; that is, it will change foreign currency for dollars at today’s spot rate and buy foreign currency back 1 year later at the spot rate prevailing then. The GBA Company has no operations in Europe. A representative of GBA contacts a local academic to provide projections of the spot rates 1 year in the future. The academic comes up with the following table: Projected Rate 1 Year in the Future Currency Spot Rate USD/GBP 1.5 1.55 USD/EUR 0.95 0.85 a. What is the expected interest rate cost for the loans in EUR and GBP? Answer: For the EUR, the expected cost is (1 + .03) × (0.85/0.95) - 1 = -0.0784 or -7.84% For the GBP, the expected cost is (1 + 0.04) x (1.55/1.50) - 1 = 0.0747 or 7.47% These costs reflect both the interest costs and the expected capital gains or losses on the currency positions. If the academic’s projections prove accurate, the interest cost in GBP is higher than the GBP interest because the pound is expected to appreciate relative to the dollar, and GBA will need more than $5,000,000 to repay the pound loan. In contrast, the EUR is expected to decrease in value by more than 10% relative to the dollar, providing a large capital gain to GBA, which borrows in a depreciating currency and hence must use much less than the initial $5,000,000 to repay the euro loan. b. What are the projected USD/GBP rate and USD/EUR rate for which the expected interest costs would be the same for the three loans? Answer: These are the exchange rates that satisfy Uncovered Interest Rate Parity,

E t [S(t+1,$/FC) ] = S(t,$/FC) ×

(1 + i(FC) )

(1 + i($) )

where FC indicates either the EUR or the GBP. For the euro we find

E t [S(t+1,$/FC) ] =

$0.95 1.015 $0.9362 × = € 1.03 €

Hence, the euro must depreciate only a little bit for the euro loan to be as cheap as the USD loan. For the pound, we obtain

E t [S(t+1,$/FC) ] =

$1.50 1.015 $1.4639 × = £ 1.04 £

74 Chapter 10: Exchange Rate Determination and Forecasting

c. Should the company borrow in the currency with the lowest interest rate cost? Why or why not? Would your answer change if GBA did generate cash flows in the UK and continental Europe? Answer: When using the forecasts of the academic, the lowest interest cost occurs in EUR. However, the academic’s forecast is quite far away from the “break-even” rates computed in part b., which may be closely related to the market determined forward rates. Moreover, currency forecasters do not have the best of records (see Chapter 10). Consequently, it is not at all clear that the “expected” low interest cost will actually be realized. If anything, the empirical evidence suggests that borrowing in low interest countries (in this case the US) may eventually save money (see Chapter 7 on the deviations from Unbiasedness). What a company can do is to investigate in what country its (multiplicative) credit spread is minimized, borrow in that country and hedge back to dollars when there is no reason, as in this case, to hold foreign exchange risk. If GBA generates cash flows in Europe, borrowing in currencies there may provide a natural hedge.

3. FE Company wishes to raise $1,000,000 with debt financing. The treasurer of FE Company considers two possible instruments: i. A 2-year floating-rate note at 1% above 1-year dollar LIBOR on which interest is paid once a year ii. A 2-year bond with an interest rate of 5% Currently, the dollar LIBOR is 1.50%. a. Is it obvious which security the Treasurer should pick? Answer: It is not at all obvious which debt to pick. While the two-year floating rate starts out at a lower rate (2.50% versus 5%), it is not clear at all what the eventual cost of the note will be to the company. The cost will also depend on the reset of the interest rate in the second year. If that interest is high enough, the 2-year bond may ex-post prove to be the cheapest financing vehicle. Typically, an upward sloping yield curve suggests the market does indeed expect that short-term interest rates will rise in the future. b. Suppose the Treasurer believes that 1-year LIBOR, 1 year from now, will rise to 4.50%. Which security has the lowest expected AIC if borrowing fees are similar for the two instruments? Answer: The AIC for the two-year bond is simply 5%. For the two-year floating rate note, we must compute the y that satisfies:

1,000,000 =

25,000 55,000 1,000,000 + + 2 2 (1 + y ) (1 + y ) (1 + y )

where we computed the coupon payments as 2.5% for year 1 and 5.5% (4.5% +1%) for year 2 on the $1,000,000 principal. The solution for y is 3.97%. Hence, at this forecast, the floating rate note is cheaper than the bond.

Chapter 10: Exchange Rate Determination and Forecasting 75

4. K3 Company wants to borrow $100 million for 5 years. Investment bankers propose to either do a syndicated Eurocredit or issue a Eurobond. The Eurocredit would be denominated in dollars, but the Eurobond would be denominated in different currencies for different markets (these issues are called tranches): Terms: Syndicated Eurocredit Amount: USD100 million Upfront fees: USD1.25% Interest rate: Interest payable every 6 months; LIBOR plus 1.00% Terms: Eurobond Tranche 1: USD 50 million, Interest rate: 3.50% Tranche 2: ¥ 5,952 million (equivalent of USD50 million), Interest rate 1.5% a. What are the net proceeds in USD for K3 for the Eurocredit loan? Answer: The net proceeds for the Euro credit are (1 - 0.0125) × $100 million = $98.75 million (the fees amount to $1.25 million). b. Assuming that the 6-month LIBOR in USD is currently at 2.00%, what is the effective annual interest cost for K3 for the first 6 months of the loan? Answer: The LIBOR convention is simple interest, so the 6-month interest rate is [2% + 1%] / 2 = 1.5%. To obtain the effective annual interest rate, we must annualize using compounding, (1 + 0.015)2 - 1 = 0.0302 or 3.02% c. Compute an effective annualized interest rate cost (all-in cost) for the USD tranche of the Eurobond. Answer: The interest rate is 3.5% and is likely payable just once a year. Hence, this would also be the AIC for the loan. Of course, the question omits mentioning the costs of issuing the bond, and these costs should be taken into account in a proper AIC computation. d. What information would you need to obtain the dollar all-in cost of the yen tranche? Answer: In addition to the transaction costs associated with the loan, we must know the terms for converting yen payments into dollar payments. For example, we could use the swap market (see Chapter 21), and we would need the terms for that, or we could use forward contracts, and we would need to know the available forward rates to convert dollars into yen for 1, 2, 3, 4, and 5 years into the future.

76 Chapter 10: Exchange Rate Determination and Forecasting

e. What elements would you take into account to choose between the two possibilities? Answer: With all the information given above (interest rate costs, loan issuance costs, and information on yen conversion rates), we can compute the AIC on the two tranches of the Eurobond issue. K3 can then compare its fixed borrowing costs with the Eurobond relative to the variable costs involved in the Eurocredit. While it appears that the floating rate Eurocredit will have interest expenses that are less than the Eurobond’s in the first year or so, this by no means guarantees that it will ex-post have the lowest costs. K3 should think of why it is optimal for the firm to incur interest rate risk. Perhaps its cash flows are cyclical and increase when short term interest rates increase, mitigating the interest rate risk embedded in the floating rate loan. 5. Suppose Intel wishes to raise USD1 billion and is deciding between a domestic dollar bond issue and a Eurobond issue. The U.S. bond can be issued at a 5-year maturity with a coupon of 4.50%, paid semiannually. The underwriting, registration, and other fees total 1.00% of the issue size. The Eurobond carries a lower annual coupon of 4.25%, but the total costs of issuing the bond runs to 1.25% of the issue size. Which loan has the lowest all-in cost? Answer: To keep things simple, we express the cash flows on bonds with a face value of 100, instead of $1 billion. We use a cash flow diagram similar to the one used in the PointCounterpoint. The U.S. bond is special as it features semi-annual coupon payments (of 4.5%/2 = 2.25%). It is best to simply compute the AIC using 10 half-years. This AIC is then a semiannual rate which must be annualized to be comparable to the annual AIC of the Eurobond. Because there are so many periods, we only show the first few and the last few. Negative numbers are in parentheses. 1. US Bond Half-Year Dollar Cash Flows 0 100 – 1.00 = 99.00 1 -2.25 2 -2.25 …. …. 9 -2.25 To annualize this AIC, we compute (1 + 0.0236)2 – 1 = 0.0478 or 4.78%. For the Eurobond, the computations are more standard: 2. Eurobond Year Euro Cash Flows 0 100 – 1.25 = 98.75 1 -4.25 2 -4.25 3 -4.25 4 -4.25

Chapter 10: Exchange Rate Determination and Forecasting 77

Hence, we see that, on an annualized basis, the Eurobond is substantially cheaper (by 24 basis points) than the U.S. bond.

Chapter
International Equity Financing
QUESTIONS

12

1. What are the differences between public, private, and banker’s bourses? Answer: In public bourses the government appoints brokers, typically ensuring them a monopoly over all stock market transactions. With the deregulation wave in the 1980s and 1990s, most stock markets are now private. A private bourse is owned and operated by a corporation founded for the purpose of trading securities. Sometimes these corporations are publicly traded, or they may be owned by a set of financial institutions, in which case they are known as banker’s bourses.

2. What is the difference between a price-driven trading system and an order-driven trading system? Which system lends itself most easily to automation? Answer: In a price-driven system, dealers who act as market markers for certain stocks stand ready to buy at a bid price and sell at an ask price. In an order-driven system, share prices are determined in an auction that brings together the supply and demand of shares. The order-driven system can be most easily automated, as it is easy to let a computer store demand and supply schedules, and determine the equilibrium price.

3. Do we have a global stock market, as we have a global foreign exchange market? Answer: In the global foreign exchange markets, it is possible to trade any currency almost anywhere in the world at any time in the day. This is not true in the stock market, even though globalization has had profound effects on stock market trading. First, there has been increased cross listing of firms on exchanges throughout the world, with London and the US as important listing markets. Second, exchanges have extending their trading hours to make their markets more accessible to foreign traders located in other time zones. In addition, some exchanges have merged or created alliances with foreign exchanges to automatically cross-list their stocks. For example, Euronext in Europe combines the stock exchanges of Amsterdam, Brussels, Paris, Lisbon and LIFFE, the London derivatives market. Very recently (in 2007), the NYSE and Euronext merged to form a new company called NYSE Euronext, Inc., getting ever closer to a truly global stock market.

4. What is turnover? Answer: Turnover is the total volume traded on an exchange during a year (or some other period) divided by the exchange’s market capitalization. It is often viewed as a liquidity indicator.

86

Chapter 12: International Financing 67

5. What are the three primary components of transaction costs in trading stocks? Answer: Trading costs consist of direct costs such as brokerage commissions, the bid–ask spread, and market impact (the fact that the price may move against you when you trade a large order).

6. Does high turnover always signal lower transaction costs? Answer: No, the tables in the Chapter indicate a clear negative relation between the two, but it is not perfect. There are a number of high turnover emerging markets (such as Taiwan) that may have higher transaction costs than some lower turnover developed markets. The Illustration Box on the Casablanca exchange provides another example of an imperfect relation between turnover and trading costs.

7. What is the difference between an ADR and a GDR? Answer: An American depositary receipt (ADR) is used to list shares in the American market. It represents a certain number of original shares issued in the home stock market, and held in custody by a depositary bank. Global depositary receipts (GDRs) are similar to ADRs, but can be traded on many exchanges in addition to U.S. exchanges.

8. What motivates companies to cross-list their shares? Answer: Cross-listing a stock can lower a company’s cost of capital through several channels, including improved liquidity and better corporate governance. It can heighten the awareness of the firm’s brands, provide direct access to foreign capital, and make future capital access easier.

9. Has cross listing been beneficial for most listed companies? If yes, why doesn’t every company cross-list? Answer: It appears that indeed cross-listing has mostly brought benefits for the firms that cross-list. However, firms for which cross listing is not beneficial should, of course, not do so. The costs associated with cross-listing have to do with the direct costs of registration, the potentially higher costs of more demanding accounting and reporting requirements, and the increased scrutiny and corporate governance that may erode the private benefits of controlling managers. Clearly, not every firm will have an incentive to cross-list.

68 Chapter 12: International Equity Financing

10. What is the difference between a GDR and a GRS? Answer: A GDR, like an ADR, represents negotiable claims on home-market ordinary shares (in bearer or registered form) and is issued by a depositary bank. Settlement of cross-border trades takes place daily through ADR issuances or cancellations (“conversions”) conducted by the depositary bank, and there are fees for such transactions. Finally, the depositary bank maintains ownership records and processes corporate actions. Global registered shares (GRSs) trade simultaneously in different markets around the world, in different currencies, with the shares being completely fungible across markets. They do not require the intervention of a depositary bank, but of course, shares can then also not be bundled or unbundled to facilitate trading in different markets. Finally, share ownership is more direct with a GRS than with a GDR. Holding a GRS gives investors the same voting privileges, rights to receive dividends, and so forth, as a regular shareholder has, whereas the depositary intermediary may impose certain restrictions.

11. What is a strategic alliance? Answer: A strategic alliance is an agreement between legally distinct companies to share the costs and benefits of a particular investment.

12. What is a joint venture? Answer: A joint venture is a type of strategic alliance where two or more independent firms form and jointly control a different entity, which is created to pursue a specific objective. The new entity tries to combine the strengths of each partner.

Chapter 12: International Financing 69

PROBLEMS
1. The following table shows how average share prices jump (in percentage) after the announcement that the stocks will be cross-listed (see Miller, 2000). The price response should be interpreted as corrected for risk and market movements that happened on the same day: 3. All ADR 4. Capital 5. Non-Capital Issues Raising Raising 2. 6. Emerging markets 7. 1.5 8. 0.9 9. 2.8 10. Developed markets 11. 0.9 12. 0.7 13. 0.9 14. Total 15. 1.2 16. 0.8 17. 1.4 Although these numbers appear small, it is important to realize that announcements of equity issues, which are by definition capital raising, in a domestic context lead to an average negative return response of 2% to 3% (see, for instance, Masulis and Korwar, 1986). The main reason is that capital-raising equity issues are viewed as a signal of the managers that the firm may be overvalued in the stock market. Given what you learned in chapter, answer the following: a. Why is there a positive price response when a company’s shares are cross-listed? Answer: The positive response likely reflects the reduction of the cost of capital (which increases the valuation of the firm) associated with cross listing. As indicated in Question 7, there are a variety of channels that may lead to a lower cost of capital, such as improved liquidity, a wider shareholder base, improved corporate governance, and effective integration within global capital markets. b. Why might the response for emerging-market firms be larger than for developedmarket firms? Answer: Because their own stock markets have poorer liquidity and corporate governance, the benefits may be relatively larger for emerging market firms. In particular, while most firms from developed markets are subject to “global pricing,” most emerging markets are still “segmented” from global capital markets, and listing in a developed market effectively integrates the firm into global capital markets. The move from segmented to global pricing tends to increase valuations because global discount rates tend to be lower than discount rates in segmented emerging markets. c. Without knowing that equity issues in a domestic context are associated with negative price responses, is the difference between capital-raising and noncapital-raising ADRs a surprise? Why or why not? Answer: Ignoring the negative signal of raising capital through the equity market, it is surprising that capital-raising ADRs would lead to a smaller price response than noncapital raising ADRs. That is because the fact that companies raise capital through the international capital market would suggest they have substantial growth opportunities that should raise the value of the firm.

2. Suppose you are a U.S.-based investor, and you would like to diversify your stock portfolio internationally. What advantages do ADRs offer you? Would it be wise to restrict your international portfolio to only ADRs?

70 Chapter 12: International Equity Financing

Answer: As we will discuss in Chapter 13, diversifying your portfolio internationally will offer significant benefits. However, since not all international firms have ADRs, the set of firms to invest in may not be large enough to exhaust the benefits of international diversification. In particular, it would tend to be the larger, more internationally oriented firms that will first cross-list, and these firms may be exactly the ones that are more heavily correlated with domestic firms (see Chapter 13 for more discussion on correlation and diversification benefits).

Chapter
International Capital Market Equilibrium
QUESTIONS

13

1. Is the volatility of the dollar return to an investment in the Japanese equity market the sum of the volatility of the Japanese equity market return in yen plus the volatility of yen/dollar exchange rate changes? Why or why not? Answer: It is not. Even though the dollar return on investing in Japanese equity is approximately the yen return on the Japanese equity market plus the rate of change in the dollar/yen exchange rate, the volatility of this sum is not the sum of the volatilities. Intuitively, because the equity risk and currency risk are not highly correlated, part of the volatility of the individual components is diversified away. Technically, the variance of the dollar returns can be written as follows: Var[r(t + 1,¥) + s(t + 1)] = Var[r(t + 1,¥)] + Var[s(t + 1)] +2ρVol[r(t + 1, ¥)]Vol[ s(t + 1)] where r(t + 1,¥) is the yen-denominated equity return, s(t+1) is the rate of change in the dollar/yen exchange rate, and ρ is the correlation between the yen equity return and dollar/yen exchange rate changes. Because volatility, Vol, is the square root of the variance, we know that the volatility of the dollar return on a Japanese equity investment is Vol[r(t + 1,¥) + s(t + 1)] = {Vol[r(t + 1,¥)]2 + Vol[s(t + 1)] 2 + 2ρVol[r(t + 1, ¥)]Vol[ s(t + 1)]}0.5 Clearly, only when the correlation is exactly 1 will the right-hand side have the form (A2 + 2AB + B2)0.5 = [(A + B)2]0.5 = (A + B) and hence, only then will the volatility of the sum be the sum of the volatilities. Because of the perfect correlation, there is no natural diversification advantage to having exposure to two sources of risk. However, as long as ρ < 1, the total dollar volatility will be less than the sum of the two volatilities.

2. Why is the variance of a portfolio of internationally diversified stocks likely to be lower than the variance of a portfolio of U.S. stocks? Answer: With international stocks, the investor can diversify away U.S.-specific sources of volatility (e.g. U.S.–specific business cycle movements, changes in U.S. monetary policy, changes in U.S. interest rates, etc.). Technically, the variance of an equally weighted portfolio converges to the average covariance between these stocks when the number of stocks gets very large. The average covariance among U.S. stocks is higher than the average covariance among a set of U.S. and international stocks.

91

Chapter 13: International Capital Market Equilibrium 67

3. How can you increase the Sharpe ratio of a portfolio? What type of stocks would you have to add to it in order to do so? Answer: To increase the Sharpe ratio on your portfolio, you must add stocks that increase the expected return on your portfolio and/or reduce the volatility of the portfolio (for instance, because the stocks exhibit low correlation with the portfolio you already have). One way to think of the problem is to compute the following hurdle rate, Hurdle rate = rf + ρ ×

E[r] × Vol [r* ] Vol[r]

In this equation rf is the risk free rate, ρ is the correlation between the portfolio you have and the stock you want to add to the portfolio, E[r] and Vol[r] are the expected return and volatility of the portfolio you are holding, and Vol[r*] is the volatility of the stock you want to add. The hurdle rate is higher when the existing portfolio has a high Sharpe ratio, the stock you are adding is more volatile, or there is high correlation between the return on the portfolio and the return on the stock you are adding to the portfolio. 4. Why is the hurdle rate in Section 13.2 lower for Japan than for Canada? Should U.S. investors still invest in Canada? Answer: From the formula in the answer to Question 3, we see that the two main drivers of the hurdle rates are the correlations between Canadian and U.S. returns and between Japanese and U.S. returns (reported in Exhibit 13.6), and the volatilities of Canadian and Japanese returns (reported in Exhibit 13.1). The most important number is the correlation. Of the G7 countries, the Canadian market returns have the highest correlation with U.S. returns, whereas the Japanese returns have the lowest correlation. It is this difference that makes Japan have the lowest hurdle rate and Canada the highest. Whether U.S. investors should still invest in Canada depends on their opportunity set. The hurdle rate for Canada, reported in Exhibit 13.7, suggests that even if the expected return on Canadian stock is a bit lower than that of the U.S., it is still a valuable investment that increases the Sharpe ratio. However, if the U.S. investor can invest in Japanese securities first, it is quite likely that the Canadian hurdle rate will exceed the expected return of the U.S.-Japan diversified portfolio. In that case, it may not be optimal to go long Canadian securities. Note that this answer depends on the historical numbers reported in the Exhibits. Some theories of portfolio choice (such as the CAPM) postulate that investors should hold portfolios that are well diversified and include all securities in line with their market capitalizations.

5. What is the mean standard deviation frontier, and what is the mean-variance-efficient (MVE) portfolio? Answer: The mean standard deviation frontier is the locus of the portfolios in expected return–standard deviation space that have the minimum variance for each expected return. It is therefore also often referred to as the minimum-variance frontier. The MVE is the portfolio on that frontier that maximizes the Sharpe ratio. It can be found by drawing a line emanating from the risk free rate that is just tangent to the mean standard deviation frontier. The tangency point represents the MVE’s expected return and standard deviation. The MVE is therefore also referred to as the tangency portfolio.

68 Chapter 13: International Capital Market Equilibrium

6. What is the prediction of the CAPM with respect to optimal portfolio choice? Answer: All investors should hold the same portfolio for risky assets, the market portfolio. The market portfolio contains all securities, and the proportion of each security is its market value as a percentage of total market value.

7. What is it prediction of the CAPM with respect to the expected return on any security? Answer: The CAPM implies that the expected return of any security equals the risk-free rate plus the beta of the security multiplied by the market risk premium. The beta of the security is the covariance of its return with the return on the market portfolio divided by the variance of the market portfolio return. Hence, the risk premium on an individual security is a function of its covariance with the market portfolio.

8. What is the beta of a security? Answer: As indicated in Question 7, the beta of the security is the covariance of its return with the return on the market portfolio divided by the variance of the market portfolio return. This beta can be estimated from a regression of excess returns on the security in question onto excess returns on the market portfolio (proxied by the world market portfolio return, for example). Sometimes, industry portfolios are used to reduce the sampling error in estimating the betas.

9. Why might it be useful to estimate the beta for a stock from returns on stocks within its industry rather than from the stock itself? Answer:Estimating a beta using a regression is often imprecise because a firm’s returns exhibit considerable idiosyncratic volatility. That is, much of the variation in a firm’s return is driven by firm-specific events. This idiosyncratic volatility reduces the fit of the regression and increases the standard errors of the estimates. If firms in the same industry have about the same systematic risk, which is a reasonable assumption, their betas will be about the same as well. A portfolio of firms diversifies away a lot of idiosyncratic risk and is consequently much less variable than an individual firm’s stock returns. Therefore, beta estimates from industry portfolios are more precise, and provide reasonable estimates for a firm’s beta.

10. What does it mean for an equity market to be integrated or segmented from the world capital market? Answer: Markets are integrated when assets of identical risk command the same expected return, irrespective of their domicile. Hence, in an integrated equity market, stocks are priced using global discount rates. In a segmented market, discount rates are country–specific. Segmentation usually arises through governmental interference with free capital markets. For example, if foreign investors are taxed or otherwise prohibited from holding the equities of a country, then that country’s assets are not part of the world market portfolio, and that country is said to be segmented from international capital markets. It is also conceivable that

Chapter 13: International Capital Market Equilibrium 69

other factors (such as poor corporate governance or liquidity) keep foreigners from investing in an equity market, causing it to be effectively segmented. 11. What would you expect to happen to the risk-free rate and equity returns when a segmented country opens its capital markets to foreign investment? Answer: When a country unexpectedly opens its capital markets to foreign investors, we expect the real interest rate to decrease, and the stock market to rise in value. The real interest rate in the country should fall because the country’s residents are now free to borrow and lend internationally (which may reduce domestic demand for local funds), and there is additional foreign supply of capital. It is conceivable that before the liberalization, the government may have kept interest rates artificially low—for instance, through interest rate ceilings—in which case the interest rate may rise upon liberalization. The equities of the country will now be priced globally, rather than locally. Using the intuition from the CAPM, equity discount rates will now be based on their covariances with the return on the world market portfolio and no longer on their covariances with the local market. The latter covariances are likely to be much larger than the covariances with the world market; hence the liberalization should lead to a lower risk premium for domestic stocks. Together with the lower risk free rate, the discount rates for local stocks should decrease, and, consequently, their valuations should increase. Simply put, foreign investors will bid up the prices of local stocks in an effort to diversify their portfolios, while all investors will shun inefficient sectors. Thus, equity prices should rise (as expected returns decrease) when a market moves from a segmented to an integrated state. 12. What accounts for the home bias phenomenon? Answer: Home bias refers to the phenomenon that investors, even in the developed world, have not fully internationally diversified their portfolios which are consequently heavily invested in their own stock markets. No well-accepted explanation for why investors forego the benefits of international diversification exists. Home bias is definitely declining over time, which suggests that the direct barriers to international investment did play a role in the past. For most countries, these barriers have been dismantled and can no longer explain why investors do not invest abroad. Arguments such as the idea that currency risk increases the riskiness of foreign investments or that foreign investments are costlier than domestic ones are unlikely to be valid explanations. Because currency changes show little correlation with local equity markets, they add little to the volatility that U.S. investors face when investing in foreign equity markets. Moreover, currency volatility can be hedged. Transaction costs may play a role, but in order to generate the observed portfolio proportions of U.S. investors, U.S. investors would have to think that the average returns on foreign stocks were 2% to 4% per annum less than the realized average returns on foreign assets. It may be that these figures represent U.S. investors’ perceived transaction costs of foreign investing, but it is unlikely. Moreover, the huge volume of international capital flows is also inconsistent with the transaction costs story, as is the fact that foreign countries are home biased. Perhaps the most popular explanation of home bias is that international investors have an informational disadvantage relative to local investors, which cause international investors to invest less abroad, or to not invest at all in unknown foreign markets. For public investments, this story also is not entirely appealing. It is easy enough to obtain information on foreign companies or to set up or use local investment managers. However, it may be that the quality of the information and a poor regulatory framework in terms of investor protection and corporate governance keep out U.S. institutional investors. This may explain

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why foreign companies like to list ADRs, which can thus be more easily included in institutional investors’ portfolios. Again, such an explanation would not explain why even investors in countries with poor corporate governance are still home biased. Ultimately, it appears that the main variable most negatively and robustly correlated with the degree of home bias is “distance,” suggesting that people invest more in countries with which they are more familiar. 13. Explain the basic principle of the APT. Answer: The arbitrage pricing theory (APT) recognizes that the return on the market portfolio may not be the only potential source of systematic risks that affect the returns on equities. The APT postulates that other economy-wide factors can systematically affect the returns on a large number of securities. These factors might include news about inflation, interest rates, gross domestic product (GDP), or the unemployment rate. Changes in these factors will affect the future profitability of corporations, and they may affect how investors view the riskiness of future cash flows. This, in turn, will affect how investors discount future uncertain cash flows. When there are economy-wide factors that affect the returns on a large number of firms, the influences of these factors on the return to a well-diversified portfolio are still present. The influences of these factors cannot be diversified away. Consequently, the risk premiums on particular securities are determined by the sensitivities of their returns to the economy-wide factors and by the compensations that investors require because of the presence of each of these different risks.

14. Suppose AZT is a small value stock and that you use both the CAPM and the FamaFrench model to compute its cost of capital. Under which model is the cost of capital for AZT likely to be higher? Answer: It is likely to be higher under the Fama-French model. The reason is that the FamaFrench model has two additional factors in addition to the return on the value-weighted market portfolio in excess of the risk-free return, as in the CAPM. These factors are the difference in the return on a portfolio of small firms and the return on a portfolio of big firms (small minus big [SMB]) and the difference between the return on a portfolio of firms with high values of book equity to market equity (BE/ME) and the return on a portfolio of firms with low values of BE/ME (high minus low [HML]). These two factors carry positive risk premiums. As a small value stock, AZT stock will have positive exposures to these two factors and therefore likely have a higher cost of capital, than if only the CAPM were used.

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PROBLEMS
1. The EAFE is the international index comprising markets in Europe, Australia, and the Far East. Consider the following annualized stock return data: Average U.S. index return: 14% Average EAFE index return: 13% Volatility of the U.S. return: 15.5% Volatility of the EAFE return: 16.5% Correlation of U.S return and EAFE return: 0.45 a. What would be the return and risk of a portfolio invested half in the EAFE (Europe, Australia and Far East index) and half in the U.S. market? Answer: Using standard formulas for the expected return and volatility of a portfolio of two assets, we find:

E[r P ] = (0.5)×14% + (0.5)×13% = 13.5% VOL[r ] = [(0.5) (15.5%) + (0.5) (16.5%) + 2(0.5) 0.45(15.5%)(16.5%)] = 0.5[(15.5%) + (16.5%) + 2 × 0.45 × 15.5% ×16.5%]
2 2 1 2 P 2 2 2 2 2 1 2

Note that this is lower than the volatility of either of the two indexes. b. Market watchers have noticed slowly increasing correlations between the United States and the EAFE index, which some ascribe to the increasing integration of markets. Given that the volatilities remain unchanged, is it possible that the volatility of a portfolio that is equally weighted between the two indexes has higher volatility than the U.S. market? Answer: Yes. For example, when ρ = 1.00, the variability of the equally weighted portfolio would just be the average volatility. There would be no risk reduction through diversification.

= 13.63%

2. Let the expected pound return on a UK equity be 15%, and let its volatility be 20%. The volatility of the dollar/pound exchange rate is 10%. a. Graph the (approximate) volatility of the dollar return on the UK equity as a function of the correlation between the UK equity’s return in pounds and changes in the dollar–pound exchange rate. Answer: The formula to use is: Vol[r($)] = [{Vol[r(£)]}2 + {Vol[s]}2 + 2 ρ Vol[r(£)] Vol[s]]1/2 where ρ is the correlation. It is easy to see that the dollar volatility will be an increasing function of ρ. In particular: Vol[r($), ρ = -1] = 10% Vol[r($), ρ = 0] = 22.36% Vol[r($), ρ = 1] = 30% This formula assumes away the “cross-term.”

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b. Suppose the correlation between the UK equity return in pounds and the exchange rate change is 0. What expected exchange rate change would you expect if the UK equity investment is to have a Sharpe ratio of 1.00? (Assume that the risk-free rate is 0 for a U.S. investor.) Does this seem like a reasonable expectation? Answer: The Sharpe ratio =

E[r($)] , and Vol(r($)) = 22.36%, see Question a. Vol[r($)]

We also have: E[r($)] ≈ E[r(£)] + E[s] = 15% + E[s], as the expected pound return was given, but the expected exchange return must be computed to make the Sharpe ratio equal to one. That is, we must have

15% + E[s] = 1 , or E[s] = 7.36%. 22.36%
It seems rather unreasonable for the expected exchange rate change to be 7.36% unless there is a large interest differential between the two currencies (with the U.K. interest rate substantially lower than the U.S. interest rate).

3. Suppose General Motors managers would like to invest in a new production line and must determine a cost of capital for the investment. The beta for GM is 1.185, the beta for the automobile industry is 0.97, the equity premium on the world market is assumed to be 6%, and the risk-free rate is 3%. Propose a range of cost-of-capital estimates to consider in the analysis. Answer: The formula to use is the following: Cost of GM equity capital = risk free rate + beta times market risk premium. We compute two estimates, using the two available beta estimates, one for GM and one for the automobile industry, which may be more precise (assuming GM’s financial leverage is not too different from that of the industry as a whole). Using GM’s beta, we obtain 3% + 1.185 x 6% = 10.11%. Using the industry beta, we obtain 3% + 0.97 x 6% =8.82%. So, considering a range between 8.80% and 10.20% is a reasonable range of cost-of-capital estimates to consider. In fact, there is also considerable uncertainty about the size of the equity premium on the world market, which may call for an ever-wider range of cost of capital estimates.

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4. Thom Yorke is a typical mean-variance investor. He likes high-expected returns and hates high variability in his portfolio returns. He is currently invested 100% in a diversified U.S. equity portfolio. The expected return on the portfolio is 12.46%, and the portfolio’s volatility (standard deviation) is 15.76%. Thom is considering adding some alternative investments to his portfolio. One investment he is considering is the STCMM fund, which invests in U.S. small-capitalization, high technology firms. Yorke has determined that the expected return on the fund is 14.69%, that its volatility is 32.5%, and that its correlation with his current portfolio is 0.7274. He is also intrigued by the LYMF fund, which invests in several emerging markets. The expected return on the fund is only 12%; it has 35% volatility and a correlation of 0.2 with his portfolio. The correlation of the LYMF fund with the STCMM fund is 0.15. Assume that the risk-free rate is 5%. a. If Yorke is interested in improving the Sharpe ratio of his portfolio, will he invest a positive amount in one of the funds? Which one? Carefully explain your reasoning. Answer: We established that you will add an asset to your portfolio if

E[r*] - rf E[r] - rf > corr[r, r*]× Vol[r*] Vol[r] with * indicating the new funds. Plugging in the numbers, we obtain: Sharpe Ratios Investment Threshold (Hurdle Rate)

U.S. portfolio 0.4734 STCMM fund 0.2982 0.3444 LYMF 0.2 0.0947 For example, 0.2982 = [14.69% - 5%]/0.325 and 0.3444 = 0.4734 x 0.7274. Although the LYMF (“Lose Your Money Fast”) fund has a much lower Sharpe ratio than the STCMM (“Short-Term Money Mis-Management”) fund, it will get added to the portfolio, because of its low correlation with Thom's portfolio. The STCMM fund pretty much looks like a levered version of the portfolio Thom already has and seems not to eliminate much systematic risk. b. Suppose Yorke is moderately risk averse (meaning he hates variability quite a bit), but his friend, Nick Cave, is really quite risk tolerant and focuses primarily on expected returns. Both cannot short-sell securities, and both are thinking of splitting their entire portfolio between the U.S. portfolio that Yorke is currently holding, the STCMM fund, and the LYMF fund. They also do not invest in the risk-free asset and do not consider levering up risky portfolios. Compare the two investors’ optimal holdings. Who will invest more in the LYMF fund, and who will invest more in the STCMM fund? Why? Answer: While it is impossible to answer this question precisely without more information about how the two funds correlate, some outcomes are very likely. Maybe somewhat surprisingly the "risky" emerging markets fund will be held by the least risk-tolerant investors. Although very risky by itself, when added in small proportions to the portfolio Thom already has, the emerging market fund is a wonderful diversifier. He will surely hold

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the fund, since he can lower his risk without lowering expected returns much. Nick Cave on the other hand may actually invest a bit in the STCMM fund. If his preferences are such that he requires more than 12.46% return, he must hold some of the fund, since he cannot reach a better return with the two other investments. Needless to say, he will move along the mean-standard deviation frontier in riskier territory. 5. International economists continue to be puzzled by the phenomenon that investors worldwide seem to be plagued by the home asset bias. Economists have pointed out that investors with mean-variance preferences (that is, they like higher expected returns and dislike higher volatility) ought to allocate much more of their wealth to foreign equities and bonds. Three explanations for the phenomenon are given below, all of them based on empirical facts. For each one of them, discuss whether the statements are true or false and in what sense they help rationalize or fail to rationalize the home bias puzzle. In answering the questions, assume that investors indeed have mean-variance preferences. a. Investors should not hold foreign equities because they are more volatile and have been yielding lower returns than U.S. stocks in recent years. Answer: This explanation is totally false. We established that you should add foreign securities to your portfolio as soon as the foreign Sharpe ratio exceeds the American Sharpe ratio times the correlation between the U.S. portfolio return and the foreign security return. Since these correlations are quite low, foreign securities definitely belong in your portfolio (at even rather low expected returns). The dimension totally forgotten in the statement here is correlation! Moreover, the statement seems to suggest that returns from the recent past will extrapolate into the future, whereas what drives optimal asset allocations is the expected return. b. Home bias arises because investors face an additional risk when investing internationally—namely, currency risk. Because currency risk makes returns more volatile but does not lead to a higher expected return, investing more in domestic assets is rational. Answer: This is a much more subtle and rather sensible statement at first. Currency volatility drives up the volatility of foreign investment returns, although not by as much as one would think because the correlations between currency returns and equity returns are small. The problem is worse for bond returns though. Is the additional risk rewarded? Well, if the unbiasedness hypothesis holds, the foreign expected return on a hedged and unhedged investment is the same, so it is not rewarded. Moreover, most of the currency risk can be hedged away using forward contracts. This latter point makes this statement an unlikely explanation for the home bias phenomenon under UIRP, because one can eliminate the unrewarded risk using a rather "cheap" hedge. If UIRP does not hold, investors in some countries will earn risk premiums by investing internationally, which should make international investing attractive for at least a number of investors. c. Home bias arises because investors have a non-traded domestic asset that they care about as well—namely human capital. The returns to this asset can be thought of as labor income. It has been empirically determined that labor income correlates quite highly with U.S. stock returns.

Chapter 13: International Capital Market Equilibrium 75

Answer: If the empirical statement about the correlation is true, human capital makes the home asset bias worse! This was the conclusion of an article by Marianne Baxter and Urban Jermann, published in the American Economic Review. To improve your portfolio's risk profile, you want to add assets, which have low correlations with your domestic assets. If investors turn out to have another domestic asset that correlates high with U.S. stocks (and which they really cannot get rid of!), they will be looking even harder for assets with low correlation with these domestic assets, which are to be found in the international securities markets.

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6. Consider Softmike, a software company. Softmike’s world market beta is 1.75. When a regression is run of Softmike’s return on the world market return and the global HML factor, the betas are 1.50 and –1.2, respectively. Assume that the world equity premium is 6%, the HML premium is 3%, and the risk-free rate is 5%. Compute the cost of equity capital using both the CAPM and the Fama-French model. Is Softmike a value company or a growth company? Answer: According to the CAPM, Softmike’s cost of equity capital is: 5% + 1.75 x 6% = 15.50%. According to the two-factor international Fama-French model, the cost of capital is: 5% + 1.50 x 6% -1.2 x 3% = 10.40%. The Fama-French model yields a much smaller cost of capital because Softmike is a growth company and loads negatively on the value factor, which in the Fama-French model is assumed to carry a positive premium.

Chapter
Political and Country Risk
QUESTIONS

14

1. Describe the differences between country risk and political risk. What is sovereign risk? Answer: Political risk is the risk that a government action will negatively affect a company’s cash flows. In the most extreme form of political risk, governments seize property without compensating the owners in a total expropriation (or nationalization). Country risk is a broader concept that encompasses both the potentially adverse effects of a country’s political environment and its economic and financial environment. For example, a recession in a country that lowers its aggregate demand and reduces the revenues of exporters to that nation is a realization of country risk. Labor strikes by a country’s dockworkers, truckers, and transit workers that disrupt production and distribution of products, thus lowering profits, also qualify as country risks. Clashes between rival ethnic or religious groups that prevent people in a country from shopping can also be considered country risks. In international bond markets, country risk refers to any factor related to a country that can cause a borrower to default on a loan. When country risk is taken in a narrow sense to be the risk associated with a government defaulting on its bond payments, it is called sovereign risk.

2. What economic variables would give some indication of the country risk present in a particular country? Answer: To help investors discriminate between financially and economically sound and financially and economically troubled countries, a number of economic variables are used, including the following: The ratio of a country’s external debt to its GDP The ratio of a country’s debt service payments to its exports The ratio of a country’s imports to its official international reserves A country’s terms of trade (the ratio of its export to import prices) A country’s current account deficit These variables are directly related to the ability of the country to generate inflows of foreign exchange. Factors such as inflation and real economic growth are useful as well.

101

Chapter 14: Political and Country Risk 67

3. Suppose an MNC is considering investing in Bolivia. Will an overall assessment of Bolivia’s country risk suffice to understand the political risk present in the investment? Answer: First, an analysis of country risk may definitely be informative about political risk in a narrow sense. The better a country’s economic situation, the less likely it is to face political and social turmoil that will inevitably harm foreign and domestic companies. However, as the answer to question 1 notes, country risk is broader than political risk. Consequently, the MNC should try to find measures and analyses that focus more narrowly on political risk in Bolivia (such as the political risk ratings from the PRS group). Second, the industry in which a multinational corporation operates can affect its exposure to political risk. Calculating a company’s industry-specific risk is not as straightforward as calculating more general political risks. The MNC should consider issues such as whether it has primarily local competitors (more subject to political risk) rather than primarily foreign competitors (less subject to political risk). Analogously, if the MNC is the source of considerable foreign exchange earnings for the host country or is the vehicle for important technology transfer, it might be less subject to government interference than one without such advantages. The MNC must also ask whether the region in which it operates has more or less political risk than Bolivia as a whole. This raises questions such as: How much power do the country’s regional governments have versus the national government? What is the attitude of local communities to the MNC’s proposed projects? Are there any armed opposition groups in the area, and how do they view the presence of a foreign company?

4. What are three political risk factors? Answer: Political risk factors include the risk of expropriation (see Question 1), contract repudiation (when government revoke contracts without compensating companies for their existing investments in projects or services), currency controls that prevent the conversion of local currencies to foreign currencies, and laws that prevent MNCs from transferring their earnings out of the host country. Corruption, civil strife, and war are also factors.

5. When, where, and why did the Debt Crisis start? Answer: The Debt Crisis started in Mexico on August 12, 1982 when Mexico announced that it could no longer make the scheduled payments on its foreign debt. Mexico requested loans from foreign governments and the IMF, and it started negotiating with its commercial bank creditors. This constituted the start of the Debt Crisis. By the end of the year, 24 other countries had requested restructuring on their commercial bank debts. The Debt Crisis indirectly resulted from the large oil price increases that occurred in the 1970s. The OPEC countries saved their windfall income in the form of Eurocurrency deposits at international banks (usually denominated in dollars) at floating interest rates. The banks in turn loaned these “petrodollars,” as they were called at the time, to developing countries, typically in the form of Eurocredits that were quoted at a spread above the floating interest rate they paid to the OPEC countries. Banks viewed the lending as profitable and relatively riskless for three reasons. First, the loans were made at a spread over the banks’ borrowing costs. Thus, the banks were not exposed to changes in interest rates, as they would have been if they had borrowed short term and loaned at long-term fixed rates. Second, the banks eliminated exchange rate

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exposure as the debts were denominated in dollars, which was the currency the OPEC countries had deposited. Third, the banks syndicated the loans, taking diversified exposures to a number of countries to avoid too much exposure to a single country. As a result, during the 1970s, the debt of non-OPEC developing countries owed to banks in industrialized countries, especially banks in the United States, increased significantly. A mix of external shocks affecting industrialized countries and developing countries in the 1980s and macroeconomic mismanagement in developing countries triggered the actual Debt Crisis. The steep increase in the oil price in the late 1970s was met with a staunchly anti-inflationary monetary policy in a number of countries, particularly in the United States under Federal Reserve Bank Governor Paul Volcker. The macroeconomic situation in the developed world was now totally different than it had been in the early 1970s: Real interest rates were high, the global economy was in recession, and the dollar was strong. This situation contributed to low prices of commodities on the world markets and low demand for the exports of developing countries. With the huge dollar appreciation and high dollar interest rates, the developing countries faced steep interest payments in dollars at the same time as their export revenues were falling. Suddenly, the default risk of the loan portfolios of international banks had greatly increased. The situation was exacerbated by the fact that developing countries often had not used the money they borrowed very productively and had run what were ultimately seen to be unsustainable economic policies.

6. What is debt overhang? Answer: Debt overhang is the notion that a country saddled with a huge debt burden has little incentive to implement economic reforms or stimulate investment because the resulting increase in income will simply be appropriated by the country’s creditors to pay an outstanding large debt. From this perspective, it may be better in certain situations for countries to stop or severely restrict repaying their debts.

7. What is a debt buyback? Why was a program of debt buybacks not sufficient to resolve the Debt Crisis? Answer: A debt buyback is one example of the policies that many countries attempted to employ in an effort to reduce their debt burden. In a debt buyback, the country repays a loan at a discount. Such efforts did not suffice to resolve the Crisis for various reasons. First, programs such as debt buybacks require monetary resources, which were in limited supply. Second, such programs may not be very effective in reducing the outstanding debt. Several economists argue that when a country uses its own resources to buy back its troubled debt at a discount, the country’s creditors are the only ones that benefit. Essentially, the debt buyback program drives up the secondary market price of the debt, reducing its effectiveness. For example, in the famous case of the 1988 Bolivia debt buyback, Bolivia used $34 million in donations to reduce the market value of its debt by only $8.8 million. It is ultimately more effective to deal with a solvency problem by taking a comprehensive approach that involves debt relief. That is essentially what the Brady plan set out to do.

Chapter 14: Political and Country Risk 69

8. What were the main characteristics of the Brady Plan? Answer: The 1989 Brady Plan, developed by then U.S. Treasury Secretary Nicholas Brady, had the following important characteristics: 1) It put pressure on banks to offer some form of debt relief to developing countries. 2) It called for an expansion in secondary market transactions aimed at debt reduction. 3) The IMF and the World Bank were urged to provide funding for these “debt or debt service reduction purposes.” 4) It offered banks a menu of different debt-reduction methods, including providing new loans. Each bank could choose the restructuring option that it found most suitable from a menu of possibilities established in a debt-reduction agreement between the debtor-country government and its creditor banks. In order to mitigate free-rider problems, no bank could opt out. Among the options available to the banks were the following: Buybacks: The debtor country was allowed to repurchase part of its debt at an agreed discount (a debt-reduction option). Discount bond exchange: The loans could be exchanged for bonds at an agreed discount, with the bonds yielding a market rate of interest. Par bond exchange: The loans could be exchanged at their face value for bonds yielding a lower interest rate than that one on the original loans. Conversion bonds combined with new money: Loans could be exchanged for bonds at par that yielded a market rate of return, but banks had to provide new money in a fixed proportion of the amount converted (an option for banks unable or unwilling to participate in debt reduction or debt service reduction). Because the bond options were particularly popular choices, the Brady Plan ended up securitizing the debt into easily tradable bonds, called Brady Bonds. Quite a few Brady bonds have “official enhancements” attached to them, such as collateral provisions funded by international organizations and certain governments.

9. Why should the discount rate not be adjusted for political risk? Answer: Consider a multinational corporation with a shareholder base that is globally diversified. In this case, the discount rate should reflect only international, systematic risks. Chapter 13 showed that systematic risks are typically related to how an MNC’s return in a particular country covaries with the world market return. If the risk of loss from political risk does not covary with the world market return, no adjustment to the discount rate is necessary. Positive covariation between the cash flows from the project and the world market return increases the required global discount rate. Consequently, unless political risk, which adversely affects the MNC’s investment returns, is systematically high when the world market return is low, political risk should not enter the calculation of the discount rate. Instead, the company’s cash flows should be adjusted for the presence of political risk. To fully understand this argument, suppose a company takes out an insurance policy against political risk and that the policy covers all contingencies and has no deductible. In this case, a company would simply compute its expected cash flows as if there were no political risk and then subtract the insurance premium it must pay each year from the cash flows of the project. The cash flows would then be discounted at the usual discount rate. While it is possible to purchase political risk insurance, it is seldom the case that an investment can be fully insured. If a company chooses not to purchase political risk insurance, it must incorporate into its forecasts of future cash flows how they might be affected by various political risks, such as expropriation, unexpected taxation, and so forth.

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10. What are some examples of organizations that provide country risk ratings? Answer: Organizations such as Euromoney, Institutional Investor, the Economist Intelligence Unit, and Political Risk Services Group produce country risk ratings for most countries in the world. Both quantitative information from countries and qualitative information obtained from experts are used to evaluate country and political risks.

11. How can we use current quantitative information to predict future political events, such as expropriation? Answer: Most risk-rating services look for measurable attributes and indicators that, in the past, have been correlated with future risk events. For example, left-wing governments may be associated with actions that harm foreign investors, such as stricter labor regulations or outright nationalization. Countries with unstable governments and frequent, forced elections have a higher probability of electing left-wing officials within a particular period than countries with stable governments. This is true even if a right-wing government may be in power currently. Consequently, the frequency of government changes is used as a risk attribute. Generally, political risk services examine indicators of political risk, such as the following: Political stability (for example, the number of different governments in power over time) Ethnic and religious unrest; the strength and organization of radical groups The level of violence and armed insurrections; the number of demonstrations Property rights enforcement The extent of xenophobia (fear of foreigners); the presence of extreme nationalism The different political variables are then weighted and added to provide one country score. Such overall scores may be the best indicators of an extreme political risk event, such as expropriation. Some services, such as the PRS Group, do provide subcomponents that may be more correlated with the specific political risk event, such as “democratic accountability” and “government stability.” In particular, one subcomponent, Investment Profile, specifically considers risk factors that directly affect the risk of expropriation.

12. Suppose a multinational corporation is particularly worried about ethnic warfare in a few countries in which it is considering investing. Do country risk ratings have information on this particular risk? Answer: Yes, some rating services, such as the PRS Group’s ICRG (International Country Risk Guide) system have subcomponents within their overall political risk rating. It so happens that “ethnic tensions” is one such subcomponent, providing assessment of disagreements and tensions between various ethnic groups that may lead to political unrest or civil war. Other subcomponents that may also be worthwhile investigating are “internal conflicts” (an assessment of internal political violence in the country) and “religious tensions” (an assessment of the activities of religious groups and their potential to evoke civil dissent or war).

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13. Can Brazil issue a bond denominated in dollars at the same terms (that is, at the same yield) as the U.S. government? Why or why not? Answer: When a sovereign borrower issues bonds in its own currency, there is technically no default risk because the government can typically simply print money to pay back the debt holders. When a sovereign borrower issues bonds in a different currency, though, a default is possible because the government must earn foreign exchange to pay off the bondholders. This possibility of default will be priced into the yield on the bond. Hence, Brazil will face a higher yield on its dollar borrowings than the U.S. government does. The difference between the two yields is called the country credit spread. For example, if the yield on a 5-year U.S. Treasury bond is 5%, and the yield on a 5-year dollar bond issued by the Brazilian government is 10%, the Brazilian country credit spread is 5%. These spreads, which vary over time as the bonds trade in secondary markets, are, of course, an indication of country risk.

14. What stops governments from defaulting on loans or bonds held by foreigners? Answer: Sovereign defaults are different from a company going bankrupt because it is very difficult to take a country to court, and there are no formal bankruptcy proceedings in place for sovereigns. Nonetheless, sovereigns still must worry about the consequences of defaulting because of the following issues: The assets of the country located in the jurisdiction of a creditor may be seized. The country will not be able to borrow as readily in the future, which can have grave economic consequences. The country could find its ability to engage in international trade severely curtailed. These costs of defaulting must be weighed against the benefit that the debt must no longer be serviced. Governments have defaulted on bonds periodically throughout history, a recent example being Argentina in 2001.

15. What is a Brady bond? Answer: Brady bonds were created as a consequence of the Brady plan which aimed at resolving the Debt Crisis for many countries. In February 1990, Mexico became the first country to issue Brady bonds, and Brady deals were subsequently done by Argentina, Brazil, Bulgaria, Costa Rica, the Dominican Republic, Jordan, Nigeria, Philippines, Poland, Uruguay, and Venezuela. The vast majority of outstanding Brady bonds are U.S. dollar denominated, and they tend to have very long maturities (20 to 30 years). The bonds are evenly divided between fixed and floating-rate instruments. Brady bonds have a number of special features: Principal collateral: All par and discount bonds are collateralized by U.S. Treasury zero-coupon securities having similar maturities. Interest collateral: For some bonds, the government issuing the Brady bonds deposits money with the New York Federal Reserve Bank in amounts covering 12 to 18 months’ of interest payments on a “rolling” basis. Sovereign portion: The remaining cash flows are subject to sovereign risk. Bonds sometimes also include detachable warrants or recovery rights predicated on a country’s economic performance. Mexico’s Value Recovery Rights (VRRs), for example,

72 Chapter 14: Political and Country Risk

were based on numerous variables, including oil prices, GDP, and oil production levels. In June 2003, Mexico retired the last of $35 billion in Brady bonds. 16. Should the “stripped” yield on a Brady bond typically be higher or lower than the regular yield? Explain. Answer: It should be higher as the stripped yield removes the effect of the collateral enhancements. It is the yield-to-maturity of the unenhanced interest stream after removing the present value of the U.S. Treasury zero-coupon bond that collateralizes the principal and the present value of the guaranteed interest stream. This stripped yield is truly based on the credit quality, or sovereign risk, of the issuing nation. The collateral enhancements imply that the difference between the yield-to-maturity on the Brady bond and a U.S. Treasury bond of comparable maturity (sometimes called the “blended” yield) cannot really be viewed as a country spread.

17. How is a political risk probability related to a country spread? Answer: First, recall that the country spread is an indication of the default risk of a bond. However, although a government might default on its bonds as a result of a political event, this does not necessarily mean that it will also expropriate the assets of the MNCs that lie within its borders. Hence, the correlation between political risk and sovereign default risk is far from perfect. Second, even when we assume that the political risk probability is perfectly correlated with the probability of default, the probability of default is not easily recovered from the yield spread. In fact, the information needed is not the spread itself but the bond’s price, coupon rate, U.S. interest rates (assuming the bond is dollar denominated) and potentially information on collateral enhancements. We can then estimate this probability by making some additional assumptions: the political risk probability is constant over time. the recovery value in the case of default is zero (although computations could be made assuming a particular recovery value). default is an idiosyncratic risk. The computations should also take into account any collateral enhancements. As a simple example, assume a bond with price equal to $92 (per $100 par value). Assume that the coupon rate is 7%, that the bond has only 2 years to go, and that the oneyear and two-year U.S. dollar interest rates are 5%. We denote the probability of default by p. The first year, the probability that $7 is paid to the bondholders is 1 – p. The second year, there is a probability of (1 – p)2 that the bond will not be in default, and there is a probability of (1 – p) p that there will be a default. It therefore must be the case that 92 = (1 - p)

7 107 + (1 - p)2 1.05 1.052

Here, we equate the value investors assign to the bond with the present value of the expected cash flows, discounted at U.S. risk-free rates. We can do this because the possibility of default is taken into account in the probabilities, and we assume that default is an idiosyncratic risk. This equation can be solved for p, the probability of default. We find p = 6.01%. If we believe sovereign risk as reflected in this default probability is perfectly correlated with the political risk embedded in a cash flow analysis for capital budgeting, this is the probability we should use.

Chapter 14: Political and Country Risk 73

18. What are Cetes? What are Tesobonos? Answer: Cetes are treasury bills issued by the Mexican government, denominated in Mexican peso. Tesobonos are also treasury bills issued by the Mexican government, but they are effectively U.S. dollar denominated. That is, while both the purchase amount and the principal payment are denominated and made in pesos, the principal payment is fully indexed to the change in the exchange rate between the dollar and the peso. Let’s consider an example using a 3-month Tesobonos. Suppose the yield on the Tesobonos is 5%. If the Mexican peso exchange rate didn’t change in value, the investor would receive 1 +

0.05 = MXN1.0125 4

after 3 months. Suppose though that the Mexican peso devalues by 5% over the 3-month period. Then, the amount paid to the investor will be ⎜1 +

⎛ ⎝

0.05 ⎞ ⎟1.05 = MXN1.063125. 4 ⎠

Note that this represents a 25.25% (6.3125% × 4) return on an annualized basis. Hence, Tesobonos provided investors with protection against peso devaluation.

19. What are the three main types of political risk covered by political risk insurance? Answer: Insurance is typically available for currency inconvertibility (when a company is unable to convert its foreign earnings to its home currency or otherwise transfer the earnings out of the host country), expropriation (protects MNCs and lenders against confiscation, expropriation, nationalization, and other acts by the host government that adversely affect the MNC’s cash flows, including “creeping expropriation” – a series of acts that cumulatively result in some expropriation of value – discriminatory legislation, the deprivation of assets or collateral, the repudiation of a concession, and the failure of a sovereign entity to honor an arbitration award issued against it), and war and political violence (compensates a company when war or civil disturbances cause damage to the MNC’s assets or cash flows).

20. What are some organizations or firms that provide political risk insurance? Answer: There are three potential sources of political risk insurance: international organizations aimed at promoting foreign direct investment (FDI) in developing countries, government agencies, and the private market. Among international organizations providing insurance, the World Bank’s Multilateral Investment Guarantee Agency (MIGA), the InterAmerican Development Bank (IDB), and the Asian Development Bank (ADB) are the best known. Most OECD countries have national agencies that provide domestic companies with political risk insurance. Examples include the Overseas Private Investment Corporation (OPIC; United States), Nippon Export and Investment Insurance (formerly EID/MITI; Japan), the Export Development Corporation (EDC; Canada), the Export Credits Guarantee Program (ECGD; United Kingdom), and the Export Finance and Insurance Corporation (EFIC; Australia). The private market has grown significantly and now includes firms such as Lloyd’s, American International Group (AIG), Sovereign Risk Insurance Ltd., and Zurich Emerging Markets Solutions.

74 Chapter 14: Political and Country Risk

21. How is it possible to embed political risk insurance in a capital budgeting analysis? Answer: Assuming that political risk insurance would be complete and perfect, it is straightforward to embed political risk insurance in capital budgeting analysis because such insurance simply generates an annual cost. The cost of the premium must be deducted from the cash flows, and the discount rate should only reflect systematic, not political risk. Of course, political risk insurance is typically somewhat incomplete, so it may be necessary to consider cash flow scenarios in which political risk events still lead to loss of cash flows in computing the expected cash flows from a project.

22. What is project finance? Answer: Project financing is a method of financing that is specific to a particular project, typically industrial in the nature, in which the providers of the funds are repaid primarily from the cash flows generated by the project.

PROBLEMS
1. In February 1994, Argentina’s currency board was in place, and 1 peso was exchangeable into 1 dollar. The following interest rates were available: U.S. LIBOR 90 days: 3.25% Peso 90-day deposits: 8.99% Dollar interest rate in Argentina, 90-day deposits: 7.10% The latter two rates were offered by Argentine banks. What risk does the difference between the 7.10% dollar interest and 3.25% LIBOR reflect? What risk does the difference between the rate on 90-day pesos and 90-day dollar deposits by Argentine banks reflect? Answer: The difference between the 7.10% dollar interest rate and the 3.25% LIBOR rate reflects country risk, the chance that the Argentine banks will not repay the loan. Both deposits are in dollars so the interest rate difference does not reflect currency risk. The difference between the rate on 90-day pesos and 90-day dollar deposits by Argentine banks reflects currency risk. The deposits are offered by Argentine banks (so the credit risk is the same), but if the currency board is abandoned, the peso may no longer be worth 1 dollar.

2. Consider the numbers in the previous question. Assume that if the peso were to depreciate, investors figure it will depreciate by 25%. Also, assume that if the Argentine bank were to default on its dollar obligations, it would pay nothing to investors. Compute the probability that the peso will devalue and the probability that there will be a default. Answer: We can follow the analysis done on the Tesobonos case in Chapter 14 to compute the default probability. We equate the return of the LIBOR rate [iLIBOR] with the return for dollar deposits in Argentina [iARG], taking into account a default probability of p.

1+i
Consequently:

LIBOR

= (1 + i )(1 - p) + 0×p
ARG

Chapter 14: Political and Country Risk 75

0.0325 4 p=1= 0.95% , or almost 1%. 0.0710 1+ 4 1+
The devaluation probability computation was first illustrated in chapter 7. Under Uncovered Interest Rate Parity, the expected return on the peso and dollar deposits at Argentine banks should offer the same expected return. Consequently, we should have

E[S(t+1)] ⎡ 0.0899 ⎤ 0.0710 ⎢1 + ⎥ =1+ S(t) ⎣ 4 ⎦ 4
E[S(t+1)] = (1 - q) S(t) + q S(t) (1 - 0.25) = S(t)[1 - 0.25×q] where S(t)=1. Substituting in Equation (*), we obtain

(*)

where S(t+1) is the spot exchange rate at time t+1 in dollars per peso. Hence, E[S(t+1)] is the expected exchange rate. Let q be the probability of devaluation. We have

0.0710 ⎤ ⎡ ⎢ 1+ 1 4 ⎥ = 1.85% q= × ⎢1 ⎥ 0.25 ⎢ 1 + 0.0899 ⎥ ⎣ 4 ⎦
The probability of a 25% devaluation is 1.85%. However, these computations implicitly assume that the devaluation and default events are independent. In this case, they very likely are not. As long as the currency board is in place, Argentine banks are much less likely to default on the dollar deposits. Let’s see what happens under the following assumptions. There are three possible states: 1. No default occurs, and the currency board remains in place. 2. The peso depreciates, but the Argentine banks do not default. 3. Both the currency board collapses and the banks default on all their deposits and pay depositors nothing. We know the probability of scenario 3 occurring, as it is simply the probability of default, p = 0.95%. Given the correlation between default and depreciation, what is the probability of the second scenario? Let’s call it q*. The total probability of the peso depreciating is consequently q*+p. However, when scenario 3 materializes, holders of peso deposits receive nothing. So the expected gross dollar return on peso deposits is:

(1 - p - q*)(1 +

0.0899 0.0899 ) + q*(1 + )0.75 + p×0 4 4

where we used the fact that if the currency devalues it devalues to $0.75 / peso. This return must equal the return on dollar deposits in the U.S. Therefore, we obtain:

0.0899 ⎤ 0.0325 ⎤ ⎡ ⎡ ⎢1 + ⎥ (1 - p) - ⎢1 + 4 ⎦ 4 ⎥ ⎣ ⎦ q* = ⎣ 0.0899 ⎤ ⎡ 0.25 ⎢1 + 4 ⎥ ⎣ ⎦
Using p = 0.95%, we find:

q* = 1.81%.
Consequently, the total chance of some bad event happening (scenarios 2 or 3) is slightly reduced under this assumption.

76 Chapter 14: Political and Country Risk

3. Consider a 10-year Brady bond issued by Brazil. The coupon payment is 6.50%, and the par value has been collateralized by a U.S. Treasury bond. The current price of the bond is $98 (per $100 in par value). Compute the (blended) yield-to-maturity for the bond. What is the stripped yield? Assume that the spot rates on the dollar are the ones reported in Exhibit 14.8. Answer: We list the cash flows as in Exhibit 14.8: Year 1 2 3 4 5 6 7 8 9 10 Dollar Cash Flows 6.5 6.5 6.5 6.5 6.5 6.5 6.5 6.5 6.5 106.5 Dollar Spot Rates 3.50 4.10 4.65 5.05 5.55 5.85 6.05 6.25 6.35 6.50

The (blended) yield to maturity for the bond is the solution to the following equation:

98 =
Using Excel, we find:

6.5 6.5 106.5 + + ... + 2 1+y (1 + y) (1 + y)10

y = 6.78% The stripped yield takes into account that part of the bond value is collateralized by U.S. Treasuries, in this case the par value of the bond. The current value of $100 worth of par value is: Collateral value =

$100 = $53.27. (1 + 0.065)10

This means that the “stripped” price equals $98.00 - $53.27 = $44.73. The stripped yield, y , then follows from re-doing the computation above, adjusting the price and stripping out the par value repayment:

44.73 =

6.5 6.5 6.5 + + ... + 1+y (1 + y)2 (1 + y)10

It follows that y = 7.45%. The stripped yield is substantially higher than the blended yield.

Chapter 14: Political and Country Risk 77

4. Right at the height of the Mexican peso crisis in January 1995, the default probabilities on U.S. dollar-denominated emerging-market bonds were quite high. A British investment bank, assuming that these bonds would pay 15 cents on the dollar upon default, calculated a 61% chance of default on Venezuelan bonds. Consider a bond with 5 years left to maturity, paying a coupon of 12%. The par value is 80% collateralized by American Treasury bonds. Assume that the U.S. interest rate is 5% for all maturities. What is the price of a bond with $100 par? Answer: The first step in the computation is to compute the value of the collateral, Value collateral =

80$ = $62.68. (1.05)5

To figure out the value of the remaining cash flows, we list the cash flows and probabilities in an exhibit: Year 1 2 3 4 5 Discount Factor 0.9524 0.9070 0.8638 0.8227 0.7835 No Default Case Cash Probability Flow 12 0.39 12 (0.39)2 12 (0.39)3 12 (0.39)4 32 (0.39)5 Default Case Cash Probability Flow 15 0.61 15 0.61(0.39) 15 0.61(0.39)2 15 0.61(0.39)3 15 0.61(0.39)4

The cash flow in year 5 reflects the coupon of 12 and the non-collateralized part of the par value (20). Note that the probability of retrieving this $32 in full in year 5 is (0.39)5 = 0.009 < 1%. The current value of these cash flows is now simply the probability-weighted sum of the cash flows, discounted using U.S. discount rates (see the formula in Equation (14.4)). The

⎛ 1 ⎞ discount factor in the 2 column reflects these interest rates and is given as ⎜ ⎟ for the ⎝ 1.05 ⎠ nd n

n-th year in the future. The present value of the “no default” cash flow is $7.18. The value of the “default” cash flows is $13.77. Hence, the total value of the bond is: $62.68 + $7.18 + $13.77 = $83.63. The collateral represents the most important part of the value.

78 Chapter 14: Political and Country Risk

5. Badwella United Company (BUC) is worried that its banana plantation in El Salvador will be expropriated during the next 2 years. However, BUC, through an agreement with El Salvador’s central bank, knows that compensation of $100 million will be paid if the plantation is expropriated. If the expropriation does not occur, the plantation will be worth $400 million 2 years from now. A wealthy El Salvadoran has just offered $160 million for the plantation. BUC would have used a discount rate of 23% to discount the cash flows from its Honduran operations if the threat of expropriation were not present. Evaluate whether BUC should sell the plantation now for $160 million. (Hint: Set up a cash flow diagram.) Answer: Let’s first make the simplifying assumption that the probability of expropriation is constant and let’s denote it by p. There are three possible scenarios as indicated in the following diagram: Scenario Probability Value Discount Factor 2 No expropriation (1 – p) 400 1 Expropriation in year 1 Expropriation in year 2 p (1 - p) p 100 100

= 0.6610 1.232 1 = 0.8130 1.23 1 = 0.6610 1.232

We assume that the 23% discount rate applies to the expected cash flows of the project, and we account for the possibility of expropriation in computing expected cash flows. Hence, we have:

400 × (1 − p) 100 × p 100 × p(1 − p) Value project = + + 2 2 1.23 (1.23) (1.23)
2

Because the problem does not mention the probability of expropriation, we cannot come up with a final answer. BUC should evaluate the probability of expropriation in El Salvador and check whether the value of the project is more or less than 160 million. A useful computation is to find that value of p for which the value of the project is exactly 160 million. Using trial and error, we find that p = 33.05%. This looks like a rather high probability of expropriation, implying that there is only a (1 – p)2 = 44.82% chance that the full value of the project will be realized two years from now.

Chapter 14: Political and Country Risk 79

6. You are the chief financial officer of Clad Metal, a U.S. multinational with operations throughout the world. Your capital budgeting department has presented a proposal to you for a 5-year ore-extraction project in Mexico. The expected year-end net dollar cash flows are as follows: Year Net Cash Flow 1 $100,000 2 200,000 3 250,000 4 250,000 5 250,000 The initial required investment in plant and equipment is $500,000, and the cost of capital is 16%. a. What is the present value of the project? Should the project be undertaken? Answer: We can construct the following cash flow diagram: Present Value of the Cash Flows 86,207 148,633 160,073 138,073 119,028

Year 1 2 3 4 5

Dollar Cash Flows 100,000 200,000 250,000 250,000 250,000

Discount Factors 0.8621 0.7432 0.6407 0.5523 0.4761

Consequently, the present value of the project is 652,105 and the NPV 152,105. The project should be undertaken. b. You notice that the proposal does not include any analysis of political risk, but you are concerned about potential expropriation of the investment. You therefore decide to call a meeting to discuss political risk. Who would you invite to this meeting? What information or data would you need? How would you arrive at a political risk probability estimate? Answer: You could invite people familiar with the local political and economic situation or, if you do not have the in-house expertise, consult political ratings and the accompanying information from any one of the political ratings services discussed in this chapter. If available, you may also consult price information on Mexican bonds (preferably issued in dollars) and information on premiums for political risk insurance for projects in Mexico. As discussed at length in this chapter, it is not straightforward to convert information on country spreads into expropriation probabilities but under certain assumptions, it can be done (see Question 17 for an example). Political insurance premiums directly give an idea of how much should be subtracted each year from expected cash flows to account for political risk.

80 Chapter 14: Political and Country Risk

c. Assume that, at the end of the meeting, you decide that the probability of expropriation is between 5% and 7%. Also assume that there is no compensation in the case of expropriation. Would you approve the project? Answer: Let p be the probability of expropriation. We recompute the present value of the cash flows, taking the probability of expropriation into account. This implies multiplying the cash flow in year t by (1 – p)t. Doing this reduces the present value to 557,921 in the case of p = 5% and 532,822 in the case of p = 7%. In both cases, you should continue to approve the project! d. Given the possibility of expropriation, might you want to reconsider converting Mexican peso expected cash flows at forward rates? Answer: It depends how these forward rates were derived. If the forward exchange rates come from the Chicago Mercantile Exchange, they only reflect currency risk (as the CME is an AAA organization). If the cash flow computations take into account expropriation risk, these are the appropriate forward rates to use. If, however, the forward exchange rates were derived using local interest rates, they will also partially reflect country and political risk. Taking into account expropriation risk in the cash flow computations would therefore account for the political risk twice.

Chapter
International Capital Budgeting
QUESTIONS

15

1. Can an investment project of a foreign subsidiary that has a positive net present value when evaluated as a stand-alone firm ever be rejected by the parent corporation? Assume that the parent accepts all projects with positive adjusted net present values. Answer: Yes, we know that countries impose withholding taxes on the dividends that are repatriated from subsidiaries to parent corporations. These taxes lower the value of the project to the parent. The parent must also be aware of the possibility of future problems accessing the foreign exchange market from the subsidiary’s country. In general, political risk could be different for a subsidiary of a multinational corporation versus a local stand-alone firm.

2. How do licensing agreements, royalties, and overhead allocation fees affect the value of a foreign project? Answer: Licensing agreements, royalties, and overhead allocation fees are true costs to the subsidiary or to the stand-alone firm that would be operating in the foreign country producing and selling the products of the multinational corporation. Thus, licensing agreements, royalties, and overhead allocation fees reduce the income in the foreign country. Nevertheless, these cash flows provide profit to the parent corporation. Licensing agreements and royalties provide pure profit to the parent as no costs are incurred, and overhead fees provide net profit as they cover costs incurred by the parent. Thus, these cash flows are quite valuable to the parent.

3. Why does an adjusted net present value analysis treat the present value of financial side effects as a separate item? Isn’t interest expense a legitimate cost of doing business? Answer: The adjusted net present value approach to capital budgeting starts by valuing the free cash flows to the all-equity cash firm. It then adds other sources of value associated with how the firm is financed. Compared to the weighted average cost of capital approach, the numerator cash flows are the same – the free cash flow to the all equity firm. In contrast to WACC analysis which discounts these cash flows with a discount rate that is a weighted average of the after-tax required return on the debt and the rate of return on the levered equity, the ANPV analysis uses the rate of return on the unlevered assets to get the all-equity value. Students sometimes think that the deductibility of interest as a business expense is therefore missing, and they want to reduce the all-equity free cash flows by the after-tax interest payments. This misses the fact that the value of the interest tax shields is being added as a separate source of value in ANPV, whereas it is included in WACC. Also, it misses the fact that when the equity holders lever the firm, they get the principal on the debt up front and don’t have to put as much equity into the firm for its investments. The present value of the future cash outflows for interest payments and repayment of principal equal the initial value of the principal, in which case it is only the tax shield that needs to be valued. ANPV does this separately.

66

Chapter 15: International Capital Budgeting 67

4. What is meant by the net present value of the financial side effects of a project? Answer: Generally, these effects arise from the costs of issuing securities, the taxes or tax deductions associated with the type of financing instrument used (including the tax deductibility of the interest paid on the debt), the costs of financial distress, and the availability of subsidized financing from governments.

5. Why is it costly to issue securities? Answer: The investment bankers who handle the issuing of securities either to the public or to private investors are financial intermediaries, and they must be compensated for the use of their scarce resources. This compensation includes a monetary fee, but it also often includes an underwriting discount, or spread. The underwriting discount between what the corporation receives from issuing the securities and what the public pays for the securities is often a large part of the compensation of the investment bank that underwrites the issue.

6. What is an interest tax shield? How do you calculate its value? Answer: The interest tax shield on a debt is the deduction for interest expense. Therefore, it is equal to the corporate tax rate times the amount of interest, τ rD D . This tax deduction is discounted at the stated debt rate, which is the market debt rate associated with that debt. Thus, the discounted present value of a perpetual interest tax shield is

τ rD D (1 + rD )

+

(1 + rD )

τ rD D

2

+

(1 + rD )

τ rD D

3

+ ... = τ D

7. What is an interest subsidy? How do you calculate its value? Answer: Interest subsidies arise when governments are willing to lend to corporations at below market interest rates. Such subsidies add value to a project. The appropriate discount rate for an interest subsidy is the market’s required rate of return on the debt of the corporation because the corporation is just as likely to default on a subsidized loan from the government as it is on a normal loan at market interest rates. Suppose that the government lets a corporation borrow a principal of D for one period at a subsidized interest rate of rS < rD, which is the market’s required rate of return on the corporation’s debt. The corporation borrows D in the first period, and it repays (1 + rS)D in the second period. Because the actual interest payment is deductible, the corporation also gets a tax deduction of τ rS D in the second period. The present value of the cash flows of the subsidized debt discounted at the market’s required rate of return on the corporation’s debt is therefore

D-

(1 + rS ) D (1 + rD )

+

( r - r ) D + τ rS D τ rS D = D S (1 + rD ) (1 + rD ) (1 + rD )

The value of a loan at a subsidized, below-market, interest rate has two components: the present value of the interest subsidy, which is the difference between the interest paid on a market loan and the interest on the subsidized loan, plus the present value of the actual interest tax shield. In both cases, the present value is taken at the market’s required rate of return on the debt.

68 Chapter 15: International Capital Budgeting

8. What are growth options? Provide an example of one in an international context. Answer: A growth option arises when a firm undertakes a project and obtains an option to do another project in the future. The option to do the second project adds value to the first project. A growth option might include a firm’s ability to sell a new product that is successful in the domestic market in the international marketplace. Growth options are specific examples of real options that also include the ability of a firm to shut down a plant or a mine until operating conditions improve or to delay an important operating decision until more information can be gathered. Real options are valuable.

9. What is the difference between EBIT and NOPLAT? Answer: The acronym EBIT is earnings before interest and taxes. It represents the before-tax operating profit of the firm. The acronym NOPLAT is net operating profit less adjusted taxes. It is found by taking the taxes out of EBIT that would be paid by the all-equity firm. It is therefore the after-tax operating profit of the all-equity firm.

10. Why is it important to understand and manage net working capital? Answer: The stock of net working capital is the amount of inventory, cash, and accounts receivable minus accounts payable that the firm must have on hand to run its business. If the business can be run with a lower net working capital, this amount of assets could be given to investors. Conversely, increases in net working capital use after-tax profits that the firm could otherwise use to finance capital expenditures or pay to investors. As such, changes in net working capital are investments that the firm makes in its future profitability.

11. What does CAPX mean, and why is it a firm’s engine of growth? Answer: CAPX is an acronym that is short for capital expenditures. These are investments that the firm is making in physical plant and equipment that will produce output in the future. Consequently, if the firm wants to grow, it will have to do CAPX, and in this sense, CAPX is the firm’s engine of growth.

12. Why is it sometimes assumed that CAPX equals depreciation in the later stages of a project? Answer: As a project matures, there are no more planned investments in which case the scale of the project is fixed. But, the physical plant and equipment have an economic lifetime and must be replaced. If accounting depreciation matches economic depreciation, setting CAPX equal to depreciation is appropriate. You should be aware that accounting depreciation often fails to match economic depreciation because of inflation. The higher the rate of inflation, the more severe this problem is unless the accounting depreciation is indexed to inflation in some way. Because CAPX will be spent on real plant and equipment, the nominal amount of expenditures may be somewhat greater than the amount the accounts are allowed to deduct for the book value of depreciation.

Chapter 15: International Capital Budgeting 69

13. What is the terminal value of a project? How is it calculated? Answer: The terminal value of a project is the present discounted value of all future free cash flows in the years beyond an explicit forecasting horizon. If we generate explicit forecasts of free cash flows for the next 10 years, the terminal value is the present discounted value of free cash flows in years 11 to infinity. One typically assumes that future free cash flows will grow at the rate g, and the discount rate for these perpetual cash flows is r. The starting value in year 11 is (1+ g) higher than the expected free cash flows in year 10. From the perpetuity formula for a growing cash flow, we know that

Terminal value in year 10 =

E t [FCF(t+10)] (1 + g )

(r - g)

After calculating the terminal value in year 10, that quantity must then be discounted to year 0 by multiplying by the appropriate discount factor, which is 1 / (1 + r)10:

Terminal value in year 0 =

Terminal value in year 10

(1 + r )

10

The growth rate g should reflect the expected rate of inflation in the currency of the forecasts because the project’s real capacity from its CAPX assumptions will be fully utilized, and new real investments would have to be made for there to be additional real growth. These real investments are typically not in the forecasts, so the only source of growth in nominal terms is expected inflation.

14. What is meant by the cannibalization of an export market? Answer: When you choose to change how you service a market to which you are exporting, either because you are building a new plant in the foreign country or you are expanding production in an existing plant, you would like to know the incremental profitability of this new project. Cannibalization of exports refers to the lost exports in this market that you are now serving differently if no market can be found for the goods that were formerly being exported to that country. These lost exports could be from the parent or from another one of its foreign subsidiaries in a different country. The lost profits on these exports must be considered to be a cost of accepting the new project. If the exports that were formerly being sent to the country can be sold elsewhere in the world, there is no cannibalization.

15. What are the primary sources of value to IWPI-U.S. in establishing a Spanish subsidiary? Answer: The primary sources of value for IWPI-U.S. are the dividends that will be received by the parent that represent the after-tax free cash flows of the subsidiary, the profits from royalties and licensing fees, and the profits on intermediate parts that are sold to the Spanish subsidiary.

16. Why are the profits on exports of intermediate goods by IWPI-U.S. to IWPI-Spain included as part of the value of the project? Answer: Even though the intermediate goods are sold by IWPI-U.S. to IWPI-Spain at an internally determined transfer price, this price should incorporate profit to the parent. We explicitly discuss transfer pricing issues in Chapter 19 where we argue that the government authorities require that transfer prices be done at market prices that would be observed between third parties. If IWPI-U.S. sells replacement parts for its hinges and handles, it will have a retail price for these intermediate parts, and those prices will determine the transfer prices.

70 Chapter 15: International Capital Budgeting

17. What risks are present in the IWPI-Spain project? How do they affect the value of the project? Answer: The primary source of risk is the business risk of selling wooden furniture in Europe. The expected free cash flows of the project are taken from a probability distribution that represents the possible ups and downs of the business due to cyclical fluctuations in Europe as well as idiosyncratic events particular to IWPI. The systematic business risk of the project is reflected in the fact that the beta of the project is 1.1. The beta is the perceived covariance of the return on the project with the return on the world market portfolio divided by the variance of the return on the world market portfolio. Thus, assuming an equity risk premium of 8.5%, the expected free cash flows are discounted by an all-equity required rate of return that is 9.35 percentage points above the risk free interest rate.

PROBLEMS
1. What percentage of the adjusted net present value of the IWPI-Spain project arises from cash flows that will occur more than 10 years in the future? Answer: The present value of the cash flows from years 11 to infinity is €32.06 million. The total ANPV of the project is €84.64 million. Thus, the terminal value of the project contributes 37.9% of the ANPV of the project. 2. How sensitive is the value of IWPI-Spain to the assumed discount rate of 20%? What happens to the value of the project if the rate is 22% instead? Answer: When the project was discounted with 20%, upon adding together all the costs and benefits of the project, we found ANPV of IWPI-Spain = – €78.40 million in initial costs + €70.66 million from dividends + €62.64 million from royalties and fees + €27.60 million from exports + €0.38 million from the interest tax shield + €1.76 million from the interest subsidy = €84.64 million When the project is discounted at 22%, the values change to ANPV of IWPI-Spain = – €78.40 million in initial costs + €59.31 million from dividends + €53.43 million from royalties and fees + €23.60 million from exports + €0.38 million from the interest tax shield + €1.76 million from the interest subsidy = €60.08 million A 10% increase in the discount rate from 20% to 22% causes the value of the project to fall by 29%. Furthermore, if there is cannibalization of exports, the value of the project becomes negative because the present value of lost exports is €64.05 million.

Chapter 15: International Capital Budgeting 71

3. What would be the terminal values of the profits from IWPI-Spain if they were expected to grow in real terms at 1% rather than 0%? Answer: We know that the ability of the project to grow in real terms requires additional real investments, that is, additional capital expenditures. If these capital expenditures are zero NPV projects, the terminal value will increase by the amount of the investment.

4. How much does the value of IWPI-Spain, viewed as a stand-alone firm, change if the royalty fee is increased by 1% and the overhead allocation fee is reduced by 1%? What is the change in value to IWPI-U.S.? What is the source of this change in value? Answer: We know that because the royalty and the overhead fee are costs to the stand-alone firm and are calculated as a percentage of revenue, the profitability of the stand-alone firm is not affected by lowering the fee from 2% to 1% and raising the royalty rate from 5% to 6%. The present value of the after-tax royalties and fees also doesn’t change because the firm gets a tax credit for the withholding tax paid, and it can fully utilize the tax credit. Therefore, the after-tax value of the royalties and fees remains €62.64 million even though the royalty is taxed at a lower rate.

5. Valuing Metallwerke’s Contract with Safe Air, Inc. Consider the discounted expected value of the 10-year contract that Metallwerke may sign with Safe Air in Chapter 9. In the initial year of the deal, Metallwerke sells an air tank to Safe Air for $400. It costs €696 to produce an air tank. The current exchange rate is €2/$. Assume that 15,000 air tanks will be sold the first year. Make the following other assumptions in your valuation: a. The demand for air tanks is expected to grow at 5% for the second year, 4% for the third and fourth years, and 3% for the remaining life of the contract. b. Euro-denominated costs are expected to increase at the euro rate of inflation of 2%. c. The base dollar price of the air tank will be increased at the U.S. rate of inflation plus onehalf of any real depreciation of the dollar relative to the euro, but the base dollar price will be reduced by one-half of any appreciation of the dollar relative to the euro. The U.S. rate of inflation is expected to be 4%. d. The dollar is currently not expected to strengthen or weaken in real terms relative to the euro. e. The German corporate income tax rate is 50%. f. The appropriate euro discount rate for the project is 17%. g. Metallwerke typically establishes an account receivable for its customers. At any given time, the stock of the account receivable is expected to equal 10% of a given year’s revenue. h. Accepting the Safe Air project will not require any major capital expenditures by Metallwerke. Can you determine the value of the contract to Metallwerke? Answer: The value of the project can be determined by discounting the expected incremental free cash flows from the project. The following spreadsheet demonstrates how to do this.

0 US Inflation Euro Inflation Euros per dollar Retail Price per tank (dollars) Cost per tank (euros) Growth in demand tanks sold All cash flows below are in euros Revenue Cost of goods sold EBIT NOPLAT @ 50% tax Working Capital Change in Working Capital Free Cash Flow Discount factors @ 17% Present value of FCF Value of Project

Valuing Metallwerke's 10-year Contract with Safe Air Year 1 2 3 4 5 6 4% 2% 1.9615 400 696 4% 2% 1.9238 416 710 5% 15,750 4% 2% 1.8868 433 724 4% 16,380 4% 2% 1.8505 450 739 4% 17,035 4% 2% 1.8149 468 753 3% 17,546 4% 2% 1.7800 487 768 3% 18,073

7 4% 2% 1.7458 506 784 3% 18,615

8 4% 2% 1.7122 526 799 3% 19,173

9 4% 2% 1.6793 547 815 3% 19,748

10 4% 2% 1.6470 569 832 3% 20,341

2.0000

15,000

11,769,231 12,604,846 13,371,221 14,184,191 14,901,911 15,655,948 16,448,139 17,280,415 18,154,804 19,073,437 10,440,000 11,181,240 11,861,059 12,582,212 13,218,872 13,887,747 14,590,467 15,328,744 16,104,379 16,919,260 1,329,231 1,423,606 1,510,161 1,601,979 1,683,039 1,768,201 1,857,672 1,951,670 2,050,425 2,154,176 664,615 711,803 755,081 800,990 841,520 884,101 928,836 975,835 1,025,212 1,077,088 1,176,923 1,260,485 1,337,122 1,418,419 1,490,191 1,565,595 1,644,814 1,728,041 1,815,480 1,907,344 1,176,923 83,562 76,637 81,297 71,772 75,404 79,219 83,228 87,439 91,863 -512,308 0.8547 -437,870 2,465,593 628,242 0.7305 458,939 678,443 0.6244 423,600 719,693 0.5337 384,064 769,748 0.4561 351,091 808,697 0.3898 315,261 849,617 0.3332 283,088 892,608 0.2848 254,199 937,774 0.2434 228,258 985,225 0.2080 204,964

72

The first lines establish the background data. U.S. inflation is forecast to be 4% and German inflation is forecast to be 2%. The real exchange rate is forecast to be constant, so the nominal euro/dollar exchange rate is forecast to satisfy relative PPP. The first year nominal exchange rate is therefore

€2 1.02 €1.9615 × = $ 1.04 $
The first year retail price is set at $400, and it is assumed to grow at the U.S. rate of inflation because there are no forecasts of real appreciation or real depreciation of the dollar. The first year unit cost of production is €696, and it is expected to grow at the German rate of inflation. Demand in the first year is 15,000 tanks, and demand is expected to grow at 5% in year 2, 4% in years 3 and 4, and 3% in all remaining years. Revenue is the €/$ exchange rate times the dollar retail price times the number of units sold. Cost of goods sold is the euro cost per unit times the number of units. EBIT (Earnings before interest and taxes) is revenue minus costs of goods sold. NOPLAT (Net operating profit less adjusted taxes) subtracts the 50% tax rate times EBIT from EBIT. The only investment that the project requires is an increase in the firm’s working capital. The stock of working capital is forecast to be 10% of revenue, and the change in working capital in the first year is therefore €1,176,923. Subtracting the change in net working capital from NOPLAT gives expected free cash flow because there is no incremental depreciation and no capital expenditures. This expected free cash flow is discounted at 17%, a rate that reflects the riskiness of the project. The value of the 10-year project is therefore €2,465,593. This valuation assumes that Metallwerke has the spare capacity to produce the extra tanks, and that it does not incur any additional capital expenditures because of the increased use of its capital. It also assumes that Metallwerke does not issue any debt to finance the project. 6. Deli-Delights Inc. Deli-Delights Inc. is a U.S. company that is considering expanding its operations into Japan. The company supplies processed foods to storefront delicatessens in large cities. This requires Deli-Delights to have a centralized production and warehousing facility in each of these cities. Deli-Delights has located a possible site for a Japanese subsidiary in Tokyo. The cost to purchase and equip the facility is ¥765,000,000. Perform an ANPV analysis to determine whether this is a good investment, under the following assumptions: a. The average per-unit sales price will initially be ¥400. b. First-year sales will be 15 million units, and physical sales will then grow at 10% per annum for the next 3 years, 5% per annum for the 3 years after that, and then stabilize at 3% per annum for the indefinite future. c. First-year variable costs of production will be ¥225 per unit of labor and $1.75 per unit of imported semi-finished goods. Administrative costs will be ¥300 million. d. Depreciation will be taken on a straight-line basis over 20 years. e. Retail prices, labor costs, and administrative expenses are expected to rise at the Japanese yen rate of inflation, which is forecast to be 1%. Dollar prices of semi-finished goods are expected to rise at the U.S. dollar rate of inflation, which is expected to be 4%. f. The yen/dollar exchange rate is currently ¥85/$, and the yen is expected to appreciate at a rate justified by the expected inflation differential between the yen and dollar rates of inflation. g. There will be a 4% royalty paid by the Japanese subsidiary to its U.S. parent. h. The Japanese corporate income tax rate is 37.5%, and there is a 10% withholding tax on dividends and royalty payments. i. The yen-denominated equity discount rate for the project is 13%.

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74 Chapter 15: International Capital Budgeting

j. k. l. m. n.

Net working capital will average 6% of total sales revenue. Capital expenditures will offset depreciation. All of the Japanese subsidiary’s free cash flow will be paid to the parent as dividends. The corporate income tax rate for the United States is 34%. Deli-Delights Inc. has sufficient other foreign income that will allow it to fully utilize any excess foreign tax credits generated by its Japanese subsidiary. o. Deli-Delights Inc. does not plan to issue any debt associated with this project.

Answer: The solution is presented in the following spread sheet pages. The first lays out the facts. Inflation is expected to be 4% in the United States and 1% in Japan. The current exchange rate is ¥85/$ and is expected to satisfy relative purchasing power parity in which case the yen is expected to appreciate. Deli-Delights expects to sell 15 million units at ¥400 per unit, and its retail price is expected to grow at the Japanese rate of inflation. Expected growth in volume is given as 10% for three years, then 5% for three years after that, and then 3%. The imported part initially costs $1.75 per part, and that price is expected to grow at the U.S. rate of inflation. The next Exhibit builds the value of the subsidiary as a stand-alone firm. Revenue is retail price time quantity. Costs of goods sold is total labor and material costs. The royalty payment is a cost to the stand-alone firm of 4% of revenue. Depreciation is 5% of the initial investment of ¥765 million. Administrative costs are ¥300 million and growing at 1%. Revenue minus costs is EBIT. Notice that the project is unprofitable for the first 6 years, in which case the stand-alone firm will not owe any tax, and it will be able to avoid future taxes by taking advantage of tax loss carry forwards. Thus, NOPLAT equals EBIT. Working capital is 6% of revenue, and we get the subsidiary’s free cash flow by subtracting the change in net working capital from NOPLAT under the assumption that expected future capital expenditures equal depreciation. With the low Japanese rate of inflation, this is not a terrible assumption. Notice that free cash flows are forecast to be negative until year 10. The discount rate is 13%, and the terminal value is calculated as a perpetuity beginning in year 11, growing at 1%, and discounted at 13%. Thus, the terminal value is

¥10 million × 1.01

( 0.13 - 0.01) × (1.13)

10

= ¥24 million

While we are told that the demand will be growing in real terms, we have chosen the conservative assumption that growth is equal to inflation because we have not included any additional capital expenditures that would be necessary to finance the additional real growth. The initial investment is ¥765 million, in which case we find that the value of the stand-alone firm is negative ¥1,492 million. Thus, no one would want to license the Deli-Delights name and pay a royalty to the U.S. corporate headquarters to operate in Japan. The third exhibit takes the Deli-Delights parent perspective. The first thing to determine is the present value of any dividends that will be received from the subsidiary. The dividends are the positive free cash flow from the subsidiary. These only arrive in year 10. The firm must pay a 10% withholding tax on the dividend, and it will receive that amount as a tax credit to offset U.S. taxes. The grossed-up dividend is just the gross dividend because there is no credit given for Japanese income taxes paid, because the Japanese subsidiary is not sufficiently profitable to have to pay tax. Thus, the U.S. parent owes 34% of the gross value of the dividend, but it only has to pay that amount minus the tax credit that it receives for the withholding tax. The real value to the parent from the subsidiary comes in the form of royalty payments. These are also subject to a Japanese withholding tax of 10%, and it will receive that amount as a tax credit to offset U.S. taxes. The grossed-up royalty is just the gross royalty. Thus, the U.S. parent owes 34% of the gross value of the royalty, but it only has to pay that amount minus the tax credit that it receives for the withholding tax. The after-tax value of the royalty starts at ¥158 million in year 1 and grows to ¥292 million in year 10. The terminal value of future royalty payments, discounted to the present is ¥723 million.

Chapter 15: International Capital Budgeting 75

The net present value of the project adds the present value of the after-tax dividends and the present value of the after-tax royalties, and subtracts the initial investment and the present value of the negative free cash flows in years 1-9 that the parent will have to send to the subsidiary as additional investments. The net present value of the project is ¥565 million or $7 million at the current exchange rate. This analysis understates the value of the project if there is profit on the intermediate parts. Since no information was given on the profit to the parent from these parts, we assumed that this source of value was zero.

Valuing Deli-Delights Japanese Subsidiary as a Stand-alone Firm: Basic Data Year 1 2 3 4 5 6 7 0 USD Inflation JPY Inflation Yen per dollar Retail Price (yen) Growth in Unit Sales Unit Sales (in millions) Labor Cost per unit (yen) Total Labor Cost (millions of yen) Imported Part Cost (dollars) Imported Part Cost (yen) Total Part Cost (millions of yen) 4% 1% 82.55 400 15.00 225 3,375 1.75 144.46 2,167 4% 1% 80.17 404 10% 16.50 227 3,750 1.82 145.90 2,407 4% 1% 77.85 408 10% 18.15 230 4,166 1.89 147.36 2,675 4% 1% 75.61 412 10% 19.97 232 4,628 1.97 148.84 2,972 4% 4% 1% 1% 73.43 71.31 4% 1% 69.25

8 4% 1% 67.25

9

10

85.00

4% 4% 1% 1% 65.31 63.43

416 420 425 5% 5% 5% 20.96 22.01 23.11 234 236 239 4,908 5,205 5,520 2.05 2.13 2.21 150.32 151.83 153.35 3,151 3,342 3,544

429 433 437 3% 3% 3% 23.81 24.52 25.26 241 244 246 5,743 5,974 6,215 2.30 2.39 2.49 154.88 156.43 157.99 3,687 3,836 3,990

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Chapter 15: International Capital Budgeting 77

Valuing Deli-Delights Japanese Subsidiary as a Stand-alone Firm: The Cash Flows All cash flows below are in millions of yen Revenue Cost of goods sold Royalty Depreciation Administrative Costs EBIT Potential Tax @ 37.5% Actual Tax NOPLAT Working Capital Change in Working Capital CAPX = Depreciation Free Cash Flow Discount factors @ 13% Present value of FCF years 1-10 Terminal Value Initial Investment NPV of Stand-alone Subsidiary NPV of Stand-alone Sub (in $s)

6,000 5,542 240 38 300 -120 -45 0 -120 360 360 -480 0.88 -425 24 765 -1,492 -18

6,666 6,157 267 38 303 -99 -37 0 -99 400 40 -139 0.78 -109

7,406 6,840 296 38 306 -75 -28 0 -75 444 44 -119 0.69 -83

8,228 7,600 329 38 309 -48 -18 0 -48 494 49 -98 0.61 -60

8,726 8,060 349 38 312 -33 -12 0 -33 524 30 -63 0.54 -34

9,254 8,547 370 38 315 -17 -6 0 -17 555 32 -49 0.48 -23

9,814 9,064 393 38 318 0 0 0 0 589 34 -34 0.43 -14

10,209 9,430 408 38 322 11 4 0 11 613 24 -12 0.38 -5

10,620 9,810 425 38 325 23 9 0 23 637 25 -2 0.33 -1

11,048 10,205 442 38 328 35 13 0 35 663 26 10 0.29 3

78 Chapter 15: International Capital Budgeting

All cash flows below are in millions of yen Dividends Declared Withholding Tax @ 10% Net of Tax Dividends Received Foreign Tax Credit Grossed Up Dividend Potential U.S. Tax @ 34% Actual U.S. Tax After-Tax Dividends Discount factors @ 13% PV of Dividends yrs 1-10 Terminal Value Royalty Cash Flows Withholding Tax @ 10% Net of Tax Royalty Received Foreign Tax Credit Grossed Up Royalty Potential U.S. Tax @ 34% Actual U.S. Tax After Tax Royalty Discount factors @ 13% PV of Royalty yrs 1-10 Terminal Value Initial Investment Aditional investments PV of additional investments NPV to Parent NPV of Stand-alone Sub (in $s)

Valuing Deli-Delights Japanese Subsidiary - The Parent Perspective Year 1 2 3 4 5 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0.88 0.78 0.69 0.61 0.54 0 0 0 0 0 18 240 24 216 24 240 82 58 158 0.88 140 723 765 425 376 563 7 109 85 83 57 60 37 34 19 267 27 240 27 267 91 64 176 0.78 138 296 30 267 30 296 101 71 196 0.69 136 329 33 296 33 329 112 79 217 0.61 133 349 35 314 35 349 119 84 230 0.54 125

6 0 0 0 0 0 0 0 0 0.48 0

7 0 0 0 0 0 0 0 0 0.43 0

8 0 0 0 0 0 0 0 0 0.38 0

9 0 0 0 0 0 0 0 0 0.33 0

10 10 1 9 1 10 3 2 7 0.29 2

370 37 333 37 370 126 89 244 0.48 117

393 39 353 39 393 133 94 259 0.43 110

408 41 368 41 408 139 98 270 0.38 101

425 42 382 42 425 144 102 280 0.33 93

442 44 398 44 442 150 106 292 0.29 86

23 11

14 6

5 2

1 0

Chapter
QUESTIONS

17

Risk Management and the Foreign Currency Hedging Decision
1. Why would an entrepreneur find it desirable to hedge his or her foreign exchange risk? Answer: An entrepreneur would find it desirable to hedge foreign exchange risk because the profits from the entrepreneurial venture are a significant part of the entrepreneur’s wealth. Unlike regular investors, entrepreneurs are unable to diversify away such risks through transactions in their own portfolios. Hence, if forward rates are unbiased predictors of future spot rates, riskaverse entrepreneurs will choose to hedge their future foreign currency cash flows because doing so will reduce the variance of the flows without changing their expected values in the domestic currency. Therefore, reducing the variance of future profits would increase the entrepreneur’s expected utility.

2. Explain Modigliani and Miller’s argument that hedging is irrelevant. What are the most likely violations of Modigliani and Miller’s assumptions in actual markets? Answer: Modigliani and Miller argued that a corporation’s financial policies, such as issuing debt, hedging foreign exchange risk, and other purely financial risk management activities, do not change the value of the firm’s assets unless these financial transactions lower the firm’s taxes, affect its investment decisions, or can be done more cheaply than individual investors’ transactions can be done. The reason that reducing the uncertainty of future cash flows, per se, does not lead to a rationale for hedging is that it may not change investors’ perceptions of the firm’s systematic risk. We know from modern portfolio theory that the required rate of return on the equity cash flows of a corporation does not depend on the standard deviation of the firm’s cash flows but only on the systematic risk associated with those cash flows. The fact that a firm’s cash flows are uncertain is a necessary but not a sufficient condition for discounting the cash flows at a discount rate higher than the risk-free interest rate. Hence, unlike in the case of an entrepreneurial firm, if hedging merely reduces the unsystematic risk of the corporation’s cash flows while leaving unchanged both the systematic risk and the expected value of the cash flows, hedging will not have any effect on the firm’s value. Investors will still discount the same expected cash flows at the same required rate of return that is appropriate for the firm’s systematic risk. The assumptions of Modigliani and Miller are strong. The investment policy of the firm is probably not invariant to the hedging decisions of the firm because of the asymmetric information environment in which the firm operates. A primary argument for hedging is to assure the management of a sufficiently large internally generated cash flow so that the investment decisions of the firm are not affected by adverse fluctuations in exchange rates. Hedging also probably can reduce the taxes that a firm pays by shifting income from good states of the world in which the firm is profitable to bad states of the world in which the firm would otherwise be unprofitable.

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3. Suppose that after joining the treasury department of a large corporation, you find out that it avoids hedging because the cost of hedging comes out of the treasury department’s budget. What argument could you make to the CFO to get the firm interested in letting you be the firm’s hedging guru? Answer: There is something wrong with the firm if losses on hedges are booked to treasury whereas the gains on the underlying assets that are being hedged are booked somewhere else. You should explain to the CFO that hedging is about avoiding losses that would adversely affect the performance of the firm. Hedging involves investing in derivative securities whose values go down when the underlying assets of the firm go up in value, while the values of the derivative securities rise when the underlying assets of the firm fall in value. It is appropriate for the costs of hedging to be borne by the treasury department, but these costs should be the personnel costs for those who are involved in the process.

4. Your CFO thinks that the value of your firm fluctuates enormously with the yen–dollar exchange rate, but he does not want to hedge because he thinks it is an impossible risk to hedge. Can you convince him otherwise? Answer: If the value of the firm fluctuates with the yen-dollar exchange rate, the firm must first determine the sign of the covariance. Suppose that the value of the firm goes up when the yen strengthens relative to the dollar and the value of the firm is low when the yen is weak versus the dollar. Then, the firm effectively has yen assets whose dollar value increases when the yen appreciates. An appropriate hedge would be to denominate some of the firm’s debt in yen, thereby getting yen liabilities which increase in value when the yen strengthens. The firm could also sell yen forward. The profits or losses on these contracts would be

⎡ 1 ⎤ 1 ⎢ F(t,¥/$) - S(t+k,¥/$) ⎥ × yen sold forward ⎣ ⎦
There would be profit when the future exchange rate of yen per dollar rose unexpectedly, that is, when the yen weakened and the value of the firm was low. Finally, the firm could buy yen puts, which would give the firm the right but not the obligation to sell yen at a fixed strike price of dollars per yen. These contracts would also provide profits when the dollar strengthened relative to the yen.

5. What does it mean for a tax code to be convex? If a country’s corporate tax rate is flat, does it make sense for a firm to hedge? Answer: A convex tax code imposes a larger tax rate on higher incomes and a smaller tax rate on lower incomes. If a country’s tax rate is flat, a key question is how losses are treated. If losses are subsidized immediately at the same rate that gains are taxed, there is no tax advantage to hedging. But, losses are usually not subsidized, as losses are typically only allowed to be deducted against future income. These tax-loss carry-forwards usually do not grow with the time value of money; nor are they indexed to inflation. Thus, the subsidy associated with a loss is less than the tax associated with a profit, and the tax code is effectively convex. There are also other legitimate reasons to hedge that are not tax related.

Chapter 17: Risk Management and the Foreign Currency Hedging Decision 81

6. If the tax code is convex and the forward rate equals the expected future spot rate, why would a firm prefer to pay taxes on the hedged value of a foreign currency cash flow rather than wait to pay the taxes on the realized foreign currency cash flow? Answer: In the presence of a convex tax code and if the forward rate equals the expected future spot rate, a firm would prefer to pay tax on its expected income with certainty rather than paying its expected tax by taking the probability weighted average of the taxes on possible incomes in the uncertain future states of the world. This is because hedging allows the firm to shift income across different states of the world. Increasing income in states with losses avoids the low subsidy rates and thus hedging reduces expected taxes. This increases the firm’s value.

7. Why is the gain in a firm’s value greater when more of its future foreign currency income is in the low tax region of the tax code? Answer: This question is somewhat poorly phrased. If all of the firm’s foreign currency income accrued in the low tax region of the tax code, there would be no gain to hedging. The gain in a firm’s value (from hedging) arises from the ability to shift income from states in which it is subject to high taxes to states in which it is subject to low taxes.

8. Why would the managers of a firm take a foreign project with a lower domestic currency NPV and a higher return variance rather than a foreign project with a higher domestic currency NPV but a lower return variance? Answer: This is an example of the asset substitution issue that we covered in Chapter 16. Because shareholders only gain in good states of the world, they like the variance of the firm to be high. When the variance of the firm is higher, the shareholders gain more in the good states of the world. The bondholders get paid their full amount in good states of the world, and they get the value of the firm in the bad states of the world. By accepting a high variance project, managers may be able to shift some value from bondholders to shareholders in an asset substitution.

9. Why would a firm ever forgo a positive NPV project? How can hedging help prevent this situation from arising? Answer: If the firm has debt in its capital structure, we know that the managers may forego a positive NPV investment that must be financed by shareholders because too much of the increase in firm value accrues to bondholders. A hedging policy can help to avoid such as situation by avoiding the losses that may plunge the firm into financial distress and make the debt risky in the first place. By reducing the variance of income, the hedging policy makes the debt less risky in which case it sells for a price closer to face value.

82 Chapter 17: Risk Management and the Foreign Currency Hedging Decision

10. Suppose the cash flows from financial hedging are pooled with the cash flows from a firm’s operations and that the shareholders cannot ascertain the ultimate sources of profits and losses. Would the managers of the firm want to hedge or to speculate in the forward foreign exchange market? Answer: The Peter DeMarzo and Darrell Duffie (1995) argument is the following. Shareholders must gauge the quality of the firm’s managers based on their observations of the firm’s profitability and its earnings, as disclosed in its accounting data. From this perspective, hedging makes good sense at first glance. Hedging reduces the amount of “noise” in earnings data that is not due to actions of the managers. That is, hedging increases the informational content about a manager’s ability that is conveyed by the firm’s reported profits. DeMarzo and Duffie demonstrate that in this situation, the accounting treatment of hedging and the optimal hedging policy are intimately linked. Because managers are better able to gauge the different financial risks the company faces, they have an incentive to hedge these risks to reduce the variability of the firm’s earnings and, with that, the variability of their own income stream, which will be linked to the firm’s earnings. A manager does not want to face an unexpected currency depreciation that adversely affects the firm’s profits. The disclosure of information, though, interacts with the ability of shareholders to gauge the true ability of a manager. With additional precision, shareholders can make the managers’ compensation more sensitive to the firm’s performance. To avoid this additional variability in their income, managers may chose not to hedge. If the additional informational content of hedged earnings is sufficiently high, the shareholders may optimally decide not to disclose the firm’s hedging activities, to give managers an incentive to hedge.

11. Why is an internally generated cash flow of such importance to Merck? Can’t Merck use the financial markets as a source of funds? Answer: Merck realized that it was operating in an environment of asymmetric information. They needed to be assured of generating sufficiently large internal cash flows such that they could finance their research and development projects over the course of many years. An alternative would be to potentially suffer losses in foreign exchange markets and try to fund its investment projects in the external capital markets. They key question to address is the following: Can the firm successfully raise the funds that it needs at reasonable required rates of return in those states of the world? The answer appears to be no, because the firm will be going to the financial markets when it is unprofitable. As a result, participants in the financial markets must assess why the firm is unprofitable. They will attribute some of the losses to adverse fluctuations in exchange rates, but they might also assign some of the blame to poor managerial decisions. In such a case, the firm’s managers will find it difficult to pursue the projects they believe will keep the firm competitive. Hedging would prevent this from happening.

Chapter 17: Risk Management and the Foreign Currency Hedging Decision 83

12. True or false: The cost or benefit of hedging foreign exchange risk when a firm is selling the foreign currency forward is accurately measured by the forward discount or premium on the foreign currency. Answer: We know that if the firm sells the foreign currency in the forward market when the foreign currency is at a discount, it will generate less domestic currency revenue than if the foreign currency had been sold at the spot rate. But, the important point is that the cash flows are in the future. They cannot be valued directly with the spot rate because the spot rate is for current cash flows or the present values of foreign currency amounts. When the foreign currency is at a discount, we know that the foreign currency interest rate is higher than the domestic currency interest rate. Thus, we must use this high foreign currency interest rate to get a present value if we are going to use the spot rate to value the cash flow. Alternatively, we can convert the foreign currency into domestic currency in the forward market and then discount it to the present with the domestic interest rate. In either case, we end up with the same amount of domestic currency if covered interest rate parity is satisfied. Thus, a forward discount does not represent a true cost of hedging, and, by analogy, a forward premium does not supply a benefit to hedging.

PROBLEMS
1. Chapeau Rouge has a Swiss project that will return either CHF300 million or CHF250 million per year of free cash flow indefinitely. Each of the possible CHF cash flows is equally likely. Chapeau Rouge’s CHF discount rate for these cash flows is 13% per annum, the cost of the project is €1,100 million, and the current exchange rate is CHF1.67/EUR. Should Chapeau Rouge accept the project? Suppose that Chapeau Rouge has a €400 million line of credit with its bank. Will Chapeau Rouge have trouble hedging the CHF cash flows? Answer: We need to take the present value of the project in Swiss francs and then convert to euros at the current spot rate. Since the project’s cash flow is a perpetuity with an expected value of CHF275 million per year, we know that the present value, when discounted at 13%, is

Present value in Swiss francs =

CHF275 million = CHF2,115 million 0.13

Converting this present value into euros at the current spot exchange rate of CHF1.67/EUR gives CHF2,115 million / (CHF1.67/EUR) = €1,266.70 million. Since this exceeds the cost of the investment of €1,100 million, Chapeau Rouge should accept the project. If Chapeau wanted to hedge the cash flows, they would want to sell CHF275 million for euros in each year out into the indefinite future. Their credit line of €400 million would not be adequate to allow such a substantial exchange-rate exposure. Moreover, we know that the transactions costs of entering into longer term forward contracts increase substantially, which would significantly increase the cost of hedging if they contract to sell more than a few years forward. Consequently, Chapeau Rouge would continue to have a large exposure of the value of the project to a depreciation of the Swiss franc relative to the euro.

2. Fleur de France has a project that will provide £20 million in revenue in 1 year. The project has a euro cost of €30 million that will be paid in 1 year. The cost of the project is certain, but the future spot exchange rate is not. Assume that there are only two possible future spot exchange rates. Either the spot rate in 1 year will be €1.54/£ with 55% probability, or it will be €1.48/£ with 45% probability. Assume that the French tax rate on positive income is 45%, that a firm’s losses are immediately refunded at a rate of 35%, and that the forward

84 Chapter 17: Risk Management and the Foreign Currency Hedging Decision

rate of euros per pound equals the expected future spot rate. a. If Fleur de France chooses not to hedge its foreign exchange risk, what is the expected value of its after-tax income on the unhedged project? Answer: If Fleur de France is unhedged, it will either experience a positive after-tax income of €0.44 million that will be taxed at 45% with 55% probability because {[(€1.54/£) × £20 million] – €30 million} × (1 – 0.45) = €0.44 million or Fleur de France will experience an after-tax loss, which is subsidized at 35%, of €0.26 million with 45% probability because {[(€1.48/£) × £20 million] – €30 million} × (1 – 0.35) = - €0.26 million The expected euro value of Fleur de France’s after-tax income on the unhedged project is therefore the probability weighted average of the two possibilities: [0.55 × €0.44 million] + [0.45 × (- €0.26 million)] = €0.125 million b. If Fleur de France chooses to hedge its foreign exchange risk, what is the expected value of its after-tax income on the hedged project? Answer: The expected future spot rate is the probability weighted average of the two possible realizations: (0.55 × €1.54/£) + (0.45 × €1.48/£) = €1.513/£ If the forward rate equals the expected future spot rate, Fleur de France will sell the £20 million forward and will have a sure income. Its after-tax income on the hedged project is {[(€1.513/£) × £20 million] – €30 million} × (1 – 0.45) = €0.143 million c. How much does Fleur de France gain by hedging? Answer: By hedging, Fleur de France shifts income from the good state of the world with pound appreciation to the bad state of the world with pound depreciation. It also avoids the loss that is only subsidized at the 35% rate. Its after-tax income in the good state falls from €0.44 million to €0.143 million, while its after-tax income in the bad state rises from a loss of €0.26 million to €0.143 million. If Fleur de France hedges, its gain is the difference between its after-tax income and its expected after-tax income, which is €0.143 million - €0.125 million = €0.018 million The gain is due to the convexity of the tax schedule. It can be demonstrated that the gain is the probability of the bad state, multiplied by the income in the bad state, multiplied by the difference in the tax rates or (0.45) × {[(€1.48/£) × £20 million] – €30 million} × (0.35 – 0.45) = €0.018 million

Chapter 17: Risk Management and the Foreign Currency Hedging Decision 85

3. How would your answer to problem 2 change if instead of allowing refunds at 35%, the refund rate were only 25%? Answer: We know that the larger the difference between the tax rates, the larger the gain to hedging. If the subsidy rate is only 25%, Fleur de France will experience an after-tax loss if it does not hedge of €0.30 million with 45% probability because {[(€1.48/£) × £20 million] – €30 million} × (1 – 0.25) = - €0.30 million The expected euro value of Fleur de France’s after-tax income on the unhedged project is therefore the probability weighted average of the two possibilities: [0.55 × €0.44 million] + [0.45 × (- €0.30 million)] = €0.107 million If Fleur de France hedges, its gain is the difference between its after-tax income and its expected after-tax income, which is €0.143 million - €0.107 million = €0.036 million Notice that this is double the gain in Problem 2 because the gain is the probability of the bad state, multiplied by the income in the bad state, multiplied by the difference in the tax rates or (0.45) × {[(€1.48/£) × £20 million] – €30 million} × (0.25 – 0.45) = €0.036 million

4. How would your answer to problem 2 change if the possible exchange rates in the future were €1.56/£ and €1.46/£? We know that with a larger variance of the possible future exchange rates, the gain to hedging is increased. Here are the numbers: a. If Fleur de France chooses not to hedge its foreign exchange risk, what is the expected value of its after-tax income on the unhedged project? Answer: If Fleur de France is unhedged, it will experience a positive after-tax income of €0.66 million that will be taxed at 45% with 55% probability because {[(€1.56/£) × £20 million] – €30 million} × (1 – 0.45) = €0.66 million or Fleur de France will experience an after-tax loss, which is subsidized at 35%, of €0.52 million with 45% probability because {[(€1.46/£) × £20 million] – €30 million} × (1 – 0.35) = - €0.52 million The expected euro value of Fleur de France’s after-tax income on the unhedged project is therefore the probability weighted average of the two possibilities: [0.55 × €0.66 million] + [0.45 × (- €0.52 million)] = €0.129 million b. If Fleur de France chooses to hedge its foreign exchange risk, what is the expected value of its after-tax income on the hedged project? Answer: The expected future spot rate is the probability weighted average of the two possible realizations: (0.55 × €1.56/£) + (0.45 × €1.46/£) = €1.515/£ If the forward rate equals the expected future spot rate, Fleur de France will sell the £20 million forward and have a sure income. Its after-tax income on the hedged project is {[(€1.515/£) × £20 million] – €30 million} × (1 – 0.45) = €0.165 million c. How much does Fleur de France gain by hedging? Answer: If Fleur de France hedges, its gain is the difference between its after-tax income and its expected after-tax income, which is €0.165 million - €0.129 million = €0.036 million

86 Chapter 17: Risk Management and the Foreign Currency Hedging Decision

5. Assume that U.S. Machine Tool has $50 million of debt outstanding that will mature next year. It currently has cash flows that fluctuate with the dollar–pound exchange rate. Over the next year, the possible exchange rates are $1.50/£ and $1.90/£, and each exchange rate is equally likely. The company thinks that it will generate $30 million of cash flow from its U.S. operations, and its expected pound cash flow is £12 million. a. If U.S. Machine Tool does not hedge its foreign exchange risk, what will be the current market value of its debt and equity, assuming, for simplicity, that the appropriate discount rates are 0? Answer: If U.S. Machine Tool does not hedge, the dollar value of its pound revenue will be either $1.50/£ × £12 million = $18 million or $1.90/£ × £12 million = $22.8 million. With $30 million of cash flow from its U.S. operations, the company will therefore only be able to pay off its debt in the good state of the world. Bondholders will either receive $48 million = $18 million + $30 million, in which case equity will be worthless, or the firm will have enough to pay the bondholders the full $50 million, in which case equity will be worth $2.8 million = $22.8 million + $30 million - $50 million. Since the two states of the world are equally likely, and assuming a zero discount rate for simplicity, the debt will sell at 0.5 × $48 million + 0.5 × $50 million = $49 million and the equity will sell for 0.5 × $0 + 0.5 × $2.8 million = $1.4 million b. Suppose that U.S. Machine Tool has access to forward contracts at a price of $1.70/£. What is the value of the firm’s debt and equity if it hedges its foreign exchange risk? Would the shareholders want the management to hedge? Answer: If the firm hedges its pound revenue, the dollar value is $1.70/£ × £12 million = $20.4 million. There would be no additional uncertainty associated with the firm, so its revenues would be $50.4 million = $20.4 million + $30 million. Debt would be riskless and would sell for $50 million, and equity would be the residual claimant to the $0.4 million. Shareholders would therefore not want the firm to hedge as they would prefer the “high variance” project. c. Suppose U.S. Machine Tool could invest $1 million today in a project that returns £1 million next period. Is this a good project for the firm? Answer: If the firm invests $1 million and gets £1 million next period, the dollar value of the pounds would be either $1.5 million or $1.9 million. So, the project is certainly a positive NPV project for the firm. d. Suppose that U.S. Machine Tool is unhedged, that its managers are trying to maximize the value of the firm’s equity, and that the $1 million must be raised from current shareholders. Will the managers accept the project? Answer: If U.S. Machine Tool does not hedge, the dollar value of its pound revenue will be either $1.50/£ × £13 million = $19.5 million or $1.90/£ × £13 million = $24.7 million. With $30 million of cash flow from its U.S. operations, the company will still only be able to pay off its debt in the good state of the world. Bondholders will either receive $49.5 million = $19.5 million + $30 million, in which case equity will be worthless, or the firm will have enough to pay the bondholders the full $50 million, in which case equity will be worth $4.7 million = $24.7 million + $30 million - $50 million. Since the two states of the world are equally likely, and assuming a zero discount rate for simplicity, the debt will sell for 0.5 × $49.5 million + 0.5 × $50 million = $49.75 million

Chapter 17: Risk Management and the Foreign Currency Hedging Decision 87

and the equity will sell for 0.5 × $0 + 0.5 × $4.7 million = $2.35 million Because the value of the equity increases from $1.4 million to $2.35 million, which is less than the $1 million cost of the project, the shareholders would want the management to reject the project. e. If U.S. Machine Tool hedges its foreign exchange risk, would the firm accept the project? Answer: Yes, if the firm is hedged, the debt is riskless and the equity is worth $0.4 million. The return on the positive NPV project would therefore accrue totally to the shareholders. They would invest $1 million and get $1.7/£ × £1 million = $1.7 million in return. Thus, their equity would increase in value by $0.7 million.