International Corporate Finance

(1) Suppose the spot exchange rate for the Canadian dollar is Can$1.13 and the six-month forward
rate is Can$1.16.
(a) Which is worth more, a U.S. dollar or a Canadian dollar?
(b) Assuming absolute PPP holds, what is the cost in the United States of an Elkhead beer if the
price in Canada is Can$2.50? Why might the beer actually sell at a different price in the United
States?
(c) Is the U.S. dollar selling at a premium or a discount relative to the Canadian dollar?
(d) Which currency is expected to appreciate in value?
(e) Which country do you think has higher interest rates—the United States or Canada? Explain.

a. The U.S. dollar, since one Canadian dollar will buy:

(Can$1)/(Can$1.13/$1) = $.8850
b. The cost in U.S. dollars is:
(Can$2.50)/(Can$1.13/$1) = $2.21
Among the reasons that absolute PPP doesn’t hold are tariffs and other barriers to trade,
transactions costs, taxes, and different tastes.

c. The U.S. dollar is selling at a premium, because it is more expensive in the forward market
than in the spot market (Can$1.13 versus Can$1.16).
d. The Canadian dollar is expected to depreciate in value relative to the dollar, because it takes
more Canadian dollars to buy one U.S. dollar in the future than it does today.
e. Interest rates in the United States are probably lower than they are in Canada.

(2) Suppose the spot and six-month forward rates on the Norwegian krone are Kr 6.97 and Kr 7.06,
respectively. The annual risk-free rate in the United States is 3 percent, and the annual risk-free
rate in Norway is 5 percent.

(a) Is there an arbitrage opportunity here? If so, how would you exploit it?
(b) What must the six-month forward rate be to prevent arbitrage?

a. If IRP holds, then:

F180 = (Kr 6.97)[1 + (.05 – .03)]1/2
F180 = Kr 7.0394

Since given F180 is Kr 7.06, an arbitrage opportunity exists; the forward premium is too high.
Borrow Kr 1 today at 5 percent interest. Agree to a 180-day forward contract at Kr 7.06.
Convert the loan proceeds into dollars:
Kr 1 ($1/Kr 6.97) = $.14347

Invest these dollars at 3 percent, ending up with $.14558. Convert the dollars back into krone
as
$.14558(Kr 7.06/$1) = Kr 1.02779
Repay the Kr 1 loan, ending with a profit of:
Kr 1.02779 – Kr 1.02435 = Kr .00343
b. To find the forward rate that eliminates arbitrage, we use the interest rate parity condition,
F180 = (Kr 6.97)[1 + (.05 – .03)]1/2
F180 = Kr 7.0394

(3) You are evaluating a proposed expansion of an existing subsidiary located in Switzerland. The
cost of the expansion would be SF 25 million. The cash flows from the project would be SF 6.9
million per year for the next five years. The dollar required return is 12 percent per year, and
the current exchange rate is SF 1.17. The going rate on Eurodollars is 6 percent per year. It is 5
percent per year on Swiss francs.

(a) What do you project will happen to exchange rates over the next four years?
(b) Based on your answer in (a), convert the projected franc flows into dollar flows and calculate
the NPV.
(c) What is the required return on franc flows? Based on your answer, calculate the NPV in francs
and then convert to dollars.

a. Implicitly, it is assumed that interest rates won’t change over the life of the project, but the
exchange rate is projected to decline because the Euroswiss rate is lower than the
Eurodollar rate.

b. We can use relative purchasing power parity to calculate the dollar cash flows at each time.
The equation is:
E[ST] = (SF 1.17)[1 + (.05 – .06)]t
E[ST] = 1.17(.99)t
So, the cash flows each year in U.S. dollar terms will be:

t SF E[St] US$
0 –25,000,000 1.1700 –$21,367,521.37
1 6,900,000 1.1583 5,957,005.96
2 6,900,000 1.1467 6,017,177.73
3 6,900,000 1.1352 6,077,957.31
4 6,900,000 1.1239 6,139,350.82
5 6,900,000 1.1127 6,201,364.46

And the NPV is:

NPV = –$21,367,521.37 + $5,957,005.96/1.12 + $6,017,177.73/1.122 + $6,077,957.31/1.123
+ $6,139,350.82/1.124 + $6,201,364.46/1.125
NPV = $494,750.33

c. Rearranging the relative purchasing power parity equation to find the required return in Swiss
francs, we get:
RSF = 1.12[1 + (.05 – .06)] – 1
RSF = 10.88%

So, the NPV in Swiss francs is:

 NPV = –SF 25,000,000 + SF 6,900,000(PVIFA10.88%,5)
NPV = SF 578,857.89
Converting the NPV to dollars at the spot rate, we get the NPV in U.S. dollars as:
NPV = (SF 578,857.89)($1/SF 1.17)
NPV = $494,750.33

(4) A currency trader observes that, in the spot exchange market, 1 U.S. dollar can be exchanged
for 9 Mexican pesos or for 111.23 Japanese yen. What is the cross rate between the yen and the
peso; that is, how many yen would you receive for every peso exchanged?

$1 = 9 Mexican pesos; $1 = 111.23 Japanese yen; Cross exchange rate, yen/peso = ?

Dollar Yen Yen

Cross Rate:  = .
Peso Dollar Peso
Note that an indirect quotation is given for Mexican; however, the cross rate formula requires
a direct quotation. The indirect quotation is the reciprocal of the direct quotation. Since $1 =
9 pesos, then 1 peso = $0.1111.
Yen/Peso = 0.1111 dollars per peso  111.23 yen per dollar
= 12.358 yen per peso.

(5) Six-month T-bills have a nominal rate of 7%, while default-free Japanese bonds that mature in
6 months have a nominal rate of 5.5%. In the spot exchange market, 1 yen equals $0.009. If
interest rate parity holds, what is the 6-month forward exchange rate?

rNom, 6-month T-bills = 7%; rNom of similar default-free 6-month Japanese bonds = 5.5%; Spot exchange
rate, e0: 1 Yen = $0.009; 6-month forward exchange rate = ft = ?

ft (1 + rh )
= .
e 0 (1 + rf )
rf = 5.5%/2 = 2.75%.
rh = 7%/2 = 3.5%.
e0 = $0.009.
ft 1.035
=
$0.009 1.0275
1.0275 ft = $0.00932
ft = $0.00907.
The 6-month forward exchange rate is 1 yen = $0.00907.

(6) A television set costs $500 in the United States. The same set costs 550 euros in France. If
purchasing power parity holds, what is the spot exchange rate between the euro and the dollar?
 U. S. Computer = $500; French Computer = 550 euros; Spot rate between euro and dollar = ?
Ph = Pf(e0)
$500 = 550 euros(e0)
500/550 = e0
$0.9091 = e0.
1 euro = $0.9091 or $1 = 1 / 0.9091 = 1.1000 euros.
If British pounds sell for $1.50 (U.S.) per pound, what should dollars sell for in pounds per
dollar?
Dollars should sell for 1/1.50, or 0.6667 euros per dollar.

(7) Suppose that 1 Swiss franc could be purchased in the foreign exchange market for 60 U.S. cents
today. If the franc appreciated 10% tomorrow against the dollar, how many francs would a
dollar buy tomorrow?

The current exchange rate is 0.60 dollars per Swiss franc. A 10 percent appreciation will make
it 0.66 dollars per Swiss franc. To find Swiss francs per dollar, divide 1 by the exchange rate:
1/0.66 = 1.5152 Swiss francs per dollar.

(8) Suppose the exchange rate between U.S. dollars and the Swiss franc is SFr1.6 = $1 and the
exchange rate between the dollar and the British pound is £1 = $1.50. What then is the cross
rate between francs and pounds?

Cross rate = Swiss francs/dollars  dollars/pounds = Swiss francs/pounds

= 1.6  1.5 = 2.4 Swiss francs per pound.

(9) Assume that interest rate parity holds. In both the spot market and the 90-day forward market,
1 Japanese yen equals 0.0086 dollar. In Japan, 90-day risk-free securities yield 4.6%. What is
the yield on 90-day risk-free securities in the United States?

Spot rate = 1 yen = $0.0086; ft = 1 yen = $0.0086; rNom of 90-day Japanese risk-free securities
= 4.6%; rNom of 90-day U. S. risk-free securities = ?

ft (1 + rh )
= .
Spot rate (1 + rf )

rf = 4.6%/4 = 1.15%; rh = ?

(1 + rh )
1 =
1.0115
1 + rh = 1.0115
rh = 0.0115.
rNom = 1.15%  4 = 4.6%.
(10) In the spot market, 7.8 pesos can be exchanged for 1 U.S. dollar. A compact disc costs
$15 in the United States. If purchasing power parity holds, what should be the price of the same
disc in Mexico?
$1 = 7.8 pesos; headphones = $15.00; Price of headphones in Mexico = ?
Ph = Pf(Spot rate).
1 Peso = 1/7.8 = $0.1282.
$15 = Pf($0.1282)
$15
= 117 pesos.
$0.1282
Check: Spot rate = $15/117 pesos = $0.1282 for 1 peso.

(11) Your Boston headquartered manufacturing company, Wruck Enterprises, obtained a 50

million peso loan from a Mexico City Bank last month to fund the expansion of you Monterrey,
Mexico plant. When you took out he loan the exchange rate was 10 US Cents per Peso, but
since then, the exchange rate has dropped to 9 US cents per Peso. Has Wruck Enterprises made
a gain or loss due to the exchange rate change, and how much? Note that your shareholders live
in the US.

The U. S. dollar liability of the corporation falls from (0.10 dollars per peso)(50,000,000 pesos)
= $5,000,000 to (0.09 dollars per peso)(50,000,000 pesos) = $4,500,000, corresponding to a
gain of 500,000 U. S. dollars for the corporation. However, the real economic situation might
be somewhat different. For example, the loan is presumably a long-term loan. The exchange
rate will surely change again before the loan is paid. What really matters, in an economic sense,
is the expected present value of future interest and principal payments denominated in U. S.
dollars. There are also possible gains and losses on inventory and other assets of the firm. A
discussion of these issues quickly takes us outside the scope of this textbook.

(12) Early in September 1998, it took 245 Japanese yen to equal $1. More than 20 years
later, today, that exchange rate had fallen to 80 yen to $1. Assume that the price of a Japanese-
manufactured automobile was $8,000 in September 1998. Assume that there has been no
inflation in the yen cost of an automobile so that all price changes are due to exchange rate
changes. What would the dollar price of the car be now in September 2018, assuming the car’s
price changes only with exchange rate?

a. The automobile’s value has increased because the dollar has declined in value relative to
the yen.

b. The 1983 cost in yen was (245 yen per dollar)(8,000 dollars) = 1,960,000 yen. At an
exchange rate of 80 yen per dollar, this is (1,960,000 yen)/(80 yen per dollar) = $24,500.00

(13) Boisjoly Watch Imports has agreed to purchase 15,000 Swiss watches for 1 million
francs at today’s spot rate. The firm’s financial manager, James Desreumaux, has noted the
following current spot and forward rates:
 (14) On the same day, Desreumaux agrees to purchase 15,000 more watches in 3 months at
the same price of 1 million francs.

(a) What is the price of the watches, in U.S. dollars, if purchased at today’s spot rate?
(b) What is the cost, in dollars, of the second 15,000 batch if payment is made in 90 days and the
spot rate at that time equals today’s 90-day forward rate?
(c) If the exchange rate for the Swiss franc is 0.50 to $1 in 90 days, how much will Desreumaux
have to pay (in dollars) for the watches?

a. (1,000,000 Swiss francs) / (0.6028 Swiss francs per dollar) = $1,658,925.

b. (1,000,000 Swiss francs) / (0.6075 Swiss francs per dollar) = $1,646,091.
c. If the exchange rate is 0.500 Swiss francs per dollar when payment is due in 3 months, the
SFr. 1,000,000 will cost:
(1,000,000 Swiss francs)/(0.500 Swiss francs per dollar) = $2,000,000,
which is more than the spot price today and more than purchasing a forward contract for
90 days.

(15) Assume that interest rate parity holds and that 90-day risk-free securities yield 5% in
the United States and 5.3% in Germany. In the spot market, 1 euro equals $1.40 dollar.

(a) What is the 90-day forward rate?

(b) Is the 90-day forward rate trading at a premium or a discount relative to the spot rate?

rNom of 90-day U. S. risk-free securities = 5%; of 90-day German risk-free securities = 5.3%; Spot rate
= 1 euro = $0.80; ft selling at premium or discount = ?
ft (1 + rh )
= .
Spot rate (1 + rf )
rh = 5%/4 = 1.25%; rf = 5.3%/4 = 1.325%; Spot rate = $1.40
ft 1.0125
=
$1.40 1.01325
ft
= 0.9993.
$1.40
ft = $1.3990.
The forward rate is selling at a discount, since a euro buys fewer dollars in the forward market
than it does in the spot. In other words, in the spot market $1 would buy 1/1.40 = 0.7143 euros,
but at the forward rate $1 would buy 1/1.3990 = 0.7148 euros; therefore, the forward currency
is said to be selling at a discount.
(16) Chapman Inc’s Mexican subsidiary, V. Gomez Corporation, is expected to pay to
Chapman 50 pesos in dividend in 1 year after all foreign and US taxes have been subtracted.
The exchange rate in 1 year is expected to be 0.10 dollar per peso. After this the peso is expected
to depreciate against the dollar at a rate of 4% a year forever due to the different inflation rates
in the United States and Mexico. The peso denominated dividend is expected to grow at a rate
of 8% a year indefinitely. Chapman owns 10 million shares of V. Gomez. What is the present
value of the dividend stream, in dollars, assuming V. Gomez’s cost of equity is 13%?

First, convert the pesos to dollars: D1 = (30 pesos)(0.10 dollars per peso) = 3 pesos.

Second, find the growth rate in dollar denominated pesos. If the peso is depreciating 4% a year
with respect to the dollar, then the exchange rate at t=2 will be (0.10 dollars per peso)(1 – 0.04)
= 0.096 dollars per peso. This is a growth rate of (0.096 – 0.10)/0.10 = −0.04 = −4%. In other
words, the exchange rate is “growing” at the rate it is depreciating. Therefore, the total growth
rate in dollar denominated dividends is:

g = (1 + 0.08)(1 − 0.04) – 1 = 3.68%.

D1
P0 =
rs − g
$3
=
(0.13 − 0.0368)
= $32.1888.
Total equity = $32.1888  10 million shares
= $321.888 million ≈ $322 million.

(17) Nam Sung Industries is a Korean multinational manufacturing company. Currently,

Nam Sung’s financial planners are considering whether to undertake a 2-year project in the
United States. The project’s expected dollar-denominated cash flows consist of an initial
investment of $1 million with cash inflows of $700,000 in Year 1 and $ 600,000 in Year 2.
Nam Sung estimates that its risk-adjusted cost of capital is 13%. Currently, 1 U.S. dollar will
buy 1,0540 Won. In addition, 1-year risk-free securities yields 4% and 2-year risk-free 4.25%
in the United States. Similarly. 1 year and 2 year risk-free rates in Korea are 3.0% and 3.25%.

(a) If this project were instead undertaken by a similar U.S.-based company with the same risk-
adjusted cost of capital, what would be the net present value and rate of return generated by this
project?
(b) What is the expected forward exchange rate 1 year from now and 2 year from now?
(c) If Nam Sung undertakes the project, what is the net present value and rate of return of the
project for Nam Sung?
a. If a U.S. based company undertakes the project, the rate of return for the project is a simple
calculation, as is the net present value.
NPV = −$1,000,000 + $700,000/1.13 + $600,000/(1.13)2 = $89,357.
Rate of return: Enter into your financial calculator or Excel cash flow register CF 0 =
−1,000,000, CF1 = 700,000, CF2 = 600,000 and calculate IRR = 20.0%

b. This analysis is from the perspective of a Korean investor, so Korea is the home country
and the U.S is the foreign country. The interest rate parity relationship uses direct quotes
for exchange rates; direct quotes are number of units of home currency per unit of foreign
currency. Therefore, a direct quote from a Korean perspective is the number of won per
dollar.
According to interest rate parity, the following condition holds:
t
Forward exchange rate  1 + rKorea 
=  
Spot exchange rate  1 + rUS 
For the 1-year forward rate:
Forward exchange rate 1.03
=
1050 1.04
Forward exchange rate
= 0.990381
1050
Forward exchange rate = 1,039.90 won per U.S. $.

The 2-year exchange rate is calculated as:

2
Forward exchange rate  1.0325 
= 
1050  1.0425 
2-year forward exchange rate = 1029.95 Won per U.S. dollar.

c. First, we must adjust the cash flows to reflect Nam Sung’s home currency.
The expected Won cash flows are
Year 0: (−1,000,000 dollars)(1,050 won per dollar) = −1,050.00 million won.
Year 1: (700,000 dollars)(1039.90 won per dollar) = 727.93 million won.
Year 2: (600,000 dollars)(1029.95 won per dollar) = 617.97 million won.

Using the won-denominated cash flows, the appropriate NPV and rate of return can be
found.
NPV = −1,050 + 727.93/1.13 + 617.97/1.132 = 78.15 million Won.

Rate of return: Enter into your financial calculator or Excel cash flow register CF0 = −1,050,
CF1 = 727.93, CF2 = 617.97 and calculate IRR = 18.85%