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WEB CHAPTER IInternational Finance

The Corporate Perspective

web-international.tex: Ivo Welch, 2004.Confidential: Access by Permission Only!

last file change: Feb 10, 2006 (18:55h).

compile date: Thursday 30th March, 2006 (14:02h).

This chapter provides a brief introduction to international finance as viewed from the perspec-

tive of a domestic CFO, who is dealing (at relative arms-length) with subsidiaries, sales, or

capital requisition in other countries. When a U.S. firm goes multinational, many issues, and

especially operational ones, can become more complex. For example, marketing to customers,

hiring employees, and dealing with suppliers, or just the accounting rules, can all be different in

other countries. Fortunately, these issues are not principally the domain of corporate finance,

and thus we shall ignore them in this chapter. Similarly, foreign managers of foreign corpora-

tions can have a whole slew of other issues that we can also ignore from our perspectivefor

example, in some European countries, managers are legally obliged to maximize a broader

stakeholder value.Ultimately, for a U.S. financiers expanding abroad, there is one primary complication: curren-

cies. Otherwise, you can treat foreign subsidiaries pretty similarly as you can treat domestic

operations. The problems and solutions look very much alike. Of course, currency issues

can pervade multiple areas of financeexchange rates for trading, foreign investment, capital

budgeting, and hedging. These are the subject of our chapter.

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Web Chapter I. International Finance.

11. Currencies

The financial markets of the United States are the largest in the world. About half of the worldsRelative size of globalmarkets. stock market capitalization and bond market capitalization is in the United States. Europe

accounts for about one quarter and Japan for about one-eighth. (It is likely that South East

Asia, including China, will soon play a more prominent role.) Corporate borrowing is even

more lopsided: U.S. corporations account for about 75% of the worlds corporate bond issues.

The most important conceptual difference between transacting within ones own country andCurrencies!

transacting with other OECD countries is that of exchange rates between currencies.

11.A. Exchange Rates and Currency-Dependent Rates of Return

An exchange rate is the price of one countrys currency in units of another currency. It isAll prices are reallyexchange rates. really no different than the price of a good. A grocery store may post an exchange rate of

0.25 $/apple or an exchange rate of 4 apples/$.

There are standardized currency quoting conventions. For example, one convention is to quoteYen/Dollar butDollar/Euro. the yen-dollar exchange rate (e.g., 120 /$) rather than the dollar-yen exchange rate; and an-

other convention is to quote the dollar-euro exchange rate (e.g., 1.08 $/) and the dollar-pound

exchange rate (e.g., 1.5 $/). Be careful: the dollar depreciates either when the /$ rate de-creases (fewer yen per dollar), or when the $/ rate increases (more dollars per euro).

The exchange rate that you pay when you travel and need physical cash, e.g., from your hotelFinancial exchange ratesare almost frictionless. or an airport exchange booth, is usually rather unfavorable. But the financial currency markets,

whose exchange rates apply to large financial transactions, are the most liquid and competitive

markets in the world, with very small transaction costs and bid-ask spreads. Although there

are no firm statistics, the typical currency trading, including forward and futures trading, is

around $1.5 trillion a day. To put this into perspective, this is more than ten times the typical

daily trading volume in equities and more than 10% of the annual U.S. gross domestic product

(GDP). In such liquid and active financial markets, we should be inclined to believe that few, if

any, people have an ability to outpredict the markets forecast of exchange rates.

11.B. Currency Futures and Interest Rate Parity

Corporations can hedge against exchange rate risk by trading currency contracts. There areCurrent currencyforward quotes. two principal types. The first is based on the spot currency rate and is for an exchange of a

fixed amount of currency immediately. The second is based on the forward currency rate and

is for an exchange of a fixed amount of currency on a fixed date in the future. The contracts

are usually structured so that they are a fair exchange between parties, so they cost nothing at

the outset.

Table I.1. Spot and Forward Rates ($/), on Friday, August 22, 2003.

Contract Last Contract Last Contract LastCash Spot 1.0886 December 03 1.0850 June 04 1.0803

September 03 1.0878 March 04 1.0825 September 04 1.0783

Table I.1 gives an example of the spot and forward currency rates on August 22, 2003. YouA round-trip transactionfixes currency forward

quotes.could receive 1.0886 dollars for each euro on the spot. Or you could commit to a dollar-euro

exchange in September 2004 (a little more than 12 months later), which would only get you

1.0783 dollars for each euro. Why? Does this mean that the euro will depreciate against the

dollar? Nothing so complex: as you will learn now, interest rate parity (IRP) is an arbitrage


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Section 11. Currencies.

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103

condition that ties the currency spot rate, the currency forward rate, and the country Treasury

interest rates together.

Figure I.1. Interest Rate Parity: Two Ways to Earn A 1.2% Dollar Interest Rate

Startrrrj

$1,000 E 918.61Spot Exchange Rate

(known at time t)

xt,t = 1.0886 $/

Forward Exchange Rate(locked in at time t)'xt,t+1 = 1.0783 $/

U.S.T-Bonds

(rknownatt)

EuroT-Bonds

(rknownatt)

cc

rUS

t,t+1=

1.012%

rEU

t,t+1=

2.09%

$1,011.2 937.81Result:

Figure I.1 illustrates interest rate parity. On August 22, the 1-year U.S. dollar Treasury interest The particularround-trip arbitragecondition.

rate was 1.12%. The 1-Year euro Treasury interest rate was 2.09%. (Each currency has its own

yield curve. You can find many such yield curves on the WWW, e.g., at www.bloomberg.com.)

Therefore, you could save $1,000 at 1.0112% to receive $1,011. 20 in 1 year. Or, you could

exchange $1,000 into 918.61 at the spot rate, invest the euros at 2.09% to receive 918 .61 (1 + 2.09%) 937.81 in 1 year, and today lock in a forward exchange at the rate of 1.0783 $/to translate the 937.81 back into $1,011.24. The 4 cents (0.004%) difference between $1,011.20

and $1,011.24 is either rounding error or a violation of IRP that is too small to be exploited

because of transaction costs.

What if, instead, the 1-year forward $/ rate (that you could lock in today) was different? For If IRP fails, we canarbitrage.example, what if it was the current spot rate (1.0886 $/) instead of the actual 1.0783 $/? If

there were no arbitrage transaction costs, you could earn a higher interest rate in euros, and

lock in to exchange the resulting euros back into dollars after one year is over. You wouldconvert your $1,000 into 918.61, earn the 2.09% interest to end up with 937.81, and lock

in the reverse currency exchange for a net of 937.81 1.0886 $/ = $1,020.90. This is 70cents more than the $1,011.20 that you would receive if you invested in U.S. Treasury bonds.

The U.S. interest rate would be inferioran arbitrage opportunity, which we consider to be an

impossibility.

We can write IRP as a formula. Call the $/ exchange rate today xt,t and the forward exchange The round-trip informula.rate that you can lock in today xt,t+1. Our arbitrage relationship is

$1,000 (1 + 1.12%)

$1,000/(1.0886 $/)

(1 + 2.09%) (1.0783 $/)

It (1 + rUSt,t+1) = It 1/xt,t (1 + r

EUt,t+1) xt,t+1 .

(I.1)

Anecdote: Currency Arbitrage in the Middle AgesCurrency arbitrage is nothing new. In the 13th century, Venetian bankers heavily speculated in currencies ona grand scale. Twice a year, 20-30 ships sailed from Venice to the mid-East, carrying silver and returning withgold. The gold/silver exchange rates were different in Europe than they were in Egypt. (Gold was exported fromChina by looting Mongols.) By the 14th century, the Venetians had de facto replaced the Eastern gold standardwith a silver standard and the Western silver standard with a gold standard. Their large currency reserves alsoallowed them to introduce cashless bank transfers among merchants accounts, with credit lines and overdrafts.By the 15th century, Mongols, the Black Death, and large-scale creditor defaults had ended the dominance ofItalian banks, beginning the reign of the German banking family of the Fuggers, the most dominant commercialcompany in history. (Partial Source: American Almanac.)
http://www.bloomberg.com/markets/rates/index.htmlhttp://www.bloomberg.com/markets/rates/index.htmlhttp://members.tripod.com/~american_almanac/pbgbardi.htmhttp://members.tripod.com/~american_almanac/pbgbardi.htmhttp://members.tripod.com/~american_almanac/pbgbardi.htmhttp://www.bloomberg.com/markets/rates/index.html


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Now simplify and rearrange Formula I.1 into the more standard way to write the interest rate

parity equation, and you get the following:

Important: Interest Rate Parity is an arbitrage condition that implies that

currency spot and forward exchange rates are linked to the country interest rates

via

xt,t+1xt,t

= (1 + rUS

t,t+1)(1 + rEUt,t+1)

= ft,t+1st

. (I.2)

The exchange rate x is defined in $/. (Easy to remember: countries must be inthe same order on both sides; here, dollar on top, euro on the bottom. For extra

clarity, we addedf to name the forward ands to name the spot rate.)

Side Note: Currencies trade both as futures and forward contracts. They differ from one another in thatfutures settle changes in value every day. For example, assume you have purchased a futures contract thattoday commits to exchange your $200 in exchange for the receipt of 100 next year. Tomorrow, the dollardepreciates and the futures exchange price changes from 2$/to 3$/. Your 100 committed receipt is nowworth $300. Instead of waiting, the futures contract immediately executes this settlement: the seller of yourfutures contract must pay you the $100 at the end of the day.

The currency futures market is an exchange market. Prevailing spot and futures exchange rates are thereforepublicly available, e.g., on www2.barchart.com. (This is traditional: Financial futures contracts have a longhistory. They were traded on the Amsterdam securities exchange as early as the 17th century.) In contrast,forward contracts are typically bought and sold in an over-the-counter (OTC) market. As in most OTC markets,there is no such thing as one unique forward rate. Corporations and other interested parties call up their localbanks, which will quote them forward rates for their desired horizon. Therefore, forward rates are similar, butnot identical, from bank to bank and from corporation to corporation. The forward market is much larger thanthe futures market.

11.C. Purchasing Power Parity

Forward exchange rates are exactly determined by interest rates through an arbitrage condition.Why are interest ratesdifferent across

countries?But there is a deeper question here: why is the interest rate in euros higher than the interest

rate in U.S. dollars?

Economists are not sure, and here is why. The most important question is whether purchasingThe real question iswhether goods cost the

same (PPP).power parity (PPP) holds. The PPP theory of exchange rates posits that prices of identical

goods should be the same in all countries, differing only in the costs of transport and duties.

But does PPP hold? Do $108.86 dollars buy the same amount of goodssay applesthat 100

buy? If an apple costs $1.0886 in the United States, and 1.00 in Europe, then PPP holds.

What if it does not hold? What if, for example, an apple costs $1.00 in the United States and

1.00 in Europe? Then we should export cheaper U.S. apples to Europe, sell them for 1, and

earn a profit of $0.08/apple. Transport costs and import/export barriers (such as tariffs) are

probably too high to permit an apple arbitrage, but there are other, more easily transportable

commodities, ranging from diamonds, to gold, to gasoline. As economists, we expect prices

for easily exportable and tradeable commodities to obey PPP. But other goods need not obey

PPP: Land in France is not the same as land in Manhattan and it cannot be exported. Concreteis too costly to transport, because shipping costs are too high. Raspberries spoil too easily to

transport long distances. Maple syrup has little demand in Europe, and is not easy to resell. A

work hour by a Czech hair stylist is not same as a work hour by an American hair stylist. And

so on. Indeed, PPP does not even hold inside one country: apartments and plumbers cost more

in Manhattan than in New Jersey. Gas costs more in San Francisco (CA) than in San Antonio

(TX). The reasons why PPP does not hold inside a country are the same as why PPP does not

hold across countries. But, if after taking transport costs into account, gas is too expensive in

San Francisco relative to San Antonio, someone will start shipping it from San Antonio to San

Francisco sooner rather than later.
http://www2.barchart.com/mktcom.asp?section=currencieshttp://www2.barchart.com/mktcom.asp?section=currencieshttp://www2.barchart.com/mktcom.asp?section=currencies


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Section 11. Currencies.


105

Still, let us assume for a moment that PPP does holdthat is, that goods in Europe and goods If PPP always holds,differential interestrates are determined bydifferential inflationrates.

in the United States are worth the sameand that PPP will also hold in the future. This will

allow us to determine relative inflation rates. For example, an apple that costs $1.0886 in the

United States today costs 1 in Europe today. If the U.S. dollar inflation rate is 2%, then the

apple will cost $1.0886 1.02 = $1.1104 next year. We can lock in a future exchange rate of

1.0783 $/, which means that next years U.S. apple will be worth $1 .1104/1.0783 = 1.0297.In sum, a Euro-apple, costing 1 today will cost 1.0297 next year, which means that the euro

inflation rate is 2.97%.Another way to state this is that purchasing power parity implies that realinterest rates must be The Fisher Hypothesis

says that expected realinterest rates are thesame across countries.

equal. After all, a real interest rate is just an inflation-adjusted nominal interest rate. (You can

think of money here as a good like apples, but one which increases not only through inflation,

but also through interest earnings.) Therefore, in our context, the PPP claim is that

1.0218

1.0307

1.012

1.02

(1 + rEUt,t+1)

(1 + Eut,t+1)=

(1 + rUSt,t+1)

(1 + USt,t+1),

(I.3)

where r is the nominal interest rate and is the inflation rate. Clearly, purchasing power parityis a strong assumption. There is a weaker form of Formula I.3, which replaces actual inflation

rates with expected inflation rates. The Fisher hypothesis states that expected real rates ofreturn are equal across countriesand it need not hold. Aside from the basic question of which

goods the inflation rate refers to, it could also be that investors on one of the two sides earn

extra compensation for sharing the risk currency movements.

Important:

If PPP holds, then interest rate differentials across countries are explained by

their inflation rate differentials.

The Fisher hypothesis is that expected real rates of return are identical across

countries.

In the real world, economists are divided about the goods for which PPP holds. For gold, for PPP holds for somegoods, but not forothers. PPP holds betteover long periods.

which there is no import duty between the European Union and the United States, the answer is

probably yes. For most other goods, the answer is probably no. As explained in Chapter ??, the

reported inflation rate is itself based on an arbitrary bundle of goods, usually the Consumer

Price Index (CPI). So, do countries with higher average inflation rates experience depreciating

currencies? The answer is only very weakly over horizons of one to five years. But, in the

long run, there are many arbitrageurs (called import/export firms) that are hard at work to

help make PPP come trueor at least to limit deviations from PPP. So, the same evidence that

suggests almost no PPP over shorter horizons suggests that PPP holds very well over ten- to

twenty-year horizons. Market forces are on the side of PPP!

Anecdote: Yales Most Famous EconomistIrving Fisher, inventor of the Fisher hypothesis, easily ranks among the best economists ever. But he was alsoan eccentric and colorful figure. When Irving Fisher wrote his 1892 dissertation, he constructed a mechanicalmachine equipped with pumps, wheels, levers and pipes in order to illustrate his price theory. (You can findimages of his first and second prototypes on a number of websites.) Socially, he was an avid advocate ofeugenics and health food diets. He made a fortune with his visible index card systemknown today as therolodexand advocated the establishment of a 100% reserve requirement banking system. His fortune was lostand his reputation was severely marred by the 1929 Wall Street Crash, when just days before the crash, he wasreassuring investors that stock prices were not overinflated but, rather, had achieved a new, permanent plateau.Even financial geniuses can be humbled by the markets.

Source: cepa.newschool.edu/het/profiles/fisher.htm:
http://cepa.newschool.edu/het/profiles/fisher.htmhttp://cepa.newschool.edu/het/profiles/fisher.htmhttp://cepa.newschool.edu/het/profiles/fisher.htm


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Solve Now!

Q I.1 How does interest rate parity differ from purchasing power parity?

Q I.2 If the / forward rate is at a forward premium relative to the spot rate (that is, the

forward rate is higher than the spot rate), is the nominal interest rate in Japanese or in European

higher?

Q I.3 If the $/ forward rate is at aforward discountrelative to the spot rate (that is, the forward

rate is higher than the spot rate), is the nominal interest rate in Europe or in the United States

higher?

Q I.4 On Friday, August 22, 2003, the Mexican Peso forward currency rates were as follows:

Contract Last Contract Last

Cash 0.09230 June 04 0.08800

September 03 0.09200 September 04 0.08660

December 03 0.09100 December 04 0.08520

March 04 0.08985

Anecdote: Purchasing Power Parity and The Big Mac IndexThe price of the Big Mac has become such a popular measure of PPP among economists that it is published

quarterly in The Economist. In May 2004, the Big Mac price index stood as follows: UPDATE THIS

Country PPP of U.S. $ Rel Value Country PPP of U.S. $ Rel Value

United States $2.90 Philippines $1.23 57%Argentina $1.48 49% Russia $1.45 50%Australia $2.27 22% Singapore $1.92 34%Brazil $1.70 41% Saudi Arabia $0.64 78%Britain $3.37 +16% South Africa $1.86 36%Canada $2.33 20% South Korea $2.72 6%China $1.26 57% Sweden $3.94 +36%Egypt $1.62 44% Switzerland $4.90 +69%Euro Area $3.28 +13% Thailand $1.45 50%Hong Kong $1.54 47% Kuwait $7.33 +153%Japan $2.33 20% Turkey $2.58 11%Mexico $2.08 28%

(China has pegged its currency to the U.S. dollar at an exchange rate that is generally believed to be too low.) Ifyou plan to retire on your U.S. social security check, Kuwait and Switzerland look financially a lot less attractivethan China, Saudi Arabia, or Thailand.

Of course, one Big Mac alone is not a representative consumption basket. In August 29, 1993a time whenmanagement gurus predicted that the Japanese model was destined to rule the worldthe New York Timesreported the following violations from PPP:

Item Manhattan TokyoDoughnut $0.75 $1.06Rice $0.89 $2.71Kirin Beer $1.50 $2.12Big Mac $2.99 $3.66Hagen Daz $2.99 $8.18Movie ticket $7.50 $17.33Sony Walkman, AM/FM Cassette $39.99 $209.92Round-trip Economy Airfare, Tokyo-NYC $1,360.45 $3,832.45Apartment, Per Sq.Ft. Purchase Price $309.00 $715.67

UPDATE THIS

Source: www.economics.com/markets/Bigmac/Index.cfm.
http://www.economist.com/markets/Bigmac/Index.cfmhttp://www.economist.com/markets/Bigmac/Index.cfmhttp://www.economics.com/markets/Bigmac/Index.cfmhttp://www.economics.com/markets/Bigmac/Index.cfmhttp://www.economics.com/markets/Bigmac/Index.cfmhttp://www.economist.com/markets/Bigmac/Index.cfm


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Section 12. Investments in Foreign Stock Markets.


107

The 1-year U.S. Treasury bond offered a yield of 1.12%. Explain what interest rate a 1-Year

Mexico Treasury investment in 1,000,000 Pesos would earn.

Q I.5 (Continued.) If PPP holds for Big Macs, and the 1-year U.S. inflation rate is 1%/annum, and

the Big Mac in Mexico costs the equivalent of $2.12 today, how much would you expect the Big

Mac to cost next year?

Q I.6 What prevents arbitrage if PPP does not hold?

Q I.7 What is the Fisher hypothesis?

12. Investments in Foreign Stock Markets

Our second subject is a necessary prelude to determining corporate cost of capital in an interna- We need to understand

investors opportunitieto determine anopportunity cost ofcapital.

tional context. If you recall the logic of the corporate cost of capital, we have to determine theopportunities that our investors have elsewhere (in the financial markets), and then infer the

cost of capital for our own corporate projects relative to these opportunities. So, we must first

discuss foreign investment opportunities. Although they are conceptually like investments in

domestic financial securities, they do have some novel componentsespecially those related

to market access and the local currency and exchange rate.

12.A. Local vs. Foreign Returns and Home Bias

An important conceptual issue to keep in mind is that the CAPM suggests that investors hold The new marketportfolio.the (value-weighted) market portfolio. This portfolio should considers all investable assets,

domestic and foreign. Consequently, investors should invest not just in the U.S. market, but also

in all foreign markets. Of course, even if the CAPM does not hold, thinking about diversificationacross all possible dimensionsincluding internationalis a good idea.

However, the empirical evidence suggests that investors tend to have strong home bias: U.S. in- Investor home bias.

vestors tend to overweight U.S. stocks, European investors tend to overweight European stocks,

Japanese investors tend to overweight Japanese stocks, and so on. In fact, many investors hold

nothing but domestic securities. This home bias holds up even after we adjust for differential

transaction costsand currency.

Currency matters because investment rates of return themselves depend on the currency in Local currency rate ofreturn vs. our currencyrate of return.

which they are earned. For example, Volkswagen AG started 2002 with a price of 52.30

and ended 2002 with a price of 34.50. Therefore, its local currency rate of return was

34.50/52.30 1 34% (incorrectly ignoring dividends). But the euro started 2002 at0.90 $/ and ended 2002 at 1.05 $/, a 16.7% appreciation of the euro against the dollar.

The Volkswagen shares therefore cost 52.30 0.90$/ $47.07 and returned 34.50 1.05 $36.23 for a Volkswagen dollar rate of return of 23%. Most U.S. investors in Volkswagen are

more concerned with the dollar rate of return; most German investors in Volkswagen are more

concerned with their local currency rate of return.

Here is an example of how this matters in a broader context. The following are historical rate Some historical statisti for illustration.of return statistics, from 1970 to 2005, in percent per month, from the Morgan-Stanley Country

Indexes (MSCI).

Country i Currency Means Sdvs i,US i,World

United States U.S.-$ 0.95 4.46 1.00 0.92 Market for the home-biased U.S. investor

MSCI World U.S.-$ 0.92 4.18 0.80 1.00 Market for the diversified U.S. investor

Germany DM/Euro 0.79 5.70 0.65 0.78 Relevant for a German investor

Germany U.S.-$ 1.02 6.19 0.64 0.93 Relevant for a U.S. investor


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Both the U.S. stock market and the world market experienced price changes of 0.95% per month

(which comes to about 11% per year). But the MSCI world index had much lower volatilitydue

to extra diversification. A home-biased U.S. investor would have missed out on this free risk

reduction.

How would a German investor and how would an American investor think about the reward andDollar vs. Euro rates ofreturn, and betas with

respect to differentmarket indices.

risk contribution of investing in the German stock market? For a German investor, the average

rate of return was 0.79% (around 9.5% per annum) in euros, of course with a beta with respect

to the German market of 1. But, for a U.S. investor, because the dollar depreciated, the euroinvestment component was more profitable, thereby earning a higher 1.02% (around 12.2% per

annum) in dollars. Furthermore, the risk contribution of Germany for our U.S. investor would

depend on whether our investor is home-biased or fully globally diversified. If our U.S. investor

holds the world portfolio, then adding a little more Germany would contribute to the overall

portfolio risk according to a market beta of 0.94. However, if our U.S. investor is home-biased

and holds the U.S. stock market, then adding a little investment in Germany would contribute

according to a market beta of 0.64much better diversification benefits. The first dollar of

investment in Germany really helps!

This leaves us with an important conceptual questionas corporate executives of a U.S. cor-What investor home biasshould do to our

corporate view.poration, what shall we assume about our investors when we judge our opportunity cost of

capital? In line with empirical reality, we will assume that most of our investors are domestic

and home-biased, and that they consume and therefore care about their investment returns indollars. It is in this context that we will evaluate adding any foreign investments to our firm.

And therefore, we are primarily interested in the expected rate of return in dollars and in the

beta of our foreign investment with respect to the U.S. market portfolionot with respect to

the world market portfolio. But we need to be aware that this scenario need not apply to every

companyand that it may change in the future if stock market investors become more globally

diversified.

12.B. Historical International Investment Performance

So, how did investment into the stock markets of different countries perform historically?From 1970 to 2000,correlations were

modest, so

diversification wouldhave helped.

Table I.2 describes the performance of various MSCI stock market returns over the last 35

years and over the last 20 years. It also shows the performance of two more global indexes,one being the equal-weighted index of the preceding 14 countries in the table, and the other

being the MSCI World index.

Reward Even though the last three decades were terrific years for the U.S. stock market, it

appears that foreign stock markets performed almost as well, if not better. (An important

factor is, of course, that the dollar generally depreciated over these years.) Scandinavia

and Hong Kong beat the U.S. market handily. Not all countries did, howeverCanada,

Singapore, and Japan beat the United States only over the full 35 years, not over the last

20 years.

Risk Contribution All foreign stock markets had betas with respect to the U.S. stock market

below 1. Austria and Japan were particularly helpful in diversifying U.S. market risk;

Canada, Hong Kong and Singapore less so.Over the full 35 years, the equal weighted index of the countries also performed better

than the U.S. stock market, although with equal volatility. The MSCI world index was

safer than the U.S. stock market, although it sacrificed a tiny 3 basis points per month

performance. In the second half, both world indexes had lower risk, but only the equal-

weighted portfolio outperformed the U.S. stock market.

Risk Contribution vs. Reward Relation Would investing in these countries stock market port-

folios have offered U.S. investors a high enough rate of return to make at least a small

investment of international investing worthwhile? To answer this question, we use a U.S.

CAPM formula. The market-beta of each countrys stock market with respect to a U.S.

stock market index is the measure of how much reward our foreign stock market has to


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Section 12. Investments in Foreign Stock Markets.


109

Table I.2. Annual Reward, Risk, and U.S.-Beta of Country Indexes, in dollars.

1970-2005 1986-2005

Country Code Mean Sdv Beta Mean Sdv Beta

Australia aus 1.00 7.0 0.76 1.29 6.5 0.70

Austria aut 1.08 6.0 0.24 1.23 6.8 0.33Canada can 0.96 5.5 0.89 0.96 5.2 0.88

France fra 1.12 6.5 0.72 1.31 6.1 0.81

Germany ger 1.02 6.2 0.64 1.16 6.7 0.83

Hong Kong hkg 1.84 10.8 0.84 1.48 8.2 0.95

Italy ita 0.86 7.4 0.48 1.26 7.3 0.59

Japan jpn 1.07 6.5 0.44 0.74 7.0 0.50

Netherlands net 1.21 5.3 0.73 1.27 5.1 0.77

Scandinavia sca 1.29 5.9 0.73 1.51 6.4 0.91

Singapore sng 1.27 8.5 0.91 0.96 7.8 0.95

Switzerland swi 1.12 5.4 0.62 1.35 5.3 0.64

United Kingdom uk 1.13 6.6 0.78 1.13 5.1 0.76

United States us 0.95 4.5 1.00 1.07 4.5 1.00

Equal-Weighted E 1.14 4.5 0.70 1.39 4.4 0.71

MSCI World W 0.92 4.2 0.80 0.97 4.3 0.80

Source: Morgan-Stanley Country Indexes. The returns are monthly U.S. dollar returns from Dec 1969 through May2005 on index-type broadly diversified stock market investments. The table shows, e.g., that the U.S. financial marketreturned about 11.4% per annum over the entire 35 years, and about 12.8% over the last 20 years. (The average U.S.index percent price changes, i.e., the return without dividends, would have been around 3% lower.) The beta is thecountry rate of return with respect to the U.S. stock marketthat is, the covariance of returns in the two stockmarkets, divided by the variance of the rate of return in the U.S. stock market, with both returns quoted in U.S.

dollars.Dollar returns are relevant if we are assuming that investors care about consuming and therefore performance indollars. Betas with respect to the U.S. stock market are relevant if we are assuming that investors are home-biasedand from the United States.

offer for its risk contribution/diversification. Alas, to use a CAPM formula, we need an

estimate for the appropriate risk-free rate in U.S. dollars. Reasonable choices would be

about 0.4% per month (5% per annum) over the last 35 years, and 0.3% per month (4%

per annum) over the last 20 years. Therefore, the ex-post CAPM in the United States was

something like

1970 2005 : E(ri) 0.4% + (0.95% 0.4%) i,M

1986 2005 : E(ri) 0.3% + (1.07% 0.3%) i,M(I.4)

So, against these formulas, how did our specific countries perform for a U.S. investor? Foreign countries weregood investment from CAPM perspective.

The majority outperformed! For example, according to a U.S. CAPM, Austria should have

earned about 0.3% + (1.07% 0.3%) aut = 0.55% per month in the most recent 20years. Instead, it offered about twice this average return. Only Canada and Singapore

did not outperform. Even Japan, which had the lowest average stock market returns, still

outperformed, because its U.S. beta was low.


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Of course, when it comes to data, you must always be cautious: being ex-post actual data, theseBut recently, stockreturns have covaried

quite a bit more.International

diversification works lesswell than it has in the

past.

are only approximate relationships, not even historical expected relationshipsand much of

the strong historical performance of foreign markets was due to the weakening of the dollar,

which is not necessarily expected to repeat. Furthermore, it could also matter what specific

stock market index and risk-free rate we are using for each country, just as it matters which

exact sample period and foreign stock market indexes we choose, and that we have ignored

taxes and transaction costs. Moreover, although the sample suggests that international diver-

sification has worked quite well and that the OECD country indexes in Table I.2 had low betaswith respect to the U.S. stock market, this empirical relationship seems to have changed in

recent years. The OECD countries stock indexes seem to now be covarying more strongly with

the U.S. stock marketperhaps a sign of increasing financial integration. Nevertheless, even if

international diversification no longer works as well as it has historically, chances are that it is

still a good financial choice.

In sum, the evidence suggests that investing in OECD countries offers decent diversificationOECD diversification iseasy, though only of

modest use.benefits. And fortunately, widely available international mutual funds have made it very easy

to obtain these modest diversification benefits. But many investors do not take advantage of

them.

The jury is still out on the diversification benefits and expected rates of return from investmentsEmerging markets: Whoknows? in emerging markets (developing countries). Many of these emerging markets did not exist or

were not easy to access for U.S. investors just twenty years ago, but have only recently come on-line in a form that a typical U.S. retail investor can take advantage of (i.e., with country-specific

mutual funds).

Solve Now!

Q I.8 If a U.S. investor in the U.S. stock market experiences a negative rate of return, is it possible

for a French investor with the same investment to experience a positive rate of return?

Q I.9 Why is it interesting to look at the risk contribution of foreign stock markets with respect

to the U.S. stock market index, rather than to the world market?

Q I.10 Should we consider the rate of return of the British stock market in terms of British pounds,or in terms of U.S. dollars?

Q I.11 How did investment in foreign stock markets perform over the last 20-30 years? Why?


11/28

Section 13. Capital Budgeting With Foreign Cash Flows.


111

13. Capital Budgeting With Foreign Cash Flows

We now turn to determining the corporate cost of capital if projects are not domestic. We Use foreign investmentin the context of adomestic CAPM.

know that it may not be exactly right for our corporation to consider the domestic CAPM for

the trade-off our investors are facingbut for most U.S. corporations, it would probably be

worse to work with an international CAPM, in which our investors come from many different

countries and care about returns in many different currencies, and in which the right market

index is the world index. Because of widespread home bias, the formerthinking about how

foreign operations reduce the risk in the S&P500is probably still more appropriate than the

latter.

For example, if you are the manager for a U.S. corporationsay. the National Football League An exampleinvesting Europe.and you care about helping your domestic investors earn expected rates of return above what

they could earn in risk-similar investments elsewhere, should you set up a German football

league (or syndicate U.S. television rights to Europe)? What should be your capital budgeting

rule?

13.A. The General Perspective

As with any domestic project, the capital budgeting principle is easy; the implementation is Capital Budgeting is eaif cash flows are certaintough. You just need to know the expected cash flows and discount rates to work out the

net present value of your project. Your task is easy if your foreign cash flows are certain. For

example, how should you value the television rights if they provided 100 (million) in September

2004 for sure?

1. You can execute a currency forward contract today to lock in an exchange rate of 1.0783 $/

for September 2004. This means that you will have 100 1.0783$/ = $107.83. You candiscount this safe dollar cash flow with the U.S. 1-year risk-free rate of 1.2%/annum to

obtain a present value of $107.83/(1+1.2%)=$106.55.

2. You can discount the certain cash flow of 100 at the euro interest rate of 2.09% into

100/(1 + 2.09%) = 97.95 of value today. Using the spot currency exchange rate, youemerge with 97.95 1.0886/$ = $106.63.

(The 0.075% difference between these two numbers is a combination of rounding error and IRP

violations, which are within transaction costs and thus unexploitable.)

Your task is, however, more difficult if your cash flows are uncertain. For example, say your Capital budgeting (NPVis always hard if cashflows are uncertain.

cash flows could be either 50 or 150. You cannot lock in the appropriate future exchange

rate, because you do not know how much cash flow you need to lock for. So, back to basics.

You need to determine two inputs: The expected cash flows of your project in dollars when the

cash flows materialize, and the appropriate discount rate.

You already know that it is usually both more important and more difficult to estimate accu- Expected cash flows: Noeasy, but similar to anyother project. Currencyuncertainty is just

another piece to thepuzzle.

rately the expected cash flows. This is probably even more the case for foreign projects, for

which you may not have a long history and/or many easy comparable international projects.

In addition, there is the additional uncertainty about future prevailing exchange rates, the riskof political expropriation, international tax issues, etc. Still, estimating expected foreign cash

flows adds little conceptual novelty, just more difficulty in practice.

Estimating the appropriate discount rate for your project, however, does add one important But currencyuncertainty can makethe CAPM and betaestimation morecomplex.

novelty. You want to know the beta of your projects rate of return with respect to the U.S. stock

market, again post-exchange rate (i.e., in U.S. dollars). There is one sense in which this is no

different from the difficult task of determining the beta of any new project. The method is the

same: you need to have a good feel for how your dollar cash flows will covary with the U.S. stock

market. Although the whole process may seem more difficult, you can conceptually decompose

it into its components. That is, as a U.S. corporation, estimating how European operations euro

cash flows, translated into dollars, covary with the U.S. stock market can benefit from some

finesse. This is our next subject.
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13.B. Valuing a Sample Foreign Project

To gain more insight into how exchange rates and local market project correlations matter, weThe model to mimicstock market and

exchange ratemovements.

will make up a simple example. As a representative of the NFL, living in a U.S. CAPM world, you

consider investing in creating a German football league, the GFL. Your problem is determining

the appropriate cost of capital for this project. You have to worry about currency movements.

Moreover, you know that project returns are typically linked to their local stock markets more

than to the U.S. stock market. We shall assume the following macroeconomic scenario:

The U.S. market can go up 16% or down 8% (expected rate of return: +4%).

The spot rate is 1.0886 $/. The one-year forward currency rate today is 1.0783 $/.

In addition, we now assume that the actual exchange rate will be either 1 .0000 $/ or1.1566 $/ next year, averaging to 1.0783 $/. It is important that we assume that cur-rency movements are independent of stock market movements.

The German stock market index, the DAX, returns whatever the U.S. market returns (ad-

justed for forward/spot rate movements), plus or minus 10%. For example, if the U.S.

market appreciates 16%, then the German market is expected to appreciate by 7.1% or

27.1%. (I have not assumed that it will be exactly 27.0%, because of the expected currency

rate change embedded in todays forward rate. The extra 0.1% is not an important factor

here.)

With two outcomes each, there are eight scenarios. We assume that they are equally likely.

Table I.3 illustrates these scenarios.

Actually, this is not a bad macroeconomic model: it has reasonable realistic annual rates of re-The model empiricallymatches market and

exchange ratemovements.

turn, exchange rates, standard deviations, and mutual correlations. When the U.S. stock market

increases by 16%, the German stock market is expected to increase by (27.1% + 7.1%)/2 = 17.1%(in Euro returns!). When the U.S. stock market decreases by 8%, the DAX is expected to change

by (2.9% 17.1%)/2 = 7.1%. So, the DAX moves about one-to-one with the S&P500thoughthe DAX returns are in euros and the S&P500 returns are in dollars. More recent historical

data suggest that this relationship is empirically higher than the 0.65 that I reported above,

and perhaps now closer to 1.0. And finally, there is also good empirical evidence that currency

movements are empirically not correlated with stock market movements.Now consider the German project. Starting the German Football League costs 100 (million)Now introduce the

project with a knownGerman beta.

today. The rate of return on this project is assumed to be

rp = 2.09% + (rGM 2.09%)1.5 , (I.5)

which really means that the GFL follows a German CAPM with a German market beta of 1.5

and a euro risk-free rate of 2.09%. For example, if the DAX were to return 7.1%, the GFL would

return 9.6% in euros. This is not what you need to know, thoughyou are not representing a

German corporation with German investorsyou are representing a U.S. corporation with U.S.

investors. What should be the projects appropriate cost of capital and value for you?

Table I.3 works through the necessary calculations. The project costs you $108.86 today. LetHow Table I.3 works.

us work through one of the brancheswhat happens if the U.S. stock market increases by +16%,if the exchange rate goes from 1.00886 today to 1.1566 next year, and if the DAX increases by

7.1%? Your project would then return 2.09% + (7.1% 2.09%) 1.5 = +9.6%. Having cost 100,

your project would now be worth 109.62. At the 1.1566 $/ exchange rate, this would be

$126.79, equivalent to a dollar rate of return of 16.47% on your $108.86 investment.

To determine the U.S. market beta, we need to find out what we can expect when the U.S.The U.S. dollar betadetermined: also 1.5. market goes up vs. when the U.S. market goes down. The table tells us that your average

return is $134.38 (or +23.44%) if the U.S. market increases by 16%, and $95.19 (or 12.56%) ifthe U.S. market decreases by 8%. Draw a line between the points (X,Y) = (+16%,+23.44%) and(X,Y) = (8%,12.56%), and you will find that the slope is

P,S&P500 =23.44% (12.56%)

16% (8%)= 1.5 . (I.6)
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Section 13. Capital Budgeting With Foreign Cash Flows.


113

Tab

leI.3.TheGermanProject

Macroeconomics

OurProject

U.S.

M

XchgRate

GerM

Act.GerM

Projectr

ProjectP

Projectr

in$

in/$

in

in$/

in

in$

in$

+27.1%

+39.6%

139.62

$139.62

+28.26%

1.0000

d

+7.1%

+9.6%

109.62

$109.62

+0.70%

+16%

d

ProjectReturn:Mean=$134.3

8(+23.4

4%)

+27.1%

+39.6%

139.62

$161.48

+48.34%

1.1566d

+7.1%

+9.6%

109.62

$126.79

+16.47%

ProjectCost:100.0

0=$10

8.8

6

+2.9%

+3.3%

103.28

$103.28

5.13%

1.000

d

17.1%

26.7%

73.28

$73.28

32.69%

8%

d

ProjectReturn:Mean=$95.1

9(12.56%)

+2.9%

+3.3%

103.28

$119.45

+9.73%

1.1566

d

17.1%

26.7%

73.28

$84.75

22.15%

M

ean:

+4%

1.0783

+4.99%

+6.45%

106.45

$114.78

5.44%

Macroeconomics:Thereareeightequ

allylikelyscenarios,thecombinationof

theU.S.stockmarketgoingupordown,

theGermanstockmarketgoingupordo

wn,andthedollar/euro

exchangerategoingupordown.The

U.S.marketwillbeeither8%or+16%.T

heGermanmarketistheU.S.marketplu

sorminus10%,plusalittleadjustmentf

ortheforwardexchange

rate(thatyoucouldlockintoday).So,+16%intheU.S.willassociateeitherwith+27.1%orwith+7.1%localcurrencyreturninGermany.Theexchangerate

of1.0886$/willeither

moveto1.00000$/orto1.1566$/Eu

ro

OurProject:OurGermanproject,the

GFL,costs100today,andhasaGermanbetaof1.5.Specifically,itwillreturn2.09%+

(rGM

2.09%)1.5.Thus,iftheGer

manmarketappreciates

by27.1%,ourGermanprojectwillreturn2.09%+

(27.1%

2.09%)1.5=

39.6%.


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So, if the German stock market moves about 1-to-1 with the U.S. stock market (both in local

currency, and even in the presence of extra volatility in the German market), and if exchange

rate movements are uncorrelated with stock market movements, then the German project beta

with respect to the DAX and quoted in euros is about the same as the project beta with respect

to the S&P500 and quoted in dollars.

Now, we assumed that our project follows the German CAPM. Does the GFL also follow the U.S.The German projectfollows the U.S. CAPM. CAPM? The U.S. CAPM would predict

E(rP) = 1.12% + (4% 1.12%) 1.5 = 5.44%

= rUSF +

E(rUSM) rUSF

USP,M .

(I.7)

Table I.3 shows that the expected rate of return on our project is [23.44% + (12.56%)]/2 5.44%. It appears that we can indeed use our U.S. CAPM. Projects are fairly priced; the world isin good order. Hooray!

What can you learn from this example? The answer is that you can mentally decompose theThree beta components:

beta with respect to the U.S. market into three multiplicative factors:

1. The first part considers the local stock market beta that a foreign operation has withReal operations beta inforeign country.

respect to its foreign stock market, in local currency. This local beta is a number that youmust estimate.

In many cases, you have useful information from your U.S. experience. For example,

gadget sales may have the same beta in the foreign country with respect to the foreign

stock market (in foreign currency units) as gadget sales have in the United States with

respect to the U.S. stock market (in U.S. dollars). Naturally, other businesses may be

different in other countries, so you must modify your intuition to fit the specific business.

2. The second part considers how the U.S. stock market and the foreign stock market comove,Foreign index marketbeta. both in local currency.

For example, if the foreign stock market index has a high beta with respect to the S&P500,

then each time the U.S. stock market moves, the foreign stock market moves even more

and with it, the foreign operations (through the projects local market-beta). This would

mean a higher U.S. beta for your project. Conversely, if the foreign stock market had nocorrelation with the U.S. stock market, then your foreign operationcomoving with the

foreign stock marketwould show little or no correlation with the U.S. market.

As was the case in our example, the beta of the German stock market with respect to

the U.S. stock market is actually pretty close to 1 nowadays. (However, the correlation

between the German and the U.S. stock markets is only around 50%, so the two indexes

can diverge quite substantially. This is because both indices have their own idiosyncratic

volatilities.)

3. The third part considers whether the euro changes (and with it your dollar receipts) sys-Foreign currency marketbeta. tematically when the U.S. stock market changes, and vice-versa.

For example, if financial asset markets and currency exchange rates tend to move together,

you will need to adjust the beta upward. If every time the S&P500 moves up, the euro ap-preciates and every time the S&P500 moves down, the euro depreciates, then any S&P500

fluctuations will be amplified in the value of the project through the currency channel.

But as it turns out empirically, there is almost no correlation between currency movements

and stock market rates of return. This is not to say that exchange rates are not a source of

risk. They arebut primarily of idiosyncratic risk, which the CAPM considers irrelevant. It

is only the systematic risk that matters to diversified U.S. investors. So, for many practical

purposes, the empirical evidence allows us to assume that currency fluctuations do not

influence your U.S. beta, and therefore can be benignly ignored. (Aside, you could lock in

some of the variation in future exchange rates through forward contracts, and you could

also hedge currency risk, which is explained in the next section.)
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Section 14. Corporate Currency Hedging.


115

In our specific example, because the German stock market has a U.S. market-beta of about one, For German operationsbetas, all in all, areprobably similar toAmerican betas.

and because the euro-dollar exchange rate is almost uncorrelated with stock market perfor-

mance, we have discovered that the German (euro) operation would have a similar beta with

respect to the U.S. stock market as an equivalent American (dollar) operation would have with

respect to the U.S. stock market.

Digging Deeper: There is also an International CAPM(ICAPM), which assumes that investors care not only

about the performance of the U.S. stock market, but also about currency performance. For example, if investorsalready have half their wealth in the U.S. stock market and the other half in euro cash, then they may not like itif our corporation adds more euro exposure. The CAPM equation would then be modified to have one additionalterm,

E(ri) = rF+

E(rM) rF

i,M + [] i,X in /$ , (I.8)

where is some constant (like the equity premium), andi,X /$ would measure the exposure of our project withrespect to euro exchange rate movements. (bookc:) The could be either a positive or a negative constant, andfunctions just like the equity premium in the CAPM formula. The empirical evidence suggests that gamma is verysmall, so this extension of the CAPM is not too importantat least for OECD countries.

Solve Now!

Q I.12 As a U.S. corporation, assuming your investors are domestic, can you evaluate projects

in terms of their expected rate of return and market beta with respect to the U.S. market?

Q I.13 Into what components can you decompose the U.S. market beta of a foreign project?

14. Corporate Currency Hedging

A corporation like the NFL thinking about building a German subsidiary like the GFL is not the A second type of firmbenefiting from euroappreciation.

only type of firm worried about declines in the value of the euro. In fact, there are three types

of firms that immediately come to mind:

1. U.S. firms thinking about establishing a foreign subsidiary or selling products in foreign

marketslike the NFL.

2. U.S. exporters. For example, Boeing builds aircraft in the United States, so its costs are

mostly in dollars. It sells aircraft in Europe, and these aircraft may be paid for in euros.

If the euro appreciates, it is good news when it is time to deliver. Instead of $108 million

per plane, Boeing might receive $116 million per plane. But if the euro depreciates, it

would be bad for Boeing. It might receive only $100 million per plane.

3. European importers. For example, the large mail-order computer retailer Vobis Germany

purchases U.S. computer hardware and software in dollars, and resells them in Germany

for euros. If the euro depreciates, its U.S. dollar inputs become more expensive.

In some cases, currency movements may not influence cash flow volatilityfor instance, it

could be that Vobis and all computer retailers in Germany can raise their selling prices in linewith their input costs, so there is no cash flow volatilitybut this is fairly rare. Our question

now is: What can firms that are worried about currency movements do to reduce their cash

flow volatilities?


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14.A. Hedging with Currency Forwards

One answer is hedging of the euro receipts. Here is an example. Recall our eight possibleThe hedge sells off ourfuture euro receipts

today.project outcomes:

Scenario Average

Euro depreciates to 1.0000 $/: $139.62 $109.62 $103.28 $73.28 $106.45, 2.22%

Euro appreciates to 1.1566 $/: $161.48 $126.79 $119.45 $84.75 $123.12, 13.10%

The idea of a hedge is to sign a contract that will yield cash if the exchange rate moves against

the real operations profits. So, what would happen if Boeing engaged in a forward contract to

deliver 100 in exchange for receipts of $107.83?

Scenario Pay Receive100

is worthProfit

(relative to value)

Euro depreciates to 1.0000 $/: 100 $107.83 $100.00 = +$7.83

Euro appreciates to 1.1566 $/: 100 $107.83 $115.66 = $7.83

If the euro depreciates to 1.0000 $/, the contract will be for $107. 83, even though the 100

would really be worth only $100.00it would have earned $7.83. If the euro appreciates to1.1566 $/, the contract will oblige us to exchange for $107.83, even though the 100 is really

worth $115.66it would have lost $7.83.

Now consider the project and forward contract together:With the hedge, we nowstill have other

uncertainty, but lesscurrency uncertainty. Scenario Average

Euro depreciates to 1.0000 $/: $147.45 $117.45 $111.11 $81.11 $114.28 +4.98%

Euro appreciates to 1.1566 $/: $153.65 $118.96 $111.62 $76.92 $115.29 +5.90%

The currency-related volatility of the GFL plus the currency contract are lower than the currency-

related volatility of the GFL alone, because the returns on the currency forward contract and

the project move in opposite directions. In fact, the contract has almost neutralized the effect

of exchange rate movements: instead of

2.22% and+

13.10%, the returns are now+

4.98% or+5.90%. Of course, the currency contract has not eliminated other sources of uncertainty. For

example, if a fourth scenario comes about, the net revenues are either $81.11 or $76.92, both

of which are significant losses relative to the $108.86 investment.

This forward contract reduces cash flow volatility, because our firm is paying for our corporateThe forward contractsother side is needed by

other corporations.expenses in dollars and is receiving our corporate revenues in euros. The currency contract

is like an insurance hedge, because it gains if the euro goes up and loses if the euro appreci-

ates. Who would buy the other side of our currency forward contract? There are three natural

candidates:

1. A European firm, like LOral, building a plant in the United States is the exact opposite

of the U.S.-based NFL starting up a German football league.

2. Airbus is the exact opposite of Boeing. It builds airplanes in Europe, so its costs areprimarily in euros, and it sells many of its airplanes to U.S. airlines.

3. American importing firms that pay for inputs in euros and sell their products in dollars are

just like LOral or Airbus. If the euro appreciates, the input costs risea bad situation.

Thus, these types of firms naturally take the other side of the Boeing currency forward contract.


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117

Most corporations with substantial foreign sales or operations use currency hedges of one kind Full hedging is oftenboth difficult andimpractical.

or another, if not to eliminate, then at least to reduce the effect of exchange rate movements.

Few companies fully eliminate currency risk for a number of reasons. First, it is not easy for

a corporation to determine how the value of a German operation changes if this operation has

cash flows not only next year, but for, say, fifty years. What exactly are the expected cash flows

in fifty years that are to be hedged? Second, currency hedges can have detrimental accounting

implications. Currency contracts have to be marked to market while the underlying hedged

assets may not be. This can lead to interim problems (such as violations of bond covenants).Third, there are many cases in which the full currency hedge would be multiples of the firm

valueand it is neither easy nor especially advisable for a company worth $1 billion to have

open currency forward hedges for, say, $10 billion. Therefore, instead of exact hedging of each

future cash flow in every year (for a complete NPV hedge), most corporations hedge only cash

flows occurring over the next few years, or only hedge some component of earnings.

Side Note: Some firmsor their investorshedge not only currency risk, but many other risks. For example,gasoline distributors can use commodity forward contracts to hedge the risk of oil price movements. Aluminummanufacturers can hedge the price of electricity. Firms can even hedge the risk of stock market movements. Forexample, if a $1 billion firm that has a market beta of 0.5 were to short $500 million of the S&P500, its marketbeta would drop to zero. (Its remaining risk would be idiosyncratic only.) You can even consider market beta ameasure of the appropriate hedging ratio!

14.B. Hedging with Real Operations

Forward contracts are not the only method of currency hedging. For example, we know that Matching inputs andoutputs in foreignoperations is a naturalhedge.

a company that purchases inputs in its home currency and has sales in a foreign country is

exposed to a rise in its home currency against the foreign currency. If it sets up a foreign

operation, which can then also purchase its inputs in the foreign market in foreign currency,

then its currency exchange risk will be much lowerboth costs and revenues would occur in the

same currency. Further, such international operations often create a real option (described in

the Web Chapter on real options), whereby companies can shift some production from the high-

cost country to the low-cost country when exchange rates shiftand they can create important

profitable or unprofitable tax implications that require armies of tax experts to understand.

Automakers in particular have invested heavily in such strategies: most Toyota Camrys for the

United States are produced in Georgetown, Kentucky (but many are reexported to Japan!); BMWhas manufacturing facilities in Georgia, Illinois, and California; and Ford and General Motors

have large European subsidiaries.

14.C. Hedging with Foreign Financing

Yet another method of hedging for corporations is to match assets and liabilities: if a firm has Financing in foreigncurrency is anothermethod of hedging.

an asset (such as a foreign operation) that has a net present value of 100, then it can create a

liability that is also worth 100. The easiest way to do this is to raise the financing for the asset

not in U.S. dollars (as we did in Table I.3) but in euros. If an operation has borrowed 100 and

is worth 100, the currency risk on the assets itself almost disappears: currency risk remains

only in the earnings performance of the euro subsidiary.

If we raise this capital in the foreign host country itself, it may also mitigate political risk: if a Host country financing(foreign bonds) canhedge political risk.

revolution were to occur in Germany and our operations were nationalized, chances are that we

would not be liable to pay German investors and lenders. This type of hedge is accomplished

with foreign bonds, which have been around for at least a hundred years. They are issued by

corporations foreign to the host country in which they are issued and denominated in host

country currency. They are named differently in different countries Yankee Bonds in the

United States (i.e., issued by a non-U.S. corporation), Samurai Bonds in Japan, matador bonds

in Spain, and Bulldog Bonds in Great Britain. For example, when Ford Motors issues a Japanese-

yen bond in Tokyo, it would be a Samurai Bond.
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14.D. Eurobonds and the Issue-and-Swap Market

Eurobonds account for a much larger share of borrowing than foreign bonds today, roughly byThe foreign market.

a factor of five. (Eurobonds were invented only in 1957, but the annual nominal issuing value

had reached around $1 trillion by 2000, with outstanding debt of over $4 trillion.) Eurobonds

are issued by corporations foreign to the host country in which they are issued, but in contrast

to foreign bonds, they are denominated in non-host country currency. For example, when Ford

issues a dollar denominated bond in Japan, it is a Eurobond despite the name. (As you saw inthe last section, when Ford issues a yen-denominated bond in Japan, it would be called a foreign

bond.) Therefore, depending on the currency that they are issued in, they may or may not serve

a hedging role. The first important public Eurobond issue was an 1822 bearer bond, issued by

Russia, denominated in British pounds, and payable at Rothschild bank offices anywhere in the

world.) For U.S. companies issuing in Europe or Japan, the Eurobond market is often less a

mechanism to hedge currency risk (many of their issues are denominated in U.S. dollars), as it

is a mechanism to escape the regulation and supervision of the SEC. The institutional customs

and features of Eurobonds are more flexible and somewhat different from those that apply to

ordinary U.S. bonds. (The typical issue costs are about 25 to 50 basis points of the market

price.)

Another very large market for corporate financing is the issue-and-swap market. A companyIssue-and-Swap

like Disney may feel that its name recognition in the United States allows it a better borrowing

rate in the United States than in Japan, even though it really wants to issue yen debt; while a

company like Matsushita may feel that its name recognition in Japan allows it a better borrowing

rate in Japan than in the United States, even though it really wants to issue dollar debt. An

investment bank arranges for these firms to raise capital in their host countries, where it is

cheap for them, and then sets up a swap. In this swap, Matsushita pays Disneys debt service

and Disney pays Matsushitas debt service. The complication is that, although the obligations

are a fairly close match at the outset, over time, one loan may become more valuable than

the other. To reduce the risk of default, a large AAA-rated company (such as an insurance

company) guarantees performance in exchange for upfront payment. So if Matsushita were to

go bankrupt and could no longer pay for Disneys debt, Disney would then no longer pay for

Matsushitas debt, either, and the difference would have to be picked up by the AAA guarantor.

14.E. Should Firms Hedge?

Hedging can reduce the volatility of cash flows. But does this add shareholder value? Maybe, butTwo strong argumentssuggest that hedging

adds little value.it should not usually be a first-order effect for two reasons. First, our shareholders should care

little about the idiosyncratic currency risk our corporation faces, because they are heavily diver-

sified. As long as the foreign currency does not comove with the (U.S.) stock market, any extra

currency risk should not change the U.S. market beta. For our investors portfolio, currency fluc-

tuations across many different companiessome net exporters, some net importersshould

mostly wash out. Second, if our shareholders dislike the risk of losing money when the euro

goes up or down, they can themselves buy the proper currency forward hedges to neutralize

any such risks.

Still, many corporations hedge currency fluctuations. Why? There are a number of possiblePossible reasons for

hedgingsecond-ordereffects. explanations, but they are probably only second-order effects. Here are some examples.

If adverse currency fluctuations could lead a firm to incur financial distress, the resulting

costs to handle the financial distress are quite real. (In a sense, hedging is really just like

capital structure policythe first-order effect should be that firms should be worth what

the underlying operations are worth, which should not strongly depend on how the firm

is financed. But if a firm is close to financial distress, too much debt can cost value.)

Managerial and corporate performance may be easier to evaluate if the firm can reduce

the effects of unexpected currency fluctuations. This can reduce agency problems.

Managers may just not like the uncertainty of currency fluctuations, and try to neutralize

this risk even if it does not increase value.


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Sadly, many firms hedge because they believe they can outguess the financial markets and

thereby increase their profits. This is often a sign of poor control, because the compensation

of lower-level employees who handle the hedging often implicitly or explicitly depends on

the profitability of their hedges. Therefore, these employees often participate more in the

upside than in the downside of their contracts. Thus, they may be quite willing to gamble with

shareholders money.

Solve Now!

Q I.14 What kind of firms are negatively affected by an appreciation of the Swiss franc?

Q I.15 The example used a $107.83currency contract. Can you do better? What kind of currency

forward contract would improve the hedge against exchange risk?

Q I.16 What methods of foreign currency hedging can firms consider?

Q I.17 Describe the international bond markets of relevance to firms.

Q I.18 Why is it that corporate hedging is unlikely to create much shareholder value?

Q I.19 How can foreign currency hedging create value?

Anecdote: 223 years of Barings; 1 year of LeesonForwards can be powerful hedging tools. But, like all derivatives, they can be an equally powerful speculationtool. In 1994, a 28-year old trader named Nick Leeson in the Singapore office of 223-year-old London investmentbank Barings lost $1.3 billionthe entire assets of Baringsin a series of bets using options on forwards on theNikkei index. (Like currency forwards, these Nikkei options can be used either for hedging or for speculation.)The lesson from Barings is that inadequate oversight of financial traderswho usually earn bonuses on tradingprofitscan easily make the situation worse, not better.

Source: BBC.
http://www.bbc.co.uk/crime/caseclosed/nickleeson.shtmlhttp://www.bbc.co.uk/crime/caseclosed/nickleeson.shtmlhttp://www.bbc.co.uk/crime/caseclosed/nickleeson.shtml


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15. Who are we working for?

I have allowed our corporation to be multinational, but I have silently sneaked in one bigPrevious sectionassumed U.S. CAPM

world.assumptionthat you are a U.S. corporation, living in a U.S. CAPM world, working on behalf of

U.S. shareholders who consumes in U.S. dollars. This is a reasonable assumption if your share-

holders (owners) are all Americans who are not otherwise internationally diversified, perhaps

because they have a strong home bias that makes them hold the U.S. stock market portfolio

only. These investors naturally like projects that help them reduce the U.S. stock market risk

and in the end, they care only about consuming in U.S. dollars. This was the scenario that you

have worked out above.

But what if your investors are not Americans, concerned only with their opportunities in the U.S.Our cost of capital arisesfrom alternative

opportunities availableto our investors, often

in their stock market.

financial markets? What if your U.S. company shares are held by Chinese investors, and you

are now considering an investment in a German plant? How should you think about the risk

contribution of your investment projects now? The answer is surprisingly clear. Ultimately, as a

corporation, you exist for the benefit of your owners. Your goal is to earn a rate of return on the

money handed to you that exceeds the opportunity cost of capital otherwise available to your

investors. This is how your corporation adds value. If your owners are Chinese investors, who

otherwise have access only to the Chinese stock market (plus your firms shares now) and who

only consume in Chinese yuan, then your appropriate cost of capital would be determined by

the Chinese stock market. You would have to compute the beta of the German plant opportunitywith respect to the overall Chinese stock market, measuring the returns produced in euro after

translation into yuan.

In an even less plausible scenario, your Chinese investors would want to consume all theirConsumption choicesdetermine the currency

we use.returns in British pounds, but still remain restricted to investment in the Chinese stock market,

plus your single firm. In this case, your opportunity cost of capital is still determined by the

alternative investments (the Chinese stock market), but all calculations, including measurement

of the expected rate of return in the Chinese stock market, should now be done in British pounds.

After all, this is what your investors care about in the end.

We forgot one little detail, though: what if Chinese investors are not allowed to invest inSegmentation, legal orde facto, may mean wecan offer really unique

opportunities toinvestors.

American companies? Like investors in many countries, Chinese investors suffer from capital

controls. And, even when there are no formal capital controls, investors in many countries fail

to diversify themselves internationally. Even U.S. investors are often not diversified, althoughinternational diversification is no longer difficult: there are U.S. traded funds that hold foreign

stocks. If your U.S. investors forget about foreign investment opportunities, your U.S. cor-

poration might still be able to do it for them through foreign operations, and thereby expand

your investors investment opportunity set.

Side Note: If your investors do not hold foreign investments, foreign subsidiaries should expand your U.S.investors opportunities. After all, the foreign operation produces cash flows in foreign currency, which in anefficient stock market should be always appropriately valued in the firms stock price. The total firm shouldjust become the portfolio of a domestic operation and a foreign operation. Thus, even if the firm is only tradedin the United States, the stock of the combined firm should covary with both the return in the U.S. financialmarket and the return in the foreign financial markets.

Unfortunately, empirical evidence suggests that this is not as much the case as it shouldfirms tend to covarytoo much with the index on the stock market on which they are trading and too little with the foreign stock

market indexes where their underlying holdings are. This puzzle is related to a number of related puzzles:closed-end mutual funds that trade on the NYSE and that hold foreign country stocks tend to covary more withthe S&P500 than with their foreign countrys stock market; and Real-Estate Investment Trusts (REITs) seem tocovary more with the S&P500 than with the value of underlying real estate.

One final task. As a corporate manager, you know that you must think of the opportunity costDetermining who ourinvestors are may not be

easy for a large publiccorporation.

of capital of your underlying corporate owners when you decide on projects. But, who are your

investors, and what do they care about? In the CAPM, you could just assume that they cared

about the portfolio with the highest expected rate of return, given minimum overall portfolio

risk. Now, you may have Chinese investors, who care about the best Chinese yuen portfolio in

the context of the Chinese financial markets, but who ultimately want to consume in Canadian

dollars; British investors, who care about the best British pound portfolio in the context of
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Section 16. Summary.


121

the British financial markets, but who ultimately want to consume some goods sold in/priced

in euro and other goods priced in British pounds; and other investors who are represented by

funds, and are thus totally anonymous. In short, the possibilities are endless. What opportunity

sets are your investors really facing, and how can your projects improve them? In what currency

should you determine the optimal alternative investments? What kind of CAPM world do you

live in? For a manager, these are not easy questions. Most managers appropriately focus only

on the project opportunities that they are providing to their domestic investors. Given home

bias, this is a reasonable assumption, even if this is not perfectly correct. Fortunately, I am justan academic, and therefore do not have to make such difficult decisions!

Solve Now!

Q I.20 Assume you are a corporate manager in Germany. You are thinking of listing on the

Brazilian stock exchange. If Brazilian investors are only allowed to invest in Brazil, and all

Brazilian investors spend all their money to pay their childrens tuition in the United States, then

how should you think about investing in a Czech plant?

16. Summary

The chapter covered the following major points:

Currency spot markets and futures markets are linked by interest rate parity (IRP).

In the real world, the prices of goods can vary across countriesa phenomenon known

as deviation from purchasing power parity (PPP).

The Fisher hypothesis is that expected real rates of returns are the same across countries.

Investors can analyze the risk and reward from investing in foreign stock markets in a

CAPM-like framework. Foreign stocks seem to add at least some diversification benefits.

Corporate managers should continue to think of capital budgeting in terms of their in-

vestors opportunity cost of capital in an international framework.

In the context of a U.S. CAPM, they can think of foreign projects as contributing both risk

and reward. To measure the risk contributionthe projects U.S. market betamanagers

can think about the foreign projects beta with respect to the foreign market (measured

in local currency), the beta of the foreign market with respect to the U.S. market (both

measured in local currency), and the correlation of exchange rate movements with U.S.

market rates of returns.

For many OECD countries, the foreign market-beta in local currency is likely to be simi-

lar to the U.S. market beta in dollars, because international stock markets tend to move

together one-to-one, and currencies tend to move uncorrelatedly.

Corporate managers can hedge exchange risk through currency forward contracts, by

creating foreign operations, or by matching foreign assets with foreign liabilities.

Market segmentation can make the portfolio problem conceptually more complex. One

important cause of market segmentation is home bias.


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Appendix

A. Advanced Appendix: Prominent International Institutions

The International Monetary Fund, www.imf.org, is a United Nations non-profit agency, madeup of 184 member nations, and established in 1946. Its prime purpose is to encourage the

smooth functioning of money flows, and to aid in the stability of currencies (e.g., by pre-

venting runs on country currencies or by facilitating information disclosure). The IMFs op-

erations consist of surveillance, financial assistance, and technical assistance. In 2003,

the IMF had about $300 billion at its disposal, from which it could make temporary loans.

(For example, in September 2002, it lent $30 billion to Brazil to dispel doubt that Brazil

might default on its foreign debt.) Member countries voting power is determined by their

contributions to the IMF capital pool. The IMFs Board of Governors consists of finance

ministers and central bank heads. Day-to-day operations are performed by a twenty-four

person executive committee. Eight countries have permanent representations, while the

remaining sixteen rotate.

The World Bank, www.worldbank.org, really five closely associated institutions, is also a UnitedNations non-profit agency, made up of the same 184 member countries (World Bank mem-

bers must be members of the IMF), and also established in 1946. The World Bank was

set up to reduce poverty in developing nations. It both extends loans itself and attempts

to coordinate third-party private and bilateral loans. The World Bank raises financing

through World Bank bonds (it has an AAA rating), and passes the resulting low interest

rates onto developing country client loans. About 20% of the $23 billion raised by the

World Bank in 2002 was used for outright grants (not loans) to poor countries.

The World Trade Organization, www.wto.org, was set up in 1995 to deal with the global rules

of trade between nations. In April 2003, it had 146 member countries and operated with an

annual budget of 154 million Swiss francs. Its main function is to ensure that trade flows

as smoothly, predictably, and freely as possible. It handles trade disputes, administers

WTO trade agreements, offers a forum for trade negotiations, monitors national trade,and provides technical assistance and training for developing countries.

The Organization for Economic Cooperation and Development (OECD), www.oecd.org, grew

out of the Marshall Plan for reconstruction after World War II. Its 30 member countries

produce about 2/3 of the world GDP. (Another 70 countries have informal links.) The

OECD is a sort of think-tank agency and/or meeting place and/or information agency

that seeks to aid economic cooperation among like-minded and well-developed countries.

Its headquarter is Paris, and its budget is $200 million per annum. It is common to refer

to the developed countries as OECD countries.

Anecdote: Free Tradewhere convenientThe OECD nations are generally proponents of free trade. Most economists would agree that free trade generallyhelps all nations develop.

Unfortunately, the OECD countries show little consistency. For example, their farmers have enormous domes-tic voting power, which has made OECD countries erect high trade barriers against potentially competitiveagricultural imports from Third World countries. On the contrary, they subsidize their farming industries, andregularly get into mutual disputes as to which nation (among them) is most unfair. Unfortunately, the ThirdWorld just does nothave enoughpowerto demanda fair playing field. Naturally, the OECD nations will press andpenalize Third World nations if they erect trade barriers against their goods. A particularly egregious exampleis the fact that the United States presses other nations not to tax American tobacco and cigarette companies.

But thinking of this as a self-interested conspiracy is too simplistic. For example, the United States and Europehave permitted South East Asian (especially Japanese and Chinese) imports in plenty, even when the playingfield has not been level for U.S. industries (which thereby suffered huge job losses or destruction). In reality,trade policy is a rather incoherent and highly politicized area.
http://www.imf.org/http://www.imf.org/http://www.worldbank.org/http://www.worldbank.org/http://www.wto.org/http://www.wto.org/http://www.oecd.org/http://www.oecd.org/http://www.oecd.org/http://www.wto.org/http://www.worldbank.org/http://www.imf.org/


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Section B. Advanced Appendix: The International MVE Frontier.


123

B. Advanced Appendix: The International MVE Frontier

Anecdote: Protesting World Bank PoliciesDespite their seemingly uncontroversial missions and intents, all these agencies have been widely criticized,ranging from economists in suits to political activists with Molotov cocktails. This is not a light matter: thedecisions of these financial organizations decide not only the fortunes of billions of people, but de facto, thevery lives of millions in the developing world. (Personally, I think it is fair to say that both the internationalorganizations and their critics have good intentions; but the issues themselves are so complex that there istremendous disagreement about what is right and what is wrong. There are no easy and obvious answers.)

On the lighter side, one of the more unusual political soap operas was created by World Bank chief economistJosef Stiglitz (former professor of economics at Stanford) in late 1999. It began when Stiglitz sharply criticizedthe IMF and its former managing director, Stanley Fischer (former professor of economics at MIT). In turn, LarrySummers (former professor of economics and now president of Harvard), tried to influence the World Bank toquiet Stiglitzs view. The World Bank president refusedonly to find Stiglitz starting to publicly criticize theWorld Bank, too. Eventually, Stiglitz resigned with a big splash in an attempt to bring more attention to hispolicy views.

Source: Partly www.globalpolicy.org.
http://www.globalpolicy.org/socecon/bwi-wto/stigltz2.htmhttp://www.globalpolicy.org/socecon/bwi-wto/stigltz2.htmhttp://www.globalpolicy.org/socecon/bwi-wto/stigltz2.htm


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Figure I.2. The Historical International MVE Frontier

0 2 4 6 8 10 12

0.0

0.5

1.0

1.5

2.0

Standard Deviation (in % per month)

Mean

(in%permonth)

E

Waus

autcan

frager

hkg

ita

jpnnet

sca sng

swi uk

us

0 2 4 6 8 10 12

0.0

0.5

1.0

1.5

2.0

Standard Deviation (in % per month)

Mean

(in%permonth

)

E

W

ausaut

can

frager

hkg

ita

jpn

net

sca

sng

swi

ukus

These figures are based on the same MSCI data as Table I.2, thus quoted in dollar rates of return. The top figureis for 19702005; the bottom figure is for 19862005. The blue inside frontier applies if investors are not allowedto short any of the country indexes. The diamonds are the minimum variance portfolio and a tangency portfolio ifthe risk-free rate is 0%. The E portfolio is the equal-weighted index of these 14 countries; the W is the MSCI worldindex.


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Section B. Advanced Appendix: The International MVE Frontier.

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