The international firm has a more complicated life than the purely domestic firm. Management must understand the connection between interest rates, foreign currency exchange rates, and inflation, and it must become aware of many different financial market regulations and tax systems. This chapter is intended to be a concise introduction to some of the financial issues that come up in international investing.
Our coverage has been necessarily brief. The main topics we discussed are the following:
Some basic vocabulary: We briefly defined some exotic terms such as LIBOR and Eurocurrency.
The basic mechanics of exchange rate quotations: We discussed the spot and forward markets and how exchange rates are interpreted.
The fundamental relationships between international financial variables:
Absolute and relative purchasing power parity, PPP.
Interest rate parity, IRP.
Unbiased forward rates, UFR.
Absolute purchasing power parity states that $1 should have the same purchasing power in each country. This means that an orange costs the same whether you buy it in New York or in Tokyo.
Relative purchasing power parity means that the expected percentage change in exchange rates between the currencies of two countries is equal to the difference in their inflation rates.
Interest rate parity implies that the percentage difference between the forward exchange rate and the spot exchange rate is equal to the interest rate differential. We showed how covered interest arbitrage forces this relationship to hold.
The unbiased forward rates condition indicates that the current forward rate is a good predictor of the future spot exchange rate.
International capital budgeting: We showed that the basic foreign exchange relationships imply two other conditions:
Uncovered interest parity.
The international Fisher effect.
By invoking these two conditions, we learned how to estimate NPVs in foreign currencies and how to convert foreign currencies into dollars to estimate NPV in the usual way.
Exchange rate and political risk: We described the various types of exchange rate risk and discussed some common approaches to managing the effect of fluctuating exchange rates on the cash flows and value of the international firm. We also discussed political risk and some ways of managing exposure to it.
