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tractual risk, we mean that the firm is committed either to pay or to receive a known
amount of foreign currency. For example, our VCR importer was committed to pay
¥100 million at the end of 12 months. If the value of the yen appreciates rapidly over
this period, those VCRs will cost more dollars than the firm expected.
Noncontractual risk arises because exchange rate fluctuations can affect the competi-
tive position of the firm. For example, during 1991 and 1992 the value of the deutsche-
mark appreciated relative to that of other major currencies. As a result, Porsche and other
German luxury car manufacturers found it increasingly difficult to compete in the United
States. American dealers that had a franchise to sell German luxury cars also took a bath.
Thus the German car producers and their dealers in the United States were exposed to ex-
change rate changes even if they had no fixed obligations to pay or receive dollars.
Exchange rate changes can get companies into big trouble and therefore most com-
panies aim to limit at least their contractual exposure to currency fluctuations. Let us
look at an example of how this can be done.
In 1989 a British company, Enterprise Oil, bought some oil properties from Texas
Eastern for $440 million.6 Since the payment was delayed a couple of months, Enter-
prise™s plans for financing the purchase could have been thrown out of kilter if the dol-
lar had strengthened during this period.
Enterprise therefore decided to avoid, or hedge, this risk. It did so by borrowing
pounds, which it converted into dollars at the current spot rate and invested for 2
months. In that way Enterprise guaranteed it would have just enough dollars available
to pay for the purchase. Of course it was possible that the dollar would depreciate over
the 2 months, in which case Enterprise would have regretted that it did not wait and buy
the dollars spot. Unfortunately, you cannot have your cake and eat it too. By fixing its
dollar cost, Enterprise forfeited the chance of pleasant as well as unpleasant surprises.
Was there any other way that Enterprise could hedge against exchange loss? Of
course. It could buy $440 million 2 months forward. No cash would change hands im-
mediately but Enterprise would fix the price at which it buys its dollars at the end of 2
months. It would therefore eliminate all exchange risk on the deal. Interest rate parity
theory tells us that the difference between buying spot and buying forward is equal to
the difference between the rate of interest that you pay at home and the interest that you
earn overseas. In other words, the two methods of eliminating risk should be equivalent.
Let us check this. In March 1989 the 2-month interest rate in the United States was
about 9.7 percent and the interest rate in the United Kingdom was 13.0 percent. The
spot exchange rate was $1.743 to the pound and the 2-month forward rate was $1.730/£.
Table 6.8 shows that the cash flows from the two methods of hedging the dollar pay-
ment for Texas Eastern were almost identical.7
What is the cost of such a hedge? You sometimes hear managers say that it is equal
to the difference between the forward rate and today™s spot rate. This is wrong. If En-
terprise did not hedge, it would pay the spot rate for dollars at the time that the payment

6 See“Enterprise Oil™s Mega Forex Option,” Corporate Finance 53 (April 1989), p. 13.
7We are not sure of Enterprise™s borrowing rate but the company is rumored to have hedged at an effective
forward rate of $1.73/£.
International Financial Management 613

Cash Flow, Millions
Enterprise Oil could hedge
its future dollar payment £ $
either by borrowing sterling
Method 1: Borrow sterling, convert proceeds
and lending dollars or by
to dollars, and invest dollars until needed
buying dollars forward
Borrow £248.6m at 13% +248.6
Convert to $ at $1.743/£ “248.6 +433.3
Invest $433.3m for 2 months at 9.7% “433.3
Net cash flow now 0 0
Month 2:
Repay £ loan with interest “253.7
Receive payment on $ loan +440
Pay for oil properties “440
Net cash flow, Month 2 “253.7 0
Method 2: Buy dollars forward
Buy $440m forward at $1.73/£ 0 0
Month 2:
Pay for $ “254.3 +440
Pay for oil properties “440
Net cash flow, Month 2 “254.3 0

for Texas Eastern was due. Therefore, the cost of hedging is the difference between the
forward rate and the expected spot rate when payment is received.
Hedge or speculate? We generally vote for hedging. First, it makes life simpler for
the firm and allows it to concentrate on its own business. Second, it does not cost much.
(In fact the cost is zero if the forward rate equals the expected spot rate, as our simple
relations imply.) Third, the foreign exchange market seems reasonably efficient, at least
for the major currencies. Speculation should be a zero-sum game unless financial man-
agers have superior information to the pros who make the market.

Suppose that the current spot rate for the euro is $1.05/ and that the 6-month forward
Self-Test 8
rate is $1.10/ . What is the cost to a U.S. company of hedging its future need for euros
by buying them in the forward market? Assume the expectations theory of exchange rates.

International Capital Budgeting
KW Corporation is an American firm manufacturing flat-packed kit wardrobes. Its ex-
port business has risen to the point that it is considering establishing a small manufac-
turing operation overseas in Narnia. KW™s decision to invest overseas should be based
on the same criteria as a decision to invest in the United States”that is, the company

needs to forecast the incremental cash flows from the project, discount the cash flows
at the opportunity cost of capital, and accept those projects with a positive NPV.
Suppose KW™s Narnian facility is expected to generate the following cash flows in
Narnian leos:
Year 0 1 2 3 4 5
Cash flow (millions of leos) “7.6 2.0 2.5 3.0 3.5 4.0

The interest rate in the United States is 5 percent. KW™s financial manager estimates
that the company requires an additional expected return of 10 percent to compensate for
the risk of the project, so the opportunity cost of capital for the project is 5 + 10 = 15
Notice that KW™s opportunity cost of capital is stated in terms of the return on a
dollar-denominated investment, but the cash flows are given in leos. A project that of-
fers a 15 percent expected return in leos could fall far short of offering the required re-
turn in dollars if the value of the leo is expected to decline. Conversely, a project that
offers an expected return of less than 15 percent in leos may be worthwhile if the leo is
likely to appreciate.

You cannot compare the project™s return measured in one currency with the
return that you require from investing in another currency. If the opportunity
cost of capital is measured as a dollar-denominated return, consistency
demands that the forecast cash flows should also be stated in dollars.

To translate the leo cash flows into dollars, KW needs a forecast of the leo/dollar ex-
change rate. Where does this come from? We suggest using the simple parity relation-
ships in Figure 6.1. These tell us that the expected annual change in the spot rate (the
southeast box in Figure 6.1) is equal to the difference between the interest rates in the
two countries (the northwest box). For example, suppose that the financial manager
looks in the newspaper and finds that the current exchange rate is 2 leos to the dollar
(sL/$ = 2.0), while the interest rate is 5 percent in the United States (r$ = .05) and 10 per-
cent in Narnia (rL = .10). Thus the manager sees right away that the leo is likely to de-
preciate by about 5 percent a year.8 For example, at the end of 1 year
Expected spot spot rate expected change

rate in Year 1 in Year 0 in spot rate
= 2.00 — = L2.095/$
The forecast exchange rates for each year of the project are calculated in a similar
way as follows:
Year Forecast Exchange Rate
0 Spot exchange rate = L2.00/$
2.00 — (1.10/1.05) = L2.095/$
2.00 — (1.10/1.05)2 = L2.195/$
2.00 — (1.10/1.05)3 = L2.300/$
2.00 — (1.10/1.05)4 = L2.409/$
2.00 — (1.10/1.05)5 = L2.524/$

8 The financial manager could equally well use the forward exchange rate (fL/$) to estimate the expected spot
rate. In practice it is usually easier to find interest rates in the financial press than yearly forward rates.
International Financial Management 615

The financial manager can use these projected exchange rates to convert the leo cash
flows into dollars:9
Year 0 1 2 3 4 5
Cash flow 7.6 2.0 2.5 3.0 3.5 4.0

($ millions) 2.00 2.095 2.195 2.300 2.409 2.524
= “$3.8 = $.95 = $1.14 = $1.30 = $1.45 = $1.58

Now the manager discounts these dollar cash flows at the 15 percent dollar cost of cap-
.95 1.14 1.30 1.45 1.58
NPV = “ 3.8 + + + + +
1.15 1.152 1.153 1.154 1.155
= $.36 million, or $360,000
Notice that the manager discounted cash flows at 15 percent, not the United States
risk-free interest rate of 5 percent. The cash flows are risky, so a risk-adjusted interest
rate is appropriate. The positive NPV tells the manager that the project is worth under-
taking; it increases shareholder wealth by $360,000.

Suppose that the nominal interest rate in Narnia is 3 percent rather than 10 percent. The
Self-Test 9
spot exchange rate is still L2.00/$ and the forecast leo cash flows on KW™s project are
also the same as before.
a. What do you deduce about the likely difference in the inflation rates in Narnia and
the United States?
b. Would you now forecast that the leo will appreciate against the dollar or depreciate?
c. Do you think that the NPV of KW™s project will now be higher or lower than the fig-
ure we calculated above? Check your answer by calculating NPV under this new as-

We did not say how KW arrived at a 15 percent dollar discount rate for its Narnian proj-
ect. That depends on the risk of overseas investment and the reward that investors re-
quire for taking this risk. These are issues on which few economists can agree, but we
will tell you where we stand.10
Remember that the risk of an investment cannot be considered in isolation; it de-
pends on the securities that the investor holds in his or her portfolio. For example, sup-
pose KW™s shareholders invest mainly in companies that do business in the United

9 Suppose KW™s managers do not go along with what market prices are telling them. For example, perhaps
they believe that the leo is likely to appreciate relative to the dollar. Should they plug their own currency fore-
casts into their present value calculations? We think not. It would be stupid to undertake what might be an un-
profitable investment just because management is optimistic about the currency. Given its exchange rate fore-
cast, KW would do better to pass up the investment in wardrobe manufacturing and buy leos instead.
10 Why don™t economists agree? One fundamental reason is that economists have never been able to agree on

what makes one country different from another. Is it just that they have different currencies? Or is it that their
citizens have different tastes? Or is it that they are subject to different regulations and taxes? The answer af-
fects the relationship between security prices in different countries.

Political Risk
When multinational companies invest abroad, their fi- But in some parts of the world foreign companies are
nancial managers need to consider the political risks particularly vulnerable. Several organizations publish
that are involved. By this, we mean the threat that gov- regular rankings of countries in terms of their political
ernments will change the rules of the game after an in- risk. For example, the PRS Group places countries on a
vestment is made. At worst, the government may ex- scale of
propriate the company™s assets without compensation. 1 to 100 based on factors such as regime stability, fi-
Or it may simply insist that the company keep in the nancial transfer, and turmoil. The following table pre-
country any profits that it makes. sents the 10 least and most risky countries based on
Businesses in every country are exposed to the risk these factors.
of unanticipated actions by governments or the courts.

Least Risky Most Risky
Finland Ecuador
Belgium Iraq
Switzerland Cuba
Singapore Russia
Denmark Myanmar
Austria Sudan
Netherlands Vietnam
Hong Kong Cameroon
Australia Pakistan
Source: PRS Group (www.prsgroup.com), May 1, 2000.

States. They would find that the value of KW™s Narnian venture was relatively unaf-
fected by fluctuations in the value of United States shares. So an investment in the
Narnian furniture business would appear to be a relatively low-risk project to KW™s
shareholders. That would not be true of a Narnian company, whose shareholders are al-
ready exposed to the fortunes of the Narnian market. To them an investment in the
Narnian furniture business might seem a relatively high-risk project. They would there-
fore demand a higher return (measured in dollars) than KW™s shareholders.

We certainly don™t pretend that we can put a precise figure on the cost of capital for for-
eign investment. But you can see that we disagree with the frequent practice of auto-
matically increasing the domestic cost of capital when foreign investment is considered.
We suspect that managers mark up the required return for foreign investment because
it is more costly to manage an operation in a foreign country and to cover the risk of ex-
propriation, foreign exchange restrictions, or unfavorable tax changes. The nearby box
discusses the sources of political risk. A fudge factor is added to the discount factor to
cover these costs.
We think managers should leave the discount rate alone and reduce expected cash
flows instead. For example, suppose that KW is expected to earn L2.5 million in the
first year if no penalties are placed on the operations of foreign firms. Suppose also that

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