International Equity

80´s and 90´s multinationals started looking to list shares in foreign Stock Exchanges.
Large expansion on Primary market Issues and secondary market trading in non-domestic equities.
Examples: Daimler-Benz (Germany), AXA (France) 1st French company in 1996, Scandals: (ENRON and
Others)
Sarbanes-Oxley (SOX) legislation: Makes managers fully responsible for maintaining adequate internal
control structures and procedures for financial reporting.
Rank Group, have withdrawn their listing in the US. However, this is not as easy as it sounds. The firm
must prove that they have less than 300 US shareholders – difficult when so many shares are held in
nominee accounts. There are 519 foreign firms with listings on the NYSE, and over 300 on NASDAQ.
SOX has encouraged the listing of Chinese, Indian and other companies in the US, as it demonstrates the
desire of firms from emerging markets to provide investors with greater shareholder rights than in their
home market TRADING IN THE MEDIUM AND LONG RUN
Small Investors versus Institutions
Private Investors Trend: US, strong tradition of equity ownership by private investors who own slightly under
35%. Germany 14% France 20%. The UK, 11.5%.
Institutional Investors: Pension funds, insurance companies and also mutual funds are now the biggest
owners of shares in the market.
Pension Funds: Funding versus Unfunding
Pension Funds influence how active the market is, due to the large impact it has on the market.
Defined benefit schemes relate to pension benefits being linked to final salaries you know roughly what
your pension will be years before you retire, as it’s linked to the number of years of contributions and a
calculation relating to final salaries. Defined contribution schemes are like any other long-term investment
pension payments are linked to the performance of the pension fund over its lifetime.
Share Buy – Backs
A company repurchases the shares of stock that once issued.In recent years this practice has overtaken
the payment of dividends.
Why would a company buy its own shares?

 Unused Cash Is Costly

 Reduce ownership
 Large amount of equity becomes a burden (Large Companies)
 Payment of dividends is a cost on equity
 Reduce the cost of capital
 Makes companies look healthy attracting investors.
 In case of recession, it helps preserve the stock price.
 Feeling of shares are undervalued (later re-issue)
 Buy Backs improves the earnings pers share ratio.
 Prevent Takeover
What is the negative aspect of buybacks
1. It reduces credit rating. 2. Can draing cash reserves of a company.
How will this affect the financial statements?
1. Reduce company cash, therefor total asset
2. Reduce Shareholders Equity (ROA and ROE should improve)
Mutual Funds: Imagine
1. You are a small investor with $3000
2. You have two choices:
– Invest all in 2 or 3 companies
– Invest in 10 companies.
What do you do??
You can invest in mutual funds, These are collective investments, run by fund managers. They may
investin: money market instruments, equities and bonds.
Two kinds of Mutual Funds: Open Ended Fund: (Unit Trusts in the UK) Closed Ended Funds
Understanding Mutual Funds:
When you buy a Unit in a Mutual Fund, you are buying the performance of its portafolio, a part of the
portfolio's value. A mutual fund is both an investment and an actual company. 
Investors typically earn a return from a mutual fund in three ways:
Dividends and Interest on Bonds, this earning are then distributed to all members/owners of the mutual
fund, Selling of a Securities (Capital Gain), By selling you own mutual fund shares for profit.
Types of Funds
Equity Funds, Fixed Income Funds (pays a set rate of return), Index Funds, Balanced Funds (stock and
bonds), Money Market Funds (Short Term Debt instruments), Income Funds (interest Streasms, mainly
bonds), International funds, Global Funds, Specialty Funds, Others.
Trading in the Short Run
Order Driven Markets
An intermediary matches buy and sell orders at a given price.
Buyer give (match) some orders: Price, Quantity, What to do in case no match is found. To seller.
1. Limit Orders: example a buyer is prepared to buy 500 shares up to a limit of €154 or a seller will
sell 400 shares, but at a price no lower than €151.
2. CATS (computer-assisted trading system)
Countries with Order Driven Systems France, Germany, Belgium, Italy, Spain and Switzerland.
Quote Driven Markets
A market maker, continuously quotes bids and offers prices at which they will buy or sell shares.

Quote Driven vs Order Driven

“Both quote- and order-driven markets refer to digital financial marketplaces—electronic stock (or bond, or
other security) exchanges.”
Order Driven: Show all bids and Offers, Biggest advantage: Transparency, No guarantee orders will be
executed.
Quote Driven: Shows bids/offers Market Makers, Bid/offer change constantly, Mayor advantage: Liquidity,
Guaratee of order fulfillment. Lacks transparency.
Hybrid Markets
Both order-driven and quote-driven features, they have an automated system that coexists with a physical
deal market, example: NYSE, SETS (London), STAR (Mylan). Hybrid markets give brokers a choice
between participating in the exchange through the traditional floor broker system, or the faster automated
electronic exchange system.

The Trading Process

Clearing and Settlement
Clearing: All activities that take place in between making a commitment to undertake a transaction until it is
paid for (settled). Settlement: paying money and receiving stock or receiving money and delivering the
stock.
IDEAL: ‘delivery versus payment’
Clearing Houses
1. Enters the picture after a buyer and seller have executed a trade.
2. Its role is to consolidate the steps that lead to settlement of the transaction.
3. Provides the security and efficiency that is integral for financial market stability.

4.

Make financial Markets stable and efficient, Settle multiple transactions among multiple parties, Reduce
Risk for buyer and seller.
The Foreign Exchange Market
provides the physical and institutional structure through which the money of one country is exchanged for
that of another country—the rate of exchange between currencies is determined and foreign exchange
transactions are physically completed.
Foreign exchange; money of a foreign country; that is, foreign currency bank balances, banknotes, checks,
and drafts.
foreign exchange transaction: Agreement between a buyer and seller that a fixed amount of one currency
will be delivered for some other currency at a specified rate.
functions of money:
1. Medium of Exchange: Element of standardized value used to settle the exchange of a given item.
In other words, it is an instrument that facilitates the trade of goods and services.exp Currency
1. Unit account: A standard monetary unit of measurement of value/cost of goods, services, or
assets.E xample: Dollars, Soles, Pesos, Pounds
1. Store of Value: An asset that can be saved, retrieved and exchanged at a later time, and be
predictably useful when retrieved. Anything that retains purchasing power into the future.Example:
Gold, Money Saved
Why is it necessary:
 Because international trade and capital transactions normally involve parties living in countries with
different national currencies.
 Because the movement of goods between countries takes time, inventory in transit must be
financed. The foreign exchange market provides a source of credit.
 The foreign exchange market provides “hedging” facilities for transferring foreign exchange risk to
someone else more willing to carry risk.
Structure of the Foreign Exchange Market
The forces driving change in the foreign exchange market are fundamental: electronic trading platforms,
algorithmic trading programs and routines, and the increasing role of currencies as an asset class.”
The largest traditional providers of foreign exchange rate information and trading systems:

 Reuters, Telerate, EBS, Bloomberg

 New foreign exchange rate information and trading systems:
 FXCM , IG, MahiFX ,Forex.com, Oanda, CMC Markets, AvaTrade, GMO Click, XE, Pepperstone
Market Participants
Five broad categories of institutional participants operate in the market:
1. bank and nonbank foreign exchange dealers
2. Individuals and firms conducting commercial or investment
transactions
3. Speculators and arbitragers
4. Central banks and treasuries
5. Foreign exchange brokers.
Bank and nonbank foreign exchange dealers:
 Profit from buying foreign exchange at a “bid” price and reselling it at a slightly higher “offer”
(also called an “ask”) price.
Individuals and Firms Conducting Commercial and Investment Transactions
 Importers and exporters, international portfolio investors, multinational corporations,
tourists, and others use the foreign exchange market to facilitate execution of commercial or
investment transactions.
Speculators and Arbitragers
 Speculators and arbitragers seek to profit from trading within the market itself. True profit seekers,
they operate in their own interest, without a need or obligation to serve clients or to ensure a
continuous market.
Central Banks and Treasuries
 Central banks and treasuries use the market to acquire or spend their country’s foreign exchange
reserves as well as to influence the price at which their own currency is traded, a practice known as
foreign exchange intervention.
Foreign Exchange Brokers
 Foreign exchange brokers are agents who facilitate trading between dealers without
themselves becoming principals in the transaction. They charge a small commission for this
service.
Transactions in the Foreign Exchange Market
“Foreign exchange market can be executed on a spot, forward, or swap basis.” (Moffett, Stonehill, Eiteman)
Spot Transactions: in the interbank market is the purchase of foreign exchange with delivery and payment
between banks taking place normally on the second following business day.
Outright Forward Transactions: requires delivery at a future value date of a specified amount of one
currency for a specified amount of another currency.
Swap Transactions
 Is the simultaneous purchase and sale of a given amount of foreign exchange for two different value
dates.
• Spot Against Forward: The dealer buys a currency in the spot market (at the spot rate) and
simultaneously sells the same amount back to the same bank in the forward market (at the
forward exchange rate).
• Forward-Forward Swaps:

• Nondeliverable Forwards (NDFs). possess the same characteristics and documentation

requirements as traditional forward contracts, except that they are settled only in U.S.
dollars; the foreign currency being sold forward or bought forward is not delivered.
Foreign Exchange Rates Quotations
Exchange Rate Quotes
A foreign exchange rate is the price of one currency expressed in terms of another currency
 It involves two currencies: CUR1 / CUR2
Base Currency - Unit Currency Price Currency - quote Currency Example: EUR / USD = 1.2174
Triangular arbitrage by a Market Trader

International Parity Conditions

Prices and Exchange Rates
Purchasing Power Parity and the Law of One Price
If identical products or services can be sold in two different markets, and no restrictions exist on the sale or
transportation of product between markets, the product’s price should be the same in both markets.
Absolute Purchasing Power Parity
In relatively efficient markets the price of a basket of goods would be the same in each market
 PI = Prices Indices
The Fisher Effect
The Fisher equation is a concept in economics that determines the relationship between nominal and real
interest rates under the effect of the inflation.

The Fisher equation describes a situation where investors or lenders ask for an additional reward to
compensate for losses in purchasing power due to higher inflation.
The Fisher effect examines the link between the inflation rate, nominal interest rates and real interest rates.
real interest rate = nominal interest rate – expected inflation.
One implication of the Fisher effect is that nominal interest rates tend to mirror inflation, making monetary
policy neutral.
If you put money in a bank and receive a nominal interest rate of 6%, but expected inflation is 4%, then the
real purchasing power of your savings is rising by 2%. For example, if the Central Bank increased money
supply and the expected inflation rose from 4% to 7%, then to maintain a stable economy, the Central Bank
would raise interest rates from 6% to 9%.
American economist Irving Fisher proposed the equation.
(1 + i)  = (1 + r) (1 + π)
 Where: i – the nominal interest rate, r – the real interest rate, π – the inflation rate

Approximate version of the previous formula: i π +r

- Example
Suppose Juan owns an investment portfolio. Last year, the portfolio earned a return of 3.25%. However,
last year’s inflation was around 2%. Juan wants to determine the real interest rate he earned from the
portfolio. In order to find the real interest rate, we should use the Fisher equation. The equation states that:

Where:

We rearrange the formula: REAL INTEREST RATE

The International Fisher Effect
• States that the difference between the nominal interest rates in two countries is directly proportional
to the changes in their currencies at any given time.
• The International Fisher Effect is based on current and future nominal interest rates, and it is used to
predict spot and future currency movements.
• The International Fisher Effect theory was designed on the basis that interest rates are independent
of other monetary variables and that they provide a strong indication of how the currency of a
specific country is performing. Changes in inflation do not impact real interest rates, since the real
interest rate is simply the nominal rate minus inflation. (Fisher Effect)
 Lower Interest Rates
Lower Inflation
Increase in the real value of the country’s currency in comparison to another country’s currency
Higher Interest Rates
Higher Inflation
Decrease in the real value of the country’s currency in comparison to another country’s currency
The International Fisher Effect Formula
Where:
E = Percentage change in the exchange rate of the country
I1 = Country’s A’s Interest rate
I2 = Country’s B’s Interest rate
i 1−i 2
E= ≈(i 1−i 2 )
1+i 2
Example of Future Spot Rate:
Let’s take the examples of two currencies, the USD (the United States) and the CAD (the Canadian Dollar).
The USD/CAD spot exchange rate is 1.30, and the interest rate of the United States is 5.0% while that of
Canada is 6.0%.

Future Spot Rate: (Current Spot rate * (1 + i 1)) / (1+i 2)

Future Spot Rate: ( 1.3 * (1 + 5%)) / (1+ 6%) = 1.312

1 USD will exchange into 1.312 CAD
The International Fisher Effect – Example of % Change
• The formula for calculating IFE is as follows:
where:
• ef = expected change in exchange rate
• ih = Nominal rate in home country
• if = Nominal rate in foreign country
1+i h
ef = −1 ≈(i 1−i 2)
1+ i f
Suppose intereste rate on a one year insured US Bank Deposit is 9% and the rate of a one year British
bank deposit is 10%. What does the IFE predict will happen to the exchange rate?
1+9 %
ef = −1 ≈.909 %
1+10 %
Implications
1. “IFE theory suggests that currencies with high interest rates will have high expected inflation (due to
the fisher effect) and the relatively high inflation will cause currencies to depreciate.“
2. “The implications are similar for foreign investors who attempt to capitalize on relatively high US
interest rates. The foreign investor will be adversely affected by the effects of a relatively high US
inflation rate if they try to capitalize on the high US interest rates.”
 Equilibrium Interest Rates and Exchage Rates

How do we determine the Foward Rate or Forward Exchange Rate???

Assume:
Spot rate of SF1.4800/$,
90-day euro Swiss franc deposit rate of 4.00%
annual
90-day eurodollar deposit rate of 8.00% annual,
Interest Rate Parity
The theory states: The difference in the national interest rates for securities of similar risk and maturity
should be equal to, but opposite in sign to, the forward rate discount or premium for the foreign currency,
except for transaction costs.

In order for the two alternatives to be equal, any differences in interest rates must be offset by the
difference between the spot and forward exchange rates (in approximate form):

Covered Interest Arbitrage (CIA)

In the international market, the spot and forward rate are not always in equilibrium This situation gives
opportunity for arbitrage at hardly no risk. .
Is it better to invest in dollars o Yen??
We compare the Forward Premium VS difference in interest rates
Difference in interest rates:

- =2

The Forward Premium:

Arbitrage is the simultaneous purchase and sale of an asset to profit from an imbalance in the price. It is a
trade that profits by exploiting the price differences of identical or similar financial instruments on different
markets or in different forms.
Comparing: 2.00% vs 4.8309%
By investing in yen and selling the yen proceeds forward at the forward rate, Fye Hong earns more on the
combined interest rate arbitrage and forward premium than if he continues to invest in dollars.
Why??
Because the the Yen is selling forward at a 4.8309% per year premium over the dollar (it takes 4.8309 %
more dollars to get a Yen at the 180-day forward rate).
Uncovered Interest Arbitrage (UIA) Borrowing instead of Lending
In UIA , investors borrow in countries and currencies exhibiting relatively low interest rates and convert the
proceeds into currencies that offer much higher interest rates. The transaction is “uncovered,” because the
investor does not sell the higher yielding currency proceeds forward, choosing to remain uncovered and
accept the currency risk of exchanging the higher yield currency into the lower yielding currency at the end
of the period.

Foreign Exchange Rate Determination Theories

  Exchange Rate Determination
There are basically three views of the exchange rate. The first takes the exchange rate as the relative price
of monies (the monetary approach); the second, as the relative price of goods (the purchasing-power-parity
approach); and the third, the relative price of bonds.”
Purchasing Power Parity Approaches
⊸ Most accepted theory
⊸ Relative Purchasing Power Parity, is thought to be the most relevant to possibly explaining what
drives exchange rate values.
1+ ∆∈foreign prices
St +1=st x
1+ ∆∈local prices
Problem:
⊸ basic assumption that the only thing that matters is relative price changes.
Balance of Payments (Flows) Approaches
⊸ 2nd most accepted theory
⊸ Involving the supply and demand for currencies in the foreign exchange market.
⊸ The basic balance of payments approach argues that the equilibrium exchange rate is found when
the net inflow (outflow) of foreign exchange arising from current account activities matches the net
outflow (inflow) of foreign exchange arising from financial account activities.
Problem:
⊸ emphasis on flows of currency and capital rather than on stocks of money or financial assets.
Basic balance is an economic measure for the balance of payments that combines the current account and
capital account balances. The current account shows the net amount of a country's income if it is in surplus,
or spending if it is in deficit. The capital account records the net change in ownership of foreign assets. The
current account is a country's trade balance plus net income and direct payments. The trade balance is a
country's imports and exports of goods and services. The current account also measures international
transfers of capital. A financial account is a component of a country's balance of payments that covers
claims on or liabilities to nonresidents, specifically with regard to financial assets. Financial account
components include direct investment, portfolio investment and reserve assets broken down by sector.
Asset Market Approach (Relative Price of Bonds)
⊸ Also called “the relative price of bonds or portfolio balance approach”
⊸ Determined by the supply and demand for financial assets of a wide variety
⊸ Shifts in the supply and demand for financial assets and changes in monetary and fiscal policy alter
expected returns and perceived relative risks of financial assets, which in turn alter rates.
Problem:
⊸ emphasis on flows of currency and capital rather than on stocks of money or financial assets.
the case for macroeconomic determinants of exchange rates is in a sorry state [The] results indicate that no
model based on such standard fundamentals like money supplies, real income, interest rates, inflation rates
and current account balances will ever succeed in explaining or predicting a high percentage of the
variation in the exchange rate, at least at short- or medium-term frequencies.
Technical Analysis
⊸ Study of past behavior (exchange rates) will allow me to determine (project) future prices
movements (exchange rates).
⊸ Assumption that currency prices follow trendes.
▫ Fair value is the true long-term value that the price will eventually retain.
▫ Market value is subject to a multitude of changes and behaviors arising from widespread
market participant perceptions and beliefs—at the time.
TRANSACTION EXPOSURE
Measures changes in the value of outstanding financial obligations incurred prior to a change in exchange
rates but not due to be settled until after the exchange rates change.
⊸ Example: I earn in Soles, but I have a loan in Dollars.
Is the potential for accounting-derived changes in owner’s equity to occur because of the need to “translate”
foreign currency financial statements of foreign subsidiaries into a single reporting currency to prepare
worldwide consolidated financial statements.
Example: Scotiabank has subsidiaries in 47 countries, all with different currencies, but they report
corporately in Canadian Dollars.
Operating exposure
measures the change in the net present value of the firm resulting from any change in future operating cash
flows of the firm caused by an unexpected change in exchange rates.
Example: Company URP is importing Smart TVs from a company in Japan. The Yen appreciates against
the Sol. Making it more expensive for Company URP to buy its products.
Hedging
Hedging protects the owner of the existing asset from loss. However, it also eliminates any gain from an
increase in the value of the asset hedged.
Hedging requires a firm to take a position—an asset, a contract, or a derivative—that will rise or fall in the
value offsetting the fall or rise in value of an existing position—the exposure.
⊸ Pros:
⊸ Reduction in risk of future cash flows improves the planning capability of the firm.
⊸ Reduction of risk in future cash flows reduces the risk of no being able to make debt-service
payments
⊸ Management has a comparative advantage over the individual shareholder in knowing the actual
currency risk of the firm.
⊸ Management is in a better position than shareholders to recognize disequilibrium conditions and to
take advantage of single opportunities to enhance firm value through selective hedging.
⊸ Cons:
⊸ Shareholders are more capable of diversifying currency risk than is the management of the firm.
⊸ Currency hedging does not increase the expected cash flows of the firm.
⊸ Currency risk management does, however, consume firm resources and so reduces cash flow.
⊸ Management often conducts hedging activities that benefit management at the expense of the
shareholders.
⊸ Managers cannot outguess the market.
⊸ Management’s motivation to reduce variability is sometimes driven by accounting reasons.
⊸ Foreign exchange losses appear in the income statement as separate line item
⊸ Higher costs of protection are buried in operating or interest expenses.
 ⊸ Adds cost.
Transaction Exposure Management
Measurment of Transaction Exposure
Transaction exposure measures gains or losses that arise from the settlement of existing financial
obligations, such as:
1. Purchasing or selling on credit goods or services when prices are stated in foreign
currencies
2. Borrowing or lending funds when repayment is to be made in a foreign currency
3. Being a party to an unperformed forward contract
4. Otherwise acquiring assets or incurring liabilities denominated in foreign currencies

Purchasing or selling in an open account

Suppose Trident Corporation sells merchandise on open account to a Belgian buyer for €1,800,000 payable
in 60 days
Further assume that the spot rate is $1.2000/€ and Trident expects to exchange the euros for €1,800,000 x
$1.2000/€ = $2,160,000 when payment is received
Transaction exposure arises because of the risk that Trident will something other than $2,160,000 expected
If the euro weakens to $1.1000/€, then Trident will receive $1,980,000
If the euro strengthens to $1.3000/€, then Trident will receive $2,340,000

What could be done??

Trident might have avoided transaction exposure by invoicing the Belgian buyer in US dollars, but this might
have lead to Trident not being able to book the sale. Even if the Belgian buyer agrees to pay in dollars,
however, Trident has not eliminated transaction exposure, instead it has transferred it to the Belgian buyer
whose dollar account payable has an unknown euro value in 60 days.
Borrowing or Lending
A second example of transaction exposure arises when funds are loaned or borrowed .Example: PepsiCo’s
largest bottler outside the US is located in Mexico, Grupo Embotellador de Mexico (Gemex)
⊸ On 12/94, Gemex had US dollar denominated debt of $264 million
⊸ The Mexican peso (Ps) was pegged at Ps$3.45/US$
⊸ On 12/22/94, the government allowed the peso to float due to internal pressures and it sank to
Ps$5.50/US$
Borrowing or Lending
Gemex’s peso obligation now looked like this
– Dollar debt mid-December, 1994:US$264,000,000 x Ps$3.45/US$ = Ps$910,800,000
– Dollar debt in mid-January, 1995: US$264,000,000 x Ps$5.50/US$ = Ps$1,452,000,000
– Dollar debt increase measured in Ps: Ps$541,200,000
Gemex’s Peso obligation increased by 59% due to transaction exposure
Other causes of exposure
Unperformed Foreign Exchange Contracts
When a firm buys a forward exchange contract, it deliberately creates transaction exposure; this risk is
incurred to hedge an existing exposure
Example: US firm wants to offset transaction exposure of ¥100 million to pay for an import from Japan in 90
days. Firm can purchase ¥100 million in forward market to cover payment in 90 days
Trident´s transaction Exposure
Maria Gonzalez, CFO of Trident, has just concluded a sale to Regency, a British firm, for £1,000,000
The sale is made in March for payment due in three months time, June
Assumptions: Spot rate is $1.7640/£, 3 month forward rate is $1.7540/£ (a 2.2676% discount), Trident’s
cost of capital is 12.0%, UK 3 month borrowing rate is 10.0% p.a., UK 3 month investing rate is 8.0% p.a.
Maria faces four possibilities: Remain unhedged. Hedge in the forward market. Hedge in the money market.
Hedge in the options market
Unhedged position
Maria may decide to accept the transaction risk. If she believes that the future spot rate will be $1.76/£, then
Trident will receive £1,000,000 x $1.76/£ = $1,760,000 in 3 months time. However, if the future spot rate is
$1.65/£, Trident will receive only $1,650,000 well below the budget rate
Forward Market hedge
A forward hedge involves a forward or futures contract and a source of funds to fulfill the contract,The
forward contract is entered at the time the A/R is created, in this case in March ,When this sale is booked,
it is recorded at the spot rate. In this case the A/R is recorded at a spot rate of  $1.7640/£, thus $1,764,000
is recorded as a sale for Trident
⊸ Should Maria want to cover this exposure with a forward contract, then she will sell £1,000,000
forward today at the 3 month rate of $1.7540/£
⊸ She is now “covered” and Trident no longer has any transaction exposure
⊸ In 3 months, Trident will received £1,000,000 and exchange those pounds at $1.7540/£ receiving
$1,754,000
⊸ This sum is $6,000 less than the uncertain $1,760,000 expected from the unhedged position
⊸ This would be recorded in Trident’s books as a foreign exchange loss of $10,000 ($1,764,000 as
booked, $1,754,000 as settled)
⊸ A money market hedge also includes a contract and a source of funds, similar to a forward contract
⊸ In this case, the contract is a loan agreement
⊸ The firm borrows in one currency and exchanges the proceeds for another currency
⊸ Hedges can be left “open” (i.e. no investment) or
⊸ “closed” (i.e. investment)
⊸ To hedge in the money market, Maria will borrow pounds in London, convert the pounds to dollars
and repay the pound loan with the proceeds from the sale
⊸ To calculate how much to borrow, Maria needs to
⊸ discount the PV of the £1,000,000 to today
⊸ £1,000,000/1.025 = £975,610 (10% annual → 2.5% 3 months)
⊸ Maria should borrow £975,610 today and in 3 months time repay this amount plus £24,390 in
interest (£1,000,000) from the proceeds of the sale
⊸ Trident would exchange the £975,610 at the spot rate of $1.7640/£ and receive $1,720,976 at once
⊸ This hedge creates a pound denominated liability that is offset with a pound denominated asset
thus creating a balance sheet hedge.
Option Market hedge
⊸ Maria could also cover the £1,000,000 exposure by purchasing a put option. This allows her to
speculate on the upside potential for appreciation of the pound while limiting her downside risk
⊸ Given the quote earlier, Maria could purchase 3 month put option at an at the money (ATM) strike
price of $1.75/£ and a premium of 1.5%
⊸ The cost of this option would be
(Size of option) x (premium) x (spot rate) = cost of option
£1,000,000 x 0.015 x $1.7640 = $26,460
⊸ Using a cost of capital of 12% p.a. or 3.0% per quarter, the premium cost of the option as of June
would be
$26,460 x 1.03 = $27,254
⊸ Since the upside potential is unlimited, Trident would not exercise its option at any rate above
$1.75/£ and would purchase pounds on the spot market
⊸ If for example, the spot rate of $1.76/£ materializes, Trident would exchange pounds on the spot
market to receive
⊸ £1,000,000 x $1.76/£ = $1,760,000 less the premium of the
⊸ option ($27,254) netting $1,732,746
⊸ Unlike the unhedged alternative, Maria has limited downside with the option
⊸ Should the pound depreciate below $1.75/£, Maria would exercise her option and exchange her
£1,000,000 at $1.75/£ receiving $1,750,000
⊸ Less the premium of the option, Maria nets $1,722,746
⊸ Although this downside is less than that of the forward or money market hedge, the upside potential
is not limited
Global Cost and availability of capital
Availability of Capital
Iliquid markets
Financing a firm in a highly illiquid domestic securities market will probably increase the cost of capital and
limit the availability of capital. This in turn will limit the firm’s ability to compete both internationally and
against firms entering its market. Firms in emerging countries, Small Business , Family owned
businesses.
Segmented Markets
Firms in segmented capital markets must devise a strategy to escape dependence on that market for their
long-term debt and equity needs. Segmented markets occur due to excessive regulatory control, perceived
political risk, anticipated FOREX risk, lack of transparency, asymmetric information, cronyism, insider
trading and other market imperfections
Cost of Capital
A domestic firm normally finds its cost of capital by evaluating where and from whom it will raise its capital.
The cost will obviously differ due:
⊸ N° of investors interested in the firm,
⊸ N° of investors willing and able to buy its equity shares
⊸ Debt available to the firm from the domestic bank and debt market.
E D
k WACC=k e + k d (1−t )
 V V Where
 kWACC = weighted average cost of capital
 ke = risk adjusted cost of equity
 kd = before tax cost of debt
 t = tax rate
 E = market value of equity
 D = market value of debt
 V = market value of firm (D+E)

Cost of Equity
Cost of equity is calculated using the Capital Asset Pricing Model (CAPM)
ke  k rf   ( k m  k rf )
 Where
 ke = expected rate of return on equity
 krf = risk free rate on bonds
 km = expected rate of return on the market
 km – krf = equity risk premium
 β = coefficient of firm’s systematic risk

Cost of Debt
Firms acquire debt in either:
 Loans from commercial
 Securities sold to the debt markets, such as bonds.
 How do you measure the Cost of debt
 Forecast of interest rates for the next few years
 Know the proportions of various classes of debt
 Corporate income tax rate
 Different debt components are then averaged according to their proportion in the debt structure .
After Tax – Cost of Debt k d ( 1−t )
Where
 kd = before tax average cost of debt
 T = Corporate Tax
Practical Excersice
URP Global Inc. CFO, believes that URP Global has access to global capital markets and because its
headquarters are in the US, the US will be its base for market risk and equity risk calculations. What is its
cost of capital?
 krf = 5.0% risk free rate on bonds
 km = 15% expected rate of return on the market
 β = 1.2 coefficient of firm’s systematic risk
 kd = 8.0% before tax average cost of debt
 T = 35% Corporate Tax
 E/V = 60%
 D/V = 40%

ke  k rf   ( k m  k rf )

E D
kWACC  ke  k d ( 1  t)
V V
Why do we want to know the WACC??
 Some uses are:
 The risk-adjusted discount rate for the future operating cash flows of a firm and thus estimating the
net present value.
 Discount Rate for New Projects
 As an indicator for pursuing an investment (hurdle rate)
 Value Investors compare WACC vs Return

International Portafolio Theory

Portfolio Risk Reduction:
  Measured by the ratio of the variance of the portfolio’s return relative to the variance of the market
return.
 The total risk of any portfolio is therefore composed of systematic risk (the market) and
unsystematic risk (the individual securities).
Foreign Exchange Risk
Reduced through international diversification

 Internationally diversified portfolios the investor is attempting to combine assets that are less than
perfectly correlated, reducing the total risk of the portfolio. The same as domestic Portfolios
 Different than domestic Portfolios, because the investor acquires two additional asset:
 the currency of denomination

 the asset subsequently purchased with the currency

ONE ASSET IN PRINCIPLE, BUT TWO IN EXPECTED RETURNS AND RISKS
The international capital asset pricing model
The Capital Asset Pricing Model (CAPM)

 Is a model that describes the relationship between the expected return and risk of investing in a
security.
 Used to calculate the required rate of return for any risky asset.
 Is used for purely domestic investments.
Why does it matter? Because is used to determine what the fair price of an investment should be.
HOW? Rate of retun is used to discount an investments future cash flow, to the present value and
thus arrive to the investment's fair value.
International Capital Asset Pricing Model
But what if globalization has opened up the global markets, integrating them, and allowing investors to
choose among stocks of a global portfolio? Why not use the CAPM Model?
It doesn´t consider:
 no transaction costs,
 taxes,
 investors who can borrow and lend at the risk-free rate
 investors who are rational and risk averse.
Expanded Model the ICAPM
It doest consider:
 Time value of money
 market risk
 Direct indirect exposure to foreign currency.

Raising Equity and Debt Globally

Designing a Strategy to Source Capital Globally
 Most firms raise their initial capital in their
own domestic market
 However, most firms that have only
raised capital in their domestic market are
not well known enough to attract foreign
investors
  Incremental steps to bridge this gap include:
 conducting an international bond offering
 Cross-listing equity shares on more highly liquid foreign stock exchanges
Optimal Financial Structure
When taxes and bankruptcy costs are considered, a firm has an optimal financial structure determined
by that particular mix of debt and equity that minimizes the firm’s cost of capital for a given level of
business risk.

Minimum Cost Range Determined by:

 Industry where it competes
 Volatility of sales and operating income
 Collateral Value of its Assets
Internationally it also includes:
 Avalilability of Capital
 Diversification of cash flows
 Foreign exchange risl
 Expectations of international portafolio inverstors.
Avalilability of Capital
 Access to capital in global markets allows an MNE to lower its cost of equity and debt
compared with most domestic firms.
 Allows an MNE to maintain its ideal Debt Ratio.
Diversification of Cashflows
Theoretical possibility exists that multinational firms are in a better position than domestic
firms to support higher debt ratios because their cash flows are diversified internationally.
 By diversifying cash flows internationally, the MNE might be able to achieve the same kind of
reduction in cash flow variability.
Foreign Exchange Risk and Cost of Debt
When a firm issues foreign currency denominated debt, the effective cost is the cost of repaying the interest
and capital and foreign exchange gains or losses.
Example:

Whats the real cost of foreign Debt?

Percent Change Calculation:

Total Cost of Borrowing:

After Tax Cost:

Expectations of International Portafolio Investors
 key to gaining a global cost and availability of capital is attracting and retaining international portfolio
investors
 Investors’ expectations for a firm’s debt ratio and overall financial structures are based on global norms
that have developed over the past 30 years.
Raising Equity Globally
Equity Issuance1
 Initial Public Offering (IPO)—the initial sale of shares to the public of a private company.
IPOs raise capital.
 Seasoned Public Offering (SPO)—a subsequent sale of additional shares in the publicly
traded company, raising additional equity capital.
 Euroequity—the initial sale of shares in two or more markets and countries simultaneously.
 Directed Issue—the sale of shares by a publicly traded company to a specific target investor
or market, public or private, often in a different country.
Equity Listing2
 Shares of a publicly traded firm are listed for purchase or sale on an exchange. An investment banking
firm is typically retained to make a market in the shares.
 Cross-listing is the listing of a company’s shares on an exchange in a different country market. It is
intended to expand the potential market for the firm’s shares to a larger universe of investors.
 Depositary receipt (DR)—a certificate of ownership in the shares of a company issued by a bank,
representing a claim on underlying foreign securities. In the United States they are termed American
Depositary Receipts (ADRs), and when sold globally, Global Depositary Receipts (GDRs).
Private Placement3
 The sale of a security (equity or debt) to a private investor. The private investors are typically institutions
such as pension funds, insurance companies, or high net-worth private entities.
 Rule 144A private placement sales are sales of securities to qualified institutional buyers (QIBs) in the
United States without SEC registration. QIBs are nonbank firms that own and invest in $100 million or
more on a discretionary basis.
 Private Equity—equity investments in firms by large limited partnerships, institutional investors, or
wealthy private investors, with the intention of taking the subject firms private, revitalizing their
businesses, and then selling them publicly or privately in one to five years.

Raising Equity en Debt

Depositary Reciepts
 Depositary receipts (DRs) are negotiable certificates issued by a bank to represent the
underlying shares of stock that are held in trust at a foreign custodian bank. Global depositary receipts
 (GDRs) refer to certificates traded outside of the United States,
 American depositary receipts (ADRs) refer to certificates traded in the United States and
denominated in U.S. dollars.
 For a company that is incorporated outside the United States and that wants to be
listed on a U.S. stock exchange, the primary way of doing so is through an ADR program.
ADR Programas
 Level I (over-the-counter or pink sheets) DR Programs. Level I programs are the easiest and
fastest programs to execute. A Level I program allows the foreign securities to be urchased and
held by U.S. investors without being registered with the SEC. It is the least costly approach but
might have a minimal favorable impact on liquidity.
 Level ii DR Programs. Level II applies to firms that want to list existing shares on a U.S.
stock exchange. They must meet the full registration requirements of the SEC and the rules
of the specific exchange. This also means reconciling their financial accounts with those used under
U.S. GAAP, raising the cost considerably.
 Level iii DR Programs. Level III applies to the sale of a new equity issued in the United
States—raising equity capital. It requires full registration with the SEC and an elaborate stock
prospectus. This is the most expensive alternative, but is the most fruitful for foreign firms
wishing to raise capital in the world’s largest capital markets and possibly generate greater
returns for all shareholders.
Global Registered Shares
 A global registered share (GRS) is a share of equity that is traded across borders and markets
without conversion, where one share on the home exchange equals one share on the foreign
exchange.
 Traded “with the sun”—following markets as they open and close around the globe and
around the clock.
The shares are traded electronically.
Difference between GRS and GDR
 Example:
A German multinational has shares listed on the Frankfurt Stock Exchange, and those shares
are currently trading at €4.00 per share.
The current spot rate is $1.20/€, those same shares would be listed on the NYSE at $4.80 per share.
4.00 * $1.20 = $4.80
This would be a standard GRS. But $4.80 per share is an extremely low share price for the
NYSE and the U.S. equity market.
If, the German firm’s shares were listed in New York as ADRs, they would be converted to a value that was
strategically priced for the target market—the United States. Strategic pricing in the U.S. means having
share prices that are generally between $10 and $20 per share, a price range long-thought to maximize
buyer interest and liquidity.
The ADR would then be constructed so that each ADR represented four shares in the company on the
home market, or:
$4.80 * 4 = $19.20 per share
Does this distinction matter?
  The GRS is much more similar to ordinary shares than depositary receipts, and it allows easier
comparison and analysis.
 But if target pricing is important in key markets like that of the U.S., then the ADR offers better
opportunities for a foreign firm to gain greater presence and activity.
EJERCICIOS
DISCUSSION
• How many total MONOPLY were paid for the five U.S. dollars in Round 1? In Round 2? In Round 3?
what was the price of a U.S. dollar in terms of yen in each round?
• How wide were the price variations of yen per dollar in each round?
• Did the successive rounds establish a price pattern?
• What determined the exchange rate of MONOPOLY and dollars?
• How does the pattern of exchange rates illustrate the interaction of supply and demand.
• In general, how is the foreign exchange value of a currency set in terms of other currencies?
• What factors might cause the exchange rate between two countries to change?
QUESTION;
1. What are the three functions of money?
2. What determines the value of any currency?
3. What do we call a decrease in value of a currency? An increase?
4. What do we call the places or means of communication by which currencies are traded and the
value of one country’s currency is established in terms of other currencies?
5. Assume the United States produces new products that citizens of other countries buy in large
quantities. All other things being equal, what will happen to the value of the U.S. dollar in terms of
foreign currencies?
6. Assume the number of U.S. citizens traveling to foreign countries greatly increases. All other things
being equal, what will happen to the value of the U.S. dollar in terms of foreign currencies?
Essay Question
Imagine a situation in which there is an increase of thousands of U.S. citizens (tourists, business
representatives, and government officials) who choose to visit MONOPOLY LAND. All of these visitors,
arriving in the Monopoly City airport, buy thousands of Monopoly´s to use during their stay in MONOPOLY
LAND. Assuming that no other changes are taking place with the MONOPOLY, explain what effect these
visitors’ actions will have on the supply of and demand for the U.S. dollar in the U.S.-MONOPOLY LAND
foreign exchange market, on the supply of and demand for the MONOPOLY, and on the price of each
currency.
Triangular arbitrage by a Market Trader
• Assume the Following information:
• Value of Australian dollars in US Dollars $.90
• Value of Jamaican Dollars in US Dollars $.30
• Value of Australian Dolar in Jamaican Dollar JC$ 3.02
What should the correct cross currency rate be between the Australian dollar and the Jamaican dollar?
(How many Jamaican Dollars should it take to buy one Australian dollar?)
 1. Given this information, is triangular arbitrage possible? If so, explain the steps that would reflect
triangular arbitrage, and compute the profit from the arbitrage if you had US$1,000,000.
2. Assume the value of Australian dollars in Jamaican dollars given above was JC$ 2.90. Do you thing
Triangular arbitrage is possible? Will you do anything different this time??
Covered Interest Arbitrage
• Assume the Following information:
• Spot Rate Nuevo Sol $.10
• 180 day Forward Rate of Nuevo Sol $.098
• 180 day Peruvian Interest Rate 12%
• 180 day US Interest Rate 10%
• What is the current forward premium on the Nuevo sol?
1. Given the information, is covered interest arbitrage worthwhile for Peruvian investors assuming the
have 1,000,000 soles to invest? Explain you answer
2. Given the information, is covered interest arbitrage worthwhile for US investors assuming the have
1,000,000 dollars to invest? Explain you answer.
.
CLASS EXERCICES -16-11-19
1. Corcovado Pharmaceuticals.
Corcovado Pharmaceutical’s cost of debt is 7%. The risk-free rate of interest is 3%. The expected return on
the market portfolio is 8%. After effective taxes, Corcovado’s effective tax rate is 25%. Its optimal capital
structure is 60% debt and 40% equity.

a) If Corcovado’s beta is estimated at 1.1, what is its weighted average cost of capital?

b) b. If Corcovado’s beta is estimated at 0.8, significantly lower because of the continuing profit
prospects in the global energy sector, what is its weighted average cost of capital?
2. Trident’s Cost of Capital.

Maria Gonzalez now estimates the risk-free rate to be 3.60%, the company’s credit risk premium is 4.40%,
the domestic beta is estimated at 1.05, and the company’s capital structure is now 30% debt. The expected
rate of return of the market portfolio is assumed to be 9%. Trident’s cost of debt the before tax cost of debt
estimated by observing the current yield on Trident’s outstanding bonds combined with bank debt, is 8%.
Using 35% as the corporate income tax rate for the United States.
Calculate the following:
c) Trident’s cost of equity
d) Trident’s cost of debt
e) Trident’s weighted average cost of capital
3. Kashmiri’s Cost of Capital.
Kashmiri is the largest and most successful specialty goods company based in Bangalore, India. It has not
yet entered the North American marketplace, but is considering establishing both manufacturing and
distribution facilities in the United States through a wholly owned subsidiary. It has approached two different
investment banking advisors, Goldman Sachs and Bank of New York, for estimates of what its costs of
capital would be several years into the future when it planned to list its American subsidiary on a U.S. stock
exchange. Using the following assumptions by the two different advisors, calculate the prospective costs of
debt, equity, and the WACC for Kashmiri (U.S.):
4. Cargill’s Cost of Capital.
Cargill is generally considered to be the largest privately held company in the world. Headquartered in
Minneapolis, Minnesota, the company has been averaging sales of over $113 billion per year over the past
five-year period. Although the company does not have publicly traded shares, it is still extremely important
for it to calculate its weighted average cost of capital properly in order to make rational decisions on new
investment proposals. Assuming a risk-free rate of 4.50%, an effective tax rate of 48%, and a market risk
premium of 5.50%, estimate the
weighted average cost of capital first for companies A and B.

ICAPM 30-11-19
1. URP CORP ICAPM
URP CORP has globalized its own business activities, and has operations in 3 different countries
(London, New York, Brazil), having several investments in the United States. Also the investor base
that owns URP CORP shares has also globally diversified. URP CORP shares are now listed
London, Sao Paulo and New York, in addition to their home listing on the Mila Exchange. The year
that started 1.1.2019 is closing in a few days on 31.12.2019. Using the ICAPM, URP CORP beta,
when calculated against a larger global equity market index, which includes these foreign markets
and their investors, is a lower 0.90. The expected world market return for a larger globally integrated
equity market is 8.00% and the Risk free rate is 4.00%. Using the following information calculate
URP CORP ICAPM

London New York Brazil

S0 = Sol 4.30/ GBP S0 = Sol 3.37/ USD S0 = Sol 0.87/ BRL
S1 = Sol 4.40/GBP S1 = Sol 3.40/USD S1 = Sol 0.80/BRL
F = Sol 4.35/ GBP F = Sol 3.35/USD F = Sol 0.83/BRL
Gamma´S For Income
ΓLondon = 0.74
ΓNewYork = 0.81
ΓBrazil = 0.59

2. ANG CORP ICAPM

ANG CORP, CFO Juan Perez Quispe, has expander even more its business activities, and now has
operations in 5 different countries (Paris, Berlin, Bogota, Tokyo, India), having several investments
 in the France and Locally. The year that started 1.1.2025 is closing in a few days on 31.12.2025.
Using the ICAPM, ANG CORP beta, 0.85. The expected world market return for a larger globally
integrated equity market is 9.00% and the Risk free rate is 5.50%. Using the following information
calculate ANG CORP International Capital Asset Pricing Model.

Paris Berlin Bogota

S0 = Sol 3.89/ EUR S0 = Sol 3.89/ EUR S0 = Sol 0.0010/ COP
S1 = Sol 3.75/EUR S1 = Sol 3.75/EUR S1 = Sol 0.00097/COP
F = Sol 3.80/EUR F = Sol 3.80/EUR F = Sol 0.00093/ COP

Tokyo New Delhi

S0 = Sol 0.031/ JPY S0 = Sol 0.048/ INR
S1 = Sol 0.032/ JPY S1 = Sol 0.047/INR
F = Sol 0.030/ JPY F = Sol 0.0475/ INR

Gamma´S For Income

ΓParis = 0.54
ΓBerlin = 0.90
ΓBogota = 0.09
ΓTokyo = 0.70
ΓN.Delhi = 0.28

3. URP Corp Perú borrowed EUR 2,500,000 for one year at a 4% interest. During the year the EURO
appreciates from an initial EUR 0.39/SOL to EUR 0.27/ SOL .
a. What is the Sol cost of debt?
b. After one year URP Corp must pay how much? In Soles?
c. What is the total cost of borrowing?
d. What is the after tax cost EURO debt, when Peru´s income tax rate is 29%.