Corporate Finance - International Financial Management

What are the three main functions of the Foreign Exchange Market?

1. Converts currencies (buying & selling) 2. Sets and quotes exchange rates 3. Offers hedging contracts to manage FX exposure

Why do investors, creditors, and borrowers each engage in international financial markets?

Investors: favourable economic conditions abroad

Creditors: higher foreign interest rates

Borrowers: lower foreign interest rates

Define a direct quote and give an example (US perspective).

Home currency per one unit of foreign currency.

Example: $1.30 per £1 (USD is home, GBP is foreign)

Define an indirect quote and give an example (US perspective).

Foreign currency per one unit of home currency.

Example: 153 JPY per $1 | Indirect = 1 ÷ Direct

In ISO notation, what are the BASE and QUOTE currencies? Use EURUSD = 1.16 as an example.

First currency = BASE (EUR), Second currency = QUOTE (USD). EURUSD = 1.16 means 1 EUR = 1.16 USD

What is the bid/ask spread formula?

Spread = (Ask rate − Bid rate) ÷ Ask rate.

Measures the dealer's profit/risk premium.

Greater risk → wider spread.

Memory rule: does the bank use bid or ask when buying the base currency?

Bank Buys Bid at Base. Bank BUYS base at BID (lower price). Bank SELLS base at ASK (higher price).

Client always gets the worse rate.

EURGBP is quoted 0.8482 – 0.8623. You have £1,000 and want euros. How many euros do you get?

EUR is base. You are BUYING euros → bank SELLS euros → use ASK (0.8623). £1,000 ÷ 0.8623 = €1,159.69

You have €1,159.69 and want to convert back to pounds at EURGBP 0.8482–0.8623. How much do you receive?

You are SELLING euros → bank BUYS euros → use BID (0.8482). €1,159.69 × 0.8482 = £983.65. Bank profit = £16.35 (spread = 1.6%)

Define appreciation and depreciation of a currency.

Appreciation (strengthening): spot rate increases in value relative to another currency.

Depreciation (weakening): spot rate decreases in value relative to another currency.

Name five factors that influence exchange rates.

1. Inflation rate 2. Interest rate 3. Income level 4. Government controls 5. Expectations (market sentiment)

What are the three types of FX exposure for a company (e.g. Toyota)?

Transaction risk: revenue/costs in different currencies

Translation risk: consolidating foreign subsidiaries

Economic risk: long-term impact on competitiveness

State the IRP formula for the forward rate (using direct quotes: home currency per foreign).

F = S × (1 + r_home) / (1 + r_foreign). F = forward rate, S = spot rate (home per foreign), r = interest rate for the period

What is the IRP premium formula?

Premium = S × [(1 + r_home)/(1 + r_foreign) − 1]. Positive premium → forward is at a premium to spot (home currency weakens forward)

Spot £0.625 = $1, UK rate = 4%, US rate = 2%. What is the 90-day forward rate (£ per $)?

F = 0.625 × (1.04/1.02) = £0.6373 per $. Both investment routes must give the same £ return to prevent riskless arbitrage.

Spot $1.30/£, r$ = 4%, r£ = 7%. Calculate the forward rates for years 1–4.

F1 = 1.30 × (1.04/1.07)^1 = $1.2636/£ | F2 = 1.30 × (1.04/1.07)^2 = $1.2281/£ | F3 = 1.30 × (1.04/1.07)^3 = $1.1937/£ | F4 = 1.30 × (1.04/1.07)^4 = $1.1602/£

What economic logic underpins Interest Rate Parity (IRP)?

The forward rate must offset the interest rate differential so no riskless arbitrage profit exists from investing in either currency.

What does Purchasing Power Parity (PPP) theory state? (No calculation required)

Exchange rates adjust to offset inflation differentials, so real purchasing power is equalised across countries. S(t+1) = S(t) × (1 + I_home)/(1 + I_foreign)

What is the difference between absolute PPP and relative PPP?

Absolute PPP: identical goods cost the same across countries in a common currency (law of one price) — rarely holds in practice. Relative PPP: price differences stay constant over time, accounting for transport costs, tariffs and quotas.

Under PPP, if home inflation > foreign inflation, what happens to the foreign currency?

The foreign currency APPRECIATES (e_f > 0), offsetting the home country's higher inflation. e_f ≈ I_home − I_foreign

What are the two methods for computing the NPV of a foreign project?

Method 1: Convert FCFs to domestic currency using IRP forward rates, then discount at domestic WACC. Method 2: Discount FCFs in foreign currency using the foreign WACC, then convert the NPV at the spot rate. Both give the same answer.

How do you convert foreign pound FCFs to dollar FCFs?

Dollar FCF = Pound FCF × Forward rate ($/£). Use the IRP forward rate for each year: F_n = S × [(1 + r$)/(1 + r£)]^n

Ityesi: pound FCFs are £11.25m per year (years 1–4), initial outflow £17.5m. Forward rates: $1.2636, $1.2281, $1.1937, $1.1602 per £. What are the dollar FCFs?

Year 0: £(17.5) × 1.300 = $(22.75)m | Year 1: £11.25 × 1.2636 = $14.215m | Year 2: £11.25 × 1.2281 = $13.816m | Year 3: £11.25 × 1.1937 = $13.429m | Year 4: £11.25 × 1.1602 = $13.052m

Ityesi WACC: D/E = 50%, cost of equity = 10%, cost of debt = 6%, tax = 25%. Calculate WACC.

WACC = 0.5 × 10% + 0.5 × 6% × (1 − 0.25) = 5% + 2.25% = 7.25%

State the formula for the foreign-denominated cost of capital.

r_foreign = [(1 + r_foreign) / (1 + r_domestic)] × (1 + r_domestic) − 1. Converts the domestic WACC into a foreign-currency WACC using IRP logic.

Ityesi: domestic WACC = 7.25%, r£ = 7%, r$ = 4%. What is the pound WACC?

r*£ = (1.07/1.04) × 1.0725 − 1 = 0.1034 = 10.34%

Using the pound WACC of 10.34%, calculate the PV of Ityesi's pound FCFs (£11.25m p.a. for 4 years) and the final dollar NPV.

PV = 11.25/1.1034 + 11.25/1.1034^2 + 11.25/1.1034^3 + 11.25/1.1034^4 = £35.40m. NPV£ = £35.40 − £17.50 = £17.90m. NPV$ = £17.90 × 1.30 = $23.27m

When is the forward-rate conversion method insufficient for a foreign project?

When the project's FCFs are correlated with exchange rates — e.g. when inputs are priced in a different currency (dollar-denominated costs in a UK project). The basic method assumes FCFs are uncorrelated with spot rates.

How do you handle FCFs that depend on multiple currencies?

Separate cash flows by currency: 1. Convert pound-only FCFs using forward rates as normal. 2. Keep dollar-denominated costs in dollars. 3. Deduct dollar costs net of tax shield from the dollar FCF total.

Name two hedging strategies a multinational (e.g. Toyota) uses to manage FX risk.

Financial hedging: forward contracts & currency options (hedges 6–12 months of forecasted FCFs). Natural/operational hedging: producing locally to match revenues and costs in the same currency (~70% of Toyota's non-Japanese sales produced locally).