Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
VIII. Risk Management 28. Managing International
Risks
© The McGraw−Hill
Companies, 2003
CHAPTER TWENTY-EIGHT
786
MANAGING
INTERNATIONAL
RI SK S
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
VIII. Risk Management 28. Managing International
Risks
© The McGraw−Hill
Companies, 2003
IN THE LAST chapter we considered the risks that flow from changes in interest rates and commodity prices.
But companies with substantial overseas interests encounter a variety of other hazards, including political
risks and currency fluctuations. Political risk means the possibility that a hostile foreign government will
expropriate your business without compensation or not allow profits to be taken out of the country.
To understand currency risk, you first need to understand how the foreign exchange market works
and how prices for foreign currency are determined. We therefore start this chapter with some basic
institutional detail about the foreign exchange market and we will look at some simple theories that
link exchange rates, interest rates, and inflation. We will use these theories to show how firms assess
and hedge their foreign currency exposure.
When we discussed investment decisions in Chapter 6, we showed that financial managers do not
need to forecast exchange rates in order to evaluate overseas investment proposals. They can simply
forecast the foreign currency cash flows and discount these flows at the foreign currency cost of capital.

3
£.6905/$
1/1.4483 ϭ £.6905£1$ˇ 1.4483/£
£1
¥120.700/$
1
The results of the triennial survey of foreign exchange business are published on www.bis.org/publ.
2
The euro is the common currency of the European Monetary Union. The 12 members of the Union are
Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portu-
gal, and Spain.
3
Foreign exchange dealers usually refer to the exchange rate between pounds and dollars as cable. In
Table 28.1 cable is 1.4483.
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
VIII. Risk Management 28. Managing International
Risks
© The McGraw−Hill
Companies, 2003
The exchange rates in the first column of Table 28.1 are the prices of currency for
immediate delivery. These are known as spot rates of exchange. The spot rate for
the yen is , and the spot rate for the pound is .
In addition to the spot exchange market, there is a forward market. In the forward
market you buy and sell currency for future delivery. If you know that you are going
to pay out or receive foreign currency at some future date, you can insure yourself
against loss by buying or selling forward. Thus, if you need one million yen in three
months, you can enter into a three-month forward contract. The forward rate on this
contract is the price you agree to pay in three months when the one million yen are

Americas:
Canada (dollar) 1.5397 1.5403 1.5415 1.545
Mexico (peso) 9.1390 9.1865 9.307 9.924
Pacific/Africa:
Hong Kong (dollar) 7.7999 7.7987 7.7962 7.7954
Japan (yen) 120.700 120.36 119.66 116.535
Singapore (dollar) 1.7542 1.7525 1.7491 1.7322
South Africa (rand) 8.3693 8.4102 8.4963 8.8278
Thailand (baht) 44.3450 44.39 44.555 45.295
TABLE 28.1
Spot and forward
exchange rates, August
28, 2001.
*Rates show the number of
units of foreign currency per
U.S. dollar, except for the
euro and the UK pound,
which show the number of
U.S. dollars per unit of
foreign currency.
Source: Financial Times,
August 29, 2001.
4
Here is an occasional point of confusion. Since the quote for the yen is indirect, we calculate the pre-
mium by taking the ratio of the spot rate to the forward rate. If we use direct quotes, then we need to
calculate the ratio of the forward rate to the spot rate. In the case of the yen, the forward premium with
direct quotes is , or 3.5 percent.
5
Forward and spot trades are often undertaken together. For example, a company might need the use
of Japanese yen for one month. In this case it would buy the yen spot and simultaneously sell them for-

rate ?
• Problem 3. What determines next year’s expected spot rate of exchange
between dollars and yen ?
• Problem 4. What is the relationship between the inflation rate in the United
States and the inflation rate in Japan ?
Suppose that individuals were not worried about risk and that there were no bar-
riers or costs to international trade. In that case the spot exchange rates, forward
exchange rates, interest rates, and inflation rates would stand in the following sim-
ple relationship to one another:
1i
¥
21i
$
2
3E1r
¥/$
24
1s
¥/$
2
1f
¥ ˇˇˇ/$
2
1r
¥
21r
$
2
Difference in
interest rates

=
Expected change
in spot rate
E
(
s
Y/$
)
s
Y/$
=
=
Why should this be so?
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
VIII. Risk Management 28. Managing International
Risks
© The McGraw−Hill
Companies, 2003
Interest Rates and Exchange Rates
It is August 2001 and you have $1 million to invest for one year. U.S. dollar deposits
are offering an interest rate of about 3.65 percent; Japanese yen deposits are offer-
ing a meager .06 percent. Where should you put your money? Does the answer
sound obvious? Let’s check:
• Dollar loan. The rate of interest on one-year dollar deposits is 3.65 percent.
Therefore at the end of the year you get .
• Yen loan. The current exchange rate is . For $1 million, you can buy
. The rate of interest on a one-year yen
deposit is .06 percent. Therefore at the end of the year you get

¥ˇ120.700/$
1,000,000 ϫ 1.0365 ϭ $
ˇ 1,036,500
790 PART VIII
Risk Management
7
The minor difference in our calculated end-of-year payoffs was mostly due to rounding in the in-
terest rates.
Difference in
interest rates
1 +
r
Y
1 +
r
$
equals
=
Difference between
forward and spot rates
f
Y/$
s
Y/$
=
=
In our example,
The Forward Premium and Changes in Spot Rates
Now let’s consider how the forward premium is related to changes in spot rates of
exchange. If people didn’t care about risk, the forward rate of exchange would de-

Y/$
equals
=
=
Expected change
in spot rate
E(
s
Y/$
)
s
Y/$
=
=
Of course, this assumes that traders don’t care about risk. If they do care, the for-
ward rate can be either higher or lower than the expected spot rate. For example,
suppose that you have contracted to receive one million yen in three months, You
can wait until you receive the money before you change it into dollars, but this
leaves you open to the risk that the price of yen may fall over the next three months.
Your alternative is to sell yen forward. In this case, you are fixing today the price
at which you will sell your yen. Since you avoid risk by selling forward, you may
be willing to do so even if the forward price of yen is a little lower than the expected
spot price.
Other companies may be in the opposite position. They may have contracted to
pay out yen in three months. They can wait until the end of the three months and
then buy yen, but this leaves them open to the risk that the price of yen may rise.
It is safer for these companies to fix the price today by buying yen forward. These
companies may, therefore, be willing to buy forward even if the forward price of
yen is a little higher than the expected spot price.
Thus some companies find it safer to sell yen forward, while others find it safer

commodity, but the same forces should act to equalize the domestic and foreign
prices of other goods. Those goods that can be bought more cheaply abroad will be
imported, and that will force down the price of domestic products. Similarly, those
goods that can be bought more cheaply in the United States will be exported, and
that will force down the price of the foreign products.
This is often called purchasing power parity.
8
Just as the price of goods in Safeway
must be roughly the same as the price of goods in A&P, so the price of goods in
Japan when converted into dollars must be roughly the same as the price in the
United States:
Purchasing power parity implies that any differences in the rates of inflation will be
offset by a change in the exchange rate. For example, if prices are rising by 2.6 per-
cent in the United States while they are declining by percent in Japan, the num-
ber of yen that you can buy for $1 must fall by , or about 3.5 percent.
Therefore purchasing power parity says that to estimate changes in the spot rate of
exchange, you need to estimate differences in inflation rates:
9
.99/1.026 Ϫ 1
Ϫ1.0
Dollar price of goods in the USA ϭ
yen price of goods in Japan
number of yen per dollar
792 PART VIII Risk Management
8
Economists use the term purchasing power parity to refer to the notion that the level of prices of goods
in general must be the same in the two countries. They tend to use the phrase law of one price when they
are talking about the price of a single good.
9
In other words, the expected difference in inflation rates equals the expected change in the exchange rate.

=
=
In our example,
Current spot rate ϫ expected difference in inflation rates ϭ expected spot rate
120.700 ϫ .99/1.026 ϭ 116.5
Interest Rates and Inflation Rates
Now for the fourth leg! Just as water always flows downhill, so capital tends to
flow where returns are greatest. But investors are not interested in nominal returns;
they care about what their money will buy. So, if investors notice that real interest
rates are higher in Japan than in the United States, they will shift their savings into
Japan until the expected real returns are the same in the two countries. If the ex-
pected real interest rates are equal, then the difference in money rates must be
equal to the difference in the expected inflation rates:
10
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
VIII. Risk Management 28. Managing International
Risks
© The McGraw−Hill
Companies, 2003
In Japan the real one-year interest rate is just over 1 percent:
Ditto for the United States:
Is Life Really That Simple?
We have described above four theories that link interest rates, forward rates, spot
exchange rates, and inflation rates. Of course, such simple economic theories are
not going to provide an exact description of reality. We need to know how well they
predict actual behavior. Let’s check.
1. Interest Rate Parity Theory Interest rate parity theory says that the yen rate of
interest covered for exchange risk should be the same as the dollar rate. In the ex-

1.026
Ϫ 1 ϭ .0102
r
¥
1real2ϭ
1 ϩ r
¥
E11 ϩ i
¥
2
Ϫ 1 ϭ
1.0006
.99
Ϫ 1 ϭ .0107
CHAPTER 28 Managing International Risks 793
Difference in
interest rates
1 +
r
Y
1 +
r
$
equals
=
Expected difference
in inflation rates
E
(1 +
i

ket to protect against exchange rate movements does not pay any extra for this
insurance.
3. Purchasing Power Parity Theory What about the third side of our quadrilat-
eral—purchasing power parity theory? No one who has compared prices in for-
eign stores with prices at home really believes that prices are the same throughout
the world. Look, for example, at Table 28.2, which shows the price of a Big Mac in
different countries. Notice that at current rates of exchange a Big Mac costs $3.65 in
Switzerland but only $2.54 in the United States. To equalize prices in Switzerland
and the United States, the number of Swiss francs that you could buy for your dol-
lar would need to increase by , or 44 percent.
This suggests a possible way to make a quick buck. Why don’t you buy a
hamburger-to-go in (say) the Philippines for the equivalent of $1.17 and take it
for resale in Switzerland, where the price in dollars is $3.65? The answer, of
course, is that the gain would not cover the costs. The same good can be sold for
3.65/2.54 Ϫ 1 ϭ .44
794 PART VIII
Risk Management
13
For evidence that forward exchange rates contain risk premia that are sometimes positive and some-
times negative, see, for example, E. F. Fama, “Forward and Spot Exchange Rates,” Journal of Monetary
Economics 14 (1984), pp. 319–338.
Nov. 83
Nov. 84
Nov. 85
Nov. 86
Nov. 87
Nov. 88
Nov. 89
Nov. 90
Nov. 91

Companies, 2003
different prices in different countries because transportation is costly and in-
convenient.
14
On the other hand, there is clearly some relationship between inflation and
changes in exchange rates. For example, between 1994 and 1999 prices in Turkey
rose about 20 times. Or, to put it another way, you could say that the purchasing
power of money in Turkey declined by about 95 percent. If exchange rates had not
adjusted, Turkish exporters would have found it impossible to sell their goods. But,
of course, exchange rates did adjust. In fact, the value of the Turkish currency de-
clined by 92 percent relative to the U.S. dollar.
Turkey is an extreme case, but in Figure 28.2 we have plotted the relative change in
purchasing power for a sample of countries against the change in the exchange rate.
Turkey is tucked in the bottom left-hand corner; the United States is closer to the top
right. You can see that although the relationship is far from exact, large differences in
inflation rates are generally accompanied by an offsetting change in the exchange rate.
Strictly speaking, purchasing power parity theory implies that the differential
inflation rate is always identical to the change in the spot rate. But we don’t need
to go as far as that. We should be content if the expected difference in the inflation
rates equals the expected change in the spot rate. That’s all we wrote on the third
side of our quadrilateral. Look, for example, at Figure 28.3. The solid line shows
that in 2000 sterling bought almost 70 percent fewer dollars than it did at the be-
ginning of the century. But this decline in the price of sterling was largely matched
by the higher inflation rate in the United Kingdom. The thin line shows that the
inflation-adjusted, or real, exchange rate ended the century at roughly the same
level as it began.
15
Of course, the real exchange rate does change, sometimes dra-
matically. For example, the real value of sterling almost halved between 1980 and
1985 before recovering in the next five years. However, if you were a financial man-

£
2/11 ϩ i
$
2ϭ 1.40 ϫ 1.1 ϭ $ˇ 1.54/£
$ˇ 1.40 ϭ £1$ˇ 1.54 ϭ £1
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
VIII. Risk Management 28. Managing International
Risks
© The McGraw−Hill
Companies, 2003
796 PART VIII Risk Management
–100
–100
–20
60
80
–40
40
20
–60
–80
0
100
–50 0 50 100
Relative change in purchasing power, percent
Relative change in exchange
rate, percent
FIGURE 28.2

8
9
10
U.S. dollar/
British pound
(in log scale)
Nominal versus Real
Exchange Rates
Real exchange rate
Nominal exchange rate
FIGURE 28.3
Since 1900 sterling has fallen sharply in
value against the dollar. But this fall has
largely offset the higher inflation rate in
the UK. The real value of sterling has
been roughly constant.
Source: N. Abuaf and P. Jorion, “Purchasing
Power Parity in the Long Run,” Journal of
Finance 45 (March 1990), pp. 157–174. We
are grateful to Li Jin for extending the data.
Brealey−Meyers:
Principles of Corporate
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VIII. Risk Management 28. Managing International
Risks
© The McGraw−Hill
Companies, 2003
have done much better than to assume that changes in the value of the currency
would offset the difference in inflation rates.
4. Equal Real Interest Rates Finally we come to the relationship between interest

Average money market rate,
percent, 1995–1999
FIGURE 28.4
Countries with the highest interest rates generally have the highest inflation rates. In this diagram, each
of the 51 points represents the experience of a different country.
28.3 HEDGING CURRENCY RISK
Sharp exchange rate movements can make a large dent in corporate profits. To illus-
trate how companies cope with this problem, we will look at a typical company in the
United States, Outland Steel, and walk through its foreign exchange operations.
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
VIII. Risk Management 28. Managing International
Risks
© The McGraw−Hill
Companies, 2003
Example: Outland Steel Outland Steel has a small but profitable export business.
Contracts involve substantial delays in payment, but since the company has a pol-
icy of always invoicing in dollars, it is fully protected against changes in exchange
rates. Recently the export department has become unhappy with this practice and
believes that it is causing the company to lose valuable export orders to firms that
are willing to quote in the customer’s own currency.
You sympathize with these arguments, but you are worried about how the
firm should price long-term export contracts when payment is to be made in for-
eign currency. If the value of that currency declines before payment is made, the
company may suffer a large loss. You want to take the currency risk into ac-
count, but you also want to give the sales force as much freedom of action as
possible.
Notice that Outland can insure against its currency risk by selling the foreign
currency forward. This means that it can separate the problem of negotiating

theory suggests that protection against exchange risk is usually worth having.
Third, interest rate parity theory reminds us that you can hedge either by selling
forward or by borrowing foreign currency and selling spot. Fourth, the cost of for-
798 PART VIII
Risk Management
17
It also relieves shareholders of worrying about the foreign exchange exposure they may have acquired
by purchase of the firm’s shares.
18
Sometimes governments also attempt to prevent currency speculation by limiting the amount that
companies can sell forward.
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Principles of Corporate
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ward cover is not the difference between the forward rate and today’s spot rate; it
is the difference between the forward rate and the expected spot rate when the for-
ward contract matures.
Perhaps we should add a fifth implication. You don’t make money simply by buy-
ing currencies that go up in value and selling those that go down. For example, sup-
pose that you buy Narnian leos and sell them after a year for 2 percent more than you
paid for them. Should you give yourself a pat on the back? That depends on the inter-
est that you have earned on your leos. If the interest rate on leos is 2 percentage points
less than the interest rate on dollars, the profit on the currency is exactly canceled out
by the reduction in interest income. Thus you make money from currency speculation
only if you can predict whether the exchange rate will change by more or less than the
interest rate differential. In other words, you must be able to predict whether the ex-

however, benefited from their rivals’ discomfiture. Thus the German and British
car producers and their dealers were affected by exchange rate changes even
CHAPTER 28
Managing International Risks 799
19
To put it another way, the hedge ratio is 1.0.
20
Of course, if purchasing power parity always held, the fall in the value of the krona would be
matched by higher inflation in Sweden. The risk for Outland is that the real value of the krona may
decline, so that when measured in dollars Swedish costs are lower than previously. Unfortunately,
it is much easier to hedge against a change in the nominal exchange rate than against a change in the
real rate.
21
Financial managers also refer to translation exposure, which measures the effect of an exchange rate
change on the company’s financial statements.
Brealey−Meyers:
Principles of Corporate
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VIII. Risk Management 28. Managing International
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© The McGraw−Hill
Companies, 2003
though they may have had no fixed obligation to pay or receive dollars. They had
economic exposure as well as possible transaction exposure.
22
Most firms do not attempt to quantify economic exposure, but that does not
mean that they ignore it. For example, when a company makes a major overseas
investment, it often finances it by foreign currency borrowing. A subsequent fall in
the value of the foreign currency may reduce the dollar value of the investment,
but this is compensated by the fall in the dollar cost of servicing the foreign debt.

28.4 EXCHANGE RISK AND INTERNATIONAL
INVESTMENT DECISIONS
Suppose that the Swiss pharmaceutical company, Roche, is evaluating a proposal
to build a new plant in the United States. To calculate the project’s net present
value, Roche forecasts the following dollar cash flows from the project:
Cash Flows ($ millions)
C
0
C
1
C
2
C
3
C
4
C
5
Ϫ1,300 400 450 510 575 650
Brealey−Meyers:
Principles of Corporate
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VIII. Risk Management 28. Managing International
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© The McGraw−Hill
Companies, 2003
These cash flows are stated in dollars. So to calculate their net present value
Roche discounts them at the dollar cost of capital. (Remember dollars need to be
discounted at a dollar rate, not the Swiss franc rate.) Suppose this cost of capital
is 12 percent. Then

SFr/$ˇ
ϫ 11 ϩ r
SFr
2
2
/11 ϩ r
$ˇ
2
2
ϭ
2 ϫ 1.04
2
1.06
2
ϭ 1.925
s
SFr/$ˇ
ϫ 11 ϩ r
SFr
2/11 ϩ r
$ˇ
2ϭ
2 ϫ 1.04
1.06
ϭ 1.962
NPV in francs ϭ NPV in dollars ϫ SFr/$
ˇ ϭ 513 ϫ 2 ϭ 1,026 million francs
NPV ϭϪ1,300 ϩ
400
1.12

© The McGraw−Hill
Companies, 2003
These cash flows are in Swiss francs and therefore they need to be discounted at
the risk-adjusted Swiss franc discount rate. Since the Swiss rate of interest is lower
than the dollar rate, the risk-adjusted discount rate must also be correspondingly
lower. The formula for converting from the required dollar return to the required
Swiss franc return is
24
In our example
Thus the risk-adjusted discount rate in dollars is 12 percent, but the discount rate
in Swiss francs is only 9.9 percent.
All that remains is to discount the Swiss franc cash flows at the 9.9 percent risk-
adjusted discount rate:
Everything checks. We obtain exactly the same net present value by (a) ignoring cur-
rency risk and discounting Roche’s dollar cash flows at the dollar cost of capital and
(b) calculating the cash flows in francs on the assumption that Roche hedges the cur-
rency risk and then discounting these Swiss franc cash flows at the franc cost of capital.
To repeat: When deciding whether to invest overseas, separate out the invest-
ment decision from the decision to take on currency risk. This means that your
views about future exchange rates should NOT enter into the investment decision.
The simplest way to calculate the NPV of an overseas investment is to forecast the
cash flows in the foreign currency and discount them at the foreign currency cost
of capital. The alternative is to calculate the cash flows that you would receive if
you hedged the foreign currency risk. In this case you need to translate the foreign
currency cash flows into your own currency using the forward exchange rate and then
discount these domestic currency cash flows at the domestic cost of capital. If the
two methods don’t give the same answer, you have made a mistake.
When Roche analyzes the proposal to build a plant in the United States, it is able
to ignore the outlook for the dollar only because it is free to hedge the currency risk. Be-
ϭ 1,026 million francs

0
C
1
C
2
C
3
C
4
C
5
Ϫ1,300 ϫ 2 400 ϫ 1.962 450 ϫ 1.925 510 ϫ 1.889 575 ϫ 1.853 650 ϫ 1.818
ϭ Ϫ2,600 ϭ 785 ϭ 866 ϭ 963 ϭ 1,066 ϭ 1,182
24
The following example should give you a feel for the idea behind this formula. Suppose the spot rate
for Swiss francs is . Interest rate parity tells us that the forward rate must be
SFr/$. Now suppose that a share costs $100 and will pay an expected $112 at
the end of the year. The cost to Swiss investors of buying the share is SFr. If the Swiss in-
vestors sell forward the expected payoff, they will receive an expected SFr. The
expected return in Swiss francs is or 9.9 percent. More simply, the Swiss franc re-
turn is .1.12 ϫ 1.04/1.06 Ϫ 1 ϭ .099
219.8/200 Ϫ 1 ϭ .099
112 ϫ 1.9623 ϭ 219.8
100 ϫ 2 ϭ 200
2 ϫ 1.04/1.06 ϭ 1.9623
2 SFr ϭ $ˇ 1
Brealey−Meyers:
Principles of Corporate
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VIII. Risk Management 28. Managing International

1.06
1.04
ϭ 1.12
11 ϩ dollar return2ϭ 11 ϩ Swiss franc return2ϫ
11 ϩ dollar interest rate2
11 ϩ Swiss franc interest rate2
ϭ 4 ϩ 1.7 ϫ 8.42ϭ 9.9%
Required return ϭ Swiss interest rate ϩ 1beta ϫ Swiss market risk premium2
CHAPTER 28
Managing International Risks 803
25
We pointed out in Chapter 9 that when we use the beta relative to the U.S. index to estimate the re-
turns required by U.S. investors, we are assuming that the U.S. market index is an efficient portfolio for
these investors. Similarly, when we use the beta relative to the Swiss index to estimate the returns that
Swiss investors require, we are assuming that the Swiss market index is an efficient portfolio for these
investors. Investors do invest largely, but not exclusively, in their home markets.
28.5 POLITICAL RISK
So far we have focused on the management of exchange rate risk, but managers
also worry about political risk. By this they mean the threat that a government will
change the rules of the game—that is, break a promise or understanding—after the
Brealey−Meyers:
Principles of Corporate
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VIII. Risk Management 28. Managing International
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© The McGraw−Hill
Companies, 2003
investment is made. Of course political risks are not confined to overseas invest-
ments. Businesses in every country are exposed to the risk of unanticipated actions
by governments or the courts. But in some parts of the world foreign companies

France 10 7 9 10 11 3 5 6 5 5 5 4 80
Japan 10 6 6 12 10 2 6 5 6 6 5 4 78
Brazil 9 4 5 9 11 3 4 6 2 4 4 2 63
China 11 4 6 10 9 2 2 5 5 4 1 2 61
India 5 5 5 8 5 3 5 2 4 2 5 3 52
Russia 7 2 3 8 10 1 4 5 3 3 2 1 49
Indonesia 10 3 5 4 9 1 1 2 2 2 2 3 44
Iraq 8 3 4 3 4 1 0 5 2 2 0 0 32
TABLE 28.3
Political risk scores for a sample of countries, 1999.
Key:
A Government stability G Military in politics
B Socioeconomic conditions H Religious tensions
C Investment profile I Law and order
D Internal conflict J Ethnic tensions
E External conflict K Democratic accountability
F Corruption L Bureaucracy quality
Source: PRS Group (www.prsgroup.com
).
Brealey−Meyers:
Principles of Corporate
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VIII. Risk Management 28. Managing International
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improve your bargaining position with foreign governments. For example, Ford
has integrated its overseas operations so that the manufacture of components, sub-
assemblies, and complete automobiles is spread across plants in a number of coun-
tries. None of these plants would have much value on its own, and Ford can switch

velopment Agency. In other words, the development agency borrows in interna-
tional capital markets and relends to the San Tomé mine. Your firm agrees to stand
behind the loan as long as the government keeps its promises. If it does keep them,
the loan is your liability. If not, the loan is its liability.
Political risk is not confined to the risk of expropriation. Multinational compa-
nies are always exposed to the criticism that they siphon funds out of countries in
which they do business, and, therefore, governments are tempted to limit their
freedom to repatriate profits. This is most likely to happen when there is consider-
able uncertainty about the rate of exchange, which is usually when you would
most like to get your money out. Here again a little forethought can help. For ex-
ample, there are often more onerous restrictions on the payment of dividends to
the parent than on the payment of interest or principal on debt. Royalty payments
and management fees are less sensitive than dividends, particularly if they are
levied equally on all foreign operations. A company can also, within limits, alter
the price of goods that are bought or sold within the group, and it can require more
or less prompt payment for such goods.
CHAPTER 28
Managing International Risks 805
27
The early history of the San Tomé mine is described in Joseph Conrad’s Nostromo.
28
In Section 25.7 we described how the World Bank provided the Hubco power project with a guaran-
tee against political risk.
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VIII. Risk Management 28. Managing International
Risks
© The McGraw−Hill
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the NPV of an overseas project. The first is to forecast the foreign currency cash flows
and to discount them at the foreign currency cost of capital. The second is to trans-
late the foreign currency cash flows into domestic currency assuming that they are
hedged against exchange rate risk. These domestic currency flows can then be dis-
counted at the domestic cost of capital. The answers should be identical.
In addition to currency risk, overseas operations may be exposed to extra polit-
ical risk. However, firms may be able to structure the financing to reduce the
chances that government will change the rules of the game.
FURTHER
READING
There are a number of useful textbooks in international finance. Here is a small selection:
D. K. Eiteman and A. I. Stonehill: Multinational Business Finance, 8th ed., Addison-Wesley
Publishing Company, Inc., Reading, MA, 1998.
J. O. Grabbe, International Financial Markets, 3rd ed., Prentice-Hall, Inc., Englewood Cliffs,
NJ, 1995.
P. Sercu and R. Uppal: International Financial Markets and the Firm, South-Western College
Publishing, Cincinnati, OH, 1995.
SUMMARY
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Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
VIII. Risk Management 28. Managing International
Risks
© The McGraw−Hill
Companies, 2003
CHAPTER 28 Managing International Risks 807
A. C. Shapiro: Multinational Financial Management, 6th ed., John Wiley & Sons, New York, 1999.
Here are some general discussions of international investment decisions and associated exchange risks:
G. W. Brown: “Managing Foreign Exchange Risk with Derivatives,” Journal of Financial Eco-

1. Look at Table 28.1.
a. How many Mexican pesos do you get for your dollar?
b. What is the one-month forward rate for the peso?
c. Is the dollar at a forward discount or premium on the peso?
d. Use the one-year forward rate to calculate the annual percentage discount or
premium on the peso.
e. If the one-year interest rate on dollars is 3.7 percent annually compounded, what
do you think is the one-year interest rate on pesos?
f. According to the expectations theory, what is the expected spot rate for the peso in
three months’ time?
g. According to the law of one price, what then is the expected difference in the rate
of price inflation in the United States and Mexico?
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Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
VIII. Risk Management 28. Managing International
Risks
© The McGraw−Hill
Companies, 2003
808 PART VIII Risk Management
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2. Define each of the following theories in a sentence or simple equation:
a. Interest rate parity theory.
b. Expectations theory of forward rates.
c. Purchasing power parity.
d. International capital market equilibrium (relationship of real and nominal interest
rates in different countries).
3. In March 1997 the exchange rate for the Indonesian rupiah was . Inflation
in the year to March 1998 was about 30 percent in Indonesia and 2 percent in the United

7. A firm in the United States is due to receive payment of a1 million in eight years’ time.
It would like to protect itself against a decline in the value of the euro, but finds it dif-
ficult to get forward cover for such a long period. Is there any other way in which it can
protect itself?
8. In August 2001 short-term interest rates were about 3.65 percent in the United States
and .06 percent in Japan. The spot exchange rate was . Suppose that one year
later interest rates are 3 percent in both countries, while the value of the yen has ap-
preciated to .
a. Benjamin Pinkerton from New York invested in a U.S. two-year zero-coupon bond
in August 2001 and sold it in August 2002. What was his return?
b. Madame Butterfly from Osaka also invested in the two-year U.S. zero-coupon
bond in August 2001 and sold it in August 2002. What was her return in yen?
c. Suppose that Ms. Butterfly had correctly forecasted the price at which she sold her
bond and that she hedged her investment against currency risk. How could she
have done so? What would have been her return in yen?
¥
ˇ115.00/$
¥
ˇˇ120.70/$
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
VIII. Risk Management 28. Managing International
Risks
© The McGraw−Hill
Companies, 2003
CHAPTER 28 Managing International Risks 809
9. It is the year 2006 and Pork Barrels Inc. is considering construction of a new barrel plant
in Spain. The forecasted cash flows in millions of euros are as follows:
C

Canadian dollars could you buy for each U.S. dollar?
d. If forward rates simply reflect market expectations, what is the likely spot
exchange rate for the New Zealand dollar in 90 days’ time?
e. Look at the table of money rates in the same issue. What is the three-month interest
rate on dollars?
f. Can you deduce the likely three-month interest rate for the Swiss franc?
g. You can also buy currency for future delivery in the financial futures market. Look
at the table of futures prices. What is the rate of exchange for Canadian dollars to
be delivered in approximately six months’ time?
2. Table 28.1 shows the 90-day forward rate on the Thai baht.
a. Is the dollar at a forward discount or premium on the baht?
b. What is the annual percentage discount or premium?
c. If you have no other information about the two currencies, what is your best guess
about the spot rate on the baht three months hence?
d. Suppose that you expect to receive 100,000 baht in three months. How many
dollars is this likely to be worth?
3. Look at Table 28.1. If the three-month interest rate on dollars is 3.5 percent, what do you
think is the three-month interest rate on South African rands? Explain what would
happen if the rate were substantially above your figure.
4. Look in The Wall Street Journal or the Financial Times. How many Swiss francs can you
buy for $1? How many Hong Kong dollars can you buy? What rate do you think a Swiss
bank would quote for buying or selling Hong Kong dollars? Explain what would hap-
pen if it quoted a rate that was substantially above your figure.
5. What do our four basic relationships imply about the relationship between two coun-
tries’ interest rates and the expected change in the exchange rate? Explain why you
would or would not expect them to be related.
6. Ms. Rosetta Stone, the treasurer of International Reprints, Inc., has noticed that the in-
terest rate in Japan is below the rates in most other countries. She is, therefore, sug-
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shares for 550 pesos each. The exchange rates when she buys the stock are shown in
Table 28.1. Suppose that the exchange rate at the time of sale is pesos 9.50/$.
a. How many dollars does she invest?
b. What is her total return in pesos? In dollars?
c. Do you think that she has made an exchange rate profit or loss? Explain.
13. Table 28.4 shows the foreign exchange rate for the Australian dollar and the Australian
and U.S. inflation rates. Using these data, plot the nominal and real exchange rates.
Which was more volatile, the nominal or the real exchange rate?
14. Look again at Table 28.4. George and Bruce each have an equal share in a trust fund that
provides them with an income of US$100,000 a year. George lives in Seattle, but Bruce
emigrated to Sydney in 1983. What has happened to George’s real income since 1983?
What was Bruce’s income in 1983 in Australian dollars? What was it in 2000? What has
happened to Bruce’s real income?
15. In 1992 a liter of scotch cost $22.84 in New York, S$69 in Singapore, and 3,240 roubles
in Moscow.
a. If the law of one price held, what was the exchange rate between U.S. dollars and
Singapore dollars? Between U.S. dollars and roubles?
b. The actual exchange rates in 1992 were and .
Where would you prefer to buy your scotch?
16. Table 28.5 shows the annual interest rate (annually compounded) and exchange rates
against the dollar for different currencies. Are there any arbitrage opportunities? If so,
how would you secure a positive cash flow today, while zeroing out all future cash flows?
17. “Last year we had a substantial income in sterling, which we hedged by selling sterling
forward. In the event sterling rose, and our decision to sell forward cost us a lot of
money. I think that in the future we should either stop hedging our currency exposure
or just hedge when we think sterling is overvalued.” As financial manager, how would
you respond to your chief executive’s comment?
18. In 1985 a German corporation bought $250 million forward to cover a future purchase
of goods from the United States. However, the dollar subsequently depreciated and the
company found that, if it had waited and then bought the dollars spot, it would have