584 SECTION SIX
federal court. Then the Hixon family, descendants of AMP’s co-founder, made public a
letter to AMP’s management expressing “dismay” and asking, “Who do management
and the board work for? The central issue is that AMP’s management will not permit
shareholders to voice their will.”
7
As the weeks passed, AMP’s defenses, while still intact, did not look quite so strong.
By mid-October, it became clear that AMP would not receive timely help from the
Pennsylvania legislature. In November, the federal court gave AlliedSignal the go-ahead
to ask shareholders to vote to remove the poison pill. Remember, 72 percent of its stock-
holders had already accepted AlliedSignal’s tender offer.
Then, suddenly, AMP gave up: management had found a white knight when Tyco
International came to its rescue. Tyco was prepared to offer stock worth $55 for each
AMP share. AlliedSignal dropped out of the bidding; it didn’t think AMP was worth
that much.
What are the lessons? First, the example illustrates some of the stratagems of merger
warfare. Firms like AMP that are worried about being taken over usually prepare their
defenses in advance. Often they will persuade shareholders to agree to shark-repellent
changes to the corporate charter. For example, the charter may be amended to require
that any merger must be approved by a supermajority of 80 percent of the shares rather
than the normal 50 percent.
Firms frequently deter potential bidders by devising poison pills, which make the
company unappetizing. For example, the poison pill may give existing shareholders the
right to buy the company’s shares at half price as soon as a bidder acquires more than
15 percent of the shares. The bidder is not entitled to the discount. Thus the bidder re-
sembles Tantalus—as soon as it has acquired 15 percent of the shares, control is lifted
away from its reach.
The battle for AMP demonstrates the strength of poison pills and other takeover de-
fenses. AlliedSignal’s offensive still gained ground, but with great expense and effort
and at a very slow pace.
The second lesson of the AMP story is the potential power of institutional investors.

The prices of their shares fell by 1 percent.
9
The value of the total package—buyer plus
seller—increased by 4 percent. Of course, these are averages; selling shareholders
sometimes obtain much higher returns. When IBM took over Lotus, it paid a premium
of 100 percent, or about $1.7 billion, for Lotus stock.
Why do sellers earn higher returns? The most important reason is the competition
among potential bidders. Once the first bidder puts the target company “in play,” one or
more additional suitors often jump in, sometimes as white knights at the invitation of
the target firm’s management. Every time one suitor tops another’s bid, more of the
merger gain slides toward the target. At the same time the target firm’s management
may mount various legal and financial counterattacks, ensuring that capitulation, if and
when it comes, is at the highest attainable price.
Of course, bidders and targets are not the only possible winners. Unsuccessful bid-
ders often win, too, by selling off their holdings in target companies at substantial prof-
its. Such shares may be sold on the open market or sold back to the target company.
10
Sometimes they are sold to the successful suitor.
Other winners include investment bankers, lawyers, accountants, and in some cases
arbitrageurs, or “arbs,” who speculate on the likely success of takeover bids.
“Speculate” has a negative ring, but it can be a useful social service. A tender offer
may present shareholders with a difficult decision. Should they accept, should they
wait to see if someone else produces a better offer, or should they sell their stock in
the market? This quandary presents an opportunity for the arbitrageurs. In other words,
they buy from the target’s shareholders and take on the risk that the deal will not go
through.
11
Leveraged Buyouts
Leveraged buyouts, or LBOs, differ from ordinary acquisitions in two ways. First, a
large fraction of the purchase price is debt-financed. Some, perhaps all, of this debt is

buy all the firm’s stock for $75 per share in cash and take the company private. John-
son’s group was backed up and advised by Shearson Lehman Hutton, the investment
bank subsidiary of American Express.
RJR’s share price immediately moved to about $75, handing shareholders a 36 per-
cent gain over the previous day’s price of $56. At the same time RJR’s bonds fell, since
it was clear that existing bondholders would soon have a lot more company.
Johnson’s offer lifted RJR onto the auction block. Once the company was in play, its
board of directors was obliged to consider other offers, which were not long coming.
Four days later, a group of investors led by LBO specialists Kohlberg Kravis Roberts
bid $90 per share, $79 in cash plus preferred stock valued at $11.
The bidding finally closed on November 30, some 32 days after the initial offer was
revealed. In the end it was Johnson’s group against KKR. KKR offered $109 per share,
after adding $1 per share (roughly $230 million) at the last hour. The KKR bid was $81
in cash, convertible subordinated debentures valued at about $10, and preferred shares
valued at about $18. Johnson’s group bid $112 in cash and securities.
But the RJR board chose KKR. True, Johnson’s group had offered $3 per share more,
but its security valuations were viewed as “softer” and perhaps overstated. Also, KKR’s
planned asset sales were less drastic; perhaps their plans for managing the business in-
spired more confidence. Finally, the Johnson group’s proposal contained a management
compensation package that seemed extremely generous and had generated an avalanche
of bad press.
But where did the merger benefits come from? What could justify offering $109 per
share, about $25 billion in all, for a company that only 33 days previously had been sell-
ing for $56 per share?
KKR and other bidders were betting on two things. First, they expected to generate
billions of additional dollars from interest tax shields, reduced capital expenditures, and
sales of assets not strictly necessary to RJR’s core businesses. Asset sales alone were
projected to generate $5 billion. Second, they expected to make those core businesses
significantly more profitable, mainly by cutting back on expenses and bureaucracy. Ap-
parently there was plenty to cut, including the RJR “Air Force,” which at one point op-

by artificially cheap funding from the junk bond markets. With hindsight it seems that
investors in junk bonds underestimated the risks of default. Default rates climbed
painfully between 1989 and 1991. At the same time the junk bond market became much
less liquid after the demise of Drexel Burnham Lambert, the chief market maker. Yields
rose dramatically, and new issues dried up. Suddenly junk-financed LBOs seemed to
disappear from the scene.
13
Leverage and Taxes. As we explained earlier, borrowing money saves taxes. But
taxes were not the main driving force behind LBOs. The value of interest tax shields
was just not big enough to explain the observed gains in market value.
Of course, if interest tax shields were the main motive for LBOs’ high debt, then
LBO managers would not be so concerned to pay off debt. We saw that this was one of
the first tasks facing RJR Nabisco’s new management.
Other Stakeholders. It is possible that the gain to the selling stockholders is just
someone else’s loss and that no value is generated overall. Therefore, we should look at
the total gain to all investors in an LBO, not just the selling stockholders.
Bondholders are the obvious losers. The debt they thought was well-secured may
turn into junk when the borrower goes through an LBO. We noted how market prices of
RJR Nabisco debt fell sharply when Ross Johnson’s first LBO offer was announced.
But again, the value losses suffered by bondholders in LBOs are not nearly large
enough to explain stockholder gains.
Leverage and Incentives. Managers and employees of LBOs work harder and often
smarter. They have to generate cash to service the extra debt. Moreover, managers’
13
There was a sharp revival of junk bond sales in 1992 and 1993 and 1996 was a banner year. But many of
these issues simply replaced existing bonds. It remains to be seen whether junk bonds will make a lasting re-
covery.
588 SECTION SIX
personal fortunes are riding on the LBO’s success. They become owners rather than or-
ganization men or women.

In the next section we sum up the long-run impact of mergers and acquisitions, in-
cluding LBOs, in the United States economy. We warn you, however, that there are no
neat answers. Our assessment has to be mixed and tentative.
Mergers and the Economy
MERGER WAVES
Mergers come in waves. The first episode of intense merger activity occurred at the turn
of the twentieth century and the second in the 1920s. There was a further boom from
1967 to 1969 and then again in the 1980s and 1990s. Each episode coincided with a pe-
14
S. Kaplan, “The Effects of Management Buyouts on Operating Performance and Value,” Journal of Finan-
cial Economics 24 (October 1989), pp. 217–254.
15
The free-cash-flow theory’s chief proponent is Michael Jensen. See M. C. Jensen, “The Eclipse of the Pub-
lic Corporation,” Harvard Business Review 67 (September–October 1989), pp. 61–74, and “The Agency
Costs of Free Cash Flow, Corporate Finance and Takeovers,” American Economic Review 76 (May 1986), pp.
323–329.
Mergers, Acquisitions, and Corporate Control 589
riod of buoyant stock prices, though in each case there were substantial differences in
the types of companies that merged and how they went about it.
We don’t really understand why merger activity is so volatile. If mergers are
prompted by economic motives, at least one of these motives must be “here today, gone
tomorrow,” and it must somehow be associated with high stock prices. But none of the
economic motives that we review in this material has anything to do with the general
level of the stock market. None of the motives burst on the scene in 1967, departed in
1970, reappeared for most of the 1980s, and reappeared again in the mid-1990s.
Some mergers may result from mistakes in valuation on the part of the stock market.
In other words, the buyer may believe that investors have underestimated the value of
the seller or may hope that they will overestimate the value of the combined firm. Why
don’t we see just as many firms hunting for bargain acquisitions when the stock market
is low? It is possible that “suckers are born every minute,” but it’s difficult to believe

Since buyers seem roughly to break even and sellers make substantial gains, it seems
that there are positive gains to mergers. But not everybody is convinced. Some believe
that investors analyzing mergers pay too much attention to short-term earnings gains
and don’t notice that these gains are at the expense of long-term prospects.
16
For a history of the role of Milken in the development of the junk bond market, see C. Bruck, The Preda-
tor’s Ball: The Junk Bond Raiders and the Man Who Staked Them (New York: Simon and Schuster, 1988).
590 SECTION SIX
Since we can’t observe how companies would have fared in the absence of a merger,
it is difficult to measure the effects on profitability. Studies of recent merger activity
suggest that mergers do seem to improve real productivity. For example, Healy, Palepu,
and Ruback examined 50 large mergers between 1979 and 1983 and found an average
increase in the companies’ pretax returns of 2.4 percentage points.
17
They argue that this
gain came from generating a higher level of sales from the same assets. There was no
evidence that the companies were mortgaging their long-term futures by cutting back
on long-term investments; expenditures on capital equipment and research and devel-
opment tracked the industry average.
If you are concerned with public policy toward mergers, you do not want to look only
at their impact on the shareholders of the companies concerned. For instance, we have
already seen that in the case of RJR Nabisco some part of the shareholders’ gain was at
the expense of the bondholders and the Internal Revenue Service (through the enlarged
interest tax shield). The acquirer’s shareholders may also gain at the expense of the tar-
get firm’s employees, who in some cases are laid off or are forced to take pay cuts after
takeovers.
Many people believe that the merger wave of the 1980s led to excessive debt levels
and left many companies ill-equipped to survive a recession. Also, many savings and
loan companies and some large insurance firms invested heavily in junk bonds. De-
faults on these bonds threatened, and in some cases extinguished, their solvency.

two business may be more valuable together than apart. Gains may stem from economies of
scale, economies of vertical integration, the combination of complementary resources, or
redeployment of surplus funds. We don’t know how frequently these benefits occur, but they
do make economic sense. Sometimes mergers are undertaken to diversify risks or artificially
increase growth of earnings per share. These motives are dubious.
How should the gains and costs of mergers to the acquiring firm be measured?
A merger generates an economic gain if the two firms are worth more together than apart.
The gain is the difference between the value of the merged firm and the value of the two
firms run independently. The cost is the premium that the buyer pays for the selling firm
over its value as a separate entity. When payment is in the form of shares, the value of this
payment naturally depends on what those shares are worth after the merger is complete. You
should go ahead with the merger if the gain exceeds the cost.
What are some takeover defenses?
Mergers are often amicably negotiated between the management and directors of the two
companies; but if the seller is reluctant, the would-be buyer can decide to make a tender
offer for the stock. We sketched some of the offensive and defensive tactics used in takeover
battles. These defenses include shark repellents (changes in the company charter meant to
make a takeover more difficult to achieve), poison pills (measures that make takeover of the
firm more costly), and the search for white knights (the attempt to find a friendly acquirer
before the unfriendly one takes over the firm).
Do mergers increase efficiency and how are the gains from mergers distributed be-
tween shareholders of the acquired and acquiring firms?
We observed that when the target firm is acquired, its shareholders typically win: target
firms’ shareholders earn abnormally large returns. The bidding firm’s shareholders roughly
break even. This suggests that the typical merger appears to generate positive net benefits,
but competition among bidders and active defense by management of the target firm pushes
most of the gains toward selling shareholders.
Mergers seem to generate economic gains, but they are also costly. Investment bankers,
lawyers, and arbitrageurs thrived during the 1980s merger and LBO boom. Many companies
were left with heavy debt burdens and had to sell assets or improve performance to stay

d. Merging to increase earnings per share.
2. Merger Motives. Explain why it might make good sense for Northeast Heating and North-
east Air Conditioning to merge into one company.
3. Empirical Facts. True or false?
a. Sellers almost always gain in mergers.
b. Buyers almost always gain in mergers.
c. Firms that do unusually well tend to be acquisition targets.
d. Merger activity in the United States varies dramatically from year to year.
e. On the average, mergers produce substantial economic gains.
f. Tender offers require the approval of the selling firm’s management.
g. The cost of a merger is always independent of the economic gain produced by the merger.
4. Merger Tactics. Connect each term to its correct definition or description:
A. LBO 1. Attempt to gain control of a firm by winning the votes of its
B. Poison pill stockholders.
C. Tender offer 2. Changes in corporate charter designed to deter unwelcome
D. Shark repellent takeover.
E. Proxy contest 3. Friendly potential acquirer sought by a threatened target firm.
Related Web
Links
Key Terms
Quiz
Mergers, Acquisitions, and Corporate Control 593
F. White knight 4. Shareholders are issued rights to buy shares if bidder acquires
large stake in the firm.
5. Offer to buy shares directly from stockholders.
6. Company or business bought out by private investors, largely
debt-financed.
5. Empirical Facts. True or false?
a. One of the first tasks of an LBO’s financial manager is to pay down debt.
b. Shareholders of bidding companies earn higher abnormal returns when the merger is fi-

a. Sleepy’s management is willing to accept a cash offer of $25 a share. Can the merger be
accomplished on a friendly basis?
b. What will happen if Sleepy’s management holds out for an offer of $28 a share?
11. Mergers and P/E Ratios. Castles in the Sand currently sells at a price-earnings multiple of
10. The firm has 2 million shares outstanding, and sells at a price per share of $40. Firm
Practice
Problems
594 SECTION SIX
Foundation has a P/E multiple of 8, has 1 million shares outstanding, and sells at a price per
share of $20.
a. If Castles acquires the other firm by exchanging one of its shares for every two of Firm
Foundation’s, what will be the earnings per share of the merged firm?
b. What should be the P/E of the new firm if the merger has no economic gains? What will
happen to Castles’s price per share? Show that shareholders of neither Castles nor Firm
Foundation realize any change in wealth.
c. What will happen to Castles’s price per share if the market does not realize that the P/E
ratio of the merged firm ought to differ from Castles’s premerger ratio?
d. How are the gains from the merger split between shareholders of the two firms if the mar-
ket is fooled as in part (c)?
12. Stock versus Cash Offers. Sweet Cola Corp. (SCC) is bidding to take over Salty Dog Pret-
zels (SDP). SCC has 3,000 shares outstanding, selling at $50 per share. SDP has 2,000
shares outstanding, selling at $17.50 a share. SCC estimates the economic gain from the
merger to be $10,000.
a. If SDP can be acquired for $20 a share, what is the NPV of the merger to SCC?
b. What will SCC sell for when the market learns that it plans to acquire SDP for $20 a
share? What will SDP sell for? What are the percentage gains to the shareholders of each
firm?
c. Now suppose that the merger takes place through an exchange of stock. Based on the
premerger prices of the firms, SCC sells for $50, so instead of paying $20 cash, SCC is-
sues .40 of its shares for every SDP share acquired. What will be the price of the merged

Forecast dividend per share $3.00 $.80
Number of shares 1,000,000 600,000
Stock price $90.00 $20.00
You estimate that investors currently expect a steady growth of about 6 percent in Plastitoys’s
earnings and dividends. You believe that Leisure Products could increase Plastitoys’s growth
rate to 8 percent per year, without any additional capital investment required.
a. What is the gain from the acquisition?
b. What is the cost of the acquisition if Leisure Products pays $25 in cash for each share of
Plastitoys?
c. What is the cost of the acquisition if Leisure Products offers one share of Leisure Prod-
ucts for every three shares of Plastitoys?
d. How would the cost of the cash offer and the share offer alter if the expected growth rate
of Plastitoys were not increased by the merger?
1 a. Horizontal merger. IBM is in the same industry as Apple Computer.
b. Conglomerate merger. Apple Computer and Stop & Shop are in different industries.
c. Vertical merger. Stop & Shop is expanding backward to acquire one of its suppliers,
Campbell Soup.
d. Conglomerate merger. Campbell Soup and IBM are in different industries.
2 Given current earnings of $2.00 a share, and a share price of $10, Muck and Slurry would
have a market value of $1,000,000 and a price-earnings ratio of only 5. It can be acquired
for only half as many shares of World Enterprises, 25,000 shares. Therefore, the merged
firm will have 125,000 shares outstanding and earnings of $400,000, resulting in earnings
per share of $3.20, higher than the $2.67 value in the third column of Table 6 2.
3 The cost of the merger is $4 million: the $4 per share premium offered to Goldfish share-
holders times 1 million shares. If the merger has positive NPV to Killer Shark, the gain
must be greater than $4 million.
4 Yes. Look again at Table 6.4. Total market value is still $540, but Cislunar will have to issue
1 million shares to complete the merger. Total shares in the merged firm will be 11 million.
The postmerger share price is $49.09, so Cislunar and its shareholders still come out ahead.
MINICASE

Investors were not persuaded of the benefits of combining a
supermarket with a department store company, and on June 11
Fenton’s shares opened lower and drifted down £.10 to close the
day at £7.90. McPhee’s shares, however, jumped to £6.32 a share.
Fenton’s financial manager was due to attend a meeting with
the company’s investment bankers that evening, but before doing
so, he decided to run the numbers once again. First he reesti-
mated the gain and cost of the merger. Then he analyzed that
day’s fall in Fenton’s stock price to see whether investors be-
lieved there were any gains to be had from merging. Finally, he
decided to revisit the issue of whether Fenton could afford to
raise its bid at a later stage. If the effect was simply a further fall
in the price of Fenton stock, the move could be self-defeating.
597
INTERNATIONAL
FINANCIAL MANAGEMENT
Foreign Exchange Markets
Some Basic Relationships
Exchange Rates and Inflation
Inflation and Interest Rates
Interest Rates and Exchange Rates
The Forward Rate and the Expected Spot Rate
Some Implications
Hedging Exchange Rate Risk
International Capital Budgeting
Net Present Value Analysis
The Cost of Capital for Foreign Investment
Avoiding Fudge Factors
Summary
hus far we have talked principally about doing business at home. But

T
Foreign Exchange Markets
An American company that imports goods from Switzerland may need to exchange
its dollars for Swiss francs in order to pay for its purchases. An American company
exporting to Switzerland may receive Swiss francs, which it sells in exchange for
dollars. Both firms must make use of the foreign exchange market, where currencies
are traded.
The foreign exchange market has no central marketplace. All business is conducted
by computer and telephone. The principal dealers are the large commercial banks, and
International Financial Management 599
any corporation that wants to buy or sell currency usually does so through a commer-
cial bank.
Turnover in the foreign exchange markets is huge. In London alone about $640 bil-
lion of currency changes hands each day. That is equivalent to an annual turnover of
$159 trillion ($159,000,000,000,000). New York and Tokyo together account for a fur-
ther $500 billion of turnover per day. Compare this to trading volume of the New York
Stock Exchange, where no more than $30 billion of stock might change hands on a typ-
ical day.
Suppose you ask someone the price of bread. He may tell you that you can buy two
loaves for a dollar, or he may say that one loaf costs 50 cents. Similarly, if you ask a for-
eign exchange dealer to quote you a price for Ruritanian francs, she may tell you that
you can buy two francs for a dollar or that one franc costs $.50. The first quote (the
number of francs that you can buy for a dollar) is known as an indirect quote of the ex-
change rate. The second quote (the number of dollars that it costs to buy one franc) is
known as a direct quote. Of course, both quotes provide the same information. If you
can buy two francs for a dollar, then you can easily calculate that the cost of one franc
is 1/2.0 = $.50.
Now look at Table 6.5, which has been adapted from the daily table of exchange rates
in the London Financial Times. The first column of figures in the table shows the ex-
change rate for a number of countries on October 6, 1999. By custom, the prices of

of another.
600 SECTION SIX
᭤
EXAMPLE 5 A Yen for Trade
How many yen will it cost a Japanese importer to purchase $1,000 worth of oranges
from a California farmer? How many dollars will it take for that farmer to buy a Japa-
nese VCR priced in Japan at 30,000 yen (¥)?
The exchange rate is ¥107.52 per dollar. The $1,000 of oranges will require the
Japanese importer to come up with 1,000 × 107.52 = ¥107,520. The VCR will require
the American importer to come up with 30,000/107.52 = $279.
᭤
Self-Test 1 Use the exchange rates in Table 6.5. How many euros can you buy for one dollar (an in-
direct quote)? How many dollars can you buy for one yen (a direct quote)?
The exchange rates in the first column of figures in Table 6.5 are the prices of cur-
rency for immediate delivery. These are known as spot rates of exchange. For exam-
ple, the spot rate of exchange for Mexican pesos is pesos9.4380/$. In other words, it
cost 9.438 Mexican pesos to buy one dollar.
Many countries allow their currencies to float, so that the exchange rate fluctuates
from day to day, and from minute to minute. When the currency increases in value,
meaning that you need less of the foreign currency to buy one dollar, the currency is
said to appreciate. When you need more of the currency to buy one dollar, the currency
is said to depreciate.
᭤
Self-Test 2 Table 6.5 shows the exchange rate for the Swiss franc on October 6, 1999. The next day
the spot rate of exchange for the Swiss franc was SFr1.4852/$. Thus you could buy
fewer Swiss francs for your dollar than one day earlier. Had the Swiss franc appreciated
or depreciated?
Some countries try to avoid fluctuations in the value of their currency and seek in-
stead to maintain a fixed exchange rate. But fixed rates seldom last forever. If every-
body tries to sell the currency, eventually the country will be forced to allow the cur-

107.52 – 101.3
× 100 = 6.14%
101.3
You could also say that the dollar was selling at a forward discount of about 6.14 per-
cent.
1
A forward purchase or sale is a made-to-order transaction between you and the bank.
It can be for any currency, any amount, and any delivery day. You could buy, say, 99,999
Vietnamese dong or Haitian gourdes for a year and a day forward as long as you can
find a bank ready to deal. Most forward transactions are for 6 months or less, but banks
are prepared to buy or sell the major currencies for up to 10 years forward.
There is also an organized market for currency for future delivery known as the cur-
rency futures market. Futures contracts are highly standardized versions of forward con-
tracts—they exist only for the main currencies, they are for specified amounts, and
choice of delivery dates is limited. The advantage of this standardization is that there is
a very low-cost market in currency futures. Huge numbers of contracts are bought and
sold daily on the futures exchanges.
᭤
Self-Test 3 A skiing vacation in Switzerland costs SFr1,500.
a. How many dollars does that represent? Use the exchange rates in Table 6.5.
b. Suppose that the dollar depreciates by 10 percent relative to the Swiss franc, so that
each dollar buys 10 percent fewer Swiss francs than before. What will be the new
value of the indirect exchange rate?
c. If the Swiss vacation continues to cost the same number of Swiss francs, what will
happen to the cost in dollars?
d. If the tour company that is offering the vacation keeps the price fixed in dollars, what
will happen to the number of Swiss francs that it will receive?
FORWARD EXCHANGE
RATE
Exchange rate for a

But let’s slow down and consider why changes in inflation and spot interest rates are
linked. Think first about the prices of the same good or service in two different coun-
tries and currencies.
Suppose you notice that gold can be bought in New York for $300 an ounce and sold
in Mexico City for 4,000 pesos an ounce. If there are no restrictions on the import of
gold, you could be onto a good thing. You buy gold for $300 and put it on the first plane
to Mexico City, where you sell it for 4,000 pesos. Then (using the exchange rates from
Table 6.5) you can exchange your 4,000 pesos for 4,000/9.438 = $424. You have made
a gross profit of $124 an ounce. Of course, you have to pay transportation and insur-
ance costs out of this, but there should still be something left over for you.
You returned from your trip with a sure-fire profit. But sure-fire profits don’t exist—
not for long. As others notice the disparity between the price of gold in Mexico and the
FIGURE 6.1
Some simple theories linking
spot and forward exchange
rates, interest rates, and
inflation rates.
Difference in
interest rates
equals
equals
equals
1 ϩ r
peso
1 ϩ r
$
Difference between forward
and spot exchange rates
f
peso/$

United States:
Dollar price of goods in USA =
peso price of goods in Mexico
number of pesos per dollar
$300 =
peso price of gold in Mexico
9.438
Price of gold in Mexico = 300 × 9.438 = 2,831 pesos
No one who has compared prices in foreign stores with prices at home really believes
that the law of one price holds exactly. Look at the first column of Table 6.6, which
TABLE 6.6
Price of a Big Mac in
different countries
Price in Local Exchange Rate Local Price
Currency (currency/dollar) Converted to Dollars
Australia A$2.65 1.59 1.66
Canada C$2.99 1.51 1.98
China Yuan 9.90 8.28 1.20
France FFr17.50 6.10 2.87
Germany DM4.95 1.82 2.72
Hong Kong HK$10.2 7.75 1.32
Israel Shekel 13.9 4.04 3.44
Italy Lire4,500 1,799 2.50
Japan ¥294 120 2.44
Malaysia M$4.52 3.80 1.19
Mexico Peso19.9 9.54 2.09
Poland Zloty5.50 3.98 1.38
Russia Ruble33.5 24.7 1.35
Switzerland SFr5.90 1.48 3.97
United Kingdom £1.90 .621 3.07

For example, beer in Kenya cost 41.25 shillings; at an exchange rate of 10.27 Kenyan
shillings per rand, this is equivalent to a price of 41.25/10.27 = 4.02 rand. This is 1.75
times the cost of beer in South Africa; for the costs to be equal, the shilling would need
to depreciate by 75 percent to a new exchange rate of 10.27 × 1.75 = 17.9 shillings per
rand. Therefore, we might say that this comparison suggests the shilling is 75 percent
overvalued against the rand.
TABLE 6.7
The price of a beer in
different countries
Under(–)/Over(+)
Beer Prices
Actual Rand Valuation
In Local In Exchange Rate, against the
Country Currency Rand March 1999 Rand, %
South Africa Rand2.30 2.30
Botswana Pula2.20 2.94 0.75 28
Ghana Cedi1,200 3.17 379.10 38
Kenya Shilling41.25 4.02 10.27 75
Malawi Kwacha18.50 2.66 6.96 16
Mauritius Rupee15.00 3.72 4.03 62
Namibia N$2.50 2.50 1.00 9
Zambia Kwacha1,200 3.52 340.68 53
Zimbabwe Z$9.00 1.46 6.15 –36
Source: The Economist, May 8, 1999.
3
Of course, it could also be that Big Macs come with a bigger smile in Switzerland. If the quality of the ham-
burgers or the service differs, we are not comparing like with like.
International Financial Management 605
A weaker version of the law of one price is known as purchasing power parity, or
PPP. PPP states that although some goods may cost different amounts in different coun-

across countries.
FIGURE 6.2
Countries with high inflation
rates tend to see their
currencies depreciate.
Annual relative change in exchange rate, percent
Annual relative change in purchasing power, percent
20
0
Ϫ20
Ϫ40
Ϫ60
Ϫ80
Ϫ100
Ϫ100 Ϫ80 Ϫ60 Ϫ40 Ϫ20
0
20
Russia
United
States
606 SECTION SIX
For example, if inflation is 2 percent in the United States and 20 percent in Mexico,
then purchasing power parity implies that the expected spot rate for the peso at the end
of the year is peso11.10/$:
Current
×
expected difference
= expected spot rate
spot rate in inflation rates
9.438 ×

concern investors, not the nominal returns. Two countries may have different
nominal interest rates but the same expected real interest rate.
Expected difference
in inflation rates
1 + i
peso
1 + i
$
Expected change in
spot exchange rate
E(s
peso/$
)
s
peso/$
equals
INTERNATIONAL
FISHER EFFECT
Theory that real interest rates
in all countries should be
equal, with differences in
nominal rates reflecting
differences in expected
inflation.
International Financial Management 607
In other words, capital market equilibrium requires that real interest rates be the
same in any two countries.
᭤
EXAMPLE 3 International Fisher Effect
If the nominal interest rate in Mexico is 25.25 percent and the expected inflation is 20

interest rates
1 + r
peso
1 + r
$
Expected differences
in inflation rates
1 + i
peso
1 + i
$
equals
FIGURE 6.3
Countries with the highest
interest rates generally have
the highest subsequent
inflation rates. In this
diagram, each point
represents a different country.
Average interest rate, percent (1994–1998)
Average inflation, percent (1994–1998)
40
30
20
15
10
5
0
25
35

11,821,000/11.153 = $1,059,900.
Thus the two investments offer almost exactly the same rate of return. They have to—
they are both risk-free. If the domestic interest rate were different from the “covered”
foreign rate, you would have a money machine: you could borrow in the market with
the lower rate and lend in the market with the higher rate.
When you make a peso loan, you gain because you get a higher interest rate. But you
lose because you sell the pesos forward at a lower price than you have to pay for them
today. The interest rate differential is
1 + r
peso
=
1.2525
= 1.1816
1 + r
$
1.06
A difference in interest rates must be offset by a difference between spot and
forward exchange rates. If the risk-free interest rate in country X is higher
than in country Y, then country X’s currency will buy less of Y’s in a forward
transaction than in a spot transaction.