FINS3616 International Business Finance - Week 6

A. Conceptual questions
1. What are the three main sources of financing for any firm?
Corporations rely on three primary types of financing for their capital expenditures:
internally generated funds, debt financing, and equity financing.

2. What is the difference between a centralized and decentralized debt denomination for a
MNC?
Under a decentralized debt-denomination model, MNCs issue debt in different currencies
to hedge the cash flows they earn in these currencies from their foreign subsidiaries.
Under a centralized model, debt is issued in the currency of the country in which the
MNC has its headquarters.

3. Should a MNC borrow primarily short term when short-term interest rates are lower than
long-term interest rates? Or should it keep the maturity the same but use a floating-rate
loan rather than a fixed-rate loan? Explain.
First, if short-term interest rates are lower than long-term interest rates, this may be an
indication of impending increases in interest rates. In fact, if the expectations hypothesis
of the term structure of interest rates holds, the long rate is simply an appropriately
weighted average of short term rates. This implies that timing the loan by having a
floating interest rate that allows for low interest payments when short rates are low and
high interest payments when short rates are high does not add value. Second, the
difference between simply borrowing short-term and using a floating rate note is that the
latter approach also locks in the MNCs credit spread. If the firm thinks its credit rating
will improve over time, it may not want to issue a floating rate note, preferring instead to
borrow short-term and borrow again at a better credit spread after the information is
incorporated by the market.

4. What is financial disintermediation?

This concept refers to the phenomenon in which firms issue securities directly to
investors in the capital markets, rather than borrowing from financial institutions that in
turn raise funds from the capital markets.

5. What are the two main segments of the international bond market, and what types of
regulations apply to them?
One segment of the international bond market is the foreign bond market, where a foreign
issuer issues bonds in a particular domestic bond market, subject to local regulations. The
other segment is the Eurobond market, where bonds are issued simultaneously in various
markets, outside the specific jurisdiction of any country. Hence, these bonds are not
subject to the regulations of any particular country.

6. Will a MNC issuing debt in lowinterest rate currencies necessarily lower its cost of
funds? Why?
No. The ultimate cost of the debt will also depend on currency movements. If uncovered
interest rate parity holds, the cost of the low interest rate debt, expressed in the home
currency, is expected to be identical to the cost of high interest rate debt. After the fact,
the debt will be either less expensive than corresponding debt denominated in the
domestic currency, if the foreign currency appreciates less than predicted by UIRP; or it
will be more expensive if the foreign currency appreciates more than predicted by UIRP.

7. Why might U.S. investors continue to purchase Eurobonds, despite the fact that the U.S.
corporate bond market is well developed?
The Eurobond market gives them access to bonds of firms that are not available in the
U.S. market thereby providing valuable diversification of default risk. Recall that the
Eurobond market is a highly liquid, unregulated, convenient market to issue bonds, which
has lead to a wide array of available bonds from which investors can choose. Also,
Eurobonds are not registered (ownership is anonymous), and it may therefore allow
certain tax avoidance benefits to non-scrupulous investors.

8. Describe how you would calculate a 5-year forward exchange rate of yen per dollar if
you knew the current spot exchange rate and the prices of 5-year pure discount bonds
denominated in yen and dollars. Explain why this has to be the market price?
The 5-year forward rate would be equal to the spot rate of yen per dollar times the ratio of
the future value in 5 years of one yen to the future value in 5 years of one dollar. The
logic is the following. If you can invest directly in yen for 5 years, you can convert one
yen into the future value of one yen in 5 years. Alternatively, you can convert the one yen
into dollars in the spot foreign exchange market, invest that dollar principal for 5 years to

get the future value of dollars, and contract today to sell those dollars in the forward
market to get back to future yen in 5 years. If the two amounts of future yen differ, there
would be an arbitrage available in which you would borrow future yen where they are
cheap and invest in future yen where they are expensive.
9. If interest rate parity is satisfied, there are no opportunities for covered interest arbitrage.
What does this imply about the relationship between spot and forward exchange rates
when the foreign currency money market investment offers a higher return than the
domestic money market investment?
If the foreign currency money market investment offers a higher return (in the foreign
currency) than the domestic money market investment, the foreign currency must be at a
discount in terms of the domestic currency in the forward market. The forward discount
locks in a capital loss when the transaction exchange risk is offset, which reduces the
higher return of the foreign currency back to the lower return offered in the domestic
money market.
10. What do economists mean by the external credit market?
The external credit market is an interbank market for deposits and loans that are
denominated in currencies that are not the currency of the country in which the bank is
operating. Its settlement procedures are identical to those of the foreign exchange market.
The first currency for which these deposits and loans began to trade was the dollar, and
the deposits were called Eurodollars because they were dollar-denominated deposits at
European banks. The market for other currencies came to be called the Eurocurrency
market, even though the trading might be done in Asia or the Americas. With the advent
of the euro as a currency, the term external currency market seems less confusing.
11. Suppose the 5-year interest rate on a dollar-denominated pure discount bond is 4.5% p.a.,
whereas in France, the euro interest rate is 7.5% p.a. on a similar pure discount bond
denominated in euros. If the current spot rate is $1.08/, what is the value of the forward
exchange rate that prevents covered interest arbitrage?
We know that the 5-year forward rate must satisfy

1+i(t,5,$)
F(t,5,$/) = S(t,$/)
5
1+i(t,5,)
5

= $1.08/

1.0455
= $0.9375/
1.0755

12. Carla Heinz is a portfolio manager for Deutsche Bank. She is considering two alternative
investments of EUR10,000,000: 180-day euro deposits or 180-day Swiss francs (CHF)
deposits. She has decided not to bear transaction foreign exchange risk. Suppose she has

the following data: 180-day CHF interest rate, 8% p.a., 180-day EUR interest rate, 10%
p.a., spot rate EUR1.1960/CHF, 180-day forward rate, EUR1.2024/CHF. Which of these
deposits provides the higher euro return in 180 days? If these were actually market prices,
what would you expect to happen?
180

5% 10%
360 , so the euros available

The euro return to investing directly in euros is

in 180 days is EUR10,000,000 1.05 = EUR10,500,000. Alternatively, the

EUR10,000,000 can be converted into Swiss francs at the spot rate of EUR1.1960/CHF.
The Swiss francs purchased would equal EUR10,000,000/EUR1.1960/CHF =
CHF8,361,204. This amount of Swiss francs can be invested to provide a
180

4% 8%

360 return over the next 180 days. Hence, interest plus principal on the

Swiss francs is CHF8,361,204 1.04 = CHF8,695,652. If we sell this amount of Swiss

francs forward for euros at the 180-day forward rate of EUR1.2024/CHF, we get a euro
return of CHF8,695,652 EUR1.2024/CHF = EUR10,455,652. This is less than the
return from investing directly in euros.
If these were the actual market prices, you should expect investors to do covered interest
arbitrages. Investors would borrow Swiss francs, which would tend to drive the CHF
interest rate up; they would sell the Swiss francs for euros in the spot foreign exchange
market, which would tend to lower the spot rate of EUR/CHF; they would deposit euros,
which would tend to drive the EUR interest rate down; and they would contract to buy
CHF with EUR in the 180-day forward market, which would put upward pressure on the
forward rate of EUR/CHF. Each of these actions would help bring the market back to
equilibrium.

B. True or False questions

1.

Domestic bonds are issued and traded within the internal market of a single country and are
denominated in the currency of that country.
True

2.

International bonds are traded in internal markets.

False

3.

The two kinds of international bonds are dollar bonds and foreign bonds
False

4.

Eurobonds are denominated in one or more currencies but are traded in external markets
outside the borders of the countries issuing those currencies.
True

5.

The most prominent bonds selling in national bond markets are foreign bonds.
False

6.

Under the centralized debt denomination model, the debt service payments are denominated
in the currency in which the subsidiary's revenues are received
False

7. The sources of funds for a multinational corporation and its subsidiaries can be subdivided
into two categories, internally-generated and externally generated.
True
8. Retained earnings is not an external source of corporate funding
True
9.

Covered interest arbitrage ensures that the ratio of forward to spot exchange rates is
determined by the inflation differential between two currencies.
False

10. Interest rate parity holds within the bounds of transactions costs in the international currency
and Eurocurrency markets.

True
11. Forward premiums and discounts depend on interest rate differentials.
True
12. External credit markets trade interest rate contracts denominated in a currency but traded
outside the borders of the country issuing that currency.
True
13. Eurocurrency markets are highly liquid and relatively unencumbered by government
regulation, resulting in borrowing and lending rates that are generally more favorable to
large retail customers than domestic rates.
True
14. The term covered means the investment is exposed to transaction foreign exchange risk.
False
15.

When the possibility exists that the government of a nation may impose some form of
exchange controls or tax on foreign investment, the risk is known as default risk.
False

16. An example of an external credit market that was the first to form was the market where the
dollar-denominated deposits were known as Eurodollars.
True
C. MCQ
1.

Which of the following is a categorization of debt markets?

a. domestic versus international
b. intermediated versus non-intermediated
c. internal versus external
d. More than one of the above
e. None of the above

2.

Which of statements a) through d) about foreign bonds is false?

a. Foreign bonds are denominated in the currency of the issuing company.
b. Foreign bonds are issued in a local market by a foreign borrower.
c. Foreign bonds are marketed to local residents.
d. Foreign bonds are regulated by local authorities.
e. All of the above are true.

3. Which of the following is a function of the external credit market?

a. foreign currency speculation
b. hedging foreign exchange risk
c. provision of credit
d. transfer of purchasing power
e. each of the above is a function of the foreign exchange market
4. When parity conditions are not in effect in currency and money markets, traders could make
extraordinary profits from a practice known as ________.
a. covered interest rate parity
b. covered interest rate arbitrage
c. triangular arbitrage
d. forward market arbitrage
e. none of the above
5. What is the name for the bank market for deposits and loans that is denominated in a currency
different to the currency of the country in which a bank is operating?
a. internal currency market
b. foreign exchange market
c. external credit market
d. interbank market
e. none of the above