Chapter 28: International Financial Management

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Okay, let's get into it.

Welcome back to the Deep Dive.

Today, we're really expanding our I mean, we're crossing borders, talking about currencies that are traded 24 seven, and trying to figure out how you make these huge investment decisions when, you know, the financial landscape can change completely from one country to the next.

It's a fundamental shift.

Absolutely.

Our deep dive today is all about international financial management.

This is really where all the corporate finance principles we know and love just meet this incredible wave of global volatility for any company that's, say, importing parts or exporting products, or maybe building a factory overseas, the complexity, it doesn't just go up a little bit, it changes the entire game.

So you're suddenly dealing with what different currencies, obviously, different currencies, completely different interest rates.

And, and this is the big one, you're dealing with very real, often unpredictable political risks.

So the mission for us today, really, is to build a kind of roadmap for managers who have to operate in this world.

We're not just summarizing concepts, we're trying to build a framework for thinking about this.

And that framework is all about managing those extra layers of complexity.

The goal is to properly value foreign cash flows, get the risk under control, and basically let the company focus on what it's actually good at.

Right, whether that's making pharmaceuticals or selling steel, you don't want to accidentally become a full time currency speculator.

You absolutely do not.

And understanding these linkages, it's just not optional for making sound decisions on a global scale.

So we're going to break down the four fundamental economic theories that connect everything, look at how the currency markets actually work, and then get into the real practical stuff.

Hedging strategies and how you actually make a capital budgeting decision for an international project.

Exactly.

Getting to a real apples to apples comparison.

It's all about the decision rules and the economic intuition behind them.

Okay, so let's start at the very beginning.

The plumbing of the whole system.

The foreign exchange market.

In the scale of this thing,

it's almost hard to wrap your head around.

It is.

I mean, you think of something like the New York Stock Exchange as being massive.

Well, the FX market, which is just trading currencies, it makes the stock market look like a, you know, a neighborhood garage sale.

It's just immense.

And it's not like there's one big building where it all happened.

Not at all.

That's what's so fascinating.

It's completely decentralized.

It's what we call an over the counter market.

So there's no single trading floor.

If a big multinational tech firm needs to switch a billion euros into dollars, they do that electronically, usually through a huge commercial bank.

And the numbers, when we talk about the scale,

they feel made up.

The data we have here from April 2019,

it shows London, just London alone, saw $3 ,576 billion of currency change hands.

Every single day.

Every day.

That's just, I can't even picture that.

It's almost impossible to, if you annualize that just for London, you're talking about something like $1 ,300 trillion in turnover.

And that's before you even add in New York or Tokyo.

Right.

Before you add in New York, Singapore, Hong Kong and Tokyo, which together were another 3 ,000 billion a day.

This volume is so huge because the market has to handle everything.

I mean, global trade, tourism, central banks stepping in, high speed arbitrage trading, and it all runs 245.

Okay.

So within that massive system, what do managers actually have to deal with?

It boils down to two main types of rates, right?

Spot and forward.

Exactly.

The spot rate is the easy one.

It's the price for right now, immediate delivery.

If you need to send 10 ,000 euros to a supplier in Germany today, you use the spot rate.

It's the current live price.

But the forward rate, this is where the real management toolkit starts to open up.

It really is.

A forward rate is a price that you agree on today for a currency trade that will happen in the future.

So three months from now, six months, maybe a year out.

Yep.

And the contract fixes that exchange rate for you right now, even though the money won't actually change hands until that future date.

So this is basically insurance.

It's the fundamental risk management tool.

Let's say you're a US company and you just landed a big sale to a British customer.

You're going to be paid in pounds in six months.

Okay.

So you're exposed.

If the pound drops against the dollar in those six months, you get less money than you thought.

Exactly.

Your revenue is at risk.

So you enter into a six -month forward contract.

You agree to sell those pounds today at a price that is locked in.

You've insured your dollar revenue.

It doesn't matter what the spot rate does six months from now.

Okay.

Now let's get into the gritty of how these rates are actually quoted, because this can trip people up.

The convention usually is that everything is quoted against the US dollar.

Right.

And most of the time, the US dollar is the base currency.

So the quote tells you how much foreign currency you get for one US dollar.

Like the Brazilian real.

The quote here is USDBRL equals 5 .1101.

So one US dollar, the base, buys you 5 .1101 Brazilian reals.

That's technically called an indirect quote, but it's just easier to think of it as dollar base.

But there are always exceptions.

And these are really important ones that managers just have to memorize.

They absolutely do.

For four of the biggest, most historically significant currencies, the euro, the British pound, the Australian dollar, and the New Zealand dollar, it's flipped.

The convention is reversed.

So the foreign currency is the base.

Exactly.

The quote tells you how many US dollars it costs to buy one unit of that currency.

So for the euro, it was URUSD equals 1 .1595.

One euro costs you one dollar and about 16 cents.

Which is a direct quote.

And if you need to know how many euros a dollar buys, you have to do the math.

You have to flip it.

You have to do the inverse calculation.

Yeah.

Yeah.

One divided by 1 .1595 gives you about 86 euro cents.

And that constant need to check which way the quote is written is why managers have to be really sharp when they're looking at these things.

This is where things get really cool with cross rates.

I mean, not every transaction in the world involves the US dollar on one side.

What if a German company needs to pay a Japanese supplier?

Right.

They have euros.

They need yen.

They need the EURJPY cross rate.

But they can't just trade euros for yen directly, can they?

Not really, no.

The US dollar is so liquid, so widely traded, that it becomes the global intermediary for almost everything.

So you don't really trade euro for yen.

You trade the euro for dollars, and then you trade those dollars for yen.

So the calculation for the cross rate just follows that logic.

Exactly.

The formula is just EURJPY equals USD times USDJPY.

You're essentially just chaining the two trades together.

Let's use the numbers.

EURSD was 1 .1595.

USDJPY was 107 .19.

So you multiply those.

And you get 124 .287.

So one euro gets you about 124 Japanese yen.

And the efficiency of this market is so incredible that those three separate rates are always, always perfectly in balance.

Any tiny deviation is arbitraged away in milliseconds.

Okay, so let's circle back to those forward rates for a second, because comparing the forward rate to the spot rate actually tells you something really important about the market.

It's incredibly informative.

It tells you what the market expects about the difference in interest rates between the two countries.

And we use these terms, forward premium and forward discount.

Let's go back to the Brazilian real.

The spot rate was 5 .1101.

The three month forward was 5 .1273.

So notice for your $1, you get more reals in the forward market than you do in the spot market.

Right.

5 .12 versus 5 .11.

So because the dollar buys more of the foreign currency in the future, we say the Brazilian real is trading at a forward discount.

It's cheaper in the forward market.

And you could flip that and say the dollar is selling at a forward premium against the real.

You can, yeah.

And you can even calculate that discount as an annual percentage.

The formula gives you about a negative 1 .34 % annual forward discount on the real.

And the negative sign just confirms it's a discount.

So why does that exist?

The simple answer is interest rates.

At the time, interest rates in Brazil were much higher than in the US.

So this forward discount is the market's balancing mechanism.

It prevents investors from making a risk -free profit by just converting dollars to reals, earning that high interest, and then converting back.

We're going to get into exactly how that works in the next section with interest rate parity.

We will.

And just as a quick aside, while these customized forward contracts are the main tool for big corporations,

managers can also use standardized futures contracts on an exchange or even options contracts, which give you more flexibility.

Right.

But not the obligation to trade.

So more tools in the toolbox.

Exactly.

All right.

So we've got the market mechanics down.

Let's move on to the real intellectual core of this, the foundational economic theories that make that market behave the way it does.

This is it.

These are the four cornerstones.

And if you're a financial manager, you have to master these to have any kind of coherent global strategy.

They're all built on a simple premise, really.

Which is?

That markets are efficient and capital can move freely.

If you assume there are no major barriers to trade or investment, then these four simple relationships have to hold true.

They connect interest rates, inflation, and how exchange rates are expected to move.

Okay.

So let's tackle the first two together.

We'll use this hypothetical currency, the Ruritanian Ruhr, or RUR, to keep it simple.

The two questions are, why is the U .S.

dollar interest rate different from the Ruritanian interest rate?

And why is the forward RUR rate different from the spot RUR rate?

And the single answer to both questions is interest rate parity, or IRP.

This is probably the most perfect no arbitrage condition in all of finance.

It says that the difference in interest rates between two countries must be exactly equal to the difference between their forward and spot exchange rates.

And if it's not?

Then a money machine exists, a guaranteed risk -free profit, and the market will not allow that to happen.

Okay.

Let's walk through the arbitrage to really see how it works.

Let's say we have $1 ,000 to invest for one year.

In the U .S., we can get 5%.

In Ruritania, the rate is a juicy 15 .5%.

The naive investor sees 15 .5 % and dives in.

The smart financial manager knows there's more to it.

The domestic option is our baseline.

It's simple.

$1 ,000 at 5 % gives you $1 ,050 at the end of the year.

Okay.

That's our benchmark.

Now, the foreign route.

To make this risk -free, you have to hedge.

So first step,

you take your $1 ,000 and convert it at the spot rate, which is 50 RUR to the dollar.

You now have 50 ,000 RUR.

Step two, invest that 50 ,000 RUR at the 15 .5 % Ruritanian rate.

At the end of the year, that grows to 57 ,750 RUR.

But that's in RUR.

It's still risky.

So here's the crucial step, the hedge.

This is everything.

Today, at the same time you do the first transaction, you enter into a one -year forward contract to sell those 57 ,750 RUR back into dollars.

And let's say the one -year forward rate is 55 RUR to the dollar.

So you take your RUR proceeds, the 57 ,750, you divide by that forward rate of 55, and you get exactly $1 ,050.

Exactly the same.

$1 ,050 either way.

The huge difference in the interest rates, that 10 .5 % gap was perfectly canceled out.

It was perfectly offset by the fact that the forward rate was so much worse than the spot rate.

You had to agree to sell your RUR back at a cheaper price.

The formula for this balance is just that the ratio of the interest rates has to equal the ratio of the exchange rates.

So 1 plus RUR rate divided by 1 plus USD rate has to equal the forward rate divided by the spot rate.

And in our example, both sides of that equation equal 1 .1.

They have to be identical.

No money machine.

Okay.

That is the clean, beautiful theory.

How well does IRP actually hold up in the real world with all its messiness?

Historically, it was considered pretty much ironclad, one of the most reliable rules in finance, because any tiny little gap would be jumped on by huge bank arbitrage desks and closed in a fraction of a second.

But you said historically, has something changed?

Something has, yeah.

The book points out a really interesting wrinkle that's appeared since the 2007 -2009 financial crisis.

Read that.

Basically, arbitrage got more expensive for the banks.

New regulations mean they have to hold a lot more capital against their trades.

So the cost of using their balance sheet for these huge leveraged arbitrage trades went up.

So they don't pounce on the small gaps as quickly.

Exactly.

The transaction costs are higher, so tiny little deviations from IRP can sometimes stick around for a bit longer now.

But for a corporation just looking to hedge, for all practical purposes, IRP is still the rock -solid principle that determines how forward contracts are priced.

Okay, that makes sense.

Let's move to the second big idea, which is related, the expectations theory of forward rates.

This is trying to answer what that forward rate really is.

What does it represent?

Well, in a world where everyone was perfectly risk neutral, the theory says the forward rate would just be the market's best guess of what the spot rate will be in the future.

It would be an unbiased forecast.

But people aren't risk neutral,

especially not corporations with real money on the line.

Right.

An exporter who is going to receive foreign currency is naturally long that currency.

They're exposed.

They are probably willing to pay a tiny premium to get rid of that risk.

Meaning they'd accept a slightly lower forward price to just lock it in and sleep at night.

Exactly.

And an importer is the opposite.

They're short the currency.

They need to buy it.

They might pay a little extra to cap their costs.

So this hedging activity can introduce what's called a risk premium into the forward rate.

So how good is the forward rate at actually predicting the future spot rate?

The data is fascinating in the short term.

It's an awful forecaster, absolutely terrible.

The book uses the example of the UK pound.

The forward rate completely missed huge swings, like a 34 % rise in the pound back in 1985.

It's just not good at predicting the timing or the magnitude of these big sudden moves.

And this is the important part for managers.

What about over the long run?

This is the critical takeaway.

While it's a bad predictor day to day, the data shows that on average, over a long period, the forward rate is almost identical to the future spot rate.

It means that if your company consistently, year after year, uses the forward market to ensure its currency risks,

the net cost of that insurance, on average, will be zero.

It's a zero NPV game.

So the lesson for a manager is, if you can get rid of a major business risk for free in the long run, you should absolutely do it.

You should do it every time.

Hedge the currency risk and focus your energy and capital on whatever your company's actual competitive advantage is.

All right, let's hit the third cornerstone.

What actually drives that expected future spot rate?

How does it connect to something fundamental like inflation?

This brings us to purchasing power parity,

or PPP.

PPP is all built on one simple idea,

the law of one price.

Which just says a product should cost the same everywhere once you adjust for the exchange rate.

Exactly.

The classic example is a commodity like silver.

If you can buy silver in Ruritania for a thousand RUR, convert that to, say, $20, but then you can sell that same ounce of silver in the US for $30.

You've got a massive risk -free profit.

A $10 arbitrage profit.

And that incentive will drive people to buy in Ruritania and sell in the US until the prices are forced back into alignment.

So PPP just expands that idea from one commodity, silver, to a whole basket of goods like the consumer price index.

But we have to make a distinction here between absolute PPP and relative PPP.

We do, because it's a crucial distinction.

Absolute PPP says the level of prices should be the same across countries.

And we know for a fact that this fails.

It just doesn't work in the real world.

The famous example being the Big Mac index.

The Big Mac index is perfect.

The table in the book shows a Big Mac in 2020 cost the equivalent of $6 .91 in Switzerland.

But only $5 .71 in the US.

That's a huge difference.

Over 20%.

Why?

Well, because absolute PPP ignores a bunch of real world factors.

Transportation costs, tariffs, and most importantly, non -traded goods and services.

Like the rent for the McDonald's location or the wages of the local workers.

Exactly.

You can't ship a hamburger from South Africa where it costs less than $2 to Switzerland to arbitrage that price difference.

So absolute PPP breaks down.

So what financial managers actually focus on is relative PPP.

Right.

Relative PPP is much more useful.

It basically ignores the fact that the price levels are different and it focuses only on the change over time.

It says that the difference in inflation rates between two countries should be offset by a change in the exchange rate.

That makes a lot of sense, intuitively.

If prices in Rotina are going up 10 % faster than in the US, their currency should weaken by about 10 % to keep things in balance.

Precisely.

The currency movement is the mechanism that preserves the relative purchasing power between the two countries.

The formula just captures that relationship.

The expected change in the spot rate should equal the expected difference in inflation.

So for a long -term planner, a CEO looking at a 30 -year investment, how reliable is this idea?

This is the really powerful insight.

The nominal exchange rate, the one you see quoted every day, can go completely off the rails over decades.

But if you adjust for inflation, what we call the real exchange rate, it tends to be remarkably stable over the very, very long run.

It always comes back to some kind of equilibrium level.

It tends to, yes.

So if you're that CEO planning a factory for the next 20 years, you can't get caught up in the daily noise.

Your best, most stable strategic guess is that the real exchange rate will stay roughly constant.

That provides a solid anchor for long -range planning.

Fantastic.

Okay, fourth and final cornerstone, the link between interest rates and inflation.

This gets us to the international Fisher effect.

Sometimes called real interest rate parity.

And this one is driven by global capital.

Investors aren't dumb.

They're not just chasing high nominal interest rates.

They want high real returns.

The return you get after you account for how much of money lost in purchasing power due to inflation.

Right.

And since capital can flow pretty freely across borders these days, it's going to seek out the highest real return.

And that flow of capital is what forces expected real interest rates to be about the same across different countries.

So the formula just says that the difference in the nominal interest rates should be equal to the difference in the expected inflation rates.

Yep.

If the Ruritanian nominal rate is 15 .5 % and their inflation is 11 .1%, the real rate is about 4%.

If the U .S.

nominal rate is 5 % and our inflation is 1%, our real rate is also 4%.

Parity holds.

And this leads us to what you said is probably the most critical warning in the entire chapter for a corporate treasurer.

It absolutely is.

And it's a mistake people and companies still make.

Do not naively borrow in a currency just because it has a low interest rate.

It seems so tempting though.

Why would I take a loan at 15 .5 % in Ruritania when I can get one for 5 % of the U .S.?

Because that low nominal rate isn't free money.

It's a signal.

It reflects the market's expectation that that country will have low inflation and crucially that its currency is expected to appreciate in the future.

So whatever you save on the interest payments, you could lose.

You could lose all of that and much, much more when you have to buy that stronger, more expensive currency later on to pay back the principal and the interest.

And the textbook cautionary tale for this is the Polish mortgage crisis.

A truly painful real world example.

Thousands of Polish borrowers took out mortgages denominated in Swiss francs because the Swiss interest rates were incredibly low, you know, one or two percent.

Compared to much higher rates in Poland.

Right.

They thought they were getting a great deal.

But what they were actually doing was making a huge unhedged bet that the exchange rate would stay stable.

When the Swiss francs then soared by over 20 % against the Polish lotty, the size of their mortgage debt in zloty terms just exploded.

Their monthly payments shot through the roof.

Catastrophically so.

They didn't save money.

They engaged in massive currency speculation without even realizing it.

This proves that this kind of trade, the professional carry trade, is pure speculation.

A cautious manager avoids it.

OK, that's a powerful lesson.

So foundation built.

Let's talk about how a real company, let's use the Outland Steel example, actually puts this into practice.

How do they manage this risk?

Right.

So Outland is an exporter.

They know they're losing sales because they only invoice in US dollars.

But if they start accepting euros or yen, they're taking on currency risk.

If those currencies fall before they get paid, they lose money.

So this is where we need to separate risk into two distinct types.

We do.

The first is transaction exposure.

And this is the easier one to understand and to manage.

So what is it exactly?

Transaction exposure comes from a specific confirmed transaction that's denominated in a foreign currency.

For Outland, it's the accounts receivable from a German customer that's going to be paid in euros.

The exposure is perfectly clear.

If the euro falls by 1%, Outland's dollar revenue from that sale falls by 1%.

It's a one -to -one relationship.

So for every euro they're owed, they need to hedge one euro.

Exactly.

The hedge ratio is one.

And thanks to interest rate parity, they have two ways to do it that are financially identical.

One, they just sell the euros forward today to lock in the dollar price.

Simple.

And the second way.

The second way is they can borrow euros today, right now, convert those euros to dollars at the spot rate, and then invest those dollars.

When their customer pays them in euros later, they just use those euros to pay off the loan they took out.

IRP ensures the net result is exactly the same.

This brings us back to a really crucial point you made earlier.

The true cost of hedging.

Managers often get this wrong.

They see the forward rate is lower than the spot rate, and they think hedging is costing me money.

That is the number one misconception.

You are not comparing the forward rate you lock in to today's spot rate.

If you don't hedge, the rate you're going to get is the future spot rate, whatever that turns out to be.

So the real cost of hedging is the difference between the forward rate and what you think the spot rate will be in the future.

The expected spot rate, exactly.

And since the expectations theory tells us that, on average, over time, those two rates are basically the same, the long -term cost of hedging is effectively zero.

The takeaway for managers is crystal clear, then.

It is.

Hedging is free insurance in the long run.

It lets you eliminate a huge source of volatility so you can focus on running your business.

Okay, now for the much tougher, much broader category of risk,

economic exposure.

This is the one that keeps CEOs up at night, because this is risk that can affect the value of your entire company, even if you don't have a single direct transaction in a foreign currency.

How does that work?

Can you give us an example of how that broader risk plays out?

Let's stick with Outland Steel.

They compete with steel companies from all over the world, including Sweden.

Now, imagine the Swedish Krona suddenly depreciates by 20%.

All of the Swedish companies, their labor, their local supplies, their electricity, are in Krona.

When you translate those costs into dollars, they've just dropped by 20%.

They've become a much lower -cost producer overnight.

So even if Outland only sells its steel for U .S.

dollars, they're now competing against a Swedish firm that can afford to slash its dollar prices.

Outland will have to cut their prices, too, or lose market share.

Precisely.

Outland's long -term profitability, its entire enterprise value, is exposed to the Swedish Krona, a currency they don't even touch.

That's economic exposure.

So how on earth do you manage something that pervasive?

It's very difficult.

Measuring it is the first hurdle that often requires some pretty sophisticated statistical analysis.

But in terms of managing it, the first line of defense is operational hedging.

Which sounds like you're actually structuring the physical business to reduce the risk.

That's exactly what it is.

The goal is to structure your global operations so that your foreign currency revenues are naturally matched by foreign currency costs.

The book uses some great examples from Swiss companies.

They're perfect examples because the strong Swiss franc makes them incredibly exposed.

Look at a company like Nestlé, or the big reinsurer Swiss Re.

They are masters of operational hedging.

What do they do right?

They decentralize their production and costs to match their sales.

So if they have a lot of sales in the U .S., they also have a lot of costs in U .S.

dollars.

If the dollar weakens against the francs, their U .S.

revenues translate into fewer francs.

But their U .S.

costs also go down in franc terms.

They create a natural offset.

They made themselves relatively immune to currency swings.

Very much so.

Now contrast that with the Swiss luxury goods companies like Swatch or Richemont.

They had the opposite problem.

A massive problem.

A huge chunk of their production costs are in Switzerland.

In super strong Swiss francs.

But their sales are all over the world.

In dollars, yen, euros.

So when the francs appreciates, their costs soar, but their foreign revenues don't keep pace when converted back.

Exactly.

They have a huge structural mismatch.

They are highly exposed to an appreciating francs.

So if you can't fix it with operational hedging, what do you do?

Then you turn to financial hedging.

But it's tougher for economic exposure because you're not hedging a single known transaction.

You're hedging future forecasted sales and costs.

Richemont, for example, had a policy of using financial instruments to hedge up to 70 % of next year's forecasted currency exposure.

It's a much more strategic forward -looking process.

So the big takeaway here, which I think is the perfect bridge to our next section, is that the fact that you can hedge this risk, even if it's imperfectly, allows the manager to make a really important separation.

Yes, it allows you to separate the investment decision from the currency speculation decision.

And that is the absolute key to properly evaluating international projects.

Okay, let's unpack that.

This is where we get to the big capital investment decisions.

How do you calculate the NPV of a project in another country?

The core principle is firm.

You have to evaluate the investment as if you are going to hedge all the currency risk.

You must ignore any personal hunches you have about where exchange rates are going.

So we have two methods to do this, and they should give us the exact same answer.

Let's use the example from the book.

Roche, the Swiss pharmaceutical company, is thinking about building a plant in the United States.

Right.

So method one is discounting the foreign currency cash flows.

The project is in the U .S., so it's going to generate cash flows in U .S.

dollars.

The first step is to discount those dollar cash flows at the appropriate U .S.

dollar cost of capital.

Let's say the initial cost is $1 .3 billion, and the project's dollar cost of capital is 12%.

So you forecast all the future dollar cash flows, C1, C2, and so on, and you discount them all back to the present at that 12 % rate.

The book's calculation gives you a positive NPV of $513 million.

So from a U .S.

investor's perspective, it's a good project.

It creates value.

It does.

Then the very last step is simple.

You take that dollar NPV, the $513 million, and you convert it back to Roche's home currency, Swiss francs, using today's spot rate.

If the spot rate is 1 .2 francs to the dollar, the NPV is 616 million francs.

Notice, we didn't have to make a single forecast about future exchange rates.

Okay, now let's prove that this works by using the second method, which seems more complicated but gets to the same place.

Method two, hedging and discounting domestic currency cash flows.

This method makes the hedging explicit.

It forces us to calculate what Roche would be to receive in Swiss francs if they hedged every single future cash flow.

And this is where all our theories come together.

Step A is to calculate all the forward exchange rates we'll need.

And we do that using interest rate parity.

We need the U .S.

interest rate, say 6%, and the Swiss interest rate, say 4%, and the spot rate of 1 .2.

IRP tells us exactly what the one -year, two -year, and three -year forward rates must be.

So the one -year forward rate would be the spot rate 1 .2 times the ratio of the interest rates, 1 .04, 1 .06.

That gives us 1 .177 francs per dollar.

And notice what's happening.

Because the Swiss interest rate is lower, IRP dictates that the Swiss franc must be trading at a forward premium.

The dollar is expected to weaken.

That's the market balancing itself.

Okay, step B.

We calculate the hedged cash flows.

We just take our forecasted dollar cash flows for each year and multiply them by the forward rate for that specific year.

Exactly.

So the $400 million cash flow in year one multiplied by the 1 .177 forward rate gives us a guaranteed cash flow of 471 million Swiss francs.

You do that for every single year.

Now step C, and this is crucial, we need the right discount rate.

We can't use a 12 % dollar rate.

We use Swiss franc discount rate.

Right.

And since the Swiss interest rate is lower than the U .S.

one, the required return in francs must also be lower.

We use the exact same interest rate parity logic to convert the required rates of return.

So the Swiss required return, RCHF, will be equal to the U .S.

return of 1 .12 times that same ratio of interest rates, 1 .04 divided by 1 .06.

And that calculation shows that the appropriate risk -adjusted discount rate in Swiss francs is 9 .9%.

This is such a critical insight.

The discount rate is lower because we've already taken out the expected currency depreciation by using the forward rates on our cash flows.

You've nailed it.

So final step, step D.

You take your initial investment in francs and you discount all of your guaranteed hedged franc cash flows at that 9 .9 % franc cost of capital.

And what do you get?

An NPV of exactly 616 million francs.

The exact same answer.

The exact same answer.

It's the proof.

The investment decision is separate from the currency decision.

You can do the analysis in either currency, and as long as you are consistent, you will always get the same answer.

We should just touch on one last thing here.

How did they get that 9 .9 % franc discount rate in the first place?

This goes back to the basics of the capital asset pricing model, CAPM.

Risk is always measured relative to the investor's portfolio.

For Roche, the investors are Swiss.

Their benchmark is the Swiss market index.

So the risk of this U .S.

project, its beta, has to be measured against the Swiss market.

Exactly.

And this is interesting because a U .S.

investment is often less risky for a Swiss investor than it would be for an American one.

Because of diversification.

The U .S.

and Swiss markets don't move in perfect lockstep.

Right.

So you run the CAPM formula using Swiss inputs.

The Swiss risk -free rate plus the project's beta relative to the Swiss market times the Swiss market risk premium.

And in the books example, that calculation gives you exactly 9 .9%.

It all ties together perfectly.

Okay.

So we've navigated the market risk.

Let's move into the final and maybe scariest territory,

political risk.

This is the one that gives managers nightmares because it's not a market risk.

It's the risk that a government can just change the rules and wipe out your investment overnight.

And we're talking about anything from outright expropriation where they just seize your factory.

To more subtle things like imposing special discriminatory taxes on foreign companies or suddenly banning you from taking your profits out of the country.

So how do you even begin to assess this?

There are specialized consulting firms that do nothing but create political risk rankings.

The PRS group is one.

They'll rank Norway as number one.

Super stable.

And Venezuela as number 139.

Extremely risky and unpredictable.

But the best companies don't just measure the risk.

They actively try to mitigate it.

That's the key.

And the first way you do that is through operational structuring.

You basically design your foreign operation to be dependent on the parent company in ways that are hard for government to replicate.

Give us an example of how that dependency works as a shield.

Think about a high -tech plant.

The parent company ensures that the local factory is totally reliant on a constant stream of proprietary components or patented technology or complex software that's all controlled from headquarters.

If the local government seizes the factory, what have they got?

A building full of machines that don't work.

An empty shell.

It's useless without the inputs that only the parent company can provide.

The value is destroyed for everyone.

Another great tactic is integrating the supply chain across several countries.

Like Ford does with its global manufacturing.

A perfect example.

They make engines in one country, transmissions in another, and do final assembly in a third.

No single government can seize a complete standalone business.

They can only seize one piece of the puzzle, which is basically worthless on its own.

It's a brilliant defense.

It shifts the power back to the company.

Now, what about the financial side, financial structuring?

This is all about making it more painful for the government to break the contract than to honor it.

And you do this with international loans.

So if you're building that Costa Guana silver mine, you don't fund it all yourself.

Absolutely not.

You finance almost all of it with loans from a big syndicate of international banks from many different countries.

And the structure of the loan guarantee is the secret weapon.

How so?

The parent company's guarantee on that loan is written so that it is valid only if the Costa Guana government keeps its promises on taxes, ownership, and so on.

If the government breaks the contract, the parent firm can legally default on the loan.

And then what happens?

The banks go after the government?

The banks go after their money, and it completely poisons that country's reputation in the international credit markets.

No government wants to be blacklisted by the world's biggest banks just to grab one silver mine.

It's a very powerful deterrent.

And bringing in an organization like the World Bank adds another layer of protection.

An incredibly powerful layer.

Very few governments are willing to default on a loan that is financed or guaranteed by the World Bank or one of its agencies.

The diplomatic and financial fallout is just too severe.

Okay, so beyond financing, what about just getting your profits out of the country?

You have to be creative.

Governments are often more sensitive about big dividend payments than other forms of cash extraction.

So you might structure things so that profits are repatriated as interest payments on loans or as royalty payments for technology or as management fees for services.

They're just less politically charged.

And there's also the idea of transfer pricing, but that can be tricky.

It's very tricky and has to be done carefully.

This is where you adjust the prices on goods sold between the subsidiary and the parent to move cash.

It's legal within certain limits, but if you push it too far, tax authorities will see it as tax evasion.

Okay, and this leads us to the final, very emphatic warning about political risk.

A conceptual error that managers often make.

The biggest one.

Do not, under any circumstances, just use a casual fudge factor in your discount rate to account for political risk.

So if your normal discount rate is 10 % and you think there's a chance the government will seize your project, you can't just say, oh, it's risky, let's use a 20 % discount rate.

You cannot.

It's a mathematical sin.

And here's why.

The discount rate is for market risk, for beta.

Risk you can't diversify away.

Political risk, like expropriation, is usually a specific diversifiable event risk.

It's not correlated with the global market.

And using a higher discount rate penalizes future cash flows more heavily, which might not be where the risk actually lies.

Exactly.

So the correct way, the disciplined way, is to adjust the expected cash flow itself.

If you have a cash flow of $20 million, but you think there's a 50 % chance it gets expropriated, then your expected cash flow for your model is only 10 million.

And then you discount that 10 million at your normal 10 % risk adjusted rate.

That's how you do it.

It provides a much more accurate and conceptually sound NPV.

That's the mark of a truly professional global financial manager.

Okay.

What an incredible tour.

So we've completed our deep dive into international financial management.

Let's try to synthesize the biggest takeaways.

I think it comes down to the four cornerstones that provide the logic for everything.

Right.

Interest rate parity, which says interest rate differences have to equal the forward spot difference.

No arbitrage.

Then the expectations theory, which tells us that on average, hedging your currency risk over the long term should cost you nothing.

Then relative purchasing power parity, the idea that over the long haul, exchange rates will move to offset inflation differences.

That's your anchor for long -term planning.

And finally, the international Fisher effect, which warns you not to borrow in a currency just because its interest rate is low.

We also really hammered home the difference between transaction exposure, which is specific and easy to hedge, and that much broader economic exposure, where the best defense is often operational hedging, matching your costs and revenues across currencies.

And of course, the big valuation principle that the investment decision is separate from the currency decision.

Your NPV calculation has to be consistent.

And both methods, the foreign currency method and the hedge domestic currency method, will give you the exact same answer if you do it right.

Finally, with political risk, it's all about mitigation through smart structuring, both operationally and financially.

And please remember to adjust your expected cash flows, not your discount rate.

Absolutely.

And I think the final thought to leave you with is this.

If you're a manager and you're forced to make a very long -term forecast, say 15 or 20 years out, the single best, most defensible assumption you can make is that the real exchange rate will stay more or less constant.

Meaning that over that long period, the currency movements will pretty much wash out the differences in inflation.

Exactly.

And that simple, powerful principle can provide a stable anchor for your most important strategic decisions, even when the world feels incredibly volatile and unpredictable.

Excellent insights.

Fantastic tour through a very complex topic.

Thank you for joining us on this incredibly detailed deep dive into international financial management.

We look forward to seeing you next time.