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International Business Finance

International Business Finance Assignment

1. A corporate treasury operations in Sydney simultaneously calls Westpac Bank in Sydney, Barclays in
London and Deutsche Bank in Frankfurt. The three banks give the following quotes at the same time:
Westpac, Sydney

Barclays, London

Deutsch, Frankfurt




Explain, using A$1 million, how the corporate treasury could make a triangular arbitrage profit with the
three exchange rate quotes. [20 marks]
All along till recent past, bank dealers used to quote all currencies against the USD while trading
among them. Now with expansion of global economy growing percentage of currency trades do not
involve the dollar. Foreign exchanges traders and speculators continuously seek to exploit the
exchange rate inconsistencies in different money centers. The exploitation involves buying a currency
in one market and selling in another. Arbitrage is the purchase and sale of equity/currency/commodity
etc. in different market to exploit the price differential. In currency market professional Arbitragers
quickly transfer fund from one currency to another and exploit discrepancies between exchange rate
in different markets. The process of arbitration also works through the foreign exchange market to
bridge interest rates in national markets. Even small discrepancies between the exchange rates and
interest rates in different markets triggers arbitrage and eliminate discrepancies quickly.
To understand the triangular arbitrage we need to understand the rationale behind this arbitrage
advantage. Cross rates are the exchange rates of 1 currency with other currencies, and those
currencies with each other. Cross rates are equalized among all currencies through a process called
triangular arbitrage. If these cross rates didn't equalize with other cross rates it would present an
arbitrage opportunity in the foreign exchange spot market. The major factor which affects the
triangular arbitrage is transaction cost among cross country transaction. If this transaction cost is
lesser than the arbitrage advantage then only its net gain to the client. Triangular arbitrage is a
process that keeps cross-rates (such as euros per British pound) in line with exchange rates quoted
relative to the U.S. dollar. A trader can conduct a triangular arbitrage in many ways. In other words,
instead of exchanging just two currencies, the trader exchanges three (hence the term triangular
arbitrage). For example if USD is my home currency i will first purchase Euro form certain amount of
USD, then i will convert it to Pound by selling same amount of Euro. Consequently i will again
purchase USD from same amount of pound. If at the end of transaction, USD which i received is
greater than the USD which i invested at the time of commencement, the difference is my gain and
If such transactions can be done profitably, the trader can generate pure arbitrage profitsthat is,
earn risk-free profits. Obviously, in perfectly competitive financial markets, it is impossible to earn
arbitrage profits for very long. If the USD price of the Euro were not equal to the USD price of the
pound multiplied by the pound price of the Euro, arbitrage activity would immediately restore equality
between the quoted cross-rate and the cross-rate implied by two dollar quotes.(USD/Euro) =
(USD/Pound) * (Pound/Euro). In other words, the direct quote for the cross-rate should equal the
implied cross-rate, using the dollar as an intermediary currency.


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There are, no doubt, many professionals and banks that have computers constantly calculating the
cross rates of all currencies. If there are any inequalities greater than transaction costs, then they will
be quick to close the gap between cross rates by routing home currency through different foreign
currency, because if they dont, someone else will grab that opportunity. One thing to be noted here
Arbitrages are profitable only if the cost incurred to perform transactions are lesser than the difference
that is exploited.
Now coming to our question, Corporate treasury operation in Sydney has Australian Dollar (A$) as its
home currency. To determine whether or not there is an arbitrage opportunity cross two of the rates
and compare the cross rate with the third rate. In this case let us cross A$/ and /. That will give us
cross A$/ = 1.2223*1.5100 = A$1.8457/.
The cross rate A$1.8457 is greater than the third rate which is 1.8410. That shows that there is an
arbitrage opportunity among given three currencies.
Now, We will understand how transaction will flow in Triangular Arbitrage and how it results in to profit.
we will do our calculation for A$1 Million and we will calculate gain as per following steps,

Firstly we convert A$100,000,0 to : 100,000,0/1.8410 = 5431,83

Then we Convert the 543,183 to : 543,183*1.5100 = 820,206
Subsequently we Convert 820,206 to A$ : 820,206*1.2223 = A$100,253,8
This depicts that we have made A$ 0.002538 on each Australian dollar traded as part of arbitrage
transaction. If we engage A$100,000,0 in to triangular arbitration transaction we can make A$2538 on
the spot. We can take an arbitrage advantage, only of we have taken the captioned

2. Calculate the cross rate between the Mexican peso (Ps) and the euro () from the following two spot
rates: Ps11.43/A$; 0.8404/A$. [5 marks]
The Cross rate is the exchange rate between two currencies implied by their exchange rates with
common third currency. For example in Japan all buy and sell transactions are routed through USD.
All deals other than a USD purchase or USD sale with respect to Yen would necessary involve
transaction involving USD. Thus If Japanese importer wishes to purchase Pound then he would have
to buy USD first and then they sell USD to buy Pound. The banker would obtain Pound/USD rate
from UK market and then apply the Yen/USD rate obtained from local market to arrive at exact Yen to
be given for purchase of Pound. Since the transaction involves two currencies we call such rate as
cross rates.
Thus a cross rate by definition involves transaction of any three currencies or more. When we have to
find the cross rates, we have to apply following formula.
After getting the cross rate If we consider the effect of premium charged by banker in form of
difference of Ask and Bid rate formula will be as follows,
Bid (A/B) =1/(Ask(B/A))


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However in given question Ask-Bid rate is not given and assumes as same we may calculate the
cross rate between the Mexican Peso and the Euro as follows,
A = Mexican Peso (Ps)
B = Euro ()
C = Australian Dollar (A$)
So, applying (A/B)=(A/C)*(C/B)
(PS/) = (Ps11.43/1A$)/ (0.8404/1A$)
= Ps11.43/ 0.8404
= Ps13.60/
So cross rate between Mexican Peso (Ps) and the Euro is Ps13.60/. It means if we consider Euro as
a home currency we get 13.60 Mexican Peso in exchange of 1 Euro.
If we consider Mexican peso as home currency cross rate is 0.0735/Ps. It means we get 0.0735 in
exchange of 1 Mexican Peso.

3. Calculate the forward discount on the Australian dollar (the Australian dollar is the home currency) if
the spot rate is A$1.8200/ and the 6-month forward rate is A$1.8000/ [5 marks]
A forward transaction is an agreement made today to exchange one currency for another, with the
date of the exchange being a specified time in the future often one month, two months, or some
other definitive calendar interval. The rate at which the two currencies will be exchanged is set today.
A forward contract between a bank and a customer calls for delivery, at a fixed future date, of a
specified amount of one currency against payment in another currency. The exchange rate specified
in the contract, called the Forward rate, is fixed at the time the parties enter into the contract.
Forward rate is specified by the bank by considering current interest cost on tax free bonds in the
country. It means, the forward rate is adjusted by including/reducing interest cost of that particular
duration to the spot rate.
Forward discount or Forward premium is relationship between forward and spot exchange rates. If
the forward price of the Pound in terms of Australian Dollars (that is, A$/) is higher than the spot
price of A$/, the Pound is said to be at a forward premium in terms of the Australian dollar.
Conversely, if the forward price of the euro in terms of dollars (A$/) is less than the spot price of A$/
, the pound is said to be at a forward discount in terms of the dollar. Please note, as with the terms
appreciation and depreciation, the terms forward premium and forward discount refer to the currency
that is in the denominator of the exchange rate. Because the forward premium and forward discount
are related to the interest rates on the two currencies, these premiums and discounts are often
expressed as annualized percentages. That is, the difference between the forward rate and the spot
rate is divided by the spot rate and then multiplied by the reciprocal of the fraction of the year over
which the forward contract is made. The result is then multiplied by 100 to convert it to a percentage.
% per annum forward premium or discount of an N day forward rate =


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((Forward-spot)/spot)*(360/N days)*100
Here, N is the number of days in the forward contract.
A$ is our home currency, so we need to find out its discount in respect to Pound.
Applying the above mentioned formula % of forward discount is
((1.8000-1.8200)/1.8200)*(360/180)*100 = -2.1978%.
So we can say that Australian Dollar quotes forward rate on forward discount of -2.1978% in respect
to pound in its 6 months forward.

4. How are foreign exchange transactions between international banks settled? Explain. [20 marks]
When a trade is agreed upon, banks communicate and transfer funds electronically through computer
networks. The most important interbank communications network is the Society of Worldwide
Interbank Financial Telecommunications (SWIFT), which began operations in Europe in 1973 and
is jointly owned by more than 2,000 member banks. The SWIFT network links more than 9,000
financial institutions in more than 200 countries. Banks use SWIFT to send and receive messages
pertaining to foreign exchange transactions, payment confirmations, documentation of international
trade, transactions in securities, and other financial matters. In particular, SWIFT is used to confirm
foreign exchange deals agreed upon on the phone. In 2010, SWIFTs global network processed close
to 4 trillion messages. After the verbal deal is electronically confirmed over SWIFT, the deal also has
to be settled. Citibank will transfer dollars to BNP Paribas in the United States, and Citibank will
receive euros from BNP Paribas in Europe. The transfer of dollars will be done through the Clearing
House Interbank Payments System (CHIPS), and the transfer of euros will be done through the
Trans-European Automated Real-time Gross Settlement Express Transfer (TARGET). Fedwire
is a real-time gross settlement (RTGS) system operated by the Federal Reserve System of the United
States. Fedwire links the computers of more than 7,000 U.S. financial institutions that have deposits
with the Federal Reserve System. Transactions of Fedwire instantly move dollar balances between
financial institutions.
After completion of foreign exchange transaction with domestic bank, Domestic bank has to settle his
account with foreign bank with whom, domestic bank has transacted on behalf o his client. The
settlement of a foreign exchange trade requires the payment of one currency and the receipt of
another. However, the settlement procedures described previously do not guarantee that the final
transfer of one currency occurs if and only if the final transfer of the other currency occurs as well.
Because foreign currency transactions often involve the payment systems of two countries in different
time zones, simultaneous exchange of currencies
When commercial banks do not have their own banking operation in a major financial centre, they
establish a correspondent relationship with a local bank to conduct trade financing, foreign exchange
services, and other activities on their behalves. Correspondent relationships allow a bank to service
its multinational corporate clients without having to locate their banking personnel in many countries.
However, the correspondent bank may not be able to give the same level of services as it would if it

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had its own facilities.The interbank market is a network of correspondent banking relationships, with
large commercial banks maintaining demand deposit accounts with one another, called
correspondent bank accounts. The correspondent bank Account network allows for the efficient
functioning of the foreign exchange market. As an example of how the network of correspondent bank
accounts facilitate international foreign exchange transactions, Consider a U.S. importer desiring to
purchase merchandise invoiced in guilders from a Dutch exporter. The U.S. importer will contact his
bank and inquire about the exchange rate. If the U.S. importer accepts the offered exchange rate, the
bank will debit the U.S. importers account for the purchase of the Dutch guilders. The bank will
instruct its correspondent bank in the Netherlands to debit its correspondent bank account the
appropriate amount of guilders and to credit the Dutch exporters bank account. The importers bank
will then debit its books to offset the debit of U.S. importers account, reflecting the decrease in its
correspondent bank account balance.
To facilitate dealing in foreign exchange, a bank in India may maintain account with banks abroad.
Similarly, some foreign banks may maintain accounts with banks in India.
There are mainly three types of accounts,

Nostro Account: In Latin Nostro means Our account with you. Nostro account is the account
maintained by the bank in India with the bank abroad. For Example, State Bank of India may
maintain an account with Citibank, New York. Obviously, the account would be in USD. All foreign
exchange transactions are routed through Nostro account.

Vostro Account: In Latin, Vostro means Your account with us . A foreign bank, say Citibank,
New York, may open rupee account with State bank of India.

Loro account: Lets Say that State bank of India is having an account with Citibank, New York.
Syndicate bank of India likes to refer to this account while corresponding with Citibank, it would
refer to it as Loro account, meaning their account with you, in Latin.

5. Many companies grant stocks and stock options to managers. Discuss the benefits and costs of using
this kind of incentive compensation scheme. [10 marks]
Ans. 5
Employee stock ownership occurs when the people who work for a corporation hold shares in that
corporation. In general, management experts believe that turning employees into shareholders
increases their loyalty to the company and leads to improved performance. Stock ownership also
offers employees the potential for significant financial rewards. For example, workers in several
fledgling high-technology companies have become millionaires by purchasing stock at the ground
floor and then watching the market price rise astronomically. Employee stock ownership takes a
number of different forms. Two of the most common forms are stock options and employee stock
ownership plans, or ESOPs. Different countries have their own set of guidelines and rules for ESOPs
under their Companies Act.
Stock options give employees the right to purchase a certain number of shares in the company at a
fixed price for a given period. The purchase price, also known as the strike price, is usually the
market value of the stock on the date that the options are granted. In most cases, employees must


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wait until the options are vested (usually four years) before exercising their right to buy shares at the
strike price. Ideally, the market value of the stock will have increased during the vesting period, so
that employees are able to purchase shares at a significant discount. The difference between the
strike price and the market price at the time the options are exercised is the employees' gain. Once
employees own stocks rather than options to buy stocks, they can either hold the shares or sell them
on the open market.
At one time, stock options were a form of compensation limited to top executives and outside
directors. But in the 1990s, fast-growing high-technology companies began granting stock options to
all employees in order to attract and retain top talent. The use of broad-based stock option plans has
since spread to other industries, as various kinds of businesses have tried to capture the dynamic
atmosphere of the high-tech companies.
Advantages of stock options:

The most visible advantage of ESOP to employee for company is that, it strengthens its Balance
sheet on books at the end of financial period. If company issues stock to general public as an
Initial Public offer, It owes money to the general public (being a stakeholder) after granting a
shares. Further, when any executive is working for company he is being paid from the company in
form of salary. Salary is claimed in Profit & Loss account which reduces profit of the company and
saves the tax. On other side it will reduces the fund outflow because in lieu of Cash/Bank
company has granted equity shares to employee. Which will ultimately adds to companys
networth and makes the company stronger on books

The most commonly cited advantage in granting stock options to employees is that they increase
employee loyalty and commitment to the organization. Employees become owners with a financial
stake in the company's performance. Talented employees will be attracted to the company, and
will be inclined to stay in order to reap the future rewards. But stock options also offer tax
advantages to businesses.

Options are shown as worthless on company books until they are exercised. Even though stock
options are technically a form of deferred employee compensation, companies are not required to
record options pending as an expense. This helps growth companies to show a healthy bottom

Once employees exercise their options, the company is allowed to take a tax deduction equal to
the difference between the strike price and the market price as compensation expense.

Disadvantage of stock option:

Critics of stock options claim that the disadvantages often outweigh the advantages. For one
thing, many employees cash out their shares immediately after exercising their option to buy.
These employees may want to diversify their personal holdings or lock in gains. In either case,
however, they do not remain shareholders very long, so any motivational value of the options is
lost. Some employees disappear with their newfound wealth as soon as they cash in their options,
looking for another quick score with a new growth company. Their loyalty lasts only until their
options mature.

Another common criticism of stock option plans is that they encourage excessive risk taking by
management. Unlike regular shareholders, employees who hold stock options share in the upside


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potential of stock price gains, but not in the downside risk of stock price losses. They simply
choose not to exercise their options if the market price falls below the strike price.

Another disclaim that the use of stock options as compensation actually places undue risk upon
unsuspecting employees. If large numbers of employees try to exercise their options in order to
take advantage of gains in the market price, it can collapse an unstable company's whole equity
structure. The company is required to issue new shares of stock when employees exercise their
options. This increases the number of shares outstanding and dilutes the value of stock held by
other investors. To forestall the dilution of value, the company has to either increase its earnings
or repurchase stock on the open market.

In general, ESOPs are likely to prove too costly for very small companies, those with
high employee turnover, or those that rely heavily on contract workers. ESOPs might also be
problematic for businesses that have uncertain cash flow, since companies are contractually
obligated to repurchase stock from employees when they retire or leave the company. Finally,
ESOPs are most appropriate for companies that are committed to allowing employees to
participate in the management of the business. Otherwise, an ESOP might tend to create
resentment among employees who become part-owners of the company and then are not treated
in accordance with their status.
There are several alternatives that solve some of the problems associated with traditional stock
options. For example, to ensure that the options act as a reward for employee performance, a
company might use premium-price options. These options feature an exercise price that is higher
than the market price at the time the option is granted, meaning that the option is worthless
unless the company's performance improves. Variable-price options are similar, except that the
exercise price moves in relation to the performance of the overall market or the stocks of an
industry group. To overcome the problem of employees cashing out their stock as soon as they
exercise their options, some companies establish guidelines requiring management to hold a
certain amount of stock in order to be eligible for future stock options.

6. It has been shown that foreign companies listed in the U.S. stock exchanges are valued more than
those from the same countries that are not listed in the U.S. Explain the reasons why U.S.-listed
foreign firms are valued more than those which are not. Also explain why not every foreign firm wants
to list stocks in the United States. [20 marks]
Ans. 6
To understand the answer to the above mentioned phenomenon, first we need to understand the
Cross Listing of Shares.
Cross listing of shares is when a firm lists its equity shares on one or more foreign stock
exchange in addition to its domestic exchange. Examples include: American Depositary
Receipt (ADR), European Depositary Receipt (EDR), International Depository Receipt (IDR)
and Global Registered Shares (GRS). Generally such a company's primary listing is on a stock
exchange in its country of incorporation, and its secondary listing(s) is on an exchange in another
country. Cross-listing is especially common for companies that started out in a small market but grew


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into a larger market. For example, numerous large non-U.S. companies are listed on the New York
Stock Exchange or NASDAQ as well as on their respective national exchanges such
as Enbridge, BlackBerry Ltd, Statoil, Ericsson, Nokia, Toyota and Sony.
Reason why U.S. listed Foreign firms are valued more than those which are not :
Most studies (for example, Miller, 1999) find that a cross-listing on a U.S. stock market by a non-U.S.
firm is associated with a significantly positive stock price reaction in the home market. This finding
suggests that the stock market expects the cross-listing to have a positive impact on firm value.
Doidge, Karolyi, and Stulz (2004) show that companies with a cross-listing in the United States have
a higher valuation than non-cross-listed corporations, especially for firms with high growth
opportunities domiciled in countries with relatively weak investor protection. The premium they find is
larger for companies listed at official US stock exchanges than for over-the-counter listings and
private placements. Doidge, Karolyi, and Stulz (2004) argue that a cross-listing in the United States
reduces the extent to which controlling shareholders can engage in expropriation (through "bonding"
to the high corporate governance standards in the United States) and thereby increases the firms
www.crosslisting.com), shows that the listing premium for cross listing has evaporated, due to new
U.S. regulations and competition from other exchanges. Some recent academic research finds that
smaller foreign firms seeking cross listing venues may be opting for UK exchanges over U.S.
exchanges due to the costs imposed by the Sarbanes-Oxley Act. On the other hand, larger firms
seeking "bonding" benefits from a U.S. listing continue to seek a U.S. exchange listing.
However, there are many cross-listings on exchanges in Europe and Asia. Even U.S. firms are crosslisted in other countries. In the 1950s there was a wave of cross-listings of U.S. firms in Belgium, in
the 1960s in France, in the 1970s in the U.K., and in the 1980s in Japan (see Sarkissian and Schill,
2014). Roosenboom and van Dijk (2009) analyze 526 cross-listings from 44 different countries on 8
major stock exchanges and document significant stock price reactions of 1.3% on average for crosslistings on US exchanges, 1.1% on London Stock Exchange, 0.6% on exchanges in continental
Europe, and 0.5% on Tokyo Stock Exchange. These findings suggest that cross-listings on AngloSaxon exchanges create more value than on other exchanges. They also highlight the incomplete
understanding of why firms cross-list outside the UK and the United States, as many of the
arguments discussed above (enhanced liquidity, improved disclosure, and bonding) do not apply. In
this respect, Sarkissian and Schill (2014) show that cross-listing activity in a given host country
coincides with the outperformance of host and proximate home countrys economies and financial
markets, thus, highlighting the market timing component in cross-listing decisions.
Benefits of Cross Listing:
The benefits of cross-listing may not be limited just to the firms that cross-list. Fernandes (2009)
shows that firms in the home country that do not cross-list but that are correlated with stocks that do
(for example, because they are in the same industry) may also experience positive price effects. In
this case, the benefits of ADR issues may spill over into the local market.
1 ) Reduction of Cost of Capital :

Liquidity :


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It is now widely recognized that liquidity is priced in stocks. More liquid stocks have lower
expected returns and hence higher prices than less liquid stocks. Thus, cross-listing on a larger,
more liquid market that lowers transaction costs for investors and improves liquidity induces lower
expected returns and, hence, increases the stock price. While there is a debate about the relative
importance of this liquidity effect, research has shown that typically, after listing abroad, stocks
experience an increase in total trading volume and a significant decrease in home market bidask
spreads, due in large part to competition from the new market. If trading in the foreign market also
leads to more efficient price discovery and fewer opportunities to exploit insider trading, there is
an additional benefit to cross-listing. Indirectly, the fact that the price effects of U.S. companies
listing in Toronto, Tokyo, or European exchanges are small shows that liquidity is an important
benefit of cross listing. Nevertheless, some policymakers are quite concerned about possible
adverse effects of multimarket trading. If cross-listing causes trading to migrate to the new market,
firms that do not cross-list may become even less liquid as the home market traders and other
people working on the local exchange are made worse off. Halling et al. (2008) found that local
turnover increases for cross-listing firms based in developed markets but decreases for firms
based in emerging markets.

Wider Shareholder Base

The listing of an ADR is usually thought to widen a corporations shareholder base, and this in
itself may generate a price effect. Merton (1987) developed a theory in which investors consider
only a subset of the available securities when constructing their portfolios. They may be unaware
of the other securities because of information problems, for example, or because the costs of
trading these stocks might be prohibitive. In this case, stocks with a wide shareholder base are
less risky, have lower expected returns than stocks with narrow shareholder bases, and receive
higher prices. If cross-listing through a depositary receipt literally expands the shareholder base,
we should see an increase in stock price and lower expected returns going forward. This
argument is particularly important because institutional investors in various countries are often
restricted either legally or through their charters with respect to their foreign investments.
However, cross-listed securities are often viewed as domestic investments and, hence, may be
the only way that some institutional investors may diversify internationally.

Market Integration
Markets are integrated when securities of similar risk have the same expected returns, whatever
the market in which they trade. A firm located in a country that is not fully integrated in the world
capital markets typically faces a higher cost of capital because the firms equity risk has to be
borne mostly by investors in its own country. If the firm finds a way to make it less costly for
foreign investors to hold its shares, these investors share some of the firms risk, and therefore,
the cost of capital falls. Investment barriers segment domestic capital markets from global capital
markets. Investment barriers are usually grouped into direct and indirect barriers. Direct
barriers comprise regulatory frictions from foreign exchange controls, foreign ownership
restrictions, taxes, and trading costs. By cross-listing in a foreign market, a firm makes its shares
more accessible to foreign investors, which can be viewed as a liberalization of the domestic
equity market. In some cases, the government literally relaxes restrictions for cross-listing stocks
in order to facilitate cross-border arbitrage between the stock prices in the local and foreign
markets. For example, even though Chile imposed capital flow and dividend repatriation
restrictions on foreign investors in the mid 1990s (that is, foreigners could not repatriate capital or
dividends for at least 1 year after the initial investment), these restrictions were lifted for the many
Chilean companies cross-listing in the United States during that time. The opposite occurs as
well. When Brazil introduced a 2% tax on foreign bond and stock purchases in 2009 to dampen


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capital inflows, Brazilian ADRs suddenly became especially attractive. However, the Brazilian
authorities proceeded to levy a tax on the ADR issuing company when the shares are deposited
with CETIP, Brazils custodial agency. If the Brazilian companies pass on the extra cost to the
(overseas) buyers of the shares, the good deal on ADRs should disappear. To sum up, crosslisting should lead to higher prices upon announcement of the listing and lower expected returns
afterward. Consistent with this hypothesis, firms from emerging markets typically experience
larger cross-listing price effects than firms from developed markets because emerging markets
are more likely to be segmented from world capital markets.

Corporate Governance Signal

Indirect barriers can be reduced through better corporate governance. In corporate finance theory,
it is now generally accepted that many firms are plagued by agency problems where controlling
shareholders or managers try to appropriate funds from the firms. These private benefits of
control may lead a firm to make suboptimal decisions (for its shareholders) with respect to
investment, recruiting, and so on. In countries with poor investor protection and poor accounting
standards, which includes not only emerging markets but also many European countries, these
private benefits of control may be substantial and can depress stock prices. When a firm crosslists in a market with better investor protection, accounting standards,and disclosure
requirements, firms commit themselves to an increased level of monitoring of both management
and controlling shareholders. If they list in the United States, they also subject themselves to the
litigious U.S. legal system. The reduction in deadweight costs resulting from agency problems
increases the present value of future cash flows. The signal of improved management quality that
the listing brings lowers the corporate governance discount,allowing the firm to face a lower cost
of capital going forward. This kind of reasoning, known as the bonding hypothesis, played a
major role in the NYSE listing of Kookmin Bank, the largest Korean bank, in November 2001.

2) Capital Needs and Growth Opportunities

Companies in emerging markets and small countries often outgrow their home markets and use
cross-listing to raise capital to continue to grow. In addition, the worldwide privatization boom
mentioned earlier created very large companies in very capital-intensive sectors, such as
telecommunication, energy, and transportation. The size of these companies, compared to their
home markets, virtually required that they raise capital outside their home countries. Fast-growing
emerging markets and their firms remain capital hungry. Companies that face constraints in the
external financing markets can invest more only if they can generate more internal cash flows.
Such a constrained firms real investments will then be sensitive to cash flow growth. Financing
constraints are most likely to exist in less financially developed markets. Both access to foreign
investment banks with the ability to certify the quality of a deal and greater competition among
providers of underwriting services help to reduce the cost of raising external capital. An Analyst
assert that almost half of the increase in firm value from U.S. cross-listing is attributable to an
increase in growth expectations.
3) Other Benefits of Cross-Listing
When SAP, a German-based software company, listed on the NYSE in 1999, it not only wanted to
enhance shareholder value, but also wanted to strengthen its commercial profile in the United
States. A foreign firm that has a U.S. customer base can increase brand awareness through a
cross-listing, given the road show and publicity it entails and the continued increased media
attention a listed security garners. Pagano et al. (2002) found that firms with cross-listings
subsequently see their foreign sales as a percentage of total sales increase by approximately
20%. Of course, it might be the case that the firms cross-listed because they planned to expand
their international activities and desired access to international capital markets to facilitate the

- 10 -

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expansion of their operations. Increasingly, ADRs play a role in cross-border acquisitions. Finally,
ADRs may help in the human resource departments because they make it easier to set up a stock
or stock option remuneration plan for top talent working in the United States.
The reason why every firms do not want to list their shares in the United States:
a) There are also studies, however, such as Sarkissian and Schill (2009), who argue that crosslistings do not create long-term valuation benefits. There are however, also disadvantages in
deciding to cross-list: increased pressure on executives due to closer public scrutiny; increased
reporting and disclosure requirements; additional scrutiny by analysts in advanced market
economies, and additional listing fees. Some financial media have argued that the implementation
of the Sarbanes-Oxley act in the United States has made the NYSE less attractive for crosslistings, but recent academic research finds little evidence to support this, see Doidge, Karolyi,
and Stulz (2007).
b) As we have said, listing on a foreign exchange is not costless. There are direct one-time
costs,such as registration and listing fees, and there are the perennial costs of additional reporting
and disclosure requirements. These latter factors are the primary inhibitors that keep more
companies from listing abroad.
c) When Daimler-Benz cross-listed its stock on the NYSE, it was not happy to find out it had to
disclose the pay packages of its management. German and Swiss firms also tend to smooth
reported earnings using various hidden accounting reserves; they cannot do this under U.S.
d) Among other things, smooth earnings help to reduce taxes when tax rates are progressive,
Doidge et al. (2004) argue that cross-listing, while good for a firm, may not be beneficial for the
controlling shareholders who may have to give up some of their private control benefits through
the disclosure that is required under U.S. GAAP. By listing in the United States, a foreign firm
increases the rights of its shareholders, especially its minority shareholders. It also constrains a
controlling shareholders ability to extract private benefits from control. From this perspective, it is
not surprising that not every large foreign firm cross-lists in the United States.
Which firms cross-list? : It seems likely that cross-listing will be done by firms with good growth
opportunities that need funds to invest but find it difficult to finance their growth with internal funds or
through debt. In these firms, the private benefits of control are relatively modest, and the controlling
shareholders benefit from the firms growth. Consequently, the growth opportunities of cross-listed
firms should be valued more highly because they can better take advantage of these opportunities
and because a smaller part of the cash flows of these firms is expropriated by controlling

7. Read the mini case below and answer the question that follows:
Shrewsbury Herbal Products, located in central England close to the Welsh border, is an old-line
producer of herbal teas, seasonings, and medicines. Its products are marketed all over the United
Kingdom and in many parts of continental Europe as well.
Shrewsbury Herbal generally invoices in British pound sterling when it sells to foreign customers in
order to guard against adverse exchange rate changes. Nevertheless, it has just received an order
from a large wholesaler in central France for 320,000 of its products, conditional upon delivery being

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International Business Finance

made in three months time and the order invoiced in euros.
Shrewsburys controller, Elton Peters, is concerned with whether the pound will appreciate versus the
euro over the next three months, thus eliminating all or most of the profit when the euro receivable is
paid. He thinks this is an unlikely possibility, but he decides to contact the firms banker for
suggestions about hedging the exchange rate exposure.
Mr. Peters learns from the banker that the current spot exchange rate is / is 1.4537, thus the
invoice amount should be 465,184. Mr. Peters also learns that the three-month forward rates for the
pound and the euro versus the U.S. dollar are $1.8990/1.00 and $1.3154/1.00, respectively. The
banker offers to set up a forward hedge for selling the euro receivable for pound sterling based on the
/ forward cross-exchange rate implicit in the forward rates against the dollar.
What would you do if you were Mr. Peters? [20 marks]


To understand the solution of above mentioned case we need to understand certain terms,
A forward transaction is an agreement made today to exchange one currency for another, with the
date of the exchange being a specified time in the future often one month, two months, or some
other definitive calendar interval. The rate at which the two currencies will be exchanged is set today.
A forward contract between a bank and a customer calls for delivery, at a fixed future date, of a
specified amount of one currency against payment in another currency. The exchange rate specified
in the contract, called the Forward rate, is fixed at the time the parties enter into the contract.
Forward rate is specified by the bank by considering current interest cost on tax free bonds in the
country. It means, the forward rate is adjusted by including/reducing interest cost of that particular
duration to the spot rate.
If you owe someone foreign currency at some date in the future, you can buy the foreign currency
forward by contracting to have a bank deliver a specific amount of foreign currency to you on the
date that you need it. At that time, you must pay the bank an amount of domestic currency equal to
the forward rate (domestic currency per foreign currency) multiplied by the amount of foreign
currency. Because the total amount you would owe the bank is determined today, it does not depend
in any way on the actual value of the future exchange rate. Thus, using a forward contract eliminates
transaction exchange risk.
Similarly, if you are scheduled to receive some foreign currency on a specific date in the future, you
can sell it forward and entirely eliminate the foreign exchange risk. You contract to have the bank
buy from you the amount of foreign currency you will receive in the future on that date in the future.
Your forward contract establishes today the amount of domestic currency that you will receive in the
future, which is equal to the forward exchange rate (domestic currency per foreign currency)
multiplied by the amount of foreign currency you will be selling. The amount of domestic currency that
you receive in the future consequently does not depend in any way on the future spot exchange rate.
Notice that in both cases, you have completely hedged your transaction exchange risk. Basically, you
eliminate your risk by acquiring a foreign currency asset or liability that exactly offsets the foreign
currency liability or asset that is given to you by your business.

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International Business Finance

The Costs and Benefits of a Forward Hedge
In light of the discussion of hedging transaction exchange risk, what is the appropriate way to think
about the cost of a forward hedge? First, it is important to ascertain when the cost is computed. Are
we looking ex post (after the fact) and examining whether we paid more or less with our forward
contract than we would have paid had we waited to transact at the realized future spot rate? Or are
we thinking of cost in an ex ante (before the fact) sense, in which case we have to examine the
expected cost? In the latter case, you should remember that if you do not hedge, you will bear the
foreign exchange risk, and the actual exchange rate at which you will transact in the future is very
likely not going to be the expected future spot rate. If you are buying foreign currency with domestic
currency because your underlying transaction gives you a foreign currency liability, you will be glad to
have hedged ex post if the future spot rate (domestic currency per foreign currency) is above the
forward rate. You will have regrets ex post if the future spot rate is below the forward rate. When you
are trying to determine whether to hedge, how the forward rate relates to the expected future spot
exchange rate dictates whether there is an expected cost or an expected benefit to hedging. If you
are buying foreign currency because your underlying transaction gives you a foreign currency liability,
you will think that there is an expected cost to hedging if the expected future spot rate of domestic
currency per unit of foreign currency is below the forward rate (domestic currency per foreign
currency). Hedging would require you to transact at a domestic currency price higher than you expect
to have to pay if you do not hedge. Conversely, you will think there is an expected benefit to hedging
if the expected future spot rate (domestic currency per foreign currency) is above the forward rate. In
this case, hedging allows you to purchase foreign currency with domestic currency more cheaply than
you would have expected to have to pay. Of course, complete hedging removes all potential benefits
as well as all possible losses.
One frequently encountered argument against hedging is that it is costly, so firms should avoid doing
it. People who make this argument often have in mind an incorrect notion of the cost of hedging. They
argue that if the firm is selling foreign currency in the forward market, a forward discount on the
foreign currency is a cost of hedging because the domestic currency forward price of foreign currency
is less than the spot price. Conversely, a forward premium is viewed as providing a benefit or profit
from hedging when the firm is selling foreign currency forward. In contrast, a forward premium is
thought to increase the costs of the firm if it is buying foreign currency in the forward market. We
noted that the argument is incorrect because it reflects an irrelevant accounting perspective on the
nature of costs rather than an appropriate economic perspective. We know that the forward rate
differs from the current spot rate because of differences in interest rates. The foreign currency cash
flow is occurring in the future, not today. This makes the current spot rate irrelevant when it comes to
valuing the future foreign currency cash flow unless the cash flow is first discounted to the present.
If I am at place of Mr.Peters my Suggested Solution to Shrewsbury Herbal Products, Ltd.
Suppose Shrewsbury sells its herbal products at 20% markup on sale value. Thus the cost to the firm
of the 320,000 order is 256,000. Thus, the pound could appreciate to 465,184/256,000 =
1.8171/1.00 before all profit was eliminated. This seems rather unlikely and on very aggressive
Nevertheless, a ten percent appreciation of the pound (1.4537 x 1.10) to 1.5991/1.00 would only
yield a profit of 34,904 (= 465,184/1.5991 - 256,000).
Both the above examples are on the basis of assumption of profit margin and appreciation of pound.
In real scenario if company wants to secure his receivable from exchange rate function It should go

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International Business Finance

for hedging by booking a forward contract to sell Euro to the bank and receives pound in return at the
expiry of 3 months. Shrewsbury can hedge the exposure by selling the Euro forward for British
pounds at 3M forward (/) = 3M forward ($/)3M forward ($/) = 1.8990 1.3154 = 1.4437. At this
forward exchange rate, Shrewsbury can lock-in a receivable of 322,217 (= 465,184/1.4437) for
the sale. The forward exchange rate indicates that the Euro is trading at a premium to the British
pound in the forward market. Thus, the forward hedge allows Shrewsbury to lock-in a greater amount
i.e 2,217 (322217-320000) than if the euro receivable was converted into pounds at the current
spot. If the euro was trading at a forward discount, Shrewsbury would end up locking-in an amount
less than 320,000. Whether that would lead to a loss for the company would depend upon the extent
of the discount and the amount of profit built into the price of 320,000. Only if the forward exchange
rate is even with the spot rate will Shrewsbury receive exactly 320,000.
Obviously, Shrewsbury could ensure that it receives exactly 320,000 at the end of three-month
accounts receivable period if it could invoice in . That, however, is not acceptable to the French
wholesaler. When invoicing in euros, Shrewsbury could establish the euro invoice amount by use of
the forward exchange rate instead of the current spot rate. The invoice amount in that case would be
461,984 = 320,000 x 1.4437. Shrewsbury can now lock-in a receipt of 320,000 if it simultaneously
hedges its euro exposure by selling 461,984 at the forward rate of 1.4437. That is, 320,000 =
461,984/1.4437. This option can be opted if same is acceptable to French wholesaler too. This
simply means if company does not wants to make extra profit from hedging transaction he has to
book forward contract for lesser amount i.e 461,984 than invoice amount.
As instructed by bank and French wholesaler, if client invoices bill for 465184, company should
definitely book a forward contract with bank which gives him gain of 2,217 over and above his
normal profit. Nevertheless, It is assumption that transaction cost of booking forward contract is Nil.

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