International Short-Term Financing and Investment 251

(1 + e_y ⁾ > (1 + L ) 291

(1+f ) 300

(1+f ) 302

International Long-Term Financing, Capital Structure and the Cost of Capital 284

D = Z D, 283

E = Z 283

k = Z 289

International Long-Term Portfolio Investment 296

Rj,t = b 0,j + b 1, jR m,t + b 2,j$t + e j,t (11.40) 311

dL 319

dm ₁ -¹'—-¹'-²'"² --v-^"³ '-³ (1149) 319

+ 2ct(S 1, S ₄)w 4 +1 1 = 0 319

= 2w3 s ² (S3 ) + 2s(S 1 , S3 )w 1 + 2s(S2 , S3 )w2 320

+ 2s(S 3 , S₄ )w 4 +2 1 = 0 = 2w4 s ² (S4 ) + 2s(S 1 , S4 )w 1 + 2s(S 2 , S4 )w2 + 2s(S 3 , S4 )w 4 + 2 2 = 0 320

= w 1 + W2 + w 3 -1 = 0 320

w' = [w 1 w 2 w 3 w 4 2 1 2 2] and 331

Foreign Direct Investment 344

i 341

References 341

i 361

Index 363

^y KS_t

which reduces to

9.4 THE EFFECTIVE FINANCING RATE AND RATE OF RETURN

(1 + e_y ) = (1 + i_y )(1 + S) (9.10)

Thus

e_y= (1 + iy )(1 + S)-1 (9.11)

By ignoring the term iy S, an approximate formula for the effective financing rate would be

ey» iy + S (9.12)

which tells us that the effective financing rate is approximately equal to the foreign nominal interest rate plus the rate of change of the exchange rate. So, if ey < i_x, foreign currency financing would be cheaper than domestic currency financing and vice versa. The effective financing rate may be negative, implying that the borrower pays back fewer units of the base currency than the amount actually borrowed.

The effective financing rate can be looked upon from an ex ante perspective (before the fact) or from an ex post perspective (after the fact). At time t, the borrower does not know what the effective financing rate will be, because it depends on the percentage change in the spot exchange rate between t and t + 1: this is unknown at time t. Decisions taken at time t then have to be based on the expected or ex ante effective financing rate. At time t + 1, however, the change in the spot exchange rate is known and so is the effective financing rate. Hence, the actual or ex post effective financing rate is realised at time t + 1. The ex post rate tells the borrower whether or not his or her decision at time t was the right decision. The right decision is indicated by an effective financing rate that is lower than the domestic interest rate, which is the cost of financing in the base currency.

Changes in the spot exchange rate cause the effective financing rate, e, to be different from the nominal interest rate on the foreign currency, iy. By observing equation (9.11), we can consider the following possibilities:

1. If the foreign currency appreciates against the domestic currency (that is, the exchange rate rises, S > 0), then the effective financing rate will be higher than the nominal foreign interest rate (ey > iy).

2. If the exchange rate at time t + 1 is the same as at time t (that is, there is no change in the exchange rate, S = 0), the effective financing rate and the nominal foreign interest rate will be equal (ey = iy).

3. 259

   If the foreign currency depreciates against the domestic currency (that is, the exchange rate declines, S < 0), then the effective financing rate will be lower than the nominal foreign interest rate (ey < iy). If the (absolute) rate of change of the exchange rate is equal to the foreign interest rate (| S | = iy or S = -iy ), the effective financing rate will be zero (ey = 0). And if the (absolute) rate of change of the exchange rate is less than the foreign interest rate ( | S | < iy or S < -iy ), the effective financing rate will be negative (ey < 0).

All of the above-mentioned possibilities can be derived from equation (9.11) or equation (9.12). For example, for the effective financing rate to be zero, we require iy + S = 0, which implies that S = -iy or | S | = iy . The relationship between the effective financing rate and the nominal foreign interest rate can be represented diagrammatically. Figure 9.5 is a diagrammatic representation of equation (9.10), which plots (1 + e) on the vertical axis and (1 + iy) on the horizontal axis, so the term (1 + S) would represent the slope of the straight line relating the two variables. So, if S = 0, the straight line representing the rela­tionship would be OB, which has a slope of 1 and an equation given by 1 + e = 1 + iy. On this line, e and iy are equal. If S > 0 then the straight line would be OA, which is steep since it has a slope greater than 1. On this line, e is greater than i_y. If the exchange rate declines by more than the foreign interest rate (that is, S < —iy ), then the line would be OE, which has a negative slope, implying a negative e.

If i_y is taken to be the deposit rather than the borrowing rate, then the effec­tive rate of return may be written as

ry= (1 + i y )(1 + S)—1 (9.13)

or

ry» i y + S (9.14)