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OUTLINE FOR CHAPTER 13

• Understand Translation Exposure– How does translation exposure arise?– Definition– How do the Current and Temporal Methods

work?– What are the U.S. rules?– Calculation of exchange gains/losses

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Chapter 13 - Translation Exposure

• Arises because financial statements of foreign affiliates which are typically stated in foreign currencies need to be restated (translated) in terms of the currency of the parent

• Main purpose of translation - preparation of consolidated financial statements

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Translation Exposure

• Definition - Potential for an increase or decrease on the parent’s net worth and reported net income caused by a change in the exchange rate

• Operating exposure is more important (for financial managers) but in the real world translation exposure is quite important

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Translation Methods

• Methods we will discuss in class:

Current Rate - most prevalent in the world

Temporal Method

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Current Rate Method

• Assets and liabilities use current rate

• Income statement - use actual exchange rate for the day when revenues, expenses, etc. were incurred or use an appropriate weighted average exchange rate

• Dividends - use exchange rate in effect on date of payment

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Current Rate Method - Continued

• Equity - common stock and paid-in capital accounts use an appropriate historical rate

• In the U.S., translation gains / losses are put in a special account (Cumulative Translation Adjustment - CTA). When foreign affiliate is sold or liquidated gains or losses become realized

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Temporal Method (similar to the Monetary/Nonmonetary Method)• Monetary assets (cash, marketable

securities, accounts receivable, etc.) and monetary liabilities (current liabilities and long-term debt) use current exchange rate

• Nonmonetary assets (inventory, fixed assets, etc.) use appropriate historical rate

• Dividends - use exchange rate in effect on date of payment

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Temporal Method - Continued

• Income statement - In general use average exchange rate for period. For depreciation and cost of goods sold use appropriate historical rate

• Common stock and paid-in capital accounts use appropriate historical rate

• Gains / losses from translation go to current consolidated income

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U.S. Rules

• For each affiliate must figure out the functional currency

• Functional currency - currency of the primary economic environment in which the affiliate operates and generates cash flows

• See page 338 for more information in deciding what is the functional currency of the subsidiary.

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U.S. Rules - Continued• From page 340 of Multinational Business Finance

• If the financial statements of the foreign affiliate are in U.S. dollars no translation is required

• If the financial statements of the foreign affiliate are in the local currency and the local currency is the functional currency use the current rate method

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U.S. Rules - Continued• If the financial statements of the foreign affiliate

are in the local currency and the dollar is the functional currency use (remeasured by) temporal method

• If the financial statements of the foreign affiliate are in the local currency and neither the local currency nor the dollar is the functional currency, then financial statements are first remeasured into the functional currency by the temporal method and then translated by the current rate method

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U.S. Rules - Continued

• If a country has cumulative inflation of approximately 100 % over a 3 year period must use the temporal method

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Examples of Translation Methods

• Exchange rates:– Plant and equipment, common stock, long-term

debt, and inventory were acquired when the exchange rate was $ .06 / peso

– Right before devaluation the exchange rate was $ .05 / peso (at end of period)

– At start of the new period the rate is $ .04 / peso

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Current Rate Method Example

Accounts Pesos Value Before in$ (rate)

Value After in$ (rate)

Cash 6000 300 (.05) 240 (.04)

AccountsReceivable

12000 600 (.05) 480 (.04)

Inventory 12000 600 (.05) 480 (.04)

Net Plant 24000 1200 (.05) 960 (.04)

Total 54000 2700 2160

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Example ContinuedAccounts Pesos Value Before in $

(rate)Value After in $

(rate)Current L. 3000 150 (.05) 120 (.04)

L.T. Debt 9000 450 (.05) 360 (.04)

Capital St. 6000 360 (.06) 360 (.06)

Ret. Earn 36000 1980 1980

CTA (240) (660)

Total 54000 2700 2160

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Notes to Previous Example

• Dollar retained earnings are the sum of additions to retained earnings each year

• Assume a prior CTA account of (240)

• The additional loss of $ 420 = cash (-$ 60) + a.r. (-$ 120) + inv (-$ 120) + net plant (-$ 240) + c. liab. (+$ 30) + l.t. debt (+$ 90)

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Exchange Gain or Loss

• Formula for exchange gain or loss:

• ($ exposed assets - $ exposed liabilities) x (percentage change in the exchange rate)

• ($ 2700 - $ 600) (-.2) = - $ 420

• where exposed means that the $ value changes when the exchange rate changes

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Accounts Pesos Value Before in$ (rate)

Value After in$ (rate)

Cash 6000 300 (.05) 240 (.04)

AccountsReceivable

12000 600 (.05) 480 (.04)

Inventory 12000 720 (.06) 720 (.06)

Net Plant 24000 1440 (.06) 1440 (.06)

Total 54000 3060 2880

Temporal Method Example

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Accounts Pesos Value Before in $(rate)

Value After in $(rate)

Current L. 3000 150 (.05) 120 (.04)

L.T. Debt 9000 450 (.05) 360 (.04)

Capital St. 6000 360 (.06) 360 (.06)

Ret. Earn. 36000 2100 2100

Translationgain / loss

(60)

Total 54000 3060 2880

Example - Continued

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Notes to the Example

• The translation gain or loss would not be shown as a separate item. Retained earnings would be $ 2040.

• Translation loss = ( $ 900 - $ 600) (-.2) = - $ 60

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Comparison of Temporal and Current Rate Methods

• Note in this example the two methods give very different magnitudes of losses

• Can also have the situation where there are accounting losses (gains) but operating gains (losses)

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Managing Translation Exposure

• Balance Sheet Hedge - make $ exposed assets = $ exposed liabilities ( no matter what the exchange rate does there will be no accounting losses or gains)

• Creating a balance sheet hedge may and probably will reduce operating efficiency (may for example have too much inventory)

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Managing - Continued

• Under the temporal method in this example could borrow 6000 pesos and convert to dollars or buy inventory or plant and equipment

• Under the current rate method could borrow 42000 pesos and convert to dollars

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Rules in Other Countries

• Many countries make a distinction between an integrated foreign entity (foreign affiliate is an extension of the parent and cash flows of affiliate are highly related to cash flows of parent) and a self-sustaining foreign entity (basically cash flows of local affiliate are “independent” of those of the parent)

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Rules - Continued

• In many countries integrated foreign entities use the temporal method and self-sustaining entities use current rate method

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Homework - Chapter 13

• # 8 (do both the current rate method and the temporal method)

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OUTLINE FOR CHAPTER 14

• Calculation of WACC

• To understand the benefits of gaining access to global capital markets

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Chapter 14 - Global Cost and Availability of Capital

• When firms get access to global markets costs can be reduced as well as availability of funds increased.

• Benefits are potentially the highest for small firms and firms in illiquid or segmented markets.

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Review - Weighted Average Cost of Capital (WACC)

• Cost of the bundle of funds employed by the firm

• Kwacc = Ke (E/V) + Kd (1-T) (D/V)

where:

Kwacc is the weighted average after tax cost of capital

Ke is the risk adjusted cost of equity

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WACC - Continued

Kd is before tax cost of debt

T is the marginal tax rate

E is the market value of the firm’s equity

D is the market value of the firm’s debt

V is the total market value of the firm

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Cost of Equity (using Capital Asset Pricing Model)

• Ke = krf + βi (km-krf)

• Where– Ke = required/expected rate of return on equity

– Krf = rate of return on risk-free bonds

– Βi = systematic risk of firmi

– Km = required/expected rate of return on the market

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Beta

• B

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Review - Marginal Return on Capital Schedule (MRR)

• Suppose a firm has three projects with the following returns and initial costs:

Project Yield Cost

A .14 10 million

B .12 6 million

C .10 8 million

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MRR - Continued

14

12

10

Rate ofReturn

Budget

10 16 24

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Improving Market Liquidity

• Market liquidity: if a firm issues a new security will market price suffer and will a change in price of any if its securities elicit a big order flow

• It is assumed that a firm can not raise unlimited funds without the cost of those funds increasing even if firm maintains optimal capital structure

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Improving Market Liquidity - Continued

• Key idea: if a firm is able to get international sources of capital, it should have a lower marginal cost of capital at some point at least in the short-run (see diagram on page 385).

• A firm would raise funds both in international markets as well as domestic markets.

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Improving Market Liquidity - Continued

• As a result, the firm may be able to take on more projects which will add value.

• These benefits may be significant for firms residing in countries with illiquid capital markets

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Overcoming Market Segmentation

• Definition of market segmentation: Return/risk tradeoffs are different in various markets after adjusting for foreign exchange risk and political risk

• Likely a firm operating in a segmented market will have a higher marginal cost of capital than if it were in an integrated market

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Gains form Overcoming Market Segmentation

• See diagram on page 385 for these gains

• Markets are becoming more and more integrated so these gains are becoming less and less

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What Causes Market Segmentation

• (1) Information barriers (language, accounting principles, quality of disclosure) - foreign investors may not have access to good information and therefore may not want to invest in a market full of these barriers

• (2) Transaction costs (taxes, commissions, etc.) - if too high investors will go to other markets

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Causes - Continued• (3) Foreign exchange risk - if exchange

rates are too volatile or if currency depreciates too much, foreigners may not want to invest there

• (4) Small-country bias (volume too low for international investors, maybe an illiquid market)

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Causes - Continued

• (5) Political Risk - fear of government intervention (example - capital controls)

• (6) Regulatory barriers (excessive rules) - discourage investors from investing in that market

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Comparing Cost of Capital for Multinationals and Domestic Firms

• Read pages 393-397.

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OUTLINE FOR CHAPTER 15

• Crosslisting

• ADRs

• Sourcing Equity Abroad

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Chapter 15 - Sourcing Equity Globally

• Emphasis in this chapter are firms operating in less liquid or segmented markets

• Often US and UK firms source overseas to fund large foreign acquisitions and not for their existing domestic or foreign operations

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Crosslisting

• Listing your company shares on a foreign market

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Why Crosslist on Foreign Stock Exchanges

• (1) Improve the liquidity for existing shareholders by letting them trade in their home markets and currencies

• (2) Possibly have a favorable effect on share price if markets are segmented or illiquid

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Why Crosslisting - Continued

• (3) If a company wants to issue stock in the future in a particular market may want to crosslist now.

• (4) Might help if trying to acquire firms in foreign markets (if pay in stock, not cash)

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Why Crosslisting - Continued

• (5) Increase firm’s visibility and political acceptance to customers, suppliers, creditors and local governments - if there is local ownership the firm may be more popular

• (6) Create a secondary market for shares to reward employees

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Barriers to Crosslisting

• For non-U.S. firms the disclosure requirements for the SEC are tough and continuous

• May also need a continual program of investor relations

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ADRs

• Crosslisting usually done through depositary receipts (shares). In U.S. foreign shares are usually traded as American depositary receipts (ADRs)

• Negotiable certificates issued by a U.S. bank to represent foreign stock which are held in trust in foreign bank

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ADRs - Continued

• ADRs represent some multiple of the foreign stock

• ADRs sold, registered, and transferred in U.S. like any other stock

• Dividends paid in U.S. dollars• Can be sponsored (created by request of

foreign firm) or unsponsored (U.S. firm initiated process)

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ADRs - Continued

• Different levels of ADRs (see page 414)– Note with level III and 144a a firm can raise

new equity capital

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Major Markets to Crosslist

New York

Tokyo

London

Germany

Euronest (merged markets of Amsterdam, Brussels, and Paris)

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Sourcing New Equity Shares

• Examples:

(1) Sale of directed public share issue to investors in a foreign country. Would be underwritten in part by institutions in that country.

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Sourcing New Equity Issues - Continued

(2) Sale of Euro-equity issues - firm issues shares simultaneously in more than one market (could be domestic as well as foreign). Underwritten by an international syndicate. Examples include some privatizations of government owned businesses (British Telecom, British Steel, and Telefonos de Mexico))

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Sourcing New Equity Issues - Continued

• (3) Private Placement Under SEC Rule 144A– Sales often to insurance and investment

companies

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OUTLINE FOR CHAPTER 16

• Explaining optimal financial structure

• Understand some of the principles involved in sourcing debt overseas– General guidelines for issuing debt– Cost of foreign debt– International debt markets

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Chapter 16 – Financial Structure and International Debt

• Chapter discusses:

• (1) Optimal Financial Structure

(2) Guidelines for issuing debt

(3) Overview of some international debt markets

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Optimal Financial Structure

• Generally argued that a moderate amount of debt is good (tax advantage) but too much debt is bad (bankruptcy risk)

• Also WACC is effectively minimized over a range of debt (say 30% -60%) and not at some precise amount say 44 %

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Optimal Financial Structure for Multinationals

• From Chapter 11, one big advantage for U.S. multinationals or large non-U.S. multinationals is that they are able to raise “lots” of capital without the cost of these funds increasing much

• This is not the case for small domestic firms and most multinationals operating in small or illiquid markets

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Financial Risk Reduction through International Diversification

• Possible to argue that multinationals can have more debt because their cash flows are more diversified and hence less bankruptcy risk

• In reality, multinationals have less debt than comparable domestic firms after adjusting for size

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Financial Structure for Foreign Affiliates

• Goal for firm: minimize WACC for entire firm, not for each affiliate

• Note when discussing debt for a subsidiary what is relevant is debt borrowed from sources outside of the multinational firm (not debt from the parent or sister affiliate. Also hard to distinguish between debt and equity from the parent)

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Advantages to Conforming to Local D/E Ratios

• Reduce criticism from local Government officials or from others (for example, too much debt or too little debt)

• Easier to evaluate firm with local competitors when all firms have same capital structure

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Disadvantage of Conforming to Local D/E Ratios

• Multinational should exploit its advantages (one of them is its ability perhaps to have a lower cost of capital). If multinational tries to localize its cost of capital for each subsidiary, it may result in losing one of its key advantages

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Conclusion - Local D/E Ratios

• The firm should strive to have the lowest overall cost of capital for the firm as a whole

• If there is no penalty for conforming to local norms, then the firm should try and do so

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Guidelines for Issuing Debt• Maturity Matching

– Firm divides its assets in three categories - (1) fixed assets, (2) permanent current assets (the minimum amount of current assets the firm has), and (3) temporary current assets (total current assets - permanent current assets)

– In theory, could finance all fixed assets and permanent current assets with long-term debt and equity and temporary current assets with short-term debt (see diagram)

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Maturity Matching - Continued– In general, short-term financing is cheaper (rates

are generally cheaper and also firm does not have to pay interest when funds are not needed)

– However, short-term financing is riskier (interest rate risk)

– So firm may deviate from maturity matching depending on its return/risk tradeoffs (a conservative firm might use relatively more long-term financing)

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Guidelines - Continued

• Currency Matching - match by cash flows not denomination of assets– For example if the firm has a lot of cash flows

in Euros then might consider borrowing in Euros

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Cost of Foreign Debt

• Discussed in Chapter 4• Example - borrow 30 Pesos at 15%, spot rate

Pesos 15/$ and expect future rate to be Pesos 16/$• Cost in Dollars = (Pesos 30)(1.15)/(Pesos 16/$) -

$2 = $.15625 on a $2 loan or an interest rate of 7.8125%

• This approach is equivalent to formula• (1 + i*) (1 + s) - 1

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Cost of Foreign Debt - Continued

• Where

i* is the foreign interest rate

s is the percentage change in the exchange rate

• (1 + .15) (1 - .0625) - 1 = .078125

Note s = (15 - 16)/ (16) = -.0625

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Cost of Foreign Debt - Continued

• Interest payments are tax deductible in the U.S.

• Cost of debt after tax = kd (1-T)

Where

kd is the before tax cost of debt

T is the marginal tax rate for the firm

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Digression - Eurocurrency or Eurodollar Market

• A Eurodollar is a U.S. $ deposited in an interest bearing deposit in a bank outside of the U.S. (foreign bank, overseas branch of a U.S. bank, or an “offshore” entity called an International Banking Facility)

• Same idea for Euroyen

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Eurocurrency Market - Continued

• Good market to deposit excess funds and also borrow funds. The market can do this because it is a wholesale market, no reserve requirements, and no FDIC (Federal Deposit Insurance Corporation) fees. Hence the spread (difference between borrowing and deposit rates) is often less than 1%, which is smaller than most domestic markets

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Eurocurrency Market - Continued

• The market originally started with Eastern European countries with dollars wanting to deposit them outside the control of the U.S. government

• Also U.K. authorities worried about the weakening of the pound in 1957 imposed controls of U.K. banks lending pounds to non-residents, so U.K. banks started loaning dollars

• Now a source and use of dollars

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International Debt Markets• Three major sources

– Bank Loans and syndicated credits

– Euronote market

– International bond market

• Purpose of this section is to give an overview of these markets and not to provide all of the facts about each of the markets

• Please read for more detail pages 418-423

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Bank Loans and Syndicated Credits

• Eurocredits - Bank loans denominated in Eurocurrencies and given by banks in countries other than the country in which the loan is denominated (if the loan is in Yen the loan is not given in Japan)

• Syndicated credits - Lending banks form a syndicate to diversify risk because size of loans is usually large

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Eurocredits - Continued• Borrowing rate based on LIBOR (London

Interbank Offered Rate) which is the deposit rate on interbank loans

• Borrower pays LIBOR + individual premium

• Loans have short and medium-term maturities

• Usually fixed term and no provision for early repayment

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Euronote Market

• Important examples:

Euronotes - short-term, negotiable, promissory, underwritten notes

Euro-Commercial Paper – short-term debt obligation of a firm or bank

Euro-Medium-Term Notes - mostly nonunderwritten and it is like a bond

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International Bond Market

• Two main types:

Eurobonds

Foreign bonds

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Eurobonds

• Underwritten by an international syndicate• Sold in countries other than the country in

which the issue is denominated (example, English borrower, denominated in pounds, and sold everywhere but U.K.)

• Bearer form (name and country of residence of the owner not on coupon)

• Call provisions and sinking funds

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Advantages of Eurobond Market

• (1) Less regulatory interference (governments would impose less stringent requirements on bonds denominated in another currency)

• (2) Less stringent disclosure requirements than SEC (less of a factor for private placements – Rule #144A)

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Advantages - Continued

• (3) Possible tax advantages - no withholding taxes and since bonds are in bearer form may result in tax avoidance

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Foreign Bonds

• Underwritten by syndicate composed of members from one country

• Sold within that country

• Denominated in that currency

• Example: U.S. firm issues bond in pounds in U.K. and underwritten by a British syndicate