Foreign currency discount rates computation involves determining an appropriate discount rate to use when evaluating cash flows denominated in a foreign currency, typically for international project investments or valuations. The key to this computation is to reflect the risk profile, interest rate environment, and currency-specific factors related to the foreign currency and market.
Basic Principle
• When you have future cash flows in a foreign currency, you discount them using a discount rate that corresponds to that foreign currency’s risk characteristics and interest rates.
• This discount rate generally includes a risk-free rate for the foreign country plus a risk premium reflecting additional risks such as political, economic, and currency risks.
How to Compute Foreign Currency Discount Rates
1. Start with the Foreign Risk-Free Rate
Use the yield on government securities or bonds of stable maturity (e.g., 10-year government bonds) denominated in the foreign currency as the baseline risk-free rate.
2. Add a Risk Premium for Country and Project-Specific Risks
Add a premium that reflects the investment’s risk above the risk-free rate. This usually covers political risk, economic instability, inflation differences, and operational risks associated with the foreign market.
3. Consider Currency Risk
Since the cash flows are exposed to exchange rate fluctuations, the discount rate may include an additional currency risk premium unless these risks are hedged or otherwise accounted for separately.
4. Use Interest Rate Parity to Inform Discount Rate
Interest Rate Parity (IRP) links the foreign and domestic discount rates through the relationship between spot and forward exchange rates:
Ff/d / Sf/d = (1 + if) / (1 + id)
Where:
• Ff/d is the forward exchange rate
• Sf/d is the spot exchange rate
• if is the foreign interest (discount) rate
• id is the domestic interest (discount) rate
This implies the foreign discount rate can be inferred if the domestic discount rate and exchange rates are known.
5. Risk-Adjusted Discount Rate Models
Applying models like the Capital Asset Pricing Model (CAPM) to the foreign market, incorporating beta relevant to the foreign market, can help estimate cost of equity as part of the discount rate.
Practical Steps for Computation
• Identify the appropriate foreign risk-free rate (e.g., government bond yield).
• Estimate country risk premium based on political, economic, and currency risk factors.
• Calculate or estimate the cost of equity and cost of debt for the foreign project if applicable; then compute a weighted average cost of capital (WACC) in the foreign currency.
• Incorporate adjustments for inflation differentials if necessary.
• Use forward and spot exchange rates with domestic discount rates to cross-check and adjust the foreign discount rate through interest rate parity.
Example
Suppose you are evaluating a project with cash flows in a foreign currency. The foreign country’s 10-year government bond yield is 4%, and you assess a country risk premium of 3% due to political and economic instability. The foreign currency discount rate would be:
4% (risk-free) + 3% (risk premium) = 7%
If the domestic discount rate is 5%, and forward/spot exchange rate data indicate a certain forward premium or discount, you can adjust this 7% slightly according to interest rate parity to maintain consistency in valuation.
Conclusion
In conclusion, foreign currency discount rates are computed by combining the foreign risk-free interest rates with relevant risk premiums and considering currency risk. Interest rate parity and risk-adjusted models often guide the estimation to ensure the discount rate reflects the total economic and financial risk of foreign cash flows accurately. This approach ensures proper valuation and capital budgeting decisions in international investments.
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