Chapte
20
Slides Developed by:
Terry Fegarty
Seneca College
International Financial
Management
Chapter 20 – Outline (1)
• Growth in International Business
 Multinational Corporations
 International Business is Different
• Currency Exchange
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The Foreign Exchange Market
Exchange Rates
Changing Exchange Rates and Exchange Rate Risk
Spot and Forward Rates
Hedging with Forward Exchange Rates
Supply and Demand—The Source of Exchange Rate
Movement
© 2006 by Nelson, a division of Thomson Canada Limited
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Chapter 20 – Outline (2)
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Why the Exchange Rate Moves
Government Influence on Exchange Rates
International Monetary System
Convertibility
• Managing International Working Capital
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International Trade Credit
Foreign Bank Loans
Global Cash Management
International Money Market Investments
Foreign Receivables
© 2006 by Nelson, a division of Thomson Canada Limited
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Chapter 20 – Outline (3)
• International Capital Markets
 The International Bond Market
 The International Stock Market
• Foreign Direct Investments
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Why Make a Foreign Direct Investment? (FDI)
Analyzing a Proposed FDI
Political Risk
Foreign Exchange Risks
© 2006 by Nelson, a division of Thomson Canada Limited
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Growth in International Business
• Canada does more business with other
countries than ever before
 Top 10 in exports and imports
 Canada/US trade is largest
• Nature of our international business has
changed
 Now includes licensing and franchising, foreign joint
ventures, foreign affiliates
• Financial markets are increasingly international
 Common to own foreign stocks and bonds (portfolio
investments)
© 2006 by Nelson, a division of Thomson Canada Limited
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Multinational Corporations
• Many Canadian companies are now multinational corporations (MNCs)
 May set up or buy a foreign affiliate to produce
goods in another country
 Wholly owned subsidiary—MNC owns 100% of
foreign affiliate
 Together with partners, may set up a foreign joint
venture
• Foreign affiliates and joint ventures are foreign
direct investments
© 2006 by Nelson, a division of Thomson Canada Limited
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Growth in International Business
Methods of Doing
International Business
Import
Export
Licensing, Franchising
Arrangements
Open a
Foreign Branch
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Joint Ventures
Foreign Affiliates
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International Business is Different
• Differences in political systems, economic
systems, legal systems, language,
culture, economic development, local
practices
• Government intervention
• Foreign exchange risks
© 2006 by Nelson, a division of Thomson Canada Limited
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Currency Exchange
• Companies operate and expect to be paid in
currency of country in which they’re located
 Anyone wanting to buy from firm in another country
has to acquire some of that country’s currency
 For example, if a Canadian importer wants to buy
from an American supplier, it has to pay the bill in
U.S. dollars. May have to exchange some Canadian
dollars for U.S. dollars (Canadian importer buys U.S.
dollars with Canadian dollars)
© 2006 by Nelson, a division of Thomson Canada Limited
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The Foreign Exchange Market
• Canadian company would purchase U.S.
dollars in foreign exchange market
 Network of brokers and banks based in
financial centres around world
• Canadian banks participate in market and
provide exchange services to clients
© 2006 by Nelson, a division of Thomson Canada Limited
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Exchange Rates
• An exchange rate states the price of
one currency in terms of another
• Direct quote—number of Canadian
dollars required to buy one unit of foreign
currency
• Indirect quote—how many units of
foreign currency it takes to buy one
Canadian dollar
• The direct and indirect quotes are
reciprocals of one another
© 2006 by Nelson, a division of Thomson Canada Limited
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Example
Exchange Rates
C$/
1 Unit
Units/
1 C$
Currency
Code
Swiss Franc
CHF
1.0042
0.9958
U.S. Dollar
USD
1.3237
0.7555
Euro
EUR
1.5518
0.6444
British Pound
GBP
2.2130
0.4519
Japanese Yen
JPY
0.01215
82.28
Exchange rates on Oct 13, 2003
Represents an indirect
quote—the inverse of a
direct quote—how many
units $1 Cdn. will buy.
Represents a direct
quote—how many Cdn.
dollars are required to
buy one unit of foreign
currency.
Q: If a Canadian company owed 35,000 U.S. dollars, how
would this cost in Canadian dollars?
A: 35,000 USD  1.3237 = $46,330
© 2006 by Nelson, a division of Thomson Canada Limited
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Exchange Rates
• Cross Rates
Example
 It is possible to develop an exchange rate between
any two currencies without going through Canadian
dollars
How many U.K. pounds will 1 U.S. dollar buy?
•
•
•
•
$1CAD = 0.4519 pounds
$1CAD = 0.7555 USD
1 pound = (0.4519 / 0.7555=)0.5981 USD
1 U.S. dollar will buy about 0.6 pounds
© 2006 by Nelson, a division of Thomson Canada Limited
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Changing Exchange Rates and
Exchange Rate Risk
• Exchange rates are constantly changing
 Sometimes rapidly and significantly
• Fluctuating exchange rates give rise to
exchange rate risk
• Exchange rate risk is chance of gain or
loss from exchange rate movements that
occur during a transaction
© 2006 by Nelson, a division of Thomson Canada Limited
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Changing Exchange Rates and
Exchange Rate Risk
• The change in exchange rates affects
profitability of firm
 For a Canadian importer
• If foreign currency strengthens/Cdn $ weakens—
$1 Cdn. will buy fewer units of foreign currency
and profitability will decrease and vice versa
© 2006 by Nelson, a division of Thomson Canada Limited
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Example
Changing Exchange Rates and
Exchange Rate Risk—Example
Q: A Canadian company orders 500 sweaters from a French
company at a cost of 35,000 euros with terms of n/60. The
exchange rate on the order date $1.6521 CAD per euro.
Calculate the gain or loss on the transaction if the bill was not
paid for 60 days, when the exchange rate was $1.95 CAD per
euro.
A: If the bill had been paid on the order date at the then current
exchange rate, the cost would have been (35,000 euros 
1.6521 =) $57,824. However, if the bill was not paid for 60 days
at the then current exchange rate, the price would have been
(35,000 euros  1.95 =) $68,250.
Thus, an $10,426 loss would have resulted due to the large shift
in exchange rates over the two months.
© 2006 by Nelson, a division of Thomson Canada Limited
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Spot and Forward Rates
• The spot rate is exchange rate for
immediate (on-the-spot) delivery of
currency
• The forward rate is price for currencies
to be delivered in the future
 Major currencies have well-developed
forward markets (1, 3 and 6 months forward)
© 2006 by Nelson, a division of Thomson Canada Limited
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Spot and Forward Rates
• Spot rates are a bit different from forward rates
 This difference reflects the movement that banks
expect in the future relationship of the currencies
• When foreign currency is expected to become
less (more) valuable in future, the forward
currency said to be selling at a discount
(premium)
• Terminology of Exchange Rate Movements
 When a currency becomes more (less) valuable in
terms of dollars, it is becoming stronger (weaker), or
rising (falling) against the dollar
© 2006 by Nelson, a division of Thomson Canada Limited
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Hedging with Forward Exchange
Rates
• Exchange rate risk can be eliminated by
hedging with a forward contract
• If company knows it will need a foreign
currency in the future it can lock in an
exchange rate
 Eliminates the uncertainty as to the price that will be
paid for the currency
• Can be done by buying the currency at the
forward rate
© 2006 by Nelson, a division of Thomson Canada Limited
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Example
Hedging with Forward Exchange
Rates
An importer has a US $100,000 payable
coming due in 30 days. To reduce exchange
rate risk, the importer can buy the US dollars
forward today for delivery in 30 days time, at
a price agreed upon today
© 2006 by Nelson, a division of Thomson Canada Limited
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Supply and Demand—The Source
of Exchange Rate Movement
• An exchange rate is just the price of a
particular currency
• The price of that currency will fluctuate with
supply & demand, like any other commodity
• What determines the supply and demand for
exchange rates?
 Primarily stems from trade and the flow of
investment capital between nations
• For example, a strong Canadian dollar means the demand
for Chinese goods in Canada will rise (because Chinese
goods will become cheaper in Canadian dollars)
• Imports from China to Canada will rise
© 2006 by Nelson, a division of Thomson Canada Limited
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Why the Exchange Rate Moves
• Trade and investment flows are sensitive to:
 Economic factors, for example:
• Demand for our principal resources
• Canadian interest rates relative to those of other advanced
economies
• Expansion or recession
• Speculation
 Political factors, for example
• Canadian government policies
• Direct government intervention
• Political turmoil
© 2006 by Nelson, a division of Thomson Canada Limited
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Government Influence on
Exchange Rates
• Governments occasionally intervene to
keep rates within reasonable limits
 Bank of Canada buys/sells their Canadian
dollars in foreign exchange market to slow
decline/advance of Canadian dollar
• In concert with U.S. and other G7 central banks
• Often occurs during periods of great speculation
• Ability to support a weakening currency is limited
because government has to pay for purchases of
its own money with limited resources of gold or
foreign currencies
© 2006 by Nelson, a division of Thomson Canada Limited
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Government Influence on
Exchange Rates
 As alternative to buying dollars, Bank
of Canada may raise interest rates to
attract foreign short-term investments
•Must buy Cdn. $ when investing in Canada
•Increases demand for Cdn.$
© 2006 by Nelson, a division of Thomson Canada Limited
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International Monetary System
• Floating exchange rate system
 Exchange rates are allowed to fluctuate
based on demand/supply in the free market
• Little government intervention
 Used for the major (“hard”) currencies
• Including British pound sterling, the European
euro, the Japanese yen, the Canadian dollar, and
the U.S. dollar
© 2006 by Nelson, a division of Thomson Canada Limited
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International Monetary System
• Pegged exchange rate system
 Some of the non-major currencies of the world are
on a fixed or pegged exchange rate system
(example: China)
 Try to maintain a fixed (or semi-fixed) relationship
with respect to the U.S. dollar, one of the other
major currencies, a combination of major currencies,
or some type of international foreign exchange
standard
• Governments set the rates and attempt to
maintain them against market pressures by
buying and selling in the foreign exchange
market
© 2006 by Nelson, a division of Thomson Canada Limited
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International Monetary System
• Pegged exchange rate system
• Sometimes impossible to keep pegged
exchange rates constant.
 Country might officially raise the value of its
currency relative to the U.S. dollar ( a
revaluation) or, more likely, lower its value
(a devaluation).
• China has recently revalued
• Several countries, including Mexico, have
devalued in the last decade due to financial and
monetary crises
© 2006 by Nelson, a division of Thomson Canada Limited
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Convertibility
• Not all currencies are convertible to other
currencies
 Inconvertible currency has restrictions on
trading currency in foreign exchange markets
• For example, Russian ruble
• For example, some currencies you can
buy at official exchange rate, but can not
sell at that rate
• Inconvertibility is impediment to
international trade
© 2006 by Nelson, a division of Thomson Canada Limited
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International Trade Credit
• Canadian importer with accounts payable
denominated in a foreign currency is
exposed to risk that Canadian dollar will
depreciate against foreign currency
 Hedge by buying currency in forward
market
© 2006 by Nelson, a division of Thomson Canada Limited
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International Trade Credit
• Foreign supplier may ask Canadian importer for
a letter of credit. Written by bank of
(Canadian) importer to foreign supplier, stating
that Canadian bank guarantees payment of
supplier’s invoice if all underlying agreements
are met
 To reduce exporter’s credit risk, and to expedite payment
• Letters of credit not used for imports from U.S.,
from affiliated companies, or from foreign
suppliers well acquainted with Canadian
exporter
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In these cases, some form of “open account” arrangement (for
example, net 30 days) is common
© 2006 by Nelson, a division of Thomson Canada Limited
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Foreign Bank Loans
• Multinational corporations (MNCs) often finance
their operations, at least in part, in foreign
financial markets
• MNC may borrow foreign currency either
directly or through foreign subsidiary. MNC
uses foreign currency in its foreign operations
or converts it to Canadian dollars for use at
home.
 For example, a Canadian company operating a
subsidiary in the United Kingdom may borrow
pounds sterling at a British bank to acquire inventory
in the U.K.
 There is foreign exchange risk with such loans
© 2006 by Nelson, a division of Thomson Canada Limited
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Foreign Bank Loans
• Eurocurrency loans— large short-term loans
denominated in one or more major foreign
currencies
 often the U.S. dollar (eurodollar loans) or the euro.
 If a British subsidiary borrowed U.S dollars in U.K.,
would constitute a eurodollar loan.
• Usually unsecured, made in multiples of $1
million, and for terms of one year or less
• Allow MNCs to arrange large loans quickly,
confidentially, and at attractive interest rates
• Also available in Canadian dollars in foreign
capital markets
© 2006 by Nelson, a division of Thomson Canada Limited
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Global Cash Management
• Global cash management in the MNC
complicated by:
 Foreign tax systems
 Foreign government restrictions on outflow of funds,
for example exchange controls
• Mechanisms to repatriate funds include dividends,
management fees, royalties, and repayment of loans and
interest.
 High rates of inflation and volatile exchange rates in
foreign countries
• Parent presumably will want to move cash back to Canada,
or to other low inflation, stable currency locations
 If funds are left overseas, MNC may hedge net
exchange exposure by currency through forward
contracts or other mechanisms
© 2006 by Nelson, a division of Thomson Canada Limited
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International Money Market
Investments
• MNC can make short-term and safe foreign currency
deposits at attractive interest rates
• Large companies may make eurocurrency deposits—
large sums of $ 1 million or more, converted to a
foreign currency (often the U.S. dollar)
 For example, if Canadian company deposited Canadian dollars
in U.K. bank, would create a eurodollar deposit
• Bank swapped deposits—foreign currency deposits in
Canadian or foreign banks
 Earn a better return than Canadian dollar deposits.
 To protect against a rise in the Canadian dollar, the deposits are
hedged using forward or future contracts.
© 2006 by Nelson, a division of Thomson Canada Limited
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Foreign Receivables
• Payments often received in foreign currency,
particularly in U.S. dollars. To reduce foreign
exchange risk, Canadian exporter may hedge
receivables by selling currency in forward
market
• To eliminate credit risk, Canadian exporter may
ask foreign customer for letter of credit from
customer’s bank
• Canadian exporter may accelerate receipt of
cash by discounting guaranteed receivable at
its own bank, or with a factor
© 2006 by Nelson, a division of Thomson Canada Limited
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Foreign Receivables
• For sales not guaranteed by letter of credit,
exporter may check potential customer’s credit
with international credit agencies such as
D&B Canada
• Credit insurance for non-payment of
receivables due to credit problems available (at
a price) from Export Development Corporation
of Canada (EDC)
• EDC also provides financing to foreign
customers to purchase equipment and other
capital goods from Canadian companies
© 2006 by Nelson, a division of Thomson Canada Limited
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International Capital Markets
• Many individuals and businesses invest in
countries other than their own
 Foreign direct investments—in facilities
 Portfolio investments—in foreign stocks and
bonds
• Require flow of capital funds among
nations
 Financing from international bond market,
international stock market
© 2006 by Nelson, a division of Thomson Canada Limited
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The International Bond Market
• Companies can borrow internationally by
selling bonds outside their own country
 Called international bonds
 Usually denominated in hard currency: U.S.
dollar, euro, pound sterling, yen
 Allow access to foreign capital markets
• Greater availability of funds, lower financing costs
 Exchange risk when denominated in foreign
currency
© 2006 by Nelson, a division of Thomson Canada Limited
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The International Bond Market
• International bond can be denominated in
 The currency of the country in which it is sold
(foreign bond)
• Example, Honda sells Canadian dollar bonds in
Canada
 The currency of the issuing company’s home
country (eurobond)
• Example, Toyota sells bonds denominated in yen
in Canada
 A third currency
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The International Bond Market
• Eurobonds
 Most eurobonds are denominated in U.S.
dollars or euros
 Securities regulations require lower levels of
disclosure—lowers issuing costs
 Eurobonds are issued in bearer form—owner
is not identified
 Most governments don’t withhold income
taxes on eurobond interest
© 2006 by Nelson, a division of Thomson Canada Limited
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The International Stock Market
• Means for Canadian multinationals to
raise equity capital abroad
• Major centres for international share
issues include the London, New York,
Tokyo, Zurich and Frankfurt stock
markets.
• Many large Canadian multinational
corporations have listed their shares on
multiple stock exchanges
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The International Stock Market
• Why issue shares abroad?
 Greater availability of capital and/or lower flotation
costs in world markets
• Toronto’s equity markets represent less than 2% of the
world’s equity markets by capitalized value
 Foreign government regulations on minimum levels
of local ownership
 To increase loyalty of foreign employees towards
firm
 To improve global image of the corporation
 Growing desire of investors to diversify their
investment portfolios internationally
© 2006 by Nelson, a division of Thomson Canada Limited
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Why Make a Foreign Direct
Investment? (FDI)
• Rate of return often higher than return on domestic
investments.
• Foreign investments may offer lower labour or other costs of
production, lower tax rates, or special foreign government
incentives.
• Strategic reasons. Most Canadian FDI is in the U.S.
 To locate production close to large regional U.S. markets
 Political stability, access to advanced technology, and continued
economic growth in U.S.
• Many companies have set up operations in Europe to
avoid European Union (EU) import tariffs on Canadian
exports
• Reduce risks by diversifying internationally
© 2006 by Nelson, a division of Thomson Canada Limited
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Analyzing a Proposed FDI
• Special case of capital budgeting
• Consider:
 Costs of initial investment
 Expected cash flows from the investment
 Possible risks
© 2006 by Nelson, a division of Thomson Canada Limited
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Analyzing a Proposed FDI
• In forecasting future cash flows, consider:
 Foreign government incentives to invest
 Double taxation—foreign taxes and Canadian taxes
on income earned in foreign country
 Foreign government restrictions on repatriating
foreign income
 Exchange rate forecasts for converting cash flow
estimates to Canadian dollars
• Consider unique risks to FDI
 Political risks, foreign exchange risks
 Increase discount rate for calculating NPV
© 2006 by Nelson, a division of Thomson Canada Limited
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Political Risk
• Political risk—chance that foreign government
will expropriate property or will impose rules
and regulations that will impair operations
• Examples include:
 Raising taxes
 Limiting amount of profit that can be withdrawn from country
 Requiring key inputs to be purchased from local suppliers at
arbitrary prices
 Limiting prices charged for product sold within the country
 Require part ownership by citizens of the host country
• Terrorist activities, including kidnapping key executives,
also included in political risk
• Risk smaller in industrialized countries
© 2006 by Nelson, a division of Thomson Canada Limited
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Political Risk
• To minimize political risk:
 Before investing in a country, investigate its
political stability, and its government’s rules,
regulations, and incentives regulating
incoming foreign direct investment
 Establish joint venture with local interests
 Buy political risk insurance from Export
Development Corporation (EDC)
 Diversify operations among countries
© 2006 by Nelson, a division of Thomson Canada Limited
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Foreign Exchange Risks
• Include Transaction Risk, Economic Risk,
Translation Risk
• Transaction Risk—Potential for change
in value of foreign-currency denominated
transaction before transaction is finalized
 Not unique to MNCs with FDI
 Transaction gains and losses are realized in
cash as they happen
© 2006 by Nelson, a division of Thomson Canada Limited
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Foreign Exchange Risks
• Economic Risk—potential long-run
impact of exchange rate fluctuations on
value of foreign affiliate
 In particular, potential long-run losses to
affiliate (and its parent) from a steady
decline in the local exchange rate
• In capital budgeting terms, dollar value of future
cash inflows can be dramatically reduced if local
currency depreciates against dollar
© 2006 by Nelson, a division of Thomson Canada Limited
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Foreign Exchange Risks
• Translation Risk—potential gain or loss
that arises from translating financial
statements of foreign subsidiary into
Canadian dollars for consolidation with
Canadian parent’s financial statements
 If local currency has weakened recently
against dollar, translating statements at new
rate gives lower dollar value for foreign
subsidiary. Translation loss is reported in
consolidated statements
 Accounting losses, not realized losses
© 2006 by Nelson, a division of Thomson Canada Limited
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Chapter 20