Essays on segmentation in international currency and asset markets: Implications for corporate finance

This study investigates the implications of segmented international capital markets on contract valuation and default. Within a two date, two "national" capital market framework, a simple valuation model is developed based on state-preference approach. Segmentation is defined as the occurrence of state-by-state disparities in the relationship between present and future exchange rates and contingent claim prices that differ in the two markets.; To analyze international corporate debt contracts, a "difference in value" function is derived. It shows the discrepencies in the value of a foreign opportunity when international rather than domestic debt is used. Analysis of this function leads to several results. First of all, if Interest Rate Parity (IRP) does not hold, international and domestic default free debt will not be equivalent, as expected. Secondly, in the case of risky debt, the default option interacts with exchange risk and, as a result, foreign debt may be preferred if IRP holds, or even if it does not hold but favors domestic debt. Thirdly, the benefits from foreign risky debt are project-specific and it is possible to obtain optimal debt levels on a project-by project basis.; Within a similar framework, currency swap contracts are also examined. Swap contract is viewed as a forward contract with default. In this case, "difference in value" function denotes the excess value gained by the counterparties due to engaging in a swap contract instead of using their slacks. It is shown that in segmented international capital markets a swap arrangement is never a zero-sum transaction. Even the risk free swap can be transacted at some contractual exchange rate and between markets with inversely correlated state prices so that both parties augment their shareholder wealth. Furthermore, the option to default emerges as an independent source of value. If the counterparties limit the states in which default occurs to unfavorable ones, they will increase shareholder wealth beyond that of a default free swap. Regulating the cash flows or choosing the payment procedure (difference checks vs total amounts) are suggested as possible strategies for this purpose. The role of intermediation in a swap arrangement is also discussed.