An International Contingent Claim Model and Its Applications.

This study develops a pricing model in the Black and Scholes tradition for an option written on a foreign stock under the assumption of perfect international capital markets. The model shows the impact of the level of the exchange rate and its covariability with the value of the underlying stock in determining the price of an option. Further, the option price is functionally related to the forward exchange rate and the expected exchange rate change. The international option pricing model is used to value the equity and debt securities of a firm whose debt is denominated in a foreign currency. It is shown that the value of the securities is independent of hedging policies of investors. Therefore the Modigliani-Miller (M-M) proposition is valid regardless of whether the forward exchange market is available to investors provided that investors can trade in debt securities and the underlying value of the firm. Subsequently, the optimal capital structure for a domestically levered firm and an internationally levered firm under the assumption of an imperfect capital market (i.e., taxes, and bankruptcy costs) is investigated. Assuming that international bonds are issued in bearer form, it is shown that there exists an optimal capital structure and that unlimited debt capacity argument is valid for a firm which issues international securities. Finally, the theoretical models for pricing international bonds are tested. We show that international investors price international risky corporate bonds issued in domestic currency differently from domestic investors. Using monthly yield data, the yield difference is shown to be explained by the existence of market imperfection in the domestic capital market and /or by the expected exchange rate changes. It is shown that the imperfections in the domestic market do not explain the yield differences between domestic bonds and international bonds denominated in a foreign currency. Rather, the exchange rate itself and the proxied expected exchange rate change explain the yield differences between domestic bonds and international bonds denominated in a foreign currency. In contrast to the international Fisher effect, the yield difference between domestic and international risky corporate bonds is a non-linear function of the expected exchange rate change.PhDFinanceUniversity of Michiganhttp://deepblue.lib.umich.edu/bitstream/2027.42/161116/1/8621314.pd