International Financial Management. Professor XXXXX Course Name / Number. Currencies float freely in this system, and exchange rates (prices) are set by supply and demand. $US, Japanese Yen, British Pound, Swiss Franc float freely. Floating exchange rate system.
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Course Name / Number
Currencies float freely in this system, and exchange rates (prices) are set by supply and demand.
Floating exchange rate system
Fixed exchange rate system
Managed floating rate system
Fixed Versus Floating Exchange Rates
Currency per $US
Exchange Rate Quotes
Spot exchange rate
Forward exchange rate
Spot and Forward Exchange Rates
The pound trades at a forward discount relative to the dollar.
Cross exchange rate
Assume you are quoted the following exchange rates
1. Exchange $1,000,000 into SF1,500,000 (at SF1.50/$).
2. Trade SF1,500,000 for €1,200,000 (at €0.80/SF).
3. Convert €1,200,000 into $1,200,000 (at $1.0000/€).
Could make a riskless, instant profit of $200,000.
Suppose the euro appreciates against the Canadian
This benefits European consumers or producers buying Canadian goods.
It hurts Canadian consumers or producers buying European goods.
Winners and losers reversed when a currency depreciates.
All U.K. (risk neutral) firms who intend to buy U.S. dollars in the future will either:
If a forward market exists, the forward rate should be approximately equal to expected future spot rate.
U.S. firms who will need to pay in pounds in the future will do the opposite.
Equilibrium: the forecast of the spot price is equal to the current forward rate (forward – spot parity).
E(S) = F
U.S. and U.K. firms are indifferent in this case whether they transact in the spot or forward market.
Forward-spot parity does not hold. Forward rate is not a reliable predictor of the direction of the spot rate.
Identical goods trading in different markets should sell at the same price.
What is the most and least that gold can sell for in London (in £) without offering arbitrage opportunity?
Differences in expected inflation between two countries are associated with expected changes in currency values.
Key empirical predictions of PPP:
Low-inflation nations appreciating currency
High-inflation nations depreciating currency
Law holds for tradable goods over time, but deviations occur in the short run. Reasons:
Interest rate parity says that the risk-free returns around the world should be equal.
An investor can either buy a domestic risk-free asset or a foreign risk-free asset using forward contract to cover currency exposure.
The currency of the country with lower risk-free rate should trade at a forward premium.
This means Canadian interest rate is “too low” or UK interest rate is “too high.” Arbitrage opportunity!
Borrow C$1,000,000 at 6% per year, convert to 500,000 pounds.
This will grow to 505,000 pounds in six months, at which time you convert back at the forward rate to C$1,035,250.
Next, repay the Canadian loan which takes C$1,030,000.
Arbitrage profit is C$5,250.
Fisher effect: the nominal interest rate R is made up of two components:
If real required return is the same across countries, then the following equation is true.
Scarcity of risk-free investments that offer fixed real, rather than nominal, returnsReal Interest Rate Parity: The Fisher Effect
What should the one year interest rate be to maintain real interest rate parity?
Deviations from real interest rate parity occur because of limits to arbitrage.
Exchange rate risk arises when the value of a company’s cash flows can be affected by a change in exchange rates.
If price is set today, but delivery is in 6 months, Boeing is exposed to significant foreign exchange risk unless it hedges that risk.
If exchange rate in 6 months is ¥110.00/$:
1. Boeing will suffer an exchange rate loss of $54,545.5.
2. Japanese customer is unaffected, since yen price is fixed.
If exchange rate in 6 months is ¥100/$ instead:
Question: who would gain/lose if price set in dollars?
Cost and revenue of the subsidiary (in foreign currency) are translated in the domestic currency to be included in the financial statements of the MNC.
Translation (accounting) exposure
Economic exposureTranslation and Economic Risk
Macro political risk
Micro political riskPolitical Risk
Actions taken by a government which have an impact on the value of foreign companies operating in that country:
In 1991, Brazil, Argentina, Paraguay, and Uruguay formed the Mercosur Group.
General Agreement on Tariffs and Trade (GATT): international treaty that regulates trade
European Monetary Union established Euro as currency for twelve countries in Western Europe.
The transfer by a multinational firm of financial, managerial, and technical assets from home country to a host country
Foreign Direct Investment (FDI)The Growth of World Trade
World trade increased at a compound interest rate of around 8% from 1973-2000.
Merchandise trade has tripled since 1986 to $6.5 trillion; services add another $2-3 trillion.
Developing country exports account for almost 40% of the world’s total.
MNCs have to answer the following questions in their capital budgeting process.
Two alternatives to compute project’s NPV
Assume risk-free in Europe is 5% and the spot rate is $0.98/€.
The company estimates that cost of capital for this project is 10% (5% risk premium).
Calculate NPV in dollar terms; risk free rate in U.S. is 4%.
Cash flow of the project converted in dollars: same results as the first approach
Need to discount the cash flow at risk-adjusted U.S. interest rate:
Multinational corporations dominate international trade and investment today.
Companies trading in the international markets are exposed to exchange rate risk.
Total volume of foreign direct investment surged during the 1990s.
MNCs can use a variety of techniques to hedge or even profit from exchange rate fluctuations.