INTERNATIONAL FINANCIAL MANAGEMENT

International Financial Management Syllabus Unit 1 Foreign Exchange Market Unit 2 Foreign Risk Unit 3 International Investment Decisions Unit 4 Evaluation and Explanations of Foreign Direct Investment Unit 5 International Investing.

Reference Books
International Finance: The Markets and Financial Management of Multinational Business Mauric D.Levi, McGraw Hill Inc, Newyork (1990)
International Financial Management Dr.P.K.Jain & others, McMillan

Financial Management and Policy, James C Van Horne, Prentice Hall of India Pvt.Ltd.,New Delhi (1994)
Principles of Corporate Finance, Richard A Brealely, Stewart C.Myers, McGraw Hill Book Company, Newyork (1988) Management of Investments, Jack Clark Francies, McGraw Hill Inc (1993). Modern Investments & Security Analysis, Russel J Fuller & fuller & James, L Farrell Jr. McGraw Hill Inc.(1981).

Foreign Exchange Markets

Foreign Exchange
It is the system or process of converting one national currency into another, and of transferring money from one country to another.
Dr. Paul Einzig

Foreign Exchange
The section of economic science which deals with the means and methods by which rights to wealth in one countrys currency are converted into rights to wealth in terms of another countrys currency.
H.E. Evitt

INTRODUCTION

Foreign exchange market: a market for converting the currency of one country into the currency of another. Exchange rate: the rate at which one currency is converted into another Foreign exchange risk: the risk that arises from changes in exchange rates.

THE FUNCTIONS OF THE FOREIGN EXCHANGE MARKET

The foreign exchange market serves two main functions: Convert the currency of one country into the currency of another Provide some insurance against foreign exchange risk
Foreign

exchange risk: the adverse consequences of unpredictable changes in the exchange rates.

CURRENCY CONVERSION

Consumers can compare the relative prices of goods and services in different countries using exchange rates. International business have four main uses of foreign exchange markets

To exchange currency received in the course of doing business abroad back into the currency of its home country.

CURRENCY CONVERSION

To pay a foreign company for its products or services in its countrys currency To invest excess cash for short terms in foreign markets To profit from the short-term movement of funds from one currency to another in the hopes of profiting from shifts in exchange rates, also called currency speculation.

THE NATURE OF THE FOREIGN EXCHANGE MARKET

The foreign exchange market is a global network of banks, brokers and foreign exchange dealers connected by electronic communications systems The most important trading centers include: London, New York, Tokyo, and Singapore Londons dominance is explained by:

History (capital of the first major industrialized nation) Geography (between Tokyo/Singapore and New York)
The market never sleeps Market is highly integrated

Two major features of the foreign exchange market:

FOREIGN EXCHANGE MARKET

The organizational setting within which

individuals, businesses, government, and

banks buy and sell foreign currencies and other debt instruments. It is an overthe-counter market consisting of a global network of inter-bank traders, primarily the banks connected by telecommunication facilities.

TYPES OF FOREIGN EXCHANGE MARKETS

Inter-bank or wholesale market: Trading between the banks where banks can obtain quotes, or they can contact brokers who sometimes act as intermediaries.
Retail market: It consists of travellers and tourists who exchange one currency to another in the form of travellers cheques or currency notes. In retail markets, transaction size of retail foreign exchange market is very small whereas the spread between buying and selling prices is large.

Participants in the Foreign Exchange Market

Traders use forward contract to eliminate or cover the risk of loss on export or import orders that are denominated in foreign currencies. Hedgers are mostly multinational firms, engage in forward contracts to protect the home currency value of various foreign currency-denominated assets and liabilities on their balance sheets that are not to be realized over the life of the contracts. Arbitrageurs seek to earn risk-free profits by taking advantage of differences in interest rates among countries. They use forward contracts to eliminate the exchange risk involved in transferring their funds from one nation to

Exchange rate: The value of one currency in units of another.

EXCHANGE RATE QUOTATIONS

Spot vs. Forward Quote
Spot rate: The price agreed for purchase or sale of foreign currency with delivery and payment to take place not more than two business days after the day the transaction has been concluded.

Forward rate: The price at which the foreign exchange rate is quoted for delivery at a specified later date. The date of maturity of a forward contract is more than two business days in a future whereas the exchange rate is fixed at the time of entering the contract.

DIRECT VS. INDIRECT QUOTES

Direct quotes: currency. Units of the home currency per unit of a foreign

For instance, Indian Rs. 39.5075 per US $ is a direct quote in India whereas Yen 106.5050 per US $ is a direct quote in Japan. Indirect quote: Units of foreign currency per unit of home currency. It may be arrived at by inversing the direct quote as follows:

Indirect quote = 1/direct quote

For instance, US$ 0.0253 per Indian Rupee is an indirect quote in India.

Cross Rates
Sometime the value of a currency in terms of another currency may not be known directly. In such an event, one currency is sold for a common currency and again the common currency is exchanged for the desired currency. This is known as cross currency trading and the rate established between the two currencies is known as the cross rate.

An Indian corporate needs Canadian dollars to buy Canadian goods, it is concerned about the Canadian dollar relative to the Indian rupee. It receives a quote of USD/INR at Rs.47.5010/47.6015 and a quote of USD/CAD at 1.0367/1.0371. Thus the rate of exchange between the rupee and the Canadian dollar can be found through the common currency the US dollar. The technique is similar for both the spot and the forward cross rates.

BID VS. ASK QUOTATIONS

Bid rate: The price that a bank is willing to pay for a

foreign currency.

Ask or offer rate: The price at which a bank is willing to

sell the currency. The bid-ask spread is the difference between the bid and ask prices.

Bid/ask spread = (ask rate- bid rate)/ask rate

Computation of Bid/Ask spread

The following are the q1uotes of the major currencies as on 23rd June2010 at 12.30. Calculate the spread percentage.

Bid/Ask spread = (Ask rate bid rate)/Ask rate X 100

Currency AUD/USD CAD/CHF CAD/JPY EUR/CHF sell 0.8724 1.07 86.94 1.3608 buy 0.8726 1.07 86.94 1.3611 spread %

Dealings on the Foreign Exchange Market

Important types of transactions conducted in the foreign exchange market:
Spot and forward exchanges Futures

Options
Swap operation Arbitrage.

In

the spot market, foreign exchange transactions are completed on the spot or immediately.

INSURING AGAINST FOREIGN EXCHANGE RISK

A spot exchange occurs when two parties agree to exchange currency and execute the deal immediately The spot exchange rate is the rate at which a foreign exchange dealer converts one currency into another currency on a particular day Reported daily Change continually

Forward Market
In a forward market, contracts are delivered at a specified future date.

The rate of exchange applicable to the forward contract is called the forward exchange rate and the market for forward transaction is known as the forward market.

INSURING AGAINST FOREIGN EXCHANGE RISK

Forward exchanges occur when two parties agree to exchange currency and execute the deal at some specific date in the future
Exchange

rates governing such future transactions are referred to as forward exchange rates For most major currencies, forward exchange rates are quoted for 30 days, 90 days, and 180 days into the future.

INSURING AGAINST FOREIGN EXCHANGE RISK

When a firm enters into a forward exchange contract, it is taking out insurance against the possibility that future exchange rate movements will make a transaction unprofitable by the time that transaction has been executed.

Forward exchange rate

With reference to its relationship with the spot rate, the forward rate may be at par, discount or premium.

At Par:
If the forward exchange rate quoted is exactly equivalent to the spot rate at the time of making the contract, the forward exchange rate is said to be at par.

At Premium:
The forward rate for a currency, say the dollar, is said to be at premium with respect to the rate when one dollar buys more units of other currency, say rupee, in the forward than in the spot market. The premium is usually expressed as a percentage deviation from the spot rate on a per annum basis.

At Discount:
The forward rate for a currency, say the dollar, is said to be at discount with respect to the spot rate when one dollar buys fewer rupees in the forward than in the spot market. The discount is usually expressed as a percentage deviation from the spot rate on a per annum basis.

The forward exchange rate is determined mostly by the demand for and supply of forward exchange. When the demand for forward exchange exceeds its supply, the forward rate will be quoted at a premium .
When the supply of forward exchange exceeds the demand for it, the rate will be quoted at discount.

When the supply is equivalent to the demand for forward exchange, the forward rate will be tend to be at par.

Forward cross rates

Here the selling rate of one currency is divided by the buying rate of another currency and vice versa. One month forward of two currencies are USD/INR at 47.6010/47.9015 and that of USD/CAD at 1.1367/1.1371. Determine the forward rate of Canadian dollar in terms of the Indian rupee.

Futures
Futures contracts have standard features while a forward contract may be customised.

Futures contract
It is the contract for buying and selling a currency in the market for currency futures.

In terms of standardisation they have the following characteristics: 1.The quantity, quality and the unit price of the asset is clearly mentioned in the contract. 2.The date, month and place of delivery 3. The minimum amount and the time duration by which the price would change etc.

Options
An option is a contract that gives the holder a right, without any obligation, to buy or sell an asset, at an agreed price, on or before a specified period of time.

Types of options
Call options
Put options
Call options:

An option to buy the underlying asset is known as a call option. An option to sell the underlying asset is known as a put option.

The key provisions of the contract includes: 1. The number and type of common shares that can be purchased 2. The price at which the shares can be purchased 3. The last date at which they can be purchased 4. Whether or not the shares can be purchased only on the last date or on any date up to and including the last date 5. Who is obligated to sell the shares?

Strike price
The price at which option can be exercised is called an exercise price or a strike price.

Underlying asset
The asset on which the put or call option is created is referred to as the underlying asset.

European option
When an option is allowed to be exercised only on the maturity date, is called a European option.

American option
When the option can be exercised any time before its maturity, is called an American option.

INSURING AGAINST FOREIGN EXCHANGE RISK

Currency swap: the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates Swaps are transacted between international businesses and their banks, between banks, and between governments when it is desirable to move out of one currency into another for a limited period without incurring foreign exchange risk .

A common kind of swap is spot against forward. Consider a company such as Apple Computer. Apple assembles laptop computers in the United States, but the screens are made in Japan. Apple also sells some of the finished laptops in Japan. So, like many companies, Apple both buys from and sells to Japan. Imagine Apple needs to change $1 million into yen to pay its supplier of laptop screens today. Apple knows that in 90 days it will be paid 120 million by the Japanese importer that buys its finished laptops. It will want to convert these yen into dollars for use in the United States. Let us say todays spot exchange rate is $1 120 and the 90-day forward exchange rate is $1 110. Apple sells $1 million to its bank in return for 120 million.

Now Apple can pay its Japanese supplier. At the same time, Apple enters into a 90-day forward exchange deal with its bank for converting 120 million into dollars. Thus, in 90 days Apple will receive $1.09 million (120 million/ 110 $1.09 million). Since the yen is trading at a premium on the 90-day forward market, Apple ends up with more dollars than it started with (although the opposite could also occur). The swap deal is just like a conventional forward deal in one important respect: It enables Apple to insure itself against foreign exchange risk. By engaging in a swap, Apple knows today that the 120 million payment it will receive in 90 days will yield $1.09 million.

Arbitrage:
Arbitrage is the simultaneous buying and selling of foreign currencies with the intention of making profits from the differences between the exchange rate prevailing at the same time in different markets.

Assume the rate of exchange in London is 1 = $ 2, while in New York 1 = $ 2.10. This presents a situation wherein one can purchase one sterling pound in London for two dollars and a yearn a profit of $ 0.10 by selling the pound sterling in New York for $ 2.10.

International Monetary System

SIGNIFICANCE OF INTERNATIONAL FINANCE

Globalization has made understanding

international
business

finance

pertinent
solely

even

to

enterprises

operating

domestically in order to assess the impact of movements in exchange rates, foreign interest rates, labour costs, and inflation on

the costs
competitors.

and

prices

of

their

foreign

The International Monetary System plays a crucial role in the financial management of a multinational business and economic and social policies of each country.

INTERNATIONAL MONETARY SYSTEMS

set

of

rules,

regulations,

policies,

practices, instruments, institutions, and mechanisms that determine exchange rates between currencies.

EVOLUTION OF THE IMS

Evolution

of the International Monetary System can be analysed in four stages: The Gold Standard: 1875-1914 Inter-war Period: 1915-1944 Bretton Woods System: 1945-1972 The Flexible Exchange Rate Regime: 1973-Present.

THE GOLD STANDARD: 1875-1914

The three important features of the gold standard were:

The

government of each country defines its national monetary unit in terms of gold. There was two-way convertibility between gold and national currencies at a stable ratio. Gold could be freely exported or imported.

The exchange rate between countrys currencies would determined by their relative contents.

two be gold

GOLD STANDARD: 1875-1914

For example, The United States declared the dollar to be convertible to at a rate of $ 20.67/ounce of gold. The British pound was pegged at 4.2474/ounce of gold. The dollar-pound exchange rate would be determined as: $20.67/ounce of gold 4.2474/ounce of gold = $4.86656/

GOLD STANDARD: 1875-1914

Highly stable exchange rates under the gold standard provided an environment that was conducive to international trade and investment. Misalignment of exchange rates and international imbalances of payment were automatically corrected by the price-specie-flow mechanism.

PRICE-SPECIE-FLOW MECHANISM

Suppose Great Britain exported more to France than France imported from Great Britain. This cannot persist under a gold standard.

Net export of goods from Great Britain to France will be accompanied by a net flow of gold from France to Great Britain. This flow of gold will lead to a lower price level in France and, at the same time, a higher price level in Britain.

The resultant change in relative price levels will slow exports from Great Britain and encourage exports from France.

The Inter-war period 1915-1944

The gold standard as an International Monetary System worked well until World War 1 interrupted trade flows and disturbed the stability of exchange rates for currencies of major countries.

There was widespread fluctuation in currencies in terms of gold during World War 1 and in the early 1920s.

In 1934, the United States returned to a modified gold standard and the US dollar was devalued from the previous $20.67/ounce of gold to $35.00/ounce of gold. The modified gold standard was known as the Gold Exchange Standard. Under this standard, the US traded gold only with foreign central banks, not with private citizens. From 1934 till the end of World War II, exchange rates were theoretically determined by each currencys value in terms of gold. World War II also resulted in many of the worlds major currencys losing their convertibility. The only major currency that continued to remain convertible was the dollar.

Thus, the inter-war period was characterised by half-hearted attempts and failure to restore the gold standard, economic and political stabilities, widely fluctuating exchange rates, bank failures and financial crisis. The Great Depression in 1929 and the stock market crash also resulted in the collapse of many banks.

BRETTON WOODS SYSTEM: 1945-1972

Named for a 1944 meeting of 44 nations at Bretton Woods, New Hampshire. The purpose was to design a postwar international monetary system. The goal was exchange rate stability without the gold standard. The result was the creation of the IMF and the World Bank.

BRETTON WOODS SYSTEM: 1945-1972

Under the Bretton Woods system, the U.S. dollar was pegged to gold at $35 per ounce and other currencies were pegged to the U.S. dollar. Each country was responsible for maintaining its exchange rate within 1% of the adopted par value by buying or selling foreign reserves as necessary. The Bretton Woods system was a dollarbased gold exchange standard.

BRETTON WOODS SYSTEM: 1945-1972

German mark

British pound

French franc

Par Value
U.S. dollar

Gold

Pegged at $35/oz.

INTERNATIONAL MONETARY FUND (IMF)

The IMF also known as the Fund, was

conceived at a UN Conference convened in

Bretton Woods, New Hampshire, US in July 1944 aimed to build a framework for economic cooperation that would avoid a repetition of the disastrous economic policies that had contributed

to the Great Depression of the 1930s.

Objective
To promote exchange stability and orderly exchange arrangements and to avoid competitive devaluation. Also it ensures devaluation is not used as a weapon of competitive trade policy. However if a currency become too weak to defend, a devaluation of up to 10% would be allowed without any formal approval of IMF.

THE FLEXIBLE EXCHANGE RATE REGIME: 1973-PRESENT.

Flexible exchange rates were declared acceptable to the IMF members.

Central

banks were allowed to intervene in the exchange rate markets.

Gold was abandoned as an international reserve asset. Non-oil-exporting countries and lessdeveloped countries were given greater access to IMF funds.

FLOATING EXCHANGE RATE SYSTEM

Currency prices are determined by market demand and supply conditions without the

intervention of the governments.

INDEPENDENT OR FREE FLOAT

The exchange rates are market-determined and central banks intervene only to

moderate the speed of change or to prevent

excessive fluctuations without any attempt to maintain it or drive it to a particular level.

MANAGED FLOAT
Although currencies are allowed to

fluctuate on a daily basis with no official

boundaries,

national

governments

intervene to prevent their currencies from moving too far in a certain direction.

Pegged Exchange Rate System

In this system, currency values are fixed in relation to another currency such as the U.S. dollar or euro. Pegging value of home currency to a foreign currency or a basket of currencies and it is allowed to move in line with that currency against other currencies.

SOFT PEGS
Conventional fixed peg: The currency fluctuates for at least three months within a band of less than 2 per cent or +/-1 per cent against another currency or a basket of currencies.

Intermediate pegs
Pegs within horizontal bands: Currencies are generally not allowed to fluctuate beyond +_1 per cent of central parity.

Crawling Peg: A currency is pegged to a single currency or a basket of

currencies, but the peg is periodically

adjusted with a range of less than 2

per cent in response to changes in

selective macro-economic indicators.

EUROPEAN MONETARY SYSTEM

Eleven

European countries maintain exchange rates among their currencies within narrow bands, and jointly float against outside currencies. Objectives:
To

establish a zone of monetary stability in Europe. To coordinate exchange rate policies vis-vis non-European currencies. To pave the way for the European Monetary Union.

WHAT IS THE EURO?

The

euro is the single currency of the European Monetary Union which was adopted by 11 Member States on 1 January 1999. These original member states were: Belgium, Germany, Spain, France, Ireland, Italy, Luxemburg, Finland, Austria, Portugal and the Netherlands.

EURO CONVERSION RATES

1 Euro is Equal to:
40.3399 BEF 1.95583 DEM 166.386 ESP 6.55957 FRF .787564 IEP 1936.27 ITL 40.3399 LUF 2.20371 NLG 13.7603 ATS 200.482 PTE 5.94573 FIM Belgian franc German mark Spanish peseta French franc Irish punt Italian lira Luxembourg franc Dutch gilder Austrian schilling Portuguese escudo Finnish markka

WHAT IS THE OFFICIAL SIGN OF THE EURO?

The sign for the new single currency looks like an E with two clearly marked, horizontal parallel lines across it.

It was inspired by the Greek letter epsilon, in reference to the cradle of European civilization and to the first letter of the word 'Europe'.

WHAT ARE THE DIFFERENT DENOMINATIONS OF THE EURO NOTES AND COINS ?
There are be 7 euro notes and 8 euro coins. The notes are: 500, 200, 100, 50, 20, 10, and 5. The coins will be: 2 euro, 1 euro, 50 euro cent, 20 euro cent, 10, euro cent, 5 euro cent, 2 euro cent, and 1 euro cent. The euro itself is divided into 100 cents, just like the U.S. dollar.

THE MEXICAN PESO CRISIS

On 20 December, 1994, the Mexican government announced a plan to devalue the peso against the dollar by 14 percent. This decision changed currency traders expectations about the future value of the peso. They stampeded for the exits. In their rush to get out the peso fell by as much as 40 percent.

THE ASIAN CURRENCY CRISIS

The Asian currency crisis turned out to be far more serious than the Mexican peso crisis in terms of the extent of the contagion and the severity of the resultant economic and social costs. Many firms with foreign currency bonds were forced into bankruptcy. The region experienced a deep, widespread recession.

Exchange rate determination

ECONOMIC THEORIES OF EXCHANGE RATE DETERMINATION

Exchange rates are determined by the demand and supply of one currency relative to the demand and supply of another. Price and exchange rates: Law of One Price Purchasing Power Parity (PPP) Money supply and price inflation Interest rates and exchange rates.

LAW OF ONE PRICE

In competitive markets free of transportation costs and trade barriers, identical products sold in different countries must sell for the same price when their price is expressed in terms of the same currency Example: US/French exchange rate: $1 = .78Eur A jacket selling for $50 in New York should retail for 39.24Eur in Paris

PURCHASING POWER PARITY

By

comparing the prices of identical products in different currencies, it should be possible to determine the PPP exchange rate if markets were efficient. relatively efficient markets (few impediment to trade and investment) then a basket of goods should be roughly equivalent in each country.

In

PPP

In the absence of government control, exchange rate between two currencies is determined by the price levels in the respective countries. While the value of the unit of one currency in terms of another currency is determined at any particular time by the market conditions of demand and supply, in the long run, that value is determined by the relative values of the two currencies as indicated by their relative purchasing power over goods and services(in their respective countries).

According to purchasing power parity theory, the exchange rate between one currency and another is in equilibrium when their domestic purchasing powers at the rate of exchange are equivalent.
Example: a particular bundle of goods in India costs Rs.48 and the same in USA costs $ 1. Then the exchange rate will be in equilibrium if the exchange rate is $ 1 = Rs.48.00. If the exchange ranges to $ 1 = 50 when the purchasing powers of these currencies remain stable, dollar holder will convert dollars into rupees because, by doing so, they can save Rs.2 when they purchase a commodity worth $ 1. This will increase the demand for the Indian currency and the supply of dollars will increase in the foreign exchange market and ultimately, the equilibrium rate of exchange will be re-established.

MONEY SUPPLY AND INFLATION

PPP theory predicts that changes in relative prices will result in a change in exchange rates.
A

country with high inflation should expect its currency to depreciate against the currency of a country with a lower inflation rate. occurs when the money supply increases faster than output increases.

Inflation

INTEREST RATES AND EXCHANGE RATES

Theory

says that interest rates reflect expectations about future exchange rates. Fisher Effect. International Fisher Effect.

Fisher Effect (FE) Theory An American economist, Irving Fisher introduced this theory. He bifurcated the nominal interest into two parts the real interest rate and the expected rate of inflation and the relationship between these two fundamentals is known as the Fisher effect. The nominal interest rate is the amalgam of real interest rate and the inflation rate.

Fisher effect can be expressed as follows: 1 + r = (1 + ) (1 + I) Where r = nominal interest rate = real interest rate I = expected rate of inflation. Example : Suppose, the required real interest rate is 5% and the expected rate of inflation is 8%, calculate the required nominal interest rate. 1 + r = (1 + 0.05) (1 + 0.08) r = 13.40%

Fisher Effect (FE) Theory The nominal interest rate r in a country is determined by the real interest rate R and the expected inflation rate i as follows: r=R+i

Fisher Effect: The proportion that the nominal interest rate varies directly with the expected inflation rate, known as the Fisher effect. International Fisher Effect: The relationship between the percentage change in the spot exchange rate over time and the differential between comparable interest rates in different national capital markets is known as the

INTERNATIONAL FISHER EFFECT (IFE) THEORY

The exchange rate movements are caused by interest rate differentials. If real interest

rates are the same across the country, any

difference in nominal interest rates could be attributed to differences in expected inflation.

The IFE theory suggests that the spot rate will change in accordance with the interest rate differentials. The PPP theory suggests that the spot rate will change in accordance with inflation rate differentials.

Interest Rate Parity Theory (IRP)

The interest rate parity theory states that equilibrium is achieved when the forward rate differential is approximately equal to the interest rate differential. The IFE states that the interest rate differential shall equal the inflation rate differential .

OTHER DETERMINANTS OF EXCHANGE RATES

In addition to inflation, real income and interest

rates, market fundamentals that influence the

exchange relationships, profitability, rates include bilateral trade

customer product

tastes,

investment productivity

availability,

changes and trade policies.