Professional Documents
Culture Documents
Background
Globalization
Meaning Firms are looking for strategic (created) assets worldwide taking the
advantages of mobility of factors of production like capital and organization. In
international production strategy, transportation is not a problem these days;
firms are more concerned about cost rather than location for raw materials or
natural resources.
New concepts of Global firms along with national firms, Global Economy or One
World Economy / Mega Trend Economy.
Problems of Firms
Agency Problems -- Information Gap, Information Arbitrage, Lemon Market,
Maximizing firms wealth or shareholders wealth?
Why IFM?
There is a misunderstanding among the managers in the domestic firms.
Sometimes, it is thought that managers of domestic firms do not need to know
IFM. International Financial Management is even important to companies that
have no intention of engaging in international business, since these companies
must recognize how their foreign competitors will be affected by the movements
in exchange rates, labor costs, and inflation. Such economic characteristics can
affect the foreign competitors cost of production and pricing policy.
Example: Indian goods in Bangladesh.
However, the following are the reasons to know about IFM:
To cope with NEP
To survive in competition
To take advantage of international financial intermediation
To reduce cost and to increase efficiency and quality
International diversification
To exploits strategic assets at anywhere in the world
Derivatives
Markets
Foreign Eurocurrency
Exchange Market
(ForEx) Market
IFMs Eurocredit
Market
Eurobonds
Market
International Stock
Exchanges
The domestic monetary system generally works well in the absence of inflation. Inflation
is a particularly a serious problem with respect tot eh second and third functions of the
domestic monetary system. Given a high rate of inflation in Bangladesh, Taka will not
maintain a stable purchasing power and will not function as an adequate standard of
deferred payments.
Terminologies
Washington Consensus
Contagion Effect
Herding Effect
Volatility
Money Making Concept
Hedging
Arbitrage
Speculation
Washington Consensus
A plausible alternative concept would be that the Washington Consensus
consists of the set of policies endorsed by the principal economic institutions
located in Washington: the U.S. Treasury, the Federal Reserve Board, the
International Monetary Fund, and the World Bank.
Govt. Agencies
Non-Bank Dealers
TNCs
Dealer Banks
Investors
Financial Institutions
Spot Exchange
Rate:
There are two methods of quotations of foreign currency.
The Direct Method of Quoting: Under this method foreign currencies are
quoted in domestic currency.
The Indirect Method: Under this system local currency is quoted in foreign
currencies, just a reciprocal rates.
Example:
Name of Foreign Currency Foreign Currency in Taka Taka in
Foreign currency
US$ 58.50 .0170
60.00 .0166
90.00 .0111
Example:
If the peso is worth $ .07 and Canadian dollar is worth $.70, what is the value of
peso in Canadian Dollar (C$)?
Thus, peso is worth C$.10. An alternative way of expressing the exchange rate is
as the number of peso equal to 1C$. The figure can be computed by taking the
reciprocal .70/.07= 10, that suggests that Canadian Dollar is worth about 10
pesos.
Forward Exchange Rate: Contract today to buy currency or sell for future
delivery.
F-S 12
Cost of Swap = Annualized Discount = 100
S n
Problem 1: A New York investor is willing to gain from FOREX Swap. He sees that the interest
rates in New York and London are 3.19% and 5.32% respectively. The Spot rate of $/ is $1.2000
and 3-months forward rate is $1.1999. Find the net advantage of swap, in any.
Solution No.1:
1.199-1.2000 12
Cost of Swap = Annualized Discount = ----------- 100 = - 2.0%
1.2000 3
Self -Test
1. A commercial bank quotes a bid rate of $0.784 for the Australian dollar and an ask rate of
$0.80. What is the bid / ask percentage spread?
2. A commercial bank quotes a spot rate of $0.190 for Peruvian currency (new sol) and a
90-day forward rate of $0.188. Determine the forward premium (or discount) of the new
sol on an annualized basis.
3. Assume that a banks bid price for Canadian dollars is $0.7938, while its ask price is
$0.81. What is the bid / ask percentage spread?
4. Compute the forward discount or premium for Mexican peso whose 90-day forward rate
is $0.102 and spot rate is $0.10. State whether your answer is a discount or premium.
5. If a dollar is worth 1.7 Singapore dollars, what is the US-dollar value of a Singapore
dollar?
6. Assume Polands currency (the zloty) is worth $0.17 and a Japanese yen is worth $0.008.
What is the cross rate of the zloty with respect to yen?
7. The Wolfpack Corporation is a US exporter that invoices its exports to the UK in British
pounds. If it expects that the pound will appreciate against the dollar in future, should it
hedge its exports with a forward contract? Explain.
Forward Quotation
The following is a chart showing a simplified spot forward quotation
Spot $1.7208/
30-day Forward $1.7090/
90-day Forward $1.6929/
For example, the 180-day forward Canadian rate would conventionally be quoted as
This means that the bid (buy) price on US$ is Can$1.3365 and the ask (sell) price on
US$ is Can$ 1.3370. The swap points 23-27 must be added and subtracted from the
spot bid and ask rates. The adding or subtracting depends on the ascending or
descending order of swap points. If the points are ascending, this must be added to
bid and ask rates respectively to get forward bid and ask prices. If these are
descending, the points are to be subtracted.
The difference between speculation and hedging is that in case of hedging, risks are minimized
by selling or buying currency forwards (contract), whereas in case of speculation no forward
selling or buying is done.
Arbitrage
The purchase of securities or commodities on one market for immediate resale on another in
order to profit from a price discrepancy.
Locational
Example:
Triangular
When three currencies rates are quoted in such a way that there might be differences in value of
currencies compared to one single currency, this is called Triangular arbitrage.
Example: Suppose that pound sterling is bid at $1.9809 in NY and Singapore Dollar (S$) is
offered at $0.6251 in Singapore. At the same time, London banks are offering pounds sterling at
S$ 3.1651.
Finish $ 1,001,242
Start
$1,000,000 1. Sell $1,000,000 in
S/Pore = $0.6251 for S$
1,599,744
Multiplied by
$1.9809/
Divided by $0.6251
3. Resell the in NY at
=$1.9809
Divided by
S$3.1650/
Covered Interest arbitrage involves swapping one currency into another. This involves
two steps: (1) Buying foreign currency spot and (2) selling foreign currency forward. By
these two steps the investor is swapped, and has no currency rate exposure. Without
hedging the position, the investor could take a substantial loss if the foreign currency
depreciates in value against the investors home currency.
Problem: The interest rate in Hong Kong Euro markets is 8% i.e. the euro dollar rate is
8% per annum. On the other hand, this is 5% for Euro Yen in Yen money market.
Morning, William Wong, an arbitrager for Hong Kong and Shanghai Banking
Corporation, Hong Kong arrives at works Tuesday morning to be faced with the currency
quotation. He has access to several major Eurocurrencies for arbitrage trading. He has
135,000,000. He sees the spot rate of against dollar is 135/$ while 180-days forward
rate is 134.5/$.
Parity Relationship
Normally, two types of Parity Relationships are discussed in the International Finance.
These are Interest Rate Parity (IRP) and Purchasing Power Parity (PPP).
Interest Rate Parity (IRP): Once market forces cause the interest rates and Exchange
rates such that CIA is no longer feasible, there is an equilibrium state referred to as
Interest Rate Parity (IRP). In equilibrium, the forward rate differs from the spot rate by a
sufficient amount to offset the interest rate differential between two currencies.
The amount of the home currency received at the end of the deposit period due to such
a strategy (called An) is
Since F = S(1+p) where p is the forward premium, we can rewrite the equation as
R = (An - Ah) / Ah
[Ah (1+ if) (1+p)] - Ah
= ----------------------------- = (1+ if) (1+p)] - 1
Ah
If interest rate parity exists, then the rate of return achieved from CIA (R) should be
equal to the rate available in the home country. Set the rate that can be achieved from
using CIA to the interest rate that can be achieved from an investment in the home
country (the return on a home investment is simply the home interest rate called ih) :
So, R = ih
By substituting the formula the way in which R is determined, we obtain:
(1+ ih )
p = --------- - 1
(1+ if)
Problem: Assume that the Mexican peso exhibits a six-month interest rate of 6
percent, while the US dollar exhibits a six-month interest rate of 5 percent. From
a US investors perspective, the dollar is the home currency. Applying IRP, what
should be the forward rate premium of the peso with respect to the US dollar?
Explain.
Solution:
(1+ ih ) (1+.05)
p = --------- = ----------- - 1
(1+ if) (1+.06)
Thus, the peso should exhibit a forward discount of about 0.94%. This implies
that the US investor would receive 0.94% less when selling pesos six month from
now than the price they pay for pesos today at the spot rate. Such a discount
would offset the interest rate advantage of the peso. If the pesos spot rate is
$0.10, a forward discount of 0.94% means that the six-month forward rate is as
follows:
Solution:
Step 1: Convert $1,000,000 into pesos(MXP) at $0.10 per peso
$1,000,000/$0.10 =MXP10,000,000
Step 2: Sell pesos six months forward. The number of pesos to be sold forward
is the anticipated accumulation of pesos over the six-month period, which is
estimated as
This means that after six months, the US investor withdraws the initial deposit of pesos
along with the accumulated interest, amounting to a total of 10,600,000 pesos. The
investor converts the pesos into dollars in accordance with the forward contract agreed
upon at a rate of $0.09906.
MXP10,600,000 = $ 1,050,036
Step 3: Explanation of the Result: The act of CIA achieves a return of about 5% here.
Rounding the forward discount at 0.94% causes the slight deviation from the 5% return.
The result suggests that, in this instance, using CIA generates a return that is
about what the US investors would have received anyway if they had simply invested
their funds domestically. This confirms that CIA is not worthwhile if interest rate parity
exists.
According to IRP,
FS
p = --------- = ih - if
S
Where
p= forward premium (or discount)
F = Forward rate in dollars
S = spot rate in dollars
ih = home interest rate
ih = foreign interest rate
c *y
Forward Discount (%)
1. qqqq